REVENUERECOGNITION

A.

B.

Revenues are inflows of assets and/or settlements of

liabilities from delivering or producing goods, rendering
services,orotheractivitiesthatconstituteanenterprise's
ongoingmajororcentraloperationsduringaperiod.
1.

Thetotalrevenuerecognizedduringanaccountingperiod
istheestimatedincreaseincashflowthatwillresult
from the productcreating and servicerendering
activities conducted during the reporting period.
Revenues arise from the operations of the primary
business activities of the entity. The proceeds from
assetsalesthataresecondarytotheprimaryoperations
arenotrevenues,butmayresultingainsorlossesfrom
continuing activities. Many significant financing and
investment transactions affect cash flows but do not
involverevenue.

2.

The earningprocess istheprocessthatbeginswiththe

investmentofcashbyowners,orthereinvestmentofcash
by the firm, and ends with the collection of cash or
equivalent resources from customers. We introduce the
notionofanearningprocesstoconsiderthecomplexity
anddiversityoftheproduction,distributionandother
activities that may be involved in the creation of
revenue. Accounting principles, assumptions and
conventions are stated in general terms to accommodate
thecomplexityofthesebusinessactivities.

3.

Revenue recognition is extremely important because

revenue is the accounting measure of the value of the
productscreatedorservicesprovidedduringareporting
period. If revenue is overstated, the financial
statementswilloverstatetheeconomicperformanceofthe
firm.

The revenue recognition principle provides that revenue is

recognizedwhen:
1.

itisrealizedorrealizable,and

2.

itisearned.

3.

"Recognition" means revenue is included in the

computationofincomefromoperations.

4.

"Realized"meansgoodsorservicesareexchangedforcash
orclaimstocash(receivables).

C.

D.

5.

"Realizable"meansgoodsandservicesareexchangedfor
assetsthatarereadilyconvertibletoknownamountsof
cashorclaimstocash.

6.

"Earned" means the earning process is virtually or

essentially complete and the entity has substantially
accomplished what it must do to be entitled to the
benefitsrepresentedbytherevenue.

Importantcharacteristicsofearningprocesses:
1.

Revenue is earned through processes that result in the

creation of products or the provision of services.
However, because most products have warranties, the
complete earning process can be quite lengthy. What
examplesoflongdelayedcostsassociatedwithproducts
orservicescometomind?

2.

Theorder(sequence)ofthevaluecreatingactivitiesmay
vary from case to case. A contractor might purchase
land,designandbuildahouse,andofferthehousefor
sale. Alternatively,alandownermightdesignahome,
contractwithabuildertoconstructthehouse,andthen
occupy it upon completion. In the first case, the
revenue, costs and timing of completion are uncertain
whentheprocessbegins. Inthelattercase,theprice
(revenuetothecontractor)isknownwhenthecontractis
signed,butthecostandcompletiondateareuncertain.

3.

Risk and uncertainty influence the recognition of

revenue.
a. The producer must be capable of completing the
earningprocessandintendtodoso.
b. The customer should have the ability and intent to
pay.
c. The amount of cash receivable must be subject to
reasonableestimation.
d. Anyremainingcostsandexpensesmustbesubjectto
reasonableestimation.
e. Any contingencies, such as final acceptance of the
product, should be resolved or predictable with
acceptablelevelsofrisk.
f. The product should be able to perform to meet
specifications.

RevenueRecognitionClassifiedbyNatureofTransaction
1. Saleofproductfrominventory
a. Revenuerecognitionatpointofsale(delivery)
b. Revenuerecognitionbeforedelivery
c. Revenuerecognitionafterdelivery

d.
2.

Revenuerecognitionatpointofsale(delivery)
a. Sales with buyback agreements that compensate the
purchaserforholdingcostswhichareincludedina
setpriceshouldnotresultinrevenuerecognition.
b. Saleswhentherightofreturnexistsarecoveredby
SFAS48.Allsixofthefollowingconditionsmustbe
met:
(1) Seller's price is substantially fixed or
determinableatsale.
(2) Buyerhaspaidthesellerandtheobligationto
payisnotcontingentonresaleofgoods.
(3) Buyer's obligation is not changed by theft, or
physicaldamagetogoods.
(4) Thebuyerhaseconomicsubstanceindependentof
theseller.
(5) Sellerdoesnothavesignificantobligationsto
bring about resale to the product to final
customers.
(6) The amount of future returns can be reasonably
estimated.
c.

3.

Revenuerecognitionforspecialsalestransactions
franchisesandconsignments

Trade Loading and Channel Stuffing are practices

designedtoinflatethesalesofmanufacturersatthe
expenseoffuturesales.
(1) "Tradeloadingisacrazy,uneconomic,insidious
practice through which manufacturerstrying to
showsales,profits,andmarketsharetheydon't
actuallyhaveinducetheirwholesalecustomers,
knownasthetrade,tobuymoreproductthanthey
can promptly resell." (Fortune [December 31,
1989],p.89.)
(2) Inotherindustriesthispracticemaybecalled
"channelstuffing."

Revenuerecognitionbeforedelivery
a. Revenuerecognition during productionusuallylong
termcontracts:percentageofcompletionmethod.
b.

Revenue recognition upon the completion of

production:
(1) When revenues have been prepaid, revenue is
recognized upon the production of the item for
which payment had been received (e.g.,
subscriptionsformagazines,etc.)
(2) Revenue may be recognized for selected
agricultural products for which market prices
existandtheproductsareavailableforsale.
(3) Revenuesfrompreciousmetalsmayberecognized

when production is complete in certain

circumstances.
(4) Forlongtermcontracts,revenuesarerecognized
when contracts are complete. This is known as
thecompletedcontractmethod.

E.

c.

Accretion is the increase in value associated with

naturalgrowthprocesses.Accretioninvolvesgrowth
of a resource, such as timber, not just a gain
through holding that resource. Income from
accretion is not reported as a matter of practice,
but producers usually provide such supplementary
information. For example, firms making wood
products report the number of board feet of lumber
reserves.

d.

Discovery basis some recognition is given to the

discovery of oil and gas reserves in the petroleum
industry.However,noincomeisrecognizeduponthe
discoveryofnaturalresources.

Warranties involvethepayment,usuallyatthebeginningof
thewarrantyperiod,ofafixedfeetoreceivemaintenance,
repairorreplacementservicesforaspecifiedperiodoftime
fornofurthercostorforareducedprice. Warrantiesare
commonlyincludedinthesalepriceofaproductorservice.
Alternatively, warranty contracts are increasingly sold to
supplement or extend the basic warranty period. Such
warrantiesarepricedseparatelyandpurchaseisvoluntary.
1.

Accountingmethods
a. Cash basis accounting is used is limited
circumstances:
(1) Theamountofthewarrentyobligationislimited
or immaterial relative to the price or cost of
theproductorserviceunderwarrenty.
(2) Thewarrantyperiodisrelativelyshort.
(3) Thewarrantycostsincurredarestableovertime
andweprojectnochangesintrend.
b. Accrual basis accounting is the generally accepted
accountingmethod.
(1) The revenue associated with the warranty is
earnedoverthelifeofthewarrenty