Tips to Avoid Revenue Recognition Accounting Pitfalls for Technology Companies

Article

November 8, 2024

Revenue recognition is a fundamental component of accrual accounting and provides transparency and consistency in financial reporting, which helps improve communication with stakeholders. While an essential element of accounting, revenue recognition can also be complex and present challenges to technology and software businesses if not properly managed.

The Accounting Codification Topic 606: Revenue from Contracts with Customers (ASC 606) introduced new disclosure requirements and asserted that revenue should be recognized when the promised goods or services are transferred to the customer, which could be.

ASC 606 also introduced a five-step model for revenue recognition:

Identify the contract with a customer
Identify the performance obligations in the contract
Determine the transaction price
Allocate the transaction price to the performance obligations in the contract
Recognize revenue when the entity satisfies a performance obligation

This standard continues to trigger new challenges for businesses, especially those with complex sales arrangements or long-term contracts.

Key Scenarios To Consider

We’ve explored a few common scenarios and challenges companies in the software industry may face as they recognize revenue, as well as ways to navigate these pitfalls and achieve compliance.

Keep in mind these are hypothetical scenarios, and each situation has its nuances. It’s important to discuss your company’s particular situation and reporting requirements with an accounting or assurance professional.

Scenario One: Free or Heavily Discounted Implementation

Slick Software Company sells cloud-based software as a service (SaaS) for the cybersecurity industry, generally through one-year subscriptions invoiced annually at the start of the contract. The SaaS platform sells for $24,000 per year.

Most customers also purchase the $5,000 implementation service, which includes a few days of training as well as configuration services. Implementation is generally completed within 30 days. However, the marketing team has started a promotion to waive the $5,000 implementation fee, and Slick Software Company is now unsure of how to recognize its revenue.

Solution

Without the implementation fee, the total contract value of $24,000 needs to be allocated to two performance obligations, SaaS and implementation, on a relative stand-alone selling price basis. Once that is determined, the revenue portion allocated to SaaS is recognized ratably over the one-year term, and the portion allocated to implementation is recognized as the services are performed.

Scenario Two: Hybrid SaaS or Cloud Arrangement

ABC Company hosts an on-premise software license and also sells that license to XYZ customer. In the contract, the hosting and software license are explicitly stated as separate elements. XYZ customer cannot use or receive any benefit from the software license without the hosting arrangement. When it comes to revenue recognition, ABC Company is not sure if it has one or two performance obligations.

Solution

Since the software license would not meet the criteria to be considered distinct from the hosting arrangement, we can determine that ABC Company has only one performance obligation. As a result, the two elements would be combined as one performance obligation and recognized over the longer period of service, which is the hosting period.

Scenario Three: Payment Processing

In a cloud-based software arrangement, AP Solutions sells its accounts payable platform to a customer. The customer can elect to utilize one of the payment processors partnered with AP Solutions to run payments for the underlying customer’s end users.

The customer elects to use PayMeNow Payment Processor. The contract between AP Solutions and PayMeNow indicates that PayMeNow will give AP Solutions 1% of total payments processed through their system for any client who signs up through AP Solutions. AP Solutions is unclear about how this contract agreement with PayMeNow impacts its revenue recognition.

Solution

First, AP Solutions must separate its contracts with PayMeNow and the accounts payable and evaluate them independently to determine proper revenue recognition. The contract with PayMeNow has one performance obligation, and therefore, the variable consideration earned from that contract would be recognized over time. AP Solutions would then evaluate the contract with the customer to determine proper revenue recognition for that contract.

Accountants for Technology Companies

Cherry Bekaert’s Accounting Services group can help you navigate complex accounting processes and avoid revenue recognition pitfalls. Our experienced business accountants focus on specific industries and remain knowledgeable on trends and regulatory shifts. We tailor each engagement to your needs, stage of growth and future plans. Contact our revenue recognition team today to learn how we can streamline your accounting process.

Connect With Us