In a January 28th article, located here, CFO magazine quotes Huron Consulting Group’s Jeffrey Szafran, as saying “revenue-recognition problems . . . are probably the leading cause of restatements among software companies.” The consequences of getting it wrong can be severe. NEC (as reported in that same article) faced with the prospect of restating earnings for the past six years as a result of revenue recognition issues in its contracts, chose instead to be delisted from NASDAQ. Because some of the basic revenue criteria for recognizing revenue are dependent on the structure and terms of a software agreement, you are likely to encounter the issue of revenue recognition when negotiating against a software company of any size.
The issue is usually encountered when a licensee asks for certain concessions or discounts that are rejected by the vendor because, according to the vendor, such concessions or discounts prevent the vendor from recognizing the revenue associated with the transaction within the current quarter. This excuse is usually met with extreme skepticism by licensees. How do you know if the software vendor’s issues are legitimate? SOP 97-2 (as amended) which is put out by The American Institute for Certified Public Accountants (AICPA) (available for purchase here) is a set of guidelines for revenue recognition in software transactions. SOP 97-2 sets forth four criteria that must be met prior to recognizing revenue from an agreement, namely:
- persuasive evidence of an arrangement exists;
- delivery has occurred;
- the software vendor’s fee is fixed or determinable; and
- collectibility is probable.
While the foregoing criteria appear relatively straightforward, the application of these criteria can be difficult and varies from vendor to vendor. As a result you will most likely not be able to determine the validity of a vendor’s claim that revenue recognition prevents the vendor from making certain concessions during the negotiation of a software transaction We have extensive experience representing software vendors during the drafting and negotiation of software transactions. In our experience, account executives and sales vice presidents are unlikely to use the issue of revenue recognition as a negotiation ploy. Further, proposed concessions and pricing discounts are usually reviewed by a vendor’s accountants during the negotiation process and prior to signature. Finally, a vendor’s inability to recognize the revenue associated with the transaction within the quarter may impact the vendor’s sense of urgency to close the deal and may impact the vendor’s desire to honor any proposed price discounts to the extent such discounts are contingent on closing the deal within the quarter. If you suspect a vendor is using the revenue recognition issue as a ploy, asking the vendor to explain specifically how the particular issue is impacted by SOP 97-2 may help. Be aware, however, that your sales representative is most likely unaware why the issue creates a revenue recognition problem. More likely he is simply being told by his accountants that the issue “rev/recs” his deal. In such a case speaking directly to the decision maker may assist you in determining the validity of the revenue recognition issue.
If the vendor remains unwilling to provide a certain discount or concession because of a revenue recognition issue, you may have to forego the requested concession or discount. However, keep in mind that the vendor may be more willing to concede other business or legal issue to get the deal done. Pursuing these other legal or business issues more vigorously and using the vendor’s inability to move on the original point because of the vendors rev/rev problem may result in additional cost savings or risk reduction.