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Monday, December 27, 2010

SaaS: Should You Defer Setup, Install and Configuration Fees?

One of the new revenue recognition rules, ASU 2009-13 (ASC 605-25), effective for revenue arrangements in fiscal years beginning on or after June 15, 2010, is changing the rules of the game for companies selling bundled services affecting SaaS companies.

As a result, SaaS companies are reevaluating their treatment of setup, installation and configuration services. Under the old rules (SAB 104), most SaaS companies deferred revenue associated with setup, installation and configuration services because they couldn’t meet the requirement to establish the “fair value” of annual or multi-year SaaS subscription services bundled in the same arrangement. As a result, the setup, installation, and configuration services revenue was deferred and recognized ratably over the expected duration of the customer relationship, typically ranging from 3 to 5 years. The new accounting rules require companies to estimate the selling price of each element within an arrangement, eliminating the “fair value” criteria. SaaS providers adopting the new rules are now closely re-examining the second criteria - i.e. whether such services have “stand-alone value” to determine if multiple-element arrangements can be unbundled.

The definition of “stand-alone value” remains unchanged under the new rules; “The item(s) have value on a standalone basis if they are sold separately by any vendor or the customer could resell the delivered item(s) on a standalone basis.1 This definition is poorly worded because it is too broad and doesn’t follow the common sense definition of standalone value - e.g. a customer would (or does) frequently buy the item on a standalone basis. We reviewed the revenue footnotes of 34 public SaaS companies to see how many had early adopted the new revenue rules and what impact adoption is having. Among the eight early adopters, five adopted an accelerated method for professional services and now recognize bundled services revenue as services are delivered, with Blackboard as the only early adopter that is continuing to defer setup fees over the contract period.2

There is an expectation that virtually every SaaS company can point to other providers that separately sell similar services. However, considering the economic reality, the benefit the customer is deriving from setup, installation and configuration services depends upon the continued use of the hosted software. Typically, customers wouldn’t pay these fees if they weren’t going to be receiving the hosted software. In addition, services that are provided subsequent to the go-live date might also not have standalone value if the customer only benefits from these services from the continued use of the hosted software.

Despite the trend among early adopters, we believe SaaS companies should continue to defer revenue from setup, installation and configuration services and recognize these fees over the customer life. Recognition over the service delivery period (or at the immediate end of delivery period) is defensible because such practice follows the written rules, but the practice of deferral more closely follows the intent of the FASB revenue rules and the economic substance of the transaction. Another benefit to deferral is that it creates a predictable future revenue stream and mirrors prior practice. The sample size of early SaaS adopters is so small; therefore, it’s too early to say what the majority will do when they adopt the new rules. SaaS companies should carefully evaluate this decision, consult with their auditors, and adopt the method they believe most closely follows the spirit of the accounting rules.

1 The criterion does not require the existence of an observable market for the deliverable(s).
2 Two disclosures did not provide enough data for us to determine the impact of early adoption.


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