AS 9 : Revenue Recognition

 Revenue is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise from the  Sale of goods  Rendering of services and  Use by others, of enterprise resources, yielding interest, royalties and dividends  Recognition - Process of recording and reporting an item as an element of financial statement

The revenue recognition principle provides that revenue is recognized: ◦ when it is earned, and ◦ when it is realized or realizable Revenue is earned when the earnings process is substantially complete Revenue is realized when goods and services are exchanged for cash or claims to cash Revenue is realizable when assets received are convertible into a known amount of cash Principles

 Revenue from selling products is recognized at the date of sale (date of delivery).  Revenue from services is recognized when services are performed and are billable.  Revenue from the use of enterprise’s assets by others is recognized as time passes or as the assets are used up.  Revenue from disposal of assets (other than inventory) is recognized at the point of sale as gain or loss. Four Types of Revenue Transactions

Revenue Recognition Classified by Nature of Transaction

Revenues from manufacturing and selling are commonly recognized at point of sale Exceptions: 1.Sales with buyback agreements 2.Sales when right of return exists (high rates that are not reliably estimable) 3.Trade loading/channel stuffing Revenue Recognition at Point of Sale

Revenue may be recognized before delivery under certain circumstances  Long-term construction contracts are a notable example Two methods available are :  The percentage-of-completion method, and  The completed contract method Revenue Recognition Before Delivery

Long-Term Construction Accounting Methods 1) Terms of contract must be certain, enforceable 2) Certainty of performance by both parties 3) Estimates of completion can be made reliably 1) To be used only when the percentage method is inapplicable [uncertain] 2) For short-term contracts Percentage-of-Completion Method Completed Contract Method Revenue Recognition Before Delivery

Costs incurred to date = Percent complete Most recent estimated total costs 1 Estimated total revenue x Percent complete = Revenue to be recognized to date 2 Total revenue to be recognized to date less Revenue recognized in PRIOR periods = Current period revenue 3 Current Period Revenue less current costs = Gross profit4 Percentage-of-Completion: Steps

Data: Contract price: $4,500,000 Estimated cost: $4,000,000 Start date: July, 2003 Finish: October, 2005 Balance sheet date: Dec. 31 Given: Costs to date$1,000,000 $2,916,000 $4,050,000 Estimated costs to complete $3,000,000 $1,134,000 $ -0- Progress Billings during year $900,000 $2,400,000 $1,200,000 Cash collected during year $750,000$1,750,000 $2,000,000 What is the percent complete, revenue and gross profit recognized each year? Percentage-of-Completion: Example

% complete to-date 1,000,000 = 25% 2,916,000= 72% 100 % 4,000,000 4,050,000 Revenue recognized 4,500,000 * 25% 4,500,000 * 72% 4,500,000 = 1,125,000 less 1,125,000 less 3,240,000 = 2,115,000 = 1,260,000 1,125,000 less 2,115,000 less 1,260,000 1,000,000 1,916,000 less 1,134,000 = 125,000 = 199,000 = 126,000 Gross Profit recognized Percentage-of-Completion: Example

Revenue recognition is deferred when collection of sales price is not reasonably assured and no reliable estimates can be made The two methods that are used are:  the installment sales method  the cost recovery method If cash is received prior to delivery, the method used is the deposit method Revenue Recognition After Delivery

 This method emphasizes income recognition in periods of collection rather than at point of sale  Title does not pass to the buyer until all cash payments have been made to the seller  Both sales and cost of sales are deferred to the periods of collection  Other expenses, selling and administrative, are not deferred The Installment Sales Method

 Seller recognizes no profit until cash payments by buyer exceed seller’s cost of merchandise.  After recovering all costs, seller includes additional cash collections in income.  This method is to be used where there is no reasonable basis for estimating collectibility as in franchises and real estate.  The income statement reports the amount of gross profit recognized and the amount deferred. The Cost Recovery Method

 Seller receives cash from buyer before transfer of goods or performance  The seller has no claim against the purchaser.  There is insufficient transfer of risks to buyer to warrant recording a sale by seller  In the case of such incomplete transactions, the deposit method is used  The deposit method thus defers sale recognition until a sale has occurred for accounting purposes The Deposit Method

Recognition Basis Criteria for UseReason of Departing from Sale Basis Percentage of Completion Method Long term construction of property, and reliable estimates and information about the project. Better measure of periodic income, and revenues and costs. Completed Contract Method Use on short term contracts, when percentage of completion method is not used Percentage of Completion Method is not applicable Completion of Production Basis Immediate marketability at quoted prices, unit interchangeability and etc Determinable revenues, but inability to determine the cost, thereby defer expense Installment-sales method and cost recovery method Absence of reasonable basis for estimating degree of collectibility and cost of collection. Collectibility of receivable is so uncertain, gross profit is recognized until cash is received Deposit Method Cash is received before the sales transaction completed Not sufficient transfer of the risks and ownership

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