Question

25. Revenue recognition is a major accounting challenge. Most industrial and retail firms recognize revenue as earned at the point of sale. More generally, according to IAS 18, revenue from the sale of goods should be recognized when the significant risks and rewards of ownership have been transferred to the buyer, the seller loses control over the items, the revenue and related costs can be measured reliably, and collection is reasonably assured. Revenue from services and long-term contracts can be recognized as the work progresses.

It is often not clear just when these general criteria are met. For example, revenue recognition at point of sale may be a reasonable tradeoff between relevance and reliability in most cases. However, relevance is increased (and reliability decreased) if revenue is recognized earlier than point of sale.

Furthermore, revenue recognition policy may be used by firms to impress investors. For example, firms with no earnings history (e.g., startup firms) and firms that are incurring significant losses or declines in earnings have an incentive to record revenue as early as possible, so as to improve, at least temporarily, the appearance of their financial statements.

Consider the case of Lucent Technologies Inc. (now called Alcatel-Lucent). In December 2000, Lucent restated its revenue for its fiscal year ended September 30, 2000, reducing the amounts (in millions) originally reported as follows:

The vendor financing component of the restatement represents previously unrecorded credits granted by Lucent to customers, to help them finance purchases of Lucent products. That is, the customer sales were originally recorded gross, rather than net, of the credits. The distribution partners’ component represents product

Vendor financing	$199
Partial shipments	28
Distribution partners	452
Total	$679

shipped to firms with which Lucent did not deal at arm’s length, but which was not resold by these firms at year-end. These firms included certain distributors in which Lucent had an ownership interest. The practice of over shipping to distributors is called “stuffing the channels.”

In its 2000 annual report, Lucent reported net income of $1,219 million, compared to $4,789 million for 1999 and $1,065 million for 1998.

Despite these December, 2000 adjustments, on May 17, 2004, the SEC announced charges against Lucent and several of its officers for overstating revenues by $1,148 million in 2000 in order to meet sales targets. The company’s share price fell by 5.5% on that day. Tactics used, the SEC claimed, included the granting of improper credits to customers to encourage them to buy company products, and invoicing sales to customers that were subject to renegotiation in subsequent periods.

Subsequently, Lucent paid a fine of $25 million for “lack of cooperation.” In addition, the company, and some of the executives charged, settled the allegations by paying penalties, without admitting or denying guilt.

Required

a. What is the most relevant point of revenue recognition? The most reliable? Explain. In your answer, consider manufacturing firms, oil and gas exploration firms, retail firms, and firms with long-term contracts.

b. Explain whether or not you feel that Lucent’s original recognition of the $679 million of items listed above as revenue was consistent with revenue recognition criteria? While Lucent was a U.S. company, assume that U.S. revenue recognition criteria are similar to the IASB criteria given in the question. In your answer, consider the tradeoff between relevance and reliability.

c. What additional revenue recognition questions arise when the vendor has an ownership interest in the customer?

Answer 1

a. The most relevant point of revenue recognition is when the income is actually realized or realizable. The most reliable in terms of revenue recognition is the matching of costs and revenues. This is accomplished through accruals and accounts receivable and payable, amortization, and provisions for warranty costs. These accruals “smooth out” cash flows so as to allocate them over the periods to which they relate.

                How does this relate to manufacturing firms, oil and gas exploration firms, retail firms, and firms with long-term contracts is through the accrual process of accounting. It helps all of these firms realize income when the incomes of these goods are transferred to the customer and the expenses incurred during this time are recognized. Net income is the explanation of how current values of assets and liabilities have changed during the period. Under IAS 16, amortization should be charged systematically over the asset’s useful life and reflect the pattern of benefit consumption.

b. I do not feel that Lucent’s original recognition of the above components as revenues that are consistent with the revenue recognition criteria. Lucent knew that it was shipping shipments and recognizing income that was not necessarily income. This is the perfect example of Krispy Kreme doughnuts. Krispy Kreme was charged with channel stuffing at the end of year. Shipping product to its franchisee’s and stores it owned by stuffing the channel. The SEC indicated the CEO, CFO, and COO with the same charges. This once again is because of pure greed.

c. When vendor has ownership interest in the customer then the additional revenue recognition question that arises is with regards to reliable estimation of collectibles. The revenue of the vendor will be biased upwards and this will in turn reduce the likelihood of collection.