Ch08 Revenue Recognition

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chapter 8Revenue RecognitionAn electronic presentation by Douglas Cloud Pepperdine University

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Learning Objectives1. 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 completedcontract methods.Continued

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Learning Objectives4. 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.

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Revenue RecognitionFASBs 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.

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

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Revenue RecognitionCriterion 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.

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

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Criterion 1 Criterion 2

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

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Criterion 1 Criterion 2

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

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Criterion 1

Criterion 2

Revenue RecognitionGenerally, 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.

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Revenue RecognitionAICPA 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 vendors fee is fixed or determinable. d. Collectibility is probable.

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Persuasive Evidence of an ArrangementThe SEC issued SEC 101 in response to specific abuses involving revenue recognition.

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Persuasive Evidence of an ArrangementSAB 101 is in a questionand-answer format. The answers given are invariably No.

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

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Persuasive Evidence of an ArrangementTypical 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.

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Persuasive Evidence of an ArrangementTypical questions from SAB 101 Question 4: Company R is a retailer that aside until the customer pays the remainder of sales to offers layaway the sales price, and takes possession of the customers. A customer pays a merchandise. When should portion of the sales price, and Company R sets the revenue? recognize ENTER Focuses on issues centered on the bill-and-hold arrangements.

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Persuasive Evidence of an ArrangementAppropriate Layaway AccountingReceipt of $100 cash as initial layaway payment: Cash Deposit Received from Customers 100 100

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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

Persuasive Evidence of an ArrangementSeller 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 monthswhich is the economic life of this service agreement.

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Persuasive Evidence of an ArrangementReceipt 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

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Persuasive Evidence of an ArrangementTypical questions from SAB 101

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Question 8: Company A owns A building and Should Company a estimate recognize a retailer. The annual leases it torevenue associated with payment sales over $25 leasethe 1% ofis $1.2 million plus million on a retailers sales in 1% of all thestraight-line basis throughout the year? excess of $25 million. ENTERAddresses the difference between estimating the future impact of past events and estimating the future impact of future events.

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

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Revenue Recognition Prior to Providing Goods or ServicesGAAP requires percentage-ofcompletion method unless certain criteria are not met.

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Percentage-ofCompletion Accounting Dependable estimates of: contract revenues contract costs progress toward completion

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Contract clearly specifies: enforceable rights of the parties consideration to be exchanged manner and terms of settlementContinued

Percentage-ofCompletion Accounting The buyer can be expected to satisfy

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obligations under the contract. Contractor can be expected to perform the contractual obligation.

Percentage-ofCompletion Accounting Recognize revenue throughout life of the

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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.

Percentage-ofCompletion AccountingInput 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.

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

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Accounting for Long-Term Construction-Type ContractsYear 2004 2005 Total 2006 Total Actual Cost Incurred $1,040,000 910,000 $1,950,000 650,000 $2,600,000 650,000 0 2,600,000 2,600,000 75 100 Estimated Cost to Complete Total Cost Cost Percentage 40

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$1,560,000 $2,600,000

Percentage-ofCompletion Accounting2004

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Construction in Progress 1,040,000 Materials, Cash, etc. 1,040,000 To record costs incurred. $1,040,000 = Accounts Receivable 1,000,000 40% $2,600,000 Progress Billings on Construction Contracts 1,000,000 To record billings. Cash 800,000 Accounts Receivable 800,000 To record cash collections.

Percentage-ofCompletion Accounting2004

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Cost of Long-Term Construction Contracts 1,040,000 Construction in Progress 160,000 Construction Contracts Actual Cost 1,200,000

$3,000,000 x .40

Percentage-ofCompletion Accounting2005 Construction in Progress 910,000 Materials, Cash, etc. To record costs incurred. Accounts Receivable 900,000 Progress Billings on Construction Contracts To record billings. Cash 850,000 Accounts Receivable To record cash collections.

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910,000

900,000

850,000

Percentage-ofCompletion Accounting2005 Cost of Long-Term Construction Contracts Construction in Progress Revenue from Long-Term Construction Contracts 910,000 140,000

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1,050,000 ($3,000,000 x .75) $1,200,000

Percentage-ofCompletion Accounting2006

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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.

Percentage-ofCompletion Accounting2006 Cost of Long-Term Construction Contracts Construction in Progress Revenue from Long-Term Construction Contracts 650,000 100,000

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750,000 $ 3,000,000 (1,200,000) (1,050,000) $ 750,000

Percentage-ofCompl