Author: Toby R. Leslie, CPA
In determining the potential value of early stage entities in the technology and bio-technology industry sectors, investors and other users of the financial statements often may not refer to traditional measurements such as Net Income or Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA). Rather these financial statement users may refer to other measurements such as “Run Rate” or Gross Revenues in measuring an entity’s progress and traction in the marketplace. Run Rates typically take the current revenues at a specific point in time and project those revenues over a specific time period (such as annually). This measurement is particularly useful when companies have had high growth within a reporting period.
Whether it’s the Run Rate or Gross Revenues, it is clear that these entities’ policies for how they record revenue is important. However, due to the complex nature of the contracts often associated with these industries, the recognition of revenue is one of the most misapplied areas of financial reporting. As an example, a July 2006 study conducted by the GAO revealed that 20.1% of all financial restatements for public issuers between July 2002 and September 2005 were related to revenue recognition (the number two reason for all restatements in that period). Some of the revenue recognition issues frequently encountered within the technology and bio- technology industry sectors include:
- Timing of revenue recognition – Contracts often contain nonrefundable upfront “implementation” fees. While the fees are nonrefundable, the accounting guidance typically does not allow revenue for upfront fees to be recognized immediately as the fees do not have “standalone” value. These fees must typically be combined with the compensation for services/products delivered and recognized over the same period as those services/products.
- Timing of cost recognition incurred on contracts – Often there are upfront costs incurred to execute a contract. If not appropriately applied, these costs may not match the expenses incurred with the related revenues. While the authoritative guidance for privately-held companies is relatively silent on the issue, the Securities and Exchange Commission (SEC) does provide some insight that is often used by those in both the public and private sectors. In a nutshell, the SEC staff believes that “incremental direct costs” incurred related to the acquisition or origination of a customer contract in a transaction that results in the deferral of revenue, shall be deferred and charged to expense in proportion to the revenue recognized. Some examples of these upfront costs could include commissions paid to salesmen, credit fee reports and cost of products incidental to the service provided.
- How much revenue to recognize – In some contracts there are multiple providers providing a service or product and compensation may be paid to both providers. In these arrangements a question arises as to who records the revenue and how much? Does the entity apply the “gross method” and record the entire amount of compensation as revenue, with a corresponding expense for compensation paid the other provider, or apply the “net method” and reduce revenues by the amount paid to the other provider? A variety of factors should be considered when analyzing these arrangements and the ultimate answer depends on the relevant facts and circumstances.
- Allocation of revenue – Contracts often obtain multiple elements within a single contract. When the timing of delivery of one of the services or products differs from the timing of delivery of another service or product, the revenues must be allocated to the separate units of accounting based upon their “relative selling price.” The methods used to determine relative selling price can be complex and subject to substantial judgment. In order to determine relative selling price, the selling price for each delivered item must be determined in the following manner:
- Vendor-specific objective evidence (VSOE) of selling price, if it exists. VSOE of selling price is limited to either: the price charged for a deliverable when it is sold separately; or for a deliverable not yet being sold separately, the price established by management having the relevant authority.
- If VSOE does not exist, third party evidence (TPE) of selling price. TPE is the price of the vendor’s or any competitor’s largely interchangeable products or services in standalone sales to similarly situated customers.
- If neither VSOE nor TPE exists, then use of best estimate of the selling price for that deliverable. The vendor’s best estimate of selling price should be consistent with the objective of determining VSOE of selling price for the deliverable; that is, the price at which the vendor would transact if the deliverable were sold by the vendor regularly on a standalone basis. The vendor should consider market conditions as well as entity-specific factors when estimating the selling price.
If you would like to learn more about any of the above issues, please contact one of the members of our Emerging Technology Industry Team and we would be glad to further discuss them with you. Our team of accounting and tax specialists has extensive experience in helping our clients navigate through their concerns in these areas related to revenue recognition.