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New Guidelines for Software Revenue Recognition
--  Practical Pointers in Providing Guidance to Clients (Part 1)



By John C. Yates, Esquire
Morris, Manning & Martin, LLP
mailto:jyates@mmmlaw.com
404.504.5444

By co-author


I. Introduction

Overview In October 1997, the American Institute of Certified Public Accountants (AICPA) adopted a new set of guidelines for revenue recognition in software transactions. The guidelines, entitled Statement of Position 97-2, "Software Revenue Recognition," (described in this article as the "New SOP") supersedes Statement of Position 91-1 ("SOP 91-1") on the same subject. The New SOP provides for prospective application of its guidelines for transactions entered into in fiscal years beginning after December 15, 1997. These guidelines will have a major impact on U.S. software companies and foreign software companies filing on U.S. securities exchanges. The New SOP is intended to address important software licensing and business issues not included in SOP 91-1 and to provide clearer guidance to reduce the inconsistent application of SOP 91-1 in software transactions.

Purpose. A lawyer who advises technology companies on software transactions plays a critical role in his or her client’s ability to recognize revenue. A software agreement will be the first place an accountant will look when determining the accounting treatment for a software transaction. Further, some of the basic revenue criteria for recognizing revenue are dependent on the structure and terms of the software agreement. The purpose of this article is to provide the lawyer with practical pointers on how to advise clients on the new revenue recognition guidelines.

The following is a process that the technology attorney might consider performing with his or her clients (usually through discussions with the Chief Financial Officer or Audit Committee of the technology client):

Discuss the client’s revenue recognition goals (i.e., early or deferred recognition of revenue). Most software companies desire to recognize revenue from their business transactions as soon as possible. However, there is a growing trend for some public and private companies that have experienced rapid growth to defer revenue to future periods.

Establish new or revise existing revenue recognition policies in view of the client’s revenue recognition goals and the New SOP’s impact on those goals.

Review the decision points for revenue recognition (see flowchart in Appendix I and the discussion in Section IV entitled "A Practical Process for Analyzing Revenue Recognition") and educate the client’s sales force as to these decision points.

Review the structure and specific terms of the client’s software agreements so that revenue recognition is triggered at the desired time in connection with the company’s revenue recognition goals.

A goal of this article is to assist the technology lawyer with guiding the client through the above process. Readers should read the New SOP in its entirety in conjunction with this article.

Organization. This article is divided into two parts. This first part focuses on providing the lawyer background information regarding the New SOP and providing the lawyer a practical process for reviewing revenue recognition issues with the client. This article includes the following sections:
Significance of Revenue Recognition

Background of SOP 91-1 and the New SOP

A Practical Process for Analyzing Revenue Recognition

Appendix I -- Flowchart - Revenue Recognition on Software Arrangements

The focus of the second part of this article will be on providing the lawyer the following:
  1. drafting practice pointers for both the early and deferred recognition of revenue to enable the lawyer to prepare software agreements according to his or her client’s desired revenue recognition goals; and

  2. suggestions relating to practical steps that the lawyer’s technology clients can take in order to maximize revenue recognition opportunities under the New SOP.

II. Significance of Revenue Recognition

Any business generating revenue from licensing, selling, leasing or otherwise marketing software will experience serious problems from failure to recognize the significance of the New SOP. This section summarizes the importance of revenue recognition.

What is Revenue Recognition? Revenue recognition is a fundamental component of generally accepted accounting principles (GAAP) and is a key consideration in maintaining the integrity of financial statements. The central issue is one of timing and amount :
when should revenue generated in a software transaction be recognized in a software company’s income statement, and

in what amounts?
In most cases, companies strive to recognize revenue as quickly as possible, thereby improving their financial performance. Even private software companies generally try to improve financial performance by accelerating revenues whenever possible. Before issuance of SOP 91-1 in December 1991, there was no specific guidance for recognizing revenue in software transactions. The ensuing lack of uniformity among software companies in their revenue recognition policies led to the inability of third parties to make meaningful comparisons among companies. Similarly, the New SOP is designed to provide even greater uniformity by addressing inconsistent applications of SOP 91-1 in software transactions.

Basic Revenue Recognition Criteria. SOP 91-1 and the New SOP each define basic criteria that must be satisfied before revenue can be recognized. Under the New SOP if an arrangement to deliver software does not require significant production, modification, or customization of the software, then the New SOP specifies four criteria which must be met prior to recognizing revenue from a single-element arrangement or for individual elements in a multiple-element arrangement.1  These four criteria are:
  1. persuasive evidence of an arrangement exists;
  2. delivery has occurred;
  3. the software vendor’s fee is fixed or determinable; and
  4. collectibility is probable.
Although these basic revenue recognition criteria are substantially the same as those contained in SOP 91-1, the New SOP takes a fundamentally different approach in certain areas such as: (1) providing detailed guidelines for recognition of revenue in "multiple-element arrangements," and (2) eliminating the concept of remaining "significant vendor obligations" under SOP 91-1.

From a lawyer’s perspective, the New SOP concentrates on three steps:
  1. Determine the legal relationship and the terms of the agreement between the software vendor and its customer/licensee.
  2. Review the agreement and divide it into the various revenue-generating elements (namely, products and services).
  3. Use the client’s experience to determine the fair value of the revenue attributable to the revenue-generating elements and then allocate the revenue among those various elements.

Parties Affected by the New SOP. Every software company has third parties with an interest in ensuring the integrity of the software company's financial statements. Among these interested parties are the following:

Public Investors. Purchasers of stock in publicly traded software companies are understandably concerned with the integrity of financial statements and uniform application of accounting methods. Although financial statements of public entities are audited by independent accountants on an annual basis, investors often analyze and compare financial trends for companies based on quarterly results. Therefore, the internal accounting procedures and revenue recognition policies adopted by a company are instrumental to many investment decisions in the public market and accurate comparisons among companies.

Employee Sales Force


Changing Sales Behavior. A software company’s sales force will be critical to implementation of the New SOP. As a general rule, software company’s tend to bundle software and services together in order to offer a turn-key software solution to the buyer. Additionally, the description of and the fees for the software and services being offered are typically combined. This bundling makes the sale easier for a sales representative because it makes the offering easier for the buyer to understand and it prevents the buyer from removing elements of the transaction that the buyer might not otherwise pay for if they knew the individual price for the element. However, as discussed below the result of this bundling could be a deferral of revenue recognition. Therefore, many software companies will have to change the manner in which their sales personnel work in order to achieve their revenue recognition goals.

Sales Force Compensation. From an internal perspective, many companies base compensation and bonus arrangements, at least in part, on recognized revenue within a specified time period. If revenue recognition policies are changed, bonus plans may be affected. With the adoption of the New SOP, benefit plans will require further examination to verify the suitability of these plans in achieving a company's objectives and motivating employees to complete all the requirements for revenue recognition as a basis for earning a bonus. The sales force will also need to be educated as to the changes made from SOP 91-1 to the New SOP.

Financial Institutions. Commercial banks and other financial institutions include covenants in financing documents, such as lines of credit and loan agreements. These covenants may require delivery to the financial institution of quarterly financial statements and annual audited statements. Also, financing instruments generally require that the debtor software company prepare all statements in accordance with GAAP, which will require compliance with the New SOP (see discussion in the section below entitled "History of SOP 91-1"). Further, financing documents may mandate maintenance by the debtor of certain financial ratios, many of which are directly affected by recognized revenue in a particular time period.

Auditors. Auditors are required to render their opinion on the financial statements of their software clients. Revenue recognition is usually the most difficult area to audit and requires substantial judgment which makes revenue recognition a high risk audit area. The auditor should meet with the client and the lawyer to determine the management’s compliance with the New SOP and suggest any changes accordingly.

Venture Capitalists. Software companies seeking financing from a venture capitalist must be ready to deliver financial statements prepared in accordance with GAAP. Since experienced investors such as venture capitalists are aware of the New SOP, they will probably insist on financial statements adhering strictly to these new guidelines. Further, the venture capitalist will require continued compliance with the New SOP in order to assure proper recognition policies are being met.

OEM, Distributors and Resellers. In many computer reseller arrangements, royalties or license fees are paid to a software vendor based on revenue recognized and/or received by an OEM, distributor or reseller during a particular period of time. The New SOP (assuming it achieves its intended purpose) clarifies the timing and amount of revenue that should be recognized by an OEM, distributor, or reseller. In some instances this clarification may cause a deferral of revenue resulting in a fundamental shift in the economic terms of an existing reseller agreement. For example, a reseller that is obligated to pay a minimum royalty each year may be negatively impacted by the New SOP if the reseller must defer revenue that would have otherwise been applied against the minimum royalty commitment under the New SOP. Given the disparate methods of recognizing revenue which have been followed throughout the software industry, the adoption of the New SOP will undoubtedly raise questions of contract interpretation with regard to royalty and license fee calculations under existing distribution arrangements.

Lawyers. From the lawyer’s perspective, knowledge of the New SOP is critical in counseling a technology company. Without an understanding of the New SOP, a lawyer may be oblivious to the reasons for client decisions that are driven by revenue recognition considerations. Further, lawyers representing software companies are likely to face issues of revenue recognition in one or more of the following contexts --

Audit Committee. Generally, the Audit Committees of many technology companies are taking a more active role in monitoring financial reporting activities. An active Audit Committee provides checks-and-balances for financial reporting decisions and enhances the integrity of financial data disclosed by a company. In counseling technology clients, lawyers are likely to play an increasing role in responding to inquiries from members of the Audit Committee of their clients, especially in response to questions as to whether their client’s license agreements require revision for their accounting polices with the New SOP.

Assessment of Legal Exposure. Audit Committees will continue to focus on the main areas of legal exposure in the financial operations of a technology company. It is no secret that revenue recognition policies of technology companies are one of the areas most likely to be attacked by plaintiffs’ lawyers embarking in a court case against a technology business. Therefore, expect more in-house and corporate counsel to be asked to respond to questions requiring knowledge of (i) the New SOP, (ii) the current and past revenue recognition policies of the client, and (iii) how the client’s license agreements and other contractual documents reflect those revenue recognition policies.

Contract Negotiations. Obviously, the New SOP must be considered by a lawyer in the actual drafting of a license agreement covering software. In the future, lawyers may be expected to understand and apply the revenue recognition guidelines during the negotiating process, rather than waiting until the end of negotiations to consult with accountants as to the revenue recognition implications of an agreement. Although when possible, the lawyer should advise the client to always consult with the accountant for an authoritative assessment of the accounting treatment of a software arrangement.

III. Background of SOP 91-1 and the New SOP

The following section describes the background and historical basis for the revenue recognition guidelines adopted by the AICPA. First, we address the issues leading up to the adoption of SOP 91-1 in December 1991. Second, we address the authoritative status of a Statement of Position. Then, we review some of the perceived inconsistencies (and in some cases, abuses) resulting from the application of SOP 91-1 by software companies.

History of SOP 91-1. Although the SOP was issued by the AICPA in December 1991, the issue of software revenue recognition had been under consideration for years. This section briefly examines the history of SOP 91-1, leading up to its adoption in late 1991. Before reviewing this history, an initial question needs to be answered -- what is a statement of position?

Authoritative Status of the Statement of Position. Statements of Position on accounting issues present the conclusions of at least two thirds of the Accounting Standards Executive Committee ("AcSEC") which is the senior technical body of the AICPA authorized to speak for the AICPA in the areas of financial accounting and reporting. Statement on Auditing Standards No. 69, identifies AICPA Statements of Position that have been cleared by the Financial Accounting Standards Board (FASB) as sources of established accounting principles in category b of the hierarchy of generally accepted accounting principles that it establishes. AICPA members are directed to consider the accounting principles in a Statement of Position if a different accounting treatment of a transaction or event is not specified by a pronouncement covered by Rule 203 of the AICPA Code of Professional Conduct. In such circumstances, the accounting treatment specified by the Statement of Position should be used, or the member should be prepared to justify a conclusion that another treatment better presents the substance of the transaction in the circumstances.

Problems and Abuses Arising Under SOP 91-1

The New SOP was prompted by concerns over the inconsistent application of various sections of SOP 91-1 by software companies. Inconsistency in applying accounting principles creates problems in comparing financial statements, as well as resulting in enhanced business and legal exposure for both a software company and those relying on its financial statements. Summarized below are certain key points of concern raised by the drafters of the New SOP.

Significant Vendor Obligations. Under SOP 91-1, the definition of "significant vendor obligations" was central to the revenue recognition analysis. If significant (versus insignificant) vendor obligations existed, then revenue could not be recognized until, at the earliest, these vendor obligations were satisfactorily completed. Little guidance was provided by SOP 91-1 in determining whether other vendor obligations were significant versus insignificant. The highly subjective nature of determining a vendor obligation resulted in disparate application of this principle and inconsistency among software companies. As noted below, the concept of "significant vendor obligations" has been eliminated from the New SOP.

Multiple Elements. Many software vendors enter into arrangements requiring delivery of multiple elements for software and services. Under SOP 91-1, some of these arrangements were considered multiple product arrangements, and others were considered "other vendor obligations." Determining the accounting effect of multiple elements and differentiating among types of obligations under SOP 91-1 has been complex and resulted in diversity in accounting practices. The New SOP directs the focus to dividing each software arrangement into its elements. There is then an allocation of the arrangement fee to each individual element based on vendor-specific objective evidence of fair value for each element.

Additional Software Products. Many software companies enter into arrangements with customers to license undelivered products in the future. For example, a vendor may introduce a family of software products but only have the initial product ready for delivery. At a future date, other products in the product family may be delivered. As noted below, the New SOP provides guidance regarding additional software products where SOP 91-1 was silent on this issue.

Fair Value Determination. In software arrangements with multiple elements, the basis of revenue recognition relies on allocation of revenue among the elements. Allocation is based on a determination of fair market value. SOP 91-1 did not provide clear guidance as to the allocation of revenue across various elements. One method for such allocation was the use of surrogate prices, such as a competitor’s pricing for similar products or industry averages. This formulation was rejected by AcSEC which concluded that there would be inherent differences between elements offered by different vendors, resulting in inconsistent accounting treatment. As noted below, the New SOP focuses on "vendor-specific objective evidence," a phrase further defined below.

Persuasive Evidence of an Arrangement. Under SOP 91-1 and the New SOP, persuasive evidence of an arrangement must exist as a pre-requisite for revenue recognition. However, the New SOP imposes a more stringent requirement. Under SOP 91-1, persuasive evidence of an agreement could be presented in a number of different forms, not necessarily in writing. Under the New SOP, a signed contract is required for those vendors that customarily use signed contracts, even if the software has been delivered and the cash has been collected from the customer.

The Fixed Fee. If a fee is not fixed or determinable, revenues may not be recognized until payments become due and all other criteria for revenue recognition are met. Under SOP 91-1, a fee would not be considered fixed if payment was due more than twelve months after delivery. Some companies interpreted this provision to mean that fees due within twelve months would be considered fixed and that revenue should, therefore, be recognized on a rolling twelve-month basis. Others interpreted this provision to mean that when an arrangement provided for payments more than twelve months after delivery, that fee would be recognized when due or collected, or, in the case of licenses to resellers, when the software was ultimately delivered to end-users. The New SOP establishes a new set of guidelines and eliminates the use of the rolling twelve-month method for recognizing revenue. The New SOP creates a presumption that a fee is not fixed or determinable if a significant portion of it is due after expiration of the license or more than twelve months after delivery. As noted below, this presumption can be overcome by the vendor demonstrating a history of entering into agreements with extended terms and collecting the designated fees under those agreements.

IV. A Practical Process for Analyzing Revenue Recognition

The New SOP includes a flowchart (see Appendix I) suggesting a step by step analysis for determining when and how much revenue may be recognized under a software arrangement. We have revised the flowchart (revisions indicated in brackets) to include several additional decision points that are covered by the New SOP. The following sections of this article track each of the main decision points in the flowchart at Appendix I. For each decision point a summary is provided of
  1. the relevant accounting rules, based on the text of the New SOP; and
  2. the lawyer’s application of the accounting rules, which is an application of how lawyers may apply the rules in performing services for their clients.

Each of the decision points are triggering events for the recognition of revenue under a software agreement. Therefore, lawyers should keep in mind their client’s revenue recognition goals as they review the following sections.

DECISION POINT #1 -- Define the Scope of the Arrangement. The lawyer’s first step in reviewing a transaction for revenue recognition purposes should be to define the scope of the arrangement. Often a technology company will enter into multiple contracts with the same customer where the multiple contracts are part of one business arrangement. For example, a technology company may enter into a separate license agreement and software development agreement for modifications to the licensed software with the misunderstanding that revenue under the license agreement will be able to be recognized independent of the services performed under the software development agreement. The lawyer should consider with the client the following questions when defining the arrangement.
  1. Were the contracts entered into simultaneously or within close proximity to each other?
  2. If one contract is not completed satisfactorily, then will the customer receive a refund under another contract, either by agreement or by established business custom? For example, if a technology company receives license fees under a license agreement, the technology company is obligated to provide the customer a refund of the license fee if software developed under a separate agreement is not accepted.
  3. Is software developed under an agreement essential for the customer’s use of software licensed under a separate agreement?
  4. Does the timing of payment under a software license agreement coincide with delivery of certain deliverables under a separate agreement?

If one or more of the above statements is answered in the affirmative, then the separate agreements are probably part of one arrangement.

DECISION POINT # 2 -- Is property, plant, or equipment included as part of a lease transaction?

Accounting Rules. Revenue attributable to leased property, plant or equipment should be accounted for in conformity with FASB Statement No. 13.3 If software, if any, associated with the leased property, plant or equipment is "incidental" to the leased items as a whole, then the software should not be accounted for separately under the New SOP. If software associated with the leased property, plant or equipment is "not incidental" to the leased items as a whole, then any revenue attributable to the software, including postcontract customer support ("PCS") should be accounted for separately according to the terms of the New SOP.

Lawyer Application. When a lawyer negotiates a lease agreement involving a bundled offering of hardware and software he or she will need to first determine whether the New SOP applies (i.e., are the software and services being offered "incidental" to the hardware). If the software is more that just operating software and software tools and provides additional functionality to the hardware, then the software probably would be considered more than "incidental." If the lawyer’s client wants to recognize revenue as soon as possible, then the lawyer should consider the following when preparing the lease agreement:
separately stating the description of and fees for the software and services; and

providing for payment for the software license and service fees within a twelve month period after delivery of the leased hardware (see Decision Point # 14 for a discussion regarding extended payment terms).

Additionally, the lawyer should advise the client to separately offer to other customers the software and services that are bundled with hardware in a lease arrangement. This advice will help the client establish vendor-specific objective evidence of fair value for the software and services (see Decision Point #6 for an explanation of vendor-specific objective evidence of fair value).

DECISION POINT # 3 -- Does contract accounting apply? Contract accounting means that revenue is recognized over an extended period of time as a contract is performed by a client. In many cases, the client will try to avoid application of contract accounting, if the software is to be delivered near the outset of the arrangement, preferring to recognize as much revenue as possible upon delivery of the software. This decision point should only be considered if the arrangement includes services that are performed by the software vendor.

Accounting Rules. In single or multiple-element arrangements, if a software arrangement requires significant production, modification, or customization of the software, then the entire arrangement should be accounted for using contract accounting.4 Additionally, in a multiple-element arrangement, if a software arrangement includes services that (i) are not essential to the functionality of other elements of the transaction, and (ii) are separately stated such that the total price would vary as a result of inclusion or exclusion of the services, then the revenue from the arrangement should be allocated among the service and software elements of the arrangement;5 provided, however that there exists vendor-specific objective evidence of fair value for both the services and the software.6 If the vendor does not have vendor-specific objective evidence for the service elements, but the services are not essential to the functionality of other elements, then the entire arrangement fee is recognized as services are performed.7 If no pattern of performance is discernible, then fees for the services element are recognized on a straight-line basis. If services are considered essential to the functionality of the other elements or the services are not separately stated in the arrangement, then contract accounting must be applied to the software and service elements included in the arrangement.8

Lawyer Application. The lawyer may be faced with a service transaction in which software is an important component, and the client desires to recognize the software revenue separately and as rapidly as possible. In assessing this decision point, the lawyer will need to assess two issues: (1) whether the software provided under the arrangement requires "significant" production modification or customization, and (2) whether the services are "essential" to the other elements of the arrangement.

Significant Modifications. The New SOP does not provide specific rules for evaluating whether an arrangement requires significant production, modification, or customization of the software. However, the lawyer should consider the following factors with the client to assess whether a modification should be considered significant.

What are the fees for software modification services in relationship to the total arrangement fee? Services revenue in excess of twenty percent has been discussed within the accounting community as a threshold test for concluding that the service fees are significant.

What is the time period over which modification or creation of new software will occur? Services performed for more than ninety days may provide support for a significant level of service meeting the threshold test for accounting purposes.

What is the extent of the changes to the functionality of the software as a result of software modifications? Changes to the software based on user preferences and aesthetic characteristics of the graphical user interface (i.e., color of the dialog box) that do not involve changes to the underlying baseline code would probably not be considered significant.

Does the timing of payment for the services coincide with the timing of payment for the other fees under the arrangement? If yes, then this may provide evidence that the modifications are significant.

Essential Elements. Are the services "essential" to the functionality of the other elements of the arrangement? This assessment will be particularly important if the lawyer’s client has a practice of licensing software and modifying the software according to the licensee’s requirements. As some technology companies transform their business from a services to a product company, often they will offer a core product that is based on various software development projects for other customers. In such a situation the lawyer should carefully review with the client the extent of the changes necessary to implement the solution at a customer location. The New SOP provides the following factors indicating that services are "essential" to the functionality of the other elements of the arrangement, and consequently should not be accounted for separately:9
  • The software is not off-the-shelf software
  • The services include significant alterations to the features and functionality of the off-the-shelf software.
  • Building complex interfaces is necessary for the vendor’s software to be functional in the customer’s environment.
  • The timing of payments for the software is coincident with performance of the services.
  • Milestones or customer-specific acceptance criteria affect the realizability of the software license fee.

If there are "significant" modifications to the software or if the services are "essential" to the other elements of the arrangement contract accounting will apply.

DECISION POINT #4 -- Is there persuasive evidence of an arrangement?

Accounting Rules. As one of the four basic revenue recognition criteria under the New SOP, revenue may not be recognized until "persuasive evidence of an arrangement exists" as determined by the software vendor’s customary practice.10 If the vendor has a customary business practice of utilizing written contracts, evidence of the arrangement is provided only by a contract signed by both parties.11 If the vendor does not ordinarily enter into signed agreements with its customers (i.e., accepts orders through an on-line, telephone, or shrinkwrap transaction), then the vendor must have other forms of evidence to document the transaction such as a purchase order or an on-line authorization.12

Lawyer Application. This decision point raises the following issues for the lawyer to discuss with the client:

If the client has a number of ways to enter into arrangements with customers that depend on the class of the customer and the type transaction, then does the client have a policy formalizing this practice and a process for overseeing compliance with the policy? For example a client may enter into shrinkwrap and clickwrap (i.e., online transactions) agreements for its mass market software and signed agreements for its enterprise software. The New SOP does not specifically address a software vendor having multiple methods of entering into agreements with its customers. Therefore, if a question ever arises whether the client’s shrinkwrap agreements evidence an arrangement when the client also enters into signed agreements, then the client can demonstrate through its written contract policy that each type of agreement is applied only to a certain type of transaction (i.e., a shrinkwrap agreement for mass market software and a signed agreement for enterprise software).

If the client enters into shrinkwrap and/or clickwrap agreements, the lawyer should discuss with the client the impact of (1) recent case law regarding the enforceability of shrinkwrap agreements, and (2) the terms relating to "mass market software" in proposed Article 2B of the Uniform Commercial Code (UCC). Recent case law in the U.S. has upheld the enforceability of shrinkwrap agreements under certain circumstances.13 The lawyer will need to review this case law with his or her clients to ensure that the client’s shrinkwrap and clickwrap agreements are enforceable. If these agreements are not enforceable, then the required "evidence of an arrangement" may not exist. Additionally, proposed Article 2B of the UCC14 may provide a default set of terms covering the licensing of information and transactions involving software contracts unless a licensor or licensee otherwise agree to terms different from those stated in Article 2B. Article 2B includes terms related to "mass market software" that would be considered enforceable for shrinkwrap and clickwrap transactions. Further, Article 2B also addresses the manner in which shrinkwrap and clickwrap agreements are entered into with an end user. For example, the current version of Article 2B (the November 1997 draft) provides that if a software provider does not provide an end user an opportunity to review the terms of the license and manifest his or her assent to the terms prior to consummation of the transaction, then the agreement may not be enforceable. Article 2B is currently going through a review and revisions process.

The lawyer should review with the client the requirement of a writing under Article 2 of the UCC, especially in those instances where hardware and software are provided to the end user, to ensure that written agreements are entered into when required under the Statute of Frauds.15

In those instances where a written agreement is not entered into by a client the lawyer should discuss with the client a method for establishing other forms of evidence to document the transaction such as purchase orders and online authorizations as suggested in the New SOP.16

DECISION POINT #5 -- Does the arrangement include multiple elements?

Accounting Rules. The New SOP refers to a multiple-element arrangement when a vendor agrees to provide to a customer more than one product or a combination of products and services.17 If contract accounting does not apply, then revenue for each element should be recognized when the basic revenue recognition criteria are satisfied.

Lawyer Application. Most software transactions will involve software products, upgrades, modifications, and related services – all of which are deemed to constitute "elements" under the New SOP. A software arrangement should be structured so that the separate elements are clearly defined and the fee for each element is separately stated. The lawyer should work with the client when structuring the agreement to identify and separately state each element of the transaction. Structuring the arrangement with presentation of the elements in as straight forward a manner as possible will assist the client with satisfying the "fixed or determinable" requirement (see Decision Point #14 below for further discussion regarding the "fixed or determinable" requirement). The following is a list of potential elements in a software arrangement. A brief description of each element is provided along with a summary of the revenue recognition treatment for the element.

\Vendor-Delivered Licensed Software. Vendor-delivered licensed software includes software owned by the software vendor and delivered to the customer. Generally, if vendor-delivered licensed software does not require significant modifications and undelivered services are not essential to use the software, then revenue for vendor-delivered licensed software is typically recognized at the time of delivery (as long as the other revenue recognition criteria are met).

Third Party Software. Often third party delivered software is required for use with vendor-delivered software. Sometimes this third party software will be specifically referred to in the agreement under a "customer requirements" or similar section. Generally, revenue for the vendor-delivered software is recognized without regard to whether the third party software has been delivered to the client; provided, however, that the software vendor is not procuring the third party software. However, if there exists a close relationship between the vendor and the third party software provider (such as the case with some system integrator arrangements), then there may be reason to defer revenue recognition for the vendor-delivered software until delivery of the third party software.

Installation Services. Installation services typically involve a vendor installing licensed software at the customer’s location. Generally, installation services are not performed on a recurring basis. The revenue recognition treatment for installation services depends upon whether the installation involves significant modification of the software, and whether the services can be accounted for separately. If the services can be accounted for separately, then typically the revenue allocated to installation services is recognized as the services are performed.

Training Services. Training services generally involve a vendor training the customer’s personnel on how to use the vendor-delivered software. Revenue for training services are generally recognized as the services are performed (assuming services under the arrangement can be accounted for separately and the other revenue recognition criteria are satisfied).

Postcontract Customer Support Services (i.e., PCS or Software Maintenance Services). PCS includes a customer’s or reseller’s right to receive services (typically telephone support and correction of errors) and/or unspecified upgrades and enhancements at designated times during the license term. PCS does not include installation, training or other services that are not typically performed on a recurring basis. The New SOP specifically excludes specified upgrade rights from the definition of PCS (specified upgrade rights were generally included in PCS under SOP 91-1). Generally, revenue for PCS is recognized ratably over the PCS term. However, if sufficient vendor-specific objective evidence does not exist to allocate revenue to the elements of the arrangement and PCS is the only undelivered element, then the entire arrangement fee should be recognized ratably over the PCS term. Therefore, if the goal of the client is to recognize revenue as soon as possible, then it is important that the lawyer advise the client as to the revenue deferral consequences of not establishing vendor-specific objective evidence of fair value for PCS. Under SOP 91-1 and the New SOP, if PCS services are expected to consist of minimal and infrequent upgrades or enhancements to a software product, then revenue from PCS services may be recognized upon delivery of the software if all estimated costs of providing the services are accrued and the following criteria are met:
  1. the PCS bundled with the license is for one year or less;
  2. the estimated cost of providing PCS during the initial period of the PCS arrangement is insignificant;
  3. enhancements offered during the initial PCS arrangement have historically been minimal and are expected to be minimal during the initial period of the PCS arrangement; and
  4. collectibility is probable.
Telephone Support (i.e., if provided on a stand-alone basis outside the scope of PCS). Telephone support generally means that the vendor answers calls during a certain time each day to respond to questions regarding operation of the software and to discuss potential errors in the software that a customer may have discovered. The lawyer should be aware that if the client’s PCS arrangement consists solely of telephone support and the support is offered within one year, then the client may recognize revenue upon delivery of the licensed software. Additionally, if the vendor has vendor-specific historical evidence to demonstrate that substantially all the telephone support is provided within one year of software delivery for a multi-year arrangement, then the client may still recognize revenue attributable to the telephone support upon delivery of the software associated with the telephone support if related costs are accrued.18

Specified Upgrade Right. In general upgrades/enhancements involve the vendor making an improvement to a software product that is currently being licensed to the customer. The New SOP distinguishes between specified and unspecified upgrade/enhancements. A specified upgrade right is an upgrade/enhancement where the features and functionality of the upgrade/enhancement are specifically identified in the software agreement. For example, a vendor may specify in the license agreement that a Year 2000 compliant software release will be offered to the customer within the next three months; this release is a specified upgrade right (assuming that the current release licensed to the customer is not Year 2000 compliant). A specified upgrade right should be accounted for as a separate element of the arrangement even if the customer would be entitled to receive the upgrade as a subscriber to PCS. Revenue allocated to a specified upgrade right is the actual price that would be charged to existing users of the software product being upgraded. Revenue allocated to a specified upgrade may be reduced by the percentage of customers not expected to exercise the upgrade right.

Unspecified Upgrade Rights. An unspecified upgrade right differs from a specified upgrade right in that the unspecified upgrade right does not indicate the specific features or functionality that will be part of the upgrade/enhancement. An unspecified upgrade right is accounted for as PCS (see explanation above regarding revenue recognition in connection with PCS).

Additional Software Products. Additional software products are products indicated in a software license agreement that the customer may elect to license some time after the customer and vendor have entered into the license agreement. Examples of additional software products:
(1) Vendor licenses Product A to customer and offers customer a license to Product B and Product C (both complimentary products to Product A) for a specified license fee; and

(2) Vendor licenses a single copy of Product X to customer and offers customer additional copies of Product X for a specified license fee for each copy.

Additional software products are considered a separate element of the arrangement even if it is included in the terms of PCS. If a software vendor agrees to deliver software currently and to deliver unspecified additional software products in the future, then all revenue under the arrangement is recognized ratably over the term of the arrangement beginning with delivery of the first product.19 For example, a vendor offering its customers all new products introduced in a family of products over the next two years is an example of an unspecified additional software product. If the goal of the client is to recognize revenue as soon as possible, then the lawyer should advise the client not to include unspecified additional software elements in its license agreements. Alternatively, if the vendor desires to defer income into the future, then adding provisions for unspecified additional software products in the agreement would be an effective means of deferring revenue recognition.

Exchanges and Returns. A software arrangement may provide the customer with the right to "return" or "exchange" software for other software products. This part of the New SOP is undoubtedly one of the more confusing sections because it characterizes a customer’s "exchange rights" as either an "exchange" or a "return" for accounting purposes. An exchange right granted to an "end user" should be accounted for as an exchange if the vendor allows the customer to exchange software for similar products with no more than minimal differences in price, functionality, and features. On the other hand, if the vendor allows the customer to exchange software for dissimilar products or for products with more than minimal differences in price, functionality, and features, then this exchange right should be accounted for as a return. In reseller agreements all exchange rights are characterized as returns rather than exchanges (including those referred to as a stock balancing arrangements).20 The main point for the lawyer is that an exchange right characterized as an exchange (i.e., minimal differences in price, functionality, and features) has no effect on revenue recognition related to the products that are subject to the exchange right. However, an exchange right characterized as a return must satisfy the requirements of FASB Statement No. 48 and a reserve must be established for the estimated amount of any returns.21 If the goal of the client is to recognize revenue as soon as possible, then the lawyer should make sure that the client’s software agreement is structured in a manner that the transaction will be considered an exchange rather than a return or an additional product. For example, if the customer continues to have a right to use a software product after it has been exchanged for a similar product (with minimal differences in price, features and functionality), then the vendor will be considered to have provided an additional product rather than an exchange to the customer. The New SOP does not require the physical return of the exchanged or returned product, but does require that the customer no longer have a right to use the exchanged or returned product.22 Therefore, if the client’s goal is the early recognition of revenue, then the license granted to the customer should not allow the customer to continue to use an exchanged or returned product.

Platform Transfer Rights. A platform transfer right is a right granted by a vendor to transfer software from one hardware platform or operating system to one or more other hardware platforms or operating systems.23 A platform transfer right can be accounted for as an additional software product, an exchange or a return depending on the terms of the license (see above for the accounting treatment of additional software products, exchanges, and returns).

Data Conversion Services. Often when a customer replaces a legacy software system with a new software system, the data residing in the existing legacy system must be converted to a format acceptable to the new system and the converted data must then be input into the new system. Revenue for data conversion services are generally recognized as the services are performed (assuming services under the arrangement can be accounted for separately and the other revenue recognition criteria are satisfied).

DECISION POINT #6 -- Is there sufficient vendor-specific objective evidence of fair value to allow allocation of the fee to the separate elements?

Accounting Rules. Generally, revenue should be allocated to each element based on the relative fair value of the element. Fair value is based on vendor-specific objective evidence of fair value (i.e., the price charged when the element is sold separately). A vendor may not use pricing of similar products or services from other vendors, also known as "surrogate pricing," to determine fair value of an element. If an element is not yet being sold separately, then the relative fair value should be established by the vendor’s management having the relevant authority to establish such a price. If vendor’s management establishes a price for an element that is not yet being sold separately, then the vendor should expect that the element will be sold separately and it must be probable that the established price will not change before the element is introduced into the marketplace. If sufficient vendor-specific objective evidence (for all elements) does not exist to allocate revenue to the elements, then all revenue from the arrangement should be deferred until evidence of fair value exists or until all elements have been delivered.

Lawyer Application. When structuring a software arrangement, the lawyer should be careful not to specify an element for which the client cannot satisfy the vendor-specific objective evidence test, unless deferral of revenue is intended. Further, the lawyer should advise the client of the deferral of revenue effect when vendor-specific objective evidence of fair value for any one element in a software arrangement cannot be established.

DECISION POINT #7 -- Has the element been delivered?

Accounting Rules. The New SOP provides that revenue should not be recognized for an element prior to delivery of the element. For software that is delivered physically to the customer or to the reseller, delivery is deemed to have occurred upon transfer of the product master or first copy (if there is no product master). The one exception to the foregoing rule occurs when the fee is a function of the number of copies made by the customer or reseller. In this case delivery is deemed to have occurred as copies are made by the customer or reseller or on the customer’s or reseller’s behalf. For software that is delivered electronically, delivery occurs when the customer either (a) takes possession of the software via a "download" (that is, when the customer takes possession of the electronic data on its hardware), or (b) has been provided with access codes that allow the customer to take immediate possession of the software on its hardware.24 A vendor’s act of transferring software to a third party to perform software fulfillment services (i.e. disk duplication) does not itself satisfy the software company’s delivery obligation to the customer.

Lawyer Application

Timing Revenue Recognition with Delivery Dates According to the Client’s Revenue Recognition Goals. It is important for the lawyer to recognize delivery as one of the basic revenue recognition criteria when assisting the client with milestone schedules and payment terms in software agreements. Placement of the delivery dates in the milestone schedule is the most effective means for controlling when revenue recognition will occur.

Delivery Term. Delivery dates may be specified based on delivery terms (i.e., FOB destination). During its redeliberations of the New SOP, the AICPA’s Accounting Standards Executive Committee (AcSEC) discussed this issue and informally concurred that delivery terms would dictate when delivery of software would be deemed to have occurred for accounting purposes.

DECISION POINT #8 --Is acceptance of the software certain?

Accounting Rule. If after software delivery uncertainty exists about customer acceptance of the software, then license revenue should not be recognized until acceptance occurs or the customer’s right to either accept or reject the software expires.25

Lawyer Application. It is important for the lawyer to understand when revenue can be recognized prior to software acceptance. The first question the lawyer must address is "what causes uncertainty about a customer’s acceptance" thereby causing a deferral of revenue under the New SOP. The lawyer should review the following factors with the client when making this determination:

Will acceptance testing be conducted over a long period of time (i.e., greater than 30 days)? Short-term rights of return, such as 30-day money-back guarantees, should not preclude revenue recognition if an estimate of the returns can be made and other FASB Statement 48 criteria have been met (see Decision Point #13 for further discussion regarding this issue).

Are the acceptance test criteria based upon an objective standard defined at the time the contract is entered into (e.g., conformity of the software to the software vendor’s written product specifications) or are the acceptance criteria based upon a subjective customer defined standard (e.g., that it satisfies the customer’s needs)?
If after reviewing the above factors the lawyer in conjunction with the client concludes that acceptance is uncertain, then the customer will be considered to have a cancellation right under the agreement. In this situation revenue for the elements that are subject to the acceptance test would be deferred until formal customer acceptance occurs or the acceptance test period lapses (assuming the agreement explicitly provides that acceptance occurs if the customer does not formally reject the software prior to the expiration of the acceptance test period). If the lawyer and client conclude that a customer’s acceptance under a software arrangement is not uncertain, then the acceptance provision is considered a contractual right of return that falls within the scope of FASB Statement No. 48.26 The lawyer should note that even if an agreement does not include an acceptance provision, the requirements in FASB Statement No. 48 may still apply if the client has a history of allowing returns or if new software is being licensed and the client is uncertain of its quality. If either of these two situations are applicable, then the lawyer should advise the client to establish return reserves and keep historical information regarding the number of returns allowed by the client. If returns cannot be reasonably estimated, then all revenue will have to be deferred.

DECISION POINT #9 -- Is any undelivered element essential to the functionality of the delivered element?

Accounting Rule. The delivery of an element is considered not to have occurred if there are undelivered elements that are essential to the functionality of the delivered element, because the customer would not have the full use of the delivered element.27

Lawyer Application. When the lawyer assists the client with the milestone schedule of a software arrangement involving multiple releases of software, consideration should be given to whether full use of any item delivered is dependent on a future deliverable. The criteria for determining what is considered "essential" is explained above in Decision Point #3, "Does Contract Accounting Apply?"

DECISION POINT #10 -- Is collectibility probable?

Accounting Rule. Whether collection of the fee allocated to an element is probable and whether the fee is fixed or determinable are two of the basic revenue recognition criteria.28 The New SOP discusses collectibility of the fee in the same context as whether the fee is fixed or determinable. As payment terms for an arrangement become longer, the likelihood increases that the fee will not be collected due to a decrease in the value in the software product. This decrease in value is usually attributed to the licensed software becoming obsolete by the vendor’s own enhancements to the product or from alternative products offered by the vendor’s competitors.

Lawyer Application. The lawyer should review terms relating to acceptance testing, warranties, and length of payment terms in a software arrangement in order to assess whether collection of the fee is probable. While making this assessment the lawyer should consider the following:
Are the acceptance testing provisions for an extended period of time and subject to poorly defined acceptance criteria (or worse, no acceptance criteria)?

Are the warranties granted to the customer extensive and not routine and short-term?

Do extended payment terms jeopardize the ultimate collectibility of the license fee due to risks of product obsolescence or substitution?

If the client answers yes to any of the above questions, then collectibility may not be probable.

DECISION POINT #11 -- Is revenue attributable to delivered elements subject to forfeiture, refund, or other concession if all delivery obligations are not fulfilled?

Accounting Rule. The New SOP provides that if any portion of the fee attributable to delivered elements is subject to forfeiture, refund or other concession if the undelivered elements are not delivered, then no portion of the fee (including the amount otherwise allocated to delivered elements) meets the criteria of collectibility.30

Lawyer Application. The lawyer should advise the client as to the impact of an express refund right on revenue recognition. The client should be advised to pay particular attention to customer’s negotiating refund rights into the software agreement. Sometimes a vendor will include a liquidated damages provision in their agreements to expressly limit damages for nonperformance. The New SOP is silent as to whether the specification of damages for nonperformance in a software agreement would violate the collectibility criterion. Of course, the amount of the liquidated damages in relation to the amount of the deferred revenue will be a relevant factor. The lawyer may want to propose limiting liquidated damages to a specified amount for each undelivered element where the damages for the undelivered elements do not exceed the revenue attributable to the undelivered elements.

DECISION POINT #12 -- Are the warranties routine, short-term and relatively minor?

Accounting Rule. The New SOP provides that warranties that are routine, short-term, and relatively minor, should be accounted for in conformity with FASB Statement No. 5.31 The implication is that if a warranty is not routine, short-term and relatively minor, then it will be considered a cancellation provision and the fees paid under the license agreement will not be considered fixed or determinable.

Lawyer Application. The lawyer should work with the client to identify the types of warranties being granted in the marketplace for similar software. The lawyer should suggest to the client that the client’s warranties not be more extensive than warranties granted by other software companies for similar software. Additionally, the lawyer should assist the client in preparing warranty terms that are for a defined period of time and are based on a defined objective standard (e.g., conformance with the documentation provided by the client to its customer). Additionally, it is typical in most software license arrangements to include a disclaimer of the implied warranties of merchantability, fitness for a particular purpose and non-infringement. Consequently, the lawyer should make sure that the client’s warranty provision includes such a disclaimer so that the warranty is considered "routine."

DECISION POINT #13 -- Does the arrangement provide the customer a money-back guarantee?

Accounting Rule. The New SOP provides that a short term right of return, such as a thirty day money-back guarantee, should not be considered a cancellation privilege and that returns related to such a thirty day money-back guarantee should be accounted for in conformity with FASB Statement No. 48.32 By inference, a money-back guarantee which exceeds thirty days may constitute a customer cancellation privilege resulting in deferral of revenue. Additionally, a provision allowing the user to receive a refund of license fees if certain conditions are not met may be construed as a money-back guarantee.

Lawyer Application. The lawyer should not include in a license or software development agreement any money-back guarantee that exceeds thirty days after the software is delivered. Generally, the lawyer will be presented with money-back guarantees in one of the following two contexts:
shrinkwrap license agreements providing for return of the software within a certain number of days if the licensee does not agree with the terms of the license; or

software development agreements where the end user negotiates a provision providing for the refund of any software development fees or license fees paid prior to acceptance of the software if certain conditions are not met.

The money-back guarantee provision in the shrinkwrap agreement typically only presents itself to the lawyer when the lawyer is preparing a client’s form shrinkwrap license agreement. A money-back guarantee provision in a software development agreement generally presents itself to the lawyer during negotiations of the agreement. Sometimes the lawyer will not be part of these negotiations. Therefore, it is important for the lawyer to review the revenue recognition deferral effect of a money-back guarantee prior to the client negotiating a software development or license agreement.

DECISION POINT #14 -- Is the fee fixed or determinable?

Accounting Rule. A software license fee is not considered 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.33 Assuming that other revenue recognition requirements are satisfied, revenue should be recognized as copies of delivered products either are (a) reproduced by the customer or (b) furnished to the customer if the software vendor is duplicating the software.34 Additionally, if payment of a significant portion of the software licensing fee is not due until after expiration of the license or more than twelve months after delivery, then the licensing fee should be presumed to not be fixed or determinable.35 The New SOP allows the vendor to overcome the presumption that payment terms greater than twelve months are not fixed or determinable if the software vendor has a practice of using contracts with extended (i.e., greater than twelve months) payment terms and a history of successfully collecting under the original payment terms without making concessions.36 The New SOP provides that, if at the outset of the arrangement, a vendor concludes that the arrangement fee is not fixed or determinable, then the entire fee should be recognized as payments become due and payable assuming all other revenue recognition criteria are met. 37

Lawyer Application. The issue of whether a fee is "fixed or determinable" presents itself to the lawyer in the context of the license and payment terms. An enterprise-wide license, site license, per copy license, and per user license are the main forms of license that software vendors usually grant. When the lawyer consults with the client regarding the form of license to grant, the lawyer should review the revenue recognition impact of each form of license under consideration. Additionally, the lawyer should discuss the deferral effect of extended payment terms with the client.

The provisions of the New SOP are complex and will be subject to varying interpretations. The lawyer should advise the software company to confirm its view of the financial accounting treatment of software licensing arrangement with its independent auditors well in advance of reporting deadlines.

Footnotes:

1    See SOP 97-2 ¶ 8. Various parts of this article (including the flowchart in Appendix I of this article) have been reprinted with permission from SOP 97-2, Copyright © 1997 by the American Institute of Certified Public Accountants.
2    See SOP 97-2 ¶ 8
3    See SOP 97-2 ¶ 4
4    See SOP 97-2 ¶ 7
5    See SOP ¶¶ 65, 66
6    See SOP 97-2 ¶ 67
7    See SOP 97-2 ¶ 67
8    See SOP 97-2 ¶ 74
9    See SOP 97-2 ¶ 70
10    See SOP 97-2 ¶ 65
11    See SOP 97-2 ¶ 16
12    See SOP 97-2 ¶ 16
13    ProCD, Inc. v. Zeidenberg, 86 F.3d 1447, 1996 U.S. App. LEXIS 14951, 39 U.S.P.Q.2d (BNA) 1161, 29 U.C.C. Rep. Serv. 2d (Callaghan) 1109 (7th Cir. Wis.1996)
14    Article 2B is currently in draft form and is undergoing revisions that are coordinated by the National Commission on the Uniform – of State Laws ("NCUSL").
15    The Statute of Frauds is included in section 2-201 of the UCC and provides, in part, as follows:
Except as otherwise provided in this section, a contract for the sale of goods for the price of $500 or more is not enforceable by way of action or defense unless there is some writing sufficient to indicate that a contract for sale has been made between the parties and signed by the party against whom enforcement is sought or by his authorized agent or broker. A writing is not insufficient because it omits or incorrectly states a term agreed upon, but the contract is not enforceable under this paragraph beyond the quantity of goods shown in such writing.

16    See SOP 97-2 ¶ 16
17    See SOP 97-2 ¶ 34
18    See SOP 97-2 ¶ 61
19    See SOP 97-2 ¶ 49
20    See SOP 97-2 ¶ 55
21    See SOP 97-2 ¶ 51
22    See SOP 97-2 ¶ 50
23    See SOP 97-2 ¶ 35
24    See SOP 97-2 ¶ 18
25    See SOP 97-2 ¶ 20
26    Paragraph 6 of FASB Statement No. 48 states that "If an enterprise sell its product, but gives the buyer the right to return the product, revenue from the sales transaction shall be recognized at time of sale only if all of the following conditions are met:
  1. The seller’s price to the buyer is substantially fixed or determinable at the date of sale.
  2. The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product.
  3. The buyer’s obligation to the seller would not be changed in the event of theft or physical distribution or damage of the product.
  4. The buyer acquiring the product for resale has economic substance apart from that provided provide the seller [footnote omitted].
  5. The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer
  6. The amount of future returns [footnote omitted] can be reasonably estimated.

27    See SOP 97-2 ¶ 13.
28    See SOP 97-2 ¶ 8.
29    See SOP 97-2 ¶ 27
30    See SOP 97-2 ¶ 14
31    See SOP 97-2 ¶ 31
32    See SOP 97-2 ¶ 31
33    See SOP 97-2 ¶ 26
34    See SOP 97-2 ¶ 44
35    See SOP 97-2 ¶ 28
36    See SOP 97-2 ¶ 28
37    See SOP 97-2 ¶ 29
 

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