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Revenue Recognition in the Software Industry

Description:

The primary accounting consideration is the Matching Principle: your costs must be expensed or capitalized in the same period in which you recognize the corresponding revenues.

Content:

The primary accounting consideration is the Matching Principle: your costs must be expensed or capitalized in the same period in which you recognize the corresponding revenues.

So if you do offer software as a subscription service, you will need to capitalize and depreciate the R&D and other costs that went into producing the software, using reasonable estimates, so that the correct proportions of the cost are matched to the associated revenues.

Another instance of the Matching Principle, per Sarbanes-Oxley, is that you should not ship an upgrade with new "features" to software that you've already sold and recorded revenues for, or you will have to restate your previous earnings to recognize some of the revenue in the current period.

There are four types of revenues in case of a software company and each has its own peculiarities:

1) Time and material based contracts for software services: Revenue should be recognized based on the time spent and expenses incurred. Generally the software company invoices the customers at the end of the month by adding up the consultants' time and costs, and revenue is immediately recognized.

2) Fixed price contracts: Revenue should be recognized in proportion to completion of the contract. A good indicator of percentage of completion is the ratio of man-months consumed to budgeted man-months, assuming that there are no other significant costs. If there are other significant costs such as third party software licenses, they should be taken into account while computing the percentage completion of the contract. The budgeted costs are reviewed and revised each month to ensure proper recognition of the revenue.

3) Software products sale- perpetual licenses: Revenue should be recognized upon delivery of the software license to customers.

4) Software subscriptions or maintenance contracts: Here the revenue should be recognized over the period of the subscription or maintenance contract.

Author: Srdjan Timotic, BSc, MBA, CCA

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