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New accounting rules could cut some firms' short-term revenues

By Jerry Ackerman, Globe Staff, 11/26/97

A silent time bomb awaits some software companies.

It takes the form of new accounting standards that kick in next month for the industry. These standards set out rules for posting financial results that could cut some companies' revenues - and perhaps earnings.

Known blandly as Statement of Position 97-2, the new rules being adopted by the accounting industry supplant a six-year-old standard that now lets companies book some revenues long before the goods or services are delivered - or even developed.

By one estimate, invoking the new standards could mean hundreds of millions of dollars in short-term revenue setbacks for the fast-growing software industry.

The arcane but significant rule change was prompted by the increasing complexity of software products and sales. Many of today's deals involve integrated systems that wrap databases, accounting tools, and graphics into complex packages. Contracts for their development, installation, and subsequent support services can stretch out many years - a far cry from when buying software was "like buying a shirt at Filene's," as one specialist put it.

At the same time, revenue recognition has long been a hot potato in the software industry, whose fast growth, aggressiveness, and eagerness to please Wall Street investors have often led firms afoul of fiscal niceties.

But today's long lead times and product complexity have provided even more wiggle room for a software firm to inflate sales, according to specialists. Under existing rules that some deem ambiguous, a company, for instance, could post the total value of a multiyear contract on the day it is signed.

"I don't use the word 'fraud,' but because there hasn't been clarification" on how existing rules should be interpreted, "a company could be either very conservative or very aggressive," says Jack Acosta, chief financial officer and a senior vice president at Sybase Inc. in Emeryville, Calif.

US Securities and Exchange Commission accountants who asked to not be quoted said that the 40-page document should assist in enforcing SEC regulations.

The old rules were written in 1991, when software companies that now sell complex "packaged solutions" were less prevalent.

The update was written by a task force assembled by the American Institute of Certified Public Accountants. The panel included members from the SEC and the Financial Accounting Standards Board. The CPA institute says that while the standards board, the final arbiter of accounting rules, has not yet adopted the changes, its participation implies support.

Elizabeth A. Fender, director of accounting at the CPA institute, says the old rules were vague about when revenues on multiyear contracts should be recognized. The new ones make clear that component parts, like software upgrades, must be "unbundled" and posted separately wherever possible - and that each part must be priced at a fair market value at the time of delivery.

Many software companies say they have been preparing for the changes since they were outlined two years ago. "If you anticipate it, you can deal with it," says James Tholen, chief financial officer at FTP Software Inc. in Andover.

Others, however, can expect a major impact.

One of the first to formally apply the new standards - and to take a hit on its financial statements - was Ovid Technologies Inc. of New York. Despite increasing sales and strong cash flow, the company reported a 58 percent drop in third-quarter revenues from 1996. Ovid's chief financial officer, Jeff Hoerle, emphasized that the plunge resulted from "simply a change in accounting principles." But the company also said the new rules will depress reported revenues "in each of the next three quarters."

David Elsbree, a partner at Deloitte & Touche LLP in Boston, says shareholders in publicly held companies will be affected if Wall Street analysts who issue quarterly earnings forecasts don't understand what lies ahead. "If a software company didn't meet analyst expectations because of some new accounting pronouncements, there might well be some reaction in the market," he says.

Accountants say that in most cases, any sales or earnings declines resulting from the shift should be recovered when revenues deferred today are recorded in the future. The CPA institute estimates this transition will last about a year.

But during that time, the hardest-hit companies could be those selling packaged solutions, which can include customized software licensed in combination with consulting services, training, product support, and software upgrades.

The deals sometimes include promises of the next generation of software, if-and-when-developed. The new rules will discourage this controversial practice.

Steven D. Krohn, a partner at the Boston office of KPMG Peat Marwick LLP, says the new rules should make clear that "you may not take 100 percent of the sale [when the contract closes] if things remain that have not been delivered."

Although the accounting industry plays down the fiscal irregularities that have repeatedly hit the software industry, there is little doubt that loose bookkeeping practices have been a problem. "A lot of [software] contracts are being written so as to create legal and accounting gray areas," says Elliott Levy, an associate professor of accountancy at Bentley College.

Companies such as Kurzweil Applied Intelligence Inc. and Kendall Square Research Corp., both of Waltham and both now defunct, have become case studies in how not to keep books.

The latest to join this list, Informix Corp. of Menlo Park, Calif., recently admitted it had been inflating its numbers since January 1994 by recognizing sales of its database products before they reached end-users. The company, with new executives in place, last week said the writedowns it must now take over that 3 1/2-year period amount to $236 million.

This story ran on page C04 of the Boston Globe on 11/26/97.
© Copyright 1997 Globe Newspaper Company.