SEC Warns on New Interpretations of Revenue Rules

Rigid accounting rules for revenue recognition may be giving way to more use of judgment, but the Securities and Exchange Commission is warning companies not to get carried away.

The increasingly common practice of bundling goods and services into a single product (think the iPhone with its two-year contracts, or a product with a service plan) is a case in point. Recognizing revenue from bundled products has long been difficult, as companies struggled to determine how much “product” had been delivered and how much revenue they could therefore recognize in a reporting period.

Under old rules, companies couldn’t recognize revenue for any part of a bundled arrangement until the entire thing was delivered, unless it met strict pricing criteria. Among the more restrictive rules, companies had to have objective evidence, either from their own business or from a competitor’s, about how the individual parts of a bundled product would be priced if they wanted to recognize the revenue over time.

With the 2010 reporting year, however, the Financial Accounting Standards Board has dropped that restriction. Companies now have more latitude to use some judgment and establish a fair value for individual elements, even if objective evidence is hard to come by—and that inspired SEC staff to take a closer look at revenue recognition practices when it met with the accounting industry last December.

At a national conference of the American Institute of Certified Public Accountants, SEC staff reminded attendees that plenty of guardrails still exist around when and how to recognize revenue. Arie Wilgenberg, professional accounting fellow for the SEC, said companies must continue to pay close attention to whether the individual elements in a bundled product have stand-alone value to the customer. “Stand-alone value” means the item or service delivered is typically sold in pieces, and the customer who purchased it could resell those parts individually, he said.

That might lead to some straightforward analysis when the bundled product involves tangible goods and follow-up services. But it may be fuzzier, Wilgenberg said, when the arrangement mixes, say, technology licensing with research and development services. Depending on the specific arrangement, the license and the R&D services may not have stand-alone value. “The analysis of standalone value must be based on the individual facts and circumstances for each arrangement,” he said.

Joshua Forgione, an associate chief accountant at the SEC, pondered how the new rules will interact with “bill and hold” allowances that have been mapped out by SEC staff over the years in a series of staff accounting bulletins. Bill-and-hold exceptions allow companies to recognize revenue for goods that have been produced and sold to a given customer, but haven’t yet been shipped for any number of common business reasons.

The SEC has long held that even “inconsequential or perfunctory” tasks associated with fulfilling a customer’s order must be completed before a company can recognize revenue under a bill-and-hold exception, Forgione said. In light of the new rules for chopping bundled products into individual pieces, he warned companies not to carve those inconsequential or perfunctory tasks into their own elements, put them aside, and then recognize revenue on everything else.

BILL-AND-HOLD RULES

Below is an excerpt from SEC Associate Chief Accountant Joshua Forgione’s speech at the AICPA National Conference.

Typically, it would not be appropriate to recognize revenue in advance of the seller satisfying performance obligations pursuant to the terms of an arrangement which generally would not occur until delivery of the product to its customer or until services have been rendered. However, in certain situations a customer may purchase goods, but for various reasons the customer may not be ready to take delivery of the product and requests that the seller hold the product for delivery at a later date. In these limited situations, the SAB provides the staff’s views as to certain criteria that should be met in order to recognize revenue prior to shipment or delivery. At the time SAB 101 (as amended by SAB 104) was issued, these views were not new and reflected the criteria set forth in various Commission enforcement cases, including Accounting and Auditing Enforcement Release (AAER) No. 108. Practically speaking, these views are an exception to the general revenue recognition criteria related to delivery and performance.

There may be instances where a customer has requested that a product be held on a bill and hold basis but for various reasons the product itself was not complete or in its final form. In this circumstance, I’ll highlight two bill and hold criteria in the SAB that would generally preclude revenue recognition if not met:

First, the seller must not have retained any specific performance obligation such that the earnings process is not complete; and

Second, the equipment or product must be complete and ready for shipment.

Let me provide an example to help illustrate these arrangements, particularly when the vendor has retained performance obligations related to the product to be delivered. Assume a vendor has an existing supply arrangement with a customer that requires the customer to purchase a minimum amount of product on a quarterly basis. Current market conditions have led to both a decline in the customer’s sales and product orders as well as a corresponding increase in inventory levels and lack of storage capacity. Although the customer’s current sales volume supports its continued need to purchase product from the vendor and it has a fixed commitment to do so, the customer requests that all purchases subject to the fixed commitment be held. The vendor holds the goods in an unfinished state because it is less costly to do so and the additional processing is usually done just prior to loading the goods for shipment.

In evaluating the bill and hold criteria in the SAB, the vendor concludes that it meets most of the criteria except that it retains certain performance obligations related to the product such that the product is not in its final form for delivery as specified and requested by the customer. Under these circumstances, we’ve considered questions on the application of the bill and hold criteria, including possible interaction of those criteria with other revenue guidance on inconsequential or perfunctory performance obligations and multiple-element arrangements.

The concept of inconsequential or perfunctory is based on the premise that the terms of the arrangement are substantially complete in order for delivery or performance to be considered to have occurred. So, assuming all other revenue recognition criteria are met, it would be appropriate for a Company to consider whether post-delivery performance obligations related to a product are inconsequential or perfunctory. However, it would generally be inappropriate to assert that the effort required to complete the product prior to delivery is inconsequential or perfunctory when the product has not been delivered to the customer and additional processing is necessary to complete the product prior to shipment.

With respect to multiple element arrangements, vendors often enter into arrangements where they provide multiple products and services to their customers. As I’m sure many of you are aware, the FASB has recently issued an update to Codification Topic 605 to codify the consensus reached by the EITF concerning how to separate, measure and allocate arrangement consideration to one or more units of accounting. Without getting into too much detail on the codification update, the consensus reached by the EITF will generally require more separation of multiple-element deliverables than previously allowed.

Source

Joshua Forgione Speech (Dec. 7, 2009).

Howell

Jay Howell, a partner at BDO Seidman, said that situation might arise when an equipment manufacturer produces a machine that the customer isn’t prepared to receive until a construction project is complete. The producer may need to do some final tuning or calibration on the equipment immediately before it is shipped, he said.

Forgione responded that such a product would not qualify for the bill-and-hold exception under new guidance any more than under the old guidance. “Since the product is not complete or in its final form, a conclusion that identifies an incomplete product in the manufacturing process as a separate deliverable, in an attempt to satisfy the bill-and-hold criteria, is questionable,” he said. “In order to qualify for revenue recognition on a bill-and-hold basis, the product held must be in the form that the customer will receive upon delivery.”

Fox

The SEC has kept a tight rein on bill-and-hold exceptions, says Bert Fox, a partner at Grant Thornton. “Bill-and-hold is a rules-based exception,” he says. “To qualify for the exception, you must meet the exception 100 percent.” That SEC staff chose to address it at the AICPA annual conference suggests that it’s still an area of confusion or uncertainty, he adds.

Thomas Murphy, a partner with Crowe Horwath, says he advises companies to write explicit contracts with customers to facilitate revenue recognition. “They have to be very clear about what activities have to take place before, during and after a sale,” he says. “That helps determine whether revenue gets recognized at the time of shipment or not.”

Doolittle

Sam Doolittle, a partner with Deloitte & Touche, says Forgione’s remarks are a good reminder for companies that the bill-and-hold exceptions for revenue recognition are stringent, regardless of the new rules on bundled products.

Meanwhile, FASB and the International Accounting Standards Board are still working on a more comprehensive review of revenue recognition requirements. So far, Doolittle says, it appears to be headed in the same general direction as FASB’s most recent guidance: Companies likely will be allowed to recognize revenue for complex offerings based on their estimates of the fair value of the various elements, and they won’t be required to produce objective evidence of pricing.

“There’s a lot that’s moving around right now, so companies will need to stay tuned to where that project is headed,” he says.

Howell says the SEC has always taken a narrow view of the bill-and-hold exceptions that allow revenue to be recognized sooner than otherwise might be allowed. “The purpose of this is to say this is an area of judgment, but you need to be aware that [the SEC] is looking at this narrowly,” he says.