CHAPTER 18: REVENUE RECOGNITION
Objectives:
1. “The General Rule”: Be able to assess
“When is a sale a sale?”
2. Be able to describe and apply “Before
delivery” rules:
% of completion method
Completed contract method
3. Be able to describe and apply “After
delivery” rules:
Installment sales
Cost recovery
Default/Repossession
4. Special rules:
Franchises
Consignments
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Objective 1: General rule
Income recognition: What we are
concerned with is
a. What to report (item defined)
Our guidance is SFAC No. 6
(Elements of financial statements
in business enterprises) which we
have already covered
CON6
Revenues
78. “Revenues are inflows or other enhancements of
assets or settlements of its liabilities (or combination of
both) from delivering or producing goods, rendering
services, or other activities that constitute the entity’s
ongoing major or central operations.”
Comprehensive income…
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Objective 1 (General Rule), continued
b. How much to report (item
measured)
c. When to report (specific
accounting period)
“How much” and “when” is
governed by RECOGNITION
CRITERIA detailed in SFAC
No. 5.
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Objective 1, continued
So the General Rule is:
Revenue is earned through a continuous
process involving production of
product, sale of product and subsequent
collection.
The revenue principle says that the
exchange has occurred (realization), the
earnings process is substantially
complete (done their work) and that
revenues are measured at exchange
values. Thus, revenue is recognized
when realized or realizable and when
earned.
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Objective 1, continued
What is difference between realized and
realizable?
Realized: when goods and services are
exchanged for cash or claims to cash.
Realizable: when assets received in exchange
are readily convertible to known amounts of
cash or claims to cash.
How the General Rule translates:
Exhibit in text is showing revenue
recognition by nature of transaction. Key is
uncertainty is removed.
Date of sale/delivery (most common)
When services performed and billed
Passage of time
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Objective 1, continued
Date of sale/delivery exceptions:
Buyback: no sale (economic substance)
High rates of returns: no sale unless
conditions met. 6 conditions noted in
text remove uncertainties and future
performance obligations.
a. Fixed price
b. Payment or obligation to pay not contingent
on resale
c. Product damage doesn’t impact obligation
d. Buyer separate “economic substance” entity
e. Minimal future performance obligations
f. Can estimate future returns (and should do so)
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Objective 2: Before delivery (LT
construction contracts)
Construction projects often span more than
one accounting period. Should we
recognize only at completion or during
earnings process?
Both are acceptable under GAAP. Choice
impacts inventory valuation and income
measurement.
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Objective 2, continued
Completed contract:
1. all costs are debited to Construction in
Process (WIP)
2. all billings are credited to Billings on
Construction in Process
3. at end of project, the accumulated
balances are closed into Construction
Expenses (for #1) and Revenue (for #2)
so that gross profit is recognized in the
last year only
cost
CIP (inventory)
xx
Wages, Material, etc.
xx
progress billings
A/R
Billings on CIP
xx
xx
Cash collected
Cash
A/R
xx
xx
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Objective 2, continued
In last year, on completed contract
Billings
xx
Revenue
xx
(recognize revenue from billings)
Costs of construction xx
CIP
xx
(move costs from inventory to expense)
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Objective 2, continued
Percentage Completion: recognize income
each year based on % complete (cost-to-cost
method)
[(actual cost incurred to date)/(estimated
cost to complete) x (estimated total
revenue)]-revenue recognized to date =
revenue for period
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Objective 2, continued
1. all costs are debited to “construction in
process”
2. all billings are credited to Billings on
construction in process
3. each year, we debit “construction in
process” for gross profit and credit
revenue from long-term contracts for
“revenue for period” computed above. A
third account, construction expenses, is
debited for the difference between gross
profit and revenue.
4. A change in estimate is prospective.
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Objective 2, continued
cost
CIP
xx
Materials, Wages
xx
Progress billings
A/R
xx
Billings
xx
collections
Cash
A/R
xx
xx
recognize revenue and gross profit
(annually)
CIP
xx
Construction exp xx
Revenue from LTK xx
Final approval of contract
Billings
xx
CIP
xx
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Objective 2, continued
Example: Frodo Construction Company received a
contract for $6,000,000 in 2004 to build a parking
deck for a large university. The following data was
accumulated during the construction period:
Costs to date
Est. costs to
complete
Progress
billings
Cash collected
2004
2005
2006
$1,800,000
$2,700,000
$2,090,000
$3,410,000
$5,000,000
$0
$2,000,000
$2,000,000
$2,000,000
$1,500,000
$2,000,000
$2,500,000
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Completed Contract:
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Completed Contract:
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Percentage of Completion:
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Percentage of Completion:
17
Percentage of Completion:
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Objective 2, continued
Projected Losses:
1.
Unprofitable contract: under both
methods, recognize in full in the
period in which a loss appears
probable.
2.
Profitable contract: expenses exceed in
current period but overall contract is
still profitable. Under % completion,
need to adjust excess gross profit
recognized in prior period (change in
accounting estimate).
Note: we did this in our previous example
(CIP is debited, that is, we absorb the loss in
the current period).
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Objective 3:After delivery
1.
Installment sales: gross profit only is
deferred until period of cash collection
due to difficulty in estimating
uncollectible amounts.
a. Cost of sales is recognized in period
of sale, however, both cost of sales
and sales are closed out to deferred
gross profit.
b. Not acceptable for financial
accounting but used extensively in
tax (cash basis accounting)
Year by year computation: Gross
profit realized is based on GP
rate for the year x cash
collections for sales for that year.
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Objective 3, continued
“After delivery” continued
d. Special installment sales problems:
Interest
Interest receivable xx
Interest revenue xx
Uncollectibles
Repossessions
2. Cost Recovery: no profit is recognized
until cash payments by the buyer exceed the
seller’s cost of merchandise sold.
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Objective 4:Special Rules
1. Franchises (SFAS No.45):
a. Nature of franchise agreements
b. Types of franchise agreements
c. Accounting for and disclosing the
following:
Initial franchise fees
Continuing franchise fees
Bargain purchases
Franchisor’s costs
Options to purchase
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Objective 4, Special Rules, continued
2. Consignment: merchandise is shipped by
consignor to consignee who acts as an agent
for the consignor in sellling the
merchandise.
a. Merchandise shipped is property of ?
b. How do we account for a sale?
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