Hard Work to Implement Amended Revenue Rules

At first glance, the new accounting rules for recognizing revenue from “bundled” products should have the tech sector and other industries doing handsprings—but on closer examination, it won’t be that simple.

Hanson

“This is a classic case of the big picture giveth, and the fine print taketh away,” says Jay Hanson, national director of accounting for McGladrey & Pullen. The new rules do allow companies to recognize revenue more quickly and to match revenue to the economics of a transaction more closely, he said, “but when you peel this back a bit—wow, this is going to be hard.”

The Financial Accounting Standards Board recently adopted two new rules that give companies more flexibility around how to recognize revenue for bundled products, which typically are comprised of some tangible item (like an iPhone) and accompanying services (like the AT&T Wireless calling plan that goes with it). Bundled products are commonplace in the tech sector, and can also crop up in other industries such as manufacturing or durable-goods sales.

Until now, bundled-product transactions have been caught up in complex rules that often delay recognition of revenue until the final element is delivered, even if that’s several years into the future. The new guidance—contained in Accounting Standards Update No. 2009-13, Multiple-Deliverable Revenue Arrangements, and ASU 2009-14, Certain Revenue Arrangements That Include Software Elements—essentially lets companies develop a price for each element of the bundled offering, even if the company doesn’t sell them separately.

Old rules required a company to defer much or all of the revenue recognition unless it had objective evidence (either from its own business or a competitor’s) of how each individual element should be priced. The new rules let companies estimate the pricing around those elements and book the revenue as they are delivered.

That does mean companies have the potential to recognize revenue much more quickly—but they’ll also encounter a good dose of complexity, Hanson warns. The new rules do away with a “residual” method that some companies used to establish pricing for individual elements; instead, they will be required to generate carefully developed individual prices. That will mean developing some assumptions and estimations, and they’ll need to be both well defended and well disclosed.

Doolittle

The first step, says Sam Doolittle, a partner with Deloitte & Touche, is to understand how the new rules will affect the company. Assess how much the company actually does bundle products or services with value-added offerings and how it currently accounts for them, he says; then determine how it might change under the new rules.

Companies may need to change the way they recognize revenue, Doolittle says, and that will give rise to a host of accounting, systems, process, and internal control issues. Companies that foresee a potential change may even reconsider how they price their bundled offerings, if pricing was predicated in some way on the accounting restrictions. Or, he adds, companies might determine that their existing accounting methods are still appropriate.

“The folks who work with the deals are used to looking to the accountants for guidance,” he says. “Now the accountants are going to the sales people and saying ‘How could we change?’ And the sales people are saying, ‘I don’t know. How could we change?’ It’s a circular challenge with companies rethinking how they could go to market.”

“Companies should take care to document their estimates so they can show later that the decision that was made had a reasonable basis. You don’t want to be explaining things out of a hat.”

—Terri Garland,

Litigation Partner,

Morrison & Foerster

If accounting changes are warranted, then companies will need to decide how to develop pricing estimates for services or updates they don’t otherwise price individually. The new rules don’t tell companies how to do this, Hanson says, but they do suggest companies begin with their own usual pricing methodologies. That means taking into account their costs, usual gross margins, and market factors.

Kyviakidis

Peter Kyviakidis, managing director for consulting firm LECG, says companies need to assure that their accounting systems capture the data necessary to perform such calculations, and they need to establish good internal controls around the methodology. “For companies where these calculations prove material to the financial statements, this will be an area of focus for the external auditors,” he says.

Start Talking

As happens with any standard that involves estimation and judgment, the new revenue recognition rules also come along with plenty of disclosure requirements in tow. Above all, companies will have lots to explain about how they establish their pricing estimates.

Swieringa

The requirements are “onerous and useful,” says Robert Swieringa, accounting professor at Cornell University and a former member of FASB. “Companies are probably going to struggle with the disclosures part of this package more than the actual accounting. There is a lot of detail required to make it more transparent and to help users understand the choices that are being made.”

Transition to the new standard also will require some planning, says Lynn Triplett, partner at Grant Thornton. Companies can adopt the new standard at the beginning of their next fiscal year, following new accounting for new transactions and old accounting for existing transactions that are still on the books. Or they can go back and unravel existing transactions still lingering on the books and account for them under the new method.

They also can elect to adopt only for the current year and going forward—but if they do so, they must account for all transactions in the current year under the new method. That also involves some unraveling of old accounting.

REV-REC REVISIONS

The following excerpt is from Deloitte’s Heads Up: “Revenue Recognition: No Longer an Issue of Separation Anxiety”—Key Provisions and Changes:

The EITF decided that Issue 08-1 should retain much of the guidance originally included

in Issue 00-21 and codified in ASC 605-25. Issue 08-1 applies to all deliverables in

contractual arrangements in all industries in which a vendor will perform multiple

revenue-generating activities, except when some or all deliverables in a multiple-

deliverable arrangement are within the scope of other, more specific sections of the

Codification (e.g., ASCs 840, 952, 360-20 (pre-Codification guidance from Statements

13, 45, and 66) and other sections of ASC 605 on revenue recognition (e.g., pre-

Codification guidance from SOPs 81-1 and 97-2)). Specifically, Issue 08-1 addresses the

unit of accounting for arrangements involving multiple deliverables. It also addresses how arrangement consideration should be allocated to the separate units of accounting, when applicable. However, guidance on determining when the criteria for revenue recognition are met and on how an entity should recognize revenue for a given unit of accounting are located in other sections of the Codification. The timing and pattern of revenue recognition for a given unit of accounting depend on the nature of the deliverable(s) composing that unit and on whether the applicable criteria for revenue recognition have been met. In determining the appropriate revenue recognition model to use, an entity should consider other accounting literature (e.g., SAB Topic 13).

Issue 08-1 requires a vendor to evaluate all deliverables in an arrangement to determine

whether they represent separate units of accounting. This evaluation must be performed

at the inception of an arrangement and as each item in the arrangement is delivered.

Issue 08-1 retains from Issue 00-21 the criteria for when delivered items in a multiple-

deliverable arrangement should be considered separate units of accounting and states:

In an arrangement with multiple deliverables, the delivered item or items shall be

considered a separate unit of accounting if both of the following criteria are met:

A. The delivered item or items have value to the customer on a standalone basis. The

item or items have value on a standalone basis if they are sold separately by any

vendor or the customer could resell the delivered item(s) on a standalone basis. In the

context of a customer’s ability to resell the delivered item(s), this criterion does not

require the existence of an observable market for the deliverable(s).

B. If the arrangement includes a general right of return relative to the delivered item,

delivery or performance of the undelivered item or items is considered probable and

substantially in the control of the vendor.

A delivered item that does not meet both of the criteria above would not qualify as

a separate unit of accounting and would be combined with other deliverables in an

arrangement. The allocation of consideration and recognition of revenue would then be

determined for those combined deliverables as a single unit of accounting.

Issue 08-1 removes the previous separation criterion under Issue 00-21 that objective and

reliable evidence of the fair value of any undelivered items must exist for the delivered

items to be considered a separate unit or separate units of accounting. Under Issue

08-1, an entity must determine the selling price of deliverables otherwise qualifying for

separation (“qualifying deliverables”) by using VSOE or TPE or by making its best estimate of the selling price. That is, under Issue 00-21, an entity could only use certain types of evidence when determining the fair values of deliverables. Issue 08-1 does not contain any such restriction.

Source

Deloitte Guidance on Revenue Recognition (Oct. 1, 2009).

Companies likely will weigh the consequence of each choice, as well as the availability of data to help unravel old accounting, when deciding which approach to follow, Triplett says. “If the information needed to develop the selling price is difficult to come by, they might want to use the prospective method,” she says. “But some companies might think it’s worth the effort to go back and apply this retrospectively.”

Governance Issues

Whatever method companies choose, adoption of the new rules is expected to accelerate revenue for companies that have been forced to defer under old accounting. That means they’ll be expected to explain the new pace of recognition in their disclosures, and they may need to consider how the rules affect other governance issues as well.

Howard

Foremost, experts say, is the risk that accelerated revenue recognition could have consequences for executive compensation. Revenue is often pivotal to determining bonuses, contingent considerations and other performance metrics, says Richard Howard of the audit firm Mayer Hoffman McCann. Companies will need to examine those agreements and determine how they might be affected.

Even further, companies should assure that the methods established to comply with accounting rules are not set by those who would personally benefit, Howard warns. “The people who are incented in terms of revenue numbers are probably not the best people to reach the ultimate conclusions” about how to estimate pricing, he explains.

The board of directors and the audit committee should have a hand in approving the methodology, Swieringa says, especially when the company is under economic pressure and the new recognition will have a material effect on financial results. “There may be some pressure to recognize more income earlier than what happened under the old rules,” he says. “Boards should be concerned about this.”

External auditors should get involved in the dialogue, Howard says, and the earlier the better. “Documentation will be key,” he says. “What kind of evidence can the management team provide, other than this is our best guess?”

Morgan

Documentation will be important to fend off any after-the-fact challenges as well, says Nick Morgan, a partner at law firm DLA Piper, and Terri Garland, a litigation partner at Morrison & Foerster. Accounting estimates are a common target for securities class action suits, they both warn, and accelerating revenue is a common tactic behind fraud schemes.

“Companies should take care to document their estimates so they can show later that the decision that was made had a reasonable basis,” Garland says. “You don’t want to be explaining things out of a hat.”