Revenue Recognition


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  • Revenue Recognition

    1. 1. Chapter 18: Revenue Recognition
    2. 2. <ul><li>Issues </li></ul><ul><ul><li>Largest single source of public company FS restatements </li></ul></ul><ul><ul><li>Required to be considered fraud risk under SAS #99 </li></ul></ul><ul><ul><li>Can occur in any industry </li></ul></ul>Revenue Recognition
    3. 3. <ul><li>Revenue recognition principle provides that revenue is recognized: </li></ul><ul><ul><li>when it is earned AND </li></ul></ul><ul><ul><li>when it is realized or realizable </li></ul></ul><ul><li>Revenue is </li></ul><ul><ul><li>Earned when earnings process is substantially complete </li></ul></ul><ul><ul><li>Realized when goods & services exchanged for cash or claims to cash </li></ul></ul><ul><ul><li>Realizable when assets received are convertible into a known amount of cash </li></ul></ul>Guidelines for Revenue Recognition
    4. 4. <ul><li>Revenue from selling products </li></ul><ul><ul><li>Recognized at the date of sale (date of delivery) </li></ul></ul><ul><li>Revenue from services </li></ul><ul><ul><li>Recognized when services are performed & are billable </li></ul></ul><ul><li>Revenue from the use of enterprise’s assets by others </li></ul><ul><ul><li>Recognized as time passes or as the assets are used up </li></ul></ul><ul><li>Revenue from disposal of assets (other than inventory) </li></ul><ul><ul><li>Recognized at the point of sale as gain or loss </li></ul></ul>Four Types of Revenue Transactions
    5. 5. Revenue Recognition Classified by Nature of Transaction
    6. 6. <ul><li>Point of sale (delivery) </li></ul><ul><li>Before delivery </li></ul><ul><li>After delivery </li></ul><ul><li>Special transactions </li></ul><ul><ul><li>Franchises </li></ul></ul><ul><ul><li>Consignments </li></ul></ul><ul><li>Comparative matrix of bases page 909 </li></ul>Revenue Recognition
    7. 7. <ul><li>Revenues from manufacturing & selling </li></ul><ul><ul><li>Realized/realizable </li></ul></ul><ul><ul><li>Earned </li></ul></ul>Revenue Recognition at Point of Sale
    8. 8. <ul><li>Exceptions: </li></ul><ul><ul><li>Sales with buyback agreements </li></ul></ul><ul><ul><li>Sales when right of return exists </li></ul></ul><ul><ul><ul><li>High rates that are not reliably estimable – continued risk of ownership </li></ul></ul></ul><ul><ul><ul><li>Criteria to meet </li></ul></ul></ul><ul><ul><ul><ul><li>Page 910 </li></ul></ul></ul></ul><ul><ul><li>Trade loading & channel stuffing </li></ul></ul>Revenue Recognition at Point of Sale
    9. 9. <ul><li>Revenue may be recognized before delivery under certain circumstances </li></ul><ul><ul><li>Long-term construction contracts are a notable example </li></ul></ul><ul><ul><ul><li>Revenue recognition methods </li></ul></ul></ul><ul><ul><ul><ul><li>Percentage-of-completion method </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Completed contract method </li></ul></ul></ul></ul>Revenue Recognition Before Delivery
    10. 10. 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
    11. 11. 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
    12. 12. <ul><li>Cost of construction: </li></ul><ul><ul><li>Construction in process (CIP) </li></ul></ul><ul><ul><li>Materials, cash, payables, etc . </li></ul></ul><ul><li>Progress billings: </li></ul><ul><ul><li>Accounts receivable </li></ul></ul><ul><ul><li>Billings on CIP </li></ul></ul><ul><li>Collections: </li></ul><ul><ul><li>Cash </li></ul></ul><ul><ul><li>Accounts receivable </li></ul></ul>Percentage-of-Completion: Entries
    13. 13. <ul><li>To recognize revenue and gross profit: </li></ul><ul><ul><li>Construction in process (gross profit) </li></ul></ul><ul><ul><li>Construction expenses </li></ul></ul><ul><ul><li>Revenue </li></ul></ul><ul><li>To record completion of project: </li></ul><ul><ul><li>Billings on CIP </li></ul></ul><ul><ul><li>Construction in process </li></ul></ul>Percentage-of-Completion: Entries
    14. 14. 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
    15. 15. 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
    16. 16. <ul><li>All revenue & GP recognized only at point of sale (when contract completed) </li></ul><ul><ul><li>Revenue is actual vs. estimate </li></ul></ul><ul><ul><li>Does not reflect current performance when extends beyond one accounting period </li></ul></ul>Completed Contract
    17. 17. <ul><li>A long-term contract may produce : </li></ul><ul><ul><li>Interim loss & overall profit OR </li></ul></ul><ul><ul><li>Overall loss for the project </li></ul></ul><ul><li>Percentage-of-completion method </li></ul><ul><ul><li>Losses in any case recognized immediately </li></ul></ul><ul><ul><li>Examples page 920-921 </li></ul></ul><ul><li>Completed contract method </li></ul><ul><ul><li>Losses recognized immediately only when overall losses indicated </li></ul></ul><ul><ul><li>Example page 921 </li></ul></ul>Recognizing Current & Overall Losses on Long-Term Contracts
    18. 18. 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.
    19. 19. <ul><li>Method of revenue recognition </li></ul><ul><li>Basis to classify A&L as current </li></ul><ul><li>Inventory basis </li></ul><ul><li>Effects of estimate revisions </li></ul><ul><li>Backlog on uncompleted contracts </li></ul><ul><li>Details re: receivables </li></ul><ul><ul><li>Billed, unbilled, interest rate, retainage, concentrations of credit risk </li></ul></ul>Financial Statement Disclosures Contractors
    20. 20. <ul><li>Revenue recognition deferred </li></ul><ul><ul><li>Collection of sales price not reasonably assured AND </li></ul></ul><ul><ul><li>No reliable estimates can be made </li></ul></ul><ul><li>Revenue recognition methods </li></ul><ul><ul><li>Installment sales method </li></ul></ul><ul><ul><li>Cost recovery method </li></ul></ul><ul><li>Cash received prior to delivery </li></ul><ul><ul><li>Use deposit method </li></ul></ul>Revenue Recognition After Delivery
    21. 21. <ul><li>Emphasizes revenue recognition in periods of collection rather than point of sale </li></ul><ul><li>Title does not pass to buyer until all cash payments made to seller </li></ul><ul><li>Sales & cost of sales deferred to periods of collection </li></ul><ul><li>Other expenses, selling & administrative, are not deferred </li></ul>The Installment Sales Method
    22. 22. <ul><li>Installment sales must be kept separate </li></ul><ul><li>Gross profit must be determinable </li></ul><ul><li>Amount of cash collected from installment accounts must be known </li></ul><ul><li>Cash collected from current year & prior years accounts must be known </li></ul><ul><li>Provision must be made to carry forward deferred gross profit </li></ul>The Installment Sales Method: Issues
    23. 23. <ul><li>For installment sales in any year </li></ul><ul><li>For installment sales made in prior years (realized gross profit) </li></ul><ul><li>Determine rate of gross profit on installment sales </li></ul><ul><li>Apply rate to cash collections of current year installment sales to yield realized gross profit </li></ul><ul><li>Gross profit not realized is deferred </li></ul><ul><li>Apply relevant rate to cash collections of prior year installment sales </li></ul>The Installment Sales Method: Steps
    24. 24. <ul><li>Given: 20X3 20X4 20X5 </li></ul><ul><li>Installment sales $200,000 $250,000 $240,000 </li></ul><ul><li>Cost of sales $150,000 $190,000 $168,000 </li></ul><ul><li>Gross Profit $ 50,000 $ 60,000 $ 72,000 </li></ul><ul><li>Cash received in: </li></ul><ul><li>from 20X3 sales $ 60,000 $ 100,000 $ 40,000 </li></ul><ul><li>from 20X4 sales $ -0- $ 100,000 $125,000 </li></ul><ul><li>from 20X5 sales $ -0- $ -0- $ 80,000 </li></ul><ul><li>Determine the realized and deferred gross profit </li></ul>The Installment Sales Method: Example
    25. 25. <ul><li>Given: 20X3 20X4 20X5 </li></ul><ul><li>Installment sales $200,000 $250,000 $240,000 </li></ul><ul><li>Gross Profit $ 50,000 $ 60,000 $ 72,000 </li></ul><ul><li>Gross profit rate 25% 24% 30% </li></ul><ul><li>See next slide for realized and deferred gross profit </li></ul>The Installment Sales Method: Example
    26. 26. <ul><li> 20X3 20X4 20X5 </li></ul><ul><li>Gross profit rate 25% 24% 30% </li></ul><ul><li>Realized Gross Profit : </li></ul><ul><li>From 20X3 sales : </li></ul><ul><li>Realized in $ 15,000 $ 25,000 $ 10,000 </li></ul><ul><li>From 20X4 sales: </li></ul><ul><li>Realized in: $ -0- $ 24,000 $ 30,000 </li></ul><ul><li>From 20X5 sales : </li></ul><ul><li>Realized in: $ -0- $ -0- $ 24,000 </li></ul>Gross profit deferred deferred The Installment Sales Method: Example
    27. 27. <ul><li>Installment Sales 200,000 </li></ul><ul><li>Cost of Sales 150,000 </li></ul><ul><li>Deferred Gross Profit, 20X3 50,000 (To close 20X3 accounts) </li></ul><ul><li>Deferred Gross Profit, 20X3 15,000 Realized Gross Profit 15,000 (Realized: $60,000 x 25%) </li></ul><ul><li>Realized Gross Profit 15,000 Income Summary 15,000 </li></ul><ul><li>(To close to Income Summary) </li></ul>The Installment Sales Method: Partial Journal Entries (20X3) for Gross Profit
    28. 28. <ul><li>If significant to sales </li></ul><ul><ul><li>Full disclosure of installment sales </li></ul></ul><ul><ul><li>Cost of installment sales </li></ul></ul><ul><ul><li>Expenses allocable to installment sales </li></ul></ul><ul><ul><li>Illustration 18-26 page 930 </li></ul></ul><ul><li>If insignificant </li></ul><ul><ul><li>Realize GP in IS as special item after GP on sales </li></ul></ul><ul><ul><li>Illustration 18-25 page 929 </li></ul></ul>The Installment Sales Method: Financial Statement Presentation
    29. 29. <ul><li>BS presentation of AR </li></ul><ul><li>Repossessed merchandise </li></ul><ul><li>Deferred GP on installment sales </li></ul><ul><ul><li>Theoretical components – difficult to allocate </li></ul></ul><ul><ul><ul><li>Income tax liability paid when sales reported as realized </li></ul></ul></ul><ul><ul><ul><li>Allowance for collection & B/D expense & repossession losses </li></ul></ul></ul><ul><ul><ul><li>Net income </li></ul></ul></ul><ul><ul><li>Contra asset per SFAS #6 </li></ul></ul><ul><ul><li>Practice is to treat all as unearned revenue </li></ul></ul>The Installment Sales Method: Miscellaneous Issues
    30. 30. <ul><li>Seller recognizes no profit </li></ul><ul><ul><li>Until cash payments by buyer exceed seller’s cost of merchandise </li></ul></ul><ul><ul><li>Deferred GP offset to related AR net of collections </li></ul></ul><ul><li>After recovering all costs </li></ul><ul><ul><li>Seller includes additional cash collections in income </li></ul></ul><ul><li>Used when there is no reasonable basis for estimating collectibility </li></ul><ul><ul><li>Franchises & real estate </li></ul></ul><ul><li>IS reports amount of gross profit recognized & amount deferred </li></ul><ul><ul><li>Separate item of revenue when recognized as earned </li></ul></ul><ul><li>Illustration 18-28 page 931 </li></ul>The Cost Recovery Method
    31. 31. <ul><li>Seller </li></ul><ul><ul><li>Receives cash from buyer before transfer of goods or performance </li></ul></ul><ul><ul><li>Has no claim against purchaser </li></ul></ul><ul><li>There is insufficient transfer of risks to buyer to warrant recording sale by seller </li></ul><ul><li>Deposit method defers sale recognition until sale has occurred for accounting purposes </li></ul>The Deposit Method
    32. 32. <ul><li>Estimates </li></ul><ul><ul><li>% complete </li></ul></ul><ul><ul><li>Costs </li></ul></ul><ul><ul><li>GP % for installment sales </li></ul></ul><ul><li>Completion dates </li></ul><ul><li>Losses on contracts </li></ul><ul><li>Rights of return – outside of sales contract </li></ul><ul><li>Trade loading & channel stuffing </li></ul>Ethics & Issues
    33. 33. <ul><li>Franchises </li></ul><ul><ul><li>Manufacturer-retailer </li></ul></ul><ul><ul><li>Manufacturer-wholesaler </li></ul></ul><ul><ul><li>Service sponsor-retailer </li></ul></ul><ul><ul><ul><li>Fastest growing, accounting issues </li></ul></ul></ul><ul><ul><li>Wholesaler-retailer </li></ul></ul><ul><li>Consignments </li></ul>Special Sales Transactions
    34. 34. <ul><li>Franchisor – grants business rights </li></ul><ul><li>Franchisee – operates business </li></ul><ul><li>Initial franchise fee </li></ul><ul><ul><li>Revenue </li></ul></ul><ul><ul><ul><li>Franchisor makes substantial performance AND </li></ul></ul></ul><ul><ul><ul><ul><li>Substantial performance = no obligation to refund any cash received/excuse nonpayment of note </li></ul></ul></ul></ul><ul><ul><ul><li>Collection of fee reasonably assured </li></ul></ul></ul><ul><ul><li>Example JEs page 937 </li></ul></ul><ul><li>Continuing franchise fees </li></ul><ul><ul><li>Revenue when earned & receivable </li></ul></ul>Special Sales Transactions Franchises
    35. 35. <ul><li>Additional issues & concerns </li></ul><ul><ul><li>Bargain purchases </li></ul></ul><ul><ul><ul><li>BPP < normal selling price = defer portion initial fee </li></ul></ul></ul><ul><ul><li>Options to purchase </li></ul></ul><ul><ul><ul><li>Probable @ time of option = liability </li></ul></ul></ul><ul><ul><li>Franchisor’s cost </li></ul></ul><ul><ul><ul><li>Direct costs – generally defer </li></ul></ul></ul><ul><ul><ul><li>Indirect costs – current IS </li></ul></ul></ul>Special Sales Transactions Franchises
    36. 36. <ul><li>Consignor – manufacturer/wholesaler </li></ul><ul><ul><li>Accepts risk merchandise might not sell </li></ul></ul><ul><li>Consignee - dealer </li></ul><ul><li>Consignment </li></ul><ul><ul><li>Consignor carries inventory </li></ul></ul><ul><ul><ul><li>Record revenue when notified of sale by consignee & cash received </li></ul></ul></ul><ul><ul><li>Consignee has liability for amount due consignor </li></ul></ul>Special Sales Transactions Consignments
    37. 37. <ul><li>E18-5 E18-6 </li></ul><ul><li>E18-9 E18-14 </li></ul><ul><li>E18-15 E18-22 </li></ul>Class Exercises