Common ASC 606 Issues: Software Entities

In 2018, the Accounting Standards Codification (ASC) Topic 606 became effective for all public companies. This major overhaul of revenue recognition has affected almost every industry, and software companies are no exception. This article provides a quick review of the key issues software companies must consider when applying the standard.

The AICPA and the Big Four accounting firms have written industry-specific revenue recognition guides that may be useful to software companies. For direct access to selected guides, see:

AICPA: Audit & Accounting Guide—Revenue Recognition
EY: Technical Line: How the revenue standard affects technology entities
KPMG: Revenue for Software and SaaS—Q&A
PWC: In depth: Revenue: Implementation in the software sector

For each of the issues we examine below, we also provide references to related RevenueHub articles that dig deeper into those issues. See our RevenueHub article, The Five-Step Method, for more general information.

1. Determining Whether a License of IP is Distinct within a Contract

The second step in the ASC 606 revenue-recognition model is to identify the separate performance obligations within a contract. Each promised good or service, or bundle of related goods or services, must meet the following two criteria to be considered a distinct obligation: (1) the customer can derive benefit from the offering either on its own or with readily available resources, and (2) the offering is able to be separated from the other offerings in the contract. The first requirement determines if the offering is capable of being distinct, while the second determines if the offering is distinct within the context of the contract.

In hosting, software as a service (SaaS), and hybrid-cloud arrangements, a software license exists as a distinct performance obligation if the licensee can derive economic benefit independent of the other products or services within the contract. Under ASC 606, the licensing implementation guidance is not applicable in a SaaS arrangement. According to the KPMG firm guide, SaaS arrangements are accounted for as service obligations, not as a transfer of a license to intellectual property (IP). In order to determine if a license falls under a hosting or SaaS arrangement, the guidance in ASC 985-20-15-5 must be reviewed. ASC 985-20-15-5 defines the two criteria that must be met for the software license to be accounted for as a hosting arrangement:

The customer has the right to take possession of the software at any point during the hosting period without significant penalty
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

If these requirements are met, the software is part of a hosting arrangement and will likely be considered distinct. Otherwise, the software is, by default, a SaaS arrangement, and will therefore likely not be considered distinct. Significant judgment is required in assessing a software license against the two requirements.

Once the license is determined to be distinct, the next step is to determine if the license is separately identifiable from the other goods or services within the context of the contract. A license is distinct within a contract if it is not significantly related to or dependent on the other goods or services in the contract. To determine if a license is distinct within a contract, the entity may consider, but is not limited to, the following factors:

The extent to which the licensor performs significant integration services on the goods or services before the customer receives the goods or services
The effect two or more promised goods or services have on each other
The utility the customer can derive from each individual promised good or service

Hosted Software

In a hosting arrangement, the licensee has as-needed access to software and related services located on third-party servers. The entity (provider) should first assess if the license meets the criteria of ASC 985-20-15-5. The AICPA Financial Reporting Executive Committee (FinREC) has concluded that software IP subject to a hosting arrangement generally meets the criteria to be distinct within a contract because the licensee derives benefit from the software, independent of other promised goods or services, throughout the license period (AICPA Audit and Accounting Guide on Revenue Recognition, Chapter 9 – Software Entities (AAG REV): 9.2.11).

Activision Blizzard, Inc. (2019 SEC Correspondence): Revenue Recognition For Hosted Software Arrangements

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In its correspondence with the SEC, Activision explains how it recognizes revenue for its hosting arrangements:

The terms and conditions for our titles related to our online hosting and subscription arrangements are covered by our Activision, Blizzard, and King end user license agreements (“EULAs”).

Our online hosted arrangements contain promises in the arrangement related to ongoing activities associated with content updates, hosting of the game play, match making, and access to the game content (this game content is not otherwise available offline as we do not provide for offline game play on our hosted arrangements). We believe these promises in our hosted arrangements are highly interrelated and interdependent and are therefore combined to form a single performance obligation in accordance with ASC 606-10-25-21. Revenues recognized from sales of our online hosted arrangements are recognized ratably over an estimated service period.

World of Warcraft differs from our other online hosted software arrangements in that it requires a subscription to play the base game (i.e. the base game can only be played by purchase of a subscription). Customers may also acquire additional content, such as expansions or in-game items, via additional purchases. If a subscription to World of Warcraft expires and is not renewed, the game cannot be played offline. Consistent with our other online hosted arrangements, World of Warcraft does not have customer cancellation provisions.

As it relates to subscription sales, these are viewed as separate and distinct from the expansion sales based on our consideration of the guidance in ASC 606-10-25-19 through 25-21. Consistent with our online hosted arrangements, we have a single performance obligation associated with our subscription sales which encompasses the same highly interrelated and interdependent promises discussed above. Revenues from the sales of subscriptions are recognized over the subscription period, commensurate with when the subscription is consumed. Additionally, revenues from the sale of a World of Warcraft expansion are accounted for consistent with our other online hosted arrangements — recognized ratably over the estimated service period. (September 2019 Letter)

SaaS

With SaaS, software IP is generally accessible to a licensee through the provider’s cloud systems. Unlike many hosting arrangements, Saas arrangements allow the licensee to access the software code only during the contracted-use term. SaaS arrangements typically do not meet the qualifications to be considered distinct because licensees do not obtain the right to use the software code on their own servers, thus these arrangements will result in revenue recognized over time in accordance with the criteria in ASC 606-10-25-27.

Ultimate Software Group, Inc. (2018 SEC Correspondence): SaaS Revenue Recognition

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In its correspondence with the SEC, Ultimate Software Group explains how certain aspects of its SaaS revenue are recognized:

In the terms of our subscription-based SaaS contracts, the Company offers printing services to certain customers for a fee. Revenue is recognized for these services at a point in time, upon shipment of the printed forms which is when control of the goods and services transfers to the customer. The printing services are aggregated with Other Services, as a component of service revenues which are broken out separately in our statement of income and disclosed as fees from Other Services in our Quarterly Report on Form 10-Q for the quarterly period ending June 30, 2018. The Company recognizes that there are no SaaS performance obligations satisfied at a point in time and designating these printing services as such is inconsistent with the nature of the underlying service activities.

To further clarify the disclosures, the Company plans to make the following changes in future filings. Below is the applicable disclosure from Note 3 of the Notes to Condensed Consolidated Financial Statements of our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2018, marked to show such proposed modified disclosure for our future filings.

“Our SaaS subscription revenues are satisfied over time, because they are simultaneously received and consumed by the customer, with certain SaaS performance obligations satisfied at a point in time. Our activation services revenues are satisfied over time because they are simultaneously received and consumed by the customer.” (October 2018 Letter)

Hybrid Software and SaaS

In a hybrid arrangement, the licensee usually receives a combination of on-site and SaaS software IP. The entity should analyze the interdependency of and the separate utility to be obtained from the downloaded and the SaaS software.

Adobe, Inc. (2019 SEC Correspondence): Interdependency Of Key Elements Within Hybrid Software And Saas Contracts

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In its correspondence with the SEC, Adobe describes the month-to-month subscription model of its “Creative Cloud” platform. Adobe also discusses several Adobe features that are dependent on the platform. Adobe then explains:

Our conclusion is that, based on how we market and promote Creative Cloud (including specific statements and videos on our website and presentations at design conferences), our promise to customers includes not only that Creative Cloud will enable these creative professionals to complete design tasks (e.g., publishing, web design and development, video and animation production, mobile app and gaming development and document creation and collaboration) but that it will provide them the tools, features, and functionalities to fulfill their design roles efficiently and in the collaborative, mobile-enabled manner they have requested of us. That is, the promise to a creative professional that is the core customer of Creative Cloud is not only that with Creative Cloud they can produce the flyer, webpage or video they have been engaged to produce, but that Creative Cloud will enable them to meet their design needs.

The capabilities and workflow efficiencies we promise, and that our customers expect, would not be available absent ongoing interaction between the on-premise and on-device software and cloud-based services. This fact, consistent with BC29 and BC33(b), as well as the AICPA Revenue Recognition Guide, (published June 2017) Example 9-2-3-Hybrid Software and SaaS, drives our conclusion that the Creative Cloud is a single, integrated solution (rather than multiple performance obligations included in a single customer contract).

The features described in Section I.F above are not possible without the Adobe cloud and are fundamental to what we promise our Creative Cloud customers and what those customers’ intended benefit is from the Creative Cloud. Our customers’ intended benefit, and our promise to those customers, is not only that with Creative Cloud our customers can create movies, video, pictures, vector graphics, scripts, video games, animations, and many other creative assets, but that Creative Cloud will enable them to work in the way they expect from a modern creative workflow – across devices, platforms, and teams. (May 2019 Letter)

2. Determining if Post-Contract Customer Support is a Separate Performance Obligation

Entities will need to evaluate the potential relationships between the two general categories of post-contract customer support (PCS)—technical support and software updates—and the licensed software. Two or more promised goods and services may be combined into a single performance obligation if all use the same measure of progress towards satisfaction. Factors such as high interdependency or interrelatedness between the PCS and the software may indicate the potential to combine the provided service with the software into a single performance obligation.

See our comprehensive Case Study for real-world examples and a more in-depth discussion on this topic.

3. Option to Purchase or Use Additional Software

This issue relates to whether a customer’s right to purchase additional copies/uses of software constitutes an option to purchase or variable consideration attached to existing purchased software rights.

If the vendor offers additional copies or uses of software for consideration, and the customer did not previously control those additional copies or uses, then the right to purchase may be accounted for as a sale. In contrast, if the vendor is entitled to additional consideration based on the level of usage by a customer who already had control of the software, and there are no additional rights included, the additional consideration is accounted for as a usage-based royalty. The determination of whether the right to purchase additional copies or uses represents an optional sale or variable consideration requires significant judgment of the individual facts and circumstances of the contract.

In a sale to an end-customer, FinREC states that generally the option to purchase additional copies or uses of software that the customer already controls is not a measure of software usage, and the option should be accounted for under the ASC 606 guidance for determining separate performance obligations (AAG REV: 9.2.19 through 9.2.22). If the right to purchase is considered a measure of usage, then accounting for the purchase as a usage-based fee would be appropriate.

In sales to resellers, if the reseller is merely purchasing and reselling the software product, the transaction is accounted for as a regular tangible-product sale. However, according to FinREC, if the reseller is doing more than just purchasing and reselling (e.g., purchasing the software to be part of a larger software program such that the purchased software loses its stand-alone identity), then the transaction should be analyzed like the end-user sale model explained above (AAG REV: 9.2.23 through 9.2.28).

Pegasystems, Inc. (2018 10-K SEC Filing): Recognizing Revenue For Options To Purchase Additional Software Usage

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In its 2018 10-K SEC filing, Pegasystems explains how it accounts for customer options to acquire additional products and services:

If the contract grants the client the option to acquire additional products or services, the Company assesses whether the option represents a material right to the client that the client would not receive without entering into that contract. Discounts on options to purchase additional products and services that are in excess of discounts available to similar clients are accounted for as an additional performance obligation.

The Company’s arrangements can include variable fees, such as the option to purchase additional usage of a previously delivered software license. The Company includes in the determination of total transaction price an estimate of variable fees if it is probable that a significant reversal of cumulative revenue recognized will not occur. The Company uses the expected value method to estimate variable consideration and the estimates are based on expected purchase volumes and the level of historical price concessions offered to clients. (2018 10-K)

4. Estimating the Standalone Selling Price of Options

When a software company provides an option to obtain future goods or services at a material discount to what other customers would pay, that option is treated as a separate performance obligation and part of the contract’s transaction price is allocated to that discount. The AICPA guide suggests two methods for allocating the transaction price to a material option:

Include the option as a distinct performance obligation, and allocate the transaction price based on the option’s determined value (ASC 606-10-55-44)
Exercise the practical expedient of “looking through” the option by calculating a hypothetical estimated transaction price of the promised future good or service, which considers the probability the option will be exercised and the value of the future goods and services to be covered by the option, and then using that estimate as an input for the allocation of the transaction price (ASC 606-10-55-45)

The entity must consider the facts and circumstances surrounding the contract to determine which of the two methods should be used to determine the standalone selling price of the options.

See our comprehensive Case Study for an in-depth example of estimating standalone selling prices.

5. Using the Residual Method to Estimate Standalone Selling Price

In the software industry, a software license is typically not sold on a standalone basis (i.e., software is usually bundled with maintenance services or other products), so its standalone selling price is not always readily available. With a highly variable or uncertain standalone selling price, the residual approach may be used if at least one of the following two conditions in ASC 606-10-32-34 are met:

The entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts (that is, the selling price is highly variable because a representative standalone selling price is not discernible from past transactions or other observable evidence)
The entity has not yet established a price for that good or service, and the good or service has not previously been sold on a standalone basis (that is, the selling price is uncertain)

With the residual approach, the standalone value of the performance obligation is calculated as the transaction price less the sum of the observable standalone values of the remaining performance obligations in the contract. The entity should consider any historical pattern in selling price, reasonableness of the estimate, and selling price for a similar good, service, or bundle in the entity’s industry.

The requirements for establishing vendor-specific objective evidence (VSOE) under the old revenue recognition standard were stricter than the criteria to qualify for the residual approach. So, FinREC has concluded that previously established VSOE is considered an observable standalone selling price (AAG REV: 9.4.16 through 9.4.19). When VSOE exists, it is preferred and should be used instead of the residual approach.

Vmware, Inc. (2018 SEC Correspondence): Estimating Standalone Price Using The Residual Method

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In its correspondence with the SEC, VMware provides an in-depth, quantitative discussion supporting its decision to use the residual approach to estimate the standalone selling price for software licenses.

First, VMware explains its main product offerings and some of the accounting implications associated with them:

VMware’s product offerings encompass compute, cloud, mobility, networking and security infrastructure software, professional services and training. Generally, our products are bundled with other products to create a comprehensive solution tailored to meet specific customer requirements. Also, our on-premise perpetual software licenses are only sold bundled with our maintenance support and services.

In addition, we have observable standalone selling price for our maintenance support and services based on data from standalone renewals of such services. Consequently, we do not have direct observable standalone selling price (“SSP”) for our on-premise perpetual software licenses.

VMware then compares the adjusted market assessment, the cost-plus margin, and the residual value approaches in depth, reaching the following conclusion:

Given the unavailability of standalone transaction pricing for our on-premise perpetual software licenses, we evaluated other methods to estimate SSP as stated in the guidance, starting with the adjusted market assessment approach and the expected cost-plus margin approach. We then evaluated the variability of our selling price for on-premise perpetual software licenses and concluded that our selling price was highly variable. As a result of the analysis conducted, we concluded that the residual approach was the appropriate approach to meet the objective of allocating a contract’s transaction price to a product bundle that is consistent with the relative selling price principal described in ASC 606.

See VMware’s August 2018 Letter for more details of the analysis and conclusion.

6. Establishing a Range of Values as the Standalone Selling Price

Standalone selling prices are needed to allocate the contract’s transaction price to each of the identified performance obligations. A range developed to represent the standalone selling price should represent the price at which management would be willing to sell the standalone good or service. Management must find a range that accurately covers a high percentage of possible price points while not allowing the range to become too wide, so as to comply with ASC 606-10-32-28.

If the stated contractual price for a distinct good or service falls outside the range used to estimate the standalone selling price, FinREC believes the use of a consistent point in the range to allocate the transaction price is appropriate (AAG REV: 9.4.41).

7. Price Concessions

When a vendor accepts a lesser amount than was originally agreed upon in the contract, it must be determined if that lesser amount is a result of a price concession or simply a product of customer credit risk. If it is determined that the reduced consideration is the result of a price concession, then that reduced amount is accounted for as variable consideration which reduces the transaction price. The price concession then follows the guidance on variable consideration as it contributes to the determination of a contract’s transaction price.

Price concessions are a form of variable consideration that are often implied or assumed, as opposed to being explicit within the contract. Variable consideration is an amount—often explicitly stated in the contract—that is not contractually guaranteed to be received in full because it is contingent on the occurrence or nonoccurrence of other factors. Per ASC 606-10-32-6, those other factors may include “discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items.” For a more detailed explanation of variable consideration, please see our article on the subject, Variable Consideration and the Constraint. In contrast to price concessions or other forms of variable consideration, a significant credit risk may lead the entity to conclude that there is not a valid contract in place. The facts and circumstances surrounding an entity’s decision to offer extended payments—including historical collection patterns, current market conditions, and forecasts—should be evaluated in the classification of the extended payments as a price concession.

Potential price concessions may be valued using the portfolio approach if the results are not materially different from those calculated on an individual contract basis.

8. Assessing the Significance of a Financing Component

When determining the existence of a significant financing component in a software license contract, entities must first decide at what point it is required to assess significance. Entities should consider strictly the significance of financing components at the individual contract level, not whether the effects of the financing component are material to a portfolio of contracts. If the financing component is material at the individual contract level, the transaction price must be adjusted.

Entities are required to evaluate (a) the difference between the amount of the promised consideration as well as the cash selling price of the promised goods or services and (b) the combined effects of (1) the length of time between when the goods or services are transferred and when payment is received and (2) the prevailing interest rate in the market. This quantitative analysis, combined with qualitative factors, will help entities to determine the significance of a financing component to the contract.

9. Transferring Control of a Software License

The transfer of control from licensor to licensee is a key determinant in the timing of revenue recognition under ASC 606. Some common instances within the industry that merit further analysis include: requiring the vendor to provide an access code, point-in-time transfer of control criteria, customer-specific acceptance provisions, timing of the transfer in a hosting arrangement, and contracting to provide software that is not yet available.

In accordance with indicators in ASC 606-10-25-30 and 55-58C, software entities may conclude that control has transferred when the customer has both access to use the software code and the legal right to such use. Even if the customer has not yet downloaded the software, FinREC believes that if a customer has received the passcode or key, it may be appropriate for the software entity to conclude that control has transferred (AAG REV: 9.5.13). Entities should consider the following questions:

Have you provided (or made available) the software to the customer?
Has the period of software usage rights begun?
Do you have a present right to receive payment?
Does the customer have the ability to direct the use of, and obtain substantially all the remaining benefits from, the software?
Has the customer accepted the software?
Does the customer bear the significant risks and rewards of ownership of the asset?

Answering these questions with the help of contractual agreements will help software entities to determine if control has transferred.

Conclusion

Software license arrangements can be organized as a hosting arrangement, SaaS, a hybrid of both hosting and SaaS, or direct delivery to the customer—all of which have different implications for the application of the revenue recognition model. Software companies are often tasked with deconstructing the typical bundles of product and services and then determining the separate selling price of each of those elements. These bundled deliverables complicate an entity’s ability to reasonably estimate the value of each promised good or service within the contract.

It is likely that many other issues and questions will arise within the software industry as entities continue to apply the revenue recognition standard. This article serves as a base reference point for your research into some of the focal issues. Similar industry-specific issues and resources are available on the RevenueHub site for all major industries.