The Accounting Onion

Revenue Recognition Sure Isn't Perfect – But Convergence will be much Worse

No one will ever say that U.S. GAAP revenue recognition standards are consistently principles-based, but few would say the system needs to be completely overhauled. Other than to achieve convergence of U.S. GAAP and IFRS, what will a new revenue recognition standard accomplish to improve financial reporting? And at what cost? Before the boards' issue their third exposure draft, they may want to answer those questions.

The sole reason for a joint revenue recognition project was that IFRS revenue recognition standards had huge holes, yet the EU would never have tolerated the details of U.S. GAAP and the attendant loss of wiggle room for the top line number of the income statement. The other side of the coin is that it would be unthinkable for the U.S. to adopt extant IFRS on revenue recognition, or anything even closely resembling that. In short, it wasn't that U.S. GAAP and IFRS were so fundamentally different as to necessitate starting from scratch, but that was the only way to avoid confronting differences that were not fundamental, but where the devil was in the details.

Thus, it comes as no surprise to me that no one has lit a fire under the boards to get a new standard out. Here's a quick list of off the top of my head of the questions that are still up in the air after ten years of "due process":

• Criteria for recognition of revenue;
• Constructive obligations;
• Measuring the transaction price;
• Allocating the transaction price to performance obligations under multiple element arrangements;
• Estimating and presenting bad debts;
• Warranty liabilities;
• Licenses;
• "Onerous" performance obligations;
• Discounting;
• Costs eligible for deferral; and last but not least,
• Whether the final standard should provide detailed examples, or just wait and see how practice 'interprets' general guidance.

I don't want to beat a dead horse, but it's astounding that practically nothing has been settled after more than 10 years by the discussion papers, draft standards, perhaps a thousand comment letters, hundreds of roundtables, hundreds of thousands of frequent flier miles, tens of thousands of man hours of staff research and the solemn deliberations of the ineffable amongst inscrutable board members.

Not Even Agreement on the Basics

There is indeed much I could choose to write about from the above list, but for starters, this post will focus on the most basic issue: the criteria for revenue recognition. I'll begin with a description of one of the bulwarks against abusive revenue recognition practices in current U.S. GAAP. We'll then review what appears to be the Boards' current tentative conclusion, and then ask whether it would be an improvement over U.S. GAAP.

In 1999, the SEC staff published Staff Accounting Bulletin No. 101 (subsequently updated in SAB 104 and codified as Topic 13 of the SAB Codification), which to my mind is a model of principles-based guidance overarching many disparate rules to be found in U.S. GAAP. It may not have been well-received by issuers, but unlike the FASB and IASB and to the staff's everlasting credit, it didn't seem to care near as much about that.

SAB 101 requires (more accurately, it interprets U.S. GAAP to require) that collectibility from the customer must be "reasonably assured" in order for revenue to be recognized. When goods have been delivered prior to the receipt of cash from a customer, this is taken to mean that there must be a high probability that the customer will pay the company all that it is legally entitled to receive. Hence, for example, "channel stuffing" is streng verborten – pumping goods into a full to overflowing pipeline to a middleman who has the option to return unsold goods to the manufacturer does not lead to revenue recognition merely upon delivery of goods to the middleman.

The "collectibility is reasonably assured" criterion also means that no sales are recognized from sketchy customers until their check clears the bank. To see why this is bedrock U.S. GAAP, take this simple example (which I first used here). Two companies, A and B, differ only in the credit quality of their customers. Company A estimates its allowance for doubtful accounts to be 2% of gross accounts receivable, and B's allowance is 30%. Without the SEC's "collectibility is reasonably assured" criterion, both companies could recognize revenue upon delivery of goods or services.

But, as is inevitably the case, both companies will err in their estimates of uncollectible trade receivables. Perhaps for both companies, uncollectibles were off by a third: that would make 3% for A and 45% for B. The premature recognition of earnings by Company A might or might not be material, but for B, it is hard to imagine that it would not be.

Now, let's begin to consider the boards' proposal. Would you feel better about company B recognizing revenues from its sketchy customers prior to collection if: (a) it was their long-established practice to sell to sketchy customers; and (b) management judged from its past experience that 30% was "predictive" (whatever that means) of the future bad debt rate?

It seems to me that many financial statement users would not be comfortable with B recognizing revenue prior to being able to cash the check, but what I just described seems to be what the boards are proposing – at least according to a Deloitte publication, for I can't even find much of a discussion of the Boards' current positions on their websites. (That by itself ought to tell you something about how well this project is going.)

Anyway, let's rely on Deloitte for the straight skinny:

"The Boards tentatively decided that when an entity satisfies a performance obligation, the entity should recognize revenue at the amount allocated to that performance obligation unless the amount is not 'reasonably assured' to be received. An entity would be reasonably assured to be entitled to the amount of consideration allocated to satisfied performance obligations only if both of the following criteria are met:

a)    the entity has experience with similar types of performance obligations (or has other evidence such as access to the experience of other entities); and

b)    the entity's experience (or other evidence) is predictive of the amount of consideration to which the entity will be entitled in exchange for satisfying those performance obligations. (page 7, italics supplied)

As a preliminary matter, Deloitte's description contains an ambiguity that I find necessary to deal with: "Reasonably assured to be received" (which sounds a lot like the SEC's current criterion that "collectability is reasonably assured") is not the same as the following sentence, which reads "reasonably assured to be entitled" to receive. Which is it?

The confusion may spring from the back and forth of the protracted deliberations. At first, the boards concluded that revenue should be recognized when the entity is legally entitled to receive (or keep) an amount from its customer*; therefore, they concluded, the revenue from a performance obligation ought to be measured at the expected amount to be collected. It follows further from this line of reasoning that trade receivables would be measured as a function of expected credit losses.

That was a pretty good decision, I thought, but the Boards yielded to pressure from issuers, who evidently decided that they didn't want the responsibility of being held accountable for the estimates – if they could make their earnings targets without them. So, the boards have backtracked towards something similar to current practice, but imbued with typical IASB-style wiggle room (my euphemism for 'management judgment'). If criteria (a) and (b), from above, are deemed by management to have been met, then it's okay to recognize revenue.

Say hello again to channel stuffing, sketchy receivables and even bill and hold sales.

 

After Ten Years, Has Any Progress Been Made?

There can be no arguing that the revenue project was begun with high aspirations. A new standard would provide greater specificity and consistency to accounting for multiple element arrangements, and it was going to resolve the inconsistencies in accounting for arrangements where performance would be satisfied over time – e.g., construction contracts, customized manufacturing, consulting, etc. All of this was supposed to happen in a principles-based manner, i.e., by treating revenues the same as expenses according to the 'asset/liability view' of recognition and measurement. Just as changes to assets and liabilities determine in which period expenses are recognized, increasing an asset or decreasing a liability would determine revenues for a period. (Under current IASB and FASB standards, for revenues it's always the other way around: meeting the revenue recognition criteria would determine whether an asset would be increased or a liability would be decreased.)

We didn't need to get into the gory details to see just how far short this project has fallen from the boards' stated goals. All we need to do is focus on the general revenue recognition criteria. In my opinion, if we were to jettison U.S. GAAP and adopt the revenue recognition criteria being proposed, it's quite possible that accounting mayhem would ensue. But whether my fears come to pass or not, I cannot think of a single area where U.S. GAAP would be improved by adopting the Boards' proposed replacement for current revenue recognition standards.

Unlike the other two major projects the Boards are grappling with – leasing and financial instruments – to the best of my knowledge, I don't believe a single user has asked either board for new revenue recognition standards. It's long past the time for the FASB to explain why its stakeholders can expect any benefit to come from a completely revamped approach to revenue recognition. No matter what a final standard will look like at this point, all I see coming out of new revenue recognition rules are mountains of wasted resources on compliance by issuers and lots of new "interpretive guidance" from regulators.

If the FASB can't satisfactorily explain how the revenue recognition project will benefit users, it should abandon the project and leave the IASB to take it where the EU wants it to go.

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*Assuming the absence of a "constructive obligation," a contrivance that I don't have the stomach to deal with today.

 

 

 

 

 

 

 

 

 

 

 

    

Another "Case" of Terrible Decisions Borne of Terrible Accounting Rules

My parable about GM's earnings-management-driven pension decisions inspired a friend of this blog (let's call him Mark) to share a story from around the same time period.

I worked at J. I. Case, the farm and construction equipment manufacturer. As was the accounting policy for car companies, we recognized sales upon shipment out the plant to a dealer.

Case financed the dealers so it was relatively easy for the salesman (based on instructions from management) to tell every dealer in August (fiscal year end at end of October), "please order x number of tractors. They will arrive in early November, having shipped from the plant in late October. We know you don't need them until next spring, but we will give you interest-free loans until next June. Presumably the tractors will have been sold by then and you will not lose any sales in the meantime."

As a result, production was really ramped up in September and October, and production then really sank in November and December. Worse, the company had to finance its "sales" to dealers for six or more months. Knowing there would be an inflow of cash, even though the company was not doing well, Case told all its vendors: "We have to be out of the banks for six weeks in order to maintain our line of credit. So we will not pay you in October but you will get everything we owe you on December 15^th." This satisfied the vendors because certainty of payment was sufficient. However, satisfied is not the same as liking it, and Case's leverage with vendors was reduced—which squeezed our margins even more.

Case had the choice of recognizing revenue at shipment, delivery or upon ultimate sale by the dealer; but once they had chosen the point of shipment to record revenue, the company (and industry for that matter) could never go back. I worked there at Case in the late '60s and this was only 10-12 years into the system, but even then the finance staff saw how a bad accounting rule really screwed up operations, financing and ultimately profitability, but there was nothing anyone could do.

In a couple of respects, this story is an even better object lesson to illustrate the principle that lousy accounting standards create costly perverse incentives for management. To begin with, pensions are a difficult financial problem, but machinery sales to dealers is relatively simple and a critical component of earnings for every company. Thus, it follows that schemes (legal and otherwise) to juice revenue abound; for example, my recollection is that the SEC general reports that about 60% of its enforcement actions for accounting violations involve revenue recognition.

Moreover, the main reason I decided to put Mark's story out there is that it is timely: revenue recognition standards are in the process of being revised by a joint FASB/IASB project. Would the same opportunities to scramble revenues and earnings have been available if the current proposal to replace extant U.S. GAAP had been in effect? YOU BETCHA!

In the revenue recognition project's nascence, the boards did solemnly aver that new standards would result in a much more faithful portrayal of economic reality: the driver of income would be changes to assets and liabilities, which would be measured at current values. But, once the boards got the message from issuers that they wouldn't easily give up the revenue recognition rules they knew and loved, the project has devolved into a (futile?) face-saving quest to put old wine in new bottles – i.e., to write one reasonably brief standard that would return the same (or better) values as hundreds of rules that comprise existing U.S. GAAP.

Ironically and tragically, the solution to the J.I. Case problem (and the general problem when cash is received after services are performed) is actually very simple. First, an entity should not be permitted to recognize a receivable from its customers (dealers) unless it owns a present legal right (conditional or unconditional) as of the balance sheet date to cash or another asset. Second, the asset (receivable) representing that economic right should be measured at its current value. Third, a detailed roll-forward of the balance of receivables from customers would be presented in the notes to the financial statements.

With those three simple guidelines, revenue recognition games for Case, and practically everyone else, would be over. Not coincidentally, financial statements would do a better job of communicating the effect of economic events on shareholder value. It is the only place that the boards could have ended up if they had stuck to their original commitments for producing a high quality revenue recognition standard.

Accounting without Rules -- or Principles

Ted's Accounting Question

My friend, Ted (not his real name), is the ex-treasurer of a very large public company where he acquired extensive experience in solving accounting problems. He departed a few years ago to run a business that he and his brother had purchased. Business had been humming along nicely until the economy took a dive.

Ted recently came to me with a question about the accounting for a renegotiated payable to a long-time supplier, ABC Printing. While the negotiations were underway, Ted discovered that recent prices being charged by ABC were much higher than he could have obtained elsewhere. Eventually, the parties agreed to the following terms (more or less): (1) reduce the amount currently owed by 40%; (2) the remainder of the trade payable would be converted to a non-interest bearing note payable with equal monthly payments over the next three years; and (3) ABC would continue to be the exclusive printer for Ted's company for the next three years -- at a 5% discount to prevailing market prices, so long as new billings were paid within 30 days of their invoice dates.

Solely for the sake of discussion, let's assume the following additional facts:

• The change to the terms of the payable would result in a $90,000 write-down, such that the remaining balance of the payable would represent the discounted present value – or equivalently, the fair value – of the 36 monthly payments over the next three years.
• The amortization schedule for the note payable results in changes to its balance that correspond to changes in its current value.
• The current value of the future purchases at discounted prices is $114,000.

Based on our collective knowledge (i.e., winging it without any formal research), Ted and I identified two potentially permissible accounting treatments:

Treatment #1 – Reduce the payable by $90,000; record a gain of $90,000; no recognition of the purchase commitment.

Treatment #2 – Reduce the payable by $90,000; record a deferred gain of $90,000; no recognition of the purchase commitment. In subsequent periods, amortize the deferred gain to income over the term of the purchase agreement.

Ted tells me that his former employer had engaged in similar deals, and it had accounted for them along the lines of Treatment #2 because it produced a smoother stream of earnings. That comes as no surprise, but it would seem to me that an auditor could find Treatment #2 to be inappropriate (even though it is more "conservative") because the deferred gain does not meet the conceptual definition of a liability, and there is no specific rule that permits it. So much for principles.

Moreover, whichever of these two treatments is elected, the parties will be able to manipulate the accounting results to their preferences by manipulating the monetary parameters of the agreement – i.e., the amount of the payable forgiveness and the amount of the discount on future purchases are interdependent. Consequently, should the executive compensation packages for either company have an earnings-based component, it's easy to see how the absence of neither rules nor principles creates perverse incentives for management that end up destroying value for shareholders. The only form of accounting that would prevent such value destruction would entail recognition of all of the assets and liabilities – including the purchase agreement – and measurement at their current values.

This is Also an Interesting Revenue Recognition Problem

I chose to blog about my conversation with Ted because the accounting issues for ABC Printing (the supplier) is even more interesting than the accounting for Ted's company. Mostly, it's a good example for thinking about how the exposure draft, Revenue Recognition (Topic 605): Revenue from Contracts with Customers, would fail to provide answers to many issues that are sure to arise if finalized in its present form.

Before considering the exposure draft, however, let's start with existing accounting standards; because ABC has an opportunity to manage its earnings in two respects. First, the writeoff of the receivable from Ted's company might not have an impact on current earnings if ABC can conclude that the allowance for bad debts is sufficient to absorb it without a charge to bad debt expense. Second, if ABC was concerned with maintaining its future profit margins, then they might be willing (and could "afford") to grant a larger forgiveness of their current receivable in order to minimize the amount of the discount on future sales in order to keep Ted's business.

None of this weirdness would be corrected by, or particularly affect the accounting under the exposure draft, without my adding one more twist to the problem: let's assume that a portion of the re-negotiated amount owed by Ted would be payable in a lump sum at the inception of the new arrangement. The exposure draft would require separate accounting for the forgiveness of the indebtedness (a financial instruments contract) and the contract to supply goods; yet, it is impossible to determine whether the lump sum payment is a partial settlement of the receivable or a prepayment for future goods. To the extent that it is seen as a prepayment, then the resulting "performance obligation" would be accounted for like a deferred gain.

It would seem that this is an issue that the FASB could resolve before finalizing the exposure draft, but my sense is that it is only one of many gaping holes in the standard. Again, the only principles-based way of accounting for this transaction would involve recognition of all assets and liabilities, and measurement at current values, as follows (for ABC):

Reduce the receivable by $90,000 and any cash received at the inception of the new arrangement; recognize a purchase agreement liability of $114,000 (to be netted against the receivable); record a gain/loss to balance the journal entry. In subsequent periods, recognize changes to the current values of the purchase agreement and receivable directly in earnings.

In addition to providing the most complete picture of the legal rights and obligations created, there would be need for highly stylized and vague accounting standards like the revenue recognition exposure draft, and no perverse incentives to manage earnings via exploitation of the gaps in GAAP.

The Revenue Recognition Project: Death by a Thousand Comments

The revenue recognition project has become a mess. Even the AICPA was forced to say as much to the FASB, while at the same time knowing that it would likely kill any prospects of IFRS adoption. But, the AICPA's definition of a mess is different than mine: theirs is that too many dues-paying oxen will be gored unless more exceptions, exemptions, accommodations and all that other stuff will be added; mine is that the original goals of the revenue recognition project have become obliterated.

This is what I believe the Boards had envisaged way back in 2002:

• Revenue recognition would be consistent with the way that expenses were supposed to be recognized: that is, defined in terms of changes to assets and liabilities. In particular, deferred costs, would no longer be recognized as assets. And since the criteria for recognition and measurement of assets and liabilities should be broad-based, a revenue recognition standard would be able to comprehend all transactions with and entity's customers, regardless of industry.
• Performance obligations would be measured at fair value.
• Revenue would be recognized as "performance obligations" are satisfied.
• Since a performance obligation is a liability, the project would propose a new conceptual definition of a liability for the sake of added consistency.
• Since the new standard would also be principles-based, it would apply to all arrangements with customers, be they consulting contracts, long-term construction contracts, software sales, leases, and even insurance – an area where no IFRS standards even existed.

The way I see it, this project has become a failure because the boards bit off too many special interests than they could chew at one time:

First came the scope exceptions. One of the great ironies for me is that if there is any industry for which the concept of a performance obligation is central to revenue accounting, it would be the insurance industry. Indeed, the boards originally intended for this project to pave the way for IFRS to cover the insurance industry. Yet, the insurance industry clearly wanted no part of this project, and the boards clearly knew that they would get steamrolled in a political battle with them. Lessor accounting is also a controversial topic the boards are struggling to complete as a separate project, so that was scoped out as well—again, for no principled or even practical reason other than political pressure.

Then came attacks on fair value measurements. One of the recurring themes of this blog is that exit prices (as opposed to entry prices) create accounting problems literally from Day One. Expensing transaction costs to acquire financial instruments is just one example the boards have had to cope with, but the even more vexing problem has turned out to be Day One gains from being able to settle performance obligations for less than what was received from the customer. For example, a company that sells an extended warranty on an automobile for $1,000 might be able to immediately subrogate their liability to some other company for a payment of $800. Thus, the fair value of the warranty is only $800, and the Day One gain is $200. The obvious (to me, at least) solution is to measure a performance obligation by the customer's replacement cost of its asset to receive warranty services over the extended period (still $1,000). But the boards traveled too quickly and too far down the fair value road to admit their errors without significant loss of face.

Consequently, in a desperate attempt to save their revenue recognition project (an integral element of convergence) from destruction, the boards pivoted away from fair value measurement and eventually settled on the time-worn notion of allocating the total arrangement consideration amongst the performance obligations in proportion to their respective fair values.

As with any allocation process in accounting, such an approach to measuring performance obligations has raised a whole host of ineffable questions. When is more than one contract an arrangement? When is one contract more than one arrangement? How to measure arrangement consideration? Most fundamentally, what attribute of the performance obligation is being measured?

I'll give you two examples of how silly the consideration allocation approach is:

    Example 1: My son lost his cell phone yesterday (true story, but the numbers are made up). So we had to buy him a new phone, and at the same time, we bought him a new service plan. The bundled plan cost us $400; but if the phone and service plan had been purchased separately, they would have cost $300 each. Therefore, the proposed accounting would allocate $200 of the arrangement consideration to the "phone sale" and the same amount to the "service plan" performance obligation. If the phone had a carrying amount in inventory of $250, then the seller would have to recognize a $50 Day One loss on the phone sale. Therefore, all of the profits from the arrangement plus $50 would be recognized over the term of the service plan.

The moral of the story is that absurd accounting is likely to result in absurd managerial decision making. If for no other reason, this standard will destroy shareholder value.

    Example 2: On the last day of a hospital's fiscal year, I checked myself into an emergency room due to severe abdominal pain (another true story – but the date is made up). When measuring the arrangement consideration becomes an integral part of revenue measurement (it is currently a recognition criteria), how on earth will the hospital be able to determine how much revenue it should recognize? So far, all it knows is that I have primary insurance coverage (lucky for them). It doesn't know whether a deductible will apply, whether I have a secondary policy, whether I am creditworthy, or whether I will attempt to negotiate a lower payment (I did). There are probably at least another five sources of uncertainty that I haven't mentioned, yet somehow the issuer is supposed to take them explicitly into account to come up with a number representing the arrangement consideration. And then, it has to discount that number at some appropriate rate of interest.

To this second example, there are two morals. The first is rather obvious: all the new systems that would be required to measure consideration in accordance with GAAP are not likely to provide better information to investors – just more jobs for accountants and auditors. The second moral is even more compelling, because it explains why healthcare providers don't seem to be protesting too much to the proposals: these complex procedures are a juicy opportunity for earnings management. How an auditor could be expected to reign in "unreasonable" probability distributions or even discount rates is a mystery to me.

Then came the construction companies who were afraid that the elimination of percentage of completion accounting would inhibit their abilities to manage their revenues and expenses. So just to get their buy-in, the boards added to the project all manner of opportunities to defer all sorts of costs, completely ignoring the balance sheet approach, which was supposed to be one of the two cornerstones of revenue recognition -- that and fair value.

And, I haven't even discussed the reasons why nobody has figured out how to revise the definition of a liability. That could take all of the wiggle room out of the definition of a performance obligation, and no issuer wants that.

The bottom line is that even after nine long years of prodding, cajoling and improvising to the point that most of the original goals for the revenue recognition standards have been long cast aside, issuers are still hopping mad. Hardly anyone actually cares whether the new rules will result in consistent application of straightforward principles, which was the reason for the project in the first place.

All issuers seem to care about is whether their expected revenue and profit streams will be as smooth, or smoother, than they currently are. All the FASB and IASB seem to care about at this point is placating the issuers – just to get something that looks like a converged revenue recognition standard out the door.

Holy unintended consequences!

Is Revenue Recognition the Death Knell for IFRS Adoption?

It is said that big surprises come in small packages. Last week's "small package" was a brief article in the AICPA's online edition of its Journal of Accountancy, reporting that its own Financial Reporting Executive Committee (formerly the Accounting Standards Executive Committee) submitted a comment letter to the FASB.  FinREC expressed "extensive concerns" with the revenue recognition exposure draft for converging FASB and IASB standards:

"We believe that based on the outcome of [what clearly must be extensive] re-deliberation by the boards, re-exposure of the proposed standard should be strongly considered to ensure sufficient and appropriate due process has been provided to those impacted by the exposure draft."

The "big surprise," however, is the last sentence of the article – which could well be the accounting understatement of the year:

"The suggestion that the proposal should be re-deliberated and re-exposed comes as FASB and the IASB are under pressure to complete the project [and numerous other major projects] by their self-imposed June 2011 deadline."

If I were an editor at JofA, this would have been the headline of that article:

IFRS ADOPTION PRONOUNCED DEAD BY FinREC!

How, with over 1,000 other comment letters having been submitted (mainly, I presume, from issuers trying to figure out how to be able to manage their earnings with impunity under a new standard) will the FASB be able to comprehensively re-deliberate, revise, re-expose, digest the next tidal wave of feedback, and then finalize? And, I didn't even mention the possibility of field testing.  The proposed rules (they are not principles, as the boards' propaganda would have us believe) are very broadly specified, with little more than a few simplistic examples to serve as implementation guidance.  This is a standard that is practically begging to be field tested.

Especially given the importance of revenue recognition, the next due process iteration would normally take at a minimum two to three more years; but the FASB and IASB have given no indication that they're giving up on getting something, anything, finalized so as not to miss their date with destiny. Give the AICPA credit at least for acknowledging the problem, albeit sotto voce, lest they be too blunt and give the SEC no option except for throwing in the towel on IFRS adoption – and losing face in the process.

The sorry state of the revenue recognition project, already eight years in the making, is also a prime opportunity to express my concerns with a statement in the staff's progress report: in evaluating the quality of the IFRS that the U.S. would adopt, the staff will consider without further evaluation converged standards to be good enough for U.S. consumption. [page 5] I'll be providing my own analysis of the revenue recognition exposure draft in my next post, but if the SEC would simply read FinREC's comment letter, they would see that what is going on here severely challenges the staff's presumption that convergence per se means high quality accounting standards. If a converged revenue recognition standard of the same scope as the exposure draft somehow is finalized in the next six months, we will have a convergence, but we could also have a standard akin to the collision of two garbage trucks at high speed. And that doesn't even take into consideration the accidents waiting to happen with the leasing and financial instruments projects.

The only way for the SEC to save face at this point is to do the right thing, right now; which is to stop this Keystone Cops approach to accounting standard setting before investors get hurt.

Even the AICPA, the captain of the IFRS adoption cheerleading squad, appears to be on the verge of openly admitting that IFRS adoption possibilities may have receded from "inevitable" to dead duck.

 

Making Revenue Recognition Simple and Informative

One thing that everyone should be able to agree on is that the accounting rules for measuring and reporting revenue ("revenue recognition") are a huge mess. There are too many of them, and far too many inconsistencies amongst them.

One of my favorite examples for illustrating how dysfunctional the rules can be is this illustrative example taken from a 1999 SEC Staff Accounting Bulletin (No. 101):

"A registrant sells a lifetime membership in a health club. After paying a nonrefundable "initiation fee," the customer is permitted to use the health club indefinitely, so long as the customer also pays an additional usage fee each month. The monthly usage fees collected from all customers are adequate to cover the operating costs of the health club. … Question: when should the revenue relating to nonrefundable, up-front fees in [this type of an arrangement] be recognized?"

If all you knew about accounting was that "assets" are what you have and "liabilities" are what you owe, then you should respond that the revenue should be recognized "when cash is received"; the health club has received an asset (from a non-owner), and it has no obligation to return cash at a later date, or even to provide services, under any circumstances.

The SEC, however, enunciated a different point of view in SAB 101, which can now be found in Topic 13 of the SAB Codification:

"Unless the up-front fee is in exchange for products delivered or services performed that represent the culmination of a separate earnings process, the deferral of revenue is appropriate. … [T]he staff does not view the activities completed by the [registrant (i.e., selling the membership) as a discrete earnings event.]"

The implication of this illustration is that revenue recognition under GAAP involves more than just the receipt of assets that you don't have to pay back; an implicit performance obligation to provide the customer with future services is deemed to exist, even though the customer has no legally enforceable right to receive the services.

In other words, current revenue recognition practices are dependent on factors that don't play into whether or not the definition of an asset or liability has been met for recognition, its subsequent measurement, or conditions for its derecognition. This disconnect of revenue recognition from the balance sheet, has led to a jagged path of positions hatched industry-by-industry, over decades of political wrangling with issuers and auditors. The resulting complexities, subtleties and inconsistencies within the revenue recognition rules are, at their very best, second only to the tangled web that is financial instruments accounting.

The Epic Revenue Recognition Project

The FASB/IASB joint project on revenue recognition seems to have been initiated as a good faith attempt by them to recapture the high ground from the SEC post-SAB 101 on a topic that arguably is the most consequential to the most financial statement issuers. After seven years (yes, the project was proposed back in January 2002) of consideration, the Boards' position has evolved essentially to these major positions as expressed in a discussion paper for which the comment deadline expired six months ago:

• The scope is limited to arrangements whereby an entity exchanges promises with a customer, leading to rights and obligations.  
• Increases in rights or decreases in obligations to customers are recognized as revenue.
• Performance obligations are to be initially measured by the transaction price, or an allocation of the arrangement consideration; subsequent measurement is still unsettled, but is likely to be a function of the initial measurement (as opposed to a market-based valuation).

The good news is that a new standard would supplant all extant revenue recognition guidance, and become the sole source of guidance on revenue recognition. The bad news is that it won't change much else. I see three major flaws.

First, revenue recognition should be nothing more than a question of income statement classification. If the FASB were fully committed to a balance sheet approach to financial reporting, it would plainly acknowledge and implement the principle that net income is merely a number derived from the changes in assets and liabilities during a period that resulted from transactions with non-owners. Hence, the only revenue recognition problem is determining which of those changes should be reported on the income statement as "revenues."   As it is invariably the case with both Boards, a piecemeal approach is being taken to avoid the larger contentious debate of accounting for rights and obligations in general.

Second, nothing worthwhile can come from including constructive performance obligations in the conceptual definition of a liability. The health club initiation fee example is the most straightforward example I can think of to illustrate this. The timing of services provided will cease to be a criteria, but the Boards are not willing to throw out the notion of a constructive obligation from their respective conceptual frameworks:

 "Sometimes an entity establishes a practice of providng particular goods or services, such as a warranty service.  Even if neither the contract nor the law explicity requires such a service, the entity by its customary business practice may have implicitly or constructively created an obligation that would be enforceable." (para. 3.6]

An "enforceable" constructive obligation?  I don't know what that means.  I imagine that what they are trying to say, but too embarassed to say directly is this: even though no legal obligation exists, an entity would harm itself by more than it would benefit if it just took a customer's money and ran.  Thus, economic forces make a constructive obligation "enforceable" through some sort of market mechanism.

I might be less cynical about the reasons for wanting to recognize constructive obligations if we actually had effective financial reporting gatekeepers. How many auditors will call a potential constructive obligation the way they see it – as opposed to the way management sees it? Investors don't need that kind of financial reporting any more, and their returns don't need to be burdened with the considerable costs of amortizing upfront fees over some fuzzy measure of the expected relationship period. 

Third, measurement of customer-related assets and obligations by allocating arrangement consideration to them is a step backwards from the FASB's putative goal of measuring financial assets and liabilities at their fair values. I presume that the FASB is legitimately concerned about introducing more subjectivity into measurement of assets and liabilities; and more fundamentally, they are rightly concerned that exit values for liabilities will inevitably generate Day 1 gains for vendors.

I can't say that there is a sure-fire solution to fair value measurement's subjectivity, for that will always be present in any approach to current valuation.  But, there is a straightforward way around the problem of Day 1 gains. Consider, for example, a one-year fire insurance policy with a $1,000 up-front premium. If an exit value approach were taken to measure the performance obligation on Day 1 (i.e., the obligation to stand ready to pay for the insured's loss should a fire occur), it would likely cost the insurance company less than $1,000 to cede the liability to a reinsurer; hence, the Day 1 gain the Boards are worried about.

But, here is, yet one more time, the compelling economic logic of replacement cost measurements. As I have stated in numerous prior posts, a liability is most appropriately measured by the replacement cost of the corresponding insurance asset in the possession of the policyholder. That number would, by definition, still be $1,000 on Day 1. Presto change-o, the problem of Day 1 gains disappears!

Summing Up

Revenue recognition is arguably the most significant project the FASB and IASB can undertake. But momentum, such as it was, appears to have stalled following the issuance a full year ago of that discussion paper purporting to contain the Boards' "preliminary views."  I believe this is because the standards setters keep bumping up against inevitable logical inconsistencies. First and foremost, is that the predilection for exit values is birthing a frightening brood of financial reporting anomalies. Here are five that come to mind without thinking about it for more than 30 seconds:

• Day 1 expensing of transaction costs when acquiring financial assets or applying the "acquisition method" to a business combination;
• Assigning an exit value to a leased asset that, by contract, cannot be transferred.
• Recording gains on the completion of a manufactured good before it is sold (specifically scoped out of the discussion paper).
• Liabilities that cannot be transferred.
• Asset markets that are either illiquid, or temporarily taken over by distressed sellers. 

I have been told by someone with access to inside information that FASB chair Bob Herz is a replacement cost guy deep down; but, he can't seem to muster the political momentum to alter course away from exit prices. The way I see it, if we continue to reject replacement cost, we are doomed to chasing our tails: (1) try exit values; (2) become discouraged as the logical inconsistencies destroy representational faithfulness; (3) give up and settle for reporting computer-generated random numbers seeded by an historic cost.

As significant as the revenue project is, a reasoned solution is being lost by a destructive problem solving strategy that the late Nobel laureate Herbert Simon and his co-author Allen Newell called "means-ends analysis"  in their 1972 treatise, Human Problem Solving. The danger is that dogged "forward progress" on a portion of a problem may actually set back the solution of the larger problem to which it is apart. After eight years of hemming and hawing, the FASB surely must realize that its approach is clearly not working. Rather than continue to propose partial fixes to flawed models, it would be better off postponing the project until it establishes more pragmatic definitions and measurements for assets and liabilities.   

If it could only solve the larger problem, the problem of revenue recognition would practically solve itself.

Going to School on Revenue Recognition

I'm a night owl, but once I hit the sack, I'm out like a light for 8-9 hours. In fact, the two things I would say that I do best are type fast and sleep like a log. One recent night was a rare exception, though. I woke up only about two hours into my hibernation and couldn't fall back asleep. After about another hour, I gave up. It was too late to have a toodle, so I decamped to my office and turned on the computer.

The first thing on the web to catch my eye was a blurb in the Chronicle of Higher Education, in which it was reported that the revenue recognition policies of the Apollo Group Inc., the parent company of the University of Phoenix, were the subject of an "informal inquiry" by the SEC's Division of Enforcement. Apollo has declined to provide any further specifics, but their share price declined about 18% around the time of the announcement. Hmm.

I decided to look further into this for three reasons: (1) I thought it might help me get to sleep; (2) I was in the midst of preparing to lead a one-day workshop on revenue recognition, so I could actually benefit by a review of some of the rules; and (3) Apollo's headquarters are in Phoenix, where I live.

What I Found – Before I Went Back to Bed

The first thing I did was to download Apollo's most recent 10-K and to read their description of critical accounting policies on revenue recognition. I also pulled 15 years worth of financial statements in spreadsheet format from a data service.

Here is what I found after a few minutes of perusal:

• Students are billed on a course-by-course basis. But, judging by the ratio of the allowance for doubtful accounts to gross student accounts receivable, 29%, it appears that a significant number of student accounts are eventually written off as uncollectible.
• Upon the first day of attendance, Apollo records a receivable and deferred revenue in the amount of the billing. As I will explain later, I was surprised to learn this; 'executory contracts' are usually not recognized (with the notable exception of capital lease accounting).
• Tuition revenue is recognized pro rata over the duration of the course, which is generally 6 - 9 weeks. As we say in the trade, it appears that Apollo has adopted a 'proportional performance' revenue recognition model. A more conservative choice would be a 'completed performance' model.
• Apollo recently changed its refund policy whereby students who attend 60% or less of a course are eligible for a refund for the portion of the course they did not attend.
• Apollo prepared its statement of cash flows under the direct method through 1997. They switched to the indirect method in 1998. I would have thought that a 'preferability letter' for such a change would have been included in the 1998 10-K, but I was unable to locate one.

What Could the SEC Be Looking At?

It appears that the SEC Enforcement Division received a referral from the Division of Corporation Finance, which reviewed Apollo's most recently filed 10-K, issued a comment letter, and received a reply from Apollo. Corp Fin's comments addressed, among other things, Apollo's revenue recognition policy for refunds, and whether bad debt expense and revenue were both overstated (i.e., certain amounts of bad debt expense should have been treated as reductions in revenue).

My own questions start at a much more basic level than Corp Fin's comments: when, if ever, it would be appropriate for Apollo to recognize revenue prior to the receipt of payment?

Accounting for the Students Who Pay in Arrears

The general rule in GAAP is that revenue cannot be recognized until it is earned, and realized or realizable (see Statement of Financial Accounting Concepts No. 5). The SEC staff has interpreted this general rule in Topic 13 of the Codification of Staff Accounting Bulletins (SAB Topic 13) to mean that four criteria must be met in order for revenue to be recognized. I won't go into all of them, but the last criteria is that "collectibility is reasonably assured." If the probability is 29% that a student won't pay Apollo, can it be said that collectibility is reasonably assured?

Apollo and its auditors might respond by stating that 71% of the billings to students are reasonably assured; moreover, Apollo has accumulated an extensive history of course delivery that enables them to reliably estimate the allowance at 29%.

But, there is no language in SAB Topic 13 that specifically allows Apollo to combine similar arrangements for the purpose of determining whether collectability is reasonably assured. SAB Topic 13 does provides that one can estimate future liabilities for warranties and returns by aggregating similar customer arrangements and estimating an average for the group; however, it did not specifically provide that those procedures were available for non-payments of enforceable claims. Notwithstanding, historic experience may not be all that helpful in determining the non-payment rate in the current economic environment. For companies with low non-payment rates, maybe, but for companies with a 29% payment rate, perhaps not.

I suppose it would have been clearer if SAB Topic 13 stated what was to be accomplished by providing that collectibility must be reasonably assured; and/or had specifically prohibited combining accounts when evaluating the criteria. Nonetheless, the following example may serve to illuminate the SEC's intent.

Take two companies, A and B; they are equally profitable and differ principally in collectibility rate of accounts receivable. Company A estimates its allowance for doubtful accounts to be 2% of gross accounts receivable, and B's allowance is 30%. Both companies discover, after the fact, that the real allowance was only two-thirds of what it should have been: that is, 3% for A and 45% for B. The premature recognition of earnings by Company A may or may not be material, but for B, it will be as cataclysmic to the income statement as was the AZ Cardinals' loss last Sunday, on a final-play touchdown pass, to my son. It could be permissible to estimate an allowance for doubtful accounts for a group of similar arrangements, but it does not seem appropriate to determine that collectibility is reasonably assured on the same basis.

When is Revenue from a Course Earned?

While collectability may be an issue for some arrangements with students, many of Apollo's students pay in advance. The comment in this section apply to all arrangements, regardless of the timing and/or uncertainty of cash flows.

SAB Topic 13 provides that revenue should not be recognized for "delivered elements" (i.e., classes in Apollo's vernacular) if remaining elements to be delivered to the customer are "…essential to the functionality of the delivered … services." The staff created an exception to this rule for undelivered elements that are "inconsequential" or "perfunctory," but it is not applicable if failure to complete the activities would result in the customer receiving a full or partial refund … (or a right to a refund…)." Stated from a balance sheet perspective, the underlying principle is that one is generally precluded from recognizing a receivable that is not backed by an enforceable right to collect it.

I am unfamiliar with the way courses are conducted by Apollo, but I assume that they all end with an evaluation leading to a final grade. In my experience, students will not pay for a course that doesn't provide them with a grade. Grading is an essential function of the service provided, and it is certainly not "perfunctory"; therefore, it would seem that SEC guidance would require Apollo to defer revenue related to a course until a grade is given to the student.

But, to be fair, I did check the revenue recognition policies of a number of other public companies in the same industry as Apollo, and they all recognize revenue in some ratable fashion as courses progress. For me, that is just one more reason why the SEC's investigation of Apollo's revenue recognition practice is significant. It could improve the quality of earnings for an entire industry.  (And, by the way, numerous competitors have non-collectibility rates that are roughly the same as Apollo's.)

Accounting for Students Who Drop a Course

The question that the SEC seems to be homing in on is whether Apollo has properly allowed for refunds to students who may drop the course before the 60% point. That also happens to be the only revenue recognition issue that analysts were asking about in Apollo's fourth quarter earnings conference call.

It could be that the analysts and the SEC are both missing the boat. The SEC may believe that Apollo should allocate a portion of the deferred revenue to an estimated liability for refunds. That would initially affect balance sheet classification of liabilities, and it may affect the pattern by which revenue hits the income statement; but it doesn't seem to be that big a deal to me. Yet, it must be said that Apollo's stock price did take an 18% hit around the time of the announcement of the SEC investigation.  If the accounting for the new refund policy is the reason for the stock price drop, then so be it.   

Other Red Flags

I have two final thoughts regarding items that I noticed in my relatively brief perusal of the financial statements. First, even though the ratio of the allowance for doubtful accounts to accounts receivable is around 30%, the ratio of the allowance to receivables for which Apollo actually has enforceable rights could be significantly higher.

That's because Apollo has a practice of recognizing receivables for which it has no enforceable rights. Recall that Apollo recognizes a receivable and deferred revenue for the price of a course when the student shows up for the first day of class. I suppose Apollo is reasoning that both parties have gone down the road somewhat, but it pretty much looks like an executory contract to me. Be that as it may, the SEC should be asking whether the allowance for doubtful accounts is based on the total reported balance of accounts receivable, or just the portion representing enforceable rights. It makes no sense to me to create an allowance for doubtful accounts (and an offset to bad debt expense) on a 'receivable' that is not owed, and may never become owed if the student drops the course. If Apollo sees it the same way, the ratio of doubtful accounts to enforceable student receivables could be significantly higher than even the 29% reported.

Second, regarding the change in the method of presenting cash flows, it would be a pretty big stretch for an auditor to maintain that the switch in accounting was to a preferable method; the FASB has stated in SFAS 95 that the direct method is the approach they encourage issuers to employ as "the more comprehensive and presumably useful." (para. 119) I sure would like to see the SEC ask Apollo and their auditors about that one.

And, perhaps, here is a Hanukah present to the FASB: Apollo could be their poster child for why the direct method for presentation of cash flows should be required. Would 18% of total shareholder value have been destroyed in one fell swoop, had Apollo reported cash flows to investors using the direct method? Perhaps not, because trends in the amount of cash collected from customers would have been disclosed.  The direct method of presenting the statement of cash flows reduces the criticality that investors accurately evaluate the quality of an issuer's revenue recognition policies.  

Winding Up

My goal for this posting was simply to raise interesting questions about Apollo's revenue recognition policies. I want to explicitly state that my intention is not to pass judgment on any of Apollo's choices, even though the market may have spoken to that effect by devaluing Apollo's shares.

Indeed, there are many more questions suggested by this case, and they go beyond the specific effects on Apollo. For example, one could consider whether the revenue recognition rules applicable to Apollo's arrangements with students are themselves representationally faithful or appropriate. We might also ask whether a different result would obtain if the revenue recognition rules under IFRS were applied.

Finally, and perhaps most interesting, we could ask how the revenue recognition project being undertaken by the FASB and the IASB jointly has the potential to improve the quality of financial reporting by companies like Apollo. Unfortunately, I am not confident that the proposed approach would be an improvement, but that's for another post.