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May 6, 2016

Revenue Recognition for Multiple Element Arrangements....

Revenue recognition for Multiple Element Arrangements, also known as Bundled Sales or contracts, is a hot issue for CFOs these days. At the heart of the issue is how you standardize the revenue recognition across multiple contracts.

Let us take an example. Assume that you, ABC Incorporated,  are signing contracts with two different customers for selling Hardware, Software License,  Implementation Consulting Services and PCS . The total contract value is the same in both cases, $10 Million. However the breakup of charges for each element vary across the customers.

The price breakup in the contracts is as follows:

Your normal practice is to recognize revenue for Hardware and Software at the contract value as soon as you bill the customer. So you recognize $8.5 Million on signing contract with Customer A and $6 Million on signing contract with Customer B.

Now the following questions arise? What is the correct value? How can you standardize the revenue from the same element across contract? How do you standardize the revenue recognition process across different customers in the same Company? If you are the body that sets accounting standards, your challenge will be how to standardize the revenue recognition process across the industries with similar business processes so that investors can make an informed choice?

This is where the new accounting standard come in. They aim to establish standardization in revenue recognition by prescribing the process by which an Organization can calculate Fair Market Value (FMV) of each element in the contract. FMV is calculated based on the data from standalone sales pooles. Once FMV is calculated, the next step is to use the calculated FMV to create revenue adjustments for each Multiple Element Arrangement (MEA, loosely can be called a 'Contract')

Here is a high level  flow diagram of the entire process.

Once the transactions from standalone systems are integrated into your revenue management system (I am assuming you have one, at least a manual system) the first step is to identify the FMV of each of the elements in a Contract. Once you know the FMV, it is easy to standardize the revenue recognition.

That is where the evolving revenue recognition standards being discussed by various accounting standard bodies, like IFRS, FASB and AICPA comes into picture. These bodies have come out with extensive criteria on how to identify FMV.

The widely discussed FMV method is VSOE, expanded as Vendor Specific Objective Evidence. In this method of calculating FMV, the Organization looks at Standalone sales of each element in the contract and try to identify a narrow band within which the FMV Calculation Criteria (Discount %, Unit Price etc) falls and fix the VSOE as a value anywhere within the band, of course, ensuring consistency of the criteria across contracts and across periods.

What if sufficient standalone sales are not available? What if it is a new product being brought into market for the first time by the Organization? In this case the standards are flexible. If similar products / services are being sold in the market by one or more competitors, the Organization could use that value as the FMV for their product / service. This approach of calculating FMV is called TPE, expanded as Third Party Evidence. If your product is totally new to the market and both VSOE and TPE do not exist, then you can fix your own FMV, after following a rigorous approval process. This approach is called ESP, expanded as Estimated Selling Price. Both TPE and ESP are estimations. Caveats while using estimated FMV? One, you should have  back up calculations to support your estimations and two, you should quickly move to VSOE as soon as you build up enough standalone sales pools history for your product / service.

The priority of using FMV in the case is VSOE, followed by TPE, finally followed by ESP.

'Sales Pool Stratification' is a very important aspect to consider while identifying the Fair Market Value. You may have different FMV for Quantity (you may be giving quantity discount), different FMV based on Sales Value (different discounts if the contract value is less than 1 Million, between 1 Million to 5 Million, 5 Million to 50 Million etc) or different FMV for the type of customers like Commercial, Individual, Educational Institutions, Government etc or different FMVs for different Geographies.

So you fix (the technical word is 'Establish') the Fair Market Value for each combination of Element - Currency - Sales pool strata

Having fixed your FMV, you now move on to the second step, that of identifying the MEA where this FMV may be applicable. If you are running on ERP, each element in the above contract will be entered in different applications including your billing system, contract management system, order entry systems  etc. You have to use common criteria like Sales Agreement Number or Customer Purchase Order Number to group all these disparate transactions into individual MEAs. Each MEA may contain different elements with their own 'Performance Obligations'.

The third step is to create revenue adjustments to these contracts so that the the revenue recognition can be as per the new norms. Why revenue adjustments? When you entered your transactions in the billing system, you would already have accounted for the revenue as per your normal process. Now that the individual transactions are grouped into MEA, you have to create revenue adjustments like 'Carve-out' or 'Carve-in' to allocate the revenue across different elements in the contract as per the new norms.

Fourth step is Revenue Recognition. This is where the system recognizes the revenue for each element in the contract and generates accounting events / accounting entries to create the appropriate revenue adjustments. As a part of this revenue recognition, it is also required to do COGS recognition so that the COGS match with the revenue.

The fifth and final step is to post the accounting entries to GL and report your financial numbers to the investing community.

Organizational Challenges
Some of the challenges that the organization will face are:

1. Mismatch between Revenue and Billing leading to inadequate representation of period activities. The new standards has an effect of deferring current period revenue to future periods and this could create mismatch between business activity (winning new contract) and the appropriate revenue recognition. To that extent you may have to understate your revenue. On the other hand, since the deferred revenue from the contracts in the past periods is recognized in the current period, Organization could show revenue even without any business activity in the current period. So both understatement and overstatement of revenue is possible.

2. Mismatch between cash flow and revenue. Logic is the same as above.

3. Manual calculation of VSOE is next to impossible. With huge number of standalone sales pools, with contract spread across different geographies, with contracts containing different types of discounts etc, manual calculation and recalculation of FMV is challenging.

4. Grouping transactions lying in different subsystems to MEAs with multiple performance obligations is a difficult task if handled manually. Challenge start with identifying the applicable transactions. Remember these transactions will be grouped into MEA and hence should not be used in VSOE calculations !. Separating standalone transactions in source systems into those that can be used to create FMV and those that will be grouped into MEA is a huge challenge to do manually.

5. Creating Manual Adjustments for Carve-out and Carve-in for each MEA can be challenging.

6. Finally simulating the entire cycle above multiple times till you reach an acceptable VSOE, Revenue Recognition and Financial Numbers is impossible to do manually and if done manually can be error-prone and lead to adverse audit comments.

Features to look for in a Revenue Compliance Application
The upshot of all these challenges is that you will require systems capable of handling all the above challenges. What could be the top ten features any revenue compliance and management system should have?

1. The system should be integration friendly. Since the revenue management system has to integrate with third party billing, contract management and order management system it should have simple, user friendly inbound integration interface. Best will be to have an easy Excel integration.

2. System should be capable of separating standalone sales and contracts.

3. Automatic calculation and recalculation of VSOE for each element-currency-Sales pool strata combination using data from stand alone sales pools

4. Audit facility. Ability to track manual interventions

5. Facility to establish, approve, cancel approval and re-establish VSOE

6. Ability to handle different types of FMV including TPE and ESP

7. Ability to automatically identify MEA and Performance Obligations.

8. Ability to approve and create automatic and manual revenue adjustments to MEA

9. Outbound Integration with GL Applications. Either automatic integration with internal GL System or flexibility to deliver Output datafile in different formats like .CSV, .TXT, .XLSX, .DAT etc.

10. Finally, extensive reporting capabilities including in-built reconciliation reports between Billing Data, Revenue Adjustment Data and Accounting Data. Additionally, the system should also allow user to create Ad-hoc reports on the fly.

The new revenue compliance and recognition standards which are expected to be effective from 1st January, 2018, introduces a number of challenges for the CFO in identifying and using Fair Market Values for contract revenue recognition. The objective of this article  is to provide an overview of the upcoming changes (they have been in use from 1997, in that sense they are not 'upcoming') and their implications to an organization from the financial reporting perspective. There are systems out there which can help the CFO to automate the revenue compliance and accounting process. I conclude this article by identifying some of the features that should be considered while procuring a revenue management system to support your revenue compliance requirements

In May 2014, FASB and IFRS has made a number of modifications to the revenue recognition standards. They have come up with a converged standard FASB through ASC 606 and IASB through IFRS15. Some of the key aspects of the above note has been discarded. For example, VSOE no longer exist. MEAs in above have been replaced with 'Contracts' and the definition of 'Contracts' have been enlarged to incorporate more elements, both explicit and implicit. Revenue recognition accounting has undergone significant changes. Revenue Carve Out accounting is no longer applicable for example. This has been replaced by 'Contract Assets' and 'Contract Liabilities'. Organizations are supposed to identify the 'Transaction Price' at the inception of contract and are supposed to report any changes in the transaction price during every quarterly reporting. These are some of the changes. I will post an updated post sometime later.

About me: I am an ERP professional who has done some work on the new Revenue Compliance process and challenges. If you need more information, you can contact me in twitter @vkrama01 or by email Since you are reading this post in LinkedIn, why don't you message me here itself?


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