Revenue is at the heart of the performance of every business, and every part of the functioning of a business relies on revenue recognition. Companies can be tempted to push the limits of what can be qualified as revenue, especially when a contract is complete and the products have been successfully delivered. Revenue recognition ensures that specific rules and procedures are followed when determining how to account for revenue. Revenue is usually recognized when a critical event has occurred, and the terms of a contract can impact the revenue recognition procedure of a given entity. The given case involved Larson Industries that entered an agreement with Dynamic Wholesale Inc. From May 31, Dynamic was to offer AM300 and gift cards for their customers. The agreement with Dynamic has multiple unique features that Larson had not yet encountered before. The company should consider revenue recognition procedures by considering four accounting issues that include warranties, bill and hold, right to return, and discounts
Relevant Facts of the Case
Larson went into an agreement with Dynamic Wholesale and shipped the AM300 goods to Dynamic on May 15. The products were to be sold to Dynamic customers on May 31. When preparing for closing the company’s books for the May 31 year-end, the Chief Financial Officer considered that appropriate accounting of the transactions with Dynamic should be undertaken. The purchases for the products were 1 million standard AM300s priced at $152, and Dynamic will have to place the goods at the warehouse on May 31. One of the terms of the agreement that could impact the revenue recognition was Dynamic purchasing a total of 1.5 million products within six months and receiving a discount. The other terms were that of dealing with returns of goods and expirations of warrants. Dynamic was also to receive a 3% commission on the sale of gift cards (McNeils et al., 2020). The different issues were to be addressed elaborately through the revenue recognition standards by the FASB.
Delegate your assignment to our experts and they will do the rest.
FASB Codification
The Financial Accounting Standards Board (FASB) strives to establish the best accounting practices that GAAP accounting professionals and companies can follow. FASB Codification involves a set of principles applied by the FASB regarding various accounting practices. One of the functions of the FASB organization is to establish The Accounting Standards Codification 606 is a revenue recognition standard indicating the transfer of goods and services to customers with the amount that reflects the considerations (Hepp, 2018). It covers revenues from contracts with customers and identifies the performance and licensing obligations. The FASB incorporates a step-by-step approach for the recognition of revenue earned from a business. The steps include identifying the contract, identifying performance obligations, determining the transaction price, allocating transaction price, and performing obligations to recognize revenue (Mattei & Paoloni, 2019). The different steps can be applied in revenue recognition.
The FASB observed that critical approaches should be followed when recognizing the revenues from a contract. The revenues of a contract cannot be recognized unless the contract exists. A contract aims to create enforceable obligations or rights. It could be available in a written or oral format or could be implied by the parties. The analysis of the given case showed that a valid contract was present. The Chief Operating Officer of Larson Industries made a verbal agreement indicated that they have entered into a contract agreement with Dynamic Wholesale Inc. in February 2019. The contract was also valid because it incorporated a commercial substance, i.e., AM300. The product was meant to be sold at Dynamic Wholesale Inc. warehouses. Some terms and conditions were also established in the contract. All the given terms would be considered as part of the contract to make it valid.
The Four Accounting Issues
Warranty on AM300
The FASB outlines the warranty issue on the codification ASC 606-10-55-30 through 55-35. The issue outlined is that an entity may seek to establish a warranty with the sale of a product. The warranty could vary significantly based on the industry and the nature of the contract. Some warranties could assure customers that the related product will function as the customers intended, and other warranties could provide the customer with service along with the assurance that the product complies with the agreed specifications. From the given case study, the nature of the warranty provided by Larson is that the product complies with agreed specifications. There was a concern with the deterioration of customer service, and Larson agreed to incorporate a warranty claim on the AM300. Larson provided the option of a warranty for customers that experience problems with the product. It offered the AM300 with a three-year manufacturer’s warranty for the basic functionality of the main product. For claims on the main product, Larson instructed Dynamic to provide customers with the option of a refund or an exchange for a new AM300. Dynamic would then return the products to Larson, where Larson will reimburse Dynamic for the refund.
The codification observes that the warranty is a form of a performance obligation. The codification ASC 606 55-33 and 55-34 observe that if a warranty is given separately or includes a form of service, then the warranty and service amount to a performance obligation (“606 Revenue from Contracts with Customers. – 10 Overall – 55 Implementation Guidance and Illustrations”, 2017). The warranties given by Larson included services like the option of a refund or getting an exchange for a new AM300. The given service amounts to a performance obligation for Larson. Therefore, the codification requires that Larson allocate a portion of the transaction price to the performance of the obligation.
One of the key requirements by the ASC 606 is that the parties involved in the transactions should consider how the given warranties could impact the transaction price. The definition of the transaction price was given as the amount of consideration a company is entitled to receive when transferring goods and services to customers. For the given case, the contract price was initially fixed at $152 each. The approach to determining the transaction price in the given scenario will involve estimating the possibility of unsold items that could be returned to Larson within the first 60 days and the possibility of products returned based on a warranty claim. The case study showed that Larson determined that 4 percent of customers historically have filed claims related to the main product (McNellis et al., 2020). The claims were also made within ten months after the original sale. Larson can use the calculation to make estimates on products that could be returned based on warranty claims.
Bill and Hold
A bill-and-hold arrangement in a contract is a scenario where an entity bills a customer for a product but the entity retains the physical possession of the product until the time it is transferred to the customer at a point in the future. The Bill-and-Hold codification was ASC 606-10-55-81 through 55-84. One example of such a scenario can occur when a customer can request an entity to enter a contract, but the customer may lack available space, or there can be delays in the delivery due to the production schedules. The Bill and Hold agreement occurred in the case after the initial delivery of the 1 million standard AM300s shipped on May 15. Dynamic indicated that it was interested in purchasing an additional 1 million products within the next year. However, Dynamic did not have the warehouse capacity to house the products, and the company managers were not sure when the inventory would have to be reordered. The offer from Larson was in the form of a Bill-and-Hold agreement as it offered to place a reservation for the additional products for Dynamic. Larson also instructed that the inventory department should set aside separate products at the given shipping locations. The accounting department was also to send an invoice immediately to confirm that Dynamic was interested in the additional goods.
The codification observes that an entity can recognize the revenue of the products on a bill-and-hold basis. In such a case, the entity should consider whether the remaining performance obligations like custodial services have been met. The entity should then allocate a portion of the transaction based on the agreement. However, for the revenue to be recorded, the given scenario should be a valid bill-and-control agreement. The codification provides an approach to determine whether a given scenario can be a bill-and-control agreement. One of the requirements is that the reason for the arrangement should be substantive. The case study shows that Dynamic was interested in additional 1 million products, but it did not have the warehouse capacity to house all the items. The second requirement is that the product should be identified separately as belonging to the customer. Larson specifically instructed the inventory department that it should set aside separate products at the respective shipping locations and put aside a given number of products aside as a form of specifically identifying that the given products belonged to the customer. The third requirement was that the products should be readily available for physical transfer to the customer. The fourth requirement is that the entity cannot have the ability to use the product by directing it to another customer. The given scenario will amount to a bill-and-control agreement once Dynamic receives the invoice and is billed for the product. In such an instance, Larson will set aside the products and not use them or direct them to another company. Larson should thus record the revenues as a bill-and-hold agreement after specifically setting aside the products for Dynamic.
Right to Return
Some contracts may give entities transfer control and the right to return a product for various reasons. The reasons for the return could vary based on multiple factors such as refunds, rebates, credits, performance bonuses, and price concessions. The agreement between Larson and Dynamic in the price protection was that any unsold items could be returned to Larson within the first 60 days after May 31. The price protection led to the possibility of returned goods that would impact the revenues.
The ASC 606 Codification 55-24 observes that an entity’s promise to accept a returned product during a given period cannot be accounted for as a performance obligation. The codification observes that an entity should recognize the amount the entity expects it will have to return to the customer in the form of a refund liability. The amounts should not be recorded in the transaction price. At the end of the reporting period, the codification observed that the entity should adjust the refund reliability by recognizing the adjustments as revenues or reductions in revenue. When formulating the company’s revenues, Larson should recognize the refund liabilities for the amount that it could refund to Dynamic after 60 days. Larson can estimate that 5% of the products may not be sold after the given period and should indicate the amount as a refund liability. At the end of the reporting period, Larson should update the measurement of the asset due to changes in the expectations about the returned products.
Discounts
The issue of discounts was covered in the codification in the form of customer options for additional goods and services. Such a provision of additional goods and services usually comes about in different forms like contract renewal options, discounts for future goods or services, customer awards, or sales incentives (Rampulla, 2020). The provision of additional goods and services in the given case came about in the form of contract renewal options and discounts for future goods. Dynamic had stated that it would order a million more goods for the following year, and Larson proposed offering a discount. From the analysis of the proposal, the incorporation of an additional 500,000 goods would have a 10% discount. Additionally, any purchases made by the company after selling 1.5 million products would have a 12% discount. The discount also included a price protection agreement where Dynamic was to price the AM300s at $249.99. The price was agreed that it would be similar to what Larson had charged at their website. A protection agreement was also included in the final price to ensure that Dynamic did not provide large discounts on their price other than the 5% discount issued for those that used its credit card.
The revenue recognition from the transfer of goods due to the discount will occur after the goods have been successfully transferred. The ASC 606 55-42 codification observes that when an entity provides the option to acquire additional goods or services, the option could result in a performance obligation contract where the customer has a material right to the products. Dynamic has a material right to the products since the discount was incremental to the range of discounts usually given to other customers. The codification further observes that a scenario can occur where the customer pays for the goods and services in advance. In such a case, the entity will recognize the revenue only after the future goods and services have been transferred or when the material right option expires. For the discount, Larson will have to record the revenues of the additional goods and services from the discount after the goods have been successfully transferred to Dynamic.
| Issue # | Agreement Characteristics/Facts | Revenue Recognition Issue |
| 1 | Larson instructed Dynamic to provide customers with the option of a refund or an exchange for a new AM300. Dynamic would then return the products to Larson, where Larson will reimburse Dynamic for the refund. |
Warranty. Revenue recognition is a form of performance obligation and is allocated to the transaction price at the end of the billing period. |
| 2 | Dynamic was interested in purchasing an additional 1 million products within the next year but did not the warehouse capacity to house the products. Larson offered to place a reservation instructing the inventory department to set aside separate products and the accounting department to send an invoice to Dynamic. |
Bill-and-hold. Revenue recognition as a bill-and-hold transaction after setting aside the products for Dynamics. |
| 3 | Any unsold items could be returned to Larson within the first 60 days after May 31. |
Right to return. Revenue recognition through a refund liability. |
| 4 | Dynamic would order 1 million more goods for the following year. Larson proposed a discount of 10% for an additional 500,000 goods. An additional discount of 12% would be included for 1.5 million products. |
Discounts leading to customer options for additional goods and services. Revenue recognition only after goods have been transferred. |
Conclusion
The given case provided an overview of revenue recognition and how the different requirements for revenue recognition could be applied to the Larson and Dynamics agreement. The FASB ASC 606 provided an approach that should guide the organization in revenue recognition for the different issues. The warranty issue was to be recorded under the transaction price at the end of the billion period. The bill-and-hold agreement was to be recognized after setting aside the products and dynamic agreeing to make the payments. The right to return was to be recorded as a refund liability, and customer options for additional goods and services from discounts would be recorded after the goods were transferred.
References
Hepp, J. (2018). ASC 606: Challenges in understanding and applying revenue recognition. Journal of Accounting Education , 42 , 49-51.
McNellis, C. J., Barone, G. J., & Herbold, J. (2020). Larson Industries: A Case on Identifying and Researching Revenue Recognition Issues. Issues in Accounting Education , 35 (2), 65-75.
Mattei, G., & Paoloni, N. (2019). Understanding the Potential Impact of IFRS 15 on the Telecommunication Listed Companies, by the Disclosures’ Study. International Journal of Business and Management , 14 (1), 169-179.
Rampulla, R. (2020). Revenue Recognition: Mastering the New FASB Requirements . John Wiley & Sons.
606 Revenue from Contracts with Customers. – 10 Overall – 55 Implementation Guidance and Illustrations. (2017). ASC-FASB. https://asc.fasb.org/link&sourceid=SL82860781-203042&objid=125985953
