Chapter 19: Revenue Recognition Intermediate Accounting, 10th Edition Kieso, Weygandt, and Warfield Chapter 19: Revenue Recognition Prepared by Krishnan Ranganathan, Angelo State University, San Angelo, Texas

Guidelines for Revenue Recognition The revenue recognition principle provides that revenue is recognized: when it is earned, and when it is realized or realizable Revenue is earned when the earnings process is substantially complete Revenue is realized when goods and services are exchanged for cash or claims to cash 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Four Types of Revenue Transactions Revenue from selling products is recognized at the date of sale (date of delivery) Revenue from services is recognized when services are performed and are billable Revenue from the use of enterprise’s assets by others is recognized as time passes or as the assets are used up Revenue from disposal of assets is recognized at the point of sale 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Revenue Recognition at Point of Sale Revenues from manufacturing and selling are commonly recognized at point of sale. Revenues from sales with buyback agreements are not recognized (not sales) Revenues from sales where rights of return exist are not generally recognized Certain trade practices such as trade loading and channel stuffing do not result in recognizable sales revenues. 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Revenue Recognition before Delivery Revenue may be recognized before delivery under certain circumstances Long term construction contracts (percentage completion method) are a notable example. The percentage method permits periodic billing at various points in the project. The completed contract method is used only when the percentage method is inapplicable. 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage of Completion Contract Accounting Long-Term Construction Accounting Methods Percentage of Completion Method Completed Contract Method 1) Terms of contract must be certain, enforceable. 2) Certainty of performance by both parties 1) To be used only when the percentage method is inapplicable [uncertain] 2) For short-term contracts 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Completion: Concept Percentage completion method permits periodic billing The amount of gross profit recognized depends upon the percent of work done See the specific steps for determining gross profit (next slide) 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Completion: Steps Costs incurred to date = Percent complete Most recent estimated total costs 1 Estimated total revenue * Percent complete = Revenue to be recognized to date 2 Total revenue to be recognized to date less Revenue recognized in PRIOR periods = Current period revenue 3 Current Period Revenue less current costs = Gross Profit 4 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Completion: Example Data: Contract price: $4,500,000 Estimated cost: $4,000,000 Start date: July, 2001 Finish: October, 2003 Balance sheet date: Dec 31. Given: 2001 2002 2003 Costs to date $1,000,000 $2,916,000 $4,050,000 Estimated costs to complete $3,000,000 $1,134,000 $ -0- Progress Billings during year $ 900,000 $2,400,000 $1,200,000 Cash collected during year $ 750,000 $1,750,000 $2,000,000 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Completion: ex-contd 2001 2002 2003 1,000,000 = 25% 2,916,000= 72% 100 % 4,000,000 4,050,000 % complete to-date 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 Revenue recognized 1,125,000 less 2,115,000 less 1,260,000 1,000,000 1,916,000 less 1,134,000 = 125,000 = 199,000 = 126,000 Gross Profit recognized 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Recognizing Current & Overall Losses on Long Term Contracts A long term contract may produce: either an interim loss and an overall profit, or an overall loss for the project Under the percentage completion method, losses in any case are immediately recognized. Under the completed contract method, losses are recognized immediately only when overall losses result. 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Recognizing Current & Overall Losses on Long Term Contracts Percentage Method: Recognize loss currently. Current Loss on an otherwise overall profitable contract Completed method: No adjustment needed Loss on an overall Unprofitable contract Loss Percentage Method: Recognize entire loss now. Completed method: Recognize loss currently. 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Method: Interim Loss on Profitable Contract - Example Data: Contract price: $3,000 Contract start date: February 2000 Contract finish date: December 2001 As of 12.31.00: Costs to date: $2,000 Estimated costs to complete:$ 500 As of 12.31.01: Costs to date: $2,300 Estimated to complete: $ 330 Compute the gross profit or loss to be recognized for 2000 and 2001. 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Method: Interim Loss on Profitable Contract - Example Note: The contract shows an overall profit for 2000 and 2001 together: Estimated total revenue: $3,000 Estimated total costs: $2,630 Estimated total gross profit: $ 370 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Method: Interim Loss on Profitable Contract - Example Gross Profit (2000) 80% * $3,000 = $2,400 Profit = $2,400 - $2,000 = $400 Gross Profit (2001) Percent complete: [$2,300] / [$2300 +330]: 88% Current revenue: [0.88 * $3,000] =$2,624 less $2,400 = $224 Loss: Revenue, $224 - Cost, $300 = $ 76 loss 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Method: Interim Loss on Profitable Contract - Example Record loss for 2001: Construction Expense $300 Construction Revenue $224 Construction in Process $ 76 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Method: Overall Unprofitable Contract - Example Data: Contract price: $3,000 Contract start date: February 2000 Contract finish date: December 2001 As of 12.31.00: Costs to date: $2,000 Estimated costs to complete:$ 500 As of 12.31.01: Costs to date: $2,600 Estimated to complete: $ 530 Compute the gross profit or loss to be recognized for 2000 and 2001. 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Method: Overall Unprofitable Contract - Example Note: The contract shows an overall profit for 2000 and 2001 together: Estimated total revenue: $3,000 Estimated total costs: $3,130 Estimated total loss: $ 130 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Method: Overall Unprofitable Contract - Example Gross Profit (2000) 80% * $3,000 = $2,400 Profit = $2,400 - $2,000 = $400 Gross Profit (2001) Percent complete: [$2,600] / [$2,600 + 530]: 83% Current revenue: [0.83 * $3,000] =$2,492 less $2,400 = $92 Loss: Revenue, $92 - Cost, $ 622 = $ 530 loss 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Method: Overall Unprofitable Contract - Example Record loss for 2001: Construction Expense $622 Construction Revenue $ 92 Construction in Process $ 530 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Percentage Method: Overall Unprofitable Contract - Example Continuing the prev. slide: We complete the contract in 2002 [costs, $530 for 2002] Revenue [2002] = $3,000 total less [ $2,400 in 00 & $92 in 2001] = $508 Construction Expense [2002] = Construction costs [2002] = $530 [no change] But, the loss of $22 [i.e. $530 - $508] has already been recognized in 2001. So: Construction Expense 508 Construction Revenue 508 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Revenue Recognition after Delivery Revenue recognition is deferred when collection of sales price is not reasonably assured The two methods that are used are: the installment sales method the cost recovery method If cash is received prior to delivery, the method used is the deposit method. 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

The Installment Sales Method This method emphasizes income recognition in periods of collection rather than at point of sale Title does not pass to the buyer until all cash payments have been made to the seller Both sales and cost of sales are deferred to the periods of collection. Other expenses, selling and administrative, are not deferred. 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

The Installment Sales Method: Special Accounts Installment sales must be kept separate Gross profit on installment sales must be determinable The amount of cash collected from installment accounts must be known The cash collected from current year’s and prior years’ accounts must be known Provision must be made for the carry forward of each year’s (deferred) gross profit 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

The Installment Sales Method: Steps 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 this rate to cash collections of current year’s installment sales to yield realized gross profit The gross profit not realized is deferred Apply the relevant rate to cash collections of prior year’s installment sales 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

The Installment Sales Method: Example Given: 2001 2002 2003 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 2001 sales $ 60,000 $ 100,000 $ 40,000 from 2002 sales $ -0- $ 100,000 $ 125,000 from 2003 sales $ -0- $ -0- $ 80,000 Determine the realized and deferred gross profit. 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

The Installment Sales Method: Example Given: 2001 2002 2003 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 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

The Installment Sales Method: Example 2001 2002 2003 Gross profit rate 25% 24% 30% Realized Gross Profit: From 2001 sales: Realized in $ 15,000 $ 25,000 $ 10,000 From 2002 sales: Realized in: $ -0- $ 24,000 $ 30,000 From 2003 sales: Realized in: $ -0- $ -0- $ 24,000 Gross profit deferred deferred 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.) The Installment Sales Method: Partial Journal Entries (2001) for Gross Profit Installment Sales 200,000 Cost of Sales 150,000 Deferred Gross Profit, 2001 50,000 (To close 2001 accounts) Deferred Gross Profit, 2001 15,000 Realized Gross Profit 15,000 (Realized: $60,000 * 25%) Realized Gross Profit 15,000 Income Summary 15,000 (To close to Income Summary) 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

The Cost Recovery Method Seller recognizes no profit until: cash payments by buyer exceed seller’s cost of merchandise. After recovering all costs, seller includes additional cash collections in income. This method is to be used where there is no reasonable basis for estimating collectibility as in franchises and real estate. The income statement reports the amount of gross profit recognized and the amount, deferred. 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.) The Deposit Method Seller receives cash from buyer before transfer of goods or performance. The seller has no claim against the purchaser There is insufficient transfer of risks to buyer to warrant recording a sale by seller In the case of such incomplete transactions, the deposit method is used The deposit method thus defers sale recognition until a sale has occurred for accounting purposes 11/9/2018 Intermediate Accounting, 10th edition, Chapter 19 (Kieso et al.)

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