Ch' 6 Revenue Recognition

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Ch. 6 - Revenue Recognition
Firms should recognize revenue only when it has
been earned. But when does that occur?
1. When the firm has accomplished substantially
all it must do in order to receive the revenue.
2. Revenue is realized or realizable.
This rule seems to work well in most
circumstances. But there are cases when it
doesnt e.g. software.
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Software Revenue Recognition
What is included in a contract to sell software
systems?
1. The software itself.
2. Service, incuding installation, training,
on-going support, upgrades and enhancements.
When should this contract revenue be recognized?
What are the possible choices?
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Software Revenue Recognition
Possible Choices
1. Aggressive - 100 when contract is signed.
2. Conservative - None until all products and
services have been delivered.
3. Somewhere in between these two extremes.
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Software Revenue Recognition
Because of divergent practices, the AICPA made
the following rule for recognition in 1999
1. Persuasive evidence of an agreement.
2. Delivery has occurred.
3. The sellers fee is fixed or determinable.
4. Collectability is probable.
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Revenue Recognition
In 2000, the SEC got involved in clarifying
revenue recognition for all firms.
The new rules were basically the same as the
AICPA had done for software.
The difference was that the Chaiman of the SEC
had made it clear that he wasnt putting up with
some of the games that were being played.
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Revenue Recognition What Did the SEC Say?
1. Persuasive evidence of an agreement.

• Sales agreement must be in writing and signed
  before the end of the reporting period.

• Contingent sales cannot be recognized.

• Side letters regarding rights of return must be
  considered and made available to auditors.

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Revenue Recognition What Did the SEC Say?
1. Persuasive evidence of an agreement.
What does this mean in practice?

• Channel stuffing does not result in revenue.

• Full disclosure of revenue from related parties.

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Revenue Recognition What Did the SEC Say?
2. Delivery occurred or services rendered.
What does this mean in practice?

• Goods must be in possession of (and accepted
  by) the buyer, or in-transit FOB shipping point
  at end of period.

• The bill-and-hold exception will be closely
  scrutinized.

• Service must have been performed or allocated
  across periods by some systematic and rational
  method.

• Revenues/gains from financing deals must use
  reasonable discount rate assumptions to calculate
  present values.

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Detection Easier Said Than Done...
Read them again!
Read the footnotes!
Compare to industry.
Cash flow from operations start lagging behind
reported income.
Receivables increase faster than revenue.
Unbilled receivables grow faster than billed
receivables.
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Enron Cash flow vs. Net Income
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Topps, Inc. Revenues and Receivables
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LHS Group Unbilled Receivables