The demands of the world economy have created a manufacturing industry that is amazing to behold, complete with just-in-time delivery and tight inventories, multiple delivery point and service contracts and product price guarantees. However, those advances have also muddied the waters of financial reporting at the same time statement users are demanding those waters be more clear.
There are many areas unique to manufacturing companies that present financial reporting risk and complexity, including inventory, contract manufacturing, financing transactions, warranty accruals and long-term service contracts. Perhaps most significantly, it isn’t always clear when a company can actually record a sale.
Revenue recognition presents unique financial reporting risks in many different industries, and in fact, is one of a couple of areas that is a presumed fraud risk by a company’s external auditors. Recognition of revenue can be delayed by estimations of what a product actually costs to produce, when it was delivered or how product returns and guarantees are handled. Since the beginning of 2012, there have been approximately 70 restatements related to revenue recognition, across all industries, for companies that file their financial statements with the Securities and Exchange Commission (SEC). This article will examine some of the most common problem areas for manufacturing companies.
Bill and Hold Transactions
A bill and hold transaction is one in which the manufacturer enters into a valid sales agreement with its customer, but the customer requests that the manufacturer either not ship the product until a specified date or store the product at the manufacturer’s premises to ship directly to the customer’s buyer. One of the criteria for recognition of revenue under U.S. Generally Accepted Accounting Principles (GAAP) is that delivery must have occurred, and the fact that the product has not shipped—even in cases where cash has been received in the reporting period—presents a potential issue in recognizing revenue during the reporting period.
Here’s an example: Contract manufacturing is becoming much more widely used as a means to remove the costs of building a manufacturing facility in order to get new technologies to market. For instance, a medical device manufacturer serves as a contract manufacturer for its customer while still developing and manufacturing its own products. The customer has developed and marketed the technology, and due to the high cost of purchasing its own manufacturing facility, hires the medical device manufacturer to produce and warehouse the product in its clean rooms and temperature-controlled storage facilities. The contract agreement requires the manufacturer to warehouse the devices until its customer sells them to a third party. Money may or may not have changed hands, which doesn’t matter when it comes down to revenue recognition, and this can be frustrating to companies.
The issue has been so pervasive and complex that the SEC dedicated a significant portion of its Staff Accounting Bulletin (SAB) on revenue recognition to bill and hold arrangements (SAB 104 or Topic 13). The SEC set forth seven criteria, all of which must be met in order to recognize revenue when delivery has not occurred:
- Risk of ownership must have passed to the buyer.
- Customer must have made a fixed commitment to purchase the goods.
- The buyer, not the seller, must request that the transaction be on a bill and hold basis and must have a substantial business purpose for ordering the goods on a bill and hold basis.
- There must be a fixed schedule for delivery of the goods.
- The seller must not have retained any specific performance obligations such that the earnings process is not complete.
- The ordered goods must have been segregated from the seller’s inventory and not be subject to being used to fill other orders.
- The equipment or product must be complete and ready for shipment.
If any one of these conditions is not met, revenue should be deferred until delivery of the product. While this guidance is specific for companies that file their financial statements with the SEC, the guidance is generally applied to private companies as well. For a company that serves customers as a contract manufacturer, it is very important to understand these criteria prior to signing the agreement. The SEC has a general presumption that revenue under bill and hold transactions may not be recognized until shipped out of the manufacturer’s warehouse until proven otherwise.
Long-term Contracts/Percentage of Completion
Although most prominent in the construction industry, many manufacturers use percentage of completion accounting for revenue recognition, which presents unique accounting risks and complexities.
Manufacturers should first be careful to ensure that they are allowed to follow the principles of revenue recognition for construction-type and production-type contracts. A good example is an equipment manufacturer where the specifications of each piece of equipment are set by the customer and the manufacturing process is of longer-term duration. Say a company makes equipment for the aluminum canning industry that is replete with custom specifications for long-term use. It could involve some on-the-line testing and development that includes a service aspect to the contract. So when do you record revenue? The answer may be to use a percentage of completion method of accounting and recognize revenue as manufacturing progresses.
In this example, assume that the duration of the manufacturing process for the equipment is six months, and as of the end of the reporting period, the manufacturer was 50 percent complete with the manufacture of the equipment. Under percentage of completion accounting, the manufacturer is able to recognize 50 percent of the revenue for the contract, whereas under the completed contract method or general revenue recognition criteria, 100 percent of the revenue is deferred until the contract is complete. The equipment manufacturer may or may not have been paid. It doesn’t matter.
The primary complexity under this method of accounting is due to the fact that the underlying costs—and not the billings—is the driver of the amount of revenue to be recognized in a period. And since the estimated cost to complete is a factor in the percentage of completion, which by definition is a subjective management estimate, this presents risk to the accounting.
Remember that when an auditor talks about accounting risk, it refers to a risk of error or even fraudulent misstatement. Estimates can be manipulated much easier than a hard invoice amount. Estimates are only as good as the person making the estimate, and in most cases will be at least somewhat off. My clients and I often remark that the only thing we do know about an estimate is that it’s not right. It will get right over time, but adjustments will need to be made, and the objective of any balance sheet date is to get the estimate as materially accurate as possible.
Contract Provisions: Rights of Return, Price Protection, Multiple Element Arrangements
Each customer contract should be analyzed very carefully to determine if clauses exist that could create accounting consequences. For instance, when selling a new product into the market and a general right of return exists for the customer, U.S. GAAP may preclude revenue recognition until the right of return period lapses or until such point in time that future returns can be reasonably estimated.
Take for example that you’re selling to a retail giant who has all the negotiating leverage. Their contract will be in their favor, and probably include a general right of return. It gets difficult to estimate what the returns on a new product will be, and deferring revenue recognition until the return period lapses may be the appropriate accounting.
Another example is where the manufacturer provides a customer with price protection, whereby if the manufacturer were to sell the same product in the future to another customer at a lower price, the manufacturer would be required to honor that lower pricing to the first customer.
A criterion for revenue recognition is that the seller’s price to the buyer is substantially fixed or determinable at the date of sale. Obviously, a price protection clause could trip over that criterion, although when manufacturers sell into retail, these clauses are common.
In order to recognize revenue at the date of sale when a price protection clause exists, at a minimum the manufacturer would need to analyze all future sales to ensure that it does not create an accounting consequence related to the price protection. Companies also need to establish internal controls over an overeager sales force to avoid too many price protections and to avoid violating existing price protections.
When a contract contains multiple deliverables to be provided by the manufacturer, U.S. GAAP provides specific guidance as to if and how the total contract price should be allocated to each element in the contract. In doing so, management estimates and judgments are introduced, which again creates additional risk associated with the revenue recognition. An example of a multiple deliverable is when the manufacturer sells installation and/or software upgrades to the technology components of its equipment.
Government Contracts and R&D Arrangements
We have also seen many manufacturers enter into the market for government or commercially funded research and development contracts. These types of arrangements may present an economical means for the manufacturer to develop new products to introduce to the market. This is a much different line of business than manufacturing and selling a widget, and with that comes unique accounting considerations.
The contracts themselves come in many different forms, such as fixed price, cost plus a fixed fee, or milestone arrangements; each presents different accounting considerations. Beyond all of this, if the contract is with the federal government, then federal government cost principles and compliance considerations are introduced into the equation. Certain federal agencies, such as the National Institute of Health and the Department of Energy, require compliance audits even for commercial entities, an area that has generally been reserved for governmental and not-for-profit entities.
Similar to the percentage of completion method of accounting discussed above, the revenue recognition for these types of contracts is often driven by the underlying costs and not the billing. Government agencies often perform cost audits, and if there is an audit and adjustment, revenue recognition by the contractor must be adjusted accordingly. In a milestone contract, there could be disputes over whether a milestone is actually reached; the revenue recognition, again, does not depend on whether cash has exchanged hands.
The mistake I’ve seen often is where a client billed a customer for, say, $105,000, which is for $100,000 of cost and $5,000 for profit. The correct revenue recognition may not be $105,000 if not all of the $100,000 of costs are allowable under the contract. The correct number depends on what part of the cost is chargeable to that customer, plus profit.
The Financial Accounting Standards Board (FASB), in conjunction with the International Accounting Standards Board (IASB), has been working on a revenue recognition project for many years now, which is expected to be finalized this year. While the final standard, when released, may change certain aspects of the accounting issues discussed above, the complexity will remain. So don’t look for future clarity from FASB or other accounting standard bodies. The world is not that simple.
Greg Pfahl, CPA, is an audit partner in the Denver office of Hein & Associates LLP, a full-service public accounting and advisory firm with additional offices in Houston, Dallas and Orange County. He specializes in financial reporting for complex transactions, including initial public offerings (IPOs), private offerings, and mergers and acquisitions, andserves as a local leader for the firm’s manufaturing and distribution practice area. He can be reached at [email protected].