Income Recognition and Measurement of Assets C hapter 18 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Intermediate Accounting 10th edition Nikolai Bazley Jones

2 1. Understand the revenue recognition alternatives. 2. Explain revenue recognition at the time of sale, during production, and at time of cash receipt. 3. Explain the conceptual issues regarding revenue recognition alternatives. 4. Describe the alternative revenue recognition methods. Objectives

3 5. Account for revenue recognition prior to the period of sale, including the percentage-of-completion and completed contract methods. 6. Account for revenue recognition after the period of sale, including the installment and cost recovery methods. 7. Account for revenue recognition delayed until a future event occurs. Objectives

4 8.Understand software revenue recognition, franchises, real estate sales, retail land sales, and consignment sales. (Appendix) Objectives

5 Recognition is the process of formally recording and reporting items in the financial statements. Revenue Recognition

6 Realization is the process of converting noncash recourses into cash or rights to cash. Revenue Recognition

7 Example 1: Revenue Recognition at Time of Sale 1.Ringwood Company manufactures the inventory. Inventory100 Cash100 2.Ringwood sells the inventory for $150. Accounts Receivable150 Revenue150 Cost of Goods Sold100 Inventory100 Revenue Recognition

8 Example 1: Revenue Recognition at Time of Sale 3.Ringwood collects cash of $60. Cash60 Accounts Receivable60 Income Statement Revenue$150 Cost of goods sold(100) Gross profit$ 50 Revenue Recognition

9 Example 2: Revenue Recognition During Production 1.Ringwood Company manufactures the inventory. Inventory100 Cash100 2.Ringwood recognizes the revenue during production (the manufacturing process). Production Expense100 Inventory50 Revenue150 Revenue Recognition

10 Example 2: Revenue Recognition During Production 3.The company bills the customer for a partial billing of $130. Accounts Receivable130 Partial Billings130 4.Ringwood collects cash of $60. Cash60 Accounts Receivable60 Revenue Recognition

11 Example 2: Revenue Recognition During Production Income Statement Revenue$150 Production expense(100) Gross profit$ 50 The balance sheet shows Inventory of $150, less Partial Billings of $130. Revenue Recognition

12 Example 3: Revenue Recognition at Time of Cash Receipt 1.Ringwood Company manufactures the inventory. Inventory100 Cash100 2.Ringwood “sells” the inventory and defers the recognition of revenue. Accounts Receivable150 Inventory100 Deferred Gross Profit50 Revenue Recognition

13 Example 3: Revenue Recognition at Time of Cash Receipt 3.Ringwood collects cash of $60. Cash60 Accounts Receivable60 4.The company recognizes revenue on the basis of the cash received. Cost of Goods Sold40 Deferred Gross Profit20 Revenue60 ($60 ÷ $150) x $100 Cash Received Revenue Recognition ($60 ÷ $150) x $100

14 Example 3: Revenue Recognition at Time of Cash Receipt Income Statement Revenue$ 60 Cost of goods sold(40) Gross profit$ 20 The balance sheet shows Accounts Receivable of $90, less Deferred Gross Profit of $30. Revenue Recognition

15  The economic substance of the event takes precedence over the legal form of the transaction.  The risks and benefits of ownership have been transferred to the buyer.  The collectibility of the receivable from the sale is reasonably assured. The decision as to when to recognize revenue focuses on three factors: Conceptual Issues

16 1. Revenue recognition in the period of sale. 2. Revenue recognition prior to the period of sale. 3. Revenue recognition at the completion of production. 4. Revenue recognition after the period of sale. 5. Revenue recognition delayed until a future event. Alternative Revenue Recognition Methods

17 Earned and Realizable Economic Substance and Transfer of Risks and Benefits of Ownership Collectibility is Not Reasonably Assured Installment Method Cost Recovery Method Percentage-of- Completion Method (for Long-Term Contracts) Completed- Contract Method (for Long-Term Contracts) Accrual Method: “Normal” Revenue Recognition at Sale Not Sufficient Transfer of Risks and Benefits of Ownership Deposit Method Recognition before Physical Transfer Recognition at Physical Transfer Collectibility is Reasonably Assured Revenue Recognized

18 Percentage-of-Completion Method  It achieves the goals of accrual accounting.  It is consistent with the argument that revenue is earned continuously over the entire earning process.  It results in a more relevant measure of periodic income. Revenue Recognition Prior to the Period of Sale

19 AICPA Statement of Position No requires that a construction company use the percentage-of-completion method for long-term contracts when all the following conditions are met: Percentage of Completion Method

20 1.The company can make reasonably dependable estimates of the extent of progress toward completion, contract revenue, and contract costs. 2.The contract clearly specifies the enforceable rights regarding goods or services to be provided and received by both the company and the buyer, the consideration to be exchanged, and the manner and terms of settlement. 3.The buyer can be expected to satisfy its obligations under the contract. 4.The company expects to perform its contractual obligations. Percentage of Completion Method

21 The Statement also requires that a company use the completed-contract method only when at least one of these conditions is not met... …for a short-term contract, and when there are inherent hazards in the contract beyond the normal business risks for which reasonably dependable estimates cannot be made. Percentage of Completion Method

Construction costs incurred during the year$100,000$186,000$314,000 Estimated costs to complete the contract400,000264, Partial billing to customer80,000350,000270,000 Collections from customer50,000330,000320,000 Total contract price: $700,000 Example Page 897 Percentage of Completion Method

23 Percentage of Completion Method 1.To record construction costs: Construction in Progress100,000 Accounts Payable, etc.100, To record partial billings: Accounts Receivable80,000 Partial Billings (contra inventory)80, To record collections: Cash50,000 Accounts Receivable50,000

24 4.To record gross profit: Construction Expense100,000 Construction in Progress (inventory) 40,000 Construction Revenue140, ($100,000 ÷ $500,000) x $700,000 Percentage of Completion Method

25 1.To record construction costs: Construction in Progress186,000 Accounts Payable, etc.186, To record partial billings: Accounts Receivable350,000 Partial Billings350, To record collections: Cash330,000 Accounts Receivable330,000 Percentage of Completion Method

26 4.To record gross profit: Construction Expense186,000 Construction in Progress38,000 Construction Revenue224, [($286,000 ÷ $550,000) x $700,000] - $140,000 Construction costs incurred to date Revised cost = $286,000 + $264,000 Previous year’s construction revenue Percentage of Completion Method

27 1.To record construction costs: Construction in Progress314,000 Accounts Payable, etc.314, To record partial billings: Accounts Receivable270,000 Partial Billings270, To record collections: Cash320,000 Accounts Receivable320,000 Percentage of Completion Method

28 4.To record gross profit and close out accounts: Construction Expense314,000 Construction in Progress22,000 Construction Revenue336, $700,000 – $140,000 – $224,000 Recognized in 2007 Recognized in 2008 Partial Billings700,000 Construction in Progress700,000 Percentage of Completion Method

29 Entries 1, 2, and 3 are the same as those used for the percentage-of-completion method. The completed-contract method does not recognize revenue until the project is completed, so there is no Entry 4 until Completed Contract Method

30 4.To record gross profit and close out accounts: Partial Billings700,000 Construction Revenue700, Construction Expense600,000 Construction in Progress600,000 $100,000 + $186,000 + $314,000 Completed Contract Method

31 If interest cost is associated with the funds used in the construction, the firm should include this cost in the Construction in Progress account. Capitalized Interest

32  Used to recognize service revenue earned by performing more than one act if services are to be rendered in more than one accounting period.  Types of service transactions  Similar performance acts-recognize an equal amount of revenue for each act  Dissimilar performance acts-recognize revenue in proportion to direct costs to perform each act.  Similar acts with a fixed period for performance- recognize revenue using straight-line method Proportional Performance Contracts

33  Revenue allocate using percentage of direct costs  Initial direct costsallocate using percentage of direct costs  Direct costsexpense as incurred  Indirect costsexpense as incurred Proportional Performance Contracts

34 Proportional Performance Contracts

35 Proportional Performance Contracts % of direct costs as incurred % of direct costs

36 Installment sales involve a financing agreement whereby the customer signs a contract,......makes a small down payment,... Installment Method

37 …and agrees to make periodic payments over an extended period, often several years. Installment Method

38 Two methods employed to defer revenue recognition until cash is received are the installment sales method and the cost recovery method. These methods are used only when the point-of-sale or other GAAP revenue recognition methods are not appropriate. These methods may be used only when there is uncertainty about whether the sales price will be collected and when an allowance for bad debts cannot be reasonably estimated. Revenue Recognized at Collection

39 1. Total sales, cost of goods sold, and collections are recorded in the normal manner during the year. 2. At the end of the year, installment sales are identified. The revenue and the related cost of goods sold are “reversed,” and the deferred gross profit is recognized. 3. At the end of the year, the gross profit rate on installment sales is computed. ContinuedContinued Installment Method

40 4. A portion of the deferred gross profit is recognized as gross profit. 5. In future years the remaining deferred gross profit is reduced and the gross profit is recognized based on the cash collected on the installment sales. Installment Method

41 Consider the following information for Lee for 2007: Total credit sales $500,000 Total cost of goods sold390,000 Installment method sales100,000 Installment method cost of goods sold75,000 Gross profit rate on installment method sales25% Cash receipts on installment method sales20,000 Cash receipts on other credit sales300,000 Lee Company uses a perpetual inventory method. Installment Method

42 Accounts Receivable500,000 Sales500,000 Cost of Goods Sold390,000 Inventory390,000 Credit sales during the year 2007: Cash320,000 Accounts Receivable320,000 Collected $300,000; $20,000 related to installment sales: ContinuedContinued Installment Method

43 Sales (closed)100,000 Cost of Goods Sold (closed)75,000 Deferred Gross Profit, ,000 Installment sales and related cost of goods sold identified and “reversed” on December 31, 2007: Deferred Gross Profit, 20075,000 Gross Profit Realized on Installment Method Sales5,000 Recognized a gross profit of 25% of cash collected on installment sales December 31, 2007 : Installment Method

44 Partial Financial Statements

45 Consider the following information for Lee for 2008: Total credit sales$600,000 Total cost of goods sold430,000 Installment method sales150,000 Installment method cost of goods sold105,000 Gross profit rate on installment method sales30% Cash receipts on installment method sales: 2007 sales30, sales40,000 Cash receipts on other credit sales480,000 Installment Method

46 Accounts Receivable600,000 Sales600,000 Cost of Goods Sold430,000 Inventory430,000 Credit sales 2008: Cash550,000 Accounts Receivable550,000 Collected $550,000; $70,000 related to installment sales: ContinuedContinued Installment Method

47 Sales150,000 Cost of Goods Sold105,000 Deferred Gross Profit, ,000 Installment sales and related cost of goods sold identified and “reversed” on December 31, 2008: ContinuedContinued Installment Method

48 Deferred Gross Profit, 20077,500 Deferred Gross Profit, ,000 Gross Profit Realized on Installment Method Sales19,500 On December 31, 2008, recognized a gross profit of 25% of cash collected on installment sales for 2007 and 30% for 2008: Installment Method

49 APB Opinion No. 10 found the cost recovery method of recognizing revenue generally to be unacceptable. However, the Board did agree that this method could be used in exceptional cases where receivables are collected over an extended period and where the terms of the transaction provide no reasonable basis for estimating the degree of collectibility. Cost Recovery Method

50 Consider the following information for the Parken Company: Sale of property under cost recovery method$20,000 Cost of property sold (net)12,000 Cash collections: 20075, , ,000 Consider the following information for the Parken Company: Sale of property under cost recovery method$20,000 Cost of property sold (net)12,000 Cash collections: 20075, , ,000 Cost Recovery Method

51 Accounts Receivable20,000 Deferred Gross Profit8,000 Property (net)12,000 During 2007 Cash5,000 Accounts Receivable5,000 Collected $5,000 ContinuedContinued Cost Recovery Method

52 Cash9,000 Accounts Receivable9,000 During 2008 Deferred Gross Profit2,000 Gross Profit Realized on Cost Recovery Transactions2,000 December 31, 2008 ContinuedContinued ($5,000 + $9,000) minus property cost of $12,000 Cost Recovery Method

53 Cash6,000 Accounts Receivable6,000 During 2009 Deferred Gross Profit6,000 Gross Profit Realized on Cost Recovery Transactions6,000 December 31, 2009 The cash collected in 2009 results in the recognition of an equal amount of gross profit. Cost Recovery Method

54 Oscar Company sells a subsidiary to the Pet Company and accepts a $500,000 down payment and a 10% note for the balance of the sale of $7 million. The net assets of the subsidiary are $5 million and Pet Company has the right to cancel the agreement for the next year. Revenue Recognition Delayed a Future Event Occurs (Deposit Method)

55 Cash500,000 Deposit from Purchaser500,000 Upon receipt of down payment (Oscar Company): Interest Receivable650,000 Note Receivable6,500,000 Deposit from Purchaser500,000 Interest Revenue650,000 Gain2,000,000 Net Assets of Subsidiary5,000,000 When circumstances allow the revenue to be recognized:liability 10% x $6,500,000 Revenue Recognition Delayed a Future Event Occurs (Deposit Method)

56 If a company has an agreement to deliver software that requires significant production, modification, or customization of software, it uses contract accounting for the agreement. Guidelines of AICPA Statement of Position No Software Revenue Recognition

57 If a company has an agreement to deliver software that does not require significant production, modification, or customization of software, it recognizes revenue when (a) persuasive evidence of an agreement exists, (b) delivery has occurred, (c) the seller’s fee is fixed or determinable, and (d) collectibility is probable. Guidelines of AICPA Statement of Position No Software Revenue Recognition

58 A company separately accounts for a service element if (a) the services are not essential to the functionality of any other element of the transaction, and (b) the services are stated separately in the contract such that the total price of the agreement would be expected to vary as the result of inclusion or exclusion of the service. Guidelines of AICPA Statement of Position No Software Revenue Recognition

59 Software arrangements may consist of multiple elements such as additional software products, upgrades and/or enhancements, rights to exchange or return software, and customer support. If contract accounting does not apply, a company must allocate its fee to the various elements based on fair values. Guidelines of AICPA Statement of Position No Software Revenue Recognition

60 A company must allocate any discounts proportionately to all the elements, except that none can be allocated to upgrade rights. Guidelines of AICPA Statement of Position No Software Revenue Recognition

61 A franchise agreement involves the granting of business rights by the franchisor to a franchisee who will operate the franchised business. Franchise

62 A franchise agreement involves the granting of business rights by the franchisor to a franchisee who will operate the franchised business. Franchise

63 Castle Company sells a franchise that requires an initial franchise fee of $70,000. A down payment of $20,000 cash is required, with the balance covered by the issuance of a $50,000, 10% note, payable by the franchisee in five equal annual installments. Franchise

64 Situation 1: Castle has substantially performed all material services, the refund period has expired, and the collectibility of the note is reasonably assured. Cash20,000 Notes Receivable50,000 Franchise Revenue70,000 Franchise

65 Situation 2: The refund period has expired and the collectibility of the note is reasonably assured, but Castle has not substantially performed all material services. Cash20,000 Notes Receivable50,000 Unearned Franchise Fees70,000 Castle will recognize the unearned franchise fees as revenue when it has performed all material services. Franchise

66 Situation 3: Castle has substantially performed all material services and the collectibility of the note is reasonably assured, but the refund period has not expired. Cash20,000 Notes Receivable50,000 Unearned Franchise Fees70,000 Castle will recognize the unearned franchise fees as revenue when the refund period expires. Franchise

67 Each year revenue of $10,000 is recognized as cash is collected. Situation 4: Castle has substantially performed all material services and the refund period has expired, but the collectibility of the note is not reasonably assured. Cash20,000 Notes Receivable50,000 Unearned Franchise Fees50,000 Franchise Revenue20,000 Franchise

68 Situation 5: The refund period has expired, but Castle has not substantially performed all material services and there is no basis for estimating the collectibility of the note. Cash20,000 Unearned Franchise Fees20,000 Castle recognizes revenue either under the accrual method (if collectibility is reasonably assured) or the installment method (if it has no basis for estimating the collectibility of the note). Franchise

69 Situation 6: Castle has earned only $30,000 from providing initial services, with the balance being a down payment for continuing services. The refund period has expired and collectibility of the note is reasonably assured. Cash20,000 Notes Receivable50,000 Franchise Revenue30,000 Unearned Franchise Fees40,000 Castle recognizes the unearned franchise fees as revenue when it performs the continuing services. Franchise

70 Continuing Franchise Fee Assume that Castle also charges a continuing franchise fee of $9,000 per year. Fee is earned by providing services Cash9,000 Continuing Franchise Fee Revenue9,000 $1,000 of the fee is for National Advertising Cash9,000 Continuing Franchise Fee Revenue8,000 Unearned Franchise Fees1,000

71 1.The buyer has made the down payment and each required subsequent payment until the period of cancellation with refund has expired. 2.The cumulative payments of principal and interest equal or exceed 10% of the contract sales price. For retail land sales, the selling company recognizes revenue and the related expenses in the period of the sale on the accrual basis if all of the following conditions are met: ContinuedContinued Real Estate Sales

72 3.Collection experience for the project indicates that at least 90% of contracts will be collected in full. (a down payment of 20% is an acceptable indication of collectibility). 4.The receivable from the sale is not subject to subordination to new loans on the property. Real Estate Sales

73 Real Estate Sales 5.The seller is not obligated to complete improvements of lots sold or to construct amenities or other facilities applicable to lots sold.

74 1.Since title remains with the consignor, when the goods are transferred from the consignor to the consignee, the consignor does not record the sale of inventory. 2.The consignor recognizes revenue only when the sale to the third party occurs. 3.The consignee uses a Consignment-in account. 4.The consignor uses a Consignment-out account, which is a special inventory account. Accounting for consignments may be summarized-- Consignment Sales

75 C hapter 18 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.