documents that a standard has been issued which the registrant will be
required to adopt in the future and (2) assist the reader in assessing
the significance of the impact that the standard will have on the
financial statements of the registrant when adopted. The staff
understands that the registrant will only be able to disclose
information that is known.
    The following disclosures should generally be considered by the
registrant:
     A brief description of the new standard, the date that
adoption is required and the date that the registrant plans to adopt,
if earlier.
     A discussion of the methods of adoption allowed by the
standard and the method expected to be utilized by the registrant, if
determined.
     A discussion of the impact that adoption of the standard
is expected to have on the financial statements of the registrant,
unless not known or reasonably estimable. In that case, a statement to
that effect may be made.
     Disclosure of the potential impact of other significant
matters that the registrant believes might result from the adoption of
the standard (such as technical violations of debt covenant agreements,
planned or intended changes in business practices, etc.) is encouraged.

N. Disclosures of The Impact of Assistance From Federal Financial
Institution Regulatory Agencies

    Facts: An entity receives financial assistance from a Federal
regulatory agency in conjunction with either an acquisition of a
troubled financial institution, transfer of nonperforming assets to a
newly-formed entity, or other reorganization.
    Question: What are the disclosure implications of the existence of
regulatory assistance?
    Interpretive Response: The staff believes that users of financial
statements must be able to assess the impact of credit and other risks
on a company following a regulatory assisted acquisition, transfer or
other reorganization on a basis comparable to that disclosed by other
institutions, i.e., as if the assistance did not exist. In this regard,
the staff believes that the amount of regulatory assistance should be
disclosed separately and should be separately identified in the
statistical information furnished pursuant to Industry Guide 3, to the
extent it impacts such information.10, 11 Further, the
nature, extent and impact of such assistance needs to be fully
discussed in Management's Discussion and Analysis.\12\
---------------------------------------------------------------------------

    \10\ The staff has previously expressed its views regarding
acceptable methods of compliance with this principle in FASB ASC
paragraph 942-10-S99-6 (Financial Services--Depository and Lending
Topic).
    \11\ See FASB ASC paragraph 942-10-S99-6 for guidance on the
appropriate period in which to record certain types of regulatory
assistance.
    \12\ See Section 501.06.c. of the Financial Reporting
Codification for further discussion of the MD&A disclosures of the
effects of regulatory assistance.
---------------------------------------------------------------------------

TOPIC 12: OIL AND GAS PRODUCING ACTIVITIES

A. Accounting Series Release 257--Requirements for Financial Accounting
and Reporting Practices for Oil and Gas Producing Activities

1. Estimates of Reserve Quantities
    Facts: Rule 4-10 of Regulation S-X contains definitions of possible
reserves, probable reserves, and proved and developed oil and gas
reserves to be used in determining quantities of oil and gas reserves
to be reported in filings with the Commission.
    Question: What pressure base should be used for reporting gas and
production, 14.73 psia or the pressure base specified by the state?
    Interpretive Response: The reporting instructions to the Department
of Energy's Form EIA-28 specify that natural gas reserves are to be
reported at 14.73 psia and 60 degrees F. There is no pressure base
specified in Regulation S-X or S-K. At the present time staff will not
object to natural gas reserves and production data calculated at other
pressure bases, if such pressure bases are identified in the filing.
2. Estimates of Future Net Revenues
    Facts: U.S. GAAP requires the disclosure of the standardized
measure of discounted future net cash flows from production of proved
oil and gas reserves.
    Question: F or purposes of determining reserves and estimated
future net revenues, what price should be used for oil and gas which
will be produced after an existing contract expires or after the
redetermination date in a contract?
    Interpretive Response: The price to be used for oil and gas which
will be produced after a contract expires or has a redetermination is
the average price during the 12-month period prior to the ending date
of the period covered by the balance sheet, determined as an unweighted
arithmetic average of the first-day-of-the-month price for each month
within such period for that oil and gas. This average price, which
should be based on the first-day-of-the-month market prices, may be
increased thereafter only for additional fixed and determinable
escalations, as appropriate. A fixed and determinable escalation is one
which is specified in amount and is not based on future events such as
rates of inflation.
3. Disclosure of Reserve Information
    a. Removed by SAB 103
    b. Removed by SAB 113
    c. Limited Partnership 10-K Reports
    Facts: Item 1201(a) of Regulation S-K contains an exemption from
the requirements to disclose certain information relating to oil and
gas operations for ``limited partnerships or joint ventures that
conduct, operate, manage, or report upon oil and gas drilling income
programs that acquire properties either for drilling and production, or
for production of oil, gas, or geothermal steam. * * *''
    Limited partnership agreements often contain buy-out provisions
under which the general partner agrees to purchase limited partnership
interests that are offered for sale, based upon a specified valuation
formula. Because of these arrangements, the requirements for

disclosure of reserve value information may be of little significance
to the limited partners.
    Question: Must the financial statements of limited partnerships
included in reports on Form 10-K contain the disclosures of estimated
future net revenues, present values and changes therein, and
supplemental summary of oil and gas activities specified in FASB ASC
paragraphs 932-235-50-23 through 932-235-50-36 (Extractive Activities--
Oil and Gas Topic)?
    Interpretive Response: The staff will not take exception to the
omission of these disclosures in a limited partnership Form 10-K if
reserve value information is available to the limited partners pursuant
to the partnership agreement (even though the valuations may be
computed differently and may be as of a date other than year end).
However, the staff will require all of the information listed in FASB
ASC paragraphs 932-235-50-23 through 932-235-50-36 for partnerships
which are the subject of a business combination or exchange offer under
which various limited partnerships are to be consolidated or combined
into a single entity.
d. Removed by SAB 113
e. Rate Regulated Companies
    Question: If a company has cost-of-service oil and gas producing
properties, how should they be treated in the supplemental disclosures
of reserve quantities and related future net revenues provided pursuant
to FASB ASC paragraphs 932-235-50-29 through 932-235-50-36?
    Interpretive Response: Rule 4-10 provides that registrants may give
effect to differences arising from the ratemaking process for cost-of-
service oil and gas properties. Accordingly, in these circumstances,
the staff believes that the company's supplemental reserve quantity
disclosures should indicate separately the quantities associated with
properties subject to cost-of-service ratemaking, and that it is
appropriate to exclude those quantities from the future net revenue
disclosures. The company should also disclose the nature and impact of
its cost-of-service ratemaking, including the unamortized cost included
in the balance sheet.
4. Removed by SAB 103

B. Removed by SAB 103

C. Methods of Accounting by Oil and Gas Producers

1. First-Time Registrants
    Facts: In ASR 300, the Commission announced that it would allow
registrants to change methods of accounting for oil and gas producing
activities so long as such changes were in accordance with GAAP.
Accordingly, the Commission stated that changes from the full cost
method to the successful efforts method would not require a
preferability letter. Changes to full cost, however, would require
justification by the company making the change and filing of a
preferability letter from the company's independent accountants.
    Question: How does this policy apply to a nonpublic company which
changes its accounting method in connection with a forthcoming public
offering or initial registration under either the 1933 Act or 1934 Act?
    Interpretive Response: The Commission's policy that first-time
registrants may change their previous accounting methods without filing
a preferability letter is applicable. Therefore, such a company may
change to the full cost method without filing a preferability letter.
2. Consistent Use of Accounting Methods Within a Consolidated Entity
    Facts: Rule 4-10(c) of Regulation S-X states in part that ``[a]
reporting entity that follows the full cost method shall apply that
method to all of its operations and to the operations of its
subsidiaries * * *''
    Question 1: May a subsidiary of the parent use the full cost method
if the parent company uses the successful efforts method of accounting
for oil and gas producing activities?
    Interpretive Response: No. The use of different methods of
accounting in the consolidated financial statements by a parent company
and its subsidiary would be inconsistent with the full cost requirement
that a parent and its subsidiaries all use the same method of
accounting.
    The staff's general policy is that an enterprise should account for
all its like operations in the same manner. However, Rule 4-10 of
Regulation S-X provides that oil and gas companies with cost-of-service
oil and gas properties may give effect to any differences resulting
from the ratemaking process, including regulatory requirements that a
certain accounting method be used for the cost-of-service properties.
    Question 2: Must the method of accounting (full cost or successful
efforts) followed by a registrant for its oil and gas producing
activities also be followed by any fifty percent or less owned
companies in which the registrant carries its investment on the equity
method (equity investees)?
    Interpretive Response: No. Conformity of accounting methods between
a registrant and its equity investees, although desirable, may not be
practicable and thus is not required. However, if a registrant
proportionately consolidates its equity investees, it will be necessary
to present them all on the same basis of accounting.

D. Application of Full Cost Method of Accounting

1. Treatment of Income Tax Effects in the Computation of the Limitation
on Capitalized Costs
    Facts: Item (D) in Rule 4-10(c)(4)(i) of Regulation S-X provides
that the income tax effects related to the properties involved should
be deducted in computing the full cost ceiling.
    Question 1: What specific types of income tax effects should be
considered in computing the income tax effects to be deducted from
estimated future net revenues?
    Interpretive Response: The rule refers to income tax effects
generally. Thus, the computation should take into account (i) the tax
basis of oil and gas properties, (ii) net operating loss carryforwards,
(iii) foreign tax credit carryforwards, (iv) investment tax credits,
(v) alternative minimum taxes on tax preference items, and (vi) the
impact of statutory (percentage) depletion.
    It may often be difficult to allocate a net operating loss (NOL)
carryforward between oil and gas assets and other assets. However, to
the extent that the NOL is clearly attributable to oil and gas
operations and is expected to be realized within the carryforward
period, it should be added to tax basis.
    Similarly, to the extent that investment tax credit (ITC)
carryforwards and foreign tax credit carryforwards are attributable to
oil and gas operations and are expected to be realized within the
carryforward period, they should be considered as a deduction from the
tax effect otherwise computed. Consideration of NOL and ITC or foreign
tax credit carryforwards should not, of course, reduce the total tax
effect below zero.
    Question 2: How should the tax effect be computed considering the
various factors discussed above?

    Interpretive Response: Theoretically, taxable income and tax could
be determined on a year-by-year basis and the present value of the
related tax computed. However, the ``shortcut'' method illustrated
below is also acceptable.

----------------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------
ASSUMPTIONS:
    Cost of proved properties being amortized............................  ...........     $396,000  ...........
    Lower of cost or estimated fair value of unproved properties to be     ...........       49,000  ...........
     amortized...........................................................
    Cost of properties not being amortized...............................  ...........       55,000  ...........
    Capitalized costs of oil and gas assets..............................  ...........      500,000  ...........
    Accumulated DD&A.....................................................  ...........    (100,000)  ...........
    Book basis of oil and gas assets.....................................  ...........  ...........     $400,000
    Excess of book basis over tax basis ($270,000) of oil and gas assets.  ...........   $(130,000)  ...........
    NOL carryforward*....................................................  ...........       20,000
                                                                                (110,000)
    Statutory tax rate (percent).........................................  ...........        x 46%  ...........
                                                                                (50,600)
    Foreign tax credit carryforward *....................................  ...........        1,000  ...........
    ITC carryforward*....................................................  ...........        2,000  ...........
    Related net deferred income tax liability............................  ...........  ...........     (47,600)
    Net book basis to be recovered.......................................  ...........  ...........     $352,400
Other Assumptions:                                                         ...........  ...........  ...........
    Present value of ITC relating to future development costs............  ...........       $1,500  ...........
    Present value of statutory depletion attributable to future            ...........      $10,000  ...........
     deductions..........................................................
    Estimated preference (minimum) tax on percentage depletion in excess   ...........         $500  ...........
     of cost depletion...................................................
    Present value of future net revenue from proved oil and gas reserves.  ...........     $272,000  ...........
CALCULATION:
    Present value of future net revenue..................................  ...........     $272,000  ...........
    Cost of properties not being amortized...............................  ...........       55,000  ...........
    Lower of cost or estimated fair value of unproved properties included  ...........       49,000  ...........
     in costs being amortized............................................
    Total ceiling limitation before tax effects..........................  ...........  ...........     $376,000
Tax Effects:                                                               ...........  ...........  ...........
    Total ceiling limitation before tax effects..........................  ...........     $376,000  ...........
    Less: Tax basis of properties........................................   $(270,000)  ...........  ...........
    Statutory depletion..................................................     (10,000)  ...........  ...........
    NOL carryforward.....................................................     (20,000)  ...........  ...........
                                                                           ...........    (300,000)  ...........
    Future taxable income................................................  ...........       76,000  ...........
    Tax rate (percent)...................................................  ...........        x 46%  ...........
    Tax at statutory rate................................................  ...........     (34,960)  ...........
    ITC (future development costs and carryforward)......................  ...........        3,500  ...........
    Foreign tax credit carryforward......................................  ...........        1,000  ...........
    Estimated preference tax.............................................  ...........        (500)  ...........
    Net tax effects......................................................  ...........  ...........     (30,960)
    Cost Center Ceiling..................................................  ...........  ...........     $345,040
    Less: Net book basis to be recovered.................................  ...........  ...........      352,400
    REQUIRED WRITE-OFF, net of tax **....................................  ...........  ...........     $(7,360)
----------------------------------------------------------------------------------------------------------------
* All carryforward amounts in this example represent amounts which are available for tax purposes and which
  relate to oil and gas operations.
** For accounting purposes, the gross write-off should be recorded to adjust both the oil and gas properties
  account and the related deferred income taxes.

----------------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------
CALCULATION OF GROSS PRE-TAX WRITE-OFF:
----------------------------------------------------------------------------------------------------------------
    Required write-off, net of tax.......................................  ...........  ...........     $(7,360)
    Divided by (100% minus the statutory rate of 46%)....................  ...........  ...........          54%
    Gross pre-tax write-off..............................................  ...........  ...........    $(13,630)
----------------------------------------------------------------------------------------------------------------
                         Related Journal Entries                                DR           CR      ...........
----------------------------------------------------------------------------------------------------------------
Full cost ceiling impairment.............................................      $13,630  ...........  ...........
Oil and gas assets.......................................................  ...........      $13,630  ...........
Deferred income tax liability............................................       $6,270  ...........  ...........
Deferred income tax benefit..............................................  ...........       $6,270  ...........
----------------------------------------------------------------------------------------------------------------

2. Exclusion of Costs From Amortization
    Facts: Rule 4-10(c)(3)(ii) indicates that the costs of acquiring
and evaluating unproved properties may be excluded from capitalized
costs to be amortized if the costs are unusually significant in
relation to aggregate costs to be amortized. Costs of major development
projects may also be incurred prior to ascertaining the quantities of
proved reserves attributable to such properties.
    Question: At what point should amortization of previously excluded
costs commence--when proved reserves have been established or when
those reserves become marketable? For instance, a determination of
proved reserves may be made before completion of an extraction plant
necessary to process sour crude or a pipeline necessary to market the
reserves. May the costs continue to be excluded from amortization until
the plant or pipeline is in service?

    Interpretive Response: No. The proved reserves and the costs
allocable to such reserves should be transferred into the amortization
base on an ongoing (well-by-well or property-by-property) basis as the
project is evaluated and proved reserves are established.
    Once the determination of proved reserves has been made, there is
no justification for continued exclusion from the full cost pool,
regardless of whether other factors prevent immediate marketing.
Moreover, at the same time that the costs are transferred into the
amortization base, it is also necessary in accordance with FASB ASC
Subtopic 932-835, Extractive Activities--Oil and Gas--Interest, and
FASB ASC Subtopic 835-20, Interest--Capitalization of Interest, to
terminate capitalization of interest on such properties.
    In this regard, registrants are reminded of their responsibilities
not to delay recognizing reserves as proved once they have met the
engineering standards.
3. Full Cost Ceiling Limitation
a. Exemptions for Purchased Properties
    Facts: During 20x1, a registrant purchases proved oil and gas
reserves in place (``the purchased reserves'') in an arm's-length
transaction for the sum of $9.8 million. Primarily because the
registrant expects oil and gas prices to escalate, it paid $1.2 million
more for the purchased reserves than the ``Present Value of Estimated
Future Net Revenues'' computed as defined in Rule 4-10(c)(4)(i)(A) of
Regulation S-X. An analysis of the registrant's full cost center in
which the purchased reserves are located at December 31, 20x1 is as
follows:

----------------------------------------------------------------------------------------------------------------
                                                                                Other
                                                                 Total      Purchased      proved      Unproved
                                                                             reserves    properties   properties
----------------------------------------------------------------------------------------------------------------
                          (Amounts in thousands)
----------------------------------------------------------------------------------------------------------------
Present value of estimated future net revenues..............      $14,100        8,600        5,500  ...........
Cost, net of amortization...................................       16,300        9,800        5,500        1,000
Related deferred taxes......................................        2,300  ...........        2,000          300
Income tax effects related to properties....................        2,500  ...........        2,500  ...........
----------------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------
                                                                            Including    Excluding
     Comparison of capitalized costs with limitation on                     purchased    purchased
           capitalized costs at December 31, 20x1:                           reserves     reserves
----------------------------------------------------------------------------------------------------------------
Capitalized costs, net of amortization......................  ...........      $16,300       $6,500  ...........
Related deferred taxes......................................  ...........      (2,300)      (2,300)  ...........
Net book cost...............................................  ...........       14,000        4,200  ...........
Present value of estimated future net revenues..............  ...........       14,100        5,500  ...........
Lower of cost or market of unproved properties..............  ...........        1,000        1,000  ...........
Income tax effects related to properties....................  ...........      (2,500)      (2,500)  ...........
Limitation on capitalized costs.............................  ...........       12,600        4,000  ...........
Excess of capitalized costs over limitation on Capitalized    ...........        1,400          200  ...........
 costs, net of tax *........................................
----------------------------------------------------------------------------------------------------------------
* For accounting purposes, the gross write-off should be recorded to adjust both the oil and gas properties
  account and the related deferred income taxes.

    Question: Is it necessary for the registrant to write down the
carrying value of its full cost center at December 31, 20x1 by
$1,400,000?
    Interpretive Response: Although the net carrying value of the full
cost center exceeds the cost center's limitation on capitalized costs,
the text of ASR 258 provides that a registrant may request an exemption
from the rule if as a result of a major purchase of proved properties,
a write down would be required even though the registrant believes the
fair value of the properties in a cost center clearly exceeds the
unamortized costs.
    Therefore, to the extent that the excess carrying value relates to
the purchased reserves, the registrant may seek a temporary waiver of
the full-cost ceiling limitation from the staff of the Commission.
Registrants requesting a waiver should be prepared to demonstrate that
the additional value exists beyond reasonable doubt.
    To the extent that the excess costs relate to properties other than
the purchased reserves, however, a write-off should be recorded in the
current period. In order to determine the portion of the total excess
carrying value which is attributable to properties other than the
purchased reserves, it is necessary to perform the ceiling computation
on a ``with and without'' basis as shown in the example above. Thus in
this case, the registrant must record a write-down of $200,000
applicable to other reserves. An additional $1,200,000 write-down would
be necessary unless a waiver was obtained.
b. Use of Cash Flow Hedges in the Computation of the Limitation on
Capitalized Costs
    Facts: Rule 4-10(c)(4) of Regulation S-X provides, in pertinent
part, that capitalized costs, net of accumulated depreciation and
amortization, and deferred income taxes, should not exceed an amount
equal to the sum of components that include the present value of
estimated future net revenues computed by applying current prices of
oil and gas reserves (with consideration of price changes only to the
extent provided by contractual arrangements) to estimated future
production of proved oil and gas reserves as of the date of the latest
balance sheet presented.
    As of the reported balance sheet date, capitalized costs of an oil
and gas producing company exceed the full cost limitation calculated
under the above-described rule based on current prices, as defined in
Rule 4-10(c)(8) of Regulation S-X, for oil and natural gas. However,
prior to the balance sheet date, the company entered into certain
hedging arrangements for a portion of its future natural gas and oil
production, thereby enabling the company to receive future cash flows
that are higher or lower than the estimated future cash flows indicated
by use of the average price during the 12-month period prior to the
balance sheet date, determined as

an unweighted arithmetic average of the first-day-of-the-month price
for each month within such period. These arrangements qualify as cash
flow hedges under the provisions of FASB ASC Topic 815, Derivatives and
Hedging, and are documented, designated, and accounted for as such
under the criteria of that standard.
    Question: Under these circumstances, must the company use the
higher or lower prices to be received after taking into account the
hedging arrangements (``hedge-adjusted prices'') in calculating the
estimated cash flows from future production of oil and gas reserves
covered by the hedges as of the reported balance sheet date?
    Interpretive Response: Yes. Derivative contracts that qualify as a
hedging instrument in a cash flow hedge and are accounted for as such
pursuant to FASB ASC Topic 815 represent the type of contractual
arrangements for which consideration of price changes should be given
under the existing rule. While the SEC staff has objected to previous
proposals to consider various hedging techniques as being equivalent to
the contractual arrangements permitted under the existing rules, the
staff's objection was based on concerns that the lack of clear,
consistent guidance in the accounting literature would lead to
inconsistent application in practice. However, the staff believes that
FASB ASC Topic 815 and related guidance (including a more systematic
approach to documentation) provides sufficient guidance so that
comparable financial reporting in comparable factual circumstances
should result.
    This interpretive response reflects the SEC staff's view that,
assuming compliance with the prerequisite accounting requirements,
hedge-adjusted prices represent the best measure of estimated cash
flows from future production of the affected oil and gas reserves to
use in calculating the ceiling limitation. Nonetheless, the staff
expects that oil and gas producing companies subject to the full cost
rules will clearly indicate the effects of using cash flow hedges in
calculating ceiling limitations within their financial statement
footnotes. The staff further expects that disclosures will indicate the
portion of future oil and gas production being hedged. The dollar
amount that would have been charged to income had the effects of the
cash flow hedges not been considered in calculating the ceiling
limitation also should be disclosed.
    The use of hedge-adjusted prices should be consistently applied in
all reporting periods, including periods in which the hedge-adjusted
price is more or less than the average price during the 12-month period
prior to the balance sheet date, determined as an unweighted arithmetic
average of the first-day-of-the-month price for each month within such
period. Oil and gas producers whose computation of the ceiling
limitation includes hedge-adjusted prices because of the use of cash
flow hedges also should consider the disclosure requirements under FASB
ASC Section 275-10-50, Risks and Uncertainties--Overall--Disclosure.
FASB ASC paragraph 275-10-50-9 calls for disclosure when it is at least
reasonably possible that the effects of cash flow hedges on capitalized
costs on the reported balance sheet date will change in the near term
due to one or more confirming events, such as potential future changes
in commodity prices.
    In addition, the use of cash flow hedges in calculating the ceiling
limitation may represent a type of critical accounting policy that oil
and gas producers should consider disclosing consistent with the
cautionary advice provided in Financial Reporting Release No. 60
(Release Nos. 33-8040; 34-45149), Cautionary Advice Regarding
Disclosure about Critical Accounting Policies (December 12, 2001), and
Financial Reporting Release No. 72 (Release Nos. 33-8350; 34-48960),
Commission Guidance Regarding Management's Discussion and Analysis of
Financial Condition and Results of Operations (December 29, 2003).
Through these releases, the Commission has encouraged companies to
include, within their MD&A disclosures, full explanations, in plain
English, of the judgments and uncertainties affecting the application
of critical accounting policies, and the likelihood that materially
different amounts would be reported under different conditions or using
different assumptions.
    The staff's guidance on this issue would apply to calculations of
ceiling limitations both in interim and annual reporting periods.
c. Effect of Subsequent Events on the Computation of the Limitation on
Capitalized Costs
    Facts: Rule 4-10(c)(4)(ii) of Regulation S-X provides that an
excess of unamortized capitalized costs within a cost center over the
related cost ceiling shall be charged to expense in the period the
excess occurs.
    Question: Assume that at the date of the company's fiscal year-end,
its capitalized costs of oil and gas producing properties exceed the
limitation prescribed by Rule 4-10(c)(4) of Regulation S-X. Thus, a
write-down is indicated. Subsequent to year-end but before the date of
the auditor's report on the company's financial statements, assume that
additional reserves are proved up (excluding the effect of increased
oil and gas prices subsequent to year-end) on properties owned at year-
end. The present value of future net revenues from the additional
reserves is sufficiently large that if the full cost ceiling limitation
were recomputed giving effect to those factors as of year-end, the
ceiling would more than cover the costs. Is it necessary to record a
write-down?
    Interpretive Response: No. In this case, the proving up of
additional reserves on properties owned at year-end indicates that the
capitalized costs were not in fact impaired at year-end. However, for
purposes of the revised computation of the ``ceiling,'' the net book
costs capitalized as of year-end should be increased by the amount of
any additional costs incurred subsequent to year-end to prove the
additional reserves or by any related costs previously excluded from
amortization.
    While the fact pattern described herein relates to annual periods,
the guidance on the effects of subsequent events applies equally to
interim period calculations of the ceiling limitation.
    The registrant's financial statements should disclose that
capitalized costs exceeded the limitation thereon at year-end and
should explain why the excess was not charged against earnings. In
addition, the registrant's supplemental disclosures of estimated proved
reserve quantities and related future net revenues and costs should not
give effect to the reserves proved up or the cost incurred after year-
end. However, such quantities may be disclosed separately, with
appropriate explanations.
    Registrants should be aware that oil and gas reserves related to
properties acquired after year-end would not justify avoiding a write-
off indicated as of year-end. Similarly, the effects of cash flow
hedging arrangements entered into after year-end cannot be factored
into the calculation of the ceiling limitation at year-end. Such
acquisitions and financial arrangements do not confirm situations
existing at year-end.

4. Interaction of FASB ASC Subtopic 410-20, Asset Retirement and
Environmental Obligations--Asset Retirement Obligations, and the Full
Cost Rules
a. Impact of FASB ASC Subtopic 410-20 on the Full Cost Ceiling Test
    Facts: A company following the full cost method of accounting under
Rule 4-10(c) of Regulation S-X must periodically calculate a limitation
on capitalized costs, i.e., the full cost ceiling. Under FASB ASC
Subtopic 410-20, a company must recognize a liability for an asset
retirement obligation (ARO) at fair value in the period in which the
obligation is incurred, if a reasonable estimate of fair value can be
made. The company also must initially capitalize the associated asset
retirement costs by increasing long-lived oil and gas assets by the
same amount as the liability. Any asset retirement costs capitalized
pursuant to FASB ASC Subtopic 410-20 are subject to the full cost
ceiling limitation under Rule 4-10(c)(4) of Regulation S-X. If a
company were to calculate the full cost ceiling by reducing expected
future net revenues by the cash flows required to settle the ARO, then
the effect would be to ``double-count'' such costs in the ceiling test.
The assets that must be recovered would be increased while the future
net revenues available to recover the assets continue to be reduced by
the amount of the ARO settlement cash flows.
    Question: How should a company compute the full cost ceiling to
avoid double-counting the expected future cash outflows associated with
asset retirement costs?
    Interpretive Response: The future cash outflows associated with
settling AROs that have been accrued on the balance sheet should be
excluded from the computation of the present value of estimated future
net revenues for purposes of the full cost ceiling calculation.\1,2\
---------------------------------------------------------------------------

    \1\ If an obligation for expected asset retirement costs has not
been accrued under FASB ASC Subtopic 410-20 for certain asset
retirement costs required to be included in the full cost ceiling
calculation under Rule 4-10(c)(4) of Regulation S-X, such costs
should continue to be included in the full cost ceiling calculation.
    \2\ This approach is consistent with the guidance in FASB ASC
Subtopic 410-20 on testing for impairment under FASB ASC Section
360-10-35, Property, Plant, and Equipment--Overall--Subsequent
Measurement. Under that guidance, the asset tested should include
capitalized asset retirement costs. The estimated cash flows related
to the associated ARO that has been recognized in the financial
statements are to be excluded from both the undiscounted cash flows
used to test for recoverability and the discounted cash flows used
to measure the asset's fair value.
---------------------------------------------------------------------------

b. Impact of FASB ASC Subtopic 410-20 on the Calculation of
Depreciation, Depletion, and Amortization
    Facts: Regarding the base for depreciation, depletion, and
amortization (DD&A) of proved reserves, Rule 4-10(c)(3)(i) of
Regulation S-X states that ``[c]osts to be amortized shall include (A)
all capitalized costs, less accumulated amortization, other than the
cost of properties described in paragraph (ii) below; \3\ (B) the
estimated future expenditures (based on current costs) to be incurred
in developing proved reserves; and (C) estimated dismantlement and
abandonment costs, net of estimated salvage values.'' FASB ASC Subtopic
410-20 requires that upon initial recognition of an ARO, the associated
asset retirement costs be included in the capitalized costs of the
company. Therefore, the estimated dismantlement and abandonment costs
described in (C) above may be included in the capitalized costs
described in (A) above, at least to the extent that an ARO has been
incurred as a result of acquisition, exploration and development
activities to date. Future development activities on proved reserves
may result in additional asset retirement obligations when such
activities are performed and the associated asset retirement costs will
be capitalized at that time.
---------------------------------------------------------------------------

    \3\ The reference to ``cost of properties described in paragraph
(ii) below'' relates to the costs of investments in unproved
properties and major development projects, as defined.
---------------------------------------------------------------------------

    Question: Should the costs to be amortized under Rule 4-10(c)(3) of
Regulation S-X include an amount for estimated dismantlement and
abandonment costs, net of estimated salvage values, that are expected
to result from future development activities?
    Interpretive Response: Yes. Companies should estimate the amount of
dismantlement and abandonment costs that will be incurred as a result
of future development activities on proved reserves and include those
amounts in the costs to be amortized.
c. Removed by SAB 113

E. Financial Statements of Royalty Trusts

    Facts: Several oil and gas exploration and production companies
have created ``royalty trusts.'' Typically, the creating company
conveys a net profits interest in certain of its oil and gas properties
to the newly created trust and then distributes units in the trust to
its shareholders. The trust is a passive entity which is prohibited
from entering into or engaging in any business or commercial activity
of any kind and from acquiring any oil and gas lease, royalty or other
mineral interest. The function of the trust is to serve as an agent to
distribute the income from the net profits interest. The amount to be
periodically distributed to the unitholders is defined in the trust
agreement and is typically determined based on the cash received from
the net profits interest less expenses of the trustee. Royalty trusts
have typically reported their earnings on the basis of cash
distributions to unitholders. The net profits interest paid to the
trust for any month is based on production from a preceding month;
therefore, the method of accounting followed by the trust for the net
profits interest income is different from the creating company's method
of accounting for the related revenue.
    Question: Will the staff accept a statement of distributable income
which reflects the amounts to be distributed for the period in question
under the terms of the trust agreement in lieu of a statement of income
prepared under GAAP?
    Interpretive Response: Yes. Although financial statements filed
with the Commission are normally required to be prepared in accordance
with GAAP, the Commission's rules provide that other presentations may
be acceptable in unusual situations. Since the operations of a royalty
trust are limited to the distribution of income from the net profits
interests contributed to it, the staff believes that the item of
primary importance to the reader of the financial statements of the
royalty trust is the amount of the cash distributions to the
unitholders for the period reported. Should there be any change in the
nature of the trust's operations due to revisions in the tax laws or
other factors,

the staff's interpretation would be reexamined.
    A note to the financial statements should disclose the method used
in determining distributable income and should also describe how
distributable income as reported differs from income determined on the
basis of GAAP.

F. Gross Revenue Method of Amortizing Capitalized Costs

    Facts: Rule 4-10(c)(3)(iii) of Regulation S-X states in part:

    ``Amortization shall be computed on the basis of physical units,
with oil and gas converted to a common unit of measure on the basis
of their approximate relative energy content, unless economic
circumstances (related to the effects of regulated prices) indicate
that use of units of revenue is a more appropriate basis of
computing amortization. In the latter case, amortization shall be
computed on the basis of current gross revenues (excluding royalty
payments and net profits disbursements) from production in relation
to future gross revenues based on current prices (including
consideration of changes in existing prices provided only by
contractual arrangements), from estimated production of proved oil
and gas reserves.'' \4\

    \4\ Rule 4-10(c)(8) of Regulation S-X defines current price as
the average price during the 12-month period prior to the ending
date of the period covered by the report, determined as an
unweighted arithmetic average of the first-day-of-the-month price
for each month within such period, unless prices are defined by
contractual arrangements, excluding escalations based upon future
conditions.
---------------------------------------------------------------------------

    Question: May entities using the full cost method of accounting for
oil and gas producing activities compute amortization based on the
gross revenue method described in the above rule when substantial
production is not subject to pricing regulation?
    Interpretive Response: Yes. Under the existing rules for cost
amortization adopted in ASR 258, the use of the gross revenue method of
amortization was permitted in those circumstances where, because of the
effect of existing pricing regulations, the use of the units of
production method would result in an amortization provision that would
be inconsistent with the current sales prices being received. While the
effect of regulation on gas prices has lessened, factors other than
price regulation (such as changes in typical contract lengths and
methods of marketing natural gas) have caused oil and gas prices to be
disproportionate to their relative energy content. The staff therefore
believes that it may be more appropriate for registrants to compute
amortization based on the gross revenue method whenever oil and gas
sales prices are disproportionate to their relative energy content to
the extent that the use of the units of production method would result
in an improper matching of the costs of oil and gas production against
the related revenue received. The method should be consistently applied
and appropriately disclosed within the financial statements.

G. Removed by SAB 113

TOPIC 13: REVENUE RECOGNITION

A. Selected Revenue Recognition Issues

1. Revenue Recognition--General
    The accounting literature on revenue recognition includes both
broad conceptual discussions as well as certain industry-specific
guidance.\1\ If a transaction is within the scope of specific
authoritative literature that provides revenue recognition guidance,
that literature should be applied. However, in the absence of
authoritative literature addressing a specific arrangement or a
specific industry, the staff will consider the existing authoritative
accounting standards as well as the broad revenue recognition criteria
specified in the FASB's conceptual framework that contain basic
guidelines for revenue recognition.
---------------------------------------------------------------------------

    \1\ The February 1999 AICPA publication ``Audit Issues in
Revenue Recognition'' provides an overview of the authoritative
accounting literature and auditing procedures for revenue
recognition and identifies indicators of improper revenue
recognition.
---------------------------------------------------------------------------

    Based on these guidelines, revenue should not be recognized until
it is realized or realizable and earned.\2\ Concepts Statement 5,
Recognition and Measurement in Financial Statements of Business
Enterprises, paragraph 83(b) states that ``an entity's revenue-earning
activities involve delivering or producing goods, rendering services,
or other activities that constitute its ongoing major or central
operations, and revenues are considered to have been earned when the
entity has substantially accomplished what it must do to be entitled to
the benefits represented by the revenues'' [footnote reference
omitted]. Paragraph 84(a) continues ``the two conditions (being
realized or realizable and being earned) are usually met by the time
product or merchandise is delivered or services are rendered to
customers, and revenues from manufacturing and selling activities and
gains and losses from sales of other assets are commonly recognized at
time of sale (usually meaning delivery)'' [footnote reference omitted].
In addition, paragraph 84(d) states that ``If services are rendered or
rights to use assets extend continuously over time (for example,
interest or rent), reliable measures based on contractual prices
established in advance are commonly available, and revenues may be
recognized as earned as time passes.''
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    \2\ Concepts Statement 5, paragraphs 83-84; FASB ASC paragraph
605-10-25-1 (Revenue Recognition Topic); FASB ASC paragraph 605-10-
25-3; FASB ASC paragraph 605-10-25-5. The citations provided herein
are not intended to present the complete population of citations
where a particular criterion is relevant. Rather, the citations are
intended to provide the reader with additional reference material.
---------------------------------------------------------------------------

    The staff believes that revenue generally is realized or realizable
and earned when all of the following criteria are met:
     Persuasive evidence of an arrangement exists,\3\
---------------------------------------------------------------------------

    \3\ Concepts Statement 2, paragraph 63 states ``Representational
faithfulness is correspondence or agreement between a measure or
description and the phenomenon it purports to represent.'' The staff
believes that evidence of an exchange arrangement must exist to
determine if the accounting treatment represents faithfully the
transaction. See also FASB ASC paragraph 985-605-25-3 (Software
Topic). The use of the term ``arrangement'' in this SAB Topic is
meant to identify the final understanding between the parties as to
the specific nature and terms of the agreed-upon transaction.
---------------------------------------------------------------------------

     Delivery has occurred or services have been rendered,\4\
---------------------------------------------------------------------------

    \4\ Concepts Statement 5, paragraph 84(a), (b), and (d). Revenue
should not be recognized until the seller has substantially
accomplished what it must do pursuant to the terms of the
arrangement, which usually occurs upon delivery or performance of
the services.
---------------------------------------------------------------------------

     The seller's price to the buyer is fixed or
determinable,\5\ and
---------------------------------------------------------------------------

    \5\ Concepts Statement 5, paragraph 83(a); FASB ASC subparagraph
605-15-25-1(a); FASB ASC paragraph 985-605-25-3. The FASB ASC Master
Glossary defines a ``fixed fee'' as a ``fee required to be paid at a
set amount that is not subject to refund or adjustment. A fixed fee
includes amounts designated as minimum royalties.'' FASB ASC
paragraphs 985-605-25-30 through 985-605-25-40 discuss how to apply
the fixed or determinable fee criterion in software transactions.
The staff believes that the guidance in FASB ASC paragraphs 985-605-
25-30 through 985-605-25-31 and 985-605-25-36 through 985-605-25-40
is appropriate for other sales transactions where authoritative
guidance does not otherwise exist. The staff notes that FASB ASC
paragraphs 985-605-25-33 through 985-605-25-35 specifically consider
software transactions, however, the staff believes that guidance
should be considered in other sales transactions in which the risk
of technological obsolescence is high.
---------------------------------------------------------------------------

     Collectibility is reasonably assured.\6\
---------------------------------------------------------------------------

    \6\ FASB ASC paragraph 605-10-25-3 through 605-10-25-5. See also
Concepts Statement 5, paragraph 84(g) and FASB ASC paragraph 985-
605-25-3.
---------------------------------------------------------------------------

    Some revenue arrangements contain multiple revenue-generating
activities. The staff believes that the determination of the units of
accounting within an arrangement should be made prior to the
application of the guidance in this SAB Topic by reference to the
applicable accounting literature.\7\
---------------------------------------------------------------------------

    \7\ See FASB ASC paragraph 605-25-15-2 through 605-25-15-3 for
additional discussion.

---------------------------------------------------------------------------

2. Persuasive Evidence of an Arrangement

Question 1

    Facts: Company A 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 that 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.\8\ 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.
---------------------------------------------------------------------------

    \8\ AU Section 560.05.
---------------------------------------------------------------------------

    Customary business practices and processes for documenting sales
transactions vary among companies and industries. Business practices
and processes may also vary within individual companies (e.g., based on
the class of customer, nature of product or service, or other
distinguishable factors). If a company does not have a standard or
customary business practice of relying on written contracts to document
a sales arrangement, it usually would be expected to have other forms
of written or electronic evidence to document the transaction. For
example, a company may not use written contracts but instead may rely
on binding purchase orders from third parties or on-line authorizations
that include the terms of the sale and that are binding on the
customer. In that situation, that documentation could represent
persuasive evidence of an arrangement.
    The staff is aware that sometimes a customer and seller enter into
``side'' agreements to a master contract that effectively amend the
master contract. Registrants should ensure that appropriate policies,
procedures, and internal controls exist and are properly documented so
as to provide reasonable assurances that sales transactions, including
those affected by side agreements, are properly accounted for in
accordance with GAAP and to ensure compliance with Section 13 of the
Securities Exchange Act of 1934 (i.e., the Foreign Corrupt Practices
Act). Side agreements could include cancellation, termination, or other
provisions that affect revenue recognition. The existence of a
subsequently executed side agreement may be an indicator that the
original agreement was not final and revenue recognition was not
appropriate.

Question 2

    Facts: Company Z enters into an arrangement with Customer A to
deliver Company Z's products to Customer A on a consignment basis.
Pursuant to the terms of the arrangement, Customer A is a consignee,
and title to the products does not pass from Company Z to Customer A
until Customer A consumes the products in its operations. Company Z
delivers product to Customer A under the terms of their arrangement.
    Question: May Company Z recognize revenue upon delivery of its
product to Customer A?
    Interpretive Response: No. Products delivered to a consignee
pursuant to a consignment arrangement are not sales and do not qualify
for revenue recognition until a sale occurs. The staff believes that
revenue recognition is not appropriate because the seller retains the
risks and rewards of ownership of the product and title usually does
not pass to the consignee.
    Other situations may exist where title to delivered products passes
to a buyer, but the substance of the transaction is that of a
consignment or a financing. Such arrangements require a careful
analysis of the facts and circumstances of the transaction, as well as
an understanding of the rights and obligations of the parties, and the
seller's customary business practices in such arrangements. The staff
believes that the presence of one or more of the following
characteristics in a transaction precludes revenue recognition even if
title to the product has passed to the buyer:
    1. The buyer has the right to return the product and:
    (a) The buyer does not pay the seller at the time of sale, and the
buyer is not obligated to pay the seller at a specified date or
dates,\9\
---------------------------------------------------------------------------

    \9\ FASB ASC subparagraph 605-15-25-1(b).
---------------------------------------------------------------------------

    (b) The buyer does not pay the seller at the time of sale but
rather is obligated to pay at a specified date or dates, and the
buyer's obligation to pay is contractually or implicitly excused until
the buyer resells the product or subsequently consumes or uses the
product,\10\
---------------------------------------------------------------------------

    \10\ FASB ASC subparagraph 605-15-25-1(b). The arrangement may
not specify that payment is contingent upon subsequent resale or
consumption. However, if the seller has an established business
practice permitting customers to defer payment beyond the specified
due date(s) until the products are resold or consumed, then the
staff believes that the seller's right to receive cash representing
the sales price is contingent.
---------------------------------------------------------------------------

    (c) The buyer's obligation to the seller would be changed (e.g.,
the seller would forgive the obligation or grant a refund) in the event
of theft or physical destruction or damage of the product,\11\
---------------------------------------------------------------------------

    \11\ FASB ASC subparagraph 605-15-25-1(c).
---------------------------------------------------------------------------

    (d) The buyer acquiring the product for resale does not have
economic substance apart from that provided by the seller,\12\ or
---------------------------------------------------------------------------

    \12\ FASB ASC subparagraph 605-15-25-1(d).
---------------------------------------------------------------------------

    (e) The seller has significant obligations for future performance
to directly bring about resale of the product by the buyer.\13\
---------------------------------------------------------------------------

    \13\ FASB ASC subparagraph 605-15-25-1(e).
---------------------------------------------------------------------------

    2. The seller is required to repurchase the product (or a
substantially identical product or processed goods of which the product
is a component) at specified prices that are not subject to change
except for fluctuations due to finance and holding costs,\14\ and the
amounts to be paid by the seller will be adjusted, as necessary, to
cover substantially all

fluctuations in costs incurred by the buyer in purchasing and holding
the product (including interest).\15\ The staff believes that
indicators of the latter condition include:
---------------------------------------------------------------------------

    \14\ FASB ASC subparagraph 470-40-15-2(a) (Debt Topic). This
paragraph provides examples of circumstances that meet this
requirement. As discussed further therein, this condition is present
if (a) a resale price guarantee exists, (b) the seller has an option
to purchase the product, the economic effect of which compels the
seller to purchase the product, or (c) the buyer has an option
whereby it can require the seller to purchase the product.
    \15\ FASB ASC subparagraph 470-40-15-2(b).
---------------------------------------------------------------------------

    (a) The seller provides interest-free or significantly below market
financing to the buyer beyond the seller's customary sales terms and
until the products are resold,
    (b) The seller pays interest costs on behalf of the buyer under a
third-party financing arrangement, or
    (c) The seller has a practice of refunding (or intends to refund) a
portion of the original sales price representative of interest expense
for the period from when the buyer paid the seller until the buyer
resells the product.
    3. The transaction possesses the characteristics set forth in FASB
ASC paragraphs 840-10-55-12 through 840-10-55-21 (Leases Topic) and
does not qualify for sales-type lease accounting.
    4. The product is delivered for demonstration purposes.\16\
---------------------------------------------------------------------------

    \16\ See FASB ASC paragraphs 985-605-25-28 through 985-605-25-
29.
---------------------------------------------------------------------------

    This list is not meant to be a checklist of all characteristics of
a consignment or financing arrangement, and other characteristics may
exist. Accordingly, the staff believes that judgment is necessary in
assessing whether the substance of a transaction is a consignment, a
financing, or other arrangement for which revenue recognition is not
appropriate. If title to the goods has passed but the substance of the
arrangement is not a sale, the consigned inventory should be reported
separately from other inventory in the consignor's financial statements
as ``inventory consigned to others'' or another appropriate caption.

Question 3

    Facts: The laws of some countries do not provide for a seller's
retention of a security interest in goods in the same manner as
established in the U.S. Uniform Commercial Code (UCC). In these
countries, it is common for a seller to retain a form of title to goods
delivered to customers until the customer makes payment so that the
seller can recover the goods in the event of customer default on
payment.
    Question: Is it acceptable to recognize revenue in these
transactions before payment is made and title has transferred?
    Interpretive Response: Presuming all other revenue recognition
criteria have been met, the staff would not object to revenue
recognition at delivery if the only rights that a seller retains with
the title are those enabling recovery of the goods in the event of
customer default on payment. This limited form of ownership may exist
in some foreign jurisdictions where, despite technically holding title,
the seller is not entitled to direct the disposition of the goods,
cannot rescind the transaction, cannot prohibit its customer from
moving, selling, or otherwise using the goods in the ordinary course of
business, and has no other rights that rest with a titleholder of
property that is subject to a lien under the U.S. UCC. On the other
hand, if retaining title results in the seller retaining rights
normally held by an owner of goods, the situation is not sufficiently
different from a delivery of goods on consignment. In this particular
case, revenue should not be recognized until payment is received.
Registrants and their auditors may wish to consult legal counsel
knowledgeable of the local law and customs outside the U.S. to
determine the seller's rights.
3. Delivery and Performance
a. Bill and Hold Arrangements
    Facts: Company A receives purchase orders for products it
manufactures. At the end of its fiscal quarters, customers may not yet
be ready to take delivery of the products for various reasons. These
reasons may include, but are not limited to, a lack of available space
for inventory, having more than sufficient inventory in their
distribution channel, or delays in customers' production schedules.
    Question: May Company A recognize revenue for the sale of its
products once it has completed manufacturing if it segregates the
inventory of the products in its own warehouse from its own products?
    May Company A recognize revenue for the sale if it ships the
products to a third-party warehouse but (1) Company A retains title to
the product and (2) payment by the customer is dependent upon ultimate
delivery to a customer-specified site?
    Interpretative Response: Generally, no. The staff believes that
delivery generally is not considered to have occurred unless the
customer has taken title and assumed the risks and rewards of ownership
of the products specified in the customer's purchase order or sales
agreement. Typically this occurs when a product is delivered to the
customer's delivery site (if the terms of the sale are ``FOB
destination'') or when a product is shipped to the customer (if the
terms are ``FOB shipping point'').
    The Commission has set forth criteria to be met in order to
recognize revenue when delivery has not occurred.\17\ These include:
---------------------------------------------------------------------------

    \17\ See In the Matter of Stewart Parness, AAER 108 (August 5,
1986); SEC v. Bollinger Industries, Inc., et al., LR 15093
(September 30, 1996); In the Matter of Laser Photonics, Inc., AAER
971 (September 30, 1997); In the Matter of Cypress Bioscience Inc.,
AAER 817 (September 19, 1996). See also Concepts Statement 5,
paragraph 84(a) and FASB ASC paragraph 985-605-25-25.
---------------------------------------------------------------------------

    1. The risks of ownership must have passed to the buyer;
    2. The customer must have made a fixed commitment to purchase the
goods, preferably in written documentation;
    3. The buyer, not the seller, must request that the transaction be
on a bill and hold basis.\18\ The buyer must have a substantial
business purpose for ordering the goods on a bill and hold basis;
---------------------------------------------------------------------------

    \18\ Such requests typically should be set forth in writing by
the buyer.
---------------------------------------------------------------------------

    4. There must be a fixed schedule for delivery of the goods. The
date for delivery must be reasonable and must be consistent with the
buyer's business purpose (e.g., storage periods are customary in the
industry);
    5. The seller must not have retained any specific performance
obligations such that the earning process is not complete;
    6. The ordered goods must have been segregated from the seller's
inventory and not be subject to being used to fill other orders; and
    7. The equipment [product] must be complete and ready for shipment.
    The above listed conditions are the important conceptual criteria
that should be used in evaluating any purported bill and hold sale.
This listing is not intended as a checklist. In some circumstances, a
transaction may meet all factors listed above but not meet the
requirements for revenue recognition. The Commission also has noted
that in applying the above criteria to a purported bill and hold sale,
the individuals responsible for the preparation and filing of financial
statements also should consider the following factors: \19\
---------------------------------------------------------------------------

    \19\ See Note 17, supra.
---------------------------------------------------------------------------

    1. The date by which the seller expects payment, and whether the
seller has modified its normal billing and credit terms for this buyer;
\20\
---------------------------------------------------------------------------

    \20\ Such individuals should consider whether FASB ASC Subtopic
835-30, Interest--Imputation of Interest, pertaining to the need for
discounting the related receivable, is applicable. FASB ASC
subparagraph 835-30-15-3(a) indicates that the requirements of that
Subtopic to record receivables at a discounted value are not
intended to apply to ``receivables and payables arising from
transactions with customers or suppliers in the normal course of
business which are due in customary trade terms not exceeding
approximately one year'' (emphasis added).

---------------------------------------------------------------------------

    2. The seller's past experiences with and pattern of bill and hold
transactions;
    3. Whether the buyer has the expected risk of loss in the event of
a decline in the market value of goods;
    4. Whether the seller's custodial risks are insurable and insured;
    5. Whether extended procedures are necessary in order to assure
that there are no exceptions to the buyer's commitment to accept and
pay for the goods sold (i.e., that the business reasons for the bill
and hold have not introduced a contingency to the buyer's commitment).
    Delivery generally is not considered to have occurred unless the
product has been delivered to the customer's place of business or
another site specified by the customer. If the customer specifies an
intermediate site but a substantial portion of the sales price is not
payable until delivery is made to a final site, then revenue should not
be recognized until final delivery has occurred.\21\
---------------------------------------------------------------------------

    \21\ FASB ASC paragraph 985-605-25-25.
---------------------------------------------------------------------------

b. Customer Acceptance
    After delivery of a product or performance of a service, if
uncertainty exists about customer acceptance, revenue should not be
recognized until acceptance occurs.\22\ Customer acceptance provisions
may be included in a contract, among other reasons, to enforce a
customer's rights to (1) test the delivered product, (2) require the
seller to perform additional services subsequent to delivery of an
initial product or performance of an initial service (e.g., a seller is
required to install or activate delivered equipment), or (3) identify
other work necessary to be done before accepting the product. The staff
presumes that such contractual customer acceptance provisions are
substantive, bargained-for terms of an arrangement. Accordingly, when
such contractual customer acceptance provisions exist, the staff
generally believes that the seller should not recognize revenue until
customer acceptance occurs or the acceptance provisions lapse.
---------------------------------------------------------------------------

    \22\ FASB ASC paragraph 985-605-25-21. Also, Concepts Statement
5, paragraph 83(b) states ``revenues are considered to have been
earned when the entity has substantially accomplished what it must
do to be entitled to the benefits represented by the revenues.'' If
an arrangement expressly requires customer acceptance, the staff
generally believes that customer acceptance should occur before the
entity has substantially accomplished what it must do to be entitled
to the benefits represented by the revenues, especially when the
seller is obligated to perform additional steps.
---------------------------------------------------------------------------

Question 1

    Question: Do circumstances exist in which formal customer sign-off
(that a contractual customer acceptance provision is met) is
unnecessary to meet the requirements to recognize revenue?
    Interpretive Response: Yes. Formal customer sign-off is not always
necessary to recognize revenue provided that the seller objectively
demonstrates that the criteria specified in the acceptance provisions
are satisfied. Customer acceptance provisions generally allow the
customer to cancel the arrangement when a seller delivers a product
that the customer has not yet agreed to purchase or delivers a product
that does not meet the specifications of the customer's order. In those
cases, revenue should not be recognized because a sale has not
occurred. In applying this concept, the staff observes that customer
acceptance provisions normally take one of four general forms. Those
forms, and how the staff generally assesses whether customer acceptance
provisions should result in revenue deferral, are described below:
    (a) Acceptance provisions in arrangements that purport to be for
trial or evaluation purposes.\23\ In these arrangements, the seller
delivers a product to a customer, and the customer agrees to receive
the product, solely to give the customer the ability to evaluate the
delivered product prior to acceptance. The customer does not agree to
purchase the delivered product until it accepts the product. In some
cases, the acceptance provisions lapse by the passage of time without
the customer rejecting the delivered product, and in other cases
affirmative acceptance from the customer is necessary to trigger a
sales transaction. Frequently, the title to the product does not
transfer and payment terms are not established prior to customer
acceptance. These arrangements are, in substance, consignment
arrangements until the customer accepts the product as set forth in the
contract with the seller. Accordingly, in arrangements where products
are delivered for trial or evaluation purposes, revenue should not be
recognized until the earlier of when acceptance occurs or the
acceptance provisions lapse.
---------------------------------------------------------------------------

    \23\ See, for example, FASB ASC paragraphs 985-605-25-28 through
985-605-25-29.
---------------------------------------------------------------------------

    In contrast, other arrangements do not purport to be for trial or
evaluation purposes. In these instances, the seller delivers a
specified product pursuant to a customer's order, establishes payment
terms, and transfers title to the delivered product to the customer.
However, customer acceptance provisions may be included in the
arrangement to give the purchaser the ability to ensure the delivered
product meets the criteria set forth in its order. The staff evaluates
these provisions as follows:
    (b) Acceptance provisions that grant a right of return or exchange
on the basis of subjective matters. An example of such a provision is
one that allows the customer to return a product if the customer is
dissatisfied with the product.\24\ The staff believes these provisions
are not different from general rights of return and should be accounted
for in accordance with FASB ASC Subtopic 605-15, Revenue Recognition--
Products. This Subtopic requires that the amount of future returns must
be reasonably estimable in order for revenue to be recognized prior to
the expiration of return rights.\25\ That estimate may not be made in
the absence of a large volume of homogeneous transactions or if
customer acceptance is likely to depend on conditions for which
sufficient historical experience is absent.\26\ Satisfaction of these
requirements may vary from product-to-product, location-to-location,
customer-to-customer, and vendor-to-vendor.
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    \24\ FASB ASC paragraph 605-15-05-3.
    \25\ FASB ASC subparagraph 605-15-25-1(f).
    \26\ FASB ASC subparagraphs 605-15-25-3(c) and 605-15-25-3(d).
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    (c) Acceptance provisions based on seller-specified objective
criteria. An example of such a provision is one that gives the customer
a right of return or replacement if the delivered product is defective
or fails to meet the vendor's published specifications for the
product.\27\ Such rights are generally identical to those granted to
all others within the same class of customer and for which satisfaction
can be generally assured without consideration of conditions specific
to the customer. Provided the seller has previously demonstrated that
the product meets the specified criteria, the staff believes that these
provisions are not different from general or specific warranties and
should be accounted for as warranties in accordance with FASB ASC
Subtopic 450-20, Contingencies--Loss Contingencies. In this case, the
cost of potentially defective goods must be reliably estimable based on
a demonstrated history of substantially similar transactions.\28\
However, if the seller has not previously demonstrated that the
delivered product meets the seller's specifications, the staff believes
that revenue should be deferred until the specifications have been
objectively achieved.
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    \27\ FASB ASC paragraph 460-10-25-5 (Guarantees Topic) and FASB
ASC subparagraph 605-15-15-3(c).
    \28\ FASB ASC paragraph 460-10-25-6.

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    (d) Acceptance provisions based on customer-specified objective
criteria. These provisions are referred to in this document as
``customer-specific acceptance provisions'' against which substantial
completion and contract fulfillment must be evaluated. While formal
customer sign-off provides the best evidence that these acceptance
criteria have been met, revenue recognition also would be appropriate,
presuming all other revenue recognition criteria have been met, if the
seller reliably demonstrates that the delivered products or services
meet all of the specified criteria prior to customer acceptance. For
example, if a seller reliably demonstrates that a delivered product
meets the customer-specified objective criteria set forth in the
arrangement, the delivery criterion would generally be satisfied when
title and the risks and rewards of ownership transfers unless product
performance may reasonably be different under the customer's testing
conditions specified by the acceptance provisions. Further, the seller
should consider whether it would be successful in enforcing a claim for
payment even in the absence of formal sign-off. Whether the vendor has
fulfilled the terms of the contract before customer acceptance is a
matter of contract law, and depending on the facts and circumstances,
an opinion of counsel may be necessary to reach a conclusion.

Question 2

    Facts: Consider an arrangement that calls for the transfer of title
to equipment upon delivery to a customer's site. However, customer-
specific acceptance provisions permit the customer to return the
equipment unless the equipment satisfies certain performance tests. The
arrangement calls for the vendor to perform the installation. Assume
the equipment and the installation are separate units of accounting
under FASB ASC Subtopic 605-25, Revenue Recognition--Multiple-Element
Arrangements.\29\
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    \29\ This fact is provided as an assumption to facilitate an
analysis of revenue recognition in this fact pattern. No
interpretation of FASB ASC Subtopic 605-25 is intended.
---------------------------------------------------------------------------

    Question: Must revenue allocated to the equipment always be
deferred until installation and on-site testing are successfully
completed?
    Interpretive Response: No. The staff would not object to revenue
recognition for the equipment upon delivery (presuming all other
revenue recognition criteria have been met for the equipment) if the
seller demonstrates that, at the time of delivery, the equipment
already meets all of the criteria and specifications in the customer-
specific acceptance provisions. This may be demonstrated if conditions
under which the customer intends to operate the equipment are
replicated in pre-shipment testing, unless the performance of the
equipment, once installed and operated at the customer's facility, may
reasonably be different from that tested prior to shipment.
    Determining whether the delivered equipment meets all of a
product's criteria and specifications is a matter of judgment that must
be evaluated in light of the facts and circumstances of a particular
transaction. Consultation with knowledgeable project managers or
engineers may be necessary in such circumstances.
    For example, if the customer acceptance provisions were based on
meeting certain size and weight characteristics, it should be possible
to determine whether those criteria have been met before shipment.
Historical experience with the same specifications and functionality of
a particular machine that demonstrates that the equipment meets the
customer's specifications also may provide sufficient evidence that the
currently shipped equipment satisfies the customer-specific acceptance
provisions.
    If an arrangement includes customer acceptance criteria or
specifications that cannot be effectively tested before delivery or
installation at the customer's site, the staff believes that revenue
recognition should be deferred until it can be demonstrated that the
criteria are met. This situation usually will exist when equipment
performance can vary based on how the equipment works in combination
with the customer's other equipment, software, or environmental
conditions. In these situations, testing to determine whether the
criteria are met cannot be reasonably performed until the products are
installed or integrated at the customer's facility.
    Although the following questions provide several examples
illustrating how the staff evaluates customer acceptance, the
determination of when customer-specific acceptance provisions of an
arrangement are met in the absence of the customer's formal
notification of acceptance depends on the weight of the evidence in the
particular circumstances. Different conclusions could be reached in
similar circumstances that vary only with respect to a single variable,
such as complexity of the equipment, nature of the interface with the
customer's environment, extent of the seller's experience with the same
type of transactions, or a particular clause in the agreement. The
staff believes management and auditors are uniquely positioned to
evaluate the facts and arrive at a reasoned conclusion. The staff will
not object to a determination that is well reasoned on the basis of
this guidance.

Question 3

    Facts: Company E is an equipment manufacturer whose main product is
generally sold in a standard model. The contracts for sale of that
model provide for customer acceptance to occur after the equipment is
received and tested by the customer. The acceptance provisions state
that if the equipment does not perform to Company E's published
specifications, the customer may return the equipment for a full refund
or a replacement unit, or may require Company E to repair the equipment
so that it performs up to published specifications. Customer acceptance
is indicated by either a formal sign-off by the customer or by the
passage of 90 days without a claim under the acceptance provisions.
Title to the equipment passes upon delivery to the customer. Company E
does not perform any installation or other services on the equipment it
sells and tests each piece of equipment against its specifications
before shipment. Payment is due under Company E's normal payment terms
for that product 30 days after customer acceptance.
    Company E receives an order from a new customer for a standard
model of its main product. Based on the customer's intended use of the
product, location and other factors, there is no reason that the
equipment would operate differently in the customer's environment than
it does in Company E's facility.
    Question: Assuming all other revenue recognition criteria are met
(other than the issue raised with respect to the acceptance provision),
when should Company E recognize revenue from the sale of this piece of
equipment?
    Interpretive Response: While the staff presumes that customer
acceptance provisions are substantive provisions that generally result
in revenue deferral, that presumption can be overcome as discussed
above. Although the contract includes a customer acceptance clause,
acceptance is based on meeting Company E's published specifications for
a standard model. Company E demonstrates that the equipment shipped
meets the specifications before shipment, and the equipment is expected
to operate the same in the customer's environment as it does in

Company E's. In this situation, Company E should evaluate the customer
acceptance provision as a warranty under FASB ASC Subtopic 450-20. If
Company E can reasonably and reliably estimate the amount of warranty
obligations, the staff believes that it should recognize revenue upon
delivery of the equipment, with an appropriate liability for probable
warranty obligations.

Question 4

    Facts: Assume the same facts about Company E's equipment, contract
terms and customary practices as in Question 3 above. Company E enters
into an arrangement with a new customer to deliver a version of its
standard product modified as necessary to fit into a space of specific
dimensions while still meeting all of the published vendor
specifications with regard to performance. In addition to the customer
acceptance provisions relating to the standard performance
specifications, the customer may reject the equipment if it does not
conform to the specified dimensions. Company E creates a testing
chamber of the exact same dimensions as specified by the customer and
makes simple design changes to the product so that it fits into the
testing chamber. The equipment still meets all of the standard
performance specifications.
    Question: Assuming all other revenue recognition criteria are met
(other than the issue raised with respect to the acceptance provision),
when should Company E recognize revenue from the sale of this piece of
equipment?
    Interpretive Response: Although the contract includes a customer
acceptance clause that is based, in part, on a customer specific
criterion, Company E demonstrates that the equipment shipped meets that
objective criterion, as well as the published specifications, before
shipment. The staff believes that the customer acceptance provisions
related to the standard performance specifications should be evaluated
as a warranty under FASB ASC Subtopic 450-20. If Company E can
reasonably and reliably estimate the amount of warranty obligations, it
should recognize revenue upon delivery of the equipment, with an
appropriate liability for probable warranty obligations.

Question 5

    Facts: Assume the same facts about Company E's equipment, contract
terms and customary practices as in Question 3 above. Company E enters
into an arrangement with a new customer to deliver a version of its
standard product modified as necessary to be integrated into the
customer's new assembly line while still meeting all of the standard
published vendor specifications with regard to performance. The
customer may reject the equipment if it fails to meet the standard
published performance specifications or cannot be satisfactorily
integrated into the new line. Company E has never modified its
equipment to work on an integrated basis in the type of assembly line
the customer has proposed. In response to the request, Company E
designs a version of its standard equipment that is modified as
believed necessary to operate in the new assembly line. The modified
equipment still meets all of the standard published performance
specifications, and Company E believes the equipment will meet the
requested specifications when integrated into the new assembly line.
However, Company E is unable to replicate the new assembly line
conditions in its testing.
    Question: Assuming all other revenue recognition criteria are met
(other than the issue raised with respect to the acceptance provision),
when should Company E recognize revenue from the sale of this piece of
equipment?
    Interpretive Response: This contract includes a customer acceptance
clause that is based, in part, on a customer specific criterion, and
Company E cannot demonstrate that the equipment shipped meets that
criterion before shipment. Accordingly, the staff believes that the
contractual customer acceptance provision has not been met at shipment.
Therefore, the staff believes that Company E should wait until the
product is successfully integrated at its customer's location and meets
the customer-specific criteria before recognizing revenue. While this
is best evidenced by formal customer acceptance, other objective
evidence that the equipment has met the customer-specific criteria may
also exist (e.g., confirmation from the customer that the
specifications were met).
c. Inconsequential or Perfunctory Performance Obligations

Question 1

    Question: Does the failure to complete all activities related to a
unit of accounting preclude recognition of revenue for that unit of
accounting?
    Interpretive Response: No. Assuming all other recognition criteria
are met, revenue for the unit of accounting may be recognized in its
entirety if the seller's remaining obligation is inconsequential or
perfunctory.
    A seller should substantially complete or fulfill the terms
specified in the arrangement related to the unit of accounting at issue
in order for delivery or performance to have occurred.\30\ When
applying the substantially complete notion, the staff believes that
only inconsequential or perfunctory actions may remain incomplete such
that the failure to complete the actions would not result in the
customer receiving a refund or rejecting the delivered products or
services performed to date. In addition, the seller should have a
demonstrated history of completing the remaining tasks in a timely
manner and reliably estimating the remaining costs. If revenue is
recognized upon substantial completion of the terms specified in the
arrangement related to the unit of accounting at issue, all related
costs of performance or delivery should be accrued.
---------------------------------------------------------------------------

    \30\ Concepts Statement 5, paragraph 83(b) states ``revenues are
considered to have been earned when the entity has substantially
accomplished what it must do to be entitled the benefits represented
by the revenues.''
---------------------------------------------------------------------------

Question 2
    Question: What factors should be considered in the evaluation of
whether a remaining obligation related to a unit of accounting is
inconsequential or perfunctory?
    Interpretive Response: A remaining performance obligation is not
inconsequential or perfunctory if it is essential to the functionality
of the delivered products or services. In addition, remaining
activities are not inconsequential or perfunctory if failure to
complete the activities would result in the customer receiving a full
or partial refund or rejecting (or a right to a refund or to reject)
the products delivered or services performed to date. The terms of the
sales contract regarding both the right to a full or partial refund and
the right of return or rejection should be considered when evaluating
whether a portion of the purchase price would be refundable. If the
company has a historical pattern of granting such rights, that
historical pattern should also be considered even if the current
contract expressly precludes such rights. Further, other factors should
be considered in assessing whether remaining obligations are
inconsequential or perfunctory. For example, the staff also considers
the following factors, which are not all-inclusive, to be indicators
that a remaining performance obligation is substantive rather than
inconsequential or perfunctory:
     The seller does not have a demonstrated history of
completing the remaining tasks in a timely manner and reliably
estimating their costs.

     The cost or time to perform the remaining obligations for
similar contracts historically has varied significantly from one
instance to another.
     The skills or equipment required to complete the remaining
activity are specialized or are not readily available in the
marketplace.
     The cost of completing the obligation, or the fair value
of that obligation, is more than insignificant in relation to such
items as the contract fee, gross profit, and operating income allocable
to the unit of accounting.
     The period before the remaining obligation will be
extinguished is lengthy. Registrants should consider whether reasonably
possible variations in the period to complete performance affect the
certainty that the remaining obligations will be completed successfully
and on budget.
     The timing of payment of a portion of the sales price is
coincident with completing performance of the remaining activity.
    Registrants' determinations of whether remaining obligations are
inconsequential or perfunctory should be consistently applied.

Question 3

    Facts: Consider a unit of accounting that includes both equipment
and installation because the two deliverables do not meet the
separation criteria under FASB ASC Subtopic 605-25. This may be because
the equipment does not have value to the customer on a standalone
basis, there is no objective and reliable evidence of fair value for
the installation or there is a general right of return when the
installation is not considered probable and in control of the vendor.
    Question: In this situation, must all revenue be deferred until
installation is performed?
    Interpretive Response: Yes, if installation is essential to the
functionality of the equipment.\31\ Examples of indicators that
installation is essential to the functionality of equipment include:
---------------------------------------------------------------------------

    \31\ FASB ASC paragraph 985-605-25-12.
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     The installation involves significant changes to the
features or capabilities of the equipment or building complex
interfaces or connections;
     The installation services are unavailable from other
vendors.\32\
---------------------------------------------------------------------------

    \32\ See FASB ASC paragraphs 985-605-25-81 through 985-605-25-85
for analogous guidance.
---------------------------------------------------------------------------

    Conversely, examples of indicators that installation is not
essential to the functionality of the equipment include:
     The equipment is a standard product;
     Installation does not significantly alter the equipment's
capabilities;
     Other companies are available to perform the
installation.\33\
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    \33\ Ibid.
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    If it is determined that the undelivered service is not essential
to the functionality of the delivered product but a portion of the
contract fee is not payable until the undelivered service is delivered,
the staff would not consider that obligation to be inconsequential or
perfunctory. Generally, the portion of the contract price that is
withheld or refundable should be deferred until the outstanding service
is delivered because that portion would not be realized or
realizable.\34\
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    \34\ Concepts Statement 5, paragraph 83(a) and FASB ASC
subparagraph 605-15-25-1(b).
---------------------------------------------------------------------------

d. License Fee Revenue
    Facts: Assume that intellectual property is physically delivered
and payment is received on December 20, upon the registrant's
consummation of an agreement granting its customer a license to use the
intellectual property for a term beginning on the following January 1.
    Question: Should the license fee be recognized in the period ending
December 31?
    Interpretive Response: No. In licensing and similar arrangements
(e.g., licenses of motion pictures, software, technology, and other
intangibles), the staff believes that delivery does not occur for
revenue recognition purposes until the license term begins.\35\
Accordingly, if a licensed product or technology is physically
delivered to the customer, but the license term has not yet begun,
revenue should not be recognized prior to inception of the license
term. Upon inception of the license term, revenue should be recognized
in a manner consistent with the nature of the transaction and the
earnings process.
---------------------------------------------------------------------------

    \35\ FASB ASC paragraph 926-605-25-1 (Entertainment--Films
Topic).
---------------------------------------------------------------------------

e. Layaway Sales Arrangements
    Facts: Company R is a retailer that offers ``layaway'' sales to its
customers. Company R retains the merchandise, sets it aside in its
inventory, and collects a cash deposit from the customer. Although
Company R may set a time period within which the customer must finalize
the purchase, Company R does not require the customer to enter into an
installment note or other fixed payment commitment or agreement when
the initial deposit is received. The merchandise generally is not
released to the customer until the customer pays the full purchase
price. In the event that the customer fails to pay the remaining
purchase price, the customer forfeits its cash deposit. In the event
the merchandise is lost, damaged, or destroyed, Company R either must
refund the cash deposit to the customer or provide replacement
merchandise.
    Question: In the staff's view, when may Company R recognize revenue
for merchandise sold under its layaway program?
    Interpretive Response: Provided that the other criteria for revenue
recognition are met, the staff believes that Company R should recognize
revenue from sales made under its layaway program upon delivery of the
merchandise to the customer. Until then, the amount of cash received
should be recognized as a liability entitled such as ``deposits
received from customers for layaway sales'' or a similarly descriptive
caption. Because Company R retains the risks of ownership of the
merchandise, receives only a deposit from the customer, and does not
have an enforceable right to the remainder of the purchase price, the
staff would object to Company R recognizing any revenue upon receipt of
the cash deposit. This is consistent with item two (2) in the
Commission's criteria for bill-and-hold transactions which states ``the
customer must have made a fixed commitment to purchase the goods.''
f. Nonrefundable Up-front Fees

Question 1

    Facts: Registrants may negotiate arrangements pursuant to which
they may receive nonrefundable fees upon entering into arrangements or
on certain specified dates. The fees may ostensibly be received for
conveyance of a license or other intangible right or for delivery of
particular products or services. Various business factors may influence
how the registrant and customer structure the payment terms. For
example, in exchange for a greater up-front fee for an intangible
right, the registrant may be willing to receive lower unit prices for
related products to be delivered in the future. In some circumstances,
the right, product, or service conveyed in conjunction with the
nonrefundable fee has no utility to the purchaser separate and
independent of the registrant's performance of the other elements of
the arrangement. Therefore, in the absence of the registrant's
continuing involvement under the arrangement, the customer would not
have paid the fee. Examples of this type of arrangement include the
following:

     A registrant sells a lifetime membership in a health club.
After paying a nonrefundable ``initiation fee,'' the customer is
permitted to use the health club indefinitely, so long as the customer
also pays an additional usage fee each month. The monthly usage fees
collected from all customers are adequate to cover the operating costs
of the health club.
     A registrant in the biotechnology industry agrees to
provide research and development activities for a customer for a
specified term. The customer needs to use certain technology owned by
the registrant for use in the research and development activities. The
technology is not sold or licensed separately without the research and
development activities. Under the terms of the arrangement, the
customer is required to pay a nonrefundable ``technology access fee''
in addition to periodic payments for research and development
activities over the term of the contract.
     A registrant requires a customer to pay a nonrefundable
``activation fee'' when entering into an arrangement to provide
telecommunications services. The terms of the arrangement require the
customer to pay a monthly usage fee that is adequate to recover the
registrant's operating costs. The costs incurred to activate the
telecommunications service are nominal.
     A registrant charges users a fee for non-exclusive access
to its Web site that contains proprietary databases. The fee allows
access to the Web site for a one-year period. After the customer is
provided with an identification number and trained in the use of the
database, there are no incremental costs that will be incurred in
serving this customer.
     A registrant charges a fee to users for advertising a
product for sale or auction on certain pages of its Web site. The
company agrees to maintain the listing for a period of time. The cost
of maintaining the advertisement on the Web site for the stated period
is minimal.
     A registrant charges a fee for hosting another company's
Web site for one year. The arrangement does not involve exclusive use
of any of the hosting company's servers or other equipment. Almost all
of the projected costs to be incurred will be incurred in the initial
loading of information on the host company's Internet server and
setting up appropriate links and network connections.
    Question: Assuming these arrangements qualify as single units of
accounting under FASB ASC Subtopic 605-25,\36\ when should the revenue
relating to nonrefundable, up-front fees in these types of arrangements
be recognized?
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    \36\ The staff believes that the vendor activities associated
with the up-front fee, even if considered a deliverable to be
evaluated under FASB ASC Subtopic 605-25, will rarely provide value
to the customer on a standalone basis.
---------------------------------------------------------------------------

    Interpretive Response: The staff believes that registrants should
consider the specific facts and circumstances to determine the
appropriate accounting for nonrefundable, up-front fees. Unless the up-
front fee is in exchange for products delivered or services performed
that represent the culmination of a separate earnings process,\37\ the
deferral of revenue is appropriate.
---------------------------------------------------------------------------

    \37\ See Concepts Statement 5, footnote 51, for a description of
the ``earning process.''
---------------------------------------------------------------------------

    In the situations described above, the staff does not view the
activities completed by the registrants (i.e., selling the membership,
signing the contract, enrolling the customer, activating
telecommunications services or providing initial set-up services) as
discrete earnings events.\38\ The terms, conditions, and amounts of
these fees typically are negotiated in conjunction with the pricing of
all the elements of the arrangement, and the customer would ascribe a
significantly lower, and perhaps no, value to elements ostensibly
associated with the up-front fee in the absence of the registrant's
performance of other contract elements. The fact that the registrants
do not sell the initial rights, products, or services separately (i.e.,
without the registrants' continuing involvement) supports the staff's
view. The staff believes that the customers are purchasing the on-going
rights, products, or services being provided through the registrants'
continuing involvement. Further, the staff believes that the earnings
process is completed by performing under the terms of the arrangements,
not simply by originating a revenue-generating arrangement.
---------------------------------------------------------------------------

    \38\ In a similar situation, lenders may collect nonrefundable
loan origination fees in connection with lending activities. The
FASB concluded in FASB ASC Subtopic 310-20, Receivables--
Nonrefundable Fees and Other Costs, that loan origination is not a
separate revenue-producing activity of a lender, and therefore,
those nonrefundable fees collected at the outset of the loan
arrangement are not recognized as revenue upon receipt but are
deferred and recognized over the life of the loan (FASB ASC
paragraph 310-20-35-2).
---------------------------------------------------------------------------

    While the incurrence of nominal up-front costs helps make it clear
that there is not a separate earnings event in the telecommunications
example above, incurrence of substantive costs, such as in the Web
hosting example above, does not necessarily indicate that there is a
separate earnings event. Whether there is a separate earnings event
should be evaluated on a case-by-case basis. Some have questioned
whether revenue may be recognized in these transactions to the extent
of the incremental direct costs incurred in the activation. Because
there is no separable deliverable or earnings event, the staff would
generally object to that approach, except where it is provided for in
the authoritative literature (e.g., FASB ASC Subtopic 922-605,
Entertainment--Cable Television--Revenue Recognition).
    Supply or service transactions may involve the charge of a
nonrefundable initial fee with subsequent periodic payments for future
products or services. The initial fees may, in substance, be wholly or
partly an advance payment for future products or services. In the
examples above, the on-going rights or services being provided or
products being delivered are essential to the customers receiving the
expected benefit of the up-front payment. Therefore, the up-front fee
and the continuing performance obligation related to the services to be
provided or products to be delivered are assessed as an integrated
package. In such circumstances, the staff believes that up-front fees,
even if nonrefundable, are earned as the products and/or services are
delivered and/or performed over the term of the arrangement or the
expected period of performance \39\ and generally should be deferred
and recognized systematically over the periods that the fees are
earned.\40\
---------------------------------------------------------------------------

    \39\ The revenue recognition period should extend beyond the
initial contractual period if the relationship with the customer is
expected to extend beyond the initial term and the customer
continues to benefit from the payment of the up-front fee (e.g., if
subsequent renewals are priced at a bargain to the initial up-front
fee).
    \40\ A systematic method would be on a straight-line basis,
unless evidence suggests that revenue is earned or obligations are
fulfilled in a different pattern, in which case that pattern should
be followed.
---------------------------------------------------------------------------

    Some propose that revenue should be recognized when the initial
set-up is completed in cases where the on-going obligation involves
minimal or no cost or effort and should, therefore, be considered
perfunctory or inconsequential. However, the staff believes that the
substance of each of these transactions indicates that the purchaser is
paying for a service that is delivered over time. Therefore, revenue
recognition should occur over time, reflecting the provision of
service.\41\
---------------------------------------------------------------------------

    \41\ Concepts Statement 5, paragraph 84(d).
---------------------------------------------------------------------------

Question 2

    Facts: Company A provides its customers with activity tracking or

similar services (e.g., tracking of property tax payment activity,
sending delinquency letters on overdue accounts, etc.) for a ten-year
period. Company A requires customers to prepay for all the services for
the term specified in the arrangement. The on-going services to be
provided are generally automated after the initial customer set-up. At
the outset of the arrangement, Company A performs set-up procedures to
facilitate delivery of its on-going services to the customers. Such
procedures consist primarily of establishing the necessary records and
files in Company A's pre-existing computer systems in order to provide
the services. Once the initial customer set-up activities are complete,
Company A provides its services in accordance with the arrangement.
Company A is not required to refund any portion of the fee if the
customer terminates the services or does not utilize all of the
services to which it is entitled. However, Company A is required to
provide a refund if Company A terminates the arrangement early. Assume
Company A's activities are not within the scope of FASB ASC Subtopic
310-20, Receivables--Nonrefundable Fees and Other Costs, and that this
arrangement qualifies as a single unit of accounting under FASB ASC
Subtopic 605-25.\42\
---------------------------------------------------------------------------

    \42\ See Note 36, supra.
---------------------------------------------------------------------------

    Question: When should Company A recognize the service revenue?
    Interpretive Response: The staff believes that, provided all other
revenue recognition criteria are met, service revenue should be
recognized on a straight-line basis, unless evidence suggests that the
revenue is earned or obligations are fulfilled in a different pattern,
over the contractual term of the arrangement or the expected period
during which those specified services will be performed,\43\ whichever
is longer. In this case, the customer contracted for the on-going
activity tracking service, not for the set-up activities. The staff
notes that the customer could not, and would not, separately purchase
the set-up services without the on-going services. The services
specified in the arrangement are performed continuously over the
contractual term of the arrangement (and any subsequent renewals).
Therefore, the staff believes that Company A should recognize revenue
on a straight-line basis, unless evidence suggests that the revenue is
earned or obligations are fulfilled in a different pattern, over the
contractual term of the arrangement or the expected period during which
those specified services will be performed, whichever is longer.
---------------------------------------------------------------------------

    \43\ See Note 39, supra.
---------------------------------------------------------------------------

    In this situation, the staff would object to Company A recognizing
revenue in proportion to the costs incurred because the set-up costs
incurred bear no direct relationship to the performance of services
specified in the arrangement. The staff also believes that it is
inappropriate to recognize the entire amount of the prepayment as
revenue at the outset of the arrangement by accruing the remaining
costs because the services required by the contract have not been
performed.

Question 3

    Facts: Assume the same facts as in Question 2 above.
    Question: Are the initial customer set-up costs incurred by Company
A within the scope of FASB ASC Subtopic 720-15, Other Expenses--Start-
Up Costs?
    Interpretive Response: FASB ASC paragraph 720-15-15-4 states that
the guidance does not address the financial reporting of costs incurred
related to ``ongoing customer acquisition costs, such as policy
acquisition costs'' addressed in FASB ASC Subtopic 944-30, Financial
Services--Insurance--Acquisition Costs, and ``loan origination costs''
addressed in FASB ASC Subtopic 310-20. This guidance addresses the more
substantive one-time efforts to establish business with an entirely new
class of customers (for example, a manufacturer who does all of its
business with retailers attempts to sell merchandise directly to the
public). As such, the set-up costs incurred in this example are not
within the scope of FASB ASC Subtopic 720-15.
    The staff believes that the incremental direct costs (the FASB ASC
Master Glossary provides a definition) incurred related to the
acquisition or origination of a customer contract in a transaction that
results in the deferral of revenue, unless specifically provided for in
the authoritative literature, may be either expensed as incurred or
accounted for in accordance with FASB ASC paragraph 605-20-25-4 or FASB
ASC paragraph 310-20-25-2. The staff believes the accounting policy
chosen for these costs should be disclosed and applied consistently.

Question 4

    Facts: Assume the same facts as in Question 2 above.
    Question: What is the staff's view of the pool of contract
acquisition and origination costs that are eligible for capitalization?
    Interpretive Response: As noted in Question 3 above, the FASB ASC
Master Glossary includes a definition of incremental direct costs. FASB
ASC Subtopic 310-10, Receivables--Overall, provides further guidance on
the types of costs eligible for capitalization as customer acquisition
costs indicating that only costs that result from successful loan
origination efforts are capitalized. Further, FASB ASC Subtopic 605-20,
Revenue Recognition--Services, also requires capitalization of
incremental direct customer acquisition costs. Although the facts of a
particular situation should be analyzed closely to capture those costs
that are truly direct and incremental, the staff generally would not
object to an accounting policy that results in the capitalization of
costs in accordance with FASB ASC Subtopic 310-20, Receivables--
Nonrefundable Fees and Other Costs, or FASB ASC Subtopic 605-20.
Registrants should disclose their policies for determining which costs
to capitalize as contract acquisition and origination costs.

Question 5

    Facts: Assume the same facts as in Question 2 above. Based on the
guidance in Questions 2, 3 and 4 above, Company A has capitalized
certain direct and incremental customer set-up costs associated with
the deferred revenue.
    Question: Over what period should Company A amortize these costs?
    Interpretive Response: When both costs and revenue (in an amount
equal to or greater than the costs) are deferred, the staff believes
that the capitalized costs should be charged to expense proportionally
and over the same period that deferred revenue is recognized as
revenue.\44\
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    \44\ FASB ASC paragraph 605-20-25-4.
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g. Deliverables Within an Arrangement
    Question: If a company (the seller) has a patent to its
intellectual property which it licenses to customers, the seller may
represent and warrant to its licensees that it has a valid patent, and
will defend and maintain that patent. Does that obligation to maintain
and defend patent rights, in and of itself, constitute a deliverable to
be evaluated under FASB ASC Subtopic 605-25?
    Interpretive Response: No. Provided the seller has legal and valid
patents upon entering the license arrangement, existing GAAP on
licenses of intellectual property (e.g., FASB ASC Subtopic 985-605,
Software--Revenue Recognition, FASB ASC Subtopic 926-605,
Entertainment--Films--Revenue Recognition, and FASB ASC Subtopic 928-
605, Entertainment--Music--Revenue Recognition) does not indicate

that an obligation to defend valid patents represents an additional
deliverable to which a portion of an arrangement fee should be
allocated in an arrangement that otherwise qualifies for sales-type
accounting. While this clause may obligate the licenser to incur costs
in the defense and maintenance of the patent, that obligation does not
involve an additional deliverable to the customer. Defending the patent
is generally consistent with the seller's representation in the license
that such patent is legal and valid. Therefore, the staff would not
consider a clause like this to represent an additional deliverable in
the arrangement.\45\
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    \45\ Note, however, the staff believes that this obligation
qualifies as a guarantee within the scope of FASB ASC Topic 460,
subject to a scope exception from the initial recognition and
measurement provisions.
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4. Fixed or Determinable Sales Price
a. Refundable Fees for Services
    A company's contracts may include customer cancellation or
termination clauses. Cancellation or termination provisions may be
indicative of a demonstration period or an otherwise incomplete
transaction. Examples of transactions that financial management and
auditors should be aware of and where such provisions may exist include
``side'' agreements and significant transactions with unusual terms and
conditions. These contractual provisions raise questions as to whether
the sales price is fixed or determinable. The sales price in
arrangements that are cancelable by the customer is neither fixed nor
determinable until the cancellation privileges lapse.\46\ If the
cancellation privileges expire ratably over a stated contractual term,
the sales price is considered to become determinable ratably over the
stated term.\47\ Short-term rights of return, such as thirty-day money-
back guarantees, and other customary rights to return products are not
considered to be cancellation privileges, but should be accounted for
in accordance with FASB ASC Subtopic 605-15, Revenue Recognition--
Products.\48\
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    \46\ FASB ASC paragraph 985-605-25-37.
    \47\ Ibid.
    \48\ Ibid.
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Question 1

    Facts: Company M is a discount retailer. It generates revenue from
annual membership fees it charges customers to shop at its stores and
from the sale of products at a discount price to those customers. The
membership arrangements with retail customers require the customer to
pay the entire membership fee (e.g., $35) at the outset of the
arrangement. However, the customer has the unilateral right to cancel
the arrangement at any time during its term and receive a full refund
of the initial fee. Based on historical data collected over time for a
large number of homogeneous transactions, Company M estimates that
approximately 40% of the customers will request a refund before the end
of the membership contract term. Company M's data for the past five
years indicates that significant variations between actual and
estimated cancellations have not occurred, and Company M does not
expect significant variations to occur in the foreseeable future.
    Question: May Company M recognize in earnings the revenue for the
membership fees and accrue the costs to provide membership services at
the outset of the arrangement?
    Interpretive Response: No. In the staff's view, it would be
inappropriate for Company M to recognize the membership fees as earned
revenue upon billing or receipt of the initial fee with a corresponding
accrual for estimated costs to provide the membership services. This
conclusion is based on Company M's remaining and unfulfilled
contractual obligation to perform services (i.e., make available and
offer products for sale at a discounted price) throughout the
membership period. Therefore, the earnings process, irrespective of
whether a cancellation clause exists, is not complete.
    In addition, the ability of the member to receive a full refund of
the membership fee up to the last day of the membership term raises an
uncertainty as to whether the fee is fixed or determinable at any point
before the end of the term. Generally, the staff believes that a sales
price is not fixed or determinable when a customer has the unilateral
right to terminate or cancel the contract and receive a cash refund. A
sales price or fee that is variable until the occurrence of future
events (other than product returns that are within the scope of FASB
ASC Subtopic 605-15) generally is not fixed or determinable until the
future event occurs. The revenue from such transactions should not be
recognized in earnings until the sales price or fee becomes fixed or
determinable. Moreover, revenue should not be recognized in earnings by
assessing the probability that significant, but unfulfilled, terms of a
contract will be fulfilled at some point in the future. Accordingly,
the revenue from such transactions should not be recognized in earnings
prior to the refund privileges expiring. The amounts received from
customers or subscribers (i.e., the $35 fee mentioned above) should be
credited to a monetary liability account such as ``customers'
refundable fees.''
    The staff believes that if a customer has the unilateral right to
receive both (1) the seller's substantial performance under an
arrangement (e.g., providing services or delivering product) and (2) a
cash refund of prepaid fees, then the prepaid fees should be accounted
for as a monetary liability. In consideration of whether the monetary
liability can be derecognized, FASB ASC Topic 860, Transfers and
Servicing, provides that liabilities may be derecognized only if (1)
the debtor pays the creditor and is relieved of its obligation for the
liability (paying the creditor includes delivery of cash, other
financial assets, goods, or services or reacquisition by the debtor of
its outstanding debt securities) or (2) the debtor is legally released
from being the primary obligor under the liability.\49\ If a customer
has the unilateral right to receive both (1) the seller's substantial
performance under the arrangement and (2) a cash refund of prepaid
fees, then the refund obligation is not relieved upon performance of
the service or delivery of the products. Rather, the seller's refund
obligation is relieved only upon refunding the cash or expiration of
the refund privilege.
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    \49\ FASB ASC paragraph 405-20-40-1 (Liabilities Topic).
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    Some have argued that there may be a limited exception to the
general rule that revenue from membership or other service transaction
fees should not be recognized in earnings prior to the refund
privileges expiring. Despite the fact that FASB ASC Subtopic 605-15
expressly does not apply to the accounting for service revenue if part
or all of the service fee is refundable under cancellation privileges
granted to the buyer,\50\ they believe that in certain circumstances a
potential refund of a membership fee may be seen as being similar to a
right of return of products under FASB ASC Subtopic 605-15. They argue
that revenue from membership fees, net of estimated refunds, may be
recognized ratably over the period the services are performed whenever
pertinent conditions of FASB ASC Subtopic 605-15 are met, namely, there
is a large population of transactions that grant customers the same
unilateral termination or cancellation rights and reasonable estimates
can be made of how many customers likely will exercise those rights.
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    \50\ FASB ASC paragraph 605-15-15-3.

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    The staff believes that, because service arrangements are
specifically excluded from the scope of FASB ASC Subtopic 605-15, the
most direct authoritative literature to be applied to the
extinguishment of obligations under such contracts is FASB ASC Topic
860. As noted above, because the refund privilege extends to the end of
the contract term irrespective of the amount of the service performed,
FASB ASC Topic 860 indicates that the liability would not be
extinguished (and therefore no revenue would be recognized in earnings)
until the cancellation or termination and related refund privileges
expire. Nonetheless, the staff recognizes that over the years the
accounting for membership refunds evolved based on analogy to FASB ASC
Subtopic 605-15 and that practice did not change when FASB ASC Topic
860 became effective. Reasonable people held, and continue to hold,
different views about the application of the accounting literature.
    Pending further action in this area by the FASB, the staff will not
object to the recognition of refundable membership fees, net of
estimated refunds, as earned revenue over the membership term in the
limited circumstances where all of the following criteria have been
met: \51\
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