SEC ADVISOR

May 2000

SAB 101'S REQUIREMENTS FOR REVENUE RECOGNITION

By Lailani Moody, CPA

Staff Accounting Bulletin 101, Revenue Recognition in Financial Statements, is the third in a series of SABs issued in response to SEC Chair Arthur Levitt's concerns over financial reporting abuses and earnings management. It provides registrants and their auditors with the staff's position on the requirements for revenue recognition under generally accepted accounting principles: The revenue must either be realized or realizable and earned. This generally does not occur until all of the following criteria are met:

* Persuasive evidence of an arrangement exists,
* Delivery has occurred or services have been rendered,
* Price is fixed or determinable, and
* Collectibility is reasonably assured.

SAB 101 presents the staff's position on various revenue recognition issues related to those four criteria, such as cancellation and termination clauses, bill-and-hold transactions, determination of delivery, up-front fees, side agreements, contingent rental income, and consignment-like arrangements. The SAB also stipulates disclosures pertaining to revenue recognition the staff expects registrants to provide in their financial statements and management's discussion and analysis. Moreover, the SAB states the staff's opinion that application of SAB 101 will require some registrants to change their revenue recognition methods, which they should report as changes in accounting principle, unless the changes are corrections of errors. Application is required no later than the first quarter of the fiscal year beginning after December 15, 1999.

Recently issued SAB 101A delays the implementation date of SAB 101 for registrants with fiscal years beginning between December 16, 1999, and March 15, 2000. Registrants should report any change in accounting principle resulting from the adoption of SAB 101 no later than the second quarter of their fiscal year.

Persuasive Evidence of an Arrangement

For purposes of SAB 101, an arrangement is "the final understanding between the parties as to the specific nature and terms of the agreed-upon transaction." Persuasive evidence that an arrangement exists is needed before revenue recognition can occur. Depending on a registrant's business practice, evidence may be in the form of a written sales agreement or other written or electronic evidence, such as a purchase order or online authorization. A registrant may have different business practices for different types of transactions, depending on the class of customer or nature of the product.

Written Agreements. If the registrant normally would be limited to a written sales agreement, persuasive evidence requires a final agreement signed by both parties. If the arrangement requires approval, say, of the board of directors, revenue recognition is not appropriate until that approval is obtained.

The staff provides the following illustration of how it applies the persuasive evidence criterion: A customer places an order near the end of a registrant's fiscal quarter, and the registrant delivers the product the day before its quarter ends. The registrant uses written sales agreements, but the customer cannot obtain written approval of the contract until a few days after the end of the quarter. Persuasive evidence of an arrangement in this situation would be a final agreement properly executed by the customer's authorized personnel. The sale is therefore considered a transaction of the subsequent period.

Side Agreements. Entities sometimes enter into side agreements that amend the sales contract, for example, by including a cancellation or termination provision. A subsequently executed side agreement could mean the original agreement was not final and revenue recognition would be inappropriate.

Consignment Arrangements and Financings. Certain "sales agreements" are in substance consignments or financings and do not qualify for revenue recognition until a sale occurs. The staff believes that a transaction with one or more of the following characteristics should not be accounted for as a sale, even if title is transferred to the buyer:

* The buyer has the right to return the product and either of the following apply:
* The buyer does not pay the seller at the time of sale and either the buyer is not obligated to pay at a specified date or the obligation to pay is contractually or implicitly excused until the buyer resells or consumes the product.
* The transaction does not meet all the requirements of paragraph 6 of SFAS No. 48, Revenue Recognition When Right of Return Exists.
* The seller is required to repurchase the product at specified prices not subject to change except for fluctuations related to finance and holding costs, and the seller's payments are adjusted to cover fluctuations in costs the buyer incurs to purchase and hold the product, including interest.
* The transaction does not qualify for sales-type lease accounting and has the characteristics described in EITF 95-1, "Revenue Recognition on Sales with a Guaranteed Minimum Resale Value," in which a manufacturer contractually guarantees that the purchaser will receive a minimum specified resale value when it disposes of the purchased equipment.
* The product is delivered for demonstration purposes.

The staff notes that the above list is not all inclusive; judgment is required to determine whether the substance of a transaction is a consignment, financing, or other transaction for which revenue recognition would not be appropriate. In addition, if title has passed in a transaction not accounted for as a sale, the consignor should report consigned inventory separately from other inventory.

Delivery and Performance of Services

A prerequisite for revenue recognition is that delivery has occurred or services have been rendered. In general, if delivery has occurred, the customer has taken title and assumed the risks and rewards of ownership and the product has been delivered to the customer's delivery site (FOB destination) or shipped to the customer (FOB shipping). If delivery has not occurred, the following are necessary prerequisites to revenue recognition:

* The risks of ownership have passed to the buyer;
* The customer has made a fixed commitment to purchase the goods, preferably in writing;
* The buyer (not the seller) requested the transaction to be on a bill-and-hold basis. The buyer should put that request in writing and have a substantial business purpose for the bill-and-hold arrangement;
* A fixed delivery date that is reasonable and consistent with the buyer's business purpose has been set;
* The seller has no remaining specific performance obligations that indicate the earnings process is not complete;
* The goods are segregated from other inventory and not available to fill other orders; and
* The product is complete and ready for shipment.

The above is not intended as a checklist. In some situations a transaction may satisfy all those factors but not meet the requirements for revenue recognition.

For "bill-and-hold" transactions, a registrant should also consider--

* whether the seller has modified its normal billing and credit terms,
* the seller's historical experiences with bill-and-hold transactions,
* whether the buyer would bear the risk of loss if the goods decline in market value,
* whether the seller's custodial function is insurable and insured, and
* whether the buyer's business reasons for the bill-and-hold arrangement indicate a contingency to the buyer's commitment.

The following are other staff positions related to the delivery criterion for revenue recognition:

Delivery to other than the customer's place of business. If the customer specifies an intermediary site but a substantial portion of the sales price is not due until delivery to a final site, revenue recognition should be delayed until delivery to the final site.

Customer acceptance. If there is uncertainty about customer acceptance, revenue recognition should be delayed until acceptance occurs.

Substantially complete. A seller should substantially complete the terms of the arrangement for delivery or performance to have occurred. Any remaining obligations should be inconsequential or perfunctory. The seller should have a history of timely satisfaction of such obligations and the ability to reliably estimate the cost.

Multiple elements. Delivery of an element is considered not to have occurred if an arrangement consists of multiple deliverables and an undelivered element is essential to the functionality of the delivered element.

Licensing arrangements. Delivery does not occur until the license term begins, even if the licensed item has been physically delivered to the customer.

Layaway programs. A registrant should not recognize revenue on layaway sales until the product is delivered to the customer.

Up-front Fees

Registrants sometimes receive nonrefundable up-front fees upon entering into an arrangement. Sometimes a larger up-front fee for an intangible right, such as health club membership or a telecommunications activation fee, is offered together with a lower unit price for products or services to be delivered in the future, such as lower monthly usage fees. Often the customer would attribute little or no value to the element for which the up-front fee is charged, such as a telecommunications activation fee, without the continuing service or product being contracted for. The staff has therefore concluded that an up-front fee and a continuing obligation to provide services or products are an integrated package. The up-front fee, even if nonrefundable, is earned as the services or products are delivered over the term of the arrangement or the expected period of performance. It should generally be deferred and recognized systematically over the period earned.

Sales Price Is Fixed or Determinable

The third prerequisite for revenue recognition is that the sales price is fixed or determinable. SAB 101 addresses three issues pertaining to whether the sales price meets that criterion: cancellation clauses, contingent income, and estimation of future returns.

Cancellation Clauses. An arrangement that includes a customer cancellation or termination clause may indicate that the arrangement is not final; for instance, the cancellation period may be a demonstration period. In SAB 101, the staff applies guidance on cancellation clauses similar to that in SOP 97-2, Software Revenue Recognition, to transactions generally:

The sales price in arrangements that are cancelable by the customer are neither fixed nor determinable until the cancellation privileges lapse. If the cancellation privileges expire ratably over a stated contractual term, the sales price is considered to become determinable ratably over the stated term. Short-term rights of return, such as 30-day money-back guarantees, and other customary rights to return products are not considered to be cancellation privileges, but should be accounted for in accordance with SFAS No. 48.

The staff's position on cancellation clauses is illustrated by an arrangement involving a membership fee paid in full at the beginning of the arrangement. The customer has the right to cancel the arrangement at any time during the 12-month term of the arrangement and receive a full refund of the initial fee. The staff believes a price is not fixed or determinable if the customer has the unilateral right to cancel the arrangement and receive a refund. The membership fee should not be recognized in earnings until the refund privilege expires. Prior to that time, it should be recorded as a monetary liability, such as "customers' refundable fees." In the staff's view, revenue should not be recognized based on a probability of future fulfillment. The basis for the staff's position is the concept in SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, that a liability should not be extinguished until the obligor is relieved of its obligation for the liability.

The staff acknowledges, however, that there is another view. Although the scope of SFAS No. 48 explicitly excludes service fees if the customer has cancellation privileges, some believe that revenue from membership fees, net of estimated refunds, may be recognized ratably over the contract period if the requirements of SFAS No. 48 for revenue recognition are met. Therefore, until FASB provides additional guidance, the staff will not object if registrants recognize revenue on refundable membership fees in that manner, but only if all of the criteria relating to the estimate of refunds and the fixed nature of the fee, as set forth in SAB 101, are met.

Contingent Rental Income. SFAS No. 29, Determining Contingent Rentals, provides that contingent rentals, such as those based on future sales volume, should be included in income as they accrue. In the staff's view, contingent rental income accrues when changes in the factor on which the contingent lease payments are based actually occur (for example, when the lessee's sales volume triggers the contingent rental income). It is inappropriate to recognize revenue based on the probability that the factor will be reached.

Estimation of Returns. Paragraph 8 of SFAS No. 48 lists four factors that could impair an entity's ability to estimate returns, thereby possibly causing the entity to defer recognition of revenue until the right of return expires or returns can be reliably estimated. The staff has identified the following six additional factors that could preclude a registrant from being able to reasonably and reliably estimate product returns:

* Channel stuffing, that is, significant increases in or excess levels of inventory in customers' distribution systems;
* The inability to determine inventory levels in resellers' distribution systems and their current level of sales to end users;
* The impending introduction of new products that may make current products technologically obsolete, causing larger than expected returns;
* The significance of a particular distributor to the registrant's operations;
* The newness of the product; and
* The introduction of competitive products with superior technology or greater market acceptance, or other developments that affect market demand.

The staff therefore advises registrants and their auditors to "carefully analyze all factors, including trends in historical data, that may affect registrants' ability to make reasonable and reliable estimates of product returns." If a transaction does not satisfy the requirements of paragraphs 6 and 8 of SFAS No. 48, revenue cannot be recognized until the requirements are met or the return privilege lapses. The staff states that deferring only the recognition of the gross margin is not appropriate.

Reporting Revenue: Gross or Net

In determining whether it should report revenue gross or net, a registrant should consider whether it--

* is acting as principal
* takes title to the products
* has the risks and rewards of ownership
* is acting as an agent or broker (including performing services, in substance, as an agent or broker) and being compensated on a commission or fee basis.

The staff states that if the registrant is acting as an agent or broker, without assuming the risks and rewards of ownership of the goods, sales should be reported net, not gross.

SAB 101 illustrates this with the following example: A registrant uses its website to sell Company T's product. Orders and credit card information are received on the website; the registrant then transfers the order and the credit card authorization to Company T for fulfillment. Company T ships the product and is responsible for defects, returns, and disputed credit card charges. The registrant does not take title to the product and has no risk of loss. The registrant receives a fixed fee for each product sold but loses the fee if a credit card transaction is rejected. The registrant should report only the net revenue (the fixed fee) it receives for products sold.

Leased or Licensed Departments. Department stores and other retailers generally report sales of leased or licensed departments in the amount reported as "total revenues." The staff believes this is inappropriate and concurs with the AICPA Technical Practice Aid, "Rental Revenue Based on Percentage of Sales," that leases of departments within retail stores are leases of tangible assets, accounted for under SFAS No. 13, Accounting for Leases. Therefore, only the rental income from leased or licensed departments should be reported as part of gross revenue. The registrant is permitted to disclose the amount of lessee sales in the financial statement notes. If the arrangement is a service arrangement and not a lease, the registrant should recognize the fee or commission as revenue when earned. The registrant should report any bad debt expense it bears in connection with the lessee's sales as required by Regulation S-X, Article 5-03(b)(5).

Disclosures Related to Revenue Recognition

The staff expects the following disclosures about registrants' revenue recognition policies:

* The revenue recognition policy for each material type of transaction, including barter sales;
* If sales transactions have multiple elements, such as a product and service, the revenue recognition policy for each type of element and how each of the elements is determined and valued; and
* Changes in estimated returns, if material (for example, a change in estimate from 2% to 1% of sales).

In addition to the requirement to separately disclose on the face of the income statement revenue from sales of products, services, and other products [Regulation S-X, Article 5-03(b)(1) and (2)], the staff expects registrants to report the costs relating to each type of revenue separately on the income statement.

The staff believes that MD&A discussion of changes in revenue should not be limited to describing volume and price changes, but should include an analysis of the factors causing the change.

Effective Date and Transition

The staff expects all registrants to apply the accounting and disclosure provisions of SAB 101. Registrants are not required to restate prior period financial statements provided they report any change in accounting principle necessary to adopt the provisions of SAB 101 no later than in the first quarter of their fiscal year beginning after December 15, 1999 (or by the second quarter, if their fiscal year begins between December 16, 1999, and March 15, 2000). In subsequent accounting periods they should disclose the amount of recognized revenue (if material to income before income taxes) that was included in the cumulative effect adjustment on adoption of SAB 101. Financial statements issued prior to adoption of the SAB should disclose the expected effect of its application.

The staff expects registrants to retroactively apply the provisions pertaining to income statement presentation of net, rather than gross, revenues discussed above, unless the effect is immaterial.

If registrants have not been complying with GAAP, for example, by not following applicable guidance for bill-and-hold transactions, they should follow the guidance for correcting an error in APB Opinion No. 20, Accounting Changes. *