Revenues Versus Gains

- A. C. Sondhi & Scott A. Taub, RevenueRecognition.com

One of the key issues in income statement classification is the determination of whether a particular item of income should be reported as revenue or as a gain. Both revenues and gains affect a company in the same way—the company has more assets (or less liabilities) than it did before the particular event occurred. However, whether the item of income is reported as revenue or a gain can greatly affect the way the transaction is viewed.

Gains are generally assumed to be onetime events that do not relate to the company’s core operations, while revenues are assumed to be part of those core operations, and thus, are more likely to be repeatable in the future. CON-6 addresses the difference between revenues and gains, indicating, “Revenues... result from an entity’s ongoing major or central operations and activities...” while “Gains... result from entities’ peripheral or incidental transactions” (CON-6, par. 87). Another way to distinguish between revenues and gains is suggested in CON-5, which points out that revenues typically result from an “earnings process” involving activities specifically targeted toward bringing in that revenue, while “Gains commonly result from transactions and other events that involve no ‘earning process,’ and for recognizing gains, being earned is generally less significant than being realized or realizable” (CON-5, par. 83b).

Obviously, the application of this guidance depends on the unique facts and circumstances of a company’s operations. In practice, it is generally not difficult to identify an entity’s “ongoing major or central operations and activities.” These activities generally include a company’s productive efforts and most of its transactions with other companies. For example, a manufacturer hires employees; buys raw materials; rents or purchases land, buildings, and equipment; and sells its output to customers. Its manufacturing operations convert all of these purchases into a product that sells at a higher price than the combined cost of the inputs. Other companies incur expenses and generate revenues in other ways—for example, retailers and distributors buy, transport, market, and sell goods, insurers charge customers to assume risks, and banks pay interest to depositors to have funds available to provide loans that earn greater interest (CON-6, par. 88).

Of course, some companies engage in many different ongoing major or central activities. It is not necessary to identify one or only a small handful of activities that make up a company’s ongoing major or central activities. Rather, any activity that the company performs repeatedly, expects to continue performing, and focuses its resources and efforts on may be an ongoing major line of business, and hence an activity that generates revenues and expenses, rather than gains and losses.

In contrast, transactions that are not part of a company’s ongoing major or central operations are typically things that the company does “on the side” and are ancillary, but still necessary, activities. For example, a company that owns the building its offices are in may rent out excess space to another entity. The rental income should not be reported as revenue. Similarly, a manufacturing or service company will typically invest cash rather than have it sit idle. The interest income earned should not be reported as revenue, even if it was earned on funds made available due to customer prepayments. Other transactions that produce gains (or losses) can be identified because they result from events that the company has little control over, such as currency fluctuations, strikes, natural disasters and related insurance recoveries, and changes in the fair value of assets and liabilities that are carried at fair value.

OBSERVATION: Many companies enter into arrangements that can result in the receipt of payments even though nothing of value is ever provided to the customer. This could occur if a customer returns a product or cancels a service, but is required to pay a termination fee. In these and similar situations in which the vendor receives payments but is never required to provide a product or service to the customer, the payments should be reported as a gain, rather than as revenue, because no earnings process ever occurred.

SEC REGISTRANT ALERT: The SEC staff continues to focus on income statement classification issues. In a December 2002 speech, the SEC staff highlighted the fact that revenues exclude equity in net income of investees, net gains or losses on sales of fixed assets or investments, and “other income.”

EXAMPLE: PRESENTATION OF REVENUES VERSUS GAINS
IBM Corporation Form 10-K—Fiscal Year Ended December 31, 2004

OBSERVATION: IBM’s Consolidated Statement of Earnings shows the following sources of revenues: Global Services, Hardware, Software, Global Financing and Enterprise Investments/Other. The Company, however, reports Intellectual property and custom development income, (“IP&CDI”), as well as asset sales and other nonrecurring gains, (which are components of Other (income) and expense), under the caption, Expense and Other Income. These sources of income are not classified as revenues by IBM because they are not considered part of the “ongoing major or central operations or activities” of the Company.

CONSOLIDATED STATEMENT OF EARNINGS
International Business Machines Corporation and Subsidiary Companies (Dollars in millions except per share amounts)

FOR THE YEAR ENDED DECEMBER 31:	2004	2003	2002
Revenue:
Global Services	$ 46,213	$ 42,635	$ 36,360
Hardware	31,154	28,239	27,456
Software	15,094	14,311	13,074
Global Financing	2,608	2,826	3,232
Enterprise Investment/Other	1,224	1,120	1,064
Total Revenue	96,293	89,131	81,186
Cost:
Global Services	34,637	31,903	26,812
Hardware	21,929	20,401	20,020
Software	1,919	1,927	2,043
Global Financing	1,045	1,248	1,416
Enterprise Investment/Other	731	634	611
Total Cost	60,261	56,113	50,902
Gross Profit	36,032	33,018	30,284
Expense and Other Income:
Selling, general and administrative	19,384	17,852	18,738
Research, development and engineering	5,673	5,077	4,750
Intellectual property and custom development income	(1,169)	(1,168)	(1,100)
Other (income) and expense	(23)	238	227
Interest Expense	139	145	145
Total Expense and Other Income	24,004	22,144	22,760

IBM describes IP&CDI as follows:

Intellectual Property and Custom Development Income

As part of the company’s business model and as a result of the company’s ongoing investment in research and development (R&D), the company licenses and sells the rights to certain of its intellectual property (IP) including internally developed patents, trade secrets and technological know-how.

Intellectual Property and Custom Development Income (Dollars in millions)

FOR THE YEAR ENDED DECEMBER 31:	2004	2003	%
Intellectual property and custom development income:
Sales and other transfers of intellectual property	$ 466	$ 562	(17.1)
Licensing royalty-based fees	393	338	16.3
Custom development income	310	268	15.7
Total	$1,169	$1,168	0.2

Intellectual property and custom development income was flat in 2004 versus 2003. The timing and amount of sales and other transfers of IP may vary significantly from period to period depending on the timing of divestitures, industry consolidation, economic conditions and the timing of new patents and know-how development.

The timing and amount of Sales and other transfers of IP may vary significantly from period to period depending upon the timing of divestitures, industry consolidation, economic conditions and the timing of new patents and know-how development.

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Copyright 2006 CCH Publishing, a WoltersKluwer business. Excerpted by permission.