The primary authority for software revenue recognition is AICPA Statement of Position (SOP) No. 97-2, Software Revenue Recognition, which is the result of about 12 years of development work from 1985 through 1997. It applies to both public companies (according to SAB 104) and private enterprises.
Under SOP 97-2, recognition of revenue generally occurs at delivery if a four-part conjunctive test is met. Software delivery should be straightforward and require no special production, modification, or authorization by the software seller (vendor). The four-part conjunctive test is as follows:
Persuasive evidence of an arrangement exists. This means that a bona fide contract needs to exist (see Part 4, Legal Rules, regarding application of Article 2 of the Uniform Commercial Code [UCC] to this arrangement).
Software Vendor has two business models. The first is a premium model, whereby it sells (licenses) to large companies an out-of-the-box software solution bundled with a one-year agreement to provide post-contract customer support (PCS). The second is a standard model, whereby it offers its out-of-the-box software solution to smaller customers in a hosting environment. Software Vendor has seen that it has two classes of customers: 1) larger customers who buy its premium solution and 2) smaller customers who use the standard services. As part of its business practice and revenue recognition policy, Software Vendor requires a written sales agreement for the larger customers who buy the software; however, it only requires a purchase order from its smaller customers.
On September 30 (the last day of the quarter), Software Vendor enters into an agreement with a large company whereby the customer will buy the software solution (bundled with PCS) for $10 million. Software Vendor receives a purchase order on September 30 and delivers the product with terms of “FOB shipping point.” Simultaneously, the CFO signs a contract and faxes it to the customer for signature. The CFO receives a faxed signed copy back on October 1 (signed on October 1).
Assuming that after the revenue allocation is performed according to SOP 97-2 (where vendor-specific objective evidence [VSOE; see below] exists for the software license and PCS) the license portion is $7 million and the PCS portion is $3 million, and no revenue will be recognized as of September 30.
One of the criteria of revenue recognition is that persuasive evidence of an arrangement must exist. Paragraph 17 of SOP 97-2 states that even if all other requirements for revenue recognition are met, revenue should not be recognized unless persuasive evidence of an arrangement exists. Since it is Software Vendor’s business practice to obtain signed contracts for its “large” customers who buy the software, it cannot recognize any revenue until it receives the signed contract back from the customer. In this case, it wouldn’t recognize any revenue in September since it received the contract in October.
Delivery has occurred. Delivery of the product master or first copy is essential, and there must be no ambiguity as to delivery. The SEC requires, via SAB 104, that title be transferred as an indicator of actual delivery.
Here the complexity begins. What if the contract is FOB destination? Since SOP 97-2 is silent on title, has delivery been accomplished for privately held companies but not for publicly traded companies? And what about Article 2 of the UCC? Title bears little significance to the risk of loss. Has risk of loss been transferred? Resolution: software vendors should stay with FOB factory contracts, and then the AICPA, SEC, and Article 2 proponents will be satisfied that delivery has occurrenced.
3. The vendor’s fee is fixed or determinable. As set forth in paragraph 2.08 of SOP 97-2, software vendors who usually grant sales incentives or concessions will suffer an impact on revenue recognition. Allowing extended payment or right of cancellation will be indications that the vendor’s fee is not fixed or determinable.
4. Collectibility is probable. SOP 97-2 uses the definition of probable from FASB Statement No. 5, Accounting for Contingencies; that is, the likelihood of occurrence.
What the preceding four tests tell us is that before revenue for computer software can be recognized, there must be a valid contract with a customer (excluding most packaged software), the software must exist and be delivered (for example, FOB factory), the price must be independent of the quantity of users, and there must be no concessions that make the price uncollectible.
Of course, the preceding four-part test applies only to that segment of the software industry not serving the market that demands significant production, modification, or customization of software. For software companies that do serve this market, AICPA Accounting Research Bulletin (ARB) No. 45, Long-Term Construction-Type Contracts, (See Chapter IND-II C, above, for a discussion of ARB 45) applies in conjunction with SOP 97-2.
Adjunct products or services provided with the software could be upgrades, training, customer support, or any other such offerings. These additional elements far exceed the delivery of the actual software, and the initial question is one of allocation of the total license fee to the software and the relevant elements. SOP 97-2 refers to arrangements in which software vendors bundle their software products with myriad services or other products as “multiple-element arrangements,” and establishes a revenue recognition allocation scheme as outlined below:
Allocation with VSOE: Where vendor-specific objective evidence (VSOE) of fair value exists for all of the elements, the total arrangement fee (license fee) must be allocated to each element of the arrangement, and can be recognized as revenue for each element only when the SOP 97-2 criteria for the element have been satisfied.
Allocation without VSOE — Residual Method: Where VSOE does not exist, all revenue recognition is deferred until the earlier of the existence of VSOE or the delivery of all of the elements in the multiple-element arrangement. Pursuant to the modification of SOP 97-2 in AICPA Statement of Position (SOP) No. 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions, the residual method must be used where VSOE exists for all undelivered elements but not for one or more of the delivered elements. Here the undiscounted VSOE fair value of the undelivered elements is deferred, and the residual or difference between the total arrangement fee (license fee) and the deferred amount for the undelivered elements is recognized as revenue for the delivered elements.
SOP 97-2 also identifies the revenue recognition treatment for specific types of post-contract customer support (PCS). In a PCS arrangement, such as provision of product upgrades during the period of contract, the fair value of the element (such as a software upgrade) is measured as of the separate price or renewal price and is recognized as revenue over the life of the contract service on a ratable basis.
In a non-PCS arrangement, such as training of customer staff in the use of the software, separate revenue recognition applies only if 1) VSOE (see above) of fair value exists to allow allocation of revenue to the service elements and the services are not essential to any other element in the arrangement, and 2) the total arrangement fee (license fee) is expected to vary as a result of such services. If separate revenue recognition applies to such elements, then recognition occurs as performance of the services (such as training) occurs. If separate revenue recognition does not apply because the VSOE requirements are not met, then the provisions of ARB 45 apply; that is, contract accounting provisions apply.
What about prepackaged, shrink-wrapped software? This is commonly referred to as "Web-based" software because the end user who purchases the software from a reseller such as Office Depot will be installing it on a personal computer and updating the software via the Web. For example, the well-known Symantec product, Norton AntiVirus, is purchased by the end user from a reseller and installed on the personal computer as a virus protection software utility. However, what keeps it effective is the virus definition updates from the Web. For this kind of software, the primary issues for revenue recognition by the developers are the two conditions of whether the vendor's fee is fixed or determinable, and whether collectibility is probable (see the discussion of collectibility above). In considering whether these two conditions have been met, SOP 97-2 requires review of: 1) the reseller's payments and whether they are contingent on cash collections; 2) whether future returns are inestimable; and 3) whether there are uncertainties as to vendor’s prices.
The application of the SOPs and SABs in this area can be confusing to software vendors. Vendors should remember that the sale of "standard" software without any adjunct products or services — the so-called "bells and whistles" — is relatively straightforward. It is simply a matter of identifying four elements under either SOP 97-2 or SAB 104.
EITF Issue No. 00-21
Prior to the FASB's issuance of EITF Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables," official guidance had failed (through SOP 97-2 and SOP 98-9) to establish a clear understanding of a "multi-deliverable," when and how to segregate an arrangement into separate units of accounting, and how to allocate revenue to these separate units. Also, the issue of contingent revenue (such as when a customer retains a right of refund in the event of vendor nonperformance) was not readily addressed until Issue 00-21.
Hospital contracts to have complex diagnostic machinery and related software installed, to have the supplier operate the hospital at completion of construction. This is a multi-deliverable contract.
It is important to recognize that multiple deliverables are within the scope of SOP 97-2, where software is clearly identified and distinguished from post-contract maintenance. SOP 97-2 also addresses “fair value” allocations to specific contract components.
Issue 00-21 goes further. It is best seen as having two parts: one addressing separation criteria and another involving measurement and revenue allocation criteria.
Issue 00-21 offers guidelines for determining when and how to divide an arrangement into separate units of accounting. Under Issue 00-21, a separate deliverable is identified if a three-part conjunctive test is met:
the deliverable has standalone value (that is, the vendor sells the deliverable separately or the customer could recall the deliverable);
fair value exists for the deliverable; and
the customer retains a right of return for the deliverable in cases where the undelivered components are probably and substantially under the vendor’s control.
Supplier contracts to deliver a weapons system with sophisticated artificial intelligence software and on-base training for a period of two years. The system has standalone value to the U.S. military, fair value exists for the weapons components and allied software, and the U.S. military has a right of return of the system since the undelivered software and training at contract inception are probably and substantially within Supplier’s control.
Measurement and Revenue Allocation
It is crucial under Issue 00-21 to have evidence of the “fair value” of each deliverable. Clearly, arms-length standalone value is such evidence. A Kelly Blue Book value for an automobile, for example, would trump a contract or list price for that automobile.
The vendor must establish applicable revenue recognition criteria for combined deliverables; that is, the deliverables that fail the first test of separability are necessarily combined and straight-line revenue recognition is applied. Also, no contingent revenue from deliverables is allocated.
Supplier has a multi-deliverable contract with Hospital and has outstanding undelivered elements of software installation and training. Under Issue 00-21, Supplier allocates revenues under the contract to these elements, which have evidence of fair value, and the contract price is allocated for each deliverable.
Effective and efficient internal controls on revenue recognition need to be in place. For public companies, these are required pursuant to section 404 of the Sarbanes-Oxley Act, and corresponding controls for private companies are required pursuant to actions of the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and the AICPA's Auditing Standards Board (ASB). Implementation of SOP 97-2, SAB 104, and Issue 00-21 will be impaired if such controls are lacking.
Excerpted by permission. Copyright 2007, Specialty Technical Publishers.