Revenue Recognition for Hardware Companies: What you need to know

Revenue recognition is essential for companies to accurately reflect their financial performance, particularly in line with US GAAP and IFRS accounting standards. 

Due to the physical nature of their products and additive services, recognizing revenue can be particularly challenging for hardware companies. Let’s take a look at these challenges and some practical steps to recognize revenue effectively.

Revenue Recognition Criteria for Hardware Companies

Revenue recognition is the act of recording revenues within financial statements when they are earned, regardless of when the cash is actually received. 

There are primary accounting standards that govern revenue recognition and these are designed to provide a comprehensive framework based on five key principles. Technically, these are governed by ASC606 and IFRS15, both named “Revenue from Contracts with Customers”.

1. Identifying the Contract with the Customer

The first step is to identify the contract with your customer.

This involves defining the terms and conditions, the rights and obligations of each party, and ensuring that the contract is legally enforceable. This may include a formal contract, or an informal contract (such as a ‘Terms of Use’ or checkout mechanism).

However, the contracts don’t necessarily end with the sales of the physical product. There are often related services to include such as installation, maintenance, and any warranties on the hardware.

2. Identifying Performance Obligations

A performance obligation consists of a promise by the selling company to transfer a good or service to the end customer. Multiple performance obligations within a single contract may exist, such as: 

Accounting then must determine whether these performance obligations should be accounted for separately or as a combined performance obligation. This involves deciding whether the goods or services are combined (such as a required bundle where the good or service is unusable without the other) or distinct and separable.

3. Determining the Transaction Price

The transaction price is the amount of value (cash and non-cash) expected to receive in exchange for transferring goods or services. 

For example, there are fixed amounts paid for the goods, but there are also variable considerations like discounts, rebates, and other incentives (that vary by customer, or usage). There are non-cash considerations too that may be provided such as rights and licenses or stocks and equity.

Accurate estimation of variable considerations is essential because this prevents the company from overstating or understating expected revenues.

4. Allocating the Transaction Price

Once the transaction price is determined, it must be allocated to the identified performance obligations. 

This allocation is based on the standalone selling price of each distinct good or service, or a suitable ratio that allocates across the various bundles, standalone products & services, and variable considerations expected over the lifetime of the contract.

5. Recognizing Revenue When Performance Obligations Are Satisfied

Revenue is finally recognized when all performance obligations are satisfied, either at a specific point in time or over time. 

For example, recognizing revenue upon the delivery of the product when control is transferred to the customer, i.e. the exchange of goods for cash has taken place, may occur when hardware has been delivered to the customer without a right of return.

If the contract includes ongoing services such as ongoing technical support, revenue for those services can be recognized over time as they are provided. Another example would be a monthly maintenance service for the goods.

Specific Challenges for Hardware Companies

Multiple-Element Arrangements

Hardware companies frequently deal with multiple-element arrangements. This is when hardware, software, and services are bundled together for a single price, and not sold separately as standalone units.

This makes it challenging to properly identify and account for each element as an individual performance obligation. 

To counteract this issue, you need to decide if each element of the bundle is distinct and separable. Doing this requires careful analysis of the contract terms and customer expectations.

Return Rights and Warranties

To ensure you are providing a high level of customer service and reliability, it is typical to sell hardware products with return rights and a warranty. This increases the level of trust for your business and assures quality.

However, when offering these, you must be sure to estimate the likelihood of returns and recognize revenue net of expected returns. 

Warranties can either be categorized as “assurance-type,” which is accounted for as part of the sale, or “service-type,” which is treated as a separate performance obligation and, therefore, recognized over the warranty period.

Financing and Leasing Arrangements

If you provide financing options such as customer payment plans, this can affect your revenue recognition.

You must differentiate between sales-type leases, where the hardware is effectively sold upfront, and operating leases, where revenue is recognized over the lease term. 

Properly accounting for these arrangements ensures your financial reporting remains accurate.

Customer Acceptance Clauses

Customer acceptance clauses stipulate that certain conditions must be met before the customer accepts the product. 

These can delay revenue recognition until the conditions are fulfilled. They can also impact the timing of the revenue received.

Carefully evaluate these clauses if you have them, and determine at what point the control of the product is transferred to the customer and revenue can be recognized.

Practical Implementation Steps

If the above information sounds like a rabbit warren of complicated information, don’t worry! There are some practical steps you can take to ensure you recognize revenue properly and accurately.

Establish Revenue Recognition Policies

You must develop clear, comprehensive revenue recognition policies and they should outline the process for identifying contracts, performance obligations, and transaction prices. 

Provide regular training and education on these policies for your staff. This ensures they are applied consistently across your organization.

Utilize Technology and Software Solutions

Automated revenue recognition systems are a godsend. They streamline the process and significantly reduce the risk of errors. Moreover, they make revenue recognition a painless and simple process.

These systems easily integrate with existing financial software, provide you with real-time insights, and ensure compliance with accounting standards.

Review and Audit Revenue Recognition Practices

Performing regular internal audits of revenue recognition practices helps identify and rectify issues promptly. 

External audits provide an additional layer of assurance and ensure your organization complies with accounting standards and regulatory requirements.

Continuous review and improvement are also crucial for maintaining accurate financial reporting.

Common Pitfalls and How to Avoid Them

It is common to misidentify performance obligations or incorrectly allocate transaction prices. 

Overlooking variable considerations or failing to update practices can also lead to errors. 

In short, proper revenue recognition is hard without the right expertise.

Getting professional assistance is a surefire way to avoid pitfalls and successfully navigate this tricky area of business. Qualified accountants are experienced in revenue recognition and can help you implement the right policies for your organization.

At Finvisor we specialize in providing financial support for hardware companies. Our team of experts understands the complexities and nuances that come with providing these essential pieces of technology.

To learn more about how Finvisor can assist with your revenue recognition and more, get in touch today.

*This blog does not constitute solicitation or provision of legal advice and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction.*

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