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EITF Issue No. 88-18:

The American Institute of Certified Public Accountants (A.I.C.P.A) Emerging Issues Task Force (EITF) Issue No. 88-18, "Sales of Future Revenues" discusses the proper accounting treatment when an enterprise receives cash from an investor, and agrees to pay to the investor for a defined period a specified percentage or amount of the revenue or of a measure of income. The measure of income (for example, gross margin, operating income, or pretax income) may be of a particular product line, business segment, trademark, patent, or contractual right. 88-18 assumes that immediate income recognition is not appropriate due to the facts and circumstances.

According to 88-18, there are three issues, of which the following two are applicable to Sales Certificates:

  1. Whether the enterprise should classify the proceeds from the investor as debt or as deferred income
  2. How that debt or deferred income should be amortized

The Task Force reached an agreement that classification as debt or deferred income depends on the specific facts and circumstances of the transaction.

Classification as debt:

The Task Force agreed that the presence of any one of six factors independently creates a presumption that classification of the proceeds, as debt is appropriate. The following are the six factors:

  1. The transaction does not purport to be a sale (that is, the form of the transaction is debt).
  2. The enterprise has significant continuing involvement in the generation of the cash flows due the investor (for example, active involvement in the generation of the operating revenues of a product line, subsidiary, or business segment).
  3. The transaction is cancelable by either the enterprise or the investor through payment of a lump sum or other transfer of assets by the enterprise.
  4. The investor's rate of return is implicitly or explicitly limited by the terms of the transaction.
  5. Variations in the enterprise's revenue or income underlying the transaction have only a trifling impact on the investor's rate of return.
  6. The investor has any recourse to the enterprise relating to the payments due the investor.

Factors 2. and 4. specifically apply to the terms of the Sales Certificate.

Factor 2. applies since a periodic percent of sales will be paid to investors, and the issuer will be involved in the generation of sales.

Factor 4. applies because the investor's rate of return is limited by the percentage of sales determined and the term of the certificates.

Thus the proceeds from the issue of Sales Certificates should be treated as debt since the presence of any one of the six factors creates a presumption that classification of the proceeds as debt is appropriate.

Publications:

An article covering this concept was published in the July/August 2006 issue of the Financial Analysts Journal entitled Revenue Recognition Certificates.

QWAFAFEW:

Schulman and LeClair to present the Tykhe model at the Boston QWAFAFEW chapter:

Details will be posted at: http://qwafafew.org/boston