The current GAAP standards for cloud and SaaS software companies, SOP 97-2 and ASC 985, will soon be obsoleted in favor of ASC 606, which is the new gold standard for revenue recognition. ASC 606 does simplify and streamline a number of revenue recognition complexities, but it also introduces a few more judgments calls, which cloud and SaaS software companies will have to get used to.

With ASC 606, software companies will be able to estimate certain aspects of revenue recognition, which will help bring revenue more in-sync with how these licenses and contracts actually work.

It might help to walk through a fictional scenario of how this new process might work.

ASC 606 will absolutely change how cloud/SaaS software companies see their piggy banks.

Let’s follow Blink, a brand-new Silicon Valley startup that’s bringing in some of their first corporate clients onto their SaaS platform for marketing automation. They sell a one-year subscription to their platform for $25,000 and have a one-time onboarding fee of $5,000. Let’s walk through the five-step ASC 606 process.

One of their new customers is getting a one-year subscription and also paying for $25,000 in consulting services. Independently, these would sell for $55,000 separately, but Blink is going to bundle some of the costs for an overall contract that’s worth $45,000.

Identifying the contract is relatively simple—there’s the one-year license (covering both hosting and the license to access the SaaS platform), the onboarding fee, and the consulting fee. The new customer is committed to the contract, and Blink is likely to collect on their fees, making this a legitimate contract.

Next, Blink needs to figure out what services are distinct so that they can track their fulfillment of performance obligations. Because their onboarding can’t be bought from a third party, and because the ability to access the platform is dependent upon this onboarding process, the company decides that onboarding is not distinct from hosting/licencing. The consulting services are considered distinct because they are often sold to existing customers on a standalone basis, and aren’t required when buying a new license.

ASC 606 makes growth easier for software companies.

Blink is now required to allocate the transaction price to the different performance obligations, and one method of doing so is based upon their standalone costs and their relative percent against the total.

Licence/hosting/onboarding: $30,000, or 55%
Consulting: $25,000, or 45%
Total: $55,000

Because the contract is for $45,000, that means Blink can allocate $24,750 toward the licence/hosting/onboarding, and $20,250 for consulting.

Because the contract begins July 1, it means that Blink will recognize revenue in two different fiscal years. The licence/hosting/onboarding can be recognized linearly over time, considering that it’s a SaaS application that’s always being delivered. Based on past experiences, Blink thinks it will spend 75% of its consulting time during the first six months, and 25% percent during the last six months.

Year One
License/hosting/onboarding: $12,375
Consulting: $15,187.50
Total: $27,562.50

Year Two
License/hosting/onboarding: $12,375
Consulting: $5,062.50
Total: $17,437.50

Obviously, this is a rather simple example of how software companies will have to deal with ASC 606, but it does illustrate how they will need to start making fair judgments about their products in order to allocate prices and determine how performance obligations are completed.

The next steps

Even if you’re not already following ASC 606 GAAP guidelines, now is a good time to start thinking about an enterprise resource management (ERP) system that’s built specifically to streamline this process and minimize complexity—we’ve got NetSuite for that (plus a 14-day free trial). Also, be sure to check out our Revenue Recognition Hub for for information about ASC 606, VSOE, and more.

As we said, ASC 606 ditches some of the truly complex rules in favor of giving software companies more opportunity to make reasonable judgments about their revenue and how it’s recognized. With more openness comes more complexity, and more opportunity to do something wrong, mistakenly or not. If you have any questions about how your particular software company should work around ASC 606, get in touch and we’ll start walking you through the process.