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Income Statement and Revenue Recognition

Introduction

Revenue recognition is important in the accurate portrayal of a company's financial condition and operations. In many instances, revenue recognition requires critical management judgments and estimates about matters that are inherently uncertain, which means actual future results may differ. Because of this, revenue recognition receives a great deal of attention from the accounting profession including the Securities and Exchange Commission (SEC), the American Institute of Certified Public Accountants and the Financial Accounting Standards Board (FASB).


Revenue Recognition


Generally accepted accounting principles (GAAP) define revenue as "Actual or expected inflows of cash or other assets or reductions in liabilities resulting from producing, delivering, or providing goods or services constituting an entity's major or central operations" (Siegel, Levine, Qureshi, & Shim, 2001). The FASB issued the following guideline for recognizing revenue: "Revenue is recognized when it is realized or realizable and it is earned" (Siegel et al., 2001). Realized means cash has been received. Realizable means the right to receive cash. Earned means an entity has substantially completed what it must do to receive the benefits represented by the revenues.


 


There are economists who argue that revenue is earned as the product is produced, because production adds value, and value added increases wealth. This simple theory makes sense when thinking about salaries. Employees earn wages, or personal revenue, while they work. For example, assume that it takes a tax preparation company 3 days to prepare a tax return. After the first day, the tax preparer has earned a full day's wages, but the tax preparation company has not realized assets because the tax return is not ready to be filed. Nonetheless, economic theory argues that the eventual receipt of assets, or cash in the above scenario, is being earned while the tax return is being prepared. Although this example only covers a few days—or a few weeks for a complex tax return—there are long-term, construction-type contracts where the production process may span a number of years. Each year, part of the total profit is earned, as progress is made toward the completion of the project.

The accounting profession takes a somewhat different approach from economists—accountants come from a realization perspective. Recognition is a judgment call that depends on the level of certainty or uncertainty associated with realization. Certainty plays a big role in the recognition of revenue for financial accounting purposes. The more certain an accountant is in regards to the eventual realization of revenue from the sale of a product, the more likely the accountant is to recognize revenue. Due to perceived certainty or uncertainty, revenue recognition can be viewed as follows:

The four major methods of revenue recognition above are appropriate under different circumstances. The point of sale is used in most circumstances, and is used when there is an exchange that can be objectively measured. The other three methods are used when specific circumstances arise. Revenue may be recognized during production when the selling price is known, such as when a contract exists, and the degree of completion can be accurately determined throughout production. Recognizing revenue during cash collection is appropriate when the collection period is uncertain, expenses associated with the revenue cannot be accurately estimated at the time of sale, there is a risk of not collecting the funds, and the selling price at the time of sales is unknown (Siegel et al., 2001).
Revenue recognition is further complicated by credit sales, discounts, bad debts, and the existence of return privileges on merchandise sold. Each of these complications must be analyzed in relation to the specific industry, company and/or transaction. In other words, there are guidelines, but there is no one right answer. The best practical solution is to possess a solid understanding of the facts and to document the approach.


Practical Application


All companies are required to disclose its revenue recognition policy in the notes of their financial statements. Some companies, like 3M Co., are able to disclose their policy in one or two simple paragraphs, while other companies, like Oracle, require extensive disclosure statements describing complex arrangements. To understand the vast differences in revenue recognition policies, review the SEC-required 10-Q and 10-K reports by going to the SEC website (http://www.sec.gov) and search by company name.
What are the ramifications for companies that do not have a consistent revenue recognition policy?


Questions to Consider


What does the term quality of earnings mean?
Why is it important to properly recognize revenue when preparing income statements?

Reference

http://beginnersinvest.about.com/od/gaap/a/aa0605.htm


Siegel, J. G., Levine, M., Qureshi, A., & Shim, J. K. (2000). GAAP Handbook of Policies and Procedures, 2001 (3rd ed.). Paramus, NJ: Prentice Hall Trade.

 

 


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