Revenue recognition: Software and SaaS entities
The current standard relating to the revenue recognition - i.e. IFRS 15 Revenue from contracts with customers - provides a unified accounting framework across industries, but software and Software-as-a-Service (SaaS) arrangements often involve specific complexities. The following areas may become of particular significance from IFRS 15’s point of view:
For instance, consider a scenario where a customer is granted a three-year software licence but has the option to cancel at the end of each year and receive a pro-rata refund of the licence fee. In this case, enforceable rights and obligations might exist for only one year at a time. The customer effectively has an option to renew the licence annually. Revenue allocated to the one-year licence would typically be recognised at the start of the term of the licence. Meanwhile, amounts allocated to the option for future renewals would be deferred until the customer exercises that option by not cancelling the licence. Importantly, the likelihood of the customer exercising the termination right is not factored into the determination of the contract term. Even if cancellation is unlikely, enforceable rights and obligations are limited to the first year.
Conversely, if a termination right lacks substance, it may not impact the accounting for the contract. For example, if a customer is granted a three-year licence but can cancel after one year without receiving a refund, or there are significant early termination penalties making the option for the customer unlikely, the termination right is likely to be non-substantive. Here, enforceable rights and obligations would span the full three years of the contract.
Determining the contract term when customer termination rights are involved often requires professional judgement. The aim is to establish the period over which enforceable rights and obligations exist. For software licences, the critical question is whether the customer is effectively making a renewal decision by not exercising the termination right. If that’s the case, the enforceable rights and obligations are confined to the non-cancellable period of the licence.
However, there are scenarios where determining the contract term could affect revenue recognition. For example:
Multiple performance obligations:
If the contract includes other obligations besides the SaaS component, only the noncancellable SaaS term and its associated fee (e.g. SAR 2,500 for one month in the above scenario) should be factored into the allocation of the transaction price across obligations.
Variable pricing:
If the SaaS price increases over the stated term, the transaction price is limited to the fee for the noncancellable term. Conversely, if the price decreases, the vendor must assess whether future discounts represent a material right for the customer.
When evaluating whether a contract exists (Step 1 of the revenue recognition process), the vendor must assess the customer’s ability and intent to pay the agreed amount when due. Extended payment terms can raise questions about the customer's creditworthiness, but they are not the sole factor in assessing collectability. Vendors need to consider all relevant facts and circumstances. If the vendor determines that it is not probable to collect substantially all of the transaction price, the contract does not meet the criteria for recognition under the revenue standard.
Additionally, extended payment terms may increase the risk of price concessions or payment forgiveness. If such concessions are implied in the agreement, they are treated as variable consideration, reducing the transaction price to reflect the expected concession.
Extended payment terms might also suggest the presence of a significant financing component within the contract. According to the guidance in IFRS 15, vendors must evaluate whether the payment terms provide a financing benefit to the customer. However, vendors can apply a practical expedient (IFRS 15.63) to ignore financing effects if payment is expected within one year of transferring the goods or services.
If a significant financing component exists, part of the contract consideration is recognised as interest income rather than revenue. In such cases, the total revenue recognised will be lower than the cash received, as the difference represents interest income.
In financial reporting, the principal versus agent framework plays a crucial role in determining which party qualifies as the reporting entity’s customer. This determination is important as it will define if the amount of revenue recognised is on gross or net basis and follows a structured two-step approach:
Examples of evidence indicating that the intermediary has control over the software or SaaS may include:
How BDO can help
The current standard relating to the revenue recognition - i.e. IFRS 15 Revenue from contracts with customers - provides a unified accounting framework across industries, but software and Software-as-a-Service (SaaS) arrangements often involve specific complexities. The following areas may become of particular significance from IFRS 15’s point of view:
- Impact of customer termination rights on accounting of software as a licence
- Impact of customer termination rights on accounting of SaaS
- Considering extended payment terms in software arrangements
- Principal versus agent considerations.
- Impact of customer termination rights on accounting of software as a licence
For instance, consider a scenario where a customer is granted a three-year software licence but has the option to cancel at the end of each year and receive a pro-rata refund of the licence fee. In this case, enforceable rights and obligations might exist for only one year at a time. The customer effectively has an option to renew the licence annually. Revenue allocated to the one-year licence would typically be recognised at the start of the term of the licence. Meanwhile, amounts allocated to the option for future renewals would be deferred until the customer exercises that option by not cancelling the licence. Importantly, the likelihood of the customer exercising the termination right is not factored into the determination of the contract term. Even if cancellation is unlikely, enforceable rights and obligations are limited to the first year.
Conversely, if a termination right lacks substance, it may not impact the accounting for the contract. For example, if a customer is granted a three-year licence but can cancel after one year without receiving a refund, or there are significant early termination penalties making the option for the customer unlikely, the termination right is likely to be non-substantive. Here, enforceable rights and obligations would span the full three years of the contract.
Determining the contract term when customer termination rights are involved often requires professional judgement. The aim is to establish the period over which enforceable rights and obligations exist. For software licences, the critical question is whether the customer is effectively making a renewal decision by not exercising the termination right. If that’s the case, the enforceable rights and obligations are confined to the non-cancellable period of the licence.
- Impact of customer termination rights on accounting of SaaS
However, there are scenarios where determining the contract term could affect revenue recognition. For example:
Multiple performance obligations:
If the contract includes other obligations besides the SaaS component, only the noncancellable SaaS term and its associated fee (e.g. SAR 2,500 for one month in the above scenario) should be factored into the allocation of the transaction price across obligations.
Variable pricing:
If the SaaS price increases over the stated term, the transaction price is limited to the fee for the noncancellable term. Conversely, if the price decreases, the vendor must assess whether future discounts represent a material right for the customer.
- Extended payment terms in software arrangements
When evaluating whether a contract exists (Step 1 of the revenue recognition process), the vendor must assess the customer’s ability and intent to pay the agreed amount when due. Extended payment terms can raise questions about the customer's creditworthiness, but they are not the sole factor in assessing collectability. Vendors need to consider all relevant facts and circumstances. If the vendor determines that it is not probable to collect substantially all of the transaction price, the contract does not meet the criteria for recognition under the revenue standard.
Additionally, extended payment terms may increase the risk of price concessions or payment forgiveness. If such concessions are implied in the agreement, they are treated as variable consideration, reducing the transaction price to reflect the expected concession.
Extended payment terms might also suggest the presence of a significant financing component within the contract. According to the guidance in IFRS 15, vendors must evaluate whether the payment terms provide a financing benefit to the customer. However, vendors can apply a practical expedient (IFRS 15.63) to ignore financing effects if payment is expected within one year of transferring the goods or services.
If a significant financing component exists, part of the contract consideration is recognised as interest income rather than revenue. In such cases, the total revenue recognised will be lower than the cash received, as the difference represents interest income.
- Principal versus agent consideration
In financial reporting, the principal versus agent framework plays a crucial role in determining which party qualifies as the reporting entity’s customer. This determination is important as it will define if the amount of revenue recognised is on gross or net basis and follows a structured two-step approach:
- Identifying the specific good or service being provided to the end consumer
- Evaluating whether the intermediary has control over the specified good or service before transferring it to the end consumer.
Examples of evidence indicating that the intermediary has control over the software or SaaS may include:
| Primary responsibility for fulfilment | Inventory risk | Pricing discretion |
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