1. Income Recognition and Measurement of Assets18
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Income Recognition and Measurement of Assets
Intermediate Accounting 10th edition
Nikolai Bazley Jones
An electronic presentation
by Norman Sunderman
Angelo State University
COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

2. Revenue Recognition
Recognition is the process of formally recording and reporting items in the financial statements.

3. Revenue Recognition
Realization is the process of converting noncash recourses into cash or rights to cash.

4. Revenue Recognition Example 1: Revenue Recognition at Time of Sale
1. Ringwood Company manufactures the inventory.
Inventory 100
Cash 100
2. Ringwood sells the inventory for $150.
Accounts Receivable 150
Revenue 150
Cost of Goods Sold 100
Inventory 100

5. Revenue Recognition Example 1: Revenue Recognition at Time of Sale
3. Ringwood collects cash of $60.
Cash 60
Accounts Receivable 60
Income Statement
Revenue $150
Cost of goods sold (100)
Gross profit $ 50

6. Revenue Recognition Example 2: Revenue Recognition During Production
1. Ringwood Company manufactures the inventory.
Inventory 100
Cash 100
2. Ringwood recognizes the revenue during production (the manufacturing process).
Production Expense 100
Inventory 50
Revenue 150

7. Revenue Recognition Example 2: Revenue Recognition During Production
3. The company bills the customer for a partial billing of $130.
Accounts Receivable 130
Partial Billings 130
4. Ringwood collects cash of $60.
Cash 60
Accounts Receivable 60

8. Revenue Recognition Example 2: Revenue Recognition During Production
Income Statement
Revenue $150
Production expense (100)
Gross profit $ 50
The balance sheet shows Inventory of $150, less Partial Billings of $130.

9. Revenue Recognition 1. Ringwood Company manufactures the inventory.
Example 3: Revenue Recognition at Time of Cash Receipt
1. Ringwood Company manufactures the inventory.
Inventory 100
Cash 100
2. Ringwood “sells” the inventory and defers the recognition of revenue.
Accounts Receivable 150
Inventory 100
Deferred Gross Profit 50

10. Revenue Recognition 3. Ringwood collects cash of $60. Cash 60
Example 3: Revenue Recognition at Time of Cash Receipt
3. Ringwood collects cash of $60.
Cash 60
Accounts Receivable 60
($60 ÷ $150) x $100
4. The company recognizes revenue on the basis of the cash received.
Cost of Goods Sold 40
Deferred Gross Profit 20
Revenue 60
($60 ÷ $150) x $100
Cash Received

11. Revenue Recognition Income Statement Revenue $ 60
Example 3: Revenue Recognition at Time of Cash Receipt
Income Statement
Revenue $ 60
Cost of goods sold (40)
Gross profit $ 20
The balance sheet shows Accounts Receivable of $90, less Deferred Gross Profit of $30.

12. Alternative Revenue Recognition Methods
Revenue recognition in the period of sale.
Revenue recognition prior to the period of sale.
Revenue recognition at the completion of production.
Revenue recognition after the period of sale.
Revenue recognition delayed until a future event.

13. Revenue Recognized Earned and Realizable
Not Sufficient Transfer of Risks and Benefits of Ownership
Deposit Method
Collectibility is Not Reasonably Assured
Installment Method
Cost Recovery Method
Economic Substance and Transfer of Risks and Benefits of Ownership
Collectibility is Reasonably Assured
Recognition before Physical Transfer
Recognition at Physical Transfer
Percentage-of-Completion Method (for Long-Term Contracts)
Completed-Contract Method (for Long-Term Contracts)
Accrual Method: “Normal” Revenue Recognition at Sale

14. Revenue Recognition Prior to the Period of Sale
Percentage-of-Completion Method
Advantages
It achieves the goals of accrual accounting.
It is consistent with the argument that revenue is earned continuously over the entire earning process.
It results in a more relevant measure of periodic income.

15. Percentage of Completion Method
AICPA Statement of Position No requires that a construction company use the percentage-of-completion method for long-term contracts when all the following conditions are met:

16. Percentage of Completion Method
The company can make reasonably dependable estimates of the extent of progress toward completion, contract revenue, and contract costs.
The contract clearly specifies the enforceable rights regarding goods or services to be provided and received by both the company and the buyer, the consideration to be exchanged, and the manner and terms of settlement.
The buyer can be expected to satisfy its obligations under the contract.
The company expects to perform its contractual obligations.

17. Percentage of Completion Method
…for a short-term contract, and when there are inherent hazards in the contract beyond the normal business risks for which reasonably dependable estimates cannot be made.
The Statement also requires that a company use the completed-contract method only when at least one of these conditions is not met...

18. Completed Contract Method
Entries 1, 2, and 3 are the same as those used for the percentage-of-completion method. The completed-contract method does not recognize revenue until the project is completed, so there is no Entry 4 until 2009.

19. Capitalized Interest
If interest cost is associated with the funds used in the construction, the firm should include this cost in the Construction in Progress account.

20. Proportional Performance Contracts
Used to recognize service revenue earned by performing more than one act if services are to be rendered in more than one accounting period.
Types of service transactions
Similar performance acts-recognize an equal amount of revenue for each act
Dissimilar performance acts-recognize revenue in proportion to direct costs to perform each act.
Similar acts with a fixed period for performance-recognize revenue using straight-line method

21. Proportional Performance Contracts
Revenue allocate using percentage of direct costs
Initial direct costs allocate using percentage of direct costs
Direct costs expense as incurred
Indirect costs expense as incurred

22. ...makes a small down payment,...
Installment Method
Installment sales involve a financing agreement whereby the customer signs a contract,...
...makes a small down payment,...

23. Installment Method
…and agrees to make periodic payments over an extended period, often several years.

24. Revenue Recognized at Collection
Two methods employed to defer revenue recognition until cash is received are the installment sales method and the cost recovery method. These methods are used only when the point-of-sale or other GAAP revenue recognition methods are not appropriate.
These methods may be used only when there is uncertainty about whether the sales price will be collected and when an allowance for bad debts cannot be reasonably estimated.

25. Installment Method
Total sales, cost of goods sold, and collections are recorded in the normal manner during the year.
At the end of the year, installment sales are identified. The revenue and the related cost of goods sold are “reversed,” and the deferred gross profit is recognized.
At the end of the year, the gross profit rate on installment sales is computed.
Continued

26. Installment Method
A portion of the deferred gross profit is recognized as gross profit.
In future years the remaining deferred gross profit is reduced and the gross profit is recognized based on the cash collected on the installment sales.

27. Installment Method Total credit sales $500,000
Consider the following information for Lee for 2007:
Total credit sales $500,000
Total cost of goods sold 390,000
Installment method sales 100,000
Installment method cost of goods sold 75,000
Gross profit rate on installment method sales 25%
Cash receipts on installment method sales 20,000
Cash receipts on other credit sales 300,000
Lee Company uses a perpetual inventory method.

28. Installment Method Accounts Receivable 500,000 Sales 500,000
Credit sales during the year 2007:
Accounts Receivable 500,000
Sales 500,000
Cost of Goods Sold 390,000
Inventory 390,000
Collected $300,000; $20,000 related to installment sales:
Cash 320,000
Accounts Receivable 320,000
Continued

29. Installment Method
Installment sales and related cost of goods sold identified and “reversed” on December 31, 2007:
Sales (closed) 100,000
Cost of Goods Sold (closed) 75,000
Deferred Gross Profit, ,000
Recognized a gross profit of 25% of cash collected on installment sales December 31, 2007 :
Deferred Gross Profit, ,000
Gross Profit Realized on Installment
Method Sales 5,000

30. Consider the following information for Lee for 2008:
Installment Method
Consider the following information for Lee for 2008:
Total credit sales $600,000
Total cost of goods sold 430,000
Installment method sales 150,000
Installment method cost of goods sold 105,000
Gross profit rate on installment method sales 30%
Cash receipts on installment method sales:
2007 sales 30,000
2008 sales 40,000
Cash receipts on other credit sales 480,000

31. Installment Method Accounts Receivable 600,000 Sales 600,000
Credit sales 2008:
Accounts Receivable 600,000
Sales 600,000
Cost of Goods Sold 430,000
Inventory 430,000
Collected $550,000; $70,000 related to installment sales:
Cash 550,000
Accounts Receivable 550,000
Continued

32. Installment Method
Installment sales and related cost of goods sold identified and “reversed” on December 31, 2008:
Sales 150,000
Cost of Goods Sold 105,000
Deferred Gross Profit, ,000
Continued

33. Installment Method Deferred Gross Profit, 2007 7,500
On December 31, 2008, recognized a gross profit of 25% of cash collected on installment sales for 2007 and 30% for 2008:
Deferred Gross Profit, ,500
Deferred Gross Profit, ,000
Gross Profit Realized on Installment
Method Sales 19,500

34. Cost Recovery Method
APB Opinion No. 10 found the cost recovery method of recognizing revenue generally to be unacceptable. However, the Board did agree that this method could be used in exceptional cases where receivables are collected over an extended period and where the terms of the transaction provide no reasonable basis for estimating the degree of collectibility.

35. Cost Recovery Method
Consider the following information for the Parken Company:
Sale of property under cost recovery
method $20,000
Cost of property sold (net) 12,000
Cash collections:
2007 5,000
2008 9,000
2009 6,000

36. Cost Recovery Method During 2007 Accounts Receivable 20,000
Deferred Gross Profit 8,000
Property (net) 12,000
Collected $5,000
Cash 5,000
Accounts Receivable 5,000
Continued

37. ($5,000 + $9,000) minus property cost of $12,000
Cost Recovery Method
During 2008
Cash 9,000
Accounts Receivable 9,000
December 31, 2008
Deferred Gross Profit 2,000
Gross Profit Realized on Cost
Recovery Transactions 2,000
($5,000 + $9,000) minus property cost of $12,000
Continued

38. Cost Recovery Method During 2009 Cash 6,000 Accounts Receivable 6,000
December 31, 2009
Deferred Gross Profit 6,000
Gross Profit Realized on Cost
Recovery Transactions 6,000
The cash collected in 2009 results in the recognition of an equal amount of gross profit.

39. Revenue Recognition Delayed a Future Event Occurs (Deposit Method)
Oscar Company sells a subsidiary to the Pet Company and accepts a $500,000 down payment and a 10% note for the balance of the sale of $7 million. The net assets of the subsidiary are $5 million and Pet Company has the right to cancel the agreement for the next year.

40. Revenue Recognition Delayed a Future Event Occurs (Deposit Method)
liability
Upon receipt of down payment (Oscar Company):
Cash 500,000
Deposit from Purchaser 500,000
When circumstances allow the revenue to be recognized:
Interest Receivable 650,000
Note Receivable 6,500,000
Deposit from Purchaser 500,000
Interest Revenue 650,000
Gain 2,000,000
Net Assets of Subsidiary 5,000,000
10% x $6,500,000

41. Software Revenue Recognition
Guidelines of AICPA Statement of Position No. 97-2
If a company has an agreement to deliver software that requires significant production, modification, or customization of software, it uses contract accounting for the agreement.

42. Software Revenue Recognition
Guidelines of AICPA Statement of Position No. 97-2
If a company has an agreement to deliver software that does not require significant production, modification, or customization of software, it recognizes revenue when (a) persuasive evidence of an agreement exists, (b) delivery has occurred, (c) the seller’s fee is fixed or determinable, and (d) collectibility is probable.

43. Software Revenue Recognition
Guidelines of AICPA Statement of Position No. 97-2
A company separately accounts for a service element if (a) the services are not essential to the functionality of any other element of the transaction, and (b) the services are stated separately in the contract such that the total price of the agreement would be expected to vary as the result of inclusion or exclusion of the service.

44. Software Revenue Recognition
Guidelines of AICPA Statement of Position No. 97-2
Software arrangements may consist of multiple elements such as additional software products, upgrades and/or enhancements, rights to exchange or return software, and customer support. If contract accounting does not apply, a company must allocate its fee to the various elements based on fair values.

45. Software Revenue Recognition
Guidelines of AICPA Statement of Position No. 97-2
A company must allocate any discounts proportionately to all the elements, except that none can be allocated to upgrade rights.

46. Franchise
A franchise agreement involves the granting of business rights by the franchisor to a franchisee who will operate the franchised business.

47. Franchise
A franchise agreement involves the granting of business rights by the franchisor to a franchisee who will operate the franchised business.

48. Franchise
Castle Company sells a franchise that requires an initial franchise fee of $70,000. A down payment of $20,000 cash is required, with the balance covered by the issuance of a $50,000, 10% note, payable by the franchisee in five equal annual installments.

49. Franchise
Situation 1: Castle has substantially performed all material services, the refund period has expired, and the collectibility of the note is reasonably assured.
Cash 20,000
Notes Receivable 50,000 Franchise Revenue 70,000

50. Franchise
Situation 2: The refund period has expired and the collectibility of the note is reasonably assured, but Castle has not substantially performed all material services.
Cash 20,000
Notes Receivable 50,000 Unearned Franchise Fees 70,000
Castle will recognize the unearned franchise fees as revenue when it has performed all material services.

51. Franchise
Situation 3: Castle has substantially performed all material services and the collectibility of the note is reasonably assured, but the refund period has not expired.
Cash 20,000
Notes Receivable 50,000 Unearned Franchise Fees 70,000
Castle will recognize the unearned franchise fees as revenue when the refund period expires.

52. Each year revenue of $10,000 is recognized as cash is collected.
Franchise
Situation 4: Castle has substantially performed all material services and the refund period has expired, but the collectibility of the note is not reasonably assured.
Cash 20,000
Notes Receivable 50,000 Unearned Franchise Fees 50,000
Franchise Revenue 20,000
Each year revenue of $10,000 is recognized as cash is collected.

53. Franchise
Situation 5: The refund period has expired, but Castle has not substantially performed all material services and there is no basis for estimating the collectibility of the note.
Cash 20,000
Unearned Franchise Fees 20,000
Castle recognizes revenue either under the accrual method (if collectibility is reasonably assured) or the installment method (if it has no basis for estimating the collectibility of the note).

54. Franchise
Situation 6: Castle has earned only $30,000 from providing initial services, with the balance being a down payment for continuing services. The refund period has expired and collectibility of the note is reasonably assured.
Cash 20,000
Notes Receivable 50,000
Franchise Revenue 30,000
Unearned Franchise Fees 40,000
Castle recognizes the unearned franchise fees as revenue when it performs the continuing services.

55. Continuing Franchise Fee
Assume that Castle also charges a continuing franchise fee of $9,000 per year.
Fee is earned by providing services
Cash 9,000
Continuing Franchise Fee Revenue 9,000
$1,000 of the fee is for National Advertising
Continuing Franchise Fee Revenue 8,000
Unearned Franchise Fees 1,000

56. Consignment Sales Accounting for consignments may be summarized--
Since title remains with the consignor, when the goods are transferred from the consignor to the consignee, the consignor does not record the sale of inventory.
The consignor recognizes revenue only when the sale to the third party occurs.
The consignee uses a Consignment-in account.
The consignor uses a Consignment-out account, which is a special inventory account.

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