Revenue Recognition for Software as a Service

How SaaS Providers Are Tackling Revenue Recognition: Part 2

In Part 1 of our series on how SaaS providers are complying with revenue recognition guidance, we reviewed how to determine contract terms as well as how to evaluate professional services with SaaS arrangements.

In Part 2 below, we’ll focus on:

  • Applying the series guidance;
    • Usage-based pricing
  • Evaluating optional purchases; and
  • Accounting for commissions and other similar costs of obtaining a customer contract.

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

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 MFA Can Help
The MFA Companies® 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. MFA professionals have a wealth of experience working with SaaS providers, and by leveraging our extensive experience with companies of all sizes across a wide range of industries, SaaS companies can benefit from a comprehensive range of services to assist and complement your internal accounting functions through a collaborative and tailored approach.

Please contact a member of our Technical Accounting Advisory team to discuss your company’s unique needs.

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Michael Piessens

Michael Piessens


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