Revenue Recognition in Tech Firms: A Matter of Interpretation? Revenue Recognition in Tech Firms: A...

Revenue Recognition in Tech Firms: A Matter of Interpretation?

1

Revenue Recognition in Tech Firms:

A Matter of Interpretation?

Edward Maddalena

Brooklyn College


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


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


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


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


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


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


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


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,


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


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


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


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


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


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


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,


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


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


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


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%


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]


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


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


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


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.

References

Apple Inc. (2008). Form 10-K 2008. Retrieved from SEC EDGAR websitehttp://www.sec.gov/edgar.shtml

Apple Inc. (2009). Form 10-K/A 2009. Retrieved from SEC EDGARwebsite http://www.sec.gov/edgar.shtml

Apple Inc. (2014). Form 10-K 2014. Retrieved from SEC EDGARwebsite http://www.sec.gov/edgar.shtml

Austin, S. (2015, February 18). Meet the Hottest Tech Startups.The Wall Street Journal. Retrieved April 12, 2015, fromhttp://www.wsj.com/articles/meet-the-hottest-tech-startups-1424308076

Crocker, S. (2009, April 6). How the Internet Got Its Rules. TheNew York Times. Retrieved April 11, 2015, fromhttp://www.nytimes.com/2009/04/07/opinion/07crocker.html?_r=0

Dutta, S. K., Caplan, D. H., & Marcinko, D. J. (2014). GrowingPains at Groupon. Issues in Accounting Education TeachingNotes, 29(1), 55-77.

Berman, S. (2013). Introduction. In Not for Free: RevenueStrategies for a New World. Harvard Business Press.

Elmer-DeWitt, P. (2009, September 14). Accounting rule change inApple’s favor. Retrieved May 2, 2015, fromhttp://fortune.com/2009/09/14/accounting-rule-change-in-apples-favor/

Emerging Issues Task Force (EITF). (2009, July 7). Applicabilityof AICPA Statement of Position 97-2 to Certain ArrangementsThat Include Software Elements. Issue No. 09-3, fromhttp://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176156347626&acceptedDisclaimer=true

Emerging Issues Task Force (EITF). (2009, July 7). RevenueArrangements with Multiple Deliverables. Issue No. 08-1,from http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1218220140132&acceptedDisclaimer=true

FASB. (2015, January 1). About the Emerging Issues Task Force(EITF). Retrieved April 27, 2015, fromhttp://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1218220137512

FASB (Financial Accounting Standards Board). ASC 605-10-25-1.Retrieved April 16, 2015, from FASB Accounting StandardsCodification database.

FASB (Financial Accounting Standards Board). ASC 605-25-25-2a.Retrieved April 16, 2015, from FASB Accounting StandardsCodification database.

FASB (Financial Accounting Standards Board). ASC 605-45-45-4.Retrieved April 16, 2015, from FASB Accounting StandardsCodification database.

FASB. (1997, October 27). SOP 97-2. Retrieved May 2, 2015, fromhttp://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176156442593&acceptedDisclaimer=true

Groupon Inc. (2011). Form S-1 2011. Retrieved from SEC EDGARwebsite http://www.sec.gov/edgar.shtml

Gent, E. (2014). Technology brands top for value in 2014.Engineering & Technology (17509637), 9(3), 38-41.

Krazit, T. (2007, January 18). Apple to charge for faster Wi-Fi.Retrieved April 29, 2015, from http://news.cnet.com/Apple-to-charge-for-faster-Wi-Fi/2100-1044_3-6151281.html

MacMillan, D., Burrows, P., & Ante, S. E. (2009). Inside the appeconomy. Business Week, 4153, 347-357.

McKinsey Global Institute. (2011, May). Internet matters: TheNet's sweeping impact on growth, jobs, and prosperity. NewYork: du Rausas, M., Manyika, J., Hazan, E., Bughin, J.,Chui, M., & Said,R.

Oliver, S. (2009, June 25). Upgrade fee sees few iPod touch usersupdating to 3.0 software. Retrieved May 4, 2015, fromhttp://appleinsider.com/articles/09/06/25/upgrade_fee_sees_few_ipod_touch_users_updating_to_3_0_software

Phillips, J. J., Luehlfing, M. S., & Daily, C. M. (2001). TheRight Way to Recognize Revenue. Journal Of Accountancy,191(6), 39-46.

Penman, S. H., & Sougiannis, T. (1998). A Comparison of Dividend,Cash Flow, and Earnings Approaches to Equity Valuation*.Contemporary Accounting Research, 15(3), 343-383.

Rashty, J., & O'Shaughnessy, J. (2010). Revenue recognition forcloud-based computing arrangements. The CPA Journal(November), 32-35.

Regan, G., & Regan, T. (2007). Software Revenue Recognition onthe Rise. Journal Of Accountancy, 204(6), 50-54.

Securities and Exchange Commission (2011a). SEC-generated letterdated to Groupon June 29. Retrieved from SEC EDGAR websitehttp://www.sec.gov/edgar.shtml

Securities and Exchange Commission (2011b). SEC-generated letterdated to Groupon August 19. Retrieved from SEC EDGAR websitehttp://www.sec.gov/edgar.shtml

Securities and Exchange Commission (2011). Codification of StaffAccounting Bulletins Topic 13: Revenue Recognition.Retrieved April 16, 2015, from SEC SAB Codification Websitehttps://www.sec.gov/interps/account/sabcode.htm

Xerox Corporation. (2010). Annual Report 2010. Retrieved fromhttp://news.xerox.com/investors/reports

Zynga Inc. (2011a). Form S-1 2011. Retrieved from SEC EDGARwebsite http://www.sec.gov/edgar.shtml

Zynga Inc. (2011b). Amendment Number 4 to Form S-1 2011.Retrieved from SEC EDGAR websitehttp://www.sec.gov/edgar.shtml

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.

Revenue Recognition in Tech Firms: A Matter of Interpretation? Revenue Recognition in Tech Firms: A...

Documents

Transcript of Revenue Recognition in Tech Firms: A Matter of Interpretation? Revenue Recognition in Tech Firms: A...