Revenue Recognition Revolutionized
The Brave New World of RFID Chips

By William Stout and Sidney J. Baxendale

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JULY 2006 - Years ago, the “ka-ching” of a cash register signaled the appropriate time to recognize revenue. With the advent of radio frequency identification (RFID) chips, revenue recognition in the future may be signaled by a “beep.”

Advances in technology, such as RFID chips, were anticipated by FASB in its conceptual framework. In Statement of Financial Accounting Concepts (SFAC) 5, “Recognition and Measurement in Financial Statements of Business Enterprises,” it noted: “The recognition criteria and guidance in this Statement are generally consistent with current practice and do not imply radical change. Nor do they foreclose the possibility of future changes in practice. FASB intends future change to occur in the gradual, evolutionary way that has characterized past change.”

FASB’s view of “gradual, evolutionary” change was written at about the same time as the introduction of IBM’s XT personal computer. What was viewed at that time as gradual is viewed today as snail’s pace. Revenue recognition may be poised to move and change even more rapidly in today’s environment.

RFID Chips

RFID chips are minitransmitters that can broadcast data over a very short range, typically only a few feet. As a chip passes a special reader, the data on the chip are recorded and transmitted to a computer, which can then track the chip’s location and the nature of the item to which it is affixed or otherwise associated. RFID chips have an advantage over bar codes, because they are less easily damaged or obscured.

In 2004, Wal-Mart Stores, Inc., announced that it was testing RFID chips at a small number of facilities, cooperating with eight vendors. A company press release referred to the test as a “new era in supply-chain management.” According to Wal-Mart, RFID technology permits a retailer to identify a specific lot of a product, including expiration dates and other important unit-specific data. (Bar codes permitted retailers to identify a product, but not a unit.) RFID chips can also permit identification of several different products on a single, shrink-wrapped pallet.

A pallet arriving at a distribution center can be automatically read as it is removed from the delivery vehicle. Individual boxes on the pallet then move through the distribution center and are again identified as they are loaded for shipment to a retail outlet. Ultimately, the same process would be followed at the retail outlet, with store inventory levels automatically updated.

Wal-Mart chose to first concentrate on the tagging of pallets and cases of merchandise. On a test basis, RFID chips are inserted in individual consumer packages, so that the movement of a product could be monitored from delivery to sale and removal of the product by a customer. (Of course, a system could presumably identify products leaving the store other than following a sale, opening potential new methods of internal control.)

Example of Delayed Revenue Recognition

In Microchip Technologies, Inc.’s (MTI) 2001 annual report, a discussion of revenue recognition demonstrated the application of SEC Staff Accounting Bulletin (SAB) 101 in a situation in which the distributor has a “right of return.” MTI’s note 1, “Revenue Recognition,” stated:

When distributors have rights to return products and price protection rights, the Company defers revenue recognition until the distributor sells the product to the end customer. Upon shipment by the Company, amounts billed to distributors with rights to product returns and price protection rights are included as accounts receivable, inventory is relieved, the sale is deferred and the gross margin is reflected as a current liability until the product is sold by the distributors to their customers.

Based on that description, the journal entries to record the transactions would be as shown in the Exhibit.

MTI’s sales to distributors are on a “right of return” basis, and the recognition of revenue is based on the manufacturer’s receiving notification from the distributor that the product has been sold to an ultimate user of the product. Title to the product passes from the seller to the buyer at the point in time when the buyer takes possession of the product; thus the provisions of the Uniform Commercial Code are not impacted in any manner as a result of the seller’s delayed revenue recognition. Furthermore, the collection of the accounts receivable by the seller is in accordance with the ordinary credit terms without regard to the delayed date of revenue recognition by the manufacturer.

To what extent can distributors be relied upon to notify the manufacturer that the product has been sold, especially when the distributor may have already paid the manufacturer for the product? It would seem that there would be a likelihood of underreporting to the manufacturer and, therefore, the underrecognition or delayed recognition of revenue by the manufacturer. In such a situation, the manufacturer would likely gain a tremendous revenue recognition benefit if the product had an RFID chip attached that would send a signal to the manufacturer, through the manufacturer’s and distributor’s linked enterprise resource planning (ERP) system, that a sale to the ultimate consumer had been completed. The signal could transmit information such as the date of the sale, the manufacturer of the product, the product number, and, if appropriate, the individual item’s serial number.

This automatic transmission of information could be triggered by the distributor ringing up the sale to the ultimate consumer. The ringing-up process could be programmed to read the information from the product’s attached RFID chip (manufacturer identification, product number, serial number, and quantity) and combine it with information captured at the point of sale (date of sale).

Access to the distributor’s information regarding the sale could be accomplished by the distributor’s granting the manufacturer a “restrictive portal” into the distributor’s ERP system. This restrictive portal would permit the manufacturer to obtain, in real time, only the information on the distributor’s sale of any of the manufacturer’s products. Upon receipt of the information regarding the sale, the manufacturer’s ERP system would prepare the journal entry, debiting the cost of goods sold and deferred income on shipments to distributors and crediting revenue.

Revenue Recognition Under GAAP

At the most basic level, GAAP specifies, in paragraph 83 of SFAC 5, that revenue should not be recognized until the revenue is either realized or realizable, and earned. More specific guidance is provided in pronouncements issued by the Committee on Accounting Procedure (CAP); the Accounting Principles Board (APB); committees of the AICPA; FASB and FASB’s Emerging Issues Task Force (EITF); and the SEC.

Despite the relative simplicity of the basic revenue recognition criteria, preparers, users, and auditors of financial reports have struggled with issues surrounding the timing of revenue recognition. In some cases, the basic revenue recognition criteria have been misapplied for fraudulent purposes. A 1999 report by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission reported that more than one-half of financial reporting frauds studied from 1987 to 1997 involved overstating revenue.

SEC Concerns About Revenue Recognition

Reacting to the COSO report in 1999, the SEC issued SAB 101, “Revenue Recognition in Financial Statements.” The bulletin summarized SEC staff views on applying revenue recognition principles to specific circumstances. SAB 101 was quickly followed by SABs 101A and 101B, which delayed the effective date of SAB 101 upon requests from SEC registrants for more time to study the guidance. That two delays were requested by registrants—and granted by the SEC—suggests that the guidance raised concerns about current practices by publicly held companies. The views of the SEC apparently did not reflect current practice, at least for some companies. The following were some of the concerns expressed by the SEC on specific revenue-recognition circumstances.

Consignment sale, title passes upon consumption. In SAB 101, question 2, the SEC set forth an example in which Company Z enters into an agreement with Customer A. Under the agreement, Z delivers product to A that is subsequently used and consumed in a production process. The product is shipped on a consignment basis, so that title to the product is retained by Z until A actually consumes the product. The SEC staff’s view was that revenue could not appropriately be recognized until the product was consumed and title transferred.

The SEC also noted that, in some instances, actual transfer of title may not justify revenue recognition. According to the SEC staff, the presence of one or more features might require delay of revenue recognition. The features identified were:

  • The buyer has the right to return the product, and payment is delayed or otherwise different from typical sales agreements.
  • The seller is required to repurchase the product at a substantially known price with adjustments that cover the buyer’s cost of holding the product, including financing.
  • The seller guarantees a minimum resale value.
  • The product is delivered for demonstration purposes.

The SEC staff cautioned that this list is not intended to be complete. Preparers of financial reports should apply professional judgment to determine if the substance of the transaction is a sale, or a consignment (or similar transaction) for which immediate recognition of revenue is not appropriate.

Other factors affecting the ability to estimate product returns. SAB 101, question 9, addressed certain additional factors that might affect the timing of revenue recognition when a right of return exists.

First, SAB 101 discussed the existence of excess inventory in the distribution channel, referred to as “channel stuffing.” In some instances, a company may have influence or power over customers and may be able to cause customers to purchase quantities of inventory above their normal levels. The customer may be willing to purchase excess inventory knowing that it can either reduce future purchases or return the excess inventory at a future date. The excess inventory may reside in multiple warehouses and retail outlets, making it difficult for the seller (and the seller’s auditor) to determine the amount of excess inventory.

The SAB discussed other factors affecting the ability of a company to estimate sales returns, including introducing new products, making existing products technologically obsolete, and competitive products. These other circumstances are beyond the primary focus of this article.

Revenue Recognition and Channel Stuffing

Using RFID chips might resolve the aforementioned revenue-recognition issues. In both cases (consignment inventory, and goods with right of return), RFID chips could provide the seller with information about the current status of those items (e.g., whether they are still on the shelf or have been sold to a final consumer).

The late 1990s provided many examples of revenue recognition abuses that had devastating effects on shareholders. Lucent Corporation was one such example. According to “Phone Numbers—Behind Lucent’s Woes: All-Out Revenue Goal and Pressure to Meet It” (The Wall Street Journal, March 29, 2001), Lucent was under tremendous pressure in 2000 to continue increasing sales at the double-digit pace of prior years. The second and third quarters of 2000 had been disappointing, however, and the company was determined not to let it happen again. When it was obvious that fourth-quarter sales would be lower than published estimates, Lucent increased the use of customer discounts, one-time credits, and other incentives designed to bolster fourth-quarter sales. The result was that Lucent booked sales for goods that were shipped merely to distribution channels and not to customers, a practice commonly called “channel stuffing.”

Coca-Cola Co. practices in 1999 provide another example. “Coca-Cola Settles Regulatory Probe-Deal Resolves Allegations by SEC That Firm Padded Profit by ‘Channel Stuffing’” (The Wall Street Journal, April 19, 2005) reported on Coca-Cola’s settlement with the SEC, stating that the channel-stuffing allegations at Coca-Cola’s operations in Japan started in a period when the spectacular growth fueled by the company’s rapid expansion throughout the world was starting to diminish. By late 1998, economic collapses in several emerging markets were decreasing growth. According to the SEC, by 1999 the inventory of the bottling operations in Japan had risen by more than 60%, compared with an 11% rise in drink sales. Regulators said that the pushing of inventory onto the bottlers are what allowed Coca-Cola to hit Wall Street profit targets in eight of 12 quarters.

Coca-Cola’s Japan operations produced their largest channel stuffing in 1999’s fourth quarter, generating revenue of more than $208 million and increasing the company’s earnings by about $.02 per share, according to the SEC. Bottlers agreed to buy unneeded concentrate in response to favorable credit terms and to maintain their relationship with Coca-Cola.

The Wall Street Journal revealed a more subtle form of channel stuffing in “Probing Price Tags—A U. S. Attorney and the SEC Shine a Light on Stores’ Murky ‘Markdown Money’” (May 13, 2005), discussing markdown allowances granted by manufacturers to retailers. The article quotes John Idol, chief executive of designer fashion company Michael Kors Inc., as saying that some publicly owned vendors have been eager to ship more merchandise in order to show revenue growth, while promising retailers huge markdown guarantees.

The promise of huge markdown guarantees suggests an incentive for channel stuffing, but the thrust of the article was that the manufacturer is at the mercy of the retailer in reporting the markdown before the merchandise is sold to the consumer. In fact, the article was prompted by a lawsuit in which an apparel designer alleged that Saks, Inc., demanded and took substantial deductions and credits that were not allowed under the existing markdown allowance agreement between the designer and Saks.

The article quotes Lloyd Constantine, chairman of the law firm Constantine Cannon and former chief of antitrust enforcement for the New York attorney general’s office, as saying that such agreements can take an illegal turn when retailers misrepresent the circumstances under which they take markdown allowances. For example, if a company asks a vendor for markdown allowances on merchandise that wasn’t put on sale, or if the company inflates how much merchandise it marked down, that would be illegal.

RFID Chips and Revenue Recognition

RFID chips also offer opportunities for solving the problem associated with the truthfulness of the retailers’ markdown claim. The practice of manufacturers promising retailers that they will underwrite a portion of any merchandise markdowns suggests that a manufacturer’s selling price at the time of delivery of the product to a retailer is uncertain, even if the retailer is truthful concerning merchandise markdowns. That uncertainty may be sufficient to place such markdown underwriting agreements in the same category as agreements under which a product is sold to the retailer with a right of return. As such, the accounting treatment discussed earlier would be appropriate, and the use of RFID chips would be useful in signaling that a sale to the ultimate consumer had taken place.

In the case of markdown underwriting agreements, an RFID chip attached to a product could additionally contain information concerning the expected retail selling price of the product and the rule for sharing any difference between the expected selling price and the marked-down price at the time of sale. The retailer would be permitted to read the information on the RFID chip, but would be unable to change the information. If the retailer chooses to mark down the product to sell it, ringing up the sale would capture the information from the chip attached to the merchandise, combine it with the information recorded at the point of sale (date and selling price), and record the combined information in the retailer’s accounting system (possibly an ERP system). The manufacturer would be granted a restrictive portal into the retailer’s sales information to determine daily sales of the product and access information related to markdowns. From this information, both the manufacturer and the retailer could calculate the amount owed as a result of the markdowns.

Such use of the RFID chip has the potential of eliminating the kind of abuse of markdowns that was alleged in the Saks, Inc., case. The Lucent and Coca-Cola channel-stuffing cases suggest instances in which the use of RFID chips could represent the “brave new world” of revenue recognition. One can imagine a future in which the use of RFID chips would eliminate the need for the revenue recognition rules embodied in SAB 101. Once the following—RFID chips are attached to all products, all companies use ERP systems, and all business partners grant restrictive portals into each other’s ERP systems—are in place, revenue recognition can be pushed down the supply chain.

Producers of raw materials or manufacturers of components would not be permitted to record the revenue from the sale of their products until the products are used by the customer to whom they sold the products. Manufacturers that sell their products to wholesalers or distributors would not be permitted to record the revenue until their products are sold by the wholesaler or distributor. Likewise, the wholesaler or distributor would not be permitted to record the revenue until the product is sold by the next level in the supply chain. In this brave new world of revenue recognition, the wholesaler’s revenue would not be recorded until the retailer sold the product to the ultimate consumer.

Admittedly, this is a futuristic view of revenue recognition, and it can come to fruition only if the cost of RFID chips is nominal. The Wall Street Journal’s December 30, 2004, “Technology Journal” reported that the current manufacturing cost of RFID chips was $0.25 to $0.45 cents. However, OrganicID, a closely held company in Colorado, has a process that applies electronic inks and organic materials onto a flexible plastic surface. Using this process, OrganicID expects the cost of manufacturing RFID chips to be $0.01 each by the end of 2006.

Revolutionizing Revenue Recognition

RFID chips have the potential to revolutionize the means by which revenue is recognized by objectively documenting the transaction that takes place downstream in the supply chain. Currently, the cost of the RFID chip is so great that such downstream revenue recognition would be economical only at the pallet level, not at the unit level. As the use of the RFID chips become more prevalent and as the manufacturing technology matures, however, the cost should become far less than one cent per chip. When that happens, use of RFID chips as the basis for revenue recognition should receive serious consideration from both preparers of financial reports and accounting standards setters.

The use of RFID chips to objectively monitor the appropriateness of a retailer’s claim for markdown credit should be given serious consideration. Likewise, in industries where revenue recognition is delayed until the distributor sells the item, the use of RFID chips can be effectively used to reduce the manufacturer’s reliance on the distributor’s reporting the sale of a unit of product on a timely basis.

Revenue recognition has been one of the more difficult issues faced by the accounting profession in recent years. Heeding FASB’s advice from the 1980s—some might call it a premonition—is not only possible, but imperative.

William Stout, PhD, CPA, is an associate professor of accountancy, and Sidney J. Baxendale, DBA, CPA, CMA, CFM, is a professor of accountancy. Both are in the College of Business of the University of Louisville, Louisville, Ky.




















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