"Companies try to boost revenue by manipulating the recognition of revenue. Think about a bottle of wine. You wouldn't pop the cork on that bottle before it was ready. But some companies are doing this with their revenue - recognizing it before a sale is complete, before the product is delivered to a customer, or at a time when the customer still has options to terminate, void, or delay the sale."

While revenue recognition should seem straightforward, recent occurrences of various techniques used to manipulate the recording and reporting of revenue suggest the need for a closer examination of the topic. Because accountants are not always aware of the possibility of intentional misstatement of revenue by clients or management, opportunities to prevent or detect improper revenue recognition are often missed.

Revenue recognition issues are among the most serious financial reporting problems. When revenue is inappropriately recognized, serious cash flow problems can result. This situation causes stock prices to plummet indefinitely, or may even cause a company to go out of business entirely.

This SAB does not change any of the accounting profession's existing rules on revenue recognition. Rather, the SAB draws upon the existing rules and explains how the staff applies those rules to other transactions that the existing rules do not specifically address.

Furthermore, this SAB spells out the basic criteria that must be met before registrants can record revenue. Those criteria reflect the recurring revenue recognition themes found in the existing accounting rules.

The SEC's requirements come at a crucial time when many dot-com companies are beginning to take on a greater role in the marketplace. For instance, a top rule-making panel at the Financial Accounting Standards Board is considering whether the rules should be changed to restrict Internet businesses from including in revenue figures the entire value of product sales or services they arrange between suppliers and buyers online.

While the SEC and FASB called it "grossing up" revenue, to many dot-com companies, it is a vital part of their financial livelihood, at a time when they have no profits to show. To illustrate this point, the SEC believes that if a Web site merely handles the sale of a product through the Internet, and does not accept title to those goods, keep them on the shelf, or actually deliver them, then it should not classify the entire transaction as revenue. Because the issue is still very unclear, there has been speculation that rules may be created soon forcing companies to meet certain criteria before booking amounts, such as whether they truly assume revenue and credit risks, and whether they actually own title to the products for a certain period.

A Little Hocus-Pocus
"Hocus-pocus" accounting, the termed coined by Levitt, is the practice of some companies improperly boosting reported earnings by manipulating the recognition of revenue. Among the most common methods of doing this are the bill-and-hold transaction and a long list of sham transactions involving shipping, billing, and/or related-party involvement.

Because many companies are under extreme pressure to report quarterly earnings that meet or exceed investors' expectations, fraudulent practices, such as the overstatement of quarterly revenue, can result.

• persuasive evidence of an arrangement
• delivery has occurred or services have been rendered
• price is defined or determinable
• collectibility is reasonably assured

The SEC expects all registrants to apply the accounting and disclosure provisions of SAB 101. Moreover, registrants are not required to restate prior period financial statements provided they report any change in accounting principle necessary to adopt the provisions of SAB 101 no later than in the first quarter of their fiscal year beginning after December 15, 1999.

In subsequent accounting periods they should disclose the amount of recognized revenue (if material to income before income taxes) that was included in the cumulative effect adjustment on adoption of SAB 101. Financial statements issued prior to adoption of the SAB should disclose the expected effect of its application.

In summary, SAB 101 provides a solid framework for improving the chances of early detection or even preventing the risk of improper revenue recognition in the first place. The additional guidance that this staff accounting bulletin provides, along with more effort on the part of finance professionals, will greatly reduce the problem of fraud and misstatement in the future. Additionally, it should create a reliable mechanism for companies that provide their investors with high quality financial reporting.

First published July 3, 2000.