Suzie's Sweater: The New Paradigm in Accounting: Revenue Recognition Is the #1 Problem in Financial and Accounting Fraud
King, Alfred M., Strategic Finance
Here is a Pop Quiz, students: At 11:30 p.m. on Dec. 31, Suzie comes into a store and buys a sweater for $100. She pays cash but is then apologetically told that her size is temporarily out of stock so she should come back on Tuesday; the store will then have the sweater in her size and she can pick it up.
You are the accountant for the store, and, unfortunately, business was slow that day so Suzie's sweater sale was the only transaction. You now have to make the accounting entries for day's business.
What are the correct entries? I'll give you one You should debit cash for $100, so only problem is what is or are the offsetting credit(s)?
If you answered that the correct credit entry should be to credit deferred revenue for $100, you would flunk the test--at least if the Financial Accounting Standards Board (FASB) were doing the grading that day. The "correct" entry, assuming the cost to the store for the sweater is $80, is to recognize $20 of income on Dec. 31 and have a liability (to deliver the sweater) of $80.
REVENUE RECOGNITION IS THE PROBLEM
Most observers of financial and accounting fraud have identified revenue recognition as the country's number-one problem. When should revenue be recognized, and in what amounts, is far more complex an issue than is generally accepted. Just a simple example will suffice.
A software company sells a customer software, which includes services to help the customer install the system, access to a help desk for the next two years, and promised upgrades to the software as and when they are available. How much of the single total selling price relates to the software and can be recognized upon delivery, and how much has to be deferred for future services?
The answer to this conundrum is complex and beyond the scope of this article. Suffice it to say that a lot of time and effort have been spent on this issue over the past 10 or more years, and there is as yet no consensus as to the correct answer. The FASB, Emerging Issues Task Force (EITF), and Securities & Exchange Commission (SEC) have all weighed in on the issue, perhaps even with seemingly conflicting advice. This example could be multiplied 100-fold, and some observers have stated that there are more than 200 separate approaches to revenue recognition in today's accounting literature.
THE FASB SOLUTION
The FASB has tackled the problem of revenue recognition and is attempting to resolve it starting from a conceptual approach. This approach has been referred to as an "Asset-and-Liability Approach" and starts with the premise that you must look at and evaluate the liability the seller assumes when the customer places an order.
Put in its simplest terms, the FASB believes that the seller of Suzie's sweater only has a liability for $80 after Suzie has paid her cash. The logic is that the store owes her a sweater, and the cost to provide the sweater (perhaps including normal operating costs) is $80. …