Revenue Regulatory Compliance Considerations inBusiness Software Implementation

by Bob Scarborough & Jeffrey Werner

INTRODUCTION

Technology companies often have complex regulatory compliance andbusiness process issues related to revenue recognition. Given theimportance of accurate and credible revenue, many companies use acombination of business process steps and software solutions to helpconsistently and accurately recognize revenue. The purpose of this paperis to discuss important considerations for your business process andsoftware deployment to most effectively recognize revenue.

This paper starts with an overview of revenue for technology companies,proposes a framework to organize your needed company processes,considers process change requirements for revenue recognition, andthen proposes important considerations when you implement any softwaresolution for revenue recognition.

REVENUE OVERVIEW

The credibility of the revenue component is probably the most importantaspect of a technology company’s financial reports. A company’s systemsand procedures for recognizing revenue are of critical importance and theyneed to be carefully evaluated and examined. Accurate revenue recognitionis key to managing and growing a company as well as providing visibleintegrity to investors, lenders, and customers.

There are some basic concepts that revenue recognition rules attempt tofollow. Revenue should be recognized when it is earned and realizable.To help define when these two premises have been met, four guide pointshave been established. To recognize revenue, a company needs to have:

1) Evidence of an arrangement

2) Fees need to be fixed and determinable

3) Fees need to be collectable

4) Delivery or performance must have occurred

Tensoft specializes in innovative,

end-to-end ERP solutions,

including complex revenue, billing

and contract management.

Revenue Regulatory Compliance Considerations 2

“The credibility of the revenue

component is probably the most

important aspect of a technology

company’s financial reports. A

company’s systems and procedures

for recognizing revenue are of

critical importance and they need

to be carefully evaluated and

examined. Accurate revenue

recognition is key to managing

and growing a company as well

as providing visible integrity to

investors, lenders, and customers.”

Technology company revenue recognition is a complex and difficult areaof accounting, with numerous, seemingly arbitrary rules and regulationsto follow. In addition, revenue recognition rules are continually evolvingand changing. New business models continue to emerge and difficult-to-account-for situations arise. Given this environment, it is no wonderthat technology companies find revenue recognition rules complex andchallenging to support.

Since revenue recognition rules are constantly evolving, companyaccounting systems and business processes need to continually beupdated to meet these new challenges. For example, when softwarebegan to be sold separately in the early 1990s, some companiesrecognized revenue on a cash basis, even if they hadn’t written a lineof the program code! More recently, the revenue recognition rules formultiple element arrangements at non-software technology companieschanged significantly. Accounting and ERP systems are still struggling tocatch up to these new requirements.

Failure to keep up with the new rules or adequately follow existing rulescan be financially devastating – potentially causing financial restatements,SEC actions and legal problems. Inadequate reporting, poor visibility andmisunderstood revenue recognition rules can also hinder managementdecision-making as well as negatively affect the company’s bottom-line.

A FRAMEWORK FOR REVENUE RECOGNITIONNEEDS ANALYSIS

Complex regulatory requirements, combined with the challenging businessmodels of the technology industry, can tax even the most flexible minds.Given this fact, it is helpful to have a framework to analyze your companyrevenue processes. Categorizing and organizing the company’s businessneeds will better prepare you to build the processes and systems requiredfor accurate revenue recognition.

The framework we recommend organizes the requirements into threedistinct categories. These categories are based on the overall revenueprocess model which consists of: determining the revenue model, applyingthe revenue model to sales that occur, and recognizing revenue based onthe revenue recognition concepts:

Revenue Regulatory Compliance Considerations 3

“The framework we recommend

organizes the requirements into

three distinct categories. These

categories are based on the overall

revenue process model which

consists of: determining the revenue

model, applying the revenue model

to sales that occur, and recognizing

revenue based on the revenue

recognition concepts.”

1) Determination. Effective revenue processes start by identifying theappropriate compliance regulations and the revenue rules for the productssold based on these concepts. For many technology companies, anindependent analysis and valuation of the items sold in multi-elementmodels is also necessary. Determination is usually completed annuallyfor private companies and quarterly for public companies, and may bemonitored during the year.

2) Application. The determination occurs in a static environment.However it is only useful if the determined revenue rules and valuesare applied to real company transactions as they occur. Applicationunderstands your sales model (how sales occur) and the transactionsthat are created to which the determined revenue rules are appliedand automates the consistent processing of the revenue.

3) Recognition. If you have applied the revenue rules and policy to theappropriate sales transactions as they occur, revenue recognitionbecomes much more streamlined. Validation of sub-ledgers andmanual review of special case or exception rules is also required.

Establishing the fair value of a single element within a multi-element saleis a Determination need. Ensuring a consistent approach to revenuerecognition based upon company policy and compliance requirementsis an Application need. Our experience shows that addressing therequirements becomes significantly more manageable once the proposedframework is applied.

The best starting point is a solid, documented understanding of the company’sgo-to-market model(s). By go-to-market we mean the combination ofchannels, sales efforts, and customer actions that result in sales. This typeof process, analysis and thinking may not be standard in many financialorganizations, but it is critical when thinking about how to best manageand implement the required business processes and systems.

Revenue Regulatory Compliance Considerations 4

“This process requires a team

approach, with sales, management,

order fulfillment, development,

marketing and finance working

together. Communication is

critical to keep all team members

informed and productively working

to resolve business and revenue

recognition issues.”

INCORPORATING REVENUE RECOGNITION INTOYOUR ORGANIZATION

So far, we have gained an understanding of the general nature of revenuerecognition. We’ve also looked at internal processes and needs andorganized them around a framework for analysis and application. Wenow need to look at incorporating and adapting this information to yourspecific company.

There are different revenue recognition methods depending on the type ofbusiness, the nature of its transactions, the company’s sophistication andits ability to perform certain accounting procedures. The choices of revenuerecognition will depend upon the company’s ability to produce dependableand reliable information to use in the revenue recognition process. Often,a company can choose more favorable accounting treatments based onits ability to make estimates, utilizing its history of past transactions andbusiness practices.

Revenue rules are guidelines that offer some interpretation and applicationflexibility to your company. It is important to align the accounting andrevenue recognition methodologies to the company’s business style andobjectives. If a company wants to emphasize upfront revenue recognitionfor delivered elements in multiple-element arrangements, it is important tohave the data and discipline to establish VSOE (Vendor Specific ObjectiveEvidence) or the value of elements when sold separately to value elementswhen sold together. If a company is involved with large service- orconstruction-type transactions, accounting must be able to estimate costsand outcomes in order to recognize revenue on a percentage basis as thework proceeds, rather than waiting until the project is completed.

Business objectives, company imperatives, and regulatory requirementshelp to determine what will be needed to support independent (determined)element values and how you plan to recognize revenue. They alsoincorporate the company’s business model into the analysis and reviewprocess, so you can match systems and business processes to yourcompany’s needs.

This process requires a team approach, with sales, management, orderfulfillment, development, marketing and finance working together.Communication is critical to keep all team members informed andproductively working to resolve business and revenue recognition issues.

Revenue Regulatory Compliance Considerations 5

Teams can craft a fast-track or devise a standard approach to transactionsthat can easily comply with revenue recognition requirements. Unusual orcomplex transactions will require a review process to develop the bestbusiness and revenue approach before negotiating or signing contractswith customers. Decisions can be made in advance with the revenuerecognition options and consequences in mind, rather than after-the-fact.

Data collection and retention systems (financial, ERP, CRM, and documentmanagement) can facilitate the flow of information to support a company’srevenue processes. They can also substantiate and implement processesonce these processes are determined. So it is important that IT andaccounting systems are able to collect, distribute and analyze transactioninformation to maximize business and revenue recognition goals.

INCORPORATING REVENUE RECOGNITIONINTO SYSTEMS

A complete understanding of a company’s revenue recognition goals,go-to-market models, and regulatory compliance needs is an excellentbase for approaching system implementation. With this information inhand, we can now use the previously proposed framework to analyze andorganize our approach to implementing business software which supportsthe revenue recognition process.

Beginning with the determination requirement, one should know whatinformation is required to support your determination needs. For example,as previously mentioned, if VSOE value determination is required for someelements, you need to make sure you are collecting the informationfor those elements clearly and apart from other sales elements. Mostcompanies start with the need for SKUs to identify products. Whatadditional information is needed about every SKU to support yourdetermination? What about the transaction type and customer category?Defining and answering the required questions will help define your solutionsetup needs. It is important to group products and services by type,transaction timing and contractual terms.

Determination, or establishing the independent value of your elementsin multi-element sales arrangements, is an often an annual process forprivate companies and quarterly process for public companies. Once thevalue for your elements is set, you need to apply these values, along with

“A complete understanding of a

company’s revenue recognition

goals, go-to-market models, and

regulatory compliance needs is an

excellent base for approaching

system implementation.”

Revenue Regulatory Compliance Considerations 6

the appropriate regulatory requirements, to the appropriate transactions forrevenue recognition. The residual method (SOP 97-2) or the relative sellingprice method (EITF 08-01) requires specific approaches to applying thetransaction face value to the individual elements of a sale.

Application and recognition are where the bulk of your system’s supportresides. Successfully deploying a system to automatically support both ofthese needs offers numerous benefits: from streamlined auditability, toimproved confidence in your revenue numbers, enhanced productivity foryour financial team, and improved valuation of your organization throughsubstantiated revenue numbers.

Application, or the consistent use of your determined revenue policy totransactions that occur requires a combination of business process andsystems support. Straightforward revenue recognition policies (sales =revenue) require little effort here. Multiple element sales, along with theimpact of other rules that define when revenue is earned and realizable,create more complex application needs. There are also issues of revenueallocation and recognition when the elements in a sale are delivered atdifferent times. Ideally your business software will support the variety ofscenarios that your company requires. At a minimum you will need tomake sure that sales transactions are captured and processed in a mannerthat supports application (and determination) analysis.

Recognition of revenue, after analysis and implementation of the precedingsteps, often appears to be easy. This is often a misleading perception for anumber of reasons:

Reason #1 is the need for transaction auditability and traceability. Theideal scenario should be a direct flow from the sales transaction throughthe policy application to the deferred and recognized revenue ledgers.

Reason #2 is the need for consistency and simplicity in the revenuerecognition process. Even the simplest multiple-element revenuerecognition becomes complex when you add substantial transactionvolume. Complex go-to-market models and customer transaction modelsdefinitely benefit from a consistent, repeatable approach to revenue.

Reason #3 is visibility – for financial reporting, for forecasting and fordetailed sales and customer analytics. Extracting the requirements forconsistent and repeatable revenue journals, traceability, and visibility willhelp to complete the requirements set needed for your company.

“Even the simplest multiple-element

revenue recognition becomes

complex when you add substantial

transaction volume. Complex

go-to-market models and customer

transaction models definitely benefit

from a consistent, repeatable

approach to revenue.”

Revenue Regulatory Compliance Considerations 7

CONCLUSIONS

In this paper we looked at revenue recognition and the factors that impactrevenue. We proposed a framework for organizing and understanding therevenue recognition requirements in your company. We discussed applyingcompliance and revenue goals to your company’s specific policies andapproach. Finally we looked at how all of these tools can be combined tohelp you select a business software solution that most effectively meetsyour business’s ongoing needs.

Revenue recognition for technology companies is complex and ever-changing.Pressures for speed and resolution are often at odds with the analysis,visibility and accuracy required for legal compliance and corporate integrity.But done logically, and supported by intelligent business systems, efficientand effective revenue recognition can do much to improve a company’s topand bottom lines.

Tensoft President and CEO, Bob Scarborough provides leadership for thecompany’s strategic direction and day-to-day operations. His background includesroles in software solution product marketing, business development, businessprocess automation and project implementation. He has managed over 200business software solutions and designed a number of highly sophisticated customand out-of-the-box software applications.

Before co-founding Tensoft, Bob was the Vice President for West Coast Operationsof Deltek Systems (PROJ). He established Deltek's first successful California fieldoffice, growing regional revenue over 500% in five years. Prior to that, Bob wasthe CFO of a Washington, D.C. consulting organization. He holds a BS in Financefrom the University of Maryland, and an Executive MBA from the Anderson Schoolat UCLA.

Jeffrey Werner is an acknowledged expert in the area of software revenuerecognition. He’s been providing revenue recognition consulting services to softwareand high tech companies since 2001. Earlier, he was the CFO for Antrim DesignSystems, a Silicon Valley mixed-signal synthesis company. He also served as V.P.of finance for TelePost, a Web-based communications services company andspent 11 years as a senior manager at the KPMG Silicon Valley office. He regularlyteaches software revenue recognition classes in the San Francisco Bay Areaand has over 15 years of experience helping companies comply with revenuerecognition regulations through sound policies and best-practices.

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