Revenue Recognition and SAB 101
The rise and fall of MicroStrategy encapsulates the boom and bust, sprinkled with accounting scandal, associated with the high-tech economy from 1998 through 2002. At its peak, MicroStrategy was worth $31.1 billion and was trading at a price-to-sales ratio of 152 and a price-to-earnings ratio of 2,220. But in a sell-off precipitated by a revenue-related accounting restatement, the shares reached a low of $0.47 on July 9, 2002, down from their peak of $333.00 on March 10, 2000 (a 99.9% drop). In the wake of this price collapse, MicroStrategy’s CEO was fined by the SEC, and the company’s auditor was sued by outraged investors. An outline of MicroStrategy’s rise and fall is given below.
Many people have described Michael Saylor as the smartest person they know. [Footnote: Mark Leibovich, “MicroStrategy's CEO Sped to the Brink,” The Washington Post, January 6, 2002, p.A01. This article was the first in a four-part series by Mr. Leibovich that ran January 6-9, 2002 in The Washington Post. All four articles serve as source material for this brief history of MicroStrategy.] He grew up outside Dayton, Ohio, the son of an Air Force sergeant, and entered MIT on a ROTC scholarship, intending to become an Air Force pilot. While at MIT, Saylor developed skills in computer simulation, and he wrote his undergraduate thesis using a computer simulation to model the reactions of different types of government systems to catastrophes such as wars or epidemics. Since a heart murmur had cut short his chances of becoming a pilot, Saylor became a computer modeler for DuPont.
In 1989, Saylor started his own computer modeling business, called MicroStrategy, in partnership with his MIT roommate, Sanjul Bansal. The foundation of MicroStrategy’s product line has been its corporate data-mining program. The program combs through terabytes of data in an unwieldy corporate database, looking for interesting relationships. For example, MicroStrategy customers McDonald’s and Wal-Mart could use the program to detect customer buying trends on, say, Monday afternoons in the summer in California compared to Texas in order to help in targeting local marketing efforts. This data-mining program was very successful, and MicroStrategy doubled its revenues each year from 1994 through 1998, growing from 1994 revenues of $4.98 million to 1998 revenues of $106.43 million. The company went public on June 11, 1998, with the shares opening at $12 per share and ending the first day of trading at $21 per share.
In early 1999, MicroStrategy was a solid software company with an impressive record of revenue and profit growth. However, the company’s price-to-sales ratio was just 12, compared to ratios routinely over 100 for dot.com companies. This was because MicroStrategy was not benefiting from any of the “Internet halo” that seemed to surround all companies in those days that were in any way affiliated with the Web. And Michael Saylor had a vision of making his company much more than a software company. This vision is captured in the company motto: “Information like water.” Saylor wanted to place the power of the data mining software that MicroStrategy provided to corporations into the hands of individuals. Accordingly, in July 1999 MicroStrategy launched Strategy.com, which promised to make personalized information available to individuals, by email, through the Web, and by wireless phone. Subscribers could receive tailored messages about finance, news, weather, sports and traffic, and that was just the beginning. By the end of 1999, Strategy.com had not yet generated a single dollar of revenue for MicroStrategy, but the initiative had brought the aura of the Internet to the valuation of MicroStrategy’s stock, causing the price-to-sales ratio to increase from 12 to 150. In January 2000, while all 1,600 MicroStrategy employees were on a company cruise in the Cayman Islands, the company’s stock increased in value by 19 percent on one day, and Michael Saylor’s holdings alone increased in value by $1 billion. “We should go on cruises more often,” joked Saylor.
A price-to-sales ratio of 150 means that investors expect substantial sales growth (and ultimately substantial profit and cash flow growth) in the future. It also means that any stumbling on the part of the company can result in a catastrophic drop in stock price. For example, if a company has a market value of $30 billion with a sales-to-price ratio of 150, like MicroStrategy in early 2000, then negative news about the future that causes the sales-to-price ratio to drop to a lower but still respectable level of, say, 6 (which was the sales-to-price ratio for Coca-Cola in early 2000) would cause the company’s stock price to drop 96% to $1.2 billion. This type of precarious valuation puts huge pressure on managers to continue to report revenue growth that meets or exceeds the market’s expectation. In the face of this pressure, MicroStrategy, like many firms before and many since, broke the accounting rules governing when sales can be reported.
On March, 12, 2000, MicroStrategy’s chief financial officer (CFO) received a call from the partner in charge of the company’s audit. The audit firm, PricewaterhouseCoopers (PwC), had been reviewing MicroStrategy’s revenue recognition practices and believed that a restatement was necessary. This investigation had been initiated in part in response to a March 6, 2000 Forbes article by reporter David Raymond questioning MicroStrategy’s reporting of sales. [Footnote: David Raymond, “MicroStrategy's Curious Success,” Forbes, March 6, 2000.] MicroStrategy’s board of directors was reluctant to restate revenue because preliminary revenue numbers for 1999 had already been announced, helping to drive the company’s stock price to its all-time high. However, finally convinced of the necessity, a press release was drafted explaining that MicroStrategy was lowering its 1999 revenues from the previously announced $205 million to between $150 and $155 million. The news announcement was issued at 8:06 a.m. on Monday, March 20, 2000. MicroStrategy’s stock opened the day trading at $226.75 per share; by the end of the day, the shares had dropped 62% to $86.75 per share.
Subsequent SEC investigation confirmed that MicroStrategy had overstated its revenue, and the inquiry uncovered a number of questionable practices. [Footnote: Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1350, Administrative Proceeding File No. 3-10388: In the Matter of MicroStrategy, Inc., December 14, 2000.] Two samples are given below:
· Contract Signing The final report on MicroStrategy from the SEC included the following: “To maintain maximum flexibility to achieve the desired quarterly financial results, MicroStrategy held, until after the close of the quarter, contracts that had been signed by customers but had not yet been signed by MicroStrategy. Only after MicroStrategy determined the desired financial results were the unsigned contracts apportioned, between the just-ended quarter and the then-current quarter, signed and given an ‘effective date.’ In some instances, the contracts were signed without affixing a date, allowing the company further flexibility to assign a date at a later time.
· The NCR Deal On October 4, 1999, MicroStrategy announced that it had sold software and services to NCR for $27.5 million under a multi-year licensing agreement. Although the deal was announced four days after the end of the third quarter, and although the licensing agreement extended for several years, MicroStrategy recognized over half the amount as revenue immediately (and perhaps retroactively) and added $17.5 million to third quarter revenue. Without this $17.5 million in revenue, MicroStrategy’s reported revenue for the third quarter would have been down 20 percent from the quarter before. The reported profit for the quarter would have instead been a loss. And perhaps worst of all, MicroStrategy would have fallen well short of analysts’ expectations, sending the stock price spiraling downward. As it was, MicroStrategy’s stock price soared 72% during the month of October 1999.
The aftermath of the MicroStrategy meltdown was bad for all of the principal characters involved. Michael Saylor was judged by the SEC to have committed fraud. He paid a fine of $350,000 and was required to forfeit an additional $8.3 million in gains from stock sales. As of July 2002, his stake in MicroStrategy was worth just $20 million, down from $14 billion at his company’s pinnacle. In May 2001, PricewaterhouseCoopers agreed to pay $55 million to settle a class-action lawsuit brought by MicroStrategy shareholders who accused the audit firm of negligence in allowing MicroStrategy’s financial reporting to go uncorrected for so long. And MicroStrategy itself has not recovered from the bursting of its revenue bubble. The company reported losses of $261 million and $81 million in 2000 and 2001, respectively. And as of July 2002, the company’s price-to-sales ratio was just 0.25.
In the MicroStrategy case, both the boom and the bust are tied to the accounting rules for revenue recognition. With high-growth companies boasting price-to-sales ratios of 150 or higher, a delay in reporting revenue from a $10 million contract can easily lead to losses in market value in excess of $1 billion. Because so much rides on how much revenue a company reports, many companies have succumbed to the temptation to either manage reported revenue or to commit outright fraud in boosting reported revenue. Because revenue recognition is such an important issue in today’s economy, the SEC released Staff Accounting Bulletin (SAB) No. 101, “Revenue Recognition in Financial Statements,” in December 1999. SAB 101 has been one of the most influential, and controversial, accounting pronouncements in the last 10 years. The FASB has also undertaken a comprehensive examination of the accounting standards related to revenue recognition. As investors struggle to guide their investment capital to its most valuable use in the uncertain, high-tech business playing field, reliable financial reporting with respect to revenue recognition is critical.
This chapter will proceed as follows. The first section includes a review of the general principles associated with revenue recognition. The next section uses SAB 101 as a framework and provides illustrations of difficult revenue recognition issues. The concluding sections cover specific revenue recognition practices and illustrate the percentage of completion, proportional performance, and installment sales methods of accounting.
1. Identify the primary criteria for revenue recognition.
REVENUE RECOGNITION
Recognition refers to the time when transactions are recorded on the books. The FASB’s two criteria for recognizing revenues and gains, articulated in FASB Concepts Statement No. 5, were identified in Chapter 4 and are repeated here for emphasis. Revenues and gains are generally recognized when:
1. They are realized or realizable.
2. They have been earned through substantial completion of the activities involved in the earnings process.
Both of these criteria generally are met at the point of sale, which most often occurs when goods are delivered or when services are rendered to customers. Usually, assets and revenues are recognized concurrently. Thus, a sale of inventory results in an increase in Cash or Accounts Receivable and an increase in Sales Revenue. However, assets are sometimes received before these revenue recognition criteria are met. For example, if a client pays for consulting services in advance, an asset, Cash, is recorded on the books even though revenue has not been earned. In these cases, a liability, Unearned Revenue, is recorded. When the revenue recognition criteria are fully met, revenue is recognized and the liability account is reduced.
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FYI: “Realized” or “realizable” can be interpreted as having received cash or other assets or a valid promise of cash or other assets to be received at some future time.
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In general, revenue is not recognized prior to the point of sale because either (1) a valid promise of payment has not been received from the customer or (2) the company has not provided the product or service. An exception occurs when the customer provides a valid promise of payment and conditions exist that contractually guarantee the sale. The most common example of this exception occurs in the case of long-term contracts where the two parties involved are legally obligated to fulfill the terms of the contract. In this case, revenue (or at least a portion of the total contract price) may be recognized prior to the point of sale.
Another exception to the general rule occurs when either of the two revenue recognition criteria is not satisfied at the point of sale. In some cases, a product or service may be provided to the customer without receiving a valid promise of payment. In these instances, revenue is not recognized until payment or the valid promise is received. Now you are saying to yourself, “Why would anyone provide a product or service to a customer without receiving a valid promise of payment?” A common example is a family doctor who frequently provides treatment first and then tries to collect payment later. Also, if a customer provides payment yet substantial services must still be provided by the company, then the recognition of revenue must be postponed until those services are provided. In any case, if both of the two revenue recognition criteria are met prior to the point of sale, revenue may be recognized. If either of the two criteria is not met at the point of sale, then the recognition of revenue must wait.
While the point-of-sale rule has dominated the practice of revenue recognition, there have been notable variations to this rule. In fact, the far right column in Exhibit 7-1, the cases in which revenue should be recognized AFTER the point of sale, has proved to be very controversial. As illustrated in the MicroStrategy scenario at the beginning of the chapter, pressure to meet market and analyst revenue expectations has made companies, especially start-up companies, reluctant to defer the recognition of revenue past the point of sale.