5 Revenue Recognition and Accruals

Revenue Recognition

Revenue is recognized when or as it is earned. What does this mean? How does a company know when it has earned revenue? Let’s take a step back. When a company enters into a transaction with a customer, both parties have obligations to fulfill. Typically, the customer transfers cash to the company, and the company provides goods or services.

This bears repeating. A company needs to record a journal entry when the company or the customer act on their obligation. Two transactions will occur:

1. The company delivers a product or service to the customer. At this point a company recognizes revenue because it has been earned.
2. The customer pays for the product or service. At this point a company recognizes cash received.

In this section we focus on the first transaction. When should revenue be recognized?

Revenue is recognized when or as it is earned. But earned is fairly vague. What does that mean? It means that the risks and rewards of ownership are transferred to the customer. The customer has received economic benefit and controls any physical goods that were contracted. Hold on, it sounds like maybe the customer now owns an asset! Yes, indeed they do. The three asset criteria are met for the customer: the asset purchased is an economic resource, controlled by the customer, arising as a result of a past event. In this case, the past event is the sale transaction. Only one party can have control of an asset, so the physical goods can no longer be an asset to the selling company. This is a sale of inventory goods.

With services, revenue recognition is easier because the risk and reward transfers immediately when the service is performed. For example, a barber cuts a client’s hair. The client immediately benefits. He is now looking stylish, and his hair is not a nuisance to him. The barber has fulfilled his obligation to his client and can recognize the revenue from the haircut.

There will be signs that control has transferred to the customer. For example:

• service is completed,
• product goes home with a customer,
• payment is owing – the customer has been invoiced, or
• company ships product to the customer freight on board (FOB) shipping pointFOB Shipping Point:
  The customer takes responsibility for the product during transit. The seller has no obligation after the goods leave their warehouse. If the goods are lost, stolen, or damaged in shipping, it’s the customer’s loss..

Let’s look at some examples and work through some problems, starting with services and moving on to sale of physical goods. I’ll get us going.

My Turn:

TreeBeGone Co. is a tree removal company. On 15 April, they signed a contract with a customer to remove two large pine trees from the customer’s backyard. The customer will pay TreeBeGone $500 within 30 days of tree removal. On 30 April, TreeBeGone removed the trees. The customer paid for the tree removal on 15 May.

Required:

On what date should TreeBeGone recognize revenue for this service contract? Explain why.

TreeBeGone will recognize revenue once the revenue is earned: 30 April. At this point, TreeBeGone has removed the trees and has met their obligation to the customer.

Your turn to practice revenue recognition.

My Turn:

TableTop Inc. is a furniture manufacturer and wholesaler. On 01 August, a customer placed an order for ten coffee tables. The order was filled on 31 August and stored in the warehouse until 10 September when it was shipped FOB destinationFOB Destination:
The seller takes responsibility for the product during transit. If the goods are lost, stolen, or damaged in shipping, the seller is responsible for replacing them. The customer takes possession of the goods when they are delivered.. The customer received the furniture on 25 September and paid their invoice on 02 October.

Required:

On what date should TableTop recognize revenue for this furniture contract? Explain why.

TableTop will recognize revenue once the revenue is earned. For the sale of goods, this occurs when the risks and rewards of ownership are transferred to the customer. Goods were shipped FOB destination, which means that TableTop retains ownership of the goods until they reach the customer. Therefore, revenue will be recognized on 25 September when the goods reach the customer.

Great work. Take a look at these company scenarios…

Sometimes a contract will have two separate obligations. Maybe a customer purchases a phone and airtime minutes, or furniture plus delivery. Let’s look at some of these hybrid contracts.

My Turn:

Boundary Ltd. sells and installs residential fences. On 07 March, Boundary received a request to deliver and install a fence on a customer’s acreage. Boundary delivered the fencing to the acreage on 31 March, and the installation took place from 3–5 April. The customer was billed on 10 April, and payment was received on 15 April.

Required:

On what date(s) should Boundary Ltd. recognize revenue for the fence and installation? Explain why.

Boundary will recognize revenue once revenue is earned. Boundary earns revenue from the fence materials when they are delivered to the customer. At this point, ownership of the fence materials has passed from Boundary to the customer. Installation service revenue is earned once the installation is complete: 05 April.

Here’s your turn!