New rule to hit revenues

Electronic News, March 30, 1998 by Carol Haber

Some companies will have to delay revenue recognition in certain transactions; a quiet but looming trap

Revenues are the bottom line of profits, and some companies stand to recognize less of them in any particular quarter under a recent rule formulated by the American Institute of Certified Public Accountants (AICPA). The Securities and Exchange Commission (SEC) will be scrutinizing companies' adherence to these rules for the first time in the March-ended quarter.

The rule applies to software companies and to hardware/electronics companies with major software components in their products; there could be a significant impact on the financial statements of certain electronics firms.

Companies like Cisco Systems, Lucent Technologies, Apple Computer or Digital Equipment Corp., in addition to software companies, are in the line of fire.

The provisions, which were issued in December of 1997, will require revenue allocation between various elements of a sales transaction based on "vendor-specific objective evidence" (VSOE) of fair values of the elements. The criteria for what qualifies as VSOE are still being worked out and guidance should be issued before year-end.

The AICPA's Statement of Position (SOP) 97-2 is directed at, among other things, "multiple element" sales transactions; those that include elements such as software products, upgrades, training, maintenance, installation and services, any one of which can be delivered later.

In the past, if the obligations related to remaining deliverables were "insignificant," companies could record the revenue up front upon initial shipment and accrue the estimated costs for the future deliverables. Under the new rules, revenue will need to be allocated to each element in the bundled transaction, thereby resulting in revenue deferral until future deliverables are delivered.

"Top managements should be forewarned," said Ed Rodriguez, partner/national director of KPMG's Silicon Valley-based Electronics Practice, to Electronic News. "They might want to seek ways to restructure transactions to minimize the impact, but it won't be easy." The new rules will potentially have a significant impact on certain hardware/electronics manufacturers that have historically recognized revenues immediately upon the shipment of products.

Revenue recognition from certain elements of a sale might be delayed; worse yet, re-statements might be necessary if companies aren't careful.

"Generally, under the old rules, companies would have been recording profits faster than they will under the new rules. It could impact analysts' expectations for some software companies," said Mary Pat McCarthy, partner/national director of KPMG's software and services unit.

Inconsistencies in reporting have been rampant for years.

Although a task force is being formed to finally delineate the criteria for VSOE, the balance of the new rule has been in effect since Dec. 15, 1997, and the SEC is on the lookout now. It affects companies whose fiscal year began after DEc. 15, 1997.

Until the task force finishes its work in about a year, the rule "may be open to various interpretations," it was said.

Networking, telecom equipment and high-end computer manufacturers are vulnerable. Mr. Rodriguez pointed to Cisco, Lucent, Apple and DEC as typical of the type of company that may be affected.

"There is a tremendous amount of concern," said Ms. McCarthy, who addressed a group of CFOs at the recent Software Publishers Association meeting in Silicon Valley. "It has to do with how to interpret the rules. The executives are being forced to rethink the way they have accounted for a lot of the software transactions they previously recognized as revenue. A number of them have had to defer revenue on transactions that previously would have allowed for earlier revenue recognition," she said.

Hardware/electronics manufacturers with a strong software component will face the same challenge.

Take Cisco.

"The public generally views Cisco as an equipment manufacturer but when you really analyze the value they deliver to the marketplace, it is principally in the software functionality," Mr. Rodriguez noted. He added that Cisco has a very significant internal software development group.

"Historically, electronics companies have been pretty safe in recognizing revenue upon shipment of product. That has been generally fine for those companies whose software component has been considered incidental to the product they are delivering."

Lucent is another example.

It has "pretty extensive" software development operations and it "spends millions of dollars developing software solutions which are embedded in their products." He pointed to Lucent's messaging division, formerly Octel Communications Corp. "Yes, they assemble; yes, they buy chips and storage devices and components, but really the value they are bringing to the marketplace is contained in the software."

Apple Computer, with its proprietary operating systems and significant software development group, and DEC, also with a significant software development group, are other likely targets.