ore than half of the financial reporting frauds among U.S. public companies from 1987 to 1997 involved overstating revenue, according to a study conducted by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Auditors have always focused on possible revenue recognition overstatement in financial statements. Understanding the components of Staff Accounting Bulletin 101, Revenue Recognition in Financial Statements— as well as the regulatory concerns the SEC addressed in issuing it—will help CPAs choose the most appropriate revenue recognition practices for their companies and their clients. This article provides an overview of SAB 101 and demonstrates to auditors how they can help improve companies’ accounting practices.
SAB 101—GENERAL REVENUE RECOGNITION RULES
The SEC issued SAB 101 in December 1999 to provide guidance to auditors and public companies on recognizing, presenting and disclosing revenue in financial statements. The official implementation date for SAB 101 was the fourth quarter of fiscal years beginning after December 15, 1999, but the SEC extended compliance with the new policies, making the quarter ending December 31, 2000 the first mandatory reporting period.
According to the SEC, SAB 101 spells out the criteria for revenue recognition based on existing accounting rules, which say that companies should not recognize revenue until it is realized or realizable and earned. Specifically, SAB 101 says transactions must meet the following criteria before revenue is recognized:
There is persuasive evidence of an arrangement.
Delivery has occurred or services have been rendered.
The seller’s price to the buyer is fixed or determinable.
Collectability is reasonably assured.
While these criteria are general, they provide guidance for revenue recognition relating to most traditional business models. For companies that do not employ traditional business models, such as e-commerce companies and companies with a large percentage of Internet transactions, however, SAB 101 provides additional guidance on these revenue recognition issues:
Timing of approval for sales agreements.
“Side” arrangements to the master contract.
Criteria for delivery (bill and hold sale).
Nonrefundable, up-front fees.
Cancellation or termination provisions.
Contingent rental income.
Right of return.
SAB 101 also requires disclosure of revenue recognition policies under APB Opinion no. 22, Disclosure of Accounting Policies. For example, companies should disclose changes in estimated product returns in financial statements if material, and the management discussion and analysis section (MD&A) should note the following:
A favorable or unfavorable material effect on revenue.
The relationship between revenue and costs of revenue.
Analysis of reasons and factors for an increase or decrease in revenue.
Transactions the SEC staff specifically has said companies should disclose or discuss because they may contain problem areas are:
Product shipments at the end of a reporting period that significantly reduce customer backlog and might be expected to result in fewer shipments and lower revenue in the next period.
Extended payment terms that will result in a longer collection period for accounts receivable (regardless of whether the revenue has been recognized) and slower cash inflows from operations, and the effect on liquidity and capital resources. (The fair value of trade receivables should be disclosed in the footnotes to the financial statements when it does not approximate the carrying amount.)
Changing trends in shipments into, and sales from, a sales channel or separate customer class that could be expected to significantly affect future sales or returns.
More sales to a different class of customer, such as a reseller distribution channel that has a lower gross profit margin than existing sales principally made to end users. Also, increasing service revenue that has a higher profit margin than product sales.
Seasonal trends or variations in sales.
A gain or loss from the sale of an asset(s).
MAKING THE GUIDANCE WORK
Finance executives typically implement a new accounting standard by discussing and analyzing its requirements with their auditors. CPA Frank Candia, managing partner of Holtz Rubenstein & Co., LLP in Melville, New York, advises finance executives who have questions about whether their company’s transactions meet the eligibility requirements for revenue recognition to first read SAB 101 and see if the transactions are similar to those discussed in the SEC’s FAQs. Besides reading SAB 101 for guidance, a company should look to recent abstracts from the emerging issues task force (EITF) which have addressed not only when revenue should be recognized, but also classification questions on whether revenue should be recorded gross (the sales price and the cost of the product) or net (just the gross margin.) If they still have doubts, Candia says, “The company should present its facts and position to the SEC prior to recording the transactions as revenue.”
Many companies are trying to comply with SAB 101’s guidelines but must contend with ad hoc interpretations by auditors and regulators. Some company executives say they do not know what is correct under the new standard. CPA Bob Johnson of Andersen’s Atlanta office (formerly Arthur Andersen) says a lot of problems occur when exceptions are made to a company’s revenue recognition policies. “Companies need to have a well-controlled, monitored process to focus on exceptions,” he says. “When there are exceptions, the CFO must be involved and communicate with the external auditors. Some transactions become complex arrangements and could require reviewing authoritative accounting literature, and in the end, involve professional judgment of auditors and finance executives in the absence of clear-cut guidance.” Johnson believes it is essential that high-level management be aware of these types of arrangements and that the CFO work with the company’s auditors to ensure that the most appropriate recognition takes place.
HOW TO AVOID TROUBLE
Several recently settled SEC civil suits in federal courts involving alleged improprieties offer examples of how not to apply revenue recognition principles, some of which may seem obvious because companies intentionally made reporting misstatements.
Recent allegations against companies and their officers include activities that violate good accounting:
Issuing press releases on the Internet regarding false and misleading projections of revenues.
Improperly reporting revenues on sales of software and improperly reporting revenues with side letters or material contingencies.
Recording sham barter deals which resulted in material misstatement of revenue.
Improperly recognizing revenue through fraudulent bill and hold transactions, recognizing revenue with material contingencies and issuing press releases which materially overstated revenues.
In the subsequent settlements, the courts ordered judgments ranging from the imposition of fines and disgorgement of ill-gotten gains to entry of temporary or permanent injunctions barring people from serving as officers of public companies or practicing before the SEC as accountants.
The SEC brought a case that is significant because it included allegations against the external auditors for failure to take appropriate action after discovering possible illegal conduct. The company, named in a federal suit over alleged overstatement of revenue for existing contracts, failed to announce termination of contracts and inappropriate recognition of fees subject to material contingencies. Further, the SEC alleged the company attempted to cover up these recognition problems. The SEC amended the initial complaint to bring a civil injunction against one of the external auditors for violating Section 10A of the Securities and Exchange Act, which compels auditors to address possible illegal activity.
Unfortunately the executives at another company did not act soon enough to ward off revenue recognition problems. As a result, both the chief operating officer and the chief financial officer at the software maker were replaced when the company investigated improper accounting practices. Taking quick action, the company said it would file restated results of operations, although it did not indicate the extent of the restatement.
For many companies, SAB 101 need not be cause for alarm, but rather a call to take a good, honest look at their revenue recognition practices. For example, Delta Air Lines recently changed its method of recognizing sales of frequent flier miles to credit card companies, hotels and other marketing partners. Previously, the company had recognized revenue as cash was received, but now Delta will show part of the revenue immediately and defer the rest until the consumer uses the miles. The change brought about a cumulative adjustment in the year it occurred.
Some companies have complex business scenarios that may not have easy solutions. The SEC questioned Priceline.com regarding its practice of reporting revenues at gross when reporting at net would seem more appropriate. Priceline serves as a “go-between” for many companies selling third-party items via the Internet and receives a portion of the proceeds for its part in the transaction, similar to a consignment arrangement. Priceline’s portion is not a fixed percentage commission, though. The amount of profit varies depending on the company’s decision regarding the ultimate sale price. The SEC has approved Priceline’s practice so far, but not everyone agrees with that decision.
In the 1990s, the stock market encouraged less than conservative financial reporting from companies. Thanks to the market’s policy of basing capitalization on revenues, companies have, until recently, enjoyed strong stock prices and market capitalization without having to make hefty profits (see exhibit 1 ). With so much market emphasis on one line item, companies are tempted to inflate revenues through “creative accounting.”
In a now-famous 1998 speech, then SEC Chairman Arthur Levitt illustrated several earnings management scenarios (see “Earnings Management and the Abuse of Materiality,” JofA , Sep.00, page 41 ). In the absence of net income, market capitalization is based on revenues as an indicator of future earnings potential. Essentially, many companies Wall Street scrutinized reported net losses and net cash outflows. These companies then tried to meet or exceed the Wall Street estimates or rumored numbers through creative accounting.
Earnings management is not new, but it draws magnified media and investor attention in an environment where the market punishes companies that do not meet their earnings estimates. Last spring software maker MicroStrategy, Inc. announced it was restating earnings for the last three years to comply with SAB 101. As a result, the company showed a net loss for that time period. MicroStrategy stock, which had been trading at $225 a share, plummeted 62% in one day, and within just weeks dropped to $25 a share. In April, the company settled a shareholder class action suit alleging fraud arising from revenue overstatement.
A similar fall in stock price at another company shows just how sensitive the market is to changes in revenue expectations. In October, Apple Computer’s stock price fell by almost half in 24 hours when the company said it would experience a 6% decline in revenue from the second to the third quarter. Surprisingly, this drop occurred even though Apple still reported a net profit for the period.
If companies choose questionable accounting practices to meet expectations of shareholders and analysts, then they will get the attention of the SEC, which has no tolerance for earnings management practices that become fraudulent financial reporting. In a June 2000 speech, SEC Commissioner Isaac Hunt said that “financial fraud constituted almost one-fifth of the cases brought by the division of enforcement in the last year,” and about one-third of these actions were for improper income recognition. Hunt added that “the commission is increasing its sanctions against individuals who commit fraud on behalf of the corporation.” The SEC also has extended its sanctions to include not just senior officials but others within the chain of command who knowingly are involved in the fraud.
In his Audit Risk Alert letter to the AICPA (October 13, 2000), SEC Chief Accountant Lynn Turner spelled out the issues on which the SEC staff has been focusing its attention, and emphasized revenue recognition. He specifically told auditors to be aware of changes in revenue growth trends, non-standard journal entries (particularly at the end of the reporting period) and side agreements that might affect proper revenue recognition ( see “Timing is of the Essence,” JofA, May01, page 78 ). In light of the Hunt and Turner comments, companies with questionable revenue recognition practices do not want the regulators at their doors and are running scared.
NEW FASB GUIDANCE
In October 1999, SEC chief accountant Turner sent a letter to Timothy Lucas, FASB director of research and technical activities, with a list of earnings management issues the SEC believed the EITF should address. Exhibit 2 presents only those issues relevant to revenue recognition, and displays the priority level the SEC assigned along with each issue’s EITF status. Although the list was based largely on problems that arose at Internet companies, many other companies now encounter these situations as business models continue to evolve.
FASB established the EITF in 1984 to help it identify problems affecting financial reporting and implementation of authoritative pronouncements. It charged the task force with providing guidance so that all publicly traded companies handled like transactions similarly. In a perfect situation, the EITF would identify emerging diversity in practice or questionable application of GAAP before the SEC had to take action. Once the EITF reaches a consensus, it becomes GAAP and is considered a mandatory requirement under SAS no. 69 and the board will not take further action.
has reached a consensus on roughly half of the issues the
SEC raised in the letter. In fact, for the three issues the
SEC identified as most important, the task force has issued
statements specifically addressing revenue recognition:
Issue no. 99-17, Accounting for Advertising Barter
Transactions, Issue no. 99-19, Reporting Revenue
Gross as a Principal versus Net as an Agent, and
Issue no. 00-3, Application of AICPA Statement of
Position (SOP) 97-2, Software Revenue Recognition, to
Arrangements That Include the Right to Use Software Stored
on Another Entity’s Hardware. While it appears the
task force addressed these issues in the context of Internet
companies, any consensus is intended to provide guidance for
all companies. The key points are summarized below.
Issue no. 99-19. Many companies sell goods or services over the Internet without stocking the inventory themselves. Instead, they employ independent warehouses to store merchandise and ship to the customer upon request. These companies may also offer services provided by an Internet service provider. Companies chose one of two ways to report revenue. The revenue is recognized:
At the gross amount charged. The cost of goods sold reflects the cost of the goods or services sold to the customer plus the company’s cost of executing the transaction.
At the net amount (reflecting only the commission or net profit). Then the cost of goods sold reflects only the company’s cost of executing the transaction.
Under either method, net income or gross profit is the same. However, companies wishing to maximize revenues to maintain executive compensation or enhance stock price prefer reporting revenue at the gross amount. Consensus: If the company performs as an agent or broker without assuming the risks and rewards of ownership of the goods, it should report sales on a net basis.
The EITF prepared a list of factors or indicators that companies should review in deciding whether to report at gross or net. The task force noted that none of these indicators was presumptive or determinative, and that companies should consider the relative strength of each indicator. The EITF Abstract for this issue also includes several examples of the applications of these indicators that should be useful in practice.
Issue no. 00-3. Sometimes a company’s software resides on its own (or a third party’s) hardware and the customer accesses and uses the software as needed over the Internet or on a dedicated line (called “hosting”). With this type of arrangement, the customer does not necessarily take possession of the software. Depending on the complexity of the software, the arrangement may also include additional services and updates or enhancements. Usually companies pay an initial fee, followed by additional periodic payments over the life of the arrangement.
Essentially, the arrangements this issue addresses involve two rights—to use the software and to store it on the vendor’s or third party’s hardware. Arrangements that do not allow customers to take possession of the software at any time during the hosting period without significant penalty (so they can run the software on their own or a third party’s hardware) are considered service contracts and fall outside the scope of both this issue and SOP 97-2. Consensus: The EITF has concluded revenue should be allocated to the software element and hosting element based on vendor-specific evidence of fair value. Revenue should be recognized on the software element when the delivery has occurred and on the hosting element when services are performed.
In the late 1980s, new franchise businesses exploded, and timing of revenue recognition from franchise fees became an issue. In the early 1990s, controversy surrounded some companies because of their practice of recording revenue when they shipped inventory to dealers even though the inventory could be returned. Companies relied on “new business transactions” to justify the unjustifiable, prompting additional pronouncements from the SEC, the FASB and the EITF. While such pronouncements offer guidance, some critics argue they enable companies to engage in questionable practices unless explicitly forbidden. However, companies can easily resolve many recognition questions if they adhere to the principle that revenue should be realized or realizable and earned before it can be recognized.
FASB’s Lucas contends that “it’s difficult to craft a rule that doesn’t catch some of the wrong fish in the net.” Companies must report transactions in a manner that reflects economic reality. The SEC is still deadly serious about SAB 101, even if the recent stock market meltdown lessens some of the importance of revenue recognition as a “hot issue.”
Regardless of the market’s fixation on revenue, all companies ultimately need real—not managed—profits. SAB 101 both reaffirms long understood revenue recognition concepts and provides helpful guidance. Perhaps, more than anything else, continued good faith efforts by accounting professionals are the best defense against revenue recognition problems.