For most firms, revenue recognition occurs at the point of product or service delivery. On the balance sheet, cash or accounts receivable increases for the amount of the sale. If returns are allowed and can be reliably estimated, the sales revenue and associated accounts receivable are reported net of the expected returns
The recognition of revenue at the time of sale (delivery) is so common that you may neglect to assess whether this timing is appropriate for a particular firm. However, firms may attempt to increase reported earnings by accelerating the timing of revenues or estimating the collectible amounts too aggressively. Consider the following three conditions, each of which is a signalthat revenue recognition at the time of sale may be too early: (1) large and volatileamounts of uncollectible accounts receivable, (2) unusually large amounts of returned goods, and (3) excessive warranty expenditures. Each of these conditions should bear a reasonably stable relation to revenues over time. Unusual year-to-year fluctuations should raise questions about the appropriateness of revenue recognition at the time of sale.
Recognizing revenues at the time of sale suffers from an even more fundamental problem at times: to accelerate revenue recognition, some firms may alter their definition of sale. Does the receipt of firm customer orders for goods held in inventory constitute a sale? Or does the sale depend on physical delivery of the product and transfer of legal title to the customer? Is completion of custom-produced goods sufficient to recognize revenue, or is physical delivery necessary? In an effort to achieve sales targets for a period, firms sometimes record sales earlier than physical delivery. Revenues must not be recognized until the earnings process is substantially complete, which would suggest that revenues should not be recognized until the firm has delivered control and legal title of the products to customers
Some firms, eager to report higher sales revenues or sales revenue increases, might be inclined to violate revenue recognition rules by recording sales based merely on an indication of interest in a product by a customer. The pressure that sales personnel facecan lead to such a violation of the revenue recognition criteria. A related earnings management strategy is to accelerate the shipment of product and the recognition of sales revenues to closely related customers (such as dealerships, franchisees, and affiliates) at the end of the year and then understate the likely sales returns by those customers (a practice known as channel-stuffing). Even more aggressive, some firms create artificial sales invoices and ship and store the goods in a remote or independently owned warehouse, hoping an independent auditor will not detect them
Delaying Revenue Recognition When Substantial Performance Remains
Cash is often collected from customers but the revenue recognition criteria have not been met, usually because the selling firm has not met some or all of its obligations to the buyer. The earlier example of insurance premiums being paid in advance, with revenues being recognized over the life of the policy is a case in point. Many other examples exist in which customers pay in advance of receiving goods or services and revenue recognition must be delayed until the revenues have been earned. Delayed revenue recognition typically arises with sales of gift cards redeemable for products (at Starbucks or Nordstrom, for instance), subscriptions, airfares, and memberships. For example, Sam’s Club (a division of Walmart that offers discount warehouse shopping) collects an annual membership fee and promises to let customers shop at Sam’s Club stores for one year. When it sells an annual membership, Walmart records the increase in cash, but must delay revenue recognition until Sam’s Club meets its obligation to members over time. Walmart records a liability (often called deferred revenue, unearned revenue, or advances from customers) for the full amount of the membership fee. Each month of the annual membership period,
Walmart removes one-twelfth of the liability and recognizes one-twelfth of the fee as revenue. At year-end, the portion of the membership fee that has not yet been earned is reported as a liability on Walmart’s balance sheet; it willbe earned as revenue during the next fiscal year. Software firms such as MicroStrategy and Microsoft bundle product and services. For example, Microsoft bundles Windows software, telephone support, and future upgrades. U.S. GAAP and IFRS require the selling price to be allocated to the individual elements of the bundle based on their relative fair values.6 Delivery of each item or performance of each service triggers revenue recognition equal to the fair value of the element in the bundle. Microsoft, for example, uses the straight-line method to recognize revenue on promised services in its software over the time period of the promise, reporting the remainder of the promised but undelivered service as ‘‘unearned revenues
When analyzing liquidity, you should take into account that deferred or unearned revenue liabilities can sometimes be large, but they are not cash-settled obligations; they are settled with the performance of services. For Starbucks, for example, the deferred revenue liability at the end of 2012 was $510 million, or 23% of the company’s total current liabilities. Starbucks satisfies this liability by delivering coffee to card-holding customers.
Recognizing revenues at the time of sale suffers from an even more fundamental problem at times: to accelerate revenue recognition, some firms may alter their definition of sale. Does the receipt of firm customer orders for goods held in inventory constitute a sale? Or does the sale depend on physical delivery of the product and transfer of legal title to the customer? Is completion of custom-produced goods sufficient to recognize revenue, or is physical delivery necessary? In an effort to achieve sales targets for a period, firms sometimes record sales earlier than physical delivery. Revenues must not be recognized until the earnings process is substantially complete, which would suggest that revenues should not be recognized until the firm has delivered control and legal title of the products to customers
Some firms, eager to report higher sales revenues or sales revenue increases, might be inclined to violate revenue recognition rules by recording sales based merely on an indication of interest in a product by a customer. The pressure that sales personnel facecan lead to such a violation of the revenue recognition criteria. A related earnings management strategy is to accelerate the shipment of product and the recognition of sales revenues to closely related customers (such as dealerships, franchisees, and affiliates) at the end of the year and then understate the likely sales returns by those customers (a practice known as channel-stuffing). Even more aggressive, some firms create artificial sales invoices and ship and store the goods in a remote or independently owned warehouse, hoping an independent auditor will not detect them
Delaying Revenue Recognition When Substantial Performance Remains
Cash is often collected from customers but the revenue recognition criteria have not been met, usually because the selling firm has not met some or all of its obligations to the buyer. The earlier example of insurance premiums being paid in advance, with revenues being recognized over the life of the policy is a case in point. Many other examples exist in which customers pay in advance of receiving goods or services and revenue recognition must be delayed until the revenues have been earned. Delayed revenue recognition typically arises with sales of gift cards redeemable for products (at Starbucks or Nordstrom, for instance), subscriptions, airfares, and memberships. For example, Sam’s Club (a division of Walmart that offers discount warehouse shopping) collects an annual membership fee and promises to let customers shop at Sam’s Club stores for one year. When it sells an annual membership, Walmart records the increase in cash, but must delay revenue recognition until Sam’s Club meets its obligation to members over time. Walmart records a liability (often called deferred revenue, unearned revenue, or advances from customers) for the full amount of the membership fee. Each month of the annual membership period,
Walmart removes one-twelfth of the liability and recognizes one-twelfth of the fee as revenue. At year-end, the portion of the membership fee that has not yet been earned is reported as a liability on Walmart’s balance sheet; it willbe earned as revenue during the next fiscal year. Software firms such as MicroStrategy and Microsoft bundle product and services. For example, Microsoft bundles Windows software, telephone support, and future upgrades. U.S. GAAP and IFRS require the selling price to be allocated to the individual elements of the bundle based on their relative fair values.6 Delivery of each item or performance of each service triggers revenue recognition equal to the fair value of the element in the bundle. Microsoft, for example, uses the straight-line method to recognize revenue on promised services in its software over the time period of the promise, reporting the remainder of the promised but undelivered service as ‘‘unearned revenues
When analyzing liquidity, you should take into account that deferred or unearned revenue liabilities can sometimes be large, but they are not cash-settled obligations; they are settled with the performance of services. For Starbucks, for example, the deferred revenue liability at the end of 2012 was $510 million, or 23% of the company’s total current liabilities. Starbucks satisfies this liability by delivering coffee to card-holding customers.
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