Risidual Method of Allocating Consideration in the Arrangement

Recognition of revenue using the residual method when (1) there is VSOE of the fair values of all undelivered elements in a multiple-element arrangement that is not accounted for using long-term contract accounting, (2) VSOE of fair value does not exist for one or more of the delivered elements in an arrangement, and (3) all revenue recognition criteria in SOP 9-2 other than the requirement for VSOE of fair value of each delivered element of the arrangement are satisfied. Under the residual method the arrangement fee is recognized as follows: (1) the total fair value of the undelivered elements, as indicated by VSOE of fair value, is deferred and subsequently recognized in accordance with the relevant section of SOP 97-2, and (2) the difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements. As a result, under the residual method, any discount on the overall arrangement is allocated entirely to the delivered elements. Example: ABC Corp enters into an arrangement to deliver Software Products 1 and 2, PCS, training services, and installation services, which are not essential to the functionality of the software, for a total arrangement consideration of $1,000,000 to Customer. ABC has VSOE of fair value for PCS ($200,000), Training ($50,000) and Installations ($350,000) but does not have VSOE of fair value for Software Products 1 and 2.

Arrangement Consideration	$ 1,000,000
PCS	$ (200,000)
Training	$ ( 50,000)
Insatllation	$ (350,000)
Software Products 1 and 2	$ 400,000

ABC would recognize $400,000 as license revenue upon delivery of Software Products 1 and 2, assuming all revenue recognition criteria in SOP 97-2 have been met. The amounts allocated to PCS, training services, and installation services would be deferred and recognized over the stated PCS term, as the training is performed, and as the installation services are performed, respectively, provided that the service elements otherwise qualify for separate accounting under 97-2. Application of the Residual Method in an Extended Payment Term Arrangement To recognize revenue under the residual method for allocating arrangement consideration to the software license and PCS when the vendor concludes that the fee is not fixed or determinable:

1. Recognize revenue under the arrangement equal to the lesser of: (a) the cumulative amount recognizable under the residual method (as if the arrangement fee were fixed or determinable), or (b) the cumulative amount due and payable (including previous cash collections).
2. Recognize no revenue for the delivered elements until the cumulaitve amount due and payable (including cash collections) exceeds the VSOE of fair value of all undelivered elements.
3. Recognize no revenue for the delivered elements until the cumulative amount due and payable (including previous cash collections) exceeds the remaining amount deferred for the undelivered elements through the next payment due date (i.e., the revenue deferral is adjusted at each reporting period based on the cumulative amount due an dpayable versus the required remaining deferral under the residual method).

Example - ABC enters into an arrangement to license customer relationship management software on a perpetual basis and to provide two years of PCS for a fee of $1,150,000. VSOE of fair value for the two years of bundled PCS is $300,000 ($150,000 per year), based on the amounts charged in PCS renewal transactions. The arrangement fee is due as follows: $500,000 at delivery and $650,000 in 13 months. As a result of the extended payment terms, ABC concludes that the arrangement fee is not fixed or determinable.

• Method 1 - ABC would recognize $500,000 of licenseing revenue upon delivery because that amount is the lower of (i) the amount due of $500,000, or (ii) revenue that would have been recognized if payments were fixed or determinable of $850,000 ($1,150,000 arrangement fee "minus" $300,000 VSOE of the value of two years PCS). ABC would recognize no further revenue until the next installment becomes due. When the final installment becomes due, ABC would defer $137,500 ($300,000 x 11/24 months), based on the VSOE of fair value for the remaining PCS obligations and recognize revenue of $512,500 ($350,000 licensing + $162,500 PCS) under the residual method. The $137,500 of deferred PCS revenue would be recognized ratably over the remaining period of the bundled PCS (11 months).
• Method 2 - ABC would recognize $200,000 of licensing revenue upon delivery and defer $300,000 based on VSOE of fair value for the two years of bundled PCS. The remaining $650,000 of licensing revenue would be recognized when due (in 13 months) and the $300,000 of deferred PCS revenue would be recognized ratably over the two-year bundled PCS period.
• Method 3 - ABC would recognize $337,5090 of licensing revenu upon delivery and defer $162,500 ($300,000 x 13/24 months) based on VSOE of fair value for the PCS that will be provided through the next payment due date (in 13 months). The $162,500 of deferred PCS revenue would be recognized ratably over the period until the next payment due date (13 months). When the final installment becomes due, ABC would defer $137,500 ($300,000 x 11/24 months), based on the VSOE of fair value for the remaining PCS obligation and recognize licensing revenue of $512,500 under the residual method. The $137,500 of deferred PCS revenue would be recognized ratably over the remaining period of bundled PCS (11 months).

Fixed or Determinable Fees and Collectibility

SOP 97-2 specifies that in order to recognize revenue for a software arrangement, a vendor's fee must be fixed or determinable, and collectible. A software licensing fee is not fixed or determinable if the amount is based on the number of units distributed or copied, or the expected number of users of the product. Factors that Affect the Determination of Whether a Fee is Fixed or Determinable and Collectible:

1. A number of arrangements that call for fixed or determinable payments, including minimum royalties or license fees from resellers, specify a payment period that is short in relation to the period during which the customer is expected to use or market the related products. Because a product's continuing value may be reduced to the subsequent introduction of enhanced products by the vendor or competitors, the possibility that the vendor still may provide a refund or concession to a creditworthy customer to liquidate outstanding amounts due under the terms of the initial transaction increases as payment terms become longer.
2. For the reason cited in #1, any extended payment terms in a software licensing arrangement may indicate that the fee is not fixed or determinable. Further, if payment of a significant portion of the software licensing fee is not due until after expiration of the license or more than 12 months after delivery, the licensing fee should be presumed not to be fixed or determinable. However, this presumption may be overcome by evidence that the vendor has a standard business practice of using long-term or installment contracts and a history of successfully collecting under the original payment terms without making concessions.
3. If it cannot be concluded that a fee is fixed or determinable at the outset of an arrangement, revenue should be recognized as payments from customers become due (assuming all other conditions for revenue recognition in this SOP have been satisfied).

If collectibility is considered reasonably assured at the outset of an arrangement and revenue is recognized, but events arise in subsequent periods such that the related account receivable is no longer deemed collectible due to the subsequent deterioration of the customer's credit worthiness, bad debt expense should be recorded rather than reversing the previously-recorded revenue. Extended Payment Terms (Pyment Due In One Year or Less) - The following factors should be considered in evaluating whether extended payment terms are fixed or determinable:

1. Susceptibility of software to technological obsolescense - If the software is susceptible to rapid technological obsolescence, it is more likely that a fee inolving extended payment terms is not fixed or determinable.
2. Costs to implement the software - If the customer will incur significant costs to implement the software or the software will be integrated into a large complex system with pervasive use of the software throughout the organization, it is more likely that a fee involving extended payment terms is fixed or determinable.

Overcoming the presumption of concessions in extended payment term arrangements - To have a "history of successfully collecting under the original payment terms without making concessions," a vendor woul dhave to have collected all payments as due under comparable arrangements without providing concessions. Examples of factors that should be assessed in evaluating a vendor's history include, but are not limited to, the following:

• Similarity of customers
• Similarity of products - types of products; stages of product life cycle; elements included in the arrangement
• Similarity of license economics - Length of payment terms; economics of li cense arrangement (the overall economics of the license arrangement should be reviewed to ensure that the vendor can conclude that the history developed under a previous arrangement is relevent, particularly if the primary products licensed are near the end of their lives and the customer would not be entitled to the updated version under a PCS arrangement).

Customer Financing with No Software Vendor Participation and Software Revenue Recognition:

How should a software vendor recognize revenue if it inters into an arrangement with an end user customer that contains customary (that is, non-extended) payment terms and the end user customer obtains, without the software vendor's participation, financing from a party unrelated to the software vendor?

Because the software arrangement's payment terms are not extended, and the software vendor does not participate in the end user cusotmer's financing, the software vendor should recognize revenue upon delivery of the software product, provided all other requirements or revenue recognition are met.

Effects of Prepayment on Software Revenue Recognition When Vendor Participates in Customer Financing?

If the the software vendor's participation in the customer's financing results in incremental risk that the software vendor will provide a refund or concession to either the end user customer or the financing party, the presumption is that the fee is not fixed or determinable.