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Required
How should Bespoke Inc. recognize this transaction?
Solution
As Bespoke Inc. has not manufactured this type of machine earlier, it is not in a position to reliably measure the cost of rectification of any faults that may
materialize. Consequently, the cost to Bespoke Inc. of the transaction cannot be reliably measured and no sale should be recognized.
Very often, contracts for the sale of goods can be subject to conditions, such as
• Subject to inspection and/or installation. If installation is a quick and simple process (i.e., it forms an insignificant part of the sales contract), revenue can be
recognized on delivery.
• On approval with a right of return. The contract is recognized when goods are accepted or a period of right of return has lapsed.
• On consignment. The contract is recognized only when the consignee has sold the goods.
• Cash on delivery. The contract is recognized when cash is received.
• “Layaway” when goods are delivered on final installment. If history shows that full payment is normally received, revenue could be recognized when a
significant deposit is received and the goods are on hand and ready for delivery. Otherwise revenue would be recognized only on delivery.
In other words, if the seller retains significant risks of ownership, the transaction is not regarded as a sale for the purposes of recognizing revenue. A seller may
retain significant risks of ownership, which may be manifested in numerous ways. The next case study shows circumstances wherein the seller retains significant risks
of ownership.
CASE STUDY 5
Which of the following situations signify that “risks and rewards” have not been transferred to the buyer?
Solution
1. XYZ Inc. sells goods to ABC Inc. In the sales contract, there is a clause that the seller has an obligation for unsatisfactory performance, which is
not governed by normal warranty provisions.
2. Zeta Inc. shipped machinery to a destination specified by the buyer. A significant part of the transaction involves installation that has not yet been
fulfilled by Zeta Inc.
3. The buyer has the right to cancel the purchase for a reason not specified in the contract of sale (duly signed by both parties) and the seller is
uncertain about the outcome.
1. According to the clause in the sales contract, XYZ Inc. has an obligation beyond the normal warranty provision. Thus “risks and rewards of
ownership” have not been transferred to the buyer on the date of the sale.
2. “Risks and rewards of ownership” have not been transferred to the buyer on the date of the delivery of the machinery because a significant part of
the transaction (i.e., installation) is yet to be done.
3. “Risks and rewards of ownership” will not be transferred to the buyer due to the “unspecified uncertainty” arising from the terms of the contract of
sale (duly signed by both parties), which allow the buyer to retain the right of cancellation of the sale due to which the seller is uncertain of the
outcome.
A transaction is not deemed a sale until it is probable that the future economic benefits will flow to the entity. In some of the cases, the receipt of consideration may
be doubtful. Until the uncertainty is removed, the sale should not be recognized.
PRACTICAL INSIGHT
When uncertainty arises about collectability of revenue booked in an earlier period, then the uncollectible amount is to be recognized as an expense as
opposed to adjusting the revenue originally recognized in an earlier period.
Revenues recognized and the costs (expenses) associated with them should be matched and recognized simultaneously—this is essential because if costs cannot be
measured reliably, then the related revenue should not be recognized. In such a situation, any consideration received from such transactions is booked as a liability.
RENDERING OF SERVICES
Revenue from the rendering of services can be recognized by reference to the stage of completion if the final outcome can be reliably estimated. This would be the
case if
• The amount of revenue can be measured reliably.
• It is probable that economic benefits associated with the transaction will flow to the seller.
• The stage of completion can be measured reliably.