Certain problems currently found in the application of the general principles of revenue recognition, which can sometimes lead to fraudulent reporting, are discussed in this post.
Financial Statement Presentation: Gross vs. Net
In general, it is well established that reporting on a “gross” basis is appropriate when the entity takes ownership of the goods being sold to its customers, with the risks and rewards of ownership accruing to it. For example: if the entity runs the risk of obsolescence or spoilage during the period it holds the merchandise, gross reporting would normally be appropriate. However, if the entity merely acts as an agent for the buyer or seller from whom it earns a commission, then “net” reporting would be more appropriate.
In recent years there have been increasing reports of enterprises that inflate revenues reported in their income statements by reporting transactions on a “gross” basis, notwithstanding that the entity’s real economic role is as an agent for buyer and/or seller. This distortion became widespread in the case of Internet companies and other start-up and innovative businesses typically not reporting earnings, for which market valuations were heavily influenced by absolute levels of and trends in gross revenues. Reporting revenues “gross” rather than “net” often had an enormous impact on the perceived value of those enterprises.
The Emerging Issues Task Force (EITF) Consensus No. 99-19 provides guidance on whether an entity is an agent for a vendor-manufacturer, and thus recognizes the net retainage (commission) for serving in that capacity, or whether that entity is a seller of goods (i.e., acting as a principal), and thus should recognize revenue for the gross amount billed to a customer and an expense for the amount paid to the vendor-manufacturer.
The EITF identifies the following factors to be considered when determining whether revenue is to be reported as the net retainage (hereinafter, “net”) or the gross amount billed to a customer (“gross”). None of the indicators are presumptive or determinative, although the relative strength of each indicator is to be considered:
- Is the company the primary obligor in the arrangement; that is, is the company responsible for the fulfillment of the order, including the acceptability of the product or service to the customer? If the company, rather than a supplier, is responsible, that fact is a strong indicator that the company records revenue gross. Responsibility for arranging transportation for the product is not responsibility for fulfillment. If a supplier is responsible for fulfillment, including the acceptability to the customer, that fact indicates that the company recognizes only the net retainage.
- Does the company have general inventory risk? General inventory risk exists if a company takes title to a product before the product is ordered by a customer or will take title to the product if the customer returns it (provided that the customer has a right of return). In considering this indicator, arrangements with a supplier that reduce or mitigate the company’s risk level are to be considered. Unmitigated general inventory risk is a strong indicator that the company recognizes revenue gross.
- Does the company have physical loss inventory risk? Physical loss inventory risk exists if the title to the product is transferred to the company at the shipping point and then transferred to the customer upon delivery. Physical loss inventory risk also exists if a company takes title to the product after the order is received but before the product is transferred to the shipper. While less persuasive than general inventory risk, this indicator provides some evidence that a company records revenue gross.
- Does the company establish the selling price? If a company establishes the selling price, that fact may indicate that the company recognizes revenue gross.
- Is the amount earned by the company fixed? If a company earns a fixed amount per transaction or if it earns a percentage of the selling price, that fact may indicate that the company reports revenue net.
- Does the company change the product or perform part of the service? If a company changes the product (beyond packaging) or performs part of the service ordered by the customer such that the selling price is greater as a result of the company’s efforts, that fact is indicative that a company recognizes revenue gross. Marketing skills, market coverage, distribution system, and reputation are not to be evaluated in determining whether the company changes the product or performs part of the service.
- Does the company have multiple suppliers for the product or service ordered by the customer? If a company has the discretion to select the supplier, that fact may indicate that the company records revenue gross.
- Is the company involved in determining the nature, type, characteristics, or specifications of the product or service by the customer? If so, that fact may indicate that the company records revenue gross.
- Does the company have credit risk for the amount billed to the customer? Credit risk exists if a company must pay the supplier after the supplier performs, regardless of whether the customer has paid. If the company has credit risk, this fact provides weak evidence that the company records revenue gross. If the supplier assumes the credit risk, the company is to record revenue net.
Barter transactions (non-monetary exchanges, as described in Accounting Principles Board Opinion No. 29) are not a problem, assuming that they represent the culmination of an earnings process. However, in recent years there have been many reports of transactions that appear to have been concocted merely to create the illusion of revenue-generating activities. Examples include advertising swaps engaged in by some entities, most commonly “dot-com” enterprises, and the excess capacity swaps of fiber-optic communications concerns under “indefeasible right to use” agreements. Both these and many other situations involved immediate recognition of revenues coupled with deferred recognition of costs, and typically, in aggregate, were equal exchanges not providing profits to either party. Furthermore, these examples do not represent culminations of the normal earnings process (e.g., fiber-optic networks were built in order to sell communications services to end users, not for the purpose of swapping capacity with other similar operations).
In hindsight, most observers can see why these and many other aggressive reporting practices deviated from established or implied GAAP; although there are still some who insist that because GAAP failed to explicitly address these precise scenarios, the accounting for the transactions was open to interpretation. Since GAAP (even the highly rules-based U.S. GAAP) cannot possibly hope to overtly address all the various innovative transaction structures that exist and will be invented, it is necessary to apply basic principles and reason by analogy to newly emerging circumstances.
Of great importance to financial statement preparers (and internal and external auditors) are obtaining a thorough understanding of the nature and normal operations of the business enterprise being reported upon, application of “substance over form” reasoning, and the goal of faithfully representing the economics of transactions.
Many difficult issues of revenue recognition involve practices that may or may not involve GAAP departures, depending on the facts and circumstances. Channel stuffing is a prime example of this issue, where sales are actually made prior to the period-end cut-off but are stimulated by “side agreements,” such as a promise to customers of extended return privileges or more liberal credit terms. In such circumstances, there might be a greater likelihood that a substantial portion of these sales may be subsequently nullified, as unrealistically large orders inevitably lead to later large returns made for full credit.
For purposes of financial reporting under GAAP, valuation allowances should be established for expected sales returns and allowances. (In practice, however, this is rarely done because the amounts involved are immaterial, unlike the amounts of the more familiar allowances for uncollectible accounts). The use of valuation accounts for anticipated returns and allowances is dictated by both the matching concept (recording returns and allowances in the same fiscal period in which the revenue is recognized) as well as by the requirement to present accounts receivable at net realizable value. When the potential product returns are not subject to reasonable estimation (as when a sales promotion effort of the type just described is first being attempted by the reporting entity) but could be material, it might not be permissible to recognize revenues at all, pending subsequent developments. Furthermore, from the SEC’s perspective, factors such as the following could require deferral of revenues at the time goods are shipped to customers, pending resolution of material uncertainties:
- Significant levels of product inventory in the distribution channel
- Lack of “visibility” into, or the inability to determine or observe, the levels of inventory in a distribution channel and the current level of sales to end users
- Expected introductions of new products that may result in the technological obsolescence of, and larger than expected returns of, current products
- The significance of a particular distributor to the company’s (or a reporting segment of the company’s) business, sales, and marketing
- The newness of a product
- The introduction of competitors’ products with superior technology or greater expected market acceptance could affect market demand and changing trends in that demand for an entity’s products.
Mischaracterization of Extraordinary or Unusual Transactions as Components of Gross Revenue
Not all revenue recognition errors and frauds involve questions of when or if revenue should be recognized. In some instances, classification in the income statement is of greater concern. While matters in this group often do not result in a distortion of net results of operations, they can seriously distort important indicators of performance trends. When this occurs, it most often involves reporting unusual or infrequent gains on sales of segments or specific assets as revenue from product or service transactions.
A variation on this involves reporting unusual gains as offsets to one or more categories of operating expenses, similarly distorting key financial ratios and other indicators, again without necessarily invalidating the net income measure.
Mischaracterizing Transactions as Involving “Arm’s-Length” Third Parties, Thus Justifying Unwarranted Gain Recognition
Transfers of inventory or other assets to a related entity typically defers gain or income recognition until subsequent transfer to an “arm’s length” party. In some cases, sales have been disguised as being to unrelated entities with gain being recognized, when in fact the “buyer” was a nominee of the seller, or the financing was provided or guaranteed by the seller, or the “buyer” was a “variable interest entity” that failed to meet the complex and changing requirements under GAAP required for gain recognition.
Depending on the facts of the situation, this can result in gains being improperly recognized or the gross amount of the transaction being improperly recognized in the seller/transferor’s financial statements.
Selling Undervalued Assets to Generate Reportable Gains
This issue again ranges from deliberate but real economic transactions that have as a goal the inflation of reportable revenues or gains, to misrepresented events having no economic substance but the same objective.
Among the former is the deliberate invasion of low-cost last-in, first-out (LIFO) inventory “layers,” which boosts gross margins and net profits for the period, albeit at the cost of having to later replenish inventories with higher-cost goods. To the extent that this depletion of lower-cost inventory really occurs, there is no GAAP alternative to reflecting these excess profits currently, although the threat of full disclosure may prove to be somewhat of a deterrent.
Regarding the latter category, in some instances the ability to generate gains could indicate that errors occurred in recording a previous transaction. Thus, large gains flowing from the sale of assets recently acquired in a purchase business combination transaction could well mean the purchase price allocation process was flawed. If this is true, a reallocation of purchase price would be called for, and some or all of the apparent gains would be eliminated.
Related to the foregoing is the strategy of retiring outstanding debt in order to generate reportable gains. In periods of higher-than-historical interest rates, lenders will agree to early extinguishment of outstanding obligations at a discount, hence creating gains for the borrower, albeit replacement debt at current yields will result in higher interest costs over future years. To the extent the debt is really retired, however, this is a real economic event, and the consequent gain is reported in current earnings under GAAP.
Deliberate Misstatement of Percentage of Completion On Long-Term Construction Contracts
Under Statement Of Position (SOP) 81-1, profits on certain long-term construction-type contracts are recognized ratably over the period of construction. An obvious and often easy way to distort periodic results of operations is to deliberately over- or understate the degree to which one or more discrete projects has been completed as of period-end. This, coupled with the difficulty and importance of estimating remaining costs to be incurred to complete each project, makes profit recognition under this required method of accounting challenging to verify.
How to prevent and spot errors or problems on revenue recognition? You may like to follow my next post: Revenue Recognition Controls