REVENUE RECOGNITION: Cases & Effects

REVENUE RECOGNITION:Cases & Effects Dr. AbdullahiYa’u DSc, PhD (Missouri), MSc (Unical), FCFA, CNA, ACCM, ACTI, MCSTA(USA), MIARCP, MPRMIA, mMBA, PMBA, CPSM, PGDEd. DEPARTMENT OF ACCOUNTANCY, KANO STATE POLYTECHNIC, KANO. Being Paper Presented on the Occasion of Mandatory Continuing Professional Development of the Associationof National Accountants of Nigeria (ANAN), 2012 Edition. Association of National Accountants of Nigeria, ANAN

Introduction • Revenue is one of the most important line item and commonly the largest item in the financial statements, but finding the appropriate model to apply in recognizing revenue can be a challenge for even the most seasoned accounting professional. Also revenue recognition is probably the single most difficult issue in accounting. • Revenue can be seen as a product of price times quantity sold over the period reported. Whereas quantity can be easy to determine, the price to use in the equation can be much more complex to find and audit. Aristotle was the first to acknowledge the existence of two values: a trading-value and a utility-value. The utility-value is the amount of consideration (currency units) a person would be willing to pay for a product given the utility he has for it while the trading value is the amount for which this same good would be traded on the market.

Why Worry About Revenue? Selecting the wrong accounting method or one that may be challenged can lead to: • Falling stock prices • Shareholder litigations • Destruction of management’s reputation and credibility --- Startups and emerging firms makes good use of Price to Sales Ratio to convince investors that strong sales will produce profits in the long-run even though these firms are unprofitable or produce little earnings.

Revenue Recognition Principles Net income informs decisions about a) sustainability b) financial strength c) growth capacity Growth can acceptably be determined by comparing net income results over a series of accounting periods made up of similar durations (i.e. monthly, quarterly or yearly). According to Donnelly R. 1999; revenues should only be recognised when, • Payment is assured – assets received readily convertible • Payment is measurable - cash or its claims are received • Payment is earned – goods/services transferred

Volatility of Revenue • The distance existing between earning a revenue and realising a revenue is very significant in accounting • Bad debts to be charged in the future should not be material on sales figures if at all the revenue amount is to be considered fair • Revenue figures are easily manipulative since they are not presented in accumulated form as assets. Also they are easily verifiable at a much later date.

CASES ON REVENUE REPORTING FRAUD: I. THE ZZZZ BEST CO. INC. In the mid-1980s, the company perpetrated a massive financial statement fraud that fooled the auditors of one of the then largest international public accounting firms (Earnst & Whinney), along with ZZZZ Best’s investors, who lost a reported $100 million. The company was a carpet cleaning business started by Barry Minkow out of his parent’s garage when he was 13 years old. Most of the fraud involved recording fictitious revenues and accounts receivable and was perpetrated to inflate the stock price when the company went public five years after its inception. As in April 1997, the company’s market value was over $200 Million but valuations done 3 months later (July) showed that it only had about $0.62 Million net assets. The company claimed to earn most of its revenues through lucrative insurance restoration jobs which involved cleaning and repairing buildings damaged by floods, fires, and other major catastrophes. However, the insurance restoration side of the business was entirely bogus, and only the carpet cleaning side of the company was legitimate (it represented approximately 2 percent of the company’s total revenue according to its fraudulent financial statements).

CASES ON REVENUE REPORTING FRAUD con’d: THE ZZZZ BEST CO. INC When the auditors insisted on physically inspecting one multi-million-dollar insurance restoration site, ZZZZ Best management found a large building under construction and was able to persuade the construction foreman to provide them with keys to the building for a weekend on the pretext that they were with a property management firm and were going to provide a tour to a prospective tenant. Before the auditor’s visit, they placed signs throughout the building indicating that ZZZZ Best was the contractor for the building’s restoration. This building had not been damaged—instead, it was under construction—but the plan went off without a hitch: The auditors were fooled. There’s also another episode in the auditors were fooled with fake subcontractors in the floors of a new building (which costs $1 million) to make the floors look restored. The CEO started serving his 25 years prison term in 1989 after being tried and convicted of 57 counts of security fraud

CASES ON REVENUE REPORTING FRAUD: II. XEROX COMPANY: In July 2002 Xerox revealed that over the past five years it has improperly classified over $6 billion in revenue, leading to an overstatement of earnings by nearly $2 billion. What accounted for the larger part of the fraudulent earnings—was the acceleration of revenue from short-term equipment rentals, which were improperly classified as long-term leases. The difference was significant because according to the GAAP the entire value of a long-term lease can be included as revenue in the first year of the agreement. The value of a rental, on the other hand, is spread out over the duration of the contract. This boosted short-term profits and allowed the company to meet profit expectations in 1997, 1998 and 1999, though it had the effect of reducing earnings during the past two years. In 1998 Xerox reported a pretax income of $579 million, while it should have reported a loss of $13 million. On the other hand, the $137 million loss for 2001 will become a $365 million gain after the manipulation is reversed. Xerox stock rose to a peak of $60 a share in mid-1999, when the company was carrying out the accounting fraud. It has since declined sharply and by July 2002 trading at about $7 - and now after 9 years from the scandal the stock price could only stay at $7.57 by November 2011. Thus it is conclusive that even though fraudulent revenue recognition practices may make a company enjoy short term benefits, the resultant negative effects may quite go long term.

REVENUE RECOGNITION LITERATURE REVIEW THE EARNINGS PROCESS: • Earnings lead to increase in assets of an entity. This could be in the form of CASH or DEBTORS • The processes that link together to make up a revenue generating activity are very important in determining the point at which revenue should be recognised. • Some earning processes are too long to finish such as the design and development process of a commercial airplane that can take 5 -10 years. FINANCIAL REPORTING OBJECTIVES: Un ethical revenue recognition practices are; • Recognising revenue at the time orders are placed • Recognising revenues on goods sent out without order commitment • Backdating invoices NOTE: revenue should be earned when risks and rewards of ownership are transferred to the customer and the vendor has no managerial control over the item of sale

BARTER TRANSACTIONS What will be the fate of transactions that are facilitated by bartering? • If the barter transaction is not considered to be the culmination (or completion) of the earnings process, then the barter transaction is valued at book value of the resource given up. The first sale is just a step along the “earnings process” path; the second product should be recorded at the book value of the first product. With no change in net asset value, there is no increase in resources to drive revenue recognition. • Only when the second product is sold for cash is revenue recognition appropriate (which would reflect the book value plus any profit element). • If two similar assets are exchanged for one another no gain on sales should be recognised – as in the case of swapping apartment buildings between property firms

APPROACHES TO REVENUE RECOGNITION Essentially, there are two approaches to revenue recognition. • Revenue can be recognized at one critical eventin the chain of activities, for example, production, delivery, or cash collection. • Alternatively, revenue can be recognized on a basis consistent with effort expended, a plan that would result in some revenue being recognized with every activity in the chain critical event METHOD CONSISTS OF; --recognition at delivery --recognition prior to delivery --recognition after delivery effort expended METHOD CONSISTS OF; --completed contract method --percentage-of-completion method

APPROACH I: REVENUE RECOGNISTION ON A CRITICAL EVENT Revenues and expenses are all recognized at the critical event, regardless of when they are incurred A critical event is that event after which all revenues and costs be precisely estimated to the final sale, e.g. Production, sales/delivery, cash collection, etc.

A. REVENUE RECOGNISED AT DELIVERY • Normal sales on goods and services are recognised at delivery (delivery being the critical event if payment is realised/realisable and since earning is confirmed by delivery) • In the case of transactions that involve continual delivery (such as rent, interests, leases), revenue is recognised; a) as time passes; or b) as asset is used. • All associated costs should be recognised at the time the revenue is recognised. These include provision for bad debts, cash discounts and warranties (excluding material ones) IN THE CASE OF FRANCHISE SALES………. --if payment is made up front, whole amount to be recognised as revenue --if payments are made on installments, revenue should be recognised on peace-meal basis (based annual payments especially where franchisee’s ability is doubted.

B. REVENUE RECOGNISED BEFORE DELIVERY • Completion of Production In certain situations, revenue can be recognized at the completion of production but prior to delivery. The key criterion for using this method is that the sale will take place without any doubt. The normal criteria for recognizing revenue before sale are; • the sale and collection of proceeds must be assured; • the product must be marketable immediately at quoted prices that cannot be influenced by the producer; and • there must be no significant costs involved in product sale or distribution. This case is common to commodities tradable in exchange markets. Companies with strong demand and assured sales may adopt this methods but the fear of markets changes may make it impracticable for longer periods.

B. REVENUE RECOGNISED BEFORE DELIVERY This is appropriate when there are uncertainties over the costs associated with the remaining activities in the earnings process, collection, or measurement. Revenue from the sale of goods should only be recognized when the risks and rewards of ownership pass from the vendor to the customer If there is a major warranty associated with the sale it may preclude revenue recognition until the task — the risk — is over Recognising revenues may take place at; • Collection of cash; • Collection of each instalment payment; or • Each point collection is made until cost is fully recovered

APPROACH II: REVENUE RECOGNISTION BY EFFORT EXPENDED This approach recognizes revenue as effort is expended along each step in the earnings process. Think about the increase in value resulting from natural causes such as the growth of timberland. This approach to revenue recognition is not practical in the vast majority of situations: imagine trying to figure out how much a forest grew in a year. But it is the only option for some type of transactions such as construction of large ships. Contracts for these projects often provide for progress billings at various points in the earnings process

A. COMPLETED CONTRACT METHOD Revenues, expenses, and resulting gross profit are recognized only when the contract is completed. As costs are incurred, they are accumulated in an inventory account (projects in progress). Progress billings are not recorded as revenues, but are accumulated in a billings on projects in progress account that is deducted from the inventory account (i.e. a contra account to inventory). At the completion of the contact, income is recognized as the difference between the accumulated credit balance in the billings on contracts account and the debit balance in the construction-in-progress inventory account, assuming that the total price of the contract has been billed The completed-contract method ranks high on the qualitative characteristic of objectivity because there is so little estimation involved. BUT it is seen by some as weak in not telling the contractor’s economic activities in a particular year’s income statement

B. PERCENTAGE-OF-COMPLETION METHOD This method recognizes revenue on a long-term project as work progresses so that timely information is provided. Revenues, expenses, and gross profit are recognized each accounting period based on an estimate of the percentage of completion of the project. Project costs and gross profit to date are accumulated in the inventory account (projects in progress). Progress billings are accumulated in a contra inventory account (billings on projects in progress). • MEASURING progress towards completion could be done using; a. input measures – costs or labour incurred and to be incurred b. output measures – results achieved and those expected to be achieved from now to completion Percent complete = Total costs incurred to date . Most recent estimate of total costs of project (past and future) Current period’s revenue = (Percent complete x Total contract revenue) – Revenue previously recognized

CHOOSING SUITABLE REVENUE RECOGNITION POLICY Revenue recognition is the most pervasive and most difficult single accounting policy choice that many companies must face. With such a plentiful supply of alternatives, how can a company choose an appropriate policy? THE CHOICE OF POLICY IS NOT A FREE GAME OF LUCK. • When there is more than one revenue-generating activity, then there may be a different policy for each • A chosen revenue recognition policy must satisfy the general recognition criteria of measurability and probability(its realisation to be highly probable).

ACCOUNTING STANDARDS ON REVENUE RECOGNITION Revenue recognition is specifically dealt with by IAS 11, 18 and 20 jointly approved by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) of the United States in 2002. These standards cover the following basic areas; • sale of goods – general rule applies only • rendering services – plus % of completion to be known • interest, royalties and dividends – plus accrual on passage of time • Multiple elements contracts – plus consider substance of transactions • construction contracts - plus consider substance of transactions • government grants – plus assurance on compliance with govt. conditions Existing standards fail to provide guidance on the following revenue related transactions;Lease agreement, Dividends arising from investments accounted for under the Equity method, Insurance contracts of insurance entities, Changes in the Future Value of financial assets and liabilities on their disposal, Changes in the value of other current assets, Initial recognition from changes in the Future Values of biological assets related to the agricultural industry, Initial recognition of agricultural produce, and Extraction of mineral ores.

CONTEMPORARY ISSUES The International Accounting Standards Board and the Financial Accounting Standards Board (FASB) are currently planning a convergence on revenue recognition to enhance applicability and compliance • The most significantly impacted industries are expected to include: Automotive, Engineering & Construction, Entertainment & Media, Healthcare, Industrial Products & Manufacturing, Pharmaceutical & Life Sciences, Retail & Consumer , Technology, Telecommunications, and Transportation & Logistics.

CONTEMPORARY ISSUES (con’d) The boards have identified the following areas which may be significantly affected: 1. Recognition of revenue based solely on the transfer of goods or services - contracts for the development of an asset (for example, construction, manufacturing, and customized software) would result in continuous revenue recognition only if the customer controls the asset as it is developed. 2. Identification of separate performance obligations - an entity would be required to divide a contract into separate performance obligations for goods or services that are distinct and are delivered at different times. 3. Licensing and rights to use - an entity would be required to evaluate whether a license to use another entity’s intellectual property (for less than the property’s economic life) is granted on an exclusive or nonexclusive basis. If a license is granted on an exclusive basis (for less than the property's economic life), an entity would be required to recognize revenue over the term of the license.

CONTEMPORARY ISSUES (con’d) 4. Effect of credit risk - in contrast to some existing standards and practices, the effect of a customer’s credit risk (that is, collectibility) would affect how much revenue an entity recognizes rather than whether an entity recognizes revenue. 5. Accounting for contract-related costs - the proposed guidance specifies which contract costs an entity would recognize as expenses when incurred and which costs may be capitalized because they give rise to an asset. Applying that cost guidance might change how an entity accounts for some costs.

The Nigerian Scenario • In Nigeria, accounting standards were issued by the defunct Nigerian Accounting Standards Board (NASB) now the Financial Reporting Council (FRC) • It has been critically observed that the standards so far issued in Nigeria and a number of developing countries are less sufficient to tackle the wider diversity in revenue recognition policies (such as by restricting companies from using the completed contract method). • This and related factors could be some of the reasons why multinationals and foreign investors in Nigeria may find it difficult to make comparative analysis with non Nigerian results and also see it unattractive to hire the services of Nigerian accountants especially on financial reporting related assignments. • With the much celebrated adoption of the IFRS in the country, the challenge of having comprehensive standards in Nigeria is not yet over as some weaknesses still do exist in the international standards in the area of revenue recognition as mentioned earlier.

In Conclusion it is important to emphasise the concept of supervision and compliance with applicable standards not only by the quoted companies but also the unquoted ones. This could possibly yield good outcomes if all relevant stakeholders engaged in financial statements integrity enhancement are equitably recognised and involved in the derive against fraudulent and incompetent financial reporting.

In My Words…………… Poor revenue recognition policies are associated with high level financial misstatement frauds and are a sign that investors and all economic actors can easily be fooled on their fortunes. The ZZZZ Best Co. is a good warning for all of us. A time to stop and think………. Do you imagine how many ZZZZ Best Co. models are existing in Nigerian corporate sector today? What the SEC, CBN, NDIC and EFCC are doing about these bad practices? Do Nigerians ever appreciated the COSO outcomes which started in the US since 1987?

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REVENUE RECOGNITION: Cases & Effects