Question
How may a vendor implicitly grant a specified upgrade right to a customer (i.e., an upgrade right that is not specified in the contract)?
Answer
In certain circumstances, sales personnel or marketing materials may refer to specific features or functionality that is expected in future versions of the product. Such statements may lead the customer to expect that these features or functionality will be delivered in the future and that they are, therefore, an implied part of the arrangement. This would require that the vendor allocate a portion of the arrangement fee to the implicitly specified upgrade right. If a vendor publishes statements in sales and marketing brochures that refer to specific features or functionality that are expected in future versions of a product, the vendor should understand the financial and legal implications.
Example
Vendor A is currently negotiating with a customer to sell Customer B a license for Version 2.0 of A’s software product. During the negotiations, the sales representative for A learns that B is looking for certain functionality in the product. The sales representative notifies B in writing that (1) while the functionality currently is not available, it will be included in the next version of the product, which is expected to be available within the next three months, and (2) B will be entitled to that version under its PCS arrangement.
Customer B agrees to purchase Version 2.0 along with an annual PCS agreement. The signed agreement does not explicitly discuss the additional functionality promised by the sales representative. However, in the absence of evidence to the contrary, A has implicitly granted a specified upgrade right to B through the correspondence from the sales representative, which created a reasonable expectation in B that the desired functionality would be available in the next version of the product. Accordingly, the specified upgrade right would be treated as a separate element of the arrangement. Revenue would need to be deferred until A has VSOE of fair value of all undelivered elements or until all the elements are delivered and all other requirements for revenue recognition have been met.
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Specified Versus Unspecified Products or Upgrades
ASC 985-605 requires vendors to distinguish between specified upgrades/enhancements and unspecified upgrades/ enhancements. This determination is important because rights to specified upgrades/enhancements, including those offered on a when-and-if-available basis, must be treated as separate elements of the software arrangement to which revenue must be allocated. Conversely, rights to unspecified upgrades/enhancements on a when-and- if-available basis are considered to be PCS. ASC 985-605 also requires vendors to distinguish between specified and unspecified additional software products, because a right to receive specified additional software products is accounted for as a separate element, while a right to receive unspecified additional software products is accounted for as a subscription. However, ASC 985-605 does not define “specified.”
Question
What distinguishes a specified upgrade or product from an unspecified upgrade or product?
Answer
An upgrade or product should be considered “specified” if it is described in enough detail for both the vendor and the customer to determine whether the vendor’s obligation to deliver the upgrade or product has been extinguished. The description can range from a detailed report on the upgrade or product’s features and functionality to a mere statement of its name or version number.
Sometimes, however, a vendor may specify an upgrade or product without such a description. For example, a vendor may grant a customer the right to receive “the next major release of Product X.” In this situation, even though neither the vendor nor the customer may completely understand what features and functionality will ultimately be included, or what the name or version number will be, for the next major release of Product X, both parties will know, once this release has been delivered, that the vendor’s obligation has been extinguished. Therefore, the right to receive the next major release of Product X should be considered a specified upgrade. These conclusions are consistent with the comments made by G. Anthony Lopez, associate chief accountant in the Office of the Chief Accountant of the SEC, at the 2005 AICPA National Conference on Current SEC and PCAOB Developments.
Example
The following are examples of commitments by software vendors that should be considered specified upgrades or products:
• Customer C purchases a perpetual license to Product A from Vendor V, with a one-year bundled PCS agreement. Vendor V also agrees to deliver Product B on a when-and-if-available basis to Customer C. Product B is a specified product.
• Customer C purchases a license to Version 2.2 of Product Z from Vendor V, with a one-year bundled PCS agreement. Vendor V also provides Customer C with a right to receive Version 3.0 of Product Z on a when-and-if-available basis. Vendor V has not yet begun developing Version 3.0 and has not decided on the additional features and functionality to include in it. Version 3.0 is a specified upgrade.
• Customer C purchases a perpetual license to Product A, photo editing software, from Vendor V. The licensing agreement includes one year of PCS services. Vendor V also agrees to develop an enhancement to Product A that will allow users to convert color photos into black and white. Customer C will have the right to receive a copy of the enhancement if it is released during the PCS term. The enhancement to Product A is a specified upgrade.