Ch08 Revenue Recognition
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chapter 8Revenue RecognitionAn electronic presentation by Douglas Cloud Pepperdine University
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
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.
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.
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.
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.
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.
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.
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.
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.
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.
Persuasive Evidence of an ArrangementThe SEC issued SEC 101 in response to specific abuses involving revenue recognition.
Persuasive Evidence of an ArrangementSAB 101 is in a questionand-answer format. The answers given are invariably No.
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.
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.
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.
Persuasive Evidence of an ArrangementAppropriate Layaway AccountingReceipt of $100 cash as initial layaway payment: Cash Deposit Received from Customers 100 100
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
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.
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
Persuasive Evidence of an ArrangementTypical questions from SAB 101
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.
Revenue Recognition Prior to Providing Goods or ServicesGAAP requires percentage-ofcompletion method unless certain criteria are not met.
Percentage-ofCompletion 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 settlementContinued
Percentage-ofCompletion Accounting The buyer can be expected to satisfy
obligations under the contract. Contractor can be expected to perform the contractual obligation.
Percentage-ofCompletion 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.
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.
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.
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
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.
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.
Percentage-ofCompletion Accounting2005 Cost of Long-Term Construction Contracts Construction in Progress Revenue from Long-Term Construction Contracts 910,000 140,000
1,050,000 ($3,000,000 x .75) $1,200,000
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
750,000 $ 3,000,000 (1,200,000) (1,050,000) $ 750,000
Percentage-ofCompletion Accounting2006Construction in Progress 1,040,000 160,000 910,000 140,000 650,000 100,000 3,000,000 Progress Billings on Construction Contracts 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
Revision of EstimatesInstead 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.
Revision of EstimatesActual Cost Incurred $1,040,000 910,000 $1,950,000 700,000 $2,650,000 720,000 0 2,670,000 2,650,000 73 100 Estimated Cost to Complete Total Cost Cost Percentage 40
Year 2004 2005 Total 2006 Total
Note that expected grossblue changed from in 2004, Items in profit was $400,000 $330,000 in 2005,the previous illustration. and the actual was $350,000 in 2006.
Revision of Estimates
The entries for 2004 would be the same as those shown in the previous example.
Revision of EstimatesAll entries for 2005 would be the same except for the entry to record revenue and cost.
Revision of Estimates2005 Cost of Long-Term Construction Contracts Construction in Progress Revenue from Long-term Construction Contracts 910,000 80,000
($3,000,000 x .73) $1,200,000
Revision of Estimates2006
Construction in Progress 700,000 Materials, Cash, etc. 700,000 To record costs incurred. Accounts Receivable 1,100,000 Progress Billings on Same Construction Contracts 1,100,000 To record billings. Cash 1,350,000 Accounts Receivable 1,350,000 To record cash collections. Same
Revision of Estimates2006 Cost of Long-Term Construction Contracts Construction in Progress Revenue from Long-Term Construction Contracts 700,000 110,000
810,000 $3,000,000 (1,200,000) (990,000) $ 810,000
Revision of Estimates2006Construction in Progress 1,040,000 160,000 910,000 80,000 700,000 110,000 3,000,000 Progress Billings on Construction Contracts 1,000,000 900,000 1,100,000 3,000,000
Progress Billings on Construction Items in red are different for Contracts 3,000,000 this illustration. Construction in Progress 3,000,000
Anticipated Loss: Percentage-ofCompletion MethodAssume 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 2005in addition, the $160,000 gross profit recognized in 2004 must be eliminated.
Anticipated Loss: Percentage-ofCompletion Method2005 Cost of Long-Term Construction Contracts Revenue from Long-Term Construction Contracts Construction in Progress 910,000
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.
Accounting for Long-Term LongService ContractsMost 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.
Accounting for Long-Term LongService ContractsProportional 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 (if sold separately, $60,000).
Accounting for Long-Term LongService ContractsReceipt of fees: Cash 50,000 Deferred Course Revenue 50,000 Initial direct costs: Deferred Liability account Initial Costs 5,000 Asset account Cash 5,000 Direct costs for lesson actually completed: Contract Costs Expense account 12,000 Cash 12,000 Continued
Accounting for Long-Term LongService ContractsCourse revenue recognized: Deferred Course Revenue 20,000 Recognized Course Revenue 20,000 Recognize contract costs from initial direct costs: $24,000 x $50,000 Contract Costs 2,000 $60,000 Deferred Initial costs 2,000 $24,000 x $5,000 $60,000
Revenue Recognition After Delivery 50 of Goods or Providing Service Installment Sales Method: Recognizes
revenues and related expenses as cash is received (used when collection is somewhat uncertain). 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.
Revenue Recognition After Delivery 51 of Goods or Providing ServiceMethod Full Accrual Installment Sales Cost Recovery Cash
Timing of Revenue Recognition At point of sale At collection of cash (portion of receipt) At collection of cash (after all costs have been recovered) At collection of cash
Treatment of Costs Revenue at point of sale Defer and match against revenue as cash is collected Defer and match against cash receipts Charge to expense as incurred
Installment Sales MethodThe installment sales method is used most commonly in cases of real estate sales.
Installment Sales MethodGeorge sells merchandise on the installment basis. Uncertainty of collection makes use of the installment method necessary. Use the accompanying data to prepare Georges journal entries.
Installment Sales Method2004 2005
Sales Cost of Sales Gross Profit Gross Profit Percentage Cash Collection 2004 Sales 2005 Sales
$150,000 100,000 $ 50,000 33.33%
$200,000 140,000 $ 60,000 30%
$ 75,000 $ 70,000
Installment Sales Method2004 Installment Accounts Receivable 2004 150,000 Installment Sales 150,000 Cost of Installment Sales Inventory Cash Installment Accounts Receivable2004 Continued 100,000 100,000 30,000 30,000
Installment Sales Method2004 Installment Sales 150,000 Cost of Installment Sales 100,000 Deferred Gross Profit2004 50,000 Deferred Gross Profit2004 Realized Gross Profit on Installment Sales 10,000 10,000 $30,000 x 33.33%
Installment Sales Method2005 Installment Accounts Receivable 2005 200,000 Installment Sales 200,000 Cost of Installment Sales Inventory Cash Installment A/R2004 Installment A/R2005 Continued 140,000 140,000 145,000 75,000 70,000
Installment Sales Method2005 Installment Sales 200,000 Cost of Installment Sales 140,000 Deferred Gross Profit2005 60,000 Deferred Gross Profit2004 25,000 Deferred Gross Profit2005 21,000 Realized Gross Profit on $75,000 x 33.33% Installment Sales 46,000 $70,000 x 30%
Cost Recovery MethodAssume George has to use the cost recovery method, but all sales and collections remain the same.
Revenue Recovered Cost Cost
Cost Recovery Method2005 All entries are the same except do not book the entry to gross profit.Deferred Gross Profit2004 Realized Gross Profit on Installment Sales 5,000 5,000
Cost Recovery Method2006Deferred Gross Profit2004 Deferred Gross Profit2005 Realized Gross Profit on Installment Sales 30,000 10,000 40,000
Cash MethodIf 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.