chapter 8
Revenue
Recognition
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2
Learning Objectives
1. Identify the primary criteria for revenue
recognition.
2. Apply the revenue recognition concepts
underlying the examples used in SAB 101.
3. Record journal entries for long-term
construction-type contracts using
percentage-of-completion and completedcontract methods.
Continued
3
Learning Objectives
4. Record journal entries for long-term service
contracts using the proportional
performance method.
5. Explain when revenue is recognized after
delivery of goods or services through
installment sales, cost recovery, and cash
methods.
4
Revenue Recognition
FASB’s two criteria for recognizing
revenues and gains:
1. They are realized or realizable.
2. They have been earned through
substantial completion of the
activities involved in the earnings
process.
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Revenue Recognition
Revenue recognition most
Both of these criteria
often occurs when goods
generally are met at the
are delivered or when
point of sale.
services are rendered.
6
Revenue Recognition
Criterion Associated With Revenue
Recognition
Criterion 1: The customer has provided
payment or a valid promise
of payment.
Criterion 2: The company has provided
a product or service.
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Revenue Recognition
Criterion 1
Criterion 2
Before the point of Sale
EXCEPTION:
Revenue can be recognized
prior to the point of sale if:
Customer provides a valid
promise of payment AND
conditions exist that
contractually guarantee
subsequent sale.
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Revenue Recognition
Criterion 1
Criterion 2
Point of Sale
NORMALLY:
Revenue is generally
recognized at this point of
time.
Criterion 1 is typically
satisfied at this point.
Critical 2 is typically
satisfied at this point.
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Revenue Recognition
After the Point of Sale
EXCEPTION:
The recognition of revenue
must be deferred if:
Criterion 1
Criterion 2
Customer does not provide
a valid promise at time of
receipt of product or service
OR
significant effort remains on
the contract.
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Revenue Recognition
Generally, revenue is not recognized prior to
the point of sale because either:
• A product or service was provided without
receiving a valid promise of payment from
customer.
• The company has not provided the product
or service.
An exception occurs when the customer provides
a valid promise of payment and conditions exist
that contractually guarantee the sale.
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Revenue Recognition
AICPA Statement of Position 97-2 gives
companies more guidance through a checklist
of four factors that amplify the two criteria:
a. Persuasive evidence of an arrangement
exists.
b. Delivery has occurred.
Earned
c. The vendor’s fee is fixed or determinable.
d. Collectibility is probable.
Realised
Persuasive Evidence of an
Arrangement
The SEC issued SAB 101
in response to specific
abuses involving revenue
recognition.
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Persuasive Evidence of an
Arrangement
SAB 101 is in a questionand-answer format. The
answers given are
invariably “No.”
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Persuasive Evidence of an
Arrangement
Typical questions from SAB 101
Question 1: Company
May Company
A requires
A recognize
each sale to
be supported
revenue
in thebycurrent
a written
quarter
salesif
agreement
the
productsigned
is delivered
by an by the
authorized
end
of the quarter
representative
but the sales
of
both Company
agreement
is not
Asigned
and theby the
ENTER
customer. until
customer
a few days after
the end of the quarter?
Addresses internal controls.
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Persuasive Evidence of an
Arrangement
Typical questions from SAB 101
Question 2: Company Z delivers product to
a customer on a consignment
basis. May Company Z
recognize revenue upon delivery
of the product to the customer?
Addresses the issue of circumventing
internal controls by side agreements.
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Delivery has occurred or service
has been rendered
Typical questions from SAB 101
Question 3: May Company A recognize
revenue when it completes
production of inventory for a
customer if it segregates that
inventory from other products in
its warehouse?
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Delivery has occurred or service
has been rendered
Typical questions from SAB 101
Question 4: Company
merchandise
R isaside
a retailer
until the
that
offers “layaway”
customer
pays thesales
remainder
to
of
customers.
the
sales price,
A customer
and takespays a
portion of the
possession
of the
sales
merchandise.
price, and
Company
When
should
R sets
Company
the… ENTER
R
recognize revenue?
Focuses on issues centered on the
“bill-and-hold” arrangements.
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Delivery has occurred or service
has been rendered
“bill-and-hold” arrangements.
In general, revenue should not be recognised
in a bill-and-hold arrangement until the seller
has transferred both legal ownership,
evidence by the buyer taking title to the
goods, and economic ownership, meaning
that the buyer accepts responsibility for the
safeguarding and preservation of the goods.
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Delivery has occurred or service
has been rendered
Appropriate Layaway Accounting
Receipt of $100 cash as initial layaway payment:
Cash
Deposit Received from Customers
100
100
Receipt of final $1,400 cash payment and delivery
of goods to customer:
Cash
1,400
Deposit Received from Customers
100
Sales
1,500
Cost of Goods Sold
1,000
Inventory
1,000
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Delivery has occurred or service
has been rendered
20
Delivery has occurred or service
has been rendered
Questions 5 & 6 – Deal with the seller
receiving some up-front fee as well as
subsequent periodic payments
E.g. Seller Company receives $1,000 cash from
a customer as the initial sign-up fee for a
service. In addition to the sign-up fee, the
customer is required to pay $50 per month for
100 months—which is the economic life of this
service agreement.
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Delivery has occurred or service
has been rendered
Receipt of $1,000 cash as initial sign-up fee:
Cash
1,000
Unearned Initial Sign-Up Fees
1,000
Receipt of first monthly payment of $50:
Cash
50
Monthly Service Revenue
50
Partial recognition of the initial signup fee as
revenue ($1,000/100 months):
Unearned Initial Sign-Up Fees
10
Initial Sign-Up Fee Revenue
10
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Delivery has occurred or service
has been rendered
Questions 7 & 9 – Deal with refundable
fees. In summary, the non-refundable
portion of the fees can be recognized on
a monthly basis if the number of
refunds can be reliably estimated.
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Price is fixed or determinable
Typical questions from SAB 101
Question 8: Company
Should Company
A owns A
a building
estimate and
leases it torevenue
recognize
a retailer.
associated
The annual
leasethe
with
payment
1% ofissales
$1.2over
million
$25 plus
1% of all
million
onthe
a straight-line
retailer’s sales
basis
in
excess of $25
throughout
themillion.
year? ENTER
Addresses the difference between estimating
the future impact of past events and
estimating the future impact of future events.
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Reporting Revenue: Gross vs. Net
• Gross = Sales + commission
• Net = Commission only
SAB 101 – Gross is inappropriate
unless the seller actually took
legal and economic ownership of
the goods being sold.
Revenue Recognition Prior to
Providing Goods or Services
• Completed-contract method recognizes all
income when project is completed.
• Percentage-of-completion method
recognizes revenue throughout the term of
the contract. (construction)
• Proportional performance method
reflects revenue earned on service contracts
under which many acts of service are to be
performed before the contract is complete.
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Revenue Recognition Prior to
Providing Goods or Services
GAAP requires percentage-ofcompletion method unless
certain criteria are not met.
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Percentage-ofCompletion Accounting
 Dependable estimates of:
• contract revenues
• contract costs
• progress toward completion
 Contract clearly specifies:
• enforceable rights of the parties
• consideration to be exchanged
• manner and terms of settlement
Continued
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Percentage-ofCompletion Accounting
 The buyer can be expected to satisfy
obligations under the contract.
 Contractor can be expected to perform
the contractual obligation.
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Percentage-ofCompletion Accounting
 Recognize revenue throughout life of the
contract.
 Revenue recognized is a function of how
complete the project is to date.
 Costs are charged to an inventory account:
Construction in Process (CIP).
 Profits are charged to CIP.
 CIP is valued at net realizable value.
 Any anticipated loss is booked for the full
amount of the loss when it becomes measurable.
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Percentage-ofCompletion Accounting
Input measures: Cost-to-cost method where
the degree of completion is determined by
comparing costs already incurred with the
most recent estimates of total expected costs
to complete the project.
Engineers are often called
in to help provide estimates.
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Accounting for Long-Term
Construction-Type Contracts
Strong Construction Company was
awarded a contract with a total price of
$3,000,000. Strong expected to earn
$400,000 profit on the contract.
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Accounting for Long-Term
Construction-Type Contracts
Year
Actual
Cost
Incurred
Estimated
Cost to
Complete
2004
$1,040,000
2005
910,000
Total
$1,950,000
650,000
2,600,000
75
2006
650,000
0
2,600,000
100
Total
$2,600,000
Total
Cost
$1,560,000 $2,600,000
Cost
Percentage
40
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Percentage-ofCompletion Accounting
34
2004
Construction in Progress
1,040,000
Materials, Cash, etc.
1,040,000
To record costs incurred.
Accounts Receivable
1,000,000
Progress Billings on
Construction Contracts
1,000,000
To record billings.
Cash
800,000
Accounts Receivable
800,000
To record cash collections.
Percentage-ofCompletion Accounting
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2004
Cost of Long-Term Construction
Contracts
1,040,000
Construction in Progress
160,000
Revenue from Construction Contracts
Actual Cost 1,200,000
$3,000,000 x .40
Percentage-ofCompletion Accounting
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2005
Construction in Progress
Materials, Cash, etc.
To record costs incurred.
Accounts Receivable
Progress Billings on
Construction Contracts
To record billings.
Cash
Accounts Receivable
To record cash collections.
910,000
910,000
900,000
900,000
850,000
850,000
Percentage-ofCompletion Accounting
37
2005
Cost of Long-Term Construction
Contracts
Construction in Progress
Revenue from Long-Term
Construction Contracts
910,000
140,000
1,050,000
($3,000,000 x .75) –
$1,200,000
Percentage-ofCompletion Accounting
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2006
Construction in Progress
650,000
Materials, Cash, etc.
650,000
To record costs incurred.
Accounts Receivable
1,100,000
Progress Billings on
Construction Contracts
1,100,000
To record billings.
Cash
1,350,000
Accounts Receivable
1,350,000
To record cash collections.
Percentage-ofCompletion Accounting
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2006
Cost of Long-Term Construction
Contracts
Construction in Progress
Revenue from Long-Term
Construction Contracts
650,000
100,000
750,000
$ 3,000,000
(1,200,000)
(1,050,000)
$ 750,000
Percentage-ofCompletion Accounting
40
2006
Construction in Progress
1,040,000
160,000
910,000
140,000
650,000
100,000
3,000,000
Progress Billings on
Construction Contracts
1,000,000
900,000
1,100,000
3,000,000
Progress Billings on Construction
Contracts
3,000,000
Construction in Progress
3,000,000
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Revision of Estimates
Instead of the previous illustration, assume
that at the end of 2005, it was estimated that
the remaining cost to complete construction
was $720,000 rather than $650,000.
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Revision of Estimates
Year
Actual
Cost
Incurred
Estimated
Cost to
Complete
2004
$1,040,000
2005
910,000
Total
$1,950,000
720,000
2,670,000
73
2006
700,000
0
2,650,000
100
Total
$2,650,000
Total
Cost
$1,560,000 $2,600,000
Cost
Percentage
40
Note that expected
Items
gross
in blue
profit
changed
was $400,000
from in 2004,
$330,000 in 2005,the
andprevious
the actual
illustration.
was $350,000 in 2006.
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Revision of Estimates
The entries for 2004 would
be the same as those shown
in the previous example.
2004
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Revision of Estimates
All entries for 2005 would
be the same except for the
entry to record revenue
and cost.
2005
45
Revision of Estimates
2005
Cost of Long-Term Construction
Contracts
Construction in Progress
Revenue from Long-term
Construction Contracts
910,000
80,000
990,000
($3,000,000 x .73) –
$1,200,000
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Revision of Estimates
2006
Construction in Progress
700,000
Materials, Cash, etc.
700,000
To record costs incurred.
Accounts Receivable
1,100,000
Progress Billings on
Same
Construction Contracts
1,100,000
To record billings.
Cash
1,350,000
Accounts Receivable
1,350,000
To record cash collections. Same
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Revision of Estimates
2006
Cost of Long-Term Construction
Contracts
Construction in Progress
Revenue from Long-Term
Construction Contracts
700,000
110,000
810,000
$3,000,000
(1,200,000)
(990,000)
$ 810,000
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Revision of Estimates
2006
Construction in Progress
1,040,000
160,000
910,000
80,000
700,000
110,000
3,000,000
Progress Billings on
Construction Contracts
1,000,000
900,000
1,100,000
3,000,000
Progress Billings on Construction
Items in red are different for
Contracts
3,000,000
this illustration.
Construction in Progress
3,000,000
Anticipated Loss: Percentage-ofCompletion Method
Assume the same facts for Strong
Construction Company, except that after
2004 entries have been made, the firm
determines that the total cost will be
$3,250,000. The entries for 2004 would be
the same, but the loss must be dealt with in
2005—in addition, the $160,000 gross profit
recognized in 2004 must be eliminated.
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Anticipated Loss: Percentage-ofCompletion Method
50
2005
Cost of Long-Term Construction
Contracts
Revenue from Long-Term
Construction Contracts
Construction in Progress
910,000
600,000
410,000
To go from a $160,000 gross profit to an
anticipated $250,000 loss ($3,000,000 –
$3,250,000), the Construction in Progess
account needs to be credited $410,000.
Accounting for Long-Term
Service Contracts
Most service contracts involve three
types of costs:
(1) Initial direct costs related to obtaining
and performing initial services on the
contract.
(2) Direct costs related to performing the
various acts of service.
(3) Indirect costs related to maintaining
the organization to service the
contract.
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Accounting for Long-Term
Service Contracts
Proportional Performance Method
A correspondence school enters into 100
contracts with students for an extended
writing course. The fee for each contract is
$500, payable in advance. The initial
direct costs related to the contracts total
$5,000. Actual direct costs for lessons for
the first period are $12,000. The sales
value of the lessons completed is $24,000
(The total value of all lessons is $60,000).
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Accounting for Long-Term
Service Contracts
Receipt of fees:
Cash
50,000
Deferred Course Revenue
50,000
Initial direct costs:
Deferred Liability
Initial Costs
5,000
account
Asset account
Cash
5,000
Direct costs for lesson actually completed:
Contract Costs
Expense account 12,000
Cash
12,000
Continued
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Accounting for Long-Term
Service Contracts
Course revenue recognized:
Deferred Course Revenue
20,000
Recognized Course Revenue
20,000
Recognize contract costs from initial
direct costs:
$24,000
x $50,000
Contract Costs
2,000
$60,000
Deferred Initial costs
2,000
$24,000 x $5,000
$60,000
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Revenue Recognition After Delivery 55
of Goods or Providing Service
 Installment Sales Method: Recognizes
revenues and related expenses as cash is
received (used when collection is
somewhat uncertain). (Not to be confused with
installment sales, which utilize accrual accounting)
 Cost Recovery Method: No income is
recognized on sale until the cost of the
item sold is recovered through cash
receipts (used when collection is very
uncertain).
 Cash Method: Recognizes all expenses
immediately as incurred and all revenues
only when cash is collected.
Revenue Recognition After Delivery 56
of Goods or Providing Service
Method
Timing of Revenue
Recognition
Full Accrual
At point of sale
Installment
Sales
At collection of cash
(portion of receipt)
Cost
Recovery
At collection of cash
(after all costs have
been recovered)
Cash
At collection of cash
Treatment
of Costs
Recognized at
point of sale
Defer and match
against revenue as
cash is collected
Defer and match
against cash
receipts
Charge to expense
as incurred
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Installment Sales Method
The installment sales
method is used most
commonly in cases of
real estate sales.
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Installment Sales Method
George sells merchandise on
the installment basis.
Uncertainty of collection
makes use of the installment
method necessary. Use the
accompanying data to prepare
George’s journal entries.
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Installment Sales Method
Sales
Cost of Sales
Gross Profit
Gross Profit
Percentage
Cash Collection
2004 Sales
2005 Sales
2004
2005
$150,000
100,000
$ 50,000
$200,000
140,000
$ 60,000
33.33%
30%
$ 30,000
$ 75,000
$ 70,000
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Installment Sales Method
2004
Installment Accounts Receivable—
2004
150,000
Installment Sales
150,000
Cost of Installment Sales
Inventory
Cash
100,000
100,000
30,000
Installment Accounts
Receivable—2004
Continued
30,000
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Installment Sales Method
2004
Installment Sales
Cost of Installment Sales
Deferred Gross Profit—2004
Deferred Gross Profit—2004
Realized Gross Profit on
Installment Sales
150,000
100,000
50,000
10,000
10,000
$30,000 x 33.33%
Continued
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Installment Sales Method
2005
Installment Accounts Receivable—
2005
200,000
Installment Sales
200,000
Cost of Installment Sales
Inventory
140,000
Cash
145,000
Installment A/R—2004
Installment A/R—2005
Continued
140,000
75,000
70,000
63
Installment Sales Method
2005
Installment Sales
Cost of Installment Sales
Deferred Gross Profit—2005
200,000
140,000
60,000
Deferred Gross Profit—2004
25,000
Deferred Gross Profit—2005
21,000
Realized Gross Profit on
$75,000 x 33.33%
Installment Sales
46,000
$70,000 x 30%
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Cost Recovery Method
Revenue
Recovered
Cost
Cost
Assume George has to
use the cost recovery
method, but all sales
and collections remain
the same.
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Cost Recovery Method
2005
All entries are the same except do not
book the entry to gross profit.
Deferred Gross Profit—2004
Realized Gross Profit on
Installment Sales
5,000
5,000
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Cost Recovery Method
2006
Deferred Gross Profit—2004
Deferred Gross Profit—2005
Realized Gross Profit on
Installment Sales
30,000
10,000
40,000
67
Cash Method
If the probability of
recovering product or
service costs is remote the
cost recovery method of
accounting can be used.
There has to be
considerable uncertainty as
to ultimate collection of the
contract price.
chapter 8
The End
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