Three concepts you should know about GAAP revenue recognition for customers with contracts
To support JMP on our journey of separating from SAS, the Finance team has grown quickly over the past year. As an organization, we strive to share the “Why?” even if it sounds like complex Finance lingo.
In this new series "Financial Literacy 101", we aim to explain basic financial topics in a way that is beneficial to all.
Welcome back to Part 2 of a two-part series that dives deeper into “Revenue”, what that means, and how to appropriately account for it. This month we will explain how JMP will define and recognize revenue as we head into our JMP First processes. Our new contracts sold by our beta groups in Germany and the U.S. are already producing the appropriate revenue recognition using the GAAP guidelines for Revenue Recognition– so exciting!!
How will we recognize revenue in our JMP First systems?
Last month, we discussed that revenue is income earned from the sale of goods and/or services provided. For JMP, this primarily means revenue earned on both the license and the post contract services, or technical support, for our product offerings. And while today it is currently recognized in full when an invoice is sent to a customer, under JMP LLC, we will be using GAAP guidelines and recognize some revenue at the time of fulfillment, and some throughout the term of the contract.
Let’s dive in!
What is GAAP anyway?
The Financial Accounting Standards Board (FASB) uses Generally Accepted Accounting Principles (GAAP) as the basis for approved accounting methods and practices. By law, following these standards is required for any company releasing financial statements to the public and/or if a company is publicly traded. The Accounting Standards Codification (ASC) is the current single source of United States GAAP and is maintained by the FASB.
ASC 606 – Revenue Recognition for Contracts
The core principle of the revenue standard is to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods and services. This is what is called “accrual” based accounting that applies to all contracts with customers whereby revenue is recognized when it is earned, not when a customer is invoiced or when cash is received.
There are five elements that are required to recognize revenue for the sale of JMP licenses.
Step 1: JMP needs to identify what we’ve agreed to with the customer and understand if the customer can pay. Example: Signed UTOF
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Step 2: JMP needs to identify what the contract obligates us to do or provide, described as the “performance obligations”.JMP has two obligations, to deliver the license to the customer and to provide Post Contract, or technical, Support (PCS) to the customer for 12 months. Example: 5 JMP Licenses (Obligation 1) with PCS (Obligation 2) as described in the UTOF
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Step 3: JMP must determine the transaction price for the contract. Our pricing is a bundled price of License and PCS. Example: Fixed Tier Pricing Schedule – bundled price of license + PCS
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Step 4: JMP is required to allocate the transaction price in Step 3 to the performance obligations in Step 2. Example: Tier Pricing – JMP 1-10 Licenses = $1,200. 5 JMP Licenses*$1,200=$6,000; outlined in the Quote. Generally, this is allocated to the license at 83% and the PCS at 17%, per our determined allocation method.
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Step 5: JMP recognizes revenue when OR as an entity satisfies a performance obligationThe license is delivered at fulfillment and PCS, delivered over the course of 12 months. Example: 5 Licenses are fulfilled and sent to customer. JMP will recognize the license revenue upfront at 83% and the PCS each month, pro-rated, over the 12-month contract at 17%.
What is Deferred Revenue?
Deferred revenue is also known as unearned revenue, and is recorded as a liability on the balance sheet. This refers to advance payments a company receives OR invoices that are sent for products or services that are to be delivered or performed in the future. In these cases, the revenue has not been earned as the products or services are still owed to a customer. As the product or service is delivered over time, it is recognized proportionally as revenue on the income statement.
In JMP’s case, the PCS is booked directly to the Deferred Revenue account at fulfilment and then recognized pro-rata each month over the 12-month term.
Reminder:
I keep hearing about Material Rights – what is this exactly?
A material right is a promise embedded in a current contract that should be accounted for as a separate performance obligation. Therefore, an option that provides a customer with discounted goods or services in the future may be a material right. If the customer receives the discount in the future based on the contract today, yet a new customer would not receive the same discount, this is a material right.
Under historical pricing, material rights were present as JMP FYF were significantly higher than RYF and a customer could only get the RYF, or discount, as a current, recurring customer. A new customer would be charged the higher fee.
Therefore, this FYF revenue cannot be recognized in the terms of the annual contract but must carry into the “life of the contract”, meaning how long does a customer typically contract with JMP.
This presents a very complex way of accounting for our contracts at JMP, since we would have to recognize portions of revenue over the “life of the contract”. The Tier Pricing Model ensures that our pricing is consistent and does not offer a discount for renewing in subsequent years. Therefore, we can more easily track and account for our revenue under GAAP policies.
Why does this matter for JMP?
As JMP moves into becoming an “auditable” company, we will need to comply with GAAP guidance when recognizing our revenue. GAAP’s purpose is to create a consistent, clear, and comparable method of accounting, giving us a complete picture of our company’s health.
- Improves consistency in financial information and accounting records
- Summarizes accounting records into complete and consistent financial statements
- Provides a basis of comparison between multiple companies
Why does this matter to me as an employee?
We all have a part to play in understanding Revenue Recognition. Each group plays a vital role when it comes to creating and enhancing pricing strategies, drafting contracts, helping customers to understand pricing, apply discounts, timeliness of fulfilment and dating, accurate accounting and reporting, and so much more.
Understanding the implications of GAAP Revenue Recognition can help in these various processes, leading us to consistent and clear financial results.
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