Chapter 8 Revenue Recognition - Accounting, - · PDF file8-18 Accounting for a Layaway Sale Recording the receipt of the final $1,400 cash payment and the delivery of goods to customers

8-1

1. The primary criteria for revenue recognition

2. The revenue recognition issues in SAB 101

3. The contract approach to revenue recognition

4. The long-term construction-type contracts using

percentage-of-completion and completed-

contract methods

5. The long-term service contacts using the

proportional performance method

6. The revenue is recognized after delivery of

goods or services through installment sales,

cost recovery and cash methods

Chapter 8 Revenue Recognition

8-2

Recognition refers to the time when

transactions are recorded on the books. The

FASB’s two criteria for recognizing revenues

and gains are when:

Revenue Recognition

1. They are realized or realizable.

2. They have been earned through substantial

completion of the activities involved in the

earnings process.

Both of these criteria generally are

met at the point of sale

Both of these criteria generally are

met at the point of sale

1. Identify the primary criteria for revenue

recognition

8-3 8-3

Revenue Recognition

8-4

• Revenue is not recognized prior to the point of sale because either:

A valid promise of payment has not been received from the customer.

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.

Revenue Recognition

8-5

AICPA Statement of Position 97-2 gives

companies more guidance through a checklist of

four factors that amplify the two criteria:

1) Persuasive evidence of an arrangement

exists.

2) Delivery has occurred.

3) The vendor’s fee is fixed or determinable.

4) Collectibility is probable.

(continued)

Revenue Recognition

8-6

• The FASB is currently engaged in a revenue

recognition project in conjunction with the

IASB (as of June 2010).

• The FASB has tentatively decided to move

away from the realization and substantial

completion criteria and to instead emphasize

the measurement of a seller’s satisfaction of

performance obligations created through

contracts with customers.

Revenue Recognition

8-7

SAB 101

• Because SAB 101 was released to curtail

specific abuses, it should not be seen as a

comprehensive treatise on the entire area of

revenue recognition.

• Revenue recognition issues covered in SAB

101 may not be comprehensive, but they are

extremely important.

2. Discuss the revenue recognition issues,

and abuses, underlying the examples used

in SAB 101

8-8

Typical questions from SAB 101 Typical questions from SAB 101

QUESTION 1: Company A requires each sale

to be supported by a written agreement signed

by an authorized representative of both

Company A and of the customer. May Company

A recognize revenue in the current quarter if the

product is delivered before the end of the

quarter but the sales agreement is not signed

by the customer until a few days after the end of

the quarter?

Persuasive Evidence of an Arrangement

8-9

Answer to Question 1: No! The company

obviously does not have a reliable, systematic,

predictable procedure in place for processing

customer contracts. Question 1 is designed to

focus on internal control surrounding revenue

recognition.


8-10

Sarbanes-Oxley Act of 2002

• Section 404 of the Sabanes-Oxley Act of

2002 instructs the SEC to require all publicly

traded companies to provide a report of the

condition of the company’s internal controls.

• This is to ensure that the public financial

statements are not rendered irrelevant by

secret side agreements.

• A good internal control system establishes

procedures to safeguard the value of a

company’s assets.

8-11

QUESTION 2: Company Z delivers product to

a customer on a consignment basis. May

Company Z recognize revenue upon delivery

of the product to the customer?


Answer to Question 2: No! Question 2

addresses the issue of circumventing internal

controls by side agreements.

8-12

Accounting for Consignments

Seller Company ships goods costing $1,000 on

consignment to Consignee Company. The retail

price of the goods is $1,500.

No sale should be recorded.

However, there may be a journal entry

made to reclassify the inventory.

No sale should be recorded.

However, there may be a journal entry

made to reclassify the inventory.

Inventory on Consignment 1,000

Inventory 1,000

8-13

QUESTION 3: May Company A recognize

revenue when it completes production of

inventory for a customer if it segregates that

inventory from other products in its

warehouse? What if Company A ships the

completed inventory to a third-party warehouse

(but retains legal title)?


8-14

Answer to Question 3: No! In general,

revenue should not be recognized in this

bill-and-hold arrangement until the seller

has transferred both legal ownership,

evidenced by the buyer taking title to the

goods, and economic ownership.


8-15

QUESTION 4: Company R is a retailer that

offers “layaway” sales to its customers. A

customer pays a portion of the sales price, and

Company R sets the merchandise aside until

the customer returns, pays for the

merchandise, and takes possession. When

should Company R recognize revenue?


8-16

Answer to Question 4: In Question 4, revenue

recognition should be dictated by the shipping

terms. For example, if the terms are FOB

destination, a layaway sale is not recognized

until the goods are delivered to the customer.


8-17

Accounting for a Layaway Sale

Seller Company receives $100 cash from a

customer. The $100 payment is a partial

payment for goods costing $1,000 with a total

retail price of $1,500. The following entry

shows the receipt of $100 cash as initial

layaway payment.

Cash 100

Deposit Received from Customers 100

(continued)

8-18

Accounting for a Layaway Sale

Recording the receipt of the final $1,400 cash

payment and the delivery of goods to

customers requires two entries. One to record

the sale and the second to remove the item

from inventory and to record its cost.

Cash 1,400

Deposit Received from Customer 100

Sales 1,500

Cost of Goods Sold 1,000

Inventory 1,000

8-19

Bill-and-Hold Arrangements

To consider merchandise as sold using the bill-

and-hold arrangement, a seller must be able to

demonstrate:

• that the goods are ready to ship,

• that they are segregated in act and cannot be

used to fill other orders, and

• that the buyer has requested, in writing, the

bill-and-hold arrangement.

8-20

Customer Acceptance Provisions

Seller Company receives $1,500 cash from a

customer as payment in full for equipment

costing $1,000. The sale is not complete until

the equipment is installed at the customer’s

place of business. The following entry is

necessary to record the advance receipt of

money:

Cash 1,500

Advance Payments Received

from Customers 1,500

(continued)

8-21

Customer Acceptance Provisions

Advance Payments Received from

Customers 1,500

Sales 1,500

Two entries are required to record customer

acceptance of the installed equipment.


Inventory 1,000

8-22

QUESTION 5: Company H requires customers

to pay an up-front, nonrefundable fee in

addition to monthly payments for its services.

When should Company H recognize the

revenue from this up-front, nonrefundable fee?


8-23

Answer to Question 5: Immediate recognition

of the nonrefundable up-front fee as revenue

cannot be justified because no customer would

pay separately to simply “sign up” for a

service. Up-front fees are integral parts of the

entire service arrangement and the entire

package should be accounted for as a unit.


8-24

QUESTION 6: Company A provides its

customers with computer-based services over

an extended period. Customers are required to

prepay the entire fee for the extended service.

Company A performs initial setup activities to

get a customer entered into its system. When

should Company A recognize revenue for this

service?


8-25

Answer to Question 6: The seller in Question 6

might agree to spread the recognition of revenue

over the life of the service contract but desire to

recognize a disproportionate amount of revenue

at the beginning of the contract. No customer

would pay for the setup activities as a separate

product, so revenue cannot be assigned to the

completion of that part of the agreement.


8-26

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

the service. The expected economic life of this

service agreement is 100 months. An entry is

required to show receipt of cash.

Appropriate Accounting for a Service

Provided Over an Extended Period

Cash 1,000

Unearned Initial Sign-up Fees 1,000

(continued)

8-27

A second entry is required to record receipt of

the monthly payment.

Cash 50

Monthly Service Revenue 50

Another entry is necessary to record partial

recognition of the initial sign-up 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

8-28

Subtopic 605-25

• The focus of Subtopic 605-25 is on the “unit

of accounting.”

• An element of multiple-element arrangement

is considered to be a unit of accounting if that

element has standalone value.

• An element has standalone value if it is sold

separately or if the customer resells it.

8-29

On April 2, Lily Kay Company sold elements A

and B to a customer for a single price of $1,000.

Lily Kay collected the $1,000 selling price in

cash on April 2. Normally, element A and element

B are sold separately, so each has standalone

value to the customer. Lily Kay has three

different methods to determine the separate

selling prices. These are shown on the following

Slide.

Subtopic 605-25

8-30

1) Vender-specific objective evidence (VSOE)

2) Third-party evidence (TPE)

3) Best estimate using other data

Lily Kay sometimes sells element A separately for

$700 (VSOE). Even though neither Lily Kay nor its

competitors sell element B separately, it is estimated

that the approximate separate selling price would be

$400. Lily Kay would make the following journal

entries on April 2 (to record the receipt of cash), on

June 6 (to record the delivery of element A), and on

July 15 (to record the delivery of element B).

Subtopic 605-25

8-31

Cash 1,000

Unearned Revenue—Element A 636*

Unearned Revenue—Element B 364**

April 2

*Element A: [$700/($700 + $400)] x $1,000 = $636

**Element B: [$400/($700 + $400)] x $1,000 = $364

Unearned Revenue—Element A 636

Revenue—Element A 636

June 6

Unearned Revenue—Element B 364

Revenue—Element B 364

June 15

Subtopic 605-25

8-32

Income Statement Presentation

of Revenue: Gross or Net

QUESTION 7: Company T ships the products

directly to the customers, and Company A

never takes title to the product. The typical

sales price is $175, of which Company A

receives $25. Should Company A report

revenue of $175 with cost of goods sold of

$150, or should Company A merely report $25

in commissions revenue?

8-33

Answer to Question 7: SAB 101 made clear

that the gross method is inappropriate when a

company merely serves as an agent or broker

and never takes legal and economic ownership

of the goods being sold. Therefore, Company A

merely reports $25 in commission revenue.



8-34



Characteristic of a transaction in which a

company should report revenue on a net basis

are given as follows:

• The company does not maintain an inventory

of the product being sold but simply forwards

orders to a supplier.

• The company is not primarily responsible for

satisfying customer requirements, request,

complaints, and so forth; those requirements

are satisfied by the supplier of goods.

8-35



• The company earns a fixed amount, or a fixed

percentage, and doesn’t bear the risk of

fluctuations in the margin between the selling

price and the cost of goods sold.

• The company does not bear the credit risk

associated with collecting from the customer;

that risk is borne by the supplier.

8-36

The contract approach contains three basic steps:

1) Identify the performance obligations accepted

by a seller in its contracts with its buyers.

2) For multiple-element transactions, allocate

transaction prices based on relative separate

selling prices.

3) Recognize revenue when performance

obligations are satisfied.

3. Describe the contract approach to revenue

recognition that is currently being considered

by the FASB and IASB

8-37

• With the contractual performance obligation

focus, the FASB and IASB have agreed that

revenue arises when a seller satisfies a

performance obligation to a buyer.

• The general idea that no revenue should be

recognized until something of value has been

delivered to the customer goes back to SAB

101 and even back to the traditional revenue

recognition criteria.

A Contract Approach to Revenue Recognition

8-38

Ashley Company has provided goods, on

account, to customers during the month of June

with a total billing price of $100,000. Bad debts

are expected to be 1.0% of the gross sales

amount, and sales returns are expected to be

2.5% of the gross sales amount. A summary

journal entry follows:


Accounts Receivable 96,500

Sales Revenue [$100,000 x

(100.0% ‒ 1.0% ‒ 2.5%)] 96,500

June 30

(continued)

8-39

Wilks Company sells a plasma TV and 2-year

warranty to a customer for the joint price of

$2,000. Wilks Company has generated the

following information regarding the sale of the

plasma TV.

• Cost of plasma TV, $1,500

• Sales price of plasma TV sold separately is

unknown. Other consumer electronic products

have profit margins that range between 16%

and 22% of cost.


8-40

TV delivery obligation: $1,700 = $2,000 x

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

Warranty service obligation: $300 = $2,000 x

[$315/$1,785 + $315)]

• Sales price of warranty if sold separately,

unknown. A 2-year warranty for a

refrigerator/freezer with the same wholesale

cost sells for $300. Wilks estimates that repair

costs for the plasma TV would be 5% higher

($300 + ($300 x .05) = $315).

(continued)


8-41

The journal entry to record the asset and liability

at the contract signing is as follows:

Cash 2,000

Contract Liability—TV 1,700

Contract Liability—Warranty 300

When the plasma TV is delivered, the following

journal entries are required:

Contract Liability—TV 1,700

Sales Revenue 1,700


Inventory 1,500


8-42

Introduction

• If a Company waits until the production or

service period is complete to recognize revenue,

this approach is referred to as the completed-

contract method. All income from the contract is

related to the year of completion.

• Percentage-of-completion accounting was

developed to relate recognition of revenue on

long-term construction-type contracts to the

activities of a firm in fulfilling these contracts.

4. Record journal entries for long-term

construction-type contracts using percentage-of-

completion and completed-contract methods

8-43

1. Dependable estimates can be made of

contract revenues, contract costs, and the

extent of progress toward completion.

2. The contract clearly specifies the enforceable

rights regarding goods or services to be

provided and received by the parties, the

consideration to be exchanged, and the

manner and terms of settlement.

In 1981, the AICPA identified several elements

that should be present if the percentage-of-

completion accounting is to be used.

Percentage-of-Completion Accounting

8-44

3. The buyer can be expected to satisfy

obligations under the contract.

4. The contractor can be expected to perform

the contractual obligation.

The completed-contract method should be

used only when an entity has primarily

short term contracts, when the conditions

of using percentage-of-completion

accounting are not met, or when there are

inherent uncertainties in the contract.

The completed-contract method should be

used only when an entity has primarily

short term contracts, when the conditions

of using percentage-of-completion

accounting are not met, or when there are

inherent uncertainties in the contract.


8-45

• 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.


8-46

In January 2012, 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

in Slide 8-47 provides the actual cost that Strong

experienced and the completion rate.

Accounting for Long-Term

Construction-Type Contracts

8-47



Continuing with the Strong Construction Company

illustration, the direct and indirect costs, billings, and

collections are as follows:

8-48

Construction in Progress 1,040,000

Materials, Cash, etc. 1,040,000

To record costs incurred.

Accounts Receivable 1,000,000

Progress Billings on

Construction Contracts 1,000,000

To record billings.

Cash 800,000


To record cash collections.

2012 2012



8-49

Construction in Progress 910,000

Materials, Cash, etc. 910,000




Construction Contracts 900,000

To record billings.

Cash 850,000



2013 2013



8-50


Materials, Cash, etc. 650,000





To record billings.

Cash 1,350,000



2014 2014



8-51

Completed-Contract Method

• No other entries would be required in 2012 and

2013 under the completed-contract method.

• In both years, the balance of Construction in

Progress exceeds the amount in Progress

Billings on Construction Contracts; thus, the

latter account would be offset against the

inventory account in the balance sheet.

8-52

Using the completed-contract method, the

balance sheet at the end of 2013 would

disclose the following balances related to the

construction contract:

Current assets:

Accounts receivable $250,000

Construction in progress $1,950,000

Less: Progress billings on

construction contracts 1,900,000 $50,000

2013 2013


8-53

2014 2014

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.



Revenue from Long-Term



Cost of Long-Term



8-54

Using Percentage-of-Completion Accounting:

Cost-to-Cost Method

2012 2012

If the company used the percentage-of-completion

method of accounting, the $400,000 profit would

have to be spread over all three years of

construction according to the estimated percentage

of completion each year. 2012 2013 2014

Percentage of completion

to date 40% 75% 100%

8-55


Cost-to-Cost Method

Cost of Long-Term

Construction Contracts* 1,040,000




*Actual costs

2012 2012

8-56

Cost of Long-Term Construction

Contracts 910,000




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


Cost-to-Cost Method

2013 2013

(continued)

8-57


Contracts 650,000




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


Cost-to-Cost Method

2014 2014

(continued)

8-58

Construction in Progress

1,040,000

160,000

910,000

140,000

650,000

100,000

3,000,000


Construction Contracts

1,000,000

900,000

1,100,000

3,000,000




3,000,000

3,000,000


Cost-to-Cost Method

2014 2014

8-59


Other Methods

In 2012, an engineering estimate measure was

used, and 42% of the contract was assumed to

be completed. The gross profit recognized

would therefore be computed and reported as

follows:

Recognized revenue (42% of $3,000,000)$1,260,000

Cost (42% of $2,600,000) 1,092,000

Gross profit (42% of $400,000) $ 168,000

8-60


Other Methods

Using the data from the previous slide and

knowing that the actual cost incurred to date is

$1,040,000, the revenue and costs to be

reported on the 2012 income statement would

be as follows:

Actual cost incurred to date $1,040,000

Recognized gross profit (42% of

$400,000) 168,000

Recognized Revenue $ 1,208,000

8-61

Revision of Estimate

Instead of the previous illustration, assume that at

the end of 2013, 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 2013 to

73% ($1,950,000/$2,670,000).

(continued)

8-62

8-63


Contracts 1,040,000




2012 2012

Under the percentage-of-completion method, the

following additional entries would be made to

recognize revenue.

Revision of Estimates

8-64


Contracts 910,000




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

2013

(continued)


8-65


Contracts 700,000




2014 2014


8-66

Assume the same facts for Strong Construction

Company, except the estimated cost to complete

construction was $836,000, and this was the

actual cost incurred in 2014.


8-67

8-68

The entry to record the revenue, costs, and

adjustments to Construction in Process for the

loss in 2012 would be as follows:

Cost of Long-Term


Construction in Process 160,000




8-69




Cost of Long-Term






8-70





Contracts 836,000





8-71

Reporting Anticipated Contract Losses

• When a loss on a total contract is anticipated,

GAAP requires reporting the loss in its entirety

in the period when the loss is first anticipated.

• This is true under either the completed-

contract or the percentage-of-completion

method.

8-72

• Assume in the earlier construction example, the estimated cost to complete the contract at the end of 2013 was $1,300,000.

• Because $1,950,000 of costs had already been incurred, the total estimated cost of the contract would be $3,250,000, or $250,000 more than the contract price.

Reporting Anticipated Contract Losses

8-73

Anticipated Contract Loss: Completed-

Contract Method

If the completed-contract method is used, the

recognition of an anticipated loss is simple.

Anticipated Loss on Long-Term

Construction Contract 250,000


8-74

Anticipated Contract Loss:

Percentage-of-Completion Method

Continuing with the construction contract example,

assume the cumulative recognized revenue at the

end of 2013 would be $1,800,000 (60% x

$3,000,000), and the cumulative cost at the same

date would be $2,050,000 ($1,800,000 +

$250,000).

A profit of $160,000 was recognized in 2012, the

total loss to be recognized in 2013 is $410,000

($160,000 + $250,000).

8-75

Anticipated Contract Loss: Percentage-of-

Completion Method

8-76


adjustments to Construction in Progress for the


Cost of Long-Term

Construction Contract 1,010,000





Completion Method

8-77 8-77


Completion Method

8-78

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

5. Record journal entries for long-term service

contracts using percentage-of-completion

and completed-contract methods

8-79

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

8-80

Receipt of fees: Cash 50,000

Deferred Course Revenue 50,000

Direct costs for lessons actually completed:

Contract Costs 12,000

Cash 12,000

Deferred Initial Costs 5,000

Cash 5,000

Initial direct costs:


Service Contracts

8-81

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

$60,000 $5,000


Service Contracts

$24,000

$60,000 x $50,000

8-82

Revenue Recognition Methods

6. Revenue Recognition After Delivery of Goods

or Performance of Services

8-83

• 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 30 to 40 years, and a high

probability of default in the early years exists

because of a small investment by the buyer.

• The market prices of the property often are

unstable.

Installment Sales Method

8-84

Riding 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.


8-85

Installment Accounts

Receivable—2012 150,000

Installment Sales 150,000

Cost of Installment Sales 100,000

Inventory 100,000

Cash 30,000

Installment Accounts

Receivable—2012 30,000

2012—During the Year 2012—During the Year


8-86



Deferred Gross Profit—2012 50,000


Realized Gross Profit on


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

2012—End of Year 2012—End of Year


8-87

2012 Income Statement 2012 Income Statement

Sales $150,000

Less: Deferred gross profit (50,000)

Add: Realized gross profit 10,000

$110,000

Less: Cost of installment sales (100,000)

Other operating expenses (5,000)

Operating income $ 5,000


8-88

Installment A/R—2013 200,000



Inventory 140,000

Cash 145,000





8-89










8-90




Inventory 204,000

Cash 210,000






8-91











8-92

Cost Recovery Method

• Under the cost recovery method, no income is

recognized on a sale until the cost of the item

sold it recovered through cash receipts.

• This method is used only when the

circumstances surrounding a sale are so

uncertain that earlier recognition is impossible.

8-93

Using the information from the Riding

Corporation example, assume that collections

are uncertain so the cost recovery method is

used.




2013 2013


8-94

Because the cash collected in 2013 for 2013

sales is less than the cost of inventory sold, no

gross profit would be recognized in 2013 on

2013 sales. The entry to recognize gross profit

in 2014 would be:






8-95


8-96

Cash Method

• If the probability of recovering product or

service costs is remote, the cash method of

accounting could be used.

• Seldom would this method be applicable for

sales of merchandise or real estate because

the right of repossession would leave

considerable value to the seller.

Documents

Chapter 8 Revenue Recognition - Accounting, - · PDF file8-18 Accounting for a Layaway Sale Recording the receipt of the final $1,400 cash payment and the delivery of goods to customers