February 2020 in Financial Reporting

Revenue Recognition for SaaS Providers: Part 1

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.

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, The MFA Companies^® has highlighted pertinent information that SaaS providers may find helpful related to revenue recognition along the customer lifecycle.

In the first of two parts, we’ll address:

• Determining the contract term; and
• Evaluating professional services with the SaaS arrangements.

Be sure to come back next week when we review:

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

A Review: 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

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.

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In Part Two of our series on Revenue Recognition for SaaS Providers, we’ll review how to apply the series guidance, usage-based pricing, evaluating optional purchases and accounting for commissions. Stay tuned!

In the meantime, please don’t hesitate to connect with a member of our Technical Accounting Advisory team if you have questions or concerns about your company’s revenue recognition compliance.

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