Unraveling the New Revenue Recognition Rules

Michael Rewkiewicz– Assurance and Advisory Services

In recent months, the Emerging Issues Task Force (EITF) has passed two new changes that modify how certain revenue will be recognized. The impact of the two EITFs are best reviewed jointly as they are interrelated.

EITF 09-3 Certain Revenue Arrangements That Include Software Elements

The first change, EITF 09-3, Certain Revenue Arrangements That Include Software Elements, states that tangible products containing software components and non-software components that function together to deliver the products essential functionality are considered non-software deliverables. These items are therefore excluded from SOP 97-2 (which applies only to software deliverables). Instead they will be accounted for under EITF 08-1 (discussed below).

EITF 09-03 has received a lot of press coverage, including commentary from Apple, IBM, and Xerox, all of whom support the changes it brings. Apple has stated that it will adopt the EITF immediately.

EITF 08-1 Revenue Arrangements with Multiple Elements

The second change, EITF 08-1, Revenue Arrangements with Multiple Elements, modifies how revenue is recognized under EITF 00-21, Revenue Arrangements with Multiple Elements. The scope of EITF 08-1 is the same as that of EITF 00-21 and is designed to cover arrangements that involve multiple deliverables, except that EITF 08-1 does not include purely software or software related arrangements. For these types of arrangements, revenue recognition remains under the guidance of SOP 97-2.

Under EITF 00-21, companies were not allowed to recognize revenue for separate elements in a multi-element arrangement without evidence of “Fair Value” for any undelivered elements. This requirement often caused companies to defer revenue for delivered elements. EITF 08-1 eliminates the fair value requirement and allows companies to value elements using a best estimated selling price. However, the best estimate approach is allowed only when neither Vendor Specific-Objective Evidence (VSOE) nor Third Party Evidence (TPE) exists to value an element. If a company uses the best estimate approach, the company must disclose both the qualitative and quantitative methodologies and inputs used in the estimation process.

This represents a significant change for companies who, under EITF 00-21, had to defer revenue when VSOE or TPE was not available for undelivered elements. The use of a best estimate selling price permits many elements to be separated, and potentially allows for items that are delivered to be recognized immediately (where under EITF 00-21, revenue recognition for these items may have been deferred).

To separate the elements of an arrangement, all of the following criteria must be met:

  • The arrangement must have multiple deliverables and be within the scope
    of EITF 08-1.
  • The delivered element must have value to the customer on a stand-alone basis.
  • If the arrangement must include a general right of return relative to the delivered item, delivery of the undelivered item must be probable and substantially controlled by the Company.

If the above three criteria are met, then the delivered item may be treated as a separate element and the revenue may be recognized. The allocation of revenue amongst the multiple elements within the arrangement is established in EITF 08-1, via a tier system of qualified evidence for an item’s selling price.

Strength of Evidence Type of Evidence
Strongest VSOE
Weakest Estimated selling price

Estimated selling prices are to be used only if neither VSOE nor TPE exist. The company should consider market conditions, labor costs, other expenses, and its gross margin in deriving an estimated price.

If VSOE or TPE exist for all elements, then the separate elements should be valued on this basis. If VSOE or TPE do not exist for all elements then the estimated selling price for each element should be used. Essentially, items with VSOE or TPE should be allocated on that basis and other elements valued using the best estimate approach.

It is anticipated that a company will need to disclose revenue recognized under EITF 00-21 and EITF 08-1 until such time as the revenue recognized under EITF 00-21 is immaterial. EITF 08-1 is expected to apply to fiscal years beginning June 15, 2010; however, early adoption is permitted.