Nothing sends chills down the spine of the investment community like the word “restatement.”
Companies that are forced to restate earnings sometimes never recover from the plunging stock prices, class-action lawsuits, Securities and Exchange Commission (SEC) enforcement actions and other unpleasant consequences that inevitably result from the correction or amendment of previously issued financial statements.
Those companies that do survive restatements can take years to recoup the confidence of Wall Street.
Restatements occur when previously issued financial statements are deemed to be incorrect, and subsequently are corrected and reissued. Restatements can also occur when companies announce earnings in a press release or analyst conference call, but then have to revise the statements prior to formal filing with the SEC.
Errors in financial statements are the result of mistakes in the application of accounting principles or oversight or “misuse of facts” in the preparation of financial statements. They can result in severe SEC enforcement actions against those officers and employees responsible for the improper financial report. In many cases, what company management may view as simply the “aggressive interpretation of existing accounting literature,” the SEC staff considers “the blatant misuse of facts.”
One accounting issue that can cause companies to restate earnings is the thorny subject of revenue recognition. The rules that govern when and how companies may account for sales are anything but simple. Fortunately, there are a number of strategies for mitigating the risks associated with revenue recognition. While these strategies do not come without their costs, they are effective, especially for pre-IPO venture-backed companies that do not yet have to face the grueling public scrutiny of their quarterly earnings reports.
Revenue recognition is particularly troublesome for technology companies.
* Because of high gross margins that many technology companies enjoy, the period in which they recognize revenue can have a much greater effect on their quarterly earnings than it would for more traditional companies, such as manufacturers of capital equipment.
* Unlike the delivery of capital goods, the delivery of products and services by technology companies is subject to a number of factors that affect revenue recognition. Office furniture, for example, can be delivered and installed in a day without requiring any extended support from the seller. On the other hand, an enterprise software package that integrates the accounting and business processes of a multinational company can take months to install and may include complexities such as a 12-month maintenance, entitlements to software upgrades, staff training, help desk support and customization.
* Technology companies often do not provide just one product or service to their customers. Instead, they sell a number of products and services bundled in a single transaction.
* The arrangements that technology companies have with their customers are complex and often subject to ongoing negotiation.
You would think that a subject as complex as revenue recognition would have volumes of accounting guidance; surprisingly, there is little. Until recently, the rules consisted principally of the Financial Accounting Standards Board’s Financial Accounting Concept Statement (FACS) No. 5, “Recognition and Measurement in Financial Statements of Business Enterprises,” which provides general guidance on revenue recognition. FACS No. 5 – which is considered broad, rather than specific – provides that companies must meet two conditions before they can recognize revenue:
* The consideration that companies receive must be realized or realizable (i.e., there was an exchange for cash or an asset readily converted into cash); and
* The consideration must be earned (i.e., the company has substantially fulfilled its obligation in order to receive its compensation). The statement goes on to say that these two conditions are usually met when products are delivered or services are rendered.
Some existing rules provide authoritative guidance on specific conditions, such as when customers have the right to return products or when products sold subject to repurchase provisions should be treated as a financing arrangement. There are more definitive rules for companies in certain industries, such as software.
Due to the large number of revenue recognition issues faced by public companies, the SEC issued Staff Accounting Bulletin (SAB) No. 101 in 1999 to provide its views on applying the basic concepts to specific situations. While the SEC does not officially set accounting standards, its bulletins become de facto accounting standards for public companies and companies that hope to some day go public.
SAB No. 101 addresses a number of revenue recognition issues and borrows heavily from the accounting standards applicable to software developers. The four principal criteria for software and other technology companies are:
* Persuasive evidence that an arrangement exists between the buyer and the seller;
* Delivery of the product has occurred or the services have been rendered;
* The sales price is fixed or able to be determined; and
* The ability to collect the sales price is reasonably assured.
All four of these criteria must be met for revenue to be recognized. There are additional criteria when the arrangement requires the delivery or performance of several elements or services. These multiple-element arrangements are common with software and other technology companies. Also, if such an arrangement includes undelivered elements that are critical to the functionality of other elements, delivery of those other elements has not occurred from an accounting perspective.
One Possible Strategy: Time-Based License Agreements
As a result of the complexity of the accounting rules associated with revenue recognition, the increased focus by the SEC, and the alarming number of restatements relating to revenue recognition, companies should consider taking steps to properly position themselves. Some companies are doing just that.
The most significant change that software companies, in particular, may consider is to change their business model. This is not a change in accounting principle, but rather a change in the way companies conduct business transactions with customers.
Historically, companies have structured transactions to meet the criteria prescribed for immediate recognition of revenues. This seemed attractive on the surface because it allowed companies to report the results of sales and product efforts in the shortest possible timeframe. However, there have been many negative consequences to this immediate gratification.”The widely reported earnings restatements generally occur when companies think they have met the criteria for immediate revenue recognition, but discover either through oversight or, in some cases, SEC hindsight, that they did not meet the criteria.
Software companies have traditionally conducted substantial end-of-quarter and end-of-year sales drives to meet or exceed the revenue and earnings numbers that most analysts had forecast. However, the smallest logistical issue by either the buyer or seller can result in the criteria not being met and sales not being eligible for recognition. Companies will then miss the analysts’ forecast and often watch their stock price plummet. Class-action lawsuits are rarely far behind.
Some customers try to use this push to make forecast to their advantage by negotiating more favorable terms on price, product, service, payment terms – or all four dimensions of the sale. Companies sometimes yield to these pressures to close sales and meet their numbers. Growing numbers of companies, however, are taking a step back to reconsider the entire scenario. They are concluding that there is a better way.
Rather than structuring their contracts to meet the criteria for immediate revenue recognition, these companies are adopting time-based license agreements that require license revenue to be recognized ratably over the term. These are, in substance, subscriptions. Revenue under a subscription license model is generally recognized pro rata over the subscription period – whether it’s a periodical like Venture Capital Journal or an enterprise software application.
The criteria for recognizing revenue in this way are easier to meet. In fact, we have not yet heard of the SEC or any other authority challenging revenue recognized in this way. Plus there are several benefits to the subscription method:
* It provides a smooth, steady, predictable stream of earnings.
* Because only a small portion of the revenues are recognized upon booking and delivering sales, there is less of a chance for a quarter-end surprise, and a greater likelihood of meeting analysts’ expectations.
* Companies will know much further in advance if it looks as though they will fall short of revenues.
* Finally, the quarter-end sales push has little impact because the revenue is spread over the license period, which is usually one year. Under this model, customers will not have the same leverage at the end of a quarter or fiscal year to squeeze the profit margins.
One Problem: The ‘Dead Zone’
For public companies, switching business models presents special difficulties. The problem is that upon adopting the subscription model, the company will create a dead zone where it will report greatly reduced revenues and profits (often losses). This happens because the stream of subscription revenues is only beginning to kick in while the revenues are no longer being recognized upon shipment or delivery. The public markets may or may not take kindly to such dead zones. To date, only a small number of public companies have been willing to make this change in business model – Computer Associates International Inc., Synopsis and Cadence Design Systems. Microsoft Inc. has announced that it will gradually adopt this model for certain of its product lines.
Consider this scenario. Assume that a technology company begins operations on Jan. 1, 2000 and ships and delivers products that, based upon a proper application of accounting and SEC rules, qualifies for revenue recognition as soon as the software is received by customers.
The company ships and delivers $10 million of product, all of which is properly reported as revenue for the year ended Dec. 31, 2000. In November 2000, the company contemplates adopting a sales contract that provides customers with the purchased software, one year of maintenance, plus the rights to all new versions of the software for 12 months from the date of purchases. (For illustrative purposes, assume that this contract requires subscription type accounting for revenues).
The company expects to book, ship and deliver $20 million for the year ending Dec. 31, 2001 (assume quarterly sales of $3 million, $4 million, $6 million and $7 million for Q1 to Q4). Assume further that each and every sale is made at the midpoint of the quarter. In addition, also assume that the company’s cost structure is such that all of its costs are fixed and they total $2.5 million per quarter.
The company’s revenues, costs and earnings under the existing model and the proposed subscription model for 2001 are shown the accompanying table.
While the subscription model inherently results in less reported revenue for a growing company, the impact is greatly exacerbated when the company starts off on a different model and therefore doesn’t have the flow of subscription revenues coming into fiscal year 2001.
For example – if our company had shipped its FY 2000 sales ratably throughout the year, but had a subscription model, it would have reported revenues of $13.25 million and earnings of $3.25 million for FY2001 instead of the huge losses shown in the accompanying table.
However, in the current circumstance, the company is faced with an interesting decision: To face two quarters of losses, for a total annual loss of $1.75 million or continue under its existing business model and report earnings each quarter and a year-end total of $10 million. Many public companies cannot afford the dead zone in earnings that this change presents, but some have opted to do so.
For companies that are not yet public, the opportunity is there to adopt a subscription model as early as possible ahead of an initial public offering filing. They can then position themselves to report the steady, predictable stream of revenues and earnings that will keep them in greater control of their circumstances and free from the vagaries of the SEC and the pressures of opportunistic customers.
Michael C. Bernstein, CPA, is partner and national director of the eHtech practice for Grant Thornton LLP. Mark K. Scoles, CPA, is partner and regional director of professional standards for Grant Thornton LLP.