VSOE and your business

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 [email protected].