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A SPECIAL REPORT FROM THE BDO TECHNOLOGY & LIFE SCIENCES PRACTICE
SAAS
SIMPLIFYING SAAS
ANACCOUNTING PRIMER
HOW DO I GET MORE
INFORMATION?
OVERVIEW now recognized as being quite secure due
to access to state of the art technology and
The SaaS business model continues to gain
security measures.
Contact:
broad acceptance. Existing companies that
historically sold software products are ADAM BROWN
increasingly rolling out SaaS offerings, and National Director of Accounting
many new SaaS companies are emerging.
SOFTWARE LICENSING 214-665-0673 / abrown@bdo.com
There are now more than 20 publicly traded VERSUS SAAS
HANK GALLIGAN
SaaS companies in the United States with The revenue and cost recognition rules that
Assurance Director Software
annual revenues in excess of $1 billion.1 SaaS companies are required to follow are
617-422-7521 / hgalligan@bdo.com
different than the accounting rules that
Trends making SaaS a much more common software licensing companies employ. KEN GEE
and frequently preferred software delivery National Assurance Partner
model include: Software licensing is generally treated for 415-490-3230 / kgee@bdo.com
accounting purposes as a sale or licensing
User demand for affordable solutions. of a product. SaaS is viewed as the sale DOUG HART
Businesses and other users are looking of a service that is provided over a period Assurance Partner
for software that can be implemented of time. As a result, it is important to 415-397-7900 / dhart@bdo.com
quickly without large upfront costs, determine whether software company
AFTAB JAMIL
and can also achieve lower total cost of sales arrangements are considered product
Assurance Partner
ownership due to reduced ongoing costs for licensing or SaaS arrangements.
Technology & Life Sciences
systemmaintenance. 408-352-1999 / ajamil@bdo.com
Generally, in a software licensing
u
Availability of world-class platform-as- arrangement, the customer obtains rights WENDY KIM
a-service (PaaS) or cloud computing to use the software on its own computers. Assurance Director Software
resources. With a plethora of low-cost PaaS 415-490-3041 / wkim@bdo.com
providers, startup SaaS companies can focus In a SaaS arrangement, the customer is
u
on innovation, releasing service offerings buying access to a hosted service based
to the market very quickly with minimal on proprietary software but does not get a
infrastructure investment and capital outlays. copy of the software to use on its own.
These resources are also making solutions
much more scalable. The determination of whether customer
arrangements should be treated as licensing
A shift in perception regarding security. or SaaS arrangements is important since it
Historically, SaaS may have been regarded as also determines which accounting rules apply
a less secure model, since SaaS applications for both revenue and cost recognition.
run outside of a users firewall. Opinions have
recently shifted, though, with the SaaS model
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2 BDO KNOWS SAAS
In many cases, software licensing software license. The criteria include On the other hand, SaaS companies often
companies can recognize a significant establishing the fair value of undelivered must recognize a large portion if not all of
portion of the arrangement fee as revenue elements in the arrangement. the arrangement fee ratably over the contract
when the software license is delivered to term. In addition, sometimes SaaS providers
thecustomer. Fair value is determined based on must defer upfront fees and amortize them
vendor specific objective evidence or to revenue over the estimated life that a
Software licensing arrangements typically
u VSOE. VSOE represents the prices customer is expected to use the hosted
include multiple elements, including that the company charges when selling service (i.e., considering renewals).
delivery of the license itself as well as the services on a standalone basis. To
future, undelivered services such as establish VSOE, the standalone sales The remainder of this publication describes in
telephone support or rights to when-and- prices must be within a sufficiently more detail the accounting rules applicable
if available upgrades (PCS) and installation narrow and consistent price range. to SaaS providers and some of the key
services (PS). Therefore, software licensing companies judgments involved in applying these rules.
often track their separate sales prices
As long as certain criteria are met,
u for purposes of assessing whether VSOE
software licensing companies can has been established. THE SAAS LIFECYCLE
recognize a large portion of the total In order to better understand the revenue
arrangement fee upon delivery of the If VSOE is established for the future recognition issues common to SaaS
deliverables and all other necessary companies, it is useful to consider the
criteria are met, a software licensing lifecycle of a typical SaaS customer as
company will typically employ a residual illustrated in the diagram below.
Finer Points value method to allocate consideration
to the software license. Under this Usually the SaaS arrangement comprises an
At times, a SaaS customer will sign method, the full fair value, as indicated initial term, such as one year, and successive
a software license agreement, and by VSOE, of the undelivered products renewal periods until the customer ceases
install interface software on its own and services is deferred. The difference to use the service or migrates to a different
computers. However, when the primary between the total contract value and version of the service.
purpose of this interface software is to the amounts deferred (i.e., the residual)
facilitate use of the hosted software is allocated to the delivered software As shown below, SaaS arrangements
services, this would still be considered and recognized as revenue immediately also can include a number of types of
as a SaaS arrangement. upon delivery of the software license. professional services during the set-up
and implementation period, as well as
In other transactions, a customer If VSOE cannot be established for
u after commencement of the initial service.
may receive a copy of the complete all future products or services in an Accordingly, most SaaS transactions are
underlying software and license arrangement, then the entire arrangement multiple element arrangements. The main
rights to use the software on its own fee is either deferred until the future accounting consideration is whether the
computers in addition to using the products and services have been delivered, various deliverables should be treated
hosted version of the software. or if the only remaining deliverable is as separate accounting units under
post-contract support, recognized ratably ASC6052525.
If the following two requirements2 are over the term of the agreement. Detailed
met, a software element is deemed to accounting guidance for software licensing
be present in the arrangement: companies is provided in ASC 985-605.
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BDO KNOWS SAAS 3
PROFESSIONAL SERVICES
AND STANDALONE VALUE What Public Companies Are Saying About Standalone Value
In a SaaS solution, normally the hosting,
access to software functionality (often
referred to as a subscription or a license), BDO analyzed the latest Form 10-K filings bad outcome for these earlier stage
upgrades and support are all considered from approximately thirty SaaS providers. companies, as treating the subscription
a single unit of accounting as they do not and professional services as separate
constitute separate deliverables. Other Most of the companies surveyed units of accounting can be highly
professional services often are included determined that there is standalone value complex and time consuming (see
in that single unit of accounting as they for at least some of their professional discussion below).
do not have standalone value. (See services offerings.
As SaaS companies mature, they
u
discussionbelow.)
often reduce their focus on providing
In reaching that conclusion, these
professional services which typically
Determining how revenues from other companies considered a number of
have lower margins and lower
professional services should be recognized factors,including:
valuation multiples. Simultaneously,
depends on whether those services have
those maturing SaaS companies are
standalone value to the customer apart The nature of the professional services.
u
more likely to get the attention of
from the hosted software services. If the
Whether the professional services were
u third party consulting firms to provide
professional services have standalone
required in order for the customer to services for their solutions. Therefore,
value, they typically can be separated from
use the subscription services. as SaaS companies mature, they are
the main SaaS arrangement, with revenue
often able to support standalone value
recognized as those services are performed. The timing of when services contracts
u
for their professional services.
If, however, the professional services do not were signed versus the subscription
have standalone value, then they would start date. A key factor that we often see in
u
generally be treated as set-up fees, and evaluating whether the professional
The contractual dependence of
u
recognized over the longer of the initial services have standalone value is
the subscription with customers
contract period or the period the customer whether the services are occurring
satisfaction with services.
is expected to benefit from payment of the behind the SaaS companys firewall- or
upfront fees.3,4 behind the customers firewall. It is
However, the most critical factor cited
unlikely that a SaaS company would
by nearly all companies surveyed
Specifically, ASC 605-25-25-5 states that allow a third party consulting firm
focused on whether the professional
delivered items should be considered a to provide services behind the SaaS
services were performed by other third-
separate unit of accounting if both of the companys own firewall.
party firms. SaaS companies that used
following criteria are met:
alliance partners, or were aware of third- We believe that the analysis should be
u
party consultants that performed the performed on a platform by platform
The delivered item or items have value to
u
exact same professional services as those basis. To demonstrate, assume that
the customer on a standalone basis.
being evaluated, concluded that there was a cloud services provider offers
standalone value for those services. implementation services on both of
If the arrangement includes a general right
u
its two product offerings one geared
of return relative to the delivered item,
Note that: for an inside sales force and the other
delivery or performance of the undelivered
targeted for outside collaboration.
item or items is considered probable and
Often SaaS companies initially do
u If third party firms provide the
substantially in the control of the vendor.
not have third parties who provide implementation services for the first
professional services for their platform, platform but not for the second, the
Since most SaaS arrangements do not
as the third-party consulting firms cloud provider might only be able to
contain a general right of return, only the first
only invest resources in training their demonstrate standalone value for the
of the above conditions is often required to
consultants to implement a specific services associated with the inside
be evaluated.
platform, if they believe the market salesoffering.
opportunity is worthwhile. As a result,
Standalone value exists if (a) the deliverable Services provided subsequent to the
u
most earlier stage SaaS companies
is sold separately by any vendor; or (b) the go-live date may not have standalone
have difficulty establishing standalone
customer could resell the delivered item value if the customer only benefits
value for their professional services.
on a standalone basis. Most professional from these services from the continued
This is often not considered to be a
services included in SaaS agreements such use of the hostedsoftware.
as implementation, training, data conversion,
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4 BDO KNOWS SAAS
Example #1:
ALLOCATING THE
Example #2:
Standalone Value Exists Standalone Value Does Not Exist
ARRANGEMENT
Smart System Solutions (SSS) provides
CONSIDERATION
Intelligent Interactions Inc. provides data
companies in the healthcare industry the When the multiple goods and services
virtualization services to a variety of
ability to upload clinical data onto its cloud- provided under a SaaS arrangement qualify
customers. The company also provides
based database, and perform various types for separation as discussed above, U.S.
set-up and implementation services
of data analysis and custom report writing. GAAP requires that the total arrangement
prior to the start of the license term and
SSS also typically provides data conversion consideration be allocated to each deliverable
charges an hourly billing rate for these
services prior to the official start date of the based on a relative standalone selling price
professionalservices.
arrangement. approach. This is different than how the
allocation typically works in a software
Intelligent does not believe that it has
licensing arrangement, which as described
standalone value for the professional services
earlier in this publication is often performed
in the arrangement because no other vendors
using a residual approach.
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BDO KNOWS SAAS 5
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6 BDO KNOWS SAAS
FUTURE RELEASE ROADMAPS USAGE FEES expensed as incurred. Exactly which costs
can be capitalized depends on whether
It is not uncommon for customers of SaaS Sometimes, cloud providers will charge a
the underlying software being developed
and software licensing companies to request fixed annual fee, as well as additional usage
is expected to be licensed for use on a
access to roadmaps of upcoming future fees if the customer exceeds a certain level
customers own computers, or solely used
upgrade and product releases, including of bandwidth, data storage, uses, or other
internally to provide hosted services to
rights to receive specified future upgrades thresholds.
customers. As a result, software licensing
and new products when released.
companies are required to follow one set of
SaaS companies should not recognize
accounting rules5 when determining whether
For companies that sell software licenses, any additional fees as revenues until
to capitalize software development costs, and
rights to specified upgrades and new earned, based on SAB Topic 13, Revenue
SaaS companies are often subject to different
products typically result in deferral of all Recognition, which precludes recognition
accounting rules6 if they do not have plans to
revenue under the license arrangement of revenues when the amounts are not
separately license the software.
until the specified upgrades or products are fixed or determinable and the guidance in
delivered. As discussed previously in this ASC60525-30-1 for SaaS arrangements
Direct customer costs incurred at the
publication, software licensors can only with multiple deliverables.
beginning of an arrangement, such as
unbundle multiple element arrangements
set-up costs or sales commissions, can
if there is VSOE of the fair value of future
either be expensed as incurred, or deferred
deliverables. Typically, it is difficult if not COSTS
and recognized as the related revenue is
impossible to establish VSOE of fair value of There are two main types of costs incurred by recognized based on an accounting policy
future upgrade or product rights. companies that license software or provide election. Once this policy is established, it
cloud services. should be consistently followed.
This same accounting outcome does not
usually occur for SaaS companies. Presuming Costs to develop and maintain the
u
SaaS companies that elect to defer these
the existing hosting service has standalone underlying software used to provide the costs and recognize them over the period
value (e.g., the company sells the as is service; and that the revenue is being recognized can have
hosting services without the future upgrade ),
Direct contract costs related to specific
u challenges with recordkeeping. For example,
a SaaS company will use its best estimate of
customers. when providing professional services during
selling prices of the upgrades or new products
the set-up period, costs that relate to services
to allocate revenue between the existing
Some development costs can be capitalized with standalone value should be recognized
hosted service and future upgrade rights or
and amortized over the expected life of the as those services are performed. Costs related
new products. These cloud services providers
software. Other development costs and to set-up services that dont have standalone
can then start recognizing the portion of
all maintenance costs are required to be value may be deferred and recognized ratably
revenue allocated to the existing hosted
over the expected period of customer use of
service as soon as the customer begins using
the hosted service.
that service.
CONCLUSION
Obtaining a strong understanding of
accounting rules that apply to SaaS
companies will help to optimize customer
arrangements for maximum value and
ensure the reliability of financial information
reported to outside investors and
otherstakeholders.
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BDO KNOWS SAAS 7
The FASB has issued new revenue Upfront fees. For arrangements where
u
FASB/IASBs Joint Transition Resource
recognition guidelines that are expected (a) the SaaS company receives an upfront Group may be forthcoming.
to become effective7 for fiscal years fee and (b) all goods and services are Distinct performance obligations.
u
beginningafter: combined into a single accounting unit The new revenue guidelines provide a
(i.e., there is no standalone value for different set of criteria for determining
December 15, 2017 for public entities
u
the various deliverables), current GAAP the accounting units within a customer
(i.e., January 1, 2018 for calendar year requires the fee to be amortized over contract. Therefore, for a given contract,
companies) the longer of the initial contract period its possible that fewer (or more) distinct/
December 15, 2018 for all other
u
or the period the customer is expected separable performance obligations may
companies to benefit from payment of the upfront be identified under the new rules versus
fees. Under the new rules, similar todaysGAAP.
Companies are permitted to early adopt upfront fees would also be amortized Costs of fulfilling a SaaS contract.
u
the new rules, but not before annual periods over the expected benefit period if the Today, SaaS companies can make an
beginning after December 15, 2016. arrangement provides the customer with election on how to treat set-up and
a material right such as being able to similar costs under a customer contract.
The new guidelines will certainly affect renew the hosted software arrangement The new guidelines will require that costs
companies that license software. Please without having to repay the upfront to fulfill a customer contract that are
refer to our Revenue From Contracts With fee. Otherwise, the upfront fee would not addressed by other standards must
Customers Software Industry Alert for be amortized over the initial contract be capitalized and amortized in a manner
additional details. periodonly. consistent with how revenues under the
Contingent fees. Under todays GAAP,
u
related contract are being recognized.
The new revenue recognition rules may contingent fees are not recognized as
also change the way SaaS companies report revenues until earned and realized. Under SaaS companies should stay tuned for
revenue and costs from software hosting the new revenue rules, SaaS companies further information, and monitor the
arrangements and related professional might be required to make an estimate activities of the joint FASB/IASB Transition
services. For example: of variable consideration including Resource Group for possible interpretative
any contingent usage fees or royalties. guidelines. See the FASBswebsite for
Further discussion on this topic at the moredetails.
1 Source: Calcbench survey of SEC registrants filing under the Standard Industrial Code 7372. Data as of June30,2015.
2 Accounting Standards codification (ASC) 985-605-55, Software Revenue Recognition, paragraphs 121 to 125.
3 SEC Staff Accounting Bulletin 104, footnote 39 states: The revenue recognition period should extend beyond the initial contractual period if the relationship with the customer is expected to extend beyond the
initial term and the customer continues to benefit from the payment of the up-front fee (e.g., if subsequent renewals are priced at a bargain to the initial up-front fee).
4 A conclusion that the benefit of these services is limited to the contractual period is often scrutinized by the SEC, so companies should be prepared to defend that conclusion.
5 ASC 985-20, Costs of Software to be Sold, Leased or Marketed
6 ASC 350-40, Internal Use Software
7 See FASB proposed Accounting Standards Update 2015-240 issued April 29, 2015 and tentative Board Decisions from the July 9, 2015 Board Meeting on the FASBs website.