Additional Topics in Income Determination Revsine/Collins/Johnson/Mittelstaedt: Chapter 3 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies,

Additional Topics in Income

Determination

Revsine/Collins/Johnson/Mittelstaedt: Chapter 3

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning objectives

1. When is it appropriate to recognize revenue before or after the point of sale?

2. Revenue recognition details for long-term construction contracts, agricultural commodities, and installment sales.

3. Revenue principles for franchise sales, right of return, and “bundled” software sales.

4. How GAAP income determination invites “earnings management”, the various techniques used, and recent SEC guidance intended to thwart such activities.

5. How error corrections and prior period restatements are reported.

6. Key differences between IFRS and U.S. GAAP rules for revenue recognition.

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Recall the criteria for revenue recognition

Condition 1: The critical event in the process of earning the revenue has taken place.

Condition 2: The amount of revenue that will be collected is reasonably assured and is measurable with a reasonable degree of reliability.

Time of sale is used in most industries

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Revenue recognition prior to sale:Long-term construction projects

Before construction begins, a formal contract has been signed. The buyer is assured and the contract price is specified.

Consequently, both revenue recognition conditions are satisfied prior to the time of sale.

Condition 1: The critical event is actual construction, thus revenue is earned over time as the project progresses toward completion.

Condition 2: Measurability is satisfied because there’s a firm contract with a known buyer at a set price.

In addition, construction costs can be estimated with reasonable accuracy so that expenses can be matched with revenues.

Percentage-of-completion method: revenue is recognized in proportion to the “work done” each period.

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Revenue recognition on Commodities

Revenue recognition conditions: Condition 1: The critical event is extraction (mining) or harvesting

(agriculture), and occurs before the sale (i.e., formal transfer of title). Condition 2: The precise time at which measurability is satisfied is open

to some dispute.

Revenue recognition could occur when the sales transaction is completed, or earlier at extraction or harvest (i.e., when the critical event is satisfied).

A farmer harvests 110,000 bushels of corn on September 30, 2011. On this date, the posted market price per bushel was $3.50. The total cost of growing the crop was $220,000 or $2.00 per bushel. The farmer decides to sell 100,000 bushels for cash on September at the posted price of $3.50 and stores the remaining 10,000 bushels. On January 2, 2012 the market price drops to $3.00. Fearing further price declines, the farmer immediately sells the bushels in storage at a price of $3.00 per bushel.

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Revenue recognition after the sale:Installment sales method

Sometimes revenue is not recognized at the point of sale even though a valid sale has taken place.

High risk of not receiving cash from the buyer (Conditions 1 and 2 are not met).

Or there is no reasonable basis for estimating uncollectible accounts (Condition 2 is not met).

Conditions 1 and 2 are both satisfied over time as cash collections take place.

So, revenue recognition occurs as cash is collected (i.e., as installment payments are made).

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Specialized transactions:Franchised sales

Continuing franchise fees are recorded as revenue in the period they are earned and received.

The initial franchise fee is comprised of two elements: Payment for the right to operate a franchise in a given area. Payment for services to be performed later by the franchisor.

The issue: How much of the initial franchise fee should be recognized as revenue up front by the franchisor?

Franchisor CustomerFranchisee

Seller Buyer

1. Initial franchisee fee2. Continuing (periodic) fees

Exercise right to sell product or service

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Specialized transactions:Sales with right of return

GAAP specifies that the following six criteria must be met for a seller to record revenue at the time of sale:

Seller’s price to buyer is substantially fixed at the date of sale. Buyer has paid seller, or is obligated to pay and the obligation is not

contingent on resale. Buyer’s obligation does not change in the event of theft, destruction, or

damage of the product. The buyer has economic substance and is distinct from seller. Seller does not have significant obligations for future performance to bring

about resale. The amount of future returns can be reasonably estimated.

Seller CustomerBuyer

Resale

Sell with right of return

Cash payment or obligation to pay

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Specialized transactions:Bundled (Multi-element) sales

Oracle sells a database software “bundle” for $1.5 million. The “bundle” includes:

Staff training “Free” software upgrades On-going customer support for

five years.

New guidance – Emerging Issues Task Force (EITF) consensus documents

Applies to arrangements entered into in fiscal years beginning on or after June 15, 2010

Customer support $150

Upgrades $300

Training $450

Software $600

Revenue recognized:

Over 5-year period

As installed

When completed

When delivered and installed

Oracle’s software and services bundle

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Earnings management

Determining when revenue has been earned (critical event) and is realized (measurability)—the two revenue recognition conditions—often requires judgment.

Managers can sometimes exploit the flexibility in GAAP to manipulate reported earnings in ways that mask the company’s underlying performance.

Some managers have even resorted to outright financial fraud (but that’s rare).

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Popular earnings management devices

“Big bath” restructuring charges: Excessive restructuring write-offs that overstate estimated charges for future expenditures.

Miscellaneous “cookie jar reserves” for bad debts, loan losses, warranties and other accruals: Reserve too much in good times and cut back on estimated charges, or even reverse previous charges, in bad times. A convenient income smoothing device.

Intentional errors deemed to be “immaterial” and intentional bias in estimates.

Premature or aggressive revenue recognition.

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Revenue recognition abuses

The SEC says revenue is earned (critical event) and realized (measurability) when all of the following are met:

Pervasive evidence of an exchange agreement exists. Delivery has occurred or services have been rendered. The seller’s price to the buyer is fixed or determinable. Collectibility is reasonably assured.

SEC Staff Accounting Bulletin (SAB) No. 104 illustrates troublesome areas of revenue recognition.

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Revenue recognition abuses:SAB No. 104 examples

Goods shipped on consignment

Sales with delayed delivery

Goods sold on lay-away

No revenue can be recognized at delivery.

Seller can’t recognize revenue until delivery… except certain buy and hold transactions.

Postpone revenue recognitionuntil merchandise is delivered to customer.

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Revenue recognition abuses:SAB No. 104 examples

Gross vs. net basisfor internet resellers

Earned as services are delivered over the full term of service engagement.

Revenue should be recognized on a “net” basis as commission revenue.

Revenue should be recognized over time as the capacity is brought on line and used by customers.

Non refundable up-front fees

Capacityswaps

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Accounting errors

Accounting errors and “irregularities” can occur for several reasons: Simple oversight. Unintentional misapplication of GAAP, especially where judgment is

required. Intentional attempts to exploit the flexibility in GAAP. Outright financial fraud.

Parties charged with discovering accounting errors and irregularities:

The company’s internal audit staff and audit committee. External auditors. SEC staff surveillance of filings.

Once discovered, accounting errors and irregularities must be corrected and disclosed. Most are corrected through a prior period adjustment.

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Global Vantage Point

IFRS and U.S. GAAP rules for revenue recognition and measurement largely overlap, although the U.S. GAAP standards are much more detailed.

Differences between IFRS and U.S. GAAP are in two areas Long-term construction contracts Installment sales method of accounting

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IFRS Revenue Recognition and Measurement

International Accounting Standard (IAS) 18 requires that the following two conditions be met before an entity can recognize revenue on the sale of goods:

The seller has transferred significant risks and rewards of ownership of the goods to the buyer

The seller retains neither continuing management involvement associated with ownership nor effective control of the goods being sold

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Global Vantage PointLong-Term Construction Accounting

IFRS rules for revenue recognition on long-term construction contracts distinguish two types of contracts:

Cost-plus contracts – those for which the contractor is reimbursed for allowable costs plus a profit mark-up

Fixed-price contract – one in which the contractor agrees to a fixed contract price or fixed rate per unit of output

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Global Vantage PointInstallment Sales Method

IRFS rules do not permit entities to use the installment sales method, the cost recovery method is required.

As installment receivables are collected, cost recovery takes place equal to the amount of cash collected that period.

Revenues and expenses would be recognized equal to the amount of cash collected each period up to the point where costs have been fully recovered.

Only after the cumulative amount of cash collected exceeds the cost of the installment sale will the entity recognize any profits.

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Summary

The “critical event” and “measurability” conditions for revenue recognition are typically satisfied at the point of sale.

There are circumstances—long-term construction contracts, production of natural resources and agricultural commodities—where it is appropriate to recognize revenue prior to the sale.

There are also circumstances where revenue recognition may be delayed until after the sale—installment sales and cost recovery methods:

There is considerable uncertainty about collectibility. There are significant costs that will be incurred after the sale that are

difficult to predict.

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Summary concluded

Franchise sales, sales with right of return, and bundled (multi-element) sales pose challenging revenue recognition issues.

Management can sometimes exploit the flexibility in GAAP revenue recognition rules to hide or misrepresent economic performance.

Once discovered, accounting errors and irregularities must be corrected and disclosed. Most are corrected through a prior period adjustment.

IFRS and U.S. GAAP rules for revenue recognition largely overlap but important differences exist for long-term construction contracts and installment sales.

The IASB and FASB have recently issued an exposure draft on revenue recognition.

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