Word Count: 2681 Justin Denman
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 companys 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 projects total cost, and the most recent
gross profit percentage. Progress to date is assumed to be the proportion of
the projects 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 dont 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.
Lets say Esco is performing a three-year contract. For simplicity, lets 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 Id 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 companys 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 Companys 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, Aerosonics financial statements are based heavily on
managements 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.