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February 2002 Vol. 6 Issue 1

Revenue is the electricity that drives business. Revenue has been the starting point on every income statement generated, every sales meeting conducted, and is on every entrepreneur’s wish list.

So, why all the fuss lately about revenue? In the business headlines, many companies are not reaching their targeted projections, and one giant in particular publicly announced that it had made an accounting “mistake,” overstating revenues by $125 million in its fourth quarter, due to “sales that were incorrectly recorded.” An outsider would think that accounting rules would have been in place regarding how and when companies are to recognize revenue.

Evolving technology and aggressive sales practices have caused the accounting profession and the Securities and Exchange Commission (SEC) to address this matter, by issuing a series of statements and bulletins, supported by its interpretation of the accounting pronouncements that are currently in place.

There are four criteria that must be met to recognize revenue:

• Persuasive evidence that an agreement exists
• Delivery has occurred or services have been rendered
• The seller’s price is fixed and determinable
• Collectability is reasonably assured

The key factors generating SEC discussion have surrounded the “delivery has occurred or services have been rendered,” coupled with the contractual aspects of client acceptance in the sales agreement itself.

The discussions have been directed to multiple element revenue arrangements, addressing the segregation on each contract into identifiable elements, such as the product itself, the installation, the training and the ultimate finality — customer acceptance of the product. The advent of many “side agreements” to large contracts is also tainting the revenue recognition process, often allowing the customer an “escape clause” from accepting the product, which defers the revenue recognition process until complete customer acceptance has occurred, either by written acceptance or by passage of a defined time. The guidance provided is applicable to all companies.

Delivery and Performance
On “multiple element” contracts, if the undelivered elements are essential to the functionality of the delivered element, then the customer does not have full use of the delivered element. If the customer can’t use the product yet because something is incomplete, then generally it is not a sale yet, with the following exceptions:

If the seller meets the criteria for recognizing revenue, except for one undelivered element of the contract, revenue can be recognized on the completed parts only: if the remaining obligation is inconsequential, the failure to complete the undelivered element would not result in the customer requesting a refund or reject the sale altogether, the costs to complete are minimal and the remaining element can be performed by any other vendor readily available elsewhere.

For any non-standard product or service customized to buyer specifications, evidence of client acceptance is critical, and usually contractually driven in determining revenue recognition. Your accountant should be involved in this discussion, particularly if your financial statements are being issued to third parties.

Another standard criterion for recognizing revenue was based on title passing during delivery. Enticing “side agreements” are also tainting the delivery and title process, creating a consignment situation by offering to the buyer, who has accepted title on delivery risk free, interest- free financing or repurchase clauses at essentially the same price. In these cases, revenue should not be recognized until there is a third party sale, despite title passing.

Other revenues, such as an activation fee or a set-up fee, cannot be recognized as revenue separately and must be amortized over the time period of the service provided. A customer does not go to a service provider and sign up for the setup without getting the regular service. They are not separate events.

Fixed and Determinable Sales Price
Revenues that are refundable, such as “100 percent satisfaction or a complete refund,” cannot be recognized as revenue until the expiration date for refund has occurred. If fees are refundable on a pro-rata basis over time, the revenue can be recognized accordingly. The SEC has made an exception for certain homogeneous fees from a standard group of customers to recognize the revenue, off-set by an allowance for refunds, based on reliable estimates calculated on a specific historical basis.

The SEC staff suggests a minimum of two years of experience be considered in determining sales allowances and that there are no wide swings in the calculation from year to year. If the rate of return is volatile from year to year, then it’s impossible to reasonably calculate a dependable estimate. In these cases, revenue cannot be recognized until the expiration date for a refund has occurred. This is a critical issue, because a “management estimate” for a sales allowance is unacceptable for any period less than two years of existence. Once you have established the historical, reliable rate of return, then you can change your accounting policy accordingly.

Time to examine your current revenue recognition policy?
There is no doubt that revenue recognition is this year’s “hot button” for professionals in financial reporting. Any company that has a formalized client product acceptance policy or highly complex contractual arrangements should revisit how they are recognizing revenues, and decide, in the light of new public scrutiny, whether they should be accounting for revenues differently.

It doesn’t matter if your company has $50 million or $5 billion in sales annually, is public or private — generally accepted accounting policies are the same. Take a moment and weigh the consequences of addressing your revenue recognition policies now, rather than taking the risk of an embarrassing restatement of financial results due to misinterpretation of the rules. Be aware that financial statement treatment of revenues may not necessarily be acceptable for tax purposes. There is more guidance today than in the past, and your accountant should be able to assist you in applying this new guidance to your particular situation.

For information, contact Diane Jay at (908)782-3021.