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If your firm has to be compliant with SOP 97-2 software revenue recognition rules, then pricing matters a lot. It is only through tracking the sales price of a product or service over time that a firm can develop vendor specific objective evidence of fair value, also known as VSOE. For unprepared companies, VSOE calculation can be nightmare.

As we noted previously, SOP 97-2 (software revenue recognition) defines VSOE of fair value as “the price charged when the same element is sold separately.” Never within the minutiae of the SOP does the Securities and Exchange Committee define a single method for establishing VSOE. Neither do the volumes of guidance written on FASB software revenue recognition rules. Instead, many software firms (and CPAs) have adopted the bell-curve approach.

Bell Curve

Courtesy of newsteelconstruction.com

The objective of the bell-curve approach is to show that for the element in question, a significant amount of sales for that item occurred within a narrow range of prices.  As the sales reach a large enough sample, a bell curve (from statistics) should form, with the most common price accepted by the market as the highest point.  This test is also known as the 80/15 test, because it is only considered valid if 80% of the sales prices fall within 15% of the median price. To truly understand this method, an example is required.

Company A introduces a widget and offers post contract support (PCS) for that widget. Here is how the accounting would be recorded on the first 555 sales:

Sale #1: Since the company has not established VSOE of fair value, it cannot recognize any revenue until after the completion of the contract. However, it can record the price that the first customer accepted in the marketplace.

Sales #2-#554: The company still has not established VSOE of fair value and still cannot recognize the revenue until after the contract is complete. However, it has continued to record the final sale price (after discounts) for each of the sales that occurred.

Sale #555: Prior to this sale, someone in accounting realizes that they have a large enough sample of prices to determine the VSOE of the PCS and inputs everything into a spreadsheet. The final sales price of each sale is tallied and graphed in a chart similar to this:

VSOE Chart

Courtesy of slideshare.net

As you can tell by the chart, the median sales price is $1,000.  Also note that in this example, 94.8% of sales fall within 15% of the median sale price. Thanks to the customers who purchased the product, Company A was able to establish VSOE of fair value for this service. With this established, revenue can now be recognized as it is earned and not differed until the end of the contract.

Company B offers a similar PCS contract and would also like to establish VSOE of fair value. Even if it knows Company A’s median price, it cannot use that information to establish VSOE for its PCS. Instead, it goes through a similar analysis with the following results:

VSOE Chart2

Courtesy of slideshare.net

Unfortunately for company B, only 79.8% of sales fall within 15% of the median. It’s best to continue to differ all revenue until a clear picture of the markets value of the product emerges. Being persuasive to auditors can only go so far.

The bell curve is just one approach to establishing VSOE. Typically, in the past, companies needed to perform this work in-house, either via spreadsheets or on-premises accounting/finances software solutions. These might be manageable for a start-up or a small-but-growing operation, but those with dozens of employees and much higher revenues, there are much better options. It’s not just a matter of correct accounting—business compliance is a critical matter, and one that should be done correctly.

Bi101 specializes in complex NetSuite installations, and offers all the technical support our customers need. Let us know if you’d like more information and top-of-the-line software solutions that will make your VSOE calculation easier than ever.