Revenue recognition: a project to watch.

Inappropriate revenue recognition continues to be one of the primary reasons for financial restatements. I believe this is due less to companies' abuse of the regulations and more to the complexity and proliferation of the literature: There is no comprehensive standard on revenue recognition, yet more than 180 pieces of authoritative literature are associated with it.

It is difficult to sort through such a volume of sometimes-conflicting literature and be confident you won't be second-guessed. The Financial Accounting Standards Board (FASB), which has had this extremely challenging project on its agenda for quite some time, aims to simplify the guidance into one comprehensive standard.

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Although the ultimate result of this project may be several years away, I think it's vital that preparers get a sense of where FASB is heading, in order to influence the process. FEI recently had a breakout session on this project at our annual Current Financial Reporting Issues conference. At first, several participants wondered why we would highlight a project that wouldn't have any authoritative literature associated with it for quite a while. After the session, participants acknowledged that they hadn't appreciated the scope of the project or the potential for major changes in revenue recognition.

Let me do my best to summarize, based on my understanding of where the FASB is today. Existing guidance associated with revenue recognition falls into four broad categories:

* Mark-to-market (such as some financial instruments);

* Proportionate performance (construction, software);

* Completed performance (some leases, construction);

* Completed performance plus collection (certain real estate).

The project's objectives are to develop a conceptual model that would apply to all industries and transaction types, eliminating existing inconsistencies in the conceptual framework. FASB and the International Accounting Standards Board (IASB) have embarked on a joint project to review the conceptual framework. The primary inconsistency in the U.S. is between CON 5 and CON 6. CON 6 defines revenue in terms of assets and liabilities, while CON 5 describes the earnings process--the recognition criteria unique to revenue. The CON 5 "earnings process" is the recognition method that most of us have learned and are familiar with.

That said, the board has tentatively decided that the asset/liability approach is the appropriate one. Its premises include:

* Contracts with customers create rights (assets) and obligations (liabilities) that are initially measured at fair value.

* Changes in assets and liabilities give rise to revenue.

* This revenue would not be overridden by notions of realization and completion of an earnings process (that is, throw away the CON 5 concept of revenue recognition).

Revenues can result from:

* Differences between contract price and the sum of the performance obligations (liabilities)--"selling" revenues.

* The extinguishment of an entity's performance obligation to its customers.

So, how would you apply this model? First, identify all of the performance obligations and measure them at fair value--not the price charged to the customer, but the lowest price that the entity could obtain to lay off each obligation with an unrelated party. If the fair value of the consideration received exceeds the fair value of all of its performance obligations, the entity would recognize the difference at inception as "selling" revenue. That is, it would be recognized up front.

Obviously, this approach is vastly different from the one we are all used to. It would change the accounting for many arrangements, particularly those spanning accounting periods. It may mean that more revenue is recognized up front (the concept of "selling" revenues). It would also change the measurement attribute for the components of multiple-element arrangements.

FASB has acknowledged that there are many open issues, among them questions surrounding measurement of the initial and subsequent performance obligations. How do you measure if there is no third-party market for an entity's products and services? (Think of Enron and its marking-to-market energy contracts when it was the market). What happens if all of the performance obligations can't be identified? What about uncertainty regarding measurement of "selling" revenue? How would you fair-value a refund obligation? How should changes in fair value be recognized?

Understanding the broad implications such a dramatic change could have, FASB has slowed the timeline a bit and has allowed for a Preliminary Views document to be issued prior to an Exposure Draft, allowing public deliberation of tentative conclusions covering both the concepts and standards-level revenue recognition. FASB also intends to do field testing on this project. FEI will continue to track it and inform members about its progress, and I encourage companies to participate in the process.

Colleen Cunningham