Balance Sheet Presentation

- A. C. Sondhi & Scott A. Taub, Miller Revenue Recognition Guide, 2006

While the recent EITF consensuses have provided needed guidance on whether certain items should be characterized as revenue or expense, guidance on the classification of cash received in advance of revenue recognition (deferred revenue) is still somewhat scarce. Although the deferred revenue liability caption is acknowledged in several FASB and EITF pronouncements, no literature actually describes what liabilities qualify to be labeled "deferred revenue."

Cash Received Before Revenue Recognition

(Deferred Revenue)

There are many reasons (as discussed throughout this book) that the recognition of revenue could be prohibited even after cash has been received. In these cases, a liability must be recorded for the portion of the cash received that exceeds whatever revenue can be recognized. For example, when a right of return exists, no revenue is recognized if returns cannot be reliably estimated. As such, any amounts received must be recognized as a liability. Even if returns can be estimated, revenue cannot be recognized to the extent of expected returns. Therefore, if full payment is made, a portion of that payment will still need to be reflected as a liability. Of course, there are a myriad of other reasons that revenue might be deferred.

When liabilities are recognized for payments received in excess of the amount that can be recognized as revenue, a question arises as to the characterization of the liability. Possible characterizations include deferred revenue, a deposit liability, debt, or even a contra-receivable account.

In general, amounts classified as deferred revenue should be limited to amounts that are ultimately expected to be recognized as revenue. Thus, advance payments that are received before services are performed should usually be classified as deferred revenue, as these amounts are expected to be recognized as revenue upon performance of the service. Similarly, payments received upon product delivery when revenue recognition is prohibited due to a customer acceptance clause may be characterized as deferred revenue in the balance sheet.

It is not acceptable to include in deferred revenue any amount that is expected to be refunded to the customer. For example, revenue that is not recognized based on expected returns should be classified in a separate monetary liability account, labeled with a caption such as "customer deposits" (SAB Topic 13A4a, ques. 1). It is also not acceptable to reflect a product return liability as an offset to accounts receivable. This is because the reserve for product returns is an estimate of cash that will be returned to customers-it is not a valuation account related to the accounts receivable balance.

The following chart lists some of the common reasons for revenue to be deferred once cash has been received, and identifies whether it is generally appropriate to record the related liability as deferred revenue. In simple terms, when the reason for the deferral is that the revenue has not yet been earned, the liability may be reflected as deferred revenue. However, if the reason for the deferral is related to a concern about whether the fee is fixed or determinable or about whether a true sale has occurred, the liability should not be characterized as deferred revenue.

Reason for Deferral Deferred Revenue?

Estimated returns or priceprotection when estimates can be made	N
Right of return or priceprotection exists and no estimate can be made	N
Estimated refunds undersales incentives	N
Product not yet delivered	Y
Service not yet performed	Y
Standard warranty whenestimate of costs cannot be made	Y
Extended warranty	Y
Product financingarrangement	N
No persuasive evidence ofan arrangement	N
Refundable deposit againstvariable fee	N
Productdelivered-awaiting acceptance	Y
Delivered element in amultiple-element arrangement does not have value to the customer on astandalone basis	Y
Insufficient evidence offair value to allocate revenue in a multiple-element arrangement	SeeNote 1

Note 1: Generally, the liability in this situation should be characterized as deferred revenue. However, classification of the liability may be affected by the approach taken to account for the totality of the arrangement (i.e., it may be effected by the approach taken to account for both the revenue and cost elements of the arrangement). For a discussion of the revenue accounting in this situation, see Chapter 4, "Multiple-Element Arrangements." For a discussion of how costs associated with the delivered element are treated in this situation, see Chapter 8, "Miscellaneous Issues."

No revenue is allocated to the delivered element in a multiple- element arrangement that meets the criteria to be accounted for separately, or only a portion of the revenue that would otherwise have been allocated to the delivered element is ultimately allocated to the delivered element, due to all or a portion of the payment for that delivered element being contingent upon delivery of an as-yet undelivered element.

Accounts Receivable and Deferred Revenue

A liability must be recorded when cash is collected before revenue may be recognized. However, there are other situations in which it is not clear whether deferred revenue, or any other liability, should be recognized. For example, consider a transaction in which delivery has occurred, there is a right of return, returns cannot be estimated, and payment, although due under normal terms, has not yet been received. Because returns cannot be estimated, revenue cannot be recognized (see Chapter 5, "Product Deliverables") and the inventory shipped should remain on the seller's books. However, the customer is legally required to remit payment on normal terms, a final sales agreement does exist, delivery has occurred, and, except for the right of return, the fee is fixed or determinable. Therefore it may not be clear whether a receivable should be recorded, with an offsetting entry to either deferred revenue or another liability account.

The SEC staff's position is that it is generally not appropriate to record a receivable in this case. Because the provisions for revenue recognition have not yet been met and payment has not been made, neither party to the contract has completed its obligations under the contract. As such, SEC registrants should treat the contract for accounting purposes the same as any executory contract under which neither party has performed-in other words, the same way as if the contract had just been signed, with performance and payment expected in the future. This treatment results in neither a receivable nor a liability being reflected in the financial statements. This position is consistent with TPA 5100.58 where the AICPA Task Force that was established to address software revenue recognition issues effectively concluded that a receivable does not exist (and therefore cannot be considered transferred for accounting purposes) when revenue cannot be recognized due to extended payment terms.

The SEC staff's position is generally preferable for private companies. However, private companies may recognize a receivable in this case if the receivable meets the definition of an asset provided in CON-6, which would require the customer to be unconditionally obligated to pay the receivable balance.

PRACTICE POINTER:Although the receivable and related deferred revenue may not be reflected in the financial statements, a company in this situation may wish to record these entries in its internal records, to ensure that receivables are properly evaluated and followed-up on, and that obligations related to potential returns are appropriately considered. When the receivable and deferred revenue are not reflected in the financial statements, a company using this procedure should ensure that these assets and liabilities are eliminated.

This is particularly important because financial statement users generally assume that amounts reflected as deferred revenue have already been paid for. As such, reflecting deferred revenue when payment has not yet been received may cause a user to misunderstand the company's cash flow position.

Sales of Future Revenue

In certain situations, a company may receive a payment from a third party and agree to pay to the third party for a defined period a specified percentage or amount of the revenue, or of a measure of income, of a particular product line, business segment, trademark, patent, or contractual right. For example, a sale of future revenue has occurred if a company sells its rights to receive payments from a customer to a third party before the revenue related to those payments has been recognized.

EITF 88-18 addresses the classification of the amounts received by the company in these situations. The nature of the payment generally precludes immediate recognition in income due to the payments owed to the third-party investor. In most cases, such payments cannot be classified as deferred revenue, but should instead be reflected as debt. In fact, any of the following factors creates a presumption that classification as debt is required (EITF 88-18):

1. The transaction does not purport to be a sale (that is, the form of the transaction is debt).
2. The enterprise has significant continuing involvement in the generation of the cash flows due the investor (for example, active involvement in the generation of the operating revenues of a product line, subsidiary, or business segment).
3. The transaction is cancelable by either the enterprise or the investor through payment of a lump sum or other transfer of assets by the enterprise.
4. The investor's rate of return is implicitly or explicitly limited by the terms of the transaction.
5. Variations in the enterprise's revenue or income underlying the transaction have only a trifling impact on the investor's rate of return.
6. The investor has any recourse to the enterprise relating to the payments due the investor.

CLASSES OF REVENUE

When a company gets its revenue from different product or service categories, separate presentation of revenue from each category may be appropriate. This is especially true if the various categories of sales transactions would be expected to have different gross margins or other economic characteristics. In SEC filings, separate presentation of revenues and related cost of sales is required for each of the following categories of transactions:

1. Tangible product sales,
2. Public utility operations,
3. Rentals,
4. Service transactions, and
5. All other sources (REG S-X, Rule 5-03(b)(1)).

DISCLOSURE ALERT: See Chapter 12, "Disclosures," for information about required disclosures.

EXAMPLE: PRESENTATION OF MULTIPLE CLASSES OF REVENUE
International Business Machines Corporation Form 10-K-Fiscal Year Ended December 31, 2004
(dollars in millions except per share amounts)

FOR THE YEAR ENDED DECEMBER 31:

Revenue:	2004	2003	2002
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 Investments/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 Investments/Other	731	611	632
Total Cost	60,261	56,113	50,902
GrossProfit	36,032	33,018	30,284

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