This Morris, Manning & Martin Revenue Recognition Bulletin reviews recent case developments in the revenue recognition 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. As discussed in the last Bulletin, those improper practices included the acceleration of purported revenue from payments by an ISP to Gateway for bundling the ISP’s Internet service with a Gateway PC purchase. This Bulletin discusses another allegedly improper practice: “bill-and-hold” sales.
This involved an arrangement with one of Gateway’s larger customers, a rent-to-own consumer leasing company. In April 2000, Gateway commenced a relationship with the leasing company that included the leasing company’s agreement to purchase PCs from Gateway to rent to its customers.
Initially, the leasing company issued a blanket purchase order for PCs for each of its stores throughout the country. It then placed smaller purchase orders with Gateway based on the needs of a particular store. Gateway then shipped the PCs directly to the store that sought them and invoiced the corporate office of the leasing company for the order.
On September 21, 2000, a Gateway sales representative sent an e-mail to the leasing company confirming that it would issue a purchase order for $16.5 million of hardware, for which it would receive a 5% discount, that it would be billed by September 30, 2000 and that it would take possession of the PCs by October 31, 2000. The e-mail did not reference any warehousing arrangements.
The parties actually agreed that the leasing company would not take the product until the fourth quarter, after it issued subsequent purchase orders from individual stores, as had been its practice. They also agreed that the leasing company would be invoiced and pay on the subsequent store purchase orders, not the $16.5 million purchase order.
On September 21, 2000, the leasing company issued a purchase order for $16.5 million in PCs and peripherals. The purchase order provided that the equipment would be shipped to “local warehousing for subsequent distribution,” and stated that the order was FOB destination. Gateway then “shipped” the products by segregating them in the third-party warehouses located adjacent to Gateway’s manufacturing facilities — the same warehouses which housed the PCs for other third parties. The leasing company did not make any arrangements with the warehouses or have any contact with the warehouses.
The SEC alleged that Gateway improperly recognized revenue of $16.5 million on the third quarter purported sale (and also failed to apply the 5% discount on the sale until the fourth quarter). Thus, Gateway increased its third quarter reported revenue by $16.5 million.
The transaction failed to satisfy three critical GAAP criteria for revenue recognition on a bill-and-hold transaction. First, revenue recognition was inappropriate because the leasing company lacked any substantial business purpose for ordering the goods on a bill-and-hold basis. Second, Gateway had specific performance obligations concerning the purchase order that it did not discharge during the third quarter, including: (1) upon receipt of a second purchase order from the leasing company, an obligation to remove the product from the warehouse inventory, send it back to Gateway’s manufacturing facility for re-entry in Gateway’s computer system, and then ship the product to the individual store specified on the order; and (2) an obligation to reverse the September 21, 2000 sale of the PC out of its system and issue a second invoice to the leasing company. These performance obligations precluded revenue recognition. Third, revenue recognition was inappropriate because the leasing company did not request that the transaction be on a bill-and-hold basis, and did not pay the cost for warehousing the inventory.
There are many lessons to be learned from the Gateway situation. Consider the suggestions below for your revenue recognition and contracting policies with respect to bill-and-hold sales. They may help keep you and your company out of trouble.
In 1986, the SEC articulated the following conditions for recognition of revenue on bill-and-hold sales:
- the risks of ownership must pass to the buyer;
- the customer must make a fixed commitment to purchase the goods, preferably reflected in written documentation;
- 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 that is reasonable and consistent with the buyer’s business purpose;
- the seller must not retain 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; and
- the equipment must be complete and ready for shipment.
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]