Accounting for Software Provided as a Service

- RevenueRecognition.com Contributor

In recent years vendors have been moving away from the traditional model of software distribution, often called the perpetual license model, in which the customer is provided with a license to use software which is installed and run on the customer’s hardware, to arrangements where the software is provided as a service with the customer accessing the software over the internet. Software can be provided as a service in either single-tenant architecture, often called Hosted Software, where a specific application is set up for a single customer or in the increasingly popular, multi-tenant architecture, called Software as a Service (“SaaS”), where multiple customers can use the same application at once.

As software is involved, the key accounting issue for Hosted Software and SaaS is to determine whether the arrangement should be accounted for as a sale of software governed by the software revenue recognition guidance outlined in Section 985 of Accounting Standards Codification (“ASC”) 605 or as a service as per the guidance outlined in the Securities and Exchange Commission (“SEC”) materials of ASC 605-S99, Staff Accounting Bulletin (“SAB”) topic 13.A3(f). In order to determine whether software guidance is applicable in Hosted Software and SaaS arrangements, one must determine whether a software element exists. A software element in a hosting (1) arrangement is only present if both of the following criteria are met (2):

a) The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty.

• A significant penalty exists when the customer does not have the ability to take delivery of the software without incurring significant cost and/or the customer cannot use the software separately without a significant diminution in utility or value.

b) 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 the above two criteria are not met the arrangement is considered a service contract.

Generally, in Hosted Software and SaaS arrangements, the customer does not have the right to take possession of the software without significant penalty nor the ability to run the software on its own hardware or to contract with an unrelated vendor to host the software. Therefore, in these circumstances the sale is accounted for as a service transaction with revenue being recognized on a straight-line basis over the term of the agreement unless the terms of the agreement indicate that revenue is earned in a different pattern (3). The accounting would be the same when the software guidance is applicable as revenue would also be earned as the Hosted Software service or SaaS is provided. An example of where revenue is not earned on a straight-line basis is when the customer is charged usage-based fees, in which case revenue is earned as the usage occurs as that is when the fee becomes fixed or determinable.

A common accounting issue is whether any up-front fees, in Hosted Software or SaaS arrangements, such as non-refundable initial set up fees can be considered a separate deliverable and recognized when performed. Up-front fees should not be considered a separate deliverable to be recognized when performed but should instead be deferred and recognized over the life of the contract or the expected customer relationship, whichever is longer when (4):

• The up-front services are not sold separately.

• The up-front services have little or no value to the customer on a stand-alone basis.

• The ongoing software service is essential to the customer receiving the expected benefit of the up-front payment.

In Hosted Software and SaaS arrangements, up-front fees are generally not discrete earnings events as the fee is typically negotiated together with the pricing of other elements of the arrangement and the customer would not receive the benefit of the up-front payment without the ongoing service. Therefore, services, for which up-front fees are charged, are not considered a separate deliverable to be recognized when performed.

Another accounting issue is how to account for any additional services, such as training and consulting, sold along with the access to the software, that make the arrangement a multiple-element arrangement. In multiple-element arrangements there is a significant difference in the guidance for separation of elements when the software guidance is applicable versus when the services guidance is applicable which makes determining the applicable guidance an important first step. In a service arrangement the multiple-element guidance indicates that in order to recognize revenue on a delivered element, the following three requirements must exist (5):

1. The delivered element must have stand-alone value to the customer.

• The delivered element has stand-alone value when it is sold separately by any vendor or the customer could re-sell the delivered element on a stand-alone basis.

2. There must be objective reliable evidence of fair value of the undelivered element.

• Fair value evidence can consist of third party evidence of selling price or management’s best estimate of selling price where vendor-specific objective evidence (“VSOE”) of fair value does not exist (6).

3. If the arrangement includes a general right of refund relative to the delivered item, delivery of the undelivered element is considered probable and substantially in control of the vendor.

Similar to the stand-alone value criteria in the multiple-element guidance applicable to services, the software guidance indicates that delivery of an element is not considered to have occurred if there are undelivered elements that are essential to the functionality of the delivered element, because the customer would not have full use of the delivered product (7). However, a significant difference is that the software guidance indicates that the fee should be allocated to the various elements based upon VSOE of fair value, which is limited to a) the price charged when the same element is sold separately or b) for an element not yet being sold separately, the price established by management having the relevant authority and it must be probable that the price, once established, will not change before the separate introduction of the element into the marketplace (8). As VSOE is often difficult to establish because the various services are often not sold separately, vendors subject to the software guidance end up deferring revenue more often than vendors subject to the service guidance who can more easily establish estimates of selling price or third-party evidence of selling price. Thus vendors which sell traditional perpetual software licenses, or provide Hosted Software or SaaS arrangements containing a software element are at a competitive disadvantage to vendors who provide Hosted Software or SaaS without a software element.

An example of the competitive disadvantage faced by vendors subject to the software guidance is that if product roadmaps, outlining planned future upgrades, are provided along with the Hosted Software or SaaS, this would often require deferral of all revenue until the specified upgrades are delivered due to the difficulty in establishing VSOE of fair value for future upgrades not yet on the market. However, vendors subject to the multiple-element guidance applicable to services can use the easier to establish best estimate of the selling price of the upgrades to allocate revenue between the upgrades and the other elements of the Hosted Software or SaaS arrangement, enabling the Hosted Software or SaaS portion of revenue to be recognized prior to delivery of the upgrades.

In summary, determining whether a Hosted Software or SaaS arrangement contains a software element is essential to determining whether an arrangement should be accounted for using the software guidance or service guidance. In single-element arrangements, revenue under both sets of guidance would be recognized on a straight-line basis, unless revenue is earned in a different pattern. However, in multiple-element arrangements, as the separation guidance applicable to services permits separation of elements based on the use of third party evidence or management’s best estimate of selling price where VSOE of fair value does not exist, while the guidance applicable to software does not, revenue deferrals are less likely to occur when arrangements are subject to the service guidance. Under both the software and service guidance any up-front fees will likely be deferred and recognized together with the Hosted Software service or SaaS.

(1) ASC 605 does not distinguish between single-tenant (Hosted) and multi-tenant (SaaS) arrangements and uses the term “hosting” for both. There is no difference in the accounting rules for Hosted Software and SaaS .

(2) ASC 605, Sections 55-119 through 55-125

(3) ASC 605-S99, SAB topic 13.A3(f), Question 2

(4) ASC 605-S99, SAB topic 13.A3(f), Question 1

(5) ASC 605-25-25-5

(6) ASC 605-25-30-2, transition guidance

(7) ASC 985-605-25-12

(8) ASC 985- 605-25-6