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Revenue Regulatory Compliance Considerations in Business Software Implementation

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by Bob Scarborough & Jeffrey Werner

INTRODUCTION

Technology companies often have complex regulatory compliance and business process issues related to revenue recognition. Given the importance of accurate and credible revenue, many companies use a combination of business process steps and software solutions to help consistently and accurately recognize revenue. The purpose of this paper is to discuss important considerations for your business process and software 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, and then proposes important considerations when you implement any software solution for revenue recognition.

REVENUE OVERVIEW

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.

There are some basic concepts that revenue recognition rules attempt to follow. Revenue should be recognized when it is earned and realizable. To help define when these two premises have been met, four guide points have 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

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“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 area of accounting, with numerous, seemingly arbitrary rules and regulations to follow. In addition, revenue recognition rules are continually evolving and changing. New business models continue to emerge and difficult-to-account-for situations arise. Given this environment, it is no wonder that technology companies find revenue recognition rules complex and challenging to support.

Since revenue recognition rules are constantly evolving, company accounting systems and business processes need to continually be updated to meet these new challenges. For example, when software began to be sold separately in the early 1990s, some companies recognized revenue on a cash basis, even if they hadn’t written a line of the program code! More recently, the revenue recognition rules for multiple element arrangements at non-software technology companies changed significantly. Accounting and ERP systems are still struggling to catch up to these new requirements.

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

A FRAMEWORK FOR REVENUE RECOGNITION

NEEDS ANALYSIS

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

The framework we recommend organizes the requirements into three distinct categories. These categories are based on the overall revenue process model which consists of:determiningthe revenue model,applying

the revenue model to sales that occur, andrecognizingrevenue based on the revenue recognition concepts:

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“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 the appropriate compliance regulations and the revenue rules for the products sold based on these concepts. For many technology companies, an independent analysis and valuation of the items sold in multi-element models is also necessary. Determination is usually completed annually for private companies and quarterly for public companies, and may be monitored during the year.

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

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

Establishing the fair value of a single element within a multi-element sale is a Determination need. Ensuring a consistent approach to revenue recognition based upon company policy and compliance requirements is an Application need. Our experience shows that addressing the requirements becomes significantly more manageable once the proposed framework is applied.

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

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“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 INTO

YOUR ORGANIZATION

So far, we have gained an understanding of the general nature of revenue recognition. We’ve also looked at internal processes and needs and organized them around a framework for analysis and application. We now need to look at incorporating and adapting this information to your specific company.

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

Revenue rules are guidelines that offer some interpretation and application flexibility to your company. It is important to align the accounting and revenue recognition methodologies to the company’s business style and objectives. If a company wants to emphasize upfront revenue recognition for delivered elements in multiple-element arrangements, it is important to have the data and discipline to establish VSOE (Vendor Specific Objective Evidence) or the value of elements when sold separately to value elements when sold together. If a company is involved with large service- or

construction-type transactions, accounting must be able to estimate costs and outcomes in order to recognize revenue on a percentage basis as the work proceeds, rather than waiting until the project is completed.

Business objectives, company imperatives, and regulatory requirements help to determine what will be needed to support independent (determined) element values and how you plan to recognize revenue. They also

incorporate the company’s business model into the analysis and review process, so you can match systems and business processes to your company’s needs.

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.

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

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

INCORPORATING REVENUE RECOGNITION

INTO SYSTEMS

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. With this information in hand, we can now use the previously proposed framework to analyze and organize our approach to implementing business software which supports the revenue recognition process.

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

Determination, or establishing the independent value of your elements in multi-element sales arrangements, is an often an annual process for private companies and quarterly process for public companies. Once the value 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.”

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

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

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

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

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

Reason #2 is the need for consistency and simplicity in the revenue recognition process. 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.

Reason #3 is visibility – for financial reporting, for forecasting and for detailed sales and customer analytics. Extracting the requirements for consistent and repeatable revenue journals, traceability, and visibility will help 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

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CONCLUSIONS

In this paper we looked at revenue recognition and the factors that impact revenue. We proposed a framework for organizing and understanding the revenue recognition requirements in your company. We discussed applying compliance and revenue goals to your company’s specific policies and approach. Finally we looked at how all of these tools can be combined to help you select a business software solution that most effectively meets your 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, efficient and effective revenue recognition can do much to improve a company’s top and bottom lines.

Tensoft President and CEO,Bob Scarboroughprovides leadership for the company’s strategic direction and day-to-day operations. His background includes roles in software solution product marketing, business development, business process automation and project implementation. He has managed over 200 business software solutions and designed a number of highly sophisticated custom and out-of-the-box software applications.

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

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

FOR MORE

INFORMATION

CONTACT TENSOFT: 2121-B Ringwood Ave. San Jose, CA 95131

www.tensoft.com

E-mail: solutions@tensoft.com Telephone: (888) 450-4030

© 2011 Tensoft, Inc. All rights reserved. Tensoft is a trademark of Tensoft, Inc. The names of actual companies and products mentioned herein may be the trademarks of their respective owners.

This document is for informational purposes only. TENSOFT INC. MAKES NO WARRANTIES, EXPRESS OR IMPLIED, IN THIS SUMMARY.

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