1. Intermediate Accounting
Chapter 17
Advanced Issues in Revenue Recognition
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2. When Can Companies Recognize Revenue? (Slide 1 of 2)
Revenues are increases in assets or settlements of liabilities during a period from delivering or producing goods, rendering services, or other activities that are the company’s ongoing major or central operations.
Revenues measure the accomplishments of the operating activities during the accounting period.
The recognition of revenue occurs when the company meets two criteria:
The earnings process is complete
Collection has occurred or is reasonably certain to occur
That is, revenue is recognized when it is earned and realized or realizable.

3. When Can Companies Recognize Revenue? (Slide 2 of 2)
SAB 104 states that revenue is generally earned and realized or realizable when the following conditions are met:
Persuasive evidence of an arrangement exists.
Delivery has occurred or services have been rendered.
The seller’s price to the buyer is fixed or determinable.
Collectibility is reasonably assured.

4. What are the Conceptual Issues Involving Revenue Recognition?
Measuring the amounts associated with revenues is usually straightforward.
The more difficult revenue recognition issues involves timing.
The decision as to when to recognize revenue depends on three factors:
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.

5. What are the Alternative Revenue Recognition Methods? (Slide 1 of 2)
Methods that recognize revenue prior to the full completion of the earnings process:
The percentage-of-completion method is used for most long-term construction contracts and some real estate sales.
The proportional performance method is used for long-term service contracts.
Methods that recognize revenue at the point the earnings process is completed:
The accrual method is used in the majority of transactions and recognizes revenue at the time the earnings process is completed and the customer pays cash or receivables that are reasonably certain to be collected.

6. What are the Alternative Revenue Recognition Methods? (Slide 2 of 2)
The deferral method is used in many transactions in which the customer pays for the goods or services in advance. Revenue recognition is delayed until the goods or services are delivered and the earnings process is completed.
The completed-contract method is used for some long-term contracts and recognizes revenue at the point in time when the earnings process is fully completed.
Methods that recognize revenue after the earnings process is complete and when realization occurs.
The installment method recognizes a portion of the revenue in proportion to the cash received.
The cost recovery method recognizes revenue in amounts equal to the cash received and cost recovered, and it delays recognition of gross profit until the entire cost of the product is recovered.

7. Long-Term Contracts (Slide 1 of 2)
Long-term construction contracts involve projects which can often take several years to complete, such as buildings, airplanes, ships, roads, bridges, and dams.
Using the percentage-of-completion method, the company recognizes revenues, expenses, and profit each period during the life of the contract in proportion to the amount of the contract completed during the period. It also increases the value of the inventory, so that inventory is reported at the costs incurred plus the profit recognized to date (minus any partial billings).
When the completed-contract method is used, the company does not recognize profit during the life of the contract, but recognizes it only when the contract is completed. It records the inventory at cost (minus any partial billings)

8. Long-Term Contracts (Slide 2 of 2)
GAAP requires that a construction company use the percentage- of-completion method for long-term contracts when all of the following conditions are met:
The company can make reasonably dependable estimates of the extent of progress toward the completion, contract revenues, and contract costs.
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.
The buyer can be expected to satisfy its obligations under the contract.
The company expects to perform its contractual obligations.

9. How Do We Account for the Percentage-of-Completion Method?
(Slide 1 of 2)
When a company uses the percentage-of-completion method, it may determine the percentage completed by using either input or output measures.
There are two methods of measuring input:
Cost-to-cost method. The percentage of completion is measured by comparing the costs incurred to date with the expected total costs for the contract. The revenue for the current period is calculated in the following manner:
Current Period Revenue
Percentage of Completion
Total Contract Revenue
Previously Recognized Revenue = × ‒

10. How Do We Account for the Percentage-of-Completion Method?
(Slide 2 of 2)
Efforts-expended method. The percentage of completion is measured by the work performed to date, such as labor hours, labor dollars, machine hours, or material quantities, compared to the expected total work to be performed in the contract.
Output measures use the results achieved to date compared to the total expected results of the contract to measure the percentage of completion.
Theoretically, output measures are preferable to input measures because they measure the results achieved.
However, output measures often cannot be reliably measured.

11. Percentage-of-Completion Method
There are two types of losses that can be incurred on construction contracts:
Loss in the current period. This type of loss occurs when estimates of future costs may indicate there is a loss in the current period but a profit is expected overall.
Overall loss on the contract. This type of loss occurs when it is expected that total costs will be greater than contract revenue.
The total expense recognized includes two components:
(1) The amount needed to create a cumulative profit of zero
(2) The amount of the overall loss recognized

12. Overhead Cost
Contract costs, like production cots for inventory, include all direct costs such as:
Direct materials
Direct labor
Indirect costs (overhead) identifiable with or allocated to the contract
Accounting for overhead costs as contract costs theoretically provides a better matching of costs as expenses against revenues than would result from treating such costs as period expenses.

13. Operating Cycle and Offsetting Amounts
GAAP requires that the net amounts of Construction in Progress and Partial Billing be included as current assets or current liabilities.
The operating-cycle concept is used to justify this classification.
Offsetting Amounts
In general, offsetting (or netting) of assets and liabilities is not allowed under U.S. GAAP.
GAAP does allow offsetting when separate contracts are part of the same project.

14. Capitalized Interest and Disclosure
When a company constructs an asset, it includes the avoidable interest association with the funds used in the construction in the cost of the asset.
If a company incurs interest cost that are related to a long-term construction contract, it includes these costs in the Construction in Progress account.
Disclosure
GAAP requires a company to disclose the method it uses to account for long-term construction contracts.
A company using the percentage-of-completion method is required to disclose the method used to determine the percentage of completion.

15. Long-Term Service Contracts (Slide 1 of 3)
A service company recognizes revenues (and expenses) under the accrual method of accounting in the period when it performs the service.
A company recognizes revenue for service transactions based on performance because performance determines the extent to which its earnings process is complete.
Using the proportionate performance method, revenue is recognized when a long-term service contract requires similar services to be performed in more than one act.

16. Long-Term Service Contracts (Slide 2 of 3)
Accounting for long-term service contracts becomes more complicated when the contracts provide dissimilar services.
If the dissimilar services can be separated, then the contract should be accounted for as a multiple-element arrangement.
If the dissimilar services are not separable, then the revenue recognized for each act should be based on a proportional performance measured with the ratio of direct costs incurred to perform each act to the total estimated direct costs for the long-term service contract.

17. Long-Term Service Contracts (Slide 3 of 3)
Service costs involved in a long-term service contract:
Initial direct costs—Costs that are directly associated with negotiating and signing a service contract (e.g., legal fees and selling commissions)
Direct costs—Costs that have a clear causal relationship to the services performed (e.g., labor costs)
Indirect costs—Costs other than initial directs costs and direct costs (e.g., advertising)

18. Revenue Recognition for Multiple Element Arrangements
When a company sells two or more products or services that are deemed separable in a single agreement with a customer, it must decide whether there are multiple “elements.”
The delivered item(s) is considered a separate unit of accounting if all of the following criteria are met:
The delivered item has value to the customer on a stand-alone basis.
It is probable that the undelivered item will be delivered and the delivery is substantially in control of the selling company.

19. Installment Method
Installment sales involve a financing agreement whereby the customer signs a contract, makes a small down payment, and agrees to make periodic payments over an extended period, often several years.
The customer takes possession of the item when the contract is signed (thereby enjoying its use during the payment period), while the seller retains legal title until the payments are complete.
A company should use the installment method of revenue recognition for a sales transaction that is not an installment sale when the collectibility of the receivable from the sale is not reasonably assured.

20. Defaults and Repossessions
When a company repossess an item, it records the inventory and writes off the related receivable and deferred gross profit.

21. Cost Recovery Method
If a company makes a sale in which there is a very high degree of uncertainty about the collectibility of the sales price, it defers recognition of any profit until the company has recovered the cost of the entire sale.
As with the installment method, the cost recovery method of recognizing revenue is generally not acceptable.
However, when receivables are collected over an extended period and where the terms of the transaction provide no reasonable basis for estimating the degree of collectibility, the cost recovery system may be used.

22. Summary of Alternative Revenue Recognition Methods