SEC comments and trends for technology companies. An analysis of current reporting issues

Transcription

1 SEC comments and trends for technology companies An analysis of current reporting issues

2 Introduction Welcome to SEC comments and trends for technology companies. This periodic Ernst & Young publication summarizes selected issues recently commented on in SEC staff reviews, accompanied by a contextual discussion of these matters. For those of you familiar with our periodic cross-industry sector analysis (issued in January and September 2007), it follows a similar format. We want to promote an awareness and understanding of the areas in which the SEC staff is focusing their review in the filings of technology companies. Our analysis is supplemented by suggested resources and additional Ernst & Young thought leadership available to help you better understand the issues and consider their applicability. The SEC staff s review process provides registrants with comments on filings where the staff believes the filing could be improved or enhanced. These reviews may result in outcomes ranging from additional disclosure in future filings to restatement of previously issued financial statements. Although each registrant s facts and circumstances are different, and the SEC staff is clear that its comments set forth its position limited to the specific facts of the filing to which the letters apply, we believe that a familiarity with the most commonly reviewed areas will be helpful to technology companies preparing and filing reports with the SEC.* We hope that you find our insights useful and that this document helps to stimulate discussion within your organization about these important financial reporting matters. SEC comments and trends for technology companies is just another way that we continue to provide you with the information and support necessary to help you achieve your potential. *The content is based on comment letters written to registrants regarding their filings with the Securities and Exchange Commission (SEC) in the US. Due to the sensitive nature of the material, we have not included any reference to specific companies. The information should be relevant to a broad range of publicly-listed US technology companies as well as to technology companies that are Foreign Private Issuers.

3 Contents Revenue recognition Vendor-specific objective evidence of fair value...2 Maintenance/post-contract customer support (PCS): specified versus unspecified upgrades and additional software products...4 Products with embedded software...6 Classification...7 Reseller arrangements...8 Contingencies such as warranties and return rights...9 Accounting for consideration given by (or received from) a vendor...10 Business combinations Identification of intangible assets and the subsequent accounting...11 Income taxes Deferred tax valuation allowances...13 Inventory Accounting for spare parts inventories...14 Management s discussion and analysis (MD&A) Material changes in financial statement line items...15 Critical accounting policies...16 Share-based payments Valuation of share-based payments granted prior to an initial public offering Valuation assumptions changes and sensitivity analysis...18 Financial instruments Warrants and embedded conversion features...20

4 Revenue recognition Vendor-specific objective evidence of fair value AICPA Statement of Position 97-2, Software Revenue Recognition (SOP 97-2), requires that vendor-specific objective evidence (VSOE) of fair value exist to account separately for elements included in multiple-element arrangements. Many registrants also assert that objective and reliable evidence (OE) of fair value exists when accounting for multiple-element arrangements under EITF Issue No , Revenue Arrangements with Multiple Deliverables (EITF 00-21). The SEC staff continues to challenge registrants in the technology industry to demonstrate whether they have sufficient support for their assertions that such evidence of fair value exists. The current line of query seems to represent a slightly more detailed request than observed previously. Until somewhat recently, the SEC staff typically asked how the method used by the registrant to establish VSOE (typically for post-contract support, or PCS) complied with paragraph 10 of SOP Lately, however, the SEC staff has asked registrants to describe the process used to evaluate the various factors that affect VSOE, including the consideration of customer type and other pricing factors. Because it appears that the SEC staff continues to focus on VSOE for PCS, in particular, we have included further discussion on this topic below. We have observed that the SEC staff has expanded their inquiries to include more frequently the establishment of OE for other elements of an arrangement, such as hardware maintenance, consulting, training and hosting, to name a few. This is true whether the registrant has asserted objective evidence of fair value under SOP 97-2 (vendor specific) or EITF Therefore, we believe the further discussion and analysis below related to VSOE for the elements above should be considered in establishing OE for other elements. We have classified the questions posed by the SEC staff on VSOE for PCS into five primary categories. The questions range along the lines of the following: Process of establishing VSOE Describe the process used to determine VSOE of fair value of PCS. Describe how factors such as the following affect the process used to establish VSOE of fair value: Purchase volume Competitive pricing Duration of arrangement Geographic region Distribution channel (e.g., resellers, distributors, etc.) Customer type Nature and type of product Specific requirements of arrangements Other factors, if applicable When vendors sell PCS separately, and the price charged for PCS varies based on any of the factors mentioned above, a company may have developed more than one VSOE of fair value for PCS. Accordingly, the company should stratify their VSOE of fair value analyses by customer class. These classes should be determined based on objective criteria. Any customer class established should be based on a population of transactions that provides a sufficient basis to conclude whether VSOE of fair value does exist. Use of sampling techniques If sampling techniques are used in evaluating pricing of PCS renewals to determine if VSOE of fair value exists: How has the company ensured the sample is a statistically valid representation of the entire population? Why are the results obtained from reviewing a sample of contracts adequate to draw conclusions about the establishment of VSOE of fair value for PCS? Generally, analyses should be designed to encompass all separate sales of an element during the period analyzed. If a sampling approach is used, it is critical to document and demonstrate how the sample is representative of the population being evaluated; such an analysis should be able to withstand scrutiny under appropriate statistical sampling concepts. SEC comments and trends for technology companies Revenue recognition

5 Bell-shaped curve approach If companies disclose VSOE of fair value based on the price of PCS when sold separately (bell-shaped curve approach): Do separate sales of PCS support a conclusion that VSOE of fair value exists? If prices vary from customer to customer, how can VSOE of fair value be reasonably estimated? If VSOE of fair value is determined as a range of pricing: How has the company determined what a reasonable range is for purposes of evaluating whether it has established VSOE of fair value? How was the percentage of contracts that fall between the low end and high end of the range calculated? How was the deviation from the median point of the range evaluated? Once a range is established, what rate is used as VSOE (e.g., the median price)? How is arrangement consideration allocated to PCS when a contractually stated rate falls outside of the range? Substantive renewal rate approach If companies disclose that VSOE of fair value is based on PCS renewal rates included in contractual arrangements with customers (substantive renewal rate approach): Do agreements explicitly state the amount customers will be required to pay to renew PCS? 1. How has the registrant determined that the stated renewal rate is substantive and how have they considered TPA , Fair Value of PCS in a multi-year time-based license and software revenue recognition, by analogy, in determining that PCS renewal rates are substantive? How has the company determined that renewal rates are substantive? What percentage of customers actually renew at the stated rates? Are rates renegotiated on renewal of PCS? If renewal rates vary from customer to customer, how can VSOE of fair value be reasonably estimated? SOP 97-2 defines VSOE of fair value of PCS as the price charged when the same element is sold separately (i.e., the renewal rate). The renewal rate represents the price charged to the customer for PCS once the initial PCS period (provided in connection with the sale of the software license) expires. To determine whether VSOE of fair value of PCS exists, we believe an analysis of PCS renewals must be performed periodically (at least annually, and more frequently if facts and circumstances dictate). Such an analysis may be performed in more than one manner, and thought should be given to whether the method used best fits the underlying facts and circumstances. We believe that two approaches have emerged as being most commonly used for establishing VSOE of fair value for PCS: (1) the substantive renewal rate and (2) the bell-shaped curve approach. Under the substantive renewal rate approach, the PCS renewal rate must be clearly stated in the contract with the customer and must be substantive. This does not imply that merely stating the renewal rate in an agreement will be automatically accepted as VSOE for PCS; rather, the company must still demonstrate that the rate is substantive and consistent with the prices it customarily charges (within a reasonable range) for PCS renewals. Determining whether a renewal rate stated in a contract is substantive requires professional judgment. Generally, we would be skeptical that a PCS renewal rate less than 10% of an initial software license fee is substantive. To support and document its customary pricing practices, a vendor should perform an analysis (similar to the bell-shaped curve approach) demonstrating the range of prices that encompasses a significant majority of actual PCS renewals is narrow. Under the bell-shaped curve approach, VSOE of fair value for PCS is determined by analyzing the entire population of historical PCS renewals to determine whether a substantial majority of PCS renewals have been priced within a narrow range (generally expressed as a percentage of the net software license fee or list price or as a dollar value). For example, if a company consistently charges 18%-20% of the net software license fee to customers in a specified class, then that range would be considered VSOE of fair value for PCS. Under both approaches, VSOE can exist if prices vary within a reasonable range. These concepts are further discussed within FAQ 57-4 of Ernst & Young s Financial Reporting Developments publication, Software Revenue Recognition, an Interpretation. Other methods of establishing VSOE Price established by management If companies disclose VSOE of fair value based on the price established by management having the relevant authority, how has the registrant concluded at the inception of the arrangements that the price established by management will not change before or on introduction of the element into the marketplace? This method is used to determine VSOE of fair value of an item that is not yet being sold separately. Again, it is not a foregone conclusion that VSOE can be established by reference to a price set by management. In evaluating whether such an approach can be supported, the factors on the following page should be considered. SEC comments and trends for technology companies Revenue recognition

6 Factors to be considered: Management that established the price must have relevant authority to do so. The period of time until the element is sold separately should be short. It must be probable that the price established by management will not change once that element is introduced into the marketplace. Is there any history of changes to management s predetermined pricing? Does VSOE of fair value exist for similar products? Because of these factors, we believe that it will be rare that a vendor will be able to establish VSOE of fair value through reference to a price set in advance of an item being sold separately. Published price list If companies disclose VSOE of fair value based on a published price list, how is VSOE of fair value established at the published list price for new offerings or offerings that have not had sufficient history of sales volume? For products or services currently sold by a vendor, VSOE of fair value only can be established by separate sales transactions. If the vendor does not and will not sell a product or service in a stand-alone transaction, then, by definition, VSOE of fair value cannot and does not exist. Accordingly, a published price list, by itself, is not a sufficient basis to establish VSOE for any element included in a multipleelement arrangement unless the vendor has an established history of selling products and services on a stand-alone basis at list price. Responding to these questions Responding to these questions has, on occasion, resulted in companies expending significant effort, in terms of both time and resources. These questions generally cannot be answered unless the company has performed an extensive analysis of the entire population of PCS renewals in order to establish that VSOE of fair value exists. In addition to asking such questions, the SEC staff has occasionally asked for registrants to submit a copy of their VSOE of fair value analyses. SOP 97-2, Software Revenue Recognition, as amended by SOP 98-9 EITF Issue No , Revenue Arrangements with Multiple Deliverables Ernst & Young Financial Reporting Developments, Software Revenue Recognition, an Interpretation (Revised October 2007) (SCORE No. BB1357) Ernst & Young Financial Reporting Developments, Revenue Arrangements with Multiple Deliverables-EITF Issue No (SCORE No. BB1185) Maintenance/post-contract customer support (PCS): specified versus unspecified upgrades and additional software products In the past several months, several technology companies have received comments from the SEC staff regarding upgrades and new version releases (minor and major) that are given to customers under PCS arrangements for no additional consideration. Specifically, the SEC staff is requesting analysis of whether a registrant s history of behavior implies that additional product or upgrade rights are included as part of PCS, even though not explicitly stated in the underlying PCS or software license arrangement, and, if so, how the registrant evaluates these rights when determining the accounting for the arrangement. Specifically, the SEC staff is asking companies to explain how they considered whether the software elements included in their PCS agreements were additional product or upgrade rights, including requests to address: The significance of differences between the features and functionality of the new releases and the vendor s existing products SEC comments and trends for technology companies Revenue recognition

7 Whether the new release is intended to replace the company s existing product The extent of development efforts required to create the new release The relationship of the price of the new release to the pricing for the company s existing products The manner in which the new release is marketed In addition, we are aware that the SEC staff routinely reviews information available on registrants websites to determine whether, for instance, discussions of future product releases, including the directionality of current or planned development (so-called roadmaps), exist. When discovered, such discussions can result in SEC staff inquiries regarding whether, in substance, they are tantamount to specifying a future upgrade, even though no specific upgrades are present in underlying contracts with customers. Registrants need to consider the factors above carefully to determine if their history of behavior implies that additional product or upgrade rights are included as part of PCS. If the registrant were to conclude that customers have the right to receive unspecified additional software products, the entire arrangement must be accounted for as a subscription, with revenue recognized ratably over the term of the arrangement or the economic life of the products covered by the arrangement. In such cases, no allocation of arrangement consideration is made among the various elements included in the arrangement (i.e., the vendor may not separately account for a software license or other elements of the arrangement). Registrants also should carefully consider whether they are providing customers the right to specified or unspecified upgrades through discussions of future product releases, including the directionality of current or planned development (so-called roadmaps). An upgrade right is defined in SOP 97-2 as the right to receive one or more specified upgrades/enhancements. SOP 97-2 distinguishes between a specified upgrade right and PCS arrangements offered by software vendors that typically provide customers the rights to receive unspecified upgrades in the future on a when-and-if-available basis. The right to receive an unspecified upgrade/ enhancement on a when-and-if-available basis is accounted for as a component of PCS, while specified upgrade rights are accounted for as separate elements of the arrangement even if a customer would otherwise be entitled to the specified upgrade/enhancement as part of PCS or the agreement stipulates that the specified upgrade only will be provided on a whenand-if-available basis. When a specified upgrade right is included in an arrangement, a portion of the total licensing fee should be allocated to that element based on VSOE of fair value, if such evidence exists (however, our experience is that it would be rare for a vendor to establish VSOE of fair value for a specified upgrade right because the right usually pertains to a product that is always sold with PCS and never in a separate standalone sale). If the arrangement includes a discount, no portion of the discount should be allocated to the specified upgrade right. If a software vendor does not have VSOE of fair value for a specified upgrade right, revenue should not be recognized for the arrangement until the earlier of one of the following events occurs: The vendor establishes VSOE of (1) the fair value of the specified upgrade right and (2) the fair value of all other undelivered elements included in the arrangement. The vendor delivers all elements included in the arrangement. The upgrade/enhancement that is the subject of the upgrade right is delivered, and VSOE of fair value exists for the remaining undelivered elements included in the arrangement (e.g., if the vendor has VSOE of fair value for PCS and that is the only remaining undelivered element once the upgrade/enhancement that is the subject of the upgrade right has been delivered); or The vendor communicates to the customer in the same manner that the specified upgrade right was initially communicated that the specified upgrade will never be delivered (and will not be included in a subsequent release). Determining that a specified upgrade right has been provided to a customer is, of course, relatively straightforward when a vendor explicitly commits to provide an upgraded version of the licensed product as a contractual term of an arrangement with a customer. However, information regarding a specified upgrade right may be communicated through means other than explicit contractual provisions (e.g., discussions on websites, trade shows, roadmaps, etc.). The key consideration in these circumstances is whether the vendor has provided a level of information to its customers regarding the features, functionality and release date of future product enhancements in sufficient detail such that it is likely the vendor has created an expectation by the customer that it will SEC comments and trends for technology companies Revenue recognition

8 receive a specific upgrade/enhancement without significant additional cost. The perspective used in making this evaluation is principally that of the customer, not the registrant, which can create difficulties in the assessment. Determining whether a specified upgrade right has been provided, by implication, to a customer (or class of customers) therefore requires the exercise of significant judgment, and we believe registrants should carefully monitor the activities of their company s sales and marketing groups to help ensure that unintended accounting consequences can be timely identified and avoided. SOP 97-2, Software Revenue Recognition, as amended by SOP 98-9 Ernst & Young Financial Reporting Developments, Software Revenue Recognition, an Interpretation (Revised October 2007) (SCORE No. BB1357) Products with embedded software The SEC staff continues to question whether registrants whose products contain software have considered the applicability of SOP The SEC staff has questioned when registrants last completed an assessment of the applicability of SOP 97-2 as well as what factors were considered in determining whether software embedded in products is more than incidental. Any entity that markets products (e.g., tangible goods) that incorporate a software component must consider, both initially and on an ongoing basis, the applicability of SOP 97-2, even if it does not consider itself to be a software company and regardless of an initial determination that software is merely incidental to the product. Accordingly, a company s conclusion that the sales of its products are not currently subject to SOP 97-2 s provisions may change as the entity s products, and the related technology, continue to evolve. SOP 97-2 s provisions are applicable to the sale of any products or services containing or utilizing software when the software content is more than incidental. The following factors must be considered when determining whether software is more than incidental: Whether the software is a significant focus of the marketing effort or is sold separately. The greater the emphasis on the features and functionality of the software in the marketing of products the more likely it is that the software is important to the customer s buying decision and is more than incidental. For instance, customer-focused discussions in printed materials or on a registrant s website regarding the specific functionality of the software component of a hardware product may indicate that software is more than incidental. Whether the vendor is providing PCS. When a vendor provides PCS such as telephone support, bug fixes and unspecified upgrades/enhancements on a when-and-if-available basis on the software included in a product sale, this may be an indicator that the software is more than incidental. Likewise, discussions of future software releases, software support or roadmaps, in print materials or on a registrant s website may indicate that software is more than incidental. Whether the vendor incurs significant costs that are within the scope of FASB Statement No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed. This includes all costs incurred in the development of the software component of a product or service, not just the costs that are capitalized. If these costs are significant relative to the costs of developing the product or service as a whole, this may be an indicator that the software is more than incidental. Determining when software is more than incidental to a company s products is dependent on the facts and circumstances and requires the use of professional judgment. SOP 97-2, Software Revenue Recognition, as amended by SOP 98-9 Ernst & Young Financial Reporting Developments, Software Revenue Recognition, an Interpretation (Revised October 2007) (SCORE No. BB1357) SEC comments and trends for technology companies Revenue recognition

9 Classification In recent months, several technology companies have received comments from the SEC staff regarding the presentation of arrangement consideration, once recognized, as either license or product revenue and service revenues for multipleelement arrangements which the company has determined must be accounted for as a single unit of accounting pursuant to the provisions of either SOP 97-2 or EITF because the company lacks evidence of fair value for undelivered services element(s). Generally, in such a case, the companies are recognizing the bundled unit of accounting arrangement ratably over the period such services are provided. In certain situations, these companies allocated the revenue, once recognized for the bundled unit of accounting, between license or product revenue and service revenues for income statement presentation based on the estimated fair value of the separate elements. Such estimated fair value does not constitute VSOE or objective and reliable evidence of fair value, but might be derived from analogous transactions. For example, a software company that sold time-based licenses with bundled co-terminus PCS might conclude that the estimated fair value of the PCS was equivalent to VSOE of fair value of PCS sold separately in perpetual license arrangements. It should be noted that neither total revenue nor the timing of revenue recognition was affected by any allocation made. Rather, such allocation was done solely for purposes of financial statement presentation. The companies making such allocations believed that their income statement presentation of revenues recognized was consistent with the provisions of Rule 5-03(b) (1) of Regulation S-X (Rule 5-03). Rule 5-03 requires separate presentation in the income statement of revenues from the sale of products and revenues from the provision of services. Questions often arise as to how a vendor might adhere to the requirements of Rule 5-03(b) when it is unable to recognize revenue separately for products and services contained in a multiple-element arrangement accounted for pursuant to either SOP 97-2 or EITF That is, if products and services included in the same multiple-element arrangement cannot be accounted for as separate units of accounting for revenue recognition purposes, how should the revenue be allocated to products and services for income statement presentation purposes once revenue is recognized for the combined unit of accounting? At the December 2007 AICPA National Conference on Current SEC and PCAOB Developments, Mr. Mark Barrysmith of the SEC s Office of the Chief Accountant addressed the SEC staff s views relating to such practices. Considering the advantages that separate revenue classifications provide to investors, the SEC staff will not object to the separation of product and service revenue arising from an arrangement in which deliverables cannot be separated for revenue recognition purposes, provided the vendor has a reasonable basis for its presentation that is consistently applied, clearly disclosed and not misleading. The SEC staff cited the following as potential examples of acceptable methodologies: Estimates based on verifiable inputs used to approximate fair value of the deliverables; For arrangements within the scope of SOP 97-2, comparisons to peers with sufficiently comparable products and services; and For arrangements within the scope of SOP 97-2, use of the residual method for customized core software products. However, the SEC staff would likely object to a separation methodology based on contractually stated amounts, or one that is simply systematic and consistent. We believe that the practice of allocating revenue, once recognized for a multipleelement arrangement for a single unit of accounting, between different income statement line items is relatively common in the technology industry. If a registrant is currently allocating the value of a bundled arrangement between license and services revenues based on the estimated fair value of the separate elements, and does not have VSOE for these elements, we suggest that the registrant consider the remarks made by the SEC staff as discussed above, and be prepared to explain why they believe they have a reasonable and acceptable methodology for such allocation. Rule 5-03(b) of Regulation S-X Ernst & Young Hot Topic: 2007 AICPA National Conference on Current SEC and PCAOB Developments (SCORE No. CC0243) December 10, 2007 Speech of SEC Professional Accounting Fellow Mr. Mark Barrysmith of the SEC Office of the Chief Accountant (available at SEC comments and trends for technology companies Revenue recognition

10 Reseller arrangements The SEC staff issued recent comment letters asking registrants to clarify how they recognize revenue for reseller arrangements, including whether they use the sell-in or sell-through method to recognize revenue from resellers. Specifically, the SEC staff is asking for further explanation as to the nature and significant terms of reseller arrangements, including any post-shipment obligations and acceptance provisions that may exist and how a registrant accounts for such obligations. Additionally, the SEC staff is asking if companies offer any incentives or grant price concessions to resellers, and if so, how they account for them. Resellers, which also may be referred to by other names such as distributors, indirect partners, system integrators or companies that integrate or embed a vendor s software into their own hardware and software products, such as value-added resellers (VARs) or original equipment manufacturers (OEMs), may be a significant source of recurring sales for a vendor. Additionally, a reseller may represent a vendor s only distribution channel for a specific product or geographic region. Accordingly, a vendor may be willing to provide resellers with greater rights than those it would provide to end users to maintain a mutually beneficial relationship and maximize future sales opportunities through the reseller. Additionally, a vendor may provide concessions it is not otherwise contractually obligated to provide if a reseller is unable to sell licensed products to end users or when the vendor announces a software or product upgrade and the reseller previously did not have product return rights. Because of these factors, there is a greater inherent risk that the fees are not fixed or determinable in an arrangement with a reseller because a vendor may not be able to: (1) reasonably estimate the effects of rights of return or other rights given to a reseller or (2) conclude that it will not grant a future concession. Accordingly, a vendor may be precluded from recognizing revenue relating to a reseller agreement until the reseller sells the licensed products to end customers, or the vendor receives cash from the reseller. Arrangements with resellers have been the subject of numerous restatements by registrants and enforcement actions brought by the SEC. In many situations, the registrant recognized revenue at the outset of the arrangement with the reseller and then subsequently provided concessions to the reseller. These concessions were held to have provided evidence that, in hindsight, the risk of the product sale had not truly been transferred to the reseller when revenue relating to the sale was initially recognized. Many of these situations were the direct result of a registrant s failure to consider one or more of the following factors appropriately: Whether the arrangement contained extended payment terms Whether the payment terms coincided with the reseller s sales to end users Whether collection of the fees associated with a reseller arrangement was appropriately assessed as probable Whether uncertainties about the potential number of copies of licensed software that would be sold by the reseller indicated that the amount of future returns could not be reasonably estimated Whether an arrangement with a reseller included rights of return, exchange or stock balancing rights Whether a reseller arrangement required a vendor to rebate or credit a portion of an arrangement s fee if the vendor subsequently reduced its price for a product and the reseller still had rights with respect to that product (sometimes referred to as price protection rights) Whether a vendor had induced a reseller to buy more product than could be promptly resold Whether the arrangement included either explicit or implicit commitments by the vendor to assist the reseller in selling the product to end users Whether the transaction contained other complexities, such as terms involving both a reseller and an end user Registrants also should consider the reseller s bargaining strength, past business practices, operating history, competitive pressures, the environment of the geographic location and any side arrangements or informal communications that may indicate that payment is substantially contingent on a reseller s success in selling units of the product to an end customer. Determining the nature and sufficiency of evidence of sales to end users required to recognize revenue when using the sellthrough method is a matter of professional judgement that depends on relevant facts and circumstances. SOP 97-2, Software Revenue Recognition, as amended by SOP 98-9 Staff Accounting Bulletin No. 104, Revenue Recognition (Topic 13) FASB Statement No. 48, Revenue Recognition When Rights of Return Exist Ernst & Young Financial Reporting Developments, Software Revenue Recognition, an Interpretation (Revised October 2007) (SCORE No. BB1357) SEC comments and trends for technology companies Revenue recognition

11 Contingencies such as warranties and return rights Recently, the SEC staff has asked registrants whether they offer terms, either to an end user or a reseller, that may represent contingencies to the recognition of revenue such as rights of return and warranties. If the registrant offers such term(s), the SEC staff asks the registrant to describe the significant assumptions, material changes and uncertainties associated with such contingencies. The SEC staff also may ask the company to address how certain revenue recognition requirements (e.g., that the price is fixed or determinable and that collectibility is reasonably assured ) have been met. Additionally, the SEC staff believes that revenue recognition policy disclosures should clearly describe each of the various customer programs and how the company determines the level of adequacy of allowances recorded for each program as well as specifically address aspects of the programs that may preclude revenue recognition. With respect to warranties in particular, the SEC staff has been asking registrants for further explanation on how warranty costs are estimated and how they determined that sufficient data existed to assess the accuracy of the warranty accrual in cases where the company has had limited operating history or limited sales, and thus warranty experience, with a particular product or line. Provided all the other basic revenue recognition criteria have been met, revenue generally can be recognized at the time of sale when the buyer has the right (either explicit or implicit) to return a product or receive a refund of consideration paid to the vendor if a reasonable estimate of future returns or refunds can be made pursuant to the provisions of FASB Statement No. 48, Revenue Recognition When Rights of Return Exist (Statement 48). An explicit right of return is one that is clearly stated in a contractual arrangement. Conversely, an implicit right of return is not stated in a contractual arrangement, but is established when a vendor has historically accepted returns as a common business practice. Regardless the type of right, revenue should not be recognized before (1) the vendor can make a reasonable estimate of the amount of future returns pursuant to the provisions of Statement 48 or (2) the return right lapses. Several restatements have occurred because companies recognized revenues without having sufficient history to estimate sales returns related to different customer programs (i.e., sufficient, relevant and reliable history to estimate the returns did not exist at the time the revenue was recorded). A significant amount of professional judgment may be required in evaluating whether a company has the ability to make a reasonable estimate of future returns as there are many factors and circumstances that will vary from case to case. Vendors must carefully document and analyze the data used to estimate returns to ensure that they have sufficient historical evidence that is predictive of future return levels. Warranties for defective products, including warranties that are routine, short-term and relatively minor should be accounted for in accordance with FASB Statement No. 5, Accounting for Contingencies (Statement 5). Unlike acceptance provisions and rights of return that are based upon whether a functional product meets the customer s needs, warranties establish an obligation for the vendor to make the product function in accordance with its published specifications. In accordance with Statement 5, vendors should accrue the estimated costs of satisfying warranty obligations when the revenue from the arrangement is recognized. However, if there are significant uncertainties about possible warranty claims and the range of possible loss pursuant to the warranty obligation is wide, consideration should be given as to whether any revenue should be recorded until sufficient experience exists or until the warranty period expires. FASB Statement No. 48, Revenue Recognition When Rights of Return Exist FASB Statement No. 5, Accounting for Contingencies SOP 97-2, Software Revenue Recognition, as amended by SOP 98-9 Staff Accounting Bulletin No. SAB 104, Revenue Recognition (Topic 13) Ernst & Young Financial Reporting Developments, Software Revenue Recognition, an Interpretation (Revised October 2007) (SCORE No. BB1357) SEC comments and trends for technology companies Revenue recognition

12 Accounting for consideration given by (or received from) a vendor The SEC staff has requested that registrants disclose how they account for rebates and allowances offered to customers. The requested disclosures include the applicable accounting literature followed, the amounts recognized in the income statement, and whether those amounts have been recognized as a reduction of revenue or as an expense. Additionally, the SEC staff has requested that registrants that receive rebates and allowances (vendor allowances) in connection with the purchase of products from others, including amounts related to the promotion of such products, make similar disclosures for such receipts. The SEC staff has indicated that registrants receiving vendor allowances should disclose the: Amount of vendor allowances received Amount of advertising reimbursements netted against gross advertising expenses Amount of vendor allowances accounted for as a reduction of cost of sales Number of vendors from which vendor allowances are received and the length of time of the related agreements Terms and conditions of significant agreements with vendors The SEC staff has also requested that registrants discuss the effect that vendor allowances have on their results of operations in MD&A. EITF Issue No. 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor s Products) (Issue 01-9), addresses the accounting for incentives offered by a vendor to any purchasers of its products at any point along the distribution chain, regardless of whether the purchaser receiving the consideration is a direct customer or the customer of a distributor or reseller. EITF Issue No , Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor (Issue 02-16), addresses the accounting by a customer for cash consideration received from a vendor. Although both Issues are based on similar concepts, Issue 01-9 addresses the income statement classification of vendor allowances from the perspective of the vendor while Issue does so from the perspective of the customer. Pursuant to Issue 01-9, cash consideration given by a vendor to a customer is presumed to be a reduction of the price of the products or services sold and, therefore, should be characterized as a reduction of revenue when recognized in the income statement. Similarly, pursuant to Issue 02-16, cash consideration received from a vendor generally is presumed to be a reduction in the price of products or services acquired and should be shown as a reduction of cost of sales. These presumptions can be overcome if, and to the extent that, both of the following conditions are met: (a) the vendor receives, or will receive, an identifiable benefit (goods or services) in exchange for the consideration, and (b) the fair value of the benefit identified under condition (a) can be reasonably estimated. In order to meet condition (a), the identified benefit must be sufficiently separable from the customer s purchase of products such that the vendor and customer could have entered into an exchange transaction with a third party to receive or provide the same benefit. If the above conditions are met, a vendor should recognize cash consideration given as an expense and a customer should recognize cash received as revenue. If the amount of consideration exceeds the estimated fair value of the identifiable benefit, that excess amount should be characterized as a reduction of revenue by a vendor and a reduction of cost of sales by a customer. Additionally, Issue provides that if consideration received by a customer from a vendor represents a reimbursement of a specific identifiable incremental cost incurred in selling the vendor s product or service, the cash consideration should be characterized as a reduction of those costs rather than as a reduction of cost of sales. EITF Issue No , Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor s Products) EITF Issue No , Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor Ernst & Young Publication, Revenue Recognition Lessons Learned from Restatements and Enforcement Actions (SCORE No. BB1158a) 10 SEC comments and trends for technology companies Revenue recognition

13 Business combinations Identification of intangible assets and the subsequent accounting The SEC staff has asked registrants questions about intangible assets: their initial identification, the basis for the amortization method and useful life selected (or why use of an indefinite life is appropriate), and, if applicable, the drivers of impairment. Likewise, the SEC staff frequently challenges the sufficiency of related disclosures made in periods preceding the impairment. Identification of intangible assets The SEC staff frequently asks registrants to provide robust disclosure of the factors that contribute to recognition of significant amounts of goodwill in a business combination transaction pursuant to paragraph 51(b) of FASB Statement No. 141, Business Combinations (Statement 141). If an entity is unable to clearly identify these factors, the SEC staff often challenges whether other intangible assets should have been recognized in the purchase price allocation. Selection of useful or indefinite life The SEC staff continues to challenge the amortization method and useful lives assigned to intangible assets pursuant to paragraph 11 of FASB Statement No. 142, Goodwill and Other Intangible Assets (Statement 142), including the relationship between the lives assigned to different intangible assets, as well as the determination that an intangible asset has an indefinite life in accordance with paragraph 11(d) of Statement 142. For instance, the SEC staff also has asked about the correlation between an assigned useful life and the number of years of cash flows assumed in an underlying valuation. Impairment disclosures The SEC staff frequently inquires as to how negative business events identified by a registrant have been considered in their impairment analyses. Furthermore, when a company discloses that it has recorded an impairment charge, the SEC staff regularly challenges the adequacy of the disclosure in accordance with paragraphs 46 and 47 of Statement 142. These comments typically focus upon the events and circumstances that precipitated the impairment and the sufficiency of prior disclosures, including those in MD&A, of the risks and uncertainties associated with the cause of the impairment. Identification of intangible assets Statement 141 requires an entity to allocate purchase price to all identifiable net assets of an acquired entity, including intangible assets that arise from contractual or other legal rights, or that are separable. The excess of the purchase price over the value allocated to the identifiable net assets, net of assumed liabilities, is recorded as goodwill. If goodwill is recorded in a business combination, paragraph 51(b) of Statement 141 requires that an entity disclose the factors that resulted in the recognition of goodwill. If an entity has not disclosed these factors, the SEC staff will frequently request such information through the comment letter process and require that future disclosure be provided. In addition, and especially when the SEC staff believes that the factors resulting in goodwill have not been satisfactorily disclosed, it often challenges whether or not there are additional assets, primarily intangible assets, that meet the criteria for recognition apart from goodwill and should be recorded pursuant to Statement 141 and EITF Issue No , Recognition of Customer Relationship Intangible Assets Acquired in a Business Combination. Selection of useful or indefinite life Statement 142 requires the accounting for a recognized intangible asset be based on its useful life to the reporting entity. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity, based on an analysis of all pertinent factors. These include the expected use SEC comments and trends for technology companies Business combinations 11

14 of the asset by the entity and any legal, regulatory or contractual provisions that enable renewal or extension of the asset s legal or contractual life without substantial cost (provided there is evidence to support renewal or extension and renewal or extension can be accomplished without material modifications of the existing terms and conditions). At the December 2004 AICPA National Conference on Current SEC Developments, the SEC staff noted that paragraph B174 of Statement 141, Business Combinations, indicates that the fair value estimate of an acquired intangible asset should incorporate assumptions that marketplace participants would use in making estimates of fair value, such as assumptions about future contract renewals and other benefits such as those that might result from acquisition-related synergies... In contrast, the SEC staff observed that the useful life concept in Statement 142 is not necessarily viewed from that of a marketplace participant, but inherently incorporates entity specific assumptions. The SEC staff noted that paragraph B47 of Statement 142 indicates that Because the useful lives of certain intangible assets depend on renewal and on the associated costs, the Board concluded that the useful lives assigned to those assets may reflect renewal only if there is evidence to support renewal without substantial cost. This causes an inconsistency between the useful life of a recognized intangible asset under Statement 142 and the period of expected cash flows used to measure the fair value of the asset under Statement 141. In current practice, the former is often shorter than the latter because of the restrictions imposed by paragraph 11(d) of Statement 142, which currently specifies that renewals should be considered only if they can be achieved without incurring substantial cost or materially modifying the arrangement. On November 26, 2007, the Financial Accounting Standards Board (FASB) proposed FASB Staff Position (FSP) FAS 142-f Determination of the Useful Life of Intangible Assets, which would amend paragraph 11(d) of Statement 142 to allow an entity to consider its own assumptions about renewal or extension of the arrangement, thus removing the current inconsistency between the period of expected cash flows used to measure fair value and the assumptions of useful life used to determine amortization. The proposed FSP would be effective for fiscal years beginning after June 15, 2008, with earlier adoption prohibited. Impairment disclosures An intangible asset that is subject to amortization shall be reviewed for impairment in accordance with FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (Statement 144), by applying the recognition and measurement provisions in paragraphs 7 24 of that Statement. An intangible asset that is not subject to amortization shall be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired, examples of which are listed in paragraph 8 of Statement 144. Goodwill is tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Examples of such events or circumstances are provided in paragraph 28 of Statement 142. As noted in FR-72, Commission Guidance Regarding Management s Discussion and Analysis of Financial Condition and Results of Operations, the SEC staff expects companies to highlight any reporting units for which impairment charges are reasonably likely to occur. Given the broad nature of the indicators of impairment provided in Statements 142 and 144, there is considerable room to question when the triggering event or events that led to the impairment occurred. As such, registrants should be able to explain the factors clearly that led to the impairment and articulate the basis for the timing of the impairment charge. The SEC staff also expects other MD&A disclosures to be consistent with the events or circumstances that resulted in the impairment. FASB Statement No. 141, Business Combinations FASB Statement No. 142, Goodwill and Other Intangible Assets FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets EITF Issue No , Recognition of Customer Relationship Intangible Assets Acquired in a Business Combination FR-72, Commission Guidance Regarding Management s Discussion and Analysis of Financial Condition and Results of Operations Proposed FASB Staff Position (FSP) FAS 142-f Determination of the Useful Life of Intangible Assets Ernst & Young Financial Reporting Developments, Accounting for Business Combinations FASB Statement 141 (Revised July 2007) (SCORE No. BB1042) Ernst & Young Publication, 2007 SEC Annual Reports - Reports to Shareholders Form 10-K (SCORE No. CC0244) 12 SEC comments and trends for technology companies Business combinations