Recurring revenue recognition: Channel grapples with cloud accounting complexity

Recurring revenue recognition is a sticky issue for cloud and managed services providers. Read up on the problems providers are facing.

How to make money is the channel's traditional financial challenge, but some partners face another quandary: how to count it.

Deciding when to record income as revenue -- the accounting task of revenue recognition -- was fairly straightforward in the traditional value-added reseller or independent software vendor (ISV) business model. The reseller sold some combination of hardware and software and realized revenue on shipping and delivery.

That tidy scenario is disappearing amid the growth of cloud services and other subscription-based recurring revenue models, such as managed services. One obvious difference: The cash doesn't arrive all at once, but incrementally over the months of a service agreement, and it must be recognized accordingly. But there are subtler considerations, such as when to record installation fees and other ancillary services surrounding a cloud-based offering.

Another wrinkle stems from companies with multi-threaded revenue streams. On any given customer engagement, an IT solutions provider may generate revenue through cloud services, managed services, and time-and-materials-based project work, as well as through traditional product reselling. It's up to a provider's accountants to unravel those streams and assign revenue to the proper buckets.

"I think the way people are bundling and selling their offerings and going to market is just more complex than the license-plus-maintenance model," said Chris Smith, a partner with PwC's Capital Markets and Accounting Advisory Services.

The situation calls for closer communication between the front-office staff, who devises and rolls out new service lines, and the back-office personnel, who have to keep track of the resulting sales. Revenue recognition may also call for a dose of IT support. Enterprise resource planning (ERP) software and specialized revenue recognition products can play a role here.

Cloud accounting

The cloud, in particular, complicates accounting matters. The revenue recognition job is particularly tricky for a company in transition, such as a traditional ISV migrating to an X as a Service business model. Smith said software companies evolving into cloud providers experience greater complexity from an accounting and reporting perspective.

The accounting becomes more complex as the relationship becomes more complex with the consumer.

Mark McCaffrey, Global Software Industry Leader, PwC

Channel companies must apply a different set of accounting rules to the new services they sell.

"Businesses that have not been in a recurring revenue environment ... are now having to support these regulations they haven't had to work with and probably aren't familiar with," said Kevin Roberts, general manager of platform and alliances for FinancialForce.com, which provides SaaS-based back-office software.

Guidance regarding revenue recognition comes from the Financial Accounting Standards Board (FASB), which establishes generally accepted accounting principles (GAAP) in the U.S., and the U.S. Securities and Exchange Commission. Roberts pointed to a few examples of rules that channel companies embarking on new service lines may not have previously encountered: AICPA Statement of Position 81-1 (now included under FASB Accounting Standards Codification Topic 105), the SEC's Staff Accounting Bulletin No. 101, and the FASB's Emerging Issues Task Force 00-21.

Smith said most of the U.S. GAAP rules regarding revenue recognition have been around for some time and are generally prescriptive. But organizations applying the rules need to exercise significant judgment, he said, noting that the rules were written before the emergence of today's business models.

One area for discernment: the installation services a cloud vendor provides when bringing on a customer. Smith used the analogy of a telecom provider's activation fee for a home phone service. The customer receives an upfront charge for activation and then pays a monthly fee for the ongoing phone services. Smith said the accounting view of such transactions is that the telecom company doesn't provide value when it essentially flicks a switch -- the customer doesn't receive any goods or services. So, the revenue from the activation fee isn't immediately recognized, but deferred over an estimated customer life or contract period, Smith explained.

In the case of the cloud, installation could involve consulting, implementation and configuration services. The question facing the cloud provider is whether the upfront installation service provides value to the customer without the ongoing cloud services.

"That is where it gets a little judgmental," Smith said. "Many companies have concluded that those services do offer standalone value and do recognize them as they are provided. In other cases, they conclude they are more like a setup fee where deferral is appropriate."

Multiple revenue sources

Multiple streams of income presents another revenue recognition complication.

"We are seeing more companies go to these multi-threaded revenue models," said Tom Brennan, vice president of product marketing at FinancialForce.

He noted that such companies could end up with four or five line items of revenue behavior in one transaction. With the time-and-materials component, revenue might be recognized at particular project milestones. Revenue from the product-reselling element would be realized on delivery. Various subscriptions would represent deferred revenue.

"The accounting becomes more complex as the relationship becomes more complex with the consumer," said Mark McCaffrey, global software industry leader at PwC and partner in the company's technology practice.

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The accountants must figure out how the multiple-element arrangement impacts revenue recognition, he added.

The accounting department may tap automation to help with the complexities of revenue recognition. ERP systems may be tweaked for this purpose. Some organizations handle revenue recognition via spreadsheet, while software specifically built for revenue recognition provides another option.

FinancialForce, which offers applications built on the Salesforce platform, introduced in November its Revenue Recognition offering. The cloud-based application applies different recognition calculation rules to each line item in a multiple-element transaction. The software links to revenue recognition source data, such as an opportunity housed in Salesforce, a FinancialForce Professional Services Automation (PSA) timecard, or a FinancialForce Accounting invoice, for instance.

Roberts said the revenue recognition system provides a stronger audit trail than spreadsheets. But, he said once revenue transaction data is exported into a spreadsheet or to a separate database, it becomes difficult to get it back to the original source.

Professional services firms and resellers are using the revenue recognition product, Roberts said. Companies already using FinancialForce PSA have been the early adopters.

Other considerations

Channel partners moving to the cloud or managed services have other financial issues to contend with beyond revenue recognition.

McCaffrey pointed to two areas in particular: pricing and billing. He said cloud providers are struggling to understand what customers are willing to pay for a monthly subscription and how to price their offerings for profitability. As for billing, cloud providers are exploring methods for consumption-based billing. In the cloud, companies also must deal with the shift from high-dollar-value, low-volume transactions to a world of low-dollar-value, high-volume transactions. That change will affect a company's IT infrastructure and go-to-market strategy, McCaffrey added.

Aria Systems offers software that aims to help cloud services providers -- and other customers -- manage subscription-based billing and recurring revenue. The company counts cloud provider Verizon Terremark among its clients.

Brendan O'Brien, co-founder of Aria, said his company targets large enterprises grappling with the billing complexity of consumption-based models.

This was first published in February 2014

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