QUESTIONS

(1) Use the five-step model to compare revenue recognition between the two versions. (15%)

(2) Consider the example on p.4 of the case, the last paragraph under the Section "Revenue Recognition for HMM", how would you account for the revenue from a contract for HMM11 products? How would you account for the revenue from a contract for HMM12 products? (20%)

Revenue Recognition at HBP In early 2014, Paul Bills, CFO of Harvard Business Publishing (HBP), sat down with David Wan, the company's CEO, to discuss budget preparations for the coming year, Bills noted that the performance of Corporate Learning, one of HBP's three business units, would be affected by a business model change for its largest product that required a change in the timing of revenue recognition. Corporate Learning was in the process of revamping its flagship product, Harvard Manage-Mentor (HMM) from version 11.0 (HMM11) to version 12.0 (HMM12). The revamped software would be hosted exclusively on HBP's server rather than on its clients' servers, allowing updates to take place continuously. Given the change, accounting standards required HBP to change the recognition of revenue from the date of software delivery (for HMM11) to ratable recognition over its contract life (for HMM12). As Bills and Wan discussed the accounting change, they recognized that its impact on Corporate Learning's and HBP's performance could be material and would have to be reflected in the budget. In addition, they wondered how the new accounting would affect the company's policy for awarding sales incentive compensation on HMM, as well as how they communicated with employees and the firm's sole shareholder, the Harvard Business School. Harvard Business Publishing Company Overview HBP was founded in 1993 as a non-profit, wholly-owned subsidiary of Harvard Business School (HBS). HBS's Dean at the time, John H. McArthur, determined that separating HBP from the School would provide it with the autonomy it needed to increase the reach and impact of the intellectual property and teaching that originated at HBS as well as other leading academic institutions and expert practitioners, At its inception, HBP focused on distributing HBS cases, and on publishing the Harvard Business Review magazine (founded in 1922) and Harvard Business Press books. HBP had its own CEO, who reported to the HBS Senior Associate Dean for Publishing, and a conventional governance structure that included a board of directors, an internal executive committee, and business unit directors. The annual dividend it paid to HBS, based on budgets agreed upon at the beginning of each year, was an important component of HES's cash flows and was used to support the School's operating budget for faculty research.Over the years, HBP expanded its reach, adding the distribution of curated case collections from schools other than HES and internally-developed corporate training products. It also expanded its global presence, adding corporate offices in Australia, Dubai, India, Mexico, Singapore, and the United Kingdom, to its Boston headquarters. The company's business was organized into three market groups, Higher Education, Harvard Business Review Group, and Corporate Learning. (Exhibit 1 shows summary financial performance of the three units from June 30, 2010-2013). Wan explained, "I came in around 2002 and shortly after we decided to organize the company along three lines of business, primarily because we felt we needed to strengthen our focus on the key customers as well as having a better understanding about who the competitors and substitutes are in those three primary markets." Higher Education marketed and distributed participant-centered teaching materials to university educators for use in the classroom. Teaching materials, which included cases and other course materials from HBS and other leading schools, as well several digital course products, interactive simulations, online exercises, and online courses developed within Higher Education, were primarily marketed and distributed through the Higher Education website and the group's field sales organization. Harvard Business Review Group, which focused on current and aspiring senior executives, edited and managed the Harvard Business Review (HBR) magazine and website, and the Harvard Business Press books. HBR generated revenues primarily from subscriptions, newsstand copies, advertising, and article reprints. In response to the challenges posed by online materials, HBR had begun transitioning from a print-only model to a print and digital model that provided premium subscribers with access to both print content and additional content on the HBR website (HBR.org). Finally, Corporate Learning focused on management training in companies, developing and distributing online learning products to client companies to support employee training. Wan explained the history of the group: At the time Dean John McArthur was creating HBP, Mckinsey did a strategic analysis on opportunities for growth in professional publishing and identified corporate training as the area that offered the greatest new growth potential, primarily through videos. ... They thought that the company [HBP] could get content from HBS and deliver it through video tapes. The company originally went into very high-end video productions. They were really well done but extremely expensive and didn't work out economically. When technology improved, we started to move more towards digital - first on CDs and eventually online. Corporate Learning's flagship product was an online resource branded Harvard ManageMentor (or HMM). Wan explained that the product was "originally conceived as an on-demand performance support tool, where a manager who is about to take on a task, such as having a difficult conversation with an employee could go to HMM, look up that topic, go through about a 45-minute program that would provide some content and ideas, an exercise, and a practice conversation. So, it provided a real had to do it." way for users to improve their ability to manage, particularly in some of the soft skills right before they By 2013, the latest version of HMM, HMMIl, was approaching three million licensed users (see Exhibit 2 for a sample page from the HMM11 learning tool). Client companies acquired a license to use the materials and could choose to either let HBP host the software or install it on their own system, in which case they were responsible for service. Users accessed the software on their desktop.Competitive Pressures on HMM11 and HMM12 By 2012, HMMII was facing increased market competition. Wan explained: As the years went on . . . companies started using [HMM] as pre-work before a face- to-face training session. They would say "everybody complete this module on managing a team and then we'll do some role playing and follow-up face-to-face with an expert." In addition, the Corporate Learning support team was also increasingly asked to help clients map HMM modules to the competencies the companies have defined for various levels of management. Managers at these companies were required to complete these modules as part of their formal leadership development plan. So, HMM needed to become both a curriculum and course-like as well as a performance support tool. Our clients were also requesting more frequent updates to the modules as well as a greater variety of media formats beyond text - visuals, infographics, videos, interactive assessments, mobile friendly, etc. In addition, our product upgrade cycle of substantial revamps or new versions of HMM every 3 to 4 years made us more vulnerable to an intensifying competitive marketplace and emerging disruptors. As a result, we became very concerned about sustaining the high renewal rates of existing clients we had experienced as well as securing licenses for HMM from new clients. In response to these factors, HBP decided to incorporate a number of substantial changes in the next version of HMM. Work on developing HMM12 began in 2012, with the release scheduled for September 2014. The new version of the product would aim to satisfy the curriculum driven and course-like approach that many clients were seeking while also providing flexibility to enable on- demand usage. In addition, the product would incorporate a variety of media formats beyond text to improve user engagement. Wan explained that "the folks on the team that architected the new version of HMM actually designed it in a way that all of the learning assets can be unbundled so that you can pull them out, mix them, and create a micro learning product of shorter bursts of learning.' An equally important challenge was addressing how the product could be updated more frequently to deliver "continuous value" to clients and thereby sustain renewal rates and respond more rapidly to competitive innovations. Even fixing bugs in the current version of HMM was cumbersome to implement given most clients hosted the software on their own servers. Therefore, HBP decided that the new version of HMM would be hosted exclusively by HBP as a cloud application software as a service (or Saa5). Wan explained, "we decided to become more like. . . Salesforce.com or a number of the other cloud type applications, enabling us to update the software and content continuously in response to changing market needs and competition." Revenue Recognition for HMM Early in the redesign of HMM12, Bills recognized that the decision for HBP to host the software would affect how revenues were recognized from sales of the new product. For HMM11, the client hosted the software on its servers and was responsible for all maintenance and operating costs. Although HBP offered to fix any software bugs, there was no contractual obligation to provide updates/point releases. As a result, the full value of any multi-year licensing contracts was recognized as revenue when the software was delivered. If the client chose to have HMM11 software hosted on HBP's server, the contract specified that the client would pay HBP an upfront licensing fee and a separate hosting fee (equivalent to about 10% of the licensing fee) at the time the contract was signed. In the majority of contracts, the client paid a non-refundable licensing fee. Some clients negotiated a Termination for Convenience (TIC) clause. Since the underlying product was not updated and clients had the option of hosting the software on their systems or on HBP systems (incurring a separate hosting fee), HBP recorded the full value of the licensing fees as revenue at the beginning of the contract period. In contrast, hosting fees were recorded as deferred revenues and recognized as revenue ratably over the life of the contract (terms were 1, 2, or 3 years). The new business model for HMM12 eliminated the option for clients to host HMM software and introduced an ongoing obligation for HBP. Clients would continue to pay an upfront licensing fee, but since only HBP could host the software there was no separate hosting fee. The license fee gave the client access to the software, the hosting, and any future improvement releases over the contract period. Accordingly, the contract was analogous to a subscription, rather than an outright sale. For accounting purposes, HBP was required to record the upfront license fee as deferred revenue on its balance sheet. At the end of each accounting period, it would recognize a portion of the deferred revenue as earned revenue in the income statement. For example, if a client paid $360,000 for a 3-year (ie., 36-month) license period, at the time of the contract HIP would record the $360,000 as deferred revenue (a liability) and cash (an asset) on the balance sheet. At the end of the first quarter (ie., 3- months), HBP would recognize $30,000 (i.e., $360,000 divided by 36 months times 3 months) as earned revenue with a corresponding $30,000 subtracted from the deferred revenue liability. Budget Implications David Wan and Paul Bills were both convinced the change in HMM12's business model was necessary. The new model allowed HBP to have more control over content and technology, and to react more quickly to client needs and competitive pressures. However, the revenue recognition change would result in a short-term decline in revenues and surplus. Bills explained one problem that would create, "HBP has long-range contribution targets with HBS, which they rely on for planning future research funding. Our performance consolidates into the HUS financials, and the resulting surplus into [Harvard] university figures." HBP's contribution to HBS and subsequently Harvard University was significant. Any accounting changes, especially if they reduced reported revenues and surplus, could have significant economic consequences for the business school and for the university. For example, Harvard University's financial statements were shared publicly and positive surplus played a role in maintaining the highest credit ratings from Moody's Investors Service (Aaa) and Standard & Poor's (AAA). From time to time, Harvard issued debt to fund eligible activities. High credit ratings helped keep borrowing costs low. (See Exhibits 3 and 4 for summary Statements of Activity for HBS and Harvard University, respectively for the years ended June 30, 2008-2013.) Bills and Wan decided that the first action required was to forecast the likely impact on HBP's financial budgets; they would then have to sit down with Dean Nitin Nohria and Rick Melnick (HBS's CFO) to explain the change and discuss potential financial implications for the School. With that meeting in mind, in early 2014, Bills sat down to estimate the impact of the change in revenue recognition for HMM12 and to construct next year's budget. Under the planned roll-out of HMM12, existing clients could convert to the new version and receive a time-bound inducement discount from the 20% price increase. Specifically, there was an 18% price increase in 2015 for switching from HMM11 to HMM12 and a 20% increase in the subsequent years. Client acquisition efforts centered on selling HMM12, though new HMMIl deals would be approved if circumstances warranted. Existing HMM11 clients were not forced to convert and could continue renewing HMM11 until its retirement date. Bills explained the logic of continuing to offer HMMII: "It takes a while to convert clients. Shifting to a completely hosted model requires increased IT and security involvement, HR hasto reconfigure their programs to the new content and repoint to an external environment, some clients have multi-year contracts and insufficient budget to absorb the price increase...operationally it would be difficult for us to convert all clients in one fell swoop. So, we felt it was important to continue to offer HMMII with a migration plan to HMM12." After some discussion, Bills' team came up with projections for the revenues expected to be generated from customers renewing HMMIl, those switching to HMM12, and HMMII and HMM12 sales to new customers in the years ended June 30, 2014 to 2017 (see Exhibit 5 for revenue projections). To judge how these forecasts affected the full HBP budget, Bills set out to develop the budget under the required new reporting method to compare with the old method. He labeled the old method as pro forma reporting (see Exhibit 6 for a summary of the HBP pro forma budget). Determining how to treat the sales force commissions associated with HMM12 was also challenging, Bills, Wan and the HMM management team debated whether they should change the method of computing commissions. Corporate Learning employed a small number of sales representatives responsible for selling HMM. They received a 6% commission on the total contract values for HMM11 sales, identical to the revenues recognized each year. Should commissions for HMM12 follow the same approach, resulting in commissions being paid out at the signing of the contract, before any revenues had yet been recognized? If so, how should the company report the commissions? Should a portion be deferred to match against revenues as they were recognized each year, or should they be recorded as an expense in the year paid? Alternatively, should HBP modify its method of paying commissions to match the method of revenue recognition for HMM12? Wan also worried about how best to explain the accounting change to Corporate Learning employees. Each month he communicated monthly and year-to-date revenues and contributions for each business unit to the employees. Wan observed, "we've built a culture . . . [that] reinforces the importance of making our commitment to HBS each year in terms of our revenue and our contributions." But he recognized that reporting a downturn in performance, even if only for an accounting change, would likely remind some employees of the downturn in the 2008 financial crisis, when HBP had been forced to make layoffs. Wan observed: "Reporting markedly lower revenues and contributions for no apparent reason will make people get nervous and think something's terribly wrong, we must have screwed up somewhere, and there's going to be more layoffs now." As Bills and Wan met once again to discuss the revenue recognition change, they realized that it would touch many aspects of the Corporate Learning business. Bills had developed a first draft of the revenues segment of the budget, but was unsure how to proceed on sales commissions. In addition, an approach would have to be developed to explain the change to employees and to HBP's shareholder.Exhibit 1 Harvard Business Publishing Summary Statement of Activity for Years Ended June 30, 2010-2013 (in $ millions) Revenue by Market Group & Total Contribution 2010 2011 2012 2013 Higher Education 39.4 42.8 44.9 50.9 Harvard Business Review Group 63.9 72.3 76.2 80.0 Corporate Learning 35.4 43.0 48.4 56.4 Total Revenue 138.7 158.1 169.5 187.3 HBP Net Contribution (Revenue - Expenses) 17.6 24.3 24.0 27.4 Source: Harvard Business Publishing- Exhibit 2 Sample page from Harvard ManageMentor Version 11 Learning Tool HARVARD ManageMentor My HMM Forum Help Search HMM. Go INCHTO CORPORATION BROWSE TOPICS HELP EMPLOYEES ACHIEVE THEIR ALL CATEGORIES ROLES Budgeting POTENTIAL Business Case Development Business Plan Development How not to coach Career Management Are you an active listener? Change Management Coaching Crisis Management Explore Coaching Customer Focus Decision Making MY HMM SPOTLIGHT COMPANY MESSAGE TIP OF THE DAY MOST RECOMMENDED TOPIC PROGRESS It's time for employee reviews at Incito. HARVARD VIDEO Take a moment to visit the BUSINESS Fair business conduct in China Performance Appraisal topic to Wil Chan (1:30 prepare Prepare for the Need Defining Moment Every important meeting has a AMEGLE defining moment that can lead to How Pixar fosters collective creativity breakthrough resuits. These Ed Can( pages) Difficult Interactions moments are often preceded by uncertainty. When the group is not FORUM sure whil to do need, there is an Difficult employes: could you be Go to My HIM to view al opportunity for someone to bake the problem? action and move things forward Before your next critical meeting, think TIPS about when those moments might Creating a high-performing global team Version 81 0. bassasia e Bots Harvard Business ichost Publicsing. all rights racarved Welcome, Rob SIGN OUT Bookmarin @Exhibit 3 Harvard Business School Summary Statement of Activity for Years Ended June 30, 2008- 2013 (in $ millions) 2008 2009 2010 2011 2012 2013 Total Revenues 451 472 467 509 546 587 Total Expenses 423 438 415 456 504 542 Surplus 28 34 52 53 42 45 Source: Harvard Business School annual reports, 2008-2013. Exhibit 4 Harvard University School Summary Statement of Activity for Years Ended June 30, 2008-2013 (in $ millions) 2008 2009 2010 2011 2012 2013 Total Revenues 3,482 3,807 3,739 3,778 4,018 4,215 Total Expenses 3,465 3,762 3,740 3,908 4,026 4,248 Surplus 17 45 (1) (130) (8) (33) Source: Harvard University annual reports, 2008-2013.Exhibit 5 Assumptions and Projections for HMM Forecasted Revenues for years ended June 30, 2014-2017 (in $ thousands) 2014F 2015F 2016F 2017F Renewals by HMM11 customers Revenue from renewals continuing with HMM11 28,220 15,989 8,411 4,518 Revenue from renewals switching to HMM12 18,751 29,913 22,111 New customer revenues HMM11 5,980 3,800 3,400 3,050 HMM12 3,900 6,868 9,541 11,140 Renewals by HMM12 customers Revenue from renewals continuing with HMM12 3,315 23,134 Additional information Percent HMM12 revenue recognized in year of sale 2014 10% 50% 40% 2015 25% 50% 25% 2016 25% 50% 2017 25% Source: Harvard Business Publishing. Note: The percentage of revenue recognized was lower in 2014 because HBP introduced HMM12 late in 2014. Sales amounts adjusted to simplify analyses. Exhibit 6 HBP Forecasted Revenues, Expenses, and Contribution for Years Ended June 30, 2014 to 2017 Using Pro Forma Reporting Standard for HMM12 (in $ thousands) 2014F 2015F 2016F 2017F Pro forma reporting: Revenues (a) 202,849 216,119 231,304 246,808 Expenses (b) 174,732 184,756 200,318 213,362 Contribution 28,117 31,363 30,986 33,446 Contribution margin 13.9% 14.5% 13.4% 13.6% Source: Harvard Business Publishing- Note: () Total revenues for all of HBP's market groups. (Total expenses for all of HBP's market groups. Expenses included ongoing development costs, as well as marketing and sales costs