Accounting & Tax

Hard Lessons

In its ongoing war on earnings management, the SEC may have outdone itself with new rules on revenue recognition.
Andrew OsterlandSeptember 28, 2000

It’s not new GAAP–it just feels like it. When Staff Accounting Bulletin No. 101 was issued by the Securities and Exchange Commission’s office of the Chief Accountant last December, it came with a disclaimer: “This SAB does not change any of the accounting profession’s existing rules on revenue recognition. Rather, [it] draws upon the existing rules and explains how the staff applies those rules.” And by extension, how corporations and their auditors will now be expected to apply them.

In the past nine months, corporations have come to realize that the SEC’s “guidance” on the recognition of revenue will force some major changes to their accounting practices. And along with the changes, there will be one-time charges; in many cases, restatements of prior financial results. There could be SEC inquiries, volatile reactions in the stock market, and, of course, shareholder lawsuits.

The effects, in fact, are already being felt. According to research conducted by Bear, Stearns & Co., some 800 companies mentioned SAB 101 in their 1999 10Ks and 10Qs from the March quarter. Of those, 241 indicated that they had changed their revenue recognition policies or intended to in order to comply with SAB 101.

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“SAB 101 is the crown jewel of the SEC’s earnings management initiative,” says Pat McConnell, senior managing director of Bear, Stearns. And, as such, it has unleashed a flood of protest from companies.

Always More Required

It’s been just two years since Arthur Levitt delivered his now famous “numbers game” speech to an unsuspecting audience of business executives and professionals in New York. It was the speech of a lifetime for the SEC chairman. He warned that the quality of reported earnings and the very integrity of the U.S. financial reporting system were being undermined by the relentless pressure to meet Wall Street expectations. He slammed corporate executives for using “accounting hocus- pocus” and “sleight of hand” to make their numbers. He blasted incompetent audit committees and complacent auditors for failing to discover and prevent it. He even called on Wall Street analysts to look beyond the latest quarterly numbers and reward companies for financial transparency rather than deceptive accounting practices.

“I am calling for … nothing less than a fundamental cultural change on the part of corporate management as well as the whole financial community,” exhorted Levitt, now into his eighth year as the nation’s top securities regulator.

Since his speech, the chairman and other members of the SEC staff have fairly rammed cultural change down the throats of the financial community. Last February, at the urging of the SEC, a blue-ribbon panel set up by the New York Stock Exchange and the National Association of Securities Dealers issued recommendations to create independent and financially literate audit committees that would actively assess the quality, not just the acceptability, of financial reporting.

More recently, the SEC has had the accounting profession up in arms because of new rules regarding auditor independence aimed at improving outside monitoring of corporate accounting practices. Meanwhile, in the past two years, the SEC has dramatically stepped up the number of inquiries into suspect accounting practices, and the enforcement actions it takes against corporate executives and auditors for accounting fraud.

For most CFOs, however, the front line of Levitt’s war on earnings management took shape with the three Staff Accounting Bulletins issued before the end of last year by the SEC. They deal with some of the more commonly used accounting tactics that smooth out or inflate reported earnings. The first bulletin, SAB 99, was issued in August 1999, and deals with accounting misstatements that fall below the traditional threshold of materiality–anywhere from 3 percent to 7 percent of earnings, depending on the company and the auditor. SAB 100 followed in November, and addressed the increasingly common practice of booking bloated one-time charges for organizational restructurings and asset impairments- -very often resulting from the acquisition of other companies. Last and most controversial is SAB 101, issued in early December, but not yet implemented, because of corporate complaints.

Finance executives and accounting experts alike say that SAB 101 will make the earlier bulletins pale in comparison. For one thing, SAB 101 deals with the most fundamental of corporate transactions, and is therefore expected to affect a far greater number of companies than SABs 99 and 100. Financial services firms and real estate outfits will have to change the way they account for contingent rental income. Retailers will change their policies on layaway sales. Biotechnology firms, computer manufacturers, telecommunications providers, and a host of other companies that have long-term service contracts will have to alter the way they record up-front fees. “It will affect essentially all our members,” wrote General Electric controller Phil Ameen and American Express Co. vice president of financial standards John “Jay” Perrell, chairs of committees at the Financial Executives Institute and the Institute of Management Accountants, in a letter to SEC chief accountant Lynn Turner asking for a delay in SAB 101.

Many Tentacles

Some industries will be affected more than others. In the semiconductor-equipment manufacturing industry, for example, the key issue in the new rules is the notion of customer acceptance. Every CFO in the industry currently recognizes revenue when the products are shipped. Title is passed to the customer, and, generally, suppliers get paid 90 percent of the cost within 30 days of shipment. The last 10 percent is paid after the equipment is installed in the chipmaker’s fabrication plant to the satisfaction of the customer.

SAB 101 guidelines say that, because the customer holds a right of return on the equipment until it is installed in the customer’s plant, the entire amount of the revenue should be deferred until ultimate acceptance by the customer. What that means, says Joseph Bronson, CFO of semiconductor-equipment manufacturer Applied Materials Inc., of Santa Clara, California, is that “if I adhere to the strict letter of acceptance, the customer could determine my revenue stream.” The result would be not only increased earnings volatility, but also a profound shift of power toward the chipmakers.

Moreover, if the whole point of Levitt’s earnings management initiative is to reduce the opportunities for corporations to manipulate the numbers, SAB 101 may do the exact opposite, says Bronson. Executives could include or exclude sales in a period by either expediting or delaying the acceptance of its customers. “If managers are trying to manage earnings, SAB 101 gives us a big cookie jar we shouldn’t have,” he adds.

SAB 101 could also have a profound effect in the biotechnology industry, says Philip Ufholz, tax and finance counsel of the Biotechnology Industry Organization, a trade group headquartered in Washington, D.C. For biotech companies, the big issue is the treatment of up-front fees and milestone payments they receive from other companies and investors for their research projects. The companies currently recognize the payments as revenue when received. The SEC wants them deferred and recognized over the life of the agreement between the parties.

The problem, says Ufholz, is that capital-hungry biotech companies rely on these payments to show financial progress that can attract new sources of capital. “They have enough trouble raising capital as it is,” says Ufholz. “SAB 101 will make it all the more difficult.” He argues that the milestone payments aren’t contingent on any future success of the biotech firm’s research or products; rather, they are made because of the company’s past performance. “When company A reaches a milestone, company B makes a payment for the progress made to that point.” The payments are typically nonrefundable, and not dependent on any future conditions being met by company A.

Ufholz fears that capital providers to biotech firms– predominantly pharmaceuticals firms–will try to reduce or spread out milestone payments, if they know that companies can recognize only part of those payments immediately. “They want to pay as little as they can, and get the most out of the investment,” he says.

Not everyone is panicking, however. In the June quarter, Delta Air Lines Inc. adopted the guidelines regarding recognition of bulk sales of frequent-flier miles to credit card companies and other marketing partners. Previously, says controller Ed Bastian, the company recorded revenue as it received the cash from the sales. Per SAB 101, the company should more appropriately book the revenue as the miles are used. Delta will now recognize parts of the sales in the year of the deal and defer the rest on the balance sheet. It took a pretax charge of $108 million in the second quarter as a cumulative adjustment for prior quarters, and it will be able to recognize that revenue again in succeeding periods.

Other than a little more bookkeeping work and some adjustments to Delta’s automated frequent- flier program, the change has been painless, says Bastian. In fact, Wall Street may view the new policy as a positive. “The analyst community never liked the volatility that cash recognition caused,” says Bastian. “This makes for a steadier accounting flow.”

Recipes For Disaster

For companies that have been consistently misrepresenting their revenue growth, however, SAB 101 could have disastrous consequences in the stock market. Unlike earnings restatements stemming from previously booked one-time charges, those related to improper revenue recognition have often resulted in spectacular collapses in stock prices, competing shareholder lawsuits, and permanent damage to a company’s ongoing business. Witness the software industry, where a number of high-flying companies crashed to earth after new rules drafted by the American Institute of Certified Public Accountants (AICPA) forced them to change their accounting practices. Indeed, SOP 97-2, which the SEC used as a model for SAB 101, has provided a grim picture of just how damaging restatements due to improper revenue recognition can be for companies.

MicroStrategy Inc., a Vienna, Virginia, manufacturer of business software, provides the most dramatic example. Shares in the company plunged 62 percent on the day the company announced it would restate revenues for the prior three years to comply with SOP 97-2. Revenues for 1999 were lowered from $205.3 million to $151.3 million, and profits of 15 cents per share became a loss of 44 cents per share. With the SEC currently investigating MicroStrategy’s accounting practices, the company declined requests for interviews. It appears, say analysts, that, among other things, MicroStrategy was booking most of its fee revenue from large long-term contracts up front, rather than recognizing it over the life of the contracts.

In general, high-growth companies , like software makers, face the most pressure to live up to Wall Street expectations. They are, consequently, the most apt to push the envelope with their accounting, and suffer severe market reactions when they are found out. “If a company is selling on momentum and some of the sales weren’t really sales yet, it can change the market’s perception of the stock,” says McConnell. And change it very quickly. Legato Systems Inc., of Mountain View, California, for example, was forced to restate earnings twice this year because of unauthorized side agreements that gave customers the right to return product. The stock of the data-storage management company, which had risen by 700 percent in the previous two years, has fallen 85 percent so far this year. CFO Stephen Wise recently tendered his resignation.

ERP vendors, such as PeopleSoft Inc. and Baan Co. NV, have also become mired in accounting morasses (see “Baan in Dutch,” CFO, May). Netherlands-based Baan, once a strong competitor to market leader SAP, spun into a death spiral after SOP 97-2 forced it to write off sales to related software resellers. Essentially, it was stuffing its distribution channel to keep growth rates up. Its shares, which had traded as high as $50 in early 1998, fell to $10 by the end of that year. The company was eventually bought by the British firm Invensys Plc, for less than $3 per share.

Will Congress Intervene?

The SEC has rightly targeted aggressive recognition of revenue by corporations. A report last year by the committee of sponsoring organizations of the Treadway Commission, found that over half of the accounting fraud committed by a sample of 200 companies involved the overstatement of revenue. But many finance executives say that SAB 101 will force them to change practices that are not abusive and have been accepted by the financial community. “The SEC has taken the guidelines for the software industry and used them as a one-size- fits-all solution,” says Jennifer Connell Dowling, director of public policy at Semiconductor Equipment and Materials International (SEMI), a trade association in San Jose, California, which is lobbying the SEC for changes to the guidelines. “We’re very different.” Other industry groups, such as biotechnology and electronics, have made similar arguments to the SEC.

Many opponents believe the SEC has overstepped its regulatory bounds. While the Commission has carefully pitched SAB 101 as simple guidance on the application of other revenue recognition rules already issued by FASB and the AICPA, corporate executives say it amounts to much more.

“This is an accounting change,” says Applied Materials’s Bronson. And as such, it should more appropriately have been drafted by one of the industry accounting standards­setting bodies, not the SEC. Proposals from FASB are subject to due process, in which the proposals are put out for public comment, and changes can be made based on feedback from interested parties. Staff bulletins, on the other hand, are simply issued by the SEC and expected to be followed.

In response to the criticism, the SEC recently agreed to delay the effective date of the bulletin to the fourth quarter of companies’ first fiscal year after December 15, 1999. Still, business lobbyists have taken their case to Capitol Hill in the hope of seeking further concessions. And in a June 30 letter to the SEC chairman, Sen. Phil Gramm (R­Tex.), chairman of the Senate Banking Committee, and Sen. Rod Grams (R­ Minn.) suggested that the implementation delay of SAB 101 “will provide an opportunity for the Commission to reassess this bulletin and its impact and evaluate its propriety as an action by Securities and Exchange Commission staff.”

Not everyone is happy with politicians entering the fray. Howard Schilit, of the Center for Financial Research & Analysis, an accounting watchdog organization in Rockville, Maryland, says the delay is ridiculous and that if companies are applying the rules of revenue recognition properly, they won’t have to resort to asking Congress to run interference. “FASB makes the rules, and the SEC has oversight of their application,” he says. “Congress has no business being involved.”

Senator Gramm, however, rarely passes on a fight with regulators. And given the extent of opposition to SAB 101 in the corporate community, there’s a good chance there will be at least some changes to the bulletin before it goes into effect at the end of the year. Bronson, for one, is optimistic. “We and [trade group] SEMI have been working with the SEC for six months explaining our contracts and our ways of doing business,” says Bronson, who is hoping for a less strict interpretation of customer acceptance. “We feel we already follow the spirit of SAB 101.” For companies that end up having to follow the letter of the new accounting bulletin, however, year-end reporting could be a nightmare this year. 

When To Recognize Revenue

Sales: Only when the buyer has taken title to the product or service and assumed all the risks and rewards of ownership can sales be recognized. There must be no side agreement that gives the buyer the right to return the product, or the seller the obligation to repurchase it or to guarantee the resale value of it.

Licensing arrangements: Delivery and revenue recognition don’t occur until the term of the license begins.

Layaway programs: Sellers should not record revenue until the product is delivered to the customer.

Upfront fees: Even if nonrefundable, these fees should be deferred and recognized over the term of the agreement.

Setup services: Should be recognized on a straight- line basis over the term of the contract, even if most of the costs are incurred up front.

Contingent rent: Income contingent on a factor other than time should be recorded only when the contingency is resolved.

Rental income: Retailers can recognize only the rental income from leased or licensed departments, not that department’s revenues.

Disclosure: All revenue recognition policies should be disclosed. Revenues and costs relating to each type of revenue should be disclosed separately. Changes in estimates of sales returns should be disclosed, if material.

The Reality Of Restatements

Arthur Levitt’s two-year- old war against earnings management has already resulted in increased numbers of restatements of prior financial results. Bear, Stearns & Co. accounting expert Pat McConnell has investigated 133 companies that came under Securities and Exchange Commission scrutiny because of accounting irregularities in the past two years–most of which were forced to restate earnings. The good news for companies is that, in many cases, the restatements registered little impact on stock prices. “The market views it as bookkeeping,” says McConnell.

The majority of the restatements, more than 60 percent, were related to charges resulting from business combinations–either restructuring reserves taken after a pooling acquisition or write-offs of in- process research and development when purchase accounting is applied. Levitt calls it “big bath” accounting, because large one-time charges can clear huge costs off corporate balance sheets that would otherwise depress future earnings of the company. And in the past two years, the Commission has stepped up the number of inquiries into such charges; SAB 101, in fact, demands more detail and better disclosure of the assumptions behind reserves and special charges.

As a result, many companies have had to reverse some of the charges and either put them in later periods or reclassify them as operating expenses. But, according to McConnell’s research, Wall Street analysts, for the most part, ignore such “nonrecurring” charges. The median market impact of 65 restatements made by companies because of charges resulting from an acquisition was just ­2 percent.

Individual company experiences vary widely, of course. In November of last year, for example, drugstore operator CVS Corp. had to adjust the timing of $86 million in merger-related charges it booked in 1997 and 1998 to the quarters in which the actual costs were incurred. The stock actually went up by 10 percent on the day of the restatement. Total Renal Care Holdings, on the other hand, saw its stock drop by 55 percent when it announced in February 1999 that its accounting practices were being investigated by the SEC. The second-largest provider of dialysis services ultimately had to reclassify $15 million in merger charges as operating costs. “Companies using restructuring charges to hide their true operating costs can end up with serious problems,” says McConnell.

What will happen to companies that end up with large restatements as a result of SAB 101, however, remains to be seen.

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