Revenue Recognition Issues

CH:5 AHM
Revenue Recognition Issues
 A company’s periodic income statement consists
essentially of two components: revenue and expense.
 Revenue for the period is generally determined by
applying the revenue recognition principle.
 According to accounting conventions revenue be
recognized when it is both realized and earned.
 Realization takes place when goods or services are exchanged
for cash or receivables.
 Revenue is considered to be earned when the company has
substantially done what it must do to be entitled to payment;
i.e., the earnings process is virtually complete.
 Under this principle, revenue from the sale of a product
would be recognized upon DELIVERY of the product,
while service revenue would be recognized when the
service has been PERFORMED.
Revenue Recognition after delivery/ before delivery

Revenue Recognition

After delivery: In certain cases,

revenue recognition problems arise
because the ultimate collection of the
selling price is not reasonably assured,
or because it is difficult to determine
when the earning process has been
completed. In these cases, companies
may wish to delay recognition of the
revenue until after delivery.
Before delivery: On the other hand, if
there is a high degree of certainty
regarding the earnings, companies may
wish to recognize the revenue before
delivery.
REVENUE RECOGNITION AT DELIVERY
 According to FASB/IAS, revenue is recognized when both
realized and earned.
 In most situations, both of these conditions are met upon
delivery of the goods, or in the case of services, when the
services are rendered.
Revenue should be recognized at sale time only if all
of the following six conditions have been met:
 1. The seller’s price to the buyer is substantially fixed at the
date of sale.
 2. The buyer has paid the seller, or is obligated to pay the seller,
and the obligation is not contingent on the resale of the product.
 3. The buyer’s obligation would not be changed in the event of
theft or damage to the product.
 4. The buyer has economic substance apart from that provided
by the seller.
 5. The seller does not have significant obligations for future
performance to directly bring about resale of the product by the
buyer.
 6. The amount of future returns can be reasonably estimated.
REVENUE RECOGNITION BEFORE
DELIVERY
 In the construction industry, two accounting approaches
have developed over the years regarding the recognition
of revenue.
 The first approach—the completed-contract method—does not
recognize any profit until the construction project is complete.
 The second approach—the percentage-of-completion method
—recognizes profit on a piecemeal basis.
REVENUE RECOGNITION AFTER DELIVERY—
THE INSTALLMENT METHOD
 If the collection of the selling price is not reasonably
assured and there is no reasonable basis for estimating the
degree of collectibility, the installment method of revenue
recognition may be used.
 Under this method, the recognition of gross profit on
the sale is deferred until cash collections take place,
rather than being recognized at the time of sale.
 The procedures to be used for this method are as follows:
 When installment sales take place, an entry is made debiting
Accounts Receivable and crediting Sales.
 An entry is also made for the cost of goods sold. Both the
Sales account and the Cost of Goods Sold account are closed at
period-end and the margin is placed into an account called
Deferred Gross Profit.
 Part of this profit is recognized when cash is collected, based
upon the gross profit percentage
Practices of Corporate
Practices of Corporate
Production process
•It is generally accepted that income is
accrued only at the time of sale and it should
not be anticipated by considering assets at
their current market price.

•However, in case of certain industries, where

products have an immediate marketability,
the revenue may be recognized, as soon as the
production process is complete.
Goods on Consignment
 In a consignment arrangement, the owner (the consignor, main firm,
or supplier) will ship merchandise goods and commodities to a
dealer (consignee, agent, or seller) with the agreement that payment
is expected only when the merchandise is sold by the consignee.
 The consignee has a right to return the unsold merchandise to the
consignor.
 Once the goods are sold, the consignee will remit the amount to the
consignor after deducting his/her service charges, commission, and other
expenses as per the agreement.
 The service charge revenue and commission earned would be treated as
revenue in the income statement of the consignee.
 The deducted amount, as explained above, would be treated as
consignment business expenses by the consignor in the income statement.