William F. Bentz1

A&MIS 521

Fin. Accounting I - Session 16

William F. Bentz

Accounting & MIS

William F. Bentz2

A&MIS 521

Revenue Allocation

In selected circumstances, revenue is recognized over 2 or more accounting periods. In many such cases, revenue is allocated in a manner that results in either a uniform gross margin, or in a uniform rate of return. We will use both methods.

William F. Bentz3

A&MIS 521

Revenue Allocation

Uniform gross margin method % is used for – construction contracts

– warranty contracts

– software development contracts

– installment sales (limited use)

William F. Bentz4

A&MIS 521

Revenue Allocation

Uniform rate-of-return method are used for – interest income (A&MIS 522,

investments)

– interest method of depreciation (chapter 5)

William F. Bentz5

A&MIS 521

Uniform Gross Margin %

For the gross margin percentage to be truly uniform, revenues and costs must be equal to the amounts forecast.

However, if one is able to forecast the revenues and the associated costs with acceptable accuracy, the intermediate reported results will be informative. The threshold for reasonable accuracy is a matter of professional judgement.

William F. Bentz6

A&MIS 521

Uniform Gross Margin %

This method is implemented by multiplying the total amount of revenue to be allocated by the proportion of the costs incurred to date to the total estimated costs. Consider the warranty problem Bentley’s.

William F. Bentz7

A&MIS 521

Bentley’s

Price of a warranty contract - $2,000 (constant)

Projected warranty costs per contract - $1,200

Projected gross margin - $800 [$2,000 - $1,200]

Term of contract - five years

William F. Bentz8

A&MIS 521

Bentley’s

Forecast of annual costs per contract: Year 1 - $ 100

Year 2 - 150

Year 3 - 250

Year 4 - 300

Year 5 - 400

Total $1,200

William F. Bentz9

A&MIS 521

Proportion of cost incurred:

Cumulative proportion to date:Y1: $100/$1,200 = 0.0833

Y2: [$100 + $150]/$1,200 = 0.2083

Y3: [$100 + 150 + 250]/$1,200 = 0.4167

Y4: [$100 + 150 +250

+ 300]/$1,200 = 0.6667

Y5: $1,200/$1,200 = 1.0

William F. Bentz10

A&MIS 521

Cumulative revenue earned

Cumulative revenue by year:

Y1: 0.0833 × $2,000 = $ 166.67

Y2: 0.2083 × $2,000 = $ 416.67

Y3: 0.4167 × $2,000 = $ 833.33

Y4: 0.6667 × $2,000 = $1,333.33

Y5: 1.0000 × $2,000 = $2,000.00

William F. Bentz11

A&MIS 521

Cumulative revenue earned

Cumulative proportion of revenue earned (CPRE) = cumulative proportion of the cost incurred to the total (forecast) cost

CPRE(0 d) = Total cost incurred to date (0 d)/Total cost forecasted (0 n)for a contract beginning at t = 0 and ending

at t = n

William F. Bentz12

A&MIS 521

0 d n

Total = 1.0

CPRE

William F. Bentz13

A&MIS 521

Annual Revenue

Y1: $ 166.67 - 0 = $ 166.67

Y2: $ 416.67 - 166.67 = 250.00

Y3: $ 833.33 - 416.67 = 416.66

Y4: $1,333.33 - 833.33 = 500.00

Y5: $2,000.00 - 1,333.33 = 667.67

Total $2,000.00

William F. Bentz14

A&MIS 521

Go to Workbook Pages

William F. Bentz15

A&MIS 521

Revenue Recognition - Long-term Contracts

Objective: To recognize revenue period-by-period as the revenue from a long-term contract is earned. The key criteria for revenue recognition are still:– Earning of the revenue– Realization/estimation of doubtful accounts– Reasonably estimable costs

William F. Bentz16

A&MIS 521

Consider the Issue of Collection

Realization is deemed to have occurred if the seller has received a valid claim to a determinable amount of money subject to reasonable payment terms by a buyer that is capable of paying the amount due.

William F. Bentz17

A&MIS 521

Revenue Recognition Methods

Revenue is recognized on long-term projects on one of two bases:– Completed contract method– Percentage-of-completion method

Annual revenues, expenses, income, and asset values are affected by the choice of method.

William F. Bentz18

A&MIS 521

Revenue Recognition Methods

With the completed contract method, project costs are accumulated in a Construction-in-Process account. The cumulative cost is matched against revenues when the contract is completed. The amount of revenue recognized is the final contract price.

William F. Bentz19

A&MIS 521

Revenue Recognition Methods

With the percentage-of-completion method, a portion of the total contract price is recognized each period. That portion is the percentage of the work completed to date, less the revenue already recognized.

William F. Bentz20

A&MIS 521

Percentage-of-completion

To use the percentage-of-completion method, one must have some way of determining the percentage of completion for each project! The percentage of the costs incurred relative to total expected project cost is the measure used.

William F. Bentz21

A&MIS 521

Calculating the Percent

Cumulative cost

Cumulative incurred to date

% complete =

Total Expected

project cost

William F. Bentz22

A&MIS 521

Example Co.

Contract Cumulative Cumulative Annual

Date Price Cost Revenue Revenue

12/00 $70,000 $20,000 $23,333 $23,333

12/01 70,000 40,000 46,666 23,333

12/02 70,000 60,000 70,000 23,334

Total $70,000

William F. Bentz23

A&MIS 521

Example Co. (B)

Cumulative Estimated Cumulative AnnualDate Cost Tot. Cost Revenue* Revenue12/00 $15,000 $60,000 $17,500 $17,50012/01 35,000 60,000 40,833 23,33312/02 59,000 59,000 70,000 29,167Total $70,000*Contract price is $70,000‘98: (15,000/60,000) x $70,000 = 17,500‘99: (35,000/60,000) x $70,000 - $17,500 = $23,333‘00: $70,000 - $17,500 - $23,333 = $29,167

William F. Bentz24

A&MIS 521

Example Co. (B)

Annual Annual Gross Margin

Date Revenue Cons. Cost Margin %

12/98 $17,500 $15,000 $ 2,500 14.3%

12/99 23,333 20,000 3,333 14.3%

12/00 29,167 24,000 5,167 17.7%

Total $70,000 $59,000 $11,000

*Contract price is $70,000

William F. Bentz25

A&MIS 521

Revenue Recognition

For our purposes, the percentage completion method of recognizing revenue is applied the same way regardless of the profitability of the contract, or the timing of the contract billings and cash collections. The method is effort (cost) driven.