Issues with revenue recognition and insights gained

Issues with revenue recognition and insights gained

Question

Kendall Square Research Corporation (KSQR)

Main problem

Founded in 1986 by Henry Burkhardt III, Kendall Square Research Corporation (KSR) developed supercomputers for markets primarily targeted at government universities, research laboratories, and commercial users. In the fall of 1991, the company shipped its first machine to Oak Ridge National Laboratory.

The main idea behind the KSR supercomputer was to build more computing power at a lower cost by connecting a large number of cheap minicomputers and dividing the computational tasks among them. The company succeeded in this approach by turning a small computer into a supercomputer by adding processors, memory and input/output devices (KSR case study).

KSR’s first problem was a misidentification of its target market. As mentioned above, the company included commercial users as its target market and increased its business market estimate to $31 billion, but its actual business market was the science and research market, estimated at $4 billion.

His second problem with the company was choosing the wrong revenue recognition policy. From the outset, KSR has elected to recognize revenue upon written customer acceptance of products before payment is made. Criteria questioned and criticized for being too liberal (KSR case).

Some laboratories that had contracts with KSR received the machines free of charge. Additionally, some of these labs were awaiting research grant approval, while others were applying for research grants, so there was no guarantee of payment.

Some contracts had to be canceled if no customers were found or if Phase 2 was canceled but revenue was recognized. KSR’s policy of recognizing revenue so early was not the right policy to develop and implement as funds recognized significantly exceeded cash collected from customers (KSR Case Study) .

Financial Accounting Standards Board (FASB) position:

In accordance with Generally Accepted Accounting Principles (GAAP), sales are recognized when incurred and collection is reasonably certain (Reimers, March 2010, p. 515). KSR violated this principle by recording income without adequately securing recovery.

As explained above, some labs had no grants or research permits. As such, the funds were not guaranteed and KSR was unsure if they would be paid.

The above revenue recognition principles have been misleading for businesses, resulting in the need for FASB, GAAP and the International Accounting Standards Board (IASB) to make improvements and issue new guidance on financial reporting. The main purpose of the new guidance is to specify the nature, amount, timing and uncertainty of contract revenue.

Position of the Financial Accounting Standards Board (FASB).

Figure 1 Source: FASB.org

Applying the new FASB standards to KSR required the company to disclose contractual uncertainties, which created uncertainty in revenue collection. Early recognition of revenue is not an issue under the new standard because revenue is recognized when each stage of the obligation is completed (FASB.org).

Revenue Recognition Status

This case study uses the Federal Mortgage Mortgage Corporation (Freddie Mac) as an example of manipulating earnings and misleading investors about their true performance and profitability.

In September 2007, the Securities and Exchange Commission (SEC) indicted Freddie Mac on securities fraud charges for improper revenue management from 1998 to 2002. The company misreported its net income and pressured accounting firms to conceal its continued steady and steady growth (SEC.gov). What’s interesting about the Freddie Mac case is that the company underestimated its $5 billion in sales, not overstated it. When interest rates declined in 2000 and 2003, the company instead purchased bonds and derivative contracts that should have been recognized and reported in ordinary income under GAAP standards. The company deferred revenue recognition to later years, resulting in deficiencies in accounting practices (Jickling, November 2007).

Table 1 Source: Jickling, November 2007

Revenue recognition can be dangerously used as a revenue manipulation tool by accounts that under- or over-report. Both practices violate FASB and GAAP.

Lesson Learned

To avoid violations of FASB and GAAP principles and standards related to revenue recognition, businesses should review their accounting entries to find unsubstantiated errors and willful misconduct. This may be accomplished by hiring a senior accountant whose job it is to check the entries before submitting the accounts.

In addition, boards and senior management should be more involved in financial disclosures from companies, rather than relying solely on accountants and CFOs.

Returning to KSR’s case, there was no guarantee that the company would receive payment from its customers, so KSR should have recognized an expected amount based on its allowance for doubtful accounts. In any event, KSR should not recognize revenue until payment is received.

Subtracting the ‘provision for bad debts’ amount from the receivables gives the company’s actual expected earnings (Bragg, November 2018). The allowance for doubtful accounts allows you to recognize sales without recognizing revenue, thereby increasing the accuracy of your financial statements. Instead, the company records expected earnings separately from actual cash received and provides information on actual earnings from sales (Bragg, December 2018).

This is done bi-directionally. If we receive payment in advance, that money should be recognized as a liability, not income, until the liability is settled under the new GAAP standards. If goods or services are provided without payment, some form of security must be provided to secure revenue. Otherwise, it should be recorded as expected revenue under the allowance for bad debts, but that revenue should not be recognized until payment is received.