A Review of the Accounting Cycle

1
Complexities of Revenue Recognition
2
Learning Objectives

• Identify the primary criteria for revenue
  recognition.
• Explain when revenue is appropriately recognized
  prior to delivery of goods or services through
  percentage-of-completion accounting.
• Record journal entries for long-term
  construction-type contracts using
  percentage-of-completion and completed-contract
  methods.

3
Learning Objectives

• Record journal entries for long-term service
  contracts using the proportional performance
  method.
• Explain when revenue is recognized after delivery
  of goods or services through installment sales,
  cost recovery, and cash methods.

4
Learning Objectives
EXPANDED MATERIAL

• Describe accounting for the transfer of assets
  prior to the recognition of revenue with the
  deposit method and consignment sales.

5
Revenue Recognition Criteria
FASBs two criteria for recognizing revenues and
gains

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

6
Revenue Recognition Criteria
This most often occurs when goods are delivered
or when services are rendered.
Both of these criteria generally are met at the
point of sale.
7
Revenue Recognition--Exceptions

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

8
Revenue Recognition--IAS 18
A company should recognize revenue from the SALE
OF GOODS when all of the following conditions
have been satisfied

• The significant risks and rewards of ownership of
  the goods have been transferred to the buyer and
  the selling company retains no effective control
  over what happens to the goods,
• Both the amount of the revenue and of the costs
  associated with the transaction can be reliably
  measured, and
• It is probable that the economic benefits of the
  sale will flow to the selling company.

9
Revenue Recognition--IAS 18
A company should recognize revenue from the
RENDERING OF SERVICES when both of the following
conditions have been satisfied

• The total amount of the revenue, the total amount
  of the costs, and the stage of completion of the
  transaction can be reliably measured, and
• It is probable that the economic benefits of the
  transaction will flow to the company rendering
  the services.

10
Revenue Recognition--Exceptional Cases

• Long-Term Contracts
• Uncertain Collections
• Deposit Method
• Consignment Sales

11
Long-Term Contracts--Recognition Choices

• Completed-Contract Method recognize all income
  when project is completed.
• Percentage-of-Completion Method recognize
  revenue throughout the term of the contract.

12
Percentage-of-Completion Criteria

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

13
Percentage-of-Completion Criteria

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

14
Percentage-of-Completion--General Concepts

• Recognize revenue throughout life of the
  contract.
• Revenue recognized is a function of how complete
  the project is.
• 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.

15
Percentage-of-Completion

• 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.

16
Percentage-of-Completion
2001 __
2002
2003
Costs incurred to date
72,000
192,000
240,000
At the beginning of the contract, costs are
expected to be incurred each year as shown.
17
Percentage-of-Completion
2001 _
2002
2003
Costs incurred to date
72,000
192,000
240,000
Total cost of the project at completion is
expected to be 240,000. The difference between
the costs incurred to date and the total
estimated costs at completion is defined as the
estimated costs remaining to complete the project.
18
Percentage-of-Completion
2001
2002
2003
Costs incurred to date
72,000
192,000
240,000
Estimated costs to complete
168,000
48,000
0
Total estimated costs
240,000
240,000
240,000
Percentage complete is the ratio of costs
incurred to date to total estimated costs at
completion.
19
Percentage-of-Completion
2001
2002
2003
Costs incurred to date
72,000
192,000
240,000
Estimated costs to complete
168,000
48,000
0
Total estimated costs
240,000
240,000
240,000
Percentage complete
30
80
100
Estimated total income is the difference between
the contract price and total expected costs.
Assume the contract price in this example is
300,000.
20
Percentage-of-Completion
2001
2002
2003
Costs incurred to date
72,000
192,000
240,000
Estimated costs to complete
168,000
48,000
0
Total estimated costs
240,000
240,000
240,000
Percentage complete
30
80
100
Estimated total income
60,000
60,000
60,000
Estimated total income to date is computed based
on the cumulative percentage complete.
21
Percentage-of-Completion
2001
2002
2003
Costs incurred to date
72,000
192,000
240,000
Estimated costs to complete
168,000
48,000
0
Total estimated costs
240,000
240,000
240,000
Income recognized in the current period is the
difference between total income to date and
income previously recognized.
Percentage complete
30
80
100
Estimated total income
60,000
60,000
60,000
Estimated total income to date
18,000
48,000
60,000
LessIincome previously recognized
18,000
48,000
0
Income recognized this period
18,000
30,000
12,000
22
Percentage-of-Completion
2001
2002
2003
Costs incurred to date
72,000
192,000
240,000
Estimated costs to complete
168,000
48,000
0
Total estimated costs
240,000
240,000
240,000
Percentage complete
30
80
100
Estimated total income
60,000
60,000
60,000
Estimated total income to date
18,000
48,000
60,000
Less Income previously recognized
18,000
48,000
0
Income recognized this period
18,000
30,000
12,000
23
Percentage-of-Completion
2001
Construction in Progress. 72,000 Materials,
Cash, etc... 72,000 To record costs
incurred.
Accounts Receivable.. 100,000 Progress
Billings on Construction Contracts 100,000
To record billings (amount assumed).
Cash. 90,000 Accounts
Receivable.. 90,000 To record cash
collections (amount assumed).
24
Percentage-of-Completion
2002
Construction in Progress 120,000 Materials,
Cash, etc.. 120,000 To record costs
incurred.
Accounts Receivable. 140,000 Progress
Billings on Construction Contracts... 140,0
00 To record billings (amount assumed).
Cash 125,000 Accounts
Receivable 125,000 To record cash
collections (amount assumed).
25
Percentage-of-Completion
2003
Construction in Progress. 48,000 Materials,
Cash, etc... 48,000 To record costs
incurred.
Accounts Receivable.. 60,000 Progress
Billings on Construction Contracts 60,000
To record billings (amount assumed).
Cash. 85,000 Accounts
Receivable.. 85,000 To record cash
collections (amount assumed).
26
Revenue Recognition--Exceptional Cases

• Long-Term Contracts
• Uncertain Collections
• Deposit Method
• Consignment Sales

27
Uncertain Collections--Recognition Alternatives

• Installment Sales Method Recognizes revenues
  and related expenses as cash is received (used
  when collection is somewhat uncertain).
• 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.

28
Uncertain Collections--Comparison of Recognition
Methods
Timing of Revenue
Treatment
Recognition
of Costs
Method
29
Installment Sales Method
The installment sales method is used most
commonly in cases of real estate sales.
30
ExampleInstallment 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.

31
ExampleInstallment Sales Method
2001 2002
Sales Cost of Sales Gross Profit Gross Profit
Percentage
150 200 100 140 50 60
33.33 30
Cash Collection 2001 Sales 30
75 2002 Sales 70
32
ExampleInstallment Sales Method

• 2001
• Accounts Receivable--2001... 150
• Installment Sales. 150

Cost of Installment Sales... 100 Inventory
. 100
Cash 30 Accounts
Receivable--2001... 30
33
ExampleInstallment Sales Method
2001 Installment Sales. 150 Cost of
Installment Sales. 100 Deferred Gross
Profit--2001... 50
Deferred Gross Profit--2001... 10 Realized
Income.. 10 (30 x 33.33)
34
ExampleInstallment Sales Method

• 2002
• Accounts Receivable--2002.. 200
• Installment Sales 200

Cost of Installment Sales.. 140 Inventory
140
Cash... 145 Accounts
Receivable--2001... 75 Accounts
Receivable--2002... 70
35
ExampleInstallment Sales Method

• 2002
• Installment Sales... 200
• Cost of Installment Sales... 140
• Deferred Gross Profit--2002.. 60

Deferred Gross Profit--2001. 25 Deferred
Gross Profit--2002. 21 Realized Gross
Profit on Installment Sales.. 46
36
Example Cost Recovery Method

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

37
Example Cost Recovery Method

• 2002
• All entries are the same except do not book the
  entry to gross profit.

Deferred Gross Profit--2001.. 5 Realized
Gross Profit on Installment Sales.. 5
38
Revenue Recognition--Exceptional Cases

• Long-Term Contracts
• Uncertain Collections
• Deposit Method
• Consignment Sales

39
Deposit Method--General Requirement

• Used when cash is received before a sale is
  completed.
• All revenue is initially deferred.
• Seller retains property sold as a recognized
  asset until sale is completed.
• Revenue is recognized when sale is completed.

40
Deposit Method and Franchises

• Relates primarily to initial franchise fees.
• Franchiser defers initial fee at time cash is
  received.
• Franchiser recognizes initial fee revenue when
  substantial performance of services is
  achieved.
• Franchiser may use any appropriate recognition
  method once substantial performance is achieved.

41
Example Franchise

• Mary sells Bob a franchise for 1,000 cash on
  June 1. Substantial performance is agreed upon
  that Mary will complete 700 of renovation on
  Bobs restaurant (which occurs on July 10).
  Prepare Marys journal entries.

42
Example Franchise

• June 1
• Cash... 1,000
• Deposit on Franchise (or
• Unearned Franchise Fee)... 1,000

July 10 Cost of Franchise Fee Revenue.
700 Cash. 700 Deposit on
Franchise (or Unearned Franchise
Fee) 1,000 Franchise Fee Revenue... 1,000
43
Revenue Recognition--Exceptional Cases

• Long-Term Contracts
• Uncertain Collections
• Deposit Method
• Consignment Sales

44
Consignment Sales--General Principles

• Definitions
• Consignee Title holder/seller of merchandise.
• Consignor Merchandise selling agent.
• Consignor does not recognize revenue upon
  shipment to consignee.
• Consignor accounts for consigned goods in
  separate Inventory on Consignment account.

45
Consignment Sales--General Principles

• Consignee does not recognize consigned goods as
  inventory.
• Consignor records all pre-sale expenses as
  Inventory on Consignment.
• Consignor recognizes revenue when informed of a
  sale by consignee.
• Consignee recognizes revenue only for consignment
  commission.

46
Example Consignment Sales

• Bob agrees to consign goods worth 1,000 to Lucy.
  Lucy agrees to sell the goods at her store for a
  5 percent of net sales consignment commission and
  reimbursement of selling expenses.

The next several slides demonstrate the
transactions and journal entries for Bob and Lucy
throughout the consignment cycle. (All numbers
are assumed.)
47
Example Consignment Sales

• Transaction Shipment of Goods

Entry in Bobs (consignors) books Inventory on
Consignment 1,000 Finished Goods
Inventory.. 1,000
Entry in Lucys (consignees) books None--memoran
dum inventory control record.
48
Example Consignment Sales

• Transaction Incurrence of 200 of selling
  expenses by Lucy.

Entry in Bobs books Inventory on Consignment.
200 Consignee Payable.. 200
Entry in Lucys books Consignor Receivable.
200 Cash. 200
49
Example Consignment Sales

• Transaction Sale of merchandise for 2,000.

Entry in Bobs books None.
Entry in Lucys books Cash
2,000 Consignor Payable.. 2,000
50
Example Consignment Sales

• Transaction Lucy notifies Bob of the sale and
  sends him net cash proceeds.

Entry in Bobs books Commission
Expense... 100 Cash.. 1,700 Consign
ee Payable... 200 Cost of Goods
Sold.. 1,000 Consignment Sales
Revenue. 2,000 Inventory on Consignment 1,00
0
51
Example Consignment Sales

• Entry in Lucys books
• Consignor Payable. 2,000
• Cash. 1,700
• Commission Revenue.. 100
• Consignor Receivable.. 200

52
The End