Revenue Recognition Accounting For Arrangements:

What You See (Or UCC) And What You Don’t See

Daniel V. Dooley*

Revenue Recognition Accounting Sine Qua Non

Staff Accounting Bulletin No. 101

The Securities and Exchange Commission (“SEC”) staff (“Staff”) has issued Staff
Accounting Bulletin (“SAB”) No. 101 – Revenue Recognition in Financial Statements,
which sets forth the Staff’s interpretation of generally accepted accounting principles
(“GAAP”) governing accounting for revenue recognition in financial statements of SEC
registrants.1 The guidance in SAB No. 101 principally sounds in contract law, that is to
say – accounting for arrangements, creating express or implied contracts between sellers
and buyers, for the exchange of consideration (usually goods and/or services for cash,
cash equivalents, rights to receive cash, or other assets). The four basic revenue
recognition criteria set forth in SAB No. 101 are:

‰ Persuasive evidence of an arrangement exists.

‰ Delivery has occurred or services have been rendered.

‰ The seller’s price to the buyer is fixed or determinable.

‰ Collectibility is reasonably assured.

Thus, SAB No. 101 applies accounting principles or practices to elements of contract
law, including: assent; reality of consent; agency; consideration; promises and covenants;
and discharge and remedies. But, accounting recognition, under SAB No.101 does not
necessarily follow legal recognition of contracts – as to timing, or the earning of
consideration by seller, or the recognition of obligations to (or rights of) buyer. While
framed in the context of business arrangements that sound in contract law, accounting
rules do not always follow the legal rules.

Generally Accepted Accounting Principles

SAB No. 101 does not establish GAAP; rather, it provides the Staff’s views in applying
GAAP to selected revenue recognition issues. In fact, SAB No. 101 expressly states:

* Daniel V. Dooley is a Partner in the firm of PricewaterhouseCoopers LLP and leads the
firm’s Securities Litigation Consulting Practice.
1
17 CFR Part 211 (Amend.), Subpart B, Topics 13, 13-A and 8-A.

1
“This Staff Accounting Bulletin is not intended to change current guidance in the
accounting literature.”2 Underlying U.S. GAAP is established by: the Financial
Accounting Standards Board (“FASB”) or its predecessor, the Accounting Principles
Board (“APB”); the American Institute of Certified Public Accountants (“AICPA”) and
its Accounting Standards Executive Committee (“AcSEC”); and, the Emerging Issues
Task Force (“EITF”) of FASB.3 The basic concept of revenue recognition is set forth in
FASB Statement of Financial Accounting Concept (“CON”) No. 5, Recognition and
Measurement in Financial Statements of Business Enterprises.4 CON No. 5, ¶ 83 states:

“Revenue and gains of an enterprise during a period are generally measured by

the exchange of values of the assets (goods or services) or liabilities involved, and
recognition involves consideration of two factors, (a) being realized or realizable
and (b) being earned ….

a. Realized or realizable. Revenues and gains are not recognized until

realized or realizable. Revenues and gains are realized when products
(goods or services), merchandise, or other assets are exchanged for cash or
claims to cash. Revenues and gains are realizable when related assets
received or held are readily convertible to known amounts of cash or
claims to cash [e.g., accounts receivables] …

b. Earned. Revenues are not recognized until earned. An entity’s revenue-

earning activities involve delivering or producing goods, rendering
services, or other activities that constitute its major or central operations,
and revenues are considered to be earned when the entity has substantially
accomplished what it must do to be entitled to the benefits represented by
the revenues … .”

CON No. 5, ¶ 84 (a) states:

“The two conditions (being realized or realizable and being earned) are usually
met by the time the product or merchandise is delivered or services are rendered
to customers, and revenues from manufacturing and selling activities and gains

2
See SAB No.101, Topic 8-B.
3
The hierarchy of GAAP is described in AICPA Statement on Auditing Standard (“SAS”) No. 69,
The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles in the
Independent Auditor’s Report. See SAS No. 69 (AU§§ 411.05 (a)-(d), .07, and .11).
4
Statements of Financial Accounting Concepts are issued by FASB and establish a framework of
accounting fundamentals and objectives. Unlike FASB Statements of Financial Accounting Standards
(“SFAS”) or Accounting Principles Board Opinions or EITF Issues or AICPA Accounting and Auditing
Guides (“AAG”), CONs do not establish standards prescribing accounting principles. Thus, CONs do not
constitute authoritative pronouncements of GAAP unless there is an absence of higher GAAP authority, in
which case CONs may constitute GAAP, as stated in AICPA SAS No. 69 ¶ 11: “In the absence of a
pronouncement [e.g., SFAS, APB, EITF Issue or AAG] … the auditor of financial statements may consider
other accounting literature … for example, FASB Statements of Financial Accounting Concepts …”

2
and losses from sales of other assets are commonly recognized at the time of sale
(usually meaning delivery).”

GAAP promulgates specific authoritative pronouncements that apply the conceptual

guidance of CON No. 5, ¶¶ 83 and 84. Among these are:

‰ AICPA Statement of Position (“SOP”) 97-2, Software Revenue Recognition.5

‰ FASB SFAS No. 48, Revenue Recognition When Right of Return Exists.6

‰ FASB SFAS No. 13, et seq., Accounting for Leases.

‰ FASB SFAS No. 45, Accounting for Franchise Fee Revenue.

‰ FASB SFAS No. 49, Accounting for Product Financing Arrangements.

‰ FASB SFAS No. 66, Accounting for Sales of Real Estate.

‰ Accounting Research Bulletin (“ARB”) No. 43, Restatement and Revision of

Accounting Research Bulletins, (Ch. 1a) and ARB No. 45, Long-Term
Construction-Type Contracts,7 and AICPA SOP 81-1, Accounting for
Performance of Construction-Type and Certain Production-Type Contracts.8

‰ FASB SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated
With Originating or Acquiring Loans and Initial Direct Costs of Leases.9

‰ FASB SFAS No. 5, Accounting for Contingencies.10

5
An AICPA SOP is an authoritative pronouncement issued by AcSEC.
6
FASB SFAS No. 48 specifies how an enterprise should account for sales of its products in which
the buyer has a right to return or exchange the product and in other circumstances when the seller’s price to
the buyer may not (yet) be fixed or determinable.
7
Accounting Research Bulletins precursed APBs and also constitute GAAP when not superseded
by any APB or FASB SFAS.
8
Collectively, ARB Nos. 43 (Ch. 1a) and 45 and AICPA SOP 81-1 establish the “percentage-of-
completion,” “cost recovery,” and “completed contract” methods for accounting for long-term contracts
involving construction, production and delivery of goods (or, in certain circumstances, services) over
periods that usually exceed one year.
9
While FASB SFAS No. 91 nominally deals with revenue recognition in the financial services
industry, in SAB No.101, the Staff have interpreted SFAS No. 91, as analogous GAAP, to apply to
nonrefundable fee arrangements in all other industries, absent specific authoritative GAAP to the contrary.
See SAB No. 101, Topic 13 (A) (3), “Delivery and Performance,” Question 5 and Interpretive Response.
10
FASB SFAS No. 5 is seminal GAAP that governs accounting for loss contingencies (e.g.,
allowance for doubtful accounts and sales returns allowances) which in turn implicates realizability under
CON 5 and the revenue recognition criteria set forth in FASB SFAS No. 48 and AICPA SOP 97-2.

3
Many other GAAP authoritative pronouncements establish industry-specific revenue
recognition accounting guidance.11 Also, the special circumstance of non-monetary
exchanges, and revenue recognition criteria relating thereto is addressed in APB No. 29,
Accounting for Nonmonetary Transactions. And, there is GAAP - established in the
interstices of FASB SFAS, APBs, SOPs, and AAGs and applicable to specific
circumstances of revenue recognition - set forth in myriad EITF Issues, FASB
Interpretations (“FIN”); FASB Technical Bulletins (“FTB”), and APB Interpretations
(“AIN”)12 Literally, there is GAAP for all occasions; and, in certain circumstances and
for certain transactions, the confluence of applicable GAAP can be difficult to interpret.

For the large majority of revenue transactions, the basic recognition template is:

Do not recognize revenue

If contract normally is until the arrangement is
used, is there a signed No
signed. [Timing and
arrangement executed Persuasive Evidence
by both parties (i.e., Arrangement Exists]
buyer and seller)?

Yes
Is the arrangement Do not recognize revenue
actually dated and until the accounting period
No
executed (not just in which contract actually is
effective) on or before executed. [Timing]
the end of the
accounting period?
Yes

11
See, inter alia: FASB SFAS Nos. 50, Financial Reporting in the Record and Music Industry; 51,
Financial Reporting by Cable Television Companies; 53, Financial Reporting by Producers and
Distributors of Motion Picture Films; 60, Accounting and Reporting by Insurance Enterprises; 63,
Financial Reporting by Broadcasters; 65, Accounting for Certain Mortgage Banking Activities; 68,
Research and Development Arrangements; and AAGs, such as “Banking and Savings Institutions,”
“Insurance,” “Audits of Entities With Oil and Gas Producing Activities,” “Audits of Federal Government
Contractors,” “Audits of Property and Liability Insurance Companies” “Construction Contractors,” and
“Brokers and Dealers in Securities.”
12
See FASB Original Pronouncements (1998/1999 Ed.), Accounting Standards, Vol. I and II for the
most current index of accounting pronouncements and a topical index cross-referenced to: “Original
Pronouncement(s),” “Current Text,” and EITF and Other [pronouncements, if applicable].” The FASB
Original Pronouncements Accounting Standards volumes usually are updated annually, as of June 30th. In
between updates notice of new authoritative guidance is given in the AICPA Journal of Accountancy and
FASB Status Reports and also may be found at: www.rutgers.edu/Accounting/raw/fasb (FASB website);
or, www.sec.gov (SEC website, which also provides access to SEC Rules and proposed Rules, SABs,
Accounting Series Releases and Litigation Series Releases, as well as recent and archived speeches and
writings of Staff and SEC Commissioners)

4

Has delivery No
occurred?
Yes
Has customer accepted No
delivery, ownership
and economic risk?
Yes
If “right of return” No
exists, have the criteria
No
set forth in FASB
SFAS No. 48, ¶ 6 (a) –
(f) been met?
Yes
If right of return
exists, and FASB
SFAS No. 48, ¶ 6 (a) –
(e) criteria are met, is
the amount of future
returns estimable
under guidance set No
forth in FASB SFAS
No. 5 and FASB
SFAS No. 48, ¶¶ 7 and
8?
Yes
Not only is evidence of
shipment to the customer
required, but also terms
(e.g., FOB destination) may
affect timing of recognition.
Delivery to third parties,
freight forwarders, and
warehouses generally does
not qualify. [Timing,
Delivery and Acceptance]
FASB SFAS No. 48, ¶ 6
revenue recognition criteria,
when right of return exists,
are: (a) seller’s price to
buyer is substantially fixed
or determinable at date of
sale; (b) buyer has paid, or
is obligated to pay, seller
and the obligation is not
Allowance for contingent on resale of the
sales returns product; (c) buyer’s
and other obligation to pay would not
“right of
change in the event of theft,
return” credits physical destruction or
and
damage of the product
adjustments (economic/insurance risk
must be
has passed to buyer); (d)
reasonably buyer has economic
estimable
substance apart from that
based on provided by seller; (e) seller
historical
does not have significant
experience, obligation for future
evaluation of performance to directly
current events bring about resale of the
and likely product by the buyer; and
future (f) the amount of future
circumstances returns can be reasonably
and other estimated. If one or more of
relevant facts – these criteria are not met,
absent which, defer revenue recognition
revenue until right of return expires
recognition is or all of the criteria are met.
deferred. [Price Determinable and
Contingency]
5
If the arrangement
provides for delivery
of separate elements
(i.e., of products or
services), and such
deliveries are not
completed, or No
delivered to the
customer, at date of
sale, can the prices of
such elements be
separately fixed or
determinable based
upon vendor specific
objective evidence?
Yes
Does the arrangement
constitute all, or in
part, delivery of a
“subscription” service
(e.g., for license or Yes
content updates, for
maintenance, etc.)
No
Does the arrangement
include nonrefundable
up-front fees paid to
Yes
the seller?
No
If a credit sale, is
receivable reasonably
assured of collection
Yes
(i.e., realizable) in the
ordinary course and
not due beyond twelve
months of sale?
No
6
Absent the ability to
separately fix the price of
multiple elements of the
contractual consideration
due buyer by seller,
supported by competent
VSOE subject to audit,
revenue must be deferred
and recognized either: (a)
on a “percentage of
completion” basis, if
applicable under SOP 81-1
or SOP 97-2, or (b) ratably,
over the term of the
contract, or (c) when
deliveries of all significant
elements of
products/services are made.
[Price Fixed or
Determinable]
Account for ratably over the
term of the arrangement.
[Delivery and Continuing
Obligation]
Generally, under SAB No.
101, such fees may be
required to be recognized
ratably over the term of the
arrangement.
[Delivery, Continuing
Obligation and Price
Fixed and Determinable]
Sale does not meet the
realizability criteria of CON
No. 5, or SOP 97-2, or
FASB SFAS No. 48, ¶ 6 (b)
and (d), and recognition of
revenue should be on the
basis of cash received.
[Realizability]
 Are costs properly
accrued and matched
with revenue in In the case of significant
respect of any No continuing obligation,
remaining obligation revenue may be required
of seller? to be deferred. For
“percentage-of-
completion” accounting,
Yes revenue recognition
requires that associated
costs must be reasonably
estimable and measurable.
For insignificant
remaining vendor
Does the transaction obligations, revenue may
involve non-monetary be recognizable if such
consideration from insignificant costs can be
Yes estimated and accrued.
buyer to seller that
does not meet the [Matching and
immediate recognition Continuing Obligation]
criteria of CON 5, ¶ 83
and APB No 29, ¶¶ 21
and 22?
Defer revenue recognition
until asset(s) received are
realizable (e.g., “sell-
No through” has occurred).
[Realizability and
Earned]
Recognize Revenue
If, by this stage in the
process, there is anything
left to recognize at date of
sale.

Implications of SOP 97-2 For the Basic Revenue Recognition Template

Although not fully acknowledged by SAB No. 101, the revenue recognition template that
it adopts derives primarily from AICPA SOP 97-2, notwithstanding the fact that this SOP
was promulgated only in respect of “when revenue should be recognized, and in what
amounts, for licensing, selling, leasing or otherwise marketing computer software.”13

13
See AICPA SOP 97-2, ¶ 2, which also states: “It [AICPA SOP 97-2] does not apply, however, to
revenue earned on products or services containing software that is incidental.”

7
The Staff of the SEC interprets GAAP, as set forth in SAB No. 101, to apply the
principles and practices promulgated in AICPA SOP 97-2 to revenue recognition
accounting in other industries and in respect of other types of revenue, by use of
“accounting transitivity,” direct invocation of relevant GAAP, and analogy, as follows:

‰ Accounting transitivity. AICPA SOP 97-2 (or, “A”) is based upon accounting
concepts and principles set forth in, inter alia: FASB CON No. 2, Qualitative
Characteristics of Accounting Information; CON No. 5; FASB SFAS Nos. 5 and
48; ARB Nos. 43 and 45; and AICPA SOP 81-1 (collectively, “C”). Likewise,
The Staff bases SAB No. 101 (or, “B”), in the main, on CON Nos. 2 and 5; FASB
SFAS Nos.5 and 48; ARB Nos. 43 and 45; and AICPA SOP 81-1. By transitivity,
if A = C and B = C, then A = B.

‰ Direct invocation of relevant GAAP. Certain GAAP, particularly FASB SFAS

No. 48, overarches all revenue recognition accounting. Rights of return are not
limited to sales of software, and as defined by FASB SFAS No. 48, a right of
return includes any transaction where: “[A] product may be returned, whether as a
matter of contract or as a matter of existing practice, either by the ultimate
customer of by a party who resells the product to others. The product may be
returned for a refund of the purchase price, for a credit applied to amounts owed
or to be owed for other purchases, or in exchange for other products.”14 Under the
broad principles established by FASB SFAS No. 48, this authoritative
pronouncement creates seminal GAAP that underpins virtually every other
authoritative pronouncement dealing with revenue recognition accounting.

‰ Analogy. AICPA SAS No. 69, permits the use of “analogous GAAP” where no
specific GAAP can be found on point. This is the case, in SAB No. 101, where
the Staff invokes FASB SFAS No. 91 – issued to address accounting for
nonrefundable up-front fees by financial services entities – to apply to similar
nonrefundable up-front fees in industries as diverse as: telecommunications,
biotechnology, software, membership clubs and education services.

The fundamental principles of AICPA SOP 97-2 are exactly the same as those set forth in
SAB No. 101, namely:15

‰ Persuasive evidence of an arrangement exists.

‰ Delivery has occurred.

‰ The vendor’s fee is fixed or determinable.

‰ Collectibility is probable.

14
See FASB SFAS No. 48, ¶ 3.
15
See AICPA SOP 97-2, ¶ 8.

8
Specific details of the revenue recognition criteria in AICPA SOP 97-2 cross over into
SAB No.101 in a number of key areas, and the original intent of SEC interpretation in
SAB No. 101 usually can be found in the guidance and background writings of AICPA
SOP 97-2, as the following examples demonstrate.

Both AICPA SOP 97-2 and SAB No. 101 mandate that persuasive evidence of an
arrangement be a contract signed by both parties, where the vendor has a customary
business practice of utilizing written contracts.16 Both condition revenue recognition on
the occurrence of product delivery or the rendering of the services contracted for. Except
in special circumstances, such delivery must be to the customer (either the ultimate user
or the reseller).17 SAB No. 101 and AICPA SOP 97-2 interpret delivery to require that the
customer has taken title and assumed the risks and rewards of ownership. SAB No. 101
also makes the point that where terms are “FOB destination” delivery has not occurred
until the product is delivered to the customer’s delivery site, while for arrangements with
terms of “FOB shipping point”, delivery typically occurs when the product actually is
shipped to the customer.18

16
See id., at ¶ 16. Where a vendor operates in a manner that does not rely on signed contracts other
forms of persuasive evidence are required to document the arrangement (e.g., a purchase order from a third
party or on-line, E-commerce, authorization).
17
For the most part, delivery to intermediaries such as freight forwarders, warehouses or other third
parties does not qualify as delivery under either AICPA SOP 97-2 or SAB No. 101. In SAB No. 101, the
Staff recites the criteria established in Accounting and Auditing Enforcement Release (“AAER”) No 108
(August 5, 1986) for revenue recognition in “bill and hold” arrangements, where delivery has not occurred.
These criteria are:

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 writing;
3. The buyer, not the seller, must request that the transaction be on a “bill and hold” basis; and the
buyer must have a substantial business purpose for ordering the goods on a “bill and hold” basis;
4. There must be a fixed schedule for delivery of the goods; the date(s) for delivery must be
reasonable and consistent with the buyer’s business purpose (e.g., customary storage periods);
5. The seller must not have retained any specific performance obligations such that the earnings
process is not complete;
6. The ordered goods must be segregated from the seller’s inventory and not be subject to being used
to fill other orders; and,
7. The product must be completed and ready for shipment.

All of the above criteria must be met, as a threshold, for revenue recognition; however, the Staff advises
that other criteria may be applicable, depending upon facts and circumstances, and even if such criteria are
met, revenue recognition may not be appropriate. The practical implications of AAER No. 108 and SAB
No. 101 are that revenue recognition for “bill and hold” transactions is a fool’s errand. Post hoc virtually
any “bill and hold” arrangement can be found by the Staff of the Division of Enforcement of the SEC) to
violate GAAP, generally, and one or more of the above criteria.
18
See SAB No. 101, Topic 13 (A) (3), Question 3 and Interpretive Response. Where multiple
product elements are to be delivered, revenue recognition must be deferred for such elements to be
delivered at later dates (until delivery actually has occurred), if the pricing of such elements can be fixed or
determinable. Absent the ability to separately fix or determine the price of undelivered product elements,
based upon VSOE, revenue recognition may require deferral until all elements are delivered.

9
In respect of customer acceptance, AICPA SOP 97-2 states: “After delivery, if
uncertainty exists about customer acceptance of the software, license revenue should not
be recognized until acceptance occurs.”19 SAB No. 101 restates the same requirement,
and expands upon it to describe types of customer acceptance contractual provisions that
the Staff would interpret as delaying revenue recognition (until acceptance has occurred
or the provisions have lapsed), including customer rights to: (1) test the product; (2)
require the seller to perform additional services subsequent to delivery (e.g., installation
or activation); or (3) identify other work necessary to be done before accepting the
product.20

Both AICPA SOP 97-2 and SAB No. 101 address the criteria of price fixed or
determinable, but AICPA SOP 97-2 provides much more specific guidance regarding
“multiple element” arrangements. This is because of the nature of many software
licensing transactions where the arrangement s call for: (a) delivery of multiple elements
of hardware, software, or both; (b) upgrade rights over the term of the arrangements (i.e.,
the right of the customer to receive subsequent versions or releases of the software); (c)
“maintenance” services bundled with the initial software license; and/or (d) provision of
other forms of post-contract support (“PCS”). AICPA SOP 97-2 describes a wide variety
of PCS and multiple element terms typical to software arrangements, including:21

‰ Vendor’s obligations for additional software deliverables and rights to exchange

or return software.

‰ Upgrade rights or buyer’s right to receive additional software, if and when,

developed.

‰ Buyer’s rights to receive software maintenance and other PCS.

‰ Bundled installation, training or integration services.

The basic criteria of revenue recognition for such multiple element arrangements are: (a)
ability to determine the respective pricing (i.e., fair value) of elements, based upon
VSOE; (b) separate description of the services and other elements in the contract, so that
the total price of the arrangement would be expected to vary based upon inclusions or
exclusion of one or more of such elements; and (c) the fact that such services or other
elements are not essential to the functionality of any other element(s) of the

19
See AICPA SOP 97-2, ¶ 20.
20
See SAB No. 101, Topic 13 (A) (3), supra. The Staff’s examples of customer acceptance
contingencies are by no means exclusive. Other commonly found acceptance terms include: trial periods;
acceptance dependant upon training, obtaining financing, “board approval,” or the product achieving stated
performance measures.
21
See AICPA SOP 97-2, ¶¶ 34-66.

10
arrangement.22 Typically, objective evidence of the price for disaggregated, or
unbundled, elements is based upon sales of such individual elements to third parties. For
example, VSOE for maintenance might be determined by the prices charged the customer
(or other) for separate maintenance contracts of the same type and providing similar
coverage. AICPA SOP 97-2 notes that the fair value of separate elements may not
necessarily be represented by individual prices for such elements that actually are stated
in the contract. In the event of a failure to meet all of the criteria of AICPA SOP 97-2, ¶
65, the entire fee arrangement should be recognized only as the service elements are
performed, if a pattern of performance is discernable (e.g., by “milestones), or on a
straight-line basis over the term of the services (or other elements’ delivery) obligation.23

Both SAB No. 101 and AICPA SOP 97-2 address the other major type of price fixed or
determinable revenue recognition criteria – contingencies relating to vendor refunds,
other express or implied rights of return granted to the buyer, customer cancellation
privileges, or other circumstances in which buyer may not be obligated to pay the stated
sales amount. Examples of such contingencies that might violate the criteria of price fixed
or determinable include:

‰ Unusually long credit terms.24

‰ Cancellation rights.

‰ Pricing and total amount of the transaction based upon the number units of
product(s) distributed.

‰ Other “variable-pricing” arrangements in which the buyer has the right to

allocate the arrangement fee (or sales amount) among different specified
products, with different stated prices, covered by the arrangement.25

‰ Uncertainties concerning buyer’s ultimate obligation created by volume rebate

terms, “most favored nation” price adjustment clauses, cooperative advertising
or other marketing contribution clauses, etc.

22
See AICPA SOP 97-2, ¶ 65.
23
See id., at ¶ 67.
24
Usually, credit terms of over 12 months from date of sale preclude immediate revenue recognition.
Such long terms imply that payment is dependent upon buyer’s ultimate resale of the product to third
parties and/or that buyer’s are likely to return unsold product for credit against their payment obligations
rather than make payment when the long-term receivable eventually comes due.
25
Because the actual mix of prices and quantities of products taken by the customer may not be
known until delivery is complete for all products covered by the arrangement, prices of the multiple
product elements may not be fixed or determinable.

11
 ‰ Uncertainties, based upon business practice, buyer history, or other factors (e.g.,
channel capacity) which indicate a likelihood that buyer’s payment to seller is
contingent on one or more future events (e.g., “sell-through”).

The realizability concept in FASB CON 5, ¶¶ 83 and 84, is applied in both SAB No. 101
and AICPA SOP 97-2 to mean, respectively: “Collectibility is reasonably assured,” and
“Collectibility is probable.”26 In defining “probable,” the AICPA AcSEC refers to the
same definition as used in FASB SFAS No. 5, which is: “The future event or events [i.e.,
collection of the account receivable arising from the sales transaction] are likely to
occur.”27 In SAB No. 101, the Staff support the criteria of “reasonably assured by citing
ARB No. 43 (Ch. 1a),28 APB NO. 10,29 and CON No. 5, ¶ 84 and AICPA SOP 97-2
(referred to above). However, nowhere in the literature cited by SAB No. 101 or AICPA
SOP 97-2 is the conceptual criteria of realizability defined or established as an
affirmative probability or assurance that collection will occur. Rather, the underlying
accounting concept and GAAP express the criteria in negative terms of loss probability or
doubt of collection. This nuance, though subtle, makes a substantial difference in
meaning and application of both AICPA SOP 97-2 and SAB No. 101. If the burden falls
on the side of proving that collection is probable, then it follows under that definition in
FASB SFAS No. 5 (interpreted by EITF Issue No. 95-5) that collectibility must be judged
likely, perhaps by odds of six, or seven, out of ten. But, if the burden falls on the side of
proving that collection is doubtful, then it follows under the same definitions that non-
collectibility must be judged likely, again perhaps by odds of six, or seven, out of ten.
The interstices between affirmative or negative burdens well might represent a significant
difference in weight of evidence required to meet these different burdens of proof.30

Accounting For Multiple-Element Arrangements

Imagine a contractual arrangement to sell software and related services bundled together
at one price. This is the common form of many software revenue recognition
transactions, whether the multiple elements are express or implied obligations, under the

26
See SAB No. 101, Topic 13 (A) (1) and AICPA SOP 97-2, ¶ 8.
27
See AICPA SOP 97-2, n. 5, citing FASB SFAS No. 5, ¶ 3 (a). But, see also EITF Issue 93-5,
Accounting for Environmental Liabilities, wherein the term “probable” is said to mean, in general practice,
“more likely than not,” and is expressed quantitatively (e.g., 60%-75%).
28
See ARB No. 43 (Ch. 1a), ¶ 1: “Profit is deemed to be realized when a sale in the ordinary course
of business is effected, unless the circumstances are such that collection of the sale price is not reasonably
assured [emphasis added].”
29
See APB No. 10, ¶ 12, which only cites ARB No. 43 (Ch.1a), ¶ 1 as referenced in n. 29 above.
30
“Doubtful accounts” in the context of FASB CON No. 5, ¶ 84, means a loss accrual, reflecting
allowance for uncollectible accounts receivable assets arising from sales, and as such is subject to the loss
accrual criteria set forth in FASB SFAS No.5, ¶ 8 (a) and (b) and the proscription against “reserves for
general contingencies” stated in FASB No. 5, ¶ 14. Thus, a reasonable case could be made for defining
realizability (i.e., collectibility) as the absence of persuasive evidence that impairment of the account
receivable is probable.

12
contract, to the customer. Now remember the second prong of the two-part revenue
recognition test in CON No.5, ¶ 83: “… [R]evenues are considered to be earned when the
entity has substantially accomplished what it must do to be entitled to the benefits
represented by the revenues … [emphasis added].” What a seller must do may be spelled
out in the contract, or it may be set forth in “side letters” to the contract, or it may obtain
by oral promises made by the entity’s agent, acting with stated or apparent authority, or it
may adhere through performance. If the arrangement calls for: (1) delivery of some
product elements now; (2) delivery of some product elements later; (3) services provided
for set-up, training, and testing; (4) integration and other services; (5) maintenance
services over several years; (6) general, or specified up-grade rights, for free or at stated
prices; and (7) in specific circumstances, rights of return or refund or price adjustment –
then these are vendor’s obligations (or buyer’s rights) and “what [vendor] must do to be
entitled to the benefits represented by the revenues.” Depending upon facts and
circumstances, each of the aforementioned types of elements may require different
accounting treatment – as to timing of revenue recognition, amounts to be recognized in
respective accounting periods, and accounting method for accrual as revenue.

In this hypothetical situation, assuming that functionality of any product element was not
critically inter-dependent and assuming that all elements could be fair-valued and
described separately, the following revenue recognition accounting might apply ($000):

Elements Key

1. Product, A Sys v2.0, GA and delivered at date of sale.

2. Product, B Sys v1.0, not GA for six months.
3. Set-up, training and testing, priced separately.
4. Integration of A Sys and B Sys into customer’s GL Sys, priced separately.
5. Maintenance services (not covering up-grades) for two years.
6. Upgrade rights for 2.1, if and when delivered, priced separately.
7. Right of refund of 20% of initial price of A Sys v.2.0 and, if customer buys
additional $1 million of product elements within next two years.

Recognize Revenue
Estimated At Sale / When When/As Ratably When
VSOE Delivery/ GA and Services Over Term Contingency
Elements Fair Value Acceptance Delivered Rendered Obligated Expires*
1. $ 1,000 $1,000
2. 500 $500
3. 100 $100
4. 400 400
5. 600 $600
6. 100 100
7. <200> < 200> _____ _____ ____ $200
$ 2,500 $ 800 $600 $500 $600 ?*

* If contingency expires, unused revenue may be recognized on unused refund credit.

13
Within one bundled contract, fair-valued at $2.5 to $2.7 million (depending upon whether
the rebate will be earned by the buyer), seven different contractual and accounting
elements obtain and require separate accounting treatments. What could be simpler?
What could go wrong?

1. Regarding product delivered on or around date of sale, being recognized as

revenue in the instant accounting period.

‰ This product may not be separately priced or able to be priced separately,

requiring that revenue only be recognized when all other significant
product elements are delivered (or ratably over the term of the
arrangement).31

‰ Functionality of this product may be critically dependant upon one or

more as yet undelivered product element(s), requiring that revenue
recognition be deferred until delivery and acceptance has occurred.32

‰ Acceptance (both de jure and de facto) must have taken place. Such
acceptance may be affected by:

ƒ Product return or sale cancellation periods;33

ƒ Contractual terms establishing “provisional acceptance” criteria;
ƒ The term, and enforceability, of payment obligations;34 or,
ƒ Performance, testing, or other acceptance criteria established by
contract.

‰ The relative prices of the multiple elements may not be supportable by

VSOE.

31
See AICPA SOP 97-2, ¶¶ 10, 12 and 65.
32
See Id., at ¶ 13: “[T]he delivery of an element is not considered to have occurred if there are
undelivered elements that are essential to the functionality of the delivered element, because the customer
would not have the full use of the delivered element.”
33
See Id., at ¶ 14: “No portion of the fee (including amounts otherwise allocated to delivered
elements) meets the criteria of collectibility if the portion of the fee allocable to delivered elements is
subject to forfeiture, refund or other concession if any of the undelivered elements are not delivered.” See
also Id., at ¶ 26: “[I]f an arrangement includes (a) rights of return or (b) rights to refund without return of
the software, FASB Statement No. 48 requires that conditions that must be met in order for the vendor to
recognize revenue include that the amount of future returns or refunds can be reasonably be estimated.”
34
See Id., at ¶28: “[A]ny extended payment terms in a software licensing arrangement may indicate
that the fee is not fixed or determinable. Further, if payment of a significant portion of the software
licensing fee is not due until after expiration of the license or more than twelve months after delivery, the
licensing fee should be presumed not to be fixed or determinable.” See also Id., at ¶ 27: “Because a
product’s continuing value may be reduced due to the subsequent introduction of enhanced products by a
vendor or its competitors, the possibility that the vendor still may provide a refund or concession to a
creditworthy customer to liquidate outstanding amounts due under the original terms of the arrangement
increases as payment terms become longer.”

14
 ‰ Any cancellation period (other than obligations relating to warranties for
defective software or similar obligations that are routine, short-term and
relatively minor) must have lapsed, or been waived by the customer,
before related license fees are considered to be fixed or determinable.35

2. Regarding product not yet GA, to be delivered subsequently:

‰ If the product to be delivered is an up-graded version of the product

delivered on or around date of sale (e.g., with enhanced functionality, new
features, etc.), this begs the question, “Was the customer really buying
(and intending to use) the earlier version?” Indications that customer
acceptance actually is tied to subsequent delivery of the other (not yet GA)
product may include:

ƒ Payment terms that extend beyond the promised delivery date for
the product up-grade;
ƒ Absence of evidence of installation or use of the earlier version
of the product;
ƒ Refund terms that forfeit substantially all of the amount of the
arrangement (or of the amount allocated to the delivered earlier
version of the product) if delivery and acceptance of the up-
graded version of the product does not occur.

‰ The product to be delivered must not be critical to the functionality of the

product(s) delivered on or around date of sale, otherwise customer
acceptance is deemed not to have occurred, and revenue recognition must
be deferred until delivery and acceptance of all functionality-
interdependent product elements.

‰ The product is separately described, separately priced, and such price is

supported by VSOE.

‰ The customer’s right to receive additional software is not in the nature of a

subscription.36

‰ The product is not actually part of PCS (which should be described and
priced separately, and should be supported by VSOE).

35
See FASB SFAS No. 5, ¶¶ 24-25. See also FASB SFAS No. 48, ¶¶ 3 and 6-8.
36
As part of a multiple-element software arrangement, a vendor may agree to deliver software
currently and unspecified additional software products in the future (where such deliverables are not merely
Post Contract Support, or “PCS,” upgrades, enhancements or minor “bug-fixes” relating to currently
delivered products). Such an arrangement should be accounted under the subscription method; no
allocation may be made among the current and potential future products in the arrangement, and generally,
revenue should be recognized ratably over the term of the arrangement beginning with delivery of the first
product.

15
 3. In respect of service(s) element(s) for set-up, installation, training.
4. In respect of service(s) element(s) for system(s)’ integration.

‰ Can the services be accounted for separately, under AICPA SOP 97-2, ¶
65 (i.e., separately described, separately priced and supported by VSOE)?

‰ Are the software elements of the arrangement, to which these services

apply, core or off-the-shelf?37

‰ Are the services also available from other vendors?

‰ Are the services primarily implementation services, such as

implementation planning, loading of software, training of customer
personnel, data conversion, building simple interfaces, running test data,
and assisting in the development and documentation of procedures?38

‰ Do the services carry any undue risk or unique acceptance criteria?

5. In connection with maintenance services.

6. In connection with PCS services and related obligations to provide up-grades,
“bug-fixes,” etc.

‰ Services must be separately described, priced and supported by VSOE.

37
See AICPA SOP 97-2, ¶¶ 68-69: “Core software … is not sold as is because customers cannot use
it unless it is customized to meet system objectives or customer specifications. Off-the-shelf software is
software that is marketed as a stock item that can be used by the customer with little or no customization…
Software should be considered off-the-shelf if it can be added to the arrangement with insignificant changes
in the underlying code and it could be used by the customer for the customer’s purposes upon
installation…. If significant modifications or additions to the off-the-shelf software are necessary to meet
the customer’s purpose (for example changing or making additions to the software, or because it would not
be usable in its off-the-shelf form in the customer’s environment), the software should be considered core
software for purposes of that arrangement …. [and] no element of the arrangement would qualify for
accounting as a service, and contract accounting [i.e., under AICPA SOP 81-1] should be applied to both
the software and service elements of the arrangement. See also AICPA SOP 97-2, ¶ 70: “Factors indicating
that the service element is essential to the functionality of the other elements of the arrangement, and
consequently should not be accounted for separately, include the following.

• The software is not off-the-shelf software.

• The services include significant alterations to the features and functionality of the off-the-shelf
software.
• Building complex interfaces is necessary for the vendor’s software to be functional in the
customer’s environment.
• The timing of payments for the software is coincident with performance of the services.
• Milestones of customer-specific acceptance criteria affect the realizability (i.e., collectibility) of
the software-license fee.”

38
Such services would qualify for accounting as separate service element(s), assuming that they can
be separately described, and separately priced (supported by VSOE), in accordance with AICPA SOP 97-2,
¶ 65. See AICPA SOP 97-2, ¶ 71.

16
 ‰ Up-grades covered by PCS must not be separate, specifically identified
products (i.e., with new functionality or features) that must be accounted
for separately, when GA, delivered and accepted by customer.

‰ Up-grades covered by PCS must not be unspecified rights to receive future

software products that should be accounted for on the subscription
method.

‰ Maintenance service fees should be recognized in accordance with the

pattern of activity, if discernable, or ratably over the term of the
arrangement.

‰ Vendor must have a record of having provided the subject PCS or

maintenance fee in order to support VSOE.

7. Regarding price adjustments, volume or activity credits and rebates or refunds.

‰ Refunds arising from future sales of products, applied to outstanding

receivables arising from prior arrangements may indicate that the price of
the earlier arrangement was not fixed or determinable.

‰ Price adjustments, volume or activity credits or rebates on “overlapping”

deals may indicate that the multiple elements should have been treated as
one arrangement and the price(s) allocated accordingly.

‰ The longer a receivable is outstanding – either by contractual term or in

practice – the more likely that subsequent price adjustments, volume or
activity credits or rebates granted to that customer will be deemed to relate
to the outstanding receivable balance and the arrangement giving rise to
such receivable balance. This in turn may implicate whether the price of
that arrangement actually was fixed or determinable.

Revenue Recognition Accounting Malefactions

Accounting irregularities are distinguished from accounting errors in AICPA SAS No.
53, The Auditor’s Responsibility to Detect and Report Errors and Irregularities, as
follows:

“The term errors refers to unintentional misstatements or omissions of amounts or

disclosures in financial statements. Errors may involve –

• Mistakes in gathering or processing accounting data from which financial

statements are prepared.
• Incorrect accounting estimates arising from oversight or misinterpretation
of facts.

17
 • Mistakes in the application of accounting principles relating to amounts,
classification, manner of presentation, or disclosure.”39

“The term irregularities refers to intentional misstatements or omissions of

amounts or disclosures in financial statements. Irregularities include fraudulent
financial reporting undertaken to render financial statements misleading,
sometimes called management fraud …. Irregularities may involve acts such as
the following:

• Manipulation, falsification, or alteration of accounting records or

supporting documents from which financial statements are prepared.
• Misrepresentation or intentional omission of events, transactions, or other
significant information.
• Intentional misapplication of accounting principles relating to amounts,
classification, manner of presentation, or disclosure.”40

AICPA SAS No. 82, Consideration of Fraud in a Financial Statement Audit, states:
“Fraud frequently involves the following: (a) pressure or an incentive to commit fraud
and (b) a perceived opportunity to do so;” and, “Fraud may be concealed through
falsified documentation, including forgery …. [and] Fraud also may be concealed
through collusion among management, employees, or third parties.”41

Revenue recognition irregularities and financial usually involve both inclusive and
exclusive fraud and acts of both commission and omission, as follows:

In Books and Records Legal and Economic Substance

1. False entries 1. Overstated revenues

Commission

2. Misstated contracts 2. Mis-timing of recognition

3. Back-dating 3. Overstated receivables
4. Misrepresentations 4. Revenue not yet realizable
5. Misapplication of 5. Mis-reported revenues and
GAAP earnings and trends
1. Side Letters 1. Remaining obligations
2. Extra-contractual 2. Material facts regarding the
Omission

promises arrangement
3. Actual dates, true 3. Allowances for returns
acceptance criteria, real 4. Contingencies
rights and obligations 5. Violations of GAAP

39
See AICPA SAS No. 53, ¶ 2 (AU§316).
40
See Id., at ¶ 3.
41
See AICPA SAS No. 82, ¶¶ 6-8 (AU§316, amended)

18
Any time that a material amount of revenue intentionally is recognized when (a) the
revenue is fictitious, (b) the timing of recognition is improper, (c) the amount being
recognized has been improperly computed or estimated, and/or (d) GAAP has been
misapplied, a false entry is recorded in the books and records of the entity. Generally, the
purpose of such false entry is to overstate revenue in the current accounting period, either
by recording an amount that is not realizable (i.e., fictitious revenue and corresponding
receivable) or by recognizing revenue before it has been earned. In support of such a
fraud, one or more of the following acts of commission (e.g., falsified documents and
misrepresentations) or omissions (e.g., failure to disclose true terms of the arrangement)
usually occurs.

Existence of Arrangement

Either the timing of the arrangement is misrepresented or the fact that a contract actually
exists is falsified, by:

‰ Back-dating documents or use of “as of” effective dating of documents.

Carefully examine, with reasonable skepticism, all contracts received on or

around period-end. Look for evidence contradicting contract dating, such
as fax transmission dates, dating of accompanying correspondence,
implausible sequence of events (e.g., shipping date, date of purchase order
or invoice date vis-à-vis contract date), absence of prior contract
negotiating history (i.e., “nick-of-time” and “out-of-the-blue” last minute
contracts. Consider confirming with counter-party’s CFO, General
Counsel, Controller, Chief Information Officer (“CIO”) and/or Purchasing
Agent the terms and execution date of the arrangement.

‰ Through collusion, arranging with a counter-party (i.e., customer representative)

for a signed contract accompanied by an undisclosed: (a) side-letter providing
cancellation rights to the buyer; (b) side-letter, contract amendment or other
extra-contractual agreement providing executory contract contingencies, such as
board approval, right of refusal by executive officers, or acceptance terms; or (c)
“trial periods” or other contingencies affecting whether any arrangement
actually is binding on the customer.

Consider confirming nature and terms of arrangement with someone other

(and preferably senior to) the counter-party signatory to the arrangement.
Specifically inquire of counter-party and seller’s representative about
existence of any undisclosed side-letters, contract amendments, or oral
promises. Include language in all contracts prohibiting amendment by side-
letter or extra-contractual agreement. Investigate the reason for any
contractual provisions that grant abnormally long payment terms, or appear
to allow cancellation, or that create right of return.

19
 ‰ Improper period-end cut-off regarding: (a) receipt of contracts as of the close of
business on the period-end date; (b) execution of received contracts by
authorized representative(s) of seller; (c) non-delivery of product(s), under the
terms of the arrangement (e.g., FOB shipping point or FOB destination), on or
before period-end; and (d) incongruence of contract dating, authority and terms
with antecedent documents such as request for proposal (“RFP”), purchase
orders, and customer correspondence.

Last minute, faxed, contracts or “letters of intent,” or arrangements drawn-

up on non-standard forms should raise a heightened degree of professional
skepticism. Arrangements must be executed by both parties, and last
minute (or post-close) arrivals of customer-signed contracts beg the
question, “How could seller have executed the final version of a contract
not received from buyer until after the close of business on the period-end
date?” Consider reviewing E-mail between seller representatives and buyer
for support (or evidence to the contrary) of asserted timing of execution.

Delivery and acceptance

Any delivery other than to the customer should be suspect and subject to investigation.
Delivery should be supported by customary evidence of shipment and receipt; where
delivery is effected by hand (e.g., seller’s sales representative), in advance of the contract
date, through freight forwarders, to third party warehouses, or to sites other than the
customer’s regular place(s) of business – beware! And, also watch for:

‰ Arrangements executed immediately in advance of, or closely preceding,

introduction of new versions of products, in which the current versions of the
product are shipped.

This naturally begs the question, “Why would the customer really want this
soon-to-be obsolesced current version of the product(s)?” Often the answer
is that the customer does not accept the current version because the terms
of the arrangement, express or implied, within the contract or by side-
letter, etc., provide for delivery of the new version when released. This in
turn implicates acceptance, functionality and/or multiple element
considerations before revenue may be recognized.

‰ Unusual acceptance criteria and any acceptance criteria with time periods that
carry over period-end.

Any acceptance period that crosses over beyond the current accounting
period may preclude revenue recognition in that accounting period.
Unusual acceptance criteria (e.g., board approval, performance
benchmarking, etc.) should be investigated.

20
 ‰ Delivery to third-parties (e.g., value-added re-sellers, OEM’s, etc.) where the
contract ultimately calls for acceptance by an end-user customer.

Such arrangements implicate whether the transaction is, in fact, a

consignment sale, or whether collectibility ultimately depends upon the
intermediary receiving payment from the end-user, or whether acceptance
actually has occurred.

‰ Any “bill and hold” arrangement.

Rarely are such arrangements supportable under the strict criteria applied
by the SEC. In practice, even the most carefully negotiated and executed
“bill and hold” arrangement can be challenged. The revenue recognition
risks far exceed any benefits; and, if the customer absolutely insists (and
the transaction makes economic sense), consignment method accounting
always is an option.

‰ Anomalies in documentation of delivery. For example, customer’s purchase

order states, “FOB destination,” while vendor’s invoice and shipping documents
reads, “FOB our dock,” and the contract is silent – if delivery occurs at or very
near period-end, this disagreement between terms may affect revenue
recognition. Or, packing slips show items not included in the arrangement (e.g.,
earlier versions of product) and do not reflect specified items (e.g., product
versions ordered, equipment and peripheral items, etc.) – this may indicate
incomplete delivery, only partial shipment, and lack of customer acceptance.

Other anomalies may include out-of-sequence shipping records (where

waybills, bills of lading, etc. dated after period-end have identifying
numbers earlier in sequence than the subject order represented as shipped
on or before period-end. Or, when period-end falls on a weekend or
holiday, shipment of equipment of product is claimed even though the
shipping department (or customer’s receiving dock) normally is closed.
Also, when delivery is represented as having been completed, but later
(i.e., after period-close) E-mail, fax and written correspondence present
contradictory evidence, delivery – in full – should be confirmed with the
customer (preferably someone other than the contract signatory.

Price fixed or determinable

The quickest way to “un-fix” a price, as an inducement to the customer to close a deal, is
the use of a side-letter or contract amendment. But, any such alteration of the contract
terms, if manifested in the legal and accounting documents (and if known), usually would

21
preclude revenue recognition until the sales contingency expired (or the terms of FASB
SFAS No. 48, ¶¶ 6-8 could be met). Revenue recognition accounting irregularities
involving exclusive fraud occur when material facts are omitted from documentation of
the arrangement, by use of concealed side-letters, concealed contract amendments, or – in
certain circumstances – by making oral promises. Concealment may occur through: (a)
use of “separate” contracts or amendments to contracts (where the modifying documents
intentionally are kept separate from the subject transaction’s contract documentation – in
another file, or misrepresented as another arrangement); (b) use of undisclosed side-
letters; (c) execution of a superseding, concealed, contract with modified terms; or use of
intentionally ambiguous (or complex) terms, subject to differing interpretation, in the
subject contract. In almost all cases, some degree of collusion exists on the part of the
customer representative (negotiator and/or signatory), who has bargained for the
contractual contingency. Typically, such contingencies involve one or more of the
following:

‰ Cancellation rights. In the matter of HBO & Company, one such concealed side-
letter granting a right of cancellation was negotiated with a hospital operated by
an order of nuns (raising the question, “Who can you trust these days?”).
Cancellation rights may provide a “free trial” period, or a right of return if
funding if not obtained or if board approval is not received. Such rights almost
always indicate that the earnings process was not complete and the revenue was
not yet (if ever) collectible.

Obviously, look for any such terms stated in the contract. Under both
AICPA SOP 97-2 and SAB No. 101, fees from licenses that contain
cancellation clauses are neither fixed nor determinable and revenue may
not be recognized until the contingency expires. (AICPA SOP 97-2, ¶¶ 32-
33 does provide for a possible exception in the circumstance of “fiscal
funding clauses” often contained in contracts with government units). No
internal control can be entirely effective in preventing a determined agent,
officer or employee of a company from executing such a sales contingency
and then concealing it. However, a regular program of confirming
arrangement terms (particularly, confirming the absence of any
cancellation clauses or any other rights of return not stated in the contract)
can serve as a significant deterrent and can help to identify instances in
which otherwise undisclosed sales contingencies do exist.

‰ Right of return (for product exchange or credit). In the case of sales to re-sellers
(e.g., wholesalers, distributors and retailers), rights of return are negotiated to
obligate the seller to take back (either in exchange for new product or for credit)
unsold goods. Such rights may be express or implied, and FASB SFAS No. 48
makes no distinction between the two forms. In the case of sales to end-users,
rights of exchange for products of the same kind (e.g., similar functionality,
same price) are not treated as rights of return, under FASB SFAS No. 48, ¶ 3.
Similarly, platform transfer rights granted to end-users also may qualify as

22
 “exchanges” and not require accounting treatment as rights of return under FAS
SFAS No. 48. However, rights to receive partial refund for undelivered products
(either not currently GA or based upon arrangements to deliver in the future
unspecified products) and rights to return (or receive partial credit for) product
based upon “performance” clauses or other contractual contingencies are “rights
of return” that fall within the ambit of FASB SFAS No. 48. Implied rights of
return are, at once, both easy and hard to conceal. Because no express obligation
exists there may be no documentation. However, the existence of such implied
rights and obligations usually manifests itself through the behavior of the parties
– as products are returned and/or credits are taken. Concealed express rights of
return usually are created by side-letter or undisclosed contract amendment. As
with other concealed contingencies, no internal control system can offer absolute
assurance that concealment of sales contingencies will be prevented or detected.

Regular monitoring of collection, credits and returns activities (“looking-

back,” post-sale, to determine if the amounts recorded were, in fact,
realized) can identify the existence of implied or concealed express rights
of return. Also, a regular program of confirming customers’ understanding
of their arrangements – as to rights of return or any other contingencies –
can serve as both a deterrent and a method of detection.

‰ Pricing involving volume credits, allocation among multiple products and other
arrangements in which “fixed” payments may be allocated among various
products. In arrangements involving products to be delivered, where such
products involve different functionality or features, AICPA SOP 97-2, ¶ 46
requires that a portion of the arrangement fee should be allocated to the
undelivered products. In arrangements in which the customer may allocate the
arrangement fee to acquire different products (with different pricing and
functionality), revenue may not be recognized until the amounts of such
allocation are determinable. Accounting irregularities in this area most often
involve attempts to misrepresent the arrangement so that elements to be
delivered in the future are undervalued (thus inflating the amount of the
arrangement qualifying for immediate revenue recognition)

Front-loaded arrangements are easier to detect than to measure. VSOE

must be credible and, regardless of contractually-stated prices, AICPA
SOP 97-2, ¶ 10 states that: “Vendor-specific objective evidence of fair
value [i.e., fair saleable value] is limited to the following:

• The price charged when the same element is sold separately

• For an element not yet being sold separately, the price established
by management having relevant authority; it must be probable that
the price, once established, will not change before the separate
introduction of the product into the marketplace.”

23
 ‰ Multiple-element arrangements (involving products and services). Again, the
arrangement fee must be fixed or determinable and it must be allocable to the
respective elements based upon VSOE supporting the fair values of such
elements. Accounting irregularities (or, for that matter, errors) typically involve
improper measurement and allocation of fair values among the elements in the
arrangement – in order to front-load revenue. This in turn usually involves
understating elements requiring deferral or accretion ratably over the term of the
arrangement and overstating elements otherwise qualifying for immediate
revenue recognition.

There is no substitute for in-depth knowledge of: the products and their
functionality; service elements and their nature, activities and obligations;
pricing history; methods used to value products and services; and, pricing
decisions to be made regarding products not yet delivered or GA. Pricing
standards, based upon fair values supported by competent VSOE, should
be developed; and any incongruities between such standards and prices
stated in contracts (or the fair values used to allocate arrangement fees
among such elements) should be investigated.

Realizability (i.e., collectibility)

Revenue recognition accounting irregularities involving only timing improprieties may

not always be detected by review of collections and receivables status (e.g., aging),
especially if the irregularities are isolated and few. But, where the accounting
irregularities involve sales contingencies, rights of return or credit, etc., such terms may
lead to subsequent cancellation, credit issued against the receivable balance or return of
amounts already collected. Or, the account receivable arising from the transaction simply
grows older and older and never is collected. Eventually, such uncollectible receivables
require allowance for doubtful accounts and, finally, write-off. Revenue also may be
recognized improperly (or prematurely) for sales to customers that are not creditworthy
(e.g., new enterprises or enterprises in rapidly changing and highly competitive
industries, under-capitalized entities, companies with no, or poor, credit histories, etc.).
Warning signs include:

‰ Increased days’ sales outstanding (“DSO”), aging of receivables and allowances

for doubtful accounts. If a vendors normal customer base is composed of well-
established, steady, and financially sound customers, something is wrong. Such
an adverse trend in DSO or aged receivables may indicate that the sales really
were not earned or realizability (i.e., collectibility) was contingent on some
future events that have not (or never) occurred.

Study DSO and receivables trends carefully, and “drill-down” to find what
accounts are causing the problem – and why.

24
 ‰ Unusual credits. Receivables reduced by large or unusual credits, or accounts
where long past-due balances suddenly are reduced should be investigated.

Such credits or changes in account balances long past due may indicate
that an initially unrealizable sale and uncollectible receivable is being
covered-up by additional accounting irregularities. Or, the initial sale
may have contained cancellation clauses or other contingencies
permitting the customer to avoid payment.

‰ “Lapping” of payments or mis-applied payments. Payments made against

current receivables may be mis-applied to reduce past-due balances, thus
distorting DSO and aging statistics and masking the fact that older balances
remain uncollectible.

Other manipulation of the status of accounts receivables can include

intervention and tampering with internal reports or write-off and re-
creation of receivables designed to re-start the their aging and make the
balances appear to be current.

‰ Intervention in and corruption of confirmation of accounts receivables and

transaction terms with customers. Through collusion with customer
representatives, misrepresentation of the terms and nature of arrangements or the
amounts owed and conditions of payment can be obtained to deceive
management, internal auditors or the company’s independent auditors.

Confirmations should be made on a “surprise” basis and strictly

controlled. Also, confirmations should be addressed to, and followed-up
with, persons other than the counter-party to the arrangements.

Revenue Recognition - On the Qui Vive

In order to be alert to potential revenue recognition accounting errors or irregularities,

one must know what to look for and what questions to ask. The following list should be a
starting point.

Organizational

1. Who are the most “aggressive” (hard-charging, driven, etc.) sales and operational
executives, management and key sales employees? Do you really know their
business philosophy, culture, methods and what motivates them?

25
2. How are sales and revenue recognition linked to compensation? Will specific
transactions be critical to individuals “making their numbers/”

3. Is there a permanent contract-review and audit function within then organization?

Is this function independent of the sales force and other operating parts of the
business? Does this function have adequate resources (including legal and
accounting personnel, access to all records, analytical programs, etc.) to be
effective?

4. Does internal audit also examine: (a) controls, procedures and processes
surrounding the revenue recognition functions; (b) selected customer relationships
and specific transactions; and (c) subsequent realization of sales amounts?

5. What is the tone at the top? Is that tone overly aggressive? Do senior management
and the directors properly and frequently communicate their insistence on
adherence to high business and ethical standards and to compliance with GAAP
Securities laws and SEC rules and regulations? Is the culture of the organization
squarely aligned with such tone at the top?

6. Are there proper, well-designed and functioning compliance monitoring and

reporting systems in place. Are such systems designed to: (a) encourage
participation and use; (b) provide for confidentiality and for due-process; (c)
achieve appropriate follow-up; (d) enlist the aid of outside advisors where
appropriate; and (e) report any significant matters to the appropriate levels within
the organization (including the audit committee of the board of directors)?

Operational

7. Are accounting policies and procedures up-dated to conform to and comply with,
inter alia SAB No. 101, AICPA SOP 97-2, and any other relevant GAAP
governing revenue recognition?

8. Are training programs designed to explain the accounting rules for revenue
recognition and educate management and employees regarding accounting rules
and risks and more complex revenue recognition issues?

9. Are management and employees (particularly the sales force) required to

periodically: (a) confirm their understanding of company policies regarding
revenue recognition, business ethics and compliance with GAAP, securities laws
and SEC rules and regulations; (b) affirm their compliance with such policies; and
(c) report any instances of the use of side-letters or any departures from
contracting and sales guidelines?

26
 Contracting

10. Are all (or a representative sample of) significant contracts executed on or around
each period-end subject to careful scrutiny, and to confirmation with customers as
to terms, delivery and acceptance, the absence of any contingencies, etc.?

11. Are contracts, amendments, side-letters and all related documentation maintained
together to facilitate review?

12. Do contracts contain language prohibiting use of side-letters unless such

modifications are authorized and signed by specifically designated individuals?

13. Are levels of authority established to review and approve significant revenue
contracts? Are such individuals knowledgeable about the nature, terms and
possible elements of such arrangements?

Accounting

14. What contracts have arrived in the final days of the period? Have these
arrangements been scrutinized?

15. Have contracts been reviewed for execution, timing of execution, and any
apparent sales contingencies, cancellation clause, etc.?

16. Have significant arrangements been confirmed with customers?

17. Have the separate contract elements been identified and separately described?

18. Has VSOE supporting respective fair valuation of contract elements been
validated?

19. Does affirmative evidence of realizability (i.e., collectibility) exist?

20. Stepping back, does the deal make sense and pass the “reasonableness test” for
accounting applied in recognizing revenue?

27