Software companies may see a temporary dip in earnings reports, but fewer shareholder lawsuits, under new accounting regulations that go into effect this year.
According to the revised "revenue recognition" policy, as it is known in accounting parlance, companies must book their revenues only after their products have actually shipped. Under the old system, many counted revenue based on expected shipments, including products that were not even out of the development stage.
"Software companies were writing their contracts to facilitate revenue recognition even though all the products weren't being delivered. But vendors would recognize all the revenue up front," said Sander Abernathy, senior manager at Coopers & Lybrand.
Then, when the real shipment numbers came in, financial reports invariably would need to be restated, and the stock market would react accordingly--creating a vicious cycle that has led to the seemingly automatic shareholder lawsuits seen today.
As software companies scramble to adjust to the regulations, they will take a hit in their short-term earnings statements. But analysts say the more conservative revenue recognition is a necessary step in the right direction.
The software industry, which has evolved faster than the rules governing their accounting practices, is sued more than any other industry, they note, and revenue recognition is often at the heart of the litigation.
"The software industry has been plagued with a number of [financial] restatements, and the resulting lawsuits spurred the new rules," said Mary Pat McCarthy, partner and national director of KPMG International's software and service business. "The goal is to provide more guidance and consistency in revenue recognition, and the result will be more conservative accounting as companies defer revenue longer."
The accounting rules will have the greatest effect on companies that sell software to corporate users, such as Oracle, SAP, and PeopleSoft. Abernathy explained that these companies often sell big packages of software, with contracts that often include terms for upgrades or future products.
The companies then book the revenue for those expected future product shipments. However, the new policy states that companies cannot book the revenue until each upgrade or product is shipped.
The old policy did not address accounting for bundled products, which did not necessarily all ship at once. However, the price of the total package was based on the sales price of each piece of the bundle and therefore the revenues were booked as one. previously, that was allowed, even if the vendor did not ship the bundled package with all the upgrades.
Under the revised policy, however, vendors will book revenues on each component separately, as each element is sold.
"These companies take an aggressive stance and then restate their financials if need be," Abernathy said. "This [updated policy] will cut down on situations where companies recognize revenue and then determine that they have to reverse it."
The change to the accounting policy--known formally as "Statement of Position 97-2"--supersedes the initial system developed in 1991. It went into effect as companies began their new fiscal year, after December 15.