Revenue Recognition
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Manufacturing Company
Phoenix, AZ
May 11, 2005
Attn: CEO:
The following is our Team C Accounting Firm’s response to your questions
concerning recognition of revenue and expense and the expensing of stock options:
Revenue Recognition
Revenue recognition is a slippery issue in accounting, and an area that has proven ripe for fraud. The Financial Accounting Standards Board (FASB) has been wrestling with revenue recognition for years. They are in the midst of an extensive project to develop a comprehensive statement that is conceptually based and framed in terms of principles. According to a recent Financial Executive article, in summarizing its goal, FASB said it is “pursuing an approach that focuses on changes in assets and liabilities, and is not overridden by tests based on notions of realization and completion of an earnings process.” It added that “earnings and realization have yet to be defined precisely, and in a manner that can be applied consistently across a range of industries and transactions.”, and that “it is difficult to identify consistently when earning or realization occurs under multiple-element revenue-generating arrangements” (Marshall, 2004, p24).
In December 1999, the SEC issued Staff Accounting Bulletin (SAB) 101, “Revenue Recognition in Financial Statements,” followed in October, 2000 by “Revenue Recognition in Financial Statements Frequently Asked Questions.” SAB 101 was effective starting the fourth fiscal quarter for fiscal years beginning after December 15, 2000.
For revenue to be recognized under SAB 101 it must meet all of the following criteria:
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.
Collectibility is reasonably assured.
Many cases of revenue recognition are simple: revenue is recognized when the goods are delivered or the services are performed. But the issue often gets more complicated because of a practice called “bundling”, which occurs when a company packages a principal product (e.g. A cell phone or satellite dish) with ancillary products or ongoing services (e.g. Providing the wireless service or maintaining a signal to the dish receiver). Bundling not only augments revenues but also extends the contract between the company and its customers beyond the traditional point of sale (DeMark,E, 2004, p.10). This leads to an accounting issue.
The accounting for multiple deliverables or elements is complex, thus the SEC’s FAQ document provides additional guidance. Elements may be considered separate if they either are or could be sold without the other elements. Revenue can be allocated among the elements based upon their fair value. Reliable, verifiable and objectively determinable fair values are often not available. In such cases, the revenue must be deferred until that evidence becomes apparent. The multiple element arrangement can often be treated as a single-element arrangement using appropriate revenue recognition principals. If an arrangement includes multiple deliverables or elements, no revenue should be recognized until all of the elements essential to functionality are delivered.
“Revenue recognition issues are more difficult to resolve when services are provided or included alongside products. Companies that received up-front nonrefundable fees had problems defining the appropriate point of revenue recognition. Going forward, it is clear that delivery of a product is not sufficient for recognizing revenue when the customer expects additional services” (Moffeit, K, Eikner, A & Colson, R., 2003, p. 57).
The timing of revenue recognition requires accrual basis accounting. Transactions for sales of goods or services on credit are recorded and reported in the period in which they occurred rather than in the period when cash is collected. This is the sales basis of revenue realization. There are four exceptions to this application:
The installment method of revenue recognition is used when customers are expected to make payments over multiple years and when they often stop making payments and return an item in the middle of a contract. In this scenario collection is not reasonably assured so revenue is recognized when the cash is actually paid instead of at the point of sale. Under this approach revenue is recognized on a cash basis.