The Public Company Accounting Oversight Board (PCAOB) outlined its 2025 priorities for company audit committees, calling out the IT sector as one that will be on its radar. A reason for the scrutiny is the industry’s increasing use of Artificial Intelligence (AI). For companies in the Software as a Service (SaaS) industry that are adopting AI and also using consumption billing models, this announcement is a call to action for reviewing their billing systems. They should confirm that their systems are set up to manage the most complex parts of consumption billing to comply with ASC 606 / IFRS 15. Consumption billing has two areas that make revenue recognition tricky. We examined the first — stand-alone selling price (SSP) — in the first part of this blog. This month, we are looking at the second area: variable consideration.
What is variable consideration in consumption billing?
Variable consideration refers to a payment amount that will change in the future. Change events that can affect variable consideration include discounts, rebates, and penalties. For consumption billing, variable consideration applies to charges that fluctuate based on the usage of a product or service. The final billed amount is determined by variable factors such as usage volume, number of users, or any applicable measurement that is outlined in the contract. In most instances of a SaaS company using a consumption-billing model, usage will be considered variable consideration.* Variable consideration is included in the transaction price to the extent that it is probable that subsequent changes in the estimate would not result in a “material reversal” of cumulative revenue.
How should SaaS companies estimate variable consideration for consumption billing?
If there is consideration promised in a contract that includes a variable amount, the company should estimate the amount of consideration to which a company will be entitled to in exchange for transferring the promised goods or services to a customer. Essentially this means to arrive at total contract value, the entity is estimating the value of future consumption. For example, the amount of consideration would be variable in situations where a product was sold with a right of return or where a fixed amount is promised as a performance bonus on achievement of a specified milestone.
There are two methods that companies can use to estimate the variable consideration; “the expected value,” which may be appropriate when a company has a large number of contracts with similar characteristics, or “the most likely amount,” which may be appropriate if the contract has only two possible outcomes. One approach should be applied consistently throughout the contract.
Example of a Calculated Variable Consideration
Let’s say Company A concludes that its contract contains two performance obligations, the SaaS and the professional services. Company A also determines that the SaaS is a single performance obligation that is comprised of a series of distinct daily services, and the usage-based fee is variable consideration.
Company A typically charges $100 per hour for professional services and estimates the services will take 200 hours to complete. Company A allocates the transaction price to the performance obligations on a relative SSP basis. The SSP of the professional services would therefore be the $20,000 amount that comes from the cost per hour at the estimated 200 hours and $180,000 for the hosted solution. Company A estimates the SSP for the hosted solution based on an estimate of 8000 transactions processed each year for $60,000 per annum. Company A allocates the total transaction price at contract inception, and Company A would estimate the number of transactions that would be processed, recognizing that amount based on an appropriate measure of progress for variable consideration. If the estimated transaction price changes, Company A would adjust the amount recognized for professional services and for the portion of the change in transaction price related to a change in the expected number of transactions in the current annual. Company A would make an adjustment to revenue recognized for the SaaS.
Ways that Variable Consideration Errors Can Happen
- Misestimating Variable Consideration: This can occur with faulty projections from incorrectly estimating expected overages, discounts, or refunds. Also, by ignoring the tenets of ASC 606 / IFRS 15, which requires variable consideration be included only to the extent it is probable that a significant reversal will not occur.
- Failure to Account for Usage Thresholds: This can come from tiered pricing errors, such as misapplying tiered consumption pricing or misaligned projections.
- Incorrect Treatment of Refunds, Credits, or Discounts: This includes refund liabilities for expected refunds or credits or improper discount allocation, such as misapplying discounts across different billing periods.
- Non-Compliance with ASC 606 / IFRS 15: This can include improper timing, which causes the premature recognition of contingent overages, or the failure to use the most likely or expected value method for variable consideration.
- Data Integration and Tracking Issues: This covers faulty data feeds and inconsistencies among systems, such as CRM and billing.
Preventing Variable Consideration Errors
There are several actions that SaaS companies can take to prevent variable consideration errors:
- Build Accurate Models: For SaaS companies especially, having the correct historical data and statistical models to estimate variable consideration is essential. These models should be regularly reassessed.
- Implement Strong Internal Controls: The company should use as much automation as possible to avoid manual processes along with reconciling billing and consumption data regularly.
- Follow ASC 606 / IFRS 15: These guidelines outline the ways to estimate and recognize variable consideration.
Conclusion
For SaaS companies looking to expand their consumption-billing offerings, the PCAOB’s publication outlining the potential of increased audits should come as a reminder to check their revenue management practices. Companies should look at how they apply variable consideration and reconcile processes with ASC 606 / IFRS 15 in mind. Doing so will give the companies a good sense of any areas needing correction and will help them position themselves for any enquiries in 2025 and beyond.
Footnote: In SaaS consumption billing models, variable consideration would not be used in certain scenarios, including prepaid usage and fixed tiers without overages.
