Question

CA18-5 (Discounts) Fahey Company sells Stairmasters to a retailer, Physical Fitness, Inc., for \(2,000,000. Fahey has a history of providing price concessions on this product if the retailer has difficulty selling the Stairmasters to customers. Fahey has experience with sales like these in the past and estimates that the maximum amount of price concessions is \)300,000.

Instructions

(a) Determine the amount of revenue that Fahey should recognize for the sale of Stairmasters to Physical Fitness, Inc.

(b) According to GAAP, in some situations, the amount of revenue recognized may be constrained. Explain how the accounting for the Stairmasters sales might be affected by the revenue constraint due to variable consideration or returns.

(c) Some believe that revenue recognition should be constrained by collectibility. Is such a view consistent with GAAP? Explain.

Short answer

1. Gross method:$2,000,000 and net method: $1,700,000.
2. The goods returned by the customer are considered a constraint in recognizing revenue from the customers.
3. Collectibilityis a constraint in recognizing revenue because the expected bad debts are not adjusted in recognizing revenue.

Step-by-step solution

Definition of Credit Risk

The risk associated with collecting cash from the receivables is known as credit risk. This risk reflects the loss that will be incurred when the borrower cannot repay the amount borrowed.

Amount of revenue to recognize

Using the gross method of reporting revenue, the business entity must recognize revenue of $2,000,000.

A business entity using the net method must report $1,700,000 .

$\left(\$2,000,000-\$300,000\right)$

Constraints to recognize revenue

The revenue from the sales that are subjected to reversal might create a constraint in revenue recognition. Therefore, the companies will recognize revenue in two situations:

1. When the company has experience of a similar contract and can determine the amount of return or variable consideration.
2. When the company has previous experience not reversing the recognized revenue.

The business entity must recognize revenue for products with the right to return as follows:

1. The business entity must recognize the revenue equal to the amount the business entity is assured of collecting from the customer.
2. Setting up liability and asset account for reporting the right to recover product from the customer.

Collectibility as constraint to revenue recognition

Collectibilityis the credit risk associated with the customer to whom sales are made on credit. The business entity does not recognize the revenue after adjusting the customer’s credit risk. Instead, the business entity creates a provision account at year-end and reports it as operating expenses in the income statement.

If there exists doubt regarding the collection of amounts from the customer, then it can be said that parties to the contract are not committed to their obligations.