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Revenue Recognition for Software Products with Multiple Deliverables

By Steven T. Petra and Nathan S. Slavin

APRIL 2005 - Selling several products and services for a single price is common practice in many industries. Many products included in such arrangements are not delivered at the time of sale. The character of the products and the nature of the earnings process affects the timing of the recognition of revenue. Depending on the accounting standard that applies to the transaction, a portion of the total price charged at the time of sale will be deferred until the products or services are delivered. Some transactions may require deferment of all of the revenue until delivery of the last portion of the package. Companies that sell software products and services that are not incidental to the products or services as a whole will generally need to follow the procedures under AICPA Statement of Position (SOP) 97-2, Software Revenue Recognition. As a result, software products that are essential to the function of any nonsoftware products will also be included under the scope of SOP 97-2. Multiple deliverable products that include software incidental to the products or services as a whole will be guided by Emerging Issues Task Force (EITF) Issue 00-21.

Background

SOP 97-2 applies to all entities that license, sell, lease, or market computer software. It also applies to “hosting” arrangements in which the customer has the option to take possession of the software. Hosting arrangements occur when end users do not take possession of the software but rather the software resides on the vendor’s or a third party’s hardware, and the customer accesses and uses the software on an as-needed basis over the Internet or some other connection. It does not, however, apply to revenue earned on products containing software incidental to the product as a whole or to hosting arrangements that do not give the customer the option of taking possession of the software.

SOP 97-2 provides that revenue should be recognized in accordance with contract accounting when the arrangement requires significant production, modification, or customization of the software. When the arrangement does not entail such requirements, revenue should be recognized when persuasive evidence of an agreement exists, delivery has occurred, the vendor’s price is fixed or determinable, and collectibility is probable.

In the software industry, the largest part of revenues stems from vendors’ license fees associated with software. Companies such as Microsoft and Computer Associates have recognized revenue from license fees when the software was shipped to the customer. The amount and timing of revenue recognition is complicated, however, by multiple-element arrangements that provide for multiple software deliverables [e.g., software products, upgrades or enhancements, postcontract customer support (PCS), or other services]. In hosting arrangements that are within the scope of SOP 97-2, multiple elements might include specified or unspecified upgrade rights, in addition to the software product and the hosting service. The software provider often charges a single fee that must be allocated to the products delivered in the present and in the future. If contract accounting is not required, SOP 97-2 requires that the vendor’s fee be allocated to the various elements based on vendor-specific objective evidence (VSOE) of fair value for each element. VSOE is limited to the price charged by the vendor for each element when it is sold separately. This requires the deferral of revenue until VSOE can be established for all elements in the arrangement or until all elements have been delivered. If PCS is the only undelivered element in the arrangement, however, the entire fee can be recognized ratably over the term of the PCS contract. In addition, recognition of revenue must be deferred if undelivered elements are essential to the functionality of any delivered elements.

Multiple-element arrangements are not limited to the software industry. Other common examples include the sale of computer networks, specialized equipment with installation and training, and cellular telephones with service contracts. EITF 00-21, Revenue Arrangements with Multiple Deliverables, identifies when separation of sales arrangements for revenue recognition purposes is appropriate.

In an arrangement with multiple deliverables, EITF 00-21 requires that the delivered items be considered a separate unit of accounting if the delivered items have value to the customer on a stand-alone basis, if there is objective and reliable evidence of the fair value of the undelivered items, and if the arrangement includes a general right of return for the delivered item, or if delivery or performance of the undelivered items is considered probable and substantially in the control of the vendor. EITF 00-21 requires allocation of the vendor’s fee to the various elements based on each element’s stand-alone value, and the deferral of revenue until the stand-alone value can be established. Stand-alone value can be determined on the basis of any vendor’s sales price or on the basis of the customer’s ability to resell the element on a stand-alone basis. This requirement is much less restrictive than the VSOE requirement of SOP 97-2, which limits stand-alone value to that established by the vendor only and does not allow the value to be determined by other vendors or by the customer’s ability to resell the element. Additionally, the stringent “essential to the functionality” criterion of SOP 97-2 is not included in EITF 00-21, so such undelivered elements would not cause the deferral of revenue recognition on the delivered elements.

In general, both SOP 97-2 and EITF 00-21 require allocating revenue to all of the elements of a multiple-deliverable arrangement using the relative fair value method, where objective and reliable evidence of fair value is present for all the products contained in the group. If objective and reliable evidence is available only for the products that have not been delivered, the residual method should be used to value the products that have been delivered. If objective and reliable evidence is available only for the delivered products, no value should be assigned to any products until all of them are delivered. Both SOP 97-2 and EITF 00-21 prohibit using the reverse residual method. The Exhibit summarizes the important provisions of these two accounting rules.

The Issue

Many software companies provide nonsoftware deliverables (e.g., hardware) in their arrangements with customers. It is unclear whether the nonsoftware deliverables fall under the scope of SOP 97-2 or EITF 00-21. Under SOP 97-2, VSOE of fair value must be established for the nonsoftware deliverables to avoid deferring revenue recognition. Also, SOP 97-2 would apply the essential-to-the-functionality criterion to nonsoftware deliverables. This could also defer revenue recognition. For example, in an arrangement that includes software and the computer hardware that will contain it, if the software is essential to the functionality of the hardware, the vendor’s fee must be deferred if the vendor cannot establish VSOE of fair value for the hardware and the hardware has not yet been delivered.

Under EITF 00-21, stand-alone values must be determined for the nonsoftware deliverables to avoid revenue deferral. The stand-alone values could be based on VSOE; however, they could also be determined from third-party evidence of fair value (e.g., the price of a competitor’s similar product). In addition, the EITF does not apply the essential-to-the-functionality criterion to the nonsoftware deliverables, thus allowing revenue recognition for delivered elements that have little or no utility to the customer until the undelivered elements arrive.

At its July 31, 2003, meeting, the EITF affirmed the following consensus, stated in EITF Issue 03-5:

In an arrangement that includes software that is more than incidental to the products or services as a whole, software and software-related elements are included within the scope of SOP 97-2. Software-related elements include software products and services such as those listed in paragraph 9 of SOP 97-2 [i.e., software products, upgrades/enhancements, postcontract customer support, or services] as well as any non-software deliverable(s) for which a software deliverable is essential to its functionality. For example, in an arrangement that includes software, computer hardware that will contain the software, and additional unrelated equipment, if the software is essential to the functionality of the hardware, the hardware would be considered software-related and, therefore, included within the scope of SOP 97-2. However, because the software is not essential to the functionality of the unrelated equipment, the equipment would not be considered software-related and would, therefore, be excluded from the scope of SOP 97-2.

At its August 13, 2003, meeting, FASB ratified the EITF’s consensus. The following examples demonstrate the application of SOP 97-2 and EITF 00-21.

Examples

A multiple-element arrangement under SOP 97-2. Company X sells computer software. On May 20, the company licenses version 1.0 of a software product to its customer for $300, including one year of “free” postcontract customer support (PCS) and a right to receive version 2.0 at no additional cost when it becomes available. The company delivers the software to the customer on May 30. The existing software is sold separately for $275. The company’s pricing committee determines that version 2.0 will be offered to users of version 1.0 as a specified upgrade/enhancement at a price of $100. In addition, the company sells annual renewals for the PCS for $20. Persuasive evidence indicates that the amount allocated to version 1.0 will not be subject to forfeiture, refund, or other concession. Company X’s experience indicates that 60% of its customers usually exercise upgrade rights.

Revenue of $224 should be recognized on May 30, the delivery date of the software. Revenue of $16 from the PCS should be recognized ratably over the one-year PCS period. Revenue of $60 should be deferred and recognized when the upgrade is delivered to the customer.

Discussion. Because this sale involves the licensing of computer software that is not incidental to the products or services as a whole, the transaction falls within the scope of SOP 97-2. Because VSOE of fair value exists for all elements in the arrangement, the $300 sales proceeds would be allocated to each of the elements as follows:

Amount allocated to upgrade right: VSOE of upgrade right ¥ Anticipated probability that the upgrade will be requested by the customer

$100 x 60% = $60

The remaining elements of the sales proceeds (the software and PCS) will be allocated in proportion to VSOE as follows:

Total sales proceeds $300
Sales proceeds attributable to upgrade right 60
Remaining amount to allocate $240

Amount allocated to software: Remaining amount to allocate
x (VSOE of software/VSOE of all elements) = Sales price allocated to software $240 x ($275/$295) = $224
Amount allocated to PCS:

Remaining amount to allocate x (VSOE of PCS/VSOE of all elements) = Sales price allocated to PCS $240 x ($20/$295) = $16

A multiple-element arrangement under EITF 00-21. Company Y sells computer systems. On May 20, a customer purchases a computer system consisting of a CPU, a monitor, and a keyboard, for $1,000. The system contains software that is incidental to the other products as a whole. On May 30, Company B delivers the CPU to the customer without the monitor or keyboard. Each item can be purchased separately at a cost of $700 for the CPU, $300 for the monitor, and $100 for the keyboard. The CPU could function with readily available monitors or keyboards manufactured by others. The customer is entitled to a refund equal to the separate price of any undelivered item. The arrangement does not include any general rights of return.

Revenue of $600 should be recognized on May 30, the delivery date of the CPU. Revenue of $400 ($364 revenue allocated to the monitor and keyboard plus $36 revenue allocated to the CPU that is subject to refund if the monitor and keyboard are not delivered) should be deferred and recognized when the monitor and keyboard are delivered to the customer.

Discussion. Because this sale involves an arrangement with multiple deliverables that does not contain computer software, the transaction falls within the scope of EITF 00-21. The $1,000 sales price would be allocated to each element in the arrangement on a relative fair value basis as follows:

Allocation to CPU:
Total sales price x (Value of CPU/Value of all elements) = Sales price allocated to CPU
$1,000 x ($700/$1,100) = $636

However, because the customer is entitled to a refund of $400 if the monitor and keyboard are not delivered, the maximum amount of revenue that can be recognized on the delivered elements is $600: $1,000 minus $400.

Allocation to the monitor and keyboard:

Total sales price x (Value of monitor and keyboard/Value of all elements) = Sales price allocated to monitor and keyboard
$1,000 x($400/$1,100) = $364

A multiple-element arrangement under SOP 97-2 and EITF 00-21 where the undelivered elements are not essential to the functionality of the delivered elements. Company A sells computer software. On May 20, a customer purchases a license to use the software, along with a computer system, for $1,900. The computer system consists of a CPU that will contain the software, a monitor, and a keyboard. On May 30, Company A delivers the software to the customer without the computer system. Each item can be purchased separately from Company A as follows: $1,000 for the software, $700 for the CPU, $300 for the monitor, and $100 for the keyboard. The software is a major focus of the sale and is not incidental to the other products. Although the software could function with a readily available computer system manufactured by others, it is essential to the functionality of the CPU. The customer is entitled to a refund equal to the separate price of any undelivered item.

Revenue of $800 should be recognized on May 30, the delivery date of the software to the customer. Revenue of $1,100 ($700 revenue allocated to the CPU, $362 to the monitor and keyboard, and $38 to the software subject to refund) should be deferred and recognized when the CPU, monitor, and keyboard are delivered.

Discussion. Because this sale involves marketing computer software that is not incidental to the products as a whole, and the software is essential to the functionality of the CPU, SOP 97-2 applies to the software and the CPU, but not to the monitor and the keyboard. Additionally, delivery of the computer software represents a separate unit of accounting under EITF 00-21: The software has value to the customer on a stand-alone basis because the software is sold separately by Company A; there is objective and reliable evidence of the fair value of the undelivered items because these values are based on the price as sold separately; and there are no general rights of return.

Under EITF 00-21, the $1,900 sales price is allocated to the software, the CPU, the monitor, and the keyboard based on their relative fair values as follows:

Allocation to software elements:
Total sales price x (Value of software elements/Value of all elements) = Sales price allocated to software elements
$1,900 x($1,700/$2,100) = $1,538

Allocation to nonsoftware elements:
Total sales price x (Value of nonsoftware elements/Value of all elements) = Sales price allocated to software elements
$1,900 x($400/$2,100) = $362

Because VSOE is available for all elements in the arrangement, revenue can be recognized under SOP 97-2 for the delivered elements as follows:

Sales price allocated to software
elements x (Fair value of delivered elements/Fair value of all elements)
$1,538 x ($1,000/$1,700) = $905

Because the customer is entitled to a refund of $1,100 if the CPU, monitor, and keyboard are not delivered, the maximum amount of revenue that can be recognized on the delivered elements is $800 ($1,900 – $700 – $300 – $100). When the CPU is delivered, Company A can recognize additional revenue as follows:

Sales price allocated to software elements – Revenue previously recognized = Additional revenue recognized.
$1,538 – $800 = $738

Because the customer is entitled to a refund of $400 if the monitor and keyboard are not delivered, the amount recognized upon delivery of the CPU is limited to $700 [$1,100 (remaining sales price) – $400 (amount subject to refund)]. When the monitor and the keyboard are delivered, revenue can be recognized under EITF 00-21 as follows:

Total sales price x (Value of nonsoftware elements/Value of all elements) = Sales price allocated to nonsoftware elements
$1,900 x ($400/$2,100) = $362

A multiple-element arrangement under SOP 97-2 and EITF 00-21 where the undelivered elements are essential to the functionality of the delivered elements. Company B sells computer software. On May 20, a customer purchases a license to use the software, along with a computer system, for $1,900. The computer system consists of a CPU that will contain the software, a monitor, and a keyboard. On May 30, Company B delivers the computer system to the customer without the software. Each item can be purchased separately from Company B at a cost of $1,000 for the software, $700 for the CPU, $300 for the monitor, and $100 for the keyboard. The software is a major focus of the sale and is not incidental to the other products. The software could function with a readily available computer system manufactured by others, but the software is essential to the functionality of the CPU. The customer is entitled to a refund equal to the separate price of any undelivered item.

Revenue of $362 should be recognized on May 30, the delivery date of the monitor and keyboard to the customer. Revenue of $1,538 should be deferred and recognized when the software is delivered.

Discussion. Because this sale involves marketing computer software that is not incidental to the products as a whole, and the software is essential to the functionality of the CPU, SOP 97-2 applies to the software and the CPU, but not to the monitor and the keyboard. Additionally, delivery of the computer system represents a separate unit of accounting under EITF 00-21: The computer system has value to the customer on a stand-alone basis because the computer system is sold separately by Company A; there is objective and reliable evidence of the fair value of the undelivered item as the price of the software sold separately; and there are no general rights of return.

Under EITF 00-21, the $1,900 sales price is allocated to the software, CPU, monitor, and keyboard based on their relative fair values as follows:

Allocation to software elements:
Total sales price x (Value of software elements/Value of all elements) = Sales price allocated to software elements
$1,900 x($1,700/$2,100) = $1,538

Allocation to nonsoftware elements:
Total sales price x (Value of nonsoftware elements/Value of all elements) = Sales price allocated to software elements
$1,900 x ($400/$2,100) = $362

None of the revenue allocated to the software elements ($1,538) can be recognized, because an undelivered element (software) is essential to the functionality of the delivered element (CPU).

Because the monitor and the keyboard are delivered, revenue can be recognized under EITF 00-21 as follows:

Total sales price x (Value of nonsoftware elements/Value of all elements) = Sales price allocated to nonsoftware elements
$1,900 x($400/$2,100) = $362


Steven T. Petra, PhD, CPA, and Nathan S. Slavin, PhD, CPA, are associate professors at Hofstra University.