Applying ASC 606: SaaS Revenue Management Considerations
You know. We know. Everyone knows.
The ASC 606 revenue recognition standard is here, has been here for a while, and, as entities moving beyond the implementing stage to the application and disclosure on financial statements stage are learning, it hits everyone a little differently.
Take the Software-as-a-Service (SaaS) sector, for instance.
As Deloitte noted in the firm’s recent Perspectives series of publications, the standard’s effect on the revenue and cost recognition models of such technology entities “may have been greater than that on many other industry groups.”
Pretty easy to understand why this has posed such a challenge when reminded the standard’s fundamental principle is that an entity must “recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”
This expectation creates potential challenges including:
- A need to determine standalone selling price of software licenses in an arrangement
- Ability to identify performance obligations in hybrid cloud-based arrangements
- Assessment of variable consideration and termination provisions
- The capitalizing of certain contract acquisition costs
A considerable amount of judgements and estimates are required to address these needs. A tricky exercise for any industry, but exponentially so in a SaaS world.
Proper revenue management allows a company to better understand both their customers and place in the market, adjusting product pricing and availability as necessary. For SaaS companies, more than most, following such a plan and utilizing tools for revenue recognition automation are strategies that are not just beneficial, but ultimately a lifeline for growth and success.
It’s no wonder, according to another Deloitte report, revenue remains a hot topic among comment letters to the SEC.
Corporations, in response to ASC 606, must collaborate and decipher:
- Significant judgements including performance obligations, determination and allocation of transaction price and identification of a measure in progress
- Performance obligation disclosures such as timing of revenue recognition, payment terms, financing components and the nature of the goods and services
- Contract costs including the method to amortize capitalized costs and considerations for commissions and renewals
- Disclosures of disaggregation of revenue including an entity’s business model and information such as earnings calls disclosed outside of financial statements
- Disclosures of how contract balances are derived
It’s a lot, yes, no matter how you slice it.
The SaaS Challenge(s)
And when we slice it with the SaaS knife (let’s just all pretend together this metaphor works), these demands can be a doozy.
In the Deloitte report, the most common themes (or trying times, headaches, whatever you wish to call them) in applying ASC 606 for entities in the SaaS space include the following:
Contract Cost - The new standard requires direct and indirect incremental costs attributable to the acquisition of a contract to be capitalized. Additionally, an organization must use judgment to determine costs associated with renewals and the appropriate amortization period.
Limitation of Revenue - ASC 606 introduces a new requirement limiting revenue to the amount for which sufficient confidence exists that no reversal will be made at a later date, which could result in earlier revenue recognition for some contracts.
Contract Modifications - Judgment will be necessary to determine whether contract modifications are to be accounted for as a separate contract, as a modification with a prospective adjustment, as a modification with a retrospective adjustment or under a combination of the methods.
Billing - ASC 606, in a change, does not limit the amount of revenue to be recognized under extended payment term arrangements.
Termination Provisions - Certain SaaS arrangements include provisions which allow for the customer to terminate a contract before it expires, and under the new standard such termination provisions can be quite complex.
Usage-Based Fees - SaaS arrangements may include minimum guarantees, volume-based pricing or rebates, or other usage-based fees. Judgment is necessary in order to account for these arrangements. Under the new standard, a corporation may be required to estimate usage, defer a portion of the transaction for future changes in price or recognize amounts earlier than under previous arrangements.
Activation Fees - SaaS arrangements often require set-up or ‘activation’ fees, typically charged in addition to the SaaS subscription fee. Under the new standard, SaaS vendors are required to recognize up-front fees unrelated to the transfer of a distinct good or service over a period extending beyond the initial contact period.
Clearly, SaaS revenue management has a unique set of complexities to be considered in order to capably apply the ASC 606 standard. And the need is only increasing as more companies move to the cloud to become the centerpiece of their digital experience.
Gartner, as part of a November 2021 symposium, laid the groundwork for the coming pervasiveness of cloud computing in the near future. The firm’s analysts - in a publication associated with the event - estimated global cloud revenue for 2022 at $474 billion, up from $408 billion in 2021.
Additionally, Gartner estimated by 2025 over 95% of new digital workloads will be deployed on cloud-native platforms, up from 30% in 2021.
“Cloud has enabled new digital experiences such as mobile payment systems where banks have invested in startups, energy companies using cloud to improve their customers’ retail experiences or car companies launching new personalization services for customer’s safety and infotainment,” said Gartner VP Milind Govekar.
And a lot more work when it comes to disclosure on financial forms, as well.