Why VSOE Spells Trouble

As software becomes more ubiquitous, many CFOs must now confront the nightmare of revenue recognition.

In practice, these rules constrain the ways companies sell their products, chew up a lot of management time, and put off some investors. “There’s a huge investment in time and effort” to stay compliant with VSOE, including vetting every sales contract for pricing conformity, says Epicor Software CFO Michael Piraino. Secure Computing Corp. CFO Tim Steinkopf adds, “VSOE is in the top handful of worries as we deal with the investment community. A lot of funds say, ‘If I have to think hard about something, I’m not even going to look at it.’”

The Variable Bell Curve

Part of the problem is the absence of an official way to establish the fair values of products within a contract. Many turn to the bell-curve approach. Typically, that means that at least 80 percent of sales prices should fall within 15 percent of the median price, says Tony Sondhi, author of the Revenue Recognition Guide 2008 and a member of FASB’s Emerging Issues Task Force.

But that rule of thumb is open to judgment. Some CFOs are more conservative, but in different ways. At E-commerce hosting and software provider ATG, CFO Julie Bradley considers her range of deviation from the median to be 10 percent. At Secure Computing, Steinkopf sticks with the 15 percent band, but applies it to 85 percent of sales. “We know that some of the firms quote that 80 percent within 15 percent rule, but we try not to treat that as a bright line,” says Mark Barrysmith, a professional accounting fellow in the SEC’s Office of the Chief Accountant. “The goal is to demonstrate consistent pricing practices.”

Another difficulty with the bell curve is that it requires a track record of sales, making the accounting treatment of new and newly acquired products challenging. It also implies firms must sell each product individually to get the sales data they need, which isn’t always appealing to customers.

The alternative is the so-called stated-renewal approach, in which companies use the renewal price for services stated in the contract as a basis for value. Some take issue with this approach because it generally applies only to post-contract services and not to items like warranties. Also, stated prices may differ from the actual prices, leading back to the need for bell-curve evidence. “I think the stated-renewal method could get you into trouble,” says Sondhi. Nonetheless, many companies continue to use it, in part because it’s easier.

Then, of course, every auditor — even within the same firm — has his or her own way of approaching the problem. Epicor’s Piraino says he was forced to restate three years’ worth of financial statements in 2006 when Deloitte assigned him a new audit partner. Before the auditor rotation, Epicor had applied whatever discount it gave to customers equally to the software and maintenance parts of its revenue. Upon an exhaustive review of renewal data, prompted by the new partner, Piraino discovered that maintenance garnered a higher price when sold separately through renewal. Accordingly, it should have been discounted less heavily in the original recording of the sales, which means more revenue should have been deferred.

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