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By Nicolas Morgan and Jennifer Feldman
Late last year, Financial Accounting Standards Board ratified several new consensuses that have important consequences for revenue recogniztion: one addresses arrangements with multiple deliverables, the other the achievement of milestones. These pronouncements provide company management with both guidance and greater flexibility and discretion in deciding how to recognize revenue.
But greater discretion for management in deciding how to recognize revenue does not provide insulation from scrutiny by the Securities and Exchange Commission. To the contrary, the SEC's Enforcement Division frequently prosecutes companies for fraudulent revenue recognition where management has exercised discretion in the application of accounting principles, and in the absence of the traditional badges of intentional misconduct.
Most recently, in February, the SEC charged the former chief financial officer and former controller of a nationwide operator of fitness centers, Bally Total Fitness, with securities fraud as a result of their roles in the recognition of revenue at the company. The SEC also charged Bally's auditors and six of its current and former partners for failing to detect the revenue recognition problems at Bally. The charges against Bally's management challenged recognition of revenue for three separate revenue sources: reactivation fees, initiation fees, and prepaid dues. The SEC alleged that Bally's financial statements were affected by more than two dozen accounting improprieties, which caused Bally to overstate its originally reported year-end 2001 stockholders' equity by nearly $1.8 billion, or more than 340 percent and understated its originally reported net loss by $92.4 million, or 9,341 percent, in one year and understated its originally reported net loss by $90.8 million, or 845 percent, in a second year.
Reactivation fees were payments from Bally members who had completed their initial contract period, but whose memberships were cancelled for failure to pay the monthly dues necessary to maintain their membership. Bally's method of accounting for reactivations was to project the reactivation payments it anticipated receiving during the coming year and immediately recognize most of these projected payments by improperly allocating them to the past period. This practice violated Generally Accepted Accounting Principles by recognizing revenue both before it was earned and before it was realized or realizable.
Initiation fees were one-time fees, either paid in full when members joined or financed over a period of time. Bally's management adopted the "deferral method" of accounting for this revenue, recognizing revenue over the estimated average membership life, whereas GAAP required Bally to recognize initiation fee revenue over the entire membership life.
Prepaid dues were generated when members opted to renew their membership for an additional period of time after completing the initial membership term. While GAAP required Bally to recognize prepaid revenue dues as monthly health club services were provided, Bally improperly accelerated revenue from prepaid dues by recognizing as revenue each year's prepaid dues at the time of prepayment instead of recognizing it over the period for which that member had prepaid.
Finally, the SEC also alleged that Bally improperly overstated its revenue from "Multiple Element Arrangements," which involved Bally's sale of health club services, personal training services, and nutritional products as a package, Bally treated the sale of each element separately allegedly to record revenue inappropriately early. The SEC alleged that GAAP required that revenue from the multiple elements of the package be treated as a single element unless Bally met certain requirements, which the SEC alleged were not met.
To settle the SEC charges against them, the former CFO consented to permanent antifraud and related injunctions, payment of $250,000, a permanent officer-and-director bar, and a permanent bar from practicing before the SEC, and the former controller agreed to permanent injunctions and a two-year bar from practicing before the SEC.
As the Bally case makes clear, the SEC continues to bring enforcement actions involving revenue recognition even in the absence of allegations of more flagrant fraudulent techniques such as fictitious invoices, roundtrip agreements, consignment sales, or various side letter arrangements.
Further, the SEC did not allege that Bally was anything less than forthcoming with its auditors. Rather, the SEC alleged that in making certain decisions about when and how to recognize revenue, Bally and its officers "knew or were reckless in not knowing" that certain accounting decisions were "not in conformity with GAAP and caused [Bally's] financial statements to be misstated." Thus, even if company management is forthcoming with their auditors in making decisions about revenue recognition, the SEC may still challenge their decisions and find fault with management's exercise of discretion. Notably, the SEC did make a point of alleging that certain accounting decisions had not been disclosed to the audit committee, and certain other accounting decisions were made after two supposedly GAAP compliant methodologies resulted in a material disparity in earnings.
The recent FASB ratifications provide greater guidance for companies facing accounting for transactions involving multiple deliverables and milestone payments. The ratifications simultaneously provide greater discretion to management in accounting for these complex transactions. With greater discretion can come greater scrutiny by the SEC's enforcement division which has historically prosecuted companies for exercise of discretion in recognizing revenue.
Company management can take certain precautions to avoid pitfalls in implementing new revenue recognition policies consistent with recent FASB guidance. Documenting what steps were taken in the exercise of discretion will be critical in defending against SEC scrutiny.
Nicolas Morgan is a partner and Jennifer Feldman an associate in the law firm of DLA Piper.
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