FASB Emerging Issues Task Force. Issue No Title: Applicability of SOP 97-2 to Certain Arrangements That Include Software Elements

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1 FASB Emerging Issues Task Force Issue No Title: Applicability of SOP 97-2 to Certain Arrangements That Include Software Elements Document: Issue Summary No. 1 Date prepared: March 10, 2009 FASB Staff: Bonn(x226)/Maples(x462) EITF Liaison: Carlo Pippolo Date previously discussed: None Previously distributed EITF materials: concurrently as Appendix 09-3A) Working Group Report No. 1 (distributed References: FASB Statement No. 13, Accounting for Leases (Statement 13) AICPA Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (SOP 81-1) AICPA Statement of Position 91-1, Software Revenue Recognition (SOP 91-1) AICPA Statement of Position 97-2, Software Revenue Recognition (SOP 97-2) SEC Staff Accounting Bulletin No. 104, Topic 13, Revenue Recognition (SAB Topic 13) EITF Issue No. 00-3, "Application of AICPA Statement of Position 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity's Hardware" (Issue 00-3) EITF Issue No , "Revenue Arrangements with Multiple Deliverables" (Issue 00-21) EITF Issue No. 03-5, "Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software" (Issue 03-5) EITF Issue No. 08-1, "Revenue Arrangements with Multiple Deliverables" (Issue 08-1) International Accounting Standard 18, Revenue (IAS 18) The alternative views presented in this Issue Summary are for purposes of discussion by the EITF. No individual views are to be presumed to be acceptable or unacceptable applications of Generally Accepted Accounting Principles until the Task Force makes such a determination, exposes it for public comment, and it is ratified by the Board. EITF Issue No Issue Summary No. 1, p. 1

2 Background 1. At the November 13, 2008 EITF meeting, the Task Force reached a consensus-for-exposure on Issue 08-1 that would modify Issue to require an entity to use its best estimate of selling price for the undelivered item(s) in an arrangement in situations in which vendor-specific objective evidence (VSOE) or third-party evidence (TPE) is not available. The consensus-forexposure also requires the use of the residual method in allocating arrangement consideration to delivered elements when the vendor's best estimate is used to determine the selling price of the undelivered element. 2. The Task Force also considered whether to (a) expand the scope of Issue 08-1 to include transactions accounted for under SOP 97-2, (b) expand the scope of Issue 08-1 to specifically include revenue related to software-enabled devices, or (c) not expand the scope of Issue 08-1 but recommend that a separate project be added to the EITF agenda to evaluate the scope of SOP 97-2 and the accounting for revenue arrangements with multiple deliverables within the scope of SOP The Task Force reached a consensus-for-exposure that the scope of Issue 08-1 should be the same as the scope of Issue and that the scope should not be expanded to include deliverables within the scope of SOP The Task Force also recommended to the FASB Chairman that a separate Issue be added to the EITF agenda to consider changes to the accounting for multiple element arrangements under SOP The FASB Chairman, who was present at the meeting, considered the Task Force recommendation and input from other Board members also in attendance, and decided to add the project to the EITF agenda. The Task Force noted that it would be preferable if any amendments arising from future Task Force deliberations on SOP 97-2 were to have an effective date that is consistent with Issue A Working Group was formed to assist the staff in advising the Task Force on this Issue. The Working Group met on February 10, 2009, and included representatives from various entities that apply SOP 97-2 in their revenue recognition; public accounting firms; financial statement users; and an observer from the SEC. The objectives of the meeting were to assist the FASB staff in advising the Task Force on (a) whether to pursue modifying the scope or the measurement criteria of SOP 97-2 and (b) what scope or measurement options should be EITF Issue No Issue Summary No. 1, p. 2

3 considered by the Task Force. The Working Group's report from this meeting is attached in Appendix 09-3A. 4. At the March 19, 2009 meeting, the staff will present various items to the Task Force for it to consider in proceeding with this Issue. The first question is whether this Issue should address the scope of SOP 97-2 or its measurement attributes. Depending on the Task Force's response to that question, the staff will then present alternatives and other considerations for the Task Force to consider in proceeding with this Issue. This Issues Summary provides: a. Analysis of proceeding with either a scope approach or a measurement approach for this Issue (Issue 1) b. Analysis of alternatives if the Task Force decides to focus on the SOP 97-2 scope (Issue 2) c. Analysis of alternatives if the Task Force decides to focus on measurement within SOP 97-2 (Issue 3) d. Analysis of additional considerations that would need to be addressed if the Task Force chooses to align the measurement criteria in SOP 97-2 with that in Issue 08-1 (Issues 4 7) Scope 5. This Issue applies to arrangements accounted for in accordance with SOP Accounting Issues and Alternatives Issue 1: Whether this Issue should modify the measurement criteria or the scope of SOP The objective of either a scope focus or a measurement focus in this Issue will ultimately impact the measurement for at least some transactions. However, for purposes of this Issues Summary, a scope approach would address measurement issues for certain transactions by excluding them from the scope of SOP 97-2; whereas a measurement approach would result in the modification of the measurement criteria within SOP Under a scoping approach, EITF Issue No Issue Summary No. 1, p. 3

4 transactions that previously were in the scope of SOP 97-2 would now be in the scope of SAB Topic 13 and/or Issue Under a measurement approach, transactions previously under SOP 97-2 would still be within its scope but the separation criteria for some or all of the elements of the arrangement could be lowered from SOP 97-2's current VSOE requirement. View A: Modify the scope of SOP Some View A proponents believe that a scoping approach would address practice issues that they perceive to be caused by arrangements being accounted for under SOP 97-2 that were not necessarily anticipated when SOP 97-2 was authored. The Working Group Report included in Appendix 09-3A provides several examples of arrangements that Working Group members believed illustrate these issues. These situations are becoming increasingly common as technological developments are made and software becomes more than incidental to the functionality of many products. The Working Group voted to recommend a scoping approach as further discussed in the Working Group Report, although there was also significant support for a measurement approach. It is important to note that none of the Working Group members objected to pursuing a scoping approach since, in their opinion, it would improve the reporting in the short-term for at least some products. 8. Some View A proponents also believe that there is the potential for greater pricing variability for software deliverables because there is little to no incremental cost associated with providing an additional license to a software product. These proponents are concerned with allowing the use of estimates in these arrangements without further field testing, which they believe would be better handled as part of the joint revenue recognition project. These proponents note that AcSEC considered allowing the use of surrogate prices, such as competitor prices for similar products or industry averages, to determine selling price. As discussed in paragraph 100 of SOP 97-2, AcSEC believed that there were inherent differences between elements offered by different vendors. Those inherent differences led AcSEC to conclude that only VSOE can be considered sufficiently objective to allow the allocation of the revenue to the various elements of the arrangement. EITF Issue No Issue Summary No. 1, p. 4

5 9. For example, a software entity may license its software products based on a discount from the product's price. Those discounts may vary significantly depending on various factors, including but not limited to (a) the volume of expected transactions under the arrangement, (b) whether the customer purchases other products sold by the vendor, or (c) the entry of a new product into the market. While these factors are not unique to the software industry, the lack of incremental cost associated with each license often times provides a software entity with greater latitude in pricing each transaction. For example, the vendor could sell the software license to one customer at 80 percent of list price while selling the license to another customer at 30 percent of list price. If one were to analyze the contract terms of each of these arrangements, it may not be clear why the pricing within those arrangements differ because they would appear to represent the license of the same asset. 10. Some View A proponents also believe that user feedback further supports the rationale for pursuing a scoping approach for this Issue. These proponents note the feedback received from software entity financial statement users obtained during deliberations on Issue 08-1 who were not supportive of allowing revenue estimates or changing the VSOE requirement for traditional software entities. These proponents note that this differs from feedback received from softwareenabled device entity users who were much more supportive of allowing estimates as further discussed in the Working Group report. These users tended to believe that revenue recognition for a delivered product, even if based on an estimate, was more reflective of the underlying economics of an entity's operations. 11. Some View A proponents believe that changing measurement broadly for all software arrangements would be a significant change for the software industry, both from an accounting and a business practice perspective. Some might argue that the software industry has largely adapted to the requirements of SOP 97-2 and modified their business practices accordingly. Therefore, the existing practice issue may be more of a concern for software-enabled device entities and their financial statement users compared to software entities and their users. These proponents would rather address the perceived practice issue for software-enabled device entities now and let the joint revenue recognition project address revenue for software arrangements. These proponents believe that a change to the measurement criteria could be disruptive to the EITF Issue No Issue Summary No. 1, p. 5

6 software industry and could create unnecessary confusion for financial statement users, particularly with the chance that additional changes might be required upon completion of the joint revenue recognition project. 12. Opponents of View A believe that if value is transferred to the customer, then the arrangement's underlying economics are better reflected when revenue is recognized as further discussed in View B. Some opponents of a scoping approach believe that such an approach would result in a somewhat arbitrary line. In their view, arrangements may still be under the scope of SOP 97-2 even though the economics of the arrangement do not conceptually support a different revenue model. View A opponents also believe that there is an inherent inconsistency associated with pursuing a scoping approach rather than addressing measurement. They note that sales of products that would now be subject to Issue 08-1 would require the use of TPE or estimates for all elements in the arrangement if VSOE does not exist. Some of those elements will be the same software-related elements such as post customer support (PCS) and specified upgrades, that may have caused some concern with the reliability of software element estimates. These opponents do not understand why estimates would be allowed for those same elements when they are provided with a software-enabled product but estimates would not be allowed when sold only with a software license. 13. Some opponents of View A also observe that while the software industry has "adapted" to the requirements of SOP 97-2, adaptation has required them to implement business practices that would not be economically justified absent the requirements of SOP For example, to ensure that VSOE is available for undelivered items, entities may preclude negotiations with a customer for newer available products for which VSOE is not available when they negotiate for products for which VSOE is available. Additionally, for those products for which VSOE is not available for undelivered elements, the "adaptation" is to defer revenue for delivered elements. Accordingly, an entity may be required to defer revenue for some delivered items, but not others. Such inconsistencies make the financial statements difficult for users to understand and may promote the use of alternative performance measures. EITF Issue No Issue Summary No. 1, p. 6

7 View B: Modify the measurement criteria of SOP Proponents of View B believe that modifying the measurement criteria for arrangements involving software is the preferred approach. They believe that there is not a conceptually sound basis to support varying revenue recognition models based on the nature of the product. The Working Group discussed this rationale and many members did not believe that software products exhibited significantly different economic characteristics that would warrant an entirely different accounting model compared to sales of tangible products. There may be greater subjectivity or difficulty involved in estimating the selling price for certain software elements, which gave rise to the issuance of SOP This may be particularly true for elements such as specified upgrade rights, software licenses and PCS (due to when-and-if-available upgrades). However, many of the Working Group members believed that reasonable estimates could be made for those elements. Some noted that the software industry has matured since the issuance of SOP 97-2, particularly with respect to the availability of TPE, which should allow for better estimates now than might have been available in the past. 15. View B proponents also believe that financial reporting is not representationally faithful of the underlying economics of arrangements when a product is delivered to a customer and no revenue is recognized for that product because the entity lacks VSOE for the undelivered elements. They believe that even when there is significant subjectivity involved in estimating the value of certain elements, allocating and recognizing that revenue based on an estimate is still better reporting and reflective of the value delivered to the customer. These proponents believe that if there are significant concerns as to subjectivity of estimates, then that concern should be alleviated through disclosure rather than application of a conservatively biased model. 16. Conceptually, many Working Group members supported a course of action that would align the measurement principle of SOP 97-2 with Issue Some of the Working Group members also suggested that the Task Force could consider breaking this project into two phases if it believed that addressing scope was the preferred course of action in the short-term. Some had a concern that it may be several years or more before the joint revenue recognition project is EITF Issue No Issue Summary No. 1, p. 7

8 completed and effective and that uneconomical reporting answers are significant enough to warrant addressing measurement issues for software before the broader project is completed. 17. Opponents of View B are generally supporters of a scoping approach based on the rationale described in View A. There are also some opponents who do not support a broad measurement change within SOP 97-2 unless it is as a result of the joint revenue recognition project, due to concerns about multiple potential accounting changes within several years for a pervasive item in the financial statements. Scoping Approach Issue 2 only has to be addressed if the Task Force selects View A for Issue 1, otherwise, continue to the Disclosure and the Transition and Effective Date sections. 18. There are multiple ways the Task Force could approach modifying the scope of SOP Issue 2 in the Scope section of this Issues Summary provides several alternatives that might be used as a basis to modify the scope if it chooses View A in Issue 1. The different scoping paths vary based on the range of transactions the Task Force wants impacted by this Issue. Under View A of Issue 2, it is likely that only some transactions involving software-enabled devices would be impacted. This view focuses on defining what is meant by incidental in SOP 97-2 and refining that term or its indicators such that SOP 97-2 does not apply to arrangements considered to be non-software. On the other hand, Views B and C would likely impact more transactions, potentially even all software-enabled devices. The difference between View B and View C is primarily the determination of whether a software-enabled device (including the embedded software) should be considered one deliverable that is excluded from the scope of SOP 97-2 in its entirety or if it should be considered two deliverables; one that is a software deliverable within the scope of SOP 97-2 and one that is a non-software deliverable within the scope of other literature (presumably SAB Topic 13 or Issue 08-1). The answer may also impact whether undelivered elements in the arrangement are accounted for as software or non-software deliverables. Another difference between Views B and C is that View C would affect all software-enabled device transactions when software is more than incidental whereas View B may only impact some of these transactions. Depending on its view on the range of transactions EITF Issue No Issue Summary No. 1, p. 8

9 to be impacted, the Task Force may want the staff to further develop the applicable approach and concepts for discussion at a later meeting. 19. The staff believes that if the Task Force decides to modify the scope exception in SOP 97-2, then it will also need to modify or nullify Issue 03-5 as well. That Issue addresses the question of whether non-software deliverables included in an arrangement that contains software that is more than incidental to the products or services as a whole are within the scope of SOP The Task Force concluded that non-software deliverables are within the scope of SOP 97-2 if the software is essential to the functionality of the non-software deliverable. That is, the non-software deliverable would be considered a software deliverable. Many of the arrangements that are driving practice concerns in this Issue would likely be pulled back into SOP 97-2 under Issue 03-5 if it were not modified or nullified. The extent of the change necessary to Issue 03-5 will depend on how the Task Force decides to modify the scope of SOP Issue 2: If the Task Force decides to change the scope of SOP 97-2, how the scope of SOP 97-2 should be modified. View A: Modify the term "incidental" and/or its indicators. 20. Proponents of View A believe that many practice issues today are caused by technological advances in tangible products that are software-driven. They believe that the term "incidental" in SOP 97-2 and its accompanying indicators set too low of a threshold for determining whether software is incidental to the product. By definition, incidental items are those that are considered to be of minor consequence. Many more products now include software that is more than minor even though the type of product may have existed for years and serves the same basic function but it now has more "bells and whistles" that are software driven. 21. SOP 97-2, paragraph 2, states that the SOP does not apply to revenue earned on products or services containing software that is incidental to the products or services as a whole. Proponents of View A believe that many of the uneconomical reporting issues could be addressed by "raising the bar" for an arrangement to be considered a software arrangement. They believe that EITF Issue No Issue Summary No. 1, p. 9

10 this could be accomplished by making the determination of whether an arrangement is a software or non-software arrangement based on the predominance of the evidence. For example, the scope exception could be modified such that the SOP does not apply to products and services if they are not considered to be predominantly software, as a whole. This approach would still require the application of judgment in making a scope determination rather than providing a bright line (such as if the software is sold separately or not), which many would view as being arbitrary. 22. If such an approach were taken, the indicators in footnote 2 of SOP 97-2 could also be modified to assist in the predominant evaluation. The standard could also be more emphatic that the assessment is based on all factors together as a whole. Although the incidental assessment is supposed to be applied based on an assessment of the products and services as a whole, many believe that these indicators are being applied using more of a checklist mentality. The indicators in footnote 2 about whether software is incidental to a product as a whole currently include (but are not limited to): a. Whether the software is a significant focus of the marketing effort or is sold separately b. Whether the vendor is providing postcustomer contract support c. Whether the vendor incurs significant costs that are within the scope of Statement Working Group members provided the staff with various indicators that might be more useful in providing guidance on making a judgmental assessment. Many of the indicators provided expand upon the indicators that are currently included in the SOP but provide more context into how those indicators should be considered. The Working Group did not assess each of these factors in detail and the Working Group members may have individually placed greater emphasis on certain indicators compared to others. For example, Working Group members tended to place less emphasis on indicators that were based on a customer perspective due to difficulties associated with assessing the motivation behind a customer's purchasing decision. Some of the suggested indicators are as follows: a. Whether the hardware product or software is considered to be the primary value driver in the arrangement EITF Issue No Issue Summary No. 1, p. 10

11 b. The software cannot be purchased or licensed separately from the non-software element c. Whether the marketing focus is on the software itself or on the features and functionalities of the product d. The cost of sale of either the tangible product or the software component is significantly greater than the other (including development costs associated with each) e. The customer views the value of PCS in the arrangement as mainly relating to hardware replacement compared to unspecified upgrades/enhancements f. There are significant development efforts and proprietary knowledge in the underlying tangible hardware component and the cost of sales of that hardware is more than insignificant g. Significant utility, features, and functionality are obtained through a subsequent purchase of a tangible product in the future (rather than through delivery of software updates/upgrades) h. The customer does not retain the right to use the software in the event that the use of the non-software element is terminated i. The tangible product is simply a delivery mechanism for software that could otherwise be run separately by the customer 24. Some opponents of View A believe that it would not change the application of SOP 97-2 as currently applied. These opponents believe that the requirement in SOP 97-2 to assess the arrangement as a whole should result in similar accounting results as is currently applied in practice. Accordingly, these opponents do not believe that such a modification would accomplish the objective of permitting separation of more arrangements. In their view, however, it might highlight instances in which the guidance in SOP 97-2 is not currently being applied appropriately in practice. View B: Tangible products containing software components and non-software components that function together to deliver the product's essential functionality should be considered nonsoftware deliverables. EITF Issue No Issue Summary No. 1, p. 11

12 25. Proponents of View B believe that such an approach would result in increased separability for tangible products without significantly increasing the complexity associated with applying the model. Under this approach, most software-enabled products would be scoped out of SOP 97-2 in their entirety. These proponents generally believe that all arrangements should be subject to the same measurement criteria and that estimates should be allowed. However, they believe that such an approach is a practical compromise if the Task Force does not want to allow for estimates for all software arrangements until after the joint revenue project is completed. They believe that there generally will be less variability involved in estimations when tangible products are involved due to the incremental costs associated with providing a tangible product compared to software. They acknowledge that this may not always be the case and that there may be similar estimation concerns with some of the elements in such arrangements. However, they believe that separation is still a better solution that will improve financial reporting for at least some transactions until the measurement criteria is universally aligned. 26. If the Task Force chooses to pursue a View B approach, there may be additional questions that it may want to consider. View B relies on the assessment of whether both the software and hardware components are essential to the functionality of the product. Based on discussions with Working Group members, the staff believes that additional questions may be raised in applying that criteria. 27. Consider the following example. A vendor sells a customer a personal computer that comes supplied with an operating system and additional software applications, such as word processing, games, document viewers, and anti-virus software. The vendor also provides PCS for two years that covers the warranty on the computer, an on-line and telephonic customer help desk for problems using the computer or software applications, and when-and-if-available upgrades on the operating system. Lastly, the vendor provides a specified upgrade right for the next version of the operating system, which is expected to be released within a year. The following questions may be relevant in applying View B: a. Assume the computer needs an operating system to function but the customer could replace the operating system with others on the market to obtain this functionality. EITF Issue No Issue Summary No. 1, p. 12

13 Would the operating system be considered essential to the functionality of the computer? b. Does essential to the functionality of the product mean that the delivered computer meets all of the technical specifications? If so, assume that the technical specifications state that the computer provides functionality to process and view documents, play specified games, and protect the computer from malicious attacks. Would this now mean that the additional software products loaded on the machine would also be viewed as being essential to functionality? c. Does it matter if the operating system is sold separately? Does it matter if the additional software products are sold separately? d. Does it matter if the software is transferable to other devices? Should technical or legal restrictions on transferability be considered? 28. A question may also exist with respect to which literature applies to the undelivered specified and unspecified upgrade software deliverables if the computer and operating system together are determined not to be software. Some may argue that if the computer and operating system are determined not to be software, then all deliverables related to that product should also be considered non-software and excluded from the scope of SOP This would be consistent with current accounting when software is considered incidental to the arrangement. Others may view the upgrades as software to which SOP 97-2 should apply. In many cases, this question may be purely conceptual in nature because it results in the same accounting answer. For example, if the only undelivered item was PCS, the vendor would likely recognize PCS ratably over its term whether SOP 97-2 or Issue 08-1 were applied. However, a different answer could result if PCS and a specified upgrade right were present. Under SOP 97-2, revenue associated with the PCS would not be recognizable until either the specified upgrade right expired or the upgrade was delivered if VSOE did not exist for the specified upgrade right. Under Issue 08-1, the vendor would likely recognize PCS ratably over its term even if it was required to estimate the selling price for the specified upgrade right. 29. Opponents of View B believe that it is not sufficiently focused on the substance and characteristics of the arrangement as a whole. This approach would ignore the importance of any EITF Issue No Issue Summary No. 1, p. 13

14 undelivered software items in the arrangement that are actually the value drivers within the arrangement. For example, those undelivered software elements may revolutionize the ability to utilize the product and the value of the product is primarily in the underlying software and the future upgrades. 30. View B opponents also question why revenue for the same software product with the same associated undelivered elements would receive different accounting treatment based on whether that software element was bundled together with a tangible product. Assume, for example, that the vendor sells the operating system for the computer separately to customers along with a specified upgrade right to its next version of the operating system. Under View B, the vendor would be allowed to estimate the value of the specified upgrade right if the operating system was considered essential to the functionality of the product and recognize that revenue upon delivery of the computer. However, if the operating system was sold separately from the product along with a specified upgrade right, VSOE of the upgrade right would be required under SOP 97-2 in order to separate the upgrade right from the operating system. View C: Software that is (a) essential to the functionality of a product and (b) more than incidental to the product as a whole should be considered a separate deliverable. 31. View C proponents believe that if software essential to the functionality of the product is present and it is considered more than incidental, then that is evidence supporting the notion that the software should be treated as a separate element or deliverable. The software is viewed as a significant component of the product and treating it as a separate deliverable supports this assessment. Under this approach, the software and all software elements would continue to be accounted for under SOP 97-2, but the hardware components of the transaction would not be considered software. The computer would be considered a non-software element and accounted for under SAB Topic 13/Issue 08-1, and the operating system would be considered a software element and accounted for under SOP This would alleviate the concern some might have in creating new "rules" in determining which model to apply to different transactions (that is, is it entirely in SOP 97-2 or in SAB 104/Issue 08-1). It would also result in at least some value being recognized for delivered items in more situations than would result from applying other scoping EITF Issue No Issue Summary No. 1, p. 14

15 approaches. Another benefit of such an approach is that it relies on existing terminology used in evaluating the software in arrangements. Taking the computer example discussed in View B, assume that the operating system was considered essential to the functionality of the computer; the computer would be viewed as two deliverables under View C. 32. Opponents of this approach do not agree that this software should be considered a separate deliverable. These opponents believe that the hardware and software are both integral to providing the functionality of the product and should not be separated. They believe this model would be inconsistent with how practice has identified deliverables and would result in a significant change for many entities. These opponents also believe that such a model would create significant complexity in that entities would now be required to estimate a value for the essential software even if it is not sold separately. This would introduce more subjectivity into the estimation process and many times may be viewed as arbitrary. Such an approach could have a significant impact on many entities and these opponents believe that such a change should not be made unless it is within the context of the joint revenue recognition project, minimizing the likelihood that entities would need to change their revenue models multiple times. 33. If this approach is taken, the Task Force may also need to consider how to account for undelivered items that relate to the combined product. For example if support services are provided that relate to both the software and non-software components of the product, a question arises about whether the revenue allocated to the support services should be associated with the software deliverable, the non-software deliverable, or a combination of both. 34. Some opponents of View C also question whether this approach would address the practice issue it is trying to solve. They believe that in some cases, the non-software component of the combined product would not have standalone value as defined in Issue 00-21, paragraph 9(a). If this component was now accounted for under Issue (Issue 08-1), View C opponents believe that revenue may still not be recognizable for that component on a standalone basis. EITF Issue No Issue Summary No. 1, p. 15

16 Measurement Issues 3 through 7 only have to be addressed if the Task Force selects View B for Issue 1, otherwise, continue to the Disclosure and the Transition and Effective Date sections. 35. If the Task Force chooses View B for Issue 1, the staff believes that there are two approaches that could be taken. One approach could be to align the measurement criteria in SOP 97-2 with that in Issue The other approach could be to take a more targeted approach and only modify the measurement criteria for specific elements within a software arrangement. Those approaches are discussed further in Issue 3. The Working Group supported the application of an Issue 08-1 model but believed that the better approach to accomplish this would be to modify the measurement criteria within SOP 97-2 rather than nullifying the SOP in its entirety. That is because there are various other matters addressed in SOP 97-2 besides measurement, and re-evaluating each of those matters could unduly delay reaching a consensus on this Issue. 36. Issues 4 7 of the Measurement section of this Issues Summary analyze the potential changes to SOP 97-2 that might occur and additional issues that the Task Force would need to consider if the Task Force were to allow the use of TPE and estimates within SOP 97-2 consistent with Issue To further assist the Task Force in understanding the impact a measurement change would have on SOP 97-2, the staff has also provided a marked draft of SOP 97-2, related examples, and technical practice aids in Appendix 09-3B. Issue 3: If the Task Force chooses to address measurement in Issue 1, how the measurement criteria within SOP 97-2 should be modified. View A Align the measurement criteria in SOP 97-2 with Issue Application of this view would require an entity to use TPE or an estimate of the selling price to allocate arrangement consideration to the undelivered elements in a software arrangement, if VSOE does not exist for those elements. View A proponents believe that one of the primary benefits of this Issue will be to reduce complexity by reducing the use of industry specific models. Aligning the measurement criteria with Issue 08-1 would simplify the EITF Issue No Issue Summary No. 1, p. 16

17 accounting for revenue transactions because revenue would be recorded to reflect that part of the earnings process has been completed for hardware and software arrangements. View A proponents believe that reasonable estimates can be made for all elements within a software arrangement. They believe that even when there is significant subjectivity involved in estimating the value of certain elements, allocating and recognizing that revenue based on an estimate is still better reporting and more reflective of the value delivered to the customer than recording no revenue at all, which can be the case currently under the SOP. They also point out that industry specific measurement criteria is not expected to be provided in the joint revenue recognition project and that a View A approach is conceptually consistent with the direction of the joint revenue recognition project, reducing the likelihood that entities would need to change their revenue accounting multiple times within a short period. Many members of the Working Group stated that they believed that reasonable estimates could be made for all undelivered elements within software arrangements. 38. Some View A opponents believe that changing the measurement for all software transactions to allow measurement of selling price based on TPE or management's best estimate of selling price is such a significant change to practice that it should be done in the context of the joint revenue recognition project, if at all. They note that the revenue recognition project has resulted in a discussion paper and that the ultimate revenue recognition model resulting from that project might differ significantly from the joint boards' preliminary views. Other opponents of View A would not support a wholesale change to the measurement of all software transactions but might support using TPE or management's best estimate for certain elements within software arrangements. View B: Reconsider the application of the measurement criteria within SOP 97-2 based on the nature of the elements contained in the transaction. 39. View B proponents generally agree with the points raised in View A except that they are not certain that reasonable estimates can be made for all deliverables associated with software arrangements. However, they believe that for elements for which TPE is more likely to exist or for which reasonable estimates could be made, the measurement criteria could be modified EITF Issue No Issue Summary No. 1, p. 17

18 accordingly in order to improve the financial reporting for transactions involving those elements. These proponents believe that it would be more appropriate to consider all of the elements within software transactions when determining whether estimates can be applied, rather than focusing on just one element (hardware). These proponents believe that the scope approaches that focus on whether there is a hardware element to the more-than-incidental software transaction is incorrectly premised on the assumption that estimates of selling price cannot be made reliably for any pure software transactions but can be made for transactions that include a hardware element. They note that after the initial element is delivered (a software license or both a hardware license and a software license), the remaining obligations will have similar characteristics. They believe that it would be a better approach to this Issue to identify whether there are specific elements for which reliable estimates cannot be made and amend the measurement criteria within SOP 97-2 to allow estimates for all others. For example, it may be reasonable to estimate the selling price for PCS but not other types of contingent obligations, such as specified upgrades. 40. As noted above, the Working Group generally believed that reasonable selling price estimates could be made for software arrangement elements. However, there was not sufficient time to engage in detailed discussion of each of the various elements and scenarios that may exist within a software arrangement. Before concluding that measurement changes will not create significant additional application issues, the Task Force may want the staff to perform additional research into estimation methods for the various software elements. If significant estimation concerns arose for a particular element from such an exercise or from feedback received from other constituents, View B provides an alternative measurement approach that could be used to alleviate at least some of the concerns with the SOP 97-2 model that are no longer deemed necessary. Issue 4: If the Task Force chooses in Issue 3 to align the measurement criteria in SOP 97-2 with Issue 08-1, whether the residual allocation method should be retained within SOP 97-2 if the Task Force decides to eliminate the residual allocation method for arrangements subject to Issue EITF Issue No Issue Summary No. 1, p. 18

19 41. The Task Force retained the residual allocation model in the consensus-for-exposure for Issue 08-1 when VSOE or TPE does not exist for all units of accounting in the arrangement. At the March 19, 2009 EITF meeting, the Task Force is expected to consider whether it wants to revise that consensus-for-exposure to eliminate the residual allocation method and require the allocation to be based on the relative selling prices of each of the units of accounting. This allocation would be required even if the selling prices of some or all of the elements are based on estimates. Issue 4 is only relevant if the Task Force decides to change the consensus-forexposure in Issue View A: Retain the residual allocation method within SOP Proponents of View A believe that the residual method should be retained within SOP 97-2 even if an allocation based upon relative selling prices is required for Issue These proponents note that the use of the residual method is pervasive throughout the software industry even though SOP 97-2 requires a relative selling price allocation to be used when VSOE exists for all units of accounting in the arrangement. This is because it is uncommon that VSOE exists for all elements within a software arrangement, particularly with respect to the license. Often times the license is not sold separately and the license fee can vary significantly. However, many software entities are still able to recognize revenue for the license using the residual method. Accordingly, modifying the measurement criteria to allow TPE and estimates of the undelivered elements while retaining the residual method would improve the ability to separate software deliverables without significantly changing practice for many entities that utilize the residual method effectively. Proponents of View A do not believe that the conceptual superiority of the relative selling price allocation model (which allocates consideration without bias) outweighs the additional costs and effort that would result from the pervasiveness of the change. The broader change to relative selling price for the entire industry could then be made upon adoption of the new revenue recognition standard if the Boards decide to adopt that approach. 43. Opponents of View A note that many of the points raised by View A proponents were also raised as reasons for retaining the residual method within Issue These opponents believe EITF Issue No Issue Summary No. 1, p. 19

20 that it would be inconsistent to retain the residual method in the software model while requiring relative selling price to be used for arrangements under Issue View B: Eliminate the residual allocation method within SOP Require the allocation to be based on the relative selling price for all units of accounting in the arrangement. 44. View B proponents do not believe that the characteristics of software arrangements should warrant a different conclusion on the use of the residual method than that reached in Issue View B proponents believe that complexity is increased when different accounting models exist for similar arrangements. They also note that the residual method is a conservative, anti-abuse based model that exists due to concerns that a discount will be inappropriately allocated to undelivered elements resulting in premature revenue recognition. That is, the residual approach introduces an inappropriate conservative bias into the allocation of consideration. View B proponents note that if the Task Force reaches a conclusion to eliminate the residual method in Issue 08-1, then it would have had to decide that the relative selling price model improves financial reporting and that such an improvement outweighs the concerns that abuse may occur or that entities would be required to change their existing practice. They also note that there are likely many deliverables within the scope of Issue 08-1, such as licenses of intellectual property, for which the estimation of selling price is highly subjective. 45. View B opponents believe that the characteristics of software arrangements may be different due to greater subjectivity in estimating certain elements. Therefore, those opponents believe that it would not necessarily be inconsistent for the Task Force to eliminate the residual method in Issue 08-1 but retain it in SOP 97-2 for the reasons discussed in View A. Issue 5: If the Task Force chooses in Issue 3 to align the measurement criteria in SOP 97-2 with Issue 08-1, whether the subscription accounting guidance in paragraphs 48 and 49 of SOP 97-2 should be retained. 46. The subscription accounting model recognizes all software related product revenue from the arrangement ratably over the term of the arrangement beginning with delivery of the first EITF Issue No Issue Summary No. 1, p. 20

21 product. The subscription accounting guidance in paragraphs 48 and 49 of SOP 97-2 specifically applies to situations in which a vendor agrees to deliver software currently and to deliver unspecified additional software products in the future (including unspecified platform transfer rights that do not qualify for exchange accounting). For example, the vendor may agree to deliver all new products to be introduced in a family of products over the next two years. These arrangements are similar to arrangements that include PCS (when-and-if-available upgrades) in that the future deliverables are unspecified. AcSEC, however, believed that there was a distinction between unspecified additional software products and unspecified upgrades because they did not believe that VSOE of an unspecified additional product could exist. Nonetheless, AcSEC was concerned that deferring all revenue from an arrangement would be unduly onerous, and therefore created the subscription accounting model as a practical compromise. 47. Subscription accounting is also used to account for sales of software licenses with PCS when VSOE for PCS does not exist. If the Issue 08-1 measurement model is applied, subscription accounting would no longer be applicable to these situations. View A: Retain the subscription accounting guidance in paragraphs 48 and 49 of SOP Proponents of View A believe that this guidance is still necessary due to concerns over the ability to estimate the value of unspecified future products. They do not believe that a reasonable estimate of the value of future unspecified additional products can be made. They would therefore choose to retain that guidance. They also believe that this guidance is necessary in accounting for in-substance subscriptions referenced in paragraph 12 of SOP There is minimal guidance on in-substance subscriptions in SOP 97-2, however, that guidance is applied in practice to the sales of licenses of some software products (for example, anti-virus software) that are sold with unspecified when-and-if-available upgrades or updates that are routinely provided on a frequent basis, perhaps even daily or hourly. The nature of the product is such that the value of the license may be fairly minimal without these updates and the arrangement may be considered more akin to that of providing a service over the arrangement term as opposed to a product sale. View A proponents believe that subscription accounting still serves a useful EITF Issue No Issue Summary No. 1, p. 21

22 purpose and retaining this guidance would limit the impact this Issue would have on software arrangements. View B: Eliminate the subscription accounting guidance in paragraphs 48 and 49 of SOP View B proponents believe that the subscription guidance is unnecessary. They believe that estimates of those elements should be allowed consistent with any other undelivered element. While there may be more subjectivity associated with estimating unspecified software products, View B proponents do not believe that the estimation concerns warrant the deferral of revenue relating to a delivered software product that provided value to the customer. With respect to insubstance subscriptions, View B proponents believe that the measurement model provides an adequate basis for allocating the revenue between the license and the updates. If the license has minimal value without the updates, View B proponents would expect that to be evidenced in the allocation of the revenue to the elements. Therefore, View B proponents believe that the reference to in-substance subscriptions in paragraph 12 of SOP 97-2 could also be eliminated. Issue 6: Paragraph 37 of SOP 97-2 requires that the amount allocated to a specified upgrade right be reduced based on an estimate of customers not expected to exercise the right ("breakage"). If the Task Force chooses in Issue 3 to align the measurement criteria in SOP 97-2 with Issue 08-1, whether the guidance in paragraph 37 of SOP 97-2 relating to breakage should be retained. View A: Retain the guidance in paragraph 37 of SOP Proponents of View A believe that AcSEC's rationale for allowing breakage is still sound in that not all customers will choose to exercise a specified upgrade right whereas they will choose to receive unspecified upgrades and unspecified additional software products. Therefore, AcSEC permitted the amount allocated to specified software upgrades to be reduced by an estimate of customers not expected to exercise the right. EITF Issue No Issue Summary No. 1, p. 22