January 2003

Implementation of SAB 101

By Kathy S. Moffeit and A. Elaine Eikner

A January 2002 Wall Street Journal article reported that more restatements of financial statements had occurred in the past three years than in the previous 10 years combined. The SEC has indicated that revenue recognition is the largest cause for financial statement restatements.

FASB recently added a major project on the recognition of revenues and liabilities to its technical agenda. Revenue recognition has been a subject of extensive interest at the SEC for several years. In December 1999, the SEC issued Staff Accounting Bulletin (SAB) 101, “Revenue Recognition in Financial Statements,” followed in October 2000 by “Revenue Recognition in Financial Statements: Frequently Asked Questions.” SAB 101 was effective starting the fourth fiscal quarter for fiscal years beginning after December 15, 2000. The first mandatory reporting period was reflected in Form 10-Ks filed with the SEC in 2001, for fiscal years ending after December 15, 2000. The authors examined changes companies have made in response to SAB 101.

SAB 101 Criteria for Revenue Recognition

For revenue to be recognized under SAB 101, it must meet all of the following criteria:

Because the purpose of SAB 101 was to provide comprehensive guidance on how the SEC interprets current requirements for revenue recognition, there is nothing to suggest that any one of the criteria has been more troublesome than the others. Each company’s Management Discussion and Analysis (MD&A) and financial footnote relating to revenue recognition were analyzed to identify the reason for the accounting change.

The Study

Through a search of the Global Access database, the authors selected 113 companies with December 16–31, 2000, year-ends that filed electronically with Edgar. The sample was limited to companies that had filed on a timely basis, and whose audit report contained a reference to revenue recognition in the paragraph following the opinion paragraph. All of the sampled companies reported a cumulative change in accounting principle in their income statement.

The majority of the companies were traded through NASDAQ (42%) and the New York Stock Exchange (25%). The National Market System and other exchanges accounted for 13% each, and the American Stock Exchange and over-the-counter stocks accounted for 3.5% each. Companies ranged broadly in age, number of employees, size, and industry. All of the companies were audited by one of the Big Five. A majority (58%) of the companies had net losses after the accounting change, with 4% placed in that position because of SAB 101 guidance. The average effect on earnings per share (EPS) was a loss of $0.37, and the largest effect on any one company was a loss of $4.37.

Of the 113 companies studied, 27% were in the pharmaceutical industry, 20% were in durable manufacturing, 12% were in a computer-related industry, and 8% were in the services category. The remaining third of the companies were in communications (7%), retail (5%), textiles and printing/publishing (5%), mining/extractive and construction (4%), food and tobacco (4%), chemicals (4%), transportation (2%), and financial, insurance, and real estate (2%).

Results of the Study

The second criterion, “delivery has occurred or services have been rendered,” was the most commonly referenced reason for a change in accounting method (92%). While delivery is generally when title and the rights and rewards of ownership are transferred, sometimes acceptance has not occurred upon delivery. Many (23% of total respondents) companies made generic disclosures about acceptance terms; for example, “upon delivery to customer,” “when risks have passed to the customer,” “goods delivered and title passed,” or just “when customer accepts.” Such companies typically sold a product, and represented varied industries, including Newmont Mining Corp., Jostens, Inc., Avon, Haverty Furniture, Idea Mall, and Applied Microsystems Corp.

When contractual provisions exist before customer acceptance (the seller is required to install or activate, testing is required, or additional services are required upon delivery), the seller cannot recognize revenue until customer acceptance occurs or the provisions expire. The seller should substantially complete and fulfill the terms of the contract; only inconsequential or perfunctory steps may be incomplete. While only a few companies surveyed used the term “inconsequential or perfunctory,” 19 companies provided disclosures that narrowed the reason for their change. For example, Datalink Corp. recognized revenue on hardware and software products when shipped or after products under evaluation were accepted; SAB 101 caused them to delay revenue recognition until they complete their installation and configuration services.

Checkpoint Systems Inc. had generally recognized revenue on equipment at shipment when title passed, but now recognizes revenue when installation or other post-shipment obligations are complete. CyberOptics Corp. had recognized revenue on sales of sensors and systems for the electronic assembly and semiconductor fabrication market upon shipment, but now defers elements of systems sales relating to installation, training, and other post-sale service support until after the service has been performed.

Multiple Deliverables

The accounting for multiple deliverables or elements is complex, thus the SEC’s FAQ document provides additional guidance. Elements may be considered separate if they either are or could be sold without the other elements. Revenue can be allocated among the elements based upon their fair value; reliable, verifiable, and objectively determinable fair values are often not available. In such cases, the revenue must be deferred until that evidence becomes apparent. Several SOPs (81-1, 97-2, and 98-9) provide additional guidance. The multiple-element arrangement can often be treated as a single-element arrangement using appropriate revenue recognition principles. If an arrangement includes multiple deliverables or elements, no revenue should be recognized until all of the elements essential to functionality are delivered. The SEC has asked the Emerging Issues Task Force and Auditing Standards Board to provide additional guidance. In the meantime, companies are cautioned to use reasoned methods that are applied consistently and disclosed appropriately.

Four companies described their change in terms of multiple deliverables or elements. For example, Waters Corp. had recognized revenue on both the sale and installation of certain products at shipment; in response to SAB 101 it now defers the revenue and recognizes it “as a multiple element arrangement in accordance with SAB 101 when installation is complete.”

Up-Front and Nonrefundable Fees

When companies disclosed different types of up-front or nonrefundable fees, they typically either disclosed that they were recognizing revenue over the “terms of the agreement” with no reference to any further performance required, or they made reference to ongoing performance. A quarter of the companies surveyed made no reference to further performance. For example, Penwest Pharmaceuticals is engaged in the research and development of drug delivery technologies. Previously, the company recognized revenue for up-front nonrefundable fees when received and when all of their contractual obligations related to the fees had been met. It had also recognized revenue relating to development milestones and other contractual fees as achieved, in accordance with collaboration agreements. Now, revenue received from nonrefundable up-front licensing fees is recognized ratably over the development period of the collaboration agreement. Pittston Co. consists of two operating segments, Brink’s and Brink’s Home Security. Before 2000, marketing and selling costs associated with obtaining new subscribers were charged against earnings as they were incurred. Now, the company defers all new installation revenue and the portion of the new installation costs considered to be direct costs of subscriber acquisition. Such revenues and costs are amortized over the expected term of the relationship with the subscriber. Because of the change, Pittston’s net income decreased by $1.4 million.

Crosswalk created an interactive website that provides information and resources to “the Christian and family-friendly community.” It generates revenues through the sale of online and offline advertising and online sponsorship contracts, and the online retailing of products. Prior to SAB 101, the company had been recording revenue for the content integration or development fee portion of sponsorships of its website upon completion of work related to the contract implementation. Now, revenue is recognized ratably over the term of the contract.

Another 27% of companies surveyed did refer to ongoing performance in recognizing revenue. For example, McGraw-Hill modified its revenue recognition policies with respect to various service contracts. Under SAB 101, it now recognizes revenue for agreements where it provides more than one service based upon the fair value to the customer of each service, rather than recognizing revenue based on the level of service effort to fulfill such contracts. If the fair value to the customer for each service is not objectively determinable, revenue will be recognized ratably over the service period. Genentech and Targeted Genetics both develop products to treat medical conditions through genetic and cell information. Previously, both recognized revenue from nonrefundable up-front license fees when the technology was transferred and they had fulfilled all of their significant contractual obligations relating to the fees. Now, nonrefundable up-front fees for licenses and rights are deferred and recognized as revenue over the period when continuing product development services are provided.

Price Communication develops and operates cellular telephone systems. Price changed its method of recognizing revenue from prepaid airtime to when the airtime is used, and revenue from activation fees over the estimated life of the subscriber’s contract. Terminex is one of the four operating segments of Servicemaster. Previously, approximately 80% of the company’s termite-baiting revenue was recognized at the time of the sale and installation, and the remaining 20% over the life of the contract. As a result of SAB 101, its policy is now to recognize revenue over the life of the contract. Sales commissions and other direct contract acquisition costs are deferred and amortized on a straight-line basis over the life of the contract.

Revenue Recognition Guidance

Despite all of the accounting pronouncements to address revenue recognition, FASB believes there is still a need for additional guidance. Many of the revenue recognition issues analyzed by the authors were related to nontraditional business models. Only 8% of companies surveyed did not change their accounting to address SAB 101’s criterion of “delivery has occurred or services have been rendered.” Revenue recognition issues are more difficult to resolve when services are provided or included alongside products. Companies that received up-front nonrefundable fees had problems defining the appropriate point of revenue recognition. Going forward, it is clear that delivery of a product is not sufficient for recognizing revenue when the customer expects additional services.

Kathy S. Moffeit, PhD, CPA, is a professor at the State University of West Georgia and
A. Elaine Eikner is an associate professor at Southwest Texas State University.

Robert H. Colson, PhD, CPA
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