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Revenue Recognition

Revenue: The inflow of an asset or extinguishment of a liability by providing goods and services.

The revenue recognition principle: revenues are recognized when they are realized or realizable, and earned.

To Recognize Revenue Recognition Can Occur
  1. The work must be substantially complete.
  2. The probability of collection must be high.
  1. At time of delivery
  2. Before time of delivery
  3. After time of delivery

Revenue recognition at time of delivery

Recognition at the time of delivery usually, referred to as at point of sale, happens when the product or service is delivered, and the payment is made (realized) or claim to payment is assured (realizable). Issues arise with revenue recognition in cases where: sales have a buyback agreement, the right of return exists and when the sales can be categorized as trade loading or channel stuffing.

  • Buyback Agreement If a buyback agreement exists, the economic substance of this sale is that the seller retains risk of ownership. If the rate of buyback is highly predictable, the prorated revenue may be recognized.

  • Right of Return FASB had determined that in situations where the seller gives the buyer the right to return the product, the transaction should not be recognized until six conditions are met.
    1. The seller’s price is substantially fixed at the date of sale
    2. The buyer has paid, or is obligated to pay the buyer, without a contingent on resale
    3. The buyer has full responsibility for the product, including damage or theft
    4. The buyer has economic substance apart from that provided by the seller
    5. The seller does not have obligations to guaranty the resale of the product
    6. The amount of future returns can be reasonably estimated

  • Trade Loading Trade loading or Channel stuffing is the practice where a company inflates its sales figures by forcing more products through a distribution channel than the channel is can promptly resell. This has the effect of booking future periods revenue in the current period. It has many negative consequences and the SEC has been known to litigate against it.

Revenue Recognition before time of delivery

Revenue is usually recognized at the point of sale because time and amount are known with certainty. One of the exceptions of this rule is long-term construction type projects. The measurements for long-term construction projects are difficult because much is forecast and estimated. Two basic methods of accounting for long-term construction contracts are recognized by the accounting profession: Percentage-of-Completion and Completed-Contract methods.

Companies must use the percentage-of-completion methods when estimates of progress toward completion, revenue, and costs are reasonably and dependably; as well as the following conditions exist.

  1. The contract clearly specifies the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement.
  2. The buyer can be expected to satisfy all obligations under contract.
  3. The contractor can be expected to perform the contractual obligations
More details can be found here on Percentage Of Completion Method

With the completed-contract method, revenue and gross profit are recognized when the contract is complete. The advantage is that revenue is based on actual results instead of estimates, while its disadvantage is the distortion of earnings timing.

Revenue recognition after time of delivery

Sometimes the collection of revenue is not assured at point of sale. When uncertainty is high, one of two methods is generally employed: the installment-sales method and the cost-recovery method. Because these methods violate the matching principle and should only be used when there is considerable uncertainty of collections.

In the installment-sales method recognize revenues and costs of sales in the period of the sale, but defer gross profit to the periods in which cash is collected. As payments are received they are applied proportionally to cost-of-sales and gross profit, until the receivable is satisfied.

In the cost-recovery method, revenue and cost-of-sales are both recognized when a sale occurs, while the gross profit is deferred. When cash is received the cost-of-goods sold is satisfied, before applying funds to gross profit.