The current standard relating to the revenue recognition - i.e. IFRS 15 Revenue from contracts with customers - provides a unified accounting framework across industries, but software and Software-as-a-Service (SaaS) arrangements often involve specific complexities. The following areas may become of particular significance from IFRS 15’s point of view:

• Impact of customer termination rights on accounting of software as a licence
• Impact of customer termination rights on accounting of SaaS
• Considering extended payment terms in software arrangements
• Principal versus agent considerations.

 

Impact of customer termination rights on accounting of software as a licence

Customer termination rights can significantly influence the contract term under IFRS 15, potentially making it shorter than the stated duration. For accounting purposes, the contract term is defined as the period during which both parties have enforceable rights and obligations. Identifying termination rights, along with any associated refunds or penalties, is critical for accurate revenue recognition.

For instance, consider a scenario where a customer is granted a three-year software licence but has the option to cancel at the end of each year and receive a pro-rata refund of the licence fee. In this case, enforceable rights and obligations might exist for only one year at a time. The customer effectively has an option to renew the licence annually. Revenue allocated to the one-year licence would typically be recognised at the start of the term of the licence. Meanwhile, amounts allocated to the option for future renewals would be deferred until the customer exercises that option by not cancelling the licence. Importantly, the likelihood of the customer exercising the termination right is not factored into the determination of the contract term. Even if cancellation is unlikely, enforceable rights and obligations are limited to the first year.

Conversely, if a termination right lacks substance, it may not impact the accounting for the contract. For example, if a customer is granted a three-year licence but can cancel after one year without receiving a refund, or there are significant early termination penalties making the option for the customer unlikely, the termination right is likely to be non-substantive. Here, enforceable rights and obligations would span the full three years of the contract.

Determining the contract term when customer termination rights are involved often requires professional judgement. The aim is to establish the period over which enforceable rights and obligations exist. For software licences, the critical question is whether the customer is effectively making a renewal decision by not exercising the termination right. If that’s the case, the enforceable rights and obligations are confined to the non-cancellable period of the licence.
 

Impact of customer termination rights on accounting of SaaS

In most cases, SaaS revenue is recognised over the contract term, and termination rights may not significantly alter this recognition. For instance, consider a three-year SaaS agreement with a total fee of SAR 90,000. The customer, however, has the option to terminate the agreement with 30 days’ notice and is only liable for the services received. In this situation, despite the stated three-year term, the contract is effectively treated as a month-to-month service agreement. If straight-line revenue recognition is deemed appropriate, the vendor would recognise SAR 2,500 per month (SAR 90,000 ÷ 36 months), regardless of whether the term is legally defined as one month or three years.

However, there are scenarios where determining the contract term could affect revenue recognition. For example:

Multiple performance obligations:

If the contract includes other obligations besides the SaaS component, only the noncancellable SaaS term and its associated fee (e.g. SAR 2,500 for one month in the above scenario) should be factored into the allocation of the transaction price across obligations.

Variable pricing:

If the SaaS price increases over the stated term, the transaction price is limited to the fee for the noncancellable term. Conversely, if the price decreases, the vendor must assess whether future discounts represent a material right for the customer.
 

Extended payment terms in software arrangements

Extended payment terms refer to payment arrangements that go beyond a software vendor's standard terms. These terms can influence the vendor's assessment of collectability and the determination of the transaction price under the revenue recognition model.

When evaluating whether a contract exists (Step 1 of the revenue recognition process), the vendor must assess the customer’s ability and intent to pay the agreed amount when due. Extended payment terms can raise questions about the customer's creditworthiness, but they are not the sole factor in assessing collectability. Vendors need to consider all relevant facts and circumstances. If the vendor determines that it is not probable to collect substantially all of the transaction price, the contract does not meet the criteria for recognition under the revenue standard.

Additionally, extended payment terms may increase the risk of price concessions or payment forgiveness. If such concessions are implied in the agreement, they are treated as variable consideration, reducing the transaction price to reflect the expected concession.

Extended payment terms might also suggest the presence of a significant financing component within the contract. According to the guidance in IFRS 15, vendors must evaluate whether the payment terms provide a financing benefit to the customer. However, vendors can apply a practical expedient (IFRS 15.63) to ignore financing effects if payment is expected within one year of transferring the goods or services.

If a significant financing component exists, part of the contract consideration is recognised as interest income rather than revenue. In such cases, the total revenue recognised will be lower than the cash received, as the difference represents interest income.
 

Principal versus agent consideration

In the software industry, many arrangements are structured in a way that determination for a reporting entity as principal or agent is highly judgemental. This issue is very common when IT companies are acting as resellers and intermediary between the software provider and end customers.
In financial reporting, the principal versus agent framework plays a crucial role in determining which party qualifies as the reporting entity’s customer. This determination is important as it will define if the amount of revenue recognised is on gross or net basis and follows a structured two-step approach:

• Identifying the specific good or service being provided to the end consumer
• Evaluating whether the intermediary has control over the specified good or service before transferring it to the end consumer.

An intermediary, such as a reseller or a digital marketplace, is considered the principal in the transaction if it has control over the software as a licence or SaaS before delivering it to the end user. This means that the intermediary (e.g. a reseller or digital marketplace) is the principal in the arrangement with the end consumer and therefore the vendor’s customer.

Examples of evidence indicating that the intermediary has control over the software or SaaS may include:
 

Primary responsibility for fulfilment	Inventory risk	Pricing discretion
• Contract terms and public communications (such as marketing materials and web site FAQs) suggest that the intermediary is accountable for delivering the software or SaaS to the end consumer • The vendor does not have the discretion to reject an arrangement with an end consumer, or any refusal rights are only protective in nature • The vendor does not engage directly with the end consumer and does not maintain a contractual relationship with them • The intermediary has the authority to reassign vendor obligations to different end consumers or restrict a vendor from providing services to a particular end consumer • The intermediary acts as the primary point of contact for customer service, including addressing and resolving complaints • Service level agreements (SLAs) or similar performance commitments are provided by the intermediary to the end consumer • The intermediary plays a significant role in guiding the end consumer toward suitable software or SaaS solutions                                    • The intermediary decides which vendors will be engaged to fulfil customer orders.	• Intermediaries may assume inventory risk when they purchase software as a licence or rights to access a SaaS offering before securing agreements with end customers. This means they bear the financial risk of holding these assets, whether for internal use or future resale.	• The intermediary has the authority to set the final price that end consumers pay for the software or SaaS product.

How BDO can help

BDO’s expert financial accounting advisory services teams apply the practical experience and knowledge gained from working with clients locally and worldwide. Please reach out to the relevant partner in your local BDO firm for further information.

Contributors:
Abdul Sharjeel, Head of Advisory, BDO Saudi Arabia
Usman Ahmed Siddiqui, Financial Accounting Advisory Services Manager, BDO Saudi Arabia