Mind the GAAP! Cloud accounting is all about matching revenue and costs to consumption…well, except for professional services!

Cloud computing is fairly different from traditional enterprise software and, unfortunately, the accounting here confirms the rule. After seeing our portfolio wrestling with GAAP accounting practices and seeing public companies like Taleo restating their financials because of their alleged aggressive stance on revenue recognition, we thought this issue earned the right to be included in the “10 Laws.” If you are a Cloud Computing CEO or CFO – even if you do not take the London tube every morning – we recommend that you “Mind the GAAP”! Before digging into some of these issues, we need to highlight that this paragraph is just scratching the surface and is not meant to replace the counsel of a certified professional.

Typically, Cloud Computing revenue is composed of two elements: subscription services and professional services, including implementation and training. Let’s tackle first the subscription revenue. In the old days of Enterprise software, the license revenue could be recognized when the CD was shipped, as software was comparable to a product – like any box you can buy at Fry’s. This was easy and intuitive as the revenue recognition was generally aligned with the cash collection. For a recurring revenue model however, the world is more complex. Even if the cash is collected upfront, the revenue needs to be recognized ratably over the lifetime of the contract. In addition, the revenue recognition cannot start before the service goes live, to ensure that revenue will match consumption. So, if you sell a product today, bill the customer upfront for one year with net 45 days, but need 60 days to implement the service and go live, you will have collected one year of cash, but won’t be able to recognize any of it before the 61st day. This explains why the GAAP revenue lags the CMRR as we have discussed earlier in law #2.

Now, let’s look at the professional services side. Initially, some companies, using the rules of Enterprise software, opted to recognize professional services as they were delivered. For example, if a customer paid $100k of professional services to get the subscription service going over a period of two months, the company would recognize the $100k ratably over these two months. Unfortunately, things are not that simple and this is (partially) why Taleo had to restate its financials. According to GAAP, professional services for recurring revenue businesses are tied to the subscription service, and therefore cannot be accounted for separately. In this respect, even if the professional services are delivered only over the first few months of the contract, the revenue recognition needs to match at least the length of the contract. Increasingly, accounting firms are going further and recommending that the revenue should be recognized over the lifetime of the customer. The notion of customer lifetime is not easily defined, but it means the revenue recognition of the initial implementation services can be amortized over 5 or 6 years if your churn is low. GAAP is supposed to match cost and revenues and this rule does not exactly support the argument, but that is how things stand at this point.

There is one exception to this rule that is worth mentioning: if you sell a professional service (e.g., training) at least 3 months before or after the initial/renewal date of the contract, then you may consider recognizing it as it is delivered if you can prove that it is not associated with the delivery of the subscription. This “rule of the 3 months” is just empirical, but some of our portfolio companies are using it and it has passed several audits from the “Big four”.

Finally, we would like to point out another element of GAAP accounting that will be useful if you consider raising venture debt. While it is better to avoid any financial covenants when raising debt, it is not always possible and one of the covenants that bankers like is a minimum “Quick ratio”. If that is the case, you need to specify that the deferred revenues (which show up as a liability in the balance sheet) should be excluded from the quick ratio. Getting upfront payment from your customer is typically a good thing for the business and you do not want to have to defer your payment terms just to avoid triggering the quick ratio covenant.