1. 1 Income Recognition and Measurement of Net Assets C hapter 17 An electronic presentation by Douglas Cloud Pepperdine University An electronic presentation by Douglas Cloud Pepperdine University

2. 2 1. Understand the revenue recognition alternatives. 2. Explain revenue recognition at the time of sale, during production, and at time of cash receipt. 3. Explain the conceptual issues regarding revenue recognition alternatives. Objectives ContinuedContinued

3. 3 4. Describe the alternative revenue recognition methods. 5.Account for revenue recognition prior to the period of sale, including the percentage-of-completion and completed contract methods. Objectives ContinuedContinued

4. 4 6.Account for revenue recognition after the period of sale, including the installment and cost recovery methods. 7.Account for revenue recognition delayed until a future event occurs. 8.Understand software revenue recognition, franchises, real estate sales, retail land sales, and consignment sales. Objectives

5. 5 Revenue Recognition Recognition is the process of formally recording and reporting items in the financial statements.

6. 6 Revenue Recognition Realization is the process of converting noncash recourses into cash or rights to cash.

7. 7 Revenue Recognition Example 1: Revenue Recognition at Time of Sale 1.Ringwood Company manufactures the inventory. Inventory100 Cash100 2.Ringwood sells the inventory for $150. Accounts Receivable150 Revenue150 Cost of Goods Sold100 Inventory100 ContinuedContinued

8. 8 Revenue Recognition Example 1: Revenue Recognition at Time of Sale 3.Ringwood collects cash of $60. Cash60 Accounts Receivable60 Income Statement Revenue$150 Cost of goods sold(100) Gross profit$ 50

9. 9 Revenue Recognition Example 2: Revenue Recognition During Production 1.Ringwood Company manufactures the inventory. Inventory100 Cash100 2.Ringwood recognizes the revenue during production. Production Expense100 Inventory50 Revenue150 ContinuedContinued

10. 10 Revenue Recognition Example 2: Revenue Recognition During Production 3.The company bills the customer for a partial billing of $130. Accounts Receivable130 Partial Billings130 4.Ringwood collects cash of $60. Cash60 Accounts Receivable60

11. 11 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.

12. 12 Revenue Recognition Example 3: Revenue Recognition at Time of Cash Receipt 1.Ringwood Company manufactures the inventory. Inventory100 Cash100 2.Ringwood “sells” the inventory and defers the recognition of revenue. Accounts Receivable150 Inventory100 Deferred Gross Profit50 ContinuedContinued

13. 13 Example 3: Revenue Recognition at Time of Cash Receipt 3.Ringwood collects cash of $60. Cash60 Accounts Receivable60 4.The company recognizes revenue on the basis of the cash received. Cost of Goods Sold40 Deferred Gross Profit20 Revenue60 Revenue Recognition ($60 ÷ $150) x $100 Cash Receive d ContinuedContinued

14. 14 Example 3: Revenue Recognition at Time of Cash Receipt Revenue Recognition 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.

15. 15 Conceptual Issues The economic substance of the event takes precedence over the legal form of the transaction. The risks and benefits of ownership have been transferred to the buyer. The collectibility of the receivable from the sale is reasonably assured. The economic substance of the event takes precedence over the legal form of the transaction. The risks and benefits of ownership have been transferred to the buyer. The collectibility of the receivable from the sale is reasonably assured. The decision as to when to recognize revenue focuses on three factors:

16. 16 Alternative Revenue Recognition Methods 1.Revenue recognition in the period of sale. 2.Revenue recognition prior to the period of sale. 3.Revenue recognition at the completion of production. 4.Revenue recognition after the period of sale. 5.Revenue recognition delayed until a future event.

17. 17 Earned and Realizable Economic Substance and Transfer of Risks and Benefits of Ownership Collectibility is Not Reasonably Assured Installment Method Cost Recovery Method Percentage-of- Completion Method (for Long-Term Contracts) Completed- Contract Method (for Long-Term Contracts) Accrual Method: “Normal” Revenue Recognition at Sale Not Sufficient Transfer of Risks and Benefits of Ownership Deposit Method Recognition before Physical Transfer Recognition at Physical Transfer Collectibility is Reasonably Assured Revenue Recognized

18. 18 Revenue Recognition Prior to the Period of Sale Percentage-of-Completion Method  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.

19. 19 Percentage-of-Completion Method AICPA Statement of Position No. 81-1 requires that a construction company use the percentage-of- completion method for long-term contracts when all the following conditions are met:

20. 20 1.The company can make reasonably dependable estimates of the extent of progress toward completion, contract revenue, and contract costs. 2.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. 3.The buyer can be expected to satisfy its obligations under the contract. 4.The company expects to perform its contractual obligations. Percentage-of-Completion Method

21. 21 Percentage-of-Completion Method The Statement also requires that a company use the completed-contract method only when at least one of these conditions is not met... …for 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.

22. 22 Percentage-of-Completion Method 2004 2005 2006 Construction costs incurred during the year$100,000$186,000$314,000 Estimated costs to complete the contract400,000264,000 --- Partial billing to customer80,000350,000270,000 Collections from customer50,000330,000320,000 Total contract price: $700,000 Example ContinuedContinued

23. 23 Percentage-of-Completion Method 1.To record construction costs: Construction in Progress100,000 Accounts Payable, etc.100,000 2. To record partial billings: Accounts Receivable80,000 Partial Billings80,000 2004 3.To record collections: Cash50,000 Accounts Receivable50,000 ContinuedContinued

24. 24 Percentage-of-Completion Method 4.To record gross profit: Construction Expense100,000 Construction in Progress40,000 Construction Revenue140,000 2004 ($100,000 ÷ $500,000) x $700,000 ContinuedContinued

25. 25 Percentage-of-Completion Method 1.To record construction costs: Construction in Progress186,000 Accounts Payable, etc.186,000 2. To record partial billings: Accounts Receivable350,000 Partial Billings350,000 2005 3.To record collections: Cash330,000 Accounts Receivable330,000 ContinuedContinued

26. 26 Percentage-of-Completion Method 4.To record gross profit: Construction Expense186,000 Construction in Progress38,000 Construction Revenue224,000 2005 [($286,000 ÷ $550,000) x $700,000] – $140,000 Construction costs incurred to date Revised cost = $286,000 + $264,000 Previous year’s construction revenue ContinuedContinued

27. 27 Percentage-of-Completion Method 1.To record construction costs: Construction in Progress314,000 Accounts Payable, etc.314,000 2. To record partial billings: Accounts Receivable270,000 Partial Billings270,000 2006 3.To record collections: Cash320,000 Accounts Receivable320,000 ContinuedContinued

28. 28 Percentage-of-Completion Method 4.To record gross profit and close out accounts: Construction Expense314,000 Construction in Progress22,000 Construction Revenue336,000 2006 $700,000 – $140,000 – $224,000 Recognized in 2004 Recognized in 2005 Partial Billings700,000 Construction in Progress700,000

29. 29 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 2006. ContinuedContinued

30. 30 4.To record gross profit and close out accounts: Partial Billings700,000 Construction Revenue700,000 2006 Completed-Contract Method Construction Expense600,000 Construction in Progress600,000 $100,000 + $186,000 + $314,000

31. 31 Capitalized Interest If interest cost is associated with the funds used in the construction, the firm should include this cost in the Construction in Process account.

32. 32 Installment sales involve a financing agreement whereby the customer signs a contract,... Installment Method...makes a small down payment,... …and agrees to make periodic payments over an extended period, often several years.

33. 33 1.Total sales, cost of goods sold, and collections are recorded in the normal manner during the year. 2.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. 3.At the end of the year, the gross profit rate on installment sales is computed. Installment Method ContinuedContinued

34. 34 4. A portion of the deferred gross profit is recognized as gross profit. 5.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. Installment Method

35. 35 Installment Method Consider the following information for Lee for 2004: Total credit sales$500,000 Total cost of goods sold390,000 Installment method sales100,000 Installment method cost of goods sold75,000 Gross profit rate on installment method sales25% Cash receipts on installment method sales20,000 Cash receipts on other credit sales300,000 Lee Company uses a perpetual inventory method. ContinuedContinued

36. 36 Installment Method Accounts Receivable500,000 Sales500,000 Cost of Goods Sold390,000 Inventory390,000 Credit sales during 2004: Cash320,000 Accounts Receivable320,000 Collected $300,000; $20,000 related to installment sales: ContinuedContinued

37. 37 Installment Method Sales100,000 Cost of Goods Sold75,000 Deferred Gross Profit, 200425,000 Installment sales and related cost of goods sold identified and “reversed” on December 31, 2004: Deferred Gross Profit, 20045,000 Gross Profit Realized on Installment Method Sales5,000 Recognized a gross profit of 25% of cash collected on installment sales on December 31, 2004: ContinuedContinued

38. 38 Installment Method Consider the following information for Lee for 2005: Total credit sales$600,000 Total cost of goods sold430,000 Installment method sales150,000 Installment method cost of goods sold105,000 Gross profit rate on installment method sales30% Cash receipts on installment method sales: 2004 sales30,000 2005 sales40,000 Cash receipts on other credit sales480,000 ContinuedContinued

39. 39 Installment Method Accounts Receivable600,000 Sales600,000 Cost of Goods Sold430,000 Inventory430,000 Credit sales during 2005: Cash550,000 Accounts Receivable550,000 Collected $550,000; $70,000 related to installment sales: ContinuedContinued

40. 40 Installment Method Sales150,000 Cost of Goods Sold105,000 Deferred Gross Profit, 200545,000 Installment sales and related cost of goods sold identified and “reversed on December 31, 2005: ContinuedContinued

41. 41 Installment Method Deferred Gross Profit, 20047,500 Deferred Gross Profit, 200512,000 Gross Profit Realized on Installment Method Sales19,500 On December 31, 2005, recognized a gross profit of 25% of cash collected on installment sales for 2004 and 30% for 2005:

42. 42 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.

43. 43 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: 20045,000 20059,000 20066,000 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: 20045,000 20059,000 20066,000

44. 44 Accounts Receivable20,000 Deferred Gross Profit8,000 Property (net)12,000 During 2004 Cash5,000 Accounts Receivable5,000 Collected $5,000 ContinuedContinued Cost Recovery Method

45. 45 Cash9,000 Accounts Receivable9,000 During 2005 Deferred Gross Profit2,000 Gross Profit Realized on Cost Recovery Transactions2,000 December 31, 2005 ContinuedContinued Cost Recovery Method ($5,000 + $9,000) minus property cost of $12,000

46. 46 Cash6,000 Accounts Receivable6,000 During 2006 Deferred Gross Profit6,000 Gross Profit Realized on Cost Recovery Transactions6,000 December 31, 2006 Cost Recovery Method The cash collected in 2006 results in the recognition of an equal amount of gross profit.

47. 47 Revenue Recognition Delayed Until 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.

48. 48 Revenue Recognition Delayed Until a Future Event Occurs (Deposit Method) Cash500,000 Deposit from Purchaser500,000 Upon receipt of down payment (Oscar Company): Interest Receivable650,000 Note Receivable6,500,000 Deposit from Purchaser500,000 Interest Revenue650,000 Gain2,000,000 Net Assets of Subsidiary5,000,000 When circumstances allow the revenue to be recognized: liability 10% x $6,500,000 $7,000,000 – $5,000,000

49. 49 Software Revenue Recognition 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. Guidelines of AICPA Statement of Position No. 97-2

50. 50 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. Software Revenue Recognition Guidelines of AICPA Statement of Position No. 97-2

51. 51 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. Software Revenue Recognition Guidelines of AICPA Statement of Position No. 97-2

52. 52 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. Software Revenue Recognition Guidelines of AICPA Statement of Position No. 97-2

53. 53 A company must allocate any discounts proportionately to all the elements, except that none can be allocated to upgrade rights. Software Revenue Recognition Guidelines of AICPA Statement of Position No. 97-2

54. 54 Franchise A franchise agreement involves the granting of business rights by the franchisor to a franchisee who will operate the franchised business.

55. 55 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.

56. 56 Situation 1: Castle has substantially performed all material services, the refund period has expired, and the collectibility of the note is reasonably assured. Franchise Cash20,000 Notes Receivable50,000 Franchise Revenue70,000 ContinueContinue

57. 57 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. Franchise Cash20,000 Notes Receivable50,000 Unearned Franchise Fees70,000 Castle will recognize the unearned franchise fees as revenue when it has performed all material services. ContinueContinue

58. 58 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. Franchise Cash20,000 Notes Receivable50,000 Unearned Franchise Fees70,000 Castle will recognize the unearned franchise fees as revenue when the refund period expires. ContinueContinue

59. 59 Each year revenue of $10,000 is recognized as cash is collected. 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. Franchise Cash20,000 Notes Receivable50,000 Unearned Franchise Fees50,000 Franchise Revenue20,000 ContinueContinue

60. 60 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. Franchise Cash20,000 Unearned Franchise Fees20,000 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). ContinueContinue

61. 61 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. Franchise Cash20,000 Notes Receivable50,000 Franchise Revenue30,000 Unearned Franchise Fees40,000 Castle recognizes the unearned franchise fees as revenue when it performs the continuing services.

62. 62 Retail Estate Sales 1.If the sale is not consummated, the deposit method is used. 2.If the buyer’s initial and continuing investment is not adequate, the installment method is used if the recovery of the cost of the property is reasonably assumed FASB Statement No. 66 states that the selling company recognizes revenue and the related expenses in the period of the sale on the accrual basis if all of the following conditions are met: ContinuedContinued

63. 63 3.If the seller’s receivable is subject to future subordination, the cost recovery method is used. 4.If the seller has continuing involvement with the property and does not transfer substantially all the risks and benefits of ownership, generally revenue and related expenses are recognized at the time of sale with a deduction for the maximum exposure to loss. Retail Estate Sales

64. 64 Consignment Sales 1.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. 2.The consignor recognizes revenue only when the sale to the third party occurs. 3.The consignee uses a Consignment-in account. 4.The consignor uses a Consignment-out account, which is a special inventory account. 1.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. 2.The consignor recognizes revenue only when the sale to the third party occurs. 3.The consignee uses a Consignment-in account. 4.The consignor uses a Consignment-out account, which is a special inventory account. Accounting for consignments may be summarized--

65. 65 C hapter 17 The End

66. 66