January accounting rule change will be painful for tech companies
Businesses always have plenty to worry about in Q4 without adding anything new to the agenda. It’s unfortunate timing then that this January marks the first time many companies will be reporting their revenues in the wake of one of the biggest changes to filing financial statements in years: ASC 606.
As your business seeks to finish the year strong, here’s why you need to keep ASC 606 at the top of your priority list.
What is ASC 606?
“ASC 606” is shorthand for Revenue from Contracts with Customers (Topic 606) of the FASB’s (Financial Accounting Standards Board) Accounting Standards Codification, the official source for U.S. Generally Accepted Accounting Principles (US GAAP). Compliance is mandatory for public and private companies that report financial statements under US GAAP.
ASC 606 completely overhauls the standards for revenue recognition, providing guidance in determining when and how much revenue to recognize from contracts with customers. ASC 606 outlines a principal-based, five-step model that businesses should follow to determine revenue recognition:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) performance obligations are satisfied.
ASC 606 applies to all contracts with customers except for transactions specifically addressed elsewhere in the ASC (such as lease contracts, insurance contracts, financial instruments and guarantees). Most companies in the software industry will be significantly impacted by the update, whether it changes the amount of revenue recognized and in turn, the valuation of the Company, or the increased burden associated with new disclosures to investors.
Why are the standards changing?
Previous US GAAP comprised various revenue recognition concepts together with numerous revenue requirements for particular industries or transactions, which sometimes resulted in different accounting for similar transactions. Most technology companies resorted to industry specific guides, which leveraged interpretations and guidance from various sources. With varying industries using different methodologies for recognizing arguably one of the most important measurements of a company’s financial success, US GAAP was in dire need of an overhaul.
Additionally, the old standards were a “rule-based” model, which often resulted in revenue that did not match the economics of a transaction. ASC 606 is a “principle-based” model, which requires significantly more judgment in its application, but the result is expected to be revenue that fits the economics of the transaction.
ASC 606 was first announced in May 2014 as a joint effort with International Accounting Standards Board (IASB) to develop common revenue standards that would remove inconsistencies in practice and improve comparability of revenue recognition practices across entities, industries and countries.
Public entities have had to follow the standards for annual reporting periods beginning after December 15, 2017. But now, more than four years later, all businesses reporting under US GAAP will have to report revenue under ASC 606 for fiscal years beginning after December 15, 2018.
From our experience, here are three big issues that upcoming technology adopters should be aware of.
1. Allocating transaction prices: Many technology companies sell packages of hardware, software and support, which was termed a “multiple-element arrangement” under legacy accounting rules. Companies ran into significant hurdles separating the software or license component from the post-contract support element, which led technology companies to defer revenue and recognize it periodically under a subscription-based model instead of upfront recognition upon the sale. ASC 606 is moving away from this model, which could significantly impact the valuation of your company. After the performance obligations are identified and the transaction price has been determined, guidance requires you to allocate the transaction price to the various performance obligations in proportion to their standalone selling prices. The new guidance under ASC 606 expects that the preparers of financial statements will be able to determine the standalone selling price through three different approaches: the adjusted market assessment approach, expected cost plus margin approach, and the residual approach. This model often leads technology companies to recognize more revenue upfront for significant deliverables along with significantly more effort in the implementation.
2. Recognizing revenue when or as performance obligations are satisfied: The determination of whether to recognize revenue over time or at a point in time can be complex in the technology space, and often contracts have distinct performance obligations within the contract that are recognized according to differing patterns. Software companies in particular, need to assess whether they are providing the right to use or the right to access their intellectual property. For most, this is determining whether you are selling a perpetual license or offering software under a software as a service model (SaaS), but it can require significant judgment depending on the circumstances. The impact of the guidance is not necessarily in the numbers but rather in the increased burden of disclosures you’ll need to make to your investors or creditors. Revenue disclosure requirements were quite minimal before ASC 606, which now requires revenue to be disaggregated to the point where the reader can understand the nature, amount, timing, and uncertainty of revenues and cash flow for each unique revenue stream. Private companies are fortunate in that they can elect to omit certain quantitative information, but the requirement to disaggregate revenue based on the timing of recognition will apply to all companies.
3. Changes to contract costs: Under prior GAAP, the costs of fulfilling a contract and costs associated with customer acquisition, such as sales commissions and setup costs, were normally expensed when they were incurred, unless other specific guidance concluded such costs met the definition of an asset, or an election was made. Under ASC 606, however, incremental costs of obtaining a contract must be recognized as an asset if the entity expects to recover those costs. These incremental costs include commissions, direct labor for employees who provide promised services, insurance, and depreciation of equipment used to fulfill the contract and written off when the related revenue is recognized. Determining how to recognize these incremental costs can become quite complex, depending on the expected duration of the customer relationship and whether contracts are frequently modified. Sales commissions can no longer be expensed at the point at which they are incurred, which for some companies poses drastic implementation issues.
ASC 606 will significantly impact not just to your accounting and finance department but also your systems, human resource policies, product road maps, and perhaps how you write your contracts with customers in the first place. If you do not currently have a plan for implementation, the time to act is now.
Will Tanem is a manager to the Technical Accounting practice at accounting and advisory firm BPM. He has experience in public accounting serving public and private companies in multiple industries, including financial services, technology, and consumer products.