◌ِ
Faculty of Commerce
Assiut University
LECTURES NOTES IN
SPECIALISED ACCOUNTING
Part I
Compiled and Edited by
Dr. Mostafa Kayed
PhD in Accounting
Preface
The accounting courses you have already studied over the previous
semesters included a general accounting framework suitable for the
economic units, whether these units take the form of sole proprietorships,
partnerships, or corporations. However, there are some economic
activities require different accounting application and the accounts’ style.
This difference extends to the books and ledgers that these units keep to
properly prepare the financial statements for the entities that perform such
activities.
This book presents some of these activities and discusses the
relevant accounting approaches to compute the profits/surplus or losses/
deficit and prepare the financial statements. Notable that this book ignores
some other activities that require special accounting applications not
because they are less important but because of the limited time allocated
for teaching this course.
The author hopes that the desired objectives of studying this book
will be realised.
Dr Mostafa Kayed
2
Table of Contents
Chapter One: Accounting for Consignment ....................... - 2 Chapter Two: Accounting For Clubs And Societies .......... - 2 Chapter Three: Revenues Recognition …………………..- 2 -
3
CHAPTER ONE
ACCOUNTING FOR CONSIGNMENT
4
Chapter One
Accounting for Consignment
Learning Objectives:
After studying this chapter, you will be able to:
• Understand the special features of the consignment business, the
meaning of the terms consignor and consignee.
• Analyse the difference between the sale and consignment
transactions and understand why consignment is termed a special
transaction.
• Practise the accounting treatments for consignment transactions
and events in the books of consignor and consignee.
• Note the variations in accounting when goods are sent at cost and
goods are sent above the cost.
• Learn the technique of computing the value of closing inventory
lying with the consignor and the amount of Inventory reserve.
• Learn the technique of computing the cost of abnormal loss and
treatment of insurance claims in relation to it.
• Understand the distinction between the ordinary commission, delcredere commission and over-riding commission paid to the
consignee.
• See the variety of accounting treatment for bad debts when the
consignee is paid ordinary commission and when the consignee is
paid del-credere commission in addition.
• Understand the reason for including/excluding various
expenditures to cost while valuing the goods returned by the
consignee.
1. The consignment as a concept:
-5-
To consign means to send. In Accounting, the term “consignment
account” relates to accounts dealing with a situation where one person
(or a firm) sends goods to another person (or a firm) on the basis that
the goods will be sold on behalf of and at the risk of the former. The
following should be noted carefully:
1) The party which sends the goods (consignor) is called the principal.
2) The party to whom goods are sent (Consignee) is called the agent.
3) The ownership of the goods, i.e., the property in the goods, remains
with the consignor or the principal – the agent does not become
their owner even though they are in his possession. On sale, of
course, the buyer will become the owner.
4) The principal does not send an invoice to the agent. He sends only
a proforma invoice, a statement that looks like an invoice but is
really not one. The object of the proforma invoice is only to convey
information to the agent regarding the particulars of the goods sent.
5) Usually, the agent recovers from the principal all expenses incurred
by him on the consignment. This, however, can be changed by
agreement between the two parties.
6) It is also usual for the agent to give an advance to the principal in
the form of cash or a bill of exchange. It is adjusted against the sale
proceeds of the goods.
7) For his work, the agent receives a commission calculated based on
the gross sale. For ordinary commission, the agent is not
responsible for any bad debt that may arise. If the agent is to be
made responsible for bad debts, he is to be paid a commission
called del-credere commission. It is calculated on total sales, not
merely on credit sales until and unless agreed.
-6-
8) Periodically, the agent sends to the principal a statement called
Account Sales. It sets out the sales made by the agent, the expenses
incurred on behalf of the principal, the commission earned by the
agent and the balance due to the principal.
9) Firms usually like to ascertain the profit or loss on each
consignment or consignments to each agent.
2. Advantages of consignment arrangements:
A consignment arrangement offers certain advantages to both the
consignor and the consignor. A consignor may prefer shipping goods
on consignment for the following reasons:
-
Wider market for a product: dealers may not be willing to assume
the risk of purchasing certain goods such as a new product or an
item that may become obsolete but may be willing to carry them
on consignment.
-
Control over selling price: if gods are sold directly to the consignee,
the consignor may find it challenging to establish and control the
selling price of goods.
-
Recovery of an asset: since the legal title does not transfer to the
consignee, the consignor has the right to possession of all unsold
goods or the right to payment for goods sold if the consignee
declares bankruptcy. Creditors of the Consignee do not have the
claim against the consigned assets that they would have if the goods
had been sold to the consignee.
On the other side, the consignee may find a consignment arrangement
attractive primarily for the following reasons:
-7-
-
Avoid risks of ownership: Goods that do not sell or become
obsolete, deteriorate, or decline in market value may be returned to
the consignor.
-
Requires less capital: the consignee does not incur liability and
does not make a cash payment on the goods until they are sold
(despite sometimes the consignor requires the consignee to send an
advance once he receives the goods on consignment). Thus the
consignee’s capital investment will be lower if the goods are held
on consignment.
3. Rights and responsibilities of the Consignee:
Before goods are transferred on consignment, a written agreement
should specify clearly the intent of the parties. The agreement should
address such issues as the amount and type of the consignee's expenses
to be reimbursed by the consignor, how the consignee's commissions
are to be computed when commissions are to be paid, the credit terms
and conditions, if any, to be considered by the consignee in granting
credit, and the responsibility for collection of receivables and losses on
receivables (bad debt written off). The agreement, also, should be
complete and attempt to avoid potential points of conflict. The
commercial law has to be applied for items not provided for in the
agreement that results in litigation.
3.1 Rights of the Consignee:
Some of the more important rights and responsibilities of the consignee
are:
- Compensation: The Consignee has a right to be compensated for
services performed. Usually, this compensation is stated as a
percentage of the sales price, or the consignee is permitted to retain
-8-
all the sales prices above a specified amount.
- Reimbursement for Advances and Necessary Expenses: Unless
otherwise provided for in the agreement, the consignor, as the
owner of the goods, is responsible (or all costs incurred that are
directly related to the sale of the goods (for example, freight and
insurance on the goods while in transit to the consignee's place of
business). Before the goods are sold, several expenses that are
directly related to the sale may be paid by the consignee for the
convenience of the consignor. In addition, in some cases, the
consignee may make an advance to the consignor before the sale is
made to a third party. The consignee has the right to be reimbursed
for such advances and expenses. Usually, recovery is made by
deducting the expenses and advances from the amounts collected
from the sale of tile consigned goods. If the collection‫ ؛‬are
insufficient to cover these expenses and advances, the consignee
has a direct claim against either unsold goods or receivable
balances on items already sold.
- Granting of credit: unless limited by an express agreement, the
consignee has the right to sell goods on credit and extend normal
credit terms. Of course, the consignee must exercise due care and
act prudently in the granting of credit. A consignee may guarantee
the collection of the receivables balance. The consignee is referred
to as a del-credere agent and generally receives additional
compensation for assuming this risk.
- Warranty of Consigned Goods. The consignee has the right to make
warranties that are normal for the product being sold.
3.2 Responsibilities of the Consignee:
-9-
- Care and protection for consigned goods: The Consignee must
provide reasonable care and protection that fits the type of goods
being held and care for the goods in accordance with specific
instructions for the consigner.
- Identification of consigned goods and receivables: Although
physical separation is not required, the consignee must establish
sufficient controls and provide adequate accounting records to
identify consigned goods and consignment receivables.
- Due care in granting and collecting receivables: The Consignee
must express reasonable effort to assure that the goods are sold at
the specified price, that normal credit terms arc granted, that a
normal warranty is made, and that a reasonable effort is made to
collect the sales price.
- Timely Periodic Reporting of Sales and Collections: The Consignee
must report the sales and collections activities during the period and
settle the account with the consignor for in the consignment
agreement. The report rendered by the consignee is referred to as
"account sales". Typically, this report presents information related
to the received goods on consignment, the expenses incurred by the
consignee, the consignee's commission, in addition to the net
amount deserved by the consignor.
4. The distinction between goods on consignment and goods on
sale:
Consignment Account relates to accounts dealing with such business
where an entity or a company (the consignor) sends goods to another
entity or company (the consignee) on the basis that such goods will be
sold on behalf of and at the risk of the consignor.
- 10 -
Consignment
Ownership of the goods remains
with the consignor until the
1 consignee sells them, no matter
whether the goods are transferred
to the consignee.
The consignee can return the
2 unsold goods to the consignor.
Sale
The ownership of the goods
transfers with the transfer of goods
from the seller to the buyer.
Goods sold are the property of the
buyer and can be returned only if the
seller agrees.
The consignor bears the loss of
It is the buyer who will bear the loss,
3 goods held with the consignee.
if any, after the delivery of goods.
The relationship between the
4 consignor and the consignee is that
of a principal and agent.
Expenses done by the consignee to
5 receive the goods and keep them
safe are borne by the consignor.
The relationship between the seller
and the buyer is that of a creditor and
a debtor.
Expenses incurred by the buyer are
to be borne by the buyer after the
delivery of goods.
5. Distinction Between Commission and Discount
Commission
Discount
The commission may be defined as
remuneration of an employee or
agent relating to services performed
in connection with sales, purchases,
collections or other types of
business transactions and is usually
based on a percentage of the
amounts involved. Commission
earned is accounted for as an income
in the books of accounts, and
commission allowed or paid is
accounted for as an expense in the
The term discount refers to any
reduction or rebate allowed and is
used to express one of the following
situations: An allowance is given to
settle a debt before it is due, i.e.
cash discount. An allowance is
given to the whole sellers or bulk
buyers on the list price or retail
price, known as a trade discount. A
trade discount is not shown in the
books of account separately, and it
- 11 -
books of the party availing such is shown by way of deduction from
facility or service.
the cost of purchases.
6. Accounting for Consignment Transactions and Events: The
Books Of The Consignor
For ascertaining profit or loss on any transaction (or series of
transactions), there is one golden rule; open an account for the
transaction (or series of transactions) and (i) put down the cost of goods
and other expenses incurred or to be incurred on the debit side, and (ii)
enter the sale proceeds as also the cost of goods remaining unsold on
the right hand or the credit side. The difference between the total of the
two sides will reveal profit or loss. There is profit if the credit side is
more.
-
Open Consignment Account and debit it with the cost of goods and
credit it with "Goods sent on Consignment Account" as follows.
Consignment to the agent ……
Goods Sent on Consignment
×××
×××
To record sending goods to the agent ……
-
-
Recording the expenses incurred by the consignor by debiting the
consignment account and crediting the cash
Consignment to the agent …….
×××
Cash
×××
To record the expenses paid to send the
merchandise to the agent …….
If the consignee sends an advance ( cash or a note receivable), debit
Cash consignee’s personal account:
Cash Or Notes Receivable
The Agent …….
To record receiving cash/ a note receivable
from the agent …….
- 12 -
×××
×××
-
When the consignor receives the sales invoices, the following entries
have to be recorded:
• Recording the total sales as follows:
The agent ……
Consignment to the agent….
×××
×××
To record receiving the sales invoice indicating
selling goods amounted …….by the agent ……
• For expenses incurred by the consignee as well as bad debts
suffered by him on behalf of the consignor, debit Consignment
Account and credit Consignee Account:
Consignment to the agent……
×××
×××
The Agent ………
To record the expenses incurred by the agent …
• For commission due to the Consignee, debit Consignment
Account and credit the consignee.
Consignment to the agent ……
×××
×××
The Agent ……..
To record the commission entitled to the agent
…… (the amount of consignment sales the
commission rate)
• Receiving the remaining balance at the consignee (agent)
Cash
×××
The Consignee…….
×××
To record receiving the remaining amount for
the consignment sales by the consignee
• For the goods that may remain unsold debit the Inventories on
Consignment Account and credit Consignment Account
- 13 -
Inventories on Consignment
Consignment to the agent……..
×××
×××
To record the remaining unsold consignment
merchandise at the agent …
Notes:
a.
The cost of unsold goods at the agent must include its part from
all the expenses incurred by the consignor, including the freight
charges and any other expenses that the consignor incurred.
b.
Inventories on Consignment Account is an asset; it w be shown
in the balance sheet of the consignor, and next year it will be
transferred to the debit of the Consignment Account.
• At this stage, the Consignment Account will reveal profit or
loss. The profit or loss will be transferred to the income
summary by debit to the Consignment Account.
Consignment to the agent…..
Income Summary
×××
×××
To recognise the profits resulting from the
consignment sales by the agent ……
OR
Income Summary (Profit and losses account) ×××
Consignment to the agent ……..
×××
To recognise the losses resulted from the
consignment sales by the agent ……
The Important ledger accounts appear as follows:
Consignment out- the consignee…….. account
To Goods sent on consignment
×× By The Agent … (Sales ×××
× Proceeds)
- 14 -
To cash (Consignment expenses)
×× By
Inventories
Consignment
To the agent …… ( the agent
expenses and bad debts)
To the agent .. (Commission)
To Income Summary (or Profit
and Losses account)
on ×××
×
×
××
×××
×××
The Consignee Account
Year
Year
To Consignment out- the×××
agent.
By Notes receivables
×××
By Consignment out- ×
the agent (Expenses and
bad debts)
By Consignment out- ×
the
agent….
( Commission)
By cash
××
×××
×××
Goods sent on Consignment Account
Year
Year
To Income Summary ×××
(Or Trading Account)
By Consignment out- the ×××
agent……
×××
×××
Inventories on Consignment Account
Year
Year
To Consignment out- the ×××
agent…
Year
To Balance B/D
×××
- 15 -
By
Balance ×××
C/D
The following example illustrates the transactions and the main ledger
accounts required to present detailed information on the consignment.
Example 1
On 1st Jul. 2018, Ahmed sent to Kareem goods costing 50,000 and
spent 1,000 on packing etc. On 3rd Jul. 2018, Kareem received the
goods and sent his acceptance to Ahmed for 30,000 payable in 3
months. Kareem spent 2,000 on freight and cartage, 500 on the godown
rent and 300 on insurance. On 31st Dec. 2018, Kareem sent his Account
Sales (along with the amount due to Ahmed) showing that 4/5 of the
goods had been sold for 55,000. Kareem is entitled to a commission of
10%. One of the customers turned insolvent and could not pay 600 due
from him.
Required:
To record these transactions in Ahmed’s books.
The Solution
First: Journal Entries:
-
Open Consignment Account:
1st
Jul.
Consignment out- Kareem
50000
Goods Sent on Consignment
50000
To record sending goods to the agent Kareem
-
Recording the expenses incurred by the consignor:
1st
Jul.
Consignment out- Kareem
Bank
1000
1000
To record the expenses paid to send the
merchandise to the agent Kareem
- 16 -
-
Receiving a note payable from the Consignee Kareem:
3rd
Jul.
Notes Receivable
The Agent Kareem
30000
30000
To record receiving a note receivable from
the agent Kareem
-
Remember that Kareem accepted a note payable to the consignor
Ahmed on 3rd Jul. that matures after three months. Therefore, Kareem
has to pay this amount to Ahmed by 3rd Oct. The entry to record
collecting the amount shall be as follows:
3rd
Oct.
Cash
30000
Notes Receivable
30000
To record collecting the amount of a note
receivable from the agent Kareem
-
When the consignor receives the sales invoice, the following entries
have to be recorded:
• Recording the total sales as follows:
31st The agent Kareem
Dec.
Consignment out- Kareem
55000
55000
To record receiving the sales invoice
indicating selling goods amounted 55000 by
the agent Kareem
• Record deducting the Consignee Kareem's expenses and bad
debts from the Consignment out- Kareem's account
31st Consignment out- Kareem
Dec.
The Agent Kareem
3400
3400
To record the expenses incurred by the agent
Kareem
• Recording the commission entitled to the agent Kareem:
- 17 -
31st Consignment out- Kareem
Dec.
The Agent Kareem
5500
5500
To record the commission entitled to the
agent Kareem (55000 × 10%)
• Receiving a cheque indicates the remaining balance at the agent
Kareem
31st Cash
Dec.
16100
16100
The Agent Kareem
To record receiving the remaining amount
for the consignment sales by the agent
Kareem
• Recording the unsold goods:
31st
Dec.
Inventories on Consignment
Consignment out- Kareem
10600
10600
To record the remaining unsold consignment
merchandise at the agent Kareem
The cost of unsold goods at the agent Kareem was calculated as
follows:
1/5 of the cost to the consignor
1/5 of expense incurred by the
consignor
1/5 of the freight charge
Total
50000× 1/5= 10000
1000× 1/5 = 200
2000× 1/5=
400
10600
• Recognising the profits from goods on Consignment out- Kareem:
31st
Dec.
Consignment out- Kareem
Income Summary
To recognise the profits resulting from the
consignment sales by the agent Kareem
Second: the main ledger accounts:
- 18 -
5700
5700
Consignment out- Kareem Account
2018
1/7
1/7
31/12
31/12
31/12
2018
on 50000 31/12
To
Goods
sent
Consignment
To Cash (Consignment
expenses)
To Kareem ( the agent
expenses and bad debts)
To Kareem (Commission)
To Income Summary (or
Profit and Losses account)
1000 31/12
By
Kareem
(Sales 55000
Proceeds)
By
Inventories
on 10600
Consignment
3400
5500
5700
65600
65600
Goods sent on Consignment Account
2018
31/12 To
Summary
(Or
Account)
2018
Income 50000 31/12 By Consignment
Kareem
Trading
50000
out 50000
50000
Inventories on Consignment Account
2018
31/12
1/1/2019
To Consignment outKareem
To Balance B/D
2018
10600 31/12 By Balance C/D 10600
12600
The Consignee Kareem’s Account
2018
31/12
To Consignment out- 55000
Kareem
2018
3/7
31/12
55000
- 19 -
By Notes receivables
30000
By Consignment out- 3400
Kareem
(Expenses and bad debts)
By Consignment out- 5500
Kareem
( Commission)
By Cash
16100
55000
7. Valuation of Inventories
The principle is that inventories should be valued at cost or net
realisable value, whichever is lower, the same principle as is practised
for preparing final accounts. In the case of consignment, cost means
not only the cost of the goods as such to the consignor but also all
expenses incurred until the goods reach the consignee's premises. Such
expenses include packaging, freight, cartage, insurance in transit, etc.
However, expenses incurred after the goods have reached the
consignee's godown (such as go down rent, insurance of godown,
delivery charges) are not treated as part of the purchase cost for valuing
inventories on hand. That is why in the case given above, inventories
have been valued, ignoring godown rent and insurance.
Sometimes an examination problem states only that the
consignor’s expenses amounted to such and such amount and that
consignee spent so much. If details are not available for valuing
inventories, the expenses incurred by the consignor should be treated
as part of the cost, while those incurred by the consignee should be
ignored. If the expected selling price of inventories on hand is lower
than the cost, the value put on the inventories should be expected net
selling price only, i.e. expected selling price, less delivery expenses,
etc.
8. Goods Invoiced Above Cost
Sometimes the proforma invoice is made out at a value higher than the
cost, and entries in the books of the consignor are made out on that
basis - even the inventories remaining unsold will initially be valued
based on the invoice price. However, it must be remembered that the
profit or loss can be ascertained only if sale proceeds (plus) inventories
- 20 -
on hand, valued on cost basis, is compared with the cost of the goods
concerned together with expenses. Hence, if entries are first made on
an invoice basis, the effect of the loading (i.e., amount added to arrive
at the invoice price) must be removed by additional entries.
Example 2:
Suppose in the example given above, if the invoice is cost plus 20%,
i.e., 60,000 for the goods sent to Kareem. The entries will be as follows:
1/7 Consignment out- Kareem
Goods Sent on Consignment
To record sending goods to the agent
Kareem (50000+50000×20%)
1/7 Consignment out- Kareem
Cash
To record the expenses paid to send the
merchandise to the agent Kareem
3/7 Notes Receivable
The Agent Kareem
To record receiving a note receivable from
the agent Kareem
Cash
3/10
Notes Receivable
To record collecting the amount of a note
receivable from the agent Kareem
31/12 The agent Kareem
Consignment out- Kareem
To record receiving the sales invoice
indicating selling goods amounted 55000
by the agent Kareem
Consignment out- Kareem
31/12
The Agent Kareem
To record the expenses incurred by the
agent Kareem
- 21 -
60000
60000
1000
1000
30000
30000
30000
30000
55000
55000
3400
3400
31/12 Consignment out- Kareem
The Agent Kareem
5500
5500
To record the commission entitled to the
agent Kareem (55000 × 10%)
31/12 Cash
16100
16100
The Agent Kareem
To record receiving the remaining amount
for the consignment sales by the agent
Kareem
31/12 Inventories on Consignment
Consignment out- Kareem
To record the remaining unsold consignment
merchandise at the agent Kareem
31/12 Consignment out- Kareem
Income Summary
12600
12600
5700
5700
To recognise the profits resulting from the
consignment sales by the agent Kareem
You can see that except for the difference in the amounts in entries
related to sending the goods on Consignment out- Kareem and the entry
to record the inventory of goods on consignment at the Consignee
Kareem. The difference in the first entry amounts $10000 ($60000 $50000), and the later entry amounts $2000 ($12600 - $10600).
In this case, where the goods on consignment are loaded on a value
that exceeds the cost; therefore, two additional entries are required to
remove the effect of loading as follows:
31/12
31/12
Goods sent on consignment
Consignment out- Kareem
To remove the loading to the consignment
merchandise sent to the agent Kareem
Consignment out- Kareem
- 22 -
10000
10000
2000
Inventory Reserve
2000
To remove the unrealised profit from
overvaluing the end of period inventory at the
Consignee Kareem
The Consignment Account will now reveal a profit of $5,700,
the same as before. It will be transferred to the income summary (profit
and losses account). Similarly, entry given in 8 above will be made to
transfer the balance in the Goods sent on Consignment Account (now
against $5,000) after entry in (a) above to the credit of Trading
Account. The accounts (except for Kareem, whose account will be the
same as already shown) are given below:
Consignment – out- to Kareem
2018
1/7 To
Goods
sent
on
Consignment
1/7 To Cash (Consignment
expenses)
To Kareem ( the agent
31/12 expenses and bad debts)
To Kareem (Commission)
31/12
To
Inventory
reserve
(Adjustment)
To Income Summary (or
31/12 Profit and Losses account)
2018
60000 31/12 By
Kareem
(Sales 55000
Proceeds)
1000 31/12 By
Inventories
on 12600
Consignment
3400
By
Goods
sent
on 10000
Consignment (Loading)
5500
2000
5700
65600
65600
Goods sent on Consignment Account
2018
2018
31/12 To Consignment out- 10000
By Consignment
Kareem
Kareem
31/12 To Income Summary 50000 31/12
(Or Trading Account)
60000
- 23 -
out- 50000
60000
Inventories on Consignment Account
2018
31/12
1/1/2019
To Consignment outKareem
To balance b/d
2018
12600 31/12 By Balance C/D 12600
12600
Inventory Adjustment Account
2018
31/12 To balance c/d
2018
2000 31/12 By
Consignment
Kareem
2019
1/1
By balance b/d
out- 2000
2000
The last two accounts will be carried forward to the following
year, and their balance will then be transferred to the Consignment
Account – $12,600 on the debit side and $2,000 on credit. This year in
the balance sheet, the net amount of $10,600 will be shown on the
assets side as shown below:
Inventories on consignment
12,600
Less: Reserve
2,000
10600
What would be the situation if the commission to Kareem includes
the del-credere commission also? In that case, Kareem would not be
able to charge the bad debt of $600 to Ahmed; he will have to bear the
loss himself. You can see that then the profit on consignment will be
$6300 (The original profit of 5700 + the bad debts 600).
In this regard, it is to be noted that when del-credere commission is
paid to the consignee, the consignee account is debited in the books of the
- 24 -
consignor for both cash and credit sales. But if no such del-credere
commission is paid, then the consignee account cannot be debited for
credit sales, and in that case, the following entry is passed in the books of
the consignor for credit sales.
Consignment Trade receivables
Consignment out- the consignee..
×××
×××
9. Abnormal Loss
If any accidental or unnecessary loss occurs, the proper thing to do is
to find out the cost of the goods thus lost and then to credit the
Consignment Account and debit income summary (the Profit and Loss
Account). This will enable the consignor to know what profit would
have been earned had the loss not occurred. Suppose 1,000 sewing
machines costing $250 each are sent on consignment basis, and
$10,000 are spent on freight etc., 20 machines are damaged beyond
repair. The amount of loss will be:
Cost =
Share of Expenses =
20 unit × $250
2×
$10000
1000 Unit
$5000
$200
$5200
This amount should be credited to the Consignment Account and
debited to the income summary (Profit & Losses Account). If any
amount, say, $4,000, is received from the insurers, then debit to the
Income Summary will be only $1,200. But the credit to the
Consignment Account will still be $5,200. $4,000 will have been
debited to the Cash Account. You should have noted that abnormal loss
is valued just like inventories in hand.
Also, you should be careful while valuing goods lost in transit
and goods lost in consignee's warehouses. Both are abnormal loss, but
- 25 -
in the case of the former consignee, non-recurring expenses are not to
be included, whereas it is to be included in the the latter casetter.
10. Normal Loss
If some losses were essential and unavoidable, they would be spread
over the entire consignment while valuing inventories. The total cost
plus expenses incurred should be divided by the quantity available after
the normal loss to ascertain the cost per unit. Suppose 1,000 kg of
apples are consigned to a wholesaler, the cost being $3 per kg, plus
$400 of freight. It is concluded that a loss of 15% is unavoidable. The
cost per kg will be ($3000+ $400)/850 kg = $4/kg. If the inventory is
100 kg, its value will be $400.
11. Commission
The commission is the remuneration paid by the consignor to the
consignee for the services rendered to the former for selling the
consigned goods. The consignor can provide three types of commission
to the consignee, as per the agreement, either simultaneously or in
isolation. They are:
11.1 Ordinary Commission
The term commission simply denotes ordinary commission. It is based
on a fixed percentage of the gross sales proceeds made by the
consignee. It is given by the consignor regardless of whether the
consignee is making credit sales or not. This type of commission does
not give any protection to the consignor from bad debts and is provided
on total sales.
- 26 -
11.2 Del-Credere Commission
To increase the sale and encourage the consignee to make credit sales,
the consignor provides an additional commission generally known as
del-credere commission. This additional commission, when provided
to the consignee, gives protection to the consignor against bad debts.
In other words, after providing the del-credere commission, bad debts
are no more the loss of the consignor. It is calculated on total sales
unless there is an agreement between the consignor and the consignee
to only provide it on credit sales.
11.3 Over-Riding Commission
It is an extra commission allowed by the consignor to promote sales at
a higher price than specified or encourage the consignee to put hard
work into introducing new products in the market. Depending on the
agreement, it is calculated on total sales or the difference between
actual sales and sales at invoice price or any specified price.
12. Return of Goods From the Consignee
Consigned goods can be returned by the consignee for many reasons
like poor quality or not up to the specimen or destroyed in transit etc.
In such a situation, the question that arises is the valuation of returned
goods. Consigned goods returned by the consignee to the consignor are
valued at the price it was consigned to the consignee. Expenses
incurred by the consignee to send those goods back to the consignor
are not considered while valuing it because only those expenses are
included in the cost of goods, which help bring the goods into present
location and condition, i.e. the saleable condition.
- 27 -
13. Account Sales
An account sale is the periodic summary statement sent by the
consignee to the consignor. It contains details regarding:
(a) sales made,
(b) expenses incurred on behalf of the consignor,
(c) commission earned,
(d) unsold inventories left with the consignee,
(e) advance payment or security deposited with the consignor and
the extent to which it has been adjusted,
(f) balance payment due or remitted.
It is a summary statement and is different from the Sales Account.
14. Accounting Books of the Consignee
The consignee is not concerned when goods are consigned to him or
when the consignor incurs expenses. He is concerned only when he
sends an advance to the consignor, makes a sale, incurs expenses on
the consignment and earns his commission. He debits or credits the
consignor for all these, as the case may be.
The entries to record consignment goods and their related
transactions in the consignee's books are as follows:
-
-
When the consignee make sales
Cash/ accounts receivable
×××
Consignment – in – the consignor…..
×××
To record sales from the consignment goods
For expenses incurred and his commission
Consignment – in – the consignor …..
×××
Cash
×××
To record loading the expenses related to the
goods on consignment
- 28 -
-
Record the advance paid to the consignor, if any:
Consignment – in – the consignor ..…..
Cash
×××
××
To record payment of an advance for the
consignor…..
-
In the case of writing off bad debts (the consignee is granted a
normal commission):
Bad debts
××
Accounts receivables – on consignment
To record writing off bad debts of the
consignment customers
Consignment – in – the consignor ..…..
Bad debts
To deduct the bad debts from the balance
entitled to the consignor…….
××
××
××
Note that if the consignment agreement states that the consignee
is entitled to a del-credere commission, therefore, he will incur any
losses result from writing off bad debts. In this case, the entries will be
as follows:
Bad debts
××
Accounts receivables – on consignment
To record writing off bad debts of the
consignment customers
Commission
××
Bad debts
To close the bad debts from the consignment
customers
××
××
Example 3
On 1st Jul. 2018; Ahmed sent to Kareem merchandise costing $50000
and spent $1000 on packing etc. On 3rd Jul. 2018, Kareem received the
- 29 -
goods and sent his acceptance to Ahmed to write a note payable of
$30000, dues after three months. Kareem spent $2000 on freight and
cartage, $500 on warehousing rent and $300 on insurance. On 31st Dec.
2018, he sent the Account Sales (along with the amount due to Ahmed)
showing that 4/5 of the goods had been sold for $55,000, of which
$15000 were sold on credit, and the remaining sold in cash. Kareem is
entitled to a commission of 10%. One of the customers turned insolvent
and could not pay $600 due from him.
Instructions:
To record the necessary journal entries in the consignee’s books.
The Solution
- On sending the acceptance of a note payable to Ahmed:
3rd
July
Consignment – in- the consignor Ahmed
Notes Payable
30000
30000
To record accepting a note payable as advance
for consignment –in- to the consignor Ahmed
- Payment of expenses related to the consignment– in Ahmed:
3rd
Jul.
Consignment – in- the consignor Ahmed
Cash
2800
2800
To record payment of freight, cartage, and
warehousing rent of consigned goods
- On 3rd Oct., paying the notes payable to the consignor Ahmed:
3rd
Oct.
Notes payable
30000
Cash
30000
To record paying the note payable to the
consignor Ahmed
- Record the sales from consigned goods:
- 30 -
Over Cash
the Accounts receivables – on consignment
period
40000
15000
Consignment – in- the consignor Ahmed
55000
To record sales from the consigned merchandise
- Recognising the bad debts of consignment-in sales:
31st Cash
14400
Dec. Bad debts
600
Accounts receivable – on consignment
15000
To record collecting consignment-in credit
sales and writing off $600
st
31
Consignment – in- the consignor Ahmed
Dec.
Bad Debts
600
600
To close the bad debts resulted from
consigned goods
Note that it is possible to gather the above two entries in a sole
entry as follows:
31st Cash
Dec. Consignment – in- the consignor Ahmed
(Bad debts)
Accounts receivable- on consignment
14400
600
15000
To record collecting consignment-in credit
sales and writing off $600
- Deducting the commission from the dues of the consignor Ahmed:
31st Consignment – in- the consignor Ahmed
Dec.
Earned Commission
5500
5500
To record the commission earned on
consigned goods ($55000× 10%)
- Settling the consignor Ahmed account and paying the remaining
balance
- 31 -
31st Consignment – in- the consignor Ahmed
Dec.
Cash
16100
16100
To record paying the residual balance
entitled to the consignor Ahmed
Also, the Consigner Ahmed account appears as follows:
Consignment – in- the consignor Ahmed
2018
---
40000
To Cash
To Accounts receivables – 15000
on consignment
2018
3/7
3/7
By Notes Payable
By Cash
30000
2800
31/12 By Bad debts
600
31/12 By Earned Commission 5500
31/12 By Cash (bal. fig.)
16100
55000
55000
Now assume that the consignment agreement entitles the Consignee
Kareem to receive a del-credere commission of 10%. In this case, the
commission that was computed covers both the consignee rewards on
sales and any bad debts as well. In that case, the debit side should be to
the Commission Earned Account, whose net balance will then be
$4,900, and he will have to pay $16,700 to Ahmed. Therefore, the
entries will be the same except for two entries as follows:
- Recognising the bad debts of consignment-in sales:
31st Cash
Dec. Bad debts
Accounts receivable– on consignment
To record collecting consignment-in credit
sales and writing off $600
st
31
Earned Commission
Dec.
Bad Debts
To close bad debts resulted from selling the
consigned merchandise
- 32 -
14400
600
15000
600
600
- Settling the consignor Ahmed account and paying the remaining
balance
31st Consignment – in- the consignor Ahmed
Dec.
Cash
16700
16700
To record paying the residual balance
entitled to the consignor Ahmed
As the consignor Ahmed account changes to be as follows:
Consignment – in- the consignor Ahmed
2018
-To Cash
-To
receivablesconsignment
2018
40000 3/7
Accounts 15000 3/7
By Notes Payable
By Cash
30000
2800
on
31/12 By Earned Commission
31/12 By Cash (bal. fig.)
55000
5500
16700
55000
15. Advance by the Consignee Vs Security Against the
Consignment
Generally, the consignor insists the consignee for some advance
payment for the goods consigned at the time of delivery of goods. This
advance payment is adjusted in full against the amount due by the
consignee on account of the goods sold.
However, if the advance money deposited by the consignee is in
the form of security against the goods consigned, then the full amount
is not adjusted against the amount due by the consignee to the
consignor on account of goods sold in case there are any unsold
inventories left with the consignee. In that case, proportionate security
- 33 -
regarding unsold goods is carried forward until the respective goods
held with the consignee are sold.
An overview of the consignment transaction between consignee
and consignor can be depicted with the help of the following chart:
Example 4
Alessandra consigned 1,000 radio sets costing $900 each to
AnnaMaria, her agent on 1st Jul. 2018. Alessandra incurred the
following expenditure on sending the consignment.
Freight
$7650
Insurance
$3250
- 34 -
AnnaMaria received the shipment of 950 radio sets. An account
sale dated 30th Nov. 2018 showed that 750 sets were sold for $900000,
and AnnaMaria incurred $10500 for carriage. AnnaMaria was entitled
to commission 6% on the sales affected by her. She incurred expenses
amounting to $2500 for repairing the damaged radio sets remaining in
the inventories.
Alessandra lodged a claim with the insurance company that was
admitted at $35000.
Instructions:
To prepare the consignment- out Account and AnnaMaria’s Account
in the books of Alessandra.
The Solution
In the books of Alessandra
The Consignee – Annamaria account
2018
30/11
2018
To consignment- 900000 30/11 By consignment-
out Annamaria
(Sales)
out Annamaria
Carriage
Repairs
Commission
By Cash
900000
900000
10500
2500
54000
67000
833000
900000
- 35 -
The Consignment- out - Annamaria
2018
1/7
1/7
To Goods sent
consignment
To cash
Freight
Insurance
2018
900000 July By Insurance company 35000
on
30/11 By Annamaria
900000
7650
3250
10900 30/11 By Income Summary 10545
30/11
To
the
Annamaria
Carriage
Repairs
Commission
(Profits and losses
Account) – abnormal
loss
By
consignment 184391
Inventories
consignee
10500
2500
5400
67000
Income
(Profits
account)
Summary
and
losses
152036
1129936
1129936
Note: We assumed that the agent had remitted the amount due from
her.
Working notes:
a. The abnormal loss is calculated as follows:
Cost to the consignor
Add: proportionate expenses incurred by the
consignor
Less: Insurance claim (compensation)
- 36 -
50 units
$10900
× $900
× 50 unit
1000unit
45000
545
45545
(35000)
10545
Remember that the damage occurred before the consignee
receives the shipment. Thus, it is necessary to compute its part from
the consignor expenses.
b. Valuation of inventory of the consigned goods at Annaamaria
warehousing is calculated as follows:
Cost to the consignor
200 units
Add: proportionate expenses incurred by
the consignor
$10900 ×
Add: The consignee expenses (Carriage) $10500
× $900
180000
200 unit
1000unit
200 unit
950 unit
2180
2211
184391
Example 5
Dora Milk Foods Company, located in Cairo, sent to Elhamed
Stores, in Assiut, 5000 kgs of baby food packed in 2000 packets of net
weight 1 kg and 6000 packets of net weight 1/2 kg for sale on a
consignment basis. The consignee’s commission was fixed at 5% of
sale proceeds. The cost price and selling price of the product were as
under:
1 kg
$10
$15
Cost Price
Selling price
½ kg
$6
$7
The consignment was booked on a freight "To Pay" basis, and
freight charges came to 2% of selling value. One case containing 50 1
kg tins were lost in transit, and the transport carrier admitted a claim of
$450.
At the end of the first half-year, the following information is
gathered from the “Account Sales” sent by the consignee:
- 37 -
• Sale proceeds: 1500 of 1 kg packets and 4000 of 1/2 kg packets.
• Store rent and insurance charges amounted to $600.
Instructions
a. Compute the value of closing inventory on consignment.
b. Prepare the consignment –out account and the consignee's account
in the books of Dora Milk Food Company, assuming that the
consignees had paid the amount due from him.
The Solution
Dora Milk Foods Company:
Consignment- out Elhamed stores
To Goods sent on
consignment
2000, 1 kg. packets
6000 ½ kg. packets
By the Consignee
Elhamed Stores
1500, 1 kg
22500
4000, ½ kg
28000
20000
36000
56000
To the Consignee
Elhamed stores
1440
Freight
600
Rent & Insurance
2225
Commission
By
Insurance
company
4565
To Income Summary
(Profits and losses
Account)
By
Income
Summary (Profits
and
losses
Account)
–
abnormal loss
7365 By consignment
Inventories
67930
- 38 -
50500
450
65
16915
67930
The Consignee Elhamed stores Account
To consignment- out
50500 By consignment-
Elhamed stores
out Elhamed stores:
Freight
1440
Rent & Insurance
600
2525
4565
By Cash
50500
45935
50500
Working notes:
a. Sale value of total consignment:
2000 unit, 1 kg packet × $15
30000
6000 unit, ½ kg packet × $7
42000
Total Sales
72000
b. Freight: 2% of above 1440
2% of the sales = 2% × 72000 =
1440
c. Inventories at the end of the six months
450 unit, 1 kg packet × $10 (selling price 6750
4500
2000 unit, ½ kg packet × $6 (selling price 14000)
12000
16500
Add: freight charge 2% of selling price
2% × (6750 + 14000)
415
The inventory cost
16915
d. Loss in transit:
Cost of 50 units 1 kg packet (50 unit × $10)
- 39 -
500
Add: proportion of the freight charges (2% × $750 selling
15
price)
515
Les: claim from the insurance company
Loss
(450)
65
Example 6
Medhat Trading Company purchased 10000 TV of which costing $100
each. Six thousand TVs were sent on consignment to Hayah Company
at the selling price of $120 per TV. The consignor paid $3000 for
packaging and freight. Hayah sold 5000 TVs at $125 per TV and
incurred $1000 for selling expenses and remitted $500000 to Cairo on
account. They are entitled to a commission of 5% on total sales plus a
further 20% commission on any surplus price realised over $120 per
TV.
Owing to a fall in market price, the value of the inventories of
TVs in hand is to be reduced by 10%.
Instructions
-
Prepare the Consignment- out Account.
-
Prepare the Consignor account in the books of Hayah Company.
The Solution
Books of the Consignee:
The Consignor Medhat Trading Company Account
To consignment- out Medhat
37250 By Cash
625000
Trading Company
To Cash
500000
To balance c/d
87750
625000
- 40 -
625000
Books of the consignor:
Consignment- out Hayah Company account
To Goods sent on
7200000 By the consignee
625000
consignment (6000 Units
Elhamed Store
۱$×20)
To Cash
3000
To the Consignee Hayah
By Goods sent on 120000
Company
consignment
1000
Expenses
(loading)
36250
Commission
37250
Inventory
Reserve
18000
(unrealised profits)
To
Income Summary
(Profits and losses
Account)
75200
By consignment 108450
inventories
853450
853450
Working Notes:
a. The commission entitled to the consignee is calculated as follows:
5% × $625000
20% × $25000
31250
5000
36250
b. The inventory at the end of the period is computed as follows:
1000 TV × $120
120000
Add: Proportionate expenses= $3000 ×
1000 unit
6000 unit
500
120500
Less: 10% reduction due to fall in market
price (10% × 120500) =
(12050)
108450
Example 7
ElSalam Stores consigns 1000 units of goods costing $100 each to
Elboghdady Shop.
- 41 -
ElSalam Stores paid the following expenses in connection with
consignment:
Carriage
1000
Freight
3000
Loading charges
1000
Elboghdady Shop sells 700 units at $140 per unit and incurs
the following expenses:
Clearing charges
850
Warehousing and storage
1700
Packing and selling expenses
600
It is found that 50 units have been lost in transit, and 100 units are still
in transit. Elboghdady Shop is entitled to a commission of 10% on
gross sales.
Instructions:
Draw up the Consignment Account and Elboghdady’s Account in the
books of ElSalam Stores.
The Solution
The books of ElSalam Stores
The Consignee Elboghdady Shop Account
To consignment- out
Elboghdady Shop
98000
98000
- 42 -
By consignmentout Elboghdady
shop
By balance c/d
12950
85050
98000
Consignment- out Elboghdady shop account
To Goods sent on
100000 By the Consignee
consignment
Elboghdady Shop
To Cash
5000
To the Consignee
By
Income
Elboghdady Shop
summary (Loss in
Transit)
Expenses
3150
(50 unit× $105 each)
Commission
9800
12950 By
consignment
inventories
In hand (150 unit× 15900
$106)
In transit (100 unit 10500
× $105)
To Income Summary
11700
(Profits and losses
Account)
129650
98000
5250
26400
129650
Working Notes:
a. Consignor’s expenses on 1000 units amounted to $5000; it comes
to $5 per unit. The cost of units lost will be computed at $105 per
unit.
b. Elboghdady shop has incurred $850 on clearing 850 units, i.e., $1
per unit; while valuing closing inventories with the agent, $1 per
unit has been added to units in hand.
Example 8
Bebo consigned goods to Besheer to be sold at invoice price,
representing 125% of the cost. Besheer is entitled to a commission of
10% on sales at invoice price, and 25% of any excess realised over
invoice price. The expenses on freight and insurance incurred by Bebo
- 43 -
were $10000. The sales report received by Bebo shows that Besheer
sold 75% of the consignment, amounting to $100000. His selling
expenses to be reimbursed were $8000.
Ten percentage of consignment goods of which valued at
$12500, were destroyed in the fire at the Cairo warehousing and the
insurance company paid $12000 net of salvage. Besheer remitted the
balance in favour of Bebo.
Instruction:
Prepare consignment account and the account of Besheer in the books
of Bebo, along with the necessary calculations.
The Solution
The books of Bebo
Consignment- out Besheer account
To Goods sent on
125000 By Goods sent on
consignment
consignment
To Cash
10000
To the consignee Besheer
By
Income
Expenses
Summary
(Profits
8000
Commission
and losses Account)
10937
– abnormal loss
18937 By the consignee
Besheer
To inventory reserve
consignment
3750 By
inventories
By
Income
summary (Profits
and
Losses
account)
157687
- 44 -
25000
11000
100000
20250
1437
157687
The Consignee Besheer Account
To consignment- out Besheer 100000
By consignment- out
Besheer shop
By consignment- out
Besheer shop
By Cash
100000
8000
10937
81063
100000
Working Notes:
a. Calculation of value of goods sent on consignment:
Abnormal Loss at Invoice price
=
12500
Abnormal loss as a percentage of total consignment = 10%.
Hence the value of goods sent on consignment = $12500 X 100/
10=
125000
b. Calculation of abnormal loss (10%):
Abnormal Loss at Invoice price
=
12500
Abnormal Loss at cost = $12500 X 100/125
=
10000
Proportionate expenses of Bebo (10 % of $10000)
=
1000
c. `Calculation of closing Inventories (15%):
Bebo’s Basic Invoice price of the consignment
125000
Bebo’s expenses on consignment
10000
135000
Value of closing inventory (15% × 135000)
20250
Unrealised profits in closing Inventories = 18750 X 25/125
(Where $18750 = (15% of 125000) is the basic invoice price
3750
of the goods sent on consignment)
d. Calculation of commission:
Invoice price of the goods sold = 75% × 125000 = 93750
Excess of selling price over invoice price =(100000- 93750) = $6250
Total Commission = 10%× 93750+ 25% × 6250
- 45 -
= 9375 + 156250 = 10937.5
Example 9
Elhoda Company purchased 10000 metres of cloth for $200000, of
which 5000 metres were sent on consignment to Assiut Company at
the selling price of $30 per metre. Elhoda paid $5000 for freight and
$500 for packing etc.
Assiut Company sold 4000 metres at $40 per metre and incurred
$2000 for selling expenses. Assiut is entitled to a commission of 5%
on total sales proceeds plus a further 20% on any surplus price realised
over $30 per metre. The agent sent a cheque that amounted to $130000,
and the remaining balance still unpaid until the end of the fiscal year.
Owing to a fall in market price, the Inventories of cloth in hand will be
reduced by 10%.
Required:
Prepare the consignment – out account and the consignee Assiut
company account in the books of Elhoda Company.
The Solution
In the books of Elhoda Company
The Consignee Assiut Company Account
To consignment- out Assiut
Company
160000
By Consignment- out
2000
Assuit Company (expenses)
By Consignment- out Assuit 16000
Company (Commission)
By Cash
130000
By balance c/d
12000
160000
160000
- 46 -
Consignment- out Assiut Company’s account
To Goods sent on
consignment
150000 By Goods sent on
consignment
(cancellation of
loading)
5500
To Cash (Freight and
Packing)
To the Consignee Assiut
Company
Expenses
2000
Commission
16000
50000
By the Consignee 160000
Assiut
Company
(Sales)
18000
To inventory reserve
9000 3750 By
consignment 27990
inventories
To Income summary
55490
(Profits and Losses
account)
237990
237990
Working Notes:
a. Calculation of commission payable to Assiut Company:
Total sale proceeds of Assiut Company
Surplus proceeds realised over $30 per metre [4000 x LE (40-30)]
160000
4000
Commission:
5% of total sale proceeds (5% × 160000)
8000
20% of surplus (20% × 40000)
8000
16000
b. Inventories on Consignment:
Cost of consignment Inventories (1000 mtrs۳$×0)
30000
Add: Expenses of the consignor (5500× 20%)
1100
31100
- 47 -
Less: Reduction of 10% due to the fall in market price (10%×
31100)
(3110)
27990
c. Inventories on Consignment:
Cost of consignment Inventories (1000 mtrs۳$×0)
30000
Add: Expenses of the consignor (5500× 20%)
1100
31100
Less: Reduction of 10% due to the fall in market price (10%×
31100)
(3110)
27990
d. Loading ( $10 x 1000 mtrs) – 10% of ( $10 x 1000 mtrs)
- 48 -
9,000
CHAPTER TWO
ACCOUNTING FOR CLUBS AND SOCIETIES
- 49 -
Chapter Two
Accounting For Clubs And Societies
Learning Objectives:
After studying this chapter, you should be able to understand:
• Understand the concept of clubs & societies.
• Comparison between businesses and clubs/societies.
• Know the accounting requirements of clubs and societies.
• Prepare the financial statements for club and societies
• Understanding the concepts of surplus/deficit and the accumulated
fund.
• Measure the profit or loss of each activity carries out by a
club/society.
1. Introduction:
Accounting practice should always reflect the actual and likely needs
of the organisation concerned and-for, the most part, those needs since
it is a waste of time producing information that no one wants. This is
as true of clubs and societies and other non-for-profits organisations
as it is of any other organisation. If all that is needed is a record of cash
currently available, then simple cash and bank accounts are sufficient.
However, the members of an organisation-even quite a small
one-may feel that they need something more than just a cash balance
at the end of the day, week, month or year. They may want to know,
for example, exactly where the money has come from over the past
year and on what it has been spent.
- 50 -
Also, a club or society does not have to be larger for its members
to see the importance of knowing what income, such as subscriptions
for the year, has been 'earned' (whether received or not) by the club
and what expenditure has been incurred (again, whether actually paid
or not). In other words, they may well see a need for an account that
follows all the principles of a profit and loss, though not described as
such.
2. Meaning and Characteristics of Not-for-Profit Organisation
Not-for-Profit Organisations refer to the organisations used for the
welfare of society and are set up as charitable institutions that function
without any profit motive. Their main aim is to provide service to a
specific group or the public at large. Normally, they do not
manufacture, purchase or sell goods and may not have credit
transactions. Hence they need not maintain many books or accounts
(as the trading concerns do) and Trading and Profit and Loss Account.
The funds raised by such organisations are credited to the capital fund
or the general fund. The major sources of their income usually are
subscriptions from their members' donations, grants-in-aid, income
from investments, etc.
The main objective of keeping records in such organisations is
to meet the statutory requirement and help them exercise control over
the utilisation of their funds. They also have to prepare the financial
statements at the end of each accounting period (usually a financial
year), ascertain their income and expenditure and the financial
position, and submit them to the statutory authority called Registrar of
Societies.
The main characteristics of such organisations are:
- 51 -
•
Such organisations are formed to provide service to a specific
group or public at large, such as education, health care, recreation,
sports, and so on, without considering caste, creed, and colour. Its
sole aim is to provide service either free of cost or at nominal cost,
and not profit.
•
These are organised as charitable trusts/societies, and subscribers
to such organisations are called members.
•
Their affairs are usually managed by a managing/executive
committee elected by its members.
•
The main sources of income of such organisations are (i)
subscriptions from members, (ii) donations, (iii) legacies, (iv)
grant-in-aid, (v) income from investments, etc.
•
The funds raised by such organisations through various sources are
credited to the capital fund or the general fund.
•
The surplus generated in the form of excess income over
expenditure is not distributed amongst the members. It is simply
added to the capital fund.
•
The Not-for-Profit Organisations earn their reputation on the basis
of their contributions to the welfare of the society rather than on the
customers’ or owners’ satisfaction.
•
The accounting information provided by such organisations is
meant for the present and potential contributors and to meet the
statutory requirement.
The following table illustrates a comparison between for-profit entities
and not-for-profit (clubs and societies) concerns.
- 52 -
For-profit entities
Clubs and societies
Set up to earn profit by selling goods Set up to promote activities of interest to
and services
its
members
(cultural,
recreational,
intellectual, sports etc.)
Sell goods and services at more than No value placed on the normal facilities
cost price to earn profit
Business
financed
by
provided to members
owners' Financed
by
monthly
or
yearly
equity, most of which invested in subscriptions from members
setting up the business
Money received and paid are Money received and paid are recorded in
recorded in the cash book
receipts and payments account
Trading account (first part of the If the club runs a restaurant, bar or
income statement) to calculate gross canteen, a trading account is prepared to
profit or gross loss as
Sales Revenue – Cost of Sales
calculate profit from the restaurant, bar
or canteen as
Trading Revenue- Trading Expenses
Main source of revenue is sales or Main source of income is subscriptions
fees received
from members
Profit and loss account (second part Income
and
Expenditure
account
of the income statement) prepared to prepared to calculate surplus or deficit
calculate the net profit as:
as:
Net Profit= Gross profit + Other
Surplus (deficit) = Revenues
Income - Expenses
Expenditure
Balance Sheet equation as
Balance Sheet equation as
Assets = Owners Equity +
Assets = Accumulated fund +
Liabilities
Liabilities
The Main revenues resources in the for-profit units and not-for-profit
units:
- 53 -
For-profit units
Clubs and Societies
Sale of goods
Subscriptions
Receipts from services
Entrance fees
Rent received
Profit from sale or refreshments
Commission received
Profit from activities
Discount received
Interest received
Interest received
Donations
Profits on disposal
3. Receipts and Payments Accounts
Nothing more is needed for many small clubs and societies than an
accurate record of cash and bank transactions. It is normal, once a year,
to prepare a year-end summary of these transactions, and this is known
as a receipts and payments account. A receipts and payments account
is nothing more nor less than a summarised cash and bank account,
and it follows all the rules of cash and bank accounts. This means that
the summarised receipts are listed as debits and the summarised
payments as credits- either in normal ledger format or as a vertical
statement. Whichever way it is presented, a receipts and payments
account starts with the opening balances of cash and bank at the
beginning of the year and ends with the closing balances at the end of
the year. If cash has been drawn from or paid into the bank account,
there will be corresponding entries in both cash and bank accounts.
These will, of course, be self-cancelling when the accounts are
combined and will not appear in the receipts and payments account.
The title 'receipts and payments' account is essential since this is
precisely what it is a summary of actual cash receipts and actual cash
payments. The account is not concerned with accruals or pre- 54 -
payments; neither does it include 'notional' expenses such as
depreciation and bad debts provisions or take any note of whether
transactions are capital or revenue. Although called an 'account', it is
not part of the double-entry system, and nothing is transferred to it or
from it.
In order to draw up a receipts and payments account, it is
necessary to do the following:
• Combine similar items-such as the various payments for rent.
This may involve combining entries in both the cash and the bank
accounts.
• Exclude transfers from bank to cash and from cash to bank.
• Ignore any reference to the dates that items refer to, and
concentrate solely on the actual sums received and the actual
payments made.
• Although a summary for the year, a receipts and payments
account follows the same basic rules as a cash account, with
receipts on the debit side and payments on the credit side. It starts
with the opening balance and ends with the closing balance of
both cash-in-hand and cash-at-bank.
Example 1
The following are the bank and cash accounts of the Fortuna Social
Club for the year ended 31st Dec. 2018.
Bank account
1st Jan. 2018
14th Feb.
Balance
Cash
1440
15th Mar.
Bequest from
late President
4000
Cash
1600
10th Aug.
b/f
1000
1st Feb.
14th
Feb.
20th
Jun.
30th
Jun.
- 55 -
Rent (Apr-Jun 2018)
Electricity (July-Dec
2017)
Rent (July-Sep 2018)
New disco equipment
300
240
300
3000
20th Nov.
Cash
500
15th
Aug.
14th
Sep.
Insurance (July 2018Jun 2019)
Rent (Oct- Dec 2019)
Electricity (Jan-June
2018)
7th Dec. Rent (Jan-Mar 2019)
31st
Bank charges
Dec.
31st
Balance
c/d
Dec.
5th Oct.
8540
1st Jan.,
2019
Balance b/d
2400
300
320
600
40
1040
8540
1040
Cash Account
1st Jan.,
2018
31st Jan.
30th May
1st Aug.
3rd Oct.
15th Nov.
Balance b/f
92
Subscriptions
1448
Refreshment
receipts
Subscriptions
Refreshment
receipts
1652
Subscriptions
590
200
240
14th
Feb.
20th
May
10th
Aug.
3rd Sep.
20th
Nov.
31st
Dec.
1440
Bank
Refreshment Costs
1600
Bank
Refreshment Costs
Bank
Balance
c/d
4222
1st Jan.,
2019
Balance b/d
160
180
500
342
4222
342
Required:
Show the receipts and payments account for the year.
The Solution:
Receipts and payments account for the year ended 31st Dec. 2018
Receipts
Payments
Balances on 1st Jan., 2018
Cash
92
Rent
Electricity
- 56 -
1500
560
Bank
1000
Subscriptions
Bequest
Refreshments
1092
3690
4000
440
Refreshments
Disco equipment
Insurance
Bank charges
340
3000
2400
40
Balances on 31st Dec., 2018
Cash 342
Bank 1040
9222
1382
9222
The cash and bank accounts shown in Example 1 were elementary
ones, and it was not difficult to combine and summarise the items
concerned. Normally, even with quite a small club or society, the
accounts for the year will be spread over a number of pages. So it
makes the task considerably easier if a cash book with analysis
columns is used, similar to those described in unit 18. Or a full set of
ledger accounts can be maintained, but this is not usually necessary,
except for large clubs and societies.
4. Income and Expenditure Accounts
a. General principles
In earlier courses, you learnt that profits and losses account take the
income earned in a trading period (whether or not it has been received)
and charges against it all items of expenditure incurred (no matter
whether they have been paid or not). It is only by doing this that a fair
view of the operating efficiency-measured by 'profit' or 'loss'-of the
organisation can be obtained. As we saw, profit is something quite
different from money received.
Strictly, the income statement ( or the profit and losses account)
only refer to commercial businesses. But the same principles can be
applied to non-profit-making organisations-the only real difference is
- 57 -
a name change. Instead of being known as a profit and loss account, it
is called an income and expenditure account; and in place of the terms
profit and loss, the terms surplus and deficit are used. These terms are
considered to be more suitable for non-profit-making organisations.
Even the Not-for-Profit Organisations would like to know the
net result of their activities of a particular period, generally one year.
Though such organisations do not engage in trading activities and their
objective is not earning profits, yet they would like to know whether
income exceeds expenditure or vice versa. The amount of such
difference is not termed Net Profit or Net Loss as it is so termed in
business organisations. In the case of Not-for-profit organisations, the
net result is termed as 'surplus’ or ‘deficit’ as the case may be. Despite
that the preparation of the Income and Expenditure Account is a legal
requirement, it helps organisations control their expenditure.
As with a P&L account, adjustments are made when preparing
an income and expenditure account for pre-payments and accruals. In
addition, any 'capital' receipts or expenditures are excluded. 'Notional'
charges, such as depreciation, are also allowed for. Also, income will
appear on the credit side and expenditure on the debit side.
The detailed figures for each item can be picked up either by
keeping a complete system of ledger accounts in the normal way or by
adjusting (where necessary) the data obtained from the cash book. An
income and expenditure account may be drawn up either instead of the
receipts and payment account or in addition to it.
b. The Main Items of income and Expenditure:
Revenues items:
- 58 -
• Subscription. It is a periodic contribution by members of the
organisation
• Entrance fees/Admission fees. It is received from members at the
time of their admission to the organisation.
• Donations. Donation is the amount received from a person, firm,
company etc., by way of gift. But only general donation that too of
smaller amount and recurring nature is treated an item of revenue
income.
• Sale of old newspapers, sports material, etc. Sale of old
newspapers or condemned books, sports material etc. is treated as
an item of revenue income.
• Interest receipt. The surplus funds may be kept in a fixed deposit
account in a bank or invested elsewhere. Interest received thereon
is an item of revenue income.
Expenditures Items:
• Salaries, wages, rent, stationery, postage, telephone charges,
electricity charges are some items of revenue expenses which are
common to all Not for Profit Organisations (NPOs).
• Depreciation. Depreciation is provided on the fixed assets such as
furniture, building and books, etc.
• Other Items.
c. Preparation of Income And Expenditure Account
In the previous section, the Income and Expenditure Account format and
the items that are usually entered in the account have been explained.
Now you will learn how to prepare the Income and Expenditure Account
from the given items. This account is prepared from the Receipts and
Payments account and additional information while preparing an Income
- 59 -
and Expenditure account. The following important points have to be kept
in mind:
 Steps for Expenditure side
The payment column of the Receipts and Payments Account contains
both revenue items as well as capital items. Revenue items such as rent,
paid salary, telephone charges etc., will be entered on the expenditure
side of the Income and Expenditure Account.
If necessary, adjustments will be made in these items for expenses
outstanding at the end of the current year and/or were outstanding at the
end of the previous year. Adjustments will also be made for prepaid
expenses at the end of the previous year and those at the end of the current
year.
 Steps for the Income side
The receipt column contains items of revenue receipts as well as capital
receipts. Revenue receipts are entered in the income column of the
Income and Expenditure Account. Examples of such items are
subscription, interest on investment, entrance fees etc.
These items need to be adjusted for the amount received for the previous
year or the following year. Similarly, adjustments should be made for
outstanding income at the current year and at the end of the previous year.
There may be other adjustments such as bad debts, depreciation, etc.,
which will also be entered in the expenditure column.
 Surplus or Deficit
Finally, this account is balanced, i.e. difference of the totals of two
amount columns is worked out. If the credit side is more than the debit
side, the difference amount is written on its debit side as surplus, and if
the debit side exceeds the credit side, the difference is a deficit is written
on the credit side of the account.
- 60 -
Illustration 1
Prepare Income and Expenditure A/c of the following information of Promising
Sportsmen’s club, Cairo for the year ending 31st Dec., 2020:
Cash balance as on 1.1.2020
Subscriptions
Interest received
Sports material
7000
30000
2500
24000
Match fund
15000
Donations
2000
Sale of grass
300
Newspaper expenses
600
Investments purchased
10000
Salaries paid
16000
Rent paid
5400
Miscellaneous receipts
600
Telephone charges
1200
Cash balance as on 31.12.2020
200
Solution:
Income & Expenditure Account
for the year ended on 31st Dec. 2020
Expenditure
Salaries
Rent
Newspaper Expense
Telephone charges
Surplus excess of income
expenditure
Amount
16000
5400
600
1200
12200
35400
- 61 -
Income
Subscriptions
Interest Received
Sale of grass
Miscellaneous receipts
Donations
Amount
30000
2500
300
600
2000
35400
d. The problem of subscriptions
Care has to be taken with club subscriptions. It must be remembered
that these are payable to a club, unlike expenses, which are payable by
a club. If subscriptions are owing at the end of the financial year, these
will be subscriptions owing to the club. The amount is added to
subscriptions for the year and will appear as an asset in the balance
sheet alongside the prepaid expenses.
If a ledger account is being kept for subscriptions, then the old
period will be credited (thus increasing the amount to be transferred to
income and expenditure), and the new period will be debited.
If, on the other hand, subscriptions have been received during
the year in advance for the following year, then the amount must be
deducted from the actual subscriptions received for the current year
and carried forward-appearing as a liability in the balance sheet. The
ledger entries will be to debit the old period of the account with the
amount paid in advance and credit the new period.
Various adjustments relating to subscription are made in the
following manner:
-
Subscription outstanding for the current year: the Journal entry
takes the following form:
Accrued ( outstanding) Subscriptions
Subscriptions
××
××
Subscription for the current year due but not received
Adjustment in Income and Expenditure
This amount will be added to subscriptions received in the Income and
Expenditure Account and will be shown on the Asset side of the
Balance Sheet.
- 62 -
-
Subscription due in the previous year but received during the
current year.
The Journal entry takes the form:
Cash
××
Accrued ( outstanding) Subscriptions
××
Adjustment of subscription due in last year but received in
the current year
Example 2
The following is information relates to the subscriptions at Assiut
Club:
Subscription received during the year 2019
15000
Subscription outstanding as of 31st Dec. 2019
1500
Subscription received in 2018 on account of 2019
800
Subscription received in the year 2019 for the outstanding
400
amount of the year 2018
Subscription received in the year 2019 for the year 2020
600
Required:
Calculate the amount of subscription received to be shown in the Income
and Expenditure Account for the year ending on 31st Dec., 2019.
Solution:
Subscription received during 2019
Add: current year outstanding
Add: received in 2018 for 2019
Less: received for 2018
Less: advance for 2020
Subscription to be shown in Income & Expenditure
Account for 2019
- 63 -
15000
1500
800
400
600
2300
17300
(1000)
16300
Subscriptions Account
Balance (Accrued
subscriptions 2018)
Subscriptions received in
advance 2020
Income & Expenditure
400
15000
Cash
Accrued Subscriptions
2019
Subscriptions received in
16300
advance
17300
1500
600
800
17300
e. Rent Paid
Rent paid is an item of expenditure. It may also require some rent
adjustments. The adjustments required to be made to the amount of rent
paid during the year may be as follows :
(i) Rent outstanding for the current year
(ii) Rent paid in the current year as advance for the next year
(iii) Rent paid in the current year on account of the outstanding amount
in the previous year
(iv) Rent paid in the previous year on account of the current year.
Journal entries will be made as follows:
Rent A/c
××
Rent outstanding A/c
(Rent due but not paid)
Rent paid in advance A/c Dr.
Bank A/c
(Rent paid in advance for the year)
××
××
××
Rent outstanding A/c Dr.
To Bank A/c
(Amount paid for outstanding rent of the previous year)
××
Rent A/c
××
Dr.
Rent paid in advance
××
××
(Rent paid in advance last year being transferred to Rent A/c)
- 64 -
Calculation of Rent Amount to be shown for the current year in the
Income and Expenditure Account
Rent paid in the current year
xx
Add :
xx
Rent paid in advance in the previous year for
the current year
Rent due in the current year but not paid
Outstanding rent paid for the previous year
in the current year
Advance rent paid for next year in the
current year
Add:
Less:
Less:
Amount of Rent to be debited to Income and
Expenditure A/c
xx
(x x)
(x x)
x xx
Example:
A club has paid rent of $20000 in the year 2020. Rent still to be paid
amounts to $2000. An amount of $1500 was paid in 2019 on account
of the year 2020. Calculate the amount to be taken to Income &
expenditure A/c of 2020.
Solution:
Rent paid in 2020
$20000
Add rent outstanding for 2020
$2000
Add rent paid in advance in 2019 for the year 2020
1500
Rent for 2020 to be charged to Income and Expenditure A/c
23500
Example 3
Change the receipts and payments account in Example 1 into an
income and expenditure account, taking into account:
(i) Rent of $260 for the first quarter of 2018 had been paid in
advance in December 2017.
- 65 -
(ii) Depreciation of $200 is to be allowed on the new disco
equipment.
(iii) Subscriptions of $700 due to the club for 2017 were received
during 1989. Overdue subscriptions at the end of 2018 amounted
to $680, but subscriptions for 2019 amounting to $80 had been
paid in advance and were entered in the cash account during
2018.
(iv) Amount owing for electricity for the period July-December 2018
was estimated at LE300.
(v) Insurance for the period January-June 2018, $960, had been paid
in advance during 2017.
Notes:
- Further information regarding accruals and pre-payments can be
picked up from the data given in the cash and bank accounts of the
original example.
- The bequest from the late President and the new disco equipment's
purchase should both be regarded as capital transactions.
- Where an item involves both income and expenditure (e.g.
refreshments in the example), the two elements can be brought
together, and a net figure worked out and entered-showing, of
course, the surplus or deficit on that particular item.
Preliminary calculations
Subscriptions
Cash received during 2018
Add: owing at the end of 2018
Less: 2017 subscriptions received in 2019
2019 subscriptions received in 2018
Electricity
- 66 -
3690
680
700
80
4370
(780)
3590
Cash paid during 2018
Add: owing at the end of 2018
Less: 2018payments for 2017
560
300
Insurance
Cash paid during 2018
Add: pre-payment in 2017 for 2018
Less: pre-payment in 2018 for 2019
2400
960
Rent
Cash paid in 2018
Add: pre-payment in 2017 for 2018
Less: pre-payment in 2018 for 2019
1500
260
860
(240)
620
3360
(1200)
2160
1760
(600)
1160
Income and expenditures account for the year ended 31st Dec. 2018
Expenditure
Revenues
Rent
1160 Subscriptions
3590
Electricity
620 Refreshments
440
Depreciation
200
less: Costs (340) 100
Insurance
2160 Deficit of the year
490
Bank charges
40
4180
4180
f. Depreciation on Assets:
Depreciation is a non-cash item. It is to be charged on every fixed asset
such as Land & Building, Furniture, Books etc., every year as per the
predetermined method. The amount of depreciation is shown on the
expenditure side of the Income & Expenditure Account. It is deducted
from the respective value of the asset while showing it on the assets
side of the Balance Sheet.
Journal Entries will be as follows:
- 67 -
××
Depreciation A/c
Asset A/c
Income and Expenditure A/c
Depreciation A/c
××
××
××
5. Other Final Accounts of Clubs and Societies
a. Trading accounts
Many clubs, societies and similar organisations, although nonprofitmaking as such, sometimes undertake trading activities to
provide a service to members or make a profit to subsidise their normal
work. Many clubs, for example, provide a bar for their members, and
many charities sell a range of merchandise (goods) to raise funds. With
these activities, it is possible to prepare a conventional trading account,
the profit (or loss) taken either to the income and expenditure account,
or directly to the balance sheet.
b. Balance sheets
Provided the appropriate information concerning assets and liabilities
is available, it is possible to draw up balance sheets for clubs and
societies. If the club concerned is maintaining (keeping) a full set of
accounts, then the data required for the balance sheet will be available
in the ledger in the usual way. If such accounts are not maintained, the
data will have to be calculated from such information as may be
available. Provided the source information is adequate and reliable, a
perfectly satisfactory balance sheet can usually be constructed. The
following points should be noted:
(i)
The term capital is considered unsuitable for a non-profitmaking
organisation; the expression accumulated fund (or sometimes
consolidated fund) is used instead.
- 68 -
(ii) It is common in examination questions to provide a list of the
balances of assets and liabilities as they stood at the beginning of
the period, plus the actual cash and bank accounts. The list of
assets may well not include the following:
- The cash and bank balances. Candidates are expected to obtain
these from cash and bank accounts.
- The opening balance of the accumulated fund. This has to be
calculated by finding the difference between assets and
liabilities at that date.
- The amount to be charged in respect of depreciation. This can
be calculated by comparing the opening and closing balances
of the assets concerned after allowing for any assets bought or
sold.
(iii) The surplus or deficit on income and expenditure account will be
added to or subtracted from the accumulated fund in the same
way that profit (or loss) is taken to the capital account in a
commercial firm.
The four sections of the Balance Sheet are:
• Fixed Assets – land, buildings, vehicles.
• Current Assets – cash, closing stock, expenses prepaid etc.
• Current Liabilities – bank overdraft, expenses due etc.
• Financed By - Accumulated Fund, excess Income over
Expenditure.
Example 4:
The assets and liabilities of Alahly Sports Club on 1st Jan. 2018 were:
(Amounts in thousands)
Premises $60000; subscriptions-in-arrears $96; equipment $6400;
bank balance $3792; bar stocks $1840; subscriptions-in-advance $68.
- 69 -
Receipts during the year were: subscriptions $3388; bar takings
$14400; disco evenings $640; sub-letting of room LE400.
Payments during the year were: new equipment $2000; equipment
maintenance LEl620; light and heating LE440; insurance $172;
general expenses $108; bar purchases $13600; rates $1400.
Further information available on 31st Dec. 2018:
(i)
Equipment at the year-end was valued at $8200, and bar
stocks at $1642.
(ii)
Subscriptions-in-arrears amounted to $90 and in-advance
$40.
(iii)
Insurance had been prepaid in the sum of $28.
(iv)
It was estimated that $100 was owing for heat and
electricity.
Draw up a receipts and payments account, the bar trading account and
the income and expenditure account for the year to 31st Dec. 2018,
and a balance sheet as of that date.
The Solution
Receipts and payments account for the year ended on 31st Dec. 2018
Receipts
Bank Balance 1.1.2018
Subscription
Sub-letting of rooms
Bar takings
Disco evening
Payments
3792
3388
400
14400
640
Equipment
Maintenance
Light and heat
Insurance
General expenses
Bar purchase
Rates
Bank balance 31.12.2018
22620
Bar trading account for the year ended on 31st Dec. 2018
- 70 -
2000
1520
440
172
108
13600
1400
3380
22620
Stocks 1.1.2018
Purchases
1840
13600
15440
Less stocks 31.12.2018 (1642)
Cost of sales
13798
Bar profit
602
14400
Bar takings
14400
14400
Income and expenditures account for the year ended on 31.12.2018
Depreciation
Insurance
Less prepaid
Maintenance
Rates
Light, heating
Add: accrued
General expenses
Surplus of the year
200
172
(28)
440
100
144
1520
1400
Subscriptions
Disco evenings
Sub-lets of room
Bar profit
3400
640
400
602
540
108
1130
5042
5042
The balance sheet as on 31st Dec. 2018
Fixed assets
Premises
Equipment
Accumulated fund 1.1.2018
Add: surplus of the year
50000
8200
62070
1130
58200
Current assets
Stock
Subs, owing
Insurance prepaid
Bank
Current liabilities:
Subs. In advance
Light, heat accrued
1642
90
28
3380
40
100
140
5140
63340
63340
Notes:
a. Depreciation
- 71 -
Equipment 1.1.2018
Purchases
6400
2000
8400
(8200)
200
Less: Equipment 31/12/2018
The year depreciation (bal.fig.)
b. Subscriptions
Cash received
Add: in advance on 1.1.2018
In arrears on 31.12.2018
3388
58
90
3536
Less: in arrears on 1.1.2018
In advance on 31.12.2018
96
40
(136)
3400
c. The accumulated fund on 1.1.2018
Fixed assets
Premises
Equipment
Stock
Subscription owing
bank
50000
6400
1840
96
3792
62128
(58)
62070
Less: subscriptions in advance
- 72 -
CHAPTER THREE
REVENUES RECOGNITION
- 73 -
Chapter Three
Revenues Recognition
Learning Objectives
After studying this chapter, you should be able to:
 Discuss the fundamental concepts related to revenue recognition
and measurement.
 Explain and apply the five-step revenue recognition process.
 Apply the five-step process to major revenue recognition issues.
 Describe presentation and disclosure regarding revenue.
Background
Revenue is one of, if not the most, important measures of financial
performance that a company reports. Revenue provides insights into a
company’s past and future performance and is a significant driver of
other performance measures, such as EBITDA, net income, and
earnings per share. Therefore, establishing robust guidelines for
recognizing revenue is a standard-setting priority.
Most revenue transactions pose few problems for revenue
recognition. That is, most companies initiate and complete transactions
at the same time. However, not all transactions are that simple. For
example, consider a cell phone contract between a company such as
Verizon and a customer. Verizon often provides a customer with a
package that may include a handset, free minutes of talk time, data
downloads, and text messaging service. In addition, some providers will
bundle that with a fixed-line broadband service. At the same time, the
customer may pay for these services in a variety of ways, possibly
receiving a discount on the handset and then paying higher prices for
connection fees and so forth. In some cases, depending on the package
purchased, the company may provide free upgrades in subsequent
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periods. How, then, should Verizon report the various pieces of this
sale? The answer is not obvious.
Both the FASB and the IASB indicated that the state of reporting
for revenue was unsatisfactory. IFRS was criticized because it lacked
guidance in a number of areas. For example, IFRS had one general
standard on revenue recognition-IAS 18-plus some limited guidance
related to certain minor topics. In contrast, GAAP had numerous
standards related to revenue recognition (by some counts, well over
100), but many believed the standards were often inconsistent with one
another. Thus, the accounting for revenue provided a most fitting
contrast of the principles-based (IFRS) and rules-based (GAAP)
approaches.
Recently, the FASB and IASB issued a converged standard on
revenue recognition entitled Revenue from Contracts with Customers.
To address the inconsistencies and weaknesses of the previous
approaches, a comprehensive revenue recognition standard now applies
to a wide range of transactions and industries. The Boards believe this
new standard will improve GAAP and IFRS by:
a. Providing a more robust framework for addressing revenue
recognition issues.
b. Improving comparability of revenue recognition practices across
entities, industries, jurisdictions, and capital markets.
c. Simplifying the preparation of financial statements by reducing the
number of requirements to which companies must refer.
d. Requiring enhanced disclosures to help financial statement users
better understand the amount, timing, and uncertainty of revenue
that is recognized.
New Revenue Recognition Standard
The new standard, Revenue from Contracts with Customers, adopts an
asset-liability approach as the basis for revenue recognition. The assetliability approach recognizes and measures revenue based on changes in
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assets and liabilities. The Boards decided that focusing on (a) the
recognition and measurement of assets and liabilities and (b) changes in
those assets or liabilities over the life of the contract brings more
discipline to the measurement of revenue, compared to the ”earned and
realized” criteria in prior standards.
Under the asset-liability approach, companies account for
revenue based on the asset or liability arising from contracts with
customers. Companies analyse contracts with customers because
contracts initiate revenue transactions. Contracts indicate the terms of
the transaction, provide the measurement of the consideration, and
specify the promises that must be met by each party.
Illustration 1 shows the key concepts related to this new
standard on revenue recognition. The new standard first identifies the
key objective of revenue recognition, followed by a five-step process
that companies should use to ensure that revenue is measured and
reported correctly.
Illustration 1: Key Concepts of Revenue Recognition
Key Objective
Recognize revenue to depict the transfer of goods or services to
customers in an amount that reflects the consideration that the company
receives, or expects to receive, in exchange for these goods or services.
Five-Step Process for Revenue Recognition
• Identify the contract with customers.
• Identify the separate performance obligations in the contract.
• Determine the transaction price.
• Allocate the transaction price to the separate performance obligations.
• Recognize revenue when each performance obligation is satisfied.
Revenue Recognition Principle
Recognize revenue in the accounting period when the performance
obligation is satisfied.
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The culmination of the process is the revenue recognition principle,
which states that revenue is recognized when the performance obligation
is satisfied. We examine all steps in more detail in the following section.
Overview of the Five-Step Process:
Boeing Example
Assume that Boeing Corporation signs a contract to sell airplanes to
Delta Air Lines for $100 million. Illustration 2 shows the five steps
that Boeing follows to recognize revenue.
As indicated, Step 5 is when Boeing recognizes revenue related to the
sale of the airplanes to Delta. At this point, Boeing delivers the airplanes
to Delta and satisfies its performance obligation. In essence, a change in
control from Boeing to Delta occurs. Delta now controls the assets
because it has the ability to direct the use of and obtain substantially all
the remaining benefits from the airplanes. Control also includes Delta’s
ability to prevent other companies from directing the use of, or receiving
the benefits from, the airplanes.
Illustration 2: Five Steps of Revenue Recognition
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Extended Example of the Five-Step Process: BEAN
To provide another application of the basic principles of the five-step
revenue recognition model, we use a coffee and wine business called
BEAN. BEAN is located in the Midwest and serves gourmet coffee,
espresso, lattes, teas, and smoothies. It also sells pastries, coffee beans,
other food products, wine, and beer.
Identifying the Contract with Customers-Step 1
Assume that Tyler Angler orders a large cup of black coffee costing $3
from BEAN. Tyler gives $3 to a BEAN barista, who pours the coffee
into a large cup and gives it to Tyler.
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Step 1 We first must determine whether a valid contract exists between BEAN
and Tyler. Here are the components of a valid contract and how it affects
BEAN and Tyler.
1. The contract has commercial substance: Tyler gives cash for the coffee.
2. The parties have approved the contract: Tyler agrees to purchase the coffee
and BEAN agrees to sell it.
3. Identification of the rights of the parties is established: Tyler has the right
to the coffee and BEAN has the right to receive $3.
4. Payment terms are identified: Tyler agrees to pay $3 for the coffee.
5. It is probable that the consideration will be collected: BEAN received $3
before it delivered the coffee.
From this information, it appears that BEAN and Tyler have a valid contract
with one another.
Step 2 The next step is to identify BEAN’s performance obligation(s), if any.
The answer is straightforward-BEAN has a performance obligation to provide
a large cup of coffee to Tyler. BEAN has no other performance obligation for
any other good or service.
Step 3 BEAN must determine the transaction price related to the sale of the
coffee. The price of the coffee is $3, and no discounts or other adjustments are
available. Therefore, the transaction price is $3.
Step 4 BEAN must allocate the transaction price to all performance
obligations. Given that BEAN has only one performance obligation, no
allocation is necessary.
Step 5 Revenue is recognized when the performance obligation is satisfied.
BEAN satisfies its performance obligation when Tyler obtains control of the
coffee. The following conditions are indicators that control of the coffee has
passed to Tyler:
a. BEAN has the right to payment for the coffee.
b. BEAN has transferred legal title to the coffee.
c. BEAN has transferred physical possession of the coffee.
d. Tyler has significant risks (e.g., he might spill the coffee) and rewards of ownership
(he gets to drink the coffee).
e. Tyler has accepted the asset.
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Solution: BEAN should recognize $3 in revenue from this transaction
when Tyler receives the coffee.
Identifying Separate Performance Obligations-Step 2
The following day, Tyler orders another large cup of coffee for $3 and
also purchases two bagels at a price of $5. The barista provides these
products and Tyler pays $8.
Question: How much revenue should BEAN recognize on the
purchase of these two items?
Step 1 A valid contract exists as it meets the five conditions necessary
for a contract to be enforceable as discussed in the previous example.
Step 2 BEAN must determine whether the sale of the coffee and the sale of
the two bagels involve one or two performance obligations. In the previous
transaction between BEAN and Tyler, this determination was straightforward
because BEAN provided a single distinct product (a large cup of coffee) and
therefore only one performance obligation existed. However, an arrangement
to purchase coffee and bagels may have more than one performance
obligation. Multiple performance obligations exist when the following two
conditions are satisfied:
1. BEAN must provide a distinct product or service. In other words, BEAN
must be able to sell the coffee and the bagels separately from one another.
2. BEAN’s products are distinct within the contract. In other words, if the
performance obligation is not highly dependent on, or interrelated with, other
promises in the contract, then each performance obligation should be
accounted for separately. Conversely, if each of these products is
interdependent and interrelated, these products are combined and reported as
one performance obligation.
The large cup of coffee and the two bagels appear to be distinct from one
another and are not highly dependent or interrelated. That is, BEAN can sell
the coffee and the two bagels separately, and Tyler benefits separately from
the coffee and the bagels.
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BEAN should therefore record two performance obligations-one for the sale
of the coffee and one for the sale of the bagels.
Step 3 The transaction price is $8 ($3 + $5).
Step 4 BEAN has two performance obligations: to provide (1) a large
cup of coffee and (2) the two bagels. Each of these obligations is distinct
and not interrelated (and priced separately); no allocation of the
transaction price is necessary. That is, the coffee sale is recorded at $3
and the sale of the bagels is priced at $5.
Step 5 BEAN has satisfied both performance obligations when the
coffee and bagels are given to Tyler (control of the product has passed
to the customer).
Solution: BEAN should recognize $8 ($3 + $5) of revenue when Tyler
receives the coffee and bagels.
Determining the Transaction Price-Step 3
BEAN decides to provide an additional incentive to its customers to
shop at its store. BEAN roasts its own coffee beans and sells the beans
wholesale to grocery stores, restaurants, and other commercial
companies. In addition, it sells the coffee beans at its retail location.
BEAN is interested in stimulating sales of its Smoke Jumper coffee
beans on Tuesdays, a slow business day for the store. Normally, these
beans sell for $10 for a 12-ounce bag, but BEAN decides to cut the price
by $1 when customers buy them on Tuesdays (the discounted price is
now $9 per bag). Tyler has come to the store on a Tuesday, decides to
purchase a bag of Smoke Jumper beans, and pays BEAN $9.
Question: How much revenue should BEAN recognize on this
transaction?
Step 1 As in our previous examples, with the sale of a large cup of coffee
or the sale of a large cup of coffee and two bagels, a valid contract exists.
The same is true for the sale of Smoke Jumper beans as well.
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Step 2 The identification of the performance obligation is
straightforward. BEAN has a performance obligation to provide a bag
of Smoke Jumper coffee beans to Tyler. BEAN has no other
performance obligation to provide a product or service.
Step 3 The transaction price for a bag of Smoke Jumper beans sold to
Tyler is $9, not $10. The transaction price is the amount that a company
expects to receive from a customer in exchange for transferring goods
and services.
The transaction price in a contract is oft en easily determined because
the customer agrees to pay a fixed amount to the company over a short
period of time. In other contracts, companies must consider adjustments
such as when they make payments or provide some other consideration
to their customers (e.g., a coupon) as part of a revenue arrangement.3
Step 4 BEAN allocates the transaction price to the performance
obligations. Given that there is only one performance obligation, no
allocation is necessary.
Step 5 BEAN has satisfied the performance obligation as control of the
product has passed to Tyler.
Solution: BEAN should recognize $9 of revenue when Tyler receives
the Smoke Jumper coffee beans.
Allocating the Transaction Price to Separate Performance
Obligations-Step 4
For revenue arrangements with multiple performance obligations,
BEAN might be required to allocate the transaction price to more than
one performance obligation in the contract. If an allocation is needed,
the transaction price is allocated to the various performance obligations
based on their relative standalone selling prices. If this information is
not available, companies should use their best estimate of what the good
or service might sell for as a standalone unit.
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BEAN wants to provide even more incentive for customers to buy its
coffee beans, as well as purchase a cup of coffee. BEAN therefore offers
customers a $2 discount on the purchase of a large cup of coffee when
they buy a bag of its premium Motor Moka beans (which normally sell
for $12) at the same time. Tyler decides this offer is too good to pass up
and buys a bag of Motor Moka beans for $12 and a large cup of coffee
for $1. As indicated earlier, a large cup of coffee normally retails for $3
at BEAN.
Question: How much revenue should BEAN recognize on the
purchase of these two items?
Step 1 In our previous situations, valid contracts have existed. The same
is also true for the sale of a bag of Motor Moka beans and the large cup
of coffee.
Step 2 The bag of Motor Moka beans and the large cup of coffee are
distinct from one another and are not highly dependent on or highly
interrelated with the other. BEAN can sell a bag of the Motor Moka
beans and a large cup of coffee separately. Furthermore, Tyler benefits
separately from both the large cup of coffee and the Motor Moka coffee
beans.
Step 3 BEAN’s transaction price is $13 ($12 for the bag of Motor Moka
beans and $1 for the large cup of coffee).
Step 4 BEAN allocates the transaction price to the two performance
obligations based on their relative standalone selling prices. The standalone
selling price of a bag of Motor Moka beans is $12 and the large cup of
coffee is $3. The allocation of the transaction price of $13 is as follows.
Product
Standalone
Selling Price
$12
Percentage
Allocated
Amount
$10.40 (413x.80)
Motor Moka beans
80% ($12 ÷ $15)
(one bag)
Large cup of coffee
3
20% ($3 ÷ $15)
2.60 ($13 x .20)
Total
$15
100%
$13.00
As indicated, the total transaction price ($13) is allocated $10.40 to the bag of
Motor Moka beans and $2.60 to the large cup of coffee.
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Step 5 BEAN has satisfied both performance obligations as control of
the bag of Motor Moka beans and the large cup of coff ee has passed to
Tyler.
Solution: BEAN should recognize revenue of $13, comprised of
revenue from the sale of the Motor Moka beans at $10.40 and the sale
of the large cup of coffee at $2.60.
Recognizing Revenue When (or as) Each Performance Obligation
Is Satisfied-Step 5
As indicted in the examples presented, BEAN satisfied its performance
obligation(s) when Tyler obtained control of the product(s). Change in
control is the deciding factor in determining when a performance
obligation is satisfied. A customer controls the product or service when
the customer has the ability to direct the use of and obtain substantially
all the remaining benefits from the product. Control also includes
Tyler’s ability to prevent other companies from directing the use of, or
receiving benefits from, the coffee or coffee beans. As discussed earlier,
the indicators that Tyler has obtained control are as follows:
a. BEAN has the right to payment for the coffee.
b. BEAN has transferred legal title to the coffee.
c. BEAN has transferred physical possession of the coffee.
d. Tyler has significant risks and rewards of ownership.
e. Tyler has accepted the asset.
The Five-Step Process Revisited
The Boeing and BEAN examples provide a basic understanding of the
five-step process used to recognize revenue. We now discuss more
technical issues related to the implementation of these five steps.
Identifying the Contract with Customers-Step 1
A contract is an agreement between two or more parties that creates
enforceable rights or obligations. Contracts can be written, oral, or
- 84 -
implied from customary business practice (such as the BEAN contract
with Tyler). Revenue is recognized only when a valid contract exists.
On entering into a contract with a customer, a company obtains rights to
receive consideration from the customer and assumes obligations to
transfer goods or services to the customer (performance obligations).
The combination of those rights and performance obligations gives rise
to an (net) asset or (net) liability.
In some cases, there are multiple contracts related to an arrangement;
accounting for each contract may or may not occur, depending upon the
circumstances. These situations often develop when not only a product
is provided but some type of service is performed as well. To be valid,
a contract must meet the five conditions illustrated in the BEAN
example. If the contract is wholly unperformed and each party can
unilaterally terminate the contract without compensation, then revenue
should not be recognized until one or both of the parties have performed.
A basic contract in which these issues are discussed is presented in
Illustration 3.
- 85 -
Illustration 3 Basic Revenue Transaction
Contracts and Recognition
Facts: On March 1, 2020, Margo Company enters into a contract to
transfer a product to Soon Yoon on July 31, 2020. The contract is
structured such that Soon Yoon is required to pay the full contract price
of $5,000 on August 31, 2020. The cost of the goods transferred is
$3,000. Either party can unilaterally terminate the contract without
compensation. Margo delivers the product to Soon Yoon on July 31,
2020.
Question: What journal entries should Margo Company make in
regards to this contract in 2020?
Solution: No entry is required on March 1, 2020, because neither party
has performed on the contract.
On July 31, 2020, Margo delivers the product and therefore should
recognize revenue on that date as it satisfies its performance obligation
by delivering the product to Soon Yoon.
The journal entry to record the sale and related cost of goods sold is as
follows.
July 31, 2020
Accounts Receivable
5000
Sales Revenue
5000
Cost of Goods Sold
3000
Inventory
3000
After receiving the cash payment on August 31, 2020, Margo
makes the following entry.
August 31, 2020
Cash
5000
Accounts Receivable
5000
A key feature of the revenue arrangement is that the contract between
the two parties is not recorded (does not result in a journal entry) until
one or both of the parties perform under the contract. Until
performance occurs, no net asset or net liability exists.5
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Identifying Separate Performance Obligations-Step 2
A performance obligation is a promise to provide a product or service
to a customer. This promise may be explicit, implicit, or possibly based
on customary business practice. To determine whether a performance
obligation exists, the company must provide a distinct product
or service to the customer.
A product or service is distinct when a customer is able to benefit from
a good or service on its own or together with other readily available
resources. This situation typically occurs when the company can sell a
good or service on a standalone basis (can be sold separately). For
example, BEAN provided a good (a large cup of coffee) on a standalone
basis to Tyler. Tyler benefited from this cup of coffee by consuming it.
To determine whether a company has to account for multiple
performance obligations, the company’s promise to sell the good or
service to the customer must be separately identifiable from other
promises within the contract (that is, the good or service must be distinct
within the contract). In other words, the objective is to determine
whether the nature of a company’s promise is to transfer individual
goods and services to the customer or to transfer a combined item
(or items) for which individual goods or services are inputs.
For example, when BEAN sold Tyler a large cup of coffee and two
bagels, two performance obligations occurred. In that case, the large cup
of coffee had a standalone selling price and the two bagels had a
standalone selling price-even though the two promises may be part of
one contract.
Conversely, assume that BEAN sold a large latte (comprised of coffee
and milk) to Tyler. In this case, BEAN sold two distinct products (coffee
and milk), but these two goods are not distinct within the contract. That
is, the coffee and milk in the latte are highly interdependent or
interrelated within the contract. As a result, the products are combined
and reported as one performance obligation.
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To illustrate another situation, assume that General Motors sells
an automobile to Marquart Auto Dealers at a price that includes six
months of telematics services such as navigation and remote
diagnostics. These telematics services are regularly sold on a standalone
basis by General Motors for a monthly fee. After the six-month period,
the consumer can renew these services on a fee basis with General
Motors. The question is whether General Motors sold one or two
products. If we look at General Motors’ objective, it appears that it is to
sell two goods, the automobile and the telematic services. Both are
distinct (they can be sold separately) and are not interdependent.
As another example, SoftTech Inc. licenses customerrelationship software to Lopez Company. In addition to providing the
software itself, SoftTech promises to perform consulting services by
extensively customizing the software to Lopez’s information
technology environment, for total consideration of $600,000. In this
case, the objective of SoftTech appears to be to transfer a combined
product and service for which individual goods and services are inputs.
In other words, SoftTech is providing a significant service by integrating
the goods and services (the license and the consulting service) into one
combined item for which Lopez has contracted. In addition, the software
is significantly customized by SoftTech in accordance with
specifications negotiated by Lopez. As a result, the license and the
consulting services are distinct but interdependent, and therefore
should be accounted for as one performance obligation.
Determining the Transaction Price-Step 3
The transaction price is the amount of consideration that a company
expects to receive from a customer in exchange for transferring goods
and services. The transaction price in a contract is often easily
determined because the customer agrees to pay a fixed amount to the
company over a short period of time. In other contracts, companies must
consider the following factors.
- 88 -
• Variable consideration.
• Time value of money.
• Noncash consideration.
• Consideration paid or payable to the customer.
Variable Consideration
In some cases, the price of a good or service is dependent on future
events. These future events might include price increases, volume
discounts, rebates, credits, performance bonuses, or royalties. In these
cases, the company estimates the amount of variable consideration it
will receive from the contract to determine the amount of revenue to
recognize. Companies use either the expected value, which is a
probability-weighted amount, or the most likely amount in a range of
possible amounts to estimate variable consideration.
Companies select among these two methods based on which approach
better predicts the amount of consideration to which a company is
entitled.
Illustration 4 highlights the issues to be considered in selecting the
appropriate method.
Most Likely Amount: The
single most likely amount in a
range of possible consideration
outcomes.
• May be appropriate if a company has a • May be appropriate if the
large number of contracts with similar
contract has only two possible
characteristics.
outcomes.
• Can be based on a limited number of
discrete outcomes and probabilities.
Expected Value: Probability-weighted
amount in a range of possible
consideration amounts.
Illustration 5 provides an application of the two estimation methods.
- 89 -
Illustration 5 Transaction Price Variable Consideration
Estimating Variable Consideration
Facts: Peabody Construction Company enters into a contract with a customer to build a warehouse for $100,000, with
a performance bonus of $50,000 that will be paid based on the timing of completion. The amount of the performance
bonus decreases by 10% per week for every week beyond the agreed-upon completion date. The contract requirements
are similar to contracts that Peabody has performed previously, and management believes that such experience is
predictive for this contract. Management estimates that there is a 60% probability that the contract will be completed
by the agreed-upon completion date, a 30% probability that it will be completed 1 week late, and only a 10% probability
that it will be completed 2 weeks late.
Solution: The transaction price should include management’s estimate of the amount of consideration to which Peabody
will be entitled. Management has concluded that the probability-weighted method is the most predictive approach for
estimating the variable consideration in this situation:
On time: 60% chance of $150,000 [$100,000 + ($50,000 × 1.0)] = $ 90,000
1 week late: 30% chance of $145,000 [$100,000 + ($50,000 × .90)] = 43,500
2 weeks late: 10% chance of $140,000 [$100,000 + ($50,000 × .80)] =
Thus, the total transaction price is $147,500 based on the probability-weighted estimate. Management should update its
estimate at each reporting date. Using a most likely outcome approach may be more predictive if a performance bonus
is binary (Peabody either will or will not earn the performance bonus), such that Peabody earns either the $50,000 bonus
for completion on the agreed-upon date or nothing for completion aft er the agreed-upon date. In this scenario, if
management believes that Peabody will meet the deadline and estimates the consideration using the most likely
outcome, the total transaction price would be $150,000 (the outcome with 60% probability).
- 90 -
A word of caution-a company only allocates variable consideration if it
is reasonably assured that it will be entitled to that amount. Companies
therefore may only recognize variable consideration if (1) they have
experience with similar contracts and are able to estimate the cumulative
amount of revenue, and (2) based on experience, it is highly probable that
there will not be a significant reversal of revenue previously recognized.7
If these criteria are not met, revenue recognition is constrained.
Illustration 6 provides an example of how the revenue constraint works.
Illustration 6 Transaction Price-Revenue Constraint
Revenue Constraint
Facts: On January 1, Shera Company enters into a contract with Hornung
Inc. to perform asset-management services for 1 year. Shera receives a
quarterly management fee based on a percentage of Hornung’s assets
under management at the end of each quarter. In addition, Shera receives
a performance-based incentive fee of 20% of the fund’s return in excess
of the return of an observable index at the end of the year.
Shera accounts for the contract as a single performance obligation to
perform investment-management services for 1 year because the services
are interdependent and interrelated. To recognize revenue for satisfying
the performance obligation over time, Shera selects an output method of
measuring progress toward complete satisfaction of the performance
obligation. Shera has had a number of these types of contracts with
customers in the past.
Question: At what point should Shera recognize the management fee and
the performance-based incentive fee related to Hornung?
Solution: Shera should record the management fee each quarter as it
performs the management of the fund. However, Shera should not record
the incentive fee until the end of the year. Although Shera has experience
with similar contracts, that experience is not predictive of the outcome of
the current contract because the amount of consideration is highly
susceptible to volatility in the market.
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In addition, the incentive fee has a large number and high variability of
possible consideration amounts. Thus, revenue related to the incentive
fee is constrained (not recognized) until the incentive fee is known at the
end of the year.
Time Value of Money
Timing of payment to the company sometimes does not match the
transfer of the goods or services to the customer. In most situations,
companies receive consideration after the product is provided or the
service performed. In essence, the company provides fi nuancing for the
customer.
Companies account for the time value of money if the contract involves
a significant financing component. When a sales transaction involves a
significant financing component (i.e., interest is accrued on consideration
to be paid over time), the fair value should be determined by discounting
the payment using an imputed interest rate. The imputed interest rate is
the more clearly determinable of either (1) the prevailing rate for a similar
instrument of an issuer with a similar credit rating, or (2) a rate of interest
that discounts the nominal amount of the instrument to the current sales
price of the goods or services. The company will report the effects of the
financing as interest revenue. Illustration 7 provides an example of a
financing transaction.
Illustration 7
Transaction Price- Extended Payment Terms
Facts: On July 1, 2020, SEK Company sold goods to Grant Company for
$900,000 in exchange for a 4-year zero-interest-bearing note with a face
amount of $1,416,163. The goods have an inventory cost on SEK’s books
of $590,000. SEK uses the perpetual inventory method.
Solution:
(a) SEK should record revenue of $900,000 on July 1, 2020, which is the
fair value of the inventory in this case.
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(b) SEK is also financing this purchase and records interest revenue on
the note over the 4-year period.
In this case, the interest rate is imputed and is determined to be 12%. SEK
records interest revenue of $54,000 (.12 × 6/12 × $900,000) at December
31, 2020.
The entry to record SEK’s sale to Grant Company is as follows.
July 1, 2020
Notes Receivable
1416163
Discount on Notes Receivable
516163
Sales Revenue
900000
Cost of Goods Sold
590000
Inventory
590000
SEK makes the following entry to record (accrue) interest
revenue at the end of the year.
December 31, 2020
Discount on Notes Receivable
54000
Interest Revenue (.12 × 6/12 × $900,000)
54000
As a practical expedient, companies are not required to reflect the time
value of money to determine the transaction price if the time-period for
payment is less than a year.
Noncash Consideration
Companies sometimes receive consideration in the form of goods,
services, or other noncash consideration. When these situations occur,
companies generally recognize revenue on the basis of the fair value of
what is received. For example, assume that Raylin Company receives
common stock of Monroe Company in payment for consulting services.
In that case, Raylin Company recognizes revenue in the amount of the
fair value of the common stock received. If Raylin cannot determine this
amount, then it should estimate the selling price of the services performed
and recognize this amount as revenue.
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In addition, companies sometimes receive contributions (e.g., donations
and gifts). A contribution is often some type of asset (e.g., securities,
land, buildings, or use of facilities) but it could be the forgiveness of debt.
In these cases, companies recognize revenue for the fair value of the
consideration received. Similarly, customers sometimes contribute goods
or services, such as equipment or labor, as consideration for goods
provided or services performed.
This consideration should be recognized as revenue based on the fair
value of the consideration received.
Consideration Paid or Payable to Customers
Companies often make payments to their customers as part of a revenue
arrangement. Consideration paid or payable may include discounts,
volume rebates, coupons, free products, or services. In general, these
elements reduce the consideration received and the revenue to be
recognized. Illustration 8 provides an example of this type of
transaction.
Illustration 8: Transaction Price-Volume Discount
Volume Discount
Facts: Sansung Company offers its customers a 3% volume discount if
they purchase at least $2 million of its product during the calendar year.
On March 31, 2020, Sansung has made sales of $700,000 to Artic Co. In
the previous 2 years, Sansung sold over $3,000,000 to Artic in the period
April 1 to December 31. Assume that Sansung prepares financial
statements quarterly.
Question: How much revenue should Sansung recognize for the first
3 months of 2020?
Solution: In this case, Sansung should reduce its revenue by $21,000
($700,000 × .03) because it is probable that it will provide this rebate.
Revenue is therefore $679,000 ($700,000 - $21,000). To not recognize
this volume discount overstates Sansung’s revenue for the first 3 months
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of 2020. In other words, the appropriate revenue to be recognized is
$679,000, not $700,000. Given these facts, Sansung makes the following
entry on March 31, 2020, to recognize revenue.
Accounts Receivable
679000
Sales Revenue
679000
Assuming that Sansung’s customer meets the discount threshold,
Sansung makes the following entry to record collection of accounts
receivable.
Cash
679000
Accounts Receivable
679000
If Sansung’s customer fails to meet the discount threshold, Sansung
makes the following entry to record collection of accounts receivable.
Cash
700000
Accounts Receivable
679000
Sales Discounts Forfeited
21000
Sales Discounts Forfeited is reported in the “Other revenues and
gains” section of the income statement.
In many cases, companies provide cash discounts to customers for
a short period of time (often referred to as prompt settlement discounts).
For example, assume that terms are payment due in 60 days, but if
payment is made within five days, a two percent discount is given
(referred to as 2/5, net 60). These prompt settlement discounts should
reduce revenues, if material. In most cases, companies record the revenue
at full price (gross) and record a sales discount if payment is made within
the discount period.
Allocating the Transaction Price to Separate Performance
Obligations-Step 4
Companies often have to allocate the transaction price to more than one
performance obligation in a contract. If an allocation is needed, the
transaction price allocated to the various performance obligations is
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based on their relative fair values. The best measure of fair value is what
the company could sell the good or service for on a standalone basis,
referred to as the standalone selling price. If this information is not
available, companies should use their best estimate of what the good or
service might sell for as a standalone unit. Illustration 9 summarizes the
approaches that companies follow (in preferred order of use).
Illustration 9 Transaction Price-allocation
Allocation Approach
Adjusted market
assessment approach
Expected cost plus a
margin approach
Residual approach
Implementation
Evaluate the market in which the company sells
goods or services and estimate the price that
customers in that market are willing to pay for
those goods or services. That approach also might
include referring to prices from the company’s
competitors for similar goods or services and
adjusting those prices as necessary to reflect the
company’s costs and margins.
Forecast expected costs of satisfying a
performance obligation and then add an
appropriate margin for that good or service.
If the standalone selling price of a good or service
is highly variable or uncertain, then a company
may estimate the standalone selling price by
reference to the total transaction price less the sum
of the observable standalone selling prices of other
goods or services promised in the contract.
To illustrate, Travis Company enters into a contract with a customer to
sell Products A, B, and C in exchange for $100,000. Travis Company
regularly sells Product A separately, and therefore the standalone selling
price is directly observable at $50,000. The standalone selling price of
Product B is estimated using the adjusted market assessment approach
and is determined to be $30,000. Travis Company decides to use the
residual approach to value Product C as it has confidence that Products
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A and B are valued correctly. The selling price for the products is
allocated as shown in Illustration 10.
Illustration 10 Residual Value Allocation:
Product
A
B
Price
$ 50000
30000
20000
C
Rationale
Directly observable using standalone selling price.
Directly observable using adjusted market
assessment approach.
[$100,000 - ($50,000 + $30,000)]; using the residual
approach given reliability of the two above
measurements.
Total trans- $100000
action price
Illustrations 11 and 12 are additional examples of the measurement
issues involved in allocating the transaction price
Illustrations 11: Allocation-Multiple Performance
Obligations Multiple Performance Obligations-Example 1
Facts: Lonnie Company enters into a contract to build, run, and maintain a
highly complex piece of electronic equipment for a period of 5 years,
commencing upon delivery of the equipment. There is a fixed fee for each of
the build, run, and maintenance deliverables, and any progress payments made
are non-refundable.
It is determined that the transaction price must be allocated to the three
performance obligations: building, running, and maintaining the equipment.
There is verifiable evidence of the selling price for the building and
maintenance but not for running the equipment.
Question: What procedure should Lonnie Company use to allocate the
transaction price to the three performance obligations?
Solution: The performance obligations relate to building the equipment,
running the equipment, and maintaining the equipment. As indicated, Lonnie
can determine verifiable standalone selling prices for the equipment and the
maintenance agreements. The company then can make a best estimate of the
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selling price for running the equipment, using the adjusted market assessment
approach or expected cost plus a margin approach. Lonnie next applies the
proportional standalone selling price method at the inception of the transaction
to determine the proper allocation to each performance obligation. Once the
allocation is performed, Lonnie recognizes revenue independently for each
performance obligation using regular revenue recognition criteria. If, on the
other hand, Lonnie is unable to estimate the standalone selling price for running
the equipment because such an estimate is highly variable or uncertain, Lonnie
may use a residual approach.
In this case, Lonnie uses the standalone selling prices of the
equipment and maintenance agreements and subtracts these prices from
the total transaction price to arrive at a residual value for running the
equipment.
Illustration 12 Multiple
Installation, and Service
Performance
Obligations-Product,
Facts: Handler Company is an established manufacturer of equipment used in
the construction industry.
Handler’s products range from small to large individual pieces of automated
machinery to complex systems containing numerous components. Unit selling
prices range from $600,000 to $4,000,000 and are quoted inclusive of
installation and training. The installation process does not involve changes to
the features of the equipment and does not require proprietary information
about the equipment in order for the installed equipment to perform to
specifications. Handler has the following arrangement with Chai Company.
• Chai purchases equipment from Handler for a price of $2,000,000 and chooses
Handler to do the installation. Handler charges the same price for the
equipment irrespective of whether it does the installation or not. (Some
companies do the installation themselves because they either prefer their
own employees to do the work or because of relationships with other
customers.) The installation service included in the arrangement is estimated
to have a standalone selling price of $20,000.
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• The standalone selling price of the training sessions is estimated at $50,000.
Other companies can also perform these training services.
• Chai is obligated to pay Handler the $2,000,000 upon the delivery and
installation of the equipment.
• Handler delivers the equipment on September 1, 2020, and completes the
installation of the equipment on November 1, 2020 (transfer of control is
complete after installation). Training related to the equipment starts once the
installation is completed and lasts for 1 year. The equipment has a useful life
of 10 years.
Questions: (a) What are the performance obligations for purposes of
accounting for the sale of the equipment? (b) If there is more than one
performance obligation, how should the payment of $2,000,000 be allocated to
various components?
Solution:
(a) Handler’s primary objective is to sell equipment. The other services
(installation and training) can be performed by other parties if
necessary. As a result, the equipment, installation, and training are
three separate products or services. Each of these items has a
standalone selling price and is not interdependent.
(b) The total revenue of $2,000,000 should be allocated to the three
components based on their relative standalone selling prices. In this
case, the standalone selling price of the equipment is $2,000,000, the
installation fee is $20,000, and the training is $50,000. The total
standalone selling price therefore is $2,070,000 ($2,000,000 +
$20,000 + $50,000). The allocation is as follows:
Equipment $1,932,367 [($2,000,000 ÷ $2,070,000) × $2,000,000]
Installation 19,324 [($20,000 ÷ $2,070,000) × $2,000,000]
Training
48,309 [($50,000 ÷ $2,070,000) × $2,000,000]
$2,000,000
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Handler makes the following entry on November 1, 2020, to record both
sales revenue and service revenue on the installation, as well as unearned
service revenue.
November 1, 2020
Cash
2000000
Service Revenue (installation)
19324
Unearned Service Revenue
48309
Sales Revenue
1932367
Assuming the cost of the equipment is $1,500,000, the entry to record cost
of goods sold is as follows:
November 1, 2020
Cost of Goods Sold
1500000
Inventory
1500000
As indicated by these entries, Handler recognizes revenue from the sale
of the equipment once the installation is completed on November 1,
2020. In addition, it recognizes revenue for the installation fee because
these services have been performed.
Handler recognizes the training revenues on a straight-line basis starting
on November 1, 2020, or $4,026 ($48,309 ÷ 12) per month for 1 year
(unless a more appropriate method such as the percentage-of completion
method-discussed in the next section-is warranted). The journal entry to
recognize the training revenue for 2 months in 2020 is as follows.
December 31, 2020
Unearned Service Revenue
Service Revenue (training) ($4026 × 2)
8052
8052
Therefore, Handler recognizes revenue at December 31, 2020, in the
amount of $1,959,743 ($1,932,367 + $19,324 + $8,052). Handler makes
the following journal entry to recognize the remaining training revenue in
2021, assuming adjusting entries are made at year-end.
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December 31, 2021
Unearned Service Revenue
40257
Service Revenue (training) ($48309 - $8052)
40257
Recognizing Revenue When (or as) Each Performance Obligation Is
Satisfied-Step 5
A company satisfies its performance obligation when the customer
obtains control of the good or service. As indicated in the Handler
example (in Illustration 18.12) and the BEAN example, the concept of
change in control is the deciding factor in determining when a
performance obligation is satisfied. The customer controls the product or
service when it has the ability to direct the use of and obtain substantially
all the remaining benefi ts from the asset or service. Control also includes
the customer’s ability to prevent other companies from directing the use
of, or receiving the benefits, from the asset or service. Illustration 13
summarizes the indicators that the customer has obtained control.
Illustration 13 Change in Control Indicators
1. The company has a right to payment for the asset.
2. The company has transferred legal title to the asset.
3. The company has transferred physical possession of the asset.
4. The customer has significant risks and rewards of ownership.
5. The customer has accepted the asset.
This is a list of indicators, not requirements or criteria. Not all of the
indicators need to be met for management to conclude that control has
transferred and revenue can be recognized. Management must use
judgment to determine whether the factors collectively indicate that the
customer has obtained control. This assessment should be focused
primarily on the customer’s perspective.
Companies satisfy performance obligations either at a point in time
or over a period of time. Companies recognize revenue over a period of
time if one of the following three criteria is met.
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1. The customer receives and consumes the benefits as the seller
performs.
2. The customer controls the asset as it is created or enhanced (e.g., a
builder constructs a building on a customer’s property).
3. The company does not have an alternative use for the asset created or
enhanced (e.g., an aircraft manufacturer builds specialty jets to a
customer’s specifications) and either (a) the customer receives
benefits as the company performs and therefore the task would not
need to be re-performed, or (b) the company has a right to payment
and this right is enforceable.
Illustration 14 provides an example of the point in time when revenue
should be recognized.
Illustration 14 Satisfying a Performance Obligation
Facts: Gomez Software Company enters into a contract with Hurly
Company to develop and install customer relationship management (CRM)
software. Progress payments are made upon completion of each stage of
the contract. If the contract is terminated, then the partly completed CRM
soft ware passes to Hurly Company. Gomez Software is prohibited from
redirecting the software to another customer.
Solution: Gomez Software does not create an asset with an alternative use
because it is prohibited from redirecting the software to another customer.
In addition, Gomez Software is entitled to payments for performance to
date and expects to complete the project. Therefore, Gomez Software
concludes that the contract meets the criteria for recognizing revenue over
time.
A company recognizes revenue from a performance obligation over time
by measuring the progress toward completion. The method selected for
measuring progress should depict the transfer of control from the
company to the customer. For many service arrangements, revenue is
recognized on a straight-line basis because the performance
obligation is being satisfied ratably over the contract period. In other
settings (e.g., long-term construction contracts), companies use various
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methods to determine the extent of progress toward completion. The most
common are the cost-to-cost and units of-delivery methods. The objective
of all these methods is to measure the extent of progress in terms of costs,
units, or value added. Companies identify the various measures (costs
incurred, labor hours worked, tons produced, floors completed, etc.) and
classify them as input or output measures.
Input measures (e.g., costs incurred and labor hours worked) are
efforts devoted to a contract. Output measures (with units of delivery
measured as tons produced, floors of a building completed, miles of a
highway completed, etc.) track results. Neither is universally applicable
to all long-term projects. Their use requires the exercise of judgment and
careful tailoring to the circumstances.
The most popular input measure used to determine the progress
toward completion is the cost-to-cost basis. Under this basis, a company
measures the percentage of completion by comparing costs incurred to
date with the most recent estimate of the total costs required to complete
the contract. The percentage-of-completion method, which examines the
accounting for long-term contracts, is discussed more fully in a following
section in this chapter.
Accounting for Revenue Recognition Issues
This section addresses revenue recognition issues found in practice. Most
of these issues relate to determining the transaction price (Step 3) and
evaluating when control of the product or service passes to the customer
(Step 5). The revenue recognition principle and the concept of control are
illustrated for the following situations:
• Sales returns and allowances.
• Consignments.
• Repurchase agreements.
• Warranties.
• Bill and hold.
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• Nonrefundable upfront fees.
• Principal-agent relationships.
Sales Returns and Allowances
Sales returns and allowances are very common for many companies that
sell goods to customers. For example, assume that Fafco Solar sells solar
panels to customers on account. Fafco grants customers the right of return
for these panels for various reasons (e.g., dissatisfaction with the
product). Customers may receive any combination of the following.
1. A full or partial refund of any consideration paid.
2. A credit that can be applied against amounts owed, or that will be
owed, to the seller.
3. Another product in exchange.
To account for these sales returns and allowances, Fafco should
recognize the following:
a. Revenue for the transferred solar panels in the amount of
consideration to which Fafco is reasonably assured to be entitled
(considering the products to be returned or allowance granted).
b. An asset (and corresponding adjustment to cost of goods sold) for
the goods returned from customers.
Credit Sales with Returns and Allowances
To illustrate the accounting for a return situation in more detail, assume
that on January 12, 2020, Venden Company sells 100 cameras for $100
each on account to Amaya Inc. Venden allows Amaya to return any
unused cameras within 45 days of purchase. The cost of each product is
$60. Venden estimates that:
1. Three products will be returned.
2. The cost of recovering the products will be immaterial.
3. The returned products are expected to be resold at a profit.
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On January 24, Amaya returns two of the cameras because they were the
wrong color. On January 31, Venden prepares financial statements and
determines that it is likely that only one more camera will be returned.
Venden makes the following entries related to these transactions.
To record the sale of the cameras and related cost of goods sold on
January 12, 2020
Accounts Receivable
10000
Sales Revenue (100 × $100)
10000
Cost of Goods Sold
6000
Inventory (100 × $60)
6000
To record the return of the two cameras on January 24, 2020
Sales Returns and Allowances
200
Accounts Receivable (2 × $100)
200
Returned Inventory
120
Cost of Goods Sold (2 × $60)
120
The Sales Returns and Allowances account is a contra-account to Sales
Revenue. The Returned Inventory account is used to separate returned
inventory from regular inventory. On January 31, 2020, Venden prepares
financial statements. As indicated earlier, Venden originally estimated
that the most likely outcome was that three cameras would be returned.
Venden believes the original estimate is correct and makes the following
adjusting entries to account for expected returns at January 31, 2020.
To record expected sales returns on January 31, 2020
Sales Returns and Allowances
100
Allowance for Sales Returns and
100
Allowances (1 × $100)
To record the expected return of the one camera and related
reduction in Cost of Goods Sold
Estimated Inventory Returns
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60
Cost of Goods Sold (1 × $60)
60
The Allowance for Sales Returns and Allowances account is a contra
account to Accounts Receivable. The Estimated Inventory Returns
account will generally be added to the Returned Inventory account at the
end of the reporting period.
For the month of January, Venden’s income statement reports the
information presented as follows:
Sales revenue (100 × $100)
$10000
Less: Sales returns and allowances ($200 + $100)
300
Net sales
9700
Cost of goods sold (97 × $60)
5820
Gross profit
$ 3880
As a result, at the end of the reporting period, the net sales refl ects the
amount that Venden expects to be entitled to collect. Venden reports the
following information in the balance sheet as of January 31, 2020, as
shown bellow:
Accounts receivable ($10,000 - $200)
Less: Allowance for sales returns and allowances
Accounts receivable (net)
Returned inventory (including estimated) (3 × $60)
$9800
100
9700
$ 180
Cash Sales with Returns and Allowances
Assume now that Venden sold the cameras to Amaya for cash instead of
on account. In this situation, Venden makes the following entries related
to these transactions.
To record the sale of the cameras and related cost of goods sold on
January 12, 2020
Cash
10000
Sales Revenue (100 × $100)
10000
Cost of Goods Sold
6000
Inventory (100 × $60)
6000
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Assuming that Venden did not pay cash at the time of the return of the
two cameras to Amaya on January 24, 2020, the entries to record the
return of the two cameras and related cost of goods sold are as follows.
To record the return of two cameras on January 24, 2020
Sales Returns and Allowances
200
Accounts Payable (2 × $100)
200
Returned Inventory
120
Cost of Goods Sold (2 × $60)
120
Venden records an accounts payable to Amaya to recognize that it owes
Amaya for the return of two cameras. As indicated earlier, the Sales
Returns and Allowances account is a contra-revenue account. The
Returned Inventory account is used to separate returned inventory from
regular inventory.
On January 31, 2020, Venden prepares financial statements. As
indicated earlier, Venden estimates that the most likely outcome is that
one more camera will be returned. Venden therefore makes the following
adjusting entries.
To record expected sales returns on January 31, 2020
Sales Returns and Allowances
Accounts Payable (1 × $100)
100
100
To record the expected return of the one camera and related Cost of
Goods Sold
Estimated Inventory Returns
60
Cost of Goods Sold (1× $60)
60
At January 31, 2020, Venden records an accounts payable to recognize
its estimated additional liability to Amaya for expected future returns.
The Estimated Inventory Returns account will generally be added to the
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Returned Inventory account at the end of the reporting period to identify
returned and estimated inventory returns.
The following table presents the information related to these sales that
will be reported on Venden’s income statement for the month of January.
Sales revenue (100 × $100)
$10000
Less: Sales returns and allowances (3 × $100)
300
Net sales
9700
Cost of goods sold (97 × $60)
5820
Gross profit
$ 3880
On Venden’s balance sheet as of January 31, 2020, the information
shown in the table is reported as follows:
Cash (assuming no cash payments to date to Amaya) $10000
Returned inventory (including estimated) (3 × $60)
180
Accounts payable ($200 + $100)
300
Companies record the returned asset in a separate account from inventory
to provide transparency. The carrying value of the returned asset is
subject to impairment testing, separate from the inventory. If a company
is unable to estimate the level of returns with any reliability, it should not
report any revenue until the returns become predictive.
Repurchase Agreements
In some cases, companies enter into repurchase agreements, which
allow them to transfer an asset to a customer but have an unconditional
(forward) obligation or unconditional right (call option) to repurchase the
asset at a later date. In these situations, the question is whether the
company sold the asset. Generally, companies report these transactions
as a financing (borrowing). That is, if the company has a forward
obligation or call option to repurchase the asset for an amount greater
than or equal to its selling price, then the transaction is a financing
transaction by the company.
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The table bellow examines the issues related to a repurchase
agreement.
Repurchase Agreement
Facts: Morgan Inc., an equipment dealer, sells equipment on January 1, 2020,
to Lane Company for $100,000 It agrees to repurchase this equipment (an
unconditional obligation) from Lane Company on December 31, 2021, for a
price of $121,000.
Question: Should Morgan Inc. record a sale for this transaction?
Solution: For a sale and repurchase agreement, the terms of the agreement need
to be analyzed to determine whether Morgan Inc. has transferred control to the
customer, Lane Company. As indicated earlier, control of an asset refers to the
ability to direct the use of and obtain substantially all the benefits from the asset.
Control also includes the ability to prevent other companies from directing the
use of and receiving the benefit from a good or service. In this case, Morgan
Inc. continues to have control of the asset because it has agreed to repurchase
the asset at an amount greater than the selling price. Therefore, this agreement
is a financing transaction and not a sale. Thus, the asset is not removed from
the books of Morgan Inc.
Assuming that an interest rate of 10% is imputed from the agreement,
Morgan Inc. makes the following entries to record this agreement.
Morgan Inc. records the financing on January 1, 2020, as follows.
January 1, 2020
Cash
100000
Liability to Lane Company
100000
Morgan Inc. records interest on December 31, 2020, as follows.
December 31, 2020
Interest Expense
100000
Liability to Lane Company ($100,000 × .10)
100000
Morgan Inc. records interest and retirement of its liability to Lane
Company as follows.
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December 31, 2021
Interest Expense
Liability to Lane Company ($110,000 × .10)
Liability to Lane Company
Cash ($100,000 + $10,000 + $11,000)
11000
11000
121000
121000
Rather than Morgan Inc. having a forward or call option to
repurchase the asset, assume that Lane Company has the option to
require Morgan Inc. to repurchase the asset at December 31, 2021. This
option is a put option; that is, Lane Company has the option to put the
asset back to Morgan Inc. In this situation, Lane Company has control of
the asset as it can keep the equipment or sell it to Morgan Inc. or to some
other third party. The value of a put option increases when the value of
the underlying asset (in this case, the equipment) decreases. In
determining how to account for this transaction, Morgan Inc. has to
determine whether Lane Company will have an economic incentive to
exercise this put option at the end of 2021.
Specifically, Lane Company has a significant economic incentive
to exercise its put option if the value of the equipment declines. In this
case, the transaction is generally reported as a financing transaction as
shown in Illustration 18.20. That is, Lane Company will return (put) the
equipment back to Morgan Inc. if the repurchase price exceeds the fair
value of the equipment. For example, if the repurchase price of the
equipment is $150,000 but its fair value is $125,000, Lane Company is
better off returning the equipment to Morgan Inc.
Conversely, if Lane Company does not have a significant economic
incentive to exercise its put option, then the transaction should be
reported as a sale of a product with a right of return.
Bill-and-Hold Arrangements
A bill-and-hold arrangement is a contract under which an entity bills a
customer for a product but the entity retains physical possession of the
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product until it is transferred to the customer at a point in time in the
future. Bill-and-hold sales result when the buyer is not yet ready to take
delivery but does take title and accepts billing. For example, a customer
may request a company to enter into such an arrangement because of (1)
lack of available space for the product, (2) delays in its production
schedule, or (3) more than sufficient inventory in its distribution channel.
The following illustration provides an example of a bill-and-hold
arrangement:
Illustration 16: Recognition-Bill and Hold
Bill and Hold
Facts: Butler Company sells $450,000 (cost $280,000) of fireplaces on
March 1, 2020, to a local coffee shop, Baristo, which is planning to
expand its locations around the city. Under the agreement, Baristo asks
Butler to retain these fireplaces in its warehouses until the new coffee
shops that will house the fireplaces are ready.
Title passes to Baristo at the time the agreement is signed.
Question: When should Butler recognize the revenue from this bill
and-hold arrangement?
Solution: When to recognize revenue in a bill-and-hold arrangement
depends on the circumstances. Butler determines when it has satisfied its
performance obligation to transfer a product by evaluating when Baristo
obtains control of that product. For Baristo to have obtained control of a
product in a bill-and-hold arrangement, it must meet all of the conditions
for change in control plus all of the following criteria:
(a) The reason for the bill-and-hold arrangement must be substantive.
(b) The product must be identified separately as belonging to Baristo.
(c) The product currently must be ready for physical transfer to Baristo.
(d) Butler cannot have the ability to use the product or to direct it to
another customer.
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In this case, assuming that the above criteria were met in the contract,
revenue recognition should be permitted at the time the contract is signed.
Butler has transferred control to Baristo; that is, Butler has a right to
payment for the fireplaces and legal title has transferred.\
Butler makes the following entry to record the bill-and-hold sale and
related cost of goods sold.
March 1, 2020
Accounts Receivable
Sales Revenue
Cost of Goods Sold
Inventory
450000
450000
280000
280000
Principal-Agent Relationships
In a principal-agent relationship, the principal’s performance
obligation is to provide goods or perform services for a customer. The
agent’s performance obligation is to arrange for the principal to provide
these goods or services to a customer. Examples of principal-agent
relationships are as follows.
• Preferred Travel Company (agent) facilitates the booking of cruise
excursions by finding customers for Regency Cruise Company
(principal).
• Priceline (agent) facilitates the sale of various services such as car
rentals for Hertz (principal).
In these types of situations, amounts collected on behalf of the principal
are not revenue of the agent. Instead, revenue for the agent is the amount
of the commission it receives (usually a percentage of total revenue). The
following illustration provides an example of the issues related to
principal-agent relationships:
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Illustration: Recognition-Principal-Agent Relationship:
Principal-Agent Relationship
Facts: Fly-Away Travel sells airplane tickets for British Airways
(BA) to various customers.
Question: What are the performance obligations in this situation
and how should revenue be recognized for both the principal and
agent?
Solution: The principal in this case is BA and the agent is Fly-Away
Travel. Because BA has the performance obligation to provide air
transportation to the customer, it is the principal. Fly-Away Travel
facilitates the sale of the airline ticket to the customer in exchange for
a fee or commission. Its performance obligation is to arrange for BA
to provide air transportation to the customer.
Although Fly-Away collects the full airfare from the customer, it then
remits this amount to BA less the commission. Fly-Away therefore
should not record the full amount of the fare as revenue on its booksto do so overstates revenue. Its revenue is the commission, not the
full price. Control of performing the air transportation is with BA, not
Fly-Away Travel.
Some might argue that there is no harm in letting Fly-Away record
revenue for the full price of the ticket and then charging the cost of the
ticket against the revenue (often referred to as the gross method of
recognizing revenue). Others note that this approach overstates the
agent’s revenue and is misleading. The revenue received is the
commission for providing the travel services, not the full fare price (often
referred to as the net approach). The profession believes the net approach
is the correct method for recognizing revenue in a principal-agent
relationship. As a result, the FASB has developed specific criteria to
determine when a principal-agent relationship exists.12 An important
feature in deciding whether Fly-Away is acting as an agent is whether the
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amount it earns is predetermined, being either a fixed fee per transaction
or a stated percentage of the amount billed to the customer.
Warranties
Companies often provide one of two types of warranties to customers:
1.Warranties that the product meets agreed-upon specifications in the
contract at the time the product is sold. This type of warranty is
included in the sales price of a company’s product and is often referred
to as an assurance-type warranty.
2.Warranties that provide an additional service beyond the assurancetype warranty. This warranty is not included in the sales price of the
product and is referred to as a service-type warranty. As a
consequence, it is recorded as a separate performance obligation.
Companies do not record a separate performance obligation for
assurance-type warranties. This type of warranty is nothing more than a
quality guarantee that the good or service is free from defects at the point
of sale. In this case, the sale of the product and the related assurance
warranty are one performance obligation as they are interdependent of and
interrelated with each other. The objective for companies that issue an
assurance warranty is to provide a combined item (product and a
warranty).
These types of obligations should be expensed in the period the
goods are provided or services performed. In addition, the company
should record a warranty liability. The estimated amount of the liability
includes all the costs that the company is expected to incur after sale due
to the correction of defects or deficiencies required under the warranty
provisions.
In addition, companies sometimes provide customers with an
option to purchase a warranty separately. In most cases, these extended
warranties provide the customer a service beyond fixing defects that
existed at the time of sale. For example, when you purchase a TV, you are
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entitled to the company’s warranty. You will also undoubtedly be offered
an extended warranty on the product at an additional cost. These servicetype warranties represent a separate service and are an additional
performance obligation. The service-type warranty is sold separately
and therefore has a standalone selling price. In this case, the objective of
the company is to sell an additional service to customers.
As a result, companies should allocate a portion of the transaction
price to this performance obligation, if provided. The company
recognizes revenue in the period that the service-type warranty is in
effect.
The following illustration presents an example of both an
assurance-type and a service-type warranty.
Warranties
Facts: Maverick Company sold 1,000 Rollomatics on October 1, 2020, at
total price of $6,000,000, with a warranty guarantee that the product was
free of defects. The cost of the Rollomatics is $4,000,000. The term of this
assurance warranty is 2 years, which Maverick estimates will cost $80,000.
In addition, Maverick sold extended warranties related to 400 Rollomatics
for 3 years beyond the 2-year period for $18,000. On November 22, 2020,
Maverick incurred labor costs of $3,000 and part costs of $25,000 related
to the assurance warranties. Maverick prepares financial statements on
December 31, 2020. It estimates that its future assurance warranty costs
will total $44,000 at December 31, 2020.
Question: What are the journal entries that Maverick Company
should make in 2020 related to the sale of the Rollomatics and the
assurance and extended warranties?
Solution: Maverick makes the following entries in 2020 related to
Rollomatics sold with warranties.
October 1, 2020
To record the sale of the Rollomatics and the related extended warranties:
Cash ($6,000,000 + $18,000)
6018000
Sales Revenue
600000
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Unearned Warranty Revenue
18000
To record the cost of goods sold and reduce the inventory of Rollomatics:
Cost of Goods Sold
4000000
Inventory
4000000
November 22, 2020
To record the warranty costs incurred:
Warranty Expense
Salaries and Wages Payable
Inventory (parts)
December 31, 2020
28000
3000
25000
To record the adjusting entry related to its assurance warranty at the
end of the year:
Warranty Expense
Warranty Liability
44000
44000
Maverick Company makes an adjusting entry on December 31,
2020, to record a liability for the expected warranty costs related to the
sale of the Rollomatics. When actual warranty costs are incurred in 2021,
the Warranty Liability account is reduced.
In most cases, Unearned Warranty Revenue (related to the servicetype warranty) is recognized on a straight-line basis as Warranty Revenue
over the three-year period to which it applies. Revenue related to the
extended warranty is not recognized until the warranty becomes effective
on October 1, 2022. If financial statements are prepared on December 31,
2022, Maverick makes the following entry to recognize revenue:
Unearned Warranty Revenue
Warranty Revenue [($18,000 ÷ 36) × 3]
1,500
1,500
Maverick Company reduces the Warranty Liability account over
the warranty period as the actual warranty costs are incurred. The
company also recognizes revenue related to the service-type warranty
over the three-year period that extends beyond the assurance warranty
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period (two years). In most cases, the unearned warranty revenue is
recognized on a straight-line basis. The costs associated with the servicetype warranty are expensed as incurred.
Nonrefundable Upfront Fees
Companies sometimes receive payments (upfront fees) from customers
before they deliver a product or perform a service. Upfront payments
generally relate to the initiation, activation, or setup of a good or service
to be provided or performed in the future.
In most cases, these upfront payments are nonrefundable.
Examples include fees paid for membership in a health club or buying
club, and activation fees for phone, Internet, or cable.
Companies must determine whether these nonrefundable advance
payments are for products or services in the current period. In most
situations, these payments are for future delivery of products and services
and should therefore not be recorded as revenue at the time of payment.
In some cases, the upfront fee is viewed similar to a renewal option for
future products and services at a reduced price. An example would be a
health club where once the initiation fee is paid, no additional fee is
necessary upon renewal. The following illustration provides an example
of an upfront fee payment.
Upfront Fee Considerations
Facts: Erica Felise signs a 1-year contract with Bigelow Health Club. The
terms of the contract are that Erica is required to pay a non-refundable
initiation fee of $200 and a membership fee of $50 per month. Bigelow
determines that its customers, on average, renew their annual
membership two times before terminating their membership.
Question: What is the amount of revenue Bigelow Health Club should
recognize in the first year?
Solution: In this case, the membership fee arrangement may be viewed as
a single performance obligation (similar services are provided in all
periods). That is, Bigelow is providing a discounted price in the second
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and third years for the same services, and this should be reflected in the
revenue recognized in those periods. Bigelow determines the total
transaction price to be $2,000—the upfront fee of $200 and the three
years of monthly fees of $1,800 ($50 × 36)—and allocates it over the
three years. In this case, Bigelow would report revenue of $55.56 ($2,000
÷ 36) each month for three years.
Unless otherwise instructed, use this approach for homework problems.
Long-Term Construction Contracts
Revenue Recognition over Time
For the most part, companies recognize revenue at the point of sale
because that is when the performance obligation is satisfied. However, as
indicated in the chapter, under certain circumstances companies
recognize revenue over time. The most notable context in which revenue
is recognized over time is long-term construction contract accounting.
Long-term contracts frequently provide that the seller (builder)
may bill the purchaser at intervals, as it reaches various points in the
project. Examples of long-term contracts are construction-type contracts,
development of military and commercial aircraft, weaponsdelivery
systems, and space exploration hardware.
When the project consists of separable units, such as a group of
buildings or miles of roadway, contract provisions may provide for
delivery in installments. In that case, the seller would bill the buyer and
transfer title at stated stages of completion, such as the completion of
each building unit or every 10 miles of road.
The accounting records should record sales when installments are
“delivered.”
A company satisfies a performance obligation and recognizes revenue
over time if at least one of the following three criteria is met:
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1. The customer simultaneously receives and consumes the benefits of
the seller’s performance as the seller performs.
2. The company’s performance creates or enhances an asset (for example,
work in process) that the customer controls as the asset is created or
enhanced; or
3. The company’s performance does not create an asset with an
alternative use. For example, the asset cannot be used by another
customer. In addition to this alternative use element, at least one of the
following criteria must be met:
a. Another company would not need to substantially re-perform the
work the company has completed to date if that other company
were to fulfill the remaining obligation to the customer.
b. The company has a right to payment for its performance completed
to date, and it expects to fulfill the contract as promised.
Therefore, if criterion 1, 2, or 3 is met, then a company recognizes
revenue over time if it can reasonably estimate its progress toward
satisfaction of the performance obligations. That is, it recognizes
revenues and gross profits each period based upon the progress of the
construction-referred to as the percentage-of-completion method. The
company accumulates construction costs plus gross profit recognized to
date in an inventory account (Construction in Process), and it
accumulates progress billings in a contra inventory account (Billings on
Construction in Process).
The rationale for using percentage-of-completion accounting is
that under most of these contracts the buyer and seller have enforceable
rights. The buyer has the legal right to require specific performance on
the contract. The seller has the right to require progress payments that
provide evidence of the buyer’s ownership interest. As a result, a
continuous sale occurs as the work progresses. Companies should
recognize revenue according to that progression.
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Alternatively, if the criteria for recognition over time are not met
(e.g., the company does not have a right to payment for work completed
to date), the company recognizes revenues and gross profit at a point in
time, that is, when the contract is completed. This approach is referred to
as the completed-contract method. The company accumulates
construction costs in an inventory account (Construction in Process), and
it accumulates progress billings in a contra inventory account (Billings
on Construction in Process).
Percentage-of-Completion Method
The percentage-of-completion method recognizes revenues, costs, and
gross profit as a company makes progress toward completion on a longterm contract. To defer recognition of these items until completion of the
entire contract is to misrepresent the efforts (costs) and accomplishments
(revenues) of the accounting periods during the contract. In order to apply
the percentage-of-completion method, a company must have some basis
or standard for measuring the progress toward completion at particular
interim dates.
Measuring the Progress Toward Completion
As one practicing accountant wrote, “The big problem in applying the
percentage-of-completion method . .. has to do with the ability to make
reasonably accurate estimates of completion and the final gross profit.”
Companies use various methods to determine the extent of progress
toward completion. The most common are the cost-to-cost and units ofdelivery methods.
As indicated in the chapter, the objective of all these methods is to
measure the extent of progress in terms of costs, units, or value added.
Companies identify the various measures (costs incurred, labor hours
worked, tons produced, floors completed, etc.) and classify them as input
or output measures. Input measures (costs incurred, labor hours worked)
are efforts devoted to a contract. Output measures (with units of
delivery measured as tons produced, floors of a building completed, miles
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of a highway completed) track results. Neither measure is universally
applicable to all long-term projects. Their use requires the exercise of
judgment and careful tailoring to the circumstances.
Both input and output measures have disadvantages. The input
measure is based on an established relationship between a unit of input
and productivity. If inefficiencies cause the productivity relationship to
change, inaccurate measurements result. Another potential problem is
front-end loading, in which significant upfront costs result in higher
estimates of completion. To avoid this problem, companies should
disregard some early-stage construction costs—for example, costs of
uninstalled materials or costs of subcontracts not yet performed-if they
do not relate to contract performance.
Similarly, output measures can produce inaccurate results if the
units used are not comparable in time, effort, or cost to complete. For
example, using floors (stories) completed can be deceiving. Completing
the first floor of an eight-story building may require more than one-eighth
the total cost because of the substructure and foundation construction.
The most popular input measure used to determine the progress
toward completion is the cost-to-cost basis. Under this basis, a company
like Halliburton measures the percentage of completion by comparing
costs incurred to date with the most recent estimate of the total costs
required to complete the contract.
The formula for the cost-to-cost basis takes is presented as
follows:
Formula for Percentage-of-Completion, Cost-to-Cost Basis:
Costs Incurred to Date
= percentage complete
Most Recent Estimate of Total Costs
Once Halliburton knows the percentage that costs incurred bear to
total estimated costs, it applies that percentage to the total revenue or the
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estimated total gross profit on the contract. The resulting amount is the
revenue or the gross profit to be recognized to date.
Formula for Total Revenue (or Gross Profit) to Be Recognized to Date:
Percent
complete
x
Estimated Total revenue
=
(or Gross Profit)
Revenue (or Gross Profit)
to Be Recognized to Date
To find the amounts of revenue and gross profit recognized each period,
Halliburton subtracts total revenue or gross profit recognized in prior
periods:
Formula for Amount of Current-Period Revenue (or Gross Profit) Costto-Cost Basis
Revenue
(or
gross
profit) to be recognized to Date
Revenue (or gross
Current-period
profit) recognized =
Revenue (or
in Prior periods
Gross Profit)
Because the cost-to-cost method is widely used (without excluding
other bases for measuring progress toward completion), we have adopted
it for use in our examples.
Example of Percentage-of-Completion Method-Cost-to-Cost Basis
To illustrate the percentage-of-completion method, assume that Hardhat
Construction Company has a contract to construct a $4,500,000 bridge at
an estimated cost of $4,000,000. The contract is to start in July 2020, and
the bridge is to be completed in October 2022. The following data pertain
to the construction period. (Note that by the end of 2021, Hardhat has
revised the estimated total cost from $4,000,000 to $4,050,000.)
2020
Costs to date
$1000000
3000000
Estimated costs to complete
Progress billings during the year 900000
750000
Cash collected during the year
2021
$2916000
1134000
2400000
1750000
2022
$4050000
1200000
2000000
Hardhat would compute the percent complete as shown below:
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Contract price
Less estimated cost:
Costs to date
Estimated costs to complete
Estimated total costs
Estimated total gross profit
Percent complete
2020
$4500000
2021
$4500000
2022
$4500000
1000000
3000000
4000000
$2916000
1134000
4050000
4050000
-4050000
$500000
$450000
$450000
72%
25%
($1000000) ($2916000)
($4000000) ($4050000)
100%
($4050000)
($4050000)
On the basis of the data above, Hardhat would make the entries shown
below to record (1) the costs of construction, (2) progress billings, and
(3) collections. These entries appear as summaries of the many
transactions that would be entered individually as they occur during the
year.
2020
2021
2022
To record costs of construction:
Construction in Process
1000000
1916000 1134000
Materials, Cash, Payables, etc.
1000000 1916000
1134000
To record progress billings:
2400000
900000
1200000
Accounts Receivable
2400000
900000
1200000
Billings on Construction in Process
To record collections:
Cash
750000
1750000 2000000
Accounts Receivable
750000 1750000
2000000
In this example, the costs incurred to date are a measure of the extent of
progress toward completion. To determine this, Hardhat evaluates the
costs incurred to date as a proportion of the estimated total costs to be
incurred on the project. The estimated revenue and gross profit that
Hardhat will recognize for each year are calculated as shown below:
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Recognized in
Prior Years
To Date
2020
Revenues ($4500000 x .25)
Costs
Gross profit
2021
Revenues ($4500000 x .72)
Costs
Gross profit
2022
Revenues ($4500000 x 1.00)
Costs
Gross profit
Recognized in
current year
$1125000
1000000
$125000
$1125000
1000000
$125000
3240000
2916000
324000
$1125000
1000000
$125000
$2115000
1916000
$199000
$4500000
4050000
$450000
$3240000
2916000
$3240000
$2160000
1134000
$1260000
Furthermore, Hardhat’s entries to recognize revenue and gross profit each
year and to record completion and final approval of the contract is shown
below:
2020
To recognize revenue and gross profit:
Construction in Process(gross profit)
Construction Expenses
Contracts
To record completion of the contract:
Billings on Construction in Process
Construction in Process
2021
2022
$125000
$199000 $126000
1000000
1916000 1134000
$1125000 2115000 $1260000
-
-
$4500000
4500000
Note that Hardhat debits gross profit to Construction in Process.
Similarly, it credits Revenue from Long Term Contracts for the amounts
computed. Hardhat then debits the difference between the amounts
recognized each year for revenue and gross profit to a nominal account,
Construction Expenses (similar to Cost of Goods Sold in a manufacturing
company). It reports that amount in the income statement as the actual
cost of construction incurred in that period. For example, in 2020 Hardhat
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uses the actual costs of $1,000,000 to compute both the gross profit of
$125,000 and the percent complete (25 percent).
Hardhat continues to accumulate costs in the Construction in Process
account, in order to maintain a record of total costs incurred (plus
recognized gross profit) to date. Although theoretically a series of “sales”
takes place using the percentage-of completion method, the selling
company cannot remove the inventory cost until the construction is
completed and transferred to the new owner. Hardhat’s Construction in
Process account for the bridge would include the summarized entries
shown below over the term of the construction project.
Construction in Process
2020 construction costs
$1000000 31/12/22 To close
project
2020 recognized gross profit 125000
2021 construction costs
1916000
2021 recognized gross profit 199000
2022 construction costs
1134000
2022 recognized gross profit 126000
Total
$4500000 Total
complete $4500000
$4500000
Recall that the Hardhat Construction Company example contained a
change in estimated costs: In the second year, 2021, it increased the
estimated total costs from $4,000,000 to $4,050,000. The change in
estimate is accounted for in a cumulative catch-up manner, as indicated
in the chapter. This is done by first adjusting the percent completed to the
new estimate of total costs. Next, Hardhat deducts the amount of revenues
and gross profit recognized in prior periods from revenues and gross
profit computed for progress to date. That is, it accounts for the change
in estimate in the period of change. That way, the balance sheet at the end
of the period of change and the accounting in subsequent periods are as
they would have been if the revised estimate had been the original
estimate.
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Financial Statement Presentation-Percentage-of-Completion
Generally, when a company records a receivable from a sale, it reduces
the Inventory account. Under the percentage-of-completion method,
however, the company continues to carry both the receivable and the
inventory. Subtracting the balance in the Billings account from
Construction in Process avoids double counting the inventory. During the
life of the contract, Hardhat reports in the balance sheet the difference
between the Construction in Process and the Billings on Construction in
Process accounts. If that amount is a debit, Hardhat reports it as a current
asset; if it is a credit, it reports it as a current liability.
At times, the costs incurred plus the gross profit recognized to date
(the balance in Construction in Process) exceed the billings. In that case,
Hardhat reports this excess as a current asset entitled “Costs and
recognized profit in excess of billings.” Hardhat can at any time calculate
the unbilled portion of revenue recognized to date by subtracting the
billings to date from the revenue recognized to date, as illustrated for
2020 for Hardhat Construction in Illustration 18A.9.
Contract revenue recognized to date:
$4500000 x
Billings to date
Unbilled revenue
$1000000
$1125000
4000000
(900000)
$225000
At other times, the billings exceed costs incurred and gross profit to date.
In that case, Hardhat reports this excess as a current liability entitled
“Billings in excess of costs and recognized profit.”
What happens, as is usually the case, when companies have more
than one project going at a time? When a company has a number of
projects, costs exceed billings on some contracts and billings exceed
costs on others. In such a case, the company segregates the contracts. The
asset side includes only those contracts on which costs and recognized
profit exceed billings. The liability side includes only those on which
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billings exceed costs and recognized profit. Separate disclosures of the
dollar volume of billings and costs are preferable to a summary
presentation of the net difference.
Using data from the bridge example, Hardhat Construction Company
would report the status and results of its long-term construction activities
in 2020 under the percentage-of-completion method as shown below.
Financial Statement Presentation-Percentage-of-Completion Method
(2020)
Hardhat Construction Company
Income Statement
Revenue from long-term contracts
Costs of construction
Gross profit
2020
$1125000
1000000
$ 125000
2020
Balance Sheet (12/31)
Current assets:
Accounts receivable
Inventory:
Construction in process
Less: Billings
1125000
$1125000
900000
Costs and recognized profit in excess of billings
225000
Financial Statement Presentation-Percentage-of-Completion Method (2021)
Hardhat Construction Company
2021
Income Statement
Revenue from long-term contracts
$2115000
Costs of construction
1916000
Gross profit
$ 199000
Balance Sheet (12/31)
Current assets:
Accounts receivable (150000+ 2400000 – 1750000)
Current liabilities
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2020
800000
Billings
$3300000
Less: Construction in process
3240000
Billings in excess of costs and recognized
60000
profit
In 2022, as shown in the table below, Hardhat’s financial
statements only include an income statement because the bridge project
was completed and settled.
Hardhat Construction Company
Income Statement
Revenue from long-term contracts
Costs of construction
Gross profit
2022
$1269000
1134000
$ 126000
Completed-Contract Method
Under the 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.
The principal advantage of the completed-contract method is that
reported revenue reflects final results rather than estimates of
unperformed work. Its major disadvantage is that it does not reflect
current performance when the period of a contract extends into more than
one accounting period. Although operations may be fairly uniform during
the period of the contract, the company will not report revenue until the
year of completion, creating a distortion of earnings.
Under the completed-contract method, the company would make
the same annual entries to record costs of construction, progress billings,
and collections from customers as those illustrated under the percentageof-completion method. The significant difference is that the company
would not make entries to recognize revenue and gross profit.
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For example, under the completed-contract method for the bridge
project previously illustrated, Hardhat Construction Company would
make the following entries in 2022 to recognize revenue and costs and to
close out the inventory and billing accounts.
Billings on Construction in Process
Revenue from Long-Term Contracts
Costs of Construction
Construction in Process
4500000
4500000
4500000
4500000
The table compares the amount of gross profit that Hardhat Construction
Company would recognize for the bridge project under the two revenue
recognition methods.
Comparison of Gross Profit Recognized under Different Method
Percentage-of-completion
Completed-contract
2020
$125000
$0
2021
199000
0
2022
126000
450000
Financial Statement Presentation-Completed Contract Method
Hardhat Construction Company
2020
2021
2022
-
-
$4500000
4050000
$450000
2020
2021
2022
$150000
$800000
$-0-
Income statement
Revenue from long-term contracts
Costs of construction
Gross profit
Hardhat Construction Company
Balance Sheet (31/12)
Current assets:
Accounts receivable
Inventory:
Construction in process
Less: Billings
$1000000
900000
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Costs in excess of Billings
Current liabilities:
Billings (3300000) in
excess of costs ($2916000)
100000
$-0-
384000
$-0-
Note 1. Summary of significant accounting policies. Long-Term Construction
Contracts.
The company recognizes revenues and reports profits from long-term
construction contracts, its principal business, under the completed
contract method. These contracts generally extend for periods in excess of
one year. Contract costs and billings are accumulated during the periods
of construction, but no revenues or profits are recognized until completion
of the contract. Costs included in construction in process include direct
material, direct labor, and project related overhead. Corporate general and
administrative expenses are charged to the periods as incurred.
Long-Term Contract Losses
Two types of losses can become evident under long-term contracts:
- Loss in the current period on a profitable contract. This condition
arises when, during construction, there is a significant increase in the
estimated total contract costs but the increase does not eliminate all
profit on the contract. Under the percentage-of-completion method
only, the estimated cost increase requires a current-period adjustment
of excess gross profit recognized on the project in prior periods. The
company records this adjustment as a loss in the current period
because it is a change in accounting estimate.
- Loss on an unprofitable contract. Cost estimates at the end of the
current period may indicate that a loss will result on completion of
the entire contract. Under both the percentage-of-completion and the
completed-contract methods, the company must recognize in the
current period the entire expected contract loss.
The treatment described for unprofitable contracts is consistent with
the accounting custom of anticipating foreseeable losses to avoid
overstatement of current and future income (conservatism).
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Loss in Current Period
To illustrate a loss in the current period on a contract expected to be
profitable upon completion, we will continue with the Hardhat
Construction Company bridge project. Assume that on December 31,
2021, Hardhat estimates the costs to complete the bridge contract at
$1468962 instead of $1134000. Assuming all other data are the same as
before, The “percent complete” has dropped, from 72 percent to 66½
percent, due to the increase in estimated future costs to complete the
contract.
Computation of Recognizable Loss, 2021-Loss in Current Period:
Cost to date (3112//21)
Estimated costs to complete (revised)
Estimated total costs
Percent complete ($2916000 ÷ $4384962)
Revenue recognized in 2021
($4500000 × .665) - $1125000
Costs incurred in 2021
Loss recognized in 2021
$2916000
1468962
$4384962
66½%
$1867500
1916000
$ (48500)
The 2021 loss of $48500 is a cumulative adjustment of the “excessive”
gross profit recognized on the contract in 2020. Instead of restating the
prior period, the company absorbs the prior period misstatement entirely
in the current period. In this illustration, the adjustment was large enough
to result in recognition of a loss. Hardhat Construction would record the
loss in 2021 as follows.
Construction Expenses
Construction in Process (loss)
Revenue from Long-Term Contracts
1916000
48500
1867500
Hardhat will report the loss of $48500 on the 2021 income statement as
the difference between the reported revenue of $1867500 and the costs
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of $1916000. Under the completed-contract method, the company does
not recognize a loss in 2021. Why not? Because the company still expects
the contract to result in a profit, to be recognized in the year of
completion.
Loss on an Unprofitable Contract
To illustrate the accounting for an overall loss on a long-term contract,
assume that at December 31, 2021, Hardhat Construction Company
estimates the costs to complete the bridge contract at $1640250 instead
of $1134000. Revised estimates for the bridge contract are as follows.
Contract price
Estimated total cost
Estimated gross profit
Estimated loss
*($2,916,000 + $1,640,250)
2020
Original
Estimates
$4500000
4000000
$500000
2021
Revised
Estimates
$4500000
4556250*
$ (56250)
Under the percentage-of-completion method, Hardhat recognized
$125000 of gross profit in 2020 (see Illustration 18A.6). This amount
must be off set in 2021 because it is no longer expected to be realized. In
addition, since losses must be recognized as soon as estimable, the
company must recognize the total estimated loss of $56250 in 2021.
Therefore, Hardhat must recognize a total loss of $181250 ($125000 +
$56250) in 2021.
The following table shows Hardhat’s computation of the revenue to be
recognized in 2021.
Revenue recognized in 2021:
Contract price
Percent complete
Revenue recognizable to date
$4500000
× .64*
2880000
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Less: Revenue recognized
prior to 2021
Revenue recognized in 2021
1125000
$1755000
*Cost to date (12/31/21)
Estimated cost to complete
Estimated total costs
$2916000
1640250
$4556250
Percent complete: $2916000 ÷ $4556250 = 64%
To compute the construction costs to be expensed in 2021, Hardhat adds
the total loss to be recognized in 2021 ($125,000 + $56,250) to the
revenue to be recognized in 2021. The table below shows this
computation.
Revenue recognized in 2021
(computed above)
Total loss recognized in 2021
Reversal of 2020 gross profit
Total estimated loss on the contract
Construction cost expensed in 2021
$1755000
$125000
56250
$125000
181250
$1936250
Hardhat Construction would record the long-term contract revenues,
expenses, and loss in 2021 as follows.
Construction Expenses
Construction in Process (loss)
Revenue from Long-Term Contracts
1936250
181250
1755000
At the end of 2021, Construction in Process has a balance of $2859750 as
shown in the following table:
Construction in Process
2020 Construction costs
1000000
2020 Recognized gross profit 125000
2021 Construction costs
1916000 2021 Recognized loss
Balance
2859750
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181250
Under the completed-contract method, Hardhat also would recognize the
contract loss of $56,250 through the following entry in 2021 (the year in
which the loss first became evident).
Loss from Long-Term Contracts
Construction in Process (loss)
56,250
56,250
Just as the Billings account balance cannot exceed the contract
price, neither can the balance in Construction in Process exceed the
contract price. In circumstances where the Construction in Process
balance exceeds the billings, the company can deduct the recognized loss
from such accumulated costs on the balance sheet. That is, under both the
percentage-of-completion and the completed-contract methods, the
provision for the loss (the credit) may be combined with Construction in
Process, thereby reducing the inventory balance. In those circumstances,
however (as in the 2021 example above), where the billings exceed the
accumulated costs, Hardhat must report separately on the balance sheet,
as a current liability, the amount of the estimated loss. That is, under both
the percentage-of-completion and the completed-contract methods,
Hardhat would take the $56,250 loss, as estimated in 2021, from the
Construction in Process account and report it separately as a current
liability titled “Estimated liability from long-term contracts.”
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