Revenue Recognition in Cloud Computing

By Nick Steiner, BPM Partner, and Reena Patel, BPM Senior Manager

Cloud computing – also known as “software as a service” or “SaaS”– is one of the fastest growing business sectors in the technology space. Forrester Research estimates that cloud computing revenues will jump from $41 billion in 2010 to $241 billion by 2020. IDC estimates that it will account for 13.1 percent of worldwide software spending by 2015.

Yet cloud computing presents some unique accounting challenges, particularly when it comes to revenue recognition. At what point can cloud companies record revenue from customer contracts that are delivered over time? How should they allocate consideration among different elements within a customer contract?

CFOs and entrepreneurs whose companies are entering the cloud marketplace need to make sure they understand the complicated rules of revenue recognition from the start – or risk having to restate their financial statements in the future under the critical gaze of investors, lenders or regulators.

Cloud computing and its accounting challenges
Cloud computing is a general term that typically refers to application, platform or infrastructure services that are delivered over the Internet by subscription or on an “as-needed” basis. Through cloud computing, businesses can access applications such as customer-relations databases or infrastructure such as data centers without having to purchase and manage the technology in-house.

Traditional software companies sell their customers a software license that is typically loaded onto the customers’ computers. But cloud computing firms generally sell a subscription to bundled services such as access to online software applications, with training and technical support.

Because cloud computing services are delivered on a subscription basis, rather than point-of-sale, the traditional accounting guidance for software revenue recognition is generally not applicable. Instead, cloud companies must look to general revenue recognition guidelines – particularly those that pertain to multiple element arrangements.

Revenue recognition criteria
Cloud services face the same general criteria for revenue recognition as most other non-software companies. As stated in SEC Staff Accounting Bulletin Topic 13 (SAB Topic 13), revenue cannot be recognized unless:

  • Persuasive evidence of an arrangement exists;
  • Delivery has occurred or services have been rendered;
  • The seller’s price to the buyer is fixed or determinable; and
  • Collectibility is reasonably assured.

As service revenue, cloud computing subscription revenue is typically recognized ratably throughout the term of the contract. SAB Topic 13 states:

Provided all other revenue recognition criteria are met, service revenue should be recognized on a straight-line basis, unless evidence suggests that revenue is earned or obligations are fulfilled in a different pattern, over the contractual term of the arrangement or the expected period during which those specified services will be performed, whichever is longer.

Conceptually, the recognition of revenue over a ratable term is relatively simple accounting. Things get more complicated in accounting for the various elements or deliverables within a cloud computing contract.

Elements of cloud computing contracts
Contracts may include multiple elements, as noted in Financial Accounting Standards Board (FASB) Accounting Standard Codification (ASC) Subtopic 605-25. For instance, elements might include professional service deliverables such as implementation, data migration or mapping as well as training and technical support.

With cloud computing contracts, common issues in revenue recognition include:
Determining what constitutes a single arrangement. Separately-issued contracts may be considered one overall arrangement if they are entered into within a short period of time, or when deliverables in separate contracts are closely related in terms of functionality.

Identifying all elements in the arrangement. Often there are multiple deliverables such as a subscription license, technical support, training and customization in a single contract. It is important to identify all elements in order to correctly allocate the arrangement consideration to individual elements and appropriately recognize revenue.

Determining elements that are separate “units of accounting.” An element can be considered a separate unit of accounting if it meets two criteria. First, delivered items must have value to the customer on a stand-alone basis. Secondly, if there is a general right of return of the delivered element, delivery of undelivered items must be probable and mainly under the control of the vendor.

Allocation of arrangement fees among the various elements. How much of the overall contract revenue should be allocated to one-time deliverables such as training? How much should be allocated to ongoing services such as hosting? Allocating arrangement fees can be tricky when certain elements are considered separate units of accounting while others are not. The next section will discuss this allocation process.

Allocating revenues through the estimation hierarchy
Cloud companies must use FASB’s estimation hierarchy in determining the value to allocate to different elements of an arrangement – in determining, for instance, the value of the technical support component of a one-year SaaS contract. The accounting guidance dictates that the best evidence of value, in descending order, is:

  1. Vendor specific objective evidence (VSOE). This covers situations where the vendor sells the element on a stand-alone basis, separately from other elements. When sold on a stand-alone basis, the price is considered VSOE, or when the element is subject to a contract renewal, the renewal rate could determine VSOE.
  2. Third party evidence. This covers situations where other vendors sell the element on a stand-alone basis, so their pricing can be used for comparison. However, many companies face the challenge of finding comparative pricing as this information is often not readily available.
  3. Estimated selling price. In this scenario, company management determines the value of an element. They might take into account factors such as how the element is priced internally, how it’s sold, profit margins, and industry comps. This process can be subjective and require significant judgment and estimation, yet is commonly used by SaaS companies.

Discounted pricing, complicated but essential
One particularly complex challenge in the process of allocating revenue involves discounted pricing. Discounts are a fact of life for many SaaS companies and there is often no easy way of accounting for varying discounts on different contracts. For a multiple-element arrangement, discounts are required to be allocated on a relative fair value basis among the various elements of that package. Therefore, it is essential to have determined an accurate fair value of each of the elements in an arrangement such that the allocation of discounts to delivered and undelivered elements is appropriate.

Many companies utilize historical pricing as a starting point for determining their estimated selling price. It can be time-consuming to analyze historical transactions to determine the estimated selling price for various different elements. This can require adjustments for pricing discounts, volume discounts and geographic differences, among other factors. Often it is best to look for consistencies across product offerings to determine if the number of elements can be grouped together.

Here at BPM, one cloud computing client came to us having identified over 200 elements – a nightmare to administer. We worked with them to understand their competitive pricing environment and customer base and helped them reduce the elements that needed to be tracked on a regular basis to fewer than ten.

This example shows the importance of retaining expert professional help in handling revenue recognition for the cloud.

As the market for cloud-based services grows over the next few years, more and more companies will look to move into this space. While the revenue recognition process more accurately aligns with the economics of the transaction, getting it right depends on a detailed understanding both of the accounting rules and of your company’s unique business. And it pays to get the process right from the beginning – rather than deal with time-consuming, costly corrections or restatements later.

For more on revenue recognition, see BPM’s .

Please contact us to determine the appropriate revenue recognition model for the services you provide.

This publication contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.