Revenue Recognition by Stephen L. Larson October 29, 2013

Introduction The transaction approach followed by accounting standards generally requires that an event occur between parties before realization takes place (Schroeder, Clark, & Cathey, 2011). The exchange is the foundation for measurement and timing of the recognition in the financial records (Schroeder, Clark, & Cathey, 2011). Measurement of a revenue event is generally not the issue as the amount of the transaction can be determined through review of the related documents supporting the event. The issue is the point of recognition.

Recognition under current Generally Accepted Accounting Principles (GAAP) is founded on the earnings process (Schipper, Schrand, Shevlin, & Wilks, 2009). Generally the recognition of revenue occurs when the entity sells its product or service and the

buying entity has accepted the product or service (Schipper, Schrand, Shevlin, & Wilks, 2009). However, other recognition points may be more appropriate based on specific issues related to the event.

GAAP directs that revenue should be recognized when the following 2 conditions have occurred: • Revenue has been earned: The selling entity has met the terms and conditions of the

relationship (Schroeder, Clark, & Cathey, 2011). • Realization is relatively assured: There is a high degree of expectation that the

products or services will be exchanged for cash or claims to cash (Schroeder, Clark, & Cathey, 2011).

The following are specific questions for the assignment on Module 2 Assignment 1.

What are the underlying conceptual issues concerning revenue recognition when the

right of return exists?

The underlying conceptual issue is whether an actual sale occurred and whether revenue should be recognized.

Accounting Standards Codification (ASC) 605-15-25-1 (ASC 605-15-25) states that if an entity sells a product with a right of return, the revenue can only be recognized if the following six 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. If the buyer does not pay at time of sale and the buyer's obligation to pay is contractually or implicitly excused until the buyer resells the product, then this condition is not met.

Revenue Recognition by Stephen L. Larson October 29, 2013

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.

4. The buyer acquiring the product for resale has economic substance apart from that provided by the seller. This condition relates primarily to buyers that exist on paper, that is, buyers that have little or no physical facilities or employees. It prevents entities from recognizing sales revenue on transactions with parties that the sellers have established primarily for the purpose of recognizing such sales revenue.

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 (see paragraphs 605-15-25-3 through 25-4). Because detailed record keeping for returns for each product line might be costly in some cases, this Subtopic permits reasonable aggregations and approximations of product returns. As explained in paragraph 605-15-15-2, exchanges by ultimate customers of one item for another of the same kind, quality, and price (for example, one color or size for another) are not considered returns for purposes of this Subtopic.

A right of return may mean that the earnings process is not complete. In such a case, this would negate recognition of revenue other than for normal deficiency issues since the buyer would have the right to return the item. As such, title has not been transferred to the buyer and revenue has not been earned by the seller. SFAS No. 48 (ASC 605-15-25 Revenue recognition when right of return exists) provides the necessary guidance to determine if sufficient evidence exists to warrant recognition of revenue.

Can any or all of the pre-SFAS No. 48 methods be justified?

Prior to SFAS No. 48, revenue guidance was provided by AICPA Statement of

Position (SOP) 75-1. Three methods were generally followed when recognizing revenue (SFAS 48, 1981):

1. No sale recognized until the product was unconditionally accepted. 2. Sale recognized along with an allowance for estimated revenue. 3. Sale recognized with no allowance for estimated returns.

This author believes that all three methods can be justified. The accounting objective is to recognize revenue that has been earned and is realizable. Each of the above methods can include the two primary components of recognition.

Method 1 is the most conservative as it waits until all issues are resolved before recognition results. Timing of the recognition may be in question, but the conservative position of waiting until unconditional acceptance is obtained provides for unquestioned completion of the earnings process. The performance obligation is met and collection is relatively assured assuming the buyer meets reasonable financial quality standards.

Method 2 allows for more timely recognition than Method 1and provides for an estimate of transactions that may not meet the completion of the earnings process requirement. This method is justifiable as the allowance, if reasonably calculated, negates any overstatement of revenues resulting from early recognition actions.

Revenue Recognition by Stephen L. Larson October 29, 2013

Method 3 is the most aggressive of the three approaches. Assuming that the earnings process is complete and that there is a reasonable expectation of collection, than the revenue should be recognized. The issue with this method is that the matching principle may not be met causing an overstatement of revenues in the current period and understatement of revenues in later periods when returns are received.

The Financial Accounting Standards Boards (FASB) did not undertake a comprehensive review of the issue and used most of the specialized accounting and reporting principles from AICPA SOP 75-1without any major changes (SFAS 48, 1981). What FASB did do was to expand the criteria to be met in order to record revenue with right of return. Consequently, FASB was basically noting the concepts in SOP 75-1 were sound, but needed only to tighten the parameters of recognition for consistency.

What is the rationale for each of the SFAS No. 48 tests before revenue is

recognized?

The rationale of each of the tests in SFAS 48 follows: • The seller's price to the buyer is substantially fixed or determinable at the date of sale.

This test was necessary to meet the measurement requirement for the transaction. • 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. If the buyer does not pay at time of sale and the buyer's obligation to pay is contractually or implicitly excused until the buyer resells the product, then this condition is not met.

This test was necessary to meet the realization requirement for the transaction. • The buyer's obligation to the seller would not be changed in the event of theft or

physical destruction or damage of the product. This test was necessary to meet the transfer of title requirement for the

transaction. Without transfer of title, there is no sale and therefore revenue cannot be recognized. • The buyer acquiring the product for resale has economic substance apart from that

provided by the seller. As noted in ASC 605-15-25 (ASC 605-15-25), this test focused on buyers that

existed on paper, in other words, were non-existent nor had minimal physical facilities or employees. It was to prevent recognizing revenue on transactions with parties that the sellers had established primarily for the purpose of fraud. The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer. • The amount of future returns can be reasonably estimated.

This test was necessary to meet the requirement of estimating the allowance for returns. Without such an ability to estimate an allowance for returns, the matching principle would be jeopardized.

Is SFAS No. 48 an example of finite uniformity or of circumstantial variables?

Finite uniformity takes into account different economic situations in broadly

similar transactions. An example of a standard that would be classified as one of finite uniformity would be SFAS 13 where a specific set of criteria is established for different

Revenue Recognition by Stephen L. Larson October 29, 2013

treatment of operating and capital leases (Woli, Dodd, & Rozycki, 2013). The concept of circumstantial variables applies to environmental conditions that are beyond the control of the entity but applicable to the industry in which the entity participates. SFAS 48 is an example of circumstantial variables (Transtutors.com, 2013) as it covers industry practices that cannot be avoided by the individual entity.

What is the role of future events in SFAS 48?

In FASB 32, the FASB noted that it was identifying specific SOPs and guides on accounting and auditing matters and issuing them in FASB Statement formats. SFAS 48 is an example of such an action. In SFAS 48, paragraph 17 notes that the FASB is currently developing a conceptual framework on accounting recognition criteria. It is anticipated that a future concepts statement will be forthcoming that may impact the requirements noted in SFAS 48. However, until such time a new standard is issued, business entities are to follow SFAS 48.

Revenue Recognition by Stephen L. Larson October 29, 2013

References

ASC 605-15-25). Revenue Recognition: Sales of product when right of return exists. Financial Accounting Standards Board website (FASB.org). (Accessed October 28, 2013)

Schipper, K., Schrand, C., Shevlin, T., & Wilks, T. (2009). Reconsidering Revenue

Recognition. Accounting Horizons. 23.1, pp. 55-68. Schroeder, R., Clark, M., & Cathey, J. (2011). Financial Accounting Theory and

Analysis, 10th ed. Hoboken, NJ: John Wiley & Sons. SFAS 48. (1981). Revenue recognition when right of return exists. Financial Accounting

Standards Board. Transtutors.com. (2013). Approach to uniformity. http://www.transtutors.com/questions/-

cadenhead-presented-an-approach-to-uniformity-referred-to-as-circumstantial-variabl-354040.htm (accessed October 28, 2013).

Woli, H., Dodd, J., & Rozycki, J. (2013). Accounting Theory: Conceptual Issues in a

Political and Economic Environment, 8th ed. Thousand Oaks, CA. Sage. http://books.google.com/books?id=4SILRT3Cr9EC&pg=PA159&lpg=PA159&dq=definition+of+finite+uniformity&source=bl&ots=Hzyy9-CSW8&sig=VW0vJ_LtF29Zuoz66egiGjJ11gM&hl=en&sa=X&ei=BM9uUvqsDqSAiwLToIDwCw&ved=0CEQQ6AEwAw#v=onepage&q=definition%20of%20finite%20uniformity&f=false. (Accessed October 28, 2013)