For the past few days, this blog has been focused on revenue recognition for software licenses. However, many software companies are implementing business models different from the traditional software licensing paradigm. There are two models that have received a lot of attention within the past few years: Software as a service (SaaS) and cloud based software solutions. Due to their explosive growth, managers should understand the revenue recognition rules on these new business models and how they differ from accounting for traditional licenses.
Under the current FASB guidelines, a sale can be counted as revenue and is recognized upon delivery. Delivery implies that the customer takes physical possession of the product or service. In other words, revenue is recognized when ownership rights and possession are passed from vendor to the customer, assuming compliance with all the other rules. In the software industry, this generally implies that software is delivered and installed on the customer’s servers.
For SaaS and cloud based business models, a strict interpretation of the delivery clause within SAB 104 would mean that revenue could never be recognized. Although both SaaS and cloud models grant customers the right to use their software, the software is never actually delivered to the customer’s location. The vendor maintains ownership over both the software and the intellectual property. Instead of receiving ownership rights, the customer receives the right to access, manipulate and interact with the software.
The inability for SaaS and cloud based companies to comply with the rules around “delivery” changes the revenue recognition polices for them. Since the customer is granted access rights and does not take actual possession of the software, the transaction cannot be treated like a “sale.” Instead, revenue is recognized following services accounting rules. Under these rules, software licensing would be ratable over the life of the agreement as the services are provided. Of course, there are some exceptions. For example, if a contact is structured around customer usage thresholds, then revenue would be recognized as the usage occurs.
Although some SaaS and cloud based software companies only offer access rights, others include more elements within their contracts such as setup, training, and consulting services. In comparison to the traditional software licensing model, these additional elements are given the same accounting consideration as PCS. And like PCS, the sale of these services can only be recognized upfront if vendor specific object evidence (VSOE) of fair value has been established. However, establishing VSOE on setup and consulting services is more difficult for cloud and SaaS based businesses then it is for PCS. With PCS, most companies are able to use the renewal rate as justification for fair value. Since setup fees and consulting services for cloud and SaaS models are frequently an upfront charge and are rarely renewed, the renewal rates cannot be used to for VSOE. The lack of renewal rates makes it difficult to establish VSOE.