Nine Areas Impacted by Revenue Recognition for Software and SaaS Companies
Monday, February 18, 2019
Posted by: Kaylin Berg
Brent Peterson, Nicole Howe & Brian Langham, Plante Moran
In a move that directly affects software companies, the FASB updated its guidelines regarding the amount and timing of revenue and cost recognition. It’s crucial that companies understand this guidance.
In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers. The standard replaces most existing revenue recognition guidance within U.S. generally accepted accounting principles and applies broadly across industries. One of the goals of the new standard is to remove the industry-specific prescriptive revenue recognition guidance that currently exists and to adopt a more principles-based standard that can be applied consistently, regardless of industry. The basic principle of the standard is that entities must recognize revenue in an amount that reflects the consideration they expect to receive as they transfer goods or services to customers.
While many companies may ultimately determine that the new guidance does not drastically impact the amount and timing of revenue and cost recognition, the software industry, and software as a service (“SaaS”) companies specifically, are significantly impacted by the application of the new standard. It requires companies to approach revenue recognition with a different mindset that takes into consideration new concepts and more reliance on professional judgment, contract terms and conditions, and customary business practices. Even for those companies that do not experience significant impacts to amounts and timing of recognition, at a minimum, expanded revenue recognition disclosures within the financial statements will be required for all entities, and judgments made throughout application of the model can impact the applicable disclosure requirements.
Some aspects of the new standard that frequently result in accounting treatment for SaaS companies that differs from current practice include:
- Contracts - Companies have traditionally viewed legal and accounting contracts as one and the same. The new standard introduces the concept of enforceable rights and obligations such that certain contract terms and/or business practices can have a significant impact on the defined contract for accounting purposes. Termination clauses, up-front payments, business practices of providing customers with pricing concessions, and oral arrangements are a few of the key areas that companies should assess and consider in relation to what constitutes a contract and the related subject consideration. Companies may discover opportunities to refine contract practices to both better align accounting controls with the spirit of the standard and to shore up contracting practices in some areas that have historically received less scrutiny. This may be especially relevant to those companies that have completed various acquisitions historically and may have various contract forms in circulation. Companies may also ultimately conclude that legal contracts may be comprised of multiple accounting contracts, which may require changes to systems and controls in order to ensure that accounting policies are applied and new disclosure requirements are followed at the appropriate level.
- Contract modifications – Many SaaS companies that offer transaction processing within their applications structure contracts to include a cap on the number of transactions included or define parameters for the number of end users serviced within the contract or a pricing tier. Companies’ practices with regard to the treatment of contracts that exceed a stated cap or user parameters are expected to require analysis to determine the impacts under the new standard. Business practices may also be considered when performing such analysis. A significant area of judgment within the new standard frequently relates to determining whether stated fees for additional processing or services, or changes in contracts, such as those due to excess fees, represent new accounting contracts, contract modifications to be accounted for on a cumulative catch-up basis, contract modifications to be accounted for on a prospective basis, material right performance obligations, or variable consideration. Conclusions reached in analyses such as these will be based on the specific facts and circumstances identified within the relevant contracts and may result in significant changes in accounting policies or differences in the application of the standard between otherwise similar-seeming business models.
- Performance obligations – Many SaaS companies have experience under current standards applying multiple deliverable arrangement accounting guidance, including performing required assessments of standalone value. The new guidance applies a similar model in requiring companies to assess all implicit and explicit promises made within a contract and then to apply criteria to determine whether each promise is a distinct performance obligation. Promises continue to be bundled together for accounting purposes until the distinct criteria are met. Each resulting distinct performance obligation within a contract then becomes the unit of account driving the application of the model to ultimately recognize revenue separately for each identified distinct performance obligation. While similarities exist between the old and new models, in many cases, the new guidance may result in the identification of more distinct performance obligations than were identified under old guidance. SaaS companies frequently encounter challenges in applying the new guidance, including:
- Most SaaS companies have traditionally treated a subscription offering and related support to be a single deliverable and unit of account. Under the new revenue recognition guidance, companies will often conclude that the base subscription and support are distinct. While some of these arrangements may qualify to practically continue to treat such offerings as a single unit of account, not all of them will. This is especially true of companies that place substantive limits on the amount of support that customers are eligible to receive. Those companies will likely find that they need to separate these services into separate performance obligations for accounting purposes.
- Specialized guidance exists for licenses of intellectual property that frequently applies to on-premise software licenses. As a result, one significant area of judgment that some SaaS companies may encounter in applying the new guidance is determining whether a hybrid offering that includes an on-premise software license and a SaaS application or a SaaS application with an offline mode include a single bundled performance obligation, or whether the offerings are distinct.
- SaaS companies frequently sell services that can be renewed or provide other customer options. To the extent that significant renewal or other discounts are offered to customers, the guidance requires assessment of such offers to determine whether they transfer a material right to the customer that should be accounted for as a distinct performance obligation. Many companies may find that even if they do not ultimately reach the conclusion that additional units of accounting exist, significant effort may be required to perform the analysis to reach that conclusion.
4. Variable consideration – The new guidance considers any variability in pricing subject to change to constitute variable consideration. SaaS companies often encounter contract terms such as usage-based fees or volume discounts, may sell software through resellers with rights of return, or may have business practices of frequently providing price concessions to customers. In many cases, such amounts may be deferred until known or identified under current guidance. While practical expedients in the new guidance are available to companies to allow for administrative ease in applying the new guidance (primarily to allow companies to recognize transaction-based fees as they are earned in specific circumstances), many SaaS companies may find that the structure of their contracts is such that they are precluded from using such expedients. For usage-based fees, the inclusion of minimum or maximum usage levels may preclude taking advantage of such practical expedients. Without the ability to take advantage of recognition as invoiced, companies will be required to develop estimates of total variable consideration within a contract, which is often a burdensome endeavor. Also, companies that sell through resellers and currently apply a sell-through model for revenue recognition purposes may accelerate recognition upon the initial transaction with the reseller and will accordingly be required to estimate the related variable consideration under the new model. Such estimates then may be recognized only to the extent it is probable there won't be a significant subsequent downward adjustment.
5. Allocation of the transaction price – The new guidance generally requires that consideration within a contract should be allocated to the distinct performance obligations within that contract on a relative standalone selling price (“SASP”) basis. Many SaaS companies may already have processes in place to evaluate deliverables for vendor-specific objective evidence, third-party evidence, or management’s best estimate in the hierarchy provided under current multiple deliverable arrangement guidance that will be useful in developing estimates of SASP to comply with the new guidance. However, developing and allocating revenues for some performance obligations can require the application of significant judgment. Material right performance obligations and new product or service offerings can especially present unique challenges to companies in completing this step in the new revenue model. Companies should be aware that while developing the related policies for allocation is generally not the most resource-intensive step in the new model, the application of those policies may require the development of new processes and controls on an ongoing basis that could be resource-intensive.
6. Recognition pattern – Many SaaS companies may conclude that the pattern of recognition for services that provide continuous access, generally on a subscription basis, will continue to be recognized on a straight-line basis over a period of time. However, many SaaS companies may also conclude that their contracts include other performance obligations that should be assessed for the appropriate pattern of recognition. These may commonly include specified upgrades, a specified amount of technical support, set-up and training activities, and other professional services. SaaS companies should be aware that each identified performance obligation will need to be reassessed to determine which attribution method will best depict the pattern of transfer to the customer of the related goods or services, which may differ from the subscription or license period, and this assessment could change the pattern of recognition from current practice.
7. Principal vs. agent analyses – The new guidance shifts the focus of principal vs. agent analyses to a model that focuses significantly on control and applies the concept of control to service models. The analysis of whether an entity acts as a principal or an agent in a transaction must be revisited for companies with performance obligations in which a third party is involved in delivering the product or service to the customer. Such analyses often require significant judgment when services are being analyzed. Many software companies that provide their products through third-party hosting arrangements or provide a marketplace service offering may find application of the relevant guidance to be challenging and may potentially change previous conclusions and resulting financial statement presentation.
7. Costs to obtain contracts – The new guidance requires companies to capitalize costs incurred solely to obtain contracts if they meet certain criteria. Many companies currently expense those costs. The new guidance provides an option to expense costs to obtain contracts if the amortization period would be one year or less. At first glance, many companies expect to meet that requirement. However, if a company specifically anticipates contract renewals, this option is often not available. SaaS companies should be aware that the structure of their internal sales force and reseller commission plans, including margins on initial sale and renewal commissions, may result in a requirement that previously expensed commission costs should now be capitalized and amortized, in which case profit margins may be impacted. Application of the new guidance could also result in changes to the income statement classification of the related costs.
9. Costs to fulfill contracts – Finally, the new guidance requires companies to capitalize and amortize costs to fulfill customer contracts if they meet certain criteria. The new guidance does not provide relief from this requirement based on the anticipated amortization period. SaaS companies with significant up-front fees often charge such fees in order to be compensated for costs incurred at the inception of a contract that do not transfer a good or service to the customer. These companies should be aware that such costs may represent fulfillment costs that will be subject to capitalization under the new guidance.
The new revenue recognition guidance will be effective for private companies for annual reporting periods in fiscal years beginning after December 15, 2018. Given the significant impacts to the industry, companies need to have a strong understanding of the new guidance in order to effectively evaluate how it might change current business activities, including contract negotiations, key metrics (including bank covenants), budgeting, commission and bonus plans, controls and processes, and accounting. Calendar year-end public companies adopted the new standard on January 1, 2018 and first reported transition disclosures and new accounting policies in Q1 10-Qs, providing additional resources for private companies to consult in determining how their public company peers have applied and been impacted by the related guidance. Given the potential resource-intensive nature of reassessing accounting policies subject to the new guidance and the reduced flexibility in considering changes to contracting terms and/or business practices, we strongly recommend that private companies undertake efforts to begin assessing their own revenue streams and contracts for impacts of the new standard. Companies will need to be able to document their policy assessments, emphasizing the factors considered contributing to significant judgments made in those assessments.
This blog originally appeared on the Plante Moran website, here.