The following are examples of funded software development arrangements and the appropriate accounting treatment under the circumstances:
Example 1 — Product Prepayment Arrangement
Vendor V licenses software to Customer Z, an end user. Under a separate agreement with Z, V agrees to develop additional software and deliver it to Z for an additional $10,000, which Z pays up front. The two agreements are not linked in any way (e.g., payment terms, acceptance). Vendor V intends to license the additional software to other users as a separate upgrade for $10,000; this price will most likely not change. The technological feasibility of the software to be developed has been established. Vendor V estimates it will cost an additional $250,000 to develop the software.
The $10,000 fee should be accounted for as a deposit (i.e., deferred revenue) and should be recognized as revenue when the software (upgrade) is delivered to Z and all other revenue recognition criteria are met.
In this example, the additional $10,000 payment is, in substance, a prepayment for the upgrade and not a funded development arrangement. The $10,000 payment is the same as the price for the upgrade that will be sold to other customers, the payment is negligible compared with the estimated cost to develop the product, and the arrangement is not a best-efforts arrangement — V is obligated to deliver the software. Once technological feasibility has been established and R&D activities have ceased, an outside party interested in the product would be unlikely to pay a significant premium for a product that will shortly be commercially available. All of these factors indicate that this transaction is not a funding arrangement but a prepayment for a product to be delivered at a future date. Notwithstanding the significant development required to produce the product in this arrangement, the arrangement is outside the scope of ASC 605-35 because the product will be sold to other customers in the ordinary course of business through the vendor’s normal marketing channels (see ASC 605-35-15-6(a)).
Example 2 — Product Development Arrangement With Input From Customer
Vendor V agrees to develop and license software to Customer Z, an end user. Vendor V intends to license the software to other users and to charge $100,000 per license; this price will most likely not change. The technological feasibility of the software has been established, and V expects that it will cost $500,000 to develop the software. Vendor V receives $130,000 from Z. In return for its payment, Z will be able to provide input during the development process. Vendor V has no other obligation under the agreement other than delivery of the software.
The $130,000 fee should be recognized as revenue when the software is delivered to Z and all other revenue recognition criteria are met. The timing of revenue recognition in this example is the same as in the previous example. However, this example is more subjective and involves a number of assumptions that only apply to this particular set of facts and circumstances. Although Z is paying an amount greater than the price that V intends to charge other customers, this is not conclusive evidence that the arrangement is a funding arrangement. Customer Z may be willing to pay a premium to (1) have input into the development process to, for example, “tailor” the products so that they require less customization), or (2) to be the “first on the block” to have the product. Because the product has reached technological feasibility, the product can almost certainly be developed, and V is obligated to deliver the product to Z but has no further substantive obligations.
The conclusion in this example is based on several factors, the most critical of which is that V will be able to sell the product to other customers. If there were significant uncertainty about whether V would be able to sell this product to other customers, the arrangement would be a contract with Z to develop software. Because the estimated development cost is $500,000 and the fee is $130,000, the contract would be accounted for as a loss contract under ASC 605-35.
Example 3 — Funded Development Arrangement
Vendor V enters into an arrangement with Customer F, a large hardware manufacturer and software reseller. Vendor V had eight projects under way for new software products. In exchange for a $10 million nonrefundable payment from F, V has agreed, on a solely best-efforts basis, to devote substantially all of its efforts to three of the projects it has already begun (X, Y, and Z, respectively). As a result, the commercial availability of X, Y, and Z is expected, but not committed, to be accelerated by six to nine months. In exchange for its $10 million payment, F will be entitled to unlimited copies of X, Y, and Z for three years and will be entitled to 2 percent of all gross sales by V of products X, Y, and Z. The technological feasibility of X, Y, and Z has not yet been established. The $10 million payment exceeds the expected costs to reach technological feasibility for X, Y, and Z and the commercial release of these products.
The $10 million payment should be accounted for pursuant to ASC 730-20. If technological feasibility is reached, any remaining portion of the $10 million payment should be offset against costs that would otherwise have been capitalized pursuant to ASC 985-20; provided that the terms of the arrangement and surrounding conditions indicate that there is no obligation to repay. If all three of the products are released commercially, V should record any remaining portion of the $10 million as revenue at that time.
This arrangement is a best-efforts contract between V and F. While delivery of products and reverse royalty
payments are contemplated in the agreement, they are conditional on the commercial release of product X, Y, or Z; therefore, F is not required to record a liability for these potential future obligations.