Risk & Compliance

The Deferred-Revenue Dilemma

Confusion reigns on how to book software companies' acquired deferred revenue. With no regulatory consensus apparently on the horizon, Oracle's acc...
Craig SchneiderFebruary 14, 2005

A technical accounting question concerning how to book an acquired software company’s deferred revenue has stumped accounting standard setters. And the uncertainty has some finance executives fearing increased regulatory scrutiny.

The debate centers on how corporate managers should record deferred post-contract customer support (PCS) revenue in a business combination. PCS is revenue the software vendor records and amortizes after a customer buys a software package. The revenue stems from a licensing contract that typically includes several years of telephone support, maintenance, and “when-and-if-available” software upgrades.

The Financial Accounting Standards Board’s (FASB) Emerging Issues Task Force (EITF) met last November to address the issue of how to book such revenue after discovering that different companies in the software industry used a diversity of accounting practices to record the liability. But the twelve-member body was split on the issue and tabled it without consensus, leaving matters up to FASB.

The Securities and Exchange Commission has no plans to address the issue of deferred revenue in software acquisitions with a ruling of its own, and has not publicly taken a position. Rather, at least one official noted that the FASB could address the topic. “This issue probably could be addressed in one of the board’s active projects,” says Scott Taub, deputy chief accountant at the Commission, who attended the EITF meeting.

Stuart Moss, a practice fellow at FASB, believes the board will not specifically address the software industry’s deferred revenue issue in Phase 2 of its business combinations project, a comprehensive look at mergers and acquisitions. An exposure draft for the project is expected to be released for it by March 31.

Another indication that finance executives might also be left to fend for themselves is that the board, in general, has been committed to a principles-based focus on standard setting. It typically leaves detailed, technical matters up to the EITF and to companies to work out with their own external auditors.

The EITF, in fact, reached a narrow consensus on deferred revenue in 2001, noting that the only time a company should recognize the liability is when it’s a “legal obligation.” Moss, however, noted that the guidance only created confusion concerning the subject of what companies should be measuring. Should software vendors, for example, gauge their legal obligations by splitting a PCS contract into individual parts covering upgrades, phone, and maintenance service or by viewing it as a whole?

The EITF could not agree on an answer when it debated the issue in 2004. To be sure, Moss says, the legal obligations could be resolved by the upcoming business-combinations exposure draft. But he said he could not be certain that FASB draft would cover the issue.

In any case, he noted, “there could potentially be other issues that are raised from a fair-value standpoint.” For instance, some vendors include the “when-and-if available” detail of the software upgrade when they calculate the fair value of PCS revenue. Others include the research and development cost of developing that upgrade, “which can be substantial,” he says.

Tom Manley, the CFO of Cognos Inc., says he errs on the side of caution in his valuation of PCS revenue. He says that without a clear interpretation of the rules, he’s forced to book acquired deferred revenue of software companies in the most conservative way – by not recording any value for it at all. There’s no legal obligation to issue the upgrades, he says, so there should be no value assigned to it. Besides, “You don’t want to be doing a restatement because you were too aggressive in your assumptions.”

Regardless of how finance managers record the deferred revenue from a software acquisition, says Jay Hansen, a partner at the McGladrey and Pullen, LLP. accounting firm, it’s important to be forthright with the users of the financial statements. “In the footnotes of your MD&A, describe what you’re doing,” he says. “If it’s clear what companies have done in their accounting policies and they follow them consistently, the SEC generally won’t have a problem with that.”

Companies should also cite specific justification of why they choose to amortize an amount of deferred revenue in the time period described. The SEC frowns upon companies that push revenue into the future arbitrarily to benefit their businesses, Hansen adds.

Another solution to the dilemma of how to book deferred revenue could be to wait and see how Oracle accounts for its purchase of PeopleSoft and follow Oracle’s lead. Manley, for one, hopes Oracle will establish an industry best practice in the absence of an official consensus from the Big Four accounting firms, the SEC, and FASB. “That’s probably going to be a precedent-setting event,” he says.

PeopleSoft recorded a total of $762 million in long and short-term deferred revenue on its balance sheet for its third quarter, ending September 30, 2004. That compares with total revenue of $537 million reported for the quarter. An Oracle spokesperson was unavailable for comment.