What Is SOP 97-2 for Software Revenue Recognition?

Statement of Position 97-2 (SOP 97-2), issued by the American Institute of Certified Public Accountants (AICPA), was the authoritative guidance for software revenue recognition for many years. It established a rules-based framework for when and how software companies could recognize revenue, which was important for complex contracts bundling software with other services. The guidance addressed the challenges of sales involving multiple deliverables over time.

SOP 97-2 is no longer the active standard, having been superseded by the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) 606. This article explores the historical framework of SOP 97-2 to provide context for the evolution of revenue recognition principles.

The Four Core Criteria for Revenue Recognition

Before a software vendor could recognize revenue under SOP 97-2, four conditions had to be met. Failure to meet any one of these conditions meant that all revenue from the arrangement had to be deferred.

The first criterion was persuasive evidence of an arrangement. This required objective proof of a finalized deal, such as a written contract signed by both parties. An unsigned contract or verbal agreement was insufficient.

Second, delivery of the software must have occurred. The customer had to take possession of the software with the right to use it, whether delivered physically or electronically. This focused on the initial delivery of the licensed product itself.

The third condition was that the vendor’s fee must be fixed or determinable. The total payment could not be subject to future events outside the vendor’s control. For example, a fee contingent on the customer’s business results would not be determinable.

Finally, collectibility of the fee had to be probable, meaning it was likely the customer would pay. This assessment was based on the customer’s creditworthiness. If collectibility was in doubt, revenue was delayed until payment was received.

Accounting for Multiple-Element Arrangements

SOP 97-2 addressed the common practice of selling software in bundled packages, known as multiple-element arrangements. These contracts included the software license plus other products and services. This created accounting complexity because components were often delivered at different times, making it inappropriate to recognize the entire fee upon initial software delivery.

Arrangements could include many components sold with the primary software license, such as:

• Post-contract customer support (PCS) for technical assistance and future updates
• Installation services
• Training for the customer’s employees
• Consulting services for customization or implementation
• Future deliverables, like a significant software upgrade

The accounting problem was that the vendor had ongoing obligations after the initial delivery. For example, if a $100,000 sale included one year of support, the full amount could not be recognized immediately. A portion of the fee was earned by providing support over the following year, and recognizing it all upfront would overstate revenue.

The standard required companies to unbundle these arrangements for accounting purposes, even if sold for a single price. The total fee had to be allocated among the various elements, like the software, support, and training. This allocation prevented companies from manipulating earnings by booking large, multi-year contract fees at the start of an agreement.

Establishing Vendor-Specific Objective Evidence (VSOE)

To allocate revenue in a multiple-element arrangement, SOP 97-2 required a strict valuation standard known as Vendor-Specific Objective Evidence (VSOE) of fair value. VSOE is the price a vendor charges for a product or service when it is sold separately. This evidence had to be specific to the vendor, as using a competitor’s pricing was not permitted.

The most common way to establish VSOE for an element like post-contract support (PCS) was to show a history of standalone sales of that same element. The prices of these standalone sales had to be concentrated within a narrow range to prove a consistent price existed. A few sales at different price points were not sufficient.

An alternative method was for management to formally approve a standalone price for an element before it was introduced, substantiated by a formal pricing policy. This was used for new products or services without a history of standalone sales.

Failing to establish VSOE for any undelivered elements in an arrangement had significant consequences. If a contract included a software license and one year of PCS, but the vendor lacked VSOE for the PCS, the entire fee had to be deferred. Revenue could not be recognized until VSOE was established or the support period ended.

This approach created challenges for companies that preferred selling integrated solutions and did not sell support on a standalone basis. They were often unable to meet VSOE requirements, leading to long revenue deferrals that could negatively impact their perceived financial performance.

Application of the Residual Method

When a company established VSOE for all undelivered elements in an arrangement, it could apply the residual method to recognize revenue for the delivered elements. This method allowed a company to recognize the portion of the fee corresponding to the delivered software license. The residual method was only applicable if VSOE existed for the undelivered items.

The calculation began with the total fee for the arrangement. From this total, the company subtracted the VSOE of fair value for all undelivered elements, such as PCS, training, or installation. The fair value of these items was determined by their standalone selling prices.

For example, a company sells a software package for a total price of $150,000, which includes the license and one year of PCS. The company has established VSOE for its PCS at a fair value of $20,000. The company subtracts the VSOE of the undelivered PCS ($20,000) from the total contract fee ($150,000).

The remaining $130,000 is the residual value, which is then allocated to the delivered software license and could be recognized immediately. The remaining $20,000 for PCS would be deferred and recognized as revenue on a straight-line basis over the one-year support period.

The Supersession by ASC 606

The Financial Accounting Standards Board (FASB) introduced a new standard, ASC 606, Revenue from Contracts with Customers, which superseded SOP 97-2. This marked a shift from detailed, rules-based standards toward a single, principles-based framework for nearly all industries. The goal was to standardize revenue recognition, making financial statements more comparable across companies.

ASC 606 is organized around a five-step model for determining when and how much revenue to recognize:

• Identify the contract
• Identify the performance obligations
• Determine the transaction price
• Allocate the price to the obligations
• Recognize revenue as obligations are satisfied

A major difference between the standards is how bundled goods and services are valued. ASC 606 replaces the rigid VSOE requirement with a more flexible approach to estimating standalone selling prices. If standalone prices are not directly observable, companies can use other methods, like an adjusted market assessment or a cost-plus-margin approach.

This change provides more judgment and flexibility in revenue allocation to better reflect the transaction’s economics. The transition to ASC 606 required companies to review their contracts and accounting policies, moving away from the prescriptive nature of SOP 97-2.