In Fits and Starts, Revisions to Revenue Recognition

Companies may soon be allowed a faster way to recognize revenue on bundled product-and-service offerings, but it won’t necessarily be easier.

Reporting revenue on multiple-element arrangements has become fraught with complications as companies seek to add value to their products while accounting rules seek to curb revenue abuses. Most often, the tension results from scenarios such as a manufacturer that sells a piece of equipment with installation and follow-up support service included in the sale price.

Hanson

Accounting rules say the manufacturer must sort out the revenue from such a sale and allocate it to the various elements: how much of the revenue is for delivering a piece of equipment, how much is for installing it, and how much is for providing follow-up service, says Jay Hanson, national director of accounting for McGladrey & Pullen. The company can book revenue only as each specific element of the bundled arrangement is delivered. The idea is to match the timing of revenue recognition with the timing of the specific event that generated the revenue.

Restrictions exist on how to allocate the revenue to the various elements of such an arrangement, to assure that companies don’t report revenue prematurely when they still have future obligations to fulfill, says Mark LaMonte, senior vice president at Moody’s Investors Service.

One piece of accounting guidance, EITF Issue No. 00-21, says companies must provide “vendor-specific objective evidence” or “third-party evidence” of the selling prices of each element in a multiple-element arrangement to recognize revenue as each element is delivered. Vendor-specific evidence means the company has its own direct pricing of each element; third-party evidence means the company can produce direct evidence of what others charge for the same elements.

And if companies can’t produce such evidence? Then they can’t recognize the revenue for any of the elements until all of them are delivered—even if the follow-up service obligation extends well into the future, Hanson says.

“Abusive activities led to the demand for verification of management estimates … If they’re getting back to letting management estimate future revenue and income where it’s not verifiable, that’s a step backward.”

—Ross Watts,

Accounting Professor,

Massachusetts Institute of Technology

In many cases, that can be a high hurdle to clear, says Richard Paul, a partner with Deloitte & Touche. If a manufacturer doesn’t separately provide installation or service for such products, it doesn’t necessarily have a price sheet that would serve as direct evidence of the pricing. If competitors follow a similar business model, third-party evidence may be hard to get as well.

“This issue applies in many different industries and business models,” Paul says. “It’s an assessment a lot of companies go through, depending on the product and lot of different factors. It does come up an awful lot.”

Catching a Break

Those evidence restrictions may soon be relaxed, however, giving companies more latitude to use internal estimates of selling prices when direct pricing information is unavailable. That will lead to more judgment—which typically means more audit tension and definitely means more disclosure, Hanson says. “Preparers will absolutely like it,” he says. “Auditors are going to struggle with it.”

Hanson and LaMonte both are members of the Emerging Issues Task Force of the Financial Accounting Standards Board, which could soon recommend the relaxed approach to FASB. The EITF has published a proposal, EITF Issue No. 08-1, “Revenue Arrangements with Multiple Deliverables,” and is seeking comment through mid-August. PricewaterhouseCoopers is alerting its clients to study the proposal and comment on it because of its implications for altering revenue recognition.

EITF WANTS YOUR INPUT

The Emerging Issues Task Force specifically requests that constituents comment on the following questions:

With respect to Issue 08-1:

1. Do you agree with the Task Force’s decision to address this Issue considering the

potential overlap between this Issue and the FASB and IASB joint project on revenue

recognition?

2. Do you agree with the Task Force’s decision to eliminate the residual method of

allocation and require a vendor to allocate arrangement consideration at the inception of

an arrangement to all deliverables in the arrangement using the relative-selling price

method? Is the relative-selling price method operational and does it provide a principle

that could be applied consistently?

3. Issue 08-1 significantly expands the disclosures that are required relating to multiple-

deliverable revenue arrangements (including those arrangements affected by Issue 09-3).

a. Do you agree that the disclosures in the consensus-for-exposure would provide

useful information for financial statement users? If you do not believe those

disclosures would provide useful information, what disclosures should be required

and why would they be useful?

b. Are there additional disclosures that would provide useful information for

financial statement users relating to multiple-deliverable revenue arrangements

that the Task Force should consider requiring?

4. The Task Force discussed whether these disclosures should also include the effects of

changes in selling prices, allocation methods, or assumptions if they have a significant

affect on profit margins but decided not to require such disclosure. Should the disclosure

requirements of Issue 08-1 be expanded to include disclosure of the effects of changes in

selling prices, allocation methods, or assumptions on profit margins, if significant?

5. Do you agree that this Issue should be applied on a prospective basis for revenue

arrangements entered into or materially modified in fiscal years beginning on or after

June 15, 2010, with earlier application permitted as of the beginning of a fiscal year

provided the vendor has not previously issued financial statements for any period within

that year?

6. The consensus-for-exposure requires an entity to disclose in the year Issue 08-1 and/or

Issue 09-3 are adopted, the amount of revenue recognized under those Issues and the

amount of revenue that would have been recognized had the entity applied Issue 00-21

and/or SOP 97-2. The Task Force believes that this information is necessary to describe the affect of the adoption of these Issues to financial statement users. Do you agree with that decision?

With respect to Issue 09-3:

7. Do you agree with the Task Force’s decision to address this Issue considering potential

overlap between this Issue and the FASB and IASB joint project on revenue recognition?

8. Do you agree with the Task Force’s decision to modify the scope of SOP 97-2 to address software enabled devices rather than to address broadly the measurement and separation criteria within SOP 97-2?

9. Do you agree that the scope modification of Issue 09-3 is operational and can be applied consistently? If not, why not?

10. If your answer to Question 10 is no, is there a better way to modify the scope of SOP 97- 2 to improve financial reporting for software enabled devices while retaining the use of SOP 97-2 for software transactions?

11. Do you agree that this Issue should be applied on a prospective basis for revenue

arrangements entered into or materially modified in fiscal years beginning on or after

June 15, 2010, with earlier application permitted as of the beginning of a fiscal year

provided the vendor has not previously issued financial statements for any period within

that year?

Responses from interested parties wishing to comment on the draft abstract must be received in writing by August 14, 2009. Interested parties should submit their comments by e-mail to director@fasb.org , File Reference No. EITF0801&0903. Responses should not be sent by fax.

Source

FASB Emerging Issues Task Force on Issue 08-1 and Issue 09-3 (July 7, 2009).

Hanson says the requirement for vendor-specific or third-party evidence of pricing often leaves companies unable to recognize revenue for the delivery of a product in a multiple-element arrangement—even though that element of the transaction has clearly occurred. “There have been lots of situations where that has given an accounting answer that didn’t match the economics,” he says.

The ability to use estimated selling prices will ameliorate such vexing situations and will accelerate revenue recognition, Paul says. “If they struggled to meet the criteria in [EITF No. 00-21], then the answer is yes, they will recognize revenue faster,” he says.

Lamonte

Coming up with internal estimates for selling prices where none already exist will require management judgment, LaMonte says. The guidance is expected to provide some examples of how it might be done, but it won’t provide details or prescriptive requirements, he adds.

“If companies are effectively managing their business, they know how to price their products,” LaMonte says. “They know what it costs to deliver something and what their margins are, so they should be able to effectively build and develop a solid rationale for selling price.”

With the added judgment comes added disclosure, Paul warns. “The key really is the disclosure requirement,” he says. “I’m afraid people may become focused on the accounting changes and may miss just how significant a change the disclosures would be.”

And when Paul describes the necessary disclosures as “significant,” he isn’t kidding: The EITF’s new proposal includes an example of such disclosure. It runs four pages long.

In fact, Paul says the EITF should be ready for criticism from companies that, as much as they clamor for the flexibility to estimate selling prices, won’t like the complexity the new guidance introduces into the reporting process. “I won’t be surprised if a lot of companies feel that way,” he says. “I expect them to.”

Hanson and LaMonte both say the new approach would be consistent with the direction FASB and the International Accounting Standards Board are taking on revenue recognition. The two boards have published a joint discussion paper mapping out a broad vision for a future standard on revenue recognition, and so far the boards assert that companies should generally recognize revenue as they fulfill performance obligations.

That discussion paper also says, however, that companies should not recognize revenue related to a contract until the contract obligations are fulfilled. Paul says the contradiction between those two principles still needs to be resolved.

Watts

Ross Watts, an accounting professor at the Massachusetts Institute of Technology who has studied the discussion paper, says the idea of allowing more management estimates into the revenue recognition process is a departure from more contemporary thinking. “Abusive activities led to the demand for verification of management estimates,” he says. “If they’re getting back to letting management estimate future revenue and income where it’s not verifiable, that’s a step backward.”