New revenue recognition rules will have the biggest impact on companies that sell tangible products that include software, but they will also have an impact on every company that sells multiple elements at once.
The hotly debated rules (formally known as ASU 2009-13 and ASU 2009-14 or EITF 08-1 and 09-3) should allow companies to recognize revenue sooner but may also create a lot of additional work for them, says Nick Steiner, a partner at Burr Pilger Mayer.
“Even if you’re not a company that includes software in your products, the rules will be changing,” he says. “This is going to impact any company that is selling multiple elements, or bundling, at once.”
Smart Business spoke with Steiner about how the new rules will affect businesses and how to begin preparing for them now.
How will the new rules change the way companies recognize revenue?
The new rules may result in significant changes to a company’s revenue model. These rules introduce a ‘selling price’ hierarchy for multiple-element arrangements and remove the requirement to use objective and reliable evidence of fair value when separately accounting for deliverables. As a result, they should allow companies to recognize revenue such that it more closely matches the economics of the transaction.
The rules have become informally known as the Apple rules, as Apple was one of the key drivers in the changes. Because of the software embedded in an iPhone, Apple was recognizing revenue under software revenue recognition rules. Under these rules, Apple previously had to defer revenue when an iPhone was sold and recognize the revenue over an estimated two-year economic useful life. This was a result of Apple providing upgrades to the software on its iPhone to customers for free. Because it did not charge customers for this element, it could not establish evidence of fair value for it. Apple felt that the resulting accounting deferral and recognition over two years did not reflect the economics of the transaction and supplementally disclosed the number of iPhones it sold each quarter to satisfy its investors. Under the new rules, Apple will be able to recognize a significant majority of iPhone revenue upon sale rather than deferring all of it.
The new rules go into effect for fiscal years starting in July 2010 or after, but Apple has been an early adopter. Apple recently announced its financial results for its first quarter after adoption and reported record earnings as a result of the accounting change.
What types of companies will the new rules impact?
While the impact of the new rules will be biggest on companies that sell hardware and software together, these rules are going to affect any company that bundles products and/or services.
How will the new rules affect how companies operate?
One of the impacts of the new rules is that companies will no longer be allowed to use the residual method for allocating revenue in an arrangement. Under the old rules, you allocated the fair value to everything that you hadn’t delivered, such as training or customer support, and whatever was left over, you recognized now. Under the new rules, you will have to allocate all of the consideration based on its relative value. This will require companies to study what the average selling price has been for all of their products and then allocate revenue relative to that. Previously a company needed to establish stand-alone evidence of fair value (either through its own sales or through objective third-party evidence) in order to ‘carve out’ an undelivered element from a transaction. Companies will now be required to use their best estimate of a component’s stand-alone sales price to allocate revenue if evidence of fair value does not exist. This will result in significant judgment in determining the estimated sales price as well as in determining whether a component requires stand-alone accounting. In situations where a company has thousands of products, studying its history of the selling price for each of those products over time will be a significant challenge.
Can a company do this analysis on its own?
Many companies will likely need additional help implementing the new rules because they’ll need help analyzing the historical selling price of each of their products. Initially, companies were excited about the prospect of recognizing more revenue sooner, but as they start to dig in, they are starting to understand the amount of work that can be involved in the rollout, and many of them are hiring consultants to help them through the process.
The fewer products you sell, the easier this is going to be, but it’s not going to be an insignificant effort for anybody. The bulk of the work will be upfront as you assess the historical selling prices for some products and develop estimates of selling prices for others. But even after adoption, companies will need to continue to perform regular assessments of their selling prices.
Another issue facing companies is that most existing accounting software wasn’t written contemplating these new rules. While accounting software vendors are working on updates, companies may have to use stopgap measures until the accounting software catches up with the new rules. This could require tracking transactions outside of accounting software during the initial implementation.
There is significant work involved in assessing historical selling prices and you should get started sooner rather than later.
Nick Steiner is a partner at Burr Pilger Mayer. Reach him at (408) 961-6375 or firstname.lastname@example.org.