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CH 05: Part A: Revenue Recognition

CH 05: Part A: Revenue Recognition. Self-Study: 1. Discuss the general objective of the timing of and the two criteria for revenue recognition. SEC’s SAB 101 3. Discuss the implications for revenue recognition of allowing customers the right of return .

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CH 05: Part A: Revenue Recognition

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  1. CH 05: Part A: Revenue Recognition Self-Study: 1. Discuss the general objective of the timing of and the two criteria for revenue recognition. SEC’s SAB 101 3. Discuss the implications for revenue recognition of allowing customers the right of return. --------------------------------------------------------------- In Class: 2. Describe the installment sales and cost recovery methods of recognizing revenue 4. Identify situations that call for the recognition of revenue over time and distinguish between the percentage-of-completion and completed contract methods of recognizing revenue for long-term contracts.

  2. Learning Objectives 5. Discuss the revenue recognition issues involvingmultiple-deliverable contracts, software, and franchise sales. 6. Identify and calculate the common ratios used to assess profitability. Addendum: Discuss the primary differences between U.S. GAAP and IFRS with respect to revenue recognition.

  3. Revenue Recognition Current Environment Revenue Recognition at the Point of Sale Revenue Recognition before Delivery Revenue Recognition after Delivery Guidelines for revenue recognition Departures from sale basis SAB 101 + Q&A Sales with buyback agreements Sales when right of return exists Trade loading and channel stuffing Consignment Sales Percentage-of-completion method Completed-contract method Long-term contract losses Disclosures Completion-of-production basis Installment-sales method Cost-recovery method Deposit method Summary of bases Concluding remarks GAAP vs. IFRS

  4. CH 5: Revenue Recognition The focus of this chapter is revenue recognition Overview The timing of revenue recognition is critical to income measurement. Revenue affects income, and, under the matching principle, expenses are recognized in the period in which the related revenues are recognized. Therefore, revenue recognition determines the recognition of some expensesas well.

  5. The Current Environment Definition of Revenue: Inflows or other enhancements of assets of an entity or settlements of its liabilities(or a combination of both) from delivery or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. [FASB Concepts Statement No. 6, Element of Financial Statements, paragraph 78] Separate definition for Gains LO 1 Apply the revenue recognition principle.

  6. The Current Environment Guidelines for Revenue Recognition The revenue recognition principle(FASB Concept Stmt. No. 5) provides that companies should recognize revenue • when it is realized or realizable and • when it is earned. Revenues are realizedwhen goods and services are exchanged for cash or claims to cash (receivables). Revenues are realizable when assets received in exchange are readily convertible to known amounts of cash or claims to cash. Revenues are earned when the entity has substantially accomplishedwhat it must do to be entitled to the benefits represented by the revenues, that is, when the earnings process is complete or virtually complete.

  7. Revenue Recognition at Delivery Recognize Revenue When the product or service has been delivered to the customer and cash has been received or a receivable has been generated that has reasonable assurance of collectibility.

  8. Consignment Sales Sometimes a company arranges for another company to sell its product under consignment. Because the consignor retains the risks and rewards of ownership of the product and title does not pass to the consignee, the consignor does not record a sale until the consignee sells the goods and title passes to the eventual customer.

  9. Revenue Recognition at Point of Sale (Delivery) • Implementation problems: • Sales with Buyback Agreements => No Sale! • Sales When Right of Return Exists => Est. Returns • Trade Loading and Channel Stuffing => No Sale!

  10. Revenue Recognition at Point of Sale (Delivery) Sales with Buyback Agreements (FAS 49) When a repurchase agreement exists at a set price and this price covers all cost of the inventory plus related holding costs, the inventory and related liability remain on the seller’s books.*In other words, no sale. * “Accounting for Product Financing Arrangements,” Statement of Financial Accounting Standards No. 49 (Stamford, Conn.: FASB, 1981). LO 2 Describe accounting issues for revenue recognition at point of sale.

  11. Right of Return In most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery. Estimate the returns Reduce both Sales and Cost of Goods Sold

  12. Revenue Recognition at Point of Sale (Delivery) Sales When Right of Return Exists Recognize revenue only if six conditions (FAS 48) have been met: • The seller’s price to the buyer is substantially fixed or determinable at the date of sale. • The buyer has paid the seller, or the buyer is obligated to pay the seller, and the obligation is not contingent on resale of the product. • The buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product (Legal Risk). LO 2 Describe accounting issues for revenue recognition at point of sale.

  13. Revenue Recognition at Point of Sale (Delivery) Sales When Right of Return Exists Recognize revenue only if six conditions have been met. • The buyer acquiring the product for resale has economic substance (Profit motive, Market risk e.g. price fluctuation, etc) apart from that provided by the seller. • The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer. • The seller can reasonably estimate the amount of future returns.

  14. Revenue Recognition at Point of Sale (Delivery) Trade Loading (Booking tomorrow’s revenues today): “Trade loading is a crazy, uneconomic, insidious practice through which manufacturers (trying to show sales, profits, and market share they don’t actually have) induce their wholesale customers, known as the trade, to buy more product than they can promptly resell.”* In other words, no sale. * “The $600 Million Cigarette Scam,” Fortune (December 4, 1989), p. 89.

  15. Revenue Recognition at Point of Sale (Delivery) Channel Stuffing (Booking tomorrow’s revenues today): In channel stuffing, the software maker offers deep discounts to its distributors to overbuy and records revenue when the software leaves its loading dock. When this process takes place, the distributors’ inventories become bloated and the marketing channel gets stuffed, but the software maker’s financial statements are improved. Found mostly in the computer software industry In other words, no sale. * “Lucent Slashes First Quarter Outlook…,” WSJ(December 22, 2000).

  16. The Current Environment Departures from the Sale Basis (Point of Delivery) • Earlier recognition is appropriate if there is a high degree of certainty about the amount of revenue earned. Example: Percentage of Completion method. • Delayedrecognition is appropriate if the • degree of uncertainty concerning the amount of revenue or costs is sufficiently high or • sale does not represent substantial completion of the collection process. • Example: Installment sales & Cost Recovery method

  17. The Current Environment The SEC has indicated that IMPROPER Revenue Recognition is the largest cause for financial Statement restatements. • One study noted restatements of revenue: • Result in larger drops in market capitalization than other types of restatement. • Caused eight of the top ten market value losses in a recent year.

  18. The Current Environment A January 2002 Wall Street Journal Article reported that more restatements of financial statements had occurred in the past three yearsthan in the previous 10 years combined.

  19. The Current Environment SEC’s SAB 101: In December 1999, the SEC issued Staff Accounting Bulletin (SAB) 101, “Revenue Recognition in Financial Statements,” Which was Followed by (in October 2000) “Revenue Recognition in Financial Statements: Frequently Asked Questions.” SAB 101 was effective starting the fourth fiscal quarter for fiscal years beginning after December 15, 2000.

  20. The Current Environment SEC’s SAB 101: SAB 101 Criteria for Revenue Recognition For revenue to be recognized under SAB 101, it mustmeet all of the fourfollowing criteria: -Persuasive evidence of an arrangement exists. -Delivery has occurred or services have been rendered. -The seller’s price to the buyer is fixed or determinable. -Collectibility is reasonably assured.

  21. The Current Environment SEC’s SAB 101: Because SAB 101 was released to curtail specific abuses, it should not be seen as a comprehensive set of guidelines on the entire area of revenue recognition. In December 2003, four years after the release of SAB 101, the SEC released SAB 104, which includes a revised version of SAB 101, adapted to include developments in revenue recognition accounting since 1999. In-Class Discussion (Next Week): Read SAB 101, Pages 1 -10, Q & A: 1- 10

  22. The Current Environment SEC’s SAB 101 (104) provides guidance on the following revenue recognition issues: -Timing of approval for sales agreements; -“Side” arrangements: Buybacks, Consignments, Extended Financing arrangements, and Right of return. - Bill and hold sales; -Layaway programs; -Nonrefundable, up-front fees; -Membership fees/services. -Cancellation or termination provisions; -Contingent rental income;

  23. SAB 101 Discussion Format • Discuss the assigned Q&A • Discuss “Sales Type” or “Issue Type” • Provide a DEMO (Numeric) Problem • Solve the DEMO Problem with JEs • Provide a REAL-WORLD Example of a Company in violation of the specific Q&A (FRAUD): 1999 -- 2005

  24. Realization Principle Revenue recognition is often tied to delivery of the product from the seller to the buyer.

  25. Revenue Recognition After Delivery When we are unable to make reasonable estimates of uncollectible amounts or customer returns of products, we delay recognizing revenue from the sale until the uncertainty has been resolved. • Installment Sales Method • Cost Recovery Method

  26. Installment-Sales Method Type of sale for which payment is required in periodic installments over an extended period of time. This is due to the fact that the ultimate profit is more uncertain in installment salesthan in ordinary sales because collection is more doubtful. Recognize income in the periods of CASH collection rather than in the period of sale.Selling and administrative expenses are not deferred.

  27. Installment Sales Method On November 1, 2011, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, 2011. The land cost $560,000 to develop. The company’s fiscal year ends on December 31. Gross Profit $240,000 ÷ $800,000 = 30%

  28. During 2011, Belmont Corporation collected $200,000 on its installment sales. This entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account. Installment Sales Method

  29. Revenue Recognition after Delivery Cost-Recovery Method Recognizes no profit until cash payments by the buyer exceed the cost of the merchandise sold. APB Opinion No. 10 allows a seller to use the cost-recovery method to account for sales in which “there is no reasonable basis for estimating collectibility.” In addition, FASB Statements No. 45 (franchises) and No. 66 (real estate) require use of this method where a high degree of uncertainty exists related to the collection of receivables.

  30. Cost Recovery Method On November 1, 2011, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, 2011. The land cost $560,000 to develop. The company’s fiscal year ends on December 31.

  31. Cost Recovery Method

  32. Exercises and Problems In Class: E 4 and E5 (2011) Home Work: E 1 and 2, Prob. 4

  33. Revenue Recognition Prior to Delivery Completed Contract Method Long-term Contracts Percentage-of-Completion Method

  34. Using the percentage-of-completion method, we recognize a portion of the estimated gross profit each period based on progress to date.

  35. Percentage-of-Completion Method Measuring the Progress toward Completionusing Cost-to-Cost basis: Percentage of completion Costs incurred to date = Most recent estimate of total costs Gross profit to be recognized to date Percent complete x Estimated total = Gross Profit Gross profit to be recognized to date Gross profit recognized in prior periods Current-period Gross profit = - LO 3 Apply the percentage-of-completion method for long-term contracts.

  36. Completed Contract and Percentage-of-Completion Methods Compared

  37. Timing of Gross Profit Recognition Under the Percentage-of-Completion Method Using the percentage-of-completion method, we recognize a portion of the estimated gross profit each period based on progress to date. We determine the amount of gross profit recognized in each period using the following logic:

  38. Percentage-of-Completion Method Allocation of Gross Profit

  39. Accounting for the Cost of Construction and Accounts Receivable With both the completed contract and percentage-of-completion methods, all costs of construction are recorded in an asset account called construction in progress.

  40. Gross Profit Recognition—General Approach In both methods the same amounts of revenue, cost, and gross profit are recognized. In both methods we add gross profit to the construction in progress asset.

  41. Gross Profit Recognition—General Approach The same journal entry is recorded to close out the billings on construction contract and construction in progress accounts under the completed contract and percentage-of-completion methods.

  42. Percentage-of-Completion Method Allocation of Gross Profit Notice that the gross profit recognized in each period is added to the construction in progress account.

  43. Balance Sheet Recognition Billings on construction contract are subtracted from construction in progress to determine balance sheet presentation. CIP > Billings Asset Billings > CIP Liability

  44. Balance Sheet Recognition The balance in the construction in progress account differs between methods because of the earlier gross profit recognition that occurs under the percentage-of-completion method.

  45. Percentage-of-Completion Method Allocation of Gross Profit The income statement for each year will report the appropriate revenue and cost of construction amounts.

  46. Income Recognition The same total amount of profit or loss is recognized under both the completed contract and the percentage-of-completion methods, but the timing of recognition differs.

  47. Timing of Gross Profit Recognition Under the Completed Contract Method Under the completed contract method, all revenues and expenses related to the project are recognized when the contract is completed.

  48. Loss Projected for Entire Project Periodic Loss for Profitable Projects Estimated loss is fully recognized in the first period the loss is anticipated and is recorded by a credit to Construction in Progress account. Determine periodic loss and record loss as a credit to the Construction in Progress account. Long-term Contract Losses

  49. Exercises and Problems In Class: E 9 (as is) + Gross Profit Schedule + JE for 2011 (% of Completion) Home Work: E10 (Requirements 1 - 3) P 5 (Requirements 1 - 3)

  50. U. S. GAAP vs. IFRS There are similarities and differences between IFRS and U.S. GAAP when considering revenue recognition for long-term construction contracts. • Requires percentage-of-completion when reliable estimates can be made. • Requires completed contract method when reliable estimates can’t be made. • Requires percentage-of-completion when reliable estimates can be made. • Requires cost recovery method when reliable estimates can’t be made.

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