Making sense of revenue recognition: revenue "mis-recognition," the leading cause of restatement, has been soaring, likely due to the myriad of more than 200 pronouncements by standard-setters. FASB has revenue recognition on its agenda--for 2007.

Three thousand years ago, revenue recognition was not a problem. You traded so many goats for so many sacks of wool. When you got home, you looked at what you had. It was your revenue.

But then somebody invented money, turning goats and wool into slugs of cast iron and copper. Then somebody invented bookkeeping, and then accounting, and the next thing you know, goats, wool and coins have been replaced by derivatives, securitizations, stock options and 10-Ks. Suddenly, some mighty big companies aren't exactly sure what their revenues are, and every once in a while somebody ends up in jail because of it.

The symptoms of revenue recognition problems show up in financial statements. For a while, the revenue recognition line says one thing, but a few months later--whoops!--a restatement rolls out a different figure. Now, most of those "whoopses" are born of innocent error, but many are evidence of fraud.

Fraud or goof, it hurts. Restatements are to financial officers what fumbles are to quarterbacks. They're not only embarrassing to the CFO but expensive for the company and startling for shareholders, who can't help but wonder whether the restatement is a case of accounting confusion or unveiled shenanigans.

Revenue "mis-recognition" is the leading cause of restatement, and the rate of restatements has been soaring. In 2005, there were 1,295 restatements, according to a Glass, Lewis & Co. study--one for every 12 public companies registered in the U.S. That's almost twice the 2004 number and three times the number in 2002. In fact, the study found from 1997 to 2005, a total equal to 30 percent of U.S. public companies had filed restatements.

[ILLUSTRATION OMITTED]

A big part of the problem is the myriad of standards--a complicated and unclear mishmash of over 200 pronouncements issued by the Financial Accounting Standards Board (FASB), the Accounting Standards Executive Committee (AcSEC) of the American Institute of Certified Public Accountants (AICPA), the Accounting Principles Board (APB), the U.S. Securities and Exchange Commission (SEC) and the Emerging Issues Task Force (EITF).

At the core is an inconsistency in FASB's conceptual framework, the philosophical underpinnings of the board's accounting standards. Concepts Statement No. 5 defines revenues in terms of changes in assets and liabilities, while Concepts Statement No. 6 uses recognition criteria based on notions of realization and completion of an earnings process.

The board is overhauling its conceptual framework, even as it works on the standard on revenue recognition. Todd Johnson, FASB senior technical advisor, has been working on both projects.

"The goal is to set some sort of principle that will deal with all the complications," Johnson says. "Unfortunately, people think we're going to change the accounting for everyone. You won't find that accounting for most transactions will change very much. This project won't affect simple, straightforward transactions. It will affect the complex transactions where you have contracts that span a number of years or accounting periods, where you have to do different things during each of those periods. That's where it gets tricky."

Johnson emphasized that FASB is trying to produce a standard that is operational, not just a "bag of rules." The board is working with its global counterpart, the International Accounting Standards Board (IASB), to develop a single standard on revenue recognition and a single conceptual framework to support it.

As FASB and IASB plod down their pensive path, the U.S. continues to use a variety of standards that were written for specific industries and types of transactions. Many industries and transactions, however, have no such specific standards. Trying to transfer principles from one industry to another often uncovers inconsistencies, leaving financial officers with little choice but to use their judgment, hoping that they have correctly figured out what FASB and the SEC have yet to figure out.

Sometimes, of course, companies hope and figure a little too hard. They fudge the definitions, slide around the closing date, smooth out their earnings by nudging a little revenue one way or the other or maybe boost their earnings just a bit by mis-recognizing the nature of a certain little pile of cash.

"The problem with our current standards is that they're quite squishy," says Rebecca McEnally, vice president, Advocacy, of the CFA Institute (whose members are certified financial analysts). "The rules say you recognize revenue when it is realized or realizable, meaning you can measure it, and when you've done all you must do to be entitled to it. But that is so squishy and unclear that it leaves the widest possible margin for people to manipulate."

Gottfried Sehringer, vice president of marketing at Softrax, a producer of software for revenue recognition and measurement, attributes the breakdowns in reporting to information overload.

"Most earnings restatements happen because people just screw up, unintentionally," Sehringer says. "It happens every day. It happens because they have a pile of paper to wade through, and are using spreadsheets to manage complex revenue processes. People either don't have the right amount of information when they make a decision, or they make the wrong decision because they don't see the details of the necessary components, they don't have the right knowledge or they have too much data to process."

Companies also get into trouble when their contracts go astronomically beyond the opening scenario of exchanging coins for goats. If the goat comes with a warranty, the seller doesn't really own all those coins until the warranty period has ended. If the exchange is linked to quarts-per-day and promises of pasturage, maintenance and stud service, the moment of recognizing revenues gets even more complicated.

And if you're selling software, skyscrapers or cellphone systems, your revenue recognition headache may stretch the limits of accountant endurance. Complex long-term contracts include such nebulous future deliverables as implementation, training, upgrades, maintenance, guarantees, specialized tools, leases, discounts on future orders and certain side promises that sales reps made but the accountants never heard about, and all stretch out over the course of years.

David Kaplan, leader of Accounting Consulting Services at PricewaterhouseCoopers, says the problem isn't so much what to recognize as when.

"Traditionally, we needed to have a point of recognition, the point where the transaction takes place," Kaplan says. "Generally, it was when you shipped the product. But all along the manufacturing cycle, there's value being produced. It's only at the final step that the transaction takes place. Under an asset-liability approach, you ought to be recording value as it is created all along that cycle."

Kaplan says that although FASB is trying to take the asset-and-liability approach, it is reluctant to mess with the slippery slope of gradual recognition. It's difficult to shift from historical cost to fair value, he says, unless FASB is willing to give up the concept of a single point of recognition at the exchange date. This would mean moving to a concept of recording additional fair value as it is created, and there are many concerns about the reliability of doing so in financial statements.

FASB did indeed run into problems with the measurement of fair value in the context of a revenue contract--the problem of prices unavailable and unobservable--and so has shifted in search of better solutions.

"Lately, the board has been focusing on the concept of customer consideration that is promised in contracts and allocating it in some fashion," FASB's Johnson says. "Accountants would look at separable elements of a contract, then allocate some part of the agreed-upon consideration to those parts, presumably with some sense of relative value."

The shift from fair value to contract allocations caused FASB to reschedule release of a Preliminary Views document from late 2005 to mid-2007. That first document may consider presenting both approaches for public comment. The discussions will explore such concepts as percentage of completion and contractual milestones where customers acknowledge delivery of value. Complicating the issue is the common scenario in which customers have no real understanding of what has been delivered.

The crucial controversy with that approach is how to establish an accounting principle that serves to divide all contracts into discrete, identifiable, measurable components, and then establish how and when to recognize an accurate value for each. The problem is especially acute at companies whose business spans various industries.

The high-tech industry epitomizes the muck that revenue recognition can fall into. Products are rarely as compact and identifiable as, say, a goat. Rather, they can be a package of promises and intangibles that include development costs, free implementation, limited warranties, licenses, maintenance programs, future upgrades, time payments, leases, etc. How much of that counts as revenue when the contract is signed? How much remains to be provided and how should it be measured?

Grant Thornton assurance partner Catherine Hyodo, who heads the firm's Southern California Technology Industry practice, helps high-tech companies find their way through the thicket of standards. She is confident that FASB will hammer out a workable solution. Until then, she believes that existing generally accepted accounting principles (GAAP) are adequate.

"It will take some time, but they will absolutely be able to do it," Hyodo says. "They'll give as much guidance as they can. Companies will try to standardize as many contracts as they can, though we don't want GAAP to drive the operation of a business, or they should put controls in place to ensure that they can review non-standard contracts, allowing CFOs to look to GAAP for guidance."

Nobody wants to restrict a company's business, Hyodo says, "but with Sarbanes-Oxley in effect and public companies under scrutiny and this being such a hot topic, it's very important for companies to look into standardizing as many contracts as they can."

Hyodo recommends that companies establish the right "tone at the top" to ensure that changes and differences in contracts are communicated to the right people. She also recommends training sales personnel so that they understand the accounting ramifications of changes to contracts.

Dominique Vincenti, chief advocacy officer of the Institute of Internal Auditors (IIA), agrees that in complex transactions, it can be tough to interpret the applicable standards. But when the recognition gets tough, she says, the tough should recognize their auditors--external as well as internal.

"There is a series of mitigating factors that will help you to make sure that you, as management, have come up with the best decision and best way possible," Vincenti says. "The auditor will look at what methodology was used, whether it is recognized, how it compares with companies in the same industry, how it compares with established rules and procedures that are endorsed by third parties--regulators and so forth.

"That is the process that the internal auditor will look at to form an independent and objective opinion on the effectiveness and efficiency of the whole process, the compliance with regulation and the residual risks."

FASB plans to spend the rest of this summer assessing several key issues: defining when contract performance has occurred, identifying a unit of account for partially executory revenue contracts, determining when performance obligations should be measured for nonperformance-related events, considering the measurement of contract assets and discussing a revised definition of revenue and how to distinguish revenue from other components of comprehensive income. The board may also pursue an approach using fair value to measure obligations to deliver goods and services with readily-determinable fair value.

If the deliberations are linearly productive--and they won't necessarily be--FASB may issue a Preliminary Views document in the second quarter of 2007. Comments may lead to an exposure draft of a new standard, and the new standard may simplify life for accountants and investors alike. It may not bring back the good old days of goats and cast iron coins, but at least revenue will be something we can make sense of.

Glenn A. Cheney is a freelance writer in Hanover, Conn., who frequently writes on business, finance and accounting issues for Financial Executive. He can be reached at [e-mail] or 860.822.1270.

RELATED ARTICLE: takeaways

* Revenue "mis-recognition" is the leading cause of restatements, with 1,295 restatements in 2005, almost twice the number in 2004, reports Glass, Lewis & Co.

* Contributing to the problem: over 200 pronouncements issued by FASB, AcSEC, AICPA, APB, SEC and EITF.

* Also contributing to the problem is the fact that FASB's conceptual framework defines revenue recognition differently in Concepts Statement Nos. 5 and 6, and the board is simultaneously trying to overhaul its framework as it works on the standard.

* FASB, working with international standard-setter IASB, may issue a Preliminary Views document in 2007.