Back to Basics, Part 11
We took an initial glance at the income statement with a brief definition
of each element. This week, we'll take a much more thorough look at
the ingredients of an income statement, leading off with sales revenue.
Sales Revenue = Price x Quantity
Revenues are the proceeds a company receives for its merchandise or services.
They are usually recorded at the time of the sale or completion of the service,
providing the earnings process is substantially complete and the collectibility
of the revenue can be estimated. Sales revenue equals the price of goods sold
multiplied by the quantity of goods sold minus returns.
The earnings process is the sequence of events necessary to complete
the sale of goods or services in order to be recorded on the income statement.
The following criteria must be met to substantially fulfill the earnings process:
- The buyer and seller have agreed on the price of the merchandise
- The buyer is not a middleman, withholding payment until a resale
- The product or service is delivered in full.
- The buyer and seller are not related (such as a parent and subsidiary).
Collectibility of Credit Sales
If the collectibility of a sale cannot be estimated, revenues
are recorded only as the customer makes payments. This deviates from
the accrual basis of accounting, recording sales when the cash is received,
rather than when it is earned. There are two methods used when recording
revenue as the customer makes payments: the installment method and
the cost-recovery method.
Under the installment method, revenues and, in turn, profits are
recognized in proportion to the percentage of the sale price collected in
a given accounting period.
For example, if Graney's Extra-Glossy Dental Floss sells Dr. Smiley one thousand
cases of shiny dentifrice with a total cost of $4,000 for a sum $5,000, to
be paid in five annual installments of $1,000 each, Graney's would record annual
revenues of $5,000/5, or $1,000 from this transaction. Given annualized costs
of $4,000/5, or $800, Graney's would record annual profits of $1,000 - $800,
The cost-recovery method matches revenues with costs until all of
the costs associated with those revenues have been recouped. After that point,
profits can be recorded on the income statement.
Using the example given above, Graney's Extra-Glossy Dental Floss would need
to collect $4,000 from Dr. Smiley before any profits could be recorded. Annual
revenues of $1,000 would match annual costs of $1,000 during the first four
years. With the cost of the floss fully recovered at the end of the fourth
year, profits of $1,000 will hit the income statement in the fifth year.
Long-Term Contracts Revenue
Companies that provide services on a long-term contract generally record revenue
under the installment method. If dependable estimates of selling price, construction
costs, and degree of completion are obtainable, revenues will be recorded as
the work is performed. This is known as the percentage-of-completion method.
An example might be a three-year contract to construct a warehouse that will
house Graney's lustrous lace. The first year we estimate that one-third of
the project will be complete, therefore the contractor will record one-third
of the estimated total revenue from the contract in year one. Years two and
three would be treated likewise.
If dependable estimates of selling price, construction costs, or stage of completion
are not obtainable, revenue is not recorded until the project is completed.
This is known as the completed contract method.
Unearned or deferred revenue is sales revenue for which the company
has not completed the earnings process.
For example, if Graney's Extra-Glossy Dental Floss has been paid to train future
Dr. Smiley employees on the finer points of polished floss use and has received
cash for this training up front, the company will not record the sales until
the time of service. However, Graney's will create a liability account on the
balance sheet, such as Advances from Customers, to properly account for the
cash that has been received.
Uncollected credit sales are accounted for as bad debt on the income
statement, as well as a deduction of accounts receivable on the balance sheet.
The amount of bad debt is estimated out of necessity since it must be recorded
in the same year as the original sale. It will often be another fiscal year
before actual determination of uncollectible debt is possible.
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