NOTE 2 – REVENUE FROM CONTRACTS WITH CUSTOMERS

In accordance with Topic 606, the Company accounts for a customer contract when both parties have approved the contract and are committed to perform their respective obligations, each party’s rights can be identified, payment terms can be identified, the contract has commercial substance, and it is probable the Company will collect substantially all of the consideration to which it is entitled. Revenue is recognized when, or as, performance obligations are satisfied by transferring control of a promised product or service to a customer.

A. Nature of products and services

The Company’s products and services can be broadly categorized as perpetual licenses to use software, term-based licenses for Software-as-a-Service (“SaaS”) and on-premise use of software, maintenance for perpetual and term-based on-premise licenses, and professional services. The Company’s software licenses and maintenance are for mainframe, enterprise, and SaaS computing environments.

Perpetual licenses: The Company sells perpetual licenses which provide customers the right to use software for an indefinite period of time in exchange for a one-time license fee, which may be paid either at contract inception or in installments over the contract term. The Company’s on-premise software licenses have standalone functionality from which customers derive a substantial portion of the benefit. Accordingly, for perpetual licenses, revenue is recognized at the point-in-time when the customer is able to use and benefit from the software, which is generally upon delivery to the customer.

Term-based arrangements: Term-based arrangements consists of on-premise term licenses, SaaS solutions, as well as maintenance.

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On-premise term licenses: The Company sells term licenses which provide customers the right to use software for a specified period of time. Like perpetual licenses, the Company’s term licenses have standalone functionality from which customers derive a substantial portion of the benefit. Accordingly, for on-premise term licenses, revenue is generally recognized at the point-in-time when the customer is able to use and benefit from the software, which is generally upon delivery to the customer or upon the commencement of the renewal term. Payments for term licenses may be paid either at contract inception or in installments over the period of the term licenses.

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SaaS solutions: The Company offers cloud-based solutions that provide customers the right to access the Company’s software through the internet for a period of time. The payment for SaaS solutions may be received either at inception of the arrangement, or over the term of the arrangement. The Company’s SaaS solutions represent a series of distinct services that are substantially the same and have the same pattern of transfer to the customer. Revenue from a SaaS solution is generally recognized ratably over the term of the arrangement. Revenue related to SaaS solutions provided on a usage basis, such as the number of users, is recognized based on customer’s utilization of the service in a given period.

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Maintenance: Maintenance is provided for both perpetual and on-premise term license arrangements, and consists primarily of telephone support and the provision of unspecified updates and upgrades on a when-and-if-available basis. Maintenance for perpetual licenses is renewable, generally on an annual basis, at the option of the customer. Maintenance for on-premise term-based licenses is always renewed concurrently with the term-based licenses for the same duration of time. Maintenance represents stand-ready obligations for which revenue is recognized ratably over the term of the arrangement. Payments for maintenance may be paid either at inception of the maintenance period or in installments over the term of the maintenance period.

Professional services: Professional services consist of product implementation, consulting, customer education and customer training services. Payment for professional services is generally a fixed fee or a fee based on time and materials. The obligation to provide professional services is generally satisfied over time, with the customer simultaneously receiving and consuming the benefits as the Company satisfies its performance obligations. For professional services, revenue is recognized by measuring progress toward the complete satisfaction of the Company’s obligation. Progress for services that are contracted for a fixed price is generally measured based on hours incurred as a portion of total estimated hours, and as a practical expedient, progress for services that are contracted for time and materials is generally based on the amount the Company has the right to invoice.

Material rights

Contracts with customers may include material rights which are also performance obligations. Material rights primarily arise when the contract gives the customer the right to renew or receive products or services at a discounted price in the future. Revenue allocated to material rights is recognized when the customer exercises the right or the right expires. If exercised by the customer, revenue is classified consistent with the products or services obtained through the exercise of the right. If expired, revenue is classified consistent with the products or services in the contract that gave rise to the material right.

Arrangements with multiple performance obligations

The Company’s contracts generally contain more than one of the products and services listed above, each of which is separately accounted for as a distinct performance obligation.

Allocation of consideration: The Company allocates total contract consideration to each distinct performance obligation in an arrangement on a relative standalone selling price basis. The standalone selling price reflects the price the Company would charge for a specific product or service if it was sold separately in similar circumstances and to similar customers.

If the arrangement contains professional services and other products or services, the Company first allocates to the professional service obligation a portion of the total contract consideration equal to the standalone selling price of professional services that is observed from consistently priced standalone sales. The Company allocates the remaining consideration among the other products and services in the contract on a relative standalone selling price basis.

The standalone selling price for perpetual and on-premise term licenses, which are always sold with maintenance, is the price for the combined license and maintenance bundle. The amount assigned to the license and maintenance bundle is separated into license and maintenance amounts using the respective standalone selling prices represented by the value relationship between the software license and maintenance.

When two or more contracts are entered into at or near the same time with the same customer, the Company evaluates the facts and circumstances associated with the negotiation of those contracts. Where the contracts are negotiated as a package, the Company will account for them as a single arrangement and allocate the consideration for the combined contracts among the performance obligations accordingly.

Standalone selling price: When available, the Company uses directly observable transactions to determine the standalone selling prices for performance obligations. Observable data is available for maintenance renewals on previously sold perpetual licenses and SaaS. When perpetual or term licenses are sold together with maintenance in a bundled arrangement, the Company estimates a narrow range of standalone selling price using observable pricing information from standalone sales of the bundle, when available, and other relevant information, such as market conditions and pricing strategies.

The value relationship the Company uses to allocate consideration between the license and maintenance performance obligations is derived from the observable relationship of the selling price of a standalone perpetual license maintenance renewal to the related perpetual license fee, which is generally 20% of the net license fee for one year of maintenance. The Company separates the license and maintenance performance obligations of a term license and maintenance bundle using the same observable value relationship as in a perpetual license and maintenance bundle because the nature of the maintenance performance obligation and its value relationship with the right to use the software were determined to be similar.

Arrangements that include a software license sold with more than one year of maintenance for the license use a value relationship which reflects an annual maintenance rate of 20% of the total value ascribed to the right to use the software. As a result, a greater portion of the bundle relates to maintenance as the length of the maintenance period included in the bundle increases.

The Company separately determines the standalone selling prices by geographic region, distribution channel and by volume when the pricing strategies include volume purchase discounts.

The Company also estimates the standalone selling prices of its material rights, which primarily include contractually stated amounts that the customer can use to acquire additional products and services. The Company estimates the value of these rights by considering the stated amount and the likelihood of the customer exercising its right. In addition, an option to purchase or receive additional products or services at a discounted price is estimated as the incremental discount the customer would obtain when exercising the option and the likelihood that the option would be exercised.

Other policies and judgments

Payment terms and conditions vary by contract type, although terms generally include a requirement of payment within 30 to 60 days of the invoice. In certain arrangements, the Company receives payment from a customer either before or after the performance obligation has been satisfied, however, the Company’s contracts generally do not contain a significant financing component.

The Company may modify contracts to offer customers additional products or services. The additional products and services will generally be considered distinct from those products or services transferred to the customer before the modification and will generally be accounted for as a separate contract. The Company evaluates whether the price for the additional products and services reflects the standalone selling price adjusted as appropriate for facts and circumstances applicable to that contract. In determining whether an adjustment is appropriate, the Company evaluates whether the incremental consideration is consistent with the prices previously paid by the customer or similar customers.

The Company reduces transaction price for an estimate of returns that is based on historical data.

B. Disaggregation

The disaggregation of revenue by region, type of performance obligation, timing of revenue recognition, and segment was as follows:



(in millions)	Three Months Ended June 30, 2018
Revenue by region:
United States	$	572
EMEA ⁽¹⁾	229
Other	137
Total revenue	$	938

Revenue by type of performance obligation:
Perpetual licenses	$	76
Renewable:
On-premise term licenses	193
Maintenance	487
SaaS	114
Professional services	68
Total revenue	$	938

Timing of revenue recognition:
Point-in-time, including professional services	$	337
Over time	601
Total revenue	$	938

Revenue by segment:
Mainframe Solutions	$	440
Enterprise Solutions	430
Services	68
Total revenue	$	938


(1)	Consists of Europe, the Middle East and Africa.

C. Contract Balances

The Company’s contract assets and deferred revenue balances for the periods indicated below were as follows:



(in millions)	Contract Assets		Deferred Revenue
Balance at April 1, 2018	$	931	$	1,751
Balance at June 30, 2018	$	914	$	1,589

The difference in the opening and closing balances of the Company’s contract assets and deferred revenue primarily results from the timing difference between the Company’s performance and the customer’s payment. The Company fulfills its obligations under a contract with a customer by transferring products and services in exchange for consideration from the customer. The Company recognizes a contract asset when it transfers products or services to a customer and the right to consideration is conditional on something other than the passage of time. Accounts receivable are recorded when the customer has been billed or the right to consideration is unconditional. The Company recognizes deferred revenue when it has received consideration or an amount of consideration is due from the customer and the Company has a future obligation to transfer products or services. Deferred revenue includes amounts billed or collected and advanced payments on contracts which may include termination for convenience clauses. The amount of revenue recognized during the three months ended June 30, 2018 that was included in the deferred revenue balance at April 1, 2018 was $434 million.

D. Transaction Price Allocated to the Remaining Performance Obligations

The following table discloses the aggregate amount of the transaction price and advanced payments allocated to remaining performance obligations as of the end of the reporting period, and when the Company expects to recognize the revenue.



(in millions)	12 months or less		Greater than 12 months ⁽¹⁾
Perpetual licenses	$	8	$	13
Renewable:
On-premise term licenses	$	160	$	80
Maintenance	$	1,504	$	1,727
SaaS	$	336	$	235
Professional services	$	66	$	34
Material rights	$	2	$	176


(1)	Of the amount of performance obligations greater than 12 months, the portion that is 2 to 3 years is approximately $1.8 billion and the remaining amount is generally between 4 and 5 years.

The Company’s multi-year contracts with government customers may have termination for convenience clauses. Approximately $88 million of advanced payments received from government customers that have termination for convenience rights are included in “Deferred revenue and advanced payments” in the Company’s Condensed Consolidated Balance Sheet and allocated to the remaining performance obligations in the table above. In addition, approximately $561 million related to the remaining unbilled contract value and performance obligations in these contracts with termination for convenience clauses are not included in the allocation of transaction price and not included in “Deferred revenue and advanced payments” in the Company’s Condensed Consolidated Balance Sheet.

E. Contract Costs

The Company pays commissions for new product sales as well as for renewals of existing contracts. Commissions paid to obtain renewal contracts are not commensurate with the commissions paid for new product sales and therefore, a portion of the commissions paid for new contracts relate to future renewals.

The Company accounts for commissions using a portfolio approach and allocates the cost of commissions in proportion to the allocation of transaction price of license and maintenance performance obligations, including assumed renewals. Commissions allocated to the license and license renewal components are expensed at the time the license revenue is recognized. Commissions allocated to maintenance are capitalized and amortized on a straight-line basis over a period of seven years for new contracts, reflecting the Company’s estimate of the expected period that the Company will benefit from those commissions. Commissions paid on renewal contracts that are allocated to maintenance are capitalized and amortized over the renewal term of approximately three years. Service contracts are generally less than one year and accordingly, as a practical expedient, commissions paid for service contracts are expensed as incurred.

Amortization of capitalized contract costs is included in “Selling and marketing” expenses in the Company’s Condensed Consolidated Statement of Operations. The amount of amortization for the three months ended June 30, 2018 was $30 million, and there was no impairment loss in relation to the costs capitalized.