FASB (Financial Accounting Standards Board) plays the role of determining Generally Accepted Accounting Principles to ensure proper accounting standards are followed. According to FASB, revenue is recognized once it is earned.
Commission in Crazy Computer's case is recognized immediately since Crazy Computers collects the cash on behalf of Third Party insurance and then pays it. Commission however should not be added to sales because when balancing the equation, Sales is equal to opening stock plus purchases less closing stock.
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This means that by adding commission to sales the equation may not balance and it will be exaggerated. The commission revenue consists of income and it is therefore used in the final statements of accounts to calculate the profit of the business.
Commission received from TPI can therefore be used when coming up with profits for the year. In case Third Party Insurance agrees to re insure, revenue to be obtained from Third Party Insurance (TPI) will only be recognized after Third Party Insurance pays up the amount to Captive Insurance Company (CIC).
Commission revenue can only be recognized immediately if Crazy Computers will automatically be deducted from the $110 that the company gives to Third Party Insurance so that it does not have to wait for TPI to pay. This would mean that Crazy Computers would have $165 at the end of the sale then give $25 to TPI.
However, it may not show whether the computers on their own were able to sustain themselves without the boost from the commissions earned. When Crazy Computers introduce CIC, they will still get the commission but it will be offset when the amount received from TPI is added.
Even as Crazy Computers recognizes revenue from sale of third party insurance on behalf of TPI, it should be careful when it comes to receiving the money back for re-insurance through CIC. The best method to account for the funds to be collected from the Captive Insurance is to do them separately from Crazy Computers.
This is because Crazy Computers and CIC are two different kinds of businesses. FASB advices that in order to check the progress of a business it is good to gauge its profitability which is done by subtracting the expenses from sales made by the business.
This will ensure that when it comes to paying claims, revenue received from Crazy Computers should not be used for CIC obligations. It will also ensure that the money collected from CIC is not to be used in the computer business unless Crazy Computers borrows from CIC.
If Crazy Computers was to account for CIC revenue together with the computer revenue, calculating profits would get complicated since the revenue received is not made from sales only. In other words, treating the two businesses as separate entities will ensure the profitability of the two can be determined.
Crazy Computer's idea to create a wholly owned subsidiary would be a good idea if the Third Party Insurer agrees to re-insure with them. Based on the transaction illustrated in the case study, currently Crazy computers pay $110 for insurance such that TPI takes responsibility for any obligations from customers.
Because CC gets commission for every sale made then from the $200 received it is left with $80 after paying the sales persons $10. With the introduction of CIC and if TPI agrees to re insure with CIC, CC will get $ 85 back out of the $110 paid to TPI.
This means that cash received goes up from $80 to $165. CIC would therefore be profitable. However, in case of any third party obligations CIC will be solely responsible. This is why it is extremely important for Crazy Computers to ensure that CIC's income does not mix with computer income so as to ensure each department can sustain its own expenses.
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FASB. (2008). Financial Accounting Standards and Revenue Recognition.
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