Why VSOE Spells Trouble

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

Hence the restatement, which consumed almost 10,000 person-hours. And the hard work didn’t end there. Notes Piraino, “Now that it’s over, we have to maintain these curves,” analyzing 100 or so on a quarterly basis.

The Stock-Price Effect

Restatements to account for VSOE issues usually affect only the timing of revenues, not the overall amount. In Epicor’s case, current revenues for three years were reduced by less than one percent in any given year. Merge Healthcare, which restated for VSOE and other issues in 2006, recorded a difference of less than $1 million, or one percent of total revenues, due to VSOE. Nevertheless, investors don’t like it. “It has been my experience with VSOE that the impact to the stock can be much worse than the real impact to the company,” says George Hill, an analyst with Leerink Swann & Co. who covers Merge. “It can be an ugly process.” Merge saw its stock drop about 40 percent when it announced the restatement.

Acquisition Blues

Even for companies that have VSOE, an acquisition or a change in business model can create the need to change the revenue-recognition model. “One of the most common scenarios is that customers ask for different configurations of products than they did initially, and then you may not have VSOE any more,” says Sondhi. Giving customers concessions to make up for poor service doesn’t help. “If it happens once, OK, but when it starts to happen with some degree of frequency, it raises questions about fair value,” says Huron Consulting’s Szafran.

In 2006, when E-commerce platform provider ATG acquired eStara, then a privately held maker of “click-to-call” customer-service software, CFO Bradley knew she would have to give up VSOE on some contracts if she wanted her sales team to package the new software with existing products. eStara tended to use customized pricing, which “does not work with VSOE,” Bradley notes, and so it would negate the VSOE model for any contract to which it was added. That pointed toward splitting up all the revenue from the sale equally over the life of the contract even when the bulk of the items were delivered upfront. As a result, ATG went from being profitable to running at a loss for at least four quarters.

Breaking the news to Wall Street was painful. “It was a very dark day,” says Bradley, recalling her announcement last February that ATG would begin deferring about 50 percent of its revenue thanks to eStara. Although it meant that the firm expected revenues over time to increase, ATG’s stock dropped about 20 percent in the days surrounding that announcement. Eventually, she says, analysts understood, and the stock has doubled from its nadir as ATG’s cash flow from operations quadrupled between the third quarter of 2006 and the third quarter of 2007. (The company still shows a GAAP loss.)

Avoiding VSOE is not really an option, unless the company doesn’t mind lumpy revenue and unbridled suspicion from investors. “The question we always get is, ‘Every company has to deal with VSOE. Why are you different?’” says Airvana CFO Jeff Glidden. He’s become practiced at the answer since his company went public last spring and he had to educate investors on why it defers all of its revenues. Why? The company, which sells software and future upgrades to major wireless-network equipment makers like Nortel, Alcatel Lucent, and Qualcomm, offers unique products, contracts, and pricing to each customer. Thus, it effectively can never establish VSOE, because its prices don’t fit a curve. “When we reviewed this with the SEC, they said this business model probably wasn’t considered in 97-2,” says Glidden. But even so, “you have to follow the rules.” In this case, following the rules means Airvana’s revenue might swing from $3 million in one quarter to $140 million in the next, as revenue deferred from one or two years earlier becomes current. “My GAAP statements are stale at best, since you’re still explaining why revenue this year is up or down based on what happened last year,” says Glidden.

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