William F. Bentz 1 A&MIS 521 Fin. Accounting I - Session 16 William F. Bentz Accounting & MIS

William F. Bentz 2 A&MIS 521 Revenue Allocation u In selected circumstances, revenue is recognized over 2 or more accounting periods. In many such cases, revenue is allocated in a manner that results in either a uniform gross margin, or in a uniform rate of return. We will use both methods.

William F. Bentz 3 A&MIS 521 Revenue Allocation u Uniform gross margin method % is used for –construction contracts –warranty contracts –software development contracts –installment sales (limited use)

William F. Bentz 4 A&MIS 521 Revenue Allocation u Uniform rate-of-return method are used for –interest income (A&MIS 522, investments) –interest method of depreciation (chapter 5)

William F. Bentz 5 A&MIS 521 Uniform Gross Margin % u For the gross margin percentage to be truly uniform, revenues and costs must be equal to the amounts forecast. u However, if one is able to forecast the revenues and the associated costs with acceptable accuracy, the intermediate reported results will be informative. The threshold for reasonable accuracy is a matter of professional judgement.

William F. Bentz 6 A&MIS 521 Uniform Gross Margin % u This method is implemented by multiplying the total amount of revenue to be allocated by the proportion of the costs incurred to date to the total estimated costs. Consider the warranty problem Bentley’s.

William F. Bentz 7 A&MIS 521 Bentley’s u Price of a warranty contract - $2,000 (constant) u Projected warranty costs per contract - $1,200 u Projected gross margin - $800 [$2,000 - $1,200] u Term of contract - five years

William F. Bentz 8 A&MIS 521 Bentley’s u Forecast of annual costs per contract:Year 1 - $ 100 Year Year Year Year Total$1,200

William F. Bentz 9 A&MIS 521 Proportion of cost incurred: u Cumulative proportion to date: Y1: $100/$1,200 = Y2: [$100 + $150]/$1,200 = Y3: [$ ]/$1,200 = Y4: [$ ]/$1,200 = Y5: $1,200/$1,200 = 1.0

William F. Bentz 10 A&MIS 521 Cumulative revenue earned u Cumulative revenue by year: Y1: × $2,000 = $ Y2: × $2,000 = $ Y3: × $2,000 = $ Y4: × $2,000 = $1, Y5: × $2,000 = $2,000.00

William F. Bentz 11 A&MIS 521 Cumulative revenue earned u Cumulative proportion of revenue earned (CPRE) = cumulative proportion of the cost incurred to the total (forecast) cost u CPRE(0 d) = Total cost incurred to date (0 d)/Total cost forecasted (0 n) for a contract beginning at t = 0 and ending at t = n

William F. Bentz 12 A&MIS d n Total = 1.0 CPRE

William F. Bentz 13 A&MIS 521 Annual Revenue Y1: $ = $ Y2: $ = Y3: $ = Y4: $1, = Y5: $2, , = Total $2,000.00

William F. Bentz 14 A&MIS 521 Go to Workbook Pages

William F. Bentz 15 A&MIS 521 Revenue Recognition - Long-term Contracts u Objective: To recognize revenue period-by-period as the revenue from a long-term contract is earned. The key criteria for revenue recognition are still: –Earning of the revenue –Realization/estimation of doubtful accounts –Reasonably estimable costs

William F. Bentz 16 A&MIS 521 Consider the Issue of Collection u Realization is deemed to have occurred if the seller has received a valid claim to a determinable amount of money subject to reasonable payment terms by a buyer that is capable of paying the amount due.

William F. Bentz 17 A&MIS 521 Revenue Recognition Methods u Revenue is recognized on long- term projects on one of two bases: –Completed contract method –Percentage-of-completion method u Annual revenues, expenses, income, and asset values are affected by the choice of method.

William F. Bentz 18 A&MIS 521 Revenue Recognition Methods u With the completed contract method, project costs are accumulated in a Construction-in-Process account. The cumulative cost is matched against revenues when the contract is completed. The amount of revenue recognized is the final contract price.

William F. Bentz 19 A&MIS 521 Revenue Recognition Methods u With the percentage-of-completion method, a portion of the total contract price is recognized each period. That portion is the percentage of the work completed to date, less the revenue already recognized.

William F. Bentz 20 A&MIS 521 Percentage-of-completion u To use the percentage-of-completion method, one must have some way of determining the percentage of completion for each project! The percentage of the costs incurred relative to total expected project cost is the measure used.

William F. Bentz 21 A&MIS 521 Calculating the Percent Cumulative cost Cumulative incurred to date % complete = Total Expected project cost

William F. Bentz 22 A&MIS 521 Example Co. ContractCumulativeCumulative Annual Date Price Cost RevenueRevenue 12/00 $70,000 $20,000 $23,333 $23,333 12/01 70,000 40,000 46,666 23,333 12/02 70,000 60,000 70,000 23,334 Total $70,000

William F. Bentz 23 A&MIS 521 Example Co. (B) CumulativeEstimated Cumulative Annual Date CostTot. Cost Revenue*Revenue 12/00 $15,000 $60,000 $17,500 $17,500 12/01 35,000 60,000 40,833 23,333 12/02 59,000 59,000 70,000 29,167 Total $70,000 *Contract price is $70,000 ‘98: (15,000/60,000) x $70,000 = 17,500 ‘99: (35,000/60,000) x $70,000 - $17,500 = $23,333 ‘00: $70,000 - $17,500 - $23,333 = $29,167

William F. Bentz 24 A&MIS 521 Example Co. (B) Annual AnnualGrossMargin DateRevenueCons. CostMargin % 12/98 $17,500$15,000$ 2, % 12/99 23,333 20,000 3, % 12/00 29,167 24,000 5, % Total $70,000$59,000$11,000 *Contract price is $70,000

William F. Bentz 25 A&MIS 521 Revenue Recognition For our purposes, the percentage completion method of recognizing revenue is applied the same way regardless of the profitability of the contract, or the timing of the contract billings and cash collections. The method is effort (cost) driven.