Complexities
of Revenue
Recognition
2
Learning Objectives
 Identify the primary criteria for revenue
recognition.
 Explain when revenue is appropriately
recognized prior to delivery of goods or
services through percentage-of-completion
accounting.
 Record journal entries for long-term
construction-type contracts using
percentage-of-completion and completedcontract methods.
3
Learning Objectives
 Record journal entries for long-term service
contracts using the proportional performance
method.
 Explain when revenue is recognized after
delivery of goods or services through
installment sales, cost recovery, and cash
methods.
4
Learning Objectives
EXPANDED MATERIAL:
 Describe accounting for the transfer of
assets prior to the recognition of revenue
with the deposit method and consignment
sales.
5
Revenue Recognition Criteria
FASB’s two criteria for recognizing
revenues and gains:
 They are realized or realizable, and
 They have been earned through
substantial completion of the
activities involved in the earnings
process.
6
Revenue Recognition Criteria
This most often occurs
Both
of these
when
goodscriteria
are
generally
areormet
at the
delivered
when
pointare
of rendered.
sale.
services
Revenue Recognition-Exceptions
• A product or service was
provided without receiving
a valid promise of payment
from customer.
• The company has not
provided the product or
service.
7
8
Revenue Recognition--IAS 18
A company should recognize revenue from the SALE
OF GOODS when all of the following conditions have
been satisfied:
 The significant risks and rewards of ownership of
the goods have been transferred to the buyer and
the selling company retains no effective control
over what happens to the goods,
 Both the amount of the revenue and of the costs
associated with the transaction can be reliably
measured, and
 It is probable that the economic benefits of the sale
will flow to the selling company.
9
Revenue Recognition--IAS 18
A company should recognize revenue from the
RENDERING OF SERVICES when both of the
following conditions have been satisfied:
 The total amount of the revenue, the total amount
of the costs, and the stage of completion of the
transaction can be reliably measured, and
 It is probable that the economic benefits of the
transaction will flow to the company rendering the
services.
Revenue Recognition-Exceptional Cases
• Long-Term Contracts
• Uncertain Collections
• Deposit Method
• Consignment Sales
10
Long-Term Contracts-Recognition Choices
• Completed-Contract Method:
recognize
all requires
incomepercentage-ofwhen project is
GAAP
completion method unless certain
completed.
criteria are not met.
• Percentage-of-Completion Method:
recognize revenue throughout the term
of the contract.
11
Percentage-ofCompletion Criteria
 Dependable estimates of:
– revenues.
– costs.
– progress toward completion.
 Contract clearly specifies:
– enforceable rights of the parties.
– consideration to be exchanged.
– manner and terms of settlement.
12
Percentage-ofCompletion Criteria
 The buyer can be expected to satisfy
obligations under the contract.
 Contractor can be expected to perform
the contractual obligation.
13
Percentage-of-Completion-General Concepts
• Recognize revenue throughout life of the
contract.
• Revenue recognized is a function of how
complete the project is.
• 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.
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15
Percentage-of-Completion
• 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.
16
Percentage-of-Completion
Costs incurred to date
2001 __
$ 72,000
2002
$192,000
At the beginning of the contract,
costs are expected to be incurred
each year as shown.
2003
$240,000
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Percentage-of-Completion
Costs incurred to date
Estimated costs to complete
Total estimated costs
2001 _
$ 72,000
2002
$192,000
2003
$240,000
168,000
48,000
0
$240,000
$240,000
$240,000
Total cost of the project at completion is
expected to be $240,000. The difference
between the costs incurred to date and the
total estimated costs at completion is
defined as the estimated costs remaining to
complete the project.
18
Percentage-of-Completion
2001
$ 72,000
2002
$192,000
2003
$240,000
168,000
48,000
0
Total estimated costs
$240,000
$240,000
$240,000
Percentage complete
30%
80%
100%
Costs incurred to date
Estimated costs to complete
Percentage complete is the ratio
of costs incurred to date to total
estimated costs at completion.
19
Percentage-of-Completion
2001
$ 72,000
2002
$192,000
2003
$240,000
168,000
48,000
0
Total estimated costs
$240,000
$240,000
$240,000
Percentage complete
30%
80%
100%
$ 60,000
$ 60,000
$ 60,000
Costs incurred to date
Estimated costs to complete
Estimated total income
Total Contract $300,000
Estimated total income is the difference between the
contract price and total expected costs. Assume the
contract price in this example is $300,000.
20
Percentage-of-Completion
2001
$ 72,000
2002
$192,000
2003
$240,000
168,000
48,000
0
Total estimated costs
$240,000
$240,000
$240,000
Percentage complete
30%
80%
100%
Estimated total income
$ 60,000
$ 60,000
$ 60,000
Estimated total income to date
$ 18,000
$ 48,000
$ 60,000
Costs incurred to date
Estimated costs to complete
Estimated total income to date is computed
based on the cumulative percentage complete.
21
Percentage-of-Completion
2001
$ 72,000
2002
$192,000
2003
$240,000
168,000
48,000
0
Total estimated costs
$240,000
$240,000
$240,000
Estimated total income to date
$ 18,000
$ 48,000
$ 60,000
0
18,000
48,000
$ 18,000
$ 30,000
$ 12,000
Costs incurred to date
Estimated costs to complete
Income recognized in the current period is the
Percentage complete
30%
80%
100%
difference between total income to date and
Estimated total income
60,000 $ 60,000 $ 60,000
income previously $recognized.
Less:Iincome previously recognized
Income recognized this period
22
Percentage-of-Completion
2001
$ 72,000
2002
$192,000
2003
$240,000
168,000
48,000
0
Total estimated costs
$240,000
$240,000
$240,000
Percentage complete
30%
80%
100%
Estimated total income
$ 60,000
$ 60,000
$ 60,000
Estimated total income to date
$ 18,000
$ 48,000
$ 60,000
0
18,000
48,000
$ 18,000
$ 30,000
$ 12,000
Costs incurred to date
Estimated costs to complete
Less: Income previously recognized
Income recognized this period
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Percentage-of-Completion
2001
Construction in Progress…………. 72,000
Materials, Cash, etc…………...
72,000
To record costs incurred.
Accounts Receivable…………….. 100,000
Progress Billings on
Construction Contracts………
100,000
To record billings (amount assumed).
Cash………………………………. 90,000
Accounts Receivable…………..
90,000
To record cash collections (amount assumed).
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Percentage-of-Completion
2002
Construction in Progress………… 120,000
Materials, Cash, etc…………..
120,000
To record costs incurred.
Accounts Receivable……………. 140,000
Progress Billings on
Construction Contracts……...
140,000
To record billings (amount assumed).
Cash……………………………… 125,000
Accounts Receivable…………
125,000
To record cash collections
(amount
assumed).
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Percentage-of-Completion
2003
Construction in Progress…………. 48,000
Materials, Cash, etc…………...
To record costs incurred.
Accounts Receivable…………….. 60,000
Progress Billings on
Construction Contracts………
To record billings (amount assumed).
Cash………………………………. 85,000
Accounts Receivable…………..
To record cash collections (amount
assumed).
48,000
60,000
85,000
Revenue Recognition-Exceptional Cases
• Long-Term Contracts
• Uncertain Collections
• Deposit Method
• Consignment Sales
26
Uncertain Collections-Recognition Alternatives
 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.
27
Uncertain Collections--Comparison
of Recognition Methods
Method
Timing of Revenue
Recognition
Full Accrual
At point of sale
Installment
Sales
At collection of cash
(portion of receipt)
Cost
Recovery
At collection of cash
(after all costs have
been recovered)
Cash
At collection of cash
Treatment
of Costs
Revenue at point
of sale
Defer and match
against revenue as
cash is collected
Defer and match
against cash
receipts
Charge to expense
as incurred
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29
Installment Sales Method
The installment sales
method is used most
commonly in cases of
real estate sales.
Example:
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.
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Example:
Installment Sales Method
Sales
Cost of Sales
Gross Profit
Gross Profit
Percentage
Cash Collection
2001 Sales
2002 Sales
2001
$150
100
$ 50
33.33%
$ 30
31
2002
$200
140
$ 60
30%
$ 75
$ 70
Example:
Installment Sales Method
32
2001:
Accounts Receivable--2001……... 150
Installment Sales……………….
150
Cost of Installment Sales………... 100
Inventory……………………….
100
Cash……………………………… 30
Accounts Receivable--2001…...
30
Example:
Installment Sales Method
33
2001:
Installment Sales…………………. 150
Cost of Installment Sales……….
100
Deferred Gross Profit--2001…...
50
Deferred Gross Profit--2001……... 10
Realized Income………………..
($30 x 33.33%)
10
Example:
Installment Sales Method
34
2002:
Accounts Receivable--2002……….. 200
Installment Sales…………………
Cost of Installment Sales………….. 140
Inventory…………………………
Cash………………………………... 145
Accounts Receivable--2001……...
Accounts Receivable--2002……...
200
140
75
70
Example:
Installment Sales Method
35
2002:
Installment Sales…………………... 200
Cost of Installment Sales………...
Deferred Gross Profit--2002……..
140
60
Deferred Gross Profit--2001………. 25
Deferred Gross Profit--2002………. 21
Realized Gross Profit on
Installment Sales………………..
46
36
Example: Cost Recovery Method
Assume George has to
use the cost recovery
method, but all sales
and collections remain
the same.
37
Example: Cost Recovery Method
2002:
All entries are the same except do not
book the entry to gross profit.
Deferred Gross Profit--2001……….. 5
Realized Gross Profit on
Installment Sales………………..
5
Revenue Recognition-Exceptional Cases
• Long-Term Contracts
• Uncertain Collections
• Deposit Method
• Consignment Sales
38
Deposit Method--General
Requirement
 Used when cash is received before a
sale is completed.
 All revenue is initially deferred.
 Seller retains property sold as a
recognized asset until sale is completed.
 Revenue is recognized when sale is
completed.
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40
Deposit Method and Franchises
 Relates primarily to initial franchise fees.
 Franchiser defers initial fee at time cash
is received.
 Franchiser recognizes initial fee revenue
when “substantial performance” of
services is achieved.
 Franchiser may use any appropriate
recognition method once substantial
performance is achieved.
41
Example: Franchise
Mary sells Bob a franchise for
$1,000 cash on June 1.
Substantial performance is
agreed upon that Mary will
complete $700 of renovation
on Bob’s restaurant (which
occurs on July 10). Prepare
Mary’s journal entries.
42
Example: Franchise
June 1
Cash……………………………... 1,000
Deposit on Franchise (or
Unearned Franchise Fee)…...
July 10
Cost of Franchise Fee Revenue…. 700
Cash………………………….
Deposit on Franchise (or
Unearned Franchise Fee)……… 1,000
Franchise Fee Revenue……...
1,000
700
1,000
Revenue Recognition-Exceptional Cases
• Long-Term Contracts
• Uncertain Collections
• Deposit Method
• Consignment Sales
43
Consignment Sales-General Principles
• Definitions:
– Consignee: Title holder/seller of
merchandise.
– Consignor: Merchandise selling agent.
• Consignor does not recognize revenue
upon shipment to consignee.
• Consignor accounts for consigned
goods in separate Inventory on
Consignment account.
44
Consignment Sales-General Principles
• Consignee does not recognize consigned
goods as inventory.
• Consignor records all pre-sale expenses
as Inventory on Consignment.
• Consignor recognizes revenue when
informed of a sale by consignee.
• Consignee recognizes revenue only for
consignment commission.
45
46
Example: Consignment Sales
Bob agrees to consign goods worth
$1,000 to Lucy. Lucy agrees to sell the
goods at her store for a 5 percent of net
sales consignment commission and
reimbursement
of selling
expenses.the
The
next several slides
demonstrate
transactions and journal entries for Bob
and Lucy throughout the consignment
cycle. (All numbers are assumed.)
47
Example: Consignment Sales
Transaction: Shipment of Goods
Entry in Bob’s (consignor’s) books:
Inventory on Consignment…… 1,000
Finished Goods Inventory…..
1,000
Entry in Lucy’s (consignee’s) books:
None--memorandum inventory control
record.
48
Example: Consignment Sales
Transaction: Incurrence of $200 of
selling expenses by Lucy.
Entry in Bob’s books:
Inventory on Consignment…. 200
Consignee Payable………..
200
Entry in Lucy’s books:
Consignor Receivable………. 200
Cash……………………….
200
49
Example: Consignment Sales
Transaction: Sale of merchandise for
$2,000.
Entry in Bob’s books:
None.
Entry in Lucy’s books:
Cash……………………… 2,000
Consignor Payable……..
2,000
50
Example: Consignment Sales
Transaction: Lucy notifies Bob of the
sale and sends him net cash proceeds.
Entry in Bob’s books:
Commission Expense…………...
100
Cash…………………………….. 1,700
Consignee Payable……………...
200
Cost of Goods Sold…………….. 1,000
Consignment Sales Revenue….
2,000
Inventory on Consignment……
1,000
51
Example: Consignment Sales
Entry in Lucy’s books:
Consignor Payable…………. 2,000
Cash……………………….
1,700
Commission Revenue……..
100
Consignor Receivable……..
200
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The End