Revenue Recognition in Technology Companies
Recognising revenue is one of the financial reporting challenges unique to companies in the technology sector. Most will report under FRS 102, which is the main focus of our analysis here. This standard lays down general principles but lacks guidance for many multiple-element revenue contracts, such as those where hardware is bundled with software and other support services and the nature of SaaS projects.
Software licences
One key distinction is often whether software provides access to software as it is at a point in time or gives a subscription to further updates. Even where the licence only runs for a fixed period of time, if the act is simply providing a licence key for that period, then revenue may be recognised up front, whilst ongoing improvements would indicate it needs to be recognised over time instead. Often, fees for the subscription are provided upfront, meaning that such businesses can end up with a very substantial deferred revenue balance.
Enhancements
An off-the-shelf product may be recognised up front, but improvements are likely to be charged separately and recognised as that service is provided. Where the two are bundled together into a single fee, this can create problems with the proportionate split of value and when each should be recognised.
Hardware with embedded software
A common arrangement is for companies to provide a piece of hardware with software installed and additional services such as upgrades, locked functionality, warranty, and support for a fixed up-front or monthly fee.
It is rare that such an arrangement would be recognised upfront. Instead, several elements may be involved that require the separation into performance obligations, such as the sale of hardware, the provision of software, and other features, all recognised at different points. This can be extremely complex to determine the correct values for and creates significant challenges for financial reporting and the audit process.
The problem
With all of this, the difference between cash flow and revenue recognition has the potential to be stark. This can cause issues with aspects such as understanding of the linkage, creating large liabilities on the balance sheet for deferred revenues, and how to value a business for an exit. For example, technology businesses may struggle with some grant funding where net assets or liabilities are a test of eligibility simply because deferred revenue can skew the balance sheet.
Case study – vehicle management
One recent example of the pitfalls was a company that came to us for help with revenue recognition after becoming uncertain of their recognition policy. The business sold small hardware pieces with its software embedded into them on fixed licence periods. The business had always accounted for this when sold (i.e., on a cash basis), but the contractual terms suggested this should be spread.
We agreed that there was no justification for a point in time. However, the business had been sold in the previous year, its value set on the old policy, and significant shareholder transactions entered into on the basis of the company having retained profits. These no longer existed when revenue was deferred, meaning multiple transactions had been entered contrary to company law rules.
The benefit
Not only does getting all of this right avoid such issues and help with the audit process, but it can also defer the point at which corporation tax is paid on the cash received. Sales are typically taxed when they are recognised in the P&L, so in some scenarios, getting this right can provide a positive cash flow benefit.
Our team of specialists can support revenue recognition projects. For more information, contact Chris Neale or Alex Hird.
This information is provided in general terms, and, as highlighted, there is significant potential complexity. You should seek advice appropriate to your circumstances. No liability is accepted for any actions taken or not taken from any party’s use of this publication.
