Revenue Recognition Odds and Ends

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Chapter 18

• Revenue Recognition Odds and Ends

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Revenue Recognition Concepts

• Revenues are recognized when EARNED and REALIZED
  or REALIZABLE (Revenue Recognition Concept).
• Earned means risks and reward of ownership
  transferred to the buyer
• REALIZED means receipt of an asset by the
  seller.
• REALIZABLE means that although a buyer has not
  delivered an asset to the seller, the good or
  service offered by the seller is sold in
  established, active markets with quoted prices,
  and thus the seller can immediately REALIZE the
  revenues at a known price (e.g., commodities like
  wheat, gold, etc).

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Revenue Recognition Concepts - continued

• Normally, revenue recognition criteria are
  satisfied at the point of sale.
• However, sometimes revenue recognition is
  accelerated with revenue recognized
• during production (long term construction and
  service contracts) or
• at the completion of production (commodities,
  e.g., wheat, gold).
• Revenue recognition prior to the point of sale is
  driven by a desire to avoid producing distorted
  financial results.
• Other times revenue recognition is delayed until
  after the point of sale.
• Revenue recognition after the point of sale
  usually is driven by a concern over collectiblity
  (i.e., collectibility is not reasonably assured
  and there is no reliable basis for estimating
  the degree of collectibility)

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Methods of Accounting Used when Revenue
Recognition is Accelerated or Delayed (Relative
to Point of Sale)

• Revenue recognition accelerated
• Percentage of completion (used for construction
  contracts)
• Proportional performance (used for service
  contracts)
• Revenue recognition delayed
• Installment method
• Cost recovery method

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Percentage of Completion Method

• Used to account for long-term construction
  contracts
• Revenue (and hence income) recognized on the
  construction project in proportion to the
  percentage of the job that has been completed to
  date.
• The difference between the cumulative revenues
  earned to-date and the revenues previously
  recognized on the job is the amount of revenue
  recognized in the current period.
• Implementing percentage of completion accounting
  requires that certain common-sense criteria be
  met (see page 895 of text), of which the most
  important is the ability to make reasonable
  estimates of
• the extent of progress made toward completing the
  contract, and
• total contract costs.

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Percentage of Completion Method - continued

• Estimating extent of progress toward completing
  the job
• Can be based on input measures (most common is
  costs incurred relative to total estimated costs,
  dubbed to cost-to-cost method)
• Can be based on out measures (e.g., miles of a
  highway project completed as a fraction of the
  total miles).

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Percentage of Completion Method - continued

• If the common-sense criteria described on page
  895 of the text cannot be met, then cannot use
  percentage of completion and instead must use
  completed contract method.
• Under completed contract method, revenue
  recognition is delayed until the contract is
  finished.
• If overall loss on project is anticipated, then
  loss is recognized in FULL during the period in
  which the facts indicate that an overall loss is
  likely (example of conservatism anticipate and
  recognized all losses).

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Percentage of Completion Method Example

• Examples 18-2 to 18-5 pages 897 to 900 in the
  text.

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Proportional Performance Method

• Used for long-term service contracts
• Revenue recognition depends upon whether the
  service contract requires the performance of
• Specified number of similar acts
• Recognize equal amount of revenue for each act.
• Specified number of dissimilar acts
• Recognize revenue for each act based on ratio of
  direct costs per act to total estimated direct
  costs for all acts over the contract life.
• Unspecified number of similar acts
• Recognize revenue on straight-line basis over the
  performance period.

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Proportional Performance Method- continued

• Implementing proportional performance accounting
  requires that costs be classified as either
• Initial direct costs that arise from negotiating
  and signing the contract.
• Deferred and recognized in proportion to service
  revenues.
• Direct costs that have a direct causal
  relationship to the services performed.
• Expense as incurred.
• Indirect costs (all other costs, e.g.,
  advertising and depreciation).
• Expense as incurred.

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Proportional Performance Method- continued

• Example 18-7 on pages 907-908 of text.

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Installment Sales Method

• Distinguish between installment sales versus
  installment sales method of accounting.
• An installment sale is a sale in which the
  seller accepts a long-term receivable from the
  buyer (e.g., buying a refrigerator from Sears
  when Sears provides the financing)
• Normally, the seller recognizes profit in FULL at
  the point of sale (normal accrual accounting)
• However, if collectibility of the receivable is
  not reasonably assured and there is no reliable
  basis for estimating the degree of collectibility
  then installment sales method of accounting is
  used (question why would a seller sell to
  someone for whom collectibility is highly
  uncertain??)
• Under installment sales method, profit is
  recognized on the sale in proportion to the
  amount of cash collected from the customer.

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Cost Recover Method

• Like the installment sales method, the cost
  recovery method is used to account for
  installment sales in which collectibility of the
  receivable is not reasonably assured and there is
  no reliable basis for estimating the degree of
  collectibility.
• Rather than recognizing profit in proportion to
  cash collections, no profit is recognized until
  cumulative cash receipts exceed the cost of item
  that was sold.