1 income recognition and measurement of net assets c hapter 17 an electronic presentation by douglas...

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Income Recognition Income Recognition and Measurement of and Measurement of

Net AssetsNet Assets

Income Recognition Income Recognition and Measurement of and Measurement of

Net AssetsNet Assets

Chapter17

An electronic presentation by Douglas Cloud

Pepperdine University

An electronic presentation by Douglas Cloud

Pepperdine University

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1. Understand the revenue recognition alternatives.

2. Explain revenue recognition at the time of sale, during production, and at time of cash receipt.

3. Explain the conceptual issues regarding revenue recognition alternatives.

ObjectivesObjectives

ContinuedContinuedContinuedContinued

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4. Describe the alternative revenue recognition methods.

5. Account for revenue recognition prior to the period of sale, including the percentage-of-completion and completed contract methods.



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6. Account for revenue recognition after the period of sale, including the installment and cost recovery methods.

7. Account for revenue recognition delayed until a future event occurs.

8. Understand software revenue recognition, franchises, real estate sales, retail land sales, and consignment sales.


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Revenue RecognitionRevenue Recognition

Recognition is the process of formally

recording and reporting items in the financial statements.

Recognition is the process of formally

recording and reporting items in the financial statements.

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Realization is the process of converting noncash recourses into cash or rights to cash.

Realization is the process of converting noncash recourses into cash or rights to cash.

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Example 1: Revenue Recognition at Time of SaleExample 1: Revenue Recognition at Time of Sale

1. Ringwood Company manufactures the inventory.

Inventory 100Cash 100

2. Ringwood sells the inventory for $150.

Accounts Receivable 150Revenue 150

Cost of Goods Sold 100Inventory 100


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Example 1: Revenue Recognition at Time of SaleExample 1: Revenue Recognition at Time of Sale

3. Ringwood collects cash of $60.Cash 60

Accounts Receivable 60

Income StatementRevenue $150 Cost of goods sold (100 )Gross profit $ 50

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Example 2: Revenue Recognition During ProductionExample 2: Revenue Recognition During Production

1. Ringwood Company manufactures the inventory.Inventory 100

Cash 1002. Ringwood recognizes the revenue during production.

Production Expense 100Inventory 50

Revenue 150


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3. The company bills the customer for a partial billing of $130.Accounts Receivable 130

Partial Billings 130

4. Ringwood collects cash of $60.

Cash 60Accounts Receivable 60

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Income StatementRevenue $150 Production expense (100 )Gross profit $ 50

The balance sheet shows Inventory of $150, less Partial Billings of $130.

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Example 3: Revenue Recognition at Time of Cash ReceiptExample 3: Revenue Recognition at Time of Cash Receipt

1. Ringwood Company manufactures the inventory.Inventory 100

Cash 100

2. Ringwood “sells” the inventory and defers the recognition of revenue.

Accounts Receivable 150Inventory 100Deferred Gross Profit 50


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3. Ringwood collects cash of $60.Cash 60

Accounts Receivable 60

4. The company recognizes revenue on the basis of the cash received.

Cost of Goods Sold 40Deferred Gross Profit 20

Revenue 60


($60 ÷ $150) x ($60 ÷ $150) x $100$100

Cash Cash ReceiveReceive

ddContinuedContinuedContinuedContinued

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Income StatementRevenue $ 60 Cost of goods sold (40 )Gross profit $ 20

The balance sheet shows Accounts Receivable of $90, less Deferred Gross Profit of $30.

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Conceptual IssuesConceptual Issues

• The economic substance of the event takes precedence over the legal form of the transaction.

• The risks and benefits of ownership have been transferred to the buyer.

• The collectibility of the receivable from the sale is reasonably assured.

• The economic substance of the event takes precedence over the legal form of the transaction.

• The risks and benefits of ownership have been transferred to the buyer.

• The collectibility of the receivable from the sale is reasonably assured.

The decision as to when to recognize revenue focuses on three factors:

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Alternative Revenue Recognition MethodsAlternative Revenue Recognition Methods

1. Revenue recognition in the period of sale.2. Revenue recognition prior to the period of

sale.3. Revenue recognition at the completion of

production.4.Revenue recognition after the period of sale.5. Revenue recognition delayed until a future

event.

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Earned and Realizable

Economic Substance and Transfer of Risks

and Benefits of Ownership

Collectibility is Not Reasonably

Assured

Installment Method

Cost Recovery Method

Percentage-of-Completion Method

(for Long-Term Contracts)

Completed-Contract Method (for Long-Term

Contracts)

Accrual Method: “Normal” Revenue Recognition at Sale

Not Sufficient Transfer of Risks and Benefits of

Ownership

Deposit Method

Recognition before Physical Transfer

Recognition at Physical Transfer

Collectibility is Reasonably

Assured

Revenue RecognizedRevenue Recognized

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Revenue Recognition Prior to the Period of Sale

Revenue Recognition Prior to the Period of Sale

Percentage-of-Completion MethodPercentage-of-Completion Method

It achieves the goals of accrual accounting.

It is consistent with the argument that revenue is earned continuously over the entire earning process.

It results in a more relevant measure of periodic income.

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AICPA Statement of Position No. 81-1 requires that a construction company use the percentage-of-

completion method for long-term contracts when all the following conditions are met:

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1. The company can make reasonably dependable estimates of the extent of progress toward completion, contract revenue, and contract costs.

2. The contract clearly specifies the enforceable rights regarding goods or services to be provided and received by both the company and the buyer, the consideration to be exchanged, and the manner and terms of settlement.

3. The buyer can be expected to satisfy its obligations under the contract.

4. The company expects to perform its contractual obligations.


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The Statement also requires that a company use the

completed-contract method only when at least one of

these conditions is not met...

The Statement also requires that a company use the

completed-contract method only when at least one of

these conditions is not met...

…for short-term contract, and when there are inherent hazards in

the contract beyond the normal business risks for which

reasonably dependable estimates cannot be made.

…for short-term contract, and when there are inherent hazards in

the contract beyond the normal business risks for which

reasonably dependable estimates cannot be made.

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2004 2005 2006

Construction costs incurred during the year $100,000 $186,000

$314,000Estimated costs to complete the

contract 400,000 264,000 ---

Partial billing to customer 80,000 350,000270,000

Collections from customer 50,000 330,000320,000

Total contract price: $700,000

Example


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1. To record construction costs:Construction in Progress 100,000

Accounts Payable, etc. 100,0002. To record partial billings:

Accounts Receivable 80,000Partial Billings 80,000

2004

3. To record collections:

Cash 50,000Accounts Receivable 50,000


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4. To record gross profit:Construction Expense 100,000Construction in Progress 40,000

Construction Revenue 140,000

2004

($100,000 ÷ $500,000) x $700,000($100,000 ÷ $500,000) x $700,000


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2005




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4. To record gross profit:Construction Expense 186,000Construction in Progress 38,000


2005

[($286,000 ÷ $550,000) x $700,000] [($286,000 ÷ $550,000) x $700,000] –– $140,000 $140,000

Construction costs incurred to date

Revised cost =$286,000 + $264,000

Previous year’s construction revenue


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2006




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4. To record gross profit and close out accounts:Construction Expense 314,000Construction in Progress 22,000


2006

$700,000 $700,000 –– $140,000 $140,000 –– $224,000 $224,000

Recognized in 2004Recognized in 2005

Partial Billings 700,000Construction in Progress 700,000

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Completed-Contract MethodCompleted-Contract Method

Entries 1, 2, and 3 are the same as those used for the percentage-of-completion method. The completed-contract method does not

recognize revenue until the project is completed, so there is no Entry 4 until 2006.

Entries 1, 2, and 3 are the same as those used for the percentage-of-completion method. The completed-contract method does not

recognize revenue until the project is completed, so there is no Entry 4 until 2006.


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4. To record gross profit and close out accounts:Partial Billings 700,000


2006

Completed-Contract MethodCompleted-Contract Method

Construction Expense 600,000Construction in Progress 600,000

$100,000 + $186,000 + $314,000$100,000 + $186,000 + $314,000

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Capitalized InterestCapitalized Interest

If interest cost is associated with the funds used in the

construction, the firm should include this cost in the

Construction in Process account.

If interest cost is associated with the funds used in the

construction, the firm should include this cost in the

Construction in Process account.

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Installment sales involve a financing agreement whereby the customer

signs a contract,...

Installment sales involve a financing agreement whereby the customer

signs a contract,...

Installment MethodInstallment Method

...makes a small down payment,...

...makes a small down payment,...

…and agrees to make periodic payments over

an extended period, often several years.

…and agrees to make periodic payments over

an extended period, often several years.

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1. Total sales, cost of goods sold, and collections are recorded in the normal manner during the year.

2. At the end of the year, installment sales are identified. The revenue and the related cost of goods sold are “reversed,” and the deferred gross profit is recognized.

3. At the end of the year, the gross profit rate on installment sales is computed.



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4. A portion of the deferred gross profit is recognized as gross profit.

5. In future years the remaining deferred gross profit is reduced and the gross profit is recognized based on the cash collected on the installment sales.


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Consider the following information for Lee for 2004:Consider the following information for Lee for 2004:

Total credit sales $500,000Total cost of goods sold 390,000Installment method sales 100,000Installment method cost of goods sold 75,000Gross profit rate on installment method sales 25%Cash receipts on installment method sales 20,000Cash receipts on other credit sales 300,000

Lee Company uses a perpetual inventory method.Lee Company uses a perpetual inventory method.ContinuedContinuedContinuedContinued

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Accounts Receivable 500,000Sales 500,000

Cost of Goods Sold 390,000Inventory 390,000

Credit sales during 2004:


Collected $300,000; $20,000 related to installment sales:


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Sales 100,000Cost of Goods Sold 75,000Deferred Gross Profit, 2004 25,000

Installment sales and related cost of goods sold identified and “reversed” on December 31, 2004:

Deferred Gross Profit, 2004 5,000Gross Profit Realized on Installment Method Sales 5,000

Recognized a gross profit of 25% of cash collected on installment sales on December 31, 2004:


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Consider the following information for Lee for 2005:Consider the following information for Lee for 2005:

Total credit sales $600,000Total cost of goods sold 430,000Installment method sales 150,000Installment method cost of goods sold 105,000Gross profit rate on installment method sales 30%Cash receipts on installment method sales: 2004 sales 30,000 2005 sales 40,000Cash receipts on other credit sales 480,000ContinuedContinuedContinuedContinued

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Accounts Receivable 600,000Sales 600,000

Cost of Goods Sold 430,000Inventory 430,000

Credit sales during 2005:


Collected $550,000; $70,000 related to installment sales:


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Sales 150,000Cost of Goods Sold 105,000Deferred Gross Profit, 2005 45,000

Installment sales and related cost of goods sold identified and “reversed on December 31, 2005:


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Deferred Gross Profit, 2004 7,500Deferred Gross Profit, 2005 12,000

Gross Profit Realized on Installment Method Sales 19,500

On December 31, 2005, recognized a gross profit of 25% of cash collected on installment sales for 2004 and 30% for 2005:

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Cost Recovery MethodCost Recovery Method

APB Opinion No. 10 found the cost recovery method of recognizing revenue

generally to be unacceptable. However, the Board did agree that this method could be

used in exceptional cases where receivables are collected over an extended period and where the terms of the transaction provide

no reasonable basis for estimating the degree of collectibility.

APB Opinion No. 10 found the cost recovery method of recognizing revenue

generally to be unacceptable. However, the Board did agree that this method could be

used in exceptional cases where receivables are collected over an extended period and where the terms of the transaction provide

no reasonable basis for estimating the degree of collectibility.

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Consider the following information for the Parken Company:

Sale of property under cost recovery method $20,000Cost of property sold (net) 12,000Cash collections: 2004 5,000 2005 9,000 2006 6,000

Consider the following information for the Parken Company:

Sale of property under cost recovery method $20,000Cost of property sold (net) 12,000Cash collections: 2004 5,000 2005 9,000 2006 6,000

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Accounts Receivable 20,000Deferred Gross Profit 8,000Property (net) 12,000

During 2004


Collected $5,000



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During 2005

Deferred Gross Profit 2,000Gross Profit Realized on Cost Recovery Transactions 2,000

December 31, 2005



($5,000 + $9,000) minus ($5,000 + $9,000) minus property cost of $12,000property cost of $12,000

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During 2006

Deferred Gross Profit 6,000Gross Profit Realized on Cost Recovery Transactions 6,000

December 31, 2006


The cash collected in 2006 results in the recognition of an equal amount of gross profit.

The cash collected in 2006 results in the recognition of an equal amount of gross profit.

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Revenue Recognition Delayed Until a Future Event Occurs (Deposit Method)Revenue Recognition Delayed Until a

Future Event Occurs (Deposit Method)

Oscar Company sells a subsidiary to the Pet Company and accepts a $500,000 down payment and a 10% note for the

balance of the sale of $7 million. The net assets of the subsidiary are $5 million

and Pet Company has the right to cancel the agreement for the next year.

Oscar Company sells a subsidiary to the Pet Company and accepts a $500,000 down payment and a 10% note for the

balance of the sale of $7 million. The net assets of the subsidiary are $5 million

and Pet Company has the right to cancel the agreement for the next year.

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Revenue Recognition Delayed Until a Future Event Occurs (Deposit Method)Revenue Recognition Delayed Until a

Future Event Occurs (Deposit Method)

Cash 500,000 Deposit from Purchaser 500,000

Upon receipt of down payment (Oscar Company):

Interest Receivable 650,000Note Receivable 6,500,000Deposit from Purchaser 500,000

Interest Revenue650,000Gain2,000,000Net Assets of Subsidiary5,000,000

When circumstances allow the revenue to be recognized:liabilityliability

10% x $6,500,00010% x $6,500,000

$7,000,000 – $5,000,000

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Software Revenue RecognitionSoftware Revenue Recognition

If a company has an agreement to deliver software that requires significant production, modification, or customization of software, it uses contract accounting for the agreement.

Guidelines of AICPA Statement of Position No. 97-2


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If a company has an agreement to deliver software that does not require significant production, modification, or customization of software, it recognizes revenue when (a) persuasive evidence of an agreement exists, (b) delivery has occurred, (c) the seller’s fee is fixed or determinable, and (d) collectibility is probable.




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A company separately accounts for a service element if (a) the services are not essential to the functionality of any other element of the transaction, and (b) the services are stated separately in the contract such that the total price of the agreement would be expected to vary as the result of inclusion or exclusion of the service.




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Software arrangements may consist of multiple elements such as additional software products, upgrades and/or enhancements, rights to exchange or return software, and customer support. If contract accounting does not apply, a company must allocate its fee to the various elements based on fair values.




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A company must allocate any discounts proportionately to all the elements, except that none can be allocated to upgrade rights.




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FranchiseFranchise

A franchise agreement involves the granting of business rights by the

franchisor to a franchisee who will operate the franchised business.

A franchise agreement involves the granting of business rights by the

franchisor to a franchisee who will operate the franchised business.

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FranchiseFranchise

Castle Company sells a franchise that requires an initial franchise fee of

$70,000. A down payment of $20,000 cash is required, with the balance covered by the issuance of a $50,000, 10% note, payable by the franchisee in five equal

annual installments.

Castle Company sells a franchise that requires an initial franchise fee of

$70,000. A down payment of $20,000 cash is required, with the balance covered by the issuance of a $50,000, 10% note, payable by the franchisee in five equal

annual installments.

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Situation 1: Castle has substantially performed all material services, the refund period has expired, and the collectibility of the note is reasonably assured.

Situation 1: Castle has substantially performed all material services, the refund period has expired, and the collectibility of the note is reasonably assured.

FranchiseFranchise

Cash 20,000Notes Receivable 50,000

Franchise Revenue 70,000

ContinueContinueContinueContinue

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Situation 2: The refund period has expired and the collectibility of the note is reasonably assured, but Castle has not substantially performed all material services.

Situation 2: The refund period has expired and the collectibility of the note is reasonably assured, but Castle has not substantially performed all material services.

FranchiseFranchise


Unearned Franchise Fees 70,000

Castle will recognize the unearned franchise fees as revenue when it has performed all material services.


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Situation 3: Castle has substantially performed all material services and the collectibility of the note is reasonably assured, but the refund period has not expired.

Situation 3: Castle has substantially performed all material services and the collectibility of the note is reasonably assured, but the refund period has not expired.

FranchiseFranchise


Unearned Franchise Fees 70,000

Castle will recognize the unearned franchise fees as revenue when the refund period expires.


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Each year revenue of $10,000 is recognized as cash is collected.

Situation 4: Castle has substantially performed all material services and the refund period has expired, but the collectibility of the note is not reasonably assured.

Situation 4: Castle has substantially performed all material services and the refund period has expired, but the collectibility of the note is not reasonably assured.

FranchiseFranchise


Unearned Franchise Fees 50,000Franchise Revenue 20,000


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Situation 5: The refund period has expired, but Castle has not substantially performed all material services and there is no basis for estimating the collectibility of the note.

Situation 5: The refund period has expired, but Castle has not substantially performed all material services and there is no basis for estimating the collectibility of the note.

FranchiseFranchise

Cash 20,000Unearned Franchise Fees 20,000

Castle recognizes revenue either under the accrual method (if collectibility is reasonably assured) or the installment method (if it has no basis for estimating

the collectibility of the note).ContinueContinueContinueContinue

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Situation 6: Castle has earned only $30,000 from providing initial services, with the balance being a down payment for continuing services. The refund period has expired and collectibility of the note is reasonably assured.

Situation 6: Castle has earned only $30,000 from providing initial services, with the balance being a down payment for continuing services. The refund period has expired and collectibility of the note is reasonably assured.

FranchiseFranchise


Franchise Revenue 30,000Unearned Franchise Fees 40,000

Castle recognizes the unearned franchise fees as revenue when it performs the continuing services.

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Retail Estate SalesRetail Estate Sales

1. If the sale is not consummated, the deposit method is used.

2. If the buyer’s initial and continuing investment is not adequate, the installment method is used if the recovery of the cost of the property is reasonably assumed

FASB Statement No. 66 states that the selling company recognizes revenue and the related expenses in the period of the sale on the accrual basis if all of the following conditions are met:


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3. If the seller’s receivable is subject to future subordination, the cost recovery method is used.

4. If the seller has continuing involvement with the property and does not transfer substantially all the risks and benefits of ownership, generally revenue and related expenses are recognized at the time of sale with a deduction for the maximum exposure to loss.

Retail Estate SalesRetail Estate Sales

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Consignment SalesConsignment Sales

1. Since title remains with the consignor, when the goods are transferred from the consignor to the consignee, the consignor does not record the sale of inventory.

2. The consignor recognizes revenue only when the sale to the third party occurs.

3. The consignee uses a Consignment-in account.

4. The consignor uses a Consignment-out account, which is a special inventory account.

1. Since title remains with the consignor, when the goods are transferred from the consignor to the consignee, the consignor does not record the sale of inventory.

2. The consignor recognizes revenue only when the sale to the third party occurs.

3. The consignee uses a Consignment-in account.

4. The consignor uses a Consignment-out account, which is a special inventory account.

Accounting for consignments may be summarized--

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Chapter17

The EndThe EndThe EndThe End

1 income recognition and measurement of net assets c hapter 17 an electronic presentation by douglas...

Documents

recognition of revenue

software revenue recognition

revenue recognition

revenue recognitionrealization

income recognition

ringwood company

time of cash receipt1

time of cash receipt3