Chapter18
Income Recognition and
Measurement of Assets
Intermediate Accounting 10th edition
Nikolai Bazley Jones
An electronic presentation
by Norman Sunderman
Angelo State University
COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation.
Thomson, the Star logo, and South-Western are trademarks used herein under license.
2
Revenue Recognition
Recognition is the
process of formally
recording and
reporting items in the
financial statements.
3
Revenue Recognition
Realization is the
process of converting
noncash recourses
into cash or rights to
cash.
4
Revenue Recognition
Example 1: Revenue Recognition at Time of Sale
1. Ringwood Company manufactures the
inventory.
Inventory
100
Cash
2. Ringwood sells the inventory for $150.
Accounts Receivable
Revenue
Cost of Goods Sold
Inventory
100
150
150
100
100
5
Revenue Recognition
Example 1: Revenue Recognition at Time of Sale
3. Ringwood collects cash of $60.
Cash
Accounts Receivable
60
60
Income Statement
Revenue
Cost of goods sold
Gross profit
$150
(100)
$ 50
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Revenue Recognition
Example 2: Revenue Recognition During Production
1. Ringwood Company manufactures the inventory.
Inventory
100
Cash
100
2. Ringwood recognizes the revenue during production
(the manufacturing process).
Production Expense
100
Inventory
50
Revenue
150
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Revenue Recognition
Example 2: Revenue Recognition During Production
3. The company bills the customer for a partial
billing of $130.
Accounts Receivable
130
Partial Billings
130
4. Ringwood collects cash of $60.
Cash
Accounts Receivable
60
60
8
Revenue Recognition
Example 2: Revenue Recognition During Production
Income Statement
Revenue
Production expense
Gross profit
$150
(100)
$ 50
The balance sheet shows Inventory of
$150, less Partial Billings of $130.
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Revenue Recognition
Example 3: Revenue Recognition at Time of Cash Receipt
1. Ringwood Company manufactures the
inventory.
Inventory
100
Cash
100
2. Ringwood “sells” the inventory and defers the
recognition of revenue.
Accounts Receivable
150
Inventory
100
Deferred Gross Profit
50
10
Revenue Recognition
Example 3: Revenue Recognition at Time of Cash Receipt
3. Ringwood collects cash of $60.
Cash
60
Accounts Receivable
($60 ÷ $150) x60
4. The company recognizes revenue on the
basis of the
$100
cash received.
Cost of Goods Sold
40
Deferred Gross Profit
20
Revenue
60
11
Revenue Recognition
Example 3: Revenue Recognition at Time of Cash Receipt
Income Statement
Revenue
Cost of goods sold
Gross profit
$ 60
(40)
$ 20
The balance sheet shows Accounts Receivable of
$90, less Deferred Gross Profit of $30.
12
Alternative Revenue Recognition
Methods
1.
2.
3.
4.
5.
Revenue recognition in the period of sale.
Revenue recognition prior to the period of
sale.
Revenue recognition at the completion of
production.
Revenue recognition after the period of sale.
Revenue recognition delayed until a future
event.
13
Revenue Recognized
Earned and
Realizable
Not Sufficient
Economic Substance
Transfer of Risks and Transfer of Risks
and Benefits of
and Benefits of
Ownership
Ownership
Deposit
Method
Collectibility is
Reasonably
Assured
Collectibility is
Not
Reasonably
Assured
Recognition before Recognition at Installment
Physical Transfer Physical Transfer Method
Percentage-ofCompletion Method
(for Long-Term
Contracts)
CompletedContract
Method (for
Long-Term
Contracts)
Cost
Recovery
Method
Accrual Method:
“Normal”
Revenue
Recognition at
Sale
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Revenue Recognition Prior to the
Period of Sale
Percentage-of-Completion Method
 It achieves the goals of accrual
accounting.
 It is consistent with the argument
that revenue is earned
continuously over the entire
earning process.
 It results in a more relevant
measure of periodic income.
15
Percentage of Completion
Method
AICPA Statement of Position No. 81-1
requires that a construction company use
the percentage-of-completion method for
long-term contracts when all the following
conditions are met:
16
Percentage of Completion
Method
1. The company can make reasonably dependable
estimates of the extent of progress toward
completion, contract revenue, and contract costs.
2. The contract clearly specifies the enforceable rights
regarding goods or services to be provided and
received by both the company and the buyer, the
consideration to be exchanged, and the manner and
terms of settlement.
3. The buyer can be expected to satisfy its obligations
under the contract.
4. The company expects to perform its contractual
obligations.
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Percentage of Completion
Method
…for
a short-term
contract, and
The
Statement also
when
there
areainherent
requires
that
companyhazards
contract beyond the
use in
thethe
completed-contract
normal business
risks
for which
method
only when
at least
reasonably
dependable
one of these
conditionsestimates
is
cannot
be made.
not met...
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Completed Contract Method
Entries 1, 2, and 3 are the same as those
used for the percentage-of-completion
method. The completed-contract
method does not recognize revenue until
the project is completed, so there is no
Entry 4 until 2009.
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Capitalized Interest
If interest cost is associated with
the funds used in the
construction, the firm should
include this cost in the
Construction in Progress account.
20
Proportional Performance
Contracts
 Used to recognize service revenue earned by
performing more than one act if services are to be
rendered in more than one accounting period.
 Types of service transactions
 Similar performance acts-recognize an equal
amount of revenue for each act
 Dissimilar performance acts-recognize revenue in
proportion to direct costs to perform each act.
 Similar acts with a fixed period for performancerecognize revenue using straight-line method
21
Proportional Performance
Contracts
Revenue
allocate using
percentage of direct
costs
Initial direct costs allocate using
percentage of direct
costs
Direct costs
expense as incurred
Indirect costs
expense as incurred
22
Installment Method
Installment sales involve
a financing agreement
whereby the customer
signs a contract,...
...makes a small
down payment,...
23
Installment Method
…and agrees to make
periodic payments over
an extended period,
often several years.
24
Revenue Recognized at
Collection
Two methods employed to defer revenue recognition
until cash is received are the installment sales
method and the cost recovery method. These
methods are used only when the point-of-sale or
other GAAP revenue recognition methods are not
appropriate.
These methods may be used only when there is
uncertainty about whether the sales price will be
collected and when an allowance for bad debts
cannot be reasonably estimated.
25
Installment Method
Total sales, cost of goods sold, and
collections are recorded in the normal
manner during the year.
2. At the end of the year, installment sales
are identified. The revenue and the
related cost of goods sold are
“reversed,” and the deferred gross
profit is recognized.
3. At the end of the year, the gross profit
rate on installment sales is computed.
1.
Continued
26
Installment Method
4. A portion of the deferred gross profit is
recognized as gross profit.
5. In future years the remaining deferred gross
profit is reduced and the gross profit is
recognized based on the cash collected on the
installment sales.
27
Installment Method
Consider the following information for Lee for 2007:
Total credit sales
$500,000
Total cost of goods sold
390,000
Installment method sales
100,000
Installment method cost of goods sold
75,000
Gross profit rate on installment method sales 25%
Cash receipts on installment method sales 20,000
Cash receipts on other credit sales
300,000
Lee Company uses a perpetual inventory method.
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Installment Method
Credit sales during the year 2007:
Accounts Receivable
Sales
Cost of Goods Sold
Inventory
500,000
500,000
390,000
390,000
Collected $300,000; $20,000 related to installment sales:
Cash
Accounts Receivable
Continued
320,000
320,000
29
Installment Method
Installment sales and related cost of goods sold
identified and “reversed” on December 31, 2007:
Sales (closed)
100,000
Cost of Goods Sold (closed)
75,000
Deferred Gross Profit, 2007
25,000
Recognized a gross profit of 25% of cash collected on
installment sales December 31, 2007 :
Deferred Gross Profit, 2007
5,000
Gross Profit Realized on Installment
Method Sales
5,000
30
Installment Method
Consider the following information for Lee for 2008:
Total credit sales
$600,000
Total cost of goods sold
430,000
Installment method sales
150,000
Installment method cost of goods sold
105,000
Gross profit rate on installment method sales 30%
Cash receipts on installment method sales:
2007 sales
30,000
2008 sales
40,000
Cash receipts on other credit sales
480,000
31
Installment Method
Credit sales 2008:
Accounts Receivable
Sales
Cost of Goods Sold
Inventory
600,000
600,000
430,000
430,000
Collected $550,000; $70,000 related to installment sales:
Cash
Accounts Receivable
Continued
550,000
550,000
32
Installment Method
Installment sales and related cost of goods sold
identified and “reversed” on December 31, 2008:
Sales
150,000
Cost of Goods Sold
105,000
Deferred Gross Profit, 2008
45,000
Continued
33
Installment Method
On December 31, 2008, recognized a gross profit of 25% of
cash collected on installment sales for 2007 and 30% for
2008:
Deferred Gross Profit, 2007
7,500
Deferred Gross Profit, 2008
12,000
Gross Profit Realized on Installment
Method Sales
19,500
34
Cost Recovery Method
APB Opinion No. 10 found the cost
recovery method of recognizing revenue
generally to be unacceptable. However,
the Board did agree that this method
could be used in exceptional cases where
receivables are collected over an
extended period and where the terms of
the transaction provide no reasonable
basis for estimating the degree of
collectibility.
35
Cost Recovery Method
Consider the following information for the Parken
Company:
Sale of property under cost recovery
method
$20,000
Cost of property sold (net)
12,000
Cash collections:
2007
5,000
2008
9,000
2009
6,000
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Cost Recovery Method
During 2007
Accounts Receivable
Deferred Gross Profit
Property (net)
20,000
8,000
12,000
Collected $5,000
Cash
Accounts Receivable
Continued
5,000
5,000
37
Cost Recovery Method
During 2008
Cash
Accounts Receivable
December 31, 2008
9,000
Deferred Gross Profit
Gross Profit Realized on Cost
Recovery Transactions
2,000
9,000
2,000
($5,000 + $9,000) minus
property cost of $12,000
Continued
38
Cost Recovery Method
During 2009
Cash
Accounts Receivable
December 31, 2009
6,000
Deferred Gross Profit
Gross Profit Realized on Cost
Recovery Transactions
6,000
6,000
The cash collected in 2009 results in the
recognition of an equal amount of gross
profit.
6,000
39
Revenue Recognition Delayed a
Future Event Occurs
(Deposit Method)
Oscar Company sells a subsidiary to
the Pet Company and accepts a
$500,000 down payment and a 10%
note for the balance of the sale of $7
million. The net assets of the
subsidiary are $5 million and Pet
Company has the right to cancel the
agreement for the next year.
Revenue Recognition Delayed a
Future Event Occurs
(Deposit Method)
liability
40
Upon receipt of down payment (Oscar Company):
Cash
500,000
Deposit from Purchaser
500,000
When circumstances allow the revenue to be recognized:
Interest Receivable
650,000
Note Receivable
6,500,000
Deposit from Purchaser
500,000
Interest Revenue
650,000
10% x $6,500,000
Gain
2,000,000
Net Assets of Subsidiary
5,000,000
41
Software Revenue Recognition
Guidelines of AICPA Statement of
Position No. 97-2
If a company has an agreement to deliver
software that requires significant
production, modification, or
customization of software, it uses contract
accounting for the agreement.
42
Software Revenue Recognition
Guidelines of AICPA Statement of
Position No. 97-2
If a company has an agreement to deliver
software that does not require significant
production, modification, or
customization of software, it recognizes
revenue when (a) persuasive evidence of
an agreement exists, (b) delivery has
occurred, (c) the seller’s fee is fixed or
determinable, and (d) collectibility is
probable.
43
Software Revenue Recognition
Guidelines of AICPA Statement of
Position No. 97-2
A company separately accounts for a
service element if (a) the services are not
essential to the functionality of any other
element of the transaction, and (b) the
services are stated separately in the
contract such that the total price of the
agreement would be expected to vary as
the result of inclusion or exclusion of the
service.
44
Software Revenue Recognition
Guidelines of AICPA Statement of
Position No. 97-2
Software arrangements may consist of
multiple elements such as additional
software products, upgrades and/or
enhancements, rights to exchange or
return software, and customer support.
If contract accounting does not apply, a
company must allocate its fee to the
various elements based on fair values.
45
Software Revenue Recognition
Guidelines of AICPA Statement of
Position No. 97-2
A company must allocate any discounts
proportionately to all the elements,
except that none can be allocated to
upgrade rights.
46
Franchise
A franchise agreement involves
the granting of business rights
by the franchisor to a franchisee
who will operate the franchised
business.
47
Franchise
A franchise agreement involves
the granting of business rights by
the franchisor to a franchisee
who will operate the franchised
business.
48
Franchise
Castle Company sells a franchise that
requires an initial franchise fee of
$70,000. A down payment of $20,000
cash is required, with the balance
covered by the issuance of a $50,000,
10% note, payable by the franchisee in
five equal annual installments.
49
Franchise
Situation 1: Castle has substantially performed all
material services, the refund period has expired,
and the collectibility of the note is reasonably
assured.
Cash
Notes Receivable
Franchise Revenue
20,000
50,000
70,000
50
Franchise
Situation 2: The refund period has expired and the
collectibility of the note is reasonably assured,
but Castle has not substantially performed all
material services.
Cash
Notes Receivable
Unearned Franchise Fees
20,000
50,000
70,000
Castle will recognize the unearned franchise fees as
revenue when it has performed all material
services.
51
Franchise
Situation 3: Castle has substantially performed all
material services and the collectibility of the note
is reasonably assured, but the refund period has
not expired.
Cash
Notes Receivable
Unearned Franchise Fees
20,000
50,000
70,000
Castle will recognize the unearned franchise fees as
revenue when the refund period expires.
52
Franchise
Situation 4: Castle has substantially performed all
material services and the refund period has
expired, but the collectibility of the note is not
reasonably assured.
Cash
Notes Receivable
Unearned Franchise Fees
Franchise Revenue
20,000
50,000
Each year revenue of $10,000 is
recognized as cash is collected.
50,000
20,000
53
Franchise
Situation 5: The refund period has expired, but
Castle has not substantially performed all
material services and there is no basis for
estimating the collectibility of the note.
Cash
Unearned Franchise Fees
20,000
20,000
Castle recognizes revenue either under the accrual
method (if collectibility is reasonably assured) or
the installment method (if it has no basis for
estimating the collectibility of the note).
54
Franchise
Situation 6: Castle has earned only $30,000 from
providing initial services, with the balance being
a down payment for continuing services. The
refund period has expired and collectibility of the
note is reasonably assured.
Cash
Notes Receivable
Franchise Revenue
Unearned Franchise Fees
20,000
50,000
30,000
40,000
Castle recognizes the unearned franchise fees as
revenue when it performs the continuing services.
55
Continuing Franchise Fee
Assume that Castle also charges a continuing
franchise fee of $9,000 per year.
Fee is earned by providing services
Cash
9,000
Continuing Franchise Fee Revenue
9,000
$1,000 of the fee is for National Advertising
Cash
9,000
Continuing Franchise Fee Revenue
Unearned Franchise Fees
8,000
1,000
56
Consignment Sales
Accounting for consignments may be summarized-1. Since title remains with the consignor, when
the goods are transferred from the consignor
to the consignee, the consignor does not
record the sale of inventory.
2. The consignor recognizes revenue only when
the sale to the third party occurs.
3. The consignee uses a Consignment-in
account.
4. The consignor uses a Consignment-out
account, which is a special inventory account.
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Chapter18
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