business Software Companies Impacted by New Revenue Recognition Rules July 22, 2014 Your credit standing, debt covenants, compensation agreements and royalty payments to third parties could be affected by GAAP changes. Companies that contract to license and service software are among those that will feel the biggest impact of new rules for reporting revenue from customer contracts under Generally Accepted Accounting Principles (GAAP). This includes those offering cloud computing services, also known as software as a service or SaaS, one of the fastest growing sectors in the technology space. Third parties often look to a business’s top line to gauge its performance and financial health. So, changes in revenue recognition could affect a software provider’s credit standing, debt covenants, compensation agreements and royalty payments to third parties. They could also result in temporary differences in book and tax earnings to the extent that the new GAAP rules don’t sync with the tax code. In many cases, software companies will report revenue sooner than under the industry-specific guidance that previously applied and will need to expand their disclosures about revenues from customer contracts. Compliance starts by reviewing existing contracts and asking critical questions about the probability of the seller not having to make a significant reversal in revenues. Consider the following questions: Ask yourself, “When does the right to use a license transfer to customers?” Does this happen when the licensor sends the access code to use the software? Or do the licensee’s rights change over time as the software company provides service? How do undelivered contract terms, such as hosting services and future upgrades, affect revenue recognition? Are unspecified updates provided on a when-and-if-available basis? How do other contract provisions, such as price protections, refunds and returns, factor into the analysis? The new rules tend to be more flexible and subjective than the old industry-specific ones. For instance, software licensors may be able to look beyond vendor-specific objective evidence (VSOE) to estimate transaction price and for allocation of revenue to the various deliverables. Companies unable to establish VSOE will likely accelerate revenue recognition because the new standard will increasingly result in unbundled performance obligations in a multiple-element contract, i.e., the sale of software and support services. The requirement to have VSOE of fair value for undelivered elements is eliminated. Other areas impacted are contingent revenue and accounting for contract costs. With such pervasive changes, the AICPA has formed a Software Entities Revenue Recognition Task Force to develop implementation materials on how to apply this new standard. We are following these developments closely so that we can offer practical advice and keep you informed. The changes won’t go live until 2017 reporting for public companies and 2018 for private companies. Early adoption is not permitted, except for private companies, which can choose to adopt the guidance at the same time as public companies. Privately held and PE/VC-backed software companies may want to do so to take advantage of recognizing income sooner. And all software companies need to start tracking these changes and modifying their reporting processes today to avoid problems tomorrow. Keep in mind that the standard is required to be applied retrospectively, meaning that all earlier periods are restated, and new disclosures are required on contract assets and liabilities as well as remaining performance obligations. Until the changes go live, you may need to concurrently track results under both the existing standards and the new global standard. Contact us for more details on the potential impact to your company and whether to consider early adoption of this new guidance.