Including Issues When the Right of Return Exists

Zach Hedrick
Jennifer Intihar
Morgan Voss
Geoff Smith
Revenue Recognition
 “Recognition is the process of formally recording or
incorporating an item into accounts and financial
statements of an entity.”

 “Recognition includes depiction of an item in both words

and numbers, with the amount included in the total of the
financial statements.”

 “For an asset or liability, recognition involves recording not

only acquisition or incurrence of the item but also later
changes in it, including removal from the financial
statements previously recognized.”
Revenue Recognition Principle
Companies should recognize revenue:
1. When it is realized or realizable
2. When it is earned

• Revenues are realized when a company exchanges goods and services

for cash or claims to cash

• Revenues are realizable when an asset a company receives in

exchange are readily convertible to known amounts of cash or claims
to cash

• Revenues are earned when a company has substantially

accomplished what it must do to be entitled to the benefits
represented by the revenues—that is, when then earnings process is
complete
Revenue Transaction
1. Companies recognize revenue from selling products at
the date of sale.

2. Companies recognize revenue from services provided,

when services have been performed and are billable

3. Companies recognize revenue from permitting others to

use enterprise assets

4. Companies recognize revenue from disposing of assets

other than products at the date of sale
 Revenue Transaction Chart
Sale of Asset
Type of Sale of Product Rendering a Permitting use Other Than
Transaction from Inventory Service of an asset Inventory

Description Revenue From Gain or Loss on

Revenue From Revenue From
of Revenue Interest, Rents, Disposition
Sales Fees or Services
and Royalties

Timing of Date of Sale Services As Time Passes

Revenue
Date of Sale or
(date of Performed and or Assets are Trade-In
Recognition delivery) Billable Used
Revenue Recognition at the Point
of Sale (Delivery)
Companies commonly recognize revenues from
manufacturing and selling activities at the point of sale
(delivery).

3 Implementation problems can arise:

• Sales with Buyback Agreements

• Sales When Right of Return Exists

• Trade Loading and Channel Stuffing

Sales with Buyback Agreements
 If a company sells a product in one period, and agrees
to buy it back in the next accounting period, has the
company sold the product?

 Answer: No. When a repurchase agreement exists at a

set price and this price covers all cost of the inventory
plus related holding costs, the inventory and related
liability remain on the seller’s books.

 FAS 49 paragraph 12-15

Sales When Right of Return Exists
There are 3 alternative revenue recognition methods for
when the right of return exposes the seller to continue
risks of ownership
1. Not recording a sale until all return privileges have
expired
2. Recording the sale, but reducing sales by an estimate
of further returns
3. Recording the sale and accounting for the returns as
they occur.
Sales When Right of Return Exists
 FAS 48 Paragraph 6 states that sales transactions shall be
recognized at the time of sale only if all the following
conditions are met:
1. The seller’s price to the buyer is substantially fixed or
determinable at the date of sale

2. The buyer has paid the seller, or the buyer is

obligated to pay the seller and the obligation is not
contingent on resale of the product

3. The buyer’s obligation to the seller would not be

changed in the event of theft or physical destruction or
damage of the product.
Sales When Right of Return Exists
4. The buyer acquiring the product for resale 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
Trade Loading and Channel Stuffing
• A way to distort operating results and “window dress”
financial statements

• If used without an appropriate allowance for sales

returns, it is a perfect example of booking tomorrow’s
revenue today

• Unethical ways of distorting shareholders view of the

company
Revenue Recognition Before
Delivery
Examples:

 Long-term construction contracts

 Development of military and commercial aircrafts
 Weapons delivery systems
 Space exploration software
Methods of Accounting for Long-
Term Construction Contracts
 Percentage-of-Completion Method- recognize
revenues and gross profits each period based upon the
progress of the construction—Percentage of
Completion

 Completed-Contact Method- recognize revenue and

gross profits only when the contract is complete
Percentage-of-Completion Method
Companies must use the percentage-of-completion method when
estimates of progress toward completion, revenues, and costs are
reasonably dependable and all of the following conditions exist:

1. The contract clearly specifies the enforceable rights regarding goods

or services to be provided and received by the parties, the
consideration to be exchanged, and the manner and terms of
settlement

2. The buyer can be expected to satisfy all obligations under the

contract

3. The contractor can be expected to perform the contractual

obligations
Percentage-of-Completion
• Example:
When a project consists of separable units, such as a
group of buildings or miles of roadway, contract
provisions may provide for delivery in installments.
In that case, the seller would bill the buyer and transfer
title at stated stages of completion, such as the
completion of each building unit or every 10 miles of
roadway.
Completed-Contract Method
Companies should use the completed-contract method when
one of the following conditions applies:

• When a company has primarily short term contracts, or

• When a company cannot meet the conditions for using the

percentage-of-completion method, or

• When there are inherent hazards in the contract beyond

normal, recurring business risks
Complete-Contract Method
 Tends to make people feel more comfortable because it
is a reflection of final results rather than estimates of
unperformed work as in the percentage-of-completion
method

 *The opinion is that percentage-of-completion

method is better to use, and should be used over
the completed-contract method if possible
Revenue Recognition After Delivery
Two methods to defer revenue recognition until the
company receives cash:
1. Installment-Sales Method- recognizes income in
the periods of collection rather than in the period of
sale
2. Cost-Recover Method- recognizes no profit until
cash payments by the buyer exceed the cost of
merchandise sold.

If cash is received prior to delivery, the method used is

the deposit method
Installment-Sales-Method
 This method is used generally when there is no
reasonable way of estimating collections, and
therefore should not be recognized until collected

 Example:
Different types of farm and home equipment as well as
home furnishings are sold on an installment basis
Cost-Recovery-Method
 FAS 45 (Franchises) and FAS 66 (real estate) require
use of this method where a high degree of uncertainty
exists related to the collect of receivables
Deposit Method
 Defers sale recognition until a sale has occurred for
accounting purposes