It is wonderful to see the floodgates open and see so many new gTLDs launch — 417 delegated as of October 4th. As registry senior management’s focus switches to operational matters post launch, it is now time to consider how the new registries will deal with revenue recognition and its impact on financial reporting. This is primarily the CFO’s responsibility, but senior management must be mindful that improper domain revenue accounting will lead to corporate reputational damage. In 2004 I faced this challenge as CFO of dotMobi, and I was then a new entrant to the industry. Since then, my experience as a finance executive within the domain industry has led to the realisation that there is widespread uncertainty on how to handle the accounting of domain revenue once you launch. CFOs and founders whose companies are entering the domain registry marketplace need to make sure they understand the complicated rules of revenue recognition from the start — or risk having to restate their financial statements in the future, under the critical gaze of investors, lenders or regulators.
Here are some misconceptions that exist, especially among new entrants.
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Misconception #1 – “Isn’t Invoiced Sales the same as accounting revenue? I’ll just use the reports my back-end provider gives me for my accounting sales.”
Most Registry Service Providers’ (RSP) contracts with new gTLDs provide for the provision of billing, invoicing and statement generation. However, your invoiced sales for the month are not your accounting revenues.
Across all industries revenue recognition has been one of the most controversial topics in accounting for business activity and there are many accounting standards, bulletins and directives to follow. Domain revenue falls under the services category so we must look more to general revenue recognition guidelines (and less to software revenue recognition rules). The key principle is that domain income is earned (and revenue recognised) ratably and equally over the term that the service is delivered. See my CircleID blog from 29th June 2011 for graphic illustration of how invoiced sales & accounting revenue can differ. In a recent position paper, using sample data, I estimated that if a registry recorded invoiced sales as their accounting revenue in their books, they could overstate revenue in year 1 by up to 380%. This error has already happened at existing registries on more than one occasion, and led to entire reinstatement of financial results for those concerned.
Misconception #2 – “I am filing my tax returns on a modified cash basis, therefore I don’t need to consider deferred revenue”
I hear this statement frequently, especially from US based registries. Even if a registry has filed for such an option, why would you decide to declare your cash invoiced sales as your accounting revenue when you can follow best accounting practices to defer the revenue over the lives of the domains? In the sample data I used in my position paper, Year 1 cash sales of $9.8m would correspond to $2m accounting revenue when you defer revenue per the accounting rules. Depending on OPEX, this could result in posting lower profits in the early years and also legitimately deferring the payment of taxes.
Misconception #3 – ” I am the sole owner of the privately held registry so this is not a priority for me”
Accounting best practice is to recognise domain revenue ratably and equally over the life of the domain. Many of the leading incumbent registries have been adopting this policy for the past 10 years or more — with most recognising domain revenue by day and rolling it up to a monthly posting to their general ledger. If a new registry chooses to diverge from this best practice by making manual estimates, they run the risk of their financial results being questioned by their own investors or outside parties. This will become particularly relevant if the registry aspires to raise new funding for expansion, or sees the possibility of selling the business in the medium to long term.
Misconception #4 – “I know all about deferred revenue, but I don’t need to worry because my back-end provider is giving me all the reports I need. No action required”
There is a large expectation gap between what new gTLD applicants believe they are receiving under the terms of their RSP contracts, and what they are contractually entitled to. RSPs do provide a suite of services, but these are not all encompassing — some new gTLD applicants are not even receiving registrar billing as part of the backend contract. With regards to revenue, RSPs will typically provide gTLDs with an invoicing service but will not perform the necessary deferred revenue calculations. In that scenario, the registry (contract holder) becomes responsible for performing these calculations once the invoicing is delivered. Note: some RSPs will offer a deferred revenue calculation tool as an optional paid extra so be sure to explore all of your options.
Misconception #5 – “Ok, so my RSP isn’t giving me deferred revenue calcs. So what? All I need to do is download billing transactions data into a spreadsheet and calculate it myself”
I hear this very often when talking to CFOs of registries with the perception that domain revenue recognition is similar to revenue recognition of other subscription services. It’s not, and I caution against trying to build a solution in a spreadsheet. The reason is that domains have a myriad of life states with many permutations (multi-year, early renewals, auto-renews, transfers, deletes, restores etc.) and many grace periods (“cool-off periods”). These create a plethora of unique rules in recognising revenue, and require unique calculations. Dealing with these exceptions in a spreadsheet environment will be problematic and error prone — especially when domains under management reach a critical mass. Revenue recognition for the registry is the most complicated area of keeping proper books and records, and I believe it requires specialist tools in order to do it correctly.
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I urge all new entrants (and veterans) to the industry to give due consideration to how you wish to approach the treatment of revenue in your books. There are real reputational risks to misstating your revenue figures, and there are real life examples to learn from in the industry. This is a complicated area and worth avoiding the easy path of short-cutting especially if you have outside investors, hope to bring in new funding, or intend to exit at any stage.
By Norbert Grey, CFO of Architelos. Mr. Grey has served in senior financial roles in both the domain name system (DNS) industry and in the technology and mobile telecommunications industries. Architelos, Inc. provides SaaS-based TLD managed services solutions, and strategic consulting for clients in the domain name (DNS) industry.