Saturday, December 12, 2009

Basic Principles of Revenue Recognition

Common sense would indicate to most people that the issue of revenue recognition shouldn't even be an issue; after all, a sale has either occurred or it hasn't right? The problem is, due to the multitude and variety of transactions that occur in the modern economy, it isn't always clear when a firm may record a given sales dollar. For instance, when several pieces of software are sold in a bundle, and a right of return exists for any of the individual bundled components, then at what point can the company reasonable assert that the sale is final? To look for guidance on this issue, we have to consult with dual sets of regulatory guidance, originating from the FASB and SEC.

The FASB guidelines for revenue recognition involve two primary criteria, both of which must be met in order for the sale to be legitimate and reportable as revenue:
  1. The revenue must be realized or realizable
  2. The revenue must be earned; that is, the company has performed it's duties under the terms of the sales agreement.
The general picture here is that the FASB has developed a relatively straightforward, common sense set of criteria for assessing when a a sale. The company must both have the cash - or be reasonably sure that it can collect the cash - and has actually delivered its product or service. The guidance doesn't stop there though; the SEC, via Staff Accounting Bulletin (SAB) 101, has issued four additional pieces of guidance in clarification of the principles of revenue recognition: 
  1. Persuasive evidence that a sales agreement/arrangement exists must be present. The SEC appears to believe that this principle is very important in relation to arrangements that customarily require a written sales agreement between the buyer and seller, specifically as it relates to the timing of product delivery and execution of a sales agreement. If product delivery and sales agreement execution fall in different fiscal periods, revenue can only be recognized in the later accounting period (during which both have been completed).
  2. Delivery has occurred or services have been rendered. The SEC seems to be interested in the passage of title and assumption of risks associated with the delivered product. A consignment store may have received delivery of a product, but it hasn't assumed title, or any of the risk associated with owning the product. As such, revenue can not be recognized until the consignment product has been paid for.
  3. The seller's price to the buyer is fixed or determinable. The SEC's primary focus with regards to this rule has to do with "side agreements" that may have attached themselves to the primary sales arrangement. Sometimes, the practical effect of these side agreements is to transform a sale into a demonstration period or otherwise incomplete sale. In such cases, the associated revenues may not be recognized. The SEC further explains that when the right of return is structured so that the dollar value of returnable product declines according to a fixed schedule over time, the associated revenue must be recognized according to that schedule.
  4. Collectibility is reasonably assured. This requirement is not explicitly addressed in SAB 101, however the general principles outlined in the bulletin can be applied towards its understanding. If the transaction is customary, historic data indicates a reasonable expectation of collectibility, and no external factors which might affect the transaction have significantly changed, then we can probably infer that the requirement has been satisfied. There are some obvious factors that could hinder the assurance of collectibility, such as bankruptcy proceedings or major litigation.
Because the SEC has issued these guidelines, they must be followed in addition to the FASB/GAAP requirements. As business practices evolve, its likely that the issue of revenue recognition will continue to be clarified and revised accordingly. Nevertheless, investors should be aware that not all revenue is created equally, and is subject to restatement, especially during times of economic turmoil. Sphere: Related Content

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