An important task in the audit of the revenue cycle is determining whether a client has appropriately recognized revenue.
a. In assessing the risks associated with revenue recognition, the auditor of U.S. companies will likely consult criteria provided by the SEC. What general criteria has the SEC used to help determine if revenue can be recognized? Why might the auditor need to do additional research and consider additional criteria on revenue recognition?
b. The following are situations in which the auditor will be required to make decisions about the amount of revenue to be recognized. For each of the following scenarios (labeled 1-6 below):
● Identify the key issues to address in determining whether or not revenue should be recognized.
● Identify additional information the auditor may want to gather in making a decision on revenue recognition.
● Based only on the information presented, develop a rationale for either the recognition or nonrecognition of revenue.
1. AOL sells software that is unique as a provider of Internet services.
The software contract includes a service fee of $19.95 for up to 500 hours of Internet service each month. The minimum requirement is a one-year contract. The company proposes to immediately recognize 30% of the first-year's contract as revenue from the sale of software and 70% as Internet services on a monthly basis as fees are collected from the customer.
2. Modis Manufacturing builds specialty packaging machinery for other manufacturers. All of the products are high end and range in sales price from $5 million to $25 million.
A major customer is rebuilding one of its factories and has ordered three machines with total revenue for Modis of $45 million. The contracted date to complete the production was November, and the company met the contract date. The customer acknowledges the contract and confirms the amount.
However, because the factory is not yet complete, it has asked Modis to hold the products in the warehouse as a courtesy until its building is complete.
3. Standish Stoneware has developed a new low-end line of banking products that will be sold directly to consumers and to lowend discount retailers. The company had previously sold highend silverware products to specialty stores and has a track record of returned items for the high-end stores. The new products tend to have more defects, but the defects are not necessarily recognizable in production. For example, they are more likely to crack when first used in baking. The company does not have a history of returns from these products, but because the products are new it grants each customer the right to return the merchandise for a full refund or replacement within one year of purchase.
4. Omer Technologies is a high-growth company that sells electronic products to the custom copying business. It is an industry with high innovation, but Omer's technology is basic. In order to achieve growth, management has empowered the sales staff to make special deals to increase sales in the fourth quarter of the year. The sales deals include a price break and an increased salesperson commission but not an extension of either the product warranty or the customer's right to return the product.
5. Electric City is a new company in the Chicago area that has the exclusive right to a new technology that saves municipalities a substantial amount of energy for large-scale lighting purposes (for example, for ball fields, parking lots, and shopping centers).
The technology has been shown to be very cost-effective in Europe. In order to get new customers to try the product, the sales force allows customers to try the product for up to six months to prove the amount of energy savings they will realize.
The company is so confident that customers will buy the product that it allows this pilot-testing period. Revenue is recognized at the time the product is installed at the customer location, with a small provision made for potential returns.
6. Jackson Products decided to quit manufacturing a line of its products and outsourced the production. However, much of its manufacturing equipment could be used by other companies. In addition, it had over $5 million of new manufacturing equipment on order in a noncancelable deal. The company decided to become a sales representative to sell the new equipment ordered and its existing equipment. All of the sales were recorded as revenue.