Software CFO: Intangible Assets, Real Pains

Mercurial assets, non-linear sales, revenue recognition pitfalls -- finance chiefs at software companies have a hard job.
Jennifer CaplanJuly 3, 2002

Finance chiefs and other senior executives at software companies are victims of their own success. Between 1993 and 2001, spending on computer applications in the U.S. grew at a compounded annual growth rate of 14 percent, according to the Information Technology Association of America. In 2001 alone, Americans spent nearly $100 billion on software products.

And therein lies the rub. During the Nineties, and particularly the latter half of that decade, software vendors could do no wrong. They sold millions of applications, and watched as their stock prices jumped at a double-digit annual clip. And they expanded operations like crazy — often through acquisitions.

But when the new economy bubble burst, so did the halcyon days for software companies — even for stalwarts like ERP vendors and business intelligence specialists. Spending on information technology — including software — hit the skids in 2001.

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Things don’t look much better for 2002. As reported in late May, corporate spending on technology will not likely increase this year. According to a recent survey of 100 U.S. and European chief information officers conducted by Merrill Lynch, corporate technology spending will be just about flat this year. That projection compares with a 2 percent increase in IT spending that the investment-banking firm was predicting at the beginning of the year.

Indeed, some CFOs report they have chosen to reinstall current versions of software — rather than upgrade to newer versions of the applications. The reasoning? It’s a lot cheaper to customize the application you have, than to buy a new one.

Learning to operate in that sort of climate is proving to be an extraordinarily difficult assignment for CFOs at software companies. Finance chiefs at traditional manufacturers can reduce costs simply by laying off employees. While painful, such layoffs don’t threaten the underlying value of the companies — fixed assets like petroleum crackers and lathes and steam turbines.

But for software companies, workers usually are the assets. “When most of your assets are your employees, you have limited flexibility,” concedes Jim Frankola, CFO of Ariba, a spend-management software vendor based in Sunnyvale, California. “Most of the time you have to get rid of your engineers and mortgage your future.”

A difficult decision at best. In fact, finance chiefs at some software companies say they must routinely make decisions to bring costs in line with revenues — while somehow coming up with the capital to fund crucial research and development projects. Without those investments — without product upgrades and new applications and breakthrough thinking — it’s very easy for a software maker to fall behind competitors, or fall out of the race altogether.

Laureen DeBuono knows the risk. DeBuono, CFO at Critical Path, an Internet messaging specialist based in San Francisco, says straight out: “We have to be very careful not to cut so deeply into our core team that we hurt ourselves in terms of new product development.”

The Mercurial Theater

If assets are downright mercurial at software companies, so too is revenue. In fact, perhaps the biggest challenge for CFOs in the software sector (and a problem that old-school manufacturers rarely face) is nailing down reliable revenue sources — and then figuring out how to treat the complicated sales agreements those sources often insist upon.

As software company finance chiefs note, sales of computer applications tend to be non-linear and sporadic. Moreover, many corporate customers of software vendors often postpone software expenditures at the last possible moment. “It is not unusual to see at least 50 percent of business transacted in the last several weeks of the quarter,” acknowledges Frankola.

But here again, software vendors only have themselves to blame for the problem. Typically, application vendors reduce prices toward the end of the quarter to help them make their revenue and earnings targets.

Nevertheless, this lack of revenue visibility makes it virtually impossible for CFOs in the software sector to accurately predict sales numbers until a quarter has actually closed. “Anyone who claims to be able to forecast software revenue more than 90 days in advance is stretching the truth,” Frankola argues. Even then, even within one quarter, software sector CFOs say revenue visibility can be murky, with forecasts well off the mark.

Compounding the problem: a single deal can spell the difference between a successful quarter and a disastrous one. “If you book one deal more than you were planning, you might exceed guidance and be fine,” notes Jim McDevit, CFO of Clarus Corporation, an Atlanta-based maker of procurement software. “But if you don’t get that deal done, you can miss your target — and pay a steep price.”

Recognizing Revenue Recognition

Once a deal is done, the fun is just beginning. Perhaps more than any other industry, the software business is beset and bedeviled by revenue recognition problems. Says Ariba’s Frankola: “For the software industry, revenue recognition is an entirely different animal.”

That’s no exaggeration. In May, for example, management at software giant Computer Associates revealed that the U.S. Attorney’s Office and the SEC are probing the company’s accounting practices. According to a CA filing, the investigations began in February.

“The investigation appears generally to be focusing on issues relating to the company’s historical revenue-recognition policies and practices,” Computer Associates management conceded in a statement at the time, adding that it is cooperating with the investigations.

Scores of other software companies have run afoul of revenue recognition standards as well. In April, Applied Digital Solutions disclosed that during the 2001, one of the company’s subsidiaries had booked revenue without “evidence of customer acceptance prior to the recognition of certain revenue.” Applied Digital, which specializes in data security and data intelligence, is now the subject of at least two shareholder lawsuits related to the apparent early recognition of revenue.

So why is revenue recognition such a bugaboo for software companies? Mostly, because business transactions in the software sector are so complicated

Typically, software agreements have various components including license terms (perpetual, annual, automatically renewable, renewable subject to written agreement), maintenance and support (which can last for different periods of time depending on customer needs) and consulting services. In additions, software contracts can be voluminous and filled with customer-specific terms, fees and restrictions. Keeping track of the nuances of each agreement and ensuring that those are properly reflected in the accounting can be a Herculean task.

Any over zealousness on the part of a company employee can lead to serious revenue recognition problems, including revenue restatements. Often, software company CFOs set up revenue recognition departments to help make sure finance staffers and sales personnel stay within the boundaries of the law. That’s easier said then done, especially when sales staffers, who get rewarded for closing deals, are pressured by customers.

Concedes Frankola: “We always need to strike a balance between the desire to satisfy our customers’ needs, with a very rigid set of accounting guidelines.”

And those guidelines might be getting tougher. The Financial Accounting Standards Board, which has already issued strict guidelines for software revenue recognition, is revisiting the whole concept. While FASB won’t likely make any changes for several years, you can bet any changes will be directed — at least in part — at software company CFOs.