The Public Company Accounting Oversight Board (PCAOB) outlined its 2025 priorities for staff inspections and interactions with company audit committees, and the IT sector will be one under the spotlight. As background, the PCAOB is placing an emphasis on selecting audits of public companies in industries that have specialized accounting and / or that can be negatively impacted by economic and geopolitical uncertainty, as well as those industries in which the PCAOB has previously found a higher number of deficiencies.
The PCAOB calls out the IT sector – defined by them as public companies offering technology, hardware, and semiconductor companies – as one they will look at given its intricacies in financial statement accounts, disclosures, and related internal controls. The PCAOB has also identified the increased use of Artificial Intelligence (AI) in the sector as a reason for the increased scrutiny. This activity by the PCAOB has important considerations for companies, both public and private, in the Software as a Service (SaaS) industry, given its increasing use of AI as well as adoption of consumption billing models.
AI, SaaS, and Consumption Billing
The PCAOB notes that IT is experiencing rapid change with the adoption of AI, and a Bank of America report on AI cites that tech incumbents are improving existing software and hardware products by embedding AI features, which “may drive incremental revenue through upselling, new consumption-based pricing models, accelerated upgrade cycles and enhanced service-fee revenue.” Of note in the Bank of America report is how AI could help to increase the use of consumption-based billing and pricing models for SaaS companies.
It is evident that consumption billing models are increasing in popularity: customers like the savings inherent in paying for what they use vs. a standard per-seat price, and SaaS companies like the ability to better align their value to cost. In fact, a report found that 61% of SaaS companies used the model in 2022. What these SaaS companies may not realize is that the consumption billing model hits complex areas of the ASC 606 / IFRS 15 standards, which ties revenue recognition to the terms of the customer contract.
What are the Complexities in Consumption Billing for SaaS?
For SaaS companies, the consumption billing model adds intricacies in revenue recognition, often including a need to manage standalone selling price (SSP) and variable consideration. Understanding these elements and why they are complex for SaaS is essential for companies looking to add or increase consumption billing.
SSP Allocation
Most SaaS companies are familiar with SSP, which is the price at which the company would sell a product or service individually to a customer. With a consumption bill model under ASC 606, SaaS companies need to consider the “distinct in the context of the contract” guidance to determine distinct performance obligations. When multiple goods or services are sold on a single or combined contract at values outside of their SSP, companies need to allocate the transaction price against the SSP.
Example: Allocating a Discount
Let’s take an example of a company that regularly sells products, X, Y, and Z.
Company B enters into a contract to license Products X, Y, and Z for a total of $100. Products X, Y, and Z are determined to be distinct performance obligations based on the rules in this part of the ASC 606 guidance. Company B regularly sells the licenses as follows: product X is $40, Product Y is $55, and Product Z is $45. The Total Contract Value (TCV) for the products selling for $100 would include the discount of $40 on the three licenses, which would be allocated proportionately to all three products in the contract when applying the relative SSP method.
Ways that SSP Errors Can Happen
For SaaS companies there are a number of ways that SSP errors can occur:
- Incorrectly Estimating the SSP, which can be the result of a lack of data. For example, the company doesn’t have sufficient historical data or market benchmarks to establish SSP accurately, so the calculated SSP might not reflect reality.
- Faulty Models for Estimation, such as relying on too simplified a model that uses averages or weighted models that then lead to errors. In addition, changing estimation methods between periods without justification can create discrepancies.
- Bundling or Unbundling Issues, such as improper allocation. Let’s say a company offers bundled services, but it does not correctly allocate the revenue to each component based on the SSP. This is an error that can have long-range consequences.
- Overstated or Understated Discounts, such as promotions, can cause errors as can applying discounts unevenly or disproportionately to components of a bundle, rather than based on the SSP.
- Lack of Audit Documentation: Failing to document how SSP was determined, especially for new products or services, can cause concern about the accuracy of reported revenue.
- Failure to Reassess SSP: SSP should be reassessed over time and with market changes, such as new competitor offerings.
- Product Changes: Introducing new features or modifying existing ones without updating the SSP could result in improper revenue allocation.
When Can SSP Errors Trigger an Audit?
- Revenue Recognition Errors / Regulatory Compliance: If revenue is not recognized correctly or if there are failures to adhere to ASC 606 / IFRS 15, regulators will be more likely to be on alert, which can lead to an audit.
- Customer Complaints: Customers raising concerns about confusing billing due to unclear pricing allocation can trigger auditors to act.
- Internal Controls Breakdown: Frequent SSP errors could mean that internal controls are weak, raising the concern of external auditors.
How to Prevent SSP Errors
There are a number of ways that SaaS companies can avoid SSP errors, including:
- Implement Robust Pricing Models: Companies should consider using tested data and market insights to set SSP.
- Regularly Reassess SSP: Updating the SSP based on changes in products, services, or market conditions is a good way to make sure the SSP is correct.
- Add Audit Trails: Companies should set documentation practices to capture how SSP is determined and allocated.
- Automate Systems: SaaS companies, especially, should look to automate their systems for allocation to reduce manual input, which leads to human error.
Check back next month for part two on variable consideration.
