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Speech by SEC Staff:
2003 Thirty-First AICPA National Conference on Current SEC Developments

by

Russell P. Hodge

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

Washington, DC
December 11, 2003

As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the SEC staff.

Introduction

Today I will comment on several issues related to the implementation of Issue 00-21¹ including (1) the scope interaction of SOP 97-2² and Issue 00-21; (2) the scope interaction of SOP 97-2 and Statement 13³; and (3) a couple of issues related to the application of the contingent revenue provision of Issue 00-21.

Earlier this year, the EITF wrapped up almost three years of debate to reach a consensus on Issue 00-21. The purpose of the consensus is to provide guidance on separation and allocation of the arrangement fee for revenue arrangements with multiple deliverables. As is typical with new literature, many questions have been raised regarding the application of Issue 00-21.

Scope Interaction of SOP 97-2 and EITF 00-21

We have recently been asked to consider a question related to the scope interaction of Issue 00-21 and SOP 97-2. For example, in information technology consulting arrangements it is common for bundled arrangements to include construction and related services as well as non-construction related services. Commonly, build-to-suit software design and installation may be bundled with ongoing information technology management services to be provided under a long-term contract. Before Issue 00-21, such arrangements have usually been accounted for in their entirety under SOP 81-1⁴ because they generally involve significant customization of software. Some have asserted that these arrangements should not be affected by the consensus reached in Issue 00-21. They believe to do so would be to override higher-level GAAP because paragraph 7 of SOP 97-2 indicates that the entire arrangement should be accounted for under SOP 81-1. However, it is important to note that none of the examples in SOP 81-1 deal with arrangements that include both construction and non-construction elements. That is, the arrangements discussed in SOP 81-1 only include construction or production related services. As such, it is not clear that SOP 81-1 contemplated such arrangements. In fact, the EITF specifically discussed this issue during the deliberations that led to the scope guidance provided in the final consensus.⁵ As a result, the SEC staff believes the consensus reached by the EITF requires that the Issue 00-21 criteria be applied in bundled arrangements involving significant customization of software to determine whether SOP 81-1 deliverables should be separated from the non SOP 81-1 deliverables.

Scope Interaction of SOP 97-2 and Statement 13

Speaking of the scope of SOP 97-2, as a reminder, Issue 00-21 emphasizes that leased assets are required to be accounted for separately under the guidance of Statement 13. That would also include hardware or equipment that has been leased as part of a software arrangement. For example, if a registrant leased a customized build-to-suit software system to its customer, the hardware or equipment components and related executory costs are required to be unbundled and accounted for separately under Statement 13.

The Contingent Revenue Provision of EITF 00-21

In addition to scope related issues, there have been several issues or questions regarding the application of the contingent revenue provision in Issue 00-21.⁶

The consensus limits the amount of revenue that can be allocated to a delivered item to the amount that is not contingent on the delivery of additional items or meeting other specified performance conditions. This provision could result in little or no revenue being allocated to a delivered item even though the separation criteria have been met. Consequently, in some cases the amount of revenue allocated to a delivered item may be less than the associated costs.

Take for example a registrant that sells equipment and installation on a bundled basis. The arrangement meets the separation criteria, yet a portion of the payment that would otherwise be allocated to the equipment is not due until installation is complete. Under 00-21, because part of the payment is dependent on the performance of the installation service, that amount is considered contingent revenue and should not be allocated to the equipment. The result of this could very well be that the amount of revenue allocated to the equipment is less than the cost of that equipment. Thus, the income statement effect of this example seems to be a loss being recognized upon delivery of the equipment as inventory is relieved, followed by significant profits on the performance of the installation services. However, I think it is fair to say that there are a number of opponents to that approach due to the perceived anomalous results.

When the application of 00-21 results in a loss on a delivered item solely as a result of the application of the contingent revenue provision, the SEC staff has been asked to consider various "solutions" to relieve the perceived anomalous results. For example, we have been asked whether a registrant can elect not to separate deliverables even though the separation criteria have been met. However, the SEC staff would object to that approach since separation was not intended to be an election under Issue 00-21. In addition, if the separation criteria have been met, we believe it is clear that the revenue allocated to a deliverable should be recognized once all other revenue recognition criteria have been met for that deliverable.

I'll also point out that the non-elective nature of the guidance under 00-21 is inconsistent with the SEC staff's interpretive guidance in the SAB 101 FAQ⁷ document that allows registrants to elect a policy of deferring revenue on equipment sold on an installed basis until installation is complete. We have updated our interpretive guidance to remove reference to this election as part of the SAB 104⁸ codification that is expected to be issued next week.

Cost of Revenue Transactions

The obvious question that follows is how to account for the direct cost incurred in a revenue arrangement in which little or no revenue is allocated to a delivered item. The cost accounting question is certainly not a new one. Even without 00-21, there are a number of reasons that costs can be incurred prior to the related revenue being recognized. For example, there are costs incurred to solicit a customer, negotiate a contract or to perform set-up activities in a service contract.

It is fair to say that Issue 00-21 is expected to increase the frequency of the cost related questions, in large part as a result of the contingent revenue provision. In analyzing the issue, it is important to note that, when applicable, the contingent revenue limitation usually does not result in the recognition of deferred revenue. That is, deferred revenue should not be recognized for the difference between the cash received or amounts billed and the relative fair value of the delivered item. The contingent revenue is merely allocated to future deliverables. The significance of that distinction is that, historically, the SEC staff has objected to costs being capitalized in excess of deferred revenues, except in limited situations where, at a minimum, an enforceable contractual arrangement exists.

Unfortunately, the existing literature in this area is very narrow in scope and does not address the majority of situations where the cost capitalization questions surface. While there are several analogies used in practice to account for set-up type costs, including Statement 91⁹ and Technical Bulletin 90-1¹⁰, there are very few analogies that are appropriate for fulfillment costs. As a result, in analyzing the issue with respect to fulfillment costs, the SEC staff believes that the focus should be on whether assets are generated and should be recognized in connection with the revenue arrangement.

With that end in mind, I thought it might be helpful to provide some examples of how at least some have thought about the circumstances in which the incurrence of costs in a revenue arrangement may result in the recognition of an asset.

For example, product sales could be in-substance consignment sales. For instance, if a vendor does not have the right to bill for a product that has been delivered, it raises a question as to whether the risks and rewards of ownership have been transferred to the customer. If a consignment sale has occurred, ARB 43¹¹ would continue to apply and would require capitalization of the costs as consigned inventory.
Also, the costs incurred might appropriately be capitalized as contractually guaranteed reimbursable costs. EITF 99-5¹² addresses the accounting for pre-production costs related to certain long-term supply arrangements and provides a model for capitalization of costs that would otherwise be expensed when a contractual guarantee for reimbursement exists.
Lastly, but perhaps most significantly, to the extent a loss is incurred on items that have been delivered, the loss might be considered an investment in the remainder of the contract if the revenue allocated to the remaining deliverables is an amount greater than the fair value of such deliverables.

In summary, there may be circumstances where it is appropriate to recognize an asset in connection with a multiple deliverable arrangement with contingent revenues. However, we believe that those circumstances are limited to situations where a loss has been incurred on the delivered item. For example, deferral of costs to produce normal margins for a delivered item or unit of accounting would be inappropriate.

In a recent fact pattern that we were asked to consider, we did not object to the recognition of an asset that was considered an investment in an existing contract. The asset recognized was equal to the loss incurred on the delivery of the first item in the arrangement. The remaining services to be provided under the contract were at above-market terms as a result of the revenue otherwise allocable to the first deliverable being allocated to the remaining deliverables due to the contingent payment terms. The asset would be tested for future impairment based on the cash flows expected to be generated through the performance of the remaining services under the contract.

It is important to note that, while we believe there are situations, such as the one I just discussed, in which recognition of an asset is appropriate, we do not believe that it would be appropriate in all circumstances. Unfortunately, the conclusion that the recognition of an asset may be appropriate in certain circumstances only raises more questions than answers.

For example:

What is the nature of the costs that should be considered in calculating the loss on a delivered item?
How and over what periods should the asset be amortized?
If the asset is recognized, what should be considered in evaluating future impairment?
Should losses be recognized upon the execution of a contract for items expected to be delivered at a loss even though the overall arrangement is expected to be profitable?
Should losses on contracts during the execution of the arrangements be evaluated at the unit of accounting level or be based on the profitability of the overall contract?

Interestingly, the EITF made a conscious decision not to address the cost issue in the consensus because the issue was considered too broad. As a result, registrants are on their own to a great extent in determining how to answer these questions. The SEC staff recognizes the position that registrants are in and we will do what we can to help. Unfortunately, for the same reasons that the EITF decided not to address the issue in the consensus, we do not have a "one size fits all" model. By the way, for those of you who have developed a workable model and would like to share it with the staff, by all means, please do. As you might expect, our assessments of the recent 00-21 cost deferral issues have, out of necessity, been very dependent upon the specific facts and circumstances and that will continue to be the case. So if you have questions or concerns about your cost deferral policy, please do not hesitate to discuss them with the SEC staff.

Endnotes

http://www.sec.gov/news/speech/spch121103rph.htm

Speech by SEC Staff: 2003 Thirty-First AICPA National Conference on Current SEC Developments

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