To be ratable or not, that is the question.
Or at leaset it’s one of the many questions that non-public companies are grappling with as the clock ticks toward the new revenue recognition adoption date (ASC 606/IFRS 15). The new guidance will be applicable for non-public calendar year companies beginning Jan. 1, 2019.
Recently, Adaptive Insights Vice President of Finance Kerman Lau shared his advice on how FP&A can help get ahead of 606 regulations. With deadlines fast approaching, it makes sense to take a deeper dive into some of the more challenging areas of the new regulations.
In this case, let’s tackle the question of whether revenue recognition for hybrid software-as-a-service (SaaS) companies will continue to be ratable. It’s important to explore this issue in depth because the answer can have significant financial, operational, and system implications for SaaS companies.
Status quo for pure-play cloud companies
Let’s start with the current state. Under existing GAAP, companies selling on-premises software licenses (term licenses or subscription licenses) that are either standalone or with their cloud application have generally been able to recognize their software revenue ratably over the term. This has been true even if the software license is considered a separate deliverable under the software rules because most companies were not able to establish fair value for their software or software-related deliverables and were able to recognize all of their software deliverables as a combined unit ratably once all deliverables had commenced and the initial login had been provided to the customer. This was known as the combined services approach.
So, for companies with a pure-play cloud model, revenue recognition will likely continue to be ratable. In a pure-play cloud model, the end user does not take possession of the software application, all of the intellectual property (IP) being used by the customer is run on the vendor’s servers, and contractual terms permit the customer only to access the IP during the term.
Hybrid cloud companies: Time for a judgment call
However, companies with hybrid cloud models face a situation in which they may not be able to keep a portion of their revenue model ratable. In a hybrid cloud model, some of the IP may reside on the vendor’s servers and will be available for access or use by the customer during the term, but other IP and software functionality may be downloaded by the customer as a desktop application. If the vendor/company concludes that the on-premises software license component is a distinct performance obligation, the company will more than likely recognize revenue for the software portion upfront at the time of delivery of the software license.
Determining whether the software is a distinct performance obligation is a judgment call and requires a thorough understanding of the business, the software application, and the hybrid cloud business model. You need to evaluate whether the cloud application and the on-premises software component each significantly affect the other. If the company can prove objectively that both are highly interrelated or highly interdependent, an argument could be made that the software component is not a separate performance obligation but an integral part of the combined hybrid cloud solution. The key requirement here is to prove that the cloud application without the on-premises component has diminished utility to the end customer.
The AICPA Software Task Force and the KPMG ASC 606 guide for SaaS companies provide good thought leadership on this topic and may be leveraged to research this topic further. However, it may also benefit the finance team to network with other hybrid SaaS finance teams to understand how policy positions have been formulated on this judgmental topic. Lastly, it is important to engage the auditors early to iron out the judgments on this issue since ratable or upfront revenue recognition is a fundamental policy question that impacts a number of key financial, operational, and system decisions downstream in your ASC 606 adoption project.
Gauging the impact
As you assess your SaaS company’s revenue recognition model, several key factors that could have an impact on your company’s processes should be top of mind.
- If software is a distinct performance obligation, a portion of the revenue will be recognized upfront rather than ratably. This will lead to more lumpiness and unpredictability in the revenue model, which will make forecasting revenue more difficult. As an FP&A practitioner , you may need to revisit the revenue forecasting process and consider whether your model needs additional inputs to account for the change.
- Accounting for two different revenue models (ratable for cloud and upfront for the software component) adds operational and system complexity, especially if the volume of hybrid SaaS deals is high and increases the risks of errors. If the company is considering adopting ASC 606 using a modified retrospective approach, there will be a period when you will be closing two sets of books (under ASC 605 and under ASC 606). Accounting for the software component and related professional services differently under ASC 605 and ASC 606 could lead to additional complexities that could delay your monthly or quarterly close cycles. You may also need additional resources, control points, and validation procedures to close revenue accurately and in a timely manner.
- Your company will need to ensure that software performance obligations are captured as separate product SKUs in order to allocate the correct revenue to the software component.
- Certain companies that bundle their cloud and software offerings in one SKU might face significant operational and system challenges since they would have to unbundle the SKUs, or they might need to manually add ghost SKUs to allocate the correct revenue to software components.
- Commission capitalization may become significantly more challenging if the commission cost needs to be split and allocated to multiple performance obligations (i.e. cloud and software components). There may also be significant data challenges to overcome as you comb through multiple years of booking data and allocate commission costs to the cloud and software components.
Gaining a competitive edge
There’s no doubt that 606 regulations pose a real challenge to FP&A and accounting teams. Yet, there is also a significant opportunity to simplify revenue recognition if ratable revenue recognition can be maintained. The organizations that stay in front of the changes and finalize their key policy positions early will have a distinct competitive edge moving forward.