March 2001

Subtle Issues in Revenue Recognition

By Russell F. Briner

In recent years, concerns related to the recognition of revenue in accordance with GAAP have risen in significance. Not only the fraudulent acts of recording revenue improperly through sham transactions, but subtler practices, such as recognizing revenue before it is earned, have drawn more intense regulatory scrutiny. New, less obvious issues involving revenue recognition in the growing online economy have also come to light. Not surprisingly, these problems have caught the attention of both the SEC and FASB.

Revenue Recognition GAAP

GAAP for revenue recognition seems fairly straightforward: According to FASB Statement of Financial Accounting Concepts No. 5, revenue is recognized when a transaction occurs and 1) the revenue is realized or realizable and 2) the revenue is earned. Revenue from a transaction must meet both criteria in order to be recognized. Revenue is generally considered realized when cash is received for the sale of a product or performance of a service. Revenue generally becomes realizable when a promise to pay is received in exchange for the sale of a product or performance of a service. The promise to pay could be verbal (account receivable) or written (note receivable). Revenue is generally earned when a legally enforceable exchange takes place (e.g., consideration has been tendered and the buyer takes possession of the product or benefits from the performance of a service).

Although the rules seem simple, transactions can become quite complicated, raising questions about the timing and measurement of revenue. At least six FASB statements of financial accounting standards (SFAS) relate directly to revenue recognition, such as SFAS No. 45, Accounting for Franchise Fee Revenue. Also, the AICPA has issued statements of position (SOP) and the FASB Emerging Issues Task Force (EITF) has issued pronouncements addressing numerous revenue recognition issues.

The SEC has recently expressed public concern about revenue recognition problems because of the large number of issues that SEC registrants encounter, and the staff has added the topic to the staff accounting bulletin (SAB) series. On December 3, 1999, the SEC issued SAB 101, “Topic 13: Revenue Recognition and Topic 13A: Views on Selected Revenue Recognition Issues.”

SAB 101 emphasizes the two revenue recognition criteria: realized (or realizable) and earned. The SEC staff has also issued guidelines that the two criteria are met when all of the following criteria are established:

  • Persuasive evidence of an arrangement exists.
  • Delivery has occurred or services have been rendered.
  • The seller’s price to the buyer is fixed or determinable.
  • Collectability is reasonably assured.

    The history of difficulties with revenue recognition in the corporate sector is replete with instances of fraud. A March 1999 report sponsored by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission, Fraudulent Financial Reporting 1987–1997: An Analysis of U.S. Public Companies, noted that more than half of frauds involved overstating revenue. Since then, the increase of online business-to-business transactions has led to even more questions about the validity of reported revenue.

    Based on a review of the current literature, the following practices have been identified as matters of concern by both the SEC and FASB, which continue to monitor most of them.

    Bill and hold transactions. This type of transaction, in its simplest form, begins with an order from a customer. The order is filled and the customer is billed. Usually the revenue is not recognized until the goods are shipped or delivered to the customer. But if the customer asks the seller to hold the goods, the seller can still recognize the revenue if the goods are segregated from the seller’s inventory.

    Past revenue recognition problems have involved businesses fraudulently setting aside inventory not actually sold. Less obvious practices include written agreements for sales that are not signed by both parties. In some cases, the seller would recognize revenue with only a verbal acknowledgment, a practice which the SEC no longer permits (SAB 101). Corporations may use a variety of agreements for sales-type transactions, so the nature of the agreement must be understood in order to ensure that revenue recognition requirements have been met. Customer acceptance has become a key focus for revenue recognition, despite some vagueness in the SEC staff’s position as to when it occurs.

    Delivery of the product does not always mean the revenue should be recognized. Under the terms of the sales agreement, the buyer may have the right to return the product or the seller may be required to repurchase the product at the buyer’s discretion (SAB 101). While not strictly bill and hold transactions, in such instances the seller should record revenue only when all obligations have been met.

    Long-term contract arrangements. Interim accounting for multi-year contracts has generated numerous challenges in the past and it should not be a surprise that the Internet business sector has added unique twists to this already complex area. For example, Think New Ideas, a website design company, recognizes revenue using the “work in process” method. Revenues were recorded based on management’s estimate of contract completion. The independent auditors questioned the process that created the estimates. The company fired its auditor, but investors remained skeptical despite assurances from its new auditor.

    Another well-known example is MicroStrategy, Inc., a software concern that restated revenues and profits downward for three years to reflect its new way of recording revenue. The company had been booking revenues from long-term contracts immediately rather than over the period of the contracts and the services performed.

    Both of these examples indicate the importance of reviewing revenue recognition practices in long-term service contracts. Revenue cannot be recognized until the service has been performed and collectability has been assured.

    Barter advertising transactions. Under this type of transaction, dot-com companies trade advertising space on each other’s sites and each company records the fees it would have charged as revenues and the fees it would have paid as expenses, resulting in an offset between the revenue and expense sections of the income statement. Some question whether the companies should have recorded any revenue or expense; rather, they should have simply disclosed the barter transaction in the financial statement footnotes. Others believe that investors, which tend to treat marketing expenses in dot-coms at least partially as investments in intangibles, are misled to mistakenly overvalue the net impact on revenue gross margin of barter transactions.

    In January 2000, the EITF issued a report (EITF 99-17) noting that a company can include revenue from advertising barter transactions only if the company has received cash for “similar transactions” within the last six months. Furthermore, FASB wants companies to disclose the barter amounts in their footnotes as a percentage of revenues.

    Agent or facilitator transactions. In certain transactions, an Internet company acts as an agent for a buyer and seller. If the agent takes title to the product, then the commission is the difference between the selling price set by the agent and the cost of the product to the agent. Because the transaction takes place entirely online, it is debatable whether the agent ever takes title to the product. Should the revenue be recognized at gross or net?

    For example, the e-tailer books revenue from sales and also records the costs in their process of acting as a sales agent. One of Priceline’s specific activities is to search for low airline fares, buy tickets online, and resell them to customers. Although Priceline contends that it bears the risk because it actually buys the tickets and takes them into inventory, it does so only when it has a buyer for them. In the nine-month period ending September 30, 1999, Priceline’s revenues would have decreased by $255 million had it netted the revenue against the expenses of these transactions.

    EITF 99-19 discusses whether an online company’s facilitation of business transactions provides an adequate basis for grossing revenues and expenses, concluding that this question “is a matter of judgment that depends on the relevant facts and circumstances,” and that the factors or indicators should be considered in making that determination (see the Exhibit). The EITF also indicated that the relative strength of each factor should be assessed against individual circumstances.

    Recommendations for Improving Revenue Recognition

    The four areas of difficulty in revenue recognition discussed above raise questions about the credibility of accounting practices and should be resolved as quickly as possible. The following are some recommendations for improving accounting practices:

  • Individuals recording and auditing revenue should have a high level of knowledge of GAAP for revenue recognition. In addition, audit committees should be keenly aware of subtler issues and make appropriate inquiries.
  • All relevant individuals should be knowledgeable about recent revenue recognition guidelines, including SAB 101 and EITF 99-17 and 99-19.
  • Where revenue recognition may be questioned—such as in the above cases—the financial statements should make the appropriate disclosures and inform users of the “grossing up” of the transactions if the transactions are not reported net of revenue earned.
    Russell F. Briner, PhD, CMA, CPA, is in the division of accounting and information systems at the University of Texas at San Antonio.

    Thomas W. Morris
    The CPA Journal

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