Call to Action for Service Organizations: BIG Changes in Revenue Recognition Rules

If “VSOE” and 97-2 mean nothing to you, you may believe that revenue recognition is a topic that simply doesn’t impact you as a technology services manager. Well, based on what I heard this week In Dallas at a TSIA roundtable on VSOE, there are SIGNIFICANT changes coming in the revenue recognition guidelines provided by FASB. And, at first glance, service managers better quickly get their arms around the impact of these pending changes.

For example: The new revenue recognition guidelines will remove the requirement for establishing vendor specific evidence for the service elements of multi-element deals to prevent product revenues from being deferred until all services are delivered. (Yes, you just read this correctly).

Recap: Navigating 97-2

Way back in 2006, I chaired a TSIA task force on the topic of revenue recognition.  The service executives and finance managers involved in the effort were having the following frustrations regarding the application of revenue recognition guidelines:

  1. PS Management and Accounting not speaking the same language.
  2. The negative impact of revenue recognition policies on PS revenues, margins, and profits is not well documented.
  3. PS organizations are struggling with defining and defending fair market values for their services.
  4. Sales reps are not aggressively positioning PS offerings because they do not want to jeopardize produce revenue recognition.

In response to these frustrations, we established a task force composed of service executives and finance experts. The task force wanted to publish guidance on three challenges being faced by embedded PS organizations:

  1. Where should PS establish VSOE? PS organizations often have several offerings. Some of these offerings are more conducive to establishing VSOE than others.
    • Daily project rates
    • Daily offshore rates
    • Staff augmentation rates
    • Standard, fixed price offerings
    • Fixed bid custom project
  2. When Is VSOE the right option for a product company? For some companies, simply using fair value may work fine. What are the critical drivers that incent a product company to establish VSOE for service offerings?
  3. What tactics simplify the process for establishing VSOE on offerings on a global basis? By aligning to the best practices currently being used by member companies, the guidelines will be designed to minimize the risk of negatively impacting corporate product and service revenues as well as service margins.

The work from this task force culminated in the publication of two papers. The last paper was titled Navigating 97-2. It provided guidance on how embedded PS organizations within both software and hardware were answering the three questions above.  This body of work provided clear examples to product companies on two fronts:

  1. How were product companies establishing and sustaining VSOE on their services?
  2. What tactics were product companies leveraging to prove the services being sold did not have a significant impact on product functionality (so that product revenue could be recognized up front)?

For information on these tactics, refer to the paper.

Tracking VSOE Practices

Over the past three years, Bo DiMuccio has been benchmarking various aspects of VSOE practices, including a country by country breakdown of where embedded PS firms typically establish VSOE for hourly rates (image below).

 

These annual data points tell us that, over the past decade, embedded service organizations within product companies have become very adept and resourceful at finding ways to establish and sustain VSOE for maintenance contracts, hourly PS rates, and education service offerings. We also know that establishing VSOE on services reduces discounting on those services. This has been the hidden benefit of VSOE for embedded service organizations.  For more information on VSOE stats, TSIA members should contact Bo DiMuccio.     

Change in Revenue Recognitions Rules

Revenue recognition in general and VSOE specifically, have been touchy topics for embedded service organizations. The service organization never wants to be responsible for delaying product revenues. Lack of VSOE always created that risk. Yet, most service organizations worked through the challenges of 97-2 and ultimately used the regulations to help reduce service discounting. Now, just as service organizations seem to have this whole revenue recognition thing under control, FASB is about to change the rules. And in a BIG WAY.  For a status on this initiative, visit this page on the FASB web site:

http://www.fasb.org/revenue_recognition.shtml

Jim French  , a partner at PWC and revenue recognition expert, spent the day briefing TSIA members on the pending changes to revenue recognition.  Jim communicated the following pending changes:

  • FASB is expected to provide new revenue recognition guidelines before the end of this calendar year.
  • These new revenue recognition guidelines will replace 97-2 for software companies and 08-01 for hardware companies.
  • -As mentioned at the beginning of this entry, these guidelines will remove the requirement for establishing vendor specific evidence for the service elements of a multi-element deal to prevent product revenues from being deferred until all services are delivered.
  • These guidelines will end the practice of the “residual method” for allocating the value of a software license in a multi-arrangement deal.

Currently, the process of residual method must be used where VSOE exists for all undelivered elements (think professional services and support services sold when the license is sold) but not for one or more of the delivered elements (think the software license). Here the undiscounted VSOE fair value of the undelivered elements (PS and support) is deferred until the services are delivered, and the residual value (or the difference between the total deal size and the deferred amount for the undelivered elements) is recognized as revenue for the delivered elements (license).

OK, right now most of the service folks are jumping up and down. No more VSOE! No more worries about messing up product revenue recognition! That is good news. But once again, let me make this observation:

VSOE, despite the pain of establishing it for new service offerings, has been a blessing in disguise for service organizations. The requirement of VSOE has dramatically reduced the discounting of service offerings from product companies.

These new regulations will remove the requirement of VSOE on service offerings. In addition, there are other aspects of these new revenue recognition guidelines that have the potential to massively disrupt the financial models of service organizations. For more information on the work we are doing on this topic and to be connected to knowledgeable experts like Jim French, contact me directly at thomas@tsia.com.

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One Response to “Call to Action for Service Organizations: BIG Changes in Revenue Recognition Rules”

  1. Death of 97-2 « Service Visions Says:

    […] Call to Action for Service Organizations: BIG Changes in Revenue Recognition Rules […]

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