A few weeks back, we introduced 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 or service.
- The buyer is not a middleman, withholding payment until a resale occurs.
- 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, or $200.
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.
This takes care our first item, revenue from sales. Tune in again next week as we continue along the income statement.
Drip on, Fools!