Why VSOE Spells Trouble

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."

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