Vendor Specific Objective Evidence

Ok, this has taken me a little further down the rabbit hole than I intended.

VSOE is a revenue recognition standard imposed by GAAP on U.S. public companies. It applies to companies who sell a package of goods and services, such as software that will require future updates, or a device with a warranty attached. Even if the company collects an up-front fee for the item, it cannot book that fee all to revenue on the income statement because GAAP considers that the company still has obligations to its customer, so it would be misleading to book all that revenue with consideration still to be delivered. An example is with Garmin, it sells GPS devices with lifetime updates, even though it takes payment up front, it has to defer revenues because it still has the obligation to update the maps over the life of the product. Three things can happen that cause stocks to be over or undervalued in the market:

1. The company might under-recognize its revenue and income and be ultra conservative to make sure it complies with VSOE standards. This would cause a stock to be underpriced. I believe this may be the case with Garmin, GRMN, and many other companies. Better to be safe now than have to restate income later.

2. The company might be forced to restate income because of a small mistake. The stock would probably plummet. Sometimes it's a big deal when restatements are made; other times it was an honest mistake and the restatement is trivial. But the market often doesn't care. The word "restatement" causes many hedge funds and mutual fund managers to flee the scene. This could cause shares to be undervalued. See this article for examples: http://www.cfo.com/article.cfm/10328463

3. The company might not comply with VSOE and state all of its revenues up front. This would come with a chance of being forced to restate earnings if an internal auditor changes. These companies might be prime for a short.

Seems simple enough right? Let's start making profits! Whoa there, hold your horses. This thing is super complicated. It involves normal probability curves and price lists and all sorts of tricks and treats. The GAAP has been trying to change it for three years and can't come up with an adequate solution. Now they have a Best Estimated Selling Price, and another current proposal is in the comment stage, and may be rolled out mid-2012. Eventually I want to put together a little VSOE portfolio of overvalued and undervalued stocks. But that will require a lot of time. Since I'm still trying to get a general grasp of the markets, I am going to put off that task until later. I will eventually get to it though. One thing I will do for now is check out a list of small-cap software companies and put in a call to their CFO to ask him/her how VSOE affects his income statements. I'll probably get blown off by most of them but maybe a few can offer some practical information.

Disclosure: I am long GRMN.