Chapter 18: Revenue Chapter 18: Revenue RecognitionRecognition

• Issues• Largest single source of public

company FS restatements• Required to be considered fraud

risk under SAS #99• Can occur in any industry

Revenue RecognitionRevenue Recognition

• Revenue recognition principle provides that revenue is recognized:• when it is earned AND• when it is realized or realizable

• Revenue is • Earned when earnings process is

substantially complete• Realized when goods & services

exchanged for cash or claims to cash• Realizable when assets received are

convertible into a known amount of cash

Guidelines for Revenue Guidelines for Revenue RecognitionRecognition

• Revenue from selling products• Recognized at the date of sale (date of

delivery)

• Revenue from services• Recognized when services are performed & are

billable

• Revenue from the use of enterprise’s assets by others • Recognized as time passes or as the assets are

used up

• Revenue from disposal of assets (other than inventory) • Recognized at the point of sale as gain or loss

Four Types of Revenue Four Types of Revenue TransactionsTransactions

Revenue Recognition Revenue Recognition Classified by Nature of Classified by Nature of

TransactionTransaction

• Point of sale (delivery)• Before delivery• After delivery• Special transactions

• Franchises • Consignments

• Comparative matrix of bases page 909

Revenue RecognitionRevenue Recognition

• Revenues from manufacturing & selling

• Realized/realizable• Earned

Revenue Recognition at Revenue Recognition at Point of SalePoint of Sale

• Exceptions:• Sales with buyback agreements• Sales when right of return exists

• High rates that are not reliably estimable – continued risk of ownership

• Criteria to meet• Page 910

• Trade loading & channel stuffing

Revenue Recognition at Revenue Recognition at Point of SalePoint of Sale

•Revenue may be recognized before delivery under certain circumstances•Long-term construction

contracts are a notable example•Revenue recognition methods

• Percentage-of-completion method• Completed contract method

Revenue Recognition Revenue Recognition Before DeliveryBefore Delivery

Long-Term ConstructionAccounting Methods

1) Terms of contract must be certain, enforceable2) Certainty of performance by both parties3) Estimates of completion can be made reliably

1) To be used only when percentage method inapplicable (uncertain)2) For short-term contracts

Percentage-of-CompletionMethod

Completed ContractMethod

Revenue Recognition Revenue Recognition Before DeliveryBefore Delivery

Costs incurred to date = Percent completeMost recent estimated total costs

11

Estimated total revenue x Percent complete = Revenue to be recognized to date

22

Total revenue to be recognized to date less Revenue recognized in PRIOR periods = Current period revenue

33

Current Period Revenue less current costs = Gross profit44

Percentage-of-Percentage-of-Completion: StepsCompletion: Steps

• Cost of construction: Construction in process (CIP)

Materials, cash, payables, etc.

• Progress billings:Accounts receivable

Billings on CIP

• Collections:Cash

Accounts receivable

Percentage-of-Percentage-of-Completion: EntriesCompletion: Entries

• To recognize revenue and gross profit:

Construction in process (gross profit) Construction expenses

Revenue• To record completion of project:

Billings on CIPConstruction in process

Percentage-of-Percentage-of-Completion: EntriesCompletion: Entries

Data: Contract price: $4,500,000 Estimated cost: $4 milStart date: July, 20X3 Finish: October, 20X5Balance sheet date: Dec. 31

Given: 20X3 20X4 20X5

Costs to date $1,000,000 $2,916,000 $4,050,000Est costs to complete $3,000,000 $1,134,000 $ -0-Progress Billings during yr $900,000 $2,400,000 $1,200,000Cash 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-Percentage-of-Completion: ExampleCompletion: Example

20X3 20X4 20X5

% 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 1,260,0001,000,000 1,916,000 less 1,134,000= 125,000 = 199,000 = 126,000

Gross Profit recognized

Percentage-of-Percentage-of-Completion: ExampleCompletion: Example

• All revenue & GP recognized only at point of sale (when contract completed)• Revenue is actual vs. estimate• Does not reflect current

performance when extends beyond one accounting period

Completed ContractCompleted Contract

• A long-term contract may produce:• Interim loss & overall profit OR• Overall loss for the project

• Percentage-of-completion method• Losses in any case recognized immediately• Examples page 920-921

• Completed contract method• Losses recognized immediately only when

overall losses indicated• Example page 921

Recognizing Current & Recognizing Current & Overall Losses on Long-Overall Losses on Long-

Term ContractsTerm Contracts

Current Loss onan otherwiseoverall profitablecontract

Completed method:No adjustment needed.

Percentage Method: Recognize loss currently.

Loss on anoverall unprofitablecontract

Percentage Method: Recognize entire loss now.

Completed method: Recognize loss currently.

Recognizing Current & Recognizing Current & Overall Losses on Long-Overall Losses on Long-

Term ContractsTerm Contracts

• Method of revenue recognition• Basis to classify A&L as current• Inventory basis• Effects of estimate revisions• Backlog on uncompleted

contracts• Details re: receivables

• Billed, unbilled, interest rate, retainage, concentrations of credit risk

Financial Statement Financial Statement DisclosuresDisclosuresContractorsContractors

• Revenue recognition deferred• Collection of sales price not

reasonably assured AND• No reliable estimates can be made

• Revenue recognition methods• Installment sales method• Cost recovery method

• Cash received prior to delivery• Use deposit method

Revenue Recognition Revenue Recognition After DeliveryAfter Delivery

• Emphasizes revenue recognition in periods of collection rather than point of sale

• Title does not pass to buyer until all cash payments made to seller

• Sales & cost of sales deferred to periods of collection

• Other expenses, selling & administrative, are not deferred

The Installment Sales The Installment Sales MethodMethod

• Installment sales must be kept separate

• Gross profit must be determinable• Amount of cash collected from

installment accounts must be known

• Cash collected from current year & prior years accounts must be known

• Provision must be made to carry forward deferred gross profit

The Installment Sales The Installment Sales Method: IssuesMethod: Issues

• For installment sales in any year

• For installment sales made in prior years (realized gross profit)

• Determine rate of gross profit on installment sales

• Apply rate to cash collections of current year installment sales to yield realized gross profit

• Gross profit not realized is deferred

• Apply relevant rate to cash collections of prior year installment sales

The Installment Sales The Installment Sales Method: StepsMethod: Steps

Given: 20X3 20X4 20X5

Installment sales $200,000 $250,000 $240,000 Cost of sales $150,000 $190,000 $168,000 Gross Profit $ 50,000 $ 60,000 $ 72,000

Cash received in: from 20X3 sales $ 60,000 $ 100,000 $ 40,000 from 20X4 sales $ -0- $ 100,000 $125,000 from 20X5 sales $ -0- $ -0- $ 80,000

Determine the realized and deferred gross profit

The Installment Sales The Installment Sales Method: ExampleMethod: Example

Given: 20X3 20X4 20X5

Installment sales $200,000 $250,000 $240,000

Gross Profit $ 50,000 $ 60,000 $ 72,000

Gross profit rate 25% 24% 30%

See next slide for realized and deferred gross profit

The Installment Sales The Installment Sales Method: ExampleMethod: Example

20X3 20X4 20X5

Gross profit rate 25% 24% 30%

Realized Gross Profit: From 20X3 sales: Realized in $ 15,000 $ 25,000 $

10,000 From 20X4 sales: Realized in: $ -0- $ 24,000 $ 30,000 From 20X5 sales: Realized in: $ -0- $ -0- $ 24,000

Gross profit deferred

deferred

The Installment Sales The Installment Sales Method: ExampleMethod: Example

Installment Sales 200,000Cost of Sales 150,000Deferred Gross Profit, 20X3 50,000 (To close 20X3 accounts)

Deferred Gross Profit, 20X3 15,000Realized Gross Profit 15,000 (Realized: $60,000 x 25%)

Realized Gross Profit 15,000Income Summary 15,000

(To close to Income Summary)

The Installment Sales The Installment Sales Method: Partial Journal Method: Partial Journal Entries (20X3) for Gross Entries (20X3) for Gross

ProfitProfit

• If significant to sales• Full disclosure of installment sales• Cost of installment sales• Expenses allocable to installment sales• Illustration 18-26 page 930

• If insignificant• Realize GP in IS as special item after GP

on sales• Illustration 18-25 page 929

The Installment Sales The Installment Sales Method: Financial Method: Financial

Statement PresentationStatement Presentation

• BS presentation of AR• Repossessed merchandise• Deferred GP on installment sales

• Theoretical components – difficult to allocate

• Income tax liability paid when sales reported as realized

• Allowance for collection & B/D expense & repossession losses

• Net income

• Contra asset per SFAS #6• Practice is to treat all as unearned

revenue

The Installment Sales The Installment Sales Method: Miscellaneous Method: Miscellaneous

IssuesIssues

• Seller recognizes no profit • Until cash payments by buyer exceed seller’s cost

of merchandise• Deferred GP offset to related AR net of collections

• After recovering all costs• Seller includes additional cash collections in

income

• Used when there is no reasonable basis for estimating collectibility • Franchises & real estate

• IS reports amount of gross profit recognized & amount deferred• Separate item of revenue when recognized as

earned

• Illustration 18-28 page 931

The Cost Recovery The Cost Recovery MethodMethod

• Seller • Receives cash from buyer before

transfer of goods or performance• Has no claim against purchaser

• There is insufficient transfer of risks to buyer to warrant recording sale by seller

• Deposit method defers sale recognition until sale has occurred for accounting purposes

The Deposit MethodThe Deposit Method

• Estimates• % complete• Costs• GP % for installment sales

• Completion dates• Losses on contracts• Rights of return – outside of sales

contract• Trade loading & channel stuffing

Ethics & IssuesEthics & Issues

• Franchises• Manufacturer-retailer• Manufacturer-wholesaler• Service sponsor-retailer

• Fastest growing, accounting issues

• Wholesaler-retailer

• Consignments

Special Sales Special Sales TransactionsTransactions

• Franchisor – grants business rights• Franchisee – operates business• Initial franchise fee

• Revenue• Franchisor makes substantial performance AND

• Substantial performance = no obligation to refund any cash received/excuse nonpayment of note

• Collection of fee reasonably assured• Example JEs page 937

• Continuing franchise fees• Revenue when earned & receivable

Special Sales Special Sales TransactionsTransactionsFranchisesFranchises

• Additional issues & concerns• Bargain purchases

• BPP < normal selling price = defer portion initial fee

• Options to purchase• Probable @ time of option = liability

• Franchisor’s cost• Direct costs – generally defer• Indirect costs – current IS

Special Sales Special Sales TransactionsTransactionsFranchisesFranchises

• Consignor – manufacturer/wholesaler• Accepts risk merchandise might not

sell

• Consignee - dealer • Consignment

• Consignor carries inventory• Record revenue when notified of sale by

consignee & cash received

• Consignee has liability for amount due consignor

Special Sales Special Sales TransactionsTransactions

ConsignmentsConsignments

E18-5 E18-6E18-9 E18-14E18-15 E18-22

Class ExercisesClass Exercises