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Software is sold in one of two ways; either the code is sold outright or it is licensed. There are a few companies in the business of selling straight code, but their numbers are declining each year. Most software companies believe there is more value in pursuing a licensing model rather than straight sales. Due to the prevalence of licensing agreements within the industry, software companies need to understand the appropriate software license revenue recognition rules.

Inadequate software license revenue recognition techniques can lead to revenue losses

Courtesy of mid-east.info

A software license consist of three main parts:

  1. Rights – A license grants the customer end user rights to the software.
  2. Terms – The license usually contains some sort of period of service, usually expressed in time (hours, weeks, months, years, perpetuity, etc.).
  3. Liability – The license usually contains provisions that allocate responsibility and liability between the vendor and the customer such as warranties and disclaimers.

These parts can be interchanged to create several different licensing types including proprietary, workstations, site, and perpetual licenses. Each of the different models modifies the user rights, terms, or the provisions associated with the software. However, for revenue recognition purposes, we will only consider two types; perpetual and term based licenses.

Perpetual licenses and software license revenue recognition

According to SAB 104 and software license revenue recognition rules, revenue for both perpetual and time based licenses can be recognized when the licenses are delivered as long as a firm has satisfied the following rules:

  • An arrangement with the customer exists
  • Collection is probable
  • Price can be determined

It is the last point that usually catches software companies. Most software licenses are sold as bundled deliverables that include both license and post contract support (PCS). If a software company wishes to recognize revenue upon delivery, each of these deliverables must have their own fair value established through proof of Vendor Specific Objective Evidence (VSOE).  As long as VSOE has been established on each component, then revenue can be recognized upfront rather then deferred until contract completion.

Basic structure of a perpetual license for software license revenue recognition

Courtesy of softsummit.com

Term-based licenses and software license revenue recognition

Term based licenses are a little more tricky then the perpetual licenses. Calculating VSOE is more complicated, because all the previously mentioned rules apply as well. Most firms establish VSOE on PCS by examining the price paid when it is sold separately, or in other words, the PCS renewal rate. However, if the renewal rate period is less than one year, VSOE cannot be established. In other words, renewal rates cannot be used to establish VOSE on PCS if the duration of the renewal is less than a year and shorter in length than the initial bundled PCS term. If this is the case, revenue could not be recognized upon delivery but would have to be deferred until after the PCS is completed.

For term licenses that are less than one year in length and bundled with PCS, VSOE cannot be established on the PCS. For terms that are longer than one year, customers must have the option of renewing PCS for a length of time equal to the bundled period in order to establish VSOE.

Basics of term license software license revenue recognition model

Courtesy of softsummit.com

There are many differences in software license revenue recognition rules when accounting for a perpetual or a term license. At Bi101, we know these differences and can help guide you in the process. Contact us if you want to know more.