Income Recognition and Measurement of Assets C hapter 18 An electronic presentation by Norman...

Income Recognition and Measurement of Assets

Chapter18

An electronic presentation by Norman Sunderman Angelo State University

An electronic presentation by Norman Sunderman Angelo State University

COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Intermediate AccountingIntermediate Accounting 10th edition 10th edition

Nikolai Bazley JonesNikolai Bazley Jones

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1. Understand the revenue recognition alternatives.

2. Explain revenue recognition at the time of sale, during production, and at time of cash receipt.

3. Explain the conceptual issues regarding revenue recognition alternatives.

4. Describe the alternative revenue recognition methods.

Objectives

3

5. Account for revenue recognition prior to the period of sale, including the percentage-of-completion and completed contract methods.

6. Account for revenue recognition after the period of sale, including the installment and cost recovery methods.

7. Account for revenue recognition delayed until a future event occurs.

Objectives

4

8. Understand software revenue recognition, franchises, real estate sales, retail land sales, and consignment sales. (Appendix)

Objectives

5

Recognition is the process of formally

recording and reporting items in the financial statements.

Recognition is the process of formally

recording and reporting items in the financial statements.

Revenue Recognition

6

Realization is the process of converting

noncash recourses into cash or rights to

cash.

Realization is the process of converting

noncash recourses into cash or rights to

cash.

Revenue Recognition

7

Example 1: Revenue Recognition at Time of SaleExample 1: Revenue Recognition at Time of Sale

1. Ringwood Company manufactures the inventory.Inventory 100

Cash 1002. Ringwood sells the inventory for $150.

Accounts Receivable 150Revenue 150

Cost of Goods Sold 100Inventory 100

Revenue Recognition

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Example 1: Revenue Recognition at Time of SaleExample 1: Revenue Recognition at Time of Sale

3. Ringwood collects cash of $60.Cash 60

Accounts Receivable 60

Income StatementRevenue $150 Cost of goods sold (100)Gross profit $ 50

Revenue Recognition

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Example 2: Revenue Recognition During ProductionExample 2: Revenue Recognition During Production


Cash 1002. Ringwood recognizes the revenue during production

(the manufacturing process).Production Expense 100Inventory 50

Revenue 150

Revenue Recognition

10


3. The company bills the customer for a partial billing of $130.Accounts Receivable 130

Partial Billings 130

4. Ringwood collects cash of $60.

Cash 60Accounts Receivable 60

Revenue Recognition

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Income StatementRevenue $150 Production expense (100)Gross profit $ 50

The balance sheet shows Inventory of $150, less Partial Billings of $130.

The balance sheet shows Inventory of $150, less Partial Billings of $130.

Revenue Recognition

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Example 3: Revenue Recognition at Time of Cash ReceiptExample 3: Revenue Recognition at Time of Cash Receipt


Cash 1002. Ringwood “sells” the inventory and defers the

recognition of revenue.

Accounts Receivable 150Inventory 100Deferred Gross Profit 50

Revenue Recognition

13


3. Ringwood collects cash of $60.Cash 60

Accounts Receivable 60

4. The company recognizes revenue on the basis of the cash received.

Cost of Goods Sold 40Deferred Gross Profit 20

Revenue 60

($60 ÷ $150) x ($60 ÷ $150) x $100$100

($60 ÷ $150) x ($60 ÷ $150) x $100$100

Cash Cash

ReceivedReceivedCash Cash

ReceivedReceived

Revenue Recognition

($60 ÷ $150) x $100($60 ÷ $150) x $100($60 ÷ $150) x $100($60 ÷ $150) x $100

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Income StatementRevenue $ 60 Cost of goods sold (40)Gross profit $ 20

The balance sheet shows Accounts Receivable of $90, less Deferred Gross Profit of $30.

Revenue Recognition

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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.

The decision as to when to recognize revenue focuses on three factors:

Conceptual Issues

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1. Revenue recognition in the period of sale.

2. Revenue recognition prior to the period of sale.

3. Revenue recognition at the completion of production.

4. Revenue recognition after the period of sale.

5. Revenue recognition delayed until a future event.

Alternative Revenue Recognition Methods

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Earned and Realizable

Economic Substance and Transfer of Risks

and Benefits of Ownership

Collectibility is Not

Reasonably Assured

Installment Method

Cost Recovery Method

Percentage-of-Completion Method

(for Long-Term Contracts)

Completed-Contract

Method (for Long-Term Contracts)

Accrual Method: “Normal” Revenue

Recognition at Sale

Not Sufficient Transfer of Risks

and Benefits of Ownership

Deposit Method

Recognition before Physical Transfer

Recognition at Physical Transfer

Collectibility is Reasonably

Assured

Revenue RecognizedRevenue RecognizedRevenue RecognizedRevenue Recognized

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Percentage-of-Completion MethodPercentage-of-Completion Method

It achieves the goals of accrual accounting.

It is consistent with the argument that revenue is earned continuously over the entire earning process.

It results in a more relevant measure of periodic income.

Revenue Recognition Prior to the Period of Sale

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AICPA Statement of Position No. 81-1 requires that a construction company use the percentage-of-completion method for

long-term contracts when all the following conditions are met:

AICPA Statement of Position No. 81-1 requires that a construction company use the percentage-of-completion method for

long-term contracts when all the following conditions are met:

Percentage of Completion Method

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1. The company can make reasonably dependable estimates of the extent of progress toward completion, contract revenue, and contract costs.

2. 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.

3. The buyer can be expected to satisfy its obligations under the contract.

4. The company expects to perform its contractual obligations.


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The Statement also requires that a company

use the completed-contract method only

when at least one of these conditions is not met...

The Statement also requires that a company

use the completed-contract method only

when at least one of these conditions is not met...

…for a short-term contract, and when there are inherent

hazards in the contract beyond the normal business risks for which reasonably dependable

estimates cannot be made.

…for a short-term contract, and when there are inherent

hazards in the contract beyond the normal business risks for which reasonably dependable

estimates cannot be made.


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2007 2008 2009

Construction costs incurred during the year $100,000 $186,000

$314,000Estimated costs to complete the

contract 400,000 264,000 ---

Partial billing to customer 80,000 350,000270,000

Collections from customer 50,000 330,000320,000

Total contract price: $700,000

Example Page 897


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1. To record construction costs:Construction in Progress 100,000

Accounts Payable, etc. 100,0002. To record partial billings:

Accounts Receivable 80,000Partial Billings (contra inventory) 80,000

2007

3. To record collections:

Cash 50,000Accounts Receivable 50,000

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4. To record gross profit:Construction Expense 100,000Construction in Progress (inventory)40,000

Construction Revenue 140,000

2007

($100,000 ÷ $500,000) x $700,000($100,000 ÷ $500,000) x $700,000($100,000 ÷ $500,000) x $700,000($100,000 ÷ $500,000) x $700,000


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Accounts Receivable 350,000Partial Billings 350,000

2008




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4. To record gross profit:Construction Expense 186,000Construction in Progress 38,000


2008

[($286,000 ÷ $550,000) x $700,000] - $140,000[($286,000 ÷ $550,000) x $700,000] - $140,000

Construction costs incurred to date

Revised cost =$286,000 + $264,000

Previous year’s construction revenue


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Accounts Receivable 270,000Partial Billings 270,000

2009




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4. To record gross profit and close out accounts:Construction Expense 314,000Construction in Progress 22,000


2009

$700,000 $700,000 –– $140,000 $140,000 –– $224,000 $224,000

Recognized in 2007Recognized in 2008Partial Billings 700,000

Construction in Progress 700,000


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Entries 1, 2, and 3 are the same as those used for the percentage-of-completion

method. The completed-contract method does not recognize revenue until the project is completed, so there is no

Entry 4 until 2009.

Entries 1, 2, and 3 are the same as those used for the percentage-of-completion

method. The completed-contract method does not recognize revenue until the project is completed, so there is no

Entry 4 until 2009.

Completed Contract Method

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4. To record gross profit and close out accounts:Partial Billings 700,000


2009

Construction Expense 600,000Construction in Progress 600,000

$100,000 + $186,000 + $314,000$100,000 + $186,000 + $314,000

Completed Contract Method

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If interest cost is associated with the funds used in the

construction, the firm should include this cost in the

Construction in Progress account.

If interest cost is associated with the funds used in the

construction, the firm should include this cost in the

Construction in Progress account.

Capitalized Interest

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Used to recognize service revenue earned by performing more than one act if services are to be rendered in more than one accounting period.

Types of service transactionsSimilar performance acts-recognize an equal

amount of revenue for each actDissimilar performance acts-recognize revenue in

proportion to direct costs to perform each act.Similar acts with a fixed period for performance-

recognize revenue using straight-line method

Proportional Performance Contracts

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Revenue allocate using percentage of direct costs

Initial direct costs allocate using percentage of direct costs

Direct costs expense as incurredIndirect costs expense as incurred


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35


% of direct costs

as incurred

% of direct costs

36

Installment sales involve a financing

agreement whereby the customer signs a

contract,...

Installment sales involve a financing

agreement whereby the customer signs a

contract,...

...makes a small down

payment,...

...makes a small down

payment,...

Installment Method

37

…and agrees to make periodic payments over

an extended period, often several years.

…and agrees to make periodic payments over

an extended period, often several years.

Installment Method

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Two methods employed to defer revenue recognition until cash is received are the installment sales method and the cost recovery method. These methods are used only when the point-of-sale or other GAAP revenue recognition methods are not appropriate.

These methods may be used only when there is uncertainty about whether the sales price will be collected and when an allowance for bad debts cannot be reasonably estimated.

Revenue Recognized at Collection

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1. Total sales, cost of goods sold, and collections are recorded in the normal manner during the year.

2. At the end of the year, installment sales are identified. The revenue and the related cost of goods sold are “reversed,” and the deferred gross profit is recognized.

3. At the end of the year, the gross profit rate on installment sales is computed.

ContinuedContinuedContinuedContinued

Installment Method

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4. A portion of the deferred gross profit is recognized as gross profit.

5. In future years the remaining deferred gross profit is reduced and the gross profit is recognized based on the cash collected on the installment sales.

Installment Method

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Consider the following information for Lee for 2007:Consider the following information for Lee for 2007:

Total credit sales $500,000Total cost of goods sold 390,000Installment method sales 100,000Installment method cost of goods sold 75,000Gross profit rate on installment method sales 25%Cash receipts on installment method sales 20,000Cash receipts on other credit sales 300,000

Lee Company uses a perpetual inventory method.Lee Company uses a perpetual inventory method.

Installment Method

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Accounts Receivable 500,000Sales 500,000

Cost of Goods Sold 390,000Inventory 390,000

Credit sales during the year 2007:


Collected $300,000; $20,000 related to installment sales:


Installment Method

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Sales (closed) 100,000Cost of Goods Sold (closed) 75,000Deferred Gross Profit, 2007 25,000

Installment sales and related cost of goods sold identified and “reversed” on December 31, 2007:

Deferred Gross Profit, 2007 5,000Gross Profit Realized on Installment Method Sales 5,000

Recognized a gross profit of 25% of cash collected on installment sales December 31, 2007 :

Installment Method

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Partial Financial Statements

45

Consider the following information for Lee for 2008:Consider the following information for Lee for 2008:

Total credit sales $600,000Total cost of goods sold 430,000Installment method sales 150,000Installment method cost of goods sold 105,000Gross profit rate on installment method sales 30%Cash receipts on installment method sales: 2007 sales 30,000 2008 sales 40,000Cash receipts on other credit sales 480,000

Installment Method

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Accounts Receivable 600,000Sales 600,000

Cost of Goods Sold 430,000Inventory 430,000

Credit sales 2008:


Collected $550,000; $70,000 related to installment sales:


Installment Method

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Sales 150,000Cost of Goods Sold 105,000Deferred Gross Profit, 2008 45,000

Installment sales and related cost of goods sold identified and “reversed” on December 31, 2008:


Installment Method

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Deferred Gross Profit, 2007 7,500Deferred Gross Profit, 2008 12,000

Gross Profit Realized on Installment Method Sales 19,500

On December 31, 2008, recognized a gross profit of 25% of cash collected on installment sales for 2007 and 30% for 2008:

Installment Method

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APB Opinion No. 10 found the cost recovery method of recognizing revenue generally to be unacceptable. However,

the Board did agree that this method could be used in exceptional cases where

receivables are collected over an extended period and where the terms of the transaction provide no reasonable

basis for estimating the degree of collectibility.

APB Opinion No. 10 found the cost recovery method of recognizing revenue generally to be unacceptable. However,

the Board did agree that this method could be used in exceptional cases where

receivables are collected over an extended period and where the terms of the transaction provide no reasonable

basis for estimating the degree of collectibility.


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Consider the following information for the Parken Company:

Sale of property under cost recovery method $20,000Cost of property sold (net) 12,000Cash collections: 2007 5,000 2008 9,000 2009 6,000

Consider the following information for the Parken Company:

Sale of property under cost recovery method $20,000Cost of property sold (net) 12,000Cash collections: 2007 5,000 2008 9,000 2009 6,000


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Accounts Receivable 20,000Deferred Gross Profit 8,000Property (net) 12,000

During 2007


Collected $5,000



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During 2008

Deferred Gross Profit 2,000Gross Profit Realized on Cost Recovery Transactions 2,000

December 31, 2008


($5,000 + $9,000) minus ($5,000 + $9,000) minus property cost of $12,000property cost of $12,000


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During 2009

Deferred Gross Profit 6,000Gross Profit Realized on Cost Recovery Transactions 6,000

December 31, 2009

The cash collected in 2009 results in the recognition of an equal amount of gross

profit.

The cash collected in 2009 results in the recognition of an equal amount of gross

profit.


54

Oscar Company sells a subsidiary to the Pet Company and accepts a

$500,000 down payment and a 10% note for the balance of the sale of $7

million. The net assets of the subsidiary are $5 million and Pet

Company has the right to cancel the agreement for the next year.

Oscar Company sells a subsidiary to the Pet Company and accepts a

$500,000 down payment and a 10% note for the balance of the sale of $7

million. The net assets of the subsidiary are $5 million and Pet

Company has the right to cancel the agreement for the next year.

Revenue Recognition Delayed a Future Event Occurs

(Deposit Method)

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Cash 500,000 Deposit from Purchaser 500,000

Upon receipt of down payment (Oscar Company):

Interest Receivable 650,000Note Receivable 6,500,000Deposit from Purchaser 500,000

Interest Revenue650,000Gain2,000,000Net Assets of Subsidiary5,000,000

When circumstances allow the revenue to be recognized:

liabilityliability

10% x $6,500,00010% x $6,500,000

Revenue Recognition Delayed a Future Event Occurs

(Deposit Method)

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If a company has an agreement to deliver software that requires significant production, modification, or customization of software, it uses contract accounting for the agreement.

Guidelines of AICPA Statement of Position No. 97-2


Software Revenue Recognition

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If a company has an agreement to deliver software that does not require significant production, modification, or customization of software, it recognizes revenue when (a) persuasive evidence of an agreement exists, (b) delivery has occurred, (c) the seller’s fee is fixed or determinable, and (d) collectibility is probable.




58

A company separately accounts for a service element if (a) the services are not essential to the functionality of any other element of the transaction, and (b) the services are stated separately in the contract such that the total price of the agreement would be expected to vary as the result of inclusion or exclusion of the service.




59

Software arrangements may consist of multiple elements such as additional software products, upgrades and/or enhancements, rights to exchange or return software, and customer support. If contract accounting does not apply, a company must allocate its fee to the various elements based on fair values.




60

A company must allocate any discounts proportionately to all the elements, except that none can be allocated to upgrade rights.




61

A franchise agreement involves the granting of business rights

by the franchisor to a franchisee who will operate the

franchised business.

A franchise agreement involves the granting of business rights

by the franchisor to a franchisee who will operate the

franchised business.

Franchise

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A franchise agreement involves the granting of business rights by

the franchisor to a franchisee who will operate the franchised

business.

A franchise agreement involves the granting of business rights by

the franchisor to a franchisee who will operate the franchised

business.

Franchise

63

Castle Company sells a franchise that requires an initial franchise fee of

$70,000. A down payment of $20,000 cash is required, with the balance

covered by the issuance of a $50,000, 10% note, payable by the franchisee in

five equal annual installments.

Castle Company sells a franchise that requires an initial franchise fee of

$70,000. A down payment of $20,000 cash is required, with the balance

covered by the issuance of a $50,000, 10% note, payable by the franchisee in

five equal annual installments.

Franchise

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Situation 1: Castle has substantially performed all material services, the refund period has expired, and the collectibility of the note is reasonably assured.

Situation 1: Castle has substantially performed all material services, the refund period has expired, and the collectibility of the note is reasonably assured.

Cash 20,000Notes Receivable 50,000

Franchise Revenue 70,000

Franchise

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Situation 2: The refund period has expired and the collectibility of the note is reasonably assured, but Castle has not substantially performed all material services.

Situation 2: The refund period has expired and the collectibility of the note is reasonably assured, but Castle has not substantially performed all material services.


Unearned Franchise Fees 70,000

Castle will recognize the unearned franchise fees as revenue when it has performed all material

services.

Castle will recognize the unearned franchise fees as revenue when it has performed all material

services.

Franchise

66

Situation 3: Castle has substantially performed all material services and the collectibility of the note is reasonably assured, but the refund period has not expired.

Situation 3: Castle has substantially performed all material services and the collectibility of the note is reasonably assured, but the refund period has not expired.


Unearned Franchise Fees 70,000

Castle will recognize the unearned franchise fees as revenue when the refund period expires.

Castle will recognize the unearned franchise fees as revenue when the refund period expires.

Franchise

67

Each year revenue of $10,000 is recognized as cash is collected.Each year revenue of $10,000 is recognized as cash is collected.

Situation 4: Castle has substantially performed all material services and the refund period has expired, but the collectibility of the note is not reasonably assured.

Situation 4: Castle has substantially performed all material services and the refund period has expired, but the collectibility of the note is not reasonably assured.


Unearned Franchise Fees 50,000Franchise Revenue 20,000

Franchise

68

Situation 5: The refund period has expired, but Castle has not substantially performed all material services and there is no basis for estimating the collectibility of the note.

Situation 5: The refund period has expired, but Castle has not substantially performed all material services and there is no basis for estimating the collectibility of the note.

Cash 20,000Unearned Franchise Fees 20,000

Castle recognizes revenue either under the accrual method (if collectibility is reasonably assured) or

the installment method (if it has no basis for estimating the collectibility of the note).

Castle recognizes revenue either under the accrual method (if collectibility is reasonably assured) or

the installment method (if it has no basis for estimating the collectibility of the note).

Franchise

69

Situation 6: Castle has earned only $30,000 from providing initial services, with the balance being a down payment for continuing services. The refund period has expired and collectibility of the note is reasonably assured.

Situation 6: Castle has earned only $30,000 from providing initial services, with the balance being a down payment for continuing services. The refund period has expired and collectibility of the note is reasonably assured.


Franchise Revenue 30,000Unearned Franchise Fees 40,000

Castle recognizes the unearned franchise fees as revenue when it performs the continuing services.Castle recognizes the unearned franchise fees as

revenue when it performs the continuing services.

Franchise

70

Continuing Franchise Fee

Assume that Castle also charges a continuing franchise fee of $9,000 per year.

Fee is earned by providing servicesCash 9,000

Continuing Franchise Fee Revenue 9,000

$1,000 of the fee is for National AdvertisingCash 9,000

Continuing Franchise Fee Revenue 8,000Unearned Franchise Fees 1,000

71

1. The buyer has made the down payment and each required subsequent payment until the period of cancellation with refund has expired.

2. The cumulative payments of principal and interest equal or exceed 10% of the contract sales price.

For retail land sales, the selling company recognizes revenue and the related expenses in the period of the sale on the accrual basis if all of the following conditions are met:


Real Estate Sales

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3. Collection experience for the project indicates that at least 90% of contracts will be collected in full. (a down payment of 20% is an acceptable indication of collectibility).

4. The receivable from the sale is not subject to subordination to new loans on the property.

Real Estate Sales

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Real Estate Sales

5. The seller is not obligated to complete improvements of lots sold or to construct amenities or other facilities applicable to lots sold.

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1. Since title remains with the consignor, when the goods are transferred from the consignor to the consignee, the consignor does not record the sale of inventory.

2. The consignor recognizes revenue only when the sale to the third party occurs.

3. The consignee uses a Consignment-in account.

4. The consignor uses a Consignment-out account, which is a special inventory account.

Accounting for consignments may be summarized--

Consignment Sales

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Chapter18

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