As we have noted previously, according to software revenue recognition rules, when a company bundles a software item with other products or services (implementation services, ongoing support services, tangible products) together in a contract, the company has to be careful how it recognizes the revenue. It cannot recognize any of the revenue from the contract until the last item has been delivered or it can prove the separate value of each item. If managers do not want to have to defer revenue, they need to establish vendor specific objective evidence or VSOE. Understanding why revenue is deferred or how VSOE is established becomes more complicated when managers and investors start looking at acquisitions.
Acquisitions may occur for many reasons. Managers make acquisitions to eliminate a competitor, gain access to a certain market or customer list, or because some synergy exists between the products the companies offer. Let’s look at three scenarios on how acquisitions affect VSOE:
Scenario 1 – Let’s say Company A has established VSOE on a service element. Company B then acquires the company for synergistic purposes. Company B has a product that would go well with the service element, so it bundles them together and sells it. Although Company B would like to use the VSOE revenue recognition models that Company A developed, it cannot. The combination of product and service actually creates a new product. The fair price for this new synergistic product has not been determined by the market and therefore the old VSOE models do not work. Company B will have to defer all revenue until VSOE can be established on the new product.
Scenario 2 – Let’s say Company C has a hot new product in the market and everyone is purchasing it. The product consists of a software component and a commitment to customers for future unreleased software updates. Unfortunately for the company, the market cannot correctly evaluate the “unreleased” software, therefore VSOE cannot be established for the product. Without VSOE, the company’s income statement constantly shows lumpy revenue each month. The lack of consistent growth makes investors suspicious. Although a group of investors makes an offer for Company C, the offer is low ball due to the inconsistencies in the revenue.
Scenario 3 – Public Company A purchases a small startup company. The startup company had a proven track record in providing excellent customer service to their customers and had established VSOE of their various elements. Unfortunately, due to the acquisition and subsequent integration, customer services started to deteriorate. To compensate, Public Company A started offering concessions to customers to make up for poor service. Unfortunately, the concessions and new price falls outside of the established VSOE range. Due to the price concessions and poorer service, Public Company A can no longer claim VSOE on the startup’s various elements. All revenue will have to be deferred until new revenue recognition models can be established.
Although these are just scenarios, VSOE compliance frequently hurts the financial statements of real companies. For example, questionable revenue recognition practices may have been at the center of Hewlett Packard’s acquisition of software company Autonomy. In the case of Autonomy, HP claims that certain subscription based revenue was booked too early and should have been deferred.
Don’t let VSOE trip up your acquisition. If you need to learn how this will affect your company, please contact us.