In this video, learn how to evaluate the revenue recognition criteria and how they are applied. Revenue is the starting point of the income statement.
- When does a sale get reported in the books? Let's use a real company example to illustrate the surprising complexity of this question. When Apple sells a person an iPhone, Apple is actually selling a bundle of three different things. First, there's the iPhone itself. Second, with respect to iPhone sales, Apple states that it may, from time to time, provide future unspecified software upgrades and features free of charge to customers. Third, Apple provides what it calls undelivered non-software services, which are extended warranty services on the hardware device itself. When a customer pays, say $600 to Apple for an iPhone, that customer is buying a bundle of goods and services. And some of those services won't be delivered for several years. The accounting question, the revenue recognition question, is this. When should Apple report the $600 sale? Right now, spread out evenly over some years in the future, some now and some spread out over the future? Now the recognition of revenue, the reporting of the $600 sale, is just a matter of timing. We aren't discussing whether the sale should be reported. We're just talking about when the sale should be reported. So who cares? If the sale will be reported eventually, who cares whether it's reported now or later? Well, to put it simply, everyone cares. The general desire of business people is to report a sale as soon as possible. This makes today's financial statements look better as a company applies for bank loans or seeks new investors. The financial accounting standards have to push back against this desire to accelerate revenue recognition to ensure that a company has provided economic value to its customers before it can recognize revenue. To illustrate, let's go back to the iPhone. Apple is actually selling a bundle of three items for one price. This is called a multiple-element transaction, one contract with more than one valuable good or service. For a particular contract between a buyer and a seller, the financial accounting standards describe three basic steps in recognizing revenue, in reporting the sale. The first is, identify the performance obligations accepted by the seller. With the iPhone, Apple has identified the three performance obligations: Functioning iPhone, free future software upgrades, and extended hardware warranty. Second, allocate the total contract price among the different elements or obligations. This is done by apportioning the overall contract price based on the relative separate selling prices of any distinct element of a multiple-element transaction. For the iPhone, Apple states that the evidence suggests that Apple customers would be unwilling to pay a large amount for a stand-alone right to unspecified future software upgrades or an extended warranty. Apple's estimate is that of the total purchase price of, say, $600 for an iPhone, only about $15 to $25 is associated with these non-iPhone elements. Now third, recognize revenue as the performance obligations are satisfied. A performance obligation is satisfied when the buyer obtains control of the good or service from the seller. For the iPhone, the revenue associated with the iPhone itself is recognized when Apple delivers the iPhone to the customer. The remaining revenue associated with the other elements is, to use Apple's exact words, recognized on a straight-line basis over the estimated period the rights are expected to be provided for each device, which ranges from two to four years. So even if you pay the entire $600 purchase price in cash to Apple today, the financial accounting rules say that some small amount of the $600 won't be reported by Apple as a sale until as long as four years from now. Now these three revenue recognition steps are: Identify the performance obligations accepted by the seller; for a contract with multiple elements, allocate the total contract price among the different elements or obligations; and recognize revenue as the performance obligations are satisfied.
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