1. chapter 8
Revenue Recognition

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

3. 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.

4. Revenue Recognition
FASB’s two criteria for recognizing revenues and gains:
1. They are realized or realizable.
2. They have been earned through substantial completion of the activities involved in the earnings process. 2

5. Both of these criteria generally are met at the point of sale.
Revenue Recognition
Revenue recognition most often occurs when goods are delivered or when services are rendered.
Both of these criteria generally are met at the point of sale.

6. Criterion Associated With Revenue Recognition
Criterion 1: The customer has provided payment or a valid promise of payment.
Criterion 2: The company has provided a product or service.

7. Before the point of Sale
Revenue Recognition
Before the point of Sale
EXCEPTION:
Revenue can be recognized prior to the point of sale if:
Customer provides a valid promise of payment AND
Criterion 1
Criterion 2
conditions exist that contractually guarantee subsequent sale.

8. Revenue Recognition Point of Sale NORMALLY:
Revenue is generally recognized at this point of time.
Criterion 1 is typically satisfied at this point.
Criterion 1
Criterion 2
Critical 2 is typically satisfied at this point.

9. Revenue Recognition After the Point of Sale EXCEPTION:
The recognition of revenue must be deferred if:
Customer does not provide a valid promise at time of receipt of product or service OR
Criterion 1
Criterion 2
significant effort remains on the contract.

10. Revenue Recognition
Generally, revenue is not recognized prior to the point of sale because either:
A product or service was provided without receiving a valid promise of payment from customer.
The company has not provided the product or service.
An exception occurs when the customer provides a valid promise of payment and conditions exist that contractually guarantee the sale. 3

11. 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.
Earned
Realised

12. Persuasive Evidence of an Arrangement
The SEC issued SAB 101 in response to specific abuses involving revenue recognition.

13. Persuasive Evidence of an Arrangement
SAB 101 is in a question-and-answer format. The answers given are invariably “No.”

14. Persuasive Evidence of an Arrangement
Typical questions from SAB 101
Question 1: May Company A recognize revenue in the current quarter if the product is delivered by the end of the quarter but the sales agreement is not signed by the customer until a few days after the end of the quarter?
Question 1: Company A requires each sale to be supported by a written sales agreement signed by an authorized representative of both Company A and the customer.
ENTER
Addresses internal controls.

15. Persuasive Evidence of an Arrangement
Typical questions from SAB 101
Question 2: Company Z delivers product to a customer on a consignment basis. May Company Z recognize revenue upon delivery of the product to the customer?
Addresses the issue of circumventing internal controls by side agreements.

16. Delivery has occurred or service has been rendered
Typical questions from SAB 101
Question 3: May Company A recognize revenue when it completes production of inventory for a customer if it segregates that inventory from other products in its warehouse?

17. Delivery has occurred or service has been rendered
Typical questions from SAB 101
Question 4: merchandise aside until the customer pays the remainder of the sales price, and takes possession of the merchandise. When should Company R recognize revenue?
Question 4: Company R is a retailer that offers “layaway” sales to customers. A customer pays a portion of the sales price, and Company R sets the…
ENTER
Focuses on issues centered on the “bill-and-hold” arrangements.

18. Delivery has occurred or service has been rendered
“bill-and-hold” arrangements.
In general, revenue should not be recognised in a bill-and-hold arrangement until the seller has transferred both legal ownership, evidence by the buyer taking title to the goods, and economic ownership, meaning that the buyer accepts responsibility for the safeguarding and preservation of the goods.

19. Delivery has occurred or service has been rendered
Appropriate Layaway Accounting
Receipt of $100 cash as initial layaway payment:
Cash 100
Deposit Received from Customers 100
Receipt of final $1,400 cash payment and delivery of goods to customer:
Cash 1,400
Deposit Received from Customers 100
Sales 1,500
Cost of Goods Sold 1,000
Inventory 1,000

20. Delivery has occurred or service has been rendered

21. Delivery has occurred or service has been rendered
Questions 5 & 6 – Deal with the seller receiving some up-front fee as well as subsequent periodic payments
E.g. Seller Company receives $1,000 cash from a customer as the initial sign-up fee for a service. In addition to the sign-up fee, the customer is required to pay $50 per month for 100 months—which is the economic life of this service agreement.

22. Delivery has occurred or service has been rendered
Receipt of $1,000 cash as initial sign-up fee:
Cash 1,000
Unearned Initial Sign-Up Fees 1,000
Receipt of first monthly payment of $50:
Cash 50
Monthly Service Revenue 50
Partial recognition of the initial signup fee as revenue ($1,000/100 months):
Unearned Initial Sign-Up Fees 10
Initial Sign-Up Fee Revenue 10

23. Delivery has occurred or service has been rendered
Questions 7 & 9 – Deal with refundable fees. In summary, the non-refundable portion of the fees can be recognized on a monthly basis if the number of refunds can be reliably estimated.

24. Price is fixed or determinable
Typical questions from SAB 101
Question 8: Company A owns a building and leases it to a retailer. The annual lease payment is $1.2 million plus 1% of all the retailer’s sales in excess of $25 million.
Question 8: Should Company A estimate and recognize revenue associated with the 1% of sales over $25 million on a straight-line basis throughout the year?
ENTER
Addresses the difference between estimating the future impact of past events and estimating the future impact of future events.

25. Reporting Revenue: Gross vs. Net
Gross = Sales + commission
Net = Commission only
SAB 101 – Gross is inappropriate unless the seller actually took legal and economic ownership of the goods being sold.

26. 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. (construction)
Proportional performance method reflects revenue earned on service contracts under which many acts of service are to be performed before the contract is complete.

27. Revenue Recognition Prior to Providing Goods or Services
GAAP requires percentage-of-completion method unless certain criteria are not met. 6

28. Percentage-of-Completion Accounting
Dependable estimates of:
contract revenues
contract costs
progress toward completion
Contract clearly specifies:
enforceable rights of the parties
consideration to be exchanged
manner and terms of settlement
Continued 7

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

30. Percentage-of-Completion Accounting
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. 9

31. Percentage-of-Completion Accounting
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

32. Accounting for Long-Term Construction-Type Contracts
Strong Construction Company was awarded a contract with a total price of $3,000,000. Strong expected to earn $400,000 profit on the contract.

33. Estimated Cost to Complete
Accounting for Long-Term Construction-Type Contracts
Actual Cost Incurred
Estimated Cost to Complete
Total Cost
Cost Percentage
Year
2004 $1,040,000 $1,560,000 $2,600,000 40
,000
Total $1,950, ,000 2,600,000 75
, ,600,
Total $2,600,000

34. Percentage-of-Completion Accounting
2004
Construction in Progress 1,040,000
Materials, Cash, etc. 1,040,000
To record costs incurred.
Accounts Receivable 1,000,000
Progress Billings on
Construction Contracts 1,000,000
To record billings.
Cash 800,000
Accounts Receivable 800,000
To record cash collections.

35. Percentage-of-Completion Accounting
2004
Cost of Long-Term Construction
Contracts 1,040,000
Construction in Progress 160,000
Revenue from Construction Contracts 1,200,000
Actual Cost
$3,000,000 x .40

36. Percentage-of-Completion Accounting
2005
Construction in Progress 910,000
Materials, Cash, etc. 910,000
To record costs incurred.
Accounts Receivable 900,000
Progress Billings on
Construction Contracts 900,000
To record billings.
Cash 850,000
Accounts Receivable 850,000
To record cash collections.

37. Percentage-of-Completion Accounting
2005
Cost of Long-Term Construction
Contracts 910,000
Construction in Progress 140,000
Revenue from Long-Term
Construction Contracts 1,050,000
($3,000,000 x .75) –
$1,200,000

38. Percentage-of-Completion Accounting
2006
Construction in Progress 650,000
Materials, Cash, etc. 650,000
To record costs incurred.
Accounts Receivable 1,100,000
Progress Billings on
Construction Contracts 1,100,000
To record billings.
Cash 1,350,000
Accounts Receivable 1,350,000
To record cash collections.

39. Percentage-of-Completion Accounting
2006
Cost of Long-Term Construction
Contracts 650,000
Construction in Progress 100,000
Revenue from Long-Term
Construction Contracts 750,000
$ 3,000,000
(1,200,000)
(1,050,000)
$ ,000

40. Construction in Progress Progress Billings on Construction Contracts
Percentage-of-Completion Accounting
2006
Construction in Progress
Progress Billings on Construction Contracts
1,040,000
160,000
910,000
140,000
650,000
100,000
3,000,000
1,000,000
900,000
1,100,000
3,000,000
Progress Billings on Construction
Contracts 3,000,000
Construction in Progress 3,000,000

41. Revision of Estimates
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.

42. Estimated Cost to Complete
Revision of Estimates
Actual Cost Incurred
Estimated Cost to Complete
Total Cost
Cost Percentage
Year
2004 $1,040,000 $1,560,000 $2,600,000 40
,000
Total $1,950, ,000 2,670,000 73
, ,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.
Items in blue changed from the previous illustration.

43. Revision of Estimates
The entries for 2004 would be the same as those shown in the previous example.
2004

44. Revision of Estimates
All entries for 2005 would be the same except for the entry to record revenue and cost.
2005

45. Revision of Estimates 2005 Cost of Long-Term Construction
Contracts 910,000
Construction in Progress 80,000
Revenue from Long-term
Construction Contracts 990,000
($3,000,000 x .73) –
$1,200,000

46. Revision of Estimates 2006 Construction in Progress 700,000
Materials, Cash, etc. 700,000
To record costs incurred.
Accounts Receivable 1,100,000
Progress Billings on
Construction Contracts 1,100,000
To record billings.
Same
Cash 1,350,000
Accounts Receivable 1,350, To record cash collections.
Same

47. Revision of Estimates 2006 Cost of Long-Term Construction
Contracts 700,000
Construction in Progress 110,000
Revenue from Long-Term
Construction Contracts 810,000
$3,000,000
(1,200,000)
(990,000)
$ 810,000

48. Construction in Progress Progress Billings on Construction Contracts
Revision of Estimates
2006
Construction in Progress
Progress Billings on Construction Contracts
1,040,000
160,000
910,000
80,000
700,000
110,000
3,000,000
1,000,000
900,000
1,100,000
3,000,000
Progress Billings on Construction
Contracts 3,000,000
Construction in Progress 3,000,000
Items in red are different for this illustration.

49. Anticipated Loss: Percentage-of-Completion Method
Assume the same facts for Strong Construction Company, except that after 2004 entries have been made, the firm determines that the total cost will be $3,250,000. The entries for 2004 would be the same, but the loss must be dealt with in 2005—in addition, the $160,000 gross profit recognized in 2004 must be eliminated.

50. Anticipated Loss: Percentage-of-Completion Method
2005
Cost of Long-Term Construction
Contracts 910,000
Revenue from Long-Term
Construction Contracts 600,000
Construction in Progress 410,000
To go from a $160,000 gross profit to an anticipated $250,000 loss ($3,000,000 – $3,250,000), the Construction in Progess account needs to be credited $410,000.

51. Accounting for Long-Term Service Contracts
Most service contracts involve three types of costs:
(1) Initial direct costs related to obtaining and performing initial services on the contract.
(2) Direct costs related to performing the various acts of service.
(3) Indirect costs related to maintaining the organization to service the contract.

52. Proportional Performance Method
Accounting for Long-Term Service Contracts
Proportional Performance Method
A correspondence school enters into 100 contracts with students for an extended writing course. The fee for each contract is $500, payable in advance. The initial direct costs related to the contracts total $5,000. Actual direct costs for lessons for the first period are $12,000. The sales value of the lessons completed is $24,000 (The total value of all lessons is $60,000).

53. Accounting for Long-Term Service Contracts
Receipt of fees:
Cash 50,000
Deferred Course Revenue 50,000
Initial direct costs:
Liability account
Deferred Initial Costs 5,000
Cash 5,000
Asset account
Direct costs for lesson actually completed:
Expense account
Contract Costs 12,000
Cash 12,000
Continued

54. Accounting for Long-Term Service Contracts
Course revenue recognized:
Deferred Course Revenue 20,000
Recognized Course Revenue 20,000
$24,000
$60,000
x $50,000
Recognize contract costs from initial direct costs:
Contract Costs 2,000
Deferred Initial costs 2,000
$24,000
$60,000
x $5,000

55. Revenue Recognition After Delivery of Goods or Providing Service
Installment Sales Method: Recognizes revenues and related expenses as cash is received (used when collection is somewhat uncertain). (Not to be confused with installment sales, which utilize accrual accounting)
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

56. Revenue Recognition After Delivery of Goods or Providing Service
Timing of Revenue
Treatment
Method
Recognition
of Costs
Full Accrual
At point of sale
Recognized 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

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

58. 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

59. Installment Sales Method
Sales
Cost of Sales
Gross Profit
Percentage
$150,000 $200,000
100, ,000 $ 50,000 $ 60,000
33.33% %
Cash Collection
2004 Sales $ 30, $ 75,000
2005 Sales $ 70,000 25

60. Installment Sales Method
2004
Installment Accounts Receivable—
,000
Installment Sales ,000
Cost of Installment Sales 100,000
Inventory ,000
Cash 30,000
Installment Accounts
Receivable— ,000
Continued 26

61. Installment Sales Method
2004
Installment Sales 150,000
Cost of Installment Sales ,000
Deferred Gross Profit— ,000
Deferred Gross Profit— ,000
Realized Gross Profit on
Installment Sales ,000
$30,000 x 33.33%
Continued

62. Installment Sales Method
2005
Installment Accounts Receivable—
,000
Installment Sales ,000
Cost of Installment Sales 140,000
Inventory ,000
Cash 145,000
Installment A/R— ,000
Installment A/R— ,000
Continued 31

63. Installment Sales Method
2005
Installment Sales 200,000
Cost of Installment Sales ,000
Deferred Gross Profit— ,000
Deferred Gross Profit— ,000
Deferred Gross Profit— ,000
Realized Gross Profit on
Installment Sales ,000
$75,000 x 33.33%
$70,000 x 30% 34

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

65. Cost Recovery Method
2005
All entries are the same except do not book the entry to gross profit.
Deferred Gross Profit—2004 5,000
Realized Gross Profit on
Installment Sales 5,000
($30,000 + $75,000) – ($100,000) 37

66. Cost Recovery Method 2006 Deferred Gross Profit—2004 30,000
Realized Gross Profit on
Installment Sales 40,000

67. Cash Method
If the probability of recovering product or service costs is remote the cost recovery method of accounting can be used. There has to be considerable uncertainty as to ultimate collection of the contract price.

68. chapter 8
The End