Revenue Recognition

1
Chapter 5

• Revenue Recognition

2
Outline

• Definition
• General criteria
• Exceptions to point of delivery
• Right of return
• Consignment sales
• Installment sales
• Construction contracts
• Service revenue
• Other
• Software
• Franchise

3
Definition

• Revenue Recognition
• Reporting revenues and related cost of sales on
  the income statement.

4
General Criteria for Revenue Recognition

• Revenues are recognized when
• the activity or activities performed by the
  company to generate the revenues (i.e., the
  earnings process ) is judged to be complete or
  virtually complete, and
• there is reasonable certainty as the
  collectibility of the asset received in payment
  or any uncertainty about collectibility can be
  quantified as part of the allowance for doubtful
  accounts.
• These two criteria are usually met when the
  product is delivered to the customer.

5
Exceptions to the Point of Delivery Rule of Thumb

• Right of return
• If sales returns can be estimated based on
  historical norms, revenues recognized at point of
  delivery (discussion of accounting for estimated
  sales returns is in Chapter 7).
• If sales returns cannot be reliably estimated,
  revenue recognition delayed until right of return
  expires.
• Example Intel Corporation page 229.

6
Exceptions to the Point of Delivery Rule of Thumb

• Consignment sales
• Consignor (manufacturer)
• Consignee (retailer)
• Title remains with consignor, consignee has
  possession and receives a commission for selling
  the product on behalf of consignor.
• Consignor recognizes revenue when consignee sells
  product.

7
Exceptions to the Point of Delivery Rule of Thumb

• Installment sales
• Seller finances product sale over time.
• Examples
• Auto purchase from GM financed over 60 months.
• Refrigerator purchase from Sears financed over 24
  months.
• Normally, revenue recognized at point of
  delivery.
• But, if significant uncertainty about
  collectibility then revenue recognized over time
  as cash is received.
• Installment method of accounting
• Profit recognized in proportion to cash received.
• Cost recovery method of accounting.
• Profit recognized only when cost is recovered.

8
Exceptions to the Point of Delivery Rule of Thumb

• Construction Contracts
• The economics of the transaction.
• Customer wants something constructed (building,
  ship, bridge, etc.)
• Customer sign a contract with construction
  company.
• Construction commences.
• Company incurs costs as construction proceeds.
• Company periodically bills customer (progress
  billings).
• Construction is eventually completed after an
  extended period of time (could be several years).

9
Exceptions to the Point of Delivery Rule of Thumb

• Construction Contracts
• Two methods of accounting.
• Percentage-of-completion (the norm).
• Completed contract (the exception).
• Percentage of completion.
• Profit on job recognized as construction proceeds
  in proportion to the percentage of the job
  completed.
• Estimate of percentage complete derived from
  percentage of estimated total job costs incurred.
• Completed contract
• Used only when cannot reliably estimate degree of
  progress on the job.

10
Exceptions to the Point of Delivery Rule of Thumb

• Service revenue
• Recognized over time as services are rendered.
• Examples
• Lessor renting property
• Magazine subscriptions
• Health club membership.

11
Other

• Software
• Product sold software technical support
  right to upgrade
• Each component has value.
• Total sales price must be allocated to each of
  these components and usual criteria applied to
  each component separately.
• Portion assigned to software usually recognized
  immediately
• Portion assigned to technical support and upgrade
  right usually recognized over time as services
  rendered or upgrades delivered.

12
Other

• Franchising
• The economics
• Franchisor has developed a business model and
  name recognition that is valuable (e.g.,
  McDonalds)
• Franchisee wants to use the franchisors name and
  business model.
• Franchise agreement signed.
• Franchisor will supply franchisee with products,
  assistance, and permit use of name in exchange
  for
• Initial, up-front fee for initial services
  provided by franchisor (e.g., aid in obtaining
  financing, selecting a location and constructing
  a restaurant, hiring employees, etc.)
• Continuing fee (usually a percentage of sales)
  for continuing services provided by franchisor.
• The accounting
• Initial fee recognized when substantially all of
  initial services finished.
• Continuing fee recognized over time as earned.

13
Other

• Interim reporting
• Quarterly financial statements
• Expenditures benefiting other quarters
  capitalized and allocated over the period
  benefited.