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Why Vendor-Specific Objective Evidence (VSOE) Spells Trouble

As software becomes more ubiquitous, many CFOs must now confront the nightmare of revenue recognition.

January 2008
by Alix Stuart/CFO Magazine

Ever since 1963, the year it first issued shares in New York, Japanese electronics giant NEC Corp. has proudly reported its financial results according to U.S. generally accepted accounting principles. The $42 billion (in revenues) maker of computers, monitors, and semiconductors was so steeped in U.S. GAAP, in fact, that its Tokyo-based finance staff had little knowledge of Japanese accounting standards.

Then, in 2006, NEC's auditors from Shin Nihon Ernst & Young began questioning how the company had recognized revenue for contracts that included multiple items such as hardware, software, maintenance, and support services. At issue was the company's approach to a one-two regulatory punch: SOP 97-2, which governs how companies that sell software recognize the revenue; and VSOE, or vendor-specific objective evidence, a method for determining the individual value of each item within a contract in order to recognize partial revenue before the entire contract is fulfilled.

Apparently unable to make a case for VSOE, NEC was faced with the prospect of restating its revenues for the previous six years. To avoid that chore, it raced into the arms of Japanese GAAP, which, unfortunately, only served to introduce new errors and force a separate restatement. This past September, after requesting multiple extensions from Nasdaq, NEC finally admitted defeat and said that the "complexities" involved in restating its results in U.S. GAAP made the exercise "not practicable." With sincere apologies to investors everywhere, NEC said its financial statements from 2000 to 2006 were now unreliable, and that it would accept delisting in New York.

NEC's saga illustrates how thorny revenue recognition for companies selling software has become under U.S. GAAP. But help is on the way. On the heels of allowing foreign issuers to file using international financial reporting standards with no reconciliation to U.S. GAAP, the Securities and Exchange Commission is now considering whether to allow U.S. companies to do the same (see "Help on the Horizon" at the end of this article). The Financial Accounting Standards Board, meanwhile, is due to release two new revenue-recognition models for comment next quarter, both of which would make valuation within multielement bundles much easier.

For the moment, though, U.S.-based companies are stuck with a system that causes plenty of "pain and agony," in the words of one CFO. Revenue-recognition problems, namely with VSOE, are probably the leading cause of restatements among software companies, says Jeffrey Szafran, managing director at Huron Consulting Group. Comverse Technology subsidiaries Verint Systems and Ulticom Inc., as well as other companies, have announced in recent months that they will restate results due to problems with VSOE. And as products from cars to medical devices rely more heavily on software, other industries are feeling the pain. Most telecommunications companies, for example, need to apply SOP 97-2, "since contracts almost always combine hardware and software now," says Hasan Imam, a telecom analyst for Thomas Weisel.

Paying for Past Sins
Ten years ago, a growing clamor about software companies trying to pretty themselves up by recognizing revenue ahead of delivery led the American Institute of Certified Public Accountants (or more precisely, the Accounting Standards Executive Committee of the AICPA) to replace SOP 91-1 with SOP 97-2, which was later amended by SOP 98-9. These rules say that when software and other items are bundled together in a contract, a company cannot recognize any of the revenue from the contract until the last item has been delivered — unless it can prove the separate value of each item. For example, if a company sells a software license with installation services and 12 months of maintenance, it must either defer all that revenue for 12 months or recognize it proportionately over the 12 months, depending on the particular circumstances, unless it can establish the independent values of the undelivered items.

In practice, these rules constrain the ways companies sell their products, chew up a lot of management time, and put off some investors. "There's a huge investment in time and effort" to stay compliant with VSOE, including vetting every sales contract for pricing conformity, says Epicor Software CFO Michael Piraino. Secure Computing Corp. CFO Tim Steinkopf adds, "VSOE is in the top handful of worries as we deal with the investment community. A lot of funds say, 'If I have to think hard about something, I'm not even going to look at it.'"

The Variable Bell Curve
Part of the problem is the absence of an official way to establish the fair values of products within a contract. Many turn to the bell-curve approach. Typically, that means that at least 80 percent of sales prices should fall within 15 percent of the median price, says Tony Sondhi, author of the Revenue Recognition Guide 2008 and a member of FASB's Emerging Issues Task Force.

But that rule of thumb is open to judgment. Some CFOs are more conservative, but in different ways. At E-commerce hosting and software provider ATG, CFO Julie Bradley considers her range of deviation from the median to be 10 percent. At Secure Computing, Steinkopf sticks with the 15 percent band, but applies it to 85 percent of sales. "We know that some of the firms quote that 80 percent within 15 percent rule, but we try not to treat that as a bright line," says Mark Barrysmith, a professional accounting fellow in the SEC's Office of the Chief Accountant. "The goal is to demonstrate consistent pricing practices."

Another difficulty with the bell curve is that it requires a track record of sales, making the accounting treatment of new and newly acquired products challenging. It also implies firms must sell each product individually to get the sales data they need, which isn't always appealing to customers.

The alternative is the so-called stated-renewal approach, in which companies use the renewal price for services stated in the contract as a basis for value. Some take issue with this approach because it generally applies only to post-contract services and not to items like warranties. Also, stated prices may differ from the actual prices, leading back to the need for bell-curve evidence. "I think the stated-renewal method could get you into trouble," says Sondhi. Nonetheless, many companies continue to use it, in part because it's easier.

Then, of course, every auditor — even within the same firm — has his or her own way of approaching the problem. Epicor's Piraino says he was forced to restate three years' worth of financial statements in 2006 when Deloitte assigned him a new audit partner. Before the auditor rotation, Epicor had applied whatever discount it gave to customers equally to the software and maintenance parts of its revenue. Upon an exhaustive review of renewal data, prompted by the new partner, Piraino discovered that maintenance garnered a higher price when sold separately through renewal. Accordingly, it should have been discounted less heavily in the original recording of the sales, which means more revenue should have been deferred.

Hence the restatement, which consumed almost 10,000 person-hours. And the hard work didn't end there. Notes Piraino, "Now that it's over, we have to maintain these curves," analyzing 100 or so on a quarterly basis.

The Stock-Price Effect
Restatements to account for VSOE issues usually affect only the timing of revenues, not the overall amount. In Epicor's case, current revenues for three years were reduced by less than one percent in any given year. Merge Healthcare, which restated for VSOE and other issues in 2006, recorded a difference of less than $1 million, or one percent of total revenues, due to VSOE. Nevertheless, investors don't like it. "It has been my experience with VSOE that the impact to the stock can be much worse than the real impact to the company," says George Hill, an analyst with Leerink Swann & Co. who covers Merge. "It can be an ugly process." Merge saw its stock drop about 40 percent when it announced the restatement.

Acquisition Blues
Even for companies that have VSOE, an acquisition or a change in business model can create the need to change the revenue-recognition model. "One of the most common scenarios is that customers ask for different configurations of products than they did initially, and then you may not have VSOE any more," says Sondhi. Giving customers concessions to make up for poor service doesn't help. "If it happens once, OK, but when it starts to happen with some degree of frequency, it raises questions about fair value," says Huron Consulting's Szafran.

In 2006, when E-commerce platform provider ATG acquired eStara, then a privately held maker of "click-to-call" customer-service software, CFO Bradley knew she would have to give up VSOE on some contracts if she wanted her sales team to package the new software with existing products. eStara tended to use customized pricing, which "does not work with VSOE," Bradley notes, and so it would negate the VSOE model for any contract to which it was added. That pointed toward splitting up all the revenue from the sale equally over the life of the contract even when the bulk of the items were delivered upfront. As a result, ATG went from being profitable to running at a loss for at least four quarters.

Breaking the news to Wall Street was painful. "It was a very dark day," says Bradley, recalling her announcement last February that ATG would begin deferring about 50 percent of its revenue thanks to eStara. Although it meant that the firm expected revenues over time to increase, ATG's stock dropped about 20 percent in the days surrounding that announcement. Eventually, she says, analysts understood, and the stock has doubled from its nadir as ATG's cash flow from operations quadrupled between the third quarter of 2006 and the third quarter of 2007. (The company still shows a GAAP loss.)

Avoiding VSOE is not really an option, unless the company doesn't mind lumpy revenue and unbridled suspicion from investors. "The question we always get is, 'Every company has to deal with VSOE. Why are you different?'" says Airvana CFO Jeff Glidden. He's become practiced at the answer since his company went public last spring and he had to educate investors on why it defers all of its revenues. Why? The company, which sells software and future upgrades to major wireless-network equipment makers like Nortel, Alcatel Lucent, and Qualcomm, offers unique products, contracts, and pricing to each customer. Thus, it effectively can never establish VSOE, because its prices don't fit a curve. "When we reviewed this with the SEC, they said this business model probably wasn't considered in 97-2," says Glidden. But even so, "you have to follow the rules." In this case, following the rules means Airvana's revenue might swing from $3 million in one quarter to $140 million in the next, as revenue deferred from one or two years earlier becomes current. "My GAAP statements are stale at best, since you're still explaining why revenue this year is up or down based on what happened last year," says Glidden.

The Road Ahead
NEC, for its part, may still have to file restated earnings before it is free and clear of its U.S. legal obligations. Other companies deal with the constraints of SOP 97-2 by pointing investors toward metrics that show current business activity, such as billings and cash flow from operations. Secure Computing's Steinkopf also shows revenues with VSOE adjustments, as if deferred revenue were considered current. But no one has a perfect solution. Most accept that their stock will trade at a discount because of the accounting, since "the vast majority of the market won't do the work to get it," says Glidden. Adds Piraino: "The auditing profession has made GAAP earnings meaningless to investors."

Still, trying to make VSOE intelligible may be worth the effort. While many CFOs will shy away from an overly technical explanation in their earnings calls, Sondhi says he finds such an attitude condescending — and possibly telling. "It's not rocket science," he says. "When CFOs say this is too complicated, it usually means they don't understand it either."

This article has been excerpted from CFO magazine. Read the full article here.

Alix Stuart is a senior writer at CFO.

© CFO Publishing Corporation 2008. All rights reserved.