Sunday, September 10, 2006

DO YOU RECOGNIZE THIS REVENUE?

The Hazards of Revenue Recognition for Non-profits
by pam ashlund


"New" nonprofit rules for recognizing revenue were established by the Financial Accounting Standards Board back in 1993 (FASB 116), links summarized in a previous post.

Then why now is the subject of Revenue Recognition suddenly so important? File it under “Blame it on Enron”. When this infamous company decided to recognize revenue based on their projection of future sales (NOT completed sales), they opened the door to a previously unimaginable new chapter in the ongoing novel of Fictional Accounting. The guys who came up with this scam were known as "The Smartest Men in the Room". Were they? The answer is yes (and no) and yes.

Madness in the Method?

Even though their method was clearly preposterous, the lesson we can learn from their sad example is that accounting is mostly, but not ALL hard science. Many accounting decisions involve significant “management discretion”. Any area of accounting that can change depending on the opinion of managers is a danger area. Revenue Recognition is one of these areas.

Booking a sale as "Income" involves a lot more speculation than completing a unit of service or finishing a work project in the nonprofit arena. But nonetheless the hammer has come down upon non-profits just as if we wielded the same power than Enron had (as if!). The for-profit world estimates that the new compliance regulations imposed after the Enron scandal added another 5% to their overhead costs (translating into billions of dollars annually). I sure hope this makes us all safer from giant acts of fraud, but somehow I doubt it.

But back to nonprofits and revenue recognition. Where can we get into trouble? Occasionally we do recognize revenue that we haven't billed for yet. Following generally accepted accounting practices, we class that income as an unbilled receivable. Exactly what is that? An unbilled receivable is an abbreviation meaning “earned, but unbilled”. I generally interpret this to mean having not invoiced. Reasons for not sending an invoice may vary, but will generally not be sent due to a contract that is not in place. The decision to classify a receivable as unbilled does involve managerial discretion.

The most significant deciding factor is not literally “did I mail the invoice”, it is “can this invoice (mailed or not) be processed for payment”. 99% of the time both conditions are true: a) the invoice cannot be processed for payment because the contract isn’t signed yet; AND b) we did not mail the invoice because we know it won’t be processed. When in doubt consider the receivable unbilled because the alternative is it might be incorrectly mistaken for an aging receivable eligible for collection when in fact it is not “payable” yet and can not be counted on for continuing cash-flow.

Auditors trained in detecting fraud now look very carefully at these as “areas of risk”. Most abuses in these areas can be spotted by trend analysis. Businesses wishing to be proactive ought apply the closest scrutiny to these areas and be sharply aware of how these figures will be perceived (by the public, by auditors, and by potential donors).

Please note that when an auditor observes a sharp rise in unbilled receivables this may indicate to them that management’s estimate of the percentage of work completed is too aggressive.

Those with responsibilities for managing finances would be wise to scrutinize receivables classified as unbilled every bit as closely as those classified as aging grants receivables.

SIDEBAR:

The Emperor Has No Clothes


Why are the "smart guys" guilty of anything when their uber-risky accounting method "mark to market" was approved by the Feds? The Securities Exchange Commission approved it (for them alone) in 1992. Why not just hold SEC accountable? This whole idea is brilliantly (and succinctly) explored in Timothy Carney’s Op-Ed piece: Feds Were Accomplices to Enron Crooks, Human Events, June 12, 2006.

Death and Taxes

Enron Founder, Key Lay, died of a massive heart attack at age 64 on July 5, 2006.

Milgram Redux

When Stanley Milgram ran his historic experiment demonstrating how far subjects would go in obedience to authority, he proved how hard it is to stand up and say no.

Two woman who really knew what was wrong had an uphill battle (when told essentially "don't worry your pretty little head about those things darling" both Bethany McLean (the fortune magazine writer) and Sherron Watkins (the whistleblower) really had to believe in themselves to overcome the mass psychosis and stand up.

Keep Your Sense of Humor

The Enron Movie site has a pretty cute interface with which to review with scandal.


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