CA18-3 (Recognition of Revenue—Theory) Revenue is usually recognized at the point of sale (a point in time). Under special circumstances, however, bases other than the point of sale are used for the timing of revenue recognition.

Instructions

(a) Why is the point of sale usually used as the basis for the timing of revenue recognition?

(b) Disregarding the special circumstances when bases other than the point of sale are used, discuss the merits of each of the following objections to the point-of-sale basis of revenue recognition:

(1) It is too conservative because revenue is earned throughout the entire process of production.

(2) It is not conservative enough because accounts receivable do not represent disposable funds, sales returns and allowances may be made, and collection and bad debt expenses may be incurred in a later period.

(c) Revenue may also be recognized over time. Give an example of the circumstances in which revenue is recognized over time and accounting merits of its use instead of the point-of-sale basis.

The reserve created by the business entity for adjusting the uncollectible debts is known as the allowance for bad debts. This allowance is made based on estimations.

All business entities generally use the point of sale as a base for the timing of revenue because it provides evidence regarding the transfer of assets and its control to the customers.

In general, the sale is said to be the point at which the performance obligations are satisfied. Revenue estimated before sales are just prospective revenue. It gets realized after the actual sale only. Therefore, the sale cannot be considered a conservative basis for revenue recognition.

Adjustments to revenue such as returns and bad debts can be measured with high accuracy and, therefore, do not degrade the information reported in the financial statement.

The business entities engaged in long-term construction projects will recognize their revenue over time. For such business entities, point of sale does not prove significant in recognizing revenue.

Suppose the business entity defers the revenue from the project until it is completed. In that case, it will affect the usefulness of the intermediate annual financial statements because a portion of the contract will get completed each period, and proportionate revenue must be recognized for it.

Recognizing revenue over the period will provide more relevant information than the point-of-sale information.