In the late 1970’s, the microcomputer were introduced and the personal computer industry was born. The industry could be divided into two groups; there were companies that sold hardware and there were companies that sold software. Under the newly established Financial Accounting Standards Board (FASB), revenue recognition rules were fairly straightforward, focusing on when income was realized and when it was earned. Since those early years, the industry has evolved and the rule of revenue recognition has changed to try and keep up.
During the 1980’s, software sales began to evolve. They moved from a programmer sending a disk with a copy of the software on it to the creation of individual software licenses where each instance installed on a computer would be counted as a license. Software companies also began to offer support and upgrades to their customers during this decade.
The evolution continued in the 1990’s. Companies began to sell “bundled services,” offering both a software product and support for that product. These bundled services were usually sold at a single price to the customers. In addition, as the internet took off, new software models emerged such as Software as a Service (SaaS) and cloud computer services.
Towards the end of the 1990’s, the FASB realized that their current accounting rules of recognizing income when it was realized and earned were not detailed enough. Bundled or multi-elemental sales made recognition rules more complicated to navigate. For example, with a service contract, when is revenue realized?
They began to evolve the rules as well. On October 27, 1997, the American Institute of Certified Public Accountants issued SOP 97-2 as guidance to these complicated issues. It was issued to address software revenue recognition rules and provide revenue guidance to anyone that included software in a product. This SOP led to the introduction of Vendor Specific Object Evidence of fair value for each element, also known simply as VSOE. VSOE is the price that would be charged for each individual element in a bundle sale, had each element been separated and sold separately.
In 2003, the Securities and Exchange Commission (SEC) released SAB No 104 which provided guidance on recognizing revenue. They created 4 criteria to guide revenue recognition for software companies.
Some are tempted to believe that SOP 97-2 software revenue recognition rules and VSOE compliance are only applicable to the software industry. Although true, software is still evolving and findings itself embedded into more and more products. For example, cell phones, medical devices, and even cars are beginning to include software components and will have to abide by software revenue recognition rules. In determining whether an arrangement is within the boundaries of SOP 97-2, a vendor must determine whether a software component is more than an incidental part of the product or service. If it is a key component, then software revenue recognition applies.
Understand the history of VSOE will help in understanding how it is recorded and calculated. In the next few posts, we are going to walk through some of the more complicated issues associated with VSOE and revenue recognition and introduce you to solutions that can simplify its tracking and reporting.