Revenue Recognition in the Software Industry

I have a specific research question in the area of revenue recognition in the software industry. It’s a somewhat pragmatic one, as it relates to the arithmetical application of revenue recognition, not the determination of when or how revenue should be recognized. We are a Canadian company, but we have followed the AICPA guidance on software revenue recognition - Statement of Position (SOP) 97-2, "Software Revenue Recognition," and SOP 98-9, "Modification of SOP 97-2 Software Revenue Recognition”. I don’t believe that this question is addressed specifically in any of that guidance material or in SAB 101, although I could easily be incorrect on that point. We are a small company, with revenues around $10 million U.S., founded in 1999. The matter discussed below would be material to our operations.

We license software pursuant to individual contracts, and the agreement usually calls for an up-front fee, usually described as an installation fee, as well as an ongoing royalty arrangement based on the use of the software. We have concluded for several years that we have one accounting unit for these arrangements, and as we provide PCS [Personal Communication Services] in the areas of upgrades and support and maintenance, we have considered the upfront fee a revenue component to recognize ratably into revenue.

To date, we have used the term of the contract as the amortization period. As a matter of practice, the term of our contracts is not fixed, as the term is not a matter that we consider important from a negotiation perspective. The term will usually reflect the wishes of the other party. Accordingly, the term varies from one year to 25 years, with the average around three years.

We want to have a minimum three-year contract to provide us with a reasonable ability to profit from the relationship. Historically, either the contract gets extended, which may or may not include renegotiated commercial terms, or the contract is breached prior to the expiry of the term, which is a separate consideration. Contracts may also be amended for commercial reasons during the term of the contract. The point is, in no case that I am aware of has the renewal date of the contract been relevant in determining the length of the business relationship. On extension of the contract, or renegotiation of the contract, there is never a new up-front fee.

The question is whether the term of the contract is an appropriate amortization period for ratable recognition for the up-front fee, or whether an estimated period representing the anticipated length of the business relationship is appropriate. We acknowledge that there is merit to using the estimated business relationship period. Our principal rationale for using the term of the contract was that we previously had insufficient history to reasonably estimate the period of the business relationship and, therefore, the term of the contract could be considered a reasonable proxy for that period. Now that our company has more history, the quality of the argument that we have insufficient history is deteriorating, and we could likely estimate a business relationship period.

As we assess this matter and discuss it with our auditors, we would greatly appreciate hearing from anyone has any pragmatic advice on how this matter has been addressed by other companies. I don’t think the royalty stream is actually relevant in this case, because the question of whether the amortization period is the term of the initial contract or the length of the relationship would still apply.

It seems to me that one of the issues with using the business relationship period is that it would be an ever-changing figure based on experience, and it probably would be an increasing period as our company continues to grow. Every year that licensees continue to deal with us, our estimate of the period of the business relationship would extend by another year. We could thus end up adjusting our amortization period annually, creating a significant administrative burden and perhaps a situation where the up-front fee might never be fully amortized into revenue – not a sensible result. Alternatively, for contracts in place, the estimated business relationship period might not be amended for new experience. Any revision to the estimate would only be applied to new contracts, which could result in up-front fees being amortized over different periods, depending on when the contract was executed. This might not be any more logical than using the term of the contract.

This matter may be unique to us, but any feedback on what other software companies have done in this area would help us ensure that whatever we do here is sensible and is in conformity with standard practice. I’d be happy to provide further background around the question if that would be helpful. I also recognize that it might be tough to find a precedent here.

Anonymous

Response:

We have contracts that can run for two to five years and can be extended. We have found that making the contracts match what one wants to do for revenue recognition is not usually an issue with customers, assuming, of course, that one’s revenue recognition objectives match the business reality. Therefore, we have continued to recognize revenue over the contractual period (before any optional extensions).

As an aside, we also faced an issue when the license period runs for a fixed period, from the date of the customer’s general release to its customers, rather than our release to our customer. That creates an issue as to how to recognize revenue before the customer’s expenses. Ordinarily, one would take the fixed revenues and amortize them over a fixed period, but when the period is unknown, that’s rather difficult. We finally concluded that we could not recognize any revenue for these contracts until the customer released the software to its customers, and the license period was known. In the unlikely event of them accepting the software but never shipping, we would recognize revenue in one lump sum, once it became clear that that was the case.

Nicholas C. White (nick.white@transitive.com )

Response:

Your question about software revenue recognition is timely and well-placed. Let me state up front that while I have about 25 years of experience with software revenue recognition, most of them as a software company CFO or Controller, I am not a CPA, so this answer will be light on GAAP-speak. The truth of the matter, though, is that GAAP can support a number of different approaches. So you should also be focused on what is most meaningful to your investors and your management team.

The bottom line is: NO, the term of the initial agreement – generally the maintenance/support agreement – is not a reasonable basis for amortizing the up-front license fees, for exactly the reasons you bring up yourself. The single most important reason is that while the term of the initial agreement is objectively verifiable, and therefore helps you get through an audit, it’s unrelated to the length of the expected business relationship.

Ratable revenue recognition has some major advantages: 

1. It makes future reported revenue more predictable and less prone to large period-to-period fluctuations. This is nice, and it’s the argument usually cited first, but not so impressive once you understand that it’s the accounting math, not any fundamental business change, that creates the smoothed revenue.
2. Reported revenue is less sensitive to slight changes in the deal structure that are at best incidental to the basic business relationship, or to the timing of the deal, or (even worse) to business concessions that are not in the company’s interest but make revenue recognition easier. This is a real, and important, advantage. But the approach you’re asking about fails here, because recognized revenue can be affected (and even manipulated) by changing the length of the support agreement. Would you be comfortable explaining to investors that the recent spike up in license revenues was not due to closing more deals, but to shortening the term of all your new maintenance agreements? Hmmm?
3. Ratable revenue recognition makes life much easier with the auditors, because the more up-front revenue you’re trying to recognize, the more pressure on you to provide clean support for VSOE [vendor-specific objective evidence] on the undelivered elements. Many of us would say that establishing VSOE is the single most horrible aspect of software revenue recognition today, and for a company early in its revenue life, it’s virtually impossible. Not only that, but being flexible about how you structure the undelivered elements like initial implementation and technical support may be in the best interests of your company, but fatal to establishing VSOE. It’s a shame that the accounting rules place companies in this dilemma.

All of this suggests that ratable revenue recognition is a great idea, but you should find a basis for the term other than the length of the initial support agreement. And then stick to it. Reasons #2 and #3 above suggest to me that your auditors should be happy to work with you to establish an expected deal life that has a sound, defensible basis in how your fundamental business relationships are structured. Their lives will be easier as well. May they give you clean opinions to the end of your days!

Good luck!

Randy Bolten (RBolten@aol.com )