Issues with Revenue Recognition and Lessons Learned

Kendall Square Research Corporation (KSR)

Main Problem

Kendall Square Research Corporation (KSR) was founded in 1986 by Henry Burkhardt III, designing supercomputers for a target market aiming mainly for the government universities, laboratories and commercial users. The company delivered its first machine to Oak Ridge National Laboratory in fall 1991.

The main idea behind KSR supercomputers was to build more computing power at lower cost by linking many low- cost minicomputers and divide the computer task among them. The company succeeded in its approach by adding processors, memory, input and output devices to small computers turning them to supercomputers (KSR Case Study).

KSR’s first problem was misidentifying its target market. As mentioned above, the company included commercial users as a target market raising business market estimate to $31 billion, whereas the real business market was the scientific and research market with estimate of $4 billion.

The company’s second problem was choosing the wrong policy in revenue recognition. From the beginning, KSR chose to recognize revenue upon written customer acceptance of the product before receiving any payment. Criteria that is been questioned and criticized to be too liberal (KSR Case Study).

 Some laboratories which signed contracts with KSR received the machines without making any payment. Morover, there was no assuarnce of payment as some of these labs were waiting for research funding approval, others requested research grants as well.

Some contracts were to be canceled if a customer could not be foud or if phase two canceled, yet revenue was recognised. KSR policy of recognizing revenue that early was not the right policy to create and follow because money recognized significantly exceeds cash collected from customers (KSR Case Study).

Financial Accounting Standards Board (FASB) Position:

According to General Accepted Accounting Principles (GAAP), revenue is recognized when it is earned and when collection is reasonably assured (Reimers, March 2010, P. 515). KSR defiantly violated this principle as it recognized revenue without having the collection reasonably assured.

As explained above, some labs did not have grants or even research approval; therefore, funding was not guaranteed leaving KSR not sure if it is going to be paid or not.

Revenue recognition principle stated above led to companies’ misjudgment that required FASB, GAAP and IASB, the International Accounting Standards Board, to go through improvements and issue new guidance for financial reporting. The main objective of the new guidance is stating the nature, amount, timing and uncertainty of revenue from contracts.

Financial Accounting Standards Board (FASB) Position

Figure 1 Source: FASB.org

Applying the new FASB standards on KSR would force the company to reveal the uncertainty of its contracts that caused uncertainty in collecting revenue. Revenue early recognition won’t be an issue under the new standards because revenue is recognized when each step of the obligation satisfaction is reached (FASB.org).

Situations on Revenue Recognition

This case study will take Federal Home Loan Mortgage Corporation (Freddie Mac) as an example for manipulating revenue and deceiving investors about its true performance and profitability.

In September 2007 the Securities and Exchange Commission (SEC) charged Freddie Mac with securities fraud for improper earnings management beginning 1998 to 2002. The company misreported its net income and pressured the audit company to cover up for keeping smooth and stable growth (SEC.gov).

What is interesting about Freddie Mac case is that the company underreported $5 billion in revenue rather than inflating and over reporting revenue. When interest rates fell in 2000- 2003 the company bought bonds and derivative contracts that should have been recognized and reported as current income according to GAAP standards, instead; the company postponed revenue recognition until later years resulting incorrect accounting practices (Jickling, Nov. 2007).

Table 1 Source: Jickling, Nov. 2007

Revenue recognition could be used dangerously as a tool manipulating income by under reporting or over reporting accounts. Both practices represent a violation of FASB and GAAP.

Lessons Learned

In order to avoid violating FASB and GAAP principles and standards in terms of revenue recognition, companies must double check their accounting entries to find innocent errors or deliberate fraud practices. This could be done by hiring senior accountants whose job is to review entries before statements submission.

In addition, the board of directors and senior management should be more involved when it comes to revealing companies’ financial information, without leaving this matter merely to accountants and chief financial officers.

Going back to KSR case, since there was no guarantee that the company will receive payments from its customers, KSR should have recorded expected amounts under Allowance for Doubtful Accounts.  In any case, KSR should not recognize any revenue until payment is received.

Subtracting amounts under Allowance for Doubtful Account from Accounts Receivable, the company will have its actual expected revenue (Bragg, November 2018). Using allowance for doubtful accounts supports financial statements accuracy as it records the sale without recognizing the revenue. Instead, the company recognizes expected revenue separately from actual cash collected, providing information about true revenue on sale (Bragg, December 2018).

It goes both ways, in case of receiving payments in advance, the money should be recorded as a liability not as revenue until obligation is satisfied according to new GAAP standards.

In case delivering goods and services without being paid, some sort of assurance should be guaranteed in order to recognize revenue otherwise it should be recorded as expected revenue under allowances for doubtful accounts, but never recognized revenue until payment is received.