Revenue Recognition

The Revenue Recognition principle of accounting states that revenue is recognized when: 1) the earning process is complete or virtually complete; and 2) an exchange transaction has taken place. Basically, you book the sale when you've earned it and are entitled to be paid. In theory this is simple and straight-forward; a company provides a product or a service, and as soon as they have delivered it they can/should record (recognize) the revenue from that product or service.

We all know that the real world does not always conform to simple theory. What if, for example:

• The product sold has a known high defect or return rate?
• Your business model is selling high-margin goods to very poor credit risks?
• The buyer agrees to advance money to the seller and have the seller hold the product for future delivery?
• The seller is a construction company and the product being sold, a building, takes three years to build?
• The buyer pays on installment?
• The product being sold is delivered on consignment?
• Both a service and a product are provided incidentally to each other but with different timing (such as software plus installation and maintenance services)?
• There is a time element to the product or service, such as a magazine subscription or an insurance policy paid in advance?
• A company ships more product to its customer than the customer ordered?
• A lawyer spends many hours giving a client advice that the client considers bad and doesn't want to pay for?

The answer to all of the above questions, plus most others related to revenue recognition, is the same; “it depends.” No matter how many rules or interpretations the accounting rule-making bodies hand down, the decision of when or even whether to record revenue will always reflect the accountant's judgment.

Of course, where there is judgment, there are rules, more rules, and interpretations of rules.

The SEC

The U.S. Securities and Exchange Commission (SEC) states on its website:

“The accounting literature on revenue recognition includes both broad conceptual discussions as well as certain industry-specific guidance. If a transaction is within the scope of specific authoritative literature that provides revenue recognition guidance, that literature should be applied. However, in the absence of authoritative literature addressing a specific arrangement or a specific industry, the staff will consider the existing authoritative accounting standards as well as the broad revenue recognition criteria specified in the FASB's conceptual framework that contain basic guidelines for revenue recognition. Based on these guidelines, revenue should not be recognized until it is realized or realizable and earned.”

The site (http://1.usa.gov/ 1cqpyh1) then goes on to give many hypothetical questions and the commission's interpretations.

The SEC seems determined that companies should not recognize revenue until as many criteria as possible are met. On the other hand, another powerful government agency, the IRS, would really appreciate, and gets somewhat insistent that, companies recognize revenue (and pay tax on it) as quickly as possible.

General Rules

There are general rules, again subject to the application of judgment, to deal with revenue recognition questions:

• Revenue from the selling of product generally is recognized when the product is delivered.
• Revenue from providing services is generally recognized when the service is provided and billed.
• Revenue from the usage of property (rent, royalties, etc.) is recognized as time passes.
• When the return rate is high or payment is uncertain, revenue should not be recognized until payment is received.
• Under a long-term contract, such as for construction or software installation, revenue can be recognized on an interim (before the end of the contract) basis based on the percentage of completion.
• If the product is a fungible commodity such as copper or corn for which there is a ready market with reasonably assured prices, revenue can be recorded when the product is ready to sell even if no sales have been consummated.
• Installment sales can be recorded either all at once when the agreement is entered into or over time as the installment payments are made.
• Product paid for in advance may have all the revenue recorded at time of payment (buy and hold agreements) or as time passes (such as with magazine subscriptions).

Abuse of the Rules

Deciding what rule you are going to follow for your revenue recognition is only the first half of the issue. How you apply that rule is also open to management discretion or abuse. One of the most common abuses is “channel stuffing” ' shipping more product to established customers than they ordered or are able to sell. Companies do this to record sales now, and worry about the blow-back later.

More subtle bending of the rules can be easily done. One way to do this is in how you define when a product “shipped.” In the fraud case of a publicly held company that I worked on, the definition of “shipped” incrementally changed over time; first, it changed from when product was received by customers to when it was loaded on the trucks to when it was in the staging area ready to be loaded. Later, the definition of the staging area started changing, from within 30 feet of the dock doors to being on a certain side of a yellow line that was drawn in the warehouse (and that kept getting redrawn further and further from the dock doors). The portion of the warehouse that was considered “sold and shipped” kept expanding ' not because business was great, but because business was declining and the decline was being hidden by accelerating (and eventually fictionalizing) sales.

In service firms, “delivery” is harder to discern, and more open to manipulation than traditional product sellers. Professional firms especially are prone to either accelerating or holding billings, depending on whether their pressure is to maximize revenue or minimize taxes.

Standards Update

In 2010, the Financial Accounting Standards Board issued an Exposure Draft of a proposed Accounting Standards Update titled “Revenue from Contracts with Customers.” It was 170 pages long, was redone in 2012, and has still not yet been decided upon. (If you are an insomniac, you can find it at http://www.fasb.org.) The primary issues still under discussion mostly involve timing and collectability. Whenever it is finally issued and becomes GAAP, these pronouncements are still unlikely to answer all revenue recognition questions once and for all, and they definitely will not even address implementation issues such as yellow lines moving across warehouses. What is important for you in any company you are working with is getting a good understanding of exactly what triggers the recording of a sale, how likely the customer is to pay, and when the recording of revenue takes place.

Michael Goldman, MBA, CPA, CVA, CFE, CFF is principal of Michael Goldman and Associates, LLC in Deerfield, IL. He may be reached at [email protected].

When is a sale a sale? This question is much more than semantics or a deep philosophical debate that college accounting majors have over a nice cold keg of Mountain Dew. Many an executive or business owner has gone to jail over this issue.

The Revenue Recognition Principle of Accounting

My 1970s vintage accounting text started the revenue chapter with the statement that “Revenue recognition is one of the most difficult and pressing problems facing the accounting profession.” Forty years later, it still is.

The Revenue Recognition principle of accounting states that revenue is recognized when: 1) the earning process is complete or virtually complete; and 2) an exchange transaction has taken place. Basically, you book the sale when you've earned it and are entitled to be paid. In theory this is simple and straight-forward; a company provides a product or a service, and as soon as they have delivered it they can/should record (recognize) the revenue from that product or service.

We all know that the real world does not always conform to simple theory. What if, for example:

• The product sold has a known high defect or return rate?
• Your business model is selling high-margin goods to very poor credit risks?
• The buyer agrees to advance money to the seller and have the seller hold the product for future delivery?
• The seller is a construction company and the product being sold, a building, takes three years to build?
• The buyer pays on installment?
• The product being sold is delivered on consignment?
• Both a service and a product are provided incidentally to each other but with different timing (such as software plus installation and maintenance services)?
• There is a time element to the product or service, such as a magazine subscription or an insurance policy paid in advance?
• A company ships more product to its customer than the customer ordered?
• A lawyer spends many hours giving a client advice that the client considers bad and doesn't want to pay for?

The answer to all of the above questions, plus most others related to revenue recognition, is the same; “it depends.” No matter how many rules or interpretations the accounting rule-making bodies hand down, the decision of when or even whether to record revenue will always reflect the accountant's judgment.

Of course, where there is judgment, there are rules, more rules, and interpretations of rules.

The SEC

The U.S. Securities and Exchange Commission (SEC) states on its website:

“The accounting literature on revenue recognition includes both broad conceptual discussions as well as certain industry-specific guidance. If a transaction is within the scope of specific authoritative literature that provides revenue recognition guidance, that literature should be applied. However, in the absence of authoritative literature addressing a specific arrangement or a specific industry, the staff will consider the existing authoritative accounting standards as well as the broad revenue recognition criteria specified in the FASB's conceptual framework that contain basic guidelines for revenue recognition. Based on these guidelines, revenue should not be recognized until it is realized or realizable and earned.”

The site (http://1.usa.gov/ 1cqpyh1) then goes on to give many hypothetical questions and the commission's interpretations.

The SEC seems determined that companies should not recognize revenue until as many criteria as possible are met. On the other hand, another powerful government agency, the IRS, would really appreciate, and gets somewhat insistent that, companies recognize revenue (and pay tax on it) as quickly as possible.

General Rules

There are general rules, again subject to the application of judgment, to deal with revenue recognition questions:

• Revenue from the selling of product generally is recognized when the product is delivered.
• Revenue from providing services is generally recognized when the service is provided and billed.
• Revenue from the usage of property (rent, royalties, etc.) is recognized as time passes.
• When the return rate is high or payment is uncertain, revenue should not be recognized until payment is received.
• Under a long-term contract, such as for construction or software installation, revenue can be recognized on an interim (before the end of the contract) basis based on the percentage of completion.
• If the product is a fungible commodity such as copper or corn for which there is a ready market with reasonably assured prices, revenue can be recorded when the product is ready to sell even if no sales have been consummated.
• Installment sales can be recorded either all at once when the agreement is entered into or over time as the installment payments are made.
• Product paid for in advance may have all the revenue recorded at time of payment (buy and hold agreements) or as time passes (such as with magazine subscriptions).

Abuse of the Rules

Deciding what rule you are going to follow for your revenue recognition is only the first half of the issue. How you apply that rule is also open to management discretion or abuse. One of the most common abuses is “channel stuffing” ' shipping more product to established customers than they ordered or are able to sell. Companies do this to record sales now, and worry about the blow-back later.

More subtle bending of the rules can be easily done. One way to do this is in how you define when a product “shipped.” In the fraud case of a publicly held company that I worked on, the definition of “shipped” incrementally changed over time; first, it changed from when product was received by customers to when it was loaded on the trucks to when it was in the staging area ready to be loaded. Later, the definition of the staging area started changing, from within 30 feet of the dock doors to being on a certain side of a yellow line that was drawn in the warehouse (and that kept getting redrawn further and further from the dock doors). The portion of the warehouse that was considered “sold and shipped” kept expanding ' not because business was great, but because business was declining and the decline was being hidden by accelerating (and eventually fictionalizing) sales.

In service firms, “delivery” is harder to discern, and more open to manipulation than traditional product sellers. Professional firms especially are prone to either accelerating or holding billings, depending on whether their pressure is to maximize revenue or minimize taxes.

Standards Update

In 2010, the Financial Accounting Standards Board issued an Exposure Draft of a proposed Accounting Standards Update titled “Revenue from Contracts with Customers.” It was 170 pages long, was redone in 2012, and has still not yet been decided upon. (If you are an insomniac, you can find it at http://www.fasb.org.) The primary issues still under discussion mostly involve timing and collectability. Whenever it is finally issued and becomes GAAP, these pronouncements are still unlikely to answer all revenue recognition questions once and for all, and they definitely will not even address implementation issues such as yellow lines moving across warehouses. What is important for you in any company you are working with is getting a good understanding of exactly what triggers the recording of a sale, how likely the customer is to pay, and when the recording of revenue takes place.

Michael Goldman, MBA, CPA, CVA, CFE, CFF is principal of Michael Goldman and Associates, LLC in Deerfield, IL. He may be reached at [email protected].