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Revenue Recognition
UAA ACCT 650
Seminar in Executive Uses of Accounting
Dr. Fred Barbee
Consider a Manufacturing
Firm . . .




Marketing the product
Receiving customers’
order
Negotiating and
signing production
contracts.
Ordering materials



Manufacturing the
product.
Delivering the
product.
Collecting the cash
from customers.
“The fundamental revenue
recognition concept is that revenues
should not be recognized by a
company until realized or realizable
and earned by the company.”
Lynn E. Turner, Chief Accountant, SEC
Speech by SEC Staff: Revenue Recognition
May 31, 2001
Revenue Recognition
At the Financial Accounting
Standards Board (FASB)
In an effort to provide better and
more comprehensive guidance as to
when companies should record
revenues, the FASB has added a
project on revenue recognition to its
agenda.
www.fasb.org
May 22, 2002
“Revenue usually is the largest item
in financial statements, and revenue
recognition issues top the list of
reasons for financial reporting
restatements.”
L. Todd Johnson
FASB Senior Project Manager
www.fasb.org/news/nr052002.shtml
A top down
approach
focusing on
conceptual
guidance.
A bottom up
approach
that provides
an inventory
of existing
revenue
recognition
guidance and
accepted
practices.
“. . . Issues involving revenue
recognition are among the most
important – and the most difficult –
that standard setters and
accountants face.”
www.fasb.org/project/revenue_recognition.shtml
Conceptual
Guidance
Significant Gap
FASB Concept
Statements
5 and 6
Authoritative
Literature
APB, FASB,
AICPA, EITF, SEC,
SAB
Conceptual
Guidance
Authoritative
Literature
FASB Concept
Statements
5 and 6
APB, FASB,
AICPA, EITF, SEC,
SAB
Revenue

Revenues are inflows of assets
and/or settlement of liabilities
from delivering or producing
goods, rendering services, or other
activities that constitute the
entity’s ongoing major or central
operations.
Statement of Financial Accounting Concepts No. 6
“Elements of Financial Statements”
Paragraph 78
Revenue

Essential Characteristics



Inflows of assets or settlements of
liabilities
Result of some productive activity of
the firm
Major or central operation
Recognition

The process of formally recording
or incorporating an item into the
financial statements of an entity as
an 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 and
statement 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 of
an element

It must be measurable

It must be relevant

It must be reliable
Principle of Revenue
Recognition

To recognize a revenue it must be:
1. Realized (or realizable)
2. Earned
Principle of Revenue
Recognition
Realized


When cash or claims to cash are
received.
Realizable


When assets received are readily
convertible to known amounts of
cash or claims to cash.
Realization Criterion



The revenue – the amount the customers
will pay – can be objectively measured.
The eventual collection of cash (or cashequivalents) can be reasonably assured.
Any remaining fulfillment costs can be
estimated with reasonable reliability and
accuracy.
The Earned Criterion


The company has completed a
substantial portion of the
production and sales effort.
The risks of ownership have been
shifted to the customer.
Whoa . . . Wait a Minute!

This all sounds
so incredibly
easy!

So . . . Why do we
have so many
problems with
revenue
recognition?
Timing of Revenue
Recognition
The Timing of Revenue
Recognition


The point at which an order is
obtained from a customer.
The point at which an order is
accepted and the terms of the sale
are finalized.
The Timing of Revenue
Recognition



The point at which goods are
delivered to a customer.
The point at which the customer is
billed
The point at which payment is
received from the customer.
Revenue Recognition
Classified by Nature of Transaction
Type of Transaction
Sale of Product
From Inventory
Revenue
Sales
Timing of Recognition
Date of Sale
(Date of Delivery)
Revenue Recognition
Classified by Nature of Transaction
Type of Transaction
Rendering a
Service
Revenue
Fees or Services
Timing of Recognition
Services Performed
and Billable
Revenue Recognition
Classified by Nature of Transaction
Type of Transaction
Permitting use
of an Asset
Revenue
Interest, Rent,
and Royalties
Timing of Recognition
As time passes or
assets are used
Revenue Recognition
Classified by Nature of Transaction
Type of Transaction
Sale of asset other
then inventory
Revenue
Gain or loss on
disposition
Timing of Recognition
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 the
point of sale.
Revenue Recognition
At the Securities and
Exchange Commission (SEC)
The SEC & Revenue Recognition
 SABs do not represent rules or
interpretations of the Commission but
rather represent the interpretations
and practices followed by the Division
of Corporation Finance and the Office
of the Chief Accountant in
administering the disclosure
requirements of the Federal securities
laws.
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 existing
guidance on revenue recognition.
SEC Staff Accounting Bulletin No. 101 - FAQs
http://www.sec.gov/info/accountants/sab101faq.htm
Revenue Recognition
Per the SEC
 Persuasive evidence of an
arrangement exists;
 Delivery has occurred or services
have been rendered;
SEC Staff Accounting Bulletin No. 101
http://www.sec.gov/interps/account/sab101.htm
Revenue Recognition
Per the SEC
 The seller’s price to the buyer is
fixed or determinable; and
 Collectibility (payment) is
reasonably assumed.
SEC Staff Accounting Bulletin No. 101
http://www.sec.gov/interps/account/sab101.htm
Revenue Recognition
Per the SEC
 SAB 101 observes
that “judgment” is
the key factor in
deciding the
timing and amount
of revenue to
recognize.
SEC Staff Accounting Bulletin No. 101
http://www.sec.gov/interps/account/sab101.htm
Let’s look at . . .
Should a company that acts as a
distributor or reseller of products or
services record revenue as gross or net?
Example – Priceline.com . . .
 Priceline.com brokered airline tickets
online and included the full price of
the ticket as Priceline.com revenues.
This greatly inflated revenues relative
to traditional ticket brokers and travel
agents who only included commissions
as revenue.
Example – eBay.com . . .
 eBay.com included the entire price of
auctioned items into its revenue even
though 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), recorded
sales at the full price, and then
charged the price discount to
marketing expense.
Resolution (EITF 99-19)
Resolution – EITF 99-19
 For gross reporting of a transaction
price, a company should meet the
following 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/service
specifications.
 Bears risk for physical loss of
inventory.
 Bears credit risk.
 Cash and price discounts must be
deducted from revenue rather than be
reported as expenses.
The Case:
Circuit City Stores, Inc. (A)
Why Study This Case?
Why Study This Case
 Examine revenue recognition
issues
 Process used by FASB
 Substance over form
 Communications with
Shareholders
Why is Mike Chalifoux
Disturbed?
Why is Mike Disturbed?
 Reported income will be reduced
and 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 from
extended warranty sales is
justifiable; and
 Deferral will not match revenues
and expenses for the substance
of the transaction.
What Actions Could
Mike Chalifoux Take
What Could Mike Do?
 Present his case to the FASB
 Rally the industry to lobby FASB
 Estimate the effect of the possible
change.
Three Possible Methods
Three Possible Methods
 Full Revenue Recognition
 Deferral of Revenue
 Partial Revenue Recognition
Full Revenue Recognition
Revenue
Cost
Profit
Stereo
Contract
Total
$1,000
$100
$1,100
900
20
920
$100
$80
$180
At date of Sale
Recognize total revenue
Recognize total costs
Profit
$1,100
920
$180
Deferral of Revenue

Sale of Stereo and Warranty are
two separate transactions
At date of Sale
Recognize total revenue
Recognize total costs
Profit

$1,000
900
$100
Defer $100 contract revenue and
allocate over 2 year period.
Partial Revenue Recognition

Transactions are linked
At date of Sale
$900/$920 x $1,100
$20/$920
Total Revenue

$1,076
24
$1,100
Defer $24 and recognize over 2year period.
How should the change
be implemented?
Implementation . . .
 Restate prior years?
 One-time cumulative adjustment?
 Phase in?
Some Concluding
Thoughts
Concluding Thoughts
 FASB sought to improve financial
disclosure 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 within
a company in a changing
environment can be a difficult
one.
What did Circuit
City Do?