Keep Fixing It Until It Breaks: How Software Revenue Recognition Works

Oct 7, 2008

I recently had an interesting conversation about software revenue recognition with a partner at one of the “Final Four” audit firms. [Yes, I know. . . only two people like us could call such a conversation “interesting.”]

We were bemoaning the fact that software revenue, as reported in accordance with GAAP (Generally Accepted Accounting Principles) by U.S. public companies, had become increasingly meaningless. The result is, obviously, increasingly meaningless Income Statements, but also a demand for other revenue-related metrics, like bookings (whatever that means), backlog (ditto), cash collections, deferred revenue, new customers, etc.

What I found most curious, though, was that my audit partner friend showed no curiosity at all about how we had gotten to this pretty pass in the first place. 10-15 years ago, GAAP reported revenue was an extremely meaningful statistic for software companies. While some of the other metrics described above were published to add depth and color, revenue was the most widely-used, and widely-accepted.

You could say the meaninglessness of reported software revenue has come about in spite of heroic efforts by the accounting profession to ensure more precise and consistent reported results. A long and arcane document called “SOP 97-2” is the best-known of these, but there are many, many others, including the nearly annual clarifications to SOP 97-2. Unfortunately, a more accurate statement would be that this meaninglessness has come about because of those heroic efforts.

Why is that? Well, as the software revenue recognition rules got more and more “clarified,” more and more transactions that were fundamentally sound (at least from the perspective of common sense) found themselves running afoul of the “rules,” and therefore couldn’t be counted as revenue. What the accounting profession has not grasped is this: efforts to be “precise,” “meaningful,” “useful,” and “complete” are often fundamentally in conflict with each other, depending on which adjective you think is most important. So make up your mind.

Audit opinions in the Annual Report always say something like, “. . . present fairly the financial position of XYZ Company in conformity with GAAP.” Please note: “present fairly” comes first, and then “in accordance with GAAP.” It’s not the other way ‘round.

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