The Trouble with Applying Revenue Guidelines in the E-Commerce Service Economy.

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Remarkable developments in internet computing technology have given birth to a more efficient inexpensive medium that delivers goods/services to consumers. This global electronic information highway now connects personal computer users to firms selling merchandise ranging from financial services to automobiles. Profit and non-profit firms focused on reducing operating costs, have chosen to display their wares to potential customers using interactive web pages instead of relying solely on brick & mortar buildings. A common scenario swiftly becoming the norm is corporations utilizing computer hardware equipment containing sophisticated data processing software that execute hundreds of sales orders which are promptly shipped to clients 24 hours a day. Even though, the internet introduced economic advantages for corporations as well as shoppers, the 20th century version of Generally Accepted Accounting Principles (GAAP): Revenue Recognition Principles has not evolved quickly enough to resolve issues emerging in the new millennium e-commerce arena. The Financial Accounting Standards Board (FASB) is a private accounting organization authorized by the U.S. government to draft and publish reporting requirements in company financial statements. It wrote GAAP, a multi-volume edition of pronouncements prescribing various techniques for recording different categories of business transactions. The Securities & Exchange Commission (SEC), a federal agency given enforcement powers in addition to policy making oversight governing the accounting industry, strives to maintain public confidence in U.S. securities markets. In the late 1990’s, SEC officials began receiving complaints from concerned investors about irregularities pertaining to revenue items in financial papers filed by publicly traded internet firms. After launching an investigation, SEC preliminary evidence revealed some Dot com companies were either prematurely recording revenues, redefining what constituted sales or blatantly misinterpreting established GAAP revenue recognition guidelines. There were no detailed instructions explaining proper accounting treatment for matters in an e-retail service sector. Unfortunately, benign regulatory neglect led to the NASDAQ-100 Index losing 66% of its valuation between March 10, 2000 and March 23, 2001 sending the stock market from 5,048.62 to 1705.02. The NASDAQ has not rebounded from its historical high closing at 2,311.77 on October 09, 2006. Share prices for technology corporations plummeted causing huge monetary losses for investors triggering much needed reform. However, the proposed amendments did not adequately ensure further misdeeds would be prevented. I will highlight some factors directly responsible for the tech stock implosion which are still present today. Internet businesses have been in a rapidly growing industry. Their initial strategy is to gain market share by satisfying rising consumer demand while building shareholder value. Despite promising future prospects, enterprises are frequently unable to generate sufficient cash flow from internal operations to satisfactorily meet annual capital expenditures. Profits may not materialize for an indefinite period requiring borrowed funds to pay for infrastructure, facilities and the like. There is a prevailing sentiment among Wall Street analysts that traditional earnings performance metrics used to assess stock price valuation for firms in mature industries should not be applied to companies in an introductory phase of the product/service life cycle. A problem occurs when there are no documents indicating a substantive fiscal track record. So the conventional formula, Sales (Revenues) - Expenses = Net Income/Loss is tossed aside. Customary standards like return on investments are abandoned in favor of unproven qualitative measurements. An entirely different grading system is devised using non-empirical measurements for success or failure. For example, Dot com start-ups’ share prices were being rated on website traffic, user friendly layout, customer lists, number of household computers and a ”healthy” increase in revenues. These metrics are not mentioned in corporate 10-k fillings so unsuspecting investors purchase stocks based on advice from prognosticators assuming probable future projections. A significant portion of management’s compensation was tied to rising stock prices leading unscrupulous corporations to use loopholes to exceed unrealistic quarterly earning targets. Usually when cutting edge technology is discovered such as a wonder drug that will revolutionize a market segment, one particular entity may possess exclusive patentable rights allowing them to reap the benefits. However, the internet has a unique feature, it is designated a public domain permitting anyone to set up a virtual store accessible to all including rogue elements looking to defraud uninformed investors. The few companies that achieve early success produce imitators with similar sounding names lacking sound business models searching for opportunities to make fast money. Investors are unable to distinguish between legitimate successful companies as opposed to one masquerading as an imposter. Language not explaining the dynamics surrounding the components used to calculate stock prices for firms in rapidly expanding industries will fuel boom-bust cycles. Accountings revenue recognition principles declare revenue is recognized first when it is realized or realizable and secondly when it is earned. Ordinarily businesses have followed four (4) conditions for proper sales recognition outlined in Staff Accounting Bulletin (SAB) No. 101: Revenue Recognition in Financial Statements issued in December 3, 1999: 1. Persuasive evidence of an arrangement exists 2. Delivery has occurred or services have been rendered 3. The seller’s price to the buyer is fixed or determinable 4. Collection of outstanding sum is reasonably assured On the other hand, an e-Market environment presents more complicated multi-leveled transactions transcending existing published edicts for receipts. It was written for a manufacturing centered economy not for software with multi-deliverable capabilities conducted via fiber optic cables/wireless technology. Until now there was no precedence for these kinds of trades thus net income could be manipulated. The practice known as booking future profits today was very prevalent especially among firms that were basing revenues on non-monetary advertising barter exchanges. For example, two internet corporations would swap advertising on their respective websites. Normally an equal amount of revenues and expenses should be recorded without a monetary gain. Since it is very difficult to appraise the cash value of an intangible asset like marketing space, the parties would often inflate expected cash flows reporting short-term profits. Later, when the estimated revenues and promised traffic to the websites didn’t materialize, there wasn’t a subsequent write-down in the contract’s impairment value disclosed in financial statements. A loss reducing net income reflected in the new cost basis would have been the appropriate notation. Investors were being short changed from barter exchanges that were worth much less than advertised. Many dot com companies failed in less than three (3) years leaving shareholders in the lurch. Currently, some proposed changes ushering in more transparency on how revenue is assessed have been instituted. Companies now entering into identical asset exchanges must use prior dollar values from similar arrangements that have taken place within 6 months as bench marks. Nevertheless, many internet firms can still misrepresent the numbers behind intricate long-term agreements due to the difficulty in pinpointing when an asset downgrade transpired. Another brewing controversy stemming from internet trade is the question, should revenue be reported at gross or net value? Stating sales in gross sum charged means a price calculated using cost of goods sold plus a markup. Sometimes e-retailers would receive less than full price (net) from delinquent accounts and not submit modified revenue figures showing the change. Routinely, total future revenue spanning more than one year for a particular service would be immediately recorded at the purchase price before any performance or dollar amount was collected. Prepayments should be correctly listed in the balance sheet as unearned revenue with adjustments to revenue periodically entered into the income statement as services are rendered. On July 20, 2000, the Emerging Issues Task Force (EITF), a branch of FASB assigned to clarify problematic accounting topics, proclaimed in Issue 99-19, “Revenue as a Principal versus Net as an Agent”, an amendment to SAB 101, asserts judgment should be used to determine if gross or net amount is suitable. This apparent inconclusive open-ended statement can be exploited for the illicit purpose of manifesting higher earnings on dubious contingent transactions including right of return, refund and termination clauses. Often times, internet firms abused their privileges recording gross quantity on net sales items. Although, SAB 101 now provides some supplementary instructions on how to acknowledge revenue pertaining to e-commerce, specific procedures are lacking. When reporting revenue in many instances it is recommended following a “reasoned method of accounting” accompanied by a brief explanation of established criteria. The contradiction continues in EITF Issue 00-21 SEC decree which lets internet businesses consider an activity as a revenue event even if all conditions for a sale are not satisfied. Revenue recognition for service type companies have long been ignored in accounting regulatory journals. Urgent Issue Task Force (UITF) Abstract 40 entitled, “Revenue Recognition and Service Contracts”, enacted in March 10, 2005 attempts to lay out appropriate methods for sales realization in the service industry. There were no specific revenue implementation policies regarding service sector organizations preceding UITF Abstract 40. Current interpretation departs from GAAP references granting professional services firms the right to record revenue sooner, long before contract terms are completed. On account of the innumerable service oriented entities coming on the scene, accounting regulatory institutions monitoring the financial community should limit alternative ways to acknowledge revenue insuring a more accurate representation of a corporation’s operations.

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  • Melissa Kennedy
    Melissa Kennedy
    Thanks for the comment.@Clint - You're right. It's important to avoid legal trouble as well.
  • Clint
    This is a very informative analysis...Did we not learn from the fraud in the past that mark to market and other non-empirical accounting for revenues leaves loopholes?

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