Accounting for Conversion from On-Premise to Cloud for Software Companies
At a High Level
Software as a Service (“SaaS”) continues to rise in popularity, offering increases in speed, universal access, scalability, and security. SaaS is hosted on a company’s servers and accessed through a web browser, which stands in contrast to legacy on-premise software installed locally on the customer’s server and hardware. Many software companies, however, do not yet have the infrastructure or technology to support a SaaS offering. To solve for this, SaaS companies often provide customers the option to convert their current on-premise subscription contracts later in the contract term. This conversion option raises questions on when revenue should be recognized under the new revenue guidance in ASC 606.
The Financial Accounting Standards Board (FASB) added contract modifications—specifically addressing the conversion of a term software license to a SaaS Arangement—as a discussion point in the Emerging Issues Task Force’s (EITF) May 2019 meeting and will discuss the issue in a future meeting.
What We’ve Seen
The complexities associated with contract modifications that allow customers to convert an on-premise license to a SaaS arrangement have resulted in diverse interpretations and applications of the guidance. This diversity is largely a result of the stark contrast between how revenue is recognized for on-premise licenses (up front when control transfers) versus SaaS arrangements (over time during the subscription period).
Here are some common interpretations of the guidance, as well as their potential challenges.
Interpretation #1:
Account for the Conversion Option as a Right to Return
The Interpretation: Under this method, companies account for the customer’s option to convert the arrangement as a “right to return.” This approach requires companies to record a return reserve at contract inception, which reduces the amount of upfront revenue recognized for the license of intellectual property (IP) and estimates the likelihood that the conversion will take place during the contract term. Subsequent revisions of the return reserve will increase or decrease revenue accordingly.
The Challenge: Implementing a potentially convoluted reserve estimation process may produce skewed revenue results depending on the availability and accuracy of historical contract conversion data.
Interpretation #2:
Account for the Conversion Option as a New Contract
The Interpretation: In certain cases, contract modifications related to conversion options that include additional fees upon conversion can be treated as a new contract due to the increase in scope and the addition of promised distinct goods or services. However, in these cases, the additional fees charged to customers for conversion do not typically represent the standalone selling price of the additional software and would need to be evaluated to determine if the departure from the standalone selling price is justified. In these situations, revenue recognized for the license of IP would remain unchanged and the company would recognize any additional fees (i.e. conversion fees, up charges per software user, etc.) charged to the customer upon conversion over the SaaS subscription term.
The Challenge: While this method is the least cumbersome for companies to implement, it can produce inconsistency in the amounts and time periods in which revenue is recognized as the majority of the company’s revenue will be recognized up front and incremental fees will be recognized over the subscription term. Additionally, the requirement to substantiate that the departure from standalone selling price is appropriate can be difficult due to the ambuigity of what is considered “justified” within the guidance.
Interpretation #3:
Recognize Revenue at Inception With No Changes at Conversion
The Interpretation: Under this interpretation, enforceable rights and obligations for the initial software license transfer to the customer at the beginning of the contract and do not change during the contract term even when converting to a SaaS model. As such, revenue recognized for the software license will remain unchanged and revenue is not recognized during the SaaS period unless additional fees are charged.
The Challenge: Accounting treatment and impacts in this scenario are essentially the same as treating the conversion option as a new contract, as discussed above.
Interpretation #4:
Reverse Revenue Upon Conversion to SaaS
The Interpretation: Upon strict reading of the guidance, the conversion represents a contract modification that should be treated as a continuation of the initial contract. Under this approach, at the time of converstion, the company records an adjustment to reverse revenue recognized for the software license, revises the transaction price of the contract and adjusts historical and future revenue to account for the contract as if it was an SaaS arrangement from contract inception.
The Challenge: The primary drawback of this approach is the need to adjust retained earnings and reverse revenue in prior reported periods on an ongoing basis, creating process and reporting difficulties.
What Companies Should Consider
Each of these interpretations can add significant complexity to management’s forecast and budgeting. Additionally, financial statement transparency can be negatively impacted when revenue is unchanged. For example, investors and other stakeholders will likely have limited insight into the true volume of SaaS arrangements or the mix of software offerings sold by the company by reviewing subscription revenue alone.
As contracts with customers are changing to include conversion options, companies need to consider the complexities and calculate the impact of the new revenue guidance. When assessing the impact, companies should consider the following: population of contracts, contract terms (including existence of termination clauses and penalties), contract length, payment terms, whether the option is explicitly written in the contract, and any fees associated with conversion. As more deliberation is expected during the EITF’s September 2019 meeting, any questions surrounding conversion options or 606 adoption are encouraged.
Riveron’s business advisory specialists are hands-on partners, working together with you to sort through the details of adopting ASC 606 and the impacts on your organization.