Revenue Recognition for Technology & Software Companies

The model for revenue recognition is changing with the Financial Accounting Standards Board’s May 28, 2014, release of Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606). The ASU eliminates most of the existing industry-specific guidance and significantly expands revenue recognition disclosures. More than 600 pieces of current revenue recognition guidance are replaced with an overriding principle and a five-step model. The standard requires entities to make more estimates and use more judgment than under current guidance. There will be changes to how technology and software companies recognize revenue under the new standard, as described below.

Five-Step Model 
Along with the core principle of “an entity must recognize revenue when it transfers promised goods and services to the customer and the amount recognized should be the consideration to which the entity expects to be entitled,” businesses will use the five-step model to determine the correct revenue recognition.

1. Identify the contract
   • To recognize revenue from a contract, the contract must:
     • Be approved by the parties to the contract
     • Have parties that are each committed to performing obligations under the contract
     • Have identifiable rights for each party
     • Have payment terms that can be identified
     • Have commercial substance
     • Have a transaction price likely to be substantially collected
2. Identify separate performance obligations
   • Types of performance obligations specific to technology and software entities
     • Software as a service (SaaS)
     • On-premises software
     • Hardware or networking equipment
     • Post-contract support (PCS)
     • Professional services
   • Does the contract contain a promise of a license?
     • Promise of a license allows the customer to take possession of the software and the customer can run the software on its own or easily contract with another entity
     • If so, licensing guidance in Topic 606 is applicable, which generally accelerates revenue recognition compared to existing guidance
     • If not, an entity would recognize revenue over time consistent with existing guidance
3. Determine the transaction price
   • The consideration paid under the contract must be substantially collectible; otherwise, delay revenue recognition until it’s deemed substantially collectible
   • Variable consideration such as price concessions, options for additional goods or services and volume discounts could change the total transaction price
4. Allocate the transaction price to the separate performance obligations
   • Allocate based on the standalone selling price of each performance obligation. For example:
     • Renewal rates for PCS
     • Labor hour rates for services
     • Term licenses will need to have allocations between the software license and PCS
   • The residual approach can be used if goods/services are sold at highly variable amounts or there’s no historical standalone selling price
   • Vendor-specific objective evidence is no longer required
5. Recognize revenue when the entity satisfies a performance obligation
   • Functional IP – point in time
   • Symbolic IP – over time
   • Other obligations – as goods and services are transferred to the customer

Want a more in-depth look at revenue recognition for technology and software companies? Join us for a complimentary webinar on July 25. Contact Mike or your trusted BKD advisor if you have further questions.