ASC 606 Challenges of Identifying Performance Obligations in the Software Industry
Companies in the software industry enter into contracts with customers to deliver items such as the following: software as a service, cloud computing or hosted software offerings (collectively referred to as SaaS), licenses of software, installation services, unspecified upgrades and post contract support or maintenance services which includes technical customer support and bug fixes (collectively referred to as PCS).
Under ASC 606, for a company to identify a performance obligation it must assess what is promised within the contract to the customer and then determine which of those goods and services are distinct and therefore separate performance obligations (i.e., individual units of accounting). In many contracts this process may be straightforward. However, in other contracts that contain multiple promises, careful analysis and critical judgment are needed. The identification of separate performance obligations is critical, as ultimately it will determine the timing of when revenue may be measured and recognized. It is reasonably possible that the identification of these separate performance obligations will change the historical patterns of revenue recognition.
ASC 606 requires a promised good or service (or a bundle of goods and services) to meet two criteria to be distinct:
- The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct).
- The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract).1
The criteria for capable of being distinct is similar, but not identical, to the stand-alone value criterion required under legacy U.S. GAAP. Specifically, under legacy U.S. GAAP, a delivered item had value on a stand-alone basis if it was sold separately by any company or if the customer could resell the delivered item on a stand-alone basis (even in a hypothetical market). Under ASC 606 this evaluation no longer depends entirely on whether the company or another entity sells an identical or largely interchangeable good or service separately, or whether the delivered item can be resold by the customer. Rather, whether the good or service is sold separately by the company or another entity or could be resold for more than scrap value are factors to consider in evaluating whether the customer can benefit from the good or service on its own. Factors beyond how the good or service is sold in the marketplace by the company or others, such as the stand-alone functional utility of the product or service, are also considered.
In assessing whether promises to transfer goods or service to the customer are separately identifiable, a company should consider the following factors:
- The entity provides a significant service of integrating the goods or services with other goods or services promised in the contract into a bundle of goods or services that represent the combined output or outputs for which the customer has contracted. In other words, the entity is using the goods or services as inputs to produce or deliver the combined output or outputs specified by the customer. Combined output or outputs might include more than one phase, element, or unit.
- One or more of the goods or services significantly modifies or customizes, or are significantly modified or customized by, one or more of the other goods or services promised in the contract.
- The goods or services are highly interdependent or highly interrelated. In other words, each of the goods or services is significantly affected by one or more of the other goods or services in the contract. For example, in some cases, two or more goods or services are significantly affected by each other because the entity would not be able to fulfill its promise by transferring each of the goods or services independently.2
If the promises do not meet the requirements for separating, the performance obligations shall be combined into one performance obligation. A contract could have several performance obligations which in themselves include sets of promises that are not distinct and cannot be separated.
A major change in ASC 606 compared to legacy U.S. GAAP is that a software company will no longer be required to have vendor-specific objective evidence of fair value (VSOE) to account for goods and services separately from each other. This may lead to the identification of additional performance obligations and earlier recognition of revenue. Under legacy U.S. GAAP software revenue recognition guidance, a delivered item (e.g., a software license delivered up-front) was only accounted for as a separate element of the arrangement if the company had VSOE for the undelivered elements (e.g., PCS, professional services, hosting services, or any specified update or specified additional software product). If the company did not have VSOE for all undelivered items, the delivered item (typically a software license) was combined with the undelivered items and the revenue attributable to those items was generally recognized either over the service period (e.g., in the case of PCS or professional services) or at the point in time the undelivered item was delivered (e.g., when a specified upgrade was delivered).
In assessing whether installation services are capable of being distinct, a company would first consider whether the customer can benefit from those services on their own. If third-party vendors offer (or are capable of offering) installation services for the company’s software, or if the customer could perform these services on its own, this would demonstrate that the installation services provide benefit to the customer on their own apart from the software purchased.
If the company concludes that the customer is not able to benefit from the installation services on their own then the company would consider whether the customer can benefit from the services together with other readily available resources. Readily available resources include the license software or SaaS from the contract if it is sold separately by the company or if it is transferred to the customer before the installation services. In assessing whether the installation services are distinct within the context of the contract, a company would need to consider whether the installation services modify or customize the software or SaaS offering and whether the company is providing a significant service of integrating the software or SaaS offering with the installation services into one combined output or whether the company would be able to fulfill its promise to transfer the software or SaaS in the contract independently from its promise to provide the installation services (i.e., whether the installation services are highly interdependent or interrelated with the software or SaaS offering).
POST CONTRACT SUPPORT OR MAINTENANCE SERVICES (PCS)
Under legacy U.S. GAAP, there is no accounting distinction between the various types of PCS services that software companies provide to customers. Services such as phone support, bug fixes, and delivery of (when and if available, unspecified) updates are all combined into a single accounting unit known as post-contract customer support, or PCS. In general, the portion of the arrangement fee allocated to PCS is recognized ratably over the period that services are being rendered.
A company will need to evaluate whether the various types of services within PCS are separate performance obligations, and whether the nature of the promise is to stand ready to provide the services to the customer.
LICENSES OF INTELLECTUAL PROPERTY (IP)
A company will need to determine whether a contract includes a promise of a license of IP within a SaaS offering. This assessment may be straightforward for contracts that include licenses of on-premise software; however, companies have to carefully evaluate the contractual rights in contracts that include hosting services.
The criteria for making this assessment in hosted arrangements were carried forward from ASC 985, Software. A separate promise of a license exists when (1) the customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty, and (2) the customer can run the software on its own hardware or contract with another party unrelated to the vendor to host the software. If both criteria are met, a separate promise of a license exists in the contract.
After determining that a contract includes an IP license, a company must determine whether the license is distinct. If the license is distinct, the company will need to determine if the license provides a right to use the IP (functional) or the right to access the IP (symbolic).
Under some contracts, a company provides a customer with the option to purchase additional goods or services or renew a contract at a stated price. These options are separate performance obligations only if they provide a material right that the customer would not receive without entering into the contract (e.g., a discount that exceeds the range of discounts the company typically provides for those goods or services to that class of customer in that geographical area or market).
If an option is determined to be a separate performance obligation, a company would have to allocate a portion of the transaction price to the material right, based on its relative standalone selling price, and recognize the allocated amount when it transfers those future goods or services or when the option expires.
NONREFUNDABLE UP-FRONT FEES
When a customer pays an up-front fee at contract inception, the company must evaluate whether the nonrefundable up-front fee relates to the transfer of a good or service. The existence of such a fee may indicate that there are promises in the contract, such as the option to renew PCS at a discounted rate or installation services (that may or may not be required) for the customer to use and benefit from. That is, the existence of a nonrefundable up-front fee may indicate that the contract includes a renewal option for future goods and services at a reduced price, which an company would need to assess to determine whether the option is a material right (i.e., another performance obligation in the contract).
If a company concludes that the nonrefundable up-front fee does not provide a material right, the fee is part of the consideration allocable to the goods or services in the contract and is recognized as the good or service (to which the consideration is allocated) is transferred to the customer. If a company concludes that the nonrefundable up-front fee provides a material right, the amount of the fee allocated to the material right is recognized over the period of benefit of the fee, which may be the estimated customer life.
This contrasts with legacy guidance from SEC Staff Accounting Bulletin Topic 13, where nonrefundable up-front fees not paid in exchange for products delivered or services performed (representing the culmination of the earnings process) were deferred and recognized over the estimated customer relationship period.
Companies often provide a range of warranties for their various products. ASC 606 allows entities to continue to use a cost accrual model to account for warranty obligations, but only for warranties ensuring that the good or service complies with agreed-upon specifications. To the extent that a warranty provides a service beyond ensuring that the good or service complies with agreed-upon specifications, it would be accounted for as a performance obligation (consideration would be allocated to this obligation and recognized as it is satisfied). Further, if the customer has the option to purchase the warranty separately, it would also be accounted for as a performance obligation.
EXAMPLE OF DISTINCT GOODS OR SERVICES3
A company enters into a contract with a customer to deliver the following: software license, installation services, unspecified software updates and technical support (online and telephone) for a two-year period. The company sells the software license, installation services and technical support separately. The installation services are routinely performed by other entities and do not significantly modify the software. The software remains functional without the updates and the technical support.
The software license is delivered before the other goods and services and remains functional without the updates and the technical support. The customer can benefit from the updates together with the software license transferred at the outset of the contract. Thus, the company concludes that the customer can benefit from each of the goods and services either on their own or together with the other goods and services that are readily available.
The company then determines that the promise to transfer each good and service to the customer is separately identifiable from each of the other promises. In reaching this determination the company considers that although it integrates the software into the customer’s system, the installation services do not significantly affect the customer’s ability to use and benefit from the software license because the installation services are routine and can be obtained from alternate providers. The software updates do not significantly affect the customer’s ability to use and benefit from the software license because the software updates in this contract are not necessary to ensure that the software maintains a high level of utility to the customer during the license period. The company further observes that none of the promised goods or services significantly modify or customize one another and the company is not providing a significant service of integrating the software and the services into a combined output. Lastly, the company concludes that the software and the services do not significantly affect each other and, therefore, are not highly interdependent or highly interrelated because the company would be able to fulfill its promise to transfer the initial software license independent from its promise to subsequently provide the installation service, software updates, or technical support.
The company identifies four performance obligations in the contract for the following goods or services:
- The software license
- An installation service
- Software updates
- Technical support