Example 1: Web-based Sales Platform (A Basic Example)

Wind in Your Sales, Inc. (WINS) has developed a sales platform that allows customers to track customer leads, develop sales proposals, and warehouse contracts. The sales platform is accessed through the cloud, and WINS does not allow its customers to license the underlying software on premise.
WINS enters into a contract with a customer on October 1, 20X1. The contract permits the customer to utilize all of the features of the sales platform and store an unlimited amount of data on WINS’s secure servers. The contract duration is for one year. The customer will pay the $100,000 subscription fee, in four quarterly installments starting at contract inception.

Even in this relatively straightforward example, there are many aspects of applying the five-step revenue recognition process to consider:

1. Identify the contract with the customer. The customer contract would need to be evaluated to ensure that it is enforceable—both from a legal and accounting perspective based on the guidance in ASC 606. For instance, WINS would need to consider whether both parties are committed to perform their respective obligations under the contract. Moreover, WINS would need to consider whether a portion of the contract may actually contain a lease for the right to use the company’s server space. If so, that portion of the contract would be accounted for outside of ASC 606.
     
For the remainder of this example, we’ll assume that the contract is enforceable under ASC 606 and does not contain a lease.

2. Identify the performance obligations in the contract. WINS would evaluate whether the promises to allow the customer to use its platform and to store an unlimited amount of data are separate or distinct performance obligations (accounting units). The two promises would be distinct if they meet the following criteria:

• The customer can benefit from the good/service on its own (i.e., each promise is capable of being distinct.)

• Each good or service is “separately identifiable.” This means that each promise is distinct within the context of the contract. For instance, the promises are not significantly interdependent or interrelated, or one promise is not an input necessary to deliver a combined output to the customer.

Let’s assume, though, that WINS concludes that these two undertakings are not distinct—that they are actually inputs to fulfilling a combined promise of providing customers with a cloud-based solution. Next, the company would then consider whether the single combined promise actually provides the customer with a distinct daily service of standing ready to allow access to its cloud-based platform. If so, WINS would account for the customer contract as a single performance obligation using the so-called “series guidance” in ASC 606. The series guidance is explained in more detail later in this publication.

3. Determine the transaction price. The transaction price seems to be fixed at $100,000. Nevertheless, WINS should consider whether its customary business practices or intent might involve granting concessions, discounts, rebates, or other credits that could vary this transaction price. This evaluation should be performed even if the contract itself is silent as to whether the customer might be entitled to or will receive these credits.

4. Allocate the transaction price to the performance obligations in the contract. Assuming that the customer contract either contains a single performance obligation or a series of distinct services that will be accounted for as a single performance obligation, there would be no need for WINS to perform this step in accounting for the contract.

5. Recognize revenue when (or as) the entity satisfies a performance obligation. WINS is fulfilling its promise under the contract each day the sales platform is made available for the customer’s use. Accordingly, as WINS is fulfilling its performance obligation, the customer is simultaneously receiving and consuming the benefits of WINS’s performance. This means that WINS would recognize revenue from the customer contract over the one-year contract term, likely on a straight-line basis. Sometimes, however, it will be more appropriate to recognize revenue in proportion to customer usage of the sales platform—this determination will be covered in more depth later in this publication.

Example 2: Example of a Series

Dashboard Inc. has created a SaaS platform that remotely monitors and diagnoses problems with a machine. Specifically, the machine is fitted with a sensor that feeds data real-time to Dashboard’s platform. The platform’s algorithms provide alerts when the machine needs replacement parts or is at risk of having a malfunction.

The nature of the promise Dashboard has made is to monitor the performance of a machine during the term of a contract. This promise is fulfilled every day through Dashboard’s “stand-ready” obligation. That is, Dashboard has agreed to effectively provide a daily service of standing ready to alert the customer if the SaaS platform detects any issues with a machine. The daily service Dashboard provides on a given day is distinct from the other daily services it has provided in the past or will provide in the future. In other words, the outcome of the monitoring service on one day doesn’t affect the outcome of that same service on any other days within the contract term.

If Dashboard were to enter into a one-year contract with a customer, it technically will make 365 distinct promises—to provide monitoring services each day of the contract. The FASB recognized that accounting for each separate promise would be burdensome. Accordingly, Dashboard’s contract would be accounted for under the series guidance in ASC 606. Specifically, while each daily increment of monitoring services is distinct, the nature of Dashboard’s stand-ready obligation each day is substantially the same (and each day’s service is being transferred over time, using a time-based measure of progress).

As indicated in the following discussion, the series guidance will result in Dashboard combining the 365 distinct daily promises into a single performance obligation for purposes of applying ASC 606.

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:

Example 3: Usage-Based Pricing Series Guidance

Let’s continue with Example 2. Recall that Dashboard Inc. has created a SaaS platform that monitors and diagnoses problems with a machine remotely. The contract is being accounted for under the series guidance.

Dashboard charges its customers $50 for every hour that the underlying machine operates and transmits data to Dashboard’s platform.

• Absent the relief provided by the series guidance, Dashboard would have to estimate the transaction price over the term of the contract, which by necessity will involve estimating the manner and extent in which the customer will use the underlying machine.

• However, applying the series guidance permits Dashboard to avoid that highly judgmental process, and simply record revenue each day based on the customer’s actual usage for that day. For instance, if the customer uses the machine for 8 hours one day and 10 hours the next, Dashboard would simply recognize daily revenues of $400 and $500, respectively.^[1]

Example 4: Variable Consideration

Under a contract, Stars Inc. allows astronomers to upload an unlimited number of telescopic images to Stars’s proprietary cloud-based platform for a period of one-year. The platform will analyze the images and perform complex calculations to identify objects that might be newly discovered planets.

Assume that this contract does not fall within the series guidance because the precise services applied to each uploaded image will differ based on the quality of the image and its luminosity.

Stars Inc. charges $1,000 per GB of data processed. The amount of data processed—and the amount charged to the customer each month—varies depending on the number of images submitted by a customer and the quality of those images.

The nature of the promise in this contract is to evaluate the data submitted by the customer. Therefore, when a customer submits images for analysis, the customer is not making a separate purchasing decision. That is, the customer already made its purchasing decision by entering into the contract initially. This means that the fluctuations resulting from the customer’s usage of the data analysis services is variable consideration that should be estimated and, subject to the constraint, included in the transaction price.

Stars would have to evaluate the appropriate pattern in which to recognize the transaction price as revenue. For example, Stars may conclude that it should recognize revenue based on the amount of computing processing time incurred during a period, relative to the total estimated amount of computing time it expects to incur in fulfilling its data analysis promise over the term of the contract.

Example 5: Optional Purchase

Lab Inc. offers a collaboration platform that allows users to simultaneously work on and save documents in the cloud. Lab charges an annual fee of $1,000 per user.

A customer entered into a one-year contract with Lab, initially for three user licenses. Three months later, the customer requested that a fourth user be added to the contract and paid a pro-rata fee of $750 once the additional user credentials were provided by Lab.

In this fact pattern, the promise in the original contract was to provide the customer with three user licenses to the Lab collaboration platform. Lab is not obligated to provide collaboration services to more than three users unless the customer elected to expand the scope of the contract and pay an additional fee. Subsequently, the customer made a separate buying decision to add the additional user. At that time, the separate purchasing decision to add the fourth user would be accounted for under the contract modification framework, most likely as a new contract since the price of the contract appears to have changed by the standalone selling price of the additional seat license.

SaaS arrangements can be modified in many different ways, some of which may be significantly more complicated than simply adding additional user licenses at standalone selling prices. Practitioners are strongly encouraged to discuss any complex modifications with knowledgeable accounting advisors.

Example 6: Material Right

Recall our earlier Example 5, in which Lab Inc. offers a collaboration platform. A customer enters into a contract to purchase three user seats for $1,000 per license.

However, now assume that as part of the contract, Lab will allow the customer to purchase up to three additional user seats for a significantly discounted $600 per license. Lab does not offer this type of discount to similar classes of customers.

Accordingly, the option to purchase additional licenses is a material right. It would be a separate performance obligation and allocated a portion of the $3,000 transaction price (3 licenses x $1,000/license) based on relative standalone selling price. However, ASC 606 allows companies to use an alternative approach to allocating arrangement consideration to a material right. Rather than determining the stand alone selling price of the material right using sophisticated option pricing models, an entity can allocate the transaction price by referencing the goods or services expected to be provided, in this case the additional licenses.

Assume Lab estimates that there is a high likelihood that the customer will purchase three additional licenses. For simplicity, also assume that the discounted pricing is not offered in connection with any renewals of the for the platform seats purchased at discounted pricing. Accordingly, Lab would estimate the transaction price to be $4,800 (3 seats x $1,000 price per seat + 3 seats expected to be purchased upon exercise of the material right x $600). Lab would then allocate $800 to each seat ($4,00 divided by 6). That is, $2,400 would be allocated to the 3 seats purchased at inception and an additional $800 would be allocated to each seat purchased in the future as the options are exercised. If the customer decides not to exercise any of the options, Lab would recognize the revenue upon expiration of the options.

Example 7: Sales Commissions^[4]

Generous Provider Inc. (GP) enters into a one-year, $100,000 SaaS contract with a new customer. The contract is renewable on an annual basis for the same $100,000 annual fee.

GP has a single salesperson, who is entitled to a 5% commission on contract signing. The salesperson will also receive a smaller 1% commission if the contract is subsequently renewed. The difference in the commission rates stems from GP’s belief that the level of effort necessary to obtain a renewal is far less than initially entering into a new contract.

In situations where commissions paid at inception of a customer contract exceed those paid upon contract renewal, careful consideration should be given as to whether GP may apply the practical expedient of immediately recording the incremental commission payments as a period expense. The FASB staff indicated that the “level of effort” to obtain a contract or renewal should not factor into determining whether the commission paid on a contract renewal is commensurate with the initial commission. Instead, a renewal commission is commensurate with an initial commission if the two commissions are reasonably proportionate to the respective contract values (e.g., both are 2% of the amounts invoiced to customers). If a contract does not contain commensurate commissions, the initial commission may relate to a contract period beyond the initial term of a customer contract.

In this example, the initial and renewal commissions are not commensurate. Accordingly, GP would not qualify for the practical expedient. Instead, GP would defer and amortize the initial commissions. The amortization period should consider both the initial contract term and any expected renewals. In practice, estimating future contractual renewals is highly judgmental and should consider factors such as historical renewal rates, expected obsolescence of the underlying software platform, and anticipated changes in technology, competition, and other economic factors. SaaS providers may find it appropriate to estimate the amortization period using a portfolio of similar contracts.

Practice Point. When determining the amortization period, preparers of financial statements should consider whether the customer relationship life, based on historical attrition, is longer than the technology life cycle for the underlying product. If the cumulative technology changes to the product being renewed are expected to be significant, the amortization period should be based on the shorter product life cycle, rather than the customer relationship period.

For purposes of this example, assume that GP determines that the contract will be renewed four times. The pattern in which amortization is recorded should be proportionate to the revenues recognized over that period. In this example, revenues from the contract will be recognized in a consistent amount of $100,000 per year, even during the renewal periods. Therefore, any deferred costs should be recognized on a similar straight-line basis.

In aggregate, GP anticipates paying commissions of $9,000 [$5,000 initial commission + (4 years x $1,000 renewal commissions)]. Accordingly, GP would record $1,800 of commission expense per annum ($9,000 / year anticipated amortization period). GP would record the initial $5,000 commission payment as a deferred cost, and would amortize $1,800 of that deferred cost in the first year of the contract. GP would then amortize $800 of the remaining balance each year for the next four years; that amount, added to the $1,000 of commissions paid in each renewal period, would result in a total $1,800 of commission expense each year.

Practice Point. Other approaches for amortizing the commission costs may be acceptable, provided they comply with the principles in ASC 340-40.