Columbia On-Line Networks (the Company) entered into a contractual arrangement with Cheaptalk (the Customer) involving the license and related documentation of the next generation technology developed and patented by the Company related to transmitting wireless communication and data signals. This contract has two phases: the option phase and the operational phase. In the option phase, the Company will provide professional services to allow the Customer to assess the technology’s feasibility before making additional investments for $200,000.
If the Customer elects not to execute the operational phase within 90 days, the Company is entitled to keep the full amount of this consideration and the option expires. Under the operational phase, the Company will receive an additional compensation of $10 million, which is due and payable upon this phase’s execution. There is no doubt that revenue should be recognized in the operational phase. However, during the option phase, revenue recognition becomes an issue.
Revenue is defined as “the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants” by IAS 18. The point when revenue is recognized is the primary issue for accounting for revenues. The CPA Journal (2001) states that: The history of difficulties with revenue recognition in the corporate sector is replete with instances of fraud.
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The purpose of incentive schemes for executives is to align their objectives with those of the owners of the company; this is what people refer to as solving the principal-agent problem. In a company, shareholders are principals and managers are agents. The main argument in favour of stock option plans is that they give executives a greater incentive to act in the interests of shareholders by ...
A March 1999 report sponsored by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission, Fraudulent Financial Reporting 1987–1997: An Analysis of U. S. Public Companies, noted that more than half of frauds involved overstating revenue. Since then, the increase of online business-to-business transactions has led to even more questions about the validity of reported revenue. Generally, revenue is recognized when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably as provided by IAS 18.
The first question to be answered is whether Columbia On-Line Networks should recognize revenue during the option phase? The Company should recognize income during the option phase, since the consideration of $200,000 fits the definition of revenue, per IAS 18, one of the prevailing GAAPs in revenue recognition. The option money of $200,000 is an inflow which results to an increase in equity, not related to owners’ contributions. The next question to be answered is: when should revenue from the option phase be recognized?
Assuming the entire 90-day period lies within one reporting period only, there is no difficulty in revenue recognition. The Company should recognize the $200,000 as revenue at the end of the option period, since this is the point where the probability of the inflow is assured, and can be measured reliably, in accordance with IAS 18. However, revenue recognition becomes more problematic if the option period spans two reporting periods. In such a case, Columbia On-Line Networks should measure the option consideration as revenue according to the percentage of completion method.
This method of revenue recognition is supported by IAS 18 which states that “when the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognized by reference to the stage of completion of the transaction at the balance sheet date”. This standard requires that the following conditions be satisfied before the outcome of a transaction can be estimated reliably: (a) the amount of revenue can be measured reliably;
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Budgets are significant in the budget formulation process. Budgeting as a tool is the make-up of public policy (Smith & Lynch, 2004). Budgets exist at all levels of government, local, state, and federal. When describing revenue sources in public budgeting, it is important to describe the source of revenue, the source of the funding, importance of informed financial decisions, financial ...
(b) it is probable that the economic benefits associated with the transaction will flow to the entity; (c) the stage of completion of the transaction at the balance sheet date can be measured reliably; and (d) the costs incurred for the transaction and the costs to complete the transaction can be measured reliably. The information available at hand is not clear whether the transaction meets the third and fourth requirement previously mentioned. It is not yet known what comprises the “professional services” that will allow the Customer to assess the feasibility of the technology.
Assuming that these professional services are already known and defined, and the costs incurred and to complete can be measured reliably, the company must apply the percentage of completion method. For the first reporting period, Columbia On-Line Networks must report an income equal to the percentage of completion (which is computed by dividing the costs incurred to date by the total estimated cost) applied to $200,000. In the succeeding reporting period, the Company should report the remaining balance of the option money as income.
In case the contractual agreement with Cheaptalk does not meet all the requirements, Columbia On-Line Networks should recognize revenue only to the extent of the expenses recognized that are recoverable, as provided in IAS 18. For the first reporting period, the Company will recognize revenue only equal to the expenses incurred that are recoverable. For the next reporting period, the Company shall recognize as revenue from the option an amount equivalent to the remainder of the $200,000 option consideration not previously recognized as income.
The option consideration should be recognized as revenue since it clearly matches the definition. However, the point of recognition will have to depend on the specific circumstances of the case.
References
IASC Foundation Education. Technical Summary, IAS 18 Revenue. Retrieved April 24, 2008, from www. iasb. org/NR/rdonlyres/1A3771B8-5627-44E4-984E-AC90FEE1A971/0/ IAS18. pdf -. The CPA Journal (2001, March).
The Term Paper on Revenue-Recognition Problems in the Communications Equipment Industry
1) In late 2000, Lucent announced that revenues would be adjusted downwards by $679m as a result of revenue recognition problems. Yet the firm’s market capitalization plummeted by $24.7bn. Why do you think the market reacted so negatively to Lucent’s announcements of the problems? The large drop in market capitalization is probably due to several factors. Historically, Lucent had successfully met ...
Subtle Issues in Revenue Recognition. Retrieved April 24, 2008, from http://www. nysscpa. org/cpajournal/2001/0300/dept/d035001. htm.
