Income Recognition and Measurement of Net Assets

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17
hapter
Income Recognition and Measurement of Net Assets
2
Objectives

• 1. Understand the revenue recognition
  alternatives.
• 2. Explain revenue recognition at the time of
  sale, during production, and at time of cash
  receipt.
• 3. Explain the conceptual issues regarding
  revenue recognition alternatives.
• 4. Describe the alternative revenue recognition
  methods.

3
Objectives
5. Account for revenue recognition prior to the
period of sale, including the percentage-of-comple
tion and completed contract methods. 6. Account
for revenue recognition after the period of sale,
including the installment and cost recovery
methods. 7. Account for revenue recognition
delayed until a future event occurs.
4
Objectives
8. Understand software revenue recognition,
franchises, real estate sales, retail land sales,
and consignment sales. 9. Understand accounting
for changes in prices (Appendix).
5
Revenue Recognition
Example 1 Revenue Recognition at Time of Sale
1. Ringwood Company manufactures the inventory.
Inventory 100 Cash 100
2. Ringwood sells the inventory for 150.
Accounts Receivable 150 Revenue 150 Cost of
Goods Sold 100 Inventory 100
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Revenue Recognition
Example 1 Revenue Recognition at Time of Sale
3. Ringwood collects cash of 60.
Cash 60 Accounts Receivable 60
7
Revenue Recognition
Example 2 Revenue Recognition During Production
1. Ringwood Company manufactures the inventory.
Inventory 100 Cash 100
2. Ringwood recognizes the revenue during
production.
Production Expense 100 Inventory 50 Revenue 150
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Revenue Recognition
Example 2 Revenue Recognition During Production
3. The company bills the customer for a partial
billing of 130.
Accounts Receivable 130 Partial Billings 130
4. Ringwood collects cash of 60.
Cash 60 Accounts Receivable 60
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Revenue Recognition
Example 2 Revenue Recognition During Production
The balance sheet shows Inventory of 150, less
Partial Billings of 130.
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Revenue Recognition
Example 3 Revenue Recognition at Time of Cash
Receipt
1. Ringwood Company manufactures the inventory.
Inventory 100 Cash 100
2. Ringwood sells the inventory and defers the
recognition of revenue.
Accounts Receivable 150 Inventory 100 Deferred
Gross Profit 50
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Revenue Recognition
Example 3 Revenue Recognition at Time of Cash
Receipt
3. Ringwood collects cash of 60.
Cash 60 Accounts Receivable 60
(60 150) x 100
4. The company recognizes revenue on the basis of
the cash received.
Cost of Goods Sold 40 Deferred Gross
Profit 20 Revenue 60
Cash Received
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Revenue Recognition
Example 3 Revenue Recognition at Time of Cash
Receipt
The balance sheet shows Accounts Receivable of
90, less Deferred Gross Profit of 30.
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Conceptual Issues
The decision as to when to recognize revenue
focuses on three factors

• The economic substance of the event takes
  precedence over the legal form of the
  transaction.
• The risks and benefits of ownership have been
  transferred to the buyer.
• The collectibility of the receivable from the
  sale is reasonably assured.

14
Alternative Revenue Recognition Methods

• Revenue recognition in the period of sale.
• Revenue recognition prior to the period of sale.
• Revenue recognition at the completion of
  production.
• Revenue recognition after the period of sale.
• Revenue recognition delayed until a future event.

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Revenue Recognized
16
Revenue Recognition Prior to the Period of Sale
Percentage-of-Completion Method

• It achieves the goals of accrual accounting.
• It is consistent with the argument that revenue
  is earned continuously over the entire earning
  process.
• It results in a more relevant measure of periodic
  income.

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Percentage-of-Completion Method
AICPA Statement of Position No. 81-1 requires
that a construction company use the
percentage-of-completion method for long-term
contracts when all the following conditions are
met
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Percentage-of-Completion Method
1. The company can make reasonably dependable
estimates of the extent of progress toward
completion, contract revenue, and contract
costs. 2. The contract clearly specifies the
enforceable rights regarding goods or services to
be provided and received by both the company and
the buyer, the consideration to be exchanged, and
the manner and terms of settlement. 3. The buyer
can be expected to satisfy its obligations under
the contract. 4. The company expects to perform
its contractual obligations.
19
Percentage-of-Completion Method
for short-term contract, and when there are
inherent hazards in the contract beyond the
normal business risks for which reasonably
dependable estimates cannot be made.
The Statement also requires that a company use
the completed-contract method only when at least
one of these conditions is not met...
20
Percentage-of-Completion Method

2000 2001 2002
Construction costs incurred during the
year 100,000 186,000 314,000 Estimated costs
to complete the contract 400,000 264,000 ---
Partial billing to customer 80,000 350,000 270,0
00 Collections from customer 50,000 330,000 320,00
0 Total contract price 700,000
Example
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Percentage-of-Completion Method
2000
1. To record construction costs
Construction in Progress 100,000 Accounts
Payable, etc. 100,000
2. To record partial billings
Accounts Receivable 80,000 Partial
Billings 80,000
3. To record collections
Cash 50,000 Accounts Receivable 50,000
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Percentage-of-Completion Method
2000
4. To record gross profit
Construction Expense 100,000 Construction in
Progress 40,000 Construction Revenue 140,000
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Percentage-of-Completion Method
2001
1. To record construction costs
Construction in Progress 186,000 Accounts
Payable, etc. 186,000
2. To record partial billings
Accounts Receivable 350,000 Partial
Billings 350,000
3. To record collections
Cash 330,000 Accounts Receivable 330,000
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Percentage-of-Completion Method
2001
4. To record gross profit
Construction Expense 186,000 Construction in
Progress 38,000 Construction Revenue 224,000
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Percentage-of-Completion Method
2002
1. To record construction costs
Construction in Progress 314,000 Accounts
Payable, etc. 314,000
2. To record partial billings
Accounts Receivable 270,000 Partial
Billings 270,000
3. To record collections
Cash 320,000 Accounts Receivable 320,000
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Percentage-of-Completion Method
2002
4. To record gross profit and close out accounts
Construction Expense 314,000 Construction in
Progress 22,000 Construction Revenue 336,000
Partial Billings 700,000 Construction in
Progress 700,000
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Completed-Contract Method
Entries 1, 2, and 3 are the same as those used
for the percentage-of-completion method. The
completed-contract method does not recognize
revenue until the project is completed, so there
is no Entry 4 until 2002.
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Completed-Contract Method
2002
4. To record gross profit and close out accounts
Partial Billings 700,000 Construction
Revenue 700,000
Construction Expense 600,000 Construction in
Progress 600,000
29
Capitalized Interest
If interest cost is associated with the funds
used in the construction, the firm should include
this cost in the Construction in Process account.
30
Installment Method
Installment sales involve a financing agreement
whereby the customer signs a contract,...
and agrees to make periodic payments over an
extended period, often several years.
...makes a small down payment,...
31
Installment Method

• Total sales, cost of goods sold, and collections
  are recorded in the normal manner during the
  year.
• At the end of the year, installment sales are
  identified. The revenue and the related cost of
  goods sold are reversed, and the deferred gross
  profit is recognized.
• At the end of the year, the gross profit rate on
  installment sales is computed.
• A portion of the deferred gross profit is
  recognized as gross profit.
• In future years the remaining deferred gross
  profit is reduced and the gross profit is
  recognized based on the cash collected on the
  installment sales.

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Installment Method
Consider the following information for Lee for
2001
Total credit sales 500,000 Total cost of goods
sold 390,000 Installment method
sales 100,000 Installment method cost of goods
sold 75,000 Gross profit rate on installment
method sales 25 Cash receipts on installment
method sales 20,000 Cash receipts on other credit
sales 300,000
Lee Company uses a perpetual inventory method.
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Installment Method
Credit sales during the year
Collected 300,000 20,000 related to
installment sales
Cash 320,000 Accounts Receivable 320,000
Continued
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Installment Method
Installment sales and related cost of goods sold
identified and reversed
Sales 100,000 Cost of Goods Sold 75,000 Deferre
d Gross Profit, 2001 25,000
Recognized a gross profit of 25 of cash
collected on installment sales
Deferred Gross Profit, 2001 5,000 Gross Profit
Realized on Installment Method Sales 5,000
35
Installment Method
Consider the following information for Lee for
2002
Total credit sales 600,000 Total cost of goods
sold 430,000 Installment method
sales 150,000 Installment method cost of goods
sold 105,000 Gross profit rate on installment
method sales 30 Cash receipts on installment
method sales 2001 sales 30,000
2002 sales 40,000 Cash receipts on other credit
sales 480,000
36
Installment Method
Credit sales during the year
Collected 550,000 70,000 related to
installment sales
Cash 550,000 Accounts Receivable 550,000
Continued
37
Installment Method
Installment sales and related cost of goods sold
identified and reversed
Sales 150,000 Cost of Goods Sold 105,000 Deferr
ed Gross Profit, 2002 45,000
Recognized a gross profit of 25 of cash
collected on installment sales for 2001 and 30
for 2002
Deferred Gross Profit, 2001 7,500 Deferred Gross
Profit, 2002 12,000 Gross Profit Realized on
Installment Method Sales 19,500
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Cost Recovery Method
Consider the following information for the Parken
Company Sale of property under cost recovery
method 20,000 Cost of property sold
(net) 12,000 Cash collections 2001 5,000
2002 9,000 2003 6,000
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Cost Recovery Method
During 2001
Accounts Receivable 20,000 Deferred Gross
Profit 8,000 Property (net) 12,000
Collected 5,000
Cash 5,000 Accounts Receivable 5,000
Continued
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Cost Recovery Method
During 2002
Cash 9,000 Accounts Receivable 9,000
December 31, 2002
Deferred Gross Profit 2,000 Gross Profit
Realized on Cost Recovery Transactions 2,000
Continued
41
Cost Recovery Method
During 2003
Cash 6,000 Accounts Receivable 6,000
December 31, 2003
Deferred Gross Profit 6,000 Gross Profit
Realized on Cost Recovery Transactions 6,000
The cash collected in 2003 results in the
recognition of an equal amount of gross profit.
42
Revenue Recognition Delayed Until a Future Event
Occurs (Deposit Method)
Oscar Company sells a subsidiary to the Pet
Company and accepts a 500,000 down payment and a
10 note for the balance of the sale of 7
million. The net assets of the subsidiary are 5
million and Pet Company has the right to cancel
the agreement for the next year.
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Revenue Recognition Delayed Until a Future Event
Occurs (Deposit Method)
Upon receipt of down payment (Oscar Company)
Cash 500,000 Deposit from Purchaser 500,000
When circumstances allow the revenue to be
recognized
Interest Receivable 650,000 Note
Receivable 6,500,000 Deposit from
Purchaser 500,000 Interest Revenue 650,000 Ga
in 2,000,000 Net Assets of Subsidiary 5,000,00
0
44
Software Revenue Recognition
Guidelines of AICPA Statement of Position No. 97-2

• If a company has an agreement to deliver
  software that requires significant production,
  modification, or customization of software, it
  uses contract accounting for the agreement.

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Software Revenue Recognition
Guidelines of AICPA Statement of Position No. 97-2
If a company has an agreement to deliver software
that does not require significant production,
modification, or customization of software, it
recognizes revenue when (a) persuasive evidence
of an agreement exists, (b) delivery has
occurred, (c) the sellers fee is fixed or
determinable, and (d) collectibility is probable.
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Software Revenue Recognition
Guidelines of AICPA Statement of Position No. 97-2
A company separately accounts for a service
element if (a) the services are not essential to
the functionality of any other element of the
transaction, and (b) the services are stated
separately in the contract such that the total
price of the agreement would be expected to vary
as the result of inclusion or exclusion of the
service.
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Software Revenue Recognition
Guidelines of AICPA Statement of Position No. 97-2
Software arrangements may consist of multiple
elements such as additional software products,
upgrades and/or enhancements, rights to exchange
or return software, and customer support. If
contract accounting does not apply, a company
must allocate its fee to the various elements
based on fair values.
48
Software Revenue Recognition
Guidelines of AICPA Statement of Position No. 97-2
A company must allocate any discounts
proportionately to all the elements, except that
none can be allocated to upgrade rights.
49
Franchise
A franchise agreement involves the granting of
business rights by the franchisor to a franchisee
who will operate the franchised business.
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Franchise
Castle Company sells a franchise that requires an
initial franchise fee of 70,000. A down payment
of 20,000 cash is required, with the balance
covered by the issuance of a 50,000, 10 note,
payable by the franchisee in five equal annual
installments.
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Franchise
Situation 1 Castle has substantially performed
all material services, the refund period has
expired, and the collectibility of the note is
reasonably assured.
Cash 20,000 Notes Receivable 50,000 Franchise
Revenue 70,000
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Franchise
Situation 2 The refund period has expired and
the collectibility of the note is reasonably
assured, but Castle has not substantially
performed all material services.
Cash 20,000 Notes Receivable 50,000 Unearned
Franchise Fees 70,000
Castle will recognize the unearned franchise fees
as revenue when it has performed all material
services.
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Franchise
Situation 3 Castle has substantially performed
all material services and the collectibility of
the note is reasonably assured, but the refund
period has not expired.
Cash 20,000 Notes Receivable 50,000 Unearned
Franchise Fees 70,000
Castle will recognize the unearned franchise fees
as revenue when the refund period expires.
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Franchise
Situation 4 Castle has substantially performed
all material services and the refund period has
expired, but the collectibility of the note is
not reasonably assured.
Cash 20,000 Notes Receivable 50,000 Unearned
Franchise Fees 50,000 Franchise Revenue 20,000
Each year revenue of 10,000 is recognized as
cash is collected.
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Franchise
Situation 5 The refund period has expired, but
Castle has not substantially performed all
material services and there is no basis for
estimating the collectibility of the note.
Cash 20,000 Unearned Franchise Fees 20,000
Castle recognizes revenue either under the
accrual method (if collectibility is reasonably
assured) or the installment method (if it has no
basis for estimating the collectibility of the
note).
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Franchise
Situation 6 Castle has earned only 30,000 from
providing initial services, with the balance
being a down payment for continuing services.
The refund period has expired and collectibility
of the note is reasonably assured.
Castle recognizes the unearned franchise fees as
revenue when it performs the continuing services.
Cash 20,000 Notes Receivable 50,000 Franchise
Revenue 30,000 Unearned Franchise Fees 40,000
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Retail Land Sales
The selling company recognizes revenue and the
related expenses in the period of the sale on the
accrual basis if all of the following conditions
are met

• The buyer has made the down payment and each
  required subsequent payment until the period of
  cancellation with refund has expired.
• The cumulative payments of principal and interest
  equal or exceed 10 of the contract sales price.

Continued
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Retail Land Sales

• Collection experience for the project indicates
  that at least 90 of the contracts will be
  collected in full (a down payment of 20 is an
  acceptable indication of collectibility).
• The receivable from the sale is not subject to
  subordination to new loans on the property.
• The seller is not obligated to complete
  improvements of lots sold or to construct
  amenities or other facilities applicable to lots
  sold.

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Consignment Sales
Accounting for consignments may be summarized--

• 1. Since title remains with the consignor, when
  the goods are transferred from the consignor to
  the consignee, the consignor does not record the
  sale of inventory.
• 2. The consignor recognizes revenue only when the
  sale to the third party occurs.
• 3. The consignee uses a Consignment-in account.
• 4. The consignor uses a Consignment-out account,
  which is a special inventory account.

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