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Revenue Recognition

UAA ACCT 650Seminar in Executive Uses of Accounting

Dr. Fred Barbee



Marketing the product

Receiving customers’

order Negotiating and

signing productioncontracts.

Ordering materials

Manufacturing theproduct.

Delivering theproduct.

Collecting the cashfrom customers.

Consider a ManufacturingFirm . . .



“The fundamental revenuerecognition concept is that revenues

should not be recognized by acompany until realized or realizableand earned by the company.”

Lynn E. Turner, Chief Accountant, SECSpeech by SEC Staff: Revenue Recognition

May 31, 2001



Revenue Recognition

At the Financial AccountingStandards Board (FASB)



In an effort to provide better andmore comprehensive guidance as to

when companies should recordrevenues, the FASB has added aproject on revenue recognition to its

agenda.www.fasb.org May 22, 2002

http://www.fasb.org/

http://www.fasb.org/



“Revenue usually is the largest itemin financial statements, and revenue

recognition issues top the list ofreasons for financial reportingrestatements.”

L. Todd JohnsonFASB Senior Project Manager

www.fasb.org/news/nr052002.shtml



A top down

approachfocusing onconceptualguidance.

A bottom upapproach

that provides

an inventoryof existingrevenue

recognitionguidance and

acceptedpractices.



“. . . Issues involving revenuerecognition are among the most

important – and the most difficult – that standard setters andaccountants face.”

www.fasb.org/project/revenue_recognition.shtml



FASB Concept

Statements5 and 6

APB, FASB,

AICPA, EITF, SEC,SAB

Conceptual

Guidance

Authoritative

Literature

S i gni f i c an t G a p



FASB Concept

Statements5 and 6

APB, FASB,

AICPA, EITF, SEC,SAB

Conceptual

Guidance

Authoritative

Literature



Revenue

Revenues are inflows of assets and/or settlement of liabilities

from delivering or producinggoods, rendering services, or otheractivities that constitute theentity’s ongoing major or central

operations.

Statement of Financial Accounting Concepts No. 6 “Elements of Financial Statements”

Paragraph 78



Recognition

The process of formally recordingor incorporating an item into the

financial statements of an entity asan asset, liability, revenue,expense, or the like.

Statement of Financial Accounting Concepts No. 5 “Recognition & Measurement in Financial Statements of

Business Enterprises” - Paragraph 6



Recognition

Essential Characteristics

Depiction in both words and numbers

Included in financial statements andstatement totals

Disclosure by other means is not

recognition

Statement of Financial Accounting Concepts No. 5 “Recognition & Measurement in Financial Statements of

Business Enterprises” - Paragraph 6



To be recognized . . .

An item must meet the definition ofan element

It must be measurable

It must be relevant

It must be reliable



Principle of RevenueRecognition

To recognize a revenue it must be:

1. Realized (or realizable)

2. Earned



Principle of RevenueRecognition

Realized

When cash or claims to cash are

received.

Realizable

When assets received are readilyconvertible to known amounts ofcash or claims to cash.



Realization Criterion

The revenue – the amount the customerswill pay – can be objectively measured.

The eventual collection of cash (or cash-equivalents) can be reasonably assured.

Any remaining fulfillment costs can be

estimated with reasonable reliability andaccuracy.



The Earned Criterion

The company has completed asubstantial portion of the

production and sales effort. The risks of ownership have been

shifted to the customer.



Whoa . . . Wait a Minute!

This all soundsso incredibly

easy!

So . . . Why do wehave so manyproblems withrevenuerecognition?



Timing of RevenueRecognition



The Timing of RevenueRecognition

The point at which an order isobtained from a customer.

The point at which an order isaccepted and the terms of the saleare finalized.



The Timing of RevenueRecognition

The point at which goods aredelivered to a customer.

The point at which the customer isbilled

The point at which payment isreceived from the customer.

R R i i



Revenue Recognition

Classified by Nature of Transaction

Timing of Recognition

Date of Sale

(Date of Delivery)

Type of Transaction

Sale of Product

From Inventory

Revenue

Sales

R R iti



Revenue Recognition



Services Performed

and Billable

Type of Transaction

Rendering a

Service

Revenue

Fees or Services

R R iti



Revenue Recognition



As time passes or

assets are used

Type of Transaction

Permitting use

of an Asset

Revenue

Interest, Rent,

and Royalties

R R iti



Revenue Recognition


Type of Transaction

Sale of asset other

then inventory

Revenue

Gain or loss on

disposition


Date of Sale

or Trade in



Figure 2.2 The Revenue Recognition Process: Industries Recognizing Revenue at Indicated Phases

Revenues may also be recognized at other times besides thepoint of sale.



Revenue Recognition

At the Securities andExchange Commission (SEC)



The SEC & Revenue Recognition

SABs do not represent rules orinterpretations of the Commission butrather represent the interpretations

and practices followed by the Divisionof Corporation Finance and the Officeof the Chief Accountant inadministering the disclosurerequirements of the Federal securitieslaws.

SEC Staff Accounting Bulletin No. 101 - FAQs

http://www.sec.gov/info/accountants/sab101faq.htm



The SEC & Revenue Recognition

SAB 101 . . .

Reflects the basic principles of revenue

recognition in existing GAAP. Does not supersede any existing

authoritative literature.

Summarizes in one location the existingguidance on revenue recognition.

SEC Staff Accounting Bulletin No. 101 - FAQs

http://www.sec.gov/info/accountants/sab101faq.htm



Revenue RecognitionPer the SEC

Persuasive evidence of anarrangement exists;

Delivery has occurred or serviceshave been rendered;

SEC Staff Accounting Bulletin No. 101http://www.sec.gov/interps/account/sab101.htm




The seller’s price to the buyer isfixed or determinable; and

Collectibility (payment) isreasonably assumed.

SEC Staff Accounting Bulletin No. 101http://www.sec.gov/interps/account/sab101.htm




SAB 101 observesthat “judgment” is

the key factor indeciding thetiming and amount

of revenue torecognize.

SEC Staff Accounting Bulletin No. 101

http://www.sec.gov/interps/account/sab101.htm



Let’s look at . . .



Should a company that acts as adistributor or reseller of products orservices record revenue as gross or net?



Example – Priceline.com . . .

Priceline.com brokered airline ticketsonline and included the full price ofthe ticket as Priceline.com revenues.

This greatly inflated revenues relativeto traditional ticket brokers and travelagents who only included commissionsas revenue.



Example – eBay.com . . .

eBay.com included the entire price ofauctioned items into its revenue eventhough it had no ownership or credit

risk for items auctioned online.



Example – Land’s End . . .

Land’s End issued discount coupons(e.g., 20% off the price), recordedsales at the full price, and then

charged the price discount tomarketing expense.



Resolution (EITF 99-19)



Resolution – EITF 99-19

For gross reporting of a transactionprice, a company should meet thefollowing tests regarding the product

or service being sold . . .



The Company . . .

Is the primary obligor.

Has general inventory risk.

Has latitude in establishing prices

Changes the product or performs part

of the service.



The Company . . .

Determines product/servicespecifications.

Bears risk for physical loss ofinventory.

Bears credit risk.

Cash and price discounts must bededucted from revenue rather than bereported as expenses.



The Case:Circuit City Stores, Inc. (A)

Why Study This Case?



Why Study This Case

Examine revenue recognitionissues

Process used by FASB

Substance over form

Communications withShareholders



Why is Mike ChalifouxDisturbed?



Why is Mike Disturbed?

Reported income will be reducedand Circuit City growth rate will

appear slower. He believes that Circuit City’s

present accounting policy is

correct.



Why is Mike Disturbed?

Full recognition of revenue fromextended warranty sales is

justifiable; and Deferral will not match revenues

and expenses for the substance

of the transaction.



What Actions CouldMike Chalifoux Take



What Could Mike Do?

Present his case to the FASB

Rally the industry to lobby FASB

Estimate the effect of the possiblechange.



Three Possible Methods



Three Possible Methods

Full Revenue Recognition

Deferral of Revenue

Partial Revenue Recognition



Full Revenue Recognition

Stereo Contract Total

Revenue $1,000 $100 $1,100

Cost 900 20 920Profit $100 $80 $180

At date of Sale

Recognize total revenue $1,100

Recognize total costs 920

Profit $180



Deferral of Revenue

Sale of Stereo and Warranty aretwo separate transactions

At date of SaleRecognize total revenue $1,000

Recognize total costs 900

Profit $100

Defer $100 contract revenue andallocate over 2 year period.



Partial Revenue Recognition

Transactions are linked

At date of Sale

$900/$920 x $1,100 $1,076$20/$920 24

Total Revenue $1,100

Defer $24 and recognize over 2- year period.



How should the changebe implemented?



Implementation . . .

Restate prior years?

One-time cumulative adjustment?

Phase in?



Some ConcludingThoughts



Concluding Thoughts

FASB sought to improve financialdisclosure by limiting diversity in

accounting practice. Good matching of revenues and

expenses is not always easy.



Concluding Thoughts

The job of determining,supporting and sustaining

financial reporting policies withina company in a changingenvironment can be a difficultone.



What did CircuitCity Do?

Revenue Recognition 62 Slideuri

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