Revenue Recognition-Software - an overview

Table of Contents

List of Abbreviations

1. Introduction

2. Meaning of revenue recognition

3. Regulations in the software industry
3.1 Scope of SOP 97-2 and SOP 98-9
3.2 Basic principles
3.2.1 Evidence of arrangement
3.2.2 Delivery of product
3.2.3 Fixed or determinable fee
3.2.4 Collectibility is probable
3.3 Multiple-element arrangements
3.3.1 Implications of vendor-specific objective evidence
3.3.2 Postcontract customer support
3.3.3 Services
3.3.4 Additional software products
3.4 Additional rules

4. Summary

Appendix

List of laws and other accounting standards

List of Internet Sources

List of Literature

List of Abbreviations

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1. Introduction

Several years ago software vendors had the possibility to implement very different accounting practices for their financial statements especially in the area of revenue recognition. About 15% of the companies, covered by a survey of ADAPSO in 1983, took use of the ability to blow up revenue and recognized it early upon signing of the contract.^[1]

Since then the rules have changed a lot. New accounting standards were introduced and software companies are now limited in how and when they can recognize revenue. This leads to the ability to compare financial statements among competitors more easily and reflects the current financial condition in a better way.^[2]

The aim of this paper is to provide an overview about US-GAAP’s regulations of software revenue recognition. Due to the detailed and highly complex rules the essay cannot cover all regulations.^[3] Hence it is limited to the relationship between software vendors and end-users. Resellers are excluded in the way that no interpretation is given for them because it is even more difficult to interpret the guidelines for them as it is for end-users.^[4] Additionally “Discount, Marketing Programs and Barter Transactions”^[5] are covered very briefly due to the many occurring forms.

2. Meaning of revenue recognition

Revenue is received from the selling of goods or performing services. Before revenue can be recognized it should be earned and realized.^[6] The earning process occurs when a company is making efforts to earn money, like producing goods, advertising products or negotiating with its customers. These activities enable the company to receive revenue. Revenue is realized when the vendor is allowed to receive money from the customer.^[7] In practice revenue is often realized when the product is delivered or service obligations are fulfilled.^[8]

When a company finally recognizes revenue in its income statement it has an effect on the balance sheet as well. Consequently either cash, accounts receivable or other assets are increasing.^[9]

3. Regulations in the software industry

The first guideline about software revenue recognition, SOP 91-1, was issued in January 1991 by the AICPA.^[10] It was superseded through SOP 97-2 on October 1997.^[11] But the renewed rules raised questions concerning AcSEC’s conclusions about multiple-element arrangements.^[12] Subsequently the AICPA released SOP 98-4, which deferred the use of certain provisions of SOP 97-2 for one year. Finally SOP 98-4 was amended by SOP 98-9, which was declared effective on December 15, 1998.^[13]

As SOP 97-2 contains a lot of detailed guidelines with ample exceptions, references to other accounting standards and many special terms it can be confusing at first sight.^[14]

3.1 Scope of SOP 97-2 and SOP 98-9

Companies which gain income from licensing, selling, leasing, or otherwise marketing computer software have to apply SOP 97-2 and SOP 98-9.^[15] However as software is included in a lot of products, like cars, domestic appliances or computers, it is necessary to distinguish between software that is incidental to the product or service as a whole or is not. Therefore the question to answer is, does the customer think of the included software as an element that has influence on his buying decision. If this is the case the software is not incidental and as a result SOP 97-2 does apply, otherwise not.^[16]

Furthermore when a software vendor enters into a leasing agreement, which contains software and property, plant or equipment (PPE), the portion of the fee for PPE is then accounted under SFAS 13.^[17]

SOP 97-2 does also not apply when the deal is regarded as contract accounting, i. e. the arrangement involves significant “production, modification or customisation”^[18] of the software. The relevant accounting rules in this case are given in ARB 45 and SOP 81-1. Nevertheless some provisions of SOP 97-2 remain in place for specific industry related rules. Refer to section 3.3.3 (page 7) for further information.^[19]

3.2 Basic principles

In this section the expression “customary business practice”^[20] will be used sometimes. This term relates to the usually used procedures a company applies to different types of customers, geographies, sizes, products.

There are four basic criteria, which all have to be met to recognize revenue.^[21] These are discussed in the following. The first two criteria refer to the process of earning revenue, as discussed before. The last two criteria relate to realize revenue.^[22]

3.2.1 Evidence of arrangement

It is necessary to have a written contract, signed by both parties, if this is the vendor’s customary business practice. If the vendor does not use written contracts other forms of evidence have to exist. These include credit card authorization, purchase order, online authorization or electronic communication.^[23]

3.2.2 Delivery of product

Delivery can occur either physically or electronically. No matter which form is used the specific element must be delivered directly to the end-customer. The delivery to a fulfillment house or a delivery agent is not sufficient to meet the criterion.^[24] Moreover if an element is delivered, but another, yet undelivered element is required for it to function, it is regarded as undelivered.^[25]

[...]

^[1] See Carmichael, D. R. (1998), p. 45.

^[2] See Yates, J. C. et al. (1997), p. 11 et seq.

^[3] See Pilhofer, J. (2002), p. 404.

^[4] See on the internet: PWC (2002), p. 7-1.

^[5] See on the internet: PWC (2002), p. 6-1.

^[6] See CON No. 5 (1984), p. 7.

^[7] See Matulich, S./Heitger, L. E. (1985), p. 122.

^[8] See Helmkamp, J. G./Smith, R. E./Imdieke, L. F. (1986), p. 501 et seq.

^[9] See Helmkamp, J. G./Smith, R. E./Imdieke, L. F. (1986), p. 18; Hermansen, R. H./Edwards, J. D./Salmonson, R. F. (1986), p. 484.

^[10] See Carmichael, D.R. (1998), p. 45.

^[11] See Murphy, P./Schuldiner (1999), p. 86; w/o author (1999), p. 96.

^[12] See Munter, P./Ratcliffe, T. A. (2000), p. 8 et seq.

^[13] See w/o author (1999), p. 98.

^[14] See Pilhofer, J. (2002), p. 404; for a better understanding of the SOP have a look on Appendix I.

^[15] See Munter, P./Ratcliffe, T. A. (2000), p. 9; Wood, D. L. (1998), p. 12.

^[16] See Munter, P./Ratcliffe, T. A. (2000), p. 9; on the internet: PWC (2002), p. 1-1.

^[17] See Yates, J. C. et al. (1997), p. 15.

^[18] Munter, P./Ratcliffe, T. A. (2000), p. 9.

^[19] See KPMG (2003), p. 231; Pilhofer, J. (2002), p. 385.

^[20] On the internet: PWC (2002), p. 2-2.

^[21] See Wood, D. L. (1998), p. 12.

^[22] See Carmichael, D. R. (1998), p. 47 et seqq.

^[23] See on the internet: PWC (2002), p. 2-2.

^[24] See Carmichael, D.R. (1998), p. 48; Mosler, C. (2001), p. 35.

^[25] See Levine, M. H./Siegel, J. G./Fitzsimons A. P. (1999), p. 52.