SIGNIFICANT ACCOUNTING POLICIES (Policies)

12 Months Ended

Dec. 31, 2016

(a) Revenue recognition

The Company’s revenue is derived primarily from software licenses, maintenance fees related to the Company’s software licenses, and consulting services. The Company’s license arrangements, whether involving a perpetual license or a term license, generally also contain multiple elements, including consulting services, training, and software maintenance services.

Software revenue recognition requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (“VSOE”) of fair value exists for those elements. The amount of arrangement consideration allocated to undelivered elements is based on the VSOE of fair value for those elements and recognized as those elements are delivered. Any remaining portion of the total arrangement fee is allocated to the software license—the first delivered element. Revenue is recognized for each element when all of the revenue recognition criteria have been met. Revenue is recognized net of any taxes collected from customers and subsequently remitted to governmental authorities.

Changes in the mix of the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue.

Before the Company can recognize revenue, the following four basic criteria must be met:

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Persuasive evidence of an arrangement—As evidence of the existence of an arrangement, the Company uses a contract or purchase order signed by the client and the Company for software, including cloud, and maintenance, and a statement of work for consulting services. In the event the client is a reseller, the Company ensures a binding agreement exists between the reseller and end user of the software.

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Delivery of product and services—The Company delivers its software electronically and/or ships it via disc media. Services are considered delivered as the work is performed or, in the case of maintenance, over the contractual service period.

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Fee is fixed or determinable—The Company assesses whether a fee is fixed or determinable at the onset of the arrangement. In addition, the Company assesses whether contract modifications to an existing arrangement constitute a concession or whether extended payment terms exist. The Company’s agreements do not include a right of return.

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Collection of fee is probable—The Company assesses the probability of collecting from each client at the onset of the arrangement based on a number of factors, including the client’s payment history, its current creditworthiness, economic conditions in the client’s industry and geographic location, and general economic conditions. If, in the Company’s judgment, collection of a fee is not probable, revenue is recognized as cash is collected, provided all other conditions for revenue recognition have been met.

Software license revenues

Perpetual software license fees are recognized as revenue when the software is delivered, any acceptance required by the contract that is not perfunctory is obtained, no significant obligations or contingencies exist related to the software, all other undelivered elements in a multiple element arrangement possess VSOE, and all other revenue recognition criteria are met.

Term software license fees are usually payable on a monthly, quarterly, or annual basis under license agreements that typically have a three to five-year term and may be renewed for additional terms at the client’s option. The Company recognizes term license revenue over the term of the agreement as payments become due or earlier if prepaid, provided all other criteria for revenue recognition have been met.

Maintenance revenues

First-year maintenance typically is sold with the related software license and renewed on an annual basis thereafter. Maintenance revenue is deferred and recognized ratably over the term of the support period, which is generally one year and subject to annual renewals. Perpetual software maintenance obligations are based on separately stated renewal rates in the arrangement that are substantive and therefore represent VSOE of fair value. Term license arrangements include separately stated maintenance fees and the Company uses stand-alone sales to determine VSOE of fair value.

Services revenues

The Company’s services revenue is comprised of fees for consulting services including software implementation, training, reimbursable expenses, and for sales of its Pega Cloud as-a-platform offering (“Pega Cloud”), which includes the Pega Cloud Dev/Test environment and the Pega Cloud Production environment. Consulting services may be provided on a “stand-alone” basis or bundled with a license and software maintenance services.

Revenue from training services and consulting services under time and materials contracts is recognized as services are performed. The Company has VSOE of fair value for its training services and consulting services under time and materials contracts in the Americas, Europe, and certain regions of Asia.

Consulting services may sometimes be provided on a fixed-price basis. The Company does not have VSOE of fair value for fixed-price services or time and materials services in certain geographical regions. When these services are part of a multiple element arrangement, and the services are not essential to the functionality of the software, and when services, including maintenance, are the only undelivered element, the Company recognizes the revenue from the total arrangement ratably over the longer of the software maintenance period or the service period. Revenue from fixed-price services that are not bundled with a software license is generally recognized ratably over the service period, which is typically less than four months.

Revenue from stand-alone sales of the Pega Cloud Dev/Test environment is recognized as services are performed because the Company has VSOE of fair value.

Revenue from stand-alone sales of the Pega Cloud Production environment is recognized ratably over the term of the service. When implementation services are sold together with the Company’s Pega Cloud offering and these services have stand-alone value to the client, the Company accounts for these services separately from this offering. Stand-alone value is established through the client’s ability to buy these services from many trained partner system integrators and from transactions sold independently from the sale of Pega Cloud. Since these multiple-element arrangements are not software license sales, the Company applies a selling price hierarchy to determine the fair value of each element in the arrangement. Under the selling price hierarchy, each element’s fair value is determined based on its VSOE, if available. If VSOE does not exist, third-party evidence of fair value (“TPE”) will be considered, and estimated selling price (“ESP”) will be used if neither VSOE nor TPE is available. The Company generally does not have VSOE of its Pega Cloud offering and is not able to determine TPE as its sales strategy is customized to the needs of its clients and the Company’s products and services are dissimilar to comparable products or services in the marketplace. In determining ESP, the Company applies significant judgment as it weighs a variety of factors, based on the facts and circumstances of the arrangement. The Company typically arrives at an ESP for a service without VSOE or TPE by considering company-specific factors such as geographies, competitive landscape, and pricing practices used to establish bundled pricing and discounting.

Deferred revenue

Deferred software license revenue typically results from client billings for which all of the criteria to recognize revenue have not been met. Deferred maintenance revenue represents software license updates and product support contracts that are typically billed in advance and are recognized ratably over the support periods. Deferred services revenue represents advanced billings for consulting, hosting, and training services that are recognized as the services are performed.

Fair value of financial instruments

(b) Fair value of financial instruments

The principal financial instruments held by the Company consist of cash equivalents, marketable securities, derivative instruments, accounts receivable, and accounts payable, which are measured at fair value. See Note 3 “Marketable Securities”, Note 4 “Derivative Instruments”, and Note 5 “Fair Value Measurements” for further discussion of financial instruments that are carried at fair value on a recurring basis.

Derivative instruments

The Company uses foreign currency forward contracts (“forward contracts”) to manage its exposures to changes in foreign currency exchange rates associated with its foreign currency denominated accounts receivable, intercompany receivable and payables, and cash. See Note 4 “Derivative Instruments” for further discussion.

Property and equipment

(d) Property and equipment

Property and equipment are recorded at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets, which are three years for computer equipment and five years for furniture and fixtures. Leasehold improvements are amortized over the lesser of the term of the lease or the useful life of the asset. Repairs and maintenance costs are expensed as incurred.

Internal-use software

(e) Internal-use software

The Company capitalizes and amortizes certain direct costs associated with computer software developed or purchased for internal use incurred during the application development stage. Costs related to preliminary project activities and post implementation activities are expensed as incurred. The Company amortizes capitalized software costs generally over three to five years commencing on the date the software is placed into service. During the fourth quarter of 2016, the Company placed $11.3 million of costs for computer software developed for internal use into service, of which $1.1 million was capitalized in 2015 and $10.2 million was capitalized in 2016. During 2014, the Company did not capitalize any costs for computer software developed for internal use.

Goodwill

(f) Goodwill

Goodwill represents the residual purchase price paid in a business combination after the fair value of all identified assets and liabilities have been recorded. Goodwill is not amortized. The Company operates as a single reporting unit. The Company performed its qualitative assessment as of November 30, 2016, 2015, and 2014, and concluded it was not more likely than not that the fair value of its reporting unit was less than its carrying value.

Intangible and long-lived assets

(g) Intangible and long-lived assets

All of the Company’s intangible assets are amortized using the straight-line method over their estimated useful life. The Company evaluates its long-lived tangible and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Impairment is assessed by comparing the undiscounted cash flows expected to be generated by the intangible asset to its carrying value. If impairment exists, the Company calculates the impairment by comparing the carrying value of the intangible asset to its fair value as determined by discounted expected cash flows. The Company did not record any impairments in 2016, 2015, or 2014.

Business combinations

(h) Business combinations

The Company uses its best estimates and assumptions to accurately assign fair value to the tangible and intangible assets acquired and liabilities assumed at the acquisition date. The Company’s estimates are inherently uncertain and subject to refinement. During the measurement period, which may be up to one year from the acquisition date, the Company may record adjustments to the fair value of these tangible and intangible assets acquired and liabilities assumed, with the corresponding offset to goodwill. In addition, uncertain tax positions and tax-related valuation allowances are initially established in connection with a business combination as of the acquisition date. The Company continues to collect information and reevaluates these estimates and assumptions quarterly and records any adjustments to the Company’s preliminary estimates to goodwill provided that the Company is within the measurement period. Upon the conclusion of the measurement period or final determination of the fair value of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to the Company’s consolidated statements of operations.

Research and development and software development costs

(i) Research and development and software development costs

Research and development costs are expensed as incurred. Capitalization of computer software developed for resale begins upon the establishment of technological feasibility, generally demonstrated by a working model or an operative version of the computer software product. Such costs have not been material to date as technological feasibility is established within a short time frame from the software’s general availability and, as a result, no costs were capitalized in 2016, 2015, or 2014.

Stock-based compensation

(j) Stock-based compensation

The Company recognizes stock-based compensation expense associated with equity awards based on the fair value of these awards at the grant date. Stock-based compensation is recognized over the requisite service period, which is generally the vesting period of the equity award, and is adjusted each period for anticipated forfeitures. See Note 14 “Stock-based Compensation” for discussion of the Company’s key assumptions included in determining the fair value of its equity awards at the grant date.

Acquisition-related expenses

(k) Acquisition-related expenses

Acquisition-related costs are expensed as incurred and include direct and incremental costs associated with an impending or completed acquisition. During 2016, 2015, and 2014, $2.6 million, $0.1 million, and $0.5 million, respectively, of acquisition-related costs were primarily professional fees associated with the Company’s acquisition of OpenSpan, Inc. (“OpenSpan”) and the acquisitions completed in 2014.

Foreign currency translation

(l) Foreign currency translation

The translation of assets and liabilities for the majority of the Company’s foreign subsidiaries are made at period-end exchange rates, while revenue and expense accounts are translated at the average exchange rates during the period transactions occurred. The resulting translation adjustments are reflected in accumulated other comprehensive income. The Company’s India subsidiary, as well as all foreign subsidiaries acquired from Antenna Software, Inc. (“Antenna”), use the U.S. dollar as their functional currency, therefore, their monetary assets and liabilities are remeasured at current rates and their non-monetary assets are recorded at historical exchange rates. Realized and unrealized exchange gains or losses from transactions and remeasurement adjustments are reflected in foreign currency transaction loss in the accompanying consolidated statements of operations.

Accounting for income taxes

(m) Accounting for income taxes

The Company uses the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on temporary differences between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The Company regularly assesses the need for a valuation allowance against its deferred tax assets. Future realization of the Company’s deferred tax assets ultimately depends on the existence of sufficient taxable income within the available carryback or carryforward periods. Sources of taxable income include taxable income in prior carryback years, future reversals of existing taxable temporary differences, tax planning strategies, and future taxable income. The Company records a valuation allowance to reduce its deferred tax assets to an amount it believes is more-likely-than-not to be realized. Changes in the valuation allowance impacts income tax expense in the period of adjustment. The Company’s deferred tax valuation allowance requires significant judgment and uncertainties, including assumptions about future taxable income that are based on historical and projected information. The Company recognizes excess tax benefits when they are realized, through a reduction in income taxes payable using the with-and-without stock option method.

The Company assesses its income tax positions and records tax benefits based upon management’s evaluation of the facts, circumstances, and information available at the reporting date. For those tax positions where it is more-likely-than-not that a tax benefit will be sustained, the Company records the largest amount of tax benefit with a greater than 50 percent likelihood of being realized upon ultimate settlement with a taxing authority having full knowledge of all relevant information. For those income tax positions where it is not more-likely-than-not that a tax benefit will be sustained, no tax benefit is recognized in the financial statements. The Company classifies liabilities for uncertain tax positions as non-current liabilities unless the uncertainty is expected to be resolved within one year. The Company classifies interest and penalties on uncertain tax positions as income tax expense.

As a global company, the Company uses significant judgment to calculate and provide for income taxes in each of the tax jurisdictions in which it operates. In the ordinary course of the Company’s business, there are transactions and calculations undertaken whose ultimate tax outcome cannot be certain. Some of these uncertainties arise as a consequence of transfer pricing for transactions with the Company’s subsidiaries and nexus and tax credit estimates. In addition, the calculation of acquired tax attributes and the associated limitations are complex. See Note 15 “Income Taxes” for further information. The Company estimates its exposure to unfavorable outcomes related to these uncertainties and estimates the probability of such outcomes.

Advertising expense

(n) Advertising expense

Advertising costs are expensed as incurred. Advertising costs were $8.9 million, $9.8 million, $1.4 million during the years ended December 31, 2016, 2015, and 2014, respectively.

New accounting pronouncements

(o) New accounting pronouncements

Measurement of Credit Losses on Financial Instruments: In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-13, “Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments,” which requires measurement and recognition of expected credit losses for financial assets measured at amortized cost, including trade accounts receivable, upon initial recognition of that financial asset based on historical experience, current conditions, and reasonable and supportable forecasts. Credit losses relating to available-for-sale debt securities should be recorded through an allowance for credit losses when the fair value is below the amortized cost of the asset, removing the concept of “other-than-temporary” impairments. The effective date for the Company will be January 1, 2020, with early adoption permitted. The Company is currently evaluating the effect this ASU will have on its consolidated financial statements and related disclosures.

Improvements to Employee Share-Based Payment Accounting: In March 2016, the FASB issued ASU No. 2016-09, “Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting” (“ASU 2016-09,”) which is intended to simplify various aspects of the accounting for employee share-based payments transactions, including accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows.

The Company elected to early adopt ASU 2016-09 in the fourth quarter of 2016, requiring the Company to reflect any adjustments as of January 1, 2016, the beginning of the annual period that includes the interim period of adoption. The most significant impacts of the ASU 2016-09 adoption were: (1) to recognize, on a prospective basis, excess tax benefits and deficiencies as part of the provision for income taxes in the consolidated statement of operations when the awards vest or are settled and (2) the elimination of the requirement to reclassify excess tax benefits from operating activities to financing activities in the consolidated statements of cash flows, which the Company adopted retrospectively. As a result, the Company recognized a reduction to its provision for income taxes of $6.7 million for the year ended December 31, 2016 related to net excess tax benefits from awards that vested or settled in 2016. The Company reclassified $5.3 million, and $3.4 million from financing activities to operating activities for the years ended December 31, 2015, and 2014, respectively, in the consolidated statements of cash flows as a result of the ASU 2016-09 adoption to conform to current year presentation. The Company also recognized upon adoption, on a modified retrospective basis, all historical excess tax benefits previously unrecognized, which resulted in a net cumulative-effect adjustment of a $0.3 million increase to retained earnings as of January 1, 2016, with an offsetting increase to long-term deferred income tax assets.

The Company elected to continue to estimate forfeitures over the service period of the award, rather than as they occur, and will continue to present taxes paid in connection with shares withheld to meet statutory tax withholdings requirements for net settlement of equity awards as a financing activity in the statement of cash flows. These aspects of ASU 2016-09 had no impact on the consolidated financial statements in any period presented upon adoption.

Adoption of the new standard also resulted in adjustments to our unaudited selected quarterly data previously reported for fiscal year 2016 as follows:


	Three Months Ended
(Dollars in thousands)	March 31, 2016						June 30, 2016						September 30, 2016
	As Reported			As Adjusted			As Reported			As Adjusted			As Reported			As Adjusted
Unaudited condensed consolidated statements of operations data:
Income before provision for income taxes	$	13,493		$	13,493		$	5,498		$	5,498		$	5,515		$	5,515
Provision for income taxes	$	4,488		$	3,093		$	1,851		$	962		$	3,097		$	2,214
Net income	$	9,005		$	10,400		$	3,647		$	4,536		$	2,418		$	3,301
Effective tax rate		33.3	%		22.9	%		33.7	%		17.5	%		56.2	%		40.1	%
Earnings per share:
Basic	$	0.12		$	0.14		$	0.05		$	0.06		$	0.03		$	0.04
Diluted	$	0.11		$	0.13		$	0.05		$	0.06		$	0.03		$	0.04
Weighted-average number of common shares outstanding:
Diluted		78,878			79,235			78,969			79,422			79,082			79,548


	Three Months Ended						Six Months Ended						Nine Months Ended
(in thousands)	March 31, 2016						June 30, 2016						September 30, 2016
	As Reported			As Adjusted			As Reported			As Adjusted			As Reported			As Adjusted
Unaudited condensed consolidated statements of cash flows data:
Net cash provided by operating activities	$	8,642		$	10,040		$	9,299		$	11,569		$	17,396		$	20,556
Net cash used in financing activities	$	(18,424	)	$	(19,822	)	$	(29,396	)	$	(31,666	)	$	(39,871	)	$	(43,031	)

Leases: In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842),” which requires lessees to record most leases on their balance sheets, recognizing a lease liability for the obligation to make lease payments and a right-of-use asset for the right to use the underlying asset for the lease term. The effective date for the Company will be January 1, 2019, with early adoption permitted. The Company currently expects that most of its operating lease commitments will be subject to this ASU and recognized as operating lease liabilities and right-of-use assets upon adoption with minimal impact to its results of operations and cash flows.

Balance Sheet Classification of Deferred Taxes: In November 2015, the FASB issued ASU No. 2015-17, “Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes.” The guidance requires that deferred income tax liabilities and assets be classified as noncurrent in a classified balance sheet. The effective date for the Company was January 1, 2017, with early adoption permitted. The Company retrospectively adopted this ASU in the fourth quarter of 2016. Upon adoption, current deferred income tax assets of $12.4 million were reclassified as long-term deferred income tax assets in the December 31, 2015 consolidated balance sheet. The adoption of this ASU had no impact on the Company’s consolidated statements of operations, equity, or cash flows in any period presented.

Revenue from Contracts with Customers: In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606)”. This ASU amends the guidance for revenue recognition, creating the new Accounting Standards Codification Topic 606 (“ASC 606”). ASC 606 requires entities to apportion consideration from contracts to performance obligations on a relative standalone selling price basis, based on a five-step model. Under ASC 606, revenue is recognized when a customer obtains control of a promised good or service and is recognized in an amount that reflects the consideration which the entity expects to receive in exchange for the good or service. In addition, ASC 606 requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. This ASU originally had an effective date for the Company of January 1, 2017. In August 2015, the FASB issued ASU No. 2015-14, “Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date,” which defers the effective date by one year while providing the option to adopt the standard on the original effective date. In addition, the FASB issued ASU No. 2016-08, ASU No. 2016-10, and ASU No. 2016-12 in March 2016, April 2016, and May 2016, respectively, to help provide interpretive clarifications on the new guidance in ASC 606.

The Company has elected the full retrospective adoption model, effective January 1, 2018. Quarterly results in the 2018 fiscal year and comparative prior periods will be compliant with ASC 606, with the first Annual Report on Form 10-K issued in compliance with ASC 606 being the December 31, 2018 report.

The Company is still in the process of quantifying the implications of the adoption of ASC 606, however the Company expects the following impacts:

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Currently, the Company recognizes revenue from term licenses and perpetual licenses with extended payment terms over the term of the agreement as payments become due or earlier if prepaid, provided all other criteria for revenue recognition have been met, and any corresponding maintenance over the term of the agreement. The adoption of ASC 606 will result in revenue for performance obligations recognized as they are satisfied therefore, revenue from the term license performance obligation is expected to be recognized upon delivery and revenue from the maintenance performance obligation is expected to be recognized on a straight-line basis over the contractual term. Due to the revenue from term licenses and perpetual licenses with extended payment terms being recognized prior to amounts being billed to the customer, we expect to recognize a net contract asset on the balance sheet.

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Currently, the Company allocates revenue to licenses under the residual method when it has VSOE for the remaining undelivered elements which allocates any future credits or significant discounts entirely to the license. The adoption of ASC 606 will result in the future credits, significant discounts, and material rights under ASC 606, being allocated to all performance obligations based upon their relative selling price. Under ASC 606, additional license revenue from the reallocation of such arrangement considerations will be recognized when control is transferred to the customer.

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Currently, the Company does not have VSOE for fixed price services, time and materials services in certain geographical areas, and unspecified future products, which results in revenue being deferred in such instances until such time as VSOE exists for all undelivered elements or recognized ratably over the longest performance period. The adoption of ASC 606 eliminates the requirement for VSOE and replaces it with the concept of a stand-alone selling price. Once the transaction price is allocated to each of the performance obligations the Company can recognize revenue as the performance obligations are delivered, either at a point in time or over time. Under ASC 606, license revenue will be recognized when control is transferred to the customer.

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Sales commissions and other third party acquisition costs resulting directly from securing contracts with customers are currently expensed when incurred. ASC 606 will require these costs of acquiring contracts to be recognized as an asset when incurred and to be expensed over the associated contract term. As a practical expedient, if the term of the contract is one year or less, the Company will expense the costs resulting directly from securing the contracts with customers. We expect this to impact our multi-year cloud offerings and perpetual licenses with additional rights of use that extend beyond one year.

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ASC 606 provides additional accounting guidance for contract modifications whereby changes must be accounted for either as a retrospective change (creating either a catch up or deferral of past revenues), prospectively with a reallocation of revenues amongst identified performance obligations, or prospectively as separate contracts which will not require any reallocation. This may result in a difference in the timing of the recognition of revenue as compared to how current contract modifications are recognized.

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There will be a corresponding effect on tax liabilities in relation to all of the above impacts.

The Company is continuing its analysis of the expected impacts of the adoption of ASC 606.