by Wanda A. Wallace
The Sarbanes-Oxley Act of 2002 (July 30, 2002 H.R. 3763) has as Section 108 a provision that the Securities and Exchange Commission "conduct a study on the adoption by the United States financial reporting system of a principles-based accounting system." The question is whether a principles-based system is intended to be parallel to substance, in contrast to a rules-based system being parallel to form.
While the general discussion of the dichotomy would suggest such an intent, it is interesting to consider the content of Staff Accounting Bulletin 101 concerning revenue recognition and ponder why this promulgation appears so prone to elevating form over substance.
One example: When is a contract in place?
To demonstrate the focus on form, consider SAB 101, Topic 13A, Question 1, which describes the following circumstance and interpretation.
"Facts: Company has product available to ship to customers prior to the end of its current fiscal quarter. Customer Beta places an order for the product and Company A delivers the product prior to the end of its current fiscal quarter. Company A’s normal and customary business practice for this class of customer is to enter into a written sales agreement that requires the signatures of the authorized representatives of the Company and its customer to be binding.
"Company A prepares a written sales agreement, and its authorized representative signs the agreement before the end of the quarter. However, Customer Beta does not sign the agreement because Customer Beta is awaiting the requisite approval by its legal department. Customer Beta’s purchasing department has orally agreed to the sale and stated that it is highly likely the contract will be approved the first week of Company A’s next fiscal quarter.
"Question: May Company A recognize the revenue in the current fiscal quarter for the sale of the product to Customer Beta when (1) the product is delivered by the end of its current fiscal quarter and (2) the final written sales agreement is executed by Customer Beta’s authorized representative within a few days after the end of the current fiscal quarter?
"Interpretive response: No. Generally, the staff believes that, in view of Company A’s business practice of requiring a written sales agreement for this class of customer, persuasive evidence of an arrangement would require a final agreement that has been executed by the properly authorized personnel of the customer.
"In the staff’s view, Customer Beta’s execution of the sales agreement after the end of the quarter causes the transaction to be considered a transaction of the subsequent period. Further, if an arrangement is subject to subsequent approval (e.g., by the management committee or board of directors) or execution of another agreement, revenue recognition would be inappropriate until that subsequent approval or agreement is complete ... ."
The purpose of contracts
The written contract is a means of avoiding future disputes with regard to what is intended by both parties, but any casual reading of contract law and associated arbitration and legal suits bears out that the substance of parties’ understanding is at least as important as the form of the arrangement.
Accountants are not practicing lawyers and are not expected to assess the legal enforceability of a contract. Rather, they are expected to identify the substance of the economic activity and to elevate associated real activities over the form of any activity. Paperwork and legal form are precisely the misplaced focus in past standards related to special purpose entities and similar off-balance-sheet financing vehicles that hinder transparency in economic activity.
Suddenly last signature date trumps all other previously used effective dates
Yet, a focus on form would seem to be the legacy of SAB 101. Specifically, no matter what the substance of underlying business activities that may have occurred, the interpretation of the SEC staff prescribes that it is the last dated signature on the contract that is the determinant of the transaction’s occurrence. The substance of the earnings process, the incurring of expenses with an understanding of forthcoming remuneration, and actual billings and collections are all set aside relative to this single signature.
To illustrate the point from a layman’s perspective, assume that you are closing on a home at which the moving truck is arriving and the spouse of the seller is abroad in military service. Everyone understands the circumstances, the effective date of closing permits you to move into the premises, and when the contract is delivered, signed, and returned by the spouse, the copy of the legal agreement is filed with city hall and all parties to the transaction. What was the substance of the exchange and what differences from legal form are and are not relevant to understanding the transaction?
By considering usual business terms and by studying diverse contract settings, any individual involved in economic activities will have observed a number of dates on legal documents - ranging from effective dates, terms, filing dates, signatory dates and various dated provisions inside the contract related to expectations and performance measures.
Consider the actual time gaps that commonly arise between effective and signature dates on diverse documents that are filed in the public domain - ranging from mergers and acquisitions, to closing real estate transactions and various compensation and credit arrangements. Even a cursory review would provide examples of the prevalence of time lapses between negotiated transactions, legally defined effective dates, and the point in time where an actual signature is attached.
Often, no date appears beside the signature but, instead, reference is made to the effective date defined in the contract itself. Such an absence raises a practical problem of how the SAB 101 provision is to be applied. Must inquiries be obtained and confirmations from each party received with regard to when the particular piece of paper was signed?
In considering the SAB 101 prescriptions, one should pause and ask the question: Would any stockholder be well served by a company rigidly holding to the idea that no service is to be provided without a totally executed agreement in hand? If an existing contract lapses before formal renewal, would a good business practice be to stop providing any service until all signatures on the renewal are again in place? Would such a strategy not almost certainly lead to the substantive demise of the reputation of the business, if not the business itself?
Again, considering a layman’s analogy, imagine that you have a rental agreement that is about to expire and happen to be in the hospital during the formal renewal date. Would you judge it reasonable for the landlord to consider the agreement ended, remove your belongings and release that apartment? Or would you expect consideration of context and behavior in line with the substance of the understanding between lessee and lessor?
Is it not ironic?
An irony of the SAB 101 guidance is that it facilitates more control over when revenue is recorded than would result from an evaluation based on economic substance. For example, if a company wished to postpone revenue recognition for itself or another party to a transaction, it need only "sit on the fully negotiated contract" by delaying the signing.
Imagine an effective date on which real events occurred, such as hiring an acquiree’s employees, assuming the service responsibility on purchased accounts and assuming responsibility for various debts. Yet, in a hypothetical setting in which one required signatory were out of the country or ill in the hospital, no revenue streams were recorded.
This makes apparent the problems when form is evaluated rather than real substance. Are the profession and the market not better served by encouraging and permitting professionals to consider context and adopting a substantive business focus rather than a legal form that is at odds with the objective of representational faithfulness and effective business practice?
The conceptual framework
As Statement of Concept 2, paragraph 160, within the accounting framework states: "The quality of reliability and, in particular, of representational faithfulness leaves no room for accounting representations that subordinate substance to form."
Concepts Statement 6, paragraph 59, similarly references Concepts Statement 2, paragraphs 63-80 and 160: "Adequate definitions are the starting point. They provide a basis for assessing, for example, the extent to which a particular application meets the qualitative characteristic of representational faithfulness, which includes the notion of reporting economic substance rather than legal form ... ."
Proceed with care
If one assumes that the implicit message of the Sarbanes-Oxley Act is a presumption that regulators will focus on substance, then an explanation for the approach of SAB 101 would seem to beg the question. As proposals by standard setters reach for 10 percent thresholds of ownership rather than 3 percent in accounting for special purpose entities, I suggest to you that they, too, are missing the point.
If one has financing for one’s line of business in which a continuing interest or obligation exists, that facet of operations is a substantive aspect of the operations of that business, which deserves reporting. The very terms "off-balance-sheet financing" and "synthetic leases" suggest that form and substance have departed and need to be realigned.
Professionals who are permitted to speak to the substance of such transactions are far more apt to reflect economic reality than those who are shackled by superficial directives that elevate mere form over substance.
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