12.6 License Renewals and Modifications

Renewals of and modifications to rights granted in a license arrangement occur frequently. Entities should consider the nature and provisions of license renewals and modifications when determining the appropriate accounting treatment. In addition, the discussions in this section should be considered in conjunction with those in Chapter 9 on contract modifications.

Stakeholders questioned how entities should account for license renewals (or extensions of the license period). Specifically, they asked whether renewals (or extensions) result in the addition of a distinct license for which control is not transferred until the new (extended) license period begins, or whether the extended license period becomes part of the original license for which control may have already been transferred to the customer (if it is an extension of a license that is already controlled by the customer). For example, suppose that an entity provides a right-to-use license to its customer for a three-year period. After two years, the customer requests an extension of the license period for an additional two years, which results in the customer’s right to use the license for a total of five years. Stakeholders questioned whether the entity providing the right-to-use license (i.e., a license for which revenue is recognized at a point in time) would recognize revenue at the point in time when the license term was extended (i.e., after two years) or at the point in time when the extension period began (i.e., the beginning of year 4).

As a result, the FASB included specific guidance in ASU 2016-10 to address stakeholders’ concerns about right-to-use and right-to-access licenses. In accordance with that guidance, renewals or extensions of licenses should be evaluated as distinct licenses (i.e., a distinct good or service), and revenue attributed to the distinct good or service cannot be recognized until (1) the entity provides the distinct license (or makes the license available) to the customer and (2) the customer is able to use and benefit from the distinct license. In reaching this conclusion, the FASB observed in paragraph BC50(a) of ASU 2016-10 that “when two parties enter into a contract to renew (or extend the license period of) a license, the renewal contract is not combined with the original license contract unless [one or more of] the criteria in paragraph 606-10-25-9 [on combining contracts] have been met.” Therefore, the renewal right should be evaluated in the same manner as any other additional rights granted after the initial contract (i.e., revenue should not be recognized until the customer can begin to use and benefit from the license, which is generally at the beginning of the license renewal period).

In addition to providing clarifying guidance in ASC 606-10-55-58C, the FASB provided the following additional example to clarify the timing of revenue recognition for renewals:

ASC 606-10

Example 59 — Right to Use Intellectual Property

Case A — Initial License

55-389 An entity, a music record label, licenses to a customer a recording of a classical symphony by a noted orchestra. The customer, a consumer products company, has the right to use the recorded symphony in all commercials, including television, radio, and online advertisements for two years in Country A starting on January 1, 20X1. In exchange for providing the license, the entity receives fixed consideration of $10,000 per month. The contract does not include any other goods or services to be provided by the entity. The contract is noncancellable.

[ASC 606-10-55-390 through 55-392 omitted.]

Case B — Renewal of the License

55-392A At the end of the first year of the license period, on December 31, 20X1, the entity and the customer agree to renew the license to the recorded symphony for two additional years, subject to the same terms and conditions as the original license. The entity will continue to receive fixed consideration of $10,000 per month during the 2-year renewal period.

55-392B The entity considers the contract combination guidance in paragraph 606-10-25-9 and assesses that the renewal was not entered into at or near the same time as the original license and, therefore, is not combined with the initial contract. The entity evaluates whether the renewal should be treated as a new license or the modification of an existing license. Assume that in this scenario, the renewal is distinct. If the price for the renewal reflects its standalone selling price, the entity will, in accordance with paragraph 606-10-25-12, account for the renewal as a separate contract with the customer. Alternatively, if the price for the renewal does not reflect the standalone selling price of the renewal, the entity will account for the renewal as a modification of the original license contract.

55-392C In determining when to recognize revenue attributable to the license renewal, the entity considers the guidance in paragraph 606-10-55-58C and determines that the customer cannot use and benefit from the license before the beginning of the two-year renewal period on January 1, 20X3. Therefore, revenue for the renewal cannot be recognized before that date.

55-392D Consistent with Case A, because the customer’s additional monthly payments for the modification to the license will be made over two years from the date the customer obtains control of the second license, the entity considers the guidance in paragraphs 606-10-32-15 through 32-20 to determine whether a significant financing component exists.

12.6.1 Early Renewal of a Term-Based License

In conjunction with a term-based license, entities often offer customers a renewal option under which a customer can renew the contract and extend the period over which the customer has the right to use the licensed IP. In many cases, the customer may exercise its option to renew the license before the end of the initial license term. Although the customer may already be using the licensed IP, revenue attributable to the renewed license cannot be recognized until the beginning of the renewal period.

Example 12-19

Entity P enters into a three-year license agreement with Customer B under which B licenses software from P. The license includes three years of PCS (e.g., upgrades, bug fixes, and support). In exchange for the license and PCS, B pays P total consideration of $2,700, which consists of a $1,500 up-front payment for the license and annual installment payments of $400 for PCS payable at the end of each year. The contract states that B may extend the license for one-year terms at any point during the three-year license term for additional consideration.

Other relevant information includes the following:

Entity P has concluded that the software license and PCS are distinct performance obligations.
The contract amounts reflect each performance obligation’s stand-alone selling price.
The software being licensed is functional IP, and the license gives B the right to use the software. As a result, P concludes that revenue allocated to the license should be recognized at the point in time that the customer obtains control of the license, which is assumed to be at contract inception.
The PCS is determined to be a stand-ready obligation that is satisfied by P ratably over the PCS term.
The initial contract does not include a material right.

At the end of year 2, B elects to extend the license for an additional year (i.e., the total license term would extend from three years to four years) in exchange for an additional $900 of consideration. Entity P determines that the additional license and PCS are priced at their respective stand-alone selling prices ($500 for the one-year term license and $400 for one year of PCS) and that the additional one-year term license and associated PCS are distinct performance obligations.

Entity P cannot recognize revenue allocated to the one-year renewal of the license granted to B before the expiration of the initial three-year license term.

In accordance with ASC 606-10-25-12, the contract extension is accounted for as a separate contract since the added goods and services (i.e., term license and PCS) are distinct and priced at their respective stand-alone selling prices. Although the customer already has the software subject to the one-year extension, the addition of one year to the right-to-use license creates a new distinct license that is transferred to the customer at the beginning of the extension period. ASC 606-10-55-58C states that an entity cannot recognize revenue from a license of IP before both of the following:

The “entity provides (or otherwise makes available) a copy of the [IP] to the customer.”
“The beginning of the period during which the customer is able to use and benefit from its right to access or its right to use the [IP].”

ASC 606-10-55-58C further notes that an entity is not permitted to recognize revenue before the beginning of the license period even if the customer receives a copy of the IP before the beginning of the license period. Specifically, an entity is precluded from recognizing revenue from a license renewal before the beginning of the renewal period.

In accordance with the guidance in ASC 606-10-55-58C, P is precluded from recognizing the consideration allocated to the one-year term license (i.e., $500) until the beginning of year 4 (i.e., upon the expiration of the initial license term and beginning of the renewal period). If B prepays the $900 before the beginning of the renewal period, P would recognize that amount as a contract liability. At the beginning of year 4, P would recognize $500 immediately upon the transfer of the one-year right-to-use license to B. Entity P would then start recognizing the $400 of consideration allocated to the additional year of PCS ratably over year 4.

Example 12-20

Assume the same facts as in the example above, except that the additional consideration paid by Customer B to extend the license for a year is $600 instead of $900 (i.e., the additional license and PCS are not priced at their stand-alone selling prices, which are $500 and $400, respectively). At the time of the extension, Entity P is still entitled to $400 for the remaining year of PCS it must provide B under the original contract.

In accordance with ASC 606-10-25-13(a), P would account for the early renewal (which is a form of a contract modification) as if it were a termination of the original contract and the creation of a new contract. Entity P would combine the additional consideration of $600 with the consideration promised by B under the original contract and not yet recognized as revenue by P (i.e., $400) and allocate the resulting sum to the remaining performance obligations under the modified contract. At the time of the modification, the three-year term license under the original contract had already been transferred to the customer along with two years of PCS. Consequently, one year of PCS still must be transferred under the original contract along with a one-year term license and an additional year of PCS, both of which were added as a result of the modification. The combined consideration of $1,000 ($600 + $400) would be allocated to the remaining performance obligations as follows:

Even though the modification is accounted for as if it were a termination of the existing contract and the creation of a new contract, the modification does not alter the original license term. That is, the modification does not change the original three-year term license to a two-year term license. Rather, the modification adds a one-year term license that begins after the expiration of the original three-year term license and requires P to allocate the consideration between the added one-year term license and the remaining two years of PCS. At the beginning of year 4, in a manner consistent with the example above, P would recognize $385 immediately upon the transfer of the one-year right-to-use license to B. Further, P would start recognizing the $615 allocated to the PCS ratably at the beginning of year 3 (the time of the modification).

12.6.2 Extension of a Right-to-Access License Agreement

Regardless of whether a modification to renew or extend a license is associated with a right to use IP or a right to access IP, the modification framework in ASC 606-10-25-12 and 25-13 should be applied. The example below illustrates the accounting for the extension of a right-to-access license agreement.

Example 12-21

Entity X and Customer Y enter into a license agreement under which Y is provided the right to access X’s IP for three years for $3 million. After one year, X and Y agree to extend the contract for an additional two years for $1.8 million.

Assume that X has concluded that the additional two years of access to its IP are distinct from access to its IP over the initial three-year period.

Entity X should apply the modification guidance in ASC 606-10-25-12 and 25-13 (see Section 9.2). Entity X should first determine whether the contract modification meets the criteria in ASC 606-10-25-12 to be accounted for as a separate contract.

In this example, the criterion in ASC 606-10-25-12(a) is met because the scope of the contract is increased by two years and the right to access X’s IP over that period is considered distinct in accordance with ASC 606-10-25-19 through 25-22. The determination that the right to access IP for an additional two years provides additional goods or services that are distinct is consistent with paragraph BC72 of ASU 2016-10, which states that in many right-to-access license arrangements, “the license may constitute a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer in accordance with paragraph 606-10-25-14(b) (for example, a series of distinct periods [month, quarter, year] of access).”

Entity X must also consider whether the contract modification meets the criterion in ASC 606-10-25-12(b), which requires the modification to increase the price of the contract “by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services.” If X determines that the contract modification increases the price of the contract by an amount of consideration that reflects the entity’s stand-alone selling price for the added rights to access the IP, the modification will be accounted for as a separate contract. When considering whether the price charged to the customer represents the stand-alone selling price of additional distinct promised goods or services, entities are allowed to adjust the stand-alone selling price to reflect a discount for costs they do not incur because they have modified a contract with an existing customer. For example, the renewal price that an entity charges a customer is sometimes lower than the initial price because the entity recognizes that the expenses associated with obtaining a new customer can be excluded from the renewal price.

If X determines that the contract modification does not increase the price of the contract by an amount of consideration that reflects the entity’s stand-alone selling price of the added rights to access the IP, the modification will be accounted for in accordance with ASC 606-10-25-13. Since the added rights to access the IP are considered distinct, X should account for the modification as a termination of the existing contract and the creation of a new contract in accordance with ASC 606-10-25-13(a).

Regardless of whether the contract modification is accounted for as a separate contract or as a termination of the original contract and the creation of a new contract, the modification should be accounted for prospectively. That is, no cumulative-effect adjustment should be recorded as a result of the modification.

If X determines that the $1.8 million represents the stand-alone selling price of the right to access its IP during the extension period, X would account for the right to access its IP in years 4 and 5 as a separate contract. Revenue for each year of the five-year arrangement would be recorded as follows:

If X determines that the $1.8 million does not represent the stand-alone selling price of the right to access its IP during the extension period, X would account for the modification as a termination of the original contract and the creation of a new contract. Revenue for each year of the five-year arrangement would then be recorded as follows:

12.6.3 Renewals of PCS in a Software Arrangement

It is common for an entity’s software contract with a customer to include both a software license and PCS for a defined term (e.g., 12 months). In some cases, the software license is perpetual, or the term of the license is greater than the initial PCS term. After the initial PCS term, the customer may be entitled to renew the PCS at a renewal rate stated in the contract. Questions have arisen about how to account for (1) a reinstatement of PCS after the initial PCS term has lapsed (see Section 12.6.3.1) and (2) an option to renew PCS when it is not distinct from a perpetual software license (see Section 12.6.3.2).

12.6.3.1 Reinstatement of PCS After Customer Lapse

As noted in Section 12.6.3, an entity could grant a license to software on a perpetual basis or for a term greater than the initial PCS term, with an option to renew the PCS at a stated renewal rate. If the customer does not elect to renew the PCS, the entity may not have an obligation (explicit or implied) to provide PCS to the customer after the initial PCS term. While the customer does not have the right to receive software updates or support if it does not renew the PCS, the customer retains the right to use the software in its then current state.

Although the entity does not have a contractual, legal, or implied obligation to provide PCS to the customer if the customer does not renew the PCS, the entity may continue to provide PCS as a courtesy to the customer. However, if there is no enforceable contract during the lapse period, the customer might not have the legal right to retain and use the benefits, including any software updates or enhancements, provided by the PCS during the lapse period. If the customer renews the PCS after the initial PCS term has lapsed, the entity may require the customer to pay a reinstatement fee equal to the amount that the customer would have paid for the PCS during the lapse period in addition to the fee for the remaining renewal period.

To account for a contract with a customer to reinstate PCS, an entity can use either of the following two methods depending on the nature of the PCS:10

Cumulative catch-up method (“Alternative A”) — Upon the customer’s reinstatement of the PCS, the entity should record a cumulative adjustment to revenue. Under this alternative, the fee paid by the customer to reinstate the PCS should be allocated to both the PCS provided during the lapse period (software updates and enhancements provided as a courtesy during the lapse period if control of these items is transferred to the customer upon reinstatement of the PCS) and the future services to be provided over the remaining PCS term after the reinstatement. The amount allocated to the software updates and enhancements provided during the lapse period is recognized immediately because control is transferred at the point in time at which the PCS is reinstated. The amount allocated to future services is recognized over time as these services are provided.
Prospective method (“Alternative B”) — Upon the customer’s reinstatement of the PCS, the entity should allocate the consideration in the contract (i.e., the reinstatement fee equal to what the customer would have paid during the lapse period and the fee for additional PCS) to the remaining months of PCS to be provided to the customer. This amount is recognized over time as the services are provided.

We believe that Alternative A is more appropriate if control over any updates or software enhancements already received by the customer (i.e., the right to legally retain bug fixes, updates, and enhancements that were provided during the lapse period) is transferred to the customer only at the point in time at which the PCS is reinstated. Under Alternative A, no revenue should be recognized during the lapse period because there is no contract with the customer. However, upon the customer’s reinstatement of the PCS, the entity should recognize a cumulative adjustment to revenue in an amount that corresponds to the rights transferred to the customer upon reinstatement (which, under the facts of this scenario, is the reinstatement fee equal to the amount that the customer would have paid for the PCS during the lapse period). Although the customer may receive PCS during the lapse period, the customer does not have the legal right to retain the benefits from the PCS during this period; however, the rights to retain and use the benefits, updates, and enhancements are transferred to the customer if the customer renews the PCS. As noted above, the total fee charged to the customer includes a reinstatement fee equal to the amount that the customer would have paid for the PCS during the lapse period and an amount related to the PCS to be provided under the remaining PCS term. Therefore, the fee paid by the customer upon renewal is related to both the PCS still to be provided under the contract and the PCS provided during the lapse period.

Because the nature of PCS can differ among entities, additional consideration may be required if the entity does not provide upgrades, enhancements, or bug fixes as part of the PCS (e.g., when the PCS includes only support). In such cases, Alternative B may be more appropriate because the customer may not receive incremental rights upon reinstatement.

Example 12-22

Entity V provides hospitals with communications solutions, which consist of hardware, software, and PCS for the software. On January 1, 20X1, V enters into a contract with Customer C to grant C a perpetual license to V’s software and 12 months of PCS. The contract states that the PCS may be renewed on an annual basis for $1,200. Entity V concludes that the $1,200 represents the stand-alone selling price of the PCS. In addition, V concludes that its obligation to provide PCS is a stand ready obligation that provides C with a benefit ratably over the contract term.

At the end of the initial 12-month term, C does not elect to renew the PCS and therefore does not make any further payment. Although V does not have an explicit or implicit obligation to provide any services, V continues to provide the PCS, including updates and enhancements to the software, as a courtesy to C because V expects that C will eventually reinstate the PCS. However, C does not have the legal right to retain or use the benefits of the updates or enhancements to the software until it reinstates the PCS.

On April 1, 20X2 (i.e., three months after the PCS has lapsed), C reinstates the PCS by paying V $1,200, of which $300 represents a reinstatement fee equal to the amount that C would have paid for the PCS during the lapse period. The new PCS term expires on December 31, 20X2. The $1,200 fee paid by C is intended to compensate V for the three months of PCS provided during the lapse period and the remaining nine months of PCS to be provided over the remaining period of the new PCS term. Entity V concludes that control of the rights to retain and use the benefits provided by the PCS (i.e., the right to retain or use the enhanced and updated software) during the three-month lapse period is immediately transferred to the customer once the PCS is reinstated.

Upon reinstatement of the PCS, it would be acceptable for V to recognize $300 as revenue immediately because this represents the value of the rights that are transferred to C immediately upon reinstatement of the PCS. In that case, V would then recognize $900 as revenue over the remaining contract period ending on December 31, 20X2.

12.6.3.2 Options to Renew PCS When PCS Is Not Distinct From a Perpetual Software License

The example below illustrates the identification of material rights in a contract involving renewable PCS that is not distinct from a perpetual software license.

Example 12-23

On January 1, 20X9, Company LN enters into a contract with a customer to transfer a perpetual antivirus software license and provide unspecified software updates as PCS for one year in exchange for an up-front, nonrefundable fee of $3,000, which is the standard price paid by all new customers. Company LN has concluded that the software license and PCS are not distinct because the functionality and utility of the software are highly dependent on the PCS and vice versa. The updates significantly modify the functionality of the software by permitting the software to protect the customer from a significant number of additional viruses that the software did not protect against previously. The updates are also integral to maintaining the utility of the software license to the customer. Therefore, the transfer of a perpetual antivirus software license and the obligation to provide PCS constitute a single performance obligation.

At the end of the year, the customer has an option to renew the PCS on an annual basis for $300. The customer may exercise this option each year on an indefinite basis. The customer is expected to renew the PCS for four additional years after the first year of the contract.

The annual renewal options exercisable by the customer each represent a material right in LN’s contract. Since the license is not distinct (separable) from the PCS, the customer is effectively renewing the single performance obligation (the combined license and PCS) each year even though the software that is being provided is in the form of a perpetual license.

Therefore, each annual renewal option represents a material right because the renewal options enable LN’s customer to renew the contract at a price that is lower than the amount that new customers are typically charged (i.e., only $300 is required to renew as compared with the $3,000 that new customers must pay). Because the material rights are accounted for as separate performance obligations, LN allocates the total transaction consideration of $3,000 for the first year to the identified performance obligations (services for the first-year contract and the material rights) on a relative stand-alone selling price basis. As described in ASC 606-10-55-45, as a practical alternative to estimating the stand-alone selling price of the renewal options, LN may be able to allocate the transaction price to the renewal options (i.e., the material rights) “by reference to the goods or services expected to be provided and the corresponding expected consideration.” In accordance with ASC 606-10-55-42, the amount allocated to each annual renewal option (i.e., the material rights) would be recognized (1) as LN provides the service to which the renewal option is related or (2) when the renewal options expire.

12.6.4 Cloud Conversion or Switching Rights

Some entities in the software industry enter into contracts that include (or are subsequently modified to include) an option that allows the customer to convert from an on-premise license arrangement to a cloud-based arrangement under which the software is hosted (e.g., SaaS). This issue has become more prevalent because customers of software entities frequently migrate from on-premise software solutions to cloud-based platforms. Often, when a customer converts from an on-premise software arrangement to a SaaS arrangement, the customer will lose or forfeit its rights to the on-premise version of the software. Views differ on how to account for the revocation of the initial licensing rights and the conversion to a hosted solution.

From inception or after modification, a software arrangement may include a feature that allows a customer to convert a nonexclusive on-premise term-based software license to a cloud-based or hosted software solution (e.g., a SaaS arrangement)11 for the same software (i.e., software with the same functionality and features). An entity may also modify a nonexclusive on-premise term-based software arrangement to immediately convert it to a SaaS arrangement. Further, an entity’s software arrangement may allow a customer to (1) deploy a certain number of licenses to software (e.g., 1,000 seats) and (2) use discretion to determine how many licenses to deploy on an on-premise basis or as SaaS at any point in time or at discrete points in time during the arrangement term. Cloud conversion or switching rights vary widely in practice, and the determination of the appropriate accounting for an arrangement that provides for such rights will depend on the particular complexities involved.

In accordance with the guidance in ASC 606, revenue from on-premise software licenses is typically recognized at the point in time when both (1) the entity provides (or otherwise makes available) a copy of the software to the customer and (2) the period in which the customer is able to use and benefit from the license has begun. Revenue from a SaaS arrangement is typically recognized over time because the performance obligation is likely to meet the conditions for such recognition, particularly if the SaaS is a stand-ready obligation. While ASC 606 includes guidance on contract modifications, material rights, and sales with a right of return, it does not directly address transactions in which a nonexclusive software license is revoked or converted to a SaaS arrangement. As a result, there are diverse views on the accounting for such arrangements, particularly those in which a nonexclusive on-premise software license for which revenue is recognized at a point in time is converted to a SaaS arrangement for the same underlying software product for which revenue is recognized over time.

We believe that there could be more than one acceptable accounting model for certain types of cloud conversion or switching arrangements. The next sections provide illustrative examples of such arrangements and discuss views on how entities may account for them. However, the examples are not all-inclusive, and entities should carefully consider their specific facts and circumstances in determining the appropriate accounting model. In addition, the accounting views discussed for each example may not necessarily be the only methods that are acceptable.

12.6.4.1 Initial Contract Includes a Cloud Conversion Right

The example below illustrates an initial nonexclusive on-premise term-based software license contract that includes the right to convert the on-premise software license to a SaaS arrangement.

Example 12-24

On January 1, 20X0, Entity A enters into a noncancelable two-year contract with a customer for an up-front fee of $1 million to provide a nonexclusive on-premise software license with maintenance or PCS for 100 seats and a right to convert any of the on-premise license seats to a SaaS arrangement at the beginning of the second year (i.e., January 1, 20X1). The SaaS has the same functionality and features as the on-premise software but would be hosted by A instead of being provided on an on-premise basis. Upon exercise of the conversion right, the customer would be required to forfeit the on-premise software license seats and related PCS, and the conversion is irrevocable (i.e., the customer cannot convert back to an on-premise software license). Upon conversion, the customer would be required to pay an incremental fee of $500 per seat and would receive a credit for a pro rata portion of the “unused” on-premise software license and related PCS to apply to the price the customer would pay (based on the stand-alone selling price) for the SaaS.

Entity A has similar arrangements with other customers and expects the customer to convert 50 seats at the beginning of the second year. The stand-alone selling prices are as follows:

12.6.4.1.1 Alternative 1A — Material Right Model (Preferred View)

Under this alternative, an entity should determine whether the conversion right represents a material right. ASC 606-10-55-42 through 55-44 state the following:

ASC 606-10

55-42 If, in a contract, an entity grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into that contract (for example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market). If the option provides a material right to the customer, the customer in effect pays the entity in advance for future goods or services, and the entity recognizes revenue when those future goods or services are transferred or when the option expires.

55-43 If a customer has the option to acquire an additional good or service at a price that would reflect the standalone selling price for that good or service, that option does not provide the customer with a material right even if the option can be exercised only by entering into a previous contract. In those cases, the entity has made a marketing offer that it should account for in accordance with the guidance in this Topic only when the customer exercises the option to purchase the additional goods or services.

55-44 Paragraph 606-10-32-29 requires an entity to allocate the transaction price to performance obligations on a relative standalone selling price basis. If the standalone selling price for a customer’s option to acquire additional goods or services is not directly observable, an entity should estimate it. That estimate should reflect the discount that the customer would obtain when exercising the option, adjusted for both of the following:

Any discount that the customer could receive without exercising the option
The likelihood that the option will be exercised.

Under the material right guidance, an entity provides a material right if the customer has the option to purchase the SaaS at a discount that is incremental to the range of discounts typically provided for the SaaS to that class of customer in similar circumstances. Any incremental fee the customer is required to pay to exercise the conversion right is compared with the stand-alone selling price of the SaaS. While the customer may receive a credit for the “unused” portion of the on-premise term-based software license and related PCS, only the incremental fee to exercise the right is considered. This is because under Alternative 1A, a nonexclusive on-premise term-based software license is not subject to the right of return guidance since the entity does not receive an asset back when the right is exercised (i.e., there is no return of an asset).12 That is, the entity is not compensated with an asset of any value as a result of the conversion since it can replicate a nonexclusive software license for sale to any of its customers for a nominal cost. If the incremental fee that the customer is required to pay to convert to the SaaS reflects the stand-alone selling price of the SaaS, no material right exists under ASC 606-10-55-43. Instead, the conversion right is accounted for only if and when it is exercised. On the other hand, if the conversion right represents a material right because the incremental fee is less than the stand-alone selling price of the SaaS, that material right would be accounted for as a separate performance obligation. In accordance with ASC 606-10-55-44, the entity would estimate the stand-alone selling price of the material right as the discount the customer would obtain when exercising the material right, adjusted for any discount the customer could receive without exercising the option and the likelihood that the option will be exercised. If the conversion option is exercised, the amount allocated to the material right plus any incremental fee paid would generally be recognized over the remaining term of the SaaS (and the PCS if not all licenses are converted).

In Example 12-24, A would need to assess whether the option to receive the SaaS at a discount represents a material right. Because the incremental fee to be paid by the customer of $500 per seat per year is significantly less than the stand-alone selling price for the SaaS of $5,500 per seat per year, A would conclude that a material right exists at contract inception. Entity A could estimate the material right’s stand-alone selling price as the $5,000 per seat per year discount ($5,500 SaaS stand-alone selling price − $500 incremental fee to be paid), adjusted for the likelihood that the option will be exercised.13 We believe that it would also be acceptable for A to estimate the stand-alone selling prices of the on-premise software license and the PCS by applying a similar adjustment for the likelihood that the option will be exercised (which could truncate the term of the on-premise software license and the PCS). For example, A might estimate the stand-alone selling prices of the on-premise software license and the PCS under the assumption that 50 seats of the license and related PCS will have only a one-year term if customers are expected to convert half the seats of the license to SaaS after one year.

Assume that A determines that the relative stand-alone selling price allocation of the transaction price results in allocations to the on-premise software license, PCS for 20X0, PCS for 20X1, and the material right of $600,000, $100,000, $50,000, and $250,000, respectively.14 Entity A will recognize $600,000 of revenue on January 1, 20X0, for the on-premise software license and $100,000 for PCS ratably over 20X0. Revenue is deferred for the $50,000 allocated to PCS for 20X1 and the $250,000 allocated to the material right, and those amounts are recognized as contract liabilities. If the customer elects to exercise the conversion right on 100 seats on January 1, 20X1, A would assess its policy for accounting for the exercise of an option that includes a material right and apply either of the following:

Separate contract model — The remaining unrecognized revenue of $50,000 related to PCS is recognized immediately since PCS for all 100 seats is forfeited and therefore will not be provided in 20X1. Revenue of $300,000, which is calculated by adding the material right allocation of $250,000 and the incremental fee of $50,000 ($500 incremental fee × 100 seats), is recognized over the remaining one-year SaaS term.
Contract modification model — Revenue of $350,000, which is calculated by adding the remaining unrecognized revenue of $50,000 related to PCS, the material right allocation of $250,000, and the incremental fee of $50,000, is recognized over the remaining one-year SaaS term.

Alternative 1A may be less costly to implement than Alternative 1B below because the stand-alone selling price of the material right is estimated only at contract inception and is not subsequently revised. In addition, because the right of return model is not applied, the variable consideration constraint would likewise not be applicable. Therefore, revenue recognition could potentially be less volatile under the material right model than under the right of return model discussed below.

12.6.4.1.2 Alternative 1B — Right of Return Model (Acceptable View)

Under this alternative, an entity applies the right of return guidance when accounting for the potential that a nonexclusive on-premise term-based software license will be converted to a SaaS arrangement. ASC 606-10-55-22 through 55-26 state the following:

ASC 606-10

55-22 In some contracts, an entity transfers control of a product to a customer and also grants the customer the right to return the product for various reasons (such as dissatisfaction with the product) and receive any combination of the following:

A full or partial refund of any consideration paid
A credit that can be applied against amounts owed, or that will be owed, to the entity
Another product in exchange.

55-23 To account for the transfer of products with a right of return (and for some services that are provided subject to a refund), an entity should recognize all of the following:

Revenue for the transferred products in the amount of consideration to which the entity expects to be entitled (therefore, revenue would not be recognized for the products expected to be returned)
A refund liability
An asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability.

55-24 An entity’s promise to stand ready to accept a returned product during the return period should not be accounted for as a performance obligation in addition to the obligation to provide a refund.

55-25 An entity should apply the guidance in paragraphs 606-10-32-2 through 32-27 (including the guidance on constraining estimates of variable consideration in paragraphs 606-10-32-11 through 32-13) to determine the amount of consideration to which the entity expects to be entitled (that is, excluding the products expected to be returned). For any amounts received (or receivable) for which an entity does not expect to be entitled, the entity should not recognize revenue when it transfers products to customers but should recognize those amounts received (or receivable) as a refund liability. Subsequently, at the end of each reporting period, the entity should update its assessment of amounts for which it expects to be entitled in exchange for the transferred products and make a corresponding change to the transaction price and, therefore, in the amount of revenue recognized.

55-26 An entity should update the measurement of the refund liability at the end of each reporting period for changes in expectations about the amount of refunds. An entity should recognize corresponding adjustments as revenue (or reductions of revenue).

Under Alternative 1B, an on-premise software license is generally treated like a tangible product, and the right of return guidance applies to the exchange of a product for another product in accordance with ASC 606-10-55-22(c). However, while an entity would generally record an asset for its right to recover a tangible product, an entity would not record an asset for its right to recover a nonexclusive software license in accordance with ASC 606-10-55-23(c) since the returned license has no value to the entity. Therefore, in applying the right of return guidance, the entity would estimate and recognize an adjustment to the transaction price (and reduce revenue) at contract inception to account for the potential conversion.15 The right of return would be accounted for as variable consideration, subject to the constraint in ASC 606-10-32-11 and 32-12.16 The estimate of the variable consideration associated with the right of return would be reassessed at the end of each reporting period in accordance with ASC 606-10-55-25 and 55-26, with changes in the estimate recognized as an adjustment to revenue. If the conversion right is exercised, the amount previously deferred as a liability17 plus the incremental fee paid would generally be recognized as revenue over the remaining term of the SaaS (and the PCS for any licenses that are not converted).

Applying this alternative to Example 12-24, A would need to determine its estimate of how much of the $1 million up-front payment, should be constrained (i.e., how many seat licenses and corresponding rights to PCS will be “returned” in exchange for a credit for the SaaS). On the basis of the assumptions in Example 12-24, A determines that $250,000 of the $1 million should be constrained. This is because A expects 50 seats to be converted (i.e., returned in exchange for a credit for the SaaS) on January 1, 20X1. Accordingly, when applying the guidance in ASC 606-10-55-22 through 55-26, A records a liability for the amount of consideration that is expected to be refunded to the customer upon conversion (i.e., the amount of credit that will be applied toward the SaaS). Therefore, A will recognize revenue of $600,000, or ($4,000 on-premise software license stand-alone selling price × 100 seats × 1 year) + ($4,000 on-premise software license stand-alone selling price × 50 seats × 1 year), on January 1, 20X0, for the on-premise software license and $100,000, or ($1,000 PCS stand-alone selling price × 100 seats × 1 year), for PCS ratably over 20X0. In addition, A will recognize (1) a liability of $250,000, or ($4,000 on-premise software license stand-alone selling price + $1,000 PCS stand-alone selling price) × 50 seats × 1 year, for the credit that the customer is expected to receive for the on-premise software license and PCS that are expected to be forfeited and (2) a PCS contract liability of $50,000 (which is to be recognized as revenue in 20X1). Entity A will reassess its estimate of variable consideration at the end of each reporting period.

Assume that on December 31, 20X0, A revises its estimate of the liability associated with the right of return to $500,000 because it now expects that the customer will convert all 100 seats to a SaaS arrangement. Entity A will reverse $200,000 of revenue for the incremental 50 seats of on-premise software expected to be forfeited ($4,000 on-premise software license stand-alone selling price × 50 seats × 1 year) and reclassify the $50,000 PCS contract liability for the incremental PCS expected to be forfeited ($1,000 PCS stand-alone selling price × 50 seats × 1 year) for a total increase in liability of $250,000 related to the credit expected to be granted to the customer. If the customer elects to exercise the conversion right on 100 seats on January 1, 20X1, revenue of $550,000, which is calculated by adding the liability of $500,000 and the incremental fee of $50,000 ($500 incremental fee × 100 seats × 1 year), is recognized over the remaining one-year SaaS term.

Because A’s initial estimate of the liability for the credit expected to be granted to the customer was not sufficient, a significant amount of revenue ultimately had to be reversed in a subsequent reporting period. This example highlights the importance of critically evaluating how much revenue should be constrained to ensure that it is probable that a significant reversal in cumulative revenue recognized will not occur. Given the risk of overestimating the amount of variable consideration to which an entity can expect to be entitled for the on-premise software license and PCS, we believe that many software entities, particularly those that do not have sufficient historical data on conversion rates, may find it challenging to determine an appropriate estimate of variable consideration and constraint as required under Alternative 1B.

12.6.4.1.3 Tabular Summary of Alternatives 1A and 1B

The following table summarizes the timing of revenue recognition under Alternatives 1A and 1B:

12.6.4.2 Initial Contract Is Modified to Convert a Term-Based License to SaaS

The example below illustrates a situation in which a nonexclusive on-premise term-based software license contract (1) initially does not include the right to convert the on-premise software license to a SaaS arrangement but (2) is subsequently modified to immediately convert the on-premise software license to a SaaS arrangement.

Example 12-25

On January 1, 20X0, Entity B enters into a noncancelable two-year contract with a customer for an up-front fee of $1 million to provide a nonexclusive on-premise software license with PCS for 100 seats. At contract inception, there is no explicit or implied right to convert any of the on-premise license seats to a SaaS arrangement.18

On January 1, 20X1, B and the customer modify the contract to convert 50 seats of the on-premise software license to a SaaS arrangement for the remaining term. The SaaS has the same functionality and features as the licensed software but would be hosted by B instead of being provided on an on-premise basis. The customer is required to forfeit the 50 on-premise software license seats and related PCS (but will retain the other 50 seats on an on-premise basis with the related PCS for the remaining term), and the conversion is irrevocable (i.e., the customer cannot convert back to an on-premise software license). Upon contract modification and conversion, the customer is required to pay an incremental fee of $500 per seat and receives a credit for the pro rata portion of the “unused” term-based license and related PCS to apply to the price the customer will pay for the SaaS.

The stand-alone selling prices are as follows:

12.6.4.2.1 Alternative 2A — Prospective Model (Preferred View)

Under this alternative, an entity should evaluate the contract modification guidance since the contract has been modified (i.e., there is a change in the scope and price). ASC 606-10-25-12 and 25-13 state the following:

ASC 606-10

25-12 An entity shall account for a contract modification as a separate contract if both of the following conditions are present:

The scope of the contract increases because of the addition of promised goods or services that are distinct (in accordance with paragraphs 606-10-25-18 through 25-22).
The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract. For example, an entity may adjust the standalone selling price of an additional good or service for a discount that the customer receives, because it is not necessary for the entity to incur the selling-related costs that it would incur when selling a similar good or service to a new customer.

25-13 If a contract modification is not accounted for as a separate contract in accordance with paragraph 606-10-25-12, an entity shall account for the promised goods or services not yet transferred at the date of the contract modification (that is, the remaining promised goods or services) in whichever of the following ways is applicable:

An entity shall account for the contract modification as if it were a termination of the existing contract, and the creation of a new contract, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. The amount of consideration to be allocated to the remaining performance obligations (or to the remaining distinct goods or services in a single performance obligation identified in accordance with paragraph 606-10-25-14(b)) is the sum of:
1. The consideration promised by the customer (including amounts already received from the customer) that was included in the estimate of the transaction price and that had not been recognized as revenue and
2. The consideration promised as part of the contract modification.
An entity shall account for the contract modification as if it were a part of the existing contract if the remaining goods or services are not distinct and, therefore, form part of a single performance obligation that is partially satisfied at the date of the contract modification. The effect that the contract modification has on the transaction price, and on the entity’s measure of progress toward complete satisfaction of the performance obligation, is recognized as an adjustment to revenue (either as an increase in or a reduction of revenue) at the date of the contract modification (that is, the adjustment to revenue is made on a cumulative catch-up basis).
If the remaining goods or services are a combination of items (a) and (b), then the entity shall account for the effects of the modification on the unsatisfied (including partially unsatisfied) performance obligations in the modified contract in a manner that is consistent with the objectives of this paragraph.

The contract modification is accounted for as a termination of the existing contract and the creation of a new contract in accordance with ASC 606-10-25-13(a) because the modification does not solely add goods or services at their stand-alone selling prices (i.e., goods and services are also forfeited, and any incremental fee paid for the SaaS is not at its stand-alone selling price) and the remaining SaaS (and PCS for any licenses that are not converted) is distinct. The contract modification is accounted for prospectively, and any unrecognized revenue that was included in the transaction price from the original contract plus any additional consideration paid as part of the contract modification is recognized over the remaining term of the SaaS (and the PCS for any licenses that are not converted). There is no adjustment to or reversal of revenue for the “unused” portion of the on-premise software license since the modification is accounted for prospectively (i.e., revenue is not “recycled”). Further, the entity does not receive a “returned” asset since, as similarly noted in the discussion of Alternative 1A, the entity does not receive an asset of any value back. Therefore, none of the pro rata credit provided for the “unused” portion of the on-premise software license that has been forfeited would be included as part of the consideration allocated to the SaaS (and PCS for any licenses that are not converted).

In Example 12-25, B will recognize revenue of $800,000 ($4,000 on-premise software license stand-alone selling price × 100 seats × 2 years) on January 1, 20X0, for the on-premise software license and $100,000 ($1,000 PCS stand-alone selling price × 100 seats × 1 year) for PCS ratably over 20X0. When the contract is modified on January 1, 20X1, B has a contract liability related to PCS of $100,000 and receives incremental consideration of $25,000 ($500 incremental fee × 50 seats). Entity B will therefore recognize $125,000 ($100,000 + $25,000) for both PCS and the SaaS over the remaining one-year term.19

12.6.4.2.2 Alternative 2B — Return Model (Acceptable View)

Under this alternative, in a manner similar to that in Alternative 2A, the contract modification is accounted for as a termination of the existing contract and the creation of a new contract because the modification does not solely add goods or services at their stand-alone selling prices (i.e., goods and services are also forfeited, and any incremental fee paid for the SaaS is not at its stand-alone selling price) and the remaining SaaS (and PCS if not all licenses are converted) is distinct. However, unlike Alternative 2A, Alternative 2B treats the “unused” portion of the on-premise software license as being effectively returned for a credit that can be applied toward the purchase of the SaaS. Therefore, revenue associated with the unused portion of the returned on-premise software license is reversed. The amount of revenue reversed (i.e., the credit associated with the unused portion of the returned on-premise software license), together with any unrecognized revenue that was included in the transaction price from the original contract and any additional consideration paid as part of the contract modification, is recognized over the remaining term of the SaaS (and the PCS for any licenses that are not converted).

In Example 12-25, B will recognize revenue of $800,000 ($4,000 on-premise software license stand-alone selling price × 100 seats × 2 years) on January 1, 20X0, for the on-premise software license and $100,000 ($1,000 PCS stand-alone selling price × 100 seats × 1 year) for PCS ratably over 20X0. When the contract is modified on January 1, 20X1, B will reverse revenue of $200,000 ($4,000 on-premise software license stand-alone selling price × 50 seats × 1 year) for the returned portion of the on-premise software license. Entity B also has a contract liability related to PCS of $100,000 and receives incremental consideration of $25,000 ($500 incremental fee × 50 seats). Entity B will therefore recognize revenue of $325,000 ($200,000 + $100,000 + $25,000) for both PCS and the SaaS over the remaining one-year term.20

12.6.4.2.3 Tabular Summary of Alternatives 2A and 2B

The following table summarizes the timing of revenue recognition under Alternatives 2A and 2B:

12.6.4.3 Initial Contract Is Modified to Add a Cloud Conversion Right

The example below illustrates a situation in which a nonexclusive on-premise term-based software license contract (1) initially does not include the right to convert the on-premise software license to a SaaS arrangement but (2) is subsequently modified to add a right to convert the on-premise software license to a SaaS arrangement.

Example 12-26

On January 1, 20X0, Entity C enters into a noncancelable three-year contract with a customer for an up-front fee of $3 million to provide a nonexclusive on-premise software license with PCS for 100 seats. At contract inception, there is no explicit or implied right to convert any of the on-premise license seats to a SaaS arrangement.21

On January 1, 20X1, C and the customer modify the contract to add a right to convert any of the on-premise license seats to a SaaS arrangement at the beginning of the third year (i.e., January 1, 20X2). The SaaS has the same functionality and features as the on-premise software but would be hosted by C instead of being provided on an on-premise basis. As in Example 12-24, the customer would be required to forfeit the on-premise software license seats and related PCS upon exercise of the conversion right, and the conversion is irrevocable (i.e., the customer cannot convert back to an on-premise software license). Upon conversion, the customer would be required to pay an incremental fee of $1,000 per seat and would receive a credit for a pro rata portion of the “unused” on-premise software license and related PCS to apply to the price the customer would pay for the SaaS.

The stand-alone selling prices are as follows:

12.6.4.3.1 Alternative 3A — Prospective Material Right Model (Preferred View)

Under this alternative, in a manner similar to that under Alternative 2A, the contract modification is accounted for as a termination of the existing contract and the creation of a new contract because the modification does not solely add goods or services at their stand-alone selling prices (i.e., a conversion right is added for no additional consideration, and any incremental fee to be paid for the SaaS is not at its stand-alone selling price) and the remaining performance obligations (PCS and a material right) are distinct. The contract modification is accounted for prospectively, and any unrecognized revenue that was included in the transaction price from the original contract is allocated to the remaining performance obligations (PCS and a material right). If the conversion option is exercised, the amount allocated to the material right plus any incremental fee paid would generally be recognized over the remaining term of the SaaS (and the PCS for any licenses that are not converted).

In Example 12-25, C will recognize revenue of $2.4 million ($8,000 on-premise software license stand-alone selling price × 100 seats × 3 years) on January 1, 20X0, for the software license and $200,000 ($2,000 PCS stand-alone selling price × 100 seats × 1 year) for PCS ratably over 20X0. When the contract is modified on January 1, 20X1, C has a contract liability related to PCS of $400,000. Entity C will allocate that amount to the remaining PCS and the material right on the basis of their relative stand-alone selling prices. The material right’s stand-alone selling price would be estimated as the $10,000 per seat per year discount ($11,000 SaaS stand-alone selling price − $1,000 incremental fee to be paid), adjusted for the likelihood that the option will be exercised. We believe that it would also be acceptable for C to estimate the stand-alone selling price of the PCS by applying a similar adjustment for the likelihood that the option will be exercised (which could truncate the term of the PCS).

Assume that C determines that the relative stand-alone selling price allocation of the transaction price results in allocations to the PCS for 20X1, the PCS for 20X2, and the material right of $100,000, $50,000, and $250,000, respectively.22 Entity C will recognize $100,000 for PCS ratably over 20X1. If the customer elects to exercise the conversion right on 100 seats on January 1, 20X2, C would assess its policy for accounting for the exercise of an option that includes a material right and apply either of the following:

Separate contract model — The remaining unrecognized revenue of $50,000 related to PCS is recognized immediately since PCS for all 100 seats is forfeited and therefore will not be provided in 20X2. Revenue of $350,000, which is calculated by adding the material right allocation of $250,000 and the incremental fee of $100,000 ($1,000 incremental fee × 100 seats), is recognized over the remaining one-year SaaS term.
Contract modification model — Revenue of $400,000, which is calculated by adding the remaining unrecognized revenue of $50,000 related to PCS, the material right allocation of $250,000, and the incremental fee of $100,000, is recognized over the remaining one-year SaaS term.

Alternative 3A may be less costly to implement than Alternative 3B below because the stand-alone selling price of the material right is estimated only upon contract modification and is not subsequently revised. In addition, because the right of return model is not applied, the variable consideration constraint would likewise not be applicable. Therefore, revenue recognition could potentially be less volatile under the prospective material right model than under the right of return model discussed below.

12.6.4.3.2 Alternative 3B — Right of Return Model (Acceptable View)

Under this alternative, in a manner similar to that under Alternative 3A, the contract modification is accounted for as a termination of the existing contract and the creation of a new contract because the modification does not solely add goods or services at their stand-alone selling prices (i.e., a conversion right is added for no additional consideration, which could result in the forfeiture of goods and services, and any incremental fee to be paid for the SaaS is not at its stand-alone selling price) and the remaining PCS is distinct. However, unlike Alternative 3A, Alternative 3B treats any “unused” portion of the on-premise software license as being effectively returned for a credit that can be applied toward the purchase of the SaaS. Therefore, revenue associated with the expected unused portion of the returned on-premise software license is reversed. The amount of revenue reversed (i.e., the credit associated with the potential unused portion of the returned on-premise software license), together with any unrecognized revenue that was included in the transaction price from the original contract, is accounted for prospectively over the remaining two-year term. In applying the right of return guidance, the entity would estimate and recognize an adjustment to the transaction price (and reduce revenue) upon contract modification to account for the potential conversion.23 The right of return would be accounted for as variable consideration, subject to the constraint in ASC 606-10-32-11 and 32-12.24 The estimate of variable consideration associated with the right of return would be reassessed at the end of each reporting period in accordance with ASC 606-10-55-25 and 55-26, with changes in the estimate recognized as an adjustment to revenue. If the conversion right is exercised, the amount previously deferred as a liability25 plus the incremental fee paid would generally be recognized as revenue over the remaining term of the SaaS (and the PCS for any licenses that are not converted).

In Example 12-26, C will recognize revenue of $2.4 million ($8,000 on-premise software license stand-alone selling price × 100 seats × 3 years) on January 1, 20X0, for the software license and $200,000 ($2,000 PCS stand-alone selling price × 100 seats × 1 year) for PCS ratably over 20X0. When the contract is modified on January 1, 20X1, C would need to determine its estimate of variable consideration and how much of that consideration, if any, should be constrained. Assume that C determines that $1 million of the original transaction price of $3 million is variable consideration, which is calculated as ($8,000 on-premise software license stand-alone selling price + $2,000 PCS stand-alone selling price) × 100 seats × 1 year. In addition, assume that C estimates variable consideration of $500,000 — calculated as ($8,000 on-premise software license stand-alone selling price + $2,000 PCS stand-alone selling price) × 50 seats × 1 year — and concludes that none of the estimated variable consideration should be constrained.26 Therefore, C will reverse revenue of $400,000 ($8,000 on-premise software license × 50 seats × 1 year) and reclassify $100,000 of the PCS contract liability for the PCS expected to be forfeited ($2,000 PCS stand-alone selling price × 50 seats × 1 year) for a total liability of $500,000 for the credit the customer is expected to receive. Entity C also has a remaining contract liability related to PCS of $300,000 and recognizes $200,000 ($2,000 PCS stand-alone selling price × 100 seats × 1 year) for PCS ratably over 20X1.

Assume that on December 31, 20X1, C revises its estimate of the liability associated with the right of return to $1 million because it now expects that the customer will convert all 100 seats to a SaaS arrangement. Entity C will reverse an additional $400,000 of revenue for the incremental 50 seats of on-premise software expected to be forfeited ($8,000 software license stand-alone selling price × 50 seats × 1 year) and reclassify $100,000 of the remaining PCS contract liability for the incremental PCS expected to be forfeited ($2,000 PCS stand-alone selling price × 50 seats × 1 year) for a total increase in liability of $500,000 related to the credit expected to be granted to the customer. If the customer elects to exercise the conversion right on 100 seats on January 1, 20X2, revenue of $1.1 million, which is calculated by adding the liability of $1 million and the incremental fee of $100,000 ($1,000 incremental fee × 100 seats × 1 year), is recognized over the remaining one-year SaaS term.

Because C’s initial estimate of the liability for the credit expected to be granted to the customer was not sufficient, a significant amount of revenue ultimately had to be reversed in a subsequent reporting period. This example highlights the importance of critically evaluating how much revenue should be constrained to ensure that it is probable that a significant reversal in cumulative revenue recognized will not occur. Given the risk of overestimating the amount of variable consideration to which an entity can expect to be entitled for the on-premise software license and PCS, we believe that many software entities, particularly those that do not have sufficient historical data on conversion rates, may find it challenging to determine an appropriate estimate of variable consideration and constraint as required under Alternative 3B.

12.6.4.3.3 Tabular Summary of Alternatives 3A and 3B

The following table summarizes the timing of revenue recognition under Alternatives 3A and 3B:

12.6.4.4 Initial Contract Includes Cloud Mixing Rights With a Cap

The example below illustrates an initial contract that gives the customer the right to use nonexclusive licensed software on both an on-premise basis and a cloud basis, subject to a cap on the total number of seats.

Example 12-27

On January 1, 20X0, Entity D enters into a noncancelable two-year contract with a customer for an up-front fee of $1 million to provide 1,000 nonexclusive software licenses. Under the terms of the contract, the customer has an option to deploy each of the 1,000 licenses as either on-premise software or SaaS throughout the two-year license term. That is, the customer can use any mix of on-premise software and SaaS at any point during the license term as long as the number of licenses used does not exceed 1,000 seats. The on-premise software license and the SaaS (1) are each fully functional on their own and (2) provide the same functionality and features (other than D’s hosting of the SaaS). At contract inception, the customer decides to use 600 licenses as on-premise software and 400 licenses as SaaS. Six months later, the customer decides to use 500 licenses as on-premise software and 500 licenses as SaaS.

We believe that D may reasonably conclude that it has promised to (1) provide the right to use on-premise software and (2) stand ready to provide SaaS (i.e., to host the software license). Since each of the promises is likely to be distinct, there are two performance obligations to which the $1 million fee should be allocated on a relative stand-alone selling price basis. We believe that it would be acceptable for D to estimate the stand-alone selling price of each performance obligation by considering the expected mix of on-premise software and SaaS. The stand-alone selling prices are determined at contract inception and should not be subsequently revised regardless of whether the mix of on-premise software and SaaS changes after the initial estimate. Consideration allocated to the on-premise software would be recognized once control of the license is transferred to the customer. In addition, since the performance obligation to provide SaaS is satisfied over time, consideration allocated to this performance obligation would be recognized as revenue over the two-year contract term (i.e., the period over which D is required to stand ready to provide SaaS).

12.6.5 Conversion of Perpetual Software Licenses to Term-Based Software Licenses

Certain entities in the software industry that provide perpetual software licenses in contracts with customers may modify those contracts to convert the licenses from perpetual to term-based. Such modification is common for entities that intend to convert customers from an on-premise license arrangement to a cloud-based arrangement under which the software is hosted (e.g., SaaS). Converting a perpetual license to a term-based license is considered an intermediary step in this process.

The example below illustrates the accounting for conversion from perpetual software licenses to term-based software licenses.

Example 12-27A

On January 1, 20X1, Entity B enters into a contract with Customer C to transfer a perpetual license for 100 seats of Software X and one year of PCS for a total price of $1.2 million. The license is distinct from the PCS; therefore, there are two performance obligations. Customer C can renew PCS for $200,000. The software has an estimated economic life of five years. Control of the perpetual license is transferred to C on January 1, 20X1.

Customer C renews PCS and receives regular updates in calendar years 20X2 and 20X3.

After calendar year 20X3, B no longer sells perpetual licenses and undertakes initiatives to transition its customers to its cloud-based offerings. In connection with this undertaking, B announces that it will no longer sell PCS renewals to existing perpetual license holders but instead will sell a one-year term license bundled with one year of PCS for the same amount at which a PCS renewal was sold. Accordingly, on January 1, 20X4, rather than renew the PCS under the existing terms, B and C enter into a contract under which C pays B $200,000 for a bundle consisting of a one-year term license for 100 seats of Software X and one year of PCS. Under this new contract, C forfeits its rights to the perpetual license. As a result, in the absence of any additional term license renewals, C will lose its right to use Software X as of January 1, 20X5.

The substance of the transaction is that, for the initial term license purchase, C is renewing the PCS for license rights it already controls. This is because the exchange of a nonexclusive software license (i.e., the exchange of a perpetual license for a term-based license) is not considered a return. Although C lost its rights to the perpetual license, it retains the right to use the software for the duration of the term license, which is not a newly granted right. As a result, B will record the $200,000 ratably as PCS (service) revenue in 20X4. That is, B does not treat the conversion as a return and does not recognize any software license (product) revenue in 20X4. This is because C already had rights to use the software and did not obtain any incremental rights upon conversion.

If B and C separately negotiate a renewal of the term license and PCS contract bundle for an additional year (i.e., beginning January 1, 20X6), the renewal will be treated the same as any other sale of a term license with associated PCS, if applicable.

Footnotes

The alternatives outlined in this section are premised on the assumption that the entity does not have an implied obligation to provide PCS during the lapse period.

In this instance, it is assumed that the SaaS arrangement is accounted for as a service contract because the customer does not have the ability to take possession of the underlying software on an on-premise basis in accordance with the requirements of ASC 985-20-15-5.

This alternative view is consistent with the accounting for on-premise term-based software licenses that enable the customer to terminate the license agreement without penalty. For example, if a customer paid for a one-year on-premise term-based software license but had the ability to cancel the arrangement for a pro rata refund with 30 days’ notice, the term of the initial arrangement would be 30 days, with optional renewals thereafter. In those circumstances, the right of return guidance would not be applied.

While the material right’s stand-alone selling price could be adjusted for any discount the customer could receive without exercising the option, this example assumes that the customer could not receive a discount without exercising the option.

The allocation of the transaction price based on relative stand-alone selling price is included for illustrative purposes only and uses simplistic assumptions; judgment will be required to determine stand-alone selling prices in this and similar fact patterns.

The variable consideration resulting from the right of return would generally be estimated on the basis of the transaction price allocated to the on-premise software and related PCS and the amount of that allocated transaction price that is expected to be refunded as a credit to the SaaS arrangement (i.e., the pro rata portion of the on-premise software and related PCS that is “unused”). If the credit plus any incremental fee required to convert to the SaaS arrangement is less than the stand-alone selling price of the SaaS, the entity may need to consider whether a material right has also been granted.

Under ASC 606-10-32-11, an entity includes variable consideration in the transaction price “only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.”

A liability for a return right is typically recognized as a refund liability in accordance with ASC 606-10-55-23(b). However, we believe that if an entity’s contract with a customer is noncancelable and consideration therefore would not be refunded to the customer, it would be acceptable to recognize the liability as a contract liability (e.g., deferred revenue) for the entity’s expected performance associated with a SaaS arrangement.

Note that if an entity’s contract does not contain a cloud conversion right at contract inception, a practice of allowing customers to convert their on-premise software license to a SaaS arrangement may create an implied right that is similar to the explicit right provided to the customer in Example 12-24. Significant judgment will be required to determine when an implied right is created in these circumstances.

Entity B would generally allocate the $125,000 between PCS and the SaaS on the basis of their relative stand-alone selling prices if required to do so for presentation or disclosure purposes. However, because both PCS and the SaaS are stand-ready obligations that are recognized ratably over the same period, the $125,000 was not allocated between the two services for purposes of this illustration.

Entity B would generally allocate the $325,000 between PCS and the SaaS on the basis of their relative stand-alone selling prices if required to do so for presentation or disclosure purposes. However, because both PCS and the SaaS are stand-ready obligations that are recognized ratably over the same period, the $325,000 was not allocated between the two services for purposes of this illustration.

See footnote 18.

See footnote 14.

See footnote 15.

See footnote 16.

See footnote 17.

See footnote 18.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.