Transcript Slide 1
CHAPTER 18
REVENUE RECOGNITION
Sommers – Intermediate I
Guidelines for Revenue Recognition
What are the two general criteria that must be satisfied
before a company can recognize revenue?
The realization principle requires that two criteria be
satisfied before revenue can be recognized:
1. When it is realized or realizable – there is reasonable
certainty as to the collectibility of the asset to be
received (usually cash).
2. When it is earned– the earnings process is judged to be
complete or virtually complete.
Discussion Question
Q18-2 What is viewed as a major criticism of GAAP as
regards to revenue recognition?
Revenue Recognition Matters
• Revenue recognition is a top fraud risk and regardless of
the accounting rules followed (IFRS or U.S. GAAP), the
risk or errors and inaccuracies in revenue reporting is
significant.
• Restatements for improper revenue recognition are
relatively common and can lead to significant share price
adjustments.
Messing with Revenue
“Trade loading is a crazy, uneconomic, insidious practice
through which manufacturers—trying to show sales, profits,
and market share they don’t actually have—induce their
wholesale customers, known as the trade, to buy more
product than they can promptly resell.”
A similar practice is referred to as channel stuffing. When
a software maker needed to make its financial results look
good, it offered deep discounts to its distributors to
overbuy, and then recorded revenue when the software left
the loading.
Rev Rec at Point of Sale (Delivery)
• Companies usually meet the two conditions for
recognizing revenue by the time they deliver products or
render services to customers.
• Implementation problems
– Sales with Discounts
– Sales When Right of Return
– Sales with Buybacks
– Bill and Hold Sales
– Principal-Agent Relationships
– Trade Loading and Channel Stuffing
– Multiple-Deliverable Arrangements
Multiple-Deliverable Arrangements
• MDAs provide multiple products or services to customers as
part of a single arrangement.
• The major accounting issues related to this type of
arrangement are how to allocate the revenue to the various
products and services and how to allocate the revenue to the
proper period.
• All units in a multiple-deliverable arrangement are considered
separate units of accounting, provided that:
– A delivered item has value to the customer on a
standalone basis; and
– The arrangement includes a general right of return relative
to the delivered item; and
– Delivery or performance of the undelivered item is
considered probable and substantially in the control of the
seller.
Revenue Recognition Standard - WSJ
• What recently happened?
• Who is affected?
• When will they be affected?
Revenue Recognition – CFO.com
• How long did this take?
• What issues do companies face?
Discussion Questions
Q18-14 What are the two basic methods of accounting for long-term
construction contracts? Indicate the circumstances that determine
when one or the other should be used.
Discussion Questions
Q18-14 What are the two basic methods of accounting for long-term
construction contracts? Indicate the circumstances that determine
when one or the other should be used.
Revenue Recognition Before Delivery
Most notable example is long-term construction contract
accounting.
Two Methods:
Percentage-of-Completion Method.
►
Rationale is that the buyer and seller have
enforceable rights.
Completed-Contract Method.
Percentage-of-Completion Method
Must use when estimates of progress toward completion,
revenues, and costs are reasonably dependable and all of the
following conditions exist:
1. Contract clearly specifies the enforceable rights regarding
goods or services by the parties, the consideration to be
exchanged, and the manner and terms of settlement.
2. Buyer can be expected to satisfy all obligations.
3. Contractor can be expected to perform under the contract.
Percentage-of-Completion Method
Formula for Total Revenue to Be Recognized to Date
Percentage-of-Completion Example
Assume Nortel Networks contracted to provide a customer with Internet infrastructure for
$2,000,000. The project began in 2011 and was completed in 2012. Data relating to the
contract are summarized below:
2011
2012
Costs incurred during the year
$ 300,000
$1,575,000
Estimated costs to complete as of 12/31
1,200,000
–0–
Billings during the year
380,000
1,620,000
Cash collections during the year
250,000
1,750,000
2011
Construction in progress
300,000
Cash, materials, etc.
300,000
Accounts receivable
380,000
Billings on construction contract
380,000
Cash
250,000
Accounts receivable
250,000
Percentage-of-Completion Example Cont.
Assume Nortel Networks contracted to provide a customer with Internet infrastructure for
$2,000,000. The project began in 2011 and was completed in 2012. Data relating to the
contract are summarized below:
2011
2012
Costs incurred during the year
$ 300,000
$1,575,000
Estimated costs to complete as of 12/31
1,200,000
–0–
Billings during the year
380,000
1,620,000
Cash collections during the year
250,000
1,750,000
Gross profit recognition:
$300,000/$1,500,000 = 20%
x $500,000 = $100,000
Balance Sheet:
Current assets:
• Accounts receivable
$130,000
Percentage-of-Completion Example Cont.
Assume Nortel Networks contracted to provide a customer with Internet infrastructure for
$2,000,000. The project began in 2011 and was completed in 2012. Data relating to the
contract are summarized below:
2011
2012
Costs incurred during the year
$ 300,000
$1,575,000
Estimated costs to complete as of 12/31
1,200,000
–0–
Billings during the year
380,000
1,620,000
Cash collections during the year
250,000
1,750,000
2012
Construction in progress
1,575,000
Cash, materials, etc.
1,575,000
Accounts receivable
1,620,000
Billings on construction contract
1,620,000
Cash
1,750,000
Accounts receivable
1,750,000
Percentage-of-Completion Example Cont.
Assume Nortel Networks contracted to provide a customer with Internet infrastructure for
$2,000,000. The project began in 2011 and was completed in 2012. Data relating to the
contract are summarized below:
2011
2012
Costs incurred during the year
$ 300,000
$1,575,000
Estimated costs to complete as of 12/31
1,200,000
–0–
Billings during the year
380,000
1,620,000
Cash collections during the year
250,000
1,750,000
Gross profit recognition:
$1,875,000/$1,875,000 = 100%
x $125,000 = $125,000
$125,000 - $100,000 = $25,000
Balance Sheet:
• Nothing, all cleared out
Completed-Contract Method
Companies should use when one of the following conditions
applies when:
1. Company has primarily short-term contracts, or
2. Company cannot meet the conditions for using the
percentage-of-completion method, or
3. There are inherent hazards in the contract beyond the normal,
recurring business risks.
Completed Contract Example
Assume Nortel Networks contracted to provide a customer with Internet infrastructure for
$2,000,000. The project began in 2011 and was completed in 2012. Data relating to the
contract are summarized below:
2011
2012
Costs incurred during the year
$ 300,000
$1,575,000
Estimated costs to complete as of 12/31
1,200,000
–0–
Billings during the year
380,000
1,620,000
Cash collections during the year
250,000
1,750,000
2011
Construction in progress
300,000
Cash, materials, etc.
300,000
Accounts receivable
380,000
Billings on construction contract
380,000
Cash
250,000
Accounts receivable
250,000
Completed Contract Example
Assume Nortel Networks contracted to provide a customer with Internet infrastructure for
$2,000,000. The project began in 2011 and was completed in 2012. Data relating to the
contract are summarized below:
2011
2012
Costs incurred during the year
$ 300,000
$1,575,000
Estimated costs to complete as of 12/31
1,200,000
–0–
Billings during the year
380,000
1,620,000
Cash collections during the year
250,000
1,750,000
Gross profit recognition:
$0
Balance sheet:
Current assets:
• Accounts receivable
Current liabilities:
$130,000
Completed Contract Example
Assume Nortel Networks contracted to provide a customer with Internet infrastructure for
$2,000,000. The project began in 2011 and was completed in 2012. Data relating to the
contract are summarized below:
2011
2012
Costs incurred during the year
$ 300,000
$1,575,000
Estimated costs to complete as of 12/31
1,200,000
–0–
Billings during the year
380,000
1,620,000
Cash collections during the year
250,000
1,750,000
2012
Construction in progress
1,575,000
Cash, materials, etc.
1,575,000
Accounts receivable
1,620,000
Billings on construction contract
1,620,000
Cash
1,750,000
Accounts receivable
1,750,000
Completed Contract Example
Assume Nortel Networks contracted to provide a customer with Internet infrastructure for
$2,000,000. The project began in 2011 and was completed in 2012. Data relating to the
contract are summarized below:
2011
2012
Costs incurred during the year
$ 300,000
$1,575,000
Estimated costs to complete as of 12/31
1,200,000
–0–
Billings during the year
380,000
1,620,000
Cash collections during the year
250,000
1,750,000
Gross profit recognition:
$2,000,000 - $1,875,000 = $125,000
Balance Sheet:
• Nothing, all cleared out
Long-Term Contract Losses
Loss in the Current Period on a Profitable Contract
►
Percentage-of-completion method only, the estimated cost
increase requires a current-period adjustment of gross profit
recognized in prior periods.
Loss on an Unprofitable Contract
►
Under both percentage-of-completion and completedcontract methods, the company must recognize in the
current period the entire expected contract loss.
Completed Contract Example – 2
Curtiss Construction Company, Inc., entered into a fixed-price contract with
Axelrod Associates on July 1, 2011, to construct a four-story office building. At
that time, Curtiss estimated that it would take between two and three years to
complete the project. The total contract price for construction of the building is
$4,000,000. Curtiss appropriately accounts for this contract under the
completed contract method in its financial statements. The building was
completed on December 31, 2013. Estimated percentage of completion,
accumulated contract costs incurred, estimated costs to complete the contract,
and accumulated billings to Axelrod under the contract were as follows:
At 12-31-11 At 12-31-12 At 12-31-13
Percentage of completion
10%
60%
100%
Costs incurred to date
$ 350,000 $2,500,000 $4,250,000
Estimated costs to complete
3,150,000
1,700,000
–0–
Billings to Axelrod, to date
720,000
2,170,000
3,600,000
Compute gross profit or loss to be recognized in each year.
Completed Contract Example – 2 Continued
The total contract price for construction of the building is $4,000,000. Curtiss
appropriately accounts for this contract under the completed contract method
in its financial statements. Estimated percentage of completion, accumulated
contract costs incurred, estimated costs to complete the contract, and
accumulated billings to Axelrod under the contract were as follows:
At 12-31-11 At 12-31-12 At 12-31-13
Percentage of completion
10%
60%
100%
Costs incurred to date
$ 350,000 $2,500,000 $4,250,000
Estimated costs to complete
3,150,000
1,700,000
–0–
Billings to Axelrod, to date
720,000
2,170,000
3,600,000
Price – actual costs – estimated remaining costs = expected profit
Completed Contract Example – 2 Continued
Just because, let’s do the journal entry to recognize profit (loss):
The total contract price for construction of the building is $4,000,000.
At 12-31-11 At 12-31-12 At 12-31-13
Percentage of completion
10%
60%
100%
Costs incurred to date
$ 350,000 $2,500,000 $4,250,000
Estimated costs to complete
3,150,000
1,700,000
–0–
Billings to Axelrod, to date
720,000
2,170,000
3,600,000
To recognize
-0(200,000)
(50,000)
Percentage-of-Completion Example – 2
Curtiss Construction Company, Inc., entered into a fixed-price contract with
Axelrod Associates on July 1, 2011, to construct a four-story office building. At
that time, Curtiss estimated that it would take between two and three years to
complete the project. The total contract price for construction of the building is
$4,000,000. Curtiss appropriately accounts for this contract under the
completed contract method in its financial statements. The building was
completed on December 31, 2013. Estimated percentage of completion,
accumulated contract costs incurred, estimated costs to complete the contract,
and accumulated billings to Axelrod under the contract were as follows:
At 12-31-11 At 12-31-12 At 12-31-13
Percentage of completion
10%
60%
100%
Costs incurred to date
$ 350,000 $2,500,000 $4,250,000
Estimated costs to complete
3,150,000
1,700,000
–0–
Billings to Axelrod, to date
720,000
2,170,000
3,600,000
Now compute gross profit or loss to be recognized in each year assuming use
of percentage-of-completion.
Percentage-of-Completion Example – 2 Cont.
The total contract price for construction of the building is $4,000,000. Estimated
percentage of completion, accumulated contract costs incurred, estimated
costs to complete the contract, and accumulated billings to Axelrod under the
contract were as follows:
At 12-31-11 At 12-31-12 At 12-31-13
Percentage of completion
10%
60%
100%
Costs incurred to date
$ 350,000 $2,500,000 $4,250,000
Estimated costs to complete
3,150,000
1,700,000
–0–
Billings to Axelrod, to date
720,000
2,170,000
3,600,000
Expected profit * Percentage of completion (Unless loss!)
Percentage-of-Completion Example – 2 Cont.
The total contract price for construction of the building is $4,000,000. Estimated
percentage of completion, accumulated contract costs incurred, estimated
costs to complete the contract, and accumulated billings to Axelrod under the
contract were as follows:
At 12-31-11 At 12-31-12 At 12-31-13
Percentage of completion
10%
60%
100%
Costs incurred to date
$ 350,000 $2,500,000 $4,250,000
Estimated costs to complete
3,150,000
1,700,000
–0–
Billings to Axelrod, to date
720,000
2,170,000
3,600,000
Reported on Balance Sheet
2011 Current liabilities:
2012 Current assets:
Percentage-of-Completion Example – 2 Cont.
Again just because, let’s do the journal entry to recognize profit (loss):
The total contract price for construction of the building is $4,000,000.
At 12-31-11 At 12-31-12 At 12-31-13
Costs incurred to date
$ 350,000 $2,500,000 $4,250,000
Estimated costs to complete
3,150,000
1,700,000
–0–
To recognize
50,000
(250,000)
(50,000)
Helpful Graphic from Another Book
Discussion Question
Q18-20 Explain the differences between the installmentsales method and the cost-recovery method.
Installment-Sales vs. Cost-Recovery
When the collection of the sales price is not reasonably
assured and revenue recognition is deferred.
Methods of deferring revenue:
Installment-sales method
Cost-recovery method
Deposit method
Generally
Employed
Installment-Sales Method
Recognizes income in the periods of collection rather
than in the period of sale.
Recognize both revenues and costs of sales in the
period of sale, but defer gross profit to periods in which
cash is collected.
Selling and administrative expenses are not deferred.
Acceptability of the Installment-Sales Method
The profession concluded that except in special
circumstances, “the installment method of recognizing
revenue is not acceptable.”
The rationale: because the installment method does not
recognize any income until cash is collected, it is not in
accordance with the accrual concept.
Cost-Recovery Method
Recognizes no profit until cash payments by the buyer
exceed the cost of the merchandise sold.
A seller is permitted to use the cost-recovery method to
account for sales in which “there is no reasonable basis
for estimating collectibility.” In addition, use of this method
is required where a high degree of uncertainty exists
related to the collection of receivables.
Point of Delivery Example
On July 1, 2011, the Foster Company sold inventory to the Slate Corporation for
$300,000. Terms of the sale called for a down payment of $75,000 and three annual
installments of $75,000 due on each July 1, beginning July 1, 2012. Each installment also
will include interest on the unpaid balance applying an appropriate interest rate. The
inventory cost Foster $120,000. The company uses the perpetual inventory system.
Point of Delivery “Normal” Method (don’t worry about interest)
July 1, 2011
Installment accounts receivable
300,000
Sales revenue
300,000
Cost of goods sold
120,000
Inventory
120,000
Cash
75,000
Installment accounts receivable
75,000
July 1, 2012
Cash
75,000
Installment accounts receivable
75,000
Example as Installment Sale
On July 1, 2011, the Foster Company sold inventory to the Slate Corporation for
$300,000. Terms of the sale called for a down payment of $75,000 and three annual
installments of $75,000 due on each July 1, beginning July 1, 2012. Each installment also
will include interest on the unpaid balance applying an appropriate interest rate. The
inventory cost Foster $120,000. The company uses the perpetual inventory system.
Installment Sales Method (don’t worry about interest)
July 1, 2011
Installment accounts receivable
300,000
Inventory
120,000
Deferred gross profit
180,000
(300–120)/300 = 60%
Cash
75,000
Installment accounts receivable
75,000
Deferred gross profit
45,000
Realized gross profit
45,000
75 * 60%
July 1, 2012
Cash
75,000
Installment accounts receivable
75,000
Deferred gross profit
45,000
Realized gross profit
45,000
Example as Cost Recovery
On July 1, 2011, the Foster Company sold inventory to the Slate Corporation for
$300,000. Terms of the sale called for a down payment of $75,000 and three annual
installments of $75,000 due on each July 1, beginning July 1, 2012. Each installment also
will include interest on the unpaid balance applying an appropriate interest rate. The
inventory cost Foster $120,000. The company uses the perpetual inventory system.
Cost Recovery Method (don’t worry about interest)
July 1, 2011
Installment accounts receivable
300,000
Inventory
Deferred gross profit
Cash
120,000
180,000
75,000
Installment accounts receivable
July 1, 2012
Cash
75,000
75,000
Installment accounts receivable
Deferred gross profit
Realized gross profit
75,000
30,000
30,000
75 + 75 – 120 = 30
IFRS
RELEVANT FACTS - Similarities
Revenue recognition fraud is a major issue in U.S. financial reporting.
The same situation occurs overseas as evidenced by revenue
recognition breakdowns at Dutch software company Baan NV, Japanese
electronics giant NEC, and Dutch grocer AHold NV.
In general, the accounting at point of sale is similar between IFRS and
GAAP. As indicated earlier, GAAP often provides detailed guidance,
such as in the accounting for right of return and multiple-deliverable
arrangements.
IFRS
RELEVANT FACTS - Differences
The IASB defines revenue to include both revenues and gains. GAAP
provides separate definitions for revenues and gains.
IFRS has one basic standard on revenue recognition—IAS 18. GAAP
has numerous standards related to revenue recognition (by some counts
over 100).
Accounting for revenue provides a most fitting contrast of the principlesbased (IFRS) and rules-based (GAAP) approaches. While both sides
have their advocates, the IASB and the FASB have identified a number
of areas for improvement in this area.
IFRS
RELEVANT FACTS - Differences
In general, the IFRS revenue recognition principle is based on the
probability that the economic benefits associated with the transaction will
flow to the company selling the goods, rendering the service, or
receiving investment income. In addition, the revenues and costs must
be capable of being measured reliably. GAAP uses concepts such as
realized, realizable, and earned as a basis for revenue recognition.
Under IFRS, revenue should be measured at fair value of the
consideration received or receivable. GAAP measures revenue based
on the fair value of what is given up (goods or services) or the fair value
of what is received—whichever is more clearly evident.
IFRS
RELEVANT FACTS - Differences
IFRS prohibits the use of the completed-contract method of accounting
for long-term construction contracts (IAS 13). Companies must use the
percentage-of-completion method. If revenues and costs are difficult to
estimate, then companies recognize revenue only to the extent of the
cost incurred—a cost-recovery (zero-profit) approach.
In long-term construction contracts, IFRS requires recognition of a loss
immediately if the overall contract is going to be unprofitable. In other
words, GAAP and IFRS are the same regarding this issue.