The payment services landscape has always posed regulatory challenges. From PCI-DSS to complying with BSA rules, paytechs have always invested resources into following the law. However, revenue recognition might be the most challenging process paytechs deal with.
More than recurring revenue firms, paytech companies find ASC 606 (the IRS revenue recognition guidelines) tough to decipher. While revenue recognition software automates several aspects of these workflows, it doesn't always aid in analyzing base conditions.
Factors like principal versus agent and the nature of goods delivered blur in the payment services world, leading to challenges. Here are four questions that every paytech finance leader must have answers to before recognizing revenue.
Who is the customer?
ASC 606 defines a customer as an entity that orders goods and services in line with the seller's ordinary activities. For some payment processors, identifying a customer is straightforward. Merchants are usually the customer, since they're the ones requiring payment processing services.
However, other payment processing entities can find themselves in a gray zone. For instance, a payment facilitator (payfac) entering a contract with an independent sales organization (ISO) might find answering this question a bit tricky. The ISO resells the payfac's product, but who is the customer here? Is it the merchant or the ISO?
In most cases, payfacs tend to earmark the ISO as a customer, but this arrangement needs special examination if the payfac delivers support services directly to merchants.
A similar scenario arises if a payfac integrates with an independent software vendor (ISV.) The ISV facilitates payments for individual merchants on its platform, and merchants reach out to the payfac directly when issues arise. Is the ISV or the merchant the customer in this case?
Practically speaking, payfacs tag ISVs and ISOs as their customers, but it’s recommended that finance teams turn to experts for help in determining if their business conditions might throw this arrangement awry.
What are the promised goods and services?
On the surface, identifying the specified goods and services is simple. However, a paytech's choices in identifying them have a knock-on effect on the remaining guidelines in ASC 606.
As a result, classifying services becomes challenging in a hurry. For instance, some payment processors facilitate access to the acquiring bank, acting as a payment gateway. In this case, the gateway is clearly the service offered.
However, many processors also act as an outsourced payment tech stack, offering everything from infrastructure to transaction clearing. In this case, they bill clients for these services as a package. However, per ASC 606's requirements, recognizing services as part of a bundle isn't so straightforward.
The guidelines state that each service must be distinct and separately identifiable to qualify as a separate service. Is preauthorization distinct from authorization? Is batching distinct from routing? Probably not, since no customer prefers one without the other, failing the "distinctiveness" test.
Paytechs can recognize these features as combined services, but this puts them in a different position when identifying as a principal or agent (as we’ll detail below), and that complicates revenue recognition.
In short, paytechs must tread carefully with this ASC 606 guideline since their choices here have knock-on effects down the road. While identifying services is simple, choosing to recognize them as distinct ones or a bundle is a task for a person with revenue recognition expertise.
Is the platform the principal or agent?
Principal and agent determination is likely the most important aspect of a paytech's revenue recognition workflow. The company's choice directly impacts the revenue it records on its income statement. Briefly, companies acting as principals record gross revenue earned from the service on their books.
A principal paying fees to other parties in the ecosystem will recognize that money as the cost of goods sold (COGS). In contrast, agents record net revenue earned from the service as total revenue earned on their books. Using the same example, a principal will deduct fees paid to other entities from top-line revenue and record that number as total revenue on its books.
This choice significantly affects revenues since the difference between gross and net revenue earned from a service is significant.
At first glance, paytechs might be tempted to tag themselves as principals and recognize their services as a bundle. However, the IRS mandates that principals control every aspect of the service they deliver. Does a paytech really control authorization workflows, or does the acquiring bank do so? Most payment industry professionals will say the bank controls authorization, along with prices in that workflow.
Faulty recognition at this point will lead to hefty fines. Paytechs must use the services of qualified auditors to help them navigate this choice, since it heavily impacts their bottom lines.
What are the performance obligations?
Identifying performance obligations lies downstream from the principal versus agent question.
The two questions are directly tied to each other, and many auditors consider the issues to be two parts of the same criterion. However, there are a few distinct points to warrant making this a separate criterion.
For starters, companies acting as principals must tag services they fully control as a combined performance obligation, recognizing the gross revenue they receive from it. When acting as an agent, the company must identify distinct services, tag them as separate performance obligations, and record net revenue.
Often, paytechs will run into issues at this step. Their distinct service might not stand out as a performance obligation due to timing and delivery modes, leading to revenue recognition confusion.
As always, using the services of a highly qualified auditor is critical to getting this step right.
Getting revenue recognition right is critical to growth
Revenue recognition for paytechs is far more complex than other businesses due to the nature of services offered. Paytech firms must walk themselves through the questions above with the help of a qualified professional to determine where they stand.
