ASU 2009-14, Subtopic 985-605 - PDF from FASB

From FASB.org, click here for pdf.

EITF Issue 09-3

The Task Force recommended to the FASB chairman that a separate Issue be added to the EITF agenda to consider changes to the accounting for multiple element arrangements under SOP 97-2. The Issues are:

Issue 1 - Whether this Issue should modify the measurement criteria or the scope of SOP 97-2. The Task force decided that the issue should focuso n amending the scope of 97-2. Other task force members thought this should be discussed in context of FASB/IASB's review of revenue recognition.

 Issue 2 - If the Task Force decides to change the scope of SOP 97-2, how the scope of SOP 97-2 should be modified. Task Force decided 97-2 should be modified such that the following products would be considered non-software deliverables and therefore be excluded from 97-2: Tangible products containing software components that function together to deliver the product's essential functionality.

Issue 3 - If the Task Force chooses to address measurement in Issue 1, how the measurement criteria within SOP 97-2 should be modified.

Issue 4 - If the Task Force chooses in Issue 3 to align the measurement criteria in SOP 97-2 with Issue 08-1, whether the resideual allocation method should be retained within SOP 97-2 if the Task Force decides to eliminate the residual allocation method for arrangements subject to Issue 08-1.

 Issue 5 - If the Task Force chooses in Issue 3 to align the measurement criteria in SOP 97-2 with Issue 08-1, whether the subscription accounting guidance in paragraphs 48 and 49 of SOP 97-2 should be retained.

Issue 6 - Paragraph 37 of SOP 97-2 requires that the amount allocated to a specified upgrade right be reduced based on an estimate of customers not expected to exercise the right ("breakage"). If the Task Force chooses in Issue 3 to align the measurement criteria in SOP 97-2 with Issue 08-1, whether the guidance in paragraph 37 of SOP 97-2 relating to breakage should be retained.

Issue 7 - Paragraphs 43-47 of SOP 97-2 provide guidance on accounting for fixed fee license or reseller arrangements that provide customers with the right to reproduce or obtain copies at a specified price per copy for two or more software products. If the Task Force chooses in Issue 3 to align the measurement criteria in SOP 97-2 with Issue 08-1, whether this guidance should be retained or revised.

SOP 97-2 Background

91-1 - issued in 1991 to provide guidance on applying generally accepted accounting principals to software transactions and to narrow the range of revenue recognition practices that were in use before.

• Evidence of an arrangement
• Fixed or determinable fees
• Not great with accounting for multiple element arrangements
• Not great with delayed payment terms
• Not great with vendor obligations

97-2 - replaced 91-1

• Specifies revenue recognition for all entities earning revenue from marketing software.

98-4 delayed effective date for VSOE aspect of 97-2 98-9 revision of 98-4

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.

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>

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.