Chapter 9
Income, expenses and profits
1. Apply the revenue recognition principle.
2. Describe accounting issues for revenue recognition at
point of sale.
3. Apply the percentage-of-completion method for longterm contracts.
4. Apply the completed-contract method for long-term
contracts.
5. Identify the proper accounting for losses on long-term
contracts.
6. Describe the installment-sales method of accounting.
7. Explain the cost-recovery method of accounting.
Concepts

Revenues
Inflows of assets or settlements of liabilities
during a period from delivering or producing
goods or services.

Expenses
Outflows of assets or incurrence of liabilities
during a period from delivering or producing
goods or services.
Revenue Recognition
Recognition is the
process of formally
recording and
reporting items in the
financial statements.
Revenue Recognition




Definition
Is the item an asset, liability, equity, revenue,
expense, gain, or loss?
Measurability
Does it possess the attributes that permit reliable
measurement?
Relevance
Will it make a difference to the decision maker?
Reliability
Is it a faithful representation?
Revenue Recognition

Revenue should be recognized in the financial
statement when . . .
It is earned, and
It is realized or realizable.
Revenue Recognition



Revenue is earned when the earnings process is
completed or virtually completed.
Revenue is realized when cash is received.
Revenue is realizable when claims to cash are
received that can be converted into a known amount
of cash.
Revenue Recognition
The decision as to when to recognize revenue focuses on
three factors:

The economic substance of the event takes precedence
over the legal form of the transaction.

The risks and benefits of ownership have been transferred
to the buyer.

The collectibility of the receivable from the sale is
reasonably assured.
Revenue Recognition
Revenue recognized

At delivery (point of sale)

After delivery

Before delivery
of product or service
Revenue Recognition
Point of Sale



Revenue is earned and realized at the point of sale.
The product or service has been delivered to the
customer and cash has been received or is
receivable.
This method is sometimes called the “sales
method”or “delivery method.”
Revenue Recognition Before Delivery

Accounting for long-term construction contracts
Completed-Contract Method
Percentage-of-Completion Method
Revenue Recognition Before Delivery

Percentage-of-completion method is appropriate
when . . .
-- Contract specifies the amount of consideration to
be exchanged and the terms of settlement.
-- Buyer is expected to satisfy the obligation.
-- Contractor can perform according to the terms of
the contract.
Measuring Progress Toward Completion

Input Measures
Effort devoted to project compared to total effort
expected (cost incurred to date compared to total
estimated costs)

Output Measures
Results to date compared to total results
Measuring Progress Toward Completion
Cost-to-Cost Method
Total costs incurred to date
Percent complete =
Most recent estimate of total
costs of the project
Measuring Progress Toward Completion
Cost-to-Cost Method
Current Period Revenue
Total Revenue from Contract
×
Percent Complete
Total Revenue to Recognize
- Revenue Recognized in Prior Periods
Revenue Recognized in Current Period
Illustration:
Casper Construction Co.
Contract price
Cost incurred current year
Estimated cost to complete
in future years
Billings to customer current year
Cash receipts from customer
Current year
2007
$675,000
150,000
2008
$675,000
287,400
2009
$675,000
170,100
450,000
135,000
170,100
360,000
0
180,000
112,500
262,500
300,000
A) Prepare the journal entries for 2007, 2008, and 2009.
Illustration:
2007
$ 150,000
450,000
600,000
25.0%
675,000
168,750
Costs incurred to date
Estimated cost to complete
Est. total contract costs
Est. percentage complete
Contract price
Revenue recognizable
Rev. recognized prior year
Rev. recognized currently
168,750
Costs incurred currently
(150,000)
Income recognized currently $ 18,750
$
$
2008
437,400
170,100
607,500
72.0%
675,000
486,000
(168,750)
317,250
(287,400)
29,850
2009
$ 607,500
607,500
100.0%
675,000
675,000
(486,000)
189,000
(170,100)
$
18,900
Illustration:
2007
150,000
150,000
2008
287,400
287,400
2009
170,100
170,100
Accounts receivable
Billings on contract
135,000
360,000
180,000
Cash
Accounts receivable
112,500
Construction in progress
Construction expense
Construction revenue
18,750
150,000
Construction in progress
Cash
Billings on contract
Construction in progress
135,000
360,000
262,500
112,500
300,000
262,500
29,850
287,400
168,750
180,000
300,000
18,900
170,100
317,250
189,000
675,000
675,000
Illustration:
Income Statement
Revenue on contracts
Cost of construction
Gross profit
Balance Sheet (12/31)
Current assets:
Accounts receivable
Cost & profits > billings
Current liabilities:
Billings > cost & profits
2007
$ 168,750
150,000
18,750
2008
$ 317,250
287,400
29,850
22,500
33,750
120,000
9,000
2009
$ 189,000
170,100
18,900
-
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.
Illustration:
2007
150,000
150,000
2008
287,400
287,400
2009
170,100
170,100
Accounts receivable
Billings on contract
135,000
360,000
180,000
Cash
Accounts receivable
112,500
Construction in progress
Cash
135,000
360,000
262,500
112,500
180,000
300,000
262,500
300,000
Construction in progress
Construction expense
Construction revenue
67,500
607,500
Billings on contract
Construction in progress
675,000
675,000
675,000
Illustration:
Income Statement
Revenue on contracts
Cost of construction
Gross profit
Balance Sheet (12/31)
Current assets:
Accounts receivable
Cost & profits > billings
Current liabilities:
Billings > cost & profits
2007
$
-
22,500
15,000
2008
$
-
120,000
57,600
2009
$ 675,000
607,500
67,500
-
Two Methods:
Loss in the Current Period on a Profitable Contract
 Percentage-of-completion method only, the estimated
cost increase requires a current-period adjustment of
gross profit recognized in prior periods.
Loss on an Unprofitable Contract
 Under both percentage-of-completion and completed-
contract methods, the company must recognize in the
current period the entire expected contract loss.
Illustration: Loss on Profitable Contract
Casper Construction Co.
Contract price
Cost incurred current year
Estimated cost to complete
in future years
Billings to customer current year
Cash receipts from customer
Current year
2007
$675,000
150,000
2008
$675,000
287,400
2009
$675,000
215,436
450,000
135,000
215,436
360,000
0
180,000
112,500
262,500
300,000
b) Prepare the journal entries for 2007, 2008, and 2009 assuming the estimated cost to
complete at the end of 2008 was $215,436 instead of $170,100.
Illustration: Loss on Profitable Contract
Costs incurred to date
Estimated cost to complete
Est. total contract costs
Est. percentage complete
Contract price
Revenue recognizable
Rev. recognized prior year
Rev. recognized currently
Costs incurred currently
Income recognized currently
2007
$ 150,000 $
450,000
600,000
25.0%
675,000
168,750
168,750
(150,000)
$ 18,750 $
2008
437,400
215,436
652,836
67.0%
675,000
452,250
(168,750)
283,500
(287,400)
(3,900)
2009
$ 652,836
652,836
100.0%
675,000
675,000
(452,250)
222,750
(215,436)
$
7,314
Illustration: Loss on Profitable Contract
2007
Construction in progress
Construction expense
Construction revenue
Construction in progress
Construction expense
Construction revenue
2008
2009
18,750
150,000
7,314
215,436
168,750
222,750
3,900
287,400
283,500
Illustration: Loss on Unprofitable Contract
Casper Construction Co.
Contract price
Cost incurred current year
Estimated cost to complete
in future years
Billings to customer current year
Cash receipts from customer
Current year
2007
$675,000
150,000
2008
$675,000
287,400
2009
$675,000
246,038
450,000
135,000
246,038
360,000
0
180,000
112,500
262,500
300,000
c) Prepare the journal entries for 2007, 2008, and 2009 assuming the
estimated cost to complete at the end of 2008 was $246,038 instead of
$170,100.
Illustration: Loss on Unprofitable Contract
Costs incurred to date
Estimated cost to complete
Est. total contract costs
Est. percentage complete
Contract price
Revenue recognizable
Rev. recognized prior year
Rev. recognized currently
Costs incurred currently
Income recognized currently
2007
$ 150,000 $
450,000
600,000
25.0%
675,000
168,750
2008
437,400
246,038
683,438
64.0%
675,000
432,000
(168,750)
168,750 Plug 263,250
(150,000)
(290,438)
$ 18,750 $
(27,188)
2009
$ 683,438
683,438
100.0%
675,000
675,000
(432,000)
243,000
(243,000)
$
-
$683,438 – 678,500 = 8,438 cumulative loss
Illustration: Loss on Unprofitable Contract
2007
Construction in progress
Construction expense
Construction revenue
Construction in progress
Construction expense
Construction revenue
2008
2009
18,750
150,000
243,000
168,750
243,000
27,188
290,438
263,250
Illustration: Loss on Unprofitable Contract
For the Completed-Contract method, companies would
recognize the following loss :
2007
Loss on construction contract
Construction in progress
2008
2009
8,438
8,438
Revenue Recognition
After Delivery

Product-financing arrangements.

Sale with right of return.

Collectibility of revenue is highly uncertain.
Product-Financing Arrangements



An agreement in which a sponsoring company sells a product to
another company and in a related transaction agrees to
repurchase the product.
The sponsoring company
-- Records a liability when the proceeds are received.
-- No sale is recorded and inventory is not adjusted.
Wait for a sale to outside party.
Right of Return
In some industries it is common practice that the
sales terms allow customers the right to return
goods under specified conditions and over long
periods of time.
Book Publishing
Equipment
Manufacturing
Right of Return
Recognize revenue at point of sale if,
Selling price is fixed or determinable.
Buyer is obligated to pay the seller and payment is
not contingent upon resale of the product.
Buyer is obligated even in case of theft or physical
destruction.
Buyer has economic substance apart from that
provided by the seller.
Seller has no obligation for future performance.
Future returns can be estimated.
Installment Sales


When we are uncertain about the collectibility of the
sales revenue, we should defer revenue recognition.
Two commonly used accounting methods are the . . .
Installment sales method.
Cost recovery method.
Installment Sales

Installment Sales Method
Sale and cost of sale recorded as usual.
Compute gross margin rate on the installment sales.
Recognize gross margin as cash is received.
Gross margin not realized is deferred until a future
period.
Installment Sales
Example
Sam’s Appliances made sales of $200,000 in 2005
that qualified for the installment sales method of
accounting. The items sold have a cost to Sam’s of
$130,000. During 2005, Sam’s collected cash from
installment customers of $90,000. The remaining
amount will be collected in 2006.
Prepare the journal entries to record the installment
sales transactions during 2005.
Installment Sales
Example
Sam's Appliances
Installment Sales
Dollars
Percent
Installment sales revenue $ 200,000
100%
Cost of goods sold
130,000
65%
Gross margin
$ 70,000
35%
Installment Sales
Example
GENERAL JOURNAL
Date
Description
Installment Accounts Receivable
Installment Revenue
Page 34
Post.
Ref.
Debit
Credit
200,000
200,000
Installment Sales
Example
GENERAL JOURNAL
Date
Description
Installment Accounts Receivable
Page 34
Post.
Ref.
Debit
200,000
Installment Revenue
Cost of Installment Sales
Inventory
Credit
200,000
130,000
130,000
Installment Sales
Example
GENERAL JOURNAL
Date
Description
Cash
Installment Accounts Receivable
Page 34
Post.
Ref.
Debit
Credit
90,000
90,000
Installment Sales
Example
GENERAL JOURNAL
Date
Description
Installment Revenue
Cost of Installment Sales
Deferred Gross Margin
Page 34
Post.
Ref.
Debit
Credit
200,000
130,000
70,000
Installment Sales
Example
GENERAL JOURNAL
Date
Description
Installment Revenue
Page 34
Post.
Ref.
Debit
200,000
Cost of Installment Sales
130,000
Deferred Gross Margin
Deferred Gross Margin
Realized Gross Margin
Credit
70,000
31,500
31,500
Installment Sales
Example
GENERAL JOURNAL
Date
Description
Installment Revenue
Page 34
Post.
Ref.
Debit
Credit
200,000
Cost of Installment Sales
130,000
Deferred Gross Margin
Deferred Gross Margin
70,000
31,500
Realized Gross Margin
Cash collection in 2005
Gross margin percentage
Gross profit to recognize
31,500
$90,000
×
35%
$31,500
Installment Sales
Example
Balance Sheet
Installment accounts receivable
$ 110,000
Less: Deferred gross margin
38,500
Net Installment accounts receivable $ 71,500
Installment Sales
Example
Balance Sheet
Installment accounts receivable
$ 110,000
Less: Deferred gross margin
38,500
Net Installment accounts receivable $ 71,500
Installment accounts receivable
Less: Cash collections
Installment accounts receivable
$ 200,000
(90,000)
$ 110,000
Deferred gross margin
Less: Gross margin recognized
Deferred gross margin
$ 70,000
(31,500)
$ 38,500
Cost Recovery Method


Like the installment sales method, cost recovery is
used when we are uncertain about the collectibility
of the sales revenue.
No profit is recognized until cost of item sold is
fully recovered.
Cost Recovery Method
Example
Sam’s Appliances made sales of $200,000 in 2005 that
qualified for the cost recovery method of accounting.
The items sold have a cost to Sam’s of $130,000.
During 2005, Sam’s collected cash from installment
customers of $90,000. The remaining amount will be
collected in 2006.
Prepare the journal entries to record the installment
sales transactions during 2005.
Cost Recovery Method
Example
GENERAL JOURNAL
Date
Description
Installment Accounts Receivable
Installment Revenue
Page 34
Post.
Ref.
Debit
Credit
200,000
200,000
Cost Recovery Method
Example
GENERAL JOURNAL
Date
Description
Installment Accounts Receivable
Page 34
Post.
Ref.
Debit
200,000
Installment Revenue
Cost of Installment Sales
Inventory
Credit
200,000
130,000
130,000
Cost Recovery Method
Example
GENERAL JOURNAL
Date
Description
Installment Revenue
Cost of Installment Sales
Deferred Gross Margin
Page 34
Post.
Ref.
Debit
Credit
200,000
130,000
70,000
Cost Recovery Method
Example
GENERAL JOURNAL
Date
Description
Cash
Installment Accounts Receivable
Page 34
Post.
Ref.
Debit
Credit
90,000
90,000
No profit is recognized in 2005 because the cost of the
item sold ($130,000) has not been recovered in the
form of cash receipts. Once we collect $130,000 in
cash, profit recognition begins.
Cost Recovery Method
Example
Balance Sheet
Installment accounts receivable
$ 110,000
Less: Deferred gross margin
(70,000)
Net Installment accounts receivable $ 40,000
All gross profit has been deferred until we recover the
$130,000 cost of the item sold.
Revenue Recognition Before Delivery

Completion of Production

Accretion Basis

Discovery Basis
Revenue Recognition for Service Sales

Specific Performance Method

Proportional Performance Method

Completed Performance Method

Collection
Specific Performance

Used to account for revenue that is earned by
performing a single act.
Franchise revenue (SFAS No. 45)
Bob’s
Burgers
Proportional Performance

Used to recognize service revenue that is earned
by more than a single act and when the service
is rendered in more than one accounting period.
Similar performance acts - equal amount for
each act
Dissimilar performance acts - in proportion to
direct costs of each act
Similar acts with a fixed period for performance
Completed Performance
Used when revenue is earned by performing a series
of acts, and the last act is so important that revenue
is only considered earned if it is performed.
Collection


Used to account for service revenue when the
uncertainty of collection is very high.
Revenue recognized when cash is received.
Chapter9
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