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Revenue Recognition

Revenue Recognition. UAA ACCT 650 Seminar in Executive Uses of Accounting Dr. Fred Barbee. Marketing the product Receiving customers’ order Negotiating and signing production contracts. Ordering materials. Manufacturing the product.

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Revenue Recognition

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  1. Revenue Recognition UAA ACCT 650 Seminar in Executive Uses of Accounting Dr. Fred Barbee

  2. Marketing the product Receiving customers’ order Negotiating and signing production contracts. Ordering materials Manufacturing the product. Delivering the product. Collecting the cash from customers. Consider a Manufacturing Firm . . . When is Income Earned?

  3. “The fundamental revenue recognition concept is that revenues should not be recognized by a company until realized or realizable and earned by the company.” Lynn E. Turner, Chief Accountant, SEC Speech by SEC Staff: Revenue Recognition May 31, 2001

  4. Revenue Recognition At the Financial Accounting Standards Board (FASB)

  5. In an effort to provide better and more comprehensive guidance as to when companies should record revenues, the FASB has added a project on revenue recognition to its agenda. www.fasb.org May 22, 2002

  6. “Revenue usually is the largest item in financial statements, and revenue recognition issues top the list of reasons for financial reporting restatements.” L. Todd Johnson FASB Senior Project Manager www.fasb.org/news/nr052002.shtml

  7. A bottom up approach that provides an inventory of existing revenue recognition guidance and accepted practices. A top down approach focusing on conceptual guidance.

  8. “. . . Issues involving revenue recognition are among the most important – and the most difficult – that standard setters and accountants face.” www.fasb.org/project/revenue_recognition.shtml

  9. Conceptual Guidance Authoritative Literature Significant Gap Standards on Revenue Recognition FASB Concept Statements 5 and 6 APB, FASB, AICPA, EITF, SEC, SAB

  10. Conceptual Guidance Authoritative Literature Standards on Revenue Recognition FASB Concept Statements 5 and 6 APB, FASB, AICPA, EITF, SEC, SAB

  11. Revenue • Revenues are inflows of assets and/or settlement of liabilities from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. Statement of Financial Accounting Concepts No. 6 “Elements of Financial Statements” Paragraph 78

  12. Revenue • Essential Characteristics • Inflows of assets or settlements of liabilities • Result of some productive activity of the firm • Major or central operation

  13. Recognition • The process of formally recording or incorporating an item into the financial statements of an entity as an asset, liability, revenue, expense, or the like. Statement of Financial Accounting Concepts No. 5 “Recognition & Measurement in Financial Statements of Business Enterprises” - Paragraph 6

  14. Recognition • Essential Characteristics • Depiction in both words and numbers • Included in financial statements and statement totals • Disclosure by other means is not recognition Statement of Financial Accounting Concepts No. 5 “Recognition & Measurement in Financial Statements of Business Enterprises” - Paragraph 6

  15. To be recognized . . . • An item must meet the definition of an element • It must be measurable • It must be relevant • It must be reliable

  16. Principle of Revenue Recognition • To recognize a revenue it must be: • Realized (or realizable) • Earned

  17. Principle of Revenue Recognition • Realized • When cash or claims to cash are received. • Realizable • When assets received are readily convertible to known amounts of cash or claims to cash.

  18. Realization Criterion • The revenue – the amount the customers will pay – can be objectively measured. • The eventual collection of cash (or cash-equivalents) can be reasonably assured. • Any remaining fulfillment costs can be estimated with reasonable reliability and accuracy.

  19. The Earned Criterion • The company has completed a substantial portion of the production and sales effort. • The risks of ownership have been shifted to the customer.

  20. Whoa . . . Wait a Minute! • This all sounds so incredibly easy! • So . . . Why do we have so many problems with revenue recognition?

  21. Timing of Revenue Recognition

  22. The Timing of Revenue Recognition • The point at which an order is obtained from a customer. • The point at which an order is accepted and the terms of the sale are finalized.

  23. The Timing of Revenue Recognition • The point at which goods are delivered to a customer. • The point at which the customer is billed • The point at which payment is received from the customer.

  24. Type of Transaction Sale of Product From Inventory Revenue Sales Timing of Recognition Date of Sale (Date of Delivery) Revenue Recognition Classified by Nature of Transaction

  25. Type of Transaction Rendering a Service Revenue Fees or Services Timing of Recognition Services Performed and Billable Revenue Recognition Classified by Nature of Transaction

  26. Type of Transaction Permitting use of an Asset Revenue Interest, Rent, and Royalties Timing of Recognition As time passes or assets are used Revenue Recognition Classified by Nature of Transaction

  27. Type of Transaction Sale of asset other then inventory Revenue Gain or loss on disposition Timing of Recognition Date of Sale or Trade in Revenue Recognition Classified by Nature of Transaction

  28. Figure 2.2 The Revenue Recognition Process: Industries Recognizing Revenue at Indicated PhasesRevenues may also be recognized at other times besides thepoint of sale.

  29. Revenue Recognition At the Securities and Exchange Commission (SEC)

  30. The SEC & Revenue Recognition • SABs do not represent rules or interpretations of the Commission but rather represent the interpretations and practices followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the Federal securities laws. SEC Staff Accounting Bulletin No. 101 - FAQs http://www.sec.gov/info/accountants/sab101faq.htm

  31. The SEC & Revenue Recognition • SAB 101 . . . • Reflects the basic principles of revenue recognition in existing GAAP. • Does not supersede any existing authoritative literature. • Summarizes in one location the existing guidance on revenue recognition. SEC Staff Accounting Bulletin No. 101 - FAQs http://www.sec.gov/info/accountants/sab101faq.htm

  32. Revenue Recognition Per the SEC • Persuasive evidence of an arrangement exists; • Delivery has occurred or services have been rendered; SEC Staff Accounting Bulletin No. 101 http://www.sec.gov/interps/account/sab101.htm

  33. Revenue Recognition Per the SEC • The seller’s price to the buyer is fixed or determinable; and • Collectibility (payment) is reasonably assumed. SEC Staff Accounting Bulletin No. 101 http://www.sec.gov/interps/account/sab101.htm

  34. Revenue Recognition Per the SEC • SAB 101 observes that “judgment” is the key factor in deciding the timing and amount of revenue to recognize. SEC Staff Accounting Bulletin No. 101 http://www.sec.gov/interps/account/sab101.htm

  35. Let’s look at . . . C O M s .

  36. Should a company that acts as a distributor or reseller of products or services record revenue as gross or net?

  37. Example – Priceline.com . . . • Priceline.com brokered airline tickets online and included the full price of the ticket as Priceline.com revenues. This greatly inflated revenues relative to traditional ticket brokers and travel agents who only included commissions as revenue.

  38. Example – eBay.com . . . • eBay.com included the entire price of auctioned items into its revenue even though it had no ownership or credit risk for items auctioned online.

  39. Example – Land’s End . . . • Land’s End issued discount coupons (e.g., 20% off the price), recorded sales at the full price, and then charged the price discount to marketing expense.

  40. Resolution (EITF 99-19)

  41. Resolution – EITF 99-19 • For gross reporting of a transaction price, a company should meet the following tests regarding the product or service being sold . . .

  42. The Company . . . • Is the primary obligor. • Has general inventory risk. • Has latitude in establishing prices • Changes the product or performs part of the service.

  43. The Company . . . • Determines product/service specifications. • Bears risk for physical loss of inventory. • Bears credit risk. • Cash and price discounts must be deducted from revenue rather than be reported as expenses.

  44. The Case: Circuit City Stores, Inc. (A) Why Study This Case?

  45. Why Study This Case • Examine revenue recognition issues • Process used by FASB • Substance over form • Communications with Shareholders

  46. Why is Mike Chalifoux Disturbed?

  47. Why is Mike Disturbed? • Reported income will be reduced and Circuit City growth rate will appear slower. • He believes that Circuit City’s present accounting policy is correct.

  48. Why is Mike Disturbed? • Full recognition of revenue from extended warranty sales is justifiable; and • Deferral will not match revenues and expenses for the substance of the transaction.

  49. What Actions Could Mike Chalifoux Take

  50. What Could Mike Do? • Present his case to the FASB • Rally the industry to lobby FASB • Estimate the effect of the possible change.

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