Chapter Six Revenue Recognition

Copyright © Houghton Mifflin Company.All rights reserved What are Revenues? Inflows or other enhancements of the assets of a business or settlements of its liabilities (or both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the central operations of the business

Copyright © Houghton Mifflin Company.All rights reserved Challenges of Revenue Recognition When should revenue be recognized? How much revenue should be recognized?

Copyright © Houghton Mifflin Company.All rights reserved Revenue Recognition Criteria 1.The amount and timing of revenue can be reasonably determined. (Revenue is realized or realizable.) 2.The earnings process is complete or virtually complete. (Revenue is earned.) Revenue Recognition Principle Revenue should be recognized (and recorded) when:

Copyright © Houghton Mifflin Company.All rights reserved Potential Points of Revenue Recognition

Copyright © Houghton Mifflin Company.All rights reserved Point-of-Sale Method Green Darner Company makes a sale on account to Farber Industries for $500,000. (Legal title passes at point of delivery). How should revenue be recorded by Green Darner Co.? Accounts Receivable $500,000 Sales $500,000

Copyright © Houghton Mifflin Company.All rights reserved When Right of Return Exists 1.Recognize revenue when: 2.Amount of future returns can be reasonably estimated 3.Transaction has fixed or determinable sales price 4.No contingent liabilities exist 5.Buyer is economically independent of seller and can make the purchase

Copyright © Houghton Mifflin Company.All rights reserved Right of Return Establish an allowance account to reflect estimated returns Defer revenue recognition until uncertainty is resolved If returns can be reasonably estimated If returns cannot be reasonably estimated

Copyright © Houghton Mifflin Company.All rights reserved Revenue Recognition During Production or Construction Choose from two methods: Percentage-of-completion method - recognize revenue, construction costs, and gross profit while project is in progress Completed-contract method - recognize revenue and gross profit when project has been completed

Copyright © Houghton Mifflin Company.All rights reserved Percentage-of-Completion Method Step 1: Calculate percentage completed based on costs incurred to date and estimated total cost of project Step 2: Calculate estimated gross profit by comparing contract price with latest estimate of total costs Step 3: Calculate estimated gross profit earned to date Step 4: Calculate amount of estimated gross profit to recognize in each year

Copyright © Houghton Mifflin Company.All rights reserved Illustration: Vulcan Construction Contract Contract with the city of Hilo on Jan. 6, 2006 Contract price = $3,000,000 Estimated construction costs = $2,500,000 Estimated completion date: December 31, 2008 Project Data Costs incurred to date$1,200,000$2,000,000$2,600,000 Estimated future costs to complete1,300,000600, Billings to date1,000,0002,000,0003,000,000 Cash collections to date1,000,0002,000,0003,000,000

Copyright © Houghton Mifflin Company.All rights reserved Step 1: Calculate Percentage Completed Divide costs incurred to date by costs incurred to date plus estimated total cost of project: 2006: $1,200,000  ($1,200,000 + $1,300,00) = 48.0% 2007: $2,000,000  ($2,000,000 + $600,000) = 76.9% 2008: $2,600,000  $2,600,000 = 100% Project Data Costs incurred to date$1,200,000$2,000,000$2,600,000 Estimated future costs to complete1,300,000600, Billings to date1,000,0002,000,0003,000,000 Cash collections to date1,000,0002,000,0003,000,000

Copyright © Houghton Mifflin Company.All rights reserved Step 2: Calculate Estimated Total Gross Profit Subtract latest estimate of total costs from total contract price 2006: $3,000,000 – $2,500,000 = $500, : $3,000,000 – $2,600,000 = $400, : $3,000,000 – $2,600,000 = $400,000* *Actual gross profit Project Data Costs incurred to date$1,200,000$2,000,000$2,600,000 Estimated future costs to complete1,300,000600,

Copyright © Houghton Mifflin Company.All rights reserved Step 3: Calculate Estimated Gross Profit Earned to Date Multiply the percentage-of-completion ratio calculated in Step 1 by the total gross profit estimate calculated in Step :.480 x $500,000 = $240, :.769 x $400,000 = $307, : 1.00 x $400,000 = $400,000

Copyright © Houghton Mifflin Company.All rights reserved Step 4: Calculate the Amount of Gross Profit to Recognize Each Period Subtract gross profit earned in previous periods from gross profit earned to date 2006: $240,000 – 0 = $240, : $307,600 – $240,000 = $67, : $400,000 – $307,600 = $92,400

Copyright © Houghton Mifflin Company.All rights reserved Percentage-of-Completion Method Record costs incurred each year 2006 Construction in Progress Inventory 1,200,000 Accounts Payable, Cash, etc. 1,200, Construction in Progress Inventory 800,000 Accounts Payable, Cash, etc. 800, Construction in Progress Inventory 600,000 Accounts Payable, Cash, etc. 600,000

Copyright © Houghton Mifflin Company.All rights reserved Percentage-of-Completion Method Record billings sent to city of Hilo 2006 Accounts Receivable 1,000,000 Billings on Construction in Progress 1,000, Accounts Receivable 1,000,000 Billings on Construction in Progress 1,000, Accounts Receivable 1,000,000 Billings on Construction in Progress 1,000,000

Copyright © Houghton Mifflin Company.All rights reserved Percentage-of-Completion Method Recognize gross profit each year 2006 Construction in Progress 240,000 Profit on Long-Term Constr. Contract 240, Construction in Progress 67,600 Profit on Long-Term Const. Contract 67, Construction in Progress 92,400 Profit on Long-Term Const. Contract 92,400

Copyright © Houghton Mifflin Company.All rights reserved Percentage-of-Completion Method Record completion of project 2006 No entry 2007 No entry 2008 Billings on Construction in Progress 3,000,000 Construction in Progress 3,000,000

Copyright © Houghton Mifflin Company.All rights reserved Income Statement: Percentage-of- Completion Method

Copyright © Houghton Mifflin Company.All rights reserved Statement of Cash Flows: Percentage- of-Completion Method

Copyright © Houghton Mifflin Company.All rights reserved Balance Sheet: Percentage-of- Completion Method Construction in Progress in Excess of Billings = Company’s net investment in the construction project

Copyright © Houghton Mifflin Company.All rights reserved Completed-Contract Method Often used for long-term contracts or projects Total costs cannot be reasonably estimated Estimated gross profit not recognized until project is complete and total costs are known

Copyright © Houghton Mifflin Company.All rights reserved Completed-Contract Method Entries to record construction costs, billings, cash collections are the same as under percentage-of-completion method What entry is made to record project completion? 2008 Billings on Construction in Progress 3,000,000 Construction in Progress 2,600,000 Profit on Long-Term Construction Project 400,000

Copyright © Houghton Mifflin Company.All rights reserved Recognizing Revenue at End of Production Used in industries like agriculture and mining Critical event in earnings process is harvesting or mining Revenue is recognized upon completion of production assuming the market price is stable and units produced are homogeneous

Copyright © Houghton Mifflin Company.All rights reserved Recognizing Revenue at End of Production Colina Farms harvests 5,000 bushels of barley, Dec. 15, 2005 (market price = $2.20 per bushel) Cost to produce each bushel = $.85 Sells 3,000 bushels for cash Dec. 15 Cash (3,000 bushels x $2.20) 6,600 Revenue from Production of Barley 6,600 Dec. 15 Cost of Good Sold (3,000 x $.85) 2,550 Barley Inventory 2,550

Copyright © Houghton Mifflin Company.All rights reserved Recognizing Revenue at End of Production Colina Farms holds the other 2,000 bushels as it expects the price to increase Revenue recognized since crop harvested – the critical event in earnings process Recognize speculation of gain at year end for holding barley Dec. 15 Barley Inventory [2,000 x ($2.20 x $.85)] 2,700 Revenue from Production of Barley 2,700 Dec. 31 Barley Inventory [2,000 x ($ $2.20)] 400 Holding Gain on Barley Held for Sale 400

Copyright © Houghton Mifflin Company.All rights reserved Recognizing Revenue at End of Production Colina Farms sells remaining 2,000 bushels on Jan. 10, 2006 at $2.34 per bushel Recognize holding loss ($ $2.34 per bushel) Jan. 10 Cash (2,000 bushels x $2.34) 4,680 Holding Loss on Barley 120 Barley Inventory 4,800

Copyright © Houghton Mifflin Company.All rights reserved Recognizing Revenue After Delivery and During Cash Collection Significant uncertainties exist concerning ultimate collection of cash (long collection periods, bad debts) Installment Sales Method Cost Recovery Method

Copyright © Houghton Mifflin Company.All rights reserved Installment Sales Method Buyer pays for purchase with a series of payments over a period of time Seller may retain title until merchandise is paid for Cash flows are uncertain Recognize revenue and cost of sales in proportion to the cash collected

Copyright © Houghton Mifflin Company.All rights reserved Cost-Recovery Method Used when the collection of payments is so uncertain that even the installment sales method is not feasible Recognize revenue only when enough cash has been collected to cover the cost of the product that was sold As more cash is received, the gross profit is recognized Used only in rare situations

Copyright © Houghton Mifflin Company.All rights reserved Quality of Earnings and Revenue Recognition Disclosure of revenue recognition policies increases transparency in reporting Conservatism should be applied when selecting the appropriate revenue recognition policy Cash sales provide the highest quality of earnings, while swaps and barters provide a lower quality of earnings

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QOutline the criteria established by the revenue recognition principle. ARevenue should be recognized when the amount and timing of revenue can be reasonably determined and the earnings process is complete or virtually complete

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QIf a product has a right of return, what criteria guide the recognition of revenue? ARevenue should be recognized when (1) the amount of future returns can be reasonably estimated, (2) the transaction has a fixed or determinable sales price, (3) no contingent obligations are related to the sale, and (4) the buyer has the economic capacity independent of the seller to complete the sale.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QDescribe the difference between the percentage-of-completion method and the completed-contract method of revenue recognition. AThe percentage-of-completion method recognizes gross profit as work is done, represented by costs incurred to date. The completed-contract method delays the recognition of gross profit until the completion of the project.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QWhat kinds of companies generally use the completed-production method? ACompanies that sell agricultural products or mined resources.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QDescribe some measures that might increase the quality of earnings for a company in regard to revenues? ADisclosure of the company’s revenue recognition policy; selection of conservative revenue recognition policies; cash-based transactions versus barter or swap transactions