Definition: Upgrade Rights

The right to receive one or more specific upgrades/enhancements that are to be sold separately. The upgrade right may be evidenced by a specific agreement, commitment, or the vendor's established practice.

Definition: Source Code

Code written by a programmer in a formal programming language and readable by people but not computers. Source code must be converted to object code or machine langugae (e.g., by a compiler or an assembler) before a computer can read or execute the program.

Definition: Platform-Transfer Right

A right granted by a vendor to transfer software from one hardware platform or operating system to one or more other hardware platform or operating systems.

Definition: Object Code

The machine code generated by a source code language processor such as an assembler or a compiler. A file of object code may be immediately executable or it may require linking with other object code files.

Definition: Milestone

A task associated with long-term contracts that, when completed, provides management with a reliable indicator of progress-to-completion on those contracts.

Definition: Firmware

Software stored in read-only memory (ROM) or programmable ROM (PROM). Firmware is responsible for the behavior of a machine when it is first switched on. An example would be a monitor program in a microcomputer that loads the full operating system from a disk or from a network and then passes on control to it.

Definition: Core Software

An inventory of software that vendors use in creating other software. Core software is not delivered as is because customers cannot use it unless it is customized to meet system objectives or customer specifications.

Setting Expectations for New Direct-Report

When a new direct report starts, a good thing to do is sit down and explain the calendar year's deliverables in a way that allows that person to be able to plan accordingly. May include:

• When not to plan vacation.
• Any day care needs.
• Reports and which reports may need lead time for review.

Foundations of the Net Present Value Rule

Capital Markets - Current vs Future consumption

example: investment returns 14% at end of year, 7% interest rate

Option A - invest $100 now and receive $114 at end of year

Option B - invest $100 and receive $106.54 ($114 x 1.07) now

B is borrowing against future income

Net Present Value Rule - investe in any project with a positive net present value

Rate of Return Rule - invest as long as the return on the investment exceeds the rate of return an equivilant investment in capital markets.

Introduction to Present Value

Present Value of $1 must be less than $1 tomorrow because a $1 today can be invested, etc. Discount Factor - present value of a delayed payoff may be found by multiplying payoff by a discount factor.

Present Value = Discount Factor x Payoff

Discount Factor = 1 (divided by) Rate of Return

Opportunity Cost - rate of return offered by equivalent investment alternatives in capital market.

Net Present Value - Present Value less Required Investment

Determing VSOE of Fair Value for PCS

We believe there are two acceptable methods for determining VSOE of fair value for PCS:

1. Bell-Shaped-Curve Approach. Under the method, VSOE of fair value is determined by evaluating the price paid for PCS sold independently of other elements (e.g., PCS renewals). In evaluating whether prices paid by customers are within an acceptable range, for each group of PCS renewal arrangements in recent periods the vendor must compile and evaluate information about the PCS renewal amounts charged. To conclude that VSOE of fair value exists for a range of prices, those prices must be sufficiently clustered within an appropirate range. For example, we believe that a range of prices which approaches 80% of a group of similar arrangements during recent periods falling within 15% (either above or below) of the median price of the range may constitute a range that is sufficiently clustered to permit a conclusion that VSOE of fair value exists for that group of similar arrangements. However, it should be noted that this range does not constitute a safe harbor and there could be situations where it would be appropriate to conclude that VSOE of fair value does not exist, even though the pricing of separate sales of a PCS element is within this range for a particular group of similar arrangements. All relevant facts and circumstances must be considered in making this determination. When VSOE of fair value for PCS is determined by an evaluation of a reasonable range of prices and the stated contractual PCS renewal price in an arrangement falls outside that range, we believe the revenue allocated to PCS for that individual arrangement can be based on either (1) the midpoint of the range, or (2) the outer limit of the range nearest the stated price. This allocation of revenue for the arrangements whose pricing falls outside the range is an accounting policy election that should be applied consistently across all of the vendor's PCS arrangements and disclosed, if the impact of the policy is material to the vendor's results. When allocating revenue to outlier arrangements, an entity should also consider the guidance in 97-2, which indicates that amounts otherwise allocated to delivered elements would not meet the criterion of collectibility if the portion of the fee allocable to delivered elements is subject to forfeiture, refund, or other concession if any of the undelivered elements are not delivered. If payment for a delivered element is not due until a future element is not delivered, the payment for the delivered element would not meet the collectibility criterion in 97-2.
2. Stated Renewal Approach. Under the method, the vendor looks to the renewal rate stated in the specific customer contract as the basis for determining VSOE of fair value for the PCS arrangement. Under this approach, the renewal rate must be substantive. The stated renewal approach is based on the guidance in paragraph 57 of 97-2, which states that "the fair value of the PCS should be determined by reference to the price the customer will be required to pay when it is sold separately (that is, the renewal rate)". To be considered substantive, the PCS renewal rate cannot be significantly below the software vendor's normal pricing practice. Judgement is necessary to evaluate whether or not the stated contractual renewal dollar amount is substantive. Under the stated renewal approach, we believe in some situations a vendor can establish VSOE of fair value for PCS before a customer has actually purchased PCS in a separate renewal transaction. When the vendor uses the stated renewal approach and the renewal rate is determined to be nonsubstantive, VSOE of fair value does not exist for the transaction and, if PCS is the only undelivered element, the entire arrangement fee would be recognized ratably over the PCS period. In some cases, a customer may have the right to cancel a bundled PCS arrangement at any time during the initial term and obtain a refund for the pro-rata portion of the stated PCS fee. Such cancellation and refund provisions applicable to the initial bundled PCS term are not equivalent to stated renewal options and would not represent VSOE of fair value for the PCS.

Example #1 - ABC Corp. uses the bell-shaped-curve approach to establishing VSOE of fair value for its PCS arrangements. It has two classes of customers.

For the first class of customers, the median CPS renewal price for one year of PCS is $20,000. Therefore, a substantial portion of the renewal price should fall within a range of $17,000 to $23,000 (($20,000 - [$20,000 x 15%]) to ($20,000 + [$20,000 x 15%])). ABC finds that during recent periods, 84% of the renewal prices fell within this range and concludes that VSOE of fair value exists for PCS with respect to the first class of customers.

For the second class of customers, the median PCS renewal price for one year of PCS is $15,000. Therefore, a substantial portion of the renewal prices should fall within a range of $12,750 to $17,250 (($15,000 - [$15,000 x 15%]) to ($15,000 + [$15,000 x 15%])). ABC finds that during recent periods, 60% of the renewal prices fell within this range and concludes that VSOE of fair value does not exist for PCS with respect to the first class of customers.

Example #2 - Assume the same information from Example #1. Also assume that ABC Corp.'s policy is to use the median of the VSOE-of-fair-value range for an element when allocating consideration in arrangements when the contractual price for an element does not fall within the VSOE-of-fair-value range for the element. ABC sells software and one year of PCS for a nonrefundable fee of $125,000 to Customer. The contract indicates that the license fee is $110,000 and the one-year PCS arrangement is $15,000. ABC determines that Customer is in the first class of customer described in Example #1, so PCS prices that are between $17,000 and $23,000 would represent VSOE of fair value. ABC does not have VSOE of fair value for the software and uses the residual method.

ABC would allocate $20,00 of the arrangement consideration to PCS based on its VSOE of fair value (median of the range, in accordance with ABC's policy) and the residual ($105,000) to the software. Assuming all other criteria of 97-2 are met, the revenue allocated to the software would be recognized upon delivery, and the revenue allocated to the PCS would be recognized ratably over the on-year PCS period.

Example #3 - ABC Corp. is a start-up enterprise that licensed its data storage software (Product A) to Customer together with one year of PCS for a nonrefundable fee of $100,000. The license agreement specifies that the customer is entitled to renew PCS in the second year of $18,000.

Based on the guidance of paragraph 57 of 97-2, the renewal rate specified in the contract is sufficient to establish VSOE of fair value of PCS for this start-up enterprise (provided that the renewal amount is deemed substantive). Under the stated renewal approach, ABC can establish VSOE of fair value of PCS before a customer has actually purchased PCS in a separate renewal transaction if the renewal rate is substantive.

Example #4 - ABC Corp. licenses its customer relationship management software (Product B) to Customer together with one year of PCS for a nonrefundable fee of $1,000,000. The license agreement states that the overall arrangement fee consists of $800,000 for a perpetual license to use Product B and $200,000 for one year of PCS. The license agreement specifies that the customer is entitled to renew PCS in the second year at ABC's then-current list price for annual PCS. ABC's licensing arrangements generally contain a substantive PCS renewal option for specified amounts, so ABC uses the stated renewal approach to establish VSOE of fair value for PCS.

The arrangement contains no stated renewal amount; it merely specifies that ABC can renew PCS in the second year at the then-current list price, which the customer would be entitled to do regardless of whether the contract includes that provision. Even though the PCS renewal amount in year two is within ABC's control, that amount is not yet known to either the vendor or the customer. Accordingly, the PCS renewal provision in this arrangement would not establish VSOE of fair value for the PCS under the stated renewal approach. Assuming PCS is the only undelivered element and all other renewal approach. Assuming PCS is the only undelivered element and all other revenue recognition criteria of 97-2 are met, the entire $1,000,000 arrangement fee would be recognized ratably over the one-year contractual PCS period.

In some licensing arrangements with bundled PCS for the first year, PCS can be renewed in the second year for the PCS amount stated in the contract for the first year plus an amount not to exceed a specified percentage increase. Such arrangements contain a range of possible renewal amounts that are potentially subject to negotiation between the software vendor and the customer. If the vendor is able to demonstrate that the range of possible renewal amounts is sufficiently narrow to establish VSOE of fair value, the vendor should consider all relevant evidence (e.g., pricing patterns established in prior PCS renewal transactions) in determining which amount within that range of possible renewal amounts needs to be sufficiently narrow in order for VSOE of fair value to exist for PCS under the stated renewal approach.

Example #5 - ABC Corp. licenses its networking software (Product A) to Customer together with one year of PCS for a nonrefundable fee of $1,000,000. The license agreement states that the overall arrangement fee consists of $800,000 for a perpetual license to use Product A for $200,000 for one year of PCS. The license agreement specifies that the customer is entitled to renew PCS in the second year for the year-one PCS fee stated in the contract plus an increase of no more than 12%. ABC uses the stated renewal approach to establish VSOE of fair value for PCS.

In the example, the ultimate amount the customer will be required to pay for PCS in year two is unknown because the renewal price can range between the amount stated in the contract for year one ($200,000, if there is no increase), up to a maximum increase of 12% ($224,000). ABC concludes that this range is not sufficiently narrow to establish VSOE of fair value for the PCS under the stated renewal approach. Assuming PCS is the only undelivered element and all other revenue recognition criteria of 97-2 are met, the entire $1,000,000 arrangement fee would be recognized ratably over the one-year PCS period.

Example #6 - ABC Corp. licenses its networking software (Product A) to Customer together with one year of PCS for a nonrefundable fee of $1,000,000. The license agreement states that the overall arrangement fee consists of $800,000 for a perpetual license to use Product A and $200,000 for one year of PCS. The license agreement specifies that the customer is entitled to renew PCS in the second year for the year-one PCS fee stated in the contract plus an increase of no more than 3%. ABC uses the stated renewal approach to establish VSOE of fair value for PCS.

In this example, the ultimate amount the customer will be required to pay for PCS in year two is unknown because the renwal price can range between the amount stated in the contract for year one ($200,000, if there is no increase), up to a maximum increase of 3% ($206,000). ABC concludes that this range is sufficiently narrow to establish VSOE of fair value for the PCS under the stated renewal approach. ABC should allocate a portion of the arrangement fee to the PCS element based on its VSOE of fair value (i.e., an amount between $200,000 and $206,000, depending on the specific facts and circumstances) and would be recognized over the one-year PCS period. The residual portion of the overall arrangement fee would be allocated to the software license.

PCS - A Seperate Element

If a multiple-element software arrangement includes explicit or implicit rights to PCS, PCS is a separate element of the arrangement. (97-2 Paragraph 57) If a multiple-element software arrangement includes explicit or implicit rights to PCS, the total fees from the arrangement should be allocated amount the elements based on vendor-specific objective evidence of fair value. The fair value of the PCS should be determined by reference to the price the customer will be required to pay when it is sold separately (that is, the renewal rate). The portion of the fee allocated to PCS should be recognized as revenue ratably over the term of the PCS arrangement, because the CPS services are assumed to be provided ratably. However, revenue should be recognized over the period of the PCS arrangement in proportion to the amounts expected to be charged to expense for the PCS services rendered during the period if -

• Sufficient vendor-specific historical evidence exists demonstrating that costs to provide PCS, are incurred on other than a straight -line basis. In making this determination, the vendor should take into consideration allocated portions of cost accounted for as research and development (R&D) costs and the amortization of costs related to the upgrade/enhancement capitalized in conformity with FASB Statement No. 86, Accounting for Costs of Computer Software to Be Sold, Leased or Otherwise Marketed. Such costs should be considered as part of the costs to provide PCS.
• The vendor believes that it is probable that the costs incurred in performing under the current arrangement will follow a similar pattern.

(SOP 97-2, Paragraph 58) If sufficient vendor specific objective evidence does not exist to allocate the fee to the separate elements and the only undelivered element is PCS, the entire arrangement fee should be recognized ratably over (a) the contractual PCS period (for those arrangements with explicit rights to PCS) or (b) the period during which PCS is expected to be provided (for those arrangements with implicit rights to PCS). Allocation of Revenue-to and Recognition-of Revenue for PCS Example - ABC Corp. enters into an arrangement with Customer to deliver Product A, which is currently available, and Product B, when available, and to provide PCS for a one-year period. ABC does not separately sell PCS and, thus, does not have sufficient VSOE of fair value to allocate revenue to the elements. Product A is delivered upon consummation of the arrangement and Product B is delivered three months later. ABC would defer the arrangement fee until Product B is delivered. Assuming all other revenue recognition criteria in 97-2 are met, upon delivery of Product B the PCS would be the only undelivered element and the entire fee would be recognized ratably over the remaining term of the PCS agreement.

PCS Term Commences at Date Subsequent to Delivery of Software

A software arrangement may stipulate that the term of the PCS arrangement commences at a date later than delivery of the software. For example, the PCS term may not begin until installation of the software is complete or until a general warranty period has expired. Upon commencement of the contractual PCS term, generally the customer is entitled to receive upgrades/enhancements that were released by the vendor, if any, during the period between delivery and commencement of the contractual PCS term. In those situations, 97-2 specifies that an implied PCS arrangement exists that commences upon product delivery.

If the criteria for recognition of PCS revenue upon delivery of the software contained in 97-2 are not met, the vendor would allocate a portion of the fee to the implied PCS arrangement (i.e., the period from delivery of the software to the commencement of the contractual PCS term) based on VSOE of fair value of the elements. VSOE of fair value for the implied PCS arrangement may be derived, on a pro rata bases, from the VSOE of fair value of the contractual PCS arrangement.

Example - ABC Corp. enters into an arrangement with Customer to deliver Product A and to provide PCS for a period of one year for a nonrefundable fee of $100,000. However, the one-year PCS term commences upon expiration of a general warranty period which ends six months after delivery of Product A. Upon commencement of the PCS arrangement, Customer is entitled to receive any upgrades/enhancements released by ABC during the general warranty period. The VSOE of fair value for annual PCS for Product A is $20,000. Because Product A is never sold without PCS, VSOE of fair value does not exist for Product A.

The arrangement fee would be allocated to the elements using the residual method as follows:

VSOE of fair value for 12-month PCS - $20,000
Implied PCS Period - 6 months
VSOE of fair value for 18-months PCS ($20,000 x 18/12 months) - $30,000

The total arrangement consideration would be allocated to Product A and PCS as follows:

Total arrangement fee	$100,000
PCS	$(30,000)
Residual, allocated to Product A	$70,000

Assuming that all the other revenue recognition criteria of 97-2 are met, the revenue allocated to Product A would be recognized upon delivery of the software. The revenue allocated to PCS would be recognized ratably over the 18-month PCS period (i.e., the 6-month implied PCS period plus the 12-month contractual PCS period).

Implied PCS Arrangements

An implied PCS arrangement exists if the vendor has a historical pattern of regularly providing all customers or certain customers with services or unspecified upgrades/enhancements normally associated with PCS, or anticipates doing so, even though there is no written contractual obligation to provide PCS.

Example - ABC Corp. enters into an arrangement with Customer to deliver Product A. ABC does not have a contractual obligation to provide PCS to Customer. However, ABC maintains an Internet site onto which it periodically places upgrades and enhancements for Product A. An implied PCS arrangement exists. Therefore, if ABC does not have VSOE of fair value of the PCS arrangement, PCS is the only undelivered element, and all other revenue recognition criteria of 97-2 are met, the entire fee would be recognized ratably over the period during which the PCS is expected to be provided.

Example - ABC Corp. enters into an arrangement with Customer to deliver payroll processing software (Product A). ABC does not have a contractual obligation to provide PCS to Customer (i.e., Customer is not contractually entitled to receive any software updates, including updates for changes in tax laws). However, ABC has a history of developing updates whenever there is a change in laws and making those updates available free of charge on its web site for customers that have previously purchased Product A.

The updates to Product A for changes in tax laws meet the definition of an upgrade/enhancement under 97-2. The updates extend the life of the software and significantly increase its marketability. Without updating the payroll processing software for changes in tax laws, the software would become obsolete whenever there is a significant change in the tax laws. Therefore update to Product A for changes in tax laws extend the life of the original product. Also, a customer would not license payroll software that is unable to accurately calculate an employee's tax withholdings, so the updates significantly improve the marketability of the original product. Although ABC is not contractually obligated to provide updates to Customer, the updates can be accessed through ABC's web site and, thus, an implied PCS arrangement exists. If ABC does not have VSOE of fair value for the PCS arrangement, PCS is the only undelivered element, and all other revenue recognition criteria in 97-2 are met, the entire fee would be recognized ratably over the period during which the PCS is expected to be provided.

Postcontract Customer Support (PCS)

PCS includes the right to receive services (typically telephone support and maintenance) or unspecified upgrades and enhancements, or both, offered to users or resellers, after the software license period begins, or after another point in time as provided for by the PCS arrangement. PCS does not include (i) installation or other services directly related to the initial license of the software, (ii) specified upgrade rights even if a customer would otherwise be entitled to the upgrade right as a subscriber to PCS, or (iii) rights to additional specified or unspecified software products.

• A vendor may develop historical patterns of regularly providing all customers or certain kinds of customers with the services or unspecified upgrades/enhancements normally associated with PCS, or may anticipate doing so, even though there is no written or contractual obligation or the stipulated PCS term commences at some date after delivery. In those situations, an implied PCS arrangement exists that commences upon product delivery. For purposes of applying the guidance in this SOP, PCS includes a vendor's expected performance based on such patterns, even if performance is entirely at the vendor's discretion and not pursuant to a formal agreement.

Under 97-2, a specified upgrade right constitutes a separate element of the arrangement whereas an unspecified upgrade right is part of PCS. Distinguishing between a specified and unspecified upgrade right requires an evaluation of all the relevent facts and circumstances to determine whether the vendor has made a commitment to provide specific funtionalities to the customer at some point in the future (regardless of whether or not the future date is specified). For example, some vendors of payroll software state in their license or PCS agreement that they will update the software as necessary for changes in payroll tax laws. Additionally, other software vendors commit to maintain compliance with a specified platform as part of their license of PCS agreements. In these instances, changes in payroll tax laws and changes to a specified platform are outside the control of both the vendor an customer and may be infrequent or nonexistent during the PCS term, so the upgrade rights are implicitly offered on a when-and-if-available basis. Accordingly, we believe that such a commitments to update software for changes in regulations or to maintain compliance with platform would be considered an unspecified upgrade right and would be deemed part of PCS.

Example - ABC Corp. is a provider of clinical software used by physician practices. ABC and its customers are subject to the requirements of the Health Insurance Portability and Accountability Act of 1996 (HIPPA), existing HIPPA standards are subject to change and new HIPPA standards may be released in the future.

Changes in HIPPA regulations are outside the control of ABC, and may be infrequent or nonexistent during the term of the PCS arrangement, so the updates are considered to be offered on a when-and-if-available basis. Also, the development effort for such updates would typically not be significant in comparison to the original development effort for the software, and updates for changes in HIPAA regulations would otherwise need to be made for ABC to continue its product offering in the marketplace. As such, the commitment to keep the software compliant with HIPAA regulations would be deemed to be an unspecified upgrade right (i.e., part of the PCS arrangement).