Intermediate accounting 19th by stice stice chapter 08

Monthly Service Revenue 50 Another entry is necessary to record partial recognition of the initial sign-up fee as revenue $1,000/100 months.. The journal entry to record the asset and li

Intermediate

Accounting

James D Stice Earl K Stice

Revenue Recognition

Chapter 8

19 th

Edition

Recognition refers to the time when

transactions are recorded on the books The

FASB’s two criteria for recognizing revenues

and gains are when:

Revenue Recognition

1 They are realized or realizable

2 They have been earned through substantial

completion of the activities involved in the earnings process

Both of these criteria generally are

met at the point of sale

Both of these criteria generally are

met at the point of sale

• Revenue is not recognized prior to the point of sale because either:

received from the customer.

service.

payment.

sale.

Revenue Recognition

AICPA Statement of Position 97-2 gives

companies more guidance through a checklist of four factors that amplify the two criteria:

1) Persuasive evidence of an arrangement

exists

2) Delivery has occurred

3) The vendor’s fee is fixed or determinable

4) Collectibility is probable

(continued)

Revenue Recognition

• The FASB is currently engaged in a

revenue recognition project in conjunction with the IASB (as of June 2010).

• The FASB has tentatively decided to move away from the realization and substantial completion criteria and to instead

emphasize the measurement of a seller’s satisfaction of performance obligations

created through contracts with customers.

Revenue Recognition

SAB 101

• Because SAB 101 was released to curtail specific abuses, it should not be seen as a comprehensive treatise on the entire area

of revenue recognition.

• Revenue recognition issues covered in

they are extremely important.

Sarbanes-Oxley Act of 2002

• Section 404 of the Sabanes-Oxley Act of

2002 instructs the SEC to require all publicly traded companies to provide a report of the condition of the company’s internal controls

• This is to ensure that the public financial

statements are not rendered irrelevant by

secret side agreements

• A good internal control system establishes

procedures to safeguard the value of a

company’s assets

Accounting for Consignments

Seller Company ships goods costing $1,000

on consignment to Consignee Company

The retail price of the goods is $1,500

No sale should be recorded

However, there may be a journal entry made to reclassify the inventory

No sale should be recorded

However, there may be a journal entry made to reclassify the inventory

Inventory on Consignment 1,000

Accounting for a Layaway Sale

Seller Company receives $100 cash from a

customer The $100 payment is a partial

payment for goods costing $1,000 with a total retail price of $1,500 The following entry shows the receipt of $100 cash as initial layaway

payment

Deposit Received from Customers 100

Accounting for a Layaway Sale

Recording the receipt of the final $1,400 cash payment and the delivery of goods to

customers requires two entries One to record the sale and the second to remove the item

from inventory and to record its cost

Bill-and-Hold Arrangements

To consider merchandise as sold using the

bill-and-hold arrangement, a seller must be able to demonstrate:

• that the goods are ready to ship,

• that they are segregated in act and cannot

be used to fill other orders, and

• that the buyer has requested, in writing, the bill-and-hold arrangement.

Customer Acceptance Provisions

Seller Company receives $1,500 cash from a customer as payment in full for equipment

costing $1,000 The sale is not complete until the equipment is installed at the customer’s

place of business The following entry is

necessary to record the advance receipt of

Customer Acceptance Provisions

Advance Payments Received from

Seller Company receives $1,000 cash from a customer as the initial sign-up fee for a

service In addition to the sign-up fee, the

customer is required to pay $50 per month for the service The expected economic life of this service agreement is 100 months An entry is required to show receipt of cash

Appropriate Accounting for a Service Provided Over an Extended Period

Unearned Initial Sign-up Fees 1,000

(continued)

A second entry is required to record receipt of the monthly payment.

Monthly Service Revenue 50

Another entry is necessary to record partial

recognition of the initial sign-up fee as revenue ($1,000/100 months)

Unearned Initial Sign-up Fees 10

Initial Sign-up Fee Revenue 10

Appropriate Accounting for a Service Provided Over an Extended Period

Subtopic 605-25

• The focus of Subtopic 605-25 is on the

“unit of accounting.”

• An element of multiple-element

arrangement is considered to be a unit

of accounting if that element has

standalone value.

• An element has standalone value if it is sold separately or if the customer

resells it.

Income Statement Presentation of

Revenue: Gross or Net

Characteristic of a transaction in which a

company should report revenue on a net basis are given as follows:

• The company does not maintain an inventory

of the product being sold but simply forwards orders to a supplier

• The company is not primarily responsible for satisfying customer requirements, request,

complaints, and so forth; those requirements are satisfied by the supplier of goods

Income Statement Presentation of

Revenue: Gross or Net

• The company earns a fixed amount, or a fixed percentage, and doesn’t bear the risk of

fluctuations in the margin between the selling price and the cost of goods sold

• The company does not bear the credit risk

associated with collecting from the customer; that risk is borne by the supplier

A Contract Approach to Revenue Recognition

The contract approach contains three basic

steps:

1) Identify the performance obligations accepted

by a seller in its contracts with its buyers

2) For multiple-element transactions, allocate

transaction prices based on relative separate selling prices

3) Recognize revenue when performance

obligations are satisfied

• With the contractual performance obligation focus, the FASB and IASB have agreed

that revenue arises when a seller satisfies a performance obligation to a buyer

• The general idea that no revenue should be recognized until something of value has

been delivered to the customer goes back

to SAB 101 and even back to the traditional revenue recognition criteria

(continued)

A Contract Approach to Revenue Recognition

Ashley Company has provided goods, on

account, to customers during the month of June with a total billing price of $100,000 Bad debts are expected to be 1.0% of the gross sales

amount, and sales returns are expected to be 2.5% of the gross sales amount A summary

journal entry follows:

A Contract Approach to Revenue Recognition

Accounts Receivable 96,500

Sales Revenue [$100,000 x

(100.0% 1.0% 2.5%)] ‒ ‒ 96,500

June 30

Wilks Company sells a plasma TV and 2-year warranty to a customer for the joint price of

$2,000 Wilks Company has generated the

following information regarding the sale of the plasma TV

• Cost of plasma TV, $1,500

• Sales price of plasma TV sold separately is

unknown Other consumer electronic products have profit margins that range between 16% and 22% of cost

A Contract Approach to Revenue Recognition

TV delivery obligation: $1,700 = $2,000 x

[$1,785/($1,785 + $315)]

Warranty service obligation: $300 = $2,000 x

[$315/$1,785 + $315)]

• Sales price of warranty if sold separately,

unknown A 2-year warranty for a

refrigerator/freezer with the same wholesale

cost sells for $300 Wilks estimates that repair costs for the plasma TV would be 5% higher ($300 + ($300 x 05) = $315)

A Contract Approach to Revenue Recognition

The journal entry to record the asset and liability

at the contract signing is as follows:

Contract Liability—TV 1,700 Contract Liability—Warranty 300

When the plasma TV is delivered, the following journal entries are required:

Contract Liability—TV 1,700

Sales Revenue 1,700 Cost of Goods Sold 1,500

A Contract Approach to Revenue Recognition

• If a Company waits until the production or

service period is complete to recognize

revenue, this approach is referred to as the

completed-contract method All income

from the contract is related to the year of

completion

• Percentage-of-completion accounting was developed to relate recognition of revenue on long-term construction-type contracts to the activities of a firm in fulfilling these contracts

1.Dependable estimates can be made of contract

revenues, contract costs, and the extent of progress

toward completion.

2.The contract clearly specifies the enforceable rights

regarding goods or services to be provided and

received by the parties, the consideration to be

exchanged, and the manner and terms of settlement.

In 1981, the AICPA identified several elements that should be present if the percentage-of-

completion accounting is to be used

Percentage-of-Completion

Accounting

3 The buyer can be expected to satisfy

obligations under the contract

4 The contractor can be expected to perform

the contractual obligation

The completed-contract method should be used only when an entity has primarily short term contracts, when the conditions

of using percentage-of-completion accounting are not met, or when there are inherent uncertainties in the contract

The completed-contract method should be

used only when an entity has primarily

short term contracts, when the conditions

of using percentage-of-completion accounting are not met, or when there are

inherent uncertainties in the contract

Percentage-of-Completion

Accounting

• Cost-to-cost method is perhaps the most

popular of the input measures The degree of completion is determined by comparing costs already incurred with the most recent estimates

of total expected costs to complete the project

• Engineers are often called in to help provide

estimates

Percentage-of-Completion

Accounting

In January 2012, Strong Construction

Company was awarded a contract with a total price of $3,000,000 Strong expects to earn

$400,000 profit on the contract The

construction was completed over a 3-year

period

Accounting for Long-Term Construction-Type Contracts

Construction in Progress 1,040,000

Materials, Cash, etc 1,040,000

To record costs incurred.

Construction in Progress 910,000

Materials, Cash, etc 910,000

To record costs incurred.

Construction in Progress 650,000

Materials, Cash, etc 650,000

To record costs incurred.

Completed-Contract Method

• No other entries would be required in 2012

and 2013 under the completed-contract

Using the completed-contract method, the

balance sheet at the end of 2013 would

disclose the following balances related to the

construction contract:

Current assets:

Accounts receivable $250,000 Construction in progress $1,950,000

Less: Progress billings on

construction contracts 1,900,000 $50,000

(continued)

2013

2013

Completed-Contract Method

2014

Under the completed-contract method, the

following entries would be made to recognize revenue and costs and to close out the

inventory and billing accounts.

Completed-Contract Method

Using Percentage-of-Completion

Accounting: Cost-to-Cost Method

2012

2012

If the company used the

percentage-of-completion method of accounting, the

$400,000 profit would have to be spread over all three years of construction according to the estimated percentage of completion each year

2012 2013 2014

Percentage of completion

(continued) 2012

2012

Cost of Long-Term Construction

Contracts 910,000

Construction in Progress 140,000

Revenue from Long-Term

Construction Contracts 1,050,000

Cost of Long-Term Construction

Contracts 650,000

Construction in Progress 100,000

Revenue from Long-Term

Construction Contracts 750,000

Construction in Progress

1,040,000

160,000 910,000 140,000 650,000 100,000

3,000,000

Progress Billings on Construction Contracts

1,000,000 900,000 1,100,000 3,000,000

Progress Billings on

Construction Contracts 3,000,000

3,000,000 3,000,000

Using Percentage-of-Completion Accounting: Cost-to-Cost Method

2014

2014

Using Percentage-of-Completion

Accounting: Other Methods

In 2012, an engineering estimate measure was used, and 42% of the contract was assumed to

be completed The gross profit recognized

would therefore be computed and reported as follows:

Recognized revenue (42% of $3,000,000)$1,260,000 Cost (42% of $2,600,000) 1,092,000 Gross profit (42% of $400,000) $ 168,000

(continued)

Using Percentage-of-Completion

Accounting: Other Methods

Using the data from the previous slide and

knowing that the actual cost incurred to date is

$1,040,000, the revenue and costs to be

reported on the 2012 income statement would

be as follows:

Actual cost incurred to date $1,040,000 Recognized gross profit (42% of

$2,600,000) 168,000 Gross profit (42% of $400,000) $ 168,000

Revision of Estimate

Instead of the previous illustration, assume that

at the end of 2013, it was estimated that the

remaining cost to complete construction was

$720,000 rather than $650,000 This would

increase the total estimated cost to $2,670,000, reduce the expected profit to $330,000, and

change the percentage of completion for 2013

to 73% ($1,950,000/$2,670,000).

(continued)

Cost of Long-Term Construction

Cost of Long-Term Construction

Contracts 910,000

Construction in Progress 80,000

Revenue from Long-Term

Construction Contracts 990,000

($3,000,000 × 0.73) − $1,200,000

2013

(continued)

Revision of Estimates

Cost of Long-Term Construction

Reporting Anticipated

Contract Losses

• When a loss on a total contract is

anticipated, GAAP requires reporting the loss in its entirety in the period when the loss is first anticipated.

• This is true under either the contract or the percentage-of-completion method.

completed-(continued)

• Assume in the earlier construction

example, the estimated cost to complete the contract at the end of 2013 was

$1,300,000.

• Because $1,950,000 of costs had

already been incurred, the total

estimated cost of the contract would be

$3,250,000, or $250,000 more than the contract price.

Reporting Anticipated

Contract Losses

Anticipated Contract Loss:

Percentage-of-Completion Method

Continuing with the construction contract

example, assume the cumulative recognized revenue at the end of 2013 would be

The entry to record the revenue, costs, and adjustments to Construction in Progress for the loss in 2013 would be as follows:

Proportional Revenue Recognition

1. Initial direct costs related to obtaining and

performing initial services on the contract

Most service contracts involve three

different types of costs :

2 Direct costs related to performing the

various service acts

3 Indirect costs related to maintaining the

organization to service the contract

• Under the installment sales method, profit is recognized as cash is collected rather than at the time of sale.

• It is used most commonly in cases of real

estate sales where contracts may involve little

or no down payment, payments are spread

over 10 to 30 to 40 years, and a high

probability of default in the early years exists because of a small investment by the buyer.

• The market prices of the property often are

Installment Sales Method