Zhang (2005) examined revenue recognition practices in the software industry. Software firms derive revenue from software licensing and post-contract customer support. Accounting standards at the time (see Section 1.2) required that revenue should be recognized when the significant risks and rewards of ownership had been transferred to the buyer, the seller had lost control over the items, and the revenue and related costs could be measured reliably for alternative revenue recognition practices in the industry. With respect to licensing, one alternative was to recognize revenue when the licensing contract was signed (early recognition); another was to wait until the software was deliv-ered to the customer (late recognition). With respect to post-contract customer support, alternatives were to recognize revenue when contracts were 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 19871997, of which 22 firms were early recognizers and 93 were late. He measured the relevance of a firms 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 is the revenue information. Zhang found that the reliability of revenue informa-tion 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. However, Zhang found higher correlation between share return and reported earnings for early revenue recognizers. Assuming reasonable securities market efficiency, this suggests that investors perceived relevance effects as outweighing reliability effects, since this finding would not arise if reliability concerns dominated.

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 recog-nizers. In your answer, assume that information about licensing contracts becomes public information when the contract is signed. b. Explain why revenue information is more reliable when cash collections for the follow-ing two quarters are closer to opening accounts receivable. c. Do Zhangs 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. d. For a firm providing both software licensing and post-contract customer support, would early or late revenue recognition policies, or some combination of the two, best satisfy