Accounting and Auditing Processes
March 4, 2000
Writing Assignment #1
Revenue Recognition Policies
The purpose of this paper is to compare the revenue recognition policies of two companies in the search, detection, navigation, guidance, and aeronautical systems industry. The two companies I have selected are Aerosonic Corporation, and Esco Electronics Company.
Esco Electronics Company is engaged in the design, manufacture, sale and support of engineered products. These products are used principally in filteration/fluid flow applications, electromagnetic compatibility (EMC) testing, and electric utility communications and control systems. The filtration/fluid flow and EMC testing products are supplied to a broad base of industrial and commercial customers worldwide. At the present time, electric utility communications systems are marketed primarily to customers in North America. The four primary industry segments of Esco are Filtration/Fluid Flow, Test, Communications, and other.
In order for Esco to conform with generally accepted accounting principles, management must make careful estimates in preparing the financial statements. These estimates are for anticipated contract costs and revenues earned during the life of the contract. These amounts affect the reported amounts of assets and liabilities on the company’s financial statements. Actual results could differ from these numbers.
Revenues are recognized on commercial sales when products are shipped or when services are performed. Revenue on production contracts are recorded when specific contract terms are fulfilled. These amounts are determined either by the units of production or delivery methods. Revenues from cost reimbursement contracts are recorded as costs are incurred, plus fees earned. Revenue under long-term contracts in which the previous two methods are inappropriate, the percentage-of-completion method is used. Revenue under engineering contracts are generally recognized as certain “milestones” are attained.
The percentage-of-completion method recognizes a portion of the estimated gross profit for each period based on progress to date. Progress to date is based on three factors. These three factors are the costs incurred to date, the most recent estimate of the project’s total cost, and the most recent gross profit percentage. Progress to date is assumed to be the proportion of the project’s costs incurred to date divided by total estimated costs. This fraction is known as the estimated percentage of completion, and is the estimated percentage of completion. However, he biggest flaw with this method is that it only deals with costs. This means that there may not be strong correlation between physical progress and costs incurred. Conceptually, one would want to match revenues when the earnings process is judged to be complete. Since costs don’t necessarily mean physical completion, the revenues may not represent actual completion. However, this method does match all revenues with appropriate expenses. The audit risks associated with this method is that cost incurrence could be accelerated to increase the estimate of the percentage completed.
Let’s say Esco is performing a three-year contract. For simplicity, let’s say the contract price is $1000. The first year of the contract, actual costs incurred to date is $200, and the estimated remaining costs is $400. This would call for a projected $400 gross profit on the entire project ($1000-$600). To figure out the gross profit for the first year, you would take the actual costs to date ($200) and divide that by the estimated total cost ($600). This equals the estimated percentage of completion (33%). You would then take this number and multiply it by the total project gross profit (33%*$400), and that would be the gross profit earned to date. In subsequent years, you would take the profit earned to date and subtract from it the gross profit recognized in previous years.
The next company I’d like to talk about is Aerosonic Corporation, who is in the same industry as Esco. The primary business of Aerosonic Corporation is to manufacture and sell aircraft instruments to government and commercial users from its plants in Florida, Virginia, and Kansas. Prior to 1996, the company also sold non-munitions components for artillery projectiles to the U.S. government and automotive and truck parts to commercial customers. The company’s customers are worldwide.
Aerosonic generally recognizes revenue from sales of its products on the accrual basis on the date such products are shipped. In certain circumstances, the U.S. government accepts title of products, even though the products are on the Company’s premises. When the U.S. government accepts title in writing, and assumes all risks associated with those products, then the Company records these items as sales. Like Esco, Aerosonic follows the percentage-of completion method to account for long-term engineering contracts. Revisions in costs and revenue estimates are reflected in the periods in which the revisions are made. Provisions for estimated losses are determined without regard to the percentage-of-completion.
Like Esco, Aerosonic’s financial statements are based heavily on management’s estimates. To auditors, this raises a red flag. Auditors must be careful when conducting the audits of these particular companies. It is rather easy, and conceivable for management to manipulate earnings to meet projected totals. Another important area is that a company like Aerosonic has one major customer, and that is U.S. government. Another important factor is that Aerosonic recognizes revenue when title transfers to the government. Since the two parties are closely related in a business sense, Aerosonic may have the incentive to push titles of products to the government to meet target revenues. Auditors should take care in determining whether or not the financial statements conform generally accepted accounting principles.