Question

Zhang (2005) examined revenue recognition practices in the software industry. Software firms derive revenue from software licensing and post- contract customer support. In both cases, the point in time when the significant risks and rewards of ownership have been transferred to the buyer, the seller loses control over the items, and the revenue and related costs can be measured reliably is unclear. Also unclear is whether collection is reasonably assured. Consequently, there is scope for alternative revenue recognition practices in the industry.
With respect to licensing, one alternative is to recognize revenue when the licensing contract is signed (early recognition). Another is to wait until the software is delivered to the customer, consistent with the usual sale basis of revenue recognition (late recognition). With respect to post- contract customer support, alternatives are to recognize revenue when contracts are signed (early recognition) or recognize revenue ratably over the term of the contract (late recognition).
Zhang examined a sample of 122 firms over the period 1987– 1997, of which 22 firms were early recognizers and 93 were late. He measured the relevance of a firm’s quarterly revenue by its association with its share returns for the quarter. Given securities market efficiency, the revenues of early recognizers should be more highly associated with their share returns than the revenues of late recognizers. Zhang reported significant statistical evidence consistent with this expectation. Zhang measured the reliability of revenue information by examining the cash flows from quarter end accounts receivable collected over the following two quarters. Recall that in Section 3.7.1 we pointed out the role of accruals in anticipating future cash flows. Here, the accrual in question is the allowance for doubtful accounts. Thus, the closer the amounts of cash collections are over these following two quarters to opening net accounts receivable, the more reliable the revenue information is. Zhang found that the reliability of revenue information measured this way was significantly less for early recognizers than for late recognizers.
Combination of these two findings suggests that relevance and reliability must be traded off, since the greater relevance of early revenue recognition is accompanied by reduced reliability.

Required
a. Explain why securities market efficiency implies that revenues of early recognizers should be more highly associated with their share returns than revenues of late recognizers. In your answer, assume that information about licensing contracts becomes public information when the contract is signed.
b. Explain why the closer cash collections are for the following two quarters to opening accounts receivable, the more reliable revenue information is.
c. Do Zhang’s findings imply that early revenue recognition for licensing contracts has the potential to be decision useful for investors? Use the concept of an information system (in particular, the effects of relevance and reliability on the main diagonal probabilities) in your answer.



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  • CreatedSeptember 09, 2014
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