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New revenue recognition rules might change the reports but not the checking account

In mid-September the US Financial Standards Accounting Board (FASB) approved a change in revenue recognition rules for IT companies that could substantially impact their perceived performance, at least across the quarters in which they make the change.

The FASB, created in 1973, is a private organization that develops the generally accepted accounting principles (GAAP) that companies listed on US stock exchanges must adhere to in reporting their results (more about the FASB at the Wikipedia). If you followed SGI’s financial results leading up to their bankruptcy this year, you read about GAAP and non-GAAP a lot (in fact, I did a feature with SGI’s then-CFO that talked about what all of this means).

At a September 23rd board meeting the FASB changed one of the revenue recognition rules that public companies follow when counting money in their various official financial reports.

Issue No. 08-1, “Revenue Arrangements with Multiple Deliverables.”
This Issue applies to multiple-deliverable revenue arrangements that are currently within the scope of Subtopic 605-25 (previously included in EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables”).

The way things are currently done in IT is that when a company sells a solution that tightly integrates hardware, software, and services, they don’t get to report that income all at once. Typically a company gets paid for the hardware and software at time of purchase acceptance, and then has some sort of multi-year service agreement for maintenance. The way your checkbook works at home is that you’d get to put this money in checking when it was paid to you, and it would be available for you to spend. The IRS would count it as income in the year’s you put the money in your account, and so on.

An IT company that makes this kind of integrated hw/sw/services sales gets the money in the same way, and can put it in its checking account and spend it right away just as you or I would. But when they issue their quarterly reports that officially report how much money they made in the quarter they got paid, they would not report the full amount of income they got from the hw/sw/services sale. Instead, they have to amortize that amount over the length of the services contract. So if they got paid $3M in year 1 for a system with services lasting 3 years, they would record $1M for each of three years. Weird, I know. (Actually, there are a lot of complications that my simple example ignores.)

The new rule, which goes into effect in corporate fiscal years beginning on or after June 15, 2010, says that companies will get to report (“book”) the full amount of hardware portion of the income and profits in their financial reports in the quarter in which they get the check. This will likely significantly boost the q-q revenue and profits reported for companies that change their reporting as a result of this rule change. It’s important to note that this only changes what’s reported; the money in the checking account, and so the real value of the company, does not change.

The question is, who will this change impact?
I sent official queries to several public companies in our ecosystem; all declined official and/or insightful comment outside of their regular financial reporting. But we can hazard a few guesses.

SGI seems likely; they made a change several years ago to adopt this deferred revenue recognition arrangement as a result of an assessment made by their auditor that sales of their storage gear (in particular) qualified. Making that change in mid-stream really hurts your reporting, and that’s why SGI included non-GAAP numbers in so many of their quarterly reports. HP and IBM are so big that their financial accounting is driven by the mothership, and doesn’t have much to do with their HPC sales.

I don’t see this affecting Cray’s routine sales, either, since I don’t believe that selling an operating system with a computer triggers the revenue deferral rule (you can install other operating systems on your hardware, so the OS isn’t intrinsically tied to the operation of the gear) and you can run a system as sold without maintenance. If, however, they have deals where the hardware sale is tied to substantial development over the installed lifecycle (I don’t have inside information but I could imagine Jaguar falling into this category, or Red Storm back in the day) then this change would impact reporting on those deals. Since Cray’s quarterly results often swing wildly from quarter-to-quarter because they typically sell few systems with a very high average selling price (ASP), getting to book all of one of these deals in a single quarter could emphasize that swing in quarters where it happens.

This almost certainly will effect some of the public companies in other spots in the HPC ecosystem. I would anticipate changes in the way that storage companies report, for example. Charlie Wuischpard, the CEO of Penguin Computing, gave us the private company view:

Multi-element revenue recognition has always been a hot topic. I’m no CPA but I have a lot of practical experience and it’s often a gray area – public or private depending on level of conservatism/risk. Typically, finance is on one side, sales on the other.

But as a private company, I worry less about the revenue recognition than the booking (win) and the cash flow. That is not quite the case with a public company, especially one in which a large percentage may be of this type.

As a technologist, it sounds like I’d rather work at a private company.

Comments

  1. Clarification on this. While your focus here is on revenue recognition, you’ve over-simplified the “checking account” side of these transactions. These can also be complicated.

    Once the system is accepted, the IT company will rarely get a check right away. They will issue an invoice right away, but the customer may wait before paying. (And there’s always a possibility that the customer might never pay if they’re having financial problems or funding falls through.) Meanwhile the IT company has to pay its staff, and has bought parts and components from all sorts of vendors – these bills have to be paid.

    To help with this, customers with really large projects will sometimes include some advance payments. Tied to milestones, such as when the order is signed, some demo is run, or the system is shipped. This can help the IT company pay its bills while they’re putting the system together, without having to wait until everything is shipped and accepted. This is cash that goes into the “checking account”.

    Bottom line is that all the finances around big HPC deals are critical to get right, and can be very complicated. CFOs and other finance VPs (and no, I’m not one) rarely get the credit they deserve to both keep their companies afloat and the SEC happy.

  2. John West says:

    Peter – thanks. You are right, I did simplify things in my post. Walking that tightrope between exposing new information for those who are really only interested in the technology but still trying to get useful information out to those like you that know more about the business. Actually, I’ve only been on the payer side of the HPC business; it sounds like you are on the payee side, and it’s good to have that perspective.

  3. RecognizeMe says:

    Peter is not incorrect but is really missing the point of the article, which, i think, is to illustrate the difference (or impact of the diff) in accounting standards. It’s important, but not relevant, to highlight those issues here.

    In my past company, recognizing hw rev as part of a solutions/bundle was already in practise…that was 2004. was not sw related, but consumables, labor & maybe a small % in sw.

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