Created by Bi101
One of the most magical and frustrating things about software is that it is customizable. If the initial software product does not solve the customer’s business problem, software companies can modify the code to address the customer’s needs. The customizability of code means that there are an infinite number of solutions to address the needs of a customer. However, according to revenue recognition GAAP rules, there are not an infinite number of ways to account for the sale of customized software.
The main difficulty with accounting on software modifications is when to recognize revenue on the software license. When a customized software product is sold, the contract may appear like any other software product. It usually includes a license for the software, an implementation component, and maybe some post-contract support. Since the contract appears the same, software companies may try to recognize the software license upon the signing of the contract. Unfortunately, their auditors would not agree with this decision.
Although the contract may appear the same to the casual observer, the revenue recognition GAAP rules require that revenue be deferred because of the following three reasons:
- Vendor Specific Object Evidence (VSOE) has not been established – As we have mentioned previously, if software companies wish to recognize licensing revenue immediately upon a sale, they need to have established VSOE over every element. Since a customized product has never been sold in the market, VSOE cannot be established.
- Revenue has to be recognized upon delivery – One of the main principals established by SAB 101 is that the product or service has to be delivered before revenue can be recognized. If the software has to be customized, then delivery has not occurred until a final product has been delivered.
- The product provides value to the customer – According to EITF 00-21, revenue can only be recognized if a product provides value on a standalone basis. Since the un-customized code does not provide value to the customer, revenue could not be recognized until the customizations have been completed.
The current GAAP guidelines state that for customized software, revenue must be recognized using long-term contract accounting. This means that the contract should include milestones or deliverables and licensing revenue should be accounted for using the percentage-of-completion method or defer all revenue until the contract is complete.
Courtesy of uidaho.edu
Of course, as the software business changes, so do the accounting rules. Currently the FASB and IASB have jointly proposed new revenue recognition guidelines that will have an effect on recognizing software licenses for customized software. The new rules try to address the three concerns listed above by determining when “control” is passed to the customer. The guidance states that “control” has passed to the customer when a usable copy of the software has been delivered. When “control” passes, then the licensing portion of revenue can be recognized.
Courtesy of nerc.imanet.org/
The revenue recognition GAAP rules will be changing drastically in the next few years. At Bi101, we are closely following the rules changes to understand their effect on the software industry. Contact us if you want to learn more.
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