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Fin. Accounting I - Session 16

Fin. Accounting I - Session 16. William F. Bentz. Accounting & MIS. Revenue Allocation.

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Fin. Accounting I - Session 16

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  1. Fin. Accounting I - Session 16 William F. Bentz Accounting & MIS A&MIS 521

  2. Revenue Allocation • In selected circumstances, revenue is recognized over 2 or more accounting periods. In many such cases, revenue is allocated in a manner that results in either a uniform gross margin, or in a uniform rate of return. We will use both methods. A&MIS 521

  3. Revenue Allocation • Uniform gross margin method % is used for • construction contracts • warranty contracts • software development contracts • installment sales (limited use) A&MIS 521

  4. Revenue Allocation • Uniform rate-of-return method are used for • interest income (A&MIS 522, investments) • interest method of depreciation (chapter 5) A&MIS 521

  5. Uniform Gross Margin % • For the gross margin percentage to be truly uniform, revenues and costs must be equal to the amounts forecast. • However, if one is able to forecast the revenues and the associated costs with acceptable accuracy, the intermediate reported results will be informative. The threshold for reasonable accuracy is a matter of professional judgement. A&MIS 521

  6. Uniform Gross Margin % • This method is implemented by multiplying the total amount of revenue to be allocated by the proportion of the costs incurred to date to the total estimated costs. Consider the warranty problem Bentley’s. A&MIS 521

  7. Bentley’s • Price of a warranty contract - $2,000 (constant) • Projected warranty costs per contract - $1,200 • Projected gross margin - $800 [$2,000 - $1,200] • Term of contract - five years A&MIS 521

  8. Bentley’s • Forecast of annual costs per contract: Year 1 - $ 100 Year 2 - 150 Year 3 - 250 Year 4 - 300 Year 5 - 400 Total $1,200 A&MIS 521

  9. Proportion of cost incurred: • Cumulative proportion to date: Y1: $100/$1,200 = 0.0833 Y2: [$100 + $150]/$1,200 = 0.2083 Y3: [$100 + 150 + 250]/$1,200 = 0.4167 Y4: [$100 + 150 +250 + 300]/$1,200 = 0.6667 Y5: $1,200/$1,200 = 1.0 A&MIS 521

  10. Cumulative revenue earned • Cumulative revenue by year: Y1: 0.0833 × $2,000 = $ 166.67 Y2: 0.2083 × $2,000 = $ 416.67 Y3: 0.4167 × $2,000 = $ 833.33 Y4: 0.6667 × $2,000 = $1,333.33 Y5: 1.0000 × $2,000 = $2,000.00 A&MIS 521

  11. Cumulative revenue earned • Cumulative proportion of revenue earned (CPRE) = cumulative proportion of the cost incurred to the total (forecast) cost • CPRE(0 d) = Total cost incurred to date (0 d)/Total cost forecasted (0 n) for a contract beginning at t = 0 and ending at t = n A&MIS 521

  12. 0 d n CPRE Total = 1.0 A&MIS 521

  13. Annual Revenue Y1: $ 166.67 - 0 = $ 166.67 Y2: $ 416.67 - 166.67 = 250.00 Y3: $ 833.33 - 416.67 = 416.66 Y4: $1,333.33 - 833.33 = 500.00 Y5: $2,000.00 - 1,333.33 = 667.67 Total $2,000.00 A&MIS 521

  14. Go to Workbook Pages A&MIS 521

  15. Revenue Recognition - Long-term Contracts • Objective: To recognize revenue period-by-period as the revenue from a long-term contract is earned. The key criteria for revenue recognition are still: • Earning of the revenue • Realization/estimation of doubtful accounts • Reasonably estimable costs A&MIS 521

  16. Consider the Issue of Collection • Realization is deemed to have occurred if the seller has received a valid claim to a determinable amount of money subject to reasonable payment terms by a buyer that is capable of paying the amount due. A&MIS 521

  17. Revenue Recognition Methods • Revenue is recognized on long-term projects on one of two bases: • Completed contract method • Percentage-of-completion method • Annual revenues, expenses, income, and asset values are affected by the choice of method. A&MIS 521

  18. Revenue Recognition Methods • With the completed contract method, project costs are accumulated in a Construction-in-Process account. The cumulative cost is matched against revenues when the contract is completed. The amount of revenue recognized is the final contract price. A&MIS 521

  19. Revenue Recognition Methods • With the percentage-of-completion method, a portion of the total contract price is recognized each period. That portion is the percentage of the work completed to date, less the revenue already recognized. A&MIS 521

  20. Percentage-of-completion • To use the percentage-of-completion method, one must have some way of determining the percentage of completion for each project! The percentage of the costs incurred relative to total expected project cost is the measure used. A&MIS 521

  21. Calculating the Percent Cumulative cost Cumulative incurred to date % complete = Total Expected project cost A&MIS 521

  22. Example Co. Contract Cumulative Cumulative Annual Date Price Cost Revenue Revenue 12/00 $70,000 $20,000 $23,333 $23,333 12/01 70,000 40,000 46,666 23,333 12/02 70,000 60,000 70,000 23,334 Total $70,000 A&MIS 521

  23. Example Co. (B) Cumulative Estimated Cumulative Annual Date Cost Tot. Cost Revenue* Revenue 12/00 $15,000 $60,000 $17,500 $17,500 12/01 35,000 60,000 40,833 23,333 12/02 59,000 59,000 70,000 29,167 Total $70,000 *Contract price is $70,000 ‘98: (15,000/60,000) x $70,000 = 17,500 ‘99: (35,000/60,000) x $70,000 - $17,500 = $23,333 ‘00: $70,000 - $17,500 - $23,333 = $29,167 A&MIS 521

  24. Example Co. (B) Annual Annual Gross Margin Date Revenue Cons. Cost Margin % 12/98 $17,500 $15,000 $ 2,500 14.3% 12/99 23,333 20,000 3,333 14.3% 12/00 29,167 24,000 5,167 17.7% Total $70,000 $59,000 $11,000 *Contract price is $70,000 A&MIS 521

  25. Revenue Recognition For our purposes, the percentage completion method of recognizing revenue is applied the same way regardless of the profitability of the contract, or the timing of the contract billings and cash collections. The method is effort (cost) driven. A&MIS 521

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