Revenue-Recognition Decisions: A Slippery Slope?
Clark, Ronald L., The CPA Journal
Consider this scenario: Capitol Motors is in its first year of operations and as of December 30 has total revenues of $5 million, projected net income of $200,000, and total assets of $40 million (Capitol's year-end is December 31). On December 31, a customer and Capitol Motors agree to terms on the purchase of a new automobile for $25,000. The customer signs and completes all paperwork for the sale but asks Capitol to hold the full-payment check until he can complete financing with a local bank. Because the bank has already closed for the day, it will be January 2 before the customer can release the check to Capitol. The customer already has a $30,000 line of credit approved by his bank, The Capitol Motors' credit manager reviews the customer's file and offers to finance the transaction through the dealership's financing company. The customer, however, wishes to use a local bank and declines the financing offer. The customer and Capitol agree to leave the automobile on the dealership lot overnight so it can be properly serviced (e.g., washed, fluid levels checked). Given these facts, should Capitol Motors record a sale as of December 31?
This case was presented to approximately 700 CPAs in continuing education courses taught by the author. On each occasion, a majority of CPAs indicated they would book the transaction as a December 31 sale. The two primary reasons given were the following:
* All significant aspects of revenuerecognition requirements had been met;
* The sale is immaterial to total revenue, therefore recording the transaction on December 31 would not be inappropriate.
The Revenue-Recognition Argument
Accountants have traditionally recognized revenues when realized and earned Matched against these revenues are expenses incurred in generating the revenues. This is referred to as the realization/earnings/matching approach. FASB, however, is working on a revenue-recognition project that is expected to follow the asset/liability approach, under which revenue is recognized and measured based on the change in assets and liabilities. The intent here is not to debate the two approaches, but for the case at hand one could argue that revenues would be recognized regardless of the approach used.
As stated above, most of the CPE session participants agreed that the automobile dealership had "earned" the revenue because all significant aspects of the sale had been met. Under the asset/liability approach it is clear the dealership has increased an asset-at a minimum as accounts receivable-and therefore should recognize the revenue.
One might argue that because the servicing of the automobile is insignificant to the purchase price, the earnings process is complete. Another possible situation deserves consideration, however What if the customer changes his mind and decides not to purchase the automobile and never returns to UK dealership? Can (or would) the dealer force the customer to purchase the automobile? One must, therefore, consider the possibility of a "right of return."
Right of Return
SFAS 48, Revenue Recognition When Right of Return Exists (released June 1981), describes how to account for a sale when the buyer has a right to return the product. Revenue from sales transactions with a right of return shall be recognized at time of sale only if certain conditions are met. Even then, the seller should accrue any estimated returns and expected costs. If the following criteria are not met, revenue recognition should be postponed:
* The price is substantially fixed or determinable at the date of sale;
* The buyer has paid or is obligated to pay the seller,
* The buyer's obligation to the seller would not be changed in the event of the theft, physical destruction, or damage of the product; and
* The amount of future returns can be reasonably estimated.
Returning to the example above, the first question is whether SFAS 48 applies. …