The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) worked together to develop a common framework for revenue recognition: ASC 606 (Accounting Standards Codification) and IFRS 15 (International Financial Reporting Standard). These new accounting guidelines seek to simplify and standardize how companies recognize revenue.
Normally, accounting changes attract the attention of investors, accountants, and financial folks — not CIOs. However, enterprise IT leaders need at least a basic familiarity with the impact of the ASC 606 core principle, since it has implications for software sales, sales compensation, and, of course financial systems.
The guidance goes into effect soon: Public organizations should apply it starting with annual periods beginning December 15, 2017 and nonpublic organizations should apply it beginning a year later on December 15, 2018.
Per the FASB site, the core principle of the new standard is to “Recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”
Software vendors will need to appropriately report revenue and expenses that correspond with the period of contracts. Generally, revenue from a one-time sale of software installed at a customer site would be recognized immediately. Similarly, revenue from a contract for access to software over a period would be recognized evenly over the period, regardless of how payments might be structured.
For salespeople, the new guidance won’t affect compensation plans. (Yes, I mentioned that first, since I know that’s what many software salespeople care about.) But commissions will be accounted for differently. Unlike today, when most commissions are immediately expensed, commissions will be amortized over the period of the contract. In some software companies, this may have the effect of not only reducing commission related expenses recognized in the short term, but also smoothing these expenses over time.
IT vendors that sign contracts to provide a mix of services and software may need a more detailed review of specific performance obligations to determine when to recognize revenue. The FASB site details the following 5-step process:
1. Identify the contract with a customer.
2. Identify the performance obligations (promises) in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the reporting organization satisfies a performance obligation.
These last two items — clarifying the performance obligation and determining the transaction price — may be particularly challenging for some IT providers. Any sort of contract that includes delayed or deferred delivery of services or software may need review.
Get help with the process. Make sure your CFO and CIO talk through the issues. Involve the CMO and head of sales, too, since your organization’s software may need updates to track information related to contracts, performance, and commissions. Consult a CPA for guidance. The big four accounting firms — Deloitte, PricewaterhouseCoopers, Ernst & Young, and KPMG — all provide general information about ASC 606 (see linked items) and have experts that can assist, as well.
If you’re a software vendor, what changes did your organization make to apply ASC 606 and IFRS 15? If you head up IT in an enterprise, are these changes already implemented in your sales and financial systems? If not, what sort of timeline are you on? Let me know in the comments below or on Twitter (@awolber).