Revenue is normally recognized when a product is delivered (title transfers to the buyer) or the service is performed. This is assuming that the two revenue recognition criteria above are satisfied and that collectibility is reasonably certain.Completion of Production BasisIncome Measurement and Profitability Analysis REVENUE RECOGNITION Revenue Recognition Principle Revenues are recognized when: (1) It is realized or realizable a) Revenue is realized when goods or services are exchanged for cash or receivables b) Revenue is realizable when assets received are convertible to cash or receivable (2) It is earned a) Revenues are earned when the earnings process is complete Quality of Earnings Some publicly traded companies have had a tendency to recognize revenue prematurely. This affects the quality of earnings and the transparency of overall financial reporting. To combat this problem the SEC issued Staff Accounting Bulletin No. 101 that provides additional criteria that must be followed in determining when revenue should be recognized. The additional criteria are as follows: 1) Persuasive evidence of an arrangement exists. 2) Delivery has occurred or services have been rendered. 3) The seller’s price to the buyer is fixed or determinable. 4) Collectibility is reasonably assured. REVENUE RECOGNITION AT A POINT IN TIME The recognition of revenue depends of the type of business transaction involved. The following is a table that lists the types of business transactions that might occur and the timing of revenue recognition. This assumes that collectibility is reasonably certain. Transaction Products Services Use of Assets Disposition of Assets Source Sales Fees Interest, rents Gain or loss Timing Date of sale (date of delivery) Services performed Passage of time Date of sale or trade-in Completion of the Earnings Process within a Single Reporting Period Revenue is normally recognized when a product is delivered (title transfers to the buyer) or the service is performed. This is assuming that the two revenue recognition criteria above are satisfied and that collectibility is reasonably certain. Completion of Production Basis Under certain circumstances revenue is recognized at the completion of production even though the product has not been sold. The circumstances that would make this possible are: 1) The sales price is reasonably assured 2) The units of product are interchangeable 3) There are no significant costs involved in product distribution Products that normally qualify for this type of accounting treatment are the harvesting of agricultural crops and the mining of metals. E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc 1/31/2007 1Income Measurement and Profitability Analysis Installment Sales Accounting Method The recognition of revenue is based on the collection of cash rather than the completion of the sale. It is used in industries where collection is relatively uncertain. To accomplish this we use a separate set of accounts to record “Installment Receivables” and “Deferred Gross Profit.” Year of Installment Sale: (1) Record all transactions as follows: ACCOUNT DEBIT CREDITInstallment receivables $XX,XXX Inventory $XX,XXX Deferred gross profit, (current year) $X,XXXTo record installment sales and related deferred gross profit for the year. (2) Calculate the gross profit percentage for all sales for the current year. Amount PercentageInstallment sales $100,000 100%Cost of installment sales 60,000 60%Gross profit on installment sales $40,000 40% (3) Record the collection of installment receivables and the recognition of gross profit as follows: ACCOUNT DEBIT CREDITCash $XX,XXX Installment receivables $XX,XXXTo record cash collected on installment receivablesDeferred gross profit, (current year) $X,XXX Realized gross profit $X,XXXTo recognize gross profit on the collection of installment receivables Installment Collections on Prior Year Sales: Apply each year’s gross profit percentage to the installment collections related to that year’s sales as follows: E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc 1/31/2007 2Income Measurement and Profitability Analysis ACCOUNT DEBIT CREDITCash $XX,XXX Installment receivables, (year 1) $XX,XXX Installment receivables, (year 2) $XX,XXXTo record cash collected on installment receivablesDeferred gross profit, (year 1) $X,XXXDeferred gross profit, (year 2) $X,XXX Realized gross profit $X,XXXTo recognize gross profit on the collection of installment receivables Financial Statement Presentation The gross profit realized in the current year is reported as a separate component of gross profit in the income statement. If a company has regular sales and installment sales the income statement would be presented as follows. Sales $500,000 Cost of goods sold 400,000Gross profit on sales 100,000 Gross profit realized on installment sales 16,200Total gross profit $116,200 Cost Recovery Method The cost recovery method is use primarily in the real estate industry. It is used when the collection of the selling price is uncertain. The same procedure is used as we demonstrated in the installment method except that during the earlier periods no gross profit is recognized. We do not recognize any gross profit until all of the costs have been recovered. Deposit Method Under the deposit method the seller has not performed on the contract but has received cash from the buyer. The seller records the cash deposit as a credit to a current liability account. When the seller has completed the service or delivered the product then the deposit will be reclassified to revenue and recognized in the income statement. Buyback Agreements There is no sale if a repurchase agreement is in place whereby the seller agrees to repurchase the entire inventory at a set price which covers the holding costs. The inventory remains on the seller’s books until the buyer resells the merchandise thus completing the transaction. Right of Return In industries where there is a high rate of returns, there are three possible alternatives to recording revenue. (1) Delay recording the sale until the privilege for return has expired (2) Recording the sale and an estimate of future returns (3) Recoding the sale and recording the returns as they occur E:\Teaching\3321\web\module2\c5\tnotes\c5a.doc 1/31/2007 3Income Measurement and Profitability Analysis The following six conditions must be