When a customer at a store pays cash for a new DVD player, puts it in his car and takes it home, it is pretty clear that a sale has occurred. But in business, not all sales are done at a retail counter, and hence, not all sales are so straightforward. Generally accepted accounting principles dictate rules for when to record sales, otherwise known as recognizing revenue. These rules are uniform because they allow investors to compare the results of a group of firms' performance on an equal footing. Firms that stretch or break these rules are said to practice aggressive revenue recognition.
Rules of Revenue Recognition
The first rule of revenue recognition is that there is persuasive evidence of an arrangement -- meaning there is some sort of agreement for sale. The second criteria is that delivery has occurred or services have been rendered. The third criteria is that the seller's price is fixed and has been determined. Lastly, collectibility is reasonably assured. There are numerous ways to violate these rules, but violations are usually done to pump up sales figures, often to get sales within a financial quarter or year.
Persuasive Evidence of an Arrangement
When companies sell items with extremely liberal return policies, it may be a form of aggressive revenue recognition designed to violate the rule that persuasive evidence of an arrangement must exist. One of the ways companies violate this rule is if they make commitments, through the use of secret "side letters," to accept returns of items the distributor cannot sell. In another case, a firm could ship product in anticipation of a buyer getting a loan from a bank. If the loan does not go through, the firm could record the sale anyway and store the product in a warehouse in anticipation of a future sale.
Quarter to quarter, companies are judged on their sales numbers. But what happens when a customer places a big order on the eve of the close of the financial quarter? In a tough quarter, a company may be tempted to record that sale as revenue, even if delivery has not occurred. This practice has the effect of holding open the sales books for longer than a quarter. Because the quarter in which a company holds open the books is longer than other quarter -- unbeknown to investors -- stock researchers cannot accurately compare financial results. Also, the practice robs future financial periods of revenue.
It's hard to think of sales that aren't conducted at a fixed price, but it does happen. Firms have violated this criteria of the generally accepted accounting principles in numerous ways. If a firm agrees to absolve resellers of the duty to pay for a product if the reseller can't sell it, then the price isn't fixed. Recording revenue with such an arrangement in place can be improper.
One of the easiest ways to pump up sales volume is to exploit every company's willingness to do business on credit. People who do not or cannot pay will agree to a price, accept shipment and sign contracts. Companies have relaxed credit terms in order to induce sales, even selling to individuals they know cannot pay. The revenue is initially booked as an account receivable. It eventually washes out as bad debt. Because all companies have bad debt and accounts receivable, investors should analyze a firm's financial ratios to detect this type of aggressive revenue recognition.
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