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Income Recognition and Measurement of Net Assets

C. 17. hapter. Income Recognition and Measurement of Net Assets. An electronic presentation by Douglas Cloud Pepperdine University. Objectives. 1. Understand the revenue recognition alternatives.

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Income Recognition and Measurement of Net Assets

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  1. C 17 hapter Income Recognition and Measurement of Net Assets An electronic presentation by Douglas Cloud Pepperdine University

  2. Objectives 1.Understand the revenue recognition alternatives. 2. Explain revenue recognition at the time of sale, during production, and at time of cash receipt. 3. Explain the conceptual issues regarding revenue recognition alternatives. Continued

  3. Objectives 4. Describe the alternative revenue recognition methods. 5. Account for revenue recognition prior to the period of sale, including the percentage-of-completion and completed contract methods. Continued

  4. Objectives 6. Account for revenue recognition after the period of sale, including the installment and cost recovery methods. 7. Account for revenue recognition delayed until a future event occurs. 8.Understand software revenue recognition, franchises, real estate sales, retail land sales, and consignment sales.

  5. Revenue Recognition Recognition is the process of formally recording and reporting items in the financial statements.

  6. Revenue Recognition Realization is the process of converting noncash recourses into cash or rights to cash.

  7. Revenue Recognition Example 1: Revenue Recognition at Time of Sale 1. Ringwood Company manufactures the inventory. Inventory 100 Cash 100 2. Ringwood sells the inventory for $150. Accounts Receivable 150 Revenue 150 Cost of Goods Sold 100 Inventory 100 Continued

  8. Income Statement Revenue$150 Cost of goods sold (100 ) Gross profit $ 50 Revenue Recognition Example 1: Revenue Recognition at Time of Sale 3. Ringwood collects cash of $60. Cash 60 Accounts Receivable 60

  9. 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. Production Expense 100 Inventory 50 Revenue 150 Continued

  10. 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 60 Accounts Receivable 60

  11. The balance sheet shows Inventory of $150, less Partial Billings of $130. Revenue Recognition Example 2: Revenue Recognition During Production Income Statement Revenue$150 Production expense (100 ) Gross profit $ 50

  12. 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 Continued

  13. Revenue Recognition Example 3: Revenue Recognition at Time of Cash Receipt 3. Ringwood collects cash of $60. Cash 60 Accounts Receivable 60 ($60 ÷ $150) x $100 4. The company recognizes revenue on the basis of the cash received. Cost of Goods Sold 40 Deferred Gross Profit 20 Revenue 60 Cash Received Continued

  14. The balance sheet shows Accounts Receivable of $90, less Deferred Gross Profit of $30. Revenue Recognition Example 3: Revenue Recognition at Time of Cash Receipt Income Statement Revenue$ 60 Cost of goods sold (40 ) Gross profit $ 20

  15. Conceptual Issues 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.

  16. Alternative Revenue Recognition Methods 1. Revenue recognition in the period of sale. 2. Revenue recognition prior to the period of sale. 3. Revenue recognition at the completion of production. 4.Revenue recognition after the period of sale. 5. Revenue recognition delayed until a future event.

  17. Earned and Realizable Collectibility is Reasonably Assured Collectibility is Not Reasonably Assured Not Sufficient Transfer of Risks and Benefits of Ownership Economic Substance and Transfer of Risks and Benefits of Ownership Cost Recovery Method Recognition at Physical Transfer Deposit Method Recognition before Physical Transfer Installment Method Percentage-of-Completion Method (for Long-Term Contracts) Completed-Contract Method (for Long-Term Contracts) Accrual Method: “Normal” Revenue Recognition at Sale Revenue Recognized

  18. Advantages 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.

  19. 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:

  20. 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.

  21. Percentage-of-Completion Method …for short-term contract, and when there are inherent hazards in the contract beyond the normal business risks for which reasonably dependable estimates cannot be made. The Statement also requires that a company use the completed-contract method only when at least one of these conditions is not met...

  22. Percentage-of-Completion Method Example 2004 2005 2006 Construction costs incurred during the year $100,000 $186,000 $314,000 Estimated costs to complete the contract 400,000 264,000 --- Partial billing to customer 80,000 350,000 270,000 Collections from customer 50,000 330,000 320,000 Total contract price: $700,000 Continued

  23. Percentage-of-Completion Method 2004 1. To record construction costs: Construction in Progress 100,000 Accounts Payable, etc. 100,000 2. To record partial billings: Accounts Receivable 80,000 Partial Billings 80,000 3. To record collections: Cash 50,000 Accounts Receivable 50,000 Continued

  24. ($100,000 ÷ $500,000) x $700,000 Percentage-of-Completion Method 2004 4. To record gross profit: Construction Expense 100,000 Construction in Progress 40,000 Construction Revenue 140,000 Continued

  25. Percentage-of-Completion Method 2005 1. To record construction costs: Construction in Progress 186,000 Accounts Payable, etc. 186,000 2. To record partial billings: Accounts Receivable 350,000 Partial Billings 350,000 3. To record collections: Cash 330,000 Accounts Receivable 330,000 Continued

  26. [($286,000 ÷ $550,000) x $700,000] – $140,000 Previous year’s construction revenue Construction costs incurred to date Revised cost = $286,000 + $264,000 Percentage-of-Completion Method 2005 4. To record gross profit: Construction Expense 186,000 Construction in Progress 38,000 Construction Revenue 224,000 Continued

  27. Percentage-of-Completion Method 2006 1. To record construction costs: Construction in Progress 314,000 Accounts Payable, etc. 314,000 2. To record partial billings: Accounts Receivable 270,000 Partial Billings 270,000 3. To record collections: Cash 320,000 Accounts Receivable 320,000 Continued

  28. $700,000 – $140,000 – $224,000 Recognized in 2005 Recognized in 2004 Percentage-of-Completion Method 2006 4. To record gross profit and close out accounts: Construction Expense 314,000 Construction in Progress 22,000 Construction Revenue 336,000 Partial Billings 700,000 Construction in Progress 700,000

  29. 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 2006. Continued

  30. $100,000 + $186,000 + $314,000 Completed-Contract Method 2006 4. To record gross profit and close out accounts: Partial Billings 700,000 Construction Revenue 700,000 Construction Expense 600,000 Construction in Progress 600,000

  31. Capitalized Interest If interest cost is associated with the funds used in the construction, the firm should include this cost in the Construction in Process account.

  32. Installment Method Installment sales involve a financing agreement whereby the customer signs a contract,... …and agrees to make periodic payments over an extended period, often several years. ...makes a small down payment,...

  33. Installment Method 1. 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. Continued

  34. 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.

  35. Installment Method Consider the following information for Lee for 2004: 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 Continued Lee Company uses a perpetual inventory method.

  36. Accounts Receivable 500,000 Sales 500,000 Cost of Goods Sold 390,000 Inventory 390,000 Installment Method Credit sales during 2004: Collected $300,000; $20,000 related to installment sales: Cash 320,000 Accounts Receivable 320,000 Continued

  37. Installment Method Installment sales and related cost of goods soldidentified and “reversed” on December 31, 2004: Sales 100,000 Cost of Goods Sold 75,000 Deferred Gross Profit, 2004 25,000 Recognized a gross profit of 25% of cash collected oninstallment sales on December 31, 2004: Deferred Gross Profit, 2004 5,000 Gross Profit Realized on Installment Method Sales 5,000 Continued

  38. Installment Method Consider the following information for Lee for 2005: 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: 2004 sales 30,000 2005 sales 40,000 Cash receipts on other credit sales 480,000 Continued

  39. Accounts Receivable 600,000 Sales 600,000 Cost of Goods Sold 430,000 Inventory 430,000 Installment Method Credit sales during 2005: Collected $550,000; $70,000 related to installment sales: Cash 550,000 Accounts Receivable 550,000 Continued

  40. Installment Method Installment sales and related cost of goods soldidentified and “reversed on December 31, 2005: Sales 150,000 Cost of Goods Sold 105,000 Deferred Gross Profit, 2005 45,000 Continued

  41. Installment Method On December 31, 2005, recognized a gross profit of 25% of cash collected oninstallment sales for 2004 and 30% for 2005: Deferred Gross Profit, 2004 7,500 Deferred Gross Profit, 2005 12,000 Gross Profit Realized on Installment Method Sales 19,500

  42. 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.

  43. 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: 2004 5,000 2005 9,000 2006 6,000

  44. Cost Recovery Method During 2004 Accounts Receivable 20,000 Deferred Gross Profit 8,000 Property (net) 12,000 Collected $5,000 Cash 5,000 Accounts Receivable 5,000 Continued

  45. ($5,000 + $9,000) minus property cost of $12,000 Cost Recovery Method During 2005 Cash 9,000 Accounts Receivable 9,000 December 31, 2005 Deferred Gross Profit 2,000 Gross Profit Realized on Cost Recovery Transactions 2,000 Continued

  46. Cost Recovery Method During 2006 Cash 6,000 Accounts Receivable 6,000 December 31, 2006 Deferred Gross Profit 6,000 Gross Profit Realized on Cost Recovery Transactions 6,000 The cash collected in 2006 results in the recognition of an equal amount of gross profit.

  47. Revenue Recognition Delayed Until 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.

  48. liability 10% x $6,500,000 Revenue Recognition Delayed Until a Future Event Occurs (Deposit Method) 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 Gain 2,000,000 Net Assets of Subsidiary 5,000,000 $7,000,000 – $5,000,000

  49. 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.

  50. 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.

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