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services to be delivered to the customer. The second criterion focuses on uncertainty
over whether cash is likely to be received. If both these criteria are satis¬ed, revenue is
recognizable.
For corporate managers and external users of ¬nancial statements, the above two cri-
teria are likely to generate questions about whether effective business processes or third-
party contracts are in place to manage the inherent risks. For example, ¬rms can manage
the risk that substantially all the goods and services have been delivered to the customer
through effective quality programs to reduce the risk of product returns and warranties,
or by sales contracts that limit customer returns and warranties. The collectibility risk
can be managed through effective credit analysis or by transferring receivables to a third
party.
Managers are likely to have the best information about the processes in place to man-
age revenue risks, but they are also likely to have incentives to manage reported earn-
ings. Consequently, analysis of revenues helps ¬nancial statement users independently
assess the reporting risks underlying revenues. Also, under accounting rules, a transac-
tion either satis¬es or does not satisfy the revenue recognition criteria. Revenue analysis
allows ¬nancial statement users to better understand where on the “product/service de-
livery“collectibility” continuum a transaction lies.
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There are several ways that ¬nancial statement users can analyze the uncertainties as-
sociated with revenue recognition. They can evaluate the processes used to manage risks
that revenues are unearned or uncollectible, such as quality programs and credit analy-
sis. They can also analyze a ¬rm™s track record in managing these types of risks. Finally,
they can analyze management™s ¬nancial reporting incentives in a particular period.



REVENUE REPORTING CHALLENGES
To provide a deeper understanding of how to analyze revenue recognition risks, we
discuss challenges in implementing the revenue recognition criteria. Although we use
speci¬c industries or transactions to illustrate the implementation challenges, the con-
ceptual issues apply at a general level.


Challenge One: Customers Pay in Advance
For some businesses, customers pay in advance of receiving the service or product. Ex-
amples include magazine subscriptions, insurance policies, and service contracts. For
these types of products, there is no uncertainty about collectibility. The only question is
when the revenue will be earned.
If revenues are recognized prior to the service delivery process, there is a risk that
subsequent costs incurred are larger than expected, particularly if dissatis¬ed purchasers
demand additional work or reimbursement from the seller. Indeed, given management™s
reporting incentives, users of ¬nancial reports are likely to be concerned that early rev-
enue recognition provides management with the opportunity to boost current earnings
by shading product quality and underreporting the cost of returns, reducing the credibil-
ity of ¬nancial reports. Of course, if accountants wait for all uncertainties associated
with sales to be fully resolved, ¬nancial statements are likely to provide tardy informa-
tion on the ¬rm™s performance.
Below we discuss revenue recognition rules for service contracts and property-casu-
alty insurance policies. These examples illustrate revenue recognition issues for con-
tracts where cash is received prior to product delivery or provision of the service.

EXAMPLE: SERVICE CONTRACTS. Many ¬rms provide service contracts for prod-
ucts that they sell. In some cases, they actually charge customers a fee for the service
contract. For example, some consumer electronics chains sell service contracts sepa-
rately from the sale of the product. Customers then pay a fee to secure protection for an
extended period. In other cases, the service contract is included as a part of the purchase
price of the product. Such is typically the case for manufacturers™ warranties on new
automobiles.
How should revenue be recognized on these contracts? Should they be recorded at the
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sale of the product, prorated over the warranty period, recognized when service is re-
quired, or deferred until the end of the contract period?
Let™s ¬rst consider cases where the service contract can be purchased separately from
the product. At this time, the product sale can be recognized; but since product servicing
has yet to be provided, there are likely to be many uncertainties about the frequency and
cost of future service claims. As a result, generally accepted accounting principles re-
quire ¬rms to record service revenues during the contract period rather than when the
contract is signed.
For service contracts that are included as a part of the purchase price, it is dif¬cult to
separate the price of the product from the price of the warranty. They are sold as a pack-
age. Indeed, some customers may buy the package primarily because of the service
agreement rather than the product itself. For such sales, the seller typically recognizes
revenue at delivery of the product or service. Most of the uncertainties associated with
the sale (collectibility and the product™s cost) have been resolved at this point. The only
outstanding uncertainty is the future service contract claims against the seller. If the fre-
quency and cost of claims can be predicted with reasonable certainty, revenues from the
bundled product and service are recognized at the sale of the product. An estimate of the
expected cost of servicing the contracts is then recorded as an expense.

EXAMPLE: PROPERTY CASUALTY INSURANCE POLICIES. Property casualty com-
panies provide policyholders with insurance against certain risks, such as property dam-
age from ¬re or natural disaster, automobile damage from an accident, or personal injury
as a result of accidents. Policyholders typically pay insurance premiums at the beginning
of the coverage period. Claims are then reported when damage or injury occurs.
When should property casualty ¬rms recognize revenue on insurance contracts? Rev-
enue could be reported when a customer is billed or pays. Alternatively, it could be rec-
ognized during (or at the end of) the contractual coverage period. Finally, it could be
recognized when the costs of meeting reported claims are known or payments are made.
Property casualty ¬rms face no collectibility risk, since premiums are received from
policyholders at the beginning of the contract period. However, as discussed in Chapter
5, there are considerable uncertainties about the timing and cost of the claims to be cov-
ered. Some claims are not reported until subsequent periods. In addition, the amounts of
the payments due for current and unreported claims are often not resolved for several
years. Given these uncertainties, a case could be made for deferring revenue recognition
until there is assurance that all claim reports have been made and the cost of the claims
is known. However, insurance companies are in the business of managing risk. They hire
actuaries to analyze the historical frequencies and costs of claims. Given these estimates
and the law of large numbers, property casualty ¬rms are able to make reasonable esti-
mates of expected claim costs. As a result, SFAS 60 requires that they recognize revenue
during the contract period and make an estimate of the expected costs of meeting both
reported and unreported claims for that period.
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Key Analysis Questions
When customers pay in advance of delivery of a product or service, accounting
rules typically require revenues to be deferred. However, if revenues can be rec-
ognized, managers are required to make reasonable forecasts of the costs of deliv-
ering the product or service. This raises the following questions for ¬nancial
analysts:
• Are management™s costs estimates comparable to those for prior years? If
not, why does management expect costs to be unusually high or low? For ex-
ample, has the firm changed its marketing strategy, or has there been a change
in the mix of its customers?
• How accurate have management™s estimates been for prior years? Does the
firm appear to systematically over- or underestimate these types of costs?
• How do the firm™s estimates compare to those for other firms in the same line
of business? If there are differences, does the firm have a different strategy
from its competitors that could explain the cost differences. For example, are
there differences in customer base, location, or product mix that are consis-
tent with the cost estimate differences?




Challenge Two: Products or Services Provided over Multiple Periods
It can also be dif¬cult to assess whether to recognize revenues for products or services
that are provided over multiple years. These may or may not be paid in advance. Exam-
ples include long-term construction contracts and airline ticket sales with frequent ¬‚yer
miles attached. The challenge for these types of contracts is to decide how to allocate
revenue over the contractual period.
Typically, long-term contracts face two types of uncertainties: (1) a risk that purchas-
ers will be dissatis¬ed with the quality of future work or service and demand additional
work or reimbursement, and (2) a risk that the cost of providing the future service will
be greater than anticipated. Both these types of risk raise concerns for ¬nancial state-
ment users that revenue recognized prior to full completion of the service provides a
misleading indicator of the value created by the completed product or service.
How, then, should revenues be recorded on these types of contracts? Should they be
recorded as the service is being performed or the product manufactured, which presum-
ably helps external readers of ¬nancial reports assess interim results? Alternatively,
should revenues be deferred until the full product or service has been completed and all
uncertainties have been resolved?
Below we discuss long-term construction contracts and frequent ¬‚yer contracts to
better understand the issues and the way that they are typically handled in ¬nancial
reporting.
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EXAMPLE: LONG-TERM CONSTRUCTION CONTRACTS. In February 1999, Turk-
menistan awarded a $2.5 billion contract to an American consortium that included Bech-
tel Enterprises and General Electric to build a pipeline for bringing natural gas out of the
Caspian Sea region. How should revenues under this contract be recorded? Conceptu-
ally, two methods can be considered. The more conservative method, the completed con-
tract method, records the revenues when the contract is actually completed. Bechtel and
GE would then show costs of construction as an asset, Construction in Progress, until the
construction is complete. These costs would then be matched against the $2.5 billion of
revenues.
The second approach, the percentage of completion method, recognizes revenues on
a contract as construction progresses. The percentage of construction progress for a
given year is estimated by the ratio of construction costs incurred during that year rela-
tive to total estimated costs of contract completion. This percentage of total contract rev-
enues is then recognized as revenues for the year. Construction costs for the year are
actual costs incurred.
Under U.S. GAAP, construction ¬rms are expected to use the percentage of comple-
tion method if “estimates of the cost to complete and extent of progress toward comple-
tion of long-term contracts are reasonably dependable” (Accounting Research Bulletin
45). Of course, implementation of this rule requires management judgment, potentially
creating an opportunity for earnings management.
In the Bechtel-GE example, the consortium faces many uncertainties. Funding for the
pipeline is unlikely to be ¬nalized until the former Soviet republic solves a territorial dis-
pute with Azerbaijan, and until the ¬ve Caspian Sea nations (Turkmenistan, Azerbaijan,
Kazakhstan, Russia, and Iran) agree on the division of the sea™s rich reserves, potentially
delaying the start of construction. These uncertainties imply that there are also likely to
be serious political risks associated with the project that could cause delays and cost
overruns once construction begins. As a result, Bechtel and GE are likely to have to
record the transaction under the completed contract method.

EXAMPLE: FREQUENT FLYER MILES. As discussed in Chapter 5, most airlines
have frequent ¬‚yer programs that enable customers to earn awards for free ¬‚ights, ¬‚ight
upgrades, hotel stays, and car rentals. For example, under United Airlines™ Star Alliance
reward system, passengers earn one free mile for each mile ¬‚own on United or its partner
airlines (Air Canada, Lufthansa, SAS, and Thai). Passengers who ¬‚y for 25,000 miles
can redeem their bonus miles for a free economy class round-trip ticket within the con-
tinental U.S.
Given its frequent ¬‚yer program, how should United record the purchase of a round-
trip ticket from London to Boston for $750? This ticket sale provides the passenger with
round-trip passage from Boston to London. But it also provides the passenger with 5000
bonus miles.
Two methods of recording the ticket sale can be considered. The ¬rst views passen-
gers as purchasing two tickets”the ¬rst for a ¬‚ight at the time the ticket is purchased,
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and the second for a possible ¬‚ight at some future date. Under this approach, revenues
are split between those earned for the current ¬‚ight and those deferred to the future in
the event the passenger redeems the bonus miles for another ¬‚ight. The second approach
views the award miles program as a form of promotion to attract passengers and records
the incremental costs expected to be incurred to provide the promotion service, such as
fuel, baggage handling, and meal costs. This method was discussed in Chapter 5. Both
methods are used by airlines throughout the world. United Airlines uses the second
method, the incremental cost approach.


Key Analysis Questions
Accounting for products or services provided over multiple periods is particularly
challenging when revenues are recognized prior to completion of the product or
service. Managers are then required to either forecast the costs of completion or
estimate revenues that are earned and those that are deferred. These challenges
raise the following questions for ¬nancial analysts:
• What are the risks associated with working on multi-period contracts? These
could include political risks, weather risks, competitive risks, forecasting
risks, and so forth. How is the firm managing these risks? What is its track
record in managing these risks? Are the risks likely to be severe enough that
the firm should defer recognizing revenues until the project is completed?
• How does management break apart current period revenues from future rev-
enues in multi-period contracts? What assumptions and estimates are inher-
ent in this analysis? What is the basis for these estimates? Are they based on
historical data or industry data? How relevant is the data used for this analy-
sis? Has the firm changed its strategy or operations significantly over time?
Does it follow a different strategy from its competitors?
• Does accounting require management to forecast the full cost of a multi-pe-
riod program? If so, what types of costs are included in the analysis and what
types are excluded? What information does management use as a basis for
their forecasts”internal budgets, industry data, historical data, etc.? How ac-
curate have management™s forecasts of costs been for prior years? If cost

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