Existing GAAP for software companies (SOP 97-2 or ASC 985) requires companies to defer revenue until all four criteria for revenue recognition have been met, and until fair value can be be established for any undelivered elements. Many technology companies, particularly software providers, are subject to this guidance.
The new revenue guidance ASC 606 will do away with these stringent standards, which often caused revenue recognition to be out-of-sync with the economic reality of sales transactions. You'll now be able to estimate aspects o revenue accounting, including fair value of promised goods and services as well as future variable consideration.
And so the question presents itself: will companies with a better grasp of their data be able to recognize more revenue earlier through better estimates?
Let’s take a look at the concept of variable consideration, which is a key aspect of Step 3: Determine the Transaction Price under the new model. From the opening summary of the new standard:
If the amount of consideration in a contract is variable, an entity should determine the amount to include in the transaction price by estimating either the expected value (that is, probability-weighted amount) or the most likely amount, depending on which method the entity expects to better predict the amount of consideration to which the entity will be entitled.
Companies may be able to begin recognizing revenue for promised goods or services that wouldn’t have met the delivery or the fees are fixed or determinable criteria under the existing standard.
But wait. There's an important caveat to variable consideration, which will potentially limit companies that don’t have a firm grasp on their historical contract data: the variable constraint.
The variable constraint concept will allow companies to only recognize revenue to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
Companies eager to pull forward revenue that would previously have been deferred under existing GAAP will need to be weary of the variable constraint when recognizing revenue from variable consideration.
Data will need to be aggregated and analyzed in ways that may not have been required in the past, as revenue can only be recognized to the extent you can support a significant adjustment is unlikely.
Ultimately, we believe in practice that companies will be required to estimate variable consideration, and the impact of the variable constraint will be based on external factors only. In other words, companies will be required to have supportable estimates, as opposed to being able to take a hit on upfront revenue in exchange for being able to delay implementation.
Do you have a plan in place for assessing the data you could be collecting now to support your revenue recognition down the road?