Revenue Recognition Introduction The Guidelines For Accounting For Revenue Are

Revenue Recognition Introduction The guidelines for accounting for revenue are simply stated as, “Revenues are not recognized until they're earned.” More specifically, "Revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues” (Donnelly 1999). However, certain FASB standards and EITF issues define earned revenues in a way that alters when companies report revenue and how much they should record at that time. FASB Codification has provided some assistance to seaming out these discrepancies. With the new codification, “the answers to hard accounting questions should be easier to track down” (Johnson 2008). Nevertheless, evaluators of financial statements still find a thread of inconsistency between companies’ methods of revenue recognition. Impairment of Estimates of Return Certain companies allow customers to make returns on merchandise, leading to a reduction in sales. Therefore it is important for those companies to make reliable estimates of future returns. According to Codification: 605-15-25-3, the following main factors impair the ability to make a reasonable estimate of returns: 1. The susceptibility of the product to significant external factors, such as technological obsolescence or changes in demand. 2. Relatively long periods in which a particular product may be returned. 3. Absence of historical experience with similar types of sales of similar products, or inability to apply such experience because of changing circumstances, for example, changes in the selling entity's marketing

policies or relationships with its customers. 4. Absence of a large volume of relatively homogeneous transactions. Recognizing Revenue when the Right of Return Exists On the contrary, companies that allow the right of returns from buyers must follow six criteria that must be met before they recognize revenue. These criteria, found in Codification: 605-15-25-1 include: 1. The seller's price to the buyer is substantially fixed or determinable at the date of sale. 2. The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product. If the buyer does not pay at time of sale and the buyer's obligation to pay is contractually or implicitly excused until the buyer resells the product, then this condition is not met. 3. The buyer's obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product. 4. The buyer acquiring the product for resale has economic substance apart from that provided by the seller. This condition relates primarily to buyers that exist on paper, that is, buyers that have little or no physical facilities or employees. It prevents entities from recognizing sales revenue on transactions with parties that the sellers have established primarily for the purpose of recognizing such sales revenue. 5. The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer. 6. The amount of future returns can be reasonably estimated because detailed record keeping for returns for each product line might be costly in some cases, this Subtopic permits reasonable aggregations and approximations of product returns. Exchanges by ultimate customers of one item for another of the same kind, quality, and price (for example, one color or size for another) are not considered returns for purposes of this Subtopic. If revenue fails to meet the criteria above, it should be recognized “when the return privilege has substantially expired or if those conditions subsequently are met, whichever occurs first” (Codification: 605-15-25-1). Hewlett Packard and Advanced Micro Devices Inc. 10-K Report Differences

Hewlett Packard Company’s 2008 10-K report

claims that they “reduce revenue for estimated customer returns,” (HP 2008 10-K report, pg 86). Advanced Micro Devices Inc.’s 2008 10-K report claims that “estimated product returns are based on actual historical experience and other known or anticipated trends and factors, [and] are recorded at the time revenue is recognized” (AMD 2008 10-K report, pg 97). While there are similar standards within each company, the policies applied are unalike. AMD treats customers and distributors differently, as stated in their notes. AMD also allows for distributors to return items after the item has been removed from the company’s price book, something not found in HP’s policy. AMD then recognizes revenue until the distributor sells the item (AMD 2008 10-K report, pg 97). Revenue Recognition: Gross or Net Method? Online retailers that act as intermediate parties to manufacturers and customers must decide whether to report its revenues on a gross or net basis. The FASB codification 605-45-45-1 notes that it is a matter of judgment on the entity’s behalf to report revenue based on the following two principles: 1. The gross amount billed to a customer because it has earned revenue (as a principal) from the sale of the goods or services 2. The net amount retained (that is, the amount billed to the customer less the amount paid to a supplier) because it has earned a commission or fee as an agent (Codification: 605-45-45-1). The FASB codification 605-45-45-[4-13] further states that there are certain elements for determining which method is appropriate. In total, there are 8 factors that suggest the gross basis for revenue recognition. 1. The Entity Is the Primary Obligor in the Arrangement. If an entity is responsible for fulfillment, including the acceptability of the products or services ordered or purchased by the customer, that fact is a strong indicator that an entity has risks and rewards of a principal in the transaction.

2. The Entity Has General Inventory Risk. Unmitigated general inventory risk is a strong indicator that an entity has risks and rewards as a principal in the transaction. 3. The Entity Has Latitude in Establishing Price. If an entity has reasonable latitude, within economic constraints, to establish the exchange price with a customer for the product or service, that fact may indicate that the entity has risks and rewards of a principal in the transaction 4. The Entity Changes the Product or Performs Part of the Service. If an entity physically changes the product (beyond its packaging) or performs part of the service ordered by a customer, that fact may indicate that the entity is primarily responsible for fulfillment, including the ultimate acceptability of the product component or portion of the total services furnished by the supplier. 5. The Entity Has Discretion in Supplier Selection. If an entity has multiple suppliers for a product or service ordered by a customer and discretion to select the supplier that will provide the product or service ordered by a customer, the entity is primarily responsible for fulfillment. 6. The Entity Is Involved in the Determination of Product or Service Specifications. If an entity must determine the nature, type, characteristics, or specifications of the product or service ordered by the customer, the entity is primarily responsible for fulfillment. 7. The Entity Has Physical Loss Inventory Risk—After Customer Order or During Shipping. Physical loss inventory risk exists if title to the product is transferred to an entity at the shipping point (for example, the supplier's facilities) and is transferred from that entity to the customer upon delivery. This indicator may provide some evidence, albeit less persuasive than general inventory risk. 8. The Entity Has Credit Risk. If an entity assumes credit risk for the amount billed to the customer, that fact may provide weaker evidence that the entity has risks and rewards as a principal in the transaction. On the other hand, Codification 605-45-45-[16-18] recognizes three scenarios in which companies would use the net method in revenue recognition. 1. The Entity's Supplier Is the Primary Obligor in the Arrangement. If a supplier (and not the entity) is responsible for fulfillment, including the acceptability of the products or services ordered or purchased by a customer, that fact may indicate that the entity does not have risks and rewards as principal in the transaction. 2. The Amount the Entity Earns Is Fixed. If an entity earns a fixed dollar amount per customer transaction regardless of the amount billed to a customer or if it earns a stated percentage of the amount billed to a customer, that fact may indicate that the entity is an agent of the supplier. 3. The Supplier Has Credit Risk. If credit risk exists but the credit risk is assumed by a supplier, that fact may indicate that the entity is an agent of the supplier and, therefore, the entity should record revenue net based on the amount retained. Revenue Recognition policy for Overstock.com Overstock.com currently uses the gross method in recording revenue from the majority of its sales, excluding auction and travel products. Agency and merchant revenues are further

recognized on the net basis (Overstock.com 2005 10-K report, pg 39). Overstock.com changed its revenue recognition policy in 2003 from the net method to the gross method. The main reason for the switch is that they started handling and taking responsibility for returned items from sales. As a result of this, Overstock.com is now considered the primary obligor for the sales transactions as of July 1, 2003. The company now assumes all risks of returned items and therefore changed its revenue recognition policy to the gross method (Overstock.com 2005 10-K report, pg F-14). Revenue Recognition Policy for Google Inc. According to Google’s 10-K report, the company reports revenues using the gross method in compliance with EITF Issue 99-19. Google specifically states that under this issue they report “revenues on a gross basis principally because [they] are the primary obligor to our advertisers” (Google Inc. 2008 10-K report, pg 69). Since Google is responsible for the “acceptability

of the product(s) or service(s) ordered or purchased by the customer,” they then obtain the “risks and rewards of a principal in the transaction and [should] record revenue gross based on the amount billed to the customer” (EITF Issue 99-19, pg 1). Works Cited Codification (605-15-25-3): Topic: 605 Revenue Recognition, Subtopic: 15 Products, Section: 25 Recognition, Sales of Product When Right of Return Exists (605-15-25-1): Topic: 605 Revenue Recognition, Subtopic: 15 Products, Section: 25 Recognition, Sales of Product When Right of Return Exists 10-K Reports Hewlett Packard Company 2008 10-K report, URL:http://sec.gov/Archives/edgar/data/47217/000104746908013240/a2189 375z10-k.htm Advanced Micro Devices Inc. 2008 10-K report, URL:http://sec.gov/Archives/edgar/data/2488/000119312509036235/d10k.ht m