In software companies, when people hear the word “contract,” they tend to either think about lawyers or sales. After all, salespeople are usually involved in the negotiation of a contract while lawyers are the ones that craft the fine print. In software companies, a third group should be thought of when the word “contract” is spoken; accounting. Although this sounds odd, there is a relationship between the contract and the accounting group centered on revenue recognition for software companies.
According the SAB 101, revenue cannot be recognized until the following criteria are met:
In the past, “persuasive evidence of an arrangement” was taken to mean a signed contract. Other proof of an arrangement such as a letter of intent would not satisfy the auditors. Revenue could not be recognized until both parties had signed the terms and conditions of the contract. This rule led to companies carving up complex agreements into smaller contracts to avoid delaying revenue recognition until the larger contract had been finalized.
However, under the latest FASB/IASB proposed model, the signed contract rule is no longer applicable. Evidence of an arrangement still needs to occur, but the form of that contract does not matter anymore. Software companies can now claim that a letter of intent is an enforceable contract and began recognizing payment as revenue, assuming all the other criteria are also met.
Although this rule change allows revenue recognition for software companies to occur sooner, other rules have become more difficult. The FASB/IASB rule change also requires managers to understand the underlying economics of an agreement and account for it properly. Understanding the underlying economics of contracts is best explained through examples:
Example 1: A software company obtains a letter of agreement for delivery of resource management software. A month later, they receive and recognize a payment while the contract is still finalized. At the same time, the customer requests a training contract. To facilitate, sales whips up a training contract independent of the first agreement. The software company recognizes revenue independently on both contracts.
Auditor Opinion: Although these are different arrangements, they have the same underlying economics. Both involve the delivery of the resource management software. Although different contracts, they are part of the same deal and should be combined for revenue recognition purposes.
Example 2: A software company sells a bundled contract that includes both a software component and a tax processing service. The firm negotiated the deal, received a letter of intent with a prepayment, and recognized the revenue.
Auditor Opinion: Although they both appear on one agreement, the underlying economics of these elements are not connected. By following the underlying economics of the deal, both elements should be separated and accounted for based upon the appropriate rules.
In the future, when combining or separating elements, management needs to understand the underlying economics of a deal. They need to consider whether the goods and services in one contract are dependent upon the goods and services of another contract. The best approach is to combine contracts when pricing and delivery is related and separate contracts if products and services are independent of each other.
The new rules can be challenging, but Bi1o1 is here to help. Contact us if you would like more information.