Lesson Objectives:- Determining when to recognize revenue
- Consignment and buyers criteria examples
- Introduction to long-term contracts
We talked about the revenue recognition criteria in the previous lesson. As a reminder, here is the criteria that should be used in determining when to recognize revenue:
Measurability must be reasonably certain. This means that the company must have a firm idea of the expectation for the pricing based on historical results and value.
The risk and rewards associated with the revenue have transferred substantially. These factors are transferred when the good is shipped to the customer.
Collectibility is reasonably assured meaning there is a greater chance than not of the payment being collected. The customer must have the ability and intent to pay for the product or service.
Let's look at a few more real life examples and how they fit into the criteria before we dive into the topic of long term contracts.
When goods are on consignment, that basically means that there is a consigner giving products to the consignee who will hopefully sell the products to a third party. The purpose of doing this is for the consignee to make a commission of the sale. An example would be when a publishing company gives books to a store to sell to their customers.
For the purpose of looking at revenue recognition, we will look at the consignor's revenue. The tricky part is that the consignor is not recognizing revenue when they give the goods to the consignee for several reasons in accordance with the criteria.
The measurability of the price is not reasonably certain because they may have to offer a discount on the product if it is not sold within a specific period of time.
The risk and rewards have not fully transferred because the consignee could still return the goods to the consignor.
Collectibility is also not assured because the goods have not yet been sold to a customer.
For a consignment situation, the revenue should be recognized when the goods are sold to a third party by the consignee.
The next example we will review is known as the buyer criteria check.
The buyer criteria check is most commonly used for art purchases, when the buyer determines whether the inventory they are purchasing is acceptable. This means that the product is subject to a check when it is received. The buyer has an opportunity to return it if it is not what they wanted or if it is damaged.
With this type of purchase, if the art doesn't pass the buyer's check and it is returned, the seller would not be able to recognize the revenue.
The seller may recognize the revenue once the buyers check is passed. At this time, measurability of the sale price will be certain and the seller is reasonably assured that payment will be collected.
Now, let's look an example of a long term contract.
Let's say the government has signed a long term contract for a laboratory building to be built over the course of four years. The job would involve a specific set of blueprints that the builders must follow when constructing the building.
This example would present a level of uncertainty when it comes to the cost performance as the risk and rewards are not transferred instantly because the laboratory building hasn't been built yet. The cost is defined in the contract but the government cannot yet reap the benefits from the building until it is completed.
Collectibility is not assured yet because again the building is not built yet as it is a long term contract. If for some reason it is not built to the proper specifications or ends up damaged, there is a risk for legal action against the contracted builder.
Recognizing revenue for long term contracts is a bit more complicated than simply using the performance and collectibility criteria. In the next lesson, we will cover exactly how to determine when revenue should be recognized when it comes to long term contracts such as the laboratory example.