REVENUE AND EXPENSE RECOGNITION 2 2 2 2

LEARNING OBJECTIVES Understand the revenue and matching principles Familiarize yourself with applications of the revenue principle with special attention to: Installment and cost recovery methods Accounting for long-term contracts Completed contract method Percentage of completion method Right of return method Product financing arrangements Franchising agreements Obtain overall understanding of matching principle

DEFINITIONS Revenues Expenses Inflows of assets or settlements of liabilities during a period from delivering or producing goods or services. Expenses Outflows of assets or incurrence of liabilities during a period from delivering or producing goods or services. Incurred in an attempt to produce revenues 3 3 3 3

Revenue should be recognized in the financial statement when . . . REVENUE PRINCIPLE Revenue should be recognized in the financial statement when . . . It is earned, and It is realized or realizable (Measurable) 7 7 7 7

REVENUE PRINCIPLE Revenue is earned when the earnings process is completed or virtually completed. Revenue is realized when cash is received. Revenue is realizable when claims to cash are received that can be converted into a known amount of cash. 8 8 8 8

Revenue is typically recognized: REVENUE PRINCIPLE Revenue is typically recognized: At delivery (point of sale) After delivery Before delivery of product or service 9 9 9 9

REVENUE RECOGNITION POINTS before delivery Recognition at delivery Recognition after delivery Design and production, construction in progress, minerals discovered Goods completed and ready for sale, contract complete Delivery of product or service Cash collected for goods or services Right of return expires Percentage-of completion method Production method Point of sale method Installment method Right of return expiration method Completed contract method Cost recovery method RELEVANCE RELIABILITY

REVENUE RECOGNITION Point of Sale Revenue is earned and realized at the point of sale. The product or service has been delivered to the customer and cash has been received or is receivable. This method is sometimes called the “sales method,” or “delivery method.” 10 10 10 10

REVENUE RECOGNITION After Delivery Uncertainties about collectibility or future performance by seller. Sale with right of return. Product-financing arrangements. 11 11 11 11

INSTALLMENT SALES When we are uncertain about the collectibility of the sales revenue or the ability of the seller to deliver futures services, we should defer revenue recognition. Two commonly used accounting methods are the . . . Installment sales method. Cost recovery method. 15 15 15 15

Installment Sales Method Sale and cost of sale recorded as usual. Compute gross margin rate on the installment sales. Recognize gross margin as cash is received. Gross margin not realized is deferred until a future period. 16 16 16 16

INSTALLMENT SALES Example Sam’s Appliances made sales of $200,000 in 19X5 that qualified for the installment sales method of accounting. The items sold have a cost to Sam’s of $130,000. During 19X5, Sam’s collected cash from installment customers of $90,000. The remaining amount will be collected in 19X6. Prepare the journal entries to record the installment sales transactions during 19X5. 17 17 17 17

INSTALLMENT SALES Example 18 18 18 18

INSTALLMENT SALES Example 19 19 19 19

INSTALLMENT SALES Example 20 20 20 20

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INSTALLMENT SALES Example 22 22 22 22

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INSTALLMENT SALES Example Cash collection in 19X5 $90,000 Gross margin percentage 35% Gross profit to recognize $31,500 24 24 24 24

INSTALLMENT SALES Example Balance Sheet 25 25 25 25

INSTALLMENT SALES Example Balance Sheet 26 26 26 26

UNCERTAINTY IS GREATER! COST RECOVERY METHOD Like the installment sales method, cost recovery is used when we are uncertain about the collectibility of the sales revenue or the ability of the seller to complete future performance. UNCERTAINTY IS GREATER! No profit is recognized until cost of item sold is fully recovered. 27 27 27 27

COST RECOVERY Example Sam’s Appliances made sales of $200,000 in 19X5 that qualified for the cost recovery method of accounting. The items sold have a cost to Sam’s of $130,000. During 19X5, Sam’s collected cash from installment customers of $90,000. The remaining amount will be collected in 19X6. Prepare the journal entries to record the installment sales transactions during 19X5. 28 28 28 28

COST RECOVERY Example 29 29 29 29

COST RECOVERY Example 30 30 30 30

COST RECOVERY Example 31 31 31 31

COST RECOVERY Example No profit is recognized in 19X5 because the cost of the item sold ($130,000) has not been recovered in the form of cash receipts. Once we collect $130,000 in cash, profit recognition begins. 32 32 32 32

All gross profit has been deferred until we recover the COST RECOVERY Example Balance Sheet All gross profit has been deferred until we recover the $130,000 cost of the item sold. 33 33 33 33

Equipment Manufacturing RIGHT OF RETURN In some industries it is common practice that the sales terms allow customers the right to return goods under specified conditions and over long periods of time. Equipment Manufacturing Book Publishing 13 13 13 13

Recognize revenue at point of sale if, RIGHT OF RETURN Recognize revenue at point of sale if, Selling price is fixed or determinable. Buyer is obligated to pay the seller and payment is not contingent upon resale of the product. Buyer is obligated even in case of theft or physical destruction. Buyer has economic substance apart from that provided by the seller. Seller has no obligation for future performance. Future returns can be estimated. 14 14 14 14

PRODUCT-FINANCING ARRANGEMENTS An agreement in which a sponsoring company sells a product to another company and in a related transaction agrees to repurchase the product. The sponsoring company Records a liability when the proceeds are received. No sale is recorded and inventory is not adjusted. Wait for a sale to outside party. 12 12 12 12

REVENUE RECOGNITION Before Delivery Accounting for long-term construction contracts Completed-Contract Method Percentage-of-Completion Method 34 34 34 34

REVENUE RECOGNITION Before Delivery Percentage-of-completion method is appropriate when . . . Contract specifies the amount of consideration to be exchanged and the terms of settlement. Buyer is expected to satisfy the obligation. Contractor can perform according to the terms of the contract. 35 35 35 35

MEASURING PROGRESS TOWARD COMPLETION Input Measures Effort devoted to project compared to total effort expected (cost incurred to date compared to total estimated costs) Output Measures Results to date compared to total results 36 36 36 36

MEASURING PROGRESS TOWARD COMPLETION Cost-to-Cost Method Total costs incurred to date Percent complete = Most recent estimate of total costs of the project 37 37 37 37

MEASURING PROGRESS TOWARD COMPLETION Cost-to-Cost Method Current Period Revenue Total Revenue from Contract × Percent Complete Total Revenue to Recognize - Revenue Recognized in Prior Periods = Revenue Recognized in Current Period 38 38 38 38

LONG-TERM CONTRACTS Example During 19X6, West, Inc. enters into a contract with Putnam County to build a bridge over Cane River. The project will take 3 years to complete and has a fixed price of $4,500,000. West’s engineers estimate the total cost of the bridge to be $3,000,000. At the end of 19X6, the information on the next page was gathered by West’s accountant. 39 39 39 39

LONG-TERM CONTRACTS Example West uses the percentage-of-completion method to account for all long-term construction projects. Prepare the necessary 19X6 journal entries for this project. 40 40 40 40

LONG-TERM CONTRACTS Example 41 41 41 41

LONG-TERM CONTRACTS Example 42 42 42 42

LONG-TERM CONTRACTS Example 43 43 43 43

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LONG-TERM CONTRACTS Example If West uses the Completed-Contract method, no revenue is recognized during 19X6. All revenue and profit is recognized at the end of the contract when delivery of the bridge to Putnam County is made. 45 45 45 45

REVENUE RECOGNITION Before Delivery Completion of Production Accretion Basis Discovery Basis 46 46 46 46

REVENUE RECOGNITION Service Sales Specific Performance Method Proportional Performance Method Completed Performance Method Collection 47 47 47 47

Used to account for revenue that is earned by performing a single act. SPECIFIC PERFORMANCE Used to account for revenue that is earned by performing a single act. Franchise revenue (SFAS No. 45) Bob’s Burgers 48 48 48 48

PROPORTIONAL PERFORMANCE Used to recognize service revenue that is earned by more than a single act and when the service is rendered in more than one accounting period. Similar performance acts - equal amount for each act Dissimilar performance acts - in proportion to direct costs of each act Similar acts with a fixed period for performance 49 49 49 49

COMPLETED PERFORMANCE Used when revenue is earned by performing a series of acts, and the last act is so important that revenue is only considered earned if it is performed. 50 50 50 50

Revenue recognized when cash is received. COLLECTION Used to account for service revenue when the uncertainty of collection is very high. Revenue recognized when cash is received. 51 51 51 51

EXPENSE RECOGNITION Expenses are outflows of assets or incurrences of liabilities during a period from delivery or producing goods or rendering services. 52 52 52 52

MATCHING Once revenues are determined, the expenses incurred in generating the revenue should be recognized. As revenues are earned, certain assets are consumed and services are used. 53 53 53 53

EXPENSES Recognition Methods Direct Period Allocated 54 54 54 54

GAINS AND LOSSES Gains and losses result from peripheral or incidental transactions, events, or circumstances. Most gains and losses are recognized when the transaction is completed. Estimated losses are recognized before realization if they are probable and can be reasonably estimated. 55 55 55 55

ETHICAL CONSIDERATIONS I’m sorry we shipped your order on Dec. 28 instead of on the delivery date of Jan. 10. But the important thing is that you have the products you need...Right? 56 56 56 56

Ready to Move On? Midterm Exam 57 57 57 57