Acct 354 - Netsuite Inc. Financial Statement Analysis

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Company Overview

NetSuite Inc. is a cloud computing business specialized in management software suite ("NetSuite Incorporated - Investors - Overview", 2016). NetSuite Inc. is the industry's leading provider of cloud-based resources, and was the first company to provide a cloud-based business management application that addressed the needs of medium-sized businesses; as Oracle did for large multinationals.

Intelligent, Integrated and Simple

NetSuite Inc. system holds company's data in a single database, giving access to performance and financial metrics on a customizable dashboard, that fits the exact needs of the firm; leading to better and faster operating results NetSuite Inc. offers a less expensive, faster business application, and modular implementations ("NetSuite Features & Benefits Summary", 2016).

Why NetSuite?

NetSuite Inc. goal is to grow their position as a leading provider of cloud-based software for medium-sized businesses. This includes: expanding market reach in cloud-based computing by continuing to provide high-quality services, and integrated business suites by adding functionalities and tailoring NetSuite Inc. application to customers' specific industries. They intend to " expand [their] direct and indirect sales efforts to grow [their] customer base" (Exhibit 1).

Revenue Recognition & Quality of Earnings

Revenue Recognition

NetSuite Inc. generates revenue from two sources: 1) subscription fees from customers using its cloud-based application and support fees; 2) professional services, which include fees form consultations services and others. NetSuite Inc. uses two methods to recognize revenue. First, for subscription and support revenues, it recognizes revenue ratably over the term of the subscription contract, starting on the day when the service is made available to customers, which follows industry practice (Oracle, 2016 & Salesforce, 2016). Second, for professional services revenues, NetSuite Inc. recognizes revenue following the proportional performance method. It therefore meets the revenue recognition criteria established by the SEC: 1) persuasive evidence of an arrangement (contract); 2) service is being provided to the customer (service is made available); 3) collectability is reasonably assured and 4) amount of fees to be paid is reliably determinable.

Cost of Revenue

I would like to start by specifying that cost of revenue differs from cost of goods sold in that it includes other costs than production, such as distribution and marketing costs. Although there is no explicit definition provided by US GAAP of what should be included in cost of revenue, many software companies seem to adopt similar accounting policies (McKenna, 2016). For a SaaS business, the cost of revenue typically includes “application hosting and monitoring costs, data communication expenses, customer support and account management costs, software license fees for products embedded in the application, website development and support costs, professional services and training personnel costs, and costs of subscriptions” (Valchev, 2016). In NetSuite Inc.’s case, “cost of revenue primarily consists of costs related to hosting the Company's cloud-based application suite, providing customer support, […], salaries and benefits of operations and support personnel, software license fees, [..], amortization expense associated with capitalized internal use software and acquired developed technology assets and property and equipment depreciation.”. In light of the previous definition, the main issue concerning NetSuite Inc. Cost of revenue would be that it includes amortization expenses associated with capitalized internal use software, acquired developed technology assets, and property and equipment depreciation. Although there seems to be no advantage for NetSuite Inc. to include such costs into their cost of revenue, there is a possibility that management is including them with the perspective of making margins look better in more profitable periods by shifting costs from cost of revenue to operating expenses. In order to provide a more accurate portrayal of NetSuite Inc.'s financial health, I would have liked to address management on the amount of depreciation included in cost of revenue in order to adjust such number.

Deferred Commissions

US GAAP allows SaaS companies to choose between two alternatives when it comes to accounting for sales commissions; they can either expense the costs in the period they are incurred, or they can defer the costs and recognize them systematically over the period in which the associated revenue is recognized (KPMG, 2016). SEC requires the elected accounting policy to be disclosed and applied in a consistent manner (McKenna, 2016). NetSuite Inc. has chosen to capitalize and amortize the “commission costs that are incremental and directly related to the acquisition of customer contracts”, and they are seemingly consistent in the way they do it. The source of my concern is the intention behind the accounting methodology they have chosen, rather than simply expensing the commission costs as they are incurred. By adjusting the related items on both the 2013 and 2012 financial statements, it is clear that NetSuite Inc. would have had an even larger Net Loss in both years (Exhibit 2). By respect to representation faithfulness, choosing the more conservative approach to expense sales commissions, and reporting a larger loss, would have been the better solution and the one I chose to pursue for the following financial analysis.

Earnings Management & Quality of Earnings

NetSuite Inc. has potential flexibility as per the timing of their revenue recognition. For Professional Services, NetSuite Inc. uses the proportional performance method for revenue recognition. By using this method, NetSuite Inc. as the freedom to determine its own estimate of contract completion. It is against this estimate that it measures progress throughout the term of the contract, measuring the revenue in proportion to the performance completed. In the software industry, the most frequently used metrics are the following: % of requirements completed, % of effort spent, % of activities complete, etc. Management has the freedom to come up with its own estimate of the total requirements needed to complete the contract, for say. By stating a high number of requirements to be completed, NetSuite Inc. would have the opportunity