Question

CA18-3 (Recognition of Revenue—Theory) Revenue is usually recognized at the point of sale (a point in time). Under special circumstances, however, bases other than the point of sale are used for the timing of revenue recognition.

Instructions

(a) Why is the point of sale usually used as the basis for the timing of revenue recognition?

(b) Disregarding the special circumstances when bases other than the point of sale are used, discuss the merits of each of the following objections to the point-of-sale basis of revenue recognition:

(1) It is too conservative because revenue is earned throughout the entire process of production.

(2) It is not conservative enough because accounts receivable do not represent disposable funds, sales returns and allowances may be made, and collection and bad debt expenses may be incurred in a later period.

(c) Revenue may also be recognized over time. Give an example of the circumstances in which revenue is recognized over time and accounting merits of its use instead of the point-of-sale basis.

Short answer

1. Point of saleprovides evidence that performance obligations are satisfied. Therefore, it is used as a base for the timing of revenue.
2. Business entity must recognize the revenue over time because a portion of the project gets completed each year, and bad debt expenses must be matched in the same period when receivables are reported.
3. The business entities generating revenue from long-term construction projects will recognize revenue over time. This method will provide more relevant information than the point of sale.

Step-by-step solution

Definition of Allowance For Bad Debts

The reserve created by the business entity for adjusting the uncollectible debts is known as the allowance for bad debts. This allowance is made based on estimations.

Point of sale as a base for timing of revenue

All business entities generally use the point of sale as a base for the timing of revenue because it provides evidence regarding the transfer of assets and its control to the customers.

Step 3:Merits of objections to the point of sale as basis of revenue recognition

1. It is too conservative because revenue is earned throughout the entire process of production: It is stated that the revenue is earned during the whole production process, but it is not convenient for the business entity to determine revenue based on operating activity. It is impossible to determine the revenue to be recognized for the period.

In general, the sale is said to be the point at which the performance obligations are satisfied. Revenue estimated before sales are just prospective revenue. It gets realized after the actual sale only. Therefore, the sale cannot be considered a conservative basis for revenue recognition.

2. Point of sale does not prove to be conservative because the accounts receivables reported by the business entity do not reflect the amount that can be collected from the sale because some of the receivables might be uncollectible. Therefore, the revenue and net income must depend upon the cash collection made by the business entity. The business entity must match the cost of managing receivables (bad debts) with the sales made on account in the same period.

Adjustments to revenue such as returns and bad debts can be measured with high accuracy and, therefore, do not degrade the information reported in the financial statement.

Recognizing revenue over time

The business entities engaged in long-term construction projects will recognize their revenue over time. For such business entities, point of sale does not prove significant in recognizing revenue.

Suppose the business entity defers the revenue from the project until it is completed. In that case, it will affect the usefulness of the intermediate annual financial statements because a portion of the contract will get completed each period, and proportionate revenue must be recognized for it.

Recognizing revenue over the period will provide more relevant information than the point-of-sale information.