Efficient Tests of Balances Series--No. 33: Auditing Revenues
Auditing revenues efficiently requires a thorough understanding of the applicable reporting framework. Principles of revenue recognition for U.S. GAAP are included in the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC).
To understand principles of revenue recognition for U.S. GAAP, we begin with the authoritative standards from the ASC.
Revenues and Gains:
605-10-25-1: The recognition of revenue and gains of an entity during a period involves consideration of the following two factors, with sometimes one and sometimes the other being more important consideration:
a. Being realized or realizable. Revenue and gains generally are not recognized until realized or realizable. Paragraph 83(a) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. That paragraph states that revenue and gains are realizable when related assets received or held are readily convertible to know amounts of cash or claims to cash.
b. Being earned. Paragraph 83(b) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue is not recognized until earned. That paragraph states that an entity’s revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations, and 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. That paragraph states that gains commonly result form transactions and other events that involve no earning process, and for recognizing gains, being earned is generally less significant than being realized or realizable.
Installment and Cost Recovery Methods of Revenue Recognition
605-10-25-3: Revenue should ordinarily be accounted for at the time a transaction is completed, with appropriate provisions for uncollectible accounts. Paragraph 605-10-25-1(a) states that revenue and gains generally are not recognized until being realized or realizable and until earned. Accordingly, unless the circumstances are such that the collection of the sale price is not reasonably assured, the installment method of recognizing revenue is not acceptable.
605-10-25-4: There may be exceptional cases where receivables are collectible over an extended period of time and, because of the terms of the transactions or other conditions, there is no reasonable basis for estimating the degree of collectability. When such circumstances exist, and as long as they exist, either the installment method or cost recovery method of accounting may be used. As defined in paragraph 360-20-55-7 through 55-9, the installment method apportions collections received between cost recovered and profit. The apportionment is in the same ratio as total cost and total profit bear to the sales value. Under the cost recovery method, equal amounts of revenue and expense are recognized as collections are made until all costs have been recovered, postponing any recognition of profit until that time.
Ordinarily, revenue from selling products should be recognized at the date of sale, and revenue from rendering services should be recognized when the services have been performed and are billable. An appropriate allowance for uncollectible accounts should also be provided. These conditions normally occur when the transaction is completed and installment sales generally aren’t acceptable unless there is doubt as to their collectibility.
Additional Revenue Recognition Guidelines
SFAC No. 5 provides the following additional guidelines:
• If a sale or cash receipt (or both) precedes production and delivery (e.g., a magazine subscription), revenue may be recognized as earned by production and delivery.
• If a product is contracted for before production, revenues may be recognized by a percentage-of-completion method as earned while production takes place, provided reasonable estimates of results at completion and reliable measures of progress are available.
• If services are rendered or rights to use assets extend continuously over time (e.g., interest or rent) and reliable measures based on contractual prices established in advance are commonly available, revenue may be earned as time passes.
• If products or other assets are readily realizable because they are salable at reliably determinable prices without significant effort (e.g., certain agricultural products, precious metals, and marketable securities), revenues and some gains or losses may be recognized at completion of production or when prices of assets change.
• If product, services or other assets are exchanged for non-monetary assets that are not readily convertible into cash, revenues or gains or losses may be recognized on the basis that they have been earned and the transaction completed, assuming that fair value can be determined within reasonable limits.
• If collectibility of assets received for product, services or other assets is doubtful, revenues may be recognized on the basis of cash already received.
Efficient substantive procedures auditing revenues and other account classifications resulting from cost-beneficial audit strategies are discussed in my live and on-demand webcasts which can be accessed by clicking the applicable box on the left side of my home page, www.cpafirmsupport.com