Revenue Recognition Intermediate Accounting,17E Stice | Stice | Skousen © 2010 Cengage Learning PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University

8-2 Revenue Recognition Recognition refers to the time when transactions are recorded on the books. The FASB’s two criteria for recognizing revenues and gains were articulated in FASB Concepts Statement No. 5.

8-3 Revenues and gains are generally recognized when: 1.They are realized or realizable. 2.They have been earned through substantial completion of the activities involved in the earnings process. Revenue Recognition

8-4 Revenue Recognition Revenue is not recognized prior to the point of sale because either: A valid promise of payment has not been received from the customer, or The company has not provided the product or service. Exceptions to these rules: The customer provides a valid promise of payment. Conditions exist that contractually guarantee the sale.

8-5 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. Revenue Recognition

8-6 Appropriate Layaway Accounting Receipt of $100 cash as initial layaway payment: Cash100 Deposit Received from Customers100 Receipt of final $1,400 cash payment and delivery of goods to customer: Cash1,400 Deposit Received from Customers 100 Sales1,500 Cost of Goods Sold1,000 Inventory1,000

8-7 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. Appropriate Accounting for a Service Provided Over an Extended Period

8-8 Receipt of $1,000 cash as initial sign-up fee: Cash1,000 Unearned Initial Sign-Up Fees1,000 Receipt of first monthly payment of $50: Cash50 Monthly Service Revenue50 Partial recognition of the initial signup fee as revenue ($1,000/100 months): Unearned Initial Sign-Up Fees10 Initial Sign-Up Fee Revenue10 Appropriate Accounting for a Service Provided Over an Extended Period

8-9 EITF A delivered element of a multiple- element arrangement is considered to be a unit of accounting if that delivered element has standalone value and if the fair value of any undelivered element can be objectively and reliably determined.

8-10 Appropriate Accounting for a Refundable Membership Seller Company receives $1,200 cash from each customer as a fully refundable, one- year membership fee. It is estimated that the cost to Seller Company to provide the membership service to each customer will be $360 for one year. Seller Company can reliably estimate that 40% of the customers will request refunds during the year. Assume all refunds occur at the end of the year. There were 1,000 customers. (continues)

8-11 Appropriate Accounting for a Refundable Membership

8-12 On January 1, Owner Company signed a 1-year rental for a total of $120,000, with monthly payments of $10,000 due at the end of each month. In addition, the renter must pay contingent rent of 10% of all annual sales in excess of $3,000,000. The contingent payment is paid in one payment on December 31. (continues) Appropriate Accounting for a Contingent Rental

8-13 On January 31, sales for the renter had reached $700,000. On July 31, the renter had reached a sales level of $3,150,000. On December 31, the renter had reached a sales level of $5,000,000, of which $1,000,000 occurred in December. (continues) Appropriate Accounting for a Contingent Rental

8-14 Appropriate Accounting for a Contingent Rental

8-15 Asset-and-Liability Approach to Revenue Recognition Example Wilks Company sells a plasma TV screen and 2- year warranty to a customer for a joint price of $2,000. All cash is collected upfront. Other relevant data: Cost of plasma TV screen, $1,500 Sales price of TV if sold separately, $1,785 Sales price of 2-year warranty if sold separately, $315 Amount payable to a TV wholesaler to accept responsibility to provide TV, $1,650 Amount payable to service company to accept responsibility of providing warranty, $240 (continues)

8-16 Journal entries on delivery of TV: Contract Liability—TV Screen1,700 Sales Revenue1,700 Cost of Goods Sold1,500 Inventory 1,500 Journal entry at point of cash receipt: Cash2,000 Contract Liability—TV Screen1,700¹ Contract Liability—Warranty300² ¹$2,000  [$1,785/($1,785 + $315)] ²$2,000  [$315/($1,785 + $315)] Asset-and-Liability Approach to Revenue Recognition Example

8-17 The fair values of the performance obligation liabilities create a contract signing. Recall that a TV wholesaler would charge $1,650 for accepting the responsibility of providing the plasma TV to the customer. Likewise, a service company would charge $240 for providing the two years of warranty. (continues) Measurement Model

8-18 The entry to record the cash asset and the two performance obligations created at the contract signing is as follows: Cash 2,000 Contract Liability—TV Screen1,650 Contract Liability—Warranty240 Revenue 110 Measurement Model

8-19 Revenue 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.

8-20 Percentage-of-Completion Method Requirements 1.Dependable estimates of: contract revenues contract costs progress toward completion 2.Contract clearly specifies: enforceable rights of the parties consideration to be exchanged manner and terms of settlement (continues)

The buyer can be expected to satisfy obligations under the contract. 4.Contractor can be expected to perform the contractual obligation. Percentage-of-Completion Method Requirements

8-22 Percentage-of-Completion Input Measures Cost-to-cost method is perhaps the most popular of the input measures. 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.

8-23 In January 2010, Strong Construction Company was awarded a contract with a total price of $3,000,000. Strong expects to earn $400,000 profit on the contract. The construction was completed over a 3-year period. The table shown next provides the actual cost that Strong experienced and the completion rate. Measuring the Percentage of Completion

8-24 Measuring the Percentage of Completion

8-25 Accounting for Long-Term Construction Contracts Continuing with the Strong Construction Company illustration, the direct and indirect costs, billings, and collections are as follows:

8-26 Completed-Contract Method Construction in Progress1,040,000 Materials, Cash, etc.1,040,000 To record costs incurred. Accounts Receivable1,000,000 Progress Billings on Construction Contracts1,000,000 To record billings. Cash800,000 Accounts Receivable800,000 To record cash collections (continues)

8-27 Construction in Progress910,000 Materials, Cash, etc.910,000 To record costs incurred. Accounts Receivable900,000 Progress Billings on Construction Contracts900,000 To record billings. Cash850,000 Accounts Receivable850,000 To record cash collections Completed-Contract Method (continues)

8-28 Construction in Progress650,000 Materials, Cash, etc.650,000 To record costs incurred. Accounts Receivable1,100,000 Progress Billings on Construction Contracts1,100,000 To record billings. Cash 1,350,000 Accounts Receivable1,350,000 To record cash collections Completed-Contract Method

8-29 Percentage-of-Completion Method The entries we recorded using the completed-contract method are also the same entries that would be used for the percentage-of-completion method. The completed-contract method is “wrapped up” using the entries shown in Slides 30 and 31. The percentage-of- completion method requires the entries presented in Slides 32 to 34.

Under the completed-contract method, the following entries would be made to recognize revenue and costs and to close out the inventory and billing accounts. Progress Billings on Construction Contracts3,000,000 Revenue from Long-Term Construction Contracts3,000,000 (continues) Completed-Contract Method

Under the completed-contract method, the following entries would be made to recognize revenue and costs and to close out the inventory and billing accounts. Cost of Long-Term Construction Contracts 2,600,000 Construction in Process2,600,000 Completed-Contract Method

8-32 Percentage-of-Completion Cost of Long-Term Construction Contracts1,040,000 Construction in Progress160,000 Revenue from Long-Term Construction Contracts1,200, (continues) Under the percentage-of-completion method, the following additional entries would be made to recognize revenue.

8-33 Cost of Long-Term Construction Contracts910,000 Construction in Progress 140,000 Revenue from Long-Term Construction Contracts1,050, ($3,000,000  0.75)  $1,200,000 Percentage-of-Completion (continues)

8-34 Cost of Long-Term Construction Contracts650,000 Construction in Progress100,000 Revenue from Long-Term Construction Contracts750, $3,000,000  $1,200,000  $1,500,000 Percentage-of-Completion

8-35 Revision of Estimate Instead of the previous illustration, assume that at the end of 2011, it was estimated that the remaining cost to complete construction was $720,000 rather than $650,000. This would increase the total estimated cost to $2,670,000, reduce the expected profit to $330,000, and change the percentage of completion for (continues)

8-36 Revision of Estimate (continues)

8-37 The entries for 2010 would be the same as those shown in the previous example. Cost of Long-Term Construction Contracts910,000 Construction in Progress80,000 Revenue from Long-Term Construction Contracts990,000 ($3,000,000  0.73)  $1,200,000 All entries for 2011 would be the same except for the entry to record revenue and cost. Revision of Estimate (continues)

8-38 Cost of Long-Term Construction Contracts700,000 Construction in Progress110,000 Revenue from Long-Term Construction Contracts810, Revision of Estimate

8-39 Assume the same facts for Strong Construction Company, except the estimated cost to complete the contract at the end of 2011 was $1,300,000. Because $1,950,000 of costs had already been incurred, the total estimated cost would be $3,250,000. Reporting Anticipated Contract Losses (continues)

8-40 Reporting Anticipated Contract Losses

8-41 Anticipated Contract Loss: Percentage-of-Completion (continues)

8-42 Anticipated Contract Loss: Percentage-of-Completion The entry to record the revenue, costs, and adjustments to Construction in Process for the loss in 2011 would be as follows: Cost of Long-Term Construction Contracts 1,010,000 Revenue from Long-Term Construction Contracts600,000 Construction in Process410,000 (continues)

8-43 Anticipated Contract Loss: Percentage-of-Completion

8-44 Proportional Revenue Recognition 1.Initial direct costs related to obtaining and performing initial services on the contract Most service contracts involve three different types of costs: 2.Direct costs related to performing the various service acts 3.Indirect costs related to maintaining the organization to service the contract

8-45 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). Accounting for Long-Term Service Contracts (continues)

8-46 Receipt of fees: Cash 50,000 Deferred Course Revenue50,000 Direct costs for lessons actually completed: Contract Costs12,000 Cash12,000 Expense account Deferred Initial Costs5,000 Cash5,000 Initial direct costs: (continues) Asset account Liability account Accounting for Long-Term Service Contracts

8-47 Recognize course revenue: Deferred Course Revenue20,000 Recognized Course Revenue 20,000 Recognize contract costs from initial direct costs: Contract Costs2,000 Deferred Initial Costs2,000 $24,000$60,000  $50,000 Accounting for Long-Term Service Contracts $24,000$60,000  $5,000

8-48 Revenue Recognition After Delivery of Goods

8-49 Installment Sales Method Under the installment sales method, profit is recognized as cash is collected rather than at the time of sale. It is used most commonly in cases of real estate sales where contracts may involve little or no down payment, payments are spread over 10 to 40 years, and a high probability of default in the early years exists.

8-50 Installment Sales Method Riding Corporation sells merchandise on the installment basis, and the uncertainties of cash collection make the use of the installment method necessary. The following data relate to three years of operations. (continues)

8-51 Installment Accounts Receivable— ,000 Installment Sales 150,000 Cost of Installment Sales100,000 Inventory 100,000 Cash30,000 Installment Accounts Receivable— , —During the Year (continues) Installment Sales Method

8-52 Installment Sales150,000 Cost of Installment Sales 100,000 Deferred Gross Profit—201050,000 Deferred Gross Profit— ,000 Realized Gross Profit on Installment Sales 10,000 $30,000  33.33% 2010—End of Year Installment Sales Method (continues)

8-53 Installment A/R— ,000 Installment Sales 200,000 Cost of Installment Sales140,000 Inventory 140,000 Cash145,000 Installment A/R— ,000 Installment A/R— , —During the Year Installment Sales Method (continues)

8-54 Installment Sales200,000 Cost of Installment Sales 140,000 Deferred Gross Profit—201160,000 Deferred Gross Profit— ,000 Deferred Gross Profit—201121,000 Realized Gross Profit on Installment Sales 46,000 $75,000  33.33% $70,000  30% 2011—End of Year Installment Sales Method (continues)

8-55 Installment A/R— ,000 Installment Sales 300,000 Cost of Installment Sales204,000 Inventory 204,000 Cash 210,000 Installment A/R— ,000 Installment A/R— ,000 Installment A/R— , —During the Year Installment Sales Method (continues)

8-56 Installment Sales300,000 Cost of Installment Sales 204,000 Deferred Gross Profit—201296,000 Deferred Gross Profit— ,000 Deferred Gross Profit—201124,000 Deferred Gross Profit—201232,000 Realized Gross Profit on Installment Sales 66,000 $30,000  33.33% $80,000  30% 2012—End of Year $100,000  32% Installment Sales Method

8-57 Cost Recovery Method If the probability of recovering product or service costs is remote, the cost recovery method of accounting can be used.

8-58 All entries are the same except do not record gross profit until all costs are recovered. Deferred Gross Profit—20105,000 Realized Gross Profit on Installment Sales5, (continues) Cost Recovery Method

8-59 Because the cash collected in 2011 for 2011 sales is less than the cost of inventory sold, no gross profit would be recognized in 2011 on 2011 sales. Deferred Gross Profit—201030,000 Deferred Gross Profit—201110,000 Realized Gross Profit on Installment Sales40, Cost Recovery Method