Chapter 5 handout - Lecture Notes for Chapter 5 Revenue...

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Lecture Notes for Chapter 5 Revenue Recognition The Revenue Recognition Principle Revenue should be recognized (recorded) when (1) The earnings process is judged to be complete or virtually complete (2) There is reasonable certainty as to the collectability of the asset to be received (usually cash) Generally, revenues are recognized when the goods are transferred (delivery) or services are provided. SEC Staff Bulletin 101 The SEC issued Staff Accounting Bulletin No. 101 to crackdown on earnings management. The bulletin provides additional guidance to determine if the realization principle is satisfied: Persuasive evidence of an arrangement exists. Delivery has occurred or services have been performed. The seller’s price to the buyer is fixed or determinable. Collectability is reasonably assured. Deviations from Standard Revenue Recognition Procedures What if the product is sold but is in transit to the buyer? What if there is great uncertainty regarding the collection of funds? What if the product takes a long time to build and deliver? Revenue recognition and Delivery: (Three Cases) Case 1: Revenue recognized upon delivery . (A) Point of delivery based on recognition principle (B) Completed contract method Case 2: Revenue recognized after delivery . (A) Installment method. (B) Cost recovery method Case 3: Revenue recognized before delivery. (A) Free on board shipping point (B) Percentage-of-completion method for long term construction contracts Case 1(A): Point of Delivery On credit: Accounts Receivable Sales Revenue Cost of goods sold Inventory Case 3(A): Goods in transit: (Record revenues or not?):
It depends on the shipping agreement. If the goods are shipped f.o.b (free on board) shipping point, then legal title of the goods are transferred to be buyer once the goods are shipped so the seller can record revenues when the items are shipped. If the goods are shipped f.o.b. destination , legal title is transferred once the goods are delivered so the seller has to wait until the products are delivered before revenues can be recorded. Revenue Recognition after Delivery Revenue recognition can be deferred beyond the point of sale in exceptional cases: collection of revenue is highly uncertain. The buyer has a right to return the product (over a long period). Two methods can be used: The Installment Sales Method. The Cost Recovery Method. NOTE: The Installment Method does not necessarily relate to all “installment sales” where payments are periodically made. Case 2 (A): Installment Method Used when there is uncertainty about the collection of revenue. Gross profit on the sale is deferred until cash is collected. Over time as cash is collected, profits are realized in proportion to cash received.

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