How to Comply With the New Revenue Recognition Rules
When the Financial Accounting Standards Board updated the business accounting rules earlier this year, Apple was quick to embrace them. Here's a look at how they went about it and why, along with a few tips on how you can switch to the new rules, too.
Fusion-io, a fast-growing start-up based in Salt Lake City, needed a more efficient way to provide its investors and bankers with a clear picture of its revenues. The company, which launched in late 2005, makes cutting-edge flash storage memory devices and also provides year-long maintenance contracts. The old accounting rules required Fusion-io to spread out its recognition of the revenue for both product sales and maintenance throughout the life of the service contract, which didn't accurately reflect their revenue realities. So when the accounting standards were updated earlier this year, Fusion-io was quick to embrace them.
These new accounting standards were developed by the Financial Accounting Standards Board (FASB), the non-profit group recognized by securities regulators in the U.S. to set accounting rules for public companies. The group has recently provided companies with a roadmap for how to recognize revenue from goods at the time they are sold and delivered, even if they are sold bundled with service contracts. In addition, another rule allows makers of goods that contain software -- from computers and cell phones to medical devices and cars -- to avoid having to follow special software revenue recognition rules in accounting for sales.
The new guidance is part of a larger accounting standards overhaul spelled out in a 170-page draft that is expected to be finalized in 2011. But the new revenue recognition provisions take effect for fiscal years beginning on or after June 15, 2010, and some companies -- including Fusion-io -- have opted for early adoption for fiscal year 2009.
'If you think about the old guidance, it was inconsistent with what our economic benefit was. We had deferred revenue on the books that we couldn't recognize but for which we had already collected the cash,' says Catherine Voutaz, Fusion-io's controller. 'When people went to look at our financial statements, they would ask why we had a huge amount of deferred revenue on our books. It gave investors a view that was not really reflective of reality.'
The new FASB rules amount to 'an easier way for us to communicate with our internal investors and the bank,' she says.
The following guide will review the background of revenue recognition rules, what type of companies are covered under the new rules, and tips on how to switch to the new rules.
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Revenue Recognition Basics
Revenue is one of the key figures that investors, bankers, customers, regulators, etc., look for in financial statements to gauge the past performance of a company, as well as its future potential. But the revenue recognition rules in the generally-accepted accounting principles (GAAP) in the U.S. are different from those used in much of the rest of the world under International Financial Reporting Standards (IFRSs).
In addition, a series of companies -- including Sunbeam, Xerox, PurchasePro, and Microstrategy -- were targeted by the U.S. Securities and Exchange Commission (SEC) in the late 1990s and early 2000s with allegations that those companies improperly recognized revenue, leading some of the companies to pay settlements and restate revenue. Those actions often roiled stock prices and market capitalizations.
In 2002, FASB and the IASB agreed to work jointly to clarify the principles for recognizing revenue and set out to write a set of common revenue standards to remove inconsistencies and weaknesses, improve comparability of revenue recognition practices, and to simplify the preparation of financial statements for companies. That process has culminated in the new rules, which are now being subject to a commentary period before their adoption.
After years of deliberation, FASB issued new guidance for revenue recognition on two highly controversial issues. FASB, under Accounting Standards Update (ASU) 2009-13, now allows companies to establish and even estimate selling prices for multiple-deliverable arrangements. Another new rule, ASU 2009-14, allows makers of computers, cell phones, and even cars to avoid special software revenue recognition accounting rules if the software included in the product was incidental or, conversely, essential to the product. Those companies can now estimate selling prices for software and recognize that over a different time period than hardware.
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Companies Impacted by the New Revenue Recognition Rules
The new rules are sometimes informally called the 'Apple rules' because Apple Computer was especially interested in the changes to the old guidance; some of the company's most successful products -- such as the iPhone -- involve the sale of both hardware and software updates that extend over a year. In the past, Apple had to defer recognizing some of the revenue from iPhone and Apple RV sales; it 'was required to account for sales of both iPhone and Apple TV using subscription accounting because the Company indicated it might from time to time provide future unspecified software upgrades and features for those products free of charge,' the company says in a press release. 'Under subscription accounting, revenue and associated product cost of sales for iPhone and Apple TV were deferred at the time of sale and recognized on a straight-line basis over each product's estimated economic life. This resulted in the deferral of significant amounts of revenue and cost of sales related to iPhone and Apple TV.'
Under the new rules, Apple can assign a value to the software to account for over time and book revenue faster for the hardware, meaning that if the company launches a successful new product it should, theoretically, drive up the company's earnings more immediately. Apple in January announced that it was retrospectively adopting the new accounting rules and revised its financial statements for each quarter dating back to 2007. 'The Company believes retrospective adoption provides analysts and investors the most comparable and useful financial information and better reflects the underlying performance of the Company's business,' Apple explains.
Other companies are also finding that they are impacted by the new rules. 'The rules involve multi-element revenue recognition for any company that may sell multiple items on a single sales order. For example, we would sell a subscription to our software service and professional services,' says Ron Gill, CFO of NetSuite, a company that sells accounting software on a software-as-a-service basis. 'The two items on the sales order may have different delivery timing.'
NetSuite was not only impacted by the new revenue recognition rules in its own business, but the software maker has developed a module to help companies implement the new revenue recognition rules. In its own business, NetSuite provides a subscription-based module for its software that customers pay on a monthly basis, meaning the company recognizes that revenue on a monthly basis. At the same time, NetSuite often provides customers with professional services to help them implement the new software module and integrate it with their existing financial systems. Those services are often provided within the first three months of a contract, but in the past NetSuite had to recognize that revenue over a 12-month period, as well, because it was often sold as a bundle with the subscription.
While many high-tech companies are impacted directly by the new rules, they can also apply to other types of businesses that sell products and services together. For example, stores such as Best Buy or Sears might sell refrigerators or washing machines along with a maintenance contract. Likewise, a consulting firm that sells multi-element arrangements -- advice and outsourcing services along with software -- might price their products in a way that causes the new revenue recognition rules to apply to that business, as well. In addition, an industrial equipment manufacturer might sell trash compactors along with a service contract or consulting services. In the latter case, the actual product might be delivered right after the contract is signed, but the service agreement may extend over the course of a year or more. In the past, if the product and service were bundled and sold together, oftentimes companies had to recognize the revenue for both over the term of the service contract.
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