Chapter5: Income Measurement and Profitability Analysis
Part A: Revenue Recognition
In Chapter 4 we discussed the nature of income and its presentation in the income statement. In this chapter we turn our attention to the measurement of periodic accounting income. Of primary interest here is the timing of revenue recognition. This is an important issue not only in its own right but also because, according to the matching principle, expenses should be recognized in the period in which the related revenues are recognized, so the timing of revenue recognition affects the timing of some expense recognition.
What is revenue? According to the FASB, “Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.”1 In other words, revenue tracks the inflow of net assets that occurs when a business provides goods or services to its customers.
Our objective, then, is to recognize revenue in the period or periods that the revenue-generating activities of the company are performed. But we also must consider that recognizing revenue presumes that an asset (usually cash) has been received or will be received in exchange for the goods or services sold. Our judgment as to the collectibility of the cash from the sale of a product or service will, therefore, affect the timing of revenue recognition. These two concepts of performance and collectibility are captured by the general guidelines for revenue recognition in the realization principle.
As part of its crackdown on earnings management, the SEC issued Staff Accounting Bulletin (SAB) No. 101,5 summarizing the SEC's views on revenue. The Bulletin provides additional criteria for judging whether or not the realization principle is satisfied:
In addition to these four criteria, SAB 101 also poses a number of revenue recognition questions relating to each of the criteria. The questions provide the facts of the scenario and then the SEC offers its interpretive response. These responses and supporting explanations provide guidance to companies with similar revenue recognition issues. For example, the following question relates to the delivery and performance criteria necessary to recognize revenue on a transaction commonly referred to as a “Bill and Hold” sale:
Facts: Company A receives purchase orders for products it manufactures. At the end of its fiscal quarters, customers may not yet be ready to take delivery of the products for various reasons. These reasons may include, but are not limited to, a lack of available space for inventory, having more than sufficient inventory in their distribution channel, or delays in customers' production schedules.
Questions: May Company A recognize revenue for the sale of its products once it has completed manufacturing if it segregates the inventory of the products in its own warehouse from its own products? May Company A recognize revenue for the sale if it ships the products to a third-party warehouse but (1) Company A retains title to the product and (2) payment by the customer is dependent upon ultimate delivery to a customer-specified site?
How would you answer these questions? The SEC's response is generally, no. It believes that delivery generally is not considered to have occurred unless the customer has taken title and assumes the risk and rewards of ownership of the specific products in the customer's purchase order or sales agreement. Typically this occurs when a product is delivered to the customer's delivery site and accepted by the customer.6
Soon after SAB No. 101 was issued, many companies changed their revenue recognition methods. In most cases, the changes resulted in a deferral of revenue recognition. As a case in point, consider the change made by Brown & Sharpe Manufacturing Company, a multinational manufacturer of metrology products, described in a disclosure note, displayed in Graphic 5-1.
Real World Financials
In requiring customer acceptance as part of the agreement, revenue recognition is delayed until this part of the earnings process is completed. Although the Brown and Sharpe example relates to product delivery, many of the changes in revenue recognition companies made in response to SAB No. 101 are related to service revenue. We discuss some of these later in the chapter.p. 236
Graphic 5-2 relates various revenue-recognition methods to critical steps in the earnings process, and Graphic 5-3 provides a more detailed overview of the methods used in current practice.7 Recall that the realization principle indicates that the central issues for recognizing revenue are (a) judging when the earnings process is substantially complete and (b) whether there is reasonable certainty as to the collectibility of the cash to be received. Often this decision is straightforward and tied to delivery of the product from the seller to the buyer. At delivery, the earnings process is virtually complete and the seller receives either cash or a receivable. At other times, though, recognizing revenue upon delivery may be inappropriate. It may be that revenue should be deferred to a point after delivery because the seller is unable to estimate whether the buyer will return the product or pay the receivable. Or, sometimes revenue should be recognized at a point prior to delivery because the earnings process occurs over multiple reporting periods and the company can better inform financial statement users by making reliable estimates of revenue and cost prior to delivery.
Now let's consider specific revenue recognition methods in more detail. We start with revenue recognition at delivery, then discuss circumstances where revenue recognition must be postponed until after delivery, and then discuss circumstances that allow revenue recognition prior to delivery.p. 237
When revenue is being earned in a multi-period contract, sometimes it is more meaningful to recognize revenue over time and prior to completion in proportion to the percentage of work completed.
We usually recognize revenue at or near the completion of the earnings process.
If collectibility is an issue, we defer revenue recognition until we can reasonably estimate the amount to be received.
1“Elements of Financial Statements,” Statement of Financial Concepts No. 6 (Stamford, Conn.: FASB, 1985, par. 78).
2In addition to reporting on an annual basis, companies often provide information quarterly and, on occasion, monthly. The SEC requires its registrants to provide information on a quarterly and annual basis. This information, referred to as interim financial statements, pertains to any financial report covering a period of less than one year. The key accounting issues related to the presentation of interim statements are discussed in Appendix 5.
3These criteria are addressed in SFAC 5, “Recognition and Measurement in Financial Statements,” Statement of Financial Accounting Concepts No. 5 (Stamford, Conn.: FASB, 1984).
4Arthur Levitt, Jr., “The Numbers Game,” The CPA Journal, December 1998, p. 18.
5FASB ASC 605–10–S99: Revenue Recognition–Overall–SEC Materials (originally “Revenue Recognition in Financial Statements,” Staff Accounting Bulletin No. 101 (Washington, D.C.: SEC, December 1999) and Staff Accounting Bulletin No. 104 (Washington, D.C.: SEC, December 2003)).
6Ibid., p. 5.
7As described in more detail on pp. 262–263, the FASB is partnering with the International Accounting Standards Board to develop a comprehensive statement on revenue recognition that could change some aspects of current practice. At the time this text was published, no new pronouncements had yet resulted from the project. Updates are available at the FASB website (see http://www.fasb.org/revenue_recognition.shtml).
8“Revenue,” International Accounting Standard No. 18 (IASCF), as amended effective January 1, 2009, par. 7.