Revenue and Expense Recognition

One of the most difficult issues facing accountants concerns the recognition of revenue and expenses by a business enterprise. Although general rules and guidelines exist, the significant variety of marketing methods for products and services make it difficult to apply the rules consistently in all situations.

The recognition issue refers to the difficulty of deciding when a business transaction should be recorded.  The recognition issue is not always solved easily.  Consider the case of an advertising agency that is asked by a client to prepare a major advertising campaign.  People may work on the campaign several hours a day for a number of weeks.  Value is added to the plan as the employees develop it.  Should this added value be recognized as the campaign is being produced or at the time it is completed?  Normally, the increase in value is recorded at the time the plan is finished and the client is billed for it.  However, if a plan is going to take a long period to develop, the agency and the client may agree that the client will be billed at key points during its development.

 

The objective of any business enterprise is to generate income that will provide owners with a return on their investment.  The major source of income for most enterprises is from its operation - the process of generating revenue by providing goods and services to outsiders.  Operations involve the incurring of costs and expenses, and unless a satisfactory level of revenue is generated a loss or a low level of income will result, no matter how carefully costs and expenses are controlled.  Consequently, the meaning of revenue and the criteria for its recognition are important not only to accountants but also to enterprise and to the users of its financial statements.

In today’s more complex and uncertain business environment, accountants are faced with two tasks relating to revenue i.e. to determine when revenue is realized and the birr amount at which it is recognized in the accounting records. Because of new and frequently complex ways of structuring business transactions, and because of the many new products and services developed in recent years, revenue recognition has become one of the most challenging problems in financial accounting.

SFAC No 5 defines recognition as the recording of an item in the accounts and financial statements as an asset, liability, revenue, expense, gain, or loss.  Recognition includes depiction of an item in both words and numbers, with the amount included in the summarized figures reported in the financial statements

Four fundamental criteria must be met before an item can be recognized.  These are definition (the item or the event must meet the definition of one of the financial statement elements (asset, revenue, expense etc), measurability (the item or event must have a relevant attribute that is reliably measurable, that is, a characteristic, trait, or aspect that can be quantified and measured.  Examples are historical cost, current cost, market value etc), Relevance (information about the item or event is capable of making a difference in users decisions), Reliability (information about the item is representational faithful, verifiable, and neutral).

In addition to the above four general recognition criteria, the revenue principle provides that revenue should be recognized in the financial statements when it is earned and it is realized or realizable.

Revenues are earned when the company has substantially accomplished all that it must do to be entitled to receive the associated benefits of the revenue.  In general, revenue is recognizable when the earning process is completed or virtually completed.

Earning process is the profit – directed activities of a business enterprise through which revenue is earned; such activities may include purchasing, manufacturing, selling, rendering services, delivering and servicing products sold, allowing others to use enterprise resources, etc.

Revenue is realized when cash is received for the goods or services sold.  Revenue is considered realizable when claims to cash (for example, non cash assets such as accounts or notes receivable) are received that are determined to be readily comfortable into known amount of cash.  This criteria is also met if the product is a commodity, such as gold or wheat, for which there is a public market in which essentially unlimited amounts of the product can be bought or sold at the known market price.  In the measurement of revenue, realization generally means that a measurable transaction (such as sale) or an event (such as the rendering of services) has been completed or is sufficiently finalized to warrant the recording of earned revenue in the accounting records.  The selection of the critical event indicating that revenue has been realized (earned) is the foundation of the revenue realization principle.  In addition, revenue to be recognized collection of the claims from customers and clients who have purchased goods and services should be reasonably assured.

In general, revenues are recognized (formally recorded in the accounting records) as soon as all criteria are met.  An accounting issue is to determine when the criteria are met for different types of revenue – generating transactions.

In making many revenue & expense recognition decisions, accountants may rely on estimates and professional judgments. For example, the amount spent for material, labor, and other services may be measured objectively, however, the continuous transformation of these cost inputs into more valuable outputs is an internal process that requires estimates based on subjective judgment.  In tracing the effect of this process and portraying it in terms of birr, accountants do not have objective external evidence supporting market transactions as a basis for measurement and recording.

However, generally accepted accounting principles provide few guidelines for making estimates and for exercising professional judgment in specific revenue & expense recognition situations.

 

Stages at which revenues are recognized.

The delivery of goods or services to a customer is a significant event that occurs in virtually all revenue – generating transitions.  Given this fact, three broad timing categories of revenue recognition can be identified:

1. Revenue recognized on delivery of the product or service (the point of sale)
2. Revenue recognized  before delivery of the product or service.
3. Revenue recognized after delivery of the product or service.

For most companies and for most goods and services, however, revenue is recognized at the time of delivery of the goods or services to the customer: Revenue is them considered both earned and realized or realizable when the product or service is delivered.

Revenue is sometimes recognized before delivery when the earning process extends over several accounting periods and it is considered important (i.e. relevant) to provide revenue information before the earning process is complete.  For example, when there is a contract to produce a product for a known birr amount that will be received when the product is delivered (i.e. it is realizable), revenue can be recognized as it is earned, before the product is delivered to the customer.

Revenue is sometimes recognized after delivery when there are concerns about the amount of revenue that will be realized.  Revenue has been earned, but recognition is delayed until the amount realizable is determined.  In these situations, providing reliable revenue information is considered more important than early, potentially more relevant but less reliable, revenue information.

 

   5.2.1 Revenue Recognized at Delivery (Point of Sale)

The conditions for revenue recognition are usually met at the time goods or services are delivered.  Thus, revenue from the sale of goods is usually recognized at the date of sale, which is the date the goods are delivered to the customer.  Revenue from services rendered is likewise recognized when the services have been performed.  This is the point – of – sale method, sometimes called the sales method or the delivery methods of revenue recognition.

Some costs associated with servicing a product or service sold with a guarantee or warranty may be incurred after delivery.  When these cost can be reasonably estimated, revenue is still recognized at the date of sale, with a provision made for future warranty cost.  In this case, revenue is considered earned and realizable.

One may question why accountants choose so late a stage in the earning process to recognize revenue and thus net income.

The answer comes in two parts: (1) At any point prior to sale, the expected selling price of a product and the ability to sell it at a profit may be so uncertain that they do not constitute sufficient evidence to justify an upward valuation of the product, and (2) for most business enterprises the actual sale of a product is the most important step – the critical event – in the earning process.  Until a sale is made and the product is delivered to and accepted by the customer, the future stream of revenue is both uncertain and unearned.

Shipment of goods on consignment does not constitute sales.  In a consignment, goods are transferred to another party (the consignee), who acts as an agent for the owner of the goods (the consignor).  Title to the goods remains with the owner until the agent sells the goods to ultimate customers, at which time a sales transaction takes place and revenue is recognized by the consignor.
 

1.  Installment method:

Business enterprises that sell goods on the installment plan may use the installment method of accounting only when accrual accounting is not considered appropriate.  The installment method is widely used for income tax purposes because it postpones the payment of income taxes until installment receivables are collected.  However, the installment method is not acceptable for financial accounting unless considerable doubt exists as to the collectibles of the receivables and a reasonable estimate of doubtful accounts expense can’t be is made.

Under the installment method, the seller recognizes gross profit on sales in proportion to the cash collected.  If the rate of gross profit on installment sales is 40%, each birr of cash collected on the installment receivables represents 40 cents of gross profit and 60 cents of cost recovery.

Repossessions are common under the installment sales method because this method is used only when there is substantial uncertainty of collection.
 

Revenue Recognition when Right of Return Exists

Even when a sale occurs, the recognition of revenue may be delayed because of unusual terms surrounding the sales transaction.  For example, in the recorded music and book publishing industries it is common practice to give retail stores the right to return products sold and delivered to them if they cannot resell these products.  When such a right of return exists, the seller continues to be exposed to the usual risks of ownership, and revenue is recognized on the date of sale only if all of the following conditions are met.

1. The seller’s price to the buyer is substantially fixed or determinable on the date of sale.
2. The buyer has paid the seller, or is obligated to pay the seller and the obligations 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.
4. the buyer acquiring the product for resale has economic substance apart from that provided by the seller.
5. the seller does not have a significant obligations for future performance to bring about resale of the product by the buyer.
6. the amount of future returns can be reasonable estimated.

If these conditions are met and sales are recorded, provision for any costs or losses that may be expected in connection with any returns is made on the date of sale.  The sales and cost of goods sold in the income statement exclude the portion for which returns are expected, and the allowance for estimated returns is deducted from trade accounts receivable in the balance sheet.  Transactions for which revenue recognition is postponed are record as sales when the return privilege expires.
 

Sales on installment plan.

A sale of goods or services on the installment plan generally provides for a cash down payment and a series of additional monthly payments.  Because payments extend over a long period, the seller customarily charges interest and carrying charges on the unpaid balance of installment receivables.  Revenue from installment sales is recorded in the same manner as from regular sales, unless the collection of the installment receivable is not assured and there is no reasonable basis for estimating the probability of collection.  If the accrual basis of accounting is not considered appropriate, an alternative method of revenue recognition such as the installment method or the recovery method which will be discussed later must be used.

 

5.2.2 Revenue Recognition Before Delivery

In some instances the earning process extends over several accounting periods.  Delivery of the final products may occur years after the initiation of the product.  Examples are construction of large ships, bridges, office buildings, and development of space exploration equipment.  Contracts for these projects often provide for progress billings at various points in the construction process.

If the builder  (seller) waits until the constriction is completed to recognize revenue, the information on revenue and expense included in the financial statements will be reliable, but may not be relevant for decision making because the – information is not timely.  In such instances, it often is worthwhile to trade – off reliability in order to provide more timely, relevant earnings information.  This is the case for a company engaging in long – construction contracts.

GAAP provides two methods of accounting for revenue on long – term constructs:

1. Completed – contract method: under this method revenues, expenses, and gross profit are recognized only when the contract is completed.  As construction costs are incurred they are accumulated in an inventory account (construction in progress). Progress billings are not recorded as revenues but are accumulated in a contra inventory account (billings on construction progress. At the completion of the contract, all the accounts are closed and the entire gross profit from the construction project is recognized.
2. Percentage – of – completion method: Under this method revenue, expenses and gross profit are recognized each accounting period based on the estimate of the percentage of completion of the construction project.

The percentage - -of – completion method recognizes revenue on a long – term project as the contract is being completed, thus timely information is provided.  However, it contains estimates and is not as reliable as information in the completed – contract method.

Management of a company has little freedom of choice in deciding between these alternative methods of accounting for long – term contracts. When estimate of costs to complete and extent of progress toward completion of long-term construction contracts are reasonably dependable, the percentage – of - completion method is preferable.  When lack of dependable estimates or inherent hazards cause forecasts to be doubtful, the completed – contract method is preferable.

Measuring progress toward completion of a long – term construction project is accomplished with input measures or out put measures.

1.  Input measures:

The effort devoted to a project to date is compared with the total effort expected to be required in order to complete the project. Examples are cost incurred to date compared with total estimated costs for the project and labor hours worked compared with total estimated labor required to complete the project  Among input measures, the cost – to – cost method is the most common.  The cost – to - cost method measures the percentage completed by the ratio of the costs incurred to date to the current estimate of the total cost required to complete the project:

                                        Total costs incurred to date

Percent complete = -------------------------------------------------

                                   Most recent estimate of total costs of the project

The most recent estimate of total project costs is the sum of the total costs incurred to date plus the estimated costs yet to be incurred to complete the project.  Once the percentage completed has been computed, the amount of revenue to be recognized in the current period is determined as:

Current period revenue = (percent complete X total revenue from contract) – total revenue recognized in prior periods

 

2.  Output measures:

Results to date are compared with total results when the project is completed.  Examples are number of stories to be built and miles of highway completed compared with total miles to be completed. 

 

Some additional methods that have been proposed, and generally rejected, for the realization of revenue prior to delivery of the product are production, accretion, discovery, receipt of order, and billing.

The recognition of revenue prior to delivery generally is viewed as a departure from the revenue realization principle.  Recognition of revenue on construction – type contracts under the percentage – 0f completion or on completion of “special order” goods has considerable theoretical and practical support.

In general, when a sale of goods is not considered to result in revenue realization, the revenue might be recognized at the following stages of the productive (earning) process prior to delivery of goods to customers:

1. Prior to production.
2. During production
3. on competition of production
4. At some other stage based, for example, on production, accretion , discovery, receipt of orders from customers, or billing of customers.

 

5.2.3 Revenue Recognition After Delivery

Under some circumstances the revenue recognition criteria are not met until some time after delivery of the goods or service to the customer.  Such is the case when :

1. The substance of the transaction if different from the form, such as in product – financing arrangements.
2. The ultimate collectablity of the sales price is highly uncertain, such as with some long – term installment sales

In such instance revenue may be recorded under the installment method, the cost recovery method , or some other method based on cash collection.

 

2.  Cost Recovery method.

The cost recovery method is sometimes called the sunk cost method.  Under this method a company recovers all the related costs incurred (the sunk costs) before it recognizes any profit.  The cost recovery method is used only for highly speculative transactions when the ultimate realization of revenue or profit is unpredictable.  The cost recovery method is also justified when there is uncertainty regarding the ultimate collectiblity of an installment sale.

Under the cost recovery method, no profit is recognized until the cost of the products sold is fully recovered.  In the period of sale, the cost of the products is deducted from sales (net of the deferred gross profit) in the income statement.  The deferred gross profit also is deducted from the related receivable in the balance sheet.  Collections of principal reduce the receivable, and any collections of interest are credited to the deferred gross profit ledger account.  Deferred gross profit subsequently recognized as earned is presented as a separate item of revenue in the income statement.

 

3. Cash Collection method.

The recognition of revenue may be delayed beyond the point of sale until additional evidence confirms the sales transaction.  For example, a significant degree of uncertainty may exist as to the collectibles of receivables resulting from revenue transactions, or a sales transaction may be lacking in economic substance and therefore may after inadequate evidence of revenue realization.  Under these circumstances revenue is recognized as cash is collected, and costs incurred are either recognized as expense or deferred, as considered appropriate in a specific situation. 

 

For companies that provide services rather than products, revenue recognition follows procedures similar to those for tangible goods transactions.  The four methods of revenue recognition for service sales are:

1. Specific performance
2. Proportional performance
3. Completed performance
4. Cash Collection method

 

Specific performance.

The specific performance method is used to account for service revenue that is earned by performing a single act. For example, a real estate broker earns sales commission revenue on completion on a real estate transaction, a dentist earns revenue on completion of a tooth filling; a laundry earns revenue on competition of the cleaning.

Franchise revenue: SFAS No 45, “Accounting for Franchise Fee Revenue”  deals with a particular type of service sale, franchises.  It prescribes the specific performance method to account for franchise fee revenue, which a franchiser earns by selling a franchise.  For revenue recognition purposes, it is often difficult to determine the point at which the franchisor has “substantially performed” the service required to earn the franchise fee revenue.

Example: Assume that on April 1, 1997, Chicago Pizza Corporation (franchisor) sold a franchise to Arthur Wilson (franchisee) for Br. 20,000 cash down and received a note that required five annual payments of Br. 8,739 beginning on March 31, 1998.  The interest rate is 14% and the note therefore has a present value of Br. 30,000.

   Two situations are examined:

Case A. If no additional services are to be performed by the franchisor and collectiblity is reasonably assured, Chicago pizza should recognize the entire amount (the Br. 20,000 cash payment and Br. 30,000 note receivable)

As revenue on April 1, as follows:

Cash--------------------------20,000

Notes receivable  ---------30,000

         Franchise fee revenue --------50,000
 

Case B.  If Chicago pizza has additional services to perform for the franchisee, such as

outfitting the new pizza restaurant, no franchise fee revenue would be recognized on April 1, 1997.

Rather, the entry would be:

Cash -----------------------------20,000

Notes receivable  -------------30,000

         Deferred franchise fee revenue  ----------50,000

On December 31,1997, Chicago pizza would make the following entry to accrue interest on the notes receivable:

Note receivable-----------------------------3150 

        Deferred franchise fee revenue (Br.30,000 X ).14 X 9/12) ------------- 3150

Assume that Chicago completes its obligations to the franchisee in January 1998, after having spent Br.2000 in the process.  The entry to record this expenditure and recognize revenue would be:

Deferred franchise fee revenue------------------50,000

Franchise service expense ----------------------2,000

            Franchise fee revenue ------------------------------50,000

            Prepaid expense, franchise services -----------2,000

Expenditures in 1997 by the franchisor related to the franchise would be deferred as prepaid expenses until the associated franchise fee is recognizes until the associated franchise fee is recognized, in conformity with the matching principle.

 

Proportional performance method.

The proportional performance method is used to recognize service revenue that is earned by more than a single act and only when the service extends beyond one accounting period.  Under this method, revenue is recognized based on the proportional performance of each act.

The proportional performance method of accounting for service revenue is similar to the percentage – of – completion method.  Proportional measurement takes different forms depending on the type of service transaction. 

1. similar performance acts: an equal amount of service revenue is recognized for each such act (for example, processing of monthly mortgage payments by a mortgage banker).
2. Dissimilar performance acts: service revenue is recognized in proportion to the server’s direct costs to perform each act (for example, providing lessons, examinations, and grading by a correspondence school)
3. Similar acts with a fixed period of performance: service revenue is recognized by the straight line method over the fixed period unless another method is more appropriate (for example, providing maintenance services on equipment for a fixed periodic fee)

           

Completed – Performance method.

The completed performance method is used to recognize service revenue earned by performing a services of acts of which the last is so important in relation to the total service transaction that service revenue is considered earned only after the final act occurs.  For example, a trucking firm earns service revenue only after delivery of freight, even though packing loading, and transporting preceded delivery.  The method is similar to the completed – contract method used for long –term contracts.

 

Cash collection method

The cash collection method is used to account for service revenue when the uncertainty of collection is so high or the estimates of expenses related to the revenues are so unreliable that the requirement of reliability is not satisfied.  Revenue is recognized only when cash is collected.  This method is similar to the cost recovery method used for product sales.

 

After the revenue of the accounting period is measured and recognized in conformity with the revenue principle, the matching principle is applied to measure and recognize the expenses of that period.  The costs of those assets and services used up should be recognized and reported as expenses of the period during which the related revenue is recognized.

Expenses can be classified into three categories:

1. Direct expenses are expenses such as cost of goods sold that are associated directly with revenues.  These expenses are recognized based on recognition of revenues that result directly and jointly from the same transactions or other events as the expenses.  This is an example of applying the matching principle.
2. Period expenses are expenses such as selling and administrative salaries, which are not associated directly with revenues.  These expenses are recognized during the period in which cash is spent or liabilities are incurred for goods and services that are used up either simultaneously at acquisition or soon after.
3. Allocated expense are expenses such as depreciation and insurance.  These expenses are allocated by systematic and rational procedures to the periods during which the related assets are expected to provide benefits.

The principles that provide accountants with guidelines for the recognition of expenses are

     A. Association cause and Effect:

Costs may be recognized as expenses based on a presumed direct association with specific revenue.  Costs that appear to be related to specific revenue are recognized as expenses concurrently with the recognition of the related revenue.  Examples of costs related to specific revenue include the direct cost of goods sold or service provided, sales commission, and direct costs incurred in relation to construction – type contracts.

 

     B. Systematic and rational allocation.

If a direct means is not available to associate cause and effect, costs may be recognized as expenses based on an orderly allocation to the accounting periods in which the costs appear to expire and presumably provide benefits received, because neither can be objectively measured.

 

      C. Immediate recognition.

Expenses are recognized in the current accounting period when

1. Costs incurred in the accounting period are expected to provide any future benefit
2.  costs deferred as assets in earlier periods no longer provide benefits, and
3.  allocation of costs to revenue or to accounting periods is impractical or is considered to serve no useful purpose.

 

Gains and losses are distinguished from revenues and expenses in that they result from peripheral or incidental transactions, events, or circumstances.

Most gains and losses are recognized when the transaction is completed. Thus, gains and losses from disposal of operational assets, sale of investments, and early extinguishment of debt are recognized in the entry made to record the transaction.  For example, an entry to record the disposal of a tract of land for cash would reflect a debit to cash, a credit to land for cash  would reflect a debit to cash, a credit to land  (for its recorded cost), and debit to loss (or a credit to gain) on disposal.

Estimated losses are recognized before their ultimate realization if they are both probable and can be reasonably estimated. Examples are losses on disposal of a segment of a business, pending litigation, and expropriation of assets.  If both conditions are met, the nature and estimated amount of the contingent loss must be disclosed in as note to the financial statements.

In contrast, gains are almost  never recognized before the completion of a transaction that establishes the existence and amount of the gain. 

Accounting for gains and losses reflects a conservative approach.  Losses may be recognized before they actually occur, but gains are recognized before a completed transaction or event.

 

Revenues are gross increase in assets or gross decreases in liabilities resulting from the profit – directed activities of an enterprise.  As an element of the income measurement process, the revenue for a period is generally determined independently of expenses by applying the revenue recognition principle.  The revenue recognition principle provides that revenue is recognized when the earning process is complete or virtually complete, and an exchange has taken place.  The earning process is complete when revenues are realized, and realization takes place when goods and services are exchanged for cash or claims to cash (receivables).  Revenues are said to be realizable when assets received in exchange are readily convertible to known amounts of cash or claims to cash.

The matching principle provides guidance for expense recognition.  The matching principle states that for any reporting period, the expenses recognized in that period ate those incurred in generating the revenues recognized in that period.

Most gains and losses are recognized when the related transaction is completed.  Estimated losses but not estimated gains are when they are probable and can be reasonably estimated.