Revenue recognition is an area that concerns managers, regulators and auditors. Arguably, managers are and should be more concerned than other parties. And why not? Selecting the wrong accounting method or one that may be challenged, and falling stock prices that can result in shareholder litigation that in turn can affect and, in some cases destroy, management’s reputation and credibility. Those possibilities are becoming more real, given revenue recognition and classification decisions are a largely subjective matter. This article identifies the issues for Canadian managers and analyzes aspects such as timing and measuring revenue recognition.
Determining and reporting revenues are among the most critical issues in financial reporting. Indeed, the timing of revenue recognition affects both the top and bottom lines of the income statement as well as the balance sheet. Such timing can have a significant impact on share prices as investors compare actual results with analysts’ forecasts. Furthermore, the classification and recognition of certain elements related to revenue activities can affect the interpretation of financial statements.
Revenue recognition issues moved into the spotlight with the emergence of the New Economy. Any fundamental analysis for equity valuation includes income-statement metrics such as earnings, margins or sales. One key ratio for start-up and emerging firms is price-to-sales ratios. The logic of using this ratio is that, though these firms are unprofitable or report negligible earnings, strong sales will produce profits in the long run.
Revenue recognition and classification decisions can be subjective if authoritative guidance either does not exist or is unclear. Management can pressure auditors to accept aggressive accounting policies affecting the quality of financial reporting.
Revenue recognition becomes a major concern as companies attempt to meet market expectations. Many firms conclude last-minute deals to reach their revenue targets and sustain revenue growth. Sometimes these deals are not profitable.
Furthermore, in trying to meet analysts’ forecasts, management may be tempted to inflate revenues. In a March 1999 study, the National Commission on Fraudulent Financial Reporting indicated that more than half of financial reporting frauds were related to revenue overstatement. The most common abuses included recording sales that never took place, shipping products before customers agreed to delivery, and booking revenue up front from long-term contracts.
In summary, revenue recognition is an area of great concern for management, regulators and auditors. Management can face tremendous difficulties if it selects an accounting method which is subsequently challenged. Stock prices may fall, resulting in shareholder litigation that can affect management’s reputation and credibility. It is therefore essential for management to be aware of the challenges in this evolving area.
In this article, we identify issues that will interest Canadian managers who are concerned with financial reporting. It analyzes some aspects of revenue recognition timing and measurement. We also provide examples to illustrate the impact of recent actions by regulators in the United States on revenue recognition practices.
GENERAL CRITERIA FOR REVENUE RECOGNITION
Revenue is recognized when two basic criteria are met. First, revenue must be earned, that is, the earnings process is either complete or virtually complete. Second, revenue must be realizable, that is, cash is received or the amount to be received can be measured. Failing to meet one of these criteria results in the deferral of revenue.
Judging whether the two criteria are met can be straightforward or present major challenges. For example, retailers recognize revenues at the time of the sale. However, for the service and high-tech industries, establishing when revenue is earned can present difficulties in situations where complex contracts are concluded with customers. Return and upgrade clauses, continuous services and conditional payments make it difficult to apply realization criteria. In addition, the absence of specific guidance results in many different accounting treatments for substantially similar transactions. For example, a company can use various procedures to account for contracts with its customers. Figure 1 presents some of the timing and measurement issues related to revenue recognition.
THE CANADIAN SETTING
Canadian revenue recognition rules do not provide any guidance with respect to the implementation of the general criteria for revenue recognition. The application of the Canadian rules, which were issued in 1986, requires considerable professional judgment in light of the growing sophistication and complexities of marketing and financing practices. Often, this judgment is based on accounting standards published by regulators in the U.S. and abroad.
Canadian revenue recognition rules are not only imprecise; they also do not require the disclosure of detailed information regarding the accounting policies adopted by firms. Because of the limited disclosure, investors cannot readily judge the level of aggressiveness of revenue recognition practices, which is particularly critical in judging the performance of high-tech firms.
Regulators in Canada have recently become concerned about this situation. The Ontario Securities Commission (OSC) has announced that it will require a number of companies to disclose more details on their revenue recognition practices in their financial statement notes, or in their management discussion and analysis. Some firms may be required to revise their accounting policies or to restate previously issued financial statements. These actions were taken subsequent to the investigation of a sample of 75 financial reports of Canadian technology companies and the publication of an OSC report in March 2001. According to this report, only five percent of the companies provided information about their revenue recognition practices that did not require follow-up questions by the OSC. When revenue recognition policies were disclosed, companies often used vague or boilerplate language that provided little relevant information. In some cases, companies recognized revenue prematurely, as all of the revenue activities had not been completed.
RECENT U.S. ACTIONS
Recently, U.S. regulators took several actions that have resulted in more stringent rules for revenue recognition. The Accounting Standards Executive Committee of the American Institute of Certified Public Accountant (AICPA) was the first body to introduce such rules. In October 1997, it issued a Statement of Position (SOP) 97-2, Software Revenue Recognition. This standard modified the practices then used. Indeed, prior to SOP 97-2, many software companies recognized revenues on their contracts by using a critical-event approach. Accordingly, the total amount of revenue was recognized upon delivery of the software. A liability was recorded for other elements of the contracts such as maintenance and product upgrades.
Since the implementation of SOP 97-2, software companies delivering available-for-sale products are required to allocate the revenue to the different components of the sales agreement. As a result, a contract price that includes software, maintenance and free upgrades cannot be fully recognized upon delivery. Price has to be allocated among the three components of the contract (see Figure 2). This approach impacts the financial results of most companies by delaying the amount of revenue recognized.
The Securities and Exchange Commission (SEC) supported SOP 97-2 because it was concerned about revenue recognition manipulations. Former chairman Arthur Levit expressed this concern in a Sept. 28, 1998, speech entitled “The Numbers Game.” In that speech, he accused some companies of recognizing revenue before a sale is complete, before the product is delivered to a customer, or when the customer still has options to terminate, void or delay the sale.
Following that speech, U.S. standard-setters initiated several actions. The AICPA developed a comprehensive guidance to enable companies and their auditors to better understand the importance of accurate revenue recognition. The guidance reinforces best practices and describes the responsibilities of management and audit committees to accurately report revenues.
Probably the most important recent development in the area of revenue recognition is the SEC’s publication of Staff Accounting Bulletin 101, Revenue Recognition in Financial Statements (SAB 101) in December 1999. Accordingly, revenue from a sale should only be recognized when:
- a bona fide sales arrangement between the buyer and the seller has been concluded,
- the delivery has occurred, and the buyer has taken title to the product and assumed all risks and rewards of ownership,
- the price has been fixed or can be determined reliably, and
- the collection has been reasonably assured.
SAB 101 interprets the above criteria very strictly. Referring back to the example in Figure 1, Seller Ltd. Will be required to use Method 3. That is, the firm could not recognize any revenue before cancellation privileges lapse, since, up to that point in time, it could be argued that price is not fixed and collection is not reasonably assured. However, if Seller Ltd. has concluded a great number of equivalent contracts with other customers and can therefore estimate reliably a provision for cancellation, it could use Method 2. Accordingly revenue is recognized taking into account Buyer Ltd. point of view with respect to the risks and rewards of ownership. Methods 1 and 4 are rejected; the former because the service portion has not been rendered, and the latter because revenue is not recognized at the time of the delivery of components.
Since the publication of SAB 101, many U.S. firms had to modify their accounting policies. Some firms facing considerable hardships even had to restate their previous financial statements. Though total revenues or cash flows were not affected, the newly adopted method makes growth look slower.
EFFECT ON CANADIAN COMPANIES
At first glance, one might believe that recent U.S. actions should not influence accounting practices adopted by Canadian firms. Indeed, these actions appear only to concern firms which are subsidiaries of U.S. companies or that file their financial statements with the SEC.
In reality, the situation is quite different. For example, SAB 101 guidelines are far-reaching. Indeed, shortly after they were issued, the OSC indicated that revenue recognition concepts as defined by SAB 101 apply to Canadian firms. The OSC also stated that Canadian firms that reconcile their financial statements with U.S. GAAP should expect to be questioned on reconciling items arising from revenue recognition policies.
In order to make informed decisions, management will need to acquire an adequate understanding of all pertinent revenue recognition rules. For complex business deals, these rules might also concern employees working in different disciplines, including marketing, law, taxation, information technology and finance.
On the positive side, recent actions in the U.S. might create an environment that will push management to handle its relations with clients more rationally. For example, management will be less inclined to negotiate last-minute deals in order to meet sales forecasts. Indeed, management will have to use conservative accounting policies, which make such deals less attractive for financial reporting purposes. For example, upfront fees will have to be allocated among different periods instead of being recognized when a contract is signed and payment is received.
The application of SOP 97-2 and SAB 101 presents challenges to all public companies. Assessing the impact of these documents requires a thorough understanding of many technical elements. Management should consult experts in drafting complex contracts, since clauses negotiated with clients might have important implications on financial reporting. Contractual terms such as acceptance clauses, upfront fees, access charges and delivery of multi-phased products will often delay revenue recognition.
It should be noted that the revenue recognition initiatives are not a one-time issue. Standard-setters are continuously issuing additional standards and guidance in this area. Management not only has to understand these standards and guidance but it has to be able to apply them when facing unique transactions and contracts. One of the positive consequences of regulators’ initiatives is that they will force management and auditors to examine sale transactions and contracts more closely. In the end, being aware of the importance of good control can enhance profitability.