While adopting the new revenue recognition standards (ASC 606 / IFRS 15) is, or should hopefully be, top of mind for companies around the world, it is important to remember that the current revenue standards (generally, ASC 605 / SAB 104 and IAS 18) still present challenges now that companies should not ignore. Facing more than just “detention on a Saturday afternoon”, a veritable Breakfast Club of beleaguered companies are currently dealing with regulatory investigations, enforcement actions, and restatements as a result of improper revenue recognition.

Historically, revenue recognition issues have been a leading culprit of financial statement restatements, and it appears this trend is not changing. Anyone paying attention to recent headlines has probably taken note of continued issues in this area by some of the world’s largest companies (e.g., Monsanto, Valeant, IMB, Boeing and Diageo,).

A blue chip, a pharmie, a techie, an innovator and a beverage company. What do these companies have in common? More than you might think! In this blog, we will explore the revenue recognition issues that occurred at a few of these companies and revisit the proper treatment under current accounting guidance.

Monsanto

In February 2016, the SEC brought an enforcement action against Monsanto, a sustainable agriculture company, that highlighted material misstatements in its 2009, 2010, and 2011 financial statements and required the company to pay an $80 million fine. According to the enforcement action, Monsanto implemented various rebate programs in 2009, 2010, and 2011 to compete against pressures from private label brands that negatively impacted its sales. In a number of instances, the impact of the rebate program was recognized in a different period than that of the revenue associated with the sales transaction triggering the rebate. Additionally, some portion of the rebate programs was recognized as selling, general, and administrative expenses.

So, what’s the issue?

You know, the whole matching principle.

Specifically, ASC 605-50-25-7 requires vendors to recognize rebate obligations in a systematic or rational manner by considering the cost of honoring the rebate offer to each underlying revenue transaction triggering the rebate. For rebates based on a single revenue transaction, ASC 605-50-25-3 generally requires a vendor to recognize the cost of the rebate at the later of the following:

1. The date at which the related revenue is recognized by the vendor, or
2. The date at which the sales incentive is offered.

From a general perspective, cash considerations or incentives provided to customers are recognized as a reduction of revenue unless the vendor:

• Receives or will receive an identified benefit in exchange for the consideration, AND
• Can estimate the fair value of the benefit.

In Monsanto’s case, the biggest issue was the fact that rebate programs were triggered by revenue transactions in an earlier reporting period (i.e., fiscal year) but were not recognized until the subsequent period. To make matters worse, once some rebates were recognized, they were accounted for as an expense rather than a reduction in revenue!

Valeant

In February 2016, Valeant, a large pharmaceutical company, announced a restatement of earnings as a result of various revenue recognition issues. The most significant item related to sales to Philidor pharmacy, an entity that Valeant helped create, with which Valeant had close ties, and that it ultimately acquired in December 2014. Valeant recognized revenue on sales to Philidor on a “sell-in” basis (i.e., when sold to Philidor), rather than a “sell-through” basis (i.e., when Philidor sold these goods to its customers).

So, what’s the issue?

Companies often sell products through distributors or resellers. When a reseller is unable to sell the products, the vendor is often compelled to grant a price concession in an effort to maintain its relationship with the reseller or distributor and to maximize sales for the product. Under U.S. GAAP, there are two potential approaches for revenue recognition:

• Sell-in – The appropriate treatment when fees are fixed or determinable because the vendor can reasonably predict the amount of price concessions that will be given to customers based on the vendor’s historical experience. Recognize revenue upon sell-in.
• Sell-through – The appropriate treatment when fees are not fixed or determinable or when significant risks and rewards of ownership have not been transferred to the customer. In this case, recognize revenue upon sell-through when the vendor has evidence of the sale of the product to end-customers by the reseller or distributor.

To determine if it is appropriate to recognize revenue on a sell-in basis vs. a sell-through basis, it is important to apply judgment and to consider all elements of a sales agreement, including:

• When title passes
• If the reseller has a right to return upon expiration of an unsold product
• Likelihood of price concessions and ability or inability to make a reasonable estimate of these price concessions
• Price protection of the reseller
• Ability or inability to make a reasonable estimate of returns

In the case of Valeant, the close business relationship leads one to question whether the sell-in arrangement was truly at arm’s length and whether any terms existed that would warrant sell-through accounting. Relationships, such as this one, are red flags for further scrutiny and consideration under ASC 605!

Diageo

In July 2015, Diageo, an international spirits and beverage company, confirmed that the SEC was investigating potential issues surrounding revenue recognition and “channel stuffing”. “Channel stuffing” is the process of shipping excess inventory to distributors, even if they don’t need it now, in an effort to boost the shipping company’s sales. This practice is more likely to take place in sales arrangements involving distributors but can happen with any sale of goods. By “selling” more product than is needed, a company recognizes more revenue!

So, what’s the issue?

It may surprise you, but from an ASC 605 perspective, “channel stuffing”, by itself, is not necessarily a problem. What is a problem, however, are the knock-on effects of a “channel stuffing” program:

1. Often, to have customers or distributors agree to take possession of more product, certain incentives, extended payment terms, or extended warranty or return provisions are made by the selling company (i.e., Diageo). In these cases, a change in terms may result in these transactions not qualifying for revenue recognition under ASC 605. For instance, the selling company may be unable to reasonably estimate returns or collectability under the new terms is not reasonably assured. It is important to review these revenue contracts to determine whether any “special” provisions are not customary in other contracts and assess the impacts of these provisions on the company’s ability to recognize revenue upon delivery.
2. An additional point, often forgotten, is an entity’s responsibility to disclose the effects of these “channel stuffing” programs, not only related to current results but also to the prospects of future sales! The SEC requires consideration of known trends and forward-looking information in its MD&A reporting. A sale of excess product than is needed in one period will likely have negative impacts on future sales at one point or another!

“Don’t mess with the bull, young man. You’ll get the horns.”

The SEC is still watching! Companies might want to heed the warnings from these recent examples of improper revenue recognition and be careful to not lose sight of current guidance, even if there is focus on adopting the new standards. By doing this, they might learn a little something about themselves and realize that they have things in common with a blue chip…a pharmie…a techie…an innovator…and a beverage company.