Revenue Recognition

Introduction

The guidelines for accounting for revenue are simply stated as, “Revenues

are not recognized until they're earned.” More specifically, "Revenues are

considered to have been earned when the entity has substantially

accomplished what it must do to be entitled to the benefits represented by

the revenues” (Donnelly 1999). However, certain FASB standards and EITF

issues define earned revenues in a way that alters when companies report

revenue and how much they should record at that time. FASB Codification

has provided some assistance to seaming out these discrepancies. With the

new codification, “the answers to hard accounting questions should be easier

to track down” (Johnson 2008). Nevertheless, evaluators of financial

statements still find a thread of inconsistency between companies’ methods

of revenue recognition.

Impairment of Estimates of Return

Certain companies allow customers to make returns on merchandise, leading

to a reduction in sales. Therefore it is important for those companies to make

reliable estimates of future returns. According to Codification: 605-15-25-3,

the following main factors impair the ability to make a reasonable estimate

of returns:

1. The susceptibility of the product to significant external factors, such as

technological obsolescence or changes in demand.
2. Relatively long periods in which a particular product may be returned.
3. Absence of historical experience with similar types of sales of similar
products, or inability to apply such experience because of changing
circumstances, for example, changes in the selling entity's marketing
 policies or relationships with its customers.
4. Absence of a large volume of relatively homogeneous transactions.

Recognizing Revenue when the Right of Return Exists

On the contrary, companies that allow the right of returns

from buyers must follow six criteria that must be met before they recognize

revenue. These criteria, found in Codification: 605-15-25-1 include:

1. The seller's price to the buyer is substantially fixed or determinable at the

date of sale.
2. The buyer has paid the seller, or the buyer is obligated to pay the seller
and the obligation is not contingent on resale of the product. If the buyer
does not pay at time of sale and the buyer's obligation to pay is
contractually or implicitly excused until the buyer resells the product,
then this condition is not met.
3. The buyer's obligation to the seller would not be changed in the event of
theft or physical destruction or damage of the product.
4. The buyer acquiring the product for resale has economic substance apart
from that provided by the seller. This condition relates primarily to buyers
that exist on paper, that is, buyers that have little or no physical facilities
or employees. It prevents entities from recognizing sales revenue on
transactions with parties that the sellers have established primarily for
the purpose of recognizing such sales revenue.
5. The seller does not have significant obligations for future performance to
directly bring about resale of the product by the buyer.
6. The amount of future returns can be reasonably estimated because
detailed record keeping for returns for each product line might be costly
in some cases, this Subtopic permits reasonable aggregations and
approximations of product returns. Exchanges by ultimate customers of
one item for another of the same kind, quality, and price (for example,
one color or size for another) are not considered returns for purposes of
this Subtopic.

If revenue fails to meet the criteria above, it should be recognized “when the

return privilege has substantially expired or if those conditions subsequently

are met, whichever occurs first” (Codification: 605-15-25-1).

Hewlett Packard and Advanced Micro Devices Inc. 10-K Report

Differences Hewlett Packard Company’s 2008 10-K report

claims that they “reduce revenue for estimated customer returns,” (HP 2008

10-K report, pg 86). Advanced Micro Devices Inc.’s 2008 10-K report claims

that “estimated product returns are based on actual historical experience

and other known or anticipated trends and factors, [and] are recorded at the

time revenue is recognized” (AMD 2008 10-K report, pg 97). While there are

similar standards within each company, the policies applied are unalike. AMD

treats customers and distributors differently, as stated in their notes. AMD

also allows for distributors to return items after the item has been removed

from the company’s price book, something not found in HP’s policy. AMD

then recognizes revenue until the distributor sells the item (AMD 2008 10-K

report, pg 97).

Revenue Recognition: Gross or Net Method?

Online retailers that act as intermediate parties to manufacturers and customers must decide

whether to report its revenues on a gross or net basis. The FASB codification 605-45-45-1 notes

that it is a matter of judgment on the entity’s behalf to report revenue based on the following two

principles:

1. The gross amount billed to a customer because it has earned revenue (as a principal) from the
sale of the goods or services
2. The net amount retained (that is, the amount billed to the customer less the amount paid to a
supplier) because it has earned a commission or fee as an agent (Codification: 605-45-45-1).

The FASB codification 605-45-45-[4-13] further states that there are certain elements for

determining which method is appropriate. In total, there are 8 factors that suggest the gross basis

for revenue recognition.

1. The Entity Is the Primary Obligor in the Arrangement. If an entity is responsible for
fulfillment, including the acceptability of the products or services ordered or purchased by
the customer, that fact is a strong indicator that an entity has risks and rewards of a principal
in the transaction.
2. The Entity Has General Inventory Risk. Unmitigated general inventory risk is a strong
indicator that an entity has risks and rewards as a principal in the transaction.
3. The Entity Has Latitude in Establishing Price. If an entity has reasonable latitude, within
economic constraints, to establish the exchange price with a customer for the product or
service, that fact may indicate that the entity has risks and rewards of a principal in the
transaction
4. The Entity Changes the Product or Performs Part of the Service. If an entity physically
changes the product (beyond its packaging) or performs part of the service ordered by a
customer, that fact may indicate that the entity is primarily responsible for fulfillment,
including the ultimate acceptability of the product component or portion of the total services
furnished by the supplier.
5. The Entity Has Discretion in Supplier Selection. If an entity has multiple suppliers for a
product or service ordered by a customer and discretion to select the supplier that will
provide the product or service ordered by a customer, the entity is primarily responsible for
fulfillment.
6. The Entity Is Involved in the Determination of Product or Service Specifications. If an entity
must determine the nature, type, characteristics, or specifications of the product or service
ordered by the customer, the entity is primarily responsible for fulfillment.
7. The Entity Has Physical Loss Inventory Risk—After Customer Order or During Shipping.
Physical loss inventory risk exists if title to the product is transferred to an entity at the
shipping point (for example, the supplier's facilities) and is transferred from that entity to the
customer upon delivery. This indicator may provide some evidence, albeit less persuasive
than general inventory risk.
8. The Entity Has Credit Risk. If an entity assumes credit risk for the amount billed to the
customer, that fact may provide weaker evidence that the entity has risks and rewards as a
principal in the transaction.

On the other hand, Codification 605-45-45-[16-18] recognizes three scenarios in which

companies would use the net method in revenue recognition.

1. The Entity's Supplier Is the Primary Obligor in the Arrangement. If a supplier (and not the
entity) is responsible for fulfillment, including the acceptability of the products or services
ordered or purchased by a customer, that fact may indicate that the entity does not have risks
and rewards as principal in the transaction.
2. The Amount the Entity Earns Is Fixed. If an entity earns a fixed dollar amount per customer
transaction regardless of the amount billed to a customer or if it earns a stated percentage of
the amount billed to a customer, that fact may indicate that the entity is an agent of the
supplier.
3. The Supplier Has Credit Risk. If credit risk exists but the credit risk is assumed by a
supplier, that fact may indicate that the entity is an agent of the supplier and, therefore, the
entity should record revenue net based on the amount retained.

Revenue Recognition policy for Overstock.com

Overstock.com currently uses the gross method in recording revenue from the majority of its

sales, excluding auction and travel products. Agency and merchant revenues are further
recognized on the net basis (Overstock.com 2005 10-K report, pg 39). Overstock.com changed

its revenue recognition policy in 2003 from the net method to the gross method. The main

reason for the switch is that they started handling and taking responsibility for returned items

from sales. As a result of this, Overstock.com is now considered the primary obligor for the

sales transactions as of July 1, 2003. The company now assumes all risks of returned items and

therefore changed its revenue recognition policy to the gross method (Overstock.com 2005 10-K

report, pg F-14).

Revenue Recognition Policy for Google Inc.

According to Google’s 10-K report, the company reports revenues using the gross method in

compliance with EITF Issue 99-19. Google specifically states that under this issue they report

“revenues on a gross basis principally because [they] are the primary obligor to our advertisers”

(Google Inc. 2008 10-K report, pg 69). Since Google is responsible for the “acceptability

of the product(s) or service(s) ordered or purchased by the customer,” they then obtain the “risks

and rewards of a principal in the transaction and [should] record revenue gross based on the

amount billed to the customer” (EITF Issue 99-19, pg 1).

Works Cited
Codification
(605-15-25-3): Topic: 605 Revenue Recognition, Subtopic: 15 Products,
Section: 25 Recognition, Sales of Product When Right of Return Exists
(605-15-25-1): Topic: 605 Revenue Recognition, Subtopic: 15 Products,
Section: 25 Recognition, Sales of Product When Right of Return Exists

10-K Reports
Hewlett Packard Company 2008 10-K report,
URL:http://sec.gov/Archives/edgar/data/47217/000104746908013240/a2189
375z10-k.htm
Advanced Micro Devices Inc. 2008 10-K report,
URL:http://sec.gov/Archives/edgar/data/2488/000119312509036235/d10k.ht
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