Complexities of Revenue Recognition

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.

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.

Learning Objectives EXPANDED MATERIAL: Describe accounting for the transfer of assets prior to the recognition of revenue with the deposit method and consignment sales.

Revenue Recognition Criteria FASB’s 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. 2

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.

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. 3

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.

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.

Revenue Recognition--Exceptional Cases Long-Term Contracts Uncertain Collections Deposit Method Consignment Sales

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. GAAP requires percentage-of-completion method unless certain criteria are not met. 6

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. 7

Percentage-of-Completion Criteria The buyer can be expected to satisfy obligations under the contract. Contractor can be expected to perform the contractual obligation. 8

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. 9

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. Engineers are often called in to help provide estimates. 10

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. 11

Percentage-of-Completion 2001 _ 2002 2003 Costs incurred to date $ 72,000 $192,000 $240,000 Total estimated costs $240,000 Estimated costs to complete 168,000 48,000 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. 12

Percentage-of-Completion 2001 2002 2003 Costs incurred to date $ 72,000 $192,000 $240,000 Estimated costs to complete 168,000 48,000 Total estimated costs $240,000 $240,000 $240,000 Percentage complete 30% 80% 100% Percentage complete is the ratio of costs incurred to date to total estimated costs at completion. 13

Percentage-of-Completion 2001 2002 2003 Costs incurred to date $ 72,000 $192,000 $240,000 Estimated costs to complete 168,000 48,000 Total estimated costs $240,000 $240,000 $240,000 Total Contract $300,000 Percentage complete 30% 80% 100% Estimated total income $ 60,000 $ 60,000 Estimated total income is the difference between the contract price and total expected costs. Assume the contract price in this example is $300,000. 14

Percentage-of-Completion 2001 2002 2003 Costs incurred to date $ 72,000 $192,000 $240,000 Estimated costs to complete 168,000 48,000 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 Estimated total income to date is computed based on the cumulative percentage complete. 15

Percentage-of-Completion 2001 2002 2003 Costs incurred to date $ 72,000 $192,000 $240,000 Estimated costs to complete 168,000 48,000 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 Less:Iincome previously recognized 18,000 48,000 Income recognized this period $ 18,000 $ 30,000 $ 12,000 16

Percentage-of-Completion 2001 2002 2003 Costs incurred to date $ 72,000 $192,000 $240,000 Estimated costs to complete 168,000 48,000 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 Income recognized this period $ 18,000 $ 30,000 $ 12,000

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).

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……... 140,000 To record billings (amount assumed). Cash……………………………… 125,000 Accounts Receivable………… 125,000 To record cash collections (amount assumed).

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).

Revenue Recognition--Exceptional Cases Long-Term Contracts Uncertain Collections Deposit Method Consignment Sales

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. 18

Uncertain Collections--Comparison of Recognition Methods Timing of Revenue Treatment Method Recognition of Costs Full Accrual At point of sale Revenue at point of sale Installment Sales At collection of cash (portion of receipt) Defer and match against revenue as cash is collected Cost Recovery At collection of cash (after all costs have been recovered) Defer and match against cash receipts Cash At collection of cash Charge to expense as incurred 19

Installment Sales Method The installment sales method is used most commonly in cases of real estate sales.

Example: Installment 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 George’s journal entries. 24

Example: Installment Sales Method 2001 2002 Sales Cost of Sales Gross Profit Percentage $150 $200 100 140 $ 50 $ 60 33.33% 30% Cash Collection 2001 Sales $ 30 $ 75 2002 Sales $ 70 25

Example: Installment Sales Method 2001: Accounts Receivable--2001……... 150 Installment Sales………………. 150 Cost of Installment Sales………... 100 Inventory………………………. 100 Cash……………………………… 30 Accounts Receivable--2001…... 30 26

Example: Installment 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%)

Example: Installment 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 31

Example: Installment 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 34

Example: Cost Recovery Method Assume George has to use the cost recovery method, but all sales and collections remain the same. 36

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 37

Revenue Recognition--Exceptional Cases Long-Term Contracts Uncertain Collections Deposit Method Consignment Sales

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 Bob’s restaurant (which occurs on July 10). Prepare Mary’s 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 45

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. 46

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. 47

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.) 48

Example: Consignment Sales Transaction: Shipment of Goods Entry in Bob’s (consignor’s) books: Inventory on Consignment…… 1,000 Finished Goods Inventory….. 1,000 Entry in Lucy’s (consignee’s) books: None--memorandum inventory control record. 49

Example: Consignment Sales Transaction: Incurrence of $200 of selling expenses by Lucy. Entry in Bob’s books: Inventory on Consignment…. 200 Consignee Payable……….. 200 Entry in Lucy’s books: Consignor Receivable………. 200 Cash………………………. 200 50

Example: Consignment Sales Transaction: Sale of merchandise for $2,000. Entry in Bob’s books: None. Entry in Lucy’s books: Cash……………………… 2,000 Consignor Payable…….. 2,000 51

Example: Consignment Sales Transaction: Lucy notifies Bob of the sale and sends him net cash proceeds. Entry in Bob’s books: Commission Expense…………... 100 Cash…………………………….. 1,700 Consignee Payable……………... 200 Cost of Goods Sold…………….. 1,000 Consignment Sales Revenue…. 2,000 Inventory on Consignment…… 1,000 52

Example: Consignment Sales Entry in Lucy’s books: Consignor Payable…………. 2,000 Cash………………………. 1,700 Commission Revenue…….. 100 Consignor Receivable…….. 200 54

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