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Chapter5: Income Measurement and Profitability Analysis

Revenue Recognition at Delivery

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Product Revenue

Consider the timing of revenue recognition for a typical manufacturing company that sells its products on credit. Graphic 5-2 shows three alternative points in time during the earnings process that could be considered the critical event for revenue recognition. It should be pointed out that revenue actually is earned throughout the earnings process. The critical event is the point in time when the realization principle is satisfied.9

   Let's first consider the date production ends. At that point, it might be said that the earnings process is virtually complete. After all, the majority of the costs that must be expended to generate revenue have been incurred. The product has been produced and the remaining tasks are to sell the product and collect the asset to be exchanged for the product, which is usually cash.

While revenue usually is earned during a period of time, it often is recognized at one specific point in time when both revenue recognition criteria are satisfied.

   However, at this point there usually exists significant uncertainties. We don't know if the product will be sold, the selling price, the buyer, or the collectibility of the asset to be received. Because of these uncertainties, revenue recognition usually is delayed until the point of sale, at product delivery. The product delivery date occurs when legal title to the goods passes from seller to buyer. This occurs either on the date the product is shipped from the seller's facility or when the goods actually are received by the buyer, depending on the terms of the sales agreement. If the goods are shipped f.o.b. (free on board) shipping point, then legal title to the goods changes hands at the point of shipment, when the seller delivers the goods to the common carrier (for example, a trucking company), and the purchaser is responsible for shipping costs and transit insurance. On the other hand, if the goods are shipped f.o.b. destination, the seller is responsible for shipping, and legal title does not pass until the goods arrive at the customer's location.10

Revenue from the sale of products usually is recognized at the point of product delivery.

The point of delivery refers to the date legal title to the product passes from seller to buyer.

   The basic journal entries to record revenue upon delivery should look familiar. As an example, assume that Taft Company sells a supercomputer for $5,000,000 that cost $4,100,000 to produce. The journal entries to record the sale, assuming that Taft uses the perpetual inventory method, would be

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This sale yields gross profit of $900,000 ($5,000,000 − 4,100,000).

   At the product delivery date we know the product has been sold, the price, and the buyer. However, usually the buyer is given a length of time, say 30 days, to pay for the goods after they have been delivered. Therefore, the only remaining uncertainty at the time of delivery involves the ultimate cash collection, which usually can be accounted for by estimating and recording allowances for possible return of the product and for uncollectibility of the cash, that is, bad debts. Both of these estimates are discussed in Chapter 7. As we discuss later in this chapter, significant uncertainty at point of product delivery related to either collectibility or product return causes a delay in revenue recognition.

Service Revenue

Service revenue, too, often is recognized at a point in time if there is one final activity that is deemed critical to the earnings process. In this case, all revenue is deferred until this final activity has been performed. For example, a moving company will pack, load, transport, and deliver household goods for a fixed fee. Although packing, loading, and transporting all are important to the earning process, delivery is the culminating event of the earnings process. So, the entire service fee is recognized as revenue after the goods have been delivered. FedEx recognizes revenue in this manner. The Company's Summary of Significant Accounting Policies disclosure note indicates that “Revenue is recognized upon delivery of shipments.” As with the sale of product, estimates of uncollectible amounts must be made for service revenue provided to customers on a credit basis.

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   However, in many instances, service revenue activities occur over extended periods, so recognizing revenue at any single date within one period would be inappropriate. Instead, it's more meaningful to recognize revenue over time as the service is performed.

   As an example, consider the revenue a property owner earns when renting office space. If a landlord charges a tenant $12,000 in rent for the upcoming year, it would seem logical to recognize $1,000 of rent revenue each month over the one-year period (i.e., straight-line method) since similar services are performed throughout the period. The landlord recognizes rent revenue in proportion to the passage of time. Likewise, Gold's Gym will recognize revenue from a two-year membership ratably over the 24-month membership period. If the customer pays in advance in such cases, the seller debits cash and credits a liability (unearned revenue) because the seller is holding the customer's cash and has the obligation to provide the service. The seller only reduces that liability when the service has been provided and therefore revenue has been earned. We discuss unearned revenue liabilities and customer advances more in Chapter 13.

Service revenue often is recognized over time, in proportion to the amount of service performed.

   A similar situation occurs if you buy a season pass to Disney World. When would Walt Disney Co. recognize revenue for the cash it collects for the sale of a 365-day pass? Rationalizing that a pass can be used any number of times during the season, thus making it difficult to determine when service is provided, many companies once recognized all revenue from the sale of season passes on the date of sale. However, the SEC's Staff Accounting Bulletin No. 101, discussed earlier in the chapter, motivated most of these companies to change to recognizing revenue throughout the service period. For example, Graphic 5-4 provides a disclosure note Walt Disney Co. included in a recent annual report. Notice that the company now recognizes revenue over time, based on the anticipated usage of the season pass over the operating season.

Disclosure of Revenue Recognition Policy—Walt Disney Co.

Real World Financials


Revenue Recognition (in part)
Revenues from advance theme park ticket sales are recognized when the tickets are used. For nonexpiring, multi-day tickets, we recognize revenue over a three-year time period based on estimated usage patterns that are derived from historical usage patterns. Revenues from corporate sponsors at the theme parks are generally recognized over the period of the applicable agreements commencing with the opening of the related attraction.

9As you will learn later in this chapter when we discuss the percentage-of-completion method, revenue can be recognized during the earnings process rather than at one particular point in time as long as particular criteria have been met.

10We discuss this aspect of title transfer in Chapter 7.

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