reminder there are two traditional
revenue recognition criteria that both must be satisfied before revenue can be
recognized the seller has to do something the work and the buyer has to
do something pay or provide a valid promise to pay
now in many many cases revenue recognition is not a big issue the
primary example here is so-called cash and carry businesses such as Walmart
Home Depot farmers markets a restaurant a cash and carry business and one in
which the customer visits the business receives a service or chooses a good
pays cash and then leaves from an accounting standpoint this is a very
simple transaction now let’s think about the biggest cash and carry business in
the world Walmart in terms of the to traditional revenue recognition criteria
let’s examine them first the work Walmart’s work is providing the
retail location and the goods for the customers to choose once the customer
has chosen the merchandise that they want put it in their shopping cart and
taking it outside the store Walmart’s work is done you can see that in this
cash-and-carry setting verifying that the work has been done is simple and
fairly non-controversial now some of you have just said to yourselves hey wait
what if I return something to Walmart how does that fit in here no problem in
fact if you look in Walmart’s income statement you will see that it doesn’t
say sales it says net sales the net means that Walmart has made a
subtraction for the amount of sales that have been returned so the net sales
reported by Walmart is the amount of final sales Walmart’s work is done but
still revenue cannot be recognized unless both criteria are satisfied the
second one a cash payment or a valid promise of payment your cash payment
questions are not a problem in cash and carry businesses such as Walmart because
the customer can’t get out of the building without paying cash for the
goods now some of you are saying to yourself well what about credit card
sales those are cash sales but from the standpoint of
the retailer such as Walmart a credit card sale is the functional equivalent
of a cash sale in fact in its financial reports Walmart reports that credit card
amounts are collected so quickly just a few days at most that the credit card
amounts that are still in process are reported as cash so with a cash and
carry business the revenue recognition issues are quite simple the work is
completed at the time of the sale when the goods are provided to the customer
to take home the cash is collected almost immediately because customers are
required to pay before they leave the store you here are the two traditional revenue
recognition criteria that must be satisfied before revenue can be
recognized the seller has to do something the work and the buyer has to
do something pay or provide a valid promise to pay so is it okay to
recognize revenue before the cash is collected well yes if the buyer has
provided a valid promise to pay this is just an ordinary credit sale the
customer buys now and pays later so let’s talk about credit sales for just a
moment selling on credit is a marketing technique providing a service to
customers to entice more customers to buy companies sell on credit to the
extent that the increase in sales justifies the increased bookkeeping bad
debt and carrying costs associated with credit sales here’s an example almost
all of Boeing sales are credit sales almost all of MacDonald’s sales are cash
sales now why does Boeing sell on credit and why doesnt McDonald sell on credit
now remember for the seller a credit card sale is the functional equivalent
of a cash sale because the credit card company sends the cash to the seller
within a couple of days at most let’s analyze the three costs of selling
on credit in order to determine why mcDonalds does not sell on credit but
Boeing does the first cost of selling on credit bad debts once a Big Mac is eaten
McDonald’s leverage in the collection process is substantially diminished they
can’t get the inventory the Big Mac back and the cost to collect going around the
people’s homes to click would exceed the cost of the meal in contrast for Boeing
the thought that an airline may fail to pay its bill is tempered by the
knowledge that Boeing can recover the airplane and sell it to someone else
the second costs of selling on credit book keeping costs we all know that
McDonald’s has served billions and billions of people imagine the number of
monthly statements that would have to be mailed if McDonald’s were to sell on
credit the posted cost alone would be huge in addition McDonald’s would have
to maintain a large computer database to track each of the millions of credit
customers also if McDonald’s were to sell on credit a credit check would need
to be run on each potential credit customer in order to keep the amounts
bad debts at a reasonable level because the transaction amounts are so small
this process would be prohibitively expensive finally each McDonald’s
location would have to hire several new staff people who would do nothing but
manage the bookie being associated with credit sales it is entirely possible
that the bookkeeping costs associated with a single credit sale would exceed
the cost of the meal in contrast for a company like Boeing where each credit
transaction totals tens of millions of dollars
The Associated bookkeeping cost is really not large enough to worry about
and the third cost of selling on credit carrying cost with cash tied up in
receivables McDonald’s would have to pay its operating expenses and finance its
expansion through increased borrowing increasing its annual interest expense
presumably the managers of Boeing have done an analysis and have concluded that
the benefit of selling on credit in terms of attracting more customers
exceeds this increased borrowing cost now in summary credit sales make the
most sense for companies like Boeing or the number of individual accounts is
small the value of each transaction is large and the recoverability of the
inventory reduces the expected cost of bad debts for all of these same reasons
of business like McDonald’s with lots of customer transactions with small dollar
values and where the inventory is not recoverable is not a good candidate for
credit sales walmart is the biggest purchaser on credit in the world the
following companies sell substantial amounts of goods to Walmart all on
credit terms with Walmart agreeing to pay in 30 to 60 days PepsiCo
with eight billion dollars of annual credit sales to Walmart Kraft Foods with
four point seven billion dollars of annual credit sales to Walmart Kellogg
3.1 billion Smuckers 2.4 billion Campbell Soup 1.6
billion and Clorox 1.5 billion now in terms of the to traditional revenue
recognition criteria the necessary work of these companies is to deliver goods
to Walmart in order to recognize revenue they must then receive a valid promise
of payment from Walmart and given the financial strength long history and
valuable reputation of Walmart these companies are almost certain to
eventually collect their cash from Walmart so Walmart’s
promised to pay later is indeed a valid promise of payment and these companies
who sell on credit to Walmart recognize revenue from credit sales a month or two
before they ever received the cash from Walmart Renta Center on the other hand
does not deal with customers who are as credit worthy as is Walmart as mentioned
earlier Renta Center states that less than 25 percent of its customers
complete the full term of their agreement meaning that 75% don’t was
such a high likelihood of customers stopping payments on the rental
agreements Renta Center cannot recognize revenue when it delivers furniture or a
TV to a customer because Renta Center has not received a valid promise of
payment with a credit sale the selling company should recognize revenue at the
time of the sale if the seller has determined that it is probable that the
buyer will eventually pay for the good or the service you both of the two traditional revenue
recognition criteria must be satisfied before revenue can be recognized the
seller has to do something the work and the buyer has to do something pay or
provide a valid promise to pay so is it okay to recognize revenue after the cash
has been collected but before the work has been done no no no you have to have
the work done let’s consider two examples airline tickets and gift cards
first airline tickets everyone who flies on an airplane pays
in advance thus between the time that you pay United Airlines for your flight
and the time that you actually fly United cannot recognize the revenue they
haven’t done the work yet they have your cash but they have not yet done the work
so United must record an obligation to give you a ride on a plane for which you
have already paid united calls this liability this obligation advanced
ticket sales as of the end of 2014 United reported this obligation to be
3.7 billion dollars this represents the amount of cash United had collected from
you and from me in 2014 for tickets that we would not be using until sometime in
2015 the numbers suggest that passengers pay United approximately 40 days before
flying on average remember revenue and cash flow are not the same
thing the three point seven billion dollars represents a cash inflow from
operations for United and would be reported in the company statement of
cash flows but this is not revenue in the income statement because United has
not yet done the work now let’s think about gift cards many companies
retailers restaurants and so forth sell gift cards the business collects the
cash now but will not provide any good or service until the future when the
gift card recipient redeems the gift card so when is the revenue recognized
well let’s analyze this question in terms of the to traditional revenue
recognition criteria let’s think about the second criterion first has the buyer
of the gift card provided a valid promise of payment well yes indeed the
buyer has paid cash so that condition is satisfied now to the first criterion has
the seller done the work No the gift card seller has done nothing
except take the buyers cash no revenue can be recognized until the buyer or the
person to whom the buyer has given the gift card actually uses the card Walmart
reports the following with respect to its revenue recognition practice for the
shopping cards that the company sells customer purchases of shopping cards are
not recognized as revenue until the card is redeemed and the customer purchases
merchandise using the shopping card now there is one more interesting little
twist here as many of us know from personal experience we sometimes forget
about these gift cards or shopping cards after we buy them we might lose the
shopping card so the card is never redeemed Walmart has our cash but we
will never redeem the card so Walmart can never do the work what happens then
Walmart and all other companies that sell gift cards do the following this is
as described in the notes to Walmart’s financial statements shopping cards in
the u.s. do not carry an expiration date therefore customers and members can
redeem their shopping cards for merchandise indefinitely shopping cards
in certain foreign countries where the company does business may have
expiration dates a certain number of shopping cards both with and without
expiration dates will not be fully redeemed management estimates unredeemed
shopping cards and recognizes revenue for these amounts over shopping card
historical usage periods based on historical redemption rates so assume
that walmart sells a thousand dollars worth of shopping cards also assume that
based on historical experience Walmart estimates that 10 percent or $100 worth
of the shopping cards will never be used also let’s assume that historically the
cards that are used have been redeemed evenly over say a two year period on
average what Walmart would then do is recognize $50 of unredeemed card revenue
in the first year and fifty dollars of unredeemed card revenue in the second
year hey the next time you go to Walmart and see shopping cards for sale or the
next time you fly on an airplane smile to yourself in the knowledge that you
are among the few to understand how the revenue for these
transactions is reported the two traditional revenue recognition criteria
are first the seller has to do something the work second the buyer has to do
something pay or provide a valid promise to pay both of these criteria must be
satisfied before revenue can be recognized these criteria makes sure
that a company cannot recognize revenue casually something real must happen
first work must be done and a valid verifiable promise of payment must have
been received you