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.