A Review of the Accounting Cycle

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chapter 8
Revenue Recognition
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Learning Objectives

• 1. Identify the primary criteria for revenue
  recognition.
• 2. Apply the revenue recognition concepts
  underlying the examples used in SAB 101.
• 3. Record journal entries for long-term
  construction-type contracts using
  percentage-of-completion and completed-contract
  methods.

Continued
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Learning Objectives
4. Record journal entries for long-term service
contracts using the proportional performance
method. 5. Explain when revenue is recognized
after delivery of goods or services through
installment sales, cost recovery, and cash
methods.
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Revenue Recognition
FASBs two criteria for recognizing revenues and
gains

• 1. They are realized or realizable.
• 2. They have been earned through substantial
  completion of the activities involved in the
  earnings process.

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Revenue Recognition
Revenue recognition most often occurs when goods
are delivered or when services are rendered.
Both of these criteria generally are met at the
point of sale.
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Revenue Recognition
Criterion Associated With Revenue Recognition
Criterion 1 The customer has provided payment
or a valid promise of payment. Criterion 2 The
company has provided a product or service.
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Revenue Recognition
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Revenue Recognition
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Revenue Recognition
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Revenue Recognition
Generally, revenue is not recognized prior to the
point of sale because either

• A product or service was provided without
  receiving a valid promise of payment from
  customer.
• The company has not provided the product or
  service.

An exception occurs when the customer provides a
valid promise of payment and conditions exist
that contractually guarantee the sale.
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Revenue Recognition
AICPA Statement of Position 97-2 gives companies
more guidance through a checklist of four factors
that amplify the two criteria
a. Persuasive evidence of an arrangement
exists. b. Delivery has occurred. c. The vendors
fee is fixed or determinable. d. Collectibility
is probable.
Earned
Realised
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Persuasive Evidence of an Arrangement
The SEC issued SAB 101 in response to specific
abuses involving revenue recognition.
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Persuasive Evidence of an Arrangement
SAB 101 is in a question-and-answer format. The
answers given are invariably No.
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Persuasive Evidence of an Arrangement
Typical questions from SAB 101
Question 1 Company A requires each sale to be
supported by a written sales agreement signed by
an authorized representative of both Company A
and the customer.
Question 1 May Company A recognize revenue in
the current quarter if the product is delivered
by the end of the quarter but the sales agreement
is not signed by the customer until a few days
after the end of the quarter?
ENTER
Addresses internal controls.
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Persuasive Evidence of an Arrangement
Typical questions from SAB 101
Question 2 Company Z delivers product to a
customer on a consignment basis. May Company Z
recognize revenue upon delivery of the product to
the customer?
Addresses the issue of circumventing internal
controls by side agreements.
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Delivery has occurred or service has been rendered
Typical questions from SAB 101
Question 3 May Company A recognize revenue when
it completes production of inventory for a
customer if it segregates that inventory from
other products in its warehouse?
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Delivery has occurred or service has been rendered
Typical questions from SAB 101
Question 4 Company R is a retailer that offers
layaway sales to customers. A customer pays a
portion of the sales price, and Company R sets
the
Question 4 merchandise aside until the customer
pays the remainder of the sales price, and takes
possession of the merchandise. When should
Company R recognize revenue?
ENTER
Focuses on issues centered on the bill-and-hold
arrangements.
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Delivery has occurred or service has been rendered
bill-and-hold arrangements.
In general, revenue should not be recognised in a
bill-and-hold arrangement until the seller has
transferred both legal ownership, evidence by the
buyer taking title to the goods, and economic
ownership, meaning that the buyer accepts
responsibility for the safeguarding and
preservation of the goods.
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Delivery has occurred or service has been rendered
Appropriate Layaway Accounting
Receipt of 100 cash as initial layaway payment
Cash 100 Deposit Received from Customers 100
Receipt of final 1,400 cash payment and delivery
of goods to customer
Cash 1,400 Deposit Received from
Customers 100 Sales 1,500 Cost of Goods
Sold 1,000 Inventory 1,000
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Delivery has occurred or service has been rendered
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Delivery has occurred or service has been rendered
Questions 5 6 Deal with the seller receiving
some up-front fee as well as subsequent periodic
payments
E.g. Seller Company receives 1,000 cash from a
customer as the initial sign-up fee for a
service. In addition to the sign-up fee, the
customer is required to pay 50 per month for 100
monthswhich is the economic life of this service
agreement.
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Delivery has occurred or service has been rendered
Receipt of 1,000 cash as initial sign-up fee
Cash 1,000 Unearned Initial Sign-Up Fees 1,000
Receipt of first monthly payment of 50
Cash 50 Monthly Service Revenue 50
Partial recognition of the initial signup fee as
revenue (1,000/100 months)
Unearned Initial Sign-Up Fees 10 Initial Sign-Up
Fee Revenue 10
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Delivery has occurred or service has been rendered
Questions 7 9 Deal with refundable fees. In
summary, the non-refundable portion of the fees
can be recognized on a monthly basis if the
number of refunds can be reliably estimated.
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Price is fixed or determinable
Typical questions from SAB 101
Question 8 Company A owns a building and leases
it to a retailer. The annual lease payment is
1.2 million plus 1 of all the retailers sales
in excess of 25 million.
Question 8 Should Company A estimate and
recognize revenue associated with the 1 of sales
over 25 million on a straight-line basis
throughout the year?
ENTER
Addresses the difference between estimating the
future impact of past events and estimating the
future impact of future events.
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Reporting Revenue Gross vs. Net

• Gross Sales commission
• Net Commission only
• SAB 101 Gross is inappropriate unless the
  seller actually took legal and economic ownership
  of the goods being sold.

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Revenue Recognition Prior to Providing Goods or
Services

• Completed-contract method recognizes all income
  when project is completed.
• Percentage-of-completion method recognizes
  revenue throughout the term of the contract.
  (construction)
• Proportional performance method reflects revenue
  earned on service contracts under which many acts
  of service are to be performed before the
  contract is complete.

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Revenue Recognition Prior to Providing Goods or
Services
GAAP requires percentage-of-completion method
unless certain criteria are not met.
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Percentage-of-Completion Accounting

• Dependable estimates of
• contract revenues
• contract costs
• progress toward completion
• Contract clearly specifies
• enforceable rights of the parties
• consideration to be exchanged
• manner and terms of settlement

Continued
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Percentage-of-Completion Accounting

• The buyer can be expected to satisfy obligations
  under the contract.
• Contractor can be expected to perform the
  contractual obligation.

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Percentage-of-Completion Accounting

• Recognize revenue throughout life of the
  contract.
• Revenue recognized is a function of how complete
  the project is to date.
• Costs are charged to an inventory account
  Construction in Process (CIP).
• Profits are charged to CIP.
• CIP is valued at net realizable value.
• Any anticipated loss is booked for the full
  amount of the loss when it becomes measurable.

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Percentage-of-Completion Accounting

• Input measures Cost-to-cost method where the
  degree of completion is determined by comparing
  costs already incurred with the most recent
  estimates of total expected costs to complete the
  project.

Engineers are often called in to help provide
estimates.
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Accounting for Long-Term Construction-Type
Contracts
Strong Construction Company was awarded a
contract with a total price of 3,000,000.
Strong expected to earn 400,000 profit on the
contract.
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Accounting for Long-Term Construction-Type
Contracts
Actual Cost Incurred
Estimated Cost to Complete
Cost Percentage
Total Cost
Year
2004 1,040,000 1,560,000 2,600,000 40 2005
910,000 Total 1,950,000 650,000 2,600,000 75 200
6 650,000 0 2,600,000 100 Total 2,600,000
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Percentage-of-Completion Accounting
2004
Construction in Progress 1,040,000 Materials,
Cash, etc. 1,040,000 To record costs
incurred.
Accounts Receivable 1,000,000 Progress Billings
on Construction Contracts 1,000,000
To record billings.
Cash 800,000 Accounts Receivable 800,000
To record cash collections.
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Percentage-of-Completion Accounting
2004
Cost of Long-Term Construction
Contracts 1,040,000 Construction in
Progress 160,000 Revenue from Construction
Contracts 1,200,000
Actual Cost
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Percentage-of-Completion Accounting
2005
Construction in Progress 910,000 Materials,
Cash, etc. 910,000 To record costs
incurred.
Accounts Receivable 900,000 Progress Billings on
Construction Contracts 900,000 To
record billings.
Cash 850,000 Accounts Receivable 850,000
To record cash collections.
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Percentage-of-Completion Accounting
2005
Cost of Long-Term Construction
Contracts 910,000 Construction in
Progress 140,000 Revenue from Long-Term
Construction Contracts 1,050,000
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Percentage-of-Completion Accounting
2006
Construction in Progress 650,000 Materials,
Cash, etc. 650,000 To record costs
incurred.
Accounts Receivable 1,100,000 Progress Billings
on Construction Contracts 1,100,000
To record billings.
Cash 1,350,000 Accounts Receivable 1,350,000
To record cash collections.
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Percentage-of-Completion Accounting
2006
Cost of Long-Term Construction
Contracts 650,000 Construction in
Progress 100,000 Revenue from Long-Term
Construction Contracts 750,000
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Percentage-of-Completion Accounting
2006
Progress Billings on Construction Contracts
Construction in Progress
1,040,000 160,000 910,000 140,000 650,000
100,000 3,000,000
1,000,000 900,000 1,100,000 3,000,000
Progress Billings on Construction
Contracts 3,000,000 Construction in
Progress 3,000,000
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Revision of Estimates
Instead of the previous illustration, assume that
at the end of 2005, it was estimated that the
remaining cost to complete construction was
720,000 rather than 650,000.
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Revision of Estimates
Actual Cost Incurred
Estimated Cost to Complete
Cost Percentage
Total Cost
Year
2004 1,040,000 1,560,000 2,600,000 40 2005
910,000 Total 1,950,000 720,000 2,670,000 73 200
6 700,000 0 2,650,000 100 Total 2,650,000
Items in blue changed from the previous
illustration.
Note that expected gross profit was 400,000 in
2004, 330,000 in 2005, and the actual was
350,000 in 2006.
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Revision of Estimates
The entries for 2004 would be the same as those
shown in the previous example.
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Revision of Estimates
All entries for 2005 would be the same except for
the entry to record revenue and cost.
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Revision of Estimates
2005
Cost of Long-Term Construction
Contracts 910,000 Construction in
Progress 80,000 Revenue from Long-term
Construction Contracts 990,000
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Revision of Estimates
2006
Construction in Progress 700,000 Materials,
Cash, etc. 700,000 To record costs
incurred.
Accounts Receivable 1,100,000 Progress Billings
on Construction Contracts 1,100,000
To record billings.
Same
Cash 1,350,000 Accounts Receivable 1,350,000
To record cash collections.
Same
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Revision of Estimates
2006
Cost of Long-Term Construction
Contracts 700,000 Construction in
Progress 110,000 Revenue from Long-Term
Construction Contracts 810,000
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Revision of Estimates
2006
Progress Billings on Construction Contracts
Construction in Progress
1,040,000 160,000 910,000 80,000 700,000
110,000 3,000,000
1,000,000 900,000 1,100,000 3,000,000
Progress Billings on Construction
Contracts 3,000,000 Construction in
Progress 3,000,000
Items in red are different for this illustration.
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Anticipated Loss Percentage-of-Completion Method
Assume the same facts for Strong Construction
Company, except that after 2004 entries have been
made, the firm determines that the total cost
will be 3,250,000. The entries for 2004 would
be the same, but the loss must be dealt with in
2005in addition, the 160,000 gross profit
recognized in 2004 must be eliminated.
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Anticipated Loss Percentage-of-Completion Method
2005
Cost of Long-Term Construction
Contracts 910,000 Revenue from Long-Term
Construction Contracts 600,000 Construction in
Progress 410,000
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Accounting for Long-Term Service Contracts
Most service contracts involve three types of
costs
(1) Initial direct costs related to obtaining and
performing initial services on the
contract. (2) Direct costs related to performing
the various acts of service. (3) Indirect costs
related to maintaining the organization to
service the contract.
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Accounting for Long-Term Service Contracts
Proportional Performance Method A correspondence
school enters into 100 contracts with students
for an extended writing course. The fee for each
contract is 500, payable in advance. The
initial direct costs related to the contracts
total 5,000. Actual direct costs for lessons
for the first period are 12,000. The sales
value of the lessons completed is 24,000 (The
total value of all lessons is 60,000).
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Accounting for Long-Term Service Contracts
Receipt of fees
Cash 50,000 Deferred Course Revenue 50,000
Liability account
Initial direct costs
Deferred Initial Costs 5,000 Cash 5,000
Asset account
Direct costs for lesson actually completed
Expense account
Contract Costs 12,000 Cash 12,000
Continued
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Accounting for Long-Term Service Contracts
Course revenue recognized
Deferred Course Revenue 20,000 Recognized Course
Revenue 20,000
Recognize contract costs from initial direct
costs
Contract Costs 2,000 Deferred Initial
costs 2,000
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Revenue Recognition After Delivery of Goods or
Providing Service

• Installment Sales Method Recognizes revenues
  and related expenses as cash is received (used
  when collection is somewhat uncertain). (Not to
  be confused with installment sales, which utilize
  accrual accounting)
• Cost Recovery Method No income is recognized on
  sale until the cost of the item sold is recovered
  through cash receipts (used when collection is
  very uncertain).
• Cash Method Recognizes all expenses immediately
  as incurred and all revenues only when cash is
  collected.

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Revenue Recognition After Delivery of Goods or
Providing Service
Timing of Revenue
Treatment
Recognition
of Costs
Method
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Installment Sales Method
The installment sales method is used most
commonly in cases of real estate sales.
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Installment Sales Method

• George sells merchandise on the installment
  basis. Uncertainty of collection makes use of
  the installment method necessary. Use the
  accompanying data to prepare Georges journal
  entries.

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Installment Sales Method
2004 2005
Sales Cost of Sales Gross Profit Gross Profit
Percentage
150,000 200,000 100,000 140,000
50,000 60,000 33.33 30
Cash Collection 2004 Sales 30,000
75,000 2005 Sales 70,000
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Installment Sales Method
2004

• Installment Accounts Receivable
• 2004 150,000
• Installment Sales 150,000

Cost of Installment Sales 100,000 Inventory
100,000
Cash 30,000 Installment Accounts
Receivable2004 30,000
Continued
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Installment Sales Method
2004
Installment Sales 150,000 Cost of Installment
Sales 100,000 Deferred Gross
Profit2004 50,000
Deferred Gross Profit2004 10,000 Realized
Gross Profit on Installment Sales
10,000
30,000 x 33.33
Continued
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Installment Sales Method
2005

• Installment Accounts Receivable
• 2005 200,000
• Installment Sales 200,000

Cost of Installment Sales 140,000 Inventory
140,000
Cash 145,000 Installment A/R2004
75,000 Installment A/R2005 70,000
Continued
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Installment Sales Method
2005
Installment Sales 200,000 Cost of Installment
Sales 140,000 Deferred Gross
Profit2005 60,000
Deferred Gross Profit2004 25,000 Deferred
Gross Profit2005 21,000 Realized Gross Profit
on Installment Sales 46,000
75,000 x 33.33
70,000 x 30
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Cost Recovery Method

• Assume George has to use the cost recovery
  method, but all sales and collections remain the
  same.

Revenue
Cost
Recovered Cost
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Cost Recovery Method

• 2005
• All entries are the same except do not book the
  entry to gross profit.

Deferred Gross Profit2004 5,000 Realized Gross
Profit on Installment Sales 5,000
(30,000 75,000) (100,000)
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Cost Recovery Method
2006
Deferred Gross Profit2004 30,000 Deferred Gross
Profit2005 10,000 Realized Gross Profit on
Installment Sales 40,000
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Cash Method
If the probability of recovering product or
service costs is remote the cost recovery method
of accounting can be used. There has to be
considerable uncertainty as to ultimate
collection of the contract price.
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chapter 8
The End
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