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Sarbanes Oxley : Technology : Financial Controls
IT As An Enabler In Revenue Recognition
By
Ravikant Karra (and Balaji Narasimhan)
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Ravikant Karra (and Balaji Narasimhan)
Infosys Technologies, Ltd
Infosys
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The focus on revenue recognition stems from an overall focus on financial statement accuracy. Regulations like the Sarbanes Oxley (SOX) Act have been passed into law in the wake of international financial scandals. Also, accounting and regulatory bodies such as the Federal Accounting Standards Board (FASB) and the Securities Exchange Commission (SEC) have provided broad guidelines for disclosure. With the onus for financial statement accuracy squarely placed on the CEOs, there is a need for enhanced internal controls that assist the identification and elimination of erroneous reporting.
One of the most important financial measures is Revenue, also referred to as Turnover/ Sales. And one would think that most companies would have their single largest financial measure well under control. However, revenue accounting continues to be one of the prime reasons for financial restatements.
Revenue Recognition - Defined
There are two requirements that need to be fulfilled - First, the revenue must be ?earned?. This means that the sales process is complete and for goods, legal title has been, or is about to be transferred to a willing buyer ? within the reporting period. In the case of services, the service in question has been rendered during the reporting period. The second requirement is that the seller has to be reasonably certain of collecting the money publicly claimed as revenue.
Common Problem Areas in Revenue Recognition
Given that revenue recognition, with its 2 fundamental principles, looks simple, let us understand its inherent complexities.
Consider a manufacturer who ships goods from his warehouse to a party in a different country. The manufacturer generates an invoice for the shipment made giving the item price, taxes, charges and discounts. There are account postings that happen during shipment and during invoice generation. The traditional accounting methods record the revenue as earned automatically upon invoice generation.
The variations of the above transaction could be as:
- The terms of trade could be varying: commonly accepted terms being FOB (Free on Board), CIF (Cost, Insurance & Freight) and the like. Each variation carries with it a different interpretation of when the risk and ownership has been transferred to the buyer.
- The ?party? in question could be an end customer or could be a warehousing agent. Depending on the variation here, this transaction could be a consignment sale or a normal sale. A consignment sale is essentially treated like a stock transfer and the goods are shown in the books of the company till the actual sale to the end customer.
- The timing of the transaction is critical for reporting. There normally has to be a cut-off time within which transactions have to be considered for the reporting period.
- The contract can also have specific clauses on recognizing the sale. Some contracts may have a ?customer acceptance? or ?quality clearance? clause - in which case the sale cannot be recognized till the customer has cleared the goods.
- If the party has pre-paid, such revenue should not be recognized as the goods have not yet been delivered.
There are other possibilities in revenue recognition:
- If the company is a service company, then the proportionate amount of revenue based on work done has to be recognized.
- In case of contract based work, the entire amount may be pre-paid but the contract is valid for a much larger period. In such cases, only a portion of the payment is revenue while the rest is deferred revenue.
- In some cases, where there is a clear refund policy, sales may not be recognized till such time the return period has elapsed.
- Also, when returns happen, this has to result in 2 events, reversal of the previously recognized revenue, if any and valuation of the goods as inventory.
- Depending on the geography in which the company is operating, there could be country specific laws. For e.g., in one country, even invoicing has to be preceded by a customer acceptance of goods.
The above variations are part of normal business processes and need to be planned for since they cannot be eliminated. These variations are commonly referred to as ?contingencies? in the guidelines issued by the governing bodies.
What does it take for appropriate revenue recognition
Considering the various scenarios listed above, it just means that revenue recognition needs utmost attention and careful understanding of the underlying transactional details. Wherever revenue is not to be recognized upfront upon invoicing, the recognition process needs to be deferred till the contingencies are met. Also, it must be noted here that deferring revenue alone would not suffice if one considers the basic accounting principles. As per the Revenue / Cost matching principle, the associated costs should be expensed in the same accounting period where the revenue was recognized. This would mean that if revenue is deferred, so would the accounting for Cost of Goods Sold (COGS).
In terms of applicability of the above variations, these are more commonly encountered in organizations related to heavy equipment manufacturing, electronics equipment manufacturing, software, international trading and the like.
However, most of the processes to recognize and act upon these contingencies are currently manual. Many organizations have grown in size considerably in the past few years thanks to various globalization initiatives, mergers and acquisitions, resulting in multiple disparate systems to handle the complexities of new business imperatives. Many of these systems and applications are quite old and have been in existence much before these regulations have come into existence. Organizations have been quite cautious not to tamper with these existing systems much and resort to manual intervention to determine if a contingency has been met. And this is where a systematic approach to studying how the current IT investments can be leveraged would significantly help.
An approach to integrate IT in the revenue recognition process
IT applications, particularly those supporting the Order ?To ? Cash business process chain, can be significantly leveraged to help businesses recognize revenue appropriately.
Most companies have ERP systems in place for transaction capture and billing. This system-of-record can be appropriately configured or customized to achieve the desired control on revenue.
The typical revenue recognition process in the industry involves interaction between the following application modules:
- Order booking
- Shipping
- Inventory
- Costing
- Receivables
And while the process may involve interaction between the modules, not all the orders may have a contingency applicable. It may be appropriate to look at the order universe as split into 2 broad categories:
- Standard orders/line items (no contingency defined or needed):
For these items, invoicing and revenue recognition may proceed without any deferment of the process.
- Non-standard orders/line items (contingencies defined):
For these, the contingencies may have to be fulfilled before invoicing and revenue recognition can happen.
IT can play a vital role in this process by customizing the underlying order-to-cash applications. These can then support the required setup for defining the type of order, various contingencies and rules for validating these at transaction time.
These modules/applications should be enhanced to support the setup and workflow requirements. Once the contingency condition is met, the applications should aid in posting or reversing the accounting entries appropriately.
Identifying the changes required and implementing them is a rigorous process and the below diagram suggests an approach that organizations can use.
Organizations should do a thorough review of their existing application modules to see if these can be tweaked in order to achieve the required results. Since the process of appropriate revenue recognition as per the required guidelines would cut across multiple application modules, any customization effort done on any specific module should be completely studied for its likely impact on other modules through a proper integration study.
The advantages
There are multiple advantages of such a structured IT-enabled approach to revenue recognition. This approach can help in the following ways:
The effort is determining the changes required to applications would have resulted in detailed process maps of the workflows involved and the various nuances. This can be of significant help to determine process changes and streamlining the processes involved. This is especially useful in a multi-division, multi-location environment where process variations often go unnoticed and are taken for granted. (Simplify)
There are also tremendous opportunities for automation. A case in point can be a typical Proof of Delivery document or Goods acceptance by Customer that can be recorded in the system through various means such as a customer portal or through EDI / XML document exchanges. These would ensure lower processing time and also avoid any possible errors due to manual intervention. (Automate)
This will result in a single repository of all information pertaining to revenue with audit trails, as to which contingency was fulfilled at what point in time. The resultant benefits in achieving compliance are obvious. (Comply)
Conclusion
It should be noted that while organizations have increased their focus on having appropriate revenue recognition practices in place, they need to ensure that the supporting IT applications are equipped well to handle these new scenarios without manual intervention, parallel accounting and errors in reconciliation. IT applications have a significant role to play in ensuring that businesses do not deviate from the standards set for such critical financial accounting requirements. When implemented properly, these applications would provide a huge benefit to the organizations not only in terms of compliance with various financial regulations, but also in increasing stakeholder confidence and an enhanced corporate image.
Ravikant Karra (and Balaji Narasimhan)
Infosys Technologies, Ltd
Infosys
Ravikant Karra is a Senior Consultant with the manufacturing and supply chain domain competency group of Infosys Technologies, Ltd. He can be reached at ravikant_karra@infosys.com
Balaji Narasimhan is a Senior Consultant with the manufacturing and supply chain domain competency group of Infosys Technologies, Ltd. He can be reached at balaji_narasimhan01@infosys.com
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