Chapter 18: Revenue Recognition

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

Issues

Largest single source of public company FS restatements

Required to be considered fraud risk under SAS #99

Can occur in any industry

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

Revenue recognition principle provides that revenue is recognized:

when it is earned AND

when it is realized or realizable

Revenue is

Earned when earnings process is substantially complete

Realized when goods & services exchanged for cash or claims to cash

Realizable when assets received are convertible into a known amount of cash

Revenue from selling products Recognized at the date of sale (date of delivery) Revenue from services Recognized when services are performed & are billable Revenue from the use of enterprise’s assets by others Recognized as time passes or as the assets are used up Revenue from disposal of assets (other than inventory) Recognized at the point of sale as gain or loss Four Types of Revenue Transactions

Revenue from selling products

Recognized at the date of sale (date of delivery)

Revenue from services

Recognized when services are performed & are billable

Revenue from the use of enterprise’s assets by others

Recognized as time passes or as the assets are used up

Revenue from disposal of assets (other than inventory)

Recognized at the point of sale as gain or loss

Revenue Recognition Classified by Nature of Transaction

Point of sale (delivery) Before delivery After delivery Special transactions Franchises Consignments Comparative matrix of bases page 909 Revenue Recognition

Point of sale (delivery)

Before delivery

After delivery

Special transactions

Franchises

Consignments

Comparative matrix of bases page 909

Revenues from manufacturing & selling Realized/realizable Earned Revenue Recognition at Point of Sale

Revenues from manufacturing & selling

Realized/realizable

Earned

Exceptions: Sales with buyback agreements Sales when right of return exists High rates that are not reliably estimable – continued risk of ownership Criteria to meet Page 910 Trade loading & channel stuffing Revenue Recognition at Point of Sale

Exceptions:

Sales with buyback agreements

Sales when right of return exists

High rates that are not reliably estimable – continued risk of ownership

Criteria to meet

Page 910

Trade loading & channel stuffing

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

Revenue may be recognized before delivery under certain circumstances

Long-term construction contracts are a notable example

Revenue recognition methods

Percentage-of-completion method

Completed contract method

Long-Term Construction Accounting Methods Revenue Recognition Before Delivery 1) Terms of contract must be certain, enforceable 2) Certainty of performance by both parties 3) Estimates of completion can be made reliably 1) To be used only when percentage method inapplicable (uncertain) 2) For short-term contracts Percentage-of-Completion Method Completed Contract Method

Percentage-of-Completion: Steps Costs incurred to date = Percent complete Most recent estimated total costs 1 Estimated total revenue x Percent complete = Revenue to be recognized to date 2 Total revenue to be recognized to date less Revenue recognized in PRIOR periods = Current period revenue 3 Current Period Revenue less current costs = Gross profit 4

Cost of construction: Construction in process (CIP) Materials, cash, payables, etc . Progress billings: Accounts receivable Billings on CIP Collections: Cash Accounts receivable Percentage-of-Completion: Entries

Cost of construction:

Construction in process (CIP)

Materials, cash, payables, etc .

Progress billings:

Accounts receivable

Billings on CIP

Collections:

Cash

Accounts receivable

To recognize revenue and gross profit: Construction in process (gross profit) Construction expenses Revenue To record completion of project: Billings on CIP Construction in process Percentage-of-Completion: Entries

To recognize revenue and gross profit:

Construction in process (gross profit)

Construction expenses

Revenue

To record completion of project:

Billings on CIP

Construction in process

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

20X3 20X4 20X5 Percentage-of-Completion: Example % complete to-date 1,000,000 = 25% 2,916,000 = 72% 100 % 4,000,000 4,050,000 Revenue recognized 4,500,000 * 25% 4,500,000 * 72% 4,500,000 = 1,125,000 less 1,125,000 less 3,240,000 = 2,115,000 = 1,260,000 1,125,000 less 2,115,000 less 1,260,000 1,000,000 1,916,000 less 1,134,000 = 125,000 = 199,000 = 126,000 Gross Profit recognized

All revenue & GP recognized only at point of sale (when contract completed) Revenue is actual vs. estimate Does not reflect current performance when extends beyond one accounting period Completed Contract

All revenue & GP recognized only at point of sale (when contract completed)

Revenue is actual vs. estimate

Does not reflect current performance when extends beyond one accounting period

A long-term contract may produce : Interim loss & overall profit OR Overall loss for the project Percentage-of-completion method Losses in any case recognized immediately Examples page 920-921 Completed contract method Losses recognized immediately only when overall losses indicated Example page 921 Recognizing Current & Overall Losses on Long-Term Contracts

A long-term contract may produce :

Interim loss & overall profit OR

Overall loss for the project

Percentage-of-completion method

Losses in any case recognized immediately

Examples page 920-921

Completed contract method

Losses recognized immediately only when overall losses indicated

Example page 921

Current Loss on an otherwise overall profitable contract Loss on an overall unprofitable contract Recognizing Current & Overall Losses on Long-Term Contracts Completed method : No adjustment needed. Percentage Method : Recognize loss currently. Percentage Method : Recognize entire loss now. Completed method : Recognize loss currently.

Method of revenue recognition Basis to classify A&L as current Inventory basis Effects of estimate revisions Backlog on uncompleted contracts Details re: receivables Billed, unbilled, interest rate, retainage, concentrations of credit risk Financial Statement Disclosures Contractors

Method of revenue recognition

Basis to classify A&L as current

Inventory basis

Effects of estimate revisions

Backlog on uncompleted contracts

Details re: receivables

Billed, unbilled, interest rate, retainage, concentrations of credit risk

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

Revenue recognition deferred

Collection of sales price not reasonably assured AND

No reliable estimates can be made

Revenue recognition methods

Installment sales method

Cost recovery method

Cash received prior to delivery

Use deposit method

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

Emphasizes revenue recognition in periods of collection rather than point of sale

Title does not pass to buyer until all cash payments made to seller

Sales & cost of sales deferred to periods of collection

Other expenses, selling & administrative, are not deferred

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

Installment sales must be kept separate

Gross profit must be determinable

Amount of cash collected from installment accounts must be known

Cash collected from current year & prior years accounts must be known

Provision must be made to carry forward deferred gross profit

For installment sales in any year For installment sales made in prior years (realized gross profit) Determine rate of gross profit on installment sales Apply rate to cash collections of current year installment sales to yield realized gross profit Gross profit not realized is deferred Apply relevant rate to cash collections of prior year installment sales The Installment Sales Method: Steps

For installment sales in any year

For installment sales made in prior years (realized gross profit)

Determine rate of gross profit on installment sales

Apply rate to cash collections of current year installment sales to yield realized gross profit

Gross profit not realized is deferred

Apply relevant rate to cash collections of prior year installment sales

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

Given: 20X3 20X4 20X5

Installment sales $200,000 $250,000 $240,000

Cost of sales $150,000 $190,000 $168,000

Gross Profit $ 50,000 $ 60,000 $ 72,000

Cash received in:

from 20X3 sales $ 60,000 $ 100,000 $ 40,000

from 20X4 sales $ -0- $ 100,000 $125,000

from 20X5 sales $ -0- $ -0- $ 80,000

Determine the realized and deferred gross profit

Given: 20X3 20X4 20X5 Installment sales $200,000 $250,000 $240,000 Gross Profit $ 50,000 $ 60,000 $ 72,000 Gross profit rate 25% 24% 30% See next slide for realized and deferred gross profit The Installment Sales Method: Example

Given: 20X3 20X4 20X5

Installment sales $200,000 $250,000 $240,000

Gross Profit $ 50,000 $ 60,000 $ 72,000

Gross profit rate 25% 24% 30%

See next slide for realized and deferred gross profit

20X3 20X4 20X5 Gross profit rate 25% 24% 30% Realized Gross Profit : From 20X3 sales : Realized in $ 15,000 $ 25,000 $ 10,000 From 20X4 sales: Realized in: $ -0- $ 24,000 $ 30,000 From 20X5 sales : Realized in: $ -0- $ -0- $ 24,000 Gross profit deferred deferred The Installment Sales Method: Example

20X3 20X4 20X5

Gross profit rate 25% 24% 30%

Realized Gross Profit :

From 20X3 sales :

Realized in $ 15,000 $ 25,000 $ 10,000

From 20X4 sales:

Realized in: $ -0- $ 24,000 $ 30,000

From 20X5 sales :

Realized in: $ -0- $ -0- $ 24,000

Installment Sales 200,000 Cost of Sales 150,000 Deferred Gross Profit, 20X3 50,000 (To close 20X3 accounts) Deferred Gross Profit, 20X3 15,000 Realized Gross Profit 15,000 (Realized: $60,000 x 25%) Realized Gross Profit 15,000 Income Summary 15,000 (To close to Income Summary) The Installment Sales Method: Partial Journal Entries (20X3) for Gross Profit

Installment Sales 200,000

Cost of Sales 150,000

Deferred Gross Profit, 20X3 50,000 (To close 20X3 accounts)

Deferred Gross Profit, 20X3 15,000 Realized Gross Profit 15,000 (Realized: $60,000 x 25%)

Realized Gross Profit 15,000 Income Summary 15,000

(To close to Income Summary)

If significant to sales Full disclosure of installment sales Cost of installment sales Expenses allocable to installment sales Illustration 18-26 page 930 If insignificant Realize GP in IS as special item after GP on sales Illustration 18-25 page 929 The Installment Sales Method: Financial Statement Presentation

If significant to sales

Full disclosure of installment sales

Cost of installment sales

Expenses allocable to installment sales

Illustration 18-26 page 930

If insignificant

Realize GP in IS as special item after GP on sales

Illustration 18-25 page 929

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

BS presentation of AR

Repossessed merchandise

Deferred GP on installment sales

Theoretical components – difficult to allocate

Income tax liability paid when sales reported as realized

Allowance for collection & B/D expense & repossession losses

Net income

Contra asset per SFAS #6

Practice is to treat all as unearned revenue

Seller recognizes no profit Until cash payments by buyer exceed seller’s cost of merchandise Deferred GP offset to related AR net of collections After recovering all costs Seller includes additional cash collections in income Used when there is no reasonable basis for estimating collectibility Franchises & real estate IS reports amount of gross profit recognized & amount deferred Separate item of revenue when recognized as earned Illustration 18-28 page 931 The Cost Recovery Method

Seller recognizes no profit

Until cash payments by buyer exceed seller’s cost of merchandise

Deferred GP offset to related AR net of collections

After recovering all costs

Seller includes additional cash collections in income

Used when there is no reasonable basis for estimating collectibility

Franchises & real estate

IS reports amount of gross profit recognized & amount deferred

Separate item of revenue when recognized as earned

Illustration 18-28 page 931

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

Seller

Receives cash from buyer before transfer of goods or performance

Has no claim against purchaser

There is insufficient transfer of risks to buyer to warrant recording sale by seller

Deposit method defers sale recognition until sale has occurred for accounting purposes

Estimates % complete Costs GP % for installment sales Completion dates Losses on contracts Rights of return – outside of sales contract Trade loading & channel stuffing Ethics & Issues

Estimates

% complete

Costs

GP % for installment sales

Completion dates

Losses on contracts

Rights of return – outside of sales contract

Trade loading & channel stuffing

Franchises Manufacturer-retailer Manufacturer-wholesaler Service sponsor-retailer Fastest growing, accounting issues Wholesaler-retailer Consignments Special Sales Transactions

Franchises

Manufacturer-retailer

Manufacturer-wholesaler

Service sponsor-retailer

Fastest growing, accounting issues

Wholesaler-retailer

Consignments

Franchisor – grants business rights Franchisee – operates business Initial franchise fee Revenue Franchisor makes substantial performance AND Substantial performance = no obligation to refund any cash received/excuse nonpayment of note Collection of fee reasonably assured Example JEs page 937 Continuing franchise fees Revenue when earned & receivable Special Sales Transactions Franchises

Franchisor – grants business rights

Franchisee – operates business

Initial franchise fee

Revenue

Franchisor makes substantial performance AND

Substantial performance = no obligation to refund any cash received/excuse nonpayment of note

Collection of fee reasonably assured

Example JEs page 937

Continuing franchise fees

Revenue when earned & receivable

Additional issues & concerns Bargain purchases BPP < normal selling price = defer portion initial fee Options to purchase Probable @ time of option = liability Franchisor’s cost Direct costs – generally defer Indirect costs – current IS Special Sales Transactions Franchises

Additional issues & concerns

Bargain purchases

BPP < normal selling price = defer portion initial fee

Options to purchase

Probable @ time of option = liability

Franchisor’s cost

Direct costs – generally defer

Indirect costs – current IS

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

Consignor – manufacturer/wholesaler

Accepts risk merchandise might not sell

Consignee - dealer

Consignment

Consignor carries inventory

Record revenue when notified of sale by consignee & cash received

Consignee has liability for amount due consignor

E18-5 E18-6 E18-9 E18-14 E18-15 E18-22 Class Exercises

E18-5 E18-6

E18-9 E18-14

E18-15 E18-22