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Premature Or Fictitious Revenue Recognition [A Closer Look]

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Criteria for Revenue Recognition [by SEC]

The Securities and Exchange Commission has long been aware that companies often use aggressive revenue recognition practices to play the financial numbers game. Revenue recognition was one of the five creative accounting practices specifically identified by the SEC as requiring action. To address the problems it sees with revenue recognition, the commission issued Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB 101). SAB 101 noted that in many industries, such as the software industry, and for many non–industry-specific revenue recognition situations, such as with leases or when a sale entails a right of return, specific revenue recognition guidance exists. The SEC did not want its SAB 101 to infringe on those preexisting standards.

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However, the commission noted that in many other ongoing situations no specific guidance was provided to help accountants and managers determine when revenue is earned and realized or realizable. This Staff Accounting Bulletin was written to provide such guidance.

SAB 101 borrows its revenue recognition criteria from SOP 97-2, the software revenue statement. In fact, the criteria for revenue recognition in SAB 101—persuasive evidence of an arrangement, delivery has occurred or services have been rendered, the seller’s price to the buyer is fixed or determinable, and collectibility is reasonably assured—are identical to those contained in SOP 97-2. In the paragraphs that follow, each of these criteria is given careful consideration. Examples are provided to show how they are applied and how companies that seek to record premature or fictitious revenue might abuse them.

 

 

Persuasive Evidence of an Arrangement

Practice varies across companies and industries as to what constitutes a valid arrangement or purchase order. In some instances a verbal order may be the norm, followed by a written confirmation. In others, a sale may require a written and signed sales agreement. SAB 101 specifically notes that if customary business practice is to use a signed sales agreement, then revenue should not be recognized without it. For example, a written sales agreement may be prepared and signed by an authorized representative of the selling company.

While verbally agreeing to the terms of the contract, the purchasing company’s representative may not have signed the agreement until approved by the company’s legal department. Even though the purchasing company’s representative provides verbal assurances of the company’s interest in the product or service, according to SAB 101 persuasive evidence of an arrangement does not exist. Revenue should not be recognized.

 

 
Channel Stuffing

Channel stuffing is closely related to revenue recognition for shipments made in the absence of outstanding orders. However, in the case of channel stuffing, orders are in fact received. Channel stuffing refers to shipments of product to distributors who are encouraged to overbuy under the short-term offer of deep discounts. While at the time of shipment, an order is in hand, revenue is recognized somewhat prematurely by the seller because its customers are purchasing goods that will not be needed or resold until a later period. The seller is effectively borrowing sales from a later period. In such cases, sales are not sustainable.

Some would refer to the practice of channel stuffing as trade loading, a term traditionally used in the tobacco industry. This quote describes the practice well: “Trade loading is a crazy, uneconomic, insidious practice through which manufacturers—trying to show sales, profits, and market share they don’t actually have—induce their wholesale customers, known as the trade, to buy more product than they can promptly resell”.

 

 
Side Letters

Sometimes a sales transaction may include what appears to be a legitimate order from a creditworthy customer, or, in the terms of the SEC, there exists persuasive evidence of an arrangement. However, outside of normal corporate reporting channels is a separate agreement between some member or members of a company’s management and the customer.

This separate agreement, or side letter as they have become known, effectively neutralizes the purchase transaction between the company and its customer. Note that there is nothing inherently wrong with a side letter that is generally known by company management and is used to clarify or modify terms of a sales agreement without somehow undermining the agreement as a whole. The problem with side agreements arises when they are maintained outside of normal reporting channels and are used to negate some or all terms of the disclosed agreement.

Stipulations of an improper side letter might include: liberal rights of return; rights to cancel orders at any time; contingencies, such as the need to raise funds on the part of the customer, that if not met make the sale null and void; being excused from payment if goods purchased are not resold; or, even worse, a total absolution of payment. As a result, there is no arrangement per se between the two companies. A sale has not taken place and revenue should not be recognized.

In a review of SEC enforcement actions against companies with alleged premature or fictitious revenue recognition practices, many companies were noted with side letters to their sales agreements. Common among the provisions of these side letters were liberal rights of return and extended payment terms, often to a point where no payment was expected unless the product shipped was resold.

 

 

Rights of Return

Several of the companies providing side letters to their customers permitted liberal rights of return. There is nothing inherently wrong with recognizing revenue in the presence of a return privilege. Even with returns, persuasive evidence of a sales arrangement can exist. In fact, most sales provide for some form of return. However, several conditions must be met before revenue with a return privilege can be recognized. In order to recognize revenue in the presence of a right of return, the sales price must be fixed or determinable and payment cannot be contingent on resale. In addition, the buyer must be economically separate from the seller, the obligation to pay must not be affected by the theft or destruction of the product sold, and, importantly, the seller must be able to estimate future returns.

Even without side letters, however, companies can get into trouble recognizing revenue when return privileges are offered. Typically, the problem arises because insufficient provisions for returns are recorded.

 

 

Related-Party Revenue

Underlying the SEC’s requirement for persuasive evidence of an arrangement before revenue can be recognized is the assumption that any sale agreement reached is the result of an arm’s length transaction negotiated with a separate entity that can pursue its own interests.

A related party is an entity whose management or operating policies can be controlled or significantly influenced. The related-party entity simply cannot pursue its own interests without considering those of the other party. Related parties include investees in whom a significant voting-share interest is held (typically 20% or more), trusts created for the benefit of employees, principal owners, management, and immediate family members of owners or management.

With related-party revenue, the issue is whether a sale would have taken place in the absence of the affiliation between the two parties. Has one party unduly pressured the other into the sales transaction?

No stipulations in revenue recognition policy preclude the recognition of revenue in such related-party situations. What generally accepted accounting principles do call for is full disclosure. That is, in related-party transactions, a reporting company must disclose the nature of the relationship, a description of the transactions, their dollar amounts, their effects on the financial statements, and amounts due to and from the related parties.38 Companies that have recognized revenue in related-party transactions without providing full disclosure of the relationship have drawn the attention of the enforcement division of the SEC.

 

 

Delivery Has Occurred or Services Have Been Rendered

This criterion of revenue recognition says effectively that revenue must be earned before it is recognized. Certainly the manner in which revenue is earned varies greatly depending on the nature of the product being sold or the service provided.

 

Sales Revenue

In the vast majority of cases in which products are sold, revenue is recognized at the time of shipment. Consider the revenue recognition policy employed by Hewlett-Packard Co.:

Revenue from product sales is generally recognized at the time the product is shipped, with provisions established for price protection programs and for estimated product returns.

 

The company recognizes revenue for product sales at the time of shipment, reducing the amount recognized for estimates of product returns. The provisions for price protection referred to in the note incorporate the effect on earnings of price concessions offered to resellers to account for price reductions occurring while inventory is held by them.

A policy of recognizing revenue for product sales at the time of shipment seems simple enough. However, it is interesting to see the extent to which variations on that theme, including some deceitful acts, are observed in practice.
The SEC stipulates several criteria that must be met before revenue can be recognized in advance of shipment. These criteria, which are summarized in below exhibit, also would guide revenue recognition for “BILL-AND-HOLD transactions”.

 

Criteria for Recognizing Revenue in Advance of Shipment

  • The risks of ownership have passed to the buyer.
  • The customer must have made a fixed commitment to purchase the goods, preferably in written documentation.
  • The buyer, not the seller, must request that the transaction be on a bill-and-hold basis.
  • The buyer must have a substantial business purpose for ordering the goods on a bill and hold basis.
  • There must be a fixed schedule for delivery of the goods. The date for delivery must be reasonable and must be consistent with the buyer’s business purpose.
  • The seller must not have retained any specific performance obligations such that the earning process is not complete.
  • The ordered goods must have been segregated from the seller’s inventory and not be subject to being used to fill other orders.
  • The goods must be complete and ready for shipment.

 

Source: Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (Washington, D.C.: Securities and Exchange Commission, December 3, 1999).

 
Thus, assuming that the exhibit criteria are satisfied, revenue can be recognized in bill-and-hold transactions. Problems do arise, however, when companies take shortcuts with some of the criteria specified by the SEC.

 

Customer Acceptance

In some sales, uncertainty may exist about customer acceptance of the product sold. For example, the customer may have the right to test the delivered product or to require the seller to perform additional services subsequent to delivery, or identify other work that must be done before accepting the product. To be effective, these conditions must be part and parcel of any sales agreement. Generally, revenue should not be recognized until all conditions of acceptance are satisfied or the rejection period has lapsed.

 

Service Revenue

Often a revenue transaction entails the provision of a service as opposed to the sale of a product. Here revenue recognition is dependent on completion of the promised services.

 

Up-front Service Fees

Some firms collect up-front fees for services to be provided over extended periods. As the related services are provided over time, revenue should be deferred and recognized as services are provided. In recent years there have been many examples where revenue related to up-front service fees has not been recognized over time. However, pursuant to the SEC’s new statement on revenue recognition, SAB 101, these firms are changing their methods of accounting for such up-front service fees. Membership shopping clubs are a case in point.

The Emerging Issues Task Force of the FASB addressed the topic and decided that in order to be able to recognize revenue and cost of sales rather than just an agent’s commission, a firm must be fully involved in a purchase and sale transaction. As such, the firm actually would purchase a product from a manufacturer or supplier at a negotiated price, take title to the product, establish a sales price and shipping charge, arrange for shipment, assume credit risk for collection and collect payment, ensure that products reach their customers, and process returns. If an e-commerce firm is not fulfilling these actions, then it is acting more as a sales agent, arranging a transaction between a buyer and seller, for which only a commission should be recorded.

 

Contract Accounting

When an extended period is required for completion of a product or service, contract accounting is commonly called for. While often contract accounting is considered relevant only for construction contractors, it is needed in many industries, including railroads, shipbuilding, road construction, various types of equipment manufacturers, engineering, and software.

With contract accounting, revenue is recognized in one of two ways: (1) the percentage- of-completion method, which recognizes revenue as progress is made toward completion, and (2) the completed-contract method, which recognizes revenue when a contract is complete. The percentage-of-completion method is the more popular of the two and should be used when reasonably dependable estimates of progress toward completion, contract revenue, and contract costs can be made. The completed-contract method is the default method and is reserved for those limited instances when dependable estimates of progress toward completion, contract revenue, and contract costs cannot be made.

According to available data, in the United States the completed-contract method is used in approximately 3% of all contracts. Note that with the percentage-of-completion method, revenue is recognized even before a product or service is formally delivered. The contractor recognizes revenue as progress is made toward completion. Estimates of progress must be made and typically are based on costs incurred as a percentage of total estimated contract costs.

As the contractor makes progress toward completion, costs incurred plus profit recognized, which have not been billed, are recorded as a current asset, commonly referred to as cost plus estimated earnings in excess of billings or, more simply, unbilled accounts receivable. As billing takes place, unbilled accounts receivable are reduced and accounts receivable are recorded.

The percentage-of-completion method can be abused by anyone interested in misleading financial statement readers. Aggressive estimates of progress toward completion can be made by increasing the costs incurred on a contract or through overly optimistic estimates of the costs to complete one (i.e., underestimating total contract costs). Either way, the completion percentage will appear to be higher, permitting the accelerated recognition of contract revenue.

 

The Seller’s Price to the Buyer Is Fixed or Determinable

Certainly in the vast majority of revenue transactions, there exists an agreed-on price for a provided product or service. Before revenue can be recognized, that fee must be a set amount that is not subject to refund or adjustment. Consider the revenue generated by membership shopping clubs mentioned earlier.

While a membership fee is paid up front, many of these clubs allow customers to cancel their memberships at any time during a membership term for a full refund of the fee paid. A strict interpretation of SAB 101 would say that because of the extended refund period, the membership fee is not determinable until the end of the membership period when the refund option expires. Revenue in such a transaction should be deferred until the end of the membership period.

The SEC did, however, soften its stance on this position. If the amount of a membership fee, exclusive of expected refunds, was fixed and reliable, estimates of refunds could be made for a large pool of homogeneous members on a timely basis using company-specific historical data, then membership fee revenue could be recognized over a membership term.

In some transactions, a customer may be given a payment term that extends over a substantial portion of the period during which the customer is expected to use or market the related products. The concern here is that the underlying product’s continuing value may be reduced due to the subsequent introduction of enhanced products by the vendor or its competitors. As a result, the vendor may be under pressure to offer the customer price concessions, refunds, or new products. In such situations, especially when the payment term extends beyond one year, revenue should not be recognized by the seller until collection is made.

In other transactions, a customer may be permitted to exchange a purchased product for another product over some extended period. As with extended payment terms, in the presence of such an exchange option, the original sales price cannot be considered fixed or determinable.

 

 

Collectibility Is Reasonably Assured

Closely related to a fixed or determinable sales price is the issue of whether the sales price is collectible or not. Collectibility hinges first and foremost on the transacting of business with a creditworthy customer.

Beyond the issue of whether a customer is creditworthy or not, collectibility can be questioned when customers are given payment terms that extend beyond one year or when collection is tied to some other event, such as the resale of the product or receipt of anticipated funding.

 

 

Detecting Premature Or Fictitious Revenue

A careful analysis can be helpful in detecting revenue that has been recognized in a premature or fictitious manner. Steps that are particularly useful in this regard are outlined below. These steps also may prove helpful in detecting revenue that has been recognized properly but whose sustainability nonetheless can be questioned.

 

Understand the Policy for Revenue Recognition

It is very easy to avoid a careful read of the footnotes that accompany an annual report. The small print and accompanying accounting terminology make the reading dense and slow-going. The notes, however, are a treasure trove of information about the company and the manner in which it accounts for the business it transacts. In particular, the first footnote, the accounting policy note, is a must-read. Among the accounting policies employed will be a company’s disclosed method of revenue recognition.

In reading the revenue recognition note, it is important to understand when during the term of a sale or service transaction revenue is recognized. For example:

  • is revenue recognized before delivery or performance?; If so
  • it is important to determine whether the revenue is, in fact, earned or not;
  • Is it recognized at the time of delivery or performance?

 

An affirmative response would help assuage questions about whether the revenue is earned. However, if some significant effort remains open, such as installation, training, or other post-sale support, then it is reasonable to expect that some portion of the revenue should be deferred.

  • Is there a right of return or price protection?
  • Has the company provided for potential returns?
  • For price protection, which grants customers automatic refunds or credits for declines in market prices, have sufficient allowances been made?

 

It is important to note that the more that estimates are used in the recognition of revenue—for example, in determining the amount of revenue to defer for installation, training, or other post-sale support, or in measuring the amounts of potential returns, or in calculating allowances for price protection—the more open that revenue becomes to creative accounting practices.

Beyond these questions, it is important to note whether there has been a change in the manner in which revenue is recognized. If so, is it now being recognized earlier than before or later? Why is that?

 

Answering these questions will provide a better understanding of a company’s revenue recognition policy. With a better understanding, questionable revenue recognition practices can be detected more readily.

 

Watch Accounts Receivable

Often, revenue that is recognized in a premature or fictitious manner is not collected. Accordingly, a balance sheet account, other than cash, will increase as this revenue is recognized. Typically that balance sheet account is accounts receivable. It is important to keep this relationship in mind because unusual increases in accounts receivable commonly accompany questionable revenue, whether due to uncertainties about the earnings process or about collectibility.

It is difficult to overstate the importance of checking the level of A/R days. An increase in accounts receivable that is faster than an increase in revenue is not a problem if it is for only a limited period and does not result in a collection period for accounts receivable that is significantly at odds with the credit terms being offered.

 

Steps Taken to Thwart Detection

Depending on their willingness to deceive financial statement readers, managers who take steps to recognize revenue prematurely or fictitiously also may attempt to cover up their acts. Aware that analysts will look for sustained relationships between sales and accounts receivable as part of their search for questionable revenue, unscrupulous managers may record artificial adjustments to accounts receivable to keep them in line.

It is important to remember that when revenue is recognized in a premature or fictitious manner, one or more accounts on the balance sheet must increase by a corresponding amount.

  • If accounts receivable is not used, then some other account must be selected. Typically, the related balance sheet accounts used are not cash or investments, because these accounts are more amenable to a precise verification.
  • Another unlikely candidate is inventory, because analysts will readily pick up problems as the reporting company’s investment in inventory grows to an outsize amount relative to its sales.
  • The more likely accounts to be used are the property, plant, and equipment accounts and other assets, which can include anything from prepaid expenses to land held for sale. These accounts tend not to be examined as carefully and as routinely as inventory and accounts receivable.
  • Companies also might offset an improper increase in revenue with a decrease in any number of liability accounts. Such an approach would be rare, however, because as revenue is increased, a liability would need to be reduced, eventually to zero, necessitating the use of some other account.

 

Thus, in detecting premature or fictitious revenue, it is important to remember that any balance sheet account—in particular accounts receivable and possibly property, plant, and equipment, and other assets—is a potential storage location for misreported amounts. Care should be taken in evaluating relationships among these accounts, in particular their relationship to revenue and their rate of change relative to the rate of change in revenue.

Calculated relationships (e.g., revenue divided by property, plant, and equipment) with revenue should be compared with industry norms and amounts for competitors. Explanations should be obtained for significant differences.

 

 

Consider Physical Capacity

Another factor to consider in evaluating whether revenue is premature or fictitious is whether the reporting company has the physical capacity to generate the amount of revenue being reported. Admittedly, a check on measures of revenue to physical capacity will be sensitive only to the more egregious cases of fictitious revenue recognition.

Update: As a supplement of this post, I provide separate checklist to detect premature or fictitious revenue recognition. You may find it useful.

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