Revenue Recognition Essay

The issue of revenue recognition practices is an area that has received a lot of attention from regulators. Whenever there is a report of financial restatements or negative earnings, regulators pay extra attention to review the financial statements in order to verify that that there are not any indications of financial fraud or that the organization overstepped their boundaries in the area of managed earnings. The reason that regulators have taken a special interest in financial accounting and potential fraud is due to the collapses of companies such as Enron, WorldCom and Tyco. Regulators and those in the accounting profession are focusing their efforts on the causes of fraud as well as the steps that can be taken to effectively detect and prevent a possible reoccurrence of fraudulent behavior especially in the area of revenue recognition and the overstatement of assets. Revenue recognition refers to the time when transactions are recorded on the books, Per Generally Accepted Accoun ting Principles (GAAP), revenues, and gains, are generally recognized when: 1. Revenues are realized or are realizable 2. They have been earned the substantial completion of the activities involved in the earnings process. Both of these items are typically met at the point of sale, which generally occurs when goods are delivered or when services are rendered to the customer. Usually revenues and assets are recognized simultaneously. However, assets can be received before the conditions of revenue recognition are met. One example would be if a customer pays in advance for goods or services which will be received at a later date. Even though the cash is received and is recorded as an asset in the company’s books, the revenue has not been earned. Typically the revenue is not recognized prior to a sale because either the customer has not paid for the goods yet or because the goods have not been delivered to the customer. The main exception to not recognizing revenue prior to a sale would be when a contract exists that guarantee the sale or that the customer has promised a valid promise of payment such as when both the seller and the buyer are legally obligated to fulfill the term of a contract (Parizek & Findley, 2008). Another exception to the revenue recognition rule occurs when a product or service may be provided to the customer without receiving a valid promise of payment. This typically occurs with a family dentist who provides services to ease a patient’s pain and then tries to collect the  payment later. Also, if a company has a substantial amount of services to provide even though the customer has provided a substantial payment, the company must wait to recognize the revenue. It is not enough that one of the criteria for recognizing revue is met; both items must be satisfied in order for the recognition of revenue. Because every income statement begins with total revenue, how revenue is measured is a fundamental concept in the field of accounting and as such, the topic of revenue recognition has received a lot of attention over the course of the past few years. The American Institute of Certified Public Accountants (AICPA) has produced specific guides to help with the topic of revenue recognition in specific situations in certain industries. The AICPA Statement of Position (SOP) 97-2, â€Å"Software Revenue Recognition† contained the following four items (Parizek & Findley, 2008): 1. Persuasive evidence of an arrangement exists 2. Delivery has occurred. 3. The vendor’s fee is fixed or determinable. 4. Collectability is probable. These four items were used as the framework in the SEC Staff Accounting Bulletin No. 101. The SAB 101 is a very unique and interesting bulletin because it provides specific cases and then proceeds with a questions and answer format. SAB was created in large part to the issues that the staff had encountered in while conducting a review. Because SAB 101 addresses specific situations, it cannot be used as an answer to every instance of revenue recognition, but it does provide a comprehensive guide for companies to use as a form of direction when faced with dealing with a complicated situation such as when there is persuasive evidence of an arrangement, delivery of goods has already occurred or services have been rendered or when the price is fixed or determinable (SEC, 1999). Questions 1 and 2 of SAB address the topic of Persuasive Evidence of an Arrangement and highlight how a seller could be tempted to bend the rules of revenue recognition in order for a more favorable time in which the sale is reported. The first question exhibited the case in which Company A required each sale to be supported by a written sales agreement signed by an authorized representative of both the customer and Company A. This issue was if Company A could recognize the revenue in the current quarter even if the  sales agreement would not be signed until a few days after the quarter had ended. This question highlighted the need for companies to have strong internal controls and the need to a reliable system to be in place for processing contracts. Without a strong internal control structure as well as clearly documented procedures, there is a possibility of managers becoming tempted to adjust how revenue is recognized based on the needs of the quarter. Questions 3 and 4 reviewe d the issue of ownership of goods and when the transfer had effectively taken place. Question 4 reviews the case of Company R that is a retailer that offers layaway sales to its customers. For the layaway option, a customer pays a portion of the sales price and Company R holds onto the merchandise until the customer returns to pay the balance remaining on the merchandise. Once the merchandise is paid in full, the customer can take possession of the merchandise. This case is an example of what is referred to as a ‘bill and hold’ arrangement where the customer is billed for the merchandise but the merchandise is held by the company for release or shipment at a later date. Question 4 is also an example of how some companies could manipulate their inventories at the end of a quarter. A company could increase revenue by pushing some of its merchandise in the warehouse aside and claim that it has already been sold but were being held for the customer. In order for the company to recognize the revenue they must be able to show that the merchandise is completely separate from its other merchandise and cannot be used for any other order. The company also must be able to show that the customer specifically requested in writing that the company hold the merchandise. Questions 5 and 6 reviewed revenue recognition when the company must perform several activities. Question 5 asks the question as to when Company H should recognize the revenue from an upfront, nonrefundable fee for an extended service contract along with regular, monthly payments. SAB 101 illustrates how the nonrefundable fee cannot be treated separately and must be treated as a part of the overall unit because no one would pay a deposit without expecting additional goods or services to follow (SEC, 1999). The questions 7, 8 and 9 in SAB 101 describe situations where the price may not fixed or determinable in the transaction. Question 8 describes how Company A owns a building and leases it to a retailer. The annual lease payment is $1.2 million plus one percent of all the retailer’s sales in excess of $25 million. It is probable that  sales during the year will exceed $25 million. Should Company A estimate and recognize revenue associated with the one percent of the sales over $25 million on a straight-line basis throughout the year? Because the buyer does not have any fixed or determinable obligation to make a payment until the $25 million sales level has been reached, none of the extra revenue can be estimated and recognized in advance. Question 10 in SAB 101 does not deal with when revenue should be recognized but instead how the revenue should be reported on the income statement. Question 10 discusses the situation where Company A operates an internet site where customers can order the products of another company, Company T. Company T ships directly to the customers and Company A never has any ownership of the merchandise but company A does receive a portion of each sale that Company T makes. Since Company A never takes legal ownership of the merchandise, it would be inappropriate for them to use the gross revenue reporting method where they would report $175 in revenue and $150 in cost of goods sold. Instead Company A should report the money that it earns from each sale as commission revenue. SAB 101 is not the only work that has tried to address the issue of revenue recognition. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are working together on joint project that would create a single standard for revenue recognition. The project is intended to solve issues in the differences between U.S. GAAP and International Financial Reporting Standards (IFRS). FASB has listed the following six for the project (FASB,2012): 1. Converging U.S. and international standards on revenue recognition 2. Eliminating inconsistencies in the existing conceptual guidance on revenue recognition. 3. Providing conceptual guidance that would be useful in addressing future revenue recognition issues. 4. Eliminating inconsistencies in existing standards-level authoritative literature and accepted practices. 5. Filing voids in revenue recognition guidance that have developed over time 6. Establishing a single, comprehensive standard on revenue recognition In creating a new revenue recognition standard, the FASB and the IASB have adjusted their focus to realization and earnings approach instead of focusing on an asset and liability approach. To assist companies with the changes, FASB issued a proposal that broke down the revenue recognition process into five steps. The first step would be to match the  contract with the customer. The second step would be for the company to identify each step of the transaction with the customer. Third, the company would have to identify the transaction price of each separate act or obligation. In the fourth step, the company reviews how much it expects to receive for preforming each step with the company recognizing the revenue in the final step once the merchandise has been transferred to the customer (FASB, 2012). The work between FASB and IASB is still a work in progress but has strong support from several groups in the accounting community some of which have already laid a foundation to work from. In 1998 former SEC Chairman Arthur Levitt delivered what is now considered to be a famous speech titled â€Å"The Numbers Game† in which he expressed great concern over how many companies engage in the practice of earnings management. In his speech Mr. Levitt identified several major accounting techniques that he thought were being used to undermine the integrity of financial reporting(Levitt, 1998). Mr. Levitt stressed how accounting involves significant judgment and he expressed concern that this judgment was being pushed aside by management due to the pressure that they were encountering to meet the numbers. Mr. Levitt mentioned the standards of objectivity, integrity and judgment in reporting accounting number and stressed that it was these standards that remain an integral part of the public accounting profession’s Code of Professional Conduct and form the foundation by which financial statements are compiled, audited and interpreted. He went on the say that the ethical dilemmas facing businesses and their accountants often revolve around the pressure placed upon companies by investors and creditors. These pressures can sometimes cause management to become involved in â€Å"accounting hocus pocus† (Levitt, 1998). Additionally, because accounting involves judgment, the reported accounting numbers can be significantly different depending on the assumptions made by those that are preparing the financial statements. Mr. Levitt stated that accounting principles â€Å"Allow for flexibility to adapt to changing circumstances† and it was this flexibility that creates many of the ethical issues that accountants are faced with. As companies come under pressure to report  favorable results, accountants also come under pressure to flex those rules almost to the point of breaking. Mr. Levitt gave credit to the Code of Professional Conduct for providing guidance to the public accounting profession members when they are faced with difficult issues (Levitt, 1998). Addressing the issues and establishing new policies and procedures is not enough in ensuring that companies are adhering to changes in methods. Communication must be maintained with those that work in the accounting profession so that they are also complying with the latest methods. In October of 2000, the Chief Accountant of the SE, Lynn Turner, wrote a letter to Ms. Arlene Thomas, the Vice President of the Professional Standards and Services office of the AICPA in order to inform auditors of topics that the SEC had been focusing their attentions on. Amount several topics that Ms. Turner included in her letter was the topic of revenue recognition. The letter discussed the issue of revenue fraud and how over half of the revenue frauds that were identified were due to companies that overstated their revenue because that had reported revenue either too early of deceptively (U.S., 2000). Ms. Turner stressed the importance for auditors to test cut off dates and stressed how auditors must place special focus and conduct testing that is above and beyond the reviewing of a few transactions. Ms. Turner also wanted to bring to of Ms. Thomas the issue that was raised with companies having â€Å"side agreements† with their customers which could alter the terms and conditions of the original contract. These adjustments could result in revenue being improperly recorded and that auditors should conduct thorough testing of contracts. This testing is important because it could assist the auditor with identifying if and side agreements exists and then can test the revenue accordingly. Ms. Turner went on to give praise to the AICPA for a document that they issued entitled â€Å"Audit Issues in Revenue Recognition† and stated how this document should be used by auditors for guidance when it comes to properly auditing revenue. Ms. Turner stated how some organizations can be quite complex and conduct several complex revenue transactions and by reading the terms and conditions of the contracts, auditors would be able to determine  the best course of action for conducting a proper and thorough audit (U.S., 2000). The topic of financial reporting fraud is one that will continue to remain the focus of the SEC, FASB and ISAB for some time to come. Revenue recognition will play a large role in the process as it encompasses two primary factors; management will need to use their own judgment in determining how their revenue should be recognized and that management should be prepared to have their judgments analyzed and questioned. By maintaining focus of the issues that have been identified, and keeping an eye out for possible future issues, the authorities can be certain that investors are making decisions based on accurate information. Constant training and communication between all agencies will ensure that the scandals and financial collapse of companies will not be repeated. References American Institute of Certified Public Accountants Accounting Standards Executive Committee Statement of Position 97-2, (1997) Software revenue recognition, p.08. FASB. (2012, October 13). Revenue recognition—joint project of the fasb and iasb. Retrieved from http://www.fasb.org/project/revenue_recognition.shtml Levitt, A. (1998, September 28). The numbers game. Retrieved from http://www.sec.gov/news/speech/speecharchive/1998/spch220.txt Parizek, G., & Findley, M. (2008). Charting a course: revenue reconition practices for toda’ys business environment. Journal of Accountancy, 20(3), 15-22. SEC. (1999, December 3). Sec staff accounting bulletin: No. 101 – revenue recognition in financial statements. Retrieved from http://sec.gov/interps/account/sab101.htm U.S., SEC. (2002, October 13). Letter: 2000 audit risk alert to the american institute of certified public accountants. Retrieved from http://www.sec.gov/info/accountantts/staffletters/audrsk2k.htm