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

Authoritative Literature

Significant Gap

FASB Concept Statements 5 and 6

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 entitys 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 sellers 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

Lets 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 Lands End . . .

Lands 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 Citys 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

Stereo Revenue Cost Profit $1,000 900 $100 Contract $100 20 $80 Total $1,100 920 $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

$1,000 900 $100

At date of Sale Recognize total revenue Recognize total costs Profit

Defer $100 contract revenue and allocate over 2 year period.

Partial Revenue Recognition

Transactions are linked

$1,076 24 $1,100

At date of Sale $900/$920 x $1,100 $20/$920 Total Revenue

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?