A firm’s earnings process often takes place over an extended period of time. A manufacturer’s typical earnings process, which is depicted in figure 3.3, entails purchasing raw materials, manufacturing, storing and selling the finished product, and collecting cash from the customer. The manufacturer creates value through all these steps, but for accounting purposes, firms usually select a discrete point in time to recognize (record) revenue.
The revenue recognition principle states that revenue should be recognized in the accounting records when
- the earnings process is substantially complete, and
- the amount to be collected is reasonably determinable.
The first criterion prevents the recognition of revenue before a firm has fulfilled its obligation to the customer. The second criterion indicates that the sales price has been set and that the customer will probably pay the amount due. Both criteria ensure that revenue is not recognized prematurely. If revenue is recognized too soon, the income statement will indicate that the firm has accomplished activities that it has not, which would mislead financial statement users.
In most situations, these criteria are met at the point of sale, that is, when a product is delivered or a service is rendered to a customer. Even if payment is not immediately received, a claim to cash (an account receivable) has been obtained, and revenue recognition is proper.
Two additional comments need to be made about revenue recognition at the point of sale. First, many sellers guarantee their products’performance for a period of time. If a product malfunctions, the seller is obligated to incur the cost of correcting the problem. Does the existence of such a warranty indicate that the earnings process is not substantially complete at the time of sale? No, it does not. For most sellers, the warranty cost is relatively minor. Thus, the earnings process is substantially complete at the time of sale. Chapter 8, “Accounts Payable, Commitments, Contingencies, and Risks,” discusses warranty costs in more depth.
Second, when accounts receivable are obtained at the point of sale, can we be certain that cash will ultimately be collected? In most cases, absolute assurance cannot be obtained, but if the seller has done a good job of checking customers’credit histories, a reasonable estimate of worthless accounts receivable can be made. This estimate is used to adjust both the income statement and the balance sheet. Chapter “Current Assets,” discusses this issue in more detail.
A number of exceptions exist to the general rule of thumb that revenue is recognized at the point of sale. One exception deals with the collectibility of receivables. If the seller is highly uncertain about the collectibility of a receivable, revenue recognition should be delayed beyond the point of sale to the point when cash is actually collected. This approach is sometimes used in the real estate industry.
Another exception deals with long-term construction contracts (for bridges, highways, and so on). These projects can take several years to complete. If revenue recognition is delayed until the earnings process is substantially complete, no revenue is recognized in any contract year except the final one, at which point all the revenue is recognized. Such an uneven pattern of revenue recognition would contrast with the actual earnings process, which takes place throughout the life of the contract. Accordingly, if
- a binding contract exists between the buyer and the seller and
- the seller can reasonably estimate the costs to complete the project,
then revenue, the related costs, and the resultant profit should be estimated and recognized each year by the percentage of completion method. This method recognizes a portion of the revenue, cost, and profit each year according to the percentage of the job completed.
A similar situation exists with some service contracts. For example, consider a health club that sells one-year memberships for an immediate payment of $600. Revenue recognition at the point of sale is inappropriate because the earnings process has barely begun. However, delaying revenue recognition until the twelfth month, when the earnings process is substantially complete, is also inadvisable. GAAP permits proportional revenue recognition each month over the contract’s life. Most firms describe their revenue recognition policies in a note to the financial statements. Following Case study 3.1 contains an excerpt from the financial statements of Reader’s Digest, which frequently receives payments for subscriptions at the inception of a contract. Because the earnings process has just begun at that point, the magazine records a liability instead of revenue. Recording a liability recognizes that Reader’s Digest has an obligation to provide its customers something of value: either the magazine or a refund. Revenue is recognized as the magazines are mailed to the customers.
Case Study 3.1
Reader’s Digest records sales of magazine subscriptions as unearned revenue at the gross subscription price at the time the orders are received. Proportionate shares of the gross subscription price are recognized as revenue when the subscriptions are fulfilled.
a. Assume that Reader’s Digest receives $48 from a customer for a two-year subscription. Analyze this transaction in terms of the basic accounting equation.
b. Assume that the subscription is for 24 monthly issues. In terms of the basic accounting equation, what analysis would Reader’s Digest undertake when each issue is mailed?