Revenue Recognition Issues in a Digital Economy

By Eugene F. DeMark

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Many traditional business models have been modified or discarded in the face of technological advances. New business models also raise significant accounting questions concerning revenue recognition, or determining the proper time to book a sale and its related expenses.

Many cases are simple: Revenue is recognized when the goods are delivered or the services are performed. But the issue often gets more complicated, particularly in the high-tech sector, because of a practice called “bundling,” which occurs when a company packages a principal product (e.g., a cellphone or satellite dish) with ancillary products or ongoing services (e.g., providing the wireless service or maintaining a signal to the dish receiver).

Bundling not only augments revenues but also extends the contract between the company and its customers beyond the traditional point of sale. This leads to an accounting issue: If a business bundles multiple revenue-generating activities into a single transaction, when is it appropriate to account for the entire arrangement as a single transaction (and recognize the revenue in the period of the initial sale), and when is it necessary to unbundle the transaction into individual elements (the delivery of a product, service, or other right to use assets) for revenue recognition purposes, possibly deferring all or a portion of the revenue (and associated expenses) to future periods?

Identifying individual products or services in multiple-element arrangements can be complicated. For example, some Internet portal companies provide electronic storefronts for their customers on a network of websites in exchange for a monthly fee. This appears to be a single element but such companies often deliver a variety of services to their customers over an extended period of time, including designing and setting up the original website, managing data and content, and performing fulfillment and order processing.

The facts and circumstances of each arrangement must be analyzed to determine if these ancillary services constitute separate elements that may call for separate accounting. This subject is being considered by FASB’s Emerging Issues Task Force (EITF). In the absence of a FASB pronouncement, the SEC has indicated that it would not object to an accounting treatment for multiple-element arrangements that includes the following conditions:

  • To be considered a separate element, the deliverable must represent a separate earnings process. In general, this is indicated by the vendor’s ability to sell the element by itself. For example, while a health club may charge a separate fee for membership initiation, a customer will typically pay that fee only in connection with the right to use the club on an ongoing basis. In this case, the health club’s initiation fee would likely not be considered a separate element.
  • Revenue must be allocated among the elements based upon their fair value. Fair value should be reliable, verifiable, and objectively determinable. The evidence, however, generally does not have to meet the standards of “vendor-specific” objective evidence (which require the company to sell each element on a stand-alone basis to establish fair value of the individual elements) unless the transaction includes the sale or license of software. Therefore, in nonsoftware transactions, a company may allocate fees to elements based on other information, such as competitor prices for similar products or renewal prices for services.
  • If an undelivered element is essential to the functionality of a delivered element, no revenue can be recognized until the essential element is also delivered. The following indicators suggest that one element is essential to the functionality of another: the undelivered element is available only from the company and may not be purchased from a third party; the customer’s requirement to pay under the arrangement coincides with the delivery of all the elements, or with the delivery of the last element; and the customer’s ability to use a delivered element depends upon, or is significantly affected by, the delivery of another element. Consider, for example, an enterprise software package (license) that a customer purchases along with implementation services. Although the customer may regard the implementation services as an essential element, they may still be accounted for separately from the software package, if the implementation services are easily obtainable from a third party and if the obligation to pay for the software license does not depend upon the seller providing the implementation services.

Eugene F. DeMark, CPA, is the northeast partner in charge of KPMG’s information communications and entertainment. He is located in the firm’s New York City office.




















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