We recently had internal training on some key aspects of revenue recognition. One area was the area of licensed software vs software as a service (“SaaS”).
Here is what makes these areas so important:
- We often need to determine when the delivery of licensed software is a distinct performance obligation
- As part of that, we need to evaluate the importance of software updates to the functionality of the licensed software
- We need to evaluate the impact on revenue recognition in an arrangement in which the customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty,
and
- We need to evaluate the impact on revenue recognition if it is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.
In the case of licensed software, to paraphrase ASC 606-10-55-140E, we must evaluate whether the software and the updates are capable of being distinct because the customer can derive economic benefit from the software on its own throughout the license period – that is, without the updates, the software would still provide its original functionality to the customer.
The above example is in contrast to the situation in ASC 606-10-55-140D, in which an entity grants a customer a three-year term license to anti-virus software and promises to provide the customer with when-and-if available updates to that software during the license period. The entity frequently provides updates that are critical to the continued utility of the software. Without the updates, the customer’s ability to benefit from the software would decline significantly.
In the first case, the license is a distinct performance obligation, and the revenue associated with the license would be recognized upon delivery of the software. However, in the second case, the license and updates are combined to create a distinct performance obligation, and the revenue is then recognized ratably.
How do we differentiate a licensed software performance obligation from a SaaS performance obligation?
This is often an issue for smaller or start up entities which offer their products to both small and larger companies. Their smaller customers often prefer to access the software in a secure cloud environment managed by Google or Amazon or Microsoft. This is the traditional SaaS model that results in ratable revenue recognition over time. But larger customers want more control and have environments either on their premises or in their cloud environments which they also control. This level of control over the software is likely going to result in the licensed software model which provides for revenue recognition for the license upon delivery of the software at a point in time instead of ratably over time.
Here are the 2 criteria to evaluate and, if both are met, cause the revenue recognition to follow the licensed software model and not the SaaS model:
If the customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty, that is an important indicator that the arrangement is not a SaaS arrangement.
And further, if it is feasible for the customer to either run the software on its own hardware, sometimes referred to as an “on premises” or “on prem” arrangement, or contract with another party, unrelated to the vendor, to host the software, such as in the unrelated party’s cloud, that is also an important indicator that the arrangement is not a SaaS arrangement.
Based on the terms and conditions of the various revenue arrangements, it is possible that an entity’s revenue stream may include both licensed software revenue recognized at a point in time and SaaS revenue recognized over time.