Post on 20-Apr-2023
Revenue Recognition in Tech Firms: A Matter of Interpretation?
1
Revenue Recognition in Tech Firms:
A Matter of Interpretation?
Edward Maddalena
Brooklyn College
Revenue Recognition in Tech Firms: A Matter of Interpretation?
2Revenue Recognition in Tech Firms: A Matter of Interpretation?
When the internet was invented in the 1970s, it was vastly
different from what we consider the internet today. What had
originally began as a system for “linking four computers at four
research centers” has spread all across the world and helped
created businesses that were unthinkable just forty years ago
(Crocker, 2009, p. A29). Based on an analysis by the consulting
firm McKinsey & Company, the internet accounted for 6% of GDP in
advanced countries, and created “an increase in real GDP per
capita of $500” during the past 15 years; an increase which took
50 years of the Industrial Revolution to attain (McKinsey Global
Institute, 2011, p. 3). Along with this incredible growth in
productivity, wealth and prosperity, the internet has helped
create new businesses such as Facebook, Google, Amazon, Priceline
and countless others. With the creation of these new businesses,
new businesses models must intuitively follow, often pushing
existing accounting standards to their logical extreme. Given
that many of these companies often end up filing for an Initial
Public Offering, their compliance with existing Generally
Revenue Recognition in Tech Firms: A Matter of Interpretation?
3Accepted Accounting Principles is tantamount, especially when it
deals with recognition of revenue. While normally important for
any company, many internet startups are well known for bringing a
product to market “without a clear and credible plan for how
their business would make money”, in order to build a critical
mass of users before implementing a method of generating revenue
(Berman, 2013, p. 1). However, when filing to “go public”, many
Silicon Valley companies run into issues with the Securities and
Exchange Commission related to revenue recognition. This paper
will discuss three high profile cases of revenue recognition as
related to the technology industry; namely Groupon Inc., Zynga
Inc., and Apple Inc. The recognition of revenue for technology
companies will continue to be important, as technology works its
way into more and more industries. Additionally, there are “at
least 73 private companies... [that] are valued at $1 billion by
venture-capital investors”, which will assumedly go public in the
near future (Austin, 2015). Of these Silicon Valley startups,
some portion of them are certain to choose an overly aggressive
interpretation of revenue recognition in order to be seen as
Revenue Recognition in Tech Firms: A Matter of Interpretation?
4financially strong by potential shareholders. Before a discussion
of the three cases, a review of existing professional literature
related to revenue recognition is necessary.
Revenue Recognition: The Basics
At the most basic, under ASC 605-10-25, revenue is
recognized when it is realized or is realizable, as well as when
the revenue is earned. Under the first criteria, recognition
occurs when the product or service being sold is exchanged for
cash or a claim for cash, while under the second criteria,
recognition occurs when “the entity has substantially
accomplished what it must do to be entitled to the benefits
represented by the revenues” (FASB, ASC 605-10-25-1). Although
seemingly simple, the determination of realization and
earnability becomes much more complicated when viewed through
various industry prisms. Within Silicon Valley, two major areas
of revenue recognition are the recognition of revenue from
multiple activity arrangements and the determination of if a
company is acting as a principal or an agent in a transaction.1
Revenue Recognition in Tech Firms: A Matter of Interpretation?
5Under multiple activity arrangements, the recognition of revenue
should be “divided into separate units of accounting if the
deliverables in the arrangement” have value to a customer on a
stand-alone basis and there is objective evidence about the fair
value of the undelivered items (FASB, ASC 605-25-25-2a). This
nuance of revenue recognition affects companies that sell
hardware devices that come combined with software updates, as
well as companies that offer service contracts for their
products. Due to the increased prevalence of the Software as a
Service2 (SaaS) business model, and the rapid proliferation of
the internet of things3 (IoT), more and more companies, even
those not affiliated with traditional Silicon Valley, are falling
under these sections of the revenue recognition standards. In
addition to revenue recognition for multiple activity
arrangements, many companies have to determine how they should
present their revenue, and if they qualify as a principal to the
transaction or they are solely an agent. If a company is
determined to be a principal to a transaction, they qualify to
present their revenue as the gross amount billed for the
Revenue Recognition in Tech Firms: A Matter of Interpretation?
6transaction. Conversely, if the company is deemed to be an agent
for the transaction, they only can present the revenue net of
amounts paid to other third parties. Under ASC 605-45-45, the
FASB has laid out eight criteria for consideration of if the
entity should present their revenue on the gross basis or net
basis.4 These eight criteria suggest that an entity can present
revenue arising from a transaction on the gross basis if it “is
responsible for providing the product or service desired by the
customer”, and bears most of the risks and rewards related to the
transaction (FASB, ASC 605-45-45-4). If the entity is not deemed
the primary obligor, or only earns a percentage of the total
amount billed to the customer, accounting codifications suggest
that the entity is an agent and should present their revenue on
the net basis.
In addition to compliance with GAAP, companies who have
“gone public”, and have shares of their company traded on public
stock exchanges, must also comply with the Securities and
Exchange Commission’s Staff Accounting Bulletins (SAB) on various
financial statement presentation, including one on Revenue
Revenue Recognition in Tech Firms: A Matter of Interpretation?
7Recognition. As the FASB is allowed by the SEC to promulgate
accounting standards, the Staff Accounting Bulletins, are updated
in instances where the SEC feels extra explanation is necessary.
Under SAB 13, the SEC says revenue should be recognized when
“persuasive evidence of an arrangement exists, delivery has
occurred or services have been rendered, the seller’s price to
the buyer is fixed or determinable, and collectability is
reasonably assured”. In short, this policy governing recognition
tries to cast as wide and as flexible of a net as possible to
ensure that companies in all industries can apply it. However, as
this paper will show, the flexibility that the SEC provides
companies with, namely those in the tech industry, is prime for
over reach and potential abuse.
Groupon: Going Gross is Great for Revenue
Groupon operates as “a local e-commerce marketplace that
connects merchants to consumers by offering goods and services at
a discount” for a short period of time (Groupon Inc., 2011, p.
44). Unlike other online merchants such as Amazon, Groupon makes
Revenue Recognition in Tech Firms: A Matter of Interpretation?
8agreements with sellers, enabling them to list their products on
the website, often at a deep discount to the listed price. For
instance, a baseball team can set up a deal on Groupon offering
tickets that normally sell for $80, but are listed at $40 on
Groupon. Once a set number of customers agree to purchase the
deal,5 the transaction is consummated, and “after providing the
service, the [merchant] would submit the voucher to Groupon and
receive [their agreed upon percentage]”6 (Dutta, Caplan, &
Marcinko, 2014 p. 230). When Groupon initially filed their S-17
with the SEC, the regulator replied with a fourteen page letter
requesting greater detail and information about a myriad of
topics, including the company's revenue recognition policies.
In Groupon’s initial S-1, they recognized all revenue on a
gross basis, where “the entire amount received from the customer
is recorded as revenue, and a corresponding cost of sales is
recorded to account for the payment made to the supplier” (Dutta
et al., 2014 p. 231). In their initial letter to Groupon, the SEC
objected to Groupon’s classification of itself as a primary
obligor under ASC 650-45-45, given that “Groupon is a means for
Revenue Recognition in Tech Firms: A Matter of Interpretation?
9the customer to purchase a product or service from a merchant at
a discounted price” and requested the company restate their
revenue on a net basis (Securities and Exchange Commission,
2011a, p. 11). Under the net basis, “only the difference between
what is received from the customer and what is paid to the
supplier is recorded as revenue”, similar to the booking of a
commission (Dutta et al., 2014 p. 231). In practical terms,
assume Groupon runs a deal for a restaurant, selling 20,000 $100
gift cards for $50 each, and providing the merchant 50% of the
proceeds of the total deal. If presented on the gross basis, the
total revenue recognized from the deal would be $1,000,000
(20,000 gift cards at $50 each) and the amount remitted to the
merchant (called Cost of Revenue in Groupon’s filings) would be
$500,000, resulting in a gross profit of $500,000. Conversely,
the same deal presented under the net basis would show revenue of
only $500,000, representing the amount that Groupon was entitled
to after the settlement of the transaction. While both methods
result in the same total amount of gross profit, presentation on
the net basis will show a much lower revenue, or top line number,
Revenue Recognition in Tech Firms: A Matter of Interpretation?
10one of the major financial statement items reviewed by analysts
and investors. In addition to impacting top line revenue, the net
presentation of revenue reduces management reporting metrics,
such as revenue per employee, while negatively increasing other
ratio such as the efficiency ratio (COGS/Revenue). This issue of
reporting at net compared to gross is not unique to Groupon, as
various other companies have run into this recognition issue,
most notably Priceline. The online hotel booking company was
questioned by the SEC “regarding its practice of reporting
revenues at gross when reporting at net would seem more
appropriate”, given that the company acted as an intermediary
between consumers and merchants, highly similar to Groupon8
(Phillips, Luehlfing, & Daily, 2001 p. 42).
Upon examining the eight indicators for gross recognition
compared to net recognition under ASC 605-45-45, it is evident
that Groupon is not a principal to the transaction, and should
report its revenue solely on the net basis. Given that customers
are transacting with Groupon in order to obtain services from a
merchant, it should be fairly evident that Groupon is not the
Revenue Recognition in Tech Firms: A Matter of Interpretation?
11primary party to the transaction. Furthermore, according to
Groupon’s website and information, any Groupon purchased is a
“special promotional offers that you [the customer] purchase from
participating Merchants through our service” and the merchant “is
fully responsible for all goods and services it provides to you
[the customer]”, clearly and unquestionably proving that Groupon
is not the primary obligor in the transaction (Securities and
Exchange Commission, 2011b). Additionally, in observing the other
factors of gross recognition, factors two9 and three10 prove that
Groupon is not the primary obligor in the transaction, and should
present its revenue on a net basis. Given that Groupon deals
directly with merchants in setting terms for deals, the company
and merchant must come to an agreement in order to have the deal
listed. Since the price of the deal, which is also determined
between Groupon and merchants, is the price that the customer
sees, it can be ascertained that Groupon does not have
unconstrained ability to establish the price, and without the
complete agreement of the merchant, the deal cannot be listed.
While Groupon runs the risk of having to provide returns for
Revenue Recognition in Tech Firms: A Matter of Interpretation?
12unsatisfied purchasers, they are not exposed to direct inventory
risk, as they do not hold any of the underlying inventory they
are offering discounts on.
Given the intense and repeated scrutiny that Groupon faced
on the proper presentation of their income statement from the
SEC, the company relented, and in an amendment to their S-1
registration, changed their recognition of revenue to the net
basis. While Groupon may seem like an isolated case, the rise of
the internet economy and new forms of selling goods and services
to customers will result in multiple situations akin to that of
Groupon. For example, the sale of applications, or apps, on a
mobile phone presents similar circumstances to that of Groupon.
In these transactions, the phone operator publishes listed apps
for digital download at a price set by the developer, of which
the operator takes a set percentage of sales. In these
transactions the operator should present their revenues on the
net basis, as they are not the primary obligor to the
transaction. This is similar to the approach that Apple11 takes,
by accounting “for such sales on a net basis by recognizing in
Revenue Recognition in Tech Firms: A Matter of Interpretation?
13net sales only the commission it retains from each sale” as it
does not set the price for the apps, and as thus is not a primary
obligor (Apple Inc., 2014, p. 51).
Zynga: Poor Performance Leads to Profitable Presentation
Much like Groupon, Zynga is a “Web 2.0” company, launched in
2007, and creates “online social games, including CityVille,
FarmVille, Mafia Wars, Words with Friends and Zynga Poker”, which
are playable on social networks such as Facebook as well as
mobile devices (Zynga Inc., 2011a, p. 69). One of their most
popular games, the eponymously named Farmville,12 is a “farming
game, where players could grow digital crops and sell them to
make virtual money”, and is offered free to players online
(MacMillan, Burrows, & Ante, 2009 p. 348). While Zynga does not
charge for basic gameplay, certain features are only able to be
accessed by paying real-world money, which are divided into two
categories: immediate consumables and long term durables.
Immediate consumables, much like the name would suggest, are in-
game items that can only be used a certain number of times before
Revenue Recognition in Tech Firms: A Matter of Interpretation?
14becoming unavailable to the player until purchased again. This
category includes various cosmetic enhancements as well as items
that speed up in-game crop growth.13 Long term durables are in-
game items “that are accessible to the player over an extended
period of time”, usually for the lifespan of the game (Zynga
Inc., 2011a, p. 62). Given that the sale of in-game items for
real world money is an integral part of Zynga’s ability to
generate revenue, an increased scrutiny of the policy surrounding
the recognition of revenue is necessary.14
According to Zynga’s initial registration statement to the
SEC, the company stated that they recognize revenue from the
purchase of immediate consumables “as the goods are consumed”,
e.g. when a player uses a bag of fertilizer in order to enhance
the overall output of planted crops (Zynga Inc., 2011a, p. 62).
If players purchase 500,000 virtual bags of fertilizer at $2
each, and then immediately used them, Zynga would recognize $1
million in revenue. Conversely, if players only used 250,000 of
the 500,000 virtual bags, Zynga would recognize $500,000 in
revenue and record $500,000 in deferred revenue on its balance
Revenue Recognition in Tech Firms: A Matter of Interpretation?
15sheet. For the accounting of the sale of long-term durables,
Zynga would recognize “revenue from the sale of durable virtual
goods ratably over the estimated average playing period of paying
players for the applicable game, which represents our best
estimate of the average life of our durable virtual goods” (Zynga
Inc., 2011a, p. 62). Conceptually this recognition policy makes
sense, as it spreads the revenue out over the lifetime of the
service rendered, in this case the service being the use of the
long-term durable item in the game. When a player ceases playing
the game, it can be understood as the player no longer using the
service. If players purchase $1.2 million of in-game durable
virtual goods, and the Zynga estimates the average playing period
to be 24 months, Zynga would recognize revenue of $50,000 every
month. However, in the same example, if Zynga estimates that the
estimated average playing period of the game is only 12 months,
they would recognize revenue of $100,000 every month. Much like
calculating the useful life for straight-line depreciation, the
average playing period for a Zynga game is only an estimate, and
can be changed if the circumstances change. This can lead to the
Revenue Recognition in Tech Firms: A Matter of Interpretation?
16counterintuitive situation where a Zynga property is losing
popularity, yet is recognizing increased revenue, partially
obscuring the true presentation of the underlying revenue
generators. Zynga changed the estimate of the average playing
period as it prepared to file for an initial public offering,
changing the estimated life from 19 months to 15 months
increasing revenue by $27.3 million, helping turn what would have
been a $9.2 million loss into an $18.1 million gain (Zynga Inc.,
2011b, p. 66). This flexible revenue recognition can lead to
Zynga making adjustments to the estimated lifetime of their games
in order to reach a pre-determined target, be it Wall Street
earnings estimates, or the threshold for vesting of managements
restricted stock units.
EITF 08-1 and 09-3: The Apple of Apple’s Eye
Apple Inc, one of the most popular and well-known companies,
“with a brand value of more than $104” billion, is a manufacturer
of phones, computers, tablets, and complimentary software
products (Gent, 2014, p. 38). As a seller of hardware devices,
Revenue Recognition in Tech Firms: A Matter of Interpretation?
17the company’s revenue recognition is very simple, and occurs
“when persuasive evidence of an arrangement exists, delivery has
occurred, the sales price is fixed or determinable and collection
is probable”, according to the regulations as laid out in SAB 13
(Apple Inc., 2014).15 However, when selling hardware with an
additional software component, the steps required to recognize
revenue become more complicated, especially if all of the
software the user would be entitled to had not yet been
delivered.16 According to the FASB and the SEC, the recognition
of revenue resulting from the sale of an integrated hardware and
software package is determined based on “a hierarchy to determine
the selling price to be used for allocating revenue to
deliverables: (i) vendor-specific objective evidence of fair
value (“VSOE”), (ii) third-party evidence of selling price
(“TPE”) and (iii) best estimate of selling price (“ESP”).”17
(Apple Inc., 2014, p. 51). Given that Apple’s software updates
are tightly integrated in the functionality of the hardware, and
have no resale value outside of the hardware, VSOE and TPE are
not applicable, and Apple uses the ESP, and recognizes the
Revenue Recognition in Tech Firms: A Matter of Interpretation?
18revenue related to the software updates on “a straight-line basis
over the estimated period the software upgrades and non-software
services are expected to be provided for each of these devices,
which ranges from two to four years” (Apple Inc., 2014, p. 39).
However, this simplified hierarchy of determining how to
recognize revenue for sales with multiple deliverables has only
been in place since 2009, where it superseded a much more
confusing and at times, counterintuitive way of recognizing
revenue.
After 2009, the recognition of revenue from hardware with
additional software components was governed by two issuances by
the Emerging Issues Task Force,18 EITF 08-1 and EITF 09-3, which
were subsequently codified into the FASB Accounting Standards.19
Before EITF 08-1 and 09-3 were approved and codified by the
FASB,20 Apple was forced to follow Statement of Position (SOP)
97-2, which “provided guidance on applying GAAP in recognizing
revenue from software and software-related transactions” and
affected the sale of hardware that had software integrated in it
(Regan & Regan, 2007 p. 51). As SOP 97-2 was written in 1997, the
Revenue Recognition in Tech Firms: A Matter of Interpretation?
19rules were surpassed by the quickly evolving software field,
forcing companies that sold devices bundled with software to
follow software revenue recognition, even though the revenue
being recognized did not primarily pertain to software. For
Apple, this led to situations where accounting policy ended up
dictating business practices, often to the detriment of the
consumer and the company.
Under SOP 97-2, if a vendor agreed to deliver unspecified
software in the future, the revenue related to the multiple
element arrangement should be accounted for as a subscription,
with “all software product-related revenue from the arrangement
[being] recognized ratably over the term of the arrangement
beginning with delivery of the first product” (FASB, 1997, p.
11). In practical terms, if a vendor sells a customer a piece of
hardware with the express understanding to deliver some number of
software upgrades in the future, the vendor would have to
recognize the revenue over the estimated life of the product,
similar to how a magazine would recognize revenue for a
subscription. When Apple first unveiled the iPhone and iPod Touch
Revenue Recognition in Tech Firms: A Matter of Interpretation?
20in 2007, they chose to recognize revenue from each device
differently. The iPhone was recognized under subscription
accounting,21 much to the chagrin of Apple, who felt that
accounting for the wildly popular device via subscription
revenue, “kept its share price from fully reflecting the success
of one most profitable products Apple has ever made”22 (Elmer-
DeWitt, 2009). Under subscription accounting requirements as laid
out in SOP 97-2, Apple had to recognize “the associated revenue
and cost of goods sold on a straight-line basis over the
currently estimated 24-month economic” life of the iPhone, as it
planned to offer iOS upgrades to customers, free of charge (Apple
Inc., 2008, p. 38). Conversely, the iPod Touch was not accounted
for via the subscription method, resulting in Apple recognizing
all revenue for the sales of the devices up front, as opposed to
spreading the recognition out over 24 months.23 However, when
Apple wanted to issue an update to the iPod touch, they were
forced to charge $19.99 for the upgrade. This disparity in
upgrade processes resulted in “just 1% of iPod touch users…
[having] upgraded to the new software, while a resounding 78%
Revenue Recognition in Tech Firms: A Matter of Interpretation?
21were still running the latest point release”, in the initial
releases of iOS software, as compared to 44% adoption for iPhones
(Oliver, 2009). As such, Apple was faced with a fragmented user
base, limiting the total number of devices that could run the
newest software, resulting in developers for the platform having
to write code for multiple versions of the operating system, all
due to accounting pronouncements overruling business decisions.
Not only did SOP 97-2’s reach force Apple to prioritize
accounting regulations over business decisions for the iPhone and
iPod, it also did the same for the companies Macbook line of
laptops. When Apple released the Macbook in 2006, it shipped with
the hardware for a state of the art wireless connection, but was
disabled, due to the fact that the specifications related to the
wireless connectivity were not finalized at release.24 When the
specifications were agreed upon in early 2007, Apple announced
that in order to activate the functionality of the hardware, they
would have to pay a “nominal distribution fee… in order for Apple
to comply with generally accepted accounting principles for
revenue recognition, which generally require that we [Apple]
Revenue Recognition in Tech Firms: A Matter of Interpretation?
22charge for significant feature enhancements, such as 802.11n,
when added to previously purchased products” (Krazit, 2007). This
business move angered many consumers, given that the software was
already included in their purchased hardware, however under SOP
97-2, if Apple wanted to recognize all of its revenue at the time
of purchase, it would have to charge for incremental upgrades to
the software. In both this case, as well as the iPod Touch
example mentioned above, by charging for the upgrade, Apple was
able to establish a vendor-specific objective evidence of fair
value, allowing the company the ability to recognize the revenue
from the sale of the device when it was delivered, and recognize
the revenue from the upgrade when a user paid for it, as set out
in paragraph .10 of SOP 97-2.
Due to the constantly changing technology sector, the
regulations as outlined in SOP 97-2 quickly became impractical,
given that more types of hardware could be considered a multiple
deliverables arrangement under SOP 97-2, despite the minimal
amount of software and software upgrades that the device
contained. For instance, Xerox’s copy machines were considered to
Revenue Recognition in Tech Firms: A Matter of Interpretation?
23fall under the scope of SOP 97-2, as the “equipment has both
software and non-software components that function together to
deliver the equipment’s essential functionality” (Xerox Inc.,
2009, p. 61). Due in part to the creeping reach in the policy, as
well as the concerted lobbying from impacted firms, the EITF
issued EITF 08-1 and EITF 09-3, which together, modified the
scope and reach of SOP 97-2. EITF 08-1, which was subsequently
codified in ASC 605-25, allowed for companies that could not
establish a VSOE or TPE to “to estimate the selling price of the
undelivered unit(s) of accounting and allocate the arrangement
consideration using the residual method” (Emerging Issues Task
Force (EITF), 2009, p. 6). This established the hierarchy that
Apple currently uses to determine the relative selling prices of
its various software components in the selling of hardware
bundled with software. Concurrently, EITF 09-3 exempted “tangible
products containing software components and non-software
components that function together to deliver the product’s
essential functionality” from SOP 97-2’s scope (Emerging Issues
Task Force (EITF), 2009, p. 4). This meant that hardware devices
Revenue Recognition in Tech Firms: A Matter of Interpretation?
24that came with software responsible for the operation of the
hardware did not have to be treated according to subscription
revenue recognition. This allowed for companies to book the
majority of the revenue25 from the sale of the hardware when it
met general revenue recognition requirements, as opposed to over
the estimated life of the hardware. These two EITF’s, when
applied to Apple’s recognition of iPhone revenue, allowed the
company the ability to recognize much more revenue upfront, as
opposed to previously, under SOP 97-2. In more practical terms,
if Apple sold an iPhone for the retail price of $600, which has
an estimated period of software upgrades of two years, Apple
would recognize $575 in revenue upfront and defer the remaining
$25 in revenue over a 24 month period26 (Apple Inc., 2009).
Additionally, these EITF issues allowed Apple to be in compliance
with software revenue recognition without having to charge
consumers for updates, as they used to have to for iPod Touches
and MacBooks.
Conclusion and Impact on Future Research
Revenue Recognition in Tech Firms: A Matter of Interpretation?
25While these three revenue recognition cases may appear to be
distinct from each other, they all share one major similarity:
the tech industry, namely Silicon Valley. As more companies and
business models are brought to market that push the established
boundaries of revenue recognition, standards setters will have to
craft rules that are flexible, allowing for recognition to occur
in line with business objectives, while not allowing companies
excess latitude to over recognize top-line revenue numbers. Given
the continued push for convergence between FASB and IASB, as well
as continual meetings on convergence revenue recognition
policies, this could be an area prime for agreement and issuance
of standards. Additionally, given that after a rudimentary search
through accounting research databases, there is little to no
academic research on the revenue recognition policies of these
three companies, this research aims to help fill that gap.
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1Footnotes
ASC 605-25-25 and ASC 605-45-05 respectively. Additionally, under ASC 605-20, thecodification has dedicated a section to the recognition of revenue for advertisingbarter transactions, in which two internet companies swap the right to placeadvertisements on each other’s websites. Given that this transaction is much lesswidespread now than it was in the dot-com bubble of the late 90’s, as well as thefact that the overall revenue impact is often close to zero, this topic is notcovered in the paper. 2 Software as a Service is a business model in which a company offers users accessto a piece of software through a web client for an annual subscription fee. As longas the user continues to pay the subscription fee, they continue to have access tothe software.3 The Internet of Things is the pending convergence of software being embedded inmainstream consumer technology, in order to provide enhanced value to consumers byhaving devices communicate with other connected consumer devices. Common examplesof IoT technology include home automation devices such as the Nest thermostat,which can be controlled by a smartphone; the Amazon Dash button, a small wirelessdevice linked to the ordering of a specific consumer brand; and the LG SmartFridge, which determines if food is spoiled or close to gone and places an orderfrom the supermarket.4 These eight criteria are used in the consideration of gross revenue reporting,and are as follows 1) the Entity Is the Primary Obligor in the Arrangement; 2) theEntity Has General Inventory Risk—Before Customer Order Is Placed or Upon CustomerReturn; 3) the Entity Has Latitude in Establishing Price; 4) the Entity Changes theProduct or Performs Part of the Service; 5) the Entity Has Discretion in SupplierSelection; 6) the Entity Is Involved in the Determination of Product or ServiceSpecifications; 7) the Entity Has Physical Loss Inventory Risk—After Customer Orderor During Shipping; 8) the Entity Has Credit Risk. 5 Groupon sets minimum quantities on most daily deals in order to make sure that asizable quantity of discounts are sold, benefitting the merchant setting up thedeal6 This percentage remitted to the merchant depends on various factors, such as thesize of the deal and the size of the merchants. 7 The Form S-1 is the form filed with the Securities and Exchange Commission forcompanies intending to issue their securities to the general public.8 In the end, Priceline was allowed to continue reporting revenue on a gross basis,as it had more determination of the price it sold hotel rooms at. As such, thecompany could be seen as having latitude in establishing price, and thus couldjustify reporting at gross. In Groupon's case, the amount Groupon charges acustomer is purely determined by the agreement between the merchant and thecompany. 9 The entity has latitude in establishing price10 The entity has general inventory risk11 Apple is the maker of the iPhone and iPad, and the complementary App Store.Google, the creator of the Android operating system and the complimentary PlayStore also undertakes these transactions, however due to the immateriality of thisrevenue compared to their total revenue, specific details are not listed in the
annual report12 While Zynga has created numerous other games such as Cityville, Mafia Wars,Words with Friends, and Zynga Poker, their most notable and successful game isFarmville, and as such will be the primary reference for purposes of revenuerecognition.13 Various crops planted in the game take differing periods of time to grow and beharvested. The general in-game rule of thumb is that the longer the crop takes togrow, the more valuable it is to harvest.14 Relatedly, Zynga also chooses to present, and emphasize to analysts, the grossbooking amount of all in-game goods purchased over the time period. Unsurprisingly,this number is much larger than GAAP Revenue, as the presentation does not deferany revenue into later periods.15 While not in the scope of this paper, Apple chooses to recognize revenue fromthe sale of peripherals and digital content such as iTunes sales “pursuant to theSecurities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No.104, Revenue Recognition” (Apple Inc., 2008, p. 38). 16 This undelivered software component typically involves a software update,bringing new features and capabilities to the hardware.17 VSOE can be more simply thought of as “the price charged for a deliverable whenit is sold separately”, while TPE is the price that third parties would sellsimilar software (Rashty & O'Shaughnessy, 2010, p. 33)18 The Emerging Issues Task Force, or EITF, is a group set up by the FASB, designedto “promulgate implementation guidance within the framework of the AccountingStandards Codification to reduce diversity in practice”, and come to an agreementon proper accounting procedures for emerging issues (FASB, 2015).19 If the EITF reaches a consensus on a proposed issue, this leads the FASB tounderstand that there is no need to write a new accounting pronouncement. If theissue is approved by the FASB, it becomes binding guidance for accounting, unlessit is superseded by an updated ASC.20 Updated under ASU 2009-13 and ASU 2009-14 respectively and codified under ASC605-25 and ASC 985-605 respectively. 21 Additionally, the Apple TV, a set top television box, was also recognized undersubscription accounting.22 Ironically, given that “equity price is based on future dividends to shareholder[a derivation of cash flows]”, the change from SOP 97-2 to EITF 08-1 and 09-3 wouldnot change the cash flows Apple recognized from sales of the iPhone, having nochange on the intrinsic value of the stock (Phillips, Luehlfing, & Daily, 2001, p.1). 23 Apple did not publicly disclose why they recognized revenue from the iPod Touchas non-subscription revenue and revenue from the iPhone as subscription revenue.However, given that the iPhone was meant to be a significant product line forApple, it is possible that being able to provide no-cost upgrades would make betterbusiness sense. Additionally, deciding on an estimated economic life for the iPodTouch may have been difficult as compared to using the timeframe of a phonecontract for determining the average economic life for the iPhone. 24 Certain computer elements, such as wireless networking, Bluetoothcommunications, and USB drives, are agreed upon by working groups which consist ofmajor industry players in order to harmonize basic computer peripherals.
25 If a company planned to offer unspecified software updates in the future, itwould still have to apportion some of the selling price out to those elements, andrecognize the deferred revenue when the updates were delivered. 26 This information was obtained from Apple’s 2009 Form 10-K, which was amended toreflect the adoption of ASU 2009-14. Although these data points may potentially beout of date, it is still a useful way to understand the change in recognition ofrevenue.