CH 05: Part A: Revenue Recognition Self-Study: 1. Discuss the general objective of the timing of and the two criteria for revenue recognition. SECs SAB

CH 05: Part A: Revenue RecognitionSelf-Study:1. Discuss the general objective of the timing of and the two criteria for revenue recognition.

SEC’s SAB 101

3. Discuss the implications for revenue recognition of allowing customers the right of return.

---------------------------------------------------------------In Class:2. Describe the installment sales and cost

recovery methods of recognizing revenue

4. Identify situations that call for the recognition of revenue over time and distinguish between the percentage-of-completion and completed contract methods of recognizing revenue for long-term contracts.

Learning Objectives

Current Current EnvironmentEnvironment

Guidelines for Guidelines for revenue revenue recognitionrecognition

Departures Departures from sale basisfrom sale basis

SAB 101 + Q&ASAB 101 + Q&A

Revenue Revenue Recognition Recognition at the at the Point of SalePoint of Sale

Revenue Revenue Recognition Recognition before before DeliveryDelivery

Revenue Revenue Recognition Recognition after after DeliveryDelivery

Sales with Sales with buyback buyback agreementsagreements

Sales when Sales when right of return right of return existsexists

Trade loading Trade loading and and channel channel stuffingstuffing

Consignment Consignment SalesSales

Installment-Installment-sales methodsales method

Cost-recovery Cost-recovery methodmethod

Deposit methodDeposit method

Summary of Summary of basesbases

Concluding Concluding remarksremarks

GAAP vs. IFRSGAAP vs. IFRS

Percentage-of-Percentage-of-completion completion methodmethod

Completed-Completed-contract contract methodmethod

Long-term Long-term contract lossescontract losses

DisclosuresDisclosures

Completion-of-Completion-of-production production basisbasis

Revenue RecognitionRevenue RecognitionRevenue RecognitionRevenue Recognition

CH 5: Revenue Recognition

The focus of this chapter is revenue recognition

OverviewThe timing of revenue recognition is critical to income measurement.

Revenue affects income, and, under the matching principle, expenses are recognized in the period in which the related revenues are recognized.

Therefore, revenue recognition determines the recognition of some expenses as well.

Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivery or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

[FASB Concepts Statement No. 6, Element of Financial Statements, paragraph 78]

Separate definition for Gains

Definition of Revenue:

The Current EnvironmentThe Current EnvironmentThe Current EnvironmentThe Current Environment

LO 1 Apply the revenue recognition principle.LO 1 Apply the revenue recognition principle.

The revenue recognition principle (FASB Concept Stmt. No. 5)

provides that companies should recognize revenue

Guidelines for Revenue Recognition


(1) when it is realized or realizable and (2) when it is earned.

Revenues are realized when goods and services are exchanged for cash or claims to cash (receivables).

Revenues are realizable when assets received in exchange are readily convertible to known amounts of cash or claims to cash.

Revenues are earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues, that is, when the earnings process is complete or virtually complete.

Revenue Recognition at Delivery

When the product or service has been delivered to the

customer and cash has been received or a receivable has

been generated that has reasonable assurance of

collectibility.

When the product or service has been delivered to the

customer and cash has been received or a receivable has

been generated that has reasonable assurance of

collectibility.

Recognize RevenueRecognize Revenue

Consignment Sales

Sometimes a company arranges for another company to sell its product under consignment.

Because the consignor retains the risks and

rewards of ownership of the product and title does not pass to the consignee,

the consignor does not record a sale until the

consignee sells the goods and title passes to the

eventual customer.

Revenue Recognition at Point of Sale (Delivery)Revenue Recognition at Point of Sale (Delivery)Revenue Recognition at Point of Sale (Delivery)Revenue Recognition at Point of Sale (Delivery)

Implementation problems:

Sales with Buyback Agreements => No Sale!

Sales When Right of Return Exists => Est. Returns

Trade Loading and Channel Stuffing => No Sale!

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.

Sales with Buyback Agreements (FAS 49)


LO 2 Describe accounting issues for revenue recognition at point of sale.LO 2 Describe accounting issues for revenue recognition at point of sale.

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

Right of Return

In most situations, even though the right to return merchandise exists, revenues

and expenses can be appropriately recognized at point of delivery.

Estimate the returns

Reduce both Sales and Cost of

Goods Sold

Recognize revenue only if six conditions (FAS 48) have

been met:

Sales When Right of Return Exists


LO 2 Describe accounting issues for revenue recognition at point of sale.LO 2 Describe accounting issues for revenue recognition at point of sale.

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 (Legal Risk).

Recognize revenue only if six conditions have been met.

Sales When Right of Return Exists


4. The buyer acquiring the product for resale has economic

substance (Profit motive, Market risk e.g. price fluctuation,

etc) 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.

“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.”*

Trade Loading (Booking tomorrow’s revenues today):


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

In other words, no sale.

In channel stuffing, the software maker offers deep discounts to its distributors to overbuy and records revenue when the software leaves its loading dock.

When this process takes place, the distributors’ inventories become bloated and the marketing channel gets stuffed, but the software maker’s financial statements are improved.

Found mostly in the computer software industry

Channel Stuffing (Booking tomorrow’s revenues today):


* “Lucent Slashes First Quarter Outlook…,” WSJ (December 22, 2000).

In other words, no sale.

Earlier recognition is appropriate if there is a high

degree of certainty about the amount of revenue earned.

Example: Percentage of Completion method.

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 collection process.

Example: Installment sales & Cost Recovery

method

Departures from the Sale Basis (Point of Delivery)


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.

The SEC has indicated that IMPROPER Revenue Recognition is the largest cause for financial Statement restatements.


A January 2002 Wall Street JournalArticle reported that more restatementsof financial statements had occurred inthe past three years than in the previous10 years combined.


SEC’s SAB 101:

In December 1999, the SEC issued Staff Accounting Bulletin

(SAB) 101, “Revenue Recognition in Financial Statements,”

Which was Followed by (in October 2000) “Revenue

Recognition in Financial Statements: Frequently Asked

Questions.”

SAB 101 was effective starting the fourth fiscal quarter for

fiscal years beginning after December 15, 2000.


SEC’s SAB 101:

SAB 101 Criteria for Revenue Recognition For revenue to be recognized under SAB 101,

it must meet all of the four following criteria:

-Persuasive evidence of an arrangement exists.

-Delivery has occurred or services have been rendered.

-The seller’s price to the buyer is fixed or determinable.

-Collectibility is reasonably assured.


SEC’s SAB 101:Because SAB 101 was released to curtail specific abuses, it should not be seen as a comprehensive set of guidelines on the entire area of revenue recognition.

In December 2003, four years after the release of SAB 101, the SEC released SAB 104, which includes a revised version of SAB 101, adapted to include developments in revenue recognition accounting since 1999.

In-Class Discussion (Next Week):

Read SAB 101, Pages 1 -10, Q & A: 1- 10


SEC’s SAB 101 (104) provides guidance on the following

revenue recognition issues:

-Timing of approval for sales agreements;

-“Side” arrangements: Buybacks, Consignments, Extended Financing arrangements, and Right of return.

- Bill and hold sales;

-Layaway programs;

-Nonrefundable, up-front fees;

-Membership fees/services. -Cancellation or termination provisions; -Contingent rental income;


1. Discuss the assigned Q&A

2. Discuss “Sales Type” or “Issue Type”

3. Provide a DEMO (Numeric) Problem

4. Solve the DEMO Problem with JEs

5. Provide a REAL-WORLD Example of a Company in

violation of the specific Q&A (FRAUD): 1999 -- 2005

SAB 101 Discussion FormatSAB 101 Discussion FormatSAB 101 Discussion FormatSAB 101 Discussion Format

Realization Principle

Revenue recognition is often tied to delivery of the product from the seller to the buyer.

Revenue Recognition After Delivery

1. Installment Sales Method

2. Cost Recovery Method

1. Installment Sales Method

2. Cost Recovery Method

When we are unable to make reasonable estimates of uncollectible amounts or customer returns of products, we delay recognizing revenue from the sale until the uncertainty has been resolved.

When we are unable to make reasonable estimates of uncollectible amounts or customer returns of products, we delay recognizing revenue from the sale until the uncertainty has been resolved.

Recognize income in the periods of CASH collection rather than in the period of sale.Selling and administrative expenses are not deferred.

Installment-Sales MethodInstallment-Sales Method

This is due to the fact that the ultimate profit is more uncertain in installment sales than in ordinary sales because collection is more doubtful.

Type of sale for which payment is required in periodic installments over an extended period of time.

Installment Sales MethodOn November 1, 2011, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, 2011. The land cost $560,000 to develop. The company’s fiscal year ends on December 31.

Gross Profit $240,000 ÷ $800,000

= 30%

Gross Profit $240,000 ÷ $800,000

= 30%

Date Cash

Collected Cost(70%)

Gross Profit (30%)

Nov. 1, 2011 $ 200,000 $ 140,000 $ 60,000 Nov. 1, 2012 200,000 140,000 60,000 Nov. 1, 2013 200,000 140,000 60,000 Nov. 1, 2014 200,000 140,000 60,000 Totals $ 800,000 $ 560,000 $ 240,000

Amount Allocated to:

Installment Sales Method

This entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account.

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.

Cost-Recovery Method

Revenue Recognition after DeliveryRevenue Recognition after DeliveryRevenue Recognition after DeliveryRevenue Recognition after Delivery

Cost Recovery MethodOn November 1, 2011, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, 2011. The land cost $560,000 to develop. The company’s fiscal year ends on December 31.

Date Cash

Collected Cost

RecoveryGross Profit Recognized

Nov. 1, 2011 $ 200,000 $ 200,000 $ - Nov. 1, 2012 200,000 200,000 - Nov. 1, 2013 200,000 160,000 40,000 Nov. 1, 2014 200,000 - 200,000 Totals $ 800,000 $ 560,000 $ 240,000

Cost Recovery Method

Exercises and Problems

In Class: E 4 and E5 (2011)

Home Work: E 1 and 2, Prob. 4

Revenue Recognition Prior to Delivery

Completed Contract Method

Completed Contract Method

Percentage-of-Completion

Method

Percentage-of-Completion

Method

Long-term Contracts

Long-term Contracts

Using the percentage-of-completion method,

we recognize a portion of the estimated gross profit

each period based on progress to date.

Measuring the Progress toward Completionusing Cost-to-Cost basis:

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

Percentage-of-Completion MethodPercentage-of-Completion MethodPercentage-of-Completion MethodPercentage-of-Completion Method

Costs incurred to date

Most recent estimate of total costs=

Percentage of completion

Percent complete x Estimated total = Gross Profit

Gross profit to be recognized to date

Gross profit to be recognized to date

Current-period Gross profit -

Gross profit recognized in prior periods

=

Completed Contract and Percentage-of-Completion Methods Compared

Timing of Gross Profit Recognition Under the Percentage-of-Completion Method

Using the percentage-of-completion method, we recognize a portion of the estimated gross profit

each period based on progress to date.

We determine the amount of gross profit recognized in each period using the following logic:

Percentage-of-Completion Method Allocation of Gross Profit

Accounting for the Cost of Construction and Accounts Receivable

With both the completed contract and percentage-of-completion methods, all costs of construction are

recorded in an asset account called construction in progress.

Gross Profit Recognition—General Approach

In both methods the same amounts of revenue, cost,

and gross profit are recognized.

In both methods we add gross profit to the

construction in progress asset.

Gross Profit Recognition—General Approach

The same journal entry is recorded to close out the billings on construction contract and construction in progress

accounts under the completed contract and percentage-of-completion methods.


Notice that the gross profit recognized in each period is added to the construction in progress account.

Balance Sheet Recognition

Billings on construction contract are subtracted from construction in progress to determine

balance sheet presentation.

CIP > Billings Asset

Billings > CIP Liability

Balance Sheet RecognitionThe balance in the construction in progress

account differs between methods because of the earlier gross profit recognition that occurs under

the percentage-of-completion method.


The income statement for each year will report the appropriate revenue and cost of

construction amounts.

Income Recognition

The same total amount of profit or loss is recognized under both the completed contract and the percentage-of-completion methods, but the timing of recognition differs.

Timing of Gross Profit Recognition Under the Completed Contract Method

Under the completed contract method, all revenues and expenses related to the project are

recognized when the contract is completed.

Long-term Contract Losses

Periodic Loss for Profitable Projects

Determine periodic loss and record loss

as a credit to the Construction in

Progress account.

Exercises and Problems

In Class: E 9 (as is) + Gross Profit Schedule + JE for 2011 (% of Completion)

Home Work: E10 (Requirements 1 - 3)

P 5 (Requirements 1 - 3)

U. S. GAAP vs. IFRS

• Requires percentage-of-completion when reliable estimates can be made.

• Requires completed contract method when reliable estimates can’t be made.

There are similarities and differences between IFRS and U.S. GAAP when considering revenue

recognition for long-term construction contracts.

• Requires percentage-of-completion when reliable estimates can be made.

• Requires cost recovery method when reliable estimates can’t be made.

U. S. GAAP vs. IFRSNotice that revenue recognition occurs earlier under the cost recovery method than under the completed contract method, but gross profit recognition occurs at the end of

the contract for both methods.

Software and Other Multiple- Deliverable Arrangements

If a sale includes multiple elements (software, future upgrades, postcontract customer support, etc.), the revenue should be allocated to the elements that have stand-alone value (e.g., aren’t contingent). Otherwise, defer revenue recognition until the last item delivered.

•Software: base allocation on VSOE

•Other: can use estimated selling prices. This includes tangible products that contain essential software.

U. S. GAAP vs. IFRS

• Revenue should be allocated to the various elements based on the stand-alone selling prices of the individual elements. These can be estimated for non-software arrangements if VSOE is not available, but have to use VSOE for software arrangements.

IFRS contains very little guidance about multiple-deliverable arrangements.

• May be necessary to apply the recognition criteria to the separately identifiable components of a single transaction.

• Allocation of total revenue to individual components are based on fair value.

U. S. GAAP vs. IFRS

• Earnings process is complete or virtually complete.

• Reasonable certainty as to the collectibility of the asset to be received.

Revenue recognition criteria for U.S. GAAP and IFRS include:

• Revenue and costs can be measured reliably.

• Probable that economic benefits will flow to the seller.

• Risk and rewards are transferred to buyer and seller does not manage or control the goods.

• Stage of completion can be measured reliably.

Franchise Sales

Initial Franchise Fees

Generally are recognized at a

point in time when the earnings

process is virtually complete.

U. S. GAAP vs. IFRS

• Has over 100 revenue-related standards that sometimes contradict each other.

The FASB and IASB are currently working on a new, comprehensive approach to revenue

recognition.

• Has two primary standards that also sometimes contradict each other and that don’t offer guidance in some important areas (like multiple deliverables).

The Boards appear committed to improving accounting in this area.

End of Chapter 5

Documents

CH 05: Part A: Revenue Recognition Self-Study: 1. Discuss the general objective of the timing of and the two criteria for revenue recognition. SECs SAB