Why I Became a CPA Journal of Accountancy – October 2005 Acct 3311 - Class 11 Why I Became a CPA Journal of Accountancy – October 2005 No other profession offers April 16 as a paid holiday. In Scrabble, Accountant (14) is worth more than either Doctor (9) or Lawyer (12). The club jacket and secret handshakes are the coolest. You get to answer all those “quick questions.” You get to enjoy the great indoors. You get to experience the five seasons a year: summer, fall, winter, spring and tax. A new IRS form gives you the chills. You can help people in what is sometimes accrual profession. Otherwise, 14 identical white dress shirts would go to waste. You know more about SOX than any fashion designer. You get to work the standard 70-hour week. Free physical fitness program for audit staff required to carry 20-pound audit bags.

Chapter 18 REVENUE RECOGNITION CONTINUED Sommers – ACCT 3311 Chapter 1: Environment and Theoretical Structure of Financial Accounting.

Primer on Long-term Contract Accounting “Three Facts” journal entries – same for both methods Costs incurred Amount billed Cash collected Holding accounts Construction in progress (CIP) – accumulates costs and profit/loss over contract life Billings on construction projects – accumulates amount billed to customer over contract life Since Revenue = Profit + Expense, by end of contract Billings = CIP

Long-Term Contract Losses Loss in the Current Period on a Profitable Contract Percentage-of-completion method only, the estimated cost increase requires a current-period adjustment of gross profit recognized in prior periods. Loss on an Unprofitable Contract Under both percentage-of-completion and completed-contract methods, the company must recognize in the current period the entire expected contract loss.

Completed Contract Example – 2 Curtiss Construction Company, Inc., entered into a fixed-price contract with Axelrod Associates on July 1, 2011, to construct a four-story office building. At that time, Curtiss estimated that it would take between two and three years to complete the project. The total contract price for construction of the building is $4,000,000. Curtiss appropriately accounts for this contract under the completed contract method in its financial statements. The building was completed on December 31, 2013. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to Axelrod under the contract were as follows: At 12-31-11 At 12-31-12 At 12-31-13 Percentage of completion 10% 60% 100% Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– Billings to Axelrod, to date 720,000 2,170,000 3,600,000 Compute gross profit or loss to be recognized in each year.

Completed Contract Example – 2 Continued The total contract price for construction of the building is $4,000,000. Curtiss appropriately accounts for this contract under the completed contract method in its financial statements. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to Axelrod under the contract were as follows: At 12-31-11 At 12-31-12 At 12-31-13 Percentage of completion 10% 60% 100% Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– Billings to Axelrod, to date 720,000 2,170,000 3,600,000 Price – actual costs – estimated remaining costs = expected profit 2011: 4,000,000 – 350,000 – 3,150,000 = 500,000 Recognize $0 2012: 4,000,000 – 2,500,000 – 1,700,000 = (200,000) Recognize $(200,000) 2013: 4,000,000 – 4,250,000 – 0 = (250,000) Recognize $(50,000)

Completed Contract Example – 2 Continued Just because, let’s do the journal entry to recognize profit (loss): The total contract price for construction of the building is $4,000,000. At 12-31-11 At 12-31-12 At 12-31-13 Percentage of completion 10% 60% 100% Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– Billings to Axelrod, to date 720,000 2,170,000 3,600,000 To recognize -0- (200,000) (50,000) 2011 – No journal entry since profit expected 2012 Loss on long-term contracts 200,000 Construction in progress 200,000 2013 Construction expenses 4,050,000 Revenue from long-term contracts 4,000,000 Construction in progress 50,000

Percentage-of-Completion Example – 2 Curtiss Construction Company, Inc., entered into a fixed-price contract with Axelrod Associates on July 1, 2011, to construct a four-story office building. At that time, Curtiss estimated that it would take between two and three years to complete the project. The total contract price for construction of the building is $4,000,000. Curtiss appropriately accounts for this contract under the completed contract method in its financial statements. The building was completed on December 31, 2013. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to Axelrod under the contract were as follows: At 12-31-11 At 12-31-12 At 12-31-13 Percentage of completion 10% 60% 100% Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– Billings to Axelrod, to date 720,000 2,170,000 3,600,000 Now compute gross profit or loss to be recognized in each year assuming use of percentage-of-completion.

Percentage-of-Completion Example – 2 Cont. The total contract price for construction of the building is $4,000,000. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to Axelrod under the contract were as follows: At 12-31-11 At 12-31-12 At 12-31-13 Percentage of completion 10% 60% 100% Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– Billings to Axelrod, to date 720,000 2,170,000 3,600,000 Expected profit * Percentage of completion (Unless loss!) 2011: 500,000 * 10% = 50,000 Recognize $50,000 2012: (200,000) Recognize $(250,000) 2013: (250,000) Recognize $(50,000)

Percentage-of-Completion Example – 2 Cont. The total contract price for construction of the building is $4,000,000. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to Axelrod under the contract were as follows: At 12-31-11 At 12-31-12 At 12-31-13 Percentage of completion 10% 60% 100% Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– Billings to Axelrod, to date 720,000 2,170,000 3,600,000 Reported on Balance Sheet 2011 Current liabilities: Billings ($720,000) in excess of costs and profit ($400,000) $320,000 2012 Current assets: Costs less loss ($2,300,000*) in excess of billings ($2,170,000) $130,000

Percentage-of-Completion Example – 2 Cont. Again just because, let’s do the journal entry to recognize profit (loss): The total contract price for construction of the building is $4,000,000. At 12-31-11 At 12-31-12 At 12-31-13 Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– To recognize 50,000 (250,000) (50,000) 2011 Construction expenses 350,000 Construction in progress 50,000 Revenue from long-term contracts 400,000 .35/(.35+3.15)*4 2012 Construction expenses 2,230,952 Plug Revenue from long-term contracts 1,980,952 2.5/(2.5+1.7)*4-0.4 Construction in progress 250,000 2013 Construction expenses 1,669,048 Plug Revenue from long-term contracts 1,619,048 The rest Construction in progress 50,000

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Discussion Question Q18-20 Explain the differences between the installment-sales method and the cost-recovery method. Under the installment-sales method, income recognition is deferred until the period of cash collection. At the end of each year, the appropriate gross profit rate is applied to the cash collections from each year’s sales to determine the realized gross profit. Under the cost-recovery method, no income is recognized until cash payments by the buyer exceed the seller’s cost of the inventory sold. After all costs have been recovered, all additional cash collections are included in income.

Installment-Sales vs. Cost-Recovery 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

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.

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.

Cost-Recovery Method Recognizes no profit until cash payments by the buyer exceed the cost of the merchandise sold. A seller is permitted to use the cost-recovery method to account for sales in which “there is no reasonable basis for estimating collectibility.” In addition, use of this method is required where a high degree of uncertainty exists related to the collection of receivables.

Point of Delivery Example On July 1, 2011, the Foster Company sold inventory to the Slate Corporation for $300,000. Terms of the sale called for a down payment of $75,000 and three annual installments of $75,000 due on each July 1, beginning July 1, 2012. Each installment also will include interest on the unpaid balance applying an appropriate interest rate. The inventory cost Foster $120,000. The company uses the perpetual inventory system. Point of Delivery “Normal” Method (don’t worry about interest) July 1, 2011 Installment accounts receivable 300,000 Sales revenue 300,000 Cost of goods sold 120,000 Inventory 120,000 Cash 75,000 Installment accounts receivable 75,000 July 1, 2012

Example as Installment Sale On July 1, 2011, the Foster Company sold inventory to the Slate Corporation for $300,000. Terms of the sale called for a down payment of $75,000 and three annual installments of $75,000 due on each July 1, beginning July 1, 2012. Each installment also will include interest on the unpaid balance applying an appropriate interest rate. The inventory cost Foster $120,000. The company uses the perpetual inventory system. Installment Sales Method (don’t worry about interest) July 1, 2011 Installment accounts receivable 300,000 Inventory 120,000 Deferred gross profit 180,000 (300–120)/300 = 60% Cash 75,000 Installment accounts receivable 75,000 Deferred gross profit 45,000 Realized gross profit 45,000 75 * 60% July 1, 2012 Realized gross profit 45,000

Example as Cost Recovery On July 1, 2011, the Foster Company sold inventory to the Slate Corporation for $300,000. Terms of the sale called for a down payment of $75,000 and three annual installments of $75,000 due on each July 1, beginning July 1, 2012. Each installment also will include interest on the unpaid balance applying an appropriate interest rate. The inventory cost Foster $120,000. The company uses the perpetual inventory system. Cost Recovery Method (don’t worry about interest) July 1, 2011 Installment accounts receivable 300,000 Inventory 120,000 Deferred gross profit 180,000 Cash 75,000 Installment accounts receivable 75,000 July 1, 2012 Deferred gross profit 30,000 Realized gross profit 30,000 75 + 75 – 120 = 30

IFRS RELEVANT FACTS - Similarities Revenue recognition fraud is a major issue in U.S. financial reporting. The same situation occurs overseas as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer AHold NV. In general, the accounting at point of sale is similar between IFRS and GAAP. As indicated earlier, GAAP often provides detailed guidance, such as in the accounting for right of return and multiple-deliverable arrangements.

IFRS RELEVANT FACTS - Differences The IASB defines revenue to include both revenues and gains. GAAP provides separate definitions for revenues and gains. IFRS has one basic standard on revenue recognition—IAS 18. GAAP has numerous standards related to revenue recognition (by some counts over 100). Accounting for revenue provides a most fitting contrast of the principles-based (IFRS) and rules-based (GAAP) approaches. While both sides have their advocates, the IASB and the FASB have identified a number of areas for improvement in this area.

IFRS RELEVANT FACTS - Differences In general, the IFRS revenue recognition principle is based on the probability that the economic benefits associated with the transaction will flow to the company selling the goods, rendering the service, or receiving investment income. In addition, the revenues and costs must be capable of being measured reliably. GAAP uses concepts such as realized, realizable, and earned as a basis for revenue recognition. Under IFRS, revenue should be measured at fair value of the consideration received or receivable. GAAP measures revenue based on the fair value of what is given up (goods or services) or the fair value of what is received—whichever is more clearly evident.

IFRS RELEVANT FACTS - Differences IFRS prohibits the use of the completed-contract method of accounting for long-term construction contracts (IAS 13). Companies must use the percentage-of-completion method. If revenues and costs are difficult to estimate, then companies recognize revenue only to the extent of the cost incurred—a cost-recovery (zero-profit) approach. In long-term construction contracts, IFRS requires recognition of a loss immediately if the overall contract is going to be unprofitable. In other words, GAAP and IFRS are the same regarding this issue.

Percentage-of-Completion Example – 3 Perfectionist Construction Company was the low bidder on an office building construction contract. The contract bid was $9,000,000, with an estimated cost to complete the project of $7,000,000. The contract period was 30 months starting May 1, 2012. Because of changes requested by the customer, the contract price was adjusted downward to $8,600,000 on May 1, 2013. A record of construction activities for the years 2012–2015 is as follows: Prepare all journal entries and the relevant balance sheet entries for 2012–2015 under the percentage-of-completion method of revenue recognition. Year Actual Cost Progress Billings Cash Receipts Remaining Cost 2012 $1,900,000 $2,500,000 $5,150,000 2013 3,600,000 3,400,000 3,100,000 1,600,000 2014 1,670,000 2,700,000 2,500,000 2015 1,100,000

Percentage-of-Completion Example – 3 2012 Construction in progress 1,900,000 Cash, materials, etc. 1,900,000 Accounts receivable 2,500,000 Billings on construction contract 2,500,000 Cash 1,900,000 Accounts receivable 1,900,000 Percent complete: 1,900,000 / (1,900,000 + 5,150,000) = 26.95% Expected profit: 9,000,000 – (1,900,000 + 5,150,000) = 1,950,000 Construction in progress 525,525 (26.95% * 1,950,000) Construction expenses 1,900,000 Revenue from long-term contract 2,425,525 (26.95% * 9 mil) (CA) Accounts receivable 600,000 (CL) Billings in excess of cost and profit 74,475

Percentage-of-Completion Example – 3 Perfectionist Construction Company was the low bidder on an office building construction contract. The contract bid was $9,000,000, with an estimated cost to complete the project of $7,000,000. The contract period was 30 months starting May 1, 2012. Because of changes requested by the customer, the contract price was adjusted downward to $8,600,000 on May 1, 2013. A record of construction activities for the years 2012–2015 is as follows: Prepare all journal entries and the relevant balance sheet entries for 2012–2015 under the percentage-of-completion method of revenue recognition. Year Actual Cost Progress Billings Cash Receipts Remaining Cost 2012 $1,900,000 $2,500,000 $5,150,000 2013 3,600,000 3,400,000 3,100,000 1,600,000 2014 1,670,000 2,700,000 2,500,000 2015 1,100,000

Percentage-of-Completion Example – 3 2013 Construction in progress 3,600,000 Cash, materials, etc. 3,600,000 Accounts receivable 3,400,000 Billings on construction contract 3,400,000 Cash 3,100,000 Accounts receivable 3,100,000 Percent complete: (1,900+3,600) / (1,900+3,600+1,600) = 77.46% Expected profit: 8,600,000 – (1,900,000+3,600,000+1,600,000) = 1,500,000 Construction in progress 636,035 Construction expenses 3,600,000 Revenue from long-term contract 4,236,035 (77.46%*8.6mil)–2,425,525 (CA) Accounts receivable 900,000 (CA) Cost and profit in excess of billings 761,560

Percentage-of-Completion Example – 3 Perfectionist Construction Company was the low bidder on an office building construction contract. The contract bid was $9,000,000, with an estimated cost to complete the project of $7,000,000. The contract period was 30 months starting May 1, 2012. Because of changes requested by the customer, the contract price was adjusted downward to $8,600,000 on May 1, 2013. A record of construction activities for the years 2012–2015 is as follows: Prepare all journal entries and the relevant balance sheet entries for 2012–2015 under the percentage-of-completion method of revenue recognition. Year Actual Cost Progress Billings Cash Receipts Remaining Cost 2012 $1,900,000 $2,500,000 $5,150,000 2013 3,600,000 3,400,000 3,100,000 1,600,000 2014 1,670,000 2,700,000 2,500,000 2015 1,100,000

Percentage-of-Completion Example – 3 2014 Construction in progress 1,670,000 Cash, materials, etc. 1,670,000 Accounts receivable 2,700,000 Billings on construction contract 2,700,000 Cash 2,500,000 Accounts receivable 2,500,000 Percent complete: 100% Expected profit: 8,600,000 – (1,900,000+3,600,000+1,670,000) = 1,430,000 Construction in progress 268,440 (1,430,000–525,525–636,035) Construction expenses 1,670,000 Revenue from long-term contract 1,938,440 The rest Billings on construction contract 8,600,000 Construction in progress 8,600,000 (CA) Accounts receivable 1,100,000

Percentage-of-Completion Example – 3 Perfectionist Construction Company was the low bidder on an office building construction contract. The contract bid was $9,000,000, with an estimated cost to complete the project of $7,000,000. The contract period was 30 months starting May 1, 2012. Because of changes requested by the customer, the contract price was adjusted downward to $8,600,000 on May 1, 2013. A record of construction activities for the years 2012–2015 is as follows: Prepare all journal entries and the relevant balance sheet entries for 2012–2015 under the percentage-of-completion method of revenue recognition. Year Actual Cost Progress Billings Cash Receipts Remaining Cost 2012 $1,900,000 $2,500,000 $5,150,000 2013 3,600,000 3,400,000 3,100,000 1,600,000 2014 1,670,000 2,700,000 2,500,000 2015 1,100,000

Percentage-of-Completion Example – 3 2015 Cash 1,100,000 Accounts receivable 1,100,000