Over the past year or so, I’ve fielded questions from a number of business people about the new revenue recognition rules, particularly in the technology sector. I’ve heard many people, some inside my own company, lament about their “VSOE issues”. So I did some investigation on the FASB website as well as those of several major accounting firms and what follows is an attempt to clarify what this all means.

With that, I give one major caveat—this post is not meant for finance professionals. Rather, this is an attempt to shed light on these evolving rules for non-financial business people who are affected by them but find them confusing. I won’t get into EITF or ASU rules, nor will I discuss the recent FASB and IASB exposure draft on converging the two standards. Instead, I’ve attempted to simplify the discussion so non-finance people can understand what this means to them without the complicated language that those of us with financial backgrounds are used to.

First, a little background: Accounting always tries to match an economic event with the period in which it is earned or realized. This “matching principle” as it pertains to revenue, tries to align revenue with associated costs in the period in which they were incurred in order to provide stakeholders with an accurate representation of how a business is performing.

 Both costs and revenue are always a thorny area because so many accounting irregularities have occurred here. The principle behind revenue is it should be recorded when it is “earned”—that is when all contractual obligations have been met by the business.

 Where this started to get unwieldy is when certain technology companies began selling products that are essentially bundles of hardware, software and services and the existing revenue recognition rules (“rev rec” in accountant speak) forced them to defer revenue even though some of the components were fully delivered. This resulted in a distorted view of revenue because particular items could not be booked as long as some deliverable remained outstanding. Rightly so, companies appealed to the accounting authorities to get the existing rules changed.

 In 2008, the Financial Accounting Standards Board’s Emerging Issues Task Force (FASB-EITF) created rules, now in effect, that govern how contracts with multiple deliverables are recorded. (There were actually two rules—the other deals with product bundles which contain hardware and software and I promised to keep this simple!)

 One of those rules (ASU 2009-13—I know, I promised to keep it simple but I couldn’t help it!) is the one where the term “VSOE” comes from. What is says is in contracts that contain multiple deliverables such as hardware, software, professional services and support—the issuing company must break all of these into their component parts and recognize them at different times (i.e. when they are delivered). The next challenge is how does the company value these component parts? The rule lays out a methodology for establishing the “fair value” of these components to determine how they are recorded. These rules establish a hierarchy of evidence that’s required in order to determine the value of these components, they are:

VSOE—Vendor-specific objective evidence.  In simple terms, this would equate to what the company would charge if the component were sold separately. The onus is on the company to provide evidence of how that item would be priced on its own (i.e. 100 hours of consulting).

 TPE—Third-party evidence. If you don’t have VSOE on what your company would charge, the accountants will look to third-parties such as competitors to determine how they would price a similar item.

 ESP—Estimated selling price. If neither VSOE or TPE can be determined, then you must provide the best estimate on what the component is worth based on market prices.

 I hope this was helpful to you non-financial people who are affected by these rules—such the many sales people I’ve talked to who find them confusing and frustrating. Again, there’s a lot of detail behind these rules that I have deliberately left out—in fact there are multiple rules and to make it even more complicated, the US and international accounting standards are quite far apart on this topic and the governing boards are working hard to reconcile these differences. For further detail into what this means for your company, ask your CFO.