EXECUTIVE SUMMARY
|
Statement of Position
(SOP) 97-2 provides guidance on
applying GAAP in recognizing revenue from
software and software-related
transactions. The SOP provides instruction
on recognition for licensing, selling,
leasing or otherwise marketing software.
As technology becomes
further entrenched in consumer
and enterprise products, companies outside
of the traditional software sector are
beginning to realize that the economic
value of their offerings resides in the
underlying technology—software—subjecting
those products to software revenue
recognition rules.
One of the critical
concepts established by SOP
97-2 is vendor specific objective evidence
(VSOE). The term is generally compatible
with fair value. If a company is unable to
assert that it possesses VSOE for each
element in a multiple-element arrangement,
the likely result is deferral of some, if
not all, of the arrangement’s associated
revenue.
Companies that want
to avoid SOP 97-2 should limit
their software support practices and
obligations. Post-contract support, such
as updates or upgrades, and ongoing
services provided to customers are often
separating factors in determining whether
SOP 97-2 is applicable, given that they
introduce multiple-element accounting and
thus may have a direct impact on a
company’s recorded revenue.
Greg Regan , CPA, MBA,
CFE, is a director in Hemming Morse’s
forensic consulting practice in San
Francisco. His e-mail address is
regang@hemming.com . Tim
Regan , CPA, is Dolby
Laboratories’ senior revenue manager in
San Francisco. His e-mail address is tjr@dolby.com
.
NOTE:
The views expressed by the authors do
not necessarily reflect those of their
employers . |
When Statement of Position 97-2,
Software Revenue Recognition , was
issued in October 1997, it was clear that all
software companies would transition to this new
standard. What was not clear was how bright lines
would blur for companies outside of the
traditional software sector as technology evolved
over the next decade. As technology
becomes further woven into consumer and enterprise
products ranging from cell phones to copiers,
companies in unlikely and sometimes unsuspecting
industries are beginning to realize that the true
economic value of their offerings is not in their
machinery or hardware, but rather in the product’s
underlying technology—its software. As a
result, software revenue recognition is becoming a
reality for many professionals, a fact that can be
unnerving in light of the complexities inherent in
software accounting rules. This article will help
CPAs address the presence of software in a
transaction and decide what revenue recognition
rules apply. It also highlights the most important
provisions of GAAP related to software revenue
recognition. SOP 97-2, Software
Revenue Recognition , provides guidance on
when revenue should be recognized and in what
amounts for licensing, selling, leasing or
otherwise marketing computer software. It should
be applied by all entities that earn such revenue.
It does not apply to revenue earned on products or
services containing software that is incidental to
the products or services as a whole. So
what are the consequences of falling within the
software revenue requirements? The same basic
revenue recognition rules, such as SEC Staff
Accounting Bulletin no. 104, Revenue
Recognition , apply. Evidence of the
arrangement or transaction must exist; the fee
must be fixed or determinable; delivery must be
complete; and collection of the fee must be
probable. However, the terms for satisfying each
requirement are different from basic revenue
recognition requirements. The consequences
of not complying with the rules loom large. If
companies are taken by surprise and are unable to
develop the requisite analysis, they may be unable
to prepare financial statements in accordance with
GAAP. Such was the case with Tokyo-based
NEC Corp. The information technology, mobile and
electronic device company announced in September
that it was unable to complete the analysis
necessary under SOP 97-2 to provide vendor
specific objective evidence (VSOE) to support
recognition of revenue from certain types of
software and maintenance and support services
provided as part of multiple-element contracts.
Without the analysis, NEC’s outside auditor
couldn’t complete the audit of the company’s
consolidated financial statements for the fiscal
year ended March 31, 2006. As a result, NEC was
unable to file its Form 20-F annual report with
the SEC. The problem affected NEC’s consolidated
financial statements dating back to early 2000.
“Because of the complexities involved in
determining the adjustments required to restate
its U.S. GAAP results, NEC has concluded that a
restatement is not practicable,” NEC said in a
press release. Nasdaq delisted NEC as of Sept. 27,
halting trading on the exchange of the company’s
American Depositary Receipts.
HAVE I SOLD SOFTWARE? The
application of software revenue recognition rules
begins with determining whether the sale of any
product or service contains software that is more
than incidental to the products or services as a
whole. The answer to this question would seem, on
its face, rather obvious. After all, Ford Motor
Co. is not Oracle. However, this
determination is not as simple as it might seem.
While historically many companies may have trusted
that SOP 97-2, as amended, only applied to pure
software companies, today periodic and thorough
reviews of the software indicators spelled out in
paragraph 2 of SOP 97-2 are necessary.
Specifically, accountants should review
marketing materials for existing and prospective
products to gauge how heavily software is promoted
as a key part of a company’s competitive
advantage. Accountants must also consider the
nature and extent of support services a company
provides for its products, and software-specific
development efforts that led to a final product.
Companies that want to avoid SOP 97-2 should
limit their software support practices and
obligations. Post-contract support, such as
updates or upgrades, and ongoing services provided
to customers is often the separating factor in
determining whether SOP 97-2 is applicable, given
that they introduce multiple-element accounting
and, thus, may have a direct impact on a company’s
recorded revenue. Even a retailer selling
boxed software has to be mindful of the
requirements of SOP 97-2 if that retailer also
sells related software services along with the
product.
APPLICATION TO NON -SOFTWARE PRODUCTS AND
SERVICES If the software is more
than incidental to a product, the next
determination required by EITF 03-05,
Applicability of AICPA Statement of Position
97-2 to Non-Software Deliverables in an
Arrangement Containing More-Than-Incidental
Software , is whether the software is
essential to the workings of the non-software
products or services. If it is, then those
non-software elements also fall within the
jurisdiction of software accounting. “The
guidance outlined in EITF 03-05 continues to be
consistent with the objectives of standard
setters, one of which is to reduce diversity in
practice,” says Stuart Harden, a member of FASB’s
Emerging Issues Task Force and the managing
director of the litigation and forensic consulting
services group of Hemming Morse Inc. (Note: Author
Greg Regan is also employed by Hemming Morse.) “I
anticipate that the FASB’s ongoing revenue
recognition project will further reduce diversity
in practice and will likely bring consistency to
revenue recognition principles among different
industries. As a result, an understanding of the
principles of SOP 97-2, including the fair value
concepts of [vendor specific objective evidence]
may provide practitioners with a solid foundation
for the future.” Professional judgment, as
well as consultations with knowledgeable internal
parties and external auditors, is often required
in performing this evaluation. For instance, would
a radio alarm clock, a high-definition television
or a photocopier operate as expected without its
embedded software? Even more difficult, would a
customer buy a network router, an iPhone or a
digital camera if the product did not come with
its related software? Increasingly, companies are
considering these types of questions carefully,
and as a result, some non-traditional software
manufacturers are now determining that they are,
in fact, software providers. Apple has
disclosed in quarterly filings that it recognizes
revenue from its new iPhone as well as the iPod
and Macintosh computers under software revenue
recognition rules. Apple will record all revenue
and related costs of sales from the iPhone on a
straight-line basis over the two-year estimated
life of this product. Historically, many hardware
companies might have recognized revenue upfront,
at the time of the sale, from a product similar to
an iPhone. However, Apple intends to provide
iPhone users with free software upgrades,
necessitating the deferral of revenue under SOP
97-2. Juniper Networks, a player in the
high-performance networking space, believes its
products are integrated with software that is
essential to the equipment. “Our customers
continue to make it clear that our JUNOS
single-source network operating system provides
competitive differentiation that is integral to
the functionality and performance of our current
generation of products, and is likely to become
even more strategic in the future,” says Ken
Miller, Juniper’s senior director of corporate
planning. “Based upon that, and other factors, we
concluded that SOP 97-2 was the right guidance for
us to employ.” The SEC staff has addressed
the question of pinpointing the bright line in
cases in which products or services within a
transaction are software-based (see comments made
in 2004 by then-SEC Associate Chief Accountant G.
Anthony Lopez at www.sec.gov/news/
speech/spch120604gal.htm ), and
reiterated the evaluation indicators provided by
SOP 97-2. The SEC also included
additional examples for consideration and
recommended periodic reviews of a company’s
underlying facts and circumstances to encourage
practitioners to make these assessments on a
timely basis. As a result, it is important that
companies consider some of the following factors
when reviewing for the presence of software.
A company should determine whether
software-like features are advertised as important
to its product’s functionality. This evaluation
includes reviewing:
Marketing materials distributed to
customers
The contents of recent press releases
Information published on the
company’s Web site
Internal and/or external training
documentation
Disclosures made within financial
statements
The underlying customer agreements
pertinent to the products in question “It
is important to know if customers are receiving
post-contract support, such as updates or upgrades
that provide new functionality to previously sold
products,” adds Jeff Pickett, a senior manager at
the Connor Group, a Silicon Valley consulting
firm. Over the past year, Pickett has
helped several hardware companies implement SOP
97-2. “This post-contract support can be
mistakenly accounted for under warranty, but in
fact it is a separate deliverable that requires
different accounting,” he says. “Companies should
have conversations with internal legal and
customer service departments to develop an
understanding of all ongoing services given to
customers and over what period of time they are
given.” Another important source of
information lies in understanding the composition
of the company’s research and development team.
While this may seem a daunting task, CPAs can
gather information through a review of a company’s
existing job titles and its job postings,
including those listed on the Web site, in search
of indicators such as whether the company employs
or is hiring software engineers.
Exhibit 1
| Sources of
Guidance | | | |
Detailed guidance is
provided in the following situations by
three key sources of revenue recognition
literature: | |
SOFTWARE ACCOUNTING: A HIGHER BAR
Often, as part of software-based
arrangements, multiple products or services are
provided to a customer. Therefore, one of the
critical concepts established by SOP 97-2 is VSOE.
This title is generally compatible with the term
fair value. VSOE is critical because if a company
cannot assert that it possesses VSOE for each
element in a multiple-element arrangement
(particularly those products or services still to
be delivered), the likely result is deferral of
some, if not all, of the arrangement’s associated
revenue. VSOE is an even higher standard
than subsequently released guidance on
multiple-element arrangements such as EITF 00-21.
Under EITF 00-21, an entity may use a competitor’s
selling price as evidence of fair value of its own
products. As its name suggests, VSOE bars such a
comparison. SOP 97-2 permits only two
methods to establish VSOE. The preferred method
involves the use of the company’s data related to
separate sales. The second method uses the figure,
set by appropriate management, for separately sold
items as determined within a short time of the
ultimate pricing decision, often considered to be
30 days. VSOE can be determined by
demonstrating that separate sales regularly occur
either at the same price or within a tight band.
For instance, a hardware networking company
recently changed its revenue recognition policy to
SOP 97-2 in anticipation of an initial public
offering. The company used a rule of thumb—a
methodology often referred to as the bell-shaped
curve approach—stating that VSOE exists when at
least 80% of separately sold products are priced
within a plus/minus 15% band. For example,
the median discount from list price in all
relevant sales was 40%, so the acceptable range
was deemed to be between 34% and 46% of list price
(that is, +/-15% of 40%). Thus, in this instance,
VSOE was obtained if 80% of included transactions
occurred within this range. One challenge
is that companies often use distinct pricing
practices based on such factors as geography,
class of customer, or transaction size. Each
disrupts homogeneity in the pricing required for
VSOE. However, the unique pricing conditions
required in these circumstances should be taken
into consideration in developing VSOE.
Other acceptable methods can be used to verify
that pricing conformity exists for separate sales
to establish VSOE. One such method is the stated
renewal rate for customer support. The use
of VSOE is intended to allocate revenue among the
transaction’s products or services in a way that
reflects the true fair value of its elements. For
example, a company should not deliver a product
along with yearly support services, yet recognize
all revenue pertinent to the arrangement at the
point of product shipment. The rules are intended
to identify the fair value associated with the
products, and to drive revenue recognition on a
representative and timely basis as those elements
are earned. As such, when VSOE of the elements
within a transaction is known, revenue is
recognized according to their respective values
once each item is delivered.
A CONTINUED TRANSITION In
addition to the notion that SOP 97-2 sets higher
standards in multiple-element accounting, it also
presents more situational examples than other,
more general revenue-recognition literature. As
such, accountants often turn to SOP 97-2 for
analogous guidance. “Given the increasing
significance of software to products in the
networking equipment, medical devices,
telecommunications equipment and other industries,
many of our clients consider the concepts and
guidance of SOP 97-2 in evaluating their
multiple-element arrangements” even if they have
concluded that these transactions are not within
the scope of the guidance, says Andrew Cotton,
Ernst & Young’s Americas director of software.
In particular, companies should consider not
only the explicit obligations that may be relevant
to a given transaction, but also the implied
commitments that may have been made. This
frequently involves considering transactions from
the customers’ perspectives. Did they expect to
receive support for the product, even if the
contract did not specifically state they would?
Did they expect to receive future products or
discounts that may have been mentioned in the
course of negotiations? Again this process
involves judgment and often highlights the
importance of training key salespeople and other
employees on the impact of certain commitments to
customers.
| AICPA
RESOURCES
Publications
Auditing Revenue in
Certain Industries—AICPA Audit Guide
(#012517)
AICPA Technical Practice
Aids (#005147)
Modification of SOP 97-2,
Software Revenue Recognition, With
Respect to Certain Transactions—SOP 98-9
(#014920PDF)
High Tech Audit Risk
Alert (#022408; scheduled for
January 2008 release)
CPE
Revenue Recognition in Today’s
Business Climate , a CPE self-study
course (#732423) For more
information or to make a purchase, go to
www.cpa2biz.com
or call the Institute at 888-777-7077.
OTHER RESOURCES
Publication
KPMG’s implementation guide, www.us.kpmg.com/microsite/attachments/2005/SoftwareRevRecognitionBook2005.pdf | |