SaaS Revenue Recognition

Let me put the disclaimers in up front.  The following is my personal opinion.  It is not an official Gartner position.  In addition, I am not an accountant.  This is also a bit of a rant (so my apologies in advance).

Taleo announced on November 10, 2008 that its Deloitte & Touche LLP, the company's independent registered public accounting firm, requested that the company re-evaluate whether the company's historical and current practices with respect to the timing for recognition of application and consulting revenues were appropriate under generally accepted accounting principles (GAAP).  Brian Sommer has some good posts here and here that provide some additional color on the situation.  As of the time of writing this post, Deloitte had still not rendered an opinion if Taleo needs to do a financial restatement (or what the scope of that restatement may be) based on the revenue recognition timing.  There are two major revenue recognition issues that Deloitte is investigating:

• when should Taleo start to recognize revenue ratably over the term of the contract?
• should its services revenue also be recognized ratably over the term of the contract? 

I am going to focus on the first issue in this post.

Taleo's policy has been to "start the clock" (when it can start to recognize revenue) when it provides customers access to its software.  My understanding is that, according to GAAP revenue recognition, a vendor cannot begin until it has "delivered" the software to the customer.  In the perpetual license/on-premise installation world, this was pretty easy to define.  When the vendor shipped a disk (CD, DVD) and it was received by the customer, it was "delivered" (unless there were specific services that were also tied to that delivery).  "Delivery" in the SaaS world is more complex.  There is nothing physically delivered to the customer.  The customer accesses the service online.

An informal look at other vendor's revenue recognition policies shows that there are differences in "when the clock starts".  Many do what Taleo does. However, some SaaS vendors do not start recognizing revenue until the customer access the software for the first time.  I know of one vendor that does not start to recognize revenue until the customer is using the software in production (and the implementation services have been delivered).

I personally believe "delivery" is when the customer has access to the solution.  The reasons are simple.  The customers can use the software at that point and it makes it consistent with the perpetual license/on-premise install (the traditional) world.  In the traditional world, a customer could not start to use the software until it received it.  Once it received the software, the customer could choose to implement it or not (if they chose not use it, that is what is commonly referred to as "shelfware").  Regardless of whether or not the customer chooses to implement the software, the software vendor in the traditional world was able to recognize the license revenue (all of it) because they "delivered" it. 

Now, why should SaaS be different in this regard?  Once access is provided, the customer can choose whether or not it wants to use the licensed service.  Remember, no matter "when the clock starts", the revenue must be recognized ratably over the term of the contract (so the vendor must make good on its service delivery before all of the revenue can be recognized), so the only question is when can they start to recognize the revenue.

It will be interesting to see what Deloitte recommends to Taleo.  It has been its auditor for seven years (approximately three years as a public company) and the revenue recognition policy has been the same.   If Deloitte tells Taleo, that the clock starts later, it will have ramifications for many other SaaS providers who recognize revenue in the same manner.  In addition, it should also have ramifications for vendors that offer perpetual licenses.  If SaaS provider cannot start to recognize revenue until the software has been accessed, then will vendors that offer perpetual licenses with on-premise implementations also be required to recognize license revenues only when a customer has accessed or implemented the software (so should they have been able to recognize revenue for "shelfware"?)?  In my view, there should be consistency.

What do you think?  When are SaaS solutions "delivered" in the GAAP context?  If SaaS vendors cannot start to recognize revenue until the software has been accessed (or is in production), should traditional vendors be held to the same standard?

Comments

[Scott Pruitt]

Very interesting debate Jim. This has long been an issue in the hosting, ASP, MSP, now SaaS world. Back when PeopleSoft initiated eCenter, their application hosting option, the business model out of the gate was a software rental license very similar to the SaaS model today. However, it was quickly determined that annuitizing the license revenue was a hit Wall Street was not excited about. Therefore the model was then changed to a hosting service as an alternative to in-house deployments of the software which allowed PeopleSoft to recognize all of the license revenue up front, yet the hosting service was recognized monthly "as earned". This added another GAAP kink as the early termination fees allowed for hosting services had to be under 10% or else it was considered the software was "given away" to achieve the hosting revenue; laughable considering the delta in potential revenues but it sure caused a lot of scrambling towards the end of the quarter when this interpretation was conveyed to management. To your initial topic of when revenue should begin to be recognized, I agree that once the customer "realizes the benefit" of the software is when recognition begins. This period is upon access to the software for implementation versus production and as you suggest should mirror the regulations which exist for traditional perpetual license transactions. It is difficult enough for SaaS vendors to show profitability as margins are backend loaded by default. Having to wait for a live production system, particularly in an extended complex implementation, would be an unjust reflection of a SaaS vendor's performance. That being said, I emulate your "I'm not an accountant" disclaimer; just a sales exec who's been in this business for awhile.

[Al Campa]

Jim, excellent points. Clearly the auditors are trying to figure out how to apply accounting principles written years ago to a new business model, SaaS. Consistency across all software and all industries is key. In on premise software, once the CD is in the mail, you can recognize the revenue. It may never reach the customer. And as you note, they certainly may never install it. I wonder how much smaller the software industry would be if "shelfware" that was never installed could not be counted as revenue? Also, I just bought some DVD's from Amazon for Xmas gifts. Do my kids have to watch Harry Potter before Amazon can recognize the revenue? Do they have to take a photo with their new digital camera before Canon can recognize that revenue? Absolutely not. Once its in the mail, its countable and SaaS revenue should not be held to a different standard. Once the customer has access to the solution, SaaS companies should be able to start to recognize the revenue (assuming not tied to services or anything else). This is how Taleo has done it since inception. Full disclosure, I am a Taleo employee and not an accountant, and these are my views, not the company's.

[Kevin Grossman]

I agree wholeheartedly, Jim. It should be as simple and analogous to buying a gym membership. The clock starts ticking once the transaction is complete, whether you use it or not. SaaS vendors should be able to recognize the revenue from point of online delivery, no question.

[Larry Kistner]

Well, its a very grey area, obviously. Given the basic principle that rev can be recognized when it has been earned, when the clock starts clicking is therefore based upon when it first becomes earned.

Actual practice with customers can impact this. For example, if a company allows a customer to return or not pay, a hard start date for rev rec becomes fluid. Depending upon their circumstances, a company may need to demonstrate a track record of practice that enforces their policy with customers.

Given how disastrous restating revenue has been for many companies, CFOs and CEOs do not want exposure to restating and will prefer to err on the conservative side.

A little pain now to save risking a lot of pain later.

Larry Kistner