Effective December 16, 2018, all private companies that report under U.S. GAAP are subject to the new revenue recognition guidance under Accounting Standards Codification (ASC) 606. The new standard requires companies to follow a 5-step approach that involves identifying the contract with a customer, identifying the performance obligations in the contract, determining the transaction price, allocating the transaction price to the identified performance obligations, and recognizing revenue when (or as) the company satisfies a performance obligation. What does this mean for your software startup?
Oftentimes, software contracts include post-contract customer support such as technical support, maintenance, and software updates. In fact, some post-contract customer support, even though not clearly defined in the contract (such as when-and-if available software upgrades), might be implied by the entity’s customary business practice. Under ASC 606, entities need to evaluate whether these services are distinct performance obligations from the license itself. If so, they will need to determine how to measure progress towards complete satisfaction of such obligations. For instance, for stand-ready services that may or may not be utilized during a specified time period, performance obligations may be satisfied with the passage of time regardless of the number or significance of updates or customer support provided during the period.
Entities will also need to consider whether software intellectual property (IP) is distinct in cloud computing arrangements. The first step is to determine whether a software license exists within the scope of ASC 606. If the customer cannot take possession of the software at any time during a hosting arrangement without significant penalty, or cannot feasibly run the software on its own hardware or a third-party hardware, then a software IP license does not exist and is therefore is not a separate performance obligation in the contract. In such cases, the software IP is only considered utilized by the entity in providing other services to the customer. This is also the case in software-as-a-service (SaaS) arrangements. Under SaaS arrangements, IP is run on the entity’s system via the “cloud” and accessed remotely by the customer. As the customer does not have the rights to obtain the software and run it on its own systems, a SaaS arrangement does not include a promise of a license.
As a sales incentive, start-ups often offer price concessions to its customers. Price concessions may take many forms, including, but not limited to, price discounts, rebates, refunds, credits, or extensions of scheduled payment obligations. Even if it’s not explicit in a contract, oftentimes customers have a valid expectation of a price concession arising from an entity’s customary business practices. Regardless of whether price concessions are explicit or implied, entities will need to estimate such concessions at the start of the contractual arrangement to determine the actual transaction price. To do so, they will need to consider all reasonably available information – historical, current, and forecasted – to identify a reasonable number of possible consideration amounts and then determine the most likely or expected amount of consideration they will receive.
The new revenue recognition standard has a large impact on how revenue is recognized and reported in GAAP-basis financial statements. This is especially true for software companies. By assessing your revenue streams under the 5-step process, considering all the nuances specific to your company, and drafting a revenue recognition policy, your start-up will be well prepared to comply with GAAP for your financial reporting needs.
By Katie Fisher, CPA