Software Hosting Arrangements

In certain arrangements, rather than selling a software license and related services to the customer, the vendor will make the functionalities of the software available to the customer through a hosting arrangement. In such arrangements, the vendor will run the software application on either its own or a third-party's hardware. Customers can access the software through the Internet or a dedicated transmission line.

In these situations , there is a question whether the arrangement is an arrangement to sell software and services within the scope of SOP 97-2 or whether the hosting arrangement is a service arrangement in its entirety. EITF 00-3 addresses the question of whether SOP 9-2 applies to arrangements that require the vendor to host the software. In EITF 00-3, the EITF concluded that:

... a software element covered by SOP 97-2 is only present in a hosting arrangement if the customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty and it is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software. Therefore, SOP 97-2 only applies to hosting arrangements in which the customer has such an option. Arrangements that do not give the customer such an option are service contracts and are outside the scope of SOP 97-2. The Task Force observed that hosting arrangements that are service arrangements may include multiple elements that affect how revenue should be attributed.

Based on the consensus in EITF 00-3, a hosting arrangement contains software that is within the scope of SOP 9-2 if both of the following conditions are met:

• The customer has the contractual right to take possession of the software at any time during the hosting period without incurring a significant penalty, and
• It is feasible for the customer to run the software either on its own hardware or on a third-party's hardware.

A significant penalty as used in EITF 00-3 embodies two distinct concepts: (1) the ability to take delivery of the software without incurring significant costs (i.e., a financial penalty), and (2) the ability to use the software separately without a significant reduction in its utility or value (i.e., a functional penalty). For example, a significant penalty would exist, and the arrangement would not be within the scope of SOP 97-2 in the following scenarios:

• The customer would have to pay a significant additional amount to the vendor in order to take possession of the software, or
• The software that the customer would receive under the arrangement has significantly less functionality than the software available under the hosting arrangement.

If the customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty and it is feasible for the customer to run the software on either its own hardware or on a third-party's hardware, the provisions of SOP 97-2 ap[ply to the arrangement. In that case, the vendor must evaluate the elements of the arrangement to determine whether all or only some of the elements are within the scope of SOP 97-2. All of the revenue recognition requirements in SOP 97-2, including VSOE of fair value for all undelivered elements and the refund, or other concession, must be met in order to recognize revenue upon delivery for the portion of the fee allocated to the software element. The portion of the fee allocated to the hosting element should be recognized as the service is provided. Any non-software elements that are not within the scope of SOP 97-2, based on the provisions in EITF 03-5 (discussed in Paragraph 1.008-1.010), should be evaluated for separation under the provisions of EITF 00-21.

If the customer does not have the contractual right to take possession of the software at any time during the hosting period without significant penalty or it is not feasible for the customer to run the software on either its own hardware or on a third party's hardware, the provisions of SOP 97-2 do not apply to the arrangement. Hosting arrangements, and revenue recognition would be determined by other appropriate literature (e.g., SAB 104 and FASB Invitation to Comment, Accounting for Certain Service Transactions). Hosting arrangements that are service arrangements may contain multiple elements, so the guidance in EITF 00-21 must be applied to determine whether those elements should be treated as separate units of accounting.

Hosting arrangements including software and non-software deliverables

Based on the guidance of EITF 00-3, a hosting arrangement may include software and non-software deliverables (e.g., hosting services, hardware, PCS). If, based on EITF 00-3, a software element subject to the guidance in SOP 97-2 is present in the hosting arrangement, the vendor should then determine whether all or only some of the elements of the arrangement are within the scope of SOP 97-2. EITF 03-5 provides guidance on determining whether non-software deliverables are within the scope of SOP 97-2 (software-related deliverables) or not (non-software-related deliverables). EITF 03-5 specifies that if the software is essential to the functionality of the non-software deliverable, then the non-software deliverable is within the scope of SOP 97-2.

By applying the guidance of EITF 00-3 and EITF 03-5, the arrangement deliverables are segregated into the following categories: (1) software, (2) software-related, and (3) non-software related. The software and software-related deliverables are accounted for in accordance with SOP 97-2. The non-software-related deliverables however, are not within the scope of SOP 97-2. Accordingly, EITF 00-21 should be applied to determine whether the non-software-related deliverables constitute separate units of accounting for the software and software-related deliverables. A further complication exists in that the software-related deliverables may be services that require the application of contract accounting (e.g., services that are essential to the functionality of the software).

A software vendor that enters into a hosting arrangement should apply the following steps to determine the applicable literature for identifying the unit(s) of accounting and the revenue recognition method for the unit(s):

• Apply the criteria of EITF 00-3 to determine whether SOP 97-2 applies to the hosting arrangement. If not, the arrangement is a service contract. If the arrangement is a service contract containing multiple elements, apply EITF 00-21 to determine if the elements constitute separate units of accounting.
• If SOP 97-2 applies to the hosting arrangement, apply EITF 03-5 to determine which elements of the arrangement are software and software-related (i.e., within the scope of SOP 97-2) and which elements are non-software-related (i.e., non within the scope of SOP 97-2).
• Apply EITF 00-21 to determine whether non-software-related elements constitute separate units of accounting.
• If software-related deliverables including services, determine whether the services require application of contract accounting to the arrangement.
• If the arrangement is not subject to contract accounting, apply the criteria of SOP 97-2 to determine whether the software and software-related elements of the arrangement qualify for separation.
• If the arrangement is accounted for using contract accounting and includes software-related deliverables that are within the scope of SOP 97-2 (based on tahe guidance in EITF 03-5) but are not within the scope of SOP 81-1 (e.g., PCS), apply SOP 97-2 and its related interpretations to determine whether those deliverables can be separated from the contract accounting unit.
• If the arrangement is accounted for using contract accounting and includes non-software-related deliverables that are not within the scope of SOP 97-2 or SOP 81-1, apply EITF 00-21 to determine whether those non-SOP 81-1 deliverables can be separated from the contract accounting unit.

Example #1 - ABC Corp. enters into an arrangement with Customer to license software Product A and provide hosting service. There are no circumstances in which Customer is entitled to take possession of Product A. As a consequence, Customer would lose the right to use Product A in the event the hosting arrangement with ABC is not renewed.

Because Customer does not have the contractual right to take possession of the software at any time during the hosting period, the guidance in EITF 00-3 specifies that a software element covered by SOP 97-2 is not present. This conclusion is not impacted by the language or pricing of the contract, which states that a software license is an element of the arrangement.

Example #2 - ABC Corp. enters into an arrangement with Customer to license software Product A and provide hosting service. Customer has a contractual right to take possession of Product A at any time without significant penalty, and it is feasible for Customer to run the software on its own hardware.

Because Customer has a contractual right to take possession of Product A at any time without significant penalty and it is feasible for Customer to run the software on its own hardware, the guidance in EITF 00-3 specifies that a software element covered by SOP 97-2 is present.

Example #3 - ABC Corp. enters into an arrangement with Customer to license software Product A and provide hosting service. The contractual terms of the arrangement specify a fee of $200,000 for the first year, due at inception. Customer has a contractual right to take possession of Product A at any time without significant penalty, and it is feasible for Customer to run the software on its own hardware.

Because Customer has a contractual right to take possession of Product A at any time without significant penalty and it is feasible for Customer to run the software on its own hardware, the guidance in EITF 00-3 specifies that a software element covered by SOP 97-2 is present. Additionally, Product A is essential to the functionality of the hosting element in this example, so the hosting service represents a software-related element within the scope of SOP 97-2.

VSOE of fair value does not exist for Product A because it is never sold separately. The median price for hosting service based on renewal transactions with other customers is $220,000 per year. ABC concludes that a substantial portion of renewal prices for one year of hosting service fall within a range of $187,000 to $253,000. The contract does not separately state a price for the hosting element; however, the $220,000 median of renewal transactions with other customers, which are consistently prices within a sufficiently narrow range, constitutes VSOE of fair value for the hosting element of this arrangement.

VSOE of fair value exists for the undelivered element (the hosting service) but not for the delivered element (the software license) . However, the fair value of the undelivered hosting element ($220,000) exceeds the total arrangement consideration ($200,000), so the application of the residual method results in a single unit of accounting for the arrangement. The hosting service is the only undelivered element, so the entire fee should be recognized over the one year period in which the hosting service will be performed.

Example #4 - ABC Corp. enters into an arrangement with Customer to sell hardware, license software Product A, and provide hosting service. The contractual terms of the arrangement specifiy a fee of $1,500,000 for the first year, dur at inception, which the contract specifies relates to the hardware ($500,000), a software license ($800,000), and one year of hosting service ($200,000). The hosting service may be renewed in subsequent years for an amount to be negotiated between ABC and Customer. There are no circumstances in which Customer is entitled to take possession of Product A. As a consequence, Customer would lose the right o use Product A in the event the hosting arrangement with ABC is not renewed. Therefore, in accordance with EITF 00-3, the arrangement does not contain a software element within the scope of SOP 97-2. Objective evidence indicates that the fair value of the hosting service based on renewal transactions with other customers is $220,000 per year. Objective evidence indicates that the fair value of the hardware element is $660,000 based on the prices charged when competitors sell the same hardware. The hardware is delivered at inception of the hosting agreement and has continued functionality in the event the hosting arrangement is not renewed (i.e., the hardware has standalone value).

The arrangement in this example represents a contract to provide hosting service and deliver hardware such that neither element of the arrangement is not within the scope of SOP 97-2. Accordingly, the guidance in EITF 00-21 should be applied to determine whether the hosting service and hardware would be separate units of accounting for revenue recognition purposes. In this example, the delivered hardware element has standalone value, fair value evidence exists for the undelivered hosting element (in this example, fair value evidence also exists for the delivered hardware element), there are no general rights of return and there are no contingent revenue provisions. Accordingly, the elements should be treated as separate units of accounting for revenue recognition purposes based on guidance in EITF 00-21. Fair value evidence exists for each of the elements in the arrangement, so the arrangement fee would be allocated based on the relative fair value of the hardware and hosting elements as follows:

	Fair value		Allocation of Arrangement Fee
Hosting	$ 660,000	75%	$1,125,000
Hosting (one year)	$ 220,000	25%	$ 375,000
Total	$ 880,000		$1,500,000

Provided all the requirements for revenue recognition under SAB 104 and FASB Invitation to Comment, Accounting for Certain Service Transactions, are met for each element, the $1,125,000 of hardware revenue should be recognized upon delivery and the $375,000 of hosting revenue should be recognized over the one-year hosting period.

Revenue Recogntition Checklist - VSOE

For multiple element arrangements, is the price charged the same as if the element was sold separately to that customer? If not, then recognition will be prorated. Where maintenance is charged is at least 15% If not, then this is deemed insubstantive and therefore discounted. Is the renewal period stated in the contract? If not, then the revenue will be deferred until renewal period is known. Is the renewal period at least as long as the initial period? If not, then revenue will be deferred until the end of the maintenance period. Does the price offered reflect the normal customer discount? If not, then pro-rated recognition will occur. Has the revenue recognition review been fully documented? If not, then pro-rated recognition will occur. Is fair value determinable? If not, then all revenue is deferred until it is or all elements of the arrangement have been delivered.

Revenue Recognition Checklist - Fixed Fee or Determinable

Are fees based on fixed clear deliverables or are there variable terms? Variable terms will stop recognition. Are there any cancellation or refund previleges? If so, then recognition may be deferred. Have we offered the customer extended payment terms or are fees due beyond normal business practice? If so, then recognition will be deferred until the due date(s)? Are there acceptance clauses associated with delivery? If so, then recognititon will be deferred until the product is tested and accepted. Are the fees related to maintenance? If so, then revenue will be recognized over the period covered.

Revenue Recognition Checklist - Evidence of Arrangement

Is there a signed contract in place? Contract or PO required to recognize revenue. Is there a signed PO in place? Is it normal business practice to accept orders on PO's? If so, then the PO bust state full terms and conditions. Contract or PO required to recognize revenue. Will the current PO be followed up by a system generated PO or a signed contract? If so, then the existing PO is insufficient for revenue recognition.

Revenue Recognition Checklist - Delivery

Delivery via download? Is evidence on file of date of transfer? If not, then delivery deemed not to have occurred. Are access codes required? Is there evidence on file that they have been provided before then end of the accounting period? If not, then revenue deferred. Physical delivery? Is there evidence on file of the date of shipment? If not, then revenue deferred. Does the invoice state "FOB Shipping Point"? If not, then revenue deferred if shipped at month end. Are there undelivered elements? If yes, then revenue deferred in total if these elements are critical.

Revenue Recognition Checklist - Collectability

What are the standard credit terms?

What are the customer credit terms on this deal?

> 90 days terms will defer recognition until due date(s).

Have there been collectability problems with this company in the past?

If so, then may have to defer recognition until collection.

Has a credit check been completed and evidence placed on file?

If not, then may have to defer recognition until collection.

Is the customer a reseller?

Refer to contract to see if recognition is possible.

Delivery & Performance

a. Bill & Hold arrangements Company A receives purchase orders for products it manufactures. At the end of its fiscal quarters, customers may not yet be ready to take delivery of the products for various reasons. Question: May Company A recognize revenue for the sale of its products once it has completed manufacturing if it segregates the inventory of the products in its own warehouse from its own products? May Company A recognize revenue for the sale if it ships the products to a third-party warehouse but (1) Company A retains title to the product and (2) payment by the customer is dependent upon ultimate delivery to a customer-specified site? Response: Generally, no. The staff believes that delivery generally is not considered to have occurred unless the customer has taken title and assumed the risks and rewards of ownership of the products specified in the customer's purchase order or sales agreement. The Commission has set forth criteria to be met in order to recognize revenue when delivery has not occurred. These include:

1. The risks of ownership must have passed to the buyer.
2. The customer must have made a fixed commitment to purchase the goods, preferably in written documentation.
3. The buyer, not the seller, must request that the transaction be on a bill and hold basis. The buyer must have a substantial business purpose for ordering the goods on a bill and hold basis.
4. There must be a fixed schedule for delivery of the goods.
5. The seller must not have retained any specific performance obligations such that the earning process is not complete.
6. The ordered goods must have been segregated from the seller's inventory and not be subject to being used to fill other orders.
7. The equipment (product) must be complete and ready for shipment.

The Commission has also noted that in applying the above criteria to a purported bill and hold sale, the individuals responsible for the preparation and filing of financial statements also should consider the following factors:

1. The date by which the seller expects payment, and whether the seller has modified its normal billing and credit terms for the buyer.
2. The seller's past experiences with and pattern of bill and hold transactions.
3. Whether the buyer has the expected risk of loss in the event of a decline in the market value of goods.
4. Whether the seller's custodial risks are insurable and insured.
5. Whether extended procedures are necessary in order to assure that there are no exceptions to the buyer's commitment to accept and pay for the goods sold (i.e., that the business reasons for the bill and hold have not introduced a contingency to the buyer's commitment).

b. Customer Acceptance

After delivery of a product or performance of a service, if uncertainty exists about customer acceptance, revenue should not be recognized until acceptance occurs. Customer acceptance provisisions may be included in a contract to (1) test the delivered product, (2) require the seller to perform additional services subsequent to delivery of an initial product or performance of an initial service (e.g., a seller is required to install or activate delivered equipment, or (3) identify other work ncecessary to be done before accepting the product.

Question: Do circumstances exist in which formal customer sign-off (that a contractual customer acceptance provision is met) is unnecessary to meet the requirements to recognize revenue?

Response: Yes. Formal customer sign-off is not always necessary to recognize revenue provided that the seller objectively demonstrates that the criteria specified in the acceptance provisions are satisified. Customer acceptance provisions generally allow the customer to cancel the arrangement when a seller delivers a product that the customer has not yet agreed to purchase or delivers a product that does not meet the specifications of the customer's order. In those cases, revenue should not be recognized because a sale has not occurred. In applying this concept, the staff observes that customer acceptance provisisons normally take one of four general forms. These forms, and how the staff generally assesses whether customer acceptance provisions should result in revenue deferral, are described below:

• Acceptance provisions in arrangements that purport to be for trial or evaluation purposes.
• Acceptance provisions that grant a right of return or exchange on the basis of subjective matters.
• Accceptance provisions based on seller-specified objective criteria. An example of such provisions is one that gives the cusotmer a right of return or replacement if the delivered product is defective or fails to meet the vendor's published specifications for the product.
• Acceptance provisions based on customer-specified objective criteria. These provisions are referred to in this document as "customer-specific acceptance provisions" against which substantial completion and contract fulfillment must be evaluated. While formal customer sign off provides the best evidence that these acceptance criteria have been met, revenue recognition also would be appropriate, presuming all other reevenue recognition criteria have been met, if the seller reliably demonstrates that the delivered products or services meet all of the specified criteria prior to customer acceptance.

Question - Consider an arrangement that caclls for the transfer of title to equipment upon delivery to a customer's site. However, customer-specific acceptance provisions permit the customer to return the equipment unless the equipment satisfies certain performance tests. The arrangement calls for the vendor to perform the installation. Must revenue allocated to the equipment always be deferred utnil installation and on-site testing are successfully compelted?

Response: No. The staff would not object to revenue recognition for the equipment upon delivery (presuming all other revneue recognition criteria have been met for the equipment) if the seller demonstrates that, at the time of delivery, the eqiopment already meets all of the criteria and specifications in the customer-specific acceptance provisions. This may be demonstrated if conditions under which the customer intends to operate the equipment are replicated in pre-shipment testing.

c. Inconsequential or perfunctory performance obligations

Question: Does the failure to complete all activities related to a unit of accounting preclude recognition of revenue for that unit of accounting?

Response: No. When applying the substantially complete notion, the staff believes that only inconsequential or perfunctory actions may remain incomplete such that the failure to complete the actions would not result in the customer receiving a refund or rejecting the delivered products or services performed to date.

For example, the staff also consideres the following factors which are not all-inclusive, to be indicators that a remaining performance obnligation is substantive rather than inconsequential or perfunctory:

• The seller does not have a demonstrated history of completing the remaining tasks in a timely manner and reliably estimating their costs.
• The cost or time to perform the remaining obligations for similar contracts historically has variedsignficantly from one instance to another.
• The skills or equipment required to complete the remaining activity are specialized or are not readily available in themarketplace.
• The cost of completing the obligation, or the fair value of that obligation, is more than insignificant in relation to such items as the contract fee, gross profit, and operating income allocable to the unit of accounting.
• The period before the remaining obligation will be extinguished is lengthy. Registrants should consider whether reasonably possible variations in the period to complete performace affect the certainty that the remaining obligation will be completed successfully and on budget.
• The timing of payment of a portion of the sales price is coincident with completing performance of the remaining activity.

Question: Consider a unit of accounting that incfludes both equipment and installation because the two deliverables do not meet the separation criteria under EITF Issue 00-21. In this situation, must all revenue be deferred util installation is performed?

Response: Yes, if installation si essential to the functionality of the equipment. Examples of indicators that installation is essential to the functionality of equipment include:

• The installation involves significant changes to the features or capabilities of the equipment or building complex interfaces or connections.
• The installation services are unavailable from other vendors.

Conversely, examples of indicators that installation is not essential to the functionality of the equipment include:

• The equipment is a standard product.
• Insatllation does not significantly alter the equipment's capabilities.
• Other companies are available to perform the installation.

Persuasive evidence of an arrangement

Question: Company A has product available to ship to customers prior to the end of its current fiscal quarter. Customer Beta places an order for the product, and Company A delivers the product prior to the end of its current fiscal quarter. Company A's normal and customary business practice for this class of customer is to enter into a written sales agreement that requires the signatures of the authorized representatives of the company and its customer to be binding. Company A prepares a written sales agreement, and its authorized representative signs the agreement before the end of the quarter. However, Customer Beta does not sign the agreement because Customer Beta is awaiting the requisite approval by its legal department. Customer Beta's purchasing department has orally agreed to the sale and stated that it is highly likely that the contract will be approved the first week of Company A's next fiscal quarter. May Company A recognize the revenue in its current fiscal quarter for the sale of the product to Customer Beta. Answer: No. Generally the staff believes that, in view of Company A's business practice of requiring a written sales agreement for this class of customer, persuasive evidence of an arrangement would require a final agreement that has been executed by the properly authorized personnel of the customer. Question: Company Z enters into an arrangement with Customer A to delivery Company Z's product to Customer A on a consignment basis. Pursuant to the terms of the of the arrangement , Customer A is a consignee, and title to the products does not pass from Company Z to Customer A until Customer A consumes the products in its operations. Company Z delivers product to Customer A under the terms of their arrangement. May Company Z recognize revenue upon delivery of its product to Customer A? Answer: No. Products delivered to a consignee pursuant to a consignment arrangement are not sales and do not qualify for revenue recognition until a sale occurs. The staff believes that revenue recognition is not appropriate because the seller retains the risks and rewards of ownership of the product and title usually does not pass to the consignee. Such arrangements require a careful analysis of the facts and circumstances of the transaction, as well as an understanding of the rights and obligations of the parties, and the seller's customary business practices in such arrangements. The staff believes that the presence of one or more of the following characteristics in a transaction precludes revenue recognition even if title to the product has passed to the buyer. 1. The buyer has the right to return the product and:

• the buyer does not pay the seller at the time of sale, and the buyer is not obligated to pay the seller at a specified date or dates.
• the buyer does not pay the seller at the time of sale but rather is obligated to pay at a specified date or dates and the buyer's obligation to pay is contractually or implicitly executed until the buyer resells the product or subsequently consumes or uses the product.
• the buyer's obligation to the seller would be changed (e.g., the seller would forgive the obligation or grant a refund) in the event of theft or physical destruction or damage of the product.
• the buyer acquiring the product for resale does not have economic substance apart from that provided by the seller.
• the seller has significant obligations for future performance to directly bring about resale of the product by the buyer.

2. The seller is required to repurchase the product (or a substantially identical product or processed goods of which the product is a component) at specified prices that are not subject to change except for fluctuations due to finance and holding costs, and the amount to be paid by the seller will be adjusted, as necessary, to cover substantially all fluctuations in costs incurred by the buyer in purchasing and holding the product (including interest). The staff believes that indicators of the latter condition include:

• the seller provides interest-free or significantly below market financing to the buyer beyond the seller's customary sales terms and until the products are resold.
• the seller pays interest costs on behalf of the buyer under a third party financing arrangement.
• the seller has a practice of refunding (or intends to refund) a portion of the original sales price representative of interest expense for the period from when the buyer paid the seller until the buyer resells the product.

3. The transaction possesses the characteristics set forth in EITF Issue 9501 and does not qualify for sales-type lease accounting

4. The product is delivered for demonstration purposes.

If the title to the goods has passed but the substance of the arrangement is not a sale, the consigned inventory should be reported separately from other inventory in the consignor's financial statement as "inventory consigned to others" or another appropriate caption.

Revenue Recognition - Basics

Revenue recognition is realized or realizable and earned when all of the following criteria are met:

• Persuasive evidence of an arrangement exists.
• Delivery has occurred or services have been rendered.
• The seller's price to the buyer is fixed or determinable.
• Collectibility is reasonably assured.

Fair Value of PCS with a Consistent Renewal % (But varying renewal dollar amount) and Software Rev Rec

Question: A software vendor charges Customer A $100,000 for a software license with a post-contract customer support (PCS) renewal rate of 15% of the license fee while a PCS renewal rate of 15% of the license fee. Does the existence of varying dollar amounts of PCS renewal fees of the same software product (resulting from using a renewal rate that is a consistent percentage of the stipulated software license fee for the same software product) indicate an absence of vendor-specific objective evidence (VSOE) of the fair value of PCS or the possible presence of discounts on PCS that should be accounted for. Answer: No. Assuming that the PCS renewal rate expressed as a consistent percentage of the stipulated license fee for customers is substantive, that PCS renewal rate would be the VSOE of the fair value of PCS>