The accounting rules in the United States for software‐as‐a‐service or "SaaS" companies are fundamentally different from the rules more traditional software licensing companies are required to follow. In addition, the revenue accounting rules applicable to SaaS companies have recently changed. Because investors and other stakeholders often evaluate SaaS company performance using revenue and gross margin metrics, application of accounting rules to SaaS companies can be significant to the perception of a company's value. This article helps to explain the key differences between accounting for SaaS versus traditional software licensing, and how the recent rule changes will affect SaaS companies.
The SaaS business model is rapidly gaining broad acceptance. Existing companies that historically sold software products are increasingly rolling out SaaS offerings, and numerous new SaaS companies are springing up. The software‐as‐a‐service model has been around for a long time, and has been referred to as an authorized service provider ("ASP") or hosted service model. However there are a number of recent trends that are converging to make this a much more common and frequently preferred software delivery model including:
- Availability of world‐class platform‐as‐a‐service ("PaaS") or cloud computing resources. Companies like Google, Amazon and Microsoft allow start‐up SaaS companies to release service offerings to the market very quickly with minimal infrastructure investment and capital outlays.
- A shift in perception regarding security. Historically, SaaS has been regarded as a less secure model, since company data and systems are not within a company's direct control; however more recently, the SaaS model is being recognized as having the ability to be more secure, due to the access to state of the art technology and security measures.
- User's demand for scalable solutions. Companies are looking for software that can be implemented quickly without large up‐front costs, and also achieve lower total cost of ownership due to reduced ongoing costs for system maintenance.
Now, more favorable accounting treatment for SaaS companies could also help propel the SaaS model.
Software licensing versus SaaS
The accounting rules that SaaS companies are required to follow pertaining to revenue and cost recognition are different than the accounting rules that software licensing companies are required to follow because the nature of the underlying transactions with customers is viewed as different. Software licensing is generally treated for accounting purposes as a sale of a product, and SaaS is treated as the sale of a service that is provided over a period of time. As a result, it is important to determine whether software company sales arrangements are considered licensing or SaaS arrangements. Generally, in a licensing arrangement, the customer obtains rights to use the software on its own computers. In a SaaS arrangement, the customer is buying a hosted service based on proprietary software but does not get a copy of the software to use on its own. At times, a SaaS customer will sign a software license agreement, and install interface software on its own computers. However when the primary purpose of this interface software is to facilitate use of the hosted software services, then this would still be treated as a SaaS arrangement. In other arrangements, the customer receives a copy of the complete underlying software and license rights to use the software on its own computers in addition to using the hosted version of the software. In these situations, if the following two requirements 1 are met, the arrangement would be treated as a licensing arrangement: 1) the customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty; and 2) 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. The determination of whether customer arrangements should be treated as licensing or SaaS arrangements is important since it determines which accounting rules apply for both revenue and cost recognition. Generally, for revenue recognition, software licensing companies can recognize a significant portion of the arrangement fee when the software is delivered to the customer, as long as certain criteria are met. SaaS companies are generally required to recognize arrangement fees ratably over the contract term or the estimated life that the customer is expected to use the hosted service.
The SaaS Lifecycle
In order to better understand the revenue recognition issues common to SaaS companies, it is useful to consider the lifecycle of a typical SaaS customer as illustrated in the following diagram:
As illustrated above, SaaS arrangements can include a number of types of services during the set‐up and implementation period, and also after commencement of the initial service. Usually there is an initial term, for example 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. Periodic fees related to the ongoing usage of the hosted service are typically required to be recognized ratably on a straight‐line basis over each periodic hosting term. Other services incurred both during and after the set‐up period would generally be recognized either when these services are performed or would be deferred and generally recognized ratably on a straight‐line basis over the estimated period the customer is expected to benefit from these services through the use of hosted software.
Determining whether the other services should be recognized when performed or over the expected period of benefit depends on the nature of the particular services. Services that have stand‐alone value2 to the customer apart from the hosted software services can generally be recognized when performed. If, however, the services do not have stand‐alone value, then they would generally be treated as set‐up fees, and recognized over the longer of the initial contract period or the period the customer is expected to benefit from payment of the up‐front fees.3 It can be difficult and judgmental to establish that other services provided to SaaS customers have stand‐alone value apart from the hosted software services. In addition, services that are provided subsequent to the go‐live date might also not have stand‐alone value if the customer only benefits from these services from the continued use of the hosted software. The primary criterion to consider when assessing the stand‐alone value of the services is whether there are other third parties that separately sell similar services, however this criterion requires careful judgment to apply. This can involve a careful analysis of the nature of the various services being provided to determine whether any have stand‐alone value. Also, it is important to note that the standalone value criterion is not applicable to software licensing companies. These companies are typically able to recognize revenue from other services when performed. They are not required to defer this revenue over the expected period of benefit, providing different applicable criteria are met.
When other services are viewed as set‐up services and recognized over the expected period of benefit, this period must be estimated using all available information. SaaS companies often closely monitor customer attrition or churn rates, and based on historical results, project future expected rates for forecasting purposes. The historic rates and projections would often serve as a starting point for assessing the expected period of customer benefit. Some SaaS companies have a high churn rate or might have technology that is subject to change and obsolescence, in which case the expected period of benefit might be shorter. Other SaaS companies have relatively sticky customers and technology that is not expected to change significantly, in which case the expected period of benefit might be longer.
Allocating the Arrangement Consideration – Changing Rules
Historically, SaaS companies have been required to establish the fair value of the hosted software service. This is necessary in order to allocate the appropriate amount of revenue to the ongoing hosted service and recognize the remaining "residual" consideration attributed to the other services when those services are performed. However this requirement to establish the fair value of hosted services was recently eliminated, making it significantly easier for SaaS companies that provide other services with stand‐alone value to recognize revenue attributable to those services when performed. The new accounting rules4 are required for arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, and can be adopted earlier. Under the new rules, companies are required to identify the other services that have stand‐alone value and allocate the total arrangement consideration on a pro rata basis between the other services and hosted services. These allocations are based on the company's best estimates of selling prices as if the different services were sold separately. As a result of this change, SaaS companies will have significantly more flexibility when pricing services. Many SaaS companies historically were careful to price their hosted service offerings in a sufficiently narrow range in order to meet the onerous fair value revenue criteria to allow other services with standalone value to be recognized when performed. These companies will now be able to price the hosted services based on market conditions without regard to accounting requirements It is expected that value‐based pricing could become more common as a result of this change.
The new requirement to use estimated selling prices will often require SaaS companies to perform additional analysis of the nature of the other services to assess which services might have stand‐alone value. Additional analysis of the respective estimated selling prices of the hosting and other services will also be required. While the stand‐alone value criterion is not new, it was often not required to be assessed because the fair value criterion was not met. Now, the stand‐alone value criterion is likely to receive renewed attention. For purposes of estimating selling prices, SaaS companies will often reference data from other transactions where similar services and the hosted service are sold separately. This data can be considered when estimating the separate selling prices of these services.
Future Release Roadmaps
It is not uncommon for customers of SaaS and software licensing companies to request access to roadmaps of upcoming future upgrade and product releases, including rights to receive specified future upgrades and new products when released. Historically when rights to specified upgrades and new products were provided to customers, this commonly required deferral of all revenue until the specified upgrades or products were delivered, since it was typically difficult to establish fair value of these future upgrade or product rights. Under the recently revised revenue accounting rules, this is no longer an issue for SaaS companies, since they will now be able to use their best estimate of selling prices of the upgrades or new products to allocate revenue between the existing hosted service and future upgrade rights or new products,. They can then start recognizing the portion of revenue related to the existing hosted service as soon as the customer begins using that service. However, since the rules for software licensing companies have not been changed, and still require establishment of fair value of the upgrades or new products, those companies would generally still be precluded from recognizing any revenue until delivery of the specified upgrades or new products. This ability to offer specified future upgrades and new service offerings can provide SaaS companies that are competing against software licensing companies with a significant competitive advantage.
There are two different types of costs incurred by SaaS companies that are relevant to consider from an accounting perspective: 1) costs to develop and maintain the underlying software used to provide the service; and 2) direct customer costs related to specific customers.
Some development costs can be capitalized and amortized over the expected life of the software and other development costs and all maintenance costs are required to be expensed as incurred. Exactly which costs can be capitalized depends on whether the underlying software being developed is expected to be licensed for use on a customer's own computers, or solely used internally to provide hosted services to customers. As a result, software licensing companies are required to follow one set of accounting rules5 when determining whether to capitalize software development costs, and SaaS companies are often subject to different accounting rules6 if they do not have plans to separately license the software.
Direct customer costs incurred at the beginning of an arrangement, such as set‐up costs or sales commissions, can either be expensed as incurred, or deferred and recognized as the related revenue is recognized based on accounting policy election.7 Once this policy is established, it should be consistently followed. Many SaaS companies elect to defer these costs and recognize them over the period that the revenue is being recognized, however this can result in an increased recordkeeping burden. For example, when providing other services during the set‐up period, costs that relate to services with stand‐alone value should be recognized as those services are performed , and costs related to set‐up services that don't have stand alone value can be deferred and recognized ratably over the expected period of customer use of the hosted service.
SaaS companies often struggle with assessing how to price their products and services because of their unique nature and the complex competitive landscape. Understanding the accounting implications of arrangement pricing is an important aspect, and SaaS companies now have much greater flexibility to price competitively under the new accounting rules. In addition, the ability of SaaS companies to offer rights to specified future products and upgrades in sales arrangements should provide the SaaS model with a significant competitive advantage over the traditional software licensing model. Obtaining a strong understanding of the application of accounting rules to SaaS companies will help to optimize customer arrangements for maximum value and ensure the reliability of financial information reported to outside investors and other stakeholders.
Fair Value and Estimated Selling Prices
Software licensing arrangements can include future services such as maintenance and support, and other future deliverables, such as rights to specified future upgrades. In order to recognize revenue pertaining to the software products delivered to the customer, it is necessary to establish the fair value of all products and services that will be delivered in the future to ensure that the appropriate amount of revenue attributable to the undelivered products and services is deferred. A residual value method is then typically used whereby the full fair value of the future products and services is deferred, and the remaining (residual) contract value is allocated to the delivered software and recognized as revenue.
Fair value is determined based on vendor specific objective evidence or "VSOE" which is defined as the prices that the company separately sells the products or services for. The separate sales prices must be within a sufficiently narrow and consistent price range in order to establish VSOE, and software licensing companies are required to track their separate sales prices for purposes of assessing whether VSOE has been established. If VSOE cannot be established for all future products or services in an arrangement, then all revenue is either deferred until the future products and services have been delivered, or recognized ratably over the term of the agreement. Detailed accounting guidance for software companies regarding the above rules is provided in ASC 985‐605 (previously SOP 97‐2 and related interpretive literature).
Historically, SaaS companies have also been required to establish VSOE of the hosted services that are delivered over the term of the arrangement in order to recognize revenue from other services that have stand alone value when those services are performed, however the rules applicable to SaaS companies came from the more general accounting literature located in ASC 605‐25 (previously EITF 00‐21). Last year, however, the FASB eliminated the requirement in ASC 605‐25 to establish VSOE of fair value for purposes of unbundling revenue arrangements. Under the new guidance, SaaS companies should use VSOE of estimated selling prices of all deliverables in an arrangement to allocated the total consideration, however if VSOE of estimated selling prices is not available, then SaaS companies can use their best estimate of the separate selling prices of each deliverable to allocate revenue. The best estimate of separate selling prices should take into account all available information, and would likely change over time. Also, under this methodology, revenue should only be separately allocated to deliverables that have stand‐alone value. Other services that have been determined not to have stand‐alone value would not be considered for arrangement allocation purposes, and fees related to these services would be treated as set‐up fees under SAB 104. The literature also allows use of third party data to determine selling prices, however SaaS companies rarely have access to third party selling price data for products and services that are sufficiently similar to their own products and services.
1. Accounting Standards Codification (ASC) 985‐605‐55, Software Revenue Recognition, paragraphs 121to125 (formerly EITF Issue 00‐3, Application of AICPA Statement of Position 97‐2 to Arrangements That Include the Right to Use Software Stored on Another Entity's Hardware)
2 ASC 605‐25‐25‐5, Multiple Element Arrangements (formerly EITF Issues 00‐21 and 08‐1)
3. SEC Staff Accounting Bulletin 104, footnote 39 states: "The revenue recognition period should extend beyond the initial contractual period if the relationship with the customer is expected to extend beyond the initial term and the customer continues to benefit from the payment of the up‐front fee (e.g., if subsequent renewals are priced at a bargain to the initial up‐front fee). "
4. The Financial Accounting Standards Board (FASB) approved Accounting Standards Update 2009‐13 in October 2009, This Update amends the criteria in ASC 605‐25 for separating consideration in multiple‐deliverable arrangements.
5. ASC 985‐20, Costs of Software to be Sold, Leased or Marketed (formerly SFAS 86)
6. ASC 350‐40, Internal Use Software (formerly SOP 98‐1)
7. SEC Staff Speech by Russell Hodge (http://www.sec.gov/news/speech/spch120604rph.htm)
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