Monday, June 22, 2009

In accounting, revenue recognition refers to the point when one is able to record a sale in the financial statements. In a typical retail environment, sales timing is straightforward because there is a clear point when a buyer makes a selection, makes a payment, and takes the merchandise. But, in many commercial environments, a sales transaction does not occur at a single moment in time, and/or the seller has ongoing responsibilities for customer service and support. Often it is difficult to measure the financial impact of these ongoing responsibilities.

In these situations, revenue recognition accounting rules are important. In the U.S., there are more than a hundred pieces of revenue recognition guidance that have been issued over decades, many in response to industry-specific questions. Despite this specific guidance, revenue recognition remains one of the most frequent areas where accounting restatements and accounting-related litigation occurs.

The Financial Accounting Standards Board (FASB), the current accounting rule maker in the U.S., proposed a revenue recognition change that would scrap the existing guidance, and start from scratch with a new principle. Generally, current accounting rules record revenue based on whether the seller or the buyer holds the risks and rewards of ownership. Under the proposal, revenues would be recognized based on when the seller satisfies a performance obligation that includes transferring goods and services to a customer. This new approach focuses more on when the customer controls that which is being sold.

If a contract contains more than one performance obligation, each portion of the contract would need to be identified and measured at the contract commencement. The amount of revenue recognized as the contract proceeds is the amount allocated to each satisfied performance obligation at contract inception.

For the most part, this is not a major change. Here are the most immediate expected changes:

1. Construction companies who build factories, public works contracts, ships, airplanes, and other large assets under long-term contracts would no longer be able to use the percentage of completion method of accounting for these projects.

2. Currently, warranties and other post-delivery services are treated as cost accruals, and not as components of the overall sales transaction. Sales of a product with related service obligations (as frequently occurs in the high technology industries), warranties, and buyer-reward programs (like airline frequent flyer programs) would need to allocate a portion of the overall transaction price and record each as a separate revenue component. Sellers will be tempted to alter their contracts to allocate the revenue to the various contract pieces to help justify the accounting treatment to auditors and regulators.

3. Some existing standards limit the use of estimates to a greater extent than would be allowed under the proposed change. Under existing restrictions, no revenue is recognized if there is no reliable and objective evidence of the selling price of the undelivered (future) items. Certain software sales are a prominent example of this practice. Under the proposal, sellers could use estimates to determine stand-alone revenues for future deliverables that are part of a contract.

4. Some entities capitalize costs of obtaining contracts (e.g., commissions) to match the costs with the related revenue recognition. Unless otherwise allowable under other standards, such sales costs would be expensed as incurred, even if this is before the time when revenue is recognized. This may cause some sales commission plans to change.

5. If there are obligations between the buyer and seller that go in both directions, as frequently occurs in collaborative research agreements, seller and buyer obligations would be netted against one another. Only the net result would be presented as an asset or liability. Revenue is recognized when the seller's net contract position increases.

This proposal is part of a much larger effort to harmonize or "converge" U.S. accounting rules with those in the rest of the world. Outside the U.S., accounting standards are not as specific, but are instead "principles based". For an explanation of this, see How Principles-Based Accounting Affects Lawyers. The current FASB revenue proposal is part of this convergence project; the International Accounting Standards Board (IASB) simultaneously issued an identical (except for minor formatting and spelling differences) proposal. Background regarding the movement to international accounting standards is at Foreign Reporting Standards in the U.S.

Public comments on the current discussion are accepted through this week. Then, expect further announcements as the process for amending these important accounting rules continues.

Fulcrum Inquiry performs forensic accounting and financial investigations.