Changes on Horizon for Revenue Recognition on Multiple Element Arrangements

by Mike Piessens September 08, 2009

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So you want to recognize revenue on your multiple element arrangement sooner?…Well, the FASB genie looks like it may actually grant that wish…but nothing comes for free…

On July 7th, the FASB released a draft abstract for public comment on EITF Issues No. 08-1, “Revenue Arrangements with Multiple Deliverables,” and No. 09-3, “Applicability of AICPA Statement of Position 97-2 to Certain Arrangements That Contain Software Elements.” Responses from interested parties on both draft abstracts were due by August 14th. Under its current form, EITF 08-1 will profoundly change the paradigm for revenue recognition on multiple element arrangements going forward (the EITF will apply prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010).

Historically, companies struggled under EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” to prove that they had “vendor objective evidence” of the selling prices of each component element, so that they could recognize revenue as each element was delivered. Where that evidence was lacking, they were forced not to recognize revenue for ANY of the elements until ALL of them had been delivered. In such a scenario, the logistics of the accounting did not match the underlying economics of the related transaction.

In practice, since companies oftentimes did not provide installation or support for their products separately, there was no vendor objective evidence of value. And furthermore, third-party evidence of value was not easy to establish and rely upon. The end result: frustration on behalf of financial statement preparers, because of the delayed and overly conservative revenue recognition pattern on those arrangements.

On the flip side of the coin, accounting abuses and scandals of the past were partially the result of empowering management with more latitude in performing estimates in grey, non-verifiable areas. Easing the requirements for verification of management estimates in the area of revenue recognition could open the flood gates (again) to similar abuses. In these troubled economic and financial times, we cannot afford (any additional) lost faith in the representational faithfulness of company financial statements.

To be more specific as far as the potential far-reaching implications of the new guidance, under EITF 08-1, evidence limitations for revenue recognition on multiple element arrangements will be relaxed, so that companies have the ability to rely upon internal estimates of selling prices (cleverly coined with the acronym “ESP”), where direct pricing data is not available. The internal estimates will require more management judgment, which will entail additional financial statement disclosure, and, as a result, more audit focus and tension. But – in the big scheme of things, accelerated revenue recognition makes sense, if management can build a solid rationale for its selling price, supported by first-hand business insights into related costs and margins.

Another change relating to the new guidance will involve the allocation algorithm for revenue recognition. Under the original EITF 00-21, the “residual method” of allocation specified recording revenue as each specific element was delivered, assuming adequate direct evidence of pricing was present. The new EITF 08-1 will instead (of the residual method) require a company to allocate arrangement consideration at arrangement inception to all related deliverables, using the “relative-selling price method”. Under EITF 08-1, selling price for each deliverable will be determined using vendor-specific objective evidence; otherwise third-party evidence; otherwise, the best estimate of selling price (as a last resort must be used).

Lastly, the new guidance will require enhanced financial statement disclosure – the new EITF proposal includes a four page example of such a disclosure (no, I am not kidding). These additional disclosure requirements will entail both qualitative and quantitative information surrounding the significant judgments involved with multiple deliverable revenue recognition.

The task force believes that additional disclosure could serve to mitigate the risk of (possible) decreased reliability of management estimates (financial statement preparers: insert headache here).

So the FASB genie gives us more flexibility to estimate selling prices – but, at the same time, interjects more complexity and reporting hoops to jump through to satisfy the requirements of the new guidance. Moral of the story: Be careful what you wish for…

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