PART II: Corporate Accounting Concepts and Issues
Lecture 21
Revenue Recognition:
Completed Contract
Method
Instructor
Adnan Shoaib
1
Learning Objectives
2
1.
Apply the completed-contract method for long-term contracts.
2.
Identify the proper accounting for losses on long-term contracts.
3.
Describe the installment-sales method of accounting.
4.
Explain the cost-recovery method of accounting.
Revenue Recognition
Current
Environment
Guidelines for
revenue
recognition
Departures from
sale basis
3
Revenue
Recognition at the
Point of Sale
Sales with
discounts
Sales with right of
return
Sales with
buybacks
Bill and hold sales
Principal-agent
relationships
Trade loading and
channel stuffing
Multiple-deliverable
arrangements
Revenue
Recognition
before Delivery
Percentage-ofcompletion
method
Completedcontract method
Long-term
contract losses
Disclosures
Completion-ofproduction basis
Revenue
Recognition after
Delivery
Installment-sales
method
Cost-recovery
method
Deposit method
Summary of
bases
Revenue Recognition Before Delivery
Completed Contract Method
Companies recognize revenue and gross profit only at point of
sale—that is, when the contract is completed.
Under this method, companies accumulate costs of long-term
contracts in process, but they make no interim charges or credits
to income statement accounts for revenues, costs, or gross
profit.
4
LO 1 Apply the completed-contract method for long-term contracts.
Completed Contract Method
Illustration:
Casper Construction Co.
Contract price
Cost incurred current year
Estimated cost to complete
in future years
Billings to customer current year
Cash receipts from customer
Current year
2010
$675,000
150,000
2011
$675,000
287,400
2012
$675,000
170,100
450,000
135,000
170,100
360,000
0
180,000
112,500
262,500
300,000
A) Prepare the journal entries for 2010, 2011, and 2012.
5
LO 3 Apply the percentage-of-completion method for long-term contracts.
Completed Contract Method
Illustration:
2010
2011
2012
$ 150,000
$ 437,400
$ 607,500
Estimated cost to complete
450,000
170,100
Est. total contract costs
600,000
607,500
Costs incurred to date
Est. percentage complete
25.0%
72.0%
100.0%
Contract price
675,000
675,000
675,000
Revenue recognizable
168,750
486,000
675,000
(168,750)
(486,000)
Rev. recognized prior year
Rev. recognized currently
168,750
317,250
189,000
Costs incurred currently
(150,000)
(287,400)
(170,100)
Gross profit recognized
6
607,500
$ 18,750
$
29,850
$ 18,900
LO 3 Apply the percentage-of-completion method for long-term contracts.
Completed Contract Method
Illustration:
2010
150,000
150,000
2011
287,400
287,400
2012
170,100
170,100
Accounts receivable
Billings on contract
135,000
360,000
180,000
Cash
Accounts receivable
112,500
Construction in progress
Cash
135,000
360,000
262,500
112,500
180,000
300,000
262,500
300,000
Construction in progress
Construction expense
Construction revenue
67,500
607,500
Billings on contract
Construction in progress
675,000
7
675,000
675,000
LO 1 Apply the completed-contract method for long-term contracts.
Completed Contract Method
Illustration:
Income Statement
Revenue on contracts
Cost of construction
Gross profit
Balance Sheet (12/31)
Current assets:
Accounts receivable
Cost & profits > billings
Current liabilities:
Billings > cost & profits
8
2010
$
-
22,500
15,000
2011
$
-
120,000
2012
$ 675,000
607,500
67,500
-
57,600
LO 1 Apply the completed-contract method for long-term contracts.
Completed Contract and Percentage-ofCompletion Methods Compared
9
Accounting for the Cost of Construction
and Accounts Receivable
With both the completed contract and percentage-ofcompletion methods, all costs of construction are
recorded in an asset account called construction in
progress.
10
Gross Profit Recognition—General
Approach
In both methods the same
amounts of revenue, cost,
and gross profit are
recognized.
11
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.
12
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.
13
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:
14
Percentage-of-Completion Method
Allocation of Gross Profit
15
Percentage-of-Completion Method
Allocation of Gross Profit
Notice that the gross profit recognized in each period is added
to the construction in progress account.
16
Percentage-of-Completion Method
Allocation of Gross Profit
The income statement for each year will report the
appropriate revenue and cost of construction
amounts.
17
Income Recognition
The same total amount of profit or loss is recognized
under both the completed contract and the percentage-ofcompletion methods, but the timing of recognition differs.
18
Balance Sheet Recognition
Billings on construction contract are subtracted from
construction in progress to determine balance sheet
presentation.
19
CIP > Billings
Asset
Billings > CIP
Liability
Balance Sheet Recognition
The balance in the construction in progress account
differs between methods because of the earlier gross
profit recognition that occurs under the percentage-ofcompletion method.
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Revenue Recognition Before Delivery
Long-Term Contract Losses

Loss in the Current Period on a Profitable Contract
►
Percentage-of-completion method only, the estimated cost
increase requires a current-period adjustment of gross profit
recognized in prior periods.

Loss on an Unprofitable Contract
►
Under both percentage-of-completion and completed-
contract methods, the company must recognize in the
current period the entire expected contract loss.
21
LO 2 Identify the proper accounting for losses on long-term contracts.
Long-Term Contract Losses
Illustration: Loss on Profitable Contract
Casper Construction Co.
Contract price
Cost incurred current year
Estimated cost to complete
in future years
Billings to customer current year
Cash receipts from customer
Current year
2010
$675,000
150,000
2011
$675,000
287,400
2012
$675,000
215,436
450,000
135,000
215,436
360,000
0
180,000
112,500
262,500
300,000
b) Prepare the journal entries for 2010, 2011, and 2012 assuming the estimated
cost to complete at the end of 2011 was $215,436 instead of $170,100.
22
LO 2 Identify the proper accounting for losses on long-term contracts.
Long-Term Contract Losses
Illustration: Loss on Profitable Contract
2010
2011
2012
$ 150,000
$ 437,400
$ 652,836
Estimated cost to complete
450,000
215,436
Est. total contract costs
600,000
652,836
Costs incurred to date
Est. percentage complete
25.0%
67.0%
100.0%
Contract price
675,000
675,000
675,000
Revenue recognizable
168,750
452,250
675,000
(168,750)
(452,250)
Rev. recognized prior year
Rev. recognized currently
168,750
283,500
222,750
Costs incurred currently
(150,000)
(287,400)
(215,436)
Gross profit recognized
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652,836
$ 18,750
$
(3,900)
$
7,314
LO 2 Identify the proper accounting for losses on long-term contracts.
Long-Term Contract Losses
Illustration: Loss on Profitable Contract
2010
Construction in progress
Construction expense
Construction revenue
Construction in progress
Construction expense
Construction revenue
24
2011
2012
18,750
150,000
7,314
215,436
168,750
222,750
3,900
287,400
283,500
LO 2 Identify the proper accounting for losses on long-term contracts.
Long-Term Contract Losses
Illustration: Loss on Unprofitable Contract
Casper Construction Co.
Contract price
Cost incurred current year
Estimated cost to complete
in future years
Billings to customer current year
Cash receipts from customer
Current year
2010
$675,000
150,000
2011
$675,000
287,400
2012
$675,000
246,038
450,000
135,000
246,038
360,000
0
180,000
112,500
262,500
300,000
c) Prepare the journal entries for 2010, 2011, and 2012 assuming the estimated
cost to complete at the end of 2011 was $246,038 instead of $170,100.
25
LO 2 Identify the proper accounting for losses on long-term contracts.
Long-Term Contract Losses
Illustration: Loss on Unprofitable Contract
2010
2011
2012
$ 150,000
$ 437,400
$ 683,438
Estimated cost to complete
450,000
246,038
Est. total contract costs
600,000
683,438
Costs incurred to date
Est. percentage complete
25.0%
683,438
64.0%
100.0%
Contract price
675,000
675,000
675,000
Revenue recognizable
168,750
432,000
675,000
(168,750)
(432,000)
Rev. recognized prior year
Rev. recognized currently
168,750
263,250
243,000
Costs incurred currently
(150,000)
(290,438)
(243,000)
Gross profit recognized
$ 18,750
$ (27,188)
$
$675,000 – 683,438 = (8,438) cumulative loss
26
-
Plug
LO 2 Identify the proper accounting for losses on long-term contracts.
Long-Term Contract Losses
Illustration: Loss on Unprofitable Contract
2010
Construction in progress
Construction expense
Construction revenue
Construction in progress
Construction expense
Construction revenue
27
2011
2012
18,750
150,000
243,000
168,750
243,000
27,188
290,438
263,250
LO 2 Identify the proper accounting for losses on long-term contracts.
Long-Term Contract Losses
Illustration: Loss on Unprofitable Contract
For the Completed-Contract method, companies would
recognize the following loss :
2010
Loss on construction contract
Construction in progress
28
2011
2012
8,438
8,438
LO 2 Identify the proper accounting for losses on long-term contracts.
Revenue Recognition Before Delivery
Disclosures in Financial Statements
Construction contractors should disclosure:

the method of recognizing revenue,

the basis used to classify assets and liabilities as current
(nature and length of the operating cycle),
29

the basis for recording inventory,

the effects of any revision of estimates,

the amount of backlog on uncompleted contracts, and

the details about receivables.
LO 2 Identify the proper accounting for losses on long-term contracts.
Revenue Recognition Before Delivery
Completion-of-Production Basis
In certain cases companies recognize revenue at the
completion of production even though no sale has been
made.
Examples are:
30

precious metals or

agricultural products.
LO 2 Identify the proper accounting for losses on long-term contracts.
Revenue Recognition After Delivery
When the collection of the sales price is not reasonably
assured and revenue recognition is deferred.
Methods of deferring revenue:
31

Installment-sales method

Cost-recovery method

Deposit method
Generally
Employed
LO 3 Describe the installment-sales method of accounting.
Revenue Recognition After Delivery
Installment-Sales Method
Recognizes income in the periods of collection rather than
in the period of sale.
Recognize both revenues and costs of sales in the period of
sale, but defer gross profit to periods in which cash is
collected.
Selling and administrative expenses are not deferred.
32
LO 3 Describe the installment-sales method of accounting.
Revenue Recognition After Delivery
Acceptability of the Installment-Sales Method
The profession concluded that except in special circumstances,
“the installment method of recognizing revenue is not
acceptable.”
The rationale: because the installment method does not
recognize any income until cash is collected, it is not in
accordance with the accrual concept.
33
LO 3 Describe the installment-sales method of accounting.
Revenue Recognition After Delivery
Cost-Recovery Method
Recognizes no profit until cash payments by the buyer exceed
the cost of the merchandise sold.
A seller is permitted to use the cost-recovery method to account
for sales in which “there is no reasonable basis for estimating
collectibility.” In addition, use of this method is required where a
high degree of uncertainty exists related to the collection of
receivables.
34
LO 4 Explain the cost-recovery method of accounting.
Cost-Recovery Method
Illustration: In 2012, Fesmire Manufacturing sells inventory with a
cost of $25,000 to Higley Company for $36,000. Higley will make
payments of $18,000 in 2012, $12,000 in 2013, and $6,000 in 2014.
If the cost-recovery method applies to this transaction and Higley
makes payments as scheduled, Fesmire recognizes cash collections,
revenue, cost, and gross profit as follows.
Illustration 18-41
35
LO 7
Cost-Recovery Method
Illustration: Fesmire’s journal entry to record the deferred
gross profit on the Higley sale transaction (after recording the
sale and the cost of sale in the normal manner) at the end of
2012 is as follows.
Sales
36
36,000
Cost of Sales
25,000
Deferred Gross Profit
11,000
LO 4 Explain the cost-recovery method of accounting.
Cost-Recovery Method
Illustration: In 2013 and 2014, the deferred gross profit
becomes realized gross profit as the cumulative cash
collections exceed the total costs, by recording the following
entries.
2013
Deferred Gross Profit
5,000
Realized Gross Profit
2014
Deferred Gross Profit
Realized Gross Profit
37
5,000
6,000
6,000
LO 4 Explain the cost-recovery method of accounting.
Revenue Recognition After Delivery
Deposit Method
Seller reports the cash received from the buyer as a deposit
on the contract and classifies it on the balance sheet as a
liability.
The seller does not recognize revenue or income until the
sale is complete.
38
LO 4 Explain the cost-recovery method of accounting.
Summary of Product Revenue Recognition
Illustration 18-42
39
LO 7
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Franchises
Four types of franchising arrangements have evolved:
1. manufacturer-retailer,
2. manufacturer-wholesaler,
3. service sponsor-retailer, and
4. wholesaler-retailer.
40
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Franchises
Fastest-growing category is service sponsor-retailer:

Soft ice cream/frozen yogurt stores (Tastee Freeze, TCBY,
Dairy Queen)
41

Food drive-ins (McDonald’s, KFC, Burger King)

Restaurants (TGI Friday’s, Pizza Hut, Denny’s)

Motels (Holiday Inn, Marriott, Best Western)

Auto rentals (Avis, Hertz, National)

Others (H & R Block, Meineke Mufflers, 7-Eleven Stores)
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Franchises
Two sources of revenue:
1. Sale of initial franchises and related assets or services,
and
2. Continuing fees based on the operations of franchises.
42
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Franchises
The franchisor normally provides the franchisee with:
1. Assistance in site selection.
2. Evaluation of potential income.
3. Supervision of construction activity.
4. Assistance in the acquisition of signs, fixtures, and equipment.
5. Bookkeeping and advisory services.
6. Employee and management training.
7. Quality control.
8. Advertising and promotion.
43
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Initial Franchise Fees
Franchisors record initial franchise fees as

revenue only when and as they make “substantial
performance” of the services they are obligated to perform and
when collection of the fee is reasonably assured.
Substantial performance occurs when the franchisor has no
remaining obligation to refund any cash received or excuse any
nonpayment of a note and has performed all the initial services
required under the contract.
44
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Example of Entries for Initial Franchise Fee
Illustration: Tum’s Pizza Inc. charges an initial franchise fee of
$50,000 for the right to operate as a franchisee of Tum’s Pizza. Of
this amount, $10,000 is payable when the franchisee signs the
agreement, and the balance is payable in five annual payments of
$8,000 each. The credit rating of the franchisee indicates that
money can be borrowed at 8 percent. The present value of an
ordinary annuity of five annual receipts of $8,000 each discounted
at 8 percent is $31,941.68. The discount of $8,058.32 represents
the interest revenue to be accrued by the franchisor over the
payment period.
45
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Example of Entries for Initial Franchise Fee
Illustration: 1. If there is reasonable expectation that Tum’s Pizza
Inc. may refund the down payment and if substantial future services
remain to be performed by Tum’s Pizza Inc., the entry should be:
Cash
10,000.00
Notes Receivable
40,000.00
Discount on Notes Receivable
Unearned Franchise Fees
46
8,058.32
41,941.68
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Example of Entries for Initial Franchise Fee
Illustration: 2. If the probability of refunding the initial franchise
fee is extremely low, the amount of future services to be provided to
the franchisee is minimal, collectibility of the note is reasonably
assured, and substantial performance has occurred, the entry
should be:
47
Cash
10,000.00
Notes Receivable
40,000.00
Discount on Notes Receivable
8,058.32
Revenue from Franchise Fees
41,941.68
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Example of Entries for Initial Franchise Fee
Illustration: 3. If the initial down payment is not refundable,
represents a fair measure of the services already provided, with a
significant amount of services still to be performed by Tum’s Pizza in
future periods, and collectibility of the note is reasonably assured, the
entry should be:
48
Cash
10,000.00
Notes Receivable
40,000.00
Discount on Notes Receivable
8,058.32
Revenue from Franchise Fees
10,000.00
Unearned Franchise Fees
31,941.68
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Example of Entries for Initial Franchise Fee
Illustration: 4. If the initial down payment is not refundable and no
future services are required by the franchisor, but collection of the
note is so uncertain that recognition of the note as an asset is
unwarranted, the entry should be:
Cash
10,000.00
Revenue from Franchise Fees
49
10,000.00
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Example of Entries for Initial Franchise Fee
Illustration: 5. Under the same conditions as those listed in case
4 above, except that the down payment is refundable or substantial
services are yet to be performed, the entry should be:
Cash
10,000.00
Unearned Franchise Fees
10,000.00
In cases 4 and 5 — where collection of the note is extremely uncertain—
franchisors may recognize cash collections using the installment-sales method
or the cost-recovery method.
50
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Continuing Franchise Fees
Continuing franchise fees are received in return for the
continuing rights granted by the franchise agreement and for
providing such services as management training, advertising
and promotion, legal assistance, and other support.
Franchisors report continuing fees as revenue when they
are earned and receivable from the franchisee.
51
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Franchisor’s Cost

Should ordinarily defer direct costs (usually incremental costs)
relating to specific franchise sales for which revenue has not
yet been recognized.

Should not defer costs without reference to anticipated revenue
and its realizability.

Indirect costs of a regular and recurring nature, such as
selling and administrative expenses that are incurred
irrespective of the level of franchise sales, should be expensed
as incurred.
52
LO 5 Explain the revenue recognition for franchises.
REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS
Disclosure of Franchisors

All significant commitments and obligations resulting from
franchise agreements.

Any resolution of uncertainties regarding the collectibility of
franchise fees.

Where possible, revenues and costs related to franchisor
owned outlets should be distinguished from those related to
franchised outlets.
53
LO 5 Explain the revenue recognition for franchises.
Profitability Ratios
Profitability Ratios
Profit Margin on Sales
Net Income ÷ Net Sales
Return on Assets
Net Income ÷ Average Total Assets
Return on Shareholders' Equity
Net Income ÷ Average Shareholders' Equity
Return on Equity Key Components
Profitability
Activity
Financial Leverage
54
DuPont Framework
The DuPont Framework helps identify how
profitability, activity, and financial leverage trade off
to determine return to shareholders:
Return on
equity
Net income
Avg. total
equity
=
Profit
margin
X
=
Net income
Total sales
X
Asset
turnover
Total sales
Avg. total
assets
X
Equity
multiplier
X
Avg. total assets
Avg. total equity
Because profit margin and asset turnover combine to
equal return on assets, the DuPont framework can also
This is called the DuPont
be written
as:
framework
because the DuPont
Return on
equity
Net income
Avg. total
equity
55
=
=
Return on
Company
was a Equity
pioneer in
assets
X
multiplier
emphasizing this relationship.
Net income
Avg. total
assets
X
Avg. total assets
Avg. total equity
RELEVANT FACTS
56

The IASB defines revenue to include both revenues and gains.
GAAP provides separate definitions for revenues and gains.

Revenue recognition fraud is a major issue in U.S. financial
reporting. The same situation occurs overseas as evidenced by
revenue recognition breakdowns at Dutch software company Baan
NV, Japanese electronics giant NEC, and Dutch grocer AHold NV.
RELEVANT FACTS
57

IFRS has one basic standard on revenue recognition—IAS 18.
GAAP has numerous standards related to revenue recognition (by
some counts over 100).

Accounting for revenue provides a most fitting contrast of the
principles-based (IFRS) and rules-based (GAAP) approaches. While
both sides have their advocates, the IASB and the FASB have
identified a number of areas for improvement in this area.

Under IFRS, revenue should be measured at fair value of the
consideration received or receivable. GAAP measures revenue
based on the fair value of what is given up (goods or services) or the
fair value of what is received—whichever is more clearly evident.
End of Lecture 21
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