Revenue recognition: now, later or never?

The issues that bear upon the details of how, when and in what amount revenue should be recognized are broad and extremely deep. When it comes to identifying transactions where revenue recognition exists, there are plenty of issues and rules governing the proper accounting treatment auditors and accountants should follow.

FRAUD USUALLY BEGINS SMALL, SOMEWHAT INNOCENTLY

Fraud is represented by intentional misstatements or omission of amounts or disclosures designed to deceive financial statement users.

Financial statement fraud usually starts as a simple "stretch" that people expect to be reversed when actual results improve. This often happens when only a small amount of additional revenue is needed to meet expectations. Those involved believe that the stretch will be a one-time event. The participants are not usually involved in a grand plan or conspiracy--they simply rationalize the misstatements.

But simple plans sometimes grow into more complex schemes that result in material misstatements of financial statements that sometimes cover several years of falsification and manipulation.

Fraud is frequently accomplished by:

* Manipulating, falsifying or altering documents from which financial statements are prepared;

* Misrepresentation or intentional omission of events, transactions or other significant information in financial statements; and

* Intentional misapplication of accounting principles relating to the amounts, classification, manner of presentation or disclosure.

WHY IS REVENUE RECOGNITION SO IMPORTANT?

In its October 2002 Report on Financial Statement Restatement, the GAO said that restatements for improper revenue recognition resulted in larger drops in market capitalization than any other type of restatement. In fact, eight out of the top 10 market value losses in 2000 related to improper revenue recognition. Of these 10, the top three lost $20 billion in market value in just three days.

Some of the most common vehicles used to overstate revenue, according to the GAO report, include:

* Sales contingencies were not disclosed to management;

* Sales were booked before delivery was completed;

* Software revenue was recognized before services were performed;

* False sales agreements and documentation were created; and

* Revenue was reported at gross rather than net.

The GAO report determined that as a result of these improprieties:

* 38 percent of the 919 announced restatements between 1997 and June 30, 2002 involved revenue recognition issues;

* Revenue recognition was the primary reason for restatements in each year;

* More than half of the immediate market losses following restatements were attributable to revenue recognition related restatements; and

* Approximately 50 percent of the SEC's enforcement cases have involved revenue recognition issues.

AN OVERVIEW OF THE RULES

Generally accepted accounting principles call for revenue to be recognized when all of the following requirements are met:

* There is appropriate evidence of an arrangement, such as a signed arrangement or an established historical business practice;

* There has been performance or delivery by the seller;

* The price has been fixed or is determinable. The customer is obligated to pay, concessions or discounts have been determined, and no contingencies or other unfilled commitments by the seller exists; and

* The unpaid amount is collectible (the amount of returns can be reasonably estimated or the customer has the financial resources to pay the amount due).

These general principles may appear simple, but the devil is in the details.

Evidence of this complexity is seen in the fact that there is a formidable list of pronouncements on revenue recognition issues that remain effective in 2003. Among them:

* FASB Concept Statements No. 5 and 6;

* 25 FASB and Technical Bulletins;

* 44 EITFs and Statements of Position (particularly SOP 97-2 re: software revenue recognition);

* Two Accounting Research Bulletins;

* Six Accounting Principle Board Opinions;

* 18 Technical Practice Aids; and

* The SEC's Staff Accounting Bulletin (SAB) No. 101 and related FAQs, and various accounting and auditing enforcement releases.

Accountants facing complex revenue recognition issues should carefully consider which of the above pronouncements are applicable to their circumstances and how they apply these pronouncements to their particular situation.

SAB 101: REVENUE RECOGNITION

SAB 101 was released in late 1999 as part of the SEC's "earnings management" initiative. At that time, the SEC noticed many registrants were manipulating revenue to manage their reported earnings and achieve desirable earnings trends to meet or exceed ever increasing "street expectations."

The SEC had become painfully aware of disparate revenue recognition practices used by registrants. It also took notice of the influence that reported revenue increases and trends were having on both the exploding IPO market and on high-tech and other early stage company valuations.

To guide accountants toward consistency and proper reporting, SAB 101 and its FAQs are a treasure chest of questions, answers and guidelines that address many key revenue recognition issues.

GUIDANCE FOR SPECIFIC ISSUES

Consignment Sales. Revenue should not be recorded for shipments on consignment or on shipments that are substantively the same as a consignment. Arrangements that may be substantively the same as a consignment shipment may contain one or more of the following:

* Buyer has lengthy return right;

* Payment is substantially contingent on resale of the product;

* Seller is required to repurchase the product at a specified price; and

* Buyer does not assume risks of ownership due to future product pricing concessions.

As an example, Company A agrees to sell its product to a wholesaler. The wholesaler is promised a price concession on future purchases that will be calculated based upon holding/financing costs for Company A's product and length of time between purchase and sale.

In this example, the wholesaler does not bear the risks of ownership despite the title transfer. As a result, the transaction should be viewed as a consignment sale.

Refund Rights: Product Transactions. When rights of return exist, or are likely to be accepted, FAS 48 dictates that it may be possible that a reasonable estimate of refunds can be made before revenue can be recognized from the transactions.

In determining whether a reasonable estimate can be made, all factors that bear upon the quantity of products to be returned should be considered.

Those factors include competition, obsolescence and the length of time over which the product can be returned. The lack of a reliable history regarding returns may preclude companies from recording product shipments with a right of return until that right expires or is terminated.

It's important to realize that the SEC has stated that a "worst case" estimate from a wide range of estimates is not an acceptable alternative to a reasonable estimate.

Bill and Hold Transactions. These arrangements occur when a company invoices its customer, but has not yet shipped the products. Such arrangements have been the subject of debate and litigation in the past few years as plaintiffs, the SEC and other regulators have battled companies over if, and when revenue from these transactions should be recorded. A good source for the SEC's guidance on these transactions is found in its AAER No. 1393 which represents findings on its Sunbeam action.

As an example of a bill and hold transaction, a contract manufacturer produces products for its customer and manages the customer's logistics, shipping when and where requested by the customer. The manufacturer would like to record sales when the manufacturing process is complete, but prior to shipment.

In this case, revenue recognition is not appropriate until a fixed delivery schedule is established. A fixed delivery is simply a date scheduled for delivery as long as that date was consistent with the customer's business purpose for requesting the bill and hold and all other criteria for recognition were met.

Another bill and hold example involves a company that leases a portion of its facility to a customer and records revenue on sales to this customer when products were delivered to the customer's portion of the facility.

The portion of the facility was leased, controlled and managed by the customer.

Here, revenue recognition may be appropriate when the products are delivered assuming the seller had no rights or risks associated with the products once they were delivered to the customer's leased space.

INCOME STATEMENT: GROSS OR NET?

The trends in the amount of revenue reported by companies are closely watched by analysts and others on Wall Street. In addition, companies may award bonuses to their employees depending on whether or not certain revenue goals are met. Companies have also been valued and purchase prices have been based upon multiples of revenue. Because of the significance of the revenue amount a company reports, it is important to determine whether the revenue amount should be reported at gross or net.

When making this determination the SEC considers whether or not the company:

* Acts as a principal in the transaction;

* Takes title to the products;

* Has risks and rewards of ownership (such as risk of loss for collection, delivery or returns); or

* Acts as an agent or broker (including performing services, in substance, as an agent or broker) with compensation on a commission or fee basis.

EITF 99-19 provides several indicators of whether revenue should be presented at gross or net.

The sale should be recorded at gross if the seller:

* Is the party responsible to the customer for satisfaction;

* Has general inventory risk (before customer order is placed or upon customer return);

* Has reasonable latitude in establishing price;

* Changes the product or performs part of the service;

* Has discretion in supplier selection;

* Is involved in determination of product or service specifications;

* Has physical loss inventory risk (after order or during shipping); or

* Bears credit risk in event of customer non-payment.

The sale should be recorded at net if:

* The supplier, not the company, is the primary obligor (responsible for fulfillment and customer satisfaction);

* The amount the company earns from the shipment is fixed; or

* The supplier, not the company, has the credit risk in event of customer non-payment.

As an example of whether revenue should be recorded as gross or net, Company B provides credit card processing services between a vendor and customer. The customer is directed by the vendor to Company B's secure website to buy the vendor's products. Once payment is approved, Company B informs the vendor, who ships out the product. Company B retains 5 percent of the amount billed to the customer as a service fee and then remits the remaining amount back to the vendor on a weekly basis.

Company B would record the net amount retained (the 5 percent service fee) as revenue. While it has credit risk, it does not have any of the other indicators of gross reporting.

The vendor, as the primary obligor, is responsible for fulfilling the product, has inventory risk and has latitude in setting prices. It must record the gross amount.

Round-Trip Transactions and Non-Monetary Exchanges. Some companies have recognized revenue for the sale of a product or services in "round-trip" transactions. These involve two companies that exchange advertising for advertising or when inventory is exchanged for barter credits between the parties. Such transactions may lack substance and fair value may not be determinable.

For example, companies A and B exchange rights to advertise on each other's websites and both exchange $1 million in cash. Should both entities record an equal amount of revenue (for the Web space they own and "sell") and expense (for the Web space they "purchase" from the other entity)?

EITF 99-17 provides the answer.

Recognize $1 million of revenue if the fair value of advertising surrendered is $1 million based on the entity's historical practice of receiving cash, marketable securities or other consideration readily convertible to cash with other unrelated parties. Otherwise the transaction is recorded based on the carrying amount of the advertising surrendered, which is likely to be zero.

Barter credits provide similar recognition challenges. For example, assume that a company exchanges inventory for barter credits which can be used to purchase goods or services and that the barter credits have a contractual expiration or may require the payment of additional cash to exercise.

In this example APB 29/EITF 93-11 consensus will provide the following revenue recognition guidance:

Presume, in the absence of persuasive evidence to the contrary, that the inventory's fair value is more evident than the barter credits received and is not greater than its carrying value, unless barter credits are readily convertible to cash or if an independent quoted prices exist for items to be received upon the exchange for barter credits.

Transfer of Title. In general, title to goods must transfer to meet the delivery requirement. Title transfer is a legal question and generally determines when risk of loss and control passes from the seller to the buyer.

WHAT'S AN ACCOUNTANT TO D0?

To be properly prepared in the area of revenue recognition, accountants should, among other things:

* Understand key contract terms;

* Determine whether there are side agreements to the contract;

* Determine whether there are significant price or other concessions that may be associated with the contract;

* Determine whether risk of loss has passed to the buyer;

* Determine whether there are multiple elements that have been sold, which call for the timing and amounts of revenue to be recognized; and

* Determine whether there are related parties involved.

Accountants also must discuss the deal with key negotiators, review delivery, terms, evaluate the customer's credit worthiness and if needed, study FASB 48 and SAB 101, and its FAQs, to be sure that revenue can be recognized and returns can be reasonably estimated.

D. Paul Regan, CPA, CFE is chairman and president of Hemming Morse Inc. CPAs in San Francisco. You can reach him at [e-mail].