Presentation on theme: "CH 05: Part A: Revenue Recognition Self-Study: 1. Discuss the general objective of the timing of and the two criteria for revenue recognition. SECs SAB."— Presentation transcript:
CH 05: Part A: Revenue Recognition Self-Study: 1. Discuss the general objective of the timing of and the two criteria for revenue recognition. SECs SAB Discuss the implications for revenue recognition of allowing customers the right of return In Class: 2. Describe the installment sales and cost recovery methods of recognizing revenue 4. Identify situations that call for the recognition of revenue over time and distinguish between the percentage-of-completion and completed contract methods of recognizing revenue for long-term contracts.
Learning Objectives 5. Discuss the revenue recognition issues involving multiple-deliverable contracts, software, and franchise sales. 6. Identify and calculate the common ratios used to assess profitability. Addendum: Discuss the primary differences between U.S. GAAP and IFRS with respect to revenue recognition.
Current Environment Guidelines for revenue recognition Departures from sale basis SAB Q&A Revenue Recognition at the Point of Sale Revenue Recognition before Delivery Revenue Recognition after Delivery Sales with buyback agreements Sales when right of return exists Trade loading and channel stuffing Consignment Sales Installment- sales method Cost-recovery method Deposit method Summary of bases Concluding remarks GAAP vs. IFRS Percentage-of- completion method Completed- contract method Long-term contract losses Disclosures Completion-of- production basis Revenue Recognition
CH 5: Revenue Recognition The focus of this chapter is revenue recognition Overview The timing of revenue recognition is critical to income measurement. Revenue affects income, and, under the matching principle, expenses are recognized in the period in which the related revenues are recognized. Therefore, revenue recognition determines the recognition of some expenses as well.
Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivery or producing goods, rendering services, or other activities that constitute the entitys ongoing major or central operations. [FASB Concepts Statement No. 6, Element of Financial Statements, paragraph 78] Separate definition for Gains Definition of Revenue: The Current Environment LO 1 Apply the revenue recognition principle.
The revenue recognition principle (FASB Concept Stmt. No. 5) provides that companies should recognize revenue Guidelines for Revenue Recognition The Current Environment (1) when it is realized or realizable and (2) when it is earned. Revenues are realized when goods and services are exchanged for cash or claims to cash (receivables). Revenues are realizable when assets received in exchange are readily convertible to known amounts of cash or claims to cash. Revenues are earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues, that is, when the earnings process is complete or virtually complete.
Revenue Recognition at Delivery When the product or service has been delivered to the customer and cash has been received or a receivable has been generated that has reasonable assurance of collectibility. Recognize Revenue
Consignment Sales Sometimes a company arranges for another company to sell its product under consignment. Because the consignor retains the risks and rewards of ownership of the product and title does not pass to the consignee, the consignor does not record a sale until the consignee sells the goods and title passes to the eventual customer.
Revenue Recognition at Point of Sale (Delivery) Implementation problems: Sales with Buyback Agreements => No Sale! Sales When Right of Return Exists => Est. Returns Trade Loading and Channel Stuffing => No Sale!
When a repurchase agreement exists at a set price and this price covers all cost of the inventory plus related holding costs, the inventory and related liability remain on the sellers books.* In other words, no sale. Sales with Buyback Agreements (FAS 49) Revenue Recognition at Point of Sale (Delivery) LO 2 Describe accounting issues for revenue recognition at point of sale. * Accounting for Product Financing Arrangements, Statement of Financial Accounting Standards No. 49 (Stamford, Conn.: FASB, 1981).
Right of Return In most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery. Estimate the returns Reduce both Sales and Cost of Goods Sold
Recognize revenue only if six conditions (FAS 48) have been met: Sales When Right of Return Exists Revenue Recognition at Point of Sale (Delivery) LO 2 Describe accounting issues for revenue recognition at point of sale. 1. The sellers price to the buyer is substantially fixed or determinable at the date of sale. 2. The buyer has paid the seller, or the buyer is obligated to pay the seller, and the obligation is not contingent on resale of the product. 3. The buyers obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product (Legal Risk).
Recognize revenue only if six conditions have been met. Sales When Right of Return Exists Revenue Recognition at Point of Sale (Delivery) 4. The buyer acquiring the product for resale has economic substance (Profit motive, Market risk e.g. price fluctuation, etc) apart from that provided by the seller. 5. The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer. 6. The seller can reasonably estimate the amount of future returns.
Trade loading is a crazy, uneconomic, insidious practice through which manufacturers (trying to show sales, profits, and market share they dont actually have) induce their wholesale customers, known as the trade, to buy more product than they can promptly resell.* Trade Loading (Booking tomorrows revenues today): Revenue Recognition at Point of Sale (Delivery) * The $600 Million Cigarette Scam, Fortune (December 4, 1989), p. 89. In other words, no sale.
In channel stuffing, the software maker offers deep discounts to its distributors to overbuy and records revenue when the software leaves its loading dock. When this process takes place, the distributors inventories become bloated and the marketing channel gets stuffed, but the software makers financial statements are improved. Found mostly in the computer software industry Channel Stuffing (Booking tomorrows revenues today): Revenue Recognition at Point of Sale (Delivery) * Lucent Slashes First Quarter Outlook…, WSJ (December 22, 2000). In other words, no sale.
Earlier recognition is appropriate if there is a high degree of certainty about the amount of revenue earned. Example: Percentage of Completion method. Delayed recognition is appropriate if the degree of uncertainty concerning the amount of revenue or costs is sufficiently high or sale does not represent substantial completion of the collection process. Example: Installment sales & Cost Recovery method Departures from the Sale Basis (Point of Delivery) The Current Environment
One study noted restatements of revenue: Result in larger drops in market capitalization than other types of restatement. Caused eight of the top ten market value losses in a recent year. The SEC has indicated that IMPROPER Revenue Recognition is the largest cause for financial Statement restatements. The Current Environment
A January 2002 Wall Street Journal Article reported that more restatements of financial statements had occurred in the past three years than in the previous 10 years combined. The Current Environment
SECs SAB 101: In December 1999, the SEC issued Staff Accounting Bulletin (SAB) 101, Revenue Recognition in Financial Statements, Which was Followed by (in October 2000) Revenue Recognition in Financial Statements: Frequently Asked Questions. SAB 101 was effective starting the fourth fiscal quarter for fiscal years beginning after December 15, The Current Environment
SECs SAB 101: SAB 101 Criteria for Revenue Recognition For revenue to be recognized under SAB 101, it must meet all of the four following criteria: -Persuasive evidence of an arrangement exists. -Delivery has occurred or services have been rendered. -The sellers price to the buyer is fixed or determinable. -Collectibility is reasonably assured. The Current Environment
SECs SAB 101: Because SAB 101 was released to curtail specific abuses, it should not be seen as a comprehensive set of guidelines on the entire area of revenue recognition. In December 2003, four years after the release of SAB 101, the SEC released SAB 104, which includes a revised version of SAB 101, adapted to include developments in revenue recognition accounting since In-Class Discussion (Next Week): Read SAB 101, Pages 1 -10, Q & A: The Current Environment
SECs SAB 101 (104) provides guidance on the following revenue recognition issues: -Timing of approval for sales agreements; -Side arrangements: Buybacks, Consignments, Extended Financing arrangements, and Right of return. - Bill and hold sales; -Layaway programs; -Nonrefundable, up-front fees; -Membership fees/services. -Cancellation or termination provisions; -Contingent rental income; The Current Environment
1. Discuss the assigned Q&A 2. Discuss Sales Type or Issue Type 3. Provide a DEMO (Numeric) Problem 4. Solve the DEMO Problem with JEs 5. Provide a REAL-WORLD Example of a Company in violation of the specific Q&A (FRAUD): SAB 101 Discussion Format
Realization Principle Revenue recognition is often tied to delivery of the product from the seller to the buyer.
Revenue Recognition After Delivery 1.Installment Sales Method 2.Cost Recovery Method 1.Installment Sales Method 2.Cost Recovery Method When we are unable to make reasonable estimates of uncollectible amounts or customer returns of products, we delay recognizing revenue from the sale until the uncertainty has been resolved.
Recognize income in the periods of CASH collection rather than in the period of sale. Selling and administrative expenses are not deferred. Installment-Sales Method This is due to the fact that the ultimate profit is more uncertain in installment sales than in ordinary sales because collection is more doubtful. Type of sale for which payment is required in periodic installments over an extended period of time.
Installment Sales Method On November 1, 2011, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, The land cost $560,000 to develop. The companys fiscal year ends on December 31. Gross Profit $240,000 ÷ $800,000 = 30%
Installment Sales Method During 2011, Belmont Corporation collected $200,000 on its installment sales. This entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account.
Recognizes no profit until cash payments by the buyer exceed the cost of the merchandise sold. APB Opinion No. 10 allows a seller to use the cost- recovery method to account for sales in which there is no reasonable basis for estimating collectibility. In addition, FASB Statements No. 45 (franchises) and No. 66 (real estate) require use of this method where a high degree of uncertainty exists related to the collection of receivables. Cost-Recovery Method Revenue Recognition after Delivery
Cost Recovery Method On November 1, 2011, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, The land cost $560,000 to develop. The companys fiscal year ends on December 31.
Cost Recovery Method
Exercises and Problems In Class: E 4 and E5 (2011) Home Work: E 1 and 2, Prob. 4
Using the percentage-of-completion method, we recognize a portion of the estimated gross profit each period based on progress to date.
Measuring the Progress toward Completion using Cost-to-Cost basis: LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Costs incurred to date Most recent estimate of total costs = Percentage of completion Percent complete x Estimated total = Gross Profit Gross profit to be recognized to date Current-period Gross profit - Gross profit recognized in prior periods =
Completed Contract and Percentage- of-Completion Methods Compared
Timing of Gross Profit Recognition Under the Percentage-of-Completion Method Using the percentage-of-completion method, we recognize a portion of the estimated gross profit each period based on progress to date. We determine the amount of gross profit recognized in each period using the following logic:
Percentage-of-Completion Method Allocation of Gross Profit
Accounting for the Cost of Construction and Accounts Receivable With both the completed contract and percentage-of- completion methods, all costs of construction are recorded in an asset account called construction in progress.
Gross Profit RecognitionGeneral Approach In both methods the same amounts of revenue, cost, and gross profit are recognized. In both methods we add gross profit to the construction in progress asset.
Gross Profit RecognitionGeneral Approach The same journal entry is recorded to close out the billings on construction contract and construction in progress accounts under the completed contract and percentage-of- completion methods.
Percentage-of-Completion Method Allocation of Gross Profit Notice that the gross profit recognized in each period is added to the construction in progress account.
Balance Sheet Recognition Billings on construction contract are subtracted from construction in progress to determine balance sheet presentation. CIP > BillingsAssetBillings > CIPLiability
Balance Sheet Recognition The balance in the construction in progress account differs between methods because of the earlier gross profit recognition that occurs under the percentage-of-completion method.
Percentage-of-Completion Method Allocation of Gross Profit The income statement for each year will report the appropriate revenue and cost of construction amounts.
Income Recognition The same total amount of profit or loss is recognized under both the completed contract and the percentage-of- completion methods, but the timing of recognition differs.
Timing of Gross Profit Recognition Under the Completed Contract Method Under the completed contract method, all revenues and expenses related to the project are recognized when the contract is completed.
Long-term Contract Losses Periodic Loss for Profitable Projects Determine periodic loss and record loss as a credit to the Construction in Progress account. Loss Projected for Entire Project Estimated loss is fully recognized in the first period the loss is anticipated and is recorded by a credit to Construction in Progress account.
Exercises and Problems In Class: E 9 (as is) + Gross Profit Schedule + JE for 2011 (% of Completion) Home Work: E10 (Requirements 1 - 3) P 5 (Requirements 1 - 3)
U. S. GAAP vs. IFRS Requires percentage-of- completion when reliable estimates can be made. Requires completed contract method when reliable estimates cant be made. There are similarities and differences between IFRS and U.S. GAAP when considering revenue recognition for long-term construction contracts. Requires percentage-of- completion when reliable estimates can be made. Requires cost recovery method when reliable estimates cant be made.
U. S. GAAP vs. IFRS Notice that revenue recognition occurs earlier under the cost recovery method than under the completed contract method, but gross profit recognition occurs at the end of the contract for both methods.
Software and Other Multiple- Deliverable Arrangements If a sale includes multiple elements (software, future upgrades, postcontract customer support, etc.), the revenue should be allocated to the elements that have stand-alone value (e.g., arent contingent). Otherwise, defer revenue recognition until the last item delivered. Software: base allocation on VSOE Other: can use estimated selling prices. This includes tangible products that contain essential software.
U. S. GAAP vs. IFRS Revenue should be allocated to the various elements based on the stand-alone selling prices of the individual elements. These can be estimated for non-software arrangements if VSOE is not available, but have to use VSOE for software arrangements. IFRS contains very little guidance about multiple-deliverable arrangements. May be necessary to apply the recognition criteria to the separately identifiable components of a single transaction. Allocation of total revenue to individual components are based on fair value.
U. S. GAAP vs. IFRS Earnings process is complete or virtually complete. Reasonable certainty as to the collectibility of the asset to be received. Revenue recognition criteria for U.S. GAAP and IFRS include: Revenue and costs can be measured reliably. Probable that economic benefits will flow to the seller. Risk and rewards are transferred to buyer and seller does not manage or control the goods. Stage of completion can be measured reliably.
Franchise Sales Initial Franchise Fees Generally are recognized at a point in time when the earnings process is virtually complete. Continuing Franchise Fees Recognized over time as the services are performed.
U. S. GAAP vs. IFRS Has over 100 revenue-related standards that sometimes contradict each other. The FASB and IASB are currently working on a new, comprehensive approach to revenue recognition. Has two primary standards that also sometimes contradict each other and that dont offer guidance in some important areas (like multiple deliverables). The Boards appear committed to improving accounting in this area.