Recognition Position Paper Uop

Introduction

Team D Consulting was hired to provide consultation and describe recommendations for recognizing revenues and expenses for a company that manufactures aircraft

. The aircraft manufacturing company is called Murugesh. Murugesh is situated in Springfield in Denver. CEO of Murugesh asked Team D to come up with recommendations for recognizing revenues and expenses that are related to Murugesh. The recommendations are to be based on discussions on issues such as, revenue recognition methods, expense recognition methods, expensing of stock options and justifications for each of the recommendations. We have studied our task, done research to gather relevant information on the business that we are focusing on. And, as a result, we are hereby presenting our recommendations and justifications for each choice.

Revenue Recognition Method

Within Generally Accepted Accounting Principles (GAAP), there are multiple ways to recognize revenue. Depending upon which method is chosen, the financial statements may look drastically different even though economic reality is the same. It is very important to choose the appropriate revenue recognition method for a company. Irrespective of the method chosen, it is very critical not to report the revenues prematurely. This is what the Chief Accountant of SEC Lynn Turner mentioned in her remarks in 2001.

"the COSO Report notes that over half the frauds in the study involved over-stating revenues by recording revenues prematurely or fictitiously. These results are consistent with a study published in the August 2000 report of the Panel on Audit Effectiveness (also known as the "O'Malley Report") entitled, Analysis of SEC Accounting and Auditing Enforcement Releases, which found that approximately 70% of the cases in the study involved overstatement of revenues - again, either premature revenue recognition or fictitious revenue." (Turner, 2001)

Our company is in the business of manufacturing aircraft

. It takes years for us to deliver the product to our customer after the order is placed. Revenue recognition method on sales basis does not makes sense to our company. Under the sales basis method, revenue is recognized at the time of sale while the company takes years to deliver the product to the customer. We need to show our shareholders that we are generating revenue and profits even though the project itself is not yet complete. As a result, we should use the percentage of completion method for revenue recognition. We need to make sure two important conditions are met: There should be a long-term legally enforceable contract and we should be able to accurately estimate the percentage of the project complete.

Percentage of completed work can be estimated in terms of certain milestones or in term of cost incurred to estimated total cost. For our company it will be very difficult to quantify the completion percentage based on milestones. Cost incurred to estimated total cost should be the way to go. While utilizing the percentage of completion revenue recognition method, we should be very careful not to prematurely book expenses such as the purchase of raw goods before it is actually used. Until the goods have actually been used in the production cycle, the cost should not be counted. A business that does not make this distinction is prone to overstate revenue, gross profit, and net income for the period as a result.

Criteria for Recognizing Expenses

When working with expense and loss recognition (income statements), you must first determine your income. In order to determine ones income, the criteria for revenue recognition and the principles for recognizing expenses and losses have to be established. These expenses are recognized in the time period when they are paid or they are incurred. There are other expenses that are not recognized as expenses because they relate to future revenues, these expenses are reported as assets. There are three kinds of expense recognition methods: direct matching, systematic and rational allocation, and immediate recognition.

q Direct Matching: Direct Matching is the process by which expenses are related to specific revenues. In this process the revenues that are produced by the sale of goods and reported in the same time period are recognized. Direct expenses include incurred expenses as well as anticipated expenses that are related to revenues of the current period. After a business delivers their goods to customers, there are other costs to deal with that cause loses, these expenses are directly related to your revenues and should be estimated and matched against recognized revenues for the accounting period.

q Systematic and Rational Allocation: Systematic and Rational Allocation involves assets that benefit more than one accounting period. The cost of assets such as buildings, equipment, patents and prepaid insurance, need to be spread across the periods of expected benefit in some systematic and rational way. These expenses are necessary for earned revenue.

q Immediate Recognition: Immediate Recognition expenses are expenses that are not related to specific revenues. They are incurred to obtain goods and services that indirectly help to generate revenues. These goods are used immediately and are known as expenses in the period of acquisition.

When doing expense recognition, accountants rely on the matching principle because it requires expenses to be matched with revenues whenever it is reasonable and practical to do so. To recognize costs for which it is difficult to adopt some association with revenues, accountants use a rational and systematic allocation policy that assigns expenses to the periods during with the related assets are expected to provide benefits such as depreciation, amortization, and insurance. Some costs are charged to the current period as expenses (or losses) merely because no future benefit is anticipated, no connection with the revenue is apparent, or no allocation is rational and systematic under the circumstances. Considering the above methods we are recommending that your company should use the direct matching method for recognizing expenses. This decision was based upon the fact that you are an aircraft manufacturing company. People will always need to fly so your business will be a prosperous one. The demand for aircraft

will be a dominant one. Your company will have contracts with airline companies to build airplanes, so you may not get all of the money up front, and may incur addition expenses while building the aircraft

. Under the direct matching expense method, your company can record those monies that you have not yet received on contracts and even