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Revenue recognition for SaaS and software companies

Applying ASC 606 - SaaS and software revenue recognition

The ASC 606 revenue recognition standard affects entities differently as they have moved from implementation to applying and disclosing the effects on their financial statements. There are some common themes and questions for organizations in the software and software-as-a-service (SaaS) sectors to explore in our Technology Alert series.

Key software and SaaS revenue recognition themes for CXOs

The Financial Accounting Standards Board’s (FASB’s) ASC 606 revenue recognition standard was effective for annual reporting periods beginning after December 15, 2017, for public entities. For all other entities, it was effective for annual reporting periods beginning after December 15, 2018 (or after December 15, 2019 if financial statements had not been issued as of June 3, 2020).

The standard’s effect on the revenue and cost recognition models of technology entities has generally been significant. The fundamental principle at the heart of the standard is that an entity must “recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”

To help software and SaaS entities better understand this principle, these publications explore common themes related to the standard’s application.

The impact of adopting the ASC 606 revenue recognition standard on software and SaaS entities may have been greater than that on many other industry groups.

For example, the standard results in the elimination of the requirement for vendor-specific objective evidence of fair value. It also introduces potential difficulties in many areas, including:

  • Determining the standalone selling prices of software licenses in an arrangement
  • Identifying performance obligations in hybrid cloud-based arrangements
  • Assessing variable consideration and termination provisions
  • Capitalizing certain contract acquisition costs

Many of such challenges can require the use of significant judgments and estimates.

Further, software and SaaS entities have been significantly affected by the standard’s disclosure requirements, including the requirement for disclosures related to significant judgments and performance obligations (including disclosures commonly referred to as “backlog disclosures”).

These and other themes related to applying the revenue recognition standard for SaaS and software companies are explored in these publications.

Termination rights

If a customer can terminate a contract without substantive cost or penalty, only the noncancelable portion of the contract is accounted for under the ASC 606 revenue recognition standard, even if the customer is unlikely to exercise its termination right. For example, if a customer can terminate at any point and receive a pro rata refund, the arrangement should be accounted for as a daily contract.

Undelivered performance obligations associated with such arrangements must be excluded from deferred revenue, as well as from the requirement in ASC 606 to disclose “remaining performance obligations,” although an entity would not necessarily be precluded from specifying amounts that are subject to termination in the notes to its financial statements if it properly describes this GAAP amount.

In this Technology Alert on software revenue recognition, you’ll find questions and answers surrounding the accounting framework for termination rights.

Nonrefundable up-front fees in software arrangements

Under some software arrangements, the customer must pay a nonrefundable up-front fee. The ASC 606 revenue recognition standard requires entities to consider whether the fee is associated with the transfer of promised goods or services or an advance payment for future goods or services. In addition, some software arrangements give the customer the right to terminate the contract at the customer’s convenience.

Questions have emerged regarding how to account for nonrefundable up-front fees associated with a software arrangement that contains a termination provision. In this Technology Alert on software revenue recognition, you’ll find examples and a discussion about the accounting considerations.

EITF project on revenue recognition for contract modifications of licenses of intellectual property

The ASC 606 revenue recognition standard generally requires an entity to recognize revenue for license renewals no earlier than the beginning of the renewal period. Additionally, a modification of a term license of intellectual property (IP) may include an extension to the original license’s term with the purchase of additional rights. Further, a modification of a term license of software may include the ability to revoke the licensing right and convert to a hosted solution. Views differ on whether to apply the guidance on license renewals and how to account for the revocation of the licensing rights and the conversion to the hosted solution.

At its May 2019 meeting, the Financial Accounting Standards Board (FASB) decided to add a project on contract modifications of licenses of IP to the technical agenda of its Emerging Issues Task Force (EITF or “Task Force”). The FASB staff has also established a working group to provide feedback to the Task Force related to the project. The scope of the project includes:

  • Accounting for contract modifications in which the contract term for existing rights is extended and additional rights are purchased
  • Accounting for situations in which licensing rights are revoked, including conversion of on-premise term licenses to cloud-based arrangements

This Technology Alert summarizes the issues and the alternatives previously developed by the FASB staff.

Scoping considerations when accounting for software and software-related costs

As technology evolves, entities typically incur a myriad of costs related to software. An increasing number of processes are managed by using automated solutions, such as customer relationship management (CRM), human resources, payroll, finance, and collaboration and communication tools. This has resulted in entities’ incurring increasing amounts of software-related costs as they either purchase licenses to on-premise software products or contract with vendors to access and use software solutions over the Internet. Further, entities may incur costs to develop software for their own internal use as well as for external sales to customers.

Entities incurring such costs will need to determine whether they represent assets that can be capitalized under the applicable accounting standards. Different accounting guidance exists for costs related to software that is:

  • Sold, leased, or marketed
  • Obtained or developed for internal use
  • Accessed in a cloud-based (or hosting) arrangement that is a service contract.

In this Technology Spotlight, you’ll find scoping considerations for entities determining whether software and software-related costs incurred should be accounted for under ASC 985-20, ASC 350-40, or other US GAAP. This is the first publication in a series that will further examine the application of the relevant guidance, including common issues and complexities.

Deloitte Accounting Research Tool (DART)

Deloitte also provides the Deloitte Accounting Research Tool (DART), a comprehensive online library of accounting and financial disclosure literature to clients. Updated every business day, DART contains material from the FASB, Emerging Issues Task Force (EITF), American Institute of Certified Public Accountants (AICPA), Public Company Accounting Oversight Board (PCAOB), International Accounting Standards Board (IASB), and Securities and Exchange Commission (SEC), in addition to Deloitte’s own accounting manuals and other interpretive guidance and publications.

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The services described herein are illustrative in nature and are intended to demonstrate our experience and capabilities in these areas; however, due to independence restrictions that may apply to audit clients (including affiliates) of Deloitte & Touche LLP, we may be unable to provide certain services based on individual facts and circumstances.

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