Chapter 18: Revenue Recognition

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Chapter 18 Revenue Recognition
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Revenue Recognition

• Issues
• Largest single source of public company FS
  restatements
• Required to be considered fraud risk under SAS
  99
• Can occur in any industry

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Guidelines for Revenue Recognition

• Revenue recognition principle provides that
  revenue is recognized
• when it is earned AND
• when it is realized or realizable
• Revenue is
• Earned when earnings process is substantially
  complete
• Realized when goods services exchanged for cash
  or claims to cash
• Realizable when assets received are convertible
  into a known amount of cash

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Four Types of Revenue Transactions

• Revenue from selling products
• Recognized at the date of sale (date of delivery)
• Revenue from services
• Recognized when services are performed are
  billable
• Revenue from the use of enterprises assets by
  others
• Recognized as time passes or as the assets are
  used up
• Revenue from disposal of assets (other than
  inventory)
• Recognized at the point of sale as gain or loss

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Revenue Recognition Classified by Nature of
Transaction
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Revenue Recognition

• Point of sale (delivery)
• Before delivery
• After delivery
• Special transactions
• Franchises
• Consignments
• Comparative matrix of bases page 929

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Revenue Recognition at Point of Sale

• Revenues from manufacturing selling
• Realized/realizable
• Earned

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Revenue Recognition at Point of Sale

• Exceptions
• Sales with buyback agreements
• Sales when right of return exists
• High rates that are not reliably estimable
  continued risk of ownership
• Criteria to meet
• Page 906
• Trade loading channel stuffing

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Revenue Recognition Before Delivery

• Revenue may be recognized before delivery under
  certain circumstances
• Long-term construction contracts are a notable
  example
• Revenue recognition methods
• Percentage-of-completion method
• Completed contract method

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Revenue Recognition Before Delivery
Long-Term Construction Accounting Methods
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Percentage-of-Completion Steps
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Percentage-of-Completion Entries

• Cost of construction
• Construction in process (CIP)
• Materials, cash, payables, etc.
• Progress billings
• Accounts receivable
• Billings on CIP
• Collections
• Cash
• Accounts receivable

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Percentage-of-Completion Entries

• To recognize revenue and gross profit
• Construction in process (gross profit)
• Construction expenses
• Revenue
• To record completion of project
• Billings on CIP
• Construction in process

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Percentage-of-Completion Example
Data Contract price 4,500,000 Estimated
cost 4 mil Start date July, 20X3
Finish October, 20X5 Balance sheet date
Dec. 31
Given 20X3 20X4
20X5 Costs to date 1,000,000 2,916,000
4,050,000 Est costs to complete 3,000,000
1,134,000 -0- Progress Billings during
yr 900,000 2,400,000 1,200,000 Cash
collected during year 750,000 1,750,000
2,000,000
What is the percent complete, revenue and gross
profit recognized each year?
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Percentage-of-Completion Example
20X3 20X4 20X5
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Completed Contract

• All revenue GP recognized only at point of sale
  (when contract completed)
• Revenue is actual vs. estimate
• Does not reflect current performance when extends
  beyond one accounting period
• Entries comparisons - page 914

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Recognizing Current Overall Losses on Long-Term
Contracts

• A long-term contract may produce
• Interim loss overall profit OR
• Overall loss for the project
• Percentage-of-completion method
• Losses in any case recognized immediately
• Examples page 915-917
• Completed contract method
• Losses recognized immediately only when overall
  losses indicated
• Example page 917

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Recognizing Current Overall Losses on Long-Term
Contracts
Current Loss on an otherwise overall
profitable contract
Loss on an overall unprofitable contract
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Financial Statement DisclosuresContractors

• Method of revenue recognition
• Basis to classify AL as current
• Inventory basis
• Effects of estimate revisions
• Backlog on uncompleted contracts
• Details re receivables
• Billed, unbilled, interest rate, retainage,
  concentrations of credit risk

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Revenue Recognition After Delivery

• Revenue recognition deferred
• Collection of sales price not reasonably assured
  AND
• No reliable estimates can be made
• Revenue recognition methods
• Installment sales method
• Cost recovery method
• Cash received prior to delivery
• Use deposit method

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The Installment Sales Method

• Emphasizes revenue recognition in periods of
  collection rather than point of sale
• Title does not pass to buyer until all cash
  payments made to seller
• Sales cost of sales deferred to periods of
  collection
• Other expenses, selling administrative, are not
  deferred

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The Installment Sales Method Issues

• Installment sales must be kept separate
• Gross profit must be determinable
• Amount of cash collected from installment
  accounts must be known
• Cash collected from current year prior years
  accounts must be known
• Provision must be made to carry forward deferred
  gross profit

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The Installment Sales Method Steps

• 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 rate to cash collections of current year
  installment sales to yield realized gross profit
• Gross profit not realized is deferred
• Apply relevant rate to cash collections of prior
  year installment sales

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The Installment Sales Method Example

• Given 20X3 20X4 20X5
• Installment sales 200,000 250,000 240,000
• Cost of sales 150,000 190,000 168,000
• Gross Profit 50,000 60,000
  72,000
• Cash received in
• from 20X3 sales 60,000 100,000 40,000
• from 20X4 sales -0- 100,000 125,000
• from 20X5 sales -0- -0- 80,000
• Determine the realized and deferred gross profit

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The Installment Sales Method Example

• Given 20X3 20X4 20X5
• Installment sales 200,000 250,000 240,000
• Gross Profit 50,000 60,000 72,000
• Gross profit rate 25 24
  30
• See next slide for realized and deferred gross
  profit

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The Installment Sales Method Example

• 20X3 20X4 20X5
• Gross profit rate 25 24
  30
• Realized Gross Profit
• From 20X3 sales
• Realized in 15,000 25,000
  10,000
• From 20X4 sales
• Realized in -0- 24,000
  30,000
• From 20X5 sales
• Realized in -0- -0-
  24,000

Gross profit deferred
deferred
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The Installment Sales Method Partial Journal
Entries (20X3) for Gross Profit

• Installment Sales 200,000 Cost of Sales
  150,000 Deferred Gross Profit, 20X3
  50,000 (To close 20X3 accounts)
• Deferred Gross Profit, 20X3 15,000 Realized
  Gross Profit 15,000 (Realized
  60,000 x 25)
• Realized Gross Profit 15,000 Income
  Summary 15,000 (To close to Income
  Summary)

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The Installment Sales Method Financial Statement
Presentation

• If significant to sales
• Full disclosure of installment sales
• Cost of installment sales
• Expenses allocable to installment sales
• Illustration 18-25 page 926
• If insignificant
• Realize GP in IS as special item after GP on
  sales
• Illustration 18-24 page 926

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The Installment Sales Method Miscellaneous Issues

• BS presentation of AR
• Repossessed merchandise
• Deferred GP on installment sales
• Theoretical components difficult to allocate
• Income tax liability paid when sales reported as
  realized
• Allowance for collection B/D expense
  repossession losses
• Net income
• Contra asset per SFAS 6
• Practice is to treat all as unearned revenue

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The Cost Recovery Method

• Seller recognizes no profit
• Until cash payments by buyer exceed sellers cost
  of merchandise
• Deferred GP offset to related AR net of
  collections
• After recovering all costs
• Seller includes additional cash collections in
  income
• Used when there is no reasonable basis for
  estimating collectibility
• Franchises real estate
• IS reports amount of gross profit recognized
  amount deferred
• Separate item of revenue when recognized as
  earned
• Illustration 18-27 page 927

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The Deposit Method

• Seller
• Receives cash from buyer before transfer of goods
  or performance
• Has no claim against purchaser
• There is insufficient transfer of risks to buyer
  to warrant recording sale by seller
• Deposit method defers sale recognition until sale
  has occurred for accounting purposes

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Ethics Issues

• Estimates
• complete
• Costs
• GP for installment sales
• Completion dates
• Losses on contracts
• Rights of return outside of sales contract
• Trade loading channel stuffing

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Special Sales Transactions

• Franchises
• Manufacturer-retailer
• Manufacturer-wholesaler
• Service sponsor-retailer
• Fastest growing, accounting issues
• Wholesaler-retailer
• Consignments

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Special Sales TransactionsFranchises

• Franchisor grants business rights
• Franchisee operates business
• Initial franchise fee
• Revenue
• Franchisor makes substantial performance AND
• Substantial performance no obligation to refund
  any cash received/excuse nonpayment of note
• Collection of fee reasonably assured
• Example JEs page 933
• Continuing franchise fees
• Revenue when earned receivable

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Special Sales TransactionsFranchises

• Additional issues concerns
• Bargain purchases
• BPP lt normal selling price defer portion
  initial fee
• Options to purchase
• Probable _at_ time of option liability
• Franchisors cost
• Direct costs generally defer
• Indirect costs current IS

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Special Sales TransactionsConsignments

• Consignor manufacturer/wholesaler
• Accepts risk merchandise might not sell
• Consignee - dealer
• Consignment
• Consignor carries inventory
• Record revenue when notified of sale by consignee
  cash received
• Consignee has liability for amount due consignor

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Class Exercises

• E18-5 E18-6
• E18-9 E18-14
• E18-15 E18-18
• E18-22
• Homework
• E18-10 E18-12