Most software companies and system integrators have enjoyed the luxury of demand-pull growth throughout the past ten years. Industry growth rates have been outstanding and customers’ appetites for new software solutions have been insatiable. This environment has now created opportunities for improvements in project management. A recent survey of high-tech firms indicates that project management has been a “loose” management orientation implemented to serve the moment. Findings also showed that if project management improved. Time and cost could be reduced by more than 25 percent and profits would increase over 5 percent [1].
Throughout this ten-year period, companies have wavered on their revenue recognition policies. The current marketing and revenue recognition practices within the software industry vary greatly among both private and publicly traded firms. Many of the practices are suspect as to the degree of conformity they have with generally accepted accounting procedures.
CHANGES IN REVENUE RECOGNITION
Consequently the investment community has called for guidelines to ensure greater consistency and predictability. Under the direction of the Securities Exchange Commission (SEC), the American Institute of Certified Public Accountants (AICPA) has proposed a Statement of Position (SOP) on software revenue recognition. This SOP provides guidance for when and how revenue should be recognized. To date there remains a couple of difficult areas within the revenue recognition controversy which do not meet Federal Accounting Standards Board (FASB) or SEC criteria. However, full support is expected by the FASB and the SEC. It is anticipated that the SEC will mandate full compliance with the SOP by 15 December 1991.
THE STATEMENT OF POSITION
The SOP addresses the wide range of software providers in the marketplace. For those companies involved in “non-shrink-wrapped” products and services, the challenge of the new practices goes beyond the accounting arena; it hits at the core of the management process within a company. It will affect product pricing, positioning, profits, sales, engineering, customer relations and the day-to-day management of projects cycles.
The changes proposed in the SOP may significantly affect the timing and representation of revenue in financial statements. In light of the many large contracts prevalent in the industry, much of the revenue recognized will be deferred to future periods for recognition.
In some cases, a company's performance ratios may be dramatically changed. Beginning in 1991, companies will probably report lower net profits. Every company in the software industry, both large and small, will be affected. The focus of this article is for those companies which derive revenues from large software projects and systems integration efforts.
The section of the SOP which addresses project work is derived from the accounting standards set for the construction industries.
Two alternative accounting methods proposed for compliance to the SOP are based upon Accounting Research Bulletin No. 45 (ARB45), Long-term Construction-type Contracts, October 1955 and SOP 81-1. They are the percentage-of-completion and the completed-contract method. It is a moot point, at this time, to argue the appropriateness of “construction-type” accounting practices being applied to software. The real questions arise from a firm's ability to estimate and manage the uncertainties of a software project environment. Unlike the construction industries, software projects lack the standards and management techniques which lend themselves to more dependable estimating practices. These custom contracts require a greater degree of iterative planning to effectively manage the project costs and outcomes.
Generally, the accounting issues are straightforward, but difficulties arise with the inconsistent practices among custom software houses, system integrators and large “software general contractors.” Although the responsibility of compliance rests with accounting organizations, the practices should be shaped by a company's business objectives and customer orientation. Instead of recognizing revenue as a “big hit” upon contract signing, it will be recognized concurrent with expenses throughout the life cycle of the project. This process will demand greater adherence to project management methods and practices, and those practices will be directly tied to quality, customer satisfaction, income and, ultimately, profitability. (See sidebar.)
Much of the current discussion and concern for the SOP stems from the accounting profession. Positions are taken and arguments are made to minimize the negative impact of such a sweeping change. Driving compliante from an accounting perspective only serves to accurately state the conditions of the business “after the fact.” It does not readily serve as a “proactive management tool” designed to ensure quality services and customer satisfaction.
Regardless of the accounting impact, companies involved in custom software development and systems integration should drive compliance from a customer's perspective. This will afford them the opportunity to build upon the strength of their customer relations.
A common mistake in most software firms is to have the individual implementing the customer's solution responsible for project management. This does not necessarily make for good project management. It can jeopardize a company in many ways-the project completions may slip, customer satisfaction may suffer, revenues may be delayed, and the corporation's fiduciary responsibilities may not be met.
With the changes in revenue recognition procedures and the dynamics of the competitive business environment, many companies will need to alter the way they do business on large software and systems projects. Companies will be required to develop their own accounting metrics. However, establishing a consistent management orientation for project work will enable companies to ensure compliance with the SOP. Project management professionals can play a major role in the revenue recognition efforts of companies affected by the proposed changes. They can provide insight into sound project management practices.
BEYOND COMPLIANCE
Understanding Sales/Costs/Profits in the Revenue Equation
Most managers can accurately state selling costs. They also can accurately state revenues. But when asked to state revenues and incomes relative to project cycles, most managers fall short. This will become more evident with compliance to the new SOP
To fully ascertain the appropriate revenue recognition policy for a software company, managers must look beyond their reporting capabilities. They must examine project management methods which will enable them to forecast and report their revenue position on each project effort. Consider the following questions.
- Are you set up to accurately state revenue ratably with the expenses of project work?
- Will the revenue recognition practices comply with accounting standards?
- Are all projects planned and controlled consistently throughout their project life cycles?
- Are implementation costs readily segmented by project, client and revenue stream?
- What is the break-even point on each project; how does that relate to capacity?
- What are the incremental costs and profits against revenue when recognized over time?
Being able to accurately answer these questions will provide companies with insight into how well they will be able to manage revenues and expenses throughout project life cycles.
THE ROLE OF PM
With revenue recognition resting on those uncertainties, project management assumes a much greater level of relevance for the management challenges facing high-tech firms. Growth alone will not be able to carry a company. AU the functional groups contributing to the sale, design, implementation and acceptance of a systems contract will need to plan, execute and control the project's activities to optimize the timely recognition of revenues while maintaining customer relations and the highest quality standards.
The challenge for management and project management professionals will be to link the business planning, project planning, project controls and customer relations with the required accounting changes. If this is accomplished, the results will be positive. Software organizations will then have the necessary tools to accurately forecast and report revenues. Companies will be provided with consistent vehicles for communication within the project teams and with client organizations. And the necessary controls to optimize profits and timing on work performed will be in place.
Instead of viewing compliance with the SOP as a financial reporting requirement, it should be viewed as an opportunity to improve project management. The result will be a win-win situation for the company and its customers.
HOW A COMPANY CAN PREPARE
Companies should begin by familiarizing themselves with the proposed SOP. The impact will vary based upon the type of software products provided. Next, companies must audit their revenue recognition process and determine if those policies and procedures will meet the SEC requirements. Precedence, objectivity, verifiability, and consistency will serve as the foundation for any compliance effort. Moreover, beyond compliance, these attributes can serve as a foundation for project management policies and procedures. They can assist project managers in meeting customer objectives while optimizing revenue streams and maintaining profits.
Once revenue recognition is clearly understood, companies should also conduct a project management audit for the revenue generating software and systems projects. Begin with the sales and marketing efforts of the company and follow the cycle through to customer acceptance. Determine how services are marketed, how each project effort is proposed and how each solution is deemed “accepted by a customer. (Simply following a milestone payment method will not substantiate a revenue recognition practice.)
Managers of organizations should have an understanding of how each function within a company impacts the revenue process. Once this is achieved, the process should be documented. Project management policies and procedures should be examined and defined to optimize the timely recognition of revenue streams and project performance. Opportunities exist for companies to drive the new revenue recognition process with more effective project management methods which support the SEC requirements.
As companies move toward compliance, project management practice can evolve to be the backbone of the revenue system and the foundation for revenue forecasting, expense control, project control, customer relations and profitability.