Chapter 19th Edition Revenue Recognition Intermediate Accounting James D Stice Earl K Stice PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University © 2014 Cengage Learning 8-1 Revenue Recognition Recognition refers to the time when transactions are recorded on the books The FASB’s two criteria for recognizing revenues and gains are when: They are realized or realizable They have been earned through substantial completion of the activities involved in the earnings process Both Bothof ofthese thesecriteria criteriagenerally generallyare are met metat at the the point point of ofsale sale 8-2 Revenue Recognition • Revenue is not recognized prior to the point of sale • because either: A valid promise of payment has not been received from the customer The company has not provided the product or service Exceptions to these rules: The customer provides a valid promise of payment Conditions exist that contractually guarantee the sale (continued) 8-3 Revenue Recognition AICPA Statement of Position 97-2 gives companies more guidance through a checklist of four factors that amplify the two criteria: 1) Persuasive evidence of an arrangement exists 2) Delivery has occurred 3) The vendor’s fee is fixed or determinable 4) Collectibility is probable (continued) 8-4 Revenue Recognition • The FASB is currently engaged in a revenue recognition project in conjunction with the IASB (as of June 2010) • The FASB has tentatively decided to move away from the realization and substantial completion criteria and to instead emphasize the measurement of a seller’s satisfaction of performance obligations created through contracts with customers 8-5 SAB 101 • Because SAB 101 was released to curtail specific abuses, it should not be seen as a comprehensive treatise on the entire area of revenue recognition • Revenue recognition issues covered in SAB 101 may not be comprehensive, but they are extremely important 8-6 Sarbanes-Oxley Act of 2002 • Section 404 of the Sabanes-Oxley Act of 2002 instructs the SEC to require all publicly traded companies to provide a report of the condition of the company’s internal controls • This is to ensure that the public financial statements are not rendered irrelevant by secret side agreements • A good internal control system establishes procedures to safeguard the value of a company’s assets 8-7 Accounting for Consignments Seller Company ships goods costing $1,000 on consignment to Consignee Company The retail price of the goods is $1,500 No No sale sale should should be be recorded recorded However, However, there there may may be be aa journal journal entry entry made made to to reclassify reclassify the the inventory inventory Inventory on Consignment Inventory 1,000 1,000 8-8 Accounting for a Layaway Sale Seller Company receives $100 cash from a customer The $100 payment is a partial payment for goods costing $1,000 with a total retail price of $1,500 The following entry shows the receipt of $100 cash as initial layaway payment Cash Deposit Received from Customers 100 100 (continued) 8-9 Accounting for a Layaway Sale Recording the receipt of the final $1,400 cash payment and the delivery of goods to customers requires two entries One to record the sale and the second to remove the item from inventory and to record its cost Cash Deposit Received from Customer Sales 1,400 100 Cost of Goods Sold Inventory 1,000 1,500 1,000 8-10 Using Percentage-of-Completion Accounting: Other Methods Using the data from the previous slide and knowing that the actual cost incurred to date is $1,040,000, the revenue and costs to be reported on the 2012 income statement would be as follows: Actual cost incurred to date Recognized gross profit (42% of $2,600,000) Gross profit (42% of $400,000) $1,040,000 168,000 $ 168,000 8-43 Revision of Estimate Instead of the previous illustration, assume that at the end of 2013, it was estimated that the remaining cost to complete construction was $720,000 rather than $650,000 This would increase the total estimated cost to $2,670,000, reduce the expected profit to $330,000, and change the percentage of completion for 2013 to 73% ($1,950,000/$2,670,000) (continued) 8-44 Revision of Estimates 2012 2012 Under the percentage-of-completion method, the following additional entries would be made to recognize revenue Cost of Long-Term Construction Contracts 1,040,000 Construction in Progress 160,000 Revenue from Long-Term Construction Contracts 1,200,000 (continued) 8-45 Revision of Estimates 2013 Cost of Long-Term Construction Contracts Construction in Progress Revenue from Long-Term Construction Contracts 910,000 80,000 990,000 ($3,000,000 × 0.73) − $1,200,000 (continued) 8-46 Revision of Estimates 2014 2014 Cost of Long-Term Construction Contracts Construction in Progress Revenue from Long-Term Construction Contracts 700,000 110,000 810,000 8-47 Reporting Anticipated Contract Losses • When a loss on a total contract is anticipated, GAAP requires reporting the loss in its entirety in the period when the loss is first anticipated • This is true under either the completedcontract or the percentage-of-completion method (continued) 8-48 Reporting Anticipated Contract Losses • Assume in the earlier construction example, the estimated cost to complete the contract at the end of 2013 was $1,300,000 • Because $1,950,000 of costs had already been incurred, the total estimated cost of the contract would be $3,250,000, or $250,000 more than the contract price (continued) 8-49 Anticipated Contract Loss: Percentage-of-Completion Method Continuing with the construction contract example, assume the cumulative recognized revenue at the end of 2013 would be $1,800,000 (60% x $3,000,000), and the cumulative cost at the same date would e $2,050,000 ($1,800,000 + $250,000) A profit of $160,000 was recognized in 2012, the total loss to be recognized in 2013 is $410,000 ($160,000 + $250,000) (continued) 8-50 Anticipated Contract Loss: Percentage-of-Completion Method The entry to record the revenue, costs, and adjustments to Construction in Progress for the loss in 2013 would be as follows: Cost of Long-Term Construction Contract Revenue from Long-Term Construction Contracts Construction in Process 1,010,000 600,000 410,000 8-51 Proportional Revenue Recognition Most service contracts involve three different types of costs: Initial direct costs related to obtaining and performing initial services on the contract Direct costs related to performing the various service acts Indirect costs related to maintaining the organization to service the contract 8-52 Installment Sales Method • Under the installment sales method, profit is recognized as cash is collected rather than at the time of sale • It is used most commonly in cases of real estate sales where contracts may involve little or no down payment, payments are spread over 10 to 30 to 40 years, and a high probability of default in the early years exists because of a small investment by the buyer • The market prices of the property often are unstable 8-53 Cost Recovery Method • Under the cost recovery method, no income is recognized on a sale until the cost of the item sold it recovered through cash receipts • This method is used only when the circumstances surrounding a sale are so uncertain that earlier recognition is impossible 8-54 Cash Method • If the probability of recovering product or service costs is remote, the cash method of accounting could be used • Seldom would this method be applicable for sales of merchandise or real estate because the right of repossession would leave considerable value to the seller 8-55 Chapter ₵ The The End End $ 8-56 8-57 ... statements are not rendered irrelevant by secret side agreements • A good internal control system establishes procedures to safeguard the value of a company’s assets 8-7 Accounting for Consignments Seller... 605-25 • The focus of Subtopic 605-25 is on the “unit of accounting. ” • An element of multiple-element arrangement is considered to be a unit of accounting if that element has standalone value • An... risk is borne by the supplier 8-18 A Contract Approach to Revenue Recognition The contract approach contains three basic steps: 1) Identify the performance obligations accepted by a seller in