Revenue Recognition

Guidance on revenue recognition

In 2002, the United States General Accounting Office issued a report entitled "Financial Statement Restatements: Trends, Market Impacts, Regulatory Responses, and Remaining Challenges." The report, which covers 919 restatements during the period from January 1, 1997 to June 30, 2002, concludes that revenue recognition is the most frequently cited reason for restating financial statements (38 percent of cases).

Canadian accounting practices related to specific aspects of revenue recognition have evolved to some degree on an industry-specific basis. Nevertheless, the fundamental accounting concepts pertaining to revenue recognition are similar under both Canadian and US GAAP.

In February 2003, the CICA Accounting Standards Board approved a project proposal to provide comprehensive guidance on revenue recognition and move toward a converged standard with the FASB and the IASB which are working jointly on a similar project.

As part of its project, the FASB will seek to eliminate inconsistencies in the existing accounting literature and accepted practices, fill voids in the guidance that have recently emerged and provide further guidance for addressing issues that arise in the future.

Because of the interrelationships and interdependencies of the issues to be addressed, the FASB decided that the project will be addressed in two parts that will be developed simultaneously.

1. One part will take a "bottom-up" approach that provides an inventory of existing revenue recognition guidance and accepted practices; that inventory will help identify inconsistencies and gaps in the literature that need to be resolved.
2. The other part will take a "top-down" approach that focuses on the conceptual guidance. The process of developing guidance at the concepts level and standards level will be iterative in that the FASB will test its tentative conclusions about the conceptual guidance by applying it to specific revenue recognition issues identified in the inventory, which might indicate the need for further improvements in the concepts.

The simultaneous pursuit of the two parts will not only facilitate the iterative process but also expedite completion of the project.

The following table presents major sources of revenue recognition accounting standards both in Canada and in the United States:

Note: this list is not meant to be a comprehensive inventory of existing standards

Canadian standards

Canada's current revenue recognition standards are outlined in CICA 3400 and are based on general principles that can be applied to a variety of circumstances. This principles-based approach is good; however, in the last few years, the number of questionable revenue recognition practices has increased substantially. Shareholders, bankers, financial analysts and regulators are now all examining revenues and revenue recognition policies more closely for indications of impropriety. When improprieties are found, they severely affect the credibility of the companies involved.

In December 2003, two EIC Abstracts were issued that will significantly affect revenue recognition practices in Canada: EIC 141 provides general revenue recognition guidance and EIC 142 discusses revenue recognition when there are multiple deliverables under a single contract.

Both EICs are consistent with US GAAP. EIC 141 includes essentially the same guidance as SAB 101 (SEC Staff Accounting Bulletin 101, Revenue Recognition) and EIC 142 is essentially the same as EITF 00-21 (Revenue Arrangements with Multiple Deliverables). Therefore, companies that follow the new Canadian guidance will also be in accordance with US GAAP.

One of the purposes of these two EICs is to help companies develop more appropriate policies by providing more guidance and eliminating unacceptable alternatives. This will lead to more consistency and more credibility in Canadian financial reporting.

Looking forward, the EICs will encourage managers to consider general revenue recognition policies when structuring business transactions to ensure that revenue can be recognized as desired. Companies must take a proactive approach to this so there are no unpleasant surprises at the end of critical accounting periods.

There are four criteria that must be met before revenue can be recognized. The first three criteria come from EIC 141 and the fourth is from CICA 3400.

1. There must be persuasive evidence of an exchange agreement between the buyer and the seller of the product or service.
2. Delivery must have occurred.
3. The selling price must be fixed or determinable.
4. There must be reasonable assurance of collectibility.

Persuasive Evidence of an Arrangement

This means there must be evidence that an exchange agreement exists between the buyer and the seller. The arrangement should clearly specify the terms of the deal and may take the form of a written contract, purchase order, electronic order or some other documentation that is binding on the customer.

There are several interesting points to note with respect to this criterion:

• Customary business practices dictate the form of the final understanding.
• Side agreements may delay revenue recognition.
• No revenue can be recognized on transactions that are, in substance, consignment sales or financing arrangements.

Delivery must have occurred

The second criterion is that delivery has occurred. EIC 141 has clarified several aspects relating to delivery that will make it more difficult to recognize revenue early.

There are several interesting points to note with respect to this criterion:

• Revenue Recognition on Bill and Hold Sales will be rare.
• Customer Acceptance is a Condition for Delivery.
• Non-refundable fees not revenue unless they represent a culmination of the earnings process.

The selling price must be fixed or determinable

The third criterion for revenue recognition is that the sales price must be fixed or it must be determinable.

A customer’s ability to return goods or cancel contracts leads to uncertainty about the number or units that are ultimately sold which affects the total sales price. When a customer can cancel an order, the sales price is not fixed until the cancellation privileges lapse; and hence, revenue recognition is delayed.

Only if all four of the following conditions are met can revenue from refundable fees (net of estimated returns) be recognized.

• The estimates deal with a large pool of homogeneous items (for example, memberships with same terms, periods, nature of service.)
• Reliable, timely estimates of expected refunds can be made.
• Also, if the customer’s cancellation privileges extend beyond one year, it is presumed that reliable estimates cannot be made.
• Other than the customer’s right to request a refund, the amount of the fee is fixed.

There must be reasonable assurance of collectibility

If there is no reasonable assurance of collectibility, then revenue recognition must be delayed. This can be done by using several methods:

• Cash Method -- Revenue is recognized as cash is received; costs are recognized as incurred.
• Cost Recovery First Method -- Revenue is recognized on a dollar for dollar basis with cash receipts until all costs are recovered. No profits are recorded until all costs have been recovered.
• Installment Method -- Gross margin is recognized in proportion to the percentage of cash received.

Disclosure

This is an area that many companies can improve on. The focus of regulators is on more disclosure, not less.

Many companies do not currently provide sufficient detail of their revenue recognition policies to enable shareholders to accurately understand when revenue is recognized.

Companies that have revenue recognition policies under which revenue is recognized when earned will need to significantly enhance the disclosure they are providing.