How to Avoid the Revenue Recognition Pitfalls That Could Sink Your Ship

Data analytics giant Comscore lost over 90% of its valuation since its accounting fraud came to light. According to the Securities and Exchange Commission (SEC), Comscore and Serge Matta, who served as chief executive from March 2014 until August 2016, improperly recognized revenue from non-monetary transactions (NMTs) and other contracts, enabling Comscore to artificially exceed analysts’ consensus revenue targets for seven consecutive quarters. To keep the company afloat, the company and CEO agreed to pay penalties of $5 million and $700,000, respectively. 

The story of Comscore and others embroiled in accounting fraud is a reminder of how inaccuracies in financial reports can be disastrous for businesses. In this blog, we unfold how you can steer clear of revenue recognition pitfalls that could spell disaster for your business, which is particularly important in our current time of weakening financial performance and the possibility of a recession.

Breaking Down Revenue Recognition Errors: Why Do They Happen?

While subscriptions offer advantages like predictable revenue and customer flexibility, specific complexities are involved in recognizing that revenue.

Missing Critical Data

Oftentimes, you need to gather sales-related information from various sources to recognize revenue accurately.

For example, sales transactions involve contract data, such as terms, prices, and products and services, which frequently reside in a CRM or quotation system. Customer credits, rebates, or discounts that influence the overall transaction price may be tracked elsewhere, such as billing systems, making it more challenging for accounting and finance teams to capture the entire arrangement. 

To achieve proper revenue recognition and reporting, data stored in the different systems have to come together ideally in one database. It typically involves consolidating revenue data from CRM, billing systems, and other sources so that finance teams can appropriately account for each transaction in accordance with ASC 606 and IFRS 15 (GAAP). Some companies rely on manual spreadsheets, while others use software solutions to generate monthly journal entries, GAAP revenue reports, and other metrics.

Companies doing business in multiple jurisdictions need to aggregate revenue data into their backend accounting or ERP system for consolidated financial reporting. Many try to manually handle the revenue accounting process on spreadsheets, which are prone to human error and are not scalable. It often leads to misstatements which can result in ugly restatements and damage a company’s reputation among its lenders and investors. So, a system that can consolidate all the necessary revenue data to ensure completeness and accuracy is critical for proper financial reporting. 

Contract Modifications

Customers can modify their plans in a subscription model, whether upgrading, downgrading, canceling, or renewing. These contract changes have implications for revenue recognition, adding complexity to the process.

Many contracts and frequent changes create significant volumes of data that exacerbate the difficulty of manually maintaining accurate revenue reporting throughout a contract term. Finance and accounting teams must gather information about contract modifications from various sources, assess the impact on revenue for each change, and adjust accordingly.

Furthermore, revenue recognition under GAAP is driven by the satisfaction of performance obligations, meaning that the timing of revenue recognition is determined by specific triggers such as activation, delivery, or consumption. Tracking these revenue triggers can be difficult, and companies generally require a centralized and systematic process to identify all events that impact revenue and process them correctly.

Bundled Offerings

SaaS companies are known for their ability to provide a wide range of products and services under a single contract, offering customers convenience and value. However, this bundling approach introduces unique challenges in revenue recognition.

Imagine a SaaS subscription with a hosted software solution and additional goods and services such as hardware, implementation and training, and consulting. Each of these elements may represent a separate and distinct performance obligation that must be individually valued based on the Standalone Selling Price (SSP) and recognized as delivered (typically when control of the good or service passes to the customer). SSP refers to the price that would be charged if a product or service is sold on a standalone basis. It requires careful evaluation and continuous monitoring of pricing plans, discounts, rebates, product age, competitor pricing, and data and events that influence the selling price of a good or service.

Developing and updating SSPs for a diverse range of products and services can be an overwhelming task for accounting and finance teams. It typically requires the consideration of various data points and methodologies to establish SSP for each product or service, further complicating the process. SaaS companies can benefit from a centralized system that can house all SSP-related data and provide the flexibility to analyze trends and adapt to changing pricing models.

Unique Revenue Recognition Issues

Revenue transactions can have features that make determining the overall deal value somewhat vague at the onset of the arrangement. Transactions can include fixed and variable amounts, such as volume discounts, rebates, refunds, credits, and performance-based incentives, which add another layer of complexity to revenue recognition.

Let’s take a closer look at some examples of variable consideration. Imagine a scenario where customers are offered volume discounts based on their purchasing quantities. Or, consider situations where companies provide rebates or refunds based on certain conditions or performance metrics. There are also cases where fees or bonuses are tied to achieving specific targets or milestones.

Additionally, contracts may include contingent consideration, where the price depends on the occurrence or non-occurrence of a future event. These scenarios can introduce uncertainty in estimating the overall transaction price and ensuring that revenue is being recognized at an amount that would not be at risk of a significant reversal in future periods.

When variable consideration is present in a contract, accurately estimating the transaction price becomes crucial. Companies must exercise judgment and apply constraints to prevent significant reversals of recognized revenue.

Revenue Misstatements

Overstating revenue forecasts

Revenue budgeting and forecasting are nuanced tasks, including significant judgment and estimates. Management can sometimes make overly optimistic assumptions about a project’s progress, leading to an overstatement of revenue. For example, estimating future costs without considering economic trends, supply chain issues, labor supply shortages, or rising material costs can lead to understated expenses and an overstatement of revenue and profit. Estimates can be complex, and erring on the side of conservatism is common practice, particularly in the early stages of a project. Appropriate data collection and a solid program evaluation process are crucial to ensuring proper revenue recognition. 

Not properly accounting for refunds, returns, and cancellations

Consumer behavior plays a significant role in how SaaS companies build their pricing plans. Companies structure deals with multiple products, offering subscription pricing tiers and payment options to appeal to customers. These situations can create complexity in revenue recognition. Moreover, changes to plans due to refunds, returns, and cancellations can make accounting difficult.

Imagine a SaaS company that has multiple product offerings, each with different cancellation and refund policies and thousands of transactions that occur each month. You can quickly realize that trying to account for refunds and cancellations can become daunting. It’s only possible to effectively manage the accounting for these transactions if you have a reliable system that can process the contract changes, match them to the related transactions and ensure the appropriate accounting treatment based on the company’s cancellation and refund policy for each product.

Understanding the Impact of Misguided Revenue Recognition

Improper revenue recognition features prominently in SEC’s enforcement actions

An analysis of SEC data cites improper revenue recognition as the most common type of accounting and auditing enforcement action. Technology services are more frequently charged, followed by finance, energy, and manufacturing companies.

Penalties for improper revenue recognition can run into hundreds of thousands of dollars. While the SEC’s enforcement actions are primarily targeted at public companies, non-compliant private companies, particularly unicorns, entities that public companies may acquire, or are large enough to consider an initial public offering, can also come under its purview, say legal experts. For instance, in 2018, the SEC charged Silicon Valley-based private company Theranos Inc., its founder and CEO, and its former President with raising more than $700 million from investors through an elaborate, years-long fraud in which they exaggerated or made false statements about the company’s financial performance. The company and its CEO were penalized $500,000 and barred from serving as an officer or director of a public company for 10 years.  

Fraud in Revenue Recognition

The risk of fraud in revenue recognition is always high, given the pressures and incentives for management to meet the expectations of shareholders, investors, and lenders. Inaccurate financial reporting due to fraud can cause irreparable damage in the markets and to customers, in addition to the substantial cost associated with legal actions and the cost of restating the financial statements. 

Costly and time-consuming remediation and restatement

Remediating audit findings due to control failures is a costly and time-consuming affair. But it’s just the tip of the iceberg. If financial statements are materially misstated, a complete evaluation of internal controls and accounting policies may be necessary to find other potential gaps in addition to the ones that led to the material misstatement.

Remediation of material weaknesses often requires external consultants and specialists in addition to the incremental cost associated with the auditors. The process is time-consuming and taxing on internal resources. Often restatements lead to significant attrition of accounting and finance personnel, leaving management teams scrabbling to recruit new talent.

For compliant revenue recognition, step away from manual processes

Manual revenue recognition is not only unviable with company growth, but it also creates the risk of inaccuracies due to human error. Automation is critical to building a financial reporting process that can scale your business. 

You must automate high-volume, routine transactions so that accounting and finance teams can focus on more complex issues and provide more insightful data and analysis to management and other constituents within the organization., Chargebee RevRec can: 

• Give you end-to-end data visibility by integrating with your CRM and billing systems on the front end and ERP/GL on the back end
• Provide flexibility to keep up with changing business or pricing models to ensure you comply with IFRS 15/ASC 606
• Support your business domestically and abroad by helping maintain revenue recognition accuracy with each reporting jurisdiction
• Provide critical financial reporting and analysis to meet reporting requirements and insights to management and the board of directors

Check out how Chargebee can help you automate the entire revenue recognition process and avoid revenue recognition pitfalls.