Accounting Standards Codification Revenue Recognition - Essay Example

Accounting Standards Codification Revenue Recognition Memorandum April 18, ASC Guidelines onRevenue Recognition Introduction Accounting Standards Codification has issued guidelines on the recognition of revenue, using the gross method and net method of revenue recognition. This paper summarizes the guidelines issues by ASC, and investigates the extent to which they are being applied in practice by examining the practices of two well-known companies in the online retail industry. Analysis ASC Guidelines on Revenue Recognition According to the ASC guidelines, an entity should report the gross or net earnings from its transactions depends on whether it is acting in the capacity of a principal seller or as an agent. The principal supplier earns the entire revenue from the sale transaction and should therefore report the gross earnings, while the agent earns a commission on the transaction and should report the net earnings. The guidelines specify eight tests to ascertain whether a particular entity is acting in the capacity of a principal. Satisfaction of many of these conditions would normally indicate that the entity is acting in the capacity of principal and should record thee gross revenue. The eight tests specified by ASC are: 1. Responsibility for providing the product: An entity that has the responsibility for supplying the product (or service) and for its acceptability is most likely to be a principal 2. Risk for Inventory: The party that has unmitigated general inventory risk would be acting in the capacity of a principal. Such party would maintain an inventory of products before sale with accompanying inventory risk and will take ownership if the product is returned by the customer. 3. Price fixation: The entity that has the power to fix or change the price would be a principal. 4. Changes to product: The entity that makes changes to the product or carries out a service ordered by the customer would be acting in the capacity of principal. 5. Supplier selection: A party that has the discretion to select a particular supplier, from several suppliers who can provide the product, for fulfilling a particular order to a customer would be acting in the capacity of principal. 6. Determination of product specification: An entity that determines the nature or characteristics of the product that must be supplied against a customer order is likely to be a principal. 7. Physical loss inventory risk: If the entity assumes risk of the product until transfer to the customer or gets the title back if the product is returned, it is most probably acting in the capacity of a principal. 8. Credit risk: An entity that takes the risk for collection of outstanding amounts is a principal. (Accounting Standards Codification) The ASC guidelines also specify three criteria to test whether an entity is acting in the capacity of agent and hence should record the net revenue. 1. The primary responsibility for supplying the product lies with the principal and not with the entity concerned. 2. The entity concerned earns a fixed amount, irrespective of the amount billed, or a fixed percentage of the price 3. The credit risk does not lie with the entity but with the supplier.i (Accounting Standards Codification) Accounting Method Adopted by Amazon.Com Amazon.Com recognizes and records gross revenue when several or all of the following conditions are satisfied. Amazon is 1. Primarily obligated to deliver the product 2. Subject to inventory risks 3. Has the power to fix the price and selecting suppliers, or The company recognizes net revenue as commission, if it is not primarily obligated to fulfill the purchase contract and does not have the freedom to establish prices.ii (Amazon.Com) Amazon.Com has included three of the eight conditions specified under the ASC. Conditions such as carrying out product changes, determination of product specifications, and assumption of credit risk have not been included by Amazon. Some of these are specified as providing weaker evidence. However, when a number of factors are being considered and judgment is made on the basis of several of these factors, it would have been more appropriate to include all of them, which Amazon has not done. Thus while Amazon’s stated practice is in conformance with the ASC guidelines, it does not include all the conditions. Accounting Method adopted by Overstock.Com Overstock.Com specifically states that it follows the ASC guidelines on Principal Agent Considerations while determining whether the gross or net revenue should be recorded. The tests applied by Overstock are similar to those used by Amazon and include (i) being the primary obligor in the transaction (ii) being subject to inventory risk and (iii) having latitude in establishing prices and selecting suppliers. Overstock records the gross revenue if most of these conditions are satisfied.iii As in the case of Amazon, Overstock also does not include all the considerations set forth by the ASC, but the conditions included are the most critical ones, and are fully in agreement with the ASC guidelines. Observations on the ASC Guidelines The ASC guidelines are fairly clear in specifying various conditions that could support the judgment in respect of the nature of a transaction and whether the gross or net revenue should be recorded. However, by classifying some of these as “weak” evidences, ASC has introduced a certain measure of ambiguity that could lead to non-uniform practices. Should the weak evidences be considered while making the judgment? The two companies reviewed apparently think that the “weak” evidences are not material. To make the process more precise, I would suggest that the conditions may be divided into two groups. The first group should list those conditions, the satisfaction of any one (or other specified number such as two) of which should cause the gross revenue to be recorded. The second group should list those conditions, more than one (or other specified number) of which should be satisfied in order to record the gross revenue. Secondly, instead of specifying two separate sets of criteria for gross and net revenue recording, there could be one set that integrates all conditions that satisfy either type of revenue recording. If a transaction is not found to be belonging to one of these types, it should be automatically included in the other. Conclusion The Accounting Standards Codification guidelines regarding recording of gross or net revenue are fairly clear and straightforward. However, the categorization of the factors that influence the final judgment into strong and weak evidences leaves room for ambiguous interpretation. It might be better to divide the conditions into two groups. Satisfaction of any condition in the first group or more than one condition in the second group should result in recording the revenue in the specified manner. Works Cited Accounting Standards Codification. "Revenue Recognition: Principal Agent Considerations - Other Presentation Matters." n.d. 17 April 2013 . Amazon.Com. "SEC Filings ." n.d. 17 April 2013 . Overstock.Com. "SEC Filings." n.d. 17 April 2013 . Read More