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 sale...is 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

Diluted EPS and the Capital Structure

Although the financial media's reporting centers almost entirely on a corporation's reported basic earnings-per-share (EPS), most analysts have historically paid attention to a different line on the income statement: Diluted Earnings per Share. Diluted EPS takes into account the potential dilutive effect that would ensue if holders of the firms preferred stock and bonds were to convert their stake into common equity. This possibility theoretically exists whenever investors purchases securities that include a conversion option. Usually there is some sort of market based trigger point, but ultimately those details will be contained on the face of the preferred stock certificate, or in the bond covenants. For the sake of simplicity, let's say that Company X earned $1000 in a given quarter, and there are 1000 shares outstanding, resulting in quarterly Basic EPS of $1/share. However, let's assume that Company X has also financed itself via 500 shares of convertible preferred stock which give holders the right to convert each preferred share into 2 shares of common equity. Assuming that all preferred holders exercised that option, Company X would record 2000 outstanding shares of common stock, and would only have earned 50 cents/share for the same quarter. This hypothetical example is rather extreme for the purposes of making a point; below is a chart showing Basic v Diluted EPS during the most recently reported quarter for 7 large firms:
Corporations must disclose both basic and diluted EPS on the income statement, however the actual calculation is below for those who must know:

Diluted EPS = (Net Income - Preferred Dividends) / (Weighted Average # of Common Shares Outstanding + Additional Shares Due to Dilutive Securities)

Arithmetically, we can see that the dilutive effect increases the denominator, reducing the amount of net income available to each shareholder. In many firms with simple capital structures, the basic and diluted EPS numbers will be identical. However, firms that utilize more complex financing instruments generally have more potential for dilutive equity conversions.

Going forward, I would expect Diluted EPS to continue to gain significance, especially with regards to analysis of financial corporations. As banks struggle to refinance trillions of dollars worth of debt, the use of convertible options should become more popular for a couple of reasons. First, a conversion option represents value to the investor and additional capital for the borrower. Second, if the conversion option is tied to a regulatory trigger like TCE ratios, then the borrower is essentially selling an automatic equity boosting instrument for times of market distress. If things play out like I anticipate regarding convertible debt, the gap between basic and diluted EPS will grow further. Equity investors need to monitor these developments to insure that they are not diluted into oblivion.

*no positions
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