The Accounting Onion

EITF 07-1: Can a Good Accounting Rule Drive Out a Bad One?

It seems that business practice tends toward greater exploitation of opportunities for collaboration over time.  On a personal note, it has been said that people don't choose to become professors because they are smart, but because they couldn't play nicely (i.e., collaborate) with other children. 

My own neuroses aside, the first standard on the accounting for collaborative arrangements, APB 18, was the subject of one of my earlier rants--I mean posts.  EITF 07-1, Accounting for Collaborative Arrangements Related to the Development and Commercialization of Intellectual Property, is a recent and interesting sequel to APB 18. 

Setting the Stage for Evaluating EITF 07-1 

At the risk of appearing to re-invent the wheel, I'll start with a broad look at collaboration itself. It seems that there are two kinds:  (1) financial arrangements to provide capital (i.e., wealth or risk transfer), and (2) operational arrangements to use capital effectively (i.e., wealth creation).  There is no dearth of detailed accounting rules governing financial collaborations, with the multi-tentacled 'Liabilities and Equity' project being just the latest example.  However, operational collaborations have not received near the same attention, despite their prominence and importance to investors.

As EITF 07-1 is about operational collaboration (my term, not theirs), let's go deeper into that concept; it seems that there are two ways to operate a business: with and without collaboration.  Here's a list, including annotations of related accounting rules, to illustrate what I mean:

• Operating modes not involving collaboration
  • Develop a product, purchase equipment and inventory, pay salaries and overhead, sell finished goods. (All of the rules you were introduced to in Accounting 101)
  • Acquire a controlling interest in another company that will take over, or complement, one or more business functions. (FAS 94, FAS 141, FAS 142, FIN 46(R))
• Operating collaboratively
  • Acquire a stake in another company that is less than controlling, but large enough to be able to influence its operations in ways that can benefit your own. (APB 18)
  • Acquire a stake in a joint venture (JV) that will do part of the work.  No investor in the JV can act without the permission of the other venturers. (The AICPA has impaled JVs with APB 18.)
  • Retain an agent, compensated with commissions, to help you sell or buy inventory. (EITF 99-19 provides guidance to determine whether you should accounting for a transaction as an agent or as a principal.)
  • Contract with another company to divide up the work. (EITF 07-1)

EITF 07-1,considers four related issues:

1. What constitutes a collaborative arrangement for the purpose of the new rule about to be created?  This is a fence-building exercise for the purpose of preventing encroachment on the scope of other standards and practices--mainly APB 18.  It would not be necessary to do so if the FASB were to take instead a way overdue fresh look at collaborative arrangements.  But, for the purpose of this post, the following example of a collaborative arrangement will suffice:
   
   Company A, having secured patents for a new product, collaborates with Company B, which has a manufacturing facility and an established distribution channel.  The companies have entered into an agreement whereby A will perform the development activities and B will perform the commercialization activities.  All revenues and costs would be split equally.
2. Reporting costs incurred and revenues generated by the collaborators from transactions with third parties.  This is the issue (hereinafter, Issue 2) that I will focus on.


3. Reporting revenues and expenses generated by a collaborator from transactions with other collaborators.  This is an important issue, but not as important as Issue 2 in terms of examining how EITF 07-1 affects the tenor of the accounting for collaborative arrangements.


4. Disclosure. 

The EITF's tentative consensus on Issue 2 is that, unless one party is acting as an agent for the other (see EITF 99-19), each party records its share of expenses and revenues separately on their income statement. 

Get to the Point!

The tentative consensus on Issue 2 makes sense.  That means they contradict the nonsensical presentation provisions of APB 18.  Under APB 18, each collaborating party would report its share of revenues and expenses net, and not gross as would be required by EITF 07-1.  In other words, the legal form of the collaboration (whether or not the collaboration is housed in its own legal entity), and not its commercial substance, will dictate presentation.  This is especially curious since the stated reason for the EITF taking up the issue was to achieve greater uniformity. 

Finally, take note that EITF 07-1 has not yet been ratified by the FASB.  I wonder if they have considered the implications of the issue on APB 18 as I have.  If so, do they care?

EITF 07-03: Which Part of 'Nonrefundable' Doesn't EITF Understand?

EITF Consensus 07-03, Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities, is very straightforward and basic; so much so that it might require less than one class period of Accounting 101 to discuss thoroughly. 

Here is a typical fact pattern: Entity A outsources R&D activities to Entity B, who requires a nonrefundable advance payment.  Should Entity A capitalize or expense the advance payment?  Proponents of the asset/liability view (i.e., expense measurement based only on changes in assets and liabilities) would support immediate expensing; proponents of the competing revenue/expense view (i.e., 'matching') would capitalize the expenditure and subsequently transfer it to expense as services are performed. 

The SEC and FASB have stated they are committed to the asset/liability approach to accounting standard setting, at minimum implying strong resistance to creation of new categories of deferred costs. The policy was officially established in 2003, as the SEC fulfilled its responsibilities under the Sarbanes-Oxley Act to report on the possibility of implementing principles-based accounting in the U.S. In its report, the SEC took the position that the revenue/expense view would be inappropriate in an objectives-oriented regime, and further stated that the FASB should maintain the asset/liability view in continuing its move to an objectives-oriented setting regime.  The FASB published a response, which agreed with the SEC study on this point. 

In a nutshell, matching had been dead for over a decade, and the SEC's SOX report should have been the last nail in the coffin.  Or so it seemed, as the EITF reached a consensus that nonrefundable advance payments for future R&D activities should be initially capitalized and subsequently transferred to expense as the goods are delivered, or services performed.  As justification, the EITF claims, without citing a source, that customers who agree to nonrefundable advance payments nonetheless have a legal right to receive a refund in the event of nonperformance.  Huh?  Are they saying that 'nonrefundable' means 'refundable'!  You say refundable, I say nonrefundable; let's call the whole thing off. 

One can only guess what forces were at play on the EITF (my money is on drug companies) as Issue 07-03 was deliberated.  As if it weren't obvious enough that the fix was in, a telltale sign is provided by the statement that the Consensus may not be applied by analogy to facts and circumstances outside of its narrow scope. 

PS - For those of you numerologist/accountants out there, you may be interested to note that my birthday is July 3rd.  Some dark force surely decreed that I should write about EITF 07-03.