Recognizing revenue when goods and services are delivered as described in the previous section assumes we are able to make reasonable estimates of amounts due from customers that potentially might be uncollectible. For product sales, this also includes amounts not collectible due to customers returning the products they purchased. Otherwise, we would violate one of the requirements of the revenue realization principle we discussed earlier—that there must be reasonable certainty as to the collectibility of cash from the customer. In this section we address a few situations in which uncertainties are so severe that they could cause a delay in recognizing revenue from a sale of a product or service. For each of these situations, notice that the accounting is essentially the same—deferring recognition of the gross profit arising from a sale of a product or service until uncertainties have been resolved.
Customers sometimes are allowed to pay for purchases in installments over a long period of time. Many large retail stores, such as Sears and J.C. Penney, sell products on an installment plan. Increasing the length of time allowed for payment usually increases the uncertainty about whether the store actually will collect a receivable. Is the uncertainty sufficient in an installment sale to cause these companies to delay recognizing revenue and related expenses beyond the point of sale? Usually, it's not.
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In most situations, the increased uncertainty concerning the collection of cash from installment sales can be accommodated satisfactorily by estimating uncollectible amounts. If, however, the installment sale creates significant uncertainty concerning cash collection, making impossible a reasonable assessment of future bad debts, then revenue and expense recognition should be delayed. For example, real estate sales often are made on an installment basis with relatively small down payments and long payment periods, perhaps 25 years or more. These payment characteristics, combined with the general speculative nature of many of these transactions, may translate into extreme uncertainty concerning the collectibility of the installment receivable.11 In fact, GAAP requires that the installment sales method (discussed below) be applied to a retail land sale that meets certain criteria.12
At times, revenue recognition is delayed due to a high degree of uncertainty related to ultimate cash collection.
When extreme uncertainty exists regarding the ultimate collectibility of cash, we delay recognizing revenue and related expenses using one of two accounting techniques, the installment sales method recognizes revenue and costs only when cash payments are received. or the cost recovery method deferral of all gross profit recognition until the cost of the item sold has been recovered.. We emphasize that these methods should be used only in situations involving exceptional uncertainty. As an example, Rouse Company acquires, develops, and manages income-producing properties throughout the United States and develops and sells land for residential, commercial, and other uses. Graphic 5-5 shows the company's revenue recognition disclosure note included with recent annual financial statements. The note indicates that the preferred method is to recognize revenue upon delivery (full accrual method), but that in certain circumstances, one of these two alternative methods could be used.
The installment sales and cost recovery methods are only used in unusual circumstances.
Disclosure of Revenue Recognition Policy—Rouse Company
Real World Financials
Revenue Recognition and Related Matters (in part)
Revenues from land sales are recognized using the full accrual method provided that various criteria relating to the terms of the transactions and any subsequent involvement by us with the land sold are met. Revenues relating to transactions that do not meet the established criteria are deferred and recognized when the criteria are met or using the installment or cost recovery methods, as appropriate in the circumstances.
INSTALLMENT SALES METHOD. To deal with the uncertainty of collection, the installment sales method recognizes revenue and costs only when cash payments are received. recognizes revenue and costs only when cash payments are received. Each payment is assumed to be composed of two components: (1) a partial recovery of the cost of the item sold and (2) a gross profit component. These components are determined by the gross profit percentage applicable to the sale. For example, if the gross profit percentage (gross profit ÷ sales price) is 40%, then 60% of each dollar collected represents cost recovery and the remaining 40% is gross profit. Consider the example in Illustration 5-1.
Installment Sales Method
On November 1, 2011, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, 2011. The land cost $560,000 to develop. The company's fiscal year ends on December 31.
The gross profit of $240,000 ($800,000 − 560,000) represents 30% of the sales price ($240,000 ÷ $800,000). The collection of cash and the recognition of gross profit under the installment method are summarized below. In this example, we ignore the collection of interest charges and the recognition of interest revenue to concentrate on the collection of the $800,000 sales price and the recognition of gross profit on the sale.
The installment sales method recognizes the gross profit by applying the gross profit percentage on the sale to the amount of cash actually received.
The gross profit recognized in a period will be equal to the gross profit percentage multiplied by the period's cash collection. The following journal entries are recorded (interest charges ignored):
The first entry records the installment receivable and the reduction of inventory. The difference between the $800,000 selling price and the $560,000 cost of sales represents the gross profit on the sale of $240,000. As it will be recognized in net income only as collections are made, it is recorded in an account called deferred gross profit. This is a contra account to the installment receivable. It will be reduced to zero as the payments are received.13
Inventory is credited for the portion of the receivable that represents the cost of the land sold. The difference is deferred gross profit.
The second set of entries records the collection of the first installment and recognizes the gross profit component of the payment, $60,000. Realized gross profit gets closed to income summary as part of the normal year-end closing process and is included in net income in the income statement. Journal entries to record the remaining three payments on November 1, 2012, 2013, and 2014, are identical.
When payments are received, gross profit is recognized, and is calculated by applying the gross profit percentage to the cash collected (30% × $200,000).
At the end of 2011, the balance sheet would report the following:
The net amount of the receivable reflects the portion of the remaining payments that represents cost recovery (70% × $600,000). The installment receivables are classified as current assets if they will be collected within one year (or within the company's operating cycle, if longer); otherwise, they are classified as noncurrent assets.
The income statement for 2011 would report gross profit from installment sales of $60,000. Sales and cost of goods sold usually are not reported in the income statement under the installment method, just the resulting gross profit. However, if those amounts aren't included in the income statement in the period in which the installment sale is made, they need to be included in the notes to the financial statements, along with the amount of gross profit that has not yet been recognized.
We discuss in significant depth in Chapter 7 the problem of accounting for bad debts. However, bad debts related to receivables on sales accounted for using the installment method create a unique problem. The reason a company uses the installment method is that it can't reliably estimate bad debts. Therefore, the company doesn't explicitly recognize bad debt expense or create an allowance for uncollectible accounts in the installment method. Rather, bad debts are dealt with implicitly by deferring gross profit until cash is collected. If the cash never is collected, the related deferred gross profit never gets included in net income. To illustrate, assume that in the example described in Illustration 5-1, the Belmont Corporation collected the first payment but the customer was unable to make the remaining payments. Typically, the seller would repossess the item sold and make the following journal entry:
| ||Repossessed inventory ........................................|
| ||Deferred gross profit ............................................|
| || Installment receivable ........................................|
This entry removes the receivable and the remaining deferred gross profit and records the repossessed land in an inventory account. This example assumes that the repossessed land's current fair value is equal to the net receivable of $420,000. If the land's fair value at the date of repossession is less than $420,000, a loss on repossession is recorded (debited).
COST RECOVERY METHOD. In situations where there is an extremely high degree of uncertainty regarding the ultimate cash collection on an installment sale, an even more conservative approach, the cost recovery method deferral of all gross profit recognition until the cost of the item sold has been recovered., can be used. This method defers all gross profit recognition until the cost of the item sold has been recovered. The gross profit recognition pattern applying the cost recovery method to the Belmont Corporation situation used in Illustration 5-1 is shown below.
The cost recovery method defers all gross profit recognition until cash equal to the cost of the item sold has been received.
The journal entries using this method are similar to those for the installment sales method except that $40,000 in gross profit is recognized in 2013 and $200,000 in 2014.
The cost recovery method’s initial journal entry is identical to the installment sales method.
Why not use the installment sales method or cost recovery method for all installment sales? Because doing so would violate the realization principle and be inconsistent with accrual accounting. If bad debts can be reasonably estimated, there is no reason to delay revenue recognition.
When payments are received, gross profit is recognized only after cost has been fully recovered.
Boatwright Implements, Inc., manufactures and sells farm machinery. For most of its sales, revenue and cost of sales are recognized at the delivery date. In 2011 Boatwright sold a cotton baler to a new customer for $100,000. The cost of the machinery was $60,000. Payment will be made in five annual installments of $20,000 each, with the first payment due in 2011. Boatwright usually does not allow its customers to pay in installments. Due to the unusual nature of the payment terms and the uncertainty of collection of the installment payments, Boatwright is considering alternative methods of recognizing profit on this sale.
Ignoring interest charges, prepare a table showing the gross profit to be recognized from 2011 through 2015 on the cotton-baler sale using the following three methods:
Point of delivery revenue recognition.
The installment sales method.
The cost recovery method.
Right of Return
Retailers usually give their customers the right to return merchandise if they are not satisfied. In most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery. Based on past experience, a company usually can estimate the returns that will result for a given volume of sales. These estimates are used to reduce both sales and cost of goods sold in anticipation of returns. The purpose of the estimates is to avoid overstating gross profit in the period of sale and understating gross profit in the period of return. The specific accounting treatment for sales returns is illustrated in Chapter 7 in conjunction with discussing the valuation of accounts receivable.
Because the return of merchandise can negate the benefits of having made a sale, the seller must meet certain criteria before revenue is recognized in situations when the right of return customers' right to return merchandise to retailers if they are not satisfied. exists. The most critical of these criteria is that the seller must be able to make reliable estimates of future returns.14 In certain situations, these criteria are not satisfied at the point of delivery of the product. For example, manufacturers of semiconductors like Intel Corporation and Motorola Corporation usually sell their products through independent distributor companies. Economic factors, competition among manufacturers, and rapid obsolescence of the product motivate these manufacturers to grant the distributors the right of return if they are unable to sell the semiconductors. So, revenue recognition often is deferred beyond the delivery point to the date the products actually are sold by the distributor to an end user. The disclosure note shown in Graphic 5-6 appeared in a recent annual report of Intel Corporation.
Disclosure of Revenue Recognition Policy—Intel Corporation
Real World Financials
The company recognizes net revenue when the earnings process is complete, as evidenced by an agreement with the customer, transfer of title and acceptance, if applicable, as well as fixed pricing and probable collectibility… . Because of frequent sales price reductions and rapid technology obsolescence in the industry, sales made to distributors under agreements allowing price protection and/or right of return are deferred until the distributors sell the merchandise.
For Intel, the event critical to revenue recognition is not the delivery of the product to a distributor but the ultimate sale of the product by the distributor to an end user.
Alternatively, the right of return could be specified contractually as expiring on some future date, and revenue recognition could be deferred to that date. Regardless, the accounting treatment in these situations would be similar to that used for the installment sales and cost recovery methods. The difference is that the journal entries we use to move deferred gross profit to realized gross profit would be recorded in whatever period that returns can be estimated reliably or the right of return no longer exists.
Similarly, sometimes, a sales agreement requires additional, important performance steps to be performed by the seller. In this case, the earnings process is not virtually complete until those steps are performed, but as in the case of significant uncertainty about cash collection, revenue recognition must be deferred. Graphic 5-1 on page 235 illustrates a situation where the seller, Brown & Sharpe, delays revenue recognition beyond delivery of machines until the performance of the machines has been accepted by the buyer. Customer acceptance is an important part of the agreement between buyer and seller.
Any time a company recognizes revenue at a point other than the point of delivery, the revenue recognition method used is disclosed in the summary of significant accounting policies. Intel's disclosure note is an example. As another example, Graphic 5-7 shows a disclosure note included with the 2009 financial statements of Helicos Biosciences Corporation, a producer of genetic analysis instrumentation for research, pharmaceutical and medical applications.
Disclosure of Revenue Recognition Policy—Helicos Biosciences Corporation
Real World Financials
2. Summary of Significant Accounting Policies: Revenue Recognition (in part)
The Company recognizes revenue in accordance with Staff Accounting Bulletin No. 104, ”Revenue Recognition in Financial Statements.” … SAB No. 104 requires that persuasive evidence of a sales arrangement exists; delivery of goods occurs through transfer of title and risk and rewards of ownership, the selling price is fixed or determinable and collectibility is reasonably assured.…
In instances where the Company sells an instrument with specified acceptance criteria, the Company will defer revenue recognition until such acceptance has been obtained.
As the note indicates, some of Helicos's revenue is delayed beyond the point of product delivery. Until the product has been installed and meets customer acceptance criteria, there is a high degree of uncertainty concerning the possibility the product might be returned, so Helicos has not completed its obligation to its customer until acceptance has occurred.
Sometimes a company arranges for another company to sell its product under consignment the consignor physically transfers the goods to the other company (the consignee), but the consignor retains legal title.. The “consignor” physically transfers the goods to the other company (the consignee), but the consignor retains legal title. If the consignee can't find a buyer within an agreed-upon time, the consignee returns the goods to the consignor. However, if a buyer is found, the consignee remits the selling price (less commission and approved expenses) to the consignor.
Because the consignor retains the risks and rewards of ownership of the product and title does not pass to the consignee, the consignor does not record a sale (revenue and related expenses) until the consignee sells the goods and title passes to the eventual customer. Of course, that means goods on consignment still are part of the consignor's inventory. As an example, Sonic Solutions earns revenue primarily from licensing, developing, maintaining, and supporting its software. Some of the company's product is sold using consignment arrangements. Graphic 5-8 shows a portion of the revenue recognition disclosure note that Sonic Solutions included in its 2009 annual report.
Consigned inventory stays in the balance sheet of the consignor until an arms-length transaction transfers title to a buyer.
Disclosure of Revenue Recognition Policy—Sonic Solutions
Real World Financials
Note 1: Business and Summary of Significant Accounting Policies: Revenue Recognition (in part)
Except in the case of consignment arrangements, the Company recognizes revenue from the sale of its packaged software products when title transfers to the distributor or retailer. When the Company sells packaged software products to distributors and retailers on a consignment basis, it recognizes revenue upon sell through to an end customer.
Up until now, we've focused on revenue-generating activities in which some specific event (e.g., delivery, collection, product performance, and resale) indicates that the earnings process is substantially completed and significant uncertainties have been alleviated, prompting us to recognize revenue and related expenses. We now turn our attention to situations in which it's desirable to recognize revenue over more than one reporting period—before a specific event indicates the earnings process is substantially completed.