Revenue recognition is always one of the most important accounting issues under US GAAP. Management is often under pressure to book sales before the end of a period, and salesmen are usually not paid commissions until the sale qualifies to be booked as revenue by the company.
Present US accounting standards (Concept Statement No. 5) require that four conditions exist before revenue is recognized:
1. Persuasive evidence of an arrangement exists;
2. Delivery has occurred or services have been rendered;
3. The seller’s price to the buyer is fixed or determinable; and
4. Collectability is reasonably assured.
This post focuses on the first condition – persuasive evidence of an arrange-ment. The SEC has provided guidance on this point in SAB Topic 13 – Revenue Recognition. The SEC says that if a company has a business practice that uses contracts, then persuasive evidence of an arrangement means a final agreement that has been executed by properly authorized personnel of the customer. In other words, before you can recognize income, you need a contract that is sign-ed by someone with the authority to sign.
Applying this standard to Chinese situations is not always easy. The point of the SEC guidance is that an enforceable contract is required before revenue can be recognized. In China, however, what is needed to make a contract enforceable is different than what is needed in the United States.
China uses rubber stamps with red ink (called chops) as the main means of legally authorizing documentation. Someone in possession of the chop can legally commit the company to contracts. There are cases where an employee has stolen the chops and effectively taken the company hostage, so security of the chops is critical.
For revenue to be recognized on a China contract, the contract must be a final agreement executed by property authorized personnel. But what does it take to make a contact such?
Dan Harris at China Law Blog wrote an excellent summary of what it takes to make a Chinese contract enforceable. In summary:
1. Any agreement chopped with the company chop is binding, regardless of who signs the agreement.
2. Any agreement signed by the legal representative of the company (each company has one legal representative) is binding with or without the chop.
3. Agreements that are not chopped and not signed by the legal representative MAY still be enforceable if the customer establishes a pattern of executing contracts this way.
Dan recommends the belts and suspenders solution of having the contracts chopped AND signed by the legal representative. That would meet the per-suasive evidence of an arrangement test. So should agreements that are just signed by the legal representative. But those contracts signed by another cust-omer employee and not chopped fall into a risky area. Are they enforceable and should the company recognize revenue?
Anyone who has contracted with Chinese enterprises knows how difficult it can be to complete documentation of a transaction. You may sign a contract, but getting the chop or legal representative’s signature may be very difficult. It is also difficult to rely on the argument that the customer has a practice of not using chops or legal representative signatures, since the company will rarely have access to other contracts the customer has signed. Add to that the fact that fake chops are ubiquitous in China and one can understand how hard it is to audit financial statements in China.
US accounting standards for revenue recognition have converged with inter-national standards. The new standards are effective in 2017 for calendar year public companies, and may result in significant changes for companies in some industries. The new standards take a different approach, but in my view will reach the same conclusion for this issue. If a contract is not enforceable, revenue should not be recognized.