[Federal Register Volume 68, Number 246 (Tuesday, December 23, 2003)]
[Rules and Regulations]
[Pages 74436-74448]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-31512]



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Part VII





Securities and Exchange Commission





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17 CFR Part 211



Staff Accounting Bulletin No. 104; Final Rule

  Federal Register / Vol. 68, No. 246 / Tuesday, December 23, 2003 / 
Rules and Regulations  

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 211

[Release No. SAB 104]


Staff Accounting Bulletin No. 104

AGENCY: Securities and Exchange Commission.

ACTION: Publication of staff accounting bulletin.

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SUMMARY: This staff accounting bulletin revises or rescinds portions of 
the interpretative guidance included in Topic 13 of the codification of 
staff accounting bulletins in order to make this interpretive guidance 
consistent with current authoritative accounting and auditing guidance 
and SEC rules and regulations. The principal revisions relate to the 
rescission of material no longer necessary because of private sector 
developments in U.S. generally accepted accounting principles.
    This staff accounting bulletin also rescinds the Revenue 
Recognition in Financial Statements Frequently Asked Questions and 
Answers document issued in conjunction with Topic 13. Selected portions 
of that document have been incorporated into Topic 13.

EFFECTIVE DATE: December 17, 2003.

FOR FURTHER INFORMATION CONTACT: Chad Kokenge or Shelly Luisi in the 
Office of the Chief Accountant (202) 942-4400, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-1103.

SUPPLEMENTARY INFORMATION: The statements in staff accounting bulletins 
are not rules or interpretations of the Commission, nor are they 
published as bearing the Commission's approval. They represent 
interpretations and practices followed by the Division of Corporation 
Finance and the Office of Chief Accountant in administering the 
disclosure requirements of the Federal securities laws.

    Dated: December 17, 2003.
Margaret H. McFarland,
Deputy Secretary.

PART 211--[AMENDED]

0
Accordingly, part 211 of title 17 of the Code of Federal Regulations is 
amended by adding Staff Accounting Bulletin No. 104 to the table found 
in subpart B.

Staff Accounting Bulletin No. 104

    Note: The text of SAB 104 will not appear in the Code of Federal 
Regulations.

    The staff hereby revises Topic 13 of the Staff Accounting 
Bulletin Series as follows:

1. Topic 13.A.1 is modified as follows:
    a. The examples of existing literature referenced in the first 
paragraph are deleted.
    b. The last paragraph, including footnote 7, is added to make 
reference to EITF Issue 00-21, ``Revenue Arrangements With Multiple 
Deliverables,'' which governs how to determine if revenue 
arrangements contain more than one unit of accounting.
2. Topic 13.A.2 is modified as follows:
    a. Question 3 (formerly Question 1 of the staff's Revenue 
Recognition in Financial Statements Frequently Asked Questions and 
Answers document (FAQ)) is added.
3. Topic 13.A.3 is modified as follows:
    a. The subheading Bill and hold arrangements is added.
    b. Topic 13.A.3(a) Question is formerly Question 3.
    c. The subheading Customer acceptance is added.
    d. Topic 13.A.3(b) Question 1 (formerly Question 5 of the FAQ) 
is added. The question format is conformed.
    e. Topic 13.A.3(b) Question 2 (formerly Question 6 of the FAQ) 
is added. The facts, question and interpretive response are modified 
to reflect the evaluation of the arrangement in the context of 
separate units of accounting. In addition, the last paragraph of the 
interpretive response is deleted due to the issuance of EITF Issue 
00-21.
    f. Footnote 29 is added to highlight that the changes to Topic 
13.A.3(b) Question 2 are to facilitate an analysis of revenue 
recognition, not interpret EITF Issue 00-21.
    g. Topic 13.A.3(b) Question 3 (formerly Exhibit A Example 1 
Scenario A of the FAQ) is added.
    h. Topic 13.A.3(b) Question 4 (formerly Exhibit A Example 1 
Scenario B of the FAQ) is added.
    i. Topic 13.A.3(b) Question 5 (formerly Exhibit A Example 1 
Scenario C of the FAQ) is added.
    j. The subheading Inconsequential or perfunctory performance 
obligations is added.
    k. Topic 13.A.3(c) Question 1 (formerly Question 2 of the FAQ) 
is added. The question and interpretive response are modified from 
the FAQ to reflect the evaluation of the arrangement in the context 
of a single unit of accounting. The question format is conformed.
    l. Topic 13.A.3(c) Question 2 (formerly Question 3 of the FAQ) 
is added. The question and interpretive response are modified from 
the FAQ to reflect the evaluation in the context of a single unit of 
accounting.
    m. Topic 13.A.3(c) Question 3 (formerly Question 7 of the FAQ) 
is added. The facts, question and interpretive response are modified 
to reflect the evaluation of the arrangement in the context of 
combined deliverables, which result in a single unit of accounting. 
In addition, the interpretive response is modified to delete the 
last four sentences as this guidance is no longer necessary due to 
the issuance of EITF 00-21.
    n. The segue sentence and related footnote discussing delivery 
or performance of multiple deliverables is deleted to eliminate 
redundancy.
    o. The subheading License fee revenue is added.
    p. Topic 13.A.3(d) Question (formerly Question 9 of the FAQ) is 
added. The interpretive response is modified to eliminate 
redundancy.
    q. The subheading Layaway sales arrangements is added.
    r. Topic 13.A.3(e) Question is formerly Question 4.
    s. The subheading Nonrefundable up-front fees is added.
    t. The examples in Topic 13.A.3(f) Question 1 (formerly Question 
5) are modified to include the examples from what was formerly 
Question 10 of the FAQ. Guidance in the interpretive response is 
added and conformed from Question 10 of the FAQ which clarifies the 
incurrence of substantive costs does not necessarily indicate there 
is a separate earnings event, and that the determination of a 
separate earnings event should be evaluated on a case-by-case basis.
    u. Footnote 36 is added to clarify the staff's view regarding 
the vendor activities associated with up-front fees.
    v. Topic 13.A.3(f) Question 2 (formerly Question 6) is modified 
to reflect the evaluation in the context of a single unit of 
accounting.
    w. Footnote 14 is deleted. The subject matter of footnote 14 is 
conformed and included in Topic 13.A.3(f) Question 3; accordingly, 
Topic 13.A.3(f) Question 3 reflects the guidance formerly located in 
footnote 14.
    x. Topic 13.A.3(f) Question 4 (formerly Question 15 of the FAQ) 
is added. The question format is conformed.
    y. Topic 13.A.3(f) Question 5 (formerly Question 16 of the FAQ) 
is added. The question format is conformed.
    z. The subheading Deliverables within an arrangement is added.
    aa. Topic 13.A.3(g) Question (formerly Question 8 of the FAQ) is 
added and is modified to reflect the evaluation of the question 
under EITF Issue 00-21.
    bb. Footnote 45 is added to clarify the staff's view of the 
obligation described in Topic 13.A.3(g) Question under FIN 45.
4. Topic 13.A.4 is modified as follows:
    a. The subheading Refundable fees for services is added.
    b. Topic 13.A.4(a) Question 1 is formerly Question 7.
    c. Footnote 56 is added to include guidance from Question 23 of 
the FAQ.
    d. Topic 13.A.4(a) Question 2 (formerly Question 18 of the FAQ) 
is added.
    e. Topic 13.A.4(a) Question 3 (formerly Question 19 of the FAQ) 
is added. The question format is conformed.
    f. Topic 13.A.4(a) Question 4 (formerly Question 20 of the FAQ) 
is added.
    g. Topic 13.A.4(a) Question 5 (formerly Question 21 of the FAQ) 
is added. The question format is conformed.
    h. Topic 13.A.4(a) Question 6 (formerly Question 22 of the FAQ) 
is added.
    i. The subheading Estimates and changes in estimates is added.

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    j. Topic 13.A.4(b) Question 1 is formerly Question 9.
    k. Topic 13.A.4(b) Question 2 (formerly Question 24 of the FAQ) 
is added.
    l. Topic 13.A.4(b) Question 3 (formerly Question 25 of the FAQ) 
is added. The question format is conformed. The last two sentences 
of the interpretive response are deleted to eliminate redundancy.
    m. Topic 13.A.4(b) Question 4 (formerly Question 26 of the FAQ) 
is added.
    n. Topic 13.A.4(b) Question 5 (formerly Question 27 of the FAQ) 
is added.
    o. The subheading Contingent rental income is added.
    p. Topic 13.A.4(c) Question is formerly Question 8.
    q. The subheading Claims processing and billing services is 
added.
    r. Topic 13.A.4(d) Question (formerly Question 28 of the FAQ) is 
added. The facts are modified to reflect to evaluation in the 
context of a single unit of accounting.
5. Topic 13.A.5 is deleted. This topic provided guidance on income 
statement presentation and whether transactions should be presented 
on a gross as a principal or net as an agent basis. EITF Issue 99-
19, ``Reporting Revenue Gross as a Principal versus Net as an 
Agent'', which was issued subsequent to SAB 101, provides such 
guidance. Therefore, this guidance is no longer necessary.
6. Topic 13.B is modified as follows:
    a. The interpretive response to Question 1 is modified to 
reference multiple units of accounting in lieu of multiple elements.
    b. Question 2 is modified to delete the reference to Question 10 
of Topic 13.A and Topic 8.A.
    c. Question 3 (formerly Question 29 of the FAQ) is added.
    d. Question 4 (formerly Question 30 of the FAQ) is added.
    e. Question 5 (formerly Question 31 of the FAQ) is added.

Topic 13: Revenue Recognition

A. Selected Revenue Recognition Issues

1. Revenue recognition--general

    The accounting literature on revenue recognition includes both 
broad conceptual discussions as well as certain industry-specific 
guidance.\1\ If a transaction is within the scope of specific 
authoritative literature that provides revenue recognition guidance, 
that literature should be applied. However, in the absence of 
authoritative literature addressing a specific arrangement or a 
specific industry, the staff will consider the existing 
authoritative accounting standards as well as the broad revenue 
recognition criteria specified in the FASB's conceptual framework 
that contain basic guidelines for revenue recognition.
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    \1\ The February 1999 AICPA publication ``Audit Issues in 
Revenue Recognition'' provides an overview of the authoritative 
accounting literature and auditing procedures for revenue 
recognition and identifies indicators of improper revenue 
recognition.
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    Based on these guidelines, revenue should not be recognized 
until it is realized or realizable and earned.\2\ Concepts Statement 
5, paragraph 83(b) states that ``an entity's revenue-earning 
activities involve delivering or producing goods, rendering 
services, or other activities that constitute its ongoing major or 
central operations, and revenues are considered to have been earned 
when the entity has substantially accomplished what it must do to be 
entitled to the benefits represented by the revenues'' [footnote 
reference omitted]. Paragraph 84(a) continues ``the two conditions 
(being realized or realizable and being earned) are usually met by 
the time product or merchandise is delivered or services are 
rendered to customers, and revenues from manufacturing and selling 
activities and gains and losses from sales of other assets are 
commonly recognized at time of sale (usually meaning delivery)'' 
[footnote reference omitted]. In addition, paragraph 84(d) states 
that ``If services are rendered or rights to use assets extend 
continuously over time (for example, interest or rent), reliable 
measures based on contractual prices established in advance are 
commonly available, and revenues may be recognized as earned as time 
passes.''
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    \2\ Concepts Statement 5, paragraphs 83-84; ARB 43, Chapter 1A, 
paragraph 1; Opinion 10, paragraph 12. The citations provided herein 
are not intended to present the complete population of citations 
where a particular criterion is relevant. Rather, the citations are 
intended to provide the reader with additional reference material.
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    The staff believes that revenue generally is realized or 
realizable and earned when all of the following criteria are met:
    [sbull] Persuasive evidence of an arrangement exists,\3\
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    \3\ Concepts Statement 2, paragraph 63 states ``Representational 
faithfulness is correspondence or agreement between a measure or 
description and the phenomenon it purports to represent.'' The staff 
believes that evidence of an exchange arrangement must exist to 
determine if the accounting treatment represents faithfully the 
transaction. See also SOP 97-2, paragraph 8. The use of the term 
``arrangement'' in this SAB Topic is meant to identify the final 
understanding between the parties as to the specific nature and 
terms of the agreed-upon transaction.
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    [sbull] Delivery has occurred or services have been rendered,\4\
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    \4\ Concepts Statement 5, paragraph 84(a), (b), and (d). Revenue 
should not be recognized until the seller has substantially 
accomplished what it must do pursuant to the terms of the 
arrangement, which usually occurs upon delivery or performance of 
the services.
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    [sbull] The seller's price to the buyer is fixed or 
determinable,\5\ and
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    \5\ Concepts Statement 5, paragraph 83(a); Statement 48, 
paragraph 6(a); SOP 97-2, paragraph 8. SOP 97-2 defines a ``fixed 
fee'' as a ``fee required to be paid at a set amount that is not 
subject to refund or adjustment. A fixed fee includes amounts 
designated as minimum royalties.'' Paragraphs 26-33 of SOP 97-2 
discuss how to apply the fixed or determinable fee criterion in 
software transactions. The staff believes that the guidance in 
paragraphs 26 and 30-33 is appropriate for other sales transactions 
where authoritative guidance does not otherwise exist. The staff 
notes that paragraphs 27 through 29 specifically consider software 
transactions, however, the staff believes that guidance should be 
considered in other sales transactions in which the risk of 
technological obsolescence is high.
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    [sbull] Collectibility is reasonably assured.\6\
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    \6\ ARB 43, Chapter 1A, paragraph 1 and Opinion 10, paragraph 
12. See also Concepts Statement 5, paragraph 84(g) and SOP 97-2, 
paragraph 8.
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    Some revenue arrangements contain multiple revenue-generating 
activities. The staff believes that the determination of the units 
of accounting within an arrangement should be made prior to the 
application of the guidance in this SAB Topic by reference to the 
applicable accounting literature.\7\
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    \7\ See EITF Issue 00-21 paragraph 4 for additional discussion.
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2. Persuasive evidence of an arrangement

Question 1

    Facts: Company A has product available to ship to customers 
prior to the end of its current fiscal quarter. Customer Beta places 
an order for the product, and Company A delivers the product prior 
to the end of its current fiscal quarter. Company A's normal and 
customary business practice for this class of customer is to enter 
into a written sales agreement that requires the signatures of the 
authorized representatives of the Company and its customer to be 
binding. Company A prepares a written sales agreement, and its 
authorized representative signs the agreement before the end of the 
quarter. However, Customer Beta does not sign the agreement because 
Customer Beta is awaiting the requisite approval by its legal 
department. Customer Beta's purchasing department has orally agreed 
to the sale and stated that it is highly likely that the contract 
will be approved the first week of Company A's next fiscal quarter.
    Question: May Company A recognize the revenue in the current 
fiscal quarter for the sale of the product to Customer Beta when (1) 
the product is delivered by the end of its current fiscal quarter 
and (2) the final written sales agreement is executed by Customer 
Beta's authorized representative within a few days after the end of 
the current fiscal quarter?
    Interpretive Response: No. Generally the staff believes that, in 
view of Company A's business practice of requiring a written sales 
agreement for this class of customer, persuasive evidence of an 
arrangement would require a final agreement that has been executed 
by the properly authorized personnel of the customer. In the staff's 
view, Customer Beta's execution of the sales agreement after the end 
of the quarter causes the transaction to be considered a transaction 
of the subsequent period.\8\ Further, if an arrangement is subject 
to subsequent approval (e.g., by the management committee or board 
of directors) or execution of another agreement, revenue recognition 
would be inappropriate until that subsequent approval or agreement 
is complete.
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    \8\ AU Section 560.05
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    Customary business practices and processes for documenting sales 
transactions vary among companies and industries. Business practices 
and processes may also vary within individual companies (e.g., based 
on the class of customer, nature of product or service, or other 
distinguishable factors). If a company does not have a standard or 
customary business practice of relying on

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written contracts to document a sales arrangement, it usually would 
be expected to have other forms of written or electronic evidence to 
document the transaction. For example, a company may not use written 
contracts but instead may rely on binding purchase orders from third 
parties or on-line authorizations that include the terms of the sale 
and that are binding on the customer. In that situation, that 
documentation could represent persuasive evidence of an arrangement.
    The staff is aware that sometimes a customer and seller enter 
into ``side'' agreements to a master contract that effectively amend 
the master contract. Registrants should ensure that appropriate 
policies, procedures, and internal controls exist and are properly 
documented so as to provide reasonable assurances that sales 
transactions, including those affected by side agreements, are 
properly accounted for in accordance with GAAP and to ensure 
compliance with Section 13 of the Securities Exchange Act of 1934 
(i.e., the Foreign Corrupt Practices Act). Side agreements could 
include cancellation, termination, or other provisions that affect 
revenue recognition. The existence of a subsequently executed side 
agreement may be an indicator that the original agreement was not 
final and revenue recognition was not appropriate.

Question 2

    Facts: Company Z enters into an arrangement with Customer A to 
deliver Company Z's products to Customer A on a consignment basis. 
Pursuant to the terms of the arrangement, Customer A is a consignee, 
and title to the products does not pass from Company Z to Customer A 
until Customer A consumes the products in its operations. Company Z 
delivers product to Customer A under the terms of their arrangement.
    Question: May Company Z recognize revenue upon delivery of its 
product to Customer A?
    Interpretive Response: No. Products delivered to a consignee 
pursuant to a consignment arrangement are not sales and do not 
qualify for revenue recognition until a sale occurs. The staff 
believes that revenue recognition is not appropriate because the 
seller retains the risks and rewards of ownership of the product and 
title usually does not pass to the consignee.
    Other situations may exist where title to delivered products 
passes to a buyer, but the substance of the transaction is that of a 
consignment or a financing. Such arrangements require a careful 
analysis of the facts and circumstances of the transaction, as well 
as an understanding of the rights and obligations of the parties, 
and the seller's customary business practices in such arrangements. 
The staff believes that the presence of one or more of the following 
characteristics in a transaction precludes revenue recognition even 
if title to the product has passed to the buyer:
    1. The buyer has the right to return the product and:
    (a) The buyer does not pay the seller at the time of sale, and 
the buyer is not obligated to pay the seller at a specified date or 
dates.\9\
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    \9\ Statement 48, paragraphs 6(b) and 22.
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    (b) The buyer does not pay the seller at the time of sale but 
rather is obligated to pay at a specified date or dates, and the 
buyer's obligation to pay is contractually or implicitly excused 
until the buyer resells the product or subsequently consumes or uses 
the product,\10\
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    \10\ Statement 48, paragraphs 6(b) and 22. The arrangement may 
not specify that payment is contingent upon subsequent resale or 
consumption. However, if the seller has an established business 
practice permitting customers to defer payment beyond the specified 
due date(s) until the products are resold or consumed, then the 
staff believes that the seller's right to receive cash representing 
the sales price is contingent.
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    (c) The buyer's obligation to the seller would be changed (e.g., 
the seller would forgive the obligation or grant a refund) in the 
event of theft or physical destruction or damage of the product,\11\
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    \11\ Statement 48, paragraph 6(c).
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    (d) The buyer acquiring the product for resale does not have 
economic substance apart from that provided by the seller,\12\ or
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    \12\ Statement 48, paragraph 6(d).
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    (e) The seller has significant obligations for future 
performance to directly bring about resale of the product by the 
buyer.\13\
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    \13\ Statement 48, paragraph 6(e).
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    2. The seller is required to repurchase the product (or a 
substantially identical product or processed goods of which the 
product is a component) at specified prices that are not subject to 
change except for fluctuations due to finance and holding costs,\14\ 
and the amounts to be paid by the seller will be adjusted, as 
necessary, to cover substantially all fluctuations in costs incurred 
by the buyer in purchasing and holding the product (including 
interest).\15\ The staff believes that indicators of the latter 
condition include:
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    \14\ Statement 49, paragraph 5(a). Paragraph 5(a) provides 
examples of circumstances that meet this requirement. As discussed 
further therein, this condition is present if (a) a resale price 
guarantee exists, (b) the seller has an option to purchase the 
product, the economic effect of which compels the seller to purchase 
the product, or (c) the buyer has an option whereby it can require 
the seller to purchase the product.
    \15\ Statement 49, paragraph 5(b).
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    (a) The seller provides interest-free or significantly below 
market financing to the buyer beyond the seller's customary sales 
terms and until the products are resold,
    (b) The seller pays interest costs on behalf of the buyer under 
a third-party financing arrangement, or
    (c) The seller has a practice of refunding (or intends to 
refund) a portion of the original sales price representative of 
interest expense for the period from when the buyer paid the seller 
until the buyer resells the product.
    3. The transaction possesses the characteristics set forth in 
EITF Issue 95-1 and does not qualify for sales-type lease 
accounting.
    4. The product is delivered for demonstration purposes.\16\
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    \16\ See SOP 97-2, paragraph 25.
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    This list is not meant to be a checklist of all characteristics 
of a consignment or a financing arrangement, and other 
characteristics may exist. Accordingly, the staff believes that 
judgment is necessary in assessing whether the substance of a 
transaction is a consignment, a financing, or other arrangement for 
which revenue recognition is not appropriate. If title to the goods 
has passed but the substance of the arrangement is not a sale, the 
consigned inventory should be reported separately from other 
inventory in the consignor's financial statements as ``inventory 
consigned to others'' or another appropriate caption.

Question 3

    Facts: The laws of some countries do not provide for a seller's 
retention of a security interest in goods in the same manner as 
established in the U.S. Uniform Commercial Code (UCC). In these 
countries, it is common for a seller to retain a form of title to 
goods delivered to customers until the customer makes payment so 
that the seller can recover the goods in the event of customer 
default on payment.
    Question: Is it acceptable to recognize revenue in these 
transactions before payment is made and title has transferred?
    Interpretive Response: Presuming all other revenue recognition 
criteria have been met, the staff would not object to revenue 
recognition at delivery if the only rights that a seller retains 
with the title are those enabling recovery of the goods in the event 
of customer default on payment. This limited form of ownership may 
exist in some foreign jurisdictions where, despite technically 
holding title, the seller is not entitled to direct the disposition 
of the goods, cannot rescind the transaction, cannot prohibit its 
customer from moving, selling, or otherwise using the goods in the 
ordinary course of business, and has no other rights that rest with 
a titleholder of property that is subject to a lien under the U.S. 
UCC. On the other hand, if retaining title results in the seller 
retaining rights normally held by an owner of goods, the situation 
is not sufficiently different from a delivery of goods on 
consignment. In this particular case, revenue should not be 
recognized until payment is received. Registrants and their auditors 
may wish to consult legal counsel knowledgeable of the local law and 
customs outside the U.S. to determine the seller's rights.

3. Delivery and performance

a. Bill and hold arrangements

    Facts: Company A receives purchase orders for products it 
manufactures. At the end of its fiscal quarters, customers may not 
yet be ready to take delivery of the products for various reasons. 
These reasons may include, but are not limited to, a lack of 
available space for inventory, having more than sufficient inventory 
in their distribution channel, or delays in customers' production 
schedules.
    Question: May Company A recognize revenue for the sale of its 
products once it has completed manufacturing if it segregates the 
inventory of the products in its own warehouse from its own 
products?
    May Company A recognize revenue for the sale if it ships the 
products to a third-party warehouse but (1) Company A retains title 
to the product and (2) payment by the customer is dependent upon 
ultimate delivery to a customer-specified site?
    Interpretative Response: Generally, no. The staff believes that 
delivery generally is not

[[Page 74439]]

considered to have occurred unless the customer has taken title and 
assumed the risks and rewards of ownership of the products specified 
in the customer's purchase order or sales agreement. Typically this 
occurs when a product is delivered to the customer's delivery site 
(if the terms of the sale are ``FOB destination'') or when a product 
is shipped to the customer (if the terms are ``FOB shipping 
point'').
    The Commission has set forth criteria to be met in order to 
recognize revenue when delivery has not occurred.\17\ These include:
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    \17\ See In the Matter of Stewart Parness, AAER 108 (August 5, 
1986); SEC v. Bollinger Industries, Inc., et al., LR 15093 
(September 30, 1996); In the Matter of Laser Photonics, Inc., AAER 
971 (September 30, 1997); In the Matter of Cypress Bioscience Inc., 
AAER 817 (September 19, 1996). Also see Concepts Statement 5, 
paragraph 84(a) and SOP 97-2, paragraph 22.
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    1. The risks of ownership must have passed to the buyer;
    2. The customer must have made a fixed commitment to purchase 
the goods, preferably in written documentation;
    3. The buyer, not the seller, must request that the transaction 
be on a bill and hold basis.\18\ The buyer must have a substantial 
business purpose for ordering the goods on a bill and hold basis;
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    \18\ Such requests typically should be set forth in writing by 
the buyer.
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    4. There must be a fixed schedule for delivery of the goods. The 
date for delivery must be reasonable and must be consistent with the 
buyer's business purpose (e.g., storage periods are customary in the 
industry);
    5. The seller must not have retained any specific performance 
obligations such that the earning process is not complete;
    6. The ordered goods must have been segregated from the seller's 
inventory and not be subject to being used to fill other orders; and
    7. The equipment [product] must be complete and ready for 
shipment.
    The above listed conditions are the important conceptual 
criteria that should be used in evaluating any purported bill and 
hold sale. This listing is not intended as a checklist. In some 
circumstances, a transaction may meet all factors listed above but 
not meet the requirements for revenue recognition. The Commission 
also has noted that in applying the above criteria to a purported 
bill and hold sale, the individuals responsible for the preparation 
and filing of financial statements also should consider the 
following factors: \19\
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    \19\ See Note 17, supra.
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    1. The date by which the seller expects payment, and whether the 
seller has modified its normal billing and credit terms for this 
buyer; \20\
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    \20\ Such individuals should consider whether Opinion 21 
pertaining to the need for discounting the related receivable, is 
applicable. Opinion 21, paragraph 3(a), indicates that the 
requirements of that Opinion to record receivables at a discounted 
value are not intended to apply to ``receivables and payables 
arising from transactions with customers or suppliers in the normal 
course of business which are due in customary trade terms not 
exceeding approximately one year'' (emphasis added).
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    2. The seller's past experiences with and pattern of bill and 
hold transactions;
    3. Whether the buyer has the expected risk of loss in the event 
of a decline in the market value of goods;
    4. Whether the seller's custodial risks are insurable and 
insured;
    5. Whether extended procedures are necessary in order to assure 
that there are no exceptions to the buyer's commitment to accept and 
pay for the goods sold (i.e., that the business reasons for the bill 
and hold have not introduced a contingency to the buyer's 
commitment).
    Delivery generally is not considered to have occurred unless the 
product has been delivered to the customer's place of business or 
another site specified by the customer. If the customer specifies an 
intermediate site but a substantial portion of the sales price is 
not payable until delivery is made to a final site, then revenue 
should not be recognized until final delivery has occurred.\21\
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    \21\ SOP 97-2, paragraph 22.
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b. Customer acceptance

    After delivery of a product or performance of a service, if 
uncertainty exists about customer acceptance, revenue should not be 
recognized until acceptance occurs.\22\ Customer acceptance 
provisions may be included in a contract, among other reasons, to 
enforce a customer's rights to (1) test the delivered product, (2) 
require the seller to perform additional services subsequent to 
delivery of an initial product or performance of an initial service 
(e.g., a seller is required to install or activate delivered 
equipment), or (3) identify other work necessary to be done before 
accepting the product. The staff presumes that such contractual 
customer acceptance provisions are substantive, bargained-for terms 
of an arrangement. Accordingly, when such contractual customer 
acceptance provisions exist, the staff generally believes that the 
seller should not recognize revenue until customer acceptance occurs 
or the acceptance provisions lapse.
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    \22\ SOP 97-2, paragraph 20. Also, Concepts Statement 5, 
paragraph 83(b) states ``revenues are considered to have been earned 
when the entity has substantially accomplished what it must do to be 
entitled to the benefits represented by the revenues.'' If an 
arrangement expressly requires customer acceptance, the staff 
generally believes that customer acceptance should occur before the 
entity has substantially accomplished what it must do to be entitled 
to the benefits represented by the revenues, especially when the 
seller is obligated to perform additional steps.
---------------------------------------------------------------------------

Question 1

    Question: Do circumstances exist in which formal customer sign-
off (that a contractual customer acceptance provision is met) is 
unnecessary to meet the requirements to recognize revenue?
    Interpretive Response: Yes. Formal customer sign-off is not 
always necessary to recognize revenue provided that the seller 
objectively demonstrates that the criteria specified in the 
acceptance provisions are satisfied. Customer acceptance provisions 
generally allow the customer to cancel the arrangement when a seller 
delivers a product that the customer has not yet agreed to purchase 
or delivers a product that does not meet the specifications of the 
customer's order. In those cases, revenue should not be recognized 
because a sale has not occurred. In applying this concept, the staff 
observes that customer acceptance provisions normally take one of 
four general forms. Those forms, and how the staff generally 
assesses whether customer acceptance provisions should result in 
revenue deferral, are described below:
    (a) Acceptance provisions in arrangements that purport to be for 
trial or evaluation purposes.\23\ In these arrangements, the seller 
delivers a product to a customer, and the customer agrees to receive 
the product, solely to give the customer the ability to evaluate the 
delivered product prior to acceptance. The customer does not agree 
to purchase the delivered product until it accepts the product. In 
some cases, the acceptance provisions lapse by the passage of time 
without the customer rejecting the delivered product, and in other 
cases affirmative acceptance from the customer is necessary to 
trigger a sales transaction. Frequently, the title to the product 
does not transfer and payment terms are not established prior to 
customer acceptance. These arrangements are, in substance, 
consignment arrangements until the customer accepts the product as 
set forth in the contract with the seller. Accordingly, in 
arrangements where products are delivered for trial or evaluation 
purposes, revenue should not be recognized until the earlier of when 
acceptance occurs or the acceptance provisions lapse.
---------------------------------------------------------------------------

    \23\ See, for example, SOP 97-2, paragraph 25.
---------------------------------------------------------------------------

    In contrast, other arrangements do not purport to be for trial 
or evaluation purposes. In these instances, the seller delivers a 
specified product pursuant to a customer's order, establishes 
payment terms, and transfers title to the delivered product to the 
customer. However, customer acceptance provisions may be included in 
the arrangement to give the purchaser the ability to ensure the 
delivered product meets the criteria set forth in its order. The 
staff evaluates these provisions as follows:
    (b) Acceptance provisions that grant a right of return or 
exchange on the basis of subjective matters. An example of such a 
provision is one that allows the customer to return a product if the 
customer is dissatisfied with the product.\24\ The staff believes 
these provisions are not different from general rights of return and 
should be accounted for in accordance with Statement 48. Statement 
48 requires that the amount of future returns must be reasonably 
estimable in order for revenue to be recognized prior to the 
expiration of return rights.\25\ That estimate may not be made in 
the absence of a large volume of homogeneous transactions or if 
customer acceptance is likely to depend on conditions for which 
sufficient historical experience is absent.\26\ Satisfaction of 
these requirements may vary from product-to-product, location-to-
location, customer-to-customer, and vendor-to-vendor.
---------------------------------------------------------------------------

    \24\ Statement 48, paragraph 13.
    \25\ Statement 48, paragraph 6(f).
    \26\ Statement 48, paragraphs 8(c) and 8(d).
---------------------------------------------------------------------------

    (c) Acceptance provisions based on seller-specified objective 
criteria. An example of such a provision is one that gives the

[[Page 74440]]

customer a right of return or replacement if the delivered product 
is defective or fails to meet the vendor's published specifications 
for the product.\27\ Such rights are generally identical to those 
granted to all others within the same class of customer and for 
which satisfaction can be generally assured without consideration of 
conditions specific to the customer. Provided the seller has 
previously demonstrated that the product meets the specified 
criteria, the staff believes that these provisions are not different 
from general or specific warranties and should be accounted for as 
warranties in accordance with Statement 5. In this case, the cost of 
potentially defective goods must be reliably estimable based on a 
demonstrated history of substantially similar transactions.\28\ 
However, if the seller has not previously demonstrated that the 
delivered product meets the seller's specifications, the staff 
believes that revenue should be deferred until the specifications 
have been objectively achieved.
---------------------------------------------------------------------------

    \27\ Statement 5, paragraph 24 and Statement 48, paragraph 4(c).
    \28\ Statement 5, paragraph 25.
---------------------------------------------------------------------------

    (d) Acceptance provisions based on customer-specified objective 
criteria. These provisions are referred to in this document as 
``customer-specific acceptance provisions'' against which 
substantial completion and contract fulfillment must be evaluated. 
While formal customer sign-off provides the best evidence that these 
acceptance criteria have been met, revenue recognition also would be 
appropriate, presuming all other revenue recognition criteria have 
been met, if the seller reliably demonstrates that the delivered 
products or services meet all of the specified criteria prior to 
customer acceptance. For example, if a seller reliably demonstrates 
that a delivered product meets the customer-specified objective 
criteria set forth in the arrangement, the delivery criterion would 
generally be satisfied when title and the risks and rewards of 
ownership transfers unless product performance may reasonably be 
different under the customer's testing conditions specified by the 
acceptance provisions. Further, the seller should consider whether 
it would be successful in enforcing a claim for payment even in the 
absence of formal sign-off. Whether the vendor has fulfilled the 
terms of the contract before customer acceptance is a matter of 
contract law, and depending on the facts and circumstances, an 
opinion of counsel may be necessary to reach a conclusion.

Question 2

    Facts: Consider an arrangement that calls for the transfer of 
title to equipment upon delivery to a customer's site. However, 
customer-specific acceptance provisions permit the customer to 
return the equipment unless the equipment satisfies certain 
performance tests. The arrangement calls for the vendor to perform 
the installation. Assume the equipment and the installation are 
separate units of accounting under EITF Issue 00-21.\29\
---------------------------------------------------------------------------

    \29\ This fact is provided as an assumption to facilitate an 
analysis of revenue recognition in this fact pattern. No 
interpretation of Issue 00-21 is intended.
---------------------------------------------------------------------------

    Question: Must revenue allocated to the equipment always be 
deferred until installation and on-site testing are successfully 
completed?
    Interpretive Response: No. The staff would not object to revenue 
recognition for the equipment upon delivery (presuming all other 
revenue recognition criteria have been met for the equipment) if the 
seller demonstrates that, at the time of delivery, the equipment 
already meets all of the criteria and specifications in the 
customer-specific acceptance provisions. This may be demonstrated if 
conditions under which the customer intends to operate the equipment 
are replicated in pre-shipment testing, unless the performance of 
the equipment, once installed and operated at the customer's 
facility, may reasonably be different from that tested prior to 
shipment.
    Determining whether the delivered equipment meets all of a 
product's criteria and specifications is a matter of judgment that 
must be evaluated in light of the facts and circumstances of a 
particular transaction. Consultation with knowledgeable project 
managers or engineers may be necessary in such circumstances.
    For example, if the customer acceptance provisions were based on 
meeting certain size and weight characteristics, it should be 
possible to determine whether those criteria have been met before 
shipment. Historical experience with the same specifications and 
functionality of a particular machine that demonstrates that the 
equipment meets the customer's specifications also may provide 
sufficient evidence that the currently shipped equipment satisfies 
the customer-specific acceptance provisions.
    If an arrangement includes customer acceptance criteria or 
specifications that cannot be effectively tested before delivery or 
installation at the customer's site, the staff believes that revenue 
recognition should be deferred until it can be demonstrated that the 
criteria are met. This situation usually will exist when equipment 
performance can vary based on how the equipment works in combination 
with the customer's other equipment, software, or environmental 
conditions. In these situations, testing to determine whether the 
criteria are met cannot be reasonably performed until the products 
are installed or integrated at the customer's facility.
    Although the following questions provide several examples 
illustrating how the staff evaluates customer acceptance, the 
determination of when customer-specific acceptance provisions of an 
arrangement are met in the absence of the customer's formal 
notification of acceptance depends on the weight of the evidence in 
the particular circumstances. Different conclusions could be reached 
in similar circumstances that vary only with respect to a single 
variable, such as complexity of the equipment, nature of the 
interface with the customer's environment, extent of the seller's 
experience with the same type of transactions, or a particular 
clause in the agreement. The staff believes management and auditors 
are uniquely positioned to evaluate the facts and arrive at a 
reasoned conclusion. The staff will not object to a determination 
that is well reasoned on the basis of this guidance.

Question 3

    Facts: Company E is an equipment manufacturer whose main product 
is generally sold in a standard model. The contracts for sale of 
that model provide for customer acceptance to occur after the 
equipment is received and tested by the customer. The acceptance 
provisions state that if the equipment does not perform to Company 
E's published specifications, the customer may return the equipment 
for a full refund or a replacement unit, or may require Company E to 
repair the equipment so that it performs up to published 
specifications. Customer acceptance is indicated by either a formal 
sign-off by the customer or by the passage of 90 days without a 
claim under the acceptance provisions. Title to the equipment passes 
upon delivery to the customer. Company E does not perform any 
installation or other services on the equipment it sells and tests 
each piece of equipment against its specifications before shipment. 
Payment is due under Company E's normal payment terms for that 
product 30 days after customer acceptance.
    Company E receives an order from a new customer for a standard 
model of its main product. Based on the customer's intended use of 
the product, location and other factors, there is no reason that the 
equipment would operate differently in the customer's environment 
than it does in Company E's facility.
    Question: Assuming all other revenue recognition criteria are 
met (other than the issue raised with respect to the acceptance 
provision), when should Company E recognize revenue from the sale of 
this piece of equipment?
    Interpretive Response: While the staff presumes that customer 
acceptance provisions are substantive provisions that generally 
result in revenue deferral, that presumption can be overcome as 
discussed above. Although the contract includes a customer 
acceptance clause, acceptance is based on meeting Company E's 
published specifications for a standard model. Company E 
demonstrates that the equipment shipped meets the specifications 
before shipment, and the equipment is expected to operate the same 
in the customer's environment as it does in Company E's. In this 
situation, Company E should evaluate the customer acceptance 
provision as a warranty under Statement 5. If Company E can 
reasonably and reliably estimate the amount of warranty obligations, 
the staff believes that it should recognize revenue upon delivery of 
the equipment, with an appropriate liability for probable warranty 
obligations.

Question 4

    Facts: Assume the same facts about Company E's equipment, 
contract terms and customary practices as in Question 3 above. 
Company E enters into an arrangement with a new customer to deliver 
a version of its standard product modified as necessary to fit into 
a space of specific dimensions while still meeting all of the 
published vendor specifications with regard to performance. In 
addition to the customer acceptance provisions relating to the 
standard

[[Page 74441]]

performance specifications, the customer may reject the equipment if 
it does not conform to the specified dimensions. Company E creates a 
testing chamber of the exact same dimensions as specified by the 
customer and makes simple design changes to the product so that it 
fits into the testing chamber. The equipment still meets all of the 
standard performance specifications.
    Question: Assuming all other revenue recognition criteria are 
met (other than the issue raised with respect to the acceptance 
provision), when should Company E recognize revenue from the sale of 
this piece of equipment?
    Interpretive Response: Although the contract includes a customer 
acceptance clause that is based, in part, on a customer specific 
criterion, Company E demonstrates that the equipment shipped meets 
that objective criterion, as well as the published specifications, 
before shipment. The staff believes that the customer acceptance 
provisions related to the standard performance specifications should 
be evaluated as a warranty under Statement 5. If Company E can 
reasonably and reliably estimate the amount of warranty obligations, 
it should recognize revenue upon delivery of the equipment, with an 
appropriate liability for probable warranty obligations.

Question 5

    Facts: Assume the same facts about Company E's equipment, 
contract terms and customary practices as in Question 3 above. 
Company E enters into an arrangement with a new customer to deliver 
a version of its standard product modified as necessary to be 
integrated into the customer's new assembly line while still meeting 
all of the standard published vendor specifications with regard to 
performance. The customer may reject the equipment if it fails to 
meet the standard published performance specifications or cannot be 
satisfactorily integrated into the new line. Company E has never 
modified its equipment to work on an integrated basis in the type of 
assembly line the customer has proposed. In response to the request, 
Company E designs a version of its standard equipment that is 
modified as believed necessary to operate in the new assembly line. 
The modified equipment still meets all of the standard published 
performance specifications, and Company E believes the equipment 
will meet the requested specifications when integrated into the new 
assembly line. However, Company E is unable to replicate the new 
assembly line conditions in its testing.
    Question: Assuming all other revenue recognition criteria are 
met (other than the issue raised with respect to the acceptance 
provision), when should Company E recognize revenue from the sale of 
this piece of equipment?
    Interpretive Response: This contract includes a customer 
acceptance clause that is based, in part, on a customer specific 
criterion, and Company E cannot demonstrate that the equipment 
shipped meets that criterion before shipment. Accordingly, the staff 
believes that the contractual customer acceptance provision has not 
been met at shipment. Therefore, the staff believes that Company E 
should wait until the product is successfully integrated at its 
customer's location and meets the customer-specific criteria before 
recognizing revenue. While this is best evidenced by formal customer 
acceptance, other objective evidence that the equipment has met the 
customer-specific criteria may also exist (e.g., confirmation from 
the customer that the specifications were met).

c. Inconsequential or Perfunctory Performance Obligations

Question 1

    Question: Does the failure to complete all activities related to 
a unit of accounting preclude recognition of revenue for that unit 
of accounting?
    Interpretive Response: No. Assuming all other recognition 
criteria are met, revenue for the unit of accounting may be 
recognized in its entirety if the seller's remaining obligation is 
inconsequential or perfunctory.
    A seller should substantially complete or fulfill the terms 
specified in the arrangement related to the unit of accounting at 
issue in order for delivery or performance to have occurred.\30\ 
When applying the substantially complete notion, the staff believes 
that only inconsequential or perfunctory actions may remain 
incomplete such that the failure to complete the actions would not 
result in the customer receiving a refund or rejecting the delivered 
products or services performed to date. In addition, the seller 
should have a demonstrated history of completing the remaining tasks 
in a timely manner and reliably estimating the remaining costs. If 
revenue is recognized upon substantial completion of the terms 
specified in the arrangement related to the unit of accounting at 
issue, all related costs of performance or delivery should be 
accrued.
---------------------------------------------------------------------------

    \30\ Concepts Statement 5, paragraph 83(b) states ``revenues are 
considered to have been earned when the entity has substantially 
accomplished what it must do to be entitled the benefits represented 
by the revenues.''
---------------------------------------------------------------------------

Question 2

    Question: What factors should be considered in the evaluation of 
whether a remaining obligation related to a unit of accounting is 
inconsequential or perfunctory?
    Interpretive Response: A remaining performance obligation is not 
inconsequential or perfunctory if it is essential to the 
functionality of the delivered products or services. In addition, 
remaining activities are not inconsequential or perfunctory if 
failure to complete the activities would result in the customer 
receiving a full or partial refund or rejecting (or a right to a 
refund or to reject) the products delivered or services performed to 
date. The terms of the sales contract regarding both the right to a 
full or partial refund and the right of return or rejection should 
be considered when evaluating whether a portion of the purchase 
price would be refundable. If the company has a historical pattern 
of granting such rights, that historical pattern should also be 
considered even if the current contract expressly precludes such 
rights. Further, other factors should be considered in assessing 
whether remaining obligations are inconsequential or perfunctory. 
For example, the staff also considers the following factors, which 
are not all-inclusive, to be indicators that a remaining performance 
obligation is substantive rather than inconsequential or 
perfunctory:
    [sbull] The seller does not have a demonstrated history of 
completing the remaining tasks in a timely manner and reliably 
estimating their costs.
    [sbull] The cost or time to perform the remaining obligations 
for similar contracts historically has varied significantly from one 
instance to another.
    [sbull] The skills or equipment required to complete the 
remaining activity are specialized or are not readily available in 
the marketplace.
    [sbull] The cost of completing the obligation, or the fair value 
of that obligation, is more than insignificant in relation to such 
items as the contract fee, gross profit, and operating income 
allocable to the unit of accounting.
    [sbull] The period before the remaining obligation will be 
extinguished is lengthy. Registrants should consider whether 
reasonably possible variations in the period to complete performance 
affect the certainty that the remaining obligations will be 
completed successfully and on budget.
    [sbull] The timing of payment of a portion of the sales price is 
coincident with completing performance of the remaining activity.
    Registrants' determinations of whether remaining obligations are 
inconsequential or perfunctory should be consistently applied.

Question 3

    Facts: Consider a unit of accounting that includes both 
equipment and installation because the two deliverables do not meet 
the separation criteria under EITF Issue 00-21. This may be because 
the equipment does not have value to the customer on a standalone 
basis, there is no objective and reliable evidence of fair value for 
the installation or there is a general right of return when the 
installation is not considered probable and in control of the 
vendor.
    Question: In this situation, must all revenue be deferred until 
installation is performed?
    Interpretive Response: Yes, if installation is essential to the 
functionality of the equipment. \31\ Examples of indicators that 
installation is essential to the functionality of equipment include:
---------------------------------------------------------------------------

    \31\ See SOP 97-2, paragraph 13.
---------------------------------------------------------------------------

    [sbull] The installation involves significant changes to the 
features or capabilities of the equipment or building complex 
interfaces or connections;
    [sbull] The installation services are unavailable from other 
vendors.\32\
---------------------------------------------------------------------------

    \32\ See SOP 97-2, paragraphs 68-71 for analogous guidance.
---------------------------------------------------------------------------

    Conversely, examples of indicators that installation is not 
essential to the functionality of the equipment include:
    [sbull] The equipment is a standard product;
    [sbull] Installation does not significantly alter the 
equipment's capabilities;

[[Page 74442]]

    [sbull] Other companies are available to perform the 
installation.\33\
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    \33\ Ibid.
---------------------------------------------------------------------------

    If it is determined that the undelivered service is not 
essential to the functionality of the delivered product but a 
portion of the contract fee is not payable until the undelivered 
service is delivered, the staff would not consider that obligation 
to be inconsequential or perfunctory. Generally, the portion of the 
contract price that is withheld or refundable should be deferred 
until the outstanding service is delivered because that portion 
would not be realized or realizable.\34\
---------------------------------------------------------------------------

    \34\ Concepts Statement 5, paragraph 83(a) and Statement 48, 
paragraph 6(b).
---------------------------------------------------------------------------

d. License Fee Revenue

    Facts: Assume that intellectual property is physically delivered 
and payment is received on December 20, upon the registrant's 
consummation of an agreement granting its customer a license to use 
the intellectual property for a term beginning on the following 
January 1.
    Question: Should the license fee be recognized in the period 
ending December 31?
    Interpretive Response: No. In licensing and similar arrangements 
(e.g., licenses of motion pictures, software, technology, and other 
intangibles), the staff believes that delivery does not occur for 
revenue recognition purposes until the license term begins.\35\ 
Accordingly, if a licensed product or technology is physically 
delivered to the customer, but the license term has not yet begun, 
revenue should not be recognized prior to inception of the license 
term. Upon inception of the license term, revenue should be 
recognized in a manner consistent with the nature of the transaction 
and the earnings process.
---------------------------------------------------------------------------

    \35\ SOP 00-2, paragraph 7.
---------------------------------------------------------------------------

e. Layaway sales arrangements

    Facts: Company R is a retailer that offers ``layaway'' sales to 
its customers. Company R retains the merchandise, sets it aside in 
its inventory, and collects a cash deposit from the customer. 
Although Company R may set a time period within which the customer 
must finalize the purchase, Company R does not require the customer 
to enter into an installment note or other fixed payment commitment 
or agreement when the initial deposit is received. The merchandise 
generally is not released to the customer until the customer pays 
the full purchase price. In the event that the customer fails to pay 
the remaining purchase price, the customer forfeits its cash 
deposit. In the event the merchandise is lost, damaged, or 
destroyed, Company R either must refund the cash deposit to the 
customer or provide replacement merchandise.
    Question: In the staff's view, when may Company R recognize 
revenue for merchandise sold under its layaway program?
    Interpretive Response: Provided that the other criteria for 
revenue recognition are met, the staff believes that Company R 
should recognize revenue from sales made under its layaway program 
upon delivery of the merchandise to the customer. Until then, the 
amount of cash received should be recognized as a liability entitled 
such as ``deposits received from customers for layaway sales'' or a 
similarly descriptive caption. Because Company R retains the risks 
of ownership of the merchandise, receives only a deposit from the 
customer, and does not have an enforceable right to the remainder of 
the purchase price, the staff would object to Company R recognizing 
any revenue upon receipt of the cash deposit. This is consistent 
with item two (2) in the Commission's criteria for bill-and-hold 
transactions which states ``the customer must have made a fixed 
commitment to purchase the goods.''

f. Nonrefundable up-front fees

Question 1

    Facts: Registrants may negotiate arrangements pursuant to which 
they may receive nonrefundable fees upon entering into arrangements 
or on certain specified dates. The fees may ostensibly be received 
for conveyance of a license or other intangible right or for 
delivery of particular products or services. Various business 
factors may influence how the registrant and customer structure the 
payment terms. For example, in exchange for a greater up-front fee 
for an intangible right, the registrant may be willing to receive 
lower unit prices for related products to be delivered in the 
future. In some circumstances, the right, product, or service 
conveyed in conjunction with the nonrefundable fee has no utility to 
the purchaser separate and independent of the registrant's 
performance of the other elements of the arrangement. Therefore, in 
the absence of the registrant's continuing involvement under the 
arrangement, the customer would not have paid the fee. Examples of 
this type of arrangement include the following:
    [sbull] A registrant sells a lifetime membership in a health 
club. After paying a nonrefundable ``initiation fee,'' the customer 
is permitted to use the health club indefinitely, so long as the 
customer also pays an additional usage fee each month. The monthly 
usage fees collected from all customers are adequate to cover the 
operating costs of the health club.
    [sbull] A registrant in the biotechnology industry agrees to 
provide research and development activities for a customer for a 
specified term. The customer needs to use certain technology owned 
by the registrant for use in the research and development 
activities. The technology is not sold or licensed separately 
without the research and development activities. Under the terms of 
the arrangement, the customer is required to pay a nonrefundable 
``technology access fee'' in addition to periodic payments for 
research and development activities over the term of the contract.
    [sbull] A registrant requires a customer to pay a nonrefundable 
``activation fee'' when entering into an arrangement to provide 
telecommunications services. The terms of the arrangement require 
the customer to pay a monthly usage fee that is adequate to recover 
the registrant's operating costs. The costs incurred to activate the 
telecommunications service are nominal.
    [sbull] A registrant charges users a fee for non-exclusive 
access to its Web site that contains proprietary databases. The fee 
allows access to the Web site for a one-year period. After the 
customer is provided with an identification number and trained in 
the use of the database, there are no incremental costs that will be 
incurred in serving this customer.
    [sbull] A registrant charges a fee to users for advertising a 
product for sale or auction on certain pages of its Web site. The 
company agrees to maintain the listing for a period of time. The 
cost of maintaining the advertisement on the Web site for the stated 
period is minimal.
    [sbull] A registrant charges a fee for hosting another company's 
Web site for one year. The arrangement does not involve exclusive 
use of any of the hosting company's servers or other equipment. 
Almost all of the projected costs to be incurred will be incurred in 
the initial loading of information on the host company's Internet 
server and setting up appropriate links and network connections.
    Question: Assuming these arrangements qualify as single units of 
accounting under EITF Issue 00-21 \36\, when should the revenue 
relating to nonrefundable, up-front fees in these types of 
arrangements be recognized?
---------------------------------------------------------------------------

    \36\ The staff believes that the vendor activities associated 
with the up-front fee, even if considered a deliverable to be 
evaluated under EITF Issue 00-21, will rarely provide value to the 
customer on a standalone basis.
---------------------------------------------------------------------------

    Interpretive Response: The staff believes that registrants 
should consider the specific facts and circumstances to determine 
the appropriate accounting for nonrefundable, up-front fees. Unless 
the up-front fee is in exchange for products delivered or services 
performed that represent the culmination of a separate earnings 
process,\37\ the deferral of revenue is appropriate.
---------------------------------------------------------------------------

    \37\ See Concepts Statement 5, footnote 51, for a description of 
the ``earning process.''
---------------------------------------------------------------------------

    In the situations described above, the staff does not view the 
activities completed by the registrants (i.e., selling the 
membership, signing the contract, enrolling the customer, activating 
telecommunications services or providing initial set-up services) as 
discrete earnings events.\38\ The terms, conditions, and amounts of 
these fees typically are negotiated in conjunction with the pricing 
of all the elements of the arrangement, and the customer would 
ascribe a significantly lower, and perhaps no, value to elements 
ostensibly associated with the up-front fee in the absence of the 
registrant's performance of other contract elements. The fact that 
the registrants do not sell the initial rights, products, or 
services separately (i.e., without the registrants' continuing 
involvement) supports the staff's view. The staff believes that the 
customers are purchasing the on-

[[Page 74443]]

going rights, products, or services being provided through the 
registrants' continuing involvement. Further, the staff believes 
that the earnings process is completed by performing under the terms 
of the arrangements, not simply by originating a revenue-generating 
arrangement.
---------------------------------------------------------------------------

    \38\ In a similar situation, lenders may collect nonrefundable 
loan origination fees in connection with lending activities. The 
FASB concluded in Statement 91 that loan origination is not a 
separate revenue-producing activity of a lender, and therefore, 
those nonrefundable fees collected at the outset of the loan 
arrangement are not recognized as revenue upon receipt but are 
deferred and recognized over the life of the loan (paragraphs 5 and 
37).
---------------------------------------------------------------------------

    While the incurrence of nominal up-front costs helps make it 
clear that there is not a separate earnings event in the 
telecommunications example above, incurrence of substantive costs, 
such as in the web hosting example above, does not necessarily 
indicate that there is a separate earnings event. Whether there is a 
separate earnings event should be evaluated on a case-by-case basis. 
Some have questioned whether revenue may be recognized in these 
transactions to the extent of the incremental direct costs incurred 
in the activation. Because there is no separable deliverable or 
earnings event, the staff would generally object to that approach, 
except where it is provided for in the authoritative literature 
(e.g., Statement 51).
    Supply or service transactions may involve the charge of a 
nonrefundable initial fee with subsequent periodic payments for 
future products or services. The initial fees may, in substance, be 
wholly or partly an advance payment for future products or services. 
In the examples above, the on-going rights or services being 
provided or products being delivered are essential to the customers 
receiving the expected benefit of the up-front payment. Therefore, 
the up-front fee and the continuing performance obligation related 
to the services to be provided or products to be delivered are 
assessed as an integrated package. In such circumstances, the staff 
believes that up-front fees, even if nonrefundable, are earned as 
the products and/or services are delivered and/or performed over the 
term of the arrangement or the expected period of performance \39\ 
and generally should be deferred and recognized systematically over 
the periods that the fees are earned.\40\
---------------------------------------------------------------------------

    \39\ The revenue recognition period should extend beyond the 
initial contractual period if the relationship with the customer is 
expected to extend beyond the initial term and the customer 
continues to benefit from the payment of the up-front fee (e.g., if 
subsequent renewals are priced at a bargain to the initial up-front 
fee).
    \40\ A systematic method would be on a straight-line basis, 
unless evidence suggests that revenue is earned or obligations are 
fulfilled in a different pattern, in which case that pattern should 
be followed.
---------------------------------------------------------------------------

    Some propose that revenue should be recognized when the initial 
set-up is completed in cases where the on-going obligation involves 
minimal or no cost or effort and should, therefore, be considered 
perfunctory or inconsequential. However, the staff believes that the 
substance of each of these transactions indicates that the purchaser 
is paying for a service that is delivered over time. Therefore, 
revenue recognition should occur over time, reflecting the provision 
of service.\41\
---------------------------------------------------------------------------

    \41\ Concepts Statement 5, paragraph 84(d).
---------------------------------------------------------------------------

Question 2

    Facts: Company A provides its customers with activity tracking 
or similar services (e.g., tracking of property tax payment 
activity, sending delinquency letters on overdue accounts, etc.) for 
a ten-year period. Company A requires customers to prepay for all 
the services for the term specified in the arrangement. The on-going 
services to be provided are generally automated after the initial 
customer set-up. At the outset of the arrangement, Company A 
performs set-up procedures to facilitate delivery of its on-going 
services to the customers. Such procedures consist primarily of 
establishing the necessary records and files in Company A's pre-
existing computer systems in order to provide the services. Once the 
initial customer set-up activities are complete, Company A provides 
its services in accordance with the arrangement. Company A is not 
required to refund any portion of the fee if the customer terminates 
the services or does not utilize all of the services to which it is 
entitled. However, Company A is required to provide a refund if 
Company A terminates the arrangement early. Assume Company A's 
activities are not within the scope of Statement 91 and that this 
arrangement qualifies as a single unit of accounting under EITF 
Issue 00-21.\42\
---------------------------------------------------------------------------

    \42\ See Note 36, supra.
---------------------------------------------------------------------------

    Question: When should Company A recognize the service revenue?
    Interpretive Response: The staff believes that, provided all 
other revenue recognition criteria are met, service revenue should 
be recognized on a straight-line basis, unless evidence suggests 
that the revenue is earned or obligations are fulfilled in a 
different pattern, over the contractual term of the arrangement or 
the expected period during which those specified services will be 
performed,\43\ whichever is longer. In this case, the customer 
contracted for the on-going activity tracking service, not for the 
set-up activities. The staff notes that the customer could not, and 
would not, separately purchase the set-up services without the on-
going services. The services specified in the arrangement are 
performed continuously over the contractual term of the arrangement 
(and any subsequent renewals). Therefore, the staff believes that 
Company A should recognize revenue on a straight-line basis, unless 
evidence suggests that the revenue is earned or obligations are 
fulfilled in a different pattern, over the contractual term of the 
arrangement or the expected period during which those specified 
services will be performed, whichever is longer.
---------------------------------------------------------------------------

    \43\ See Note 39, supra.
---------------------------------------------------------------------------

    In this situation, the staff would object to Company A 
recognizing revenue in proportion to the costs incurred because the 
set-up costs incurred bear no direct relationship to the performance 
of services specified in the arrangement. The staff also believes 
that it is inappropriate to recognize the entire amount of the 
prepayment as revenue at the outset of the arrangement by accruing 
the remaining costs because the services required by the contract 
have not been performed.

Question 3

    Facts: Assume the same facts as in Question 2 above.
    Question: Are the initial customer set-up costs incurred by 
Company A within the scope of SOP 98-5?
    Interpretive Response: Footnote 1 of SOP 98-5 states that ``this 
SOP does not address the financial reporting of costs incurred 
related to ongoing customer acquisition, such as policy acquisition 
costs in Statement 60 * * * and loan origination costs in Statement 
91 * * * The SOP addresses the more substantive one-time efforts to 
establish business with an entirely new class of customers (for 
example, a manufacturer who does all of its business with retailers 
attempts to sell merchandise directly to the public).'' As such, the 
set-up costs incurred in this example are not within the scope of 
SOP 98-5.
    The staff believes that the incremental direct costs (Statement 
91 provides an analogous definition) incurred related to the 
acquisition or origination of a customer contract in a transaction 
that results in the deferral of revenue, unless specifically 
provided for in the authoritative literature, may be either expensed 
as incurred or accounted for in accordance with paragraph 4 of 
Technical Bulletin 90-1 or paragraph 5 of Statement 91. The staff 
believes the accounting policy chosen for these costs should be 
disclosed and applied consistently.

Question 4

    Facts: Assume the same facts as in Question 2 above.
    Question: What is the staff's view of the pool of contract 
acquisition and origination costs that are eligible for 
capitalization?
    Interpretive Response: As noted in Question 3 above, Statement 
91 includes a definition of incremental direct costs in its 
glossary. Paragraph 6 of Statement 91 provides further guidance on 
the types of costs eligible for capitalization as customer 
acquisition costs indicating that only costs that result from 
successful loan origination efforts are capitalized. The FASB staff 
has published an Implementation Guide on Statement 91 that provides 
additional guidance on the costs that qualify for capitalization as 
customer acquisition costs. Further, Technical Bulletin 90-1 also 
requires capitalization of incremental direct customer acquisition 
costs and requires that those costs be ``identified consistent with 
the guidance in paragraph 6 of Statement 91.'' Although the facts of 
a particular situation should be analyzed closely to capture those 
costs that are truly direct and incremental, the staff generally 
would not object to an accounting policy that results in the 
capitalization of costs in accordance with paragraph 6(a) and (b) of 
Statement 91 or Technical Bulletin 90-1. Registrants should disclose 
their policies for determining which costs to capitalize as contract 
acquisition and origination costs.

Question 5

    Facts: Assume the same facts as in Question 2 above. Based on 
the guidance in Questions 2, 3 and 4 above, Company A has 
capitalized certain direct and incremental customer set-up costs 
associated with the deferred revenue.
    Question: Over what period should Company A amortize these 
costs?

[[Page 74444]]

    Interpretive Response: When both costs and revenue (in an amount 
equal to or greater than the costs) are deferred, the staff believes 
that the capitalized costs should be charged to expense 
proportionally and over the same period that deferred revenue is 
recognized as revenue.\44\
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    \44\ Technical Bulletin 90-1, paragraph 4.
---------------------------------------------------------------------------

g. Deliverables within an arrangement

    Question: If a company (the seller) has a patent to its 
intellectual property which it licenses to customers, the seller may 
represent and warrant to its licensees that it has a valid patent, 
and will defend and maintain that patent. Does that obligation to 
maintain and defend patent rights, in and of itself, constitute a 
deliverable to be evaluated under EITF Issue 00-21?
    Interpretive Response: No. Provided the seller has legal and 
valid patents upon entering the license arrangement, existing GAAP 
on licenses of intellectual property (e.g., SOP 97-2, SOP 00-2, and 
SFAS No. 50) does not indicate that an obligation to defend valid 
patents represents an additional deliverable to which a portion of 
an arrangement fee should be allocated in an arrangement that 
otherwise qualifies for sales-type accounting. While this clause may 
obligate the licenser to incur costs in the defense and maintenance 
of the patent, that obligation does not involve an additional 
deliverable to the customer. Defending the patent is generally 
consistent with the seller's representation in the license that such 
patent is legal and valid. Therefore, the staff would not consider a 
clause like this to represent an additional deliverable in the 
arrangement.\45\
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    \45\ Note, however, the staff believes that this obligation 
qualifies as a guarantee within the scope of FIN 45, subject to a 
scope exception from the initial recognition and measurement 
provisions.
---------------------------------------------------------------------------

4. Fixed or determinable sales price

a. Refundable fees for services

    A company's contracts may include customer cancellation or 
termination clauses. Cancellation or termination provisions may be 
indicative of a demonstration period or an otherwise incomplete 
transaction. Examples of transactions that financial management and 
auditors should be aware of and where such provisions may exist 
include ``side'' agreements and significant transactions with 
unusual terms and conditions. These contractual provisions raise 
questions as to whether the sales price is fixed or determinable. 
The sales price in arrangements that are cancelable by the customer 
is neither fixed nor determinable until the cancellation privileges 
lapse.\46\ If the cancellation privileges expire ratably over a 
stated contractual term, the sales price is considered to become 
determinable ratably over the stated term.\47\ Short-term rights of 
return, such as thirty-day money-back guarantees, and other 
customary rights to return products are not considered to be 
cancellation privileges, but should be accounted for in accordance 
with Statement 48.\48\
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    \46\ SOP 97-2, paragraph 31.
    \47\ Ibid.
    \48\ Ibid.
---------------------------------------------------------------------------

Question 1

    Facts: Company M is a discount retailer. It generates revenue 
from annual membership fees it charges customers to shop at its 
stores and from the sale of products at a discount price to those 
customers. The membership arrangements with retail customers require 
the customer to pay the entire membership fee (e.g., $35) at the 
outset of the arrangement. However, the customer has the unilateral 
right to cancel the arrangement at any time during its term and 
receive a full refund of the initial fee. Based on historical data 
collected over time for a large number of homogeneous transactions, 
Company M estimates that approximately 40% of the customers will 
request a refund before the end of the membership contract term. 
Company M's data for the past five years indicates that significant 
variations between actual and estimated cancellations have not 
occurred, and Company M does not expect significant variations to 
occur in the foreseeable future.
    Question: May Company M recognize in earnings the revenue for 
the membership fees and accrue the costs to provide membership 
services at the outset of the arrangement?
    Interpretive Response: No. In the staff's view, it would be 
inappropriate for Company M to recognize the membership fees as 
earned revenue upon billing or receipt of the initial fee with a 
corresponding accrual for estimated costs to provide the membership 
services. This conclusion is based on Company M's remaining and 
unfulfilled contractual obligation to perform services (i.e., make 
available and offer products for sale at a discounted price) 
throughout the membership period. Therefore, the earnings process, 
irrespective of whether a cancellation clause exists, is not 
complete.
    In addition, the ability of the member to receive a full refund 
of the membership fee up to the last day of the membership term 
raises an uncertainty as to whether the fee is fixed or determinable 
at any point before the end of the term. Generally, the staff 
believes that a sales price is not fixed or determinable when a 
customer has the unilateral right to terminate or cancel the 
contract and receive a cash refund. A sales price or fee that is 
variable until the occurrence of future events (other than product 
returns that are within the scope of Statement 48) generally is not 
fixed or determinable until the future event occurs. The revenue 
from such transactions should not be recognized in earnings until 
the sales price or fee becomes fixed or determinable. Moreover, 
revenue should not be recognized in earnings by assessing the 
probability that significant, but unfulfilled, terms of a contract 
will be fulfilled at some point in the future. Accordingly, the 
revenue from such transactions should not be recognized in earnings 
prior to the refund privileges expiring. The amounts received from 
customers or subscribers (i.e., the $35 fee mentioned above) should 
be credited to a monetary liability account such as ``customers' 
refundable fees.''
    The staff believes that if a customer has the unilateral right 
to receive both (1) the seller's substantial performance under an 
arrangement (e.g., providing services or delivering product) and (2) 
a cash refund of prepaid fees, then the prepaid fees should be 
accounted for as a monetary liability. In consideration of whether 
the monetary liability can be derecognized, Statement 140 provides 
that liabilities may be derecognized only if (1) the debtor pays the 
creditor and is relieved of its obligation for the liability (paying 
the creditor includes delivery of cash, other financial assets, 
goods, or services or reacquisition by the debtor of its outstanding 
debt securities) or (2) the debtor is legally released from being 
the primary obligor under the liability.\49\ If a customer has the 
unilateral right to receive both (1) the seller's substantial 
performance under the arrangement and (2) a cash refund of prepaid 
fees, then the refund obligation is not relieved upon performance of 
the service or delivery of the products. Rather, the seller's refund 
obligation is relieved only upon refunding the cash or expiration of 
the refund privilege.
---------------------------------------------------------------------------

    \49\ Statement 140, paragraph 16.
---------------------------------------------------------------------------

    Some have argued that there may be a limited exception to the 
general rule that revenue from membership or other service 
transaction fees should not be recognized in earnings prior to the 
refund privileges expiring. Despite the fact that Statement 48 
expressly does not apply to the accounting for service revenue if 
part or all of the service fee is refundable under cancellation 
privileges granted to the buyer,\50\ they believe that in certain 
circumstances a potential refund of a membership fee may be seen as 
being similar to a right of return of products under Statement 48. 
They argue that revenue from membership fees, net of estimated 
refunds, may be recognized ratably over the period the services are 
performed whenever pertinent conditions of Statement 48 are met, 
namely, there is a large population of transactions that grant 
customers the same unilateral termination or cancellation rights and 
reasonable estimates can be made of how many customers likely will 
exercise those rights.
---------------------------------------------------------------------------

    \50\ Statement 48, paragraph 4.
---------------------------------------------------------------------------

    The staff believes that, because service arrangements are 
specifically excluded from the scope of Statement 48, the most 
direct authoritative literature to be applied to the extinguishment 
of obligations under such contracts is Statement 140. As noted 
above, because the refund privilege extends to the end of the 
contract term irrespective of the amount of the service performed, 
Statement 140 indicates that the liability would not be extinguished 
(and therefore no revenue would be recognized in earnings) until the 
cancellation or termination and related refund privileges expire. 
Nonetheless, the staff recognizes that over the years the accounting 
for membership refunds evolved based on analogy to Statement 48 and 
that practice did not change when Statement 140 became effective. 
Reasonable people held, and continue to hold, different views about 
the application of the accounting literature.
    Pending further action in this area by the FASB, the staff will 
not object to the recognition of refundable membership fees, net of 
estimated refunds, as earned revenue over the membership term in the 
limited

[[Page 74445]]

circumstances where all of the following criteria have been met:\51\
---------------------------------------------------------------------------

    \51\ The staff will question further analogies to the guidance 
in Statement 48 for transactions expressly excluded from its scope.
---------------------------------------------------------------------------

    [sbull] The estimates of terminations or cancellations and 
refunded revenues are being made for a large pool of homogeneous 
items (e.g., membership or other service transactions with the same 
characteristics such as terms, periods, class of customers, nature 
of service, etc.).
    [sbull] Reliable estimates of the expected refunds can be made 
on a timely basis.\52\ Either of the following two items would be 
considered indicative of an inability to make reliable estimates: 
(1) Recurring, significant differences between actual experience and 
estimated cancellation or termination rates (e.g., an actual 
cancellation rate of 40% versus an estimated rate of 25%) even if 
the impact of the difference on the amount of estimated refunds is 
not material to the consolidated financial statements \53\ or (2) 
recurring variances between the actual and estimated amount of 
refunds that are material to either revenue or net income in 
quarterly or annual financial statements. In addition, the staff 
believes that an estimate, for purposes of meeting this criterion, 
would not be reliable unless it is remote \54\ that material 
adjustments (both individually and in the aggregate) to previously 
recognized revenue would be required. The staff presumes that 
reliable estimates cannot be made if the customer's termination or 
cancellation and refund privileges exceed one year.
---------------------------------------------------------------------------

    \52\ Reliability is defined in Concepts Statement 2 as ``the 
quality of information that assures that information is reasonably 
free from error and bias and faithfully represents what it purports 
to represent.'' Paragraph 63 of Concepts Statement 5 reiterates the 
definition of reliability, requiring that ``the information is 
representationally faithful, verifiable, and neutral.''
    \53\ For example, if an estimate of the expected cancellation 
rate varies from the actual cancellation rate by 100% but the dollar 
amount of the error is immaterial to the consolidated financial 
statements, some would argue that the estimate could still be viewed 
as reliable. The staff disagrees with that argument.
    \54\ The term ``remote'' is used here with the same definition 
as used in Statement 5.
---------------------------------------------------------------------------

    [sbull] There is a sufficient company-specific historical basis 
upon which to estimate the refunds,\55\ and the company believes 
that such historical experience is predictive of future events. In 
assessing these items, the staff believes that estimates of future 
refunds should take into consideration, among other things, such 
factors as historical experience by service type and class of 
customer, changing trends in historical experience and the basis 
thereof (e.g., economic conditions), the impact or introduction of 
competing services or products, and changes in the customer's 
``accessibility'' to the refund (i.e., how easy it is for customers 
to obtain the refund).
---------------------------------------------------------------------------

    \55\ Paragraph 8 of Statement 48 notes various factors that may 
impair the ability to make a reasonable estimate of returns, 
including the lack of sufficient historical experience. The staff 
typically expects that the historical experience be based on the 
particular registrant's historical experience for a service and/or 
class of customer. In general, the staff typically expects a start-
up company, a company introducing new services, or a company 
introducing services to a new class of customer to have at least two 
years of experience to be able to make reasonable and reliable 
estimates.
---------------------------------------------------------------------------

    [sbull] The amount of the membership fee specified in the 
agreement at the outset of the arrangement is fixed, other than the 
customer's right to request a refund.
    If Company M does not meet all of the foregoing criteria, the 
staff believes that Company M should not recognize in earnings any 
revenue for the membership fee until the cancellation privileges and 
refund rights expire.
    If revenue is recognized in earnings over the membership period 
pursuant to the above criteria, the initial amounts received from 
customer or subscribers (i.e., the $35 fee mentioned above) should 
be allocated to two liability accounts. The amount of the fee 
representing estimated refunds should be credited to a monetary 
liability account, such as ``customers' refundable fees,'' and the 
remaining amount of the fee representing unearned revenue should be 
credited to a nonmonetary liability account, such as ``unearned 
revenues.'' For each income statement presented, registrants should 
disclose in the footnotes to the financial statements the amounts of 
(1) the unearned revenue and (2) refund obligations as of the 
beginning of each period, the amount of cash received from 
customers, the amount of revenue recognized in earnings, the amount 
of refunds paid, other adjustments (with an explanation thereof), 
and the ending balance of (1) unearned revenue and (2) refund 
obligations.
    If revenue is recognized in earnings over the membership period 
pursuant to the above criteria, the staff believes that adjustments 
for changes in estimated refunds should be recorded using a 
retrospective approach whereby the unearned revenue and refund 
obligations are remeasured and adjusted at each balance sheet date 
with the offset being recorded as earned revenue.\56\
---------------------------------------------------------------------------

    \56\ The staff believes deferred costs being amortized on a 
basis consistent with the deferred revenue should be similarly 
adjusted. Such an approach is generally consistent with the 
amortization methodology in Statement 91, paragraph 19.
---------------------------------------------------------------------------

    Companies offering memberships often distribute membership 
packets describing and discussing the terms, conditions, and 
benefits of membership. Packets may include vouchers, for example, 
that provide new members with discounts or other benefits from third 
parties. The costs associated with the vouchers should be expensed 
when distributed. Advertising costs to solicit members should be 
accounted for in accordance with SOP 93-7. Incremental direct costs 
incurred in connection with enrolling customers (e.g., commissions 
paid to agents) should be accounted for as follows: (1) If revenue 
is deferred until the cancellation or termination privileges expire, 
incremental direct costs should be either (a) charged to expense 
when incurred if the costs are not refundable to the company in the 
event the customer obtains a refund of the membership fee, or (b) if 
the costs are refundable to the company in the event the customer 
obtains a refund of the membership fee, recorded as an asset until 
the earlier of termination or cancellation or refund; or (2) if 
revenue, net of estimated refunds, is recognized in earnings over 
the membership period, a like percentage of incremental direct costs 
should be deferred and recognized in earnings in the same pattern as 
revenue is recognized, and the remaining portion should be either 
(a) charged to expense when incurred if the costs are not refundable 
to the company in the event the customer obtains a refund of the 
membership fee, or (b) if the costs are refundable to the company in 
the event the customer obtains a refund of the membership fee, 
recorded as an asset until the refund occurs.\57\ All costs other 
than incremental direct costs (e.g., indirect costs) should be 
expensed as incurred.
---------------------------------------------------------------------------

    \57\ Statement 91, paragraph 5 and Technical Bulletin 90-1, 
paragraph 4 both provide for the deferral of incremental direct 
costs associated with acquiring a revenue-producing contract. Even 
though the revenue discussed in this example is refundable, if a 
registrant meets the aforementioned criteria for revenue recognition 
over the membership period, the staff would analogize to this 
guidance. However, if neither a nonrefundable contract nor a 
reliable basis for estimating net cash inflows under refundable 
contracts exists to provide a basis for recovery of incremental 
direct costs, the staff believes that such costs should be expensed 
as incurred. See SAB Topic 13.A.3.f. Question 3.
---------------------------------------------------------------------------

Question 2

    Question: Will the staff accept an analogy to Statement 48 for 
service transactions subject to customer cancellation privileges 
other than those specifically addressed in the previous question?
    Interpretive Response: The staff has accepted the analogy in 
limited circumstances due to the existence of a large pool of 
homogeneous transactions and satisfaction of the criteria in the 
previous question. Examples of other arrangements involving customer 
cancellation privileges and refundable service fees that the staff 
has addressed include the following:
    [sbull] A leasing broker whose commission from the lessor upon a 
commercial tenant's signing of a lease agreement is refundable (or 
in some cases, is not due) under lessor cancellation privileges if 
the tenant fails to move into the leased premises by a specified 
date.
    [sbull] A talent agent whose fee receivable from its principal 
(i.e., a celebrity) for arranging a celebrity endorsement for a 
five-year term is cancelable by the celebrity if the celebrity 
breaches the endorsement contract with its customer.
    [sbull] An insurance agent whose commission received from the 
insurer upon selling an insurance policy is refundable in whole for 
the 30-day period that state law permits the consumer to repudiate 
the contract and then refundable on a declining pro rata basis until 
the consumer has made six monthly payments.
    In the first two of these cases, the staff advised the 
registrants that the portion of revenue subject to customer 
cancellation and refund must be deferred until no longer subject to 
that contingency because the registrants did not have an ability to 
make reliable estimates of customer cancellations due to the lack of 
a large pool of

[[Page 74446]]

homogeneous transactions. In the case of the insurance agent, 
however, the particular registrant demonstrated that it had a 
sufficient history of homogeneous transactions with the same 
characteristics from which to reliably estimate contract 
cancellations and satisfy all the criteria specified in the previous 
question. Accordingly, the staff did not object to that registrant's 
policy of recognizing its sales commission as revenue when its 
performance was complete, with an appropriate allowance for 
estimated cancellations.

Question 3

    Question: Must a registrant analogize to Statement 48, or may it 
choose to defer all revenue until the refund period lapses as 
suggested by Statement 140 even if the criteria above for analogy to 
Statement 48 are met?
    Interpretive Response: The analogy to Statement 48 is presented 
as an alternative that would be acceptable to the staff when the 
listed conditions are met. However, a registrant may choose to defer 
all revenue until the refund period lapses. The policy chosen should 
be disclosed and applied consistently.

Question 4

    Question: May a registrant that meets the above criteria for 
reliable estimates of cancellations choose at some point in the 
future to change from the Statement 48 method to the Statement 140 
method of accounting for these refundable fees? May a registrant 
change from the Statement 140 method to the Statement 48 method?
    Interpretive Response: The staff believes that Statement 140 
provides a preferable accounting model for service transactions 
subject to potential refunds. Therefore, the staff would not object 
to a change from the Statement 48 method to the Statement 140 
method. However, if a registrant had previously chosen the Statement 
140 method, the staff would object to a change to the Statement 48 
method.

Question 5

    Question: Is there a minimum level of customers that must be 
projected not to cancel before use of Statement 48 type accounting 
is appropriate?
    Interpretive Response: Statement 48 does not include any such 
minimum. Therefore, the staff does not believe that a minimum must 
apply in service transactions either. However, as the refund rate 
increases, it may be increasingly difficult to make reasonable and 
reliable estimates of cancellation rates.

Question 6

    Question: When a registrant first determines that reliable 
estimates of cancellations of service contracts can be made (e.g., 
two years of historical evidence becomes available), how should the 
change from the complete deferral method to the method of 
recognizing revenue, net of estimated cancellations, over time be 
reflected?
    Interpretive Response: Changes in the ability to meet the 
criteria set forth above should be accounted for in the manner 
described in paragraph 6 of Statement 48, which addresses the 
accounting when a company experiences a change in the ability to 
make reasonable estimates of future product returns.

b. Estimates and changes in estimates

    Accounting for revenues and costs of revenues requires estimates 
in many cases; those estimates sometimes change. Registrants should 
ensure that they have appropriate internal controls and adequate 
books and records that will result in timely identification of 
necessary changes in estimates that should be reflected in the 
financial statements and notes thereto.

Question 1

    Facts: Paragraph 8 of Statement 48 lists a number of factors 
that may impair the ability to make a reasonable estimate of product 
returns in sales transactions when a right of return exists.\58\ The 
paragraph concludes by stating ``other factors may preclude a 
reasonable estimate.''
---------------------------------------------------------------------------

    \58\ These factors include ``(a) the susceptibility of the 
product to significant external factors, such as technological 
obsolescence or changes in demand, (b) relatively long periods in 
which a particular product may be returned, (c) absence of 
historical experience with similar types of sales of similar 
products, or inability to apply such experience because of changing 
circumstances, for example, changes in the selling enterprise's 
marketing policies and relationships with its customers, and (d) 
absence of a large volume of relatively homogeneous transactions.''
---------------------------------------------------------------------------

    Question: What ``other factors,'' in addition to those listed in 
paragraph 8 of Statement 48, has the staff identified that may 
preclude a registrant from making a reasonable and reliable estimate 
of product returns?
    Interpretive Response: The staff believes that the following 
additional factors, among others, may affect or preclude the ability 
to make reasonable and reliable estimates of product returns: (1) 
Significant increases in or excess levels of inventory in a 
distribution channel (sometimes referred to as ``channel 
stuffing''), (2) lack of ``visibility'' into or the inability to 
determine or observe the levels of inventory in a distribution 
channel and the current level of sales to end users, (3) expected 
introductions of new products that may result in the technological 
obsolescence of and larger than expected returns of current 
products, (4) the significance of a particular distributor to the 
registrant's (or a reporting segment's) business, sales and 
marketing, (5) the newness of a product, (6) the introduction of 
competitors' products with superior technology or greater expected 
market acceptance, and (7) other factors that affect market demand 
and changing trends in that demand for the registrant's products. 
Registrants and their auditors should carefully analyze all factors, 
including trends in historical data, which may affect registrants' 
ability to make reasonable and reliable estimates of product 
returns.
    The staff reminds registrants that if a transaction fails to 
meet all of the conditions of paragraphs 6 and 8 in Statement 48, no 
revenue may be recognized until those conditions are subsequently 
met or the return privilege has substantially expired, whichever 
occurs first.\59\ Simply deferring recognition of the gross margin 
on the transaction is not appropriate.
---------------------------------------------------------------------------

    \59\ Statement 48, paragraph 6.
---------------------------------------------------------------------------

Question 2

    Question: Is the requirement cited in the previous question for 
``reliable'' estimates meant to imply a new, higher requirement than 
the ``reasonable'' estimates discussed in Statement 48?
    Interpretive Response: No. ``Reliability'' of financial 
information is one of the qualities of accounting information 
discussed in Concepts Statement 2. The staff's expectation that 
estimates be reliable does not change the existing requirement of 
Statement 48. If management cannot develop an estimate that is 
sufficiently reliable for use by investors, the staff believes it 
cannot make a reasonable estimate meeting the requirements of that 
standard.

Question 3

    Question: Does the staff expect registrants to apply the 
guidance in Question 1 of Topic 13.A.4(a) above to sales of tangible 
goods and other transactions specifically within the scope of 
Statement 48?
    Interpretive Response: The specific guidance above does not 
apply to transactions within the scope of Statement 48. The views 
set forth in Question 1 of Topic 13.A.4(a) are applicable to the 
service transactions discussed in that Question. Service 
transactions are explicitly outside the scope of Statement 48.

Question 4

    Question: Question 1 of Topic 13.A.4(a) above states that the 
staff would expect a two-year history of selling a new service in 
order to be able to make reliable estimates of cancellations. How 
long a history does the staff believe is necessary to estimate 
returns in a product sale transaction that is within the scope of 
Statement 48?
    Interpretive Response: The staff does not believe there is any 
specific length of time necessary in a product transaction. However, 
Statement 48 states that returns must be subject to reasonable 
estimation. Preparers and auditors should be skeptical of estimates 
of product returns when little history with a particular product 
line exists, when there is inadequate verifiable evidence of 
historical experience, or when there are inadequate internal 
controls that ensure the reliability and timeliness of the reporting 
of the appropriate historical information. Start-up companies and 
companies selling new or significantly modified products are 
frequently unable to develop the requisite historical data on which 
to base estimates of returns.

Question 5

    Question: If a company selling products subject to a right of 
return concludes that it cannot reasonably estimate the actual 
return rate due to its limited history, but it can conservatively 
estimate the maximum possible returns, does the staff believe that 
the company may recognize revenue for the portion of the sales that 
exceeds the maximum estimated return rate?
    Interpretive Response: No. If a reasonable estimate of future 
returns cannot be made, Statement 48 requires that revenue not be 
recognized until the return period lapses or

[[Page 74447]]

a reasonable estimate can be made.\60\ Deferring revenue recognition 
based on the upper end of a wide range of potential return rates is 
inconsistent with the provisions of Statement 48.
---------------------------------------------------------------------------

    \60\ Statement 48, paragraph 6(f).
---------------------------------------------------------------------------

c. Contingent rental income

    Facts: Company A owns and leases retail space to retailers. 
Company A (lessor) renews a lease with a customer (lessee) that is 
classified as an operating lease. The lease term is one year and 
provides that the lease payments are $1.2 million, payable in equal 
monthly installments on the first day of each month, plus one 
percent of the lessee's net sales in excess of $25 million if the 
net sales exceed $25 million during the lease term (i.e., contingent 
rental). The lessee has historically experienced annual net sales in 
excess of $25 million in the particular space being leased, and it 
is probable that the lessee will generate in excess of $25 million 
net sales during the term of the lease.
    Question: In the staff's view, should the lessor recognize any 
rental income attributable to the one percent of the lessee's net 
sales exceeding $25 million before the lessee actually achieves the 
$25 million net sales threshold?
    Interpretive Response: No. The staff believes that contingent 
rental income ``accrues'' (i.e., it should be recognized as revenue) 
when the changes in the factor(s) on which the contingent lease 
payments is (are) based actually occur.\61\
---------------------------------------------------------------------------

    \61\ Lessees should follow the guidance established in EITF 
Issue 98-9.
---------------------------------------------------------------------------

    Statement 13 paragraph 19(b) states that lessors should account 
for operating leases as follows: ``Rent shall be reported in income 
over the lease term as it becomes receivable according to the 
provisions of the lease. However, if the rentals vary from a 
straight-line basis, the income shall be recognized on a straight-
line basis unless another systematic and rational basis is more 
representative of the time pattern in which use benefit from the 
leased property is diminished, in which case that basis shall be 
used.''
    Statement 29 amended Statement 13 and clarifies that ``lease 
payments that depend on a factor that does not exist or is not 
measurable at the inception of the lease, such as future sales 
volume, would be contingent rentals in their entirety and, 
accordingly, would be excluded from minimum lease payments and 
included in the determination of income as they accrue.'' [Summary] 
Paragraph 17 of Statement 29 provides the following example of 
determining contingent rentals:
    A lease agreement for retail store space could stipulate a 
monthly base rental of $200 and a monthly supplemental rental of 
one-fourth of one percent of monthly sales volume during the lease 
term. Even if the lease agreement is a renewal for store space that 
had averaged monthly sales of $25,000 for the past 2 years, minimum 
lease payments would include only the $200 monthly base rental; the 
supplemental rental is a contingent rental that is excluded from 
minimum lease payments. The future sales for the lease term do not 
exist at the inception of the lease, and future rentals would be 
limited to $200 per month if the store were subsequently closed and 
no sales were made thereafter.
    Technical Bulletin 85-3 addresses whether it is appropriate for 
lessors in operating leases to recognize scheduled rent increases on 
a basis other than as required in Statement 13, paragraph 19(b). 
Paragraph 2 of Technical Bulletin 85-3 states ``using factors such 
as the time value of money, anticipated inflation, or expected 
future revenues [emphasis added] to allocate scheduled rent 
increases is inappropriate because these factors do not relate to 
the time pattern of the physical usage of the leased property. 
However, such factors may affect the periodic reported rental income 
or expense if the lease agreement involves contingent rentals, which 
are excluded from minimum lease payments and accounted for 
separately under Statement 13, as amended by Statement 29.'' In 
developing the basis for why scheduled rent increases should be 
recognized on a straight-line basis, the FASB distinguishes the 
accounting for scheduled rent increases from contingent rentals. 
Paragraph 13 states ``There is an important substantive difference 
between lease rentals that are contingent upon some specified future 
event and scheduled rent increases that are unaffected by future 
events; the accounting under Statement 13 reflects that difference. 
If the lessor and lessee eliminate the risk of variable payments by 
agreeing to scheduled rent increases, the accounting should reflect 
those different circumstances.''
    The example provided in Statement 29 implies that contingent 
rental income in leases classified as sales-type or direct-financing 
leases becomes ``accruable'' when the changes in the factors on 
which the contingent lease payments are based actually occur. 
Technical Bulletin 85-3 indicates that contingent rental income in 
operating leases should not be recognized in a manner consistent 
with scheduled rent increases (i.e., on a straight-line basis over 
the lease term or another systematic and rational allocation basis 
if it is more representative of the time pattern in which the leased 
property is physically employed) because the risk of variable 
payments inherent in contingent rentals is substantively different 
than scheduled rent increases. The staff believes that the reasoning 
in Technical Bulletin 85-3 supports the conclusion that the risks 
inherent in variable payments associated with contingent rentals 
should be reflected in financial statements on a basis different 
than rental payments that adjust on a scheduled basis and, 
therefore, operating lease income associated with contingent rents 
would not be recognized as time passes or as the leased property is 
physically employed. Furthermore, prior to the lessee's achievement 
of the target upon which contingent rentals are based, the lessor 
has no legal claims on the contingent amounts. Consequently, the 
staff believes that it is inappropriate to anticipate changes in the 
factors on which contingent rental income in operating leases is 
based and recognize rental income prior to the resolution of the 
lease contingencies.
    Because Company A's contingent rental income is based upon 
whether the customer achieves net sales of $25 million, the 
contingent rentals, which may not materialize, should not be 
recognized until the customer's net sales actually exceed $25 
million. Once the $25 million threshold is met, Company A would 
recognize the contingent rental income as it becomes accruable, in 
this case, as the customer recognizes net sales. The staff does not 
believe that it is appropriate to recognize revenue based upon the 
probability of a factor being achieved. The contingent revenue 
should be recorded in the period in which the contingency is 
resolved.

d. Claims processing and billing services

    Facts: Company M performs claims processing and medical billing 
services for healthcare providers. In this role, Company M is 
responsible for preparing and submitting claims to third-party 
payers, tracking outstanding billings, and collecting amounts 
billed. Company M's fee is a fixed percentage (e.g., five percent) 
of the amount collected. If no collections are made, no fee is due 
to Company M. Company M has historical evidence indicating that the 
third-party payers pay 85 percent of the billings submitted with no 
further effort by Company M. Company M has determined that the 
services performed under the arrangement are a single unit of 
accounting.
    Question: May Company M recognize as revenue its five percent 
fee on 85 percent of the gross billings at the time it prepares and 
submits billings, or should it wait until collections occur to 
recognize any revenue?
    Interpretive Response: The staff believes that Company M must 
wait until collections occur before recognizing revenue. Before the 
third-party payer has remitted payment to Company M's customers for 
the services billed, Company M is not entitled to any revenue. That 
is, its revenue is not yet realized or realizable.\62\ Until Company 
M's customers collect on the billings, Company M has not performed 
the requisite activity under its contract to be entitled to a 
fee.\63\ Further, no amount of the fee is fixed or determinable or 
collectible until Company Ms' customers collect on the billings.
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    \62\ Concepts Statement 5, paragraph 83(a).
    \63\ Concepts Statement 5, paragraph 83(b).
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B. Disclosures

Question 1

    Question: What disclosures are required with respect to the 
recognition of revenue?
    Interpretive Response: A registrant should disclose its 
accounting policy for the recognition of revenue pursuant to Opinion 
22. Paragraph 12 thereof states that ``the disclosure should 
encompass important judgments as to appropriateness of principles 
relating to recognition of revenue * * *.'' Because revenue 
recognition generally involves some level of judgment, the staff 
believes that a registrant should always disclose its revenue 
recognition policy. If a company has different policies for 
different types of revenue transactions, including barter sales, the 
policy for each material type of transaction should be disclosed. If 
sales transactions have multiple units of accounting, such as a 
product and service,

[[Page 74448]]

the accounting policy should clearly state the accounting policy for 
each unit of accounting as well as how units of accounting are 
determined and valued. In addition, the staff believes that changes 
in estimated returns recognized in accordance with Statement 48 
should be disclosed, if material (e.g., a change in estimate from 
two percent of sales to one percent of sales).
    Regulation S-X requires that revenue from the sales of products, 
services, and other products each be separately disclosed on the 
face of the income statement.\64\ The staff believes that costs 
relating to each type of revenue similarly should be reported 
separately on the face of the income statement.
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    \64\ See Regulation S-X, Article 5-03(b)(1) and (2).
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    MD&A requires a discussion of liquidity, capital resources, 
results of operations and other information necessary to an 
understanding of a registrant's financial condition, changes in 
financial condition and results of operations.\65\ This includes 
unusual or infrequent transactions, known trends or uncertainties 
that have had, or might reasonably be expected to have, a favorable 
or unfavorable material effect on revenue, operating income or net 
income and the relationship between revenue and the costs of the 
revenue. Changes in revenue should not be evaluated solely in terms 
of volume and price changes, but should also include an analysis of 
the reasons and factors contributing to the increase or decrease. 
The Commission stated in FRR 36 that MD&A should ``give investors an 
opportunity to look at the registrant through the eyes of management 
by providing a historical and prospective analysis of the 
registrant's financial condition and results of operations, with a 
particular emphasis on the registrant's prospects for the future.'' 
\66\
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    \65\ See Regulation S-K, Article 303 and FRR 36.
    \66\ FRR 36, also see In the Matter of Caterpillar Inc., AAER 
363 (March 31, 1992).
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    Examples of such revenue transactions or events that the staff 
has asked to be disclosed and discussed in accordance with FRR 36 
are:
    [sbull] Shipments of product at the end of a reporting period 
that significantly reduce customer backlog and that reasonably might 
be expected to result in lower shipments and revenue in the next 
period.
    [sbull] Granting of extended payment terms that will result in a 
longer collection period for accounts receivable (regardless of 
whether revenue has been recognized) and slower cash inflows from 
operations, and the effect on liquidity and capital resources. (The 
fair value of trade receivables should be disclosed in the footnotes 
to the financial statements when the fair value does not approximate 
the carrying amount.) \67\
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    \67\ Statement 107.
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    [sbull] Changing trends in shipments into, and sales from, a 
sales channel or separate class of customer that could be expected 
to have a significant effect on future sales or sales returns.
    [sbull] An increasing trend toward sales to a different class of 
customer, such as a reseller distribution channel that has a lower 
gross profit margin than existing sales that are principally made to 
end users. Also, increasing service revenue that has a higher profit 
margin than product sales.
    [sbull] Seasonal trends or variations in sales.
    [sbull] A gain or loss from the sale of an asset(s).\68\
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    \68\ Gains or losses from the sale of assets should be reported 
as ``other general expenses'' pursuant to Regulation S-X, Article 5-
03(b)(6). Any material item should be stated separately.
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Question 2

    Question: Will the staff expect retroactive changes by 
registrants to comply with the accounting described in this 
bulletin?
    Interpretive Response: All registrants are expected to apply the 
accounting and disclosures described in this bulletin. The staff, 
however, will not object if registrants that have not applied this 
accounting do not restate prior financial statements provided they 
report a change in accounting principle in accordance with Opinion 
20 and Statement 3 no later than the fourth fiscal quarter of the 
fiscal year beginning after December 15, 1999. In periods subsequent 
to transition, registrants should disclose the amount of revenue (if 
material to income before income taxes) recognized in those periods 
that was included in the cumulative effect adjustment. If a 
registrant files financial statements with the Commission before 
applying the guidance in this bulletin, disclosures similar to those 
described in SAB Topic 11.M should be provided.
    However, if registrants have not previously complied with GAAP, 
for example, by recording revenue for products prior to delivery 
that did not comply with the applicable bill-and-hold guidance, 
those registrants should apply the guidance in Opinion 20 for the 
correction of an error.\69\ In addition, registrants should be aware 
that the Commission may take enforcement action where a registrant 
in prior financial statements has violated the antifraud or 
disclosure provisions of the securities laws with respect to revenue 
recognition.
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    \69\ Opinion 20, paragraph 13 and paragraphs 36-37 describe and 
provide the accounting and disclosure requirements applicable to the 
correction of an error in previously issued financial statements. 
Because the term ``error'' as used in Opinion 20 includes 
``oversight or misuse of facts that existed at the time that the 
financial statements were prepared,'' that term includes both 
unintentional errors as well as intentional fraudulent financial 
reporting and misappropriation of assets as described in SAS 99.
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Question 3

    Question: The previous question indicates that the staff will 
not object to cumulative effect-type transition so long as the prior 
accounting does not represent an error. Could a company whose prior 
accounting does not represent an error voluntarily adopt a new 
method consistent with this SAB Topic by restatement of prior 
periods, rather than through a cumulative catch-up adjustment?
    Interpretive Response: In most instances, no. Opinion 20 does 
not permit restatement of financial statements for a change in 
accounting principle that does not represent correction of an error, 
except in very rare circumstances.\70\ An exception is a company 
that is filing publicly for the first time. As stated in paragraph 
29 of Opinion 20, those companies are permitted to reflect the 
adoption of the new policy via a restatement, and the staff believes 
that approach is usually necessary to avoid confusing investors in 
an initial public offering.
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    \70\ See, for example, Opinion 20, paragraph 27.
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Question 4

    Question: Should a registrant reporting a change in accounting 
principle as a result of this SAB Topic file a preferability letter?
    Interpretive Response: No preferability letter is required if an 
accounting change is made in response to a newly issued Staff 
Accounting Bulletin.

Question 5

    Question: If a company had not previously adjusted sales 
revenues, but deferred recognition of the gross margin of estimated 
returns for a transaction subject to Statement 48, how should it 
present a current change in accounting to reduce revenue and cost of 
sales for estimated returns?
    Interpretive Response: Paragraph 7 of Statement 48 states that 
``sales revenue and cost of sales reported in the income statement 
shall be reduced to reflect estimated returns.'' Statement 48 does 
not provide for recognition of sales and costs of sales while 
deferring gross margin under any circumstance. This SAB Topic 
provides no new guidance on this point. If a registrant has failed 
to comply with GAAP, the registrant should retroactively revise 
prior financial statements in the manner set forth in Opinion 20 and 
Statement 16.

[FR Doc. 03-31512 Filed 12-22-03; 8:45 am]
BILLING CODE 8010-01-P