New Rules on Revenue Arrangements with Multiple Deliverables
Companies with multiple element arrangements are no strangers to the rigid exercise and stringent accounting literature requirements of establishing verifiable and objective fair value in order to recognize revenue for elements delivered up front.
The recent release of two Accounting Standards (ASU 2009-13 and ASU 2009-14), formerly known as Emerging Issues Task Force (EITF) 08-1 and 09-3, have undoubtedly brought some good news to most companies previously applying EITF 00-21 and/or Statements of Position (SOP) 97-2. From device manufacturers with embedded software to software-as-a-service providers, companies are gearing up the efforts to understand the impact of the new guidance and planning for policy, process and system updates to adapt to the changes. Companies that sell software licenses for customer possession, however, are not affected by the new standards and still need to comply with the software revenue recognition guidance formerly known as SOP 97-2.
*Revenue allocation refers to the allocation of the total contract amount into each of the elements that can be separately recognized when all the revenue recognition criteria are met.
With the relaxed rule of establishing the fair value allocation basis, all companies should be able to develop at least an estimated selling price (ESP) for each separate element in the arrangement. Therefore, this change will likely result in more elements being separated and earlier revenue recognition for delivered items in multiple element arrangements.
With more types of elements pulled out of scope from the stringent SOP 97-2 requirements, combined with relaxed rules for establishing fair values in multiple element arrangements, these changes will likely result in earlier revenue recognition for devices sold with software.
Timing and Disclosure
ASU 2009-13 and 14 must be adopted on a prospective basis no later than the first fiscal year beginning on or after June 15, 2010. Companies are also allowed to early adopt but must provide comparative financial statements for the affected prior periods.
Although the overall requirements of revenue recognition have been modified to better reflect the underlying economics of a transaction, the new rules significantly expand the disclosures related to vendor multiple element arrangements.
- Ongoing: Need to provide both qualitative and quantitative information regarding the significant judgments made in applying the new guidance and their effect on revenue.
- Transition disclosure requires comparative revenue data.
- Early adoption during interim period requires disclosures of revenue recast on all prior interim periods presented.
Some Practical Considerations
- Although ESP is now allowed to be the third alternative of revenue allocation basis, the new guidance establishes a hierarchy among the three. This means companies that previously were able to establish VSOE/TPE would need to continue to use those alternatives and cannot switch to ESP without adequate justification.
- Prospective adoption will only impact new arrangements or materially modified arrangements entered after the adoption date. Early adoption requires retrospective application to the beginning of the early adopt year. This means existing arrangements will continue to use old authoritative requirements.
- Heavy use of spreadsheets for VSOE analysis and manual allocation for pre-adoption date arrangements will probably still remain.
- The new ESP evidence brings more flexibility and, as a result, more judgment into the picture. The new disclosure rules require companies to provide more documentation of the methodology and critical factors to support the key estimates and assumptions made.
The Impact on Business – Six Elements of Infrastructure
At Protiviti, we have established a proven methodology that highlights the six elements of infrastructure that every business is built upon. We apply this methodology to help our clients address new issues, and adapt to new challenges. We believe the new revenue recognition rules will likely impact all of the infrastructure elements, and a thorough consideration of each element helps a company identify appropriate actions. Below are some examples of consideration points.
Methodology – Companies shall revisit and modify their current revenue recognition methodology. Key changes to consider are:
- The timing of adoption and determination of assumptions and assertions
- A new approach for estimating selling price for each element
- An ongoing review and monitoring of the methodology
Policy – Companies need to update the existing revenue recognition policy. In addition, a review of existing pricing/discount policies may also be appropriate, as the newly allowed ESP allocation method provides more flexibility in compliance with accounting rules, while giving management better control in pricing to respond to market demand.
System – Companies can take this opportunity to review current system capabilities and data availability in reporting key revenue and sales information. Additionally, companies will need to assess system functionalities in automating element allocation and revenue calculation. This will also result in a review of system controls around integrity of key revenue data.
Process – As part of the adoption of the guidance, companies will need to assess and update existing controls around revenuerelated estimates. Should companies attempt to automate the process, this will require revision of business processes such as order entry, invoicing and revenue recognition to facilitate these changes and the extensive disclosure requirements for the new guidance.
People – The new procedures and internal controls could initially bring additional workload for the revenue accounting team. Management should ensure there is the appropriate level of competency in the finance and accounting teams for proper application of the guidance. Various departments, such as order administration, legal and sales operations, should also be educated on the changes and the implications to the internal control environment. New procedures and controls should be properly communicated to the accounting team for revenue recognition purposes, the sales team for contract negotiation and the legal team for contract review requirements.
Report – A change in guidance gives companies an opportunity to evaluate accessibility of key data to be used and reassess existing reporting capabilities. This will also determine future reporting requirements based on disclosure requirements of the new guidance.
The new multiple element revenue recognition guidance has the advantages of better aligning the accounting treatment with the nature of the economic transactions, more transparency in disclosures, better allocation of revenue among elements, and moving closer to the International Financial Reporting Standards (IFRS).
As we enter into a new decade in 2010, the adoption deadlines are quickly approaching. Start writing down action items with your finance and IT teams, marking your calendar to meet with external auditor and outside consultants, because change is on its way!