Comparing apples with apples

The software industry is unlike any other. In which other market would you sign off an invoice before you’ve even installed and properly tested the product? And if the software needs customising before it starts to add real value to the business, should the vendor receive all the revenue up front or only after benefits have been transferred to the client? This debate currently rages on between the various international accounting standards bodies, financial analysts and the software vendors themselves. But is this even an issue for manufacturing companies? It should be. First, any firm considering buying an enterprise (ERP) system, or similar software, reaches a stage in its selection process when it needs to check and compare the financial health of shortlisted suppliers. If you don’t do a thorough job on this, you could end up buying technically sound software, but from a supplier that goes out of business a year later. You end up with little or no technical support for a product you’ve already invested heavily in. Vendor comparisons are not easy. Problems stem from the fact that there’s no authoritative UK accounting standard or prescriptive guidance available today for measuring and recognising revenue in the software and IT services sector. So vendors are relatively free to ‘adjust’ their figures to make things appear rosier than they actually might be. Hence industry analysts are now calling for more regulation, particularly in the aftermath of the general devaluation of the software industry. There is help available. Aside from paying for advice or using a financial checking service such as Dunn & Bradstreet, there’s also the accounting bodies. In July 2001, a paper entitled ‘Revenue Recognition’ was published by the UK Accounting Standards Board to promote awareness of these issues and to try to agree on a unified standard for revenue recognition in the UK. Why? Because the widely-adopted International Accounting Standard, IAS 18, was last revised in 1993 and so doesn’t properly address software revenue. The paper proposed that, “A contract must exist before revenue can be recognised by the software supplier, not simply after delivering the product...” Best practice amongst suppliers today is simply to recognise revenue in line with costs incurred. Second, it suggested, “A link be established between recognition of revenue and the vendor’s contractual performance... and revenue should be based on benefits transferred to the customer.” This has quite serious implications. It means software vendors may have to start focusing, not on the cost of work done to date, but on the value transferred to the client. How do you measure? The debate intensifies when you consider the complexity of IT contracts. Some suppliers separate contracts for software licences, implementation, support and maintenance. Others prefer ‘bundled’ deals. Questions begin to arise such as, ‘How do you ‘unbundle’ IT contracts to measure revenue or benefits? Does the grant of licences to use software represent transfer of benefit to the client? Is there extra benefit once the software’s installed but before acceptance testing? Many suppliers recognise revenue from a sale to a third party even though the licenses can be returned at any time by the client. The answers are unclear. And it’s not just bloated revenue figures we need to be aware of. Take ‘Profit Before Tax’ (PBT) for example. You may choose to examine the PBT of two suplliers and discover one is making a profit while the other’s making a loss. But on closer inspection of the financial notes, you may discover the loss-maker’s actually writing off its goodwill over a shorter period than the other. Or perhaps the firm making a profit is capitalising its expenses and thus not showing them in their Profit & Loss accounts – both standard ‘tricks of the trade’. And making a profit doesn’t necessarily mean you increase cashflow. A supplier may capitalise its spend on software development and thus show profit. However, it may have cut its cash balance from the last period as it spent more than it received in actual sales revenues. The message is simple: always ensure you compare like-for-like when reviewing financials and apply the same measurements consistently across time and different suppliers.