SAB 101: New Revenue Recognition Guidelines.
What's different about SAB 101? Isn't revenue recognition just fundamental GAAP? Financial Executive spoke with Paul Munter, KPMG professor and chair man of the department of accounting at the University of Miami, about SAB 101's purpose and impact, and how to adapt to it.
A majority of the corporate financial reporting problems over the last several years have been related to revenue recognition, and the SEC has dealt with these cases through a variety of traditional ways, such as enforcement actions and restatements.
"It's somewhat ironic, because although revenue recognition is fundamental to the financial reporting process, there's relatively little authoritative literture on it," says Munter. Indeed, the plethora of new business models and focus on short-term earnings are but two of the many factors causing companies to rethink their revenue recognition policies. "Certainly, marketplace pressures to meet current earnings -- quarterly numbers -- is causing companies to look for opportunities to accelerate revenues and profits," says Munter, adding that "new business models and structures do not refer to only e-commerce, since traditional companies are conducting business differently, such as more joint ventures and alliances."
Add to that the tremendous penalties imposed on companies falling short of expectations, and it's clear that this environment has spurred companies to rethink what constitutes revenue and when they think they have it, he says. "I believe the SEC staff [at this point] felt it necessary to give some clearer guidance to provide practitioners with a framework to work with."
SAB 101, issued by the Office of the Chief Accountant at the SEC, isn't an official rule, per se, as it doesn't modify existing regulations. Rather, it's a statement of the staff's views about the application of an accounting principle and, as such, carries a lot of weight -- making it imperative that SEC registrants, or would-be registrants, be very aware of its provisions.
Accounting 101 all over again?
Since revenue recognition is fundamental to accounting and business, you'd think that the new guidelines would simplify the management and reporting process. In reality, the solution itself seems to have become a problem.
Issued during the first week of December 1999, SAB 101 was scheduled to become effective for the first quarter of calendar 2000. Companies struggling to implement SAB 101 in that short time horizon -- many were consumed changing systems and documentation processes -- asked the SEC for relief. First delayed to the second quarter, it was ultimately delayed to the fourth quarter for calendar 2000 companies.
"As 10-Ks are filed, we're seeing the vast majority of changes in practice are companies delaying the recognition of revenue, since SAB 101 uses a much more stringent model than had been in place and practice prior to it," says Munter.
Many of the reporting problems stem from the number of companies implementing changes. While not all of the 14,000 registrants have changed their models, Munter says, a significant number have. A vast majority of registrants have at least "revisited" their policies to guarantee compliance -- a wise practice from the perspective of sound business strategy, he argues, since as "businesses and the types of transactions and customers they deal with continually change and evolve, revenue recognition practices need to change and evolve to keep up."
SAB 101's differences
Companies' struggles with SAB 101 can be traced to two main causes. The first is its stringent criteria. Munter explains that SAB 101 uses a similar model and parallels very closely SOP 97-1, which provided guidance on recognition of revenue for software.
According to the SEC, under SAB 101, revenue generally is realized or realizable and earned when all of four criteria are met: 1) Persuasive evidence of an arrangement exists; 2) Delivery has occurred or services have been rendered; 3) The seller's price to the buyer is fixed or determinable; and 4) Collectibility is reasonably assured.
The first two of those four conditions are targeted toward the question of whether the revenue is earned and the third and fourth criteria look at the question of realization. Munter says that there've been companies who've had to revisit or change revenue recognition practices with regard to each of those four criteria.
Non-public companies are also feeling the impact of SAB 101. Entities aspiring to going public are required to have "SEC-like" financial reporting processes in place for several periods prior to actually going public that have, for example, comparative statements included with the filing.
In addition, explains Munter, there's actually a "spillover" effect. In the aftermath of the issuance of SAB 101, the Emerging Issues Task Force has reached consensus on a variety of revenue recognition issues has been looking at over the last 14-15 months. Thus, since, EITF consensus is applicable to any entity issuing GAAP financial statements -- whether public or private -- the concepts inherent in SAB 101 end up being applicable to all companies issuing financial statements that comply with GAAP.
The blame game
While many companies have "blamed" SAB 101 for recent restatements of revenue, you'd think they'd know better. Munter says that while the bulletin makes the argument that it's not changing the authoritative literature, you could argue that if you had to change your revenue recognition policies in response to SAB 101, your policies may not have been in compliance with GAAP.
He says that some companies responding to SAB 101 have indeed restated prior results because they've concluded prior practices were not GAAP-compliant. Several technology and software firms have restated in response to the issue of undeliverable elements being essential to the product's functionality, having decided they should have deferred more or all of the revenue.
Also, Munter says that a lot of revision is occurring as companies change from gross versus net reporting, and that while a lot of attention is given to e-commerce and technology companies, it's not exclusive to that arena. "There are companies reporting revenues on a gross basis where they were not the principle in the transaction; they were acting as an agent or intermediary on behalf of someone else," he says.
Another area where Munter is seeing change is in non-refundable cash collections. Companies were often recognizing revenue, but SAB 101 says it has to be deferred and amortized over the period for which services are provided. In these cases, he says, the responses have been two-fold. Some companies have restated earnings, which is really acknowledging that previous revenue recognition policies were not GAAP-compliant. Others have done it prospectively, which is allowable under SAB 101 -- in the form of discussion, particularly in the management discussion and analysis section of their SEC documents -- about the consequences, the impact on future operations, the issue of comparability, etc. This, in a sense, says Munter, is "blaming SAB 101 for their need to change."
Assessing blame, he says, is often a "chicken-and-egg sort of thing." Should companies have known or not? Each situation is different, he notes. "You can make an argument [that] the company should have known better and been doing it differently; while in other situations it's not as clear, and you could reach a different interpretation."
Control and comparability
CFOs buried in the midst of implementing the transition may be hard-pressed to see that in the long run, both companies and investors will be better off, but Munter sees a few positives. First, he says, the "more concrete guidance" provides safety and better control of your operations.
For example, a company can deal better with certain problems by saying: "Here are our revenue recognition policies, and here's why we have these policies." Then, when salespeople promise customers returns, not realizing they've added a contingent component to the sale, a CFO can say to the salesperson, "Here's our policy. If you alter the transaction -- with your bonus tied to the recognition of revenue -- you've delayed not only the recognition of revenue, but also your bonus." This provides a vehicle for a CFO to have a more consistent business model within the company, as well as more control over the overall operations. Consistency also translates into providing greater comparability between companies, which benefits investors.
Finally, Munter says that the impact of SAB 101 will be "much better" revenue-recognition policies, though, as often happens when new reporting practices are implemented, adjustments and disruptions occur in the transition phase. In the long run, he says, "Clearly, every body is better off."
REVENUE RECOGNITION CRITERIA
Under SAB 101, revenue generally is realized or realizable and earned when all of the following four criteria are met:
1. Persuasive evidence of an arrangement exists.
2. Delivery has occurred or services have been rendered.
3. The seller's price to the buyer is fixed or determinable.
4. Collectibility is reasonably assured.