REVENUE RECOGNITION TRAPS - EXTENDED PAYMENT TERMS

The subject of revenue recognition is dry stuff, but you’ll be helping your company and yourself if you are aware of some of the general rules relating to the accounting for revenue for software contracts contained in SOP 97-2. These rules have ramifications to your company’s financial well being, as well as for the timely booking and payment of commission compensation.

The rules for revenue recognition for computer software contracts contained in SOP 97-2 are the most convoluted set of rules the accounting profession has ever devised, at least in my experience. For continuing developments in this area, refer to the AICPA’s site, http://www.aicpa.org/members/div/acctstd/general/tpa4.htm. They are designed to delay revenue recognition until it is clear that all the work has been completed and there are no obligations of any kind floating around. The interpretation of SOP 97-2 has become more restrictive since its inception. And, given the genesis of SOP 97-2, that’s not surprising.

  1. Section 28 of the SOP indicates that revenue recognition is presumed to be delayed “if a significant portion of the licensee fee is due… more than 12 months after delivery”. If commissions are based on recorded revenues, they also are delayed. However, if the licensor “has a standard business practice of using long-term or installment contracts and a history of successfully collecting under the original payments terms without making concessions”, then revenue can be recognized (assuming all the other conditions of SOP are met).

    The result – an established software company, such as Oracle, can recognize revenue at the time of sale since it has used long-term contracts for a long time. But Oracle’s newer and smaller competitors which want to offer the same contracts can’t recognize the revenue upfront because they have no history of so doing. They will thus be penalized from a financial statement perspective and their stock price and ability to borrow from banks or raise equity may be impacted.

  2. That’s only the beginning. We understand that the Big 5 have agreed that a licensor will not be able to recognize revenue upfront if the extended payment terms are less than 12 months, but are longer than its normal terms. Their rule of thumb is that terms more than 90 days will delay revenue recognition! (In the U.K. the cutoff is 6 months.)THIS IS A REAL TRAP FOR THE UNWARY! Many software companies who were not aware of the rule have been burned. Talk to your accountants to get guidance.

  3. Next, a few words about the sale of existing contracts. If you’ve extended payment terms that delayed revenue recognition until cash is received, one would think that if a licensor sold the extended payment term contract (whether a lease or rider to a license or a promissory note or whatever) to a third party (a leasing company or bank), the revenue could be recognized when the sale took place. NOT SO! The Big 5 accounting firms (with one nonpublic dissent, I understand) have concluded that the sale has to be recognized over the original schedule. ANOTHER TRAP FOR THE UNWARY! This one, if you know about it, can be dealt with – if you are aware of it. Have the licensee contract directly with the third party.

  4. Conclusions -

    •If you have to enter into an extended payment contract, be aware of the delay in revenue recognition.

    •If you are planning to sell an extended payment contract to a third party, have the third party involved before the contract is concluded AND have the licensee contract directly with the third party.

    •In either case, your objective is to structure the sale agreement such that you are able to recognize the revenue upfront, just as you would with a normal cash sale with the licensee.

    •P.S. If you need to reduce days sales outstanding, you can often do so by selling the extended payment contract, but revenue will not be accelerated.

Next month- the financial statement effects of moving to a subscription or term license model.

Some sources of information on the Web

AICPA - Software Revenue Recognition Q + A

DiCarta - SAB 101 Resource Center

Ernst & Young - Software Revenue Recognition, As Affected by SOP 98-4

LPI - Presentation to Leasing Industry Accountants on Software Accounting and Tax Issues

PriceWaterhouse Coopers - User-Friendly Guide to Understanding Software Revenue Recognition

SEC - Staff Accounting Bulletin No. 101 - Revenue Recognition in Financial Statements

Softrax - Avoiding Revenue Management Surprises

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                         February 27, 2006