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PwC Sees Revenue Recognition Snags in IFRS

For software outfits, and other companies, too, the consultancy suggests a careful look at potentially thorny accounting issues.
Roy Harris, CFO.com | US
July 8, 2008

Some American companies see the shift to International Financial Reporting Standards as relatively harmless, figuring that they're safe because they've been weaned on the stricter requirements of U.S. generally accepted accounting principles. But in some areas — especially among software companies with complex sales-contract structures — there's still a need to be concerned, PricewaterhouseCoopers is cautioning.

"The biggest accounting challenge that we see for software companies is revenue recognition," Dean Petracca, PwC's global and U.S. software leader, tells CFO.com in an interview. And while software may be the area with the biggest headaches, "these problems are definitely portable to other industries," he adds.

PwC recently prepared a study titled "A Shifting Software Revenue Recognition Landscape?" introduced by Petracca and European software leader Pierre Marty, in which they led off by noting the common assumption in corporate finance that conversion to IFRS will "simplify financial reporting and reduce the compliance burden for listed companies." (It's no longer proper to call it convergence, Petracca says. "It was once assumed that U.S. GAAP and IFRS would come together and be reconciled. Hence, the term convergence. Now the thinking is that U.S. GAAP goes away, and IFRS takes over.")

The PwC study then laid out a case that the "economic and technical characteristics of the software industry make revenue recognition not only a thorny issue, but one of strategic importance for companies." The principles-based approach of IFRS, with its "greater scope for judgment" allowed, may offer little comfort as a replacement to GAAP, with its "complex set of rules dedicated to the software industry," the report said.

From Evaluation to "Close-down"
PwC, of course, is hardly alone in analyzing these issues. "All the Big Four firms are engaged," Petracca says, "but we believe that we're a few steps a head of some other firms when it comes to software. We've had a lot of experience helping companies in Europe and Australia, who've already made the conversion to IFRS." That conversion involves three phases, he says, starting with a three-to-six-month evaluation, followed by 18 to 24 months of detailed work plotting out organizational changes that might have to occur, and a relatively short "close-down phase."

Most companies in the software industry — where Petracca says PwC's affiliations are very strong — are in the first review phase in preparation for IFRS. And there, they are learning that converting to IFRS can run far deeper into their organizations than they expected.

"Within the software industry, the effects of the changes may be exaggerated," he says. "The requirements are that when you sell more than one product or service at one time, you have to break down the total sale value in individual pieces. Establishing the individual values under U.S. GAAP is solely a function of how the company prices those products and services over time." Contracts typically include such multiple "deliverables" as hardware, software, professional services, maintenance, and support — all of which are valued and accounted for differently.

Furthermore, "sales force activity ultimately determines the accounting result," he notes. "And it's taken years and years to establish an understanding with the sales force of the rules in the U.S — to establish a level of discipline so that working with customers does not result in adverse accounting treatments."

Petracca points out that in a contract, "the overriding principle does exist under both U.S. GAAP and IFRS that you determine the fair value of the individual elements, and you parse out the total sale value to those individual elements." Under GAAP, very restrictive interpretations and rules govern this process, "starting with the definition of what constitutes fair value," and the high standards for vendor specific objective evidence (VSOE.) Under IFRS, meanwhile, "you can establish fair value in a number of ways." But not every method used under IFRS is acceptable under U.S. GAAP, and some conflicts may result.

When to Sign the Contract?
Another case in which the approaches of GAAP and IFRS may conflict relates to the signing of a contract, PwC's study indicated. "Under U.S. GAAP, no revenue can be recognized unless persuasive evidence of an arrangement exists," which most software companies typically define as a signed contract. Under International Accounting Standard 18, however, revenue "is recognized when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably." That may suggest that a signed contract is not required to be fully executed for the recognition of revenue, as long as the reporting company is comfortable that there is agreement between the parties.

Other sources of potential conflict between GAAP and IFRS? Some involve the system for accounting for customer services after the contract, the allocation of discounts when using the residual method, and accounting for time-based licenses. All these cases relate to the timing of the revenue recognition. Says Petracca, "If reporting companies have differing methods of allocating total sale value to the pieces, and differing trigger points for when revenue is recognized, then comparability of the reporting across companies may be impaired."


Petracca says that, while acknowledging these potential conflicts as likely at the time of conversion to IFRS, "many software company finance people I've talked to don't want to give up the structure that now exists in the industry. They're going to try to keep those kinds of procedures in place, and not make significant changes to take advantage of the more-broad definitions of IFRS." Instead, he explains, they "favor the discipline around negotiating with customers that has built up in their companies, making the revenue recognition more predictable and the business practices controlled."

That may create a problem, however, "when the companies are under pressure to make their quarterly numbers, and that unusual transaction comes in — recognition of which might be justifiable under IFRS."

Lessons from Europe and Australia
Witness a case in which "one can question whether revenue that is deferred under the more restrictive guidance of U.S. GAAP should potentially be recognized earlier in applying the more-broad guidance of IFRS," the PwC software leader says. "I'm not prepared to give you an answer to that question."

Indeed, "the end of the story is not written yet," he adds. And educating finance departments about the potential GAAP-IFRS conflicts, especially for software businesses, will be necessary.

So far, according to Petracca, the lessons learned from the switch to IFRS in Europe and Australia have been more generic. "The first lesson is to start early," in his view. "Organizations are like ships; it takes some time to turn them. We all like to think we're nimble." But, of course, some companies are deluding themselves.

Starting early can also help control conversion costs, he says. Despite the peculiar problems of software, "I don't think it should be remarkably more expensive for a software company to go through this experience." We saw in the U.S. the cost of change when we all went through the adoption of Sarbanes-Oxley Section 404. There were lessons there, as well, for those who started late. Oftentimes, if you don't have a well-planned conversion effort, it ends up being more costly. And if you don it early, you'll have less need for dependence on outside resources."

Adds Petracca, "I don't anticipate this conversion being as traumatic as 404. There was no playbook for that. At least in this case, it has been done," in other countries.




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