A Jittery Public Appears Unforgiving about Revenue Management Missteps

WHAT'S A HIGH-TECH COMPANY TO DO?

Call it the "perfect storm", a wholesale accounting industry crisis, or the biggest series of financial scandals in decades. However you choose to characterize it, the US economy is at the kind of business reform crossroads that only occur as the messy aftermath of enormously bad news. Whether you are fascinated by the ever-unfolding Enron situation, mesmerized by the relentless and pervasive upheaval in the accounting profession, or transfixed by the almost-daily commentary of the FASB, AICPA, SEC, the Congress and the White House, you have to agree that this is big stuff. And regardless of what business you’re engaged in, or companies whose stock you may hold, there’s no debate about one fact: the ripple effects of the last 4 months of intense corporate accounting scrutiny will be felt for years to come.

But this is not the first time that poor judgment, opaque accounting methods and revenue management questions have plagued the minds of America’s populace. It’s merely the most impressive display of grand-scale improprieties with billion-dollar price tags, and the most publicized. This is a time that strikes fear into the hearts of many public companies, when the outside world is poised to pounce without mercy onto any financial wrongdoing, real or perceived. It’s also a climate in which the line between honest mistake, and intentional deceit, has ceased to matter to most people. Troubling for all companies, to be certain; but most potentially frightening to those businesses in our high-tech sectors, where rapidly evolving business models add operational complexity that grows exponentially. Taking advantage of different options for new market entry opportunities, and responding to frequently shifting market conditions requires incorporating business models never known before. The result is uncharted territory: complex combinations of service, product, license and subscription contracts (“multi-element” contracts), and the very real requirement to manage revenue generated by multiple sources over differing contract component cycles.

In the “Enron Age”, proper revenue recognition can mean the difference between viability one quarter, and being out of business the next. Very few constituents are willing to wait out the results of restated financials without bailing on their investments, and retreating from even the hint of tainted financial activities. Even a scant 6 months ago, it was considered important to recognize multi-element contract revenue in an organized way to support ongoing fiscal health, and create the ability to produce accurate forecasts. Now, it’s the cornerstone concern of the high-tech enterprise, and the rules and regulations can be as confusing and difficult to correctly apply as ever.

Most of these companies manage their multiple revenue streams with an uneasy mix of financial, accounting, and contract management software systems. Because none of these contains the unique functionality that allows revenue management to be a key corporate activity, updated spreadsheets, paper files, and custom-built point solutions are thrown into the mix as well. But in a scenario such as this, the core infrastructure of the business is self-limiting. When a company is unable to clearly delineate the revenue streams that sustain its business, it’s usually losing revenue, increasing operating costs, and limiting vital cash flow.

Increasingly more exacting SEC and FASB (AICPA) guidance and regulations surrounding revenue recognition demand a high level of attention. AICPA’s SOP(“Statement of Position”) 97-2 and SOP 98-9, and SEC SAB (“Staff Accounting Bulletin”) 101/ SAB 104 are the regulations that software companies must comply with. If a company’s current revenue management processes are open-ended, or the methodology is inconsistent, the risks for improperly allocated revenue and incorrect billing only complicate financial closing processes, and increases inefficiency. It goes without saying that transactions that violate SOPs 97-2 and 98-9, and SAB 101/ SAB 104, are more common in this context.

SOP 97-2 applied directly to the software business by focusing on what had become the industry norm: multi-element contracts. In summary, it was intended to ensure that revenue was booked not on orders, but on shipped, and fully received, contractual elements. Thus, license, maintenance, services and product revenues were individually accounted for with unique invoicing and revenue allocation schedules. Mandatory documental evidence of a business arrangement, like a signed contract, would be used to support each contract and related schedules. In addition, charges associated with the contract needed to have fixed or determinable fees. SOP 97-2 guidance also addressed revenue allocation using VSOE (vendor specific objective evidence) — price books that delineate component pricing when sold separately, or prices set by management with “appropriate authority”. If there isn’t any existing VSOE for a contract, SOP 97-2 requires that the entire contract be deferred. SOP 98-9 extended the main principles of 97-2. It added the “residual method” for situations when VSOE exists for undelivered contractual elements, but does not exist for delivered elements, but all other revenue recognition criteria have been met.

Then, the SEC issued SAB 101/ SAB 104, which stated that as of the fourth fiscal quarter of (fiscal) years beginning after 12.15.99, all public companies in the USA should hold to SOP 97-2-like accounting standards. The core motivation behind creating SAB 101/ SAB 104 was SEC concern about earnings management. During the past three years, more than 400 companies have restated earnings. The sharp increase has been accompanied by shocking market losses. From 1995 to 2000, the loss was $78.3 billion. And in 2000, seven of the top 10 restatements were directly tied to revenue recognition issues.

High profile examples are of Cendant, who restated $11.4 billion, Microstrategy ($11.3 billion), and Lucent ($10.9 billion). Today, Microstrategy is still feeling the effects: during the company’s fourth fiscal quarter of 2001, it recorded a charge of $11.6 million, all tied to litigation settlement costs that were a by-product of the restatements for 1997 through 1999. Cendant’s streak of bad fortune has continued. The real estate and travel company, who has a 19% ownership stake in Internet real estate portal Homestore.com, announced in February of this year that it would take a hit of $285 million, an after-tax charge associated with Homestore.com. What did Homestore.com do? In January 2002, it confessed to overstating online ad revenue in 2001 (the first three quarters) by between $54 and $95 million. Nasdaq had already suspended trading of Homestore.com shares in December after an internal accounting audit was announced. It seems the exposure of corporate accounting problems is a daily occurrence.

More recently, there has been 24/7 public discussion of restated earnings reports, and the media is delving into the mysteries of each instance with an eagerness matched only by the public’s hunger for more scandalous news about Big Bad Corporate America. While many companies see their stock fall substantially, sometimes disastrously, on rumors of upcoming restatements, others suffer capitalization decreases simply because they’re in the same business as a tainted corporation, even though their books are clean. There seems to be a domino effect within the Nasdaq listing these days, and if one company falls, others stumble with it.

The frustration for many organizations is that they can’t avert negative impact before it occurs: there’s no time to head off the selling frenzy. Some businesses are guilty of misapplied accounting procedures and unintentional financial statement mistakes. Others are perpetrators of planned deceit, recognizing revenue before its time, altering records, leaving things off the balance sheet. The interesting aspect of today’s business climate is that many people just don’t care: if it poses a potential risk to their portfolios, they would rather shoot first, and ask questions later. It seems unfair, but can you blame them? In 2000, investors in companies with restated earnings had losses of 31.2 billion in the three days following the announcements.

The successful operation of a high-tech business, and the retention of satisfied investors, can be enormously facilitated, and safeguarded, by employing a sophisticated revenue management system. Such a system will optimize all revenue management activities. It starts with contract entry and establishing automated schedules for billing and revenue recognition. It progresses to consolidation activities that make it possible to create single customer bills regardless of the number of transactions in various categories. Detailed reporting functions are streamlined. And everything is supported by the capability to apply consistent pricing methodologies from contract to contract.

For those high-tech entities that operate within the parameters of 97-2, 98-9 and 101/104, the challenge is to comply, while still meeting revenue expectations. There is enormous pressure to recognize as much revenue as possible, as early as possible. In this climate, hard numbers for revenue projections and forecasts become the lifeblood of the company. This is critical to maneuvering safely around revenue management surprises.

A specialized revenue management solution will enable compliance with SEC and FASB guidelines. By automating key processes, it will provide stable methods for recurring billing, deferred revenue scheduling, VSOE pricing and revenue allocation, and revenue recognition. Hundreds and sometimes thousands of multi-element contracts make up the core business of high-tech companies. And business models keep developing, causing contracts to be adjusted, pricing systems to evolve, and transaction volume to increase. By centralizing data in a revenue management system, the gain is the capability to manage any type of contract activity from one place. Additionally, a centralized system will provide an audit trail and improved visibility for the auditor.

Right now, revenue management is the key for America’s technology companies, and a mandatory area of expertise. If your business isn’t using one, implement as soon as you can to stay clear of revenue recognition entanglements and headlines, which may cost hundreds of millions in market valuation.

About the Author
Robert O’Connor is President and Chief Executive Officer of Softrax Corporation. With over 15 years’ experience in executive management of software companies, Mr. O’Connor has led Softrax to a leadership position in revenue management enterprise solutions. He was recognized by Ernst &Young as a finalist for their 2001 Entrepreneur of the Year Award. O’Connor is an active member of the ITAA and the Massachusetts Software Council, and a frequent speaker on revenue recognition, business models, and other operational topics nation-wide. He is a guest speaker at Harvard Business School. Mr. O'Connor is a graduate of Georgetown University and received his MBA from the University of Connecticut.

Softrax is a leading enterprise software company providing revenue management solutions that fundamentally change the way technology companies manage, analyze, and predict their revenue streams. Headquartered in Canton, MA, Softrax Corporation is privately held. Further information is available at www.softrax.com or 1.888. 4 SOFTRAX.