No Option Principle

Probably the second most significant change under the new revenue recognition standard is the requirement to defer incremental costs to obtain a contract and costs (notice the word incremental is not listed here) to fulfill a contract. This change, like many of the most significant changes, impacts service and technology companies more than traditional manufacturers. Under current rules, companies have options when it comes to these costs and most companies chose to only defer such costs up to the amount of any upfront activation fees deferred under today’s revenue rules. Some companies make an accounting policy election to defer additional upfront costs over the life of the customer contract. Those companies will likely see less impact from the new requirement with changes mainly coming from aligning the costs being deferred to the new definitions.

Companies that defer upfront costs today, however, are in the minority. In fact, the irony of the Boards’ position on these costs is that over the last two decades many companies have moved from deferring all upfront costs to only deferring costs up to the amount of deferred revenue, and they received “preferability” opinions in the process of making that accounting policy change. I guess the fact that the accounting firms issued and the SEC accepted those opinions carried little weight with the Boards when it came to their effort to revise the matching of revenue and expense.

Companies are going to need to set up new processes and systems to accumulate and account for such costs. Today, many companies simply look at qualifying costs overall, stop counting when they get to the amount of deferred revenue, and simply book an entry deferring the same amount of cost as they have deferred for revenue. They also use the revenue amortization schedule to amortize the deferred costs. This process results in no need to look at all possible costs and allows the procurement and payable systems to book expenses straight to the general ledger without the need to additional sub ledgers or systems.

Under the new rules, that process won’t be so simple any more. Companies will need to evaluate costs to determine if they are incremental costs to obtain a contract (probably fairly obvious) or upfront costs, such as setting up a customer in your system or connecting them to your service (that include labor and other less obvious and easily isolated costs). Once they have determined the costs to be deferred, amortization schedules will need to be set up and the costs will need to be evaluated for impairment on an ongoing basis.

It is hard to disagree that the proposed process does a better job matching expense to the recognition of the related revenue. The problem is that the better job comes at the cost of a much more difficult accounting process that is also less conservative.

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