Revenue Recognition Rules for Bundling Take Effect

The day of reckoning has arrived for companies that chose to delay the adoption of revenue recognition rules for bundled product and service offerings—and with it, plenty of hazards to avoid.

The Financial Accounting Standards Board issued the rules, which allow companies to speed up the recognition of revenue for certain bundled offerings, in October 2009 and allowed companies to begin adopting them immediately if they chose. However, adoption is now required for those with fiscal years beginning on or after June 15, 2010, meaning all calendar-year companies must start using them in their 2011 reports.

Revenue recognition rules generally allow a company to book revenue only after it fully delivers a good or service to a customer and can show evidence of the value. The new rules, contained in Accounting Standards Update No. 2009-13, give companies more flexibility to make judgments and to estimate the standalone value of products and services they don't ordinarily provide on a standalone basis. That leeway enables them to recognize revenue on each deliverable as it is provided.

The new rules apply when, for example, a company sells a product with a promise of technical service, future upgrades, delivery, installation, or other enticements. Such bundling is common in the technology sector where cell phones, hand-held electronics, and computers are often sold with promises of future upgrades as new technology emerges. Based on rules in place before the update, companies had a tough time meeting that threshold of evidence around value if they didn't separately price and sell all the individual elements of the bundled arrangements. That meant deferring recognition of revenue on the entire transaction until all the promised add-ons were delivered, even if it spanned years into the future.

While the new standard can accelerate the recognition of revenue, it is complex, warns Steve Hobbs, managing director at consulting firm Protiviti, who worked with a number of companies that chose to adopt the standard as soon as it was available. “I think many underestimate the effort that this is going to take and the impact it will have on the business,” he says.

Among the complexities is estimating prices for items and services that are not actually for sale. At first, many viewed it as an accounting and finance exercise, but soon discovered they needed the help of sales, marketing, and other operational staff to establish estimated selling prices, says Sam Doolittle, a partner with Deloitte & Touche. “The adoption is most smooth if you have those people at the table as early as possible,” he says.

Even then, the task has proved daunting for some companies, Hobbs says. “There's an awful lot of data that companies need to look at that they may not have looked at before,” he says. For example, if companies have customers spread across multiple countries, delivery naturally involves multiple currencies and distribution channels. “You have to stratify that data, but how far?” he says.

Early adopters moved too quickly and established estimated selling prices without considering all the data that should be taken into account, says Brian Marshall, a partner with audit firm McGladrey & Pullen. Companies would start with cost plus margin, for example, and call it an estimated selling price. But to meet the standard of evidence in the accounting rule, the analysis needs to go further, he says. “You have to look at other potential data points out there that support how you would price this if you sold it on a standalone basis,” he says.

“The historic revenue recognition rules often put handcuffs on companies in the way they could sell their products and services. To a large degree, those handcuffs have been removed.”

—Jay Howell,

Partner,

BDO

That's been a common message from the auditors and even the Securities and Exchange Commission, says Hobbs. Auditors are looking for companies to dig deep and explain their analysis in reaching their estimated selling prices, he says. While the SEC hasn't issued a large volume of comment letters to early adopters, the letters so far have focused on disclosure to explain the estimation process. The SEC also has scrutinized the sensitivity analysis, he says. The SEC is asking, for example, “If this estimate was blown by X percent, what impact would that have on your financial statements?” Hobbs says.

Free to Bundle

On the plus side, the change in accounting rules has had a positive effect on some critical business decisions, says Jay Howell, a partner with audit firm BDO. “The historic revenue recognition rules often put handcuffs on companies in the way they could sell their products and services,” he says. “To a large degree, those handcuffs have been removed. That allows companies to implement selling practices that they might not have found appropriate because of the accounting limitations in the past.”

REV-REC REDO

The following excerpts from the Financial Accounting Standards Board revenue recognition rule explain how the main provisions differ from GAAP and IFRS:

How Do the Main Provisions Differ From Current U.S. Generally Accepted Accounting Principles (GAAP) and Why Are They an Improvement?

The amendments in this Update will significantly improve the reporting of transactions to more closely reflect the underlying economics of the transactions. currently, the absence of vendor-specific objective evidence or third-party evidence of selling price of the undelivered item in an arrangement is a common reason that vendors are unable to separate deliverables in an arrangement. In those situations, the timing of revenue recognition may be deferred until the delivery of the last deliverable or the entire fee may be recognized over the period during which the last deliverable is delivered or performed. Constituents have asserted that the current accounting often does not reflect the underlying economics of a transaction. As a result, the amendments in this Update will require allocation of the overall consideration to each deliverable using the estimated selling price in the absence of vendor-specific objective evidence or third-party evidence of selling price for deliverables.

Additionally, eliminating the residual method of allocation will improve financial reporting because the relative selling price method spreads any discount in an arrangement across all of the deliverables in that arrangement rather than allocating the entire discount to the delivered items. However, this change will require a vendor to estimate a selling price for delivered items regardless of whether vendor-specific objective evidence or third-party evidence of selling price exists for these items.

The disclosures required by the amendments in this Update also will significantly improve financial reporting by providing users of financial statements with greater transparency of how a vendor allocates revenue in its arrangements, the significant judgments made, and changes to those judgments in allocating that revenue, and how those judgments affect the timing and amount of revenue recognition.

How Do the Main Provisions Compare With International Financial Reporting Standards (IFRS)?

IFRS provides little guidance about the allocation of consideration in multiple-deliverable arrangements. However, IFRS requires companies to assess the substance of a transaction when determining whether multiple deliverables should be separated or combined for accounting purposes. Accordingly, the amendments in this Update are expected to more closely align the accounting for multiple-deliverable revenue arrangements in U.S. GAAP with IFRS.

Because U.S. GAAP provides detailed guidance about separation and allocation of multiple-deliverable arrangements in comparison to the guidance of IRS, differences may still exist in the separation and allocation of consideration with respect to some multiple-deliverable arrangements after the amendments in this Update become effective. These differences may affect the timing or amount of revenue recognized fora deliverable.

Source

Financial Accounting Standards Board (October 2009).

For example, says Howell, companies have long shied away from promising customers access to emerging products or upgrades that were still in development because pricing was too difficult to pin down for revenue recognition purposes. “Now you can include deliverables for things that are still on the drawing board,” he says. “That's a powerful selling tool.”

The standard update isn't the last word from FASB on revenue recognition. The Board is developing a bigger new standard around revenue recognition generally. The new rules on multiple-element arrangements are carried into the new standard, so they're not expected to change. But it might affect how companies want to manage their information systems, he says. Companies adopting the new standards now need to also give thought to new requirements on the horizon and how their systems will handle both sets of rules.

Auditors also see some differences of opinion over the extent to which companies can use the “residual method” of determining estimated selling prices for purposes of the new rule. The residual method is simply a mathematical equation where companies start with the price of the bundled offering, subtract the amount that can be ascribed to readily priced elements, and assign the rest to an un-priced element. The new rules for multiple-element arrangements prohibit the residual method, requiring companies to do more work in setting those prices.

Howell says the new standard on the drawing board at FASB includes some references to using a residual method in estimating selling prices, so some companies have viewed it as tacit permission to continue using the residual method. Doolittle acknowledges the residual method still has a place in other areas of revenue recognition, but he cautions companies against relying on it for multiple element arrangements. “Under the current standards today, it is no longer an option,” he says. “So for companies adopting now, that's where it stands.”