Revenue Recognition: 4 Questions for Software Companies to Consider

For the past year, we have helped our software company clients implement the new revenue recognition standard and prepared them to comply with reporting requirements.  The new standard, ASC 606, is effective for annual reporting periods beginning after December 15, 2018, for non-public companies. Although the standard seems relatively simple on the surface, there are a lot of complexities once you dive into the details, especially for businesses in the technology industry.

As software companies adopt the new standard, they should consider the following four questions.

1. Is your accounting software sophisticated enough to record revenue in the way required by ASC 606?

Your accounting software may not be sophisticated enough to record transactions in a way that makes it easy to integrate with ASC 606 reporting requirements. For example, the accounting software may not have the capability to allocate the transaction price for a transaction encompassing multiple performance obligations as determined by your contracts. It’s possible it is unable to monitor performance obligations that are satisfied over time – such as hosting or software support.

Not properly recording revenue from the start could potentially turn into a record-keeping nightmare. You should have a candid conversation with your accounting department and decide whether any updates are needed to comply with new requirements.

2. Do your contracts with customers include a software license?

An important factor for revenue recognition is to determine if the agreement includes a software license or is a ‘software-as-a-service’ (SaaS) arrangement. Per the new standard, a software license is not present in an agreement unless the customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty. It must also be feasible for the customer to either run the software on the customer’s own hardware or contract another party, unrelated to the entity, to host the software.

It is important for software companies to make this determination, as the licensing guidance does not apply to SaaS arrangements. SaaS arrangements are accounted for as service obligations, which are subject to the general revenue model and the related revenue is typically recognized ratably over the term of the agreement.

If the agreement does include a software license, the full portion of the transaction price that is allocated to the license may be recognized once control of the software license has been transferred to the customer at the beginning of the license term. The remaining transaction price may be allocated to other performance obligations, such as implementation, hosting, and post-contract support services, and is typically recognized over time. Usually, a greater portion of the transaction price is allocated to the license, which may result in fluctuating earnings or “lumpy revenue,” depending on the timing of the sales and term of the agreements.

3. Do you fully understand the impact of the new recording standard and will you be able to clearly communicate its implications to third parties?

 You may have certain reporting requirements, perhaps to shareholders, lenders, or to a potential buyer. If the revenue from the transfer of a software license is recognized at a point in time and other performance obligations are recognized over time, it could translate to variations in your expected top line for the year in which ASC 606 was implemented. When compared to the prior year, you may see major changes to trailing revenue and other financial metrics.

You should understand and be prepared to communicate the impact on historical revenue and revenue trajectory when discussing financial metrics with stakeholders.  In addition, the new standard requires significantly more disclosures in GAAP basis financial statements.

4. Are you properly capitalizing and amortizing incremental costs such as sales commissions?

ASC 606 requires capitalization of “incremental costs of obtaining a contract with a customer” if the company expects to recover those costs.  Incremental costs are those incurred only if the contract is executed and typically includes sales commissions.

Sales commissions associated with obtaining contracts that meet the definition of incremental costs should be capitalized and amortized. This means you should consider commissions that can be directly linked to a sale, as well as aggregate performance-based commissions and bonuses. The amounts capitalized should include fringe benefit costs that are based on the amount of the commission.

The standard provides a practical expedient that allows these costs to be expensed right away if the amortization period is one year or shorter.

You must determine the amortization period considering a systematic basis that is consistent with the transfer of goods or services to which the asset relates. As you make your determination, be sure to consider renewal options and renewal commissions, contract termination provisions, the product life cycle, and the customer lifetime.

Software companies are among the businesses most heavily impacted by the new revenue recognition standard, and these are just some of the questions you should ask yourself as you work through your implementation. As a software company, the way your contracts are structured will determine your performance obligations, and how and when revenue should be recorded. Prepare for this new revenue recognition standard by assessing your contracts and accounting function to fully understand potential impacts to your processes, billings, and bottom line.

Contact me or another member of our assurance team for assistance with your business’ adoption of the new standard.