Traditional software vendors that have historically sold on-premise software licenses are increasingly transitioning to a cloud service provider model of selling software-as-a-service (SaaS). Advances in cloud technologies, an abundance of third-party hosting providers, and the proliferation of smart technologies and other integrated solutions have significantly enabled this migration, while customers are increasingly looking for cloud-based solutions. However, no matter how exciting the migration journey is, there are numerous factors to consider before embarking on it. These include the accounting and financial reporting implications of the migration, and companies should generally understand those in order to have well-informed conversations with investors and other stakeholders.
While there are a number of such implications, the focus here is on the company’s revenue recognition and cost accounting.
Integral to understanding the revenue recognition and cost accounting implications of your cloud offering is knowing and defining what that offering is – e.g. whether it is a pure cloud offering or a hybrid offering (incorporating on-premise or on-device software and cloud-based features). Understanding related services, such as post-contract customer support for on-premise or on-device software in a hybrid model or implementation services is also an imperative. Understanding how the offering will be delivered to customers and whether it includes one or more software licenses can drive significant differences in the revenue and cost accounting models and drive significant impacts on the ability of the company to model financial projections. When an offering includes one or more software licenses in addition to cloud-based features, significant judgment is often involved to determine whether the sales of those software licenses must be accounted for separately from the access to the cloud-based features of the offering.
Company accounting personnel, as well as the company’s auditors or other accounting advisors, should be involved early in this process. During the transition to the cloud, it is essential to understand all the features and functionalities that are being marketed to customers, how they are being delivered to customers, and to consistently update that understanding as the offering(s) evolve. It is important to remember that as an offering changes, so too can its accounting.
For most companies contemplating or already undertaking a migration, there is appeal in the steady and predictable revenue stream the cloud business model generally provides. However, revenue recognition may not be entirely that simple. As outlined earlier, in a hybrid cloud model, separate software license elements may exist, the revenue for which is generally recognized at a point in time upfront rather than over the subscription period. In addition, even in pure cloud offerings, companies need to consider the appropriate revenue recognition for implementation services and any variable usage-based fees.
The migration period can create special challenges for a company as customers modify existing contracts or enter into new contracts for the company’s cloud offering(s). Contract modifications to convert software licenses to cloud subscriptions and transition contracts that either (or both) grant the customer an option to convert from on-premise to SaaS during the license period or permit the customer to use both legacy on-premise software and the company’s cloud-based software for a transition period can create accounting complexities. Close and early integration between the accounting and finance departments and the salesforce to understand how the company is planning to transition customers to the cloud is important.
Companies undergoing or considering the transition should also be aware of different development cost accounting models that apply to software that is licensed versus software customers can access only through the cloud. In addition, the company’s accounting for contract acquisition and fulfillment costs (e.g. commissions and provisioning costs) may differ substantially under a cloud versus a licensing model.
In addition to these accounting and reporting implications, companies migrating to the cloud may find themselves facing additional such implications and other challenges, such as explaining the changed business model to investors and evaluating and responding to new business risks.
For more information or to arrange an interview with Alison Barr, contact Libby Langsdorf.