In 1985, the FASB issued SFAS 86 dealing with the topic of whether to capitalize or expense computer software costs. It did not, however, address the related issues of revenue recognition from the sale and licensing of computer software. One primary issue is the timing of the recognition of such revenue. In a 1984 survey, the Association of Data Processing Service Organizations (ADAPSO) found that companies were using at least four different points in time to recognize revenue. The earliest recognition was at contract signing, while the latest was at the date of payment.

In April of 1987 the Accounting Standards Committee of the AICPA sent an issues paper on this topic to the FASB. As a result of this paper, the AICPA was asked to issue a statement of position (SOP), an exposure draft of which is expected by late 1989.

The purpose of this article is to discuss, clarify and condense the primary issues and subissues involved in the recognition of revenue for computer software products. It is based upon the 1987 AICPA issues paper and on the results of the ADAPSO survey.

Software Product Types

There are a variety of software products presently being marketed to the public. They consist of:

* Software that is licensed to end users for their own use, with no right to reproduce the software for resale to others;

* Software that is licensed to distributors for the purpose of reproduction and resale to end users;

* Contracts to develop and create software for end users;

* Service bureau operations that offer processing services and charge a subscription fee and a usage fee for the use of software owned by the service bureau. Payment for these different products can be required in total at contract signing time, or in installments over the life of the agreement. Pricing terms range from a fixed price to a variable price based upon the volume of usage.

Timing of Revenue Recognition

There are a number of different points at which revenue could be recognized from the above products. Revenue can be recognized at contract signing, deliverability, actual delivery, installation, acceptance, billing, or payment. Payment time is an unacceptable approach since it violates the accrual method of accounting. Billing is also theoretically deficient since it is discretionary and does not represent the point of completion of the transaction.

In the ADAPSO survey, 45% of the companies recognized some revenue at contract signing, 51% at installation, 44% at customer acceptance and 15% at some other event such as 30 day usage, 90 days after contract signing or ratably over two years. More than 80% of the companies also invoiced at the point of recognition of the revenue.

The Issues

Consider the simplest case first: the software company licenses its software to an end user. The software is deliverable--nothing needs to be done to complete or modify it before delivery. All that is required is for the delivery to take place. The collectibility of the licensing fee is assumed to be reasonably assured. The issue is: Should the revenue from these fees be recognized upon contract signing or upon delivery?

Those who favor contract signing believe that an exchange of rights has already taken place at contract signing and that delivery is incidental and should not be a factor in the accounting decision. They argue that a software license is not the sale of a product, but the sale of a right to use a product. Accordingly, the revenue recognition principles for product sales do not apply. Instead, they compare this to the licensing of films for television use discussed in SFAS 53, which states that delivery is insignificant and should not delay revenue recognition. They also observe that since under SFAS 86 much of the cost of software development is charged to expense, to delay recognition of the revenue until delivery would result in an improper matching of revenue with expense and a violation of the matching principle.

On the other hand, proponents of recognition upon delivery consider licensing of software to be, in substance, the sale of a product. Product revenue is ordinarily recognized at delivery, because that is considered to be the completion of the earning process. It is the delivery, and not the contract signing, that creates the customer's obligation to pay, and earlier payments are mere deposits rather than receipts of earned revenue. They also argue that the analogy to television films of SFAS 53 is incorrect, because the key criteria mentioned in that statement are availability and acceptance. For computer software, if the vendor needs additional time after contract signing to make the software available, then those criteria have not been met.

The advisory conclusion reached by the AICPA task force on this issue was to recognize the revenue upon delivery. A related subissue involves a situation where the customer, due to a lack of certain essential hardware parts, asks the vendor to delay delivery of the software. In this case, should the revenue be recognized upon contract signing, substantive delivery, or actual delivery?

Those who favor contract signing put forth the same arguments mentioned earlier. Even some of those who argued against contract signing would now be in favor of it, because the buyer's request to delay delivery is in and of itself a form of control over the product, thereby indicating an exchange of economic rights.

Furthermore, they hold that this is similar to "bill and hold" in product sales, which is covered in International Accounting Standard 18. According to that standard, if delivery is delayed at the buyer's request and the buyer takes title and accepts billing, revenue should be recognized as long as delivery is expected to be made.

Proponents of actual delivery contend that the "bill and hold" concept only applies to tangible products for which the buyer lacks the physical facilities to accept delivery. This is not the case for computer software.

A third group argues for "substantive delivery." This has been defined as the date on which the amounts due are billable, customer support services have begun, and the software has been prepared and segregated by the vendor and designated for delivery to the customer. Since all of these criteria have been met, in essence an exchange has occurred, and the location of the software should not be a factor in the revenue recognition.

The advisory conclusion was to use substantive delivery.

Sales to Non-End Users

Consider a different kind of marketing situation--a situation where the software is licensed to a non-end user such as a distributor or retailer who will reproduce the software for sale to eventual end-users. Such licenses differ significantly from licenses to end users. The issues revolve around the accounting for the nonrefundable fixed fees charged under the contract. The main issue is: Should the fixed fee be recognized at contract signing, upon delivery, or over the estimated period of use by the licensee?

Those who advocate contract signing do so because at that point the seller contractually delivers to the buyer the right to reproduce the software. Such rights have substance in and of themselves and are often sold separately from the right to use the product. Those who oppose feel that the sale of reproduction rights has no substance without delivery of the first copy, and therefore the vendor still has a significant obligation to perform. They also argue against recognition over the period of use because the obligation of the licensee to pay is not contingent whatsoever upon his using the license. Furthermore, because the period of use is unlimited, it would be too difficult to make an estimate of how long it will actually turn out to be.

In the ADAPSO survey, 8% recognized revenue upon delivery, 34% upon invoicing, 18% at the time of contract signing, and 24% upon payment. The rest used other arbitrary points in time.

The advisory conclusion was to use the point of delivery.

A related subissue results from contracts involving extended payment terms. Should the revenue be recognized upon delivery, deferred until payable by the customer, or recognized based on the specific circumstances of each case?

The advisory conclusion was to examine each case according to its particular circumstances.

The type of fees discussed until this point were fixed fees. For variable fees--fees that increase according to the passage of time and the volume of usage--there is no question that they should be recognized gradually as earned. However, if the agreement calls for both fixed and variable fees, a new issue arises. The issue is: Are the fixed fees considered mere advances vis-a-vis variable fees? Or should they not be affected by the co-existence of the variable fees?

The advisory conclusion held according to the latter view and, therefore, these fees should be recognized upon delivery.

Software Development Contracts

The next major set of issues involves a contract in which the vendor obligates itself to either create software from scratch or to make major modifications to existing software. This is in contrast to the previous cases that involved selling existing software off-the-shelf without modification. A typical example of such a contract would be the sale of a "turnkey system"--a complete hardware and software system tailor-made to a particular customer. In this situation there are significant vendor obligations to be fulfilled beyond the delivery date, such as data conversion, installation and product training. It is assumed that there are no major uncertainties regarding collection.

The issue is: Which one of the following alternatives should be used for revenue recognition?

* Accrue all revenue and related expenses at contract signing or delivery;

* Accrue all revenue gradually over the installation period as per the percentage-of-completion method;

* Defer all revenue until completion of installation as per the completed-contract method.

Those in favor of the percentage approach point to ARB 45 which recommends this approach for long term construction contracts, and to SOP 81-1 which interprets this bulletin to apply to a broad category of contracts not limited to construction. They feel the completed-contract method should be used only if collection is uncertain, percentage estimation or work completed is unreliable, or if there are significant doubts about the vendor's ability to complete the project.

Others argue that ARB 45 does not apply to software contracts because these contracts do not meet the criteria specified for long-term contracts as mentioned in ARB 45. They also contend that, unlike construction contracts, it is too difficult to measure the percentage of work that has been completed. Accordingly, they recommend the completed- contract method.

In the ADAPSO survey, 40% recognized revenue in the period in which the work was performed, 50% as invoiced, 6% upon payment and the remainder as a percentage-of-completion approach.

The advisory conclusion decided in favor of the percentage-of- completion approach.

Post-Delivery Customer Support Services (PCSS)

Many companies provide post-delivery customer support services such as telephone support and the correction of programming errors ("bugs"). Others may commit themselves to provide product enhancements at a reduced cost to the licensee. Some vendors include these services in the price of the license while others sell them separately. Thus an important new issue arises: Should the revenue from these services be recognized immediately upon delivery of the software, gradually over time, or deferred until performance?

Those who favor immediate recognition do so because this approach is easy to apply and it is too difficult to measure the portions that should be deferred. Others feel that it should be recognized over time on a straight-line basis because a liability to perform these services is created at contract time. The liability is discharged gradually over the contract period. Those who favor deferal until final performance do so for several reasons. First, they argue that this type of agreement is, in effect, an option to receive the next edition of the software for free, or at a reduced price. Accordingly, the revenue should be deferred until that takes place. (They agree that if the portion of the PCSS revenue relating to the telephone hot line can be identified, it should be recognized on a straight-line basis.)

Second, since under SFAS 86 the costs of various enhancements should be capitalized, to recognize revenue from these enhancements while deferring their costs would be a violation of the matching principle.

The advisory conclusion was to recognize the revenue ratably over time. It was also concluded that an implied amount for PCSS is included in the original licensing fee which should be "unbundled" and recognized over time. (In the ADAPSO survey, 81% of the companies surveyed stated that PCSS fees are bundled into the original license fee.)

Data Services Revenue

Data service companies provide processing services involving their own software. A typical example would be a company that processes payrolls. They usually charge a subscription fee at the inception of the contract. In addition, there are usage fees based on the volume of the transactions, data storage fees and software development fees for tailoring the software to the customer's needs. A key issue is: Should the non-refundable subscription fees be recognized at contract time, or over the period of service?

Those who favor contract time feel that the process of signing up customers is a separate and distinct revenue generating activity and the subscription fee is earned at that time. They also contend that this fee should be matched with the expenses incurred at contract time, such as commissions, legal fees and hookup charges, in accordance with the matching principle.

Those against contract time argue that subscription fees are a component of the total revenue the processing company receives for performing services over time, and that few costs are incurred at subscription time anyhow. Furthermore, in many cases, the customer is entitled to a refund of this fee if no data services are subsequently performed. Accordingly, they favor deferal over the period of service.

In the ADAPSO survey, 72% recognized initial subscription fees at the time of initiation, 17% over the term of the contract and 11% at other times.

The advisory conclusion was to defer the fees over the period of service.