Generic VSOE Lesson

Everything you need to know about VSOE (but are afraid to ask) Paul Lamparski Finance Director, Global Revenues

VSOE V endor- S pecific O bjective E vidence of Fair Value V endor- S pecific – specific to our company; not another firm O bjective E vidence – evidence supported by factual data and information WHY? | WWW.cfoconnect.COM For transaction that include multiple elements (i.e., license and PCS), the basis of revenue recognition relies on a justifiable allocation of revenue among the elements; Not subjective assessments nor contract prices

Objectives VSOE Basics Multiple-Element Arrangements What is VSOE, Why is it Necessary? Practical Approach to VSOE Residual Method VSOE, a Practical Approach Impact - License Sales, Subscriptions & Services Impact of VSOE Failures Bell-Curve Approach Other Issues and Challenges Specified Upgrades Product Roadmaps | WWW.cfoconnect.COM

Statement of Position 97-2 (SOP 97-2) “Software Revenue Recognition” SOP 97-2 was issued by the American Institute of Certified Public Accountants (AICPA) in 1997 VSOE, as defined in SOP 97-2, is the best evidence of fair value In 1998, SOP 98-9 modified SOP 97-2 by requiring recognition of revenue using the “residual method” in certain instances SOP 97-2 (as amended) provides specific guidance for determining when and how much revenue may be recognized under a software arrangement | WWW.cfoconnect.COM

What is a Multiple-Element Arrangement? An arrangement that involves the delivery of multiple products and/or services (deliverables or elements), often over an extended period of time Example: software license with post-contract customer support (PCS) Identify the deliverables Separation – when and how to divide into separate units of accounting Allocation – apportioning arrangement consideration to the separate elements Revenue is recognized for each deliverable when the revenue recognition criteria for that specific deliverable are achieved

Separate Contracts with One Customer – Multiple-Element Presumption Contracts or agreements negotiated or executed within a short time frame of each other Elements are closely interrelated or interdependent in terms of design, technology, or function Fee for one agreement is subject to refund, forfeiture or other concession if another contract is not completed satisfactorily An element in one contract is essential to the functionality of an element in another contract Payment terms under one contract or agreement coincide with performance criteria of another contract or agreement Negotiations are conducted jointly with two or more parties (i.e., different divisions of the same company) to do what in essence is a single project

What is VSOE? Vendor-Specific Objective Evidence The price charged when that deliverable or element is sold separately For an element not yet being sold separately, the price established by management having relevant authority; it must be probable that the price, once established, will not change before the separate introduction of the element into the marketplace. VSOE errors are a leading cause of restatements among public software companies

What VSOE is Not Vendor-Specific Objective Evidence is Not… Separately stated or listed prices in an arrangement are not necessarily VSOE Price book values are not necessarily VSOE Surrogate prices – prices for similar software marketed by another vendor Functionality and features will differ; therefore prices cannot be assumed to be the same Cost plus a “normal” profit margin cannot be used to allocate arrangement consideration Stated prices for individual products and/or services in an arrangement with multiple deliverables should not be presumed to be representative of fair value. The best evidence of fair value is the price of a deliverable when it is regularly sold on a standalone basis.

Why is VSOE necessary? Software company’s tend to bundle software and services together in order to offer a turn-key software solution to the end user Stock prices of public software firms are greatly influenced by revenues Inconsistency in revenue recognition arose as software firms unbundled complex multiple-element arrangements based on subjective interpretations of the earnings process Revenue recognition became a priority for the SEC and the AICPA was asked to create stringent revenue recognition rules for the software industry Today revenue recognition standards impose strict objectivity and verifiability conditions rather than rely on managers’ subjective assessments

How is VSOE determined? (part 1) VSOE is determined by demonstrating that separate sales regularly occur either at the same price or within a tight band Bell-shaped curve approach – VSOE exists when at least 80% of separately sold products are priced within a plus/minus 15% band of the median price VSOE may differ based on multiple factors… Customer type Transaction size Geographic territory Channel of distribution When a vendor's pricing is based on multiple factors such as the number of products and the number of users, the amount allocated to the same element when sold separately must consider all the factors of the vendor's pricing structure

How is VSOE determined? (part 2) When multiple factors influence pricing, VSOE must consider all the factors of the pricing structure To determine median price for VSOE purposes, separate sub-groupings are created for each distinct pricing structure Examples: The median price Software Product A sold in France (in €) is computed separately from the median price of Software Product A sold in the USA (in $) The median price Software Product A sold to “large” customers that receive a standard volume discount of 40% is computed separately from the median price of Software Product A sold to smaller customers that receive a standard volume discount of 15%

Strict Objectivity and Verifiability vs. Subjective Assessments Revenue recognition is founded on principles and a “conceptual framework” Revenue should not be recognized until it is realized or realizable and earned Complex, multiple-element transactions can result in seemingly arbitrary results as to the measurement of component revenues and the timing of recognition “ I know what revenue is when I see it!” Comparability of revenue results from one company to another requires consistent measurement practices Fair value must be reliable, verifiable, and objectively determinable – If sufficient evidence of fair value does not exist, revenue cannot be recognized on the individual element.

A Practical Approach to VSOE Neither SOP 97-2 nor any of the related guidance documents establish an “official way” to determine fair values for VSOE Many software firms establish VSOE using the bell-curve approach Major CPA firms endorse the bell-curve approach To conclude that VSOE of fair value exists for a range of prices, those prices must be sufficiently clustered within an appropriate range Typically, that means that at least 80 percent of sales prices should fall within 15 percent of the median price

A Practical Approach to VSOE Example of the Bell-Curve Approach Using the Bell-Curve Approach to evaluate whether VSOE of fair value exists by analyzing the entire population of actual PCS renewals VSOE of fair value of PCS exists when a substantial majority of actual PCS renewals are within a narrow range of pricing For example, if 80% of PCS renewal transactions fall within a range of plus or minus 15% from the midpoint (median) of the range | WWW.cfoconnect.COM

A Practical Approach to VSOE Example of the Bell-Curve Approach Each scenario below includes 554 actual renewal transactions; in each case the median renewal price is $1,000 | WWW.cfoconnect.COM Scenario #1 Scenario #2 Median Median Values within +/- 15% of median Values within +/- 15% of median

Example of the Bell-Curve Approach Scenario #1 | WWW.cfoconnect.COM VSOE  94.8% within +/- 15% of Median

Example of the Bell-Curve Approach Scenario #2 | WWW.cfoconnect.COM VSOE Does Not Exist 79.8% within +/- 15% of Median

What is the Residual Method? Statement of Position No. 98-9 (SOP 98-9) Modification of SOP 97-2 The residual method allows revenue to be recognized for a delivered element with no VSOE of fair value if, and only if, there is VSOE of fair value for all undelivered elements Residual value is the difference between the total arrangement fee (i.e., the total price of all elements in the contract) and the sum of the specific fair values (VSOE) of the undelivered elements Residual value recognized as revenue related to the delivered element

Delivered vs. Undelivered The method used to allocate arrangement consideration differs depending on whether VSOE of fair value exists for all elements included in the arrangement, or only for the undelivered elements When the fair values of all the units of accounting in an arrangement are known (i.e., both the delivered and undelivered elements), the discount, if any, included in the arrangement is allocated proportionately to each element “ Relative fair value method” When the fair value of undelivered elements is known but the fair value of delivered elements is not known, discount is allocated to the delivered element(s) in its entirety “ Residual method” In practice, the relative fair value method is rarely used because software firms generally cannot establish VSOE of fair value for software licenses that are almost always sold in conjunction with PCS

Discounts and the Residual Method The residual method has the effect of allocating the entire discount to the delivered element Example: End-user is granted a 20% non-standard discount from Price book values and sales agreement allocates the discount ratable among the license and PCS fees License Fee PCS 1 year Total Price Stated in Agreement/Contract $ 40,000 $ 8,000 $ 48,000 Price Book Values 50,000 10,000 60,000 VSOE of Fair Value unknown 10,000 Revenue Allocation 38,000 10,000 48,000

VSOE a Practical Approach – An Overview Fundamental Issue – License revenues recognized upon delivery are “at risk” if they cannot be “unbundled” due to lack of appropriate VSOE for undelivered elements Focus of VSOE administration is the undelivered element; specifically – PCS Delivered elements can be recognized under “residual method” Even if there is no VSOE for the delivered element!! | WWW.cfoconnect.COM

ARR / Subscriptions Many Software Firms value “Annual Recurring Revenue” or ARR PCS, Subscriptions, ELS, etc. VSOE of fair value for ARR can be established through consistent pricing of renewals Standard discounts (i.e., volume discount) do not adversely impact VSOE Non-standard discounts (i.e., discretionary discounts) undermine VSOE and should be avoided | WWW.cfoconnect.COM

License Sales License revenues are frequently bundled with other elements (i.e., PCS) Establishing VSOE for license sales is challenging because there are relatively few instances where licenses are sold separately Therefore, Software Firms often utilize “residual method” VSOE for product licenses is not maintained nor is it needed due to “residual method” approach | WWW.cfoconnect.COM

Professional Services Establishing VSOE for service revenues and PS hourly rates is a huge challenge for software firms In a recent survey, 39% of participants had not established VSOE for PS in any geography Technology Professional Services Association When VSOE does not exist for the service element Entire arrangement fee should be recognized as the services are performed If no pattern of performance is discernible, the entire arrangement fee should be recognized on a straight-line basis over the service period | WWW.cfoconnect.COM

Training Training element can usually be separated from multi-element arrangements assuming fees are regularly assessed at published prices less applicable, “standard” discounts Training subscription revenues are recognized on a straight-line basis over the subscription period Customized training offerings are similar to professional services VSOE does not exist and recognition of other revenues may be delayed until training is delivered | WWW.cfoconnect.COM

Bell-Curve Approach To establish VSOE for PCS, the “Bell-Curve Approach” can be used Transactions within previous 12 months VSOE of fair value exists when 80% of PCS renewal transactions fall within a range of plus or minus 15% from the midpoint (median) of the range for a particular PCS part or material

Segmenting and Stratifying Unique PCS “materials” are further separated into subgroups based on: Country, Currency, Price Book Value Separate medians and +/- 15% bands are computed for each subgroup Price for each relevant transaction in the preceding 12 months is compared to the +/- 15% band and flagged as being within or outside the band NOTE – each individual transaction is weighted the same regardless of quantity of units

Re-aggregating for Assessment Subgroups are re-aggregated into PCS material groups; one group for each PCS material code Number of items flagged as being within the +/- 15% bands are compared to total number of items in the material code group If at least 80% are within the band – VSOE exists If less than 80% are within the band – VSOE does not exist

Impact of VSOE Failures When VSOE does not exist for an undelivered element in a multi-element agreement, all revenue from the arrangement would be deferred until the earlier of: (a) the availability of VSOE for all elements to the arrangement, or (b) all elements of the arrangement have been delivered If the only undelivered element is Post Contract Support, the entire fee (including license fees) should be recognized ratably over the service period .

Impact of VSOE Failures Worst Case Scenario Failed VSOE for a relatively small PCS component included in a LARGE deal that includes significant new license/product deliveries The seemingly insignificant VSOE failure taints the ENTIRE deal License/product revenue must be deferred and recognized over the term of PCS services Otherwise “good” license revenue becomes unrecognizable on delivery and must be deferred | WWW.cfoconnect.COM

Specified Upgrades “ Specified” upgrades must be accounted for as separate elements even if the customer is otherwise entitled to the upgrade (e.g., as a benefit of a PCS subscription) Issue; all revenue may be deferred until the “specified” upgrade is delivered An unspecified upgrade is not a separate element; rather, it is included in PCS Unspecified upgrades/enhancements are generally described using terms such as “when-and-if-available”

Product Roadmaps Sharing information with customers and potential customers about future product enhancements and features comes under the broad topic of “roadmaps” Sharing product roadmaps or information about future products with customers has the potential to create implied “specified” deliverables; should this occur, revenue from current products may have to be deferred until future products are delivered The key factor to consider in assessing whether product roadmap information creates a “specified” deliverable is the role the information played in the customer’s purchase decision

Review (slide 1 of 2) VSOE Basics VSOE used to allocate revenues of multiple-element arrangements Imposes objective and verifiable standards; eliminates subjective assessments Residual Method Delivered vs. undelivered elements Non-standard discounts allocated entirely to delivered elements | WWW.cfoconnect.COM

Review (slide 2 of 2) VSOE, a Practical Apporach Focus on PCS/Subscription elements Bell-Curve Approach; granular medians and aggregate analysis Impact of VSOE Failures; deferred license revenues Other Issues and Challenges Specified Upgrades Product Roadmaps Avoid specifying a deliverable that is not yet available | WWW.cfoconnect.COM

Generic VSOE Lesson

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