Software Revenue Recognition Under ASC 606: Licensed Software, SaaS, and Hybrid Arrangements Explained
Learn how to recognize software revenue under US GAAP and ASC 606. Explore licensed software, SaaS, hybrid arrangements, and hosting scenarios with clear guidance for accounting professionals.
Background
We list common scenarios of performance obligations in software revenue arrangements relevant for the majority of businesses selling software or related services and identify the appropriate treatment of each scenario under US GAAP.
Licensed Software Arrangements
The term “Licensed software” refers to the licensing of software by granting the customer the right to use the software. Software is the intellectual property (IP) that has significant standalone functionality. The customer in this arrangement would acquire the right to use the IP because it has standalone functionality, and the customer can use the IP as it exists at a specific point in time.
Outside of one exception that we will address below, revenue from licensed software is recognized at the point in time of the license term's inception date. It is regardless of the license term's duration and whether it is finite or perpetual. However, the license term remains relevant, as its duration will affect the standalone selling price estimate, and consequently, it will impact the allocation of the transaction price.
Now, as we mentioned earlier, there is one exception to this rule. This exception addresses situations in which a software license grants the right to access the underlying intellectual property rather than to use it. Both of the following conditions should have been satisfied for this exception to be applicable:
“a) The functionality of the intellectual property to which the customer has rights is expected to substantively change during the license period as a result of activities of the entity that do not transfer a promised good or service to the customer (see paragraphs 606-10-25-16 through 25-18). Additional promised goods or services (for example, intellectual property upgrade rights or rights to use or access additional intellectual property) are not considered in assessing this criterion.
b) The customer is contractually or practically required to use the updated intellectual property resulting from criterion (a).”
[FASB ASC 606-10-55-62]
For both conditions to be satisfied, the software license and its subsequent updates should be viewed as a single combined performance obligation (PO), rather than distinct POs. As a result, the revenue recognition from a combined performance obligation will usually follow the over-time recognition pattern with a time-based measure.
Software as a Service Arrangements (SaaS)
The term “SaaS” may refer to either:
Granting the customer the right to access the functional IP (software).
Specified cloud-based services.
This assessment is highly judgmental and may be based on the following non-exhaustive lists, where no single factor has a greater weight:
a) “Right to access” factors:
Right of access/use of the platform that has either no limit or a non-substantive limit.
Service is not sold separately on a pay-as-you-go basis.
The vendor continues to provide platform access support services throughout the contract term.
The customer consumes benefits from the platform over a contract term, rather than specific usage or outputs, such as processing transactions or data.
When SaaS is a promise to provide access to the platform during a specified time period, the revenue progress measure is a time-based measure.
b) “Specified services” factors:
A specified amount of usage/transactions is fixed, and any incremental consumption must be purchased separately once the initial allowance is exhausted.
The platform allows rolling over unused pre-purchased consumption credits.
Service is being sold separately on a pay-as-you-go basis.
Access to the platform by itself does not significantly benefit customers unless it is utilized or applied, such as through the consumption of its outputs, including data or processed transactions.
When SaaS is a promise to provide specified services, the measure of progress is based on the services provided, i.e., the revenue is recognized based on the amount of service consumed by customers or via a usage-based measure.
Hybrid arrangements
Both SaaS and Licensed software may be present in the same “hybrid” arrangement. Here, the accounting will depend on the assessment of whether licensed software and SaaS components are considered distinct. This assessment requires significant judgment and an understanding of the functionality of each component and the service, as well as how they interact with each other.
For example:
If the customer is required to use the licensed software and SaaS service together to benefit from the purchase, both elements are combined into a single performance obligation in accordance with ASC 606-10-55-56.
On the other hand, licensed software with significant standalone functionality is typically distinct from SaaS services because the customer can benefit from the license even without the service.
The following considerations support the conclusion that both elements are to be combined into a single performance obligation:
Significant degree of interaction on a regular basis with a “two-way” dependency between the on-premises software and SaaS.
The interaction between licensed software and SaaS enables customers to derive the intended benefits.
Together, licensed software and SaaS provide new functionality or significantly modify existing functionality due to the transformative rather than additive relationships.
The two elements together provide new or different functionality; in other words, the SaaS functionality is transformative rather than additive.
Similar benefits cannot be practically obtained from SaaS provided by alternative vendors.
Marketing materials communicate the value of the product offering on a combined, rather than a standalone, basis.
Revenue allocated to a performance obligation combining a license and cloud-based services is generally recognized over time using a time-based measure.
Hosting arrangements
A hosting arrangement exists where a customer does not obtain the licensed software in its possession but rather remotely accesses the software hosted on third-party hardware. As per ASC 985-20, Costs of Software to be Sold, Leased, or Marketed, a hosting arrangement includes a distinct software license only if:
It is feasible for the customer to run the software on its own or by contracting with an unrelated third party, and
There is a contractual right that allows the customer, at any time during the hosting period, to take possession of the software without significant penalty.
The relevant considerations related to the above two criteria incorporate:
The significance of incremental infrastructure costs required in order for a customer to host the software locally.
The ability to use software separately without diminishing its utility.
The ability to absorb penalties for terminating the hosting arrangement (including forfeitures of nonrefundable upfront payments for services).
If the hosting arrangement meets both criteria, both licensed software and SaaS service elements are considered distinct, and revenue is recognized for:
Initial license (distinct): at a point in time.
Future upgrades (distinct): at a point in time.
Initial license combined with upgrades: time-based measure.
Hosting service (distinct): using a service usage measure.
Otherwise, the two elements of the hosting arrangements would be treated as a hosting service contract. Such an arrangement would typically be accounted for based on a series of guidance as per ASC 606-10-25-14(b).
Arrangements where the licensed software is not distinct from other services and products in the contract (including SaaS)
In arrangements where software licenses are not distinct from other products or services, it is possible that software will not be separately accounted for. Software will be combined with different promises, and revenue will be recognized based on the combined performance obligation. Specifically, ASC 606-10-55-56 requires this approach when the software is:
A license integral for the functionality of a tangible good.
A license that the customer can benefit from only when such a license is combined with a related service (for example, an online service enabling the customer access to content by granting a license).
For example, an arrangement to deliver software and customer support for a period of twenty-four months. The software vendor must determine whether the software license and post-purchase customer support are distinct or should be accounted for as a single performance obligation. As per ASC 606-10-55-46(b), a license is not distinct if it can only be used in conjunction with a related service (e.g., a license that solely enables a customer to access an online service).
For licenses that are not distinct and are bundled with other goods or services, reporting entities will need to apply judgment to assess the nature of the combined item and determine whether the combined performance obligation is satisfied at a point in time or over time.
Conclusion
Software revenue recognition can be complex due to the numerous models that may apply, depending on subtle variations in contract terms and conditions. The insights shared in this article help bring clarity to this question. If you have any additional questions related to the assessment of your contracts under ASC 606, reach out.