Informix Revenue Recognition

MEMORANDUM

Date: February 22, 2005

To: Deborah Jones, Coordinator of WSU-Financial Accounting Research Program

From: Alina Tousain, Shruti Likhite, Karthik Krishnamurthy

Re: Group 2 - Case 2.1 "Software Revenue Recognition: Informix Corporation"

Companies following GAAP can manage earnings by simply altering its accounting policy to select those accounting principles that benefit them the most. Entities have a host of reasons for selecting those principles that will paint the rosiest financial picture. Some would argue that the market demands it, as reflected by the stock price punishment for companies that differ by as little as one penny per share from prior estimates. External market pressures to "meet the numbers" conflicts with market pressure for transparency in financial reporting.

Most fraudulent financial reporting schemes involve "earnings management" techniques, which inflate earnings, create an improved financial picture, or conversely, mask a deteriorating one. Premature revenue recognition is one of the most common forms of fraudulent earnings management and the case of Informix Software Inc. unfortunately illustrates closely this practice.

The analysis of this case will shed light on issues like:

v Informix's revenue recognition policy prior to 1990 and its compliance with FASB Concept #5, FASB Statement #86, GAAP protocols.

v Informix's reactions to AICPA SOP in changing the revenue recognition procedures and Informix's reason to prematurely and voluntarily implement the new policy

v The changes that took place at Informix and the financial results reported during 1990

Furthermore, we will also evaluate the software industry practices and the regulations in place at that time. We conclude with lessons learnt and recommendations towards identifying and discouraging non-GAAP revenue recognition practices.

1986-1990 Revenue Recognition Policy at Informix Corporation

REVENUE RECOGNITION POLICY BEFORE THE PROPOSED AICPA SOP

Prior to 1990 the software industry had the FASB Statement of Financial Accounting Concept No.5 and the FASB Statement No. 86 to provide guidance in the revenue recognition concepts. The Accounting Research Bulletin (ARB) No. 45 which discussed long-term construction type contract was also available but did not specify application for the software industry and so it was ignored.

Before 1990 (refer exhibit 1) Informix recognized product revenue - general contracts for sale of software license - at the time of shipment and thus in accordance with FASB. The nonrefundable license fee contracts were recognized at contract signing thereby deviating from FASB's inference and thus violating GAAP's Conservatism Principal. The revenues recognized at the time of contract signing were neither realized nor earned, which led to an overestimate of Net Income in Informix's financial statements.

The revenues from maintenance contracts were recognized over the term of the contract conforming to GAAP and finally the research and development costs were amortized on a straight-line basis over the life of the product, deviating from FASB statement no.86 Due to the fact that majority of the revenues for Informix were from contract licensing, one can imply that GAAP's Matching Principle was violated due to the fact that the revenues were recognized much earlier than the effort in building the software or providing the service. Thus, the company failed to match the accomplishments with the expenses, which also resulted in the overstatement of accounts receivables.

Informix's financial statements indicated a significant increase in net income (22.8% on 40.1% increase in revenues) and accounts receivables (28.4%) in 1989 from 1988. Informix's Notes to Consolidated Financial Statements as of December 31, 1989 indicated existing high accounts receivable balance, pertaining to the remaining unbilled balance of the already recognized revenue, probably the result of bad debt. Allocating for proper bad debt expense would have better aligned the accounts receivables thereby providing for a truer statement than provided. Also Informix's profit margin on sales year over the year declined from a high of 12.8% in 1986 to a low of 4.4% in 1989. This indicates that revenues were being booked early and expenses and costs were catching up in later years especially with the application of research and development costs.

INFORMIX CORPORATION AT CROSS ROADS

In the early 1990's, due to the above mentioned irregularities in the application of the revenue recognition policies by the software industry, AICPA through its Statement of Position (SOP) decided to take a leadership role in providing guidance on financial reporting topics till the FASB set standards on the issues in question.

AICPA clearly sought to provide guidance for the industry, which many perceived as questionably applying the revenue recognition principle. Also there was the need to eliminate a conflict of interest that existed between a manager's responsibility towards the company and the financial community and their personal interests of wealth maximization.

AICPA's primary goal was to eliminate the artificial inflation or deflation of the stock price and increase the confidence in the information published through the financial statements.

The basic idea that revenue was being recognized even when the actual product was not delivered probably moved AICPA to provide guidance that matched with the FASB's conceptual framework of SFAC No. 5. But the main reason to change the revenue recognition policy was to stop the industry from overstating the current period's revenues at the expense of future period's income.

Even before the new AICPA SOP was implemented and adopted by the Software Industry at large, Informix surprised everybody with its announcement of implementing the new policy retroactively to January 1, 1990. Informix reported that year an operating loss of $18.7 million compared to 1989, after an increase of $10.9 million in the operating income between 1988 and 1989, this suggests that Informix hoped to disguise their reported results on the upcoming AICPA guidance rather than have auditors