Question

Revenue Recognition The Company generally recognizes sales, which include shipping fees where applicable, net of estimated returns, at the time the member takes possession of merchandise or receives services. When the Company collects payments from customers prior to the transfer of ownership of merchandise or the performance of services, the amounts received are generally recorded as deferred sales, included in other current liabilities on the consolidated balance sheets, until the sale or service is completed. The Company reserves for estimated sales returns based on historical trends in merchandise returns, net of the estimated net realizable value of merchandise inventories to be returned and any estimated disposition costs. Amounts collected from members, which under common trade practices are referred to as sales taxes, are recorded on a net basis. The Company evaluates whether it is appropriate to record the gross amount of merchandise sales and related costs or the net amount earned as commissions. Generally, when Costco is the primary obligor, is subject to inventory risk, has latitude in establishing prices and selecting suppliers, can influence product or service specifications, or has several but not all of these indicators, revenue and related shipping fees are recorded on a gross basis. If the Company is not the primary obligor and does not possess other indicators of gross reporting as noted above, it records the net amounts as commissions earned, which is reflected in net sales. The Company accounts for membership fee revenue, net of estimated refunds, on a deferred basis, whereby revenue is recognized ratably over the one-year membership period. The Company’s Executive Members qualify for a 2% reward (up to a maximum of $750 per year on qualified purchases), which can be redeemed at Costco warehouses. The Company accounts for this reward as a reduction in sales. The sales reduction and corresponding liability (classified as accrued member rewards on the consolidated balance sheets) are computed after giving effect to the estimated impact of non-redemptions based on historical data. The net reduction in sales was $970, $900, and $790 in 2013, 2012, and 2011, respectively.

Required:

a.      a.      Explain in plain English how Costco recognizes revenue from annual memberships.

         b.      Does Costco recognize revenue in consistence with the revenue recognition principle in GAAP? Explain your answer.

Answer 1

a. Members pay the membership fees on an annual basis i.e. they pay the membership fees in advance for the entire year. The fees is recognized by Costco over the year i.e. 1/12^th of the fees is recognized as revenue at the end of each month. The balance amount is treated as a liability.

For example suppose that a member pays $1,200 as annual membership fee at the start of year (on 1^st January). On this date the entire amount of $1,200 is a liability and no revenue is recognized. At the end of January (on 1/31) 1200/12 = $100 will be recognized as revenue. Similarly $100 will be recognized as revenue at the end of each month from February to December.

b. Yes, Costco recognize revenue in consistence with the revenue recognition principle in GAAP. GAAP requires the use of accrual basis of accounting and Costco is recognizing its revenue from membership on an accrual basis. Timing of the cash flow is ignored by Costco and revenue is recognized upon completion of the service (in this case time period of a month).