3. How would you judge whether a firm is likely to face revenue recognition problems?
Revenue recognition issues are the subjects of headlines in our daily newspapers, primarily because major corporations have recognized revenues that did not meet its revenue recognition rule. For businesses that use cash basis accounting, revenue recognition is a simple process; a sale equals revenue, but not for companies that use accrual basis accounting. The more complex the business, the more specialized the industry, the more difficult the decision becomes for that business as to when to recognize earnings. Revenue recognition is one of the areas where managers can exercise their accounting discretion to achieve certain objectives. By looking at some potential red flags we can see if the company has a revenue recognition problem.
One of the red flags at Lucent Technologies, Inc. is unusual decrease in accounts receivable in relation to sales decrease. During 2000 fiscal year revenue decreased from $10, 256 to $8,713 to $4,939 in a second, third, and fourth quarters respectively (Exhibit 4 - Consolidated Income Statement) compared to accounts receivables which also decreased but at a much slower pace from $10,573 to $10,101 to $9,558 in a second, third, and fourth quarters respectively in the same fiscal year (Exhibit 4 - Consolidated Balance Sheet). This shows that Lucent was "channel stuffing" its distribution channels to record the revenue is earlier periods than they would otherwise be recorded in. We can see this when Lucent recognized revenue on the sale of system that had not been completely shipped and have to lower their revenue by $28 million in the forth quarter of 2000 according to the case "Revenue recognition problems in the communication equipment industry".
Second red flag is increase in inventory in relation to decrease in sales. Decline in sales while a build-up in inventory is an indication that the demand for the firm's product is slowing down,...
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