In 1983, Association of Data Processing Service Organizations (ADAPSO) performed a survey of the large software companies (revenue over $10 million,) inquiring of them regarding their revenue recognition practices. Particular inquiry was made regarding that point at which a sale becomes revenue. The more aggressive companies, tended to recognize revenue upon contract signing while the more conservative ones waited until payment was received. Everyone else fell somewhere in between.
This disparity between software companies eventually led to the issuance of Statement of Purpose (SOP) 97-2 in 1997. SOP 97-2 settled the debate started in 1983 by establishing rules dictating that sales can be recognized only upon delivery if Vendor Specific Object Evidence (VSOE) of Fair Value has first been established on each element in the contract.
Bi101 is a software company and as such, we understand the pain associated with VSOE compliance. To help newer software companies that face this same situation, but may not have our same experience, here are 3 suggestions we have learned from dealing with VSOE:
- Understand the Benefits of VSOE Compliance – Companies that establish VSOE are able to recognize revenue on their products and services upon delivery. This means that revenue on the income statement is consistent and the balance sheet does not consist of large amounts of “deferred revenue.” Although deferred revenue is an asset, it creates uneven revenue flows. Uneven revenue flows are not looked favorable upon by investors.
- Educate the Salesforce about VSOE Compliance – Salespeople do not need to know the difference between the residual method and the bell curve, but they should understand the basics of revenue recognition. At a minimum, they need to understand the following:
- Different Elements within a Contract – Sales people need to understand that there are different product offerings buried within a sales contract including licensing, warranties, support, and implementation services.
- Each Element has a different Price – Although the contract is negotiated at a single price, that price is determined by adding up the separate prices for each element.
- Sales may have to be turned down – In our opinion, the benefits of VSOE compliance outweigh the costs of discounts and rebates. Since discounts and rebates put pricing pressure on the VSOE established products and services, these should be used sparingly.
- Avoid maintaining VSOE compliance in spreadsheets – Tracking VSOE requires the maintenance of the final sales price on every sale for every product and service sold. If a company only has 10 products or services and 100 sales in a year, it would be possible to use a spreadsheet to calculate VSOE. Add more products, services, or sales and spreadsheets become difficult to manage.
We at Bi101 understand the benefits of VSOE compliance for software companies. That is why we use NetSuite to track and perform these calculations. NetSuite revenue recognition module tracks the final sales price for each element, calculates the fair value, and books the revenue when appropriate. The entire process is automated.
If you would like to know more regarding VSOE compliance and how NetSuite can help your software company, please contact us.