Summary of Significant Accounting Policies

6 Months Ended

Jun. 30, 2011

Summary of Significant Accounting Policies

Summary of Significant Accounting Policies

1. Summary of Significant Accounting Policies

Basis of Presentation

All amounts included herein related to the condensed consolidated financial statements as of June 30, 2011 and the three and six months ended June 30, 2011 and 2010 are unaudited and should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) have been condensed or omitted pursuant to the Securities and Exchange Commission (SEC) rules and regulations regarding interim financial statements.

In the opinion of management, the accompanying condensed consolidated financial statements include all necessary adjustments for the fair presentation of the Company’s financial position, results of operations and cash flows. The results of operations for the interim periods presented are not necessarily indicative of the operating results to be expected for any subsequent interim period or for the full fiscal year ending December 31, 2011.

Principles of Consolidation

The condensed consolidated financial statements include the accounts of Callidus Software Inc. and its wholly owned subsidiaries (collectively, the “Company”), which include wholly owned subsidiaries in Australia, Canada, Germany, Hong Kong, Singapore, New Zealand and the United Kingdom. All intercompany transactions and balances have been eliminated upon consolidation.

Certain Risks and Uncertainties

The Company’s products and services are concentrated in the software industry, which is characterized by rapid technological advances and changes in customer requirements. A critical success factor is management’s ability to anticipate and to respond quickly and adequately to technological developments and changes in customer requirements. Any significant delays in the development or introduction of products or services could have a material adverse effect on the Company’s business and operating results.

Historically, a substantial portion of the Company’s revenues have been derived from sales of its products and services to customers in the financial and insurance industries.  Disruptions in these industries as we have observed in the recent economic turmoil may result in these customers deferring or cancelling future planned expenditures on the Company’s products and services. The Company is also subject to fluctuations in sales for the TrueComp product, and its revenues are typically dependent on a small volume of transactions.  Continued macroeconomic weakness may keep potential customers from purchasing the Company’s products or existing customers from renewing their subscriptions for the Company’s on-demand services or maintenance support.

Use of Estimates

Preparation of the condensed consolidated financial statements in conformity with GAAP and the rules and regulations of the SEC requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, the reported amounts of revenues and expenses during the reporting period and the accompanying notes. Estimates are used for, but not limited to, the allocation of the value of purchase consideration for business acquisitions, uncertain tax liabilities, valuation of certain investments, allowances for doubtful accounts and service remediation reserves, the useful lives of fixed assets and intangible assets, goodwill and intangible asset impairment charges, accrued liabilities and other contingencies.  These estimates and assumptions are based on management’s best estimates and judgment.  Management evaluates such estimates and assumptions on an ongoing basis using historical experience and considers other factors, including the current economic environment, for continued reasonableness. Appropriate adjustments, if any, to the estimates used are made prospectively based upon such evaluation. Illiquid credit markets, volatile equity and foreign currency markets and declines in IT spending by companies have combined to increase the uncertainty inherent in such estimates and assumptions.  As future events and their effects cannot be determined with precision, actual results could differ materially from those estimates.  Changes in those estimates, if any, resulting from continuing changes in the economic environment, will be reflected in the financial statements in future periods.

Foreign Currency Translation

The functional currencies of the Company’s foreign subsidiaries are their respective local currencies. Accordingly, the foreign currencies are translated into U.S. dollars using exchange rates in effect at period end for assets and liabilities and average rates during each reporting period for the results of operations. Adjustments resulting from the translation of the financial statements of the foreign subsidiaries are reported as a separate component of accumulated other comprehensive income (loss). Foreign currency transaction gains and losses are included in interest and other expense, net in the accompanying condensed consolidated statements of operations.

Fair Value of Financial Instruments and Concentrations of Credit Risk

The fair value of some of the Company’s financial instruments, including cash and cash equivalents, accounts receivable and accounts payable, approximate their respective carrying value due to their short maturity. See Note 5 for discussion regarding the valuation of the Company’s financial instruments.  Financial instruments that potentially subject the Company to concentrations of credit risk are short-term investments, long-term investments and trade receivables.  The Company mitigates concentration of risk by monitoring ratings, credit spreads and potential downgrades for all bank counterparties on at least a quarterly basis.  Based on the Company’s ongoing assessment of counterparty risk, the Company will adjust its exposure to various counterparties.

The Company’s customer base consists of businesses throughout the Americas, Europe, Middle East, Africa and Asia-Pacific.  The Company performs ongoing credit evaluations of its customers and generally does not require collateral on accounts receivable. As of June 30, 2011, the Company had one customer comprising greater than 10% of net accounts receivable.

Prepaid and other current assets and deposits and other assets

Included in prepaid and other current assets and deposits and other assets in the consolidated balance sheets at June 30, 2011 and December 31, 2010 is restricted cash totaling $678,000, related to security deposits on leased facilities for the Company’s New York, New York and Pleasanton, California offices. The restricted cash represents investments in certificates of deposit required by landlords to meet security deposit requirements for the leased facilities. Restricted cash is included in prepaid and other current assets and deposits and other assets based on the contractual term for the release of the restriction.

Also included in the prepaid and other current assets and deposits and other assets is certain costs related to configuration and implementation services incurred as a result of implementing hosted third party software applications that the company uses to operate its business. These configuration costs are recorded as a prepaid asset as the company has determined that they have probable future economic benefit and amortized over their useful life. As of June 30, 2011, we have capitalized $463,118 worth of these costs, which we are amortizing over their useful life. These costs do not include the cost of training, business process reengineering, and data migration, which are expensed as incurred.

Revenue Recognition

The Company generates revenues by providing its software applications as a service through an on-demand subscription and providing related professional services to its customers, as well as through perpetual or time-based term licenses and providing related software support. The Company presents revenue net of sales taxes and any similar assessments.

The Company recognizes revenue when all of the following elements are met:

Evidence of an Arrangement.

Delivery.

Fixed or Determinable Fee.

Collection is Deemed Probable.

Recurring Revenues

Recurring revenues include on-demand services revenues, time-based term license revenues and maintenance revenues. On-demand services revenues are principally derived from technical operation fees earned through the Company’s services offering of the on-demand TrueComp suite, Coaching SaaS services, and business operations services. Time-based term license revenues are derived from fees earned through the licensing of the Company’s software bundled with maintenance for a specified period of time. Maintenance revenues are derived from maintaining, supporting and providing periodic updates for the Company’s licensed software. Customers that own perpetual licenses can receive the benefits of upgrades, updates, and support from either subscribing to the Company’s on-demand services or purchasing maintenance services.

On-Demand Services Revenues. In October 2009, the Financial Accounting Standards Board (“FASB”) amended the accounting standards for multiple-element revenue arrangements with Accounting Standards Update (ASU) 2009-13, “Multiple-Deliverable Revenue Arrangements”, to:

· provide updated guidance on whether multiple deliverables exist, how the elements in an arrangement should be separated, and how the consideration should be allocated;

· require an entity to allocate revenue in an arrangement using estimated selling prices (“ESP”) of each element if a vendor does not have vendor specific objective evidence of selling price (“VSOE”) or third-party evidence of selling price (“TPE”); and

· eliminate the use of the residual method and requires a vendor to allocate revenue using the relative selling price method.

The Company adopted this accounting guidance on January 1, 2011, for applicable arrangements entered into or materially modified after January 1, 2011.

Prior to the adoption of ASU 2009-13, the Company had VSOE for on-demand services fees based on a contractually stated renewal rate and for time and material services based on the Company’s historical pricing and discounting when the element was sold standalone.  The Company was never able to establish VSOE or TPE on fixed fee service arrangements for the implementation of our on-demand services due to establishing pricing practices that did not allow for the strict VSOE criteria to be met.

Upon adoption of the new accounting standard, the Company evaluates each element in a multiple-element arrangement to determine whether it represents a separate unit of accounting.  An element constitutes a separate unit of accounting when the delivered item has standalone value and delivery of the undelivered element is probable and within the Company’s control.  On-demand services have standalone value because the Company routinely sells them separately.  Implementation and configuration services have standalone value because the Company has sold these services separately and there are several third party vendors that routinely provide similar services to our customers on a standalone basis.

The Company determines the best estimated selling price of each element in an arrangement based on a selling price hierarchy. The best estimated selling price for a deliverable is based on its VSOE, if available, TPE, if VSOE is not available, or ESP, if neither VSOE nor TPE is available.  Total arrangement fees will be allocated to each element using the relative selling price method.

The Company considered the following factors to establish the ESP for fixed fee service arrangements when sold with its on-demand services:  the weighted average of actual sales prices of professional services sold on a standalone basis for on-demand services; average billing rate for fixed fee service agreements when sold with on-demand services and other factors such as gross margin objectives, pricing practices and growth strategy.

The consideration allocated to on-demand services is recognized as revenue over the stated contractual period in accordance with the provision of Staff Accounting Bulletin No.104, “Revenue Recognition” (“SAB 104”).

The consideration allocated to implementation and configuration services, when sold with the on-demand services is based on whether the services are provided on a time and material basis or a fixed fee basis.  Time and material services are recognized as the services are delivered based on inputs to the project, such as hours incurred.  Fixed fee engagements are generally recognized ratably over the estimated deployment period of the services in accordance with SAB 104.

Under the relative selling price method the Company can recognize revenue only up to the amount that is non-contingent.  Revenue would be contingent if the amount allocated to an element requires one or both of following items:

· Delivery of additional items, or

· Meeting other specified performance conditions.

If revenue is deemed contingent because of either of the above listed items, then the arrangement consideration allocated to delivered items is limited to the amounts that are not contingent.  This amount would be the lesser of the amount initially allocated using the relative selling price method or the non-contingent amount.

Prior to the adoption of ASU 2009-13 if the Company entered into a multiple element on-demand agreement that did not qualify for separation due to the lack of fair value for all undelivered elements, the Company would defer the direct costs of the implementation and configuration services and amortize those costs over the same time period as the related revenue is recognized. The deferred costs previously deferred, or related to ongoing arrangements entered into prior to January 1, 2011 on the Company’s condensed consolidated balance sheets for these consulting arrangements totaled $2.2 million and $3.0 million at June 30, 2011 and December 31, 2010, respectively. As of June 30, 2011 and December 31, 2010, $1.5 million and $2.3 million, respectively, of the deferred costs are included in prepaid and other current assets, with the remaining amount included in deposits and other assets in the condensed consolidated balance sheets. Due to the adoption of ASU 2009-13, the Company will no longer be able to defer direct costs associated with implementation and configurations services for agreements entered into after January 1, 2011.  These direct costs of the implementation and configuration will be expensed as they are incurred and at the same time the related revenue will no longer be deferred.

Included in the deferred costs for on-demand arrangements is the deferral of commission payments to the Company’s direct sales force, which the Company amortizes over the non-cancelable term of the contract as the related revenue is recognized. The commission payments are a direct and incremental cost of the revenue arrangements. The deferral of commission expenditures related to the Company’s on-demand offering was $1.1 million and $1.2 million at June 30, 2011 and December 31, 2010, respectively.

Given the nature of our transactions entered into after January 1, 2011, the adoption of the new accounting rules has not had a material impact on the Company’s revenue.

Time-Based Term License.  These types of transactions are governed by ASC 985-605, “Software Revenue Recognition”.  The Company offers on-premise licenses of its software as a time-based term license arrangement. Such arrangements typically include an initial fee, which covers the time-based term license for a specified period and the maintenance and support for the first year of the arrangement. If a customer wishes to receive maintenance after the first year, then the customer must pay the maintenance fee for each year it wishes to receive maintenance. Revenue for these arrangements is generally recognized ratably over the term of the agreement. If the Company sells a time-based term license with additional multiple elements besides maintenance, those elements generally include configuration and implementation services, and training.

For a single-year time-based term license that is sold with multiple elements, the entire arrangement fee is recognized ratably. In these arrangements, both the time-based term licenses and the maintenance agreements have durations of one year; therefore, the fair value of the bundled maintenance services is not reliably measured by reference to a maintenance renewal rate. In these situations, the Company will defer all revenue until either the services or the maintenance is the only undelivered element. If the maintenance term expires before the services are completed, the entire arrangement fee would be recognized ratably over the remaining period during which the services are completed (beginning upon expiration of the maintenance term). If services are completed before the maintenance term expires, the entire fee will be recognized ratably over the remaining maintenance period. In these arrangements, the Company will defer all direct costs of the implementation and configuration services, and amortize those costs over the same time period as the related revenue is recognized. Sales commissions and partner fees attributable to the sale of time-based term licenses are deferred and amortized over the same period as the related revenue is recognized.

Multi-year time-based term license arrangements often include multiple elements (e.g., software technology, maintenance, training, consulting and other services). The Company allocates revenue to each element of the arrangement based on the VSOE of each element’s fair value when the Company can demonstrate that sufficient evidence exists of the fair value for the undelivered elements. The VSOE of fair value of each element in multiple element arrangements is determined based on either (i) in the case of maintenance, providing the customer with the ability during the term of the arrangement to renew maintenance at a substantive renewal rate or (ii) in the case of professional services, selling the element on a stand-alone basis.

In multi-year time-based term license arrangements that include multiple elements and for which fair value of VSOE cannot be established for the undelivered elements, the entire arrangement fee is recognized ratably over the remaining non-cancellable term of the arrangement after completion of professional services, if any.

The Company defers the direct costs, and amortizes those costs over the same time period as the related revenue is recognized. The deferred costs on the Company’s condensed consolidated balance sheets for these arrangements totaled $1.2 million and $0.7 million at June 30, 2011 and December 31, 2010, respectively. As of June 30, 2011, $0.6 million of the deferred costs are included in prepaid and other current assets, with the remaining amount of $0.6 million included in deposits and other assets in the condensed consolidated balance sheets. As of December 31, 2010, $0.2 million of the deferred costs are included in prepaid and other current assets, with the remaining amount of $0.5 million included in deposits and other assets in the condensed consolidated balance sheets.  The deferred costs mainly represent commission payments to the Company’s direct sales force for time-based term license arrangements, which the Company amortizes over the non-cancelable term of the contract as the related revenue is recognized. The commission payments are a direct and incremental cost of the revenue arrangements.

Maintenance Revenue. Under perpetual software license arrangements, a customer typically pre-pays maintenance for the first twelve months, and the related maintenance revenues are deferred and recognized ratably over the term of the initial maintenance contract. Maintenance is renewable by the customer on an annual basis thereafter. Rates for maintenance, including subsequent renewal rates, are typically established based upon a specified percentage of net license fees as set forth in the arrangement.

Services Revenue

Professional Service Revenue. Professional service revenues primarily consist of integration services related to the integration and configuration of the Company’s products as well as training. The Company’s integration and configuration services do not involve customization to, or development of, the underlying software code. Generally, the Company’s professional services arrangements are on a time-and-materials basis. Reimbursements, including those related to travel and out-of-pocket expenses, are included in services revenues, and an equivalent amount of reimbursable expenses is included in cost of services revenues. For professional service arrangements with a fixed fee, the Company recognizes revenue utilizing the proportional performance method of accounting. The Company estimates the proportional performance on fixed-fee services contracts on a monthly basis, if possible, utilizing hours incurred to date as a percentage of total estimated hours to complete the project. If the Company does not have a sufficient basis to measure progress toward completion, revenue is recognized upon completion of performance. To the extent the Company enters into a fixed-fee services contract, a loss will be recognized any time the total estimated project cost exceeds project revenues.

In certain arrangements, the Company has provided for unique acceptance criteria associated with the delivery of professional services. In these instances, the Company has recognized revenue in accordance with the provisions of Staff Accounting Bulletin (SAB) No. 104: Revenue Recognition. To the extent there is contingent revenue because of acceptance in these arrangements, the Company will defer the revenue until the acceptance has been received.

Perpetual License Revenue

The Company recognizes license revenues using the residual method pursuant to the requirements of accounting guidance for software revenue recognition. Under the residual method, revenues are recognized when VSOE for fair value exists for all of the undelivered elements in the arrangement (i.e., professional services and maintenance), but does not exist for one or more of the delivered elements in the arrangement (i.e., the software product). The Company allocates revenue to each undelivered element based on its fair value, with the fair value determined by the price charged when that element is sold separately. For a certain class of transactions, the fair value of the maintenance portion of the Company’s arrangements is based on substantive stated renewal rates rather than stand-alone sales. The fair value of the professional services portion of the arrangement is based on the hourly rates that the Company charges for these services when sold independently from a software license. If evidence of fair value cannot be established for the undelivered elements of a license agreement, the entire amount of revenue from the arrangement is deferred until evidence of fair value can be established, or until the items for which evidence of fair value cannot be established are delivered. If the only undelivered element is maintenance, then the entire amount of revenue is recognized over the maintenance delivery period.

Cost of Revenues

Cost of recurring revenues consists primarily of salaries, benefits, allocated overhead costs related to on-demand operations and technical support personnel, as well as allocated amortization of purchased technology. Cost of license revenues consists primarily of amortization of purchased technology. Cost of services revenues consists primarily of salaries, benefits, travel and allocated overhead costs related to consulting, training and other professional services personnel, including cost of services provided by third-party consultants engaged by the Company.

Net Loss Per Share

Basic net loss per share is calculated by dividing net loss for the period by the weighted average common shares outstanding during the period, less shares subject to repurchase. Diluted net loss per share is calculated by dividing the net loss for the period by the weighted average common shares outstanding, adjusted for all dilutive potential common shares, which includes shares issuable upon the convertible senior notes, the exercise of outstanding common stock options, the release of restricted stock and purchases of employee stock purchase plan (“ESPP”) shares to the extent these shares are dilutive.

Diluted net loss per share does not include the effect of the following potential weighted average common shares because to do so would be anti-dilutive for the periods presented (in thousands):

	Three Months Ended June 30,		Six Months Ended June 30,
	2011	2010	2011	2010
Restricted stock	3,940	2,115	3,571	1,765
Stock options	4,649	6,507	4,943	6,543
ESPP	79	142	69	123
Convertible Senior Notes	4,475	—	2,250	—
Totals	13,143	8,764	10,833	8,431

The weighted-average exercise price of stock options excluded from weighted average common shares during the three and six months ended June 30, 2011 was $3.71 and $3.75 per share, as compared to the weighted average exercise price of stock options excluded from weighted average common shares during the three and six months ended June 30, 2010 of $4.47 and $4.54 per share. The conversion price of our Convertible Senior Note is $7.71. Please refer to Note 6 of our Notes to Condensed Consolidated Financial Statements below for details.

Recent Accounting Pronouncements

In January 2010, the FASB issued an accounting standards update on improving disclosures about fair value measurements to add additional disclosures about the different classes of assets and liabilities measured at fair value, the valuation techniques and inputs used, the activity in Level 3 fair value measurements and the transfers between Levels 1, 2 and 3. Levels 1, 2 and 3 of fair value measurements are defined in Note 5 below. We adopted the new disclosure requirements and clarifications of existing disclosures in the first quarter of 2010, except for the disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measurements. Although we adopted these new disclosure requirements in the first quarter of 2011, there were no additional disclosures required.