New Rules on Recognizing Revenue

SuccessFactors sells business software that companies use to evaluate, hire, compensate and communicate with employees. The $150 million San Mateo, California, company also typically sells consulting services that help its clients set up the software and teach employees to use it.

Accounting for those two different types of sales – software and services – has created an accounting wrinkle.

SuccessFactors customers pay an ongoing monthly subscription for the software, but a lump sum up front for the services. While the company usually delivers the services at the time of installation, existing accounting rules say the company must recognize both types of revenue over the duration of a client’s contract, which could be a year or two. That can affect everything from a company’s financial reports to the ways it compensates its employees.

SuccessFactors’ quandary underscores the fundamental problem of applying 20th century accounting rules to 21st century transactions.

Accounting standards organizations are trying to fix that problem by developing new rules governing revenue recognition. The move could be a boon to businesses in an era where technology allows for online product distribution and sales across global borders and blurs the distinction between kinds of products – these days everything from toys to automobiles contains software, for example.

A joint proposal from the Financial Accounting Standards Board (FASB), which sets accounting rules followed by all U.S. public companies and many private ones, and the International Accounting Standards Board (IASB) seeks to end questions about when companies can and should recognize revenue. Rule changes are expected to be finalized sometime this year.

Overhauling Revenue Rules
How and when companies recognize revenue has been a hot-button issue for almost a decade, ever since public companies such as ConAgra, Sunbeam and Xerox had to restate earnings, pay multi-million-dollar fines and admit to securities violations for improperly booking revenue, in some cases to reach earnings targets.

SuccessFactors’ quandary underscores the fundamental problem of applying 20th century accounting rules to 21st century transactions.

Revenue recognition is critical. Investors, bankers, partners and customers measure revenue to compare companies across industries and markets. In the United States, most private and public companies follow generally accepted accounting principles (GAAP). But GAAP rules on recognizing revenue have industry-specific and transaction-specific requirements that can result in different accounting for similar transactions. The construction industry, for example, can account for revenue from long-term contracts based on the percentage of a building or project that’s completed, whereas revenue from the selling apparel is recognized at the point of sale.

The push to reform revenue recognition is part of a move to merge U.S. accounting standards with International Financial Reporting Standards (IFRS) used by much of the rest of the world. IFRS rules can be difficult to apply to complicated transactions and offer limited guidance on some issues that have plagued U.S. companies, such as accounting for software sales.

“Innovation really blurs the line between industries,” says Ken Bement, FASB’s revenue recognition project manager. “If revenue rules differ by industry, when you get a new business model or a transaction that crosses into different industries, it creates problems. What we’re trying to do is come up with a single framework to apply to all industries and similar accounting rules. This will hopefully make it easier to account for contracts and minimize the need for standards bodies to issue industry-specific guidance.”

The draft proposals include several changes to existing revenue recognition practices, including some that are already proving controversial. Late last year, the American Institute of CPAs submitted a critique to FASB saying that while the group agrees with the theories behind the proposals, some concepts might be difficult for companies to implement without incurring major expense. For example, under the proposals, revenue would be recognized when control over goods or services transfers to a customer. But according to the American Institute of CPAs, in industries such as construction, a building often doesn’t transfer until the last brick is set. The AICPA also questions whether frequent flyer and other customer loyalty programs force companies to defer revenue because the new rules call for recognizing revenue only after all “performance obligations” to customers are met.

FASB and IASB expect to review public comments and re-examine their revenue recognition proposals through May, then begin the process of putting the final rules in place, though they have not come up with a specific timeline for doing so.

Meanwhile, the process is giving some CFOs the chills. Part of the reason is misinformation being spread, including a suggestion that U.S. companies will be forced to adopt international standards, which often aren’t as detailed as the GAAP rules. “It does strike fear in to the hearts of some financial executives,” Bement says.

Until things are settled, here are steps finance executives can take to prepare:

1. Determine whether changes impact your company. Gather the appropriate data, consult your accountants and look at your contracts, says Steve Hobbs, managing director of Protiviti, a Menlo Park, California, business consulting and internal audit firm. Understand how you sell goods or services and when you recognize the revenue in your financial statements. “We suggest that very early on companies meet with their outside auditors to talk about their approach and get their auditors engaged,” Hobbs says.

2. Figure out who will be responsible for implementing changes. Appoint the company’s project management officer or someone in the CFO’s office to lead implementation of revenue recognition changes. “A lot of key stakeholders – for example, the sales organization – are going to be very interested because if you recognize revenue differently it may impact the way they are incentivized,” Hobbs says.

3. Analyze the impact on internal and external financial reporting. While financial statements are created for external use, also look at internal reporting and how the accounting changes will impact your ability to forecast revenue, create budgets and structure commissions. “Does it also become a cash flow issue?” Hobbs asks.

4. Communicate changes. If you decide to recognize revenue differently, brief shareholders, employees – and if you’re publicly traded – analysts, Hobbs says. If changes impact how commissions are paid, communicate that to the sales staff.

Companies like SuccessFactors have relied on FASB for help in preparing for the new rules. In 2009, the organization’s Emerging Issues Task Force offered guidance on how to recognize revenue from sales with multiple elements, such as software and services. “We do a lot of work up front, and it’s better to take the revenue when that work is done,” says Paul Henderson, SuccessFactors’ senior director of worldwide revenue control.

Last year, SuccessFactors separated its two kinds of revenue with the help of NetSuite, a cloud-based accounting and ERP software seller, which developed an add-on module that supports FASB’s new guidance, among other rules.

SuccessFactors began using NetSuite’s software in the third quarter of 2010. “When you get a contract in, you have to allocate the contract value to each different element based on the relative selling price,” Henderson explains. “That can become complex when you’re dealing with hundreds of different contracts.”