As we have noted in previous posts, the current software revenue recognition rules require that any products with “more-than-incidental” software components comply with SOP 97-2. Under this standard, contract elements are accounted individually and a market price is determined for each element. There are multiple ways to determine the market price of an element but one of the more common approaches is to track sales price and graph it using the bell curve approach. When a firm cannot establish VSOE for an element, the revenue has to be deferred until the commitments within the contract have been completed. Companies that have to comply with software revenue recognition rules know that establishing VSOE can be very painful. Luckily, the FASB is introducing new rules that will reduce the complexities of VSOE compliance.

Evolving rules of VSOE

In 2009, the FASB introduced EITF 08-1 and EITF 09-3. Both standards change the rules regarding software revenue recognition. One of the more significant changes is modifications to the criteria regarding VSOE compliance. Previously, firms could not separate a contract element unless they could prove that it had some kind of individual value to the market. This value was established through VSOE compliance. The new standard created a hierarchy of ways to determine the market value of an element.

The new rules state that if VSOE is available, it should be used to determine the fair value of an element. If it is not available, then Third Party evidence like a competitor’s price for a similar product could be used instead. And if neither of those were available, the rules now allowed for management to determine an estimated sales price for the element.

New VSOE rules for software companies

Although we have discussed how VSOE affected Apple in an earlier post, it is worth discussing them again in order to understand how the new rules affect software companies. In 2007, Apple released the iPhone, a product that involved both hardware and software components. To support their product, Apple committed to customers that they would release “free software updates” over the life of the phone. These software updates probably had not been designed yet and Apple had little understanding of either their costs or their market value. Since VSOE had not been established, revenue from the sale of the phone was spread evenly over two years, the expected life of the phone.

This led to a large amount of deferred revenue on Apple’s balance sheet. By 2009, it had grown to nearly $4 billion in deferred revenue. When the FABS introduced EITF 08-1 and EITF 09-3, Apple jumped at the chance to recognize revenue it had previously deferred because it could not establish VSOE. The balance sheet effect of the new rules was huge:

Effect of new rules on Apple's balance sheet

The changes allowed Apple to recognize revenue based on the estimated selling price. Instead of waiting years to recognize the revenue, they were able to estimate a selling price and recognize more upon the initial sale of the iPhone.

If your company is affected by these rules, Bi101 can help. Contact us and we will provide the guidance you need to navigate the various revenue recognition rules.