US GAAP – Revenue Recognition 

Are you thinking of adopting or converting to US GAAP either for an IPO or potential acquisition by a US reporting entity?  Well, for a technology company, usually one of the key areas of concern is revenue recognition which is what I’m going to discuss briefly in this presentation.

My name is Krista Pound and I work for KPMG in London in our US Accounting & Reporting Group.

 I should note that there is an Exposure Draft on Revenue Recognition which is intended to apply to all industries and also to converge with IFRS, but until that is finalized, we must utilize the existing technical literature to apply US GAAP to revenue arrangements – and current guidance is what I’m discussing here.  There is a separate presentation covering the ED which can be accessed for your reference.

Now, in the technology sector, whether specifically software or otherwise, multiple-element or bundled arrangements are commonplace.  The guidance under US GAAP is extensive and sits within section 605 of the FASB codification.  Beyond that there is also an abundance of industry specific guidance and one of  the key issues I always stress to companies is to make sure they ascertain which piece of literature they are within the scope of – get that wrong and you can easily head down the wrong path. 

For all industries, there are four key principles:

• Persuasive evidence of arrangement
• Delivery and performance
• Fixed and determinable sales price
• Collectability is reasonably assured

These 4 concepts may sound simple enough but applying them in practice may get tricky especially in bundled arrangements or when it relates to services or intangibles.  And don’t forget, the auditors and internal controls over financial reporting processes require sufficient evidence to support your conclusions.  But what I really want to focus on here is the literature applicable to software companies and to non-software entities with multiple element arrangements.

Software companies take note – in looking at how to apply the literature, you may actually be outside the scope of software revenue recognition.  Current US GAAP guidance excludes tangible products with both software and non-software components from the software guidance if those components function together to deliver the product’s essential functionality.  You would assume that the SW elements are essential to the functionality if sales without the SW are infrequent.   An example would be a personal computer sold with an operating system.  In addition, undelivered elements related to “essential” software are also scoped out.

You are probably wondering what this really means?  Let me boil it down for you – if you are within SW revenue recognition guidance, you have a higher threshold of evidence required to recognize revenue– this being that you must have Vendor Specific Objective Evidence of fair value (or VSOE) in order to recognize revenue for the sale of that product.  Absent VSOE, recognition is delayed.  Don’t forget you still have to meet all the other criteria but obtaining VSOE is specific for software providers.  If you are outside SW literature, there is a hierarchy of evidence required, but in almost all cases, it is expected that a value can be ascribed to individual deliverables.  I will touch on the hierarchy a bit more later.

If I focus on software providers for a minute- the 4 basic principles are similar but not exactly the same and have some key considerations which are:

1.      Persuasive evidence of arrangement  - are there any side agreements, what is the normal practice for the entity: written contracts, master agreements, online orders, are there different practices which vary by customer type?

2.      Delivery has occurred – is this physical or electronic delivery?  Is delivery to someone other than the customer? Are there any bill and hold transactions?  What if delivery happens prior to commencement of the license term?  What about customer acceptance provisions, warranty obligations or multiple licenses?  What do you do for usage based fees?

3.      Fixed or determinable fees and 4. collectability – are there extended payment terms?  What about rights of return?  Is collectability probable – this is different to ‘reasonably assured’ as set out for other industries?

Now – what about multiple element arrangement for software sales? Think upgrades, postcontract customer support (or PCS) or other services. This is where the key VSOE guidance kicks in – if an arrangement includes multiple elements, the fee shall be allocated to the various elements based on vendor-specific objective evidence of fair value, regardless of any separate prices stated in the contract for each element. Vendor-specific objective evidence of fair value is limited to the following:

a The price charged when the same element is sold separately

b For an element not yet being sold separately, the price established by management having the relevant authority; it must be probable that the price, once established, will not change before the separate introduction of the element into the marketplace.

I could go on for hours on this topic but as we don’t have time for that, all I’ll say is that the literature has guidance on how to allocate when VSOE is not available, when discounts are provided and also sets out exceptions to the general rules.  Establishing VSOE for a company’s different elements should not be rushed.  If you are firmly within the Software revenue recognition guidance, spend the time to work through the literature as the application of the detailed guidance can be time consuming and difficult. 

I will now move on to multiple element arrangement accounting when it is not a software sale. 

• If a multiple-element arrangement meets both of the following criteria, the delivered item(s) is a separate unit of accounting:

1. Delivered items have stand-alone value to the customer.
2. This is demonstrated if the seller or its competitors sell an item separately or if the customer could resell the item, recovering a substantial portion of the fair value (i.e. not for scrap).
3. If arrangement includes a general right of return, delivery of the undelivered items is probable and substantially in the control of the vendor.
4. General return rights include the right to return delivered items for any reason, including subjective matters (e.g. dissatisfaction with the product or inability to resell). Whether delivery is probable and substantially under the vendor’s control should be analyzed on a case-by-case basis considering historical experience as well as forecasts. If a deliverable does not meet the separation criteria, then combine it with other deliverables into a single “unit of accounting” and recognize revenue using the 4 basic principles discussed earlier 

• Once you have your units of accounting, the total arrangement consideration is then allocated among the deliverables based on their relative selling prices in accordance with the following hierarchy: 

1. VSOE – is generally the price that a vendor charges when it sells a product or service on a standalone basis. 
2. Third Party Evidence (TPE) – is generally the price at which a competitor or third party sells the same or similar deliverable on a standalone basis.  TPE may also include a vendor’s standalone selling price for similar and largely interchangeable products or services but not the same product or service.
3. Estimated selling price (ESP) – the price at which the vendor would transact if the deliverable were sold by the vendor regularly on a standalone basis.  The vendor considers market conditions as well as entity-specific factors when estimating a selling price.

In deciding whether the vendor can determine VSOE or TPE of selling price, the vendor cannot ignore information that is reasonably available without undue cost and effort.  What this means it that you cannot simply jump to using ESP as your basis of allocation – THIS is a hierarchy and we are no longer talking about software specific guidance!  Entities should use VSOE if they have it, TPE if VSOE is not available and may only default to the use of estimated selling price if neither VSOE nor TPE exists.

One thing I should point out is that companies must consider whether there are any contingent revenue provisions.  A contingent revenue provision is a customer right to not pay for or return a delivered item, only if the seller does not complete performance under the arrangement.  A vendor cannot allocate more to a delivered item than the amount that is NOT contingent on delivery of additional items or meeting other specified performance conditions (meaning the non-contingent amount).

Now, I’ve briefly covered just 2 aspects of revenue recognition under US GAAP:

• Software industry guidance and
• Multiple element arrangement accounting for arrangements outside the scope of the software literature.

Under IFRS, general revenue recognition requirements exist within IAS 11 and IAS 18.  But there is no specific accounting guidance for software revenue recognition or multiple deliverable arrangements, but some general guidance exists within the Appendix to IAS 18.

For Multiple Element Arrangements,  IAS 18.13 suggests that an arrangement with multiple-elements requires separation into the separate components and recognition of revenue should be determined separately for each component. 

However, there is no guidance on how to allocate value to each separate component and therefore in practice some entities follow the guidance within US GAAP, but other methods are permitted for allocating value such as the expected costs plus a reasonable profit allocation..

Therefore in practice, the specific and detailed guidance  in US GAAP will often create differences with IFRS.

For your reference, the key pieces of literature discussed here are:

ASC 605-25    Multiple Element Arrangements

ASC 985-605  Revenue Recognition - Software

Thank you