Our series on non-standard contract terms that could potentially impact your revenue recognition and accounting brings us to non-standard billing and / or payment terms. Each of these will have a different impact on your accounting treatment, but customers usually negotiate these together which is why we’ve classified them in one subject.
Given the current economic and global climate, your company may find itself in a negotiation for longer payment terms and a more frequent billing cycle. Customers are looking to delay payments and break billings up into smaller increments to keep cash on hand to fund operations or “for a rainy day”. We discussed how to approach contract negotiations in the current climate here, so will focus on the accounting impact.
Billing Frequency
Enterprise software companies will generally bill up-front for an annual term (even on multi-year contracts). However, there are a few different ways that customers like to get creative here.
Customers are looking to delay payments and break billings up into smaller increments to keep cash on hand to fund operations or “for a rainy day”.
Less than annual billing
Even if the term of your agreement is annual or multi-year, customers will sometimes ask for a less than annual billing frequency. This can impact how you present your balance sheet and disclosures in a given period. Specifically, deferred revenue, or unearned revenue, is made up of advance payments a company receives for products or services that are to be delivered or performed in the future. If an annual contract is billed in quarterly installments, deferred revenue will only reflect what has been billed. Also, there will be an impact to calculated billings (revenue plus the sequential change in total deferred revenue as presented on the balance sheet), which is a key metric for investors. For example:
Company A contracts with Customer Z for an annual license purchase for their SaaS product for $1,200,000.
Scenario 1:
Company A has granted the customer quarterly billing. In this case, upon contract execution, Company A will bill the customer $300,000, and deferred revenue will be represented as $300k. Please note that this billing frequency alone does not impact revenue recognition, and the company can still recognize revenue based on $1,200,000 for the annual term unless other non-standard contract terms are introduced. In addition, calculated billings would only reflect $300k in the change in deferred revenue.
Specifically, deferred revenue, or unearned revenue, is made up of advance payments a company receives for products or services that are to be delivered or performed in the future.
Scenario 2:
Company A has billed the customer for the full $1,2m up-front as per their standard policy. In this case, $1.2m will be reflected on the balance sheet as deferred revenue upon contract execution and all $1.2m would be reflected in calculated billings.
More than annual billing
If a multi-year contract is billed in totality up-front, deferred revenue will reflect the full amount billed (e.g. a 3 year deal for $1m / year would be reflected as $3m in deferred revenue), and the calculated billings will be derived using the $3m change in deferred revenue.
Payment Terms
Potential customers may negotiate for extended payment terms. Each company must determine what is an acceptable payment term and establish a policy, such as any payment terms greater than Net 90 are non-standard. Although the standard does not have a bright line here, and payment terms vary greatly by practice in different industries, a company must explicitly determine the intent of the extended payment terms and if there is, or is not, a financing component to the term.
Significant Financing Component
One additional consideration for billing frequency and payment term analysis is the significant financing component. The company must determine if a customer paying in advance for a multi-year deal (such as paying up-front for a 3 year deal) provides a financial benefit to the company. Also, the company must determine if they are delivering the contracted goods or services before the customer pays if the customer has a financial benefit from delayed payment. This assessment may result in a change to the transaction price of the contract.
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