Revenue Recognition in Auditing

Revenue is the electricity that drives business. Revenue has been the starting point on every income statement generated, every sales meeting conducted, and is on every entrepreneur’s wish list. The basic concept for revenue recognition is that revenue should not be recognized until it is realized or realizable and earned. There are also four criteria must be met in order to recognize revenue:

1. persuasive evidence of an arrangement exists: Consider the substance of the transaction and not merely its form.
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   Because the SEC believes that a sale has not taken place if a "sale" is only intended for demonstration purposes, or if the seller is obligated to repurchase the product at specific prices, or if the buyer can return the goods and the buyer has no specific payment obligation;

2. delivery has occurred or services have been rendered: Ownership and risk must have been transferred to the buyer. The SEC does not consider delivery to have occurred unless the product has been delivered to either the customer or another site specified by the customer.
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   This also means that the goods have been accepted by the customer;

3. the seller’s price to the buyer is fixed or determinable: This occurs when the customer does not have the unilateral right to terminate or cancel the contract and receive a cash refund. If you cannot reliably estimate the amount of any future cash refunds, then you must defer revenue recognition. If a price is conditional on a future event, then it is not fixed or determinable, so revenue recognition cannot occur;
4. collectability is reasonably assured: If you cannot reasonably estimate an allowance for doubtful account, then you cannot recognize revenue until you can make such an estimation.
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Revenue Recognition Scenarios

Overall, AOL is selling two things in a one-year contract: software and Internet services. Let’s look at the software first. When AOL sells software to a customer, there is a contract between AOL and the customer, as described in the scenario, so that there is persuasive evidence that an arrangement exists. However, the auditor doesn’t know whether the software supposed to be delivered to the customer or not, because the customer may not install the software or may return it. The scenario also shows that a service fee of $19. 95 per month is included in the contract, which means that is $239. 4 for a year and 30% of that will be recognized immediately as revenue from the sale of software. But, the specific price of the software is unknown. In addition, we could not assure the collectability. Now, let’s look at the Internet services. Obviously, it dose meet the first criteria. However, the key issues that we have to determine are the actual month that AOL provides the Internet services to the customers and the number of customers. In conclusion, the auditor may want to know the actual month that AOL provides the Internet services to each customer. Based on the information presented, the revenue should be recognized when the customer received the service for that certain month. The remaining balance is regarded as unearned revenue and should not be recognized.

Modis Manufacturing does meet the first criteria since the company met the contract date. Also, the seller’s price to the buyer is fixed, which is $45 million, so that the company met the third criteria. However, the key issue is that the products have been completed but are still not delivered to the customer according to customer’s request. In this case, the ownership of those products has already been transferred to the customer. The auditor may also want to know that whether the customer has made the payment to Modis Manufacturing or not. If the payment has been made, then the revenue should be recognized since the company meets the contract date and does not carry any obligations. In this scenario, criteria 1, 3 and 4 have been met. However, the key issue here is that we have to determine is the right to return the merchandise for a full refund or replacement with one year of purchase, since Standish Stoneware grants each customer the right to return the merchandise within a year. The additional information the auditor may want to know is that how many of the merchandise that has been sold and not being returned for a full refund, because the company still has the obligation to customers within the year. Based on the information presented, the revenue of the company would be recognized only after the sale for one year.

According to this scenario, Omer Technologies only met criteria 1, 2 and 4. For criteria 3, they key issue is that to find out what is the price break made by the sales staff, otherwise, we will not know whether the seller’s price to the buyer is determinable or not. Additionally, the auditor may also want to know the exact price that the sales staff offered to their customers during the fourth quarter of the year. In conclusion, after the company provides the additional information, the revenue of the company would be recognized only after the warranty period of the product ended and that no product returns from the customers. Base on this scenario, the criteria 1, 3 and 4 have been met. Even though Electric City is so confident that customers will buy the product after the “pilot” period, it still cannot 100% sure that all customers will buy the product. The key issue that we have to determine is that how many customers will continue to install the company’s product after the trial period after six months ended. The auditor may want to know that how many customers continued using the product as well as how many customers discontinued using the product. Revenue cannot be recognized at the time the product is installed at the customer location, because it is still within the six months period. Based only on the information presented, the revenue of the company would be recognized only after the trial period of six months ended.

Criteria 1, 3 and 4 have been met. The key issue here is to determine when the new manufacturing equipment on order is completed and delivered by the outsourced company, since we only know that Jacksons Products had over $5 million of new manufacturing on order and it is in a non-cancelable deal. Based on the information presented, the revenue should be recognized only when the new manufacturing equipment on order is completed and delivered by the outsourced company because the order is non-cancelable and agreed upon between the two parties, for example, Jackson Products and the customer, not the outsourced company.