GAAP is a set of specific common guidelines, provided by the institutions such as the Financial Accounting Standards Board, the American Institute of Certified Public Accountants and the Securities and Exchange Commission, about "acceptable accounting practices"
These acceptable practices should not necessarily be regarded as a set of ground rules. In fact, it is a common denominator, useful when foreign firms, especially auditing companies, proceed to financial verifications. The GAAP provide for an easier task from the auditing companies and anybody else who interprets the financial statements.
In the case of Legal Plan Services, the GAAP guidelines will provide the necessary information that will permit a common evaluation, a common ground on which revenue and expenses can be considered. Besides being interpretable by more than one side, the GAAP guidelines are, in this case, rules which allow for the company's accounting methods to be understood by others and would permit, in the future, an IPO preparation. We will be using Financial Accounting Standards Board documents in order to be able to identify the best and most suitable means by which the company can account for its revenues and expenses.
The first part of the essay will be a presentation of the different issues concerning the revenue and expense recognition, as identified by the Financial Accounting Standards Board in several documents over the past couple of years. This will be the theoretical base on which we can thereafter develop a discussion around the type of revenue and expense, as related to the company's specific area of expertise. In the second part of the assignment, we will be explaining and summarizing our findings for the company's president, with a series of conclusions thereafter.
Part 1 -- Revenue and Expense Recognition
Because of the issues concerned with revenue recognition and its importance within the company, the standards proposed and used for revenue recognition in the financial statements are among the most important and the most difficult to agree upon. Besides the FASB propositions, there are several other authorities that have laid opinions related to revenue recognition, among these the Accounting Principles Board, the American Institute of Certified Public Accountants or the Security and Exchange Commission through its Staff Accounting Bulletin (SAB).
As the Legal Plan Services company we are analyzing is planning an IPO in the near future, we should hereby state that the SAB lists two different criteria that should be used in the case of revenue. If "a transaction falls within the scope of specific authoritative literature on revenue recognition, that guidance should be followed"
. However, if this does not occur, SAB recommends "the use of the revenue recognition criteria in FASB Concepts Statement No.5, Recognition and Measurement in Financial Statements of Business Enterprises"
In my opinion, the FASB concepts are very important and refer to the fact that a revenue should not be recognized until it is realized or realizable and earned. The SAB methodology is not as applicable at this point for our company, mainly because it generally addresses companies that are already listed on the Stock Exchange and not necessarily those that are preparing for an IPO.
As such, referring to the FASB statements seems closer to our company's reality. The FASB Concepts Statement No.6, Elements of Financial Statements, refers to revenues as "changes in assets and liabilities"
. As we can see from the previous paragraph, we are already faced with two somewhat different types of revenue recognition. One refers to revenues as earnings, where earnings would be a similar concept to net income, while in the other case, revenue includes an operational change in assets and liabilities.
Given these introductory concepts of revenue recognition, it may be the proper time to have a brief look at the nature of the company's service, in order to be able to fit the company's revenues into one of the statements described previously. As we have seen from the case study, the company is designs, underwrites and markets legal service plans. These are obviously intangible products and their underwriting would probably place us closer to the first concept, where a revenue is recognized as it is realized or realizable and earned. Let's further examine these two key concepts.
The realized criterion refers to "changes in assets (in the form of receipts of cash or claims to cash or transformations into readily convertible assets)"
. The earned criterion refers to the fact that the company must have "substantially accomplished" what it must do to be entitled to the benefits."
There are several things that are still unclear about the way the FASB have defined these two crucial terms. For instance, what does substantially accomplished actually mean? It could mean that the service has been provided for in a 50% ratio or a 75% ratio or somewhere in-between?
Referring to Legal Plan Services, new members, for example, have to pay a $10 enrollment fee. According to the FASB Statement, this cannot be listed as revenue unless a significant part of the service has been accomplished. We may assume, following the reasoning previously presented, that Legal Plan Services has already performed services for the respective customer in the past and, in this sense, the monthly retribution he pays is actually for the past rather than for the month to come. On the other hand, what happens to new members?
The FASB Statement No. 48 also refers to revenue recognition, however, this discusses "revenue on a sale in which a product may be returned"
. In our case, the "product" that the company sells is not returnable. The customer who is not satisfied with the quality of the service offered will probably refuse to renew his membership the following month. In this sense, this statement does not actually need to be applied in Legal Plan Services' accounting methodology.
In terms of expense recording, the FASB Statement No. 33 seems most appropriate to be used. Here, it is stated that "expenses are to be measured at current cost or lower recoverable amount"
. On the other hand, the concept of current cost hereby refers to assets owned and is quite flexible in that it encourages "price indexes or other evidence of a more direct nature"
On the other hand, expenses can also be included in the company's liabilities' category and a definition of liabilities, as from the Concepts Statement No. 6 is in order here. As such, "liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events"
Referring to the particular service provided for the company, what can we include in the future sacrifices that arise from present obligations? If we have a look at the consolidated statement of income, the first thing that comes to mind is the membership benefits and the associate services and direct marketing. These are expenses directly linked with the company's core activity and follow the exact definition of liabilities, as presented previously.
Going back to revenue recognition, there is also the problem of when exactly should revenue be recognized, as related to the exact time the service is delivered. In this case, we have three separate situations: pre-delivery, recognition at delivery and post-delivery recognition. In my opinion, following the case study, at present, Legal Plans Services recognizes revenue on a pre-delivery basis. Indeed, the case study states that the membership is recognized as income "when due accordance with Membership terms, usually monthly"
. Is this the best method to recorded revenue in the case of Legal Plans Services? We should have a look at the other types of revenue recognition as compared to the delivery period and see which is the best match.
The on-delivery method is used when the actual product or service is exchanged for a certain amount of cash. On the other hand, post-delivery revenue recognition refers to a deference of the recognition process until the "cash is collected"
In my opinion, the pre-delivery revenue & expense recognition methodology is the best method that Legal Plans Services can actually use in this case. The best clue as to the methodology is given by the relationship between the benefits received and the services rendered and, even more specifically, between the time that these two actually occur.
In this particular case, the clients pay a certain membership fee, upon a monthly, biannually or annually basis. Upon the payment of this fee, the client is provided legal advice and services for the month to come, month for which he has paid the membership fee. As such, revenue recognition may occur as the client pays for the services he will be provided in the future.
In the case of training, with a fee of $184, we are in a different situation, namely a post-delivery revenue recognition situation. Indeed, even if the customer has paid in advance, we cannot actually recognize this as revenue until a significant part of the service, namely the training…