If the remaining obligations are not inconsequential or perfunctory, the arrangement is considered a multiple-element arrangement. A lack of accounting guidance for multiple-element arrangements has led to diversity in accounting practice. Consequently, the SEC staff asked the Emerging Issues Task Force (EITF) to address this issue. Until guidance is established, the staff recommends that registrants consistently apply a reasoned method of accounting. In the FAQ, the staff said that it would not object to a method that includes the following conditions:

Customer acceptance. In SAB 101, the staff stated that it presumes that contractual customer acceptance provisions are substantive, bargained-for terms of an arrangement; therefore, revenue should not be recognized until customer acceptance occurs or the provisions lapse. The FAQ posed the question: Is a formal customer sign-off evidencing acceptance always necessary to satisfy the delivery criterion? According to the staff, a formal sign-off is not always necessary provided the seller can objectively demonstrate that the acceptance conditions have been met. In the FAQ, the staff described four forms of customer acceptance provisions. Those forms and the staff’s evaluation process for determining whether revenue should be deferred are described below:

On this last point, the FAQ examined the timing of revenue recognition when an arrangement specifies that title to equipment is transferred to a buyer on delivery but the customer has the right to return the equipment if it does not pass specified performance tests. The staff does not object to the seller recognizing revenue on delivery if the seller can demonstrate that the equipment meets performance requirements at that time. According to the staff, the seller must perform tests in an environment that replicates the conditions under which the customer intends to operate the equipment. If the equipment cannot be tested prior to delivery or installation, revenue should be deferred until customer acceptance criteria are met.

The staff also addressed whether revenue recognition should always be deferred when a customer does not have to pay a portion of the price for equipment until installation or completion of some other service. The staff concluded that revenue would be deferred if the undelivered service is essential to the functionality of the delivered equipment. Installation is essential to the functionality of the equipment if installation services are not available from other companies and significant changes to equipment features or capabilities or building complex interfaces are necessary.

Installation is not essential if equipment is standard, installation does not change the equipment’s capabilities, and installation can be performed by other companies. Although the installation is not essential to the functionality of the equipment, the staff does not consider that obligation inconsequential or perfunctory if a portion of the fee is not payable. The portion of the fee withheld or refundable should be deferred until the undelivered element is delivered. For equipment sold on an installed basis, the staff said a registrant could follow a policy to recognize revenue when installation is complete if it is consistently applied and properly disclosed.

Nonrefundable Payments

The staff thinks registrants should consider two questions in their assessment of the appropriate accounting for nonrefundable, upfront fees:

The staff also believes registrants should bear in mind the customer’s perspective when considering these questions.

Revenue should be recognized when a company—

Although the ongoing obligations in each of these situations appear to be minimal, the staff believes the customer is paying for a service that is delivered over time; therefore, revenue should be recognized over time.

In another situation, the staff concluded that payment for the installation of a phone jack represents a separate earnings event and could be recognized on installation. The staff considered the following factors in reaching its conclusion:

Additionally, the staff clarified guidance in response to question 5 of the FAQ, deciding that, even though nominal activation costs result in deferral of revenue because they are not treated as a separate earnings event, incurring more than nominal costs does not necessarily indicate a separate earnings event. Furthermore, revenue should not be recognized to the extent of incremental direct costs incurred.

The staff discussed research and development arrangements in which the terms include a nonrefundable, up-front payment, scheduled payments during the term, and additional payments based on milestones. For example, where a customer has to purchase R&D services on an ongoing basis to realize the benefit of technology purchased for a one-time fee, revenue from the fee would be deferred because the ongoing services would be essential to the technology, and because there is no basis to value the technology separately from the ongoing activities.

In the FAQ, the staff clarified that an outright sale of technology could result in separate revenue recognition when there is sufficient evidence of fair value. However, in those cases where an R&D arrangement includes granting access to facilities, technologies, or other properties, immediate recognition of an up-front fee would generally be inappropriate.

Accounting for Certain Costs of Revenue

The staff clarified that the deferral of incremental direct costs, which are referred to in footnote 29 of SAB 101, applies only to transactions in which revenue has been deferred. In accordance with paragraph 6(a) and (b) of SFAS 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases,” and FASB Technical Bulletin 90-1, “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts,” the staff does not object to the capitalization of direct and incremental contract acquisition and origination costs. Deferral of contract acquisition and origination costs for the transactions addressed in SAB 101 is permitted, but not required. Registrants are, however, required to disclose their accounting policy for these costs and, if capitalized, the policy for determining which costs to capitalize. Deferred costs should be amortized in proportion to and over the same period in which revenue is recognized.

Refundable Fees for Services

In SAB 101, the staff addressed the timing of revenue recognition for refundable service fees. In accordance with SFAS 125, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” the staff said the preferred method is to account for refundable service fees as deposits. The staff does not object, however, to a registrant accounting for refundable fees under the guidance in SFAS 48 if the criteria listed in SAB 101 are met.

A registrant cannot change from an SFAS 125 method to an SFAS 48 method. The staff did not object to accounting by analogy to SFAS 48 for service transactions not limited to those described in SAB 101. An analogy would be acceptable where there is a large pool of homogenous transactions and in which the criteria in SAB 101 are met. The FAQ includes several examples that explore the question.

Estimates and Changes in Estimates

SAB 101 includes a requirement for “reliable estimates,” which raised the question of whether that requirement is a higher threshold than “reasonable estimates,” as required by SFAS 48. The staff said the expectation that estimates be reliable does not change the existing SFAS 48 requirement: If management’s estimates are unreliable, they cannot be reasonable. In SAB 101, the staff said that in order to make reliable estimates of cancellation, a registrant would need a two-year history of selling a new service.

The staff did not designate a specific length of time as necessary in order to make reliable estimates of returns for a product transaction; however, the staff warned registrants and their auditors to be skeptical of estimates when there is inadequate verifiable historical experience or inadequate internal controls. The same skepticism should be applied to start-up companies and companies selling new or significantly modified products. The staff also said that a company could not use the maximum expected amount of returns where an actual return rate cannot be reasonably estimated.

Fixed or Determinable Fees

The staff concluded that a medical claims processing company whose fee is based on a percentage of fees collected could not recognize revenues until collections occur. Traditionally, third-party payers pay 85% of billings without any processing company follow-up. Until collection occurs, the company has not performed the activity necessary for fee entitlement.

Implementing the Guidance in SAB 101

The staff looked into the question of whether a registrant can restate prior periods if electing to report the transition to SAB 101 as a cumulative effect-type change. The staff concluded that APB Opinion 20, “Accounting Changes,” does not permit restatement for a change in an accounting principle that is not a correction of an error, except in rare circumstances such as an initial public filing. The staff said a preferability letter is not required if an accounting change stems from a new SAB. Responding to other concerns, the staff also emphasized that SFAS 48 does not allow recognition of sales and cost of sales while deferring only the gross margin associated with estimated returns. SAB 101 did not develop new guidance in this area. Accordingly, any registrant that has failed to comply with existing GAAP should retroactively revise prior financial statements.

Editor:
Gary Illiano, CPA
Grant Thornton LLP

©2009 The New York State Society of CPAs. Legal Notices