Challenges Ahead for Software and SaaS Companies with ASC 606
Some industry experts say that implementing FASB’s new revenue recognition guidance, ASC 606, will be more difficult for software as a service (SaaS) and software companies than Sarbanes-Oxley implementation. The previous standards included detailed guidance for software companies, but the new principles-based guidance will require more judgment in resolving ambiguities. You can find an overview of the new guidance here, and a discussion of the role of timing here and treatment of contract costs here.
Public companies began implementing this for periods ending after Dec. 15, 2017. Non-public companies got an extra year and will be implementing it starting next year.
The new guidance requires analysis of contracts into separate performance obligations, with a share of revenue to be recognized for each distinct performance obligation. A distinct performance obligation exists if that component of the contract has value to the customer as a stand-alone item.
Post-contract services. Software contracts frequently include post-contract services (PCS) such as phone support, bug fixes, updates and enhancements. Under legacy GAAP, these services were lumped together and the related revenue was recognized ratably over the term of the contract. If these items were deemed to have vendor-specific objective evidence of fair value (VSOE), these items were separated from the rest of the contract. If no VSOE could be obtained, PSC was combined with the contract.
Under ASC 606, VSOE analysis is eliminated. Instead, if the PSC or its components have value as stand-alone deliverables, then they are treated as separate performance obligations. Revenue is allocated to each performance obligation based on the relative selling price. If they have no value as separate items, they are treated as part of the overall contract.
For example, ABC Software sells a one-year license with an optional technical support package. Since the software is functional without the support, ABC determines that these are separate performance obligations.
Professional services. Software sales commonly include professional services such as consulting, integration, implementation and customization. Under legacy GAAP, revenue for these services was recognized using the percentage of completion method. But, under ASC 606, these services are considered separate performance obligations only if they have value as standalone items. Integration, implementation and customization have little value without the software in question, so in most cases, these services won’t be a separate performance obligation.
Term licenses. Companies that license software for a specific term have two options to consider:
- If the purchaser is granted access to the software as it exists at the point in time at which the license is granted, revenue will be recognized at that point in time. This may mean that upgrades may be distinct performance obligations. For many software vendors, this will accelerate revenue recognition.
- If the purchaser is granted access to the software as it exists through the license period, then revenue is recognized ratably over the license period.
Upgrades. Under legacy GAAP, if a customer purchases a license for the version of the software currently available and is promised access to an advanced version when it is released, all revenue would be deferred until the advanced version is delivered. But, under ASC 606, these may be considered separate performance obligations, which means that revenue may be recognized earlier than under legacy GAAP.
If continued updates are essential to the utility of the software – as is the case with virus protection software – then updates are not treated as distinct performance obligations, and are included as a single contract.
Commissions. Accruing sales commissions becomes much more complex under ASC 606. Under legacy GAAP, commissions were expensed as incurred and sales commissions will now be amortized as contract costs. Commissions and bonuses based on overall company performance are still expensed as incurred.
Like revenue, the commissions must be allocated between the different performance obligations and recognized in sync with the related revenue. If commissions paid at renewal are similar in amount to the original commissions, then they’re recognized over the term of the original contract. However, if little or no commission is paid with renewal, then the original commission is amortized over the expected life of the customer. This may mean commissions are recognized over a longer period than the revenue from the original contract.
But, if the average customer sticks around for ten or fifteen years, then a shorter amortization period might make more sense, as the version available fifteen years after the sale may have little relation to the original version.
Software and SaaS companies will need your guidance now more than ever; so don’t delay in getting up to speed on this new guidance!