One of the most significant reasons why I was able to take advantage of this opportunity is because of the work I’ve been fortunate enough to be involved in with my clients.  Together, we have fit evolving business models into the often “square hole” of revenue recognition literature.  I have immensely enjoyed the issues, but will most cherish the relationships I’ve developed.  Regardless of accounting rules, businesses are still run by the people that have to make those “significant judgments”.

I have a few weeks to wind down my involvement with RevRec.Net and to finalize certain client deliverables and complete other commitments.  One of my final duties as a consultant will be later this month in Minneapolis where I’m one of the speakers at CBI’s Revenue Recognition for MedTech Companies.  If you are interested in going, use Promo Code YSD389 when you register and you’ll get $300 off.  I’ll be doing a 45 minute session on how to deal with those often minor undelivered elements like training, installation, and training.

While the other consultants in the RevRec.Net group will continue on with their projects, I won’t be offering any more training.  I’ll be updating the website to remove the training content, and will keep the appropriate participant records on file as required by the standards for CPE programs, but don’t currently have the bandwidth to continue to offer these courses.  I thoroughly enjoyed my days spent trying to solve the real life problems participants brought to these sessions and that direct dialogue will be missed.

I will publish my new contact information on LinkedIn.  Look for the new “Revenue Recognition Network” group that I started for discussion of technical rev rec issues that we will continue to face as IFRS, EITF 09-3, and EITF 08-1 inevitably hit us.

Notwithstanding the debate currently raging about fair-value accounting in this credit crisis, as far as I know, the same revenue recognition guidelines apply whether your company’s revenue is growing in good times, or shrinking in bad times.  All those policies you put in place to comply with US GAAP are still relevant.  The only difference when times are tough is that they will be tested more as pressure on earnings and revenue increases.

Here are some areas that you may be tested on these days.

Side Agreements.  Salespeople may be more inclined to promise things outside the documented arrangement to get an order from a customer.  Now may be a good time to remind everyone about your policy on disclosing such commitments (or get such a policy in place).

Returns.  A downturn is not necessarily a reason to conclude you no longer have the ability to estimate returns under FAS 48 (unless perhaps all your customers are in one industry that is on the verge of collapse).  However, if your practice has never been to offer customers rights of return, stock rotation rights, buy-back arrangements, and the like, then you may start seeing such requests as customers de-risk their own operations.  Trouble is, if you’ve haven’t offered such terms before, you don’t have a history to support your ability to reasonably estimate returns.  Be prepared to have to defer revenue until you can establish a history (which may be a few quarters depending on the length of return cycle you agree to).

Financing.  Resellers and distributors that have had their traditional sources of short term financing for operations either become more expensive or disappear may turn to you as the vendor to help them.  Examples of such assistance are:

• extended payment terms:  this can cause revenue to be considered not fixed or determinable if terms are beyond what you have already defined as “normal”.
• third party financing:  if a bank or other financing source is involved in the transaction, this may change the definition of who your customer is (e.g. if the order comes directly from a leasing company), or may cause you to be incurring incremental risk by participating in the financing (in which case, revenue may have to be recognized as payments are due under the financing arrangement).
• direct financing:  giving a loan or taking an equity stake in a customer not only entails other accounting guidance for that transaction, but could also impact how revenue is recognized (e.g. conversion of outstanding accounts receivable into a longer term note would be considered a concession that would likely make revenue on subsequent sales at least to that customer not fixed or determinable).

Non-standard Arrangements.  Depending on the pressures they face themselves, customers may demand a variety of terms and conditions that you do not routinely deal with.  There is no all inclusive list of what these could be, but some of the more common demands seem to be:  assistance with marketing, commitments to a technology roadmap, PCS buy-downs, and future discounts.  These all have revenue recognition implications that must be assessed at the outset.

VSOE.  All the hard work you did over the past months and years to finally establish VSOE of fair value may be unwound if price reductions impact those elements of your arrangements that typically remain undelivered.  Under the bell-shaped curve approach, lower prices may cause too many outlying transactions.  If you use a stated price approach, not actually charging the stated price when the time comes could lead to a retroactive lack of VSOE of fair value resulting in your losing the ability to apply that method; or worse, a restatement of prior periods if material enough.  Ensure you assess these risks when deciding what element to deep discount.

In the end, bad times may create new and differing facts and circumstances to deal with.  But for any given set of facts and circumstances, the rev rec answer should be the same regardless of the strength of the economy.

If you don’t have VSOE of fair value, paragraph 12 of SOP 97-2 actually tells you to defer all revenue “until the earlier of the point at which (a) such sufficient vendor-specific objective evidence does exist or (b) all elements of the arrangement have been delivered”, but then goes on to provide at least two exceptions:

• “if the only undelivered element is PCS, the entire fee should be recognized ratably”, and
• “if the only undelivered element is services… (for example, training or installation), the entire fee should be recognized ratably”.

So here’s the rule:  if no VSOE of fair value, then ratable treatment over the service period.  I get it.

But what if you establish VSOE of fair value in a subsequent reporting period?  Maybe, with another quarter or two of data, your population of standalone transactions at long last now demonstrates the magic 80/15 bell shape (see discussion of other ways to get VSOE here).

Certainly, we don’t go back and restate prior periods now that we have established VSOE of fair value in a current period.  But what do we do with the millions stuck in the huge deferred revenue waterfall slowly tricking into revenue over the service period?  Do we let that waterfall keep trickling, or do we now reassess those arrangements by applying VSOE of fair value to the remaining undelivered services and recognize the residual in the current period.

Answer:  there isn’t one (which means you get to make a policy choice).  When I chat with some knowledgeable Big 4 colleagues on this topic, about half say the newly established VSOE of fair value should only be applied to new arrangements, while the other half say that you should take the residual revenue in the current period.  One firm actually has come out and explained this issue in their commentary, while others seem not to object to either approach.  In any case, before you go materially altering revenue, ensure your audit team is on board with your choice as these are the sort of judgment calls that evolve.

Personally, I can see it both ways.  Paragraph 12 does indeed say defer revenue until you get VSOE, but doing such a “catch-up” of revenue in a period where nothing else fundamentally happened with the transaction seems like “mark-to-market” accounting for rev rec.

On the other hand, perhaps the exceptions listed in paragraph 12 are supposed to apply for the “life” of the arrangement without our being able to revisit the accounting determined at the outset.

Your call.  Just be consistent.

Ready for what?!  Since this craziness ramped up late last year, the recently approved and highly anticipated roadmap from the SEC simply says that they will look at the matter for another three years or so and make their decision in 2011.  Don’t get me wrong - as a revenue recognition consultant, I always knew there would be enough years of grief with US GAAP that I’d have more than enough work until someone tried to fix it.  Then my practice would have a few years of implementation/conversion work under whatever the new standards were, followed by a few more years of dealing with the new grief caused by the inevitable interpretations of interpretations of the guidance that was meant to fix everything.  I initially thought this chain of opportunity would stem from the joint IASB/FASB project on revenue recognition (which has been going on since 2002, by the way).  However, it appears I now have an alternative benefactor in IFRS – or do I?

Despite the usual internal objections to actually having a deadline at all for the FASB Board to finally issue a revenue recognition standard (2011), I hope the timing is not just coincidental with when the SEC will make their decision as to whether to proceed with IFRS.  I have to hope the benefits that come from discussing improvements over accounting for the biggest number on your P&L for almost a decade will not go to waste.

For those who are so eagerly anticipating the introduction of IFRS, let’s do a reality check for a moment:

• for nearly 75 years, it has been the job of the SEC to protect investors by issuing very specific guidance, often in response to abuses;
• the accounting standard setters have evolved US GAAP into its “rules-based” approach by issuing guidance like SOP 97-2 for companies that sell software;
• we have trained generations of accountants and auditors in this “rules-based” regime; and
• if a judgment call is not objectionable under GAAP, management will (as expected) push the limits of interpretations of principles to report desired financial results. 

The question is not whether companies are ready to adopt IFRS, but rather whether the regulators, standard setters, and the accounting profession itself are ready.  Companies will do what they did when SOX was introduced – spend a lot of money in a short period of time based on someone else’s advise on what they think section 404 means, and those who start sooner with an appropriate level of resources will be better off than those who wait to address this issue.  At least with IFRS, we have a bit of runway, but first I have to ask a basic question:  If we can’t figure out something as fundamental as what VSOE of fair value is under rules-based guidance like SOP 97-2, how will we even begin to entertain adoption of a principles-based approach like IFRS when the level of judgment is widened?

In response to this rhetorical question, here is what I predict the next several years will look like:

• on or before 2011, the SEC will say that it needs more time to look at IFRS because they will have done their own reality check of the situation;
• the SEC won’t abandon it altogether because it will become increasingly embarrassing that rest of the world has long moved on to the standard;
• instead, it will become clear IFRS is the way to go, but that there are still some specific rules that are needed to continue to ensure consistency and comparability;
• the SEC will need to work on these rules and interpretations for a while which will include the revenue recognition standards that come out of the joint IASB/FASB project (assuming the project is actually completed);
• we will end up with a “rules-based” version of IFRS for US companies; and
• despite the roadmap just introduced, the majority of filers will be allowed (or forced) to adopt IFRS somewhere near 2020. 

Global standards are nothing new and even IFRS is nothing new.  I do believe the long term benefits of adopting IFRS will be improvements to comparability and consistency in financial statements.  However, when given a choice between usefulness of financial statements and protection, investors will choose protection.

The mandate of the SEC is to protect investors, and that is what they will continue to do no matter what form of GAAP companies file under.

On the other hand, I certainly would not put auditors in the category of a “necessary evil”.  They are necessary, but they are not evil (for the most part).  While management is responsible for the financial statements, the auditors are the ones putting a signature on the opinion.  None of us should deny they have a key stake.

f you do any public filings of financial statements or otherwise need an opinion on GAAP financial statements, you have to go through an auditor to get them.  If you don’t mind a frustrating audit or review process combined with needless cycles of inefficient discussions, rework, and/or adjusting journal entries, don’t bother reading on.  However, if you want to continue to improve the process of issuing financial statements, here are a few things I’ve noted along the way that tend to create useful paths of least resistance.

Take responsibility for your financial statements.  The audit opinion states the “financial statements are the responsibility of management”.  I still come across some finance executives that think the best way to deal with an issue is to wait until the auditors find it.  This is poor management, not to mention poor control.  However, don’t let your audit team unduly influence your decision when there is a judgment call to make.  Just because it may be a more aggressive position, this does not mean it is objectionable under GAAP, or even inconsistent with their firm’s official position.

Consult and communicate.  Auditors don’t write those memos telling you how to account for transactions like they used to.  However, what they often do now is publish 3-400 page commentaries on certain topics.  Where you have a complex arrangement, these guides are good sources of more fully described interpretations.  And if the arrangement is so complex (provided the transaction is not yet under audit), get the audit team in a room and discuss the issues.  I have not yet found an audit team that is unwilling to do this.  It is not an internal control issue if management is considering all the potential alternatives of accounting for a transaction.

Own the audit process.  Again, they are your financial statements.  So when you get those extensive “to be prepared by client” lists, ensure they are asking for the right things, and update it yourself for any changes in accounts, policies, or any other matters.  And if you are being held to deadlines of various sorts, ensure the audit team reciprocates the emphasis on when things need to be done.  An audit is just another project that needs to be managed like one.

Find productive counterparts.  If you know there is a complex issue to resolve, don’t start with the junior on the job and let him or her escalate it.  Pick the level of responsibility that is required at the beginning of the discussion (at least senior manager or partner) so that any further escalation to their technical group can be done quickly if needed.

Get them comfortable, and get them out.  This works much better if complex issues are resolved during the quarter as deals come in.  At any rate, at some point, once appropriate decisions are made around accounting methodology, and everything is appropriately documented, the audit of the transaction has to have an end (some people call this “pencils down”).  Once you find the remaining issues in your technical memo are your grammar and writing style, that’s a pretty good sign the auditors have what they need.

Some or all of these may seem obvious, but I still observe many management teams struggling with their audit teams.

If anyone has any other helpful hints, feel free to add them via a comment.

I don’t disagree with too many things in the revenue recognition world, but the thresholds to what “consistent” have evolved, while they may be quantitatively straightforward, are not useful in many circumstances, which means the resulting financial statements that get produced are also not useful (and I thought usefulness was an important objective in financial statement reporting, unless I’ve read the very first Statement of Financial Accounting Concepts incorrectly).

Let’s say a  company ships millions of dollars worth of product (for which software is more than incidental) to a customer and throws in a bunch of training for which they have either:  a) not yet sold on a standalone basis (because they are too busy shipping millions worth of product and have not had time to scale their training organization), or b) sold it on a standalone basis but not at pricing “consistent” enough (because of course they will give large and varying discounts to customers who are willing to buy millions worth of product).  In other words, no VSOE of fair value for training; therefore, spread everything over the period during which the training occurs (which could be years) – this is not useful.  Depending on the terms of the agreement, it is not infeasible that the customer could depreciate the asset faster than revenue is recognized (all because the company included a few training courses in the arrangement).  It also makes the financial statements not comparable to a competitor who just happened to have a handful of standalone training sales to assert the much sought after VSOE of fair value.  For investors, I would hope the question of “Did you sell training at the same price?” falls much lower on the relevant scale than “Are you doing all you can to continue to get millions of dollars worth of product orders, even if it means giving away or highly discounting other minor elements of the transaction?”

Let me digress, because it is not useful for me to continue to spout off my feelings without summarizing how to handle the interpretations of what constitutes VSOE of fair value we currently have to deal with.  Until someone blesses a more reasonable “but can’t be more than” approach, here is some direction about establishing VSOE of fair value.

Quite simply, paragraph 10 of SOP 97-2 (Software Revenue Recognition) defines VSOE of fair value as either “the price charged when the same element is sold separately” or “for an element not yet being sold separately, the price established by management having the relevant authority”.

Don’t get too excited about using your authority to set pricing because the fact that you may actually have that authority is only one aspect.  And it is not just the list price, but the actual price (after planned discounts) that has to be established.  Here is why it is rarely used:

1. it only is applicable for elements that you have not yet introduced separately, so it can’t be used to establish VSOE of fair value for that element you’ve been discounting all over the place for years;
2. it must be “probable” that the price you assert will actually be the price when you happen to sell it separately, so don’t plan on doing a last minute change to the price based on competitive pressure or other market conditions that you would normally do as a sound business decision (and the longer it is expected to take to sell it separately, the harder it will be to defend the probability);
3. you need to have a track record (preferably for similar products or services) of setting expected prices internally (usually marketing does this) and having those prices play out in the market place.

It is much more common for companies to establish fair value using one of methods that look at the price when the element is sold separately.  Generally, there are two acceptable methodologies in practice (or three if you have a particular firm as your auditors, and it is ridiculous to me that firms disagree on a concept that can have such an impact on financial results – comparability should not depend on who your auditors are!).

At any rate, let’s talk about the “bell-shaped curve” and the “stated price” methods. 

Reference to a bell shape is very literal as you want to price your elements in such a way that a large number of transactions (i.e. standalone deals for that particular element) fall within a consistent band (forming a shape like a bell if you remember your graphs of data sets from statistics class).  Some people call this the “80/15” test because the current interpretation of what could be sufficient is having 80% of the transactions fall within +/-15% of the median of the data.  A little stats lesson:  median = mid-point; mean = average.  Don’t use the average to calculate the range as that could mask the price you actually charge most frequently (which is what you are trying to get to).  On the other hand, don’t get discouraged if you get in the 70’s instead of in the 80’s (especially if the band of pricing is still narrow and/or there is an upward trend).  If you are in the 60’s, then it will be a challenge to assert you charge a consistent price.  However, some interpret consistency as being a “substantial majority” (generally, at least two-thirds), so maybe 66.7% is enough!  This is actually close to the mathematical three sigma rule (or empirical rule) which states that 68.3% of a set of values in a normal distribution lie within one standard deviation from the mean.  My point:  see what you have and don’t give up unless it is very clear you can’t come close to approaching 70%.

There are two versions of the stated price method:  one audit firm says just state the price in the order for which you need VSOE and that’s the fair value (i.e. quote what the price of that element will be if they buy it again).  You still have to support the idea that the price is substantive, and ensure you can demonstrate the likelihood of that future transaction even happening, but it generally is that easy.  However, if you don’t stick to that price when the time comes, that means you did not actually have VSOE of fair value back when you relied on that stated price to establish it.  This can lead to restatements to past periods, so it’s a pretty high risk endeavor, not to mention that it locks both the supplier and customer into a price sometimes years in advance (which, from a business perspective, is not usually desired).

The second “more accepted” approach to the stated price method is to state what the price of that element will be if the customer buys it again outside of the current arrangement (same as above), but use a population of stated prices in various orders to build support for the notion that to price the element at that level is indeed the customary practice.  And if you have at least one standalone transaction to back test that assertion, you may have VSOE of fair value.  Some explain this as applying the bell-shaped approach to stated prices in bundled arrangements.

So…lot’s of interpretations, most of which are difficult to apply if you are a start-up, introducing new products/services, pricing into new markets, or varying pricing for other valid business reasons.  Companies that are successful in establishing VSOE of fair value first recognize that the current interpretations are what they are, select an approach that works for them, put in place measures to limit flexibility in negotiations on elements that typically remain undelivered in an arrangement (e.g. support, maintenance, training, professional services), and drive towards consistent pricing behavior, usually with a strategy of negotiating the pricing, if necessary, on elements that typically are delivered up front (e.g. equipment, software licenses).

Learn more:

• Software Revenue Recognition
• Advanced Revenue Recognition Topics