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.
- 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 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.
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 |
