64
1 Revenue Revenue Recognition Recognition An electronic An electronic presentation presentation by Douglas Cloud by Douglas Cloud Pepperdine University Pepperdine University chapter chapter 8

Ch08 Revenue Recognition

Embed Size (px)

Citation preview

Page 1: Ch08 Revenue Recognition

1

Revenue Revenue RecognitionRecognition

An electronic presentationAn electronic presentation by Douglas Cloudby Douglas Cloud

Pepperdine UniversityPepperdine University

An electronic presentationAn electronic presentation by Douglas Cloudby Douglas Cloud

Pepperdine UniversityPepperdine University

chapterchapter 8

Page 2: Ch08 Revenue Recognition

2

1. Identify the primary criteria for revenue recognition.

2. Apply the revenue recognition concepts underlying the examples used in SAB 101.

3. Record journal entries for long-term construction-type contracts using percentage-of-completion and completed-contract methods.

Learning Objectives

ContinuedContinuedContinuedContinued

Page 3: Ch08 Revenue Recognition

3

4. Record journal entries for long-term service contracts using the proportional performance method.

5. Explain when revenue is recognized after delivery of goods or services through installment sales, cost recovery, and cash methods.

Learning Objectives

Page 4: Ch08 Revenue Recognition

4

Revenue Recognition

1. They are realized or realizable.2. They have been earned through

substantial completion of the activities involved in the earnings process.

FASB’s two criteria for recognizing revenues and gains:

Page 5: Ch08 Revenue Recognition

5

Both of these criteria generally are met at

the point of sale.

Both of these criteria generally are met at

the point of sale.

Revenue recognition most often occurs when goods

are delivered or when services are rendered.

Revenue recognition most often occurs when goods

are delivered or when services are rendered.

Revenue Recognition

Page 6: Ch08 Revenue Recognition

6

Revenue Recognition

Criterion Associated With Criterion Associated With Revenue RecognitionRevenue Recognition

Criterion Associated With Criterion Associated With Revenue RecognitionRevenue Recognition

Criterion 1: The customer has provided payment or a valid promise of payment.

Criterion 2: The company has provided a product or service.

Page 7: Ch08 Revenue Recognition

7

Revenue Recognition

Before the point of SaleEXCEPTION:Revenue can be recognized prior to the point of sale if:

Customer provides a valid promise of payment AND

Criterion 1

Criterion 2 conditions exist that contractually guarantee subsequent sale.

Page 8: Ch08 Revenue Recognition

8

Revenue Recognition

Point of SaleNORMALLY:Revenue is generally recognized at this point of time.Criterion 1 is typically satisfied at this point.

Criterion 1

Criterion 2 Critical 2 is typically satisfied at this point.

Page 9: Ch08 Revenue Recognition

9

Revenue Recognition

After the Point of SaleEXCEPTION:The recognition of revenue must be deferred if:

Customer does not provide a valid promise of time of receipt of product or service OR

Criterion 1

Criterion 2 significant effort remains on the contract.

Page 10: Ch08 Revenue Recognition

10

• A product or service was provided without receiving a valid promise of payment from customer.

• The company has not provided the product or service.

Revenue Recognition

Generally, revenue is not recognized prior to the point of sale because either:

An exception occurs when the customer provides An exception occurs when the customer provides a valid promise of payment and conditions exist a valid promise of payment and conditions exist

that contractually guarantee the sale.that contractually guarantee the sale.

An exception occurs when the customer provides An exception occurs when the customer provides a valid promise of payment and conditions exist a valid promise of payment and conditions exist

that contractually guarantee the sale.that contractually guarantee the sale.

Page 11: Ch08 Revenue Recognition

11

Revenue Recognition

AICPA Statement of Position 97-2 gives companies more guidance through a checklist of four factors that amplify the two criteria:

a. Persuasive evidence of an arrangement exists.

b. Delivery has occurred.

c. The vendor’s fee is fixed or determinable.

d. Collectibility is probable.

Page 12: Ch08 Revenue Recognition

12Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement

The SEC issued SEC 101 in response to

specific abuses involving revenue recognition.

The SEC issued SEC 101 in response to

specific abuses involving revenue recognition.

Page 13: Ch08 Revenue Recognition

13

SAB 101 is in a question-and-answer format. The

answers given are invariably “No.”

SAB 101 is in a question-and-answer format. The

answers given are invariably “No.”

Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement

Page 14: Ch08 Revenue Recognition

14Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement

Typical questions from SAB 101Typical questions from SAB 101

Question 1:Question 1: Company A requires each sale to be supported by a written sales agreement signed by an authorized representative of both Company A and the customer.

Addresses internal controls.Addresses internal controls.

Question 1:Question 1: May Company A recognize revenue in the current quarter if the product is delivered by the end of the quarter but the sales agreement is not signed by the customer until a few days after the end of the quarter?

ENTERENTER

Page 15: Ch08 Revenue Recognition

15Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement

Typical questions from SAB 101Typical questions from SAB 101

Question 2:Question 2: Company Z delivers product to a customer on a consignment basis. May Company Z recognize revenue upon delivery of the product to the customer?

Addresses the issue of circumventing internal controls by side agreements.

Addresses the issue of circumventing internal controls by side agreements.

Page 16: Ch08 Revenue Recognition

16Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement

Typical questions from SAB 101Typical questions from SAB 101

Question 4:Question 4: Company R is a retailer that offers “layaway” sales to customers. A customer pays a portion of the sales price, and Company R sets the…

Focuses on issues centered on the “bill-and-hold” arrangements.

Focuses on issues centered on the “bill-and-hold” arrangements.

Question 4:Question 4: …aside until the customer pays the remainder of the sales price, and takes possession of the merchandise. When should Company R recognize revenue?ENTERENTER

Page 17: Ch08 Revenue Recognition

17Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement

Receipt of $100 cash as initial layaway payment:

Cash 100Deposit Received from Customers 100

Receipt of final $1,400 cash payment and delivery of goods to customer:Cash 1,400Deposit Received from Customers 100

Sales 1,500Cost of Goods Sold 1,000

Inventory 1,000

Appropriate Layaway Accounting

Page 18: Ch08 Revenue Recognition

18Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement

Seller Company receives $1,000 cash from a customer as the initial sign-up fee for a

service. In addition to the sign-up fee, the customer is

required to pay $50 per month for 100 months—which is the economic life of this service

agreement.

Seller Company receives $1,000 cash from a customer as the initial sign-up fee for a

service. In addition to the sign-up fee, the customer is

required to pay $50 per month for 100 months—which is the economic life of this service

agreement.

Page 19: Ch08 Revenue Recognition

19Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement

Receipt of $1,000 cash as initial sign-up fee:

Cash 1,000Unearned Initial Sign-Up Fees 1,000

Receipt of first monthly payment of $50:Cash 50

Monthly Service Revenue 50

Partial recognition of the initial signup fee as revenue ($1,000/100 months):Unearned Initial Sign-Up Fees 10

Initial Sign-Up Fee Revenue 10

Page 20: Ch08 Revenue Recognition

20Persuasive Evidence of an Persuasive Evidence of an ArrangementArrangement

Typical questions from SAB 101Typical questions from SAB 101

Addresses the difference between estimating the future impact of past events and

estimating the future impact of future events.

Addresses the difference between estimating the future impact of past events and

estimating the future impact of future events.

Question 8:Question 8: Company A owns a building and leases it to a retailer. The annual lease payment is $1.2 million plus 1% of all the retailer’s sales in excess of $25 million.

Question 8:Question 8: Should Company A estimate and recognize revenue associated with the 1% of sales over $25 million on a straight-line basis throughout the year? ENTERENTER

Page 21: Ch08 Revenue Recognition

21Revenue Recognition Prior to Providing Goods or Services

• Completed-contract method recognizes all income when project is completed.

• Percentage-of-completion method recognizes revenue throughout the term of the contract.

• Proportional performance method reflects revenue earned on service contracts under which many acts of service are to be performed before the contract is complete.

Page 22: Ch08 Revenue Recognition

22

GAAP requires percentage-of-completion method unless certain criteria are not met.

GAAP requires percentage-of-completion method unless certain criteria are not met.

Revenue Recognition Prior to Providing Goods or Services

Page 23: Ch08 Revenue Recognition

23Percentage-of-Completion Accounting

Dependable estimates of:• contract revenues• contract costs• progress toward completion

Contract clearly specifies:• enforceable rights of the parties• consideration to be exchanged• manner and terms of settlement

Dependable estimates of:• contract revenues• contract costs• progress toward completion

Contract clearly specifies:• enforceable rights of the parties• consideration to be exchanged• manner and terms of settlement

ContinuedContinuedContinuedContinued

Page 24: Ch08 Revenue Recognition

24Percentage-of-Completion Accounting

The buyer can be expected to satisfy obligations under the contract.

Contractor can be expected to perform the contractual obligation.

The buyer can be expected to satisfy obligations under the contract.

Contractor can be expected to perform the contractual obligation.

Page 25: Ch08 Revenue Recognition

25

Recognize revenue throughout life of the contract.

Revenue recognized is a function of how complete the project is to date.

Costs are charged to an inventory account: Construction in Process (CIP).

Profits are charged to CIP.CIP is valued at net realizable value.Any anticipated loss is booked for the full

amount of the loss when it becomes measurable.

Percentage-of-Completion Accounting

Page 26: Ch08 Revenue Recognition

26

Input measures: Cost-to-cost method where the degree of completion is determined by comparing costs already incurred with the most recent estimates of total expected costs to complete the project.

Input measures: Cost-to-cost method where the degree of completion is determined by comparing costs already incurred with the most recent estimates of total expected costs to complete the project.

Engineers are often called in to help provide estimates.

Engineers are often called in to help provide estimates.

Percentage-of-Completion Accounting

Page 27: Ch08 Revenue Recognition

27Accounting for Long-Term Construction-Type Contracts

Strong Construction Company was awarded a contract with a total price of $3,000,000. Strong expected to earn

$400,000 profit on the contract.

Page 28: Ch08 Revenue Recognition

28Accounting for Long-Term Construction-Type Contracts

Actual Cost

Incurred

Estimated Cost to

CompleteYearCost

PercentageTotal Cost

2004 $1,040,000 $1,560,000 $2,600,000 40

2005 910,000

Total $1,950,000 650,000 2,600,000 75

2006 650,000 0 2,600,000 100

Total $2,600,000

Page 29: Ch08 Revenue Recognition

29

Construction in Progress 1,040,000Materials, Cash, etc. 1,040,000

To record costs incurred.

Accounts Receivable 1,000,000Progress Billings on Construction Contracts 1,000,000

To record billings.

Cash 800,000Accounts Receivable 800,000

To record cash collections.

2004200420042004

Percentage-of-Completion Accounting

$1,040,000$1,040,000

$2,600,000$2,600,000= 40%= 40%

Page 30: Ch08 Revenue Recognition

30

Cost of Long-Term Construction Contracts 1,040,000Construction in Progress 160,000

Construction Contracts 1,200,000

2004200420042004

Percentage-of-Completion Accounting

Actual CostActual Cost

$3,000,000 x .40

Page 31: Ch08 Revenue Recognition

31

Construction in Progress 910,000Materials, Cash, etc. 910,000

To record costs incurred.

Accounts Receivable 900,000Progress Billings on Construction Contracts 900,000

To record billings.

Cash 850,000Accounts Receivable 850,000

To record cash collections.

2005200520052005

Percentage-of-Completion Accounting

Page 32: Ch08 Revenue Recognition

32

Cost of Long-Term Construction Contracts 910,000Construction in Progress 140,000

Revenue from Long-Term Construction Contracts 1,050,000

2005200520052005

Percentage-of-Completion Accounting

($3,000,000 x .75) –

$1,200,000

Page 33: Ch08 Revenue Recognition

33

Construction in Progress 650,000Materials, Cash, etc. 650,000

To record costs incurred.

Accounts Receivable 1,100,000Progress Billings on Construction Contracts 1,100,000

To record billings.

Cash 1,350,000Accounts Receivable 1,350,000

To record cash collections.

2006200620062006

Percentage-of-Completion Accounting

Page 34: Ch08 Revenue Recognition

34

Cost of Long-Term Construction Contracts 650,000Construction in Progress 100,000

Revenue from Long-Term Construction Contracts 750,000

2006200620062006

$ 3,000,000

(1,200,000)

(1,050,000)

$ 750,000

Percentage-of-Completion Accounting

Page 35: Ch08 Revenue Recognition

35

Progress Billings on Construction Contracts 3,000,000

Construction in Progress 3,000,000

2006200620062006

Percentage-of-Completion Accounting

Construction in Progress

1,040,000160,000910,000140,000650,000

100,0003,000,000

Progress Billings on Construction Contracts

1,000,000900,000

1,100,0003,000,000

Page 36: Ch08 Revenue Recognition

36

Revision of Estimates

Instead of the previous illustration, assume that at the end of 2005, it was estimated that the remaining cost to complete construction

was $720,000 rather than $650,000.

Page 37: Ch08 Revenue Recognition

37

Items in blue changed from the previous illustration.

Revision of Estimates

Actual Cost

Incurred

Estimated Cost to

CompleteYearCost

PercentageTotal Cost

2004 $1,040,000 $1,560,000 $2,600,000 40

2005 910,000

Total $1,950,000 720,000 2,670,000 73

2006 700,000 0 2,650,000 100

Total $2,650,000

Note that expected gross profit was $400,000 in 2004, Note that expected gross profit was $400,000 in 2004, $330,000 in 2005, and the actual was $350,000 in 2006.$330,000 in 2005, and the actual was $350,000 in 2006.

Note that expected gross profit was $400,000 in 2004, Note that expected gross profit was $400,000 in 2004, $330,000 in 2005, and the actual was $350,000 in 2006.$330,000 in 2005, and the actual was $350,000 in 2006.

Page 38: Ch08 Revenue Recognition

38

Revision of Estimates

20042004

The entries for 2004 would be the same as those shown

in the previous example.

The entries for 2004 would be the same as those shown

in the previous example.

Page 39: Ch08 Revenue Recognition

39

Revision of Estimates

20052005

All entries for 2005 would be the same

except for the entry to record revenue and cost.

All entries for 2005 would be the same

except for the entry to record revenue and cost.

Page 40: Ch08 Revenue Recognition

40

Revision of Estimates

Cost of Long-Term Construction Contracts 910,000Construction in Progress 80,000

Revenue from Long-term Construction Contracts 990,000

2005200520052005

($3,000,000 x .73) –

$1,200,000

Page 41: Ch08 Revenue Recognition

41

Revision of Estimates

Construction in Progress 700,000Materials, Cash, etc. 700,000

To record costs incurred.

Accounts Receivable 1,100,000Progress Billings on Construction Contracts 1,100,000

To record billings.

Cash 1,350,000Accounts Receivable 1,350,000

To record cash collections.

2006200620062006

SameSame

SameSame

Page 42: Ch08 Revenue Recognition

42

Revision of Estimates

Cost of Long-Term Construction Contracts 700,000Construction in Progress 110,000

Revenue from Long-Term Construction Contracts 810,000

2006200620062006

$3,000,000

(1,200,000)

(990,000)

$ 810,000

Page 43: Ch08 Revenue Recognition

43

2006200620062006

Construction in Progress

1,040,000160,000910,000

80,000700,000

110,0003,000,000

Progress Billings on Construction Contracts

1,000,000900,000

1,100,0003,000,000

Revision of Estimates

Items in red are different for this illustration.

Progress Billings on Construction Contracts 3,000,000

Construction in Progress 3,000,000

Page 44: Ch08 Revenue Recognition

44Anticipated Loss: Percentage-of-Completion Method

Assume the same facts for Strong Construction Company, except that after 2004 entries have been made, the firm determines that the total cost will be

$3,250,000. The entries for 2004 would be the same, but the loss must be dealt with in

2005—in addition, the $160,000 gross profit recognized in 2004 must be eliminated.

Assume the same facts for Strong Construction Company, except that after 2004 entries have been made, the firm determines that the total cost will be

$3,250,000. The entries for 2004 would be the same, but the loss must be dealt with in

2005—in addition, the $160,000 gross profit recognized in 2004 must be eliminated.

Page 45: Ch08 Revenue Recognition

45Anticipated Loss: Percentage-of-Completion Method

Cost of Long-Term Construction Contracts 910,000

Revenue from Long-Term Construction Contracts 600,000Construction in Progress 410,000

2005200520052005

To go from a $160,000 gross profit to an anticipated $250,000 loss ($3,000,000 –

$3,250,000), the Construction in Progess account needs to be credited $410,000.

Page 46: Ch08 Revenue Recognition

46Accounting for Long-Term Accounting for Long-Term Service ContractsService Contracts

Most service contracts involve three types of costs:(1) Initial direct costs related to

obtaining and performing initial services on the contract.

(2) Direct costs related to performing the various acts of service.

(3) Indirect costs related to maintaining the organization to service the contract.

Page 47: Ch08 Revenue Recognition

47Accounting for Long-Term Accounting for Long-Term Service ContractsService Contracts

Proportional Performance Method

A correspondence school enters into 100 contracts with students for an extended

writing course. The fee for each contract is $500, payable in advance. The initial

direct costs related to the contracts total $5,000. Actual direct costs for lessons for

the first period are $12,000. The sales value of the lessons completed is $24,000

(if sold separately, $60,000).

Proportional Performance Method

A correspondence school enters into 100 contracts with students for an extended

writing course. The fee for each contract is $500, payable in advance. The initial

direct costs related to the contracts total $5,000. Actual direct costs for lessons for

the first period are $12,000. The sales value of the lessons completed is $24,000

(if sold separately, $60,000).

Page 48: Ch08 Revenue Recognition

48Accounting for Long-Term Accounting for Long-Term Service ContractsService Contracts

Receipt of fees:Cash 50,000

Deferred Course Revenue 50,000

Liability accountLiability accountLiability accountLiability accountInitial direct costs:Deferred Initial Costs 5,000

Cash 5,000

Direct costs for lesson actually completed:Contract Costs 12,000

Cash 12,000Expense accountExpense accountExpense accountExpense account

Asset accountAsset accountAsset accountAsset account

ContinuedContinuedContinuedContinued

Page 49: Ch08 Revenue Recognition

49Accounting for Long-Term Accounting for Long-Term Service ContractsService Contracts

Course revenue recognized:Deferred Course Revenue 20,000

Recognized Course Revenue 20,000

Recognize contract costs from initial direct costs:Contract Costs 2,000

Deferred Initial costs 2,000

$24,000$24,000$60,000$60,000

x $50,000x $50,000

$24,000$24,000$60,000$60,000

x $5,000x $5,000

Page 50: Ch08 Revenue Recognition

50Revenue Recognition After Delivery of Goods or Providing Service

Installment Sales Method: Recognizes revenues and related expenses as cash is received (used when collection is somewhat uncertain).

Cost Recovery Method: No income is recognized on sale until the cost of the item sold is recovered through cash receipts (used when collection is very uncertain).

Cash Method: Recognizes all expenses immediately as incurred and all revenues only when cash is collected.

Page 51: Ch08 Revenue Recognition

51

Full Accrual At point of sale Revenue at point of sale

Installment Sales

At collection of cash (portion of receipt)

Defer and matchagainst revenue ascash is collected

Cost Recovery

At collection of cash(after all costs havebeen recovered)

Defer and matchagainst cashreceipts

Cash At collection of cash Charge to expenseas incurred

MethodTiming of Revenue

RecognitionTreatmentof Costs

Revenue Recognition After Delivery of Goods or Providing Service

Page 52: Ch08 Revenue Recognition

52

Installment Sales Method

The installment sales method is used most

commonly in cases of real estate sales.

The installment sales method is used most

commonly in cases of real estate sales.

Page 53: Ch08 Revenue Recognition

53

Installment Sales Method

George sells merchandise on the installment basis.

Uncertainty of collection makes use of the installment method necessary. Use the

accompanying data to prepare George’s journal entries.

George sells merchandise on the installment basis.

Uncertainty of collection makes use of the installment method necessary. Use the

accompanying data to prepare George’s journal entries.

Page 54: Ch08 Revenue Recognition

54

SalesCost of SalesGross ProfitGross Profit Percentage

2004 2005

$150,000 $200,000 100,000 140,000

$ 50,000 $ 60,000

33.33% 30%

Cash Collection 2004 Sales $ 30,000 $ 75,000 2005 Sales $ 70,000

Installment Sales Method

Page 55: Ch08 Revenue Recognition

55

Installment Accounts Receivable— 2004 150,000

Installment Sales 150,000

Cost of Installment Sales 100,000Inventory 100,000

Cash 30,000Installment Accounts Receivable—2004 30,000

Installment Sales Method

2004

ContinuedContinuedContinuedContinued

Page 56: Ch08 Revenue Recognition

56

Installment Sales 150,000Cost of Installment Sales 100,000Deferred Gross Profit—2004 50,000

Deferred Gross Profit—2004 10,000Realized Gross Profit on Installment Sales 10,000

Installment Sales Method

2004

$30,000 x 33.33%$30,000 x 33.33%$30,000 x 33.33%$30,000 x 33.33%

ContinuedContinuedContinuedContinued

Page 57: Ch08 Revenue Recognition

57

Installment Sales Method

Installment Accounts Receivable— 2005 200,000

Installment Sales 200,000

Cost of Installment Sales 140,000Inventory 140,000

Cash 145,000Installment A/R—2004 75,000Installment A/R—2005 70,000

2005

ContinuedContinuedContinuedContinued

Page 58: Ch08 Revenue Recognition

58

Installment Sales Method

Installment Sales 200,000Cost of Installment Sales 140,000Deferred Gross Profit—2005 60,000

Deferred Gross Profit—2004 25,000Deferred Gross Profit—2005 21,000

Realized Gross Profit on Installment Sales 46,000

2005

$75,000 x 33.33%$75,000 x 33.33%$75,000 x 33.33%$75,000 x 33.33%

$70,000 x 30%$70,000 x 30%$70,000 x 30%$70,000 x 30%

Page 59: Ch08 Revenue Recognition

59

Cost Recovery Method

Assume George has to use the cost recovery method, but all sales

and collections remain the same.

Assume George has to use the cost recovery method, but all sales

and collections remain the same.

CostCostRecovered Recovered

CostCost

RevenueRevenue

Page 60: Ch08 Revenue Recognition

60

2005

All entries are the same except do not book the entry to gross profit.Deferred Gross Profit—2004 5,000

Realized Gross Profit on Installment Sales 5,000

Cost Recovery Method

Page 61: Ch08 Revenue Recognition

61

2006Deferred Gross Profit—2004 30,000Deferred Gross Profit—2005 10,000

Realized Gross Profit on Installment Sales 40,000

Cost Recovery Method

Page 62: Ch08 Revenue Recognition

62

If the probability of recovering product or

service costs is remote the cost recovery method of accounting can be used.

There has to be considerable uncertainty as to ultimate collection of the

contract price.

If the probability of recovering product or

service costs is remote the cost recovery method of accounting can be used.

There has to be considerable uncertainty as to ultimate collection of the

contract price.

Cash Method

Page 63: Ch08 Revenue Recognition

63

The EndThe End

chapter 8

Page 64: Ch08 Revenue Recognition

64