Upcoming Rules to Impact When to Recognize Revenue

Upcoming Rules to Impact When to Recognize Revenue

 28 May, 2004

This article appeared in Business First of Columbus

When I started out as a young accountant over twenty-five years ago, I thought I had a good understanding of when revenue was recognized. A sale (revenue) was recognized when a customer received a product or service and was obligated to pay for it. This is a simple contract between the buyer and the seller. Many companies, small and large, still use this method to determine when revenue is recognized.

However, the complexity of business has given some companies flexibility in the recognition of revenue. As long as the recognition method is not outside the standards for an industry, it will meet the requirements of generally accepted accounting principles.

So what’s the problem with a little creative accounting for revenue? The problem is that revenue is usually the largest single item in the financial statements of a company and it is often the reason companies restate their financial statements. WorldCom is a good example of how overstated revenues can hurt a company. WorldCom had a $11 billion overstatement in revenue that led to its bankruptcy.

These creative recognition practices have brought the issue of revenue to the top of the list of projects for accounting reform at the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). The top accounting standards setting bodies in the world are working together in an effort to standardize revenue recognition in most major economic markets.

In the United States, there is no current broad-based standard for revenue recognition. The existing revenue recognition standards are hidden in a wide variety of accounting rules. Some practices have been developed for specific industries based on the practices of the industry.

But, is flexibility really that bad? The variety of the methods used by companies is unbelievable. Let us look at two examples � Merck and Time Warner � both of which are in “conformity with generally accepted accounting principles in the United States of America,” as expressed in their auditors’ opinions.

In the 2003 annual report, Merck disclosed its policy for revenue recognition as: “Revenues from sales of products are recognized when title and risk of loss passes to the customer. Revenues are recorded net of rebates, discounts, and returns, which are established at the time of sale.” Even to an old accountant, this makes sense.

Now compare Merck’s disclosure of revenue recognition to that of Time Warner. It is important to note that these companies are in different industries so there is an expectation that some differences would exist.

The Time Warner annual report disclosed the policy for revenue recognition in a note to the financial statement that is about five and a half pages long. The disclosure includes separate policies for revenue for AOL, cable, publishing, networks, filmed entertainment, barter transactions, multi-element transactions, including contemporaneous purchases and sales, and sales of multiple products and services and finally gross versus net revenue recognition.

As a result of these recognition policies, Merck has no deferred revenue on its balance sheet, while Time Warner has almost $3 billion of deferred revenue. Both companies are within the accounting standards applicable to the industries in which they operate, but the revenue recognition standards, or lack of standards, can create significant differences in the financial appearance of a company.

Closely held businesses are not immune to creativity in revenue recognition either. Some companies have taken the position to “book the income” as soon as the contract is signed. This aggressive approach has been taken even though the contract has contingencies like approval of financing or completion of significant services.

Soon businesses will lose some flexibility in revenue recognition. FASB is currently developing a new standard for revenue recognition. As the discussions are moving today, the standard will be principle-based as opposed to rule-based. On March 16, 2004, FASB reached some tentative conclusions regarding revenue recognition:

-- The standard will follow “customary business practice as it is used in the context of contracts.”

-- Explanatory guidance, including the definition of a contact will be included in the standard.

-- Implementation guidance will be included in the general standard to clarify that a contract does not have to be worthy of enforcement in order to give rise to and asset or liability.

-- Only legally enforceable obligations should be included in the scope of the revenue recognition standard.

Once FASB announces the finalized standards, it will be imperative for all businesses to make the necessary changes. Make sure to consult your financial advisor to stay abreast of the changing situation.