Going to School on Revenue Recognition
I'm a night owl, but once I hit the sack, I'm out like a light for 8-9 hours. In fact, the two things I would say that I do best are type fast and sleep like a log. One recent night was a rare exception, though. I woke up only about two hours into my hibernation and couldn't fall back asleep. After about another hour, I gave up. It was too late to have a toodle, so I decamped to my office and turned on the computer.
The first thing on the web to catch my eye was a blurb in the Chronicle of Higher Education, in which it was reported that the revenue recognition policies of the Apollo Group Inc., the parent company of the University of Phoenix, were the subject of an "informal inquiry" by the SEC's Division of Enforcement. Apollo has declined to provide any further specifics, but their share price declined about 18% around the time of the announcement. Hmm.
I decided to look further into this for three reasons: (1) I thought it might help me get to sleep; (2) I was in the midst of preparing to lead a one-day workshop on revenue recognition, so I could actually benefit by a review of some of the rules; and (3) Apollo's headquarters are in Phoenix, where I live.
What I Found – Before I Went Back to Bed
The first thing I did was to download Apollo's most recent 10-K and to read their description of critical accounting policies on revenue recognition. I also pulled 15 years worth of financial statements in spreadsheet format from a data service.
Here is what I found after a few minutes of perusal:
- Students are billed on a course-by-course basis. But, judging by the ratio of the allowance for doubtful accounts to gross student accounts receivable, 29%, it appears that a significant number of student accounts are eventually written off as uncollectible.
- Upon the first day of attendance, Apollo records a receivable and deferred revenue in the amount of the billing. As I will explain later, I was surprised to learn this; 'executory contracts' are usually not recognized (with the notable exception of capital lease accounting).
- Tuition revenue is recognized pro rata over the duration of the course, which is generally 6 – 9 weeks. As we say in the trade, it appears that Apollo has adopted a 'proportional performance' revenue recognition model. A more conservative choice would be a 'completed performance' model.
- Apollo recently changed its refund policy whereby students who attend 60% or less of a course are eligible for a refund for the portion of the course they did not attend.
- Apollo prepared its statement of cash flows under the direct method through 1997. They switched to the indirect method in 1998. I would have thought that a 'preferability letter' for such a change would have been included in the 1998 10-K, but I was unable to locate one.
What Could the SEC Be Looking At?
It appears that the SEC Enforcement Division received a referral from the Division of Corporation Finance, which reviewed Apollo's most recently filed 10-K, issued a comment letter, and received a reply from Apollo. Corp Fin's comments addressed, among other things, Apollo's revenue recognition policy for refunds, and whether bad debt expense and revenue were both overstated (i.e., certain amounts of bad debt expense should have been treated as reductions in revenue).
My own questions start at a much more basic level than Corp Fin's comments: when, if ever, it would be appropriate for Apollo to recognize revenue prior to the receipt of payment?
Accounting for the Students Who Pay in Arrears
The general rule in GAAP is that revenue cannot be recognized until it is earned, and realized or realizable (see Statement of Financial Accounting Concepts No. 5). The SEC staff has interpreted this general rule in Topic 13 of the Codification of Staff Accounting Bulletins (SAB Topic 13) to mean that four criteria must be met in order for revenue to be recognized. I won't go into all of them, but the last criteria is that "collectibility is reasonably assured." If the probability is 29% that a student won't pay Apollo, can it be said that collectibility is reasonably assured?
Apollo and its auditors might respond by stating that 71% of the billings to students are reasonably assured; moreover, Apollo has accumulated an extensive history of course delivery that enables them to reliably estimate the allowance at 29%.
But, there is no language in SAB Topic 13 that specifically allows Apollo to combine similar arrangements for the purpose of determining whether collectability is reasonably assured. SAB Topic 13 does provides that one can estimate future liabilities for warranties and returns by aggregating similar customer arrangements and estimating an average for the group; however, it did not specifically provide that those procedures were available for non-payments of enforceable claims. Notwithstanding, historic experience may not be all that helpful in determining the non-payment rate in the current economic environment. For companies with low non-payment rates, maybe, but for companies with a 29% payment rate, perhaps not.
I suppose it would have been clearer if SAB Topic 13 stated what was to be accomplished by providing that collectibility must be reasonably assured; and/or had specifically prohibited combining accounts when evaluating the criteria. Nonetheless, the following example may serve to illuminate the SEC's intent.
Take two companies, A and B; they are equally profitable and differ principally in collectibility rate of accounts receivable. Company A estimates its allowance for doubtful accounts to be 2% of gross accounts receivable, and B's allowance is 30%. Both companies discover, after the fact, that the real allowance was only two-thirds of what it should have been: that is, 3% for A and 45% for B. The premature recognition of earnings by Company A may or may not be material, but for B, it will be as cataclysmic to the income statement as was the AZ Cardinals' loss last Sunday, on a final-play touchdown pass, to my son. It could be permissible to estimate an allowance for doubtful accounts for a group of similar arrangements, but it does not seem appropriate to determine that collectibility is reasonably assured on the same basis.
When is Revenue from a Course Earned?
While collectability may be an issue for some arrangements with students, many of Apollo's students pay in advance. The comment in this section apply to all arrangements, regardless of the timing and/or uncertainty of cash flows.
SAB Topic 13 provides that revenue should not be recognized for "delivered elements" (i.e., classes in Apollo's vernacular) if remaining elements to be delivered to the customer are "…essential to the functionality of the delivered … services." The staff created an exception to this rule for undelivered elements that are "inconsequential" or "perfunctory," but it is not applicable if failure to complete the activities would result in the customer receiving a full or partial refund … (or a right to a refund…)." Stated from a balance sheet perspective, the underlying principle is that one is generally precluded from recognizing a receivable that is not backed by an enforceable right to collect it.
I am unfamiliar with the way courses are conducted by Apollo, but I assume that they all end with an evaluation leading to a final grade. In my experience, students will not pay for a course that doesn't provide them with a grade. Grading is an essential function of the service provided, and it is certainly not "perfunctory"; therefore, it would seem that SEC guidance would require Apollo to defer revenue related to a course until a grade is given to the student.
But, to be fair, I did check the revenue recognition policies of a number of other public companies in the same industry as Apollo, and they all recognize revenue in some ratable fashion as courses progress. For me, that is just one more reason why the SEC's investigation of Apollo's revenue recognition practice is significant. It could improve the quality of earnings for an entire industry. (And, by the way, numerous competitors have non-collectibility rates that are roughly the same as Apollo's.)
Accounting for Students Who Drop a Course
The question that the SEC seems to be homing in on is whether Apollo has properly allowed for refunds to students who may drop the course before the 60% point. That also happens to be the only revenue recognition issue that analysts were asking about in Apollo's fourth quarter earnings conference call.
It could be that the analysts and the SEC are both missing the boat. The SEC may believe that Apollo should allocate a portion of the deferred revenue to an estimated liability for refunds. That would initially affect balance sheet classification of liabilities, and it may affect the pattern by which revenue hits the income statement; but it doesn't seem to be that big a deal to me. Yet, it must be said that Apollo's stock price did take an 18% hit around the time of the announcement of the SEC investigation. If the accounting for the new refund policy is the reason for the stock price drop, then so be it.
Other Red Flags
I have two final thoughts regarding items that I noticed in my relatively brief perusal of the financial statements. First, even though the ratio of the allowance for doubtful accounts to accounts receivable is around 30%, the ratio of the allowance to receivables for which Apollo actually has enforceable rights could be significantly higher.
That's because Apollo has a practice of recognizing receivables for which it has no enforceable rights. Recall that Apollo recognizes a receivable and deferred revenue for the price of a course when the student shows up for the first day of class. I suppose Apollo is reasoning that both parties have gone down the road somewhat, but it pretty much looks like an executory contract to me. Be that as it may, the SEC should be asking whether the allowance for doubtful accounts is based on the total reported balance of accounts receivable, or just the portion representing enforceable rights. It makes no sense to me to create an allowance for doubtful accounts (and an offset to bad debt expense) on a 'receivable' that is not owed, and may never become owed if the student drops the course. If Apollo sees it the same way, the ratio of doubtful accounts to enforceable student receivables could be significantly higher than even the 29% reported.
Second, regarding the change in the method of presenting cash flows, it would be a pretty big stretch for an auditor to maintain that the switch in accounting was to a preferable method; the FASB has stated in SFAS 95 that the direct method is the approach they encourage issuers to employ as "the more comprehensive and presumably useful." (para. 119) I sure would like to see the SEC ask Apollo and their auditors about that one.
And, perhaps, here is a Hanukah present to the FASB: Apollo could be their poster child for why the direct method for presentation of cash flows should be required. Would 18% of total shareholder value have been destroyed in one fell swoop, had Apollo reported cash flows to investors using the direct method? Perhaps not, because trends in the amount of cash collected from customers would have been disclosed. The direct method of presenting the statement of cash flows reduces the criticality that investors accurately evaluate the quality of an issuer's revenue recognition policies.
Winding Up
My goal for this posting was simply to raise interesting questions about Apollo's revenue recognition policies. I want to explicitly state that my intention is not to pass judgment on any of Apollo's choices, even though the market may have spoken to that effect by devaluing Apollo's shares.
Indeed, there are many more questions suggested by this case, and they go beyond the specific effects on Apollo. For example, one could consider whether the revenue recognition rules applicable to Apollo's arrangements with students are themselves representationally faithful or appropriate. We might also ask whether a different result would obtain if the revenue recognition rules under IFRS were applied.
Finally, and perhaps most interesting, we could ask how the revenue recognition project being undertaken by the FASB and the IASB jointly has the potential to improve the quality of financial reporting by companies like Apollo. Unfortunately, I am not confident that the proposed approach would be an improvement, but that's for another post.