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understanding revenue recognition main 3 phases before, same time, and after FAST - YouTube
Channel: selfLearn-en
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reminder there are two traditional
revenue recognition criteria that both
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must be satisfied before revenue can be
recognized the seller has to do
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something the work and the buyer has to
do something
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pay or provide a valid promise to pay
now in many many cases revenue
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recognition is not a big issue the
primary example here is so-called cash
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and carry businesses such as Walmart
Home Depot farmers markets a restaurant
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a cash and carry business and one in
which the customer visits the business
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receives a service or chooses a good
pays cash and then leaves from an
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accounting standpoint this is a very
simple transaction now let's think about
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the biggest cash and carry business in
the world Walmart in terms of the to
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traditional revenue recognition criteria
let's examine them first
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the work Walmart's work is providing the
retail location and the goods for the
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customers to choose once the customer
has chosen the merchandise that they
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want put it in their shopping cart and
taking it outside the store Walmart's
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work is done you can see that in this
cash-and-carry setting verifying that
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the work has been done is simple and
fairly non-controversial now some of you
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have just said to yourselves hey wait
what if I return something to Walmart
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how does that fit in here no problem in
fact if you look in Walmart's income
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statement you will see that it doesn't
say sales it says net sales the net
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means that Walmart has made a
subtraction for the amount of sales that
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have been returned so the net sales
reported by Walmart is the amount of
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final sales Walmart's work is done but
still revenue cannot be recognized
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unless both criteria are satisfied the
second one a cash payment or a valid
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promise of payment your cash payment
questions are not a problem in cash and
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carry businesses such as Walmart because
the customer can't get out of the
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building without paying cash for the
goods now some of you are saying to
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yourself well what about credit card
sales those are
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cash sales but from the standpoint of
the retailer such as Walmart a credit
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card sale is the functional equivalent
of a cash sale in fact in its financial
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reports Walmart reports that credit card
amounts are collected so quickly just a
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few days at most that the credit card
amounts that are still in process are
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reported as cash so with a cash and
carry business the revenue recognition
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issues are quite simple the work is
completed at the time of the sale when
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the goods are provided to the customer
to take home the cash is collected
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almost immediately because customers are
required to pay before they leave the
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store
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you
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here are the two traditional revenue
recognition criteria that must be
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satisfied before revenue can be
recognized the seller has to do
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something the work and the buyer has to
do something pay or provide a valid
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promise to pay so is it okay to
recognize revenue before the cash is
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collected well yes if the buyer has
provided a valid promise to pay this is
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just an ordinary credit sale the
customer buys now and pays later so
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let's talk about credit sales for just a
moment selling on credit is a marketing
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technique providing a service to
customers to entice more customers to
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buy companies sell on credit to the
extent that the increase in sales
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justifies the increased bookkeeping bad
debt and carrying costs associated with
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credit sales here's an example almost
all of Boeing sales are credit sales
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almost all of MacDonald's sales are cash
sales now why does Boeing sell on credit
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and why doesnt McDonald sell on credit
now remember for the seller a credit
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card sale is the functional equivalent
of a cash sale because the credit card
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company sends the cash to the seller
within a couple of days at most
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let's analyze the three costs of selling
on credit in order to determine why
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mcDonalds does not sell on credit but
Boeing does the first cost of selling on
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credit bad debts once a Big Mac is eaten
McDonald's leverage in the collection
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process is substantially diminished they
can't get the inventory the Big Mac back
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and the cost to collect going around the
people's homes to click would exceed the
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cost of the meal in contrast for Boeing
the thought that an airline may fail to
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pay its bill is tempered by the
knowledge that Boeing can recover the
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airplane and sell it to someone else
the second costs of selling on credit
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book keeping costs we all know that
McDonald's has served billions and
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billions of people imagine the number of
monthly statements that would have to be
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mailed if McDonald's were to sell on
credit the posted cost alone would be
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huge in addition McDonald's would have
to maintain a large computer database to
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track each of the millions of credit
customers also if McDonald's were to
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sell on credit a credit check would need
to be run on each potential credit
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customer in order to keep the amounts
bad debts at a reasonable level because
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the transaction amounts are so small
this process would be prohibitively
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expensive finally each McDonald's
location would have to hire several new
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staff people who would do nothing but
manage the bookie being associated with
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credit sales it is entirely possible
that the bookkeeping costs associated
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with a single credit sale would exceed
the cost of the meal in contrast for a
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company like Boeing where each credit
transaction totals tens of millions of
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dollars
The Associated bookkeeping cost is
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really not large enough to worry about
and the third cost of selling on credit
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carrying cost with cash tied up in
receivables McDonald's would have to pay
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its operating expenses and finance its
expansion through increased borrowing
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increasing its annual interest expense
presumably the managers of Boeing have
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done an analysis and have concluded that
the benefit of selling on credit in
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terms of attracting more customers
exceeds this increased borrowing cost
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now in summary credit sales make the
most sense for companies like Boeing or
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the number of individual accounts is
small the value of each transaction is
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large and the recoverability of the
inventory reduces the expected cost of
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bad debts for all of these same reasons
of business like McDonald's with lots of
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customer transactions with small dollar
values and where the inventory is not
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recoverable is not a good candidate for
credit sales walmart is the biggest
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purchaser on credit in the world the
following companies sell substantial
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amounts of goods to Walmart all on
credit terms with Walmart agreeing to
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pay in 30 to 60 days PepsiCo
with eight billion dollars of annual
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credit sales to Walmart Kraft Foods with
four point seven billion dollars of
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annual credit sales to Walmart Kellogg
3.1 billion
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Smuckers 2.4 billion Campbell Soup 1.6
billion and Clorox 1.5 billion now in
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terms of the to traditional revenue
recognition criteria the necessary work
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of these companies is to deliver goods
to Walmart in order to recognize revenue
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they must then receive a valid promise
of payment from Walmart and given the
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financial strength long history and
valuable reputation of Walmart these
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companies are almost certain to
eventually collect
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their cash from Walmart so Walmart's
promised to pay later is indeed a valid
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promise of payment and these companies
who sell on credit to Walmart recognize
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revenue from credit sales a month or two
before they ever received the cash from
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Walmart Renta Center on the other hand
does not deal with customers who are as
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credit worthy as is Walmart as mentioned
earlier Renta Center states that less
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than 25 percent of its customers
complete the full term of their
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agreement meaning that 75% don't was
such a high likelihood of customers
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stopping payments on the rental
agreements Renta Center cannot recognize
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revenue when it delivers furniture or a
TV to a customer because Renta Center
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has not received a valid promise of
payment with a credit sale the selling
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company should recognize revenue at the
time of the sale if the seller has
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determined that it is probable that the
buyer will eventually pay for the good
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or the service
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you
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both of the two traditional revenue
recognition criteria must be satisfied
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before revenue can be recognized the
seller has to do something the work and
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the buyer has to do something pay or
provide a valid promise to pay so is it
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okay to recognize revenue after the cash
has been collected but before the work
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has been done no no no you have to have
the work done let's consider two
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examples airline tickets and gift cards
first airline tickets
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everyone who flies on an airplane pays
in advance thus between the time that
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you pay United Airlines for your flight
and the time that you actually fly
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United cannot recognize the revenue they
haven't done the work yet they have your
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cash but they have not yet done the work
so United must record an obligation to
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give you a ride on a plane for which you
have already paid united calls this
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liability this obligation advanced
ticket sales as of the end of 2014
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United reported this obligation to be
3.7 billion dollars this represents the
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amount of cash United had collected from
you and from me in 2014 for tickets that
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we would not be using until sometime in
2015 the numbers suggest that passengers
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pay United approximately 40 days before
flying on average remember
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revenue and cash flow are not the same
thing the three point seven billion
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dollars represents a cash inflow from
operations for United and would be
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reported in the company statement of
cash flows but this is not revenue in
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the income statement because United has
not yet done the work now let's think
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about gift cards many companies
retailers restaurants and so forth sell
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gift cards the business collects the
cash now but will not provide any good
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or service until the future when the
gift card recipient redeems the gift
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card so when is the revenue recognized
well let's analyze this question in
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terms of the to traditional revenue
recognition criteria let's think about
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the second criterion first has the buyer
of the gift card provided a valid
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promise of payment well yes indeed the
buyer has paid cash so that condition is
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satisfied now to the first criterion has
the seller done the work
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No the gift card seller has done nothing
except take the buyers cash no revenue
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can be recognized until the buyer or the
person to whom the buyer has given the
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gift card actually uses the card Walmart
reports the following with respect to
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its revenue recognition practice for the
shopping cards that the company sells
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customer purchases of shopping cards are
not recognized as revenue until the card
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is redeemed and the customer purchases
merchandise using the shopping card now
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there is one more interesting little
twist here as many of us know from
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personal experience we sometimes forget
about these gift cards or shopping cards
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after we buy them we might lose the
shopping card so the card is never
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redeemed Walmart has our cash but we
will never redeem the card so Walmart
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can never do the work what happens then
Walmart and all other companies that
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sell gift cards do the following this is
as described in the notes to Walmart's
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financial statements shopping cards in
the u.s. do not carry an expiration date
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therefore customers and members can
redeem their shopping cards for
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merchandise indefinitely shopping cards
in certain foreign countries where the
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company does business may have
expiration dates a certain number of
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shopping cards both with and without
expiration dates will not be fully
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redeemed management estimates unredeemed
shopping cards and recognizes revenue
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for these amounts over shopping card
historical usage periods based on
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historical redemption rates so assume
that walmart sells a thousand dollars
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worth of shopping cards also assume that
based on historical experience Walmart
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estimates that 10 percent or $100 worth
of the shopping cards will never be used
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also let's assume that historically the
cards that are used have been redeemed
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evenly over say a two year period on
average what Walmart would then do is
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recognize $50 of unredeemed card revenue
in the first year and fifty dollars of
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unredeemed card revenue in the second
year hey the next time you go to Walmart
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and see shopping cards for sale or the
next time you fly on an airplane smile
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to yourself in the knowledge that you
are among the few
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to understand how the revenue for these
transactions is reported the two
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traditional revenue recognition criteria
are first the seller has to do something
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the work second the buyer has to do
something pay or provide a valid promise
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to pay both of these criteria must be
satisfied before revenue can be
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recognized these criteria makes sure
that a company cannot recognize revenue
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casually something real must happen
first work must be done and a valid
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verifiable promise of payment must have
been received
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you
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