William F. Bentz1 Revenue Recognition Revenue recognition is a crucial concept in accounting. It is the stage in the production cycle that revenue--and thus income--is recognized. Premature revenue recognition tends to overstate the profitability and growth prospects of a firm, while very conservative methods tend to understate a firm’s current profitability.

William F. Bentz2 Revenue Recognized When u Revenue is substantially earned –Remaining costs reasonably estimable –Remaining costs and obligations minor relative to total costs and obligations –Critical event has been completed u Revenue is realized in –Cash, or assets easily convertible to cash –Collections are reasonably estimable

William F. Bentz3 Examples u Sale of a car with warranties u Sale of house with warranties u Completion of a software project u Sale of clothing when returns accepted

William F. Bentz4 Revenue Recognition u For revenue to be recognized, it must be both earned and realized (or realizable). Both conditions must be met before there is realization. A few revenue recognition practices are industry- specific, but the criteria for recognition are universal.

William F. Bentz5 Consider the Collection Issue u Realization is deemed to have occurred if the seller has received a valid claim to a determinable amount of money subject to reasonable payment terms by a buyer that is capable of paying the amount due.

William F. Bentz6 Consider the buyers u Without a financially sound buyer, we do not have realization even if all the other terms are met. Consider the example of Prosoft I- Net Solutions, Inc.

William F. Bentz7 Practical Example u Prosoft and their auditors, Ernst & Young are parting company. Prosoft-I E&Y

William F. Bentz8 Prosoft/E&Y Issues “...Under the accrual method of accounting, the Company reported the entire amounts to be received under those contracts as revenue in the quarter in which the contract was entered into, based on the terms and conditions of such contracts. The Former Accountants raised concerns as to whether these contracts with the two customers represented currently recognizable revenue and income under generally accepted accounting principles. Of particular concern to the Former Accountants was the lack of information available to evaluate the creditworthiness of these customers.” Form 8-K, dated 4/6/1998

William F. Bentz9 Disposition u Cash basis adopted for recognition of licensing contract revenue u Ernst & Young LLP no longer to serve as Prosoft's independent auditor

William F. Bentz10 Earning Revenue u What is the earning process and what does it mean for the earning process to be “substantially complete”?

William F. Bentz11 Cash Buy Land Buy Materials Build House Sell House Close Sale House Construction Cycle

William F. Bentz12 Get Cash Buy Land Buy Materials Plant Crop Harvest Sell Crop Grain Farming

William F. Bentz13 Get Cash Hire people Proposals Sign Contract Design Appl. Code Appl. Software Development Testing Customer Acceptance

William F. Bentz14 Long-term Contracts u Many projects take more than a year or two to complete. Since many of these projects involve the provision of goods and services in accordance with a contract, they are called long-term contracts. They are long-term when the operating cycle is over 1 year.

William F. Bentz15 Examples u Construction of office buildings u Construction of a factory u Fabrication of equipment such as the luggage-handling equipment in the Denver Airport u Development of enterprise software systems.

William F. Bentz16 Examples u Building a cruise ship u Constructing a power plant u Making an animated film

William F. Bentz17 The Reporting Problem u The problem is that a company’s main activity may involve relatively few large projects, none of which may be completed in a particular period. How can we report to investors the results of operations if no contracts are completed?

William F. Bentz18 Revenue Recognition - Long-term Contracts Objective: To recognize revenue period- by-period as the revenue from a long-term contract is earned. The key criteria for revenue recognition are still: u Earning of the revenue – Reasonably estimable project costs u Realization –Doubtful accounts estimable

William F. Bentz19 Revenue Recognition Methods u Revenue is recognized on long- term projects on one of two bases: – Completed contract method – Percentage-of-completion method u Annual revenues, expenses, income, and asset values are affected by the choice of method.

William F. Bentz20 Completed Contract Method u With the completed contract method, project costs are accumulated in a Construction-in-Process account. The cumulative cost is matched against revenues when the contract is completed. The amount of revenue recognized is the final contract price.

William F. Bentz21 Percentage Completion Method u With the percentage-of-completion method, a portion of the total contract price is recognized each period. That portion is the percentage of the work completed to date, less the revenue already recognized.

William F. Bentz22 Percentage-of-completion u To use the percentage-of-completion method, one must have some way of determining the percentage of completion for each project! The percentage of the costs incurred, relative to total expected project cost, is one measure of completion.

William F. Bentz23 Calculating the Percent Total project costs incurred to date +Total estimated costs to complete the project or contract

William F. Bentz24 Cost as a Measure of Effort u Warranties & warranty contracts u Construction costs (long-term contracts) u Franchise agreements u Other cases where the amount of revenue can be determined when a contract is signed

William F. Bentz25 Annual Revenue u Annual revenue = [Cumulative revenue earned - revenue recognized previously]

William F. Bentz26 Cumulative Revenue u Cumulative revenue earned = Cumulative cost incurred Total estimated cost X Contract Price

William F. Bentz27 What Investors Can Learn u In many businesses, investors monitor gross margins. u Margins will increase if: –Contract prices are increased by incentives, etc. –Costs are less than expected earlier –New projects are more profitable than earlier contracts

William F. Bentz28 What Investors Can Learn u Margins will decrease if: –Contract prices are decreased by penalties, etc. –Costs are higher that expected earlier –New projects are less profitable that earlier contracts

William F. Bentz29 What Investors Can Learn u Margins will stay the same so long as: –Project costs are consistent with estimates. –Contract modifications do not result in changed project profit margins –New projects are equally profitable as earlier projects.

William F. Bentz30 Important Considerations u Revenue must be known or subject to little variation (i.e., a contract exists and the final price can be reasonably estimated) u The amount of effort (cost) determines the recognition of revenue, not the total contract value. Annual gross margin amounts will vary with the work done, even when the contract price is constant.

William F. Bentz31 THE END