USA Revenue recognition on subscription with option to convert to perpetual license at end of term

[FastAggie]

We are looking at providing a subscription over a specific term to a customer likely ~$4M with an option for a yet to be determined price to convert to a perpetual license at the end of the term. What is the revenue treatment for this? The perpetual license will not allow access to any updates, enhancements, future data, just perpetual rights to historical IP. Does it matter if the option is at FMV or a nominal value? Trying to figure out how to structure and would prefer it to be considered subscription (ACV) rather than a perpetual license from the jump. Is this accounted for as two separate transactions?

 

[Werner Reisacher]

Unless there are some specific guidelines in your industry like in the financial market, (stock options) you need to set up a contingent liability on an estimated basis. Revenue recognition, matching principle, and above all, the most conservative approach in valuing the future liability, based on the worst-case scenario must be taken into account when calculating an exposure of such magnitude. Do not forget your duty to fully disclose the details of this exposure.

 

[Kat Maple]

Hi Mr. Werner
I studied contingent liabilities and this does not seem like any of the examples they gave us in school. Can you help me by pointing out why this is a contingent liability? I do not see what is the contingency. Really it looks like the contract is just a revenue item and not really a contingency.

Thank you

Kat

 

[Werner Reisacher]

Since you are asking, I realize that my answer might have been misleading. The answer to the question depends on the way you are offering your initial subscription. If the price of the first subscription covers all your initial and/or incremental costs incurred to generate a marketable product, and if there are no credit/warranty or any other potential liabilities involved, you can apply the matching principle and spread the revenue and the matching cost over the time periods of that subscription. If the customer exercises the option, it depends on the contractual agreement of that new subscription. As a baseline, I would consider the contractual value as the revenue base. And again, the revenue needs to be matched with any possible future incremental costs and you will have to assess whether there are any possible liabilities created by such an extension, such as product warranty or related issues. Depending on the assessment, the question about the "contingent liability" might come into play before you record all of the revenue.