Read the following the case and answer the questions: Reike Technology Co. Ltd. was an IT consulting and outsourcing company. Founded in 1995 with less than 50 people, it became one of the largest IT companies in China, with over 23,000 employees and approximately 500 million RMB in annual revenue. In 2005, it successfully made an IPO on the Shanghai Stock Exchange. Reike’s headquarters were in Beijing, with four branches in Shanghai, Shenzhen, Xi’an, and Ningbo. Reike’s core competitive strength was its rich experience in IT solutions- from localization, testing, and development services to system level design. Since its launch, the company had accumulated experience in the high tech, telecommunications, financial services, manufacturing, retail, and distribution industries. In the 1990s, more and more western software companies were entering the Chinese market. Localization was the first thing they all had to face. Reike took the opportunity to build partnerships with Fortune 500 software companies and continuously earned contracts as these companies expanded their business in China. This strategy helped Reike gradually increase its reputation in the software outsourcing industry. By 2011, the company had become one of the largest professional software outsourcing service providers in China. It had also built strong cooperative partnerships with some large international companies. Reike’s Business Department No. 3 has co-operated with software giant Shenghui Co. Ltd. (Shenghui) on various projects. The settlement between the two companies has generally been on a monthly basis according to project progress. Reike and Shenghui had a good partnership until they collaborated on a project with Zhongjiao International Group (Zhongjiao) and Shenghui proposed a contract containing a “pay-when-paid” clause to handle the payments to Reike. According to this clause, payments to Reike would be based on the percentage of the project completed upon review, as long as Shenghui received the corresponding proportion of payments from the owner (Zhongjiao). In the Zhongjiao project, Zhongjiao is the owner, Shenghui is the general contractor, and Reike is the subcontractor.
Hint: What is the meaning of “pay-when-paid”? The terms set by the general contractor specifying that payment from the owner is a precondition to paying the subcontractor. The core content is that the payment of the contract price by the owner to the general contractor is a prerequisite for the general contractor to pay the subcontract price to the subcontractor. If the owner fails to pay the funds to the general contractor, the condition for the general contractor to pay the subcontractor is not met, in this case, not only is the general contractor not responsible for paying the subcontract price, but the general contractor is also not liable for breach of overdue payments.
1. You are a sell-side analyst who has followed Reike since its IPO and aware the unusual term of a ‘pay-when-paid’ clause newly included in the contract between Reike and Shenghui. Indicate your concern regarding the clause. (6 marks)
2. Provide your suggestion on the revenue recognition by Reike. When should Reike recognize the Zhongjiao project revenue? Explain. (6 marks)