The Legal Side of Revenue Recognition
By Ken Mitchell-Phillips, Sr.
August 1, 2009
Although analyzing financial statements has traditionally been a task for investment bankers, accountants, or financial managers, the role of lawyer in analyzing financial statements has significantly increased. The reason for the increase is partly due to the Sarbanes-Oxley Act – enacted in response to the corporate and accounting scandals of companies like Enron, Tyco International, Adelphia, and Worldcom. Also, the accounting scandals of the leading public accounting firms like Arthur Andersen, Deloitee & Touche, Ernst & Young, KPMG also a played an important role in the increase when these leading firms were held partly responsible for misleading impressions of the financial status of large companies. As a result, if you aren’t allowing your lawyer to analyze your financial statements you may be taken on some unnecessary risk.
One of the key areas where companies encounter problems is in the area of revenue recognition. Over half of all securities fraud cases involve revenue recognition issues. Under the U.S. generally accepted accounting principles (“GAAP”), revenue should only be recognized when the earning process is complete and an exchange has taken place. The Securities Exchange Commission has issued rules further explaining the GAAP principles of revenue recognition (e.g. SAB No. 104) and although the rules are only applicable to public companies, the rules are also useful for private companies to follow to avoid costly litigation.
The following is a list of revenue recognition red flags commonly found in financial statements that both private and public companies should avoid:
- Revenue Gross-Up: Revenue Gross-Up is a practice that many internet firms used in the early part of this decade. The companies would report the entire sales price a customer paid at their site when in reality the companies kept only a small percentage of the amount they collected. Priceline.com was criticized for this strategy because about 72% of amount the customers paid to Priceline.com went to airlines, hotels, or other vendors. Although the SEC in 2005 accepted Priceline.com’s practice of revenue gross-up, other companies have not received acceptance of this practice.
- Right to Return. When a company sells a product to another company and the contract gives the company buying the product a right to return it, the selling company may have a financial accounting duty not to recognize the revenue from the sale of the product until the right to return the product has elapsed. Companies like Delphi Corp. had problems in 2005 with this right to return issue when senior executives recorded sales of inventory to outside companies despite an agreement with that company to buy back those same assets at a later date.
Channel –Stuffing. Over the years, many companies have engaged in inflating their financial results by shipping more goods than their customers want or need. Companies will accompany the shipment with a guarantee that the customer will get the benefit of any future price reductions or by a promise that the customer may return the goods if not sold. A red flag for this activity is when accounts received growth is in excess of revenue growth.
- Bill and Hold. Bill and Hold is another revenue recognition problem that arises when the seller has not yet shipped goods but books revenues on the grounds the customer has agreed to take the goods but wants the vendor to hold off on shipping them. In response to this type of revenue recognition, the SEC in SAB 104 has set forth criteria for the companies to use when recognizing revenue before delivering the product.
- Prepayment. Companies that collect payments in advance should not book the sales until the goods or services have been rendered. For example if a magazine publisher sells an annual subscription of a weekly magazine for $26, it should book revenue of $.50 a week as it ships the magazines throughout the year. Until then the cash it collects is offset by a liability representing the obligation to deliver the magazines. The SEC’s position is that revenue should not be booked until the goods have been delivered to the customer.
- Upgrades. Companies also might run into revenue recognition problems when there are potential upgrades involved. For example, if a vendor has a contract that gives a retailer the right to return the product within a certain amount of time, the vendor should estimate the number of cables to be returned and treat that percentage as a doubtful account. The vendor should defer revenue recognition until the time for return has lapsed.
- Related Service Agreements. Similar to upgrades, related service agreements may cause revenue recognition problems. So for example, if a computer system is sold on a bundled basis at $125 million at the time of installation and $25 million/yr for each of the three years of service, then the company should book $125 million at the time of installation and $25 million per year for the length of the service contract. Xerox received one of the largest civil penalties of the time for its leasing arrangements when it bundled the sale , financing, and service elements of its equipment together and recognized revenue all at once.
- Sale of Franchises. When a franchisor collects a high front-end fee in return for exclusive rights to a territory the franchisers may book the fee as revenue. However, this practice could make the growth rate in early years look spectacular but significantly drop in later years. Jiffy Lube International ran into this problem when its stock price jumped from $78 per share in 1986 to $250 share in 1997. The price run up was directly related to reported revenue growth. When the growth tapered off and investors looked at royalty revenues instead of the front-end fees, the stock price fell to $3.50 a share in 1990.
- Large Projects. When companies have large contracts that span several years, the GAAP rules permit those companies to book revenues before the entire projects is completed. However, companies must use the percentage completion methods. Problems may arise when the parties to the contract change and the contract is subsequently cancelled.
If your business needs help navigating the risk involved with revenue recognition on financial statements, be sure to set up an appointment today by contacting Ken Mitchell-Phillips at 503-471-1330 or ken@mitchellphillipslaw.com.
