Handbook: Revenue for software and SaaS

Transcript

1 Revenue for software and SaaS Handbook US GAAP December 201 8 _____ kpmg.com/us/ frv

2 Contents Foreword 1 ... ... 2 About this publication 5 ... Software and SaaS industry overview cope ... 19 S A. B. Step 1: Identify the contract with the customer ... 64 C. ... 128 Step 2: Identify the performance obligations in the contract D tep 3: Determine the transaction price ... 2 63 . S E. S tep 4: Allocate the transaction price to the performance obligations in the contract ... 3 43 F. Step 5: Recognize revenue when (or as) the entity satisfies a ... 438 performance obligation . C G ... 5 52 ontract modifications . C ontract costs ... 6 12 H Appendices 666 ... Applicable to all industries ... 666 Index of Q&As ... 677 Index of examples ... 699 KPMG Financial Reporting View ... 709 ... 7 Acknowledgments 10 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member © 2018 firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

3 Revenue for software and SaaS 1 Foreword - A world without software revenue guidance specific and without VSOE The new revenue standard was issued in 2014, and the 2018 application date once seemed like a long way off. Now, as 2018 nears an end, most public companies have adopted the new revenue recognition standard (Topic 606) and private companies near their 2019 application date. Topic 606 represents the dawn of an accounting world where software arrangements are not subject to industry -specific GAAP and where the concept of vendor -specific objective evidence of fair value (VSOE) no longer exists. Topic 606 requires software and software- as-a- service (SaaS) entit ies to determine its effect on their accounting and their operations . As software and d into the details, most have delve that the new have found SaaS entities that Topic 606 will guidance will affect them in some way. Many have found affect them significantly . H owever, the effect of Topic 606 will often vary from entity to entity . In November 2018 , we published an updated edition of KPMG’s Handbook, Revenue recognition, which illustrates how Topic 606 applies to common transactions, provides examples about common scenarios, explains our emerging thinking on key interpretative issues and compares the new requirements to legacy US GAAP. provides detailed This updated Handbook technical guidance on key issues when applying Topic 606 to software licensing and SaaS arrangements, focusing on the implications for US GAAP reporting entities. We address a wide variety of questions that have arisen during the implementation period about the effects of Topic 606 on software licensing and SaaS arrangements. We also address the effects of Topic 606 on many longstanding software and SaaS practice issues, and in both cases, we compare the effects of Topic 606 to legacy US GAAP. logue We hope this Handbook will continue to advance the dia on the issues pertinent to this industry . Prabhakar Kalavacherla and Scott Muir Departm ent of Professional Practice, KPMG LLP © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

4 Revenue for software and SaaS 2 About this publication About this publication Purpose The purpose of this Handbook is to assist you in understanding the new revenue standard, Topic 606, as it applies to contracts with customers in the software and SaaS industry. This Handbook is intended for use by preparers and other interested parties with a working knowledge of the legacy software industry guidance in Subtopic -605, the legacy general revenue guidance in Topic 605 as it 985 applies to SaaS arrangements and the new revenue model in Topic 606. Accounting literature Unless otherwise stated, references to the revenue standard and/or Topic 606 comprise all of the following Accounting Standards Updates: — No. 2014- 09, Revenue from Contracts with Customers (Topic 606) — No. 2016- 08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net) 10, Revenue from Contracts with Customers (Topic 606): No. 2016- — Identifying Performance Obligations and Licensing 11, Revenue Recognition (Topic 605) and Derivatives and Hedging — No. 2016- (Topic 815): Rescission of SEC Guidance Because of Accounting Standards Updates 2014-09 and 2014 -16 Pursuant to Staff Announcements at the March 3, 2016 EITF Meeting No. 2016- 12, Revenue from Contracts with Customers (Topic 606): Narrow- — Scope Improvements and Practical Expedients — No. 2016- 20, Technical Corrections and Improvements to Topic 60 6, Revenue from Contracts with Customers. — No. 2017- 13, Revenue Recognition (Topic 605), Revenue from Contracts with Customers (Topic 606), Leases (Topic 840), and Leases (Topic 842): Amendments to SEC Paragraphs Pursuant to the Staff Announcement at the July 20, 2017 EITF Meeting and Rescission of Prior SEC Staff Announcements and Observer Comments — No. 2017- 14, Income Statement —Reporting Comprehensive Income (Topic 220), Revenue Recognition (Topic 605), and Revenue from Contracts with Customers (Topic 606): Amendments to SEC Paragraphs Pursuant to Staff Accounting Bulletin No. 116 and SEC Release No. 33- 10403 © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

5 Revenue for software and SaaS 3 About this publication Organization of the text Each chapter of this Handbook includes excerpts from the FASB’s Accounting ® and overviews of the relevant requirements. Our in- Standards Codification depth guidance is explained through Q&As that reflect the questions we are encountering in practice. We include examples to explain key concepts, and we explain the changes from legacy US GAAP. Our commentary is referenced to the dification and to other literature, where Co applicable. The following are examples: -10. — 16 of ASC Subtopic 606 606- 10-25 -16 is paragraph 25- ASU 2014- 09.BC87 is paragraph 87 of the basis for conclusions to — Accounting Standards Update No. 2014- 09. — TRG Agenda Paper No. 30 is agenda paper no. 30 from the meeting of the IASB and the FASB’s Joint Transition Resource Group for Revenue Recognition (TRG) held in March 2015. 3 is SEC Staff Accounting Bulletin Topic 1 SAB Topic 1 3. — Terminology Throughout this Handbook , the terms ‘software licensing arrangement’ and ‘SaaS arrangement’ are used. A ‘software licensing arrangement’ refers to an arrangement in which a software license is transferred to the customer in with paragraph 606- 10-55 -54(a) accordance aS arrangement’ . In contrast, ‘Sa the refers to an arrangement that, even if contract states that a license to software is conveyed, a license does not exist in accordance with paragraph 606- 10-55 -54(a) because the hosted software does not meet the criteria in paragraph 985- 20 -15-5. This distinction is important because, under Topic 606, the licensing based implementation guidance, including that related to sales -based and usage- not apply to SaaS arrangements . SaaS arrangements are royalties, does accounted for as ser . The vice obligations, subject to the general revenue model first section of the ‘Software and SaaS Industry Overview’ and Chapter A – Scope , discuss the requirements for distinguishing between a software licensing arrangement and a SaaS arrangement in further detail. Pending content In some cases, the Codification is subject to content that becomes effective after the revenue standard. For example, Accounting Standards Update No. 2016-13, Financial Instruments —Credit Losses (Topic 326), includes consequentia l amendments to Topic 606. When an excerpt from the Codification is affected by pending content: — the specific sentences that have been superseded are underlined; and the amended sentences are included at the end of the excerpt, marked as — pending content. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

6 Revenue for software and SaaS 4 About this publication December 2018 edition of the version This Revenue for software and SaaS Handbook includes new and updated interpretations based on our experiences with companies implementing Topic 606, as well as discussions with the FASB and SEC staff. New Questions and Examples are identified throughout the Handbook with ** # and items that have been significantly updated or revised are identified with . © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

7 Revenue for software and SaaS 5 Software and SaaS industry overview Software and SaaS industry overview Is there a software license? Whether the customer obtains a software license affects the guidance that the entity will apply in accounting for the arrangement. Instead of selling a software license and related services to the customer, a software entity might make the same software functionality available to the cus -as-a- service , or SaaS ) tomer through a cloud computing (e.g. software arrangement. Under legacy US GAAP , a software license was present in a cloud computing arrangement only if the following criteria were met: — the customer had the contractual right to take possession of the software from the entity at any time without significant penalty; and s feasible for the customer to host the software independent of the it wa — software entity – hird party’s e.g. to host the software themselves or in a t environment. If not, the entire arrangement was a service arrangement. In our experience, most cloud computi ng arrangements were accounte d for as service contracts under legacy US GAAP . Topic 606 applies the same tests as legacy US GAAP to determine if a contract with a customer includes a software license. As a result, entities will likely reach similar conclusions for cloud computing arrangements about whether the contract includes a software license. Under Topic 606, whether the customer obtains a software license affects the guidance that the entity will apply in accounting for the arrangement. If a ), the licensing software license is not granted (i.e. the arrangement is for SaaS implementation guidance does not apply, including the specific guidance on sales- or usage-based royalties promised in exchange for a license. Instead, the entity applies the general revenue model to determine the recognition of revenue for SaaS arrangements. Application of the general revenue model will res ult in a time -based, ratable recognition of fixed fees in those arrangements. The accounting for variable consideration (e.g. transaction- - or usage-based royalties based fees) is discussed in the section ‘Sales ’. Some contracts will include both software licensing elements subject to the licensing implementation guidance and SaaS elements subject to the general revenue model. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

8 6 Revenue for software and SaaS Software and SaaS industry overview Performance o bligations A software entity’s determination of the performance obligations in the contract may accelerate software lice nse revenue recognition compared with legacy GAAP . US Under Topic 606, an entity accounts for the performance obligations in the contract – i.e. the performance obligation is the unit of account for revenue recognition. To determine the performance obligations in a contract, an entity first identifies the promised goods or services – e.g. a software license, SaaS, professional -contract customer support (PCS), or specified upgrade or services, post additional product rights. These may be promised to the cus tomer explicitly or implicitly (e.g. by the entity’s customary business practices), and/or promised to the customer’s customers (e.g. a promise to provide technical support or unspecified upgrades to customers that purchase the entity’s software from a res eller). Promised goods or services do not include administrative or other activities that an entity undertakes to set up a contract; for example, certain SaaS installation or activation activities or a promise to provide additional copies of a delivered software application that is not a promise to deliver additional licenses might not transfer a promised good or service to the customer. Judgment will be required in some cases to distinguish promised goods or services from administrative tasks or set -up activities. However, an entity’s identification of the promised goods or services in a software or a SaaS arrangement is likely to be similar to that under legacy US GAAP in most cases. ines Once an entity identifies the promised goods or services, it then determ whether they are distinct from each other. Under Topic 606, two or more goods or services (e.g. a software license and professional services or PCS, or SaaS and professional services) are distinct from each other, and therefore separate performance obligations, when they are not in effect inputs to a single combined item that is the object of the contract. In making this determination, an entity considers factors such as whether: it is providing a significant integration service (using its expertise to create a — combined output using the promised goods or services as inputs); — one good or service significantly modifies or customizes the other; — the goods or services are highly dependent on, or highly interrelated with, each other. Unlike legacy US GAAP for software licensing arrangements, vendor -specific objective evidence of fair value (VSOE) does not factor into an entity’s determination of the performance obligations in the contract. In many cases, this difference will accelerate software license revenue recognition compared with legacy US GAAP . For example, a software license is separable from PCS under legacy US GAAP only if the entity has VSOE for the PCS (as well as for any other undelivered elements in the contract). VSOE is established for P CS alone PCS renewals). based on stand-alone sales (e.g. stand- © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

9 7 Revenue for software and SaaS Software and SaaS industry overview Software/SaaS and professional services Consistent with legacy US GAAP , an on -premise software license and significant customization or modification of that software will generally not be distinct from each other; therefore, they will be accounted for as a single complex performance obligation. Conversely, a software license and non- implementation services will generally be distinct from each other and accounted for as separate performance obligations; this is especially, but not exclusively, the case if the services can be performed by alternative providers. However, judgment may be required in assessing whether a software license and professional services are separate performance obligati ons in other circumstances. Topic 606 may result in combining a software license and services even when the services are not essential to the software’s functionality. For example, some entities may conclude that services are not distinct from the software license when they do not customize or modify the software, but nonetheless are more complex in nature (e.g. complex interfacing), proprietary and integral to the customer’s ability to derive substantive benefit from the software. The considerations for a SaaS arrangement that includes professional services will be similar to those for on- premise software licensing arrangements. SaaS entities will also need to evaluate whether up- front activities are a promised . Set -up activities, which can -up activities service to the customer or merely set range from simply ‘activating’ the customer to other activities performed by the SaaS provider that enable the customer to access the SaaS from its IT platform, are activities that do not provide incremental benefit to the customer beyond that which the customer receives from access to the hosted application. Software and PCS Software licensing arrangements often include PCS. Thi s typically includes technical support and the right to receive unspecified updates, upgrades and Legacy US GAAP treated PCS as a single element. enhancements. Under Topic 606, the components of PCS (e.g. technical support and the right to unspecified updates, upgrades and enhancements) will typically be distinct from each other, and therefore separate performance obligations. However, if they are provided over the same period and have the same pattern of transfer to the customer – e.g. if they are both stand- ready obligations satisfied ratably over the PCS period – a software entity could account for both elements as if they were a single performance obligation. In most cases, software, technical support and rights to unspecified updates or upgrades/enhancements (or rights to unspecified additional software products) will be distinct from each other, even if the technical support and the right to unspecified updates , upgrades and enhancem ents is mandatory. However, Topic 606 illustrates that, in limited fact patterns, a software license may not be distinct from a right to unspecified updates , upgrades and enhancements (or unspecified additional software products) if those updates are critical to the - customer’s ability to derive benefit and value from the license (e.g. in an anti virus scenario). In those limited cases, the software and the right to the pecified items would be a single performance obligation. uns © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

10 Revenue for software and SaaS 8 Software and SaaS industry overview Specified upgrades or additional software products What constitutes a specified upgrade or an additional software product is not legacy US GAAP , including the effect of expected to change substantively from product roadmaps on determining whether a specified upgrade or enhancement has been implicitly promised to the customer. VSOE requirement for undelivered items However, the elimination of the legacy in a contract means that entities will no longer be required to defer substantially all of the revenue in the contract until any specified upgrades or additional software products are transferred to the customer, as was typical under legacy US GAAP . This is because specified upgrades and specified additional product rights will generally be distinct from the original software license and other elements (e.g. technical support or unspecified upgrade/additional product rights) in a software licensing arrangement. In SaaS arrangements, judgment will be required to determine whether a promise to provide additional or upgraded functionalities is an additional promised service, or merely part of providing the ongoing SaaS – e.g. keeping the hosted application current and relevant. An important part of that judgment might be whether the promised functionalities are significantly different, significantly improved and/or independent from the original functionalities. arrangements /Cloud Hybrid SaaS premise It is increasingly common for arrangements to include both an on- software element and a SaaS element – e.g. an on -premise software application and a SaaS application or a SaaS application with an ‘offline’ mode. In many cases, those two elements will be distinct, but in others they will not. If the customer cannot derive benefit from its right to use the on- premise software without the SaaS element, or can only derive an insignificant portion of the benefit the customer would be able to obtain from using the on-premise software together with the SaaS element, the on- premise software license is not distinct from the SaaS element. premise software and the SaaS element each have In situations where the on- substantive functionality , a key consideration in deciding whether the two elements are distinct may be whether the two elements are transformative to each other rather than merely additive to each other. Transformative means that the two elements together provide a combined functionality or utility t hat is greater than or different from the aggregate functionality or utility of the elements independently. Explained another way, if the customer obtains a license to Software Product A and access to SaaS element B, the distinct analysis would generally hinge on whether the combination of A + B equals AB (i.e. the combined funct ionality is merely the sum of the two elements’ individual functionalities), in which case the two elements would generally be distinct from each other, or whether the combination of A + B equals X (i.e. the combination of the two elements results in incremental or changed functionalities that don’t exist in either element x (i.e. the combination of the elements produces an enhanced separately) or AB of the two elements’ individual level of functionality that is greater than the sum functionalities). © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

11 Revenue for software and SaaS 9 Software and SaaS industry overview If the on -premise software and the SaaS element are transformative to each other, rather than merely additive, we would generally conclude that the two elements are not distinct from each other and account for the combined item as a service arrangement, rather than as a license. Determining stand-alone selling price VSOE is no longer the only basis for allocating contract revenue. Software entities often agree to provide more than one software license or a combination of software licenses and services to a customer in an arrangement. Multiple- element arrangements may include licenses to additional software products, legacy specified upgrades or enhancements, PCS or other services. Under US GAAP for software li censing arrangements, revenue was allocated between contract elements on the basis of VSOE and, typically, to separate license elements on a residual basis. Under Topic 606, the transaction price is allocated to the performance obligat ions based on the stand- alone selling price of the goods or services underlying each performance obligation. If VSOE (or another observable stand- alone selling price) does not exist for a performance obligation, the entity price. estimates the stand- alone selling related elements For many software entities that have VSOE for their software- (e.g. PCS or professional services), this may not result in a significant change; permits use of a residual approach to this is principally because Topic 606 determine the stand-alone selling price for performance obligations (or bundles of performance obligations) that are sold at widely varying or uncertain prices (e.g. enterprise software licenses) when the other elements of the contract have observable prices. However, the requirement to determine estimated stand -alone selling prices for each performance obligation in the contract will be challenging for many other entities that either: do not sell their software- — related elements on a stand -alone basis – e.g. customer s always purchase PCS that is co -terminus with a term software license ; or — e.g. licenses to multiple software have multiple software licenses – in their products or a license and one or more specified upgrades – contracts that are not transferred to the c ustomer at the same time. Customer options A customer option may be an additional performance obligation. However, distinguishing a contractual option from a usage- based fee will require judgment. Software entities may provide a customer option to acquire additional goods or services (including new software licenses or additional licenses of previously delivered software). Under legacy US GAAP , a customer option to purchase additional copies (or seats, users, etc.) of products licensed by and delivered to the customer under the same arrangement was not subject to the guidance for a significant, incremental discount. In contrast, under Topic 606, a customer option is an additional performance obligation if it provides the customer with a ‘material right’ that the customer e.g. a discount would not have received without entering into the contract – © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

12 Revenue for software and SaaS 10 Software and SaaS industry overview unavailable to customers that had not entered into a similar contract with the entity. Distinguishing a contractual option to acquire additional licenses of a previously delivered software product from a usage- based fee will require judgment in many cases. The following should be distinguished: an option to acquire additional rights to use the software (e.g. increased — capabilities); the acquisition of which constitutes an additional purchasing decision by the customer and requires the entity to grant those additional rights; versus — a customer’s exercise of rights that it already controls (e.g. processing transactions using the licensed software) for which the consideration is variable (i.e. in the form of a usage- based fee). Timing of revenue Revenue from licenses The software license is subject to the new licensing guidance. If a license is not distinct, an entity considers the licensing guidance in applying the general revenue recognition model to the performance obligation that includes the (e.g. in determining an appropriate measure of progress towards license complete satisfaction of the combined performance obligation that includes . the license) Topic 606 ides intellectual property ( IP) into two categories. div — Functional IP. IP that has significant stand -alone functionality – e.g. the ability to process a transaction, perform a function or task, or be played or aired. Functional IP derives a substantial portion of its utility (i.e. its ability to provide benefit or value) fro m its significant stand -alone functionality. Topic 606 states that software is functional IP, along with biological compounds or drug formulas, completed media content (e.g. films, television shows or music) and patents underlying highly functional items. Symbolic IP. IP that does not have significant stand- alone functionality and, — therefore, substantially all of the utility of symbolic IP is derived from its association with the licensor’s past or ongoing activities. Symbolic IP includes brands, trade names such as a sports team name, logos and franchise rights. Revenue attributable to a software license that is a separate performance obligation will be recognized at the point in time that the customer obtains control of the license. A customer does not obtain control of a software license before the later of (1) the point in time the customer is provided a copy of the software (or one is made available) and (2) the beginning of the license period. If a software license is not a separate performance obligation (e.g. the software license is combined with professional services), the entity will apply the general revenue recognition model to determine whether the combined performance obligation should be recognized over time or at a point in time; and, if recognized over time, what the appropriate measure of progress should be. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

13 11 Revenue for software and SaaS Software and SaaS industry overview Electronic delivery A copy of the software has been provided (or otherwise made available) to the customer when the customer: — takes possession of the software via download; has been provided with the access code (or key) that allows the customer — to take immediate possession of the software; or — has the right to request such access code (or key) at any time and the transfer of such key is effectively administrative or perfunctory. In a hosting arrangement that includes a software license, control of the license will generally be considered to have been transferred to the customer at the point in time that the hosting services commence. License renewals Consistent with revenue attributable to an initial software license, revenue attributable to a software license renewal cannot be recognized before the beginning of the renewal period. This is a change from legacy US GAAP under to a software license renewal was recognized when which revenue attributable agreed to by the parties (as long as the other revenue the renewal was recognition requirements were met). Revenue from other elements Rights to unspecified software updates or upgrades/ enhancements The timing of revenue recognition for unspec ified updates, upgrades and enhancements and professional services will be similar to that under legacy . US GAAP Software entities often provide unspecified updates, upgrades and enhancements to customers on a when- and- if available basis as long as the customers have purchased PCS. updates, upgrades and Under legacy US GAAP , the right to unspecified s wa s not considered to be a separate element of the enhancement ent; instead, it was considered part of PCS. The portio n of the fee arrangem allocated to PCS was generally recognized ratably over the term of the PCS arrangement. Under Topic 606, a promise to provide unspecified updates, upgrades and (or unspecified additional software products) is generally a enhancements stand -ready obligation to provide those items on a when- and- if available basis that is satisfi ed ratably over the PCS period. However, an entity’s customary business practice of fulfilling its promise to provide updates, upgrades or enhancements at specific points in time during the PCS period (e.g. regularly providing one updated release each year) might suggest the underlying nature of the entity’s promise is not a stand- ready obligation satisfied over time but, rather, a promise to deliver an implied number of updates or upgrades/ enhancements at discrete points in time during the contract period. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

14 12 Revenue for software and SaaS Software and SaaS industry overview Professional services Software arrangements often include both software and service elements (other than PCS -related services). The serv ices may include training, installation and/or consulting. Consulting services often include implementation support, software design or development or the customization or modification of the licensed software. Under , revenue allocated to a service element that qualified legacy US GAAP for separate accounting was recognized as services were performed; or, if no pattern of performance was discernible, on a straight -line basis over the period during which the services were performed. Under Topic 606 , entitie s must meet one of three criteria to recognize revenue over time; if none of those criteria are met, recognition occurs at a point in time. Entities providing professional services in SaaS or software licensing arrangements, either as a separate performance obligation or part of a combined performance obligation, will find in most cases that professional services meet at least one of the over -time recognition criteria. -based royalties Sales- or usage Sales based fees promised in exchange for a software license will - or usage- typically not be subject to the general guidance on variable consideration. However, exceptions may arise if the royalty is also promised in exchange for other goods or services. Software entities often enter into arrangements that include sales - or usage-based royalties. Sales- or u sage -based royalties in a software licensing arrangement contains an exception to the general guidance on variable Topic 606 consideration for sales - or usage-based royalties that are (1) promised solely in exchange for a license of IP or (2) promised in exchange for a license of IP and other goods or services when the license is the predominant item to which th e royalty relates. Topic 606 states that the license may be the predominant item “when the customer would ascribe significantly more value to the license than to the other goods or services to which the royalty rel ates.” Fees earned from the royalty in either of these cases are recognized at the later of when the subsequent sales or usage occurs, and the satisfaction or partial satisfaction of the performance obligation to which the royalty relates. In most cases, fees earned from a sales - or usage-based royalty promised in exchange for a software license that is a separate performance obligation will be recognized when the subsequent sales or usage occur. However, exceptions may arise if the royalty is also promise d in exchange for other goods or services, regardless of whether the software license is distinct. In addition, any guaranteed royalties (e.g. a fixed minimum amount) are accounted for as fixed consideration and will be recognized in the same manner as any other fixed consideration in the contract. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

15 Revenue for software and SaaS 13 Software and SaaS industry overview Royalty reporting on a lag no longer permissible legacy US GAAP , some software entities recognize d sales- or usage - Under based royalties on a ‘lag’ basis – i.e. they recognized revenue in the period subsequent to red because they do not that in which the sales or usage occur receive reporting about the royalties that the customer owes until the subsequent period. Under Topic 606, lag reporting is not permitted. If subsequent sales or usage of the entity’s software is not known, it must be estimated using the model for estimating variable consideration. Usage -based fees in a SaaS arrangement In a SaaS arrangement, the royalties exception does not apply because the arrangement does not contain a software license. Consequently, the general - and rather than the sales applies e consideration guidance in Topic 606 variabl usage-based royalties exception. Unlike , Topic 606 neither legacy US GAAP limits fees that can be recognized to only those that are fixed or determinabl e, nor precludes the recognition of contingent revenue. The new variable consideration guidance may require the SaaS provider to make an estimate of the total usage- based fees (e.g. per transaction fees) that it will earn over the course of the contract, subject to the variable consideration constraint, unless: — the ‘as -invoiced’ practical expedient can be applied that permits an entity to recognize revenue in the amount to which it has a right to invoice the customer. This applies if that amount corresponds directly with the value to the customer of the entity’s performance completed to date. A significant up-front fee or a usage- based fee rate that changes during the contract period in a manner that cannot be directly linked to a change in value of the ent ity’s services to the customer may preclude use of this expedient; or — the SaaS performance obligation is determined to be a series of distinct service periods (e.g. a series of distinct daily, monthly or annual periods of service), and allocation of the fees earned to each distinct service period based on the customer’s usage each period would reasonably reflect the fees to which the entity expects to be entitled for providing the SaaS for that period. Consistent with the as -invoiced practical expedient, a usage- based fee rate that differs from period to period during the contract may prevent allocation of the fees earned in a single distinct service period to that period, as might a discount or rebate that is based on metrics that rvice periods. However, unlike the as -invoiced cross multiple distinct se front fee generally will not affect whether this practical expedient, an up- condition is met. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

16 14 Revenue for software and SaaS Software and SaaS industry overview Combination of contracts Whether multiple contracts are combined for software and SaaS entities will be similar to legacy US GAAP in most cases. Software entities may include multiple promised goods or services in separately executed contracts with the same customer. Under legacy US GAAP , a rose as to whether the separate contracts should be accounted for question a ind whether the separate contracts were, in ividually as distinct arrangements or substance, a multiple- element arrangement subject to the revenue allocation provisions. Under Topic 606, entities are required to combine contracts if (1) the contracts are entered into at or near the same time with the same customer (or related parties) and (2) any one of three criteria is met: — the contracts are negotiated as a package with a single commercial objective; — the amount of consideration to be paid in one contract depends on the price or performance of the other contract; or — the goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation. Although this is similar to legacy US GAAP , it may result in some different conclusions about whether multiple contracts are combined for software and SaaS entities. Comparison to current software revenue guidance Legacy US GAAP software revenue guidance evaluate d whether two or more contracts between an entity and a customer should be combined and accounted for as a single arrangement based on six indicators. S ome of the one of the indicators is indicators were s imilar to the criteria in Topic 606 – e.g. that the contracts are negotiated or executed within a short timeframe of each . However, none of the six indicators is determinative, which could lead to other differences in practice under Topic 606. Comparison to current guidance applied by SaaS providers applicable to SaaS Legacy US GAAP general revenue guidance, wh ich was providers , contains a rebuttable presumption that contracts entered into at or near the same time should be combined. Because Topic 606 does not contain this presumption and additional criteria must be met, it is possible for ent ities to come to different conclusions. Contract costs Software and SaaS entities will no longer have the choice to expense commissions as incurred if certain criteria are met. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

17 Revenue for software and SaaS 15 Software and SaaS industry overview Capitalization of contract costs Software entities frequently incur either or both: — costs to obtain a customer contract, including renewal contracts and costs to obtain contract modifications, that are incremental (i.e. would not have been incurred but for obtaining the contract) – e.g. sales commissions and attributable to payment of that commission, such as fringe benefits directly additional 401(k) match or payroll taxes. Costs that are not incremental to obtaining a customer contract are expensed as incurred unless capitalized in accordance with other US GAAP. The following are not incremental costs (not exhaustive): — costs that are incurred regardless of whether the contract is obtained – e.g. costs incurred in negotiating or drafting a contract; — costs that depend on further substantive performance by the commission recipient, such as continued employment at a future date when all or a portion of the commission will be paid; and — payments based on operating metrics like EBITDA or operating income that are not solely linked to obtaining one or more customer contracts. — costs to fulfi ll a contract – e.g. costs associated with set -up activities that do not provide a service to the customer in a SaaS arrangement. Under SEC guidance related to legacy US GAAP, an entity could elect to capitalize direct and incremental contract acquisition costs (e.g. sales commissions) in certain circumstances, although many entities expense d such costs as incurred. In contrast, under Topic 606, incremental costs to obtain a customer contract and costs to fulfill a contract that meet specified criteria are required to be capitalized as contract cost assets if they are recoverable. Costs to obtain a contract are not required to be capitalized if the expected amortization period, which includes s is 12 months or less. An entity pecifically anticipated renewals, electing not to capitalize costs to obtain a contract should apply this practical expedient consistently across all of its business units or segments. The requirement to capitalize contract acquisition and fulfillment costs will be new to most software entities and some SaaS providers and may be complex to apply, especially for entities with many contracts and a variety of contract terms and commission and incentive structures. And for those SaaS providers that currently capitalize contract acquisition costs, they may find the types of costs that can be capitalized will differ because only costs that are incremental to obtaining the contract are capitalizable – allocable costs are not, unless they meet the criteria to be capitalized as fulfillment costs. Those entities that have not previously tracked the costs of acquiring a contract may find it difficult to determine which costs to capitalize, both for the transition amounts on adoption (regardless of the transition method used) and in the ongoing application of Topic 606. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

18 16 Revenue for software and SaaS Software and SaaS industry overview Amortization and impairment of contract cost assets Contract cost assets are amortized consistent with the transfer to the customer of the goods or services to which the asset relates, which means that: — if a contract cost asset relates to two or more goods or services that have a different pattern of transfer to the customer (e.g. one transferred at a point in time and another provided over time), entities should either (1) allocate the contract cost asset to those multiple goods or services on a systematic and rational basis or (2) select a single measure that best reflects the ‘use’ of the asset as the goods and services are transferred; and/or — the entity amortizes a contract cost asset over more than the contract period when the asset relates to goods or services that will be provided under an anticipated contract that the entity can identify specifically. For example, an entity will amortize a commission paid for a service contract over the contract period plus any anticipated renewal periods unless the entity also pays commissions for renewals that are commensurate with the commission paid on initial service contracts. ‘Commensurate’ refers to the commission paid as compared to the margin the entity will earn. For those SaaS providers that currently capitalize contract acquisition costs, they may find that the amortization period for those costs changes because of the Topic 606 requirement to amortize such costs over specifically anticipated renewal periods (in many cases), which precludes the current practice of cancellable contract period. amortizing such costs over only the non- Contract cost assets are assessed for impairment in accordance with specific guidance in Topic 606, which assesses the remaining balance of a contract cost asset against the remaining amount of consideration (including variable consideration) that the entity expects to receive from the customer less direct costs to fulfill the related goods or serv ices. Other considerations Extended or advanced payments Software entities often enter into arrangements where payment of a significa nt portion of the license fee is not due until after expiration of the license, or more than 12 months after delivery of the software. legacy US GAAP , the arrangement fee was presumed not to be fixed or Under determinable for those arrangements. Unless sufficient evidence existed to ome this presumption, revenue was overc generally not recognized until the payments became due and payable. Under Topic 606, extended payment terms do not preclude revenue recognition so long as collectibility of those payments is considered probable and a contract exists between the parties. Instead, such terms may indicate that there is a risk of a future price concession, which might lead to the conclusion that the transaction price is variable. In that case , the entity will need to consider whether it expects to provide a concession, and the transaction price would be subject to Topic 606’s variable consideration guidance, including the variable consideration constraint. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

19 Revenue for software and SaaS 17 Software and SaaS industry overview Where extended payment terms are granted, the entity needs to consider whether a significant financing component exists in the contract. Similarly, , hosting services or SaaS (and where a customer prepays in advance for PCS that prepayment relates to a service period greater than one year), the entity will also need to consider whether a significant financing component exists (i.e. whether there is a valid business reason for the advance payment other than the provision of financing and, if not, whether the financing component is ‘significant’ to the contract). The presence of a significant financing component in either situation would affect the amount of revenue to be recognized by the entity under the contract, with an offsetting amount of interest income (deferred payment terms) or interest expense (advanced payment terms). Whether a significant financing element exists is evaluated at the contract -level; it is not assessed at the performance obligation level or in ‘aggregate’ for the entity. Discounted or free services SaaS providers frequently offer customers free or discounted services in return for entering into longer -term SaaS contracts (e.g. the customer may receive three free or six discounted months of the SaaS service in return for entering into a three -year con tract or may receive discounted implementation services). - , arrangement consideration was limited to only non legacy US GAAP Under contingent amounts (often referred to as the ‘contingent cash cap’). That means, in a SaaS contract that provides the customer with three free or six discounted months of service or discounted implementation services, revenue recognized as those free or discounted services are provided was limited to amounts not contingent on the provision of future services. In contrast, Topic 606 does not have a contingent revenue prohibition. Therefore, SaaS providers will generally allocate additional revenues to free or discounted services provided at the outset of the arrangement compared with legacy US GAAP , which will accelerate overall revenue recognition under contract. Concessions Software entities may have a history of granting price or other concessions – e.g. free licenses or services. Under legacy US GAAP , a history of granting price or other concessions meant that the arrangement fees were not fixed or determinable. Revenue under arrangements for these entities may have been significantly deferred, even beyond the point at which cash was received, and was recognized only once the arrangement consideration was deemed to be eterminable. fixed or d Under Topic 606, because the fixed or determinable notion does not exist, a history of price or other concessions will generally not result in the complete deferral of revenue. Instead: An expectation, based on relevant history or otherwise, of a price — concession creates variability in the transaction price for a contract. The existence of variable consideration does not affect the timing of revenue recognition; instead, it affects the amount of revenue that is recognized when (or as) the entity satisfies its performance obligation(s). © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

20 Revenue for software and SaaS 18 Software and SaaS industry overview — An expectation of providing free goods or services creates additional performance obligations that are accounted for in the same manner as any other performance obligations in the contract. For example, a history of granting free technical support to customers in periods subsequent to the initial support period likely creates an additional performance obligation in the contract for the expected free support periods; therefore, a portion of the transaction price is allocated to this performance obligation and is recognized when (or as) this performance obligation is satisfied. If an entity grants a concession that was not anticipated at contract inception, that concession will be accounted for as a contract modification. Sales through distributors or resellers Many software products are sold to end customers through distributors or resellers. In that case, the entity may grant price concessions through price protection, or accept returns if the distributor is unable to sell the products. , some software entities that sell through distributors or Under legacy US GAAP that the resellers concluded fees for their software sales were not fixed or determinable because of the risk of granting price concessions or of accepting product returns. Those entities recognized revenue upon sell -through of the software to the end customer. Under Topic 606, either an expectation of price concessions or returns is accounted for as variable consideration. And because variable consideration does not affect the timing of revenue recognized from the satisfaction of a performance obligation (only the amount), software entities in distributor or reseller arrangements cannot default to a sell -through method under Topic 606. Rather, a n entity is re quired to determine the total amount of consideration to e.g. the number of units it expects not to be which it expects to be entitled – returned and the amount it expects to be entitled to, after any price concessions, for those units – subject to the variable consideration constraint. The entity recognizes that amount at the time control of the good or service transfers to the distributor or reseller. Certain repurchase rights that exist in some distributor relationships – e.g. the right of the entity to buy back a good until the point in time it is sold to an end customer – will affect when control of the good or service transfers. After control of the good or service transfers, the transaction price is updated each reporting period until the uncertainty for conc essions and returns is resolved. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

21 Revenue for software and SaaS 19 A. Scope A. Scope Questions and Examples New item added to this chapter: ** Item significantly updated in this chapter: # Scope of Topic 606 Q&A A10 How does the scoping guidance in Topic 606 apply to arrangements that include parts that are within the scope of Topic 606 and parts that are not (e.g. lease and lease- related # elements such as hardware maintenance)? Example A10.1: Partially in scope transaction ** Q&A A20 What constitutes a ‘collaborative arrangement’ and what determines whether a collaboration partner is a customer of the software entity? # Example A20.1: Collaborative arrangement that is within the scope of Topic 606 for one party but not the other party Q&A A30 Are funded software development arrangements within the scope of Topic 606? Example A30.1: Not a funded software development arrangement Example A30.2: Funded software development (1) arrangement Example A30.3: Funded software development (2) arrangement Example A30.4: Income -producing arrangement under Subtopic 730 -20 (1) Income Example A30.5: -producing arrangement under -20 (2) Subtopic 730 Example A30.6: Entity can be required to repay funding Example A30.7: Technological feasibility established before contract inception Q&A A40 Are nonmonetary exchanges of software within the scope of Topic 606? Example A40.1: Nonmonetary exchanges of software What is the accounting for an exchange of software licenses Q&A A50 between entities in the same line of business to facilitate sales to customers, or to potential customers, other than the parties to the exchange? Q&A A60 Can a n entity record proceeds received from the settlement of a patent infringement with another party as revenue? © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

22 Revenue for software and SaaS 20 A. Scope Scope of licensing implementation guidance and illustrations A70 Q&A Can the customer have a “contractual right to take possession of the software at any time during the hosting period” if no such right is explicitly provided for in the contract (or in any contract or other agreement that is combined with that contract)? Criterion (a) in paragraph 985- Q&A A80 20- 15- 5 requires the customer to have the right to take possession of the software at any time during the hosting period without significant penalty. How should entities interpret ‘at any time’ in the context of this criterion? 20 A90 Paragraph 985- -15- 6(a) explains that having the right to take Q&A possession of the software ‘without significant penalty’ includes ‘the ability to take delivery of the software without incurring significant cost’. What costs should an entity consider in determining if there is a significant penalty and what would be considered significant? What considerations should be made in determining whether Q&A A100 the customer can use the software separately from the entity’s hosting services without a significant diminution in utility or value when evaluating criterion (b) in paragraph 985-20-15-6? Example A100.1: Software license or SaaS (1) Example A100.2: Software license or SaaS (2) Example A100.3: Software license or SaaS (3) If software will be hosted on entity servers that are leased by A110 Q&A the customer, is there a software license? A120 Is the conclusion about whether a software license is present Q&A in a contract with a customer affected by the customer’s or the software entity’s use of a third- party hosting service? Example A120.1: Software license or SaaS © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

23 Revenue for software and SaaS 21 A. Scope Scope of Topic 606 General scoping considerations Topic 606 replaces substantially all previous US GAAP revenue recognition guidance, including all of the revenue recognition guidance in Topic 605, Revenue Recognition , and in Subtopic 985-605, Software – R evenue 2014-09 did However, ASU . supersede the requirements in not Recognition Subtopic 605 -35 or Subtopic 985- 605 that pertain to recognizing: type — a provision for losses on long- term construction - and production- significant production, contracts , such as contracts involving the modification or customization of software; and — a loss i f it becomes probable that the amount of the transaction price allocated to an unsatisfied or partially unsatisfied performance obligation will result in a loss on that performance obligation. to all broadly contracts to deliver goods or services to a Topic 606 applies , including contracts to license software to customers (i.e. software ‘customer’ licensing arrangements) and contracts to provide customers with ‘software-as- a- service’ (i.e. SaaS arrangements). However, a contract with a customer is outside the scope of Topic 606 if it comes under the scope of other specific in US GAAP requirements . In some cases, Topic 606 will be applied to part of a n circumstances, to a portfolio of contracts. contract or, in certai A ‘customer’ is a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration. The definition of a customer focuses on an entity’s ordinary activities. However, Topic 606 does not define ‘ordinary activities’. Instead, the B asis for Conclusions to ASU (BC53) refers to the definition of revenue from 2014-09 FASB Concepts Statement No. 6, Elements of Financial Statements (CON 6). CON 6 (paragraph 78) defines revenue as “Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operat ions.” Therefore, we ‘ordinary activities’ should be considered equivalent to term believe the ‘activities that constitute the entity’s ongoing major or central operations’. Contracts outside – or partially outside – the scope of Topic 606 Topic 606 exclud es from its scope: — lease contracts; — contracts with in the scope of Topic 944, Financial Services – Insurance ; — financial instruments and other contractual rights or obligations in the scope of other specific guidance; — guarantees (other than product or service warranties); and — nonmonetary exchanges between entities in the same line of business that facilitate sales to customers other than the parties to the exchange. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

24 Revenue for software and SaaS 22 A. Scope A contract with a customer may be partially in the scope of Topic 606 and partially in t he scope of other accounting guidance (e.g. a software licensing or SaaS arrangement that includes a lease of related hardware). If the other accounting guidance specifies how to separate or initially measure one or more parts of the contract, then the entity first applies those requirements. Otherwise, the entity applies Topic 606 to separate or initially measure the separately identified parts of the contract. Topic 606, therefore, constitutes ‘residual guidance’ Topic 606 elements from ng non-Topic 606 for separati elements within a contract and allocating consideration to those elements . the scope of That is, it is applied to the part of the contract that is not within . another Topic The following flow chart highlights the key considerations when determi ning the accounting for a contract that is partially in the scope of Topic 606 . Is contract fully in the Apply other Topics ? scope of other Topics Yes No Does the other Topic Is contract partially in Apply the other Topic to /or have separation and separate and /or initially the scope of another initial measurement Yes Yes Topi c ? measure the contract ? guidance that applies No Exclude amount initially 606 Appl y Topi c to measured under the /or initially separate and No other Topic from the measure the contract transaction price to Apply Topic 606 contract (or part of ) contract in scope Topic 606 excludes from its scope contracts with a collaborator or a partner that customer, but rather shares risks and significant with the entity the is not a benefits of participating in an activity or process. However, a contract with a is in the scope of Topic 606 if collaborator or a partner , or part of that contract, the counterparty meets the definition of a customer for part or all of the of an overall part arrangement. That is , a contract with a customer may be collaborative arrangement and Topic 606 is applied to that part. It will be important for an entity that engages in collaborative arrangements to whether the other parties to these arrangements are customers for analyze some activities. Making this assessment will require judgment and consideration of all applicable facts and circumstances of the arrangement. KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member © 2018 firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved .

25 Revenue for software and SaaS 23 A. Scope Portfolio approach generally applied to an individual contract Topic 606 and Subtopic 340-40 are with a customer. However, as a practical expedient, an entity may apply the with revenue model to a portfolio of contracts (or performance obligations) similar characteristics if the entity reasonably expects that the financial cts of applying Topic 606 or Subtopic 340-40 statement effe to that portfolio would not differ materially from applying it to the individual contracts (or -40 performance obligations) within that portfolio . Topic 606 and Subtopic 340 do not provide specific guidance on how an entity should assess whether the results of a portfolio approach would differ materially from applying the new -by-contract basis. However, t he B asis for C onclusions to guidance on a contract ASU 2014- 09 (BC69) notes that the Boards did not intend for entities, in order to use the portfolio approach, to have to quantitatively evaluate the accounting outcomes from applying a portfolio approach and not applying a portfolio approach. In some circumstances when applying Topic 606, an entity will develop estimates using a ‘ portfolio of data ’ to account for a specific contract with a ample, entities may use historical data from a population of customer. For ex similar contracts to develop estimates about future sales returns , variable consideration, or expected customer lives. Using a portfolio of data to develop is estimates required to apply the guidance in Topic 606 and Subtopic 340-40 pproach. not the same as applying the portfolio a 606-10 ASC from Excerpt 10-4 This guidance specifies the accounting for an individual contract with a customer. However, as a practical expedient, an entity may apply this guidance to a portfolio of contracts (or obligations ) with similar performance characteristics if the entity rea sonably expects that the effects on the financial statements of applying this guidance to the portfolio would not differ materially from applying this guidance to the individual contracts (or performance obligations) within that portfolio. When accounting for a portfolio, an entity shall use estimates and assumptions that reflect the size and composition of the portfolio. 15 1 The guidance in this Subtopic applies to all entities. - 15-2 An entity shall apply the guidance in this T opic to all contracts with customers , except the following: a. Leases Lease contracts within the scope of Topic 840, and Topic 842, Leases [When adopted] Contracts within the scope of Topic 944, Financial Services—Insurance. b. c. Financial instruments and other c ontractual rights or obligations within the scope of the following Topics: 1. Topic 310, Receivables 2. Topic 320, Investments —Debt Securities 2a. Topic 321, Investments —Equity Securities [When adopted] 3. Topic 323, Investments —Equity Method and Joint Ventures — Investments Topic 325, Other 4. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

26 24 Revenue for software and SaaS A. Scope 5. Topic 405, Liabilities 6. Topic 470, Debt Topic 815, Derivatives and Hedging 7. 8. Topic 825, Financial Instruments 9. Topic 860, Transfers and Servicing. d. Guarantees (other than product or service warranties) within the scope of Topic 460, Guarantees . e. Nonmonetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers. For example, this Topic would not apply to a contract between two oil companies that agree to an exchange of oil to fulfill demand from their customers in different specified locations on a timely basis. Topic 845 on nonmonetary transactions may apply to nonmonetary exchanges that are not within the scope of this Topic. An entity shall apply the guidance in this Topic to a contract (other than a 15-3 contract listed in paragraph 606- -2) only if the counterparty to the contract 10-15 is a customer. A customer is a party that has contracte d with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration. A counterparty to the contract would not be a customer if, for example, the counterparty has contracted with the entity to participate in an activity or process in which the parties to the contract share in the risks and benefits that result from the activity or process (such as developing an asset in a collaboration arrangement) rather than to obtain the output of the entity’s ordinary activities. 15-4 A contract with a customer may be partially within the scope of this Topic and partially within the scope of other Topics listed in paragraph 606- 10-15 -2. a. If the other Topics specify how to separate and/or initially measure one or more parts of the contract, then an entity shall first apply the separation and/or measurement guidance in those Topics. An entity shall exclude from the transaction price the amount of the part (or parts) of the contract that are initially measured in accordance with other Topics and shall apply 10 41 to allocate the amount of the -28 through 32- paragraphs 606- -32 transaction price that remains (if any) to each performance obligation within the scope of this Topic and to any other parts of the contract ide ntified by paragraph 606 -10-15 -4(b). b. If the other Topics do not specify how to separate and/or initially measure one or more parts of the contract, then the entity shall apply the guidance in this Topic to separate and/or initially measure the part (or pa rts) of the contract. 15-5 Subtopic 340- 40 on other assets and deferred costs from contracts with customers includes guidance on accounting for the incremental costs of obtaining a contract with a customer and for the costs incurred to fulfill a contract w ith a customer if those costs are not within the scope of another Topic (see Subtopic 340 -40). An entity shall apply that guidance only to the costs incurred that relate to a contract with a customer (or part of that contract) he guidance in this Topic. that is within the scope of t © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

27 25 Revenue for software and SaaS A. Scope 20 Glossary Customer A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration. Revenue Inflows or other enhancements of assets of an entity or settlements of its of both) from delivering or producing goods, liabilities (or a combination rendering services, or other activities that constitute the entity’s ongoing major or central operations. Pending Content Transition Date: (P) June 16, 2018; (N) December 16, 2018 ¦ Transition Guidance: 958 -10- 65-2 - 605 on not An entity shall consider the guidance in Subtopic 958- 2A 15- -for profit entities —contributions when determining whether —revenue recognition a transaction is a contribution within the scope of Subtopic 958- 605 or a transaction is within the scope of this Topic. Pending Content (P) December 16, 2019; (N) December 16, 2020 ¦ sition Transition Date: Tran Guidance: 808 -10- 65-2 15-3 ...A counterparty to the contract would not be a customer if, for example, the counterparty has contracted with the entity to participate in an activity or process in which the parties to the contract share in the risks and benefits that result from the activity or process (such as developing an asset in a collaboration arrangement) rather than to obtain the output of the entity’s ordinary activities. Comparison to legacy US GAAP Scoping of software licensing arrangements and SaaS arrangements In general, the guidance in Topic 606 applies to the same population of covered by the legacy US GAAP revenue software and SaaS contracts that is recognition guidance in Topic 605 and Subtopic 985 -605. However, unlike legacy US GAAP, under which software licensing arrangements were subject to the revenue guidance in Subtopic 985- 605 (or the guidance in Subtopic 605- 35 for arrangements that included the significant production, modification or customization of software) and SaaS arrangements were subject to the general guidance in Topic 605, all software contracts, whether software licensing arrangements or SaaS arrangements, will be guidance in subject to the requirements of Topic 606. Consequently, there is no or service and the Topic 606 on whether software is incidental to a product legacy guidance that previously distinguished software licensing arrangements from SaaS arrangements does not affect whether Topic 606 applies. However, the legacy US GAAP guidance distinguishing software licensing arrangements © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

28 Revenue for software and SaaS 26 A. Scope from SaaS arrangements (previously included in paragraphs 985- 605 -55- 119 through 55- 123, and now included in paragraphs 985 -20 -15- 5 through 15- 6) still in Topic 606 applies to affects whether the licensing implementation guidance the contract. The licensing guidance in paragraph 606- -54(a) states that a 10-55 software license is not present in a hosting arrangement that does not meet the criteria in paragraph 985- 20 -15-5. The questions in this chapter beginning with Question A70 address the application of that guidance. Accounting for contracts partially in the scope of Topic 606 The guidance on separation and measurement for contracts that are partially in the scope of Topic 606 is consistent with the legacy revenue guidance on multiple -element arrangements. Collaborative arrangements The guidance about what constitutes a ‘collaborative arrangement’ in Topic 808, Collaborative Arrangements, has not changed. Collaborative arrangements continue to be defined as arrangements where: the parties are active participants in the arrangement; and — — the participants are exposed to significant risks and rewards that depend o n the endeavor’s ultimate commercial success. The guidance in Topic 808 does not address the recognition and measurement of collaborative arrangements, while the guidance on presentation refers entities to other authoritative literature or, if there is no appropriate analogy, suggests that they apply a reasonable, rational and consistently applied accounting policy election. However, Topic 808 was amended by ASU 2014- 09 to require that parties to collaborative arrangements specifically consider whether the guidance in Topic 606 is applicable. Topic 808 did not previously require consideration of any specific revenue guidance; however, the implementation guidance in section 808- 10- 55 (Example 1) now explicitly states that an entity must consider whether the guidance in Topic 606 applies when determining the appropriate accounting for a collaborative arrangement. Question A10 # How does the scoping guidance in Topic 606 apply to arrangements that include parts that are within the scope of Topic 606 and parts that are not (e.g. lease and lease -related elements such as hardware maintenance)? that is, paragraph 606- ’ guidance – Topic 606 is ‘residual Interpretive response: -4 states that if another Topic (e.g. Topic 840 on leases) specifies how to 10-15 separate or measure one or more parts of a contract, then the entity first applies that separation or measurement guidance. Topic 606 applies only to those parts of the contract that are not within the scope of another Topic. Topic 840 provides guidance requiring the separation of lease elements, including related executory costs (which include taxes, maintenance and substantial services’ include ‘ such as operating services insurance, but do not ents or the supply of things like consumables or utilities), from non-lease elem © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

29 Revenue for software and SaaS 27 A. Scope outside of its scope. Paragraph 840-10 -15- 19 does not provide specific guidance on how to allocate arrangement consideration between deliverables within its scope and deliverables outside of its scope. Instead, it refers to the transaction -32 606-10 41 (i.e. the -28 through 32- price allocation guidance in paragraphs contract consideration should be allocated on a relative stan d- alone selling price basis, subject to the specific guidance on allocating discounts and variable consideration). Therefore, in the case of a contract that includes the transfer of a software license provision of SaaS 15 for 10- , or the 840- , and a lease ( see ASC Section guidance on identifying a lease), the contract consideration is allocated to the lease elements (which would include the hardware lease , for example, any and lease elements (e.g. a software maintenance services thereon) and the non- license a nd PCS) using the transaction price allocation guidance in Topic 606. Adoption of Topic 842 (new leases guidance) After an entity adopts Topic 842, maintenance services provided on leased in the scope of Topic 606 and therefore will not be considered a items will be lease component of the contract. This is because Topic 842 does not distinguish between maintenance services and other ‘substantial services’ as Topic 840 does; any element other than the right to use the underlying asset is outside the scope of Topic 842. Like Topic 840, Topic 842 provides guidance on separating lease from non- lease components and measuring the consideration in the contract. Paragraph 842- 10-15 -38 also refers to the transaction price allocation guidance in Topic 606 to allocate consideration to the lease and non- lease components. ASU 2018- 11 amended Topic 842 to provide lessors with a practical expedient to not require the separation of lease from non- lease components of a contract if certain criteria are met. This practical expedient is an accounting policy election that is made by class of underlying asset if the following criteria are met: — the timing and pattern of transfer to the lessee of the lease component and the non-lease component(s) associated with that lease component are the same; and — the lease component, if accounted for separately, would be classified as an operating lease. If a contract includes multiple non- lease components (one or more that meet these criteria and one or more that do not), the lessor combines those components that meet the criteria with the lease component and separately accounts for each non- lease component that does not. If the non-lease component(s) is (are) the component(s) of the predominant combined component, the lessor should account for the combined component under Topic 606 instead of the leases guidance in Topic 842. All other combined components would be accounted for under Topic 842 as a single mponent classified as an operating lease. This includes situations in lease co lease component(s) are equally significant to the which the lease and non- contract. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

30 Revenue for software and SaaS 28 A. Scope See section 4.4 of KPMG’s Handbook, Leases , for further discussion and analysis, including the disclosure requirements when the practical expedient is elected. Example A10.1** Partially in scope transaction ABC Corp . enters into a contract that includes a promise to provide video services to Customer. ABC Corp. first applies Topic 840 or equipment and SaaS Topic 842 (when adopted) to assess whether the arrangement contains a lease. Scenario 1: Topic 842 adopted ABC Corp. has adopted Topic 842 and determines that: — use of the video equipment represents an operating lease; and the timing and pattern of transfer of the lease is the same as the S aaS — services. elects to apply the practical expedient, and accounts for the lease ABC Corp. and S services combined under Topic 606 as Customer can reasonably aaS expect to ascribe more value to the S aaS services (non -lease component) than to the video equipment (lease component) (i.e. the guidance in paragraph 842- 10-15 -42B) . Scenario 2: Practical expedient not elected / Topic 842 not adopted ABC Corp. elects not to apply the practical expedient in Topic 842 (or ABC Corp. has not yet adopted Topic 842), and therefore accounts for the video equipment lease under the applicable leasing guidance (Topic 842 or Topic 840). first applies the guidance to identify the lease applicable leasing ABC Corp. component and then applies the transaction price allocation guidance in Topic 606 to allocate consideration between the lease and non- lease components. Lastly, ABC Corp. accounts for the allocated consideration for the leased video equipment under Topic 840 and the or Topic 842 (when adopted) SaaS services under Topic 606. concludes that the video equipment is not leased, then it accounts If ABC Corp. could entire contract under Topic 606. In applying Topic 606, ABC Corp. for the providing the equipment is distinct from providing the services (see find that – Step 2: Identify the performance obligations in the contract Chapter C ). © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

31 Revenue for software and SaaS 29 A. Scope A20 # Question What constitutes a ‘collaborative arrangement’ and tner is what determines whether a collaboration par a customer of the software entity? from ASC 808-10 Excerpt 20 Glossary Collaborative Arrangement A contractual arrangement that involves a joint operating activity (see paragraph 808- 10-15 -7). These arrangements involve two (or more) parties that meet both of the following requirements: a. They are active participants in the activity (see paragraphs 808 -10 -15- 8 through 15- 9). They are exposed to significant risks and rewards dependent on the b. commercial success of the activity (see paragraphs 808 10 through 15- -10- 15-13). 15 Scope and Scope Exceptions Joint Operating Activity The joint operating activities of a collaborative arrangement might involve 15-7 joint development and commercialization of intellectual property, a drug candidate, software, computer hardware, or a motion picture. For example, a joint operating activity involving a drug candidate may include research and development, marketing (including promotional activities and physician detailing), general and administrative activities, manufacturing, and distribution. However, relate to intellectual there may also be collaborative arrangements that do not property. For example, the activities of a collaborative arrangement may involve joint operation of a facility, such as a hospital. A collaborative arrangement may provide that one participant has sole or primary responsibility for certain activities or that two or more participants have shared responsibility for certain activities. For example, the arrangement may provide for one participant to have primary responsibility for research and development and another participant to have primary responsibility for commercialization of the final product or service. Active Participation Whether the parties in a collaborative arrangement are active participants 15-8 will depend on the facts and circumstances specific to the arrangement. Examp les of situations that may evidence active participation of the parties in a collaborative arrangement include, but are not limited to, the following: a. Directing and carrying out the activities of the joint operating activity b. Participating on a steering committee or other oversight or governance mechanism Holding a contractual or other legal right to the underlying intellectual c. property. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

32 Revenue for software and SaaS 30 A. Scope 15 - 9 An entity that solely provides financial resources to an endeavor is generally not an active participant in a collaborative arrangement within the scope of this Topic. Significant Risks and Rewards 15- 10 Whether the participants in a collaborative arrangement are exposed to significant risks and rewards dependent on the commercial success of the joint operating activity depends on the facts and circumstances specific to the arrangement, including, but not limited to, the terms and conditions of the arrangement. 15- 11 The terms and conditions of the arrangement might indicate that participants are not exposed to significant risks and rewards if, for example: Services are performed in exchange for fees paid at market rates. a. b. A participant is able to exit the arrangement without cause and recover all (or a significant portion) of its cumulative economic participation to date. c. Initial profits are allocated to only one participant. d. There is a limit on the reward that accrues to a participant. 12 Other factors that shall be considered in evaluating risks and rewards 15- include: a. The stage of the endeavor's life cycle b. The expected duration or extent of the participants' financial participation in the arrangement in relation to the endeavor's total expected life or total expected value. 15 - 13 Many collaborative arrangements involve licenses of intellectual property, and the participants may exchange consideration related to the license at the inception of the arrangement. Such an exchange does not necessarily indicate that the participants are not exposed to significant risks and rewards dependent on the ultimate commercial success of the endeavor. An entity shall use judgment in determining whether its participation in an arrangement subjects it to significant risks and rewards. Pending Content (P) December 16, 2019; (N) December 16, 2020 ¦ Transition Transition Date: Guidance: 808 -10- 65-2 15- 5A A collaborative arrangement within the scope of this Topic may be partially within the scope of other topics, including, but not limited to, Topic 606 on revenue from contracts with customers. rangement is partially in scope of Topic 606, if a unit of 15- 5B A collaborative ar account, identified as a promised good or service (or bundle of goods or services) that is distinct within the collaborative arrangement using the -1 9 through 25- -25 22, is with a guidance in paragraphs 606 -10-15 -4 and 606-10 . An entity shall apply the guidance in Topic 606 to a unit of account customer that is within the scope of that Topic, including the recognition, measurement, presentation, and disclosure requirements. If a portion of a distinct bundle of goods or services is not with a customer, the unit of account is not within the scope of Topic 606. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

33 Revenue for software and SaaS 31 A. Scope Software entities frequently enter into arrangements Interpretive response: that are described as ‘collaborative arrangements’. Topic 606 excludes from its scope contracts with a collaborator or a partner that is not a customer , but rather , instead, has contracted with the entity to share in the risks and benefits that result from the collaborative activity or process rather than to obtain an output of the entity’s ordinary activities. If an entity’s activities in a collaborative the entity should apply the arrangement are not within the scope of Topic 606, guidance in Topic 808. That guidance does not address the recognition and measurement of collaborative arrangements. However, the guidance on presentation refers entities to other authoritative literature or, if there is no appropriate analogy, states that they apply a reasonable, rational and consistently applied accounting policy election. Therefore, it will be important for a software entity to determine whether : — an arrangement is a ‘collaborative arrangement’; and is a ‘ or a partner a collaborator ’ for any portion of the customer — . arrangement Even if the arrangement is a ‘collaborative arrangement’, if the collaborator is a customer for some or all of the contract, the entity’s activities related to transferring goods or services that are an output of its ordinary activities are revenue- generating and within the scope of Topic 606. The guidance in Topic 808 defines a collaborative arrangement, while Topic 606 defines a ‘customer’. Has the party contracted with the entity to obtain ’s goods or services that are an output of the entity ? ordinary activities in exchange for consideration No Yes Customer Not a customer Note : Ordinary activities are considered an entity ’s ongoing major or central operations 6] [CON Whether an arrangement is a collaboration and whether a party in a collaborative arrangement meets the definition of a customer is judgmental and will depend on the facts and circumstances of the arrangement. The Basis for Conclusions to ASU 2014- 09 (BC54 ) provides examples of arrangements for which the facts and circumstances will affect whether the arrangements are collaborations , but does not conclude as to whether they are or are not): © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

34 Revenue for software and SaaS 32 A. Scope — collaborative research and development efforts between biotechnology and pharmaceutical entities or similar arrangements in the aerospace and defense, technology, and healthcare industries, or in higher education; — arrangements in the oil and gas industry in which partners in an offshore oil to each other to settle any differences and gas field may make payments between their proportionate entitlements to production volumes from the field during a reporting period; and arrangements in the not — -for -profit industry in which an entity receives grants and sponsorship for research activity and the grantor or sponsor may specify how any output from the research activity will be used. 18: Clarifying the Interaction between Topic 808 and Topic 606 ASU 2018- ASU 2018- 18 was issued in November 2018 and clarifies that certain s between collaborative partners should be accounted for as revenue transaction under Topic 606 when the collaborative partner is a customer. This clarification is consistent with the view expressed above which we believe is also an prior to appropriate application of the guidance in Topic 606 and Topic 808 adoption of this ASU . The ASU also specifies that the determination of whether there is a customer i.e. relationship is made in the context of a unit of account ( a distinct good or service). Topic 606 guidance, including recognition, measurement, presentation and disclosure requirements, is applied to the unit of account where the collaboration partner is a customer. When a portion of a bundled unit of account (i.e. a bundle that includes multiple promises that are not individually distinct) is not with a customer the entire unit of account is not in the scope of Topic 606. For those collaboration arrangements or aspects of the arrangement that are in the scope of Topic 808 but are not in the scope of Topic 606, an entity may (but is not required to) analogize to the recognition and measurement guidance in Topic 606. If an entity analogizes to Topic 606, it should not present the related revenue together with revenues from contracts with customers that are directly in scope of Topic 606. A20.1 Example Collaborative arrangement that is within the scope of Topic 606 for one party but not the other party A software entity and an equipment manufacturer enter into an arrangement to jointly develop software to power a new class of consumer product that the equipment manufacturer will then produce and sell to customers. The entities will both actively participate in the development of the software (e.g. both participate in a joint development committee that is responsible for outlining required specifications for the software and in testing the software in various prototypes of the new consumer product) and will jointly share in the research and development costs of the new software, and, if successful, share in the profi ts from sales of the new consumer product that uses the software. The software entity will own the IP, and have the right to license it to other customers for applications that do not compete with the equipment manufacturer’s product, while the equipment manufacturer will obtain a perpetual license to the IP. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

35 Revenue for software and SaaS 33 A. Scope Based on these facts and circumstances, both entities conclude that the arrangement is a ‘collaborative arrangement’. However, the two entities reach is in the scope of different conclusions about whether the arrangement 606: Topic — The software entity’s ordinary activities include developing and licensing software; and therefore, the equipment manufacturer, in contracting to obtain a perpetual license to the software entity’s software, is contracting to obtain an output of the software entity’s ordinary activities. Thus, the equipment manufacturer is a customer and the software development and licensing aspects of this contract are within the scope of Topic 606 for the software entity. Software entities receiving funding in these types of arrangements should analyze the guidance related to funded software development arrangements as discussed in Question A30. The equipment manufacturer will participate in the development of — software that the software entity will own at the conclusion of the collaboration. The equipment manufacturer does not, as part of its ordinary activities, engage in software development or sell software (or other IP) to other parties. Consequently, the equipment manufacturer concludes that its services, as part of the collaboration, to assist the software entity in developing the software are not within the scope of Topic 606. It should be noted, however, that once the product is developed, the equipment manufacturer’s sales of equipment will be within the scope of Topic 606. A30 Question Are funded software development arrangements within the scope of Topic 606? Excerpt from ASC 730-20 15- 1A This Subtopic also applies to software- development arrangements that are fully or partially funded by a party other than the vendor that is developing the software and for which technological feasibility of the computer software 20 on software has 985- the provisions of Subtopic product in accordance with not been established before entering into the arrangement. Those arrangements typically provide the funding party with some or all of the following benefits: a. Royalties payable to the funding party based solely on future sales of the product by the software vendor (that is, reverse royalties) b. Discounts on future purchases by the funding party of products produced under the arrangement A nonexclusive sublicense to the funding party, at no additional charge, for c. up nonexclusive the use of any product developed (a prepaid or paid- sublicense). © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

36 Revenue for software and SaaS 34 A. Scope from ASC 985-20 Excerpt 25- 12 A funded software -development arrangement within the scope of Subtopic 730 -20 shall be accounted for in conformity with that Subtopic. If the technological feasibility of the computer software product pursuant to the provisions of this Subtopic has been established before the arrangement has been 20 does not apply because the arrangement is not a entered into, Subtopic 730- research and development arrangement. If capitalization of the software- development costs commences pursuant to this Subtopic and the funding party is a collaborator or a partner, any income from the funding party under a funded software -development arrangement shall be credited first to the amount of the development costs capitalized. If the income from the funding party exceeds the amount of development costs capitalized, the excess shall be deferred and credited against future amounts that subsequently qualify for capitalization. Any deferred amount remaining after the project is completed (that is, when the software is available for general release to customers and capitalization has ted to income. If the counterparty is a , the entity customer ceased) shall be credi from shall apply the guidance of Topic 606 on revenue contracts with customers. -development arrangements that are fully or partially funded For software 60-3 by a party other than the vendor that is developing the software and for which technological feasibility of the computer software product has not been 730 on -20 established before entering into the arrangement, see Subtopic research and development arrangements. It depends. The entity would have to consider both: (1) Interpretive response: whether the arrangement should be accounted under Subtopic 730 -20, —Research and Development Arrangements Research and Development 730-20) and (2) whether the funding party meets the definition of a (Subtopic 20 paragraphs 985- -25 customer. If technological feasibility (see -2 and 985-20 - 55-4 through 55 -9) of the related software product has not been established before commencement of a funded software- development arrangement, the guidance in Subtopic 730- 20 should be evaluated. Subtopic 730-20 would not entering into the apply if technological feasibility is achieved before arrangement because the arrangement is not a research and development arrangement . In addition, Subtopic 730-20 would 12) ( see paragraph 985- 20 -25- not apply where the entity does not have the right to retain or acquire the results of the funded software- development arrangement. Under Subtopic 730 -20, all or portions of the funding proceeds are considered to be either: (1) a liability to the funding party or (2) an agreement to provide services. The determination is dependent on whether the entity has an obligation (either implied or stated) to repay the funding regardless of the outcome of the research and development activities. If a funded software development arrangement is determined to be a service arrangement (i.e. the entity's obligation is to perform research and development services, rather than a debt obligation to the funding party), regardless of whether based on the guidanc e in Subtopic 730- 20 (i.e. where the arrangement is not in the scope of if -20 for either reason outlined above), then Topic 606 would apply Subtopic 730 ’. customer the funding party meets the definition of a ‘ © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

37 Revenue for software and SaaS 35 A. Scope Topic 606 does not apply to contracts with parties to a contract that are not customers such as partners or some collaborators with the entity in developing . Whether the funding party meets the A20) Question goods or services (see definition of a customer is judgmental and will likely depend on the facts and circumstances of the funded software development arrangement. Consider the following two scenarios: Scenario 1 to Software Entity X receives funding from a third party (funding party) develop a software application to map out the locations of oil and natural gas deposits. The third party will obtain a nonexclusive, perpetual license to the software and intends to embed that software as a module into its enterprise resource planning (ERP) software for sale to oil and gas producing entities. In addition to the research funding that it does not have to repay, Software Entity X will also receive future royalties on the third party’s sales of its ERP software that includes Software Entity X’s module. Since Entity X is in the business of developing and licensing software to is contracting to provide Entity X concludes in this scenario it third parties, its ‘ ordinary activities’ software and services that are an output of ; and re therefore, the funding party is a customer. This funded softwa development arrangement should be accounted for by Software Entity X in accordance with Topic 606, which will include reporting any funding received ahead of the entity’s performance in fulfilling its performance . We believe this would be obligation(s) in the contract as a contr act liability the appropriate conclusion even if Software Entity X doesn’t normally develop mapping software or develop software for oil and gas entities. We believe ‘ ordinary activities’ would apply to the broader consideration that Software Entity X is in business as a software developer that licenses software to third parties. Scenario 2 party to develop a Equipment Entity Y receives funding from a third software application to be used in semiconductor research. Equipment it puts forth ‘best efforts ’ in Entity Y does not have to repay the funding if the research and development. Equipment Entity Y will own the developed software, while the funding party will receive a perpetual license to that software. Both parties intend to use the developed software to increase their research efficiency. Equipment Entity Y is not a software developer, ; however, both parties nor has it licensed software to customers previously have agreed that, subject to their joint approval, they would license this affect their application of software to another party if it would not negatively the software. In such case, they would split any license fees earned on a 50/50 basis. The funding party is determined to be a collaboration partner, rather than a customer, in this fact pattern because Equipment Entity Y’s ordinary activities do not include the development and licensing of software. We believe this would be the appropriate conclusion even if Equipment Entity Y had entered into a similar transaction in the past; engaging in an activity on more than one occasion would not in and of itself create a presumption that ordinary pattern an activity is ‘ ’ for that entity. We believe a of such transactions could call into question whether the funding party is a © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

38 36 Revenue for software and SaaS A. Scope customer even if Equipment Entity Y’s ‘ primary ’ activities were semiconductor research and development and licensing the results of those efforts. uestion A20 As discussed in Q is , in circumstances where the funding party partner in a ‘collaborative arrangement’ , Topic 808 provides determined to be a income statement presentation guidance for collaborative arrangements. However, because Topic 808 does not provide recognition and measurement guidance for collaborative ar rangements , the entity will have to apply a reasonable, rational and consistent accounting policy for such arrangements . arrangements f development unded or software Decision tree for a nalyzing funded by o thers partially Arrangement is not Is arrangement funded partially or entirely by a funded software No . ? development arrangement others Yes Does entity retain results of — Account for arrangement or does it have arrangement under an option to acquire results No as one to 606 Topic ? of arrangement transfer software and / or provide software development services . — Account for software development costs -20, 985 per Subtopic unless they relate to a Yes contract to deliver /software software . system Has technological feasibility See been established before Part B arrangement was entered No ? into Yes Proceeds from funding Is contract with party are : a customer ? No — offset first against Subtopic -20 985 capitalized costs , and Yes second against excess deferred and ; capitalizable costs Recognize revenue based and 606 on guidance in Topic . any remaining — Account for software deferred amount is development costs per credited to income Subtopic 985 -20, unless upon c om pl eti on of they are accounted for as project . contract costs per [985 -20-25-12] Subtopic -40. 340 and the U.S. member firm of the KPMG network of independent member KPMG LLP, a Delaware limited liability partnership © 2018 . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

39 Revenue for software and SaaS 37 A. Scope From Par t A Account for arrangement as — contract to transfer a software Evaluate accounting for proceeds /or provide software license and received under funding arrangement . development services -20: 730 based on guidance in Subtopic — Recognize revenue based on the Does entity have implied or stated . 606 guidance in Topic No obligation to repay all or a portion of Account for software development — the funding regardless of outcome of costs per Subtopic 985 -20, unless arrangement ? they relate to a contract to deliver software /software system Yes Note : If entity does not automatically Record funding proceeds with — retain results of software development stated or implied repayment arrangement , but subsequently obligation as liability to funding exercises an option to purchase results . par ty of arrangement from funding party , the Account for funding proceeds not — nature of those results and their future subject to repayment as payment use determines the accounting for the for software license and /or purchase . Consider the guidance in . software development services – 55-14. -20-55-13 paras 985 Recognize payments in — 606 (if accordance with Topic counterparty is customer ) or other (e.g . Topic 808 if the US GAAP counterparty is collaborator or par tner ). Account for software development — costs per Subtopic -20, unless 985 they relate to a contract to deliver software /software system others? ntirely by partially or e funded rrangement Is the a receives funds from a third party to be used in performing If a software entity software -development activities, the nature and terms of the arrangement should be analyzed to determine the appropriate accounting for the , it is arrangement. If the arrangement is funded entirely by the software entity not subject to the guidance in this section (i.e. it is not a funded software- developed arrangement). esults of the a Does the software entity r etain the r rrangement or d oes it those acquire ption to have an o results? If the software entity does not retain or have the right to acquire the results of the funded software -development arrangement and the financial risk associated with the arrangement rests solely with the funding parties, the arrangement -development services. would be treated as a contract to perform software the results of the retains , or has the right to acquire, If the software entity development arrangement, depending on whether funded software- technological feasibility had been established before the arrangement was KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member © 2018 . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

40 Revenue for software and SaaS 38 A. Scope or paragraph 985-20 -25 entered into, either the guidance in Subtopic 730- 20 -12 20 provides guidance for would apply to the arrangement. Subtopic 730- (1) has an obligation to repay the funding parties or (2) determining if the entity has an income- producing contra ct to transfer a software license and/or perform research and development services for others. Example A30.1 Not a funded software development arrangement ABC Corp., a systems integrator, entered into an arrangement to customize Customer’s -specific functionality requirements. software based on certain entity The customized software developed by ABC under this arrangement is the property of Customer, and ABC does not have any rights to obtain the software that is developed as part of this engagement. development ABC does not have the right to acquire the results of the software- arrangement, and the financial risk associated with the arrangement rests solely with the funding parties, so the arrangement should be accounted for as a contract to perform software -development services (i.e. it is not a funded software -development arrangement). Example A30.2 Funded software development arrangement (1) ABC Corp. entered into an arrangement to develop a new networking software application for Customer. The software developed by ABC under this arrangement is the property of ABC and can be marketed to other customers of ABC in the future. the results of the software- development arrangement, so the ABC is entitled to development arrangement should be accounted for as a funded software- arrangement pursuant to the guidance in Subtopic 730 -20 or paragraph 985- 20- 25-12, depending on whether technological feasibility of the software had been established at inception of the arrangement. Example A30.3 Funded software development arrangement (2) ABC Corp. entered into an arrangement to develop a new data mining software application for Customer. The software developed by ABC under this arrangement is the property of ABC and can be marketed to other customers of ABC in the future. Customer will receive a royalty equal to 3% of all future sales of the software product developed by ABC under this arrangement. ABC is entitled to retain the results of the software- development arrangement in exchange for future royalties to Customer, so the arrangement should be development arrangement pursuant to the accounted for as a funded software- © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

41 39 Revenue for software and SaaS A. Scope guidance in Subtopic 7 30- 20 or paragraph 985- 20 -25 -12, depending on whether technological feasibility had been established at inception of the arrangement. established been feasibility before the Has technological arrangement was e ntered into? If technological feasibility, as defined in Subtopic 985- 20, Software – Costs of Software to be Sold, Leased, or Marketed , has been established before the arrangement is entered into, Subtopic 730- 20 does not apply because the arrangement is not a research and development arrangement. In that situation, paragraph 985- 20-25 -12 would apply and the accounting model would be based the on whether the contract is with a customer as discussed further below. If contract is with a customer, Topic 606 would govern the accounting for the arrangement. If technological feasibility has not been established before a funded software- development arrangement is 20 applies to the entered into, Subtopic 730- arrangement. Is the contract with a customer? Topic 606 does not apply to contracts with parties to a contract that are not customers, such as partners or collaborators with the entity in developing goods or services to be sold to customers that are not, themselves, customers (see Q uestion A20). If the contract is not with a customer, paragraph 985- -25- 12 requires that the 20 proceeds from the funding parties first be offset against any costs capitalized for the related software pursuant to Subtopic 985- 20. To the extent that the proceeds from the funding parties exceed the software- development costs capitalized, the excess would be deferred and credited against future capitalizable costs. Any remaining deferred amount would be credited to income upon completion of the development activities (i.e. when the software is available for general release to customers). If the contract is with a customer, paragraph 985- -25 -12 states that the entity 20 should apply the guidance of Topic 606 on revenue from contracts with customers. Software development costs should be accounted for in accordance with Subtopic 985-20, unless such costs are accounted for as contract costs under Topic 606. all or a p Is the software entity o bligated to repay ortion of the funding? If a software entity enters into a funded software- development arrangement subject to the provisions of Subtopic 730- 20 (i.e. because technological feasibility of the software was not established at inception of the arrangement), that arrangement is accounted for as either (1) a liability to the funding party or or provide software (or a software license) (2) an arrangement to transfer -development services. If the enterprise may be obligated to repay any software amounts to the funding party regardless of the outcome of the software- development arrangement, the software entity ognize should estimate and rec © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

42 Revenue for software and SaaS 40 A. Scope that liability as a debt obligation. This requirement applies regardless of whether the software entity can settle its obligation by paying cash, issuing securities or by other means (e.g. transferring other assets). The following are examples of funded software- development arrangements that contain an obligation to repay amounts to the funding party regardless of the outcome of the software development . — The software entity guarantees repayment of the funds, regardless of the the software development. outcome of — The funding party can require the software entity to purchase its interest in the software development, regardless of the outcome. — The funding party is entitled to receive debt or equity securities of the software entity upon completion of the software development, regardless of the outcome. In some cases, conditions related to the arrangement may indicate that the software entity does not transfer the financial risk of the research and -development agreement does development, even though the funded software not explicitly require repayment of funded amounts. If those conditions suggest that it is probable that the software entity will repay any of the funds regardless of the outcome of the software development, there is a presumption that the enterprise has an obligation to repay the funding party. This presumption can be overcome only by substantial evidence to the contrary. Conditions leading to may be obligated to repay the funding the presumption that the software entity party include the following. The software entity — has indicated its intent to repay all or a portion of the development activities. funding regardless of the outcome of the software- — The software entity would incur a severe economic penalty if it did not repay all or a portion of the funding regardless of the outcome of the -development activities. software — A significant related party relationship exists between the software entity and the funding party. — The software entity has essentially completed the entire development effort before entering into the arrangement. significant related As indicated in the preceding paragraph, the existence of a party relationship between the enterprise and the parties funding the research and development creates a presumption that the enterprise will repay the funds provided by other parties under a research and development arrangement. Paragraph 730-20 -S99- 1 clarifies the SEC’s view that a significant related party -20 relationship exists for purposes of applying the guidance in Subtopic 730 when related parties of the entity receiving the funds own 10% or more of the Paragraph 730-20 -S99-1 also specifies that the entity providing the funds. presumption that funding will be repaid cannot be overcome by evidence that the entity receiving the funds does not have the resources to repay those amounts based on its current and expected future financial condition. Additionally, the SEC has taken the position that funds received in research and development arrangements from a related party should be accounted for as a : liability (i.e. the presumption of repayment cannot be overcome) if the registrant is required to make royalty payments to the related funding — party based on its revenues as a whole and not just on the revenues stemming from the products developed with funds provided by the funding ; or party © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

43 41 Revenue for software and SaaS A. Scope — the registrant has an option, other than a fair value purchase option, to acquire the results of the research and development arrangement. that incurs a liability to r A software entity epay funding parties in connection with a development arrangement should account for the related software - 20 (i.e. in the same manner development costs in accordance with Subtopic 985- as software development costs incurred absent the funding arrangement). If the aggregate proceeds to be received under a funded- development arrangement will exceed the liability for the software entity ’s repayment obligation to the funding party, paragraph 730-20 -25-7 requires that the entity recognize its portion of the resea rch and development expense in the same manner as the liability to the funding party is incurred (e.g. as the initial funds are expended or on a pro rata basis). If technological feasibility of the software is established subsequent to the inception of the funding arrangement, we believe the guidance in Subtopic 730 -20 and Subtopic 985-20 should continue to be applied, rather than the guidance in paragraph 985- 20-25 -12 . involving under recognition funded Income arrangements development software If technological feasibility has not been established before a funded software- development arrangement is entered into and the software entity cannot be obligated to repay any amounts to the funding party regardless of the outcome of the research arrangement (i.e. any repayment provisions depend solely on the results of the research and development having a future economic benefit), the entity should account for the arrangement as an obligation to transfer tware -development services. software (or a software license) and/or perform sof consideration should be recognized in income based As such, the arrangement on the provisions of Topic 606 (if the counterparty is a customer) or Topic 610 (if the entity will be transferring a nonfinancial asset – i.e. the software or a license to the software – to a non-customer) , in the same manner as arrangements that do not involve the receipt of proceeds from a customer before completion of the related product development. If technological feasibility has not been established before a funded software- development arrangement is entered into and the aggregate proceeds to be -development arrangement will exceed the software received under the funded entity guarantees ’s liability to the funding party (e.g. the software entity repayment of only a portion of the funding regardless of the outcome of the research and development), the excess proceeds should be accounted for in the same manner as the arrangement consideration in the preceding paragraph. funds credited to Income statement presentation f or income arrangements under funded software -d evelopment It is necessary to consider all relevant factors when determining the appropriate income statement presentation for funding amounts that are recognized as income. Funding amounts recognized as income should be presented as ’s financial statements if the counterparty is a revenue in the software entity . However, in other situations, funding amounts recognized as ‘customer’ if the entity concludes income should be presented as other operating income the arrangement is for the sale of a nonfinancial asset to non- s or as a customer © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

44 Revenue for software and SaaS 42 A. Scope reduction of research and development expense (e.g. in certain collaboration . scenarios) Example A30.4 Income -producing arrangement under Subtopic 730 -20 (1) ABC Corp. is developing a new human resources software application (Product X). Before development was complete, ABC entered into a perpetual license agreement with Customer to license software Product X for $1,000,000, due at inception of the arrangement. Product X will be delivered to Customer upon its general release. Additionally, Customer will receive a royalty equal to 3% of all future sales of Product X by ABC. In addition: ABC cannot be obligated to repay any amounts to Customer other than the — 3% royalty regardless of the outcome of the research arrangement (i.e. the future royalty payments depend solely on the results of the research and development having a future economic benefit). — ABC retains the results of the development arrangement (Product X) and technological feasibility of Product X has not been established. Product X is currently in development and it will be made available for — general release concurrently with its delivery to Customer. Because ABC retains the results of the development arrangement and 20 should be technological feasibility has not been established, Subtopic 730- applied. Further, because ABC cannot be obligated to repay any amounts to Customer regardless of the outcome of the research and development, ABC should account for the arrangement as a contract to transfer a license to Product X, when available, in accordance with Topic 606. ABC should account for the software -development costs in accordance with Subtopic 985-20, Software – Costs of Software to be Sold, Leased, or Marketed (i.e. in the same development costs incurred absent the funding manner as software- arrangement). Royalties payable to Customer under this arrangement should be recognized as incurred (i.e. when Product X is licensed to third parties). Example A30.5 Income -producing arrangement under Subtopic 730 -20 (2) ABC Corp.’s current product roadmap (development plan) documents ABC’s intent to develop additional features and functionality for a future version of its existing data storage software (Product X); however, development of such features has not yet commenced. ABC enters into an arrangement with Customer to license its existing software Product X on a perpetual basis and to perform significant customization services to develop additional features and functionality, including certain of the features included in ABC’s current development plan, as well as additional features specifically desired by Customer. The arrangement consideration is $1,000,000, due at inception. ABC i.e. the software – retains the intellectual property (or IP) – resulting from the © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

45 Revenue for software and SaaS 43 A. Scope arrangement with Customer; however, Customer will receive a royalty equal to 3% of all future sales of subsequent versions of Product X that contain features and functionality developed under this arrangement. At inception of the arrangement with Customer, technological feasibility had not been established software to be delivered under this arrangement or for either the customized for the next version of Product X. ABC cannot be obligated to repay any amounts to Customer. ABC believes the development work performed under the arrangement with Customer will expedite development of the next version of Product X containing the features and functionality identified in ABC’s current development plan. However, certain of the customized features to be developed under this arrangement are unique to Customer and will not be incorporated in a future version of Product X. ABC believes that the next version of Product X containing certain of the features and functionality to be developed under the arrangement with Customer, as well as additional features identified in ABC’s development plan, will be available for general release within months after completion of the arrangement with Customer. Absent the six arrangement with Customer, ABC believes it would have taken several months longer to release the next version of Product X. ABC (1) retains the IP resulting from the arrangement with Customer, (2) software has not been established customized technological feasibility of the before the arrangement was entered into, and (3) the software entity cannot be obligated to repay any amounts to the funding party regardless of the outcome of the research arrangement (i.e. the future royalty payments depend solely on the results of the research and development having a future economic benefit). Therefore, the entity should account for the arrangement as an obligation to transfer a software license and perform software- development services. Although this arrangement encompasses development of features that are in ABC’s development plan, it also includes development of features that are not in ABC’s development plan, the next version of Product X is not expected to be released until six months after completion of the arrangement with Customer, and the next version of Product X will contain features and functionality that are arrangement. in connection with this not being developed Because the counterparty in this contract is a customer, the consideration of $1,000,000 paid to ABC by Customer should be recognized as revenue based on the guidance in Topic 606. The software development costs shoul d be accounted for as costs to fulfill the contract with Customer as enumerated in 20-15 -3. paragraph 985- Royalties payable to Customer under this arrangement should be recognized as incurred (i.e. when Product X is licensed to third parties). A30.6 Example Entity can be required to repay funding ABC Corp. is developing a new human resources software application (Product X). Before development was complete, ABC entered into a perpetual license arrangement with Customer to license software Product X for $1,000,000, due at inception of the arrangement. Product X will be delivered to Customer upon its general release. Additionally, Customer will receive a royalty © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

46 Revenue for software and SaaS 44 A. Scope equal to 3% of future sales of Product X by ABC for a three- year period. Technological feasibility of Product X has not been established as of the inception of the arrangement. If ABC has not paid at least $1,000,000 in royalties to Customer after three years, ABC must pay Customer the difference between $1,000,000 and the actual royalties that were paid during the three- year period. ABC retains the results of the research and development arrangement (Product X) and technological feasibility has not been established, so Subtopic 730 -20 should be applied. ABC can be obligated to repay amounts to Cust omer up to $1,000,000 regardless of the outcome of the research arrangement (i.e. Customer is guaranteed at least $1,000,000). As such, ABC should account for the funding proceeds as a liability to the funding party. That liability should be reduced in future periods as royalty payments are made. ABC should account for software- development costs in accordance with development costs 985 Subtopic -20 (i.e. in the same manner as software- incurred absent the funding arrangement). Example A30.7 Technological f easibility established before contract inception -management software application ABC Corp. is developing a new inventory (Product A). Technological feasibility has been established for Product A, and $50,000 of software- development costs have been capitalized pursuant to Subtopic 985 -20. On November 15, 20X5, Product A is expected to be made available for general release to customers, at which time capitalization of development costs will cease. On October 15, 20X5, ABC entered into an arrangement with XYZ (who is not a customer) to license Product A for $200,000 due at inception of the contract. As consideration for entering into the license before development is complete, Entity is entitled to a royalty equal to 3% of all future sales of Product A by ABC, up to a maximum of $200,000. ABC cannot be obligated to pay any amounts to Entity other than the 3% royalty. ABC retains the results of the research and development arrangement (Product A) and technological feasibility has been established, so para graph 985- 20- 25-12 should be applied. ABC should apply $50,000 of the arrangement fee to reduce the existing capitalized development costs for Product A to zero and should record the remaining $150,000 of the fee as a deferred credit. That deferred credit should be applied as a reduction of future Product A development costs that qualify for capitalization under Subtopic 985- 20. Any remaining credit at completion of Product A development (i.e. upon general release of the software) should be recorded in income at that time. Therefore, if ABC incurred an additional $40,000 of development costs on Product A before general release, $40,000 of the deferred credit would be offset against those capitalizable costs al release of Product A. and $110,000 would be credited to income upon gener Royalties payable to Customer under this arrangement should be recognized as incurred (i.e. when Product A is licensed to third parties). Alternatively, if ABC had a similar arrangement with a customer, ABC would account for the arrangement in accordance with the guidance in Topic 606. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

47 45 Revenue for software and SaaS A. Scope software - unded Accounting for the a cquisition of r esults of f development arrangements If the software entity does not automatically retain the results of the arrangement (i.e. the intellectual property developed), but subsequently exercises an option to purchase the results of the software development from the funding party, the nature of those results and their future use should determine the accounting for the purchase transaction. When making that determination, we believe the guidance on accounting for purchased software -55 -14 should be considered. in paragraphs 985- 20 -13 and 55 Comparison to legacy US GAAP 20 with respect to -20 and the provisions of Subtopic 985- Subtopic 730 determining whether software was technologically feasible were not changed. As a result, the determination of whether a funded software development arrangement is in the scope of Subtopic 730- 20 has not changed, nor has the accounting for such arrangements that represent a liability to a funding party. Funded software development arrangements that are considered ‘income- producing’ arrangements (i.e. those to transfer software licenses and/or provide software development services) are accounted for differently subsequent to the adoption of Topic 606 because the standard superseded the legacy US GAAP guidance previously applicable to those arrangements (principally, Subtopics -35). 605 and 605 985- are still Funded software development arrangements that are collaborations 808. subject, as they were under legacy US GAAP, to the provisions in Topic Topic 808 does not provide recognition or measurement guidance for those arrangements; therefore, entities are likely to continue to account for such arrangements in their historical manner. Question A40 Are nonmonetary exchanges of software within the scope of Topic 606? enter into barter It depends. Many software entities Interpretive response: transactions to exchange the right to use their software product for rights to use another entity’s software product or other nonmonetary goods (e.g. hardware). These transactions vary, but examples include: license to the entity’s software for a license to another — exchanges of a entity’s (either resold on its software that will then be sold to customers own or as part of larger arrangement) ; software to a customer for a license — exchanges of a license to the entity’s is permitted to to the customer’s software , which the software entity sublicense to other customers as a component of the software entity ’s products ; © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

48 Revenue for software and SaaS 46 A. Scope — exchanges of a license to the entity’s software for a license to a customer’s software that the software entity plans to use for internal purposes; and exchanges of a license to the entity’s so ftware that is not an output of its — ordinary business activities in exchange for a license to another entity’s (i.e. a non-customer’s) software/technology that the entity plans to use for internal purposes . exchanges one This question does not address situations in whic h a customer – Step Chapter C entity software license for another one. This is discussed in 2: Identify the performance o bligations in the c ontract. The following diagram illustrates which guidance is applicable to nonmonetary exchanges of software, and discussion follows the diagram. Nonmonetary exchange between entities in Account for arrangement under same line of business to facilitate sales to 845 ) Subtopic -10 (record at historical cost Yes customers or potential customers ? No Account for arrangement under /software license – software 606 Topic (s ) ? Contract with a customer Yes received is noncash consideration . No Account for arrangement as sale of nonfinancial asset in exchange for noncash consideration to entity that is not under Subtopic 610 -20 a cust om er -15- 2(e) states that nonmonetary exchanges between entities Paragraph 606-10 in the same line of business to facilitate sales to customers, or to potential customers, other than the parties to the exchange, which would include such exchanges of software, are outside the scope of Topic 606. A software license for software license exchange should be reviewed carefully ; the facts and circumstances of each nonmonetary transaction should be considered on a -by-case basis in determining whether the exchange is of the nature case -2(e). -10-15 described in paragraph 606 software exchange transaction is not between entities in the same line of If a business to facilitate sales to customers, or to potential customers, other than the parties to the exchange, the accounting for that transaction depends on whether the counterparty to the exchange is a customer. This includes A softwa exchange transactions for software for internal use. re exchange with a customer is accounted for as a contract with a customer involving noncash consideration and is within the scope of Topic 606. A software exchange with an entity that is not a customer is accounted for as the sale of a nonfinancial asset (whether the sale of the software or sale of a license to the software) in Other , 20 exchange for noncash consideration in accordance with Subtopic 610- Income – , Gains and Losses from the Derecognition of Nonfinancial Assets © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

49 47 Revenue for software and SaaS A. Scope which applies the contract identification, transaction price measurement and recognition guidance in Topic 606 . For a software exchange to meet the contract identification criteria in Topic 606, it must have commercial substance (see Chapter B – Step 1: Identify the contract with the customer ). A contract without commercial substance would not meet the criterion in paragraph 606- ’ commercial substance -1(d), which states that the contract must have ’ 10-25 (that is, the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract) . Excerpt from ASC 845-10 15-4 n the Nonmonetary Transactions Topic does not apply to The guidance i the following transactions: k. The transfer of a nonfinancial asset within the scope of Subtopic 610- 20 in exchange for noncash consideration (see paragraphs 610-20 -32 -2 through 10- 21 32- 32-3 , which require measurement consistent with paragraphs 606- 24). through 32- accounted for in accor For software exchanges dance with either Topic 606 or opic 610 -20, which applies the same transaction price guidance as Subt price Topic 606 (see Chapter D – Step 3: Determine the t ransaction ), the transaction price is measured based on the fair value, at contract inception, of the noncash consideration (i.e. the software or software license) to be received. If the fair value of the noncash consideration to be received cannot be selling -alone reasonably estimated by the entity, the entity looks to the stand price of the goods or services ( i.e . the software or software license) that will be transferred to the other party . Example A40.1 Nonmonetary exchanges of software Software Entity XYZ licenses software Product A (a suite of financial accounting applications) to customers in the normal course of business. Product A includes software (Product B) licensed by XYZ from Company PQR (i.e. Product B is PQR’s software). XYZ agrees to exchange a license to Product A with PQR for licenses to -alone product or license Product B (as a stand Product B. XYZ intends to re- embedded in Product A) to its customers. PQR intends to use Product A for internal use. The fair value of a license to Product A is reasonably estimable. XYZ is a customer of PQR (XYZ’s Product A includes PQR’s Product B that is an output of PQR’s ordinary activities) and vice versa (PQR is licensing XYZ’s Product A that is an output of its ordinary activities). wever, from XYZ’s perspective, the transaction is not in the scope of Ho 606 because the arrangement is a nonmonetary exchange between Topic © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

50 Revenue for software and SaaS 48 A. Scope entities in the same line of business to facilitate sales to XYZ’s customers (Product B is used in Product A). PQR’s perspective, the arrangement is within the scope of Topic 606 From because PQR is receiving a license to Product A in exchange for licenses to Product B that are an output of PQR’s ordinary activities (i.e. the arrangement is a contract with a customer). Accounting by Software Entity XYZ The exchange of a license to Product A for a license to Product B is an exchange of a product held for sale in the ordinary course of business for a product to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange. The exchange is, therefore, recorded at carryover basis (which might be $0) under the guidance of Subtopic 845- 10 – i.e. no revenue is recognized until Product B is sublicensed to other customers in a subsequent transaction (through XYZ licensing Product A that includes a sublicense to Product B). Accounting by Company PQR As outlined above, the exchange of licenses to Product B for a license to Product A by Company PQR is a transaction with a customer within the scope PQR of Topic 606. The exchange is, therefore, accounted for by Company under the Topic 606 guidance for noncash consideration. Therefore, PQR the license to Product A – measures the noncash consideration – at fair value and revenue is recognized by PQR when it transfers control of the license to Product B to XYZ. Comparison to legacy US GAAP Software or software licenses received by the software entity sold, licensed or leased in the same line of business as the software entity ’s software or software licenses Nonmonetary exchanges of software were specifically addressed in Non- 845 . Subtopic 985- Subtopic 985 -845, Software – monetary Transactions specified that the software entity should record an exchange at carryover basis when the technology/products received by the software entity in the exchange would be sold, licensed or leased in the same line of business as the software entity’s products that were delivered in the exchange. The amendments to 09 will generally not change the accounting US GAAP resulting from ASU 2014- for exchanges of software between entities in the same line of business to facilitate sales to customers, or to potential customers, other than the parties to the exchange. In general, such exchanges will continue to be recorded at carryover basis in accordance with Subtopic 845- 10. ges Other software exchan However, if the software or software license received by the software entity in the exchange would not be sold, licensed or leased in the same line of business as the software entity’s software or licenses that were delivered in the exchange, the software entity would record the exchange at fair value, that: provided © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

51 Revenue for software and SaaS 49 A. Scope — the fair value of the software/software licenses exchanged or received hin reasonable limits (for an exchange transaction could be determined wit involving software, entity -specific evidence of fair value (VSOE) for the deliverables given up or received was required to meet this criterion); and — the software/software licenses received in the exchang e were expected, at the time of the exchange, to be used by the software entity and the value ascribed to the transaction reasonably reflected the expected use. If either condition was not met, the exchange was recorded at carryover basis. Under legacy US GAAP, the fair value of the software received or transferred was established only through VSOE, which was typically not available. Consequently, most software exchanges under legacy US GAAP were recorded at carryover basis, rather than at fair value. -10 (e.g. the For nonmonetary exchanges not within the scope of Subtopic 845 entity transfers a license to its software that is an output of its ordinary activities in exchange for a license to the counterparty’s software that the entity will use for internal purposes), the application of Topic 606 or Subtopic 610- 20 to the exchange may result in substantially different accounting from legacy GAAP. Software exchanges within the scope of Topic 606 or Subtopic 610- US 20 will never be recorded at carryover basis; they will be recorded based on the fair value of the software (or software licenses) the entity receives in the exchange if that is reasonably estimable and, if not, based on the stand- alone selling price of the software (or software licenses) that will be transferred to the counterparty. VSOE does not apply either to the determination of the fair value of the software (or licenses) received nor to the stand- alone selling price of the software (or licenses) to be transferred. Question A50 Wh at is the accounting for an exchange of software licenses between entities in the same line of business to facilitate sales to customers, or to potential customers, other than the parties to the exchange? Interpretive response: between entities Nonmonetary exchanges of software in the same line of business to facilitate sales to customers, or to potential customers, other than the parties to the exchange will follow the general nonmonetary exchanges guidance in Subtopic 845- 10. In accordance with Subtopic 845 -10, a software entity should record an exchange at carryover basis when the software licenses received by the software entity in the exchange will be sold, licensed or leased in the same line of business as the software entity’s software licenses that were delivered in the exchange (i.e. no revenue should be recognized until the counterparty’s software is sublicensed to other customers in a subsequent transaction) . © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

52 50 Revenue for software and SaaS A. Scope Question A60 Can an entity record proceeds received from the settlement of a patent infringement with another party as revenue? asis for 09 Conclusions to ASU 2014- he B It depends. T Interpretive response: revenue ’ in (BC29) states that the ASU does not amend the definition of ‘ CON 6 . In addition, legacy US GAAP looked to the conceptual framework for determining the classification of the settlement amount and there was no reconsideration of the conceptual framewor k as par t of the development of 09. Therefore, we believe the analysis with respect to ASU the 2014- recognition of settlement proceeds in these scenarios has not changed such that the classification of the settlement proceeds depends on the relevant facts and circumstances. First, the settlement of a patent infringement should be distinguished from a settlement of past due license fees. If an entity is in the business of licensing intellectual property (e.g. licensing software) and is required to pursue legal to enforce its licensing rights, whether from an existing customer (e.g. to action – see Question F212) or from an entity that is not collect unpaid license fees party to an existing contract (e.g. an unrelated entity that has obtained – see Question F216 unauthorized use of the entity’s IP ), the settlement amount allocated between ‘ past due license fees ’ (which would be should be recognized as revenue in accordance with Topic 606) and any settlement gain. Generally , this would be based on the stand-alone selling price of the license with amounts in excess of the stand-alone selling price of the license being characterized as a settlement gain. However, in other scenarios, one entity (Entity A) may infringe on another does not license to other parties as part of (Entity B) patent tha t Entity B entity’s . For example, Entity A may infringe upon its ongoing major or central operations Entity B’s patent when it develops a similar consumer product to one previously developed by Entity B. In those scenarios, because licensing is not part of the ongoing major or central operations, the settlement enti ty’s (Entity B’s) ould generally not be characterized as license revenue. w proceeds bservation O We believe that the considerations outlined in an SEC staff speech (Eric C. AICPA National Conference on Current SEC and PCAOB West) at the 2007 Developments are still relevant in analyzing the substance of these arrangements. That SEC staff speech discussed various matters including potential elements of the arrangement, allocation of considerati on, classification of the settlement (including treatment of payment to customers) and consideration received by a customer as a result of a settlement. The SEC staff noted that accounting for litigation settlements requires judgment in determining the elements within the arrangement, when to recognize those elements and the value to allocate to them. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

53 Revenue for software and SaaS 51 A. Scope Scope of licensing implementation guidance and illustrations Excerpt from ASC 606-10 55- 54 A license establishes a customer’s rights to the intellectual property of an entity. Licenses of intellectual property may include, but are not limited to, licenses of any of the following: a. Software (other than software subject to a hosting arrangement that does 20 -15- not meet the criteria in paragraph 985- 5) and technology b. Motion pictures, music, and other forms of media and entertainment c. Franchises , trademarks, and copyrights. Patents d. Topic 606 provides implementation guidance specific to licenses of IP . The -55-54 through 55-65B) licensing implementation guidance (paragraphs 606- 10 and related examples (Examples 54 through 61B in paragraphs 606- 10- 55- 362 apply only to licenses of software 399O) that meet the criteria in through 55- paragraph 985- 20-15 -5. Even if a contract states that a license to software is part of the arrangement, a license does not exist for accounting purposes, and the licensing implementation guidance (including the related examples) does not apply, when those criteria are not met. Instead, the contract is for SaaS, to apply. which the licensing implementation guidance does not As will be outlined throughout this publication, determining whether an arrangement involving software includes a license of IP for accounting purposes, and therefore whether the licensing implementation guidance applies, will significantly affect the accounting for that arrangement. decision tree summarizes how Topic 606 applies to arrangements The following not that include a software license as compared to arrangements that do include a software license, such as SaaS arrangements . © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

54 Revenue for software and SaaS 52 A. Scope Is the contract a sale or license of Sale IP? License Does the contract involving software License of IP Yes i ncl ude a li cense ? No Is the license distinct from non - Apply general SaaS license goods or model services? Yes No Apply the general guidance to the combined bundle Does the customer have a and consider the nature of †s right to access the entity the license when applying IP? 5. Step No Yes Over Poi nt -in- -time time perf . perf . obligation obligation If the contract includes a - or usage -based Sal es sales- or usage -based royalties are estimated , is the license royalty (or and subject to general licenses ) the predominant No model †s constraint item (s ) to which the royalty under Step 3 relates ? Yes - or usage -based royalties Sal es recognized at later of when sales or usage occurs and satisfaction of performance obligation Under Topic 606, the licensing implementation guidance does not apply to SaaS does not meet arrangements for which the hosted software arrangements – i.e. the criteria in paragraph 985- 5. SaaS arrangements are accounted for as 15- 20- license to IP. This means service obligations, not arrangements that transfer a that, as outlined in the preceding diagram, entities entering into SaaS will apply the arrangements general revenue guidance – i.e. rather than the licensing implementation guidance – on: ime whether to recognize revenue over time or at a point in t — ; © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

55 Revenue for software and SaaS 53 A. Scope — how to measure progress toward satisfaction of the performance obligation (whe n revenue is recognized over time ); and — variable consideration (e.g. usage- or transaction -based fees). It is important to highlight, however, that t he licensing implementat ion guidance will come into play, to differing extents depending on the facts and circumstances, if a combined performance obligation (i.e. a performance obligation comprised of two or more promised goods or services) includes a element ( discusses considerations in Question C310 software license and a SaaS evaluating whether a software license and a SaaS element are separate in a contract that includes both ). For example, an entity performance obligations will generally need to consider the nature of the software license (i.e. as a right to use the entity’s intellectual property, which would be satisfied at a point in time if it were distinct, or a right to access the entity’s inte llectual property, which would be satisfied over time) that is part of the combined performance obligation in if there is a determining how to account for that performance obligation. And sales- -based royalty, the licensing implementation guidance on such or usage royalties will apply if the software license is the predominant item to which the royalty relates (the general guidance on variable consideration will apply if it is not). The following chapters will furt her address each of these issues : – Step 2: Identify the performance o bligations — Chapter C in the contract addresses considerations for determining whether a software license and a SaaS element are separate performance obligations (see Question ). C310 — Chapter F – Step 5: Recognize r evenue when (or a s) the entity satisfies a performance o bligation addresses: — identifying the nature of a software license; — identifying the nature of a combined performance obligation that includes a license and other goods or services (e.g. a SaaS, professional services or PCS element); and — the applicability of the exception for sales - or usage- based royalties for licenses of IP. from ASC 985-20 Excerpt Software Subject to a Hosting Arrangement 15-5 hosting arrangement is within the scope of The software subject to a this Subtopic only if both of the following criteria are met: a. The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty. b. It is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software. 15-6 For purposes of criterion (a) in the preceding paragraph 985- 20 -15- 5, the term significant penalty contains two distinct concepts: The ability to take delivery of the software without incurring significant cost a. b. The ability to use the software separately without a significant diminution in utility or value. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

56 Revenue for software and SaaS 54 A. Scope 15 - 7 If the software subject to a hosting arrangement never meets the criteria in paragraph 985- 20-15 -5, then the software is utilized in providing services and is not within the scope of this Subtopic and, therefore, the development costs of the software should be accounted for in accordance with Subtopic 350- 40 - 2). on internal - use software (see also paragraph 985 - 2 0 - 55 In many arrangements that involve the customer’s use of the entity’s software, the customer does not host the software – that is, the customer does not download the software on to servers or computers that i t owns or leases. Rather, the software is hosted by the software entity/SaaS provider or a third party. The software entity/SaaS provider will make the functionalities of the software available to the customer through the internet or a dedicated transmissio n line and will run the software application on either its own or a third party’s hardware. In such arrangements, the question arises as to whether the arrangement includes a software license or whether the customer, instead, service’ (SaaS). is receiving ‘software-as-a- These arrangements may or may not include a license of the software (explicitly or implicitly) and the customer may of the software. or may not have the option to take possession Paragraph 606- 10 -55- 54(a) states that , even in a contract that relies upon software for its fulfillment, a software license is not present in that arrangement -15- 5 are met. Those criteria are: unless the criteria in paragraph 985- 20 the customer has the contractual right to take possession of the software at a. any time during the hosting period without significant penalty; and b. it is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the entity to host the software. (a), the notion of ‘without significant penalty’ riterion With respect to the c includes two concepts: — The ability of the customer to take delivery of the software without incurring significant costs. The ability of the customer to use the software separately (i.e. on the — customer’s own hardware or that of a third party) without a significant diminution in utility or value of the software. Meanwhile, criterion (b) is met if: the customer has the IT infrastructure to host the software or is readily able — to obtain such IT infrastructure (e.g. the customer can obtain the necessary ; or party) hardware, and potentially services, from a third — party hosting services readily available to the there are unrelated, third- customer. in paragraph 985 -20-15- 5 is not met, the If either criterion does not arrangement include a software license; rather, the entit y is providing SaaS . As outlined above, SaaS is not subject to the licensing implementation guidance in Topic 606. As the industry has evolved, and continues to evolve, it is increasingly common for arrangements to include both an on-premise software element and a SaaS element (e.g. a license to an on- premise software application – including one that is hosted, but meets the requirements in paragraph 606-10 -55 -54(a) – and a offline SaaS element or a SaaS application with an ‘ ’ mode). These ’ or ‘ hybrid SaaS arrangements are often referred to as ‘ ’ hybrid cloud © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

57 Revenue for software and SaaS 55 A. Scope arrangements. Question C310 addresses what an entity should consider in determining whether the on- premise element and the SaaS element are distinct from each other in a hybrid SaaS (hybrid cloud) arrangement. If the on- premise and SaaS elements are not distinct from each other , the entity will generally account for the combined performance obligation (comprised of the on- premise and the SaaS elements) as a single service . , and below illustrates the two paragraph 985 -20 -15- 5 criteria The diagram . criteria Questions A70 – A1 20 address applicatio n questions surrounding those ‘Without ability to take delivery — Criterion (a ): significant without incurring significant The customer has the penalty’ ; and cost contractual right to take : refers to — ability to use the software possession of the software at separately without a any time during the hosting significant reduction in period without significant utility or value . penalty . (b ) Criterion — the customer has the IT (b ): Criterion is met infrastructure to host the It is feasible for the customer to if either : software or is readily able either run the software on its to obtain such IT own hardware or contract with ; or infrastructure another party unrelated to the , third — there are unrelated . entity to host the software party hosting services readily available to the customer . » — If both criteria met softwa re license If either criterion not met — » SaaS arrangement and the U.S. member firm of the KPMG network of independent member KPMG LLP, a Delaware limited liability partnership © 2018 . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

58 Revenue for software and SaaS 56 A. Scope Question A70 Can the customer have a “contractual right to take possession of the software at any time during the hosting period” if no such right is explicitly provided for in the contract (or in any contract or other agreement that is combined with that contract)? Interpretive response: Yes. If the customer has an enforceable right to take possession of the software as a matter of law, the fact that the contract does does not matter. It may be the case not explicitly provide for that right in writing in some jurisdictions in which the entity contracts that the relevant laws or regulations provide the customer , or the entity’s customary business practices, right even if neither the customer, nor the entity, intended with that enforceable for the contract to convey that right. Question A80 Criterion (a) in paragraph 985 -20- 15-5 requires the customer to have the right to take possession of the software at any time during the hosting period without significant penalty. How should entities interpret ‘at any time’ in the context of this criterion? We believe that judgment will need to be applied to the Interpretive response: specific facts and circumstances in order to determine whether this part of the criterion 5(a) is met, and that a contractual right to take -15- 20 in paragraph 985- A7 0) can meet that criterion even if possession of the software (see Question the customer did not have the right to take possession at every single point in e following table provides time of the hosting arrangement. Th our analysis of some common situations encountered in practice. Conclusion Scenario The customer has the right to take The customer has the contractual right of the software possession at every single to take possession of the software at point in time during the contract . during the hosting period. any time The customer has the right to take take The customer has the right to possession of the software at any time possession of the software throughout during the hosting period; the arrangement except for the hosting : restrictions described are not — the last few days of the hosting substantive. arrangement ( onths of a long- or m term hosting arrangement) ; or — a few days of each month (e.g. the last five days or the first five days of each month) in a long- term hosting arrangement . © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

59 Revenue for software and SaaS 57 A. Scope Scenario Conclusion The customer does not have the right to The customer has the right to take take possession of the software at any possession of the software either: time during the hosting period and, — only at sporadic or specific points in therefore, the arrangement does not each time (e.g. only on the last day of include a software license (i.e. it is a year) during the hosting arrangement; SaaS arrangement). or — only upon the occurrence of a contingent event that is neither within the control of the customer to certain to reasonably make occur, nor occur. The customer does not have the right to The customer has the right to take possession of the software if the entity take possession of the software at any eaches the contract. time during the hosting period and, materially br therefore, the arrangement does not include a software license (i.e. it is a SaaS arrangement). Question A90 Paragraph 985 -20-15- 6(a) explains that having the right to take possession of the software ‘without significant penalty’ includes ‘the ability to take delivery of the software without incurring significant cost’. What costs should an entity consider in det ermining if there is a significant penalty and what would be considered significant? The focus of the analysis in this regard should be on Interpretive response: direct and incremental costs. The mere existence of some level of cost in connection with taking possession of the software would not, by itself, result in a ‘significant penalty ’. ) fees, Direct and incremental costs include forfeited hosting (or other up -front termination fees or penalties incurred to cancel the hosting arrangement. Penalties inc lude hosting fees the customer is required to continue to pay to the entity after termination of the entity’s hosting services. Similarly, if the , that would also generally customer would incur significant ‘switching costs’ constitute a penalty. For example, if the customer would be required to in the IT infrastructure to host/support the software but would not invest receive a commensurate reduction in hosting fees under the contract, that deficiency would generally be considered a penalty from taking possession of the software. Although determining whether penalty costs are significant will require 10% of the total contract fees costs that exceed judgment, we believe that cancellable PCS and/or (e.g. software license fees as well as any initial, non- © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

60 58 Revenue for software and SaaS A. Scope hosting services fees) usually would be a strong indicator that the costs are significant. However, all facts and circumstances should be considered, and a penalty of less than 10% might be considered significant if it creates a substantial disincentive for the customer to take possession of the software. A100 Question What considerations should be made in e the determining whether the customer can us software separately from the entity’s hosting services without a significant diminution in utility or value when evaluating criterion (b) in 985- 6? 20-15- paragraph The determination of whether a customer in a hosting Interpretive response: arrangement will suffer a significant diminution in utility or value of the software depend on a variety of factors, if it takes possession of the software may including, but not limited to, the following: — the customer’s Whether taking possession of the hosted software negates right to receive one or more specified upgrades or unspecified updates or upgrades that are considered integral to maintaining the utility of the software (see Question C170). If the customer forfeits its right to receive integral updates or upgrades by taking possession of the software, this would indicate the customer will incur a significant diminution in utility and value of the software from terminating the hosting services. — Whether there are significant features or functionaliti es available to the customer when the software is hosted by the entity that would no longer be available to the customer if the customer took possession of the software . This would indicate the customer will incur a signi ficant diminution in utility or val ue of the software from terminating the hosting services. incremental Whether resources must be obtained by the customer to — maintain the functionality of the software if the customer elects to take possession of the software. For example, the customer may need to obtain an additional software product (e.g. relational database software) or implement additional manual procedures to compensate for a loss of utility in the software included in the hosting arrangement. The need to obtain incremental resources to maintain the functionality of the software would indicate that the customer will experience a significant reduction in utility of the software from taking possession of it . If the customer has the ability to transfer the hosting services to another — provider, while retaining the right to future specified or unspecified upgrades and enhancements of the software, that may be an indicator that it would not incur a significant diminution of utility or value from taking possession of the software. However, we believe that a significant diminution in utility or value from taking a ‘significant penalty’ on impose the possession of the software does not customer if: © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

61 Revenue for software and SaaS 59 A. Scope — there are readily available resources (e.g. on- premise software, third -party hosting services or hardware that is sold separately) that can replace the significant diminution in utility or value the customer would experience from taking possession of the software; and the cost to obtain those readily available resources is comparable to the — cost of the hosting services they will replace. Importantly, e ven if both of the criteria in the preceding paragraph are met, the customer may still incur a ‘significant penalty’ . For example, as outlined in Question A , if the customer has to pay a significant te rminatio n fee, forfeit a 90 fee or continue to pay the entity hosting fees, the fact that it significant up-front at a cost comparable to the can replace a significant diminution in utility or value would software entity’s hosting services does not mean the customer not incur from taking possession of the software. a significant penalty A100.1 Example Software license or SaaS (1) year contract with ABC Corp. to access ABC’s Customer enters into a three- software (Product H) in a hosting arrangement. The contract requires an up- front payment of $500,000, and also includes a stated monthly fee of $25,000 for the hosting services provided by ABC. In addition to these basic facts: — Customer has the enforceable right under the contract to take possession of the software at any time for no additional fee and, if it does so, will no longer be required to pay the $25,000 monthly fee for the hosting services. — If Customer takes possession of Product H, it loses the right to future unspecified updates, upgrades and enhancements. However, Product H is a mature product that ABC updates infrequently and updates are typically minor in nature and not integral to maintaining the utility of Produc t H. — Customer has significant and established IT capacity and resources such that the incremental costs of electing to take possession of the software from ABC would not be significant in comparison to the hosting service fees it would avoid. The stated hosting fees are equal to the observable stand- alone selling — price for those services. ABC determines that the contract includes a license to the Product H software -15 and hosting services. In accordance with paragraph 985- 20 -5: — Customer has the contractual right to take possession of the Product H software at any time, and can do so without incurring a significant penalty. ABC concludes that Customer will not incur a significant penalty if it takes possession of the software because: — there is no fee or penalty for terminating the hosting services; — Customer does not have to continue to pay for the hosting services after they are terminated; and — despite the fact that Customer will lose the right to obtain future updates, upgrades and enhancements, those items are not integral to maintaining the utility of Product H outside of the hosting environment because Product H is a mature software product. As such, Customer © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

62 60 Revenue for software and SaaS A. Scope will not experience a significant diminution in utility or value of n of Product H. Product H from taking possessio — It is feasible for Customer to run (i.e. host) the Product H software on its own because of its significant and established IT capacity and resources. Because Customer has a significant and established IT capacity it will incur no (or minimal) incremental costs to host the Product H software. A100.2 Example Software license or SaaS (2) Assume the same basic facts as in Example A100.1. In addition: — Customer has the enforceable right under the contract to take possession of the software at any time for no additional fee and, if it does so, will no longer be required to pay the $25,000 monthly fee for the hosting services. H — There are third-party hosting service providers that can host the Product software for Customer for a comparable monthly fee as the hosting services provided by ABC. All of the core functionality of Product H will remain available to Customer if — they choose to take possession of the Product H software. However, significant search and data reporting functionalities are available to Customer only when the Product H software is connected to ABC’s proprietary, hosted database, which is only accessible to customers using Product H within ABC’s hosting environment. H ABC determines that the contract does not include a license to the Product software and, therefore, is a SaaS arrangement . This is because, while it is feasible for Customer to have a third- party host software Product H in place of ABC and Customer has the contractual right to take possession of the Product H software at any time, it cannot take possession of the software without incurring a ‘significant penalty’. ABC concludes that Customer will incur a significant penalty if it takes possession of the Product H software because: — Customer will lose access to ABC’s proprietary, hosted database, without which significant functionalities will not be available to Customer; and — there are no other readily available resources Customer could use to replace those functionalities because ABC’s database is proprietary and only available to customer using Product H within ABC’s hosting environment. Example A100.3 Software license or SaaS ( 3) A100.2. Assume the same basic facts as in Examples A100.1 and In addition to the basic facts, the following additional facts are relevant: Customer has the enforceable right under the contract to take possession — of the software at any time. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

63 Revenue for software and SaaS 61 A. Scope — The contract requires that Customer provide six months’ notice to terminate the hosting services. That is, on Day 1, if Customer takes possession of the Product H software and terminates the hosting services accordingly, it will still have to pay $150,000 in hosting services fees ($25,000 x 6 months). ABC determines that the contract does not include a license to the Product H software and, therefore, is a SaaS arrangement. This is because, while Customer has the contractual right to take possession of the Product H sof . it cannot do so without incurring a ‘significant penalty’ tware at any time, ABC concludes that Customer will incur a significant penalty if it takes possession of the Product H software based on the six -month ‘notice period’. The six -month notice requirement constitutes a significant penalty because Customer must pay this amount without receiving benefit for the fees paid (i.e. it will receive no services in return for those fees) and because that amount of $150,000 exceeds 10% of the fees under the contract ($500,000 up fee + -front $900,000 in hosting services fees). Comparison to legacy US GAAP The criteria for determining whether a hosting arrangement includes a software 09 or any of the subsequent revenue- license was not changed by ASU 2014- related ASUs. Consequently, the analysis of whether a hosting arrangement includes a software license under Topic 606 should be relatively consistent with the analysis of whether a hosting arrangement ftware element includes a so under legacy US GAAP. Question A110 If software will be hosted on entity servers that are leased by the customer, is there a software license? servers Yes. Hosting software on entity that are leased Interpretive response: by the customer is no different from hosting the software on servers owned by the customer. In either case, there is a software license because the customer has possession of the software. a lease is determined to exist. For example, Importantly, i t does not matter why in some customers will explicitly lease equipment from the entity . In cases, those cases, there is also typically an explicit software license (i.e. the intent of the arrangement is to grant the customer a software license) . However, in other cases, an ‘embedded lease ’ may exist , under either Topic 840 (the current leasing guidance) even if there is no or Topic 842 (the new leasing guidance) explicit lease agreement or any lease mentioned in the contract with the customer. For example, a customer may, under the leasing guidance (current or is dedicated to new) , be leasing a server from the software entity if the server the customer (i.e. the server is not used to host software or provide services for any other cus tomer) even if there is no mention of a lease in the contract and viewed (e.g. the server may be that server is housed in the entity’s data center © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

64 Revenue for software and SaaS 62 A. Scope by the entity as merely part of the data center). Because the entity’s accounting significantly depending on whether there is or is not for the contract may differ a software license in the arrangement, it will be important for entities that enter hosting arrangements (including those that may be characterized solely as into SaaS arrangements) with customers to consider whether they are leasing the f so, the entity . And i equipment used to host the software to the customer should account for the arrangement as one that includes a software license (i.e. rather than a s a SaaS arrangement) . Entities should be aware that the analysis of whether a lease exists, though not the result of that analysis, will change upon necessarily the adoption of Topic 842. The guidance in Topic 842 for identifying a lease is different from the guidance in Topic 840. Question A120 Is the conclusion about whether a software license is present in a contract with a customer affected by the custome r’s or the software entity’s use of a third -party hosting service? Determining whether a contract includes a software Interpretive response: license is not affected by whether the customer uses a third party to host the entity’s software or whether the entity engages a thi rd party to host the software. The fact that the customer uses , or would be -party hosting provider a third required to use a third -party hosting provider if it were to exercise its right to take possession of the software in a hosting arrangement , rather than hosting the software on its own IT equipment , does not affect the conclusion that by the entity about whether the contract includes would otherwise be reached a software license. Similarly, the fact that the entity uses a third party to host its software, rather than hosting the software in its own data center, should not change the conclusion that would otherwise be reached as to whether the contract includes a software license fro m that which would be reached if the entity were hosting the software itself; this includes the possibility that the customer be deemed to be leasing (likely sub- leasing could ) the third from the entity party’s equipment. Example A120.1 license or SaaS Software ABC Corp.’s typical customer contract provides customers with the right to use party its software (Product J) on a SaaS basis. ABC hosts Product J using a third- hosting provider (XYZ), rather than hosting Product J in its own data center. ABC’s customers are not permitted to take possession of Product J. ABC manages and controls the hosting services from XYZ associated with Product J, i.e. ABC has the contract with XYZ for the hosting services. ABC bills customers on a monthly or quarterly basis, which includes proportional © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

65 Revenue for software and SaaS 63 A. Scope reimbursement of ABC’s actual costs for the XYZ hosting services related to Product J. Customer A (an existing customer of XYZ) has expressed an interest in deploying Product J in its own XYZ hosting environment, rather than ABC’s, to take advantage of Customer A ’s favorable contract terms and pricing arrangement – i.e. Customer A will realize savings in hosting actual with XYZ costs by structuring the arrangement in this manner. Notwithstanding Customer A’s desire to achieve these cost savings, it is the intent of both ABC and Customer A to have ABC manage and control the hosting of Product J in the same manner as ABC manages and controls its typical arrangements; this that Product J cannot be removed from the XYZ includes the provision environment. hosting To permit this arrangement, a provision has been added to Customer A’s agreement with XYZ to give ABC access, billing, control and management rights/responsibilities for a separate Customer A account with XYZ that is dedicated to hosting Product J. Customer A is not permitted to take possession of the Product J software or transfer the software to another hosting provider or another Customer A account with XYZ. Notwithstanding the specifics of the new contractual provision, ABC determines that its contract with Customer A includes a license to Product J include hosting (i.e. that the contract is not a SaaS arrangement), and does not services. This is because under its contract with Customer A, ABC’s performance obligations do not include hosting Product J for Customer A because XYZ is providing the hosting services to Customer A, not ABC. In contrast, under ABC’s typical customer arrangements, even though XYZ also hosts Product J, ABC is the principal to the customer arrangement for those hosting services. ABC is not a principal in the Customer A arrangement with XYZ. Because ABC concludes that there is a license to Product J in the Customer A arrangement, that license is subject to the licensing implementation guidance in Topic 606. ABC transfers control of the license to Customer A when ABC delivers the license to Customer A’s hosting agent (XYZ) – i.e. assuming the license term has begun and other considerations outlined in Chapter F – Recognize revenue when (or as) the entity satisfies a performance obligat ion have been satisfied. In addition, ABC will need to consider whether its promises to provide technical support and unspecified updates, upgrades and enhancements (which it will provide to Customer A in connection with Product J), and to manage A’s hosting account for Product J are separate performance Customer Step 2: Identify the performance obligations in obligations (see – Chapter C the contract ). © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

66 64 Revenue for software and SaaS B. Step 1: Identify the contract with the customer B. S tep 1: Identify the contract with the customer Questions and Examples New item added to this chapter: ** Item significantly updated in this edition: # Overview Determining whether a contract exists Questions & answers Q&A If a software entity obtains signed contracts as its customary B 10 business practice does the contract have to be signed by both parties in order for a contract to exist? What should a contract with a customer describe in order to Q&A B20 demonstrate that the parties can each identify their rights regarding the promised goods or services and the payment terms for those goods or services (i.e. that criteria b. and c. in 10-25 -1 are met)? paragraph 606- Example B20.1: Contract approval and customary business practice, Part I Example B20.2: Contract approval and customary business practice, Part II Q&A B30 If a Master Servic e Agreement (MSA) exists between an entity and a customer under which the customer requests goods and services through purchase orders is the MSA a contract under Topic 606? Prepaid spending account Example B30.1: B40 Does the form of an entity’s contracts and evidence of approval Q&A have to be consistent across customers? Example B40.1: Form of the contract and approval does not affect contract conclusion Q&A B50 Are ‘side agreements’ contracts under Topic 606? Q&A B60 Does a contract exist for services such as PCS or SaaS when an entity continues to provide the services after the expiration of the contract with the customer? Contract continuation for PCS Example B60.1: Q&A B70 Does a fiscal funding clause affect whether a contract exists under Topic 606? © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

67 Revenue for software and SaaS 65 B. Step 1: Identify the contract with the customer What factors should an entity consider in determining whether Q&A B80 the amount of consideration to which an entity expects to be entitled includes an implicit price concession? Example B80.1: Collectibility threshold assessed based on amount the entity expects to receive for the goods or services transferred In assessing collectibility, an entity considers only the likelihood B90 Q&A of payment for goods or services that ‘will be transferred to the customer’. What does this mean in the context of typical software related service arrangements (e.g. SaaS arrangements or PCS services sold separately from a software license)? Q&A Does an entity’s ability and intent to stop providing goods or B100 services automatically mean that the collectibility criterion will be met? Example B100.1: Assessment of collectibility for low credit quality new customer How are software licenses considered when determining the Q&A B110 ‘goods or services that will be transferred to the customer’? Example B110.1: Credit risk is not mitigated for a software license and PCS Q&A Do extended payment terms affect the evaluation of the B120 collectibility criterion? B125 Can revenue be recognized on a cash basis when the Q&A collectibility criterion is not met and the entity continues to provide goods or services to the customer? ** Q&A B130 What is the contract term in a period- to-period (e.g. month- to- month or year -to-year) contract that (a) may be cancelled by either party or (b) may be cancelled by the customer only? Example B130.1: Contract with unspecified term cancellable by either party Example B130.2: Contract with a specified term cancellable by either party # -based license with a reseller with Term Example B130.3: monthly cancellation ** ** Example B130.4: Perpetual license Q&A B140 How does a termination penalty affect the assessment of the contract term? Example B140.1: Past practice of allowing customers to terminate without enforcing collection of the termination penalty Contract term with decreasing termination Example B140.2: penalty Q&A Does forfeiture of a significant up- B150 front fee constitute a termination penalty? © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

68 Revenue for software and SaaS 66 B. Step 1: Identify the contract with the customer Does a cancellation provision exist if the contract is silent as to B160 Q&A cancellation or termination? Does a cancellation provision available only upon a substantive Q&A B170 breach of contract affect the contract term? trial’ periods before the Does a contract exist during ‘free- Q&A B180 customer accepts an offer to continue the services beyond the -trial period? free Free-trial period Example B180.1: Q&A What constitutes ‘at or near the same time’ when evaluating B190 whether two or more contracts should be combined? Q&A B200 If an entity and/or its customer have multiple divisions (business units), should contracts entered into between different divisions be evaluated for possible combination? B210 25-9 similar to the 10- Are the criteria in paragraph 606- Q&A indicators of contract combination in le gacy US GAAP? Example B210.1: Combining contracts, Part I Combining contracts, Part II Example B210.2: Combining contracts, Part III Example B210.3: © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

69 Revenue for software and SaaS 67 B. Step 1: Identify the contract with the customer Step Step 3 5 Step 2 Step 1 Step 4 Allocate the Determine Identify Recognize Identify the transaction transaction performance revenue contract obligations price price Overview identifies when a contract 606 with a customer exists and, therefore, is Topic how to account for consideration received accounted for under Topic 606; and when two or more contracts before co ncluding that a contract exists; should be combined for purposes of applying the model. 606-10 from ASC Excerpt 20 Contract An agreement between two or more parties that creates enforceable rights and obligations. Customer A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration. > Identifying the Contract 25-1 An entity shall account for a contract with a customer that is within the scope of this Topic only when all of the following criteria are met: a. The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations. b. The entity can identify each party’s rights regarding the goods or services to be transferred. c. The entity can identify the payment terms for the goods or servi ces to be transferred. d. The contract has commercial substance (that is, the risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract). e. It is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer (see paragraphs 606- -3C). In evaluating whethe 3A through 55 r collectibility of an 55- 10- amount of consideration is probable, an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due. The amount of consideration to which the entity will be entitled may be less than the price stated in the contract if the © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

70 Revenue for software and SaaS 68 B. Step 1: Identify the contract with the customer consideration is variable because the entity may offer the customer a price concession (see paragraph 606 -10- 32- 7). 2 25- A contract is an agreement between two or more parties that creates enforceable rights and obligations. Enforceability of the rights and obligations in a contract is a matter of law. Contracts can be written, oral, or implied by an entity’s customary business practices. The practices and processes for across legal jurisdictions, industries, establishing contracts with customers vary and entities. In addition, they may vary within an entity (for example, they may depend on the class of customer or the nature of the promised goods or services). An entity shall consider those practices and processes in determining whether and when an agreement with a customer creates enforceable rights and obligations. Some contracts with customers may have no fixed duration and can be 25-3 terminated or modified by either party at any time. Other contracts may aut omatically renew on a periodic basis that is specified in the contract. An entity shall apply the guidance in this Topic to the duration of the contract (that is, the contractual period) in which the parties to the contract have present enforceable rights and obligations. In evaluating the criterion in paragraph 606- 10-25 -1(e), an entity shall assess the collectibility of the consideration promised in a contract for the goods or services that will be transferred to the customer rather than assessing the collectibility of the consideration promised in the - -55 10 contract for all of the promised goods or services (see paragraphs 606- 3C). However, if an entity determines that all of the criteria in 3A through 55- 10-25 paragraph 606- -1 are met, the remainder of the guidance in this Topic shall be applied to all of the promised goods or services in the contract. 25-4 For the purpose of applying the guidance in this Topic, a contract does not exist if each party to the contract has the unilateral enforceable right t o terminate a wholly unperformed contract without compensating the other party (or parties). A contract is wholly unperformed if both of the following criteria are met: a. The entity has not yet transferred any promised goods or services to the customer. b. The entity has not yet received, and is not yet entitled to receive, any consideration in exchange for promised goods or services. 1 10 25-5 If a contract with a customer meets the criteria in paragraph 606- -25- at contract inception, an entity shall not reassess those criteria unless there is an indication of a significant change in facts and circumstances. For example, if a customer’s ability to pay the consideration deteriorates significantly, an entity would reassess whether it is probable that the entity will collect the consideration to which the entity will be entitled in exchange for the remaining goods or services that will be transferred to the customer (see paragraphs 606- 10-55 -3A through 55- 3C). 25-6 If a contract with a customer does not meet the criteria in paragraph 606- 10-25 -1, an entity shall continue to assess the contract to determine whether the criteria in paragraph 606-10- 25- 1 are subsequently met. 25-7 When a contract with a customer does not meet the criteria in paragraph 606- 10-25 -1 and an entity receives consideration from the customer, revenue only when the entity shall recognize the consideration received as have occurred: one or more of the following events © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

71 Revenue for software and SaaS 69 B. Step 1: Identify the contract with the customer a. The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable. The contract has been terminated, and the consideration received from the b. customer is nonrefundable. c. The entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is nonrefundable. 25- 8 An entity shall recognize the consideration received from a customer as a liability until one of the events in paragraph 606- 10 -25 -7 occurs or until the criteria in pa ragraph 606- 10 -25-1 are subsequently met (see paragraph 606-10 - 25-6). Depending on the facts and circumstances relating to the contract, the liability recognized represents the entity’s obligation to either transfer goods or services in the future or refund the consideration received. In either case, the liability shall be measured at the amount of consideration received from the customer. > > Assessing Collectibility 3A 55- -1(e) requires an entity to assess whether it is -25 10 Paragraph 606- that the entity will collect substantially all of the consideration to probable which it will be entitled in exchange for the goods or services that will be transferred to the customer . The assessment, which is part of identifying contract whether there is a customer, is based on whether the with a customer has the ability and intention to pay the consideration to which the entity will be entitled in exchange for the goods or services that will be transferred to the customer. The objective of this assessment is to evaluate whether there is a substantive transaction between the entity and the customer, which is a necessary condition for the contract to be accounted for under the revenue model in this Topic. -1(e) is partly a The collectibility assessment in paragraph 606 -10-25 55- 3B forward -looking assessment. It requires an entity to use judgment and consider all of the facts and circumstances, including the entity’s customary business practices and its knowledge of the customer, in determining whether it is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that the entity expects to transfer to the customer. The assessment is not necessarily based on the customer’s ability and intention to pay the entire amount of promised consideration for the entire duration of the contract. 55- 3C When assessing whether a contract meets the criterion in paragraph 606- 10-25 -1(e), an entity should determine whether the contractual terms and its customary business practices indicate that the entity’s exposure to credit risk is less than the entire consideration promised in the contract because the entity has the ability to mitigate its credit risk. Examples of contractual terms or customary busin ess practices that might mitigate the entity’s credit risk include the following: —In some contracts, payment terms limit an entity’s a. Payment terms exposure to credit risk. For example, a customer may be required to pay a portion of the consideration promised in the contract before the entity transfers promised goods or services to the c ustomer. In those cases, any © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

72 Revenue for software and SaaS 70 B. Step 1: Identify the contract with the customer consideration that will be received before the entity transfers promised goods or services to the customer would not be subject to credit risk. —An entity may The ability to stop transferring promised goods or services b. limit its exposure to credit risk if it has the right to stop transferring additional goods or services to a customer in the event that the customer fails to pay consideration when it is due. In those cases, an entity should assess only the collectibility of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer on the basis of the entity’s rights and customary business practices. Therefore, if the customer fails to perform as promised and, consequently, the entity would respond to the customer’s failure to perform by not transferring additional goods or services to the customer, the entity would not consider the likelihood of payment for the promised goods or services that will not be transferred under the contract. An entity’s ability to repossess an asset transferred to a customer should not be considered for the purpose of assessing the entity’s ability to mitigate its exposure to credit risk. > > > Example 1 —Collectibility of the Considerati on > > > > Case A —Collectibility Is Not Probable - An entity, a real estate developer, enters into a contract with a customer 55 95 for the sale of a building for $1 million. The customer intends to open a restaurant in the building. The building is located in an area where new restaurants face high levels of competition, and the customer has little experience in the restaurant industry. 96 55- The customer pays a nonrefundable deposit of $50,000 at inception of term financing agreement with the entity for the contract and enters into a long- the remaining 95 percent of the promised consideration. The financing arrangement is provided on a nonrecourse basis, which means that if the customer defaults, the entity can repossess the building but cannot seek further compensation from the customer, even if the collateral does not cover the full value of the amount owed. 97 55- The entity concludes that not all of the criteria in paragraph 606- 10- 25-1 are met. The entity concludes that the criterion in paragraph 606- 10 -25- 1(e) is not met because it is not probable that the entity will collect substantially all of the consideration to which it is entitled in exchange for the transfer of the building. In reaching this conclusion, the entity observes that the customer’s ability and intention to pay may be in doubt because of the following factors: a. The customer intends to repay the loan (which has a significant balance) primarily from income derived from its restaurant business (which is a business facing significant risks because of high competition in the industry and the customer’s limited experience). b. The customer lacks other income or assets that could be used to repay the loan. c. The customer’s liability under the loan is limited because the loan is nonrecourse. 55- 98 The entity continues to assess the contract in accordance with - 6 to determine whether the criteria in paragraph 606 - 25 - 10 paragraph 606 - 10 - © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

73 Revenue for software and SaaS 71 B. Step 1: Identify the contract with the customer 25 - 1 are subsequently met or whether the events in paragraph 606 - 10 - 25 - 7 have occurred. > > > > Case B— Credit Risk Is Mitigated 55- 98A An entity, a service provider, enters into a three- year service contract with a new customer of low credit quality at the beginning of a calendar month. 55- 98B The transaction price of the contract is $720, and $20 is due at the end of each month. The standalone selling price of the mo nthly service is $20. Both parties are subject to termination penalties if the contract is cancelled. 55- 98C The entity’s history with this class of customer indicates that while the entity cannot conclude it is probable the customer will pay the transaction price of $720, the customer is expected to make the payments required under the contract for at least 9 m onths. If, during the contract term, the customer stops making the required payments, the entity’s customary business practice is to limit its credit risk by not transferring further services to the customer and to . pursue collection for the unpaid services 98D 55- - 606 In assessing whether the contract meets the criteria in paragraph -1, the entity assesses whether it is probable that the entity will collect 10-25 substantially all of the consideration to which it will be entitled in exchange for the services that will be transferred to the customer. This includes assessing the entity’s history with this class of customer in accordance with paragraph 606- 10-55 -3B and its business practice of stopping service in response to customer nonpayment in accordance with paragraph 606- 10 -55- 3C. Consequently, as part of this analysis, the entity does not consider the likelihood of payment for services that would not be provided in the event of the customer’s nonpayment because the entity is not exposed to credit risk for those services. 55- 98E It is not probable that the entity will collect the entire transaction price ($720) because of the customer’s low credit rating. However, the entity’s exposure to credit risk is mitigated because the entity has the ability and intention (as evidenced by its customary business practice) to stop providing services if the customer does not pay the promised consideration for services provided when it is due. Therefore, the entity concludes that the contract meets the criterion in paragraph 606- 10- 25-1(e) because it is probable that the customer will pay substantially all of the consideration to which the entity is entitled for the services the entity will transfer to the customer (that is, for the services the entity will provide for as long as the customer continues to pay for the services provided). Consequently, assuming the criteria in paragraph 606- -1(a) through (d) are met, the entity would apply the remaining guidance 10-25 in this Topic to recognize revenue and only reassess the cri teria in paragraph 606- 10-25 -1 if there is an indication of a significant change in facts or circumstances such as the customer not making its required payments. > > > > Case C —Credit Risk Is Not Mitigated 98F C, except that the entity’s 55- The same facts as in Case B apply to Case history with this class of customer indicates that there is a risk that the customer will not pay substantially all of the consideration for services received e any payment from the entity, including the risk that the entity will never receiv for any services provided. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

74 Revenue for software and SaaS 72 B. Step 1: Identify the contract with the customer - 98G In assessing whether the contract with the customer meets the 55 10 -25-1, the entity assesses whether it is probable criteria in paragraph 606- that it will collect substantially all of the consideration to whic h it will be entitled in exchange for the goods or services that will be transferred to the customer. This includes assessing the entity’s history with this class of customer and its business practice of stopping service in response to the 10-55 606- customer’s nonpayment in accordance with paragraph -3C. 55- 98H At contract inception, the entity concludes that the criterion in paragraph 606- 10-25 -1(e) is not met because it is not probable that the customer will pay substantially all of the consideration to which the entity will be entitled under the contract for the services that will be transferred to the customer. The entity concludes that not only is there a risk that the customer will not pay for services received from the entity, but also there is a risk that the entity will never receive any payment for any services provided. Subsequently, when the customer initially pays for one month of service, the entity accounts for the consideration received in accordance with 8. The entity concludes that none of the -7 through 25- paragraphs 606-10 -25 events in paragraph 606- -25-7 have occurred because the contract has not 10 been terminated, the entity has not received substantially all of the ovide consideration promised in the contract, and the entity is continuing to pr services to the customer. 55- 98I Assume that the customer has made timely payments for several 10-25-6, the entity assesses the months. In accordance with paragraph 606- 10-25-1 are contract to determine whether the criteria in paragraph 606- subsequently met. In making that evaluation, the entity considers, among other things, its experience with this specific customer. On the basis of the customer’s performance under the contract, the entity concludes that the criteria in 606- 10-25-1 have been met, i ncluding the collectibility criterion in paragraph 606 -10-25-1(e). Once the criteria in paragraph 606- 10-25- 1 are met, the entity applies the remaining guidance in this Topic to recognize revenue. —Advance Payment > > > > Case D 98J year membership with a An entity, a health club, enters into a one- 55- customer of low credit quality. The transaction price of the contract is $120, and $10 is due at the beginning of each month. The standalone selling price of the monthly service is $10. 55- 98K On the basis of the customer’s credit history and in accordance with the entity’s customary business practice, the customer is required to pay each month before the entity provides the customer with access to the health club. In response to nonpayment, the entity’s customary business practice is to stop providing service to the customer upon nonpayment. The entity does not have exposure to credit risk because all payments are made in advance and the entity does not provide services unless the advance payment has been received. -1(e) because it T he contract meets the criterion in paragraph 606- -25 55- 98L 10 is probable that the entity will collect the consideration to which it will be ustomer entitled in exchange for the services that will be transferred to the c (that is, one month of payment in advance for each month of service). © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

75 Revenue for software and SaaS 73 B. Step 1: Identify the contract with the customer Determining whether a contract exists Definition of a contract Topic 606 defines a ‘contract’ as an agreement between two or more parties that creates enforceable rights and obligations and specifies that enforceability a matter of law is . Consequently, the assessment of whether a contract exists does not focus on the form of the contract . Contracts can be written, oral or implied by an entity’s customary business practices, depending on the relevant laws and regulations under which the contract is governed. The assessment of whether a contract exists may require significant j udgment in some jurisdictions or for some arrangements, and may result in different conclusions for similar contracts in different jurisdictions. In some cases, the parties to an oral or an implied contract (in accordance with customary business practices) may have agreed to fulfill their respective obligations. In cases of significant uncertainty about enforceability (e.g. oral or an implied contract), a written contract and legal interpretation by qualified counsel may be required to support a conclusion that the parties to the contract have approved and are committed to perform their respective obligations. An entity should assess whether the parties intend to be bound by the terms and conditions of the contract. This evaluation may include an assessment of an entity’s customary business practices and past practice of what has been enforced. unperformed contracts Wholly for accounting purposes A contract does not exist if each party to the contract has the unilateral right to terminate unperformed’ contract without a ‘wholly compensating the other party (or parties). A contract is wholly unperformed if two criteria are met: — the entity has not yet transferred any promised goods or services to the customer; and — the entity has not yet received, and is not yet entitled to receive, any consideration in exchange for promised goods or services. Contract identification criteria Board a contract by specifying the definition of s decided to supplement The additional beyond legal enforceability that must be me t for an entity to criteria conclude a contract exists in accordance with Topic 606 and can apply the revenue model in Topic 606 to that contract. The Boards decided that when some or all of those criteria are not met, it is questionable whether the contract a contract wit establishes enforceable rights and obligations. Therefore, h a Topic customer is subject to the revenue model in only when i t is legally 606 meets all of the following criteria. enforceable and © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

76 Revenue for software and SaaS 74 B. Step 1: Identify the contract with the customer ... A contract exists if Rights to goods or services and payment Collection of consideration is probable terms can be identified It is approved and the parties are It has commercial substance com mitt ed t o their obligations Two of tho se criteria are that (1) the parties must have approved the contract and be committed to perfor ming their respective obligations and (2) each party’s rights with respect to the goods and services, as well as the payment may still be terms, can be identified. contract At the financial reporting date, a (a ) subject to contingencies (such as a substantive additional reviews yet to occur and authorizations yet to be obtained), (b ) in a preliminary stage (such as a letter of intent) or (c ) require additional negotiations and subsequent . In such cases, criteria (1) and (2) are likely not met s or revisions amendment , a contract does not exist and the revenue model in Topic 606 and, therefore . will not yet apply However, there may be scenarios in which an entity continues to provide services to a customer after expiration of a contract but during contract extension negotiations. These fact patterns are discussed in Q uestion B60 and Example B60.1 . to account for a contract with a customer under Topic If all of the criteria 606 have not been met, the entity continually reassesses the arrangement against them and applies the revenue model in Topic 606 to the contract from the date on which all of the criteria are met, which may result in a cumulative effect date (e.g. to recognize revenue adjustment for the entity’s performance to- revenue based on the goods or services transferred to the customer before a . In contrast, if a contract meets all of the contract was determined to exist) at contract inception, an entity does not reassess any of those criteria criteria , on unless there is a significant change in facts and circumstances. If reassessment , an entity determines that the criteria are no longer met, then it ceases to apply the revenue model to the contract from that date, but does not reverse any revenue previously recognized. An entity may have a pattern of frequently renegotiating the terms of the contract or have a history of providing concessions to the customer. Typically, such a pattern or history will not affect whether enforceable rights and obligations exist before the renegotiation or concession, or prevent the parties from id entifying those rights and obligations; and therefore, will not affect whether there is a contract between the parties within the scope of the revenue model. Rather, subsequent renegotiations would follow the contract – ) and a pattern of Contract m odifications modific ation guidance (see Chapter G granting concessions would affect either (or both) the entity’s identification of © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

77 Revenue for software and SaaS 75 B. Step 1: Identify the contract with the customer the promised goods or services in the contr act (see Question C90 ) or its Question D130). determination of the transaction price for the contract (see However, we believe it is possible that in very unusual circumstances (e.g. significant actions that are unpredictable), an entity’s pattern or history could be of such a nature that the entity would not be able to conclude the parties to the contract can identify all of their respective rights and obligations (including customer payment terms). In that case, the criteria in paragraph 606- 10-25 -1 would not be met and a contract within the scope of the revenue model would not yet exist. Consideration received from a customer before meeting the contract identification criteria the accounting for consideration received The following flow chart describes in Topic for contract existence from a customer when the criteria 606 are not 10- met ( see p aragraph 606- 25-7). This is also referred to as the alternative model. Has the contract been terminated and is the consideration received Yes nonrefundable? No Are there no remaining performance obligations and has Recognize consideration all , or substantially all , of the received as revenue Yes consideration been received and ? is nonrefundable No Has the entity stopped transferring goods or services and there is no obligation to transfer additional goods or services and Yes all consideration received is nonrefundable ? No Recognize consideration received as a liability © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

78 Revenue for software and SaaS 76 B. Step 1: Identify the contract with the customer Comparison to legacy US GAAP , if a Legacy US GAAP software revenue recognition guidance specified that software entity has a customary business practice of using written contracts , persuasive evidence of the arrangement is provided only by a contract signed by both parties. Therefore persuasive evidence of an arrangement would not exist before the fin al license agreement being executed by both parties. In the end circumstances where both parties had not executed the contract before revenue would not be recognized in that of the financial reporting period, if the placement of the period. Under Topic 606 customer order and shipment of the goods constitute a legally enforceable contract and the other criteria are , then the new revenue model is applied even if it differs from an entity’s met customary business practices. Similar arrangements in different jurisdictions may be treated differently if the determination of a legally enforceable differs. contract Legally enforceable rights may be less restrictive than persuasive evidence guidance, an entity wa s required to have persuasive evidence Under the legacy both parties in a transaction understand the specific nature and terms of an that agreed-upon transaction. The form of persuasive evidence is required to be consistent with customary business practices, such as a signed contract. Under Topic 606, a contract must exist but it may be oral, written or implied by customary business practices and does not have to follow a consistent form. An entity will need to consider the jurisdiction in which the transaction occurs to determine whether an agreement has created legally enforceable rights and obligations. Similar contracts may produce different results based on the jurisdiction. Therefore, it may be prudent to receive legal advice or a legal opinion in certain situations. Collectibility One of the criteria tha t must be met in order for a contract to be within the scope of the Topic 606 revenue model is that “it is probable that the entity will collect substantially all of the consideration to which it will be entitled in .” exchange for the goods or services that will be transferred to the customer That is, in contrast to legacy US GAAP, under which collectibility was a recognition criterion ‘gating question’ , collectibility is a 606 , under Topic designed to prevent entities from applying the revenue model to contracts with customers who lack an ability to pay . In making the collectibility assessment, an entity considers the customer’s ability and intention (which includes assessing its creditworthiness) to pay substantially all of the amount of consideration to which the entity is entitled when it is due. This assessment is made after taking into consideration any price concessions that the entity may offer to the customer. Concessions are ’s ability and intention to pay the consideration in the not related to a customer contract; rather, concessions are typically granted in response to other factors such as competition and price pressures, sales channel overload and regulatory 606; however, based on the . ‘Substantially all’ is not defined in Topic changes © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

79 Revenue for software and SaaS 77 B. Step 1: Identify the contract with the customer s deliberations of this concept when developing ASU 2016- FASB’ 12, we believe it is a high threshold. Judgment will be required in evaluating whether the likelihood that an entity will not receive the full amount of stated consideration in a contract gives rise to a collectibility issue or a price concession. Topic 606 includes two examples of implicit price concessions: a life science prescription drug sale (Example 2) and -pay) self a transaction to provide healthcare services to an uninsured ( i.e. patient (Example 3). In both examples, the entity concludes that the transaction price is not the stated price or standard rate and that the promised consideration is variable. Consequently, an entity may need to determine the Step 3: Determine the transaction price in Step 3 of the mo del (see Chapter D – transaction price ), including any price concessions, before concluding on the collectibility criterion in Step 1 of the model. The collectibility threshold is applied to the amount to which the entity expects to be entitled in exchange for the goods and services that will be transferred to the customer, which may not be the stated contract price or the entire transaction price of the contract. The assessment considers: the entity’s legal rights; — past practice; — — how the entity intends to manage its exposure to credit risk throughout the contract; and — the customer’s ability and intention to pay. The collectibility assessment is limited to the consideration attributable to the goods or services to be transferred to the customer for the non- cancellable term of the contract. For example, if a contract has a two- year term but either party can terminate after one year without penalty, then an entity assesses the collectibility of the consideration promised in the first year of the contract (i.e. the non-cancellable term of the contract). The collectibility assessment is also limited to the consideration attributable to the goods or services the entity will transfer to the customer after considering y credit risk of the customer. That is, if there is a its ability to mitigate an question about the customer’s ability and intent to pay for all of the promised and the intent goods or services in the contract, but the entity has the ability (e.g. based on its customary business pra ctices) to mitigate that credit risk by goods or services if the customer does not fulfill i refusing to transfer further ts obligations to pay the entity, the collectibility assessment is limited to whether the customer will pay substantially all of the consideration to which the entity is entitled for those goods or services the entity will transfer before it discontinues further performance. For example, if it is not probable that a customer will pay all of the monthly fees to which a SaaS provider expects to be entitled under a three- year SaaS arrangement , the contract may still be subject to the revenue model if it is probable the customer will pay for some of the services (e.g. the first year of the SaaS) and SaaS provider has the ability and intent to shut off the customer’s access to the SaaS in a timely manner if the customer does not pay for the , if a contract exists the contract term However service as amounts come due. for purposes of applying the Topic 606 revenue model is three years (see 10-25 paragraph 606- -3). © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

80 Revenue for software and SaaS 78 B. Step 1: Identify the contract with the customer An entity may further mitigate its credit risk by requiring security deposits or advance payments. The security deposit, or requiring payments for service periods in advance, may still not make it probable that the customer will pay substantially all of the consideration for the promised goods or services in the contract, but may ensure the entity will collect substantially all of the consideration to which it expects to be entitled for the goods or services that it will transfer to the customer after taking into consideration its ability and intent to stop transferring goods or services as discussed in the preceding paragraph. Term of the contract 606 Topic is applied to the duration of the contract (i.e. the contractual period) in which the parties to the contract have presently enforceable rights and obligations. The determination of the contract term is important because it affects many other aspects of the model. For example, it may affect : — the measurement and allocation of the transaction price — the collectibility assessment — the timing of revenue recognition for non- refundable up- front fees when such fees will be recognized over the contract period – i.e. rather than over the customer with a material right a longer period when the fee provides contract modifications — the identification of material rights. — The following are some key considerations applicable to determining the term of a contract with a customer: — Consideration payable on termination can affect assessment of contract term If a contract can be terminated (by either party or just by one party) only by compensating the other party (e.g. a penalty must be paid by the terminating party) and the right to compensation exists and i s substantive throughout the contract period, then the contract term (i.e. the period for i s the which enforceable rights and obligations exist for both parties) contractual period. However, a right to compensation may not exist, or may not be substantive , for the entire contract period. Under this circumstance, the term of the contract for revenue recognition purposes is the shorter of the specified contract period and the period up to the point at which the contract can be terminated without compensating the other party (or for . For example, if a which the termination penalty is no longer substantive) year arrangement that can SaaS provider and a customer enter into a five- be cancelled by the customer at any time by paying the SaaS provider a substantive c ompensation amount that decreases over the contract term until it reaches zero at the end of the fourth (or a non-substantive amount) year of the contract, then the contract term is four years. ompensation However, if a contract can be terminated without substantive c being paid, then its term does not extend beyond the goods and services already provided. In making the assessment of whether the right to compensation is substantive, an entity considers all relevant factors, including legal enforceability of the right to compensation on termination. In general, an entity’s past practice of not enforcing a termination penalty (e.g. not pursuing collection of a penalty not paid by the customer) does not affect the contract © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

81 Revenue for software and SaaS 79 B. Step 1: Identify the contract with the customer the legally enforceable rights and past practice changes that term unless it could affect the contract obligations of the parties, in which case term. Only the customer has a right to terminate the contract — may have the right to terminate the contract without penalty, A customer the entity is obligated to continue to perform until the end of a specified while contract period . In that case, the contract is evaluated to determine whether the option for the customer to continue the contract (i.e. by not exercising its a material right to extend the with termination right) provides the customer contract beyond the date at which it can first terminate the contract . For example, a material right may exists if the contractual fee the customer will pay for periods after a termination option are at an incremental discount ( see C4 Question 10). Unless the option to continue the contract provides the customer with a material right, there is no accounting by the entity for the not to include periods customer option and the contract term is presumed . subsequent to the date of the termination option — Compensation is broader than termination payments A payment to compensate the other party upon termination is any amount e.g. equity instruments) other than a payment (or other transfer of value – due as a result of goods or services transferred up to the termination date. It is not restricted only to payments explicitly characterized as termination penalties. — Ability of either party to cancel the contract at discrete points in time may contract limit the term of the If an entity enters into a contract with a customer that can be renewed or cancelled by either party at discrete points in time (e.g. at the end of each year) without paying substantive compensation to the other party, then the contract term is the period for which the contract cannot be cancelled by either party. Upon commencement of each service period (e.g. a month in a ), -month arrangement or a year in a year -to-year arrangement month-to where the entity has begun to perform and the customer has not cancelled the contract, the entity generally has enforceable rights relative to fees owed for those services, and a contract exists for that period. For example, oftware a customer may have the right to cancel a SaaS arrangement or a s post -contract customer support (PCS) arrangement at the end of each and the entity begins service year. If the customer does not cancel, providing SaaS or PCS services for the next service year following the optional termination date, generally there is a contract only for the period of time until the next optional termination date (i.e. only for the next year) and the entity has an enforceable right to payment for services provided during . the period of time until the next optional termination date only — Evergreen contracts For purposes of assessing the contract term, an evergreen contract , such , that as a PCS arrangement that auto -renews is cancellable by either party (or just the customer) each period without a substantive penalty is no renewal of different from a similar contract structured to require a ffirmative the contract each period (e.g. one that requires the customer to place a new order or the parties to sign a new contract). In these situations, an entity should not automatically assume a contract period that extends beyond the current period (e.g. the current month ). or year © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

82 Revenue for software and SaaS 80 B. Step 1: Identify the contract with the customer Combining contracts Excerpt from ASC 606-10 25- 9 An entity shall combine two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) and account for the contracts as a single contract if one or more of the following criteria are met: a. The contracts are negotiated as a package with a single commercial objective. b. The amount of consideration to be paid in one contract depends on the price or performance of the other contracts. c. The goods or services promised in the contracts (or some goods or performance services promised in each of the contracts) are a si ngle 10- in accordance with 606- obligation 25-14 through 25-22. Determin ing when multiple contracts should be combined requires the use of judgment, and both the form and the substance of an arrangement must be considered in the evaluation. Often entities have continuing and multi- faceted relationships with their customers (including resellers), and this business relationship will lead to numerous signed or oral arrangements between the two parties. The following 606 for determining when flow chart outlines the criteria in Topic an entity combines two or more contracts and accounts for them as a single contract. Are the contracts entered into at or near No the same time with the same customer or related parties of the customer ? Yes Account for as separate contracts Are one or more of the following criteria met ? Contracts were negotiated as a — single commercial package Consideration in one contract — No depends on the other contract — Goods or services (or some of the goods or services) are a single performance obligation (see Chapter C ) Yes Account for contracts together as a single contract © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

83 Revenue for software and SaaS 81 B. Step 1: Identify the contract with the customer Comparison to legacy US GAAP The legacy US GAAP software revenue recognition guidance provided six indicators for an entity to consider in determining whether multiple contracts with the same customer should be combined and accounted for as a single multiple -element arrangement. Although one of the indicators was that the contracts are negotiated or executed within a short timeframe of each other, it five along with other indicators. was only an indicator to be considered Under Topic 606, entities are required to combine contracts if they are both (a) entered into at or near the same time with the same customer (or related parties) and (b) any one of three specified criteria is met. Although the 606 Topic contract combination guidance is similar in concept to that in legacy US GAAP versus indicators in legacy guidance, the use of criteria in Topic 606 US GAAP may r esult in some different conclusions about whether multiple contracts are combined. Software -specific indicators versus specified criteria , five legacy US GAAP are similar to the three specified Of the six indicators in if two contracts are entered into criteria in Topic 606 that must be considered discussed in further detail . This is also ‘at or near the same time’ as each other in Question B210. The indicator that negotiations are conducted jointly with two or more parties (e.g. from different divisions of the same company) to do what in essence is a 10 -25 single project is similar to paragraph 606- that is, the criterion to -9(a) – evaluate whether the contracts are negotiated as a package with a single commercial objective. The ind icators that : ( 1) the fee for one or more contracts or agreements is subject to refund, forfeiture or another concession if another contract is not and ( 2) the payment terms under one contract or completed satisfactorily, agreement coincide with performance criteria of another contract or agreement are similar to paragraph 606- 10- 25- 9(b) – that is, the criterion to evaluate whether the amount of consideration to be paid in one contract depends on the price or performance of the other contract. in the legacy US GAAP software guidance The other two indicators : (1) the different elements are closely interrelated or interdependent in terms of design, technology or function, and ( 2) one or more elements in one contract or agreement are essential to the functionality of an element in another contract are similar to the guidance an entity evaluates in assessing whether the is met. criterion in paragraph 606- 10 -25- 9(c) The contracts being negotiated or executed within a short timeframe of each other is an indicator that two contracts should be combined under legacy US s but is a gating question under Topic 606 – that is, an entity evaluate GAAP -9 are met only 10-25 whether any of the three specific criteria in paragraph 606- the contracts are entered into at or nea if r the same time (see Question B190). © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

84 Revenue for software and SaaS 82 B. Step 1: Identify the contract with the customer Legacy US GAAP guidance applied by SaaS providers Legacy US GAAP revenue guidance applicable to SaaS providers contains a rebuttable presumption that contracts entered into at or near the same time with the same entity or related parties are a single contract. Topic 606 does not include a similar rebuttable presumption and additional criteria must be met. Therefore, it is possible that entities could come to different conclusions under Topic 606 than they did under legacy US GAAP. However, we believe, in most -25 10 cases, if none of the three additional criteria in paragraph 606- -9 are met, an entity would have overcome the rebuttable presumption that existed in legacy US GAAP and, therefore, would reach the same conclusion under either Topic 606 or legacy US GAAP. Questions & answers Determining whether a contract exists Question B10 If a software entity obtains signed contracts as its customary business practice does the contract have to be signed by both parties in order for a contract to exist? . Even when a software entity obtains contracts Interpretive response: No signed by both parties as its customary business practice, a contract may exist rty’s without, or before, both parties’ signatures (or even without either pa signature). This is because t a contract exists for he assessment of whether 606 focuses on whether enforceable rights and purposes of applying Topic obligations exist on the parties based on the relevant laws and regulations , the form of the contract ( i.e. whether it is oral, implied, electronic rather than on assent or written). The assessment of whether there is an enforceable contract may require significant judgment in some circumstances or jurisdictions and may require the ounsel. Further, entities should be cautious about involvement of legal c reaching conclusions that enforceability exists if there are substantive additional reviews of the contract that have not yet occurred or authorizations not yet obtained that could substantively alter the terms and conditions of the contract. for It will be important for entities to establish a process (and related controls) determining when enforceability exists because the contract identification s not optional – 606 i guidance in Topic that is, an entity cannot elect an accounting policy to only account for contracts with customers that have been dually -signed by both parties . For example, if a software entity transfers control – Chapter F Step 5: of a software license on or before the reporting date (see performance o Recognize r evenue w hen (or as) the entity satisfies a bligation ), but incorrectly determines whether a contract with the customer exists on or - o r understated for before that reporting date, revenue may be significantly over the period. will also need to remember that for the revenue model in Topic 606 to Entities 10-25 apply to a contract, all of the criteria in paragraph 606- -1 must be met, including the collectibility criterion. Therefore, even if enforceability is © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

85 Revenue for software and SaaS 83 B. Step 1: Identify the contract with the customer established, entities will have further work to do before they can begin to apply 606 revenue model to the contract. the Topic Question B20 What should a contract with a customer describe in order to demonstrate that the parties can each identify their rights regarding the promised goods or services and the payment terms for those goods or services (i.e. that criteria b. and c. in paragraph 1 are met)? 10-25- 606- In general, we believe an entity should consider Interpretive response: whether a contract include s a description of the following terms or conditions (not exhaustive) : — the products (e.g. software licenses) and/or services (e.g. SaaS, PCS, implementation services) promised in the arrangement ; ( e.g. transferred to the customer software license — the key at tributes of any perpetual or time- is it based, or limited as to geography or use?); payment terms and fees due from the customer ; — — delivery terms ; warranties, rights — (e.g. return right s), obligations and termination provisions – if any ; and — any other pertinent contractual provisions (e.g. price protection, service level guarantees ). it may be questionable as to whether an entity would be able Absent the above, rights and obligations to identify each party’s regarding the transfer of goods or services, including the customer’s obligation to pay for the goods or services . However, the list above is not necessarily all -inclusive, nor does the absence of one or more of these items necessarily mean that criteri a b . and c . in paragraph 6 10-25 met. 06- -1 cannot be If an entity does not have a standard or customary business practice of relying on written contracts to document an arrangement, it may have other forms of should written or electronic evidence to document the transaction. An entity what constitutes enforceable rights and consider developing policies for may be obligations for each line of business or class of customer as they different for each. However, regardless of the form of documentation, the be final and include (or reference) all of the relevant terms and evidence should conditions of the arrangement. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

86 Revenue for software and SaaS 84 B. Step 1: Identify the contract with the customer B20.1 Example Contract approval and customary business practice, Part I ABC Corp. licenses software and has a customary business practice of entering into written contracts with its customers that describe the terms and conditions of delivering under which customers can obtain a license to ABC’s software and software upon receipt of an approved customer purchase order in writing. Customer has established a purchasing policy that requires execution of a contract with its vendors before it will accept delivery of any software products. ABC and Customer negotiate the terms of an arrangement and execute a written master agreement that is signed by both parties on December 29, 20X4. The master agreement specifies the terms and conditions for the licensing of ABC’s various software products (ABC licenses software products ding the price for each license of each software product; A- Z), inclu however, the master agreement does not commit Customer to purchase or ABC to transfer any licenses. Subsequent to the execution of the master manager that ABC agreement, Customer requests via an email to the account transfer 100 perpetual user licenses to Software Product A in accordance with 29 master agreement, for which it will submit a written purchase the December order. ABC transfers control of the licenses to Customer on December 30, 20X4 (i.e. ABC has both provided a copy of the licensed software to Customer see and Customer can begin to use and benefit from the licenses – Chapter F – Step 5: Recognize revenue when (or as) the entity satisfies a performance ). The actual obligation purchase order from Customer is not received by ABC until January 2, 20X5. The master agreement signed by both parties on December 29, 20X4 does not, by itself, create enforceable rights and obligations to transfer software licenses because Customer may, or may not, choose to order under the master agreement. However, that agreement, when combined with the email from Customer requesting the 100 perpetual user licenses to Product A that references the December 29 agreement, may constitute a contract in accordance with Topic 606; however, whether the customer email creates enforceable rights and obligations may vary depending on the jurisdiction. After consultation with legal counsel, ABC concludes that the master agreement in combination with the email communication from Customer establish enforceable rights and obligations between the parties with sufficient specificity to meet the contract criteria of Topic 606. Consequently, assuming that this is a single element arrangement or that the 100 user licenses to Product A are distinct from any services (e.g. PCS or professional services) in the arrangement, ABC would recognize revenue for the transfer of the 100 user licenses on December 30, 20X4. By way of comparison, under legacy US GAAP, ABC would not have had persuasive evidence of an arrangement because ABC has a standard business practice of obtaining an approved customer purchase order in writing to evidence its arrangements (which was not received until January 2, 20X5) and, of the 100 user licenses could not therefore, revenue related to the delivery have been recognized any earlier than January 2, 20X5. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

87 Revenue for software and SaaS 85 B. Step 1: Identify the contract with the customer Example B20.2 Contract approval and customary business practice, Part II , except B20.1 Assume the same basic facts and circumstances as in Example that: — the master agreement outlining the terms and conditions for the licensing of ABC’s various software products (ABC licenses software products A -Z), including the price for each license of each software product, is signed, dated and returned by Customer on January 2, 20X5. ABC signed the contract on December 22, 20X4 and it was confirmed received via email by Customer the same day; — ABC receives a written purchase order from Customer for the 100 perpetual user licenses to Product A on December 26, 20X4, referencing the master contract; — ABC transfers control of the 100 perpetual user licenses to Customer on December 30, 20X4; — ABC’s legal counsel represents that ABC had a valid contract as of December 26, 20X4 because the contract, signed by ABC and sent to Customer, constituted an offer that Customer accepted by executing the purchase order, even if it did not execute the agreement until a few days later. 26, There is a contract between the parties under Topic 606 as of December 20X4. Consequently, assuming that this is a single element arrangement or that the 100 user licenses to Product A are distinct from any services (e.g. PCS or professional services) in the contract, ABC would recognize revenue for the transfer of the 100 user licenses on December 30, 20X4. By wa y of comparison, under legacy US GAAP, ABC would not have had persuasive evidence of an arrangement because ABC has a standard business practice of using signed written contracts. Because the contract was not signed by both parties until January 2, 20X5, revenue related to the delivery of the 100 user licenses could not have been recognized any earlier than that date. Question B30 If a Master Service Agreement (MSA) exists between an entity and a customer under which the ces through customer requests goods and servi purchase orders is the MSA a contract under Topic 606? Interpretive response: It depends , and this is illustrated in Example B20.1. If the MSA merely defines the terms and conditions under which the customer services from the entity, but does not create enforceable can order goods and rights and obligations on the parties (i.e. for the entity to transfer goods or services and for the customer to pay for those goods or services), there is not a (PO) contract between the parties until the customer places a purchase order under the MSA. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

88 Revenue for software and SaaS 86 B. Step 1: Identify the contract with the customer with customers, which specify the basic terms Some entities enter into MSAs and conditions for subsequent transactions between the parties and are signed and customer. Under such arrangements, no additional by both the entity contractual agreement is executed and customers request products through POs that specify the products and quantities. An MSA under which a customer places POs in order to obtain goods or services does not itself constitute a contract with a customer. This is because the MSA usually does not create enforceable rights and obligations for the parties. As discussed in Question 0, in order for a contract to be enforceable an entity should be able B2 to identify each party’s rights regarding the goods and services to be transferred. While the MSA may specify the payment terms for goods or (e.g. licenses) services to be transferred, it usually does not specify the goods to be transferred . Absent those and services, including quantities thereof, a contract within the revenue model of specific terms and conditions, Topic 606 does not exist (i.e. the contract will not meet the criteria in paragraph 606- 10-25 -1). However, s ome MSAs may include a requirement for the customer to purchase may be a a minimum quantity of goods or services from the entity . This cumulative minimum for the MSA period or for periods within the MSA (e.g. the MSA -year MSA) each year of a multi . If the minimum is enforceable, then itself may constitute a contract under Topic , if the entity’s past 606. However practice of not enforcing MSA minimums results in a conclusion that the minimums are not enforceable, the MSA would not be a contract under legally Topic 606 (i.e. jus t as if the minimum were not included in the MSA at all). In addition, if relevant experience with the customer suggests that the customer will not meet the required minimums, and that the entity will not enforce them, this would typically demonstrate the entity and the customer are not committed to the minimums in the contract as per paragraph 606 -10-25 -1 (a). Consequently, even if the entity’s past practice of not enforcing MSA minimums doesn’t result in a conclusion that the minimums are not legally enfor ceable, the contract may still not meet all of the criteria in paragraph 606- 10-25 -1 . It would therefore not be a contract within the revenue model of Topic 606. When an MSA does not create enforceable rights and obligations with respect combination to transferring goods or services on its own, it will normally be the with the MSA that does so. Therefore the MSA and the PO would be of a PO to determine whether the Step 1 criteria are met and a evaluated together contract exists. However, if additional steps must be taken for the PO to create legally enforceable rights and obligations ( e.g. executing a supplemental contract or addendum to the MSA subsequent to receipt of the PO), then a Other contract with a customer does not exist until those steps are completed. examples of additional steps may include acceptance of the PO and/or issuance of a sales order acknowledgment form by the entity In some to the customer. cases, the customer may have to accept the invoice issued by the in entity order for payment of consideration to be legally enforceable. If either par ty can cancel a PO entered into under an MSA without penalty before the entity transferring the ordered goods or services (e.g. before , a contract does not exist, even if all the transferring a software license) -1 are met. In this situation, a contract is not -10-25 conditions in paragraph 606 deemed to exist because each party has a right to terminate the contract and the contract is wholly unperformed (the entity has not transferred any goods or services to the customer and the entity has not yet received, and is not yet © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

89 Revenue for software and SaaS 87 B. Step 1: Identify the contract with the customer entitled to receive, any consideration in exchange for the promised goods or -25-4. 606-10 in accordance with paragraph services) However, in contrast, if the entity transfers some or all of the goods or services in the PO, the contract unperformed. The entity would at least be entitled to would no longer be wholly receive consideration in exchange for the goods or services transferred to the customer. Example B30.1 Prepaid spending account Corp. n arrangement with Customer whereby Customer enters into a ABC year period. Customer prepays agrees to spend $2 million with ABC over a two- the $2 million at the date the prepaid spending account (PSA) is agreed to and year period by issuing then ‘draws down’ from that balance over the two- purchase orders (POs) for specific software licenses and services (which may also require additional Statements of Work (SOWs) depending on the nature of mutually agreed price list. The price list includes most of the service) against a ABC’s software licenses and services. The PSA agreement establishes the prepaid amount, the two -year term, and the price list that includes all of the other relevant terms and conditions under which draw -downs (through POs) will be made (e.g. warranties, delivery mechanisms and scope of rights granted for the various software licenses). The $2 million up- front payment is subject to a ‘use it or lose it’ provision – that is, any amounts Customer does not use downs by the end of the two- through draw- year PSA term is forfeited and none of the $2 million is refundable to Customer. The price list in the PSA permits Customer to select from a wide variety and quantity of ABC’s software licenses and services. For many of the services, an additional SOW would be necessary to establish the parameters of the services to be provided, the PSA merely sets out the hourly rate that will be applied to services of that nature. Consequently, even though the PSA sets out many terms and conditions, and establishes, in effect, a minimum quantity of ABC’s software and services that Customer will acquire, until Customer executes a PO (and potentially also an SOW in the case of most professional services offerings on the price list), ABC cannot identify each party’s rights regarding the licenses or services to be transferred because the entity does not know what software licenses or services it will be required to transfer. ABC also has no obligation to transfer any licenses or services until Customer executes a PO making its selections. Only at the point in time that Customer executes a PO (and potentially also an SOW) under the PSA does ABC have a present obligation to transfer licenses and/or services to Customer and can ABC identify each party’s rights regarding specific licenses and services it will transfer to Customer. Consequently, the contract between ABC and Customer under Topic 606 is the combination of the PSA and the PO (or PO/SOW if the PO includes services that require an SOW). Each PO will be a separate contract unless it is combined with another PO 25-9. 10- based on the contract combinations guidance in Topic paragraph 606- © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

90 88 Revenue for software and SaaS B. Step 1: Identify the contract with the customer Comparison to legacy US GAAP Under legacy US GAAP, an MSA did not provide ‘persuasive evidence of an arrangement’ if the entity’s customary business practice was to obtain a purchase order (PO) from its customers to specify the products /services and quantities evidence of an arrangement criterion would . If so, the persuasive only be satisfied upon receipt of the customer’s PO. However, if the entity intends to execute a supplemental contract or addendum to the MSA subsequent to receipt of a PO, revenue may not be recognized until both the entity and the customer execute that additional agreement. The guidance in Topic 606 is similar from the perspective that an MSA may not create enforceable rights and obligations on an entity and its customer. However, under Topic 606, the question is about whether enforceable rights and obligations exist without the PO, rather than on whether the form of the contract without the PO is consistent with the entity’s customary business practices. Because of this, entities may, in some circumstances, reach different conclusions about the effect of having a PO on whether a contract exists under Topic 606 than they would have reached about whether a PO was necessary to having persuasive evidence of an arrangement. Question B40 ontracts and evidence Does the form of an entity’s c of approval have to be consistent across customers? No. An entity Interpretive response: may have a customary business practice of using written contracts or purchase orders to evidence an arrangement. However, the entity may enter into arrangements with certain customers whose business practices of providing evidence of an arrangement differ from certain customers i.e. the entity’s customary practice of using written contracts ( may se orders). In fact, the entity may license software products only by purcha not have a customary business practice if it principally relies on whatever method its customer s prefer . For example, an entity may not have a customary contracts or purchase orders but certain of business practice of using written the entity’s customers may require signed written contracts or the issuance of written purchase orders to purchase goods or services . Because, u nder Topic 606, the form of the contract does not, in and of itself, determine whether a contract exists (see the discussion on enforceable rights and obligations in the overview to this chapter, as well as the discussion in –B30); Questions whether the entity is consistent in the form of its B10 contracts and/or its evidence of approval of those contracts also do not, in . isolation, affect whether a contract exists © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

91 89 Revenue for software and SaaS B. Step 1: Identify the contract with the customer Example B 40.1 Form of the contract and approval does not affect usion contract concl ABC Corp. is a provider of computer security software. ABC provides time- based licenses to its customers. ABC has a customary business practice of executing formal license agreements with its customers, including amendments for license renewals. has licensed ABC’s software for the last two years and its current Customer term license will expire on December 31, 20X0, which is also ABC’s fiscal year - end. On December 30, 20X0, ABC and Customer (i.e. an authorized officer of nd via email in which Customer Customer) correspo requests to renew its license for an additional two years and ABC quotes Customer a fee of $ 200,000 for the renewal. The email offer from ABC includes all of the substantive terms and conditions normally included in ABC’s renewal amendments. Customer responds via email accepting the offer later on December 30, 20X0, and on December 31, 20X0, Customer emails ABC a purchase order for the two- year var upon fee. For renewal license at the agreed- ious reasons, a written renewal license agreement is not executed or signed amendment to the parties’ master by both parties until January 8, 20X1. A contract may exist as of ABC’s December 31 fiscal year- end. Unlike under legacy US GAAP, the absence of an executed, written renewal amendment does not, in isolation, preclude a contract from existing before that amendment being formally executed. Depending on various facts and circumstances (e.g. the governing jurisdiction), either the email accepting ABC’s offer (which occurred on December 30, 20X0) 31, 20X0) may create or the written purchase order (issued on December enforceable rights and obligations on the parties as well as permit ABC to conclude that the contract existence criteria in paragraph 606- 10 -25 -1 have been met before executing the formal written amendment. ABC’s evaluation of whether enforceable rights and obligations exist would include an assessment of its customary business practices and past typically in the jurisdiction governing this what has been enforced experience with contrac t. Meanwhile, the substance of the email communications (which, in this case, included all of the substantive terms and conditions normally included in ABC’s renewal amendments) and the written purchase order would affect whether the criteria in paragraph 606- 10 -25- 1 are met (e.g. whether t he entity can identify each party’s rights regarding the goods or services to be transferred and/or the payment terms for the goods or services to be transferred). Note that even if a contract exists as of ABC’s fiscal year -end, ABC will not necessarily recognize revenue from the license renewal during its current fiscal year. ABC will need to consider the guidance in paragraphs 606- 10 -55 -58B – 58C in order to make that determination (see F Step 5: Chapter through 55- Recognize revenue when (or as) the entity satisfies a ). performance obligation © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

92 Revenue for software and SaaS 90 B. Step 1: Identify the contract with the customer Question B50 Are ‘side agreements’ contracts under Topic 606? Side agreements Software entities may enter into side agreements with customers outside of the normal contracting process (e.g. as part of the negotiation process or in response to an actual or perceived customer service issue). Those entities’ sales and marketing staff may be motivated to make commitments to e.g. email) that are customers (verbally, written or electronically transmitted – not part of the master arrangement with the customer (often referred to as side agreements or side deals) in order to consummate a sale. Interpretive response: All terms and conditions that create enforceable rights and obligations need to be considered in evaluating a contract, regardless of (e.g. in an email or whether the form of some of those terms and conditions letter agreement, which may be considered a ‘side agreem ) differs from ent’ other terms and conditions in the contract (e.g. those included in a formal ‘master agreement’ or ‘statement of work’). The form in which additional terms and conditions are agreed generally will not affect whether those terms and 606 condit ions are part of the contract under Topic 606. This is because Topic does not focus on the form of the contract or its approval, but rather on whether enforceable rights and obligations on the parties are specified and the are committed to meeting their respective obligations. parties However, an entity should whether the form used to communicate assess of the master agreement certain terms and conditions being different from that (or associated agreements) affects whether the terms and conditions have ed or change the been establish enforceable rights and obligations to which the parties are committed. ‘ Side agreements ’ often occur outside the entity’s standard contract procedures. Tho se contract procedures may have been established by an entity to ensur entered into with e enforceability of contracts its customers. , create enforceable rights A particular side agreement may not, in and of itself and obligations on the parties. However, in accordance with paragraphs 606 -10- 32-7, respectively, the side agreement may create a 25-16 and 606- 10- reasonable expectation on the part of the customer that a promised good or a valid expectation that a discount, rebate or some service will be transferred; other form of price concession (including extended payment t erms) will be granted; . A or even that the terms of the written contract will not be enforced by the entity of providing free or discounted good or services pattern , or providing subsequent discounts, rebates or extended payments, as a result of may create implied that are not legally enforceable contracts side agreements performance obligations, variable consideration and/or significant financing if they components that the entity will need to account for in future contracts create a reasonable expectation on the part of those customers that they will receive those items or price concessions . © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

93 Revenue for software and SaaS 91 B. Step 1: Identify the contract with the customer Comparison to legacy US GAAP legacy US GAAP Under , side agreements were particularly troublesome in - to have vendor software licensing arrangements because of the requirement specific objective evidence of fair value (VSOE) for each undelivered item in order to account for delivered items separately from the undelivered items – . If there were that is, in order to recognize revenue for delivered items undelivered items for which VSOE was not established, all of the revenue under the related contract would be deferred, including for delivered items, until VSOE established for all remaining undelivered items or until the last item was was delivered (unless the only undelivered item was PCS or hosting services in which case the total consideration would be recognized ratably over that period). service Side agreements were also troublesome because of the relatively punitive guidance that applied to entities with a history of granting concessions to customers. A history of granting concessions to customers would call into question whether the fees in the entity’s arrangements were fixed or determinable. Revenue under arrangements for these entities was often ly deferred, even beyond the point at which cash was received, and significant the arrangement consideration was deemed to be recognized only once was fixed (i.e. the risk of concession had abated). software Topic 606 eliminates the VSOE requirement that previously applied to licensing arrangements and substantially changes the effect on a software entity’s revenue recognition of a pattern of concessions (see Questions C90 and D130). T herefore , the accounting consequences of many side agreements may not be (e.g. those that grant price or additional good/service concessions) as significant as under legacy US GAAP. That is, these types of side agreements may result in the deferral of some of the contract consideration – for example, for additional, undelivered goods or services or for potential discounts or rebates – but will typically not result in the deferral of all contract consideration as frequently occurred under legacy US GAAP due to the VSOE requirement and the restrictive guidance on concessions. However, other types of side agreements may still result in an entity not recognizing any revenue from a contract even as it transfers goods (including licenses) or services. For example, a side agreement that negates the customer’s obligation to pay for good or services would generally prohibit the entity from recognizing any revenue until either one of the events in -7 are met or until the entity’s enforceable rights to paragraph 606- 10-32 consideration are re- established (e.g. through a modification to the side agreement). Similarly, a side agreement that promises unspecified future concessions may result in a conclusion that the entity cannot identify each party’s rights and obligations in the contract, which is a requirement for a contract to exist in accordance with paragraph 606- -25-1. 10 © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

94 92 Revenue for software and SaaS B. Step 1: Identify the contract with the customer Question B60 Does a contract exist for services such as PCS or SaaS when an entity continues to provide the services after the expiration of the contract with the customer? may continue to provide services to a Entities Interpretive response: customer (e.g. PCS, hosting services , or SaaS) after the expiration of the contract. Whether a contract exists in those circumstances depends on whether enforceable rights and obligations exist after the expiration of the previous contract. Determining whether an enforceable contract exists Even if there are no provisions in the contract to continue the services after of the contract and the entity continues to provide the services under expiration the terms of the expired contract while a new contractual arrangement is being negotiated, enforceable rights and obligations may still exist and there may be . evidence that both parties are committed to those obligations There may be circumstances in which an entity could conclude that there are legally enforceable rights and obligations of a formal even in the absence renewal agreement. Judgment may be required to support that both parties are committed to their respective obligations after the expiration of the written its Additional evidence might include consideration by the entity of agreement. past practice of invoicing for the continuation of services subsequent to an expired agreement and whether its customers, including the present customer if this situation has previously arisen, have continued to pay (and the had they not ).The entity’s provision of the enforceability of those amounts services and the customer’s continued payment of the service fees may provide evidence to demonstrate such commitment. Additionally, an entity might consider in it s evaluation any received customer purchase orders, whether contract negotiations have begun and/or any email communications evidencing the customer’s intent to continue the services and pay for such services. An entity might also consider its history with the customer, and potentially other similar customers, in terms of whether the customer has previously continued services after contract expiration and paid for such services or entered into a contract extension that addressed those services. Ultimately, evidence of behaviors may not be sufficient to conclude that enforceable rights and obligations exist and legal interpretation by competent counsel may be required. Lastly, the entity would need to conclude that collectibil ity of amounts due for the continued services is probable. If there is an enforceable contract within the scope of the revenue model Revenue would continue to be recognized as the services are provided based on the terms and conditions of the contract . If the fees for the services are uncertain because of ongoing negotiations to enter into a formal agreement, the entity would be required to estimate the total amount of variable consideration (subject to the constraint) to which it would be entitled in exchange for providing the services (for further discussion of variable consideration and the price transaction the Step 3 : Determine ). When the constraint, see Chapter D – © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

95 Revenue for software and SaaS 93 B. Step 1: Identify the contract with the customer formal agreement is executed, if the fees for the services provided post - expiration are changed (e.g. the parties agree on a monthly service fee of $100, while the entity had been invoicing, and the customer paying, $105), this would either result in an adjustment to the variable consideration included in the by the entity or, if the consideration was not deemed to be transaction price variable (e.g. because the entity had no indication that the formal contract would not codify the monthly services fees it was charging the customer), as a see Chapter G – contract modification ( odification s ). Contract m If there is not an enforceable contract within the scope of the revenue model The entity would first consider the guidance for consideration received before 10-25 -7) to determine if revenue concluding a contract exists (paragraph 606- can be can be recognized. We believe the conclusion about whether revenue recognized based on that guidance could differ depending on whether the guidance applies : a. because enforceable rights and obligations do not exist (i.e. a legally binding contract does not exist) ; or a. solely because the collectibility criterion is not met. binding If there is not a contract within the revenue model because a legally ((a) contract does not exist (a-c) in , we do not believe any of the criteria above) 10-25 -7 can be met . That is, in the absence of a legally binding paragraph 606- contract, we do not believe it is possible for the entity to conclude that it has (1) no remaining obligations to transfer goods or services, (2 ) received all, or substantially all, of the consideration promised (the entity does not have an enforceable promise from the customer to pay any amount of consideration) or (3) received consideration that is nonrefundable. Item ( 1) must be met to meet criteria (a) or (c). Meanwhile, item (2) must be met to meet criterion (a) and item -25- 7. (3) must be met to meet any of the criteria in paragraph 606- 10 Excerpt from 606-10 ASC 7 When a contract with a customer does not meet the criteria in 25- paragraph 606- 10-25 -1 and an entity receives consideration from the customer, the entity shall recognize the consideration received as revenue only when one or more of the following events have occurred: a. The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable. The contract has been terminated, and the consideration received from the b. customer is nonrefundable. c. The entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is nonrefundable. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

96 Revenue for software and SaaS 94 B. Step 1: Identify the contract with the customer In contrast, i f a legally binding contract exists, but the contract is not within the scope of the revenue model such that the guidance in paragraph 606- 10- 25-7 applies solely because the collectibility criterion is not met (b. above) , the entity (3) may be able to conclude on each of the items (1) – outlined in the preceding paragraph. For example, if the legally binding contract does not obligate the entity to provide services beyond either those it has already performed or those for which the customer has already paid (e.g. the current month’s services paid in advance) , the entity would likely be able to recognize revenue for the services it has already provided and for which it has received substantially all of the consideration to which it is legally entitled. That is, in accordance with paragraph 606- conclude that it has no the entity might be able to 10-25 -7(a), remai ning obligation to provide further services (i.e. beyond those already provided after the previous contract expired) and has received substantially all of the consideration to which it is entitled for those services such that it can he services once those services are complete and recognize revenue for t substantially all of the consideration to which it is entitled for those services has been received. Regardless of the reason for concluding that there is not an enforceable contract within the scope of the revenue model, if none of the criteria in -7 are met, the entity would defer any consideration 10-25 paragraph 606- received from the customer and recognize it as a deposit liability until there is within the scope of the revenue model . At that point in an enforceable contract time, the entity would recognize revenue on a cumulative catch- up basis for the services already provided under the newly -established contract and account for the remainder of the contract in the same manner as any other services contra ct within the scope of Topic 606. Example B 60.1 Contract continuation for PCS ABC and Customer have a longstanding relationship. The parties’ latest 12-month PCS agreement expired on May 31, 20X3 and did not include any Customer paid $12,000 up- provision for automatic renewal of the PCS. front for the 12 months of PCS on June 1, 20X2, which was the observable stand- alone selling price for the PCS . A new PCS agreement requiring a fee month period of of $10,800 for the 12- June 1, 20X3 to May 31, 20X4 is signed on July 31, 20X3. No agreement existed from June 1, 20X3 until July 31, 20X3, although ABC continued to provide PCS in anticipation of executing an agreement for the 12- month period following the expiration of the prior agreement . As per its customary business ABC invoiced Customer for the June 1, 20X3 through May 31, 20X4 practice, PCS in May 20X3 at the amount that was agreed for the preceding year (i.e. $12,000). ABC concludes, based on advice of legal counsel, that an enforceable contract did not exist between June 1, 20X3 and July 31, 20X3. based measure of ABC recognizes its PCS revenue over time using a time- progress (see Question F220). © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

97 Revenue for software and SaaS 95 B. Step 1: Identify the contract with the customer Scenario 1: Customer does not pay initial invoice Customer did not pay ABC’s $12,000 invoice issued in May 20X3. ABC cancelled that invoice on July 31, 20X3 when the new contract was executed, and issued a new invoice for the agreed- upon $10,800, which Customer timely. paid On July 31, 20X3 ABC recognizes PCS revenue of $1,800, which is equal to two mont hs’ of PCS at an annual rate of $10,800, on a cumulative catch- up basis, that ABC has already provided under the newly established contract. ABC also recognizes a receivable of $10,800 (Customer pays the $10,800 timely thereafter) and a contract liability (deferred revenue) of $9,000. ABC will recognize $900 in PCS revenue per month for the remaining 10 months. Scenario 2: Customer partially pays the initial invoice Customer partially paid ($4,000) the $12,000 invoice issued by ABC in May 20X3. When the new contract was concluded on July 31, 20X3, Customer paid ABC the balance of the $10,800 new contract PCS fee ($10,800 – $4,000 = $6,800). mer partially paid the $12,000 invoice, ABC does not Despite the fact that Custo recognize any revenue until the new agreement is established on July 31, 20X3. Notwithstanding the fact that services have been provided and cash received from Customer, ABC is unable to conclude that any of the criteria in -7 are met before the new agreement is entered into. 10-25 paragraph 606- Therefore, ABC records the $4,000 received from Customer as a deposit liability. On July 31, 20X3, ABC recognizes $1,800 in PCS revenue consistent with Scenario 1. However, because of the $4,000 prepayment by Customer, at July 31, 20X3, ABC only has a receivable of $6,800 (versus $10,800 in Scenario 1), and has a contract liability of $9,000. Customer Scenario 3: partially pays and entity has history of enforcing pa yment Assume the same facts as in Scenario 2 except that ABC concludes an enforceable contract does exist based on relevant experience with enforcing similar arrangements and the advice of legal counsel. Because an enforceable contract exists on June 1, 20X3, ABC continues to recognize PCS revenue as it provides the PCS to Customer, only at an amount other than the $1,000 per month it had been recognizing under the previous PCS contract. B transaction price for the PCS it is providing ecause the subsequent to expiration of the prior agreement is uncertain – i.e. ABC knows from relevant experience that Customer will likely negotiate a lower PCS fee ABC is required to estimate the than the $12,000 in the prior year – consideration to which it will be entitled (subject to the constraint on variable consideration) for providing the PCS during the post -expiration period and recognize revenue based on that estimate. Chapter D – Step 3: Determine the discusses estimating variable consideration, subject to the transaction price constraint, in further detail. When the new agreement is signed on July 31, 20X3 (assuming, in this scenario, that ABC is unable to resolve the uncertainty associated with the new agreement’s transaction price before execution of the new agreement), ABC -up the revenue recognized for the post will true -expiration period based on resolution of the uncertainty surrounding the transaction price for the PCS © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

98 Revenue for software and SaaS 96 B. Step 1: Identify the contract with the customer provided during those periods. For example, if ABC estimated, subject to the -expiration constraint, that it would be entitled to $700 for each of the two post months of PCS, on July 31 when the new agreement is signed with a transaction price for the full year of $10,800 (which equates to $900 per month for the year June 1, 20X3 through May 31, 20X4), ABC would recognize a cumulative catch -up revenue adjustment of $400 ($1,800 – $1,400). Comparison to legacy US GAAP While in some of the scenarios addressed by Question B60 an entity may conclude that an enforceable contract exists, under legacy US GAAP, it was generally not the case that an entity could conclude that persuasive evidence of an arrangement existed after expiration of the contract period if its customary busin ess practice was to obtain a signed contract for the extension or period. renewal -up versus prospective catch Cumulative -expiration service Under legacy US GAAP, no revenue was recognized in post periods if persuasive evidence of an arrangement did not exist and/or the fees for the services were not fixed or determinable. Once persuasive evidence of an arrangement had been obtained, and the fees were fixed or determinable, the PCS fees were recognized prospectively, on a ratable basis, over the remainder of the new PCS contract term (other than in some scenarios, such as the reinstatement of PCS, where additional deliverables – e.g. specified updates or upgrades – had been transferred to the customer during the lapse in agreement period) . For example, in Scenario 1 of Example B60.1, ABC would have recognized the $10,800 PCS fees in the agreement executed on July 31, 20X3 ratably over the period from August 1, 20X3 through May 31, 20X4 ($1,080 per month). up basis, as described in Recognizing revenue on a cumulative catch- 2), is (in Scenario 1 and Scenario B60 and illustrated in Example B60.1 Question a significant change from legacy US GAAP. Question B70 Does a fiscal funding clause affect whether a contract exists under Topic 606? Interpretive response: It depends. Fiscal funding clauses sometimes are found in software licensing and other (e.g. SaaS) arrangements in which the customers are governmental units. Such clauses generally provide that the contract is cancellable if the legislature or funding authority does not appropriate the funds necessary for the governmental unit to fulfill its obligations under the contract. A funding contingency, from a business enterprise or governmental unit, may render the agreement to not be an enforceable contract under applicable laws and/or regulations if the chance of the fiscal funding contingency being triggered is more than remote. Judgment will need to be applied in those © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

99 Revenue for software and SaaS 97 B. Step 1: Identify the contract with the customer contracts to determine whether a contract exists before funding has been i.e. whether the contract existence criteria in paragraph 606- 10 -25- approved – 1 are met . Even if a contract is determined to exist in an arrangement with a fiscal funding clause, a fiscal funding clause that has a more than remote chance of being triggered may affect t he enforceable contract term. This is because, in in accordance with paragra ph 606- 10-25 -3, an entity applies the guidance Topic to the duration of the contract (i.e. the contractual period) for which 606 the parties to the contract have present enforceabl e rights and obligations, and such rights may not presently exist beyond the existing fiscal authorization (i.e. the customer has the right to unilaterally terminate services without penalty by not approving funding) . For example, an agreement may be for a stated three- year period, but if the entity’s enforceable right to payment for providing the services in years 2 and 3 is contingent on the customer obtaining fiscal authorization (i.e. the customer may cancel the contract if the legislature or funding authority does not authorize the expenditure), an enforceable contract 606 may only exist for one year. In that scenario, the contract term under Topic would only covered by the current funding commitment period be the one-year and any period beyond that would be considered cancellable by the customer. An alternative view exists that we believe is also acceptable when the customer is a governmental unit and a contract otherwise exists in accordance Under that 10- 25-1. view, with paragraph 606- the unfunded por tion of the contract , even if the chance of the fiscal funding contingency being triggered is more than remote, should be considered variable consideration; the software subject to the entity includes variable consideration in the transaction price 3: Determine the t ). price ransaction cons traint (see Chapter D Step – Whichever view an entity ascribes to we would expect it to be applied consistently to similar arrangements. Comparison to legacy US GAAP Under legacy US GAAP, the existence of a fiscal funding clause in a software arrangement with a governmental unit necessitated an assessment of the likelihood of cancellation through exercise of the fiscal funding clause. If the likelihood of exercise of the fiscal funding clause with a governmental unit was assessed as being remote (i.e. the chance of the future event or events occurring is slight), the software arrangement would be considered non- cancellable and, thus, revenue would be recognized if the other revenue recognition criteria were met. If the likelihood of exercise was assessed as other than remote, the license was considered cancellable, thus precluding revenue recognition until the funding was authorized or the contingency became remote. A fiscal funding clause with a customer other than a governmental unit created a contingency that precluded revenue recognition until the requirements of the clause were met. For software entities that ascribe to the first view outlined in the question , we do not expect that the effect of a fiscal funding clause will be substantially © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

100 Revenue for software and SaaS 98 B. Step 1: Identify the contract with the customer different under Topic 606 than it was under legacy US GAAP. However, the variable consideration approach to the unfunded portion of the contract will be a significant change in how fiscal funding clauses are considered for those entities that apply that alternative to governmental contracts. Collectibility Question B80 What factors should an entity consider in determining whether the amount of consideration to which an entity ex pects to be entitled includes an implicit price concession? Interpretive response: The collectibility criterion is applied to the amount to which the entity expects to be entitled in exchange for the goods and services may not be the stated that ‘ will be transferred to the customer ’. That amount contract price for those goods or services that will be transferred to the customer. The amount of consideration to which the entity expects to be e (i.e. is entitled considers whether the promised consideration is variabl different from the stated contract price) due to facts and circumstances that , at offer a price concession to the entity may contract inception, indicate the customer. It may be difficult to distinguish between situations in which there is risk the customer will not pay the promised consideration for the a significant goods and services that will be transferred to the customer (i.e. a collectibility an amount of consideration accept issue) and situations in which the entity will the promised amount in return for those goods and services that is less than (i.e. an implicit price concession) . Topic 606, including the two examples of implicit price concessions (Examples 2 10-55- and 3 in paragraphs 606- -105), 99 through 55 does not provide any explicit guidance about how to determine if an entity may grant an implicit price concession. However, the Basis for Conclusions to ASU 2014 -09 (BC192) states that an entity’s customary business practices, published policies or specif ic and/or create a valid expectation on the part of statements may provide evidence the customer that the entity is willing to accept a lower price in exchange for the promised goods and services. BC192 also indicates that price concessions may be more lik ely to be granted in situations where doing so would enhance a customer relationship or encourage future sales. The Boards decided against providing further guidance on implicit price concessions. However, the FASB and IASB staffs proposed some additional would factors that , to varying degrees (i.e. in some cases , the factors may merely contribute to a price concession conclusion rather than provide determinative evidence in that respect), indicate that, at the time of entering into a contract, an entity intends to offer a price concession if there is a significant risk that the customer will not pay the promised consideration for the goods and services that will be transferred. While these factors are not ic 606, we believe they may because they were not included in Top authoritative be useful for software entities to consider in the absence of authoritative guidance. These factors along with our view on how those factors might relate are: to software entities © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

101 Revenue for software and SaaS 99 B. Step 1: Identify the contract with the customer a. The goods or services promised to the customer are not expected to expose the entity to a significant economic loss if the customer does not pay the promised consideration. For example, an entity would not be expected to incur a significant economic loss in any of the following circumstances: The incremental costs that an entity incurs to produce the good or i. This service or transfer it to the customer would be negligible – circumstance may frequently arise in software licensing arrangements because the incremental costs to transfer a software license are typically negligible. It may also frequently be the case that the incremental costs of providing PCS services or SaaS to a customer in a multi- tenant SaaS environment are minor. The entity can deny the customer further access to the promised good ii. or service if the customer fails to meet its obligations under the contract but may This is typically the case in SaaS arrangements, – also be the case in some software licensing arrangements if the entity only provides temporary software keys or has the ability to send out a ‘kill ’ code if the customer does not pay the license fees. iii. expected to depreciate The good that transfers to the customer is not substantially (or diminish in value) and, therefore, the good provides the entity with sufficient collateral in the event of the customer failing to meet its obligations under the contract. For example, the good is a tangible asset that is not expected to have depreciated substantially if and when the entity obtains control of the good from the customer – This circumstance would not typically be the case in software or SaaS arrangements. b. The entity has previously chosen not to enfor ce its rights to the promised consideration in similar contracts with the customer (or class of customer) under similar circumstances – Evidence that the entity has previously accepted consideration less than the promised amount in similar contracts may call into question whether the entity will accept consideration less than the promised amount in this contract . c. The entity has experience (or other evidence) about the customer not contracts promised consideration in other fulfilling its obligations to pay the – If the entity has history of the customer not paying some or all of the promised consideration in prior contracts, the entity’s willingness to enter into new contracts with the customer despite that history may suggest it will accept a partial payment as complete performance by the customer . evidence) about the class of customer d. The entity has experience (or other their obligations to pay the to which the customer belongs not fulfilling ircumstances – promised consideration in similar contracts under similar c Similar to c. the entity’s willingness to enter into a contract with a customer – i.e. a class of customer where there is a significant ’ class in a ‘ suspect credit risk – may suggest the entity will accept a partial payment as complete performance by the customer. Variable consideration and price concessions are discussed in Chapter D – 3: Determine the transaction price. Step © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

102 Revenue for software and SaaS 100 B. Step 1: Identify the contract with the customer Example B 80.1 Collectibility threshold assessed based on amount the entity expects to receive for the goods or services transferred ABC Corp. enters int o an arrangement with Customer to license 1,000 seats of standard payment terms for Product X for two years for $ 1,000,000. ABC’s are for Customer to make two similar customers entering into similar licenses equal payments, one due at contract inception and the second due at the beginning of Year 2 of the license. ABC has a prior history with Customer. Customer of has a history with ABC requesting a reduction in the second payment due, which ABC has frequently ed in order to incent Customer to make additional purchases, including grant ABC further notes that this practice is not isolated to renewals, in the future. Customer; other similar high- volume customers have made similar requests that ABC has granted. Based on all relevant facts and circumstances, ABC assesses that it is likely to accept an amount of consideration that is less than the $1,000,000 promised amount. In this contract, after consideration of the guidance on variable 32-5 through 32-13 (see further discussion consideration in paragraphs 606- 10- ) of this in Chapter D – Step 3: Determine the transaction price , ABC concludes that the amount of consideration to which it expects to be entitled is $900,000. assesses Accordingly, when assessing whether collectibility is probable, ABC whether it is probable that it will receive $900,000 – i.e. the amount to which it expects to be entitled after the expected price concession. See also Example B100.1, Scenario 2. Comparison to legacy US GAAP Under legacy US GAAP for software entities, collectibility was assessed against the fixed or determinable fees in the arrangement in their entirety – i.e. there was no concept of considering whether collectibility wa s probable only for a portion of the fixed or determinable fees. In contrast, collectibility under Topic 606 may be assessed against an amount that is less than that promised in the contract either (1) because of an implied price concession or (2) because the goods or services that ‘will be transferred to the customer’ (see Questions B90 and B110) differ from the promised goods or services in the contract. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

103 Revenue for software and SaaS 101 B. Step 1: Identify the contract with the customer Question B90 In assessing collectibility, an entity considers only the likelihood of payment for goods or services that d to the customer’. What does this ‘will be transferre mean in the context of typical software related service arrangements (e.g. SaaS arrangements or ces sold separately from a soft ware PCS servi license)? – ability the 606 provides that when an entity has Interpretive response: Topic and the intent (typically, evidenced by its both the right and the capability – i.e. customary business practices) to stop providing services in the event of customer non- payment, the entity does not have credit risk with respect to those servic es it would not be required to provide. It is for this reason that Topic 606 requires an entity to consider only the collectibility of the promised consideration in the contract (i.e. its exposure to credit risk) for the goods or services that the entity will transfer to the customer before it would be able to payment. stop providing further goods or services in the event of customer non- , in Topic demonstrate application of this 606 Example 1, Cases B through D concept to service contracts. In Cases B and C by the entity to , even though the contract includes a promise provide three years of services, for which the customer pays monthly fees in arrears , the entity has the ability and intent to stop providing the promised services in the event of customer non -payment. Therefore, the services that ‘will be transferred to the customer’ include only those services that the entity will provide before it follows it s customary business practice to stop services to the customer. While not specifically illustrated in either Case, this might mean the services that ‘will be transferred to the customer’ are only one or two months’ of service or some longer period, depending on the entity’s customary business practice with respect to how long it permits a non- paying customer to continue receiving services. In Case D, the illustrated scenario is a one- year gym membership, but the advance contract requires payment each month by the customer and services (i.e. access to the gym) are not provided for any given month if the adva nce payment has not been received. Consequently, in Case D, the services that will be provided to the customer are only the one month of services for which the customer has prepaid. There may be circumstances where the entity does not have either the abili ty to stop providing services to the customer or the demonstrated intent to do so, in which case the collectibility criterion is assessed against the promised consideration for all of the promised services in the contract. For example, an entity : event of — may n ot have the right to stop providing promised services in the customer bankruptcy because bankruptcy r ules in some jurisdictions require service providers to continue providing services that are essential to the customer while it undergoes restructuring; to discontinue a service, such as a transportation service able may not be — practical reasons ship) cannot for because the transportation asset (e.g. a © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

104 Revenue for software and SaaS 102 B. Step 1: Identify the contract with the customer dump the cargo into the sea and the ship is needed at the port of call in any event in order to fulfill the entity’s next contract; or — may have demonstrated its intent not to discontinue services in a timely manner in the event of customer non -payment. Particularly if the incremental costs of providing services to the customer are minor, an entity may continue providing services and merely intend to pursue collection at a later point. circumstance of this nature however may strongly indicate a A likely price concession (see Q uestion B80 ). When an entity does conclude that it has the ability and the intent to discontinue services in the event of customer non- payment, how long the entity ’s customary business practices (or other evidence of the entity’s intent ) indicate that the entity will continue to provide services to a non- paying customer may influence whether the collectibility criterion is met for that contract (see Q uestion B10 0). arrangements that are Collectibility will generally not be a concern in service prepaid. For example, if the customer is required to prepay for all of the year SaaS (e.g. prepay for a three- ices in the contract serv promised arrangement) . , then the ‘will be transferred’ notion will not apply Comparison to legacy US GAAP Under legacy US GAAP, collectibility was assessed against the entire fixed or determinable fees in the contract. When collectibility of the arrangement was not reasonably assured, revenue was generally recognized on a cash basis when the other recognition criteria had been met. There is no mecha nism whereby an entity concludes collectibility is probable (or reasonably assured for non -software licensing arrangements, such as SaaS arrangements) based on a partial assessment of the fixed or determinable fees, such as occurs under Topic 606 when the entity concludes there is a likely price concession (see Question B80) or that the goods or services that ‘will be transferred to the customer’ are not the promised goods or services in the contract. As a result, entities may more frequently pass the collectibility threshold in Topic 606 than they did the collectibility threshold under legacy GAAP. US Further, as discussed in Question B 125, u nder Topic 606 cash basis recognition is not the default accounting when collectibility is not probable but an entit y has transferred control of the related good or service. Question B100 Does an entity’s ability and intent to stop providing goods or services automatically mean that the collectibility criterion will be met? is when it The collectibility criterion is met only Interpretive response: No. of the consideration to which substantially all probable that the entity will collect © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

105 Revenue for software and SaaS 103 B. Step 1: Identify the contract with the customer the goods or services that will be transferred it will be entitled in exchange for . If (1) it is not probable the entity will collect any consideration to the customer from the customer or (2) the entity does not have the ability or the demonstrated intent to discontinue services in a timely manner after the customer stops paying for the entity’s services, the entity may not be able to of the consideration to conclude that it is probable it will collect substantially all which it will provide. Consider the it is entitled for the goods or services following examples: Consistent with Example 1, Case C — of Topic 606, if an entity has the ability and the intent to timely discontinue services but it is not probable it will collect substantially all of the promised consideration for any services it would provide before it discontinues services, the arrangement is not a genuine and substantive transaction ( see paragraph 606- -3A and -55 10 paragraph BC12 of ASU 2016 -12) . — Assume an entity concludes it is probable a customer will pay for the first of service in a 36-month contract, but that collectibili ty of the 12 months probable. If the entity does not have the ability remainder of the fees is not or the intent to discontinue services for a number of months (e.g. four months) after a customer stops paying for those services, the entity may of the conclude that it is not probable that it will collect substantially all consideration to which it will be entitled for the services that will be the monthly service fee is provided to the customer. For example, assume $100 and the entity ‘will’ provide 16 months of service, for which the it is only probable that the promised consideration is $1,600. However, . In that case, it is not entity will collect $1,200 ($100/month × 12 months) probable the entity will collect substantially all of the promised consideration for the services it ‘ will’ provide to the customer unless the entity concludes that the $1,200 it expects to collect is also the amount to which it expects to be entitled (i.e. it expects to grant a price concession to the customer – see next paragraph) . In either of the above cases, the entity would account for the contract using the -25 alternative model in paragraph 606- 10 -7 until either (1) one of the events in that is, -7 occur or (2) collectibility of a sufficient portion – -25 paragraphs 606-10 substantially all – of the promised consideration for the services that will be provided becomes probable. However, in the latter case, it may be that the entity is implicitly willing to accept an amount of consideration that is less than the promised amount (i.e. the entity will grant an implicit price concession) even ee Question B80 the entity pursues collection of all amounts owed – s for if additional discussion of implicit pric e concessions. If that is the case, the entity is may conclude it probable that it will collect the reduced amount to which it expects to be entitled ($1,200 in the preceding bullet) and that, therefore, the collectibility criterion is met. Example B 100.1 Assessment of collectibility for low credit quality new customer cancellable 36-month contract to provide SaaS to ABC Corp. enters into a non- . The consideration Customer. Customer is a new customer of low credit quality © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

106 Revenue for software and SaaS 104 B. Step 1: Identify the contract with the customer promised in the contract is $3,600, with $100 payable in advance each month. ABC has substantive history with this class of customer , based on which ABC it is probable the customer will pay all of the promised not concludes consideration for the promised 36 months of SaaS. However, based on its experience with similar customers, ABC expects Customer to make the payments required under the contract for at least 10 months. If a customer stops making the required payments (i.e. is in material breach of the contract), deny that customer further access to the SaaS and ABC’s ABC has the right to customary business practice is to mitigate its credit risk by doing so. In the event of customer default, ABC always pursues collection for unpaid services such that no explicit price concession by ABC is expected. Scenario 1: Discontinuation of services at the end of the month ABC’s customary business practice is to discontinue services by the end of the month for which a customer has not paid. For example, if a customer pays in advance for May, but does not pay for June, ABC typically discontinues services by the end of June. ABC vigorously pursues collection from all its customers and typically is successful in recovering some portion of the fees for which the customer has not paid. ABC concludes it is probable it will collect substantially all of the consideration for services that will be provided to in exchange to which it is entitled Customer. This is because ABC expects to collect all of the promised consideration in the contract for at least 10 months of service and, if Customer defaults, some portion of the fees to which it would be entitled for whatever month of service after that Customer does not pay. Scenario 2: Discontinuation of service after 5 months ABC’s customary business practice is to discontinue services only after a customer has not paid for the service for five months. For example, if a customer pays in advance for May, but does not pay for June – October, ABC typically discontinues services by the end of October. ABC only discontinues services in this timeframe because its incremental costs to provide the services is minor and, even if it cannot recover the entire contracted fees for the unpaid months, it pursues collection vigorously and will usually recover a portion of those fees that is sufficient to cover its costs of providing the SaaS and an acceptable profit margin. That portion of the promised fees, however, is a minor portion of the promised consideration. ABC concludes that a substantive contract exists because it will provide services to Customer for a significant period of time and expects to recover consideration that will provide a reasonable profit margin on the c ontract. ABC’s experience with this class of customer and its history of providing services well after a customer has defaulted on its payments suggests ABC is implicitly willing to accept a lower fee than that stated in the contract with Customer. As a re sult, Customer concludes it is probable that it will collect substantially all of the consideration to which it will be entitled in exchange for the services that will be provided to C ustomer . However, the transaction price includes variable consideration that ABC must estimate subject to the variable consideration such that Step 3: – ) constraint (see Chapter D Determine the transaction price ABC will not recognize revenue of $100/month at least during the earlier part of the contract period. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

107 Revenue for software and SaaS 105 B. Step 1: Identify the contract with the customer Question B1 10 How are software licenses considered when determining the ‘goods or services that will be transferred to the customer’? Software licenses are goods transferred at a point in Interpretive response: Questions time (see and F20). They are not services satisfied over the F10 license period, even if the entity has the legal right to revoke that right of use kill code ’ or similar in the event of customer and/or has the ability to send out a ‘ non- payment. the entity’s software is a Therefore, revoking a customer’s right to use repossession of the software license (i.e. repossession of a good); it is not equivalent to shutting off a service in response to a customer’s failure to pay for services already provided. -55- 3C states: “ An enti ty’s ability to Paragraph 606-10 considered for the repossess an asset transferred to a customer should not be purpose of assessing the entity’s ability to mitigate its exposure to credit risk. ” Consequently, the ability to revoke a customer’s right to use the entity’s sof payment of software license fees being paid over tware in the event of non- time is not considered in assessing whether collectibility of the consideration to which the entity will be entitled for the software license is probable. If the software license is part of a combined performance obligation In some circumstances under Topic 606, a software license will not be distinct from other goods or services and, therefore, will be part of a combined B) and performance obligation. Example 10 (Case C), Example 11 (Case is part of a illustrate examples of a license that 606 of Topic Example 55 combined performance obligation together with associated updates or services . llustrate s that the entity determines the nature of the Each of those examples i combined item in evaluating whether the performance obligation is satisfied over time or at a point in time and in determining the appropriate measure of progress to apply to that performance obligation if it is satisfied over time. Similarly, we believe the entity would consider the nature of the combined item that includes the license in determining whether the entity would be able to stop transferring that good or service in response to customer non -payment, and that this would mean the following for each of the three combined license 606: and updates or services examples in Topic — Exampl e 10 (Case C) – Because the combined good or service is the provision of anti -virus protection to the customer for three years (see and the intent to stop paragraph 606- 10-55 -140F) , if the entity has the abili ty providing anti the revoke the customer’s right to use -virus protection – i.e. anti software and stop providing future updates – the ‘ goods or -virus services that will be transferred to the customer ’ may be less than the three years of anti -virus protection promised in the contract. Because the combined good or service is ‘ — Example 55 – ongoing access ’ to the entity’s continually changing intellectual property for three years (see paragraph 606- 10-55 -365A) , if the entity has the abil ity and the intent to stop providing ‘access’ to its intellectual property – i.e. revoke the to use the intellectual property and stop providing future customer’s right – the ‘ updates/upgrades be transferred to the goods or services that will © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

108 Revenue for software and SaaS 106 B. Step 1: Identify the contract with the customer ’ may customer access promised in the be less than the three years’ contract. — The combined good or service is the software Example 11 (Case B) – customization, which uses the base software and the entity’s customization (see services as inputs to produce customized software as the output paragraph 606- 10-55 . If the entity has the ability and the intent to stop -149) performing the software customization – i.e. revoke the customer’s right to use the base software and stop the customization services – the ‘ goods or services that will be transferred to the customer ’ may be different from the intended combined output in the contract (i.e. the customized software). Note: the technical support and the The discussion in this bullet ignores software updates in the example, which are each determined to be distinct and would be considered in the same manner as any other over -time performance obligation for purposes of determining the ‘goods or services that will be transferred to the customer’. Example B 110.1 Credit risk is not mitigated for a software license and PCS ABC Corp. enters into a contract to license its software to Customer along with technical support and unspecified update, upgrade and enhancement rights Customer is of low credi years. PCS) for three (collectively, t quality. Despite Customer’s credit rating, the contract fees are $100 per year, payable he transaction price is $ 300 (for ease at the beginning of each year. Therefore, t of illustration, this example ignores any potential significant financing component that may result from paying for the software license over a selling price of the software year period) . The stand -alone license three- is $180 and the stand-alone selling price of the PCS (the PCS is determined to be a single performance obligation – see Question C150) is $120 for the three -year period. Both parties are subject to termination penalties if the contract is cancelled. The termination penalty is considered to be substantive. n In assessing whether the contract with Customer meets the criteria i paragraph 606- 10-25 assesses whether it is probable that it will collect -1, ABC substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. This includes assessing ABC ’s history with Customer’s class of customer and its business practice of stopping PCS services within a reasonable period of time in response to a customer’s nonpayment in accordance with paragraph 606- 10- 55-3C. At contract inception, ABC concludes that the criterion in paragraph 606- 10- 25- 1(e) is not met because it is not probable that C ust omer will pay substantially all of the consideration to which the entity will be entitled under the contract for the software license and PCS services that will be transferred to the customer. ABC concludes that not only is there a risk that the customer will not pay for the license and PCS services received from ABC, but also there is a risk that ing payment for any PCS services provided (consider ABC will never receive any 40 per year). Subsequently, selling price of the services is $ -alone the stand © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

109 Revenue for software and SaaS 107 B. Step 1: Identify the contract with the customer when C ustomer initially pays $ 100, ABC accounts for the consideration 10- received as a deposit liability in accordance with paragraphs 606- 25-7 through 25- 8. ABC concludes that none of the events in paragraph 606- 10 -25- 7 have occurred because the contract has not been terminated, the entity has not received substantially all of the consideration promised in the contract (i.e. tinuing to provide services is con ABC ABC has received only $100 of $300), and to C ustomer. Assume that in year 2, ABC continues to conclude that the collectibility criterion has not been met. Customer’s credit rating remains poor and even though $200 has now been collected, on a stand- alone selling price basis ABC has provided $220 worth of goods and services (3- year license and one year of PCS) and will provide another $40 worth of PCS before it can contractually terminate PCS if Customer does not pay the Year 3 fees of $100. Therefore, it is not yet probable Customer will pay at least substantially all of the promised consideration to which ABC is entitled for the license and PCS it will provide to Customer. Therefore, t he additional $100 paid by the customer at the beginning of year 2 is, like the paymen t for Year 1, recorded as a deposit liability , resulting $ 200 cumulative deposit . liability in a $100 payment from Customer B. At this receives the remaining In year 3, ABC point in time, none of the criteria in paragraph 606 25-7 have been met. -10- However , ABC concludes that the criterion in paragraph 606- 10 -25- 1(e) is now met because it is probable that the customer will pay substantially all of the consideration to which ABC will be entitled for the goods and services. In other words, once the final advance payment is made ( $100) at the beginning of year 3, A BC concludes that it is probable that it will receive all of the consideration to which it will be entitled in exchange for the license and all three years of PCS services that are transferred to Customer. applies the -1 are met in year 3, ABC -25 Once the criteria in paragraph 606- 10 to recognize revenue and the following journal remaining guidance in Topic 606 recorded: entry is Debit Credit 200 Deposit liability Cash 100 License revenue 180 PCS revenue 80 Contract liability (deferred revenue) 40 © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

110 Revenue for software and SaaS 108 B. Step 1: Identify the contract with the customer Question B120 Do extended payment terms affect the evaluation of the collectibility criterion? Interpretive response: Extended payment terms, which would include situations in which an entity pays for a distinct license through equal payments for the license and PCS over an extended period (e.g. three years) , do not in and of themselves affect whether the collectibility criterion in paragraph 606- 10-25 - 1(e) is met. However, they will likely factor into the entity’s assessment of the credit risk to which it is subject as a result of the contract. That is, extended payment terms introduce credit risk as a consideration about the customer’s abilit y or intention to pay the consideration to which the entity is entitled for the goods and services that ‘will be transferred to the customer’ where no such question would exist if the customer were required to pay for the goods or services as transferred o r under non- extended payment terms. ransaction 3: Determine the t Step – , price As discussed further in Chapter D extended payment terms may indicate either or both that: there is the risk of a future price concession, which would result in a — conclusion that the transaction price is variable. In that case, the entity would need to consider whether it expects to provide a concession, and the raint on variable 606 ’s const transaction price would be subject to Topic consideration; — a significant financing component exists in the contract. Comparison to legacy US GAAP Under legacy US GAAP applicable to software licensing arrangements, extended payment terms do not affect whether persuasive evidence of an arrangement exists. Rather, the arrangement fee is presumed not to be fixed or determinable if payment of a signification portion of the license fee is not due until after expiration of the license, or more than 12 months after delivery of the licensed software. As such, revenue is generally not recognized until the payments become due and payable. The fact that the collectibility of extended payments affects whether a contract exists for purposes of applying Topic 606 is a change from legacy US GAAP. In of measurement addition, the fact that extended payment terms may affect the revenue (i.e. if there is determined to be variable consideration or a significant financing component in the contract), but not the timing of revenue recognition, is a substantial change from legacy US GAAP. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

111 Revenue for software and SaaS 109 B. Step 1: Identify the contract with the customer B125** Question Can revenue be recognized on a cash basis when the collectibility criterion is not met and the entity continues to provide goods or services to the customer? No. If the collectibility criterion is not met, an entity Interpretive response: continuing to provide goods or services to the customer cannot record revenue based on its collections unless the alternative model criteria in paragraph 606 - 10-25 -7 are met (see decision tree at the beginning of this chapter). Under the alternative model, an entity cannot recognize revenue when it has a remaining obligation to transfer goods or services to a customer or it chooses to continue ially all of the to transfer goods or services to a customer when substant consideration to which it is legally entitled has not been received. There are limited scenarios in which an entity can continue to transfer goods or services under a contract, determine collectibility is not probable, but nevertheless recognize some revenue. This is because the collectibility criterion is evaluated based only on the goods or services expected to be transferred. See Questions B90 and B100 for the evaluation of arrangements where an entity has the ability and intent to stop providing the promised goods or services due to customer non- payment. Term of the contract Question B130 What is the contract term in a period -to-period (e.g. -to-month or year -to-year) contract that (a) month ay be may be cancelled by either party or (b) m cancelled by the customer only? 2014-09 Excerpt from ASU Topic 606 should not apply to wholly The Boards decided that BC50. unperformed contracts if each party to the contract has the unilateral enforceable right to terminate the contract without penalty. Those contracts position or performance until either part y would not affect an entity’s financial performs. In contrast, there could be an effect on an entity’s financial position and performance if only one party could terminate a wholly unperformed contract without penalty. For instance, if only the customer could terminate the wholly unperformed contract without penalty, the entity is obliged to stand ready to perform at the discretion of the customer. Similarly, if only the entity could terminate the wholly unperformed contract without penalty, it has an enforceable right to payment from the customer if it chooses to perform. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

112 Revenue for software and SaaS 110 B. Step 1: Identify the contract with the customer A renewal option gives a customer the right to acquire additional goods BC391. or services of the same type as those supplied under an existing contract. This type of option could be described as a renewal option within a rela tively short year contract with an option to renew that contract (for example, a one- contract for a further year at the end of the first and second years) or a cancellation option within a longer contract (for example, a three- year contract that allows the customer to discontinue the contract at the end of each year). A be viewed similarly to other options to provide additional renewal option could goods or services. In other words, the renewal option could be a performance obligation in the contract if it provides the customer with a material right that it otherwise could not obtain without entering into that contract. -to- Interpretive response: A contract under which services are provided period period (e.g. month- -to-year) unless cancelled by either party, to-month or year and for which no penalty must be paid for cancellation (i.e. other than paying amounts due as a result of goods or services already transferred up to the termination date), is no different from a similar contract structured to require the parties to actively elect to renew the contract each period (e.g. place a new contract). This is regardless of whether both entities may order, sign a new not cancel the contract or solely the customer. Consequently, an entity does assume a contract period that extends beyond the then- current period. This is contract period (e.g. a the case regardless of whether the contract has a stated two-year stated term, but either entity can cancel the contract at the end of any month during that period for no penalty) . When both parties to the contract have the unilateral right to terminate the contract at the end of any designated period, a contract does not exist for periods beyond the then- 10- current period in accordance with paragraph 606- 25-4. Only upon commencement of the next service period, whereby enforceable rights and obligations exist for both parties until the next available termination date (i.e. the end of that period), does a contract for that period exist under Topic 606. has a unilateral option to terminate a period- to-period customer only When the contract, some enforceable rights and obligations continue to exist. That is, the customer has the unilateral right to continue to receive services and the entity an obligation to stand-ready to provide those services if elected by the customer for an optional period. However, because those services are optional to the customer, unless they provide the customer with a material right, there is no accounting by the entity for the customer option. The entity only accounts for the current period’s services, which are not subject to cancellation, until the customer elects its option to obtain services for the next period (which includes by not cancelling the services), creating additional enforceable rights and obligations for the entity – i.e. the customer’s decision not to cancel the services creates an enforceable obligation on the entity to provide the services and an enforceable right to receive payment for those services. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

113 Revenue for software and SaaS 111 B. Step 1: Identify the contract with the customer ple B130.1 Exam Contract with unspecified term cancellable by either party ABC Corp. contracts with Customer to provide its SaaS offering for a flat fee of $130 per month, subject to annual increases based on the lesser of 5% or changes in the consumer price index (CPI). $130 is the stand- alone selling price of SaaS at contract inception. The contract term is indefinite and it is cancellable at the end of each month by either party without penalty. ABC determines that the initial contract term is only one month and that the contract term will always be one month under this arrangement. This is because each subsequent month represents a wholly unperformed contract – that is, each party has the unilateral, enforceable right to terminate the contract at the end of the then-current month without compensating the other party. A new contract will be deemed to exist for purposes of applying Topic 606 each month once each party forgoes its cancellation right for that period. ABC considers whether Customer’s option to renew on an indefinite basis provides it with a material right. Consistent with the discussion in C410, ABC concludes the options to renew do not provide Customer Question with a material right because the renewal price will only be greater than or alone selling price of the SaaS as of contract inception. equal to the stand- 130.2# Example B Contract with a specified term cancellable by either party ABC Corp. enters into a contract with Customer to transfer a three -year term license to software product G, and provide technical support and unspecified updates, upgrades and enhancements (collectively, PCS) for a one- year period. The stand- alone selling price and the contract price of the term license is $600,000 and the stand- alone selling price and contract price of one year of PCS is $120,000. Customer pays $720,000 in combined fees at contract inception. option for only part of the license term Scenario 1 – Termination Cust has the option to terminate the contract at the end of any month omer during the first year after the first month and would be entitled to a pro rata refund of the license and the PCS fees paid. For example, if Customer terminates at the end of Month 6, Customer would be entitled to a refund of 30/36ths of the $600,000 license fee ($500,000) and 6/12ths of the $120,000 PCS fee ($60,000). ABC concludes that while the PCS is a single performance obligation (see Question C150), the PCS is distinct from the software license (see Questions C160 and C170). ABC expects Customer to exercise renewal options to continue PCS for Years 2 and 3 at the same price as for Year 1, but there is no obligation for Customer to do so. After Year 1, Customer is no longer permitted to terminate the software license before the end of the contractual three-year term, even if Customer does not renew PCS. ABC concludes that the performance obligations in the contract include only a -year than the three one-month software license and one month of PCS, rather © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

114 Revenue for software and SaaS 112 B. Step 1: Identify the contract with the customer term license and one year of PCS outlined in the contract. Because Customer has the enforceable right to cancel the contract at the end of any month during the initial PCS term after Month 1 and receive a pro rata refund, each subseque nt month (i.e. beyond Month 1) embodies a customer option to continue to license software product G and obtain PCS for an additional fee. month renewal options of the software Therefore, the contract includes 11 one- month PCS renewal options, and options to renew the license and 11 one- product G license for two years at the end of Year 1, and to renew PCS for one year at the end of Year 1 and Year 2. The license and PCS renewal options do not provide Customer with a material right. ABC reaches this conclusion on the basis that the price of each monthly license and PCS renewal, i.e. during the first year of the contractual license -month license and PCS (calculated term, is equal to the price of the initial one as the contractual fees paid, less the pro rata refund due to Customer if the contract is cancelled at the end of Month 1). ABC further notes that the two-year product G renewal option, and the two one -year PCS renewal options are also priced consistently with the initial one- month license/PCS contract, and that Customer is entitled to a full pro rata refund of the license fees for the remaining two years if Customer terminates the license. Therefore, because none of the options grant Customer a material right, each renewal is accounted for as a new, separate contract when exercised (see Question G40). ABC will recognize the same amount in each month of the first year of the contract: month on the first day of the month, the revenue attributable to a one- — license to software product G; and — the revenue attributable to one month of PCS over the course of the month using an appropriate measure of progress (see Question F220). During the second year of the contract, ABC will recognize: — on the first day of Year 2, the revenue attributable to the two -year softwar e product G license; and — the revenue attributable to Year 2 PCS over the course of Year 2 using an appropriate measure of progress. Over the third year of the contract, ABC will recognize the revenue attributable to the Year 3 PCS using an appropriate measure of progress. ermin ation option for the entire license term Scenario 2 – T Assume the same facts as in Scenario 1, except that the license and PCS term is three years . Customer pays $720,000 at contract inception ($600,000 for the three- year license and $120,000 for Year 1 of PCS) and pays PCS fee s for each subsequent year at the beginning of Year 2 and Year 3. Customer has the right - to terminat e the license and PCS at the end of each month during the three term. For example, if Customer terminates the license at the end of year stated month 30, Customer would be entitled to a refund of 6/36ths of the $600,000 license fee ($100,000) and 6/12ths of the Year 3 $120,000 PCS fee paid at the beginning of Year 3 ($60,000). For the same reasons as in Scenario 1, Customer’s options to renew the license for another month each month throughout the contract period, do not grant Customer a material right. Consequently, ABC’s revenue recognition will © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

115 113 Revenue for software and SaaS B. Step 1: Identify the contract with the customer be the same each month during the three -year contract. Each month, ABC will recognize: month — on the first day of the month, the revenue attributable to a one- license to software product G; and — the revenue attributable to one month of PCS over the course of the month using an appropriate measure of progress. Scenario 3 – Nonrefundable up- front fee Assume the same facts as in Scenario 2, except that Customer a pays nonrefundable up- front fee of $960,000 at contract inception for the three- year term license and PCS. The stand- alone selling price and the contract price of the alone selling price and contract price of term license is $600,000 and the stand- three years of PCS is $360,000. Customer has the option to terminate the contract at the end of any month during the three- mination, year term. On ter the customer is not entitled to a refund and loses the right to use the software. year contract. As discussed ounts for this arrangement as a three- ABC Corp. acc in Question B150, the termination right is not substantive because the up -front fee is the only consideration in the contract. In contrast nonrefundable to Scenario 2, the absence of a pro- rata refund option indicates that Customer does not have to make a substantive, separate purchasing decision (i.e. substantive option) at the end of any month about whether to acquire additional software licenses, because it is not deciding whether to exercise a right to spend more money to acquire an additional license and PCS. ABC Corp. allocates $600,000 to the term license, which is recognized up- fro nt on transfer of control (right to use and benefit from the license) and $360,000 to the PCS, which is recognized using an appropriate measure of progress. Refund is unknown Scenario 4 – the Assume the same facts as in Scenario 2, except that on termination, contract states that ABC Corp. and Customer will negotiate a refund for Customer. ABC Corp. accounts for this contract as a three- year contract. Unless ABC Corp. can demonstrate it has enforceable rights and obligations to provide a pro rata because the customer does not refund, the termination right is not substantive, have a separate purchasing decision that it can make without ABC Corp., and therefore the termination right is not similar to a customer option to renew. ABC Corp. allocates $600,000 to the term license, which is recognized up- front on transfer of control (right to use and benefit from the license) and $360,000 to the PCS, which is recognized using an appropriate measure of progress. Example B 130. 3** Term -based license with a resell er with monthly cancellation enters into a contract with a reseller to transfer a one- Corp. ABC year term license to software product G, and provide technical support and unspecified period. year updates, upgrades and enhancements (collectively, PCS) for a one- ABC Corp. determines that there are two distinct performance obligations (term © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

116 114 Revenue for software and SaaS B. Step 1: Identify the contract with the customer license and PCS). The stand- alone selling price and the contract price of the term license is $200,000 and the stand- alone selling price and contract price of one year of PCS is $120,000. Customer pays at $320,000 in combined fees contract inception. The reseller has the option to terminate the contract at the end of any month during the one -year term. On termination, the reseller is entitled to a pro rata refund and loses the right to use the software. In a separate arrangement, the reseller agrees to provide software product G and PCS to a third party end -user for a one-year term. The contract between the reseller and end- user is non-cancellable. determines ABC that the reseller is the customer and that the reseller takes user. control of the license and PCS before they transfer to the third party end- user. Further, PCS is provided directly to the reseller and not the third party end- -to-principal The contract between ABC Corp. and the reseller is a principal contract. ABC Corp. accounts for this arrangement as 12 individual monthly contracts, i.e. month period in the lesser of the contractual period of one year and the one- which the contract can be terminated without penalty. Therefore, ABC Corp. year term (monthly would recognize as revenue $26,667 per month for the one- ratable recognition). The options to renew do not provide Customer with a e material right because the renewal price will be greater than or equal to th stand -alone selling price of the PCS as of contract inception. ABC Corp. is not a party to the contract with the third party end-user customer (who is the customer of the reseller) and does not provide services to the end user. ABC Corp.’s customer is the reseller and the contract between reseller user does not affect the conclusion reached on the and the third party end- contract between ABC Corp. and the reseller. Example B 130. 4** Perpetual license Corp. enters into a contract with Customer to transfer a perpetual license ABC to software product G, and provide technical support and unspecified updates, upgrades and enhancements (collectively, PCS) for a three- year period, which is the economic life of the software. ABC Corp. determines that there are two distinct performance obligations (perpetual license and PCS). The stand- alone selling price and the contract price of the perpetual license is $600,000 and the stand -alone selling price and contract price of three years of PCS is $360,000. Customer pays $960,000 in combined fees at contract inception. Scenario 1 – Perpetual license and PCS with pro rata refund Customer has the option to terminate the contract at the end of any month. On termination of either the license or PCS, the customer is entitled to a pro rata refund for the PCS and perpetual license and loses the right to use the software. The pro rata refund for the perpetual license is calculated based on the economic life of the license of three years. For example, if Customer terminat es the license at the end of month 30, Customer would be entitled to a . ($160,000) refund of 6/36ths of the $960,000 license and PCS fees © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

117 Revenue for software and SaaS 115 B. Step 1: Identify the contract with the customer s therein discus Question C200 and the examples (C200.1 through C200.3) mandatory PCS in which a customer forfeits its rights to a perpetual license if it does not renew PCS. Scenario 1 is similar, as Customer must renew the contract and PCS to maintain the software license. Consistent with Question C200 and the related examples, the option to terminate the contract end of each month and obtain a pro rata refund of the PCS license fee at the results in a one-month contract for a term license and PCS with 35 monthly renewal options. In this scenario , the renewal period lasts for the economic life of the licensed software and, therefore, we do not believe an additional perpetual license is granted at the end of the term. However, if the economic life of the software was longer than three years, at the end of the three- year term a perpetual license would be granted, which like ly indicates that there is a material right. Refer to Question C200 and Example C200.2 on mandatory PCS for further discussion. Scenario 2 – Perpetual license with pro rata refund for PCS only Assume the same facts as in Scenario 1, except that the contractual price for the perpetual license is $300,000, the PCS is $360,000 and the pro rata refund relates to PCS only (i.e. the license fee is nonrefundable). The stand- alone selling price of the perpetual license is $600,000 and the stand- alone selling price of PCS is $360,000. ABC Corp. accounts for this agreement as a contract for the perpetual license the PCS. and one month of PCS with 35 individual monthly options to renew front The total non -cancellable amount of $310,000 is allocated to the up- perpetua alone l license and one month of PCS based on their relative stand- Therefore, ABC Corp. would recognize license revenue of selling prices. -front and PCS of $5,082 in the first month. $304,918 up ABC allocates the transaction price as follows. Stand - Contract Price Performance alone Selling price selling price obligation price ratio allocation 98.36% $600,000 $304,918 Perpetual license $300,000 1 PCS 10,000 10, 000 1.64% 5,082 $310,000 Total $310,000 % $610,000 100.0 Note : cancellable amount of the PCS fee for the current month (i.e. if the 1. $10,000 is the non- contract is terminated at the end of month 1, Customer would be entitled to a refund ). of 35/36ths of the $360,000 PCS fee ($350,000) Each month thereafter, ABC Corp would recognize $10,000 in PCS revenue. Note that this treatment results in an accounting model that is capped by the cash amounts collected. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

118 Revenue for software and SaaS 116 B. Step 1: Identify the contract with the customer B140 Question How does a termination penalty affect the assessment of the contract term? Interpretive response: It may be the case that services provided under a be terminated only by compensating the other party. For example, contract can one party may be required to pay the other a termination penalty , which may be characterized (e.g. characterized explicitly as a termination penalty or otherwise as a requirement to either (1) continue to pay the contractual fees for a period of time even after services are no longer being provided n or (2) forfeit of a otherwise refundable deposit paid to the entity up-front). If the right to compensation in the event of termination is substantive, then the duration of the contract is the shorter of the stated term or the period up to the point at paying substantive which the contract can be terminated without compensation . A substantive termination penalty that compensates the other party is evidence that enforceable rights and obligations exist throughout the entire stated term. In other words, only by paying the penalty is the terminating party relieved of its , and only in return for that compensation remaining enforceable obligations -terminating party does the non forgo its remaining enforceable rights. Discussions of the TRG at the November 2015 meeting concluded that entities should reach the same conclusion as outlined in the preceding paragraphs regardless of whether both entities have the right to terminate the contract or only the customer. Therefore, if only the customer has the right to terminate the contract in return for paying a substantive penalt y, the contract term is the shorter of the stated term or the period up to the point at which the customer has the right to terminate the contract without paying a substantive penalty . In making the assessment of whether a termination penalty is substantive, an entity is considers all relevant factors, including whether the penalty insignificant . A penalty that is insignificant would generally not change the enforceable rights or obligations of the parties from those that would exist absent the requirement to pay a penalty. consideration of the The substantive evaluation would also generally include legal enforceability of the right to compensation on termination. For example, p ast practice of not depending on the facts and circumstances, an entity’s allowing customers to terminate the enforcing termination penalties (e.g. contract without enforcing collection of the ) may result in a termination penalty conclusion that the termination penalty is not enforceable under the relevant laws of the jurisd iction governing the contract . These types of circumstanc es may require legal analysis the entity’s past practice makes its right to . If compensation upon termination (and the customer’s obligation to pay that amount) unenforceable based on the applicable laws and regulations, then the entity would assess the contract term as it would for a contract without a termination penalty (see Question B 130). In contrast, i f the entity’s past practice does not change the parties’ legally enforceable rights and obligations, then that . affect whether the termination penalty is substantive past practice would not When a cancellation occurs If a cancellation occurs during the contract term determined in accordance with the first paragraph of this question (e.g. the customer terminates the contract © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

119 Revenue for software and SaaS 117 B. Step 1: Identify the contract with the customer regardless of having to pay a substantive termination penalty), the termination is accounted for as a contract modification as it changes the scope of the contract by shortening it. Example B 140.1 practice of allowing customers to terminate Past without enforcing collection of the termination penalty ABC Corp. enters into a contract to provide services to Customer for 24 months. Customer has the enforceable right to terminate the contract by paying a su bstantive penalty to ABC. The penalty does not change during the contract term. ABC has a past practice of allowing customers to term inate substantially similar contracts after 12 months without enforcing collection of the termination penalty. Because the termination penalty is substantive, it affects the enforceable rights and obligations under the contract for both parties such that the contract term is the shorter of the 24 month stated term or the period for which Customer must substantive pay a tion penalty. termina The period during which Customer must pay a substantive penalty may be affected by ABC’s past practice of not enforcing the termination penalty after 12 months if that pa st practice is considered to restrict its legal right to enforce the termination penalty, or Customer’s legal obligation to pay, after 12 months. The determination in this regard could vary depending on the laws and regulations of the jurisdiction governing the contract and potentially other factors. If ABC’s past practice d oes not change its enforceable rights (and, correspondingly Customer’s enforceable obligations), the contract term will be the full 24-month stated term. However, if ABC’s past practice results in the conclusion that the termination penalty is not enforceable under the relevant laws and regulations of the governing jurisdiction, the contract term is only 12 months – that is, the period during which a substantive penalty applies. Example B 140.2 Contract term with decreasing termination penalty ABC Corp. enters into a four -year contract with Customer . The to provide SaaS contract requires Customer to pay an annual fee of $100. Customer can 4 would incur a terminate the contract at any point without cause, but until year termination penalty. ABC always enforces its right to receive a termination penalty. The penalty decreases annually throughout the contract term. The under the contract, as well as the following table illustrates the payments termination penalty that would apply during each year of the stated term contract . © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

120 Revenue for software and SaaS 118 B. Step 1: Identify the contract with the customer Year 1 Year 2 Year 3 Year 4 $100 $100 $100 Annual fee $100 Termination penalty 30 20 10 - Cumulative fee if customer cancels in this year $400 $310 $130 $220 ABC concludes that the penalty is substantive as it is neither insignificant, nor is there any question as to the enforceability of the termination penalty. In this example, the termination penalty represents at least 10% of the remaining annual fees (in a in the periods subsequent to the period in which the ggregate) contract is terminated until it goes away in year 4, which ABC concludes is not . an insignificant penalty ABC determines that the contract term is three years under Topic 606. Three years is t he shorter of the stated contract term (four years) and the period during which a substantive termination penalty applies to any Customer cancellation (three years). The termination penalty does not affect ABC’s accounting for the three- year contract (i.e. no portion of the penalty is factored into the transaction price of the contract, nor does the penalty change that ABC’s performance obligation is to provide the SaaS for three years) unless the contract is terminated, at whic h point the termination will be accounted for as a modification of the contract. Question B150 Does forfeiture of a significant up -front fee constitute a termination penalty? -front Interpretive response: It depends. A customer may pay a significant up of the contract. Whether forfeiture of fee that it would forfeit upon termination this fee constitutes a termination penalty depends on whether the fee would be . refundable if the contract is not terminated In general, forfeiture of an up- Up -fron t fee is refundable. front fee does not constitute a termination penalty unless the customer would be entitled to a refund of that fee if it does not terminate the contract . For example, if a customer -front fee to an entity at the beginning of a four -year contract, and pays a $100 up will receive that fee (or a significant portion thereof) back only if it chooses not to exercise a termination right, we believe the requirement to forfeit the up- front fee is no different from having to pay a $100 fee upon termination. Up -front fee is nonrefundable. If an up-front fee is nonrefundable, its generally does not constitute a termination penalty because the forfeiture . Instead, an entity refundability is not contingent on termination generally considers whether payment of the fee provides the customer with a material right with respect to renewing the services (including by not electing an option to cancel the services). Whether payment of a nonrefundable up -front fee provides the customer with a material right upon renewal of a services contract is discussed in Question C410. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

121 119 Revenue for software and SaaS B. Step 1: Identify the contract with the customer Notwithstanding that the non- refundable fee generally does not constitute a termination penalty, there are fact patterns where the customer’s ability to termina te a contract with an up- front fee does not affect the contract term . This f a nonrefundable up- front fee is the only consideration in a would be the case i the customer contract that meets the contract existence criterion. In that case, does not have a separate purchasing decision to make with respect to renewing (i.e. by not terminating) the contract because it has prepaid, on a nonrefundable basis, for all the goods or services promised in the contract. Therefore, the termination option is not substantive and any contractual termination right does and a material rights analysis would not be not affect the contract term performed. For example, a one-year service contract where the customer pays a nonrefundable up -front fee that is the only consideration would be considered a one-year contract regardless of whether the customer could technically terminate the contract. B160 Question Does a cancellation provision exist if the contract is silent as to cancellation or termination? general, if a contract does not provide In Interpretive response: for conclude the cancellation or termination, the entity should generally contract term is the stated term in the contract. However, as discussed in contract ( paragraph 606- 10-25 -3, the duration of a customer i.e. the contractual period) is dictated by the present enforceable rights and obligations of the parties to the contract. Therefore, it may be that a legally enforceable cancellation or termination provision exists even if the written contract is silent such a provision exists, entities still need to consider whether a If in this regard. termination penalty would apply (see Questions B140 and B15 0). Question B170 Does a cancellation provision available only upon a substantive breach of contract affect the cont ract term? Interpretive response: No. If a contract exists under Topic 606, that means the parties can identify their rights and obligations under the contract and are . committed to perform their respective obligations – see paragraph 606- 10 -25-1 Therefor substantive ould not assume that a e, if a contract exists, an entity w breach of contract will occur when determining the contract term. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

122 120 Revenue for software and SaaS B. Step 1: Identify the contract with the customer Question B180 Does a contract exist during ‘free -trial’ periods before the customer accepts an offer to continue trial period? the services beyond the free- Entities such as SaaS providers frequently offer Interpretive response: the right to obtain their services for free for a period of time (i.e. a customers ‘free -trial period ’) during which the customer can decide to contract for the services going forward (e.g. the customer can decide to obtain the entity’s SaaS trial period). SaaS providers for 12 or 36 months after the end of the free- frequently offer additional incentives (e.g. free or discounted professional serv ices or a discounted price of the SaaS) if the customer enters into a long- term contract for the entity’s SaaS. Some stakeholders in the United States asked the question about what services would be sales incentives and what services would be part of a contract with a customer if the customer accepts the entity’s offer before the -trial period ends. Based on discussions with the FASB staff, it is our free trial period, understanding that their view is that services provided during a free- before the customer accepts the entity’s offer to provide services beyond the , should be accounted for as sales incentives. No contract exists -trial period free until the customer accepts the entity’s offer to provide services after the free- trial period because the customer can opt -out anytime during the free -trial period. That is, no enforceable right to consideration exists for the entity until . Once the customer the customer contracts for post -trial period services accepts the entity’s offer, the entity should account for remaining free trial period services (from the date a contract exists) and the post -free trial services as committed performance obligations of the co ntract. The FASB staff further indicated that, in limited circumstances, it may be -free trial period goods or services (i.e. reasonable to account for only the post those that were part of the offer to the customer) as performance obligations of the customer contract. The staff indicated this would be the case only if either (1) the customer’s right to the remaining free- trial period goods or services was not enforceable, or (2) on a portfolio -free trial basis, accounting for only the post period goods or services as performance obligations would not materially differ from accounting for both the remaining free trial period goods or services and the post -free trial period goods or services as performance obligations of the contract with the customer. Exam ple B180.1 Free -trial period ABC Corp. offers three free months of its SaaS to Customer. At any time during the three-month free -trial period, Customer can decide to continue the SaaS for 12 months after the end of the three- -trial period for a fee of month free - month post $12,000, payable $1,000 in advance of each month during the 12- trial period. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

123 Revenue for software and SaaS 121 B. Step 1: Identify the contract with the customer ABC’s accounting for this contract depends on when Customer accepts ABC’s offer to provide 12 months of its SaaS after the end of the free- trial period. For exam ple: If C -trial period services on ustomer accepts and agrees to pay for the post — Day 1 of the free- to provide ’s performance obligation is trial period, ABC 15 months of SaaS for $12,000 and, therefore, would recognize $800 each is provided under the contract ($12,000 ÷ of the 15 months that SaaS None of the cost of providing the SaaS during the free- 15 months = $800). trial period would be recognized as a sales and marketing expense. — If C ustomer accepts and agrees to pay for the post -trial period services at the beginning of the third month of the three -month free-trial period, ABC ’s to provide 13 months of its SaaS performance obligation is for $12,000 and, therefore, would recognize $923 is each of the 13 months that SaaS ). The cost of provided under the contract ($12,000 ÷ 13 months = $923 during the free-trial period would providing the first two months of the SaaS be recognized as a sales and marketing expense. — If C ustomer accepts and agrees to pay for the post -trial period SaaS on the last day of the three- month free-trial period, ABC ’s performance obligation is to provide 12 months of SaaS for $12,000 and, therefore, would recognize $1,000 each of the 12 months that SaaS is provided under the contract ($12,000 ÷ 12 months = $1,000). The cost of providing the three free -trial months of the SaaS would be recognized as a sales and marketing expense. Note that in either of the first two scenarios, ABC would be recognizing revenue on the SaaS before it is legally entitled to receive any consideration from C ustomer. For example, in the first scenario, ABC will recognize $2,400 before it is legally permitted to bill Customer for the SaaS. ABC’s offsetting entry is to a contract asset, which ABC will derecognize over the 12- month contract period once it begins to bill Customer under the terms of the contract. Alternatively, it be reasonable, regardless of when Customer accepts and may agrees to pay for the post -trial period services, to consider ABC’s performance obligation as one to provide 12 months of post -trial period SaaS for $12,000. In that case, ABC would recognize $1,000 each of the 12 months that SaaS is provided under the contract ($12,000 ÷ 12 months = $1,000). The cost of trial months of the SaaS would be recognized providing the remaining free- would only be appropriate as a sales and marketing expense. This alternative if either: a. ABC does not have an enforceable obligation, as a result of entering into the contract with Customer, to provide the remaining free- trial period SaaS, or ABC has a number of similar contracts that would permit it to apply this e. accounting on a portfolio approach basis (i.e. on a portfolio basis, accounting for committed free- trial period SaaS as a sales and marketing cost for contracts in the portfolio would not materially a ffect the entity’s accounting results). © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

124 Revenue for software and SaaS 122 B. Step 1: Identify the contract with the customer Comparison to legacy US GAAP Under legacy US GAAP, arrangement consideration is limited to only non - contingent amounts (often referred to as the ‘contingent cash cap’). That means, in a SaaS contract that provides the customer with three free or six discounted months of service or discounted implementation services, revenue recognized as those free or discounted services are provided is limited to amounts that are not contingent on the provision of future s ervices. Entities 606 has no prohibition on recognizing contingent revenue. Topic B180.1 will applying the approach illustrated as Alternative 1 in Example generally allocate more revenue to free or discounted services provided at the outset of a contract than they do under legacy US GAAP , which will accelerate overall revenue recognition under contract. Combining contracts Question B190 What constitutes ‘at or near the same time’ when evaluating whether two or more contracts should be combined? Interpretive response: or evaluating ‘bright line’ f Topic 606 does not provide a ’ to determine whether two or more what constitutes ‘at or near the same time contracts should be combined. Therefore, we believe an entity might adopt an accounting policy as to what represents a minimum period of time that would ’. time evidence two or more contracts were entered into ‘at or near the same Many entities have had an accounting policy under legacy US GAAP in this provided that remain reasonable under Topic 606, regard, and that policy may policy (or any new policy) appropriately considers the entity’s customary business practices and other reasonable expectations, such as recent changes to contracting practices or licenses/services offered. For example, an entity m ay perform services for a majority of the customers that license its software -as-a- products or obtain its software service and have a business practice of s to provide those services w- on contract into follo entering . In this scenario, the entity might speci fically consider the period of time that generally elapses of the contract for the software license or the SaaS between the initiation and in determining what represents a -on contract for the services the follow minimum period of time within which the entity would conclude two or more contracts were entered into at or near the same time. However, just because two contracts are not entered into within the minimum period of time established by the entity does not mean they were not entered into ‘at or near the same time’. An entity should have processes in place that customary’ consider specific facts and circumstances in cases that may not be ‘ - or usual. For example, an entity should not ignore the fact that two non , such as ones that are different from or larger than the standard agreements were being discussed or negotiated over the entity’s typical arrangements, same period of time and would appear to be significantly interrelated solely © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

125 Revenue for software and SaaS 123 B. Step 1: Identify the contract with the customer because they were not executed within the entity’s established period’. ‘minimum An entity should establish procedures to ensure multiple contracts initiated with the same customer at or near the same time are identified on a timely basis and, therefore, appropriately considered as to whet her they should be a single c accounted for as ontract. Question B200 If an entity and/or its customer have multiple divisions (business units), should contracts entered into between different divisions be evaluated for possible combination? Interpretive response: Yes. There is no exception for considering whether two or more contracts should be combined because they were executed by different divisions of the entity and/or the customer; in fact, contracts with related parties of the customer that are not part of the same consolidated entity are considered for possible combination. However, whether the contracts were negotiated by the same parties or, instead, were negotiated with different of the entity or the customer may influence whether any of the three divisions specified criteria in paragraph 606- -9 are met. For example, two contracts -25 10 entered into by different divisions of one or both parties be less likely to may have been ‘ negotiated as a package with a single commercial objective ’ or to have goods or services that are a single performance obligation. B210 Question -10- 25- 9 similar to Are the criteria in paragraph 606 the indicators of contract combination in legacy US GAAP? Interpreti ve response: Legacy US GAAP software revenue recognition guidance included a series of indicators to consider when determining whether two or more contracts should be combined. Because the contract combination 606 that in legacy US GAAP, we is similar in concept to guidance in Topic believe it is useful to consider how the legacy US GAAP indicators, with which entities should be familiar, compare to the specified contract combination . The following table describes the similarities betw criteria in Topic 606 the een revenue recognition guidance indicators under the legacy US GAAP software 606. Note that there and the specified criteria under Topic were six indicators in GAAP guidance, and some of them relate to more than one of the legacy US 606 criteria. the Topic © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

126 Revenue for software and SaaS 124 B. Step 1: Identify the contract with the customer software under a) (or criteri on riteri Related c Indicator under legacy 606 guidance Topic 605- (para 985- 55 (para 606- 10- 25- 9) -4) in Topic The contracts or agreements are for a. 606 on first criteri The negotiated or executed within a determining when an entity combines short timeframe of each other. two or more contracts and accounts for them as a single contract is that the contracts have to be entered into at or near the same time. This indicator is similar to that first criterion . a. The contracts were negotiated as a different elements are closely b. The package with a single commercial interrelated or interdependent in objective; and/or terms of design, technology or function. c. The goods or services promised in the contracts (or som e goods or services promised in each of the contracts) are a single performance obligation in accordance with 25-14 through 10- 606- paragraphs 25- 22. c. The fee for one or more contracts or The amount of consideration to be b. agreements is subject to refund, paid in one contract depends on the forfeiture or other concession if price or performance of the other another contract is not completed contracts. satisfactorily. d. One or more elements in one The contracts are negotiated as a a. contract or agreement are essential package wit h a single commercial lity of an element in to the functiona objective; and/or another contract or agreement. The goods or services promised in c. the contracts (or some goods or services promised in each of the contracts) are a single performance obligation in accordance with 25-14 through 25- paragraphs 606- 10- 22. b. The amount of consideration to be e. Payment terms under one contract paid in one contract depends on the or agreement coincide with price or performance of the other performance criteria of another contracts. contract or agreement. racts are negotiated as a The cont a. f. The negotiations are conducted package wit h a single commercial e.g. jointly with two or more parties ( objective; and/or from different divisions of the same entity) to do what in essence is a c. The goods or services promised in single project. the contracts (or some goods or services promised in each of the contracts) are a single performance obligation in accordance with 25-14 through paragraph s 606- 10- 25- 22. The preceding table is just a ‘bridge’ between the legacy and the new guidance. Just like under legacy US GAAP, significant judgment will be required in many 25-9 are 10- paragraph 606- cases to determine if one or more of the criteria in met. And while, as outlined in the preceding table, there is a relationship © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

127 Revenue for software and SaaS 125 B. Step 1: Identify the contract with the customer between the legacy indicators and the new criteria, that relationship does not mean a particular Topic 606 criterion will be evalua ted in the same way as the – Step 2: legacy US GAAP indicator. For example, as discussed in Chapter C bligations in the contract , an entity may reach Identify the performance o different conclusions under legacy US GAAP about whether an element is interrelated or interdependent in terms ‘essential to the functionality ’ or ‘ closely of design, technology or function’ to another element and whether two or more promised goods or services are distinct from each other under Topic 606. An entity should establish processes and controls to be able to identify multiple contracts entered into with the same customer on a timely manner to ensure that the entity is appropriately determining whether such contracts should be es and controls to identify ongoing This may include process combined. ween the entity and the customer so that revenue related to a negotiations bet un contract is not recognized d whether the contract(s) til the entity has evaluate under negotiation should be combined. Example B 210.1 Combining contracts, Part I ABC Corp. licenses trust asset management system software called Product B. The Product B software enables users, typically large financial institutions, to access and value individual US dollar denominated trust account portfolios on a real -time basis. Product B functions as designed without any customization or modification services and can be implemented without ABC’s assistance in most cases. ABC entered into a specific contract with Customer, a large international commercial bank, to grant a license to the Product B software and, to approximately 45 days later, enters into a separately papered agreement provide services to modify the customer’s instance of the software. The includ e modification of the software code and configuration of certain services modified and off -the-she lf settings to allow Customer to access and value its trust account portfolios in multiple foreign currencies. While executed separately, the two agreements were negotiated during the same time period (even though commencement and completion of the negoti terminus) and largely by the same ABC and ations of each were not co- Customer personnel. ABC concludes that, if the two contracts were combined, the license to Product B and the professional services to customize and configure the licensed software would be a single performance obligation (see Question C230 and Example C230.1). ABC also concludes that the two agreements were i.e. to enable negotiated as a package with a single commercial objective – Customer to use ABC’s software across its international operations. Therefore, because the software license agreement and the services agreement were entered into near the same time, the two agreements constitute a single contract and ABC will account for the Product B license and the professional services as a single performance obligation. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

128 Revenue for software and SaaS 126 B. Step 1: Identify the contract with the customer Example B 210.2 Combining contracts, Part II Assume the same facts as in Example B210.1 except for the following: — The services agreement is executed nearly five months after the software license agreement. — The size of the two agreements and the extent of the services are larger than any other arrangement ABC has entered into in recent years. — ABC has an accounting policy, based on its customary business practices, that contracts entered into within 90 days of each other have been entered into ‘at or near the same time’. Consistent with Example B210.1, ABC concludes both: — That if the two contracts were combined, the license to Product B and the professional services to customize and configure the licensed software C230 would be a single performance obligation (see Question ); and — The two agreements were negotiated as a package with a single that is, to enable Customer to use ABC’s software commercial objective – across its international operat ions. In this case, ABC concludes the two agreements were entered into near the same time as each other even though five months is longer than its established policy of treating 90 days or less as ‘at or near the same time’. Consistent with the discussion in Question B190, even though ABC has an accounting policy in this regard that is reasonable to ABC’s customary customer arrangements, ABC i.e. it is unusually considers that this is an ‘atypical’ customer arrangement – large and complex – such that the specific facts and circumstances shou ld also be considered. The significantly overlapping negotiations and negotiating parties, along with the overall context of the two agreements, leads ABC to conclude that a delay in obtaining final agreement on the services contract does not mean that contract and the license agreement were not entered into near the same time as each other. 210.3 Example B Combining contracts, Part III ABC Corp. enters into a software license agreement with Customer to license Product E. Product E is fully functional upon basic installation that most customers can perform themselves or obtain from numerous service providers other than ABC. However, approximately one month after the license agreement is concluded, Customer decides that it wants ABC to provide some services so that Customer can more effectively use the Product E software. to Consequently, ABC and Customer enter into a services agreement for ABC provide specified implementation and configuration services. The implementation and configuration services are not complex; ABC will build some simple interfaces, configure available features in the Product E software to Customer’s specifications, and then perform some user acceptance testing to ensure everything works as intended. However, Customer views the services as important to its ability to immediately begin using the Product E © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

129 Revenue for software and SaaS 127 B. Step 1: Identify the contract with the customer software as intended such that when it concludes the services agreement, Customer requires inclusion of a clause that states Customer is permitted to withhold up to 50% of installment license fees required under the software license agreement until the services are successfully completed and accepted. Even though there are two agreements, they were executed near the same and the services – that is, only approximately one month apart – time agreement effectively modifies the license agreement by changing its payment terms (i.e. permitting a delay in Customer’s payments due under the license agreement until the services agreement is fulfilled successfully). In addition, the consideration to be paid for the Product E software license is dependent on the successful completion of the implementation and configuration services in the . Therefore, ABC concludes that the license agreement and services agreement the services agreement should be combined for accounting purposes under Topic 606. It is important to note, however, that just because ABC concludes that the agreements should be combined, it does not necessarily follow that the Product E software license and the implementation/configuration services are a single performance obligation in the combined contract. For further discussion on identifying the performance obligations in a contract (i.e. Step 2 of the model), see – Step 2: Identify the performance obligations in Chapter C . the contract © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

130 128 Revenue for software and SaaS C. Step 2 : Identify the performance obligations in the contract C. Step 2: Identify the performance obligations in the contract Questions and Examples Identify the promised goods and services Determine which promised goods or services are performance obligations A series of distinct goods or services Questions & answers Q&A C10 Do restrictions as to time, geography and/or use affect how many software licenses are promised to the customer in the contract? Example C10.1: License restrictions Are Q&A C20 remix rights in a software contract an additional promised good or service to the customer? Q&A C30 Is a contractual requirement to put the source code of a software application into escrow a performance obligation? When does a promise to transfer multiple copies of a software Q&A C40 product constitute a promise to transfer multiple licenses? Example C40.1: Multiple copies are multiple licenses Example C40.2: Multiple copies are not multiple licenses user documentation a Is a promise to provide appropriate end- Q&A C50 promise to transfer a good to the customer? Is a software entity’s participation in a joint steering committee Q&A C60 (JSC) considered a promised service in a contract with a customer? Is a customer’s right to return a product or a right to a refund Q&A C70 for services a performance obli gation? Under what circumstances is the right to exchange one or Q&A C80 more software licenses for one or more alternative licenses considered an additional performance obligation? Example C80.1: Right to exchange a software license Right to exchange a software license for an Example C80.2: unspecified sof tware license Example C80.3: Right to return software licenses in exchange for credit toward unspecified software licenses © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

131 Revenue for software and SaaS 129 C. Step 2 : Identify the performance obligations in the contract Q&A C90 How does a pattern of granting concessions to customers in the form of free or significantly discounted goods or services affect an entity’s identification of the promised goods or services in contracts with its customers? Example C90.1: Pattern of granting concessions Q&A C100 Are promises to provide services to a reseller’s end customers perform ware entity in its contract ance obligations of the soft with the reseller? Example C100.1: Technical support and unspecified upgrade rights provided to a reseller’s end- user customers Q&A C110 Are software licenses capable of being distinct in accordance with paragraph 606- 10- 25-19(a)? includes multiple software licenses (e.g. Q&A C120 If an arrangement licenses to multiple software applications or modules), which may or may not be transferred to the customer at different points in time, how should an entity evaluate if those licenses are separate performance obl igations? Is the nature of an entity’s promise to provide technical support Q&A C130 and or unspecified (when- -if available) updates, upgrades and enhancements a stand- ready obligation? Q&A C140 If an obligation to provide technical support services or one to provide unspecified update/upgrade/enhancement rights is a stand -ready obligation, is the obligation a ‘series’ of distinct service periods? Q&A C150 Are the component services of PCS separate performance obligations? Are technical supp ort services distinct from the software Q&A C160 license to which they relate? Q&A C170 How should a software vendor evaluate whether a software license is distinct from a promise to provide unspecif ied updates, upgrades and enhancements? Example C170.1: Software license and PCS Example C170.2: Software license and updates Q&A C175 If a software license and update rights are not distinct from each other, what is the effect of a renewal option for the - update rights if the license and those initial rights are not co terminus? Are the considerations with respect to determining the Q&A C180 performance obligations for promises of technical support and unspecified updates, upgrades and enhancements different in a SaaS arrangement and a software licensing arrangement? Q&A C190 Can a promise to provide technical support services or to provide unspecified updates, upgrades and enhancements be implied? © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

132 Revenue for software and SaaS 130 : Identify the performance obligations in the contract C. Step 2 Q&A C200 If technical support services or unspecified update, upgrade and enhancement rights are mandatory, does that affect the conclusion about whether the software license and those services are distinct? Software license and mandatory PCS (term Example C200.1: license) Software license and mandatory PCS Example C200.2: (perpetual license) Example C200.3: Software license and mandatory PCS – license fee paid over time Q&A C210 If a customer reinstates technical support and/or unspecified update, upgrade and enhancement rights after allowing them to lapse, are those services distinct from any promises to provide updated or enhanced software (i.e. releases the customer did not get during the lapse) as part of the reinstatement? Q&A C220 front What should a SaaS provider consider in evaluating if up- services it provides in a SaaS arrangement are a promised -up activity that does service or solely an administrative task/set not transfer a good or service to the customer? Example C220.1: -up activities versus implementation Set services i n a SaaS arrangement How should an entity evaluate whether professional services to Q&A C230 significantly customize or modify the licensed software are license? distinct from the associated software Software license and customization services Example C230.1: How should an entity evaluate whether implementation and Q&A C240 -type services are distinct from the associated installation software license? Example C240.1: Software and implementation services 0 If an entity provides multiple implementation services, are each Q&A C25 of those services a separate performance obligation? How does an entity evaluate whether implementation services Q&A C260 that are complex, but do not significantly customize or modify the software, are distinct from the associated software license? Example C260.1: Software license and complex implementation services (complex interfacing) Q&A C270 Are there instances where configuration services, not accompanied by customization services, would not be distinct from the associated software license? Q&A C280 Are the considerations for a SaaS provider different from the considerations for an entity licensing software when determining whether professional services are distinct from the SaaS? -front professional services and SaaS Example C280.1: Up © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

133 Revenue for software and SaaS 131 : Identify the performance obligations in the contract C. Step 2 Example C280.2: SaaS and complex implementation services Q&A C290 How should an entity evaluate whether a license is a component of a tangible good that is integral to the functionality of the good? Q&A C300 In an arrangement that includes a software license and hosting services, are the software license and the hosting services separate performance obligations? Example C300.1: Software license, customization services and hosting services Q&A C310 What should an entity consider when evaluating whether a software license and a SaaS element in a ‘hybrid SaaS’ (or ‘hybrid cloud’) arrangement are distinct from each other? Example C310.1: On -premise software part of a combined solution Example C310.2: SaaS with an ‘offline mode’ Example C310.3: On -premise software with ‘additive’ SaaS functionality Flexible hybrid arrangement Example C310.4: Q&A C320 and -if available) additional Are rights to use unspecified (when- software products and an initial software license(s) distinct from each other in a software licensing arrangement? Example C320.1: Contract with rights to unspecified additional software products Non- distinct unspecified update/upgrade and Example C320.2: additional software product rights Q&A C330 Are the considerations as to whether promised S aaS and a right to access unspecified additional software products as a service distinct from each other different from those in a software licensing arrangement? Q&A C340 Are specified upgrades and rights to specified additional software products additional promised goods in a contract with a customer? If so, are they distinct from the other goods or services in the contract? Implicit specified upgrade Example C340.1: Q&A C350 If a SaaS provider makes a promise to a customer to add functionalities or features to its SaaS, is that an additional promised service in the contract with the customer? If so, is that promised service distinct from the original SaaS service? Example C350.1: Additional SaaS features/functionalities not accounted for as an additional promise to the customer Q&A C360 Should a platform transfer right be accounted for as an additional promise to the customer or as a right to exchange software licenses? Platform transfer rights Example C360.1: © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

134 Revenue for software and SaaS 132 : Identify the performance obligations in the contract C. Step 2 Unspecified platform transfer rights Example C360.2: Q&A Is a sunset clause included in a contract with a customer a C370 promised good or service? If so, is it distinct? Custom er options Q&A C380 If, in a software licensing or a SaaS arrangement, the customer pays the entity a usage (or transaction) based fee, is each usage (or transaction) an ‘optional purchase’ made by the customer? Q&A C390 Is a provision permitting a customer to obtain additional copies of a software product subject to the customer option guidance based royalty? or does it describe a usage- Example C390.1: Option to acquire additional licenses versus usage-based fee Example C390.2: User -based provision that is a usage -based fee Example C390.3: -based provision Metric Is a provision permitting a customer to add users (or seats) to a Q&A C400 SaaS subscri ption subject to the customer option guidance or does it describe a usage- based royalty? Q&A C410 Are renewal options for services promised goods or services in a contract? Example C410.1: SaaS renewal option Q&A C420 When assessing the amount of an incremental discount offered to a customer, should the entity look to the high- end of any “range of discounts typically given for those goods or services to that ‘class of customer’ in that geographical area or market”, to the midpoint of that range or the median, or some other amount such as the mean? Q&A C430 How should an entity evaluate if an option provides the customer with a material right when the stand- alone selling price of the good or service subject to the option is highly variable or uncertai n? Example C430.1: Evaluating whether an option for a good or service with a highly variable stand -alone selling price grants a material right to the customer Does a customer option to convert a term software license into Q&A C440 a perpetual license represent an additional promised good or service in the contract? © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

135 Revenue for software and SaaS 133 C. Step 2 : Identify the performance obligations in the contract Step 5 2 Step Step Step 1 Step 4 3 Allocate the Determine Identify Recognize Identify the transaction performance transaction contract revenue price obligations price Identify the promised goods and services Excerpt from ASC 606-10 > > Promises in Contracts with Customers A 16 generally explicitly states the goods or customer with a contract 25- services that an entity promises to transfer to a customer. However, the promised goods and services identified in a contract with a customer may not n that contract. be limited to the goods or services that are explicitly stated i This is because a contract with a customer also may include promises that are implied by an entity’s customary business practices, published policies, or specific statements if, at the time of entering into the contract, those promises cre ate a reasonable expectation of the customer that the entity will transfer a good or service to the customer. 25- 16A An entity is not required to assess whether promised goods or services are performance obligations if they are immaterial in the context of the contract with the customer. If the revenue related to a performance obligation that includes goods or services that are immaterial in the context of the contract is recognized before those immaterial goods or services are transferred to the customer, then the related costs to transfer those goods or services shall be accrued. - 25 25 16A to a - - 16B An entity shall not apply the guidance in paragraph 606 - 10 customer option to acquire additional goods or services that provides the -55 customer with a material right, in accordance with paragraphs 606- 10 -41 through 55- 45. Promised goods or services do not include activities that an entity must 25- 17 undertake to fulfill a contract unless those activities transfer a good or service to a customer. For example, a services provider may need to perform various act. The performance of those tasks does administrative tasks to set up a contr not transfer a service to the customer as the tasks are performed. Therefore, those setup activities are not promised goods or services in the contract with the customer. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

136 Revenue for software and SaaS 134 C. Step 2 : Identify the performance obligations in the contract 25 - 18 Depending on the contract , promised goods or services may include, but are not limited to, the following: a. Sale of goods produced by an entity (for example, inventory of a manufacturer) b. Resale of goods purchased by an entity (for example, merchandise of a retailer) Resale of rights to goods or services purchased by an entity (for example, c. a ticket resold by an entity acting as a principal, as described in 606-10 -55 -36 through 55- 40) paragraphs d. Performing a contractually agreed- upon task (or tasks) for a customer e. Providing a service of standing ready to provide goods or services (for example, unspecified updates to software that are provided on a when - and-if -available basis) or of making goods or services available for a customer to use as and when the customer decides f. Providing a service of arranging for another party to transfer goods or services to a customer (for example, acting as an agent of another party, as 40) described in paragraphs 606- 10- 55- 36 through 55- g. a Granting rights to goods or services to be provided in the future that customer can resell or provide to its customer (for example, an entity selling a product to a retailer promises to transfer an additional good or service to an individual who purchases the product from the retailer) h. Constructing, manufacturing, or developing an asset on behalf of a customer Granting licenses (see paragraphs 606- 10- i. 55-54 through 55-6555- 60 and paragraphs 606- 10 -55 -62 through 55- 65B) Granting options to purchase additional goods or services (when those options -55 provide a customer with a material right, as described in paragraphs 606-10 - 45). - 41 through 55 from ASC 606-10 Excerpt > > > Other Licensing Considerations 55- 64 Contractual provisions that explicitly or implicitly require an entity to transfer control of additional goods or services to a customer (for example, by requiring the entity to transfer control of additional rights to use or rights to access intellectual property that the customer does not already control) should be distinguished from contractual provisions that explicitly or implicitly define the attributes of a single promised license (for example, restrictions of time, geographical region, or use). Attributes of a promised license define the scope of a customer’s right to use or right to access the entity’s int ellectual property and, therefore, do not define whether the entity satisfies its performance obligation at a point in time or over time and do not create an obligation for the entity to transfer any additional rights to use or access its intellectual property. - 64A Guarantees provided by the entity that it has a valid patent to 55 intellectual property and that it will defend that patent from unauthorized use do not affect whether a license provides a right to access the entity’s © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

137 Revenue for software and SaaS 135 C. Step 2 : Identify the performance obligations in the contract a right to use the entity’s intellectual property. Similarly, intellectual property or a promise to defend a patent right is not a promised good or service because it provides assurance to the customer that the license transferred meets the specifications of the license promised in the contract. Distinguishing Multiple Licenses from Attributes of a > > > Example 61B — Single License 55- 399K On December 15, 20X0, an entity enters into a contract with a customer that permits the customer to embed the entity’s functional property in two classes of the customer’s consumer products intellectual (Class 1 and Class 2) for five years beginning on January 1, 20X1. During the first year of the license period, the customer is permitted to embed the entity’s intellectual property only in Class 1. Beginning in Year 2 (that is, beginning on January 1, 20X2), the customer is permitted to embed the entity’s intellectual property in Class 2. There is no expectation that the entity will undertake activities to change the functionality of the intellectual property during the license period. There are no other promised goods or services in the contract. The entity provides (or otherwise makes available —for example, makes available for download) a copy of the intellectual property to the customer on December 20, 20X0. 399L 55- In identifying the goods and services promised to the customer in the contract (in accordance with guidance in paragraphs 606- 10 -25 -14 through 25 - 18), the entity considers whether the contract grants the customer a single promise, for which an attribute of the promised license is that during Year 1 of the contract the customer is restricted from embedding the intellectual property in the Class 2 consumer products), or two promises (that is, a license for a right to embed the entity’s intellectual property in Class 1 for a five- year period beginning on January 1, 20X1, and a right to embed the entity’s intellectual property in Class 2 for a four -year period beginning on January 1, 20X2). 399M ermines that the provision in In making this assessment, the entity det 55- the contract stipulating that the right for the customer to embed the entity’s intellectual property in Class 2 only commences one year after the right for the customer to embed the entity’s intellectual property in Class 1 means that after the customer can begin to use and benefit from its right to embed the entity’s intellectual property in Class 1 on January 1, 20X1, the entity must still fulfill a second promise to transfer an additional right to use the licensed intellectual property (that is, the entity must still fulfill its promise to grant the customer the right to embed the entity’s intellectual property in Class 2). The entity does not transfer control of the right to embed the entity’s intellectual property in Class 2 before the customer can begin to use and benefit from that right on January 1, 20X2. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

138 Revenue for software and SaaS 136 : Identify the performance obligations in the contract C. Step 2 - 399N 55 The entity then concludes that the first promise (the right to embed the entity’s intellectual property in Class 1) and the second promise (the right to embed the entity’s intellectual property in Class 2) are distinct from each other. The customer can benefit from each right on its own and independently of the other. Therefore, each right is capable of being distinct in accordance 25-19(a)). In addition, the entity concludes that the 10- with paragraph 606- promise to transfer each license is separately identifiable (that is, each right meets the criterion in paragraph 606- 10- 25-19(b)) on the basis of an evaluation - of the principle and the factors in paragraph 606- 10 -25 21. The entity concludes that it is not providing any integration service with respect to the two rights (that is, the two rights are not inputs to a combined output with functionality that is different from the functionality provided by the licenses independently), neither right significantly modifies or customizes the other, and the entity can fulfill its promise to transfer each right to the customer independently of the other (that is, the entity could transfer either right to the customer without transferring the other). In addition, neither the Class 1 license nor the Class 2 license is integral to the customer’s ability to use or benefit from the other. Because each right is distinct, they constitute separate performance 399O 55- obligations. On the basis of the nature of the licensed intellectual property and the fact that there is no expectation that the entity will undertake activities to change the functionality of the intellectual property during the license period, each promise to transfer one of the two licenses in this contract provides the customer with a right to use the entity’s intellectual property and the entity’s promise to transfer each license is, therefore, satisfied at a point in time. The entity determines at what point in time to recognize the revenue allocable to each performance obligation in accordance with paragraphs 606- 10- 55-58B through 55- 58C. Because a customer does not control a license until it can begin to use and benefit from the rights conveyed, the entity recognizes revenue allocated to the Class 1 license no earlier than January 1, 20X1, and the revenue on the Class 2 license no earlier than January 1, 20X2. from ASC Excerpt 606-10 > > > Example 44 — Warranties , a manufacturer, provides its 309 An entity 55- customer with a warranty with the purchase of a product. The warranty provides assurance that the product complies with agreed-upon specifications and will operate as promised for one year from the date of purchase. The contract also provides the customer with the right to receive up to 20 hours of training services on how to operate the product at no additional cost. The training services will help the customer optimize its use of the product in a short time frame. Therefore, although the training services are only for 20 hours and are not essential to the customer’s ability to use the product, the entity determines that the training services are material in the context of the contract on the basis of the facts and circumstances of the arrangement. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

139 Revenue for software and SaaS 137 C. Step 2 : Identify the performance obligations in the contract 55- 310 The entity assesses the goods and services in the contract to determine whether they are distinct and therefore give rise to separate performance obligations. 55- 311 The product and training services are each capable of being distinct in -19(a) and 606- -20 because the 10-25 accordance with paragraphs 606- 10 -25 customer can benefit from the product on its own without the training services and can benefit from the training services together with the product that already has been transferred by the entity. The entity regularly sells the product separately without the training services. The entity next assesses whether its promises to transfer the product 55- 312 and to provide the training services are separately identifiable in accordance with paragraphs 606- 10 -25 -19(b) and 606- 10-25 -21. The entity does not provide a significant service of integrating the training services with the product (see paragraph 606- 10-25 -21(a)). The training services and product do not significantly modify or customize each other (see paragraph 21(b)). -25- 606-10 The product and the training services are not highly interdependent or highly 10-25 interrelated as described in paragraph 606- -21(c). The entity would be able to fulfill its promise to transfer the product independent of its efforts to subsequently provide the training services and would be able to provide training services to any customer that previously acquired its product. Consequently, the entity concludes that its promise to transfer the product and its promise to provide training services are not inputs to a combined item and, therefore, are each separately identifiable. 55- 313 The product and training services are each distinct in accordance with paragraph 606- 10-25 -19 and therefore give rise to two separate performance obl igations. 55- 314 Finally, the entity assesses the promise to provide a warranty and observes that the warranty provides the customer with the assurance that the product will function as intended for one year. The entity concludes, in accordance with paragraphs 606- 10 -30 through 55- 35, that the warranty -55 does not provide the customer with a good or service in addition to that assurance and, therefore, the entity does not account for it as a performance obligation. The entity accounts for the assurance- typ e warranty in accordance with the requirements on product warranties in Subtopic 460 -10. As a result, the entity allocates the transaction price to the two 315 55- performance obligations (the product and the training services) and recognizes revenue when (or as) those performance obligations are satisfied. Step 2 of the revenue model requires an entity to identify the promised goods or services in the contract with a customer, and then determine which are separate ‘performance obligations’. Therefore, the first task in applying this step of the revenue model is to identify the goods or services promised in a contract with a customer. Such promises can be explicit in the contract or implied based on the entity’s actions, including its customary business practices, published policies, and other statements or communications such that the customer has a reasonable expectation of receiving those goods or services as a result of entering into the contract. Promised goods or services in a contract with a customer also include explicit © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

140 Revenue for software and SaaS 138 : Identify the performance obligations in the contract C. Step 2 or implicit promises to provide goods or services to the customer’s customers, often referred to as sales incentives (e.g. a software entity that implicitly promises, through its customary business practices, to provide technical support or unspecified updates/upgrades to entities that purchase its software from a reseller or distributor). -up activities or administrative Promised goods or services do not include set tasks that an entity will undertake to fulfill a contract unless those activities or tasks transfer a good or service to the customer. Determining whether activities required to fulfill a contract are promised services to the customer, rather than administrative tasks/set -up activities, requires judgment based on the specific e of the activities. In general, administrative tasks (or set -up activities) natur provide no incremental benefit to the customer beyond enabling that customer to obtain a promised good or service – that is, the activities provide no value to the customer separate from the promised good or service the activities permit the customer to obtain, even if those activities are necessary for the customer service (SaaS) to obtain the good or service. For example, a software- as-a- provider may have to undertake activities at the outset of a SaaS arrangement n enabling them to that provide no benefit or value to the customer other tha access the online service (see Question C220). A strong indicator that activities are not administrative tasks or set transfer a promised -up activities, but rather good or service, is if another party provides those activities separately. If another service provider sells those activities separately that would strongly indicate the activities the entity is providing transfer a promised service to the customer. An entity is permitted, as a practical expedient, not to assess whether promised goods or services are performance obligations if they are ‘ immaterial in the context of the contract with the customer ’. An entity is not required to consider whether promised goods or services that are immaterial in the context of the contract are material in the aggregate. The evaluation of whether a promised both good or service is immaterial in the context of the contract considers qualitati and factors. If the revenue related to a performance ve quantitative obligation that includes goods or services that are immaterial in the context of the contract is recognized before those immaterial goods or services are transferred to the customer, then the related costs to transfer those goods or when (or as) the revenue related to the performance services are accrued obligation that includes those immaterial goods or services is recognized. ) that are C380 Customer options (discussed in further detail before Question determined to provide the customer with a ‘material right’ cannot be deemed immaterial in the context of the contract. Even if goods or services are not immaterial in the context of the contract, an entity may conclude that accounting for such goods or services are immaterial to the financial statements taken as a whole, similar to the conclusion many entities reach with respect to not capitalizing items of property, plant and equipment below a certain threshold. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

141 139 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 Comparison to legacy US GAAP The concept of a ‘promised good or service’ in Topic 606 is similar (but not necessarily identical) to the notion of a ‘deliverable’ under existing US GAAP – although neither term is defined. Therefore, entities may evaluate whether an item in a contract with a customer transfers a promised good or service similarly to how they evaluate whether an item is a deliverable under legacy GAAP. In an SEC staff speech (Mark S. Barrysmith speech at the 2007 US AICPA National Conference on Current SEC and PCAOB Developments), the SEC staff noted that the following criteria are a helpful starting point in determining, under legacy US GAAP, whether an item is a deliverable in the arrangement: the item is explicitly referred to as an obligation of the entity in a contrac tual 1. arrangement; 2. the item requires a distinct action by the entity; 3. if the item is not completed, the entity would incur a significant contractual penalty; or including or excluding the item from the arrangement would cause the 4. more than an insignificant amount. arrangement fee to vary by Implied promises/sales incentives Applying Topic 606 should generally be consistent with the legacy US GAAP software revenue recognition practice. That guidance required software entities that provide technical support services to a reseller’s customer, or grant a reseller the right to provide upgrades and enhancements to the reseller’s customer, to account for those services as an implied deliverable in the arrangement between the software entity and the reseller. Admini strative tasks/set- up activities of an administrative task exists in SEC guidance applied under The notion legacy US GAAP and refers to activities that do not represent discrete earnings events – i.e. selling a membership, signing a contract, enrolling a c ustomer, activating telecommunications services or providing initial set -up services. That SEC guidance distinguishes between deliverables and these activities. It states that activities that do not represent discrete earnings events are typically negotiat ed in conjunction with the pricing of the deliverables to the contract, deliverable activities as having and that the customer generally views these non- significantly lower or no value separate from the entity’s overall performance under the contract. In general, entities are unlikely to reach a substantially different conclusion under the new standard when they attempt to identify administrative tasks or set -up activities from the conclusion reached under the SEC guidance related to identifying activities that do not represent discrete earnings events. Promised goods or services that are ‘immaterial in the context of the contract’ Legacy US GAAP provided that, in limited circumstances, revenue for a unit of accounting could be recognized in its entirety even if the entity had a remaining obligation, provided that remaining obligation was inconsequential or perfunctory. An undelivered item was not inconsequential or perfunctory if it © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

142 Revenue for software and SaaS 140 : Identify the performance obligations in the contract C. Step 2 was essential to the functionality of the delivered goods or services. Also, activities were not inconsequential or perfunctory if the failure to complete the activities would result in a full or partial refund or the customer’s right to reject the delivered goods or services. The assessment of whether a promised good or service is ‘immaterial in the context of the contract’ includes both qualitative and quantitative factors, including consideration of what may be important to the customer. Therefore, we believe application of the ‘immaterial in the context of the contract’ guidance may be similar to the legacy US GAAP guidance on inconsequential or perfunctory deliverables. Determine which promised goods or servic es are performance obligations Excerpt from ASC 606-10 Distinct Goods or Services > > A good or service that is promised to a customer is distinct if both of the 25 -19 following criteria are met: a. The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct). The entity’s promise to transfer the good or service to the customer is b. separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract). 20 25- A customer can benefit from a good or service in accordance with -19(a) if the good or service could be used, consumed, 10-25 paragraph 606- sold for an amount that is greater than scrap value, or otherwise held in a way some goods or services, a customer that generates economic benefits. For may be able to benefit from a good or service on its own. For other goods or services, a customer may be able to benefit from the good or service only in conjunction with other readily available resources. A readily available resource is a good or service that is sold separately (by the entity or another entity) or a resource that the customer has already obtained from the entity (including goods or services that the entity will have already transferred to the customer under the contract) or from other transactions or events. Various factors may provide evidence that the customer can benefit from a good or service either on its own or in conjunction with other readily available resources. For example, the fact that the ent ity regularly sells a good or service separately would indicate that a customer can benefit from the good or service on its own or with other readily available resources. 21 25- In assessing whether an entity’s promises to transfer goods or services to the customer are separately identifiable in accordance with paragraph 606 - -19(b), the objective is to determine whether the nature of the promise, 10-25 within the context of the contract, is to transfer each of those goods or services individually or, instead, to transfer a combined item or items to which © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

143 141 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 the promised goods or services are inputs. Factors that indicate that two or more promises to transfer goods or services to a customer are not separately identifiable include, but are not limited to, the following: a. a significant service of integrating the goods or The entity provides services with other goods or services promised in the contract into a bundle of goods or services that represent the combined output or outputs for which the customer has contracted. In other words, the entity is using the goods or services as inputs to produce or deliver the combined output or outputs specified by the customer. A combined output or outputs might include more than one phase, element, or unit. One or more of the goods or services significantly modifies or customizes, b. or are significantly modified or customized by, one or more of the other goods or services promised in the contract. c. The goods or services are highly interdependent or highly interrelated. In other words, each of the goods or services is significantly affected by one or more of the other goods or services in the contract. For example, in some cases, two or more goods or services are significantly affected by each other because the entity would not be able to fulfill its promise by transferring each of the goods or services independently. 25 22 If a promised good or service is not distinct, an entity shall combine that - service with other promised goods or services until it identifies a good or bundle of goods or services that is distinct. In some cases, that would result in the entity accounting for all the goods or services promised in a contract as a performance obliga tion . single Excerpt 606-10 from ASC > > > Example 10 — Goods and Services Are Not Distinct > > > > Case C — Combined Item year term license to anti 140D -virus An entity grants a customer a three- 55- software and promises to provide the customer with when- and -if available updates to that software during the license period. The entity frequently continued utility of the software. provides updates that are critical to the Without the updates, the customer’s ability to benefit from the software would decline significantly during the three- year arrangement. 55- 140E The entity concludes that the software and the updates are each promised goods or services in the contract and are each capable of being -19(a). The software and the distinct in accordance with paragraph 606- 10-25 updates are capable of being distinct because the customer can derive economic benefit from the software on its own throughout the license period (that is, without the updates the software would still provide its original functionality to the customer), while the customer can benefit from the updates together with the software license transferred at the outset of ract. the cont © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

144 Revenue for software and SaaS 142 C. Step 2 : Identify the performance obligations in the contract The entity concludes that its promises to transfer the software license 55 - 140F and to provide the updates, when- and- if available, are not separately identifiable (in accordance with paragraph 606- 10- 25-19(b)) because the license and the updates are, in effect, inputs to a combined item (anti -virus protection) in the contract. The updates significantly modify the functionality of the software (that is, they permit the software to protect the customer from a significant number of additional viruses that the software did not protect against previously) and are integral to maintaining the utility of the software license to the customer. Consequently, the license and updates fulfill a single promise to the customer in the contract (a promise to provide protection from computer viruses for three years). Therefore, in this Example, the entity accounts for the software license and the when- and -if available updates as a single performance obligation. In accordance with paragraph 606- 10 -25- 33, the entity concludes that the nature of the combined good or service it promised to transfer to the customer in this Example is computer virus protection for three years. The entity considers the nature of the combined good or service (that is, -virus protec tion for three years) in determining whether the to provide anti performance obligation is satisfied over time or at a point in time in accordance with paragraphs 606- 10 -25 -23 through 25- 30 and in determining the appropriate method for measuring progress toward complete s atisfaction of 10 -25- 31 the performance obligation in accordance with paragraphs 606- 37. through 25- > > > Example 11 Determining Whether Goods or Services Are Distinct — > > > > Case A — Distinct Goods or Services 55- 141 An entity, a software developer, enters into a contract with a customer to transfer a software license, perform an installation service, and provide unspecified software updates and technical support (online and telephone) for a two-year period. The entity sells the license, installation service, and technical support separately. The installation service includes changing the web screen for each type of user (for example, marketing, inventory management, and information technology). The installation service is routinely performed by other entities and does not significantly modify the software. The software remains functional without the updates and the technical support. 55- The entity assesses the goods and services promised to the customer 142 to determine which goods and services are distinct in accordance with 10-25 -19. The entity observes that the software is delivered paragraph 606- before the other goods and services and remains functional without the updates and the technical support. The customer can benefit from the updates together with the software license transferred at the outset of the contract. Thus, the entity concludes that the customer can benefit from each of the goods and services either on their own or together with the other goods and 10-25 services that are readily available and the criterion in paragraph 606- -19(a) is met. 55- 143 The entity also considers the principle and the factors in paragraph 606- 10-25 -21 and determines that the promise to transfer each good and service to the customer is separately identifiable from each of the other promises (thus, 10 -19(b) is met). In reaching this the criterion in paragraph 606- -25 determination the entity considers that although it integrates the software into the customer’s system, the installa tion services do not significantly affect the © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

145 Revenue for software and SaaS 143 : Identify the performance obligations in the contract C. Step 2 customer’s ability to use and benefit from the software license because the installation services are routine and can be obtained from alternate providers. The software updates do not significantly affect the customer’s ability to use and benefit from the software license because, in contrast with Example 10 (Case C), the software updates in this contract are not necessary to ensure that the software maintains a high level of utility to the customer during the license period. The entity further observes that none of the promised goods or services significantly modify or customize one another and the entity is not providing a significant service of integrating the software and the services into a combined output. Lastly, the entity concludes that the software and the services do not significantly affect each other and, therefore, are not highly interdependent or highly interrelated because the entity would be able to fulfill its promise to transfer the initial software license independent from its promise to subsequently provide the installation service, software updates, or technical support. 55- 144 On the basis of this assessment, the entity identifies four performance obligations in the contract for the following goods or services: a. The software license b. An installation service c. Software updates d. Technical support. 25- 55- The entity applies paragraphs 606- 10- 145 23 through 25- 30 to determine whether each of the performance obligations for the installation service, software updates, and technical support are satisfied at a point in time or over time. The entity also assesses the nature of the entity’s promise to transfer the 60 59 through 55- -55- -10 606 software license in accordance with paragraphs -55 and 606-10 64A (see Example 54 in paragraphs 606- 10 62 through 55- - -55- 362 through 55 - 363B). > > > > Case B — Significant Customization 55- 146 The promised goods and services are the same as in Case A, except that the contract specifies that, as part of the installation service, the software is to be substantially customized to add significant new functionality to enable the software to interface with other customized software applications used by the customer. The customized installation service can be provided by other entities. 55- 147 The entity assesses the goods and services promised to the customer to determine which goods and services are distinct in accordance with paragraph 606- 10-25 -19. The entity first assesses whether the criterion in paragraph 606- 10-25 -19(a) has been met. For the same reasons as in Case A, the entity determines that the software license, installation, software updates, and technical support each meet that criterion. The entity next assesses whether the criterion in paragraph 10- 25-19(b) has been met by evaluating 606- the principle and the factors in paragraph 606- 10 -25 -21. The entity observes that the terms of the contract result in a promise to provide a significant service of integrating the licensed software into the existing software system by performing a customized installation service as specified in the contract. In other words, the entity is using the license and the customized installation service as inputs to produce the combined output (that is, a functional and 10 - rated software system) specified in the contract (see paragraph 606 integ - © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

146 Revenue for software and SaaS 144 : Identify the performance obligations in the contract C. Step 2 25 - 21(a)). The software is significantly modified and customized by the service 10 (see paragraph 606- -21(b)). Consequently, the entity determines that the -25 promise to transfer the license is not separately identifiable from the customized installation service and, therefore, the criterion in paragraph 606- 10-25 -19(b) is not met. Thus, the software license and the customized installation service are not distinct. 55- 148 On the basis of the same analysis as in Case A, the entity concludes that the software updates and technical support are distinct from the other promises in the contract. 55- 149 On the basis of this assessment, the entity identifies three performance obligations in the contract for the following goods or services: a. Software customization (which is comprised of the license to the software and the customized installation service) b. Software updates c. Technical support. 10- The entity applies paragraphs 606- 30 to determine 23 through 25- 25- 55- 150 whether each performance obligation is satisfied at a point in time or over time and paragraphs 606- 10- 25- 31 through 25- 37 to measure progress toward complete satisfaction of those performance obligations determined to be ed over time. In applying those paragraphs to the software satisfi customization, the entity considers that the customized software to which the customer will have rights is functional intellectual property and that the functionality of that software will not change during the license period as a result of activities that do not transfer a good or service to the customer. Therefore, the entity is providing a right to use the customized software. Consequently, the software customization performance obligation is com pletely satisfied upon completion of the customized installation service. The entity considers the other specific facts and circumstances of the contract 10 -25-23 through 25- 30 in in the context of the guidance in paragraphs 606- determining whether it should recognize revenue related to the single customization performance obligation as it performs the customized software installation service or at the point in time the customized software is transferred to the customer. > > > Example 55 — License of Intellectual Property 55- 364 An entity enters into a contract with a customer to license (for a period of three years) intellectual property related to the design and production processes for a good. The contract also specifies that the customer will obtain any updates to that intellectual property for new designs or production processes that may be developed by the entity. The updates are integral to the customer’s ability to derive benefit from the license during the license period because the intellectual property is used in an industry in which technologies change rapidly. 365 55- The entity assesses the goods and services promised to the customer to determine which goods and services are distinct in accordance with benefit 10-25 -19. The entity determines that the customer can paragraph 606- from (a) the license on its own without the updates and (b) the updates together with the initial license. Although the benefit the customer can derive from the license on its own (that is, without the updates) is limited because the © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

147 Revenue for software and SaaS 145 C. Step 2 : Identify the performance obligations in the contract ntegral to the customer’s ability to continue to use the intellectual updates are i property in an industry in which technologies change rapidly, the license can be used in a way that generates some economic benefits. Therefore, the criterion ) is met for the license and the updates. in paragraph 606- 10-25 -19(a The fact that the benefit the customer can derive from the license on 55- 365A its own (that is, without the updates) is limited (because the updates are integral to the customer’s ability to continue to use the license in the rapidly changing technological environment) also is considered in assessing whether 10 -25 -19(b) is met. Because the benefit that the the criterion in paragraph 606- customer could obtain from the license over the three- year term without the updates would be significantly limited, the entity’s promises to grant the license and to provide the expected updates are, in effect, inputs that, together fulfill a single promise to deliver a combined item to the customer. That is, the nature of the entity’s promise in the contract is to provide ongoing access to the entity’s intellectual property related to the design and production processes for a good for the three -year term of the contract. The promises within that combined item (that is, to grant the license and to provide when- and- if available updates) are therefore not separately identifiable in accordance with the 19(b). criterion in paragraph 606 - 10 - 25 - 366 55- The nature of the combined good or service that the entity promised to ustomer is ongoing access to the entity’s intellectual property transfer to the c related to the design and production processes for a good for the three- year term of the contract. Based on this conclusion, the entity applies 30 to determine whether the single paragraphs 606-10 -25 -23 through 25- performance obligation is satisfied at a point in time or over time and paragraphs 606- 10 -25 -31 through 25- 37 to determine the appropriate method for measuring progress toward complete satisfaction of the performance obligation. The entity concludes that because the customer simultaneously receives and consumes the benefits of the entity’s performance as it occurs, the performance obligation is satisfied over time in accordance with paragraph -27(a) and that a time- 606- based input measure of progress is appropriate 10-25 because the entity expects, on the basis of its relevant history with similar contracts, to expend efforts to develop and transfer updates to the customer - year term. on a generally even basis throughout the three After an entity has identified the ‘promised goods and services’ in the contract, the entity then determines which such goods or services (either individually or in combination with others) are ‘performance obligations’. The ‘performance that is, an entity does not obligation’ is the ‘unit of account’ under Topic 606 – account for the promised goods or services in the contract, it accounts for the performance obligations. A ‘performance obligation’ is either: — a promised good or service (or bundle of promised goods or services) that is distinct; or — a series of and distinct goods or services that are substantially the same meet both of the following criteria: — Each distinct good or service in the series that the entity promises to transfer to the customer would be a performance obligation satisfied © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

148 Revenue for software and SaaS 146 : Identify the performance obligations in the contract C. Step 2 over time (see s) the Step 5: Recognize r evenue when (or a Chapter F – entity satisfies a p erformance o ). bligation — The same method would be used to measure the entity’s progress toward complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer (see Chapter F – Step 5: Recognize r evenue when (or a s) the entity satisfies a p erformance o bligation ). distinct, it must be combined with another If a promised good or service is not distinct good or service (or distinct bundle of goods or services). Consequently, even if a promised good or service is distinct, it may not be a separate goods or services is (are) performance obligation if one or more other promised not distinct. For example, if in a contract with a customer, Product A is determined to be distinct, but Service B is not distinct and those are the only two promised goods and services in the contract, Product A and Service B would be accounted for as a single performance obligation. Assessing whether a promised good or service (or bundle of promised goods or services) is distinct is distinct if of the following criteria are met: both A promised good or service 2: 1: Cr iterion Cr iterion Distinct within the Capable of being context of the contract distinct If both criteria met : Can the customer benefit 's promise to Is the entity -performance Distinct from the good or service transfer the good or obligation service separately on its own or together with other readily identifiable from other promises in the contract ? ? available resources No - com bine Not distinct with other goods and services Good or service is capable of being distinct A customer can benefit from a good or service if it can be used, consumed, sold for an amount that is greater than scrap value or otherwise held in a way that generates economic benefits. A customer can benefit from a good or service on its own (i.e. it can be used, consumed, sold for an amount other than scrap value or otherwise held in a way that generates economic benefits) or in conjunction with either: — other readily available resources that are either sold separately: — by the entity, which includ es services only sold separately in renewal -contract customer support ( PCS – e.g. post ) that is always sold periods ods; initially with a software license, but sold separately in renewal peri © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

149 Revenue for software and SaaS 147 : Identify the performance obligations in the contract C. Step 2 or SaaS that is always sold initially together with implementation services, but sold separately to existing customers in renewal periods; or — ; by another entity — resources that the customer has already obtained from the entity – e.g. a , such as a software license transferred good or service delivered up -front – or from other transactions or events. up-front The assessment of whether the customer can benefit from the goods or services on its own should be based on the characteristics of the goods or services themselves instead of the way in which the customer may use the goods or services, and the fact that a good or service is regularly sold separately indicator that the customer can benefit from a good or by the entity is a strong service on its own or with other readily available resources. Contractual restrictions affecting either the customer’s ability to derive benefit from the good or service on its own (e.g. a restriction on use or resale of a good) or the customer’s ability to access a readily available resource (e.g. a prohibition against the customer obtaining implementation from an available alternative provider) would not affect the entity’s evaluation of whether the that is, the evaluation ignores the good or service is capable of being distinct – contractual restriction. Importantly, this is also the case when considering the second distinct criterion (i.e. whether the entity’s promises to the customer in the contract are separately identifiable). The entity’s promises to transfer the goods or services in the contract are ‘separately identifiable’ The objective when assessing whether an entity’s promises to transfer goods or services are separately identifiable (i.e. distinct within the context of the contract) is to determine whether the nature of the entity’s overall promise to the customer is to transfer each of those promised goods or services individually or, instead, to transfer a combined item (or items) to which the promised goods or services are inputs. Topic 606 provides the following indicators that two or more promises to transfer goods or services to a customer are not separately identifiable: The entity provides a significant service of integrating the goods or services — with other goods or services promised in the contract into a bundle of goods or services that represent the combined output or outputs for which the customer has contracted. This occurs when the entity is using the goods or services as inputs to produce or deliver the output or outputs specified by the customer. A combined output (or outputs) might include more than one phase, element or unit. — One or more of the goods or services significantly modifies or customizes, or is significantly modified or customized by, one or more of the other goods or services promised in the contract. — The goods or services are highly interdependent or highly interrelated, such that each of the goods or services is significantly affected by one or more of the other goods or services. For example, in some cases, two or more goods or serv by each other ices are significantly affected because the entity would not be able to fulfill its promise by transferring each of the goods or services independently. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

150 148 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 The indicators are not an exhaustive list and are not intended to be evaluated as criteri a or to be considered in isolation from the principle that they support . Entities should evaluate whether the nature of the entity’s promise to the customer within the context of the contract is to transfer (a) multiple goods or comprised of services (i.e. multiple outputs) or (b) a combined item that is the multiple promised goods or services in the contract (i.e. the individual promised goods or services are inputs to the combined item). The indicators will be more or less relevant to the evaluation depending on the nature of the contract, and entities will likely attach more or less importance to a particular indicator depending on the facts and circumstances (e.g. the first indicator may provide more persuasive evidence in one contract, while the second or third provides more persuasive evidence in another contract). The Basis for Conclusions to ASU 2016-10 expands on the Board’s intent and on the application of the separately identifiable principle. BC29 explains that an entity’s promises to transfer two or more promised goods or services are not separately identifiable when they will be used to create a combined item (or the sum) items) that is more than, or different from, merely the aggregate ( i.e. of those component goods or services. BC32 further art iculates that this refers of the goods or services significantly affecting the other; two goods or each to services should not be combined into a single performance obligation solely because one good or service significantly affects, or depends upon, the other (e.g. the fact that a maintenance or an installation service depends on the entity transferring the equipment or the licensed software that will be maintained or installed does not mean the entity’s promises to transfer the equipment or the license an d to provide the services are not separately identifiable). Stated another way, we believe that the separately identifiable evaluation transformative hinges on whether the promised goods or services have a ‘ ’ relationship on each other, rather than merely a ’ relationship to n ‘additive each other. Consistent with the discussion of ‘capable of being distinct’, Topic 606 provides that the evaluation of whether an entity’s promises to transfer two or more goods or services are separately identifiable looks at the nature of the goods or services; contractual restrictions or requirements (e.g. to use the entity’s services rather than an alternative provider’s services) do not affect the separately identifiable evaluation. Comparison to legacy US GAAP The general legacy US GAAP separation model – applicable to software-as-a- service, hardware and related deliverables – focused on the separability of the alone value or a delivered item (i.e. whether the delivered item had stand- of return existed relative to the delivered item) and did not require general right an analysis of the remaining deliverables (e.g. whether the undelivered item(s) had stand- alone value) at the time the delivered item was transferred to the customer. If a delivered item in a contract with two deliverables met the separation criteria, the remaining deliverable was accounted for separately without evaluation of whether it met the separation criteria. If the contract contained more than two deliverables, an evaluation of each item’s separability © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

151 Revenue for software and SaaS 149 C. Step 2 : Identify the performance obligations in the contract occurred only when that item was delivered, without consideration of the remaining undelivered items. In addition, the legacy guidance that prohibited allocating contingent revenue to a delivered item, in most cases, had the alone llocating no revenue to a delivered item that had stand- practical effect of a value (i.e. negating the effect of any separation conclusion). Meanwhile, the legacy US GAAP separation model applicable to software and -related elements focused on the undelivered item – i.e. a delivered (s) software software license was only separable if the entity had vendor -specific objective evidence of fair value (VSOE) for all of the undelivered items in the arrangement (e.g. PCS, professional services, hosting services) and any professiona l in the arrangement were not essential to the functionality of the services delivered software. Under Topic 606, all goods and services are required to either be distinct (i.e. capable of being distinct and distinct within the context of the contract), and therefore separate (unless the distinct goods or services meet the series ), or grouped into bundles of goods and services that are distinct from criteria the remaining goods or services in the arrangement. The requirement to establish that all of the promised goods or services in the contract are distinct or to group them into distinct bundles may have an effect, as compared to legacy US GAAP, on whether goods or services qualify for separate accounting since separation depends on the characteristics of all the promised goods or services in the contract rather than solely upon the characteristics of the item software arrangement or upon the undelivered that has been delivered in a non- items in a software licensing arrangement. For example, whether a softwa re license to Product A is distinct now depends on its characteristics as well as those of any bundled services that are undelivered at the point in time the software license is transferred to the customer, and whether SaaS Offering B is distinct depends not only on its characteristics but also on those of the other goods or services in the contract (e.g. whether Product B and Service C are also distinct, either individually or as a bundle). Topic 606 does not contain a contingent revenue ‘cap’. Therefore, separation of goods or services under Topic 606 is not affected by such provisions in the manner it could be under legacy US GAAP. With the elimination of the contingent revenue ‘cap’ and the VSOE requirement for software arrangements, Topic 606 could lead to more performance obligations (or units of account) than was the case under legacy US GAAP. Capable of being distinct The ‘capable of being distinct’ criterion is similar, but not identical, to the stand- alone value criterion required under legacy US GAAP. Specifically, under legacy US GAAP, a delivered item had value on a stand- alone basis if it was sold separately by any entity or if the customer could resell the delivered item on a stand -alone basis (even in a hypothetical market). Under Topic 606, an entity evaluates whether the customer can benefit from the good or service on its own or together with other readily available resources. This evaluation no longer depends entirely on whether the entity or another entity sells an identical or largely interchangeable good or service separately, or whether the delivered item can be resold by the customer. Rather, whether the good or service is sold separately by the entity or another entity or could be resold for more than scrap value are factors to consider in © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

152 Revenue for software and SaaS 150 : Identify the performance obligations in the contract C. Step 2 evaluating whether the customer can benefit from the good or service on its own. Factors beyond how the good or service is sold in the marketplace by the entity or others, such as the stand- alone functional utility of the product or service, are also considered in this evaluation. Therefore, more promised goods and services may meet the capable of being distinct criterion than meet the stand- alone value criterion in legacy US GAAP. or services must still meet the second, ‘separately However, those goods identifiable’ criterion in order to be distinct. ‘Separately identifiable’ versus ‘Essential to the functionality’ Under Topic 606, an entity’s consideration of whether its promises to transfer a software license and provide services are separately identifiable considers whether the nature of the arrangement is for the entity to provide the software license and services, or instead, to transfer a combined item (e.g. a customized software application) that uses the software license and the entity’s services as inputs to produce that combined item. Topic 606 states that the following -inclusive, entities should be considered in making that determination (not all should consider the overall principle): – that is, to whether the entity is providing a significant integration service — combine the promised goods and services (the inputs) into the combined item (the output) for the customer; — whether the services significantly modify or customize the licensed software; or whether the software license and the services are highly dependent on, or — highly interrelated with, each other such that each significantly affects the other in the contract. In contrast, when determining whether a software license and services promised in a contract with a customer should be accounted for separately under legacy US GAAP, an entity considered whether the service element is essential to the functionality of the other elements in the arrangement, including the software license. However, legacy US GAAP considered additional factors, inherent to its risks and rewards model, in determining whether software and related services should be considered a single unit of account. We do not believe these additional factors would affect the question of separation under Topic 606. These factors includ ed whether: The timing of payments for the software was coincident with performance — of the services. — Milestones or customer -specific acceptance criteria affecting the realizability of the software -license fee. The services carried a significant degree of risk or unique acceptance — criteria. — The entity was an experienced provider of the services. In many circumstances, entities will come to similar separation conclusions under Topic 606 as under legacy US GAAP; however, the conclusions reached between ‘separately identifiable’ and ‘essential to the functionality’ may not always be the same. For example, some entities may conclude that a software license and services should be combined under Topic 606 (i.e. because they are not separately identifiable) even though the services are not currently considered essential to the software’s functionality. The converse is also possible. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

153 Revenue for software and SaaS 151 : Identify the performance obligations in the contract C. Step 2 Effect of contractual restrictions/limitations An SEC staff speech from 2009 (Arie S. Wilgenburg speech at the 2009 AICPA l Conference on Current SEC and PCAOB Developments) stated that, Nationa generally, separability of deliverables in a revenue arrangement should be evaluated on the basis of the inherent nature of those deliverables, rather than on specific restrictions in the contract. Topic 606 similarly looks to the inherent nature/characteristics of the goods or services in evaluating whether a good or service is capable of being distinct and whether an entity’s promises to transfer two or more goods or services are y identifiable. Contractual restrictions, therefore, do not affect separatel those evaluations. VSOE no longer affects separability in software licensing arrangements Under legacy US GAAP software revenue recognition guidance, a delivered item (e.g. a software license delivered up -front) was only accounted for as a separate element of the arrangement if the software entity had VSOE for the undelivered elements (e.g. PCS, professional services, hosting services, or any specified update or specified additional software product). If the entity did not have VSOE for all undelivered items, the delivered item (typically a software license) was combined with the undelivered items and the revenue attributable to those items was generally recognized either over the service period (e.g. in the case of PCS or professional services) or at the point in time the undelivered item was delivered (e.g. when a specified upgrade was delivered). In contrast, under Topic 606, the presence or absence of VSOE has no effect on whether two promised goods or services in a software licensing arrangement are separate performance obligations. Because VSOE was often difficult to establish under legacy US GAAP, the elimination of the VSOE requirement for separation will generally result in more items in software licensing arrangements being accounted for as separate performance obligations than are accounted for as separate elements under the legacy guidance. A series of distinct goods or services Excerpt from ASC 606-10 Performance Obligations Identifying 25- At contract inception, an entity shall assess the goods or services 14 promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either: a. A good or service (or a bundle of goods or services) that is distinct b. A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer (see -15). 25 paragraph 606- 10- 15 25- A series of distinct goods or services has the same pattern of transfer to the customer if both of the following criteria are met: © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

154 Revenue for software and SaaS 152 C. Step 2 : Identify the performance obligations in the contract a. Each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria in paragraph 606- 10- 25-27 to be a performance obligation satisfied over time. 31 through 25-32, the same -25- b. In accordance with paragraphs 606- 10 method would be used to measure the entity’s progress toward complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer. Example 12A — Series of Distinct Goods or Services 55- 157B An entity, a hotel manager, enters into a contract with a customer to manage a customer -owned property for 20 years. The entity receives consideration monthly that is equal to 1 percent of the revenue from the customer -owned property. 55- 157C The entity evaluates the nature of its promise to the customer in this contract and determines that its promise is to provide a hotel management service. The service comprises various activities that may vary each day (for example, cleaning services, reservation services, and property maintenance). However, those tasks are activities to fulfill the hotel management service and are not separate promises in the contract. The entity determines that each increment of the promised service (for example, each day of the management -10 service) is distinct in accordance with paragraph 606 19. This is because -25- the customer can benefit from each increment of service on its own (that is, it is capable of being distinct) and each increment of service is separately ause no day of service significantly modifies or customizes identifiable bec another and no day of service significantly affects either the entity’s ability to fulfill another day of service or the benefit to the customer of another day of service. 157D 55- The entity also evaluates whether it is providing a series of distinct goods or services in accordance with paragraphs 606- 10-25 -14 through 25-15. First, the entity determines that the services provided each day are substantially the same. This is because the nature of th e entity’s promise is the same each day and the entity is providing the same overall management service each day (although the underlying tasks or activities the entity performs to provide that service may vary from day to day). The entity then determines that the services have the same pattern of transfer to the customer because -15 are met. The entity determines that the both criteria in paragraph 606- 10 -25 15(a) is met because each distinct service -25- 10 criterion in paragraph 606- meets the criteria in paragraph 606-10 -25- 27 to be a performance obligation satisfied over time. The customer simultaneously receives and consumes the benefits provided by the entity as it performs. The entity determines that the because the same measure criterion in paragraph 606- 10 -25- 15(b) also is met of progress (in this case, a time- based output method) would be used to measure the entity’s progress toward satisfying its promise to provide the hotel management service each day. After determining that the entity is p roviding a series of distinct daily 55 - 157E hotel management services over the 20 -year management period, the entity next determines the transaction price. The entity determines that the entire iders amount of the consideration is variable consideration. The entity cons whether the variable consideration may be allocated to one or more, but not all, of the distinct days of service in the series in accordance with paragraph 606 - © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

155 Revenue for software and SaaS 153 C. Step 2 : Identify the performance obligations in the contract 40 and - 10 - 32 - 39(b). The entity evaluates the criteria in paragraph 606 - 10 - 32 determines that the terms of the variable consideration relate specifically to the entity’s efforts to transfer each distinct daily service and that allocation of the variable consideration earned based on the activities performed by the entity each day to the distinct day in which those activities are performed is consistent with the overall allocation objective. Therefore, as each distinct daily service is completed, the variable consideration allocated to that period may be riable consideration. recognized, subject to the constraint on va A contract may contain a promise to transfer a series of distinct goods or year services services that are substantially the same. For example, a two- contract may consist of 24 monthly (or even 73 0 daily) service periods during which the entity is providing the same service to the customer. At contract inception, an entity assesses the goods or services promised in the contract whether there is a series of goods or services that is a single and determines performance obligation. This is the case when they meet the following criteria. The same method Each distinct good would be used to or service in the measure progress The goods or series is a A single toward satisfaction services are performance performance of each distinct substantially the obligation satisfied obligation good or service in same over ti me the series ) (see Chapter F ) ( see Chapter F Accounting for a series of distinct goods or services that meet the criteria as a single performance obligation is not optional. It is also not an option to disregard that a single performance obligation consists of a series of distinct goods or services that meet the above- criteria – i.e. an entity is not permitted to account for a single performance obligation comprised of a series of distinct goods or services in the same manner as a single performance obligation that is comprised of non -distinct goods or services. Determining the nature of the entity’s promise to the customer is the first step in applying the series guidance De termining the nature of the entity’s promise to the customer is the first step in determining whether the series guidance applies. For example, if the nature of the promise is the delivery of a specified quantity of a good or service, then the evaluation should consider whether each good or service is distinct and substantially the same. Conversely, if the nature of the entity’s promise is to stand- ready or to provide a single service for a period of time (i.e. there is not a specified quantity of activitie s to be performed, such as in the hotel management scenario illustrated ), then the in Example 12A of Topic 606 – paragraphs 606- 10-55 -157B – 55-157E evaluation will typically focus on whether each time increment, rather than the vities, is distinct and substantially the same. For underlying fulfillment acti example, a three-year SaaS arrangement providing unlimited access (or a e.g. because the customer is unlikely defined quantity that is not substantive – to surpass the defined limit) will typically be vie wed as a series of distinct © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

156 154 Revenue for software and SaaS C. Step 2 : Identify the performance obligations in the contract service periods (e.g. each day, week or month of the three- year arrangement) that provide substantially the same service (i.e. continuous access to the that entity’s hosted application) each period. It will generally not be important the entity might undertake different activities with respect to the hosted application or maintaining its data center each of those distinct service periods , or that the customer may use the hosted application differently or in different amounts each of those periods. Certain software -related services will also typically be a series of distinct service periods. For example, technical support services and rights to unspecified updates, upgrades and/or enhancements will typically constitute either a ser ies of distinct service periods (if those are determined to be ‘stand- ready see Question C130) or a series of distinct individual (if services obligations’ – not a ‘stand-ready obligation’). Hosting services provided with respect to licensed software will also generally constitute a series of distinct service periods. goods Not necessary for or services to be provided consecutively To apply the series guidance, it is not necessary that the goods be delivered or services performed consecutively over the contract period. There may be a gap when the overall nature of the entity’s or an overlap in delivery or performance promise is not a ‘stand- (e.g. there will be gaps between ready obligation’ technical support calls or the provision of software updates), and this would not affect the assessment of whether the series guidance applies. Although the act (e.g. a delivered contr Boards specifically contemplated a consecutively repetitive service arrangement), they did not make this distinction a criterion for applying the series guidance. Identifying distinct goods or services as a series may allocation of variable consideration and the affect the accounting for contract modifications Identifying a service obligation (such as a SaaS arrangement) as a series of distinct service periods can significantly affect the accounting for variable consideration in the contract. This is because, in such cases, Topic 606 permits (discussed in entities, if the criteria in paragraph 606- 10- 32-40 are also met Chapter E – price Step 4: Allocat to the performance detail in ransaction e the t ), to allocate variable consideration entirely to distinct obligations in the contract service periods (e.g. each day, month, quarter or year) within a single, series performance obligation – i.e. rather than to the performance obligation as a whole. Therefore, if the consideration for a service (e.g. a SaaS obligation) es in (e.g. based on varies based on discrete activiti each distinct service period the customer’s use of the SaaS platform), the entity may be able to allocate all of th e variable fees attributable to those activities to that distinct service period. In the absence of a conclusion that the single service performance obligation is meeting the variable consideration a series of distinct service periods and -32- 39 through 32-40, entities will 10 allocation criteria in paragraphs 606- generally be required to estimate such fees for the entire performance obligation period and true- up that estimate, as well as revenue recognized to- © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

157 Revenue for software and SaaS 155 C. Step 2 : Identify the performance obligations in the contract date for the performance obligation as a whole , throughout the overall service period (e.g. the three-year SaaS contract period) . A conclusion that a service obligation i s a series of distinct service periods , can also significantly ready obligations, which will typically be the case for stand- affect the accounting for contract modifications. This is because the contract modifications accounting model in Topic 606 differs depending on whether the remaining goods or services to be provided after a contract modification are or are not distinct from the goods or services provided before the modification (rather than on whether they are separate performance obligations) . Consequently, the accounting for a modification to a SaaS arrangement, or to a software licensing arrangement that includes PCS or hosting services, will differ depending on whether the entity concludes that the SaaS, or the PCS or hosting services, is a series of distinct service periods (i.e. such that each period subsequent to the modification is distinct from those preceding it). further guidance on contract Chapter G – Contract m odifications provides modifications. nswers Questions & a C10 Question restrictions as to time, geography and/or use Do affect how many software licenses are promised to the customer in the contract? Interpretive response: It depends. Software licenses frequently include restrictions as to time, geography and/or use of the software. For example, a license may be for a period of time that is less than the economic life of the software, for use only within one or more specified geographies (e.g. within the United States or North America only), and/or may only permit specified uses of the software (e.g. for use only in a specified class of product). In most cases, restrictions o n a software license are attributes of the bundle of at make up the license and do not create additional promises to transfer rights th licenses . However, in some cases, a restriction is substantively to the customer a promise by the entity to grant additional rights to use the entity’s software (i.e. one or more addi tional license s) to the customer at a point in time later than when the customer obtains control of an to use ’ license (i.e. initial rights ‘ initial the entity’s software). Example C10.1 License restrictions Scenario 1: Restrictions do not create an additional promise to the customer year term license to use its software ABC Corp. grants Customer a three- beginning on January 1, 20X6. The terms of the license only permit Customer to have 10 named users, to load the software on servers maintained in the United States (for protective reasons related to the entity’s intellectual © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

158 Revenue for software and SaaS 156 C. Step 2 : Identify the performance obligations in the contract (IP)) and to use the software in the development of a particular class property of product (video game development). ABC makes available to Customer a copy of the software and Customer’s rights to use the software commence on January 1, 20X6. Even though there are restrictions on this license (i.e. it is not perpetual, worldwide or unlimited as to permitted uses of the software), those restrictions represent attributes of a single license that is transferred to the customer on January 1, 20X6 (January 1, 20X6 being the date that the customer can begin to use and benefit from the rights granted). After the entity transfers control of the no additional promised rights 1, there are license to the customer on January remaining to be transferred – e.g. rights for the customer to use the software in additional geographies or for additional uses, or to permit additional named users to use the software. The customer controls all of the rights to use ABC’s software that it will ever control under the contract as of that date. Scenario 2: Restrictions are indicative of an additional promise to the customer to the rights granted to Customer in Scenario 1, assume the contract In addition also provides that, beginning on January 1, 20X7 (i.e. one year after Customer obtains controls of the rights granted in Scenario 1), either Customer is permitted: — 20 named users (an increase from 10 named users permitted as of 1, 20X6); or January — to begin to use the software for the development of products in the field of from video game consumer robotics (i.e. a different application development). In either case, ABC must grant additional rights to use its software on January 1, 20X7 that Customer does not control before that date (i.e. from January 1, 20X6 through December 31, 20X6). Consequently, at contract inception, ABC has two promises to fulfill to Customer: — a promise to transfer a software license comprising the rights and attributes described in Scenario 1 on January 1, 20X6; and a second promise to transfer an additional license, comprising additional — (i.e. 10 additional users or additional use rights to use ABC’s software rights) , on January 1, 20X7. The distinction between the scenarios in Example C10 .1 arises because : — a license is the contractual right to use (or right to access) IP, and not the IP itself ; and the FASB decided that a customer does not control a license until it can — , even if a begin to use and benefit from the rights conveyed by that license copy of the IP (e.g. the licensed software) has been provided – see Chapter F – Step 5: Recognize revenue when (or as ) the entity satisfies a performance obligation . Therefore, it is not sufficient that an entity has delivered a copy of the licensed software and the customer can begin to use and benefit from some rights to use that software. I f the entity has promised to grant additional rights to use ), the of Example C10.1 io 2 ( as illustrated in Scenar that software in the future © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

159 157 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 entity still has one or more additional promises to fulfill . The fact that the entity may not have to deliver any additional software to fulfill the additional promises does not affect this conclusion. Comparison to legacy US GAAP The explicit distinction Topic 606 draws between the delivery of software and the transfer of the rights to use the delivered software may appear new to some that have not previously considered the right to use software separately from the software itself. However, this notion that incremental rights to use previously delivered software constitute an additional deliverable existed in the legacy US GAAP software guidance on concessions (paragraphs 985- 605-55 -18 through 55- 21). That guidance identified extending the geographic area in which a reseller is allowed to sell the software, or the number of locations in which an end user can use the software without commensurate additional consideration ional deliverables. as examples of a concession to a customer involving addit Question C20 Are remix rights in a software contract an additional promised good or service to the customer? Remix rights Software arrangements may allow a user to change or alternate its use of multiple products/licenses (license mix) included in a license arrangement. The user has obtained the right under the arrangement to deploy and use at least one copy of each licensed product – i.e. the user has a license to use each delivered product and solely controls whether to change its license mix. The products may or may not be similar in functionality. These arrangements may allow the customer to use at any time any mix or com bination of the products provided the cumulative value of all products in use does not exceed the total license fee. Certain of these arrangements may not limit usage of a product or products, but instead may limit the number of users that simultaneously can use the products (concurrent user pricing). No an . T he right to remix software licenses is Interpretive response: not In contracts that include remix rights additional promised good or service. (which are separate from any rights conveyed in the contract to specified or unspecified future additional software products ), the software subject to those -front rights is delivered up and the customer has control over its rights to use that software (e.g. number of seats or users and software products deployed) . the customer already attribute of the rights that Remix rights are, therefore, an the part of the software entity controls. There is no obligation left to fulfill on © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

160 Revenue for software and SaaS 158 : Identify the performance obligations in the contract C. Step 2 once the software subject to the remix rights is provided and the customer can begin to use and benefit from its rights under the licenses . software undelivered Remix rights do not include the ability to remix into licenses (e.g. a software product that is not yet delivered or a right the customer does not yet control, such as a right the customer will only have in the future to use one of the delivered software products for an additional ple, some remix arrangements permit the customer to remix purpose) . For exam into future software products developed during the license period. In such cases, the remix rights themselves are not an additional promised good or service, but instead there is a specified or unspecified additional software product right in the contract (see Question C320 ). Remix rights are not equivalent to exchange or return rights because, when the are returned to and no new customer remixes, no software licenses the entity software licenses to previously undelivered software products are transferred the entity by . Comparison to legacy US GAAP Accounting for remix rights under Topic 606 is consistent with the accounting for those rights under legacy US GAAP. Question C30 Is a contractual requirement to put the source code pplication into escrow a perfor mance of a software a obligation? Interpretive response: It depends. To protect the customer in the event that a software entity ceases operations, some licensing arrangements require the entity to deliver the source code for the licensed software into an escrow account. The customer obtains access to that code only in the event that the software entity ceases operations. Those requirements are customary in software licensing arrangements . We believe that a standard escrow requirement for the licensed software’s rather than an additional source code is a protective right to the customer promised good or service in the cont ract , similar to other protective rights such as a promise to defend a patent right with respect to the IP. However, the specific terms of each contract should be evaluated, and unique provisions could result in a different conclusion. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

161 Revenue for software and SaaS 159 : Identify the performance obligations in the contract C. Step 2 Question C40 promise to transfer multiple copies of When does a a software product constitute a promise to transfer multiple licenses? Interpretive response: In general, we believe that a promise to transfer multiple copies software of a (whether characterized as users, seats or similar) the customer’ s product constitutes a promise to transfer multiple licenses if ability to make use of (or derive benefit from) the licensed software varies in proportion to the number of copies transferred. Example C40.1 Multiple copies are multiple licenses Assume that a single copy of software product G either enables a customer to process 100,000 transactions or operate 10 customer locations, and that copies of product G would enable that same customer to process five 500,000 or operate 50 customer locations. transactions In this example, a customer’s processing capacity (i.e. its ability to derive benefit from the use of product G) is a function of the number of copies transferred. Therefore, an arrangement to provide 5 copies would be considered a contract to transfer 5 licenses to the customer. A further strong indicator of a multiple license arrangement is when the consideration in the contract is proportional to the number of copies transferred, and is due and payable when the additional copies are transferred to the customer. not In other cases, a promise to transfer multiple copies may be a promise to – e.g. if the customer’s ability to make use of (or transfer multiple licenses derive benefit from) the software does not vary in proportion to the number of copies transferred. Example C40.2 Multiple copies are not multiple licenses Two comparable customers (Customer A and Customer B) enter into the same licensing arrangement to use an entity’s accounting software on a worldwide basis. Each customer is permitted as many copies of the software as it deems necessary. — Customer A’s accounting staff work at one central location, and therefore re is necessary. only one copy of the softwa Customer B’s similar number of accounting staff are distributed at several — regional locations, and multiple copies of the software are required for Customer B to load on its servers at each location. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

162 Revenue for software and SaaS 160 : Identify the performance obligations in the contract C. Step 2 The customers’ ability to use the software for their respective accounting activities is not affected by the number of copies of the software delivered to the customer. Customer A’s one copy will permit Customer A to perform the same volume of accounting as Customer B’s multiple copies. In this example, the nature of the arrangement is not different (one license versus multiple licenses) solely because Customer B has made a decision, unrelated to the capabilities of the software, to have a distributed accounting function. If p romise to transfe r copies is not a promise to transfer multiple licenses If a promise by the entity to transfer multiple copies of the licensed software B in is not a promise to transfer multiple licenses (as for Customer Example ), it must then consider whether that promise to provide C40.2 copies of the licensed software either: 1. still represent s a promise to produce and deliver additional copies of the licensed software; or 2. is solely a fulfillment activity that does not transfer any additional good or service to the customer (as described in paragraph 606- 10- 25- 17) – i.e. the activity does not provide any substantive incremental benefit to the customer . a promise to provide additional copies of licensed software falls We believe that : both only if (2) into category the customer could make the additional copies without the entity ’s — participation – i.e. suggesting that the production and delivery of additional copies is effectively a convenience to the customer; and — the costs to produce and deliver the additional copies is largely nomina l. A greater cost would suggest that the entity’s promise to transfer the additional copies provides a service to the customer. is not met, we believe that the promise to provi de If either of these criteria additional copies of the licensed software is providing a service to the customer – i.e. it falls into category (1) . promised There may be circumstances in which the entity concludes that a service of producing and delivering additional copies is immaterial in the context 25- [606- 16A] 10- of the contract . Concluding that a promised good or service is immaterial in the context of the contract involves consideration of both quantitative and qualitative factors. Consequently, a promised service of providing additional copies may not be immaterial in the context of the contract, even if the cost of producing the additional copies is nominal. This will depend on the importance to the customer of those additional copies and the customer’s ability to produce the copies itself. If the customer needs those copies to make effective use of the software and cannot produce those copies itself, that may suggest the entity’s promised service to provide those copies is not qualitatively immaterial in the context of the contract. discusses a related question about whether an Question option to acquire C390 additional copies of licensed software (including rights to additional seats, users © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

163 Revenue for software and SaaS 161 C. Step 2 : Identify the performance obligations in the contract ased or similar) is an option to acquire additional software licenses or a usage-b variable fee. Site license A site license is a license that permits a customer to use either specified or unlimited numbers of copies of a software product either, throughout the enses, company or at a specified location. For arrangements involving site lic the licensing fee is payable regardless of the number of copies requested by the customer. Multiple single license arrangements For arrangements that involve multiple single licenses, the licensing fee is a function of the number of copies delivered to, made by, or deployed by the user or reseller. The licensing fee is not due and payable until the copies of the software are delivered to or made by the customer. Comparison to legacy US GAAP Under legacy US GAAP, entities generally categorized arrangements as either for a site license or for multiple single licenses. The key distinction was whether “the licensing fee is a function of the number of copies delivered to, made by, or deployed by the user or reseller.” If so, the arrangement was for multiple licenses rather than a site license. The guidance in Topic 606 is not linked to the payment provisions in the contract. However, it is similar with respect to linking the single versus multiple license question to whether the customer’s ability to make use of the licensed software varies in proportion to the number of copies/seats/users licensed. In practice, most multiple single license arrangements have fees that are a function of the number of copies/seats/users delivered to, made by or deployed. C50 Question -user Is a promise to provide appropriate end documentation a promise to transfer a good to the customer? Interpretive response: user no. We believe that providing end- In general, documentation (e.g. training manuals) is an administrative task if that documentation merely pertains to instructing the customer on how to obtain the inherent utility of the software (or SaaS). In that case, the end- user , and provide incremental benefit to the customer documentation does not . contract therefore is not an additional promised good in the The end- user documentation might be necessary for the customer to begin to i.e. the customer cannot make substantive use and benefit from the software – © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

164 Revenue for software and SaaS 162 C. Step 2 : Identify the performance obligations in the contract , and there are no alternative ation use of the software without the document resources available that would allow the customer to make substantive use of such as consultants or third- the software ( party documentation). In that case, the entity may conclude that the license has not been transferred to the customer until the documentation has been provided. end-user documentation should be distinguished from a standard Providing promise to provide additional materials that would provide incremental benefit to the customer information of a consulting nature that helps . One example is the customer do more than simply achieve the core utility from the software or the SaaS. C60 Question Is a software entity’s participation in a joint steering committee (JSC) considered a promised service in a contract with a customer? Interpretive response: It depends . JSCs are often created through collaborative R&D agreements to ensure that all the parties are working to achieve the goals of the activity . For example, an entity may license its software , and anufacturer (OEM) equipment m to another software vendor or o riginal services to develop technology that will benefit sales of R&D agree to provide both part ies’ products. As part of this arrangement, the entity may agree to participate with the other party on a joint development steering committee. Topic 606 explicitly excludes from its scope contracts, or portions of a contract, that are with a collaborator or partner that are not customers, but rather share with the entity the risks and benefits of developing a product to be marketed. Therefore, it is important for an entity that engages in collaborative arrangements to analyze whether the other parties in its contracts are customers – i.e. a party that has contracted with the entity to obtain goods or services t hat are an output of the entity’s ordinary activities . For further discussion on whether an arrangement is a collaboration, see – Chapter A Scope . When an entity agrees to participate in a JSC in a contract with a customer, it should evaluate the substance of the contractual provision relative to JSC participation. If participation in a JSC is required under the contract with the , that participation is customer generally an additional promised service . However, if participation in the JSC is permit ted but not required, JSC participation may not be an additional promised service in the contract, but rather a right of the entity to protect its own interest in the arrangement. The presence of any of actors generally indicates that the following f parti cipation on the JSC is a promised service in the contract, rather than solely a protective or participating right of the entity: — participation requires specific action by the entity – e.g. specific persons with unique skills that are significant to the project or a specific time ; commitment — to perform would result in a substantive penalty for the entity; and/or failure © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

165 163 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 the contract would — the inclusion or exclusion of the JSC participation from (e.g. the transaction significantly affect the other terms of the contract . price, timing of payments or customer acceptance) Promised goods and services in a contract do not have to be explicit contractual requirements, but rather can be implied promises that a customer would reasonably expect the entity to perform based on the entity’s customary business practices and policies . As such, entities may need to evaluate their customary business practices and policies with respect to JSC participation to determine whether JSC participation is implied, even if the contract is silent or where such participation is optional in accordance with the terms of the [606- 10-25- 16] contract. Comparison to legacy US GAAP In general, the accounting for JSCs is similar to legacy US GAAP. However, both the timing of revenue recognition and allocation of the transaction price may be significantly different for contracts that include the sale or licensing of software. Legacy US GAAP required vendor specific observa ble evidence of fair value (VSOE) of all undelivered elements in order to separate the elements in the arrangement; this included any JSC participation that was determined to be a deliverable. If the entity did not have VSOE for its JSC participation, this often resulted in recognition of the combined arrangement fees over the JSC participation period. Under Topic 606, if the JSC is determined to be a performance obligation, a portion of the transaction price is allocated to the JSC participation based on the relative stand -alone selling price of the JSC participation, without regard to whether VSOE exists for the JSC participation. In addition, the relative stand- alone selling price allocation to the various performance obligations in the contract that includes JSC participation (e.g. a software license, other professional services) may differ from the allocation that would result from applying legacy US GAAP. For a discussion of allocation issues, see Step 4: Allocate the transaction price to the Chapter E – . performance obligations in the contract Question C70 Is a customer’s right to return a product or a right to a refund for services a performance obligation? Interpretive response: Typically, n o. Paragraph 606-10 -55- 24 states “an entity’s promise to stand ready to accept product returns should not be accounted for as a performance obligation in addition to the obligation to ns 606-10 23 addresses the accounting for retur -55- provide a refund.” Paragraph and includes “transfer of products with a right of return (and some services that are provided subject to a refund)” in the scope of that guidance. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

166 164 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 An obligation to accept product returns or to provide refunds (whether in the form of cash or credit toward future products or services) for services (including SaaS) other than as discussed in Question C80 is not a performance obligation pertaining to situations where a customer has the right to exercise a certain return right an unlimited number of times . Instead, rights of return or refund are treated as variable consideration, regardless of whether the customer is entitled to a cash refund as a result of the return or, instead, is only entitled to a credit toward future purchases from the entity . Therefor e, estimated returns normally should be considered by the entity in determining the transaction price of the – 55-24] 55-23 [606- 10- contract . Comparison to legacy US GAAP Legacy US GAAP allowed entities to recognize the sale of products subject to a right of return when risks and rewards of ownership had passed to the customer and the amount of future returns could be reasonably estimated, among other criteria. Sales revenue (and cost of sales) that was not recognized at the time of sale – because the amount of future returns could not be was recognized at the earlier of the return right expiring, reasonably estimated – or the criteria related to making a reasonable estimate of returns being met. The guidance under legacy US GAAP applied to products only, and not to services. However, SEC guidance allowed entities to analogize to the product right of return guidance with respect to services in limited circumstances. The Top ic 606 approach of adjusting revenue for the expected level of returns and recognizing a refund liability is broadly similar to the legacy guidance when the entity can make a reasonable estimate of the returns. However, the detailed methodology for estimating revenue may be different. The Topic 606 methodology requires the use of either the expected value or most likely amount method to determine the expected returns, depending on which better predicts the consideration to which the entity will be entitled. After an estimate of expected returns is made, the entity assesses whether it is probable that using that estimate would not result in a significant revenue reversal and, if not, the amount of revenue to be recognized is constrained. The variable conside ration constraint is designed so that most adjustments to revenue occur upward (i.e. are to revenue). Because legacy US GAAP increases only required future returns to be reasonably estimable, entities often recorded upward and downward adjustments to revenue as a result of the right of return guidance. Although revenue could conceivably be constrained to zero under Topic 606, it is likely that most entities will have sufficient information to recognize they would not be consideration for an amount greater than zero even when able to ‘reasonably estimate’ returns under legacy US GAAP. This is because revenue is recognized to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized under the contract will not occur and recognition does not necessarily default to zero (as happened under legacy US GAAP when a reasonable estimate of returns could not be made). As © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

167 Revenue for software and SaaS 165 : Identify the performance obligations in the contract C. Step 2 a consequence, entities that are unable to make a reasonable estimate of returns may recognize some amount of revenue sooner under Topic 606. Question C80 Under what circumstances is the right to exchange one or more softw are licenses for one or more ternative licenses considered an additional al performance obligation? Interpretive response: The determination of whether an exchange right should be acco unted for as a right to obtain additional software licenses is based on is contractually entitled to continue using whether the customer the originally delivered software. retains the right delivered software license Customer to use the originally If the contract permits the customer to continue using the original software , the exchange right license right to obtain an additional is accounted for as a software license. This is because the customer is entitled to two licenses r ather than one, which should be evaluated in the same manner as any other to C380 customer option to acquire a software license (see Questions ). 40 C4 or only has to pay a nominal fee to If the customer does not have to pay a fee ( obtain the additional software license – e .g. the cost of shipping a CD containing additional software , if the license is to an additional software product ), or has the option to acquire the additional software license for a fee that is substantially discounted from its stand -alone selling price, then that right is a ‘material right’ and constitutes a performance obligation in the contract – i.e. in addition to the initial promised software license. Customer is not entitled to continue using the originally delivered license software Right to exchange for a software that has no more than minimal license differences in price, functionality or features Under Topic 606, rights to exchange one product for another of the same type, quality, condition and price are not considered returns or additional promised goods in the contract . Therefore, the right to exchange one software license for another that has no more than minimal differences in price, functionality or features is neither a return right nor a right to an additional software license. Therefore, it should be accounted for as a like- kind exchange, which will have no effect on the revenue recognition related to the transferred license . A license is a right to use software; it is not the software itself. Therefore, a license does not necessarily have no more than minimal differences in price, functionality or features solely because the license the customer will receive in exchange grants the customer rights to use the same software product as the a limited license to For example, a right to exchange initial software license. software product X (e.g. limited as to geography or use) for an unlimited license or a license with substantially different limitations (e.g. different or expanded geography or use rights) also to software product X is a license with more than minimal differences in price, functionality or features. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

168 Revenue for software and SaaS 166 C. Step 2 : Identify the performance obligations in the contract Right to exchange for software license that has more than minimal differences in price, functionality or features Right s to exchange software licenses for dissimilar licenses (i.e. those with more than minimal differences in price, functionality or features ) are accounted rights of retu for as rn. In a situation where the license the customer can exchange into is of significantly greater value (e.g. it provides significantly more rights or is for a product with significantly more features or functionality), and the customer is not required to pay commensurate additional consideration, the right of return guidance would likely result in deferral of all (or substantially all ) the initial license fee until the exchange occurs or the likelihood of the exchange becomes remote. Topic 606 does not provide guidance about determining if two licenses have more than minimal differences in price, functionality or features; therefore, the comparison should be based on the relevant facts and circumstances on a case- by-case basis. Further, it is important to remember that the promised good in a the software itself. software license arrangement is a license, and not Therefore, the determination does not depend solely on whether the license the same being evaluated is for a different software product. A license for software product may be significantly different in terms of the rights it conveys to the customer. Factors indicating that there may be more than minimal differences in price, functionality or features between two software licenses may include the follow ing. — The license to be received is for a software product that has a different name the software product subject to the original license. from Marketing materials for the software product to be licensed promote — software product subject to the different functionality and features than the original license . — The software product for which a license will be received operates outside the performance domain of the software product subject to the original license. — In independent transactions, a license to the software product to be the original license. received is sold for a price significantly different from — The license that will be received conveys to the customer substantive delivered software product that it does not rights to use a previously already control. For example, the license that will be received permits additional (or different) rights to use the software, such as the right to use the software in additional geographies or for additional uses. Right to exchange for unspecified future software licenses In general, rights to exchange software licenses for unspecified future software licenses do not qualify for like- kind exchange accounting because it is not possible to conclude that unspecified future licenses will have no more than minimal differences in price, functionality or features from the original software so be hard to conclude that an unspecified future license will It may al license. not provide significantly greater value to the customer than the initial license; and therefore, may frequently result in deferral of all (or substantially all) the initial license fee until the exchange occurs or the likelihood of the exchange becomes remote. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

169 167 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 Therefore, a right to exchange a software license for an unspecified software license is generally accounted for as a right to return the initial software license. Right to exchange for unspecified software licenses an unlimited number of times An unspecified software license exchange right (including a provision characterized as a right of return under which the customer only obtains a credit which it can acquire additional software licenses from the entity ) may be with period. In such exercisable an unlimited number of times over a specified cases, in we believe it may be appropriate for the entity to account for that right (see the same manner as a right to unspecified additional software licenses the credit the customer obtains toward additional Question C320) provided that software licenses decreases over the exchange right period in a manner generally consistent with the customer’s consumption of its right to use the . licensed software originally This approach would not be appropriate if the customer can return the software because that license for a full credit throughout the exchange right period approach would result in recognition of revenue ahead of the entity’s performance. Instead, the right of return guidance would apply. It is also not appropriate under Topic 606 to account for the entire arrangement that includes a right to exchange software an unlimited number of times as a subscription, and therefore to recognize all of the arrangement revenue ratably over the exchange right period, because such an approach would result in failure to recognize revenue upon transfer of control of the initial license(s) to the customer . Comparison to legacy US GAAP End -user considerations The guidance on accounting for rights to exchange one or more software licenses for one or more alternative licenses is substantially similar to that under legacy US GAAP, other than with respect to exchange rights that can be exercised an unlimited number of times over a specified period or multiple times over a significantly extended period (e.g. the entire economic life of the software or for as long as the customer renews PCS). That is, under legacy US GAAP, exchange rights of this nature resulted in the entire arrangement being accounted for as a subscription (i.e. in those cases, the arrangement revenue would be recognized ratably over the subscription period). In contrast, under Topic 606, those arrangements will not be accounted for as subscriptions. Rather, they will be accounted for as returns or, in some circumstances, as an arrangement that includes a right to unspecified additional software licenses, which results in a portion of the revenue recognized upon the transfer of the initial license(s) and a portion of the revenue recognized as the entity fulfills its obligation to provide unspecified additional software licenses. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

170 Revenue for software and SaaS 168 C. Step 2 : Identify the performance obligations in the contract Reseller considerations If software entities grant resellers the right to exchange unsold software for other software (including software that runs on a different hardware platform or operating system), such exchanges were accounted for as returns under legacy included stock balancing arrangements, was US GAAP. This accounting, which on the basis that the reseller is not the ultimate customer. Accounting for such exchanges as returns was required even if the entities required resellers to purchase additional software to exercise the exchange rights. Exchange accounting was only considered appropriate when conducted with the ultimate customer. Topic 606 does not contain explicit guidance for exchange rights granted to resellers. Therefore, we do not believe that exchange rights with resellers would always be treated as return rights; instead, the criteria outlined above would apply regardless of where the customer resides on the distribution chain. Entities still have to consider other guidance in Topic 606 (e.g. on consignment arrangements and the applicable transfer of control guidance, such as that in -58B – 55-58C for licenses of functional IP) to determine if -55 10 paragraphs 606- the reseller obtains control of the license to which the exchange rights apply. Example C80.1 e a software license Right to exchang ABC Corp. enters into an arrangement with Customer to transfer a license to Product A, a basic word processing software product, for a nonrefundable fee of $500. In addition, ABC grants Customer the right to exchange its Product A license for a generally equivalent (in terms of rights conveyed to Customer) license to Product B in six months when it is released. Product B is also a word processing software product; it contains essentially the same basic features and functionality Product A except that Product B also contains a grammar -check feature that of permits the user to check the grammatical consistency of text. A license to Product B is expected to be sold for $520 in separate transactions. Customer is not entitled to continue using Product A if the Product A license is exchanged for a license to Product B. Generally, a license to Product B would not be considered to have more than minimal differences in price, functionality or features from a license to Product A. ABC concludes that the right to exchange the Product A license for a Product B license is not an additional promised good or service in the contract. This is A if it exchanges the because Customer will not retain the rights to use Product Product A license for a Product B license. ABC also concludes that the exchange right is not akin to a return because Product A and Product B have no more than minimal differences in price, functionality or features and the rights conveyed by the two licenses are generally equivalent. As a result, there is no accounting that must occur for the exchange right. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

171 169 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 Example C80.2 Right to exchange a software license for an unspecified software license ABC Corp. enters into an arrangement with Customer to transfer a license to Product A for $1,000. In addition, ABC grants Customer the right to receive full credit for the Product A license fee (i.e. no cash will be refunded) if Customer returns that license, and instead licenses any product introduced by ABC in the Product A family over a two -year period. This return provision can be exercised only once and the estimated economic life of the Product A software is five years. If the Product A license is re turned, Customer is no longer entitled to use Product A. ABC concludes that it should account for the sale of the license to Product A as a sale with a right of return. This is because it cannot conclude that the unspecified software product for which Customer might obtain a license in return for the Product A license would have only minimal differences in price, functionality or features from Product A. The return right is not an additional right to promised item in the contract because Customer does not retain the use Product A if it is exercised. ABC does not expect based on its development plan, within the two- year period to which the right applies, to develop any software product within the Product A family that has significantly enhanced features or fu nctionality. Therefore, ABC will recognize revenue for the sale of the Product A license when the license is transferred to Customer. However, in accordance with the guidance on product returns, the transaction price is subject to the guidance on [606- 10- variable consideration, including the constraint on variable consideration. – 55- 55- 22 29] ABC estimates the following based on relevant evidence (e.g. from similar past offers and industry experience): — that 40% of customers will exercise the right to exchange Product A; it is reasonably possible that up to 60% of customers will exercise the right; — and — it is remote that more than 60% of customers will exercise the right. There are no costs to recover the license to Product A if it is returned and there is no cost basis to the license. Accordingly, when the Product A license is transferred to Customer, ABC will recognize revenue of $400 (based on the reasonably possible returns of 60%). It is probable that recognizing this amount will not result in a subsequent significant revenue reversal when the uncertainty as to whether Customer will return Product A is resolved. The introduction of the constraint on variable consideration results in a different GAAP. This outcome for this example than what would result under legacy US is because, under legacy US GAAP, ABC uses its best estimate that 40% of A. In contrast, under customers will exercise the right to exchange Product Topic 606, ABC must constrain that estimate with the intent that it be probable any subsequent adjustments are increases to revenue, rather than reversals. Consequently, in contrast to the example above, under legacy US GAAP, ABC would have: © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

172 Revenue for software and SaaS 170 C. Step 2 : Identify the performance obligations in the contract recognized revenue of $600 on delivery of Product A to Customer; and — established a return reserve of $400 ($1,000 x 40%). — C80.3 Example Right to return software licenses in exchange for credit toward unspecified software licenses year term ABC Corp. enters into an arrangement with Customer to transfer five- licenses to Products J, K, L and M. Customer has the right to return any of those licenses for a credit toward the purchase of licenses to any other ABC software products, including software products that do not yet exist at contract inception or when Customer initiates a return. Customer is not entitled to a cash refund under any circumstances and any return credit expires at the end of the five- year license term. The amount of the credit to which Customer is entitled declines during the license period (e.g. if Customer returns the Product J lice nse on Day 1, Customer will receive a full credit of the contractual Product J license fee, but if Customer returns the Product J license at the end of Year 1, it will receive a credit equal to 80% of the contractual license fee). Customer is entitled to return any of the licenses to which it obtains rights in the contract and can also return any licenses it obtains using a credit from the exchange of another software license (e.g. Customer could exchange its Product J license for a credit, which is used to acquire a license to Product Q and then exchange the Product Q license for a credit that could be used to acquire another license). Customer’s return/exchange rights are unlimited and include rights to use return/exchange credits for licenses to unspecified software products and the amount of the available return/exchange credits decreases commensurate with based rights to use the initially licensed Customer’s consumption of its time- software. Therefore, ABC concludes that the return/exchange rights are akin to a right to obtain future additional software licenses (see Question C320 ). Assuming those rights are distinct, ABC allocates a portion of the transaction price to those unspecified additional software license rights and recognizes that revenue over the return/exchange rights period (in this case, the full five- year license period). Because the return/exchange rights are unlimited and the additional software licenses Customer can exchange into are unspecified, ABC concludes that recognizing that revenue on a time- elapsed basis is appropriate, consistent with the generally equal benefit Customer obtains from those rights over the license period. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

173 Revenue for software and SaaS 171 C. Step 2 : Identify the performance obligations in the contract Question C90 How does a pattern of granting concessions to customers in the form of free or significantly discounted goods or services affect an entity’s identification of the promised goods or services in contracts with its customers? Interpretive response: Promised goods or services include those implied by an entity’s customary business practices, published policies or specific statements if a customer would reasonably expect to obtain additional goods or services as . Therefore, an entity’s a result of entering into the contract with the entity historical pattern of giving customers free or significantly discounted goods or services may create additional promised goods or services that an entity would need to identify in a contract with the customer . This may include an implied promise to deliver a good or service or an implied material right to obtain a good or service at a significant discount . The following are examples (not exhaustive) that may represent implied promises , if a pattern exists of granting them to customers : — providing discounted or free services or products that were not included in the terms of the original contract — allowing the customer to access or receive additional products (including additional without a commensurate increase in the transaction licenses) price — -based services, extending the time period for which a customer for time receives the service for little or no additional consideration extendi ng the geographic area in which a customer can use a software — license — permitting additional uses of licensed software (if the license included use restrictions initially) . Price concessions do not affect the determination of the promised goods or services in the contract . Price concessions expected at contract inception result 3: – Step Chapter D in the transaction price for the contract being variable (see Determine the transact ion price ). Unexpected concessions , whether price concessions or additional good or are accounted for as contract modifications – as a e.g. service concessions, when they occur – change to the price and/or scope of the contract they do not affect the tran saction price of the contract , or create implied promised goods or at contract inception. Unexpected concessions generally arise from services, situations where a pattern of granting concessions did not exist at the time of entering into the and there was no reasonable expectation of contract granting one. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

174 172 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 Example C90.1 Pattern of granting concessions -tier player ABC Corp. licenses ERP software to its customers. ABC is a second in the ERP software market; it therefore has a significant incentive to try to ensure it keeps its existing customers from moving to one of the larger software providers, and to try to develop a competitive advantage against the larger ERP software providers. ABC’s contracts do not generally include rights to new software modules that are developed; they hope to be able to charge their customers for those. However, ABC has developed a practice of providing any new modules to its largest customers or those nearing the end of their current term licenses or their current PCS term free of charge. It does this to incentivize those customers to renew their term license and/or their PCS services. Because customers in the marketplace communicate (e.g. personnel move from one customer to another), ABC’s customary business practice is known by both renewing and prospective customers. to additional software ABC concludes that its history of providing free licenses products to its customer base creates an implied promise in its software license contracts to transfer rights to use unspecified additional software products, -and- if developed. The duration of that promise depends on ABC’s when cust i.e. ABC will need to determine for what period omary business practice – time it typically provides such free items, which may differ for different classes of customer (e.g. ABC’s largest customers versus smaller customers, and term license customers versus perpetual license customers). Question C320 and Examples C320.1 and C320.2 discuss whether unspecified additional software product rights are distinct from a transferred software license. Comparison to legacy US GAAP Accounting effect of a history of granting concessions Legacy US GAAP software revenue recognition guidance described changes to an arrangement that constitute concessions, including: changes that would have affected the original amount of revenue — recognized; — changes that reduce the arrangement fee or extend payment terms; and changes — that increase deliverables or extend the customer’s rights without a commensurate increase in fees. Examples of each type of concession were provided in the legacy guidance. The examples of concessions that increased deliverables or extended the customer’s rights are consistent with the examples provided in this publication, Chapter D – . including 3: Determine the transaction price Step Under legacy US GAAP, concessions could result in all contract revenues being deferred. A pattern of granting concessions called into question the fixed or © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

175 Revenue for software and SaaS 173 : Identify the performance obligations in the contract C. Step 2 determinable nature of the fees under the arrangement, meaning none were eligible for recognition until the risk of concession had been abated. Often this ly later than when revenue would have been recognized absent was significant the entity’s pattern of granting concessions; and could be after all of the stated elements in the contract were delivered and all of the arrangement fees collected. The accounting effect of a pattern of concessions under Topic 606 is considerably different from the effect under legacy US GAAP. An entity’s historical pattern of granting concessions that reduce the — transaction price or extend payment terms affects the measurement of the transaction price under Topic 606 (creating variable consideration), rather than delaying revenue recognition altogether. This may result in a portion (but typically not all) of the contract consideration being recognized when the promised goods or services are transferred to the customer – with some portion being deferred until the uncertainty associated with the potential concession is resolved. — An entity’s historical pattern of giving customers free or significantly discounted goods e additional, implied promised or services may creat goods or services (including material rights) that an entity would need to account for in the contract. This will typically not result in deferral of all portion of the transaction price will be contract revenues but rather a deferred until either those implied goods or services are transferred to the customer or the risk of concession has abated. Accounting for unexpected concessions Under legacy US GAAP, the accounting for a concession that was not reasonably foreseeable when the arrangement was entered into occurred when the concession was granted and depended on the nature of the concession. If the substance of the concession was the right to return one product for a new product, cash or other benefit, the concession was accounted for as a -15. return right under legacy Subtopic 605 the form or substance of the concession was a modification of the However, if original arrangement to provide additional deliverables, then either of the following accounting policies were acceptable alternatives that could be elected and applied consistently by the entity: — Prospective approach: The concession was accounted for as a new arrangement or a contract renegotiation or modification. Any remaining deferred revenue from the original arrangement plus any further consideration to be received under the modified arrangement were reallocated to the deliverables under the modified arrangement. If the remaining revenue allocated to an undelivered element did not equal or exceed estimated remaining costs for the undelivered element – i.e. because some or all arrangement consideration has been recognized as a loss was recognized at the date of the revenue before the modification – concession. For purposes of applying the prospective approach, it was necessary to analyze the facts and circumstances to determine the original arrangement(s) to which the concession related for purposes of identifying the existing deferred revenue that would be considered for reallocation to greement. the elements of the modified a © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

176 Revenue for software and SaaS 174 C. Step 2 : Identify the performance obligations in the contract Alternatively, the concession was accounted for — Balance sheet approach: similar to a return. The entity increased deferred revenue to the full amount that would have been recorded at that date had the concession been part of the original contract , with a corresponding reduction in revenue for the period in which the concession was granted. Under Topic 606, an unexpected change in the scope of the contract (i.e. by adding additional goods or services) is accounted for as a contract modification. The accounting for a contract modification that increases the scope of the contract through a concession – i.e. by granting free or significantly discounted additional largely depends on whether the additional goods or services goods or services – and the remaining goods or services that were part of the existing contract are distinct from the goods or services transferred before the modification. i.e. If they are distinct, the modified contract is accounted for prospectively – there is no cumulative effect adjustment resulting from the modification. If the additional goods or services and the remaining goods or services that were part of the existing contract are not distinct from the goods or services transferred before the modification, there will typically be a cumulative effect adjustment resulting from the modification. – Chapter G Contract modifications , addresses the accounting for contract modifications in further detail. C100 Question Are promises to provide services to a reseller’s end performance obligations of the soft customers ware entity in its contract with the reseller? Interpretive response: It depends. To illustrate, a ssume a software entity licenses to its reseller or distributor transfers control of software tomer. The cus entity then pr omises other goods or services as sales incentives to end customers to encourage the sale of those products that have become part of the intermediary’s inventory. The sales incentives might comprise free technical hancements. support or unspecified updates/upgrades/en If the promise to transfer goods or services that are sales incentives is made at the time of transfer of control of the related good or service to the intermediary (i.e. the distributor or reseller), it should be identified or as a promised good service of the contract between the entity and the intermediary . This would occur when the promise to transfer those goods or services was made in the contract , or implied by an entity’s customary business practices, published policies or specific state created a reasonable expectation of ments such that it the ultimate customer that the entity will transfer a good or service. to However, if the promise was made after the transfer of control of the license see preceding the intermediary (and no implied promise was made – in the original paragraph) , the promise would not be a promised good or service , when sale between the entity and its customer (i.e. the distributor or reseller) action is not solely an agent of the entity in its trans the distributor or reseller with the end customer . © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

177 Revenue for software and SaaS 175 : Identify the performance obligations in the contract C. Step 2 Example C100.1 Technical support and unspecified upgrade rights -user customers provided to a reseller’s end Description of the contract ABC Corp. licenses its software to satellite radio providers. ABC has entered -front fee, into a licensing arrangement with Customer that, for a fixed up permits Customer to sell ABC’s software together with Customer’s satellite radio hardware systems. ABC has a customary business practice of providing telephone support, as well as unspecified updates, upgrades and enhancements (collectively, PCS) to Customer’s customers (end user) free of charge. End users and Customer reasonably expect ABC to continue this practice. Evaluation ABC evaluates whether the technical support and the right to receive unspecified updates, upgrades and enhancements are additional promised services (collectively, PCS) in its contract with Customer. ABC notes the promise to provide PCS free of charge to end users is a sales incentive that is an additional promised service in the contract. Based on ABC’s customary business practice, Customer and end users reasonably expect (at the time of transfer of control of the software license to Customer) to receive the PCS. As a result, the PCS is an additional promised service in its contract with Customer. If that PCS is a separate performance obligation (see Questions C150 -C170), ABC will defer a portion of the proceeds from the sale of the software license to the reseller. That portion will be recognized as (see Question F235). revenue as ABC satisfies the PCS performance obligation Software licenses C110 Question Are software licenses capable of being distinct in -10- 25-19(a)? accordance with paragraph 606 Interpretive response: Generally, yes. Being capable of being distinct means benefit from the that a customer can software license on its own or together with other readily available resources. Therefore, even if the economic benefits that can be derived from the software license on its own or together with readily available resources might be minor compared to the economic benefits the customer can obtain from the software license together with the other goods or services promised in the contract, the software license will generally be considered capable of being distinct. This conclusion is supported by the fact that each example of a software license in Topic 606, including those for which the conclusion is that the separately identifiable from a promised service in the not software license is [606- 10- 25- contract, concludes the software license is capable of being distinct. 10 Case C 19( a); Example 10- – paragraphs 606- 55-140D – 55- 140F; Example 11 Case A – 146 11 Case B – paragraphs 606- – 55-150] 10-55- paragraphs 606 -10- 55- 141 – 55- 145 ; Example © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

178 Revenue for software and SaaS 176 : Identify the performance obligations in the contract C. Step 2 However, a software license may not always be capable of being distinct and how this determination is reached may vary depending on the nature of the ’s conclu A software entity are being licensed. sion and/or basis for softw evaluation in this regard may differ depending on whether the software is off - the-shelf software or core software. Off- the -shelf software is often defined as software marketed as a stock item that customers can use with little or no c ustomization. Off-the-shelf software can be added to a contract with insignificant changes in the underlying code and it could be used by the customer for the customer’s purposes upon installation. Customers generally can benefit from off -the-shelf software on its own or together with implementation or other services that are readily available from rofessional service providers. If the software vendor or other third- party p significant services, such as to significantly modify or customize the software code, were necessary for the software to provide even a baseline economic benefit to the customer, this would call into question whether the software was really off -the-shelf software, as opposed to core software. is generally defined as an inventory of software that vendors Core software use in creating other software. Core software is not delivered ‘as is’ because customers cannot use it unless it is customized to meet system objectives or customer specifications . A software product that is never licensed without significant additional coding services is a strong indicator that the product may be core software. Core software does not, in most circumstances, provide the customer with benefit on its own; it can only provide benefit to the customer if readily available resources, such as available services, exist that would allow the customer to benefit from use of the software. Readily available resources could consist of services ’s own customization if it sells such services separately (1) the entity in contracts separate from the licensing of its software) or (2) the (i.e. . customization services of a third party Given that , in many cases, significant customization or modification of an ( the second scena , rio) entity’s software cannot be performed by a third party there are likely to be many instances where there is no third party that can customize the entity ’s core software to enable it to function. In such the first sells such services separately ( entity circumstances, unless the ), core software may not provide benefit to the customer independent scenario of other goods and services with which it is bundled. T will not be herefore, it . capable of being distinct © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

179 Revenue for software and SaaS 177 : Identify the performance obligations in the contract C. Step 2 C120 Question If an arrangement includes multiple software licenses (e.g. licenses to multiple software applications or modules), which may or may not be transferred to the customer at different points in time, how should an entity evaluate if those licenses are separate performance obligations? Interpretive response: Two or more software licenses will typically be distinct additive ’ to each other . They will typically not be if the licenses are merely ‘ distinct when the different licenses have a ‘ ’ or significantly transformative ’ effect on each other ‘magnifying . Put a nother way , if an entity licenses software products A and B to a customer, the distinct analysis would generally hinge on whether : the combination of A + B equals AB (i.e. — the combined functionality of the two applications is merely the sum of the two licenses’ individual functionalities ). I n that case , the two licenses would generally be distinct from each other; or i.e. s X ( of A + B equal the combination — the combination of the two in elements results in incremental or changed functionalities that don’t exist x (i.e. the combination of the either software application separately) or AB level licenses produces a significantly enhanced of functionality that is greater than the aggregate of the two elements’ individual functionalities ). re Either of these scenarios would generally suggest that the two licenses a not distinct from each other. This notion also affects the distinct analysis for other software- related elements, such as in determining whether software and SaaS elements are distinct from each other (see Question C310) and whether a software license and certain implementation/configuration services are distinct from each other (see Question C260). We believe that the analysis above is consistent with the underlying principle the FASB in the Basis for C onclusions to for the distinct evaluation described by 10. ASU 2016- 2016-10 m ASU Excerpt fro The Board intends to convey that an entity should evaluate whether the BC29. contract is to deliver (a) multiple goods or services or (b) a combined item or items that is comprised of the individual goods or services promised in the contract. That is, entities should evaluate whether the multiple promised goods or services in the contract are outputs or, instead, are inputs to a combined item (or items). The inputs to a combined item (or items) concept might be further explained, in many cases, as those in which an entity’s promise to transfer the promised goods or services results in a combined item (or items) that is greater than (or substantively different from) the sum of those promised (component) goods and services. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

180 Revenue for software and SaaS 178 C. Step 2 : Identify the performance obligations in the contract ple is intended to consider the level of BC32 . ... The separately identifiable princi integration, interrelation, or interdependence among promises to transfer goods or services. That is, the separately identifiable principle is intended to evaluate when an entity’s performance in transferring a bundle of goods or services in a contract is, in substance, fulfilling a single promise to a customer. Therefore, the entity should evaluate whether two or more promised goods or services (for example, a delivered item and an undelivered item) each ly affect the other (and, therefore, are highly interdependent or highly significant The entity should not merely evaluate whether one interrelated) in the contract. item, by its nature, depends on the other (for example, an undelivered item that would never be obtained by a customer absent the presence of the delivered item in the contract or the customer having obtained that item in a different contract)... Professional services are discussed starting at Question C220. H owever, we believe that professional services provided to effect a software system (or solution) by implementing/integrating multiple software applications that are not distinct from each other (e.g. as described in the preceding paragraphs) would typically provide a ‘signi ficant integration service’ . An example is the installation and interfacing of multiple, non- distinct software applications that comprise the system/solution. T he professional services would be an additional input, distinct software licenses, to the combined together with the multiple, non- which the customer contracted, system/solution output for and therefore such professional services . would not be distinct from the software licenses Post -contract customer support (PCS) C130 Question Is the nature of an entity’s promise to provide technical support or unspecified (when -and -if available) updates, upgrades and enhancements a stand -ready obligation? Technical support Technical support will typically be a stand -ready Interpretive response: obligation. This is because software entities that provide technical support usually maintain an infrastructure – e.g. dedicated customer support personnel, a call center and/or a website for online support assistance – that ‘ stands ready ’ to provide support to customers when -and-as needed. In addition, customers generally have the right and ability to obtain such support when- and-as needed throughout the support period and are not limited to a defined number of support calls or requests (subject to possible restrictions on times of day or days of the week that support is available) . However, if the technical support obligation is to provide a specified number of support events (or up to a specified number of support events that is s of any realistic expectation of the i.e. it is not in exces substantive - use of those services), then the technical support obligation is not customer’s -ready obligation. a stand © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

181 Revenue for software and SaaS 179 C. Step 2 : Identify the performance obligations in the contract Promise to provide unspecified updates, upgrades and enhancements A promise to provide u nspecified updates, upgrades Interpretive response: ready obligation and enhancements will also be a stand- when the nature of the of updates, upgrades or entity’s promise is to transfe r an undefined number enhancements (i.e. any and all) that are developed during the support per In iod. that case, the customer benefits throughout the support period from the assurance that any updates or upgrades developed by the entity during the period will be made available. In contrast, if an entity’s promise to the customer or its customary business practice is to provide a defined number of updates, upgrades or enhancements (e.g. a single release each year with all of the accumulated updates, upgrades and enhancements developed since the previous year’s release) that would typically suggest the nature of the entity ’s promise is to transfer that defined number of releases . It is not a stand -ready obligation to transfer any and all updates, upgrades and enhancements (of an undefined type and quantity) during the support period. If the nature of the entity’s promise to provide unspecified updates, upgrades and enhancements is that of standing ready to transfer to the customer such the customer is when-and -if they become available, benefitting items generally evenly throughout the obligation period from the assurance tha t any such items . Therefore, developed by the entity during the period will be made available to it a time -based measure of progress will typically be appropriate. However, a measure of progress other tha n time -based may be appropriate in some circumstances even when the entity’s promise to provide unspecified ready obligation. At the updates, upgrades and enhancements is a stand- January 2015 meeting of the TRG , members generally agreed with members of the FASB staff that a straight- line, time -based measure of progress should not always be applied to a stand- ready obligation. For example: If it is expected (based on an explicit promise to the customer or the — entity’s customary business practice) that releases will always or predominantly occur at a specific time (or in a specified period – e.g. the easure, reflective of the uneven -based m fourth quarter) each year, an input efforts that the entity will undertake to transfer the releases to the customer each year of the obligation period , may be appropriate. — It may be expected at contract inception that there will be a significant upgrade or enhancement) upgrade or enhancement (that is not a specified transferred to the customer at a specific point in time during the support expects to release principally bug fixes and other period (e.g. the entity minor updates throughout the support period, but also expects to release a significant enhancement or version upgrade 12 months after contract inception that will substantially enhance the licensed software). In that unspecified updates , case, the benefit the customer will receive from the upgrades, s provision may not be even throughout the and enhancement a different measure of progress (i.e. other than obligation period. Therefore, appropriate. one that is time-based) may be © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

182 Revenue for software and SaaS 180 : Identify the performance obligations in the contract C. Step 2 Question C140 If an obligation to provide technical support one to services or provide unspecified update/ upgrade/enhancement rights is a stand -ready obligation, is the obligation a ‘series’ of distinct service periods? Interpretive response: In general, if the obligation, either to provide technical support or to provide unspecified updates, upgrades and enhancements, is a For stand -ready obligation (see Question C130) , it will qualify as a series. example, a two- year technical support or unspecified be a series of distinct updates/upgrades/enhancements obligation would mont hly, weekly or daily support periods. must be multiple time For a service obligation to be a series, there generally periods within the overall obligation period that: are d istinct from each other; a. b. are substantially the same; c. are satisfi ed over time (based on the over -time recognition criteria in paragraph 606- 10-25 -27); and have d. e.g. the entity would the same pattern of transfer to the customer – measure progress towar d complete satisfaction of each distinct service measure of progress . period obligation using the same criteria in turn for a multi -year technical support or Taking each of the above unspecified update/upgrade/enhancement rights obligation: a. Distinct. E ach service period (e.g. each month, or even each day) within the larger obligation period that the entity stands ready provides benefit to the customer on its own – i.e. each service period is capable of being . In addition, the entity’s promises to provide support services or distinct transfer any updates, upgrades or enhancements released in on e service is separately identifiable from those service periods preceding and period following it of service is essential to, dependent on, or – i.e. no one period significantly modifies or customizes another period of service. b. Substantially the same. E ven though the mix and quantity of activities that the entity will perform each distinct period (e.g. number of support inquiries fielded or number and type of updates, upgrades and/or h enhancements released) may differ, the nature of the entity’s promise eac period is substant ially the same . This conclusion and underlying rationale is consistent with examples of transaction processors and electricity suppliers discussed by the TRG one for a hotel at its July 2015 meeting, as well as manager in Topic 606 (Example 12A) . In each of those examples, the quantity and mix of activities differ s from one distinct service period to another but, because the nature of the entity’s promise was the same integrated or stand- ready service each period, each service period was deemed to be ‘substantially the same’. Satisfied over time. c. Because the nature of the entity’s promise is a stand- rather than to provide specified goods or perform specified ready obligation, activities, the customer consumes and receives benefit from the technical support services and the unspecified update/upgrade/enhancement rights © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

183 Revenue for software and SaaS 181 C. Step 2 : Identify the performance obligations in the contract throughout the overall obligation period . Therefore, the entity’s promise to perform each service period is satisfied over time. d. Same pattern of transfer. Regardless of the measure of progress selected for the stand- ready obligation (see Q uestion C130), we would expect the same measure of progress to be applied to each distinct service period. C150 Question Are the component services of PCS separate performance obligat ions? Post -contract customer support (PCS) PCS includes the right to receive services (typically telephone support and maintenance) or unspecified upgrades and enhancements, or both, offered to users or resellers, after the software license period begins, or after another point in time as provided for by the PCS agreement. PCS does not include (i) installation or other services directly related to the initial license of the software, (ii) specified upgrade rights even if a customer would otherwise b e entitled to the upgrade right as a subscriber to PCS, or (iii) rights to additional specified or unspecified software products. PCS often involves, at a minimum, some form of Interpretive response: technical support and a promise to provide the customer with updates/upgrades or other enhancements on a when- and -if available basis. This is illustrated in the implementation guidance to Topic . 606 (Example 11) Technical support services and a promise to provide unspecified updates, be distinct from each other because: generally upgrades and enhancements will receive benefit from — each service is capable of being distinct . C ustomers each service together with the associated software license to which the service relates ; and the software license is transferred b efore either providing technical support or unspecified updates, upgrades or enhancements ; and — the two promises to provide those services are separately identifiable: — the two services are not inputs to a combined output for which the des any significant integration service; software vendor provi — the provision (or not) of each service does not significantly modify or and customize the other; — a software entity could typically provide either service irrespective of whether it provided the other, which m eans the two services are not highly interrelated or interdependent. Even though technical support services and unspecified update, upgrade and enhancement rights will typically be distinct, we expect that many software entities will account for PCS as a single performance obligation. This is because they will conclude that the technical support and the right to unspecified updates, upgrades and enhancements are both stand -ready obligations being provided over the same period of time and have the same pattern of transfer to the customer (e.g. the entity would apply a time- based measure of progress to © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

184 Revenue for software and SaaS 182 C. Step 2 : Identify the performance obligations in the contract . Topic 606 permits entities to account for two each ) – s ee Q uestion C130 distinct goods or services as a single performance obligation if they are concurrently delivered (i.e. in this case, if the technical support services and the and have the unspecified update/upgrade/enhancement rights are co- terminus) 09, BC116] 2014- [ASU same pattern of transfer to the customer. Comparison to legacy US GAAP Legacy Subtopic 985- 605 defined PCS as a single software- related element. Consequently, entities did not consider separating the components of PCS, even when the customer paid for ‘platinum’ PCS – e.g. 24/7 technical support and rights to receive certain significant upgrades or enhancements that were not included as part of the entity’s ‘standard’ PCS. In addition, because the component services of PCS are rarely, if ever, sold separately from each other by software entities, they generally would not have been separable under legacy US GAAP. This is because entities would have -specific objective evidence of fair value (VSOE) been unable to establish vendor for those components. The requirement under Topic 606 to separate the technical support component of PCS from the right to unspecified updates, upgrades and enhancements in some cases (as outlined in this question) will be a significant change for those entities that need to do so. C160 Question technical support services distinct from the Are software license to which they relate? Interpretive response: In general, yes . T echnical support services and the will be distinct software license to which those technical support services relate from each other . While the software license will generally be capable of being distinct for the reasons outlined in Q uestion C110 , the technical support services will be (a). capable of being distinct in accordance with paragraph 606- 10-25 -19 This is because the customer will benefit from those services together with the software license transferred to the customer before providing the technical support services. entity’s promises to transfer the software license and to provide technic al The support services will typically be separately identifiable in accordance with inputs to a combined item paragraph 606- 10-25 -19(b) – i.e. not . This is because: — neither the license, nor the support services, customize or modify the other – e.g. technical support services do not change or enhance the functionality of the software; and — the software entity is able to transfer the license and provide the support the entity is able to services independent . For example, ly of each other license without ever providing support services to the transfer the software © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

185 Revenue for software and SaaS 183 C. Step 2 : Identify the performance obligations in the contract that customer , and is also able to provide support services to a customer acquired its license to the software product from a third party, such as a reseller . Consequently, it will generally be clear that there is neither a significant integration service being performed by the software entity to create a combined item comprised of the licensed software and the support services, nor any license and significant level of interrelationship or interdependence between the the support services . Question C170 How should a software vendor evaluate whether a software license is distinct from a promise to provide unspecified updates, upgrades and enhancements? Interpretive response: If a software license is capable of being distinct ( see Question C110), a promise to provide unspecified updates, upgrades and enhancements to that software license will also be capable of being distinct . will benefit from that promise together with the This is because the customer software license transferred to customer before it could ever receive updates, upgrades or enhancements to the software. contracts, the promise to transfer the software license and a promise to In most prov ide unspecified updates, upgrades or enhancements related to that software based on the . This is product will be separately identifiable from each other following reasons 606 -10- 25-19(b)) . (in accordance with paragraph — Similar to the disc ussion in Q uestion C160 related to technical support services, the software entity is able to transfer the license and provide future updates, upgrades and enhancements independent of each other. The entity can, and in general must, transfer the initial software license bef ore it can provide updates, upgrades or enhancements to the software. In addition, as with technical support services, the entity is able to transfer promising to provide future unspecified a license to the software without updates, upgrades or enhancements and is able to provide such items to a customer that acquired its license to the software product from a third . Consequently, the license and unspecified party, such as reseller update/upgrade/enhancement rights are not highly interrelated or interdependent. — The promise to later (i.e. subsequent to transfer of the initial software license) transfer any updates, upgrades or enhancements produced means that the entity is not providing a significant integration service to transfer a hat uses the initial license and later updates, single, combined output t upgrades or enhancements as inputs. — The updates, upgrades and enhancements will modify the software to in general, many updates or which the customer has rights . However, upgrades that will be received during the course of a support period will not significantly modify the software – i.e. the update, upgrade or enhancement may be minor an update, upgrade or enhancement provided nd frequently . A © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

186 Revenue for software and SaaS 184 C. Step 2 : Identify the performance obligations in the contract to the customer will not modify the customer’s instance of the software because the customer is not required to, and will not, install it. However, in limited circumstances, Topic 606 illustrates that a software license may not be distinct from a promise to provide unspecified updates, upgrades or enhancements . This is because there is, effectively, a reasonable certainty that to the integral that are customer’s ability to continue to updates will be provided derive substantive benefit from the software license (i.e. its utility to the – 140D [Ex 10 Case C – paragraphs 606 -10- 55- throughout the license period. customer) 140F, ASU 2016- 55- 10.BC33(b)] Example 10 Case C in Topic 606 further illustrates, as part of the basis for the conclusion reached, that the updates are expected to significantly modify the functionality of the software by enabling the software to protect the customer from a significant number of additional viruses. The typical anti -virus scenario differs from the discussion in the third bullet above because customers almost updates and upgrades received; this is because the anti -virus universally install ion to the fundamental purpose of the arrangement is to provide ongoing protect customer from existing and emerging threats . especially We provide expect the conclusion that a software license and a promise to unspecified updates, upgrades and enhancements are not distinct from each other to be supported by both: — evidence that the utility of the software will degrade significantly during the license period (and not predominantly at or near the end of that period only) if updates, upgrades or enhancements are not provided; and — evidence that the updates are, in fact, integral to the customer continuing to obtain substantive utility from the software license. This might be evidenced, for example, by information supporting that the vast majority of updates, upgrades or customers regularly and timely download do not If customers do so, that would call into enhancements released. question whether those updates are truly integral to maintaining the utility of the softwa re, and therefore whether the license and the updates are inputs to a combined item or solution. Example C170.1 Software license and PCS ABC Corp. enters into a contract with Customer to provide a three- year license to Customer for its off- the- shelf software and also to provide both technical support services and any updates, upgrades and enhancements developed during the three- year term. ABC never sells its software licenses, its technical support services, or its unspecified update, upgrade or enhancement rights separately. The software functions to its specifications without the support services or the updates, upgrades or enhancements. In addition, the following facts are relevant: — The utility of the software (i.e. its ability to provide benefit or value to the customer) is not expected to degrade significantly over the three- year term © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

187 Revenue for software and SaaS 185 : Identify the performance obligations in the contract C. Step 2 if no updates, upgrades or enhancements are delivered to the customer (or the customer chose not to install them). — ABC maintains a substantive infrastructure to provide support to customers -and-as needed. when ABC has historically provided releases ranging from minor bug fixes, minor — and major version upgrades (i.e. ‘right of the dot’ and ‘left of the dot’ upgrades), and functionality enhancements to its customers, but the type, timing and quantity of such releases has not been consistent or predictable in the past. This means that the type, timing and quantity of updates, upgrades and enhancements that will be provided is unpredictable at contract inception. ABC first identifies that there are three promised goods and services in the contract: the software license, technical support services, and the promise to provide unspecified updates, upgrades and enhancements. Next, ABC concludes that it will account for the technical support services and the promise to provide unspecified updates, upgrades and enhancements as a single performance obligation; this is because they will be provided over the same period (three years) and have the same pattern of transfer to the customer. ABC concludes that both the technical support services and the ready obligations based on: unspecified upgrade rights are stand- — the technical support infrastructure that ABC maintains; and the indeterminate type, quantity and timing of support services and — updates, upgrades or enhancements that ABC will provide over the three - year term. These factors also support that a time- based attribution method for both of those promised services would be reasonable. Lastly, ABC concludes that the software license and the PCS (the combined technical support and unspecified update, upgrade and enhancement rights) are distinct from each other based on the following: — The software license and the PCS are capable of being distinct. Because the software functions to its specifications without the PCS, Customer can benefit from the software license on its own without the PCS and can benefit from the PCS together with the software license transferred before the performance of the PCS. — The entity’s promise to transfer the software license and to provide PCS are separately identifiable. ABC would be able to transfer the software license and the two components of the PCS independently. This supports that the license and the PCS are not highly interrelated or interdependent, and that the entity is not providing a significant integration service in the contract to produce a combined output (using the license and the PCS as inputs). Furthermore, neither the technical support nor the unspecified updates, upgrades or enhancements is expected to significantly modify or customize the licensed software. Finally, the utility of the software to Customer will not significantly degrade during the license period if updates, upgrades or enhancements are not provided; therefore, this example is not analogous to the anti- virus example in Topic 606. Consequently, ABC concludes that there are two performance obligations in this contract: the software license and PCS. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

188 Revenue for software and SaaS 186 : Identify the performance obligations in the contract C. Step 2 Under legacy US GAAP, because ABC never sells the undelivered PCS on a stand -alone basis, it would not have been able to establish VSOE for the PCS services; therefore, ABC would not have separated the license element from the PCS services. Example C320.2 demonstrates a scenario where a promise to provide unspecified updates, upgrades and enhancements (as well as a promise to distinct provide the right to use unspecified future software products) is not from an initial software license. Example C170.2 Software license and updates ABC Corp. enters into a contract with Customer to provide a three- year term license to Customer for its trad e compliance (TC) software and to provide updates to critical trade data (i.e. content) that the software uses to assist Customer in complying with trade regulations. The trade data include s restricted party lists, import/export regulations (including dut ies, taxes and fees), freight rates , Free Trade Agreement rules and tra nsportation schedules/tariffs. The content updates deliver the latest version anti -virus for trade data (similar to the manner in which of the contracted- software provides updated virus definition files) . Content updates are provided on a when- -if available basis throughout the and three- year term, and the right to content updates is co- termin us with the license term. TC licenses are never sold without the c ontent updates. Additionally: 1. There are typically multiple content updates provided to a customer each day during the license term. 2. Content updates are automatically ‘pushed’ to customers and universally available. implemented by customers as soon as they are made 3. , and to comply with US trade law Customers rely on the content updates the laws and regulations in many other countries. Failure to receive timely information about changes to relevant trade data could result in the customer failing to comply with trade laws and regulations, with potentially significant ramifications. For example, failure to comply with trade laws and regulations could subject the customer to penalties or fines, possible ‘cease and desist’ orders from Customs authorities and other legal issues. There also could be shipment/delivery delays or reputational damage resulting from trade compliance issues that result in lost or reduced business . Although ABC concludes that the software license and the content updates are distinct from each other (i.e. they are not capable of being distinct, they are not formance distinct in the context of the contract) and, therefore, are a single per 3) obligation to Customer. This is because, based on the key facts (Nos. 1- that the utility of the software to Customer outlined above, ABC determines (i.e. the benefit Customer will obtain from its right to use the software) will significantly degrade during the license period if ABC does not provide content updates. The content updates are integral to the customer obtaining its intended benefit from the TC software license. This is because Customer’s use © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

189 Revenue for software and SaaS 187 C. Step 2 : Identify the performance obligations in the contract of the TC software is intended to protect Customer from costly trade noncompliance issues, and without frequent and timely updates, the TC perform that function adequately for more than a minor software will not year license term. portion of the three- Consequently, ABC concludes that its promises to grant the TC license and to provide unspecified content updates are not separately identifiable; the TC license and the content updates are, in effect, inputs to the combined item (a trade compliance solution) that Customer entered into the contract with ABC to obtain. Question C175 If a software license and update rights are not is the effect of a distinct from each other, what renewal option for the update rights if the license and those initial rights are not co -terminus? Interpretive response: Question C170 addresses when a software license and a right to unspecified updates, upgrades and enhancements (‘update rights’) are not distinct from each other, and therefore, are a single performance obligation. when the software license is perpetual or for It may be the case that this occurs a term longer than the initial bundled update rights, and the contract grants the customer the option to renew the update rights. In those cases, unless the renewal option is priced commensurate with the price for the initial bundled offering, the renewal option generally provides the customer with a material right. Inherent in the conclusion that the license and the update rights are not distinct from each other is the premise that those update rights are integral to maintaining the utility of the software license and fulfilling the promise to the customer (e.g. of computer virus protection) . Consequently, a renewal price for the update rights that is not substantially commensurate with the initial bundled offering price, reflective of the significant value one would ascribe to the would generally not be considered to reflect the stand- integral update rights, rights. alone selling price for the renewed update A software entity that concludes that the renewal option(s) is (are) a material right(s) would allocate the transaction price of the contract for the initial bundled license/update rights to the performance obligations that were identified, i.e. (1) the license and initial the combined performance obligation comprised of update rights and (2) the material right(s). This would generally result in the software entity recognizing a significant portion of the transaction price of the initial contract (i.e. the portion allocated to the material right(s)) over future renewal periods of the update rights. In contrast, if the renewal fee is substantially consistent with the initial, bundled material right price of the license and the update rights, it may be that no s exist exercising the renewal option would be and, consistent with Question G40, accounted for as a separate contract from the initial contract for the bundled license/update rights. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

190 Revenue for software and SaaS 188 : Identify the performance obligations in the contract C. Step 2 Question C180 Are the considerations with respect to determining the performance obligations for promises of te chnical support and unspecified updates, upgrades and enhancements different in a SaaS arrangement and a software licensing arrangement? , respectively, address C170 Interpretive response: Questions C160 and ed whether technical support services and unspecifi update/upgrade/enhancement rights and the related software license(s) are distinct from each other. In general, there is no difference in the answer s to these questions in the context of a SaaS arrangement . However, to some extent the ‘ distinct ’ analysis differs depending on whether the customer is accessing a dedicated instance of the SaaS provider’s software (a ‘single -tenant’ architecture) or a shared -tenant’ ). instance of the software (a ‘multi architecture -tenant architecture -tenant architecture versus multi Single A multi- tenant architecture is one in which a single instance of a hosted software application serves multiple customers. Each customer is called a tenant. Tenants may be given the ability to customize some parts of the applicatio n, such as color of the user interface (UI) or business rules, but they cannot customize the application's code. -tenant architecture is one in which only a single In contrast, a single customer (or tenant) uses an instance of a hosted software application. Multi -t enant environment If the customer is accessing a multi -tenant SaaS environment, the customer is always accessing only the most current version and features of the software. The SaaS provider’s updates, upgrades or enhancements of the hosted implementing those softwa re do not fulfill a promise to a customer . Therefore, -tenant instance of the software is not a promised service items into the multi to any tenant environment . This conclusion is individual customer in the multi- further supported by the fact that the SaaS provider is generally continuing to update its multi -tenant environment for purposes of attracting prospective customers and encouraging existing customer s to extend or renew their arrangements . With respect to technical support obligations, we believe the considerations as to whether the SaaS and the technical support services are distinct would generally be consistent with the discussion in Q uestion C160 . However , because SaaS is provided over t , like the technical support services, rather ime than at a point in time like a software license, an entity may conclude that the SaaS and the technical support services can be accounted for as a single performance obligation if they are coterminous and have the same pattern of transfer to the customer . © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

191 Revenue for software and SaaS 189 C. Step 2 : Identify the performance obligations in the contract It may frequently be concluded that both the SaaS and the technical support services are stand -ready obligations that have the same pattern of transfer to the – i.e. on a ratable basis. This conclusion is reached for the SaaS on the customer basis that the customer typically has equal access to the SaaS throughout the C130. SaaS period, and for the technical support as described in Question -t enant Single environment The considerations in a single- tenant environment will differ from a multi -tenant environment with respect to unspecified updates, upgrades and enhancements . This is because a promise to provide such items is fulfilled by specifically to the customer’s single-tenant instance of the application. uploading them not Because it is a single -tenant environment, the entity would be able to provide those items to the specific customer, unlike in a multi -tenant environment. upgrades updates, ied T heref ore, the promise to provide unspecif to the be considered a promised service and enhancements would generally single-tenant customer. However, we believe the considerations about whether (1) the SaaS is distinct from the technical support and unspecified update, upgrade and enhancement rights; (2) whether the technical support is distinct from the unspecified update, upgrade and enhancement rights; and (3) whether any (or all) of those items can be combined because they are concurrently delivered and have the same n of transfer to the customer are consistent with the considerations patter -tenant environment outlined in Questions C150 – C170 and in the multi discussion above. Question C190 Can a promise to provide technical support services or to provide unspecified updates, upgrades and enhancements be implied? Interpretive response: Topic 606 states that a promise to provide a good or n implied ’s customary business practices. A service may be implied by an entity obligation to provide technical support or unspecified updates, upgrades and enhancements exist has a historical pattern of s in a contract if the entity regularly providing all customers or certain customers with technical support or unspecified updates, upgrades or enhancements (or anticipates doing so) even though there is no written c ontractual obligation. One common scenario arises when the stipulated term of the explicit technical support and/or unspecified update/upgrade/enhancement period begins six months after transfer of control of the software license – e.g. the stipulated term may not begin until installation of the software is complete or until a general warranty period has expired. However, the entity has a history of regularly making availab le to all customers technical support or unspecified In that updates/upgrades/enhancements as soon as the license is transferred. scenario, there would be an implied (by the entity ’s c ustomary business the start for the six months before practice) promise to provide those services of the explicit service period. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

192 Revenue for software and SaaS 190 : Identify the performance obligations in the contract C. Step 2 Comparison to legacy US GAAP The determination of when an implied PCS obligation exists, and how to account for that implied obligation, is generally consistent between Topic 606 and legacy US GAAP. However, the different separation models under 985 -605 (e.g. the VSOE requirement) and Topic 606 means that the Subtopic determination of whether the implied PCS obligation can be separated from other performance obligations in the contract (e.g. the software license) may differ between Topic 606 and legacy US GAAP. With respect to the common scenario outlined above, the determination that an implied PCS obligation would exist under Topic 606 for the six -month period subsequent to software delivery, but before the commencement of the explicit 55- – 55- 55] 605- [985- 53 GAAP. PCS term, is consistent with legacy US Question C200 If technical support services or unspecified update, upgrade and enhancement rights are mandatory, does that affect the conclusion about whether the software license and those services are distinct? Mandatory PCS Some software arrangements contain provisions that require the customer to renew PCS annually in order to maintain active use of a perpetual or a term license – i.e. the customer loses the right to use the software if it does not obtain or renew those services. In such arrangements, the customer is not only deciding whether to renew PCS each year, it is also deciding whether to renew the license. The renewal payments after the initial PCS period in a mandatory PCS scenario apply to both the continued use of the license and the PCS renewal. Additionally, the fee for the initial period may be disproportionate to the fee for the renewal periods, even though the deliverables in each period are the – e.g. in each period, the deliverables consist of a one- year software same license bundled with one year of PCS. For example, the fee for the license/PCS bundle in the first year may be $1,000,000, and the renewal fee for the license/PCS bundle in each subsequent year may be $150,000. In this fact pattern, the $850,000 delta between the $1,000,000 up -front fee for the license/PCS bundle and the renewal fee for the license/PCS bundle in each subsequent year of -front payment that relates to $150,000 could be deemed an incremental up the license/PCS bundle in the subsequent years. 606 makes Example 11 Case D in Topic it clear that the Interpretive response: distinct evaluation for promised goods or services is based on an evaluation of the characteristics of the goods or services themselves, and a contractual requirement to obtain one or more of the goods or services (or to obtain one or © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

193 Revenue for software and SaaS 191 : Identify the performance obligations in the contract C. Step 2 from the entity ) does not affect that evaluation. more of the goods or services Consequently, the distinct evaluation for a contract that includes mandatory technical support services or mandatory unspecified update, upgrade and enhancement rights is no different from the distinct evaluation undertaken for a contract for which those promised services are not mandatory (see 150F] – 55- 150E 55- 10- [606- ). C170 C160 Questions and even though the mandatory nature of those However, s may not change service the di stinct analysis, it may affect the identification of the promised goods or services in the contract , and that analysis may differ depending on whether the software license is perpetual or term -based. Term licenses Consider a five -year term license that in cludes promised technical support services and unspecified update, upgrade and enhancement rights (collectively, PCS). If renewal of the PCS is mandatory throughout the license period (e.g. after an initial one- year term), that may change the parties’ enforceable rights and obligations compared to the same arrangement for which renewal of those services is not mandatory. Depending on the facts and circumstances, the mandatory provision likely means that the contract includes only an initial one-year softwar by both to renew options e license and one year of PCS, with paying the stated mandatory PCS renewal fee. If the customer pays a signifi cant up-front fee for the term license, such that the fees the customer will pay for the subsequent years’ one- year license and PCS renewals are substantively lower than the fees paid for the license and the PCS in Year 1, payment of that up- front fee will provide the customer with a material right with respect to renewal of the in- substance one-year term license and PCS. Example C200.1 illustrates this scenario. Perpetual licenses Consider the same scenario described in the preceding paragraphs except that the five- yea r license is, instead, a perpetual license. Consistent with the above that the contract means scenario, the mandatory PCS provision (1) likely includes only an initial one -year software license and one year of PCS, with a n ee to renew both by paying the stated mandatory PCS renewal f option and (2) fee likely provides the customer with a payment of a significant up- front material right as to renewal of the one- year term license and PCS. will t fee a portion (potentially significant) of the up -fron However, in addition, also relate to a material right to acquire a perpetual license once the mandatory PCS provision is satisfied. Example C200.2 illustrates this in a perpetual software license context. It is possible in a perpetual license scenario that the mandatory PCS period lasts for all (or substantially all) of the economic life of the licensed software. For example, the software subject to a perpetual license has an economic life of 7 years and the customer is required to maintain PCS in order to retain its right to use the software for 7 years. In such cases, we do not believe any additional is granted in the contract. Therefore, the accounting perpetual license right would follow that described for term licenses. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

194 Revenue for software and SaaS 192 C. Step 2 : Identify the performance obligations in the contract Licen se fee paid over time versus up -front We do not believe the accounting for term or perpetual license mandatory PCS arrangements is affected by whether a legally enforceable license fee is paid that is time. That is, the timing of payment for a license fee or over up-front legally enforceable does not affect this analysis. However, in contrast, if the remainder of the license fee still owed by the customer subsequent to cancelling PCS and losing the right to use the software is not legally enforceable, that would change the character of the overall contract. C200. Example 3 illustrates a license fee paid over -time scenario. C200.1 Example Software license and mandatory PCS (term license) ABC Corp. enters into a contract with Customer to provide a five -year license to Product G and also to provide both technical support services and any updates, upgrades and enhancements developed (collectively, PCS) for one year. If PCS each year of the five -year term it loses the right Customer does not renew i.e. there is a mandatory PCS provision in the contract. to use the software – ABC has determined that: it can account for its PCS as a single performance obligation (see — C150); and Question — the PC S, even though mandatory, is distinct from the Product G license. -front fee of $1,200,000 for the license and the first year of Customer pays an up the mandatory PCS. The contract states that Customer must pay a fee of $200,000 each year to renew the man datory PCS. ABC concludes that the mandatory PCS provision means that the enforceable rights and obligations of the parties under the contract are for only a one- year term license to Product G and one year of PCS. Absent Customer deciding to renew stomer only has a right to a one- PCS, Cu PCS. year license and to one year of -front fee ($1.2 million) is substantially larger than However, the significant up the fee Customer would pay during the potential renewal periods ($200,000 per year in Years 2 -5). Theref ore, ABC concludes that the initial contract for Year 1 includes a material right with respect to Customer’s options to renew the one- year license and PCS in Years 2 -5. 5 options provide Customer with a material ABC concludes that the Years 2- right with respect to renewal of the license/PCS for Years 2- 5. ABC reaches this 5 conclusion based on the fact that allocating the up- front fee to each of Years 1- 45, which permits ABC to 55- using the practical alternative in paragraph 606- 10- price to the optional goods or services by reference to allocate the transaction the goods or services expected to be provided and the corresponding expected consideration ($2 million in total [$1.2 million in Year 1 + $200,000 per year for -5]), would result in an equal allocation of $400,000 to each of those Years 2 years. Note that this analysis assumes that based on relevant experience with similar customers, no breakage is expected (i.e. Customer is expected to exercise all four renewal options). 5 for the ABC will therefore recognize $400,000 each year during Years 1- license and the PCS, with the portion allocable to the license each year © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

195 Revenue for software and SaaS 193 C. Step 2 : Identify the performance obligations in the contract recognized at the beginning of the renewal period (see Question F100) and the portion allocable to the PCS each year recognized over the one- year PCS period. As a consequence, a material right contract liability of $800,000 would be established at contract inception. If Customer were to decide not to renew the contract for any of those optional years, the remaining amount of the contract liability for the material right (which would be $800,000 at the end of Year 1; $600,000 at the end of Year 2; $400,000 at the end of Year 3; and $200,000 at the end of Year 4) would be recognized as revenue at that point in time. Example C200.2 Software license and mandatory PCS (perpetual license) ABC Corp. enters into a contract with Customer to provide a perpetual license for Product H and also to provide both technical support services and any updates, upgrades and enhancements developed (collectivel y, PCS) for one year. If Customer does not renew PCS each year it loses the right to use the software – i.e. there is a mandatory PCS provision in the contract. ABC has determined that: — it can account for its PCS as a single performance obligation (see ); and Question C150 the PCS, even though mandatory, is distinct from the Product H license. — In addition, the following facts are relevant: — the stand-alone selling price for a perpetual license to Product H is $2,000,000 — the stand-alone selling price for one year of ABC’s PCS on a perpetual license at contract inception is $400,000 — the stand-alone selling price for a one -year license to Product H and co- terminus PCS on a one- year license (which are never sold separately from each other) is $600,000. the economic life of Product H is eight years. — Customer pays an up -front fee of $2,400,000 for the license and the first year of the mandatory PCS. The contract states that Customer must pay a fee of $400,000 each year to renew the mandatory PCS. After five years, Customer may choose not to renew the PCS, but retains its right to use Product H. ABC concludes that the mandatory PCS provision means that the enforceable rights and obligations of the parties under the contract are for only a one- year term license to Product H and one year of PCS. Absent Customer deciding to renew PCS, Customer only has a right to a one- year license and to one year of PCS. front fee ($2.4 million) is substantially larger than the fee However, the up- Customer would pay during the potential renewal periods ($400,000 per year in -5). Therefore, ABC concludes that the initial contract for Year 1 includes Years 2 with respect to renewing the one- a material right year license and related PCS -4. In addition, ABC concludes that Customer is obtaining a material for Years 2 © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

196 Revenue for software and SaaS 194 : Identify the performance obligations in the contract C. Step 2 right to a perpetual license (bundled with one year of PCS) that it will control upon renewing PCS for Year 5. That is, upon accepting the option to renew PCS for Year 5 at the beginning of Year 5 (which includes accepting its obligation to pay the Year 5 PCS fee), Customer now controls a perpetual right to use Product H. Consequently, at contract inception there are the following performance obligations in the contract: — -year license to Product H A one — One year of PCS related to Product H Material rights to obtain further one -year licenses to Product H and related — -4 PCS in each of Years 2 — A material right to obtain a perpetual license to Product H and one- year of related PCS at the beginning of Year 5 The perpetual license to Product H that Customer may acquire at the beginning of Year 5 is not similar to the one- year term licenses Customer obtains initially right to obtain in Years 2- and has the 4. Therefore, ABC cannot apply the practical alternative in paragraph 606- 10 -55- 45; ABC must estimate the stand- alone selling price of the option to obtain a perpetual license to Product H. Various facts and circumstances, inclu alone selling ding the estimated stand- price of a perpetual license to Product H (which may be highly variable or uncertain) and consideration of breakage (i.e. the likelihood that Customer will forgo its material right by choosing not to renew PCS for Yea rs 2 -5), will affect the estimated stand- alone selling price of the perpetual license option. Assume the following stand- alone selling prices are estimated for the material rights in the contract: -alone Stand Probability of e xercise Discount Option selling p rice $196,000 98% $200,000 Year 2 one -year license/PCS option Year 3 200,000 95% 190,000 -year license/PCS option one one -year license/PCS option 200,000 91% 182,000 Year 4 Year 5 perpetual license/ -year of one PCS option $1,800,000 $2,000,000 90% Consequently, the contract inception relative stand- alone selling price allocation is as follows (rounded to nearest dollar and tenth of a percent): Sta nd-alone Allocated Relative selling price allocation % Performance Obligation amount Year 1 License/PCS 20.2% $485,175 $600,000 196,000 6.6% 158,490 Year 2 option Year 3 option 190,000 6.4% 153,639 Year 4 option 182,000 6.1% 147,170 Year 1,8 00,000 60.7% 1,455,526 5 option $2,4 100.0% 968,000 $2, 00,000 © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

197 Revenue for software and SaaS 195 C. Step 2 : Identify the performance obligations in the contract The $485,175 allocated to Year 1 is then allocated between the license and the PCS based on the relative stand- alone selling price of each. ABC will recognize the portion allocated to the license at the beginning of Year 1 and recognize the year PCS period. portion allocated to the PCS over the one- The amounts allocated to the options will remain deferred (i.e. as contract liabilities) until the respective option is exercised. When the option is exercised, the consideration for the additional license and PCS (e.g. the $400,000 fee applicable to Year 2) is added to the amount allocated to the Year 2 option for a total amount of consideration of $558,490. Consistent with the accounting for the license and PCS in Year 1, ABC will allocate the $558,490 between the license and PCS on a relative stand- alone selling price basis. ABC will recognize the portion allocated to the license at the beginning of Year 2 and recognize the portion allocated to the PCS over the one- year PCS period. The accounting for Years 3- 5 will generally be consistent with that for Year 2 other than with respect to the amounts recognized (due to the differing amounts allocated to the options). Note: The preceding two paragraphs assume that ABC accounts for the exercise of the Year 2 material right as a continuation of the existing contract. At the March 2015 TRG meeting, TRG members generally agreed that it would also be acceptable for an entity to account Papers for the exercise of a material right as a contract modification (see TRG Agenda Nos. 32 and 34). That ‘contract modification’ approach would result in different accounting from that outlined in the preceding paragraphs as it would generally account for each exercise of one of the options in the contract as a termination of the existing contract and the creation of a new contract. For purposes of this example, we have not illustrated the results of that approach. Example C200.3 Software license and mandatory PCS – license fee paid over time Scenario 1: Entire license fee is legally enforceable if Customer cancels PCS ABC Corp. enters into a contract with Customer to provide a three- year license to Product T and also to provide both technical support services and any updates, upgrades and enhancements developed (collectively, PCS) for one year. If Customer does not renew PCS for Years 2 and 3 it loses the right to use the software – i.e. there is a mandatory PCS provision in the contract. Under the terms of the contract, Customer pays the $300,000 license fee in three equal installments of $100,000 at the beginning of each year of the license term. PCS is $60,000 each year, payable in advance. Customer has a legally enforceable obligation to pay the entire $300,000 license fee even if it chooses not to renew PCS in either Year 2 or Year 3 (note: even if ABC has a history of not enforcing remaining license fee installments if the PCS is not renewed, ABC may still have an enforceable right to such fees – see es Question ). The stand-alone selling price for ABC’s PCS on term licens B140 at contract inception is $60,000. year PCS service is a single performance obligation ABC determines that the one- (see Question C150) and is distinct from the license to Product T. Despite the fact © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

198 196 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 up- front the license fee is paid over time, rather than , the conclusion in this scenario is consistent with that in Example C200.1 . This is because the license fee is legally enforceable regardless of whether Customer renews PCS; therefore, the timing of payment of the license fee alone does not change the accounting from that outlined in Example C200.1 , with the exception that there may be a significant financing component in the contract as a result of Customer Step paying for the license to Product T over time (see Chapter D – 3: Determine the ). transaction price Scenario 2: The unpaid portion of the license fee is no longer owed if Customer cancels PCS Assume the same facts as in Scenario 1 except that if Customer does not renew PCS for Year 2 or Year 3, the remaining balance of the license fee is no longer owed by Customer. year term license with co- In this case, the substance of the contract is a one- terminus PCS. Customer, in effect, has an option each year to renew both the license and the PCS for another year. Consequently, the transaction price at contract inception is only the enforceable $160,000 ($100,000 Year 1 license payment + $60,000 Year 1 PCS payment). Consistent with Scenario 1, ABC determines that the PCS is a single performance obligation that is distinct from the one-year license to Product T. Consequently, ABC recognizes the portion of that $160,000 transaction price allocable to the Product T license at the beginning of the one -year term (which is when Customer obtains control of the license) and the portion allocable to the PCS over the one- year term using an ). appropriate measure of progress (see Question C130 ABC’s accounting for the contract in Years 2 and 3 will, absent any modification to the contract, be consistent with that for Year 1. Comparison to legacy US GAAP Under legacy US GAAP, the contract could be characterized as a perpetual -based license (i.e. the contract may be license or a multi- year time worded/structured in such manner). This is because the customer loses the continued right to use the software if PCS is not renewed, so in substance the -year time -based licenses arrangement was considered to be a series of one bundled with annual PCS. Because the renewal payments after the initial one- year PCS period in a mandatory PCS scenario apply to both the continued use of the license and the PCS renewal, the entity did not have a separate renewal rate for PCS. Therefore, the entity could not establish VSOE of fair value for PCS and could not separate the one- year time -based license from the one- year PCS. As a result, in practice, either of the following accounting policies were considered acceptable alternatives to account for the amounts received in the initial term of the arrangement. Recognize the entire initial fee for the license/PCS bundle over the initial — term, provided such term was considered substantive, and recognize renewal fees in subsequent years over the respective renewal periods. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

199 Revenue for software and SaaS 197 C. Step 2 : Identify the performance obligations in the contract Defer and amortize the incremental portion of the initial fee for the — license/PCS bundle (i.e. the amount of the initial fee that was greater than the stated renewal period fee) over the estimated term of the arrangement. If the term of the arrangement was not determinable, then the incremental portion of the initial fee was deferred and amortized over the economic life of the software product. If the customer elected not to renew PCS in a future period, any remaining deferred revenue was recognized at that time. The accounting model for mandatory PCS arrangements outlined in the Question will represent a significant change for most entities with these arrangements from the accounting under legacy US GAAP. C210 Question If a customer reinstates technical support and/or unspecified update, upgrade and enhancement rights after allowing them to lapse, are those any promises to provide services distinct from updated or enhanced software (i.e. releases the customer did not get during the lapse) as part of the reinstatement? Reinstated PCS For perpetual or time- based licensing arrangements in which the customer has cancelled PCS (or allowed PCS to lapse), entities frequently charge an additional fee to customers who wish to reinstate the PCS arrangement. In certain circumstances, the customer will receive previously released upgrades or enhancements upon reinstatement of an inactive PCS arrangement. Contractual provisions requiring incremental fees to reinstate a PCS arrangement that has lapsed are common in the software industry. Such fees may be in the form of a penalty or they may be equivalent to the actual PCS fees that would have been charged had the customer remained a current PCS subscriber (i.e. back PCS). In addition, there may be circumstances where the entity offers an amnesty program to persuade customers to reinstate the PCS that has elapsed under the arrangement. Under such a program, upon reinstatement of the inactive PCS the entity may offer to waive a portion or all of the previously released upgrades or enhancements and any penalties that may be due contractually under the arrangement. Upon reinstatement of the PCS, such arrangement would be accounted for as a concession because a substantive incremental payment was waived by the entity. However, we believe that an amnesty program that is offered once to all its customers is more akin to a sales incentive and generally does not establish a history of concessions. of the contract as one for a The characterization Interpretive response: , ‘reinstatement ’ of PCS or otherwise does not matter. Such an arrangement however characterized, is no different from any other new contract for one or more specified software licenses (e.g. an upgrade to Version 3.0 and provision © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

200 198 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 of an enhancement in the form of a new module) , technical support services and a right to future unspecified updates, upgrades and enhancements . Regardless of whether the entity does or does not charge a ‘reinstatement fee’, s a portion of the transaction or the amount of any such fee, the entity allocate released upgrades or enhancements the customer will price to any previously specifically receive as part o f the arrangement – i.e. those are specified upgrades or enhancements. This might result in the entity recognizing a contract asset if there are no fees paid by the customer under the reinstatement , or if those fees are less than the transaction price allocated to those items , at the time the previously released upgrades or enhancements are transferred to the customer . The considerations to determine whether any specified software licenses or ade/enhancement upgrades, technical support services and unspecified update/upgr are distinct in this context are consistent with those outlined in rights Questions . – C170 C150 If, at contract inception, (1) there is a reasonable expectation that the customer will cancel PCS and later reinstate PCS and (2) the entity has a pattern (i.e. customary business practice) of providing previously released updates, upgrades and enhancements without charging a substantive incremental fee upon PCS reinstatement , this may result in a conclusion that the customer’s payment of the c urrent contract fees also provides the customer with a material right to previously released updates, upgrades and enhancements upon reinstatement of PCS in the future. Therefore, entities may want to ensure that in PCS reinstatement scenarios they charge a substan tive fee for previously to avoid evaluating, and released updates, upgrades and enhancements potentially accounting for, a material right. Comparison to legacy US GAAP Under legacy US GAAP, the appropriate revenue recognition treatment for a transaction to reinstate an inactive PCS arrangement depended on whether the renewal transaction involved multiple elements. When a customer received previously released upgrades upon reinstatement of an inactive PCS arrangement, the reinstatement arrangement was equivalent to a multiple -element transaction to purchase software upgrades and PCS from the date of reinstatement. When VSOE existed for the go- forward PCS but not for the software elements, which may include new software licenses as well as previously released upgrades or enhancements, the residual method was applied to assign the arrangement consideration to the elements of the arrangement. Application of the residual method could result in the recognition of all or a portion of the PCS ment fee upon delivery of the software element(s). reinstate -front in a However, it was generally not appropriate to recognize revenue up single-element PCS reinstatement arrangement where (1) the customer was not entitled to receive upgrades or enhancements previously provided to active PCS subscribers or (2) the customer was entitled to receive upgrades or © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

201 199 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 enhancements previously provided to active PCS subscribers, but no upgrades or enhancements were released during the period(s) in which the customer’s PCS was i nactive. Instead, when a PCS renewal arrangement did not involve multiple elements, any reinstatement fee charged at inception of the PCS renewal, regardless of form, was ascribed to the future PCS services. It was not deemed appropriate to recognize the PCS reinstatement fee upon renewal in those situations because the reinstatement itself did not constitute a separate deliverable of the arrangement, even if the related agreements state that the fee is attributable to PCS for prior periods. In general, the accounting for PCS reinstatements will not be significantly different under Topic 606, with the following exceptions. — The amounts allocated to the various elements in a multiple- element reinstatement may differ because of the changes in the transaction price measurement and allocation guidance (see Chapter D – Step 3: Determine Chapter E – and the transaction price 4 : Allocate the transaction price Step ). to the performance obligations in the contract Under legacy US GAAP, if the reinstatement included rights to previously — released updates, upgrades or enhancements, and a commensurate fee was not charged for those items, provision thereof was treated as a concession to the customer. No revenue was recognized upon delivery of those upgrades or enhancements if any payments to be received from the customer were contingent on future performance. Under Topic 606, revenue will ge nerally be recognized upon transfer of the previously released upgrades and enhancements, even if all of the consideration in the contract is contingent on the provision of future PCS. As noted in the question, the consideration in the contract for the rei nstated PCS may include consideration from a previous contract deferred as a material right to receive the previously released updates, upgrades or enhancements for free or at a significant discount. Professional services frequently include professional services Software and SaaS contracts . For purposes of evaluating whether professional services sold in a contract with one or more software licenses, and potentially additional goods or services such as PCS or hosting services or specified software upgrades, the basic categories of professional services need to be understood . In general, the following are the principal types of professional services that may be included in a bundled software arrangement : Implementation s . Software implementation generally includes — ervices tasks such as (not exhaustive ): software selection, defining software requirements, implementation planning, system architecture and network planning, software installation, software and systems integration and -deployment interfacing, testing of the installed software/system, post review. Implementation services are often available from the software vendor providing the license(s), as well as from alternate providers. Implementation can also, typically, be at least partially per service formed by the customer’s . in-house personnel © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

202 Revenue for software and SaaS 200 : Identify the performance obligations in the contract C. Step 2 Software implementation services can range from being non- complex to significantly complex. Often the level of complexity of the implementation services determines whether parties other than the entity can perf orm all or owever, in some cases, there are a significant portion of the services . H sophisticated service providers that can provide even extremely complex implementation services, including services that require access to the software code – e.g. if the service provider has an access permission agreement with the software provider . Configuration services . Configuration refers to how a system is set up, or — . With respect to the assortment of components that make up the system software, typical configuration services relate to the setting of various ‘flags ’ or ‘switches’ within the software, or defining certain values or parameters, to implement a particular set -up for the software’s existing functionality . Configuration does not involve the modification or writing of additional software code, but rather involves setting up the software’s existing code to function in a particular way. Customization — . A software vendor or another service provider services provides customization services that ty pically involve m odifying existing software code in the application or writing additional code. The effect of significantly altering or adding software code is generally to change, or create additional, functionalities within the software. . services Training — Software vendors and other service providers often offer their customers services to train their personnel on the use of, and in some cases how to provide at least first -tier support for, licensed or purchased software. . — Other consulting services Software vendors and other consulting firms and service providers may provide a variety of ‘ other ’ services that may not be directly linked to a specific software application. SaaS arrangements also frequently include professional services . Many of the premise services SaaS providers o ffer are similar to those provided for on- software solutions . For example, implementation services in SaaS arrangements will frequently include configuration and/or interfacing, data ng. -user traini migration/conversion, user acceptance testing and end Customization of the SaaS (e.g. developing additional functionalities) may also occur in some cases. C220 Question What should a SaaS provider consider in evaluating -front services it provides in a SaaS if up arrangement are a promised service or solely an administrative task/set -up activity that does not transfer a good or service to the customer? Set -up activities, as opposed to promised services, Interpretive response: provide no incremental benefit to the customer beyond that which they will -up activities receive from access to the hosted application. In other words, set represent those tasks that are for the customer to begin to use and necessary benefit from the hosted application. For example, a SaaS provider may perform tasks that range from simple activation activities necessary for the © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

203 201 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 customer to access the web- based software application to more complex up- front activities needed to allow the customer to access the SaaS services represent from the customer’s IT platform . I n either case, those tasks activities that are necessary solely for the customer to access and begin to use the hosted application. In contrast, promised services provide some measure of benefit beyond that of solely being able to access and use the hosted software applic . Examples ation of promised services include: assisting the customer in interfacing their existing operating software ( e.g. an ERP system) with the hosted software application, performing customer -specific configuration services so that the software will operate most effectively in the customer’s business environment, providing training services to permit the customer to use the application effectively, and performing data migration/conversion services related to the customer’s that the customer would otherwise have to perform itself (or existing data . obtain from a third party) If another entity provides the services in question (e.g. a consulting services , we would generally expect those entity provides data conversion/migration) would be promised services when provided by the software entity, rather than set -up activities. However, the fact that another entity does not provide those -up activities when performed by services is not determinative that they are set the software entity. Example C220.1 - Set up activities versus implementation services in a SaaS arrangement ABC Corp. enters into a contract to provide Customer with access to its SaaS for three years. As part of the contract, before commencement of the SaaS term, ABC will set up the user interface that Customer will need to access the online application, and will also undertake data conversion and migration activities for Customer to configure and move its relevant, existing data from Customer’s current on- premise solution to ABC’s hosted environment. ABC will also provide training to relevant Customer personnel on use of ABC’s hosted application. ABC evaluates each of the activities it agrees to undertake as part of the set -up of the user interface, data conversion and migration contract: the activities, and training of Customer’s personnel. ABC concludes that set -up of the user interface is a set -up activity, rather than a benefit to Customer incremental promised service to Customer. It provides no beyond permitting Customer to access and use the hosted application. In contrast, the data conversion and migration activities, and the training of Customer’s personnel, are services that will provide Customer with incremental benefits beyond just the ability to access and use the hosted application. The data conversion and migration activities ABC will perform would otherwise need to be performed by Customer or another service provider and, even though it would be inefficient, Customer would be able to use the hosted application for new transactions without converting and migrating its old data. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

204 Revenue for software and SaaS 202 C. Step 2 : Identify the performance obligations in the contract The training of Customer’s personnel will permit Customer to effectively use ABC’s hosted application. In both cases, the data conversion/migration and the training, ABC’s activities are doing more than simply setting up or enabling Customer to access and use the SaaS. Question C230 How should an entity evaluate whether professional services to significantly customize or are are distinct from the modify the licensed softw associated software license? Interpretive response: Professional services provided in a software licensing arrangement can vary greatly from contract to contract; therefore, the contract - specific facts and circumstances should always be considered. However, in general, a software license and professional services to significantly modify or customize that software for the customer’s use will comprise a single oftware performance obligation, as will an entity’s services to produce a new s application for a customer and grant a license thereto. The basis for that conclusion is likely to differ depending on whether the nature of the arrangement is customizing or modifying an existing software product for the customer or producing new software. New s oftware production the development of a new, customized software A production scenario entails product for a customer . T he customer cannot use and benefit from the license i.e. to the customized software product until the development is complete – license does not transfer until the development is control of the software . complete This ordering of how the license and the associated services are transferred to the assessme nt of whether those items are capable of the customer affects being dis . The license is not transferred before the performance of the tinct development services and is , by nature of it being a new, customized software product, not licensed separately by the entity . Therefore, the development services do not provide benefit to the customer on their own or with any then- readily available resource. Because the development services are not capable of being distinct , the development services are combined with the license to the developed software that will be transferred to the customer upon completion of the development services into a single performance obligation. xisting software product Customizing or modifying an e In a modification/customization scenario, if the customer obtains the right to use and benefit from the underlying software (i.e. is granted the license to use the software that will be modified/customized by the entity’s services), the software license and the customization services will typically be capable of being distinct . This is because the customer can benefit from the : vailable — underlying software on its own or together with other readily a ; and C110) uestion resources (see Q © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

205 Revenue for software and SaaS 203 : Identify the performance obligations in the contract C. Step 2 — customization services together with the delivered license to the underlying software . that services essional cludes prof in a software contract that in However, significantly modify or customize the customer’s instance of the software, the entity’s promise to transfer the software license and its promise to provide the not be separately identifiable. This professional s ervices will typically is because: — the underlying software and the customization services are inputs to the combined output (i.e. the customized software) for which the customer has contracted, such that the entity is providing a significant integration service ; and of combining those inputs into that combined output the customization services are significantly modifying and/or customizing — the software license. The separately identifiable evaluation will generally not be affected by whether . This is because that another entity could provide the professional services would not affect whether the entity is providing a significant integration service in this contract or that the professional services are significantly modifying and/or customizing the software license. Comparison to legacy US GAAP Legacy Subtopic 985- 605 specified that if a software arrangement required significant production, modification or customization of the software, the entire arrangement was accounted for using contract accounting. This is because, in an arrangement that involved significant production, modification or customization of the licensed software, the service element is essential to the functionality of the software. oduce, Therefore, the conclusion that a software license and services to pr modify or customize the licensed software will generally constitute a single performance obligation under Topic 606 is consistent with the unit of account conclusion under legacy US GAAP for those same elements. Questions F200 F260, respectively, discuss whether a single performance obligation and comprised of a software license and significant customization services is satisfied over time or at a point in time and appropriate measures of progress to apply (i.e. timing of revenue recognition) if the performance obligation is satisfied over time. Example C230.1 Software license and customization services ABC Corp. licenses trust asset management system software called Product B. The Product B software enables users, typically large financial institutions, to access and value individual US dollar denominated trust account portfolios on a -time basis. Pr real oduct B functions as designed without any customization or © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

206 Revenue for software and SaaS 204 C. Step 2 : Identify the performance obligations in the contract modification services and can be implemented without ABC’s assistance in most cases. ABC entered into a specific contract with Customer, a large bank, to grant a license to the Product B software and to provide services to modify the customer’s instance of the software. This includes modification of the software code and configuration of certain modified and off -the- shelf settings to allow Customer to access and value its trust account portfolios in multiple foreign configuration currencies in addition to US dollars. The modification and significantly affect the Customer’s ability to use the Product B software as it intends. ABC expects that it will take approximately 18 months to perform the services. ABC concludes that there are two promised goods and services in this contract: the software license, and the professional services to customize and configure the software. In this example, the software license and the professional services are each cap able of being distinct. Customer could derive benefit from the license for Product B on its own or with readily available implementation services. Customer can benefit from the professional services together with the license to Product B that is transferre d at contract inception. However, ABC determines that the promises to transfer a license to Product B and to provide the associated professional services are not separately identifiable in the context of the contract – i.e. there is a single performance obligation. This is because: — -the-shelf form and the professional services to be Product B in its off applied to that software to modify the software code and effect the required configuration are both inputs to the combined output the customer has contracte d for (i.e. the customized software). The professional services will significantly modify and customize the — customer’s instance of the Product B software. Note that the configuration aspect of the professional services does not modify or customize the soft ware because these services merely configure functionality that already exists in the software code; no software code is modified or additionally written. Question C240 How should an entity evaluate whether -type services are implementation and installation distinct from the associated software license? Interpretive response: The nature and extent of p rofessional services provided in a software licensing arrangement can vary greatly from contract to contract; -specific facts and ci therefore, the contract rcumstances should always be considered. However, in general, a s oftware license and related professional services that are principally implementation in nature and that are not complex will they are separate perform . ance obligations be distinct from each other; therefore, additional considerations with respect to more Question discusses C260 complex implementation services. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

207 Revenue for software and SaaS 205 C. Step 2 : Identify the performance obligations in the contract Provide benefit on their own or t ogether with o ther readily available resources Implementation ser vices do not significantly change the functionality of the software – i.e. implementation services do not involve changing or appending software code. : typically conclude that will Therefore, entities — the software provides benefit to the customer on its own or together with other implementation services generally available from alternate providers ; but the services provide benefit to the customer together with the software — that is generally transferred . up-front license In some arrangements, the license term does not begin until the lementation services are completed. In that case, the license is not imp the implementation services are after to the customer until transferred completed because the customer is not able to use and benefit from the software until the license term commences (s ee Question F30). However, even in that circumstance, the customer can benefit from the implementation services together with a ‘readily available resource’ if the entity . T he software license is a readily sells licenses to the software separately available resource if the entity either sells licenses to customers without . This implementation services or sells renewal licenses to customers separately is because a readily available resource is defined as ‘a good or service that is [606- 10- 25- 20] sold separately (by . the entity or another entity)’ As a further observation, even if the entity only sells those licenses together with PCS, such that it does not sell the software license separately, the bundle containing the license and the PCS can be the readily available resource with which the customer can benefit from the implementation services. Separately i dentifiable from o ther promises in the c ontract An entity’s promises to transfer a software license and to provide professional services that do not significantly modify or customize (i.e. change) the licensed software will typically be separately identifiable. Because implementation services do not modify or customize the licensed software, the software are not inputs to a combined output license and the implementation services . the licensed Rather, to software; services are applied the implementation therefore, the entity is not providing a significant integration service. Furthermore, the software license and implementation services typically will not the other each significantly affect , and therefore are not highly interrelated or interdependent in this contract . While t he implementation services necessarily depend on the transfer of the software license – i.e. the customer can only benefit from the services after it has obtained the software license – in general, the implementation services do not significantly affect the software license. The entity will be able to fulfill its promise to transfer the software license independently of . That is, its promise to provide the implementation services because the licensed software will not be changed by the entity’s services, when (or whether) it performs the implementation services does not affect the entity’s ability to fulfill its promise to transfer the software license. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

208 Revenue for software and SaaS 206 : Identify the performance obligations in the contract C. Step 2 C240.1 Example Software and implementation services ABC Corp. licenses Software Product A to Customer on a perpetual basis along with specified implementation services. The implementation services consist of developing non-complex interfaces, performing data conversion and migration, loading/installing the software, and running test data. Product A can be used by the customer upon basic installation without any significant customization or lementation services. ABC providing the specified imp Due to the magnitude of global operations of Customer, the implementation services are expected to take 12- 15 months to complete. The stated fees for the implementation services exceed the fees attributable to the Product A BC is an experienced provider of implementation services for Product license. A A and has a history of successfully providing services of this nature to the satisfaction of customers. The services do not carry a significant degree of risk or unique acceptance criteria. Customer is expected to assign internal IT personnel to work closely with ABC on the implementation effort, including project management. ABC concludes that the software license to Product A and the implementation services (which are determined to be a single performance obligation in this see Question C250) are each capable of being distinct. contract – The Product A software is fully functional to its off -the -shelf specifications as soon as it is installed in Customer’s IT environment. This means that Customer is able to benefit from the software either on its own (if its own personnel could install the Product A software) or together with basic installation services that are readily available from numerous alternate providers. Customer can benefit from the implementation services together with the front. software license transferred up- ABC also concludes that its promises to transfer the Product A license and to provide the implementation services are separately identifiable. This is because the implementation services are not significantly modifying or customizing the -the-shelf software and ABC’s services are, in effect, each software; the off outputs of this contract rather than inputs to a combined output of the contract. ABC determines that, because the contracted services will not change the licensed software (i.e. modify or customize the software code), the services do not significantly affect the software license such that ABC would be unable to independently from fulfilling its fulfill its promise to transfer the software license promise to implement that software. Consequently, the services and the contract. license are not highly interrelated or interdependent in this Because the Product A license and the implementation services are distinct m each other in this contract, the license and the services are separate fro performance obligations. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

209 Revenue for software and SaaS 207 C. Step 2 : Identify the performance obligations in the contract Question C250 If an entity provides multiple implementation services, are each of those services a separate performance obligation? What entities consider to be ‘implementation services’ Interpretive response: may actually encompass a number of services that would each be distinct . loading of software, data conversion and migration, Examples include the building interfaces and end- user acceptance testing. For example, an entity’s services to convert and migrate customer data to its software may be distinct from its services to build certain interfaces or provide each of those services may be able to be training to customer personnel; fulfilled, and provide benefit to the customer, independently, such that they are separate performance obligations . However , it may frequently be the case that either: — the various implementation services will be provided over the same implementation period and have the same pattern of transfer to the -to-cost or labor hours input customer – e.g. the entity may use a cost method to measure progress toward the satisfaction of each promised ; or service — the service will not be provided concurrently, but the measure of progress for each service is the same and there would be a consistent transaction price allocation between each service – e.g. because the entity’s stand - alone selling price for its professional services is its observable hourly rate, which is consistent between the services . In either case, the entity is permitted to account for the multiple services as a single performance obligation because the accounting outcome sh ould be the same as accounting for those services as separate performance obligations. [ASU 2014- 09.BC116] Question C260 How does an entity evaluate whether implementation services that are complex, but do not significantly customize or modify the software, are distinct from the associated software license? Interpretive response: Implementation services that consist principally of tasks or activities such as implementation planning, loading of software, training of customer personnel, data conversion or migration, building simple interfaces, running test data, user acceptance testing, and assisting in the development and documentation of procedures are not generally considered ‘ complex ’. addresses whether non Question C240 -complex implementation services are distinct from the associated software license(s). What constitutes complex implementation services will be a matter of judgment, but we believe such services include tasks such as developing complex interfaces t hose and would generally take more time to complete than © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

210 208 Revenue for software and SaaS C. Step 2 : Identify the performance obligations in the contract of a simple nature. The complexity of the implementation services might be further evidenced if the customer’s personnel or other service providers could not perform significant portions of the services . Distinguishing complex interfaces from those of a simple nature will require judgment because there is no standard definition ‘complex interface’. Over of a time, practice has developed whereby a number of factors are assessed in attempting to delineate simple from complex interfaces . We believe tha t the following factors are relevant to identifying complex interfaces and being able to to services that include the building of such apply Topic 606’s separation model interfaces and the presence or absence of one of the list is not exhaustive, . This fac tors would not necessarily be conclusive of whether requested interfaces are complex . The time and effort to complete the interfaces . If the building of the — requested interfaces will take a substantial amount of time and/or extensive effort to complete, this indicate s a greater level of complexity. — Whether another provider or in -house customer personnel could complete the interfaces . If another service provider or the customer’s in- house IT personnel could not complete (or substantially complete) the , interfaces (e.g. because it requires access to the software’s source code) this indicate factor is this The evaluation of s a greater level of complexity. not affected by any e.g. any restriction in the contractual restrictions – . contract prohibiting the customer from using an alternate provider — Whether there is a significant level of risk in successfully completing the interfaces . If there i s a significant level of uncertainty with respect to the entity’s ability to complete the interfaces (which may be evidenced by the contract’s payment terms or acceptance, termination or cancellation that the requested interfaces are of a more provisions), this would suggest complex nature. Capable of being distinct The evaluation of complex implementation services will require judgment . However, we believe a software license and even complex implementation services will generally be capable of being distinct for the same reasons outlined in Q C240 ). ( implementation services in general uestion Separately identifiable We expect that an entity’s promise to transfer a software license and provide even complex implementation services will be separately identifiable in most cases. The analysis leading to that conclusion will likely be consistent with that outlined in Question C240 . This is b ecause even complex implementation services are not modifying or customizing the licensed software (i.e. changing or appending the software code) or vice versa, and the license and the services do not each significantly affect the other – i.e. while the services necessarily depend upon the license, in general, the entity can fulfill its obligation to transfer the software license independently of fulfilling its obligation to provide the services (e.g. build complex interfaces) . an entity may conclude that the However, in circumstances, more limited entity’s promise to provide complex implementation services is not separately identifiable from its promise to transfer the software license(s) in the contract . Consider the following: © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

211 Revenue for software and SaaS 209 : Identify the performance obligations in the contract C. Step 2 — In some contract s, the entity may be providing a significant integration (as described in paragraph 606- 10- service )), using the licensed 25-21(a software and those interfaces as inputs to produce a ‘ solution’ that is the combined output the customer entered into the contract to obtain. This might be the case if the act of interfacing the licensed software and the software/system s with which the licensed software will interface will create combined functionality – i.e. functionality that is dependent on both the licensed softwa re (e.g. Product A) and the other software with which (e.g. Product B the licensed software is interfaced ). The situation described not refer to a situation in which one (or both) in this bullet point does applications/systems merely ‘feeds’ (e.g. supplies data to the the other other) ; rather, it ref ers to a situation in which the interfaces permit the two applications , together, to perform additional functions or tasks that neither can perform individually . That is, the interface(s) permit Product A and Product B to perform additional functions or tasks that cannot be performed by either software application separately . The analysis in this regard is substantially similar to that outlined in Question C120 for determining whether two promised software licenses are distinct from each other. principle of that the 2016-10 states basis for conclusions to ASU The — determining whether two promises are separately identifiable considers whether the customer’s ability to derive its intended benefit from the contract depends on the entity fulfilling both promises. There may be circumstances in which complex implementation services are so integral to the customer’s ability to derive benefit from the software license that the software license and the services are effectively inputs to a single promise [ASU 2016- 10.BC33(b)] to the customer. For example, if complex interfacing ( or a specialized configuration of the software ) is necessary for the customer to derive its intended benefit from no other entity can the software within the context of the contract and (e.g. because the services rely upon proprietary perform those services code), that may result in a knowledge of, or access to, the software source conclusion that the software license and the implementation services are a single performance obligation. no other entity (including the customer) being capable of We believe that perform ing th e necessary services is required in order to reach the If the customer could obtain the conclusion in the preceding paragraph. neces (regardless of any contractual sary services from another entity rest rictions requiring the customer to obtain the services from the entity ), that would mean the entity’s promise to provide the services is not to the customer’s ability to derive its intended benefit from the integral software license. ample C260.1 Ex Software license and complex implementation services (complex interfacing) ABC Corp. licenses investment portfolio management software (Product C). Typically, a customer can use the Product C software upon installation with little or no customization. ABC entered into a contract with Customer, a large © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

212 Revenue for software and SaaS 210 C. Step 2 : Identify the performance obligations in the contract international bank. Customer has numerous branches and subsidiaries around the world and wishes to centralize its investment function. The branches and subsidiaries of Customer operate using various hardware and operating software. As part of the arrangement with Customer, ABC agrees to license the Product C software to Customer and to provide services to build interfaces that will allow Product C to interface with the various hardware and operating software used by Customer’s branches and subsidiaries, and with Customer’s current -ledger software. It is clear to ABC from the negotiation and contract general drafting process that Customer would view the Product C license as having relatively limited value without the ability to use it across its many branches and subsidiaries and being able to interface Product C with its general ledger software. ABC estimates that it will take approximately one year to complete the interfaces, at which time the Product C software will be fully functional in all of Customer’s branches and subsidiaries. There are no other service providers that the requisite expertise to build these interfaces because of the complex have nature of the Product C software; and Customer does not have the requisite expertise in-house. ABC concludes that there are two promised goods and services in this contract: the Product C license, and the implementation services. ABC concludes that it is providing complex implementation services given the nature of the requested interfacing; this is because no other party could build the interfaces, and because of the amount of time and level of effort it will take to complete the work. C As the first step in its separation analysis, ABC concludes that the Product license and the complex implementation services are capable of being distinct because each is capable of providing benefit to Customer either on its own or together with other readily available resources. Customer can derive benefit from the Product C license together with readily available installation services (basic installation services would be internally available or available from other service providers) and can derive benefit from the complex implementation services together with the license to Product C that is transferred at inception. contract Next, ABC analyzes whether its promises to transfer the license to Produc t C and to provide the implementation services are separately identifiable. In the first instance, ABC considers the following two factors from paragraph 606- 10- 25-21, which support a view that those promises are separately identifiable. — While ABC’s services to develop interfaces for Customer are an important component of the contract, the development of the interfaces will not result in new or combined functionalities that rely on Product C and Customer’s existing systems. Consequently, Product C and the implementation services are not inputs to a combined output and ABC is not providing a significant integration service in this contract. — The implementation services will not significantly modify or customize the customer’s licensed instance of Product C or vice versa. This fact also further supports that the Product C license and ABC’s implementation services are not inputs to a combined output sought by Customer. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

213 Revenue for software and SaaS 211 C. Step 2 : Identify the performance obligations in the contract Despite the evidence suggested by those factors, ABC concludes that its Product C license and its promise to provide the promise to transfer the implementation services in this contract are not separately identifiable. This is because, within the context of this contract, the Product C license and the implementation services ABC will provide are both integral to delivering C Customer’s desired output from this contract – i.e. the ability to use Product across its global network of branches and subsidiaries – and no other vendor can provide the complex implementation services. The benefit Customer wou ld be able to derive from the Product C license alone – i.e. without the implementation services – is significantly limited as compared to Customer’s objectives when entering into the contract (as understood by ABC through the negotiation and sales process); and Customer is unable to perform the implementation services itself or obtain those services from any other entity besides ABC. Meanwhile, the benefit Customer would be able to derive from license. the implementation services would be nil without the Product C Consequently, the nature of ABC’s overall promise to Customer is to provide an appropriately interfaced software solution (i.e. the combined item) to which the base Product C license and its implementation services are inputs. Because ABC’s promises to transfer the Product C license and to provide the implementation services are not separately identifiable, they are not distinct and comprise a single performance obligation. Comparison to legacy US GAAP Legacy Subtopic 985- 605 did not provide explicit guidance for determining if services to build complex interfaces that are necessary for the off -the-shelf software to be functional in the customer’s environment would result in contract accounting for the arrangement. However, during the deliberations of the legacy US GAAP literature, some members of the Accounting Standards Executive Committee (AcSEC) of the AICPA expressed the view that services that entail building interfaces to enable off -the-shelf software to function in the customer’s environment generally would not be considered essential to the functionality of the software unless the interfaces are very complex. As a result of that observation, practice developed whereby services to build complex interfaces were determined to be essential to the functionality of the software. Therefore, the software license and those services were accounted for as a single contract accounting unit. For the reasons outlined above, we do not believe entities should account for a software license and services that entail complex interfacing as a single performance obligation in all cases under Topic 606. Therefore, it is possible that some entities will come to different conclusions about the separability of a software license and services to build complex interfaces under Topic 606 than they did under legacy US GAAP. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

214 Revenue for software and SaaS 212 : Identify the performance obligations in the contract C. Step 2 C270 Question Are there instances where configuration services, not accompanied by customization services, would not be distinct from the associated software license? In general, a software license and associated Interpretive response: configuration services will be separate performance obligations . A software license for off -the-shelf software is generally capable of being uestion C110), while the configuration services are capable of distinct (see Q being distinct together with the software license that is generally transferred up-front . Configuration services do not modify or customize (i.e. change) software, but merely set the parameters for how existing functionalities already written into the software code will function – e.g. if a software application has the ability to round numbers, a configuration task may be to set its default rounding to three decimal points, rather than two or four . Becaus e configuration services do not modify the software code, a promise to transfer a software license and a promise to provide configuration services will typically be separately identifiable. This is supported by an evaluation of the factors 10- 25-21 . in paragraph 606- — As noted above, neither the software license nor the configuration service significantly modify or customize the other. — Because the configuration services do not modify the licensed software, this is not providing a significant integration service; the entity is generally notwithstandi in a purely literal sense, the existing software and the ng that, services are both inputs to the configured output that the customer will use. Rather it is applying its configuration services to the existing software – i.e. in contrast to , for example, using the software and customization services as two inputs to produce significantly modified software. — Consistent with the discussion of non- complex imple mentation services (see Q uestion C240 ), we believe that where professional services will not modify the licensed software, those services do not significantly affect the software license. T herefore , because the software license and the services , they are not highly interrel ated do not each significantly affect the other or interdependent. However, consistent in principle with the discussion of complex more ion services in Question C260 , we believe that in implementat limited circumstances an entity’s promise to provide configuration services may not be separately identifiable from its promise to transfer the associated software license. This is the case when specialized configuration services both: — are integral (i.e. fundamental) to the customer’s ability to derive its intended benefit from the software license – see discussion of ‘integral’ in [ASU 2016- 10.BC33(b)] Question C260 ; and (e.g. because the services rely upon — cannot be performed by another entity ontractual . C proprietary knowledge of, or access to, the software code) are restrictions requiring the customer to obtain the services from the entity not considered in making this assessment . © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

215 Revenue for software and SaaS 213 C. Step 2 : Identify the performance obligations in the contract In that case, the software license and the configuration services would be a single performance obligation. C280 Question Are the considerations for a SaaS provider different from the considerations for an entity licensing software when determining whether professional services are distinct from the SaaS? Interpretive response: front activities Question C220 discusses whether up- performed by the SaaS provider in a SaaS arrangement are determined to transfer a promised service to the customer. In most cases, the SaaS provider’s considerations will be similar to those of an entity that licenses software; however, potentially, there are differences. These ences in the considerations about whether professional services include differ are capable of being distinct, and differences in how an entity should consider whether the SaaS provider’s promises to the customer are separately identifiable. Capable of being distinct Typically, even if only as a result of customer renewals, SaaS providers sell their core SaaS offerings separately . This suggests that the core SaaS offering is 10- capable of being distinct (i.e. in accordance with paragraph 606- 25-20, stand- alone sales indicate the customer can benefit from the SaaS offering on its own). It also suggests that up- front professional services are capable of being distinct. Because the SaaS offering is sold separately, the professional services will provide benefit to the customer together with the readily available (by virtue of being sold separately) SaaS offering. However, if a SaaS provider promises to significantly customize its SaaS offering for a customer (i.e. implement significant new functionalities or substantially modi fy existing functionalities), the up- front customization services may not be capable of being distinct unless the SaaS provider regularly sells customization services separately – e.g. if the entity sells customization customers of the provider. This would services to parties that are not SaaS indicate that the services provide benefit on their own. If those services are not sold separately, they typically would be incapable of providing benefit to the customer on their own. In addition, the customer generally could not benefit from the customization services together with any readily available resource customized because neither the SaaS provider, nor any other entity, sells that SaaS offering separately; it presumably does not yet exist until the customization services are complete. Consistent with our view under legacy US GAAP, even though an entity may enter into a new contract with a customer to provide customization services that would not be combined with an original contract to provide SaaS, those subsequent customization services are not ‘sold separately’. This is because with each feature added or change made, there is the implied promise to provide access to that additional or modified functionality or feature on a hosted basis. As a result, a subsequent contract to develop or modify features or © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

216 Revenue for software and SaaS 214 C. Step 2 : Identify the performance obligations in the contract functionality is a multiple- element contract, even though the hosting element is not explicitly stated. Therefore, only through sales of customization services that will not be accompanied by hosting the customized software will an entity conclude it sells those services separately. Separately identifiable Consistent with previous questions specific to professional services and software licensing entities (see Questions C240 – C270), professional services that do not customize the customer’s instance of a SaaS offering will typically be separately identifiable (i.e. distinct within the context of the contract). er, in some, more limited, circumstances, an entity’s promise to provide Howev professional services other than those that customize the SaaS offering may not be separately identifiable from the entity’s promise to provide the SaaS. Consistent with the guidance for complex implementation services and configuration services provided in a software licensing arrangement (see - Questions C260 and C270, respectively), this may be the case if the SaaS related services: — are integral (i.e. fundamental) to the customer’s ability to derive its intended benefit from the SaaS offering – see discussion of ‘integral’ in 10.BC33(b)] [ASU 2016- C260 ; and Question — – if other entities are presently cannot be performed by another entity the services (e.g. there is a capable and available to the customer to provide readily available ‘ecosystem’ for the services), the entity’s services are not integral to the customer’s ability to derive its intended benefit from the SaaS offering. Contractual restrictions requiring the customer to obtain the services from the SaaS provider are not considered in making this assessment. This means that other than for customization services, which will typically not be distinct from the SaaS in a SaaS arrangement, as long as another entity is capable of providing the professional services agreed to in the contract, the entity’s promise to provide professional services and its promise to provide the SaaS will be separately identifiable. Comparison to legacy US GAAP Legacy SEC guidance in SAB Topic 13.A.3( -front fees’ f), ‘Nonrefundable up front professional provided guidance about determining whether the up- services in an arrangement represented a separate deliverable that should be accounted for as a separate element. Under legacy US GAAP, the up- front services in a hosting arrangement did not represent a separate deliverable if: 1. the up-front services were essential and inseparable from the hosting services; 2. the up-front services had little or no value to the customer on a stand- alone basis; or -front services or hosting services the vendor did not separately sell the up 3. without causing a significant reduction in the value of the other element. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

217 Revenue for software and SaaS 215 : Identify the performance obligations in the contract C. Step 2 In those situations, the entire arrangement was accounted for as a single unit of front fees were deferred and recognized systematically over the accounting. Up- periods in which the hosting services were performed. In general, under Topic 606, we believe up- front services that meet the second -up activities, rather than criterion above would likely be considered set promised services and, therefore, would be inseparable from the SaaS offering itself (see Question C220). The other two criteria applied under legacy US GAAP seem mostly consistent with the conditions identified in this question for when SaaS -related services would not be distinct from the related SaaS offering under Topic 606. That is, it seems that for professional services to be ‘essential’ (first criterion) or for their absence from the arrangement to result in a significant reduction in value of the SaaS offering (third criterion), they would also have to be ‘integral’ and unavailable from an alternative provider. C280.1 Example Up -front professional services and SaaS ABC Corp. provides a hosted software solution to customers for which customers generally pay a fixed monthly or quarterly fee. Customers are not permitted to take possession of ABC’s software. ABC and Customer enter into a contract for Customer to use ABC’s SaaS for three years. Scenario 1: Distinct services As part of the contract, ABC agrees to perform a variety of services before Customer going live with ABC’s SaaS. These services include training Customer’s personnel, converting and migrating Customer’s data from its current on-premise solution to ABC’s hosted environment, and building an interface to permit the hosted application to supply data to Customer’s on- premise general ledger system. The following additional facts are relevant: — ABC’s SaaS is regularly sold separately, principally through renewals with existing customers, but some new customers also choose not to obtain any professional services from ABC. — The interface needed to permit Customer to interface the SaaS with its general ledger system is not complex, such that another entity could build that interface. — There are third-party consultants that provide each of the services requested by Customer. ABC first concludes that each of the promised services provide incremental benefit to Customer beyond merely permitting Customer to access ABC’s hos ted application (see also Question C220). Therefore, they are promised services in the contract (rather than set -up activities). ABC next concludes that the SaaS and each of the promised services are capable of being distinct: separately (principally through renewals), ABC regularly sells the SaaS — that customers can benefit from the SaaS on its own; and indicating © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

218 Revenue for software and SaaS 216 C. Step 2 : Identify the performance obligations in the contract — Customer can benefit from each of the promised services – i.e. the training, complex interfacing conversion/migration and non- – together with the data readily available SaaS (the SaaS being ‘readily available’ by virtue of being regularly sold separately by ABC). Finally, ABC concludes that its promises to provide each of the services and to provide the SaaS are separately identifiable. This conclusion is based on the fact that Customer could obtain each of the services from other providers, or could perform the services itself. As a result, ABC’s fulfillment of its promise to provide the requested services is not integral to Customer’s ability to derive its intended benefit from the contract. As a result, ABC concludes that the SaaS and each of the services outlined above are separate performance obligations However, ABC may account for the services as a single performance obligation are met. if either of the conditions outlined in Question C250 Scenario 2: Customization services not sold separately In addition to the services described in Scenario 1, ABC agrees to develop an additional functionality for the hosted application that it will introduce into the tenant environment before multi- Customer going live. ABC does not sell customization services separately and no other entities have access to ABC’s source code for the application; therefore, no entities other than ABC could develop the requested functionality. ABC concludes that the significant customization services in the contract transfer a promised service to the customer that has incremental benefit to Customer beyond merely setting Customer up on the existing SaaS offering such that they are not solely a set -up activity. ABC then concludes that Customer cannot benefit from the significant customization services on their own and ABC does not sell the customized SaaS offering separately (nor does any other SaaS provider). This means that there are no readily available resources with which ABC could benefit from the customization services such that those customization services are not capable of being distinct. Because the customization services are not distinct, the SaaS and the customization services are a single performance obligation addresses the accounting for a combined SaaS Question F240 in this contract. and professional services performance obligation. However, the combined customized SaaS performance obligation is distinct other professional services (i.e. those described in Scenario 1) for the from the same reasons that the non- customized SaaS offering and the services are distinct from each other in Scenario 1. Scenario 3: Customization services sold separately Assume the same facts as in Scenario 2, except that ABC regularly provides customization services separately. For example, ABC provides customization services for other entities. ABC concludes that the customization services are capable of providing benefit alone sales thereof). The SaaS to Customer on their own (evidenced by stand- offering would also be capable of providing benefit together with the customization services provided first in the contract. However, ABC concludes its promises to provide the SaaS and to provide the customization services are not separately identifiable because: © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

219 217 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 — the customization services are significantly customizing the core SaaS offering; and — the customization services and ABC’s core SaaS offering are inputs to the customized SaaS offering that is the desired output of this contract, indicating that ABC is providing a significant integration service in the contract. Therefore, even in this variation of Scenario 2, the SaaS and the customization services are a single performance obligation. Ques tion F240 addresses the accounting for a combined SaaS and professional services performance obligation. Example C280.2 SaaS and complex implementation services ABC Corp. provides access to its proprietary investment portfolio management software (Product C). Typically, a customer can use the Product C software- as- a- service (SaaS) with little or no customization once the basic user interface is established. ABC entered into a contract with Customer, a large international bank. Customer has numerous branches and subsidiaries around the world that operate using highly customized on- premise software. As part of the arrangement with Customer, ABC agrees to provide Customer access to Product C on a SaaS basis, and to provide services to configure the Pro duct C software for Customer so that it operates effectively with Customer’s branch/subsidiary software and its ERP system. In addition, ABC agrees to provide training and data migration services (migrating Customer data from multiple existing systems to A BC’s hosted environment). In evaluating its performance obligations in the contract with Customer, ABC considers first that the Product C SaaS, the configuration services, the training and the data migration services are each capable of being distinct. The Product C SaaS is capable of being distinct on the basis that it is sold separately (i.e. to customers that do not purchase professional services, and to customers that purchase the SaaS in renewal periods). Each of the services (configuration, data migration and training) is capable of being distinct because customers benefit from each service together with the readily available Product C can SaaS resource. ABC next concludes that its promises to provide the SaaS and to provide the configuration services are not separately identifiable. ABC determines that the specialized configuration it will implement for Customer is integral to Customer’s intended use of the Product C SaaS across all of its branches and subsidiaries. Stated another way, without the specialized configuration work, Customer would not be able to effectively use Product C with its different, specialized on-premise systems. Furthermore, no resources other than ABC (i.e. no other service providers or Customer’s personnel) are presently capabl e of providing the integral configuration services. Consistent with the discussion in paragraph BC33(b) of ASU 2016- 10, Customer’s ability to derive its intended and the the SaaS benefit from this contract depends on ABC providing both configuration services. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

220 Revenue for software and SaaS 218 C. Step 2 : Identify the performance obligations in the contract Finally, ABC concludes that the training and data migration services are distinct from the combined SaaS/configuration services performance obligation. The training and data migration services do not customize the hosted software, and are not integral to Customer’s intended use of the SaaS. The training services, while useful and valuable, are not essential to Customer’s ability to use the software in view of the end -user documentation and available technical support provided as part of the SaaS. Meanwhile, the data migration services can be provided by many service providers other than ABC and do not affect the functionality of the SaaS in Customer’s IT environment ( in contrast to the configuration services, which do affect the functionality of the SaaS in ). Customer’s IT environment Therefore, ABC concludes there are three performance obligations in the contract with Customer: — the combined SaaS/configuration services; — the training services; and — the data migration services. Hardware Question C2 90 How should an entity evaluate whether a license is a component of a tangible good that is integral to the functionality of the good? 10- Paragraph 606- Interpretive response: 55-56(a) states that “a license that forms a component of a tangible good and that is integral to the functionality of the good” is not distinct. Topic 606 does not explain whether this statement is based on a conclusion that the license is, under the circumstances described, not capable of being distinct (paragraph 606-10 -25-19(a)) or whether it is based on a conclusion that the entity’s promises to transfer the license and the hardware are not separately identifiable (paragraph 606- 10 -25- 19(b)). Consequently, paragraph 606- 10-55 -56(a) could be viewed as establishing a distinct test specifically for licenses and hardware. discussion However, we do not believe that was the Boards’ intent. Based on to ASU , we believe the Boards view the 2014-09 in the basis for conclusions -56(a) as merely an application of the core 10-55 guidance in paragraph 606- 19 through 25-22. The basis for distinct guidance in paragraphs 606- 10 -25- conclusions states that, fundamentally, the guidance in paragraph 606- 10- 55- 56(a) refers to a situation in which the Boards believe the licensed IP and the hardware components are inputs to a combined output in accordance with 09.BC406] [ASU 2014- -21(a). 10-25 paragraph 606- Therefore, consistent with other Questions that consider whether two items are inputs to a combined output (e.g. C120 and C310), w e believe the key question in determining whether a software license is a component of a tangible good that is integral to the functionality of the good is whether the produce the essential together software and the hardware components only © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

221 Revenue for software and SaaS 9 21 C. Step 2 : Identify the performance obligations in the contract functionality of the tangible good. Each element (software and hardware) contributes substantively to the essential functionality of the tangible good. The hardware element(s) cannot simply be a delivery mechanism for the software. For example, a smartphone’s operating system software and its hardware components work together to produce the smartphone’s essential functionality (e.g. make calls, connect to the network and internet, take pictures and video); a customer would not purchase an operating system software license without a device for the software to operate, and would not purchase a smartphone without operating system software to perform the key functions that a smartphone is expected to perform. In contrast, if the software or the hardware merely provides or contributes functionality, the software license is additive functionality rather than essential not an integral component of the tangible good. Continuing the prior example, many smartphone software applications, even if the applications come installed on the smartphone at the time of customer purchase, do not contribute to the smartphone’s essential, combined functionality; they merely provide added functionality. In that case, the application is not an input to the smartphone – it is an additive feature. It may require significant judgment to determine what is essential versus additive functionality. In making this determination, it may be relevant to consider whether the tangible good is ever sold without the functionality in question and whether the functionality in question is optional to the customer. This might include not only the option to include that functionality in the tangible good but also the ability to remove that functionality – e.g. uninstall the related software. The fact that a software element included in the tangible good is also sold separately from the tangible good does not affect the assessment of whether the software and hardware elements function together to deliver that tangible good’s essential functionality. Nor does the fact that the hardware elements are sold as a tangible good either without the software element or with a different software element affect this determination – e.g. a different model of the tangi ble good may have different essential functionality. Comparison to legacy US GAAP Under legacy US GAAP, the question about whether the sale of a tangible good included a software license element that functioned together with the hardware element(s) to deliver the tangible good’s essential functionality was important to the accounting. This was because of the substantially different related services) and other goods accounting models for software (and software- and services. However, under Topic 606, if the software license is transferred to the customer at the same time as the tangible good as a whole, the question about whether the software license is or is not distinct from the tangible good, as well as any related question as to whether any services in the contract are or are not -related, may not matter. software © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

222 Revenue for software and SaaS 220 : Identify the performance obligations in the contract C. Step 2 An entity’s evaluation of whether licensed software forms a component of a tangible good that is integral to its functionality will likely yield similar results as the evaluation under legacy US GAAP, but that may not always be the case. This is because the evaluation under Topic 606 is anchored to the notion that what the entity should be evaluating is whether the software and the hardware elements of the tangible good are each inputs to a combined good. This is consistent with how the factor in paragraph 606-10 -25 -21(a), which was not part of legacy US GAAP, is evaluated in other circumstances. and hybrid arrangements Hosting services Question C300 In an arrangement that includes a software license and hosting services, are the software license and the hosting services separate performance obligations? Hosting services In certain arrangements, rather than selling a software license and related services to the customer, the vendor will make the functionalities of the software available to the customer through a hosting arrangement. In such arrangements, the vendor will run the software application on either its own or third -party hardware. Customers can access the software through the internet or a dedicated transmission line. In contracts that include a software license (see Interpretive response: – Scope Chapter A , we believe the software ) and services to host that software license and those services will generally be distinct from each other (Question C310 addresses ‘hybrid cloud’ arrangements with cloud- based . services more substantive than simply hosting the licensed software) The software license will generally be capable of being distinct (as described in Question C110). The hosting services will also be capable of being distinct because the customer can benefit from the hosting services together with the software license that is transferred up- front . The software license in a hosted the software licensing arrangement is transferred to the customer no later than point in time it can first access the software through the hosted environment (see Question F110). The entity’s promises to transfer the software license and to provide the hosting services will generally be separately identifiable from each other in the contract based on the following: Neither the license, nor the hosting services, significantly modify or — customize the other . — The entity could fulfill those two promises independently from each other . -5 to be considered 15 By virtue of meeting the criteria in paragraph 985- 20- licensing arrangement, it should be clear that the entity can a software . transfer the software license independent of providing the hosting services Further, the entity could provide the hosting services at any point during the © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

223 Revenue for software and SaaS 221 : Identify the performance obligations in the contract C. Step 2 arrangement without regard to when it transfers the software license. As a consequence of determining that the entity could fulfill the two promises independently of each other, the two promises do not each si gnificantly affect the other. — The customer can either host the software itself or obtain hosting services from an available third party with no significant diminution in utility of the software (a requirement for there to be a software license in the gement ). This means that the software license and the hosting arran services are not inputs to a combined output for which the entity is providing a significant integration service to create. Comparison to legacy US GAAP The criteria for determining whether an arrangement includes a software license or, instead, is for SaaS has not changed as a result of the new revenue guidance. The existing US GAAP guidance for making this determination has -20 from Subtopic merely been relocated to Subtopic 985 – Chapter A 985-605. Scope discusses application of this guidance in detail. Under legacy US GAAP, when a software license was present, the software license was only separable from the hosting services if the vendor had vendor - spec ific objective evidence of fair value (VSOE) for the undelivered hosting services. If the arrangement included additional elements such as PCS, the software license could only be separated from the service elements if the software entity had VSOE over all of the undelivered elements (e.g. hosting and PCS services). If the entity did not have VSOE over one or both of these elements, which was often the case, the combined arrangement fee was recognized over the longer of the hosting or PCS term, provided that term was deemed to be substantive. Having VSOE is no longer required in order to separate goods and services in software contracts, and therefore hosting services will generally be a separate performance obligation from the software licenses and other services (e.g. PCS or implementation) in the contract. Therefore, entities that enter into software licensing arrangements with hosting services will generally separate the license and the hosting services more frequently than they do under legacy US GAAP. C300.1 Example Software license, customization services and hosting services ABC Corp. enters into an arrangement with Customer to license software Product A, provide significant customization services and provide hosting services. The hosting services commence upon completion of the mately six months. customization, which is expected to take approxi © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

224 Revenue for software and SaaS 222 C. Step 2 : Identify the performance obligations in the contract The hosting services may be renewed in subsequent years for an amount to be negotiated between ABC and Customer. Customer has a contractual right to take possession of Product A at any time without significant penalty, and it is e for Customer to run the software on its own hardware. feasibl Because Customer has a contractual right to take possession of Product A at any time without significant penalty and it is feasible for Customer to run the there is a software license and software on its hardware, ABC concludes that associated hosting services in this contract. The significant customization services transfer a promised service in this contract – i.e. they provide incremental benefit to the customer; therefore, they constitute a third promised good or service in the contract. ABC concludes that the software license and each of the services is capable of being distinct because the: Customer can benefit from the software on its own. Customer can run the — is capable of providing economic software on its own hardware and it benefit to the customer without significant customization; — Customer can benefit from the customization services together with the software license that is granted at the outset of the contract; and — Customer can benefit from the hosting services together with the software that is transferred to the customer when the hosting services commence (i.e. when Customer is able to begin to access the software). ABC next determines that its promises to transfer the software license and to provide the customization services are not separately identifiable. This is because the services are significantly customizing ABC’s software such that the licensed software and the customization services are inputs to the combined, customized software offering for which the customer has contracted (see Example C230.1). Finally, ABC determines that its single promise to provide the customized software license (comprised of the license to the software and the ntifiable from the hosting services. The customization services) is separately ide hosting services are not changing (i.e. customizing or modifying), or being changed by, the customized software license such that each is an input to a combined output. Furthermore, because Customer can host the cus tomized software on its own, ABC could fulfill its promise to transfer the customized software license independent of its promise to host the customized software. And because ABC could provide equivalent hosting services to Customer for another application, it could also fulfill its promise to provide hosting services independent of its promise to transfer the customized software license. Therefore, the customized software license and the hosting services are not highly interrelated or interdependent. As a result of the preceding analysis, ABC concludes that there are two i.e. the customized software license performance obligations in this contract – and hosting services. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

225 223 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 C310 Question What should an entity consider when evaluating whether a software license and a SaaS element in a ‘hybrid SaaS’ (or ‘hybrid cloud’) arrangement are distinct from each other? Interpretive response: It is increasingly common for arrangements to include on-premise or on- device software and SaaS features and functionality ( a SaaS premise software application and file storage (including element), e.g. an on- sharing and collaboration through a web host), or a SaaS application with an offline mode. These arrangements are often referred to as hybrid SaaS or hybrid cloud arrangem ents. 56(b) states explicitly that a license that the customer can Paragraph 606- 10 -55- benefit from only in conjunction with a related service (e.g. as an online service provided by the entity that enables, by granting a license, the customer to access co ntent) is not distinct. If the customer cannot derive benefit from its right to use licensed software without a contracted SaaS element, that license is not distinct from the SaaS cense -user li element. This is the case even if that license is subject to an end agreement or the license is explicitly stated to be an element of the contract. We believe this conclusion would extend, not only to a situation in which the premise software customer receives no independent benefit from the on- license, but to any situation in which the benefit (or utility) that the customer can derive from the on- premise software independently is insignificant. When the on-premise software and the SaaS element each have substantive functionality on their own, we believe that the evaluation an entity should undertake in determining whether the on- premise license and the SaaS element are distinct is broadly consistent with the approach outlined in Question C120 (contract with multiple software licenses). That is, we believe the underlying principle for the separation model in Topic 606 (as outlined in paragraphs BC29, BC32 and BC33(b) in ASU 2016- 10) tinct if provides that a software license and a SaaS element will typically be dis be distinct from each not ‘additive’ to each other, but will the two elements are other when those two elements have a ‘transformative’ or significantly ‘magnifying’ effect on each other, or when the customer’s ability to derive its intended benefit from the contract depends on the software entity transferring providing the SaaS features (see the on- premise software license and paragraph BC33(b) in ASU 2016 -10). -10 ASU 2016 Excerpt from The Board intends to convey that an entity should evaluate whether the BC29. contract is to deliver (a) multiple goods or services or (b) a combined item or items that is comprised of the individual goods or services promised in the contract. That is, entities should evaluate whether the multiple promised goods or services in the contract are outputs or, instead, are inputs to a combined The inputs to a combined item (or items) concept might be item (or items). © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

226 Revenue for software and SaaS 224 : Identify the performance obligations in the contract C. Step 2 further explained, in many cases, as those in which an entity’s promise to transfer the promised goods or services results in a combined item (or items) that is greater than (or substantively different from) the sum of those promised (component) goods and services. BC32 . The separately identifiable principle is intended to consider the level of integration, interrelation, or interdependence among promises to transfer goods or services. That is, the separately identifiable principle is intended to evaluate when an entity’s performance in transferring a bundle of goods or services in a contract is, in substance, fulfilling a single promise to a customer. the entity should evaluate whether two or more promised goods or Therefore, services (for example, a delivered item and an undelivered item) each significan tly affect the other (and, therefore, are highly interdependent or highly entity should not merely evaluate whether one interrelated) in the contract. The item, by its nature, depends on the other (for example, an undelivered item that would never be obtained by a customer absent the presence of the delivered item in the contract or the customer having obtained that item in a different contract)... In addition to reframing the factors in the context of a bundle of goods BC33. or services, the Board also: b. Observed that the evaluation of whether two or more promises in a contract are separately identifiable also considers the utility of the promised goods or services (that is, the ability of each good or service to provide benefit or value). This is because an entity may be able to fulfill its promise to transfer each good or service in a contract independently of the other, but each good or service may significantly affect the other’s utility to the customer. For example, in Example 10, Case C, or in Example 55, the entity’s ability to transfer the initial license is not affected by its promise to transfer the updates or vice versa, but the provision (or not) of the updates will significantly affect the utility of the licensed intellectual property to the customer such that the license and the updates are not separately identifiable. They are, in effect, inputs to the combined solution for which the customer contracted. The “capable of being distinct” criterion also considers the utility of the promised good or service, but merely establishes the baseline level of economic substance a good or service must have to be “capable of being distinct.” Therefore, utility also is relevant in evaluating whether two or more promises in a contract are separately identifiable because even if two or more goods or services are capable of being distinct because the customer can derive some economic benefit from each one, the customer’s ability to derive its intended benefit from the contract may depend on the entity transferring each of those . goods or services Stated another way, if the customer obtains a license to Software Product A and access to SaaS element B, the distinct analysis would frequently hinge on whether: the combination of A + B equals AB (i.e. the combined functionality is the — sum of the two elements’ individual functionalities), in which case the two elements would generally be distinct from each other; or the combination of A + B equals X (where X is greater than AB). That is, the — combination of the two elements results in incremental or changed functionalities that don’t exist in either element separately or the © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

227 225 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 combination of the elements (e.g. ongoing interactions between the licensed software and the SaaS) produces an enhanced level of functiona lity that is greater than the aggregate of the individual functionalities of the two elements, which would generally suggest the two elements are not distinct from each other. Additionally, the distinct analysis may hinge on whether elements (i.e. the both on-premise/on-device software and the SaaS element) are essential to fulfilling the promise to the customer. That is, the nature of the promise to the customer in a hybrid SaaS arrangement may include the promise of access to important features or functionalities that depend on elements. A situation in which both the entity must provide both elements (i.e. there are not substantially equivalent alternatives for either the licensed software or the SaaS features/functionality available from other providers), might suggest that the software license and SaaS elements are not distinct from each other. C310.1 Example -premise software part of a combined solution On contracts with customers to provide access to its proprietary ABC Corp. solution that permits entities to obtain specific data and manipulate it in premise numerous ways. ABC’s solution includes hosted software and an on- application. The hosted application is proprietary and ABC never permits customers to take possession of the hosted application or have another entity host the application. The on-premise application is licensed to and used by ABC’s customers to view search results and data presentations processed by the hosted application, but the on- premise application is unable to produce search results or work with searched data when not connected to the hosted application. A customer uses the on- premise application to convert the results into other, more usable formats (e.g. Word, Excel and PDF) and can send the results to others using the application. Customers enter into end- user licensing premise application as part of the contracting process agreements for the on- -terminus with their access to the hosted application. that are co The on-premise application has some inherent functionality, i.e. as a stand -alone application, it permits a user to convert results into other formats and to share results with others. Notwithstanding that fact, ABC concludes that neither the on-premise application nor the hosted application provide independent functionality to customers. Without the hosted application, the on- premise application would not be able to obtain search results or data reports to convert or send to others, while a customer cannot obtain the results produced by the hosted application without the on- premise (user interface) application. Consequently, ABC concludes that the on -premise application license is not capable of being distinct. Customers cannot benefit from the on- premise application on its own (i.e. without the hosted application) or together with other readily available resources. No other hosted applications exist that a customer can use with ABC’s on- premise application, and ABC does not sell access to its hosted application separately. It sells that access only with co - terminus licenses to the on -premise application. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

228 Revenue for software and SaaS 226 : Identify the performance obligations in the contract C. Step 2 Because the on- premise application is not capable of being distinct, it is combined with the hosted application into a single performance obligation. The providing substance of that combined performance obligation is the service of access to ABC’s solution for the defined contract period. Example C310.2 SaaS with an ‘offline mode’ ABC Corp.’s core solution to customers is marketed as a Cloud Service; however, the solution includes on- premise software subject to an end- user license agreement. Customers can perform many of the solution's functionalities when they are not connected to ABC's cloud (i.e. they are offline, using the on-premise software only), but other functionalities are accessible only if connected to ABC's cloud. ABC does not sell the on-premise software or functionalities separate from its cloud service. Consistent with Example C310.1, customers cannot access the premise software; that software is what cloud functionalities without the on- permits the customer to access the cloud features. While there are substantive capabilities available to the customer in offline mode, without the cloud features, customers would not be able to complete projects using the software. This is because the offline mode permits the customer to perform only some tasks toward completing projects using the software while other significant features and functionalities integral to completing projects are available only when using the software while connected to the cloud. The ability to create and complete entire projects is the reason customers acquire ABC's solution. There are (1) no other on- premise applications that work together with the cloud component of the solution and (2) no other on- premise or cloud solutions -premise software and available that customers could combine with ABC' s on achieve the functionality provided by ABC's overall solution. Customers would -work to achieve have to backtrack substantially or do a significant amount of re the same results outside of ABC's application. Despite the characterization of the solution as a single Cloud Service, the premise software and access to ABC's solution includes a license to the on- hosted application in the cloud. Therefore, ABC determines that it must evaluate whether the license and the cloud- based SaaS are distinct from each other. ABC concludes that the license and the cloud- based SaaS are capable of being distinct. This is because customers (1) can benefit from the on- premise software on its own and (2) can benefit from the SaaS together with the on- premi se software license transferred to the customer up- front. premise software on its own despite the Customers can benefit from the on- fact that they would generally have to backtrack or undertake re- work to -premise software on its own. Customers complete projects started with the on premise software are able to derive economic benefits from use of the on- because they would not have to re- perform all of the work they had completed using the offline mode only. For example, even if the customer would have to © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

229 227 Revenue for software and SaaS C. Step 2 : Identify the performance obligations in the contract re-input and modify data or configurations developed using ABC's on -premise software into another application to complete the project, ABC's software would have provided the customer with a platform to try out various models, processes and/or configurations that would generally provide benefit when solution. moving forward using another Despite concluding that the license and the SaaS are capable of being distinct, ABC concludes that its promise to grant the on- premise software license and to provide the cloud- based SaaS are not separately identifiable. ABC concludes that its solution, the combination of the license and the SaaS, provides combined functionality that is essential to the customer deriving its intended benefit from the arrangement. That intended benefit cannot be provided by either the license and other cloud -based services or software, or other software and ABC's cloud -based services. In substance, the on- premise software license and the cloud -based SaaS are inputs to the combined output (i.e. the solution) that the customer entered into the contract to obtain, and each element significantly affects the utility of the other to the customer such that the nature of ABC's overall promise to its customers is to provide the solution as a whole, not to transfer a license and provide access to additional cloud -based services. C310.3 Example -premise software with ‘additive’ SaaS On functionality ABC Corp. markets its core software development solution to customers as a Cloud Service; however, the solution includes both on- premise software subject -user license agreement and cloud- to an end based services. Neither the license, nor the cloud -based services, are optional in ABC's contracts and ABC does not sell the on- premise software separate from the cloud services. The on- premise software license and the cloud services are co- terminus in all of contracts. ABC's The essential functionalities of the solution are in the on- premise software and are ervices offer customers accessible offline or connected to ABC's cloud. The cloud s app information protected data storage and can be accessed by multiple users, in- sharing and real -time collaborative abilities, e.g. the ability for two users in separate locations to work in the same template simultaneously. Howeve r, they do not change or significantly enhance what a single user can develop using the software – i.e. a customer working offline would be able to undertake the entire software development project permitted by ABC's solution – or significantly affect the workflows to accomplish the customer’s development tasks. Consistent with Example C310.2, ABC concludes that there are two promised goods and services in the contract: a license to the on -premise software, and based features. access to the cloud- based features are capable Next, ABC concludes that the license and the cloud- of being distinct. This is because customers can benefit from the on- premise software on its own and can benefit from the cloud features together with the front. Customers on-premise software license transferred to the customer up- can benefit from the on- premise software on its own because they can take a © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

230 228 Revenue for software and SaaS C. Step 2 : Identify the performance obligations in the contract software development project through the entire project lifecycle using the software in an offline mode – i.e. without accessing the cloud- based features. ABC next concludes that its promises to transfer the on- premise software license and provide access to its cloud- based features are separately identifiable. ABC decides that the cloud- based features, while valuable and likely in fluential to a customer's decision to purchase ABC's solution, are additive to the on- premise software, rather than transformative. The cloud- based features provide a collaborative and secure environment for sharing and storing files and other data and, while those features (and others), may enhance the productivity of a team working together to complete a project, they do not premise software change (i.e. modify or customize) the functionality of the on- or significantly enhance the on- premise software's capabilities, nor do those features significantly optimize the workflows to complete those projects. A customer can complete the same software development projects in offline mode as it could using the software together with the cloud- based features and in a similar manner (i.e. the customer does not have to undertake significant, incremental efforts when in offline mode compared with cloud- enabled mode to complete a development project). Consequently, the software license and the inputs to one overall solution. based features are not cloud- Example C310.4 Flexible hybrid arrangement ABC Corp. licenses its software (Product Q) on an on- premise (term license) basis and on a software- as-a- service (SaaS) basis. Some of ABC’s customers enter into ‘Flex’ arrangements whereby they are permitted a designated the mix between number of concurrent users (e.g. 100 concurrent users), but on-premise and SaaS users can vary over time. For example, the customer would be permitted to have all 100 concurrent users accessing the on- premise software, all 100 concurrent users accessing the software via the cloud, or any mix in between. There is also no requirement for a specific employee of one of premise software or these customers to always access the software via the on- via the cloud. The Flex arrangements include technical support and the right to unspecified updates, upgrades and enhancements (collectively, PCS). Updates, upgrades and enhancements are implemented by ABC to the hosted instance of Product Q immediately on release. In evaluating the number of performance obligations in its Flex contracts, ABC considers that: — the Product Q software is the same software, whether accessed on - premise or via the cloud (note: the possible exception would be the period of time between when the customer is provided an update or upgrade and when they implement that update or upgrade to their on- premise software); — -based cloud a customer user is not accessing the on- premise software and premise instance of the software concurrently; the user is using the on- is accessing the hosted instance of the or Product Q software software; and © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

231 Revenue for software and SaaS 229 : Identify the performance obligations in the contract C. Step 2 ased software — a user is not accessing the on- premise software and cloud-b concurrently, therefore, there are not ongoing interactions between the two or any ‘integrated (or combined)’ features or functionalities. ABC concludes that its Flex contracts include a term license to the Product Q software that is distinct from a Product Q SaaS element (i. e. the right to access Product Q via ABC’s cloud). ABC next considers whether the PCS related to the term license, consistent with Questions C150 – C170, is a single performance obligation, separate from the performance obligation to transfer the Product Q license. If ABC concludes PCS is a single, distinct performance obligation, it would have three performance obligations in the arrangement – i.e. the term license, SaaS, and PCS. Unspecified additional software product rights Question C320 -and- Are rights to use unspecified (when if available) additional software products and an initial soft - ware license(s) distinct from each other in a software licensing arrangement? Rights to use unspecified additional softwa re products As part of a multiple- element arrangement with a user, an entity may agree to tra nsfer software licenses currently and to transfer unspecified additional software licenses in the future. For example, the entity may agree to transfer licenses to all new software products to be introduced in a family of products over the next two years. A right to receive unspecified additional software licenses is typically evidenced by the entity’s agreement to grant the customer rights to use new products introduced by the entity within a specified time period without regard to the specific features and functionality of the new products. These arrangements are similar to arrangements that include rights to unspecified upgrades. Nevertheless, they are distinguished from arrangements that include unspecified update/upgrade rights because the future deliverables are rights to use additional software products, not unspecified updates, upgrades or enhancements to existing software products to which the customer has rights to use. Interpretive response: Question C110 discusses when a software license is considered capable of being distinct. In addition, we expect that, by nature, the right to unspecified future software licenses would have benefit to the customer either: on its own – e.g. those licensed products may be off -the-shelf applications — or the customer can benefit from immediately upon download; © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved .

232 230 Revenue for software and SaaS C. Step 2 : Identify the performance obligations in the contract — together with readily available resources – e.g. implementation services it could obtain relative to those additional products or the initial software the contract license(s) provided . initially under We believe the analysis of whether promises to transfer a software license and and-if additional software to provide unspecified future software licenses when- products are developed are separately identifiable will be similar to that for a and unspecified update/upgrade/enhancement rights (see software license Question C170). Similarly, we believe that in most contracts, the promise to transfer the software license and the promise to provide unspecified future software licenses will be separately identifiable from each other. This is because: The promise to later — (i.e. subsequent to transfer of the initial software license) transfer a license to any future software products produced means that the entity is not providing a significant integration service to transfer a single, combined output that uses the initial license and subsequently developed software products as inputs. These arrangements are not C120 analogous to the multiple license scenario described in Question . The — unspecified licenses that may be initial license and additional, transferred in the future are not inputs to a combined output – i.e. inputs to that generally the a combined software system or solution. This means entity can fulfill its promise to transfer the initial software license separately from fulfilling its promise to transfer future unspecified licenses. Typically, promised software the entity will fulfill its promise to transfer any initially licenses before any future additional software products are even developed and will likely sell licenses to the future software products to new or existing customers that have not licensed the software promised initially in can transfer the promised and the contract; this evidences that the entity the future licenses independently. Consequently, the license and the unspecified future software product rights are not highly interrelated or interdependent. — By definition, an additional software product does not modify or customize the initially licensed software because it is a new product; a release that modifies or customizes existing software would be characterized as an upgrade or an enhancement. limited However, in more circumstances, the promise to transfer a software license may not be separately identifiable from the promise to provide if additional software products and- pecified future software licenses when- uns are developed. We believe that the fundamental question to be asked in determining whether those two promises are separately identifiable is whether: — the future software licenses will be ‘additive’ to the initial software license – i.e. those future software licenses will provide additional ; or instead functionality/utility to the customer — will effectively ‘replace’ the software license(s) initially provided – i.e. the because it is (e.g. customer wil l stop using the initially licensed software ) in favor of the new software. made obsolete by the new software products In the former, ‘additive’ case, we believe the two promises are separately significantly identifiable; the unspecified future software licenses right does not affect the utility of the initial software license(s) to the customer. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

233 231 Revenue for software and SaaS C. Step 2 : Identify the performance obligations in the contract In contrast, a customer may enter into a license, for which it is expected that the initially licensed software will need to be, in effect, r eplaced by one or more new software products in order to continue to provide the customer with substantive utility; this would suggest that the nature of the entity’s overall promise to the customer is, fundamentally, to provide ongoing access to the y’s software developments throughout the license period. The initial entit software license(s) and the unspecified future software license right are inputs to that overall, combined promise. : In these cases during the — the utility of the initially licensed software degrades significantly license period (and ); not predominantly at or near the end of that period only — customers’ use of the initially licensed software ceases or substantially e.g. from use in commercial production to use solely changes in character – within a reasonably short period of time in supporting prior production – ; and from the release of new software products updates, upgrades and new software products to which customers obtain — rights are downloaded and used by the customers. For example, cus tomers /or install timely downloading and the software or, if the contracts include ing remix rights into future software products, demonstrating that customers regularly remix their existing licenses into newly -released software products. egacy US GAAP Comparison to l If an arrangement included unspecified additional software products, legacy GAAP specified that the entire arrangement be accounted for as a US subscription even if the vendor did not intend to develop any new products during the term of the arrangement. Under subscription accounting, no allocation of revenue was made among any of the software products, and all software -related revenue (including PCS) from the arrangement was recognized ratably over the term of the arrangement beginning with delivery of the first product. If the term of the arrangement was not stated, revenue was recognized ratably over the estimated economic life of the products covered by the arrangement, beginning with delivery of the first product. In subscription arrangements that included professional services, entities separated the subscription element (i.e. the combined element of the up -front software product and the rights to unspecified future additional software products) from the services element based on vendor -specific evidence of fair value (VSOE). Revenue allocable to the subscription element was recognized ratably over the subscription period (or the economic life of the software if no term was specified), and revenue allocable to the services was recognized as they were performed. If the vendor did not have VSOE over the subscription element, which was typically the case, the entire arrangement fee was required to be recognized ratably over the longer of the term of the subscription (or the he software if no term was specified) or the period over economic life of t the services were to be provided, beginning with delivery of the first which software product. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

234 Revenue for software and SaaS 232 : Identify the performance obligations in the contract C. Step 2 If a subscription element existed in an arrangement that would have been accounted for under contract accounting, it was not considered separable from the contract accounting element. Therefore, vendors recognized revenue equal to the lesser of (1) the amount resulting from the application of contract accounting or (2) the amount resulting from the application of subscription accounting (ratable). Due to the nature of unspecified additional software products, vendors generally could not reasonably estimate progress toward completion and the range of costs under the arrangement. Therefore, vendors measured the amount of revenue resulting from the application of contract accounting either under the completed contract method or, if some level of as reasonably assured, a zero gross margin percentage- of- profitability w completion approach. In most cases, rights to unspecified additional software products will be distinct from a software license or from a combined software license and professional services performance obligation – e.g. software license and customization services. Therefore, under Topic 606, there will likely be a significant change in accounting for many entities that include unspecified additional software product rights in their contracts. Entiti es will, in those cases, recognize revenue for the: — software license at the point in time that it is transferred to the customer; or for a combined software license/services performance obligation, over the period that the services are performed; and unspecified additional software product rights, in most cases ratably over — the period that those rights exist. The same considerations as outlined in Question C130 for unspecified update/upgrade/enhancement rights will generally apply to unspecified additional software product rights when determining whether those rights are a stand- ready obligation, and in determining the appropriate measure of progress to apply when revenue. recognizing Questions F230 and F270 address accounting for combined performance obligations that include a right to unspecified updates, upgrades and enhancements or unspecified additional software product rights. C320.1 Example Contract with rights to unspecified additional software products ABC Corp. is a vendor of financial accounting software. ABC enters into a contract with Customer to license its revenue accounting software, which is currently available. In addition, ABC agrees to grant Customer a license to any related software introduced over the next three years that is designed to work specifically with the revenue accounting software (e.g. customer relationship management or billing software). ABC considers any new software developed that would be subject to this provision to be additional software products, rather than upgrades or enhancements, because such software would be alone products that do not need to be used marketed and licensed as stand- with the revenue accounting software. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

235 Revenue for software and SaaS 233 : Identify the performance obligations in the contract C. Step 2 The revenue accounting software is, and any future software products ABC develops will be, off -the-shelf software that is fully functional upon basic installation. Customer can do the installation itself or engage any number of alternative providers. ABC first determines that there are two promised goods or services in the contract: and the software license for the revenue accounting software; — — the right to use unspecified additional software products (when- and -if developed). ABC next concludes that the revenue accounting software license and the right to use unspecified future software products are each capable of being distinct. Customer can benefit from the initial revenue accounting software license and any future licenses to additional software products on their own (or together able). This is because the with basic installation services that are readily avail revenue accounting software is, and any future software products are expected to be, fully functional after only basic installation. Lastly, ABC concludes that its promises to transfer the revenue accounting software license and to transfer a license to any future software products are complementary separately identifiable. This is because, even if , the new software products will not change the functionality of the revenue accounting software. Similarly, the revenue accounting software will not change the functionality of the additional software, which will be marketed (and is expected to be license d) separately from the revenue accounting software. Consequently: — neither the initial software license, nor the right to use future software products, is significantly modifying or customizing the other; — the initial software license and the right to use future software products are not inputs to a combined software system or solution; and because the revenue accounting software is licensed on its own and the — future software products are similarly expected to be licensed on their own, they are not highly interrelated or interdependent. Based on the above, the revenue accounting software license and the right to use unspecified future software products are distinct from each other, and therefore separate performance obligations. C320.2 Example Non -distinc t unspecified update/upgrade and additional software product rights ABC Corp. enters into a contract with Customer to license its current commercial software applications for three years. ABC also promises to provide Customer with all updates, upgrades and enhancements it develops for that software, as well as to provide Customer with a license to any new software it develops during the license period within the same family of software products. the ng field – ABC develops software used by customers in a rapidly changi parameters of the field itself have been changing for some time, and are © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

236 234 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 expected to continue to change for the foreseeable future. Therefore, ABC’s software must also change rapidly in order for ABC’s customers to use ABC’s software within this field of development. ABC’s customers expect regular and timely updates, upgrades and new products that keep pace with the changes in their field because such updates are necessary for them to continue to derive benefit from the software. ABC’s software would not be expected to remain useful, in any substantive respect, to its customers throughout its typical year (and sometimes five- year) license periods. Consequently, ABC’s three- customers never purchase ABC’s software licenses without unspecified update/upgrade/enhancement and unspecified future software product rights, while ABC invests heavily in R&D and regularly releases either updates (or upgrades) to its existing software products or new software products (that, in effect, take the place of older software products) to address new areas of research within the field of its customers. The necessity of ABC’s updates and new software products to its customers, as well as the pending obsolescence of older versions and software products at the time new versions and products are released, is evidenced by the fact that those customers: almost universally download nearly all (1) updates and upgrades to existing — software products and (2) new software products within a short period of time; and — a substantial portion of their licenses from older products to remix all or new software products immediately or shortly after ABC releases them. ABC determines that there are three promised goods and services in this contract: the licenses to ABC’s existing software products (which are transferred to the customer at contract inception) for three years, rights to any updates/upgrades of the existing software developed during the three- year contract term and rights to use additional software products developed by ABC during the three-year contract term. ABC concludes that all three promised items are capable of being distinct. Each provides benefit to ABC either: — e.g. customers can derive economic benefits from the initial on its own – software licenses and software licenses granted during the contract term on a when- and -if available basis; or -and- together with other readily available resources – e.g. the right to when — if available updates/upgrades of the existing software provide benefit to Customer together with the initial software licenses transferred at contract inception. However, ABC concludes that its promises to transfer the initial software licenses, provide unspecified updates/upgrades/enhancements and provide software product rights are not separately identifiable. unspecified additional The three individual promises are inputs to a combined overall promise to Customer in the contract. In reaching this conclusion, ABC considers that its initial software licenses, without substantive updates/upgrades, would not provide significant benefit to Customer throughout the license period. Absent timely updates/upgrades (or new, replacement software products) Customer would likely stop using ABC’s software and develop/acquire an alternative solution well before the end of the license period. Consequently, Customer would be highly unlikely to enter into a © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

237 Revenue for software and SaaS 235 : Identify the performance obligations in the contract C. Step 2 year license arrangement with ABC absent the promise of timely three- updates/upgrades and/or replacement software products to keep pace with rapid developments in its field. As outlined above, the significant decline in utility of the initially licensed software, as well as the need for the updates/upgrades and additional software products, is evidenced by the fact that ABC’s customers: all of the updates/upgrades (or new — almost universally download nearly software products) provided immediately (or shortly after they are released); and — exercise their remix rights to remix into the new software products (or upgraded versions of existing products) to which they obtain rights immediately (or shortly after) ABC provides them and out of older versions or older products once updates/upgrades or replacement products are provided. Therefore, ABC concludes that the initial licenses, the unspecified update/upgrade/enhancement rights and the unspecified future software product rights are a single performance obligation. This is despite the fact that (1) ABC would generally be able to fulfill each of the three promises independently and (2) ABC is not providing a significant service of integrating the initial licenses, the unspecified updates/upgrades/enhancements and the unspecified future software licenses into a single, integrated ‘solution’ or ‘system’. The nature of ABC’s combined performance obligation in this arrangement is to provide Customer with ongoing access to its evolving year term of the contract. software in Customer’s field for the three- C330 Question Are the considerations as to whether promised SaaS and a right to access unspecified additional software products as a service distinct from each other different from those in a software licensing arrangement? he considerations would be Interpretive response: In general, no. We believe t substantially the same as those outlined in Question C320. However, the promise to provide access to future hosted software products -terminus with the promised SaaS, and the two promises may have may be co the same pattern of transfer to the customer – e.g. if the entity concludes that -based measure of both promises are satisfied over time and that a ti me progress toward satisfaction of each promise is appropriate. In that case, the entity is permitted to account for the SaaS and the right to access future hosted software products as a single performance obligation, regardless of whether the two items are distinct. provides considerations about whether a right to unspecified Question C130 ready obligation; and, if it is, updates, upgrades and enhancements is a stand- determining the measure of progress toward complete satisfaction of that obligation. We believe the considerations for a right to access future hosted uestion. software products are substantially the same as those outlined in that q © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

238 Revenue for software and SaaS 236 C. Step 2 : Identify the performance obligations in the contract Specified upgrades and rights to use additional software products Question C340 Are specified upgrades and rights to specified additional software products additional promised goods in a contract with a customer? If so, are they distinct from the other goods or services in the contract? Specified upgrades A specified upgrade right is generally an entity’s explicit commitment to deliver, or agreement to deliver on a when- -if available basis, a specific and version of the software or an upgrade with specific features and functionality. Any discussion in the contract with the customer of possible features and functionality of future versions of the software would generally represent a specified upgrade right. An entity may implicitly grant its customer a specified upgrade right, without there being explicit discussion in the contract. This is the case when the entity provides assurance to the customer that a future product release will contain specific features and/or functionality. This might occur, for example, through communication of a detailed software product roadmap (i.e. marketing materials) or in a non-contractual response to a customer’s request for proposal. As a practical matter, claims made in marketing materials available to customers and commitments by sales personnel may be considered by the customer to be part of the arrangement, and therefore represent a specified upgrade right. The specific facts and circumstances should be evaluated on a case -by-case basis, and the entity may need to consult with its financial and legal advisers to determine if a specified upgrade right has been gra nted implicitly to a customer. Factors to consider when evaluating whether an implicit specified upgrade right has been granted to a customer include the following: — Upgrade/enhancement detail – the level of detail of the features, functionality and general release timeframe of the future product that has been provided to the customer. The greater the level of detail and the closer the release date of the enhancement to the initial contract, the greater the likelihood that the entity has created an expectation by the customer of the release of the future identifiable upgrade/enhancement that may have affected the customer’s purchase decision. Caveat language — – whether the entity’s use of caveat language detailing the product roadmap and future development efforts in a license arrangement gives rise to uncertainty about whether the customer will receive the product upgrades/enhancements. The greater the level of uncertainty about the future delivery of an upgrade/enhancement, the less likely that the entity has created an expectation by the customer of © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

239 Revenue for software and SaaS 237 : Identify the performance obligations in the contract C. Step 2 the release of the future identifiable upgrade/enhancement. Customer communication whether the entity communicates the – — features, functionality and timeframe for general release of the future product, or communicates a release to only certain identifiable customers. The broader the intended distribution of the product and the more specific the communication is about functionality and features of the program, the greater the likelihood that customers would expect to receive the specified product upgrades/enhancements. — Entity’s history – an entity’s history of charging a substantive amount for product upgrades/enhancements would indicate that the product may not be a specified upgrade. – whether the customer requests or requires a — Customer request roadmap to specify specific features and/or functionality that are not available currently in the marketed product. Such a request or requirement would indicate that the product roadmap may be a specified upgrade. Specified additional software products element arrangement, an entity may agree to deliver As part of a multiple- software currently and deliver specified additional software products in the future. The rights to these additional products may be included either in the terms of a PCS contract or in a separate agreement, or may be implied in s. much the same manner as specified upgrade right In determining if a specified software deliverable is an upgrade/enhancement or a product, a vendor should consider carefully the specific facts and circumstances on a case -by-case basis. Factors to consider include the following: The significance of the differences in the features and functionality — of the new deliverable from the vendor’s existing products. If the new deliverable has significant differences in the features and functionality from the vendor’s existing products, or if the new deliverable performs functions outside the domain of the vendor’s existing products, it may indicate that the deliverable is a product rather than an upgrade/enhancement. If the new deliverable is intended to — Replacement of existing products. he vendor’s existing products, it may indicate that substantially replace t the deliverable is an upgrade/enhancement rather than a product. The extent of development activities. If the new deliverable required a — significant development effort, it may indicate that the deliverable is a product rather than an upgrade/enhancement. The relationship of the price of the new deliverable to the pricing for — the vendor’s existing products , including price discounts to existing customers. If the new deliverable is priced (or expected to be priced) at an amount that is significantly higher than the price of the entity’s existing products, or if the existing users of the vendor’s products are offered no discount or only an insignificant discount for the purchase of the new deliverable, it may indicate that the deliverable is a product rather than an upgrade/enhancement. The manner in which the new deliverable is marketed. — If the new deliverable is marketed as a different product, it may indicate that the new deliverable is a product rather than an upgrade/enhancement. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

240 Revenue for software and SaaS 238 : Identify the performance obligations in the contract C. Step 2 — Product name. If the new deliverable has a different name than the entity’s existing products it may indicate that the deliverable is a product rather than an upgrade/enhancement. A promise to grant a customer the right to use specific Interpretive response: IP (e.g. an upgraded version of software, a new functionality or a new software product) is a promised good under Topic 606. Both specified upgrade rights and rights to specified additional software products, whether explicit in the contract or implicit through another form of commitment or customary business practice, represent promises to deliver a specified good to the customer. The considerations with respect to whether specified upgrades or enhancements or additional software products are distinct from other goods or services in a contract are not different from those that apply to other promised goods and services. However, we typically expect rights to use software that will be transferred in the future to be distinct from goods or services that are: transferred or front; – e.g. a software license transferred up- up-front — e.g. PCS related to a — begin to be provided at the beginning of the contract – transferred software license or professional services to implement that licensed software. This is because something that will come only later will typically not be an input to a combined item together with a software license to (e.g. an earlier version or a different software product) that is transferred first or services that pertain to the software license that is transferred first. Furthermore, the initial license can be transferred and services related to that license provided before the specified version, enhancement or additional software product is available for release; and the specified version, enhancement or additional software product can be transferred to the customer (or new customers) independently at a later date. This indicates that those items are not highly interrelated or interdependent. However, all relevant facts and circumstances will need to be considered. Comparison to legacy US GAAP -specific objective evidence of fair Under legacy US GAAP, because vendor value (VSOE) rarely, if ever, existed for specified upgrades, enhancements or additional software products, the inclusion of one of those items in arrangement generally resulted in the deferral of all consideration in the arrangement until the specified item was delivered to the customer. When a specified upgrade, enhancement or additional software product was promised to the customer that was not yet developed, this meant that the software entity might recognize no revenue under the arrangement for a significant period of time. This was the case even if all of the other elements of the contract were delivered – e.g. software and professional services. The accounting effect of promising specified upgrades, enhancements or additional software products is significantly less onerous under Topic 606 because of the elimination of the VSOE separability requirement. In most cases, © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

241 Revenue for software and SaaS 239 C. Step 2 : Identify the performance obligations in the contract because the specified item will be distinct from the other promised goods or fied item will not services in the contract, the promise to transfer the speci contract consideration. Instead, only the portion of all result in the deferral of the contract consideration allocated to that promised good or service will be deferred until the specified item is transferred to the customer. Example C340.1 Implicit specified upgrade ABC Corp. receives a request for proposal (RFP) from Customer that indicates that Customer desires incremental XYZ functionality in the general ledger software it plans to purchase. In a written response to Customer’s RFP, ABC states that although XYZ functionality currently is not available in Version 4.0 of Product A (ABC’s currently available general ledger software), ABC anticipates that XYZ functionality will be available in Version 4.1 of Product A, which is expected to be released in approximately six months. Subsequent to the RFP process, ABC enters into a contract with Customer to transfer a license to Version 4.0 of Product A and to provide Customer with a future updates, upgrades and enhancements to Product A, when- right to any and-if available, for a period of one year. The arrangement does not explicitly discuss the XYZ functionality. ABC determines that there are three promised goods and services in this contract: the software license for the general ledger software (Version 4.0), the right to unspecified updates/upgrades/enhancements and the specified upgrade right to XYZ functionality. ABC has implicitly promised to provide XYZ functionality to Customer through its communication in the RFP. This created a reasonable expectation on Customer’s part that ABC will deliver the functionality through a future update. ABC concludes that the general ledger software license and the right to unspecified updates, upgrades and enhancements are distinct from each other ). (see Question C170 and Examples C170.1 and C320.1 ABC also concludes that the specified upgrade right to XYZ functionality is distinct: — Customer will be able to benefit from the XYZ functionality together with the Product A software specifically licensed in the contract – i.e. the XYZ specified upgrade is capable of being distinct; and — ABC’s promise to transfer the XYZ functionality is separately identifiable from the other promises in the contract (i.e. to transfer a license to Version 4.0 and future unspecified updates/upgrades/enhancements). This is because the XYZ functionality will not significantly modify or customize the Version 4.0 software; rather it will provide an incremental functionality. ly, the XYZ functionality is not an input, together with the Consequent Product A software or the unspecified updates/upgrades/enhancements, to a combined output in this contract. Lastly, ABC is able to transfer a license to the Version 4.0 software independently of transferring any future XYZ upgrade, and similarly would be able to transfer a license to a later version of the software independently – e.g. to a new customer that enters into a © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

242 240 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 contract to license the software once XYZ functionality is part of the rcial release version of the software. Therefore, the initial comme 4.0 license and the XYZ upgrade are not highly interrelated or Version interdependent. Based on the above, ABC concludes that the initial, Version 4.0 software license, the unspecified update/upgrade/enhancement rights and the XYZ specified upgrade are each distinct, and therefore each separate performance obligations. C350 Question If a SaaS provider makes a promise to a customer t to add functionalities or features to its SaaS, is tha an additional promised service in the contract with the customer? If so, is that promised service distinct from the original SaaS service? Interpretive response: SaaS providers frequently either provide customers with an explicit promise that its SaaS will include new or changed features or functionality or provide customers with marketing or similar information that describes expected future updates, upgrades or enhancements to its hosted software. In contrast to specified upgrades in a software licensing arrangement, because the customer is already accessing the entity’s hosted software, the entity does any additional software (e.g. a new version) to the customer not have to deliver se to a to satisfy the explicit or implicit upgrade promise. This has given ri in a SaaS question as to whether a promised update, upgrade or enhancement arrangement is: — an additional promised service to the customer (i.e. an additional SaaS element) that is satisfied by the SaaS provider when the update/upgrade/enhancement ‘goes live’; or SaaS ; and therefore, not an — merely part of the overall promise to provide additional promised good or service in the contract with the SaaS customer . Those that assert the latter point of view state that the nature of a SaaS arrangement ( at least in a multi -tenant architecture) is the customer having access to whatever version of the software the entity hosts in its multi-tenant environment. The fact that the entity communicated to a customer its intent to software does not constitute a add features and/or functionality to its hosted promise to any specific customer. Identifying additional promises to the customer We believe the specific facts and circumstances will affect the determination of whether communication of planned feature or functionality enhancements in a promise a SaaS environment results in an additional promised service – i.e. new features and/or functionalities in addition to to provide access to those the SaaS provider’s promise of providing access to its core SaaS offering. Any indicators would typically suggest the one of the following three communication of planned feature or functionality enhancements reflects a promise to the customer : © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

243 Revenue for software and SaaS 241 C. Step 2 : Identify the performance obligations in the contract — The SaaS provider intends to sell the new features or functionalities on a stand -alone basis If the SaaS provider intends to sell the new features or functionalities on a stand -alone basis, it generally suggests that the provision of access to those items to the customer is an additional promised service in the For example, a promise to transfer a new module that the SaaS contract. provider intends to sell to other customers independently or bundled with an entirely different suite of products from that to which the customer has access before introduction of the new module would generally be a promise to provide additional SaaS to the customer in the future – i.e. in addition to the SaaS to which the entity initially promises to provide. — The added features or functionalities provide new, discrete capabilities (i.e. the ability to perform tasks or functions independent of the original features or functionalities) with independent value to the customer A SaaS provider may only intend to provide access to a new module or new application as part of a suite. The fact that the SaaS provider does not intend to sell access to the new module/application on a stand- alone basis does not mean promised access to that new module/application (when available) is not a promise to the customer. Regardless of whether the SaaS provider intends to sell the new features or functionalities on a stand- alone basis, if the new features or functionalities provide discrete capabilities that – i.e. independent from the have independent value to the customer existing functionalities to which the customer has access it generally – suggests that the provision of access to those new features or functionalities is an additional promised service in the cont ract. — The customer is accessing the SaaS in a single -tenant architecture A promise to add features or functionalities, whether explicitly or implicitly, to a hosted software application in a single- tenant architecture would generally be viewed in the same manner as a promise to provide a specified software upgrade in a software licensing arrangement – i.e. the promise to add the specified features or functionality is an additional promise specific to that customer to provide the customer with access to those added features or functionality . believe the communication of , then we If none of the se indicators is present would planned feature or functionality enhancements in a SaaS environment not normally be additional promises to the customer. Evaluating whether additional promises are distinct Broadly consistent with the evaluation in Question C340 relative to specified upgrades in a software licensing arrangement, we would typically expect additional SaaS functionalities that represent promises to the customer (see above) to be distinct . Given the underlying principle of the distinct evaluation – which is to evaluate whether two or more promised items are, in effect, inputs to a single combined – an additional feature/functionality that will be made available to the item not be an input to a combined ’ will typically customer substantially after ‘go-live [ASU 2016- 10.BC29] item. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

244 Revenue for software and SaaS 242 : Identify the performance obligations in the contract C. Step 2 Furthermore, the distinct evaluation considers the level of integration, promised items to the customer (in this interrelation or interdependence among case, the SaaS offering and the additional feature or functionality) . Therefore, even if the additional feature or functionality depends on the hosted application to which the customer already has access (in the same manner additional software code in a specified update or upgrade likely just adds to existi ng software code to which the customer already has rights of use), the customer’s ability to make substantial use of the SaaS offering before implementation of the additional feature or functionality, and the entity’s ability to fulfill its promise to provide the SaaS offering before developing the additional feature/functionality, supports that the two items are not highly interrelated or [ASU 2016- 10.BC32] highly interdependent. C350.1 Example Additional SaaS features/functionalities not as an additional promise to the accounted for customer i.e. ABC provides ABC Corp. is a SaaS provider of tax preparation software – software -as-a- service, and does not license its software. ABC’s customers -tenant environment. ABC access ABC’s tax preparation software in a multi enters into a three- year SaaS arrangement with Customer. Scenario 1: No additional promise to the customer In response to an inquiry from Customer during the contract negotiation process, ABC provides Customer with a product development pl an demonstrating that by the end of Year 1 of the arrangement, ABC’s software will incorporate the necessary fields and calculations to address new government regulations that come into effect during Year 2 of the ABC/Customer SaaS arrangement. The new features will not provide any discrete functionality to users of the tax software; the new fields and calculations are an integrated part of the software the production of complete and being able to perform its core function – accurate tax returns. The new features were planned for introduction into ABC’s tax software before, and independent of, the negotiation with ABC because the new regulations will affect all of ABC’s tax software customers. or ABC observes that the updated features do not provide a discrete independent functionality to any customer. Rather, these feature enhancements are necessary to keep ABC’s tax preparation software current and relevant for all of its existing and future customers. Without the updates, ABC’s software could not produce complete and accurate tax returns, which is its core function. Therefore, the updates are more about the software. enhancing the utility of the software than maintaining As a result, ABC concludes that provision of its product development plan does not result in an additional promise to Customer to provide the features and functionalities described. This is even though the expected updates were expressly communicated to the customer in response to a direct inquiry during the contract negotiation process; and were likely something that if ABC was not © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

245 Revenue for software and SaaS 243 C. Step 2 : Identify the performance obligations in the contract committed to providing would have adversely affected ABC’s chances of winning the contract. the customer Scenario 2: Additional promise to In response to an inquiry from Customer during the contract negotiation process, ABC provides Customer with its current product development plan, which includes introducing a new module for producing and filing UK tax returns by the end of Year 1 of the arrangement. The new module will permit entities to produce and file UK tax returns regardless of whether they first produce the tax returns that ABC’s software is already designed to produce – e.g. US federal and state returns. ABC has not yet decided whether it will sell this module independently. ABC observes that the new UK tax return preparation module will provide a new, significant and independent functionality to its customers that does not currently exist; and that, if ABC chooses to do so, could be sold independently to UK tax filers. This, combined with the fact that the expectation of deploying a new UK module was communicated to the customer in response to a direct inquiry during the contract negotiation process, leads ABC to conclude that providing access to the UK module constitutes an additional promised service. Because the UK module functions independently from the existing modules (which have functioned without a UK module for many years), ABC concludes that access to the existing software and access to the UK module are distinct from each other, and therefore separate performance obligations. Other software -specific elements 60 C3 Question Should a platform transfer right be accounted for as an additional promise to the customer or as a right to exchange software licenses? Platform transfers A software arrangement may provide the customer with the right to transfer software from one hardware platform or operating system to different hardware platforms or operating systems. Platform transfer rights may be relative to a specified or an unspecified platform. Interpretive response: If a software contract permits the customer, either explicitly or implicitly (e.g. by customary business practice), to continue using the original platform software in addition to the new platform software, the platform transfer right is accounted for as a promise to transfer an additional software license – to an additional software product. This is because the customer will be entitled to use two software products rather than one. However, a platform transfer right that does not permit the customer to kind continue to use the original platform software is accounted for as a like- exchange if the right: © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

246 244 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 — is for a software product with no more than minimal differences; and not increase the number of copies or concurrent users of the software — does product available under the license. Question C80 addresses factors to consider in evaluating whether software products contain more than minimal differences. If the contract does not permit the customer to continue to use the original but is for a platform software in addition to the new platform software – software product with more than minimal differences from the original licensed platform software – the platform transfer right should be accounted for in accordance with the right of return guidance in Topic 606. The entity treats the exercise of the platform transfer right as a return of the original platform sof tware and a purchase of the new platform software, but not as an additional promised license in the contract. If the platform transfer right is granted to a reseller of the entity’s products, the same considerations generally apply. Therefore, that right is treated either as a return right, as a right to an additional specified or unspecified software product, or as a consignment. Comparison to legacy US GAAP If a software arrangement contractually permitted the customer to continue using the original platform software in addition to the new platform software, the platform transfer right was accounted for as an additional software product because the customer was entitled to two products rather than one. The resulting accounting differed depending on whether the additional software product was specified or unspecified. — If specified, because entities only rarely had VSOE over their software licenses, the entity deferred all revenue under the arrangement until the additional software was delivered. — If unspecified, if the platform transfer right did not qualify for exchange accounting, the entire arrangement (including the unspecified platform transfer right) was accounted for as a subscription. The accounting under for arrangements that tion C320 Ques legacy US GAAP is described in included rights to unspecified additional software products. However, a platform transfer right that did not permit the customer to continue to use the original platform software was accounted for as a like- kind exchange if the right: — was for the same software product; and — did not increase the number of copies or concurrent users of the software product available under the license. Products were considered to be the same product if there were no more than minimal differences among them in price, features and functions, and the products were marketed as the same product. If the platform transfer right not qualify for like- did kind exchange accounting, the right was accounted for as a return. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

247 Revenue for software and SaaS 245 C. Step 2 : Identify the performance obligations in the contract Platform transfer rights granted to resellers, rather than end customers, were accounted for as returns. In general, the evaluation of whether a platform transfer right is accounted for as an additional promise to the customer, as a like- kind exchange right, or as a return right is consistent between Topic 606 and legacy US GAAP. However, if a platform transfer right is accounted for as an additional promise to the customer (specified or unspecified), it will typically be distinct from the other promised goods and services in the contract. Therefore, unlike under legacy US GAAP, it will not result in either deferral of all contract revenue until the specified additional software license is transferred, or recognizing revenue for the entire arrangement as a subscription (if the additional software license right unspecified ). is Example C360.1 Platform transfer rights ABC Corp. enters into a contract with Customer to transfer a license to Software Product X on Platform A (X on A software) and grants Customer the right to exchange the X on A software for Software Product X on Platform B (X -if available. on B software) when- and Scenario 1: Customer may continue to use original software Customer may continue to use the X on A software if the platform transfer right is exercised. The X on B software has no more than minimal differences in price, features and functions from the X on A software and the two products are marketed as the same product. There are no other promises to Customer in the contract. Because Customer is entitled to continue to use the X on A software in addition to the X on B software, the X on B software is accounted for as an additional promised software license. ABC then concludes that the X on B software is distinct from the X on A software. ABC regularly sells licenses to the X on A software without also promising to transfer a license to the X on B software, and vice versa. In addition, the two software applications do not create a combined functionality in this contract, nor do they modify or customize one another. Consequently, ABC i.e. concludes that the two applications are each capable of being distinct – customers can benefit from each software product on its own or together with other readily available resources – and that the promises to transfer each parately identifiable. license are se Scenario 2: Customer may continue to use original software not Unlike Scenario 1, Customer is not contractually entitled to continue to use the X on A software if it exercises the platform transfer right; The X on B software has no more than minimal differences in price, features or functionality from the X on A software, and it is assumed that the platform transfer does not grant incremental user rights to Customer. Therefore, the platform transfer right is not an additional promised good or service in the © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

248 Revenue for software and SaaS 246 C. Step 2 : Identify the performance obligations in the contract -kind exchange right, which contract. Instead, it is accounted for as a like requires no additional accounting by ABC. Example C360.2 Unspecified platform transfer rights ABC Corp. enters into a contract with Customer to transfer a license to Software Product X on Platform A (X on A software) and grants Customer the right to exchange the X on A software for a license to Software Product X on a different operating system. The right does not expire. The different operating system is not specified in the arrangement. Customer would not retain rights to use the X on A software. There are two promises in this contract: the promise to transfer a license to the X on A software, and an unspecified platform transfer right that does not expire. ended nature of The platform transfer right is unspecified. However, the open- that right means that there is a high likelihood that the product to which Customer would receive a license upon exercise would have more than minimal differences from the X on A software with respect to features, functionality and price. Therefore, the platform transfer right is not an exchange right. ABC concludes that the X on A software license and the unspecified platform transfer right are distinct from each oth er, and therefore separate performance obligations. ABC’s evaluation of whether the unspecified platform transfer right is distinct is consistent with the analysis in Example C320.1. C370 Question Is a sunset clause included in a contract with a customer a promised good or service? If so, is it distinct? Sunset clauses Under the provisions of a sunset clause, a customer is entitled to replace a software product – if the entity discontinues support of the licensed product and has migrated to a new product – provided the customer was current on its right to receive unspecified updates, upgrades and enhancements. Such a -of-life clause. clause is also referred to as an end Under Topic 606, exchange rights that allow customers Interpretive response: to exchange one product for another of the same type, quality, condition and price are not additional promised goods or services in a contract. Therefore, if the sunset clause entitles the customer only to a replacement software product that has no more than minimal differences in price, features and functionality as compared to the licensed product, we expect that a sunset clause will not be considered an additional promise in the contract. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

249 247 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 However, if the replacement product is expected to have more than minimal differences in price, features or functionality when the clause is triggered (or these factors are unknown), the entity needs to consider whether the right is, in-substance: — a contingent return right (i.e. right of return that is contingent upon the end- of-life of the existing product); or — a specified when-and -if available upgrade right. All facts and circumstances need to be considered when determining the accounting for such provisions. Entities that include sunset clauses in their contracts should consider including language specifying that replacement products will have no more than minimal differences in price, features and functionality. Comparison to legacy US GAAP The legacy US GAAP accounting guidance with respect to what constituted an exchange, and how to account for an exchange, is essentially the same as that in Topic 606. If the sunset clause is deemed to provide a specified upgrade right, the accounting effect of that conclusion under Topic 606 differs substantially from the accounting effect of that conclusion under legacy US GAAP (see Question ). C340 er options Custom from ASC 606-10 Excerpt > > Customer Options for A dditional Goods or Services 55- 41 Customer options to acquire additional goods or services for free or at a discount come in many forms, including sales incentives, customer award credits (or points), contract renewal options, or other discount s on future goods or services. contract , an entity grants a 55- 42 If, in a the option to acquire customer performance additional goods or services, that option gives rise to a 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 a discount that is incremental to the range of discounts typically example, 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. 43 If a customer has the option to acquire an additional good or service at a 55- price that would reflect the for that good or service, standalone selling price © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

250 Revenue for software and SaaS 248 : Identify the performance obligations in the contract C. Step 2 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 with the guidance in this Topic only when the customer exercises accordance the option to purchase the additional goods or service s. Topic 606 states that an option for additional goods or services (such as a renewal option) constitutes a separate performance obligation if the option that it would not receive without entering gives the customer a material right into that contract – i.e. the customer effectively pays the entity in advance for the right to acquire future goods or services. Use of the term ‘material right’ means that the right must be material to the cust omer. Materiality is assessed both quantitatively and qualitatively. Therefore, a material right may exist even if it is not quantitatively material – e.g. when a right is qualitatively material because it accumulates such as in the case of airline miles o r hotel points. incremental to Topic 606 further describes a material right as a discount that is the range of discounts typically given for those goods or services to that class of customer in that geographical area or market. In the basis for conclusions, the Boards noted that the existing concept of a significant and incremental discount forms the basis for the principle of a material right that is used to differentiate between an option and a marketing or promotional offer. Therefore, we believe a material right is one that is both significant to the customer and incremental to the range of discounts typically given for those goods or services to that class of customer in the applicable area or market. GAAP below, there are However, as outlined in the comparison to legacy US differences in the application of this concept between legacy US GAAP and [ASU 2014- 09.BC387] Topic 606. 40 Questions C380 – C4 address what constitutes a customer option, and whether a customer option is a performance obligation because it provides the customer with a material right. Other matters with respect to accounting for customer options that are determined to provide the customer with a material – e.g. the allocation of consideration to material rights, and accounting for right the exercise of a material right – are addressed elsewhere in this book. Comparison to legacy US GAAP The evaluation of whether a discount offered on future purchases provides a customer with a material right is similar to (but not the same as) legacy US GAAP, and could lead to different units of accounting than under legacy US GAAP. Under legacy US GAAP, an offer of a discount on future purchases of goods or services was generally separately accounted for if it was significant both: and incremental to — the range of discounts typically given in comparable transactions; and the range of discounts reflected in the pricing of other elements in that — contract. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

251 Revenue for software and SaaS 249 : Identify the performance obligations in the contract C. Step 2 In assessing whether an option gives the customer a material right under 606, the discount on future purchases of goods or services is considered Topic to be a separate performance obligation if that discount 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. The discount offered does not need to be incremental to the discount given for other goods or services in the contract to be a material right, which is different from the requirements in legacy US GAAP. This change could result in the identification of more options as material rights under Topic 606 than under legacy US GAAP. Question C380 If, in a software licensing or a SaaS arrangement, the customer pays the entity a usage (or transaction) based fee, is each usage (or transaction) an ‘optional purchase’ made by the customer? Software licensing arrangements Interpretive response: For software licensing arrangements, the answer is generally no. This is because, in a software licensing arrangement, the nature of the entity’s promise to the customer is to grant the customer a right to use the entity’s software (i.e. a license). Once that right of use is transferred to the Step 5: Recognize revenue when ( Chapter F – customer (see ) the entity or as ), the entity does not have to transfer satisfies a performance obligation additional rights of use (or other goods or services) to the custom er for them to be able to use that right – e.g. process transactions using the software. That the customer will pay for the license based on its usage thereof – e.g. number of transactions processed or sales of the customer’s products that use the entity’s software – rather than a fixed fee, does not change the nature of the arrangement; fundamentally, the promise to the customer is to grant the software license. Once the customer controls its right to use the software, the customer’s subsequent use of that right does not involve the customer , and undertaking a decision to make an additional purchase from the entity therefore each usage is not an optional service. Instead, the usage- based fee is variable consideration related to the transferred software lic ense. SaaS arrangements In a SaaS arrangement, because the SaaS provider continues to perform in i.e. in contrast to the software providing the SaaS throughout the contract – licensing entity that completely satisfies its performance obligation to transfer a the individual facts and circumstances may software license at a point in time – affect the answer to this question. In general, we believe that if the nature of the arrangement is fundamentally for application, a customer’s the entity to provide continuous access to its hosted use of its access to the hosted application does not involve the customer undertaking a decision to make an additional purchase from the entity. Therefore, each usage of the SaaS is not the purchase of an optional service. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

252 Revenue for software and SaaS 250 : Identify the performance obligations in the contract C. Step 2 In contrast, a SaaS arrangement could be structured in a manner similar to service arrangements in which a service provider agrees to perform a many defined task if called upon to do so for a specified fee. For example, a customer may have the right under a contract to upload data to a hosted application and have that application produce one or more reports using that data for a fee specific to that request. The arrangement in that case may involve little more than the promise that if the customer accesses the service via the internet and uploads the data, the hosted application will return the requested report and, in that case, the customer makes an affirmative decision to acquire a report using and pay the required fee. the system Determining the nature of the promise to the customer in a SaaS arrangement may require significant judgment. However, we believe the following factors would typically suggest that the arrangement is one to provide a service of continuous access to a hosted application ( i.e. rather than providing the customer an option to obtain a service – e.g. production of a specific report or processing of a specific transaction – that merely uses software hosted by the entity or a third party engaged by the entity to provide). — The entity maintains significant infrastructure , particularly dedicated infrastructure, to fulfill the terms of the contract. service — The presence of a -level provision anchored to availability of the SaaS. For example, a provision that entitles the customer to service-level credits if system or application availability is less than XX% during the the nature of the promise to the customer is measurement period suggests continuous access to that system or application. — The presence of a significant fixed fee component (regardless of whether up-front it is payable or over time), particularly if that fixed fee is a significant portion of the overall consideration the expects to earn entity from the contract, suggests that the customer ascribes significant value to the availability of the system or application, not just on the ability to obtain specified outputs. A significant fixed fee component may be written in the contract as a guaranteed transaction - or usage-based minimum. Usage of the hosted system or application is outside the control of the — customer. For example, if the arrangement between the entity and the and -as they are initiated in the customer is to process transactions when- customer’s customers system, but the initiate those transactions in the an ‘optional syst em, it implies that each transaction processed is not purchase’ because the customer has no role in deciding whether . This is transactions are initiated in the system. Question C390 Is a provision permitting a customer to obtain copies of a software product subject to additional the customer option guidance or does it describe a usage -based royalty? Interpretive response: A software license is just an example of a promised good or service. Consequently, a provision that permits a customer to obtain (whether characterized as users, seats or additional software licenses otherwise) is subject to the same customer option guidance as any other © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

253 Revenue for software and SaaS 251 C. Step 2 : Identify the performance obligations in the contract provision that permits a customer to obtain additional goods or services that are not licenses. In contrast, as outlined in Question C40, a customer’s usage of a i.e. the license that it already controls is not the exercise of a customer option – customer is not making an ‘optional purchase’. a customer to obtain additional copies Whether a contract provision permitting of a software product is an option to acquire additional software licenses is to provide multiple fundamentally the same question as whether a promise copies of licensed software is a promise to transfer multiple software licenses promise (see Question C40). If a to transfer multiple copies of a software product is considered a promise to transfer multiple software licenses to the customer, a right to acquire those same copies is an option to acquire additional software licenses. Consequently, in determining whether a contract provision describes an option to acquire additional licenses to a software product or a usage- based fee, an entity must determine whether that contract provision, however characterized: — capabilities to describes a right for the customer to acquire incremental make use of the software – for which, by nature, the customer makes an additional purchasing decision when it decides to acquire those incremental ; or rights — merely describes how the customer will compensate the vendor for the it already controls. use of the rights and capabilities that This determination will frequently require judgment because the two types of provisions are often worded similarly in contracts. However, we believe the following are some factors to consider in making this distinction (none of which : should be considered individually determinative) — Whether t he customer is required to execute an additional contract – whether characterized as an addendum, an amendment, or papered as either a modification of the existing contract or a termination of the existing typically contract and creation of a new contract. This suggests an affirmative, additional purchasing decision to acquire incremental rights and capabilities to use the entity’s software that the customer does not already control. A customer would not be expected to enter into an additional contract merely to exercise rights that it already controls under an existing , usage of existing rights of contract . In fact, as outlined in Question C380 . For use is often outside the control of those making purchasing decisions , or may be example, usage may be triggered by the customer’s customers the result of employees far from the procurement process using tools that process transactions, conduct research or they have been provided to produce reports . — Whether t he customer is required to make an affirmative request of the e.g. to deliver additional copies or additional software keys. This vendor – may the customer is making an affirmative decision to request suggest that additional rights or capabilities from the vendor. A customer would not, in contrast, typically enter into a contract that requires such affirmative action from the vendor merely to exercise the ri ghts that it already controls ; any such provision would likely call into question whether the customer actually controls those rights . An right or capability usually exists concurrently with the — incremental existing right(s) that have previously been transferred to the customer. For example, in Example 61B in Topic 606, the customer obtains the © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

254 Revenue for software and SaaS 252 : Identify the performance obligations in the contract C. Step 2 incremental right to embed the entity’s software into another class of its consumer products one year after obtaining the initial right to embed the softwar entity’s e in the first class of consumer products. That right rights under the contract and the customer’s the customer’s increases ability to derive benefit from use of the software. The example concludes that the customer now has rights to embed the vendor’s sof tware into [606- – 10- 399K 55- classes of consumer products rather than only the one. two 55- 399O] For instance, a customer’s utilization of software may be directly linked to the number of users or seats the customer has rights to deploy. If that customer has the right to increase from 50 user or seat licenses to 75 user or seat licenses, it has the present right (at its option) to significantly increase its capabilities from use of the software. Those incremental capabilities from the additional 25 user or seat licenses will exist together with the capabilities from the original 50 user or seat licenses. In contrast, usage typically occurs and is consumed – e.g. a transaction is processed, a call is fielded or a product is sold that includes the embedded software. One ‘usage’ is not additive to another. — An incremental right, once obtained, will frequently be granted for the remainder of the term of the original right(s) of use and/or have to be cancelled. For example, a customer that decides to add 100 user licenses may have a continuing obligation to pay for those additional licenses (e.g. additional periodic license fees and/or PCS fees) until it elects to terminate those rights. Termination includes not electing to renew; Topic 606 does not distinguish between decisions to renew and decisions not to terminate, [ASU 2014- 09.BC391] or vice versa. In contrast, usage typically occurs and resets each measurement period – i.e. the usage occurs and ends on its own. For example, while an entity might expect a customer to process at least a minimum number of transactions during a given measurement period, those transactions occur -based transactions that trigger additional usage new and end, and it is only fees to the entity in the next measurement period. son to legacy US GAAP Compari The requirement to account for a significant incremental discount on additional licenses of a software product for which one or more licenses have already been transferred to the customer is a change from the legacy US GAAP. Legacy US GAAP provided an exception to its guidance on accounting for significant incremental discounts as additional elements to a software arrangement for discounts offered on additional copies of software products for which the delivered to the customer. product master had already been With respect to identifying contract provisions as options to acquire additional based fees, in general, the distinction was not important licenses or as usage- under legacy US GAAP. Because legacy US GAAP provided the above ption, the accounting that would result from either conclusion (i.e. that a exce based fee) provision was an option to acquire additional licenses or a usage- © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

255 Revenue for software and SaaS 253 : Identify the performance obligations in the contract C. Step 2 based fees when the was the same. Entities generally recognized usage- customer’s subsequent usage occurred and recognized revenue from customer options when the option was exercised (assuming no additional deliveries of software were required). Consequently, there was little guidance in legacy US GAAP, or developed interpretively, distinguishing between options and usage- based fees. That being based fees were said, Subtopic 985- 605- 55 included guidance that usage- determined by applying a constant multiplier to the frequency that the licensee e.g. customer call center software wherein a fee of $.01 is used the software – charged for each call handled. Under Topic 606, the distinction between options and usage- based fees matters: — an option to acquire additional software licenses may provide the customer with a material right; — usage-based fees associated with software licenses will, consistent with legacy US GAAP, generally be recognized when the customer’s usage or usage-based royalties guidance for licenses of occurs (due to the sale- intellectual property Step 5: Recognize revenue when (or – Chapter F – see ). as) the entity satisfies a performance obligation Topic 606 does not define a ‘usage- based fee’. Therefore, judgment is necessary to distinguish between customer options to acquire additional based fee provisions. software licenses and usage- Example C390.1 Option to acquire additional licenses versus usage -based fee Software Vendor S enters into a contract with Customer T to license its on- premise software used to route customer service tickets to the appropriate rtments and locations for four years. Under the contract, 50 concurrent depa users are permitted to use the software. With 50 concurrent users, Customer T can route approximately 100,000 tickets each week. t fee of $500,000 and will Per the contract, Customer T will pay a fixed, up- fron also pay $0.50 per ticket routed using the software. The contract permits Customer T to increase its concurrent user maximum for the duration of the license period in blocks of five concurrent users at a rate of $4,000 per block. That $4,000 rate decreases throughout the license period in proportion to how much of the license period remains at the time concurrent users are added – e.g. the fixed, incremental fee for a five- user ‘block’ when there are two years remaining in the license period would be $2,000. The per ticket fee of $0.50 applies to all tickets routed using Software Vendor S’s software, regardless of how many concurrent users are presently permitted to use the software. Software Vendor S concludes that: the provision permitting Customer T to add concurrent users is a customer — option to acquire additional licenses to Software Vendor S’s software; and © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

256 254 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 based royalty that links the contract the $0.50 per ticket fee is a usage- — consideration to the customer’s use of the license rights it has transferred initially. Customer T already controls the right, upon transfer of the original 50 concurrent user rights, to process up to 100,000 tickets per week. There are no further rights for Software Vendor S to transfer to Customer T, and it is not an optional purchase by Customer T, reflective of an additional purchasing decision, to exercise the rights it already controls. In contrast, the addition of concurrent users increases Customer T’s ability to derive benefit from use of the software by increasing its capability to route customer service tickets on a basis proportional to the incremental user rights it obtains; those increased rights are additive to and exist concurrently with those it already controls. The addition of concurrent users therefore represents the acquisition of additional licenses to use Software Vendor S’s software, which Customer T undertakes an additional purchasing decision to acquire. Example C390.2 User -based provision that is a usage -base d fee Software Entity R enters into a three -year software licensing arrangement with Customer W for its research application whereby Customer W will pay Software Entity R a fixed up -front fee of $10,000 plus a $50 fee for each user that logs into the application each month. If a user logs into the system each of the 36 months of the arrangement, Customer W will owe Software Entity R $1,800 for that user, on top of the front. All users require a unique username and fixed license fee paid up- password, and Software Entity R has various audit rights to help ensure all users are registering. Software Entity R concludes that the user -based fee is a usage- based royalty, rather than a customer option to acquire incremental rights (beyond those transferred at contract inception) to use the research software. Software Entity R considers the following in making this judgment. A Customer W employee does not have to obtain anything from Software — Entity R to use the software. It can create a username and password and use the software under that username and password without notifying or contacting Software Entity R. — Customer W does not execute an additional contract with Software Entity R when one of its employees creates an account or uses the research software. — A use r’s usage in a given month, which triggers the user -based fee, does not create an ongoing obligation for the remainder of the license term or require an affirmative action to cancel. Rather, it resets each month. For example, if User #1 uses the research software in Month 1 of the arrangement and never uses it again, Customer W will only owe the $50 -based fee for User #1 for Month 1. user A user’s use of the system does not create an incremental right that — to Customer W in the way increases the overall capabilities of the software © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

257 Revenue for software and SaaS 255 C. Step 2 : Identify the performance obligations in the contract it did in Example 390.1. The rights that Customer W controls for its employees to use Software Entity R’s research software are not different in a month in which 100 Customer W employees use the software versus a or 500 Customer W employees use the software. month in which 10 C390.3 Example Metric -based provision Software Entity Q enters into a perpetual software licensing arrangement with Customer G for its accounting application. Customer G’s license fee is initially determined based on its annual revenues. At contract inception, the fee (to be $100,000 is based on annual revenues of $100 million. paid up-front) of If Customer G’s annual revenues increase beyond defined thresholds, Customer G will pay additional license fees. For example, Customer G will owe an additional license fee if its annual revenues surpass $125 million, a further fee if they then surpass $150 million, etc. Software Entity Q concludes that the revenue- based fee provision does not represent a customer option to acquire additional licenses. This is because while Customer G is likely to make greater use of Software Entity Q’s software as it grows (evidenced by its increasing revenues), at the point in time the license is transferred to Customer G, Customer’s G license is already capable of company. supporting Customer G as a $125 million or $150 million Therefore, the additional fee does not represent an option for Customer G to acquire additional rights and capabilities that it does not control when the initial license is transferred. Rather, the revenue- based fee provision represents an additional fee based on Customer G’s usage – based on a revenue metric rather than a direct measure of usage such as transactions processed – of those rights and capabilities. Question C400 Is a provision permitting a customer to add users (or a SaaS subscription subject to the seats) to customer option guidance or does it describe a -based royalty? usage In general, we believe determining whether a provision Interpretive response: permitting the customer to add users or seats to a SaaS subscription desc ribes a customer option or a usage- based fee involves fundamentally the same considerations as outlined in Question C390 for determining whether a right to acquire additional copies of licensed software (whether characterized as copies, users, seats, etc.) constitutes a customer option or a usage- based fee. For example, we do not believe the evaluation in any of the examples in C390 would differ if the arrangement were a SaaS arrangement rather Question than a software licensing arrangement. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

258 Revenue for software and SaaS 256 : Identify the performance obligations in the contract C. Step 2 0 C41 Question Are renewal options for services promised goods or services in a contract? Interpretive response: A renewal option for services (e.g. SaaS, PCS or hosting services in a software licensing arrangement) gives a customer the right to acquire additional goods or services of the same type as those supplied under an existing contract. It does not create enforceable rights and obligations for the parties, and therefore a renewal option does not represent a promised service in the contract. Furthermore, as described in the basis for conclusions to ASU 2014- 09, a three- year contract that allows the customer to cancel at the end of each year is no different from a one- year contract with two one- year renewal options – there is not a substantive termination penalty the customer must pay provided s an option to cancel. If a customer must pay a substantive if it elect termination penalty to cancel a service contract, the contracted service period includes all of the periods for which, if the customer cancelled the service, the termination penalty would apply. This issue is addressed in further detail in 09.BC391] 2014- [ASU – Step 1: Identify the contract with the customer . Chapter B However, a renewal option (or an option to continue a service contract by not terminating) does create an additional performance obligation in a contract if it provides the customer with a material right that it could not otherwise obtain provide the without entering into the contract. A renewal option that does not iginal customer with a material right is not accounted for as part of the or contract; rather, it is treated as a new contract when it is exercised by the provides the customer with a material right customer. A renewal option usually if the renewal price for the services is lower than the price for the same services the enti ty offers to similarly situated customers that have not entered . into a contract with the entity previously A renewal price may be discounted either explicitly or implicitly. A renewal price is discounted explicitly when there is a stated renewal price in the contract that is lower than the price for the same services that the entity offers to similarly situated customers that have not entered into a contract with the entity previously. An implicit discount might arise when the customer fee in connection with the initial services pays a nonrefundable up- front contract that it does not have to pay again in order to renew the service; for example, a fee that is not a payment for a promised service, such as implementation services. An entity considers both quantitative and qualitative factors when assessing whether a nonrefundable up- fee provides the customer with a material front right, because it would likely affect the customer’s decision about whether to exercise the option to continue buying the entity’s service. This is consistent with the notion that an entity considers reasonable expectations of the customer when identifying promised goods or services. Therefore, a customer’s perspective on what constitutes a ‘material right’ includes consideration of qualitative factors as well as quantitative factors. Some have questioned whether an entity considers the renewal option price as ices at contract compared to the stand- alone selling price for the goods or serv to an expected renewal price at the end of the contracted , instead, inception or © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

259 257 Revenue for software and SaaS : Identify the performance obligations in the contract C. Step 2 service period. In general, we do not believe a renewal option priced at the contract inception stand- alone selling price of the service provides a material right to the customer. This is because, even though this may not occur frequently, the customer could exercise the option immediately after contract We do not believe an entity is required to forecast what the stand- inception. alone selling price for a good or service will be in the future and, in any event, believe that any such forecast would be potentially unreliable given that economic circumstances could change significantly or new competition could enter the marketplace that render any previous expectations obsolete. Example C410.1 SaaS renewal option Scenario 1: Option to renew is a material right SaaS Provider A enters into a contract with Customer D to provide D access to its payroll processing software through a SaaS arrangement. Customer D can based interface, but cannot download the use the software through a web- software for use offline. Customer D pays the contracted SaaS fees on a quarterly basis, in advance. D The arrangement is for one year, for a contracted rate of $1,200. Customer year periods at SaaS Provider A’s can renew the contract for additional one- then-current market rate for similar customers. refundable up- front fee to SaaS Customer D is required to pay a $200 non- Provider A at contract inception, but will not have to make that payment again if it renews the contract for additional one -year periods. The $200 fee is not a payment for an additional good or service (i.e. in addition to the SaaS). Th is is because, while SaaS Provider A undertakes activities to set up the customer’s access to the software application, those activities do not provide any incremental benefit to the customer. They are merely necessary for Customer D to be able to access the SaaS promised in the contract. As a result, in substance, the fee for the contracted one- year period of service , which is the only promised good or service in the contract, is $1,400. ovides SaaS Provider A concludes that the option to renew the arrangement pr Customer D with a material right. In reaching this conclusion, SaaS Provider A considers that there are factors other than payment of the up- front fee that will likely influence Customer D’s od – e.g. decision to renew the arrangement after the one- year peri consideration of costs incurred by Customer D to migrate data to the SaaS solution or train HR employees, SaaS Provider A’s performance and customer service and the availability/cost of suitable alternatives. However, the up- front fee of $200 is quantitatively material enough to the contracted SaaS fee of front provides a material right to $1,200 such that payment of that amount up- Customer D compared to other similar customers that are not currently pay that $200 fee to obtain customers of SaaS Provider A that would have to access to the SaaS. That investment would be expected to affect the customer’s decision about whether to renew the arrangement independent of the other factors that would also typically influence Customer A’s renewal decision. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

260 Revenue for software and SaaS 258 C. Step 2 : Identify the performance obligations in the contract a material right (1) not Scenario 2: Option to renew is Assume the same facts and circumstances as Scenario 1 except that the committed contract term is three years, rather than one year. Therefore, the contracted fee is $3,800. SaaS Provider A concludes that the payment of the $200 up- front fee does not provide Customer D with a material right with respect to renewal of the SaaS – i.e. the ability to renew the contract after three years without having to pay a second up- front fee is not a material right. In reaching this conclusion, SaaS Provider A considers the effective annual SaaS year contract of $1,267 ($3,800 ÷ 3 years) versus the fee for the initial three- annual renewal price of $1,200. It concludes that that difference, and payment of the up fee three years ago, are not likely to significantly affect Customer D’s -front decision to renew the SaaS. term nature of the initial SaaS period, other factors are more Given the long- likely to significantly influence Customer D’s decision to renew the SaaS. These factors include the costs Customer D would incur to transition to another alternative, the availability/cost of a suitable alternative and SaaS Provider A’s performance under the initial arrangement (e.g. service uptime versus downtime and performance in providing technical support). a material right (2) Scenario 3: Option to renew is not Assume the same facts and circumstances as Scenario 1, except that there is no up-front fee and Customer D has the option to renew the SaaS at a price of $1,200, consistent with the fee for the committed one -year term. alone selling The price of $1,200 for the renewal period represents the stand- price of the SaaS at contract inception, but is likely to be less than the renewal date stand-alone selling price to a new, similar customer. This is because SaaS year contract pricing by approximately Provider A has been increasing its one- 5% each year over the last seven years; and expects to continue to do so, because its market share and reputation has grown in the marketplace and in order to keep its fees paced with inflation and other increasing costs. The option in this scenario does not provide Customer D with a material right. to increase expected Even though the stand- alone selling price of the SaaS is during the term of the arrangement based on historical pricing changes and current plans of SaaS Provider A management, Customer D could elect to exercise the renewal option immediately after contract inception. At that point, the renewal price is the same as the stand-a lone selling price of the SaaS. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

261 Revenue for software and SaaS 259 C. Step 2 : Identify the performance obligations in the contract Question C420 When assessing the amount of an incremental discount offered to a customer, should the entity look to the high -end of any “range of discounts typically given for those goods or services to that ‘class of cus tomer’ in that geographical area or , to the midpoint of that range or the market” median, or some other amount such as the mean? Interpretive response: We believe entities should adopt a reasonable approach and apply that approach on a consistent basis. Depending on the circumstances, any of those might be a reasonable approach to determine the incremental discount of a customer option. Question C430 How should an entity evaluate if an option provides the customer with a material right when the stand - a lone selling price of the good or service subject to the option is highly variable or uncertain? Interpretive response: Determining if a material right exists for options to purchase licenses of IP or other products for which the stand- alone selling price is highly variable or uncertain may require significant judgment. This is because stand a -alone selling price (or even a a comparison of the option price to alone selling prices) is not possible. relatively narrow range of stand- Entities need to consider all relevant and available evidence in determining whether the purchase option is a material right in these circumstances, and we believe that there may be multiple, acceptable approaches to undertaking this evaluation. — One example of an approach we believe is acceptable is to analyze the option price against a range of stand- alone selling prices for that good or service established in previous contracts . This is even if those stand- alone uding where selling prices were established using a residual approach (incl residual bundle’ that license was part of a ‘ of goods or services). — Another approach we believe is acceptable is to evaluate whether the purchase option provides a discount to the customer that is incremental to the range of discounts reflected in the pricing of the other promised goods and services in the contract (e.g. discounts from list price offered on the promised goods or services in the contract) . The implementation guidance in Topic 606 does not contain the notion that existed in legac y US GAAP that a ‘more -than-insignificant discount’ must be ‘incremental to the range of discounts reflected in the pricing of the other elements of the arrangement’. Therefore, we do not believe the range of promised goods or services in the discounts reflected in the pricing of the other contract should influence the determination of whether an option provides the alone selling price of the customer with a material right when the stand- except good or service that is the subject of the option is highly variable or uncertain. I n © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

262 Revenue for software and SaaS 260 : Identify the performance obligations in the contract C. Step 2 that circumstance, we believe consideration of the pricing of the limited promised goods and services in the contract is a reasonable approach because a comparison to the stand- alone selling price of the good or service (as per the stand-alone selling because -43) would be meaningless 10-55 raph 606- parag price is highly variable or uncertain. In any approach where the entity’s established list prices are a data point expect the entity’s established list (including the above examples), we would prices to be substantive. This means that changes to the price list must be subject to the entity’s effective internal controls (including who can authorize its updating) and there is a systematic process for any triggers resulting in adju stments to the price list. Whatever approach an entity adopts to make this judgmental evaluation, we expect it to be applied consistently in similar circumstances. C430.1 Example Evaluating whether an option for a good or service stand- alone selling price with a highly variable grants a material right to the customer ABC Corp. sells a software license for Product A along with technical support and rights to when- and- if available updates/upgrades (i.e. PCS) for one year to Customer XYZ. The contract also includes an option to purchase a license for Product B at a 65% discount from the published list price of $1,000,000 (i.e. for $350,000). The contract price for the license to Product A and the related PCS (which is based on a percentage of the stated license fee) are discounted 50% from the entity’s price list. ABC’s price list is substantive and well controlled. Product B has been licensed to 25 similar customers in the United States within the last few months, always bundled with technical support and unspecified alone selling price for its update/upgrade rights. ABC has an observable stand- technical support and unspecified update/upgrade rights (as a PCS bundle), but has determined that the stand- alone selling price for a license to Product B is highly variable. Therefore, ABC has used the residual approach to estimate the -alone selling price for Product B in each of its 25 previous contracts that stand included a license to Product B. Alternative 1 ABC compares the discount offered on the license t o Product B in its 25 previous license sales, calculated as the difference between the estimated stand -alone selling prices established through the residual approach and the then-current list price to the discount from the current list price being offered to XYZ. From this process, ABC determines that the normal range of discounts it has previously provided from the list price on licenses of Product B is 30% to 50%. Therefore, the 65% discount being offered from list price on the option to license Product B provides Customer XYZ with a material right. This is because it is incremental to the range of discounts (30% to 50%) previously provided for Product B to similar customers. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

263 Revenue for software and SaaS 261 : Identify the performance obligations in the contract C. Step 2 2 Alternative ABC compares the discount from list price offered on the license to Product B of 65% to the 50% discount from list price provided in the same contract with XYZ on the license to Product A and related PCS. As a result, ABC concludes that the incremental discount (i.e. 15%) on the option to purchase a license to Product B provides XYZ with a material right. ABC will estimate the stand- alone -55 10 selling price of the option based on the guidance in paragraphs 606- -44 – 55-45. Note: If the discount from list price offered on the license to Product B was 50% (or less), ABC would have concluded that the option to purchase a license to Product B did not provide Customer XYZ with a material right. Question C4 40 Does a customer option to convert a term softwar e license into a perpetual license represent an additional promised good or service in the contract? A customer option to convert a term software license Interpretive response: into a perpetual license represents an additional promised good or service in the only contract if the option provides the customer with a material right. In that case, the material right is an additional performance obligation in the contract. A perpetual license to a software product is a different good from a term license to the same software product. Consequently, an option to acquire a perpetual license to a software product already subject to a term license is, fundamentally, no different from an option to acquire a perpetual license to a different software product not already subject to a term license. Question C4 30 discusses how an entity should evaluate whether an option to acquire a software license with a highly variable or uncertain stand- alone selling selling price alone price provides the customer with a material right. If the stand- for the perpetual license is highly variable or uncertain, the considerations not about whether the option provides a material right to the customer are no different from any customer option to acquire any other good or service. If the customer exercises its option to convert a term license to a perpetual license, and that perpetual license is distinct – i.e. the option is not exercised together with services that are not distinct from that license, such as services the fee attributable to the perpetual to customize the licensed software – license cannot be recognized until after the end of the current term license period. For example, if the customer currently has a three- year license expiring on December 31, Year 7, and exercises its perpetual conversion option on June 30, Year 7, the entity cannot recognize revenue from the exercise of that option before January 1, Year 8. We believe that this is consistent with the guidance in Topic 606 that if the customer exercises an option to renew a term license, the entity cannot recognize revenue from that renewal until the beginning of the renewal period Step 5: Recognize revenue when ( or as ) the entity satisfies a (see Chapter F – ). The equivalent notion for the exercise of a perpetual performance obligation © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

264 Revenue for software and SaaS 262 : Identify the performance obligations in the contract C. Step 2 conversion option is to recognize that revenue no earlier than after the end of the current term license period when, in effect, the perpetual renewal commences. Consistent with any other software license, the entity will also need to consider the other guidance in Topic 606 when determining the point in time to recognize the perpetual license – e.g. whether the entity has to provide another copy of the software because the copy of the software delivered for the term license contains a self -destruct or similar mechanism to allow the entity to control the usage of its software. However, we expect that typically the commencement of the perpetual license period will be the ‘limiting factor’ that 58B 55- 10- 58C] – 55- [606- will trigger revenue recognition. Comparison to legacy US GAAP from the accounting under Topic 606 in two Legacy US GAAP is different respects. — Legacy US GAAP concluded that the perpetual conversion option was not of the arrangement, even if it was being offered at a an additional element significant and incremental discount. Therefore, there are perpetual conversion options that may be accounted for as performance obligations under Topic 606 (i.e. if they provide the customer with a ma terial right) that are not accounted for as additional arrangement elements under legacy US GAAP. — Neither Topic 606 nor legacy US GAAP would permit recognition of any fee for the perpetual license to be recognized before any additional (or new) copy of the software that is necessary to extend the term license perpetually is provided. However, legacy US GAAP recognized the option fee when that software was delivered (or at the option exercise date if no additional software delivery was required). This is likely earlier than when Topic 606 will permit recognition, which is not until after the then- current term license expires. KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member © 2018 . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

265 Revenue for software and SaaS 263 D. Step 3 : Determine the transaction price D. S tep 3: D etermine the transaction price Questions and Examples New item added to this chapter: ** Transaction price Q&A D10 Should an entity present out -of-pocket costs and related customer reimbursements on a gross basis (i.e. the customer reimbursement as additional transaction price and the out -of- pocket costs as costs of revenue or operating expenses) or a net basis? Example D10.1: Reimbursable and pass -through costs (comprehensive example) Q&A D20 -front fees included in the transaction Are nonrefundable up price for a contract w ith a customer? Variable consideration Q&A D30 Can management simply use its ‘best estimate’ when estimating variable consideration? What should a software entity consider in deciding whether it Q&A D40 has a sufficient number of similar contracts to use the expected value method for estimating variable consideration? Q&A D50 When estimating the expected value or when applying the most likely amount method, does an entity need to consider all possible outcomes? Is an entity required to use a single method to estimate the Q&A D60 transaction price consistently for all variable payment terms in the same contract? Q&A D70 Once an entity has elected to apply either the ‘most likely amount’ method or the ‘expected value’ method for estimating a variable consideration element, is the selected method applied consistently throughout the course of the contract? Q&A D80 Is an entity required to apply the same method of estimating variable consideration to all similar variable fee terms within a portfolio of contracts with customers? Is using relevant information from a portfolio of similar Q&A D90 contracts to estimate variable consideration the same as applying the portfolio approach practical expedient? Q&A D100 Does denomination in a currency other than the entity’s functional currency mean the contract includes variable consideration? © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

266 264 Revenue for software and SaaS : Determine the transaction price D. Step 3 Q&A D110 Does the transaction price in a contract with variable consideration have to equal a possible outcome of the contract? Example D110.1: Transaction price is not a possible outcome of the contract Q&A D120 Should variable consideration be included in the transaction price when the entity believes it is unlikely to earn the variable consideration? Q&A D13 0 How does a pattern of granting price concessions to customers affect the transaction price? Example D130.1: Pattern of granting price concessions and estim ating the transaction price Q&A D140 How do customer price protection (i.e. retroactive most -favored nations) clauses affect the transaction price? Example D Reseller arrangement and price protection 140.1: capped by the contract Q&A D150 Do extended payment terms create variable consideration in a contract with a customer? Example D150.1: Extended payment terms Q&A D160 How should prompt payment discounts be considered when determining the transaction price of a contract? Q&A D170 How do service level agreements (SLAs) that could result in refunds or credits to the customer affect the transaction price? Example D170.1: Service level agreements Q&A D180 What factors influence the potential magnitude of a revenue reversal that would result from a downward adjustment to an entity’s estimate of variable consideration? Effect of various scenarios on the potential Example D180.1: magnitude of a revenue reversal Q&A D190 Are subsequent sales or usage of licensed software variable consideration or is each subsequent sale or usage an ‘optional purchase’? Is the contractual right to acquire additional users, seats or Q&A D200 - or usage-based fee (i.e. variable copies of software a sales consideration) or a customer option to acquire additional software licenses? Are SaaS providers required to estimate transaction- Q&A based fees D210 that will be earned from customers in SaaS arrangements? Q&A D220 How do volume- based discounts and rebates affect the estimation of the transaction price in SaaS arrangements? © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

267 265 Revenue for software and SaaS D. Step 3 : Determine the transaction price The existence of a significant financing component in the contract Illustrative Example D1: Time value of money in a single performance obligation arrangement Illustrative Example D2: Time value of money in a multiple- element arrangement Determining whether an arrangement Illustrative Example D3: has a significant financing component – Payment in advance Illustrative Example D4: Determining whether an arrangement has a significant financing component – Payment in arrears Is the assessment of whether a financing component is D230 Q&A o a contract a quantitative or qualitative ‘significant’ t assessment? Q&A Does an entity need to evaluate whether there is a significant D240 financing component in a long- term contract that transfers a software license to the customer at a point in time for which the consideration is a sales - or usage-based royalty? D250 Do extended payment terms result in a significant financing Q&A component? D260 What is the accounting if an entity applies the 12- month Q&A practical expedient not to account for a significant financing component but subsequently changes its expectation that customer payment and/or its performance will not occur within 12 months? Q&A D270 Is the transaction price of a software contract with a customer with standard payment terms affected when the customer obtains financing from a third party unrelated to the software entity? D280 Q&A Is the transaction price of a software contract with a customer with standard (i.e. non -extended) payment terms affected where the software entity participates in the customer’s financing? Q&A D290 Does a prepayment in advance of scheduled payments result in a change to the transaction pr ice for a contract that contains a significant financing component? Q&A -year contract with annual prepayments qualify for D300 Does a multi the practical expedient? Q&A D310 Does a contract with a payment that is due more than one year before, or one year after, delivery of the related goods or services qualify for the practical expedient? Application of the practical expedient Example D310.1: Q&A For contracts with multiple performance obligations, how D320 should payments be allocated to the performance obligations for purposes of determining whether a significant financing © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

268 Revenue for software and SaaS 266 D. Step 3 : Determine the transaction price component exists or whether the practical expedient is applicable? Allocation of customer payments Example D320.1: D330 Q&A When determining whether a financing component is significant to the contract, can an entity exclude the effect of payments made within 12 months from the transfer of the related goods or services? Calculation of the financing component Example D330.1: D335 Q&A Can a significant financing component exist because of a material right? ** Q&A Under what circumstances, if any, would an entity use a D340 -specific? discount rate that is not entity - or customer Noncash consideration Consideration payable to a customer Payments to customers – Illustrative Example D5: Variable consideration Q&A D Are payments to customers in the form of equity, rather than 350 cash, considered ‘consideration payable to a customer’? ** © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

269 Revenue for software and SaaS 267 : Determine the transaction price D. Step 3 5 Step 4 Step 3 Step 2 Step 1 Step Allocate the Identify Determine Recognize Identify the transaction performance transaction revenue contract obligations price price This chapter is organized into five sections: Transaction price — — Variable consideration — The existence of a significant financing component in the contract Noncash consideration — Consideration — payable to a customer Transaction price from ASC 606-10 Excerpt 1 When (or as) a performance obligation is satisfied, an entity shall 32- recognize as revenue the amount of the transaction price (which excludes estimates of variable consideration that are constrained in accordance with paragraphs 606 -10 -32 -11 through 32 -13) that is allocated to that performance obligation. > Determining the Transaction Price 32- 2 An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both. 32- 2A An entity may make an accounting policy election to exclude from the measurement of the transaction price all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue- producing transaction and collected by the entity from a customer (for example, sales, use, value added, and some excise taxes). Taxes assessed on an entity’s total gross receipts or imposed during the inventory procurement process shall be excluded from the scope of the election. An entity that makes this election shall exclude from the transaction price all taxes in the scope of the election and shall comply with the applicable accounting policy guidance, including the disclosure requirements in paragraphs 235- 10- 50- 1 through 50- 6. 32-3 The nature, timing, and amount of consideration promised by a customer affect the estimate of the transaction price. When determining the transaction price, an entity shall consider the effects of all of the following: a. 10 and 606- Variable consideration (see paragraphs 606-10 -32 -5 through 32- 14) - 10 32 - © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

270 Revenue for software and SaaS 268 : Determine the transaction price D. Step 3 Constraining estimates of variable consideration (see paragraphs 606 - 10 - b. 32-11 through 32-13) The existence of a significant financing component in the contract (see c. paragraphs 606- -32 -15 through 32- 20 ) 10 24) 32-21 through 32- d. Noncash consideration (see paragraphs 606- 10- - Consideration payable to a customer (see paragraphs 606- 10-32 e. 25 through 32-27). For the purpose of determining the transaction price, an entity shall 32-4 assume that the goods or services will be transferred to the customer as promised in accordance with the existing contract and that the contract will not be cancelled, renewed, or modified. n entity The transaction price is the amount of consideration to which a expects to be entitled in exchange for transferring goods or services, excluding amounts collected on behalf of third parties. To determine the transaction price, a n entity considers the terms of the contract; its customary business practices; and the eff ects of variable consideration, the constraint on variable consideration, the time value of money, noncash consideration, and consideration payable to the customer. Transaction price ) (and the constraint Variable consideration Significant financing component An entity estimates the amount of variable For contracts with a significant financing , consideration to which it expects to be entitled , an entity adjusts the promised amount component giving consideration to the risk of revenue reversal of consideration to reflect the time value of money in making the estimate Noncash consideration Consideration payable to a customer Noncash consideration is measured at fair value , if An entity needs to determine whether consideration , an entity that can be reasonably estimated ; if not payable to a customer represents a reduction of the -alone selling price of the good or uses the stand transaction price , a payment for a distinct good or service that was promised in exchange for noncash ser vice , or a combination of the two consideration The transaction price does not include the effects of a customer’s credit risk, except for contracts that contain a significant financing component (whereby the discount rate is credit Rather, credit risk affects whether a -adjusted). contract with a customer exists. In general, the transaction price includes an entity’s estimate of variable consideration. However, a n entity will generally not be required to make such an estimate for either: — variable consideration arising from sales- or usage -based royalties promised licenses of intellectual proper in exchange for ty – s ee Chapter F – Step 5: Recognize r evenue when (or as) the entity satisfies a performance obligation ; or — variable consideration that will be recognized in the period in which it is earned based on the variable consideration allocation guidance in Chapter E – Step 4: Allocate the transaction See paragraph 606- 10-32 -40 – price to the performance obligations in the contract . © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

271 269 Revenue for software and SaaS D. Step 3 : Determine the transaction price When determining the transaction price, an entity assum es that the goods or services will be transferred to the customer based on the terms of the existing contract and does not take into consideration the possibility of a contract being cancelled, renewed or modified. The transaction price includes only amounts (including variable consideration, consideration) to which the entity has rights subject to the constraint on variable . For example, the transaction price does not include under the present contract estimates of consideration from (a) the future exercise of options for additional goods or services or (b) future change orders until the customer exercises its option or a pproves a change order because the entity does not have a present 09.BC186] [ASU 2014- right to that consideration. The transaction price does not include amounts collected on behalf of third parties (e.g. sales taxes collected by the entity for which it is not the primary obligor to the taxing authority or sales taxes when the entity has elected the – see the US GAAP practical expedient to report sales taxes on a net basis , or payments the entity collects for goods or services following paragraph) provided to the customer by third parties when the entity is acting as an agent with respect to those goods or services. Judgment will be required in some collected cases to determine whether a payment from a customer is an amount on behalf of a third party or an element of the transaction price. present with respect to The FASB recognized the challenge this judgment can some forms of taxes , Topic 606 permits entities to make an . Consequently accounting policy election to exclude all sales taxes and other similar taxes (sales, use, value added and some excise taxes that are imposed on and concurrent with a specific revenue -producing transaction and collected by the entity from a customer) from the measurement of the transaction price. That is, it permits the entity to present all collections from customers for these taxes on a net basis, rather than having to assess whether the entity is acting as an agent with respect to these taxes in each jurisdiction. Question D10 Should an entity present out -of-pocket costs and related customer reimbursements on a gross basis (i.e. the customer reimbursement as additional transaction price and the out -of-pocket costs as costs of revenue or operating expenses) or a net basis? Int erpretive response: It depends on whether the out -of-pocket costs are the entity’s costs (i.e. because it is receiving the good or service from the third party), or the customer’s costs (i.e. because the customer is the party receiving the good or service from the third party) for which the entity is merely collecting payment in its role as an agent to the customer or the third party . Entities performing services for customers (including services in which the -of-pocket costs as part of entity’s role is that of an agent) often incur out delivering that service, such as travel and lodging. This is frequently the case when software entities provide professional services (e.g. implementation services -as-a- or software and training) in connection with software licensing © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

272 Revenue for software and SaaS 270 : Determine the transaction price D. Step 3 SaaS ) arrangements . In these situations, the entity’s engineers or service ( consultants incur such costs in fulfilling the entity’s performance obligation to provide the profess ional services to the customer . Customers fre quently agree to reimburse the out -of-pocket costs, often subject to restrictions such as imposing a ceiling on total reimbursements or requiring the entity to follow specific policies (e.g. the customer’s expense reimbursement policies) or use the customer’s preferred airline or hotel vendor(s). Regardless of whether a customer imposes restrictions or limits on its reimbursement of out -of-pocket costs, t ypical out -of-pocket costs (e.g. travel, meals, lodging) a nd the reimbursements thereof from the customer should be presented on a gross basis. This is because the goods or services (e.g. the transportation, the meal served or lodging provided to the entity’s employee) giving rise to the out -of-pocket costs do not transfer a good or service to the customer. Rather, the good or serv ice is used or consumed by the entity in fulfilling its performance obligation to the customer. Therefore, the out -of- pocket cost is the entity’s cost rather than the customer ’s. The costs, while reimbursable, should be accounted for in the same manner as any other , the ). Meanwhile osts Contract c – fulfillment costs (see Chapter H reimbursements are variable consideration, subject to the same accounting ideration. guidance as any other variable cons Customer reimbursements of the entity’s out -of-pocket costs should be distinguished from situations in which the entity is being reimbursed for ’ costs the entity has paid ‘ on behalf of the customer ‘customer ’ to a third party. For example, an agent may, as part of providing a service of arranging for a third party to provide a specified good or service (e.g. SaaS or cloud -based storage) , remit payment to the third party (i.e. the principal) for the specified good or service and then obtain reimbursement for that payment from the customer at a later date. In that case, because the payment to the third party is payment for the customer’s cost (rather than the entity’s cost), the reimbursement is not part of the transaction price of the entity’s contract with its customer. Consequently, the customer payments reimbursement is presented net of the made to the third- party principal . 0.1 Example D1 Reimbursable and pass -through costs (comprehensive example) ABC Corp. enters into a contract with Customer to provide SaaS and certain implementation services (e.g. some training and basic interfacing). Assume the SaaS and the implementation services are distinct from each other (see Question C280) and both are performance obligations satisfied over time (see F190). ABC also arranges for a third -party vendor to provide Questions F130 and data conversion and migration services to Customer that ABC does not provide to any of its customers. Customer enters into a contract for those data conversion and migration services directly with the third- party service vendor, party vendor. ABC which designates ABC as an authorized agent of the third- does not control the services before they are provided to Customer by the third party and, therefore, is an agent with respect to the services. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

273 Revenue for software and SaaS 271 : Determine the transaction price D. Step 3 Under the terms of the contract between ABC and Customer, Customer will reimburse ABC for any out -of-pocket costs incurred in performing the implementation services (e.g. ABC personnel travel- related costs to Customer’s location or the printing and shipping of training- related materials). The contracts, together, stipulate that Customer will remit payment for both the ABC -provided SaaS and the third- party -provided data conversion and migration services to ABC, who will then remit the agreed payment to the third- party vendor net of the commission to which it is entitled under its contract with the third- party vendor (i.e. ABC receives 5% of the contract price between Customer and the third party). The contract price for the SaaS and the implementation services is $100,000; the contract price for the third -party services is $10,000 (5% of which is $500). The stand- alone selling prices for the SaaS and the implementation services are $85,000 and $25,000, respectively. -party services Third The payment made to ABC for the third -party data conversion and migration services is not part of the transaction price of the contract between ABC and Customer. Consistent with paragraph 606- -2, that payment is an amount 10-32 collected on behalf of the third- party service vendor for services the third party is providing (as a principal) to Customer. ABC further concludes that, in this case, the $500 it retains from the payment as an agency fee is also not part of the transaction price of its contract with Customer. In this case, because ABC has a partnership agreement with the third- party partner, it concludes that the third party is its customer for the agency service (i.e. it is providing the agency service to the third party, not to Customer). Consequently, the $500 agency fee is not a part of its contract with Customer, but rather part of a separate contract with the third -party partner that is unrelated to Customer. ABC will recognize the $500 agency fee when it has satisfied its performance obligation to arrange for the third -party partner to provide the data conversion and migration services. pocket costs Out -of- The out -of-pocket costs (e.g. for travel and printed training materials) are fulfillment costs of ABC to satisfy its performance obligation to provide -of-pocket costs are implementation services to Customer. Because the out ABC’s fulfillment costs incurred to satisfy its services performance obligation to Customer, rather than Customer costs for third- party services being provided to Customer, those costs are presented on a gross basis separate from the related customer reimbursements. The out -of-pocket fulfillment costs are expensed as incurred, consistent with any other fulfillment costs ABC incurs related to the implementation services, because when incurred they relate to a partially satisfied implementation services performance obligation (see Question H230). The reimbursements of the out -of-pocket costs represent variable consideration such that the tr ansaction price for the contract is variable. Based on its relevant 32-5 through 10- experience, ABC estimates, in accordance with paragraphs 606- 32-9, that its out -of-pocket costs will be $2,000. ABC further concludes that it does not need to ‘constrain’ that estimate of variable consideration. This is because both (1) ABC has significant relevant experience that is driving its -of-pocket costs and (2) any potential revenue reversal estimate of the out against cumulative revenue recognized under the contract to that point that © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

274 Revenue for software and SaaS 272 D. Step 3 : Determine the transaction price -of-pocket cost amount will be might result is not significant given that the out known relatively early in the performance of the implementation services (i.e. terials related ma ABC’s travel costs to get to Customer’s site or to print training- will be known before the services are performed) such that little revenue will likely have been recognized under the contract at the point any substantive ‘true -up’ of the out -of-pocket cost estimate is required. which only results from Next, ABC concludes that the variable consideration – -of-pocket costs reimbursement – should be allocated entirely to the the out implementation services performance obligation. In accordance with paragraph 606- -40 (see Chapter E – Step 4: Allocate the transaction price 10-32 ), ABC concludes that (1) the out to the performance obligations in the contract - of-pocket costs to be incurred relate solely to ABC’s efforts to fulfill the implementation services and (2) allocating this relatively minor amount entirely to the implementation services is consistent with the overall transaction price allocation objective in paragraph 606- 10- 32-28. ABC reaches the latter conclusion on the basis that the allocation of the $2,000 entirely to the elative stand -alone selling price that is implementation services results in a r consistent with the stand- alone selling price for the services and because an entity providing the services separately (e.g. a consulting services provider not providing the SaaS) would typically price those services either to include a contract or reimbursement provision similar to the one in the ABC/ Customer include a fixed amount intended to recover similar out -of-pocket costs. Consequently, ABC’s transaction price allocation for the contract with Customer is as follows : - Stand Total alone allocated selling % of transaction Relative Variable price consideration SSP SSP price (SSP) $85,000 77.3% $77,273 $ 0 $77,273 SaaS 22,727 Implementation 25,000 22.7% 2,000 24,727 $102,000 $2,000 $100,000 $110,000 100.0% Assuming the SaaS, like the implementation services, is a performance obligation satisfied over time, ABC will recognize the transaction price allocated to each of the two performance obligations as the SaaS and the implementation services are pr ovided using an appropriate measure of progress for each (see Chapter F – Step 5: Recognize revenue when (or as) the entity satisfies a for further discussion about whether a SaaS performance obligation performance obligation is satisfied over time and appropriate measures of progress). Because Topic 606 requires entities to use a single measure of progress toward satisfaction of a performance obligation, it would not be appropriate to apply one measure of progress to the $22,727 and another to the n anticipated customer out $2,000 i -of-pocket cost reimbursements. Therefore, it would only be acceptable to recognize the reimbursements when the costs -to-cost measure of progress for the are incurred if (1) ABC were using a cost implementation services performance obligation as a whole and (2) the -of-pocket costs represents progress towards satisfaction incurrence of the out 10 -21). -55 of the performance obligation (see paragraph 606- partnership and the U.S. member firm of the KPMG network of independent member KPMG LLP, a Delaware limited liability © 2018 . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

275 Revenue for software and SaaS 273 D. Step 3 : Determine the transaction price Comparison to legacy US GAAP Under legacy US GAAP (paragraph 605- 45-45 -23), reimbursements of out -of- pocket expenses were required to be presented as revenue, gross from the associated out -of-pocket costs, in all circumstances. In contrast, Topic 606 does not include an explicit ‘rule’ in this regard; rather an entity considers whether it is a principal or an agent with respect to the cost (i.e. whether the cost for which it will receive payment from the customer is its cost or the customer’s cost). However, while the guidance in Topic 606 does not have the same explicit rule, and relies instead upon a principal versus agent concept, we do not believe the changes to the guidance will result in any significant changes from current practice with respect to how entities present most out -of-pocket costs, including customer reimbursements thereof. However, the timing of revenue recognition for customer reimbursements may be earlier or later than under legacy US GAAP because of the guidance in Topic 606 about estimating variable consideration – i.e. under Topic 606, the estimated customer reimbursements will be recognized, consistent with the entity’s measure of progress for the related performance obligation, which could be earlier or later than when the costs are incurred and when such amounts were recognized under legacy US GAAP. Question D20 -front fees included in the Are nonrefundable up transaction price for a contract with a customer? Yes. Interpretive response: front nonrefundable up- Some contracts include fees that are paid at or near contract inception – e.g. joining fees for health club membership, activation fees for telecommunication contracts and set -up fees for SaaS arrangements or hosting services . Often a nonrefundable up- fro nt fee relates to an activity that does not transfer a e.g. set good or service to the customer – -up activities in a SaaS arrangement (see Question C220) or an ‘administrative task’ such as setting up the customer’s billing account . In other cases an up -front fee will relate to the transfer of a good or service (e.g. a software license that is transferred at or near contract inception or implementation services provided by the entity in a software licensing or a SaaS arrangement). front fee is identified in the Regardless of whether the nonrefundable up- contract as relating to a specific good or service to be provided to the customer, a part of the transaction price of the contract that will be , nevertheless, it is allocated to the contract’s performance obligations. As discussed in Question C4 10 , the inclusion of a nonrefundable up -front fee in a contract may indicate a ‘material right’ exists, which is an additional performance obligation of the contract that will receive an allocation of the transaction price. Chapter E – bligations t Step 4: Allocat e the t ransaction price to p erformance o in the contrac discusses the key considerations relative to allocating a transaction price that includes a nonrefundable up- front fee. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

276 Revenue for software and SaaS 274 D. Step 3 : Determine the transaction price in accounting for a requirements The following figure summarizes the . front fee nonrefundable up- Account for the promised good or Nonrefundable fee related to a service in same manner as any other promised good or service ? Yes promised good or service No The fee is an advance payment for other f ut ur e goods or services Recognize amount allocated to the material right over period for which the upfront fee is important to Does the fee create a material ’s decision to acquire the customer ? ri ght Yes additional goods or to renew a service No Recognize the fee in the same manner as the other consideration for the promised goods or services in the contract Comparison to legacy US GAAP front fee represents a payment for a Concluding whether a nonrefundable up- promised good or service under Topic 606 may involve an analysis similar to that undertaken for legacy US GAAP to determine whether the up- front fee is payment for delivery of a good or a service that represents the culmination of a separate earnings process. When performing the analysis under Topic 606, an entity considers the guidance in Step 2 of the model, which is not necessarily the same as legacy US GAAP. Under the SEC guidance (SAB Topic 13) applicable to legacy US GAAP, an up- front fee that is not a payment for delivery of a good or a service that represents the culmination of a separate earnings process is deferred and recognized over the expected period of performance, which can extend beyond the initial contract period. In our experience, this has often resulted in an entity recognizing nonrefundable up -front fees over the average customer relationship period. Under Topic 606, an entity assesses the up- front fee to determine whether it and, if so, for how long. This provides the customer with a material right – means that an entity no longer defaults to an average customer relationship KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member © 2018 . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

277 Revenue for software and SaaS 275 D. Step 3 : Determine the transaction price period, which may be driven by factors other than the payment of an up -front fee. These factors may include the availability of viable alternatives, the entity’s customer service, the inconvenience of changing service providers, or the quality of the product or service offering. Variable consideration Excerpt from ASC 606-10 Variable Consideration > > If the consideration promised in a includes a variable amount, an contract 32-5 entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer . An amount of consideration can vary because of discounts, rebates, 32-6 refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items. The promised consideration also can vary if an entity’s entitlement to the consideration is contingent on the occurrence or nonoccurrence of a future event. For example, an amount of consideration would be variable if either a product was sold with a right of return or a fixed specified amount is promised as a performance bonus on achievement of a milestone. The variability relating to the consideration promised by a customer may 32-7 be explicitly stated in the contract. In addition to the terms of the contract, the promised consideration is variable if either of the following circumsta nces exists: a. The customer has a valid expectation arising from an entity’s customary business practices, published policies, or specific statements that the entity will accept an amount of consideration that is less than the price stated in the contract. That is, it is expected that the entity will offer a price concession. Depending on the jurisdiction, industry, or customer this offer may be referred to as a discount, rebate, refund, or credit. Other facts and circumstances indicate that the entity’s in b. tention, when entering into the contract with the customer, is to offer a price concession to the customer. 32-8 An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled: a. The expected value—The expected value is the sum of probability - weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable acts with similar consideration if an entity has a large number of contr characteristics. The most likely amount b. —The most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

278 Revenue for software and SaaS 276 : Determine the transaction price D. Step 3 opriate estimate of the amount of variable consideration if the contract appr has only two possible outcomes (for example, an entity either achieves a performance bonus or does not). 32-9 An entity shall apply one method consistently throughout the contract when estimating the effect of an uncertainty on an amount of variable consideration to which the entity will be entitled. In addition, an entity shall consider all the information (historical, current, and forecast) that is reasonably available to the entity and shall identify a reasonable number of possible consideration amounts. The information that an entity uses to estimate the amount of variable consideration typically would be similar to the information that the entity’s management uses during the bid-a nd -proposal process and in establishing prices for promised goods or services. Refund Liabilities 32- 10 An entity shall recognize a refund liability if the entity receives consideration from a customer and expects to refund some or all of that ion to the customer. A refund liability is measured at the amount of considerat consideration received (or receivable) for which the entity does not expect to be entitled (that is, amounts not included in the transaction price ). The refund liability (and corresponding change in the transaction price and, therefore, the contract liability ) shall be updated at the end of each reporting period for changes in circumstances. To account for a refund liability relating to a sale with a right of return, an entity shall apply the guidance in paragraphs 606- 10 - 55-22 through 55-29. Types of variable consideration expects to be entitled can vary n entity The amount of consideration to which a one or more of the following: due to the existence of — discounts — rebates — refunds — credits price concessions — — incentives — performance bonuses or p enalties . The promised consideration also can vary if the entity ’s entitlement to the consideration is contingent on the occurrence or nonoccurrence of a future , even if the contract price appears to be fixed. For example, the amount event of consideration promised in a fixed- contract would be variable if the price SaaS contract includes service level guarantees that could result in the entity providing credits or refunds to the customer as a penalty for not meeting the specified service levels (see Question D170). be explicit or implicit, arising from Variability in the contract consideration may customary business practices, published policies or specific statements, or any other facts and circumstances that would create a valid expectation by the rice concessions may be granted to enhance a For example, explicit p customer. customer relationship to encourage future sales to that customer or as part of an overall strategy to develop the customer relationship, while implicit price © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

279 Revenue for software and SaaS 277 : Determine the transaction price D. Step 3 concessions occur when the entity’s customary business practices, published s, or other relevant facts and circumstances policies or specific statement indicate that the entity may accept a lower price than that stated in the contract . Accounting for variable consideration An entity es an amount of variable consideration by using one of the estimat following methods , applied consistently to similar contracts, depending on which method the entity expects to better predic t the amount of consideration to which the entity will be entitled (i.e. it is not a ‘free choice’) : Expected value The entity considers the probability -weighted amounts for a range of possible consideration outcomes . This may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contrac ts with similar characteristics and may be more appropriate when an entity has a large number of possible outcomes. Most likely amount The entity considers the single most likely amount from a range of possible consideration outcomes . This may be an appropriate estimate of the amount of variable consideration if the contract has only two (or perhaps a few) an entity either will (e.g. outcomes possible a achieve perfo . not) rmance bonus or In general, it is important for an entity to have a sufficiently large number of similar transactions to conclude that the expected value method is more appropriate than the most likely amount method. Judgment is required to e whether : determin — the transactions are sufficiently similar; — the transactions from which the expected value is derived are expected to be consistent with the current contract; and — the volume of similar contracts is sufficient to develop an expected value. An consider of s all information available when making its estimate entity variable consideration and updates the estimate at each reporting date. An entity recognizes a refund liability for consideration received or receivable if all of the consideration to the customer. it expects to refund some or Topic 606 applies the mechanics of estimating variable consideration in a variety of scenarios, some of which include fixed consideration – e.g. sales with a right of return and customers’ unexercised rights (breakage). Question D30 ‘best estimate’ Can management simply use its when estimating variable consideration? No. The Boards considered, and ultimately rejected Interpretive response: allowing a method of applying management’s best estimate without an appropriate framework that would ensure rigor in the process of estimation. The Boards concluded that, without such a framework, the measurement of revenue might not be understandable to users and might lack comparability © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

280 Revenue for software and SaaS 278 D. Step 3 : Determine the transaction price between entities. As a result, the Boards developed a framework requiring that an entity use either the expected value method or the most likely amount method, depending on the specific facts and circumstances , for estimating 09.BC198] [ASU 2014- outlined. variable consideration Question D40 What should a software entity consider in deciding whether it has a sufficient number of similar contracts to use the expected value method for estimating variable consideration? In some cases, a software entity’s ability to use the Interpretive response: expected value method will be clear. For example, SaaS providers that have substantially similar contracts with all customers accessing its hosted software in a multi- tenant environment will generally have a sufficient portfolio of data from which to use an expected value method to estimating variable consideration resulting from items such as service level guarantees. Another example could be a software licensing entity that, as its standard practice, year licenses for the same products and services with all (or enters into three- most) of its customers. However, an entity’s s -specific. often quite customer also oftware contracts are entities, customers rarely obtain licenses to For example, for some software the same mix of software products , or even similar product mixes may include very different licenses (e.g. perpetual versus term licenses or licenses that include different restrictions on use). For other entities , their customers acquire diffe rent software -related services – e.g. one customer may request customization, while another does not but contracts for a more extensive suite of implementation services, and a third requests that the entity host the licensed software. Use of the expected value method does not necessarily requir e homogenous rather, it merely requires that there be common customer contracts; characteristics relevant to the estimation of the variable consideration . For example, even if a software entity never licenses the same mix of software products to any two customers or has a wide variety of license terms, its implementation or hosting services provided for its different software products and licenses may be substantially similar such that it can use the expected value method to estimate the likelihood of earning performance bonuses or incurring penalties related to those services. Similarly, even if the entity’s customers enter into widely varied arrangements for different mixes of software licenses and services, the ent ity’s hosting services may be generally consistent such that, even though the software being hosted may differ substantially between customers, the portfolio of customer contracts that include hosting services provide relevant, predictive evidence about whether the entity will be required to provide service level credits or refunds to customers. There are various attributes of a software entity’s customer contract portfolio that may provide similarities relevant to different types of variable consideration. of attributes around which an entity may be able to develop a Some examples © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

281 Revenue for software and SaaS 279 : Determine the transaction price D. Step 3 portfolio of data (even if the contracts are not substantially similar overall), and relevance to variable consideration, include (not exhaustive): — – it may Perpetual versus term licensing be that customers under term licenses are more likely to be granted concessions (which are variable consideration – see Question D130 ) to induce renewal than customers with perpetual licenses. – it may be that larger customers are granted — Type or class of customer concessions, but smaller customers are not; that larger customers have more stringent performance bonus/penalty provisions in their cont racts than user smaller customers; or that reseller customers (as compared to end- customers) are more likely to return software licenses . Payment terms – it may be that customers with extended payment terms — are more likely to be granted concessions (see Question D150). — – it may be that the software entity’s Types of products or services performance record on implementing or customizing software successfully within a predetermined timeframe differs depending on the nature of those services or the software products being implemented or customized. Question D50 When estimating the expected value or when applying the most likely amount method, does an entity need to consider all possible outcomes? No. Although in theory, an entity using the most likely Interpretive response: amount method considers all the possible outcomes to identify the most likely one, in practice, there is no need to quantify the less probable outcomes . [ASU 2014- 09. BC201] -weighted Similarly, in practice, estimating the expected value using a probability method does not require an entity to explicitly quantify probabilities for all possible outcomes using complex models and techniques. Using a smaller number of discrete outcomes might provide a reasonable estimate of the distribution of possible outcomes. Regardless of the method used, an entity should consider all the information (historical, current and forecasted) that is reasonably available when making its estimate. Question D60 Is an entity required to use a single method to all estimate the transaction price consistently for variable payment terms in the same contract? Interpretive response: No. Using a different method for different payment streams within the same contract is permissible, provided the methods are Fo r example, it would be the duration of the contract. consistently applied for permissible to apply the to a performance bonus most likely amount method © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

282 Revenue for software and SaaS 280 : Determine the transaction price D. Step 3 related to implementation services provided under the contract, while using the expected value method to estimate the variable consideration for a right of return on the software licenses or in estimating service level credits (see Question D170) in a SaaS arrangement. D70 Question Once an entity has elected to apply either the ‘most likely amount’ method or the ‘expected value’ method for estimating a variable consideration element, is the selected method applied consistently throughout the course of the contract? 9 states that “when Interpretive response: -32- Yes. Paragraph 606-10 estimating the transaction price, an entity shall apply one method consi ste ntly throughout the contract.” Therefore, the method selected for a variable on element (e.g. in estimating the performance bonus or the right of considerati return used as an is consistently applied to that Question D60) example in element for the duration of the contract. individual D80 Question Is an entity required to apply the same method of estimating variable consideration to all similar variable fee terms within a portfolio of contracts with customers? Interpretive response: We would generally expect the same method of estimating a variable transaction price to be applied to similar variable fee terms across an entity’s portfolio of contracts absent a change in circumstances or business practices. However, the objective for each contract is to develop an estimate of the amount that is most predictive of amount to which the entity will be entitled to and therefore there may be exceptions due to the specific . circumstances of a contract with a particular customer Question D90 Is using releva nt information from a portfolio of similar contracts to estimate variable consideration the same as applying the portfolio approach practical expedient? Interpretive response: No. This question was discussed by the TRG at the March 2015 meeting. The TRG members agreed with the views of the FASB and IASB staffs that using a portfolio of data to develop estimates required to apply the revenue model in Topic 606, including estimates of variable , is not the same as applying the consideration using the expected value method practical expedient portfolio approach . This means that there is no requirement © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

283 Revenue for software and SaaS 281 D. Step 3 : Determine the transaction price for entities using a portfolio of data of similar contracts to apply the expected value evaluate whether the results of using that portfolio of data to method to develop the estimate would differ materially from developing a n estimate based on contract -specific data. Question D110 highlights that an entity’s estimate resulting from an expected- value method estimate does not have to equal a possible outcome of the contract . Question D100 Does denomination in a currency other than the entity’s functional currency mean the contract includes variable consideration? No. Interpretive response: Entities may enter into contracts denominated in a foreign currency. Although the contract may state a fixed price in that foreign currency , the amount received by the entity in its functional c urrency will vary based on the changes in the exchange rate in effect between the date the contract is entered into and when the payment is received. Foreign currency is not ‘noncash consideration’; it is still ‘cash’. P aragraph 830- in stating that the statement of cash flows “reports the 45-1 supports this 230- effect of exchange rate changes on cash balances held in foreign currencies as a separate part of the reconciliation of the change in cash and cash equivalents The measurement of during the period.” -denominated cash that foreign the amount to record for accounting purposes, as described in quantifies paragraph 830- 10-55 -1. Therefore, contracts denominated in a currency other than the entity’s functional currency should be measured into the entity’s f unctional currency using the foreign exchange rate in effect on the date of either transfer of the goods or services or payment in advance by the customer, whichever is f irst (see Topic 830, Foreign Currency Matters ). Changes in the foreign exchange rate between contract inception and the date of either transfer of the goods or irst , would services or payment in advance by the customer, whichever is f therefore affect the amount of revenue recognized. Constraint on variable consideration Excerpt from ASC 606-10 > > > Constraining Estimates of Variable Consideration 32- An entity shall include in the transaction price some or all of an amount 11 of variable consideration estimated in accordance with paragraph 606- 10-32 -8 only to the extent that it is probable that a significant reversal in the amount of cumulative recognized will not occur when the uncertainty associated revenue with the variable consideration is subsequently resolved. In assessing whether it is probable that a significant reversal in the 12 32- amount of cumulative revenue recognized will not occur once the uncertainty related to the variable consideration is subsequently resolved, an entity shall © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

284 282 Revenue for software and SaaS D. Step 3 : Determine the transaction price and the magnitude of the revenue reversal. Factors consider both the likelihood that could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of the following: a. The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service. b. The uncertainty about the amount of consideration is not expected to be resolved for a long period of time. c. The entity’s experience (or other evidence) with similar types of contracts ve is limited, or that experience (or other evidence) has limited predicti value. d. The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances. The contract has a large number and broad range of possible consideration amounts. 32- 10-55 -65 to account for consideration 13 An entity shall apply paragraph 606- based royalty that is promised in -based or usage- in the form of a sales exchange for a license of intellectual property. > > > Example 22— Right of Return 202 An entity enters into 100 contracts with customers. Each contract 55- includes the sale of 1 product for $100 (100 total products × $100 = $10,000 total consideration). Cash is received when control of a product transfers. The entity’s customary business practice is to allow a customer to return any unused product within 30 days and receive a full refund. The entity’s cost of each product is $60. 55- 203 The entity applies the guidance in this Topic to the portfolio of 100 contracts because it reasonably expect s that, in accordance with paragraph 606- 10-10 -4, the effects on the financial statements from applying this guidance to the portfolio would not differ materially from applying the guidance to the individual contracts within the portfolio. Because the contract allows a customer to return the products, the 55- 204 consideratio n received from the customer is variable. To estimate the variable consideration to which the entity will be entitled, the entity decides to use the expected value method (see paragraph 606- 10 -32- 8(a)) because it is the method that the entity expects to better predict the amount of consideration to which it will be entitled. Using the expected value method, the entity estimates that 97 products will not be returned. 205 55- The entity also considers the guidance in paragraphs 606- 32-11 10- through 32- 13 on constraining estimates of variable consideration to determine whether the estimated amount of variable consideration of $9,700 ($100 × 97 products not expected to be returned) can be included in the transaction price. -12 and determines that The entity considers the factors in paragraph 606 -10- 32 although the returns are outside the entity’s influence, it has significant experience in estimating returns for this product and customer class. In addition, the uncertainty will be resolved within a short time frame (that is, the day return period). Thus, the entity concludes that it is probable tha - 30 t a © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

285 Revenue for software and SaaS 283 : Determine the transaction price D. Step 3 cumulativ e amount of revenue recognized (that is, significant reversal in the is resolved (that is, over the return $9,700) will not occur as the uncertainty period). 55 - 206 The entity estimates that the costs of recovering the products will be immaterial and exp ects that the returned produc ts can be resold at a profit. 55- Upon transfer of control of the 100 products, the entity does not 207 recognize revenue for the 3 products that it expects to be returned. -10- 32 -10 and 606-10 -55- 23, Consequently, in accordance with paragraphs 606 the entity recognizes the following: Cash $10,000 ($100 x 100 products transferred) Revenue $9,700 ($100 x 97 products not expected to be returned) Refund liabilities $300 ($100 refund x 3 products expected to be returned) $5,820 ($60 x 97 products not expected to returned) Cost of sale $180 ($60 x 3 products for its right to recover products Asset form customers on settling the refund liability) Inventory $6,000 ($60 x 100 products) > > > Example 23—Price Concessions 55- 208 An entity enters into a contract with a customer, a distributor, on December 1, 20X7. The entity transfers 1,000 products at contract inception for a price stated in the contract of $100 per product (total consideration is $100,000). Payment from the customer is due when the customer sells the products to the end customers. The entity’s customer generally sells the products within 90 days of obtaining them. Control of the products transfers to the customer on December 1, 20X7. 55- On the basis of its past practices and to maintain its relationship with 209 the customer, the entity anticipates granting a price concession to its customer because this will enable the customer to discount the product and thereby move the product through the distribution chain. Consequently, the on in the contract is variable. considerati > > > > Case A —Estimate of Variable Consideration Is Not Constrained 55- The entity has significant experience selling this and similar products. 210 The observable data indicate that historically the entity grants a price concession of approximately 20 percent of the sales price for these products. Current market information suggests that a 20 percent reduction in price will be sufficient to move the products through the distribution chain. The entity has not granted a price concession significantly greater than 20 percent in many years. 55- To estimate the variable consideration to which the entity will be 211 entitled, the entity decides to use the expected value method (see 10-32 -8(a)) because it is the method that the entity expects to paragraph 606- better predict the amount of consideration to which it will be entitled. Using the expected value method, the entity estimates the transaction price to be $80,000 ($80 × 1,000 products). © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

286 Revenue for software and SaaS 284 D. Step 3 : Determine the transaction price 32-11 55- 212 The entity also considers the guidance in paragraphs 606- 10- through 32- ine 13 on constraining estimates of variable consideration to determ whether the estimated amount of variable consideration of $80,000 can be included in the transaction price. The entity considers the factors in paragraph 606- 10-32 -12 and determines that it has significant previous experience with this product and current market information that supports its estimate. In addition, despite some uncertainty resulting from factors outside its influence, based on its current market estimates, the entity expects the price to be resolved within a short time frame. Thus, the entity concludes that it is probable that a significant reversal in the cumulative amount of revenue recognized (that is, $80,000) will not occur when the uncertainty is resolved (that is, when the total amount of price concessions is determined). Consequently, the entity recognizes $80,000 as revenue when the products are transferred on December 1, 20X7. Constrained > > > > Case B —Estimate of Variable Consideration Is The entity has experience selling similar products. However, the 55- 213 entity’s products have a high risk of obsolescence, and the entity is experiencing high volatility in the pricing of its products. The observable data indicate that historically the entity grants a broad range of price concessions ranging from 20 to 60 percent of the sales price for similar products. Current market information also suggests that a 15 to 50 percent reduction in price may be necessary to move the products through the distribution chain. 55- 214 To estimate the variable consideration to which the entity will be entitled, the entity decides to use the expected value method (see paragraph 606- 10-32 -8(a)) because it is the method that the entity expects to better predict the amount of consideration to which it will be entitled. Using the expected value method, the entity estimates that a discount of 40 percent will be provided and, therefore, the estimate of the variable consideration is $60,000 ($60 × 1,000 products). s the guidance in paragraphs 606- 55- 215 The entity also consider 32-11 10- through 32- estimates of variable consideration to determine ing 13 on constrain whether some or all of the estimated amount of variable consideration of $60,000 can be included in the transaction price. The entity considers the amount of factors in paragraph 606- 10-32-12 and observes that the consideration is highly susceptible to factors outside the entity’s influence (that is, risk of obsolescence) and it is likely that the entity may be required to provide a broad range of price concessions to move the products through the distrib ution chain. Consequently, the entity cannot include its estimate of $60,000 (that is, a discount of 40 percent) in the transaction price because it cannot conclude that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. Although the entity’s historical price concessions have ranged from 20 to 60 percent, market information currently suggests that a price concession of 15 to 50 percent will be current necessary. The entity’s actual results have been consistent with then- market information in previous, similar transactions. Consequently, the entity concludes that it is probable that a significant reversal in the cumulative amount of revenue recognized will not occur if the entity includes $50,000 in the transaction price ($100 sales price and a 50 percent price concession) and, therefore, recognizes revenue at that amount. Therefore, the entity recognizes revenue of $50,000 when the products are transferred and reassesses the © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

287 Revenue for software and SaaS 285 : Determine the transaction price D. Step 3 estimates of the transaction p rice at each reporting date until the uncertainty is -32- 14. resolved in accordance with paragraph 606- 10 Volume Discount Incentive > > > Example 24— 55- 216 An entity enters into a contract with a customer on January 1, 20X8, to sell Product A for $100 per unit. If the customer purchases more than 1,000 units of Product A in a calendar year, the contract specifies that the price per unit is retrospectively reduced to $90 per unit. Consequently, the consideration in the contract is variable. 55- 217 For the first quarter ended March 31, 20X8, the entity sells 75 units of Product A to the customer. The entity estimates that the customer’s -unit threshold required for the volume purchases will not exceed the 1,000 discount in the calendar year. e entity considers the guidance in paragraphs 606- 10-32-11 through 218 Th 55- 32- 13 on constraining estimates of variable consideration, including the factors in -10-32-12. The entity determines that it has significant experience paragraph 606 with this product and with the purchasing pattern of the entity. Thus, the entity concludes that it is probable that a significant reversal in the cumulative amount of revenue recognized (that is, $100 per unit) will not occur when the uncertainty is resolved (that is, when the total amount of purchases is known). Consequently, the entity recognizes revenue of $7,500 (75 units × $100 per unit) for the quarter ended March 31, 20X8. 55- 219 In May 20X8, the entity’s customer acquires another company and in the second quarter ended June 30, 20X8, the entity sells an additional 500 units of Product A to the customer. In light of the new fact, the entity estimates that the customer’s purchases will exceed the 1,000 -unit threshold for the calendar year and, therefore, it will be required to retrospectively reduce the price per unit to $90. 55- 220 Consequently, the entity recognizes revenue of $44,250 for the quarter ended June 30, 20X8. That amount is calculated from $45,000 for the sale of 500 units (500 units × $90 per unit) less the cha nge in transaction price of $750 (75 units × $10 price reduction) for the reduction of revenue relating to units 10 -32 sold for the quarter ended March 31, 20X8 (see paragraphs 606- -42 43). through 32- > > > Example 25— Management Fees Subject to the Constra int 221 55- On January 1, 20X8, an entity enters into a contract with a client to provide asset management services for five years. The entity receives a 2 percent quarterly management fee based on the client’s assets under management at the end of each quarter. In addition, the entity receives a performance-based incentive fee of 20 percent of the fund’s return in excess of the return of an observable market index over the 5 -year period. Consequently, both the management fee and the performance fee in the contract are variable consideration. 55- The entity accounts for the services as a single performance obligation 222 -14(b), because it is providing a series in accordance with paragraph 606- -25 10 of distinct services that are substantially the same and ha ve the same pattern © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

288 Revenue for software and SaaS 286 : Determine the transaction price D. Step 3 of transfer (the services transfer to the customer over time and use the same method to measure progress —that is, a time -based measure of progress). 55- 223 At contract inception, the entity considers the guidance in 9 on estimating variable consideration and -5 through 32- -32 606-10 paragraphs the guidance in paragraphs 606- 10-32 -11 through 32-13 on constraining estimates of variable consideration, including the factors in paragraph 606- 10 - 32-12. The entity observes that the promised consideration is dependent on the market and, thus, is highly susceptible to factors outside the entity’s influence. In addition, the incentive fee has a large number and a broad range of possible consideration amounts. The entity also observes that although it has experience with similar contracts, that experience is of little predictive value in determining the future performance of the market. Therefore, at contract inception, the entity cannot conclude that it is probable that a significant reversal in the cumulative amount of revenue recognized would not occur if the entity included its estimate of the management fee or the incentive fee in the transaction price. 55- At each reporting date, the entity updates its estimate of the 224 transaction price. Consequently, at the end of each quarter, the entity concludes that it can include in the transaction price the actual amount of the quarterly management fee because the uncertainty is resolved. However, the entity concludes that it cannot include its estimate of the incentive fee in the transaction price at those dates. This is because there has not been a change in its assessment from contract inception—the variability of the fee based on the market index indicates that the entity cannot conclude that it is probable that a significant reversal in the cumulative amount of revenue recognized would not occur if the entity included its estimate of the incentive fee in the 31, 20X8, the client’s assets under management transaction price. At March are $100 million. Therefore, the resulting quarterly management fee and the transaction price is $2 million. 55- 225 At the end of each quarter, the entity allocates the quarterly management fee to the distinct services provided during the quarter in -39(b) and 606- -40. This is because 10-32 accordance with paragraphs 606- 10 -32 the fee relates specifically to the entity’s efforts to transfer the services for that quarter, which are distinct from the services provided in other quarters, and the resulting allocation will be consistent with the allocation objective in 10-32 -28. Consequently, the entity recognizes $2 million as paragraph 606- revenue for the quarter ended March 31, 20X8. The objective of the constraint on variable consideration is to reduce the risk a significant revenue reversal (a downward adjustment that an entity recognizes to revenue ) from subsequent changes in the estimate of the amount of variable consideration to which the entity is expected to be entitled. As described in the Basis for Conclusions to ASU 2014-09 (BC207), t he constraint introduces a downward bias into estimates, requiring entities to exercise prudence before -neutral estimate. they recognize revenue – to make a non i.e. they are required This exception to the revenue recognition model, and to the Boards’ respective conceptual frameworks’ requirement to make neutral estimates, reflects the particular sensitivity with which revenue reversals are viewed by many users and regulators. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

289 Revenue for software and SaaS 287 D. Step 3 : Determine the transaction price Therefore, in accordance with the objective of the constraint, a n entity includes an estimated amount of variable consideration in the transaction pri ce only if it is proba ble that a subsequent change in the estimate of the amount of variable consideration would not result in a significant revenue reversal. A significant revenue reversal would occur if a subsequent change in the estimate of the variable consideration would result in a significant downward adjustment on the amount of cumulative revenue recognized from that contract when the change in it is in is used in the same way as probable’ estimate occurs . The term ‘ 450, Contingencies – i.e. “the future event or events are likely to occur .” Topic Because probable is not as high of a threshold as, for example, ‘virtually certain’, even though the intent of the constraint is to prevent significant downward recognized adjustments to previously revenue, such adjustments may occur. The entity would meet the objective of the constraint if it has sufficient experience or evidence to support that an amount of variable consideration, if included in the transaction price and recognized as revenue , does not risk a significant revenue reversal. I mportantly, not having sufficient experience or amount of variable consideration in entire evidence to support that including the of resulting in a significant revenue have a risk the transaction price does not reversal does not mean the transaction price should not include some portion of the variable consideration. If an entity expects that including some, but not all, of the estimated amount of variable consideration ( i.e. a minimum amount) in the transaction price would not result in a significant revenue reversal, the entity includ es that amount (and subsequent changes to that amount) in the estimate of the transaction price. This means that, in many cases, even if there is significant uncertainty about variable consideration, the amount of variable consideration included in the transaction price will be greater than zero. The entity’s assessment of whether its experience or other evidence is sufficient to support its assessment is qualitative and should take into account all the relevant facts and circumstances associated with both: — the likelihood of a downward adjustment in the estimate of variable consideration (e.g. the risk of such an adjustment arising from an uncertain future event ), and the magnitude of the reversal if that uncertain event were to occur or fail to — An entity assesses the potential magnitude of a significant revenue occur. reversal relative to the cumulative revenue recognized to- date under the contract – i.e. for both variable and fixed consideration, rather than on a reversal of only the variable consideration. The assessment of magnitude is relative to the transaction price for the contract , rather than the amount allocated to a specific performance obligation . Factors th at indicate that including an estimate of variable consideration in the transaction price could result in a significant revenue reversal include, but are not limited to, the following: — The amount of consideration is highly susceptible to factors outside the entity‘s influence. Those factors include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service. The uncertainty about the amount of consideration is not expected to be — resolved for a long period of time. The entity‘s experience (or other evidence) with similar types of contracts is — limited or that experience (or other evidence) has limited predictive value. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

290 Revenue for software and SaaS 288 D. Step 3 : Determine the transaction price — The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances. — The contract has a large number and broad range of possible consideration amounts. downward adjustment in the estimate of variable consideration is If the risk of a low or the potential magnitude of the revenue reversal that would result from that downward adjustment is minor, then the constraint does not affect the estimated amount of variable consideration. entity does An not consider collectibility of the consideration (i.e. customer credit risk ) when evaluating either its estimate of variable consideration or the applicability of the constraint. The effect of credit risk is addressed separately in . Step 1 of the Model : Identify a contract with a customer – Chapter B Step 1 includes an explicit collectibility threshold as a criterion to conclude that a model. contract exists within the Topic 606 revenue Reassessment of variable consideration Excerpt from ASC 606-10 Reassessment of Variable Consideration 32- 14 At the end of each reporting period, an entity shall update the estimated transaction pr ice (including updating its assessment of whether an estimate of variable consideration is constrained) to represent faithf ully the circumstances present at the end of the reporting period and the changes in circumstances during the reporting period. The entity shall account for changes in the 42 through 32- -32- -10 45. transaction price in accordance with paragraphs 606 An entity’s estimate of variable consideration will frequently change after contract inception. For example, uncertainties will be resolved or new information will arise with respect to remaining uncertainties such that the consideration entity must revise its expectations about the amount of variable to which it expects to be entitled . To account for conditions that exist at each reporting date (and changes in conditions during the reporting period), an entity s of variable consideration and amounts of that variable updates its estimate consideration that should be constrained throughout the contract. Question D110 Does the transaction price in a contract with variable consideration have to equal a possible outcome of the contract? Some variable consideration arrangements have a Interpretive response: No. limited number of possible outcomes. For example, an arrangement under which an entity provides services may include incentives or penalties for good or poor performance that only have a limited number of possible outcomes. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

291 Revenue for software and SaaS 289 : Determine the transaction price D. Step 3 300, Consider a scenario where the entity stands to earn potential bonuses of $ 100 if a project is completed before specified dates and penalties of $200 or $ $100, $ 200 and $ 300 if the project is completed after specified dates. On- time performance results in the entity earning $ 500. In this scenario the only 600, possible outcomes for the transaction price are $ 200, $300, $ 400, $500, $ $700 and $ 800. This is a scenario that may occur in some software or SaaS development projects or large- scale implementation projects. In scenarios such as this , e ntities having a sufficient volume of similar arrangements (see Question D40 ) may determine that the expected value method is the most appropriate method to estimate the variable consideration. At the July 2015 TRG meeting, it was discussed whether the transaction price must equal a possible outcome of the contract – e.g. in the scenario above, must the estimated transaction price be one of those possible outcomes. The B and IASB staffs expressed the view, with which most TRG members FAS agreed, that w method for variable expected value estimation the hen using consideration, the estimated transaction price does not need to be an amount idual contract – i.e. in the scenario above, that is a possible outcome for an indiv the estimated transaction price, before and after consideration of the constraint, can be a number other than those listed. However, because of the transaction price reassessment requirements, at some point, the transaction price (and the revenue recognized) will be trued up to the actual outcome achieved. Example D110.1 Transaction price is not a possible outcome of the contract ABC Corp. enters into a contract for a large -scale software customization project with Customer (i.e. a software license and customization services). Customer wants to ensure the project is completed on a timely basis and, therefore, has The built into the contract penalties for not meeting the agreed ‘go live’ date. contract fe es if ABC meets the agreed deadline are $130,000. If the project is not completed within three months of the deadline, the transaction price is reduced to $120,000. If the contract is not completed within five months of the deadline, the transaction price is further reduced to $110,000; completion any time after six months results in a transaction price of $100,000. However, if ABC completes of schedule, the transaction price the project more than three months ahead increases to $150,000. Based on these contract terms, there are five possible outcomes for the transaction price – $150,000; $130,000; $120,000; $110,000; and $100,000. ABC concludes that the contract includes only a single performance obligation (see Question C230) that is satisfied over time (see Question F200 ). ABC decides that the expected value method is the most appropriate to estimate the transaction price given the number of possible outcomes and the fact that ABC enters into a large number of similar significant software implementation arrangements. weightings to each possible Using the expected value method, ABC assigns outcome and estimates the transaction price ( before consideration of the constraint) as follows. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

292 Revenue for software and SaaS 290 : Determine the transaction price D. Step 3 Probability Transaction price Weighting $100,000 5% $5,000 11,000 10% 11 0,000 0,000 20% 24,000 12 0,000 13 50% 65,000 22,500 15% 15 0,000 $127,500 Expected value ABC concludes that it does not need to further constrain the transaction price from the amount estimated using the expected value method. This is because the difference between the expected value of $127,500 and the amount to entitled ($120,000 – i.e. ABC has an 85% which ABC is probable of being likelihood of being entitled to at least $120,000) is not significant enough to significant revenue reversal given that the have the potential to result in a performance obligation will be satisfied over time. Alt hough $127,500 is not a possible outcome of the contract, ABC uses this amount as the transaction price at contract inception. In accordance with 10-32 -14, ABC will continue to update the transaction price until paragraph 606- the uncertainty associated with the project’s completion is resolved. Question D120 Should variable consideration be included in the transaction price when the entity believes it is unlikely to earn the variable consideration? It depends. An entity’s objective Interpretive response: when determining the transaction price for a contract is to estimate the total amount of consideration that it expects to be entitled to under the contract, subject to the constraint on variable consideration. If the entity concludes that using the most likely amount is the more appropriate approach and that amount is zero, then variable consideration would be excluded from the transaction price at contract In contrast, if the entity concludes that using the expected value inception. method is more appropriate, some amount of variable consideration (i.e. more be in than zero) will generally cluded in the transaction price, even if the entity thinks it is unlikely to be entitled to any of the variable consideration, unless application of the constraint results in a minimum amount of zero. Comparison to legacy US GAAP Topic 606 differs from legacy US GAAP because under Topic 606, an entity is required to estimate variable consideration and include it in the transaction price if an entity concludes that it is probable that the estimate of variable consideration is not subject to a risk of significant revenue reversal. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

293 Revenue for software and SaaS 291 : Determine the transaction price D. Step 3 Under legacy US GAAP, which is based on a realization concept, an entity situations, entities assesses whether the fee is fixed or determinable. In many concluded that the fee was not fixed or determinable until the underlying contingency was resolved. Question D130 How does a pattern of granting price concessions to customers affect the transaction price? Price concessions generally refer to either: Interpretive response: — changes that would have affected the original amount of revenue recognized; or changes that reduce the arrangement fee or extend the terms of payment . — Changes that increase the promised goods or services or extend the customer’s rights beyond those in the original transaction are not price concessions and the effect of such concessions is discussed in Question C90 . Examples of price concessions include, but are not limited to, the following: — Extending payment due dates in the arrangement. arrangement Decreasing total payments due under the — . — Paying financing fees on a customer’s financing arrangement that was not contemplated in the original arrangement. Accepting returns that were not required to be accepted under the terms of — the original arrangement. Anticipated price concessions affect the transaction price of a contract with a customer because the transaction price includes estimates of variable consideration, which includes any estimated price concessions . An entity with a history of granting price concessions should estimate the amount of consideration to which it expects to be entitled after consideration of any price concessions (i.e. using the expected value method or most likely amount method) and then should constrain that estimate to the extent it is both (1) ’, and therefore more than remote (i.e. remote meaning ‘unlikely to occur the , which is defined as ‘likely to occur’) additional converse of ‘probable’ (beyond those factored into the expected value or most likely concessions will be granted and (2) the effect of amount estimate) granting such additional concession(s) would be a significant revenue reversal (i.e. the change in the transaction price from the concession would result in a significant revenue reversal) . grants a price concession where no previous pattern of such If a software entity concessions has existed, and therefore, no concession was estimated in the would account for that price concession as initial transaction price, the entity a Contract contract modification affecting price only (see Chapter G – modifications ). We would expect accounting for concessions as modifications to be relatively infrequent because it would generally not require an excessive number of such concessions before the entity should be factoring those granted concessions into the transaction price of future contracts. previously © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

294 Revenue for software and SaaS 292 D. Step 3 : Determine the transaction price due dates or decreasing contract If concessions, such as extending payment payments, occur due to customer credit problems, it may also follow that the entity should reassess whether a contract with the customer exists in accordance with paragraph 606- 10-25 -5. Comparison to legacy US GAAP See the discussion in Question C90 . Example D130.1 Pattern of granting price concessions and estimating the transaction price ABC Corp. licenses ERP software to its customers, typically on a two or -, three- five -year term basis, with coterminous PCS services that are paid either tier player in the ERP annually or quarterly in advance. ABC is a second- software market, and therefore, has a significant incentive to try to ensure it keeps its existing customers from moving to one of the larger software providers. As a result, ABC has developed a practice of frequently providing its customers a discount on its PCS fees from those stated in the original contract for the final year. This discount has ranged from 20% to 60% with no discernible pattern and is generally expressed to the customer as a ‘reward’ for their past loyalty and is reflected on the applicable PCS invoice ABC sends for the discounted period. ABC enters into a contract with Customer for a three -year license of its ERP software and concurrent PCS services for stated contractual fees of $300,000 -front) and $180,000 in total for three years of for the three-year license (paid up PCS, paid in three $60,000 installments at the beginning of each year ($480,000 in total contractual fees). The software license and the three years of PCS constitute two separate performance obligations, and ABC transfers the software license to Customer at contract inception. ABC concludes that its substantive history of providing these PCS fee discounts requires it to include an estimate of the future discount it expects to provide Customer in the transaction price and to consider the constraint on variable consideration. ABC estimates the discount amount using an expected value method as there is no most likely discount amount, estimating that a discount of 42% in the third- year PCS fees will be granted. Consequently, absent constraint, the transaction price at contract inception would consideration of the $25,200, which represents 42% of the $60,000 Year 3 be $454,800 ($480,000 – alone selling prices of the license and the PCS PCS fees). Assuming the stand- are $300,000 and $200,000, respectively, the relative stand-alone selling price allocation would be: © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

295 Revenue for software and SaaS 293 : Determine the transaction price D. Step 3 Stand -alone -alone Relative stand selling price selling price License $272,880 $300,000 PCS $200,000 $181,920 Because ABC has a history of granting price concessions and those discounts can range, unpredictably (based on the entity’s customary business practices and experience), between 20% and 60% of the final year’s contractual PCS fees, including any of the potential PCS discount less than the 60% maximum in the transaction price carries the risk of a revenue reversal. However, ABC does not constrain its estimate of the transaction price below $454,800 because the revenue reversal that would result from the possible incremental discount of 18% (60% – 42%), or $10,800, regardless of when it occurs during would not be significant to the cumulative revenue the contract period, recognized to date under the contract. For example, an adjustment to the immediately after transfer of control of the software license transaction price 1 (as compared to cumulative revenue would result in a reversal of only $6,480 recognized of $272,880), while an adjustment at the end of Year 2 of the issuing the Year 3 PCS invoice), would only contract (i.e. immediately before 2 (as compared to cumulative revenue recognized result in a reversal of $9,360 3 assuming a time -based measure of progress is applied to the of $394,160, three- year PCS performance obligation). Notes: 1. $10,800 × ($272,880 ÷ $454,800) = $6,480 2. $10,800 x ($394,160 ÷ $454,800) = $9,360 $272,880 + ($181,920 × 2/3) = $394,160 3. D140 Question How do customer price protection (i.e. retroactive most -favored nations) clauses affect the transaction price? Price protection clauses An entity may enter into an arrangement with an end customer or a reseller and agree to provide a rebate or credit for a portion of the arrangement fee in the event the entity reduces the price for the entity’s products. This may include reseller scenarios where the reseller has not yet sold the products to end customers. These clauses may also apply to services or usage -based fees (e.g. a promise that if the entity offers better per -transaction pricing to another customer, that it will provide the customer a credit for the difference between what it paid and what the new customer is paying). Interpretive response: Software entit ies should apply the price concession accounting model outlined in Question (i.e. the variable consideration D130 model) price protection clauses retroactively change the price paid for . Because (e.g. licenses already transferred) or goods or services already transferred © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

296 Revenue for software and SaaS 294 D. Step 3 : Determine the transaction price completed software customization project) partially transferred (e.g. a partially to the customer, they are, in essence, just another form of potential price concession. Price protection clauses, which apply retrospectively, should be distinguished to from most -favored nations (MFN) clauses that apply only prospectively (including distinct goods or services within promised goods or services distinct a single performance obligation), or optional goods or services, not yet transferred to the customer. Such clauses do not create variable consideration. Rather, when the transaction price changes, the entity would account for the 10- price change as a contract modification in accordance with paragraph 606- 25-13(a). D140.1 Example Reseller arrangement and price protection capped by the contract ABC Corp. enters into a distribution agreement with Reseller on January 1, 20X1. The distribution agreement contains a clause that stipulates that in the event ABC reduces the price of any product in a transaction with a similarly situated customer, ABC will provide Reseller with a credit equal to the difference between the original purchase price and the new purchase price of the product for any units in Reseller’s inventory at the time of the price reduction, as well as any units of the product purchased and sold by the Reseller within 180 days of the price reduction up to a maximum amount of 40% of the original purchase price. On January 1, 20X1 (same day that the contract is entered into), ABC transfers control of 1,000 licenses of Product A for a nonrefundable fee of $100,000. At this same time, ABC’s pricing committee is working to determine the amount of a price reduction for Product A licenses that would apply to similar customers. Scenario 1 Because the pricing committee is evaluating a variety of considerations in attempting to determine the future pricing for licenses to Product A, there is significant risk in both the amount and the timing of the price concession that he will be granted to Reseller. As a result of the significant uncertainty as to t price protection ABC will provide the Reseller, ABC concludes that only $60,000 of the $100,000 contract price is not subject to the risk of a significant revenue reversal – i.e. ABC assumes the maximum amount of price protection stipulated in the agreement with Reseller will be provided (i.e. at 40% of the $100,000 contract price). Consequently, the transaction price is only $60,000 at the point in time ABC transfers control of the 1,000 licenses to Reseller. If ABC’s pricing committee subsequently (e.g. April 1, 20X1) decides to reduce the price from $100 per license to $70 per license, and determines that no further price reductions are reasonably expected during the 180- day price ion protection period with Reseller, ABC would update its estimated transact price for this contract from $60,000 to $70,000, and therefore, would recognize an additional $10,000 in revenue at that time. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

297 Revenue for software and SaaS 295 D. Step 3 : Determine the transaction price Scenario 2 Alternatively, assume ABC’s pricing committee is further along in its deliberations of the pricing for Product A licenses such that it is probable that the price reduction will not exceed 25% of the original $1,000 fee per license. In this case, the transaction price would be $75,000, which would be recognized at the point in time ABC transfers control of the 1,000 licenses to Reseller. If ABC’s pricing committee subsequently (e.g. February 1, 20X1) decides to reduce the price from $100 per license to $80 per license, and determines that no further price reductions are reasonably expected during the 180- day price protection period with Reseller, ABC would update its estimated transaction price for this contract from $75,000 to $80,000, and therefore, would recognize an additional $5,000 in revenue at that time. Comparison to legacy US GAAP protection clauses under Topic 606 will differ from that The accounting for price under legacy US GAAP as follows: Software entity was unable to reasonably estimate effect of the price protection unable Under legacy US GAAP, if the software entity was to reasonably estimate future price changes (e.g. in light of competitive conditions), or if significant uncertainties existed about the entity’s ability to maintain its price, the arrangement fee was not fixed or determinable. In such circumstances, revenue from the arrangement was deferred until the entity was able to reasonably estimate the effects of future price changes. Under Topic 606, the entity estimates the transaction price, subject to the constraint, generally resulting in at least some revenue recognition for d software licenses where no revenue would have been recognized transferre under legacy US GAAP. Software entity was able to reasonably estimate effect of the price protection Under legacy US GAAP, if the software entity was to reasonably estimate able the amount of the fee that may be subject to rebate or forfeiture as a result of the entity reducing its price for a product, the entity generally would recognize revenue for the arrangement with a reserve established (classified as a reduction of revenue) for the estimated amount of the price concessions to be granted assuming all of the other legacy US GAAP software revenue recognition criteria were met. This situation is similar to the requirements under Topic 606; however, legacy US GAAP differs from Topic 606 because, under legacy US GAAP in this scenario, a software entity would use its best estimate to determine the amount of revenue it could recognize when it delivered the software, while under Topic 606 the entity would have to consider the variable consideration i.e. incorporate a conservative bias to the determination of the constraint – transaction price. The conservative nature of the constraint versus a ‘best © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

298 Revenue for software and SaaS 296 D. Step 3 : Determine the transaction price estimate’ may mean entities in this scenario would recognize less revenue at the time the software licenses are transferred to the customer under Topic 606 than they would have under legacy US GAAP. Software entity was able to reasonably estimate, but estimated amount was unusually large Under legacy US GAAP, even if the entity was able to reasonably estimate the amount of the fee, including within a narrow range, that may be subject to rebate or forfeiture as a result of the entity reducing its price for a product, it would also need to consider whether the amount (or narrow range) associated with the estimated price concession was unusually large. If so, the entity would evaluate whether revenue recognition was appropriate at all because an unusually large amount of estimated price protection may have been indicative of an arrangement granting the use of software for evaluation or demonstration purposes rather than an arrangement involving a valid sale. It might otherwise also call into question whether the fee is fixed or determinable. While no revenue recognition might occur in these scenarios under legacy US some GAAP, under Topic 606, the entity would generally recognize at least revenue once it transferred control of the license because the transaction price will include the entity’s estimate of the amount to which it will ultimately be ch even if subject to the constraint will typically be an amount entitled, whi greater than zero. Question D150 Do extended payment terms create variable consideration in a contract with a customer? Extended payment terms Extended payment terms in software arrangements have generally been defined as those in which payment of a significant portion of the license fee is not required until more than 12 months after software delivery; however, ’s they can include any payment terms that are elongated from the entity customary payment terms. Interpretive response: Extended payment terms may be explicitly stated in a ’s past actions or customer contract or they may be implied through a n entity Extended payment terms are not in and of themselves a form of expectations. variable consideration, provided those payment terms are fixed. However, contracts that feature extended payment terms may be more likely to include ample, the risk that an entity will other forms of variable consideration. For ex grant a concession to the customer increases in situations where there are extended payment terms. This is because an entity’s commitment to enforce payment may diminish if new or enhanced products are introduced by the entity or its competitors. This risk increases to the extent that the software is susceptible to rapid technological obsolescence. That is, if the underlying software is at risk of becoming technologically obsolete before a customer is required to make payment to the software entity, a concession becomes even more likely. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

299 Revenue for software and SaaS 297 D. Step 3 : Determine the transaction price As part of their overall assessment of the risk of concessions, software entit ies generally should consider their historical collection history for sales of similar when software licenses estimating the frequency, extent and likelihood of potential price concessions for a group of contracts, or for a specific contract. If a contract, or group of contracts, have payment terms that are longer than a software entity typically offers for a give n type of software product, then historical collection patterns may be a less useful predictive measure when estimating the likelihood and amount of potential price concessions. This may also be the case when a software entity enters a new market with a pr oduct that may have a different technological useful life than the entity ’s other products. The existence of extended payment terms and the payment term length offered to different customers could also be considered when applying an approach that uses a portfolio of data for the purposes of estimating payment concessions. Software entit ies should apply the price concession accounting model outlined in Question D130 in the transaction in accounting for any potential changes price related to concessions arising from extended payment terms. Even if a contract with extended payment terms does not give rise to a potential concession, contracts with extended payment terms may include a significant financing component that should be accounted for in determining the transaction price. The existence and accounting for significant financing . components is discussed in the next section of this chapter Example D150.1 Extended payment terms year license to Software Product X with Customer ABC Corp. enters into a five- for $1,500,000. Customer will pay that fee in equal quarterly installments over the five- year license period. ABC’s current product development roadmap (which is not provided to Customer) shows that it expects to introduce a replacement software product to Product X before the end of the third year of the contract with Customer. The contract with Customer does not include rights to future when- and- if developed software products or any specified right to obtain a license to the expected replacement software product. ABC does not have a history of granting price or other concessions to customers; however, it has not previously introduced a replacement of one of its core software products. Because Customer has no history of granting concessio ns, these circumstances of forthcoming product release alone may not mean a concession is reasonably possible, especially if there is a risk the replacement product will not be developed and released on schedule. If the likelihood of a concession is remote, then it may have no effect on the transaction price. This is concession will be granted (i.e. it is probable no because it would be probable that that no significant revenue reversal would result from use of the stated contract price, without consideration of a possible concession, as the transaction price). It should be noted that use by ABC of an expected value estimation technique could still result in a reduction the transaction price for the effect of a of concession (e.g. if there is a chance of a concession that is more than ‘remote’). However, given no history of concessions in similar arrangements, ABC might conclude an expected value method is not appropriate or may conclude, © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

300 Revenue for software and SaaS 298 D. Step 3 : Determine the transaction price consistent with Question D50, that it does not need to include the remote possibility of granting a concession in its expected value determination. ABC needs to apply judgment in this example to determine whether the likelihood of a concession is more than remote (e.g. whether ABC might grant Customer a license to the replacement software product, reduce Customer’s remaining payments for its Product X license after the replacement product is released or grant Customer X a discounted license to Product X). Individual facts and circumstances could significantly affect the conclu sion. For example, accounting for a possible concession (whether a price concession or otherwise, such as a license to the replacement software product) would likely be appropriate if ABC’s management is discussing possible concessions or incentives that should be offered in order to retain customers like Customer who might be on term licenses to the older Product X when the replacement addresses the accounting for concessions C90 product is released. Question consisting of free or discounted goods or servi Question D130 ces, while addresses concessions. ABC will also need to consider whether the price year software license mean the contract extended payment terms for the five- includes a significant financing component. Significant financing components are discussed in beginning with Question D230. Comparison to legacy US GAAP Legacy US GAAP contained considerable guidance, including implementation guidance, on the effect of extended payment terms in software arrangements. In general, legacy US GAAP specified that an arrangement fee should be presumed not to be fixed or determinable if payment of a significant portion of the licensing fee is not due until after expiration of the license or more than 12 months after delivery. That presumption could be overcome by evidence that the entity had a standard business practice of using l ong-term or installment contracts and a history of successfully collecting under the original 605 22 through -55- payment terms without making concessions (paragraphs 985- 55-25). If, at the outset of an arrangement, an entity concluded that the arrangement fee was not fixed or determinable, the entire fee would be recognized only as payments became due and payable, assuming all other revenue recognition criteria were met. In addition, legacy US GAAP provided that: of payment terms at a subsequent date would not trigger a A modification — reassessment of whether the fees were fixed or determinable. However, in cases where an existing arrangement with a customer was replaced by a substantially new arrangement (e.g. the entity and the customer contract for substantial additional deliverables with an appropriate corresponding increase in aggregate fees), it was considered appropriate to reassess whether the fees were fixed or determinable at inception of the new arrangement. — In an extended payment terms scenario where the entity recognizes revenue as the payments became due and payable, an entity could recognize revenue at the time the prepayments were received (i.e. before they were due and payable under the terms of the original contract) © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

301 Revenue for software and SaaS 299 D. Step 3 : Determine the transaction price provided all other revenue recognition criteria were met (paragraph 985- 55-15). 605- — If an entity entered into a software arrangement with extended payment terms, and then received payment in full subsequent to its financial reporting period- end, but before issuing its financial statements for that period, it was not appropriate to reassess whether the fees were fixed or determinable at period-end (i.e. this subsequent payment would not allow the software entity to recognize the license fees in the reporting period that just ended). The entity would recognize the license fees as revenue of the period in which they were paid (paragraphs 985- 605- 55 -26 through 55 -30). The presumption that a software license fee was not fixed or determinable — overcome if, not was (e.g. under an extended payment terms scenario) whether at the outset of the arrangement or subsequently, the software entity transferred its rights to receive amounts due under an extended payment term arrangement to an independent third party. This transfer did not change the nature or structure of the transaction between the software entity and customer, even if the extended payment term arrangement is irrevocably transferred or otherwise converted to cash without recourse to 605- 55-31 and 985 -605-55 -32). the entity (paragraphs 985- Under Topic 606 there is not a fixed or determinable criterion for revenue recognition, and therefore extended payment terms do not create the presumption of a price concession. And even where a concession may be expected because of extended payment terms, the accounting for expected price or other concessions under Topic 606 will generally not delay revenue recognition under the contract as significantly as the expectation of concessions did under legacy US GAAP. That is, entities that expect to grant price or other concessions under a contract will generally recognize revenue for that contract in advance of when they would have been able to recognize revenue for that same contract under legacy US GAAP. See further discussion in Question C90. Question D160 How should prompt payment discounts be considered when determining the transaction price of a contract? Interpretive response: Contracts with customers often have terms that incentivize prompt payment by the customer such as ‘ 2/10 net 30’ (2% n entity within 10 days or pay the full invoice amount discount for payment to a within 30 days). The potential 2% discount is variable consideration that affects the transaction price in the same manner as any other variable consideration. As such, the entity would make an estimate of the consideration it expects to as a result of offering these terms using the most likely amount or be entitled to . Consistent with the overall variable consideration the expected value method model, the entity would analyze their experience with similar customers and and that estimate would then be subject to transactions in making this estimate . the variable consideration constraint © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

302 Revenue for software and SaaS 300 D. Step 3 : Determine the transaction price D170 Question How do service level agreements (SLAs) that could efunds or credits to the customer affect result in r the transaction price? Interpretive response: Credits or refunds to a customer that result from the failure of the entity to meet certain standards under the contract are adjustments to the transaction price (reductions of revenue), and therefore they should be estimated at the outset of the arrangement in the same manner as any other variable consideration – i.e. using the most likely amount or the expected value method. As with other forms of variable consideration, t hose estimates are then subject to the constraint on variable consideration. The are , including the effect of the constraint on those estimates, revised estimates and the transaction price adjusted until the uncertainty is resolved. D170.1 Example Service level agreements SaaS Company enters into a standard contract with Customer to provide access to its hosted application for three years. Monthly fees are $100 throughout the three- year term, subject to a service level provision under which SaaS Company warrants that the hosted application will be available and functioning to specifications during the service period at least 99% of the time (i.e. the maximum percentage of downtime for maintenance or due to increased network traffic will be 1%). In any month that the downtime is greater than 1%, Customer will be entitled to a 10% credit of that month’s fees against the next month’s $100 payment – i.e. Customer will pay $90 in any month following a month in which downtime is greater than 1%. In addition, if the downtime is greater than 5%, SaaS Company will be required to provide a 25% credit of that month’s fees in the next month. Scenario 1 SaaS Company has significant experience with similar contracts and has an established history of rarely having to grant service level credits to customers. Based on this significant experience, SaaS Company concludes that using the most likely amount method to estimate the variable consideration in the contract resulting from the possible service level credits will best predict the consideration to which it will be entitled. Applying that method, SaaS Company concludes that it expects to be entitled to 100% of the contract price (i.e. downtime will be less than 1% for the duration of the agreement because it does not expect to issue any credits or refunds). Further, SaaS Company’s experience is of such a substantive nature and so rarely has to grant service level credits that the estimate of variable consideration does need to be constrained – including the entire stated fees for the i.e. it is probable that year term of $3,600, without any reduction for possible service level three- credits, in the transaction price at contract inception will not result in a significant revenue reversal. Consequently, the transaction price does not reflect any expectation of service level credits. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

303 Revenue for software and SaaS 301 D. Step 3 : Determine the transaction price Scenario 2 SaaS Company has been operating for a relatively short period of time such that its experience with these types of arrangements is limited. Consequently, SaaS Company cannot conclude that it is probable it will not grant any service level credits to Customer during the course of the contract and will need to estimate expected service level credits over the three -year term. SaaS Company considers all of its available and relevant evid ence, including knowledge about the quality of its infrastructure, industry benchmarks and its own limited experience in developing an expected value method to estimate the credits it expects to provide to Customer over the three- year term. SaaS Company further considers whether it is probable, if it uses that estimate as the transaction price, that no significant revenue reversal will result. ABC will continue to re- evaluate its estimate of the transaction price, including the effect of the constraint (if applicable), at the end of each reporting period for changes in circumstances (e.g. additional experience gained). Question D180 What factors influence the potential magnitude of a revenue reversal that would result from a entity’s estimate of downward adjustment to an variable consideration? Because the constraint is intended to significantly Interpretive response: cumulative reduce the likelihood that a significant reversal in the amount of revenue recognized for the contract will occur (i.e. it c onsiders the magnitude of any potential revenue reversal), the following affect (1) whether the constraint results in an adjustment to the entity’s most likely amount or expected- value that method estimate of variable consideration and, if so, (2) the amount of adjustment. — The identification of the performance obligations in the contract (e.g. whether a license and professional services are or are not distinct) . — If there are multiple performance obligations in the contract, the order in which those performance obligations are satisfied. — Whether some or all of the performance obligations in the contract are satisfied over time or at a point in time. D180.1 Example Effect of various scenarios on the potential magnitude of a revenue reversal This example outlines three scenarios in order to illustrate how the above- outlined factors affect the potential magnitude of a revenue reversal resulting from a change in the amount of estimated variable consideration. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

304 Revenue for software and SaaS 302 D. Step 3 : Determine the transaction price Scenario 1 ABC enters into a contract with Customer that includes a software license and implementation services that are separate performance obligations. The software license is transferred at contract inception and the implementation services are provided over the subsequent 12 months. The fixed consideration is $1,000,000, and ABC can earn up to a $200,000 bonus depending on when the implementation services are completed. Based on the stand- alone selling prices of the license and the services, determined using a residual approach and Step 4: alone selling price, respectively (see – the observable stand- Chapter E Allocate the transaction price to the performance obligations in the contract ); the transaction price is allocated on an 80:20 ratio to the license and implementation services, r espectively. On a most likely amount basis, ABC concludes that it expects to be entitled to $150,000 of the performance bonus. However, it is only ‘probable’ that ABC will be entitled to $50,000. Assume ABC concludes that it cannot allocate the performance bonus to only the license or the implementation services. Because the distinct software license is transferred to Customer at contract inception, if ABC were to include $150,000 of variable consideration in the to constrain any of not transaction price at contract inception (i.e. if ABC were its most likely estimate of variable consideration), and later have to revise its estimate to the probable amount of $50,000, ABC would record a revenue at least (i.e. depending on progress toward satisfaction of the reversal of implementation services at the time the estimate is revised) $80,000 ($100,000 [$150,000 – $50,000] × 80%). The portion of the remaining $20,000 of the change in the transaction price ($100,000 – $80,000) that will be ’s completion of the immediately reversed against revenue depends on ABC implementation services when the change in the transaction price occurs (e.g. if ABC is 50% complete with the implementation services, ABC’s total enue reversal will be $90,000 [$80,000 attributable to the license; $10,000 rev attributable to the services]). Because the potential revenue reversal could be significant, ABC concludes that the variable consideration constraint should be applied. Scenario 2 ABC enters into a contract with Customer that includes a software license and customization services that are a single, combined performance obligation. The combined performance obligation is satisfied over time and is expected to be satisfied over 12- 15 months after contract inception. The fixed consideration is $1,000,000; and ABC can earn up to a $200,000 bonus depending on when the software customization is completed. On a most likely amount basis, ABC concludes that it expects to be entitled to 000 of the performance bonus. However, it is only ‘probable’ that ABC will $150, be entitled to $50,000. If ABC were to include $150,000 of variable consideration in the transaction price at contract inception, and later have to revise its estimate to the probable amount of $50,000, ABC’s revenue reversal at that point in time would be less than that in Scenario 1 and would depend on ABC’s progress toward satisfaction of the performance obligation. For example: © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

305 Revenue for software and SaaS 303 D. Step 3 : Determine the transaction price % Complete Revenue reversal 10% $10,000 25% $25,000 $60,000 60% Consequently, the magnitude of the revenue reversal that would result from a potential downward adjustment in ABC’s estimate of variable consideration to which it expects to be entitled in this scenario is less significant throughout the contract period than in Scenario 1. As a result, ABC concludes that it does not need to constrain its estimate of the variable consideration to which it expects to be entitled and includes the entire $150,000 estimate in the contract inception transaction price. Scenario 3 Assume the same facts and circumstances as Scenario 2 except that the single, combined performance obligation is satisfied at a point -in-time (e.g. due to highly specialized customer acceptance provisions – see Question F210) upon pletion of the software customization. com On a most likely amount basis, ABC concludes that it expects to be entitled to $150,000 of the performance bonus. However, it is only ‘probable’ that ABC will be entitled to $50,000. In this scenario , the constraint would not result in an adjustment to the because no revenue will be recognized until the uncertainty transaction price giving rise to the variable consideration is resolved – i.e. because no revenue will be recognized until the performance obligation is completely satisfied, no cumulative revenue will have been recognized at the point in time any downward adjustments to ABC’s estimate of the variable consideration to which it expects to be entitled are made. Based on the above, software entities should be aware that the constraint is distinct software license is more likely to apply in arrangements where a to the customer up- front and a significant portion of the transaction transferred price is allocated to that up- front software license – i.e. unless the source of the variable consideration is a sales- or usage- based royalty, to which the constraint on variable consideration does not apply (see below) . As illustrated in the example, Scenario 1, a change in the estimate of, for example, a performance implementation services would not only affect revenue bonus on distinct completed implementation services, but also recognized to- date for the partially for the already -transferred software license. Sales- and usage -based royalties Variable consideration in the form of a sales- or usage -based royalty that is promised in exchange for a license of intellectual property (e.g. a software license) is not subject to the constraint on variable consideration. Rather, such royalties are subject to a specific sales- and usa ge-based royalties recognition exception (‘the royalties constraint’) that is further discussed in Chapter F – evenue when (or a s) the entity satisfies a performance Step 5: Recognize r . obligation © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

306 304 Revenue for software and SaaS : Determine the transaction price D. Step 3 The royalties constraint does not apply to either: — sales of intellectual property (e.g. the sale of a software application and all related rights to that application to another party); or — -based fees in SaaS arrangements because, as described in usage Chapter A – Scope , SaaS arrangements do not include a license to software. intellectual Sales based fees promised in exchange for the sale of - and usage- property or included in SaaS arrangements are subject to the general guidance on variable consideration, including the constraint on variable consideration, outlined earlier in this chapter. entity should When determining the applicability of the royalties constraint, an in not attempt to discern whether a license to intellectual property is an ‘ ’ of that intellectual property. The FASB reached this conclusion substance sale on the basis that attempting to distinguish between licenses that are, or are not, in substance sales would add significant complexity (i.e. trying to distinguish what licenses constitute in substance sales) and that it may be legal differences between a inappropriate to ignore, for accounting purposes, contract for a license and a contract for an outright sale of intellectual property . 2016- 10.BC78(b) [ASU ] . Comparison to legacy US GAAP -ba Variable consideration that is not a sales - or usage sed royalty promised in exchange for a license Under legacy US GAAP, arrangement fees were not recognized as revenue until they were fixed or determinable and any fees contingent on future performance (e.g. delivery of an additional good or service) were deferred until the contingency was resolved (the ‘contingent cash cap’). Topic 606 does not require fees to be fixed or determinable and does not have a contingent cash cap, rather Topic 606 follows the estimation and constraint guidance described above. The change in the guidance pertaining to variable/contingent consideration will likely result in many entities recognizing revenue earlier than they did under legacy US GAAP and also require many entities to implement new processes and controls in order to permit them to meet the new estimation requirements and make the judgments necessary to apply the constraint. - or usage Sales -based royalties promised in exchange for a license See Chapter F – Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation . Sell -through -in versus sell Under legacy US GAAP, some software entities that sell their software licenses through distributors or resellers conclude that the fees for its sales to distributors or resellers are not fixed or determinable because of the risk of granting price concessions or of accepting returns. Those entities recognize revenue upon ‘sell - © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

307 Revenue for software and SaaS 305 D. Step 3 : Determine the transaction price through’ of the software license to the end customer (i.e. when an end customer obtains the software from the reseller). In contrast, under Topic 606, an expectation of price concessions or returns is variable consideration. And because variable consideration does not affect the timing of revenue, which is recognized when or as the performance obligation is satisfied, only t he amount, software entities in distributor or reseller arrangements cannot default to a sell- through method. Under Topic 606, the software entity is generally required to determine the total amount of consideration to which it expects to be entitled (e.g. the number of units it expects not to be returned and the amount it expects to be entitled to, after any price concessions, for those units), subject to the variable consideration constraint. The entity recognizes that amount at the time control of the license(s) transfers to the distributor or reseller. Sell- through (or a result approximating sell -through) would typically not be appropriate unless: — e.g. control of the licenses has not transferred to the distributor or reseller – certain (substantive) repurchase rights of the entity that exist in some distributor relationships to buy back a good until the point in time it is sold to an end customer will affect when control of the license transfers; or — by applying the constraint, the amount recognized upon transfer of control of the licenses to the distributor or reseller is zero (which will not usually be the case) – i.e. the entire amount of consideration is at risk of a significant revenue reversal (which would be an infrequent fact pattern). Given that t he entity needs to update its assessment of whether an estimate of the amount is constrained, and if so, by how much, at each reporting date, even if the initial transaction price is zero at the point in time control transfers to the distributor or reseller, the transaction price likely will be updated to an amount above zero, and revenue recognized, before sell - through occurs. The transaction price is updated each reporting period until the uncertainty for concessions and returns is resolved. As a result, it is likely that revenue will be recognized on many sales to Topic 606 than it was under legacy distributors or resellers earlier under US GAAP. Question D190 Are subsequent sales or usage of licensed software variable consideration or is each subsequent sale or usage an ‘optional purchase’? – Step 2: Identify the performance obligations Question C380 Chapter C in See . in the contract © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

308 306 Revenue for software and SaaS : Determine the transaction price D. Step 3 D200 Question Is the contractual right to acquire additional users, seats or copies of software a sales - or usage -based fee (i.e. variable consideration) or a customer option to acquire additional software licenses? – Chapter C Step 2: Identify the performance obligations See Question C390 in in the contract . Question D210 mate Are SaaS providers required to esti transaction -based fees that will be earned from customers in SaaS arrangements? Interpretive response: It depends. Transaction- (e.g. fees charged based fees for each use by the customer, or the customer’s customer of the SaaS (see provider’s application) are just one form of variable consideration Question C 400 for discussion of options to add users or seats in a SaaS . Therefore, SaaS providers are required to estimate such arrangement) just as they would other forms of variable consideration (e.g. service fees, agreements – see Question D170), unless they meet one of two level either: conditions; can be — -invoiced' practical expedient in paragraph 606- 10-55 -18 the 'as applied that permits an entity to recognize revenue from items like transaction -based fees in the amount to which it has a right to invoice the customer. This applies if that amount corresponds directly with the value to the customer of the entity's performance completed to date. A significant based fee rate that changes during the contract up-front fee or a usage- period in a manner that cannot be directly linked to a change in value of the entity’s services to the customer may preclude use of this expedient. Chapter F – Step 5: Recognize r evenue when (or a s) the entity satisfies a discusses performance obligation in further detail when use of this practical expedient is, and is not, appropriate. — the SaaS performance obligation is determined to be a series of distinct service periods (e.g. a series of distinct daily, monthly or annual periods of – which will generally be the case (see the Overview section of service) – Step 2: Identify the performance obligations in the contract ), Chapter C and allocation of the fees earned to each distinct service period based on the customer's usage each period would reasonably reflect the fees to which the entity expects to be entitled for providing the SaaS for that period. Consistent with the as -invoiced practical expedient, a usage -based fee rate that differs from period to period during the contract may prevent allocation of the fees earned in a single distinct service period to that period, as might a discount or rebate that is based on metrics that cross multiple distinct service periods. However, unlike the as -invoiced practical expedient, an up- fro nt fee generally will not affect whether this condition is Chapter E met. Step 4: Allocate the transaction price to the performance – © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

309 Revenue for software and SaaS 307 : Determine the transaction price D. Step 3 obligations in the contract discusse s when SaaS providers will and will not based fees to distinct service periods within be able to allocate transaction- a SaaS performance obligation. Question D220 How do volume -based discounts and rebates affect the estimation of the transaction price in SaaS arrangements? -based pricing should - and usage Interpretive response: First, transaction be distinguished from customer options to add users or seats (see 400). Question C SaaS arrangements that include transaction- or usage- based fees often include tiered pricing and/or volume rebates or credits. The following are examples: — Per transaction pricing that decreases prospectively as the customer makes greater use of the provider’s platform (e.g. $0.10 per transaction for the first 100 transactions; $0.09 per transaction for the next 100; and $0.075 per transaction for those above 200). — Per transaction pricing that decreases as the customer makes greater use basis. For example, the retrospective of the provider’s platform on a customer is required to pay $0.10 per transaction for the first 100 transactions, and if the customer reaches that milestone it will pay $0.09 on and all transactions going forward receive a rebate (or credit toward future transaction fees) of $0.01 on the first 100 transactions processed. Pricing arrangements such as these sometimes apply to an entire contract term or to distinct periods within the contract. For example, a tiered- pricing or volume rebate/credit structure may apply to each month, quarter or year within -term SaaS arrangement and reset at the beginning of the next distinct a longer period. These are just examples as there are many different transaction - and usage-based pricing structures that exist and they frequently co- exist with varied fixed price components. In general, transaction-based fees in a SaaS arrangement constitute variable consideration, rather than optional purchases (see Questio n C380). The complexity of the pricing structure (e.g. the presence of pricing tiers, rebate/credit provisions and resets) does not change that, but may influence whether the SaaS provider can make use of either approach described in 210 to avoid having to estimate that variable consideration – i.e. the Question D less ‘vanilla ’ the transaction -based pricing structure, the more likely the provider will have to undertake some measure of estimation of the variable consideration in order to recognize revenue on the arrangement under 606. price to the p erformance Topic ransaction Chapter E e the t – Step 4: Allocat in further detail the effect of these types of obligations in the contract discusses pricing structures on the SaaS provider’s ability to apply the variable consideration allocation guidance. If the SaaS provider is required to estimate the variable consideration in the whether for the entire contract term or just for a distinct period arrangement – possible refunds, within the overall contract term – rebates or credits will factor into the estimate of variable consideration, just as the expected transaction © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

310 Revenue for software and SaaS 308 : Determine the transaction price D. Step 3 volume will. Multiple variables – i.e. variable usage and variable pricing – will increase the complexity of the estimation process and likely result in more variability throughout the contract term, meaning entities in these situations may have to undertake multiple re- estimations of the transaction price over the course of the contract (and likely more so in circumstances where the estimation period is the entire contract term or a longer distinct period within the contract term, such as a year versus a quarter or month). The existence of a significant financing component in the contract from ASC 606-10 Excerpt > > The Existence of a Significant Financing Component in the Contract 32- 15 In determining the transaction price, an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (eith er explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. In those circumstances, the contract contains a significant financing component. A cing component may exist regardless of whether the promise significant finan of financing is explicitly stated in the contract or implied by the payment terms agreed to by the parties to the contract. 32- The objective when adjusting the promised amount of consideration for 16 revenue at an a significant financing component is for an entity to recognize amount that reflects the price that a customer would have paid for the promised goods or services if the customer had paid cash for those goods or services when (or as) they transfer to the customer (that is, the cash selling price). An entity shall consider all relevant facts and circumstances in assessing whether a contract contains a financing component and whether that financing component is significant to the contract, including both of the following: a. The difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services b. The combined effect of both of the following: The expected length of time between when the entity transfers the 1. promised goods or services to the customer and when the customer pays for those goods or services The prevailing interest rates in the relevant market. 2. Notwithstanding the assessment in paragraph 606 - 17 - 32 10 - 32 - 16, a contract with a customer would not have a significant financing component if any of the following factors exist: a. The customer paid for the goods or services in advance, and the timing of nsfer of those goods or services is at the discretion of the customer. the tra b. A substantial amount of the consideration promised by the customer is variable, and the amount or timing of that consideration varies on the basis of the occurrence or nonoccurrence of a future event that is not © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

311 Revenue for software and SaaS 309 : Determine the transaction price D. Step 3 substantially within the control of the customer or the entity (for example, if the consideration is a sales -based royalty). c. The difference between the promised consideration and the cash selling 10-32 described in paragraph 606- price of the good or service (as 16) arises - for reasons other than the provision of finance to either the customer or the entity, and the difference between those amounts is proportional to the reason for the difference. For example, the payment terms might provide the entity or the customer with protection from the other party failing to adequately complete some or all of its obligations under the contract. 18 32- As a practical expedient, an entity need not adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised good or service to a customer and when the customer pays for that good or service will be one year or less. 16 when adjusting the To meet the objective in paragraph 606- 10 -32- 32- 19 promised amount of consideration for a significant financing component, an entity shall use the discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception. That rate would reflect the credit characteristics of the party receiving financing in the contract, as well as any collateral or security provided by the customer or the entity, including assets transferred in the contract. An entity may be able to determine that rate by identifying the rate that discounts the nominal amount of the promised consideration to the price that the customer would pay in cash for the goods or services when (or as) they transfer to the customer. After contract inception, an entity shall not update the discount rate for changes in interest rates or other circumstances (such as a change in the assessment of the customer’s credit risk). An entity shall present the effects of 32- 20 financing (interest income or interest expense) separately from revenue from contracts with customers in the statement of comprehensive income (statement of activities). Interest income or interest expense is recognized only to the extent that a contract asset (or receivable) or a contract liability is recognized in accounting for a contract with a customer. In accounting for the effects of the time value of money, an entity also shall consider the subsequent measurement guidance in 30 -1A through -45 Subtopic 835 -30, specifically the guidance in paragraphs 835- 45-3 on presentation of the discount and premium in the financial statements 30 -55- 2 through 55-3 on the application of and the guidance in paragraphs 835- the interest method. ning the Discount Rate > > > Example 28— Determi 55- 235 An entity enters into a contract with a customer to sell equipment. Control of the equipment transfers to the customer when the contract is signed. The price stated in the contract is $1 million plus a 5 percent contractual rate of interest, payable in 60 monthly installments of $18,871. Rate in a Separate Contractual Discount Rate Reflects the > > > > Case A — Financing Transaction In evaluating the discount rate in the contract that contains a significant 236 55- financing component, the entity observes th at the 5 percent contractual rate of © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

312 310 Revenue for software and SaaS D. Step 3 : Determine the transaction price interest reflects the rate that would be used in a separate financing transaction between the entity and its customer at contract inception (that is, the racteristics of the contractual rate of interest of 5 percent reflects the credit cha customer). 55- The market terms of the financing mean that the cash selling price of 237 the equipment is $1 million. This amount is recognized as revenue and as a loan receivable when control of the equipment transfers to the customer. The entity accounts for the receivable in accordance with Topic 310 on receivables 30 on the imputation of interest. and Subtopic 835- Reflect the Rate in a > > > > Case B —Contractual Discount Rate Does Not Transaction Separate Financing 238 In evaluating the discount rate in the contract that contains a significant 55- financing component, the entity observes that the 5 percent contractual rate of interest is significantly lower than the 12 percent interest rate that would be used in a separate financing transaction between the entity and its customer at contract inception (that is, the contractual rate of interest of 5 percent does not reflect the credit characteristics of the customer). This suggests that the cash selling price is less than $1 mill ion. -19, the entity determines the 239 10-32 In accordance with paragraph 606- 55- transaction price by adjusting the promised amount of consideration to reflect the contractual payments using the 12 percent interest rate that reflects the tics of the customer. Consequently, the entity determines credit characteris that the transaction price is $848,357 (60 monthly payments of $18,871 discounted at 12 percent). The entity recognizes revenue and a loan receivable for that amount. The entity accounts for the loan receivable in accordance with Topic 310 on receivables and Subtopic 835- 30 on the imputation of interest. Pending Content Transition Date: (P) December 16, 2019; (N) December 16, 2020 ¦ Transition Guidance: 326 -10- 65-1 The entity accounts for the receivable in accordance with Topic 310 ... 237 55- on receivables, Subtopic 326- 20 on financial instruments measured at amortized cost, and Subtopic 835 -30 on the imputation of interest. 55- 239 ... The entity accounts for the loan receivable in accordance with 20 on financial instruments Subt opic 310 -10 on receivables, Subtopic 326- 30 on the imputation of measured at amortized cost, and Subtopic 835- interest. Advance Payment > > > Example 30— An entity, a technology product manufacturer, enters into a contract 244 55- with a customer to provide global telephone technology support and repair coverage for three years along with its technology product. The customer purchases this support service at the time of buying the product. Consideration for the service is an additional $300. Customers electing to buy this service must pay for it upfront (that is, a monthly payment option is not available). 245 To determine whether there is a significant financing component in the 55- contract, the entity considers the nature of the service being offered and the purpose of the payment terms. The entity charges a single upfront amount, not © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

313 311 Revenue for software and SaaS D. Step 3 : Determine the transaction price with the primary purpose of obtaining financing from the customer but, instead, to maximize profitability, taking into consideration the risks associated with providing the service. Specifically, if customers could pay monthly, they of customers that continue to would be less likely to renew, and the population use the support service in the later years may become smaller and less diverse over time (that is, customers that choose to renew historically are those that make greater use of the service, thereby increasing the entity’s cos ts). In addition, customers tend to use services more if they pay monthly rather than making an upfront payment. Finally, the entity would incur higher administration costs such as the costs related to administering renewals and collection of monthly payments. 17(c), the entity In assessing the guidance in paragraph 606 55 - 246 - 32 - 10 - determines that the payment terms were structured primarily for reasons other than the provision of finance to the entity. The entity charges a single upfront amount for the services because other payment terms (such as a monthly payment plan) would affect the nature of the risks assumed by the entity to provide the service and may make it uneconomical to provide the service. As a result of its analysis, the entity concludes that there is not a significant financing component. Topic 606 financing component (time requires an adjustment for the effect of a The value of money) if the financing component is significant to the contract. requirement to adjust for the time value a significant financing component (i.e. of money ) reflects the fact that: — entities are not indifferent to the timing of cash flows in a contract (i.e. cash now is more valuable than cash later); — exclusion of the financing component could misrepresent the profit in the contract (e.g. a payment made in arrears would result in full profit upon transfer of the good or service, even though the entity bears ongoing cost of financing to the customer, conversely, a payment made in advance would result in the financing cost that the entity incurs being included in gross profit from the sale of the good or service); and contracts with an explicitly stated interest rate (where interest income is — recognized) should not be treated differently from contracts with an implied interest rate. Identifying a significant financing component Generally, a contract has a financing component if the promised amount of consideration differs from the cash- selling price of the promised goods or services or there is a sign ificant timing difference between when control of the goods or services is transferred to the customer and when the customer pays for the goods or services. The financing component may be explicit, where a stated interest rate is charged, or implied – i.e. the amount of consideration payable to the entity would differ if the customer paid cash at the same time as Whether that financing component is it received the good or service. and must be factored into the determination of the to the contract ‘significant’ transaction price is a matter of judgment. When the consideration to be received for a good or service with extended payment terms is the same as the cash selling price, the implied interest rate is zero. However, a significant financing component may still exist in that a © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

314 312 Revenue for software and SaaS : Determine the transaction price D. Step 3 difference between the promised consideration for a good or service and the cash selling price , as discussed by the TRG at the March 2015 TRG meeting, is only one factor to consider in making this determination. Two factors should be considered in determining whether a financing component is significant to the contract: Relevant facts and circumstances a) Difference between the amount of promised consideration and the cash selling price b) Combined effect of : 1. Expected length of time between when the entity transfers the promised goods or services and when the customer pays 2. Prevailing interest rates in the relevant market financing component is determined at The significance of a the contract level only , rather than for each performance obligation or at a n aggregated portfolio not evaluate whether the combined effects of level – i.e. an entity does a portfolio individually insignificant financing components would be material to of contracts or to ’s financial statements as a whole. the entity agreed at members Even if a financing component is not significant, the TRG the March 2015 meeting that an entity is not precluded from accounting for that component following the significant financing guidance. A contract does not have a significant financing component if any of the following factors exists. Factor Example An entity receives an advance A flexible spending arrangement where payment, and the timing of the the customer pays the entity a fixed transfer of goods or services to a amount up draws the customer -front and customer is at the discretion of the down against that prepaid amount (e.g. customer issues purchase orders to acquire various software licenses and related services) at its discretion over the term of the arrangement. A substantial portion of the A software license transferred to the consideration is variable, and the customer at contract inception that the amount or timing of the consideration customer will embed in its products and is outside the customer’s or entity’s the consideration for the software license control is a sales royalty. -based The difference between the amount of Protection against the counterparty not promised consideration and the cash completing its obligations under the selling price of the promised goods or contract services arises for non -finance reasons © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

315 Revenue for software and SaaS 313 : Determine the transaction price D. Step 3 Determining whether a difference between the amount of promised consideration and the cash selling price of the goods or services arises for reasons other than the provision of finance requires judgment. An entity cons iders all relevant facts and circumstances, including whether the difference is proportionate to any other reason provided – i.e. in addition to having a reason 17(c) requires the difference between -32- 10 other than financing, paragraph 606- the promised consideration and the cash selling price of the good or service to be proportional to the reason for the difference. A payment in advance or arrears on terms that are typical for the industry and have a primary purpose other than financing. For example, a jurisdiction may customer may withhold an amount of consideration that is payable only on successful completion of the contract or the achievement of a specified milestone (e.g. successful implementation or customization of software) . The primary purpose of these payment terms, as illustrated in Example 27 of , may be to provide the customer with assurance that the entity will Topic 606 perform its obligations under the contract, rather than provide financing to the An entity should monitor practices within its industry and geography customer. (including its own customary payment terms) and consider documenting how the payment terms in certain contracts conform to these practices and ncing whether, if at all, the primary purpose of these practices is other than fina When considering practices within its industry and geography (e.g. retainage). (including its own customary payment terms) entities should use current actual transaction data and contracts with similar terms to the contract under consideration. Importantly, the fact that payment in advance or arrears is typical for an industry or in a jurisdiction is not determinative that such payment occurs i.e. the fact that such payment terms are typical for for non-finance reasons – the industry or the jurisdiction does not automatically mean there is not a significant financing component in the contract. Alt hough it seems that the Boards were attempting to address retention payments in the construction industry with these observations, this concept -term software customization or might apply to other situations (e.g. long implementation projects that may have some characteristics similar to many -term construction contracts ). The Boards explicitly considered advance long payments received by an entity during their redeliberations – e.g. compensating the entity for incurring up -front costs – but decided not to exempt entities from when the account ing for the time value of money effect of advance payments embedded financing is significant to the contract with the customer . Accounting for a significant financing component When a contract includes a significant financing component as a result of an advance payment to the entity , the accounting effect of the financing component increases the amount of revenue recognized, with a corresponding because the customer has provided financing to increase to interest expense the entity. Conversely, when a contract includes a significant financing component because the entity receives payments in arrears, the adjustment for decreases the amount of revenue recognized with a the financing component corresponding increase to interest income because the entity has provided . financing to the customer © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

316 Revenue for software and SaaS 314 : Determine the transaction price D. Step 3 These effects impact various financial metrics such as EBITDA (earnings before inter est, tax, depreciation and amortization), which may, in turn, affect compensation and other contractual arrangements. s of a entity’s reflected in the significant financing component are The effect as either an increase (for advanced payments) estimate of the transaction price or a decrease (in post -paid scenarios) using a discount rate that reflects the credit standing of the party receiving the financing (i.e. the entity’s credit and the customer’s credit standing for advance payment circumstances standing for payments in arrears) . Determining the effect of the time value of money for a contract with a significant financing component can be complex for long- term or multiple- element arrangements. In these contracts: — goods or services are transferred at various points in time; — cash payments may be made throughout the contract; and — there may be a change in the estimated timing of the transfer of goods or services to the customer. If additional variable elements are present in the contract – e.g. contingent consideration – then these calculations can be even more complicated. For example, a software entity may offer payment terms that allows customers to buy software products and pay the cash selling price two years after del ivery. Judgment is required to evaluate whether in these circumstances an entity is offering a discount or other promotional incentive for customers who pay the cash selling price at the end of the promotional period equal to the financing charge that woul d otherwise have been charged in exchange for financing the purchase. If the entity concludes that financing has been provided to the customer, then the transaction price is reduced by the implicit financing amount and interest income is accreted. The implicit financing amount is calculated using the rate that would be used in a separate financing transaction between the entity and commensurate with the customer’s credit standing. its customer Determining the discount rate The discount rate to be used in accounting for a significant financing component: — is determined at contract inception and is not updated for changes in facts or circumstances, such as the customer’s interest rates or changes in or the entity’s credit standing (however, the discount rate is updated if there is a contract modification not accounted for as a separate contract and a significant financing component is determined to exist in the modified contract) ; and is the rate that would be reflected in a separate financing transaction — en the entity and the customer, reflecting the credit characteristics of betwe the party (i.e. the entity or the customer) receiving the financing. For payments received in advance of the transfer of the goods or services to should reflect the creditworthiness of the the customer, the discount rate used entity. Conversely, for payments received in arrears (i.e. after the transfer of the goods or services to the customer ), the discount rate used should reflect the © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

317 Revenue for software and SaaS 315 D. Step 3 : Determine the transaction price creditworthiness of the customer and any effect on the rate (presumably downward) if collateral or other security is provided by the customer. The entity should not use a , unless the customer is the U.S. -free rate risk government or another entity with a n equivalent credit standing, as it does not reflect the risk characteristics of the parties to the contract (i.e. if the entity provides the customer financing, the entity likely would charge more for the financing when the customer’s creditworthiness is lower). It also may not be appropriate to use an interest rate that is explicitly specified in the contract because the entity might offer below- market financing as a marketing incentive. Consequently, an entity applies the rate that would be used in a separate financing transaction between the entity and its customer. This can lead to practical difficulties for entities with large volumes of customer contracts and/or multinational operations, because they will have to determine a specific discount rate for each customer, class of customer or geographical when a contract contains a significant financing component . region of customer Presentation of the effects of the time value of money i.e. the An entity should present the effects of the financing component ( unwinding of the discount) separately from revenue from customers as interest income or interest expense. The unwinding of the discount should not be an element of revenue from customers because contracts with financing components that are significant to the contract have two separate economic features: one relating to the transfer of goods or services (revenue from customers ) and the other relating to the financing component (interest expense that some entities regularly enter into financing The Boards noted or income). s and, therefore, interest represents income arising from ordinary transaction activities for those entities. Topic 606 does not preclude an entity from presenting interest as a type of revenue in circumstances in which the interest represents income from the entity’s ordinary activities. Practical expedient to adjusting for a significant financing component Paragraph 606-10 -32- 18 states that an entity is not required to make an adjustment if, at contract inception, the entity does not expect the period by the customer of the consideration promised and the between payment transfer of control of the promised good or service to the customer to exceed one year. This exception applies regardless of whether control of goods or services occurs before payment is made or payment occurs before transfer of the goods or services. For contracts with an overall duration greater than one year, the practical expedient applies if the period between performance and payment for that performance is one year or less. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

318 Revenue for software and SaaS 316 D. Step 3 : Determine the transaction price ? Significant financing component Interest expense Interest income Practical expedient available Payment in Payment in t 0 advance arrears mont hs t- 12 mont hs t+ 12 Per for mance In a contract with two or more performance obligations, identifying the period between customer payment and the transfer of goods or services may present challenges, especially when the performance obligations are satisfied at different points in time and consideration is paid over time or all at once. examples Illustrative Illustrative E xample D1 Time value of money in a single performance obligation arrangement ABC Corp. enters into a contract to transfer a license to Software Product A to front cash payment of $300,000. At contract inception, ABC Customer for an up- expects to deliver Software Product A to Customer in two years and determines that the contract has a significant financing component. ABC’s borrowing rate is 5%. At contract inc eption, ABC recognizes a contract liability of $300,000 for the cash received. Over the two years, ABC recognizes interest expense and b a in year 1 and $15,750 in year 2. At increases its contract liability by $15,000 the end of the two- year period when it transfers control of Software Product A c . to Customer, ABC recognizes revenue of $330,750 Notes: a. $ 300,000 x 5% = $15,000 b. ($300,000 + $15,000) x 5% = $15,750 c. $300,000 + $15,000 + $15,750 = $330,750 © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

319 Revenue for software and SaaS 317 D. Step 3 : Determine the transaction price D2 Illustrative E xample Time value of money in -element a multiple arrangement ABC Corp. enters into a contract with Customer to transfer licenses to Software Product X and Software Product Y for $150,000 payable up- front. The license to Software Product X will be transferred in two years, and the license to Software Product Y will be transferred in five years. ABC determines that the contract contains two performance obligations that are satisfied at the points in time at which the licenses are transferred to Customer. ABC allocates the $150,000 to the Software Products X and Y licenses at amounts of $37,500 and $112,500, respectively – i.e. based on their relative stand -alone selling prices. ABC concludes that the contract contains a significant financing component and that a financing rate of 6% is appropriate based on ABC’s credit -standing at contract inception. ABC accounts for the contract as follows. Recognize a contract liability for the payment of $150,000 Contract inception During the two years from contract inception until the transfer of the license to Software Product X, recognize (a) 9,540 interest expense of $ 9,000 and $ on $150,000 at 6% for Years 1 and 2, respectively, for a cumulative interest Years 1 and 2 expense of $18,540 (b) for the transfer of the Recognize revenue of $42,135 license of Software Product X Recognize annual interest expense of $7,584, $8,039 and (c) $8,522 for Years 3, 4 and 5, respectively, based on the (d) contract liability at the beginning of Year 3 of $126,405 Years 3, 4 and 5 (e) for the transfer of the Recognize revenue of $150,550 license to Software Product Y Notes: a. Calculated as $150,000 × 6% for Year 1 and $159,000 × 6% for Year 2. b. Calculated as $37,500 + $4,635, being the initial allocation to Product X license plus Product X’s portion of the interest for Years 1 and 2 of the contract ($37,500 ÷ $150,000 × $18,540). c. Calculated as $126,405(d) × 6% = $7 ,584; ($126,405 + $7,584) × 6%= $8,039; and ($126,405 + $7,584 + $8,039) × 6% = $8,522. − $42,135, being the initial contract liability plus d. Calculated as $150,000 + $18,540 interest for two years less the amount derecognized from the transfer of the license to Product X. e. Calculated as $126,405 + $24,145, being the contract liability balance after years plus interest for three years. two © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

320 Revenue for software and SaaS 318 : Determine the transaction price D. Step 3 D3 xample Illustrative E Determining whether an arrangement has a – Payment in significant financing component advance SaaS Company signs a three -year, non-cancellable agreement with Customer to provide SaaS. Customer may elect to either pay: $140 per month (total payment is $5,040); or a. b. $4,200 at the beginning of the contract term, with no additional monthly payments. The contract includes a financing component. The difference in pricing between option (a) and option (b), together with the timing difference between when Customer will pay the promised consideration and SaaS Company’s provision of the SaaS under option (b), indicates that the contractual payment terms under option (b) have the primary purpose of selling price is the monthly providing SaaS Company with financing. The cash- fee of $140 because it reflects the amount due when the monthly hosting services are provided to Customer. A comparison of the payment terms between options (a) and (b) indicates the total cumulative interest of $840 and an implied discount rate of 13%. SaaS Company considers if factors indicating that a significant financing component does not exist apply in this case and concludes that they do not. is significant because SaaS Company determines that the financing component the difference between the cumulative cash- selling price of $5,040 and the financed amounts of $4,200 is $840, or 20% of the financed amount. Therefore, an adjustment to reflect the time value of money will be needed if Customer ele cts option (b) to pay at the beginning of the contract. SaaS Company evaluates whether the implied discount rate of 13% is consistent with the market rate of interest for companies with the same credit rating as its own. Assuming that it is, SaaS Company recognizes revenue of $5,040 ratably over the contract term as the performance obligation is satisfied and interest expense of $840 using the effective interest method. The amount ct of interest expense to recognize each period is based on the projected contra liability, which decreases as services are provided and increases for the accrual of interest. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

321 Revenue for software and SaaS 319 D. Step 3 : Determine the transaction price Below is one example interest calculation under the effective interest method. Interest Contract expense at liability – 1.083% Contract Transaction price/delivery beginning of (Monthly rate = liability – End service of Period month of month 13% ÷ 12) (A-B) x 1.083% A B = C SaaS A – B + C 1 $140 $44 $4,104 $4,200 2 4,104 140 43 4,007 3,909 42 140 3 4,007 4 3,909 140 41 3,810 140 5 3,810 3,710 40 Continue for each period... $0 $0 36 $140 $140 If, in the above example, the implied discount rate of 13% was determined to be an above -market rate, then the transaction price would be adjusted to reflect a market rate, based on SaaS Company’s creditworthiness (i.e. because it is the party receiving the financing in this contract). The difference between the implied discount rate and the market rate would represent a discount granted to the customer for purposes other than financing; that discount would (1) reduce the amount of revenue recognized – i.e. to an amount less than $5,040 – and (2) reduce the amount of interest expense recognized by SaaS Company over the contract term (i.e. because the revenue amount is reduced, the difference between the cash paid and the revenue to be recognized, reflected as interest expense, is smaller). xample D4 Illustrative E Determining whether an arrangement has a significant financing component – Payment in arrears ABC enters into a contract to transfer a software license to Customer priced at -up entity with limited cash, and ABC agrees $2,000,000. Customer is a start that Customer can pay for the license over two years through monthly installments of $92,000. The contract includes a financing component. The difference in pricing between the selling price of $2,000,000 and the total of the monthly payments of $2,208,000 (24 x $92,000), together with the timing difference between when Customer will pay the promised consideration and ABC’s transfer of the lice nse, indicates that the contractual payment terms have the primary purpose selling price is $2,000,000 of providing Customer with financing. The cash- because it reflects the amount due at the point in time the license is transferred to Customer. A comparison of the cash selling price and the total payments to © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

322 Revenue for software and SaaS 320 D. Step 3 : Determine the transaction price be received indicates the total cumulative interest of $208,000 and an implied interest rate of 9.7%. ABC considers if factors indicating that a significant financing component does not exist are present and concludes that they do not. ABC determines that the financing component is significant because the difference between the cash- selling price of $2,000,000 and the total promised consideration of $2,208,000 is $208,000, or 10.4% of the financed amount. Therefore, an adjustment to reflect the time value of money is needed. ABC evaluates whether the implied interest rate of 9.7% is consistent with the -standing as Customer. market rate of interest for companies with the same credit ABC recognizes revenue of $2,000,000 upon transfer of the Assuming that it is, software license – i.e. when the performance obligation is satisfied – and interest income on a monthly basis using the effective interest method. The amount of interest income for each month is based on the balance of the receivable for software license sold, which decreases as payments are received. The following is one example interest calculation under the effective interest method. Interest income Monthly Receivable – at 0.81% Beginning of payment − (Monthly rate = Receivable – Period month 9.7% ÷ 12) End of month End of month B B + C A – A × 0.81% = C SaaS A $92,000 $16,143 $1,924,143 $2,000,000 1 2 1,924,143 92,000 15,531 1,847,674 3 1,847,674 92,000 14,913 1,770,587 4 92,000 1,692,878 14,291 1,770,587 5 1,692,878 92,000 13,664 1,614,542 Continue for each period... $0 24 $91,263 $92,000 $737 If, in the above example, the implied interest rate of 9.7% was determined to be a below-market rate, then the transaction price would be adjusted to reflect a market rate, based on Customer’s creditworthiness. The difference between the implied interest rate and the market rate would represent a discount granted to the customer for purposes other than financing, reducing the amount of revenue recognized for the license and increasing the amount of interest income to reflect a market rate of interest. © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

323 Revenue for software and SaaS 321 D. Step 3 : Determine the transaction price Comparison to legacy US GAAP Advance payments Amounts that do not require repayment in the future, but that will instead be applied to the purchase price of the property, goods or services involved, were excluded from the requirement to impute interest under legacy US GAAP. This – i.e. deferred revenue – is not a financial liability. is because the liabili ty The requirements under Topic 606 when a significant financing component exists are therefore a change from legacy US GAAP because they will result in the entity recognizing more revenue than the cash received from the customer, and therefore, more revenue and more interest expense than what was recognized under legacy US GAAP for the same arrangements. This change may particularly d significantly affect software entities with contracts in which payment is receive e.g. software licensing before the transfer of control of goods or services – entities that bundle several years of PCS or hosting services in arrangements with payments received at the outset or in the early stages of a contract or SaaS providers that receive up- term SaaS arrangements (e.g. if front payments in long- -year SaaS arrangement in advance or pays a a customer pays for a three significant up -front fee that relates to services that will be provided over an extended period of time). Accounting for financing components for payments in arrears may be more frequent Under legacy US GAAP, extended payment terms could result in a conclusion that revenue was not fixed or determinable, which would preclude revenue recognition before payments became due and payable. In those cases, entities did not account for a financing element. Under Topic 606, the transaction price is estimated and a separate evaluation is performed to determine whether the payment terms provide financing to As a result, the accounting for financing in arrangements where the customer. the customer pays in arrears will likely arise more frequently. This accounting will result in a decrease in revenue and an increase in interest income as compared to similar arrangements under legacy US GAAP; however, it also will accelerate when the decreased total amount of revenue is recognized since revenue will no longer be recognized on a ‘due and payable’ basis for many of these arrangements. D230 Question Is the assessment of whether a financing component is ‘significant’ to a contract a quantitative or qualitative assessment? Interpretive response: Once a financing component is determined to exist 10-32 e (e.g. none of the factors in paragraph 606- -17 exist), it may or may not b Topic 606, either nor the basis for conclusions to any of the ‘significant’. And n address explicitly how to determine whether a financing revenue ASUs, component is significant. However, discussions of the term ‘material’ that are © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

324 Revenue for software and SaaS 322 : Determine the transaction price D. Step 3 s 2014-09 and 2016- included in the basis for conclusions to ASU 10 state that ‘material’ takes both qualitative and quantitative factors into consideration – e.g. in determining whether a customer option provides the customer with a material right or whether a promised good or service is ‘immaterial in the context of the contract’. ’ was the significant Therefore, it is, in some respects, conspicuous that ‘ threshold selected for assessing financing components, indicating an intent to depart from the qualitative and quantitative nature of the term ‘material’. Consequently, we believe ‘significant’, at least in the context of determining whether a financing component is significant , is principally a quantitative analysis. Further, because the Boards did not provide guidance on what quantitative amounts would be significant, judgment will be required to determine at what point a financing component becomes significant to the contract. Question D240 Does an entity need to evaluate whether there is a mponent in a long- term significant financing co contract that transfers a software license to the customer at a point in time for which the -based royalty? - or usage consideration is a sales Interpretive response: 10- 32-17 (b) states that a It depends. Paragraph 606- contract with a customer does not have a significant financing component if a substantial amount of the consideration promised by the customer is variable and the amount or timing of that consideration varies on the basis of the occurrence or nonoccurrence of a future event that is not substantially within the control of the customer or the entity (e.g. if the consideration is a sales - based royalty). Therefore, a significant financing component does not exist when a software front, but all or a substantial portion of the license is transferred up- - -based royalty, or a usage consideration for that license is in the form of a sales based fee is dictated based royalty whereby the usage giving rise to the usage- by third -party actions – e.g. the customer’s customers’ use of the platform or transaction activity – or outside events or circumstances (e.g. usage of the software depends on the occurrence of weather phenomena or changes in a stock market index ). is In contrast, a usage-based fee whereby usage ‘ within the control of the would not qualify for application of the guidance in or the entity’ customer paragraph 606- -17(b) 10-32 . © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

325 Revenue for software and SaaS 323 D. Step 3 : Determine the transaction price Question D250 Do extended payment terms result in a significant ponent? financing com Extended payment terms Extended payment terms in software arrangements have generally been defined as those in which payment of a significant portion of the license fee is not required until more than 12 months after software delivery; however, they can include any payment terms that are elongated from the entity’s customary payment terms. Interpretive response: The existence of extended payment terms will generally lead to a conclusion that there is a financing component in the contract. Contract - specific facts and circumstances will affect whether that financing component is as a result of the practical expedient, significant to the contract. However entit ies need not consider whether extended payment terms of less than 12 months ’s customary payment terms, but less than entity (i.e. those that are beyond an months) include a significant financing component. 12 expects to provide a refund or other concession to the customer as If the entity a result of the extended payment terms, the entity should account for the 150. uestion D expected concession as outlined in Q Comparison to legacy US GAAP See Question D150. Question D260 What is the accounting if an entity applies the -month practical expedient not to account for a 12 significant financing component but subsequently changes its expectation that customer payment and/or its performance will not occur within 12 months? aph 606- 10- 32-18 provides that an entity is not Paragr Interpretive response: , the entity at contract inception does not required to make an adjustment if, expect the period between payment by the customer of the consideration promised and the transfer of control of the promised good or service to th e customer to exceed one year. Therefore, it is possible that the entity’s expectation of payment by the customer, or transfer of control of the promised . For example: good or service, wit hin one year may not be achieved — A customer may prepa y a software entity to customize or implement , or to deliver a specified upgrade or enhancement. The entity may software or transfer the specified upgrade or expect to complete those services © 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member . firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved

326 Revenue for software and SaaS 324 : Determine the transaction price D. Step 3 enhancement in less than a year from receipt of the prepayment, but later , due to unforeseen circumstances, conclude that it will not meet that expected timeline. The terms of a contract may require the customer to pay for a suite of — professional services only upon completion. The entity may expect to provide all of the services in less than a year, such that the customer ’s payment will be within one year of the performance of all services, but later concludes that it will not complete the services with in one year. In that performed shortly after case, the customer will pay for some services contract inception more than one year after those services were provided. Paragraph 606-10 -32- 18 is explicit to the timing of the assessment (i.e. ‘at contract inception’) and, unlike the guidance on collectibility (see paragraph 606 - 10-25 -5), the remainder of the guidance on significant financing components makes no m