Now or later: when should SaaS companies recognize revenue under ASC 606?
The impacts of ASC 606 are broad and significant. A particular area of confusion surrounds when companies are to recognize revenue on term-licensing contracts that also include maintenance and updates.
Terms of confusion
As you’re well aware, software providers typically sell their products through either perpetual or term licenses. Under today’s GAAP, revenues from perpetual software licenses are recognized upon delivery of the software, while revenues associated with term licenses are often recognized proportionately over the license term. Regardless of the licensing, Post Contract Services (PCS) such as maintenance and updates are typically lumped together with the portion of the contract fee allocated to PCS and recognized monthly over the period that the services are supplied. Simple enough to understand.
Things will change under ASC 606. First, you’ll need to determine whether the software license is distinct from the maintenance and updates in the arrangement. If so, then the license and the PCS would be considered separate deliverables, regardless of whether the license was time-based or perpetual. Distinct is the operative word here. To be considered distinct, a deliverable must meet the following tests:
- The customer can benefit from the license and the upgraded features individually.
- The deliverables are distinct from one another within the context of the contract. For example, the customer does not need the upgraded feature set for the licensed software to function and provide value.
A Summary of the subtleties in the interpretation
The following example can help illustrate and summarize how a subtle change in the situation changes the revenue recognition landscape:
Company A is a SaaS company that sells ERP software licenses. Company A typically provides periodic updates to the software containing bug fixes and general improvements. They have determined that the updates are a distinct deliverable under the contract, as each individual component (software plus future updates) provides value to the customer. Under the new revenue recognition guidelines, Company A would likely decide to recognize revenue attributed to the term license at the point in time when the software is transferred to the customer, while the revenue associated with the updates would be recognized over time.
Company B is a SaaS company that sells licenses to its traffic-mapping software, Company B may update the software as frequently as daily to ensure accuracy. Under the new revenue recognition guidelines, Company B would likely determine that the updates it provides are not distinct, since a customer might not purchase a product containing outdated maps. Company B’s revenues for both the software and the updates would be recognized over time.
As you can see, ASC 606 will require SaaS companies to make more judgment calls than they may be used to making. And you’ll want to ensure there is consistency in those judgment calls. It’s well worth the investment to seek out your professional accounting advisors who can make the most prudent and defensible recommendations to ensure you obtain and retain compliance.
BTerrell Group works with software and cloud services companies to help them obtain and retain compliance and grow their success.