Revenue Recognition

1
Revenue Recognition

• Chapter
• 18

2
The Current Environment
Revenue recognition has been the largest source
of public company restatements over the past
decade.

• One study noted restatements of revenue
• Result in larger drops in market capitalization
  than other types of restatement.
• Caused eight of the top ten market value losses
  in a recent year.

3
The Current Environment
Guidelines for Revenue Recognition
The revenue recognition principle provides that
companies should recognize revenue

• when it is realized or realizable and
• when it is earned.

LO 1 Apply the revenue recognition principle.
4
The Current Environment
Departures from the Sale Basis

• Earlier recognition is appropriate if there is a
  high degree of certainty about the amount of
  revenue earned.
• Delayed recognition is appropriate if the
• degree of uncertainty concerning the amount of
  revenue or costs is sufficiently high or
• sale does not represent substantial completion of
  the earnings process.

LO 1 Apply the revenue recognition principle.
5
Revenue Recognition at Point of Sale (Delivery)
Departures from the Sale Basis
FASBs Concepts Statement No. 5, companies
usually meet the two conditions for recognizing
revenue by the time they deliver products or
render services to customers.

• Implementation problems,
• Sales with Buyback Agreements
• Sales When Right of Return Exists
• Trade Loading and Channel Stuffing

LO 2 Describe accounting issues for revenue
recognition at point of sale.
6
What Method Do We Use When
Revenue Recognition Before Delivery

• Two methods are available
• The percentage-of-completion method, and
• The completed contract method

Revenue Recognition After Delivery

• The two methods that are used are
• The installment sales method
• The cost recovery method
• If cash is received prior to delivery, use the
  deposit method.

7
Revenue Recognition Before Delivery
Long-Term Construction Accounting Methods
8
Percentage-of-Completion Steps
9
Percentage-of-Completion Entries
Inventory Acct

• Cost of construction
• Construction in process (CIP)
• Materials, cash, payables, etc.
• Progress billings
• Accounts receivable
• Billings on CIP
• Collections
• Cash
• Accounts receivable

Contra Inventory Acct
10
Percentage-of-Completion Entries

• To recognize revenue, cost and gross profit
• CIP gross profit
• Expenses Costs incurred during YR
• Revenue Current period revenue
• To record completion of project
• (Only once at the end of the construction)
• Billings on CIP Contract Price
• CIP Contract Price

11
Percentage-of-Completion Example
Data Contract price 4,500,000 Estimated
cost 4,000,000 Start date July, 2003
Finish October, 2005 Balance sheet date
Dec. 31
Given 2003 2004
2005 Costs to date 1,000,000 2,916,000
4,050,000 Estimated costs to complete
3,000,000 1,134,000 -0- Progress
Billings during year 900,000 2,400,000
1,200,000 Cash collected during year
750,000 1,750,000 2,000,000
What is the percent complete, revenue and gross
profit recognized each year?
12
Percentage-of-Completion Example
Given 2003 2004
2005 Costs to date 1,000,000 2,916,000
4,050,000 Estimated costs to complete
3,000,000 1,134,000 -0- Costs To
Complete 4,000000
4,050,000 4,050,000
13
Percentage-of-Completion Example
2003 2004 2005
14
Completed Contract Method

• Under the completed-contract method, revenue and
  gross profit are recognized when the contract is
  completed.
• Advantage - reported revenue is based on final
  results rather than on estimates of unperformed
  work
• Disadvantage - the distortion of earnings that
  may occur. The accounting entries made under the
  completed-contract method are the same as those
  made under the percentage-of-completion method,
  with the notable exception of periodic income
  recognition.

15
Completed Contract Entries
Inventory Acct

• Cost of construction
• Construction in process (CIP)
• Materials, cash, payables, etc.
• Progress billings
• Accounts receivable
• Billings on CIP
• Collections
• Cash
• Accounts receivable

Contra Inventory Acct
16
Completed Contract Entries(4) (5) NOT UNTIL
complete

• To recognize revenue and gross profit
• CIP gross profit
• Expenses Costs incurred during YR
• Revenue Current period revenue
• To record completion of project
• (Only once at the end of the construction)
• Billings on CIP Contract Price
• CIP Contract Price

17
Recognizing Current Overall Losses on Long-Term
Contracts

• A long-term contract may produce
• either an interim loss and an overall profit,
• or an overall loss for the project
• Under the percentage-of-completion method,
  losses in any case are immediately recognized.
• Under the completed contract method, losses are
  recognized immediately only when overall losses
  are indicated.

18
Recognizing Current Overall Losses on Long-Term
Contracts
Current Loss on an otherwise overall
profitable contract
Loss on an overall unprofitable contract
19
Revenue Recognition Before Delivery
Disclosures in Financial Statements

• Construction contractors should disclosure
• the method of recognizing revenue,
• the basis used to classify assets and liabilities
  as current (length of the operating cycle),
• the basis for recording inventory,
• the effects of any revision of estimates,
• the amount of backlog on uncompleted contracts,
  and
• the details about receivables.

LO 5 Identify the proper accounting for losses on
long-term contracts.
20
What Method Do We Use When
Revenue Recognition Before Delivery

• Two methods are available
• The percentage-of-completion method, and
• The completed contract method

Revenue Recognition After Delivery

• The two methods that are used are
• The installment sales method
• The cost recovery method
• If cash is received prior to delivery, use the
  deposit method.

21
Revenue Recognition After Delivery
When the collection of the sales price is not
reasonably assured and revenue recognition is
deferred.

• Methods of deferring revenue
• Installment-sales method
• Cost-recovery method
• Deposit method

Generally Employed
LO 6 Describe the installment-sales method of
accounting.
22
Revenue Recognition after Delivery
Installment-Sales Method
Recognizes income in the periods of collection
rather than in the period of sale. Recognize both
revenues and costs of sales in the period of
sale, but defer gross profit to periods in which
cash is collected. Selling and administrative
expenses are not deferred.
LO 6 Describe the installment-sales method of
accounting.
23
Revenue Recognition after Delivery
Acceptability of the Installment-Sales Method
The profession concluded that except in special
circumstances, the installment method of
recognizing revenue is not acceptable. The
rationale because the installment method does
not recognize any income until cash is collected,
it is not in accordance with the accrual concept.
Omnibus Opinion, Opinions of the Accounting
Principles Board No. 10 (New York AICPA, 1966),
par. 12.
LO 6 Describe the installment-sales method of
accounting.
24
Revenue Recognition after Delivery
Cost-Recovery Method
Recognizes no profit until cash payments by the
buyer exceed the cost of the merchandise
sold. APB Opinion No. 10 allows a seller to use
the cost-recovery method to account for sales in
which there is no reasonable basis for
estimating collectibility. In addition, FASB
Statements No. 45 (franchises) and No. 66 (real
estate) require use of this method where a high
degree of uncertainty exists related to the
collection of receivables.
LO 7 Explain the cost-recovery method of
accounting.
25
Revenue Recognition after Delivery
Deposit Method
Seller reports the cash received from the buyer
as a deposit on the contract and classifies it on
the balance sheet as a liability. The seller does
not recognize revenue or income until the sale is
complete.
LO 7 Explain the cost-recovery method of
accounting.
26
The Installment Sales Method Example

• Given 2003 2004 2005
• Installment sales 200,000 250,000 240,000
• Cost of sales 150,000 190,000 168,000
• Gross Profit 50,000 60,000
  72,000
• Cash received in
• from 2003 sales 60,000 100,000 40,000
• from 2004 sales -0- 100,000 125,000
• from 2005 sales -0- -0- 80,000
• Determine the realized and deferred gross profit.

27
The Installment Sales Method Example

• Given 2003 2004 2005
• Installment sales 200,000 250,000 240,000
• Cost of sales 150,000 190,000 168,000
• Gross Profit 50,000 60,000 72,000
• Gross profit rate 25 24 30
• Gross Profit / Installment Sales

28
The Installment Sales Method

• Given 2003 2004 2005
• Gross profit rate 25 24 30
• Cash received in
• from 2003 sales 60,000 100,000 40,000
• from 2004 sales -0- 100,000 125,000
• from 2005 sales -0- -0- 80,000
• Realized Gross Profit cash flow appropriate
  gross profit rate

29
The Installment Sales Method

• 2003 2004 2005
• Gross profit rate 25 24
  30
• Realized Gross Profit
• From 2003 sales
• Realized in 15,000 25,000
  10,000
• From 2004 sales
• Realized in -0- 24,000
  30,000
• From 2005 sales
• Realized in -0- -0-
  24,000
• Total 15,000 49,000 64,000

30
The Installment Sales Method Example

• Given 2003 2004 2005
• Installment sales 200,000 250,000 240,000
• Cost of sales 150,000 190,000 168,000
• Gross Profit 50,000 60,000 72,000
• Gross profit rate 25 24 30
• Realized Gross Profit 15,000 49,000 64,000

31
Percentage-of-Completion Entries

• Record Revenue
• Installment A/R YEAR
• Installment Sales
• Record Cost of Installment Sales
• Cost of installment sales
• Inventory
• Record Cash Collected on Installment Sales Cash
• Installment A/R - YEAR

32
Percentage-of-Completion Entries

• Close Sales and Cost to Deferred Gross Profit
• Installment Sales
• Cost of Installment Sales
• Deferred Gross Profit (XA)
• To Remove from Deferred Gross profit the Profit
  Realized
• Deferred Gross Profit
• Realized Gross Profit
• Close Realized Gross Profit to Income Summary
• Realized Gross Profit
• Income Summary