A Revenue Recognition Primer for SaaS Providers: Finding insights in recognizing revenues under ASC 606

February 2020

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The software as a service (SaaS) delivery model has been on a tear and shows no signs of slowing down. Indeed, according to Gartner, 2020 revenues will reach $110.5 billion, up from a projected $94.8 billion in 2019.

In a high growth industry, companies are moving fast to stay competitive—introducing new offerings, adjusting their services to improve customer retention, and finding new revenue streams.
 

The Evolving SaaS Model

As the SaaS delivery model matures so does its business model in order to satisfy customer demands as well as retain profitability. For example, a typical scenario for a growing SaaS provider is to provide an enhanced service offering for customers up-front that would include individualized professional services and other customized solutions in order to gain a better understanding of customers’ needs. Eventually the SaaS providers can standardize these offerings, thus reducing the level of individual professional services performed by themselves or partners they have engaged.

The lifecycle of a SaaS contract
The lifecycle of a typical SaaS customer, along with typical events that may require accounting considerations, is illustrated in the following diagram: 

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SaaS arrangements can include various services during the set-up and implementation period, and after go-live. Usually there is an initial term—for instance, one year or one month—and successive renewal periods until the customer ceases to use the service or migrates to a different version of the service.
 


 
As a result, this changing nature of the SaaS model can make it difficult to apply the revenue recognition guidance in Accounting Standards Codification Topic 606, Revenue from Contracts with Customers (ASC 606). 

As the industry evolves, so too must SaaS companies’ approach to revenue recognition.

To that end, BDO has identified the following insights that SaaS providers may find helpful related to revenue recognition along the customer lifecycle. Through a series of examples, this primer demonstrates the application of these insights.

The matters addressed in this publication are as follows:

  • Determining the contract term
  • Evaluating professional services with the SaaS arrangements
  • Applying the series guidance
    • Usage-based pricing
  • Evaluating optional purchases
  • Accounting for commissions and other similar costs of obtaining a customer contract


Brief Refresher – The Main Principles of ASC 606

Under ASC 606, a SaaS provider recognizes revenue when it transfers a service to the customer. The amount of revenue recognized is based on the consideration the SaaS provider expects to be entitled to in exchange for those services.

To apply these principles, ASC 606 requires entities to employ the following five-step process:
1.  Identify the contract with the customer
2.  Identify the performance obligations in the contract
3.  Determine the transaction price
4.  Allocate the transaction price to the performance obligations in the contract using Stand Alone Selling Price (SSP)
5.  Recognize revenue when (or as) the entity satisfies a performance obligation




Please consider reading this publication in conjunction with ASC 606 itself, as well as our companion piece BDO Knows FASB: Topic 606 Revenue from Contracts with Customers, which describes the requirements of the standard in more detail.


Determining the Contract Term

Many SaaS arrangements contain a stated term of one year or longer. However the “accounting term” might be much shorter if the arrangement contains termination for convenience provisions. A termination for convenience clause allows one or both of the parties to cancel the contract without having to pay any type of substantive penalty.

A shorter accounting term might reduce the transaction price of the contract, potentially introduce new performance obligations (material rights), and/or change the period over which certain deferred costs are amortized, as summarized in the following table:

Table 1: Accounting Implications of Termination for Convenience Rights
 

Party Possessing the Rights Accounting Implications
Both Parties When both parties can opt out of the contract at any time for convenience, the contract effectively becomes a day-to-day contract for accounting purposes. This means that the SaaS provider should not consider any future variable consideration in determining the transaction price. 
Customer Only The term of the contract is limited to the notice period, if any, that the customer must provide when electing its right to opt out of the contract. Moreover, if the customer initially paid a nonrefundable fee at the commencement of the contract, the SaaS contract might contain a material right, since the customer can effectively opt to remain in the contract (i.e., by not exercising the termination right), and receive future periods of access to the SaaS solution without having to pay that same initial upfront payment. The concept of material rights is explained in more detail later in this publication.
SaaS Provider Only No implications—the accounting term of the contract is presumed to be its stated term.



 

Evaluating Professional Services Associated with the SaaS Agreement

Most SaaS arrangements involve more than just “hosting”—i.e., allowing customers access to a software solution through the web. Commonly, SaaS providers will also offer customers professional services (PS), which may include configuration of the SaaS solution, interfacing the SaaS solution with the customer’s existing software, building customized reports, or many other types of value-added services.

When a customer contract includes PS, it may be challenging to determine whether these services are performance obligations under ASC 606 versus set-up activities that are necessary for the SaaS provider to fulfill its promise(s) in the contract. This distinction is important because it significantly affects the timing of revenue—and cost—recognition in the income statement, as shown in the following table:
 

Table 2: Performance Obligation vs. Set-up Activity for Professional Services
 

  Performance Obligation Set-Up Activity and/or Non-Distinct Performance Obligation
Description/Distinction The PS will be evaluated as a potential performance obligation if it transfers a good or service to the customer.
Moreover, the PS will be a distinct performance obligation—i.e., one that is accounted for separately from other promises in the contract—if the PS meets both of the following criteria:

1. The customer can benefit from the PS on its own, or together with resources that are readily available to the customer
2. The promise to provide PS is separately identifiable from other promises in the contract

The first criterion is typically met when the SaaS provider or others regularly sell the PS separately, without also requiring the customer to purchase the hosting services. In some cases, this criterion can also be met even if the PS is only sold in conjunction with the hosted software, depending on facts and circumstances. For example, if the PS will be provided after the hosting services have commenced, the customer can benefit from PS together with resources readily available to the customer, namely the hosting services that have already been transferred.

The objective of the second criterion is to assess whether the nature of the promise in the customer contract is to deliver PS and other goods and services individually or, instead, to transfer a combined item. Factors suggesting that the PS is not separately identifiable from the hosting and other services in the contract (and therefore not a separate performance obligation) include:
a. The PS is an input necessary to fulfill a promise of delivering a combined output to the customer, i.e., they are integral and they can not be performed by someone else.
b. The PS significantly modifies or customizes the hosting solution, or vice versa.
c.  The PS and other goods and services in the contract are highly interrelated or interdependent. This means that the SaaS provider would not be able to fulfill its contractual promise by transferring each of the goods or services independently.

In practice, application of this second criterion involves significant judgment.
If the PS does not meet the criteria to be a separate performance obligation (i.e., is a non-distinct performance obligation), a SaaS provider should consider whether the activities are items that the entity must undertake to fulfill a contract—i.e., set-up activities. Set-up activities do not transfer a good or service to a customer.

For example, a SaaS provider may need to perform various administrative tasks to configure a cloud-based platform for use by a customer. The SaaS provider may even charge the customer an “activation” or similar fee to recover the cost of performing the tasks.

However, the performance of those tasks does not transfer a good or service to the customer. Therefore, those set-up activities cannot be considered performance obligations in the contract with the customer.
Accounting Guidance See paragraphs 19-21 of ASC 606-10-25 See paragraph 17 of ASC 606-10-25
Accounting implications If the PS is considered to be a distinct performance obligation, a portion of the transaction price would be allocated to the PS (based on SSP) and recognized as revenue when or as the PS is transferred to the customer.

​If costs of fulfilling PS are incurred prior to the transfer of the PS to the customer, such costs will typically be deferred under ASC 340-40. Once transfer of control of the PS begins, any costs previously deferred as fulfillment costs should be recognized on a systematic basis that is consistent with the transfered goods and serivces to which the asset relates.
Any fees charged to the customer for the set-up activities are allocated to other performance obligations in the contract and recognized as revenue with those performance obligations. That is, no revenue is recognized upon completion of the set-up activities.

​The costs of performing the set-up activities are typically accounted for as a fulfillment cost; such costs are deferred and amortized in proportion to the revenue recognized under the contract, including consideration of any expected renewal periods.
Example Hosting Co. (HC) enters into a one-year contract with a customer. The contract permits the customer to use HC’s cloud-based platform to process an unlimited number of transactions each month. HC also agrees to migrate the customer’s historical data onto the platform for comparative purposes only—such data is not required for the platform to operate. In addition, HC will provide training on how to use the platform to the customer’s sales professionals. The customer will pay a fixed amount of $12,000 per month over the contract term.

Assume that HC has separately sold data migration services to other customers. Accordingly, the data migration services meet the first criterion to be a separate performance obligation.

However, further assume that HC never sells training separately. Nevertheless, the training services can still meet the first criterion to be a separate performance obligation because the customer can benefit from the training services with resources that are readily available to the customer. Simply, the training services would not be provided until after the customer has access to the transaction processing platform, making it a resource readily available to the customer at the time the training is delivered.

The transaction processing platform can function without the training and data migration services. Accordingly, it does not appear that the items work in concert to deliver a combined output, or that they are significantly interdependent or interrelated. The items also do not significantly customize or modify one another.

Accordingly, the training, data migration, and hosting services would all be separate performance obligations. The total transaction price of $144,000 ($12,000/month for one-year) would be allocated to the three items on a relative standalone selling price basis. The amount allocated to the hosting services would be recognized as revenue over time, while the amounts allocated to the training and data migration services would likely be recognized when those services are transferred to the customer.
Internet Provider Inc. (IPI) enters into a contract that allows a customer to process an unlimited number of sales transactions each month. IPI also agrees to modify the platform so that it calculates appropriate sales tax depending on where a customer resides and the tax laws in that state. The customer has engaged IPI to perform these modification activities for a fixed fee of $10,000. The modification services are necessary for the platform to operate as designed and to ensure that its customers comply with sales and use tax regulations.

Assume that both the modification services and the SaaS offering are capable of being distinct. Therefore, these services would meet the first criterion to be a separate performance obligation under ASC 606.

However, the modification services appear to be necessary for the transaction processing platform to properly operate. Accordingly, the modification services would be an input necessary to fulfill IPI’s promise of delivering a functioning transaction processing platform. Therefore, IPI concludes that it has one combined performance obligation that includes both the modification services and the SaaS services.

The $10,000 fee charged by IPI for modification would be added to the consideration for the hosting service, and the total amount recognized over the contract period as the services are provided. Any costs incurred in performing the modification services would be deferred under ASC 340-40 and recognized in proportion to revenues recognized. The amortization period may extend beyond the initial contract term if customer renewals are expected to occur.

 

Applying the Series Guidance

ASC 606 introduces a concept known as the “series guidance.” The series guidance was intended to make it easier for companies that perform repetitive services to apply ASC 606. The guidance is neither optional nor an accounting policy election—instead, it must be applied by a SaaS provider for those contracts that meet the criteria to be accounted for as a series.

The series guidance applies when a SaaS provider transfers similar goods and services over the course of the contract. Specifically, those goods or services must be:

  • Individually distinct - that is, each good or service is independent of the other goods and services transferred in the contract, and are not inputs to fulfilling a promise to deliver a combined output
  • Substantially the same
  • Transferred to the customer over time, using the same pattern of transfer




Again, the series guidance must be applied for those contracts that meet the criteria to be accounted for as a series. In contrast, the series guidance cannot be applied to contracts that do not otherwise meet the series guidelines—for instance, when:

  • Each service in the contract is not similar in nature
  • The pricing of the individual promises is inconsistent
  • Each service is not distinct—perhaps because the service rendered one day influences the services performed in subsequent days
  • The services are not transferred over time, but instead at discrete points in time


Contracts that do comprise a series of distinct goods and services are accounted for as though the entire series were a single performance obligation. While the series guidance can simplify the application of the revenue model in ASC 606, it also can introduce new challenges, such as the accounting for a modification or amendment of a contract containing a series.
 

Usage-Based pricing

As discussed previously, some SaaS contracts contain usage-based pricing. ASC 606-10-55-65 provides a usage and sales-based royalty exception, which precludes a company from recognizing revenues from sales-based or usage-based fees associated with licenses of IP until the subsequent sale or usage occurs. However, this exception from the general guidance to recognize variable consideration does not apply to most SaaS arrangements because hosted software arrangements are typically scoped out of this guidance as noted in ASC 606‑10‑55-54(a).

As a result, SaaS providers could be required to estimate the variable consideration from usage-based pricing, subject to the general constraint in ASC 606, in determining the transaction price. Fortunately, though, many SaaS arrangements will qualify as a series, as mentioned earlier in this publication, which will likely provide relief from the need to estimate this variable consideration. This is because entities are required to allocate variable consideration solely to distinct goods or services promised in a series of distinct goods and services that forms a part of a single performance obligation if (1) it relates specifically to the entity's efforts to deliver that performance obligation and (2) allocating it only to that performance obligation wouldn't violate the overall allocation guidance. This means that generally the SaaS provider can simply recognize income based on the customer’s usage during the reporting period, similar to the outcome that would have been obtained by applying the usage and sale-based royalty exception in ASC 606-10-55-65.

Note that ASC 606-10-55-18 also provides a so-called “invoicing practical expedient.” Under this practical expedient, an entity would simply recognize revenue equal to the amount that it has a right to invoice during a reporting period. This would allow the entity to avoid having to estimate the transaction price, or even determine the proper pattern in which the good or service is being transferred to the customer (e.g., straight-line or based on usage). To qualify for the practical expedient, an entity must have a right to receive consideration from the customer that corresponds directly with the value of the goods or services transferred to the customer for performance completed to date.


Evaluating Optional Purchases[2]

Many SaaS contracts offer flexibility to customers. For instance, some contracts allow the customer to increase the number of users with access to the cloud platform for an additional fee. Other contracts may charge customers a fee for each transaction processed through the SaaS platform, where the number of transactions varies each day.

It is important for SaaS providers to ascertain whether certain contractual provisions represent variable consideration or optional purchases, as the accounting is very different for these two items:

  • Variable Consideration. Unless subject to the series guidance (as discussed in the previous section), a SaaS provider would estimate the amount of variable consideration in a customer contract and include the estimate in the transaction price, subject to a constraint.[3]
  • Optional Purchases. The SaaS provider must first determine whether the optional purchase represents a material right. If so, then the material right would be a performance obligation, meaning that a portion of the transaction price would have to be allocated to the right. Revenue from the material right would be recognized at the earlier of when the purchase right expires or, if exercised, when the underlying good or service is transferred to the customer. The next section of this publication discusses the accounting for material rights in more depth.








When a contract contains the right to make additional purchases, a SaaS provider must determine whether those purchases represent material rights. A material right results when the SaaS provider offers an optional benefit that the customer would not have received without entering into the contract.

For example, by entering into a contract, a customer might obtain the right to purchase a good or service at a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market.




A material right is a performance obligation under ASC 606. It must be allocated a portion of the transaction price based on its relative standalone selling price, although ASC 606 does provide an alternative that SaaS providers can use instead of estimating the standalone selling price of a material right.

Revenue from the material right would be recognized at the earlier of when the purchase right expires or, if exercised, when the underlying good or service is transferred to the customer.


 

The Accounting for Commissions and Other Similar Costs of Obtaining a Customer Contract

ASC 340-40 requires that incremental costs to obtain a contract be deferred and amortized on a systematic basis consistent with the pattern in which revenue related to the contract is being recognized. However, as a practical expedient, a company may recognize the incremental costs of obtaining a contract as a period expense if the amortization period would have been one year or less.

ASC 340-40 defines the incremental costs of obtaining a contract as those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained. A common example of a qualifying cost is a sales commission payable to a sales agent or employee upon contract signing.

In practice, SaaS providers may sometimes find it challenging to determine the period over which qualifying costs should be amortized and the pattern in which amortization should be recorded.


 

How BDO can help

BDO is well-equipped to help preparers navigate the myriad of complex accounting, SEC reporting, tax, and audit considerations needed to be addressed by SaaS providers as they determine the proper accounting for revenue. BDO professionals have a wealth of experience working with "best in class" SaaS providers. By leveraging our extensive experience with companies of all sizes across a wide range of industries, we have the ability to offer a comprehensive range of services to assist and complement your internal accounting functions through a collaborative and tailored approach.
 



CONTACT:
 

Adam Brown
National Assurance Managing Partner – Accounting
  Doug Hart
Assurance Office Managing Partner

 
Aftab Jamil
National Technology Industry Leader
  Jennifer Kimmel
National Assurance Director

 
Hank Galligan
Assurance Partner
  Angela Newell
National Assurance Partner

 
Ken Gee
Assurance Partner
  Michael Stevenson
National Practice Leader, Accounting & Reporting Advisory Services
 
[1] Refer to Transition Resource Group Memo No. 39, Application of the Series Provision and Allocation of Variable Consideration.
[2] Refer to Transition Resource Group Memo No. 48, Customer Options for Additional Goods and Services, Memo No. 39, Application of the Series Provision and Allocation of Variable Consideration, and Memo No. 6, Customer Options for Additional Goods and Services and Nonrefundable Upfront Fees, for further information and examples on this topic.
[3] The estimate of variable consideration may be based on a most likely amount or an expected value, considering probability-weighted assumptions. The transaction price will then be constrained, or limited, to an estimate of variable consideration for which it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty is subsequently resolved.
[4] Refer to Transition Resource Group Memo No. 23, Costs to Obtain a Contract, and Memo No. 57, Capitalization and Amortization of Incremental Costs of Obtaining a Contract, for further information and examples.