The software revenue recognition picture begins to crystallize

Transcription

1 Software Industry Revenue Recognition and the Revised Revenue Recognition Exposure Draft The software revenue recognition picture begins to crystallize As proposed in the November 2011 revised joint revenue recognition exposure draft, revenue recognition for software companies is likely to be among the most substantially impacted This article reflects considerations from review of the November 2011 exposure draft and the Boards deliberations to date; all aspects of the proposed standard and its impacts are tentative until a final standard is issued. Introduction 1 Background 1 Key Provisions of the 2011 ED and Software Industry Impact 3 The Separation Model and Distinct Goods or Services 3 Allocation of Transaction Price to Separate Performance Obligations 9 Revenue Recognition Over Time 11 Contingent and Variable Consideration 12 Collectibility 15 Time Value of Money 16 Selling Costs 17 Costs to Fulfill a Contract 18 Retrospective Transition 20 Appendix A 21 Introduction The FASB and IASB s revised joint revenue recognition exposure draft was issued on November 14, 2011 (the 2011 ED) and is now open for public comment through March 13, This article discusses the ways in which the 2011 ED would impact the revenue recognition practices of companies operating in the software industry. In addition, Appendix A outlines how the 2011 ED would affect the accounting for specific deliverables that are common in the software industry. The views and considerations outlined in this article are preliminary and subject to change and/or clarification as the FASB and IASB redeliberate the 2011 ED and issue a final standard. Background On June 24, 2010, the FASB and IASB (collectively, the Boards) published for public comment an exposure draft of a new revenue recognition standard (the 2010 ED) that would replace substantially all currently existing U.S. GAAP and IFRS revenue recognition accounting standards, including FASB Accounting Standards Codification (ASC) subtopic (ASC ) originally issued as Statement of Position (SOP) 97-2, as amended by SOP 98-9, and related Technical Practice Aids issued by the American Institute of Certified Public 1 The Revised FASB/IASB Revenue

2 Accountants (AICPA). The Boards initiated this joint project to develop a common revenue standard for U.S. GAAP and IFRS, remove industry- and transaction-specific guidance in U.S. GAAP, provide a more robust framework for revenue recognition under IFRS, and improve comparability across industries and jurisdictions. The 2010 ED was open for public comment until October 22, 2010, and a wide cross-section of companies submitted nearly 1,000 comment letters to the Boards. Companies in the software industry that apply U.S. GAAP currently apply industry-specific revenue recognition guidance. Accounting systems and marketing, sales, and contracting practices in this industry have evolved in response to this guidance. As a result, the U.S. software industry could be particularly affected by the proposed revenue recognition standard. Many software companies submitted comment letters in response to the 2010 ED and a number of software companies can be expected to submit comment letters on the 2011 ED as well. While most software companies that submitted comment letters on the 2010 ED supported the Boards primary objective of establishing a converged revenue recognition standard for U.S. GAAP and IFRS, these companies raised many concerns about the application of the proposed guidance to the specific circumstances faced by the software industry. Certain of the software industry s comments, such as those related to the 2010 ED s provisions for retrospective application, treatment of the assessment of a customer s credit risk, and the time value of money, were similar to the concerns expressed by respondents across a wide cross-section of industries. However, many software industry respondents also expressed concern related to the unique impacts certain of the 2010 ED s provisions would have had on the revenue recognition accounting of the software industry such as the proposed changes to the multiple-element separation model, which includes eliminating the requirement for vendor-specific objective evidence of fair value (VSOE) to separate deliverables within a software arrangement, particularly as it impacts those arrangements currently accounted for under subscription accounting. Subsequent to the end of the public comment period on the 2010 ED, the Boards held a series of roundtable discussions to hear from various constituents. The Boards redeliberated the proposed standard over the course of January through October 2011 and decided to reexpose the proposed standard because revenue recognition affects virtually all business entities and they wanted to identify potential unintended consequences from applying the proposed standard before it is finalized. The Boards are providing a 120-day comment period on the 2011 ED, which will end on March 13, In addition, the FASB released the proposed codification amendments for public comment on January 4, 2012 which also has a comment deadline of March 13, The Revised FASB/IASB Revenue

3 Key Provisions of the 2011 ED and Software Industry Impact The Separation Model and Distinct Goods or Services The 2011 ED proposes that when a contract with a customer contains a promise to deliver multiple goods or services, each of the distinct goods or services will be accounted for as separate performance obligations (distinct is discussed below). Promised goods or services included in a contract are not distinct, and should be accounted for as a single, integrated performance obligation, if: 1. The promised goods or services are highly interrelated and transferring them to the customer requires the vendor to provide a significant service of integrating the goods or services into the combined item for which the customer has contracted; and 2. The bundle of goods or services is significantly modified or customized to fulfill the contract. Observations: Under the 2011 ED, the degree of integration and customization performed by the vendor in fulfilling the terms of the contract would be key to determining whether an integrated performance obligation exists. The implementation guidance in the 2011 ED provides an example in which a software vendor provides software along with professional services to significantly customize that software to that customer s requirements. The example concludes that the vendor was fulfilling a single, integrated performance obligation under the customer contract because (a) the vendor is providing a significant service of integrating the goods and services (the license and the consulting services) into the combined item for which the customer has contracted and (b) the software is significantly customized by the entity in accordance with the specifications negotiated with the customer. Under current U.S. GAAP software revenue recognition guidance, a software license and associated professional services are treated as one contract accounting unit when the professional services in the contract are considered essential to the functionality of the software being licensed, such as when the services involve significant production, modification, or customization of the software. Based on the implementation guidance in the 2011 ED, it is generally expected that contracts to produce or significantly customize or modify software would similarly be considered a single performance obligation. Many of the same considerations outlined under current U.S. GAAP 1 may be relevant in helping companies to determine whether integration is a significant aspect of a software contract with professional services and whether the bundled software and services are significantly modified or customized under the contract for these types of arrangements. However, it is unclear as to whether the Boards believe this guidance could be used in evaluating implementation, installation, and other software-related professional services that do not involve 3 The Revised FASB/IASB Revenue 1 Outlined within FASB Accounting Standards Codification paragraphs to , available at

4 significant production, modification, or customization of the software. For example, consider a software company that licenses its enterprise software to a customer and agrees to implement the software for the customer in the customer s environment. While the implementation services do not typically involve significant customization of the software code, the services are necessary and do entail configuring the various features of the software for utilization by a particular customer and can only be performed by a trained service provider. The software vendor often sells its software to customers without the implementation services because other service providers can and do perform implementation services for its customers. In addition, the software vendor often sells implementation services separately in situations where the customer decides to implement the licensed software in another location. Under current U.S. GAAP software guidance, the software vendor would likely conclude that the services are not essential to the functionality of the software due to the fact that they do not entail significant modification or customization of the software and the services are available from other service providers. Thus, the software and services would be accounted for separately under current U.S. GAAP. If the guidance in the 2011 ED was intended to apply to arrangements that include implementation services such as those described in the preceding example, it is unclear as to whether the software vendor could reach a conclusion that the software and services are a single integrated performance obligation on the basis that the services and software are highly interrelated and the implementation service is a significant service to integrate the software into the customer s environment. While the services do not significantly modify the software code, the services do entail significant configuration of the available features of the software. Where the vendor s service does not involve integrating the promised goods and services, each promised good or service would be accounted for as a separate performance obligation if it is distinct. A promised good or service would be distinct if: 1. The vendor regularly sells the good or service separately, or 2. The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer. Readily available resources are goods or services that are sold separately by the vendor or by another vendor, or resources that the customer already has obtained from the vendor or from other transactions or events. The 2011 ED also would allow entities, as a practical expedient, to account for two or more distinct promised goods or services as a single performance obligation if those promised goods or services have the same pattern of transfer to the customer. Observations: When determining whether a good or service is distinct, resources are considered to be readily available to the customer if the resources are sold separately by the vendor or can be purchased separately in the marketplace; or 4 The Revised FASB/IASB Revenue

5 the customer previously acquired from the vendor the resources necessary to make the good or service usable. In this last instance, the sequence of delivery of goods or services could affect a vendor s conclusion about whether a good or service is distinct. The 2011 ED would eliminate the requirement under existing accounting literature for vendors to separate deliverables in software contracts only after having established VSOE for the undelivered elements. As discussed further below, under the 2011 ED, if the goods and services are distinct, they are accounted for as separate performance obligations using the estimated standalone selling price if the selling price is not observable, similar to the current U.S. GAAP guidance for multiple-element arrangements that do not fall within the scope of the software revenue recognition guidance. The practical impact of the elimination of the VSOE requirement to separate contract elements under the 2011 ED is that because software in most instances will be considered distinct from other products and services in the arrangement, additional performance obligations will qualify for separation for many software vendors without regard to whether VSOE-level evidence of selling price for the performance obligations exists. This change could have significance both for accounting and the structuring of software arrangements: 1. Software companies will have more leeway in pricing their goods and services, without impacting their ability to separate contract deliverables, since they will no longer be constrained by the requirement that the pricing for stand-alone sales of particular elements be within a narrow range in order to establish VSOE and separate the performance obligations within the arrangement. 2. Software companies that currently follow a subscription-like revenue model as a result of not having VSOE for all undelivered elements such as Post-Contract Customer Support (PCS) or certain rights such as those to unspecified additional software products would recognize a portion of the revenue upon delivery of the software license thereby resulting in a more accelerated revenue recognition model. 3. Software companies will have the flexibility to include future deliverables in an arrangement, such as specified upgrades or specified additional product rights, without creating the need to defer all of the revenue under a contract due to lack of VSOE over one or more of those undelivered future performance obligations. Consider the following examples, all of which assume that the related software and services to the contract are not determined to be a single, integrated performance obligation of the nature outlined above: Software licenses delivered up front in a contract with nonessential professional services and PCS generally would be considered distinct as long as the customer would be able to use the software on its own, separate from the professional services and PCS. The PCS and professional services generally would be considered distinct if they are 5 The Revised FASB/IASB Revenue

6 regularly sold on a stand-alone basis (for example, PCS renewals) or they will be delivered subsequent to the delivery of the software, and therefore have benefit to the customer together with resources already delivered (the software license). As a result, a software company that cannot currently apply the residual method because it lacks VSOE over its PCS or professional services would likely be able to recognize the relative selling price of its software licenses upon delivery of the software under the provisions of the 2011 ED. Many software companies do not sell their professional services separately from their software licenses, and where they do, such services might not be of a substantially similar nature to those it performs for customers as part of a bundled software contract. Under current U.S. GAAP, VSOE of those professional services would not exist, which results in the professional services and the software license being deemed one deliverable and the combined fees being recognized over the service period. Under the 2011 ED, VSOE is not required and the focus of the analysis would instead be on whether the services are distinct. Since the professional services in this example are not sold separately, they can be distinct only if the customer can benefit from those services from other resources that are readily available. The sequence of delivery would be important in this instance since the services will presumably have benefit to the customer subsequent to the vendor s delivery of the software. When the services are considered distinct, the revenue allocated to each performance obligation would be recognized when the performance obligation is satisfied (i.e., when the license is transferred to the customer and as the services are provided). Software vendors frequently are unable to establish VSOE over a specified upgrade. As a result, under current U.S. GAAP, the revenue for the entire arrangement would be deferred until the specified upgrade is delivered. Under the proposed standard, a specified upgrade may be considered distinct when the initial software license to which the upgrade applies has already been delivered, resulting in the ability to recognize revenue for the software license (or any other delivered items) up front based on their relative selling price. 6 The Revised FASB/IASB Revenue Contractual PCS agreements often include the following components: technical support, bug fixes, and rights to upgrades on a when-and-if available basis. Under current accounting practice, companies generally do not sell these component services on a stand-alone basis, and therefore, cannot establish VSOE. Therefore, these components are generally considered to be one PCS accounting element. However, based on the distinct definition, each of these service components would likely be considered to have benefit to the customer together with the delivered software, and therefore distinct, once the up front software license is delivered, requiring companies to account for these services as separate performance obligations. It is unclear whether companies would be able to apply the practical expedient outlined above to account for these components as one performance obligation. While the actual pattern of

7 transfer of the component services may not be the same or similar, the services are provided over the same period of time. The 2011 ED indicates that rights to when-and-if available software products are an example of a stand-ready performance obligation. The rights to technical support also would be a form of stand-ready performance obligation. This might be a practical avenue for concluding that the component services have the same pattern of transfer. However, it is unclear if that is the intent of the practical expedient. In software arrangements that provide the customer with rights to unspecified additional software products, and both the initial software licenses and the unspecified additional product rights are distinct, the relative selling price of the initial license would be recognized upon delivery, and the relative selling price of the unspecified additional software product rights would be recognized as the performance obligation related to those rights is satisfied. This would differ from the current subscription accounting for such arrangements that generally results under current U.S. GAAP. Conversely, the following are examples of instances where certain software elements may not be considered distinct: Professional services are necessary for the software to be utilized by the customer (i.e., installation, configuration, or other setup services) and the company is the only vendor capable of performing the services and does not sell the services separately; such services may call into question whether the software is distinct. In other instances, the order of delivery may result in the delivered item not being distinct. For example, consider an arrangement where a software company enters into an arrangement to deliver software licenses A and B, where License A can be used on its own but License B can only be used in conjunction with License A. In this situation, if License A is delivered before License B, each of the two products (License A and License B) would be distinct. Conversely, if License B is delivered before License A, then License B would not be distinct. Many Software-as-a-Service (SaaS) providers determined upon the amendments to ASC included in ASU that they could separate certain of their implementation and other upfront professional services on the basis that such services have stand-alone value. SaaS providers likely will reach similar conclusions relative to similar professional services under the provisions of the 2011 ED; however, setup activities that do not transfer any good or service to the customer would generally not be considered performance obligations under the 2011 ED. 7 The Revised FASB/IASB Revenue 2 FASB Accounting Standards Codification Subtopic , Multiple-Element Arrangements, available at 3 FASB Accounting Standards Update No , Multiple-Deliverable Revenue Arrangements, available at

8 The 2011 ED outlines that options granted to a customer to purchase additional products or services in the future constitute additional separate performance obligations only if the options provide a material right to the customer that the customer would not receive without entering into that contract (e.g., a discount that is incremental to the range of discounts typically given for those products or services to a class of customers in the same market). Where such material rights are granted, the customer in effect prepays the entity for the option and would recognize revenue only when the option is exercised through the acquisition of additional products or services or the option expires. Observations: Current U.S. GAAP 4 provides that a more-than-insignificant discount related to future purchases is a discount that is (1) incremental to the range of discounts reflected in the pricing of the other elements of the arrangement, (2) incremental to the range of discounts typically given in comparable transactions, and (3) significant. It also specifies that an option within a software arrangement that allows the customer to purchase additional copies of products licensed by and delivered to the customer under the same arrangement is not considered an additional element to the contract. Certain discounts in software contracts that are not currently considered to be separate accounting elements may be considered additional performance obligations under the provisions of the 2011 ED. First, there is no specific exception relative to options to acquire additional copies of already-delivered software or add additional customer users as exists currently under U.S. 5 GAAP; however, there is currently uncertainty as to whether the tasks that the software vendor would perform to fulfill an order for additional copies of software or additional user licenses would constitute additional performance obligations or be considered solely administrative tasks as they are described in paragraph 25 of the 2011 ED. Second, while current U.S. GAAP has established that a future discount that is not incremental to the range of discounts reflected in the customer arrangement is not an additional element to the arrangement, there is no such provision within the 2011 ED. For example, consider an option to purchase an additional product or service at a 40 percent discount from list prices. If that discount is commensurate with the discount provided to the customer for the performance obligations in the current contract, it would not be significant and incremental under current U.S. GAAP and not treated as a separate performance obligation. However, if such discount were incremental to the discount that similarly situated customers were receiving in the same market, it would be considered an additional separate performance obligation under the provisions of the 2011 ED. Many software companies may find this impact challenging with respect to the 2011 ED s transition provisions in that data necessary to apply this concept retrospectively may not be readily available. Software companies may need to 8 The Revised FASB/IASB Revenue 4 FASB Accounting Standards Codification paragraph (d), formerly AICPA Technical Practice Aid No , Definition of More-Than-Insignificant Discount and Software Revenue Recognition, available at 5 ASC paragraphs and Applicability of Discount Accounting to Option to Buy Additional Copies of Software, available at

9 implement additional data-gathering processes to capture all of the options that may require additional accounting under the provisions of the proposed standard. Allocation of Transaction Price to Separate Performance Obligations Under the 2011 ED, a vendor generally would allocate the transaction price to all performance obligations in proportion to the stand-alone selling price of the promised goods or services. The best evidence of stand-alone selling price would be the observable price for which the vendor sells goods or services separately. In the absence of separate observable sales, the stand-alone selling price would be estimated. The 2011 ED would require a vendor to consider all information that is reasonably available and maximize observable inputs when estimating the stand-alone selling price. Estimation approaches under the relative stand-alone selling price method include, but are not limited to, (a) the adjusted market assessment approach, (b) the expected-cost plus a margin approach, and (c) the residual approach. The residual approach would be appropriate only if the stand-alone selling price of a good or service is highly variable or uncertain and the stand-alone selling prices of the other performance obligations in the contract are observable. The residual approach involves determining a standalone selling price by referring to the total transaction price less the observable stand-alone selling prices of all other goods and services in a contract. It differs from the residual method under current U.S. GAAP for software arrangements because (a) VSOE would not be required for the other performance obligations in the contract (although observable stand-alone selling prices would be required) and (b) the highly variable performance obligation to which the residual approach may be applied would not be limited to delivered items (e.g., the reverse residual approach may be appropriate). Observations: Given that the residual approach can only be applied to one performance obligation in a contract, and only where there are observable stand-alone selling prices for all of the other performance obligations within the contract, many software companies would need to develop processes to ensure they can reasonably estimate selling prices for all of its performance obligations where these criteria for application of the residual approach are not met, such as where multiple separate performance obligations do not have observable stand-alone selling prices (e.g., multiple software licenses are sold that will not be delivered concurrently). A vendor might conclude that its best estimate of the stand-alone selling price of a bundle of software that will not be delivered concurrently is a residual amount; however, the company would still be required to determine the stand-alone selling price of the software included in the bundle. 9 The Revised FASB/IASB Revenue The 2011 ED s proposed requirement to maximize the use of observable inputs when determining the estimated stand-alone selling price would likely prevent a software vendor from abandoning the use of a measure substantially

10 equivalent to VSOE (i.e., one based on the vendor s stand-alone selling prices) where such observable pricing information to determine VSOE currently exists. The 2011 ED provides certain exceptions to the relative stand-alone selling price model for allocation of the transaction price. In cases where the sum of the stand-alone selling prices exceeds the transaction price (i.e., the customer receives a discount for the bundle of goods), the discount would be allocated to all of the performance obligations on a relative stand-alone selling price basis unless (a) the vendor regularly sells each good or service or each bundle of goods or services in the contract on a stand-alone basis and (b) the observable selling prices from those stand-alone sales provide evidence of the performance obligation(s) to which the entire discount belongs. If both criteria are met, the entire discount would be allocated to one or a group of separate performance obligations. Observations: Given that many software vendors rarely, if ever, sell software licenses on a stand-alone basis, it is unlikely that this exception to the relative stand-alone selling price allocation model would be applicable to typical enterprise software contracts; however, utilization of the residual approach outlined above, where allowable, would result in similar accounting by allocating the discount entirely to the one deliverable to which the residual technique is applied. The second exception to using relative stand-alone selling price for allocation of the transaction price relates to a scenario where the transaction price includes an amount that is contingent on a future event or circumstance. The contingent amount would be allocated entirely to one performance obligation if (a) the contingent payment terms for the good or service relate specifically to the vendor s efforts to satisfy that performance obligation or to a specific outcome from satisfying that separate performance obligation and (b) allocating the contingent amount of consideration entirely to the separate performance obligation, when considering all of the performance obligations and payment terms in the contract, would depict the amount of consideration to which the vendor expects to be entitled for satisfying each performance obligation. Observations: By way of example, in a software licensing contract where the software vendor is licensing two software products, if the pricing for one of the software products is fixed and the other is variable (i.e., royalty-based), it may be appropriate to allocate the estimated royalties entirely to the second software product. As a result, the fixed portion of the consideration allocated to the first software product would be recognized upon transfer of control of the license to the customer, while the estimated royalties allocated entirely to the second product would not be eligible for recognition until the uncertainties regarding the amount of the royalties is resolved (based on the revenue recognition constraint relative to variable consideration outlined later in this document). 10 The Revised FASB/IASB Revenue

11 Revenue Recognition Over Time Under the 2011 ED, a vendor transfers control of a good or service over time, and therefore, recognizes related revenue over a period of time rather than at a point in time if either of the following criteria is met: 1. The vendor s performance creates or enhances an asset that the customer controls as the asset is created or enhanced; or 2. The vendor s performance does not create an asset with an alternative use to the vendor and at least one of the following conditions is met: (a) the customer simultaneously receives and consumes the benefits as the vendor performs each task, (b) another vendor would not need to substantially reperform work the vendor has completed to date if that other vendor were to fulfill the remaining obligation to the customer, or (c) the vendor has a right to payment for performance to date and the vendor is expected to fulfill the contract as promised. If a performance obligation is satisfied over time, the vendor would recognize revenue only if it can reasonably measure its progress toward satisfaction of the performance obligation. The objective when measuring progress is to depict the transfer of control of goods or services to the customer. A vendor would measure its progress using an output method or an input method that depicts the transfer of control over the good or service and would be required to apply that method consistently to similar performance obligations and in similar circumstances. Output methods use direct measurements of the value to the customer of the goods or services transferred to date. Input methods use a vendor s inputs (e.g., costs incurred or hours incurred) relative to the total expected inputs to the satisfaction of that performance obligation. When the vendor s efforts are expended evenly over time, it may be appropriate to recognize revenue on a straight-line basis. Observations: Under current U.S. GAAP software revenue recognition guidance, arrangements that involve the significant modification or customization of software are usually accounted for in accordance with the contract accounting provisions of FASB ASC Subtopic (ASC ), thereby most commonly recognizing revenue utilizing the percentage of completion (POC) method. However, under the 2011 ED, a performance obligation would qualify for revenue recognition over time only if it meets the criteria outlined above. Software companies may find that many of its contracts to customize or modify software as currently structured do not meet these criteria. For example: Customized software may be delivered only at the conclusion of the customization process, meaning that the customer likely would not control the asset as it was being developed. Therefore, the first criterion would not be met. 11 The Revised FASB/IASB Revenue 6 FASB Accounting Standards Codification Subtopic , Construction-Type and Production-Type Contracts, available at

12 The asset being created may not have alternative use to the vendor, while none of the additional criteria may be met because (a) the customer doesn t receive a benefit as the customization services are performed, (b) the proprietary nature of most vendors software would generally preclude an alternate vendor from completing the customization were the software company to terminate the project prior to completion, and/or (c) the vendor may not be entitled to payment for performance completed to date if the customer cancels the contract. As a result, it may become important for software vendors to ensure they structure their contracts in such a manner as to ensure they have a right to payment under the contract for performance to date in the event of early termination by the customer. The right to payment under the contract for performance to date does not have to be a current right to payment throughout the contract, only a right to such payment upon termination by the customer. If the contract did not meet any of the criteria for satisfaction over time, revenue would be recognized only upon delivery of the customized software. Conversely, certain contracts that currently are accounted for under the completed contract method of ASC due to circumstances such as not having VSOE over an undelivered element to the contract such as PCS would no longer be precluded from revenue recognition over time. Companies also should remain aware of the implications of customer-specific acceptance provisions on their customer contracts as the proposed accounting requirements relative to acceptance provisions remains substantially unchanged from current guidance. Contingent and Variable Consideration Contingent or variable consideration may include discounts, rebates, incentives, performance bonuses, penalties, royalties, and price concessions. The 2011 ED stipulates that a vendor should follow these steps when a contract is subject to variable consideration: Step #1: Determine the transaction price A vendor s objective when determining the transaction price would be to estimate the total amount of consideration that it will be entitled to under the contract. To meet that objective, a vendor would estimate the transaction price using either the probability-weighted amount or the most likely amount depending on which is more predictive of the consideration that the vendor will be entitled to. In circumstances where there is a large pool of homogeneous transactions with a number of possible outcomes for each transaction, a probabilityweighted amount may be more predictive. When there are binary outcomes (e.g., a single performance bonus amount that will be paid only if certain criteria are satisfied), a most likely amount approach may be more appropriate. The transaction price would not be limited to an amount that is reasonably estimable as it was in the 2010 ED, and would include estimates of all potential 12 The Revised FASB/IASB Revenue

13 consideration, including usage-based royalties and other variable fees. However, as outlined below in Step #3, the cumulative amount of that transaction price that could be recognized as revenue at any given point may be constrained to such amounts to which the vendor is reasonably assured to be entitled. Observations: Under current U.S. GAAP, 7 where a software vendor has a pattern of granting concessions to its customers, it may conclude that its contract prices are not fixed or determinable, having a significant impact on its revenue recognition. There is no fixed or determinable criterion in the 2011 ED; however, it is within this step that a software vendor would estimate any expected customer price concessions, particularly when a pattern of granting price concessions (e.g., price discounts, rebates, credits) exists. For example: A software company has a history of entering into initial PCS terms with its customers of three to five years; however, the company also has substantial experience with customers threatening to cancel or not renew the PCS when the term is over, and as a result often agrees to provide the customer a price concession for the remaining term to retain the business and the customer relationship. The software company must factor this pattern of granting price concessions on the initial contract price into its estimation of the transaction price at the contract s outset, reducing the total estimated transaction price by an amount reflective of the discount it expects to provide under the contract based on its common practices. Price concessions that were not expected at the outset of the contract would be governed by the 2011 ED s provisions relative to accounting for contract modifications. Step #2: Allocate the transaction price to the separate performance obligations Refer to discussions earlier in this document on the 2011 ED s provisions on allocating transaction price to separate performance obligations. Step #3: Recognize revenue as performance obligation is satisfied with the cumulative revenue limited to amounts that the vendor is reasonably assured to be entitled Cumulative recognized revenue for a performance obligation would be limited to amounts that the vendor is reasonably assured to be entitled. A vendor would not be reasonably assured of being entitled to an amount of uncertain consideration when the: a. Vendor has no experience with similar types of performance obligations or has no other persuasive evidence upon which to base its estimate of uncertain consideration; or b. Vendor has experience, but that experience is not predictive of the outcome of satisfying the performance obligation. Indicators that past 13 The Revised FASB/IASB Revenue 7 FASB Accounting Standards Codification paragraphs through Concessions by a Software Vendor to Customers, available at

14 experience is not predictive of the outcome of satisfying a performance obligation include situations where the ultimate amount of consideration to be received is highly susceptible to factors outside the influence of the entity, will be determined over a significant period of time, and experience is limited or is highly variable (i.e., there are numerous potential outcomes, none of which are significantly more likely of being the result than the others). The Boards also specified that a vendor is not reasonably assured of being entitled to consideration that varies on the basis of the customer s subsequent sales of a good or service (i.e., a sales-based royalty) until the uncertainty is resolved (that is, when the customer s subsequent sales occur). Observations: These provisions represent a significant change from the 2010 ED, which would have required royalties, as well as all other variable fees, to be included in the transaction price if they were reasonably estimable without being subject to any further constraint. To comply with the reasonably assured to be entitled threshold, software companies would not recognize revenue for future software royalties that are dependent on sales by resellers to end users. However, usage-based fees, such as those charged for the number of seat licenses used over a particular software platform, would not be subject to the cumulative constraint when the vendor has predictive experience on which to estimate the variable consideration. In such cases, software vendors would be required to determine if they have relevant, predictive experience that would allow them to reliably estimate such fees for recognition upon transfer of control of the software. SaaS providers likely would continue to recognize usage-based fees over its hosted platforms on an as earned basis, not because of the above guidance specific to royalties relative to intellectual property, but because SaaS customers do not control the intellectual property they utilize. Rather, such arrangements generally would meet the requirements for transfer of control for revenue recognition with the number of transactions processed being the applicable measure of satisfaction of the performance obligation. 14 The Revised FASB/IASB Revenue

15 Collectibility The 2011 ED does not include collectibility as a recognition threshold that would require an assessment of the customer s ability to pay the promised amount of consideration for revenue to be recognized. Instead, revenue would be recognized (even when collectibility is not probable or reasonably assured) and a vendor would recognize an allowance for any expected credit loss from contracts with customers following the guidance that applies to financial instruments (accounts receivable). The corresponding amounts (i.e., bad debt expense) would be presented as a separate line item adjacent to the revenue line item, except where credit risk is factored into the discount rate utilized in accounting for a significant financing element in the contract. The 2011 ED provides that companies should not bifurcate the credit risk component embedded within the accounting for a significant financing element. Time value of money considerations relative to the 2011 ED are outlined in the next section. The Boards note in the Basis for Conclusions that if there is significant doubt at contract inception about the collectibility of consideration from the customer, that doubt may indicate that the parties are not committed to perform their respective obligations under the contract and the criteria for a contract may not be met. Observations: The Boards, in revising the 2010 ED s provisions relative to accounting for a customer s credit risk, acknowledged constituents concerns, including those expressed by the software industry, that netting within revenue for initial estimates and presentation of subsequent adjustments through a separate line item was inconsistent and may result in revenue being recognized that was not reflective of the amounts collected from customers. The Boards agreed that the best solution to this concern was having a gross revenue line and then a separate line item adjacent to revenue to show both the contract price and subsequent adjustments from credit risk. The practical effects of the provisions of the 2011 ED as compared to current accounting would likely be: There will be fewer instances in which revenue is completely deferred as a result of collectibility concerns because significant doubt about collectibility appears to be a lower threshold than collectibility is probable. Under current U.S. GAAP, 8 complete revenue deferral would occur if collectibility was not probable. Under the 2011 ED, complete deferral would only occur if a vendor concluded that a contract did not exist under the proposed standard as a result of significant doubt at contract inception about collectibility. However, this potential increase to top-line revenues might be partially offset by credit losses that would be recognized by the company in such situations, which in extreme cases would result in reporting credit losses adjacent to revenue in an amount equal to the related revenue amount. Such extreme cases would be 8 FASB Accounting Standards Codification Subtopic , Software Revenue 15 The Revised FASB/IASB Revenue Recognition, as available at

16 expected to be infrequent given that if there is significant doubt at contract inception about the collectibility of consideration from the customer, that likely would call into question whether the customer is committed to perform its obligations under the contract, and therefore, whether a contract exists between the parties upon which to recognize revenue. An overall degradation to companies gross margins, since adjustments for customer credit risk would, under the provisions of the 2011 ED, be recorded as adjustments before gross margin. As reversals of previously recorded credit losses also would be recorded through this line item, in certain periods, companies might see the impact of this provision in the proposed standard having a positive impact on gross margin. Time Value of Money Under the 2011 ED, an entity would adjust the promised amount of consideration to reflect the time value of money if the contract includes a financing component that is significant to the contract. To determine whether a financing component is significant to the contract, a vendor would be required to consider all relevant factors. In particular, the 2011 ED stipulates that vendors should consider: 1. The expected length of time between when the vendor transfers the promised goods or services to the customer and when the customer pays for those goods or services 2. Whether the amount of customer consideration would differ substantially if the customer paid cash promptly under the typical credit terms in the industry and jurisdiction; and 3. The interest rate in the contract and prevailing interest rates. As a practical expedient, the 2011 ED indicates that a vendor would not be required to reflect the time value of money in its estimate of the transaction price if the vendor expects at contract inception that the period between customer payment and the transfer of goods or services is one year or less. Observations: Certain common software transactions, such as the prepayment of PCS for a one year (or less) term, would qualify for application of the practical expedient. Other contracts, where payments under that contract are spread over a greater than one-year period, but which correspond to the timing of the transfer of goods or services to the customer, likely would not be considered to contain a significant financing element. Software companies should remain aware that vendors with extended payment terms greater than one year or who enter into contracts with multiyear PCS terms that are prepaid could be impacted by the time value of money provisions. Vendors would need to broadly link payment terms to the expected pattern of transfer of control of the software and/or services in order to avoid time value of money implications. 16 The Revised FASB/IASB Revenue

17 Selling Costs The 2011 ED requires a vendor to recognize an asset for the incremental costs of obtaining a contract that are expected to be recovered. However, this guidance would be optional if the amortization period of those costs would be one year or less. Capitalized acquisition cost assets would be presented as a separate line on the statement of financial position and subsequently amortized on a systematic and rational basis consistent with the pattern of transfer of the goods or services to which the asset relates. In some cases, the asset may be amortized over more than one contract when the asset relates to an anticipated contract that the vendor can identify specifically (e.g., renewal options). Incremental costs of obtaining a contract have been defined as those costs that are directly attributable to obtaining a contract that would not have been incurred if the contract had not been obtained (e.g., sales commissions). Most costs incurred during the selling process would not meet this criterion because the costs would have been incurred even if the vendor was ultimately not successful at obtaining the contract. For example, wages payable to sales personnel or in-house legal personnel associated with drafting a contract likely would not meet this criterion since those costs would be incurred regardless of whether the contract was ultimately executed. Software vendors would need to monitor their selling cost assets on an ongoing basis to determine whether such assets were recoverable based on the remaining value of the related contracts. Observations: This process would likely not be something new for SaaS providers that currently capitalize such costs (under current SEC guidance, companies make a policy election on whether to capitalize selling costs or expense those costs as incurred). However, as many SaaS vendors currently amortize contract acquisition costs over the noncancelable contract term, the 2011 ED s requirement to amortize such costs, under certain circumstances, over a period beyond the initial contract term may result in an accounting change for vendors that determine their historical experience indicates the contract is expected to be renewed. Additionally, SaaS providers that currently expense such costs would need to capitalize the costs for assets with amortization periods (including anticipated renewals) extending beyond one year. Currently, software vendors not operating on a SaaS model typically do not capitalize selling costs. As such, the requirement in the 2011 ED to capitalize these costs for assets with amortization periods extending beyond one year may result in additional accounting issues for software vendors. Examples of typical arrangements that may be subject to the requirement are contracts that include PCS services extending beyond a term of one year, or arrangement terms of one year or less in which renewals are anticipated which would be the case for many PCS arrangements. It would be difficult for a software vendor to conclude that a sales commission earned on a new software 17 The Revised FASB/IASB Revenue