Revenue Rules

It's still the standard measure, but how to report it is evolving.

The Interactive 500 is based, as it has been previously, on revenue generated from companies online operations. Revenue has always been seen as one of the best barometers to measure the new economy, and its still considered a valid gauge of successful e-commerce strategies.

However, in the past 12 months weve seen unprecedented changes in our economy and capital markets. Wild swings in both have been well documented. In terms of reporting financial results, weve gone from an environment where "revenue is regal" to "profits are preferred." The capital markets are no longer rewarding revenue, market share, subscribers, members, page hits and similar metrics that were driving valuations throughout 1999 and early 2000.

Additionally, we now know that the decline that began in the spring of 2000 was not a short-term blip or buying opportunity, but rather a return to conventional business fundamentals. As a result, reporting earnings is once again the central concern of investors, analysts, and, of course, the business and technology managers with bottom-line responsibility for corporate Web activity.

These past 12 months also have brought a sharpened focus on how companies should recognize revenue and account for other transactions, all of which may affect bottom-line earnings. Despite this more intense focus, we continue to see high-profile companies forced to restate their revenue and earnings.

This testifies to the complexity of the rules regarding revenue recognition, and the difficulty that even sophisticated companies have had in implementing them. Improperly recognizing revenue can result in an inquiry — and possible compliance action — from the Securities and Exchange Commission, loss of corporate credibility and confidence, and lower stock valuations.

Revenue Recognition: What You Need to Know

Revenue recognition is a highly sensitive issue because the amount acknowledged as revenue will usually have a direct impact on earnings. The amount of revenue that flows to the bottom line will depend, of course, on the nature of a companys business. A software company, for example, has very little in the way of "cost of goods sold" when selling a site license for thousands of users to a major corporation. Nearly all of the revenue it recognizes after completing the sale flow to pretax earnings.

The basics of revenue recognition include four criteria, all of which must be met: Evidence of an arrangement between a buyer and seller must exist; delivery of the product has occurred, or the services have been rendered; sales price must be fixed or determinable; and collectibility is reasonably assured.

Following is an examination of each criterion and highlights of frequently encountered problems:

Evidence of an arrangement. Proof of an arrangement must exist as of the reporting date. What constitutes evidence depends on the companys own business practices. For example, if a company requires a formal contract, then having a purchase order or a cover letter would ordinarily not suffice. A company may also believe that a deal is complete, only to find that the customer signed off on the contract a few days after the reporting period.

Delivery. Delivery must be made by the balance sheet date. There are some specific rules for software companies regarding this, in terms of transmitting the software or master copies, or providing access keys or codes. Delivery problems do crop up. But a more common issue arises with respect to customer acceptance, which is a more difficult data point to pin down and document.

Price fixed and determinable. Situations typically arise with price protection arrangements that render the prices to be considered not-fixed or determinable. Side agreements can also be an issue. These could provide for any number of rights to the customer, which may prevent revenue from being recognized — e.g., promise of future products, or right to return if not satisfied.

Collectibility is reasonably assured. The classic example of a failure to comply with this criterion is a company whose primary customers were dot-coms. Bear in mind that these rules mean more than setting up reserves for bad debts: They maintain that revenue should not have been recognized in the first place.

What should executives overseeing e-commerce activities learn from these experiences? Here are some practical suggestions:

  • Make sure key people in your finance and accounting group understand the four criteria and their implications.
  • Focus on controls. Your system should identify the four basic criteria of revenue recognition and allow company personnel to receive good information to determine if the criteria have been met.
  • Consider using standardized contracts. You generally evaluate them once and have the ability to determine revenue on a systematic basis. A separate evaluation for each transaction greatly increases the opportunity for error.
  • Carefully review your companys policy requiring documentation. If youre not receiving signed documents regularly, it may make sense to change the policy. Of course, you dont want to sacrifice good business practices to fit the financial reporting models, but they should be consistent — and reasonable. And consider specific procedures requiring documentation that will support customer acceptance.
  • Communicate with sales personnel to avoid issuing unauthorized side agreements and similar instruments that undermine the intent of the original contract.
  • Perform periodic credit checks and reviews for major customers and customers in industries that are performing poorly.

    Understanding financial reporting consequences early can yield great benefits down the road. Companies that take precautions to ensure sound practices stand the best chance for capitalizing on their efforts.

    Michael C. Bernstein is partner and national technology industry practice director of Grant Thornton, a leading accounting, tax and management consulting firm. Bernstein has more than 20 years of experience in public accounting, with areas of specialization including technology and services companies, public companies and initial public offerings. He is a co-author of Raising Capital: The Grant Thornton LLP Guide for Entrepreneurs.