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Taking Account of the New Software Revenue Recognition Rules

There are few more sensitive and urgent issues for public companies and enterprises grooming themselves to go public than financial performance. However, in order for revenue to reach the bottom line, it must first enter on the top line. Since temptations to recognize revenue as soon as possible are great, one of the principal concerns of the accounting profession is to agree upon and maintain rules which regulate what sales may reasonably be deemed to be “good” sales which are not likely to later be lost through cancellation, rebating or other causes. Any reader of the financial press will certainly recall the periodic stories (inevitably followed by shareholder suits) where companies have failed to abide by these rules, to their later regret.

An imminent change in generally accepted accounting principles (GAAP) is now pending which, if adopted, will have significant impact on how and when vendors of software and related services may recognize revenues. In order to continue to recognize revenues as quickly as possible, such companies will be well advised to examine and consider changing some of their business practices and contractual arrangements to conform to the tests of the new rules.

The new requirements proposed by the American Institute of Certified Public Accountants (AICPA) are contained in a Statement of Position (SOP) on software revenue recognition, effective for fiscal years beginning after December 15, 1996. If approved and issued as final, the new SOP would replace rules last adopted in 1991; the purpose of the change is to tailor the old rules more closely to the realities of the software industry. Although most of the basic principles of the old rules are retained in the proposal, there are some important differences and clarifications which demand the attention of affected vendors.

One aspect of the new rules which will be lamented by those affected would require some revenues to be deferred longer than under existing rules. While this feature may be useful to some mature companies seeking to present a picture of sustained, controlled growth, most early-stage public and pre-public companies want to recognize the most revenue at the earliest possible time. Any company affected by the proposal — and this includes not just companies in the software industry, but any company marketing non-incidental software as a component of products or services — should plan on meeting soon with its accountants to discuss the proposed SOP’s impact and methods of complying with its requirements, consistent with the company’s financial reporting objectives.

The proposed SOP would not change the requirement that “contract accounting” must be used where there is significant production, modification or customization of software for a customer. Under this type of accounting, the contract is treated as a whole and revenue is generally realized over the contract term as work progresses, in proportion to contract costs incurred, regardless of when the various parts of the contract obligations (e.g., initial product delivery, customization and maintenance) may in fact be performed and become payable. The proposal would also retain the basic requirements for recognition of software revenue where contract accounting isn’t required, to wit: (1) delivery must have occurred, (2) collectibility must be probable, (3) there must be persuasive evidence that an “arrangement” (i.e., an agreement or two or more related agreements) exists with the customer, and (4) the fee must be fixed or determinable. However, the proposed SOP puts new emphases and glosses on the rules, and would impose stricter requirements for certain arrangements, notably, where products (or products and services) are “bundled.”

The following are some of the proposed changes or clarifications that may require a company to adjust its business practices or standard contract terms, as well as some suggestions on how to adapt business practices to address the new rules:

The proposed SOP generally would require that each element in a multiple-element arrangement be unbundled, and revenue attributable to each element recognized when the recognition criteria are met with respect to that element. (An “element” can be, for example, a software product, post-contract support (“PCS”) or other service, or a right such as a right to a future enhancement or upgrade.) However, if undelivered elements are essential to the functionality of a delivered element, then revenue for the delivered element would have to be deferred. Also, if the fair value of any contract element cannot be determined by “vendor-specific objective evidence,” revenue would have to be deferred on the delivered elements until that determination can be made, or until all elements have been delivered. Only two types of evidence would qualify as vendor-specific objective evidence. First, fair value could be established by the price actually charged by the vendor for the element when that element is sold separately by the vendor. Alternatively, if the vendor does not yet sell the element separately, it could be the price determined by management having the relevant authority and likely, based on historical experience, to hold firm through the element’s introduction. A contractual allocation of the fee would not be sufficient evidence of the fair value of an element .

Where service is one of the elements in a non-contract accounting agreement, the proposed rules would permit revenue on the delivered software to be recognized, and service revenue to be reported separately, if the services are an insignificant part of the arrangement. However, the proposed SOP would permit this only if certain additional conditions are met, one of which is a requirement that the services be stated separately so that the customer would expect the total contract price to be affected by whether the services are or are not included. Thus, in some circumstances, a vendor could be trapped into using contract accounting merely by having failed to state the services separately in the contract .

Although “persuasive evidence of an arrangement” could exist in a variety of forms, the proposal would require that, where a vendor has a customary practice of using written contracts, the only evidence of an arrangement that would be considered persuasive would be a written contract signed by both parties. A vendor should be communicating this requirement to its sales representatives and adapting its standard contract forms.

The proposal clarifies that delivery to a fulfillment house or other delivery agent does not permit the vendor to recognize revenue; delivery must be made to the customer (whether the customer is a user or a reseller).Agreements with agents should therefore provide for prompt reporting of shipments to customers .

In arrangements under which the vendor is required to deliver more than one element, collectibility is not considered to be probable for delivered elements if the vendor’s practice or obligation is to refund or forfeit part of the fee, or to provide other concessions, if additional elements are not delivered. Where there is historical evidence that the vendor has a practice of doing so (or of not doing so), that evidence will likely be persuasive. In the absence of such evidence, the proposed SOP specifies certain factors that would have to be considered. These include actions that would indicate customer acceptance, such as installation and use of the delivered software and support services, as well as the presence or absence of certain other contractual terms referred to in the proposed rules. Thus, although not necessarily controlling, the language in customer agreements can influence or even determine whether, or how much, revenue could be recognized when not all elements of an arrangement have been delivered.

TLB Comment : Meeting the tests for revenue recognition under the proposed SOP would, in many cases, require favorable historical data relating to a variety of sale situations (e.g., to support a reasonable estimate of the amount of future returns, or to support a reasonable estimate of the percentage of customers who are not expected to exercise upgrade rights, where the fair value of a multiple-element arrangement upgrade right was in question). Companies should therefore identify what historical information and evidence of business practices they are going to need, and put procedures in place to gather and maintain that data.Companies without a significant operating history will be at an obvious disadvantage where historical data is relevant if the proposed SOP is adopted. Needless to say, it is extremely important that a software product and/or service provider meet with knowledgeable accountants to set up proper procedures promptly if the new rules are adopted, to avoid needless confusion, cost and unfavorable accounting results.