Revenue Recognition Concerns

The principles guiding recognition of revenues for financial reporting purposes are central to GAAP and in most instances are unambiguous and straightforward.

However, while the currently effective basic principles are uncomplicated, it is nonetheless true that a large percentage of financial reporting frauds over the period beginning about 1995 were the result of misapplications, often deliberate, of revenue recognition practices prescribed under GAAP. Apart from outright fraud (e.g., recording nonexistent transactions), there were several factors contributing to this unfortunate state of affairs.

First, business practices have continued to grow increasingly complex, involving, among other things, a marked shift from manufacturing to a service-based economy, where the proper timing for revenue recognition is often more difficult to ascertain. Second, there has been an undeniable increase in the willingness of managers, whose compensation packages are often directly linked to the company's stock price and reported earnings, to “stretch” accounting rules to facilitate earnings management. This has particularly been the case where GAAP requirements have been vague, complex, or abstruse. And third, it has been well documented that, too often, independent auditors have been willing to accommodate managements' wishes, particularly in the absence of specific rules under GAAP to support a denial of such requests. These actions have often had disastrous consequences, if not immediately, then in the longer run.

Errors or deliberate distortions involving revenue recognition fall into two categories: situations in which revenue legitimately earned is reported in the incorrect fiscal (financial reporting) period, often referred to as “cutoff” errors, and situations in which revenue is recognized although never actually earned. Given the emphasis on periodic reporting (e.g., quarterly earnings announcements in the case of publicly held entities), even simple “cutoff” errors can have enormous impact, notwithstanding the fact that these should tend to offset over several periods. As a practical matter, all instances of improper revenue recognition constitute a challenge to all accountants attempting to properly interpret and apply GAAP, including independent auditors.

Revenue Recognition—General Guidelines

Revenue, whether from the sale of product or provision of services, is to be recognized only when it has been earned. According to CON 5, Recognition and Measurement in Financial Statements of Business Enterprises:

…An entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations, and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. (Para. 83)

In other words, in order to be recognized revenue must be realized or realizable, and it must have been earned.

CON 5 notes that “the two conditions (being realized or realizable, and being earned) are usually met by the time product or merchandise is delivered or services are rendered to customers, and revenues from manufacturing and selling activities and gains and losses from sales of other assets are commonly recognized at time of sale (usually meaning delivery).” Moreover, “if services are rendered or rights to use assets extend continuously over time (for example, interest or rent), reliable measures based on contractual prices established in advance are commonly available, and revenues may be recognized as earned as time passes.” In other words, for most traditional and familiar types of transactions, the point at which it is appropriate to recognize revenue will be quite clear. (CON5, Para. 84a)

The SEC, reflecting on the conceptual foundation for revenue recognition, observed in Staff Accounting Bulletin (SAB) 104, that:

…revenue generally is realized or realizable and earned when all of the following criteria are met:

1. There is persuasive evidence that an arrangement exists
2. Delivery has occurred or services have been rendered
3. The seller's price to the buyer is fixed or determinable, and
4. Collectibility is reasonably assured.

Note that, while Securities and Exchange Commission (SEC) rules and “unofficial” guidance are not necessarily to be deemed GAAP for nonpublic companies, to the extent that these provide insights into the application of the Accounting Standards Codification (ASC), they should always be viewed as relevant guidance and followed, absent other, contradictory rules established under GAAP. In the absence of any other authoritative source, SEC pronouncements may represent the best thinking on the subject and would thus be considered authoritative for all reporting entities.

With regard to the four criteria set forth above, consideration should be directed at the following discussion, which is drawn partially from SAB 101 and SAB 104.

First, regarding persuasive evidence of an arrangement, attention must be paid to the customary manner in which the reporting entity engages in revenue-producing transactions with its customers or clients. Since these transactions are negotiated between the buyer and seller and can have unique or unusual terms, there are (and can be) no absolute standards. Thus, for an enterprise that traditionally obtains appropriate documentation (purchase orders, etc.) from its customers before concluding sales to them, advance deliveries to customers, even if later ratified by receipt of the proper paperwork, would not be deemed a valid basis for revenue recognition at the time of delivery.

When evaluating purported revenue transactions, the substance of the transactions must always be considered, and not merely their form. It has become increasingly commonplace to “paper over” transactions in ways that can create the basis for inappropriate revenue recognition. For example, transactions that are actually consignment arrangements might be described as “sales” or as “conditional sales,” but revenue recognition would not be appropriate until the consigned goods are later sold to a third-party purchaser.

Careful analysis of the rights and obligations of the parties and the risks borne by each at various stages of the transactions should reveal when and whether an actual sale has occurred and whether revenue recognition is warranted. In general, if the buyer has a right to return the product in question, coupled with a deferred or conditional payment obligation and/or significant remaining performance obligations by the seller, revenue will not be recognizable by the seller at the time of initial delivery. Similarly, if there is an implicit or explicit obligation by the seller to repurchase the item transferred, a real sales transaction has not occurred. The buyer must assume the risks of ownership in all cases if revenue is to be recognized.

With regard to whether delivery has occurred or services have been rendered, ownership and risk taking must have been transferred to the buyer if revenue is to be recognized by the seller. Thus, if the seller is holding goods for delivery to the buyer because the buyer's receiving dock workers are on strike and no deliveries are being accepted, revenue generally cannot be recognized in the reporting period, even if these delayed deliveries are made subsequent to period end. (There are limited exceptions to this general principle, typically involving a written request from the buyer for delayed delivery under a “bill-and-hold“ arrangement, having a valid business purpose.)

The SEC frowns upon bill-and-hold transactions. It will generally not allow revenue recognition in either of the following circumstances:

• When a company completes manufacturing of a product and segregates the inventory within its facility; or
• When a company ships products to a third-party storage facility while retaining title to the product and payment by the buyer will not occur until it is delivered to the buyer.

The SEC bases its opinion on the underlying concepts that revenue recognition does not occur until the customer takes title to the goods and assumes the risks and rewards of ownership. Consequently, the SEC uses all of the following criteria when determining whether revenue should be recognized:

1. Ownership risk must pass to the buyer;
2. The customer makes a (preferably) written commitment to buy the goods;
3. The buyer must require that the sale be on a bill-and-hold basis, and have a substantial business purpose for doing so;
4. There is a reasonable delivery schedule for the goods;
5. The seller has no remaining performance obligations;
6. The goods have been segregated, and cannot be used to fill other orders received by the seller; and
7. The product must be complete.

The SEC further states that generally delivery has not occurred unless the product has been delivered to either the customer or another site specified by the customer. If the customer specifies delivery to a staging site but a substantial portion of the sales price is not payable until delivery is ultimately made to the customer, then revenue recognition must be delayed until final delivery to the customer has been completed.

Delivery, as used here, implies more than simply the physical relocation of the goods to the buyer's place of business. Rather, it means that the goods have actually been accepted by the customer, which, depending on the terms of the relevant contract, could be conditioned on whether inspection, testing, and/or installation have been completed, and the buyer has committed to pay for the items purchased. For revenue recognition to be justified, substantial performance of the terms of delivery must have occurred, and if any terms remain uncompleted, there should be a basis grounded on historical experience to assume that these matters will be satisfactorily attended to.

In some instances there are multiple “deliverables.” In such cases, revenue is not recognized for any given element if later deliverables are essential for the functionality of the already delivered element. In other situations, such as in various licensing arrangements, physical “delivery” may occur well before product usage by the buyer can take place (e.g., software for the future year's tax preparation delivered before the current year end), and revenue is not to be recognized prior to the initial date of expected use by the buyer.

The SEC holds that revenue should not be recognized until such time as any uncertainty about customer acceptance of goods or services has been eliminated. This requires an examination of customer acceptance provisions in the purchase agreement. For example, the agreement may allow the customer to test the product or require additional services subsequent to delivery, such as product installation. If these provisions exist, the SEC assumes that the customer specifically bargained for their inclusion in the agreement, which makes them substantive parts of the agreement. Consequently, revenue cannot be recognized until either the customer has accepted the goods or services, or the acceptance provisions have lapsed.

The SEC states that formal customer sign-off on a contractual customer acceptance provision is not always necessary. Instead, the seller can demonstrate that the criteria specified in the acceptance provisions are satisfied.

The SEC considers customer acceptance provisions to take one of four general forms, which are:

1. Acceptance for trial or evaluation purposes. The customer agrees to accept the product strictly for evaluation purposes, so title remains with the seller. The customer may then actively affirm acceptance or do so simply through the passage of time; in either case, this is essentially a consignment arrangement where the seller should not recognize revenue until the customer confirms that it will purchase the product.
2. Acceptance granting a right to return or exchange on the basis of subjective issues. The customer has the right to return the product if dissatisfied with it. In this case, a company can recognize revenue at the initial point of sale, but only if it can reasonably estimate the amount of future returns and accrue for them. If the seller cannot make this estimate, then it must wait until the right of return has expired before recognizing revenue.
3. Acceptance based on seller-specified objective criteria. The customer has a right of return or replacement if the delivered product is defective or fails to meet its published specifications. If the seller has already demonstrated that the product meets its specifications and can reasonably estimate the amount of defective products, then it can create a warranty reserve and recognize revenue at the point of sale. If the seller cannot prove that the product meets its published specifications, then it should defer revenue recognition until the specifications have been achieved.
4. Acceptance based on customer-specified objective criteria. The customer has created a specific set of acceptance criteria that the seller must meet before the customer will accept the delivery. This is best achieved with a formal sign-off document. Alternatively, the seller can demonstrate that the delivered product meets the customer's criteria (such as through preshipment testing). However, it may not be possible to conduct such testing prior to delivery, because performance may vary based on how the product works in combination with the customer's other systems. In this case, revenue recognition should be deferred until the product is actually installed and meets the stated criteria. Also, the seller must evaluate its ability to enforce a payment claim in the absence of a formal sign-off. If payment enforcement would be difficult, then revenue recognition should be deferred until formal customer sign-off.

   This is perhaps the most subjective of the four forms of customer acceptance, so the SEC states that it will not object to a determination that is well reasoned on the basis of the guidance just described.

In the case of many service transactions, large up-front fees are often charged, nominally in recognition of the selling of a membership, the signing of a contract, or for enrolling the customer in a program. (For example, initiation fees to join a health club where the terms of membership also obligate the member to pay ongoing fees.) Unless the services provided to the customer at inception are substantial, the presumption is that the revenue received has not been earned, but rather must be deferred and recognized, usually ratably, over the period that substantive services are provided. Thus, initiation fees are amortized over the membership period.

In cases where the seller is providing a service and requires an up-front fee, the SEC prefers that the fee be accounted for as revenue on a straight-line basis; this recognition shall be either over the term of the arrangement or the expected period during which services are to be performed, whichever is longer. The only situation where revenue is not recognized on a straight-line basis is when revenue is earned or obligations are fulfilled in a different pattern.

Even in cases where the seller's obligations to the buyer are inconsequential or perfunctory, the SEC believes that the substance of these transactions indicates that the buyer is paying for a service that is delivered over a period of time, which therefore calls for revenue recognition over the period of performance.

The seller's price to the buyer is fixed or determinable when a customer does not have the unilateral right to terminate or cancel the contract and receive a cash refund. Depending on customary practice, extended return privileges might imply that this condition has not been met in given circumstances. Prices that are conditional on the occurrence of future events are not fixed or determinable from the perspective of revenue recognition.

In theory, until the refund rights have expired, or the specified future events have occurred, revenue should not be recognized. As a practical matter, however, assuming that the amount of refunds can be reliably estimated (based on past experience, industry data, etc.), revenues, net of expected refunds, can be recognized on a pro rata basis. Absent this ability to reliably estimate, however, revenue recognition is deferred.

The final factor, reasonable assurance of collectibility, implies that the accrual for bad debts (uncollectible accounts receivable) can be estimated with reasonable accuracy, both to accomplish proper periodic matching of revenue and expenses, and to enable the presentation of receivables at net realizable value, as required under GAAP. An inability to accomplish this objective necessitates deferral of revenue recognition—generally until collection occurs, or at least until it becomes feasible to estimate the uncollectible portion with sufficient accuracy.

The SEC holds that revenue may be recognized in its entirety if the seller's remaining obligation is inconsequential or perfunctory. This means that the seller should have substantially completed the terms specified in the sales arrangement in order for delivery or performance to have occurred. Any remaining incomplete actions can only be considered inconsequential if the failure to complete them would not result in the customer receiving a refund or rejecting the products or services. Further, the seller should have a history of completing the remaining tasks in a timely manner, and of being able to estimate all remaining costs associated with those activities. If revenue is recognized prior to the completion of any inconsequential items, then the estimated cost of those inconsequential items should be accrued when the revenue is recognized.

An extreme situation, calling for not merely accrual of losses from estimated uncollectible receivables, is to defer revenue recognition entirely until collectibility is assured (or actually achieved). The most conservative accounting alternative, as set forth in CON 5, is to record revenue only as collected. It states: “(i)f collectibility of assets received for product, services, or other assets is doubtful, revenues and gains may be recognized on the basis of cash received” (emphasis added). The permissive language, which (it must be assumed) was deliberately selected in preference to a mandatory exhortation (e.g., “must”), suggests that even in such a situation this hyperconservative departure from accrual accounting is not truly prescriptive, but is a possible solution to a fact-specific set of circumstances.

Financial Statement Presentation: Gross Versus Net

In general, it is well established that reporting on a “gross” basis is appropriate when the entity takes ownership of the goods being sold to its customers, with the risks and rewards of ownership accruing to it. For example, if the entity runs the risk of obsolescence or spoilage during the period it holds the merchandise, gross reporting would normally be appropriate. On the other hand, if the entity merely acts as an agent for the buyer or seller from whom it earns a commission, then “net” reporting would be more appropriate.

Enterprises may inflate the revenues reported in their income statements by reporting transactions on a “gross” basis, notwithstanding that the entity's real economic role is as an agent for buyer and/or seller. This distortion became widespread in the case of Internet commerce-based “dot-com companies” and other start-up and innovative businesses typically not reporting earnings, for which market valuations were heavily influenced by absolute levels of and trends in gross revenues. Reporting revenues “gross” rather than “net” often had an enormous impact on the perceived value of those enterprises.

Factors to consider in determining whether sales are properly reported “gross” or “net” include:

1. Whether the entity acts as a principal or an agent in the transactions
2. Whether the entity takes title to the property
3. Whether the entity has the normal risks and rewards of ownership
4. Whether the entity acts as an agent or broker (including performing services, in substance, as an agent or broker) with compensation on a commission or fee basis.

Reporting Taxes Collected as Revenue

Most businesses must collect certain taxes which must subsequently be transmitted to governmental bodies, making the entity in effect an agent of the state. The most obvious example of this situation is the imposition of sales taxes, which are almost universally applicable to retail merchandise transactions and, increasingly, to service transactions as well. Historically accounting practice has varied, with some entities reporting gross revenue inclusive of taxes—which are then later reported as expenses when remitted—while other entities report revenue net of these taxes, treating them as purely a statement of financial position event. ASC 605-45-50-3 confirms that either methodology is acceptable, and if material, should be defined in the accounting policies note to the financial statements. As an elective accounting policy, accordingly, any change in method should be justified as being warranted as a means of improving financial reporting.

Barter Transactions

Barter transactions (nonmonetary exchanges, as described in ASC 845-10) are not a problem, assuming that they represent the culmination of an earnings process. However, in recent years there have been many reports of transactions that appear to have been concocted merely to create the illusion of revenue-generating activities. Examples include advertising swaps engaged in by some entities, most commonly “dot-com” enterprises, and the excess capacity swaps of fiber optic communications concerns under “indefeasible right to use” agreements. Both of these and many other situations involved immediate recognition of revenues coupled with deferred recognition of costs, and typically in aggregate were equal exchanges not providing profits to either party. Furthermore, these examples do not represent culminations of the normal earnings process (e.g., fiber optic networks were built in order to sell communications services to end users, not for the purpose of swapping capacity with other similar operations).

In hindsight, most observers can see why these and many other aggressive reporting practices deviated from established or implied GAAP; although there are still some who insist that because GAAP failed to explicitly address these precise scenarios, the accounting for the transactions was open to interpretation. Since GAAP (even the highly rules-based U.S. GAAP) cannot possibly hope to overtly address all the various innovative transaction structures that exist and will be invented, it is necessary to apply basic principles and reason by analogy to newly emerging circumstances. Of great importance to financial statement preparers (and internal and external auditors) is obtaining a thorough understanding of the nature and normal operations of the business enterprise being reported upon, application of “substance over form” reasoning, and the goal of faithfully representing the economics of transactions.

Channel Stuffing

Many difficult issues of revenue recognition involve practices that may or may not involve GAAP departures, depending on the situation-specific facts and circumstances. Channel stuffing, a prime example of this issue, occurs when sales are actually made prior to the period-end cutoff but may have been stimulated by “side agreements,” such as a promise to customers of extended return privileges or more liberal credit terms. In such circumstances, there might be a greater likelihood that a substantial portion of these sales may be subsequently nullified, as unrealistically large orders inevitably lead to later large returns made for full credit.

For purposes of financial reporting under GAAP, valuation allowances should be established for expected sales returns and allowances. (In practice, however, this is rarely done because the amounts involved are immaterial, unlike the amounts of the more familiar allowances for uncollectible accounts.) The use of valuation accounts for anticipated returns and allowances is dictated by both the matching concept (recording returns and allowances in the same fiscal period in which the revenue is recognized) as well as by the requirement to present accounts receivable at net realizable value. When the potential product returns are not subject to reasonable estimation (as when a sales promotion effort of the type just described is first being attempted by the reporting entity) but could be material, it might not be permissible to recognize revenues at all, pending subsequent developments. (ASC 605-15-25) Furthermore, from the SEC's perspective, factors such as the following could require deferral of revenues at the time goods are shipped to customers, pending resolution of material uncertainties:

1. Significant levels of product inventory in the distribution channel
2. Lack of “visibility” into, or the inability to determine or observe, the levels of inventory in a distribution channel and the current level of sales to end users
3. Expected introductions of new products that may result in the technological obsolescence of, and larger than expected returns of, current products
4. The significance of a particular distributor to the company's (or a reporting segment of the company's) business, sales, and marketing
5. The newness of a product
6. The introduction of competitors' products with superior technology or greater expected market acceptance could affect market demand and changing trends in that demand for an entity's products.

Mischaracterization of Extraordinary or Unusual Transactions as Components of Gross Revenue

Not all revenue recognition errors and frauds involve questions of when or if revenue should be recognized. In some instances, classification in the income statement is of greater concern. While matters in this group often do not result in a distortion of net results of operations, they can seriously distort important indicators of performance trends. When this occurs, it most often involves reporting unusual or infrequent gains on sales of segments or specific assets as revenue from product or service transactions. A variation on this involves reporting unusual gains as offsets to one or more categories of operating expenses, similarly distorting key financial ratios and other indicators, again without necessarily invalidating the net income measure.

Mischaracterizing Transactions as Involving “Arm's-Length” Third Parties, Thus Justifying Unwarranted Gain Recognition

Transfers of inventory or other assets to a related entity typically defer gain or income recognition until subsequent transfer to an “arm's-length” party. In some cases, sales have been disguised as being to unrelated entities with gain being recognized, when in fact the “buyer” was a nominee of the seller, or the financing was provided or guaranteed by the seller, or the “buyer” was a “variable interest entity” that failed to meet the complex and changing requirements under GAAP required for gain recognition. Depending upon the facts of the situation, this can result in gains being improperly recognized, or the gross amount of the transaction being improperly recognized in the seller/transferor's financial statements.

Selling Undervalued Assets to Generate Reportable Gains

This issue again ranges from deliberate but real economic transactions that have as a goal the inflation of reportable revenues or gains, to misrepresented events having no economic substance but the same objective. Among the former is the deliberate invasion of low-cost LIFO inventory “layers,” which boosts gross margins and net profits for the period, albeit at the cost of having to later replenish inventories with higher-cost goods. To the extent that this depletion of lower-cost inventory really occurs, there is no GAAP alternative to reflecting these excess profits currently, although the threat of full disclosure may prove to be somewhat of a deterrent.

Regarding the latter category, in some instances the ability to generate gains could indicate that errors occurred in recording a previous transaction. Thus, large gains flowing from the sale of assets recently acquired in a purchase business combination transaction could well mean the purchase price allocation process was flawed. If this is true, a reallocation of purchase price would be called for, and some or all of the apparent gains would be eliminated.

Related to the foregoing is the strategy of retiring outstanding debt to generate reportable gains. In periods of higher-than-historically-typical interest rates, lenders will often agree to early extinguishment of outstanding low-coupon obligations at a discount, hence creating accounting gains for the borrower, albeit replacement debt at current yields will result in higher interest costs over future years. To the extent the debt is really retired, however, this is a real economic event, and the consequent gain is reported in current earnings under GAAP.

Deliberate Misstatement of Percentage of Completion on Long-Term Construction Contracts

Under ASC 605-35 (detailed later in this chapter), profits on certain long-term construction-type contracts are recognized ratably over the period of construction. An obvious and often easy way to distort periodic results of operations is to deliberately over- or understate the degree to which one or more discrete projects has been completed as of period end. This, coupled with the difficulty and importance of estimating remaining costs to be incurred to complete each project, makes profit recognition under this required method of accounting challenging to verify.

The Percentage-of-Completion Method

ASC 605-35 states that:

The percentage-of-completion method recognizes income as work on a contract (or group of closely related contracts) progresses. The recognition of revenues and profits is generally related to costs incurred in providing the services required under the contract.

Under this method, work-in-progress (WIP) is accumulated in the accounting records. At any point in time if the cumulative billings to date under the contract exceed the amount of the WIP plus the portion of the contract's estimated gross profit attributable to that WIP, then the contractor recognizes a current liability captioned “billings in excess of costs and estimated earnings.” This liability recognizes the remaining obligation of the contractor to complete additional work prior to recognizing the excess billing as revenue.

If the reverse is true, that is, the accumulated WIP and gross profit earned exceed billings to date, then the contractor recognizes a current asset captioned “costs and estimated earnings in excess of billings.” This asset represents the portion of the contractor's revenues under the contract that have been earned but not yet billed under the contract provisions. Where more than one contract exists, these assets and liabilities are determined on a project-by-project basis, with the accumulated assets and liabilities being separately stated on the statement of financial position. Assets and liabilities are not offset unless a right of offset exists. Thus, the net debit balances for certain contracts are not ordinarily offset against net credit balances for other contracts. An exception may exist if the balances relate to contracts that meet the criteria for combining described in ASC 605-35 and discussed later in this section.

Under the percentage-of-completion method, income is not based on cash collections or interim billings. Cash collections and interim billings are based upon contract terms that do not necessarily measure contract performance.

The completed-Contract Method

ASC 605-35 states that:

The completed-contract method recognizes income only when the contract is complete, or substantially complete.

Under this method, contract costs and related billings are accumulated in the accounting records and reported as deferred items on the statement of financial position until the project is complete or substantially complete. A contract is regarded as substantially complete if remaining costs of completion are immaterial. When the accumulated costs (WIP) exceed the related billings, the excess is presented as a current asset (inventory account). If billings exceed related costs, the difference is presented as a current liability. This determination is also made on a project-by-project basis with the accumulated assets and liabilities being separately stated on the statement of financial position. An excess of accumulated costs over related billings is presented as a current asset, and an excess of accumulated billings over related costs is presented in most cases as a current liability.

Preferability Assessment

ASC 605-35 deems the percentage-of-completion method to be preferable when estimates are reasonably dependable and the following conditions exist:

1. Contracts executed by the parties include provisions that clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement.
2. The buyer can be expected to satisfy his or her obligations under the contract.
3. The contractor can be expected to perform his or her contractual obligations.

ASC 605-35 presumes that contractors generally have the ability to produce estimates that are sufficiently dependable to justify the use of the percentage-of-completion method of accounting. Persuasive evidence to the contrary is necessary to overcome this presumption.

The principal advantage of the completed-contract method is that it is based on final results, whereas the percentage-of-completion method is dependent upon estimates for unperformed work. The principal disadvantage of the completed-contract method is that when the period of a contract extends into more than one accounting period, there will be an irregular recognition of income.

These two methods are not equally acceptable alternatives for the same set of circumstances. ASC 605-35 states that, in general, when estimates of costs to complete and extent of progress toward completion of long-term contracts are reasonably dependable, the percentage-of-completion method is preferable. When lack of dependable estimates or inherent hazards cause forecasts to be doubtful, the completed-contract method is preferable.

The completed-contract method may also be acceptable when a contractor has numerous relatively short-term contracts and when results of operations do not vary materially from those that would be reported under the percentage-of-completion method.

Based on the contractor's individual circumstances, a decision is made as to whether to apply completed-contract or percentage-of-completion accounting as the entity's basic accounting policy. If warranted by different facts and circumstances regarding a particular contract or group of contracts, that contract or group of contracts is to be accounted for under the other method with accompanying financial statement disclosures of this departure from the normal policy.

Precontract Costs

Precontract costs are costs incurred before a contract has been entered into, with the expectation of the contract being accepted and thereby recoverable through future billings. Precontract costs include architectural designs, costs of learning a new process, and any other costs that are expected to be recovered if the contract is accepted. ASC 720-15 requires that precontract costs be expensed as incurred, as they are the equivalent of start-up costs in other types of businesses. Consequently, precontract costs are not permitted to be included in WIP. Contract costs incurred after the acceptance of the contract are costs incurred toward the completion of the project and are accumulated in work-in-progress (WIP).

If precontract costs are incurred in connection with a current contract in anticipation of obtaining additional future contracts, those costs are nevertheless accounted for as costs of the current contract. If such costs are not incurred in connection with a current contract, then they must be expensed as incurred. There is no look-back provision permitted by this rule. A contractor may not retroactively record precontract costs as WIP if a contract is subsequently executed.

Contract Costs

Contract costs are costs identifiable with or allocable to specific contracts. Generally, contract costs include all direct costs, such as direct materials, direct labor, and any indirect costs (overhead) allocable to the contracts. Contract costs can be broken down into two categories: costs incurred to date and estimated costs to complete.

The company may choose to defer costs related to producing excess goods in anticipation of future orders of the same item. Costs associated with excess production can be treated as inventory if the costs are considered recoverable.

Estimated Costs to Complete

These are the anticipated costs required to complete a project at a scheduled time. They are comprised of the same elements as the original total estimated contract costs and are based on prices expected to be in effect when the costs will be incurred.

The latest estimates are used to determine the progress toward completion. ASC 605-35 provides the practices to be followed when estimating costs to complete.

Systematic and consistent procedures are to be used. These procedures are to be correlated with the cost accounting system in order to facilitate a comparison between actual and estimated costs. Additionally, the determination of estimated total contract costs is to identify the significant cost elements.

Estimated costs are to reflect any expected price increases. These expected price increases are not “blanket provisions” for all contract costs, but rather specific provisions for each specific type of cost. Expected increases in each of the cost elements, such as wages, materials, and overhead items, are considered separately.

Finally, estimates of costs to complete are to be reviewed periodically to reflect new information. Estimates of costs are to be examined for price fluctuations and reviewed for possible future problems, such as labor strikes or direct material delivery delays.

Accounting for contract costs is similar to accounting for inventory. Costs necessary to ready the asset for sale (transfer of possession and occupancy by the customer) are recorded in WIP as incurred. WIP includes both direct and indirect costs but not general and administrative expenses or selling expenses, since by definition they are not identifiable with a particular contract and are therefore treated as period costs. However, general and administrative expenses may be included in contract costs under the completed contract method since this could result in better matching of revenues and costs, especially in years when no contracts were completed.

Subcontractor Costs

Since a contractor may not be able to perform all facets of a construction project, one or more subcontractors may be engaged. Amounts earned by the subcontractor are included in contract costs as the work is completed. These amounts are directly attributable to the project and included in WIP, similar to direct materials and direct labor.

Back Charges

Contract costs may require adjustment for back charges. A back charge is a billing by the contractor to a subcontractor (or a reduction in the amount due to that subcontractor under the subcontract) for costs incurred by the contractor to complete or correct work that the contract stipulated was to have been performed by the subcontractor. These charges are often disputed by the parties involved.

Accounting for Transactions with Unrelated Third Parties

A participant in a collaborative arrangement recognizes revenue earned and costs incurred in transactions with third parties (parties that are not participants to the collaborative arrangement) in its income statement based on whether the participant is serving as a principal or an agent in the transaction under ASC 605-45. If the transacting participant is considered a principal in the transaction, the revenues and costs are recorded gross. If the transacting participant is considered an agent in the transaction, the revenues and costs are recorded net. Under no circumstances is a participant in a collaborative arrangement permitted to use the equity method to account for its activities associated with the collaborative arrangement.

ASC 605-45 does not provide a “bright-line” test that definitively would characterize the role of a participant in a transaction. Rather, it provides a series of indicators of gross reporting and a series of indicators of net reporting, the purpose of which is to enable management to analyze the facts and circumstances associated with the transaction to make a well-reasoned determination.

Indicators of Gross Reporting (Principals)

• Participant is primary obligor. Under ASC 605-45, this is considered to be a “strong indicator” of the participant's role in the transaction.
• Participant has authority, within reasonable limits, to establish price. Even when subject to reasonable, preestablished economic constraints, if the participant has the authority to negotiate price with the customer, this may indicate that the participant possesses risks and rewards of a principal to the transaction.
• Participant involvement in determining specifications. If the participant has the authority to determine the nature, type, characteristics, or specifications of the products and/or services ordered by the customer, this may be indicative of the participant having primary responsibility for fulfillment. For the purposes of analyzing the applicability of this indicator, the evaluator considers whether the participant makes physical alterations to the product or performs services that add value sufficient to increase the selling price to the customer.
• Participant performance. The participant changes the product or performs part of the service.
• Participant discretion in supplier selection.
• Participant exposed to inventory risks. The participant bears inventory risk in one or both of the following manners:
  • General inventory risk either before the customer places the order or upon the return of the inventory by the customer
  • Specific risk of physical inventory loss after the customer places the order or during shipping of the inventory.
• Participant bears credit risk.

Indicators of Net Reporting (Agents)

• Participant is not the primary obligor. The supplier of the goods or services, not the participant, is the primary obligor in the transaction.
• Participant earnings are fixed. The amount the participant earns is fixed.
• Participant is not exposed to credit risk. The supplier and not the participant bears credit risk in connection with the transaction.

Accounting for Transactions Between Participants

In evaluating the income statement characterization of transactions between participants to a collaborative arrangement, management is to consider:

• The nature of the arrangement
• The contractual terms of the arrangement
• The nature of the participant's business operations
• Whether the transactions are included in the scope of other authoritative GAAP literature on income statement classification, either directly or by analogy.

If no authoritative GAAP is identified that is relevant directly or by analogy, management elects a reasonable and rational accounting policy to be consistently applied to all such similar transactions.

Accounting Treatment

The costs listed above are accounted for as follows:

1. Precontract or preengagement costs. Expense as incurred as start-up costs under all of the service revenue recognition methods.
2. Direct costs. Expense as incurred under all of the service revenue recognition methods because of the close correlation between the amount of direct costs incurred and the extent of performance achieved. Direct costs incurred prior to performance, referred to as initial direct costs (e.g., expendable materials purchased for use on the job/engagement that are purchased and held by the service enterprise as a form of inventory), are deferred and recorded as prepayments (or supplies inventory, depending on the nature of the item). Under the specific performance or completed performance methods, these costs are recognized as expenses at the time of service performance at the point that revenue is recognized. Under the proportional performance method, initial direct costs are charged to expense in proportion to the recognition of service revenue (i.e., by applying the ratio of revenues recognized in the period to total expected revenues over the life of the contract).
3. Indirect costs. Under all of the revenue recognition methods, indirect costs are expensed as incurred.
4. Out-of-pocket costs. Under all of the revenue recognition methods, out-of-pocket costs are expensed as incurred with the related client billings presented as revenue in the statement of income.
5. Overhead. Under all of the revenue recognition methods, overhead is expensed as incurred.

Losses on Service Transactions

These are recognized when direct costs incurred to date plus estimated remaining direct costs of performance exceed the current estimated net realizable revenue from the contract. The loss (given as the Direct costs incurred to date + Estimated remaining direct costs − Estimated realizable revenue) is first applied to reduce any recorded deferred costs to zero, with any remaining loss recognized on the income statement and credited to an estimated liability.

Initiation or Activation Fees

If there is an objectively determinable value for the right or privilege granted by the fee, that value is recognized as revenue on the initiation date. Any related direct costs are recognized as expense on the initiation date. If the value of the right or privilege cannot be objectively determined, the fee is recorded as a liability for future services and recognized as revenue in accordance with one of the revenue recognition methods.

Installation Fees

If the equipment and its installation costs are essential for the service to be provided and if customers cannot normally purchase the equipment in a separate transaction, the installation fee is considered an advance charge for future services. The fee is recognized as revenue over the estimated service period. The costs of installation and the installed equipment are amortized over the period the equipment is expected to generate revenue. If customers can normally purchase the equipment in a separate transaction, the installation fee is part of a product transaction that is accounted for separately as such.

Freight Services in Process

ASC 605-20-25 addresses the manner in which revenue and expense pertaining to freight services in process as of the date of the statement of financial position are to be given financial statement recognition. It holds that recognition of revenue when freight is received from the shipper or when freight leaves the carrier's terminal, with expenses recognized as incurred, is not acceptable accounting.

Reporting Reimbursable Costs

While not limited to service providers, a common situation for many professional service providers is the incurrence of costs that are later billed to clients, with or without a mark-up over actual cost. Examples of out-of-pocket expenses include meals, lodging, airfares, taxi fares, etc. Prior practice had been varied, with many reporting entities showing reimbursements, implicitly as offsets to expenses; others reported such reimbursements as revenue. While the net effect on reported earnings was the same under either approach, certain key performance measures, such as gross revenue, could vary considerably depending on choice of accounting method. ASC 605-45-15 mandates that any billings for out-of-pocket costs are to be classified as revenue in the statement of income and not as a reduction in expenses. This guidance is equally applicable whether expenses are billed to clients (1) as a pass-through (i.e., at actual cost to the service firm without a markup), (2) at a marked-up amount, or (3) are included in the billing rate or negotiated price for the services.

Separately Priced Extended Warranties

Extended warranties provide additional protection beyond that of the manufacturer's original warranty, lengthen the period of coverage specified in the manufacturer's original warranty, or both. Similarly, a product maintenance contract is an agreement for services to maintain a product for a certain length of time. Clearly, revenue recognition at inception is not acceptable, and it is often impossible to estimate the actual pattern of service that will be provided to the customers over the terms of the contracts. ASC 605-20-25 directs that revenue from these contracts be deferred and recognized on a straight-line basis unless evidence exists that costs are incurred on some other basis. If so, revenue is allocated to each period using the ratio of the period's cost to estimated total cost.

Direct costs of obtaining extended warranty or maintenance contracts are to be capitalized and recognized as expense in the ratio that revenues recognized each period bear to total anticipated revenues from the respective contracts. Any other costs are charged to expense as incurred. Losses on these contracts are recognized immediately if the sum of the future costs and remaining unamortized direct acquisition costs exceed the related unearned revenue. When recognizing a loss, any unamortized acquisition costs are first charged to expense, and a liability for any remaining loss is then recorded.

Applying the Installment Method

When a seller uses the installment method, both revenue and cost of sales are recognized at the point of sale, but the related gross profit is deferred to those periods during which cash will be collected. As receivables are collected, a portion of the deferred gross profit equal to the gross profit rate times the cash collected is recognized as income. When this method is used, the seller must compute each year's gross profit rate and also must maintain records of installment accounts receivable and deferred revenue that are separately identified by the year of sale. All general and administrative expenses are normally expensed in the period incurred.

The steps to use in accounting for sales under the installment method are as follows:

1. During the current year, record sales and cost of sales in the regular manner. Record installment sales transactions separately from other sales. Set up installment accounts receivable identified by the year of sale (e.g., Installment Accounts Receivable—20X1).
2. Record cash collections from installment accounts receivable. Care must be taken so that the cash receipts are properly identified as to the year in which the receivable arose.
3. At the end of the current year, transfer installment sales revenue and installment cost of sales to deferred gross profit properly identified by the year of sale. Compute the current year's gross profit rate on installment sales as follows:
   $$\text{Gross profit rate}=1-\left(\frac{\text{Cost of installment sales}}{\text{Installment sales revenue}}\right)$$

   Alternatively, the gross profit rate can be computed as follows:

   Gross profit rate	=	Installment sales revenue − Cost of installment sales
   Installment sales revenue

4. Apply the current year's gross profit rate to the cash collections from the current year's installment sales to compute the realized gross profit from the current year's installment sales:

   Realized gross profit

   =

   Cash collections from the current year's installment sales

   ×

   Current year's gross profit rate

5. Separately apply each of the previous years' gross profit rates to cash collections from those years' installment sales to compute the realized gross profit from each of the previous years' installment sales:

   Realized gross profit

   =

   Cash collections from the previous years' installment sales

   ×

   Previous years' gross profit rate

6. Defer the current year's unrealized gross profit to future years. The deferred gross profit to carry forward to future years is computed as follows:

   Deferred gross profit (20X1)

   =

   Ending balance installment account receivable (20X1)

   ×

   Gross profit rate (20X1)

Financial Statement Presentation

If installment sales transactions represent a significant portion of the company's total sales, the following three items of gross profit would, theoretically, be reported on the company's income statement:

1. Total gross profit from current year's sales
2. Realized gross profit from current year's sales
3. Realized gross profit from prior years' sales

The statement of financial position presentation of installment accounts receivable depends upon whether installment sales are a normal part of operations. If a company sells most of its products on an installment basis, installment accounts receivable are classified as a current asset because the operating cycle of the business (the length of which is to be disclosed in the notes to the financial statements) is the average period of time covered by its installment contracts. If installment sales are not a normal part of operations, installment accounts receivable that are not to be collected for more than a year (or the length of the company's operating cycle, if different than a year) are reported as noncurrent assets. In all cases, to avoid confusion, it is desirable to fully disclose the year of maturity next to each group of installment accounts receivable.

Accounting for deferred gross profit is addressed in CON 6 which states that deferred gross profit is not a liability. The reason is that the seller company is not obligated to pay cash or provide services to the customer. Rather, the deferral arose because of the uncertainty surrounding the collectibility of the sales price. CON 6 goes on to say, “deferred gross profit on installment sales is conceptually an asset valuation allowance (sometimes referred to as a ‘contra asset’)—that is, a reduction of an asset.” However, in practice, deferred gross profit is generally presented either as unearned revenue classified in the current liability section of the statement of financial position or as a deferred credit displayed between liabilities and equity.

Interest on Installment Method Receivables

The previous examples ignored interest, a major component of most installment sales contracts. It is customary for the seller to charge interest to the buyer on the unpaid installment receivable balance. Generally, installment contracts call for equal payments, each with an amount attributable to interest on the unpaid balance and the remainder to the installment receivable balance. As the maturity date nears, a smaller amount of each installment payment is attributable to interest and a larger amount is attributable to principal. Therefore, to determine the amount of gross profit to recognize, the interest must first be deducted from the installment payment and then the difference (representing the principal portion of the payment) is multiplied by the gross profit rate as follows:

The interest portion of the installment payment is recorded as interest revenue at the time of the cash receipt. Appropriate accounting entries are required to accrue interest revenue when the collection dates do not correspond with the period end.

Bad Debts and Repossessions

The standard accounting treatment for uncollectible accounts is to accrue a bad debt loss in the year of sale by estimating the amount expected to be uncollectible. This treatment is consistent with the accrual and matching concepts. However, just as revenue recognition under the accrual basis is sometimes abandoned for certain installment basis sales, the accrual basis of recognizing bad debts is also sometimes abandoned.

When the installment method is used, it is usually appropriate to recognize bad debts by the direct write-off method (i.e., bad debts are not recognized until the receivable has been determined to be uncollectible). This practice is acceptable because most installment contracts contain a provision that allows the seller to repossess the merchandise when the buyer defaults on the installment payments. The loss on the account may be eliminated or reduced because the seller has the option of reselling the repossessed merchandise. To write off an uncollectible installment receivable, the following three steps are followed:

1. The installment account receivable and the deferred gross profit are eliminated.
2. The repossessed merchandise is recorded as used inventory at its net realizable value. Net realizable value is resale value less any selling or reconditioning costs. The repossessed asset is recorded at this fair value because any asset acquired is recorded at the best approximation of its fair value.
3. Bad debt expense and a gain or loss on repossession are recognized. The bad debt expense or repossession gain or loss is the difference between the unrecovered cost (installment account receivable minus deferred gross profit) and the net realizable value of the repossessed merchandise.

Requirements for Revenue Recognition Met

If all six of the requirements were met, the following journal entries would be appropriate:

The revenue and cost of goods sold recognized in 20X1 are based on the number of units expected to be returned, 300 (15% × 2,000 units). The net revenue recognized is $76,500 (85% × 2,000 units × $45 per unit) and the cost of goods sold recognized is $51,000 (85% × 2,000 units × $30 per unit). The deferred gross profit balance is carried forward until either the textbooks are returned or the return privilege expires.

Requirements for Revenue Recognition not Met

If all of the six conditions are not met, revenue and cost of sales from the sales transactions must be deferred until either the return privilege has substantially expired or the point when all the conditions are subsequently met is reached, whichever comes first.

If the facts in the Lipkis case were altered so that the bookstores were not required to pay Lipkis until the later of the date the books were actually sold, or the expiration date of the return privilege, condition b. would not be met until the store remitted payment. The following entries would be required. The return privilege is, of course, assumed to lapse when the books are sold to final customers.

Future returns cannot be estimated. In the relatively unlikely situation where the reporting entity is unable to make a reasonable estimate of the amount of future returns, the sale cannot be recognized until the return privilege has expired or conditions permit the loss to be estimated, at which point it would become reportable. Examples of factors that might impair the ability to reasonably estimate a loss are:

1. Susceptibility of the product to technological or other obsolescence
2. A lengthy period over which returns are permitted
3. Absence of experience with returns on similar products sold to similar markets
4. Sales are few, significant, and have unique terms (rather than a large number of relatively homogeneous sales of small dollar amounts).

Basic Principles Established

ASC 605-25 set forth three basic principles, the application of which is the subject of the discussion that follows:

1. MDA are divided into separate units of accounting if the deliverables included in the arrangement meet all three of the criteria presented in the table below.
2. Subject to certain limits regarding contingent amounts to be received under the MDA, relative selling prices (as determined, in declining order, using VSOE, third-party evidence, or the vendor's best estimate of the selling price) are used to allocate MDA proceeds to the separate units of accounting. The VSOE of a selling price is based on either the price charged for a deliverable when sold separately, or (if not sold separately) the price established by management. Third-party evidence of a selling price is the price of a competitor's essentially interchangeable products in stand-alone sales to similar customers.
3. The revenue recognition criteria to be applied are determined separately for each unit of accounting.

Disclosures

The financial statements of a vendor are to include the following disclosures, when applicable:

1. The nature of the vendor's MDA
2. Significant deliverables
3. Delivery timing for significant deliverables
4. Whether deliverables qualify as separate units of accounting, and why
5. The timing of revenue recognition for the various units of accounting
6. The effect of changes in price for a unit of accounting if it impacts the allocation of consideration.

Reporting Revenue Gross as a Principal Versus Net as an Agent (ASC 605-45)

A longstanding issue in financial reporting has been whether certain entities more accurately convey the nature of their operations by reporting as revenue only the “net” amount they retain when acting effectively as an agent for another entity. While in some situations the answer is obvious, in other cases it has been less clear. Historically this may not have been an urgent issue to be resolved, since users of financial statements were deemed capable of deriving correct inferences regardless of the manner of presentation of the income statement. However, in recent years an unfortunate trend developed, whereby analysts and others cited only revenue growth as an indicator of the entity's success, making the question of income statement presentation of revenue somewhat more important.

ASC 605-45 provides guidance on whether an entity is an agent for a vendor-manufacturer, and thus recognizes the net retainage (commission) for serving in that capacity, or whether that entity is a seller of goods (i.e., acting as a principal), and thus should recognize revenue for the gross amount billed to a customer and an expense for the amount paid to the vendor-manufacturer.

The codification identifies the following factors to be considered when determining whether revenue is to be reported as the net retainage (hereinafter, “net”) or the gross amount billed to a customer (“gross”). None of the indicators are presumptive or determinative, although the relative strength of each indicator is to be considered.

• Is the company the primary obligor in the arrangement; that is, is the company responsible for the fulfillment of the order, including the acceptability of the product or service to the customer? If the company, rather than a supplier, is responsible, that fact is a strong indicator that the company records revenue gross. Responsibility for arranging transportation for the product is not responsibility for fulfillment. If a supplier is responsible for fulfillment, including the acceptability to the customer, that fact indicates that the company recognizes only the net retainage.
• Does the company have general inventory risk? General inventory risk exists if a company takes title to a product before the product is ordered by a customer or will take title to the product if the customer returns it (provided that the customer has a right of return). In considering this indicator, arrangements with a supplier that reduce or mitigate the company's risk level are to be considered. Unmitigated general inventory risk is a strong indicator that the company recognizes revenue gross.
• Does the company have physical loss inventory risk? Physical loss inventory risk exists if the title to the product is transferred to the company at the shipping point and then transferred to the customer upon delivery. Physical loss inventory risk also exists if a company takes title to the product after the order is received but before the product is transferred to the shipper. While less persuasive than general inventory risk, this indicator provides some evidence that a company record revenue gross.
• Does the company establish the selling price? If a company establishes the selling price, that fact may indicate that the company recognizes revenue gross.
• Is the amount earned by the company fixed? If a company earns a fixed amount per transaction or if it earns a percentage of the selling price, that fact may indicate that the company report revenue net.
• Does the company change the product or perform part of the service? If a company changes the product (beyond packaging) or performs part of the service ordered by the customer such that the selling price is greater as a result of the company's efforts, that fact is indicative that a company recognizes revenue gross. Marketing skills, market coverage, distribution system, or reputation are not to be evaluated in determining whether the company changes the product or performs part of the service.
• Does the company have multiple suppliers for the product or service ordered by the customer? If a company has the discretion to select the supplier, that fact may indicate that the company record revenue gross.
• Is the company involved in determining the nature, type, characteristics, or specifications of the product or service by the customer? If so, that fact may indicate that the company records revenue gross.
• Does the company have credit risk for the amount billed to the customer? Credit risk exists if a company must pay the supplier after the supplier performs, regardless of whether the customer has paid. If the company has credit risk, this fact provides weak evidence that the company records revenue gross. If the supplier assumes the credit risk, the company is to record revenue net.

ASC 605-45 includes thirteen examples to assist in implementation.

Accounting by a Grantee for an Equity Instrument to Be Received in Conjunction with Providing Goods or Services

The accounting for such equity issuances by the reporting entity is addressed by ASC 718. ASC 505-50 has resolved the proper accounting by the recipient of such payments.

In exchange for goods or services, an entity (the grantee) may receive equity instruments that have conversion or exercisability terms that vary based on future events, such as attainment of sales levels or a successful initial public offering. This issue describes the appropriate accounting if ASC 718 does not apply because the instruments received have underlyings based on either the grantee's or issuer's performance.

The grantee measures the fair value of the equity instruments received using the stock price and measurement assumptions as of the earlier of two dates. The first date is the date on which the grantee and the issuer reach a mutual understanding of both the terms of the equity-based compensation and the goods to be delivered (or services to be performed). The second date is the date at which the performance necessary to earn the equity is completed by the grantee, that is, the grantee's rights have vested.

If the terms of the equity agreement are dependent on the achievement of a market condition, the fair value of the instrument is to include the effects on fair value of the commitment to change the terms if the market condition is met. Pricing models are available to value path-dependent equity instruments.

If the terms of the equity agreement are dependent on the achievement of certain performance goals (beyond those that initially established the goods to be delivered or services to be performed), the fair value of the instrument is computed without the effects of the commitment to change the terms if the goals are met. If those goals are subsequently met, the fair value is adjusted to reflect the new terms and the adjustment is reported as additional revenue (as described in the Share-Based Payments section in Chapter 27).

Accounting for Consideration Given by a Vendor to a Customer (ASC 605-50)

ASC 605-50 provides guidance regarding the recognition, measurement, and income statement display of consideration given by a vendor to purchasers of the vendor's products. This consideration can be provided to a purchaser at any point along the distribution chain, irrespective of whether the purchaser receiving the consideration is a direct or indirect customer of the vendor. Examples of arrangements include, but are not limited to, sales incentive offers labeled as discounts, coupons, rebates, and “free” products or services as well as arrangements referred to as slotting fees, cooperative advertising, and buydowns. The issue does not apply to:

1. Coupons, rebates, and other forms of rights for free or significantly discounted products or services received by a customer in a prior exchange transaction that were accounted for by the vendor as a separate deliverable in that prior exchange, or
2. An offer to a customer, in connection with a current revenue transaction, for free or discounted products or services that is redeemable by the customer at a future date without a further exchange transaction with the vendor. Covered by ASC 605-25, summarized previously.

The issue also does not discuss the accounting for offers of free or discounted products or services that are exercisable after a customer has completed a specified cumulative level of revenue transactions or remained a customer for a specified time period (for example, “point” and loyalty programs).

ASC 605-50 contains the following separately addressed issues:

1. Cash consideration given by a vendor to a customer is presumed to be a reduction of selling price and is classified as a reduction of revenue when recognized in the vendor's income statement. That presumption is overcome and the consideration is classified as a cost incurred if, and to the extent that, both of the following conditions are met:
   1. The vendor receives, or will receive, an identifiable benefit (goods or services) in exchange for the consideration. In order to meet this condition, the identified benefit must be of a type that the vendor could have acquired in an exchange transaction with a party other than a purchaser of its products or services, that is, that the benefit must be separable from the sale of the vendor's goods or services, and
   2. The vendor can reasonably estimate the fair value of that identifiable benefit. If the amount of consideration paid by the vendor exceeds the estimated fair value of the benefit received, that excess amount is classified as a reduction of revenue when recognized in the vendor's income statement.

      If the consideration is a “free” product or service or anything other than cash (including “credits” that the customer can apply against trade amounts owed to the vendor) or equity instruments, the cost of the consideration is characterized as an expense (as opposed to a reduction of revenue) when recognized in the vendor's income statement. ASC 605-50 contains fifteen examples of the application of this issue to various fact scenarios.

2. The amounts representing reduced revenue are classified as expense only if a vendor can demonstrate that classification of those amounts as a reduction of revenue results in negative revenue for a specific customer on a cumulative basis (that is, since the inception of the overall relationship between the vendor and the customer). However, classification as an expense would not be appropriate if a supply arrangement exists that either:
   1. Provides the vendor with the right to be a provider of a certain type or class of goods or services for a specified period of time and it is probable that the customer will order the vendor's goods or services, or
   2. Requires the customer to order a minimum amount of goods or services from the vendor in the future, except to the extent that the consideration given exceeds future revenue from the customer under the arrangement.
3. If the consideration (in the form of products, services, or cash) offered voluntarily by a vendor and without charge to customers can be used or becomes exercisable by a customer as a result of a single exchange transaction, and that consideration will not result in a loss on the sale, the vendor recognizes the “cost” of the consideration at the later of the following:
   1. The date the related revenue is recognized by the vendor, or
   2. The date the sales incentive is offered. (For example, a vendor recognizes a liability for a mail-in rebate coupon that requires proof of purchase, based on the estimated amount of refunds or rebates that will be claimed by customers.)
4. If the consideration (in the form of products, services, or cash) offered voluntarily by a vendor and without charge to customers can be used or becomes exercisable by a customer as a result of a single exchange transaction, and that consideration results in a loss on the sale, a vendor does not recognize a liability prior to the date on which the related revenue is recognized (this would be improper matching). However, the offer of consideration in an amount that will result in a loss on the sale of a product may indicate an impairment of existing inventory.
5. If a vendor offers a customer a rebate or refund of a specified amount of cash consideration that is redeemable only if the customer completes a specified cumulative level of purchases or remains a customer for a specified time, the vendor recognizes the cost of the offer in a systematic and rational manner over the period in which the underlying revenue transactions that qualify the customer for the rebate or refund take place. Measurement of the total rebate or refund obligation is based on the estimated number of customers that will ultimately earn and claim rebates or refunds under the offer. If the amount cannot be reasonably estimated, the maximum potential amount is to be recognized.

Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor

ASC 605-50 also addresses accounting issues from the standpoint of how the vendor's customer—either the end user or a reseller of the vendor's products or services—is to account for cash consideration it receives from its vendor.

In general, there is a rebuttable presumption that cash consideration received from a vendor is a purchase-price concession that should be recognized by the customer as a reduction of cost of goods sold (and/or the inventory of unsold units). This presumption is overcome if payment of the consideration is for either:

1. Delivery of goods and/or services. Payment to the customer in exchange for goods or services delivered to the vendor is accounted for by the customer as revenue. In order for the customer to recognize revenue, the goods and/or services must be “sufficiently separable” from the customer's purchase of the vendor's products by meeting two criteria:
   1. The customer would have obtained the goods and/or services from a party other than the vendor, and
   2. The customer is able to reasonably estimate the fair value of the goods and/or services provided to the vendor.

      Any excess of cash consideration received by the customer over the fair value of the goods and/or services delivered to the vendor reduces the customer's cost of sales.

2. Reimbursement of costs. A reimbursement of the customer's specific incremental, identifiable costs incurred to sell the vendor's products or services, which is accounted for by the customer as a reduction of that cost. To the extent the cash consideration received exceeds the actual cost being reimbursed, the excess reduces cost of sales and/or inventory.

Vendors sometimes enter into binding arrangements that offer customers specified amounts of cash rebates or refunds payable in the future only if the customer remains a customer for a specified period of time, or purchases a specified cumulative dollar amount of goods or services from the vendor. In general, these arrangements are to be recorded by the customer as reductions of cost of sales by systematically allocating a portion of the benefits to be received to each transaction that results in progress toward meeting the target that results in earning the benefit. In order to use this pro rata accounting, however, the amount of the refund must be both probable and reasonably estimable (as those terms are defined in ASC 450). The codification provided indicators that, if present, may impair the customer's ability to determine that the refund is both probable and estimable:

1. The rebate or refund applies to purchases that are to occur over a “relatively long period” (which term is undefined in the ASC)
2. An absence of historical experience with similar products or changed circumstances that make historical experience irrelevant
3. A past history of significant adjustments to expected rebates or refunds
4. Susceptibility of the product to significant external factors such as technological obsolescence or changes in demand.

If the rebate or refund is not considered both probable and estimable, it is not recognized by the customer until it is fully earned by reaching the specified milestone (e.g., the dollar amount of cumulative purchases is reached or the time period for remaining a customer has expired).

Changes in a customer's estimate of the amount of future rebates or refunds, and retroactive changes by a vendor to a previous offer are recognized using a “cumulative catch-up adjustment.” This is accomplished by the customer immediately charging or crediting cost of sales in an amount that will adjust the cumulative amounts recognized under the arrangement to the changed terms. Of course, if any portion of the adjustment impacts goods still in the customer's inventory, that portion would adjust the valuation of the inventory and not cost of sales.

The SEC observer cautioned registrants to consider whether certain transactions between vendors and customers (e.g., simultaneous agreements between the parties to purchase equal amounts of each other's goods) are covered by the provisions of ASC 845 regarding nonmonetary exchanges that are not the culmination of an earning process.

Applying the Foregoing Guidance to Sales Incentives Offered by Manufacturers to Consumers

The rule described immediately above is applicable to situations in which cash consideration is received by a customer from a vendor, and is presumed to be a reduction of the prices of the vendor's products or services. Such incentives are to be characterized as a reduction of cost of sales when recognized in the customer's income statement. There are other instances, however, where consideration is a reimbursement for incentives offered to end users (e.g., retail customers) honored by the vendor's customer (retailer). The common example is coupons given to end users to be redeemed at the retailers offering the vendor's products for sale.

ASC 605-50-45-19 states that this guidance is limited to a vendor's incentive that meets all of the following criteria:

1. The incentive can be tendered by a consumer at resellers that accept manufacturer's incentives in partial (or full) payment of the price charged by the reseller for the vendor's product;
2. The reseller receives a direct reimbursement from the vendor (or a clearinghouse authorized by the vendor) based on the face amount of the incentive;
3. The terms of reimbursement to the reseller for the vendor's sales incentive offered to the consumer are not influenced by or negotiated in conjunction with any other incentive arrangements between the vendor and the reseller, but rather, may only be determined by the terms of the incentive offered to consumers; and
4. The reseller is subject to an agency relationship with the vendor, whether expressed or implied, in the sales incentive transaction between the vendor and the consumer.

Sales incentives that do not meet all of the foregoing criteria are subject to the guidance in ASC 605-50-45-2 through 45-3, and ASC 605-50-45-12 through 45-14, as applicable.

Accounting for Consideration Given by a Service Provider to a Manufacturer or Reseller

There are cases, such as in the cell phone service industry, where companies provide services to their customers under arrangements that require the customers to purchase equipment in order to utilize those services. To spur demand, the companies provide incentives to the equipment manufacturers or resellers to reduce the selling price of the equipment. The accounting for this situation is addressed by ASC 605-50, which states that, if the consideration given by the service provider to the manufacturer or reseller can be linked contractually to the benefit received by the service provider's customers, then the service provider can use the guidance noted above in ASC 605-50 to properly characterize the consideration paid. If the form of consideration to be paid to the service provider's customers is not cash or the service provider does not control the type of consideration paid, then the service provider should record such payments as an expense. If the form of consideration to be paid to the service provider's customers is cash (such as a mail-in rebate), then the service provider should record such payments as a reduction of revenue. The service provider should disclose the nature of the incentive program and the amounts recognized in the statement of operations for the incentive program and their classification for each period presented.

Accounting for Revenues Related to Vaccine Stockpiles

The SEC has indicated in Accounting Standards Update (ASU) 2009-07 that it will not object if a registrant with vaccine manufacturing operations recognizes revenue from the sale of vaccines to federal government stockpile programs, even if product delivery and inventory segregation requirements have not been met. This exemption only applies to childhood disease vaccines, influenza vaccines, and other vaccines and countermeasures sold to a federal government stockpile program. A registrant using this exemption should disclose the transactions and their effect on the financial statements.

Accounting for Management Fees Based on a Formula

An arrangement may contain a performance-based incentive fee that will not be finalized until the end of a predetermined period of time; for example, a real estate management company may receive a bonus for attaining building occupancy above a specified level. The SEC has indicated in ASU 2010-04 that a registrant can either recognize such revenue at the end of the measurement period or the amount that would be due under the formula as if the contract were terminated at an interim date, though it prefers the first method. However, the SEC will object to measurements as of an interim period that are based on projected future results; it will only accept revenue recognition in an interim period that is based on management fees earned as of that date, as though the arrangement had been terminated at that time.

Accounting for Research and Development Revenues Using the Milestone Method (ASC 605-28)

The milestone method can be used to recognize revenue related to research and development arrangements. A milestone is an event that occurs only due to vendor performance, and where there is substantive uncertainty that the event will be achieved. Also, the event will result in additional payments to the vendor. A milestone is not contingent solely upon the passage of time.

Under the milestone method, a vendor is allowed to recognize revenue that is contingent upon the achievement of a substantive milestone. Whether a milestone is considered achievable is decided at the beginning of the arrangement. To be substantive, the consideration a vendor earns by completing a milestone must be commensurate with either the vendor's performance to complete the milestone or the enhancement of value delivered. The consideration must also be related only to past performance, and be reasonable relative to the other deliverables and payments in the contract. It is acceptable if a vendor chooses to use some other method of revenue recognition that defers some portion of the consideration arising from a milestone.

The vendor must disclose its policy for the recognition of milestone payments as revenue, as well as a description of each arrangement involving milestone payments, and the amount of milestone consideration recognized during the period.

Fees for Guaranteeing a Loan

According to ASC 605-20-25-9, fees received for guaranteeing another entity's obligation are to be recognized as income over the guarantee period, rather than at the time of receipt, consistent with other standards governing service fee income recognition. The guarantor is to perform ongoing assessments of the probability of loss related to the guarantee and recognize a liability if the conditions in ASC 450 are met. Upon entering into a guarantee arrangement, the guarantor is required to recognize the stand-ready obligation under the guarantee. The contingent aspect of the guarantee would only be recognized if the conditions defined by ASC 450 are met.

Appendix—Overview of ASC 606²

1. Background and Overview
   1. The New Revenue Standard
   2. Development of Revenue Guidance
   3. The Revenue Recognition Project
      1. The New Standard
      2. Project Goals
      3. Customer Loyalty Programs
      4. Scope
   4. Scope Exceptions
      1. Contracts Partially in Scope
   5. Objective of the Standard
   6. Effective Dates
   7. Implementation Options
   8. Core Principle and Five Steps
   9. Disclosures
   10. Other Changes
   11. SEC
   12. Transition Resource Group
2. Exhibit—Summary of FASB Tentative Decisions
   1. Industry-Specific Guidance Superseded
      1. AICPA Industry Committees
3. Exhibit—Status of Industry-Specific Guidance in ASU 2014-09 for Affected Industries

The New Standard

ASU 2014-09:

• Superseded 200 separate items of U.S. Financial Accounting Standards Board (FASB) Accounting Standards Codification® (ASC) guidance, most of it industry-specific.
• Created Topic 606, uppercase From Contracts with Customers, and Subtopic 340-40, Other Assets and Deferred Costs—Contracts with Customers.

ASU 2014-09 is over 700 pages long and was released in the following sections:

• Amendments to the FASB Accounting Standards Codification
  • Section A—Summary and Amendments That Create Revenue from Contracts with Customers (Topic 606) and Other Assets and Deferred Costs—Contracts with Customers (Subtopic 340-40)
  • Section B—Conforming Amendments to Other Topics and Subtopics in the Codification and Status Tables
    • Background Information and Basis for Conclusions
    • Appendix: Comparison of Topic 606 and IFRS 15
• Amendments to XPRL Taxonomy.

Project Goals

The FASB and the IASB believe the final documents meet two major goals— simplification of revenue recognition guidance and consistency globally and across entities, jurisdictions, markets and industries. According to FASB in Focus,³ the Boards believe that the standard meets their goals to:

• Remove inconsistencies and weaknesses in existing revenue requirements
• Provide a more robust framework for addressing revenue issues
• Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets
• Provide more useful information to users of financial statements through improved disclosure requirements, and
• Simplify the preparation of financial statements by reducing the number of requirements to which an organization must refer.

  (FASB in Focus, May 28, 2014)

The revenue standard provides a robust framework that is expected to simplify preparation of financial statements by reducing the sources of guidance and replacing them with a single source that users can understand. The revenue standard adds new guidance for contract modifications and consistent application for service contracts. The standard also provides guidance for related topics, such as warrantees, licenses, and when to capitalize the cost of obtaining a contract and some costs of fulfilling a contract.

Customer Loyalty Programs

In addition, the changes may affect customer loyalty programs. Companies will have to make new estimates. It is expected that entities will be reviewing their loyalty programs to evaluate their effects, if any, on revenue, and some companies may choose to amend contracts with customers.

Scope

The scope is wide, and the standard affects all public companies, nonpublic companies, and nonprofit organizations. The standard applies to contracts with customers and defines customer as:

…a party that has contracted with a company to obtain a good or service that is an output of the company's ordinary activities in exchange for consideration. (ASC 606-10-15-3)

Care should be taken to determine whether a contract is with a customer or if it is a collaborative effort. To make the recognition and measurement consistent with revenue transactions, the standard applies to transfers of nonfinancial assets, such as property and equipment that give rise to revenue. Revenue can be generated by contracts that are not with customers. Examples are alternative revenue programs of utilities and not-for-profit contributions. The standard is applicable to those transactions.

Contracts Partially in Scope

If a contract is partially within the scope of the standard and partially within the scope of other guidance, the entity should apply the other guidance first. That is, if the other standard specifies how to separate or initially measure parts of the contract, then the entity should apply those requirements first. The remaining portion is accounted for under the requirements of the new standard. If the other standard does not have applicable separate and/or initial measurement guidance, the entity should apply the revenue standard to separate and/or initially measure the contract. (ASC 606-10-15-4)

AICPA Industry Committees

The AICPA has “formed sixteen industry-specific task forces to identify implementation issues and aid in the development of a new AICPA accounting guide on revenue recognition.” The industries included in the project are:

• Aerospace and Defense
• Airlines
• Asset Management
• Broker-Dealers
• Construction Contractors
• Depository Institutions
• Gaming
• Health Care
• Hospitality
• Insurance
• Not-for-Profit
• Oil and Gas
• Power and Utility
• Software
• Telecommunications
• Timeshare.

Comments submitted to the task forces can be viewed on aicpa.org.

Exhibit—Status of Industry-Specific Guidance in ASU 2014-09 for Affected Industries