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Speech by SEC Staff:
Remarks before the 2004 AICPA National Conference on Current SEC and PCAOB Developments


G. Anthony Lopez

Associate Chief Accountant, Office of the Chief Accountant
U.S. Securities and Exchange Commission

Washington, D.C.
December 6, 2004

As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.


Good afternoon. It's a pleasure to speak at today's conference. Based upon both the formal and no-name inquires we receive regarding revenue recognition, that topic continues to be a significant area of interest. Thus, I would like to share with you some views on a number of revenue recognition issues including: (1) how changes in a registrant's circumstances may necessitate a change in its revenue recognition policies, (2) the timing and income statement characterization of nonmonetary exchanges that culminate in the earnings process, and (3) renewals and extensions of intellectual property.

Revenue Recognition and Changes in Circumstances

The first issue that I want to address is in the nature of a reminder that changes in circumstances or contractual provisions must be constantly considered in determining whether revenue recognition policies are still appropriate. While this is true for all areas of accounting, the nature and complexity of revenue arrangements when combined with the complexity of an accounting model that has very different guidance for different earnings processes, means that revenue recognition is an area where policies may need to be updated more often than other areas. We have noted that registrants sometimes make an initial assessment of the appropriate revenue recognition policy and do not update that policy as their business changes. For example, if a registrant initially sells products, but its business arrangements evolve to include intellectual property or service deliverables, then SOP 97-2, SAB Topic 13, or other literature may require that such arrangements be accounted for as subscription or service arrangements, which would, of course, have an entirely different revenue recognition pattern.1 The situation is especially troubling for financial statement users if companies that have basically the same revenue arrangements wind up using vastly different revenue recognition policies simply because their business models took different paths to get to the same place.

Companies in technology industries, where the environment is often rapidly changing, must be particularly alert to these kinds of situations. A specific example of this that commonly arises is the evolution of software embedded in products or used to provide services and how that evolution may change a registrant's previous conclusion that the software is incidental to those products or services. As you may know, if software is deemed more-than-incidental to a product or a service, it must be accounted for as software under SOP 97-2. Footnote 2 to SOP 97-2 includes some indicators to be used in determining whether the software is incidental. However, those indicators are just that, indicators. The indicators are neither determinative nor presumptive, nor are they all-inclusive. Also, those indicators are often difficult to apply to products and services that have traditionally been viewed as non-software-centric. I'd like to provide a few thoughts about evaluations of whether software is incidental, in an attempt to illustrate the kind of process that all companies should go through to re-evaluate their revenue recognition policies.

  • Is the software a significant focus of the marketing effort of the product or service?2 - In evaluating this indicator, I would focus on whether any changes to the features and functionality of the product or service being promoted by the advertisements directly result from the software.
  • Is the software sold separately from the product or service?3 - In some situations, hardware manufacturers or service providers find the underlying software works so well that it develops a market among their competitors. They then begin to license that software separately for sale so their competitors can use the software in their product and service offerings. That would represent a change in circumstances that may suggest a change in accounting toward the embedded software being more-than-incidental.
  • Does the vendor incur significant costs related to software that are within the scope of FASB Statement 86?4 - Changes in circumstances may also affect a registrant's accounting for software costs therefore registrants should carefully consider the interaction between FASB Statement 86 and SOP 98-1 as it relates to accounting for the costs of software related to product or service offerings.5

In addition, registrants who have software underlying products and services that they believe are non-software centric, may also want to consider the following indicators of whether the software is more-than-incidental:

  • Do the rights to use the software remain solely with the vendor or are the rights transferred to the customer as a part of the product or service offering? If the rights to use the software survive cessation of the service or sale of the product, that is an indicator that the software is more-than-incidental.
  • Does the licensed software require the customer to provide dedicated information technology (IT) support? - If the customer must maintain and troubleshoot the underlying software, it may be more-than-incidental.

I would also like to point out that if a registrant concludes that software underlying its product and services becomes more-than-incidental, it may need to perform an evaluation under EITF Issue 03-5 to determine whether the software is essential to the functionality of other items in the arrangement, which would require software accounting for those other items as well.6

My comments on whether software is more-than-incidental are intended to encourage registrants and auditors to be proactive by developing procedures to periodically re-assess their revenue recognition policies in light of changes in facts and circumstances. When such re-assessments are done, it is important for registrants to document the considerations and conclusions they made about the changing nature of the product or service offerings and related impacts on the accounting. That documentation may be useful to registrants in deciding what information to include in their revenue recognition policy footnote.

Nonmonetary Exchanges

Next, I would like to discuss a couple of points related to nonmonetary exchanges of products or services that culminate the earnings process.7 As you may be aware, the FASB issued a proposed amendment to APB 29 as a part of its short-term convergence project.8 However, APB 29, its proposed amendments, and related interpretations do not address the timing of revenue or gain and related expense or loss recognition within the income statement for nonmonetary exchanges that culminate the earnings process.9 In addition, although the EITF has taken up an issue that involves considering the scope of the so-called "inventory-for-inventory" exception to fair value accounting for nonmonetary exchanges, there is still little explicit guidance on determining whether the income statement debits and credits resulting from nonmonetary exchanges that are recorded at fair value should be characterized as either revenue or gain and expense or loss.10 I would like to share few thoughts to consider in such situations.

First, if the timing of the products or services to be delivered differs from the timing of the products or services to be received in the exchange, at what point in time should the revenue or gain be recognized in the income statement? I believe that the earned and realized criteria of FASB Concepts Statement 5 and the performance and delivery principles in SAB Topic 13 should be applied in determining the appropriate timing of revenue or gain recognition for nonmonetary exchanges that culminate the earnings process. Concepts Statement 5 states that "in recognizing revenue and gains the two conditions (being realized… and being earned) are usually met by the time product…is delivered or services are rendered to customers..."11 SAB Topic 13 contains similar delivery and performance requirements for revenue recognition and discusses additional considerations such as customer acceptance, FOB shipping terms, and other factors.12 Consider the following example. Assume Vendor A exchanges services with Vendor B that result in a culmination of the earnings process and Vendor A receives services from Vendor B over 12 months but delivers services to Vendor B over 18 months. Assuming all other revenue recognition criteria are met, Vendor A should recognize revenue over the 18 month period as it meets the earned and realized requirements of Concepts Statement 5 and the performance requirements of SAB Topic 13 - that is, Vendor A should recognize revenue as it moves through its earnings process. Similarly, Concepts Statement 5 would suggest that the recognition of the corollary expense or loss related to the service that is delivered in the exchange be recognized when "an entity's economic benefits are used up in… rendering services…," which would occur over the 12 month period that services are performed.13

As it relates to the characterization of the credit in the income statement as either revenue or gain, the guidance in Concepts Statement 6 should be considered. Thus, for a nonmonetary exchange that is recorded at fair value to be characterized as revenue, the exchanged item would need to be an item the company normally sells in its operations, so that the receipt of value would represent an inflow resulting from "activities that constitute the entity's ongoing major or central operations."14 However, if the exchanged item can be characterized as a transaction that is "peripheral or incidental" to the entity's operations, characterization as a gain may be appropriate.15 Likewise, I believe the characterization of the debit should be based upon similar considerations.16 Also, consideration of Rule 5-03 of Regulation S-X should be made in determining the appropriate income statement classification.17

Revenue Recognition for Extensions or Renewals of Intellectual Property

Finally, I want to share with you a question that we received about intellectual property. After SAB 104 was issued, we received an inquiry as to whether the staff believed it was appropriate to extend by analogy the guidance in a software technical practice aid or TPA to a similar circumstance regarding renewals and extensions of intellectual property. The issue is whether revenue can be recognized upon renewal or extension of a license prior to the commencement of the renewal or extension period.

I believe in this situation that recognition of revenue from the renewal or extension of intellectual property prior to the commencement of the renewal or extension period may be appropriate based upon analogy to the software TPA provided that (1) all other revenue recognition criteria of SAB Topic 13 are met and (2) the customer already has possession of and the right to use the intellectual property to which the extension/renewal applies. If the initial license for the intellectual property has lapsed (that is, it is not currently active), then the renewal or extension should be accounted for as an initial arrangement. Accordingly, revenue would be deferred until commencement of the license period of the subsequent arrangement under SAB Topic 13.

That concludes my prepared remarks. Thank you for your attention.



Modified: 12/06/2004