The Financial Accounting Standards Board (FASB) has been working on updating its rules for revenue recognition since 2002. This year, it announced new guidance created jointly with the International Accounting Standards Board (IASB). The changes are slated to go into effect in 2017 for public companies and in 2018 for private ones.
The new rules are designed to improve comparability of statements across companies, industries, and countries; increase disclosure and reporting quality; tamp down on fraud; and help investors to better gauge performance. They cover everything from when revenue is recognized, to the amount of required disclosures, to the degree of discretion in the use of estimates.
They’ll have wide impact, especially for technology companies.
What does this mean for your business?
First, the changes will affect GAAP filers only. I covered the importance of GAAP accounting in an earlier post, but basically, accrual accounting is the most consistent, widely accepted financial reporting method. It’s also essential for attracting debt and most other types of financing.
The new financial reporting rules will replace a slew of industry-specific ones. For software companies especially, revenue could be pulled forward, since companies will now be allowed to record a greater proportion of revenue at contract signing rather than amortizing it over time. But the reverse could be true in some cases.
Revenue Recognition will now involve 5 steps:
- 1.Identifying contracts — These must be approved, have identifiable rights and payment terms, commercial substance, and probable collectibility.
- 2.Identifying discrete performance obligations — Define the goods and services to be delivered over the course of the contract (explicit or implied).
- 3.Determining transaction price — Set the overall price to be received by taking into account the price of each performance obligation (for example, the price of a bundle might include a software licensing agreement plus a service contract, and/or upgrades).
- 4.Allocating price — Determine the price of each component on a relative standalone basis. FASB will allow companies to have greater discretion than previously in pricing the contract pieces, but,in return, companies will have to disclose more. Footnotes will have to more fully spell out assumptions and the underlying estimates.
- 5.Recognize revenue as performance obligations are fulfilled — The general rule of thumb is for sales of goods to be recognized at a point in time while services are recognized over time. But this really depends on your business.
What should you do now to get ready?
Familiarize yourself with the rules — Make sure you fully understand the changes you’ll be required to comply with going forward.
Consult a financial expert — This is definitely not something you want to just muddle through. Whether you’re relying on occasional outsourced financial help, a part-time CFO, or are at the point where you’re considering adding a full-time finance manager, get him or her involved early and often. It’s really the best way to make sure you have enough time to analyze the business impact and take the right steps to prepare for compliance.
Plan for implementation — What does this look like? It might mean spending on new systems, adding staff or making other process changes to beef up your financial controls (and reduce your audit risk!), retooling your pricing strategy, and/or changing your sales commission model and calculations.
More questions about revenue recognition? Tell us in the comments section below or contact Early Growth Financial Services for help assessing your financial reporting needs.
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Sirk Roh is COO for Early Growth Financial Services. He’s an accomplished finance executive focused on leading early-stage companies through strategic financial decisions. Sirk’s areas of expertise include debt and equity financings, planning/budgeting, financial analysis, cash flow management, high growth management, and cost reductions/rightsizing.