18-1 Prepared by Coby Harmon University of California, Santa Barbara Intermediate Accounting

18-2 Intermediate Accounting 14th Edition 18 Revenue Recognition Kieso, Weygandt, and Warfield

Apply the revenue recognition principle Describe accounting issues for revenue recognition at point of sale Apply the percentage-of-completion method for long-term contracts Apply the completed-contract method for long-term contracts Identify the proper accounting for losses on long-term contracts Describe the installment-sales method of accounting Explain the cost-recovery method of accounting. Learning Objectives

18-4 The Current Environment Restatements for improper revenue recognition are relatively common and can lead to significant share price adjustments. Revenue recognition is a top fraud risk and regardless of the accounting rules followed (IFRS or U.S. GAAP), the risk or errors and inaccuracies in revenue reporting is significant.

18-5 The revenue recognition principle provides that companies should recognize revenue Guidelines for Revenue Recognition The Current Environment LO 1 Apply the revenue recognition principle. (1)when it is realized or realizable and (2)when it is earned.

18-6 The Current Environment LO 1 Apply the revenue recognition principle. Illustration 18-2 Revenue Recognition Alternatives

18-7 FASB’s Concepts Statement No. 5, companies usually meet the two conditions for recognizing revenue by the time they deliver products or render services to customers. LO 2 Describe accounting issues for revenue recognition at point of sale. Implementation problems,  Sales with Discounts  Sales When Right of Return  Sales with Buybacks  Bill and Hold Sales  Principal-Agent Relationships  Trade Loading and Channel Stuffing  Multiple-Deliverable Arrangements Revenue Recognition at Point of Sale (Delivery)

18-8 Bill and Hold Sales Revenue Recognition at Point of Sale Buyer is not yet ready to take delivery but does take title. Illustration 18-4 BILL AND HOLD Illustration 18-7 Facts: Butler Company sells $450,000 of fireplaces to a local coffee shop, Baristo, which is planning to expand its locations around the city. Under the agreement, Baristo asks Butler to retain these fireplaces in its warehouses until the new coffee shops that will house the fireplaces are ready. Title passes to Baristo at the time the agreement is signed. Question: Should Butler report the revenue from this bill and hold arrangement when the agreement is signed, or should revenue be deferred and reported when the fireplaces are delivered? LO 2

18-9 Revenue Recognition at Point of Sale Solution: Butler should record the revenue at the time title passes, provided 1.the risks of ownership have passed to Baristo, that is, Butler does not have specific performance obligations other than storage; 2.Baristo makes a fixed commitment to purchase the goods, requests that the transaction be on a bill and hold basis, and sets a fixed delivery date; and 3.goods must be segregated, complete, and ready for shipment. LO 2 Describe accounting issues for revenue recognition at point of sale.

18-10 Revenue Recognition at Point of Sale LO 2 Describe accounting issues for revenue recognition at point of sale. Accounts receivable 450,000 Sales 450,000 Illustration 18-4 BILL AND HOLD Illustration 18-7 Facts: Butler Company sells $450,000 of fireplaces to a local coffee shop, Baristo, which is planning to expand its locations around the city. Under the agreement, Baristo asks Butler to retain these fireplaces in its warehouses until the new coffee shops that will house the fireplaces are ready. Title passes to Baristo at the time the agreement is signed. Butler makes the following entry.

18-11 Consignments Revenue Recognition at Point of Sale LO 2 Describe accounting issues for revenue recognition at point of sale.  Manufacturers (or wholesalers) deliver goods but retain title to the goods until they are sold.  Consignor (manufacturer or wholesaler) ships merchandise to the consignee (dealer), who is to act as an agent for the consignor in selling the merchandise.  Consignor makes a profit on the sale.  Consignee makes a commission on the sale.

18-12 Two Methods:  Percentage-of-Completion Method. ► Rationale is that the buyer and seller have enforceable rights.  Completed-Contract Method. Most notable example is long-term construction contract accounting. Revenue Recognition Before Delivery LO 2 Describe accounting issues for revenue recognition at point of sale.

18-13 Must use Percentage-of-Completion method when estimates of progress toward completion, revenues, and costs are reasonably dependable and all of the following conditions exist: Revenue Recognition Before Delivery 1.Contract clearly specifies the enforceable rights regarding goods or services by the parties, the consideration to be exchanged, and the manner and terms of settlement. 2.Buyer can be expected to satisfy all obligations. 3.Contractor can be expected to perform under the contract. LO 2 Describe accounting issues for revenue recognition at point of sale.

18-14 Companies should use the Completed-Contract method when one of the following conditions applies when: Revenue Recognition Before Delivery 1.Company has primarily short-term contracts, or 2.Company cannot meet the conditions for using the percentage-of-completion method, or 3.There are inherent hazards in the contract beyond the normal, recurring business risks. LO 2 Describe accounting issues for revenue recognition at point of sale.

18-15 Formula for Total Revenue to Be Recognized to Date LO 3 Apply the percentage-of-completion method for long-term contracts. Illustration Percentage-of-Completion Method Illustration Illustration Percentage-of-Completion Method

18-16 LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Illustration: Compute percentage complete. Illustration 18-16

18-17 Percentage-of-Completion Method Illustration: Percentage-of-Completion Revenue, Costs, and Gross Profit by Year Illustration LO 3 Apply the percentage-of-completion method for long-term contracts.

18-18 Companies recognize revenue and gross profit only at point of sale—that is, when the contract is completed. Under this method, companies accumulate costs of long-term contracts in process, but they make no interim charges or credits to income statement accounts for revenues, costs, or gross profit. LO 4 Apply the completed-contract method for long-term contracts. Revenue Recognition Before Delivery Completed Contract Method

18-19 LO 4 Apply the completed-contract method for long-term contracts. Completed Contract Method Illustration:

18-20 Construction contractors should disclosure:  the method of recognizing revenue,  the basis used to classify assets and liabilities as current (nature and length of the operating cycle),  the basis for recording inventory,  the effects of any revision of estimates,  the amount of backlog on uncompleted contracts, and  the details about receivables. Disclosures in Financial Statements Revenue Recognition Before Delivery LO 5 Identify the proper accounting for losses on long-term contracts.

18-21 In certain cases companies recognize revenue at the completion of production even though no sale has been made. Completion-of-Production Basis Revenue Recognition Before Delivery LO 5 Identify the proper accounting for losses on long-term contracts. Examples are:  precious metals or  agricultural products.

18-22 When the collection of the sales price is not reasonably assured and revenue recognition is deferred. Revenue Recognition After Delivery LO 6 Describe the installment-sales method of accounting. Methods of deferring revenue:  Installment-sales method  Cost-recovery method  Deposit method Generally Employed

18-23 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. Installment-Sales Method Revenue Recognition After Delivery LO 6 Describe the installment-sales method of accounting.

18-24 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. Acceptability of the Installment-Sales Method Revenue Recognition After Delivery LO 6 Describe the installment-sales method of accounting.

18-25 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. Cost-Recovery Method Revenue Recognition After Delivery LO 7 Explain the cost-recovery method of accounting.

18-26 Seller reports the cash received from the buyer as a deposit on the contract and classifies it on the balance sheet as a liability. The seller does not recognize revenue or income until the sale is complete. Deposit Method Revenue Recognition After Delivery LO 7 Explain the cost-recovery method of accounting.

18-27 Summary of Product Revenue Recognition Illustration LO 7