SAB No. 104: revenue recognition

RMA Journal, The, May, 2004 by Alan Reinstein

As SAB No. 104 was issued very late in 2003, no actual disclosures exist as yet. However, its provisions should provide important tools to help bankers assess their clients' present and future operating plans and conditions.

On December 17, 2003, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition, corrected copy, which amends parts of SAB No. 103 (in part, recognizing that many prior SEC standards are no longer necessary due to private-sector developments in U.S. generally accepted accounting principles [GAAP]). SAB No. 104 also provides new guidance on how publicly traded entities should recognize income. It focuses on applying the provisions of the Financial Accounting Standards Board's (FASB) Emerging Issues Task Force Issue 00-21, Revenue Arrangements with Multiple Deliverables, to publicly traded entities, especially in the areas of bill-and-hold-arrangements, immaterial obligations, and nonrefundable up-front fees, all relating to the delivery of sold goods and the resulting revenues. Bankers should also understand these provisions for their clients that soon expect to "go public" or seek to provide disclosures similar to their publicly traded competitors.

EITF No. 00-21

Much controversy has long existed over when entities should recognize revenue if sales arrangements contain more than one "deliverable." For example, how much revenue should a company recognize in the current year if it sells a product that is "almost" installed at year end. EITF No. 00-21 resolves this issue by requiring separate units of accounting measurement when all of the following three conditions exist:

1. The delivered item has standalone value to the customer (e.g., the customer or its competitors could normally resell the separable items, or the customer could resell the composite item).

2. Using specific, objective sales history, the customer could reliably measure the undelivered items (e.g., a competitor regularly sells a large interchangeable product in unbundled arrangements).

3. Based upon past experiences and reasonable future expectations, the seller "controls" the delivery of the undelivered items.

Now, the SEC has adapted many of the above principles in SAB No. 104. Following is a summary of its three major components.

1. Bill-and-hold arrangements. Bill-and-hold arrangements arise when a company invoices its customer but has not yet shipped the products. Many bankruptcies have arisen from improper use of this methodology, including one involving Sunbeam (see the SEC's Accounting and Auditing Enforcement Release [AAER] no. 1393). Assume that a contract manufacturer that produces products for a specific customer also manages this customer's logistics, shipping the products when and where the customer requests. The manufacturer frequently would want to record sales after it completes the manufacturing process but before shipment. However, the manufacturer should not recognize revenues until it establishes a fixed delivery schedule consistent with the customer's business purposes.

Another bill-and-hold arrangement could involve a company that leases part of its production facility to a customer and records sales to this customer when it delivers products to the customer's portion of the facility. It can recognize such revenues only when the customer leased, managed, or otherwise "controlled" this portion of the facility and the seller had no rights or risks associated with the products once they were delivered to the customer's leased space.

SAB No. 104 now contains criteria to recognize revenue for bill-and-hold arrangements. Specifically, entities can recognize such revenues only when written arrangements contain substantial business purposes and allow the parties to evaluate all relevant facts and circumstances for entering into such arrangements. Moreover, these arrangements must adhere to all other relevant accounting requirements (e.g., SEAS No. 48, Revenue Recognition When a Right of Return Exists). Entities should also apply the separation model found in EITF No. 00-21s to ascertain the number of accounting units in such arrangements. Also, since bill-and-hold arrangements often include both the "sale" and warehousing services of products, SAB No. 104 states that if such transactions meet the EITF criteria fur this matter, entities should recognize revenues on the warehousing element of the transactions as the warehousing services are provided.

2. Immaterial remaining obligations to complete delivery and sale. SAB No. 104 next discusses when entities should recognize sales if their remaining obligations are inconsequential or perfunctory to the earnings process. For example, should a company who must still install a minor part of an expensive, complex machine at its year-end date recognize the sale this year or the next, or should it treat the sale and subsequent installation as two separate transactional units? SAB No. 104 follows EITF No. 00-21 in focusing on the "deliverables" associated with such transactions. For example, entities with immaterial (i.e., both inconsequential and unessential) elements to the functioning of the delivered element should recognize such revenues at the time of delivery. Otherwise (e.g., the undelivered element is essential to the functionality of the delivered element), they should defer the revenue for the delivered element.