Accounting: The Language of Business - Vol. 2 (Intermediate: Part 132)

Bookkeepers most likely emerged while society was still using the barter system to trade (before 2000 B.C.) rather than a cash-and-commerce economy. Ledgers from these times read like narratives, with dates and descriptions of trades made or terms for services rendered (investopedia).

Revenue Recognition (Part S)

by

Charles Lamson

Other Principal Agent Transactions

Other common principal agent transactions---such as travel agency transactions, transactions related to advertisements and mailing lists, and auction transactions—require special accounting. For example, a travel agent can arrange airline tickets, hotel reservations, and car rentals, or travelers can make these arrangements online using a service such as Priceline.com. Whether the arrangements are made in person or online, the agent will recognize some amount of revenue. 

To illustrate, let's assume that a travel agent books a flight for a client. Consequently, there are two options for recognizing the revenue:

1. Record the total amount of the ticket (the gross amount) as revenue and recognize the cost of sales for the amount remitted to the airline. The gross revenue reporting approach records the gross amount as revenue and the amount remitted to the supplier of the product in cost of revenues.

2. Record only the net fee—that is, the amount billed to the customer less the amount paid to the airline for the tickets. The net revenue reporting approach records only the net amount in revenue.

An entity determines which of these methods to use based on weather it is the principal or the agent in the transaction. If the entity obtains control of the product before passing it to the consumer, it is the principal and should use the gross revenue reporting approach. If it never obtains control, then it is the agent and should use the net revenue reporting approach. For example, Priceline.com Incorporated, the online travel company, uses both methods depending on the types of transactions. For transactions in which Priceline is the seller of record—that is, it selects suppliers and determines the price it will accept from the customer—it uses the gross revenue reporting approach. In transactions in which customers purchase hotel room reservations or rental car reservations directly from suppliers at disclosed contractual rates, Priceline recognizes revenue using the net revenue reporting approach.

Gross profit is the same under the gross and net methods—so is the approach used important to the financial statement user? Because companies are often evaluated, at least partially, on their revenues, the implications of the two different approaches can be significant, as Illustrated in Example 8.26. 

Bill-and-Hold Arrangements

Bill-and-hold arrangements are transactions in which a buyer accepts title and billings but delays the physical receipt of the goods. The buyer may request a delay in delivery for several reasons: temporary shortage of warehouse space, current excess inventory levels, a significant backlog in the production cycle, or the construction of a new facility. 

If the seller has transferred control of the goods to the buyer, then the seller can recognize revenue at the point of sale. The seller determines if it has transferred control by considering the normal indicators of control discussed in Part 131. In addition, the seller must meet all of the following four criteria to claim that it has transferred control to the buyer:

1. The reason for the bill-and-hold must be substantive. An example of this would be that the customer requested the bill-and-hold arrangement.

2. The product must be separately identified as belonging to the customer.

3. The product must be ready for physical transfer to the customer.

4. The seller cannot have the ability to use the product in any way, including delivering it to another customer.

If the seller meets all four of these conditions, it can recognize revenue at the time of sale; otherwise, the seller must wait until it meets the conditions or it delivers the goods to the buyer.

Broadwind Energy, Inc., an alternative energy company, was accused in 2015 of accelerating $3 million in revenues through improper bill-and-hold arrangements. Broadwind shipped products at the end of the month, knowing customers would not accept them until the next month or period. If Broadwind had not mistated its revenue, it would have been at risk of violating its debt covenants.

Channel Stuffing

Companies often engage in channel stuffing selling practices designed to accelerate revenue recognition. Channel stuffing (also referred to as trade loading) is a practice in which a company induces wholesale distributors to buy more inventory than they can sell in the current period, thus “stuffing” the distribution channel with increase discounts or liberal return policies. If the distributors cannot sell the inventory in the next period, they return the goods to the seller.

Channel stuffing inflates sales to the current period, thus making the seller's financial statements look better. Although this technique allows an entity to recognize increased sales in the current period, it reduces the sales in the next period or increases sale returns significantly (sales in the next period may not be affected if channel stuffing can be repeated in the following year). For example, in 2015, Diageo PLC, a large U.K. beverage company, was investigated for shipping excess inventory to distributors to increase sales to boost the company's results. Channel stuffing caused a buildup of the customers inventory levels that posed risks to the company's future sales and earnings.

Firms should not recognize revenue from a channel stuffing arrangement because the risks and rewards of ownership have not passed to the buyer given the buyer's ability to return the product. Also, the SEC has explicitly stated that a significant increase in the amount of inventory in the distribution channel is a factor that precludes the ability of the seller to make a reliable estimate of returns, meaning the seller should not recognize the revenue. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 413-415*

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