Slide 4 revenue recognition revisi

Recognizing Revenue
Recognizing Revenue

Chapter
18
Intermediate Accounting
12th Edition
Kieso, Weygandt, and Warfield

Chapter
18-1

Revenue Recognition
Revenue Recognition

Revenue Revenue Revenue
Current
Recognition at the Recognition Recognition after
Environment
Point of Sale before Delivery Delivery

Guidelines for Sales with Percentage-of- Installment-sales
revenue buyback completion method
recognition agreements method Cost-recovery
Departures from Sales when right Completed- method
sale basis of return exists contract method Deposit method
Trade loading Long-term Summary of
and channel contract losses bases
stuffing Disclosures Concluding
Completion-of- remarks
production basis

Chapter
18-2

The Current Environment

Revenue recognition has been the largest
source of public company restatements over
the past decade.

One study noted restatements of revenue:
Result in larger drops in market capitalization than
other types of restatement.
Caused eight of the top ten market value losses in
a recent year.
Of the ten companies, the leading three lost $20
billion in market value in just three days following
disclosure of revenue recognition problems.
Chapter (PricewaterhouseCoopers, 2002)
18-3


Guidelines for Revenue Recognition

The revenue recognition principle provides
that companies should recognize revenue

(1) when it is realized or realizable and

(2) when it is earned.

Chapter
18-4

Guidelines for Revenue Recognition

Proper revenue recognition revolves around three
terms:

1. Revenue are realized when a company exchange goods
and services for cash or claims to cash (receivables)

2. Revenue are realizable when assets a company
receives in exchange are readily convertible to known
amounts of cash or claims to cash .
3. Revenue are earned when a company has substantially
accomplished what it must do to be entitled to the
benefits represented by the revenues—that is, when the
Chapter earnings process is complete or virtually complete.
18-5


Guidelines for Revenue Recognition (IFRS)
Revenue recognition principle:
Revenue is recognized
(1) when it is probable that the economic benefits
will flow to the company and

(2) when the benefits can be measured reliably.

Chapter
18-6 LO 1 Apply the revenue recognition principle.

Revenue Recognition Classified by Type of Transaction

Chapter 18 Chapter 18

Type of Sale of Sale of asset
Rendering a Permitting use
Transaction product from other than
service of an asset
inventory inventory

Description Revenue from Revenue from Gain or loss on
Revenue from
of Revenue fees or interest, rents, disposition
sales
services and royalties

Timing of Date of sale Services As time passes
Date of sale or
Revenue (date of performed and or assets are
trade-in
Recognition delivery) billable used

Chapter
18-7


Departures from the Sale Basis
Earlier recognition is appropriate if there is a high
degree of certainty about the amount of revenue
earned.
Delayed recognition is appropriate if the
 degree of uncertainty concerning the amount of
revenue or costs is sufficiently high or
 sale does not represent substantial completion
of the earnings process.
Chapter
18-8


Departures
from the
Sale Basis

Chapter
18-9

Revenue Recognition at Point of Sale

Recognition of Sale Revenue
Revenue from the sale of goods is recognized when all the following
conditions are met:

1. Company has transferred to the buyer the significant risks and
rewards of ownership of the goods;

2. Company retains neither continuing managerial involvement to the
degree usually associated with ownership nor effective control over
the goods sold;

3. The amount of revenue can be measured reliably;

4. It is probable that the economic benefits will flow to the company; and

5. The costs incurred or to be incurred can be estimated reliably.
Chapter
18-10 LO 2

Revenue Recognition at Point of Sale (Delivery)

Departures from the Sale Basis
FASB’s Concepts Statement No. 5, companies
usually meet the two conditions for recognizing
revenue by the time they deliver products or render
services to customers.
Implementation problems,
 Sales with Buyback Agreements
 Sales When Right of Return Exists
 Trade Loading and Channel Stuffing

Chapter
18-11


Sales with Buyback Agreements
When a repurchase agreement exists at a set price
and this price covers all cost of the inventory plus
related holding costs, the inventory and related
liability remain on the seller’s books.* In other
words, no sale.

* “Accounting for Product Financing Arrangements,” Statement of
Financial Accounting Standards No. 49 (Stamford, Conn.: FASB, 1981).

Chapter
18-12


Sales When Right of Return Exists
Recognize revenue only if six conditions have been
met.
1. The seller’s price to the buyer is substantially fixed or
determinable at the date of sale.
2. The buyer has paid the seller, or the buyer is obligated
to pay the seller, and the obligation is not contingent
on resale of the product.
3. The buyer’s obligation to the seller would not be
changed in the event of theft or physical destruction
or damage of the product.
Chapter
18-13


Sales When Right of Return Exists
Recognize revenue only if six conditions have been met.
4. The buyer acquiring the product for resale has
economic substance apart from that provided by the
seller.
5. The seller does not have significant obligations for
future performance to directly bring about resale of
the product by the buyer.
6. The seller can reasonably estimate the amount of
future returns.
Chapter
18-14


Sales with Right of Return
Two possible revenue recognition methods are available when
the right of return exposes the seller to continued risks of
ownership:

1. not recording a sale until all return privileges have expired
or

2. recording the sale, but reducing sales by an estimate of
future returns.

Chapter
18-15 LO 2 Describe accounting issues for revenue recognition at point of sale.


Trade Loading and Channel Stuffing
“Trade loading is a crazy, uneconomic, insidious
practice through which manufacturers—trying to
show sales, profits, and market share they don’t
actually have—induce their wholesale customers,
known as the trade, to buy more product than they
can promptly resell.”*

* “The $600 Million Cigarette Scam,” Fortune (December 4, 1989), p. 89.

Chapter
18-16

Revenue Recognition Before Delivery

Most notable example is long-term construction
contract accounting.

Two Methods:

Percentage-of-Completion Method.
 Rationale is that the buyer and seller have
enforceable rights.

Completed-Contract Method.

Chapter
18-17

Long-Term Contracts (Construction)

Two methods (under IFRS) of accounting for long-term
construction contracts:
 Percentage-of-completion method.
 Cost-recovery (zero-profit) method.

Chapter
18-18

Must use Percentage-of-Completion method when
estimates of progress toward completion, revenues, and
costs are reasonably dependable and all of the following
conditions exist:
1. The contract clearly specifies the enforceable rights
regarding goods or services by the parties, the
consideration to be exchanged, and the manner and terms
of settlement.
2. The buyer can be expected to satisfy all obligations.
3. The contractor can be expected to perform under the
contract.
Chapter
18-19


Companies should use the Completed-Contract method
when one of the following conditions applies when:

1. Company has primarily short-term contracts, or
2. Company cannot meet the conditions for using the
percentage-of-completion method, or
3. There are inherent hazards in the contract beyond the
normal, recurring business risks.

Chapter
18-20

Percentage-of-Completion Method

Measuring the Progress toward Completion
Most popular measure is the cost-to-cost basis.

The percentage that costs incurred bear to total
estimated costs, can be applied to the total
revenue or the estimated total gross profit on
the contract.

Chapter
18-21


Measuring the Progress toward Completion
Cost-to-cost basis

Costs incurred to date
= Percent complete
Most recent estimate of total costs
Revenue to
Percent complete x Estimated total revenue = be recognized
to date
Revenue to Revenue
Current-period
be recognized - recognized in =
Revenue
to date prior periods

Chapter
18-22 LO 3 Apply the percentage-of-completion method for long-term contracts.


Illustration:
Casper Construction Co.
2007 2008 2009
Contract price $675,000 $675,000 $675,000
Cost incurred current year 150,000 287,400 170,100
Estimated cost to complete
in future years 450,000 170,100 0
Billings to customer current year 135,000 360,000 180,000
Cash receipts from customer
Current year 112,500 262,500 300,000

A) Prepare the journal entries for 2007, 2008, and 2009.
A) Prepare the journal entries for 2007, 2008, and 2009.

Chapter
18-23


Illustration: 2007 2008 2009
Costs incurred to date $ 150,000 $ 437,400 $ 607,500
Estimated cost to complete 450,000 170,100
Est. total contract costs 600,000 607,500 607,500
Est. percentage complete 25.0% 72.0% 100.0%
Contract price 675,000 675,000 675,000
Revenue recognizable 168,750 486,000 675,000
Rev. recognized prior year (168,750) (486,000)
Rev. recognized currently 168,750 317,250 189,000
Costs incurred currently (150,000) (287,400) (170,100)
Income recognized currently $ 18,750 $ 29,850 $ 18,900

Chapter
18-24

Illustration:
2007 2008 2009
Construction in progress 150,000 287,400 170,100
Cash 150,000 287,400 170,100

Accounts receivable 135,000 360,000 180,000
Billings on contract 135,000 360,000 180,000

Cash 112,500 262,500 300,000

Construction expense 150,000 287,400 170,100
Construction revenue 168,750 317,250 189,000

Billings on contract 675,000
Construction in progress 675,000

Chapter
18-25

Illustration:
Income Statement 2007 2008 2009
Revenue on contracts $ 168,750 $ 317,250 $ 189,000
Cost of construction 150,000 287,400 170,100
Gross profit 18,750 29,850 18,900

Balance Sheet (12/31)
Current assets:
Accounts receivable 22,500 120,000 -
Cost & profits > billings 33,750
Current liabilities:
Billings > cost & profits 9,000

Chapter
18-26

Completed Contract Method

Companies recognize revenue and gross profit only at
point of sale—that is, when the contract is completed.

Under this method, companies accumulate costs of long-
term contracts in process, but they make no interim
charges or credits to income statement accounts for
revenues, costs, or gross profit.

Chapter
18-27

Illustration:
2007 2008 2009
Cash 150,000 287,400 170,100


Cash 112,500 262,500 300,000

Construction expense 607,500
Construction revenue 675,000


Chapter
18-28

Illustration:
Revenue on contracts $ - $ - $ 675,000
Cost of construction - - 607,500
Gross profit - - 67,500

Current assets:

Chapter
18-29


Cost-Recovery Method

Companies recognize revenue only to the extent of costs
incurred that are expected to be recoverable.

Only after all costs are incurred is gross profit recognized.

Chapter
18-30 LO 4 Apply the cost-recovery method for long-term contracts.

Illustration:
2010 2011 2012
Cash 150,000 287,400 170,100


Cash 112,500 262,500 300,000

Construction expense 150,000 287,400 170,100
Construction revenue 150,000 287,400 237,600


Chapter

Illustration:
Revenue on contracts €0 €0 € 675,000
Cost of construction - - 607,500
Gross profit - - 67,500

Current assets:

Chapter

Long-Term Contract Losses
Two Methods:
Loss in the Current Period on a Profitable Contract
 Percentage-of-completion method only, the estimated
cost increase requires a current-period adjustment of
gross profit recognized in prior periods.

Loss on an Unprofitable Contract
 Under both percentage-of-completion and completed-
contract methods, the company must recognize in the
current period the entire expected contract loss.

Chapter
18-33

Illustration: Loss on Profitable Contract
2007 2008 2009
Contract price $675,000 $675,000 $675,000
in future years 450,000 215,436 0
Current year 112,500 262,500 300,000
b) Prepare the journal entries for 2007, 2008, and 2009 assuming the
b) Prepare the journal entries for 2007, 2008, and 2009 assuming the
estimated cost to complete at the end of 2008 was $215,436 instead of
$170,100.
$170,100.
Chapter
18-34

2007 2008 2009
Contract price 675,000 675,000 675,000
Costs incurred currently (150,000) (287,400) (215,436)
Income recognized currently $ 18,750 $ (3,900) $ 7,314

Chapter
18-35

2007 2008 2009

Construction in progress 18,750 7,314
Construction expense 150,000 215,436
Construction revenue 168,750 222,750


Chapter
18-36

Illustration: Loss on Unprofitable Contract
2007 2008 2009
Contract price $675,000 $675,000 $675,000
in future years 450,000 246,038 0
Current year 112,500 262,500 300,000

c) Prepare the journal entries for 2007, 2008, and 2009 assuming the
c) Prepare the journal entries for 2007, 2008, and 2009 assuming the
$170,100.
$170,100.
Chapter
18-37

2007 2008 2009
Contract price 675,000 675,000 675,000
Costs incurred currently (150,000) Plug (290,438) (243,000)
Income recognized currently $ 18,750 $ (27,188) $ -

$683,438 – 678,500 = 8,438 cumulative loss
Chapter
18-38

2007 2008 2009

Construction in progress 18,750 -
Construction expense 150,000 243,000
Construction revenue 168,750 243,000


Chapter
18-39

For the Completed-Contract method, companies would
recognize the following loss :

2007 2008 2009

Loss on construction contract 8,438

Chapter
18-40

Disclosures in Financial Statements
Construction contractors should disclosure:
the method of recognizing revenue,
the basis used to classify assets and liabilities as
current (length of the operating cycle),
the basis for recording inventory,
the effects of any revision of estimates,
the amount of backlog on uncompleted contracts, and
the details about receivables.

Chapter
18-41


Completion-of-Production Basis
In certain cases companies recognize revenue at the
completion of production even though no sale has been
made.

Examples are:
precious metals or
agricultural products.

Chapter
18-42

Revenue Recognition After Delivery
Revenue Recognition After Delivery

When the collection of the sales price is not
reasonably assured and revenue recognition is
deferred.

Methods of deferring revenue:
Installment-sales method Generally
Employed
Cost-recovery method
Deposit method

Chapter
18-43

Revenue Recognition after Delivery

Installment-Sales Method
Recognizes income in the periods of collection rather
than in the period of sale.

Recognize both revenues and costs of sales in the
period of sale, but defer gross profit to periods in
which cash is collected.

Selling and administrative expenses are not deferred.

Chapter
18-44


Acceptability of the Installment-Sales Method
The profession concluded that except in special
circumstances, “the installment method of recognizing
revenue is not acceptable.”*
The rationale: because the installment method does
not recognize any income until cash is collected, it is
not in accordance with the accrual concept.

*“Omnibus Opinion,” Opinions of the Accounting Principles Board No. 10
(New York: AICPA, 1966), par. 12.

Chapter
18-45


Recognizes no profit until cash payments by the buyer
exceed the cost of the merchandise sold.

APB Opinion No. 10 allows a seller to use the cost-
recovery method to account for sales in which “there
is no reasonable basis for estimating collectibility.” In
addition, FASB Statements No. 45 (franchises) and
No. 66 (real estate) require use of this method where
a high degree of uncertainty exists related to the
collection of receivables.
Chapter
18-46


Deposit Method
Seller reports the cash received from the buyer as a
deposit on the contract and classifies it on the balance
sheet as a liability.

The seller does not recognize revenue or income until
the sale is complete.

Chapter
18-47

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