Question: For companies with no history of positive earnings such as

For companies with no history of positive earnings, such as startup companies, growth of revenues provides an alternative performance measure and indicator of possible future earning power. This is particularly the case if the new company incurs high R& D costs, advertising, and other startup expenditures that delay the advent of profitability. Without positive reported earnings, such companies may inflate reported revenues to impress investors. In an article in The Globe and Mail, December 30, 2000, Janet McFarland discusses some of these practices. They include
Recognizing full revenue even though products or systems can be returned, or when there are future obligations such as servicing the products and systems sold
Recording revenue on long- term contracts in advance of billings to the customer ( billings may be delayed as a form of vendor financing to the customer, a practice frequently used to attract business from cash- short firms)
Recording revenue from gross sales when the company is an agent rather than a principal
Examples of such practices include Imax Corp., which reported the ( discounted) full amounts of minimum royalties due under 10- year or more leases of its theatre systems. While, at the time, this was in accordance with GAAP for long- term leases, it left Imax open to the possibility that customers might default on payments due in future. Other examples include JetForm Corp., which recognized revenue from consulting contracts on the percentage- of- completion method, although amounts billed to customers were less. Bid.Com , a firm that conducted online auctions as agent for the seller, included the pur-chase price, rather than its commission on the purchase, as revenue.
One of the problems surrounding reporting of revenue is that while a firm’s revenue recognition policy must be disclosed, the disclosure standards are vague. Thus, companies typically stated that revenue is recognized as goods are shipped or services rendered, or that revenues on long- term contracts are recognized on a percentage- of- completion basis. These statements are sufficiently general that practices such as the above may be unknown to the market.

a. To what extent can revenue growth substitute for net income as a predictor of future earning power? Explain. Use efficient securities market concepts in your answer, and consider the requirement under GAAP for immediate writeoff of research and startup costs.
b. Use the concept of relevance to defend the revenue recognition policies outlined above.
c. Use the concept of reliability to criticize the revenue recognition policies outlined above.
d. To the extent that investors are aware of the possible use of revenue recognition policies that overstate revenues (even though, for a specific firm, they may not know the extent to which that firm is using such policies), what is the effect on the opera-tion of the capital market? Explain. A good answer will draw on the concept of an information system.

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