Chapter 8
18th
Edition
Revenue
Recognition
Intermediate
Financial Accounting
Earl K. Stice James D. Stice
PowerPoint presented by Douglas Cloud
Professor Emeritus of Accounting, Pepperdine University
© 2012 Cengage Learning
8-1
Revenue Recognition
Recognition refers to the time when
transactions are recorded on the books. The
FASB’s two criteria for recognizing revenues
and gains are when:
1. They are realized or realizable.
2. They have been earned through substantial
completion of the activities involved in the
earnings process.
Both of these criteria generally are
met at the point of sale
8-2
Revenue Recognition
•
•
Revenue is not recognized prior to the point of
sale because either:
 A valid promise of payment has not been
received from the customer.
 The company has not provided the product
or service.
Exceptions to these rules:
 The customer provides a valid promise of
payment.
 Conditions exist that contractually guarantee
the sale.
(continued)
8-3
Revenue Recognition
AICPA Statement of Position 97-2 gives
companies more guidance through a checklist of
four factors that amplify the two criteria:
1) Persuasive evidence of an arrangement
exists.
2) Delivery has occurred.
3) The vendor’s fee is fixed or determinable.
4) Collectibility is probable.
(continued)
8-4
Revenue Recognition
•
The FASB is currently engaged in a
revenue recognition project in conjunction
with the IASB (as of June 2010).
•
The FASB has tentatively decided to move
away from the realization and substantial
completion criteria and to instead
emphasize the measurement of a seller’s
satisfaction of performance obligations
created through contracts with customers.
8-5
SAB 101
•
Because SAB 101 was released to curtail
specific abuses, it should not be seen as a
comprehensive treatise on the entire area
of revenue recognition.
•
Revenue recognition issues covered in
SAB 101 may not be comprehensive, but
they are extremely important.
8-6
Sarbanes-Oxley Act of 2002
•
Section 404 of the Sabanes-Oxley Act of
2002 instructs the SEC to require all publicly
traded companies to provide a report of the
condition of the company’s internal controls.
•
This is to ensure that the public financial
statements are not rendered irrelevant by
secret side agreements.
•
A good internal control system establishes
procedures to safeguard the value of a
company’s assets.
8-7
Accounting for Consignments
Seller Company ships goods costing $1,000
on consignment to Consignee Company.
The retail price of the goods is $1,500.
No sale should be recorded.
However, there may be a journal entry
made to reclassify the inventory.
Inventory on Consignment
Inventory
1,000
1,000
8-8
Accounting for a Layaway Sale
Seller Company receives $100 cash from a
customer. The $100 payment is a partial
payment for goods costing $1,000 with a total
retail price of $1,500. The following entry
shows the receipt of $100 cash as initial
layaway payment.
Cash
Deposit Received from Customers
100
100
(continued)
8-9
Accounting for a Layaway Sale
Recording the receipt of the final $1,400 cash
payment and the delivery of goods to
customers requires two entries. One to record
the sale and the second to remove the item
from inventory and to record its cost.
Cash
Deposit Received from Customer
Sales
1,400
100
Cost of Goods Sold
Inventory
1,000
1,500
1,000
8-10
Bill-and-Hold Arrangements
To consider merchandise as sold using the
bill-and-hold arrangement, a seller must be
able to demonstrate:
• that the goods are ready to ship,
•
that they are segregated in act and cannot
be used to fill other orders, and
•
that the buyer has requested, in writing, the
bill-and-hold arrangement.
8-11
Customer Acceptance Provisions
Seller Company receives $1,500 cash from a
customer as payment in full for equipment
costing $1,000. The sale is not complete until
the equipment is installed at the customer’s
place of business. The following entry is
necessary to record the advance receipt of
money:
Cash
Advance Payments Received
from Customers
1,500
1,500
(continued)
8-12
Customer Acceptance Provisions
Two entries are required to record customer
acceptance of the installed equipment.
Advance Payments Received from
Customers
Sales
Cost of Goods Sold
Inventory
1,500
1,500
1,000
1,000
8-13
Appropriate Accounting for a Service
Provided Over an Extended Period
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
the service. The expected economic life of this
service agreement is 100 months. An entry is
required to show receipt of cash.
Cash
Unearned Initial Sign-up Fees
1,000
1,000
(continued)
8-14
Appropriate Accounting for a Service
Provided Over an Extended Period
A second entry is required to record receipt of
the monthly payment.
Cash
Monthly Service Revenue
50
50
Another entry is necessary to record partial
recognition of the initial sign-up fee as revenue
($1,000/100 months).
Unearned Initial Sign-up Fees
Initial Sign-up Fee Revenue
10
10
8-15
Subtopic 605-25
• The focus of Subtopic 605-25 is on the
“unit of accounting.”
• An element of multiple-element
arrangement is considered to be a unit
of accounting if that element has
standalone value.
• An element has standalone value if it is
sold separately or if the customer
resells it.
8-16
Income Statement Presentation of
Revenue: Gross or Net
Characteristic of a transaction in which a
company should report revenue on a net basis
are given as follows:
• The company does not maintain an inventory
of the product being sold but simply forwards
orders to a supplier.
•
The company is not primarily responsible for
satisfying customer requirements, request,
complaints, and so forth; those requirements
are satisfied by the supplier of goods.
(continued)
8-17
Income Statement Presentation of
Revenue: Gross or Net
•
The company earns a fixed amount, or a fixed
percentage, and doesn’t bear the risk of
fluctuations in the margin between the selling
price and the cost of goods sold.
•
The company does not bear the credit risk
associated with collecting from the customer;
that risk is borne by the supplier.
8-18
A Contract Approach to
Revenue Recognition
The contract approach contains three basic
steps:
1) Identify the performance obligations
accepted by a seller in its contracts with its
buyers.
2) For multiple-element transactions, allocate
transaction prices based on relative separate
selling prices.
3) Recognize revenue when performance
obligations are satisfied.
(continued)
8-19
A Contract Approach to
Revenue Recognition
• With the contractual performance obligation
focus, the FASB and IASB have agreed that
revenue arises when a seller satisfies a
performance obligation to a buyer.
• The general idea that no revenue should be
recognized until something of value has
been delivered to the customer goes back
to SAB 101 and even back to the traditional
revenue recognition criteria.
(continued)
8-20
A Contract Approach to
Revenue Recognition
Ashley Company has provided goods, on
account, to customers during the month of June
with a total billing price of $100,000. Bad debts
are expected to be 1.0% of the gross sales
amount, and sales returns are expected to be
2.5% of the gross sales amount. A summary
journal entry follows:
June 30
Accounts Receivable
Sales Revenue [$100,000 x
(100.0% ‒ 1.0% ‒ 2.5%)]
(continued)
96,500
96,500
8-21
A Contract Approach to
Revenue Recognition
Wilks Company sells a plasma TV and 2-year
warranty to a customer for the joint price of
$2,000. Wilks Company has generated the
following information regarding the sale of the
plasma TV.
• Cost of plasma TV, $1,500
•
Sales price of plasma TV sold separately is
unknown. Other consumer electronic products
have profit margins that range between 16%
and 22% of cost.
(continued)
8-22
A Contract Approach to
Revenue Recognition
•
Sales price of warranty if sold separately,
unknown. A 2-year warranty for a
refrigerator/freezer with the same wholesale
cost sells for $300. Wilks estimates that repair
costs for the plasma TV would be 5% higher
($300 + ($300 x .05) = $315).
TV delivery obligation: $1,700 = $2,000 x
[$1,785/($1,785 + $315)]
Warranty service obligation: $300 = $2,000 x
[$315/$1,785 + $315)]
(continued)
8-23
A Contract Approach to
Revenue Recognition
The journal entry to record the asset and liability
at the contract signing is as follows:
Cash
Contract Liability—TV
Contract Liability—Warranty
2,000
1,700
300
When the plasma TV is delivered, the following
journal entries are required:
Contract Liability—TV
Sales Revenue
Cost of Goods Sold
Inventory
1,700
1,700
1,500
1,500
8-24
Introduction
•
If a Company waits until the production or
service period is complete to recognize
revenue, this approach is referred to as the
completed-contract method. All income
from the contract is related to the year of
completion.
•
Percentage-of-completion accounting was
developed to relate recognition of revenue on
long-term construction-type contracts to the
activities of a firm in fulfilling these contracts.
8-25
Percentage-of-Completion
Accounting
In 1981, the AICPA identified several elements
that should be present if the percentage-ofcompletion accounting is to be used.
1. Dependable estimates can be made of
contract revenues, contract costs, and the
extent of progress toward completion.
2. The contract clearly specifies the enforceable
rights regarding goods or services to be
provided and received by the parties, the
consideration to be exchanged, and the
manner and terms of settlement.
(continued)
8-26
Percentage-of-Completion
Accounting
3. The buyer can be expected to satisfy
obligations under the contract.
4. The contractor can be expected to perform
the contractual obligation.
The completed-contract method should be
used only when an entity has primarily
short term contracts, when the conditions
of using percentage-of-completion
accounting are not met, or when there are
inherent uncertainties in the contract.
(continued)
8-27
Percentage-of-Completion
Accounting
•
•
Cost-to-cost method is perhaps the most
popular of the input measures. 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.
8-28
Accounting for Long-Term
Construction-Type Contracts
In January 2012, Strong Construction
Company was awarded a contract with a total
price of $3,000,000. Strong expects to earn
$400,000 profit on the contract. The
construction was completed over a 3-year
period.
(continued)
8-29
Accounting for Long-Term
Construction-Type Contracts
2012
Construction in Progress
Materials, Cash, etc.
To record costs incurred.
1,040,000
1,040,000
Accounts Receivable
1,000,000
Progress Billings on
Construction Contracts
1,000,000
To record billings.
Cash
800,000
Accounts Receivable
800,000
To record cash collections.
(continued)
8-30
Accounting for Long-Term
Construction-Type Contracts
2013
Construction in Progress
Materials, Cash, etc.
To record costs incurred.
910,000
Accounts Receivable
Progress Billings on
Construction Contracts
To record billings.
Cash
Accounts Receivable
To record cash collections.
900,000
(continued)
910,000
900,000
850,000
850,000
8-31
Accounting for Long-Term
Construction-Type Contracts
2014
Construction in Progress
Materials, Cash, etc.
To record costs incurred.
650,000
650,000
Accounts Receivable
1,100,000
Progress Billings on
Construction Contracts
1,100,000
To record billings.
Cash
1,350,000
Accounts Receivable
1,350,000
To record cash collections.
8-32
Completed-Contract Method
•
No other entries would be required in 2012
and 2013 under the completed-contract
method.
•
In both years, the balance of Construction in
Progress exceeds the amount in Progress
Billings on Construction Contracts; thus, the
latter account would be offset against the
inventory account in the balance sheet.
(continued)
8-33
Completed-Contract Method
2013
Using the completed-contract method, the
balance sheet at the end of 2013 would
disclose the following balances related to the
construction contract:
Current assets:
Accounts receivable
$250,000
Construction in progress $1,950,000
Less: Progress billings on
construction contracts 1,900,000 $50,000
(continued)
8-34
Completed-Contract Method
2014
Under the completed-contract method, the
following entries would be made to recognize
revenue and costs and to close out the
inventory and billing accounts.
Progress Billings on
Construction Contracts
Revenue from Long-Term
Construction Contracts
(continued)
3,000,000
3,000,000
8-35
Completed-Contract Method
2014
Cost of Long-Term
Construction Contracts
Construction in Progress
2,600,000
2,600,000
8-36
Using Percentage-of-Completion
Accounting: Cost-to-Cost Method
2012
If the company used the percentage-ofcompletion method of accounting, the
$400,000 profit would have to be spread over
all three years of construction according to the
estimated percentage of completion each year.
Percentage of completion
to date
2012
2013
40%
75%
(continued)
2014
100%
8-37
Using Percentage-of-Completion
Accounting: Cost-to-Cost Method
2012
Cost of Long-Term
Construction Contracts*
Construction in Progress
Revenue from Long-Term
Construction Contracts
*Actual costs
1,040,000
160,000
1,200,000
(continued)
8-38
Using Percentage-of-Completion
Accounting: Cost-to-Cost Method
2013
Cost of Long-Term Construction
Contracts
Construction in Progress
Revenue from Long-Term
Construction Contracts
910,000
140,000
1,050,000
($3,000,000  0.75)  $1,200,000
(continued)
8-39
Using Percentage-of-Completion
Accounting: Cost-to-Cost Method
2014
Cost of Long-Term Construction
Contracts
Construction in Progress
Revenue from Long-Term
Construction Contracts
650,000
100,000
750,000
$3,000,000  $1,200,000  $1,500,000
(continued)
8-40
Using Percentage-of-Completion
Accounting: Cost-to-Cost Method
2014
Construction in Progress
1,040,000
160,000
910,000
140,000
650,000
100,000
3,000,000
3,000,000
Progress Billings on
Construction Contracts
Construction in Progress
Progress Billings on
Construction Contracts
3,000,000
1,000,000
900,000
1,100,000
3,000,000
3,000,000
3,000,000
8-41
Using Percentage-of-Completion
Accounting: Other Methods
In 2012, an engineering estimate measure was
used, and 42% of the contract was assumed to
be completed. The gross profit recognized
would therefore be computed and reported as
follows:
Recognized revenue (42% of $3,000,000)$1,260,000
Cost (42% of $2,600,000)
1,092,000
Gross profit (42% of $400,000)
$ 168,000
(continued)
8-42
Using Percentage-of-Completion
Accounting: Other Methods
Using the data from the previous slide and
knowing that the actual cost incurred to date is
$1,040,000, the revenue and costs to be
reported on the 2012 income statement would
be as follows:
Actual cost incurred to date
Recognized gross profit (42% of
$2,600,000)
Gross profit (42% of $400,000)
$1,040,000
168,000
$ 168,000
8-43
Revision of Estimate
Instead of the previous illustration, assume that
at the end of 2013, it was estimated that the
remaining cost to complete construction was
$720,000 rather than $650,000. This would
increase the total estimated cost to $2,670,000,
reduce the expected profit to $330,000, and
change the percentage of completion for 2013
to 73% ($1,950,000/$2,670,000).
(continued)
8-44
Revision of Estimates
2012
Under the percentage-of-completion method,
the following additional entries would be made
to recognize revenue.
Cost of Long-Term Construction
Contracts
1,040,000
Construction in Progress
160,000
Revenue from Long-Term
Construction Contracts
1,200,000
(continued)
8-45
Revision of Estimates
2013
Cost of Long-Term Construction
Contracts
Construction in Progress
Revenue from Long-Term
Construction Contracts
910,000
80,000
990,000
($3,000,000  0.73)  $1,200,000
(continued)
8-46
Revision of Estimates
2014
Cost of Long-Term Construction
Contracts
Construction in Progress
Revenue from Long-Term
Construction Contracts
700,000
110,000
810,000
8-47
Reporting Anticipated
Contract Losses
• When a loss on a total contract is
anticipated, GAAP requires reporting the
loss in its entirety in the period when the
loss is first anticipated.
• This is true under either the completedcontract or the percentage-of-completion
method.
(continued)
8-48
Reporting Anticipated
Contract Losses
• Assume in the earlier construction
example, the estimated cost to complete
the contract at the end of 2013 was
$1,300,000.
• Because $1,950,000 of costs had
already been incurred, the total
estimated cost of the contract would be
$3,250,000, or $250,000 more than the
contract price.
(continued)
8-49
Anticipated Contract Loss:
Percentage-of-Completion Method
Continuing with the construction contract
example, assume the cumulative recognized
revenue at the end of 2013 would be
$1,800,000 (60% x $3,000,000), and the
cumulative cost at the same date would e
$2,050,000 ($1,800,000 + $250,000).
A profit of $160,000 was recognized in 2012,
the total loss to be recognized in 2013 is
$410,000 ($160,000 + $250,000).
(continued)
8-50
Anticipated Contract Loss:
Percentage-of-Completion Method
The entry to record the revenue, costs, and
adjustments to Construction in Progress for
the loss in 2013 would be as follows:
Cost of Long-Term
Construction Contract
Revenue from Long-Term
Construction Contracts
Construction in Process
1,010,000
600,000
410,000
8-51
Proportional Revenue Recognition
Most service contracts involve three
different 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 service acts
3. Indirect costs related to maintaining the
organization to service the contract
8-52
Installment Sales Method
• Under the installment sales method, profit is
recognized as cash is collected rather than at
the time of sale.
• It is used most commonly in cases of real
estate sales where contracts may involve little
or no down payment, payments are spread
over 10 to 30 to 40 years, and a high
probability of default in the early years exists
because of a small investment by the buyer.
• The market prices of the property often are
unstable.
8-53
Cost Recovery Method
•
Under the cost recovery method, no
income is recognized on a sale until the
cost of the item sold it recovered
through cash receipts.
•
This method is used only when the
circumstances surrounding a sale are
so uncertain that earlier recognition is
impossible.
8-54
Cash Method
•
If the probability of recovering product or
service costs is remote, the cash method
of accounting could be used.
•
Seldom would this method be applicable
for sales of merchandise or real estate
because the right of repossession would
leave considerable value to the seller.
8-55
Chapter 8
₵
The End
$
8-56
8-57