Revenue recognition is a very specific issue for a number of IT and technology companies. When you sell a product such as software, for example, it’s not obvious how the profits from that sale relate to the different products and service elements contained within it. So accounting for these in financial statements for tax purposes can be difficult.
Why is revenue recognition important?
If you’re an IT or tech company, you’re likely to be seeking investment at an early stage, potentially from venture capitalists, and, like a lot of tech companies, you may be looking for a trade sale. This means you have to be certain that you’ve accurately reported your revenue.
If you haven’t correctly reported your revenue, and, through the due diligence of the investor or person buying your company, they find that you haven’t got it right, it will destroy your credibility and potentially the entire track record that you’ve built in your financials. Ultimately it could sour the whole deal.
Revenue recognition is also really important to make sure that you’re paying the right tax.
How to unbundle your profits
When you sell a product such as software, you sell it as an entire package. But to recognise the revenue on it, the elements of that package need to be split out and assigned the appropriate amount of profit. These overarching elements include:
- the product – this could be the software that you provide
- the licence – this allows the customer and other users to access your software
- professional day work – you may provide a team of professionals that go in and train up the customer on your software
- tailoring – your customer may require some bespoke work or tweaking of your software so it works for their particular needs
The product will be an upfront cost. You can recognise it on your documentation once the customer has accepted it.
The licence is recognised slightly differently. Even though the customer pays for the licence or subscription up front, that income is deferred in accounting terms over the course of the licence or subscription. If a licence spans over a year, and only six months have elapsed before you complete your tax return, then you can only recognise half of that licence as income.
Day rate work will need some checks. See if it’s charged at usual market rates for that kind of work, and check whether that work has been delivered in order to recognise the profits.
As a guide, you may want to compare your charges for your own product, licence and day rates with any existing market rates and charges for these kinds of products and services.
To apply this mechanism to your own products and services, you’ll also need to be aware of any differences in the way charges on these components are calculated, and why. Licences, for example, are normally calculated as a percentage of the cost of the software.
Evidence of your completed service
If you’re stuck on exactly when you need to recognise revenue, you may need to gather vendor-specific objective evidence or VSOE, before you set out your profits. VSOE should show that you have delivered everything you’ve agreed to your customer.
This could be in the form of a courier’s note, if you’re looking for evidence that a product has been delivered. It could be a signature from the customer that the bespoke work they wanted has been carried out and they’re happy with it.
The customer may also need to confirm that their product is up and running. If there’s a trial or refund period, you may need to wait until that time has elapsed before you recognise that revenue.
Use previous transactions as a guide
As there are no hard and fast rules for revenue recognition, you should always seek professional advice. In the software industry, many UK companies currently adopt the US accounting standard SOP 97/2 for their accounting policy on revenue recognition. It’s one of the most common industry norms and also contains clear and practical guidance. But you may also find evidence in your own operations that can help to guide you in your documentation.
Looking over previous transactions with a customer or client, such as a refund, can reveal how you calculated and charged for certain product or service elements. This information can then be used as a guide when unbundling and accounting for the separate elements of your revenue on tax documentation.
By looking at your own product policies, at what other people are doing, and any best practice that’s out there, you should find a solution to revenue recognition that is fair and appropriate for your business.
For more information on Chris Cairns, visit Alliotts.
If your business currently provides cloud services at home or abroad, or you’re looking to venture into this field, read Part three: IT professionals: How tax is applied to your cloud services.
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