UK: Revenue Recognition – Myths and Implications for IT Contract Negotiations (part 2)

Last Updated: 12 July 2006
Article by Bridget Treacy and Nicola Fulford

In the last edition of Technology Law review, we explained how the Sarbanes-Oxley Act and the accounting practices developed around revenue recognition in the US have had some unforeseen consequences.

Those negotiating contracts with US IT suppliers have experienced increased reluctance in relation to the acceptance of terms previously regarded as standard. In part 2 of this article, we examine some of the arguments and counter-arguments commonly proposed in contract negotiations and suggest some potential solutions.

Acceptance criteria

Some suppliers claim that they cannot agree to acceptance criteria for deliverables where payment is linked to acceptance. Their justification is that they would be unable to recognise the revenue relating to those deliverables until the time the customer confirms final acceptance of the deliverables.

From the customer’s perspective, there must be a process by which deliverables are tested to ensure that they meet the contractual requirements. If they do not, customers will be reluctant to pay for them.

In this situation, a reasonable compromise may be that the contract contains clearly defined criteria, with strict timeframes for testing. If testing is not carried out in time, a long-stop "deemed acceptance" date might apply. Further, the acceptance criteria may be structured so that, provided key criteria are met, the deliverables are deemed to be "partially" (or "substantially") accepted, perhaps with a price reduction or the retention of part of the price while minor failings are rectified. If partial acceptance itself causes issues, the deliverable could be divided and the retention treated as a separate deliverable, allowing certainty as to the acceptance of the remainder.

Remedies for breach of warranty Whilst a claim in damages may be the remedy at law for a breach of warranty, customers often require an express option to require the supplier either to repair or replace a deliverable, or to refund the relevant fees if warranties are breached. Suppliers sometimes use SarbOx to reject an obligation to refund fees, claiming a possibility of a refund will prevent them from recognising the revenue. The solution here probably lies in imposing a time limit within which the remedy must be exercised.

Revenue recognition issues also sometimes arise in relation to long periods prior to the point from which a warranty period of a number of days or even months may run. For example, where the warranty period for each deliverable only commences on live use of the entire system in a complex systems implementation project.

This may be resolved by agreeing intermediate dates related to milestone deliveries, or including long-stop dates for the commencement of warranty periods in the contract, particularly if the commencement of the warranty period is not entirely within the supplier’s control. As the accountants require certainty above all, it seems that the existence of even a very distant long-stop date will satisfy SarbOx concerns.

Service credits

Customers tend to view service credits as a price adjustment to reflect poor service. This is often put in terms of the customer having received only 90 per cent (instead of the agreed 100 per cent) of the services and an assertion made that the customer should not then be required to pay 100 per cent of the price. Reference to "price" may then attract the attention of the supplier’s accountants as a revenue recognition concern. This should be capable of resolution by careful drafting; however, some suppliers prefer to receive only the 90 per cent with certainty and to receive the balance once it is clear whether service credits have been incurred.

Liquidated damages

Suppliers have been known to argue that the inclusion of liquidated damages provisions leaves them unable to recognise any of the associated revenue until the events that might trigger an entitlement to liquidated damages have passed. So, for example, if 15 per cent of the value of a project is at risk unless it is delivered on time, no revenue can be recognised until the project has been delivered in its entirety. This concern ought to be manageable by structuring the liquidated damages so as to allow milestone payments to be made (and recognised) if interim targets are met. Fundamentally, this becomes a commercial issue as it is legitimate for customers to withhold payment until delivery is made; however, it may be unreasonable to delay all payment until the entire contract has been delivered.

Liability cap

Most suppliers seek to cap their liability and generally customers accept this. Often, liability will be linked to the value of the fees payable under the contract. Suppliers often seek to link liability to value in a given period. However, customers often want the comfort of knowing that if it all goes wrong they can recover all of their money.

The conventional suppliers’ argument against this is that such a position is unfair: as the life of the contract extends over years, their risk profile keeps increasing. Some suppliers have attempted to use SarbOx to support this, arguing that a cap linked to the value of fees (which are not fixed) over the life of a longer term contract exposes them to an unknown liability and that their accountants will not agree to what they perceive to be unquantifiable liability.

This point is not a revenue recognition point at all and can be countered by expressing the liability cap as a monetary amount. Alternatively, a maximum contract value may be stipulated. For the customer, this should be some margin above their realistic expectations plus contingency, and should clearly state that the customer is not bound to spend that much. It should also be reviewed if, over the term, it appears that the customer may spend more.

Conclusion

From the customer’s perspective, SarbOx may seem to have come to the aid of suppliers, providing additional arguments to support their preferred position on their top five issues. Some suppliers are relying on these arguments in order to shift the balance of power in what are essentially commercial negotiations. However, SarbOx is a genuine concern for suppliers and significantly influences the way in which many conduct their business. If deals are to be concluded, these concerns should be addressed as constructively as possible. With some creative thought and careful drafting, workable solutions for both parties can be reached.

Some thoughts from the US

Part 1 of our revenue recognition article obviously struck a chord with one reader, a US counsel acting for a well-known multinational corporation. He had the following comments:

""Problems" with revenue recognition has become a standard vendor response to almost any situation in which fees are not guaranteed or there is a possibility of having to refund fees. This pre-dates SarbOx (or SOX, as we call it here) by a number of years.

The "pain" that US software vendors suffer from this issue is largely due to selfinflicted wounds. The experiences of a number of leading IT companies over the last few years, such as Computer Associates, illustrates the fact that the long-standing problem stems from booking revenue that vendors never had any business booking. Even before SOX was passed, software vendors were becoming incredibly abusive with regard to trotting out the "rev rec" argument. It has even reached the point where vendors are unwilling to consider the issuance of a refund for a breach of the initial product warranty. According to vendors, this is a new requirement of SOX. However, as was pointed out in part 1 of this article, this is absolutely not the case. SOX has merely given vendors a tool in negotiations that, ironically enough, arises from a situation that vendors created in the first place."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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