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Revenue Recognition

Revenue Recognition. Yongtao (David) Hong. Revenue Recognition in Financial Statement. Inflating revenue: more than 50% of financial reporting Frauds. Chapter 14 Revenue Recognition of Financial Shenanigans:

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Revenue Recognition

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  1. Revenue Recognition Yongtao (David) Hong

  2. Revenue Recognition in Financial Statement Inflating revenue: more than 50% of financial reporting Frauds. Chapter 14 Revenue Recognition of Financial Shenanigans: Revenue from long-term construction contracts, consignment sales, installment sales, and revenue from leasing assets SEC Staff Accounting Bulletin: No. 101 Revenue Recognition in Financial Statement: Broader areas and some other specific industries

  3. Table 1: Accounting Literature on Revenue Recognition

  4. SFAC No. 5: the general principles, revenue should not be recognized until it’s realized or realizable and earned. Four criteria: a. Persuasive evidence of an arrangement exists, b. Delivery has occurred or services have been rendered, c. The seller’s price to the buyer is fixed or determinable, and d. Collectibility is reasonably assured.

  5. 1. Persuasive evidence of an arrangement Case 1: final agreement and side agreement • Company A delivers product to customer Beta • A final agreement executed by the proper authority of Beta Comment: a. A final agreement constitutes the persuasive evidence of an arrangement b. Side agreement signals the incompleteness of original agreement

  6. 1. Persuasive evidence of an arrangement Case 2 (consignor) and the consignment sale (consignee) in Chpt: 14 • no sale is made when products delivered to a consignee Comment: no revenue be recognized on consignor’s book if a transaction possesses at least one of following characteristics a. The buyer has the right to return the product; b. The seller is required to repurchase the product at specified prices that are not subject to change except for fluctuations due to finance and holding costs, and the amounts to be paid by the seller will be adjusted as necessary, to cover substantially all fluctuations in costs incurred by the buyer. c. The transaction possesses the characteristics set forth in EITF Issue No. 95-1, Revenue Recognition on Sales with a Guaranteed Minimum Resale Value, and does not qualify for sales-type lease accounting. d. The product is delivered for demonstration purposes.

  7. 2. Delivery and performance Case 3: bill and hold sale • Company A: completes manufacturing customer ordered products • Customers: not ready to take the delivery Comment: unless transfer of title and ownership is completed, delivery generally is not assumed to have occurred Seven conceptual criteria: a. The risks of ownership must have passed to the buyer; b. The customer must have made a fixed commitment to purchase the goods, preferably in written documentation; c. The buyer, not the seller, must request that the transaction be on a bill and hold basis. The buyer must have a substantial business purpose for ordering the goods on a bill and hold basis; d. There must be a fixed schedule for delivery of the goods. The date for delivery must be reasonable and must be consistent with the buyer's business purpose (e.g., storage periods are customary in the industry);

  8. 2. Delivery and performance Case 3: bill and hold sale (continued) e. The seller must not have retained any specific performance obligations such that the earning process is not complete; f. The ordered goods must have been segregated from the seller's inventory and not be subject to being used to fill other orders; and g. The equipment [product] must be complete and ready for shipment Other factors to be considered: a. preparation and fulfillment of financial statement b. customer specified delivery site c. the certainty of customer acceptance d. seller’s complement of the specified arrangement terms e. the reliance of multiple deliveries, and f. the commencement of license term in licensing and similar arrangement

  9. 2. Delivery and performance Case 4: “layaway” sales • Company R holds and separates the merchandise in its inventory. • The customer pays cash deposit first, and has to pay the balance of the full amount later. Otherwise the customer may lose the deposit. Comment: Should the other criteria for revenue recognition be met, a company may recognize sales revenue under layaway program upon delivery of the specified product to the customer. – Item 2 of Commission for bill and hold transactions.

  10. 2. Delivery and performance Case 5: non-refundable, up-front fee Sources: • selling lifetime membership in the health club, • research and development services promised by biotech companies to a customer for a particular period, and • “activation fee” for telecommunication services charged by the provider to a customer Comment: Deferring the revenue If the up-front fee and the continuing performance are undividable, the up-front fees, even if nonrefundable, are earned as the products and /or services are delivered and/or performed over the term of the arrangement or the expected period of performance.

  11. 2. Delivery and performance Case 6: Long term automated tracking services • The company set up a specific procedure and then offers nearly automated activity tracking or similar services in 10 years • The customer needs to prepay all the services over the term Comment: straight-linerevenue recognition, unless evidence suggest that the revenue is earned or obligation are fulfilled in a different pattern

  12. 3. Fixed or determinable sales price Case 7: club membership fee • M charges customers annual membership fees • the customer can unilaterally terminate the arrangement at any time during its term and get a full refund of the initial fee Comment: not to recognize revenue at the beginning. a. Unfulfilled contractual obligation to perform service determines that the earnings process is incomplete. b. SFAS No. 125, which indicates that the liability would not be extinguished (and therefore no revenue would be recognized in earnings) until the cancellation or termination and related refund privileges expire.

  13. 3. Fixed or determinable sales price Lease payment: Case 8: • SFAS No. 13 and No. 29, contingent rental income should be accrued when some changes should be waited for actually occur. • When supplement rental is a contingent rental, not included into minimum lease payments. • Company has to wait for the occurrence of the contingent rental income, then recognize it. Example in Chpt 14: a company takes advantage of the uncertainties in lease to a. disguise an operating lease as a capital lease, hence boosting its revenue in the early period of the project b. change assumed discount rate and residual value to inflate revenue from capital lease

  14. 3. Fixed or determinable sales price Case 9: product return estimate • Paragraph 8 of SFAS No. 48 lists factors impair return estimates • Other factors: a. significant increases in or excess levels of inventory in a distribution channel (sometimes referred to as "channel stuffing"), b. lack of "visibility" into or the inability to determine or observe the levels of inventory in a distribution channel and the current level of sales to end users, c. expected introductions of new products that may result in the technological obsolescence of and larger than expected returns of current products, d. the significance of a particular distributor to the registrant's (or a reporting segment's) business, sales and marketing, e. the newness of a product, f. the introduction of competitors' products with superior technology or greater expected market acceptance, and other factors that affect market demand and changing trends in that demand for the registrant's products.

  15. 3. Fixed or determinable sales price Examples in Chpt 14: long-term construction contracts Questions: • Is it likely that the contract can be completed? • Any important uncertainties exist? And • Can the completion rate can be measured accurately? Answer: Yes: Percentage completion method No: Completed-contract method. More conservative. Otherwise, inappropiate

  16. 4. Assurance of Collectibility Example of installment sale in Chpt 14 Principle: • uncertain whether payment to be made • the conservative installment method (defer the gross profit only after cash are collected from the sale) Aggressive accounting is not acceptable, and should be paid much attention to.

  17. 5. Income statement presentation and other issues • Case 10: internet company If it’s an agent or broker only, recognize revenue on a net basis. • Disclose registrant’s accounting policy for the recognition of revenue in accordance with APB Opinion No. 22, Disclosure of Accounting Policies. • No registrants are compelled to restate prior financial reports • Retail companies: SFAS No. 13 determines that including the sales of the leased or licensed departments will boost its revenue and is not acceptable

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