Revenue-Recognition Decisions: A Slippery Slope?

By Ronald L. Clark

OCTOBER 2006 - Consider this scenario: Capitol Motors is in its first year of operations and as of December 30 has total revenues of $5 million, projected net income of $200,000, and total assets of $40 million (Capitol’s year-end is December 31). On December 31, a customer and Capitol Motors agree to terms on the purchase of a new automobile for $25,000. Theonsider this scenario: Capitol Motors is in its first year of operations and as of December 30 has total revenues of $5 million, projected net income of $200,000, and total assets of $40 million (Capitol’s year-end is December 31). On December 31, a customer and Capitol Motors agree to terms on the purchase of a new automobile for $25,000. The customer signs and completes all paperwork for the sale but asks Capitol to hold the full-payment check until he can complete financing with a local bank. Because the bank has already closed for the day, it will be January 2 before the customer can release the check to Capitol. The customer already has a $30,000 line of credit approved by his bank. The Capitol Motors’ credit manager reviews the customer’s file and offers to finance the transaction through the dealership’s financing company. The customer, however, wishes to use a local bank and declines the financing offer. The customer and Capitol agree to leave the automobile on the dealership lot overnight so it can be properly serviced (e.g., washed, fluid levels checked). Given these facts, should Capitol Motors record a sale as of December 31?

This case was presented to approximately 700 CPAs in continuing education courses taught by the author. On each occasion, a majority of CPAs indicated they would book the transaction as a December 31 sale. The two primary reasons given were the following:

  • All significant aspects of revenue-recognition requirements had been met;
  • The sale is immaterial to total revenue, therefore recording the transaction on December 31 would not be inappropriate.

The Revenue-Recognition Argument

Accountants have traditionally recognized revenues when realized and earned. Matched against these revenues are expenses incurred in generating the revenues. This is referred to as the realization/earnings/matching approach. FASB, however, is working on a revenue-recognition project that is expected to follow the asset/liability approach, under which revenue is recognized and measured based on the change in assets and liabilities. The intent here is not to debate the two approaches, but for the case at hand one could argue that revenues would be recognized regardless of the approach used.

As stated above, most of the CPE session participants agreed that the automobile dealership had “earned” the revenue because all significant aspects of the sale had been met. Under the asset/liability approach it is clear the dealership has increased an asset—at a minimum as accounts receivable—and therefore should recognize the revenue.

One might argue that because the servicing of the automobile is insignificant to the purchase price, the earnings process is complete. Another possible situation deserves consideration, however: What if the customer changes his mind and decides not to purchase the automobile and never returns to the dealership? Can (or would) the dealer force the customer to purchase the automobile? One must, therefore, consider the possibility of a “right of return.”

Right of Return

SFAS 48, Revenue Recognition When Right of Return Exists (released June 1981), describes how to account for a sale when the buyer has a right to return the product. Revenue from sales transactions with a right of return shall be recognized at time of sale only if certain conditions are met. Even then, the seller should accrue any estimated returns and expected costs. If the following criteria are not met, revenue recognition should be postponed:

  • The price is substantially fixed or determinable at the date of sale;
  • The buyer has paid or is obligated to pay the seller;
  • The buyer’s obligation to the seller would not be changed in the event of the theft, physical destruction, or damage of the product; and
  • The amount of future returns can be reasonably estimated.

Returning to the example above, the first question is whether SFAS 48 applies. Some auto dealers do provide a right of return clause in their sales contract. Also, some state laws automatically provide for the right of return (e.g., providing for minors who enter into a contract sale). This case, however, does not mention a right of return clause and, therefore, one must assume none exists.

Before dismissing SFAS 48, consider the third criterion: The buyer’s obligation to the seller would not be changed in the event of the theft, physical destruction, or damage of the product. This concept is also contained in the SEC Staff Accounting Bulletins (SAB) 101 and 104.

SABs 101 and 104

The SEC released SAB 101, Revenue Recognition in Financial Statements, in 1999. In 2003, the SEC revised that guidance in SAB 104. SABs 101 and 104 describe four criteria for recording revenue:

  • Persuasive evidence of an arrangement exists;
  • The price is fixed or determinable;
  • Collectability is reasonably assured; and
  • Delivery has occurred.

While nonpublic companies and their auditors are not subject to SABs, it would be a mistake not to consider their advice, especially when it relates to fundamental accounting transactions such as recording revenues.

Persuasive evidence of arrangement. Given that the customer signed all necessary paperwork and had financing arranged at a local bank, there appears to be sufficient evidence that a sales arrangement exists. The participants agreed that this criterion was met.

Price fixed and collectability assured. The buyer and seller have agreed on a price. Some participants concluded that payment is not assured because Capitol Motors faces a risk that the customer cannot obtain financing from his local bank. Other CPAs argued that because the dealership offered to finance the purchase even if the customer cannot obtain a loan, the dealership will finance the automobile and, therefore, payment is realizable. Without any evidence to the contrary, the most likely conclusion is that the price and collectability criteria are met for revenue recognition.

Delivery made. Some of the CPAs that participated in the discussion of the example above argued for constructive receipt—that, for all practical purposes, the delivery of the car was made. Others, however, contended that although the “checking of fluids and washing the automobile” are minor, delivery was not completed. This part of the discussion led to the following hypothetical questions: What would happen if the automobile was damaged or stolen from the dealer’s lot before the customer returns to pick up the automobile? Who would be responsible: the dealer, or the customer? A key question is whether the right and risk of ownership was transferred to the customer. If the automobile was stolen or damaged, most participants were quite confident that the customer would refuse delivery of this specific automobile. In several cases, discussion of the delivery criterion came down to an interpretation of law.

The Materiality Argument

Common responses from CPAs when presented with this case centered on the concept of materiality. Most CPAs decided they would book the transaction at December 31 because the following conditions were met:

  • All significant elements of a sale have been accomplished;
  • The risk of the customer’s not completing the sales transaction is low; and
  • The sale is immaterial to total revenue, net income, and total assets.

Evaluating this argument requires examining the concept of materiality.

Accounting standards. One can find several references to materiality in FASB or Accounting Principles Board statements. For example, materiality is a consideration in Accounting Changes and Error Corrections as covered by SFAS 154 (previously APB Opinion 20). Perhaps the most familiar discussion of materiality is in APB 30, on accounting for extraordinary items. APB 30 states that an event or transaction may be classified separately in the income statement as an extraordinary item “if it is material in relation to income before extraordinary items.” SFASs also carry the following phrase: “The provisions of this Statement need not be applied to immaterial items.”

One could argue, therefore, that because the particular sale in this case is not material, it would not be inappropriate to book the transaction at year-end. Existing SFASs and APBs, however, do not support this argument. The materiality provisions of standards such as APB 30 deal primarily with presentation and disclosure, not whether a transaction should be recorded. For example, if a farmer in Florida lost an orange crop due to frost, the decision is whether the loss should be shown as extraordinary, not whether the loss should be recorded.

The materiality phrase in a FASB statement applies to that specific type of transaction, and it would be inappropriate to extrapolate that reasoning to other types of transactions. In other words, even if FASB were to add the materiality phrase to every statement it published, there is no foundation to assume that future FASB statements would contain the same provision. Nor should one assume that materiality is a relevant factor for any generally accepted accounting principle that is not specifically addressed by a promulgated standard.

Auditing standards. Materiality has long been a relevant concept in audit engagements. The concept, however, is quite different for auditing than for financial accounting. Materiality in an audit relates to the auditor’s judgment concerning evidence and the appropriate type of audit opinion required under the circumstances.

One source of confusion may be an auditor’s decision to pass on certain adjustments to the financial statements because an adjusting journal entry will have no impact on the auditor’s decision concerning the appropriate type of audit report to issue. In other words, materiality reflects an auditor’s judgment, not the application of accounting principles.

CPE session participants discussing this case often noted that the amount of the transaction was immaterial based on traditional “rules of thumb” used to set materiality levels. SAB 99, Materiality (issued in 1999), however, requires one to consider both quantitative and qualitative factors in assessing an item’s materiality. The auditor must consider all relevant facts, including the nature and circumstances of the misstatement. SAB 99 points out that intentional misstatement may signal other potential problems, such as reportable internal control conditions or even illegal acts.

The Answer

Many readers may have concluded that the answer to the automobile case is “It depends” or “It’s a matter of judgment.” Based on current accounting literature and tentative decisions made by FASB on its revenue-recognition project, however, there is strong evidence that supports not booking the sale on December 31:

  • Have absolute ownership and the related risks passed to the customer? Are accountants prepared to interpret the “law” in this case? Perhaps the conservative approach would be best: As long as the seller retains some risk, the sale should not be recorded.
  • Materiality is not a concept to apply in determining when a fundamental transaction such as a sale should be recorded. Recording sales is a basic accounting function, and the question is not whether to record but when one should make the entry. A key element of any accounting information system is the set of well-defined procedures that trigger the recording of a transaction. Exceptions are created when one deviates from those procedures either intentionally (perhaps fraud) or when a materiality measure is applied. Frequently, these exceptions are what create audit and financial reporting problems and issues.

The Slippery Slope of Accounting

Whether you agree or disagree with the above conclusion of not booking the sale on December 31, there is an important point: the potential for fraud. The author asked his CPE participants an additional question: “If your general ledger is out of balance by a nickel, would you look for the nickel?” The answer was always no, giving the reason that the nickel is immaterial. While a nickel is certainly immaterial, if the general ledger is out of balance by any amount, then the financial statements are inaccurate. Our books and subsequent financial statements are either right or wrong. And this introduces the slippery slope of accounting.

Let’s expand the year-end sale example with Capitol Motors. What if the sales manager presented the bookkeeper with the sale and the transaction was recorded and accepted by the auditor? A door has now been opened that will facilitate booking future transactions that may be fraudulent. Assume that next year the sales manager says to the bookkeeper, “While these contracts are not totally completed, let’s record them so the salesperson will be paid her commission.” The bookkeeper is likely to respond, “What a great manager, always thinking about others!” Then the year after that, the sales manager needs to meet a quota and makes up three or four fraudulent sales transactions. One can imagine how the bookkeeper would respond to this “act of kindness.”

In many of the major frauds over the last few years, revenue recognition was a key ingredient. Both the SEC and FASB have made revenue recognition a major focus for standards setting and scrutiny. Controllers and auditors need to adopt strict policies and controls over when revenue is recognized. Revenue is the driving force to earnings. It’s important to get it right. Once an opportunity to commit fraud has been created, closing the door is difficult. Even immaterial transactions can create an atmosphere where major fraud can be perpetrated. A final note: The author presented this case to six general managers of automobile dealerships. All six managers agreed: Book the sale at December 31. What had started out as a seemingly simple accounting issue very quickly turned complex. Perhaps those of us in academe are partly to blame for current revenue-recognition issues. In principles and intermediate accounting courses, in every problem the sale is always a “given.”

Has the profession become complacent when it comes to recording routine transactions? Some sound advice might be: “When it comes to revenues, get it right.” After all, every district attorney in the country has by now heard the term revenue recognition. They may not understand all the theory, but rest assured they know that revenue recognition has been the source of many a recent fraud.

On May 16, 2005, the Public Company Accounting Oversight Board (PCAOB) published its findings regarding the first round of corporate reporting under the Sarbanes-Oxley Act (SOX) and, more specifically, PCAOB Auditing Standard 2. While there are interpretation issues with SOX, the greater focus seems to be on internal controls and “tone at the top.” Even though SOX applies only to registered companies and their auditors, one need only look at Statements on Auditing Standards (SAS) and Statements on Standards for Accounting and Review Services (SSARS) to find evidence that corporate governance applies to all size entities.

Whether auditing a Fortune 500 company or compiling financial statements for a local sole proprietorship, accountants must pay particular attention to revenue recognition. “Getting it right” has been and must continue to be the byword of accountants. One thing the profession has learned during the last several years is that if revenues are misstated, then a host of other accounting issues is likely. Judging violations to revenue recognition as immaterial is the start of a slippery slope.

Ronald L. Clark, PhD, CPA, is a professor in the school of accountancy at Auburn University, Auburn, Ala.