Rev.

Recog - 1

REVENUE AND EXPENSE RECOGNITION

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LEARNING OBJECTIVES
Understand the revenue and matching principles Familiarize yourself with applications of the revenue principle with special attention to:
Installment and cost recovery methods Accounting for long-term contracts
Completed contract method Percentage of completion method

Right of return method Product financing arrangements Franchising agreements

Obtain overall understanding of matching principle

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Revenues

DEFINITIONS

Inflows of assets or settlements of liabilities during a period from delivering or producing goods or services.

Expenses
Outflows of assets or incurrence of liabilities during a period from delivering or producing goods or services.
Incurred in an attempt to produce revenues

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REVENUE PRINCIPLE

Revenue should be recognized in the financial statement when . . .

It is earned, and

It is realized or realizable
(Measurable)

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REVENUE PRINCIPLE
Revenue is earned when the earnings process is completed or virtually completed. Revenue is realized when cash is received. Revenue is realizable when claims to cash are received that can be converted into a known amount of cash.

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REVENUE PRINCIPLE

Revenue is typically recognized:

At delivery (point of sale) After delivery Before delivery

of product or service

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REVENUE RECOGNITION POINTS

Recognition before delivery
Design and production, construction in progress, minerals discovered Goods completed and ready for sale, contract complete

Recognition at delivery
Delivery of product or service

Recognition after delivery

Cash collected for goods or services Right of return expires

Percentage-of completion method

Production method

Point of sale method

Installment method Cost recovery method

Completed contract method

Right of return expiration method

RELEVANCE

RELIABILITY

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REVENUE RECOGNITION Point of Sale Revenue is earned and realized at the point of sale. The product or service has been delivered to the customer and cash has been received or is receivable.
This method is sometimes called the sales method, or delivery method.

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REVENUE RECOGNITION After Delivery

Uncertainties about collectibility or future performance by seller. Sale with right of return.
Product-financing arrangements.

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INSTALLMENT SALES
When we are uncertain about the collectibility of the sales revenue or the ability of the seller to deliver futures services, we should defer revenue recognition. Two commonly used accounting methods are the . . .
Installment sales method. Cost recovery method.

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INSTALLMENT SALES

Installment Sales Method

Sale and cost of sale recorded as usual. Compute gross margin rate on the installment sales. Recognize gross margin as cash is received. Gross margin not realized is deferred until a future period.

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INSTALLMENT SALES
Example

Sams Appliances made sales of $200,000 in 19X5 that qualified for the installment sales method of accounting. The items sold have a cost to Sams of $130,000. During 19X5, Sams collected cash from installment customers of $90,000. The remaining amount will be collected in 19X6. Prepare the journal entries to record the installment sales transactions during 19X5.

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INSTALLMENT SALES
Example

Sam's Appliances Installment Sales Dollars Percent Installment sales revenue $ 200,000 100% Cost of goods sold 130,000 65% Gross margin $ 70,000 35%

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INSTALLMENT SALES
Example
GENERAL JOURNAL
Date Description Installment Accounts Receivable Installment Revenue Post. Ref. Debit 200,000 200,000

Page 34
Credit

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INSTALLMENT SALES
Example
GENERAL JOURNAL
Date Description Installment Accounts Receivable Installment Revenue Post. Ref. Debit 200,000 200,000

Page 34
Credit

Cost of Installment Sales Inventory

130,000 130,000

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INSTALLMENT SALES
Example
GENERAL JOURNAL
Date Cash Installment Accounts Receivable Description Post. Ref. Debit 90,000 90,000

Page 34
Credit

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INSTALLMENT SALES
Example
GENERAL JOURNAL
Date Description Installment Revenue Cost of Installment Sales Deferred Gross Margin Post. Ref. Debit 200,000 130,000 70,000

Page 34
Credit

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INSTALLMENT SALES
Example
GENERAL JOURNAL
Date Description Installment Revenue Cost of Installment Sales Deferred Gross Margin Deferred Gross Margin Realized Gross Margin 31,500 31,500 Post. Ref. Debit 200,000 130,000 70,000

Page 34
Credit

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INSTALLMENT SALES
Example
GENERAL JOURNAL
Date Description Installment Revenue Cost of Installment Sales Deferred Gross Margin Deferred Gross Margin Realized Gross Margin 31,500 31,500 Post. Ref. Debit 200,000 130,000 70,000

Page 34
Credit

Cash collection in 19X5 Gross margin percentage Gross profit to recognize

$90,000 35% $31,500

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INSTALLMENT SALES
Example

Balance Sheet
Installment accounts receivable $ 110,000 Less: Deferred gross margin 38,500 Net Installment accounts receivable $ 71,500

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INSTALLMENT SALES
Example

Balance Sheet
Installment accounts receivable $ 110,000 Less: Deferred gross margin 38,500 Net Installment accounts receivable $ 71,500
Installment accounts receivable Less: Cash collections Installment accounts receivable Deferred gross margin Less: Gross margin recognized Deferred gross margin $ 200,000 (90,000) $ 110,000 $ 70,000 (31,500) $ 38,500

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COST RECOVERY METHOD

Like the installment sales method, cost recovery is used when we are uncertain about the collectibility of the sales revenue or the ability of the seller to complete future performance.

UNCERTAINTY IS GREATER!
No profit is recognized until cost of item sold is fully recovered.

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COST RECOVERY
Sams Appliances made sales of $200,000 in 19X5 that qualified for the cost recovery method of accounting. The items sold have a cost to Sams of $130,000. During 19X5, Sams collected cash from installment customers of $90,000. The remaining amount will be collected in 19X6. Prepare the journal entries to record the installment sales transactions during 19X5.
Example

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COST RECOVERY
Example
GENERAL JOURNAL
Date Description Installment Accounts Receivable Installment Revenue Post. Ref. Debit 200,000 200,000

Page 34
Credit

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COST RECOVERY
Example
GENERAL JOURNAL
Date Description Installment Accounts Receivable Installment Revenue Post. Ref. Debit 200,000 200,000

Page 34
Credit

Cost of Installment Sales Inventory

130,000 130,000

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COST RECOVERY
Example
GENERAL JOURNAL
Date Description Installment Revenue Cost of Installment Sales Deferred Gross Margin Post. Ref. Debit 200,000 130,000 70,000

Page 34
Credit

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COST RECOVERY
Example
GENERAL JOURNAL
Date Cash Installment Accounts Receivable Description Post. Ref. Debit 90,000 90,000

Page 34
Credit

No profit is recognized in 19X5 because the cost of the item sold ($130,000) has not been recovered in the form of cash receipts. Once we collect $130,000 in cash, profit recognition begins.

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COST RECOVERY
Example

Balance Sheet
Installment accounts receivable $ 110,000 Less: Deferred gross margin (70,000) Net Installment accounts receivable $ 40,000
All gross profit has been deferred until we recover the $130,000 cost of the item sold.

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RIGHT OF RETURN

In some industries it is common practice that the sales terms allow customers the right to return goods under specified conditions and over long periods of time.

Book Publishing

Equipment Manufacturing

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RIGHT OF RETURN
Recognize revenue at point of sale if,
Selling price is fixed or determinable. Buyer is obligated to pay the seller and payment is not contingent upon resale of the product. Buyer is obligated even in case of theft or physical destruction. Buyer has economic substance apart from that provided by the seller. Seller has no obligation for future performance. Future returns can be estimated.

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PRODUCT-FINANCING ARRANGEMENTS An agreement in which a sponsoring company sells a product to another company and in a related transaction agrees to repurchase the product. The sponsoring company

Wait for a sale to outside party.

Records a liability when the proceeds are received. No sale is recorded and inventory is not adjusted.

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REVENUE RECOGNITION Before Delivery Accounting for long-term construction contracts

Completed-Contract Method Percentage-of-Completion Method

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REVENUE RECOGNITION Before Delivery

Percentage-of-completion method is appropriate when . . .

Contract specifies the amount of consideration to be exchanged and the terms of settlement. Buyer is expected to satisfy the obligation. Contractor can perform according to the terms of the contract.

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MEASURING PROGRESS TOWARD COMPLETION Input Measures

Effort devoted to project compared to total effort expected (cost incurred to date compared to total estimated costs)

Output Measures
Results to date compared to total results

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MEASURING PROGRESS TOWARD COMPLETION Cost-to-Cost Method

Total costs incurred to date Percent complete =

Most recent estimate of total costs of the project

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MEASURING PROGRESS TOWARD COMPLETION

Cost-to-Cost Method

Current Period Revenue

Total Revenue from Contract Percent Complete Total Revenue to Recognize - Revenue Recognized in Prior Periods = Revenue Recognized in Current Period

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LONG-TERM CONTRACTS
Example

During 19X6, West, Inc. enters into a contract with Putnam County to build a bridge over Cane River. The project will take 3 years to complete and has a fixed price of $4,500,000. Wests engineers estimate the total cost of the bridge to be $3,000,000. At the end of 19X6, the information on the next page was gathered by Wests accountant.

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Example Project costs incurred during 19X6 $ 750,000 Estimated cost to complete the bridge 2,250,000 Amounts billed to Putnam Co. in 19X6 800,000 Cash collections from Putnam Co. 790,000

LONG-TERM CONTRACTS

West uses the percentage-of-completion method to account for all long-term construction projects.
Prepare the necessary 19X6 journal entries for this project.

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LONG-TERM CONTRACTS
Example
GENERAL JOURNAL
Date Description Construction-In-Process Cash, Payables, etc. Post. Ref. Debit 750,000 750,000

Page 34
Credit

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LONG-TERM CONTRACTS
Example
GENERAL JOURNAL
Date Description Construction-In-Process Cash, Payables, etc. Accounts Receivable Billings on Contracts 800,000 800,000 Post. Ref. Debit 750,000 750,000

Page 34
Credit

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LONG-TERM CONTRACTS
Example
GENERAL JOURNAL
Date Description Construction-In-Process Cash, Payables, etc. Accounts Receivable Billings on Contracts Cash Accounts Receivable 790,000 790,000 800,000 800,000 Post. Ref. Debit 750,000 750,000

Page 34
Credit

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LONG-TERM CONTRACTS
Example
GENERAL JOURNAL
Date Description Construction-In-Process Cost of Construction Construction Revenue Post. Ref. Debit 375,000 750,000 1,125,000

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Credit

$ 750,000 $ 3,000,000 = 25% complete $ 4,500,000 25% = $ 1,125,000 revenue $ 1,500,000 25% = $ 375,000 profit

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LONG-TERM CONTRACTS
Example
GENERAL JOURNAL
Date Description Construction-In-Process Cost of Construction Construction Revenue Post. Ref. Debit 375,000 750,000 1,125,000

Page 34
Credit

If West uses the Completed-Contract method, no revenue is recognized during 19X6. All revenue and profit is recognized at the end of the contract when delivery of the bridge to Putnam County is made.

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REVENUE RECOGNITION Before Delivery

Completion of Production
Accretion Basis Discovery Basis

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REVENUE RECOGNITION Service Sales Specific Performance Method

Proportional Performance Method Completed Performance Method

Collection

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SPECIFIC PERFORMANCE

Used to account for revenue that is earned by performing a single act.

Franchise revenue (SFAS No. 45)

Bobs Burgers

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PROPORTIONAL PERFORMANCE

Used to recognize service revenue that is earned by more than a single act and when the service is rendered in more than one accounting period.
Similar performance acts - equal amount for each act Dissimilar performance acts - in proportion to direct costs of each act Similar acts with a fixed period for performance

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COMPLETED PERFORMANCE

Used when revenue is earned by performing a series of acts, and the last act is so important that revenue is only considered earned if it is performed.

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COLLECTION

Used to account for service revenue when the uncertainty of collection is very high. Revenue recognized when cash is received.

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EXPENSE RECOGNITION

Expenses are outflows of assets or incurrences of liabilities during a period from delivery or producing goods or rendering services.

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MATCHING

Once revenues are determined, the expenses incurred in generating the revenue should be recognized.
As revenues are earned, certain assets are consumed and services are used.

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EXPENSES Recognition Methods

Direct

Period
Allocated

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GAINS AND LOSSES

Gains and losses result from peripheral or incidental transactions, events, or circumstances. Most gains and losses are recognized when the transaction is completed.

Estimated losses are recognized before realization if they are probable and can be

reasonably estimated.

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ETHICAL CONSIDERATIONS
Im sorry we shipped your order on Dec. 28 instead of on the delivery date of Jan. 10. But the important thing is that you have the products you need...Right?

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Midterm Exam