Revenue Recognition - CA Journal Apr 2006

8/9/2019 Revenue Recognition - CA Journal Apr 2006

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1414 The Chartered Accountant April 2006

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Revenue Recognition

Revenue is usually the larg-est single item in nancialstatements, and the issues

involving revenue recognitionare among the most importantand difcult ones that standard-setters and accountants face. Inrecent years, concerns related tothe recognition of revenue in ac-cordance with Accounting Stan-dards have heightened signi-cantly. Quite often, companiesend up tweaking the Revenuenumbers, besides some otherreasons. Recording revenue im-properly is also a commonlyused earnings managementtechnique. The ever evolvingbusiness models and the grow-ing online economy have only

compounded the issue. Earn-ings Management/Issues withrevenue recognition have beenthe subject of headlines in theUnited States and in the otherparts of the world in the last fewyears.

Revenue RecognitionUnder US GAAP

It is estimated that Revenue

Recognition related aspects ap-pear in close to two hundreddifferent pieces of accountingliterature; of course these piecesof literature include many nu-ances, some of which are uniqueto particular transactions.

Since no comprehensivestandard on revenue recogni-tion exists, there is a signicantgap between the broad concep-

tual guidance in the Financial

Accounting Standards Boards(FASB) Concepts Statementsand the detailed guidance in theauthoritative literature. Most ofthe authoritative literature provides industry or transaction-specic implementation guid-ance, and it has been developedlargely on an ad-hoc basis andissued in numerous pronounce-ments with differing degrees ofauthority. Those pronounce-ments include Accounting Prin-ciples Board (APB) Opinions,FASB Statements, AmericanInstitute of Certied Public Ac-countants (AICPA) Audit and Accounting Guides, AICPAStatements of Position (SOPs),FASB Interpretations, Emerg-ing Issues Task Force (EITF)Issues, Securities and ExchangeCommission (SEC) Staff Ac-counting Bulletins (SAB), andthe like. Each focuses on a spe-cic practice problem and has anarrow scope, and the guidanceis not always consistent acrosspronouncements.

As can be seen from theabove paragraph, regulation

comes from three bodies:1. Securities Exchange Com-

mission (SEC)2. Financial Accounting Stan-

dards Board (FASB)3. American Institute of Cer-

tied Public Accountants(AICPA)

Sarbanes Oxley Act, 2002also contains clauses related toRevenue.

a. Revenue: The broad guid-ance for revenue recognition

International Accounting

Standards (IAS) are draft-ed on a Principles-based

approach. The same is

the case with Indian Ac-

counting Standards, which

adopts the IAS framework.

The United States Gener-

ally Accepted Accounting

Principles (US GAAP) are

more along the lines of a

Rules-based framework.

The more complex the busi-ness, the more specialised

the industry, the more dif-

cult the decision becomes

for that business as to

when to recognise earn-

ings. This article attempts

to understand the Revenue

recognition literature that

exists today in US GAAP,

International Accounting

Standards and Indian Ac-

counting Standards.

The author is a member of the In-stitute as well as AICPA, workingwith Lason Systems Inc, MI, USA.He can be reached at shrikant_

[email protected]

-Shrikant Sortur


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is set forth in the (FASB)Conceptual Framework

which denes the objectivesof nancial reporting in theU.S., qualitative characteris-tics of accounting, elementsof nancial statements andrecognition and measure-ment criteria.

Two essential characteristics of rev-enues are:

1. They arise from thecompanys principal

business activities (asopposed to investmentactivities and sale ofassets, which generategains).

2. They are recurring.b. Recognition: FASB State-

ment of Financial Account-ing Concepts No. 5 denesrecognition as the processof recording and reporting

an item as an element ofnancial statements. In or-der to be recognised in the

nancial statements, an itemmust satisfy all four of the

following criteria:1. Meet the denition ofan element of nancialstatements

2. Can be reliably mea-sured (historical cost,current cost, market

value, net present valueor net realisable value)

3. Is relevant to a user ofnancial statements

4. Is reliable, which meansit can be veried and isfree of bias

c. The Revenue RecognitionPrinciple: Once an itemqualies as revenue to berecognised, the question is when to recognise it. Con-ceptually, in order to berelevant to a user, it shouldbe recorded as soon as pos-

sible. However, in order tobe reliable, it is preferable torecord it as late as possible

when all uncertainties havebeen resolved and measure-ment is certain.

In order to achieve a balance,two other factors must be con-sidered to determine when rev-enue should be recognised:1. It is realised or realisable.2. It is earned.

Revenue from a transactionmust meet both criteria in or-der to be recognised. Revenueis generally considered realisedwhen cash is received for the saleof a product or performance ofa service. Revenue generally be-comes realisable when a promiseto pay is received in exchange forthe sale of a product or perfor-mance of a service. The promiseto pay could be verbal (accountreceivable) or written (note re-ceivable). Revenue is generallyearned when a legally enforce-able exchange takes place (e.g.,consideration has been tenderedand the buyer takes possessionof the product or benets fromthe performance of a service).d. Securities Exchange Com-

mission Staff AccountingBulletins: All public com-panies are regulated by theSEC. The SEC sought toll the gap in the account-ing literature with SAB No.101, Revenue Recognition inFinancial Statements, which was issued in December1999 and the companiondocument, Revenue Rec-ognition in Financial State-ments Frequently AskedQuestions and Answers,which was issued in October2000. SAB 101 was super-ceded by SAB 104, RevenueRecognition, in December2003.

SAB 101 provides specic ex-amples of applying revenue rec-

ognition principles and helps toclarify the concepts of realised

Important Pronouncements Containing topics on Revenue Recognition

Pronouncement Topic

SFAC 5 Recognition and Measurement in Financial Statements of

Business Enterprises

SAB 101 Revenue Recognition in Financial Statements (Dec 1999 Su-

perseded by SAB 104)

SAB 104 Revenue Recognition

SOP 81-1 Accounting for Performance of construction type and cer-

tain production type contracts

SOP 97-2 Software Revenue Recognition amended by SOP 98-9

EITF 00-21 Accounting for Revenue Arrangements with Multiple De-

liverables

EITF 99-17 Accounting for Advertising Barter Transactions

EITF 99-19 Reporting Revenue Gross versus Net

FTB 90-1 Accounting for Separately Priced Extended Warranty and

Product Maintenance Contracts

FASB 48 Revenue Recognition when a right of return exists

Other topics (not being discussed in this article)

FASB 45 Accounting for Franchise Fee Revenue

FASB 116 Accounting for Contributions Received and Contributions

Made

FASB

Interpretation 42

Accounting for Transfer of assets in which a not for prot

organisation is granted variance power


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or realisable and earned.SAB 104 states that if a trans-

action falls within the scope ofspecic authoritative literatureon revenue recognition, thatguidance should be followed; inthe absence of such guidance,the revenue recognition criteriain Concepts Statement 5 (name-ly, that revenue should not berecognised until it is (a) realisedor realisable and (b) earned),should be followed. However,SAB 104 is more specic, stat-ing additional requirements formeeting those criteria, and re-ects the SEC staff s view thatthe four basic criteria for revenuerecognition in AICPA SOP 97-2,Software Revenue Recognition,should be a foundation for allbasic revenue recognition prin-ciples. Those criteria are:

Persuasive evidence ofan arrangement exists.

Delivery has occurredor services have beenrendered.

The sellers price to thebuyer is xed or deter-minable.

Collectibility is reason-ably assured.

SAB 104 provides furtherguidance on the interpretationand consideration of the criterianoted above. As additional ques-tions arise, the SECs Emerg-ing Issues Task Force addressesthem in updated SABs. The vol-ume and detail of the examplesprovided in these documentsfurther demonstrate the com-plexity of revenue recognitionconsiderations. The topics cov-ered by SAB 104 are:

A. Selected Revenue Recognition Is-sues1. Revenue Recognition Gen-

eral2. Persuasive evidence of an

arrangement3. Delivery & Performance

a) Bill and hold arrange-ments

b) Customer acceptancec) Inconsequential or per-

functory performanceobligations

d) License fee revenuee) Layaway sales arrange-

mentsf) Non refundable upfront

feesg) Deliverables within an

arrangement4. Fixed or determinable sales

pricea) Refundable fees for ser-

vicesb) Estimates and changes

in estimatesc) Contingent rental in-

comed) Claims processing &

billing services

B. Disclosurese. Accounting for Perfor-

mance of constructiontype and certain pro-duction type contracts:

Guidance is dened fromthe perspective of the contrac-tor rather than the contract, asin IAS. Scope is not limited toconstruction type contracts;guidance is also applicable tounit-price and time-and-materi-als contracts.

Recognition Method: Thepercentage of completion meth-od is preferred. However, in rare

circumstances, when the extentof progress towards completionis not reasonably measurable, thecompleted should be used.

Applying the percentage ofcompletion method: Two differ-ent approaches permitted.1. The Revenue Cost approach

(similar to IAS) multipliesthe estimated percentage ofcompletion by the estimated

total revenues to determineestimated revenue, and mul-

tiplies the estimated per-centage of completion bythe estimated total contractcost to determine the costof earned revenue; and

2. The Gross Prot approachmultiplies the estimated per-centage of completion bythe estimated gross protto determine the estimatedgross prot earned to date.

Losses are recognised whenincurred or when the expectedcontract costs exceed the expect-ed contract revenue, regardlessof which accounting methodused.

Completed contract method:Allowed only in rare circum-

stances where estimates of coststo completion and the extentof progress towards comple-tion cannot be determined withenough certainty. Revenue isrecognised only when the con-tract is completed or substantial-ly completed. Losses are recog-nised when incurred or when theexpected contract costs exceedthe expected contract revenue.

f. SOP 97-2 - SoftwareRevenue Recognition(Amended in part bySOP 98-9): SOP 97-2 applies to all entitiesthat license, sell, lease,or market computersoftware. It also appliesto hosting arrange-ments in which thecustomer has the op-tion to take possessionof the software. Host-ing arrangements oc-cur when end users donot take possession ofthe software but ratherthe software resides onthe vendors or a thirdpartys hardware, andthe customer accesses

and uses the softwareon an as-needed ba-


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The Chartered Accountant 1419April 2006

sis over the Internet orsome other connection.It does not, however,apply to revenue earnedon products containingsoftware incidental tothe product as a wholeor to hosting arrange-ments that do not givethe customer the optionof taking possession ofthe software.

SOP 97-2 provides that rev-enue should be recognised inaccordance with contract ac-counting when the arrangementrequires signicant production,modication, or customisationof the software. When the ar-rangement does not entail suchrequirements, revenue should berecognised when persuasive evi-dence of an agreement exists, de-livery has occurred, the vendorsprice is xed or determinable,and collectibility is probable.

In the software industry, thelargest part of revenues stemsfrom vendors license fees asso-ciated with software. Companiessuch as Microsoft and ComputerAssociates have recognised rev-enue from license fees whenthe software was shipped to thecustomer. The amount and tim-ing of revenue recognition iscomplicated, however, by mul-tiple-element arrangements thatprovide for multiple softwaredeliverables [e.g., software prod-ucts, upgrades or enhancements,post-contract customer support(PCS), or other services]. Inhosting arrangements that arewithin the scope of SOP 97-2,multiple elements might includespecied or unspecied upgraderights, in addition to the softwareproduct and the hosting service. The software provider oftencharges a single fee that must

be allocated to the products de-livered in the present and in the

future. If contract accounting isnot required, SOP 97-2 requiresthat the vendors fee be allocatedto the various elements basedon vendor-specic objective evi-dence (VSOE) of fair value foreach element. VSOE is limitedto the price charged by the ven-dor for each element when it issold separately. This requires thedeferral of revenue until VSOEcan be established for all ele-ments in the arrangement or untilall elements have been delivered.If PCS is the only undeliveredelement in the arrangement,however, the entire fee can berecognised ratably over the termof the PCS contract. In addition,recognition of revenue must bedeferred if undelivered elementsare essential to the functionalityof any delivered elements.

g. EITF 00-21 - Ac-counting for Revenue Arrangements withMultiple Deliverables:Multiple-element ar-rangements are notlimited to the softwareindustry. Common ex-amples include the saleof computer networks,specialised equipment with installation andtraining, and cellulartelephones with servicecontracts. EITF 00-21,Revenue Arrangements with Multiple Deliver-ables, identies whenseparation of sales ar-rangements for revenuerecognition purposes isappropriate.

In an arrangement with mul-tiple deliverables, EITF 00-21requires that the delivered itemsbe considered a separate unit ofaccounting if the delivered itemshave value to the customer on a

stand-alone basis, if there is ob-jective and reliable evidence of

the fair value of the undelivereditems, and if the arrangementincludes a general right of re-turn for the delivered item, or ifdelivery or performance of theundelivered items is consideredprobable and substantially inthe control of the vendor. EITF00-21 requires allocation of the vendors fee to the various ele-ments based on each elementsstand-alone value, and the defer-ral of revenue until the stand-alone value can be established.Stand-alone value can be deter-mined on the basis of any ven-dors sales price or on the basisof the customers ability to resellthe element on a stand-alonebasis. This requirement is muchless restrictive than the VSOErequirement of SOP 97-2, whichlimits stand-alone value to thatestablished by the vendor onlyand does not allow the value tobe determined by other vendorsor by the customers ability toresell the element. Additionally,the stringent essential to thefunctionality criterion of SOP97-2 is not included in EITF 00-21, so such undelivered elementswould not cause the deferral ofrevenue recognition on the deliv-ered elements.

In general, both SOP 97-2and EITF 00-21 require allo-cating revenue to all of the ele-ments of a multiple-deliverablearrangement using the relativefair value method, where objec-tive and reliable evidence of fair

value is present for all the prod-ucts contained in the group. Ifobjective and reliable evidenceis available only for the productsthat have not been delivered, theresidual method should be usedto value the products that havebeen delivered. If objective andreliable evidence is available

only for the delivered products,no value should be assigned to


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any products until all of themare delivered. Both SOP 97-2and EITF 00-21 prohibit usingthe reverse residual method.

In an arrangement that in-cludes software that is morethan incidental to the productsor services as a whole, softwareand software-related elementsare included within the scopeof SOP 97-2. Software-relat-ed elements include softwareproducts and services such asthose listed in paragraph 9 ofSOP 97-2 [i.e., software prod-ucts, upgrades/enhancements,post-contract customer sup-port, or services] as well as anynon-software deliverable(s) forwhich a software deliverable isessential to its functionality. Forexample, in an arrangement thatincludes software, computerhardware that will contain thesoftware, and additional unre-lated equipment, if the softwareis essential to the functionalityof the hardware, the hardware would be considered software-related and, therefore, includedwithin the scope of SOP 97-2.However, because the softwareis not essential to the function-

ality of the unrelated equip-ment, the equipment would

not be considered software-re-lated and would, therefore, beexcluded from the scope ofSOP 97-2.

h. EITF 99-17 Accountingfor Advertising Barter Transac-tions: Revenue and expenses mustbe recognised at the fair value ofthe advertising given. Fair valuemust be based on the entitys ownhistorical practice of receivingcash for similar advertising fromunrelated entities. Similar transac-tions used as a guide to fair valuemust not be older than six monthsprior to the date of the bartertransaction. If the fair value of theadvertising given cannot be de-termined within these criteria, thecarrying amount of the advertise-ment surrendered, which is likelyto be zero, must be used.

i. EITF 99-19 Report-ing Revenue Gross ver-sus Net:

Provides several indicators ofwhether revenue should be pre-sented at gross or net:

The sale should be recordedat gross if the seller:

- Is the party responsibleto the customer for sat-isfaction

- Has general inventoryrisk (before customer

order is placed or uponcustomer return)

- Has reasonable latitudein establishing price

- Changes the product orperforms part of theservice

- Has discretion in sup-plier selection

- Is involved in determi-nation of product orservice specications

- Has physical loss inven-tory risk (after order orduring shipping); or

- Bears credit risk in theevent of customer nonpayment

The sale should be recordedat net if:- The supplier, not the com-

pany, is the primary obligator(responsible for fulllmentand customer satisfaction)

- The amount the companyearns from the shipment isxed; or

- The supplier, not the com-pany, has the credit risk inevent of customer non pay-ment

j. FTB 90-1 Accountingfor Separately Priced Ex-

tended Warranty And Prod-uct Maintenance Contracts:

Criteria for Multiple Deliverable Products

Item SOP 97-2 EITF 00-21Software and software relatedproducts

Applicable Not Applicable

Non software products Not Applicable Applicable

Basis for revenue recognition Vendor specic objective evidence(VSOE) of fair value. Price must beavailable for each product provided bythe seller

Stand alone value. VSOE is the best,but competitor prices and the custom-ers ability to sell the product may beused

Residual method Allowed Allowed

Reverse residual method Not allowed Not allowed

Undelivered products essential to thefunctionality of any delivered product Revenue deferred on the delivered prod-uct until the undelivered product is de-livered

Revenue may be recognised for the de-livered product


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Revenue must be recognizedon a straight-line basis unlessthe pattern of costs indicatesotherwise. A loss must berecognised immediately ifthe expected cost to provideservices during the warrantyperiod exceeds unearnedrevenue

k. FAS 48 Revenue Recogni-tion when a right of returnexists: When rights of returnexist, or are likely to be ac-cepted, FAS 48 dictates thatit may be possible that a rea-sonable estimate can be madebefore revenue can be recog-nised from the transactions

In determining whether a rea-sonable estimate can be made, allfactors that bear upon the quan-tity of products to be returnedshould be considered. These fac-tors include competition, obso-lescence and the length of timeover which the product can bereturned. The lack of reliable his-tory regarding returns may pre-clude companies from recording

product shipments with a right ofreturn until that right expires or isterminated.

The Way ForwardWith the increasing focus on

Revenue Recognition issues andthe need to for a comprehen-sive statement, FASB has un-dertaken a project on RevenueRecognition

The objective of this projectis to develop conceptual guid-ance for revenue recognitionand a comprehensive Statementon revenue recognition that would be based on that guid-ance. In particular, the projectis intended to improve nancialreporting by:1. Eliminating inconsistencies

in the existing conceptual

guidance on revenues in cer-tain FASB Concepts State-ments

2. Providing conceptual guid-ance that would be useful inaddressing issues that mayarise in the future

3. Eliminating inconsistenciesin the existing authoritativeliterature and accepted prac-tices

4. Filling voids that haveemerged in revenue recogni-tion guidance in recent years.

The comprehensive Statementthat is expected to result fromthis project is initially plannedto apply to business entities gen-erally; however, the FASB mayconclude that certain transactionsor industries requiring additional

study should be excluded fromthe scope of that Statement andbe addressed separately.

Revenue Recognition UnderInternational Accounting Stan-dards

IAS framework contains spe-cic standard on revenue recog-nition, IAS 18 Revenue and IAS11-Construction Contracts.

IAS 18: Revenue -- IAS 18

prescribes the accounting treat-ment for revenue arising from:l The sale of goods;l The rendering of services;

andl The use by others of entity

assets yielding interest, royal-ties and dividends.

It does not deal with revenuearising from transactions coveredby other Standards (e.g. revenue

arising from lease agreementsdealt with in IAS 17 leases).

Revenue is measured at thefair value of the considerationreceived or receivable. The con-sideration is usually cash. If theinow of cash is signicantlydeferred, and there is no interestor a below-market rate of inter-est, the fair value of the consider-ation is determined by discount-

ing expected future receipts. Ifdissimilar goods or services areexchanged (as in barter transac-

tions), revenue is the fair value ofthe goods or services received or,if this is not reliably measurable,the fair value of the goods or ser-vices given up.

Revenue from the sale ofgoods is recognised when:l Signicant risks and rewards

of ownership are transferredto the buyer;

l The seller has no continuingmanagerial involvement orcontrol over the goods;

l The amount of revenue canbe measured reliably;

l It is probable that economicbenets will ow to the sell-er; and

l The costs of the transaction(including future costs) canbe measured reliably.

Revenue from rendering services is recognised by referenceto the stage of completion if thefollowing conditions are satised:l The amount of revenue can

be measured reliably;l It is probable that economic

benets will ow to the ser-

vice provider;l The stage of completion of

the transaction can be mea-sured reliably; and

l The costs of the transaction(including future costs) canbe measured reliably.v If the outcome cannot

be measured reliably,revenue is recognisedonly to the extent of the

expenses recognised thatare recoverable.

v Interest revenue is recog-nised on a time-propor-tion basis using the ef-fective interest method.

v Royalties are recognisedon an accruals basis inaccordance with the sub-stance of the relevantagreement.

v Dividend revenue isrecognised when theshareholders right to


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receive the dividend isestablished.

v IAS 18 also species dis-closures about revenue.

IAS 11: Construction Con-tracts IAS 11 prescribes the ac-counting treatment of revenue

and costs associated with con-struction contracts.

When the outcome of a con-struction contract can be esti-mated reliably, contract revenueand contract costs are recognisedas revenue and expenses respec-tively by reference to the stageof completion of the contractactivity (percentage of comple-tion method). The outcome

can be estimated reliably whenthe contract revenue, contactscosts to date and to completion,and the stage of completion canbe measured reliably.

When the outcome of aconstruction contract cannotbe estimated reliably, revenueis recognised only to the extentof contract costs incurred, thatit is probable are recoverable.

Contract costs are recognised asexpenses when incurred. If theoutcome of the contract subse-quently can be estimated reliably,the percentage of completionmethod is used for recognitionof revenue and expenses.

Any expected loss on a con-struction contract is recognisedas an expense immediately.

IAS 11 also species disclo-sures about construction con-

tracts.

Revenue RecognitionUnder Indian AccountingStandards

Indian Accounting Standardsfollow the framework of Interna-tional Accounting Standards andare similar in nature. AccountingStandards for Revenue Recogni-tion in India corresponding to

IAS are found in AS 9- RevenueRecognition and AS 7 Con-struction Contracts.

Key differences between IASand Indian Accounting Stan-dardsRevenue Recognition:a) IAS 18 contains a clause

that prohibits revenue tobe recognised from sale ofgoods when the entity re-tains continuing managerialownership or effective con-trol over the goods sold. AS9 does not specify this.

b) IAS 18 allows only Percent-age of completion methodfor recognising revenue fromrendering of services. AS 9allows Completed servicecontract method or Propor-

tionate completion methodc) IAS 18 requires the effec-

tive interest method to befollowed for revenue recog-nition of Interest incomewhereas AS 9 requires inter-est income recognition on atime proportion basis

d) IAS 18 does not allow reve-nue to be recognised for pay-ments received in advance

for goods yet to be manu-factured or third party salesuntil such goods are deliv-ered to the buyer whereas AS9 permits recognition whenthe goods are manufactured,identied and ready for deliv-ery in such instances.

Construction Contracts: Con-tract revenue under IAS 11 ismeasured at the fair value of the

consideration received or receiv-able whereas under AS 7 the con-tract revenue is measured at theconsideration received or receiv-able (i.e. there is no fair value con-cept in AS 7)

Key Issues for RevenueRecognition

Revenue recognition is muchmore complex than it might seem

to the average investor / user ofnancial statements. Much of thecomplexity is caused by the need

to issue periodic reports, whichrequires that what is essentially acontinuous earnings process bedivided into discrete periods. Is-sues that must be considered in-clude:l When is delivery complete?l When does the title to goods

and the risk of loss transferfrom the seller to the buyer?

l Does the buyer have the rightto return the product?

l Has payment been receivedfor a service to be providedin the future?

l Is any or all of a sales agree-ment contingent on a futureevent?

Principal RevenueRecognition Risk

The principal accounting riskis obviously the temptation to re-port higher revenues than wereactually earned. This is typicallydone to make the organisationappear more attractive to existingand potential investors and canbe accomplished through one of

several means:a. Moving revenues forward

into a current period in orderto meet the budget or fore-cast

b. Failing to fully meet the re-quirements for revenue tobe both realised or realisable,and earned

c. Recording revenue whenproduction is complete, but

delivery, title transfer, andrisk of loss transfer to thebuyer have not yet occurred

d. Treating sales between differ-ent company business unitsas outside sales

e. Establishing contingenciesor guarantees that may resultin product returns

f. Failing to adequately con-sider collectibility at time of

saleg. Treating sales on consign-ment as outside sales r

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Revenue Recognition - CA Journal Apr 2006