DobarTech is a software-as-a-service (SaaS) company that offers encrypted cloud-based enterprise resource planning (ERP), order management, customer relationship management (CRM), and e-commerce application services. The software suite operates entirely on the cloud, hosted on DobarTech’s digital infrastructure. DobarTech does not provide offline access to its software, and the software is inoperable without a subscription to DobarTech servers.
To deliver its platform, DobarTech sells its customers a license to access the software online with customized or generic packages according to customers’ desired functionality. A customer’s purchase of a customized package requires DobarTech engineers to make modifications to the suite so it is compatible and integrated with a customer’s preexisting systems. However, these modifications can be performed by third-parties. Custom implementation services are only available when a customer purchases a new subscription, but a customer is not required to purchase them. Typically, the implementation services require three months to complete and during this time customers do not have access to the software services. Additionally, the customer has the option to purchase premium support services. These grant the customer’s employees anytime access to phone/e-mail/live chat support. DobarTech also offers consulting services to ensure effective utilization of the DobarTech suite through consultation and training. Both of these services (consulting and premium support) are available at any time to a customer. However, premium support services are only sold in 12-month increments.
On March 30, 20X1 DobarTech enters into an arrangement with Cadmus. Cadmus will use the software to revamp its materials acquisition, resource management, and global distribution operations. The parties agree to the following:
- One (1) year subscription to the web-based DobarTech Suite beginning July 1, 20X1.
- Implementation services, beginning April 1, 20X1.
- Premium support services for one (1) year beginning July 1, 20X1.
- Consulting services for one (1) year beginning July 1, 20X1.
The total contract price is $1,000,000. A one-year web subscription (and implementation) for a comparably sized customer without any of the additional services typically sells for $800,000. The premium support services ordinarily sell for $150,000. Consulting services are typically worth $300,000.
1) Identify the contract with a customer
Identifying the contract is relatively straightforward as the entities have formally agreed on the terms of the arrangement through the executed document. DobarTech also determines Cadmus is substantially committed to the contract, and collectability is probable.
2) Identify the performance obligations in the contract
According to ASC 606-10-25-14, an entity assesses the goods or services in a contract with a customer and identifies each performance obligation. ASC 606-10-25-18 outlines the criteria for a promised good or service (or series) to be distinct (See RevenueHub article Series of Distinct Goods or Services).
License & Hosting Services
DobarTech must examine whether it is providing the software license as a separate performance obligation, distinct from the hosting services, or a service wherein the license and hosting services together constitute a single performance obligation. DobarTech’s analysis is relatively straightforward: the software does not operate independently on Cadmus’ systems; the web-based platform is only accessible via the internet with an active subscription to DobarTech’s remote services. Therefore, the hosting and software license are not distinct and represent a single performance obligation. As such, DobarTech does not need to separately determine the relative standalone selling price of the hosting and licensing aspects of the arrangement.
DobarTech also examined the relationship with the other included elements of the arrangement to determine whether they are distinct.
DobarTech must determine whether the implementation services should be treated as a separate performance obligation. According to ASC 606-10-25-19, a service is distinct when the entity’s promise is (1) capable of being distinct and (2) separately identifiable from other promises in the contract (distinct within the context of the contract).
Capable of Being Distinct
Capable of being distinct is conceptually similar to standalone value in ASC 605. For the implementation to be capable of being distinct, Cadmus must be able to benefit from the service separately or together with other readily available resources. Generally, services being sold on a standalone basis provide evidence that said services are capable of being distinct. In this case, customers are not required to purchase customized implementation services and these services are sold on a standalone basis with new subscriptions to customers needing added integration functionality. Further, these services can be performed by third parties. Given this analysis, the implementation is capable of being distinct.
To determine whether promises to transfer goods or services to a customer are separately identifiable in accordance with ASC 606-10-25-19(b), DobarTech examined whether the goods or services are transferred individually, or whether they are instead a promise to deliver a combined set of items to which the promised goods/services are inputs using the three factors given in ASC 606-10-25-21 and other facts and circumstances, if applicable. (For more on these factors, see RevenueHub article Distinct within the Context of the Contract.)
Significant integration service. The implementation services to be performed by DobarTech create functionalities that integrate Cadmus’ other systems with the suite. These functionalities are necessary for Cadmus to receive the intended benefit from the subscription. Further, DobarTech does not deliver access to the suite until the three month implementation period is completed. In this way, the hosting/license service and the implementation are inputs used to deliver a combined output of an integrated system.
Significant modification or customization. The implementation services require suite modifications by DobarTech engineers. The nature of these modifications are specific and customized to Cadmus (based on its needs and preexisting systems) and, as stated above, create necessary functionalities. Therefore, the implementation significantly modifies and customizes the software license.
Highly interdependent or interrelated. DobarTech customers can purchase the generic package and use a third party to complete the implementation service. This provides evidence that DobarTech is capable of delivering the two services separately without significantly affecting either service. The two services are not highly interdependent or interrelated.
Given the analysis above, DobarTech concludes that the implementation services are not separately identifiable from the software hosting and licensing promises in the contract. The nature of the promise to the customer is to provide a customized, implemented SaaS platform over the one-year term after go-live. Therefore, the implementation services are not distinct from those services and will be treated as a single performance obligation.
Premium Support Services & Consulting Services
DobarTech evaluated whether both the premium support and consulting services are distinct from the other performance obligations based on the same criteria analyzed above.
Capable of Being Distinct
DobarTech sells both the premium support and consulting services on a standalone basis and Cadmus is able to benefit from these services with its subscription, which is a readily available resource. Therefore, both services are capable of being distinct.
The premium support and consulting services to be provided to Cadmus are entirely supplemental to the license/hosting and implementation services, are sold separately by DobarTech, and do not affect the functionality of the suite. Further, DobarTech will provide these services over a period following the delivery of the subscription. The two services are not inputs to a combined output (of an integrated system or otherwise), do not significantly modify or customize any other services in the contract, and are not highly interdependent or interrelated with the other contract services. The premium support and consulting services are each distinct from one another for the same reasons.
Considering this analysis, DobarTech concludes that each of these services is distinct and will be treated as separate performance obligations.
DobarTech concludes that this contract is comprised of three performance obligations:
- License/Hosting & Implementation Services
- Premium Support Services
- Consulting Services
3) Determine the transaction price
Under ASC 606, the “transaction price” is the amount of consideration to which an entity expects to be entitled. This may include an estimate of variable consideration, implied price concessions, non-cash consideration, or significant financing components. In this case, determining transaction price is relatively straightforward. The total contract price is $1,000,000. There are no general right of return or refund provisions in the contract. Thus, the amount is fixed at $1,000,000 and DobarTech anticipates receiving the entire amount. Therefore, DobarTech will use this amount as its transaction price.
4) Allocate the transaction price to the performance obligations in the contract
ASC 606 requires an entity to allocate the transaction price to each performance obligation based on its relative standalone selling price. The standalone selling price is the price at which an entity would sell a good or service on a standalone basis at contract inception. To determine these prices, an entity must use observable information if available. If these prices are not directly observable, an entity will make estimates. The guidance outlines three possible approaches: (1) an adjusted market assessment, (2) an expected cost plus margin, and (3) a residual approach. However, ASC 606 allows for a combination of one or more of those methods, or a different estimation method. (For more, see RevenueHub articles: Standalone Selling Prices, Case Study: Estimating Standalone Selling Prices, and Case Study: Transaction Price Allocation.) This approach is not significantly different from the approach taken under ASC 605, given these case facts. Specifically, ASC 605 utilizes VSOE, TPE, or BESP to allocate arrangement consideration using a relative standalone selling price method. However, the residual method would not be an acceptable approach for non-software items under ASC 605.
DobarTech performed historical analysis and established standalone selling prices for each the performance obligations. Therefore, DobarTech can proceed with its transaction price allocation by first determining the relative standalone percentages.
Once the relative percentages have been calculated, DobarTech can allocate the transaction price ($1,000,000) among the performance obligations based on those percentages.
5) Recognize revenue when (or as) the entity satisfies a performance obligation
DobarTech will recognize revenue as it satisfies each performance obligation either at a point in time or over time. The license/hosting and implementation and premium support are, in essence, stand-ready promises to provide access to DobarTech’s SaaS platform and support services at the customer’s discretion over the contract term. As such, Cadmus simultaneously receives and consumes the benefit from DobarTech’s standing ready to perform these services. Therefore, these performance obligations qualify for recognition over time in accordance with ASC 606-10-25-27a.
The consulting services provide consultation and training meant to improve Cadmus’ utilization of the suite during the contract term. In this way, as DobarTech performs these services, Cadmus simultaneously receives and consumes the benefits. For example, Cadmus employees can better utilize the suite immediately as they receive customized training. Further, a third-party would not need to substantially reperform the services previously provided by DobarTech if the third-party were to take over the consulting services at any point during the contract term. Given this analysis, DobarTech concludes that the consulting services also qualify for recognition over time in accordance with ASC 606-10-25-27a.
To faithfully depict the fulfillment of performance obligations satisfied over time, DobarTech considers the appropriate measurement for each obligation. As noted above, the license/hosting and implementation and premium support services are stand-ready promises that provide Cadmus access to the services irrespective of usage. Therefore, the method that best represents the transfer of these stand-ready promises is an output method based on time elapsed because the services are delivered equally throughout each increment of time. For the consulting services, DobarTech expends hours in planning, training, and consulting to transfer the service to its customers. Therefore, DobarTech will use an input method based on hours incurred because this method best represents the transfer of services to the customer. DobarTech estimates that it will provide 320 hours of consulting services to Cadmus over the one year subscription. As the consulting services are intended to assist Cadmus in effectively utilizing the suite, DobarTech further estimates that the consulting services will largely be performed in the first six months of the subscription (240 hours in Year 1 and 80 hours in Year 2).
DobarTech can expect to recognize revenue as outlined in the table below:
* Commence April 1, Year 1.
** Commence July 1, Year 1
*** 240 hours in Year 1 and 80 hours in Year 2.
SaaS companies may face certain issues in transitioning to ASC 606 which are not addressed in the case above, including contingent revenue arrangements, deferred commissions, and the treatment of nonrefundable upfront fees.
Contingent Revenue. Under ASC 605, revenue related to contingent arrangements is deferred. Under ASC 606, such revenue may be accelerated. This is because ASC 606 does not require companies to constrain contingent revenue; i.e. there is no ‘fixed and determinable’ language.
Deferred Commissions. Under ASC 605, companies may elect to either capitalize direct, incremental commission costs or expense these costs as they are incurred. Such expenses are required to be capitalized under ASC 606.
Non-refundable Upfront Fees. Arrangements may exist that require customers to pay certain nonrefundable upfront fees such as a fee to activate a SaaS platform. In cases when this fee does not relate to a separate promised good or service with standalone value, the treatment of such fees may differ between ASC 605 and ASC 606. Under ASC 605, nonrefundable upfront fees are generally recognized ratably over the longer of the contractual term or estimated customer relationship. In contrast, under ASC 606, nonrefundable upfront fees may be deemed to create a material right. A material right may exist if the customer has an option to renew a contract at a significant discount such that the upfront fee is effectively payment in advance for additional services in the renewal period. For example, a significant activation fee required by a SaaS provider at contract inception, but not required upon renewal, would likely create a material right. In this case, ASC 606 requires that a portion of the transaction price be allocated to the material right (proportional to its relative SSP) and recognized when that right is exercised or expires. For more on non-refundable upfront fees, please see our article Nonrefundable Upfront Fees.
- ASC 606-10-25-14 to 55-21; ASC 606-10-25-27; ASC 606-10-55-5 to 55-6; ASC 606-10-55-140D through 55-150
- EY, Technical Line FASB – final guidance: the new revenue recognition standard – software and cloud services. August 2014.
- Deloitte, Technology Spotlight: The Future of Revenue Recognition. July 2014.
- PWC, Revenue from contracts with customers. August 2016. Section 3.3 Assessing whether a good or service is unique.