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Chapter 18 REVENUE RECOGNITION Sommers – Intermediate I

Chapter 18 REVENUE RECOGNITION Sommers – Intermediate I. Guidelines for Revenue Recognition. What are the two general criteria that must be satisfied before a company can recognize revenue ? The realization principle requires that two criteria be satisfied before revenue can be recognized :

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Chapter 18 REVENUE RECOGNITION Sommers – Intermediate I

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  1. Chapter 18 REVENUE RECOGNITIONSommers – Intermediate I

  2. Guidelines for Revenue Recognition What are the two general criteria that must be satisfied before a company can recognize revenue? The realization principle requires that two criteria be satisfied before revenue can be recognized: • When it is realized or realizable – there is reasonable certainty as to the collectibility of the asset to be received (usually cash). • When it is earned– the earnings process is judged to be complete or virtually complete.

  3. Discussion Question Q18-2 What is viewed as a major criticism of GAAP as regards to revenue recognition?

  4. Revenue Recognition Matters • Revenue recognition is a top fraud risk and regardless of the accounting rules followed (IFRS or U.S. GAAP), the risk or errors and inaccuracies in revenue reporting is significant. • Restatements for improper revenue recognition are relatively common and can lead to significant share price adjustments.

  5. Messing with Revenue “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.” A similar practice is referred to as channel stuffing. When a software maker needed to make its financial results look good, it offered deep discounts to its distributors to overbuy, and then recorded revenue when the software left the loading.

  6. Rev Rec at Point of Sale (Delivery) • Companies usually meet the two conditions for recognizing revenue by the time they deliver products or render services to customers. • Implementation problems • Sales with Discounts • Sales When Right of Return • Sales with Buybacks • Bill and Hold Sales • Principal-Agent Relationships • Trade Loading and Channel Stuffing • Multiple-Deliverable Arrangements

  7. Multiple-Deliverable Arrangements • MDAs provide multiple products or services to customers as part of a single arrangement. • The major accounting issues related to this type of arrangement are how to allocate the revenue to the various products and services and how to allocate the revenue to the proper period. • All units in a multiple-deliverable arrangement are considered separate units of accounting, provided that: • A delivered item has value to the customer on a standalone basis; and • The arrangement includes a general right of return relative to the delivered item; and • Delivery or performance of the undelivered item is considered probable and substantially in the control of the seller.

  8. Revenue Recognition Standard - WSJ • What recently happened? • Who is affected? • When will they be affected?

  9. Revenue Recognition – CFO.com • How long did this take? • What issues do companies face?

  10. Discussion Questions Q18-14 What are the two basic methods of accounting for long-term construction contracts? Indicate the circumstances that determine when one or the other should be used.

  11. Discussion Questions Q18-14 What are the two basic methods of accounting for long-term construction contracts? Indicate the circumstances that determine when one or the other should be used.

  12. Revenue Recognition Before Delivery Most notable example is long-term construction contract accounting. • Two Methods: • Percentage-of-Completion Method. • Rationale is that the buyer and seller have enforceable rights. • Completed-Contract Method.

  13. Percentage-of-Completion Method Must use when estimates of progress toward completion, revenues, and costs are reasonably dependable and allof the following conditions exist: • Contract clearly specifies the enforceable rights regarding goods or services by the parties, the consideration to be exchanged, and the manner and terms of settlement. • Buyer can be expected to satisfy all obligations. • Contractor can be expected to perform under the contract.

  14. Percentage-of-Completion Method Formula for Total Revenue to Be Recognized to Date

  15. Percentage-of-Completion Example Assume Nortel Networks contracted to provide a customer with Internet infrastructure for $2,000,000. The project began in 2011 and was completed in 2012. Data relating to the contract are summarized below: 20112012 Costs incurred during the year $ 300,000 $1,575,000 Estimated costs to complete as of 12/31 1,200,000 –0– Billings during the year 380,000 1,620,000 Cash collections during the year 250,000 1,750,000 2011 Construction in progress 300,000 Cash, materials, etc. 300,000 Accounts receivable 380,000 Billings on construction contract 380,000 Cash 250,000 Accounts receivable 250,000

  16. Percentage-of-Completion Example Cont. Assume Nortel Networks contracted to provide a customer with Internet infrastructure for $2,000,000. The project began in 2011 and was completed in 2012. Data relating to the contract are summarized below: 20112012 Costs incurred during the year $ 300,000 $1,575,000 Estimated costs to complete as of 12/31 1,200,000 –0– Billings during the year 380,000 1,620,000 Cash collections during the year 250,000 1,750,000 Gross profit recognition: $300,000/$1,500,000 = 20% x $500,000 = $100,000 Balance Sheet: Current assets: • Accounts receivable $130,000

  17. Percentage-of-Completion Example Cont. Assume Nortel Networks contracted to provide a customer with Internet infrastructure for $2,000,000. The project began in 2011 and was completed in 2012. Data relating to the contract are summarized below: 20112012 Costs incurred during the year $ 300,000 $1,575,000 Estimated costs to complete as of 12/31 1,200,000 –0– Billings during the year 380,000 1,620,000 Cash collections during the year 250,000 1,750,000 2012 Construction in progress 1,575,000 Cash, materials, etc. 1,575,000 Accounts receivable 1,620,000 Billings on construction contract 1,620,000 Cash 1,750,000 Accounts receivable 1,750,000

  18. Percentage-of-Completion Example Cont. Assume Nortel Networks contracted to provide a customer with Internet infrastructure for $2,000,000. The project began in 2011 and was completed in 2012. Data relating to the contract are summarized below: 20112012 Costs incurred during the year $ 300,000 $1,575,000 Estimated costs to complete as of 12/31 1,200,000 –0– Billings during the year 380,000 1,620,000 Cash collections during the year 250,000 1,750,000 Gross profit recognition: $1,875,000/$1,875,000 = 100% x $125,000 = $125,000 $125,000 - $100,000 = $25,000 Balance Sheet: • Nothing, all cleared out

  19. Completed-Contract Method Companies should use when one of the following conditions applies when: • Company has primarily short-term contracts, or • Company cannot meet the conditions for using the percentage-of-completion method, or • There are inherent hazards in the contract beyond the normal, recurring business risks.

  20. Completed Contract Example Assume Nortel Networks contracted to provide a customer with Internet infrastructure for $2,000,000. The project began in 2011 and was completed in 2012. Data relating to the contract are summarized below: 20112012 Costs incurred during the year $ 300,000 $1,575,000 Estimated costs to complete as of 12/31 1,200,000 –0– Billings during the year 380,000 1,620,000 Cash collections during the year 250,000 1,750,000 2011 Construction in progress 300,000 Cash, materials, etc. 300,000 Accounts receivable 380,000 Billings on construction contract 380,000 Cash 250,000 Accounts receivable 250,000

  21. Completed Contract Example Assume Nortel Networks contracted to provide a customer with Internet infrastructure for $2,000,000. The project began in 2011 and was completed in 2012. Data relating to the contract are summarized below: 20112012 Costs incurred during the year $ 300,000 $1,575,000 Estimated costs to complete as of 12/31 1,200,000 –0– Billings during the year 380,000 1,620,000 Cash collections during the year 250,000 1,750,000 Gross profit recognition: $0 Balance sheet: Current assets: • Accounts receivable $130,000 Current liabilities:

  22. Completed Contract Example Assume Nortel Networks contracted to provide a customer with Internet infrastructure for $2,000,000. The project began in 2011 and was completed in 2012. Data relating to the contract are summarized below: 20112012 Costs incurred during the year $ 300,000 $1,575,000 Estimated costs to complete as of 12/31 1,200,000 –0– Billings during the year 380,000 1,620,000 Cash collections during the year 250,000 1,750,000 2012 Construction in progress 1,575,000 Cash, materials, etc. 1,575,000 Accounts receivable 1,620,000 Billings on construction contract 1,620,000 Cash 1,750,000 Accounts receivable 1,750,000

  23. Completed Contract Example Assume Nortel Networks contracted to provide a customer with Internet infrastructure for $2,000,000. The project began in 2011 and was completed in 2012. Data relating to the contract are summarized below: 20112012 Costs incurred during the year $ 300,000 $1,575,000 Estimated costs to complete as of 12/31 1,200,000 –0– Billings during the year 380,000 1,620,000 Cash collections during the year 250,000 1,750,000 Gross profit recognition: $2,000,000 - $1,875,000 = $125,000 Balance Sheet: • Nothing, all cleared out

  24. Long-Term Contract Losses • Loss in the Current Period on a Profitable Contract • Percentage-of-completion method only, the estimated cost increase requires a current-period adjustment of gross profit recognized in prior periods. • Loss on an Unprofitable Contract • Under both percentage-of-completion and completed-contract methods, the company must recognize in the current period the entire expected contract loss.

  25. Completed Contract Example – 2 Curtiss Construction Company, Inc., entered into a fixed-price contract with Axelrod Associates on July 1, 2011, to construct a four-story office building. At that time, Curtiss estimated that it would take between two and three years to complete the project. The total contract price for construction of the building is $4,000,000. Curtiss appropriately accounts for this contract under the completed contract method in its financial statements. The building was completed on December 31, 2013. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to Axelrod under the contract were as follows: At 12-31-11At 12-31-12At 12-31-13 Percentage of completion 10% 60% 100% Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– Billings to Axelrod, to date 720,000 2,170,000 3,600,000 Compute gross profit or loss to be recognized in each year.

  26. Completed Contract Example – 2 Continued The total contract price for construction of the building is $4,000,000. Curtiss appropriately accounts for this contract under the completed contract method in its financial statements. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to Axelrod under the contract were as follows: At 12-31-11At 12-31-12At 12-31-13 Percentage of completion 10% 60% 100% Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– Billings to Axelrod, to date 720,000 2,170,000 3,600,000 Price – actual costs – estimated remaining costs = expected profit

  27. Completed Contract Example – 2 Continued Just because, let’s do the journal entry to recognize profit (loss): The total contract price for construction of the building is $4,000,000. At 12-31-11At 12-31-12At 12-31-13 Percentage of completion 10% 60% 100% Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– Billings to Axelrod, to date 720,000 2,170,000 3,600,000 To recognize -0- (200,000) (50,000)

  28. Percentage-of-Completion Example – 2 Curtiss Construction Company, Inc., entered into a fixed-price contract with Axelrod Associates on July 1, 2011, to construct a four-story office building. At that time, Curtiss estimated that it would take between two and three years to complete the project. The total contract price for construction of the building is $4,000,000. Curtiss appropriately accounts for this contract under the completed contract method in its financial statements. The building was completed on December 31, 2013. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to Axelrod under the contract were as follows: At 12-31-11At 12-31-12At 12-31-13 Percentage of completion 10% 60% 100% Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– Billings to Axelrod, to date 720,000 2,170,000 3,600,000 Now compute gross profit or loss to be recognized in each year assuming use of percentage-of-completion.

  29. Percentage-of-Completion Example – 2 Cont. The total contract price for construction of the building is $4,000,000. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to Axelrod under the contract were as follows: At 12-31-11At 12-31-12At 12-31-13 Percentage of completion 10% 60% 100% Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– Billings to Axelrod, to date 720,000 2,170,000 3,600,000 Expected profit * Percentage of completion (Unless loss!)

  30. Percentage-of-Completion Example – 2 Cont. The total contract price for construction of the building is $4,000,000. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to Axelrod under the contract were as follows: At 12-31-11At 12-31-12At 12-31-13 Percentage of completion 10% 60% 100% Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– Billings to Axelrod, to date 720,000 2,170,000 3,600,000 Reported on Balance Sheet 2011 Current liabilities: 2012 Current assets:

  31. Percentage-of-Completion Example – 2 Cont. Again just because, let’s do the journal entry to recognize profit (loss): The total contract price for construction of the building is $4,000,000. At 12-31-11At 12-31-12At 12-31-13 Costs incurred to date $ 350,000 $2,500,000 $4,250,000 Estimated costs to complete 3,150,000 1,700,000 –0– To recognize 50,000 (250,000) (50,000)

  32. Helpful Graphic from Another Book

  33. Discussion Question Q18-20 Explain the differences between the installment-sales method and the cost-recovery method.

  34. Installment-Sales vs. Cost-Recovery When the collection of the sales price is not reasonably assured and revenue recognition is deferred. • Methods of deferring revenue: • Installment-sales method • Cost-recovery method • Deposit method Generally Employed

  35. Installment-Sales Method Recognizes income in the periods of collection rather than in the period of sale. Recognize both revenues and costs of sales in the period of sale, but defer gross profit to periods in which cash is collected. Selling and administrative expenses are not deferred.

  36. Acceptability of the Installment-Sales Method The profession concluded that except in special circumstances, “the installment method of recognizing revenue is not acceptable.” The rationale: because the installment method does not recognize any income until cash is collected, it is not in accordance with the accrual concept.

  37. Cost-Recovery Method Recognizes no profit until cash payments by the buyer exceed the cost of the merchandise sold. A seller is permitted to use the cost-recovery method to account for sales in which “there is no reasonable basis for estimating collectibility.” In addition, use of this method is required where a high degree of uncertainty exists related to the collection of receivables.

  38. Point of Delivery Example On July 1, 2011, the Foster Company sold inventory to the Slate Corporation for $300,000. Terms of the sale called for a down payment of $75,000 and three annual installments of $75,000 due on each July 1, beginning July 1, 2012. Each installment also will include interest on the unpaid balance applying an appropriate interest rate. The inventory cost Foster $120,000. The company uses the perpetual inventory system. Point of Delivery “Normal” Method (don’t worry about interest) July 1, 2011 Installment accounts receivable 300,000 Sales revenue 300,000 Cost of goods sold 120,000 Inventory 120,000 Cash 75,000 Installment accounts receivable 75,000 July 1, 2012 Cash 75,000 Installment accounts receivable 75,000

  39. Example as Installment Sale On July 1, 2011, the Foster Company sold inventory to the Slate Corporation for $300,000. Terms of the sale called for a down payment of $75,000 and three annual installments of $75,000 due on each July 1, beginning July 1, 2012. Each installment also will include interest on the unpaid balance applying an appropriate interest rate. The inventory cost Foster $120,000. The company uses the perpetual inventory system. Installment Sales Method (don’t worry about interest) July 1, 2011 Installment accounts receivable300,000 Inventory 120,000 Deferred gross profit 180,000 (300–120)/300 = 60% Cash 75,000 Installment accounts receivable 75,000 Deferred gross profit 45,000 Realized gross profit 45,000 75 * 60% July 1, 2012 Cash 75,000 Installment accounts receivable 75,000 Deferred gross profit 45,000 Realized gross profit 45,000

  40. Example as Cost Recovery On July 1, 2011, the Foster Company sold inventory to the Slate Corporation for $300,000. Terms of the sale called for a down payment of $75,000 and three annual installments of $75,000 due on each July 1, beginning July 1, 2012. Each installment also will include interest on the unpaid balance applying an appropriate interest rate. The inventory cost Foster $120,000. The company uses the perpetual inventory system. Cost Recovery Method (don’t worry about interest) July 1, 2011 Installment accounts receivable 300,000 Inventory 120,000 Deferred gross profit 180,000 Cash 75,000 Installment accounts receivable 75,000 July 1, 2012 Cash 75,000 Installment accounts receivable 75,000 Deferred gross profit 30,000 Realized gross profit 30,000 75 + 75 – 120 = 30

  41. IFRS RELEVANT FACTS - Similarities • Revenue recognition fraud is a major issue in U.S. financial reporting. The same situation occurs overseas as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer AHold NV. • In general, the accounting at point of sale is similar between IFRS and GAAP. As indicated earlier, GAAP often provides detailed guidance, such as in the accounting for right of return and multiple-deliverable arrangements.

  42. IFRS RELEVANT FACTS - Differences • The IASB defines revenue to include both revenues and gains. GAAP provides separate definitions for revenues and gains. • IFRS has one basic standard on revenue recognition—IAS 18. GAAP has numerous standards related to revenue recognition (by some counts over 100). • Accounting for revenue provides a most fitting contrast of the principles-based (IFRS) and rules-based (GAAP) approaches. While both sides have their advocates, the IASB and the FASB have identified a number of areas for improvement in this area.

  43. IFRS RELEVANT FACTS - Differences • In general, the IFRS revenue recognition principle is based on the probability that the economic benefits associated with the transaction will flow to the company selling the goods, rendering the service, or receiving investment income. In addition, the revenues and costs must be capable of being measured reliably. GAAP uses concepts such as realized, realizable, and earned as a basis for revenue recognition. • Under IFRS, revenue should be measured at fair value of the consideration received or receivable. GAAP measures revenue based on the fair value of what is given up (goods or services) or the fair value of what is received—whichever is more clearly evident.

  44. IFRS RELEVANT FACTS - Differences • IFRS prohibits the use of the completed-contract method of accounting for long-term construction contracts (IAS 13). Companies must use the percentage-of-completion method. If revenues and costs are difficult to estimate, then companies recognize revenue only to the extent of the cost incurred—a cost-recovery (zero-profit) approach. • In long-term construction contracts, IFRS requires recognition of a loss immediately if the overall contract is going to be unprofitable. In other words, GAAP and IFRS are the same regarding this issue.

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