The revenue recognition is a principle of accrual accounting and matching principle that determine the accounting period in which revenues and expenses both are recognized. Revenue is recognized when it is realizable and is earned no matter when cash is received. The criteria that have to be met are persuasive evidence of an arrangement; delivery has occurred and services have rendered; the price of sellers to the buyer is fixed or determinable.
In the case sale of future revenues, in 2009 Phantasy, Inc developed and patented a product and then licensed Thurber Company to produce and sell it, in the same year Phantasy, Inc contracted with and Sumi, Inc that will pay $5,000,000 to Phantasy, Inc, it is a kind of investment which is non-refundable and the return of this investment is the 17% of the royalties earned by Thurber Company product sales paid by Phantasy, Inc. $5,000,000 cannot be recognized as revenue because the above mentioned criteria has not been achieved yet services has not been rendered and Phantasy, Inc has not determined exact price with Thurber Company but rather it is fixed upon the total sale of product. Order case study writing service from Qualified Writers UK.
When a company receives money for a service or product that has yet to be fulfilled is unearned revenue because services and products for that money are not paid yet or in other words it is a payment received prior to deliver goods or services. FASB defines:
“Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
According to this definition, unearned revenue is liability and remains liability unless it is earned. According to Greuning& Koen (2001), all type of borrowing from other business entity for improving a business which is payable during short or long time is a liability.
Liability embodies a duty to others that involves settlement transfer of assets in future, provision of services and other economic benefits, in specific time, on occurrence of a particular demand. The duty obligates the entity leaving it little discretion to avoid it. The transaction obligating the entity has already taken place. In accounting, liabilities are based on equitable obligations. An equitable obligation is a duty based on moral considerations and can be conditional with some facts in particular situation as opposed to a contractually based obligation (Flynn et al, 2005).
Debt, on the other hand, is that which is owed. In the case of assets, the debt earned in return of asset is a means of using future buying power in the present prior a rundown has been earned. Loan is the simplest form of debt. It is composed of an agreement to lend a particular sum for a particular period of time, and to be repaid by a specific date.
In commercial loans, interest percentage is calculated of the sum per years will also has to be paid by particular date.
Before identifying the amount whether as unearned revenue or debt, there is need of assessment of the statement. If $5,000,000 is recognized as unearned revenue that means Phantasy, Inc is obliged to provide a product or service and this provision of service can be recognized as 17% from the total sale of the product earned from Thurber Company. The fact that amount of sale can vary and it may be higher than it is anticipated. 17% of the total sale amount calculated from 2010 to 2015 will exceed $7,500,000; the percentage of payment paid by Phantasy, Inc. will drop from 17% to 5% on future payment. Moreover, there is no guarantee of payment from Phantasy, Inc and Sumi, Inc. estimates its expected rate of return to be approximately 35%. If Phantasy, Inc recognizes the amount as unearned revenue, it will have to pay the settle price of sale.
On the other hand, if Phantasy, Inc recognizes the amount as debt, it will assume all responsibility and costs of protecting the patent against patent infringement and against all law suits asserting patent infringement. By recognizing the amount as debt Phantasy, Inc will consider the following benefits: (a) it will be obliged to pay the settled amount only that is 17% of the share out of total sale of the product; and if sale is good and Phantasy, Inc earns huge amount it will pay only 17% of it and if the sale is down and little amount is earned by Phantasy, Inc, Sumi, Inc. will receive 17% of the amount.