1. 1 Revenue Recognition An electronic presentation by Douglas Cloud by Douglas Cloud Pepperdine University Pepperdine University An electronic presentation by Douglas Cloud by Douglas Cloud Pepperdine University Pepperdine University chapter chapter 8

2. 2 1.Identify the primary criteria for revenue recognition. 2.Apply the revenue recognition concepts underlying the examples used in SAB 101. 3.Record journal entries for long-term construction-type contracts using percentage-of-completion and completed- contract methods. Learning ObjectivesContinuedContinued

3. 3 4.Record journal entries for long-term service contracts using the proportional performance method. 5.Explain when revenue is recognized after delivery of goods or services through installment sales, cost recovery, and cash methods. Learning Objectives

4. 4 Revenue Recognition 1.They are realized or realizable. 2.They have been earned through substantial completion of the activities involved in the earnings process. FASB’s two criteria for recognizing revenues and gains:

5. 5 Both of these criteria generally are met at the point of sale. Revenue recognition most often occurs when goods are delivered or when services are rendered. Revenue Recognition

6. 6 Criterion Associated With Revenue Recognition Criterion 1: The customer has provided payment or a valid promise of payment. Criterion 2:The company has provided a product or service.

7. 7 Revenue Recognition Before the point of Sale EXCEPTION: Revenue can be recognized prior to the point of sale if: Customer provides a valid promise of payment AND Criterion 1 Criterion 2 conditions exist that contractually guarantee subsequent sale.

8. 8 Revenue Recognition Point of Sale NORMALLY: Revenue is generally recognized at this point of time. Criterion 1 is typically satisfied at this point. Criterion 1 Criterion 2 Critical 2 is typically satisfied at this point.

9. 9 Revenue Recognition After the Point of Sale EXCEPTION: The recognition of revenue must be deferred if: Customer does not provide a valid promise of time of receipt of product or service OR Criterion 1 Criterion 2 significant effort remains on the contract.

10. 10 A product or service was provided without receiving a valid promise of payment from customer. The company has not provided the product or service. Revenue Recognition Generally, revenue is not recognized prior to the point of sale because either: An exception occurs when the customer provides a valid promise of payment and conditions exist that contractually guarantee the sale.

11. 11 Revenue Recognition 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.

12. 12 Persuasive Evidence of an Arrangement The SEC issued SEC 101 in response to specific abuses involving revenue recognition.

13. 13 SAB 101 is in a question- and-answer format. The answers given are invariably “No.” Persuasive Evidence of an Arrangement

14. 14 Persuasive Evidence of an Arrangement Typical questions from SAB 101 Question 1: Question 1: Company A requires each sale to be supported by a written sales agreement signed by an authorized representative of both Company A and the customer. Addresses internal controls. Question 1: Question 1: May Company A recognize revenue in the current quarter if the product is delivered by the end of the quarter but the sales agreement is not signed by the customer until a few days after the end of the quarter? ENTER

15. 15 Persuasive Evidence of an Arrangement Typical questions from SAB 101 Question 2: Question 2: Company Z delivers product to a customer on a consignment basis. May Company Z recognize revenue upon delivery of the product to the customer? Addresses the issue of circumventing internal controls by side agreements.

16. 16 Persuasive Evidence of an Arrangement Typical questions from SAB 101 Question 4: Question 4: Company R is a retailer that offers “layaway” sales to customers. A customer pays a portion of the sales price, and Company R sets the… Focuses on issues centered on the “bill-and-hold” arrangements. Question 4: Question 4: …aside until the customer pays the remainder of the sales price, and takes possession of the merchandise. When should Company R recognize revenue? ENTER

17. 17 Persuasive Evidence of an Arrangement 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 Customers100 Sales1,500 Cost of Goods Sold1,000 Inventory1,000 Appropriate Layaway Accounting

18. 18 Persuasive Evidence of an Arrangement 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.

19. 19 Persuasive Evidence of an Arrangement 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

20. 20 Persuasive Evidence of an Arrangement Typical questions from SAB 101 Addresses the difference between estimating the future impact of past events and estimating the future impact of future events. Question 8: Question 8: Company A owns a building and leases it to a retailer. The annual lease payment is $1.2 million plus 1% of all the retailer’s sales in excess of $25 million. Question 8: Question 8: Should Company A estimate and recognize revenue associated with the 1% of sales over $25 million on a straight-line basis throughout the year? ENTER

21. 21 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.

22. 22 GAAP requires percentage-of- completion method unless certain criteria are not met. Revenue Recognition Prior to Providing Goods or Services

23. 23 Percentage-of- Completion Accounting  Dependable estimates of: contract revenues contract costs progress toward completion  Contract clearly specifies: enforceable rights of the parties consideration to be exchanged manner and terms of settlement  Dependable estimates of: contract revenues contract costs progress toward completion  Contract clearly specifies: enforceable rights of the parties consideration to be exchanged manner and terms of settlement ContinuedContinued

24. 24 Percentage-of- Completion Accounting  The buyer can be expected to satisfy obligations under the contract.  Contractor can be expected to perform the contractual obligation.  The buyer can be expected to satisfy obligations under the contract.  Contractor can be expected to perform the contractual obligation.

25. 25 Recognize revenue throughout life of the contract. Revenue recognized is a function of how complete the project is to date. Costs are charged to an inventory account: Construction in Process (CIP). Profits are charged to CIP. CIP is valued at net realizable value. Any anticipated loss is booked for the full amount of the loss when it becomes measurable. Percentage-of- Completion Accounting

26. 26 Input measures: Cost-to-cost method where 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. Percentage-of- Completion Accounting

27. 27 Accounting for Long-Term Construction-Type Contracts Strong Construction Company was awarded a contract with a total price of $3,000,000. Strong expected to earn $400,000 profit on the contract.

28. 28 Accounting for Long-Term Construction-Type Contracts Actual Cost Incurred Estimated Cost to Complete Year Cost Percentage Total Cost 2004$1,040,000$1,560,000$2,600,00040 2005 910,000 Total$1,950,000650,0002,600,00075 2006 650,00002,600,000100 Total$2,600,000

29. 29 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. 20042004 Percentage-of- Completion Accounting$1,040,000$2,600,000 = 40%

30. 30 Cost of Long-Term Construction Contracts1,040,000 Construction in Progress160,000 Construction Contracts1,200,000 20042004 Percentage-of- Completion Accounting Actual Cost $3,000,000 x.40

31. 31 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. 20052005 Percentage-of- Completion Accounting

32. 32 Cost of Long-Term Construction Contracts910,000 Construction in Progress140,000 Revenue from Long-Term Construction Contracts1,050,000 20052005 Percentage-of- Completion Accounting ($3,000,000 x.75) – $1,200,000

33. 33 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. Cash1,350,000 Accounts Receivable1,350,000 To record cash collections. 20062006 Percentage-of- Completion Accounting

34. 34 Cost of Long-Term Construction Contracts650,000 Construction in Progress100,000 Revenue from Long-Term Construction Contracts750,000 20062006 $ 3,000,000 (1,200,000) (1,050,000) $ 750,000 Percentage-of- Completion Accounting

35. 35 Progress Billings on Construction Contracts3,000,000 Construction in Progress3,000,000 20062006 Percentage-of- Completion Accounting Construction in Progress 1,040,000 160,000 910,000 140,000 650,000 100,000 3,000,000 Progress Billings on Construction Contracts 1,000,000 900,000 1,100,000 3,000,000

36. 36 Revision of Estimates Instead of the previous illustration, assume that at the end of 2005, it was estimated that the remaining cost to complete construction was $720,000 rather than $650,000.

37. 37 Items in blue changed from the previous illustration. Revision of Estimates Actual Cost Incurred Estimated Cost to Complete Year Cost Percentage Total Cost 2004$1,040,000$1,560,000$2,600,00040 2005 910,000 Total$1,950,000720,0002,670,00073 2006 700,00002,650,000100 Total$2,650,000 Note that expected gross profit was $400,000 in 2004, $330,000 in 2005, and the actual was $350,000 in 2006.

38. 38 Revision of Estimates2004 The entries for 2004 would be the same as those shown in the previous example.

39. 39 Revision of Estimates2005 All entries for 2005 would be the same except for the entry to record revenue and cost.

40. 40 Revision of Estimates Cost of Long-Term Construction Contracts910,000 Construction in Progress80,000 Revenue from Long-term Construction Contracts990,000 20052005 ($3,000,000 x.73) – $1,200,000

41. 41 Revision of Estimates Construction in Progress700,000 Materials, Cash, etc.700,000 To record costs incurred. Accounts Receivable1,100,000 Progress Billings on Construction Contracts1,100,000 To record billings. Cash1,350,000 Accounts Receivable1,350,000 To record cash collections. 20062006 Same Same

42. 42 Revision of Estimates Cost of Long-Term Construction Contracts700,000 Construction in Progress110,000 Revenue from Long-Term Construction Contracts810,000 20062006 $3,000,000 (1,200,000) (990,000) $ 810,000

43. 4320062006 Construction in Progress 1,040,000 160,000 910,000 80,000 700,000 110,000 3,000,000 Progress Billings on Construction Contracts 1,000,000 900,000 1,100,000 3,000,000 Revision of Estimates Items in red are different for this illustration. Progress Billings on Construction Contracts3,000,000 Construction in Progress3,000,000

44. 44 Anticipated Loss: Percentage-of- Completion Method Assume the same facts for Strong Construction Company, except that after 2004 entries have been made, the firm determines that the total cost will be $3,250,000. The entries for 2004 would be the same, but the loss must be dealt with in 2005—in addition, the $160,000 gross profit recognized in 2004 must be eliminated.

45. 45 Anticipated Loss: Percentage-of- Completion Method Cost of Long-Term Construction Contracts910,000 Revenue from Long-Term Construction Contracts600,000 Construction in Progress410,000 20052005 To go from a $160,000 gross profit to an anticipated $250,000 loss ($3,000,000 – $3,250,000), the Construction in Progess account needs to be credited $410,000.

46. 46 Accounting for Long-Term Service Contracts Most service contracts involve three types of costs: (1)Initial direct costs related to obtaining and performing initial services on the contract. (2)Direct costs related to performing the various acts of service. (3)Indirect costs related to maintaining the organization to service the contract.

47. 47 Accounting for Long-Term Service Contracts Proportional Performance Method 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). Proportional Performance Method 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).

48. 48 Accounting for Long-Term Service Contracts Receipt of fees: Cash50,000 Deferred Course Revenue50,000 Liability account Initial direct costs: Deferred Initial Costs5,000 Cash5,000 Direct costs for lesson actually completed: Contract Costs12,000 Cash12,000 Expense account Asset account ContinuedContinued

49. 49 Accounting for Long-Term Service Contracts Course revenue recognized: Deferred Course Revenue20,000 Recognized Course Revenue20,000 Recognize contract costs from initial direct costs: Contract Costs2,000 Deferred Initial costs2,000 $24,000$60,000 x $50,000 $24,000$60,000 x $5,000

50. 50 Revenue Recognition After Delivery of Goods or Providing Service Installment Sales Method: Recognizes revenues and related expenses as cash is received (used when collection is somewhat uncertain). Cost Recovery Method: No income is recognized on sale until the cost of the item sold is recovered through cash receipts (used when collection is very uncertain). Cash Method: Recognizes all expenses immediately as incurred and all revenues only when cash is collected.

51. 51 Full Accrual At point of sale Revenue at point of sale Installment Sales At collection of cash (portion of receipt) Defer and match against revenue as cash is collected Cost Recovery At collection of cash (after all costs have been recovered) Defer and match against cash receipts Cash At collection of cashCharge to expense as incurred Method Timing of Revenue Recognition Treatment of Costs Revenue Recognition After Delivery of Goods or Providing Service

52. 52 Installment Sales Method The installment sales method is used most commonly in cases of real estate sales.

53. 53 Installment Sales Method George sells merchandise on the installment basis. Uncertainty of collection makes use of the installment method necessary. Use the accompanying data to prepare George’s journal entries.

54. 54 Sales Cost of Sales Gross Profit Percentage 2004 2005 $150,000$200,000 100,000 140,000 $ 50,000$ 60,000 33.33% 30% Cash Collection 2004 Sales $ 30,000 $ 75,000 2005 Sales $ 70,000 Installment Sales Method

55. 55 Installment Accounts Receivable— 2004150,000 Installment Sales 150,000 Cost of Installment Sales100,000 Inventory 100,000 Cash 30,000 Installment Accounts Receivable—2004 30,000 Installment Sales Method 2004 ContinuedContinued

56. 56 Installment Sales150,000 Cost of Installment Sales 100,000 Deferred Gross Profit—200450,000 Deferred Gross Profit—2004 10,000 Realized Gross Profit on Installment Sales 10,000 Installment Sales Method 2004 $30,000 x 33.33% ContinuedContinued

57. 57 Installment Sales Method Installment Accounts Receivable— 2005200,000 Installment Sales 200,000 Cost of Installment Sales140,000 Inventory 140,000 Cash 145,000 Installment A/R—2004 75,000 Installment A/R—200570,000 2005 ContinuedContinued

58. 58 Installment Sales Method Installment Sales200,000 Cost of Installment Sales 140,000 Deferred Gross Profit—200560,000 Deferred Gross Profit—2004 25,000 Deferred Gross Profit—200521,000 Realized Gross Profit on Installment Sales 46,000 2005 $75,000 x 33.33% $70,000 x 30%

59. 59 Cost Recovery Method Assume George has to use the cost recovery method, but all sales and collections remain the same. Cost Recovered Cost Revenue

60. 60 2005 All entries are the same except do not book the entry to gross profit. Deferred Gross Profit—20045,000 Realized Gross Profit on Installment Sales5,000 Cost Recovery Method

61. 61 2006 Deferred Gross Profit—200430,000 Deferred Gross Profit—200510,000 Realized Gross Profit on Installment Sales40,000 Cost Recovery Method

62. 62 If the probability of recovering product or service costs is remote the cost recovery method of accounting can be used. There has to be considerable uncertainty as to ultimate collection of the contract price. Cash Method

63. 63 The End chapter 8

64. 64