Note: This blog addresses OLD revenue recognition guidance under U.S. GAAP (ASC 605). If you're looking for the NEW guidance (ASC 606), we've summarized our ASC 606 posts here.
Many companies are scared that ASC Topic 606, Revenue from Contracts with Customers, will dramatically change when and how they recognize revenue. Although companies should begin to think about its impact now, it is not effective until 2019 for calendar year private entities. Until then, existing revenue recognition guidance within ASC 605, as interpreted by SEC Staff Accounting Bulletin No. 104 (SAB 104), still applies. We thought a series of blog posts, starting with a refresher of existing accounting guidance, might relieve some of the fear!
Introducing the four criteria for revenue recognition
For years, U.S. GAAP had only very general guidance for revenue recognition. Luckily, the SEC stepped in to provide further guidance with the issuance of SAB 101, which SAB 104 amended. Although, technically, the SABs are only applicable to public companies, many private companies follow the guidance in SAB 104 due to the lack of general revenue recognition guidance in ASC Topic 605.
SAB 104 (codified in ASC 605-10-S99) sets out the SEC staff’s view on when to recognize revenue for a particular unit of accounting. That is, the criteria that needs to be met in order to recognize revenue. It is written in a Q&A format and provides interpretive guidance about:
- the significance of title transfer,
- meaning of substantial performance and customer acceptance,
- effect of undelivered items on nonrefundable payments,
- the conditions for recognition of refundable revenue,
- and various other revenue recognition issues.
ASC 605-10-25 states that revenue is not recognized until it is realized or realizable and earned. This is considered to be the case when all four of the following criteria within SAB 104 are met:
- Persuasive evidence of an arrangement exists;
- Delivery has occurred or services have been rendered;
- Seller’s price to the buyer is fixed or determinable; and
- Collectability is reasonably assured.
1. Persuasive evidence of an arrangement exists
Typically, “persuasive evidence” is in the form of a written agreement or binding purchase order signed by both parties. However, other types of evidence can exist to replace a written contract if that is normal and customary business practice for an entity. For example, Amazon (and many other Internet businesses) does not require a written/signed agreement, but another type of authorization/electronic evidence can be acceptable. Whatever is determined to be “persuasive evidence” should be applied consistently for all transactions of the same kind within a company.
Oral agreements typically would not constitute persuasive evidence and delivery is not considered a substitute. If persuasive evidence of an arrangement does not exist, including evidence that is not in accordance with their normal and customary business practices, no revenues are recognized until all the other criteria are met and cash is received, which is non-refundable.
2. Delivery has occurred or services have been rendered
Delivery of the product or performance of the services must be met before revenue can be recognized. It is important to note that whether or not the seller has performed should be viewed from the customer’s perspective. SAB 104 sets out the following requirements with respect to delivery of goods or performance of services:
- Product is delivered to the customer’s place of business or another site specified by the customer in accordance with the arrangement.
- Purchaser assumes the risk and rewards of ownership.
- Title was transferred to the purchaser.
- Seller substantially completes or fulfills the terms specified in the arrangement with only inconsequential obligations remaining.
If customer acceptance is required and there is uncertainty as to whether the customer will provide such acceptance, revenue should not be recognized until customer acceptance occurs. This is due to the fact that the SEC views customer acceptance provisions as substantive.
Inconsequential actions that have yet to be completed by the seller would necessarily mean the arrangement is not “substantially complete.” However, the SEC believes that remaining obligations are rarely considered inconsequential! In fact, in situations where the remaining obligations are considered more than inconsequential, there may be a multiple element transaction to evaluate first in accordance with guidance within ASC Subtopic 605-25 (see below).
3. Seller’s price to the buyer is fixed or determinable
If the selling price cannot be determined, the seller cannot determine what revenue to record and, therefore, the price needs to be fixed or determinable. An example is contingent rental income, which you cannot recognize until it is no longer contingent. Consider a lessor who leases retail space to a lessee where sales volumes determine the rent amount. SAB 104 guidance requires that the lessor only recognize rental revenue in the period in which the sales are made and the amount of revenue could be calculated.
If the customer has a right of return, either specified in the contract or based on existing practice, ASC 605-15-25 requires them to meet the following conditions before they can recognize revenue:
- Seller’s price is substantially fixed or determinable;
- Buyer has paid or is obligated to pay the seller;
- Buyer’s obligation to pay the seller is not contingent on resale;
- Buyer has economic substance apart from the seller;
- Seller is not obligated to aid in resale; and
- Future returns are reasonably estimable.
If all the conditions are met, then the seller can record sales revenue and related cost of goods sold, with a corresponding reduction in both line items in the income statement for the estimated returns. If these conditions are not met, revenue is deferred until either all the conditions are met or the right of return expires.
4. Collectability is reasonably assured
The collectability criterion needs to be met at the time of sale. If the collectability is met, revenue is recognized and a receivable is recorded. If this receivable becomes a bad debt later, they will not reverse the revenue but will charge it against an allowance for doubtful accounts they established at the time of sale.
Since companies normally make sales to counterparties with acceptable credit risk, many, but not all, cases meet this criterion. For example, consider a fertilizer manufacturer that sells fertilizer to farmers in developing countries and only requires payment at the time of harvest. When they make the sale, collectability depends on whether the harvest fails or not. Where collectability is doubtful, revenues and gains may be recognized as cash is received.
Applying SAB 104 guidance to multiple element arrangements
When a sale includes several different elements (a so-called “multiple element arrangement”), the guidance in Subtopic 605-25 (Revenue Recognition – Multiple Element Arrangements) needs to be applied first to determine if the different elements can be separated into different units of accounting, to each of which the revenue recognition criteria are applied separately, or whether all or some of the elements are combined into one unit of accounting. Thus, for a multiple element arrangement, the analysis required by Subtopic 605-25 is performed before ASC Topic 605 revenue recognition criteria are applied to determine when revenue can be recognized.
Think companies don’t need reminding? Think again!
The Securities and Exchange Commission (SEC) recently charged two former executives at OCZ Technology Group Inc. for accounting failures relating to a scheme to materially inflate the company’s revenue and gross margins from 2010 to 2012. According to the SEC’s complaint, the company allegedly:
- Mischaracterized sales discounts as marketing expenses by having employees create false documentation to conceal the scheme;
- Engaged in channel-stuffing by shipping more goods to its largest customer than the customer could sell in the normal course of business;
- Concealed large product returns from OCZ’s finance department and external auditors so they would not record those returns in the books and records;
- Recognized revenue upon product shipment rather than upon delivery of the product to the customer; and
- Understated accrual for product returns.
This scandal mirrors many accounting scandals of the past, with the main theme being fraud and improperly recognizing revenue in accordance with ASC 605 and SAB 104. Perhaps they and their auditors should have read this blog!
Well adopting ASC 606, of course! We've authored a ton of blog posts, which are summarized in this post. In addition, we've just released a series of online training courses to help companies and accounting firms with the new guidance.