By | Dawn Castell
In 2014, the Financial Accounting Standards Board (FASB) issued new guidance for recognizing revenue, ASC 606, to help align the method of revenue calculation across industries, as well as internationally. This change primarily impacts professional service firms regarding when and how much revenue gets allocated to each accounting period for transactions related to contracts with customers. There are several changes in the new rules that impact the way software companies allocate revenue for annual subscriptions and maintenance agreements, which may require the unbundling of products for accounting purposes. There is much documentation available to review in preparation for the transition to this new accounting method, but here are four changes that apply specifically to companies that sell software products and services.
1. Post-Contract Services (PCS)
Historically, software licenses, phone or online support and delivery of upgrades have been sold together as a bundle. However, under the new guidance for revenue recognition, companies will have to change the way they account for this internally. According to ASC 606, revenue is recognized based on the fulfillment of performance obligations. So, companies will have to consider each of the various components of a software agreement separately to determine the correct timing of the revenue stream. The software license revenue will now be recognized when the customer receives access to the product and the support plan revenue amortized over the term of the contract.
2. Professional services
In addition to product licenses and ongoing support, software companies often sell consulting services to help clients with the installation. They may also provide user training classes or assist with the implementation process. Some companies offer software customization. These professional services may be performed on an hourly basis, in which case the revenue is recognized when the work is completed and invoiced. Or, if the contract for services is on a fixed-fee basis, revenue is recognized as a percentage of completion. The new guidance considers these professional services as separate performance obligations only if they can stand alone. So, in the case of software customization that can’t stand as a unique product without the software, it has to be recognized as part of the sale.
Revenue for periodic software upgrades, typically included in the annual support contract, may now have to be separated from that bundle, depending on the terms of the upgrade agreement. Under ASC 606, software upgrades may have to become separate performance obligations, depending on the terms of the contract. The old guidance said that if you sell a license today and promise an upgrade later, the revenue for that upgrade can be part of the sale of the license. The new guidance says that the upgrade should be treated as a separate obligation, which means not recognizing that revenue until the updated software gets delivered to customers.
4. Term Licenses
Recognizing revenue for an annual contract is usually straightforward. The fee is divided by twelve to determine how much income to record for each month. However, sometimes customers cancel their subscription partway through the year. They may upgrade to a more comprehensive support contract, or downgrade to a more basic plan. Or, they might even switch from a monthly subscription to an annual one in the middle of the year. All of these things will affect the timing of when revenue is recognized and recorded. The changes above may cause recorded income to be either over- or under-reported, in which case, a revenue adjustment will be necessary.
The main principle in this new FASB code states that companies must “recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration [that is, payment] to which the entity expects to be entitled in exchange for those goods or services.” In the case of software companies, it will require unbundling products to separate the portion that is from “contracts with customers” from other types of revenue, such as professional services and post-contract services. The transition process is a time-consuming one that necessitates a thorough review of all contracts to determine the appropriate timing of their revenue streams. Once established, a company may choose to restate revenue from prior years or leave closed accounting periods in line with the legacy guidance for generally accepted accounting principles. The transition will definitely take some time and effort. Public companies have already made the transition, as have some private ones. But due to delays caused by COVID-19, FASB recently extended the deadline for those private companies that haven’t yet completed their conversion.