Decoding the major Challenges in Revenue Recognition from the Software Industry
A software company’s Accounting Advisory Services team adopts Ind AS 115 revenue from contracts with customers to recognise revenue from its contracts. The revenue recognition guidance provided by Ind AS 115 is not specific to any industry.
This blog outlines common challenges software entities face when appropriately recognising revenue. When applying the accounting guidance by Ind AS 115, management will need to exercise professional judgment based on the specific facts and circumstances.
Licensing and SaaS
Determining whether a software entity is granting a software license or providing Software-as-a-Service (SaaS) is essential. Hybrid cloud arrangements, where both on-premises software licenses and cloud-based services are offered, add complexity. The distinction between a software license and SaaS depends on the customer’s rights over the software entity’s intellectual property (IP).
Free trials or Contract
Sometimes, a software entity may provide free services, such as Software-as-a-Service (SaaS), for a limited duration, allowing customers to evaluate the offering before committing to a longer-term purchase. Throughout the trial period, customers can either discontinue the free trial at any point or continue using the services by opting for a longer-term subscription.
Understanding Contract Term
The contract term refers to the duration the parties involved hold current and enforceable rights and responsibilities. This duration influences the assessment and distribution of the transaction price and the recognition of revenue.
Contractual Performance Obligations
Accurately identifying performance obligations is essential for a software entity to properly recognise revenue from customer contracts. Each performance obligation is a unit that determines the timing and amount of revenue to be recognised.
Deciding If SaaS is a “Stand-Ready” Obligation
A software entity must evaluate its commitment to ascertain whether it has pledged to provide a predefined quantity of services or remains prepared to fulfil customer requests. Assessing whether a SaaS subscription entails a stand-ready obligation necessitates exercising professional judgment and considering the specifics of each case individually.
How are Set-up or Administrative Works Accounted?
A software entity selling a software license or SaaS to a customer may undertake initial administrative or set-up activities. However, activities performed to fulfil a contract that does not directly transfer goods or services to the customer are not regarded as promised goods or services. Despite being necessary to successfully transfer contracted goods or services, revenue recognition does not apply to these activities. Revenue is only recognised when control over the identified promised goods or services is transferred to the customer. Nonetheless, the software entity should assess whether the costs incurred for such activities should be capitalised, following the guidance on contract fulfilment costs.
Do Significant Financing Components exist?
A software entity should assess if a significant financing component exists in contracts. If the difference between promised consideration and the cash selling price arises from factors other than financing, no significant financing component exists. Similarly, when customers pay in advance for PCS or SaaS for more than a year, the entity must evaluate if a significant financing component is present.
Deciding Principal or Agent
Software entities often use intermediaries to distribute software or SaaS. To determine the customer relationship, they must ascertain whether the intermediary or end consumer is the customer:
- If the intermediary is the customer, revenue is based on what the entity receives from them, irrespective of any subsequent pricing changes.
- If the end consumer is the customer, revenue reflects their price, with an expense recognised for the intermediary’s share.
The intermediary must also determine if they act as a principal or agent:
- If they’re the principal, revenue is based on the gross amount paid by the end customer.
- Revenue is based on the net commission received if they’re an agent.
- Each arrangement component is evaluated separately, with Ind AS 115 providing guidance.
Transaction Price Allocation
Entities often bundle software licenses with other goods or services, like post-contract support (PCS). Ind AS 115 requires them to allocate the transaction price based on each component’s relative standalone selling prices (SSP). SSP is the price at which the entity would sell the goods or services separately. Observable prices for standalone sales are preferred, considering pricing policies and practices. However, determining SSP for each component can be challenging, especially for entities not selling software-related elements separately.
Deciding When To Recognise Revenue
Revenue from a software license is recognised immediately or over time, depending on the nature of the vendor’s promise to the customer. This promise entails providing the customer with either:
- Right to use: This grants the customer access to the software entity’s intellectual property (IP) as it exists when the license is granted.
- Right to access: If shorter, the customer can access the software entity’s IP throughout the license period or its remaining economic life.
Conclusion
Software entities encounter distinct challenges in applying particular aspects of the guidance. The causes for the challenges are the inherent judgments, the unique software product characteristics, and the dynamic nature of the software industry in terms of products and pricing practices.
