Revenue from contracts with customers: Practical implications for technology companies 

Phillip Rogers: So we’re here with Simon to talk about the new exposure draft revenue with contracts from customers. Simon you and I have been looking at this exposure draft for some time now, back from its first iterations in 2010, we now have the new exposure draft in 2011, and a lot has changed since then, what do you think are the key practical considerations that our technology clients will be thinking about?

Simon Baxter: Well I think it depends a bit where you start from, I certainly think that software companies are going to have a harder time with the standard than hardware services or cloud companies, and there are more changes for them. And also you know you’ve got the difference between US GAAP companies that have been following strict rules and the IFRS guys who will be starting on different points depending on accounting policy choices, but what’s true is all of them have got something to look for in this standard and all of them will need to think carefully about how they are going to take their accounting forward.

Phillip Rogers: Okay, so if we look through some of the steps within the proposed model, theirs five steps. The first one is identifying the contract with the customer, When I guess my thoughts on this is that the guidance in terms of combining contracts is probably similar for US reporters certainly. I’m not quite sure if there is a difference but it’s the level of evidence of arrangement that’s the area that I think there are some differences.

Simon Baxter: Yeah, I picked up on a subtle difference, the contract the ED talks about legal enforcement contracts being the benchmark for revenue recognition and I think for US GAAP reporters they may find that’s a slightly lower threshold than their used to when they have been applying evidence for arrangement which sometimes can be in advance of the legal enforceable arrangement, so perhaps in the past they would have made sure they had a PON contract when in actual fact the y have a legally enforceable arrangement just for the PO. 

Phillip Rogers: Yeah and that’s because they are customary practices ways to get a contract, so just having the purchase order wouldn’t be enough in those cases. What about the second step? I guess when we talk about identifying individual performance obligations in the contracts again I think there are some guidance there which is not dissimilar in what the elements of a contract are within US GAAP and thinking about what the performance obligations, so I’m not sure I see a particular difference on a bundling of those elements together, but I see one of the biggest changes in relation to unspecified upgrade rights and how those are going to be accounted for under the new ED.

Simon Baxter: Yeah I mean that’s certainly a change I mean US GAAP reporters have been used to the fact that if they’ve got unspecified upgrade rights that means they apply subscription accounting and recognise the license revenue rateably over the term of engagement.

Phillip Rogers:  That’s a specific change, however I think that companies were more genuinely need to look more closely at what they have got in there contracts and some IFRS reporters wont have been so used to scanning their contracts picking out each of the individual obligations and realising that each of those obligations may have a different revenue profile, so there could be some more care and diligence over how the contracts are written and how they are read by accounting teams. The one thing we of course  haven’t mentioned is that for US GAAP reporters this whole identification of elements is a stressful thing currently because they’re worried that an element they find they may not have evidence of fair value under the strict rules. Under the new ED that worry goes away.

Simon Baxter: Yep

Phillip Rogers: Because as we will talk about later you will always be able to get fair value, so those companies will be free in terms of finding these elements and accounting for them.

Simon Baxter: And thinking about the different performance obligations you can identify in those contracts, one of the areas is options and additional elements within their contract, so an option to extend the life of a license or options for additional services and goods.

Phillip Rogers: That’s an area where US GAAP very prescriptive guidance particularly for software companies and the new ED also includes some reasonably complex guidance and there’s a subtle change there and I think this will force technology companies to look closely at their pricing policies in that the new ED takes as much more of a market approach to assessing whether a discount is significant or not rather than a customer specific approach. And therefore you’ll see the need to re word and re phrase in some discount clauses for companies going forward.

Simon Baxter: Yeah, there’s a lot of guidance under US GAAP bonds whether an option is significant and incremental and the new guidance is different talking about material rights for similar items.

Phillip Rogers: So there’s a judgment there but there’s also some complexity. So lets turn to the third step in the model, determining the transaction price, so I suppose again here a lot of the rules are similar but there’s one big change, which is collectability, I mean that’s not there in the exposure draft and of course were very familiar of that particularly under US GAAP, where you have to make sure the collectability is reasonably assured before you take your revenue.

Simon Baxter: Yeah this is a change for companies and the ED is reasonably drafted, side steps collectability, you just work out whether the revenue can be recognised and then you consider collectability separately, account for that and then recognise the associated expense on a separate line item in the income state, adjacent to revenue, here’s how good revenue and here’s what we think we won’t collect, that’s the proposal.

 Phillip Rogers: I know there’s some recent debate about whether they will carry that thought to the final standard, So we will just have to watch to see what happens on that. The one thing they have actually firmed up on is the consideration for time value for money, whether you discount revenue, they.ve now settled on the idea that you will only need to do that if there is a significant period between performance and collecting cash and they’ve identified that period as being one year, which is fairly consistent with current US GAAP and I think in broad terms will probably mean most IFRS reporters also won’t end up discounting there revenue, so a lot of companies will find that quite a useful practice guidance on when they have to apply that time value for money. And the fourth step is once you have identified your transaction price allocating that to the individual performance obligations, now we’ve talked already about the idea firstly that we don’t have this hurdle of VSOE’s, that’s the biggest change I guess for software companies thinking about having to defer revenue just because they don’t have the SOE for a particular element, so that’s all gone.

Simon Baxter: Yeah, and you and I many times have seen a situation where companies have deferred large amounts of revenue simply because they did not have the SOE of any value. For a very small element to be delivered in the future. That all goes and I think my view is that opens up a wider commercial possibilities for technology companies who have been reporting under US GAAP, we have had a flavour of that because the harder companies have recently had some relief from that under US GAAP but that’s never been across the board and will free up dales teams to offer additional products not having to worry about the fact that may cause difficult revenue recognition.

Phillip Rogers: They will no longer have to consult anything to their customers and go into their accounting departments first, they will be able to give a broader range of services.

Simon Baxter: I think that’s a real keeled key change particularly for reporters, And of course they are going to allow the residual method as wealth calculating.

Phillip Rogers: That’s in there so that useful and gets around the complexity of working out what the fair value of a license that's never sold separately, so its good to see that there as well.

Simon Baxter: There's still an area where the boards are still discussing this, so I guess the final positions could change. And they’ve got the caveat that you can only use the residual method when fees are highly variable, that's not been defined and there could be some additional guidance on that.

Phillip Rogers: Ok, let’s turn to the fifth section which is on when to recognise the revenue when you’ve identified your performance measures and your trying to spread the revenue over that in relation to the performance managers, I guess again here their may not be a change for US reporters they’ll be used to the idea of identifying the inputs and output measures and spreading revenue based on that, so I'm not sure there's a difference in general but one area again time based licenses still may not be finalised at the moment, the guidance in the exposure drafts suggest that time based licenses will be recognised up front.

Simon Baxter: Yeah, and which will be a change for a lot of US GAAP reporters and some IFRS reporters and really the boards just need to reach a final conclusion on this one and everyone sort of fall in line, I think there's likely to be change for a lot of companies in this area.

Phillip Roger: And there's a bit of debate in the boards at the moment between the fads and BSIB between which ones should be going on a time based license recognising it over a period of time.

Simon Baxter: That right, I mean the practical commotional impact would be that there's a clear rule that these licenses are recognisable up front that bring them back into the kit bags of sales teams who previously have had to deal with the fact they have been recognised rateably.

Phillip Rogers: Yep, and I guess one area of which people will welcome is the changes in the exposure draft and later deliberations to assess honourees’ contracts at a contract level rather than individual performance level. That makes sense to me, it seems they decide that they’re going to keep the existing guidance where you would look at whether the whole contract has a whole is loss making rather than one particular performance obligation.

Simon Baxter : Yeah I think that right although I’ve not spent too much time looking at that because I don’t know about you Phil but I don’t have that many loss making contracts.

Phillip Roger: And I guess thinking about the transition requirements the exposure draft has given some additional reliefs there, so of course this is going to be applied retrospectively and I think a lot of people had concerns about that particularly for longer contracts and they have given some reliefs for contracts that are beginning and ending within a year and are finished before the transition date or the application of the new standard.

Simon Baxter: Yeah that’s right I mean transitions always is a difficult area there's always some work to be done looking at historical contracts but I guess my senses practically should not ignore the fact this could have implication and create opportunities commercially as well to do different things in terms of the commercial proposition and they shouldn’t over look that as they think about transition as well.

Phillips Rogers: Yep, so a lot for all our companies and our clients to think about.

Simon Baxter: Every technology company is going to have to look at this, and they will see some impacts along the way.

Phillip Rogers: Thank you Simon.