2/6/2008
Revenue Recognition
© E J Walsh, 2006
The Basic Rules
.... And what went wrong
FUNDAMENTALS OF
REVENUE RECOGNITION
Revenue Recognition Principles
• RT NYC – Sydney - $400
• Property
• Buy property 100 units at $100K
• Refurbish $50K per unit
• Sell at 300K or 18K payable end of each year for
25 years (APR = 3.5%)
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Recognition of revenue – US GAAP
•
SFAC 5 - Recognition & Measurement
Revenue must be
•
•
•
Realised - when products are exchanged for cash
or claims to cash
Realisable - when assets received are readily
convertible to cash
Earned - when the entity has substantially
accomplished what it must do to be entitled to the
benefits represented by the revenues
Guidance – US GAAP
• The basic theory for revenue recognition is
included in the Statements of Financial
Accounting Concepts (SFAC)
• SFAC 5 - Recognition & Management
• SFAC 6 - Elements of Financial Statements
• No overall revenue standard exists, more than
140 pronouncements issued by various
standard setters (SEC, FASB, AICPA)
Recognition of revenue – US GAAP
Examples:
a) Recognise at delivery if product is delivered or
services rendered
b) If sale or cash receipt precedes delivery (e.g.
c)
d)
magazine subscriptions), recognise when produced
and delivered
If contracted for before production, recognise by a
percentage-of-completion method as production
takes place if reasonable estimates are available
If rights to use assets extend continuously over time
(e.g. interest or rent), recognise as time passes
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Recognition of revenue – US GAAP
Examples:
a) If product, services, or other assets are exchanged
b)
for non-monetary assets that are not readily
convertible into cash, revenues or gains or losses
may be recognised on the basis that they have been
earned and the transaction is completed if the fair
values can be determined within reasonable limits
If collectability of assets received is doubtful,
revenues and gains may be recognised on the basis
of cash received
Revenue recognition – US GAAP
• FASB recognition criteria:
Generally, the ‘Full Accrual’ Method is required
Type of Revenue
Recognition Criteria
Sale of products
Date of delivery
Services
Performed and billable
Use of assets
Passage of time or usage
Asset disposal
Date of sale
AND WHAT WENT WRONG ...
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Primary issue: Timing and
Measurement of Revenue
• Recently, revenue recognition has been
one of the most likely source of
disagreement between issuers and the
SEC
• Revenue recognition related
restatements account for 20% of the
1390 restatement announcements
identified from July 2002 – September
2005.
Restatements Increasing
Revenue Recognition Important
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Economic Consequences – 90 Day
Economic Consequences – contd.
But…Subtle Changes since 2002
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Microstrategy - Software
What went wrong?
• The basic principles for revenue recognition are
unambiguous and straightforward
• Recent problems due to:
•
•
•
•
Increasingly complex business practices
Shift from manufacturing to a service economy
Compensation packages being linked to share price
and earnings
In some instances, auditors have capitulated to
clients to facilitate earnings management
BBQ Example
• Shipped barbecue grills to retailers during the
fall and winter of 1996–97
• Allowed to defer payment until they had sold
the grills.
• Allowed to return any unsold goods.
• Picked up the tab for the warehouses where
the grills were stored for the winter
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Substantive similarity to Consignment
• Buyer has lengthy return right
• Payment is substantially contingent on resale
of the product
• Seller is required to repurchase the product at
•
a specified price; and
Buyer does not assume risks of ownership
due to future product pricing concessions
Trade Loading
• Bristol Myers Squibb – many of the products
•
•
consumed at a constant rate (e.g. blood
thinner)
Sales growth a key indicator of future
performance
Sales incentives at end of quarter to
encourage wholesalers to accept more
product
BMS – Sales Growth
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2/6/2008
Widespread concern with …
• revenue is reported in the incorrect period
•
(“cutoff” errors)
revenue is recognised although never
actually earned
The Four Criteria
THE SEC GUIDANCE
SAB 104 Overview
• Why Do We Need SAB 104?
•
•
•
FASB has never issued a specific standard on
revenue recognition
Many cases of inappropriate recognition have led to
enforcement cases
SAB 104 does not depart from FASB requirements,
but provides guidance in specific cases
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SAB 104 Overview
• SAB 104 and Non-Public Companies
•
•
•
SEC rules and guidance are established for public
companies
To the extent that SEC rules provide insights into
standards found in the GAAP hierarchy, they should
always be followed
If no other source material in the GAAP hierarchy
exists, SEC pronouncements are considered
authoritative for all reporting entities
SAB 104 Overview
• Revenue generally is realized or realizable and
earned when all of the following criteria are met:
•
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
SAB 104 Overview
• Revenue is NOT recognized if
•
Title and risks and rewards of ownership have not
transferred
•
Revenue is contingent on meeting performance
factors that have not been realized
•
•
An enforceable claim does not exist
•
Individual elements of a multiple element
arrangement do not satisfy certain criteria
Activity does not constitute a “separate earnings
process”
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GOING FORWARD
Going Forward
• FASB Project
• Replace Earnings Process Model with
Asset/Liability Model
• e.g. Revenue is an increase in a contract asset or
a decrease in a contract liability (or a combination
of the two) that results from providing goods and
services to a customer.
• Aiming to issue Preliminary Views Q2 08
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