1

Recall: Revenue is recognized at the earliest moment

that both of the following conditions are met:
1.Earned: The critical event in the process of earning
revenue has taken place. (seller)

2. Realized: The amount of revenue that will be collected is
reasonably assured and measurable with a reasonable
degree of reliability. (buyer)
Chapter 18 & 18A
Complex Revenue Recognition
2
Basic Idea:
Various types of franchise arrangements, we will
focus on service sponsor-retailer
Franchisor sells
(1) right to operate business and
(2) provides on-going support activities.
Revenue streams
(1) initial sale of franchise and related assets/services
(2) fees based on the operation of the franchise

So how does franchisor record this revenue?
Franchise Revenue
(Appendix 18A)
3
Initial Franchise fee
Revenue recorded when there is:
Substantial performance
No remaining obligation to refund any cash or excuse any
non-payment of note. Generally assumed to be when
franchisee commences operations
Collection of fee is reasonably assured
If terms not met, then Unearned Franchise Fees
Often payment is in cash and a LT note receivable
Continuing Fees
When earned and receivable.
Often amount must be verified
Franchise Revenue
4
On 3/31/09 the Red Hot Chicken Wing Corp. entered into a
franchise agreement with Thomas Keller. In exchange for an initial
franchise fee of $50,000, Red Hot will provide initial services to
include the selection of location, construction of building,
employee training and consulting services over several years.
$10,000 is payable on 3/31/09, with the remaining $40,000 payable
in annual installments. 10% interest on the note (at market rate) is
payable annually. In addition, the franchisee will pay continuing
franchise fees of $1000 per month for advertising and promotion
provided by Red Hot, beginning immediately after the franchise
begins operations. Thomas Keller opened his Red Hot franchise for
business on 9/30/09
Franchise Revenue Example
5
Initial Franchise fee
3/31/09 Cash 10,000
Note Receivable 40,000
Unearned franchise fee revenue 50,000

9/30/09 Unearned franchise fee revenue 50,000
Franchise fee revenue 50,000
Continuing Fees
10/31/09 Cash 1000
(& monthly) Service Revenue 1000
Debt Service
3/31/10 Cash 4000
Interest revenue 4000
Franchise Revenue Example
6
Basic idea:
Consignor gives merchandise to a a reseller to sell on your behalf
to an end user.
Cant recognize revenue until sold to end user

Entries:
Ships to consignee
Inventory on consignment xxx
Finished good inventory xxx
Notified of sale to end user
Cash xxx
Commission expense xxx
Revenue from consigned sales xxx
COGS xxx
Inventory on consignment xxx
Consignments (Appendix 18A)
7
What type of sales terms would result
in an in substance consignment
arrangement?
Often take form of side deal
Consignments
Revenue may be recognized before
delivery under certain circumstances.
Long-term construction contracts are a
notable example
US GAAP
The percentage-of-completion method, and
The completed contract method
Revenue Recognition Before
Delivery
Long-Term Construction
Accounting Methods
1) Terms of contract must
be certain, enforceable.
2) Certainty of performance
by both parties
3) Estimates of completion
can be made reliably
1) To be used only when
the percentage method is
inapplicable [uncertain]
2) For short-term contracts
Percentage-of-Completion
Method
Completed Contract
Method
Revenue Recognition Before
Delivery
1. Long-term construction contracts when outcomes
cannot be reasonably estimated:
US GAAP: must use Completed Contract Method (No revenue
or expense is recognized until the end of the contract)
IFRS: must use the zero-profit method (revenues are
recognized only to the extent of costs)
2. Service Revenue
US GAAP: follow specific industry guidance for revenue
recognition
IFRS: typically use the % Completion method (or straight-
line if services are specified over a period of time)

Revenue Recognition:
US GAAP vs. IFRS
11
Want to reflect economic substance of the
activities of the company
I/S: Revenues earned and expenses incurred
B/S: Value of asset being constructed
Requires the use of estimates
What information do we need?
Contract revenue
Expenses incurred
Estimated remaining expenses
Billing and cash from customer
Percentage of Completion: Basic Idea
12
Data: Contract price: $4,500,000 Estimated cost: $4,000,000
Start date: July, 2003 Finish: October, 2005
Balance sheet date: Dec. 31
Given: 2003 2004 2005

Costs to date $1,000,000 $2,916,000 $4,050,000
Estimated costs to complete $3,000,000 $1,134,000 $ -0-
Progress Billings during year $900,000 $2,400,000 $1,200,000
Cash collected during year $750,000 $1,750,000 $2,000,000
What is the percent complete, revenue, and gross
profit recognized each year?
Percentage-of-Completion:
Example
13
2003
To record cost of construction:
DR Construction in process (CIP) 1,000,000
CR Accounts Payable 1,000,000

To record progress billings to customer:
DR Accounts receivable 900,000
CR Billings on CIP 900,000

To record cash collections:
DR Cash 750,000
CR Accounts receivable 750,000
Percentage-of-Completion: Entries
Involving Third Parties
14
Construction in Process
Similar to a Work-In-Process inventory account
Accumulates all costs and profits

Billings on Construction in Process
Similar to a deferred revenue account
Gets offset to CIP (i.e., think of as a contra-account to
Construction in Process)

At the end of any accounting period, the difference between the
balance in CIP and Billings on CIP will appear on the balance
sheet.
If CIP > Billings on CIP, the difference will be reported as an
asset.
If Billing on CIP > CIP, the difference will appear as a
liability.
Percentage-of-Completion:
Balance Sheet Accounts
15
Costs incurred to date = Percent complete
Most recent estimated total costs
1
Estimated total revenue x Percent complete
= Revenue to be recognized to date
2
Total revenue to be recognized to date less Revenue
recognized in PRIOR periods = Current period revenue
3
Current Period Revenue less current costs = Gross profit
4
Percentage-of-Completion: Entries
to Record Revenue & Expense
16
2003 2004 2005
% complete
to-date
1,000,000 = 25% 2,916,000= 72% 100 %
4,000,000 4,050,000
Revenue
recognized
4,500,000 * 25% 4,500,000 * 72% 4,500,000
= 1,125,000 less 1,125,000 less 3,240,000
= 2,115,000 = 1,260,000
1,125,000 less 2,115,000 less 1,260,000
1,000,000 1,916,000 less 1,134,000
= 125,000 = 199,000 = 126,000
Gross Profit
recognized
Percentage-of-Completion:
Example
17
2003
To record revenue and expense
DR CIP (plug gross profit here) 125,000
DR Construction Expenses 1,000,000
CR Revenue (1m/(1m+3m)x4.5m) 1,125,000


Note: Construction expenses = actual expenditures for the
period
Percentage-of-Completion: Entries
Involving Third Parties
18
Balance Sheet 2003
Construction In Progress
1,000,000
125,000

1,125,000
Billings
900,000

900,000
Balance Sheet
in current assets:
CIP 1,125,000
Billings (900,000)
Costs and Recognized Gross Profit
in excess of Billings 225,000
19
2004:
Construction in Progress (2.916m 1.0m) 1,916,000
A/P, etc. 1,916,000

A/R 2,400,000
Billings 2,400,000

Cash 1,750,000
A/R 1,750,000

CIP 199,000
Construction Expenses 1,916,000
Revenue (2.916m/4.050m x 4.5m) 1,125,000 2,115,000
Percentage-of-Completion:
Journal Entries
20
% Completion Balance Sheet 2004
Construction In Progress
1,000,000
125,000
1,916,000
199,000
3,240,000
Billings
900,000
2,400,000
3,300,000
Balance Sheet
in current liabilities:
Billings 3,300,000
Less: CIP (3,240,000)
Billings in excess of cost
and recognized gross profit 60,000
21
2005:
CIP (4,050 2,916) 1,134,000
A/P, etc. 1,134,000


A/R 1,200,000
Billings 1,200,000


Cash 2,000,000
A/R 2,000,000


CIP 126,000
Construction Expenses 1,134,000
Revenue (4,050/4,050 x 4,500) 1,125 - 2,115 1,260,000

Percentage-of-Completion: Journal Entries
22
% Completion Balance Sheet 2005
CIP Billings
1,000,000 900,000
125,000 2,400,000
1,916,000 1,200,000
199,000 4,500,000
1,134,000 -
126,000
4,500,000
-
23
At the end of the contract:

To record completion of project:
DR Billings on CIP 4,500,000
CR Construction in process 4,500,000

Over the life of the contract, the total credits to Billings on CIP
will equal the total amount billed to the customer, which is the
total revenue received over the life of the contract.
Percentage-of-Completion: Entries
24
Note that Gross Profit is stored in the CIP Account this is very
different from ordinary sales transactions, where gross profit is
not in any specific account
A T-account analysis of the CIP account is very useful in answering
questions
For example, you could be told that Daniels Construction incurred
$1 million in construction costs on a new contract this year. They
expect to incur another $7 million to complete the project. The
balance in the CIP account at year end is $1.2 million. What is
the total revenue they expect to earn on the contract?
Answer: 1.2 1 = 200,000 in GP recognized
Project is 1/(1+7) or 12.5% complete, so 200,000 / 0.125 = $1,600,000
in total profit
Since profit is revenues minus expenses, total revenues must be 1.6 +
8 = $9.6 million
Percentage-of-Completion: the Construction
in Progress Account
25
Use when is a lack of dependable estimates
No revenue, no expense, no gross profit recognized until
the project is actually completed.
Journal entries prepared during the life of contract are
the same as those prepared under the percentage-of-
completion method with the exception of the last
journal entry that recognizes periodic revenue, expense
and gross profit.
Instead, the entire revenue, expense and gross profit are
recorded at the end of the project.
Completed Contract Method
26
Completed Contract
Assuming the same numbers as example
before, what are the journal entries under
the completed contract method?
All journal entries for 2003, 2004, and 2005
would appear exactly as before, except that
there would be no revenue recognition journal
entry in each year
Therefore, the balance in CIP at the end of each
year would represent only the inventoried
construction costs
27
2003:
Construction in Progress (CIP) 1,000,000
Cash, A/P, etc. 1,000,000

A/R 900,000
Billings 900,000

Cash 750,000
A/R 750,000

Entries above same as for % Completion. No entry to record
revenues and expenses.
Completed Contract: Journal Entries
28
Balance Sheet 2003 Completed Contract
Construction In Progress
1,000,000


1,000,000
Billings
900,000

900,000
Balance Sheet
in current assets:
CIP 1,000,000
Billings (900,000)
Costs
in excess of Billings 100,000
29
2004:
Construction in Progress (2,916 1,000) 1,916,000
Cash, A/P, etc. 1,916,000

A/R 2,400,000
Billings 2,400,000

Cash 1,750,000
A/R 1,750,000

J/E above are same as for % Completion (no entry made for
revenue and expense)
Completed Contract: Journal Entries
30
Completed Contract Balance Sheet 2004
Construction In Progress
1,000,000
1,916,000

2,916,000
Billings
900,000
2,400,000
3,300,000
Balance Sheet
in current liabilities:
Billings 3,300,000
Less: CIP (2,916,000)

Billings in excess of cost 384,000
31
2005:
CIP (4,050 2,916) 1,134,000
Cash, A/P, etc. 1,134,000

A/R 1,200,000
Billings 1,200,000

Cash 2,000,000
A/R 2,000,000

Now that the project is done, we can close out the Billings and CIP accounts and
record Construction Revenue and Construction Expense:

Billings 4,500,000
Revenue 4,500,000

Construction Expenses 4.050,000
CIP 4,050,000

Completed Contract: Journal Entries
32
Completed Contract Balance Sheet 2005
CIP Billings
1,000,000 900,000
2,400,000
1,916,000 1,200,000
4,500,000
1,134,000 -

4,050,000
-
33
Losses on Contracts
Need to determine if the loss is for the current
period or if for the contract overall.
If on overall profitable contract, recognize the
loss in the period incurred via negative gross
profit
Overall unprofitable contract
Percentage of completion: Recognize entire contract
loss now by backing out previous gross profit
Completed contract: Recognize the entire loss now.

What is the theoretical justification for this?
34
Loss on an
overall unprofitable
contract
Percentage Method: Recognize entire
loss now (this means backing out any
previously recognized gross profit)
Completed method:
Recognize loss currently.
Recognizing Overall Losses on
Long-Term Contracts
35
Revenue recognition is deferred when
collection of sales price is not reasonably
assured and no reliable estimates can be
made. GAAP allows:
the installment sales method
the cost recovery method

Revenue Recognition After
Delivery
36
Emphasizes income recognition in periods of
collection rather than at point of sale.
Title does not pass to the buyer until all cash
payments have been made to the seller.
Gross profit is deferred to the periods of
collection.
Other expenses, selling and administrative,
are not deferred.
The Installment Sales Method
37
Installment sales must be kept separate
Gross profit on installment sales must be
determinable
The amount of cash collected from
installment accounts must be known
The cash collected from current years and
prior years accounts must be known
Provision must be made for the carry forward
of each years deferred gross profit
The Installment Sales Method
38
Installment Sales Issues - Interest
and Repossessions
Interest: recognize at time of receipt (do
not defer)
Repossessions:
Be sure to account for all payments and
recognition of gross profit until the repossession
date
Set up repossessed goods at their fair value at
repossession (not what they were worth when
originally sold)
Write off any remaining A/R and deferred GP,
plugging a gain/loss to make entry balance
39
For installment sales in
any year








For installment sales
made in prior years
(realized gross profit)
Determine rate of gross
profit on installment
sales
Apply this rate to cash
collections of current
years installment sales
to yield realized gross
profit
The gross profit not
realized is deferred
Apply the relevant rate
to cash collections of
prior years installment
sales
The Installment Sales Method:
Steps
40
Given: 2003 2004 2005

Installment sales $200,000 $250,000 $240,000
Cost of sales $150,000 $190,000 $168,000
Gross Profit $ 50,000 $ 60,000 $ 72,000

Cash received in:
from 2003 sales $ 60,000 $ 100,000 $ 40,000
from 2004 sales $ -0- $ 100,000 $125,000
from 2005 sales $ -0- $ -0- $ 80,000
Determine the realized and deferred gross profit.
The Installment Sales Method:
Example
41
2003 2004 2005

Gross profit rate 25% 24% 30%
Realized Gross Profit:
From 2003 sales (e.g., 60,000 x 25%)
Realized in $ 15,000 $ 25,000 $ 10,000
From 2004 sales:
Realized in: $ -0- $ 24,000 $ 30,000
From 2005 sales:
Realized in: $ -0- $ -0- $ 24,000
The Installment Sales Method:
Example
42
When the 2003 installment sale is made:
Installment A/R (2003) 200,000
Installment Sales 200,000

Installment Cost of Sales 150,000
Inventory 150,000

Installment Sales 200,000
Installment Cost of Sales 150,000
Deferred Gross Profit, 2003 50,000

When cash is received, some deferred GP is recogd as revenue:
Cash 60,000
Installment A/R (2003) 60,000

Deferred Gross Profit, 2003 15,000
Realized Gross Profit (I/S) 15,000
(Realized: $60,000 x 25%)

The Installment Sales Method: 2003
Journal Entries for Gross Profit
43
Installment A/R (2004) 250,000
Installment Sales 250,000
Installment Cost of Sales 190,000
Inventory 190,000

Installment Sales 250,000
Installment Cost of Sales 190,000
Deferred Gross Profit, 2004 60,000

When cash is received, some deferred GP is recogd as revenue:
Cash 200,000
Installment A/R (2003) 100,000
Installment A/R (2004) 100,000

Deferred Gross Profit, 2003 25,000
Deferred Gross Profit, 2004 24,000
Realized Gross Profit (I/S) 49,000
(Realized: 03: $100K x 25% + 04 $100K X 24%)


The Installment Sales Method: 2004 Journal
Entries for Gross Profit
44
Installment A/R (2005) 240,000
Installment Sales 240,000
Installment Cost of Sales 168,000
Inventory 168,000

Installment Sales 240,000
Installment Cost of Sales 168,000
Deferred Gross Profit, 2005 72,000

When cash is received, some deferred GP is recognized as revenue:
Cash 245,000
Installment A/R (2003) 40,000
Installment A/R (2004) 125,000
Installment A/R (2005) 80,000

Deferred Gross Profit, 2003 10,000
Deferred Gross Profit, 2004 30,000
Deferred Gross Profit, 2005 24,000
Realized Gross Profit (I/S) 64,000
(Realized: 03: $40K x 25% + 04 $125K X 24% + 05 80K X 30%)
Installment Sales Method: 2005 Journal
Entries
45
Used when no reasonable basis for estimating
collectibility as in franchises and real estate.
Seller recognizes no profit until cash
payments by buyer exceed sellers cost of
merchandise.
After recovering all costs, seller includes
additional cash collections in income.
The income statement reports the amount of
gross profit recognized and the amount
deferred.
The Cost Recovery Method
46
Given: 2003 2004 2005

Installment sales $200,000 $250,000 $240,000
Cost of sales $150,000 $190,000 $168,000
Gross Profit $ 50,000 $ 60,000 $ 72,000

Cash received in:
from 2003 sales $ 60,000 $ 100,000 $ 40,000
from 2004 sales $ -0- $ 100,000 $125,000
from 2005 sales $ -0- $ -0- $ 80,000
Determine the realized and deferred gross profit.
The Original Example Cost
Recovery Method
47
2003:
(J/Es for sales and deferral of GP are same as in installment method)

Installment A/R (2003) 200,000
Installment Sales 200,000
Cost of Installment sales 150,000
Inventory 150,000

Installment Sales 200,000
Cost of Installment Sales 150,000
Deferred Gross Profit 50,000

Cash collection J/Es:
Cash 60,000
Installment A/R (2003)
60,000

Note: costs remaining to recover = 150,000 60,000 = 90,000 before
any recognition of profit
The Cost Recovery Method
48
2004:
J/Es for sales and deferral of GP are same as in installment method

Cash 200,000
Installment A/R (2003) 100,000
Installment A/R (2004) 100,000

2003 GP can be recognized: 150,000 60,000 100,000 = 10,000 to
be recognized
No 2004 GP to be recognized: 190,000 100,000 = 90,000

Deferred GP, 2003 sales 10,000
Recognized GP 10,000
The Cost Recovery Method
49
2005:
J/Es for sales and deferral of GP are same as in installment method

Cash 245,000
Installment A/R (2003) 40,000
Installment A/R (2004) 125,000
Installment A/R (2005) 80,000

All cash collected in 2003 can be recognized as GP because costs
covered in 2004
2004 GP to be recognized: 190,000 100,000 125,000 = 35,000
No GP for 2005: 168,000 80,000 = 88,000

Deferred GP, 2003 sales 40,000
Deferred GP, 2004 sales 35,000
Recognized GP 75,000
The Cost Recovery Method