IMPORTANT NOTE: The information in this post is still accurate for current GAAP, until the ASC 606 standard is adopted. That will be in Jan 2018 for public companies, and Jan 2019 for most private companies.
Last November, Jeffrey Werner gave a two-part training course on revenue recognition that covered a wide range of topics including VSOE, multi-element arrangements, EITF 08-1, EITF 09-3, SaaS, FASB/IASB, and other revenue recognition issues. See the event details here and be sure to check out our Revenue Recognition page for more information on this topic!
Here are the questions posed during that webcast, along with Mr. Werner’s responses.
Question 1: We have a sales promotion running whereby the customer buys 3 products (SKU #ABC) and gets a free product (SKU #XYZ) at the time of purchase. The selling price of SKU #XYZ will be discounted to zero so I am fine with that. My question is what about the COGS for that product, should it be reclassified as a selling expense or should it flow through COGS?
Response: The free products would be considered revenue elements and be allocated revenue based on ESP and the relative selling price. If all priced and free items are delivered at the same time then revenue recognition is not an issue.
- The cost of the free goods would be cost of goods sold just like the priced products.
- There may be a different accounting for items that are not regular products.
- See 605-25 payments and customer incentives
Question 2: I have read 605-25 and have a follow-up question. If the free item is delivered at a later date I am assuming that at the time of the original transaction that we would need to allocate the additional discount to the priced and delivered items?
Response: At the inception of the contract, the free items would be treated the same as all elements and receive revenue allocation based on ESP (Estimated Selling Price). Then – when delivered – that revenue would be recognized, just like the other deliverables.
If the free items (which are not products of the vendor) were not included in the contract but were a later item for sales promotion or other purpose, you would need to consider if they should have been included in the contract and allocation or if they meet the conditions of an other incentive that is expensed.
Question 3: I am currently working on a policy regarding tiered discount based on future volume purchase. We have various scenarios, but what I struggled most is the scenario that amount of future discount is not clearly specified and pertains to purchase of multiple products, meanwhile, it is a significant and incremental discount (should be considered an additional element in a multiple-element arrangement?). Below is a summarized case for analysis: Vendor A enters into an arrangement to sell products M $200,000 (VSOE $250,000) and S $300,000 (ESP $320,000) to customer B for a total $500,000. Additionally, the vendor agrees to provide tiered discounts on all future purchases the customer makes based on quarterly purchase (see below tiered discount table). the vendor determines that the future discount is significant and incremental. Should the future discounts be considered an additional element at the inception of the arrangement? How to allocate the revenue at the inception of the arrangement?
| Quarterly Spend | Discount | |
| Tier 1 | 100,000 to 149,999 | 45% |
| Tier 2 | 150,000 to 199,999 | 50% |
| Tier 3 | 200,000 or above | 60% |
Response: Future discounts for additional copies of products in the original order are generally not considered incremental and significant discounts and therefore are not considered an element of the arrangement and do not receive revenue allocation. See below for TPA 50 which is now in the 985 codification section. Revenue allocation would be 44% (VSOE $250,000/Total value $570,000) to product M and 56% (ESP $320,000/ Total value $570,000) to product S based on the relative selling prices.
TPA 5100.50 – Definition of more-than-insignificant discount and software revenue recognition
Inquiry – As discussed in paragraph 3 of SOP 97-2, Software Revenue Recognition, in connection with the licensing of an existing product, a vendor might offer a small or insignificant discount on additional licenses of the licensed product or other products that exist at the time of the offer but are not part of the arrangement. Paragraph 3 indicates that those discounts are not within the scope of SOP 97-2. However, footnote 3 to paragraph 3 states that “[i]f the discount or other concessions in an arrangement are more than insignificant, a presumption is created that an additional element(s) (as defined in paragraph 9) is being offered in the arrangement.” What is a “more-than-insignificant” discount, as discussed in footnote 3 to paragraph 3 of SOP 97-2?
Reply – For purposes of SOP 97-2, a more-than-insignificant discount with respect to future purchases that is provided in a software arrangement 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. Insignificant discounts and discounts that are not incremental to discounts typically given in comparable transactions (for example, volume purchase discounts comparable to those generally provided in comparable transactions) are not unique to software transactions and are not included in the scope of SOP 97-2. Judgment is required when assessing whether an incremental discount is significant.
The provisions of footnote 3 to paragraph 3 of SOP 97-2 should not be applied to 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. In that case, revenue should be recognized as the rights to additional copies are purchased, based on the price per copy as stated in the arrangement. Additional copies of delivered software are not considered an undelivered element. Paragraph 21 of SOP 97-2 says that duplication of software is considered incidental to an arrangement, and the delivery criterion is met upon the delivery of the first copy or product master.
Question 4: We use a bell-curve approach to establish VSOE (80% of standalone maintenance purchases are within +/- 15% of the medium of the VSOE study. When a carve-out is required, would we carve out to the VSOE price (median price established from the study), or do we carve out to the minimum of the VSOE range (+/- 15% of the VSOE price)?
Response: When carving out for below VSOE sales, companies have the option of what point in the VSOE range to use. Most companies use the low end of the VSOE range. Other companies use the mid-point. This option should be applied consistently. As long as the value used to carve out is in the VSOE range, then the accounting is appropriate.
Question 5: if the customer has 90 days refund right? we have to wait 90 days to recognize revenue?
Response: Generally, yes. The fee is not fixed and determinable until the 90 day return period has expired. If there is sufficient historical data and experience, it may be possible to estimate the amount of potential returns and defer that amount instead of the entire arrangement value.
Question 6: When is delivery of license considered “delivered”?
Response: Licenses are considered delivered when the software or intellectual property is made available to the customer. For software this could be when the email is sent to the customer with the password and the download site. At that point, the customer can access and use the software. The software or intellectual property license term must also have begun.
Question 7: What if there is no PO and the master agreement is not signed and there is no order confirmation. What is acceptable arrangement if there is no signed contract or agreement?
Response: It is difficult to see how the evidence of the arrangement requirement is met if there is no PO, contract or other written documentation of the terms and conditions of the sale. Is there a legally binding contract? If not, it is difficult to see how revenue could be recognized.
Question 8: When allocating revenue using the relative selling price method, should certain billable expenses (i.e. shipping) be included in the allocation.
Response: Generally, billable expenses for shipping are not material and so they are not included in the arrangement. If they are material, the third party evidence of the shipping price could be used in the revenue allocation. Billable expenses for travel and other costs generally are not included in the revenue allocation because they have not been incurred at the outset of the arrangement and the amounts are not known.
Under US GAAP, billable expenses and shipping are considered revenue items accounted for as revenue rather than as a contra-expense.
Question 9: Is there a good test or list of questions out there that would help determine if multiple contracts are linked?
Response: Codification section 985-605-55-4 (formerly TPA 39) has the criteria:
Software vendors may execute more than one contract or agreement with a single customer. However, a group of contracts or agreements may be so closely related that they are, in effect, parts of a single arrangement and should be viewed as one multiple-element arrangement when determining the appropriate amount of revenue to be recognized in accordance with this Subtopic. The form of an arrangement is not necessarily the only indicator of the substance of an arrangement. The existence of any of the following factors (which are not all-inclusive) may indicate that a group of contracts should be accounted for as a single multiple- element arrangement:
- The contracts or agreements are negotiated or executed within a short timeframe of each other.
- The different elements are closely interrelated or interdependent in terms of design, technology, or function.
- The fee for one or more contracts or agreements is subject to refund, forfeiture, or other concession if another contract is not completed satisfactorily.
- One or more elements in one contract or agreement are essential to the functionality of an element in another contract or agreement.
- Payment terms under one contract or agreement coincide with performance criteria of another contract or agreement.
- The negotiations are conducted jointly with two or more parties (for example, from different divisions of the same entity) to do what in essence is a single project.
Question 10: I want to make sure I am following proper determination of methodology to utilize. I noted that software companies must continue accounting for revenue recognition under Residual Value methods and non-software companies under the Relative Selling Price, is that correct? If so, my question is on the determination of whether “company” is software or non-software. Is this determination made at the total company level ? If an acquisition is made of a clear software company by a non-software company, is the newly merged total company determined to be software or non-software and – going forward – what method should the business unit that was software utilize?
Response: The determination of whether a transaction is accounted for under software revenue recognition or “non-software” rules is made at a transaction level, not a company level. A company may have separate transactions that are accounted for under both methods.
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