“Revenue Recognition Woes”
Worldwide Wires (“WW”) is a company that provides computer network and communications services around the globe. The company offers its services either directly to the customer or through a network of partners that are scattered around the globe. Their business model can be compared to that of a principal and an agent, with WW being the former and the partners being the later. The company and the partners enter into 5 year service agreements which give each side has their own rights and responsibilities. Below are just a few key elements of those rights and responsibilities: • The partner has the responsibility to execute the legal contract with the customer • The partner has the responsibility to collecting revenue from the customer • The partner retains the risk of customer bad debt
• The partner is responsible to pay amounts due for services provided by other partners • WW has the right to approve customers
• WW sets the price the customer pays
• WW sets any deviations from standard pricing of products. • WW has the right to invoice the partners for the gross amounts billed to customers. There are a few more, but these are definitely the more important ones. As you can see, WW has a lot more rights than responsibilities. Main Issues
The last bullet point mentioned above constitutes the main issue in this case and it pertains to the age old dilemma of revenue recognition. As we all know, the revenue recognition principle provides that companies should recognize revenue (1) when it is realized or realizable and (2) when it is earned. Sounds simple enough to implement, but in reality the revenue recognition principle is one that can be manipulated and defined in a vast variety of manners. All one has to do is look at the cause of the majority of financial restatement for public companies and the culprit will most likely be revenue recognition. The case that we are looking at deals with the issue of recording revenues gross vs. net of the amounts received by the customers. WW currently recognizes revenue for gross billings to customers and correspondingly recognizes cost of services for the services provided by the partners. The alternative that WW has is to recognize revenue based on the net amount that will be received by the partner. One might state that the effect on net income will be the same regardless of the use of gross or net, and that is true, but the issue here is that total revenues will definitely differ depending on which method is used. The gross method will boost revenues to a higher level as compared to the net method. A good example of why revenue growth is preferred to net income growth can be found from an article in the Financial Times Press written after the dot.com crash of 2001 involving the Priceline: In a 2000 quarterly filing, the company reported revenue of $152 million. Priceline arrived at that figure by grossing up—summing the full amount customers paid for those tickets, rooms, and cars. Like any travel agency, though, the company kept only a small portion of gross bookings—the spread between the customers’ accepted bids and the price it paid to travel and lodging providers. In Priceline’s case, that spread was $18 million, meaning that it claimed $134 million in revenue that it actually passed on to various providers, booking the payments as expenses. Why? Perhaps Priceline’s senior managers actually believed their public pronouncements that as “merchant of record” the company assumed all the risks of ownership. But there is another possible explanation: The rewards that were lavished on companies reporting rapid revenue growth during the Internet boom. Investors paid stratospheric prices for the shares of companies that had never recorded a profit and weren’t likely to do so in the foreseeable future (Financial Times Press). There is a lot to be gained from significant...