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Revenue Revenue RecognitionRecognition
An electronic presentationAn electronic presentation by Douglas Cloudby Douglas Cloud
Pepperdine UniversityPepperdine University
An electronic presentationAn electronic presentation by Douglas Cloudby Douglas Cloud
Pepperdine UniversityPepperdine University
chapterchapter 8
2
1. 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 completed-contract methods.
Learning Objectives
ContinuedContinuedContinuedContinued
3
4. 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.
Learning Objectives
4
Revenue Recognition
1. They are realized or realizable.2. They have been earned through
substantial completion of the activities involved in the earnings process.
FASB’s two criteria for recognizing revenues and gains:
5
Both of these criteria generally are met at
the point of sale.
Both of these criteria generally are met at
the point of sale.
Revenue recognition most often occurs when goods
are delivered or when services are rendered.
Revenue recognition most often occurs when goods
are delivered or when services are rendered.
Revenue Recognition
6
Revenue Recognition
Criterion Associated With Criterion Associated With Revenue RecognitionRevenue Recognition
Criterion Associated With Criterion Associated With Revenue RecognitionRevenue Recognition
Criterion 1: The customer has provided payment or a valid promise of payment.
Criterion 2: The company has provided a product or service.
7
Revenue Recognition
Before the point of SaleEXCEPTION:Revenue can be recognized prior to the point of sale if:
Customer provides a valid promise of payment AND
Criterion 1
Criterion 2 conditions exist that contractually guarantee subsequent sale.
8
Revenue Recognition
Point of SaleNORMALLY:Revenue is generally recognized at this point of time.Criterion 1 is typically satisfied at this point.
Criterion 1
Criterion 2 Critical 2 is typically satisfied at this point.
9
Revenue Recognition
After the Point of SaleEXCEPTION:The recognition of revenue must be deferred if:
Customer does not provide a valid promise of time of receipt of product or service OR
Criterion 1
Criterion 2 significant effort remains on the contract.
10
• A product or service was provided without receiving a valid promise of payment from customer.
• The company has not provided the product or service.
Revenue Recognition
Generally, revenue is not recognized prior to the point of sale because either:
An exception occurs when the customer provides An exception occurs when the customer provides a valid promise of payment and conditions exist a valid promise of payment and conditions exist
that contractually guarantee the sale.that contractually guarantee the sale.
An exception occurs when the customer provides An exception occurs when the customer provides a valid promise of payment and conditions exist a valid promise of payment and conditions exist
that contractually guarantee the sale.that contractually guarantee the sale.
11
Revenue Recognition
AICPA 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 vendor’s fee is fixed or determinable.
d. Collectibility is probable.
12Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement
The SEC issued SEC 101 in response to
specific abuses involving revenue recognition.
The SEC issued SEC 101 in response to
specific abuses involving revenue recognition.
13
SAB 101 is in a question-and-answer format. The
answers given are invariably “No.”
SAB 101 is in a question-and-answer format. The
answers given are invariably “No.”
Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement
14Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement
Typical questions from SAB 101Typical questions from SAB 101
Question 1:Question 1: Company A requires each sale to be supported by a written sales agreement signed by an authorized representative of both Company A and the customer.
Addresses internal controls.Addresses internal controls.
Question 1:Question 1: May Company A recognize revenue in the current quarter if the product is delivered by the end of the quarter but the sales agreement is not signed by the customer until a few days after the end of the quarter?
ENTERENTER
15Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement
Typical questions from SAB 101Typical questions from SAB 101
Question 2: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.
Addresses the issue of circumventing internal controls by side agreements.
16Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement
Typical questions from SAB 101Typical questions from SAB 101
Question 4:Question 4: Company R is a retailer that offers “layaway” sales to customers. A customer pays a portion of the sales price, and Company R sets the…
Focuses on issues centered on the “bill-and-hold” arrangements.
Focuses on issues centered on the “bill-and-hold” arrangements.
Question 4:Question 4: …aside until the customer pays the remainder of the sales price, and takes possession of the merchandise. When should Company R recognize revenue?ENTERENTER
17Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement
Receipt of $100 cash as initial layaway payment:
Cash 100Deposit Received from Customers 100
Receipt of final $1,400 cash payment and delivery of goods to customer:Cash 1,400Deposit Received from Customers 100
Sales 1,500Cost of Goods Sold 1,000
Inventory 1,000
Appropriate Layaway Accounting
18Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement
Seller 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 months—which is the economic life of this service
agreement.
Seller 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 months—which is the economic life of this service
agreement.
19Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement
Receipt of $1,000 cash as initial sign-up fee:
Cash 1,000Unearned 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
20Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement
Typical questions from SAB 101Typical questions from SAB 101
Addresses the difference between estimating the future impact of past events and
estimating the future impact of future events.
Addresses the difference between estimating the future impact of past events and
estimating the future impact of future events.
Question 8:Question 8: Company A owns a building and leases it to a retailer. The annual lease payment is $1.2 million plus 1% of all the retailer’s sales in excess of $25 million.
Question 8:Question 8: Should Company A estimate and recognize revenue associated with the 1% of sales over $25 million on a straight-line basis throughout the year? ENTERENTER
21Revenue 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.
22
GAAP requires percentage-of-completion method unless certain criteria are not met.
GAAP requires percentage-of-completion method unless certain criteria are not met.
Revenue Recognition Prior to Providing Goods or Services
23Percentage-of-Completion 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 settlement
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 settlement
ContinuedContinuedContinuedContinued
24Percentage-of-Completion Accounting
The buyer can be expected to satisfy obligations under the contract.
Contractor can be expected to perform the contractual obligation.
The buyer can be expected to satisfy obligations under the contract.
Contractor can be expected to perform the contractual obligation.
25
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-of-Completion Accounting
26
Input 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.
Input 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.
Engineers are often called in to help provide estimates.
Percentage-of-Completion Accounting
27Accounting for Long-Term Construction-Type Contracts
Strong Construction Company was awarded a contract with a total price of $3,000,000. Strong expected to earn
$400,000 profit on the contract.
28Accounting for Long-Term Construction-Type Contracts
Actual Cost
Incurred
Estimated Cost to
CompleteYearCost
PercentageTotal Cost
2004 $1,040,000 $1,560,000 $2,600,000 40
2005 910,000
Total $1,950,000 650,000 2,600,000 75
2006 650,000 0 2,600,000 100
Total $2,600,000
29
Construction in Progress 1,040,000Materials, Cash, etc. 1,040,000
To record costs incurred.
Accounts Receivable 1,000,000Progress Billings on Construction Contracts 1,000,000
To record billings.
Cash 800,000Accounts Receivable 800,000
To record cash collections.
2004200420042004
Percentage-of-Completion Accounting
$1,040,000$1,040,000
$2,600,000$2,600,000= 40%= 40%
30
Cost of Long-Term Construction Contracts 1,040,000Construction in Progress 160,000
Construction Contracts 1,200,000
2004200420042004
Percentage-of-Completion Accounting
Actual CostActual Cost
$3,000,000 x .40
31
Construction in Progress 910,000Materials, Cash, etc. 910,000
To record costs incurred.
Accounts Receivable 900,000Progress Billings on Construction Contracts 900,000
To record billings.
Cash 850,000Accounts Receivable 850,000
To record cash collections.
2005200520052005
Percentage-of-Completion Accounting
32
Cost of Long-Term Construction Contracts 910,000Construction in Progress 140,000
Revenue from Long-Term Construction Contracts 1,050,000
2005200520052005
Percentage-of-Completion Accounting
($3,000,000 x .75) –
$1,200,000
33
Construction in Progress 650,000Materials, Cash, etc. 650,000
To record costs incurred.
Accounts Receivable 1,100,000Progress Billings on Construction Contracts 1,100,000
To record billings.
Cash 1,350,000Accounts Receivable 1,350,000
To record cash collections.
2006200620062006
Percentage-of-Completion Accounting
34
Cost of Long-Term Construction Contracts 650,000Construction in Progress 100,000
Revenue from Long-Term Construction Contracts 750,000
2006200620062006
$ 3,000,000
(1,200,000)
(1,050,000)
$ 750,000
Percentage-of-Completion Accounting
35
Progress Billings on Construction Contracts 3,000,000
Construction in Progress 3,000,000
2006200620062006
Percentage-of-Completion Accounting
Construction in Progress
1,040,000160,000910,000140,000650,000
100,0003,000,000
Progress Billings on Construction Contracts
1,000,000900,000
1,100,0003,000,000
36
Revision of Estimates
Instead 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.
37
Items in blue changed from the previous illustration.
Revision of Estimates
Actual Cost
Incurred
Estimated Cost to
CompleteYearCost
PercentageTotal Cost
2004 $1,040,000 $1,560,000 $2,600,000 40
2005 910,000
Total $1,950,000 720,000 2,670,000 73
2006 700,000 0 2,650,000 100
Total $2,650,000
Note that expected gross profit was $400,000 in 2004, Note that expected gross profit was $400,000 in 2004, $330,000 in 2005, and the actual was $350,000 in 2006.$330,000 in 2005, and the actual was $350,000 in 2006.
Note that expected gross profit was $400,000 in 2004, Note that expected gross profit was $400,000 in 2004, $330,000 in 2005, and the actual was $350,000 in 2006.$330,000 in 2005, and the actual was $350,000 in 2006.
38
Revision of Estimates
20042004
The entries for 2004 would be the same as those shown
in the previous example.
The entries for 2004 would be the same as those shown
in the previous example.
39
Revision of Estimates
20052005
All entries for 2005 would be the same
except for the entry to record revenue and cost.
All entries for 2005 would be the same
except for the entry to record revenue and cost.
40
Revision of Estimates
Cost of Long-Term Construction Contracts 910,000Construction in Progress 80,000
Revenue from Long-term Construction Contracts 990,000
2005200520052005
($3,000,000 x .73) –
$1,200,000
41
Revision of Estimates
Construction in Progress 700,000Materials, Cash, etc. 700,000
To record costs incurred.
Accounts Receivable 1,100,000Progress Billings on Construction Contracts 1,100,000
To record billings.
Cash 1,350,000Accounts Receivable 1,350,000
To record cash collections.
2006200620062006
SameSame
SameSame
42
Revision of Estimates
Cost of Long-Term Construction Contracts 700,000Construction in Progress 110,000
Revenue from Long-Term Construction Contracts 810,000
2006200620062006
$3,000,000
(1,200,000)
(990,000)
$ 810,000
43
2006200620062006
Construction in Progress
1,040,000160,000910,000
80,000700,000
110,0003,000,000
Progress Billings on Construction Contracts
1,000,000900,000
1,100,0003,000,000
Revision of Estimates
Items in red are different for this illustration.
Progress Billings on Construction Contracts 3,000,000
Construction in Progress 3,000,000
44Anticipated Loss: Percentage-of-Completion Method
Assume 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
2005—in addition, the $160,000 gross profit recognized in 2004 must be eliminated.
Assume 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
2005—in addition, the $160,000 gross profit recognized in 2004 must be eliminated.
45Anticipated Loss: Percentage-of-Completion Method
Cost of Long-Term Construction Contracts 910,000
Revenue from Long-Term Construction Contracts 600,000Construction in Progress 410,000
2005200520052005
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.
46Accounting for Long-Term Accounting for Long-Term Service ContractsService Contracts
Most 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.
47Accounting for Long-Term Accounting for Long-Term Service ContractsService Contracts
Proportional 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).
Proportional 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).
48Accounting for Long-Term Accounting for Long-Term Service ContractsService Contracts
Receipt of fees:Cash 50,000
Deferred Course Revenue 50,000
Liability accountLiability accountLiability accountLiability accountInitial direct costs:Deferred Initial Costs 5,000
Cash 5,000
Direct costs for lesson actually completed:Contract Costs 12,000
Cash 12,000Expense accountExpense accountExpense accountExpense account
Asset accountAsset accountAsset accountAsset account
ContinuedContinuedContinuedContinued
49Accounting for Long-Term Accounting for Long-Term Service ContractsService Contracts
Course revenue recognized:Deferred Course Revenue 20,000
Recognized Course Revenue 20,000
Recognize contract costs from initial direct costs:Contract Costs 2,000
Deferred Initial costs 2,000
$24,000$24,000$60,000$60,000
x $50,000x $50,000
$24,000$24,000$60,000$60,000
x $5,000x $5,000
50Revenue Recognition After Delivery 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.
51
Full Accrual At point of sale Revenue at point of sale
Installment Sales
At collection of cash (portion of receipt)
Defer and matchagainst revenue ascash is collected
Cost Recovery
At collection of cash(after all costs havebeen recovered)
Defer and matchagainst cashreceipts
Cash At collection of cash Charge to expenseas incurred
MethodTiming of Revenue
RecognitionTreatmentof Costs
Revenue Recognition After Delivery of Goods or Providing Service
52
Installment Sales Method
The installment sales method is used most
commonly in cases of real estate sales.
The installment sales method is used most
commonly in cases of real estate sales.
53
Installment Sales Method
George sells merchandise on the installment basis.
Uncertainty of collection makes use of the installment method necessary. Use the
accompanying data to prepare George’s journal entries.
George sells merchandise on the installment basis.
Uncertainty of collection makes use of the installment method necessary. Use the
accompanying data to prepare George’s journal entries.
54
SalesCost of SalesGross ProfitGross Profit Percentage
2004 2005
$150,000 $200,000 100,000 140,000
$ 50,000 $ 60,000
33.33% 30%
Cash Collection 2004 Sales $ 30,000 $ 75,000 2005 Sales $ 70,000
Installment Sales Method
55
Installment Accounts Receivable— 2004 150,000
Installment Sales 150,000
Cost of Installment Sales 100,000Inventory 100,000
Cash 30,000Installment Accounts Receivable—2004 30,000
Installment Sales Method
2004
ContinuedContinuedContinuedContinued
56
Installment Sales 150,000Cost of Installment Sales 100,000Deferred Gross Profit—2004 50,000
Deferred Gross Profit—2004 10,000Realized Gross Profit on Installment Sales 10,000
Installment Sales Method
2004
$30,000 x 33.33%$30,000 x 33.33%$30,000 x 33.33%$30,000 x 33.33%
ContinuedContinuedContinuedContinued
57
Installment Sales Method
Installment Accounts Receivable— 2005 200,000
Installment Sales 200,000
Cost of Installment Sales 140,000Inventory 140,000
Cash 145,000Installment A/R—2004 75,000Installment A/R—2005 70,000
2005
ContinuedContinuedContinuedContinued
58
Installment Sales Method
Installment Sales 200,000Cost of Installment Sales 140,000Deferred Gross Profit—2005 60,000
Deferred Gross Profit—2004 25,000Deferred Gross Profit—2005 21,000
Realized Gross Profit on Installment Sales 46,000
2005
$75,000 x 33.33%$75,000 x 33.33%$75,000 x 33.33%$75,000 x 33.33%
$70,000 x 30%$70,000 x 30%$70,000 x 30%$70,000 x 30%
59
Cost Recovery Method
Assume George has to use the cost recovery method, but all sales
and collections remain the same.
Assume George has to use the cost recovery method, but all sales
and collections remain the same.
CostCostRecovered Recovered
CostCost
RevenueRevenue
60
2005
All entries are the same except do not book the entry to gross profit.Deferred Gross Profit—2004 5,000
Realized Gross Profit on Installment Sales 5,000
Cost Recovery Method
61
2006Deferred Gross Profit—2004 30,000Deferred Gross Profit—2005 10,000
Realized Gross Profit on Installment Sales 40,000
Cost Recovery Method
62
If 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.
If 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.
Cash Method
63
The EndThe End
chapter 8
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