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— Industry Insight —
Technology companies' sales arrangements are often characterized by having multiple deliverables -- for example, hardware, software and professional services all sold together as part of the same customer arrangement. In order to recognize revenue for delivered items in partially completed sales, companies often opt for economically suboptimal sales and pricing policies in lieu of the less desirable alternative -- deferring all revenue until the last product or service is delivered. Current proposals to change U.S Generally Accepted Accounting Principles, or GAAP, could eliminate this accounting-driven economic inefficiency for some companies. The goal is to have the new standards in place by January. Meanwhile, technology companies should assess how the competitive landscape could be affected if the proposed rules are finalized.
The Emerging Issues Task Force, or EITF, is developing new accounting guidance that, if issued, would significantly change revenue recognition for many multiple deliverable arrangements typical in the technology industry. The changes are being proposed in two Issues expected to be released this summer for public comment: 1. EITF Issue 08-1, Revenue Arrangements with Multiple Deliverables 2. EITF Issue 09-3, Applicability of AICPA Statement of Position (SOP) 97-2 to Certain Arrangements That Include Software Elements Issue 08-1 would replace and significantly change the guidance in EITF Issue 00-21. Currently, in order to recognize revenue for delivered products and services, companies are required to obtain sufficient evidence of fair value of the undelivered products and services. This commonly involves establishing vendor specific objective evidence, or VSOE, of fair value of the undelivered products or services, a complicated process of setting and consistently following pricing policies. Unfortunately, this process can also result in a company making economically undesirable pricing choices in sales arrangements with customers. For example, many technology companies sell products together with related consulting services and offer price discounts to certain customers to discourage them from buying from a competitor. These discounts could preclude a company from meeting the fair value criteria in Issue 00-21, because of the lack of pricing consistency. This in turn could result in deferral of recognition of the product revenues until the services are provided. If a company instead wants to recognize the product revenues when the products are delivered to the customer, it would need to limit its practice of providing discounts, which could also result in losing customers to competitors. To address this issue, the EITF has proposed eliminating the requirement to establish fair value of undelivered products or services and instead proposes to separate revenue recognition based on management's estimated selling prices of the separate deliverables, assuming the other criteria of Issue 08-1 are met. These other criteria are largely carried forward from Issue 00-21 intact, and include establishing standalone value of the delivered items, among other items. The elimination of the requirement to establish fair value represents a significant change in practice. Issue 08-1 would apply to companies that are not subject to SOP 97-2, Software Revenue Recognition. This will apply to many technology companies, including hardware, telecommunications equipment, semiconductor, and biotech companies, as well as software companies that follow a software-as-a-service, or SaaS, delivery model. With Issue 09-3, the EITF is considering whether to modify the scope of SOP 97-2 such that companies selling a joint hardware and software product would no longer be subject to SOP 97-2 and would instead follow Issue 00-21 and SAB 104 for revenue recognition guidance. The EITF has tentatively proposed that this change would apply to "tangible products containing software components and non-software components that function together to deliver the product's essential functionality." This change would result in many technology companies with products that include a software component no longer needing to establish VSOE of fair value for products and services. The EITF is considering whether and how companies would assess multiple software components to determine which components are part of delivering a product's essential functionality, something that could be difficult to do for products with closely integrated software components. Software companies that license their software and do not sell a joint hardware and software product, however, would still be required to obtain VSOE of fair value of undelivered products or services in order to recognize revenue for delivered items. The EITF considered but has tentatively decided against changing the accounting standards for software revenue recognition at this time due to the unique issues related to how software companies license and sell software products and services, and due to the nature and timing of efforts required to reconsider and change these rules. The two new proposed EITF Issues are likely to affect the technology industry's competitive landscape in the following ways: 1. Many affected companies will likely change their pricing policies and sales practices to employ greater variability in pricing products and services. For example, if the proposed EITF Issues are adopted, a competitor could more aggressively discount prices of certain products or services to entice a prospect and gain market share, and value-based pricing strategies will become easier to implement. 2. Technology companies have typically avoided offering rights to future products in sales agreements since these rights often preclude any revenue recognition until the future product is delivered. It is likely that companies will start including future products and specified software upgrade rights ("vaporware") in sales agreements to entice customers to buy existing products since this would no longer adversely affect current revenue. 3. Technology companies often compete against other technology companies that have a different business model. As a result, competitively-opposed companies would sometimes be treated inconsistently under these proposed GAAP changes. For example, SaaS companies often compete against traditional software licensing companies, and the SaaS companies would benefit from the proposed changes but their software licensing competitors would not. Depending on how the final rules are structured, it is possible that Oracle Corp., which has historically been a pure-play software company, could be able to take advantage of the proposed revenue changes in its pricing and sales polices as a result of its recent deal for Sun Microsystems Inc. This potential advantage arises since Oracle will presumably sell hardware and software as a combined and integrated product. Such integrated products could potentially fall under the new and more favorable accounting rules of EITFs 08-1 and 09-3. If this occurs, Oracle might be able to offer discounts and other incentives such as future product upgrades to customers without adversely affecting the timing of its revenues. It would still be able to allocate and recognize revenues using estimated selling prices without having to establish VSOE of fair value as required in SOP 97-2. Most of Oracle's software competitors, however, do not also sell hardware. Therefore, they would continue to recognize revenue using the accounting rules in SOP 97-2, and would not be able to offer similar incentives without potentially adversely affecting the timing of revenue recognition. Given the potential strategic significance of the proposed new
revenue recognition rules, technology companies are advised to closely
monitor their progress and carefully consider ways the competitive
landscape could be affected since these proposed changes could be in
effect by year's end. Companies are encouraged to comment to the EITF
on their views on these proposals once they're released this summer. Jay Howell is a partner in the technology practice of BDO Seidman LLP, a national accounting firm providing assurance, tax, financial advisory and consulting services. He is based in San Francisco. |
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