Revenue recognition: a perennial problem; Concerns about revenue recognition have intensified, and Financial Executives Research Foundation looks at some current developments affecting FASB's ongoing project--which aims to develop guidance that would apply to both public and private businesses.

It's back. With most companies having completed their first internal control attestation--and thus, with less demanding focus on Sarbanes-Oxley Section 404 (at least in the short run)--attention for many is shifting to revenue recognition. The topic is still a main priority for standard-setters and regulators, as well as for financial statement preparers and users.

Earlier this year, FEI President and CEO Colleen Cunningham identified revenue recognition as number three in the top 10 financial reporting issues for 2005. Similarly, an October 2004 survey of the Financial Accounting Standards Advisory Council (FASAC) identified revenue recognition by 21 FASAC members and five of the seven members of the Financial Accounting Standards Board (FASB) as the FASB's top priority.

Also, in the April 2005 issue of Financial Executive, Linda Thomsen, then deputy enforcement director (and now director of enforcement) at the Securities and Exchange Commission (SEC), identified revenue recognition as a "classic" accounting issue that will repeat itself and even morph, depending on the circumstances.

With the preponderence of SEC litigation stemming from revenue recognition issues, some recent actions are worth noting:

* On March 15, after seven other legal actions taken over the past two years, the SEC charged the former co-chairman and CEO of Qwest Communications International Inc. and eight other former Qwest officers and employees with fraud and other violations of the federal securities laws. In SEC filings and other public statements, three of these individuals fraudulently characterized nonrecurring revenue from one-time sales as recurring data and Internet service revenues. The release notes that Qwest's dependence on these transactions to fill the gap between actual and projected revenue was likened internally to an addiction.

* On March 23, the SEC filed a complaint against three former senior officers of iGo Corp., alleging that the defendants collectively caused iGo to improperly recognize revenue on consignment sales and products that were not shipped or that were shipped after the end of a fiscal quarter.

* On April 27, the SEC filed a complaint against the former CEO and chairman of Homestore Inc. and its former executive vice president of business development, alleging that they engaged in a fraudulent scheme to overstate advertising and subscription revenues. The scheme involved a complex structure of "round-trip" transactions using various third-party companies that, in essence, allowed Homestore to recognize its own cash as revenue.

Though the cases cited involved fraud and irregularity, not all revenue recognition errors are intentional. For example, in April, American Home Mortgage Investment Corp. announced that revenue recognized from its fourth-quarter 2004 loan securitization would be reversed, and recognized in the first quarter of 2005. As a result, American Home restated its financial results for 2004. And Huron Consulting Group reports that of five categories of accounting issues chiefly responsible for restatements, revenue recognition was the most prevalent, accounting for nearly 60 percent of financial restatements in 2004. (Restatements increased to 414, more than 28 percent above the prior year's total.)

So, how does a company go about ensuring transactions are being recorded properly? Searching on the SEC Web site results in 647 documents, ranging from comments on 404 citing revenue recognition controls to Staff Accounting Bulletin No. 104 that pertains to revenue recognition. And a Google search on the subject garners 2,700,000 hits!

E. Anson Thrower, CFO of Contec Inc., a South Carolina manufacturer of diversified industrial products and a member of FASB's Small Business Advisory Committee (SBAC), as well as FASAC, notes that "the definition of revenue based on the concept of an earnings process has always been flawed." He says that as far back as the 1960s, then-University of Kansas Professor Robert Sterling demonstrated that the terms embodied in the standard definition of that time--revenue, realization, earnings process and exchange transaction--were redundant synonyms and, therefore, circular, repetitious and ambiguous.

FASB/IASB Joint Project

There are currently more than 190 pieces of literature relative to revenue recognition--from the FASB, SEC and others--but no general standard. Enter FASB's revenue recognition project, which it is working on in conjunction with the International Accounting Standards Board (IASB). The objective of this project is to develop conceptual guidance for revenue recognition and a statement that would apply to all business entities, both public and private. In particular, the project with IASB intends to improve financial reporting by eliminating inconsistencies in existing authoritative literature and accepted practices and filling voids that have emerged in revenue recognition guidance over time.

FASB is pursuing an approach that focuses on changes in assets and liabilities rather than the notions of realization and earned contained in Concepts Statement No. 5. Consistent with the definition of revenues in Concepts Statement No. 6 and not overridden by tests based on the notions of realization and earned, the approach was chosen because, in certain instances, the realization-and-earned approach under Concepts Statement No. 5 involves recognizing deferred debits and deferred credits that do not meet the definitions of assets and liabilities.

The approach was also chosen because the notions of earned and realization have yet to be defined precisely and in a manner that can be applied consistently across a range of industries and transactions. Furthermore, it is difficult to identify consistently when something is earned or realization occurs under multiple-element revenue-generating arrangements. In a change from previous deliberations, the board recently agreed to pursue an approach under which performance obligations would be measured by allocation of the customer consideration rather than fair value.

Simply put, revenue recognition would result from changes in assets and liabilities rather than from satisfaction of the realization and earned criteria. However, FASB Project Manager Mike Tovey notes that extinguishment of a performance obligation (or liability) would be based on the seller's performance, which is operationally similar to the earned criterion.

For a simple transaction, such as selling a hamburger in exchange for cash, there will be little change in the way revenue is recorded. However, for more complicated transactions, such as those involving multiple elements delivered over multiple reporting periods, the FASB model is not completely developed, and companies may be faced with some changes.

Finding the Solution

In the FASAC survey, many respondents said a comprehensive solution to revenue recognition is necessary. However, FASAC member Raymond J. Bromark, partner at PricewaterhouseCoopers, noted that the asset-and-liability approach represents a dramatic shift from current generally accepted accounting principles (GAAP) that will require changes on the part of preparers, users and auditors of financial statements. "The differences between the two approaches, while possibly viewed as subtle to financial statement users, may result in significantly different accounting, which may cause confusion in the capital markets," he warns.

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However, more recently Bromark stressed that FASB should consider change management in moving away from a completion-of-earnings process model. "It is important that the revenue recognition standard balance simplicity with robustness," he stated, urging that field testing be conducted in order to manage the cost benefit of a potential change.

Representative of a small-company view, Thrower argues, "After 40 more years of chasing our own revenue tail round and round, the FASB has stated that the terms 'earnings process' and 'realization' have yet to be, and may be impossible to be, defined precisely." He believes that it's time to try a different approach, and he supports the FASB's efforts, consistent with its dominant view of the balance sheet.

However, he believes the FASB should keep in mind that many smaller companies represented by the SBAC are "ship-and-invoice" companies whose underlying transaction-based systems work just fine. He says he would not want the board to unnecessarily require these companies to do valuation estimates, such as performance obligations independent of existing transaction recording systems.

"Some of these small companies already have trouble making balance sheet valuations independently of their underlying transactional accounting systems," Thrower says, and the board would need to consider if users of these types of small-company financial statements really need anything more.

Since the project's inception a few years ago, its timetable has slowed. FASB has announced that it does not expect to issue a preliminary views document (these precede Exposure Drafts) this year, as some had previously thought. Once a preliminary views document is issued, both FASB and IASB want to be able to provide enough time and due process to educate people on the preliminary revenue recognition model and solicit constituent input. Once these primary goals are achieved, cost-benefit considerations related to the proposed revenue recognition model will be considered before an Exposure Draft is issued.

By the time this article is published, the FASB and IASB may have discussed a memorandum that summarizes the FASB discussion and tentative decisions on the direction of the revenue recognition project. In the meantime, while this will likely not be effective for several years, stakeholders are advised to understand the approach and determine how it will impact their organizations and stay abreast of the project's progress.

The chairman of the FASB/IASB subcommittee of FEI's Committee on Corporate Reporting (CCR), Ronald Olejniczak, vice president and controller at Aetna Inc., says, "The current accounting literature for revenue recognition is comprised of a number of loosely fitting pieces of guidance which have evolved over time in response to specific situations, as well as concept statements."

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As a whole, Olejniczak believes there are inconsistencies between the sources of accounting literature that have developed on this subject. He strongly agrees with the need for FASB to address this area of accounting and reporting. However, he adds, "a project of this scope and complexity will affect all preparers and users of financial statements and, therefore, care should be taken to ensure full and appropriate deliberations."

Olejniczak also questions FASB's initial decisions to eliminate the earnings realization approach in its entirety, and he is looking forward to a "healthy and spirited debate on an asset/liability approach versus an earnings realization focus." Finally, he suggests, "A goal of this project should be to provide clear, concise and easily understood conceptual guidance and a comprehensive standard, [and that] education, as well as open communication, will be critical to the achievement of this goal."

RELATED ARTICLE: Tightening the Revenue Recognition Process

One of the basic elements of whether or not revenue is realized or realizable and earned is that collectibility is reasonably assured. According to Veena Gundavelli, CEO and founder of Emagia, a cash management software provider, careful monitoring of the receivables and analysis of cash flow patterns can assist companies in determining whether or not they have revenue recognition issues.

Gundavelli provides the following key points on how companies can tighten the revenue recognition process:

* Identify revenue risk. Determine the degree of accounting risk posed by the company's business model, considering collectibility of receivables, as well as the long-term or short-term nature of revenues and credit policies and terms extended to customers.

* Assess revenue irregularities. Study the cash flow statement, comparing collections with growth in revenues, receivables and bad debt allowances. Look for invoice and billing irregularity. Parse organic growth from the other sources, and be skeptical of any onetime revenue gains not tied directly to cash that can affect the quality of the receivables.

* Streamline processes. Establish uniform credit and receivable portfolio management policies, based on identification of risk and irregularity.

Gundavelli says that one of its technology software customers that derived most of its revenues from service maintenance contracts watched its stock suffer when collections did not keep pace with revenue growth. The company worked with Emagia to identify the root causes of the problem (problematic product lines and inconsistent credit terms).

Asked about the potential impact of accounting rule changes on Emagia's products, Gundavelli says system modifications are likely if revenue is recognized differently. But, he feels strongly that a focus on consistent policies is crucial in dealing with any future standard changes.

--Cheryl de Mesa Graziano

RELATED ARTICLE: takeaways

* Revenue recognition has been identified as one of the key issues in financial reporting by standard-setters, the SEC and preparers and users of financial statements.

* Among the issues commonly cited for financial restatements, revenue recognition is by far the most common, representing 60 percent of the 2004 totals.

* FASB is pursuing a joint project with the IASB that both hope would create a definitive standard applicable to all public and private companies.

* FASB is considering an assets-and-liability approach to recognition that would represent a dramatic change from current practices.

Cheryl de Mesa Graziano, CPA ([e-mail]), is Director of Research at Financial Executives Research Foundation (FERF).