Revenue Recognition - Cash Basis
When is cash basis, rather than accrual, preferable or required?
In the case of a company selling inventory, the accrual basis is used. However, the cash basis of revenue recognition is used under certain circumstances, namely, when revenue is recognized upon collection of the account. Note that a service business that does not deal in inventory (e.g., accountant, doctor, lawyer) has the option of either using the accrual basis or cash basis. The cash basis instead of the accrual basis must be used when one or more of the following exist:
o Inability to objectively determine selling price at the time of sale
o Inability to estimate expenses at the time of sale
o Risks as to collections from customers
o Uncertain collection period
How do I compute revenue under the installment method?
Revenue recognition under the installment method equals the cash collected times the gross profit percent. Any gross profit not collected is deferred on the balance sheet until collection occurs. When collections are received, realized gross profit is recognized by debiting the deferred gross profit account. The balance sheet presentation is:
Accounts Receivable (Cost + Profit)
Less: Deferred Gross Profit
Net Accounts Receivable (Cost)
How is revenue recognized if the buyer can return the goods?
When a buyer has a right to return the merchandise bought, the seller can only recognize revenue at the time of sale in accordance with FASB 48 provided that all of the following conditions are satisfied:
o Selling price is known.
o Buyer has to pay for the goods even if the buyer is unable to resell them. EXAMPLE: A sale of goods from a manufacturer to wholesaler. No provision must exist that the wholesaler has to be able to sell the items to the retailer.
o If the buyer loses the item or it is damaged in some way, the buyer still has to pay for it.
o Purchase by the buyer of the item has economic feasibility.
o Seller does not have to render future performance in order that the buyer will be able to resell the goods.
If any of above criteria are not met, revenue must be deferred along with deferral of related expenses until the criteria have been satisfied or right of return provision has expired. As an alternative to deferring the revenue, record a memo entry as to the sale.
What factors affect the ability of a company to predict returns?
The following considerations may be used in predicting returns:
o Predictability is hampered when there is technological obsolescence risk of the product, uncertain product demand changes, or other material external factors.
o Predictability is lessened when there is a long time period involved for returns.
o Predictability is enhanced when there exists a large volume of similar transactions.
o The seller's previous experience
o The nature of customer relationship
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