COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Revenue Recognition Chapter 8 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

Learning Objectives 1.Identify the primary criteria for revenue recognition. 2.Apply the revenue recognition concepts underlying the examples used in SAB 101/ Record journal entries for long- term constructions-type contracts using percentage of completion and completed-contract methods.

Learning Objectives 4.Record journal entries for long- term service contracts using the proportional performance method. 5.Explain when revenue is recognized after delivery of goods or services through installment sales, cost recovery, and cash methods.

Revenue Recognition Revenue is not recognized prior to the point of sale because either: 1.A valid promise of payment has not been received from the customer or 2.The company has not provided the product or service. Exceptions to these rules: 1.The customer provides a valid promise of payment. 2.Conditions exist that contractually guarantee the sale.

Revenue Recognition AICPA Statement of Position 97-2 gives companies more guidance through a checklist of four factors that amplify the two criteria: a.Persuasive evidence of an arrangement exists. b.Delivery has occurred. c.The vendor’s fee is fixed or determinable. d.Collectibility is probable.

Revenue Recognition The SEC issued SEC 101 in response to specific abuses involving revenue recognition. SAB 101 is in a question-and-answer format. The answers given are invariably “No.”

Revenue Recognition Prior to Providing Goods or Services Completed-contract method recognizes all income when project is completed. Percentage-of-completion method recognizes revenue throughout the term of the contract. Proportional performance method reflects revenue earned on service contracts under which many acts of service are to be performed before the contract is complete. GAAP requires percentage-of-completion method unless certain criteria are not met.

Percentage-of-Completion Method Requires Dependable estimates of: –contract revenues –contract costs –progress toward completion Contract clearly specifies: –enforceable rights of the parties –consideration to be exchange –manner and terms of settlement The buyer can be expected to satisfy obligations under the contract. Contractor can be expected to perform the contractual obligation.

Percentage-of-Completion Method Requires Recognize revenue throughout life of the contract. Revenue recognized is a function of how complete the project is to date. 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.

Percentage-of-Completion Input Measures Cost-to-cost method-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.

Revision of Estimate Instead of the previous illustration, assume that at the end of 2005, it was estimated that the remaining cost to complete construction was $720,000 rather than $650,000.

Revision of Estimate Items in blue changed from the previous illustration. Actual Cost Incurred Estimated Cost to Complete Year Cost Percentage Total Cost 2004$1,040,000$1,560,000 $2,600, ,000 Total$1,950,000720,0002,670, ,00002,650, Total$2,650,000 Note that expected gross profit was $400,000 in 2004, $330,000 in 2005, and the actual was $350,000 in 2006.

Revision of Estimate The entries for 2004 would be the same as those shown in the previous example. All entries for 2005 would be the same except for the entry to record revenue and cost. Cost of Long-Term Construction Contracts910,000 Construction in Progress80,000 Revenue from Long-term Construction Contracts990,000 ($3,000,000 x.73) – $1,200,000

Revision of Estimate Construction in Progress700,000 Materials, Cash, etc.700,000 To record costs incurred. Accounts Receivable1,100,000 Progress Billings on Construction Contracts1,100,000 To record billings. CashL1,350,000 Accounts Receivable1,350,000 To record cash collections Same Same

Revision of Estimate Cost of Long-Term Construction Contracts700,000 Construction in Progress110,000 Revenue from Long-Term Construction Contracts810, $3,000,000 (1,200,000) (990,000) $ 810,000

Revenue Recognition After Delivery of Goods 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.