Asc 606 Nonrefundable Upfront Fees

What does ASC 606 mean for your subscription business?

As a subscription business organisation, you are prone to become through consistent changes in your client's subscription lifecycle. An upgrade hither, a downgrade at that place, a mid-cycle cancellation, a refund due to dissatisfaction, discounts, and custom pricing that has borne out of negotiations. As you prepare out to acquire more customers, grow your business, retain your revenue and customers, and scale globally, y'all will need to accept into account all the modifications to the contract as well as the acquirement recognition for whatever change in the subscription lifecycle.

ASC 606 leads to adjustments in accounting practice for upfront and contingent fees, usage-based pricing, distinct operation obligations, discounts, and more. The new standard requires your company to capture and report all this information, which may non accept been previously considered.

Compliance with the new standards presents a particularly hard challenge for subscription-based companies, who tin can be tripped upwardly at each pace of the model.

Here'south where the trouble arises:

Subscriptions modify ofttimes. Whether a client upgrades, downgrades or adds a few seats, contract changes are the norm. Typically subscription contracts undergo an average of four mid-term changes. These changes can make compliance with step 1 (place the contract) of the "v Step Model" hard. In some circumstances, contract changes are handled every bit a modification to the existing contract, while in other situations, a split up contract is created. Revenue recognition is impacted accordingly.
Subscriptions are circuitous and rolled out over time, creating uncertainty for steps 2 through 5 of the 5 Step Model. The handling of common subscription characteristics—e.g. evergreen subscriptions, nonrefundable upfront fees—becomes problematic as companies must determine whether to recognize revenue right away or defer it. Similarly, usage-based pricing can make conclusion of the transaction price (step three of the five Step Model) more complicated than before. This all adds to the difficulty of accurately tracking contracted, recognized, and unbilled deferred acquirement.

WHAT ARE THE Furnishings ON GROWTH?

While the new standards volition predominantly have an result on finance and bookkeeping teams across companies to recalibrate how they report revenue, more teams are expected to cope with the unprecedented wave of accounting changes for instance:

Marketing

Affect on get-to-market strategies
Bear on on designing discounts and coupon campaigns
Impact on referral payouts
Impact on pricing strategies

Sales and Customer Success

Impact on bookings
Impact on sales and commissions
Affect on pricing negotiations
Impact on upgrades and downgrades

Homo Resources

Impact on bonuses
Impact on compensation plans

Example: Volume Discounts

Your hard-working sales squad proposes a form of tiered pricing. The squad strongly believes the initiative will eternalize growth—a top objective for every business. When a client subscribes for a certain number of seats, the cost per seat is reduced, either for futurity additional seats, or retrospectively for the already-purchased seats.

Simply your finance section is nervous. Contracts would be modified on the fly—both prospectively and retrospectively—and prices would be continually changing, roiling all 5 steps of the revenue recognition model. Their transmission procedure can't scale up and exist compliant at the same time. Without a subscription direction system/revenue module you lot're forced to choose compliance over growth, vetoing the tiered pricing proposal.

Practical Applications of ASC 606 for SaaS Companies

Instance written report one—Contingent revenue from escalating subscription fees

What's the bookkeeping correct now? Current bookkeeping guidance precludes the recognition of revenue that is contingent upon futurity performance (often referred to as the "contingent cap"). If y'all have only legally earned $ane,000 of revenue to date, then you lot can't record more than $1,000 acquirement. The future revenue is "contingent" upon the functioning of the remainder of the contract. SaaS companies often run into contingent revenue when multi-year contracts accept escalating prices.

For example, nosotros sell a three-year subscription to a customer for annual fees of $10,000, $12,000, and $14,000. If not for the contingent revenue cap, acquirement would be recognized evenly over the contract ($12,000 per year over 3 years). All the same, the existence of contingent revenue caps your revenue for year 1 at the $ten,000 contractually earned. The remaining $2,000 of contingent revenue is not recognized nether current accounting guidance.

What'due south irresolute under ASC 606? Under ASC 606, nosotros recognize $12,000 in acquirement in the first yr every bit the contingent acquirement cap no longer applies: cash of $x,000, and a contract asset of $2,000. A contract asset is essentially money that we've earned but don't have the right to invoice for yet. This is the opposite of a contract liability (formerly known as deferred revenue) that is money we've received, but haven't earned yet. In this case, we've performed to earn the $2,000 of revenue, simply won't have the contractual right to invoice for these services until later.

Currently, many SaaS entities simply recognize revenue according to the annual contract amounts because of the contingent revenue rules. This simplification will go away and many entities may now have to begin reallocating their contract revenue between years.

Case study ii—Contingent revenue from subscription and implementation

What's the accounting right now? Contingent revenue is also mutual in the SaaS model when a visitor delivers both subscription and professional services. For example, we sell a 1-year subscription to a customer for $12,000, payable monthly in advance. We besides agree to provide an implementation service for $two,000 that we unremarkably sell for $3,000. The total contract revenue is allocated to each deliverable based on their estimated selling price (VSOE or BESP today). The intention of this allocation is to ensure that all products inside a contract have the same disbelieve or premium for the estimated sales cost. The following table illustrates the calculation of the allocation:

No alt text provided for this image

Without the contingent revenue cap, revenue recorded later one month of the subscription and the completion of the implementation services would exist $3,733 ($11,200 / 12 months = $933, plus $two,800 for the implementation service). However, only $3,000 has been contractually earned at this point of the contract ($one,000 for one month of subscription and $2,000 for the implementation fee). Thus we will record $3,000 of acquirement with $733 of unrecognized contingent revenue.

What's changing under ASC 606? There is no modify to the allocation under ASC 606. The distinct POBs (performance obligations) are allocated contract acquirement proportionate to their SSP, but the constraint of contingent revenue goes abroad nether ASC 606. Under the new guidance, we will record $3,733 of revenue, with a corresponding $3,000 in greenbacks and $733 of contract nugget. The removal of the concept of contingent revenue may affect the timing of acquirement recognition.

Example study three—Combining operation obligations

What'due south the bookkeeping right now? Currently, each deliverable with standalone value is accounted for separately. Consider once again the example in Case 2 above, with the modify that the implementation services will significantly integrate the subscription services into the customer'southward existing systems on a turnkey basis.

Under electric current guidance, we have identical accounting to Instance two to a higher place. We volition record two deliverables with standalone value, a subscription and an implementation service. At the end of the first month, we accept potential revenue of $3,733 and only $3,000 has been contractually earned. Therefore, nosotros will record $3,000 of acquirement with $733 of unrecognized contingent revenue.

What's changing nether ASC 606? At that place is an boosted criterion for a "deliverable with standalone value" to be considered a "distinct POB" under ASC 606: the POB must be singled-out from other POBs provided to the client. A common case used to demonstrate this concept is the construction of a home. When building a dwelling, many of the individual parts that you tin can find downwardly at the local hardware store (i.e., have standalone value): nails, paint, a kitchen sink and plenty of other things. All the same, nether ASC 606, the appurtenances and services are not distinct from other promises in the contract, as the overall promise is to transfer a combined item—the house.

Then, what are some things that tell yous that a POB isn't distinct from other POBs? Each contract is dissimilar but some cardinal indicators to consider include significant integrations, modifications, or customization, or high amounts of interdependencies between POBs. For SaaS subscriptions, a disquisitional factor to consider is how much the customer can benefit from the software prior to implementation. Are your implementation services mainly configuration, training and setup, or practice they require significant customization? These are highly judgmental and may change company by company.

Let's assume that our implementation is and so meaning that we determine the integration and the subscription services are one combined POB in the contract. That $14,000 is going to be recognized over the combined term of 12 months.

Revenue recorded afterwards one calendar month of the subscription and the completion of the implementation services could potentially be $ane,167 ($fourteen,000 / 12 months). Considering we've invoiced for $3,000 nether the terms of the contract, nosotros will too record a contract liability of $1,833 representing cash we've received simply oasis't delivered the service. When combining professional services and subscription services into one POB, it is likely that acquirement recognized will be slower nether ASC 606.

Case study four—Setup (or upfront) fees

What'southward the accounting right now? Let's take the aforementioned case from Instance 2, but instead of an implementation service, the $two,000 billing is a setup fee. These may be treated a few dissimilar ways in practice today, but it's mutual for setup fees to exist recognized ratably over the life of a customer. Say that customer's life is four years. After one month, we'll record $1,042 of revenue ($12,000 / 12 months for the subscription, and $2,000 / 48 months = $42 for the setup fee). Since we billed $3,000 for the subscription and the upfront fee, we volition have recorded $one,958 of deferred revenue for the cash we've received but haven't nevertheless earned.

What'due south changing under ASC 606? The key change under ASC 606 is that setup fees are no longer considered a downward payment past the customer for services to exist delivered over the entire customer life. Instead, upfront fees are considered part of the current contract and allocated to the POBs in the contract. In our case, the only POB is the subscription service. Later on ane month, we'll tape $1,167 of acquirement ($14,000 / 12 months), $3,000 of billings, and $i,833 of contract liability.

In summary, setup fees will be recognized proportionate to the revenue recognized nether the contract rather than over the client life. This will typically speed up acquirement recognition for SaaS companies.

While the changes for SaaS companies may seem straightforward, at that place are many nuances to consider that may impact the timing and amounts of revenue recognition. In addition to the examples to a higher place, other significant issues you should consider include:

Options to acquire future appurtenances or services that may provide cloth rights to customers, such as opt-ins, opt-outs, discounts on future purchases;
Meaning setup fees that provide material rights to customers;
Contracts with variable consideration;
Contract modifications; and
Capitalization and amortization of contract origination costs, such equally sales commissions.