The Financial Accounting Standards Board’s (FASB) new revenue recognition standard will have a major impact on a number of companies, particularly Software-as-a-Service (Saas) firms, according to guest author Jim Perry, the director of EPM Enablement at Infor.
Subscription billing is the foundation of the SaaS business model.
New revenue recognition guidelines put forth by FASB — under ASU 2014-09 (ASC 606) — will change how revenue is recognized from SaaS contracts. The core principle of ASC 606 is that sellers should recognize revenue when the customer obtains control of a good or service, in an amount to which the seller expects to be entitled in exchange for those goods or services.
FASB has developed a five-step approach to determine when revenue from SaaS contracts should be recognized:
- Identify the contract with the customer.
- Identify the performance obligations in the contract. A “performance obligation” is defined as a distinct service included in the contract. A service is distinct if the customer can benefit from that specific element on its own, without corresponding service or software use.
- Determine the transaction price.
- Allocate the transaction price to separate performance obligations. Each “performance obligation” requires its own transaction price.
- Recognize revenue as each performance obligation is satisfied.
SaaS obligations are satisfied over of the lifetime of the agreement, and therefore revenues are recognized on a month-to-month basis.
The new FASB guidelines became effective for public corporations for fiscal years beginning after December 15, 2016, and for private companies will take effect this coming December. Current contracts that end on or after those dates must be accounted for under both sets of rules.
ASC 606 will impact SaaS companies in a few key areas:
Upfront fees. Where (a) the SaaS company receives an upfront fee and (b) all goods and services are combined into a single accounting unit, current GAAP requires that the fee be amortized over the longer of the initial contract period, or the period the customer is expected to benefit from payment of the upfront fees. Under the new rules, upfront fees would also be amortized over the expected benefit period if the arrangement provides the customer with a material right – such as the ability to renew the hosted software arrangement without having to repay the upfront fee. Otherwise, the upfront fee would be amortized over the initial contract period only. The new FASB rule will enable SaaS firms to recognize services revenues as soon as they are provided, rather than at the end of the engagement or amortized over the lifetime of the contract, thereby increasing the potential for short-term gains.
Contingent fees. Under current GAAP rules, contingent fees are not recognized as revenues until earned and realized. Under the new revenue rules, SaaS companies may be required to make an estimate of “variable consideration” – including any contingent usage fees or royalties.
Distinct performance obligations. The new FASB revenue guidelines provide a different set of criteria for determining the accounting units within a customer contract. Therefore, for a given contract, it is possible that fewer (or more) separable performance obligations may be identified by the vendor under the new rules versus today’s GAAP.
Costs of fulfilling a SaaS contract. Today, SaaS companies can make an election on how to treat implementation fees under a customer contract. The new guidelines will require that costs to fulfill a contract be capitalized and amortized in a manner consistent with how revenues under the related contract are being recognized.
To address the operational impacts from the new accounting rules, many EPM providers are offering sophisticated revenue recognition tools to help SaaS customers ensure a sustainable transition, and to capitalize on the new revenue recognition guidelines. This transition will be key to the success—and survival—of companies with a SaaS business model.