Revenue Recognition

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Revenue Recognition

• UAA ACCT 650
  Seminar in Executive Uses of Accounting Dr.
  Fred Barbee

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Consider a Manufacturing Firm . . .

• Manufacturing the product.
• Delivering the product.
• Collecting the cash from customers.

• Marketing the product
• Receiving customers order
• Negotiating and signing production contracts.
• Ordering materials

When is Income Earned?
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• 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
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Revenue Recognition

• At the Financial Accounting
  Standards Board (FASB)

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• 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
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• 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
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A bottom up approach that provides an inventory
of existing revenue recognition guidance and
accepted practices.
A top down approach focusing on conceptual
guidance.
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• . . . 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
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Standards on Revenue Recognition
FASB Concept Statements
5 and 6
APB, FASB, AICPA, EITF, SEC, SAB
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Standards on Revenue Recognition
FASB Concept Statements
5 and 6
APB, FASB, AICPA, EITF, SEC, SAB
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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
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Revenue

• Essential Characteristics
• Inflows of assets or settlements of liabilities
• Result of some productive activity of the firm
• Major or central operation

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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
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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
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To be recognized . . .

• An item must meet the definition of an element
• It must be measurable
• It must be relevant
• It must be reliable

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Principle of Revenue Recognition

• To recognize a revenue it must be
• Realized (or realizable)
• Earned

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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.

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Realization Criterion

• The revenue the amount the customers will 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 and accuracy.

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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.

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Whoa . . . Wait a Minute!

• This all sounds so incredibly easy!

• So . . . Why do we have so many problems with
  revenue recognition?

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Lets Approach This From a Different Perspective
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Criteria for Revenue Recognition

• The critical event in the process of earning the
  revenue has taken place.

Condition 1

• The amount of revenue that will be collected is
  reasonably assured and is measurable with a
  reasonable degree of certainty.

Condition 2
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Timing of Revenue Recognition
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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.

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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.

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Revenue Recognition Classified by Nature of
Transaction
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Revenue Recognition Classified by Nature of
Transaction
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Revenue Recognition Classified by Nature of
Transaction
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Revenue Recognition Classified by Nature of
Transaction
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And then. there were . . .
C
O
M
s
.
Now what?????
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Figure 2.2 The Revenue Recognition Process
Industries Recognizing Revenue at Indicated
PhasesRevenues may also be recognized at other
times besides thepoint of sale.
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Revenue Recognition

• At the Securities and
  Exchange Commission (SEC)

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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
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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
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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
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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
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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
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Lets look at . . .
C
O
M
s
.
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Should a company that acts as a distributor or
reseller of products or services record revenue
as gross or net?
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Motivations for Reporting at Gross

• Typical e-Commerce firm had negative earnings and
  P/E multiples
• Investors substitute revenue reports for earnings
  reports, especially revenue growth.
• Companies that report at gross may inflate market
  share proportions.

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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.

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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.

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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.

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Resolution (EITF 99-19)
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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 . . .

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The Company . . .

• Is the primary obligor.
• Has general inventory risk.
• Has latitude in establishing prices
• Changes the product or performs part of the
  service.

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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.

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The Case Circuit City
Stores, Inc. (A)

• Why Study This Case?

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Why Study This Case

• Examine revenue recognition issues
• Process used by FASB
• Substance over form
• Communications with Shareholders

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Why is Mike Chalifoux
Disturbed?
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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.

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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.

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What Actions Could Mike Chalifoux Take
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What Could Mike Do?

• Present his case to the FASB
• Rally the industry to lobby FASB
• Estimate the effect of the possible change.

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Three Possible Methods
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Three Possible Methods

• Full Revenue Recognition
• Deferral of Revenue
• Partial Revenue Recognition

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Full Revenue Recognition
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Deferral of Revenue

• Sale of Stereo and Warranty are two separate
  transactions

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

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Partial Revenue Recognition

• Transactions are linked

• Defer 24 and recognize over 2-year period.

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How should the change be implemented?
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Implementation . . .

• Restate prior years?
• One-time cumulative adjustment?
• Phase in?

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Some Concluding Thoughts
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Concluding Thoughts

• FASB sought to improve financial disclosure by
  limiting diversity in accounting practice.
• Good matching of revenues and expenses is not
  always easy.

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Concluding Thoughts

• The job of determining, supporting and sustaining
  financial reporting policies within a company in
  a changing environment can be a difficult one.

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What did Circuit City Do?