This Morris, Manning & Martin Revenue Recognition Bulletin reviews recent case developments in the Rev. Rec. area and identifies practical suggestions for addressing these recent developments.
In November 2003, the Securities and Exchange Commission and Gateway, Inc. settled cease-and-desist proceedings. The SEC alleged various improper accounting practices, including the acceleration of purported revenue from payments by an Internet service provider (ISP) to Gateway for bundling the ISP’s Internet service with a Gateway PC purchase.
The initial agreement between Gateway and the ISP was entered in December 1999. It provided that the ISP would make an upfront bounty payment to Gateway for each end user who both purchased a PC bundled with a one-year Internet service package and registered for the service. Gateway would then pay the ISP for each end user, as a service fee. Gateway recorded the initial bounty payments received from the ISP as revenue and expensed the amounts paid to the ISP as cost of goods sold.
This was Gateway’s first mistake. In connection with selling goods and services, normally a company accounts for the transaction by recording as revenue the amounts received from the customer and recording as expenses the amounts incurred in producing those products or services. However, when the services are being principally provided by a third party, different accounting rules may apply. Here, according to the consent order, because the primary provider of the service is the ISP, not Gateway, and because the amounts being received by Gateway are a fixed fee per user, Gateway should have accounted for these transactions on a net basis. See EITF 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent.”
There were additional problems, however. In a July 2000 amendment, the parties adjusted the bounty and service payments to be equal amounts. While Gateway was reporting the amounts as income, the net effect of the transaction was now zero to each party.
In September 2000, someone in Gateway’s accounting department suggested a new wrinkle. Since the payments are a wash, why not apply them to all PC’s shipped and not just to those who subscribe for the ISP service? Gateway entered into negotiations with the ISP, resulting in another amendment to the agreement. The parties signed the amendment on September 30, 2000 and dated the amendment as of July 1, 2000. After the amendment, a Gateway executive sent an email to the ISP thanking the ISP for the “favorable accounting treatment.”
Gateway then retroactively adjusted its revenue from the ISP bounties back to July 1, 2000, increasing its third quarter revenue by $70 million, in a quarter in which it exceeded analysts’ expectations for revenue by just $30 million. Without the revenue associated with the amended agreement, Gateway would not have met analysts’ expectations.
The SEC alleged that there was no economic reason for the amendment, that the transaction should be accounted for in accordance with its economic substance, and that even if the change in the method of calculating the bounty revenue had satisfied the requirements of revenue recognition, Gateway would have been required to disclose the change in method since it was a significant change in accounting principle or practice.
Without admitting or denying the SEC’s findings, Gateway consented to the SEC’s order to cease and desist from committing or causing any violation or future violation of these types.
There are many lessons to be learned from the Gateway situation. Consider the suggestions below for your revenue recognition and contracting policies. They may help keep you and your company out of trouble.
- Examine carefully the revenue recognition issues in transactions that involve offsetting fees.
- If the agreement involves a third party providing products or services to your customers, be aware that accounting rules may require you to record revenue on a net, rather than gross, basis.
- Avoid retroactive application of an amendment to an agreement.
- Consider whether a change in business practices will trigger the disclosure requirements for significant changes in accounting principles or practices.
- Due to market conditions, Gateway was under intense pressure to increase revenues. Remember that times of stress may be the times when scrutiny of transactions is the most important.
For more information please contact a member of our Revenue Recognition Advisory team, or contact authors Paul Arne, at 404.504.7784 or [email protected], and Stephen Combs, at 404.495.3655 or [email protected]