The benefits of an integrated, cloud-based solution for today’s software providers

By Dennis Howlett

If you are a senior finance officer, the last thing you want on your CV is: “He didn’t appreciate the implications of a poorly defined billing process on revenue recognition, which led to substantial restatements. His last company was fined $50 million and he was fired.” The inconvenient truth is that regulators are asking more pointed questions in an environment where the mix of revenue types is leading to complexity. Why? They know “rev rec” is problematic.

Revenue recognition rules have always followed the same basic principle: You can only account for that which you have delivered. You are not allowed to account for things that have not been delivered. Simple. Not anymore. Following in the wake of Sarbanes- Oxley, regulators have issued a slew of new requirements that render the “simple” view of the world almost useless. Do you, for instance, understand the interweaving impact of SOP 81-1, SAB 101, EITF 00-21, EITF 08-01, and EITF 09-03? What’s worse, from everything that we see, this is a movable feast that has special meaning for software businesses.

In the past, software companies sold readily identifiable products. A deal was struck for delivering XYZ software, which in turn was handed over in accordance with a clearly defined contract on a specific date. Invoices were raised and everyone was happy. In some cases, the deal involved consulting or implementation services that could be readily prorated according to agreed milestones. Again, relatively simple, provided that software and services were separately billed. Change orders could usually be dealt with as discrete items. All relatively straightforward, although not without the possibility of having to make minor adjustments from time to time.

The big “gotcha” came when Vendor Specific Objective Evidence (VSOE) came into view. This is all about assessing fair value and was designed specifically for the software industry. Without it, many vendors would not be able to record revenue until every bit and piece of a multi-part contract is fulfilled. The destabilizing impact on revenue projections alone would make an understanding of a software company’s activity almost impossible.

Even now, VSOE, while providing a way to overcome the overarching rule, provides enough flexibility that companies can easily be caught out. From USLegal.com: “VSOE refers to a method of revenue recognition in accounting practices allowed by the U.S. Generally Accepted Accounting Principles (USGAAP). It enables companies to recognize revenue on specific items on a multi-item sale based on evidence specific to a company that the product has been delivered.” While the wording is simple to understand, the reality is altogether different.

The example I like to use is that of a software and services business operating in today’s business climate. Whereas in the past I might only have sold software and some implementation services as outlined above, I may now offer consulting, backup, help desk, maintenance, and storage options in the “menu” of deliverables. Some may be sold as discrete units of deliverables, others might be paid for on a subscription basis. Each item will be priced separately with discounts applied. But in the end, deals are most often struck on the basis of a fixed price. The vendor accounting department now has to work out the rateable fair value of each component, spread over time. This can be a daunting prospect.

The basic problem comes in the fact that VSOE requires the exercise of judgment within the context of a tight, rules-based framework. It is a bit like mixing oil and water. First, the company has to define, articulate, and document the method it proposes to use, giving explanations for the way in which it exercises judgment in particular cases. It needs processes in place that evidence the chosen method in action. Next, it will require assurance from auditors that not only is the chosen method sound, but also that the company processes can be reliably tested. Finally, it has to ensure that not only is the method verifiable, but also that it is consistently applied to all transactions.

Despite the initial effort, in most day-to-day circumstances the “system” works reasonably well, provided the controllers ensure that methods are rigorously followed. But to give you an indication of the scale of the problem, one large vendor I spoke with said they have 70 people involved in this process alone. It doesn’t stop there.

In the past we often saw deals where buyers would be required to estimate the number of seats needed and purchase accordingly. That led to shelfware. The growth of subscription models means that shelfware disappears. Buyers pay for what they use in what some term a consumption model. Vendors expect to revisit companies for fresh seats and services as the business expands. They might also anticipate a reduction in seats if the business contracts. In either case, the vendor now has to revisit their VSOE calculations while remaining cognizant of any impact on sales compensation.

It should come as no surprise that many companies attempt to heft these movable calculations using spreadsheets. This is a precarious approach. Spreadsheets were never purpose-designed for this type of activity. They are notorious for masking significant users. Moreover, it is difficult to audit something that is prone to inaccuracies. Even where spreadsheets can be audited, it represents an additional expense.

The good news is that some vendors have recognized the scale of the problem and are now offering embedded solutions that remove complexity. Like all software, they cannot solve all problems. Effectiveness depends on the buyer being prepared to provide a workable VSOE model. The best software solutions are not only flexible but also scalable, with the ability to test assumptions on the fly while preserving or enhancing workflow. Of course it’s up to you, the finance officer, to ensure that you are taking full advantage of the investment you made when you selected NetSuite as your financial systems foundation.

The choice is simple: Do you want to brave the perils of revenue recognition alone, or do you want to join forces with NetSuite’s advanced templates, automated capabilities, and continuous monitoring? The choice is yours.

About Author

Dennis Howlett has been taking the buyer’s perspective in analyzing application vendor offerings for more than 22 years following a successful 20-year career in IT and finance-related roles. “Never knowingly under opinionated,” Howlett takes strong positions in the interests of getting to the truth of what drives customer value.

The statements and opinions contained herein are those of the author and not of NetSuite. NetSuite has not verified any statements or claims herein and assumes no responsibility for such statements or claims. If you need specific advice (for example, legal, financial, or risk management) please seek a professional who is licensed or knowledgeable in that area.