1. 1 Revenue Recognition Instructor Adnan Shoaib PART II: Corporate Accounting Concepts and Issues Lecture 20

2. 2 1. 1.Apply the revenue recognition principle. 2. 2.Describe accounting issues for revenue recognition at point of sale. 3. 3.Apply the percentage-of-completion method for long-term contracts. 4. 4.Apply the completed-contract method for long-term contracts. 5. 5.Identify the proper accounting for losses on long-term contracts. 6. 6.Describe the installment-sales method of accounting. 7. 7.Explain the cost-recovery method of accounting. Learning Objectives

3. 3 Current Environment Guidelines for revenue recognition Departures from sale basis Revenue Recognition at the Point of Sale Revenue Recognition before Delivery Revenue Recognition after Delivery Sales with discounts Sales with right of return Sales with buybacks Bill and hold sales Principal-agent relationships Trade loading and channel stuffing Multiple-deliverable arrangements Installment-sales method Cost-recovery method Deposit method Summary of bases Percentage-of- completion method Completed- contract method Long-term contract losses Disclosures Completion-of- production basis Revenue Recognition

4. 4 Realization Principle Record revenue when: AND there is reasonable certainty as to the collectibility of the asset to be received (usually cash). the earnings process is complete or virtually complete. Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

5. 5 Realization Principle Revenue recognition is often tied to delivery of the product from the seller to the buyer.

6. 6 The Current Environment Restatements for improper revenue recognition are relatively common and can lead to significant share price adjustments. Revenue recognition is a top fraud risk and regardless of the accounting rules followed (IFRS or U.S. GAAP), the risk or errors and inaccuracies in revenue reporting is significant.

7. 7 The revenue recognition principle provides that companies should recognize revenue Guidelines for Revenue Recognition The Current Environment LO 1 Apply the revenue recognition principle. (1)when it is realized or realizable and (2)when it is earned.

8. 8 Sale of product from inventory Type of Transaction Rendering a service Permitting use of an asset Sale of asset other than inventory Date of sale (date of delivery) Services performed and billable As time passes or assets are used Date of sale or trade-in Gain or loss on disposition Revenue from interest, rents, and royalties Revenue from fees or services Revenue from sales Description of Revenue Timing of Revenue Recognition The Current Environment LO 1 Apply the revenue recognition principle. Revenue Recognition Classified by Type of Transaction

9. 9 Earlier recognition is appropriate if there is a high degree of certainty about the amount of revenue earned. 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 earnings process. Departures from the Sale Basis The Current Environment LO 1 Apply the revenue recognition principle.

10. 10 The Current Environment LO 1 Apply the revenue recognition principle. Illustration 18-2 Revenue Recognition Alternatives

11. 11 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

12. 12 FASB’s Concepts Statement No. 5, companies usually meet the two conditions for recognizing revenue by the time they deliver products or render services to customers. LO 2 Describe accounting issues for revenue recognition at point of sale. Implementation problems,  Sales with Discounts  Sales When Right of Return  Sales with Buybacks  Bill and Hold Sales  Principal-Agent Relationships  Trade Loading and Channel Stuffing  Multiple-Deliverable Arrangements Revenue Recognition at Point of Sale (Delivery)

13. 13 LO 2 Describe accounting issues for revenue recognition at point of sale.  Trade discounts or volume rebates should reduce consideration received or receivable and the related revenue.  If payment is delayed, seller should impute an interest rate for the difference between the cash or cash equivalent price and the deferred amount. Sales with Discounts Revenue Recognition at Point of Sale

14. 14 Facts: Sansung Company has an arrangement with its customers that it will provide a 3% volume discount to its customers if they purchase at least $2 million of its product during the calendar year. On March 31, 2012, Sansung has made sales of $700,000 to Artic Co. In the previous two years, Sansung sold over $3,000,000 to Artic in the period April 1 to December 31. Sansung makes the following entry on March 31, 2012. LO 2 Describe accounting issues for revenue recognition at point of sale. Accounts receivable 679,000 Sales revenue679,000 Illustration 18-3 Revenue Recognition at Point of Sale VOLUME DISCOUNT Illustration 18-3

15. 15 LO 2 Describe accounting issues for revenue recognition at point of sale. Cash 679,000 Accounts receivable 679,000 Illustration 18-3 Facts: Sansung Company has an arrangement with its customers that it will provide a 3% volume discount to its customers if they purchase at least $2 million of its product during the calendar year. On March 31, 2012, Sansung has made sales of $700,000 to Artic Co. In the previous two years, Sansung sold over $3,000,000 to Artic in the period April 1 to December 31. Assuming Sansung’s customers meet the discount threshold, Sansung makes the following entry. Revenue Recognition at Point of Sale VOLUME DISCOUNT Illustration 18-3

16. 16 VOLUME DISCOUNT LO 2 Cash 700,000 Accounts receivable 679,000 Sales discounts forfeited21,000 Illustration 18-3 Facts: Sansung Company has an arrangement with its customers that it will provide a 3% volume discount to its customers if they purchase at least $2 million of its product during the calendar year. On March 31, 2012, Sansung has made sales of $700,000 to Artic Co. In the previous two years, Sansung sold over $3,000,000 to Artic in the period April 1 to December 31. Sansung makes the following entry on March 31, 2012. If Sansung’s customers fail to meet the discount threshold, Sansung makes the following entry upon payment. Revenue Recognition at Point of Sale

17. 17 Sales with Right of Return Revenue Recognition at Point of Sale LO 2 Describe accounting issues for revenue recognition at point of sale. Three possible revenue recognition methods are available when the right of return exposes the seller to continued risks of ownership: 1.not recording a sale until all return privileges have expired or 2.recording the sale, but reducing sales by an estimate of future returns. 3.Recording the sale and accounting for the returns as they occur.

18. 18 Recognize revenue only if six conditions have been met. LO 2 Describe accounting issues for revenue recognition at point of sale. 1.The seller’s 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 buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product. Revenue Recognition at Point of Sale Sales with Right of Return

19. 19 LO 2 Describe accounting issues for revenue recognition at point of sale. Revenue Recognition at Point of Sale Sales with Right of Return Recognize revenue only if six conditions have been met. 4.The buyer acquiring the product for resale has economic substance 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.

20. 20 Question: When should Pesido recognize the revenue for the sale of the new laser equipment? Facts: Pesido Company is in the beta-testing stage for new laser equipment that will help patients who have acid reflux problems. The product that Pesido is selling has been very successful in trials to date. As a result, Pesido has received regulatory authority to sell this equipment to various hospitals. Because of the uncertainty surrounding this product, Pesido has granted to the participating hospitals the right to return the device and receive full reimbursement for a period of 9 months. Revenue Recognition at Point of Sale LO 2 Illustration 18-5 SALES WITH RETURNS Illustration 18-5 Solution: Given that the hospital has the right to rescind the purchase for a reason specified in the sales contract and Pesido is uncertain about the probability of return, Pesido should not record revenue at time of delivery.

21. 21 Revenue Recognition at Point of Sale LO 2 Pesido sold $300,000 of laser equipment on August 1, 2012, and retains only an insignificant risk of ownership. On October 15, 2012, $10,000 in equipment was returned. August 1, 2012 Accounts receivable 300,000 Sales 300,000 October 15, 20121 Sales returns and allowances 10,000 Accounts receivable10,000 SALES WITH RETURNS

22. 22 Revenue Recognition at Point of Sale At December 31, 2012, based on prior experience, Pesido estimates that returns on the remaining balance will be 4 percent. Pesido makes the following entry to record the expected returns. December 31, 2012 Sales returns and allowances 11,600 Allowance for sales returns and allowances11,600 [($300,000 - $10,000) x 4% = 11,600] LO 2 Describe accounting issues for revenue recognition at point of sale. SALES WITH RETURNS

23. 23 If a company sells a product in one period and agrees to buy it back in the next period, has the company sold the product? The economic substance of this transaction is that the seller retains the risks of ownership. Sales with Buybacks LO 2 Describe accounting issues for revenue recognition at point of sale. Revenue Recognition at Point of Sale

24. 24 Revenue Recognition at Point of Sale Facts: Morgan Inc., an equipment dealer, sells equipment to Lane Company for $135,000. The equipment has a cost of $115,000. Morgan agrees to repurchase the equipment at the end of 2 years at its fair value. Lane Company pays full price at the sales date, and there are no restrictions on the use of the equipment over the 2 years. Morgan records the sale as follows: Cash 135,000 Sales Revenue 135,000 Cost of Goods Sold 115,000 Inventory 115,000 LO 2 SALES WITH BUYBACK

25. 25 Bill and Hold Sales Revenue Recognition at Point of Sale Buyer is not yet ready to take delivery but does take title. Illustration 18-4 BILL AND HOLD Illustration 18-7 Facts: Butler Company sells $450,000 of fireplaces to a local coffee shop, Baristo, which is planning to expand its locations around the city. Under the agreement, Baristo asks Butler to retain these fireplaces in its warehouses until the new coffee shops that will house the fireplaces are ready. Title passes to Baristo at the time the agreement is signed. Question: Should Butler report the revenue from this bill and hold arrangement when the agreement is signed, or should revenue be deferred and reported when the fireplaces are delivered? LO 2

26. 26 Revenue Recognition at Point of Sale Solution: Butler should record the revenue at the time title passes, provided 1.the risks of ownership have passed to Baristo, that is, Butler does not have specific performance obligations other than storage; 2.Baristo makes a fixed commitment to purchase the goods, requests that the transaction be on a bill and hold basis, and sets a fixed delivery date; and 3.goods must be segregated, complete, and ready for shipment. LO 2 Describe accounting issues for revenue recognition at point of sale.

27. 27 Revenue Recognition at Point of Sale LO 2 Describe accounting issues for revenue recognition at point of sale. Accounts receivable 450,000 Sales 450,000 Illustration 18-4 BILL AND HOLD Illustration 18-7 Facts: Butler Company sells $450,000 of fireplaces to a local coffee shop, Baristo, which is planning to expand its locations around the city. Under the agreement, Baristo asks Butler to retain these fireplaces in its warehouses until the new coffee shops that will house the fireplaces are ready. Title passes to Baristo at the time the agreement is signed. Butler makes the following entry.

28. 28 Principal-Agent Relationships Revenue Recognition at Point of Sale LO 2 Describe accounting issues for revenue recognition at point of sale.  Amounts collected on behalf of the principal are not revenue of the agent.  Revenue for the agent is the amount of the commission it receives.

29. 29 Consignments Revenue Recognition at Point of Sale LO 2 Describe accounting issues for revenue recognition at point of sale.  Manufacturers (or wholesalers) deliver goods but retain title to the goods until they are sold.  Consignor (manufacturer or wholesaler) ships merchandise to the consignee (dealer), who is to act as an agent for the consignor in selling the merchandise.  Consignor makes a profit on the sale.  Consignee makes a commission on the sale.

30. 30 “Trade loading is a crazy, uneconomic, insidious practice through which manufacturers—trying to show sales, profits, and market share they don’t actually have—induce their wholesale customers, known as the trade, to buy more product than they can promptly resell.” Trade Loading and Channel Stuffing LO 2 Describe accounting issues for revenue recognition at point of sale. Revenue Recognition at Point of Sale

31. 31 A similar practice is referred to as channel stuffing. When a software maker needed to make its financial results look good, it offered deep discounts to its distributors to overbuy, and then recorded revenue when the software left the loading. Trade Loading and Channel Stuffing LO 2 Describe accounting issues for revenue recognition at point of sale. Revenue Recognition at Point of Sale

32. 32 MDAs provide multiple products or services to customers as part of a single arrangement. The major accounting issues related to this type of arrangement are how to allocate the revenue to the various products and services and how to allocate the revenue to the proper period. Multiple-Deliverable Arrangements LO 2 Describe accounting issues for revenue recognition at point of sale. Revenue Recognition at Point of Sale

33. 33 All units in a multiple-deliverable arrangement are considered separate units of accounting, provided that: 1.A delivered item has value to the customer on a standalone basis; and 2.The arrangement includes a general right of return relative to the delivered item; and 3.Delivery or performance of the undelivered item is considered probable and substantially in the control of the seller. Multiple-Deliverable Arrangements LO 2 Describe accounting issues for revenue recognition at point of sale. Revenue Recognition at Point of Sale

34. 34 Multiple-Deliverable Evaluation Process Multiple-Deliverable Arrangements LO 2 Describe accounting issues for revenue recognition at point of sale. Revenue Recognition at Point of Sale Illustration 18-9

35. 35 Two Methods:  Percentage-of-Completion Method. ► Rationale is that the buyer and seller have enforceable rights.  Completed-Contract Method. Most notable example is long-term construction contract accounting. Revenue Recognition Before Delivery LO 2 Describe accounting issues for revenue recognition at point of sale.

36. 36 Must use Percentage-of-Completion method when estimates of progress toward completion, revenues, and costs are reasonably dependable and all of the following conditions exist: Revenue Recognition Before Delivery 1.Contract clearly specifies the enforceable rights regarding goods or services by the parties, the consideration to be exchanged, and the manner and terms of settlement. 2.Buyer can be expected to satisfy all obligations. 3.Contractor can be expected to perform under the contract. LO 2 Describe accounting issues for revenue recognition at point of sale.

37. 37 Companies should use the Completed-Contract method when one of the following conditions applies when: Revenue Recognition Before Delivery 1.Company has primarily short-term contracts, or 2.Company cannot meet the conditions for using the percentage-of-completion method, or 3.There are inherent hazards in the contract beyond the normal, recurring business risks. LO 2 Describe accounting issues for revenue recognition at point of sale.

38. 38 Formula for Total Revenue to Be Recognized to Date LO 3 Apply the percentage-of-completion method for long-term contracts. Illustration 18-13 Percentage-of-Completion Method Illustration 18-14 Illustration 18-15 Percentage-of-Completion Method

39. 39 LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Illustration: Blue Diamond Construction Company has a contract to construct a $4,500,000 bridge at an estimated cost of $4,000,000. The contract is to start in July 2012, and the bridge is to be completed in October 2014. The following data pertain to the construction period.

40. 40 LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Illustration: Compute percentage complete. Illustration 18-16

41. 41 LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Illustration: Blue Diamond would make the following entries to record (1) the costs of construction, (2) progress billings, and (3) collections. Illustration 18-17

42. 42 Percentage-of-Completion Method Illustration: Percentage-of-Completion Revenue, Costs, and Gross Profit by Year Illustration 18-18 LO 3 Apply the percentage-of-completion method for long-term contracts.

43. 43 LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Illustration: Blue Diamond’s entries to recognize revenue and gross profit each year and to record completion and final approval of the contract. Illustration 18-19

44. 44 LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Illustration: Content of Construction in Process Account— Percentage-of-Completion Method Illustration 18-20

45. 45 LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Financial Statement Presentation—Percentage-of- Completion Illustration 18-21 Computation of Unbilled Contract Price at 12/31/12

46. 46 LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Financial Statement—Percentage-of-Completion Illustration 18-22 Blue Diamond Construction Company 2012

47. 47 LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Financial Statement—Percentage-of-Completion Illustration 18-23 Blue Diamond Construction Company 2013

48. 48 A) Prepare the journal entries for 2010, 2011, and 2012. Casper Construction Co. LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Illustration:

49. 49 LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Illustration:

50. 50 LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Illustration:

51. 51 LO 3 Apply the percentage-of-completion method for long-term contracts. Percentage-of-Completion Method Illustration:

52. 52 End of Lecture 20