Adding a module to existing multi-module system

Real Example - A customer with an existing software system, 2 existing modules, is adding a third module which has not been released yet and thus revenue cannot be recognized yet. Issue - How should deal be structured so that the existing, reliable revenue stream can be recognized and the new module's revenue is deferred? Resolution - This can be done as long as the new module is not intertwined into the functionality of the older system. For example, if the system fundamentally changes with the new module, such as upgrading from Windows 95 to Windows 2000, then the new module is not truly separate. However if the new module is like adding Excel to a system that has Word and Outlook, then revenue for the incumbent modules can continue to be recognized. Other indicators that the new module is separate from the current system and modules include:

1. If the new module's contract is separate and does not tie into the original deal.
2. If the new module's contract does not change the terms, or fee of the original deal.
3. If the module's sale is not linked to the renewal of the existing deal.
4. The customer is currently happy with their current system and paying their bills.
5. The customer would continue paying their bills should the new module's roll out be problematic.

Authorized users

Real example - Preliminary contract included language that authorized users (customer's potential customers) of a subscription service by inclusion of a list of "potential affiliates" that would be reviewed annually. Each affiliate would have their own license fee, but the total in this deal was based on a total number of affiliates multiplied by the license fee. Issue - by including a list of users, revenue would only be able to be recognized when all those users were 'live' on the system. Resolution - language was re-written to define contract based on the main client, thus recognizing revenue when that particular client was 'live' but also included that subsequent affiliates would be added by addendum or statement of work, and bound by the terms of this deal. In other words, each affiliate that was added would have the same terms (the contract would not have to be re-written each time, and revenue could be recognized for each affiliate as each went live.

Concessions

Any change to an arrangement that reduces the total revenue to be recognized, extends the payment terms, increases the customer's rights, or increases the seller's obligations consitutes a concession. Examples:

• extending payment due dates in arrangement
• decreasing total payments due
• accepting returns beyond terms
• discounted or free PCS
• discounted or free upgrades.

Refunds

Revenue allocated to an element is not considered collectible and is subject to forfeiture, refund or other concessions. Therefore management must intend not to accept returns or grant concessions. If a vendor has a historical pattern of making refunds or granting concessions on delivered elements not required under the original provisions of its arrangements due to non-delivery of the elements, no other lvidence is persuasive enough to reach a conclusion that revenue in current arrangements with similar elements is not subject to forteiture.

Acceptance

License revenue should not be recognized if uncertanty exists about customer acceptance. Often the case when a customer acceptance clause is based on customer or arrangement specific criteria that cannot be evaluated until the software is installed and operating in the customer's environment.

Revenue Arrangements with Multiple Deliverables (EITF 00-21)

Issue #1 - Many companies offer multiple solutions to their customer's needs. Those solutions may involve the delivery or performance of multiple products, services, or rights to use assets, and performance may occur at different points in time or over different periods of time. In some cases, the arrangements include initial installation, initiation, or activation services and involve consideration in the form of a fixed fee or a fixed fee coupled with a continuing payment stream. The continuing payment stream generally corresponds to the continuing performance, and the amount of the payment may be fixed, variable based on future performance, or a combination of fixed and variable payment amounts. Issue #2 - This issue addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. This issue also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. Issue #3 - This issue does not address when the criteria for revenue recognition are met or provide guidance on the appropriate revenue recognition convention for a given unit of accounting. For example, this Issue does not address when revenue attributable to a unit of accounting should be recognized based on proportional performance. Issue #4 - This issue applies to all deliverables (that is, products, services, or rights to use assets) within contractually binding arrangements (whether written, oral, or implied, and hereinafter referred to as "arrangements") in all industries under which a vendor will perform multiple revenue-generating activities except the following: A. The following describes the three categories into which that higher-level literature falls and the application of this Issue or the higher-level literature in determining separate units of accounting and allocating arrangement consideration: If higher-level literature provides guidance regarding the determination of separate units of accounting and how to allocate arrangement consideration to those separate units of accounting and how to allocate arrangement consideration to those separate units of accounting, the arrangement or the deliverable(s) in the arrangement that is within the scope of that higher-level literature should be accounted for in accordance with the relevant provisions of that literature rather than the guidance in this Issue. If higher-level literature provides guidance requiring separation of deliverables within the scope of higher-level literature from deliverables not within the scope of higher-level literature, but does not specify how to allocate arrangement consideration to each separate unit of accounting, such allocation should be performed on a relative fair value basis using the entity's best estimate of the fair value of the deliverable(s) within the scope of higher-level literature and the deliverable(s) not within the scope of higher-level literature. If higher-level literature provides no guidance regarding the separation of the deliverables within the scope of higher-level literature from those deliverables that are not or the allocation of arrangement consideration to deliverables within the scope of the higher-level literature and to those that are not, then the guidance in this Issue should be followed for purposes of such separation and allocation. B. Arrangements that include vendor offers to a customer for either (1) free or discounted products or services that will be delivered at a future date; or (2) a rebate or refund, are excluded from the scope of this Issue. The Issues are: Issue #1 - How to determine whether an arrangement with multiple deliverables consists of more than one unit of accounting Issue #2 - If an arrangement consists of more than one unit of accounting, how the arrangement consideration should be allocated among the separate units of accounting. Issue #3 - What effect, if any, certain customer rights due to vendor nonperformance have on the measurement of arrangement consideration and/or the allocation of consideration to the delivered units of accounting. Issue #4 - How to account for direct costs incurred related to an arrangement that (a) are not associated with a specific deliverable or (b) are associated with a specific deliverable but that deliverable is required to be combined with another deliverable (or other deliverables). Issue 5A - The impact, if any, of a customer's ability to cancel a contract and incur a cancellation penalty on the measurement of arrangement consideration. Issue 5B - The impact, if any, of consideration that varies as a result of future customer action on the measurement and/or allocation of arrangement consideration. Issue 5C - The impact, if any, of consideration that varies as a result of future vendor actions on the measurement and/or allocation of arrangement consideration. Issue 6 - The impact of a vendor's intent not to enforce its contractual rights in the event of customer cancellation on the measurement and/or allocation of arrangement consideration. EITF Discussion: Principals Revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables in the arrangement meet the criteria. Arrangement consideration should be allotted among the separate units of accounting based on their relative fair values. Applicable revenue recognition criteria should be considered separately for separate units of accounting. EITF Discussion: Guidance Units of Accounting (Issue 1) A vendor should evaluate all deliverables in an arrangement to determine whether they represent separate units of accounting. That evaluation must be performed at the inception of the arrangement and as each item in the arrangement is delivered. In an arrangement with multiple deliverables, the delivered item(s) should be considered a separate unit of accounting if all of the following criteria are met: The delivered item(s) has value to the customer on a standalone basis. There is objective and reliable evidence of the fair value of the undelivered item(s) If the arrangement concludes a general right of return relative to the delivered item, delivery or performance of the undelivered item(s) is considered probably and substantially in the control of the vendor. The arrangement consideration allocable to a delivered item(s) that does not qualify as a separate unit of accounting within the arrangement should be combined with the amount allocable to the other applicable undelivered item(s) within the arrangement. The appropriate recognition of revenue should then be determined for those combined deliverables as a single unit of accounting. Measurement and Allocation of Arrangement Consideration (Issues 2, 3, 5A, 5B, 5C and 6) The amount of total arrangement consideration must be fixed or determinable other than with respect to the impact of (a) any refund rights or other concessions (hereinafter collectively referred to as "refund rights") to which the customer may be entitled or (b) performance bonuses to which the vendor may be entitled. (paragraph 12) If there is objective and reliable evidence of fair value for all units of accounting in an arrangement, the arrangement consideration should be allocated to the separate units of accounting based on their relative fair values, except as specified in paragraph 13. However, there may be cases in which there is objective and reliable evidence of the fair value(s) of the undelivered item(s) in an arrangement but no such evidence for the delivered item(s). In those cases the residual method should be used to allocate the arrangement consideration. Under the residual method, the amount of consideration allocated to the delivered item(s) equals the total arrangement consideration less the aggregate fair value of the undelivered item(s). The "reverse" residual method (that is, using a residual method to determine the fair value of an undelivered item) is not an acceptable method of allocating arrangement consideration to the separate units of accounting, except as described in paragraph 13. (paragraph 13) To the extent that any separate unit of accounting in the arrangement (including a delivered item) is required under GAAP to be recorded at fair value (and marked to market each reporting period thereafter), the amount allocated to that unit of accounting should be its fair value. Under those circumstances, the remainder of arrangement consideration should be allocated to the other units of accounting in accordance with the requirements in paragraph 12. (paragraph 14) The amount allocable to a delivered item(s) is limited to the amount that is not contingent upon the delivery of additional items or meeting other specified performance conditions (the noncontingent amount). That is, the amount allocable to the delivered item(s) is the lesser of the amount otherwise allocable in accordance with paragraph 12 and 13, or the noncontingent amount. (paragraph 16) Contractually stated prices for individual products and/or services in an arrangement with multiple deliverables should not be presumed to be representative of fair value. The best evidence of fair value is the price of a deliverable when it is regularly sold on a standalone basis.

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>

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).

Specified Upgrade Rights & Specified Additional Software Product

If a vendor agrees to deliver specified additional software products in the future, the revenue attributable to the additional software products would be accounted for a separate element of the arrangement, even if the rights to the additional software products were included in the terms of a PCS agreement. Additional Software Deliverables and Rights to Exchange or Return Software

• As part of a multiple-element arrangement, a vendor may agree to deliver software currently and to deliver additional software in the future. The additional deliverables may include upgrades/enhancements or additional software products. Additionally, a vendor may provide the customer with the right to exchange or return software, including the right to transfer software from one hardware platform or operating system to one or more other platforms or operating system (a platform-transfer right)
• Upgrades/enhancements. As part of a multiple-element arrangement, a vendor may agree to deliver software currently and provide the customer with an upgrade right for a specified upgrade/enhancement. The upgrade right may be evidenced by a specific agreement, commitment, or the vendor's established practice. (Rights to receive unspecified upgrades/enhancements on a when-and-if-available basis are PCS, as it has been redefined in this SOP.)

Specified Upgrade Right Versus Specified Additional Software Product - specified upgrade rights differs from the amount of revenue allocated to a specified additional software product. Determining if a software deliverable is an upgrade/enhancement or a product, the vendor should consider carefully the specific facts and circumstances on a case-by-case basis. Factors to consider would include the following:

1. The significance of the differences in the features and functionality of the new deliverable from the vendor's existing products.
2. Replacement of existing products - if the new deliverable is intended to substantially replace the vendor's existing products.
3. The extent of development activities - if the new deliverable required a significant development effort, that may indicate that the deliverable is a product rather than an upgrade/enhancement.
4. The relationship of the price of the new deliverable to the pricing for the vendor's existing products, including price discounts to existing customers - if the new deliverable is priced at an amount that is significantly higher than the price of the vendor's existing products, or if the existing users of the vendor's products are offered no discount or only an indicate that the deliverable is a product rather than an upgrade/enhancement.
5. The manner in which the new deliverable is marketing.
6. The product's name.

Rights to Specified Additional Undelivered Software Products - 97-2 distinguishes between the right to receive specified additional software products and the right to receive unspecified additional software products. A right to receive specified additional software products is accounted for as a separate element, which a right to receive unspecified additional software products is accounted for as a subscription. The SOP provides the following guidance:

• Additional Software Prodcuts. As part of a multiple-element arrangement, a vendor may agree to deliver software currently and deliver specified additional software products in the future. The rights to these additional products may be included either in the terms of a PCS arrangement or in a separate agreement. Even if the rights to the additional software products are included in a PCS arrangement, the revenue allocable to the additional software products should be accounted for separately from the PCS arrangement as an element of a multiple-element arrangement.

More-Than-Insignificant Discount and Software Revenue Recognition

A more-than-insignificant discount with respect to future purchases that is provided in a software arrangement is a discount that is: (1) incremental to the range of discounts reflected in the pricing of the other elements of the arrangement, (2) incremental to the range of discounts typically given in comparable transactions, and (3) significant. Other factors to consider in determining whether a discount is significant enough to conclude that an additional element is being offered in the arrangement would include the following:

1. Is the discounted product currently being sold in the marketplace, or is it a product under development that will be sold in the future? If the discounted product currently is sold in the marketplace at its normal, undiscounted selling price or is under development, that may indicate that the discounted product is a negotiated element of the current arrangement rather than a marketing strategy designed by the vendor (i.e., the vendor is giving up current value as opposed to eliminating slow-moving or obsolete inventory).
2. Do a large percentage of customers exercise the right to receive the additional product? If a significant percentage of customers exercise the right to receive the additional product, or historically, a significant percentage of customers have exercised the right to receive additional products in similar arrangements, that may indicate that the discounted product is a negotiated element of the current arrangement and, thus, should be considered an additional element of the arrangement.
3. Is the discount a function of the volume of purchases from the vendor? If the discount offered on a product is a funtion of the volume of purchases from the vendor, that may indicate that the arrangement is a marketing strategy similar to a rebate arrangement and, thus, the discounted product would not be considered an additional element of the arrangement. The discount offered is consistent with the discount that was likely to have been affered had the customer purchased the product in a single order.

Accounting for significant incremental discounts - If a software arrangement includes a right to a significant incremental discount on a customer's future purchase of a product(s) or service(s), a proportionate amount of that significant incremental discount should be applied to each element covered by the arrangement based on each element's fair value (VSOE) without regard to the significant incremental discount.

If (a) future product(s) or service(s) to which the discount is to be applied is not specified in the arrangement (for example, a customer is allowed a discount on any future purchases), or (b) the fair value of the future purchases cannot be determined but the maximum amount of the incremental discount on the future purchases is quantifiable, that quantifiable amount should be allocated to the elements of the arrangement and the future purchases assuming that the customer will purchase the minimum amount necessary to utilize the maximum discount.

Example - A software vendor sells Product A for $40 along with a right to a discount (the "coupon") of 50% off list price on any future purchases of its other software products, Products B through Z, with a maximum cumulative discount of $100. VSOE of fair value for Product A is $40 and VSOE of fair value for Products B through Z ranges from $20 to $100. The 50% discount is a significant incremental discount that would not normally be given in comparable transactions.

The vendor should assume that the maximum discount will be utilized. Therefore, the vendor would allocate the $100 discount across Product A and the assumed additional product to be purchased. The overall discount is 41.67% ($100/$240). Therefore, upon the delivery of Product A, the vendor would recognize $23.33 of revenue and defer $16.67. If the customer uses the discount by purchasing additional products with fair value totaling $200, the vendor would recognize $116.67 in revenue upon delivery of those products ($100 in cash received plus the $16.67 previously deferred). If the discount expires unused, the $16.67 in deferred revenue would be recognized at that time.

VSOE for a Group of Elements

A vendor may not sell separately all of the individual elements included in a multiple-element arrangement. However, the vendor may sell separately two or more of the software products included in the multiple-element arrangement. We believe that a software vendor can establish VSOE of fair value for a group of software products for purposes of allocating revenue to elements included ina multiple-element arrangement. Upon allocation of revenue to a group of software products, the revenue recognition provisions of SOP 97-2 should be applied as if the group were a single element (e.g., the delivery criterion cannot be met until all specified software products in the group have been delivered). Also, the vendor may use the residual method for purposes of allocating the arrangement consideration if VSOE of fair value exists for all of the undelivered elements.

Elements Sold at Varying Discounts

For element sold at varying discounts there is no specific amount that represents VSOE of fair value. We believe that an acceptable interpretation would be for a vendor to evaluate whether each element has VSOE of fair value by applying the following three-step approach:

1. Stratify the vendor's sales transactions into meaningful groups based on type of customer, volume of sales to customer (e.g., licensing arrangements > $X), geography, distribution channel, or other relevant groupings.
2. For each stratum, compile information about the amount charged in recent transactions when the element was sold separately. This information would reflect all separate sales of the element within the stratum during recent periods. In some cases, a software vendor may apply a random sampling approach to compile this information (i.e., when the number of specific sales within a stratum is substantial). We believe this approach is acceptable provided that the sampling methodology is statistically valid and representative of the population of the stratum as a whole.
3. For each stratum, analyze the information obtained in step 2 to determine whether the results fall within a reasonable range of prices that would represent VSOE of fair value. For example, we believe that a range of prices of the separate sales of an element within a stratum for which the lowest and highest price within the range are not more than 15% from the median price in the range and that range includes an amount approaching 80% of the sales transaction for that stratum, may be reasonable range of prices to represent that VSOE of fair value for the element exists for transactions within that stratum. 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 an element is within this range for tranactions within a particular stratum. All relevant facts and circumstances must be considered in making this determination.

Example #1 - ABC Corp sells Product A separately to its customers, but the price varies for different customers. ABC has determined that all customers that have purchased Product A constitute a single stratum. ABC has gathered the following information related to the separate sales of Product A.

Median sales price	$100,000
15% above median price	$115,000
15% below median price	$85,000
% of sales falling within $85k to $115k	84%

ABC has determined that VSOE of fair value exists for Product A.

Example #2 - ABC Corp sells Product A separately to its customers, but the price varies for different customers. ABC has determined that alll customers that have purchased Product A constitute a signle stratum. ABC has gathered the following information related to the separate sales of Product A.

Median sales price	$100,000
15% above median price	$115,000
15% below median price	$85,000
% of sales falling within $85k to $115k	60%

ABC has determined that VSOE of fair value does not exists for Product A.

Example #3 - ABC Corp, a software vendor, separately sells Product A, Product B, Product C at various amounts and frequently bundles two or more of the products together in one arrangement. ABC has historical evidence to demonstrate that substantially all of the separate sales of the products to this class of customer fall within the following acceptable ranges: Product A, $425,000 to $575,000; Product B, $5595,000 to $805,000; and Product C, $510,000 to $690,000. ABC considers any price stated in a multiple element arrangement which falls within the acceptable ranges for Products A, B, and C, respectively, to represent VSOE of fair value for each product.

ABC enters into an arrangement with Customer 1 to deliver Products A and B for a nonrefundable fee of $1,200,000, due at inception. The prices stated in the arrangement for Products A and B are $450,000 and $750,000 respectively. Because the prices stated in the arrangement for Products A and B fall within the acceptable range of prices for the two products, ABC considers the stated prices to be VSOE of fair value of the products for this transaction (however, the terms stated in the contract would not establish VSOE of fair value when evaluating another contract since the elements ar enot being sold separately in this arrangement). Accordingly, assuming that all other revenue recognition criteria have been met, ABC should recognize revenue of $450,000 upon the delivery of Product A, and $750,000 upon the delivery of Product B.

Example #4 - Assume the same facts as Exampel #3. ABC Corp enters into an arrangement with Customer 2 to deliver Products A, B and C for a nonrefundable fee of $1,700,000, due at inception. The prices stated in the arrangement for Products A, B and C are $450,000, $500,000 and $750,000, respecitvely. The price stated in the arrangement for Product A falls within its acceptable range of prices; however, the prices stated for Products B and C do not fall within their acceptable range of prices. For multiple-element outlier arrangements where the stated price for an element is outside the acceeptable VSOE-of-fair-value range, ABC's policy is to establish VSOE of fair value equal to the midpoint of the range. Therefore ABC would allocate the arrangement fee to the elements as follows:

Product	Fair Value	%	Revenue
A	$ 450,000	26%	$ 442,000
B	$ 700,000	40%	$ 680,000
C	$ 600,000	34%	$ 578,000
	$1,750,000	100%	$1,700,000

The prices stated in the arrangement for Product A falls within the acceptable range of prices , so that stated amount ($450,000) represents VSOE of fair value. However, the prices stated in the arrangement for Product B and Product C do not fall within their acceptable range of prices, so the midpoint price in each of their ranges ($700,000 and $600,000, respectively) is considered to be VSOE of fair value based on ABC's accounting policy for such outlier arrangements. Assuming that all other revenue recognition criteria have been met, the revenue allocable to Products A, B and C ($442,000, $680,000, and $578,000, respectively) would be recognized upon delivery of each product. However, this allocation of revenue maqy be subject to limitations (i.e., if a portion of the fee allocable to a delivered element is subject to forgeiture, refund, or other concession if any of the other elements are not delivered), depending on the terms of the arrangement and the order of delivery.

Example #5 - ABC Corp, a software vendor, separately sells Product B and Product C at various amounts and frequently bundles the two products together in one arrangement. ABC has historical evidence to demonstrate that substantially all of the separate sales of Product B and C to this class of customer fall within the following acceptable ranges: Product B, $595,000 to $805,000, and Product C, $510,000 to $690,000. ABC considers any price stated in a multiple-element arrangement that falls within the acceptable ranges for Product B and C, repectively, to represent VSOE of fair value for each product. ABC does not separately sell Product A and, as a result, does not have VSOE of fair value for that element. For multiple-element outlier arrangements where the stated price for an element is outside the acceptable VSOE-of-fair-value range, ABC's policy is to establish VSOE of fair value equal to the midpoint of the range.

ABC enters into an arrangement with Customer 3 to deliver Products A, B, and C for a nonrefundable fee of $1,700,000, due at inception. The prices stated in the arrangement for Products A, B, and C are $450,000, $750,000, and $500,000, respectively. Products A and B are delivered to Customer 3 prior to ABC's year-end and product C is delivered subsequent to year-end.

Because ABC has VSOE of fair value for the undelivered element (Product C), but does not have VSOE of fair value for all the delivered elements (there is no VSOE of fair value for Product A), revenue should be recognized using hte residual mthod. ABC should defer revenue for Product C based on VSOE of fair value. In this example, the $500,000 stated price does not fall within the range of prices that represents VSOE of fair value. Because VSOE of fair value for Product C is a reasonable range of prices, the midpoint price of the range ($600,000) is considered to be VSOE of fair value based on ABC's accounting policy for such outlier arrangements. Accordingly, residual arrangement considerations of $1,100,000 ($1,700,000 less $600,000) should be ascribed to the delivered elements (Products A and C) and recognized upon delivery assuming all other revenue recognition criteria are met.

Element #6 - ABC Corp, a software vendor, separately sells Products B and C at various amounts and frequently bundles the two products together in one arrangement. ABC has historical evidence to demonstrate that substantially all of the separate sales of Product B and C to this class of customer fall within the following acceptable ranges: Product B, $595,000 to $805,000, and Product C, $510,000 to $690,000. ABC considers any price stated in a multiple-element arrangement that falls within the acceptable ranges for Product B and C, respectively, to represent VSOE of fair value for each product. ABC does not separately sell Product A and, as a result, does not have VSOE of fair value for the product. For multiple-element outlier arrangements where the stated price for an element is outside the acceptable VSOE-of-fair-value range, ABC's policy is to establish VSOE of fair value equal to the outer limit of the range nearest to the stated price.

ABC enters into an arrangement with Customer 4 to deliver Products A, B, and C for a nonrefundable fee of $1,700,000, due at inception. The prices stated in the arrangement for Products A, B, and C are $450,000, $750,000, and $500,000, respectively. Products A and B are delivered to Customer 4 prior to ABC's eyear-end and Product C is delivered subsequent to year-end.

Because ABC has VSOE of fair value for the undelivered element (Product C), but does not have VSOE of fair value for all the delivered elements (there is no VSOE of fair value for Product A), revenue should be recognized using the residual method. ABC should defer revenue for Product C based on VSOE of fair value. In this example, the $500,000 stated prices does not fall within the range of prices that represents VSOE of fair value. Because VSOE of fair value for Product C is a reasonable range of prices, the outer limit of the range nearest to the stated price ($510,000) is considered to be VSOE of fair value based on ABC's accounting policy for such outlier arrangements. Accordinly, residual arrangement consideration of $1,190,000 ($1,700,000 less $510,000) should be ascribed to the delivered elements (Products A and C) and recognized upon delivery assuming all other revenue recognition criteria are met.