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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Current Accounting Projects

Remarks by

Scott A. Taub

Professional Accounting Fellow, Office of the Chief Accountant
U.S. Securities & Exchange Commission

27th Annual National AICPA Conference on Current SEC Developments

December 8, 1999

As a matter of policy, the Commission disclaims responsibility for any private publications or statements by any of its employees. The views expressed are those of the author, and do not necessarily represent the views of the Commission or the author's colleagues on the staff.

Good morning, everybody. It is my pleasure to speak at this conference. It is also my pleasure to report that none of the topics that I'll be speaking about have anything to do with pooling of interests or derivatives. Instead, I'll be speaking today about several issues the staff has addressed with regards to revenue recognition. The first deals with extended warranty contracts, the second with revenue recognition in certain internet arrangements, and the third with certain franchise-type arrangements.

Revenue Recognition for Separately Priced Extended Warranty Contracts

FASB Technical Bulletin No. 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts, requires that revenues from the sale of such contracts be recognized on a straight-line basis over the term of the contract, unless evidence exists that indicates that the costs of performing services under the contract are incurred on some other basis.1 Recently, the staff was asked whether Technical Bulletin 90-1 applies in a situation in which the company providing the warranty insures its obligations with a third-party insurance company.

In order to answer the question, it is important to understand how these extended warranty programs are managed. In general, the warranty and extended service programs are developed, marketed, and administered by companies whose business focuses on those activities. These companies, which I will refer to as administrators, do not sell retail goods, and often do not sell extended warranties directly to consumers. Instead, they work with retailers on the extended warranty contracts that the retailer sells. Typically, the administrator enters into an arrangement with a retailer that provides for the retailer to offer the warranty to customers who purchase applicable products. For each warranty sold, the retailer pays a specified fee to the administrator, and retains any excess as profit. During the term of the contract, the administrator has responsibility for processing claims, providing customer service, making arrangements for needed repairs or replacement products, and all other aspects of servicing the contracts.

The administrator generally uses a portion of the fee received from the retailer to purchase insurance from an insurance company that has agreed to accept the risk of loss under the contracts in exchange for a fixed premium per contract. The insurance agreement provides that the insurance company will insure the obligor under the extended warranty against all losses incurred. However, the identity of the obligor varies, depending in large part on applicable state law. In some cases, the retailer is the legal obligor, and the insurance agreement is between the insurer and the retailer. In other cases, the administrator is the obligor, and the insurance agreement is between the insurer and the administrator. In either case, the insurance company assumes the risk of loss under the contracts, but does not legally replace the retailer or administrator as obligor.

The staff considered this issue from two different registrant perspectives. One registrant was a retailer, and the other was an administrator. Both registrants believed that the identity of the legal obligor should not affect the accounting, because their respective performance obligations were the same in either circumstance. For example, whether it was the obligor or not, the administrator believed its performance consisted of marketing and administrative services. The administrator therefore recognized a portion of the revenue from the extended service contracts up front, while deferring a portion to recognize its obligation to perform administrative services.

On the other hand, the retailer argued that it had no performance obligation at all after the contract was entered into, as the administrator assumed all ongoing responsibilities to the consumer, and the insurance company assumed all risk of loss. The retailer therefore recognized revenue for the amount collected from the consumer at the point of sale, with a cost of sales entry for the amount owed to the administrator.

Neither registrant believed that Technical Bulletin 90-1 was applicable, even when it was the legal obligor under the warranty contracts, because the risk of loss was assumed by the insurance company.

The staff, however, believes that the identity of the obligor is important in determining the appropriate accounting. Technical Bulletin 90-1 states that it's conclusions are based on the accounting for short-duration insurance contracts set forth in FASB Statement 60, Accounting and Reporting by Insurance Enterprises. FASB Statement 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, states that purchasing reinsurance results in the removal of related assets and liabilities from the balance sheet of the primary insurer only when the reinsurance results in a legal replacement of one insurer by another. Because the insurance company that assumes risk of loss in these arrangements does not legally replace the obligor on the warranty contract, the staff concluded that the obligor, whether it is the retailer or the administrator, should recognize revenue over the life of the underlying contracts as specified in Technical Bulletin 90-1. The staff also concluded that the reinsurance should be accounted for in accordance with Statement 113.

The staff did not object to the conclusion that Technical Bulletin 90-1 does not apply when the registrant is not the named obligor. However, the staff noted that when the retailer is the obligor, the administrator is acting as an agent with regard to the insurance contract between the retailer and the insurance company. Similarly, when the administrator is the obligor, the retailer is acting only as an agent with regard to the warranty contract between the administrator and the consumer. Therefore, the staff concluded that the non-obligor registrant should present only its net commission as revenue as it performs under the contracts.

Up-Front Revenue Recognition When Costs of Performing
Are Nominal

My next topic deals with an issue that we have seen on multiple occasions, most commonly in internet companies. Let me illustrate this issue for you through the following examples:

Example 1: A company charges users a fee for access to its web site that contains proprietary information and other content. The fee allows access to the web site for a period of time. The company recognizes the revenue as soon as it sets up the user's account number and password.

Example 2: An internet company 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 company recognizes the revenue once the ad is posted to the site.

Example 3: A company charges a fee for hosting another company's web site for a period of time. Once the information is established on the host company's internet server and the appropriate links and network connections are set up, the host company recognizes all of the revenue.

In each of these situations, the company receiving the fee believes that revenue may be recognized once the initial set-up is done, because its ongoing obligation does not involve significant cost or effort. The reasoning is generally that an obligation that involves only minimal (or no) cost and effort is clearly not a significant one, and that such an obligation should therefore not impact revenue recognition.

The staff believes that the substance of the transactions I just described indicates that the purchaser is paying for a service that is delivered over time. Therefore, the staff believes revenue recognition should occur over time as the service is performed.

The staff acknowledges that some performance obligations may be so insignificant as to not affect revenue recognition. However, we believe that the determination of whether a performance obligation is substantive cannot be made without considering the purchaser's viewpoint. If the continuing obligation is valuable to the purchaser, it is difficult to conclude that it is not significant. Therefore, we believe that looking only at the costs the vendor will incur or the effort it will expend is not sufficient when evaluating whether a continuing obligation should affect revenue recognition.

Franchise Development Arrangements

By now, you've noticed that my first two topics concerned the recognition of revenue when an up-front fee is received and there is an ongoing service commitment. In order to add diversity to my speech, I will now address an issue dealing with recognition of revenue when an up-front fee is received and there is an ongoing service commitment.

In this case, the registrant was a restaurant franchisor. This franchisor had entered into a number of agreements in which the counterparty agreed to act as an agent for the company in expanding its franchise network in a particular territory. These agents, or Area Developers, perform a number of duties, including identifying potential franchise owners and store locations in the territory. In addition, the Area Developers take on certain responsibilities for assisting with franchise openings and for monitoring the performance of franchises in the territory on an ongoing basis. However, the Area Developers are not granted a franchise to operate any restaurants, nor are the Area Developers authorized to enter into any franchise agreements. Rather, once the Area Developer believes it has found a good franchisee and location the franchisor makes its own assessment and, if it agrees with the Area Developer, enters into a standard franchise agreement with the franchisee. The Area Developer is not a party to the franchise agreement.

A number of cash flows are associated with the Area Developer arrangements. First, the Area Developer pays a fee to the franchisor upon entering into the contract. This fee gives the Area Developer the right to be the company's exclusive agent in the territory for a particular period of time, so long as certain performance criteria are met. In return, the Area Developer is entitled to a portion of the initial and continuing franchise fees paid to the franchisor by any franchisees in the territory.

The accounting question that arose out of this situation was how the franchisor should account for the initial fee received from the Area Developer.

The franchisor viewed the Area Developer agreement as a type of franchise agreement, and therefore looked to the guidance on accounting for area franchise sales in FASB Statement No. 45, Accounting for Franchise Fee Revenue. Statement 45, in discussing revenue recognition for initial franchise fees related to area franchise sales, states that if the services to be provided by the franchisor do not vary based upon the number of franchises established, the initial franchise fee may be recognized when substantially all of the initial services have been performed.2

Other than the exclusivity commitment, this franchisor's obligations to the Area Developers consist mostly of providing training and sales materials. The agreements do not require the franchisor to perform any significant duties related to the opening of franchises. As its obligations to provide training and sales materials are performed shortly after the signing of an agreement, the registrant concluded that the initial fee should be recognized as revenue at contract inception, or very shortly thereafter.

In evaluating the registrant's accounting, the staff focused in part on the definition of Area Franchise included in Statement 45, which reads as follows:

An agreement that transfers franchise rights within a geographical area permitting the opening of a number of franchised outlets. Under those circumstances, decisions regarding the number of outlets, their location, and so forth are more likely made unilaterally by the franchisee than in collaboration with the franchisor.

The staff noted that the Area Developer agreements in question do not include the right to open any franchised outlets. Instead, the franchisor retained the sole right to offer and sell franchises, with the Area Developer acting as an agent. The staff believes that the right to open one or more franchises is a necessary part of any franchise sale. As a result, the staff believes that the contracts entered into by this registrant do not meet the definition of a franchise sale and, therefore, Statement 45 does not provide applicable revenue recognition guidance.

Instead, the staff viewed the payment made by the Area Developer as a payment to enter into a contractual arrangement in which the Area Developer would act as an exclusive sales agent in a territory. The franchisor, meanwhile, had, in substance, outsourced its sales department to the Area Developer, and had committed to use the Area Developer as its agent. Because performance under its commitment occurs over time, we asked the registrant to change its accounting policy to one in which the initial fees collected from the Area Developers are recognized in income over the term of the Area Developer's contract.


That concludes my prepared remarks. I will be glad to respond to questions later today. Thank you.


1FASB Technical Bulletin No. 90-1, paragraph 3.

2ASB Statement No. 45, paragraphs 8 and 9.