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Remarks before the 2014 AICPA National Conference on Current SEC and PCAOB Developments

Steve Mack
Professional Accounting Fellow, Office of the Chief Accountant

Washington, D.C.

Dec. 8, 2014

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the speaker and do not necessarily reflect the views of the Commission or of the speaker’s colleagues upon the staff of the Commission.


Good morning.  It’s a pleasure to be here.  I would like to talk to you about two revenue recognition issues today.  The first issue impacts current accounting for presenting revenues on a gross or net basis.  The second issue is about the new revenue recognition standard that was released in May 2014, specifically highlighting what some view as a significant increase in the use of estimates and management judgments.

Principal versus agent

Let’s first tackle the current accounting issue of presenting revenues on a gross or net basis.  There continues to be an emergence of new business models controlling how content and services are delivered to consumers through the internet and mobile devices.  The staff has noticed that applying the indicators in Subtopic 605-45 to these business models has generated many inquiries from issuers.  Additionally, some of you have received a comment letter or two regarding your principal versus agent assessment. 

Existing guidance, including the indicators and examples in Subtopic 605-45, were developed in a period where internet based transactions were being compared to traditional brick and mortar companies.  Today, digital advertising on the internet and mobile devices, digital coupons and social gaming are examples of emerging business models that don’t have updated examples in Subtopic 605-45.  To help frame our discussion, consider, for example, an internet-based advertising company that facilitates the delivery of advertising impressions to consumers.  Unlike the internet-based advertising example in the current guidance, this company does not purchase advertising impressions in advance, but instead allows advertisers to bid on impressions through real-time bidding auctions.  Given the conclusion in the current guidance is based, at least in part, on the company purchasing impressions in advance of the arrangement with advertisers, this difference is one example that has led to some pause in applying the indicators in the current guidance. 

Nevertheless, the staff believes that the existing principles of Subtopic 605-45 are still relevant to these emerging business models; but we acknowledge that more judgment may apply. Companies should also have evidence to support these judgments and assertions made in their assessment of the indicators in the current guidance; and auditors should review this evidence with professional skepticism, no different than any other accounting judgment.

The current guidance still applies

In my view, the staff’s consideration of the indicators in the guidance today remains consistent with the past. The indicators in the guidance focus on determining which party is obligated to perform and ultimately which party bears the risk and rewards as a principal before delivery of a good or service to a customer.  The application of these indicators requires judgment, and no one indicator is presumptive or determinative.  However, it is important to highlight that the guidance requires you to consider the relative strength of each indicator.  For example, credit risk may not be as strong an indicator as primary obligor.  The guidance itself highlights primary obligor and general inventory risk as stronger indicators and the examples tend to rely on some combination of latitude in establishing price and general inventory risk when primary obligor is not clearly identified.

Let’s take a step back; this analysis should begin with understanding the company’s business model and identifying the “deliverable” in the transaction.  While this may seem like an easy task, from an accounting perspective, there is no specific guidance in the current revenue standard as to how to identify a deliverable.  To cut to the chase, we are trying to determine what the deliverable is in the transaction and what party is responsible for fulfilling that deliverable.  Like most accounting judgments, the principal versus agent assessment should be supported by evidence.  By evidence I mean customer contracts and marketing materials.  Additionally, the identified deliverable in the principal versus agent assessment should be aligned with the identified deliverable in the revenue recognition assessment, as well as management’s discussion of the business in MD&A. 

Challenges with applying the indicators

Now let’s address the stronger indicators.  The staff has received a number of inquiries regarding the application of some of the stronger indicators to emerging business models.  For example, some inquiries involve how an issuer should assess the primary obligor if the identified deliverable is not consistent with contractual terms or marketing materials.  In my view, primary obligor is an indicator that is often the focus of staff consideration and the subject of public inquiry.  The reasons for this include but are not limited to: (1) the identified deliverable integrates multiple goods or services into one, (2) one party is responsible for delivering one part of the good or service and one party is responsible for delivering another part, and (3) one party is the reseller of services or intangible goods.  The staff may look to customer contracts and marketing materials as evidence to support the company’s assertion of the identified deliverable and primary obligor. And believe it or not, the staff may actually look at company websites for further corroboration.  From our perspective, the story should hang together.

If primary obligor is not as clear, we may rely more on other indicators such as general inventory risk and latitude in establishing price.  Subtopic 605-45 includes examples that demonstrate situations where primary obligor is not clearly identified, and we believe that applying a similar approach is consistent with the guidance. That being said, the staff has observed that companies often do not consider general inventory risk as applicable to intangible goods or services, even though the standard contemplates the assessment of general inventory risk with respect to services.  The guidance states that inventory risk may be present if a party is obligated to compensate the service provider for work performed regardless of whether the customer accepts that work.  As such, the staff will evaluate if one party is economically at risk or committed to provide the good or perform the service in accordance with the guidance.

The staff has also received inquiries regarding the application of latitude in establishing price when a party may be able to establish pricing within certain parameters set by the vendor, or in auction situations where pricing is determined by the interaction of two parties.  We also see situations where latitude in establishing price may only go in one direction, or may be as a result of offering discounts.  In all cases, we still believe that it is important to consider the economic constraints in latitude in establishing price as discussed in Subtopic 605-45 to assess this indicator.

At the end of the day, the principal versus agent assessment is more than a presentation exercise. The results of the assessment provide information to financial statement users on: (1) who is the customer in the transaction, (2) what is being sold to that customer, and (3) the ultimate revenue stream earned for that transaction.  Just keep in mind that as companies continue to make assertions in applying the indicators, the evidence should support the assertions made.

New Revenue Recognition Standard

Now I’d like to address some thoughts on the new revenue recognition standard.  The increased use of estimates and management judgments in some areas of the new revenue standard may result in varying results in financial reporting amongst companies and, as such, require more detailed quantitative and qualitative disclosures.  Furthermore, systems, processes, and controls will need to be either updated or implemented to support the increased use of management judgment.  I would like to highlight a couple of areas of judgment in the new revenue standard that may differ from current accounting guidance.

Variable Consideration – the new revenue standard will introduce a new model for evaluating uncertainties with respect to variable consideration.  Keep in mind that variable consideration is more than the common performance bonus.  Variable consideration may include price concessions, volume discounts, rebates, incentives, and royalties.  Under the new standard, revenue will be recognized up to the amount that is probable of not being reversed, even in situations where the uncertainty is not yet resolved.  Because the assessment of variable consideration is not meant to be a quantitative threshold, but more of a qualitative assessment subject to the constraint, judgment will be needed when selecting either a probability weighted or most likely outcome approach to best estimate the ultimate outcome.  This may result in the need for new processes and controls supporting the estimate of variable amounts, and this would need to be revisited each reporting period.

Disclosures – the new revenue standard also includes a number of disclosure requirements that allow financial statement users to understand judgments made with respect to revenue recognition and corresponding cash flows.  The disclosures will include qualitative and quantitative information.  The disclosure requirements can be quite involved. For example, companies will now need to disclose remaining performance obligations and provide a narrative discussion of potential additional revenue that is constrained.  Companies will also have to disclose significant judgments describing the methods used to recognize performance obligations over time, and assumptions used to determine and allocate the transaction price.

Overall, the new revenue standard allows for greater use of management judgment, but also results in more robust and transparent disclosure.  Companies that are not used to making management estimates and providing the supplemental information in disclosures will need to evaluate systems, processes, and controls to support the application of the new revenue standard.  Thank you for your time and attention.

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