We are all familiar with the basic revenue recognition rule: revenue should generally be recognized when it is realized or realizable and when it is earned. Although seemingly simple, that rule can be difficult to apply, particularly in rapidly evolving high-tech industries. Revenue recognition within the software industry has been a complex and controversial issue since the inception of that industry during the latter part of the twentieth century. The FASB addressed that issue at length in Statement of Position 97-2 (pre-codification GAAP), which was released in October 1997. A more general discussion of revenue recognition can be found in the SEC’s Staff Accounting Bulletin No. 101 that was issued in December 1999.
SOP 97-2 identified four conditions that must be met to recognize revenue on the sale of software and related “arrangements,” which would include the licensing of technology:
Persuasive evidence exists of an arrangement: In most cases, such evidence will be provided by a written contract between the software vendor and customer. Delivery has occurred: Since software may be delivered electronically, SOP 97-2 provides guidance on when this criterion is met. For example, if a customer has been provided access codes to download the given software off the Internet, then delivery is generally assumed to have occurred (whether or not the download has actually taken place). The vendor’s fee is fixed or determinable: Again, SOP 97-2 provides interpretive guidance for this revenue recognition criterion. For example, the vendor’s fee is not considered to be fixed or determinable if the total revenue from the sale of the software will be a function of the number of copies of that software ultimately distributed to the buyer. Likewise, if the buyer has a right to return the software, then before revenue can be recognized on the sale of the software there must be a means to reasonably estimate the expected sales returns. Collectibility is probable: The term “probable” in this context has the same meaning as in SFAS No. 5, Accounting for Contingencies. That pre-codification standard equates “probable” with “likely to occur.”
In addition to these specific rules, the broad conceptual guidelines of accounting can be and should be applied in determining when to record revenue for software sales or for the licensing of software or technology. “Conservatism” is clearly among the most applicable accounting concepts in this context. If there is significant doubt that revenue has been realized or earned, then that revenue should likely be deferred. Another critical concept in this context is “representational faithfulness,” that is, does the accounting for a given transaction “square up” with what really happened or took place. Too often, software companies have manufactured elaborate scenarios to justify the recording of revenue. Accountants and auditors should be extremely leery when the circumstances surrounding a given software sale appear to be overly contrived.
A final important point here is that SOP 97-2 indicates that in certain cases, particularly when software licensing is involved, a sale of software may be analogous to a long-term construction contract. That is, the given software may be subject to required modification or customization over the entire licensing period. In such cases, the revenue should be recognized similarly to revenue under long-term construction contracts.
If you study a sample of audit failures or breakdowns, I believe you will find that a fairly small set of factors or circumstances are responsible for most deficient audits. The following list is not intended to be comprehensive, but, nevertheless, I believe that these items are easily among the most common antecedents to audit failures. [As a sidebar: students are better equipped to address this question if they have already studied several problem audits. If your students have studied several...
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