1 Chapter 6: Revenue Analysis

2 Revenue Recognition Criteria Both the criteria should be satisfied: Good and service has been delivered Cash is collected or is reasonably likely to be collected Revenue Reporting Challenges 1.Customer pay in advance of delivery 2.Product/service provided over multiple period 3.Rights to use product/service sold, but seller retains residual rights 4.Credit worthiness of customer questionable 5.Refunds of dissatisfied customers.

3 Revenue Reporting Challenge 1: Customers Pay in Advance For some businesses, customers pay in advance of receiving the service or product. Examples: magazine subscriptions, insurance policies, and service contracts. Early revenue recognition provides management with the opportunity to boost current earnings by shading product quality and underreporting the cost of returned goods, reducing the credibility of financial reports. Service Contracts may be included in the product sale or excluded as a separate contract. If included, it is difficult to separate the price of the product from the price of the warranty. If the frequency and cost of claims can be predicted with reasonable certainty, an estimate of the expected cost of servicing the contract is then recorded as an expense. If the service contract purchased separately, it is difficult to ascertain the sale as the servicing is yet to be provided. As a result, GAAP requires firms to record service revenues during the contract period rather than when the contract is signed.

4 Example 1: Accounting of revenue recognition A car dealer sells a car together with one year’s insurance and one year’s servicing, for $27,000. The fair value of these are: car $28,000, insurance $1,200 and servicing $800. How should the $27,000 be recognized as sales? Solution: Total fair value of the package is $30,000 ($28,000+$1,200+$800) but is sold at $27,000. So a discount of $3,000 or 10% Discounted fair value of the car should be recognized as revenue upon delivery: $28,000x90%=$25,200 The discounted fair value of insurance should be recognized as revenue on a straight line basis over the next 12 months: $1,200x90%=$1,080 The discounted fair value of servicing should be recognized as revenue at the earlier of when the servicing is provided and the end of the year: $800x90%=$720

5 Example 2: Accounting of service revenue A new equipment is sold on January 1, 2008 at $1.5 million with free support services for next 2 years. The cost of support is estimated as $120,000 in total. The gross margin of the firm is 20%. Account closing takes place on April 30, What would be the sales revenue? Revenue: Sale of goods$1,350,000 Sale of services$ 25,000 Total$1,375,000 Working After sales support $120,000/(100%-20%)$ 150,000 Reminder (sale of goods)$1,350,000 Total revenue$1,500,000 Revenue for sale of services recognized in the 4 months to April 30, 2008 is $150,000/2years x 4/12 months =$25,000

6 1.Customers Pay in Advance Key Analysis Question 1. Are management’s cost estimates comparable to those of prior years? If not why? 2. How accurate have management’s estimates been for prior years? 3. How do the firm’s estimates compare to those for other firms in the same line of business?

7 Revenue Reporting Challenge 2: Goods or Services Provided over Multiple Periods It is difficult to assess whether to recognize revenues for product and services that are provided over multiple years. These may or may not be paid in advance. Examples, long term construction contracts and airlines ticket sales with frequent flyer obligations, etc. Risk of Long- term contracts:  Purchaser may be dissatisfied and then demand additional work  Cost of providing the future service may be higher than anticipated Revenue can either be recorded on the basis of percentage of completion or be deferred until the full product or service has been completed and all uncertainties have been resolved. GAAP suggests the use of percentage completion method. This requires management judgment potentially creating an opportunity of earnings management.

8 Example 3: Accounting of cost of construction An entity is involved in a number of construction contracts and has incurred following costs in respect of construction contracts during the year ended March 31, $000 –Labor 632 –Materials1,325 –Design costs for specific contracts 463 –Research costs 321 –General Administrative costs 243 –Borrowing costs 56 –Selling costs 106 –What is the amount of costs which should be allocated to construction contract in the year ended March 31, 2008? Answer: Costs= Labor+ Materials+ Design costs (632+1, ) = $2,420,000

9 2. Goods or Services Provided over Multiple Periods Key Analysis Questions What are the risks associated with working on multi-period contracts? These could include political risk, weather risks, competitive risks, forecasting risks, etc. Does this justify to defer recognizing the revenue until the project is completed? How does management break apart current period revenues from future revenues? What assumptions and estimates are inherent in the analysis? Compare these with the past data of the firm and the current data of the industry. If accounting requires management to forecast the full cost of multi- period program, then what types of cost are included and what are excluded?

10 Revenue Reporting Challenge 3: Outputs Sold but Residual Rights Retained by Seller –Selling receivables to a bank, but bank has the recourse against the seller if creditors fails to pay off the receivables. Is it a sale or borrowing? GAAP suggestion to apportion the risk between the bank and the company makes accounting complex. –Lease (sale or rent?)  For sale type of lease or capital lease, (1) present value of all the lease payments should be the revenue and (2) surplus of residual claim over book value would be treated as profit. Thus, sales revenue would be recognized as the present value of the lease payments. This would also be shown as a receivable under investment on the Balance Sheet. Example: IBM sale of mainframe computer under long term lease agreement.  For operating lease, the rental incomes are revenue throughout the lease term and depreciation of the assets should be the cost.

11 3. Outputs Sold but Residual Rights Retained by Seller Key Analysis Questions What are the residual risks borne by the seller? What factors affect these risks? Does the seller have control over these risks? What have been historical outcomes of risk borne by the sellers relative to forecasts? What has been the seller’s experiences in managing its residual risks relative to the other firms of the industry? If the firm does not have strong track record in managing and forecasting residual risks, it is appropriate to view the transaction as a sale.

12 Revenue Reporting Challenges 4. Credit-Worthiness of Customer –Under seller-financed sales: sale type lease or rental arrangement? Who does bear the risk of obsolesce? –How to measure and manage credit risks of customer –Real Estate transactions require all the following conditions to be satisfied for recognition as revenue : Non refundable down payment of 10% or more Collection experience in similar sales like 90% of receivable is collectable, and so recognize as sales; or 20% or more down payment Receivable is not subject to subordination of new loans No obligation to improve

13 Example 4: Accounting of sales through financing A car seller requiring 20% deposit now and the rest to be paid after 2 years from now. The price of the car is calculated using 10% per annum finance charge. A customer took delivery of a car costing $20,000 on January 1, Show the accounts of revenue and receivables as on Dec 31, Revenue Sales ($4,000+($16,000/((1.1) 2 ))=$4,000+$13,223=$17,223 Financing income=10% on $13,223 =$ 1,322 Carrying amount of receivables = $13,223*1.1=$14,545

14 4. Credit-Worthiness of Customer Key Analysis questions What is the seller’s business strategy and how does the strategy affect its ability to manage credit risk? Like low cost financing for marketing with high prices. Does the firm have detail information of clients and does the firm make use of that? Compare with the past and against the industry.

15 Revenue Reporting Challenges 5. Refunds for Dissatisfied Customers –Magazine and textbook publishers –Product differentiation –Sale is recognized at the point of delivery –Can amount of returns be reasonably estimated in advance? GAAP suggests to recognize the sale at the point of delivery of the product or service plus at the end of the period an estimate is made for the cost of returns based of management judgment. This can be done only if the future returns can be reasonably estimated. Other wise, sales can not be recognized until the return privilege has effectively expired.

16 5. Refunds for Dissatisfied Customers Key Analysis Question How does the selling firm position its business relative to other firms? How does the strategy of the firm relate to the offer? How does the firm manage the return risk? Is the practice consistent with the past of the firm and with the present of other firms in the industry?