Intermediate Financial Accounting I Revenue Recognition

Intermediate Financial Accounting I

Revenue Recognition

Income Measurement And Profit Analysis 2

Objectives of the Chapter

1. Discuss the revenue recognition principle and the problems associated with revenue recognition at point of sale.

2. Discuss the cases that revenue is recognized at a point other than at point of sale (i.e., before delivery).

3. Study the percentage-of-completion method for long-term contracts.


Objectives of the Chapter (contd.)

4. Study the completed-contract method for long-term contracts.

5. Discuss the installment method of accounting.

6. Study the accounting treatments for franchise, software sales and consignment.


Revenue Recognition Principle (SFAS No. 5) (-An Accrual Basis) Revenue is recognized when it is earned and

realized or realizable (SFAC 5, par. 83). Earned : the entity has substantially accomplished

what it must do to be entitled to compensation. Realized: goods are exchanged for cash or

claims. Realizable: assets received as compensation are

readily convertible into cash or claims to cash. In general, these conditions are met at time of sale

(delivery) or when services are rendered (SFAC 5, par. 84).

.


Revenue Recognition Principle

Other conditions for revenue recognition (Staff Accounting Bulletin No. 101(1999)):

Persuasive evidence of a sale. Price is fixed or determinable. Collectibility is reasonably assured. Delivery has occurred or services

have been rendered.


Impact of SAB 101 on Revenue Recognition for Service Industry FedEx: Recognizes revenue upon delivery of

shipments (not during the packing, loading or transporting).

United Airlines (UA): (Accounting Changes) Beginning Q1, 2000, UA recognizes mileage sale through Citibank credit card or long-distance phone companies after the transportation is provided, not when mileage were sold.

Others: season tickets, annual membership, etc.


Type of Transactions Sale of product from Inventory: revenue

recognized at time of sale. Rendering a service: revenue recognized

when services have been performed and billable.

Permitting use of an asset: revenue (i.e., interest, rents and royalties) recognized as time passes or assets are used.

Sale of asset other than inventory: gain or loss recognized at date of sale or trade-in.


Problems Associated with Revenue Recognized at Point of Sale (Delivery)

1. Sales with buyback agreements: inventory should remain on the seller’s book and no revenue can be recognized.

2a. Sales with right of return exists: Revenue recognized if expecting insignificant amount of returns.


Problems Associated with Revenue Recognized at Point of Sale (contd.)

2b. Sales with right of return: When expecting high sales returns, no revenue can be recognized unless the following six conditions are met.

(i) Sales price is determined;

(ii) Buyers have paid or have the obligations to pay;


Problems Associated with Revenue Recognized at Point of Sale (contd.)

2b. Sales with right of return (contd.)(iii) The buyers’ obligation would not be

changed due to theft of damage of the product after sales;

(iv)Sellers are not responsible for the performance of the product;

(v) Buyers and sellers are two separate economic entities;

(vi)The amount of returns can be estimated.


Problems Associated with Revenue Recognized at Point of Sale (contd.)3. Trade loading: Manufacturers reduced

the price for wholesale at the fiscal year end to create instant sales. The wholesaler is loaded with more inventory than it can promptly resell.


Revenue Recognition over Time (during the earnings process) and others 1. During the production process(i.e.,

long-term contract): accounting methods of revenue recognition are percentage-of completion method and completed-contract method.

2. At the completion of production (i.e., for agriculture products and precious metals).


Revenue Recognition after Delivery

3. Installment Sales: revenue recognized after time of sale (delivery) as cash is collected.

4. Revenue recognition delayed until a future event occurred (i.e., real estate sale, sale of division). Accounting method: Deposit method.


Conditions for Revenue to Be Recognized at Completion of Production

Market is reasonably assured;

Costs of selling and distribution are insignificant and can be estimated;

Production, not sale, is considered to be the most critical event in the earning process.


Conditions for Revenue to Be Recognized at Completion of Production (contd.)

Example: Revenue is recognized when precious metals are mined or when agricultural crops are harvested because all conditions are met.


Conditions for Recognizing Revenue during Production Buyers can be identified and price has

been agreed on;

Future costs can be estimated and significant portion of service has been performed;

The collectability of cash can be reasonable assured;


Conditions for Recognizing Revenue during Production The contract specifies the rights about

goods or services to be performed and received by both parties;

Both parties are expected to fulfil their obligations (AICPA statement of position 81).


If all conditions are met, the percentage-of-completion (P-O-C) method must be applied to recognize construction revenue prior to the completion date.

If conditions are not met, the completed-contract method will be applied to recognize revenue at or after the completion date.

Choice of P-O-C vs. C-C Method


Example: For long-term construction contract, when all conditions are met, the P-O-C method is used to account for construction revenue and construction expenses.

Choice of P-O-C vs. C-C Method (contd.)


Financial Reporting of Long-Term (Construction) Contract Percentage-of-completion method:

revenue is recognized according to the percentage of completion. The percentage of completion is computed based on costs.

Completed-contract method: postpone the revenue recognition until time of sale.


Construction Estimated Estimated Cummulative Costs Costs to Total Percentage of

Year Incurred Complete Cost Completion (%)

x1 $100 $400 $500 1 20% 4

x2 $186 $264 $550 2 52% 5

x3 $314 - $ 600 3 100% 6

Example A: (Long-Term Construction Contract)

1. 500=100+4002. 550=100+186+2643. 600=100+186+314

(actual)

4. 20% = 100/5005. 52% = (100 + 186)/5506. 100%=(100+186+314)/ 600

Contract Price = $700


Example A (contd.)

Partial Cash Year Billings Collection x1 $ 80 $ 50 x2 350 330 x3 270 320Total $700 $700


Cumulative Current Current Gross

Year Revenue Revenue Expense7 Profit8

x1 $ 140 1 $ 140 4 100 $40x2 364 2 224 5 186 38x3 700 3 336 6 314 22

Total $700 $600 $100

Example A (contd.)

1. $140 = 700 x 20% (contract price x cumulative % of completion)

2. 364 = 700 x 52%3. 700 = 700 x 100%4. 140 = 140 - 0 (cumulative

revenue - previous years’ revenue)

5. 224 = 364 -1406. 336 = 700 - 140 - 2247. Current expense =

construction costs incurred

8. Net Income = current revenue - current expense

(P-O-C)

23


Total % Cum.Estimated of Gross Gross

Year Profit Completion Profit Profitx1 $200 20% $40 $40x2 150 52% 78 38x3 100 100% 100 22

Example A (contd.)

An alternative method to compute the gross profit:


Year x1 Year x2 Year x3a. To Record Actual

Cost:Construction in Progress A/P

100100

186186

314314

b. Partial Billings:A/R Progress Billings

8080

350350

270270

c. Cash CollectionCash A/R

5050

330330

320320

Example A - Journal Entries (P-O-C)

Note: Progress Billings = Billings on Construction

construction contract25


Example A - Journal Entries (P-O-C) (contd.)

Note: Construction Expense = Cost of Construction Construction Revenue = Revenue from Long-Term Contracts

Year x1 Year x2 Year x3d. End of Period- Recognition

of annual income1. Construction Expense C-I-P

Construction Revenue2. Closing Entries: Construction Revenue

Construction ExpenseIncome Summary

10040

140

140100

40

18638

224

224186 38

31422

336

336314

22e. The end of Construction(Customer is fully Billed)Progress Billings

C-I-P

NoEntry

NoEntry 700

700

26


B/S Year x3C.A.:CIP 700 P.B (700)

0

B/S Year x1Current Assets:CIP 140 Progress Billings (80)

60 Unbilled Revenue

Example AFinancial Statement Presentation (P-O-C)

B/S Year x2

Current Liability:P-B

430 C-I-P

(364)

66

Billing in excess of costs and recognized profit


CIP100401863831422

Year x1($140)

Year x2($224)

Year x3($336)

Financial Statement Presentation (P-O-C)(contd.)

Note: Balance of CIP = cumulative revenue

Progress Billings 80 -- 1998350 -- 1999270 -- 2000700 -- E.B.


Financial Statement Presentation (P-O-C)(contd.)Income Statement Year x1 Year x2 Year x3Revenue from

Long-term contract 140 224336

Construction Expenses 100 186

314

Gross Profit 40 3822


Financial Statement Presentation (P-O-C)(contd.) Year Balance Sheet(12/31) x1 x2 x3 Current Assets:

A/R 30 50 -- Inventories Construction in Progress 140 700 Less: Billings (80) (700)Costs and recognized profits in excess of billings 60 0

Current Liabilities:Billings 430 Construction in Progress (364)Billings in excess of costs and recognized profits 66


Financial Statement Presentation (P-O-C)(contd.)Note1 Summary of significant accounting policyLong-Term Construction Contracts. The company recognized revenues and reports profits from long-term construction contracts under the percentage-of-completion method….


Example A (contd.) - Completed-Contract Method

Gross Profit:X1 $0X2 $0X3 $100X3: Total Revenues - Total Expenses

= $ 700 - (100+186+314)= $ 700 - 600= 100


Example A (contd.) - Journal Entries (Completed-Contract)

Year x1 Year x2 Year x3a. Recording Actual Cost:CIP A/P

100100

186186

314314


8080

350350

270270


5050

330330

320320

d. End of Period -Recognition of annualincome

NoEntry

NoEntry

NoEntry


Journal Entries(Completed-Contract)(contd.)

Year x1 Year x2 Year x3e. The End of Construction(Recognize total expenseand total revenue)1. Construction Exp.

C-I-P Construction Revenue

No No 600100

7002. Construction Revenue Construction Expense Income Summary

No No700

600100

3. Progress Billings CIP

No No 700700


Financial Statement Presentation (C-C Method)

Income Statement Year x1 Year x2 Year x3Revenue from

Long-term contract --- ---700

Construction Expenses --- ---

600

Gross Profit --- ---100


Financial Statement Presentation (C-C Method) (contd.)

Balance Sheet (12/31) Year x1 Year x2 Year x3Current Assets:

A/R 30 50 --- Inventories:

Construction in Progress 100 700 Less: Billings (80) (700)

Contract Costs in Excess of Billings 20 0

Current Liabilities:Billings 430 Construction in Progress (286)

Billing in Excess of Contract Costs 144

36


EstimatedConstruction Costs to Estimated Cumulative

Costs Complete Total % of Year Incurred the Contract Cost Completionx1 $100 400 $500 20%x2 186 364 650 44%x3 314 - 600 100%

Example B

Contract Price $700


Cummulative Current Current G.P. G.P.Year Revenue Revenue Expense (L) (L)

x1 $140 $140 $100 40 0

x2 308 168 186 -18 0

x3 700 392 314 78 100

Total $700 $600 $100 $100

Example B (contd.)

P-O-C C-C


Example B (contd.)


Total Cumm. Cumm.Estimated % of Gross Gross

Year G. Profit Completion Profit Profitx1 $200 20% $40 $40x2 50 44% 22 (18)x3 100 100% 100 78


Example B (contd.)

Other Information (Billing and cash collection):

Year Partial Billings Cash Collection

x1 $80 $50

x2 350 330

x3 270 320

Total $ 700 $ 700


Year x1 Year x2 Year x3a. Recording Actual

Cost:C-I-P A/P

100100

186186

314314


8080

350350

270270


5050

330330

320320

Example B - Journal Entries (P-O-C)


Example B - Journal Entries (P-O-C) (contd.)

Year x1 Year x2 Year x3 d. End of Period 1. Construction Expense C-I-P Construction Revenue C-I-P 2. Closing Entries: Construction Revenue I/S Construction Expense Income Summary

100 40 140

- 140 - 100 40

186 - 168 18 168 18 186

-

314 78 392

- 392 - 314 78

e. The end of Construction Progress Billings C-I-P

No

No

700 700


Progress Billings 80 -- x1350 -- x2270 -- x3

Example B (contd.)

C-I-P100 18 4018631478700

Year x1

x2

x3

x2


Example B (contd.) - Journal Entries (Completed-Contract)

Year x1 Year x2 Year x3a. Recording Actual Cost:CIP A/P

100100

186186

314314


8080

350350

270270


5050

330330

320320

d. End of Period No No No


Journal Entries(Completed-Contract)(contd.)

Year x1 Year x2 Year x3e. The End of Construction(Recognize total expenseand total revenue)1. Construction Exp.

C-I-P Construction Revenue

No No 600100

7002. Construction Revenue Construction Expense Income Summary

No No700

600100

3. Progress Billings CIP

No No 700700


(Long-Term Contract Example C with an Overall Loss)

* $715 > 700 (contract price) => a total estimated loss occurs and must be recognized immediately (source: ARB 45 and AICPA statement of position 81-1)

EstimatedConstruction Costs to Estimated Cumulative

Costs Complete Total % of Year Incurred the Contract Cost Completionx1 $100 400 $500 20%x2 186 429 715* 40%x3 429 - 715 100%

Contract Price $700


Example C (contd.)

* $40 gross profit was recognized in year x1. This profit is not expected to be realized in the future. Thus, the $40 profit must be offset in year x2. In addition, the estimated total loss of $15 should also be recognized immediately in year x2. Therefore, a loss of $55 ($40+$15) should be recognized in year x2.

** Billings and cash collection data are the same as those of example A.

Cummulative Current Current G.P. G.P.Year Revenue Revenue Expense (L) (L)x1 $140 $140 $100 40 0x2 280 140 186 (55)* (15)x3 700 420 429 0 0

Total $700 $715 ($15) ($15)

P-O-C C-C


Example C (contd.)


Total Cumm. Cumm.Estimated % of Gross Gross

Year G. Profit Completion Profit Profitx1 $200 20% $40 $40x2 (15) 40% (15) (55)x3 (15) 100% (15) 0


Example C (contd.) - Journal Entries (P-O-C)

Year x1 Year x2 Year x3a. CIP A/P

100100

186186

429429

b. A/R Progress Billings

8080

350350

270270

c. Cash A/R

5050

330330

320320


Journal Entries(P-O-C) (contd.)

Year x1 Year x2 Year x3d. End of Period:1. Construction Expense

C-I-P Construction Revenue C-I-P

10040

140 -

195 -

14055*

420 -

420 -

2. Closing Entries

e. The End of Construction: Progress Billings

C-I-P700

700

* C-I-P and provision for loss on contract are combined.


CIP (Year x1)100 40140

Partial Billings (x1) 80

B/S (x1)Current Assets:CIP 140P-B (80)

60

Example C (contd.)

Year x1:


Year x2: (with a total estimated loss of $15) CIP (Year x2) 100 55 40 186 271

P-B (Year x2) 80

350 430

* The estimated overall loss must be reported separately on the B/S as a current lia. The overall loss needs to be taken out of the CIP account for reporting purposes.

Example C (contd.)

B/S (Year x2)Current Lia:P-B

430 CIP

(286)*Billings in excess of costs and recognized profit

144 Estimated liability from long-term contract

15

52


Example C (contd.)

CIP (2000)100 55 40186429700

P-B (2000) 80350270700


Example C (contd.) - Journal Entries (C-C)

Year x1 Year x2 Year x3a. CIP A/P

100100

186186

429429

b. A/R Progress Billings

8080

350350

270270

c. Cash A/R

5050

330330

320320


Journal Entries(C-C) (contd.)

Year x1 Year x2 Year x3d. End of Period:Estimated Loss from Long- Term Contract

C-I-P15*

15*e. The End of Construction:Contract Expense Construction Revenue

700700

Progress Billings C-I-P 700

700

* To recognize the total estimated loss of ($15).


EstimatedConstruction Costs Estimated Cummulative

Costs to Complete Total % ofYear Incurred the Contract Cost Completionx1 $100 $400 500 20%x2 186 429 715 * 40%x3 529 - 815 ** 100%

L-T Construction Contract with a Total Estimated Loss

Example D

* a total estimated loss of $15 incurred.** a total estimated loss of $115.




x1 $140 $140 $100 40 0

x2 280 140 186 (55) (15)

x3 700 420 529 (100) (100)

Total $700 $815 ($115) ($115)

Example D (contd.)

Billings and cash collection data are the same as those in example A.

P-O-C C-C



Costs to Complete Total % ofYear Incurred the Contract Cost Completionx1 $100 $400 $500 20%x2 $186 $429 $715 * 40%x3 $329 - $615 100%


Example E

* a total estimated loss of $15 incurred.




x1 $140 $140 $100 40 0

x2 280 140 186 (55) (15)

x3 700 420 329 100* 100*

Total $700 $615 $85 $85

Example E (contd.)

* $15 total estimated loss was recognized in Year x2. The overall income of Year x3 is $ 85. In order to have an overall income of x3 equals to $ 85, we need to recognize $100 income in x3.


P-O-C C-C

59



Costs to Complete Total % ofYear Incurred the Contract Cost Completionx1 $100 $700 800 * 13%x2 186 429 715 ** 40%x3 529 - 815 100%


Example F

* an estimated loss of $100 incurred.** an estimated loss of $15 incurred.*** an loss of $115 incurred.




x1 $91 $91 $100 ($100) ($100)

x2 280 189 186 85 85

x3 700 420 529 (100) (100)

Total $700 $815 ($115) ($115)

Example F (contd.)


P-O-C C-C


The Application of the P-O-C Method in the Service Industry

Many transactions in the service industry require the performance of several acts that extend over a period of time.

An accounting method called "proportional performance method” can be used to account for the revenues and expenses for these transactions.


The Application of the P-O-C Method (contd.) Example:

With fixed number of acts:

Additional acts are not fixed:

Estimation of additional acts is required to compute the proportion of revenue to be recognized (as in P-O-C method).

Note: If the service requires a final act, a completed performance method will be applied to account for revenues and expenses.


The Application of the P-O-C Method (contd.)

Aging product: Wine, lumber, etc. No value increase can be recognized as

revenue, unless

a. a contract to age a specific product for a specific customer has been signed; and

b. no return of product even if the customer is not satisfied with the product; and

c. if future cost can be estimated.


The Application of the P-O-C Method (contd.)

If all three conditions are met, the P-O-C method may (referred to as an accretion method) be applied to account for revenues and expenses prior to the completion of the production.

IFRS Insights

IFRS only allows the POC method. If future costs cannot be estimated, the

recognized cost will be set to equal the revenue (therefore, zero profit).

Similar to GAAP, IFRS also requires the recognition of the projected overall loss when loss is expected for the entire long-term construction contracts.



Revenue Recognition after Time of Sale (i.e., at time of cash collection)

Accounting Methods:

a. Installment Sales Method

b. Cost Recovery Method


a. Installment Method1

Postpone the recognition of revenue (or profit) until the period of cash collection. This is not consistent with accrual accounting concept.1. Rarely used for financial reporting (except for special

cases)2 but commonly used for tax filing purposes.

2. Special case: when receivables are collectible over an extended period of time and no reasonable basis for estimating the degree of collectibility (i.e., B/D expense Estimation) --> Source: APB 10, para. 12, footnote 8.


a. Installment Method (contd.)

If uncollectible account is expected, bad debt expense should be estimated and recognized rather than postponing the recognition of revenue until cash is collected.


b. Cost Recovery Method1

Postpone the recognition of revenue until cost is recovered.

1. Not acceptable for tax filing purposes; rarely used for financially reporting except for special cases.


Installment Sales Method

Example Assume the following information:

20x1 20x2Installment sales $1,200 $2,000Cost of installment 900 1,700Gross profit $300 $300

Rate of gross profit on sales 25% 15%

Cash receipts20x1 Sales $600 $60020x2 Sales $500



Example (contd.) Note: the following entries are based on

the procedures which only defer the gross profit. This procedure has the same effect as deferring both sales revenue and cost of goods sold.



Example (contd.) 20x1 20x2 1. Installment A/R 1,200 2,000

Installment Sales 1,200 2,0002. Cash 600 1,100

I A/R 600 1,1003. Cost of Install. Sales 900 1,700

Inventory 900 1,7004. Installment Sales 1,200 2,000

Cost of Install. Sales 900 1,700Deferred Gross Profit 300 300

(to close installment sales and cost of installment sales and to recognize entire profit as deferred profit)



Example (contd.) 20x1 20x2 5. Deferred Gross Profit 150a

225b

Realized Gross Profit on Installment sales 150

225

a. 25% x $600 = $150.b. 25% x $600 + 15% x $500 = $225.


Additional Problems of Installment Sales Accounting The following three problems are

related to accounting for installment sales:

1. Interest on installment contract;

2. Uncollectible accounts;

3. Defaults and repossessions.


1. Interest on Installment Contract

Using the installment sales made in 20x1 and assuming a 3% interest charge per quarter, the quarterly installment payment from customers should be:

? 3.7171 = $1,200

P4]3% present value of an annuity

? = $1,200 3.7171 = $322.83


1. Interest on Installment Contract (contd.)

The following table summaries the interest earned, cash received, installment A/R, installment A/R balance and realized gross profit of each quarter:


1. Interest on Installment Contract (contd.)

(1) (2) (3) (4) (5)Cash Interest Install. Bal. Of Realized

Earned A/R Install. Gross(Debit) (Credit) (Credit) A/R Profit

5/1/x1 --- --- --- $1,200 ---Q3, x1 $322.83 $36 $286.83 $913.17 $71.70Q4, x1 322.83 27.40 295.43 617.74 73.86Q1, x2 322.83 18.53 304.30 313.44 76.08Q2, x2 322.83 9.40 313.43 0 78.36

$300

(1) as computed on previous page.(2) 3% x previous balance in (4).(3) (1) - (2).

(4) previous balance of (4) - (3).

(5) 25% x (3).


2. Uncollectible Accounts

If repossession cannot compensate for uncollectible balances, the potential loss should be charged against bad debt expense account as in the case of other credit sales.


3. Defaults and Repossessions

Assuming merchandize of $800 of installment sales made in 20x2 was repossessed in 20x3. The fair value of the repossessed item is only $400. Therefore, a loss of $280 occurs.

If a bad debt expense was charged in 20x2, the allowance for uncollectible account will be debited instead of the loss account.


3. Defaults and Repossessions (contd.)

When repossession occurs in year 20x3, the following entry will be recorded:

Repossessed Merchandize 400Deferred Gross Profit 120Loss on Repossession 280

Installment A/R 800


Financial Statement Presentation of Installment Sales Transactions

A. Installment sales constitute an insignificant part of total sales.

B. Installment sales are a significant part of total sales.


A. Installment Sales Constitute an Insignificant Part of Total Sales

In this case, the accountant only needs to include the realized gross profit of the installment sales in the income statement as a special item following the gross profit on other sales.


Income StatementFor the Year Ended 12/31/x1

Sales $500,000 Cost of Goods Sold (270,000)Gross Profit on Sales $230,000 Gross Profit realized on

Installment Sales 150 Total Gross Profit on Sales $230,150


B. Installment Sales Are a Significant Part of Total Sales

If installment sales are a significant part of total sales, the following presentation may be used:


Income StatementFor the Year Ended 12/31/x2a

Install. Other Sales Sales Total

Sales 150,000 200,000 350,000Cost of goods sold (80,000) (150,000) (230,000)Gross profit 70,000 50,000 120,000Less deferred gross profit on install. sales of this year(50,000) (50,000)Realized gross profit on this year’s sales 20,000 50,000 70,000Add gross profit realized on prior years 15,000 15,000Gross profit real. this year 35,000 50,000 85,000

a. All amounts are assumed.

86


Cost Recovery Method

No gross profit is recognized until cash collected exceeding the cost. Thus, all gross profit is deferred until cash collected exceeding the cost.


Cost Recovery MethodExample Assuming in Jan. 20x1, Gateway Corp.

sells merchandize costing $10,000 to Mendy Corp. for $15,000 with payments receivable of $9,000, $3,000 and $3,000 in 20x1, 20x2, and 20x3, respectively. The following entries will be recorded following the cost recovery method:



Example (contd.)

20x1 A/R 15,000Sales 15,000

CGS 10,000Inventory 10,000

Cash 9,000A/R 9,000

Sales 15,000CGS 10,000Deferred Gross Profit 5,000



Example (contd.)(To close sales and CGS and to record deferred gross profit under the cost recovery method)

20x2 Cash 3,000A/R 3,000Deferred Gross Profit 2,000Gross Profit 2,000

20x3 Cash 3,000A/R 3,000Deferred Gross Profit 3,000Gross Profit 3,000


Gift Card Sale Revenue Recognition

Revenue should be recognized when service is provided to the gift-card holder.

When to recognize the expired unused balance on the gift-card?


States Do Not Require to Turn Over the Abandoned and Unclaimed Property For states recognize expiration date: Can recognize the revenue upon the expiration date.

For states do not recognize expiration date: In order to recognize the unused expired balance as revenue, the company needs to prove that the expired unused balance is unlikely to be redeemed after certain periods statistically.


States Require to Turn Over the Abandoned and Unclaimed Property

The expired unused balance of gift-card may need to be remitted to the state after five- year period.


Franchise Sales

Many retail outlets (I.e., fast food, restaurants,etc.) are operated as franchises.

A franchise agreement: the franchisor (I.e., McDonald's Corporation) grants the franchisee (I.e., an individual) the right to sell the franchisor's product and use its name for a specific period of time.

The fees paid by the franchisee include: 1) the initial franchise fee and 2) continuing franchise fees.


Franchise Sales (contd.)

The initial franchise fee is to cover: 1)the right to use its name and sell

its products; 2)assistance in finding a location

and constructing the facilities, 3) training employees.

The initial franchise fee is usually a fixed amount but payable in installments.



The continuing franchise fees are paid for continuing rights and for advertising and promotion provided by the franchisor.

These fees can be a fixed monthly or annual amount or a % of the sales.



Recognition of Franchise Fees:For the initial franchise fee: (based on SFAS 45) can only be recognized as revenue after substantial amount of the initial services (required by the franchise agreement) have been performed .

For the continuing franchise fees: these fees are recognized by the franchisor as revenue in the periods they are received.


Franchise Sales –Example

On 3/31/x2, the Applebee Corporation entered into a franchise agreement with Mary Armstrong in exchange for an initial franchise fee of $100,000.

The initial services provided by Applebee include the selection of a location, construction of the building, training of employees and consulting services over several year.


Franchise Sales –Example (Contd.)

$30,000 is payable on 3/31/x2, with the remaining balance payable in annual installments over a 3-year periods with a 7% annual interest rate.

The franchisee will also pay continuing franchise fees of $2,000 per month for advertising and promotion provided by Applebee, beginning immediately after the franchise begins operations.

Mary Armstrong opens her Applebee Restaurant on 9/6/x2.



Assume that the initial services to be performed by Applebee subsequent to the contract signing are substantial and the collectibility of the fee is reasonable certain the following entry is recorded: 3/31/x2:

Cash 30,000 Note Receivable 70,000 Unearned franchise fee revenue 100,000

to record franchise agreement and down payment



Assume that substantial performance have occurred when the franchise began operation on 9/6/x2, the following entry would be recorded:

9/6/x2 Unearned franchise fee revenue 100,000 Franchise fee revenue 100,000 To recognize franchise fee revenue



Note:If collectibility of the initial fee is uncertain and there is no basis for estimating the uncollectible amounts, the initial entry(on 3/31/02) should be:

Cash 30,000 Note Receivable 70,000

Deferred franchise fee revenue 100,000 The deferred franchise fee revenue is recognized as revenue using either the installment sales or cost recovery methods.



Revenue Recognition for Continuing Franchise Fees:

Continuing franchise fee is recognized on a monthly basis as follows:

Cash 2,000 Service revenue 2,000

Multiple-Element Arrangements (ASC605-25-25-5) When one price is paid for multiple

elements (i.e., software, upgrade, maintenance, etc.), this transaction is referred to as a multiple-element arrangement.

These elements are considered separate deliverables (or separate units of accounting) if both of the following conditions are met:


Multiple-Element Arrangements (contd.)1. the delivered item or items have value to

the customer on a standalone basis and

2. If the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item or items is considered probable and substantially in the control of the vendor.

When both conditions are met, the elements are considered separate deliverables.


Multiple-Element Arrangements (contd.) The consideration/fee of the arrangement will

be allocated to all deliverables/elements based on the relative fair value of these elements.

The revenue of each element will be recognized upon the completion of each element.

Fair value (ASU2009-13): Vendor’s sales price, or Third-party evidence of sales price, or Vendor’s estimates .Income Measurement And Profit Analysis 106

Multiple-Element Arrangements (contd.) If the conditions are not met, the delivered

item(s) should be combined with other undelivered item(s) within the arrangement as one unit of accounting.

The revenue of the arrangement will be deferred until all elements are delivered.



Consignment A manufacturer or a wholesaler may transfer

goods to a dealer but the title of the goods remains with the manufacturer or the wholesaler.

Party Manufacturer DealerAccount Used Consignment-out Consignment-inPurpose ofaccount

To record thetransfer of thegoods (Debit) andtransportationcost (Debit)

To record any saleof consignmentgoods (Credit) andto record expensesoccurred for theconsignment(Debit)


Consignment

Example On 2/8/98, 300 units of goods were shipped to a

dealer on a consignment basis. The total cost of goods is $ 1,800 ($6 each). The transportation cost $150 was paid by the consignor on 2/8. The consignee spent $100 on advertisement on 2/9/98.

On 4/4, all the consignment units were sold for $10 each and the proceeds subtracted advertising expense ($100) and commission charge ($100), have been forwarded to the consignor on 4/20/98.


Consignment

Example (contd.) Consignor (manufacturer) Consignee (Dealer)

2/8 Consignmentout

Inventory1800

1800

No Entry

2/8 Consignmentout

Cash150

150

No Entry

2/9 No Entry 2/9 (Adv.)Consignment-In Cash

100100

2/9 No Entry 4/4 Sale of 300Units at $10

Cash Consignment- In

3000

3000110


Consignment

Example (contd.) Consignor (manufacturer) Consignee (Dealer)

4/20 receiving $2800 fromdealer (deduct $100commission and $100Advertisement)1. Cash 2800

Commission Exp. 100Adv. Exp. 100

Sales Rev. 30002. CGS 1950

Consignment-out 1950

*If consignment-out has adebit balance, it is a currentasset account to theconsignor.

4/20Consignment- In 2900 Cash 2800 Commission

Earned 100

* If the consignment-In hasa debit balance, it would bea current asset account forthe consignee. If theconsignment-In has a creditbalance, it would be acurrent liability account tothe consignee.

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Documents

Intermediate Financial Accounting I Revenue Recognition