Recognizing the Unrecognizable

Revenue recognition has perennially been one of the hottest of the SEC’s buttons, but perhaps never more so than now. During the past year the Commission has mounted high-profile investigations of such brand name companies as Xerox, Lucent and K-Mart, as well as several energy and telecommunication companies. SEC staff members have also recently said that the Commission will conduct a sweeping investigation into revenue recognition practices across a range of industries.

Such intense focus on revenue recognition raises at least two concerns for dealmakers. First, this may well be a case of smoke indicating real fire. Studies of detected accounting irregularities have found that more than half of the fraudulent financial reporting cases involves overstated revenue. If a target’s revenues are important in pricing a potential acquisition, the reliability of reported revenue is obviously critical.

Second, given the level of attention that the SEC is paying to this issue, almost any publicly held target’s past revenue recognition practices could be the subject of a post-acquisition SEC investigation. If the parties structure the acquisition as a stock purchase or a merger, the problem will become the acquiror’s.

In such an environment, pre-acquisition due diligence should include critical tests of the target’s revenue recognition practices. The following list, although not exhaustive, suggests important due diligence procedures regarding revenue recognition that an acquiror should consider:

• Define what matters. Before deciding on any particular due diligence procedures, the acquiror should think carefully about the specific types of revenues for which it would be willing to give value. Revenues that a target may report without violating generally accepted accounting principles do not necessarily reflect the quality of economic performance that would interest the acquiror.

The SEC’s recent settlement with Edison Schools illustrates this point. Edison manages approximately 130 schools under agreements with various school districts. It included in its reported revenues the gross amounts of per-pupil funding paid by the districts, even though a portion of those amounts consisted of teacher salaries and other school operating expenses that the districts paid not to Edison, but directly to the teachers and other vendors. Although the SEC found that Edison’s filings were inaccurate (because they stated that Edison “receives” all per pupil funding), the SEC did not find that Edison’s revenue recognition practices violated GAAP. Nevertheless, in evaluating a potential acquisition, a buyer might well discount revenue numbers that include cash the target never touches.

• Read what management says. The acquiror should thoroughly familiarize itself with the target’s revenue recognition policies. APB No. 22 requires companies to disclose their revenue recognition principles as part of their GAAP-prepared financial statements. An acquiror, therefore, should carefully review the footnotes to the target’s financial statements to learn what the target says about how it recognizes revenue. In addition, if the target files reports with the SEC, the MD&A portion of those filings may provide useful insight into potential revenue recognition issues.
• Timing can be everything. Companies under pressure to meet quarterly or annual sales targets may be tempted to respond creatively as the deadline approaches. Inappropriate responses to such pressure may include recognition of revenue before the target has substantially completed its performance or “holding the ledger open” to capture sales within one reporting period that actually occur in the subsequent reporting period. An acquiror should consider requesting a printout of the target’s sales ledger showing the dates on which the target recognized each sale. If the ledger indicates a significant concentration of sales at the end of a fiscal quarter or year, further inquiry may be advisable.
• Review customer and vendor lists. Recent SEC scrutiny has focused on barter and so-called “round trip” transactions. In barter transactions, two companies swap the same commodity, with each company recognizing revenue from the exchange, even though little of economic substance has actually transpired. “Round trip” transactions are similar to barter transactions except that in a “round trip” transaction, one company sells a product for cash to another company, which in turn sells an equivalent product back to the initial seller for a similar price, with each company recognizing revenue on its “sale”.

  Barter and “round trip” transactions often involve counterparties in the same line of business. An acquiror, therefore, should review a list of the target’s significant customers. If the list indicates customers in the same line of business as the target, specific inquiry regarding possible barter or “round trip” transactions may be appropriate. The acquiror’s due diligence should also include a request for a list of the target’s vendors, which the acquiror should compare to the target’s customer list. Appearance of the same entity on both lists may suggest possible bartering or “round tripping”.

  A company intent on disguising barter transactions or “round tripping” may try to do so by running the transactions through an intermediary rather than dealing directly with the ultimate counterparty. Given that possibility, the appearance on a customer list of parties that are not users of the target’s product, or on a vendor list of parties that are not producers of products that the target uses, may also suggest the need for questions about possible bartering or “round tripping”.

• Customer support. Due diligence should include inquiry into the types of inducements that a target offers to persuade its customers to make purchases. Some of these inducements may have revenue recognition implications. For example, an acquiror should review the terms of any vendor financing of a customer’s purchase to make sure that the risk of ownership has passed to the customer before the target recognized revenue from the sale. If the target offers its customers “credits” that the customers may use to pay for purchases of the target’s products, the acquiror should understand whether the target recognizes revenue based on the “list price” of its products or net of customer credits.
• Industry specific issues. In addition to these general due diligence questions, an acquiror should consider whether other, more specific inquiries are appropriate in light of the industry in which the target operates. Many industries have their own unique sales practices (for example, up front membership fees, liberal product return policies, prepayment for long term service contracts, layaway sales, etc.) that raise particular revenue recognition considerations.

About the Author:

Joseph J. Basile is a Partner in Bingham McCutchen's corporate and finance areas. Mr. Basile's practice involves mergers, acquisitions, divestitures, joint ventures and strategic alliances, and private equity and institutional finance transactions. In addition to practicing law, he has taught corporate and commercial law courses as both a full-time and adjunct professor at Western New England College School of Law. He can be reached at joe.basile@bingham.com