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Revenue Recognition

Revenue Recognition. Objectives of the Chapter. 1. Discuss the revenue recognition principle and the problems associated with revenue recognition at point of sale. 2. Discuss the cases that revenue is recognized at a point other than at point of sale (i.e., before delivery).

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Revenue Recognition

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  1. Revenue Recognition

  2. Objectives of the Chapter 1. Discuss the revenue recognition principle and the problems associated with revenue recognition at point of sale. 2. Discuss the cases that revenue is recognized at a point other than at point of sale (i.e., before delivery). 3. Study the percentage-of-completion method for long-term contracts. Income Measurement And Profit Analysis

  3. Objectives of the Chapter (contd.) 4. Study the completed-contract method for long-term contracts. 5. Discuss the installment method of accounting. 6. Study the accounting treatments for franchise, software sales and consignment. Income Measurement And Profit Analysis

  4. Revenue Recognition Principle (SFAS No. 5) (-An Accrual Basis) • Revenue is recognized when it is earned and realized or realizable (SFAC 5, par. 83). • Earned: the entity has substantially accomplished what it must do to be entitled to compensation. • Realized: goods are exchanged for cash or claims. • Realizable: assets received as compensation are readily convertible into cash or claims to cash. • In general, these conditions are met at time of sale (delivery) or when services are rendered (SFAC 5, par. 84). • . Income Measurement And Profit Analysis

  5. Revenue Recognition Principle • Other conditions for revenue recognition (Staff Accounting Bulletin No. 101(1999)): • Persuasive evidence of a sale. • Price is fixed or determinable. • Collectibility is reasonably assured. • Delivery has occurred or services have been rendered. Income Measurement And Profit Analysis

  6. Impact of SAB 101 on Revenue Recognition for Service Industry • FedEx: Recognizes revenue upon delivery of shipments (not during the packing, loading or transporting). • United Airlines (UA): (Accounting Changes) Beginning Q1, 2000, UA recognizes mileage sale through Citibank credit card or long-distance phone companies after the transportation is provided, not when mileage were sold. • Others: season tickets, annual membership, etc. Income Measurement And Profit Analysis

  7. Type of Transactions • Sale of product from Inventory: revenue recognized at time of sale. • Rendering a service: revenue recognized when services have been performed and billable. • Permitting use of an asset: revenue (i.e., interest, rents and royalties) recognized as time passes or assets are used. • Sale of asset other than inventory: gain or loss recognized at date of sale or trade-in. Income Measurement And Profit Analysis

  8. Problems Associated with Revenue Recognized at Point of Sale (Delivery) 1. Sales with buyback agreements: inventory should remain on the seller’s book and no revenue can be recognized. 2a. Sales with right of return exists: Revenue recognized if expecting insignificant amount of returns. Income Measurement And Profit Analysis

  9. Problems Associated with Revenue Recognized at Point of Sale (contd.) 2b.Sales with right of return: When expecting high sales returns, no revenue can be recognized unless the following six conditions are met. (i) Sales price is determined; (ii) Buyers have paid or have the obligations to pay; Income Measurement And Profit Analysis

  10. Problems Associated with Revenue Recognized at Point of Sale (contd.) 2b.Sales with right of return (contd.) (iii) The buyers’ obligation would not be changed due to theft of damage of the product after sales; (iv) Sellers are not responsible for the performance of the product; (v) Buyers and sellers are two separate economic entities; (vi) The amount of returns can be estimated. Income Measurement And Profit Analysis

  11. Problems Associated with Revenue Recognized at Point of Sale (contd.) 3. Trade loading: Manufacturers reduced the price for wholesale at the fiscal year end to create instant sales. The wholesaler is loaded with more inventory than it can promptly resell. Income Measurement And Profit Analysis

  12. Revenue Recognition over Time (during the earnings process) and others • 1. During the production process(i.e., long-term contract): accounting methods of revenue recognition are percentage-of completion method and completed-contract method. • 2. At the completion of production (i.e., for agriculture products and precious metals). Income Measurement And Profit Analysis

  13. Revenue Recognition after Delivery • 3. Installment Sales: revenue recognized after time of sale (delivery) as cash is collected. • 4. Revenue recognition delayed until a future event occurred (i.e., real estate sale, sale of division). Accounting method: Deposit method. Income Measurement And Profit Analysis

  14. Conditions for Revenue to Be Recognized at Completion of Production • Market is reasonably assured; • Costs of selling and distribution are insignificant and can be estimated; • Production, not sale, is considered to be the most critical event in the earning process. Income Measurement And Profit Analysis

  15. Conditions for Revenue to Be Recognized at Completion of Production (contd.) • Example: Revenue is recognized when precious metals are mined or when agricultural crops are harvested because all conditions are met. Income Measurement And Profit Analysis

  16. Conditions for Recognizing Revenue during Production • Buyers can be identified and price has been agreed on; • Future costs can be estimated and significant portion of service has been performed; • The collectability of cash can be reasonable assured; Income Measurement And Profit Analysis

  17. Conditions for Recognizing Revenue during Production • The contract specifies the rights about goods or services to be performed and received by both parties; • Both parties are expected to fulfil their obligations (AICPA statement of position 81). Income Measurement And Profit Analysis

  18. Choice of P-O-C vs. C-C Method • If all conditions are met, the percentage-of-completion (P-O-C) method must be applied to recognize construction revenue prior to the completion date. • If conditions are not met, the completed-contract method will be applied to recognize revenue at or after the completion date. Income Measurement And Profit Analysis

  19. Choice of P-O-C vs. C-C Method (contd.) • Example: For long-term construction contract, when all conditions are met, the P-O-C method is used to account for construction revenue and construction expenses. Income Measurement And Profit Analysis

  20. Financial Reporting of Long-Term (Construction) Contract • Percentage-of-completion method: revenue is recognized according to the percentage of completion. The percentage of completion is computed based on costs. • Completed-contract method: postpone the revenue recognition until time of sale. Income Measurement And Profit Analysis

  21. 1. 500=100+400 2. 550=100+186+264 3. 600=100+186+314 (actual) 4. 20% = 100/500 5. 52% = (100 + 186)/550 6. 100%=(100+186+314)/ 600 Example A:(Long-Term Construction Contract) Contract Price = $700 Income Measurement And Profit Analysis

  22. Example A (contd.) Partial Cash YearBillingsCollection x1 $ 80 $ 50 x2 350 330 x3 270 320 Total $700$700 Income Measurement And Profit Analysis

  23. Example A (contd.) • 5. 224 = 364 -140 • 6. 336 = 700 - 140 - 224 • 7. Current expense = construction costs incurred • 8. Net Income = current revenue - current expense (P-O-C) 1. $140 = 700 x 20% (contract price x cumulative % of completion) 2. 364 = 700 x 52% 3. 700 = 700 x 100% 4. 140 = 140 - 0 (cumulative revenue - previous years’ revenue) Income Measurement And Profit Analysis 23

  24. Example A (contd.) • An alternative method to compute the gross profit: Income Measurement And Profit Analysis

  25. Example A - Journal Entries (P-O-C) Note: Progress Billings = Billings on Construction construction contract Income Measurement And Profit Analysis 25

  26. Example A - Journal Entries (P-O-C) (contd.) Note: Construction Expense = Cost of Construction Construction Revenue = Revenue from Long-Term Contracts Income Measurement And Profit Analysis 26

  27. B/S Year x1 Current Assets: CIP 140 Progress Billings (80) 60 Unbilled Revenue B/S Year x3 C.A.: CIP 700 P.B (700) 0 Billing inexcess of costs and recognized profit B/S Year x2 Current Liability: P-B 430 C-I-P (364) 66 Example AFinancial Statement Presentation (P-O-C) Income Measurement And Profit Analysis

  28. CIP 100 40 186 38 314 22 Year x1 ($140) Progress Billings 80 -- 1998 350 -- 1999 270 -- 2000 700 -- E.B. Year x2 ($224) Year x3 ($336) Financial Statement Presentation (P-O-C)(contd.) Note: Balance of CIP = cumulative revenue Income Measurement And Profit Analysis

  29. Financial Statement Presentation (P-O-C)(contd.) Income Statement Year x1Year x2Year x3 Revenue from Long-term contract 140 224 336 Construction Expenses 100 186 314 Gross Profit 40 38 22 Income Measurement And Profit Analysis

  30. Financial Statement Presentation (P-O-C)(contd.) Year Balance Sheet(12/31) x1 x2 x3 Current Assets: A/R 30 50 -- Inventories Construction in Progress 140 700 Less: Billings (80) (700) Costs and recognized profits in excess of billings 60 0 Current Liabilities: Billings 430 Construction in Progress (364) Billings in excess of costs and recognized profits 66 Income Measurement And Profit Analysis

  31. Financial Statement Presentation (P-O-C)(contd.) Note1 Summary of significant accounting policy Long-Term Construction Contracts. The company recognized revenues and reports profits from long-term construction contracts under the percentage-of-completion method…. Income Measurement And Profit Analysis

  32. Example A (contd.) - Completed-Contract Method Gross Profit: X1 $0 X2 $0 X3 $100 X3: Total Revenues - Total Expenses = $ 700 - (100+186+314) = $ 700 - 600 = 100 Income Measurement And Profit Analysis

  33. Example A (contd.) - Journal Entries (Completed-Contract) Income Measurement And Profit Analysis

  34. Journal Entries(Completed-Contract)(contd.) Income Measurement And Profit Analysis

  35. Financial Statement Presentation (C-C Method) Income Statement Year x1Year x2Year x3 Revenue from Long-term contract --- --- 700 Construction Expenses --- --- 600 Gross Profit --- --- 100 Income Measurement And Profit Analysis

  36. Financial Statement Presentation (C-C Method) (contd.) Balance Sheet (12/31) Year x1Year x2Year x3 Current Assets: A/R 30 50 --- Inventories: Construction in Progress 100 700 Less: Billings (80) (700) Contract Costs in Excess of Billings 20 0 Current Liabilities: Billings 430 Construction in Progress (286) Billing in Excess of Contract Costs 144 Income Measurement And Profit Analysis 36

  37. Example B Contract Price $700 Income Measurement And Profit Analysis

  38. Example B (contd.) P-O-C C-C Income Measurement And Profit Analysis

  39. Example B (contd.) • An alternative method to compute the gross profit: Income Measurement And Profit Analysis

  40. Example B (contd.) Other Information (Billing and cash collection): Year Partial BillingsCash Collection x1 $80 $50 x2 350 330 x3 270 320 Total $ 700 $ 700 Income Measurement And Profit Analysis

  41. Example B - Journal Entries (P-O-C) Income Measurement And Profit Analysis

  42. Example B - Journal Entries (P-O-C) (contd.) Income Measurement And Profit Analysis

  43. C-I-P 100 18 40 186 314 78 700 Year x1 x2 x3 x2 Progress Billings 80 -- x1 350 -- x2 270 -- x3 Example B (contd.) Income Measurement And Profit Analysis

  44. Example B (contd.) - Journal Entries (Completed-Contract) Income Measurement And Profit Analysis

  45. Journal Entries(Completed-Contract)(contd.) Income Measurement And Profit Analysis

  46. (Long-Term Contract Example Cwith an Overall Loss) Contract Price $700 * $715 > 700 (contract price) => a total estimated loss occurs and must be recognized immediately (source: ARB 45 and AICPA statement of position 81-1) Income Measurement And Profit Analysis

  47. Example C (contd.) P-O-C C-C * $40 gross profit was recognized in year x1. This profit is not expected to be realized in the future. Thus, the $40 profit must be offset in year x2. In addition, the estimated total loss of $15 should also be recognized immediately in year x2. Therefore, a loss of $55 ($40+$15) should be recognized in year x2. ** Billings and cash collection data are the same as those of example A. Income Measurement And Profit Analysis

  48. Example C (contd.) • An alternative method to compute the gross profit: Income Measurement And Profit Analysis

  49. Example C (contd.)- Journal Entries (P-O-C) Income Measurement And Profit Analysis

  50. Journal Entries(P-O-C) (contd.) * C-I-P and provision for loss on contract are combined. Income Measurement And Profit Analysis

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