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Like many companies, software firms sometime try to make themselves look better than they are. Here are a couple of accounting issues to watch out for when you're analyzing software firms.

Revenue Recognition Changes

According to the Securities and Exchange Commission, Improper revenue recognition is the biggest issue involved in the restatement of financial re­sults, and the corporate graveyard is scattered with software companies that illegally recognized revenues.

Going by the book, revenues should not be recognized until they're actually earned, which takes place when products have been delivered or services have been performed, a price has been agreed on, and there's reasonable assurance that payment will be collected.

Watch out "when management changes the rules for recognizing revenue. In 2001, for example, RSA Security began booking some sales after products "were shipped to distributors, whereas it had previously recognized sales only after end users had purchased products.

Even though management felt that relationships with certain distributors were strong enough that the eventual sale of products to customers was guaranteed, RSA was able to boost sales artificially by stuffing its distribution channels with more inventory than could be sold in a normal amount of time. This practice stole revenue from future quarters and ultimately led to massive sales shortfalls.

Questionable Transactions

Shady deals that boost sales are notorious in the software industry. One of the most prevalent occurs when an organization both sells to and invests in an­other company.

Another questionable transaction—called a swap deal—takes place when a vendor and customer simultaneously buy the other's products. Although engaging in these back-scratching techniques is legal, these transactions give a false picture of the overall health of business.

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