UK: Accounting In The Technology Industry - Re-Computing Revenue

The new Exposure Draft on revenue recognition, released on 24 June 2010, is another significant draft standard developed jointly by the two main standardsetters, the IASB and FASB, as part of their path towards convergence. What makes this standard even more significant is that it is in one of the areas that the two GAAPs differ most in their approach: IFRS as it stands has little guidance on revenue recognition compared to US GAAP which has a series of detailed rules dealing with many situations of application.

CFOs of technology companies are all aware that an accounting conclusion on revenue recognition can have a material impact on the financial results of any particular financial year and hence alter both an investor's valuation of the business and KPIs used for management incentive arrangements. Responses from technology companies to the preceding Discussion Paper issued in 2009 were generally positive and most welcomed the single revenue recognition model and convergence between frameworks, though some responses highlighted areas of complexity for further review by the two accounting boards. Some of these thoughts from leading technology companies have been included within this document to show that the impacts of a new revenue recognition standard could be far-reaching and warrant timely consideration by all companies in the sector. The resulting Exposure Draft develops the key principles proposed by the standardsetters into a comprehensive framework that can be applied to a range of industries.

Exposure Draft overview

The new Exposure Draft proposes to replace both IAS 11 Construction Contracts and IAS 18 Revenue in IFRS, and most of the numerous and extensive US GAAP revenue guidance, including most notably EITF 08-01 (which replaced EITF 00-21), SOP 81-1 and SOP 97-2 under the pre-codification references (currently codified in ASC 605). Certain areas of revenue recognition such as leasing are out of scope of this Exposure Draft.

The Exposure Draft includes specific guidance on a number of key areas. This includes:

  • the combining of two or more contracts into a single contract if the pricing is interdependent;
  • the splitting of a single contract into multiple contracts if elements within the contract are priced independently;
  • accounting for a good or service as a separate performance obligation if it is distinct, meaning that the good or service is either sold separately in the customer's market or could be sold separately because it would be useful in itself or in conjunction with another product that is available separately;
  • determining the transaction price through considering the time value of money, variable consideration and the credit risk of the customer; and
  • allocation of transaction price to the separate performance obligations in proportion to the standalone selling price of each element (including, where this is not available, developing an estimate of the stand-alone selling price based on a reasonable approach).

"We agree that it would be desirable to have a single revenue recognition model that is applied to all revenue generating transactions. However, we believe that a single revenue recognition model should only replace the current mixed model if it is superior to the current mixed model ... [W]e do not believe that the model proposed in the [Discussion Paper] meets this superiority requirement."

Group of major software companies – response to the preceding Discussion Paper

The Exposure Draft proposes a five stage approach to revenue recognition transactions, which can be summarised as follows:

Within step 5 there is a focus on the concept of control that has been further developed for the Exposure Draft. A performance obligation is deemed to be satisfied when control of the good or service is obtained by the customer, which may in some cases be different from the equivalent existing IAS 18 revenue recognition requirement that the significant risks and rewards of ownership have been transferred. Control can pass either at a point in time (akin to goods under IAS 18) or continuously (akin to services under IAS 18). However the new concept will potentially require increased application of judgement to determine when control has been obtained, and some transactions currently accounted for as services may be accounted for differently under the Exposure Draft. The Exposure Draft gives some guidance on indicators that may suggest when control has passed, but there are some possible scenarios that may require further clarification.

"We do not believe that a Standard should be drafted so as to focus directly on the 'transfer of control'. The concept is too ambiguous and too far removed from the practicalities of accounting for revenue recognition, and we believe that it would lead to very significant lack of comparability between entities as a result of different interpretation and application.

Deloitte response to the preceding

Discussion Paper, June 19 2009 The Exposure Draft should be assessed by technology companies now, ahead of the final standard, in order to determine the potential impact of these changes on their own businesses.

Some of the key areas are as follows:

  • Percentage of completion
  • Bundled arrangements
  • Intellectual Property
  • Variable consideration
  • Contract modifications
  • Disclosures

Each of these is discussed below, highlighting some of the more significant changes brought about by the Exposure Draft.

Percentage of completion

The new Exposure Draft focuses on the concept of "control" in determining when revenue should be recognised. For software providers who develop customised software for their customers, the structuring of contracts with customers will make it clear if title passes at any stage of the development. In a significant number of situations, the software developer retains legal title to the IP and instead licences the software to the customer or in a number of other instances, legal title to the product only passes at the end of the development phase. The Exposure Draft gives several other factors for consideration in assessing when control has passed, such as a customer-specific design or function, the ability to specify changes to functionality during the construction process and the customer's requirement to pay for work completed to date, however this is an area where judgement will be required on a case-by-case basis.

Example

Seller X enters into a contract to develop a software module for Customer A. Customer A has determined the functionality that the software needs and retains the right to modify the functionality during the contract but Seller X retains title to the final product. In the event of a contract termination, Customer A would recompense Seller X for the costs incurred todate. Seller X agrees to install the software for Customer A however because it is a module of a standard software system, the installation could be performed by a third party.

In this situation, although legal title remains with Seller X, this right may be judged to be a protective right as outlined under the Exposure Draft. While it is clear that Customer A would gain control at the end of the contract, Seller X needs to consider whether Customer A has control of the development work throughout the development phase.

In this case, the customer has neither possession of nor physical title to the software as it is being developed. However, the customer-specific functionality of the software, the customer's ability to significantly alter the functionality during the development process and the contractual obligation of Customer A to recompense Seller X for work completed to date, appear to be indicators that would support Customer A having control of the software as it is developed. Accordingly, there are mixed indicators and the ED requires judgement over whether the customer has control – i.e. the present right to use the asset for its remaining life and to obtain substantially all the potential cash flows from it.

Example

In a different contract to the above, Seller X has a separate performance obligation, which is the supply and installation of a piece of standard software on existing hardware already owned by Customer A. This arrangement requires Seller X to use its knowledge of the developed software in order to install it successfully and so installation could not be performed by another party. Customer A retains the right to terminate the installation at any point in time and recompense Seller X for the costs incurred to-date.

In this example, Seller X again looks to see when the customer has control. Benefit from the software is clearly with the customer by the time the installation is complete, however it would appear probable that in this example the Seller would find it harder to demonstrate that Customer A has control during the installation process. Instead it could be possible to conclude that that Seller X retains control until the installation process is complete, mainly as a result of the proprietary knowledge relating to the installation process, which effectively prevents another supplier coming in mid-way and completing the installation work where Supplier X left off, should Customer A request it. Therefore the cancellation right may appear to lack substance and appear more to be a protective right granted to Customer A.

It would therefore appear possible that in this situation Seller X would conclude under the new Exposure Draft that no revenue should be recognised until the installation is complete.

"In addition to long-term construction contracts, we have identified the following situations where there is satisfaction of performance obligations without clear transfer of control ... :

a) Right to use or licensing arrangements ... c) Software-as-a-service (SaaS)"

Global hardware manufacturer and systems provider – response to the preceding Discussion Paper

Allocation of transaction pricing

The new Exposure Draft provides significantly more guidance than the current IFRSs as it considers several key areas such as bundled arrangements and related contracts. In assessing the revenue recognition of bundled arrangements, the IASB has proposed a rule that prescribes how companies should allocate the total contract price between the various elements of a bundled arrangement. It appears that this allocation will be required by the Exposure Draft even where it may appear that it does not reflect the economic substance of how the elements within the arrangement have been priced.

Good news for US software companies

For technology companies that report transactions under US GAAP, other than those that fall within the scope of SOP 97-2 (ASC 605-985), EITF 08-01 has eased the requirement to demonstrate fair value for all elements of arrangements that would have previously been accounted for under EITF 00-21. However software companies are currently still required to demonstrate fair value through Vendor Specific Objective Evidence ("VSOE") for transactions that remain under SOP 97-2.

The new Exposure Draft will therefore be a welcome change when implemented by FASB as it is proposed that it will replace all existing revenue recognition guidance, including SOP 97-2.

"[Company name] is concerned that the proposed model could result in an onerous exercise to identify and account for numerous performance obligations. As indicated in the [Discussion Paper], even a simple contract can comprise many performance obligations."

Global software company – response to the preceding

Discussion Paper

Example

Seller Y enters into a contact with Customer B for a software licence and for 12 months of maintenance services. The stand-alone price of the software licence is £100,000, though significant discounts are sometimes granted, and the stand-alone price of the maintenance services is £120,000 per annum. The contractual prices agreed by Seller Y with Customer B are £20,000 for the software licence and £90,000 per annum for the maintenance, giving a total transaction price of £110,000.

Assuming that the Seller can demonstrate the licence and the maintenance services are separate performance obligations as defined under the Exposure Draft, Seller Y must then consider how to allocate the transaction price to the separate obligations.

Under the Exposure Draft, the transaction price for the contract should be allocated to the separate performance obligations in proportion to the stand-alone selling price at contract inception.

Transaction price = £110,000

Total of stand-alone prices = £220,000

Allocation factor = 0.5

Consideration allocated to licence: £100,000*0.5 = £50,000

Consideration allocated to maintenance: £120,000*0.5 = £60,000

The answer that is proposed under the Exposure Draft might be regarded as favourable for Seller Y's revenue recognition profile compared with how many companies would currently account for this transaction, with £30,000 of maintenance consideration being brought forward and recognised as part of the licence fee. But in some cases this allocation may not reflect the substance of the arrangement, which is often that a high-margin licence fee is more heavily discounted than low-margin maintenance services. In some cases, this allocation of revenue to maintenance services may even result in them being provided at a loss, with the result that an onerous contract provision would be required at contract inception.

Intellectual Property

Nearly all technology companies have some Intellectual Property ("IP") and the Application Guidance in Appendix B of the new Exposure Draft goes some way in outlining how revenue should be recognised from the licensing of this IP to third parties.

The Exposure Draft considers the three main types of IP contracts, which are summarised in the table below along with their respective revenue recognition conclusions.

The final scenario could arise when sellers and customers enter into an arrangement for the entire duration of an IP contract but structure the contract so that a portion of the contract life is in the form of a customer renewal option at the end of an initial contract period. While the seller and customer may for all intents and purposes intend to enact the renewal, the form of the contract may lead to the conclusion that revenue is recognised over the duration of the contract, as opposed to recognising revenue up-front.

In a recent webcast held by the IASB and FASB to discuss the impact of the Exposure Draft on technology companies, one of the questions from attendees was how the Boards had arrived at the conclusion to recognise revenue over the duration of the contract for exclusive licence arrangements that are not considered to be out-right sales (the third option in the table above).

The response was that the Boards applied a similar logic to this transaction as had been applied in the Leases Exposure Draft: namely that there was a right to use the asset over time and no outright sale hence revenue should be recognised over the duration of the contract.

Variable consideration

One area the Exposure Draft addresses in a new way compared to the approaches allowed previously under IFRS and US GAAP is that of variable consideration. If sellers cannot yet predict reliably the probabilities associated with different outcomes for variable consideration, the revenue recognised is based only on any fixed element of consideration. However, sellers who are able to predict contract outcomes reliably are required to allocate probabilities to the various outcomes and to determine a weighted average consideration at contract inception. This assessment is then regularly updated, which will lead to adjustments throughout the contract life as the outcomes and associated probabilities are reconsidered at each reporting period.

US GAAP guidance on contingent fees is generally obtained from the SEC Staff Accounting Bulletin Topic 13.A.14."Contingent Rental Income." The staff guidance is that contingent revenue which does not exist at the start of the arrangement becomes "accruable" when the change in factors on which the contingent payments are based actually occur, regardless of historical trends that may support the recognition of additional amounts at the start of the arrangement. The new Exposure Draft would therefore allow companies having transactions with variable consideration and reliable outcomes to recognise a proportion of these amounts up-front, which would represent a marked change from current guidance.

Contract modifications

For technology companies that enter into long-term contracts, contract modifications are a normal part of business activity. The new Exposure Draft outlines a method of accounting for these but the accounting that results can be very significantly different depending on relatively small changes in the revised pricing that is adopted.

As the below example shows, a contract modification can result in a one-off change in revenue recognised at the point of the amendment. Whilst our example considers only the simple case of going from a market value transaction price to a non-market value transaction price, this may get more complex when the arrangement has multiple elements.

Disclosures

The new Exposure Draft proposes a raft of new disclosures to help the users of financial statements. However, some have expressed concern that the additional compliance burden placed upon preparers may be onerous.

The Exposure Draft proposes extensive disclosures in the following key areas:

  • analysis of revenue disaggregated to an appropriate level;
  • reconciliation of opening and closing contract assets and liabilities showing revenue recognised, changes in transaction pricing, consideration received (both cash and non-cash), and contracts acquired as part of a business combination;
  • detail of future performance obligations, including the typical periods and manner of settlement;
  • aggregated analysis of amounts receivable in future years from long-term contracts; and
  • analysis of onerous performance obligations along with supporting explanations.

Final thoughts

The Exposure Draft proposed by the IASB will greatly increase the amount of detailed revenue guidance included within IFRS as it addresses a number of areas where previously there was little guidance. Whether US regulators and US listed companies will welcome the extent to which companies will be required to exercise judgement remains to be seen.

What is certain is that this Exposure Draft helps with convergence of US GAAP and IFRS in one of the most diverse, and sometimes most complex, areas of accounting.

As highlighted above there are certain aspects of the Exposure Draft that could have serious implications for technology companies. We hope that the IASB refines and improves the final standard in these areas but recommend that technology companies act now in considering the implications of accounting for revenue under the new regime.

Those who wish to communicate their thoughts directly to the IASB should visit their website at www.iasb.org – the closing date for comments is 22 October 2010.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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