Fuqua School of Business, Duke University

ACCOUNTG 590: Financial Accounting

Lecture Note: Revenue Recognition

*Please note, there have been substantial updates to accounting for revenue recognition standards
(ASC 606) for financial statement filings after December 15, 2017. The notes below reflect the most
recent standards and will therefore differ from the textbook in outlining the conditions for
recognizing revenue (I.B. below). As always, you should read both the textbook and the notes for
complete understanding.

I. Revenue Recognition - Concept

A. Revenue recognition is a critical step in the accounting process. The timing of the recognition of
many expenses (e.g., cost of goods sold, “CGS”) is designed to match the recognition of revenue.
We call this the matching convention (or some refer to it as the matching principle), and we will
illustrate it later in this lecture note.

B. Revenue is recognized upon completion of the following 5-step process:

1. Identify the contract the seller has with the buyer.

2. Identify the performance obligations in the contract, i.e., promises to deliver goods and/or
services to the customer.
3. Determine the transaction price, which refers to the amount the entity expects to be entitled to
once it has completed its performance obligations.
4. Allocate the transaction price to the performance obligations identified in the contract
5. Recognize revenue when the selling entity satisfies a performance obligation by transferring
promised goods and/or services to a customer.

C. Let us consider a transaction cash sale of $100 of product.

1. Financial statement effect of transaction:

Assets Liabilities Owners’ Equity

 Cash 100  Sales Revenue (I/S) 100

2. We “match” the costs associated with the sale with the recording of the sale transaction; this is
the matching convention in action. In this setting, matching means there is a companion
financial statement effect (made at the same time as the sale occurs) to record the cost of goods
sold. For this example, assume that the cost of the product is $75. Show the financial statement
effect.
a. As a side note, this transaction easily meets the five steps of recognition above. This
was a cash sale, 1. suggesting there was evidence of a contract between the buyer and
seller, 2. with a performance obligation the seller has to the buyer, 3. with a fixed and
determinable transaction price, 4. that is allocated to the sale, 5. and for which the seller
provided the product to the buyer. Therefore, revenue is recognized.

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 Assets Liabilities Owners’ Equity
 Inventory 75  Cost of Goods Sold (I/S) 75

3. Note that the above transaction implies net income of $25 (Sales of $100 less CGS of $75).
Also recall that Sales and CGS are both Retained Earnings (RE) accounts, in the sense they are
closed to RE at the end of the period. Given this, is the balance sheet in balance after the above
transaction? Yes, because net assets increased by $25 ($100 Cash less $75 credit to Inventory)
and the net liability plus equity also increased by $25 (i.e., net income from the sale that affects
the RE component of equity).
4. What if the sale is made on credit? Credit means that the customer did not give us cash in
return for the product or service, she gave us a promise to pay cash in the future. Show the
financial statement effect.

Assets Liabilities Owners’ Equity

 Accounts Receivable 100  Sales Revenue (I/S) 100

There is again a companion entry to record the cost of goods sold (assume that the cost of the
product is $75).

Assets Liabilities Owners’ Equity

 Inventory 75  Cost of Goods Sold (I/S) 75

The only thing different is that now we must record when the cash is collected from the
customer: Assuming it is all collected next period, what is the financial statement effect?

Assets Liabilities Owners’ Equity

 Cash 100
 Accounts Receivable 100

Note: The hard issues with credit sales are with respect to the fact that some customers will not
pay, and we don’t know, at the time of the sale, which customers they will be. Unless there is
obvious evidence of a lack of payment expected by the seller, we treat credit sales as
collectible at the time of sale (otherwise, we wouldn’t sell to them). We deal with this issue by
setting up a reserve, called “allowance for doubtful accounts” to cover such non-payments. We
will discuss this in more detail in the lecture note on Accounts Receivable.

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II. More Complex Issues

A. Discounts (two main types):

1. Trade discounts: commonly used when one is quoting special prices or is giving discounts for
quantities purchased. They are usually quoted in percentages, e.g., a 30% net trade discount on
an item with a stated selling price of $100 means that the effective sales price is $70. The normal
procedure is just to record the sale and receivable at the net amount, so in the above example,
the financial statement effect is:

Assets Liabilities Owners’ Equity

 Accounts Receivable 70  Sales Revenue (I/S) 70

2. Sales (sometimes called cash) discounts: these are discounts offered to customers to induce
prompter payment. They are usually quoted as something like “2/10 net 30” which means a 2%
discount if paid within 10 days, gross amount due in 30 days). Most of the time, we use what is
called the gross method to record sales with such terms. The gross method records the initial
sales transaction at the gross value, and subsequently records the sales discount if monies are
received within the discount period. For example, suppose there is a sale of a product at $1000,
cost of $450, terms are “3/10 net 60”. The customer pays us in full in one week from the date of
the sales transaction. The financial statement effect is as follows:

At the time of the sale:

Assets Liabilities Owners’ Equity

 Accounts Receivable 1000  Sales Revenue (I/S) 1000
 Inventory 450  CGS 450

Within next 10 days:

Assets Liabilities Owners’ Equity

 Cash 970
 Sales Discount (I/S) 30
 Accounts Receivable 1000

The account “Sales Discount” would be netted against Sales for display on the income
statement. That is, Sales Discounts is not an expense item; it is recorded as a net against sales.

What if in the above example the 10 days passed, but the customer paid within 60 days? Then
we would not have the financial statement effect shown above for “within next 10 days” but we
would have the following financial statement effect:

After 10 but before 60 days:

Assets Liabilities Owners’ Equity

 Cash 1000
 Accounts Receivable 1000

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B. Sales Returns

For convenience, we often wait until they happen and then adjust the accounts. For example, suppose
we sold products worth $1000 on credit in quarter 1 (costing $450), and those products were returned
in quarter 2. The financial statement effect is as follows:

Quarter 1:

Assets Liabilities Owners’ Equity

 Accounts Receivable 1000  Sales Revenue (I/S) 1000
 Inventory 450  CGS 450

Quarter 2: (item returned)

Assets Liabilities Owners’ Equity

 Accounts Receivable 1000  Sales Revenue (I/S) 1000
 Inventory 450  CGS 450

Suppose, however, the product was returned because it was defective in some way. If we thought we
could repair it without additional cost, the financial statement effect would be the same as above:

Assets Liabilities Owners’ Equity

 Accounts Receivable 1000  Sales Revenue (I/S) 1000
 Rework Inventory 450  CGS 450

However, suppose the items were returned and there is no way we can rework them into saleable
products. Then the financial statement effect would instead be:

Assets Liabilities Owners’ Equity

 Sales Revenue (I/S) 1000
 Accounts Receivable 1000  CGS (I/S) 450
 Defective product expense (I/S) 450

Frankly, the above account called “defective product expense” would almost surely just be
summarized within the CGS account.

B. What if it is too hard to estimate the amount of sales that will be uncollectible and the likelihood of
collection is small? In this case, we don’t recognize revenues right away, we wait until cash is
received.

1. Installment Method - recognize profit in proportion to the cash that has been collected so far.
2. Cost Recovery Method - don't recognize any profit until enough cash has been collected to cover
the cost of goods sold.

C. Sometimes revenue is recorded before the product is delivered

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 Long term construction contracts: common here to use something like the percentage of completion
method. This method recognizes revenues (and profit) in accordance with how close the project is to
completion at specified points or milestones in the project’s like. For example, if the halfway point
is a critical stage, we might recognize half expected revenues and profits will have been recognized.

III. Sales Transactions with Multiple Elements

A. Warranties

Many firms sell product warranties at the same time, or near in time, to the sale of a
product. (For example, how many times have you shopped for a piece of electronic
equipment such as a television and not been asked if you want to buy an extended warranty
on the television?). How do we treat warranties from a revenue recognition standpoint?
Note that the attributes of warranties that makes them difficult are that they usually extend
beyond one period (e.g., a 3-year extended warranty) and it is unknown at the time the
warranty is sold whether the warranty will be “used.”

A warranty can take the form of a promise to repair or replace a product based on defects that
presumably existed at the time of sale, typically within a specified warranty period, based on the
idea that product should perform as specified in the contract; these warranties are typically included
in the purchase price. ASC 606 calls these “assurance-type warranties.” A warranty may also take
the form of additional services beyond those provided by an assurance-type warranty. ASC 606 calls
these “service-type warranties.” Any warranty that can be sold separately is a service-type warranty
and the category might include other types of warranties as well, based on complex criteria that are
beyond the scope of our introductory course. Under ASC 606, a service-type warranty is a distinct
performance obligation, to be accounted for in the same way as any other performance obligation
discussed above. However, ASC 606 also specifies that an assurance-type warranty is not a separate
performance obligation (it is treated as a “guarantee of quality”). For these warranties, the practice
described in the textbook does not change; they are recognized as liabilities at the time of sale based
on the estimated cost of satisfying the obligation, which we now illustrate using an example. 1

Assume on January 1, you purchase from Best Buy a 40-inch LCD television for $4,000, costing
$2,500. The salesperson convinces you to purchase a 5-year extended warranty for $500 that will
cover minor repairs and any defectives in the screen. Best Buy’s expected cost of servicing the
warranty is $100. Assume that Best Buy has a December fiscal year end and all of the purchases are
made on credit.

In determining the financial statement effect of the transactions for Best Buy, remember the
following basic ideas:
a. Account for the product sale as well as the warranty contract.
b. Recognize the revenue for the product (e.g., $4,000) in the year of the sale and
match the product cost (e.g., $2,500) to this revenue.
c. Defer the warranty contract price (e.g., $500) until the service has been provided. That is,
recognize the warranty contract price over the life of the service period (uniformly, unless
evidence to the contrary). When you recognize a portion of the revenue, match the cost to it.

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Other examples include sales of insurance contracts, publisher subscriptions, and receipt of rent in advance by a
landlord.

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 Here is the financial statement effect of the transactions (note that this is a simple case because we
are assuming no new sales in the years following the first year):

At time of television sale:

Assets Liabilities Owners’ Equity

 Accounts Receivable 4,500  Sales Revenue (I/S) 4,000
 Deferred Rev 500
Inventory 2,500  CGS (I/S) 2,500

You also have to account for the costs of the warranty. That is, the firm who sold the warranty
incurs costs when the warranty is “exercised”, that is, when the customer has problems and calls the
firm to fix or replace the television. How are the costs accounted for? The most common method is
estimate the warranty costs at the time of the sale of the warranty, record expenses for that estimated
cost when you record the revenue from the warranty (matching), and then adjust the estimate as
actual warranty costs become known. Recall that in the above example, Best Buy estimates the cost
of the 5-year extended warranty on the 40-inch LCD television to be $100, and expect this total cost
to be incurred in roughly equal proportions. The financial statement effect of the warranty for Best
Buy at the end of each of years 1-5 would be:

At end of years 1 - 5:

Assets Liabilities Owners’ Equity

 Deferred Rev 100  Sales Revenue (I/S) 100
 Warranty liability 20  Warranty expense (I/S) 20

The $100 recognized as revenue at the end of year 1 reflects 1/5th of the warranty sale. The 1/5th
corresponds to the fact that one of the five years of the warranty has expired. So, if you had bought
the television on July 1, then the above transaction would have been for $50, not $100, since only 6
months would have been earned.

Note that by the end of the 5 years, the unearned/deferred revenue account is zero, and all of the
warranty has been recognized as a sale. Unearned/deferred revenue is a liability account on the
firm’s balance sheet. It is a liability because the firm has already recorded the asset received on the
sale (the accounts receivable or the cash, depending on whether the sale was on credit or in cash [on
credit in the above example]).

Note that in the above example, the warranty liability has $100 in it at the end of year 5. However,
as and when customers return with their Televisions to be repaired Best Buy would extinguish this
warranty liability for the actual labor and spare parts used in servicing the product. At each time
when Best Buy repairs goods under warranty there is the following financial statement effect:

Assets Liabilities Owners’ Equity

 Cash XXX  Warranty liability XXX

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 Actual warranty costs may be more than or less than this amount. When the amount of the estimate
is found, subsequently, to be too high or too low, we adjust the total amount in the account. (We’ll
see more detail about what this means when we discuss Accounts Receivable and its allowance for
uncollectible accounts.)

B. More general types of multiple-element sales contracts

Consider for example, the following sale:

General Electric (GE) sells medical diagnostic equipment to a hospital. The equipment in question is
an expensive, new technology MRI machine. The machine must be delivered, installed and tested;
then the hospital staff must be taught to use it properly. In addition to the above services, the
contract has a 10-year warranty on certain parts of the machine, and contains a 5-year maintenance
servicing agreement whereby GE agrees to service the machine for normal maintenance. The total
contract price is $3.4 million. How should GE recognize the revenues on this transaction?

GE must first identify the separate elements in the transaction. This means they must, to the best of
their ability, discern the pieces and the value of each of the pieces (the sum of the value should equal
$3.4 million). For purposes of this discussion, let’s assume they do this and the pieces are as
follows:

Machine itself $1.6

Delivery 0.2
Installation 0.3
Testing 0.1
Training 0.5
Warranty 0.4
Maintenance 0.3
Total $3.4

They must then determine when each of those pieces has met the criteria for revenue recognition.
What does this mean? It means that it is unlikely that GE should be able to book, for example,
revenue of $1.6 million (the machine) and delivery (of $0.2) the minute the machine lands at the
doorstep of the hospital. Why? Because it is unlikely that at this stage that GE has earned those
revenues. The reason is that without the MRI being a functioning machine for the hospital, the
hospital will not accept this transaction. So, in all likelihood what you would see is that GE would
be able to recognize the machine, delivery, installation, and testing costs when it was determined
that the machine was functioning. The training revenues could be recognized after GE provided
those services. The warranty and maintenance revenues would be recognized as we have seen with
other sorts of warranty contracts.

Many times firms build into their contracts milestones which make it clear when one part of the
earnings process has been complete. Such milestones provide the firm with clearer evidence on
when portions of revenues of multi-element sales transactions can be recognized.