The Xerox case deals with accounting for multiple deliverables. Explain what this means in the context of the Xerox fraud.

Question

What will be an ideal response?

Answer 1

The challenge of transactions with multiple deliverables is to decide whether each element should be separated out and recognized as revenue immediately at the point of sale or whether one or more elements can stand-alone and be recognized over the life of the agreement.

Xerox sold copiers and other office equipment to its customers for cash, but it more frequently entered into long-term lease agreements in which customers paid a single negotiated monthly fee in return for the equipment, service, supplies, and financing. Xerox referred to these arrangements as "bundled leases." These transactions created revenue recognition issues because of the "multiple deliverables."

The leases met the criteria under SFAS 13 to be accounted for as "sales-type" leases, whereby the fair value of the equipment leased would be recognized as income in the period the lease is delivered, less any residual value the equipment was expected to retain once the lease expired. GAAP permits the financing revenue portion of the lease to be recognized only as it is earned over the life of the lease. SFAS 13 also specifies that the portion of the lease payments that represents the fee for repair services and copier supplies be prorated over the term of the lease, matching it against the financing income. These are the multiple deliverables.

As competition grew for Xerox in the 1990s the company encountered challenges to continue reporting earnings. The management told KPMG that it was no longer able to reasonably assign a fair value to the equipment as it had in the past. The company abandoned the value determinations made at the lease inception, for public financial reporting purposes, but not for internal operating purposes, and substituted a formula that management could manipulate at will. Xerox did not test the value determinations to assess the reliability of the original method or if the new method did a better job of accurately reflecting the fair value of copier equipment.

Xerox's "topside" lease accounting devices consistently increased the amount of lease revenues that Xerox recognized at the inception of the lease and reduced the amount it recognized over the life of the lease. One method was called return on equity (ROE), which pulled forward a portion of finance income and recognized it immediately as equipment revenue. The second, called margin normalization, pulled forward a portion of service income and recognized it immediately as equipment revenue. These income acceleration methods did not comply with GAAP because there was no matching of revenue with the period during which: (1) financing was provided, (2) copier supplies were provided, and (3) repairs were made to the leased equipment.

Extended Discussion (This is a good research question).

FASB's Accounting Standards Update (ASU) 2009-13 requires a vendor to evaluate all deliverables in an arrangement to determine whether they represent separate units of accounting. This evaluation must be performed at the inception of an arrangement and as each item in the arrangement is delivered. ASU 2009-13 retains from Issue 00-21 two of the three criteria for when delivered items in a multiple-deliverable arrangement should be considered separate units of accounting and states (codified in ASC 605-25-25-3):

In an arrangement with multiple deliverables, the delivered item or items are considered to be a separate unit of accounting when both of the following criteria are met:

(a) The delivered item or items have value to the customer on a standalone basis. The item or items have value on a standalone basis if they are sold separately by any vendor or the customer could resell the delivered item(s) on a standalone basis. In the context of a customer's ability to resell the delivered item(s), this criterion does not require the existence of an observable market for the deliverable(s).

(b) If the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item or items is considered probable and substantially in the control of the vendor.

Example:

Entity A, a manufacturer of highly specialized electronic equipment, enters into a $3 million arrangement to deliver this equipment and provide implementation services after the delivery. The effort "A" must expend to perform the implementation services can vary significantly from customer to customer. Thus, "A" cannot reliably estimate the amount of time it needs to perform the implementation services for any particular customer. Entity A therefore determines that it does not have objective and reliable evidence of fair value for the implementation services. The electronic equipment has stand-alone value to the customer, and the agreement has no general right of return.

Evaluation Under Issue 00-21

Because A does not have objective and reliable evidence of fair value for the implementation services, the electronic equipment and implementation services are one unit of accounting. Entity A determines that an appropriate method of revenue recognition for its single unit of accounting is to recognize the $3 million fee as implementation services are provided.

The separation criteria for the electronic equipment are met because the equipment has stand-alone value to the customer and no general right of return exists. Therefore, both the electronic equipment and the implementation services deliverables are accounted for as separate units of accounting and "A" must determine the selling price for each deliverable and allocate a portion of the fee to each deliverable.

Entity A determines that an appropriate method of revenue recognition is to recognize the portion of the fee allocated to the electronic equipment upon its delivery and the remaining portion of the fee as implementation services are provided.