Revenue Recognition Intermediate Accounting,17E Stice | Stice | Skousen 2010 Cengage Learning...

Revenue Recognition

Intermediate Accounting,17E

Stice | Stice | Skousen

© 2010 Cengage Learning

PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University

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Revenue RecognitionRecognition refers to the time when transactions are recorded on the books. The FASB’s two criteria for recognizing revenues and gains were articulated in FASB Concepts Statement No. 5.

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Revenues and gains are generally recognized when:1. They are realized or

realizable.2. They have been earned through substantial completion of the activities involved in the earnings process.

Revenue Recognition

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Revenue Recognition• Revenue is not recognized prior to the

point of sale because either:• A valid promise of payment has not been

received from the customer, or• The company has not provided the product or

service.• Exceptions to these rules:

• The customer provides a valid promise of payment.

• Conditions exist that contractually guarantee the sale.

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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.

Revenue Recognition

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Appropriate Layaway Accounting

Receipt of $100 cash as initial layaway payment:Cash 100

Deposit Received from Customers 100

Receipt of final $1,400 cash payment and delivery of goods to customer:Cash 1,400Deposit Received from Customers 100 Sales 1,500Cost of Goods Sold 1,000

Inventory 1,000

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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.

Appropriate Accounting for a Service Provided Over an Extended Period

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Receipt of $1,000 cash as initial sign-up fee:Cash 1,000

Unearned Initial Sign-Up Fees 1,000

Receipt of first monthly payment of $50:Cash 50

Monthly Service Revenue 50

Partial recognition of the initial signup fee as revenue ($1,000/100 months):Unearned Initial Sign-Up Fees 10

Initial Sign-Up Fee Revenue 10

Appropriate Accounting for a Service Provided Over an Extended Period

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EITF 00-21

A delivered element of a multiple-element arrangement is considered to be a unit of accounting if that delivered element has standalone value and if the fair value of any undelivered element can be objectively and reliably determined.

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Appropriate Accounting for a Refundable Membership

Seller Company receives $1,200 cash from each customer as a fully refundable, one-year membership fee. It is estimated that the cost to Seller Company to provide the membership service to each customer will be $360 for one year. Seller Company can reliably estimate that 40% of the customers will request refunds during the year. Assume all refunds occur at the end of the year. There were 1,000 customers.

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Appropriate Accounting for a Refundable Membership

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On January 1, Owner Company signed a 1-year rental for a total of $120,000, with monthly payments of $10,000 due at the end of each month. In addition, the renter must pay contingent rent of 10% of all annual sales in excess of $3,000,000. The contingent payment is paid in one payment on December 31.

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Appropriate Accounting for a Contingent Rental

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On January 31, sales for the renter had reached $700,000. On July 31, the renter had reached a sales level of $3,150,000. On December 31, the renter had reached a sales level of $5,000,000, of which $1,000,000 occurred in December.

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Appropriate Accounting for a Contingent Rental

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Appropriate Accounting for a Contingent Rental

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Asset-and-Liability Approach to Revenue Recognition ExampleWilks Company sells a plasma TV screen and 2-year warranty to a customer for a joint price of $2,000. All cash is collected upfront. Other relevant data:• Cost of plasma TV screen, $1,500• Sales price of TV if sold separately, $1,785• Sales price of 2-year warranty if sold separately,

$315• Amount payable to a TV wholesaler to accept

responsibility to provide TV, $1,650• Amount payable to service company to accept

responsibility of providing warranty, $240(continues)

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Journal entries on delivery of TV:Contract Liability—TV Screen 1,700

Sales Revenue 1,700Cost of Goods Sold 1,500

Inventory 1,500

Journal entry at point of cash receipt:Cash 2,000

Contract Liability—TV Screen 1,700¹Contract Liability—Warranty 300²

¹$2,000 [$1,785/($1,785 + $315)]²$2,000 [$315/($1,785 + $315)]

Asset-and-Liability Approach to Revenue Recognition Example

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The fair values of the performance obligation liabilities create a contract signing. Recall that a TV wholesaler would charge $1,650 for accepting the responsibility of providing the plasma TV to the customer. Likewise, a service company would charge $240 for providing the two years of warranty. (continues)

Measurement Model

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The entry to record the cash asset and the two performance obligations created at the contract signing is as follows:Cash 2,000

Contract Liability—TV Screen 1,650Contract Liability—Warranty 240 Revenue 110

Measurement Model

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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.

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Percentage-of-Completion Method Requirements

1. Dependable estimates of:• contract revenues• contract costs• progress toward completion

2. Contract clearly specifies:• enforceable rights of the parties• consideration to be exchanged• manner and terms of settlement

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3. The buyer can be expected to satisfy obligations under the contract.

4. Contractor can be expected to perform the contractual obligation.

Percentage-of-Completion Method Requirements

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Percentage-of-Completion Input Measures

• Cost-to-cost method is perhaps the most popular of the input measures. 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.

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In January 2010, Strong Construction Company was awarded a contract with a total price of $3,000,000. Strong expects to earn $400,000 profit on the contract. The construction was completed over a 3-year period. The table shown next provides the actual cost that Strong experienced and the completion rate.

Measuring the Percentage of Completion

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Measuring the Percentage of Completion

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Accounting for Long-Term Construction Contracts

Continuing with the Strong Construction Company illustration, the direct and indirect costs, billings, and collections are as follows:

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Completed-Contract Method

Construction in Progress 1,040,000Materials, Cash, etc. 1,040,000

To record costs incurred.

Accounts Receivable 1,000,000Progress Billings on Construction Contracts 1,000,000

To record billings.Cash 800,000

Accounts Receivable 800,000 To record cash collections.

20102010

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Construction in Progress 910,000Materials, Cash, etc. 910,000

To record costs incurred.Accounts Receivable 900,000

Progress Billings on Construction Contracts 900,000

To record billings.Cash 850,000

Accounts Receivable 850,000 To record cash collections.

20112011

Completed-Contract Method

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Construction in Progress 650,000Materials, Cash, etc. 650,000

To record costs incurred.

Accounts Receivable 1,100,000Progress Billings on Construction Contracts 1,100,000

To record billings.Cash 1,350,000

Accounts Receivable 1,350,000 To record cash collections.

20122012

Completed-Contract Method

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Percentage-of-Completion Method

• The entries we recorded using the completed-contract method are also the same entries that would be used for the percentage-of-completion method.

• The completed-contract method is “wrapped up” using the entries shown in Slides 30 and 31. The percentage-of-completion method requires the entries presented in Slides 32 to 34.

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20122012

Under the completed-contract method, the following entries would be made to recognize revenue and costs and to close out the inventory and billing accounts.Progress Billings on Construction Contracts 3,000,000

Revenue from Long-Term Construction Contracts 3,000,000

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Completed-Contract Method

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20122012

Under the completed-contract method, the following entries would be made to recognize revenue and costs and to close out the inventory and billing accounts.Cost of Long-Term Construction Contracts 2,600,000

Construction in Process 2,600,000

Completed-Contract Method

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Percentage-of-Completion

Cost of Long-Term Construction Contracts 1,040,000Construction in Progress 160,000

Revenue from Long-Term Construction Contracts 1,200,000

20102010

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Under the percentage-of-completion method, the following additional entries would be made to recognize revenue.

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Cost of Long-Term Construction Contracts 910,000Construction in Progress 140,000

Revenue from Long-Term Construction Contracts 1,050,000

20112011

($3,000,000 0.75) $1,200,000

Percentage-of-Completion

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Cost of Long-Term Construction Contracts 650,000Construction in Progress 100,000

Revenue from Long-Term Construction Contracts 750,000

20122012

$3,000,000 $1,200,000 $1,500,000

Percentage-of-Completion

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Revision of EstimateInstead of the previous illustration, assume that at the end of 2011, it was estimated that the remaining cost to complete construction was $720,000 rather than $650,000. This would increase the total estimated cost to $2,670,000, reduce the expected profit to $330,000, and change the percentage of completion for 2011.

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Revision of Estimate

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• The entries for 2010 would be the same as those shown in the previous example.

Cost of Long-Term Construction Contracts 910,000Construction in Progress 80,000

Revenue from Long-Term Construction Contracts 990,000

($3,000,000 0.73) $1,200,000

• All entries for 2011 would be the same except for the entry to record revenue and cost.

Revision of Estimate

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Cost of Long-Term Construction Contracts 700,000Construction in Progress 110,000

Revenue from Long-Term Construction Contracts 810,000

20122012

Revision of Estimate

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Assume the same facts for Strong Construction Company, except the estimated cost to complete the contract at the end of 2011 was $1,300,000. Because $1,950,000 of costs had already been incurred, the total estimated cost would be $3,250,000.

Reporting Anticipated Contract Losses

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Reporting Anticipated Contract Losses

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Anticipated Contract Loss: Percentage-of-Completion

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Anticipated Contract Loss: Percentage-of-Completion

The entry to record the revenue, costs, and adjustments to Construction in Process for the loss in 2011 would be as follows:Cost of Long-Term Construction Contracts 1,010,000

Revenue from Long-Term Construction Contracts 600,000Construction in Process 410,000

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Anticipated Contract Loss: Percentage-of-Completion

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Proportional Revenue Recognition

1. Initial direct costs related to obtaining and performing initial services on the contract

Most service contracts involve three different types of costs:

2. Direct costs related to performing the various service acts

3. Indirect costs related to maintaining the organization to service the contract

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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).

Accounting for Long-Term Service Contracts

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Receipt of fees:Cash 50,000

Deferred Course Revenue 50,000

Direct costs for lessons actually completed:Contract Costs 12,000

Cash 12,000Expense accountExpense account

Deferred Initial Costs 5,000Cash 5,000

Initial direct costs:

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Asset accountAsset accountLiability accountLiability account

Accounting for Long-Term Service Contracts

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Recognize course revenue:Deferred Course Revenue 20,000

Recognized Course Revenue 20,000

Recognize contract costs from initial direct costs:Contract Costs 2,000

Deferred Initial Costs 2,000

$24,000$24,000$60,000$60,000

$50,000$50,000

Accounting for Long-Term Service Contracts

$24,000$24,000$60,000$60,000

$5,000$5,000

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Revenue Recognition After Delivery of Goods

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Installment Sales Method• Under the installment sales method,

profit is recognized as cash is collected rather than at the time of sale.

• It is used most commonly in cases of real estate sales where contracts may involve little or no down payment, payments are spread over 10 to 40 years, and a high probability of default in the early years exists.

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Installment Sales MethodRiding Corporation sells merchandise on the installment basis, and the uncertainties of cash collection make the use of the installment method necessary. The following data relate to three years of operations.

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Installment Accounts Receivable—2010 150,000

Installment Sales 150,000

Cost of Installment Sales 100,000Inventory 100,000

Cash 30,000Installment Accounts Receivable—2010 30,000

20102010—During the Year—During the Year

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Installment Sales Method

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Installment Sales 150,000Cost of Installment Sales 100,000Deferred Gross Profit—2010 50,000

Deferred Gross Profit—2010 10,000Realized Gross Profit on Installment Sales 10,000

$30,000 $30,000 33.33% 33.33%

20102010—End of Year—End of Year

Installment Sales Method

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Installment A/R—2011 200,000Installment Sales 200,000

Cost of Installment Sales 140,000Inventory 140,000

Cash 145,000Installment A/R—2010 75,000Installment A/R—2011 70,000

20112011—During the Year—During the Year

Installment Sales Method

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Installment Sales 200,000Cost of Installment Sales 140,000Deferred Gross Profit—2011 60,000

Deferred Gross Profit—2010 25,000Deferred Gross Profit—2011 21,000

Realized Gross Profit on Installment Sales 46,000$75,000 $75,000 33.33% 33.33%

$70,000 $70,000 30% 30%

20112011—End of Year—End of Year

Installment Sales Method

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Installment A/R—2012 300,000Installment Sales 300,000

Cost of Installment Sales 204,000Inventory 204,000

Cash 210,000Installment A/R—2010 30,000Installment A/R—2011 80,000Installment A/R—2012 100,000

20122012—During the Year—During the Year

Installment Sales Method

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Installment Sales 300,000Cost of Installment Sales 204,000Deferred Gross Profit—2012 96,000

Deferred Gross Profit—2010 10,000Deferred Gross Profit—2011 24,000Deferred Gross Profit—2012 32,000

Realized Gross Profit on Installment Sales 66,000$30,000 $30,000 33.33% 33.33%

$80,000 $80,000 30% 30%

20122012—End of Year—End of Year

$100,000 $100,000 32% 32%

Installment Sales Method

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Cost Recovery Method

If the probability of recovering product or service costs is remote, the cost recovery method of accounting can be used.

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All entries are the same except do not record gross profit until all costs are recovered.

Deferred Gross Profit—2010 5,000Realized Gross Profit on Installment Sales 5,000

20112011

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Cost Recovery Method

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Because the cash collected in 2011 for 2011 sales is less than the cost of inventory sold, no gross profit would be recognized in 2011 on 2011 sales.

Deferred Gross Profit—2010 30,000Deferred Gross Profit—2011 10,000

Realized Gross Profit on Installment Sales 40,000

20122012

Cost Recovery Method