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Compliance : Sarbanes Oxley : Technology : Business Process Management
Sarbanes-Oxley and Business Model Innovation Part 3
A practical guide to establishing key controls
By
Robert O'Connor
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Robert O'Connor
CEO
Softrax
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This is the last part in a three-part series on the impact of Sarbanes-Oxley. This article addresses compliance issues specific to licensing, subscription, and utility revenue streams.
Introduction
For most companies, the path to growth involves developing more sophisticated customer relationships involving products, services, and long term commitments. Multiple business models begin to operate simultaneously and internal controls for each must be equally well established and documented to maintain compliance with Sarbanes-Oxley.
Some of the common issues for managing multiple business models include:
1. A wide range of variation in customer contracts and lack of standardization create inconsistent revenue policies.
2. Acquisitions, partnerships, and distribution channels produce different business processes, and interpretation of revenue management rules.
3. New business units and cross selling opportunities increase the accounting transactions that need to be executed.
4. International expansion leads to the need to account for ongoing fluctuations in the value of billing and revenue recognition amounts.
5. Planning for future financing requires squeaky-clean financial reports and disclosures.
6. Increased executive interest in non-GAAP information and pro-forma financial statements.
These issues occur as part of the normal growth of any business, and few businesses can afford to start, staff and implement a scalable solution. Growth companies invest over time in infrastructure and ERP systems, and compensate for functional deficiencies with a myriad of spreadsheets and disparate databases. It is hardly surprising that closer examinations have revealed weakness in revenue accounting, which has led to numerous financial restatements and delays in reporting.
To optimize performance and efficiently maintain compliance, each business model must be analyzed with respect to its unique requirements. To that end, we have presented previously a set of key issues that pertain to the first two business models in the list below.
• Services
• Support
• Licensing
• Subscription
• Utility/Usage
In this article, we will highlight the critical reporting and control issues for the last three: licensing, subscription, and utility models.
Licensing
The Licensing model generally applies to software, intellectual property, and technology products. The complexity of licensing generally introduces a number of revenue considerations, including:
Term of license: There are often tangible and non-tangible changes to the terms made. A contract might be subjected to multiple provisions that impact just a phase or certain products within the licensing agreement. The changes to the terms must be documented and evaluated for their revenue impact.
Ability to perform alone: Although the original product may be sold standalone, additional information may be needed to assess if upgrades are necessary.
Delivery of license: The delivery of the license and what constitutes delivery must be established. Other items that will be processed as part of the same arrangement often impact this. The delivery of a license is often accompanied by a deployment schedule or less frequently, the staged delivery of multiple licenses.
Value of bundled licenses: The mechanism for unbundling components within a license must be defined and vendor specified objective evidence (VSOE) must be applied as needed. The unbundling process may involve the following:
• Identification of items based on bill-of-materials
• Identification of items based on pre-defined allocation break-out
• Identification of related items by virtue of grouping with the sales order
• Identification of items related to information relayed within the contract
• Identification of items linked by delivery or acceptance time frames.
Effective date of license: The effective date of the license may dictate the revenue term as opposed to delivery. In these cases this information must be clearly identified as part of the process. The effective date can only be used if the other requirements for revenue recognition have been met. This requires constant monitoring of these future dates to ensure the effective date of the license is valid for revenue management purposes.
Re-mediation clauses: Any clauses, which allow returns, or trials, must be identified. This is particularly frequent with product promotions and bundled arrangements.
Subscription
The subscription model is increasingly being applied to many different offerings in an increasing number of industries. Implied with a subscription are future deliveries and payments on a periodic basis. A subscription service sold as part of an arrangement will need to be revalued in line with the Security and Exchange Commissions? Staff Accounting Bulletin (SAB) 101, and VSOE will need to be established where necessary.
It has been interesting to see the growth of bundling of subscription services with many different types of products. For example, it is now commonplace for membership subscriptions to health clubs to now be bundled with free personal services. ?Smart services? are being applied to a wide spectrum of offerings from household products that notify the manufacturer of a potential malfunction to transportation satellite information and security systems such as OnStar.
Product activation: The driver for activation of the product must be identified. Subscription services are often sold as part of an offering. However, the activation for revenue purposes can depend on many factors which must be documented and tracked.
Subscription term: The term and value associated with the term will dictate the appropriate spreading of revenue. Any additional or optional terms need to be included in the revenue calculations. The situation is often complicated since subscription services may be offered as part of a hardware agreement (e.g. cellular phone companies) and may include right to cancel clauses that place a limit on the cancellation penalty or remediation terms.
Extension impact: Subscription contracts are often extended by customer care as an effective means of retaining customers. This must be captured and evaluated to determine if additional treatment is necessary or a change of policy is required.
Utility/Usage
Utility/usage arrangements are based on the delivery of product measured in a transaction or usage-based manner. Utility/usage arrangements that bill the customer based on usage or transactions are common in many industries and growing in major sectors.
Transaction value: The value of each transaction should take into account volume pricing. The transaction model can be complicated especially when volume is very high and the pricing model is time dependent. This essentially demands a systematic approach for capturing and tracking how value is applied to each transaction.
Transactional Volume: Very high volumes of small dollar transactions may necessitate bucketing revenue and the summarization of revenue amounts, e.g. gift cards in the retail industry. In many cases it is more efficient to capture similar transactions in revenue ?buckets.? This gives the system the ability to handle very large transaction volume, and still maintain a detailed audit trail of exceptions and revenue schedules that get changed.
Time-based commitments: Commitment to deliver certain levels of transactions must be identified. To record this information in the system the following is necessary:
• Rate of transaction commitment
• Amount of transaction commitment
• Value of transaction commitment
• Actual usage at time of commitment
• Billing/Unbilled issues at time of commitment
Prepayment and scheduled payment options: The payment amounts and the application to the transactions are necessary to correctly account for revenue and backlog. This can be one of the most complex areas for which to determine correct booking of receivables. This may be an issue if:
• Billing is done from a disparate system
• The invoice detail does not match the service detail
• The invoice amounts are not easily mapped to revenue amounts
• The payment schedules includes partial payments not tied to revenue
• The payments include amounts for other services unrelated by revenue
True-up processing: Payments made in advance for transactional volume need to be reconciled with actual usage. This is typically the case where a minimum payment is made each month. The complication is that the payment at the beginning of the period is continually being apportioned between deferred revenue and revenue at the end of the period. To complicate this further, this true-up may affect the future month billing.
Minimum commitments: These can permit revenue to be recognized ahead of the transactional usage. The minimum commitments may cross product and agreement boundaries. In general, these relationships must be captured within the VSOE pricing mechanism to associate fair value across product boundaries.
End-of-term processing: Any residual transactional amounts that remain after the contract has expired must be accommodated. The process for this can vary based on the revenue policy; however there are strict accounting guidelines that cover this process (e.g. EITF 01-09). This is often referred to as ?salvage? or ?Es-cheat? and is common with gift cards, etc. It is important that these amounts are removed from the deferred revenue ?buckets? and handled appropriately so that the amount of deferred revenue is not inflated.
Closing Thoughts
The documentation requirements of Sarbanes-Oxley are burdensome, especially when multiple revenue streams are present in your business. Revenue policies and controls must be established independently for each business model. The upside is that once the full revenue cycle from order entry to billing, revenue accounting, reporting, and forecasting is optimized and integrated, a host of benefits accrue. Billing is more accurate and timely, improving cash flow. The contract renewals process is formalized, decreasing churn rates. Reporting is faster and more accurate, enabling better decisions. And internal controls can be systematically established, lowering risk.
Robert O'Connor
CEO
Softrax
Robert O?Connor is President and CEO of Softrax Corporation, a leading provider of enterprise billing and revenue management solutions.
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