Statement of Financial Accounting Concepts (SFAC) No. 6, Elements of Financial Statements (pars. 78, 79, and 82), issued in December 1985, defines revenues and gains in this way:

Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.

Revenues represent actual or expected cash inflows (or the equivalent) that have occurred or will eventuate as a result of the entity's ongoing major or central operations. The assets increased by revenues may be of various kinds—for example, cash, claims against customers or clients, other goods or services received, or increased value of a product resulting from production. Similarly, the transactions and events from which revenues arise and the revenues themselves are in many forms and are called by various names—for example, output, deliveries, sales, fees, interest, dividends, royalties, and rent—depending on the kinds of operations involved and the way revenues are recognized.

Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners.

SFAC No. 6 (pars. 87–89) distinguishes revenues from gains (and expenses from losses) in this way:

Revenues and gains are similar, and expenses and losses are similar, but some differences are significant in conveying information about an enterprise's performance. Revenues and expenses result from an entity's ongoing major or central operations and activities—that is, from activities such as producing or delivering goods, rendering services, lending, insuring, investing, and financing. In contrast, gains and losses result from incidental or peripheral transactions of an enterprise with other entities and from other events and circumstances affecting it. Some gains and losses may be considered “operating” gains and losses and may be closely related to revenues and expenses. Revenues and expenses are commonly displayed as gross inflows or outflows of net assets, while gains and losses are usually displayed as net inflows or outflows.

The definitions and discussion of revenues, expenses, gains, and losses in this Statement give broad guidance but do not distinguish precisely between revenues and gains or between expenses and losses. Distinctions between revenues and gains and between expenses and losses in a particular entity depend to a significant extent on the nature of the entity, its operations, and its other activities. Items that are revenues for one kind of entity may be gains for another, and items that are expenses for one kind of entity may be losses for another. For example, investments in securities that may be sources of revenues and expenses for insurance or investment companies may be sources of gains and losses in manufacturing or merchandising companies. Technological changes may be sources of gains or losses for most kinds of enterprises but may be characteristic of the operations of high-technology or research-oriented enterprises. Events such as commodity price changes and foreign exchange rate changes that occur while assets are being used or produced or liabilities are owed may directly or indirectly affect the amounts of revenues or expenses for most enterprises, but they are sources of revenues or expenses only for enterprises for which trading in foreign exchange or commodities is a major or central activity.

Since a primary purpose of distinguishing gains and losses from revenues and expenses is to make displays of information about an enterprise's sources of comprehensive income as useful as possible, fine distinctions between revenues and gains and between expenses and losses are principally matters of display or reporting (paragraphs 64, 219–220, and 228).

The Financial Accounting Standards Board (FASB) currently is reconsidering the definition of revenue it provided in SFAC No. 6 in order to clarify whether transactions give rise to revenues or gains (see Section 12.4(d)). This chapter does not distinguish between gains and revenues because the distinction is not important in resolving the major issues of revenue recognition and measurement. The distinction is significant, however, in considering income statement presentation of earnings, particularly whether asset inflows and outflows should be shown gross or net and where gains and losses should be reported.

(b) Classification of Revenue

O'Reilly, Hirsch, Defliese, and Jaenicke note that:

Most companies have one or more major sources of revenues and several less significant types of miscellaneous revenues, commonly referred to as other income. The term used for a given type of revenue usually depends on whether it is derived from one of the enterprise's principal business activities. For example, sales of transformers by an electrical supply company would be “sales,” while such transactions would be “other income” to an electric utility. Conversely, interest and dividends from investments would be “other income” to almost all enterprises except investment companies, for which interest and dividends are a primary source of revenues.¹

(c) Measurement, Earning, Realization, and Recognition of Revenue

There is general agreement on the meaning of the terms measurement and earning as they apply to revenue. However, there has been disagreement regarding usage of two other terms—realization and recognition—that are significant in establishing the accounting period in which revenue should be reported.

(i) Measurement of Revenue

Paragraph 83 of SFAC No. 5, Recognition and Measurement in Financial Statements, states that revenues “are generally measured by the exchange values of the assets (goods or services) or liabilities involved.” That measurement criterion, coupled with the FASB definition of revenues, thus excludes from revenues those items commonly referred to as revenue adjustments, such as bad debts, discounts, returns, and allowances. (See the discussion in Section 12.5.) In certain circumstances, the time value of money should be acknowledged, and interest implicit in a revenue transaction should be classified separately.

Revenue can be measured by the prices (i.e., “gross” amounts) of goods or services sold to customers or the differences (i.e., “net” amounts) between those prices and the amounts due to third parties that supply the goods or services. Staff Accounting Bulletin (SAB) No. 101 (Topic 13-A.5, Question 10), Revenue Recognition, discusses two major questions to be answered when deciding whether to record revenue at gross or net amounts:

1. Does the entity act as a principal (where its compensation, in substance, is gross profit from the transaction) or as an agent or broker (where its compensation, in substance, is a commission or fee)?

2. Does the entity take title to the goods sold or otherwise bear the risks and rewards of ownership (such as the risk of loss for collection, delivery, or returns)?

The Standards Executive Committee Staff concluded that if the entity functions as a principal and bears the risks and rewards of ownership, revenue should be reported at gross amounts, with separate reporting of cost of sales. If, instead, the entity functions as an agent and does not bear those risks and rewards—for example, Internet companies, travel agents, and retailers that stock little or no inventory, do not take title to goods sold to customers, and use third-party service providers to fill orders and ship products to customers—revenue should be reported at net amounts.

Additional factors to consider are provided in Accounting Standards Codification (ASC) 605-45-45, Overall Considerations of Reporting Revenue Gross as a Principal versus Net as an Agent. Although its consensus acknowledges that the decisions often involve judgment, ASC 605-45-45, Sections 3 through 14, provides a list of indicators supporting revenue measurement at gross amounts:

The entity, rather than the supplier, is primarily responsible for meeting customers' needs and ensuring customer satisfaction (i.e., entity is the “primary obligor”).
The entity has the risk of loss before a customer order is placed or after a customer return (i.e., entity bears “general inventory risk”).
The entity has latitude in setting the selling price.
The entity adds value, such as by physically changing the product or performing part of the service.
The entity has discretion in choosing from among the different suppliers for the product or service.
The entity is involved in determining and communicating product or service specifications to the supplier.
The entity has the risk of loss after a customer order is placed or during shipping (i.e., entity bears “physical loss inventory risk”).
The entity is responsible for collecting the sales price from the customer and paying the supplier, regardless of whether the customer pays the total price (i.e., entity bears “credit risk”).

ASC 605-45-45, Sections 15 through 18, provides three indicators that support recognizing revenue at net amounts:

1. The supplier, rather than the entity, is primarily responsible for meeting the customer's needs and ensuring customer satisfaction (i.e., supplier is the “primary obligor”).

2. The entity earns a fixed amount, expressed either in terms of dollars or a percentage of the gross amount billed to the customer, suggesting that the entity is serving as an agent of the supplier.

3. The supplier assumes the credit risk, and the entity has little or no credit risk.

No single indicator determines which method should be used. For example, although an entity's not taking title to products sold to customers generally indicates a lack of “general inventory risk” and, therefore, net revenue reporting, an entity's taking title to products is not sufficient, by itself, to justify gross reporting.

For those entities that record revenue based on the gross amount billed to the customer, shipping and handling fees billed to the customer should also be reported at gross amounts and classified as revenue (ASC 605-45-45-20). The costs of shipping and handling should not be netted against those gross revenues.

Disclosures that may be appropriate for entities reporting revenues at net amounts are addressed in ASC 605-45-50. Voluntary disclosure of gross transaction volume for those revenues reported at net amounts is encouraged. Gross amounts can be reported either parenthetically on the face of the income statement or in the related notes, but they may not be characterized as “revenues” or be included in a column that reports net income or loss, with the exception of disclosure of taxes collected and remitted to governmental authorities. The presentation of such taxes on either a gross or net basis is considered to be an accounting policy decision requiring disclosure (ASC 605-45-50-3).

(ii) Earning of Revenue

There is not clear agreement on the question of what “earning” revenue means. According to paragraph 83b of SFAC No. 5, revenues are not recognized until earned. An entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations. Revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. In complex transactions such as multiple-deliverable revenue arrangements, however, it may not be apparent when revenue has been earned. When there are many activities being performed, it is not immediately clear whether revenue is earned as each action is performed or only upon completion of all the agreed-on deliverables. Understanding when revenue should be recognized may require knowledge of the nature of the specific earning process in certain industries.

(iii) Revenue Realization and Recognition

To “recognize” revenue means to report it in the entity's financial statements or to formally record it in the entity's accounts by crediting a revenue account and simultaneously debiting an asset or a liability. At the time revenue is recognized, closely related expenses (such as cost of goods sold) also are recognized, although the particular accounting system (e.g., a periodic inventory system) may cause the actual bookkeeping entry to be made later in the accounting period. At the point of revenue recognition, the accounting for related assets switches from recording entry values—that is, amounts based on purchase prices (such as the historical cost of an asset)—to recording exit values—that is, amounts based on selling prices (such as the selling price of an asset sold in the ordinary course of business). “In traditional accounting terminology, the accountant is said to ‘recognize revenue’ when he [or she] switches from one measurement approach to the other.”²

Some authors have used the term realization in a very broad sense to mean that the necessary conditions for recognizing revenue have been met. The 1957 revision of the American Accounting Association (AAA) Accounting and Reporting Standards for Corporate Financial Statements, for example, states: “The essential meaning of realization is that a change in an asset or liability has become sufficiently definite and objective to warrant recognition in the accounts.”³ Under this broad view, the point of realization (recognition) is movable, and specific rules must be provided to define when it occurs in different types of revenue transactions and earning processes.

ASC 605-10-25, Revenue Recognition: Overall, clarifies the term realization. Consistent with paragraph 83a of SFAC No. 5, revenues are realized when products, merchandise, or other assets are exchanged for cash or claims to cash. Revenues are realizable when any related assets received in such an exchange are readily convertible to known amounts of cash or claims to cash.

Despite the widely held view that realization takes place at a single specific point in time, such as the sale date, and recognition of revenue at all other points in time is a departure from or an exception to the realization principle, some departures or exceptions are necessary. ASC 605-10-25-1 notes that revenue recognition depends on consideration of both whether the revenue is earned and whether it is realized or realizable. The Standard further states that sometimes one of those factors is more important and sometimes the other. (See Section 12.3(c).)

(d) Revenue Recognition Alternatives

Revenue can be recognized at various points in the earning process, depending on the circumstances.

Paragraph 84 of SFAC No. 5 notes that revenue is commonly recognized “at time of sale,” although six other points are described:

1. After production and delivery—if a sale, cash receipt, or both occur before production and delivery of goods or services.

2. During production—if a contract exists for which reliable estimates of revenue, total costs, and progress can be made.

3. As time passes—if reliable, contractually based measures established in advance are available for services rendered or rights to use assets are provided continuously over a period of time.

4. At completion of production—if a product or service can be sold at a price that can be reliably determined with little effort before delivery.

5. At the time of exchange for nonmonetary assets—if the fair value of goods or services sold or of nonmonetary assets received can be reliably measured.

6. As cash is collected—if collectibility of assets received from the sale of goods or services is doubtful.

The use of each alternative (or basis) in different circumstances is discussed in the next subsections. The general criteria for recognizing revenue and specific factors to be considered in applying those criteria are considered later in this chapter. (See Section 12.3.)

(i) Delivery

Recognizing revenue when a product is delivered or service rendered, often referred to as the sale basis, is most common and has been most widely supported in the literature.

Paton and Littleton state:

For the great majority of business enterprises the sale basis of measuring revenue clearly meets the requirements of accounting standards more effectively than any other possible basis. Revenue is the financial expression of the product of business operation and hence should be gauged in terms of the decisive stage or step in the stream of activity. Revenue, moreover, should be evidenced and supported by new and dependable assets, preferably cash or near-cash. These fundamental requirements are well met by adopting the completed sale as the test of the realization of revenue.

For most concerns engaged in making or dealing with tangible goods the sale is the most conclusive, and the most financially significant, of the chain of events making up the business process; the sale is the capstone of activity, the end toward which all efforts are directed….

If product is in the form of service, as in transportation, banking, etc., the act or process of furnishing service may be viewed as the equivalent of sale for the purpose of measuring revenue.⁴

One of the six rules adopted by the membership of the American Institute of Certified Public Accountants (AICPA) in 1934, and reprinted in Accounting Research Bulletin (ARB) No. 43, Restatement and Revision of Accounting Research Bulletins (Chapter .1, Section A, par. 1), states: “Profit is deemed to be realized when a sale in the ordinary course of business is effected, unless the circumstances are such that the collection of the sale price is not reasonably assured.” The APB reaffirmed that view in 1966 in APB Opinion No. 10, Omnibus Opinion—1966 (par. 12), stating: “Revenues should ordinarily be accounted for at the time a transaction is completed, with appropriate provision for uncollectible accounts,” a viewpoint adopted in ASC 605-10-25-3.

George O. May stated the rationale behind the widespread use of the sale basis as long ago as 1943:

The problem of allocation of income to particular short periods obviously offers great difficulty—indeed, it is the point at which conventional treatment becomes indispensable, and it must be recognized that some conventions are scarcely in harmony with the facts. Manifestly, when a laborious process of manufacture and sale culminates in the delivery of the product at a profit, that profit is not attributable, except conventionally, to the moment when the sale or delivery occurred. The accounting convention which makes such an attribution is justified only by its demonstrated practical utility.

It is instructive to consider how it happens that a rule which is violative of fact produces results that are practically useful and reliable. The explanation is, that in the normal business there are at any one moment transactions at every stage of the production of profit, from beginning to end. If the distribution were exactly uniform, an allocation of income according to the proportion of completion of each unit would produce the same result as the attribution of the entire profit to a single stage.

A number of conclusions immediately suggest themselves: first, that the convention is valid for the greatest variety of purposes where the flow of product is most uniform; second, that it is likely to be more generally valid for a longer than for a shorter period; and, third, that its applicability is seriously open to question for some purposes where the final consummation is irregular in time and in amount. Thus, the rule is almost completely valid in regard to a business which is turning out a standard product in relatively small units at a reasonable stable rate of production. It is less generally valid—or, to put it otherwise, the figure of profit reached is less generally significant—in the case of a company engaged in building large units, such as battleships, or carrying out construction contracts.⁵

Objections to Using Delivery.

Using delivery as the point of revenue recognition is not without shortcomings. Paton and Paton noted these objections that others have raised to this basis as a measure of revenue:

Accounts receivable may become uncollectible.
Collection expenses and other costs may be incurred subsequent to sale.
Merchandise returns and allowances may be made.
Accounts receivable are not the equivalent of cash and hence do not represent immediately disposable funds.
Revenue is earned through the entire process of production. Hence it is unduly conservative to postpone recognition until the time of sale.⁶

The first three objections can be overcome through periodic adjustments for uncollectible accounts, anticipated expenses, and returns and allowances. These are considered later in this chapter. (See Section 12.3.)

The fourth objection reflects confusion between income and cash flows. Under the accrual basis of accounting, revenue is not equated with cash receipts, as is implied by the objection. Moreover, that net income may not be disposable need not invalidate delivery as the point of revenue recognition. The measurement of income (results of operations) and the administration of funds generated by those operations are separate and distinct.

The fifth objection—that is, delivery is unduly conservative because revenue is earned throughout the production process—suggests that there should be no distinction between the earning and the recognition of revenue. Revenue is recognized during the entire earning process, as in the percentage-of-completion method, only when certain conditions, discussed under Construction-Type Contracts, are present. If those conditions are not present, a more conservative approach is appropriate.

(ii) Recognition Before Delivery

As indicated, in certain situations the recognition of revenue may occur prior to the time of delivery. Revenue may be recognized during production, as in the construction industry, or at completion of production, as in farming.

Construction-Type and Production-Type Contracts.

In the construction industry, as well as in other situations in which contract specifications are provided by the customer or another third party, such as a regulatory agency or financial institution, revenue may be recognized on the completed contract or the percentage-of-completion (including units of delivery) basis. (See the detailed discussion in Chapter 31.) As noted in ASC 605-35-05, Revenue Recognition: Construction-Type and Production-Type Contracts, long-term contracts are more likely than short-term contracts to give rise to problems in accounting for revenue, and the point or points at which to recognize revenue as earned and costs as expenses is a major issue in accounting for long-term contractual arrangements.

Recognizing revenue in construction-type contracts on the basis of production often is regarded as a desirable departure from the sale basis if total revenue and cost can be reliably estimated.

Accounting for revenue by the completed contract method—that is, when the contract has been fully performed—is appropriate if estimates of revenue, expenses, or progress toward completion are not reliable. This method, which is the equivalent of the point of delivery, is conservative because it eliminates the problems created when a contract is canceled after revenue and profit have been recognized. Also, the amount of profit can be more accurately determined because the need for estimates is greatly reduced. The principal limitation of this basis in connection with long-term contracts is that periodic income statements do not reveal what is happening in the enterprise if revenue is recognized in the period of completion rather than as the work progresses. Despite continuous performance, revenue is recognized only sporadically, when contracts are completed, resulting in recognition of income only at the end of the entire earnings process.

For long-term contracts, as in the construction of roads, buildings, ships, complex aerospace and electronic equipment, and some software or software systems, the recognition of revenue using the percentage-of-completion method generally results in periodic net income that is more nearly related to the earning process. Thus, the entity's financial statements reflect the economic substance of transactions more clearly and more timely, with less distortion of the relationships between gross profit from contracts and the related period costs. The use of that basis is justified, however, only if there is reasonable assurance of the profit margin and its ultimate realization. The term percentage of completion ordinarily refers to the relationship between costs incurred and the total estimated cost of the completed project, although a percentage based on time or physical units of production may be used. While the basic presumption is that each contract is an individual profit center, there are occasions when a group of contracts may be so closely related that they may be treated as a single profit center. There may also be times when a single contract should be segmented into two or more profit centers.

The percentage-of-completion method, as developed in the construction industry, has been applied, sometimes improperly, to seemingly analogous situations in other industries. Nevertheless, the method is widely used to recognize revenue from production-type contracts and certain service transactions. Contracts specifically not appropriate for percentage-of-completion treatment include sales of standard items even if produced to buyer specifications, magazine subscriptions, and consumer-oriented service contracts, among others.

Extractive Industries and Agriculture.

Recognizing revenue when production is complete may be acceptable in certain extractive industries and agriculture when interchangeable units of the commodities are immediately salable at quoted market prices and without significant distribution costs. The mining of precious metals and growing of crops such as wheat, cotton, and oats are examples. Revenue is recognized before delivery by valuing inventory of products on hand at net realizable value.⁷

ASC 330-10-35-16, Inventory: Overall, sanctions this procedure, as described:

It is generally recognized that income accrues only at the time of sale, and that gains may not be anticipated by reflecting assets at their current sales prices. However, exceptions for reflecting assets at selling prices are permissible for both of the following:

a. Inventories of gold and silver, when there is an effective government-controlled market at a fixed monetary value

b. Inventories representing agricultural, mineral, and other products, with all the following criteria:

1. Units of which are interchangeable

2. Units of which have an immediate marketability at quoted prices

3. Units for which appropriate costs may be difficult to obtain.

Where such inventories are stated at sales prices, they should of course be reduced by expenditures to be incurred in disposal.

Despite the support for recognition prior to delivery in the authoritative accounting literature, in practice revenue is generally recognized on mineral products at the time of delivery. The authoritative literature is silent on the appropriateness of recognizing revenue on agricultural products still in the growth or production stage, even if they are readily marketable at quoted prices.

Multiple-Element Arrangements.

Many companies, particularly technology firms, offer multiple deliverable arrangements (MDAs) to address their customers' needs. For instance, a cellular telephone company may offer an arrangement that includes equipment, activation, and ongoing service. Because there are multiple revenue-generating activities, questions arise as to how to allocate total revenue among the various products and services and how to allocate revenue to the proper period.

In general, in an arrangement with multiple deliverables, each delivered item is considered to be a separate unit of accounting as long as the delivered item has value on a stand-alone basis, the fair value of the undelivered items may be objectively determined, and the delivery or performance of the undelivered item(s) is considered probable and substantially under the seller's control (ASC 605-25-25-2, Revenue Recognition: Multiple-Element Arrangements). After the separate units of accounting are determined and an objective, reliable fair value is established for each unit, revenue should be allocated to the separate accounting units based on their relative fair values. Required disclosures include the description and nature of the arrangements and provisions for performance, cancelation, and the like. It is important to realize that separate contracts with the same entity, if entered into at or near the same time, are presumed to be negotiated as a single arrangement unless there is sufficient evidence to the contrary. Sales transactions with multiple deliverables are discussed further in Subsection 12.4(a)(ix).

Milestone Method.

Contracts for research and development (R&D) transactions often include provisions where all or a substantial portion of the consideration is paid upon achieving a milestone event in the R&D efforts. In such an arrangement, or in other situations in which the seller satisfies its performance obligations over a period of time, one or more payments may be contingent upon achieving an uncertain future milestone. Under ASC 605-28 Revenue Recognition: Milestone Method, sellers are permitted, but not required, to recognize milestone revenue in its entirety in the period in which the substantive milestone is achieved. In the event the seller elects to recognize revenue using the milestone method, disclosures of the overall arrangement and the contingent consideration, as well as other information, are required by ASC 605-28-50-2.

Accretion.

Paton and Littleton reject considering accretion (increase in value from natural growth or aging) as revenue:

Allied to the question of the significance of production in relation to revenue is the problem of increase resulting from growth and other natural processes…. In this situation there is no doubt that assets have increased, and the amount of the physical increase is subject to objective verification. The technical process of production, however, remains to be undertaken, followed by conversion into new liquid assets. Assuming that the final product of the enterprise is lumber, it is clearly incorrect to treat accretion as revenue.⁸

They add, however, that there is no serious objection to disclosing measurable increases from accretion as supplementary information, provided cost is not obscured and the resulting credit is clearly labeled as unrealized income. Because revenue from accretion is not recognized, the costs incurred for the purpose of encouraging accretion should, theoretically at least, be added to inventory and recognized as expenses when revenues are recognized at the time the timber, nursery stock, or other property is delivered.

Hendriksen and van Breda note that, in an economic sense, accretion gives rise to revenue. However, from a practical standpoint, the discounted value required to make the necessary comparative inventory valuations often is difficult to determine “because it depends upon expectations regarding future market prices and expectations regarding future costs of providing for growth and future costs of harvesting and getting the product ready for market.”⁹ Periodic recognition of accretion as revenue has not been adopted in practice.

Appreciation.

Accounting authorities for many years generally have agreed that appreciation of asset values attributable to market changes does not constitute revenue. Paton and Littleton summarize the proposition in this way:

Appreciation in its various forms is not income. The case for introducing estimated appreciation (or “declination”) into the accounts and reports otherwise than as supplementary data is not strong….

Without doubt the movement of prices has an important bearing on the economic significance of existing business assets, but there is little warrant for the view that sheer enhancement of market value, however determined, represents effective income. Appreciation, in general, does not reflect or measure the progress of operating activity; appreciation is not the result of any transaction or any act of conversion; appreciation makes available no additional liquid resources which may be used to meet obligations or make disbursements to investors; appreciation has little or no legal standing as income.¹⁰

Several authorities have expressed approval, to varying degrees, of certain departures from historical practice and for the adoption of alternative approaches to income recognition. Statement of Financial Accounting Standards (SFAS) No. 33, Financial Reporting and Changing Prices, provides a good example. Its requirements, however, were amended by SFAS No. 82, Financial Reporting and Changing Prices: Elimination of Certain Disclosures, and No. 89, Financial Reporting and Changing Prices. Both of those Statements have been subsumed by ASC 255, Changing Prices, which makes the supplementary disclosure of current cost/constant purchasing power information voluntary. Also, some financial assets are measured at fair value, and, in some cases, changes in their fair values are recognized as gains or losses.

Cost Savings versus Revenue.

Savings resulting from efficient operation or fortunate purchases generally are classified as reductions of costs, not as revenue. Edwards and Bell define the term cost saving as “an increase in the current cost of assets held.”¹¹ That usage of the term has not been widely accepted and is not adopted in this chapter.

(iii) Recognition After Delivery

As noted earlier, in certain circumstances, revenue may be recognized after delivery. Methods used include the deposit method (which is really a nonrecognition method), the cost recovery method, and the installment method. Both the cost recovery and installment methods are sometimes referred to as cash bases of revenue recognition.

The cash basis of revenue recognition should not be confused with the cash basis of accounting. As Paton and Littleton noted almost 60 years ago:

Placing revenue on a cash basis when such treatment is appropriate, it is hardly necessary to say, does not imply that expense should be measured by expenditure. Revenue is the controlling element; expense is the cost of the amount of revenue acknowledged. If receipts from customers are viewed as revenue the applicable expense is the cost of producing such receipts, not the cash disbursements made during the period.¹²

The cash basis of accounting reports revenues collected, expenses paid, and the excess or deficiency of revenues collected over expenses paid rather than revenues, expenses, and income. Revenues collected are measured by cash receipts from customers; expenses paid are measured by cash disbursements to vendors and suppliers.

It also is important to distinguish between an installment sale and the method used to recognize revenue, expense, and income from that type of sale. In installment sales, the purchaser agrees to pay for the purchase in a series of periodic payments, usually, but not always, preceded by an initial disbursement customarily termed a down payment. The vendor may account for installment sales in the same manner as other charge sales (i.e., by recognizing income at the time of delivery), or may recognize income either proportionally as the installments are collected or after all costs have been recovered. The latter methods, known as the installment method and cost recovery method, respectively, are acceptable if certain conditions are present.

Installment Method and Cost Recovery Method.

As noted in ASC 605-25-3, “Revenue should ordinarily be accounted for at the time a transaction is completed.” Because revenues should not be recognized until realized (or realizable) and earned, the installment method of revenue recognition is generally not acceptable. However, ASC 605-25-4 allows for exceptional cases when the seller has no reasonable basis to assume it will collect the sale price.

When such circumstances exist, and as long as they exist, either the installment method or the cost recovery method of accounting may be used…. [T]he installment method apportions collections received between cost recovered and profit…. Under the cost recovery method, equal amounts of revenue and expense are recognized as collections are made until all costs have been recovered, postponing any recognition of profit until that time.

Deposit Method.

In some circumstances, such as in contracts that do not qualify to be recorded as sales in retail land transactions, the deposit method should be used (ASC 360-10-55-17, Property, Plant, and Equipment: Overall, Implementation Guidance and Instructions). A liability is recognized when cash is received, and no amounts are recognized as revenue until the period has expired during which the customer may cancel and receive a full refund.

12.2 Nature and Significance of Receivables

(a) Receivables Defined

Receivables is a broad designation applicable to claims for future receipt of money, goods, and services. Receivables include claims against customers and others arising from the sale of goods or provision of services as well as from the advancement of funds and may either be originated by an entity or purchased from another entity (ASC 310-10-05-4, Receivables: Overall). This broad designation thus includes deposits for purchases and payments for services to be rendered in the future, such as insurance, advertising, and utilities. This chapter uses the more restrictive, but common, definition of receivables as a designation for claims collectible in money. Claims collectible in goods or services are termed prepayments.

The general classification of receivables depends on whether they are evidenced by a written statement. Thus, receivables are either:

Accounts receivable. Receivables for which no written statement acknowledging the obligation has been received from the obligor.
Notes receivable. Receivables for which a written statement acknowledging the obligation has been received from the obligor.

In addition, receivables may be due for purchases of goods and services charged on credit cards issued by the entity itself or by a financial institution or other organization. The types of receivables are further classified by the situation in which the receivable arose (origin), whether a security interest was obtained with the receivable, and the time of expected cash receipt.

(b) Types of Accounts Receivable

Accounts receivable are first classified by the situation giving rise to the receivable. The most frequent situation is the delivery of goods. In practice, the term accounts receivable normally is used to designate the recorded amounts owed by trade customers. Other terms are used to designate accounts receivable arising from revenue recognition in the normal course of business in various industries. Examples of such designations are revenues receivable (used by public utilities), rents receivable (used by real estate agencies), and subscriptions receivable (used by publishers).

(c) Types of Notes Receivable

The term notes, used broadly, includes two types of instruments: promissory notes and drafts. (Capital leases required to be accounted for as receivables in accordance with ASC 840, Leases, are discussed in Chapter 15 of this Handbook.) Promissory notes and drafts are defined by Mallor et al. in this way:

A promissory note is a promise made by one person, called the maker, to pay to the order of another person, called the payee (or to bearer), a certain sum of money on demand or at a definite future time.
A draft is an instrument in which one person, called the drawer, orders another person, called the drawee, to pay a certain sum of money to another person, called the payee (or to bearer), on demand or at a definite future time. The drawer and payee may be the same person.¹³

To be “negotiable” within the meaning of the Uniform Commercial Code (Article 3 Section 104), all such instruments must meet these conditions:

Be written
Be signed by the maker or drawer
Contain an unconditional promise or order to pay a certain fixed sum in money
Be payable to order or to bearer, or otherwise qualify as a check
Be payable on demand or at a specific time
Not include any instructions to take any action other than paying money, except as specified in Article 3

A distinctive feature of the typical commercial draft, as compared with a note, is that the former is initiated by the creditor rather than by the debtor. Bills are “orders” to pay; notes are “promises” to pay. Bills arising in domestic commerce are usually referred to as commercial drafts; the term bills of exchange is generally restricted to instruments used in foreign commerce.

(d) Credit Card Receivables

A retail business that accepts credit card drafts in payment of purchases may accept one of three types: (1) bank credit cards, (2) travel and entertainment credit cards, and (3) company credit cards (also called in-house credit cards). Each of these requires separate treatment by the retailer. Issuers of travel and entertainment and bank credit cards treat credit card receivables in the same fashion as a retailer treats company credit card receivables (except, of course, that the receivables are forwarded by a retailer rather than being direct sales).

For the retailer, bank and travel and entertainment credit card drafts are receivables from the issuer of the credit card. Although procedures for individual card issuers vary slightly, they generally require that the credit card drafts be accumulated and deposited with a bank, which acts as the issuer's agent. There usually is a merchant's charge (discount) for the credit card drafts, which may be recorded as cash at the time of depositing the accumulated drafts or when the payment is received from the issuer of the card. Company credit card drafts are receivables under a credit card agreement. These agreements vary, but normally they provide for a minimum payment with interest on the unpaid balance.

12.3 Criteria for Recognizing Revenue

(a) General Criteria

As discussed earlier in this chapter, the general criteria for recognition traditionally have followed the realization principle stated in ASC 605, Revenue Recognition, namely, that the revenue has been earned and an exchange has taken place. One of the most difficult tasks the accountant faces is applying those general criteria to specific transactions and events for the purpose of determining the most appropriate time in the earning process to recognize all or part of the revenue. For some transactions and events and for some industries, authoritative or quasi-authoritative literature provides, on an ad hoc basis, more specific criteria—and sometimes conditions—that must be met before revenue is recognized; those instances are described in Sections 12.4(a) and (b). The next sections provide guidance for selecting the appropriate method of revenue recognition in the absence of specific authoritative or quasi-authoritative pronouncements.

(b) Attributes Measured by Entry and Exit Values

As noted earlier, recognizing revenue results in a shift from accounting for entry values to accounting for exit values. In theory, two attributes of assets can be measured using entry values: historical cost and current cost. Similarly, three attributes, according to SFAC No. 5 (par. 67), can be measured using exit values: (1) current market value, (2) net realizable value, and (3) present value of expected cash flows.

In general, the existing accounting model measures assets at historical cost before revenues and related expenses are recognized. When revenue is recognized, the attribute measured becomes (expected) selling price in due course of business (i.e., net realizable value). For example, inventory is usually accounted for at historical cost until it is sold. At that time, the cost of inventory is recognized as an expense, and the inventory disappears from the balance sheet. The inventory is replaced by a new asset, often a receivable, which is accounted for at net realizable value, and an equal amount of revenue is recognized.

Of course, other attributes of elements of financial statements besides historical cost or proceeds and the (expected) selling price in due course of business can be measured. The significant point is that when revenue is recognized, a switch is made from some entry to some exit value. Unless otherwise specified, however, this discussion assumes that the entry value is historical cost or proceeds and the exit value is net realizable value—that is, “the historical cost model.”

(c) Financial Accounting Standards Board Conceptual Framework and Revenue Recognition

SFAC No. 1, Objectives of Financial Reporting by Business Enterprises (pars. 34 and 37), states the first two objectives of financial reporting by business enterprises:

Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.

Financial reporting should provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans. The prospects for those cash receipts are affected by an enterprise's ability to generate enough cash to meet its obligations…. Thus, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.

SFAC No. 5 (par. 6) defines recognition as “the process of formally recording or incorporating an item into the financial statements of an entity as an asset, liability, revenue, expense, or the like.” Paragraph 63 specifies “fundamental recognition criteria” for recognizing a financial statement element:

An item and information about it should meet four fundamental recognition criteria to be recognized and should be recognized when the criteria are met, subject to a cost–benefit constraint and a materiality threshold. Those criteria are:

Definitions—The item meets the definition of an element of financial statements.

Measurability—It has a relevant attribute measurable with sufficient reliability.

Relevance—The information about it is capable of making a difference in user decisions.

Reliability—The information is representationally faithful, verifiable, and neutral.

All four criteria are subject to a pervasive cost–benefit constraint: the expected benefits from recognizing a particular item should justify perceived costs of providing and using the information.

Recognition is also subject to a materiality threshold; an item and information about it need not be recognized in a set of financial statements if the item is not large enough to be material and the aggregate of individually immaterial items is not large enough to be material to those financial statements.

The measurability criterion states that the financial statement element “must have a relevant attribute that can be quantified in monetary units with sufficient reliability. Measurability must be considered together with both relevance and reliability” (par. 65). The qualities of relevance and reliability sometimes conflict with each other and require that trade-offs be made. Generally, the sooner that reliable information about revenue transactions can be conveyed to financial statement users, the more relevant it will be to them. By the same token, the earlier in the earning process revenue is recognized, the greater the likelihood of a divergence between the information and the underlying economic reality. Accordingly, the later in the earning process revenue is recognized, the greater the likelihood that the information presented will be reliable, but the lesser the likelihood that it will be relevant for users' decisions.

Because proper revenue recognition is critical, SFAC No. 5 (pars. 83a and 83b) specifies that two conditions must be satisfied, namely, being realized or realizable and being earned.

Revenues are realized when products, other assets, or services are exchanged for cash or claims to cash, and revenues are realizable when assets received or held are readily convertible to known amounts of cash or claims to cash. Assets that are readily convertible have “(i) interchangeable (fungible) units and (ii) quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price” (par. 83a).
Revenues are earned “when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues” (par. 83b).

These provisions form the basis of ASC 605-10-25. The FASB, however, may revise the criteria based on the results of a major project on revenue recognition that it began in mid-2002. (See Section 12.4(c).)

(d) Specific Recognition Criteria

The specific criteria discussed in Exhibit 12.1 have been suggested by various individuals or groups as being significant to the timing of revenue recognition. They address characteristics of the event or transaction that gives rise to the revenue, characteristics of the asset received in the transaction, and characteristics of the revenue recognized (see Exhibit 12.1). Despite some degree of overlap in the criteria, the classification scheme seems useful, particularly in resolving problems that are not addressed by authoritative pronouncements.

Exhibit 12.1 Specific Criteria for Recognizing Revenue

Characteristics of the Revenue Event or Transaction

1. The economic substance of the transaction that precedes the recognition of revenue should be such that:

a. Reversal of the transaction is remote—that is, the revenue recognized has permanence.

b. If ownership of property has changed hands, the risks and rewards of ownership also should be transferred.

2. Either an event that serves as the basis of recognizing revenue should not be within the control of the entity, or it should be verifiable by external evidence.

Characteristics of the Asset Received

The asset recorded in a revenue transaction should be:

1. Liquid

2. Free from significant obligations and restrictions

3. Collectible

4. Reliably measurable

Characteristics of the Revenue Recognized

The revenue should be “earned” to the extent that it has been recognized. If the earning process is not complete or substantially complete, either the critical event in the earning process should have occurred or measurable progress should have been made toward the completion of the earning process before revenue is recognized.

(e) Characteristics of the Revenue Event or Transaction

Before revenue is recognized, the event or transaction should be nonreversible and the risks and rewards of ownership should be transferred. Both criteria should be applied to the substance, not merely to the form, of the event or transaction. APB Statement No. 4 “Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises” (par. 127) discusses substance over form as one of the basic features of financial accounting:

F-12. Substance over form. Financial accounting emphasizes the economic substance of events even though the legal form may differ from the economic substance and suggest different treatment. Usually the economic substance of events to be accounted for agrees with the legal form. Sometimes, however, substance and form differ. Accountants emphasize the substance of events rather than their form so that the information provided better reflects the economic activities represented.

SAB No. 114 (Topic 1), Financial Statements, Section I, suggests that economic substance should take priority over legal form to determine the accounting and reporting of a transaction. Although the literature provides such guidance for determining the economic substance of particular transactions in specific industries, it provides little guidance for applying the substance over form notion in general. That may well be because, as noted in SFAC No. 2, Qualitative Characteristics of Accounting Information (par. 160), “[S]ubstance over form is, in any case, a rather vague idea that defies precise definition.” (See Jaenicke for further discussion.)¹⁴

(i) Nonreversibility

If revenue is recognized on the basis of a particular event or transaction and subsequent events or transactions reverse the effect of the earlier one, the problem is not that revenue has been recognized in the wrong accounting period—it should never have been recognized at all because the definition of revenue or asset (or both) has not been met. Thus, in addition to affecting the timing of revenue recognition, the possibility of reversal of the revenue transaction also affects the determination of whether the revenue exists. Windal states that “for an item to be sufficiently definite [to warrant recognition], it must appear unlikely to be reversed. We might say it must appear to have permanence.”¹⁵

In some cases, as in sales with right of return, the possibility of the transaction being permanent exists, and the likelihood of reversal may be predictable. In those cases, revenue should be recognized and appropriate allowances recorded for the estimated returns. In other cases, as in many product financing arrangements that contain repurchase agreements, the possibility of permanence is zero or extremely remote. If the economic substance of the “sale” rather than its formal designation is judged and the “sale” transaction is found to be fictitious, completion of the transaction and permanence of the revenue are absent and no revenue should be recognized. As another example, the receipt of a small down payment and small periodic payments, with a large final “balloon” payment, often suggests that an option to buy an asset has been sold, not the asset itself; the sale of the asset itself may never take place.

“Bill and hold” sales represent another type of transaction that, depending on the underlying circumstances, could be reversible. According to the Securities and Exchange (SEC) Release No. 17878 (June 22, 1981), in a bill-and-hold transaction, “a customer agrees to purchase the goods but the seller retains physical possession until the customer requests shipment to designated locations.” SAB No. 114, Topic 13-A.3.a, Revenue Recognition, “Bill and Hold Arrangements” (see Section 12.3(h)), provides examples of criteria that must be met when delivery has not occurred.

(ii) Transfer of the Risks and Rewards of Ownership

The criterion that the risks and rewards of ownership should be transferred before revenue is recognized appears in several places in the accounting literature. For example, ASC 840-10-10, Leases, states:

The objective of the lease classification in this Subtopic derives from the concept that a lease that transfers substantially all of the benefits and risks incident to the ownership of property should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee and as a sale or financing by the lessor.

SAB No. 114, Topic 13-A.3.d states that in resolving the issue discussed, “the delivery criterion would generally be satisfied when title and the risks and rewards of ownership transfers.” In practice, however, applying the criterion does not always yield a definitive answer because, in many transactions, the risks and rewards are divided between the two parties.¹⁶

Determining whether the “risks and other incidents of ownership” have been transferred to the buyer requires an examination of the underlying facts and circumstances. Five circumstances may raise questions about whether the risks of ownership have, in substance, been transferred:

1. A continuing involvement by the seller in the transaction or in the assets transferred, such as through the exercise of managerial authority to a degree usually associated with ownership, perhaps in the form of a remarketing agreement or a commitment to operate the property

2. Absence of significant financial investment by the buyer in the asset transferred, as evidenced, for example, by a token down payment or by a concurrent loan to the buyer

3. Repayment of debt that constitutes the principal consideration in the transaction dependent on the generation of sufficient funds from the asset transferred

4. Limitations or restrictions on the buyer's use of the asset transferred or on the profits from it

5. Retention of effective control of the asset by the seller

The first three items on the list are suggested by SAB No. 114; the last two are found in Accounting Series Release (ASR) No. 95, Accounting for Real Estate Transactions Where Circumstances Indicate That Profits Were Not Earned at the Time the Transactions Were Recorded.

Some of the circumstances just listed may also be useful in assessing whether other criteria noted in Exhibit 12.1 have been met. For example, a continuing involvement by the seller may affect the criteria that the asset received be free of significant obligations, that the earning process be substantially complete, and that the asset received be measurable.

(iii) Recognition Based on Events

Revenues are sometimes recognized on the basis of events rather than transactions. For example, production that precedes revenue recognized on the percentage-of-completion basis is more properly described as an event than as a transaction because it need not involve a transfer of something of value between two or more entities.

An event occurring within the enterprise that precedes the recognition of revenue, such as production, should be verifiable by evidence external to the enterprise, such as an increase in market price or the existence of a firm contract. If revenue recognition is based on an event external to the enterprise, such as a price increase, the event should not be within the control of the enterprise.

(f) Characteristics of the Asset Received

Reflecting paragraph 83 of SFAC No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, ASC 605-10-25 states that, before it can be recognized, revenue must be realized or realizable. This criterion is based on the presumption that, at least to some degree, the asset received is liquid, free from significant obligations or restrictions, collectible, and reliably measurable. ASC 605-10-25 specifically requires that the asset received must be readily convertible to known amounts of cash or claims for cash in order for the revenue to be considered realizable. Those tests would be relevant in addition to any characteristics of assets included in the FASB's asset definition in SFAC No. 6.

(i) Asset Liquidity

Asset liquidity has long been suggested as a prerequisite for recognizing revenue. Canning observes that one of the usual conditions for recognizing revenue is that “the future receipt of money within one year has become highly probable.”¹⁷ Paton and Littleton note that “revenue is realized, according to the dominant view, when it is evidenced by cash receipts or receivables, or other new liquid assets.”¹⁸ The liquidity criterion also is generally interpreted as having been met if the financial flow is in the form of a reduction of liabilities that would obviate the subsequent use of liquid assets.

Contrary to the views just expressed, however, the APB did not consider asset liquidity a significant condition for revenue recognition. ASC 845, Nonmonetary Transactions, implements APB Opinion No. 29, Accounting for Nonmonetary Transactions (par. 18). ASC 845-10-30-1 states:

In general, accounting for nonmonetary transactions should be based on the fair values of the assets (or services) involved, which is the same basis as that used in monetary transactions. Thus, the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered to obtain it, and a gain or loss should be recognized on the exchange.

ASC 845 continues, however, indicating that the recorded amount of the nonmonetary asset(s) relinquished should be used in place of fair value of the exchanged assets if neither the fair value of the asset(s) given up nor the asset(s) received is reasonably determinable (ASC 845-10-30-3). This suggests that illiquidity of a nonmonetary asset may prevent its fair value from being determinable (i.e. measurable) and, consequently, prevent the recognition of gain or loss.

The issue of illiquidity interfering with the fair valuation of a nonmonetary asset is reinforced in ASC 845-10-30-8, which states:

Fair value should be regarded as not determinable within reasonable limits if major uncertainties exist about the realizability of the value that would be assigned to an asset received in a nonmonetary transaction accounted for at fair value…. If neither the fair value of a nonmonetary asset transferred nor the fair value of a nonmonetary asset received in exchange is determinable within reasonable limits, the recorded amount of the nonmonetary asset transferred from the entity may be the only available measure of the transaction.

Horngren contends that the receipt of liquid assets per se should not be a condition for recognizing revenue but should serve as evidence that the measurability criterion has been met.¹⁹

(ii) Absence of Obligations and Restrictions

The absence of obligations and restrictions as a criterion is expressed by Vatter in this way: “Revenue differs from other asset-increasing transactions in that the new assets are completely free of equity restrictions other than the residual equity of the fund itself.” The obligations and restrictions that Vatter had in mind—repayment obligations, obligations to share income, voting rights, and dividend preferences—characterize debt and equity financing. Under this view, sales and excise taxes collected by an enterprise should be recognized as liabilities, not as revenue, because the amounts collected are earmarked for remittance to a governmental agency.²⁰

It is conceivable for a “buyer” to impose conditions on a transferred asset which suggest that the risks and rewards of the asset's ownership are not transferred to the “seller.” This would be analogous to the condition that the seller's risks and rewards of ownership should transfer to the buyer if revenue is to be recognized (See Section 12.1(c)).

(iii) Asset Collectibility

As noted in Section 12.1(d), the earliest authoritative statement of revenue recognition, ARB No. 43 (Chap. .1, par. 1), emphasized the collectibility criterion when the asset received is other than cash: “Profit is deemed to be realized when a sale in the ordinary course of business is effected, unless the circumstances are such that the collection of the sale price is not reasonably assured.” As discussed in subsequent authoritative and quasi-authoritative pronouncements about typical revenue recognition issues and specialized industry problems, much of the literature has been concerned with defining and refining the collectibility criterion in specific circumstances, such as for retail land sales. Little discussion of collectibility in general exists in the pronouncements of authoritative bodies; however, the collectibility criterion is rarely questioned.

From the case-by-case approach to collectibility taken by rule-making bodies, these conditions may suggest doubtful collectibility:

Evidence of financial weakness of the purchaser
Uncertainty resulting from the form of consideration or method of settlement, for example, nonrecourse notes and purchaser's stock
Small or no down payment
Concurrent loans to purchasers, presumably to finance the down payment

This list comes from ASR No. 95. Although that release is titled Accounting for Real Estate Transactions Where Circumstances Indicate That Profits Were Not Earned at the Time the Transactions Were Recorded, the circumstances discussed have wider applicability and appear in slightly different versions in AICPA Guides issued in the 1970s and subsequently incorporated into FASB Statements. If the conditions listed are present, an event or transaction also may fail to meet other recognition criteria, particularly the “transfer of risks and rewards of ownership” test.

(iv) Asset Measurability

The asset measurability criterion is suggested by Canning as well as by a committee of the AAA. Canning notes that the measurability criterion has two aspects: that “the amount to be received can be estimated with a high degree of reliability” and that “the expenses incurred or to be incurred in the (income) cycle can be estimated with a high degree of accuracy.”²¹ The AAA 1964 Concepts and Standards Research Committee on the Realization Concept noted in “The Realization Concept” (pp. 314–315):

It is difficult to be precise about what is the current prevailing practice, but it appears that presently accepted tests for realization require receipt of a current (or liquid) asset capable of objective measurement in a market transaction for services rendered…. The committee would stress measurability, and not liquidity, as the essential attribute required for recognition of realized revenue.

The measurability criterion is related to the verifiability, and hence the objectivity, of evidence supporting the amount of revenue to be recognized. Thus the FASB has stated:

Verifiability…generally means that independent measurers using the same methods obtain essentially the same result. Verifiability is in one sense a measure of the objectivity (freedom from bias) of financial statement measures because the more the measure reflects the characteristics of the object or event measured, the more likely that different measurers will agree.²²

For revenue to be recognized, the asset received should be measurable with a degree of verifiability such that approximately the same amount would be used by all accountants and it would thus be free from measurer bias—that is, it would be objective. As discussed previously, measurability is one of the four recognition criteria provided in paragraph 63 of SFAC No. 5 and is defined in terms of a financial statement item having “a relevant attribute measurable with sufficient reliability.”

The measurability of the asset received, and thus of the revenue recognized, is enhanced if the asset received is liquid. Measurability also is related to the nonreversibility and collectibility criteria discussed earlier. Those criteria suggest that possible later reductions in recorded revenue should be small; the measurability criterion suggests that any such reductions be capable of reasonable estimation.

Measurability problems may arise when the assets received are a customer's common stock, preferred stock, stock warrants, stock options, or other equity instruments. (Accounting by entities issuing the instruments is addressed in ASC 505-50, Equity-Based Payments to Non-Employees, and ASC 718, Compensation—Stock Compensation, regarding share-based payment transactions.)

Section 10-30-1 of ASC 845, Nonmonetary Transactions, requires revenue in these situations to be measured at the fair value of the assets or services sold or the equity instrument received, whichever is more reliably measurable. This is echoed in ASC 505-50-05-5, which specifies

for transactions involving the receipt of equity instruments in exchange for providing goods or services…the fair value of the equity instruments to be received may be more reliably measurable than the fair value of the goods or services to be given.

According to paragraph 7 of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, “[q]uoted market prices in active markets are the best evidence of fair value.” ASC 323-10-50, Investments—Equity Method and Joint Ventures, ASC 420-10-30-2, Exit or Disposal Cost Obligations, ASC 820-10-35, Fair Value Measurement, and ASC 940-820-50, Financial Services—Brokers and Dealers, are a few of the many Standards that require or encourage the use of a quoted market price as the measurement of fair value. Several methods are available to estimate the value of equity instruments when no public market exists, such as obtaining valuations from independent experts; using valuation models, such as the Black-Scholes model for options and warrants; and using comparable arm's-length transactions with independent third parties.

Some transactions involving the receipt of equity instruments, especially those involving multiperiod arrangements or arrangements in which the terms may change after the goods or services are provided, raise more complex issues. ASC 505-50 addresses two revenue-related questions when equity instruments are involved. First, the date at which fair value should be measured (i.e., the measurement date) is the earlier of the dates at which (a) “the parties come to a mutual understanding of the terms of the equity-based compensation arrangement and a commitment for performance by the grantee [i.e., the seller] to earn the equity instruments (a ‘performance commitment’) is reached” or (b) “the grantee's performance necessary to earn the equity instruments is complete (that is, the vesting date)” (ASC 505-50-30-18).

The second question concerns accounting for transactions in which the terms of the equity instruments may be adjusted after the measurement date based on either market conditions or future performance by the seller. ASC 505-50-30-28 indicates that if, on the measurement date, any of the terms of an equity instrument depend on achieving a market condition—for example, when the number of shares to be issued depends on the market price of the stock at some future point—total revenue should be measured as the sum of the fair value of the equity interest without regard to the market condition and the fair value of the issuer's commitment to change those terms if the market condition is met. In the performance-based conditions—for example, when the life of the options originally granted to the seller will be extended if the total number of hits on a buyer's Web site exceeds a specified number—the potential fair value of the commitment to change the terms if the future performance conditions are met should not be taken into account when initially measuring the fair value of the equity instruments. Instead, a range of aggregate fair values should be calculated based on the different possible performance outcomes, and the issuer should use the lowest aggregate amount within that range, even if the amount is zero (ASC 505-50-30-30).

Agreements involving equity instruments issued as consideration in sales transactions also may include a seller's contingent right to receive an equity instrument after performance is completed. These arrangements are discussed in ASC 505-50.

(g) Characteristics of the Revenue Recognized

One of the most commonly suggested criteria for recognizing revenue is that it be “earned” before it is recognized. SFAC No. 5 (par. 83) states that “revenues are not recognized until earned.” This criterion takes several forms.

The first form requires completion or substantial completion of the earning process. As noted earlier, APB Statement No. 4, Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises, (par. 150) states: “Revenue is generally recognized when both of the following conditions are met: (1) the earning process is complete or virtually complete and (2) an exchange has taken place.” Paragraph 153 notes that the earning requirement

usually causes no problems because the earning process is usually complete or nearly complete by the time of the required exchange. The requirement that revenue be earned becomes important, however, if money is received or amounts are billed in advance of the delivery of goods or rendering of services.

APB Statement No. 4 then suggests that the substantial completion test is not always followed and that revenue is sometimes recognized, as on long-term construction contracts, on the basis of recognizable progress toward completion of the earning process, a second form of the criterion. A third variation of the earning criterion, first suggested by Meyers, is that recognition be related to the critical event in the earning process.²³

Waiting until the earning process is substantially complete may, depending on the nature of the transaction, delay the recognition of revenue more than either the “recognizable progress” or the “critical event” form of the earning criterion, thus minimizing the risk of error from incorrectly identifying the critical event or the extent of progress. Moreover, at the point of “substantial completion,” the costs associated with the revenue transaction are known with more certainty than under the other two approaches because those costs have already been incurred.

The critical event, or “milestone,” form of the earning criterion permits greater flexibility in the timing of revenue, depending on the nature of the event or transaction. The recognizable progress version emphasizes that revenue is, in fact, not earned at a single point in time. Because these two forms of the earning criterion may result in revenue recognition earlier than would the substantial completion form, their use could provide information that is more relevant to the needs of users than that attainable from the substantial completion form, but at a possible sacrifice of reliability.

Determining either the point of substantial completion or the critical event may be difficult if the seller has continuing obligations after the initial transfer of the asset. Thus the criterion that the principal risks and rewards of ownership be transferred is related to the criterion that the revenue be earned. For example, special warranties by the seller, remarketing agreements, or the seller's commitment to operate the property not only may raise the question of whether the critical event or substantial completion has taken place but also whether the risks and rewards of ownership have been transferred.

When sales of products are involved, the condition that “an exchange has taken place” is met “at the date of sale, usually interpreted to mean the date of delivery to customers” (APB Statement No. 4, par. 151). Date of delivery usually coincides with the transfer of title. The FOB (free on board) terms specify precisely when title passes: FOB destination indicates that title passes at the buyer's location; FOB shipping point indicates that title passes at the seller's location. Revenue should not be recognized when products are shipped if the terms are FOB destination.

(h) Securities and Exchange Commission Staff's Views on Recognizing Revenues

In its SAB No. 114, Topic 13, Revenue Recognition, the SEC Staff summarized certain of its views on applying generally accepted accounting principles (GAAP) to revenue reporting. The Staff issued the Bulletin in part because of revenue reporting issues encountered by registrants that came to the Commission's attention, including issues related to earnings management (see Section 12.1).

Topic 13-A.1 of SAB No. 114, incorporated as ASC 605-10-S99, discusses four criteria, all of which must be met to satisfy the GAAP requirement that revenue has been realized or is realizable and has been earned and therefore should be recognized:

1. There is persuasive evidence that an exchange arrangement exists.

2. The product has been delivered or services have been rendered.

3. The price is fixed or determinable.

4. Collectibility is reasonably assured.

(i) Persuasive Evidence of an Arrangement

The SEC Staff intends the term arrangement here to mean the final understanding between the parties as to the specific nature and terms of the transaction. This criterion may be implied in the APB literature, but it is not made explicit there. The implication is that revenue may not be recognizable even though the product has been delivered or service has been rendered, the price is fixed or determinable, and collectibility is reasonably assured.

The Staff provides three examples (Topic 13-A.2) (incorporated in ASC 605-10-S99) to illustrate how the first criterion can be applied:

1. The seller, whose normal and customary business practice for this class of customer is to have a written sales agreement signed by both parties, delivers the product. The seller has signed the agreement but the buyer has not.

The Staff concludes that the seller may not recognize revenue on the sale. If the buyer had signed the agreement but its final commitment is subject to subsequent approval or execution of another agreement, the seller may not recognize revenue until the subsequent approval is obtained or the other agreement is complete.

Other kinds of persuasive evidence of an exchange agreement could exist depending on the business practices and processes of the parties, including various forms of written or electronic evidence, such as binding purchase orders or online authorizations. Care must be taken to ensure that all the terms of the arrangement, including concurrent or subsequently executed side agreements, provide the needed persuasive evidence.

2. A seller delivers products to a customer on a consignment basis. Title to the products pass to the customer as the customer consumes the products in its operations. The Staff concludes that the seller may not recognize revenue on the sale until the products are consumed, because until then the seller retains the risks and rewards of ownership of the products.

However, the Staff does provide an example when revenue may be recognized even though there is limited retention of the title to the goods.

3. A seller in a country that does not provide for a seller's retention of a security interest in goods following the U.S. Uniform Commercial Code may retain a form of title to those goods delivered to customers until the customer actually makes payment. The Staff concludes that, presuming all other revenue recognition criteria are met, this limited form of retained ownership to enable recovery of goods in the event of nonpayment by the customer does not necessarily preclude revenue recognition at the time of delivery.

The Staff also describes examples of circumstances in which revenue may not be recognized even though title has passed:

1. The buyer has a right to return the product and:²⁴

The buyer does not pay at the time of sale, and that obligation to pay is contractually or implicitly excused until the buyer resells, consumes, or uses the product.
The buyer's obligation would be changed—for example, the seller would forgive the debt or grant a refund—if the product is stolen, destroyed, or damaged.
The seller and the buyer do not have separate economic substance.
The seller must subsequently perform significantly in causing the buyer to resell the product.

2. The seller must repurchase the product, a substantially identical product, or processed goods that include the product, at specified prices not subject to change except for those due to changes in finance and holding costs, and the payments by the seller will be adjusted to cover substantially all changes in costs, including interest, the buyer incurs in buying and holding the product.²⁵ The Staff believes that each of the following examples is an indicator of the latter condition:

The seller provides financing to the buyer until the products are resold without interest or at interest significantly below market beyond the seller's customary sales terms.
The seller pays interest costs to a third party on behalf of the buyer.
The seller customarily refunds or intends to refund part of the sales price equal to interest for the period from when the buyer paid the seller until the buyer resells the product.

3. The transaction neither avoids the prohibition on reporting revenue in ASC 840-10-55-12, Sales of Equipment with Guaranteed Minimum Resale Amount, nor qualifies for sales-type lease accounting.

4. The product is delivered for demonstration purposes.²⁶

SAB No. 114 Topic 13-A.3.f, Question 1, contains six examples developed by the SEC Staff illustrating when revenue from nonrefundable up-front fees should be deferred. The examples include initiation fees at health clubs, activation fees for cellular phone service, fees for various Web site services, and technology access fees for R&D activities.

(ii) Delivery and Performance

The SEC Staff provides examples (SAB No. 114 Topic 13-A.3, incorporated in ASC 605-10-S99) in which questions arise as to whether delivery and performance have been accomplished:

A seller has received a purchase order for products but the buyer is not yet ready to take delivery.
The seller has completed manufacturing the products and has segregated them in its own warehouse or has shipped them to a third party but has retained title, and payment by the buyer depends on delivery to a site specified by the buyer.

The Staff concludes that revenue may not be recognized in either of these cases. It believes that title and the risks and rewards of ownership must pass to the buyer, typically when the product is delivered to the buyer (if the terms of sale are FOB destination) or shipped to the buyer (if the terms of sale are FOB shipping point).

Examples of criteria that must be met for revenue to be recognizable when delivery has not occurred are listed next (although meeting all the criteria does not necessarily guarantee that revenue will be recognized):

The risks of ownership must have passed to the buyer.
The buyer must have made a fixed commitment to buy, preferably in writing.
The buyer must have requested, preferably in writing, that the transaction be on a bill-and-hold basis and must have a substantial business reason for doing so.
The schedule for delivery must be fixed, reasonable, and consistent with the buyer's business purpose.
The seller must not have retained any duty to perform, making the earning process incomplete.
The products must have been segregated and not available for shipment to other buyers.
The product must be complete and ready for shipment.

The next circumstances also should be considered before revenue is recognized under bill-and-hold arrangements:

The date by which payment is expected and whether the seller has modified its normal billing and credit terms
The seller's experiences with such transactions
Whether the buyer has the risk of loss in case the market value of the products declines
Whether the seller's risks as custodian have been insured
Whether extended procedures are needed to make sure that the buyer's business reasons for the bill-and-hold have not introduced a contingency to the buyer's commitment

Delivery to an intermediate site should not result in revenue reporting if a substantial part of the price is payable only on delivery to a specified final site.

In addition to delivery, revenue recognition requires that the products or services have been accepted by the buyer. If the contract contains provisions concerning acceptance by the buyer, such as the right to test the product after receipt, buyer acceptance must occur or the provisions must have lapsed before revenue can be recognized.

The seller's duties under the contract must be substantially complete for delivery or performance to have occurred. Inconsequential or perfunctory actions, however, may remain incomplete if they would not result in a refund or rejection of the products delivered or services performed to date. The costs of all such actions should be accrued.

The delivery or performance of one of multiple deliverables is considered not to have occurred if undelivered deliverables are essential to the functioning of the delivered element. (See Subsection 12.4(a)(ix).)

Revenue recognition should begin in a licensing or similar arrangement when its term begins. During the term, revenue should be recognized based on the substance of the arrangement.

The Staff provides three examples (SAB No. 114 Topic 13-A.3) illustrating how these guidelines should be applied:

1. A company sells goods on layaway, setting the goods aside and collecting a cash deposit. Although a time period to finalize the sale may be set, the buyer need not enter a fixed payment commitment. The buyer receives the goods only on payment of the balance. If the buyer does not pay the balance, the deposit is forfeited. If the goods are lost, damaged, or destroyed, the deposit is refundable or substitute goods are provided.

The Staff concludes that revenue may be recognized no earlier than when the goods are delivered to the buyer. Until then, the seller has a liability for the deposit.

2. A provider of goods or services may receive a nonrefundable fee at the inception of an arrangement, such as a lifetime membership in a health club or an activation fee for telecommunications services. The buyer may agree to pay the fee to obtain a continuing right to purchase the goods or services, at or below the usual prices. Goods or services may or may not be provided at the inception of the arrangement, and, if so, they may or may not be useful to the buyer without provision of further goods or services.

The Staff concludes that revenue should be recognized only to the extent that the nonrefundable fee is for products delivered or services performed that represent the culmination of a separate earnings process, but that the rest of the fee should be deferred. Revenue should be recognized systematically as those fees are earned. Activities of the seller such as selling memberships, signing contracts, enrolling buyers, or activating telecommunications services do not constitute culmination of a separate earnings process. The earnings process is completed by performing under the terms of the arrangement.

3. A seller provides a buyer with activity tracking or similar services, such as tracking property tax payment activity or sending delinquency letters on overdue accounts, for a 10-year period. (The arrangement is not covered by ASC 310-20, Nonrefundable Fees and Other Costs.) The buyer is required to prepay for all the services to be provided during the period. The seller provides setup procedures at the outset and ongoing services in accordance with the arrangement. None of the fees is refundable if the buyer terminates the arrangement or does not use all the services to which it is entitled. The seller must refund a portion of the fee if the seller terminates the arrangement early.

The Staff concludes that the seller should report revenue on a straight-line basis over the term of the contract or the expected period of service, whichever is longer, unless there is evidence that revenue is earned in a different pattern, in which case revenue should be reported in the different pattern. Revenue should not be recognized as costs are incurred because the setup costs bear no direct relationship to the performance of the contracted services. Also, not all revenue should be reported at the outset with accrual of the remaining costs because the services have not been performed.

(iii) Fixed or Determinable Sales Price

Cancelation or termination clauses, side agreements, and significant transactions with unusual terms and conditions may suggest the existence of a demonstration period, an incomplete transaction, or that the price is otherwise not fixed or determinable. For example, the sales price is not fixed or determinable if the buyer has a cancelation privilege; it becomes determinable ratably if a cancelation privilege expires ratably. Customary short-term rights of return are not cancelation privileges and should be treated in conformity with ASC 605-15-25, Revenue Recognition—Sales of Product When Right of Return Exists. (See Subsection 12.4(a)(iv).)

The SEC Staff provides examples to illustrate when to recognize revenue in situations where the existence of a fixed or determinable sales price is questionable (SAB 114 Topic 13-A.4; ASC 605-10-S99):

1. A seller charges a membership fee at the beginning of a contract term for the buyer to have the privilege to buy goods from the seller at discount prices during the membership period. The buyer may cancel the arrangement at any time during the term and receive a full refund of the fee.

The Staff believes that revenue should not be recognized for the fee at the beginning of the term with estimated costs accrued because the seller has an unfulfilled duty to perform services; the earnings process is not complete. Further, the ability of the buyer to obtain a full refund of the fee during the membership period makes the sales price involved in the fee not fixed or determinable during the membership period. The fee should be reported as a liability, which is extinguished only on refund of the fee or expiration of the refund privilege. This conclusion holds regardless of whether there is a large population of transactions that grant buyers the same cancelation privileges and reasonable estimates can be made of the number of buyers who will cancel; service arrangements are specifically excluded from the scope of ASC 605-15.

Nevertheless, existing practice had developed contrary to those conclusions, and the Staff believes it should not require practice to be changed without formal rule making or standard setting. The Staff will therefore not object to recognizing refundable membership fees as revenue, net of estimated refunds, over the membership period, if all of these criteria have been met:

The estimated refunds are for a large pool of homogeneous items.
Timely reliable estimates of expected refunds can be made. Such estimates cannot be made if:
- There are recurring, significant differences between experience and estimated cancelation or termination rates, even if the effect of the differences is not material to the consolidated financial statements.
- There are recurring variances between experience and estimated amounts of refunds that are material to revenue or net income in quarterly or annual financial statements.
- The likelihood of required material adjustments to previously reported revenue is not “remote.”
- Buyers' termination or cancelation and refund privileges exceed one year.
Sufficient company-specific historical experience predictive of future events exists on which to estimate the refunds.
The amount of the fee is fixed other than the right to obtain a refund.

If any of those conditions are not met, revenue should not be recognized until the cancelation privileges and refund rights expire. If all of the conditions are met and revenue is recognized over the membership period:

The amount of the fees representing estimated refunds should be credited to a refund liability account and the rest to a nonmonetary liability account for unearned revenue.
At each reporting date, a footnote schedule should be provided of the beginning and ending balances of refund obligations and unearned revenue, cash received for fees, revenue recognized, refunds paid, and adjustments explained.
Adjustments, if any, should be based on a retrospective approach, remeasuring the refund liability and the unearned revenue at each reporting date with the offset to revenue (consistent with ASC 310-20-35-26).

The costs of vouchers issued with new memberships for discounts or other benefits should be charged to expense when issued. Other advertising costs relating to new membership offers should be reported in conformity with ASC 720-35, Other Expenses: Advertising Costs. If revenue is deferred until the cancelation or termination privileges expire, incremental direct costs of enrolling customers, such as agents' commissions, should be (a) charged to expense when incurred if the costs are not refundable to the reporting entity when fees are refunded, or (b) reported as an asset until the earlier of termination, cancelation, or refund, if the costs are refundable to the reporting entity when fees are refunded. If revenue, net of estimated refunds, is recognized over the membership period, a like percentage of incremental direct costs should be included in earnings in the same pattern that revenue is recognized. The remainder of the incremental costs should be charged to expense when incurred if the costs are not refundable to the reporting entity when the fees are refundable. If those costs are refundable to the reporting entity when the fees are refundable, they should be reported as an asset (until the refund occurs). All costs other than incremental direct costs should be reported as expense as incurred.

2. A lessor leases retail space under an operating lease for one year for $1.2 million, payable in equal monthly installments on the first day of each month plus contingent rentals of 1 percent of the lessee's net sales in excess of $25 million during the year.

The Staff believes that the contingent rentals should be recognized as revenue beginning with the date the lessee's sales first exceed $25 million and continuing in subsequent periods as it becomes accruable. This position is consistent with ASC 840-10-55-11, which notes that lease payments that depend on a factor that is not measurable at the inception of the lease are contingent rentals and should be included in income as they accrue.

3. The Staff believes that the next examples of the “other factors” referred to in ASC 605-15-25 that may preclude making a reasonable estimate of product returns:

“Channel stuffing”—significant increases in or excess levels of inventory in a distribution channel
The inability to determine or observe the levels of inventory in a distribution channel and the current level of sales to end users
Expected introductions of new products that may cause technological obsolescence or larger-than-expected returns of current products
A particular distributor's significance to the reporting entity's or to its segment's business, sales, and marketing
The newness of the product
Introduction of competitor's products with superior technology and the like²⁷

(iv) Sales of Leased or Licensed Departments

Retailers customarily recognized revenue for sales made by departments leased or licensed to others. Because of developments since the SEC issued SAB No. 1, which did not object to that treatment because of existing industry practices, the Staff now concludes (SAB No. 114, Topic 8-A, included at ASC 605-15-S99-2) that such sales should no longer be included in the retailer's revenue. Retailers may disclose the amounts of such sales in notes to their financial statements. Rents and fees under such arrangements should be recognized when earned.

(v) Staff Accounting Bulletin No. 114

The SEC issued SAB No. 114 in March 2011, to update the guidance contained in all preceding SABs. SAB No. 114 revises or rescinds portions of the SAB guidance to make such guidance consistent with FASB's Accounting Standards Codification. SAB No. 114 is fully incorporated as ASC 605-10-S99. In SAB No. 114 Topic 13.A.1, the Staff applies ASC 605-25, Revenue Recognition: Multiple-Element Arrangements,” to various types of revenue transactions. For example, if the deliverables in a contractual arrangement meet the separability criteria in the ASC 605-25, vendors should determine an appropriate revenue recognition policy for each deliverable and should apply that policy when accounting for each separable unit they have identified. If the deliverables in a contractual arrangement do not meet the separability criteria, an appropriate revenue recognition policy should be applied to the entire arrangement.

SAB No. 114 also clarified the accounting for contractual arrangements that do not meet the separability criteria but for which vendors have remaining obligations, including those that are inconsequential or perfunctory as well as those that are essential to the functioning of the delivered portion of the arrangement. Although judgment must be applied in determining how consequential the remaining obligations are and the functionality of the delivered portion, the next guidance applies:

Revenue should be recognized at the time of delivery and the cost of providing the remaining goods or services should be accrued if (1) other criteria for revenue recognition are met, (2) the undelivered element is inconsequential or perfunctory, and (3) the undelivered element is not essential for the delivered portion of the arrangement to function.
Revenue should not be recognized at the time of delivery if (1) the undelivered element is essential to the functioning of the delivered portion of the arrangement or (2) failure to complete the undelivered portion of the arrangement would result in customers receiving refunds or rejecting the goods previously delivered or services previously performed.

Subsection 12.4(a)(ix) discusses ASC 605-25 in more detail.

(vi) Revenue Recognition Criteria Used Outside the United States

Rule-making bodies outside the United States also have developed criteria for revenue recognition. For example, paragraphs 14–19 of International Accounting Standard (IAS) No. 18, Revenue Recognition, issued in 1982 and modified in 1993, discuss five criteria for recognizing revenue from sales of products:

1. The seller has transferred to the buyer the significant risks and rewards of ownership.

2. The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold.

3. The amount of revenue can be measured reliably.

4. It is probable that the economic benefits associated with the transaction will flow to the seller.

5. The costs incurred or to be incurred related to the transaction can be measured reliably.

For service transactions, IAS 18 (par. 20) specifies the last three of these criteria plus one additional criterion—the stage of completion at the balance sheet date can be measured reliably—that must be met in order for revenue to be recognized using a percentage-of-completion method. If those criteria are not met, a cost-recovery approach should be used. Other recognition criteria are provided for interest, royalty, and dividend revenues.

The broad recognition criteria and limited number of examples contained in IAS 18 have not, in many people's minds, provided sufficient guidance to cover the range and complexity of revenue transactions. In addition, GAAP and industry practices in many countries are not always consistent with that guidance. As a result, the International Accounting Standards Board (IASB) began a project in 2002 to replace IAS 18 and, if necessary, to revise its Framework for the Preparation and Presentation of Financial Statements. That project, being conducted jointly with the FASB to help ensure the guidance issued by both boards converge, is described in Section 12.4(d).

Because of increasing inconsistencies in practice, the United Kingdom's Accounting Standards Board (ASB) began a project to develop additional guidance on accounting for revenue recognition by U.K. companies. Based on a Discussion Paper, Revenue Recognition, published in July 2001, the ASB issued Application Note G to its Financial Reporting Standard No. 5, Reporting the Substance of Transactions. That Note indicates that turnover (i.e., revenue) should be recognized only after companies have performed under contractual arrangements with customers. Specific guidance also is provided on recognizing revenue for various types of transactions, including long-term contracts, bill-and-hold arrangements, and sales with rights of return. Other issues addressed in the Note include reporting revenue at gross or net amounts and measuring revenue from sales with deferred payment terms and when significant risks exist about customers' ability to pay. The Application Note was issued as interim guidance because the ASB supports the joint FASB/IASB revenue recognition project. (See Section 12.4(d).) The FASB and IASB issued a revised Exposure Draft, Revenue from Contracts with Customers, on November 14, 2011 and noted that the effective date of the Standard would be no earlier than for annual periods beginning on or after February 15, 2015. The ASB intends to issue a new Standard for U.K. companies after the IASB completes that project.

12.4 Types of Revenue Transactions

(a) Special Revenue Recognition Problems

Special revenue recognition problems are posed by events and transactions in which the source of revenue is something other than the sale of a product or the rendering of service in a transaction that is completed over a relatively short period. In some cases, authoritative or quasi-authoritative pronouncements have addressed the issue of the proper timing of revenue recognition. In other cases, such pronouncements do not exist, and the proper recognition policies can be determined only by reference to the criteria suggested earlier in this chapter. Specialized industry practices are discussed in Section 12.4(b).

(i) Revenue Recognition Problems Discussed in Other Chapters

To avoid duplication, the special revenue recognition problems that are discussed elsewhere in this Handbook are listed next, with the relevant chapter numbers.

Contributions. ASC 958-605, Not-for-Profit Entities Revenue Recognition, applies to all entities that receive or make contributions. The Standard is discussed in Handbook Chapter 28.
Installment sales. Revenue from installment sales contracts extending over more than one accounting period may be recognized at the time of sale, on the installment basis, or on the cost recovery basis, depending on circumstances.
Nonmonetary exchanges of fixed assets. ASC 845, Nonmonetary Transactions, specifies the conditions under which gains and losses should be recognized on the exchange of nonmonetary assets; the required accounting varies according to whether the exchange has commercial substance. Nonmonetary barter transactions are discussed in Subsections 12.4(a)(vii) and (b)(vii).
Sale and leaseback transactions. Recognition or deferral of gains by the seller-lessee in a sale and leaseback transaction is specified ASC 840-40, Leases: Sale-Leaseback Transactions. This issue is further discussed in Handbook Chapter 15. Accounting for leases by a lessor is prescribed by ASC 840. Leases that are classified in ASC 840-30-25, Leases: Capital Leases, as sales-type leases result in recognition of revenue by the lessor at the inception of the lease. Sales-type leases involving real estate are further addressed in ASC 360-20, Property, Plant, and Equipment: Real Estate Sales. Chapter 15 also discusses sales-type leases; ASC 840-10-55-12 through 55-25, Leases: Sales of Equipment with Guaranteed Minimum Resale Amount; and ASC 605-15-25-5, Products Sold and Subsequently Repurchased Subject to an Operating Lease.

(ii) Transfers of Receivables

ASC 860-20, Transfers and Servicing: Sales of Financial Assets, provides accounting and reporting standards for distinguishing transfers of financial assets that are sales (in which the entity derecognizes the assets transferred) from transfers that are secured borrowings (in which the entity continues to recognize the assets transferred and recognizes the liabilities it has incurred).

ASC 860 is based on a “financial components” approach that focuses on control. Under that approach, a transferor accounts for a transfer of financial assets as a sale if the transferor surrenders control over the assets to the transferee, to the extent that the transferor receives consideration other than beneficial interests (i.e., rights to receive all or part of the underlying cash flows) in the transferred assets. ASC 860-10-40-5, Transfers and Servicing: Overall, states that the transferor is deemed to have surrendered control over the transferred assets if and only if all of these three conditions are met:

1. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership.

2. Each transferee (or, if the transferee is a qualifying special-purpose entity whose sole purpose is to engage in securitization or asset-backed financing activities, each third-party holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (par. 860-10-40-15 through 40-21).

3. The transferor does not maintain effective control over the transferred assets through: (a) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (par. 860-10-40-23 through 40-27); (b) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (par. 860-10-40-28 through 40-39); or (c) the agreement permits the transferee to require the transferor to repurchase the assets at a price that makes it probable that the transferee will exercise that requirement (par. 860-10-55-42D).

(iii) Product Financing Arrangements

ASC 470-40, Debt: Product Financing Arrangements, establishes accounting and reporting standards for transactions in which an enterprise sells and agrees to repurchase inventory, with the repurchase price equal to the original sale price plus carrying and financing costs or other similar terms. ASC 470-40-25-1 requires that a product financing arrangement be accounted for as a borrowing rather than as a sale.

Under ASC 470-40-25-2, product financing arrangements include agreements in which an enterprise seeking to finance a product (referred to as a sponsor):

1. Sells the product to another entity (the enterprise through which the financing flows), and in a related transaction agrees to repurchase the product (or a substantially identical product); or

2. Arranges for another entity to purchase the product on the sponsor's behalf and, in a related transaction, agrees to purchase the product from the other entity.

Other characteristics that are found in many, but not all, product financing arrangements are specified in ASC 470-40-05-4:

1. The entity that purchases the product from the sponsor or purchases it directly from a third party on behalf of the sponsor was established expressly for that purpose or is an existing trust, nonbusiness organization, or credit grantor.

2. The product covered by the financing arrangement is to be used or sold by the sponsor, although a portion may be sold by the other entity directly to third parties.

3. The product covered by the financing arrangement is stored on the sponsor's premises.

4. The debt of the entity that purchases the product being financed is guaranteed by the sponsor.

According to ASC 470-40-25-2, product financing arrangements that require the sponsor to repurchase the product or a substantially identical product at specified prices, adjusted to cover all costs incurred by the other entity in purchasing and holding the product, should be accounted for by the sponsor in this way:

1. If a sponsor sells a product to another entity and, in a related transaction, agrees to repurchase the product (or a substantially identical product) or processed goods of which the product is a component, the sponsor must record a liability at the time the proceeds are received from the other entity to the extent that the product is covered by the financing arrangement. The sponsor must not record the transaction as a sale and must not remove the covered product from its balance sheet.

2. If the sponsor is party to an arrangement whereby another entity purchases a product on the sponsor's behalf and, in a related transaction, the sponsor agrees to purchase the product or processed goods of which the product is a component from the entity, the sponsor must record the asset and the related liability when the product is purchased by the other entity.

(iv) Revenue Recognition When Right of Return Exists

ASC 605-15-25-1, Revenue Recognition: Sales of Product When Right of Return Exists, establishes accounting and reporting standards for sales of an enterprise's product in which the buyer has a right to return the product. Revenue from those sales transactions should be recognized at the time of sale only if all of these 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.

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 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 (par. 8).

ASC 605-15-25-2 states that if revenue is recognized because the listed conditions are met, provision should be made immediately for any costs or losses that may be expected in connection with any returns. In accordance with ASC 450-20, Contingencies: Loss Contingencies, amounts of sales revenue and cost of sales reported in the income statement should exclude the portion for which returns are expected. Transactions for which revenue recognition is postponed should be recognized as revenue when the return privilege has substantially expired.

The ability to reasonably predict the amount of future returns depends on many factors. Although circumstances vary from one case to the next, the existence of the next four factors would appear to impair the ability to make a reasonable prediction, as presented in ASC 605-15-25:

1. The susceptibility of the product to significant external factors, such as technological obsolescence or changes in demand.

2. Relatively long periods in which a particular product may be returned.

3. Absence of historical experience with similar types of sales of similar products, or inability to apply such experience because of changing circumstances (e.g., changes in the selling enterprise's marketing policies or relationships with its customers).

4. Absence of a large volume of relatively homogeneous transactions.

(v) Service Transactions

As of this writing, the FASB has not issued a comprehensive statement on accounting for service transactions, although ASC 605-20, Revenue Recognition: Services, and ASC 605-25, Revenue Recognition: Multiple-Element Arrangements, are clearly relevant to the accounting for service transactions. That may change as the FASB continues to work on its revenue recognition project. (See Section 12.4(d).)

The guidance in ASC 605-20 applies to listed service activities and arrangements including these five:

1. Separately priced extended warranty and product maintenance contracts

2. Commissions from certain insurance arrangements

3. The income from fees for guaranteeing a loan subsequent to the initial recognition of the liability.

4. Services for in-transit freight at the end of a reporting period

5. Advertising barter transactions, in which entities exchange rights to place advertisements with each other

Each of those five service arrangements is unrelated, and the accounting for each is specific to that particular service arrangement. ASC 605-20 covers each of the five under separate headings. Additional information on accounting for warranties may be found in Section 12.5(f); for fees for loan guarantees, in Section 12.6(h); for freight, in Section 12.6(g); and for barter transactions, in Subsection 12.4(a)(vii).

Specifically excluded from the guidance in ASC 605-20 are:

1. Guarantees accounted for as derivatives (covered by ASC 815, Derivatives and Hedging)

2. Product warranties other than separately priced extended warranty and product maintenance contracts (see ASC 460-10-25-5 through 25-7, Guarantees: Recognition—Product Warranties)

3. Guarantees required to be accounted for as financial guarantee insurance contracts in accordance with ASC 944, Financial Services: Insurance.

If a seller offers both a product and a service in a single transaction, or offers multiple services in a single transaction, or any other arrangement in which the seller performs multiple revenue-generating activities, the accounting should be in accordance with ASC 605-25, Multiple-Element Arrangements. ASC 605-25 generally requires that the arrangement should be divided into separate units of accounting, that the consideration for the arrangement is allocated among the separate units of accounting based on their relative fair values, and that appropriate revenue recognition criteria are considered separately for each of the separate units of accounting.

A multiple-element arrangement may be within the scope of another Codification Topic, such as Leases (ASC 840), Franchises (ASC 952), and Software (ASC 985), among others. ASC 605-25-15-3A, Revenue Recognition: Multiple-Element Arrangements—Interaction with Other Codification Topics, provides guidance for deciding whether ASC 605-25 or another Topic should be primary in determining the appropriate recognition of revenue for each element. (See also Subsection 12.4(a)(ix).)

Various standard setters have used the general criteria for revenue and expense recognition of service transactions to develop specific guidance for a wide variety of service-related industries, including:

Airlines (AICPA Industry Audit Guide, Airlines, Chap. 3)
Banking (see Handbook Chapter 30)
Broadcasting (see Subsection 12.4(b)(v))
Brokers and dealers in securities (AICPA Accounting and Audit Guide, Brokers and Dealers in Securities, Chap. 15)
Cable television (see Subsection 12.4(b)(ii))
Casinos (AICPA Accounting and Audit Guide, Gaming, Chap. 2)
Computer software (see Subsection 12.4(b)(vi))
Contractors (AICPA Accounting and Audit Guides, Construction Contractors, Chap. 2, and Government Auditing Standards and Circular A-133 Audits, Chap. 3)
Franchising (see Subsection 12.4(b)(iii))
Freight service (ASC 605-20-25-13, Revenue Recognition: Services for Freight-in-Transit at the End of a Reporting Period)
Internet (see Subsection 12.4(b)(vii))
Leasing (see Chapter 15 in this Handbook)
Motion picture films (see Subsection 12.4(b)(v))
Not-for-profit organizations (see Chapter 28 in this Handbook)
Record and music (see Subsection 12.4(b)(iv))
Regulated entities (ASC 980, Regulated Operations)

SAB No. 114 Topic 13 and the related FAQs address several issues related to revenue from services, including:

Receipt of nonrefundable up-front fees. To be recognized as revenue over the expected period of performance (SAB No. 114, Topic 13-A.3.f, Question 1, incorporated in ASC 605-10-S99).
Receipt of refundable fees for services. To be recognized ratably if the refund privileges expire ratably over the term of the contract; to be recognized either at expiration or ratably if they expire at the end of the term (SAB No. 114, Topic 13-A.4.a, Question 1, incorporated at ASC 605-10-S99). Revenue should be recognized ratably in the latter situation only if all of these four criteria are met: (1) “the estimates of termination or cancellations and refunded revenues are being made for a large pool of homogenous items”; (2) “reliable estimates of the expected refunds can be made on a timely basis”; (3) “there is a sufficient company-specific historical basis upon which to estimate the refunds, and the company believes that such historical experience is predictive of future events”; and (4) “the amount of the membership fee specified in the agreement at the outset of the arrangement is fixed, other than the customer's right to request a refund.”
Initial setup fees. If all other recognition criteria are met, revenue is to be recognized, generally on a straight-line basis, over the longer of (1) the term of the arrangement or (2) the expected period during which the specific services will be performed (SAB No. 114, Topic 13-A.3.f, Question 3). Different accounting, however, is required in different situations, such as activation fees for basic telephone service and installation fees for additional phone jacks, in which additional services are to be provided, depending on whether they can be separated for recognition purposes from the initial services (see FAQ, Topic 13-A.3, Questions 11–12).
Licensing and similar arrangement. Revenue should not be recognized prior to the beginning of the license term (SAB No. 114, Topic 13-A.3.d).

The SEC Staff also notes that long-term contracts to provide services often are similar to other revenue arrangements. Assuming the general criteria for revenue recognition are satisfied, the timing of recognition should mirror the timing in which customers' obligations are satisfied.²⁸

Some service providers incur incidental costs in connection with their ongoing operations that are reimbursed by their customers, either as part of the fee charged for the service or based on the actual amount of costs incurred by the service provider. Those “out-of-pocket” costs include airfare, automobile mileage, food and lodging expenditures, photocopies, and other items. ASC 605-45-45-23, Revenue Recognition: Reimbursements Received for Out-of-Pocket Expenses Incurred, concludes that reimbursements received for such costs should be reported as revenue, rather than as reduction of expenses, unless specific guidance for the reimbursement transaction has been provided by other Subtopics of the Codification (ASC 605-45-15-4b), such as the guidance for insurance and reinsurance premiums, lending transactions, sales of financial assets, broker-dealer transactions, and certain other specialized industry transactions.

As of this writing, the ASC has issued several other Topics that address various aspects of service revenue. For example:

Other transactions involving the right to use assets may also inform the accounting for licenses for the use of intellectual property. For example, ASC 840, Leases, may offer insight for licenses of intellectual property and suggests that accounting for these arrangements should be similar to leases of physical assets, where initial fees are recognized over the lease term. ASC 926-605, Entertainment—Films: Revenue Recognition, and ASC 928-605, Entertainment—Music: Revenue Recognition, may be relevant because the nature of the licensed items may be similar to other intellectual property. ASC 952-605, Franchisors: Revenue Recognition, which addresses franchise fee recognition, also may be appropriate, although franchise fees generally involve far more than simply intellectual property.
ASC 985-605, Software: Revenue Recognition, specifically addresses recognition of revenue in arrangements regarding the intellectual property of software, regardless of its delivery via a tangible medium. The guidance provided for software may be considered analogous to other intellectual property and, therefore, useful in determining the accounting for sales of nonsoftware intellectual property.

(vi) Sales of Future Revenues

Sales of future revenues occur when an enterprise receives cash from an investor, often a financial institution, and agrees to pay the investor a specified percentage or amount of revenue or income that the enterprise will receive from a particular product line, business segment, trademark, patent, or contractual right. The payment to the investor and the related future revenue or income may be denominated either in dollars or in a foreign currency.

Those types of transactions raise two fundamental issues, which are addressed in ASC 470-10-25, Debt: Sales of Future Revenues or Various Other Measures of Income, and ASC 470-10-35, Debt: Subsequent Measurement. These major issues are:

1. Whether the enterprise should classify the proceeds from the investor as debt or as deferred income

2. How that debt or deferred income should be amortized

On the first issue, ASC 470 notes that classification as debt or deferred income depends on the specific facts and circumstances of the transaction. However, the existence of any one of the next six factors independently makes the classification of the proceeds as debt appropriate:

1. The transaction does not purport to be a sale (i.e., the form of the transaction is debt).

2. The entity has significant continuing involvement in the generation of the cash flows due the investor (e.g., active involvement in the generation of the operating revenues of a product line, subsidiary, or business segment).

3. The transaction is cancelable by either the entity or the investor through payment of a lump sum or other transfer of assets by the enterprise.

4. The investor's rate of return is implicitly or explicitly limited by the terms of the transaction.

5. Variations in the entity's revenue or income underlying the transaction have only a trifling impact on the investor's rate of return.

6. The investor has any recourse to the entity relating to the payments due the investor.

The second factor appears to indicate that deferred income accounting applies only to sales where the seller has no significant control over the timing and amount of cash flows. However, the circumstances in which immediate income recognition might be appropriate have not been clarified.

Concerning the second issue, ASC 470-10-35-3 states that amounts recorded as debt should be amortized under the interest method and that amounts recorded as deferred income should be amortized under the units-of-revenue method. The latter method requires calculating a ratio of the proceeds received from the investor to the total payments expected to be made to the investor over the term of the agreement and then applying that ratio to the period's cash payment.

If the debt is considered a foreign currency transaction, cash flow hedge accounting specified in ASC 815-30, Derivatives and Hedging: Cash Flow Hedges, may apply.

(vii) Barter Transactions Involving Barter Credits

In a barter transaction involving barter credits, an enterprise enters into a transaction to exchange a nonmonetary asset (e.g., inventory) for barter credits. Those transactions may occur directly between principals to the transaction or include a third party whose business is to facilitate these types of exchanges (e.g., a barter company).

The barter credits can be used to purchase goods or services, such as advertising time, from either the barter company or members of its barter exchange network. The goods and services to be purchased may be specified in a barter contract or limited to items made available by members of the exchange network. Some arrangements may require the payment of cash in addition to the barter credits to purchase goods or services. Barter credits also may have a contractual expiration date, at which time they become worthless.

ASC 845-10-5-9 and 10, Nonmonetary Transactions: Barter, clarify that transactions in which nonmonetary assets are exchanged for barter credits should be accounted for in accordance with ASC 845. An impairment of the nonmonetary asset exchanged should be recognized before recording the exchange if the fair value of that asset is less than its carrying amount. Recognition of an impairment loss also would be required in an exchange of assets or contractual rights not reported in the balance sheet (e.g., operating leases) if the transferor is not relieved of primary liability for the related obligation. (As discussed ASC 360-10-35-15 through 49, Property, Plant, and Equipment: Subsequent Measurement—Impairment or Disposal of Long-Lived Assets, requires that certain long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, establishes accounting standards for the recognition and measurement of impairment losses and sets forth an approach to determining an asset's fair value. Also, ASC 360-10-35-43 requires that certain long-lived assets held for sale be reported at the lower of their carrying amounts or fair values less costs to sell.)

If an exchange involves the transfer of an operating lease, ASC 360-10-35 also concludes that the impairment of that lease should be measured as the remaining lease costs (rental payments and unamortized leasehold improvements) in excess of the estimated fair value of probable sublease rentals for the remaining lease term.

In reporting the exchange of a nonmonetary asset for barter credits, the fair value of the nonmonetary asset exchanged is presumed to measure more clearly the fair value of the barter credits received, so that the barter credits should be reported at the fair value of the nonmonetary asset exchanged. This presumption might be overcome if an entity can convert the barter credits into cash, as evidenced by a historical practice of converting barter credits into cash, or if independent quoted market prices exist for items to be received upon exchange of the barter credits. It should also be presumed that the fair value of the nonmonetary asset does not exceed its carrying amount unless there is persuasive evidence supporting a higher value. An impairment loss on the barter credits should be recognized if it subsequently becomes apparent that (1) the fair value of any remaining barter credits is less than the carrying amount or (2) it is probable that the enterprise will not use all of the remaining barter credits.

(viii) Revenue Recognition for Separately Priced Extended Warranty and Product Maintenance Contracts

Accounting for sales of separately-priced extended warranty and/or product maintenance contracts are addressed in ASC 605-20-25, Revenue Recognition: Separately Priced Extended Warranty and Product Maintenance Contracts. Those contracts should be treated in a manner similar to short-duration insurance contracts. As such, full recognition of the revenue and the accrual of the related estimated future costs at the time of sale is inappropriate. Revenue from separately priced extended warranty and product maintenance contracts should be deferred and recognized in income on a straight-line basis over the contract period, except in those circumstances in which sufficient historical evidence indicates that the costs of performing services under the contract are incurred on other than a straight-line basis. In those circumstances, revenue should be recognized over the contract period in proportion to the costs expected to be incurred in performing services under the contract. Costs of providing those services should be expensed as incurred. This accounting treatment is formulated on the premise that sellers of extended warranty or product maintenance contracts have an obligation to the buyer to perform services throughout the period of the contract and, therefore, revenue should be recognized over the period in which the seller is obligated to perform.

Recognition and measurement issues related to warranties and guarantees that are not separately priced are discussed in Section 12.5(f).

(ix) Sales with Multiple Deliverables

Sales transactions may include arrangements in which entities deliver to customers multiple products at different points in time, provide multiple services over different periods of time, or do a combination of both. Those arrangements may involve up-front fees as well as continuing payments over a period of time. For example, a cellular phone company may sign a contract with a customer to provide phone service and a “free” phone in exchange for an up-front activation fee and a monthly service fee. As another example, an entity may provide unlimited Internet access to customers for a monthly fee and, for an up-front fee, sell specific equipment necessary to access the Internet. Transactions with multiple deliverables may result in the recognition of revenue prior to the time of completion of the contract, as discussed in Subsection 12.1(d)(ii).

ASC 605-25 contains specific guidance concerning when vendors should identify separate units of an arrangement for revenue recognition purposes, when smaller units should be combined or excluded, how total revenue should be allocated to each unit based on its relative fair value, and how revenue recognition is affected by cancelation privileges and future vendor and customer actions. The guidance applies to all arrangements with multiple deliverables except in the next situations:

The arrangements involve vendors offering customers future consideration for achieving certain levels of sales or remaining as customers for certain time periods. Those types of arrangements are discussed in ASC 605-50, Revenue Recognition: Customer Payments and Incentives, as are arrangements for the sale of award credits by loyalty program operators.
The arrangement qualifies for treatment under the milestone method of revenue recognition, particularly R&D deliverables, as addressed in ASC 605-28, Milestone Method.

Additionally, the general guidelines provided in ASC 605-25 may be affected by other sections of the Codification. If the arrangements are within the scope of another section—such as ASC 840, Leases; ASC 952, Franchisors; ASC 97X, Real Estate; ASC 460, Guarantees; ASC 605-20, Revenue Recognition: Services, which addresses separately priced extended warranties and product maintenance contracts; ASC 360, Property, Plant, and Equipment; ASC 605-35, Revenue Recognition: Construction-Type and Production-Type Contracts; ASC 985, Software; and ASC 926, Entertainment—Films—then more specific guidance applies. The three types of accounting treatments are as follows:

1. When another section addresses both the determination of separate units of accounting and the allocation of the arrangement consideration, the arrangement is fully within the scope of that section and should be accounted for in accordance with the provisions of that section rather than ASC 605-25.

2. When another section addresses the determination of separate units of accounting but not the allocation of the consideration, the other section should be used to determine which elements are inside and outside the scope of that section; the arrangement consideration should be allocated based on the relative selling price of the deliverable elements within and without that section. The elements that do not fall within that particular section should then be further segregated among other relevant section and accounted for within the provisions of that portion of the Codification. Any remaining elements not addressed by other sections of the Codification should then be accounted for by ASC 605-25.

3. When another section provides neither separation nor allocation guidance and is silent on multiple-element arrangements, ASC 605-25 should be followed.

ASC 605-25-25-5 requires that combinations of goods, services, and rights to use assets sold to customers under single contractual arrangements should be divided by vendors into separate units of accounting at an arrangement's inception and as each item is delivered when all of these three criteria exist:

1. Delivered items can be either (1) sold separately by a vendor or (2) resold by customers on a stand-alone basis.

2. Evidence of the undelivered items' fair values is objective and reliable.

3. If customers have general refund rights under the arrangements, future deliveries of the items are probable and controlled by the vendors.

If these three criteria are met, ASC 605-25-30 clarifies that vendors should allocate total consideration to each of the separate accounting units based on each unit's relative fair value. When reliable and objective information about each unit's fair value is available, the allocation of total consideration should be based on those fair values. If reliable and objective information about fair value is available only for undelivered items, revenue should be allocated using the residual method—revenue for delivered items should be determined by subtracting the fair value of the undelivered items from the total consideration. ASC 605-25-30-7 notes that “[t]he best evidence of fair value is the price of a deliverable when it is regularly sold on a standalone basis.” Such evidence often is “vendor-specific objective evidence,” and the guidance in ASC 985-605-25, Revenue Recognition: Software, should be followed. The consensus also requires vendors to use appropriate revenue recognition criteria for each unit of accounting, but it does not include specific guidance on those criteria or on how to allocate direct costs to the units.

In March 2011, the SEC issued SAB No. 114, of which Topic 13, Revenue Recognition, provides additional guidance on applying ASC 605-25. That guidance is described in Subsection 12.3(h)(v).

(x) Inventory Purchases and Sales with Same Counterparty

Some enterprises sell inventory to customers from whom they also purchase inventory. Accounting for these types of transactions—commonly called buy-sell arrangements in the oil and gas industry²⁹—are addressed in ASC 845-10-05-08, Nonmonetary Transactions: Purchases and Sales of Inventory with the Same Counterparty. All purchases and sales of inventory with the same counterparty (except for transactions in the software and real estate industries, which are discussed in other authoritative literature, or those accounted for as derivatives, which are discussed in ASC 815) should be combined and considered as a single arrangement if their substance suggests they were undertaken “in contemplation” of one another. ASC 845-10-25-4 delineates factors indicating the purchase and sale transactions were undertaken in contemplation of one another, including:

The purchase and sale transactions occur simultaneously.
The transactions do not include terms typical of market transactions.
The parties to the transactions have a legal right to offset the receivables and payables.
The reciprocal transaction is relatively certain to occur.

If the substance of the transactions indicates that a single arrangement exists, the next accounting is appropriate:

Exchanges of finished goods for raw materials or work in progress should be measured at fair value as long as the exchange has commercial substance.
Exchanges of finished goods for finished goods, or exchanges of raw materials or work in process for other raw materials or work in process or for finished goods, should be measured based on book values of those items, following the principles discussed in ASC 845.

(b) Specialized Industry Problems

Many problems concerning when to recognize revenue are specific to entire industries. For example, all franchisors face the problem of when to recognize as revenue the initial fees from the sale of franchises. As with many non-industry-specific revenue recognition problems, the source of the difficulty is the relatively long period, often several accounting periods, over which the earning of revenue (in its broadest sense, extending through completed performance and collection) takes place. In many instances, authoritative or quasi-authoritative pronouncements have specified the appropriate timing of revenue in various circumstances. In others, the accountant must rely on judgment, but the general revenue recognition criteria suggested earlier in this chapter may be helpful.

(i) Specialized Industries Discussed in Other Chapters

To avoid duplication, the industries that are discussed elsewhere in this Handbook are listed next along with the relevant chapter numbers:

Construction industry. Revenue may be recognized when long-term construction contracts are completed (completed contract method) or as construction progresses (percentage-of-completion method), depending on the circumstances surrounding each contract. Those methods and their applicability in varying circumstances are discussed in Chapter 31. The primary sources for information about accounting issues for the construction industry are ASC 605-35, Revenue Recognition: Construction-Type and Production-Type Contracts, and ASC 910, Contractors—Construction.

Not-for-profit organizations. Recognition and measurement of contributions received are addressed by ASC 958-605, Not-for-Profit Entities: Revenue Recognition, and discussed in Chapter 28 of this book.

Real estate industry. Revenue recognition from the sale of real estate and from retail land sales depends largely on the buyer's assuming the normal risks and rewards of ownership, often evidenced by the size of the down payment, and on the seller's performance under the terms of the sales agreement. Those conditions and other related criteria for recognizing revenue are discussed in ASC 970-605, Real Estate—General: Revenue Recognition, and Chapter 31 of this book.

Banking. Various recognition and measurement issues related to loans, leases, and other revenue generating activities of banks and other financial institutions are discussed in Chapter 30 of this book.

(ii) Cable Television Companies

ASC 922, Entertainment—Cable Television, discusses revenue recognition and related accounting problems. ASC 922-360-25 suggests that costs incurred during construction before the first subscriber hookup and a portion of certain costs after the first subscriber hookup, but before construction of the entire system is complete, usually may be capitalized. During that “prematurity” period, all revenues except those from hookups should be reported as system revenues, and the portion of costs, depreciation, and amortization charged to expense, as well as specified period costs, should be included in appropriate categories of costs of services. According to ASC 922-605-25-3, “Initial hookup revenue shall be recognized as revenue to the extent of direct selling costs incurred.” According to ASC 922-430-25-1, the remainder in excess of direct selling costs should be deferred. ASC 922-430-35-1 requires that those deferred revenues should be amortized to income over the estimated average period that subscribers are expected to remain connected to the system.

(iii) Franchising Companies

The major franchise accounting problem concerns the recognition of revenue from the initial franchise fee. ASC 952-605 establishes accounting and reporting standards for franchisors. ASC 952-605-25 requires that initial franchise fees from individual and area franchise sales be recognized as revenue only when a franchisor has satisfied all material conditions or performed substantially all material services relating to the sale. It also discusses accounting for continuing franchise fees, continuing product sales, agency sales, repossessed franchises, franchising costs, commingled revenue, and relationships between a franchisor and a franchisee.

(iv) Record and Music Industry

ASC 928-605 requires the licensor of a record master or music copyright to recognize the licensing fee as revenue if collectibility of the full fee is reasonably assured and if the licensor:

Has signed a noncancelable contract
Has agreed to a fixed fee
Has delivered the rights to the licensee, who is free to exercise them
Has no remaining significant obligations to furnish music or records

(v) Motion Picture Films; Broadcasting Industry

ASC 926-605 discusses revenue recognition for sales and licensing arrangements of feature films, television specials and series, and similar items. According to ASC 926-605-25-1, a licensor should recognize revenue from a sale or licensing arrangement of a film when all of these five conditions are met:

1. Persuasive evidence of a sale or licensing agreement with a customer exists.

2. The film is complete and, in accordance with the terms of the arrangement, has been delivered or is available for immediate and unconditional delivery.

3. The license period of the arrangement has begun and the customer can begin its exploitation, exhibit, or sale.

4. The arrangement fee is fixed or determinable.

5. Collection of the arrangement fee is reasonably assured.

ASC 920-350-25-2, Entertainment—Broadcasters: Intangibles—Goodwill and Other, and ASC 920-405-25-1, Entertainment—Broadcasters: Liabilities, conclude that broadcasters' accounting for television film license agreements should parallel accounting by the licensor as prescribed in ASC 926, and, accordingly, assets and liabilities should be recorded for the rights acquired and the obligations incurred under such agreements.

ASC 920-845, Entertainment—Broadcasters: Nonmonetary Transactions, establishes standards of reporting by broadcasters for transactions in which unsold advertising time is bartered for products or services. According to ASC 920-845-25-1: “Broadcasters may barter unsold advertising time for products or services. Barter revenue shall be reported when commercials are broadcast, and merchandise or services shall be reported when received or used.”

(vi) Software Revenue Recognition

ASC 985-605, provides guidance for recognizing and measuring revenues associated with licensing, selling, leasing, or otherwise marketing various computer software products, updates, enhancements, and related services, including postcontract customer support, installation, training, and consulting. ASC 985-20, Software: Costs of Software to Be Sold, Leased, or Marketed, provides guidance for recognizing and measuring associated expenses. Costs related to computer software for an entity's own use should be accounted for in conformity with ASC 350-40, Intangibles—Goodwill and Other: Internal-Use Software.

If an arrangement to deliver software requires significant production, modification, or customization of software, it should be accounted for as a construction-type or production-type contract in conformity with ASC 605-35, and the relevant guidelines in ASC 985-605-25-88 through 107. Otherwise, ASC 985-605 requires that revenue be recognized when all of these four criteria are met:

1. Persuasive evidence of an arrangement exists.

2. Delivery has occurred.

3. The vendor's fee is fixed or determinable.

4. Collectibility is probable.

ASC 985-605-25-6 stipulates that, if an arrangement includes multiple deliverables, the allocation should be based on “vendor-specific objective evidence of fair value,” such as a price list reflecting the price charged when the same element is sold separately. The revenue allocated to a specific product or service should be recognized when the preceding criteria are met with respect to the product or service. ASC 985-605-25-7 through 14 offer additional guidance for recognizing revenue when a software arrangement includes multiple deliverables.

Some entities sell software or rights to use software that have elements of film, music, or similar types of materials. Revenues from the sale of these multiple elements should be separated based on ASC 605-25. If those guidelines do not require the revenue on bundled deliverables to be separated, general revenue recognition principles should be applied (see Subsection 12.4(a)(ix)).

Instead of selling copies of software, some vendors provide customers with access to software over the Internet or by other electronic means; the software actually resides on a server maintained by vendors or third parties. In those situations, vendors provide customers with both the right to use software and storage of the software (a service called hosting). ASC 985-605-55-121 concludes that a hosting arrangement represents a separate software element only if customers (1) have a contractual right to take physical possession of the software during the hosting period without significant penalty and (2) feasibly can run the software on their own computers or can contract with third parties to do so. If those criteria are met, ASC 985-605-55-124 concludes that:

Delivery of the software is presumed to occur when the customer has the ability to take immediate possession.
All of the recognition criteria in ASC 985-605-55 must be satisfied before the vendor can recognize revenue.
A portion of the total revenue must be allocated to each separate element of the transaction, including the hosting arrangement.
The portion of total revenue allocated to the hosting element should be recognized as that service is provided.

Some software vendors enter into barter transactions in which they accept, in exchange for software and related services, customers' products or services or shares of customers' stock. Revenue would be recognized based on the guidance in ASC 985-845, Software: Nonmonetary Transactions. Implementation guidance for nonmonetary transactions involving software and accounting for exchanges of software between companies is discussed in ASC 985-845-55.

Software manufacturers may offer price protection agreements, under which they refund or credit a portion of the original selling price to customers if they subsequently reduce the price offered to other customers. Software manufacturers should set up appropriate allowances for those price concessions when they are authorized.

(vii) Internet Companies

Many accounting issues have emerged as a result of e-commerce activities and other ways to provide products and services to customers. Those activities have also led to the formation of new types of entities that offer Internet and other services and hardware and other products. Those entities include:

Service providers—entities that charge fees for providing Internet access
Portal companies—entities that provide Web site content, accessible with their own or through other entities' search engines, in exchange for fees from arrangements with advertisers that may involve performance guarantees based on benchmarks, such as the number of hits on a Web site
E-commerce companies—entities that sell goods or services exclusively through the Internet or that earn fees for facilitating transactions between other parties
Internet-related companies—entities that provide hardware and software for Internet and other electronic transactions

Because of the unique nature of these companies and the goods and services they offer, specific revenue recognition and measurement rules cover a variety of e-commerce and related activities. Some of those issues—such as sales arrangements with separate deliverables (Subsection 12.4(a)(ix)), various types of sales incentives (Section 12.5(d)), and gross versus net reporting (Subsection 12.1(c)(i))—are discussed elsewhere in this chapter. Some types of revenue-related arrangements are unique to Internet companies; these are discussed next.

Some Internet companies receive fees from customers that include payments for providing access to, posting information on, and maintenance of customers' Web sites. ASC 605 requires those fees to be recognized as revenue over the periods in which the services are performed. ASC 605-25 provides additional guidance on arrangements that include separate deliverables (see Subsection 12.4(a)(ix)).

Internet companies also may host customers' auction sites or run their own auction sites. In those situations, the companies ordinarily do not take title to the products sold on the site. Instead, they charge up-front fees for listing products and services for sale as well as fees for facilitating transactions. The guidance provided in ASC 605-20 requires the initial fees to be recognized over the performance period—the period during which customers' products and services are listed on the auction site. Nonrefundable transaction fees ordinarily should be recognized as revenue when the underlying sales transactions are completed. If those fees are refundable, or if the company hosting the auction site is substantially involved with the products or services sold on the site after the sale is completed, some or all of the refundable fees should be deferred until the earnings process is complete.

ASC 605-20-25-14 through 18 concern “banner-for-banner,” “click-through for click-through,” and similar types of reciprocal or comarketing arrangements in which two entities exchange advertising on each others' Web sites without, in substance, any cash being exchanged. The ASC requires entities to recognize revenues and related expenses from those transactions at fair value when the fair value of the advertising provided can be determined from an entity's past experience involving similar cash transactions with unrelated parties. ASC 605-20-25-16 through 18 provide detailed guidance on how fair value should be determined. If fair value cannot be determined, barter transactions should be recorded based on the carrying value (which in most cases will be zero) of the advertising provided.

Some advertising arrangements made by Internet companies include guarantees on a minimum number of hits or click-throughs during a period. If that minimum is not achieved, the arrangements may include automatic extensions of the advertising until that number, or a larger number, of hits is achieved. Depending on the specific arrangements and the likelihood of achieving the minimum number guaranteed, revenue may be recognized when the guaranteed minimum is achieved or ratably over the period of the arrangement.

Cloud computing is “a style of computing where massively scalable and elastic IT [information technology]–related capabilities are provided ‘as a service’ using Internet technologies to multiple external customers.”³⁰ A typical cloud service provider (CSP) offering will have multiple elements delivered at different times over the course of the relationship. Separating the multiple elements will drive the timing of revenue recognition for each element, in accordance with ASC 605-25. (See Subsection 12.4(a)(ix).) CSPs may use a subscription model, a usage-based pricing model, an advertising-supported model that is free to users, or a combination thereof. Because this is a quickly-evolving business, capturing radically different contract terms for ongoing activities may drive complex and varied revenue recognition conclusions. CSPs that provide software and application program interfaces in addition to services may need to comply with the revenue recognition standards at ASC 985-605. (See Subsection 12.4(b)(vi).)

(c) Need for Additional Guidance

Despite the conceptual guidance and detailed, industry-specific principles described in various sections of this chapter, numerous questions continue to arise concerning when entities should recognize revenue and how it should be measured. Arriving at sound answers to those questions is critical to ensuring that an entity's financial statements present fairly the entity's operating results and financial position. Revenues typically are the largest financial statement item, and many financial statement users analyze revenue numbers and trends in those numbers when making investment, credit, and similar decisions.

Accounting problems involving revenue continue to arise frequently. In its 1999 report, “Fraudulent Financial Reporting: 1987–1997, An Analysis of U.S. Public Companies,” the Treadway Commission's Committee of Sponsoring Organizations (COSO) notes that revenue recognition problems existed in about half of the financial reporting misstatement cases described in the SEC's Accounting and Auditing Enforcement Releases (AAER) issued during that period. Similar issues were identified in a study reported by the Panel on Audit Effectiveness's “Report and Recommendations” (Panel Report). That study of AAER cases shows that 70 percent of the problems concerned premature or fictitious revenue, including recognizing revenue before recognition criteria were met (e.g., on consignment sales and bill-and-hold transactions); in the wrong period (e.g., on products shipped after year end); or for transactions that never took place (pars. 2.126–2.142 and Appendix F).

The SEC has grown increasingly concerned about revenue recognition issues and management's ability to use aggressive recognition policies to manage earnings. (See Chapter 5 in this Handbook.) In September 1999, the SEC announced charges against 68 organizations and individuals that were accused of financial reporting abuses, many of which involved revenue recognition problems similar to those cited by COSO and the Panel Report. Later that year, the SEC asked the Emerging Issues Task Force (EITF) to consider 20 major Internet-related revenue problems, including recognizing revenue for services provided to customers free of charge, reporting gross instead of net revenues, and recognizing revenue from barter transactions. Those problems are summarized in EITF Issue No. 99-V, Remaining Issues from the SEC's October 18, 1999 Letter to the EITF.

As a result of the need for more detailed guidance, the SEC issued SAB No. 101, Revenue Recognition, in December 1999. (See Section 12.3(h).) The SEC did not intend to create or change revenue recognition principles but to provide guidelines useful for public companies, especially those involved in buying and selling over the Internet, in deciding how to apply existing GAAP. Applying the four criteria that form the foundation of SAB No. 101, however, has proven to be difficult. Part of the problem is that the criteria are drawn from the SEC's experience with Internet-related transactions but the SAB applies to all types of revenue transactions. In addition, the guidance in the SAB is discussed in a series of questions and answers illustrating what the SEC Staff considered to be sound revenue recognition practices in fact-specific situations. A small change in those facts, however, can have a major effect on how the four criteria would apply. As a result, entities and their auditors found it difficult to apply SAB No. 101 to new and increasingly more complex revenue arrangements.

Several developments improved that situation. For example, in response to numerous requests from public companies and their auditors, the SEC issued an FAQ document in October 2000 providing additional, but still very situation-specific, guidance on applying the SAB No. 101 criteria. In addition, the EITF issued consensuses on several significant revenue-related projects described previously, such as Issues No. 99-19 on gross versus net revenue reporting and No. 01-9 on sales incentives. In March 2011, SAB No. 114 was issued to revise or rescind portions of the interpretive guidance included in the codification of the SAB Series, updating the relevant interpretive guidance consistent with the FASB Accounting Standards Codification. Consequently, the SAB Series is represented in its entirety in SAB No. 114.

Despite that additional guidance, revenue recognition problems have continued to arise. For example, the SEC investigated accounting by Dynergy, Global Crossing, and Qwest Communications for “round-trip” swap transactions involving asset and service transfers whose sole purpose seemed to be inflating the companies' reported revenues. Other entities, including Xerox and ConAgra, have restated prior years' revenues following SEC investigations of their allegedly “aggressive” recognition policies.³¹ The SEC also has charged members of senior management at several companies, including Homestore and L90, with inflating online advertising revenues through various barter transactions and misleading auditors about the nature of those transactions.³² The SEC charged Gemstar-TV Guide International with misstating $250 million of revenue from 1999 to 2002 in a variety of ways, including front-end loading revenue from long-term and multiple-element contracts, inflating revenue from barter transactions, and shifting revenue among accounting periods. Gemstar agreed to pay $10 million to settle the SEC's civil case.³³ The SEC subsequently sanctioned the company's auditing firm, KPMG, and four of the firm's auditors for repeated failures in auditing Gemstar's revenue.³⁴

More recently, the SEC:

Charged various executives at Vitesse Semiconductor Corporation with an elaborate channel-stuffing scheme, materially inflating revenue for at least 14 quarters.³⁵
Accused the former chief financial officer of International Commercial Television, Inc. of prematurely and fraudulently recognizing revenue on sales of products through infomercials and through the Home Shopping Network.³⁶ In addition, Dohan & Company CPAs and three of its principals were accused of improper professional conduct during their audit of ICTV, particularly with regard to revenue recognition issues.³⁷
Elicited a $25 million civil penalty from Diebold, Inc., and filed fraud and other charges against several of its top executives. The firm and its executives were accused of improper use of bill-and-hold accounting and fraudulent recognition of revenue on a lease agreement, among other charges.³⁸

In addition, many companies—including Green Mountain Coffee Roasters, Inc. (Form 8-K, November 19, 2010), Dell, Inc. (Form 8-K, August 13, 2007), and Overstock.com, Inc. (Form 8-K, February 4, 2010)—have had to restate their financial results as a result of errors in recognizing revenue. Huron Consulting Group found that almost 60 percent of the restatements made by public companies in 2004 resulted from revenue problems.³⁹

The continuing problems have highlighted the need for what the Panel Report called “an authoritative statement on the broad principles of revenue recognition: (par. 2.142). The broad conceptual guidance provided by SFAC No. 5 and SAB No. 101 has not resulted in entities reporting consistent and comparable information about revenues. In addition, the more detailed guidance issued by the SEC, the EITF, and the AICPA often (1) is issued without adequate due process, (2) applies to a narrow range of problems, and, (3) at times is inconsistent with other literature.

(d) Financial Accounting Standards Board Project on Revenue Recognition

In mid-2002, the FASB formally recognized the need to provide additional guidance and to promote international convergence of accounting standards for revenue recognition. It initiated a joint project with the IASB to eliminate inconsistencies in the authoritative literature and provide a conceptual foundation for resolving new and emerging revenue recognition and measurement issues. The project's two components were (1) the reorganization of U.S. GAAP into a more user-friendly single source of authoritative standards and (2) the clarification of the principles for recognizing revenue with the goal of developing a common revenue standard for U.S. GAAP and International Financial Reporting Standards.

The objective of the project's first component included developing a comprehensive, principles-based standard on revenue recognition containing clear, concise implementation guidelines for business entities. The FASB's Staff compiled an inventory of the authoritative literature and other sources of guidance (such as industry-specific practices) dealing with revenue recognition. The inventory included over 180 sources of accounting principles,³⁶ classified under one of four “conventions”:

1. Mark to market. Revenue is recognized when the fair values of assets or liabilities change.

2. Proportionate performance. Revenue is recognized when performance occurs or with the passage of time.

3. Sales and delivery. Revenue is recognized when performance is substantially complete.

4. Collection. Revenue is recognized when consideration is collected following an exchange or performance.

As noted in Section 12.4(c), much of the then-existing guidance was narrow, applying only to specific industries or types of transactions, and was issued by many different organizations—including the APB, the FASB, and various groups within the AICPA—over a long period of time. The FASB's goals in this first component of the project were to eliminate the inconsistencies and provide more comprehensive guidance for recognizing revenue.

On July 1, 2009, FASB launched the FASB Accounting Standards Codification (ASC) as the single source of authoritative nongovernmental U.S. GAAP. The use of the ASC became effective with interim and annual reporting after September 15, 2009, when it superseded all other accounting standards. The Codification reorganized thousands of GAAP pronouncements into a consistent structure and included relevant SEC guidance. Guidelines for revenue recognition are found primarily in ASC 605 but appear in a number of other sections as well.

The second FASB/IASB project component, the “convergence effort,” focuses on the need to:

Remove from existing revenue recognition standards any weaknesses and inconsistencies
Develop a more robust authoritative framework for addressing revenue recognition issues
Improve the comparability of revenue recognition practices across jurisdictional and other boundaries
Reduce the number of authoritative requirements to which entities must refer when preparing financial statements.

The boards issued joint proposals in June 2010. FASB published an Exposure Draft for public comment of proposed Accounting Standards Update (ASU) No. 1820-100, Revenue Recognition (Topic 605): Revenue from Contracts with Customers). The IASB Exposure Draft was similar except for minor differences in spelling, style, and format. About 1,000 comment letters were received, with the two boards agreeing some redrafting was necessary. FASB and IASB anticipate issuing a revised Exposure Draft in the last quarter of 2011 and note that the effective date of the standard would be no earlier than for annual periods beginning on or after January 1, 2015. As of this writing, the boards are undecided whether to permit early application of the standard.⁴⁰

12.5 Revenue Adjustments and Aftercosts

(a) Nature of Revenue Adjustments and Aftercosts

Revenue adjustments include sales returns and allowances, discounts, and bad debts; warranties and guarantees may be treated either as future revenue or as “aftercosts,” depending on the circumstances; costs related to product defects should be treated as expenses.

Practice does not always clearly distinguish between events and transactions that give rise to expenses and those that are more properly treated as adjustments or valuations of revenue. Alternative definitions of the term revenue were presented at the beginning of this chapter; expenses are defined in paragraph 80 of SFAC No. 6 as outflows or expirations of assets sold or liabilities incurred in the process of earning revenue (as “earning” was previously defined). Hendriksen and van Breda state that:

[S]ales returns and allowances, sales discounts, and bad debt losses are all more appropriately treated as reductions of gross revenues than as expenses. None of them represents the use of goods or services to generate revenues; each represents a reduction of the amount to be received in exchange for the product.⁴¹

(b) Sales Returns

Merchandise returned by a customer is, in effect, a cancelation of the original sales transaction, in whole or in part, and should be treated as a direct offset to gross sales rather than as a revenue adjustment. To maintain a record of sales returns as well as of the amount of gross sales, however, returns are ordinarily recorded in a contra sales account, “sales returns.” A special problem arises if the returned merchandise has been used or has deteriorated to a point substantially below its original value. In those cases, the returned goods should be recorded at their net realizable value based on their present condition and estimated costs of making them ready for resale. Losses attributable to returned goods should be recognized as appropriate.

(c) Sales Allowances

Allowances to customers fall into these two general classes:

1. Specific allowances on certain products, such as those for shortages in shipments, breakage, spoilage, inferior quality, failure to meet specifications, or errors in billing or handling of freight

2. Policy allowances, or allowances that the seller makes only because of the possible loss of future business it might suffer in related lines if it did not offer such allowances

Allowances falling in the first class should be treated as a direct offset to gross sales. Allowances in the second class are generally classified as revenue deductions.

(d) Sales Incentives

Some vendors provide cash, credits, and other consideration to their customers in the form of discounts, coupons, rebates, and free products or services. For example, deductions from gross invoice prices, order quotations, published price lists, and other forms of discounts may be offered as:

Cash discounts. Credit terms often allow customers a cash discount for payment of invoices within a certain period. In the past, cash discounts sometimes were viewed as interest allowances to customers for prompt payment. Sales discounts taken were thus treated as financial expenses; discounts not taken were implicitly included in gross revenue. This accounting can still be found in the literature. The preferred method, however, is to regard cash discounts as revenue adjustments, either by deducting discounts taken from gross sales revenue on the income statement or by initially recording the sales at net prices and treating forfeited discounts as financing revenue. As a practical matter, the amounts involved are usually not material to the financial statements.
Trade discounts. Trade discounts are deductions from list prices, allowed to customers for quantities purchased or for the purpose of establishing different price levels for different classes of customers, such as wholesalers and retailers. Trade discounts also are employed to enable vendors to change the effective prices of articles included in catalogs or similar sales publications by the relatively simple process of issuing a revised discount sheet. Revenues should be recorded after deduction of such discounts.
Employee discounts. Employees are often allowed special discounts on purchases made through the company. The discount may be limited to the company's ordinary products or merchandise, or it may extend to clothing, food, and other commodities carried in a general company store for the benefit of employees and sold to them at cost. If the sales are not recorded net of discounts initially, the total discounts generally should be treated as a revenue deduction. If a discount is in substance additional compensation, it should be treated as an operating expense.

A variety of more complex sales incentive arrangements also are used by companies in the Internet, hospitality, airline, and other industries. These include:

Free products or services delivered when customers purchase another specified product or service (e.g., two-for-one offers)
Shares of vendors' stock, stock options, or stock warrants to purchase vendors' stock
Points or other credits that can be redeemed for various goods and services after customers have accumulated a specified amount “loyalty programs)
Fees paid to customers to obtain space in customers' selling areas (slotting fees)
Reimbursements for a portion of customers' advertising costs relating to vendors' products or services (cooperative advertising)
Reimbursements up to specified amounts if the customers do not resell the vendors' products at greater than a specified minimum price during a specified time period (e.g., buydowns, shortfalls, factory incentives, dealer holdbacks, price protection, and factory-to-dealer incentives)

The accounting issues raised by sales incentives such as these concern how vendors should measure the costs of these arrangements and how those costs should be reported on vendors' income statements. ASC 605-50 provides guidance for accounting for sales incentives. As discussed in Subsection 12.5(d)(i), the appropriate accounting depends on the type of consideration offered.

(i) Cash or Equity Consideration

When cash or equity consideration is offered voluntarily and without charge by a vendor to be used in a single exchange transaction or that becomes exercisable by the customer as a result of a single exchange transaction, and this incentive will not result in a loss on the sale of the product or service, the cost of the incentive should be measured at the later of two dates: when the related revenue is recognized by the vendor or when the incentive is offered. ASC 605-50-45 requires that cash consideration be presumed to be a reduction of the selling price of the product or service and should be recognized as a reduction in revenue. This presumption may be overcome if the seller receives, or will receive, an identifiable benefit in exchange for the consideration, and the seller can reasonably estimate the fair value of the benefit received. If the transaction overcomes the presumption, the excess amount of consideration over the fair value of the benefit should be treated as a reduction in revenue.

(ii) Other Forms of Consideration

Sales incentives offered to customers may involve consideration other than cash or equity instruments, such as gift certificates and offers of “free” products or services. ASC 605-50-45-3 considers those types of incentives to be separate deliverables and requires their cost to be reported as expenses. Although the consensus does not specify the appropriate expense classification, the SEC Staff believes they should be included in cost of sales if they are delivered at the time of the sale of other goods or services. Accounting for points or loyalty programs that offer customers free or discounted goods or services only after reaching a certain level or after being a customer for a certain period of time is specifically excluded from the scope of ASC 605-25, due to their unique nature. However, companies may elect to treat points as a separate unit of accounting under ASC 605-25; the relevant revenue would be deferred and recognized when the points are redeemed.

(iii) Customers' Accounting for Sales Incentives

ASC 605-50-45-12 presumes that cash consideration received by customers is a reduction in the price of a vendor's goods or services. Customers should not report such consideration as revenue but as reductions in their cost of sales. This presumption can be overcome if either of two conditions exist: (1) the cash consideration is a payment for goods or services delivered to the vendor, in which case the cash consideration should simply be recognized as income; or (2) the cash consideration is a reimbursement of costs to sell the vendor's product, in which case the cash consideration should be treated as a reduction of that cost.

Two common arrangements involving payments from vendors to customers are specifically addressed by ASC 605-50-45-4, Slotting Fees. The first type is payments made by a seller to a retailer so the retailer will stock the seller's product in its stores. These and similar product placement fees are to be treated as a reduction of revenue by the vendor. They should generally be treated by the customer as a reduction in the cost of sales, even when the slotting fee arrangement is written in the form of a lease. The second type of arrangement includes buydowns, such as factory to dealer incentives in the automobile industry. These generally involve a vendor agreeing to reimburse a retailer for a specified amount of shortfall in a sales price on specific products during a specific promotional period. Buydowns are required to be treated as a reduction of revenue by the vendor and should generally be treated as a reduction in cost of sales by the retailer customer.

Rebates and coupons are two means by which manufacturers will offer sales discounts to consumers in order to stimulate demand. Frequently, a manufacturer will sell its product to a reseller/retailer, which then sells the product to consumers. Typically, consumers present coupons to the reseller, who honors the coupons at the point of sale and tenders them to the manufacturer for reimbursement. ASC 605-50-45-16 through 22, Reseller's Characterization of Sales Incentives Offered to Customers by Manufacturers, concludes that resellers should account for those reimbursements as reductions in cost of goods sold if the incentives meet all four of these criteria:

1. The incentives are available to consumers to reduce the price paid at any reseller of the manufacturers' products.

2. They are paid directly to resellers from vendors (or vendor-authorized third parties) based on the face value of the incentives.

3. The incentives are determined solely by the terms offered to consumers by manufacturers (i.e., have no terms affected by other incentive arrangements between the manufacturers and resellers).

4. They arise from express or applied agency relationships between manufacturers and vendors in connection with the sales incentive offered by the manufacturers to consumers.

If a sales incentive does not meet all four of these criteria, resellers should apply the guidance in ASC 605-50-45-2 through 45-3.

(e) Uncollectible Receivables

According to ASC 310-10-35-16, Receivables: Subsequent Measurement, “a loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.” (As defined in ASC 310-10-20, loans include accounts receivable with terms exceeding one year and notes receivable.) ASC 310 applies to all creditors; its applicability to financial institutions is discussed in Chapter 30 of this Handbook. However, ASC 310, Receivables, guidance for the accounting for impairment of a loan specifically excludes these four types:

1. Large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment such as credit card loans, residential mortgages, and consumer installment loans

2. Loans that are measured at fair value or lower of cost or fair value, the treatment of which should be in accordance with specialized industry practice

3. Leases, which are addressed in ASC 840

4. Debt securities as defined in ASC 320, Investments: Debt and Equity Securities

Uncollectible receivables are accounts and note receivables that probably will not be collected in the future. Providing an allowance for uncollectible receivables is required under SFAS No. 5, Accounting for Contingencies, when a loss is probable and can be reasonably estimated. Under the allowance method, an allowance account is used to report the estimated uncollectible amount of receivables. ASC 310-10-45-4 specifies that the allowance account be reflected as a contra to the controlling (i.e., gross) receivables account and the individual subsidiary accounts be left intact. When it is decided that a specific amount is uncollectible, it is charged against the allowance account. Bad debt expense is recorded when the allowance account is increased. Although not acceptable for financial statements prepared in conformity with GAAP, the direct write-off method is acceptable for income tax purposes. Under this method, no allowance is required; instead, uncollectible accounts are written off during the period in which they are determined to be uncollectible. The loss is charged directly to bad debt expense.

Bad debts can be classified on the income statement as (1) a financial expense or loss, (2) an operating expense (either selling or administrative), or (3) a sales adjustment. The first view assumes that all customers' claims are initially valid in the amount of their face value and that subsequent lack of collection is a financing cost that must be borne by the business as a whole. Under the second interpretation, bad debts are considered one of the costs of operating the business. The third alternative recognizes at the outset that a certain percentage of customers' claims will become uncollectible, that total credit sales are therefore tentative and subject to subsequent adjustment, and that, consequently, no expense or loss should be recognized because no asset has expired or liability been incurred.

When the allowance account is used, there are three methods for estimating its appropriate balance: percentage-of-sales method, percentage-of-receivables method, and aging-of-receivables method.

(i) Percentage-of-Sales Method

The percentage-of-sales method requires charging bad debt expense and crediting the allowance account for an amount determined by applying an estimate of uncollectibles to sales revenue for the period. It can be used with both accounts and notes receivable, either together or separately. As a practical matter, however, this method can be used advantageously with notes only when the notes are numerous and arise as a regular credit term granted at the time of the sale. Although the uncollectible expense percentage usually should be based on recent experience and applied to credit sales, often substantially the same result can be attained by using a smaller percentage applied to total sales (assuming the relationship of cash sales to credit sales remains fairly constant). The balance in the allowance account may become excessive or inadequate unless there are periodic reviews of probable losses and consequent adjustments of the allowance account as necessary.

(ii) Percentage-of-Receivables Method

The percentage-of-receivables method requires a determination of collection experience. The total of estimated uncollectibles is thus ascertained by applying the loss percentage to total receivables. The allowance account is then adjusted by the amount necessary to bring the existing balance to the required amount. This method also can be used with both accounts and notes receivable. When the notes held are relatively few in number and originate in the process of collection of accounts receivable or through loans and advances, the percentage-of-receivables method is an appropriate means of valuing notes receivable.

This method often results in a fairly accurate approximation of expected net realizable value of receivables. In terms of bad debt expense on the income statement, however, the method may be deficient in that bad debts are related to all open receivables irrespective of the period in which the claims originated, with the result that uncollectible receivable losses may not be recognized in the period in which the revenue is recorded.

(iii) Aging-of-Receivables Method

The aging-of-receivables method is a variation of the percentage-of-receivables method. The basis for using this method is that the older the receivable, the less likely it is to be collected. The first step in aging receivables is classifying them as to time since (1) billing, (2) end of regular credit period granted, (3) payment due date, or (4) date of last payment. The amount of expected uncollectibles as determined by the aging process becomes the balance to be reflected in the allowance account. The allowance account is adjusted to bring the current balance into agreement with the required balance; the amount of the adjustment is charged to bad debt expense for the period.

If properly applied, the aging method, including use of appropriate supplemental information, provides the most accurate approximation of the expected net realizable value of receivables. Like the percentage-of-receivables method, however, the aging method may fail to recognize bad debt expenses in the period in which they arise. In the aging process, bad debts are related to impairment-of-asset values irrespective of the time of the sales activity. Receivables resulting from the most recent sales, for example, may be regarded as fully collectible in the aging process, only to prove uncollectible in the subsequent period. The aging method can be costly and time consuming when many accounts are involved, although computerized receivables systems have greatly reduced the costs and time required.

(f) Warranties and Guarantees

According to ASC 460-20, Revenue Recognition: Services, a warranty is:

A guarantee for which the underlying is related to the performance (regarding function, not price) of nonfinancial assets that are owned by the guaranteed party. The obligation may be incurred in connection with the sale of goods or services; if so, it may require further performance by the seller after the sale has taken place.

As a result of the uncertain nature of the claims that may be made under warranties, ASC 460-10-25-5 requires that warranty obligations be treated as a contingency. Therefore, losses from warranty obligations must be accrued when the conditions in ASC 450-20-25-2 are met. Those conditions require accrual when it is (1) probable that an asset has been impaired or liability incurred at the date of the financial statements and (2) the amount of the loss can be reasonably estimated. The first accrual condition is met if it is probable that customers will make claims under warranties related to either goods or services that have been sold. The second may be satisfied based on either the experience of the entity or reference to the experience of other entities in the same business. If an enterprise cannot reasonably estimate the amount of the loss, accrual is precluded.

Accounting for separately priced extended warranty and product maintenance contracts is discussed in Subsection 12.4(a)(viii).

(g) Obligations Related to Product Defects

Obligations, other than warranty obligations, may arise due to injury or damage caused by products or services that have been sold. Such obligations are likely to meet the definition of a loss contingency provided in ASC 450, Contingencies: “An existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that will ultimately be resolved when one or more future events occur or fail to occur.” The treatment of such a contingency will depend on the probability of the adverse event occurring and whether the loss can be reasonably estimated. ASC 450-20-25 requires accrual if both those criteria are met and the underlying causal event happened before the balance sheet date. ASC 450-20-30-1 provides additional guidance if only a range of loss can be determined.

12.6 Ancillary Revenue

(a) Dividends

Generally, investors in equity securities classified as trading or available for sale report cash dividends and dividends paid in property of the payor corporation as “other income” unless the dividends are a major source of income to the recipient; then they are classified as operating revenue. Dividends received in property of the payor corporation are recorded as revenue in amounts equivalent to the fair market value of the property (ASC 845-10-30). The date an investor becomes entitled to receive a dividend is the accepted time for recognizing it as revenue. In practice, organizations often record the revenue when the cash or property is actually received.

As indicated by ASC 505-20-30-7, Equity: Stock Dividends and Stock Splits, stock dividends consisting of shares received on holdings of the same class of stock do not represent income to the recipient because the “shareholder's interest in the corporation remains unchanged…except as to the number of share units constituting such interest.”

Liquidating dividends do not normally result in income until their cumulative total exceeds the recipient's cost of the investment to which they apply.

(b) Interest

Interest generally is classified as “other income,” unless, as in financial institutions, it is a major source of income; then it is classified as operating revenue. Interest on obligations of debtors generally should be recorded as it accrues. If collectibility of interest is doubtful, the recognition of interest should be postponed until the interest is received or its collection becomes reasonably certain.

Interest income on long-term investments purchased at a premium is subject to reduction by the amount of the amortization of the premium from the date of purchase to the earliest call date or maturity. The amount of discount on investments purchased at less than face value should be similarly amortized and included in income. If collection of the principal amount of the investment is uncertain, the discount should not be amortized.

(c) Profits on Sales of Miscellaneous Assets

Profits on sales of miscellaneous assets—those not regularly and customarily offered for sale in the normal conduct of the business—are usually classified as “other income.” Such profits include gains and losses on sales of securities, real estate, machinery and equipment, automobiles and trucks, furniture and fixtures, and sundry salvaged materials. Profits on those sales generally are recorded “net”; that is, the selling price is not recorded as revenue and the carrying value of the asset sold is not shown as expense.

A derivative should be reported as either an asset or a liability at fair value. ASC 815, Derivatives and Hedging, specifies that any gains or losses, whether realized or unrealized, on derivative instruments held for trading purposes should be shown net when recognized in the income statement (815-10-45-9). Mark-to-market accounting is precluded for energy trading contracts that are not derivatives (ASC 932-330-35-1, Extractive Activities—Oil and Gas: Inventory).

(d) Rents

Rents receivable should be recorded as revenue in the accounting period during which they accrue. Rents received in advance should be deferred and included in revenue in the period to which they apply.

(e) Royalties

Royalties may be broadly defined as a compensation or a portion of the proceeds paid to an owner for the right to use the owner's property. The payment may be in the form of a share in kind of the product or the right that is exploited or in the form of monetary compensation at agreed rates based on units produced, used, or sold or the equivalent of their market value. The types of property for which royalties may be paid include forests, mineral and oil lands, copyrights, patents, processes, and equipment.

Royalties should be recognized as revenue as they accrue. Periodic royalty reports from the user of the property customarily form the basis for determining the amount to be accrued. Amounts collected as advance royalties or as minimum periodic royalties should be deferred to the extent that such collections may be applied in settlement of royalties accruing in a period subsequent to the period of receipt.

(f) By-product, Joint Product, and Scrap Sales

Horngren, Datar and Rajan state:

Industries abound in which a production process simultaneously yields two or more products, either at the splitoff point or after further processing…. [N]o individual product can be produced without the accompanying products appearing….

When a joint production process yields one product with a high total sales value, compared with total sales values of other products of the process, that product is called a main product. When a joint production process yields two or more products with high total sales values compared with the total sales values of other products, if any, those products are called joint products. The products of a joint production process that have low total sales values compared with the total sales value of the main product or of joint products are called byproducts.

Distinctions among main products, joint products, and byproducts are not so definite in practice…. Moreover, the classification of products—main, joint, or byproduct—can change over time…. In practice, it is important to understand how a specific company chooses to classify its products.⁴²

Joint product sales normally are recorded in the same manner as the seller's principal sources of revenue. The major accounting problem in this connection is determining the proportionate share of total product costs to be assigned to joint products. The value of by-products and scrap may be treated either as a reduction of cost or as revenue (or other income), either at the time of production or at the time of sale.

(g) Shipping and Handling Fees

Fees billed to customers in sales transactions for shipping and handling and related costs should be reported as revenue rather than netted against the costs incurred. According to ASC 605-45-45-21, Revenue Recognition: Shipping and Handling Fees and Costs, that is appropriate whether amounts billed to customers equal the actual shipping and handling costs incurred or the amounts billed exceed those costs. Although the SEC Staff prefers shipping and handling costs to be reported as part of cost of sales, they may be included in some other income statement classification as long as the total amount of those costs, if material, and the line item in which they are included are disclosed. ASC 605-45-45-21 does not specify what costs are to be considered “shipping and handling” and notes that the components may differ among entities. ASC 605-45-50-2 instructs that shipping and handling costs may be reported in cost of sales or separately on other lines in the income statement. If they are not included in cost of sales, disclosure is required in accordance with ASC 235, Notes to Financial Statements.

(h) Loan Guarantees

Entities may guarantee other entities' loans in order to improve those other entities' ability to borrow, or the terms under which those other entities can borrow, from third parties. ASC 605-20-25-9, Revenue Recognition: Fees for Guaranteeing a Loan, requires entities to recognize fee revenue from providing those guarantees, and any direct costs associated with the guarantees, over the period during which the guarantees apply. If, however, a fee is in substance a “lending commitment” as defined in ASC 310-20-20, Receivables: Nonrefundable Fees and Other Costs, the guidance in ASC 310-20-25-11 through 25-14 applies.

ASC 460-10-50, Guarantees: Disclosure, requires entities to disclose in notes to their financial statements these six points of information about material financial guarantees:

1. The nature of the obligation guaranteed, including the approximate term and how the guarantee arose, among other information

2. Substantial information about the maximum amount at risk

3. The current carrying amount of the liability

4. The nature of any recourse provisions

5. The nature of any assets held as collateral or assets held by third parties that the guarantor can liquidate to recover all or a portion of the guaranteed amount

6. If estimable, the extent to which the proceeds from the liquidation of the assets noted in item 5 would cover the maximum amount at risk.

Financial guarantee contracts are considered derivatives under ASC 815 if the payment under the guarantee is based on changes in an underlying, such as the other party's creditworthiness. In conformity with ASC 815-10-30-1, those contracts would be reported at fair value; accounting for changes in fair value is discussed in ASC 815-10-35. ASC 815 does not apply, however, if the contracts “provide for payments to be made solely to reimburse the guaranteed party for failure of the debtor to satisfy its required payment obligations under a nonderivative contract” (ASC 815-10-15-58).

12.7 Statement Presentation

(a) Income Statement and Revenue-Related Disclosures

The income statement should disclose sales for the period, usually net of discounts, returns, and allowances.

Various authoritative pronouncements contain guidance on disclosures about revenue recognition policies and the impact of events and trends on revenue. In addition to the specific disclosures described in various sections of this chapter, this information should be disclosed:

In providing information about its accounting policies for the reporting of revenue in conformity with ASC 235, a company should disclose:
- Different policies for different kinds of revenue transactions, including barter sales
- The policies for each element, such as product and service, of transactions with multiple elements
- How each of multiple elements are determined and valued
- Changes in estimated returns if material
- The amount of revenue from sales of merchandise, services, and other products and the related costs for each (reported separately)
- ASC 280-10-50, Segment Reporting: Disclosure, provides guidance regarding the disclosure of operating segment information in notes to the financial statements. If the chief operating decision maker reviews information about a portion of an entity, such as its Internet operations, separately from other portions, it may be considered a reportable operating segment. Reportable segment disclosures relating to revenue include types of goods and services from which revenues are derived, total revenues from external customers and from other operating segments of the entity, interest revenue, a reconciliation of total reportable segment revenue to total consolidated revenues, and a number of other items (as listed in ASC 280-10-50-21 through 50-31). For interim periods, revenues from external customers and intersegment revenues for each reportable segment are among the items that should be disclosed (see ASC 280-10-50-32 and 50-33).
Amounts recovered under business interruption insurance claims typically include (1) gross margin that would have been earned if normal operations had not been suspended; (2) a portion of normal fixed costs incurred during the interruption period; and (3) other out-of-pocket costs incurred as a result of the interruption of business. ASC 225-30-45, Income Statement: Business Interruption Insurance, concludes that these recoveries could be shown in any section of the income statement as long as the classification is consistent with GAAP. For example, reporting a recovery as an extraordinary gain is acceptable only if the extraordinary item criteria in ASC 225-20, Income Statement: Extraordinary and Unusual Items, are satisfied. ASC 225-30 requires the disclosure of a description of the event causing the loss, the total amount of the recoveries included in the income statement, and the line item or items on the income statement in which the recoveries are reported. Companies should describe the types of multiple deliverable arrangements they have with customers, including provisions related to performance, refunds, terminations, and cancelations. Companies also should disclose the recognition policies they use for such arrangements (ASC 605-25).

The SEC Staff has suggested that this information about revenue be disclosed:

In its management discussion and analysis (MD&A), a company should discuss unusual or infrequent transactions and known trends or uncertainties that have had or might reasonably be expected to have a favorable or unfavorable material effect on revenue, operating income, or net income and the relationship between revenue and the costs of the revenue. The company should evaluate changes in revenue in terms of volume and price changes and disclose the reasons and factors contributing to the changes. Examples of transactions or events that should be disclosed in the MD&A (SAB No. 114, Topic 10.B.1, incorporated at ASC 605-10-S99) include:
- Late-period shipments that significantly reduce backlog and might reasonably be expected to result in lower shipments and revenue in the next period
- Granting of extended payment terms and the effect on liquidity and capital resources (the fair value of trade receivables, if it does not approximate the reported amount, should be disclosed in the notes)
- Changing trends in shipments to and sales from a sales channel or separate class of buyer that could be expected to significantly affect future sales or sales returns
- Increasing trends toward different classes of buyer, such as to a revenue distribution channel that has a lower gross profit margin or increasing service revenue with higher profit margins
- Seasonal trends or variations in revenue
- Gains or losses from the sales of assets
Other disclosures as appropriate,⁴³ such as:
- Disaggregated product and service information:
- Product and service revenues (and costs of revenues) separately on the face of the income statement
- Separate revenues of each major product or service within segment data
- Description of major revenue-generating products or services
- For major contracts or groups of similar contracts, descriptions of essential terms, including payment terms and unusual provisions or conditions
- Details concerning when revenue is recognized, such as:
  - At delivery (indicate whether terms are customarily FOB shipping point or FOB destination)
  - At completion of service
  - At commencement of service
  - Ratably over service period
  - At satisfaction of a significant condition of sale and a description of that condition
  - After customer acceptance
  - After testing of product sold
  - After completion of all terms of contract
  - Over performance period based on progress toward completion
  - At delivery of separate elements in multi-element arrangement
- If revenue is recognized over the service period based on progress toward completion, or based on separate contract elements or milestones:
  - How the period's revenue is measured
  - How progress is measured—for example, cost to cost, time and materials, units of delivery, units of work performed
  - Types of contract payment milestones, with an explanation of how they relate to substantive performance and revenue recognition events
- Description of whether contracts with a single counterparty are combined or bifurcated
- Identification of contract elements permitting separate revenue recognition and a description of how they are distinguished
- How contract revenue is allocated among elements
- Whether the relative fair value or residual method is used to allocate elements
- Whether fair values are based on vendor specific evidence or by other means
- Material assumptions, estimates, and uncertainties, including:
- Existing contingencies such as rights of return, conditions of acceptance, warranties, and price protection
- How those contingencies are accounted for
- Significant assumptions, material changes, and reasonably likely uncertainties
- Disclosures and conditions as specified by SAB No. 114 for companies that recognize refundable revenues by analogy to ASC 605-15, Revenue Recognition: Products.

The SEC Staff has emphasized that, in order to ensure fair presentation, income statement disclosures of revenues should be classified based on the nature of the underlying events. For example, reported revenues should be reported net of consideration given to customers or resellers and should not include:

1. Amounts intended to offset costs incurred

2. Equity in investees' income

3. Gains or losses from fixed asset or investment sales

4. Other income

The Staff expects companies to clarify and expand their disclosures in SEC filings regarding the accounting policies used for each material revenue-generating activity the company undertakes.⁴⁴

(b) Balance Sheet Disclosures

The basis for presentation of receivables in the balance sheet is the expected time of collection. Receivables expected to be collected within the next operating cycle or fiscal year, whichever is longer, are ordinarily classified as current assets. Several exceptions allowed by ASC 310 are discussed next. Specialized reporting requirements also are discussed.

Kieso, Weygandt, and Warfield summarize the general rules for statement presentation in the receivables section of the balance sheet:

1. Segregate the different types of receivables that an enterprise possesses, if material.

2. Ensure that the valuation accounts are appropriately offset against the proper receivable accounts.

3. Determine that receivables classified in the current assets section will be converted into cash within the year or the operating cycle, whichever is longer.

4. Disclose any loss contingencies that exist on the receivables.

5. Disclose any receivables designated or pledged as collateral.

6. Disclose all significant concentrations of credit risk arising from receivables.⁴⁵

(i) Presentation of Single-Payment Accounts Receivable

Ordinarily accounts receivable are classified in the balance sheet as current assets. Amounts that will not be collected until the next operating cycle or fiscal year, however, should be shown as noncurrent. In the interest of full disclosure, it is considered desirable to limit the accounts receivable designation to current claims attaching to trade customers and to identify separately other major types of receivables, such as amounts due from officers and employees, prepayments, and stock subscriptions receivable.

(ii) Presentation of Installment Receivables

ASC 310-10-45, Receivables: Other Presentation Matters, specifically provides for the inclusion within current assets of “installment or deferred accounts and notes receivable if they conform generally to normal trade practices and terms within the business.” Thus, installment receivables may be classified as current regardless of the length of the collection period. Designation of annual maturity dates by separate listing of contracts receivable or by parenthetical or note disclosure is recommended to enable readers to ascertain the current position.

Conflicting opinions exist as to the proper classification of the deferred gross profit account related to installment receivables. The FASB concludes⁴⁶ that deferred gross profit conceptually should be treated as an asset valuation account. Because deferred gross profit is part of revenue from installment sales not yet realized, the related receivable will be overstated unless deferred gross profit is deducted. Another alternative is to report deferred gross profit as unearned revenue in the liability section. This alternative has been criticized, however, because the credit is not an obligation to an outsider.

In preparing an income statement, installment sales, cost of installment sales, and realized gross profit may be shown in the statement, or only the realized gross profit may be reported, with installment sales and cost of sales reflected in a separate supporting schedule. ASC 976-605-55, Revenue Recognition: Real Estate—Retail Land, illustrates the financial statement presentation when the installment method is used for retail land sales. Also see Section 12.4(b) of this chapter.

(iii) Interest on Receivables

Notes receivable arise in many situations in which the legal form of the note specifies an interest rate (including lack of an interest rate) that varies from prevailing interest rates. ASC 835-30, Interest: Imputation of Interest, requires that, in these situations, the note receivable be recorded at its present value and that interest be imputed at an appropriate rate. The resulting discount or premium is amortized over the life of the note. ASC 835-30-55-3 exempts these seven receivables:

1. Receivables arising from transactions with customers in the normal course of business which are due in customary trade terms not exceeding approximately one year

2. Receivables that will be applied to the purchase price of other property, goods, or services rather than being repaid

3. Security deposits, retainages, or other amounts intended to provide security to a party to an agreement

4. Receivables from the customary cash lending activities of financial institutions

5. Receivables where interest rates are affected by the tax attributes or legal restrictions prescribed by a governmental agency

6. Receivables from a parent, subsidiary, or another firm with a common parent

7. Obligations assumed in connection with the sale of property, goods, or services, such as product warranties, to which present value measurement techniques are applied

¹ V. M. O'Reilly, M. B. Hirsch, P. L. Defliese, and H. R. Jaenicke, Montgomery's Auditing, 11th ed. (New York: John Wiley & Sons, 1990), p. 371.

² G. J. Staubus, Making Accounting Decisions (Houston: Scholars Book Co., , 1977), p. 172.

³ AAA, Committee on Accounting Concepts and Standards, Accounting and Reporting Standards for Corporate Financial Statements, 1957 revision (Sarasota, FL: Author, 1957), p. 3.

⁴ W. A. Paton and A. C. Littleton, An Introduction to Corporate Accounting Standards (Sarasota, FL: AAA, 1940), pp. 53–54.

⁵ G. O. May, Financial Accounting: A Distillation of Experience (New York: Macmillan, 1943), pp. 30–31.

⁶ W. A. Paton and W. A. Paton Jr., Corporation Accounts and Statements (New York: Macmillan, 1955), pp. 278–279.

⁷ D. E. Kieso, J. J. Weygandt, and T. D. Warfield, Intermediate Accounting, 14th ed. (Hoboken, NJ: John Wiley & Sons, 2012), p. 1092.

⁸ Paton and Littleton, Corporation Accounts and Statements, p. 52.

⁹ E. S. Hendriksen and M. F. van Breda, Accounting Theory, 5th ed.(Homewood, IL: Irwin, 1992), p. 365.

¹⁰ Paton and Littleton, Corporation Accounts and Statements, pp. 46, 62.

¹¹ E. O. Edwards and P. W. Bell, The Theory and Measurement of Business Income (Berkelely: University of California Press, 1965), p. 93.

¹² Paton and Littleton, Corporation Accounts and Statements, p. 59.

¹³ J. P. Mallor et al., Business Law and the Regulatory Environment: Concepts and Cases, 11th ed. (Chicago: Irwin McGraw-Hill, 2001), pp. 654–655.

¹⁴ H. R. Jaenicke, Survey of Present Practices in Recognizing Revenues, Expenses, Gains, and Losses (Norwalk, CT: FASB, January 1981).

¹⁵ F. W. Windal, “The Accounting Concept of Realization,” Accounting Review (April 1961): 252.

¹⁶ See Jaenicke, Survey of Present Practices, Chapter 2, for further discussion.

¹⁷ J. B. Canning, The Economics of Accounting (New York: Ronald Press 1929), p. 102.

¹⁸ Paton and Littleton, Corporation Accounts and Statements, p. 49.

¹⁹ C. T. Horngren, “How Should We Interpret the Realization Concept?” Accounting Review (April 1965): 330.

²⁰ W. J. Vatter, The Fund Theory of Accounting and Its Implications for Financial Reports (Chicago: University of Chicago Press, 1947), p. 25.

²¹ Canning, Economics of Accounting, p. 102.

²² FASB Discussion Memorandum, An Analysis of Issued Related to the Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and Their Measurement (Norwalk, CT: FASB, 1976), p. 158.

²³ J. H. Meyers, “The Critical Event and the Recognition of Net Profit,” Accounting Review (October 1959): 528.

²⁴ See ASC 605-15-25.

²⁵ See ASC 470-40-15

²⁶ See AICPA Statement of Position 97-2. Software Revenue Reconition. October, 1997.

²⁷ SAB No. 114 as presented in ASC 605-10-S99, Topic 13.A.4.b, Question 1.

²⁸ SEC Division of Corporate Finance, “Current Accounting and Disclosure Issues in the Division of Corporate Finance,” December 1, 2005, Section II.F.2.

²⁹ The SEC Staff discusses accounting for “buy-sell arrangements” in letters (see www.sec.gov/divisions/corpfin/guidance/oilgas021105.htm) sent to various registrants in February 2005 describing recognition, measurement, and disclosure requirements for these transactions. See SEC Division of Corporation Finance, “Current Accounting and Disclosure Issues,” December 1, 2005, Section II.F.1.

³⁰ P. Iyengar, “Application Development in the Cloud: Strategies and Tactics for a New Generation,” Gartner, Inc., November 2009.

³¹ See SEC Accounting and Auditing Enforcement Release No. 1864, September 18, 2003, and No. 1874, September 26, 2003.

³² See SEC Accounting and Auditing Enforcement Release No. 2045, June 23, 2004.

³³ See SEC Accounting and Auditing Enforcement Release No. 2125, October 20, 2004.

³⁴ See SEC Accounting and Auditing Enforcement Release No. 3137, June 2, 2010.

³⁵ See SEC Accounting and Enforcement Release No. 3217, December 10, 2010.

³⁶ See SEC Accounting and Enforcement Release No. 3311, August 4, 2011.

³⁷ See SEC Accounting and Enforcement Release No. 3171, August 9, 2010.

³⁸ C. Graciano, “Revenue Recognition: A Perennial Problem,” Financial Executive Magazine, July 14, 2005.

³⁹ As of this writing, the FASB's inventory has not been made available to the public.

⁴⁰ FASB Project Update, Revenue Recognition—Joint Project of the FASB and IASB, September 21, 2011, available at www.fasb.org.

⁴¹ Hendriksen and van Breda, Accounting Theory, p. 370.

⁴² C. T. Horngren, S. M. Datar, and M. Rajan, Cost Accounting: A Managerial Emphasis, 14th ed. (Englewood Cliffs, NJ: Prentice-Hall, 2012).

⁴³ SEC Division of Corporate Finance, Current Accounting and Disclosure Issues, December 1, 2005, Section II.F.3.

⁴⁴ Ibid.

⁴⁵ Kieso, Weygandt, and Warfield, Intermediate Accounting, p. 391.

⁴⁶ SFAC No. 6, par. 234.

12.8 Sources and Suggested References

American Institute of Certified Public Accountants. APB Opinion No. 10, Omnibus Opinion—1966. New York: Author, 1966.

_____. APB Opinion No. 29, Accounting for Nonmonetary Transactions. New York: Author, 1973.

_____. APB Statement No. 4, Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises. New York: Author, 1970.

_____. Civil Aeronautics Subcommittee. Industry Audit Guide, Airlines. New York: Author, 2010.

_____. Committee on Accounting Procedure. Accounting Research Bulletin No. 43, Restatement and Revision of Accounting Research Bulletins. New York: Author, 1953.

_____. Construction Contractors Guide Committee. Audit and Accounting Guide, Construction Contractors and Real Estate Ventures. New York: Author, 2010.

_____. Gaming Industry Special Committee. Audit and Accounting Guide, Gaming. New York: Author, 2010.

_____. Government Contractors Guide Special Committee, Audit and Accounting Guide, Government Auditing Standards and Circular A-133 Audits. New York: Author, 2010.

_____. Statement of Position 97-2, Software Revenue Recognition. New York: AICPA, 1997.

_____. Stockbrokerage and Investment Banking Committee. Audit and Accounting Guide, Brokers and Dealers in Securities. New York: Author, 2010.

_____. Technical Practice Aids, Accounting and Auditing Publications Technical Questions and Answers (TIS Section 5100), Revenue Recognition. New York: AICPA, 2002.

Accounting Standards Board (U.K.). Amendment to Financial Reporting Standard No. 5, Application Note G, Reporting the Substance of Transactions: Revenue Recognition. London: Author, 2003.

_____. Discussion Paper, Revenue Recognition. London: Author, July 2001.

American Accounting Association. Committee on Accounting Concepts and Standards, Accounting and Reporting Standards for Corporate Financial Statements (1957 Revision. Sarasota, FL: Author, 1957.

_____. Concepts and Standards Research Committee on the Realization Concept, “The Realization Concept,” Accounting Review, April 1965.

Canning, J. B. The Economics of Accounting. New York: Ronald Press, 1929.

Committee of Sponsoring Organizations of the Treadway Commission. Fraudulent Financial Reporting: 1987–1997. An Analysis of U.S. Public Companies. New York: Author, March 1999.

Dell, Inc. Form 8-K Non-Reliance on Previously Issued Financial Statements for the event date August 13, 2007.

Edwards, E. O., and P. W. Bell. The Theory and Measurement of Business Income. Berkeley: University of California Press, 1965.

Financial Accounting Standards Board. Accounting Standards Codification. Norwalk, CT: Author, 2009.

_____. Discussion Memorandum, An Analysis of Issues Related to Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and Their Measurement. Norwalk, CT: Author, 1976.

_____. Exposure Draft of Accounting Standards Update No. 1820-100, Revenue Recognition (Topic 605): Revenue from Contracts with Customers. Norwalk, CT: Author, June 2010.

_____. Invitation to Comment, Accounting for Certain Service Transactions. Norwalk, CT: Author, 1978.

_____. Emerging Issues Task Force, Issue No. 91-9, Revenue and Expense Recognition for Freight Services in Process. Norwalk, CT: Author, 1992.

_____. Issue No. 99-V, Remaining Issues from the SEC's October 18, 1999 Letter to the EITF. Norwalk, CT: Author, 2002.

_____. Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. Norwalk, CT: Author, 2002.

_____. “Project Updates—Revenue Recognition—Joint Project of the FASB and IASB.” Norwalk, CT: Author, September 21, 2011.

_____. Statement of Financial Accounting Concepts No. 1, Objectives of Financial Reporting by Business Enterprises. Norwalk, CT: Author, 1978.

_____. Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information. Norwalk, CT: Author, 1980.

_____. Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises. Norwalk, CT: Author, 1984.

_____. Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements. Norwalk, CT: Author, 1985.

_____. Statement of Financial Accounting Standards No. 13, Accounting for Leases. Norwalk, CT: Author, 1977.

_____. Statement of Financial Accounting Standards No. 48, Revenue Recognition When Right of Return Exists. Norwalk, CT: Author, 1981.

_____. Statement of Financial Accounting Standards No. 52, Foreign Currency Translation. Norwalk, CT: Author, 1981.

_____. Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. Norwalk, CT: Author, 995.

_____. Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities. Norwalk, CT: Author, 1998.

_____. Statement of Financial Accounting Standards No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities; An Amendment of FASB Statement No. 133. Norwalk, CT: Author, 2000.

Graciano, G. “Revenue Recognition: A Perennial Problem,” Financial Executive Magazine, July 14, 2005.

Green Mountain Coffee Roasters, Inc. Form 8-K Non-Reliance on Previously Issued Financial Statements for the event date November 15, 2010.

Hendriksen, E. S., and M. F. van Breda. Accounting Theory, 5th ed. Homewood, IL: Irwin, 1992.

Horngren, C. T. “How Should We Interpret the Realization Concept?” Accounting Review (April 1965).

Horngren, C.T., S. M. Datar, and M. Rajan. Cost Accounting: A Managerial Emphasis, 14th ed. Englewood Cliffs, NJ: Prentice-Hall, 2012.

International Accounting Standards Committee. International Accounting Standard No. 18, Revenue. London: Author, 1993 (amended 1998 and 2009).

Iyengar, P. “Application Development in the Cloud: Strategies and Tactics for a New Generation,” Gartner, Inc. (November 2009).

Jaenicke, H. R. Survey of Present Practices in Recognizing Revenues, Expenses, Gains, and Losses. Norwalk, CT: FASB, January 1981.

Kieso, D. E., J. J. Weygandt, and T. D. Warfield. Intermediate Accounting, 14th ed. Hoboken, NJ: John Wiley & Sons, 2011.

Mallor, J. P., A. J. Barnes, T. Bowers, M. J. Phillips, and A. W. Langvardt. Business Law and the Regulatory Environment: Concepts and Cases, 11th ed. Chicago: Irwin McGraw-Hill, 2001.

May, G. O., Financial Accounting: A Distillation of Experience. New York: Macmillan 1943.

Meyers, J. H. “The Critical Event and the Recognition of Net Profit,” Accounting Review (October 1959).

O'Reilly, V. M., M. B. Hirsch, P. L. Defliese, and H. R. Jaenicke. Montgomery's Auditing, 11 ed. New York: John Wiley & Sons, 1990.

Overstock.com, Inc. Form 8-K Non-Reliance on Previously Issued Financial Statements or a Related Audit Report of Completed Interim Review for the event date January 29, 2010.

Paton, W. A., and A. C. Littleton. An Introduction to Corporate Accounting Standards. Sarasota, FL: AAA, 1940.

Paton, W. A., and W. A. Paton Jr., Corporation Accounts and Statements. New York: Macmillan, 1955.

Pulliam, S., and R. Blumenstein. “SEC Broadens Investigation into Revenue-Boosting Tricks,” Wall Street Journal, May 16, 2002.

Securities and Exchange Commission. Accounting and Auditing Enforcement Release No. 1864, SEC and United States Attorney Charge Former Homestore Executives with Scheme to Inflate Advertising Revenue. Washington, DC: Author, September 18, 2003.

_____. Accounting and Auditing Enforcement Release No. 1874, SEC and Justice Department Bring Civil and Criminal Actions Charging Former CFO of Company that Engaged in Fraudulent Barter Deals with Homestore. Washington, DC: Author, September 26, 2003.

_____. Accounting and Auditing Enforcement Release No. 2045, Gemstar-TV Guide International Agrees to Settle SEC Enforcement Action Charging the Company with Overstating Its Revenues. Washington, DC: Author, June 21, 2004.

_____. Accounting and Auditing Enforcement Release No. 2125, Order Instituting Public Administrative Proceedings Pursuant to Rule 102(E) of the Commission's Rules of Practice, Making Findings, and Imposing Remedial Sanctions in the Matter of KPMG LLP, Bryan E. Palbaum, CPA, John M. Wong, CPA, Kenneth B. Janeski, CPA, David A. Hori, CPA. Washington, DC: Author, October 20, 2004.

_____. Accounting and Auditing Enforcement Release No. 3137, SEC Charges Diebold and Former Financial Executives with Accounting Fraud. Washington, DC: Author, June 2, 2010.

_____. Accounting and Auditing Enforcement Release No. 3171, Order Instituting Public Administrative Proceedings Pursuant to Section 4C of the Securities Exchange Act of 1934 and Rule 102(e) of the Commission's Rules of Practice, In the Matter of Dohan & Company CPAs, Steven H. Dohan, CPA, Nancy L. Brown, CPA and Erez Bahar, Chartered Accountant (CA). Washington, DC: Author, August 9, 2010.

_____. Accounting Series Release No. 95, Accounting for Real Estate Transactions Where Circumstances Indicate That Profits Were Not Earned at the Time the Transactions Were Recorded. Washington, DC: Author, 1972.

_____. Accounting and Auditing Enforcement Release No. 3217, SEC Charges Vitesse Semiconductor Corporation and Four Former Vitesse Executives in Revenue Recognition and Options Backdating Schemes. Washington, DC: SEC, December 10, 2010.

_____. Accounting and Auditing Enforcement Release No. 3311, Judgement of Permanent Injunction and Other Relief Entered Against Defendant Karlheinz Redekopp and Order Instituting Administrative Proceedings, Making Findings and Imposing Sanctions. Washington, DC: Author, August 4, 2011.

_____. Division of Corporation Finance. Current Accounting and Disclosure Issues. Washington, DC: Author, December 1, 2005.

_____. Exchange Act Release No. 17878, “Order Instituting Proceedings and Opinion and Order Pursuant to Rule 2(e) of the Commission's Rules of Practice In the Matter of Arthur Andersen & Co.” Washington, DC: Author, 1981.

_____. Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements. Washington, DC: Author, 1999.

_____. Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements—Frequently Asked Questions and Answers. Washington, DC: Author, October 2000.

Staubus, G. J. Making Accounting Decisions. Houston: Scholars Book Co., 1977.

Vatter, W. J. The Fund Theory of Accounting and Its Implications for Financial Reports. Chicago: University of Chicago Press, 1947.

Windal, F. W. “The Accounting Concept of Realization,” Accounting Review (April 1961).

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Table of Contents for Chapter 12: Revenues and Receivables

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12.1 Nature and Measurement of Revenue

(a) Definition and Components of Revenue