Chapter 16
Revenue recognition issues
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-1
Objectives
• Understand some of the concepts of income and revenue
• Understand the points of an organisation’s operating cycle at
which income can be recognised
• Appreciate that the amount of income recognised in a particular
period will relate directly to the accounting measurement model
that has been adopted
• Understand how the existence of particular conditions associated
with a sale (such as attached put and call options, or the right of
return) will affect the timing of revenue recognition
• Understand the issues associated with recognising revenues for
long-term construction projects and be aware of the
requirements of AASB 111 ‘Construction Contracts’
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Slides prepared by Craig Deegan
16-2
Definition of income and revenue
Income defined (par. 70 of the AASB Framework) as
• Increases in economic benefits during the accounting period in
the form of inflows or enhancements of assets or decreases in
liabilities that result in an increase in equity, other than those
relating to contributions from equity participants
• Income is divided into ‘revenues’ and ‘gains’
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16-3
Definition of income and
revenue (cont.)
Revenues and gains (par. 74 of the AASB Framework)
• Revenue arises in the course of the ordinary activities of an
entity and is referred to by a variety of different names, including
sales, fees, interest, dividends, royalties and rent
Gains (pars 74 and 75, AASB Framework)
• Other items that meet the definition of income and may or may
not arise in the course of the ordinary activities of an entity.
Gains represent increases in economic benefits and as such are
not different in nature from revenue.
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16-4
Definition of income and
revenue (cont.)
Revenues and gains (par. 75, AASB Framework)
• Gains include, for example, those arising on the disposal of noncurrent assets. The definition of income also includes unrealised
gains, for example those arising on the revaluation of marketable
securities and those resulting from increases in the carrying
amount of long-term assets. When gains are recognised in the
income statement, they are usually displayed separately because
knowledge of them is useful in making economic decisions. Gains
are often reported net of related expenses.
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
16-5
Definition of income and
revenue (cont.)
• Generally speaking, revenues relate to the ordinary
income-generating activities of an entity, e.g. sales or
rental receipts
• Gains relate to ‘other income’—not necessarily part of
the ordinary activities of an entity
• Differentiation based on some degree of professional
judgment
• What is an ‘ordinary’ activity for one business may not
be ‘ordinary’ for another—so the benefits might be
deemed ‘revenue’ in one entity and a ‘gain’ in another
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16-6
Definition of income and
revenue (cont.)
• Differentiation between revenue and gains also
embraced by AASB 118 ‘Revenue’ (par. 7)
– the gross inflow of economic benefits during the period arising
in the course of the ordinary activities of an entity when those
inflows result in increases in equity, other than increases
relating to contributions from equity participants
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-7
Definition of income and
revenue (cont.)
Scope of AASB 118 ‘Revenue’ is fairly restricted—applies
to accounting for revenue arising from transactions and
events relating to (par. 1)
a) the sale of goods
b) the rendering of services
c) the use by others of entity assets yielding interest,
royalties and dividends
Recognition criteria provided for each of the above
categories of revenue, e.g. sale of goods (par. 14)
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16-8
Definition of income and
revenue (cont.)
Revenue from the sale of goods is to be recognised
when all of the following conditions have been satisfied:
•
•
•
•
•
the entity has transferred to the buyer the significant risks
and rewards of ownership of the goods
the entity retains neither continuing managerial
involvement to the degree usually associated with
ownership nor effective control over the goods
the amount of revenue can be measured reliably
it is probable that the economic benefits associated with
the transaction will flow to the entity
the costs incurred or to be incurred in respect of the
transaction can be measured reliably
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-9
Definition of income and revenue
(cont.)
Where revenue has been recognised, AASB 118 requires
that the revenue be measured at the fair value of the
consideration or contributions received or receivable
(par. 9)
–
–
if cash is not to be received for some period of time the
future amount to be received would need to be discounted
to its present value and the present value recognised as
revenue (refer to AASB 118, par. 11)
if cash is received for goods and services provided the
revenue recorded is equal to the cash received
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-10
Income and revenue recognition—current
practice
AASB 118 (Appendix A) provides guidance in relation to
the recognition of different types of revenues. In relation
to the sale of goods, guidance is provided in relation to
–
–
–
–
–
–
goods sold subject to conditions
lay-by sales
orders when partial payment received in advance
subscriptions to publications
instalment sales
real estate sales
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-11
Income and revenue recognition—current
practice (cont.)
•
Traditionally, revenue has been recognised at several
points in the earnings cycle (refer to Figure 16.1 on page
560—The earnings cycle), for example
(i) at point 5 (progressively throughout production) in the
building industry for long-term construction contracts
(ii) at point 7 (receipt of orders after completing
production) where it is the responsibility of the
purchaser to collect the goods
(iii) at point 8 (delivery of goods to customers)—in most
cases
(iv) at point 9 (receipt of cash) by some professional
practices and for instalment credit sales
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-12
Income and revenue recognition—current
practice (cont.)
• Rarely, if ever, recognised prior to point 5 (progressively
throughout production)
- uncertainty surrounding the ultimate irrevocable and
unconditional claim to cash (or its equivalent) prior to this
point
• In practice, point 9 (receipt of cash) is considered too
conservative to be the general criterion
• At point 8 (delivery of goods to customers) any uncertainty
remaining is accounted for by creating a ‘provision for
doubtful debts’
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-13
Income and revenue recognition—current
practice (cont.)
• Currently, we have a system of accounting based
predominantly on a historical cost, transaction-based system of
accounting
• We also make use of other approaches to valuation (e.g.
market values)
– Increases in market values of marketable securities are
recognised as part of income—a departure from traditional
historical accounting but still consistent with the definition of
income provided in the AASB Framework
Note
• Different measurement models of assets and liabilities, e.g.
historical cost vs the modified historical cost system, will
generate different calculations of income and hence profits
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-14
Income and revenue recognition—according to
the AASB Framework
Paragraph 83 of the AASB Framework
An item that meets the definition of an element (e.g.
income) should be recognised if
(a) the item has a cost or value that can be measured with
reliability
(b) it is probable that any future economic benefit
associated with the item will flow to or from the entity
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-15
Income and revenue recognition—according to
the AASB Framework (cont.)
Note
• Probable refers to more likely than less likely
• AASB 118 ‘Revenue’ provides recognition criteria
for revenue items
–
–
revenue that relates to sale of goods, rendering of
services, and interest, royalties and dividends
revenue from sales of goods and services is to be
recognised when the entity has transferred to the buyer
the significant risks and rewards of ownership of the
goods (refer to pars 16 and 17 AASB 118 for additional
guidance)
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Craig Deegan
16-16
Income and revenue recognition—at
completion of production
• At times, revenue may be recognised at the
completion of production, even when no sale has
been made
• Examples of such cases include the production of
precious metals or agricultural products
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16-17
Income and revenue recognition—at the
time of sale
• The two conditions (probable economic benefits and
reliable measurement) for recognising revenue are
usually met by the time the product or merchandise
is delivered, or the services are rendered to
customers
• Normally determined by shipping terms, i.e. time of
sale is commonly interpreted as when title passes
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-18
Income and revenue recognition—at the
time of sale (cont.)
• F.O.B. shipping point
– title passes to the buyer (and revenue is recognised) when
the seller delivers goods to a common carrier who acts as
an agent for the buyer
• F.O.B. destination
– title does not pass (and revenue is not recognised) until the
buyer receives the goods from the carrier
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-19
Income and revenue recognition—at the
time of sale (cont.)
In advance of cash receipt
• When revenue is recognised in advance of receipt of
cash, it is common to recognise a ‘provision for
doubtful debts’
– determined on basis of past experience and industry averages
– journal entry
Dr
Doubtful debts expense
Cr
Provision for doubtful debts
– provision for doubtful debts is contra account to debtors
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16-20
Income and revenue recognition—at the
time of sale (cont.)
In advance of cash receipt (cont.)
• If goods are sold or services provided on credit terms,
not all amounts due from debtors will ultimately be
collected
• To ignore this fact would lead to an overstatement of
receivables and assets in the balance sheet
• This is consistent with the general principle provided in
par. 18 of AASB 118
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16-21
Income and revenue recognition—at the
time of sale (cont.)
In advance of cash receipt (cont.)
Accounting for bad and doubtful debts
• When actual debtor is identified as unlikely to pay when amount
was previously anticipated
Dr
Provision for doubtful debts
Cr Debtors
• When debtor is identified as unlikely to pay and amount was not
previously anticipated
Dr Bad debts expense
Cr Debtors
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-22
Accounting for sales with associated
conditions
• Transactions involving the sale of assets with
conditions attached should be reviewed to assess
whether
– control of the future economic benefits has passed from the
seller to the purchaser; and
– it is probable that the inflow of economic benefits to the
seller has occurred
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-23
Accounting for sales with associated
conditions—call and put options
Call option
• Provides the holder of the option with the right to buy an asset at
a specified exercise price on or before a specified date
• The party that writes the call option agrees to deliver a particular
asset to the call-option buyer, if that buyer instructs the other
party to do so
• A call option is considered to have value when the value of the
underlying asset exceeds the option’s exercise price
• If at exercise date the exercise price is above or equal to the
market value of the asset, the option has no value and a sale
could be recorded
• However, if something is sold to another party, but as part of the
sales conditions, the seller has a call option which enables them
to buy back the asset at a future date, then to the extent that the
market price is greater than, or likely to be greater than, the
option’s exercise price, then no sale should be recorded
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-24
Accounting for sales with associated
conditions—call and put options (cont.)
Put option
• Operates in reverse manner to a call option
• Holder has the right to sell an asset at a specified exercise price
on or before a specified date
• The writer or the seller of the put option agrees to buy the asset
at a future date for the exercise price if the put option holder
(buyer) so requests
• The holder of the put option would typically exercise the option
(require the other party to buy the asset) only if the exercise price
is above the market price
• Guarantees holders a minimum price for their assets
• If an asset is sold to another party, and the buyer has a put option
which enables that party to sell the asset back to the original
seller, then a sale should not be recognised if the exercise price
is, or is likely to be, above the market price
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-25
Accounting for sales with associated
conditions—call and put options (cont.)
• Where a transaction involves concurrent use of a
financial instrument, it is necessary to evaluate the
conditions attaching to the transaction to establish
whether, in substance, the transaction is a financial
arrangement rather than a sale
• Probability of the exercise of the options must be
considered in recognising revenue
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-26
Accounting for sales with associated
conditions—revenue recognition when right of
return exists
• Alternative treatments available when the seller is
exposed to continued risks of ownership through
return of the product
– not recording the sale until all return privileges have
expired
– recording the sale but reducing sales by an estimate of
future returns
– recording the sale and accounting for the returns as they
occur
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16-27
Accounting for sales with associated
conditions—revenue recognition when right of
return exists (cont.)
• If a company sells its product but gives the buyer the right to
return the product, revenue from the sales transaction may be
recognised at the time of sale if all of the following conditions
have been met
– the seller’s price to the buyer is substantially fixed or determinable
at the date of sale
– the buyer has paid the seller, or the buyer is obligated to pay the
seller and the obligation is not contingent on the resale of the
product
– the buyer’s obligation to the seller would not be changed in the
event of theft or physical destruction or damage of the product
– the buyer acquiring the product for resale has economic
substance apart from that provided by the seller
– the seller does not have significant obligations for future
performance to directly bring about the resale of the product by
the buyer
– the amount of future returns can be reasonably estimated
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16-28
Accounting for sales with associated conditions—
sale and leaseback
• Although ownership of the leased property has been
transferred to the purchaser/lessor, the vendor/lessee
normally retains control
• The vendor/lessee has in effect entered into a
financing arrangement—leased property used as
collateral for a loan
• Transaction does not constitute a sale and does not
give rise to revenue
– inflow of economic benefits (proceeds from disposal) have
resulted in an equivalent liability (lease payable)
– result is no increase in equity
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16-29
Interest and dividends—interest revenue
• Interest revenue is recognised over time as the
borrower has the benefit of the borrowings and the
lender establishes claims for interest earned
• Prepayment of interest not regarded as revenue to
lender as lender has present obligation to provide
finance for the period to which the prepayment relates
• Interest revenue might be implicit in the terms of a
transaction
– for example, where goods are sold on extended credit, vendor
is effectively financing the purchaser
– transaction gives rise to two forms of revenue
1. Sales revenue—present value of future payments
2. Interest revenue from financing activities
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16-30
Interest and dividends—interest
revenue (cont.)
• To estimate the present value of the proceeds, an
applicable interest rate inherent in the agreement
must be determined
• AASB 118 (par. 11)
– when the arrangement effectively constitutes a financing
transaction, the fair value of the consideration is determined by
discounting all future receipts using an imputed rate of interest.
The imputed rate of interest is the more clearly determinable of
either
(a) the prevailing rate for a similar instrument of an issuer with a
similar credit rating; or
(b) a rate of interest that discounts the nominal amount of the
instrument to the current cash sales price of the goods or
services
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-31
Interest and dividends—interest
revenue (cont.)
• The difference between the fair value and the nominal amount
of the consideration is recognised as interest revenue
• Rate used for valuation purposes will normally be at least
equal to the rate at which the debtor can obtain financing of a
similar nature from other sources at the date of the transaction
• Objective is to approximate the rate that would have resulted if
an independent borrower and an independent lender had
negotiated a similar transaction on comparable terms and
conditions
Refer to Worked Example 16.1 on pp. 571—Recognition of
interest inherent in a sales transaction
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16-32
Interest and dividends—dividend revenue
• Dividends do not accrue over time but usually result
from a decision of the board of directors
• Dividend revenue should be recorded once it is
considered probable that inflow of future economic
benefits has occurred and when these benefits can be
measured reliably
– in most cases this will be at the time the board of directors or
other governing body proposed the dividend
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16-33
Unearned revenue
• Recorded when payment is received in advance of
services or resources being provided
• The receipts have not been earned
• Considered to be liabilities
– under present obligation to transfer future economic benefits
at a future date
Refer to Worked Example 16.2 on page 573—
Revenue received in advance
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16-34
Accounting for
construction contracts
• Accounting issues result from some construction
projects taking a number of financial periods to
complete
– should revenue be recognised progressively throughout
the contract?
– if so, how would the amount of revenue be determined?
• Deferral of revenue recognition until completion of
project would result in greater volatility of reported
revenues and of related profits or losses
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-35
Accounting for
construction contracts (cont.)
• Governed by AASB 111 ‘Construction Contracts’
• Applies to the accounting methods adopted by a
contractor for all construction contracts
• Construction contract defined (AASB 111, par. 3)
– a contract specifically negotiated for the construction of an
asset or a combination of assets that are closely
interrelated or interdependent in terms of their design,
technology and function of their ultimate purpose or use
• Refer also to AASB 111 (par. 4)
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-36
Accounting for
construction contracts (cont.)
Accounting requirements
• Individual construction contracts must be accounted for
separately and the requirements of the standard must be
applied separately to each contract
• AASB 111 (par. 9)
– a group of contracts, whether with a single customer or with
several customers, is to be treated as a single contract
when
(a) the group of contracts is negotiated as a single package;
(b) the contracts are so closely interrelated that they are, in
effect, part of a single project with an overall profit margin;
and
(c) the contracts are performed concurrently or in a continuous
sequence
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-37
Accounting for
construction contracts (cont.)
Accounting requirements (cont.)
• AASB 111 requires (if certain criteria are satisfied)
that contractors use the percentage-of-completion
method to account for construction contracts
– Profit on construction contract is recognised in proportion to
the work performed in each reporting period in which
construction occurs
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16-38
Accounting for
construction contracts (cont.)
• Construction costs plus gross profit earned to date
accumulated in inventory account (construction in
progress)
• Progress billings accumulated in contra inventory
account (billings on construction in progress
account)
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16-39
Accounting for
construction contracts (cont.)
• Percentage-of-completion method should be used
provided that certain conditions are met that enable
the outcome of the contract to be reliably estimated
AASB 111 (par. 22)
• When the outcome of a construction contract can be
estimated reliably, contract revenue and contract
costs associated with the construction contract are
to be recognised as revenue and expenses
respectively by reference to the stage of completion
of the contract activity at the reporting date
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16-40
Accounting for
construction contracts (cont.)
Types of construction contracts
• Fixed-price contracts
• Cost-plus contracts
• Type of contract determines the conditions that must
be satisfied to use the percentage-of-completion
method
• Defined in par. 3 of AASB 111
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16-41
Accounting for
construction contracts (cont.)
Conditions of use of percentage-of-completion
method (AASB 111, par. 23)
• With fixed-price contract
– total contract revenue can be measured reliably;
– it is probable that economic benefits arising from the
contract will flow to the contractor;
– both the contract costs to complete the contract and stage
of contract completion as at reporting date can be
measured reliably; and
– the contract costs attributable to the contract can be
clearly identified and measured reliably so that actual
costs can be compared with prior estimates
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16-42
Accounting for
construction contracts (cont.)
Conditions of use of percentage-of-completion
method (AASB 111, par. 24)
• With cost-plus contract
– it is probable that the economic benefits arising from the
contract will flow to the contractor; and
– the contract costs attributable to the contract, whether or
not specifically reimbursable can be clearly identified and
measured reliably
Copyright  2007 McGraw-Hill Australia Pty Ltd
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16-43
Accounting for
construction contracts (cont.)
•
If conditions are not satisfied
- no profit is to be brought to account until they are satisfied
- at the extreme, no profit to be recognised until project
completion
Note
• When outcome of construction contract cannot
be estimated reliably (AASB 111, par. 32)
(a) revenue is to be recognised only to the extent of
contract costs incurred that it is probable will be
recoverable; and
(b) contract costs are to be recognised as an expense in
the period in which they are incurred
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16-44
Accounting for
construction contracts (cont.)
Measuring progress towards completion
•
Percentage of completion can be measured in a number of
ways (per AASB 111, par. 30)
– the entity uses the method that measures reliably the
work performed. Depending on the nature of the contract,
the methods may include
(a) the proportion that contract costs incurred for work
performed to date bear to the estimated total contract costs;
(b) surveys of work performed; or
(c) completion of physical proportion of the contract work.
•
Progress payments and advances received from customers
often do not reflect the work performed
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16-45
Accounting for
construction contracts (cont.)
Measuring progress towards completion
Cost basis
•
The percentage of completion is measured by comparing
costs incurred to date with the most recent estimate of the
total costs to complete the contract
•
Only those contract costs that reflect the work performed are
included in costs incurred to date. Examples of contract
costs excluded are
–
–
contract costs that relate to future activity on the contract, such
as costs of materials delivered or set aside but as yet not
installed, used or applied
payments made to subcontractors in advance of work
performed
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16-46
Accounting for construction contracts
(cont.)
Types of costs incurred by contractors
(a)
Costs related directly to a specific contract, e.g. direct materials, direct labour,
depreciation of equipment, costs of moving plant and equipment, expected
warranty costs, costs of design and technical assistance directly related to
contract, costs of securing contract, costs of hiring plant and equipment
Costs that are attributable to contract activity in general and capable of being
allocated on a reasonable basis to specific contracts, e.g. tender preparation,
insurance, design and technical assistance
Costs that relate to the activities of the reporting entity generally or that relate
to contract activity generally and are not normally related to specific contracts,
e.g. general administration and selling costs, finance costs and research and
development costs not directly related to contract
(b)
(c)
Note
•
•
Costs (a) and (b) are normally included in accumulated contract costs
Costs (c) are usually excluded from accumulated contract costs because
they do not relate to reaching the present stage of completion of a
specific contract
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16-47
Accounting for
construction contracts (cont.)
•
Calculation of percentage of completion (cost
method)
Costs incurred to the end of the current period
Most recent estimate of total costs
•
Current period revenue or gross profit
- estimated total revenue or gross profit from the contract
multiplied by percentage complete less total revenue or gross
profit recognised in prior periods
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-48
Accounting for
construction contracts (cont.)
Journal entries for construction contract accounting
To record costs of construction
Dr
Cr
Construction in process
Materials, cash, payables, etc.
To record billings to customers
Dr
Cr
Accounts receivable
Billings on construction in process
To record collections of billings
Dr
Cr
Cash
Accounts receivable
To record contract revenue and contract expenses
Dr
Dr
Cr
Construction in process
Construction expenses (costs incurred)
Revenue from long-term contracts
To record final approval of contract
Dr
Cr
Billings on construction in process
Construction in process
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-49
Accounting for
construction contracts (cont.)
Disclosure requirements
• AASB 111 requires that the balance sheet or
accompanying notes
– disclose the gross amount of work in progress (or contract
costs incurred)
– the related aggregate billings deducted from the work in
progress
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-50
Accounting for
construction contracts (cont.)
Disclosure requirements (cont.)
• Work in progress will include the profit recognised throughout
the contract
• If progress billings exceed the gross amount of construction
work in progress, the net amount should be shown as a
liability or otherwise disclosed as an asset
• Disclosure requirements are outlined in AASB 111 (pars 39–
42)
• Appendix to AASB 111 provides an example of a disclosure
that might appear in an entity’s financial report
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-51
Accounting for
construction contracts (cont.)
Application of percentage-of-completion method to
account for construction contracts
– Refer to Worked Example 16.3 on pp. 581—Percentage-ofcompletion method
– Refer to Worked Example 16.4 on pp. 582—Construction
contract where outcome cannot be reliably estimated
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-52
Accounting for
construction contracts (cont.)
Accounting for long-term contract losses
When current estimates of total contract costs and revenues
for any contract indicate that a loss is probable
– provision should be made for any foreseeable loss on the contract
regardless of the amount of work already performed
– loss is to be brought to account as soon as it is foreseeable
AASB 111 (par. 36)
When it is probable that total contract costs will exceed total
contract revenue, the expected loss shall be recognised as an
expense immediately
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-53
Accounting for
construction costs (cont.)
AASB 111 (par. 37)
Expected loss (excess of total contract costs over total
contract revenue) arising from a construction contract
is recognised as an expense irrespective of
– whether work has commenced on the project
– the stage of completion of the activity; or
– the difference between total contract costs and total contract
revenue expected to arise from other construction contracts
Refer to Worked Example 16.5 on page 583—Percentage of completion
with recognition of a loss
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-54
Illustration – accounting for a construction
contract
XYZ signed a contract on January 1, 2008, agreeing to build a
warehouse for ABC at a contract price of $20,000,000. XYZ estimated
that construction costs would be as follows
2008 $5,000,000
2009 $8,000,000
2010 $3,000,000
$16,000,000
The contact provided that ABC would make payments on December 31
of each year as follows
2008 $ 4,000,000
2009 $10,000,000
2010 $ 6,000,000
$20,000,000
The contract was completed and accepted on December 31, 2010.
Assume that actual costs and cash collections coincided with
expectations.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-55
Illustration – accounting for a construction
contract (cont.)
(a) INCOME RECOGNISED EACH YEAR
YEAR
P.O.C.
2008
$1.25
2009
$2.00
2010
$0.75
$4.00
P.O.C.
Revenue
(5/16)x20
(13/16)x20-6.25
(16/16)x20-16.25
Expense
5/16 x 16
13/16 x 16 - 5
16/16 x 16 - 13
2008
2010
6.25
10.0
3.75
(5)
(8.0)
(3.0)
1.25
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
2009
2.00
0.75
16-56
(b)
Journal Entries P.O.C. Method
2008 2009 2010
(i) To record costs incurred
Dr. Construction in process
5
8
3
Cr. Cash, accounts payable
5
8
3
(ii)To record billings to customers
Dr. Accounts Receivable4
10
Cr. Billings on Contracts
4
in Process
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
6
10
6
16-57
(iii)To record cash collections
Dr. Cash
Cr. Accounts Receivable
2008
4
4
2009 2010
10
6
10
6
(iv) To record periodic income recognised
Dr. Construction in Process
1.25
2
0.75
Dr. Construction expenses
5.00
8.00 3.00
Cr. Revenue from L.T. Contract
6.25
10
3.75
(or could separately show the revenue and expense)
(v) To record final approval and acceptance
Dr. Billings on Contracts in Process Cr. Construction in Process
-
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
-
20
20
16-58
Summary
• In this chapter the recognition of income and
revenue has been considered
• AASB ‘Framework for the Preparation and
Presentation of Financial Statements’ requires that
for income to be recognised the associated inflow
of economic benefits or associated reduction in
liabilities must be both probable and measurable
with reasonable accuracy
• AASB 118 ‘Revenue’ provides a number of
additional recognition criteria, e.g. for revenue to
be recognised, the risks and rewards of ownership
of the asset (for the sale of the goods) must be
transferred to the purchaser
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-59
Summary (cont.)
• Sales transactions are often made with associated
conditions (e.g. call and put options or a right to
return the assets)
– it is necessary to consider whether they reduce the probability
that the inflow of resources will ultimately occur
– if it appears that an option that will reduce the inflow of
resources will probably be exercised or that the right of return
will be exercised, the revenue should not be recognised by the
reporting entity until such time as the requisite degree of
certainty is attained and in the inflow of economic benefits will
occur
– determining whether revenue should be recognised will also
depend on the system of accounting being used, i.e.
measurement model being adopted
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-60
Summary (cont.)
• Under historical-cost accounting the increase in the value of
marketable securities would not be considered as revenue
until such time as the securitiies are sold
• If a market values-based system is used increased market
prices of assets could be treated as part of the period’s
income
• Revenue and expenses related to a construction contract
are to be recognised by applying the percentage-ofcompletion method if the outcome and stage of completion
of the construction contract can be reliably estimated
• Where percentage-of-completion method is applied,
revenue is brought to account with a corresponding increase
in construction in progress on the basis of percentage of
completion
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-61
Summary (cont.)
• Percentage of completion is measured typically by
comparing costs incurred to date with the most recent
estimate of the total costs to complete the contract
• Revenue will be recognised throughout the life of the
contract, but if the percentage-of-completion method is
used and it becomes apparent that a loss will be
made, the entire loss must be recognised as soon as it
is foreseeable
• For disclosure purposes, billings on construction in
progress account is shown in the balance sheet as a
deduction from construction in progress account—if
billings account balance exceeds construction in
progress account the net amount represents a liability
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Australian Financial Accounting 5e by Craig Deegan
Slides prepared by Craig Deegan
16-62