VSOE and your business Featured

8:00pm EDT July 26, 2008

Companies often struggle with revenue recognition when dealing with multiple-element contracts. Vendor specific objective evidence (VSOE) plays a significant role in the decision of when to recognize revenue and how much.

Smart Business asked Brian Woodman, CPA, senior audit manager at Tauber & Balser, P.C., to explain VSOE and outline the conditions for applying it.

What does VSOE apply to?

In the software industry, most revenues arise from vendors’ license fees associated with software. However, the amount and timing of the recognition of software revenue is complicated by multiple-element arrangements that provide for other deliverables in addition to the license fee — for example, software products, upgrades or enhancements, post-contract customer support (PCS), or other services.

Can you provide other examples of multiple elements?

Multiple elements might include specified or unspecified upgrade rights in addition to the software product as well as support after the software is installed. Often, the customer is quoted a single fee that must be allocated to the products delivered currently as well as in the future.

How does VSOE apply in this circumstance?
SOP 97-2, Software Revenue Recognition, requires that the invoice amounts be allocated to the various elements based on vendor-specific objective evidence of fair value for each element. VSOE is limited to the price charged by the vendor for each element when it is sold separately.

How is VSOE established?

Actually, there is no official way to establish the fair values of products within a contract. Tony Sondhi, author of the ‘Revenue Recognition Guide 2008’ and a member of Financial Accounting Standards Board’s Emerging Issues Task Force, has indicated that a bell-curve approach, where 80 percent of sales prices should fall within 15 percent of the median price, would be a very good guideline. But this is open to interpretation. The goal should be to demonstrate consistent pricing practices.

Also, the bell-curve approach does not provide a mechanism to handle new and newly acquired products. Also, it implies that each product is sold individually to get the sales data it needs, which isn’t always the case.

What happens if VSOE cannot be established?

Where VSOE does not exist, all revenue recognition is deferred until the earlier of the existence of VSOE or the delivery of all of the elements in the multiple-element arrangement. Pursuant to the modification of SOP 97-2 in AICPA Statement of Position (SOP) No. 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions, the residual method must be used where VSOE exists for all undelivered elements but not for one or more of the delivered elements. In these situations, the undiscounted VSOE fair value of the undelivered elements is deferred, and the residual or difference between the total arrangement fee and the deferred amount for the undelivered elements is recognized as revenue for the delivered elements.

Are multiple element arrangements limited to the software industry?

Not at all. Other common examples arise in industries such as the sale of computer networks or other specialized equipment and installation and training.

Will International Financial Reporting Standards have any effect on VSOE?

Being principles-based, International Financial Reporting Standards (IFRS) currently contain no industry specific guidance regarding revenue recognition that allows companies selling software more latitude in their pricing policies and related revenue recognition than under generally accepted accounting principles (GAAP). While the SEC is still considering whether U.S. companies can report using IFRS, foreign filers already have this alternative and since November 2007 do not have to reconcile IFRS results of operations to GAAP earnings. As more foreign technology firms submit filings using IFRS, there will be increasing pressure to allow U.S. firms to adopt these standards.

In the meantime, can you recommend any strategies to help establish VSOE?

  • Maintain accurate records of actual selling prices for products: A price list is not sufficient to establish VSOE.

  • Rein in the sales force: Eliminate the number of one-off deals, since side agreements and special concessions will complicate establishing VSOE.

  • Compensate the sales force in a manner consistent with GAAP: Pay commissions only when sales contracts are consummated, in the same way that revenue is recognized.

  • Be prepared to defend your pricing policies with data of the prices that you have actually charged your customers.

BRIAN WOODMAN, CPA, is a senior audit manager at Tauber & Balser, P.C. He has more than eight years of public accounting experience with a concentration in assurance and attestation services for both publicly held and privately owned companies. He has worked extensively in the technology, manufacturing and wholesale distribution industries, among others. Reach him at (404) 814-4967 or bwoodman@tbcpa.com.