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Chapter5: Income Measurement and Profitability Analysis

Part A: Revenue Recognition

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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.

   Why is the timing of revenue recognition so important? An income statement should report the results of operations only for the time period specified in the report. That is, a one-year income statement should report the company's accomplishments and sacrifices (revenues and expenses) only for that one-year period.2 Revenue recognition criteria help ensure that a proper cutoff is made each period and that no more than one year's activity is reported in the annual income statement. Revenues reflect positive inflows from activities that eventually generate cash flows. By comparing these activity levels period to period, a user can better assess future activities and thus future cash flows.

Revenue recognition criteria help ensure that an income statement reflects the actual accomplishments of a company for the period.

   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.

   The realization principle requires that the earnings process is judged to be complete or virtually complete, and there is reasonable certainty as to the collectibility of the asset to be received (usually cash) before revenue can be recognized. requires that two criteria be satisfied before revenue can be recognized (recorded):3

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1.

  

The earnings process is judged to be complete or virtually complete (the earnings process refers to the activity or activities performed by the company to generate revenue).

  

2.

  

There is reasonable certainty as to the collectibility of the asset to be received (usually cash).

   Even with these guidelines, revenue recognition continues to be a controversial issue. Premature revenue recognition reduces the quality of reported earnings, particularly if those revenues never materialize. Many sad stories have surfaced involving companies forced to revise earnings numbers downward due to a restatement of revenues. The case of Krispy Kreme Doughnuts offers a prime example. In January 2005, the company announced that it would be restating its earnings for the last three quarters of fiscal 2004. Investors were already alarmed by the recent filing of a lawsuit that alleged the company routinely padded sales by doubling shipments to wholesale customers at the end of the quarter. In the two-day period following the announced restatement, the company's stock price dropped over 20% in value!

  

ARTHUR LEVITT, JR.
Lastly, companies try to boost earnings by manipulating the recognition of revenue. Think about a bottle of fine wine. You wouldn't pop the cork on that bottle before it was ready. But some companies are doing this with their revenue…4

  
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   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:

  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.

   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.

GRAPHIC 5-1
Disclosure of Change in Revenue Recognition Policy—Brown & Sharpe Manufacturing Company

Real World Financials

 

2. Accounting Change (in part)
In 2000, the Company adopted SEC Staff Accounting Bulletin No. 101 (SAB 101). As a result of adopting SAB 101, the Company changed the way it recognizes revenue for machines sold to customers. Prior to the adoption of SAB 101, the Company recognized revenue when the machines were shipped and title passed to the customer. Effective as of January 1, 2001, the Company recognizes revenue for machines sold to customers once the performance of machines is accepted by the customers.


   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.

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ETHICAL DILEMMA
 

The Precision Parts Corporation manufactures automobile parts. The company has reported a profit every year since the company's inception in 1980. Management prides itself on this accomplishment and believes one important contributing factor is the company's incentive plan that rewards top management a bonus equal to a percentage of operating income if the operating income goal for the year is achieved. However, 2011 has been a tough year, and prospects for attaining the income goal for the year are bleak.

   Tony Smith, the company's chief financial officer, has determined a way to increase December sales by an amount sufficient to boost operating income over the goal for the year and earn bonuses for all top management. A reputable customer ordered $120,000 of parts to be shipped on January 15, 2012. Tony told the rest of top management “I know we can get that order ready by December 31 even though it will require some production line overtime. We can then just leave the order on the loading dock until shipment. I see nothing wrong with recognizing the sale in 2011, since the parts will have been manufactured and we do have a firm order from a reputable customer.” The company's normal procedure is to ship goods f.o.b. destination and to recognize sales revenue when the customer receives the parts.

   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.

GRAPHIC 5-2
Relation between Earnings Process and Revenue Recognition Methods

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   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.

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GRAPHIC 5-3
Revenue Recognition Methods

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.

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INTERNATIONAL FINANCIAL REPORTING STANDARDS

 

Revenue Recognition Concepts. IAS No. 18 governs most revenue recognition under IFRS. Similar to U.S. GAAP, it defines revenue as “the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.”8 IFRS allows revenue to be recognized when the following conditions have been satisfied:

(a)  The amount of revenue and costs associated with the transaction can be measured reliably,
(b)  It is probable that the economic benefits associated with the transaction will flow to the seller,
(c)  (for sales of goods) the seller has transferred to the buyer the risks and rewards of ownership, and doesn't effectively manage or control the goods,
(d)  (for sales of services) the stage of completion can be measured reliably.

     These general conditions typically will lead to revenue recognition at the same time and in the same amount as would occur under U.S. GAAP, but there are exceptions. For example, later in this chapter we discuss differences between IFRS and U.S. GAAP that may affect the timing of revenue recognition with respect to multiple-deliverable contracts. More generally, IFRS has much less industry-specific guidance that does U.S. GAAP, leading to fewer exceptions to applying these revenue recognition conditions.

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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. 262263, 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.

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