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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
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