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As consultants analyzing the economic stability of Skeer Manufacturing, it is important in the early stages of implementation that the company follow the recommendations set forth by our team of consultants, of how expenses and revenues are to be calculated to maximize profit. In general, accounting posses a wide ranging set of methodologies that can steer a company in different directions if the correct recommendations are not readily recognized.
Basic revenue recognition is the process of recording revenue under one of the various methods in an accounting period. In the period of revenue recognition, related expenses should be matched to revenue. The most often used method of recognizing revenue is at the time of sale or rendering of service. In addition, when analyzing a service based company like Skeer Manufacturing, the cash basis of revenue recognition is the preferred method industry wide.
Other methods of revenue recognition include during production and the completion of production. Revenue recognition is one of the most difficult problems facing the accounting profession; this problem arises from the difficulty in developing guidelines applicable to all situations. Recognition principle of revenue is recognized when it is realized at the time of sale of merchandise in the retail business or at the time of rendering the service if it’s a service business. During realization the earnings process is complete because the transactions is consummated, and selling price is determinable, cost of sale is known.
You can also determine revenue recognition during sales transactions at the point of sales; an example is cash sales versus credit sales. There’s also a revenue recognition method, which is the percentage of completion. This method recognizes profit on a long-term construction contract as it is earned gradually during the construction period. Under this method, the measure of revenue to be recognized each year is equal to percentage completed times the contract price. Any revenue that had been recognized in a prior period is subtracted from the cumulative total in arriving at the current periods income.
Expense Recognition There are many methods for recognizing expenses. Expenses such as cost of goods are recognized concurrently with the revenues to which they relate within your Manufacturing Company. Expenses such as salaries are recognized in the period in which they are incurred because the benefit is soon after the occurrence. Expenses such as depreciation result from an allocation of the cost of an asset to the periods that are expected to benefit from its use. Each expense is incurred to support the revenue-generating process.
Learn under what circumstances should a company’s management team give serious consideration
Expenses are recognized in the profit and loss account on the basis of a direct association between the costs incurred and the earning of specific items of revenue within Skeer Manufacturing. This is a process known as revenue/cost matching. Matching would be the allocation of expense to the period expected to benefit from the expenditure. Revenue/cost matching has an indirect association with specific revenues. The Statement of Principles rejects revenue/cost matching. Under the Statement of Principles, expenditure must meet the criteria for recognition of an asset before it can be carried forward to set against future revenues, otherwise it must be recognized as an expense immediately. As noted from www.wku.edu, the recognition of expense typically follows one of the three principles:
Immediate recognition: Some costs are associated with the current accounting period as expenses because (1) costs incurred during the period provide no discernible future benefits, (2) cost recorded as assets in prior periods no longer provide discernible benefits, or (3) allocated costs either on the basis of association with revenue or among several accounting periods is considered to serve no useful purpose.
Expense recognition must be accompanied by a decrease in the net assets of Skeer Manufacturing. The assets must decrease or liabilities must increase as a result of revenues being realized. Expenses are the cost associated with the revenue of the period to which the revenue has been assigned. They represent the gross outflow of (net) assets resulting from profit directed activities of the company.
Expensing of Stock Options There is a considerable amount of debate around whether or not expensing stock options is of great benefit to organizations. Companies are required to estimate the value of there stock options in documentation that is filed with the Securities and Exchange Commission (SEC).
The Financial Accounting Standards Board (FASB) is working on a proposed rule that would mandate the expensing of options.
Opponents believe that expensing options would lower earnings per share. Most complain that this would put an undue burden on over exhausted financial and accounting departments. (Roberts, 2004) There are others that feel that companies that are facing cuts in profits or sharp losses will be most affected if forced to report options as expenses in the reporting statements. The theory is that it will directly impact the cost per share of stock. (Burkholder, 2004) However, they have been told that expensing will not affect cash flow but only the amount of profit the companies report.
As a result of corporate scandals that were ever present in major newspapers, many investors believe that it is a good business move to publicly record the value of company issued stock as a compensation expense. (Johnson, 2004) Many of the large companies have used the option to own sizable portions of stock as methods to lure new employees. Therefore, stock ownership is presented in compensation material that is supplied to their most valuable asset, human capital (employees).
There are some schools of thought that suggest that some companies would stop offering stock options as a recruitment/retaining tool offered to employees. Therefore, completely eliminating this option all together as a form of compensation. This has become quite a political issue. There are elected officials that have joined the discussions around expensing stock options. Many members of the Senate Banking Committee have expressed the thought that Congress should not interfere with company wide accounting departments.
There are benefits and possible barriers to expensing stock options. However, the benefits are much greater. It is recommended that Skeer Manufacturing voluntarily report their stock options as expenses. This will be favorable in the eyes of their investors as well as the employees of the company. Justification of Recommendations: Recognizing revenue as the time of sale or rendering of service is the most effective way to ensure an “arms-length” deal has been reached. Since Skeer Manufacturing makes significant use of inventory, using this method puts the company in a more stabilized financial environment.
Contractual pre-orders where funds are collected later do exactly the opposite. It fails to capture revenue for a specific period, leaving Skeer Manufacturing susceptible to applying different accounting methods to account for revenue coming in the future; all the while raising the cost of the goods sold. The alternative method that was given careful thought is to use the percentage of completion method, which often times results in the overstatement of revenue in the income statement. Most major manufactures (i.e. homebuilders) that preside over labor intensive and time consuming projects prefer this method. However, Skeer Manufacturing has an average turnaround of 30 days from implementation, affording it the luxury to have an inventory where it can sell directly under no long-term contracts.
The endorsement of the cost matching principle of expensing costs for Skeer Manufacturing can be attributed to the measure it takes to ensure that expenses are recognized concurrently with the revenues to which they directly relate. The revenue generating stream within Skeer Manufacturing is directly measured in cash or other assets; and therefore subjected to a recognition based principle that matches the current value of all future cash flow as the amount of the expense (Cron & Hayes, 2004)
. This straightforward approach benefits the company in many ways. First, this method eliminates the need to make forecasts on expenditures from revenue for future periods. And finally, aids in the inventory control analysis of determining cost of goods sold by firmly accounting for net gains and losses in a specific period. Alternative expense recognitions like the inventory cost-flow assumption bases its expenses primarily on weighted averages. Although the cost of goods sold needs a recognition method that appropriately measures inventory, averages do not do a good job of capturing real expense.
The justification of using the intrinsic value method for measuring stock option expense is that the calculation is also straightforward for Skeer manufacturing. This method is measured by the difference between the market price and the measurement date. The logic here is since there is no reliable way of measuring the value of the option at the date of grant there is no reliable way of measuring expense associated with the issue of an option (Cron & Hayes, 2004).
Historically, this is the template used by many companies for years when reporting stock options as an expense. It would be in the best interest of Skeer Manufacturing to implore the same method. An alternative method that does not work particularly well is the Grant-Date method. Although this method allows for companies to report some value for their options they provide to employees, its central problem is that options are dynamic in nature (Cron & Hayes, 2004). An option’s value, and hence the cost of the option to the grantor, changes each period. This one time date of grant aims to put a value, but fails to change as the options change (Cron & Hayes, 2004). In summary, we ask that you give careful consideration to the recommendations we proposed for Skeer Manufacturing. We are confident that the accounting methods for revenue and expense are time tested methods that fit the overall size of your organization. We are confident that the recommendations set forth will maximize overall profit and ensure stability for your company.