Prepared by:Gabriela H. Schneider, CMA; Grant MacEwan College

INTERMEDIATEACCOUNTING

Sixth Canadian Edition

KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

C H A P T E R

6

Revenue Recognition

Learning Objectives

1. Apply the revenue recognition principle.

2. Describe accounting issues involved with revenue recognition for sale of goods.

3. Explain accounting for consignment sales.

4. Describe accounting issues involved with revenue recognition for services and long-term contracts.

Learning Objectives

5. Apply the percentage-of-completion method for long-term contracts.

6. Apply the completed-contract method for long-term contracts.

7. Identify the proper accounting for losses on long-term contracts.

8. Discuss how to deal with measurement uncertainty.

Learning Objectives

9. Discuss how to deal with collection uncertainty.

10.Explain and apply the instalment sales method of accounting.

11.Explain and apply the cost recovery method of accounting.

Revenue Recognition

Current EnvironmentRevenue recognition criteria

Measurement UncertaintySales with buy-back

Sales when right of return exists

Trade loading and channel stuffing

Earnings ProcessSale of goods

Risks and rewards

Disposition of assets other than inventory

Consignment sales

Continuing managerial involvement

Completion of production

Rendering of services and long-term contracts

% of completion method

Completed contract method

Long-term contract losses

Disclosures

Uncertainty Associated

with Collectibility

Instalment sales

Instalment method

Cost recovery method

Guidelines for Revenue Recognition

• Revenue is recognized based on two criteria:• Performance• Collectibility

• Revenue is earned when the earnings process is substantially complete• Earnings Process: actions taken to add value• Substantial Performance: when little or no

uncertainty exists as to the completion of the product or service (at this point revenue is recognized)

• Revenue is realized when goods and services are exchanged for cash or claims to cash

Four Types of Revenue Transactions

• Revenue from selling products is recognized at the date of sale (date of delivery)

• Revenue from services is recognized when services are performed and are billable

• Revenue from the use of enterprise’s assets by others is recognized as time passes or as the assets are used up

• Revenue from disposal of assets is recognized at the point of sale

Risks and Rewards

• Risks and rewards (benefits) of ownership:– Who has possession of the goods?– Who has legal title?

• When the risks and rewards of ownership have transferred – Determines when a sale has occurred

Revenue Recognition at Point of Sale

• Revenues from manufacturing and selling are commonly recognized at point of sale

• Revenues from sales with buyback agreements are not recognized (not sales)

• Revenues from sales where rights of return exist are not generally recognized

• Certain trade practices such as trade loading and channel stuffing do not result in recognizable sales revenues

Consignment Sales

• Possession has transferred; however legal title remains with the seller

• Risks and rewards have not transferred

• Seller acts as an agent

• Goods are held by seller as Merchandise on Consignment

• Not held as inventory on consignee’s books

Consignment Sales

Goods shipped to ConsigneeInventory on Consignment $$$ Finished Goods Inventory $$$Payment of FreightInventory on Consignment $$ Cash $$Notification of SaleAccounts Receivable $$$Relevant Expenses $$ Revenue $$$Receipt of Cash from SaleCash $$$ Accounts Receivable $$$Cost of Goods Sold $$$ Inventory on Consignment $$$(Note: cost includes freight)

No Entry

No Entry

Notification/Payment of SaleCash $$$ Payable to Consignor $$$

Consignor’s Books Consignee’s Books

Revenue Recognition Before Delivery

• Revenue may be recognized before delivery under certain circumstances

• Long-term construction contracts (percentage of completion method), are a notable example

• The percentage method permits periodic billing at various points in the project

• The completed contract method is used only when the percentage method is inapplicable

Contract Accounting

Long-Term ConstructionAccounting Methods

Percentage of CompletionMethod

Completed ContractMethod

1) Terms of contract must be certain, enforceable• Certainty of performance by both parties

1) To be used only when the percentage method is inapplicable [uncertain]• For short-term contracts

Percentage Completion: Concept

• Percentage completion method permits periodic billing

• The amount of gross profit recognized depends upon the percent of work done

• Application of percentage completion method requires a basis for measuring the progress toward completion at interim dates

• See the specific steps for determining gross profit (next slide)

Percentage Completion:Steps

Costs incurred to date = Percent completeMost recent estimated total costs

1

Percent complete X Estimated total revenue = Revenue to be recognized to date

2

Revenue to be recognized to date –Revenue recognized in prior periods = Current period revenue

3

Current Period Revenue – Current costs = Gross Profit4

Percentage Completion: Cost-to-Cost Basis

Data: Contract price: $4,500,000 Estimated cost: $4,000,000

Start date: July, 2001 Finish: October, 2003

Balance sheet date: December 31st

Given: 2001 2002 2003

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

Percentage Completion: Cost-to-Cost Basis

2001 2002 2003

$4,500,000 $4,500,000 $4,500,000 Contract Price

1,000,000 2,916,000 4,050,000 3,000,000 1,134,000 -0- 4,000,000 4,050,000 4,050,000

Estimated Costs:To DateEst. Cost to CompleteEst. Total Costs

25% 72% 100% 1,000,000 2,916,000 4,050,000 4,000,000 4,050,000 4,050,000

Percent Complete

$ 500,000 $ 450,000 $ 450,000Estimated Total GrossProfit

Percentage Completion: Cost-to-Cost Basis

2001 2002 2003

$4,500,000 $4,500,000 $4,500,000 Contract Price

25% 72% 100%

Percent Complete

$1,125,000 $3,240,000 $4,500,000 -0- 1,125,000 3,240,000 $1,125,000 $2,115,000 $1,260,000

Revenue Recognized:Current YearLess: Prior Year= Revenue

$ 125,000 $ 324,000 $ 450,000 -0- 125,000 324,000 $ 125,000 $ 199,000 $ 126,000

Gross Profit Recognized:Current YearLess: Prior Year= Revenue

Completed-Contract Method

• Revenue and gross profit recognized on completion of contract

• Advantage: reported revenue is based on actual results, not estimates

• Disadvantage: does not reflect current performance; creates distortion of earnings

• Progress billings are reported contra to ‘Construction in Progress’ account on the Balance Sheet

• Construction in Progress used to accumulate contract costs

Long-Term Contract Losses

• A long-term contract may produce:• either an interim loss and an overall profit• or an overall loss for the project

• Under the percentage completion method, losses in any case are immediately recognized

• Under the completed contract method, losses are recognized only when overall losses result

Recognizing Current and OverallLosses on Long-Term Contracts

Current Loss onan otherwiseoverall profitablecontract

Completed Method:No adjustment needed

Percentage Method: Recognize loss currently

Loss on anoverall unprofitablecontract

Percentage Method: Recognize entire loss now

Completed Method: Recognize entire loss now

Percentage Method: Interim Loss on Profitable Contract - Example

2001 2002 2003 $4,500,000 $4,500,000 $4,500,000 Contract Price

1,000,000 2,916,000 4,384,962 3,000,000 1,468,962 -0- 4,000,000 4,384,962 4,384,962

Estimated Costs:To DateEst. Cost to CompleteEst. Total Costs

25% 66.5% 100% 1,000,000 2,916,000 4,384,962 4,000,000 4,384,962 4,384,962

Percent Complete

Data as previously given, except for the 2002 cost estimate

Revenue recognized in 2002: $4,500,000 * 66.5% = $2,992,500Less: amount recognized in 2001 1,125,000

1,867,500Less: actual costs incurred in 2002 1,916,000Loss recognized in 2002 48,500

Percentage Method: Interim Loss on Profitable Contract –

ExampleRecord loss for 2002:

Construction Expense 1,916,000 Construction in Process (loss) 48,500 Revenue from Long-Term Contract 1,867,500

Loss of $48,500 reported on Income StatementDifference between the reported revenues andcosts for the current periodUnder the completed-contract method, no lossRecognized in 2002

Percentage Method: Interim Loss on Overall Unprofitable Contract – Example

2001 2002 2003 $4,500,000 $4,500,000 $4,500,000 Contract Price

1,000,000 2,916,000 4,556,250 3,000,000 1,640,250 -0- 4,000,000 4,556,250 4,556,250

Estimated Costs:To DateEst. Cost to CompleteEst. Total Costs

25% 64% 100% 1,000,000 2,916,000 Gross Profit 4,000,000 4,556,250 (56,250)

Percent Complete

Data as previously given, except for the 2002 cost estimate

Losses recognized in 2002:Gross Profit recognized in 2001 $125,000Expected Loss on Unprofitable Contract 56,250

$181,250

Percentage Method: Interim Loss on Overall Unprofitable Contract –

ExampleRecord loss for 2002:

Construction Costs expensed in 2002:Revenue recognized in 2002: (4,500,000 X 64%) $2,880,000Less: revenue recognized in 2001 1,125,000Revenue recognized in 2002 1,755,000Less: loss recognized in 2002 181,250Construction Cost Expense 1,936,250

Construction Expense 1,36,250 Construction in Process (loss) 181,250 Revenue from Long-Term Contract 1,755,000

Completed Contract Method: Interim Loss on Overall Unprofitable Contract –

Example

Record loss for 2002:

Loss from Long-Term Contract 56,250Construction in Process (Loss) 56,250

The loss is recognized in the year it first becomesevident.

Revenue Recognition after Delivery

• Revenue recognition is deferred when collection of sales price is not reasonably assured

• The two methods that are used are:• the instalment sales method• the cost recovery method

• If cash is received prior to delivery, the method used is the deposit method

The Instalment Sales Method

• This method 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

• Income recognition deferred to period of cash collection• Both sales and cost of sales are recognized

in the period of sale• Gross profit is deferred to the period of

collection • Other expenses, selling and

administrative, are not deferred

The Instalment Sales Method: Special Accounts

• Instalment sales must be kept separate• Gross profit on instalment sales must be

determinable• The amount of cash collected from

instalment accounts must be known• The cash collected from current year’s

and prior years’ accounts must be known

• Provision must be made for the carry forward of each year’s (deferred) gross profit

The Instalment Sales Method:

Steps• For instalment sales in any year

• For instalment sales made in prior years (realized gross profit)

• Determine rate of gross profit on instalment sales

• Apply this rate to cash collections of current year’s instalment sales to yield realized gross profit

• The gross profit not realized is deferred

• Apply the relevant rate to cash collections of prior year’s instalment sales

The Instalment Sales Method: Example

Given: 2001 2002 2003

Instalment 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 2001 sales $ 60,000 $ 100,000 $ 40,000

from 2002 sales $ -0- $ 100,000 $ 125,000

from 2003 sales $ -0- $ -0- $ 80,000

Determine the realized and deferred gross profit.

The Instalment Sales Method: Example

Given: 2001 2002 2003

Instalment sales $200,000 $250,000 $240,000

Gross Profit $ 50,000 $ 60,000 $ 72,000 Gross profit rate 25% 24%

30%Realized Gross Profit:

From 2001 sales: Realized in $15,000 $25,000

$10,000 From 2002 sales: Realized in: $ -0- $24,000

$30,000 From 2003 sales: Realized in: $ -0- $ -0-

$24,000

The Instalment Sales Method: Partial Journal Entries (2001) for Gross Profit

Instalment Sales 200,000Cost of Sales

150,000 Deferred Gross Profit, 2001 50,000 (To close 2001

accounts)

Deferred Gross Profit, 2001 15,000Realized Gross Profit

15,000 (Realized: $60,000 * 25%)

Realized Gross Profit 15,000Income Summary

15,000(To close to Income Summary)

Instalment Sales Accounting Problems

1. Interest on instalment contracts• Accounted for separately from the gross

profit• Recognized when cash is collected, as

Interest Revenue

2. Uncollectible accounts• Through the use of a special bad debts

expense account

3. Defaults and repossessions• On repossession, the Account Receivable

and related deferred Gross Profit are written-off

The Cost Recovery Method

• Seller recognizes no profit until cash payments by buyer exceed seller’s cost of merchandise

• After recovering all costs, seller includes additional cash collections in income

• This method is to be used where there is no reasonable basis for estimating collectibility as in franchises and real estate

• The income statement reports the amount of gross profit recognized and the deferred amount

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