The Current Environment

Revenue recognition is a top fraud risk and regardless of the accounting rules followed (IFRS or U.S. GAAP), the risk or errors and
inaccuracies in revenue reporting is significant.

Restatements for improper revenue recognition are relatively common and can lead to significant share price adjustments.

Guidelines for Revenue Recognition

Revenue recognition principle: Revenue is recognized :

(1) when it is probable that the economic benefits will flow to the company and

(2) when the benefits can be measured reliably.

Revenue Recognition Classified by Nature of Transaction

Departures from the Sale Basis

Earlier recognition is appropriate if there is a high degree of certainty about the amount of revenue earned.

Delayed recognition is appropriate if the

 degree of uncertainty concerning the amount of revenue or costs is sufficiently high or

 sale does not represent substantial completion of the earnings process.

Revenue Recognition at Point of Sale

Measurement of Sale Revenue

Revenue should be measured at the fair value of consideration received or receivable.

 Trade discounts or volume rebates should reduce consideration received or receivable and the related revenue.

 If payment is delayed, seller should impute an interest rate for the difference between the cash or cash equivalent
price and the deferred amount.
Sansung makes the following entry on March 31, 2011.

Accounts receivable 679,000

Sales 679,000

Assuming Sansung’s customers meet the discount threshold, Sansung makes the following entry.

Cash 679,000

Accounts receivable 679,000

If Sansung’s customers fail to meet the discount threshold, Sansung makes the following entry upon payment.

Cash 700,000

Accounts receivable 679,000

Sales discounts forfeited 21,000

Measurement of Sale Revenue

When a sales transaction involves a financing arrangement, the fair value is determined by discounting the payment using an
imputed interest rate.

Imputed interest rate is the more clearly determinable of either

1. the prevailing rate for a similar instrument of an issuer with a similar credit rating, or

2. a rate of interest that discounts the nominal amount of the instrument to the current sales price of the goods or
services.

The journal entry to record SEK’s sale to Grant Company on July 1, 2011, is as follows (ignoring cost of goods sold entry).

Notes receivable 900,000

Sales 900,000

SEK makes the following entry to record interest revenue.

Notes receivable 54,000

Interest revenue (12% x ½ x €900,000) 54,000

Recognition of Sale Revenue

Revenue from the sale of goods is recognized when all the following conditions are met:

1. Company has transferred to the buyer the significant risks and rewards of ownership of the goods;

2. Company retains neither continuing managerial involvement to the degree usually associated with ownership nor
effective control over the goods sold;

3. The amount of revenue can be measured reliably;

4. It is probable that the economic benefits will flow to the company; and

5. The costs incurred or to be incurred can be estimated reliably.

Bill and Hold Sales

Buyer is not yet ready to take delivery but does take title and accept billing.
Solution: Butler should record the revenue at the time title passes, provided

1. it is probable that delivery will be made;

2. the item is on hand, identified, and ready for delivery at the time the sale is recognized;

3. Baristo acknowledges the deferred delivery arrangement; and

4. the usual payment terms apply.

It appears that these conditions were probably met and therefore revenue recognition should be permitted at the time the
agreement is signed.

Butler makes the following entry to record the bill and hold sale

Accounts receivable 450,000

Sales 450,000

Sales with Right of Return

Two possible revenue recognition methods are available when the right of return exposes the seller to continued risks of ownership:

1. not recording a sale until all return privileges have expired or

2. recording the sale, but reducing sales by an estimate of future returns.

Pesido sold $300,000 of laser equipment on August 1, 2011, and retains only an insignificant risk of ownership. On October 15, 2011,
$10,000 in equipment was returned.

August 1, 2011

Accounts receivable 300,000

Sales 300,000

October 15, 2011

Sales returns and allowances 10,000

Accounts receivable 10,000

At December 31, 2011, based on prior experience, Pesido estimates that returns on the remaining balance will be 4 percent. Pesido
makes the following entry to record the expected returns.

December 31, 2011

Sales returns and allowances 11,600

Allowance for sales returns and allowances 11,600

[($300,000 - $10,000) x 4% = 11,600]

Morgan records the sale and related cost of goods sold as follows.

Cash 135,000

Sales 135,000

Cost of Goods Sold 115,000

Inventory 115,000

Principal-Agent Relationships

 Amounts collected on behalf of the principal are not revenue of the agent.

 Revenue for the agent is the amount of the commission it receives.

Long-Term Contracts (Construction)

Two methods of accounting for long-term construction contracts:

 Percentage-of-completion method.

 Cost-recovery (zero-profit) method.

Rationale for using percentage-of-completion accounting is that under most of these contracts, the

 Buyer and seller have enforceable rights.

 Buyer has the legal right to require specific performance on the contract.

 Seller has the right to require progress payments that provide evidence of the buyer’s ownership interest.

 As a result, a continuous sale occurs as the work progresses and companies should recognize revenue according to
that progression.
Companies must use the percentage-of-completion method when all of the following conditions exist.

1. Total contract revenue can be measured reliably;

2. It is probable that the economic benefits associated with the contract will flow to the company;

3. Both the contract costs to complete the contract and the stage of contract completion at the end of the reporting
period can be measured reliably; and

4. The contract costs attributable to the contract can be clearly identified and measured reliably so the actual contract
costs incurred can be compared with prior estimates.

Companies should use the cost-recovery method when one of the following conditions applies:

1. When a company cannot meet the conditions for using the percentage-of-completion method, or

2. When there are inherent hazards in the contract beyond the normal, recurring business risks.

Percentage-of-Completion Method : Calculation for Revenue to Be Recognized