Sarbanes Oxley Origins
sarbanes oxley origins
Does Sarbanes-Oxley preclude corps from recognizing revenue at shipping point end with FOB Origin terms?
I am being told by Auditors that with out customer acceptance I cannot recognize revenue. Our point is that in the past our acceptance by customer of the product is 99.9% and I am that sure that end of period shipments will be accepted.
The basic fundamental of revenue recognition is Statement of Accounting Concept (CON) 5, which states that revenue should not be recognized before both the following occur:
1) Revenue is realized or realizable (products / services exchanged for cash or claims to cash)
2) Revenue is earned (performance obligations are substantially complete).
CON5 establishes fundamental concepts but there is no overarching revenue recognition standard building on this. Therefore, there is a great deal of authoritative literature developed on an ad-hoc basis.
SAB104 which was drafted by SEC buids on CON 5 fundamental which states SEC’s views that revenue is not realized and earned until all of the following criteria are met:
1) Persuasive evidence of arrangement exists
2) Delivery has occurred or services have been rendered
3) Seller’s fee is fixed and determinable
4) Collectibility is assured.
In your case, clearly the matter being disputed is number 2 – “delivery has occurred or services have been rendered”. Delivery generally occurs when customer has taken title and assumes the risks and rewards of ownership. Some foreign jurisdisctions, however, may not require title transfer. For product sales, delivery and performance typically occurs when a product reaches customer’s site (FOB destination) or when shipped (FOB shipping point).
However, revenue recognition is not allowed even if title passes, if:
1) reliable estimates of returns cannot be made pursuant to FAS48
2) arrangement is a product financing arrangement
Customer acceptance, however, is a mandatory for revenue recognition. Existence of customer acceptance provisions, generally presumed to be substantive, bargained-for-term of an arrangement, requires DEFERRAL of revenue until either:
1) evidence of acceptance is received or
2) acceptance provisions have lapsed.
Judgment is required when assessing whether customer acceptance has been received.
There are generally four general forms of customer acceptance provisions:
1) For trial or evaluation purposes (e.g in life science companies, drugs are provided to customers on a trial-and-return basis)
2) Provides a right of return or exchange based on subjective matters (e.g change of mind)
3) Based on seller-specified objective criteria (seller warrants that the product is going to perform what it says it would)
4) Based on customer-specified objective criteria
There are four differring treatment for the above:
1) For trial-and-return, revenue recognition should be deferred until the earlier of when acceptance occurs or the lapse of acceptance provisions.
2) For rights of return / exchange based on subjective matters, revenue can be recognized provided the rate of return can be estimated and factored in as ‘return provision’ in accordance with FAS48.
3) For seller-specified objective criteria, revenue can be recognized provided provided a warranty provision is also recognized in accordance with FAS5.
4) For customer-specified objective criteria, formal customer sign of provides the best evidence that these acceptance criteria have been met, BUT it’s not always required. Revenue can be recognized upon shipment if the seller understands customer’s objective criteria AND know that the products can meet such criteria and as such satisfy the customer and results in meeting the acceptance criteria.
Therefore, you have to ask yourself, ‘what is the deal breaker?’ i.e what could result in the goods being returned? It would fall under one of the four categories above and then apply accounting treatment accordingly.
For example, if the customer acceptance is not achieved due to subjective matter, then you can go back and analyse the historical return rate, and then apply that rate to come up with a (judgmental) return provision, which effectively reduces the revenue that you recognized, but at least at this point you are able to recognize the revenue.
In the absence of historical rate of return or warranty rate which would result in your inability to predict the appropriate provisions, unfortunately you will have to defer revenue until the products are duly accepted by the customers.
Hope this helps!
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