Revenue-Recognition Weaknesses

It’s clear that the sweeping reforms in accounting and financial reporting ushered in by Sarbanes-Oxley is exposing a wide range of problems for companies to address—ones that go well beyond crackdowns on cooking the books, but also a panoply of sloppy practices and a general misapplication of Generally Accepted Accounting Principles.

Carcello

Take revenue recognition. Intuitively, it would seem simple enough for a company to tally up its sales and put a figure on paper. “If it’s a cash-based business and we’re auditing McDonald’s, it’s hard to imagine how a company could mess up revenue recognition,” says Joseph Carcello, director of research at the the University of Tennessee’s Corporate Governance Center. “I give you 2 bucks, you give me a hamburger. That’s revenue.”

But, as is true with so much in the post-SOX world, nothing is as simple as one might assume it should be. That $2 burger might be subject to a return, for example, if the customer was unhappy to find it dressed with pickles.

“You can sell it and even get paid for it, and you still don’t have revenue,” says Lynne Triplett, partner-in-charge of accounting principles for Grant Thornton. “It’s very fact-and-circumstances specific.”

Revenue recognition rules are scattered among more than 200 different pieces of accounting literature throughout GAAP, documents issued by the Securities and Exchange Commission, the Financial Accounting Standards Board, its Emerging Issues Task Force, and the American Institute of Certified Public Accountants. Sarbanes-Oxley didn’t necessarily make the accounting of revenue any more complicated—that’s been a headache for corporate accountants and auditors for years, experts say—but has exposed companies’ inability to apply the rules precisely and adds a measure of urgency to iron out complexities.

In a Compliance Week analysis of 400 companies that disclosed material weaknesses in internal control over financial reporting in 2005, 58 said they had problems with the proper recognition of revenue from goods and services. Companies wrestled with a host of other accounting problems as well, like taxes, cash flow, leases, derivatives, and many other issues that tripped up internal controls and led to findings of material weaknesses.

Revenue recognition, however, is the red flag that most easily raises an eyebrow at the SEC.

Selling

“It’s well-understood that revenue recognition in financial reporting is responsible for a significant majority of enforcement cases for the SEC,” says Tom Selling, a financial-reporting consultant.

Where Complexity Comes From

A variety of forces converge to make revenue recognition so problematic and significant to regulators. It is the biggest number in the financial statements, yet no single, comprehensive standard governs it, and the relevant guidance is widely dispersed throughout GAAP. It’s also been a prime target for executives bent on managing earnings and is touched not just by a select few in upper management, but also by people at a variety of levels and functional areas throughout a company.

Ernest Dixon, a director at Navigant Consulting, says a number has to meet four basic criteria to be added to revenue in a given period: you must have a contract with a customer; you must deliver the product or service; you must know the price of the product; and you must ensure that you collect the amount due.

Then there are “hundreds and hundreds of pages of guidance” regarding how those principles are applied in different industries and under different circumstances, he says.

Software and other technology companies endure some of the most complicated revenue-recognition rules, Dixon explains, because of the nature of the business and the various criteria that must be met for a transaction to qualify as a sale.

GUIDANCE

Excerpts from FASB’s project-plan update on developing conceptual guidance for revenue recognition follows.

OBJECTIVES AND SCOPE

The objective of this project is to develop coherent conceptual guidance for revenue recognition and a comprehensive Statement on revenue recognition that would be based on those concepts. In particular,

[T]he project intends to improve financial reporting by:

Eliminating inconsistencies in the existing conceptual guidance on revenues in certain FASB Concepts Statements

Providing conceptual guidance that would be useful in addressing revenue recognition issues that may arise in the future

Eliminating inconsistencies in existing standards-level authoritative literature and accepted practices

Filling voids in revenue recognition guidance that have developed over time

Establishing a single, comprehensive standard on revenue recognition.

There are a variety of practical and conceptual reasons that support the Board's decision to address revenue recognition in this project, including:

Much of existing US GAAP for revenues was developed before the Conceptual Framework.

US GAAP contains no comprehensive standard for revenue recognition that is generally applicable.

US GAAP for revenue recognition consists of over 200 pronouncements by various standard setting bodies that is hard to retrieve and sometimes inconsistent.

Despite the large number of revenue recognition pronouncements, there is little guidance for service activities, which is the fastest growing part of the U.S. economy.

Revenue recognition is a primary source of restatements due to application errors and fraud. Those restatements decrease investor confidence in financial reporting.

As business models evolve or emerge, selecting the appropriate literature becomes more difficult because much of the existing guidance is transaction-specific or industry-specific.

Financial statement users face noncomparability among entities and industries, with little information to assist in identifying and adjusting for the differences.

Accounting policy disclosures are too general to be informative.

Revenue data are highly aggregated, and users say they would like more details about specific revenue-generating activities.

IMMEDIATE PLANS AND NEXT EXPECTED DUE PROCESS DOCUMENT

The Board's goal is to issue a Preliminary Views in the second half of 2007 covering both concepts- and standards-level revenue recognition guidance.

Source

FASB Revenue Recognition Project Update (Oct. 6, 2006)

When a company sells software, for example, the customer also usually receives rights to support services and perhaps upgrade options. Those offerings obligate a company to do more work after the initial sale, so it hasn’t fully delivered and therefore can’t fully recognize the sale price as revenue. Companies that extend such follow-up offers must establish fair values for the various deliverables and recognize them only after each element of the promise is fulfilled.

In addition to the sheer complexity of such a transaction, Triplett says companies often use systems that simply don’t keep adequate revenue records, and they don’t always account for side agreements that affect the proper accounting for revenue.

It’s also not uncommon, Triplett and Dixon say, for sales or marketing staff to make oral agreements with customers that may disqualify a sale for revenue recognition in some certain period, or at all—whether it’s done intentionally to meet a sales target or unintentionally simply to accommodate a customer.

It could be that the sales staff promises special payment terms, extraordinary rights to return product, an extended warranty, special financing, a trial period, or other exceptional terms that disqualify the sale for revenue classification based on accounting rules, Dixon says.

“It may not even be in a crooked sense,” Triplett says, “but they’re compensated to sell, so they do what they can to sell.”

Sometimes, however, the sales staff crosses the line, says Charles Mulford, director of the Financial Analysis Lab at Georgia Tech University. “Some of the special provisions can be quite outlandish,” he says.

Mulford

Sales staff may offer to bill a customer and hold the product for future shipment, or simply require no payment just to book a sale, Mulford says. They may offer to take back or buy back the product, or they may entice customers with better-than-usual terms to buy larger-than-usual quantities. Such side deals, if not reported to the finance function, result in revenue being recognized where it hasn’t been earned in accordance with accounting rules.

Those side deals can be tough to spot, Carcello adds. “There are lots of ways of overstating revenue inappropriately,” he says. “It’s not always easy for an auditor to detect that, particularly if the [purported customer] colludes with management to mislead the auditor.”

Mulford believes that before SOX, revenue-recognition problems usually were rooted in efforts to manage earnings. “Now as we get better controls on revenue recognition issues, I think it’s less about gaming and more about just getting things fixed,” he says. “It’s more about fixing errors and uncertainties around revenue recognition.”

Getting Out Of The Woods

The experts have lots of advice for companies that need to get a better handle on revenue recognition.

Howell

For starters, keep current with continuing education, says Jay Howell, an associate director of assurance for tax consulting firm BDO Seidman. “I’m continually surprised by the number of people in industry who are not getting outside training on technical accounting issues,” he says. “I often see a correlation between accounting restatements and whether the CPAs at the company are proactively maintaining education requirements.”

In addition, Howell says companies need to take what GAAP requires and write their own, reader-friendly revenue-recognition policy so people outside accounting whose duties impact the revenue figures understand what they can and can’t do.

Triplett says companies need a process so different contractual arrangements can be evaluated from an accounting perspective to assure that they are allowed by accounting rules. Then they need to assure that the evaluation process is well documented so it will withstand audit scrutiny.

Carcello says companies may need more training for their sales force to assure that they understand the accounting implications of any side deals they may offer customers. “This is where the company would say we want to push sales, but we don’t want to do it illegally,” he says. “Show examples of how revenue has been gamed or abused in the past and establish a policy. Communicate that if there’s evidence of this behavior, the person is terminated.”

Meanwhile, FASB is picking away at a long-term project in conjunction with the International Accounting Standards Board to develop a single, comprehensive standard that would establish the governing principles of how companies recognize revenue.

“FASB wants to move away from a performance-based model toward an asset-liability-based model,” Selling explains. “They want to achieve symmetry between expense recognition and revenue recognition.” That would enable the software company offering lots of follow-up services and options the freedom to call the upfront payment revenue, even if additional duties must be discharged related to that revenue down the line.

While the market might welcome simplification, experts say it’s a tough promise to deliver, and it’s years away from having any consequence to the reporting process. FASB opened the project two years ago but hasn’t issued any significant findings.

“It’s too early to say whether this will result in significant simplification, but my guess is that this area of accounting will remain fairly complex,” Howell says.