Revenue Recognition what’s all the VSOE about?
Last week, I posted a blog about the planned convergence between US GAAP and IFRS and how that might impact revenue recognition (http://scn.sap.com/people/jim.daddario/blog/2013/05/04/revenue-recognition-and-the-planned-convergence-with-ifrs). I realize that I got a little ahead of myself in that I talked about the potential impact on recently-enacted accounting standards without providing much explanation. Relative to these standards, I’ve heard many people, some inside my own company, lament about their “VSOE issues”. So I did some investigation on the FASB website as well as those of several major accounting firms and what follows is an attempt to clarify what this all means.
Again a caveat; this post is not meant for finance professionals. Rather, this is an attempt to explain some rather complex issues for non-financial business and IT people who are effected by them. I’ve attempted to simplify the discussion so non-finance people can understand the key concepts without the complicated language that those of us with financial backgrounds are used to.
As I said in the previous blog, the accounting profession always tries to match revenue with the costs incurred to produce that revenue, in period in which it is earned or realized. This is called the “matching principle”. This is critical for financial reporting as it provides stakeholders with a more accurate picture of how a business is performing.
Both costs and revenue can be a thorny subject because so many accounting irregularities have occurred when the numbers are miscalculated or misrepresented. The concept behind revenue is that it should be recorded when it is “earned”—that is when all contractual obligations have been met by the seller. Besides the issue of timing, US GAAP also requires that in order for revenue to be recognized, certain criteria must be met: There must be persuasive evidence of an agreement, delivery has occurred or services rendered, the seller’s price is fixed or determinable and collectability is reasonably assured.
At face value, revenue recognition is pretty simple—fulfill the obligation and record the revenue. It gets complicated when certain agreements between two parties contain obligations to deliver multiple goods and services whose timing and value is either uncertain or delivered on different time schedules. A good example is when technology companies sell solutions that are essentially bundles of hardware, software and services–all delivered on different time schedules. Even the services component can be complicated because there are different types of services and they are delivered differently. For example, professional services to configure and install software are essentially completed (and the revenue recognizable) on the go-live date. However, support services—the people you call when you have a problem—extend for the life of the contract which can be a year or more. Under previous revenue recognition rules (“rev rec” in accountant speak), software providers were forced to defer all of the revenue, even though some of the components were fully delivered. This resulted in a distorted view of revenue because particular items could not be booked as long as some deliverable remained outstanding. This also penalized the providing company who had to wait until the entire contract was fulfilled before they could record revenue. Rightly so, companies appealed to the accounting authorities.
In 2008, the Financial Accounting Standards Board’s Emerging Issues Task Force (FASB-EITF) introduced a new pronouncement (EITF 08-01) that changed the way revenue, stemming from contracts with multiple deliverables, was recorded. (There were actually two rules—the other deals with product bundles which contain hardware and software)
EITF 08-01 evolved into a new accounting standard (Accounting Standards Update (ASU) 2009-13. But ASU 2009-13 is far from easy to understand. What is says is in the case of contracts that contain multiple deliverables such as hardware, software, professional services and support—the issuing company must break all of these into their component parts and recognize them independently at different times (i.e. when they are delivered) and rates. This helps to more closely align revenue with costs and allow companies to recognize revenue on individual items faster. The next challenge is how does the company value these standalone components? Remember the previously mentioned US GAAP criterion that states “the seller’s price must be fixed and determinable”. This is not always as straightforward as it sounds. To do this, the standard lays out a methodology for establishing the “fair value” of the individual components to arrive at the monetary amount that should be recorded. ASU 2009-13 establishes a hierarchy that must be used in order to determine the monetary value of separate components, they are:
VSOE—Vendor-specific objective evidence. In simple terms, this would equate to what the company would charge if the component were sold separately. The onus is on the company to provide evidence of how that item would be priced on its own (i.e. 100 hours of consulting at the standard rate of $150/hour).
TPE—Third-party evidence. If you don’t have VSOE on what your company would charge, the accountants will look to third-parties such as competitors to determine how they would price a similar item.
ESP—Estimated selling price. If neither VSOE or TPE can be determined, then you must provide the best estimate on what the component is worth based on market prices.
Once the individual selling price for each item has been established using he above methodology, companies can begin to recognize or defer revenue, depending on whether or not the component has been completely delivered.
For most companies, managing revenue is a tedious process involving complicated, error-prone spreadsheets. Fortunately, financial software can help. For example, SAP Financials OnDemand includes a robust project management module that allows companies who provide professional services to manage the project and include billing milestones that simplify revenue recognition. I hope this was helpful to you non-financial managers. Again, there’s a lot of detail behind these rules that I have deliberately omitted for the sake of simplification—in fact there are multiple rules and to make it even more complicated, the US and international accounting standards are quite far apart on this topic and the governing boards are working hard to reconcile these differences. For further detail into what this means for your company, talk to your CFO.
Thanks for this really introductory explanation. It helped me a Lot.