guidance for revenue and expense recognition methods, both standard and percentage of completion criteria. It also discusses the pros and cons of expensing stock options.
It concludes with recommendations for a manufacturing company to carry out given this information.
Revenue and Expense Recognition Methods
SEC Staff Accounting Bulletin No. 101 (SAB 101) – Revenue Recognition in Financial Statements summarizes views in applying generally accepted accounting principles (GAAP) to revenue recognition in financial statements (Turner, 2001). SAB 101 is based on four principles established in GAAP. Those principles state that revenue generally is realized or realizable and earned when all of the following criteria are met:
Persuasive evidence of an arrangement exists, 2. Delivery has occurred or services have been rendered, 3. The seller’s price to the buyer is fixed or determinable, and, 4. Collectibility is reasonably assured.
These conditions reflect the simple idea that revenue on a sale should not be recognized until the seller has fulfilled its obligations to the buyer under the sale arrangement. Expenses are recognized in the same period in which the benefits derived from those costs are recognized; this is referred to as the matching principle (Adjusting the accounts). Thus, recognition of expenses is dictated by revenue recognition, so associations between revenues and costs must be established.
The revenue recognition and matching principles mentioned above are used under the accrual basis of accounting (Adjusting the accounts). Under cash-basis accounting, revenue is recorded only when cash is received, and expenses are recorded only when paid. However, GAAP requires accrual basis accounting because the cash basis often causes misleading financial statements. With accrual basis, revenue must be recognized in the accounting period in which it is earned, not just when money is exchanged. In a service business, revenue is earned at the time the service is performed as discussed below.
Revenue from the rendering of services can be recognized by reference to the stage of completion of the transaction when the following conditions are met (Service and construction contract revenue, 2002):
1. The amount of revenue can be measured reliably
2. The flow of economic benefits to the entity is probable
3. The stage of completion at the period end can be measured reliably
4. The costs incurred to date and the costs to completion can be measured reliably
Management should delay the recognition of revenue until the above criteria are met. Revenue might therefore be recognized in certain instances after all conditions of the service or construction contract have been fulfilled, even when the contract spans more than one accounting period.
A straight line basis of revenue recognition should only be used for service revenues when the service is provided by an indeterminate number of acts over a specified time period and when there is no other method available that provides a better measure of the stage of completion (Service and construction contract revenue, 2002). Instead, revenue should be recognized according to the stage, or percentage of completion of the contract. There are different methods that determine the stage of completion that depend on the type of contract. Whatever method is chosen, it must be applied consistently to similar contracts. The most common methods of revenue recognition are:
The proportion of costs incurred for work performed to date compared to the total estimated contract costs
The proportion of physical work performed to date compared to total work required
The proportion of services performed to date as a percentage of total services to be performed.
Expensing of Stock Options
Expensing of stock options is a far more complicated issue. The Federal Accounting Standards Board (FAS) strongly recommends expensing of options and is trying to make it a legal requirement (Rash, 2004).
The pros of expensing options include providing a level playing field so that companies that use cash bonuses and companies that use stock options each have an expense on the income statement (McPeak). and, some believe it will improve corporate governance by reducing the incentives to inflate income and earnings per share.
However, there are many significant challenges for a company that expenses options (McPeak). Many companies have issued options to multiple levels of employees to attract high quality employees and to motivate them. If companies expense options at the time they are granted, it will be difficult to continue to grant options to as many employees. Some feel that there is already a level field between companies that use cash bonuses and companies that use stock options because the shares awarded become outstanding for purposes of calculating earnings per share. Therefore, a company recording an expense for the option as well as upping the number of shares outstanding is taking a double hit to earnings per share. Still others argue that it is futile to make a company record stock option expenses as accounting entries because they have no cash impact and that the behavior of unscrupulous management will never change. Further, there is no universally accepted method to determine the value of a stock option
The manufacturing company should use accrual basis accounting and follow GAAP guidelines for revenue and expense recognition. Stage of completion of the transaction applied to revenue recognition is desirable in circumstances where the company wishes to record revenue as soon as possible to meet earnings forecasts and to have a smoother flow of revenue and expenses over time when there are large contracts, provided the company meets the guidelines for this method.
With regards to expensing stock options, the company might explore the use of stock awards instead of stock options. Unlike stock options, which gain value only if the company’s stock price rises, restricted stock awards represent an actual gift of shares. This would keep the company from becoming a victim of corporate governance critics and being subject to possible forthcoming FASB requirements to expense the options, an expensive and complicated endeavor.
Adjusting the accounts. Retrieved February 9, 2005 from Web site: http://22.214.171.124/search?q=cache:IFCF5xnQ7gwJ:www2.ac.edu/faculty/JDavis/course_files/acc201/ch03.ppt+%22expense+recognition%22+%22matching+principle%22&hl=en
Rash, M.C. (2004, August 6). Considering options. The Business Journal. Retrieved February 9, 2005 from Web site: http://www.bizjournals.com/triad/stories/2004/08/09/focus1.html
Service and construction contract revenue. (2002). PricewaterhouseCoopers. Retrieved February 9, 2005 from Web site: http://www.pwcglobal.com/Extweb/service.nsf/0/829224D1965E9B6A80256C7C0042A50C?opendocument
Turner, L.E. (2001, May 31). Speech by SEC staff: Revenue recognition. USC SEC and Financial Reporting Institute. Retrieved February 9, 2005 from Web site: http://www.sec.gov/news/speech/spch495.htm
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