Revenue Recognition

While the Financial Accounting Standards Board (FASB) recently proposed delaying the implementation of four standards for private companies, including leases and credit losses, private companies are in the midst of the adoption year for revenue recognition and there is no relief coming from the need to follow the new standard in 2019 financial statements. I recently provided some guidance to a fellow TXCPA member on TXCPA Exchange, which is a forum for knowledge exchange with your professional colleagues. The initial question was about recognizing revenue in a contract that included professional services and software. Excerpts on our exchange are as follows.

If the product has to have professional services in order to function, then the services and license would not be distinct. Is that correct?

No. The question of distinct is not based on if the license would have to have professional services to be distinct. If the customer could get those services from a different vendor, the license would still be distinct even if professional services (from some vendor) were required.

Is distinction considered on a contract-by-contract basis or by product?

Technically, you look at each contract separately. There are two factors to consider when determining if a product or service is distinct:

  1. Can the customer benefit from the product or service on its own or together with resources that are readily available to the customer?
  2. Is the entities promise separately identifiable from other promises in the contract – that is, it is distinct in the context of the contract?

The first test can really be done at the product level. Either the product, service or software license is “capable” of being distinct; remember, this doesn’t mean the product, service or license is not dependent on other items. It just means that the customer can get those other items from other sources.

The second test is a contract-by-contract test, although in reality most businesses have standard contracts or at least generally standard formats, so often the same conclusion can be reached for all “similar contracts.” When it comes to software and services, a key factor to consider is the 606-10-25-21 b. factor, which indicates that a promise is separately identifiable. The factor is:

“The good or service does not significantly modify or customize another good or service promised in the contract.”

If the professional services are changing the underlying code of the licensed software, then I think the professional services do “significantly modify or customize” the software, so the services are not separately identifiable. On the other hand, if those services are standard configuration work, they would likely be considered a separate, distinct service.

If I have a $500k contract, and the professional services are worth $200k, would it be appropriate to then recognize the $200k professional services as % of completion or milestone?

Probably. To recognize revenue over time (that is what is implied by % of completion or milestone), you must meet one of three criteria:

  1. The customer simultaneously receives and consumes the benefits provided by the seller.
  2. The seller creates or enhances an asset that the customer controls as the asset is created or enhanced.
  3. The seller does not create an asset with an alternative use to the customer and the seller has an enforceable right to payment for performance completed to date.

Professional service revenue, if recognized over time, generally falls to the third criteria above. Think of the first criteria for things like cable TV service. The second criteria is generally about building a building. Because many professional services do not result in the creation of an asset, recognition over time falls to the third criteria. (An exception to this is professional services where the output is a software program or website, in which case an asset is being created. In that case, you do have to consider whether the customer is taking control of the asset as it is being created.)

If I have a $500k contract and the software is worth $300k, would it be appropriate to recognize the $300k ratably over the license term?

No (most likely). This was one of the big changes in the new revenue standard. Once you turn over the software license, even if it is for multiple years, there is nothing more for the seller to provide to the customer, so the entire amount of the revenue for the software licenses is recognized at a point in time “upfront.” If the license also includes rights to future upgrades, those future upgrades are considered a distinct performance obligation and should be separated from the software license and valued distinctly, with revenue recognized as those upgrades are provided. But the portion of revenue allocated to the initial licenses is recognized immediately upon the license being available to the customer for use.

I also want to note that software as a service, where a license and “code” is not provided to the customer, but instead the customer accesses the software on the seller provided platform, is different from selling a software license and must be evaluated differently for when to recognize the revenue, but I won’t get into that here, because that does not seem to be the question at hand.

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