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The general revenue recognition standard, FASB Concepts Statement (CON) No. 5, Recognition and Measurement in Financial Statements, is met for cash sales in retail stores — the revenue is both realized and earned. For cash sales, revenue is therefore recognized at the point of sale.
Right of Return
The general rule is modified if a right of return exists, unless all six conjunctive conditions of FASB Statement No. 48, Revenue Recognition when Right of Return Exists, are met. These six conditions were discussed in Chapter FIN-I C.2.a.iv and Procedure FIN-I 2. For retailers, these conditions are essentially about the ability to estimate future returns in the typical retail sale. Since estimating returns is possible in most instances, the general rule of revenue recognition at the time of sale applies. In situations where the retailer cannot estimate the future returns, such as when a new type of product is sold, then revenue is recognized at the termination of the return period (for example, after 30 days).
Club memberships are typically sold by discount retailers to customers who want the privilege of shopping in the discount store. Such memberships are cancelable, in most cases, for the life of the membership whereas others are for a stated period. Recognition of the revenue from a membership fee occurs only at expiration of the membership (or the stated period), according to SEC Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition. Since the SEC believes that full refund of the membership fee creates an uncertainty as to whether it is fixed or determinable, no recognition is permitted until expiration.
While this is the rule for publicly traded enterprises, a privately held entity could arguably estimate the amount of refunds and book the net revenue at the time the membership fee is collected. This approach is in accordance with the treatment of revenue under Statement 48.
Gift Certificate revenue is not booked until it is earned; that is, until the holder redeems the certificate. An unearned revenue or contingent liability must be established until such time as the certificates are redeemed. As for unredeemed certificates, the accounting policy of a “reasonable” period of expiration should be indicated on the certificate. At the point when the certificate has expired, revenue is recognized on the unredeemed certificate.
William buys his spouse a $1,000 spa package gift certificate. It has a one-year expiration. She divorces William six months later and destroys the gift certificate. At the end of the expiration period, despite the certificate’s destruction, the spa has earned and can recognize the revenue.
In addition to gift certificates, retail stores have begun to offer a vast array of “reward programs.”
Here are just a few:
Customer Appreciation Cards: Best Buy Co., for example, will give a customer a gift or appreciation card for purchasing a big-ticket item.
Cash Vouchers: Numerous retail stores, such as Pacific Sunwear of California, Inc., award customers cash vouchers for future purchases if the customer purchases a certain type of merchandise or quantity of goods.
Loyalty Programs: Circuit City Stores, Inc., for example, will award customers points that are good for future store discounts. Men’s Wearhouse, Inc. has a “Perfect Fit” loyalty program whereby customers receive a $50 award for every $500 spent in the store.
While gift certificates must be redeemed or expire before the retailer can legitimately recognize the revenue, it seems advisable, for reward programs, to create a liability that adjusts the revenue account based on an estimate of customer use. The FASB’s revenue recognition project will likely address the proper revenue treatment for these award and loyalty programs. This FASB project is discussed in Chapter FIN I.C.2.a.iii.
These are found in most department stores and, to a degree, in discount stores. In a layaway plan, the customer pays for the merchandise over time and then takes possession of the merchandise at a future date. The SEC has found that recognition of any revenue received from the customer must be deferred until the merchandise is available to the customer according to SAB 104.
Although, as with refundable membership fees, only publicly traded retailers need be concerned about this rule, privately held companies should follow this public standard because of the analogy to “bill-and-hold” transactions. The payments made by the customer are retailer liabilities, and unclaimed merchandise is still the property, as before, of the merchant. The financial accounting and legal rules are therefore in agreement that no sale has taken place in a layaway (or bill-and-hold) arrangement for either the publicly traded or the privately held retailer.
Revenue recognition rules for e-retailers (dot.coms) receiving online orders are the same as for the brick-and-mortar retailers. Revenue is recognized upon shipment of the merchandise, subject to the right-of-return rules of Statement 48. If the e-retailer is a mere commission agent, then it is entitled to recognize as revenue only its commission, not the sales revenue from the customer offset by the amount paid to the seller as a cost of sales. See EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent.”
Because Issue 99-19 applies rather broadly, online retailers or merchants engaged in transactions related to advertisements, event or other ticket programs, auctions, catalogs, or other such marketing ventures should review certain indicators to determine whether to report the entire amount received from the customer (end user) as revenue and the amount paid to the vendor as cost of sales or to report only the net amount as revenue. In other words, should revenue be recognized based on the gross amount billed to a customer or the net amount retained? Issue 99-19 attempts to answer this question.
While Internet retailers are particularly affected by Issue. 99-19, it clearly also applies to non-Internet or non-virtual retailers and service providers.
Under Issue 99-19, gross revenue reporting is indicated by eight factors.
The company is the primary obligor — that is, the party to whom the customer looks for ultimate satisfaction. Think of this as a legal criterion whereby the benefits and burdens of the contractual arrangement rest with the company and not another vendor. Of the eight factors, this is by far a most critical. In a nutshell, if the end user views the company as the ultimate seller in the chain of distribution — and can hold the company legally responsible for defective goods or services — then the remaining factors, while important, generally will not overcome the rebuttable presumption of gross revenue reporting.
The company bears general inventory risk; that is, the risk of resale rests with the company, which purchased the inventory with the intent to resell (this is the typical retail case). Similarly, if a service provider has contracted to purchase service from its supplier without the assurance of ultimate customers, gross revenue reporting is appropriate.
The company is a price maker not a price taker; that is, the company has discretion in setting the ultimate price for its goods or services. This factor underlies the theory behind gross revenue reporting: that the company is acting as a principal and not as an agent under fundamental legal maxims of the principal-agency relationship.
The company retains the obligation to alter the product when requested or to perform part of a customer demanded service.
The company is the ultimate arbiter of vendor selection. Indeed, it may seek to have multiple vendors (as back-up vendors) to mitigate an out-of-stock condition. This further emphasizes its principal status.
The company assists the customer in product or service specifications. This supports gross revenue reporting.
The company carries the physical risk of loss during shipment. This factor is probably the weakest. Given the fact that risk of loss can be negotiated (with larger customers) and that most transportation contracts are FOB destination point, as described in Part IV, Legal Rules, many practitioners feel this factor has little substance in the ultimate determination of gross revenue reporting.
In a similar vein, the company must bear credit risk. However, in today’s e-credit world, a company will rarely ship merchandise without first obtaining a valid credit authorization — particularly if the retail company is an e-retailer. So, like the preceding factor, this is not a critical factor for gross revenue reporting.
The following example illustrates gross revenue reporting under Issue 99-19:
Mr. and Mrs. Retiree are living on a fixed income. Their prescriptions have been increasing in cost in Florida, so they decide to have their prescriptions filled in Canada. Company is a U.S. service provider of Canadian prescription drugs and enrolls the Retirees, taking their prescriptions with the physician information.
Company requires that the Retirees enter into an arrangement with Company as the sole provider of the drugs and the Retirees will look to Company for fulfillment and satisfaction. Company has general inventory risk (including currency exchange risk on inventory value), sets the retail drug price, will substitute the generic brand if requested by the customer, sets pharmacy/drug vendor policy, and incurs physical inventory loss (if any) on shipment and credit risk.
Under Issue 99-19, this U.S. enterprise selling the drugs to the Retirees is allowed to recognize revenue on a gross basis.
In contrast, Issue 99-19 sets forth three criteria as indicators of net revenue reporting:
The company is not a principal but a mere agent of the vendor. It is the latter entity that acts as the primary obligor in the customer arrangement.
The company is compensated by the vendor on a fixed transaction basis, such as $100 per transaction or 10% of the total customer fee.This is evidence of the agency relationship and that net revenue reporting is required.
In cases where credit is an issue or payment is not preauthorized, the credit risk is wholly the vendor’s.
The following example illustrates net revenue reporting under Issue 99-19.
The facts are the same as in the preceding example, except that the Retirees enter into an arrangement with a U.S. commission-based company selling Canadian drugs. They are informed of the agency relationship and that any credit transactions must be approved by the Canadian vendor. The U.S. commission-based company is compensated at a 10% rate on the value of the customer’s order.
Under Issue 99-19, the U.S. commission-based company selling the drugs to the Retirees is required to recognize revenue on a net basis.
See Procedure IND-II L1 for a checklist that helps evaluate whether revenue recognition should be on a gross or net basis.
Many retail sales are accompanied by service agreements. In specialty stores such as appliance, furniture, or electronics retailers, it is standard business practice to attempt to sell a lucrative service agreement with the item. Revenue from such an agreements is deferred at the point of sale and recognized over the life of the agreement. Recognition is based on the rate at which cost is incurred. If 25% of the costs for the extended maintenance agreement occur in the last year of the three-year contract, then 25% of the deferred revenue is recognized in that year, as per FASB Technical Bulletin (FTB) No. 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts.
Excerpted by permission. Copyright 2007, Specialty Technical Publishers.