[Federal Register Volume 64, Number 236 (Thursday, December 9, 1999)]
[Rules and Regulations]
[Pages 68936-68945]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-31832]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 211
[Release No. SAB 101]
Staff Accounting Bulletin No. 101
AGENCY: Securities and Exchange Commission.
ACTION: Publication of Staff Accounting Bulletin.
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SUMMARY: This staff accounting bulletin summarizes certain of the
staff's views in applying generally accepted accounting principles to
revenue recognition in financial statements. The staff is providing
this guidance due, in part, to the large number of revenue recognition
issues that registrants encounter. For example, a March 1999 report
entitled Fraudulent Financial Reporting: 1987-1997 An Analysis of U. S.
Public Companies, sponsored by the Committee of Sponsoring
Organizations (COSO) of the Treadway Commission, indicated that over
half of financial reporting frauds in the study involved overstating
revenue.
EFFECTIVE DATES: December 3, 1999.
FOR FURTHER INFORMATION CONTACT: Richard Rodgers, Scott Taub, or Eric
Jacobsen, Professional Accounting Fellows (202/942-4400) or Robert
Bayless, Division of Corporation Finance (202/942-2960), Securities and
Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549;
electronic addresses: [email protected]; [email protected];
[email protected]; [email protected]
SUPPLEMENTARY INFORMATION: The statements in the staff accounting
bulletins are not rules or interpretations of the Commission, nor are
they published as bearing the Commission's official approval. They
represent interpretations and practices followed by the Division of
Corporation Finance and the Office of the Chief Accountant in
administering the disclosure requirements of the Federal securities
laws.
Dated: December 3, 1999
Jonathan G. Katz,
Secretary.
PART 211--[AMENDED]
Subpart B
Accordingly, Part 211 of Title 17 of the Code of Federal
Regulations is amended by adding Staff Accounting Bulletin No. 101 to
the table found in Subpart B.
Staff Accounting Bulletin No. 101
[The text of Staff Accounting Bulletin No. 101 will not appear in the
CFR.]
The staff hereby adds new major Topic 13, ``Revenue Recognition,''
and Topic 13-A, ``Views on Selected Revenue Recognition Issues,'' to
the Staff Accounting Bulletin Series. Topic 13-A provides the staff's
views in applying generally accepted accounting principles to selected
revenue recognition issues. In addition, the staff hereby revises Topic
8-A to conform to FASB Statement No. 13, Accounting for Leases.
Topic 13: Revenue Recognition
A. Selected Revenue Recognition Issues
1. Revenue Recognition--General
The accounting literature on revenue recognition includes both
broad conceptual discussions as well as certain industry-specific
guidance. Examples of existing literature on revenue recognition
include Financial Accounting Standards Board (FASB) Statements of
Financial Accounting Standards (SFAS) No. 13, Accounting for Leases,
No. 45, Accounting for Franchise Fee Revenue, No. 48, Revenue
Recognition When Right of Return Exists, No. 49, Accounting for Product
Financing Arrangements, No. 50, Financial Reporting in the Record and
Music Industry, No. 51, Financial Reporting by Cable Television
Companies, and No. 66, Accounting for Sales of Real Estate; Accounting
Principles Board (APB) Opinion No. 10, Omnibus Opinion--1966;
Accounting Research Bulletin (ARB) Nos. 43 (Chapter 1a) and 45, Long-
Term Construction-Type Contracts; American Institute of Certified
Public Accountants (AICPA) Statements of Position (SOP) No. 81-1,
Accounting for Performance of Construction-Type and Certain Production-
Type Contracts, and No. 97-2, Software Revenue Recognition; Emerging
Issues Task Force (EITF) Issue No. 88-18, Sales of Future Revenues, No.
91-9, Revenue and Expense Recognition for Freight Services in Process,
No. 95-1, Revenue Recognition on Sales with a Guaranteed Minimum Resale
Value, and No. 95-4, Revenue Recognition on Equipment Sold and
Subsequently Repurchased Subject to an Operating Lease; and FASB
Statement of Financial Accounting Concepts (SFAC) No. 5, Recognition
and Measurement in Financial Statements of Business Enterprises.\1\ If
a transaction is within the scope of specific authoritative literature
that provides revenue recognition guidance, that literature should be
applied. However, in the absence of authoritative literature addressing
a specific arrangement or a specific industry, the staff will consider
the existing authoritative accounting standards as well as the broad
revenue recognition criteria specified in the FASB's conceptual
framework that contain basic guidelines for revenue recognition.
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\1\ In February 1999, the AICPA published a booklet entitled
``Audit Issues in Revenue Recognition.'' This booklet provides an
overview of the current authoritative accounting literature and
auditing procedures for revenue recognition and identifies
indicators of improper revenue recognition.
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Based on these guidelines, revenue should not be recognized until
it is realized or realizable and earned.\2\ SFAC No. 5, paragraph 83(b)
states that ``an entity's revenue-earning activities involve delivering
or producing goods, rendering services, or other activities that
constitute its ongoing major or central operations, and revenues are
considered to have been earned when the entity has substantially
accomplished what it must do to be entitled to the benefits represented
by the revenues'' [footnote reference omitted]. Paragraph 84(a)
continues ``the two conditions (being realized or realizable and being
earned) are usually met by the time product or merchandise is delivered
or services are rendered to customers, and revenues from manufacturing
and selling activities and gains and losses from sales of other assets
are commonly recognized at time of sale (usually meaning delivery)''
[footnote reference omitted]. In addition, paragraph 84(d) states that
``If services are rendered or rights to use assets extend continuously
over time (for example, interest or rent), reliable measures based on
contractual prices
[[Page 68937]]
established in advance are commonly available, and revenues may be
recognized as earned as time passes.''
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\2\ SFAC No. 5, para. 83-84; ARB No. 43, Chapter 1A, para. 1;
APB Opinion No. 10, para. 12. The citations provided herein are not
intended to present the complete population of citations where a
particular criterion is relevant. Rather, the citations are intended
to provide the reader with additional reference material.
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The staff believes that revenue generally is realized or realizable
and earned when all of the following criteria are met:
Persuasive evidence of an arrangement exists,\3\
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\3\ SFAC No. 2, Qualitative Characteristics of Accounting
Information, para. 63 states ``Representational faithfulness is
correspondence or agreement between a measure or description and the
phenomenon it purports to represent.'' The staff believes that
evidence of an exchange arrangement must exist to determine if the
accounting treatment represents faithfully the transaction. See also
SOP 97-2, para. 8. The use of the term ``arrangement'' in this Staff
Accounting Bulletin is meant to identify the final understanding
between the parties as to the specific nature and terms of the
agreed-upon transaction.
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Delivery has occurred or services have been rendered,\4\
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\4\ SFAC No. 5, para. 84(a), (b), and (d). Revenue should not be
recognized until the seller has substantially accomplished what it
must do pursuant to the terms of the arrangement, which usually
occurs upon delivery or performance of the services.
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The seller's price to the buyer is fixed or
determinable,\5\ and
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\5\ SFAC No. 5, para. 83(a); SFAS No. 48, para. 6(a); SOP 97-2,
para. 8. SOP 97-2 defines a ``fixed fee'' as a ``fee required to be
paid at a set amount that is not subject to refund or adjustment. A
fixed fee includes amounts designated as minimum royalties.''
Paragraphs 26-33 of SOP 97-2 discuss how to apply the fixed or
determinable fee criterion in software transactions. The staff
believes that the guidance in paragraphs 26 and 30-33 is appropriate
for other sales transactions where authoritative guidance does not
otherwise exist. The staff notes that paragraphs 27 through 29
specifically consider software transactions, however, the staff
believes that guidance should be considered in other sales
transactions in which the risk of technological obsolescence is
high.
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Collectibility is reasonably assured.\6\
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\6\ ARB No. 43, Chapter 1A, para. 1 and APB Opinion No. 10,
para. 12. See also SFAC No. 5, para. 84(g) and SOP 97-2, para. 8.
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2. Persuasive Evidence of an Arrangement
Question 1
Facts: Company A has product available to ship to customers prior
to the end of its current fiscal quarter. Customer Beta places an order
for the product, and Company A delivers the product prior to the end of
its current fiscal quarter. Company A's normal and customary business
practice for this class of customer is to enter into a written sales
agreement that requires the signatures of the authorized
representatives of the Company and its customer to be binding. Company
A prepares a written sales agreement, and its authorized representative
signs the agreement before the end of the quarter. However, Customer
Beta does not sign the agreement because Customer Beta is awaiting the
requisite approval by its legal department. Customer Beta's purchasing
department has orally agreed to the sale and stated that it is highly
likely that the contract will be approved the first week of Company A's
next fiscal quarter.
Question: May Company A recognize the revenue in the current fiscal
quarter for the sale of the product to Customer Beta when (1) the
product is delivered by the end of its current fiscal quarter and (2)
the final written sales agreement is executed by Customer Beta's
authorized representative within a few days after the end of the
current fiscal quarter?
Interpretive Response: No. Generally the staff believes that, in
view of Company A's business practice of requiring a written sales
agreement for this class of customer, persuasive evidence of an
arrangement would require a final agreement that has been executed by
the properly authorized personnel of the customer. In the staff's view,
Customer Beta's execution of the sales agreement after the end of the
quarter causes the transaction to be considered a transaction of the
subsequent period.\7\ Further, if an arrangement is subject to
subsequent approval (e.g., by the management committee or board of
directors) or execution of another agreement, revenue recognition would
be inappropriate until that subsequent approval or agreement is
complete.
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\7\ AICPA, Codification of Statements on Auditing Standards (AU)
Sec. 560.05, Subsequent Events.
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Customary business practices and processes for documenting sales
transactions vary among companies and industries. Business practices
and processes may also vary within individual companies (e.g., based on
the class of customer, nature of product or service, or other
distinguishable factors). If a company does not have a standard or
customary business practice of relying on written contracts to document
a sales arrangement, it usually would be expected to have other forms
of written or electronic evidence to document the transaction. For
example, a company may not use written contracts but instead may rely
on binding purchase orders from third parties or on-line authorizations
that include the terms of the sale and that are binding on the
customer. In that situation, that documentation could represent
persuasive evidence of an arrangement.
The staff is aware that sometimes a customer and seller enter into
``side'' agreements to a master contract that effectively amend the
master contract. Registrants should ensure that appropriate policies,
procedures, and internal controls exist and are properly documented so
as to provide reasonable assurances that sales transactions, including
those affected by side agreements, are properly accounted for in
accordance with generally accepted accounting principles and to ensure
compliance with Section 13 of the Securities Exchange Act of 1934
(i.e., the Foreign Corrupt Practices Act). Side agreements could
include cancellation, termination, or other provisions that affect
revenue recognition. The existence of a subsequently executed side
agreement may be an indicator that the original agreement was not final
and revenue recognition was not appropriate.
Question 2
Facts: Company Z enters into an arrangement with Customer A to
deliver Company Z's products to Customer A on a consignment basis.
Pursuant to the terms of the arrangement, Customer A is a consignee,
and title to the products does not pass from Company Z to Customer A
until Customer A consumes the products in its operations. Company Z
delivers product to Customer A under the terms of their arrangement.
Question: May Company Z recognize revenue upon delivery of its
product to Customer A?
Interpretive Response: No. Products delivered to a consignee
pursuant to a consignment arrangement are not sales and do not qualify
for revenue recognition until a sale occurs. The staff believes that
revenue recognition is not appropriate because the seller retains the
risks and rewards of ownership of the product and title usually does
not pass to the consignee.
Other situations may exist where title to delivered products passes
to a buyer, but the substance of the transaction is that of a
consignment or a financing. Such arrangements require a careful
analysis of the facts and circumstances of the transaction, as well as
an understanding of the rights and obligations of the parties, and the
seller's customary business practices in such arrangements. The staff
believes that the presence of one or more of the following
characteristics in a transaction precludes revenue recognition even if
title to the product has passed to the buyer:
1. The buyer has the right to return the product and:
(a) the buyer does not pay the seller at the time of sale, and the
buyer is not
[[Page 68938]]
obligated to pay the seller at a specified date or dates.\8\
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\8\ SFAS No. 48, para. 6(b) and 22.
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(b) the buyer does not pay the seller at the time of sale but
rather is obligated to pay at a specified date or dates, and the
buyer's obligation to pay is contractually or implicitly excused until
the buyer resells the product or subsequently consumes or uses the
product,\9\
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\9\ SFAS No. 48, para. 6(b) and 22. The arrangement may not
specify that payment is contingent upon subsequent resale or
consumption. However, if the seller has an established business
practice permitting customers to defer payment beyond the specified
due date(s) until the products are resold or consumed, then the
staff believes that the seller's right to receive cash representing
the sales price is contingent.
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(c) the buyer's obligation to the seller would be changed (e.g.,
the seller would forgive the obligation or grant a refund) in the event
of theft or physical destruction or damage of the product,\10\
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\10\ SFAS No. 48, para. 6(c).
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(d) the buyer acquiring the product for resale does not have
economic substance apart from that provided by the seller,\11\ or
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\11\ SFAS No. 48, para. 6(d).
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(e) the seller has significant obligations for future performance
to directly bring about resale of the product by the buyer.\12\
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\12\ 12 SFAS No. 48, para. 6(e).
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2. The seller is required to repurchase the product (or a
substantially identical product or processed goods of which the product
is a component) at specified prices that are not subject to change
except for fluctuations due to finance and holding costs,\13\ and the
amounts to be paid by the seller will be adjusted, as necessary, to
cover substantially all fluctuations in costs incurred by the buyer in
purchasing and holding the product (including interest).\14\ The staff
believes that indicators of the latter condition include:
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\13\ SFAS No. 49, para. 5(a). Paragraph 5(a) provides examples
of circumstances that meet this requirement. As discussed further
therein, this condition is present if (a) a resale price guarantee
exists, (b) the seller has an option to purchase the product, the
economic effect of which compels the seller to purchase the product,
or (c) the buyer has an option whereby it can require the seller to
purchase the product.
\14\ SFAS No. 49, para. 5(b).
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(a) the seller provides interest-free or significantly below market
financing to the buyer beyond the seller's customary sales terms and
until the products are resold,
(b) the seller pays interest costs on behalf of the buyer under a
third-party financing arrangement, or
(c) the seller has a practice of refunding (or intends to refund) a
portion of the original sales price representative of interest expense
for the period from when the buyer paid the seller until the buyer
resells the product.
3. The transaction possesses the characteristics set forth in EITF
Issue No. 95-1, Revenue Recognition on Sales with a Guaranteed Minimum
Resale Value, and does not qualify for sales-type lease accounting.
4. The product is delivered for demonstration purposes.\15\
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\15\ See SOP 97-2, para. 25.
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This list is not meant to be a checklist of all characteristics of
a consignment or a financing arrangement, and other characteristics may
exist. Accordingly, the staff believes that judgment is necessary in
assessing whether the substance of a transaction is a consignment, a
financing, or other arrangement for which revenue recognition is not
appropriate. If title to the goods has passed but the substance of the
arrangement is not a sale, the consigned inventory should be reported
separately from other inventory in the consignor's financial statements
as ``inventory consigned to others'' or another appropriate caption.
3. Delivery and Performance
Question 3
Facts: Company A receives purchase orders for products it
manufactures. At the end of its fiscal quarters, customers may not yet
be ready to take delivery of the products for various reasons. These
reasons may include, but are not limited to, a lack of available space
for inventory, having more than sufficient inventory in their
distribution channel, or delays in customers' production schedules.
Questions: May Company A recognize revenue for the sale of its
products once it has completed manufacturing if it segregates the
inventory of the products in its own warehouse from its own products?
May Company A recognize revenue for the sale if it ships the
products to a third-party warehouse but (1) Company A retains title to
the product and (2) payment by the customer is dependent upon ultimate
delivery to a customer-specified site?
Interpretative Response: Generally, no. The staff believes that
delivery generally is not considered to have occurred unless the
customer has taken title and assumed the risks and rewards of ownership
of the products specified in the customer's purchase order or sales
agreement. Typically this occurs when a product is delivered to the
customer's delivery site (if the terms of the sale are ``FOB
destination'') or when a product is shipped to the customer (if the
terms are ``FOB shipping point'').
The Commission has set forth criteria to be met in order to
recognize revenue when delivery has not occurred.\16\ These include:
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\16\ See In the Matter of Stewart Parness, Accounting and
Auditing Enforcement (AAER) Release No. 108 (August 5, 1986); SEC v.
Bollinger Industries, Inc., et al, Lit. Rel. No. 15093 (September
30, 1996); In the Matter of Laser Photonics, Inc., AAER No. 971
(September 30, 1997); In the Matter of Cypress Bioscience Inc., AAER
No. 817 (September 19, 1996). Also see SFAC No. 5, para. 84(a). and
SOP 97-2, para. 22.
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1. The risks of ownership must have passed to the buyer;
2. The customer must have made a fixed commitment to purchase the
goods, preferably in written documentation;
3. The buyer, not the seller, must request that the transaction be
on a bill and hold basis.\17\ The buyer must have a substantial
business purpose for ordering the goods on a bill and hold basis;
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\17\ Such requests typically should be set forth in writing by
the buyer.
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4. There must be a fixed schedule for delivery of the goods. The
date for delivery must be reasonable and must be consistent with the
buyer's business purpose (e.g., storage periods are customary in the
industry);
5. The seller must not have retained any specific performance
obligations such that the earning process is not complete;
6. The ordered goods must have been segregated from the seller's
inventory and not be subject to being used to fill other orders; and
7. The equipment [product] must be complete and ready for shipment.
The above listed conditions are the important conceptual criteria
which should be used in evaluating any purported bill and hold sale.
This listing is not intended as a checklist. In some circumstances, a
transaction may meet all factors listed above but not meet the
requirements for revenue recognition. The Commission also has noted
that in applying the above criteria to a purported bill and hold sale,
the individuals responsible for the preparation and filing of financial
statements also should consider the following factors:\18\
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\18\ See Note 16, supra.
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1. The date by which the seller expects payment, and whether the
seller has modified its normal billing and credit terms for this
buyer;\19\
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\19\ Such individuals should consider whether APB Opinion No.
21, Interest on Receivables and Payables, pertaining to the need for
discounting the related receivable, is applicable. APB Opinion No.
21, para. 3(a), indicates that the requirements of that Opinion to
record receivables at a discounted value are not intended to apply
to ``receivables and payables arising from transactions with
customers or suppliers in the normal course of business which are
due in customary trade terms not exceeding approximately one year''
(emphasis added).
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[[Page 68939]]
2. The seller's past experiences with and pattern of bill and hold
transactions;
3. Whether the buyer has the expected risk of loss in the event of
a decline in the market value of goods;
4. Whether the seller's custodial risks are insurable and insured;
5. Whether extended procedures are necessary in order to assure
that there are no exceptions to the buyer's commitment to accept and
pay for the goods sold (i.e., that the business reasons for the bill
and hold have not introduced a contingency to the buyer's commitment).
Delivery generally is not considered to have occurred unless the
product has been delivered to the customer's place of business or
another site specified by the customer. If the customer specifies an
intermediate site but a substantial portion of the sales price is not
payable until delivery is made to a final site, then revenue should not
be recognized until final delivery has occurred.\20\
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\20\ SOP 97-2, para. 22.
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After delivery of a product or performance of a service, if
uncertainty exists about customer acceptance, revenue should not be
recognized until acceptance occurs.\21\ Customer acceptance provisions
may be included in a contract, among other reasons, to enforce a
customer's rights to (1) test the delivered product, (2) require the
seller to perform additional services subsequent to delivery of an
initial product or performance of an initial service (e.g., a seller is
required to install or activate delivered equipment), or (3) identify
other work necessary to be done before accepting the product. The staff
presumes that such contractual customer acceptance provisions are
substantive, bargained-for terms of an arrangement. Accordingly, when
such contractual customer acceptance provisions exist, the staff
generally believes that the seller should not recognize revenue until
customer acceptance occurs or the acceptance provisions lapse.
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\21\ SOP 97-2, para. 20. Also, SFAC No. 5, para. 83(b) states
``revenues are considered to have been earned when the entity has
substantially accomplished what it must do to be entitled to the
benefits represented by the revenues.'' If an arrangement expressly
requires customer acceptance, the staff generally believes that
customer acceptance should occur before the entity has substantially
accomplished what it must do to be entitled to the benefits
represented by the revenues, especially when the seller is obligated
to perform additional steps.
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A seller should substantially complete or fulfill the terms
specified in the arrangement in order for delivery or performance to
have occurred.\22\ When applying the substantially complete notion, the
staff believes that only inconsequential or perfunctory actions may
remain incomplete such that the failure to complete the actions would
not result in the customer receiving a refund or rejecting the
delivered products or services performed to date. In addition, the
seller should have a demonstrated history of completing the remaining
tasks in a timely manner and reliably estimating the remaining costs.
If revenue is recognized upon substantial completion of the
arrangement, all remaining costs of performance or delivery should be
accrued.
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\22\ 22 SFAC No. 5, para. 83(b) states that ``revenues are
considered to have been earned when the entity has substantially
accomplished what it must do to be entitled the benefits represented
by the revenues.''
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If an arrangement (i.e., outside the scope of SOP 81-1) requires
the delivery or performance of multiple deliverables, or ``elements,''
the delivery of an individual element is considered not to have
occurred if there are undelivered elements that are essential to the
functionality of the delivered element because the customer does not
have the full use of the delivered element.\23\
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\23\ SOP 97-2, para. 13, and 68-70.
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In licensing and similar arrangements (e.g., licenses of motion
pictures, software, technology, and other intangibles), the staff
believes that delivery does not occur for revenue recognition purposes
until the license term begins.\24\ Accordingly, if a licensed product
or technology is physically delivered to the customer, but the license
term has not yet begun, revenue should not be recognized prior to
inception of the license term. Upon inception of the license term,
revenue should be recognized in a manner consistent with the nature of
the transaction and the earnings process.
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\24\ SFAS No. 53, Financial Reporting by Producers and
Distributors of Motion Picture Films, para. 6. The FASB has issued
an Exposure Draft to rescind SFAS No. 53. The AICPA's Accounting
Standards Executive Committee intends to issue a new SOP that would
replace SFAS No. 53 and provide authoritative guidance on accounting
for motion pictures. The Exposure Draft of the proposed new SOP
contains a similar criterion for revenue recognition of a licensed
film (i.e., the license period of the arrangement has begun and the
customer can begin its exploitation, exhibition, or sale).
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Question 4
Facts: Company R is a retailer that offers ``layaway'' sales to its
customers. Company R retains the merchandise, sets it aside in its
inventory, and collects a cash deposit from the customer. Although
Company R may set a time period within which the customer must finalize
the purchase, Company R does not require the customer to enter into an
installment note or other fixed payment commitment or agreement when
the initial deposit is received. The merchandise generally is not
released to the customer until the customer pays the full purchase
price. In the event that the customer fails to pay the remaining
purchase price, the customer forfeits its cash deposit. In the event
the merchandise is lost, damaged, or destroyed, Company R either must
refund the cash deposit to the customer or provide replacement
merchandise.
Question: In the staff's view, when may Company R recognize revenue
for merchandise sold under its layaway program?
Interpretive Response: Provided that the other criteria for revenue
recognition are met, the staff believes that Company R should recognize
revenue from sales made under its layaway program upon delivery of the
merchandise to the customer. Until then, the amount of cash received
should be recognized as a liability entitled such as ``deposits
received from customers for layaway sales'' or a similarly descriptive
caption. Because Company R retains the risks of ownership of the
merchandise, receives only a deposit from the customer, and does not
have an enforceable right to the remainder of the purchase price, the
staff would object to Company R recognizing any revenue upon receipt of
the cash deposit. This is consistent with item two (2) in the
Commission's criteria for bill-and-hold transactions which states that
``the customer must have made a fixed commitment to purchase the
goods.''
Question 5
Facts: Registrants may negotiate arrangements pursuant to which
they may receive nonrefundable fees upon entering into arrangements or
on certain specified dates. The fees may ostensibly be received for
conveyance of a license or other intangible right or for delivery of
particular products or services. Various business factors may influence
how the registrant and customer structure the payment terms. For
example, in exchange for a greater up-front fee for an intangible
right, the registrant may be willing to receive lower unit prices for
related products to be delivered in the future. In some circumstances,
the right, product, or service conveyed in conjunction with the
nonrefundable fee has no utility to the purchaser separate and
independent
[[Page 68940]]
of the registrant's performance of the other elements of the
arrangement. Therefore, in the absence of the registrant's continuing
involvement under the arrangement, the customer would not have paid the
fee. Examples of this type of arrangement include the following:
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.
A registrant in the biotechnology industry agrees to
provide research and development activities for a customer for a
specified term. The customer needs to use certain technology owned by
the registrant for use in the research and development activities. The
technology is not sold or licensed separately without the research and
development activities. Under the terms of the arrangement, the
customer is required to pay a nonrefundable ``technology access fee''
in addition to periodic payments for research and development
activities over the term of the contract.
A registrant requires a customer to pay a nonrefundable
``activation fee'' when entering into an arrangement to provide
telecommunications services. The terms of the arrangement require the
customer to pay a monthly usage fee that is adequate to recover the
registrant's operating costs. The costs incurred to activate the
telecommunications service are nominal.
Question: When should the revenue relating to nonrefundable, up-
front fees in these types of arrangements be recognized?
Interpretive Response: The staff believes that registrants should
consider the specific facts and circumstances to determine the
appropriate accounting for nonrefundable, up-front fees. Unless the up-
front fee is in exchange for products delivered or services performed
that represent the culmination of a separate earnings process,\25\ the
deferral of revenue is appropriate.
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\25\ See SFAC No. 5, footnote 51, for a description of the
``earning process.''
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In the situations described above, the staff does not view the
activities completed by the registrants (i.e., selling the membership,
signing the contract, or enrolling the customer or activating
telecommunications services) as discrete earnings events.\26\ The
terms, conditions, and amounts of these fees typically are negotiated
in conjunction with the pricing of all the elements of the arrangement,
and the customer would ascribe a significantly lower, and perhaps no,
value to elements ostensibly associated with the up-front fee in the
absence of the registrant's performance of other contract elements. The
fact that the registrants do not sell the initial rights, products, or
services separately (i.e., without the registrants' continuing
involvement) supports the staff's view. The staff believes that the
customers are purchasing the on-going rights, products, or services
being provided through the registrants' continuing involvement.
Further, the staff believes that the earnings process is completed by
performing under the terms of the arrangements, not simply by
originating a revenue-generating arrangement.
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\26\ In a similar situation, lenders may collect nonrefundable
loan origination fees in connection with lending activities. The
FASB concluded in SFAS No. 91, Accounting for Nonrefundable Fees and
Costs Associated with Originating or Acquiring Loans and Initial
Direct Costs of Leases, that loan origination is not a separate
revenue-producing activity of a lender, and therefore, those
nonrefundable fees collected at the outset of the loan arrangement
are not recognized as revenue upon receipt but are deferred and
recognized over the life of the loan (paragraphs 5 and 37).
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Supply or service transactions may involve the charge of a
nonrefundable initial fee with subsequent periodic payments for future
products or services. The initial fees may, in substance, be wholly or
partly an advance payment for future products or services. In the
examples above, the on-going rights or services being provided or
products being delivered are essential to the customers receiving the
expected benefit of the up-front payment. Therefore, the up-front fee
and the continuing performance obligation related to the services to be
provided or products to be delivered are assessed as an integrated
package. In such circumstances, the staff believes that up-front fees,
even if nonrefundable, are earned as the products and/or services are
delivered and/or performed over the term of the arrangement or the
expected period of performance \27\ and generally should be deferred
and recognized systematically over the periods that the fees are
earned.\28\
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\27\ The revenue recognition period should extend beyond the
initial contractual period if the relationship with the customer is
expected to extend beyond the initial term and the customer
continues to benefit from the payment of the up-front fee (e.g., if
subsequent renewals are priced at a bargain to the initial up-front
fee).
\28\ A systematic method would be on a straight-line basis,
unless evidence suggests that revenue is earned or obligations are
fulfilled in a different pattern, in which case that pattern should
be followed.
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Question 6
Facts: Company A provides its customers with activity tracking or
similar services (e.g., tracking of property tax payment activity,
sending delinquency letters on overdue accounts, etc.) for a ten-year
period. Company A requires customers to prepay for all the services for
the term specified in the arrangement. The on-going services to be
provided are generally automated after the initial customer set-up. At
the outset of the arrangement, Company A performs set-up procedures to
facilitate delivery of its on-going services to the customers.\29\ Such
procedures consist primarily of establishing the necessary records and
files in Company A's pre-existing computer systems in order to provide
the services. Once the initial customer set-up activities are complete,
Company A provides its services in accordance with the arrangement.
Company A is not required to refund any portion of the fee if the
customer terminates the services or does not utilize all of the
services to which it is entitled. However, Company A is required to
provide a refund if Company A terminates the arrangement early. Assume
Company A's activities are not within the scope of SFAS No. 91.
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\29\ Footnote 1 of SOP 98-5, Reporting on the Costs of Start-Up
Activities, states that ``this SOP does not address the financial
reporting of costs incurred related to ongoing customer acquisition,
such as policy acquisition costs in Financial Accounting Standards
Board (FASB) Statement No. 60, Accounting and Reporting by Insurance
Enterprises, and loan origination costs in FASB Statement No. 91,
Accounting for Nonrefundable Fees and Costs Associated with
Originating or Acquiring Loans and Initial Direct Costs of Leases.
The SOP addresses the more substantive one-time efforts to establish
business with an entirely new class of customers (for example, a
manufacturer who does all of its business with retailers attempts to
sell merchandise directly to the public).'' As such, the set-up
costs incurred in this example are not within the scope of SOP 98-5.
The staff believes that the incremental direct costs (SFAS No. 91
provides an analogous definition) incurred related to the
acquisition or origination of a customer contract, unless
specifically provided for in the authoritative literature, should be
accounted for in accordance with paragraph 4 of FASB Technical
Bulletin (FTB) 90-1, Accounting for Separately Priced Extended
Warranty and Product Maintenance Contracts or paragraph 5 of SFAS
No. 91.
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Question: When should Company A recognize the service revenue?
Interpretive Response: The staff believes that, provided all other
revenue recognition criteria are met, service revenue should be
recognized on a straight-line basis, unless evidence suggests that the
revenue is earned or obligations are fulfilled in a different pattern,
over the contractual term of the arrangement or the expected period
[[Page 68941]]
during which those specified services will be performed,\30\ whichever
is longer. In this case, the customer contracted for the on-going
activity tracking service, not for the set-up activities. The staff
notes that the customer could not, and would not, separately purchase
the set-up services without the on-going services. The services
specified in the arrangement are performed continuously over the
contractual term of the arrangement (and any subsequent renewals).
Therefore, the staff believes that Company A should recognize revenue
on a straight-line basis, unless evidence suggests that the revenue is
earned or obligations are fulfilled in a different pattern, over the
contractual term of the arrangement or the expected period during which
those specified services will be performed, whichever is longer.
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\30\ See Note 27, supra.
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In this situation, the staff would object to Company A recognizing
revenue in proportion to the costs incurred because the set-up costs
incurred bear no direct relationship to the performance of services
specified in the arrangement. The staff also believes that it is
inappropriate to recognize the entire amount of the prepayment as
revenue at the outset of the arrangement by accruing the remaining
costs because the services required by the contract have not been
performed.
4. Fixed or Determinable Sales Price
A company's contracts may include customer cancellation or
termination clauses. Cancellation or termination provisions may be
indicative of a demonstration period or an otherwise incomplete
transaction. Examples of transactions that financial management and
auditors should be aware of and where such provisions may exist include
``side'' agreements and significant transactions with unusual terms and
conditions. These contractual provisions raise questions as to whether
the sales price is fixed or determinable. The sales price in
arrangements that are cancelable by the customer are neither fixed nor
determinable until the cancellation privileges lapse.\31\ If the
cancellation privileges expire ratably over a stated contractual term,
the sales price is considered to become determinable ratably over the
stated term.\32\ Short-term rights of return, such as thirty-day money-
back guarantees, and other customary rights to return products are not
considered to be cancellation privileges, but should be accounted for
in accordance with SFAS No. 48.\33\
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\31\ SOP 97-2, para.31.
\32\ Ibid.
\33\ Ibid.
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Question 7
Facts: Company M is a discount retailer. It generates revenue from
annual membership fees it charges customers to shop at its stores and
from the sale of products at a discount price to those customers. The
membership arrangements with retail customers require the customer to
pay the entire membership fee (e.g., $35) at the outset of the
arrangement. However, the customer has the unilateral right to cancel
the arrangement at any time during its term and receive a full refund
of the initial fee. Based on historical data collected over time for a
large number of homogeneous transactions, Company M estimates that
approximately 40% of the customers will request a refund before the end
of the membership contract term. Company M's data for the past five
years indicates that significant variations between actual and
estimated cancellations have not occurred, and Company M does not
expect significant variations to occur in the foreseeable future.
Question: May Company M recognize in earnings the revenue for the
membership fees and accrue the costs to provide membership services at
the outset of the arrangement?
Interpretive Response: No. In the staff's view, it would be
inappropriate for Company M to recognize the membership fees as earned
revenue upon billing or receipt of the initial fee with a corresponding
accrual for estimated costs to provide the membership services. This
conclusion is based on Company M's remaining and unfulfilled
contractual obligation to perform services (i.e., make available and
offer products for sale at a discounted price) throughout the
membership period. Therefore, the earnings process, irrespective of
whether a cancellation clause exists, is not complete.
In addition, the ability of the member to receive a full refund of
the membership fee up to the last day of the membership term raises an
uncertainty as to whether the fee is fixed or determinable at any point
before the end of the term. Generally, the staff believes that a sales
price is not fixed or determinable when a customer has the unilateral
right to terminate or cancel the contract and receive a cash refund. A
sales price or fee that is variable until the occurrence of future
events (other than product returns that are within the scope of SFAS
No. 48) generally is not fixed or determinable until the future event
occurs. The revenue from such transactions should not be recognized in
earnings until the sales price or fee becomes fixed or determinable.
Moreover, revenue should not be recognized in earnings by assessing the
probability that significant, but unfulfilled, terms of a contract will
be fulfilled at some point in the future. Accordingly, the revenue from
such transactions should not be recognized in earnings prior to the
refund privileges expiring. The amounts received from customers or
subscribers (i.e., the $35 fee mentioned above) should be credited to a
monetary liability account such as ``customers' refundable fees.''
The staff believes that if a customer has the unilateral right to
receive both (1) the seller's substantial performance under an
arrangement (e.g., providing services or delivering product) and (2) a
cash refund of prepaid fees, then the prepaid fees should be accounted
for as a monetary liability in accordance with SFAS No. 125, Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities, paragraph 16. SFAS No. 125 provides that liabilities may
be derecognized only if (1) the debtor pays the creditor and is
relieved of its obligation for the liability (paying the creditor
includes delivery of cash, other financial assets, goods, or services
or reacquisition by the debtor of its outstanding debt securities) or
(2) the debtor is legally released from being the primary obligor under
the liability.\34\ If a customer has the unilateral right to receive
both (1) the seller's substantial performance under the arrangement and
(2) a cash refund of prepaid fees, then the refund obligation is not
relieved upon performance of the service or delivery of the products.
Rather, the seller's refund obligation is relieved only upon refunding
the cash or expiration of the refund privilege.
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\34\ 34 SFAS No. 125, para. 16.
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Some have argued that there may be a limited exception to the
general rule that revenue from membership or other service transaction
fees should not be recognized in earnings prior to the refund
privileges expiring. Despite the fact that SFAS No. 48 expressly does
not apply to the accounting for service revenue if part or all of the
service fee is refundable under cancellation privileges granted to the
buyer,\35\ they believe that in certain circumstances a potential
refund of a membership fee may be seen as being similar to a right of
return of products under SFAS No. 48. They argue that revenue from
[[Page 68942]]
membership fees, net of estimated refunds, may be recognized ratably
over the period the services are performed whenever pertinent
conditions of SFAS No. 48 are met, namely, there is a large population
of transactions that grant customers the same unilateral termination or
cancellation rights and reasonable estimates can be made of how many
customers likely will exercise those rights.
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\35\ SFAS No. 48, para. 4.
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The staff believes that, because service arrangements are
specifically excluded from the scope of SFAS No. 48, the most direct
authoritative literature to be applied to the extinguishment of
obligations under such contracts is SFAS No. 125. As noted above,
because the refund privilege extends to the end of the contract term
irrespective of the amount of the service performed, SFAS No. 125
indicates that the liability would not be extinguished (and therefore
no revenue would be recognized in earnings) until the cancellation or
termination and related refund privileges expire. Nonetheless, the
staff recognizes that over the years the accounting for membership
refunds evolved based on analogy to SFAS No. 48 and that practice did
not change when SFAS No. 125 became effective. Reasonable people held,
and continue to hold, different views about the application of the
accounting literature. For the staff to prohibit such accounting in
this SAB may result in significant change in practice that, in these
particular circumstances, may be more appropriately addressed in a
formal rulemaking or standards-setting project.
Pending further action in this area by the FASB, the staff will not
object to the recognition of refundable membership fees, net of
estimated refunds, as earned revenue over the membership term in the
limited circumstances where all of the following criteria have been
met:\36\
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\36\ The staff will question further analogies to the guidance
in SFAS No. 48 for transactions expressly excluded from its scope.
---------------------------------------------------------------------------
The estimates of terminations or cancellations and
refunded revenues are being made for a large pool of homogeneous items
(e.g., membership or other service transactions with the same
characteristics such as terms, periods, class of customers, nature of
service, etc.).
Reliable estimates of the expected refunds can be made on
a timely basis.\37\ Either of the following two items would be
considered indicative of an inability to make reliable estimates: (1)
recurring, significant differences between actual experience and
estimated cancellation or termination rates (e.g., an actual
cancellation rate of 40% versus an estimated rate of 25%) even if the
impact of the difference on the amount of estimated refunds is not
material to the consolidated financial statements \38\ or (2) recurring
variances between the actual and estimated amount of refunds that are
material to either revenue or net income in quarterly or annual
financial statements. In addition, the staff believes that an estimate,
for purposes of meeting this criterion, would not be reliable unless it
is remote \39\ that material adjustments (both individually and in the
aggregate) to previously recognized revenue would be required. The
staff presumes that reliable estimates cannot be made if the customer's
termination or cancellation and refund privileges exceed one year.
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\37\ Reliability is defined in SFAC No. 2 as ``the quality of
information that assures that information is reasonably free from
error and bias and faithfully represents what it purports to
represent.'' Paragraph 63 of SFAC No. 5 reiterates the definition of
reliability, requiring that ``the information is representationally
faithful, verifiable, and neutral.''
\38\ For example, if an estimate of the expected cancellation
rate varies from the actual cancellation rate by 100% but the dollar
amount of the error is immaterial to the consolidated financial
statements, some would argue that the estimate could still be viewed
as reliable. The staff disagrees with that argument.
\39\ The term ``remote'' is used here with the same definition
as used in SFAS No. 5, Accounting for Contingencies.
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There is a sufficient company-specific historical basis
upon which to estimate the refunds,\40\ and the company believes that
such historical experience is predictive of future events. In assessing
these items, the staff believes that estimates of future refunds should
take into consideration, among other things, such factors as historical
experience by service type and class of customer, changing trends in
historical experience and the basis thereof (e.g., economic
conditions), the impact or introduction of competing services or
products, and changes in the customer's ``accessibility'' to the refund
(i.e., how easy it is for customers to obtain the refund).
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\40\ Paragraph 8 of SFAS No. 48 notes various factors that may
impair the ability to make a reasonable estimate of returns,
including the lack of sufficient historical experience. The staff
typically expects that the historical experience be based on the
particular registrant's historical experience for a service and/or
class of customer. In general, the staff typically expects a start-
up company, a company introducing new services, or a company
introducing services to a new class of customer to have at least two
years of experience to be able to make reasonable and reliable
estimates.
---------------------------------------------------------------------------
The amount of the membership fee specified in the
agreement at the outset of the arrangement is fixed, other than the
customer's right to request a refund.
If Company M does not meet all of the foregoing criteria, the staff
believes that Company M should not recognize in earnings any revenue
for the membership fee until the cancellation privileges and refund
rights expire.
If revenue is recognized in earnings over the membership period
pursuant to the above criteria, the initial amounts received from
customer or subscribers (i.e., the $35 fee mentioned above) should be
allocated to two liability accounts. The amount of the fee representing
estimated refunds should be credited to a monetary liability account,
such as ``customers' refundable fees,'' and the remaining amount of the
fee representing unearned revenue should be credited to a nonmonetary
liability account, such as ``unearned revenues.'' For each income
statement presented, registrants should disclose in the footnotes to
the financial statements the amounts of (1) the unearned revenue and
(2) refund obligations as of the beginning of each period, the amount
of cash received from customers, the amount of revenue recognized in
earnings, the amount of refunds paid, other adjustments (with an
explanation thereof), and the ending balance of (1) unearned revenue
and (2) refund obligations.
If revenue is recognized in earnings over the membership period
pursuant to the above criteria, the staff believes that adjustments for
changes in estimated refunds should be recorded using a retrospective
approach whereby the unearned revenue and refund obligations are
remeasured and adjusted at each balance sheet date with the offset
being recorded as earned revenue.
Companies offering memberships often distribute membership packets
describing and discussing the terms, conditions, and benefits of
membership. Packets may include vouchers, for example, that provide new
members with discounts or other benefits. The costs associated with the
vouchers should be expensed when distributed. Advertising costs to
solicit members should be accounted for in accordance with SOP 93-7,
Reporting on Advertising Costs. Incremental direct costs incurred in
connection with enrolling customers (e.g., commissions paid to agents)
should be accounted for as follows: (1) If revenue is deferred until
the cancellation or termination privileges expire, incremental direct
costs should be either (a) charged to expense when incurred if the
costs are not refundable to the company in the event the customer
obtains a refund of the membership fee, or (b) if the costs are
refundable to the company in the event the customer obtains a refund of
the membership fee, recorded as an asset until the earlier of
termination or cancellation or refund; or (2) if revenue,
[[Page 68943]]
net of estimated refunds, is recognized in earnings over the membership
period, a like percentage of incremental direct costs should be
deferred and recognized in earnings in the same pattern as revenue is
recognized, and the remaining portion should be either (a) charged to
expense when incurred if the costs are not refundable to the company in
the event the customer obtains a refund of the membership fee, or (b)
if the costs are refundable to the company in the event the customer
obtains a refund of the membership fee, recorded as an asset until the
refund occurs.\41\ All costs other than incremental direct costs (e.g.,
indirect costs) should be expensed as incurred.
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\41\ SFAS No. 91, paragraph 5 and FTB 90-1, paragraph 4 both
provide for the deferral of incremental direct costs associated with
acquiring a revenue-producing contract. Even though the revenue
discussed in this example is refundable, if a registrant meets the
aforementioned criteria for revenue recognition over the membership
period, the staff would analogize to this guidance. However, if
neither a nonrefundable contract nor a reliable basis for estimating
net cash inflows under refundable contracts exists to provide a
basis for recovery of incremental direct costs, the staff believes
that such costs should be expensed as incurred. See Note 29, supra.
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Question 8
Facts: Company A owns and leases retail space to retailers. Company
A (lessor) renews a lease with a customer (lessee) that is classified
as an operating lease. The lease term is one year and provides that the
lease payments are $1.2 million, payable in equal monthly installments
on the first day of each month, plus one percent of the lessee's net
sales in excess of $25 million if the net sales exceed $25 million
during the lease term (i.e., contingent rental). The lessee has
historically experienced annual net sales in excess of $25 million in
the particular space being leased, and it is probable that the lessee
will generate in excess of $25 million net sales during the term of the
lease.
Question: In the staff's view, should the lessor recognize any
rental income attributable to the one percent of the lessee's net sales
exceeding $25 million before the lessee actually achieves the $25
million net sales threshold?
Interpretive Response: No. The staff believes that contingent
rental income ``accrues'' (i.e., it should be recognized as revenue)
when the changes in the factor(s) on which the contingent lease
payments is (are) based actually occur.\42\
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\42\ Lessees should follow the guidance established in EITF
Issue No. 98-9, Accounting for Contingent Rent.
---------------------------------------------------------------------------
SFAS No. 13, Accounting for Leases, paragraph 19(b) states that
lessors should account for operating leases as follows: ``Rent shall be
reported in income over the lease term as it becomes receivable
according to the provisions of the lease. However, if the rentals vary
from a straight-line basis, the income shall be recognized on a
straight-line basis unless another systematic and rational basis is
more representative of the time pattern in which use benefit from the
leased property is diminished, in which case that basis shall be
used.''
SFAS No. 29, Determining Contingent Rentals, amended SFAS No. 13
and clarifies that ``lease payments that depend on a factor that does
not exist or is not measurable at the inception of the lease, such as
future sales volume, would be contingent rentals in their entirety and,
accordingly, would be excluded from minimum lease payments and included
in the determination of income as they accrue.'' [Summary] Paragraph 17
of SFAS No. 29 provides the following example of determining contingent
rentals:
A lease agreement for retail store space could stipulate a
monthly base rental of $200 and a monthly supplemental rental of
one-fourth of one percent of monthly sales volume during the lease
term. Even if the lease agreement is a renewal for store space that
had averaged monthly sales of $25,000 for the past 2 years, minimum
lease payments would include only the $200 monthly base rental; the
supplemental rental is a contingent rental that is excluded from
minimum lease payments. The future sales for the lease term do not
exist at the inception of the lease, and future rentals would be
limited to $200 per month if the store were subsequently closed and
no sales were made thereafter.
FASB Technical Bulletin (FTB) 85-3, Accounting for Operating Leases
with Scheduled Rent Increases, addresses whether it is appropriate for
lessors in operating leases to recognize scheduled rent increases on a
basis other than as required in SFAS No. 13, paragraph 19(b). Paragraph
2 of FTB 85-3 states ``using factors such as the time value of money,
anticipated inflation, or expected future revenues [emphasis added] to
allocate scheduled rent increases is inappropriate because these
factors do not relate to the time pattern of the physical usage of the
leased property. However, such factors may affect the periodic reported
rental income or expense if the lease agreement involves contingent
rentals, which are excluded from minimum lease payments and accounted
for separately under Statement 13, as amended by Statement 29.'' In
developing the basis for why scheduled rent increases should be
recognized on a straight-line basis, the FASB distinguishes the
accounting for scheduled rent increases from contingent rentals.
Paragraph 13 states ``There is an important substantive difference
between lease rentals that are contingent upon some specified future
event and scheduled rent increases that are unaffected by future
events; the accounting under Statement 13 reflects that difference. If
the lessor and lessee eliminate the risk of variable payments by
agreeing to scheduled rent increases, the accounting should reflect
those different circumstances.''
The example provided in SFAS No. 29 implies that contingent rental
income in leases classified as sales-type or direct-financing leases
becomes ``accruable'' when the changes in the factors on which the
contingent lease payments are based actually occur. FTB 85-3 indicates
that contingent rental income in operating leases should not be
recognized in a manner consistent with scheduled rent increases (i.e.,
on a straight-line basis over the lease term or another systematic and
rational allocation basis if it is more representative of the time
pattern in which the leased property is physically employed) because
the risk of variable payments inherent in contingent rentals is
substantively different than scheduled rent increases. The staff
believes that the reasoning in FTB 85-3 supports the conclusion that
the risks inherent in variable payments associated with contingent
rentals should be reflected in financial statements on a basis
different than rental payments that adjust on a scheduled basis and,
therefore, operating lease income associated with contingent rents
would not be recognized as time passes or as the leased property is
physically employed. Furthermore, prior to the lessee's achievement of
the target upon which contingent rentals are based, the lessor has no
legal claims on the contingent amounts. Consequently, the staff
believes that it is inappropriate to anticipate changes in the factors
on which contingent rental income in operating leases is based and
recognize rental income prior to the resolution of the lease
contingencies.
Because Company A's contingent rental income is based upon whether
the customer achieves net sales of $25 million, the contingent rentals,
which may not materialize, should not be recognized until the
customer's net sales actually exceed $25 million. Once the $25 million
threshold is met, Company A would recognize the contingent rental
income as it becomes accruable, in this case, as the customer
recognizes net sales. The staff does not believe that it is appropriate
to recognize revenue
[[Page 68944]]
based upon the probability of a factor being achieved. The contingent
revenue should be recorded in the period in which the contingency is
resolved.
Question 9
Facts: Paragraph 8 of SFAS No. 48 lists a number of factors that
may impair the ability to make a reasonable estimate of product returns
in sales transactions when a right of return exists.\43\ The paragraph
concludes by stating ``other factors may preclude a reasonable
estimate.''
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\43\ These factors include ``(a) the susceptibility of the
product to significant external factors, such as technological
obsolescence or changes in demand, (b) relatively long periods in
which a particular product may be returned, (c) absence of
historical experience with similar types of sales of similar
products, or inability to apply such experience because of changing
circumstances, for example, changes in the selling enterprise's
marketing policies and relationships with its customers, and (d)
absence of a large volume of relatively homogeneous transactions.''
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Question: What ``other factors,'' in addition to those listed in
paragraph 8 of SFAS No. 48, has the staff identified that may preclude
a registrant from making a reasonable and reliable estimate of product
returns?
Interpretive Response: The staff believes that the following
additional factors, among others, may affect or preclude the ability to
make reasonable and reliable estimates of product returns: (1)
Significant increases in or excess levels of inventory in a
distribution channel (sometimes referred to as ``channel stuffing''),
(2) lack of ``visibility'' into or the inability to determine or
observe the levels of inventory in a distribution channel and the
current level of sales to end users, (3) expected introductions of new
products that may result in the technological obsolescence of and
larger than expected returns of current products, (4) the significance
of a particular distributor to the registrant's (or a reporting
segment's) business, sales and marketing, (5) the newness of a product,
(6) the introduction of competitors' products with superior technology
or greater expected market acceptance, and other factors that affect
market demand and changing trends in that demand for the registrant's
products. Registrants and their auditors should carefully analyze all
factors, including trends in historical data, that may affect
registrants' ability to make reasonable and reliable estimates of
product returns.
The staff reminds registrants that if a transaction fails to meet
all of the conditions of paragraphs 6 and 8 in SFAS No. 48, no revenue
may be recognized until those conditions are subsequently met or the
return privilege has substantially expired, whichever occurs first.\44\
Simply deferring recognition of the gross margin on the transaction is
not appropriate.
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\44\ SFAS No. 48, para.6.
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5. Income Statement Presentation
Question 10
Facts: Company A operates an internet site from which it will sell
Company T's products. Customers place their orders for the product by
making a product selection directly from the internet site and
providing a credit card number for the payment. Company A receives the
order and authorization from the credit card company, and passes the
order on to Company T. Company T ships the product directly to the
customer. Company A does not take title to the product and has no risk
of loss or other responsibility for the product. Company T is
responsible for all product returns, defects, and disputed credit card
charges. The product is typically sold for $175 of which Company A
receives $25. In the event a credit card transaction is rejected,
Company A loses its margin on the sale (i.e., the $25).
Question: In the staff's view, should Company A report revenue on a
gross basis as $175 along with costs of sales of $150 or on a net basis
as $25, similar to a commission?
Interpretive Response: Company A should report the revenue from the
product on a net basis. In assessing whether revenue should be reported
gross with separate display of cost of sales to arrive at gross profit
or on a net basis, the staff considers whether the registrant:
1. Acts as principal in the transaction,
2. Takes title to the products,
3. Has risks and rewards of ownership, such as the risk of loss for
collection, delivery, or returns, and
4. Acts as an agent or broker (including performing services, in
substance, as an agent or broker) with compensation on a commission or
fee basis.\45\
\45\ See, for example, ARB 43, Chapter 11A, para.20; SOP 81-1,
para.58-60; and SFAS No. 45, para.16.
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If the company performs as an agent or broker without assuming the
risks and rewards of ownership of the goods, sales should be reported
on a net basis.
B. Disclosures
Question 1
Question: What disclosures are required with respect to the
recognition of revenue?
Interpretive Response: A registrant should disclose its accounting
policy for the recognition of revenue pursuant to APB Opinion No. 22,
Disclosure of Accounting Policies. Paragraph 12 thereof states that
``the disclosure should encompass important judgments as to
appropriateness of principles relating to recognition of revenue. * * *
'' Because revenue recognition generally involves some level of
judgment, the staff believes that a registrant should always disclose
its revenue recognition policy. If a company has different policies for
different types of revenue transactions, including barter sales, the
policy for each material type of transaction should be disclosed. If
sales transactions have multiple elements, such as a product and
service, the accounting policy should clearly state the accounting
policy for each element as well as how multiple elements are determined
and valued. In addition, the staff believes that changes in estimated
returns recognized in accordance with SFAS No. 48 should be disclosed,
if material (e.g., a change in estimate from two percent of sales to
one percent of sales).
Regulation S-X requires that revenue from the sales of products,
services, and other products each be separately disclosed on the face
of the income statement.\46\ The staff believes that costs relating to
each type of revenue similarly should be reported separately on the
face of the income statement.
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\46\ See Regulation S-X, Article 5-03 (b) (1) and (2).
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Management's Discussion and Analysis (MD&A) requires a discussion
of liquidity, capital resources, results of operations and other
information necessary to an understanding of a registrant's financial
condition, changes in financial condition and results of
operations.\47\ This includes unusual or infrequent transactions, known
trends or uncertainties that have had, or might reasonably be expected
to have, a favorable or unfavorable material effect on revenue,
operating income or net income and the relationship between revenue and
the costs of the revenue. Changes in revenue should not be evaluated
solely in terms of volume and price changes, but should also include an
analysis of the reasons and factors contributing to the increase or
decrease. The Commission stated in Financial Reporting Release (FRR) 36
that MD&A should ``give investors an opportunity to look at the
registrant through the eyes of management by providing a historical and
prospective analysis of the registrant's financial condition and
results of operations, with a particular emphasis on the registrant's
prospects
[[Page 68945]]
for the future.''\48\ Examples of such revenue transactions or events
that the staff has asked to be disclosed and discussed in accordance
with FRR 36 are:
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\47\ See Regulation S-K, Article 303 and Financial Reporting
Release No. 36.
\48\ FRR 36, also see In the Matter of Caterpillar Inc., AAER
No. 363 (March 31, 1992).
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Shipments of product at the end of a reporting period that
significantly reduce customer backlog and that reasonably might be
expected to result in lower shipments and revenue in the next period.
Granting of extended payment terms that will result in a
longer collection period for accounts receivable (regardless of whether
revenue has been recognized) and slower cash inflows from operations,
and the effect on liquidity and capital resources. (The fair value of
trade receivables should be disclosed in the footnotes to the financial
statements when the fair value does not approximate the carrying
amount.)\49\
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\49\ SFAS No. 107, Disclosures about Fair Values of Financial
Instruments.
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Changing trends in shipments into, and sales from, a sales
channel or separate class of customer that could be expected to have a
significant effect on future sales or sales returns.
An increasing trend toward sales to a different class of
customer, such as a reseller distribution channel that has a lower
gross profit margin than existing sales that are principally made to
end users. Also, increasing service revenue that has a higher profit
margin than product sales.
Seasonal trends or variations in sales.
A gain or loss from the sale of an asset(s).\50\
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\50\ Gains or losses from the sale of assets should be reported
as ``other general expenses'' pursuant to Regulation S-X, Article 5-
03(b)(6). Any material item should be stated separately.
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Question 2
Question: Will the staff expect retroactive changes by registrants
to comply with the accounting described in this bulletin?
Interpretive Response: All registrants are expected to apply the
accounting and disclosures described in this bulletin. The staff,
however, will not object if registrants that have not applied this
accounting do not restate prior financial statements provided they
report a change in accounting principle in accordance with APB Opinion
No. 20, Accounting Changes, no later than the first fiscal quarter of
the fiscal year beginning after December 15, 1999. In periods
subsequent to transition, registrants should disclose the amount of
revenue (if material to income before income taxes) recognized in those
periods that was included in the cumulative effect adjustment. If a
registrant files financial statements with the Commission before
applying the guidance in this bulletin, disclosures similar to those
described in Staff Accounting Bulletin Topic 11-M, Disclosure of the
Impact that Recently Issued Accounting Standards Will Have on the
Financial Statements of a Registrant When Adopted in a Future Period,
should be provided. With regard to question 10 of Topic 13-A and Topic
8-A regarding income statement presentation, the staff would normally
expect retroactive application to all periods presented unless the
effect of applying the guidance herein is immaterial.
However, if registrants have not previously complied with generally
accepted accounting principles, for example, by recording revenue for
products prior to delivery that did not comply with the applicable
bill-and-hold guidance, those registrants should apply the guidance in
APB Opinion No. 20 for the correction of an error.\51\ In addition,
registrants should be aware that the Commission may take enforcement
action where a registrant in prior financial statements has violated
the antifraud or disclosure provisions of the securities laws with
respect to revenue recognition.
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\51\ APB Opinion No. 20, para.13 and para.36-37 describe and
provide the accounting and disclosure requirements applicable to the
correction of an error in previously issued financial statements.
Because the term ``error'' as used in APB Opinion No. 20 includes
``oversight or misuse of facts that existed at the time that the
financial statements were prepared,'' that term includes both
unintentional errors as well as intentional fraudulent financial
reporting and misappropriation of assets as described in Statement
on Auditing Standards No. 82, Consideration of Fraud in a Financial
Statement Audit.
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Topic 8: Retail Companies
A. Sales of Leased or Licensed Departments
Facts: Department stores and other retailers customarily include
the sales of leased or licensed departments in the amount reported as
``total revenues.''
Question: Does the staff have any objection to this practice?
Interpretive Response: In November 1975 the staff issued staff
accounting bulletin number 1 that addressed this issue. In that
bulletin the staff did not object to retailers presenting sales of
leased or licensed departments in the amount reported as ``total
revenues'' because of industry practice. Subsequently, in November 1976
the FASB issued SFAS No. 13. In June 1995, the AICPA staff amended its
Technical Practice Aid (TPA) section 5100.16, Rental Revenue Based on
Percentage of Sales, based upon an interpretation of SFAS No. 13 that
leases of departments within a retail establishment are leases of
tangible assets within the scope of SFAS No. 13.\52\ Consistent with
the interpretation in TPA section 5100.16, the staff believes that SFAS
No. 13 requires department stores and other retailers that lease or
license store space to account for rental income from leased
departments in accordance with SFAS No. 13. Accordingly, it would be
inappropriate for a department store or other retailer to include in
its revenue the sales of the leased or licensed departments. Rather,
the department store or other retailer should include the rental income
as part of its gross revenue. The staff would not object to disclosure
in the footnotes to the financial statements of the amount of the
lessee's sales from leased departments. If the arrangement is not a
lease but rather a service arrangement that provides for payment of a
fee or commission, the retailer should recognize the fee or commission
as revenue when earned. If the retailer assumes the risk of bad debts
associated with the lessee's merchandise sales, the retailer generally
should present bad debt expense in accordance with Regulation S-X
article 5-03 (b)(5).
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\52\ SFAS No. 13, para.1 defines a lease as ``the right to use
property, plant, or equipment (land or depreciable assets or both)
usually for a stated period of time.''
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B. * * *
This Staff Accounting Bulletin is not intended to change current
guidance in the accounting literature. For this reason, adherence to
the principles described in this Staff Accounting Bulletin should not
raise the costs associated with record-keeping or with audits of
financial statements.
[FR Doc. 99-31832 Filed 12-8-99; 8:45 am]
BILLING CODE 8010-01-P
