Guidelines for Revenue Recognition

1
Guidelines for Revenue Recognition

• The revenue recognition principle provides that
  revenue is recognized
• when it is earned, and
• when it is realized or realizable
• Revenue is earned when the earnings process is
  substantially complete.
• Revenue is realized when goods and services are
  exchanged for cash or claims to cash.
• Revenue is realizable when assets received in
  exchange are readily convertible to cash or known
  amounts of cash.

2
Four Types of Revenue Transactions

• Revenue from selling products is recognized at
  the date of sale (date of delivery)
• Revenue from services is recognized when services
  are performed and are billable
• Revenue from the use of enterprises assets by
  others is recognized as time passes or as the
  assets are used up
• Revenue from disposal of assets is recognized
  at the point of sale

3
Revenue Recognition at Point of Sale

• Revenues from manufacturing and selling are
  commonly recognized at point of sale.
• Revenues from sales with buyback agreements are
  not recognized (not sales)
• Revenues from sales where rights of return exist
  are recognized if six conditions are met.
• Trade loading and channel surfing are practices
  that need to be discouraged.

4
Sales with right of return

• Seller may recognize revenue at the date of sale
  if all 6 criteria are met
• Sellers price is fixed and determinable.
• Buyer has paid or buyers obligation is not
  contingent on resale of the product
• Buyers obligation would not be changed upon
  theft, destruction, or damage
• Buyer has economic substance apart from that
  provided by seller
• Seller does not have significant obligations for
  future performance
• Amount of future returns can be reasonably
  estimated

5
Revenue Recognition before Delivery

• Revenue may be recognized before delivery under
  certain circumstances.
• Long term construction contracts (percentage
  completion method) are a notable example.
• The completed contract method is used only when
  the percentage method is inapplicable

6
Percentage Completion Steps
Costs incurred to date Percent
complete Most recent estimated total
costs Estimated total revenue Percent
complete
Revenue to be recognized to date Total revenue
to be recognized to date less revenue
recognized in PRIOR periods Current period
revenue Current Period Revenue less current
costs Gross Profit
7
Percentage Completion Example

• Data Contract price 4,500,000 Estimated
  cost 4,000,000
• Start date July, 2003 Finish
  October, 2005
• Balance sheet date Dec 31.
• Given (000s) 2003 2004
  2005
• Costs to date 1,000 2,916
  4,050
• Estimated costs to complete 3,000 1,134
  -0-
• Progress Billings during year 900
  2,400 1,200
• Cash collected during year 750
  1,750 2,000

8
Percentage Completion Example

• 2003 2004 2005
• complete
• costs to date 1,000 2,916 4,050
• estimated total 4,000 4,050 4,050
• 25 72 100
• Revenue recognized
• total 1,125 3,240 4,500
• previously 0 1,125 3,240
• this year 1,125 2,115 1,260

9
Journal Entries

• Percentage of completion (2003)
• Construction in process 1,000
• Cash, payables, etc. 1,000
• Accounts receivable 900
• Billings 900
• Cash 750
• Accounts receivable 750
• Construction in process 125
• Cost of goods sold 1,000
• Revenues 1,125

10
Journal Entries

• Percentage of completion (2004)
• Construction in process 1,916
• Cash, payables, etc. 1,916
• Accounts receivable 2,400
• Billings 2,400
• Cash 1,750
• Accounts receivable 1,750
• Construction in process 199
• Cost of goods sold 1,916
• Revenues 2,115

11
Journal Entries

• Percentage of completion (2005)
• Construction in process 1,134
• Cash, payables, etc. 1,134
• Accounts receivable 1,200
• Billings 1,200
• Cash 2,000
• Accounts receivable 2,000
• Construction in process 126
• Cost of goods sold 1,134
• Revenues 1,260

12
Journal Entries

• Percentage of completion (2005)
• Billings 4,500
• Construction in process 4,500

13
Journal Entries

• Completed contract (2003)
• Construction in process 1,000
• Cash, payables, etc. 1,000
• Accounts receivable 900
• Billings 900
• Cash 750
• Accounts receivable 750

14
Journal Entries

• Completed contract (2004)
• Construction in process 1,916
• Cash, payables, etc. 1,916
• Accounts receivable 2,400
• Billings 2,400
• Cash 1,750
• Accounts receivable 1,750

15
Journal Entries

• Percentage of completion (2005)
• Construction in process 1,134
• Cash, payables, etc. 1,134
• Accounts receivable 1,200
• Billings 1,200
• Cash 2,000
• Accounts receivable 2,000
• Construction in process 450
• Cost of goods sold 4,050
• Revenues 4,500

16
Journal Entries

• Completed contract (2005)
• Billings 4,500
• Construction in process 4,500

17
Recap income statement

• 2003 2004 2005 Total
• Pct. of completion
• Revenue 1,125 2,115 1,260 4,500
• CGS 1,000 1,916 1,134 4,050
• Gross profit 125 199 126 450
• Completed contract
• Revenue -0- -0- 4,500 4,500
• CGS -0- -0- 4,050 4,050
• Gross profit -0- -0- 450 450

18
Recap - balance sheet

• 2003 2004 2005
• Pct. of completion
• CIP 1,125 3,240 -0-
• Billings 900 3,300 -0-
• Net asset (liab.) 225 ( 60) -0-
• Completed contract
• CIP 1,000 2,916 -0-
• Billings 900 3,300 -0-
• Net asset (liab.) 100 (384) -0-

19
Losses on long-term contracts

• A long term contract may produce
• either an interim loss and an overall profit,
• or an overall loss for the project
• Under the percentage completion method, losses in
  any case are immediately recognized.
• Under the completed contract method, losses are
  recognized immediately only when overall losses
  result.

20
Revenue Recognition after Delivery

• Revenue recognition is deferred when collection
  of sales price is not reasonably assured
• The two methods that are used are
• the installment sales method
• the cost recovery method
• If cash is received prior to delivery, the method
  used is the deposit method.

21
Installment sales method

• This method emphasizes income recognition in
  periods of collection rather than at point of
  sale
• Gross profit is therefore recognized in the
  period in which the cash is collected
• Title does not pass to the buyer until all cash
  payments have been made to the seller
• Other expenses, selling and administrative, are
  not deferred

22
Installment sales method

• For installment sales in any year
• For installment sales made in prior years
  (realized gross profit)

• Determine rate of gross profit on installment
  sales
• Apply this rate to cash collections of current
  years installment sales to yield realized gross
  profit
• The gross profit not realized is deferred
• Apply the relevant rate to cash collections of
  prior years installment sales

23
The Cost Recovery Method

• Seller recognizes no profit until cash payments
  by buyer exceed sellers cost of merchandise.
• After recovering all costs, seller includes
  additional cash collections in income.
• This method is to be used where there is no
  reasonable basis for estimating collectibility.

24
The Deposit Method

• Seller receives cash from buyer before transfer
  of goods or performance
• Report cash received as liability (refundable
  deposit or customer advance)
• The seller has no claim against the purchaser
• There is insufficient transfer of risks to buyer
  to warrant recording a sale by seller
• The deposit method thus defers sale recognition
  until a sale has occurred for accounting purposes