Under GAAP, sales revenue can be recognized only if the buyer assumes the risks and rewards of ownership of merchandise—for example, the risk of damage or physical loss. A sale with a right of return can be recognized as revenue only if the seller takes a reserve against possible future returns. The size of this reserve must be based on the company’s history with returns; the sales revenue may not be recorded if no such history exists.

Beginning with the first quarter of 1997, Sunbeam began offering its customers discounts and other incentives if they placed their orders in the current period rather than holding off until the next period. Sunbeam did not disclose its practice of accelerating expected sales from later periods in its financial statements, however. In the other quarters of 1997, Sunbeam also allegedly relied on additional price discounting and other incentives in an attempt to accelerate recognition of revenue from future periods.3 One example of a special arrangement with a customer took place at the end of March 1997, just before the first quarter closed. Sunbeam recognized \($1.5\) million in revenue and contributed \($400,000\) toward net income from the sale of barbecue grills to a wholesaler. The contract with the wholesaler provided that the wholesaler could return all of the merchandise, with Sunbeam paying all costs of shipment and storage, if it was unable to sell it. In fact, the wholesaler wound up returning all of the grills to Sunbeam during the third quarter of 1997, and the wholesaler incurred no expenses in the transaction.4 In December 1997 Sunbeam devised a “distributor program” that would help improve the company’s sales. The program was designed to help Sunbeam accelerate the recognition of sales revenue for merchandise it placed with distributors in advance of actual retail demand. Sunbeam allegedly used favorable payment terms, discounts, guaranteed markups, and, consistently, the right to return unsold product as incentives for distributors to participate in the program.
The sales under the distributor program represented a new distribution channel for the company. Therefore Sunbeam was unable to set an appropriate level of reserves for any returns.5 In the second quarter of 1997 Sunbeam recognized \($14\) million in sales revenue from bill and hold sales. By the fourth quarter Sunbeam had recognized \($29\) million in revenues and contributed an additional \($4.5\) million toward net income in bill and hold sales after it began promoting its bill and hold program.
In all, bill and hold sales contributed to 10 percent of the fourth quarter’s revenue.6 At year-end 1997, Sunbeam disclosed in its annual filing to the SEC that “the amount of [the] bill and hold sales at December 29, 1997, was approximately 3 percent of consolidated revenues.” It did not disclose the extent to which the bill and hold sales had been booked in the final quarter.

Case Questions

1. Consider the principles, assumptions, and constraints of Generally Accepted Accounting Principles (GAAP). Define the revenue recognition principle and explain why it is important to users of financial statements.

2. Provide one specific example of how Sunbeam violated the revenue recognition principle in this situation.

3. As an auditor, what type of evidence would you want to examine to determine whether Sunbeam was inappropriately recording revenue from special discount sales?

4. Identify one action that the audit committee of Sunbeam could have taken to help ensure that revenue recognition fraud would not have occurred.

5. Consider a customer that receives extraordinary discounts and terms to purchase merchandise at the end of the year (e.g., the wholesaler that purchased grills from Sunbeam). Do you believe that a customer has a moral obligation to report these actions to a company’s audit committee? Why or why not?