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CHAPTER 18: Revenue Recognition (pages 931-987)

LEARNING OBJECTIVES

1. Apply the revenue recognition principle.


2. Describe accounting issues for revenue recognition at point of sale.
3. Apply the percentage-of-completion method for long-term contracts.
4. Apply the completed-contract method for long-term contracts.
5. Identify the proper accounting for losses on long-term contracts.
6. Describe the installment-sales method of accounting.
7. Explain the cost-recovery method of accounting.
*8. Explain revenue recognition for franchises and consignment sales.

*This material is covered in an Appendix to the Chapter.

A. When do you recognize revenue?


1. selling products - date of sale
2. Services rendered - when services have been performed and are billable.
3. from permitting others to use enterprise assets ( interest, rent, and royalties) -
as time passes or as the assets are used
4. Selling assets other than products - at the date of sale.

A. Revenue Recognition Principle

1. Revenue is recognized when it is:


a. Realized - convertible into cash or claims to cash
b. Realizable – assets received are convertible to known amounts of cash
c. Earned
(1) entity has substantially performed the required acts
(2) earnings process is virtually complete

2. Problems in recognition
a. Sales with buyback
b. Right of return
c. Trade loading
(1) Attempts to show sales, profits and market share an entity does not have
(2) Induces wholesale customers to buy more product than they can sell
d. Channel stuffing
(1) Undesirable managerial and marketing policy decisions
(2) Actions that distort operating results.
(3) found in computer software industry
(4) Deep discounts offered to distributors to overbuy and records revenue when software leaves the
dock.
(5) distributors’ inventories become “bloated”
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marketing channel gets stuffed but financial statements are improved

B. Revenue Recognition before Delivery


1. Percentage-of-completion method
a. Used for long-term construction contracts
b. Gross profit recognized based on the percentage of the job that is
complete
c. Use when estimates of costs to complete and extent of progress
toward completion, revenue and costs of long-term contracts are
reasonably dependable.
d. Measured using a cost-to-cost method.
e. Collect costs plus gross profit accumulated in a Construction in
Process account (CIP)
f. Revenue each period is a percentage of total revenue on the contract:
g. Journal Entries:
(1) Costs of Construction: Construction in Process
Materials/Cash/Payables
(2) Progress Billings: Accounts Receivable
Billings on Construction in Process
(3) Collections: Cash
Accounts Receivable
(4) Revenue/Gross Profit: Construction in Process (Gross Profit)
Construction Expense (Costs)
Revenue from Long-term Contracts
(Costs incurred to date/estimated total revenue – revenue
recognized in prior periods)

2. Completed-contract method.
a. Recognize revenue, cost of goods sold, and gross profit when the
contract is completed.
Use only when using the percentage of completion method is inappropriate
Journal Entries:
(1)Costs of Construction: Construction in Process
Materials/Cash/Payables
(2)Progress Billings: Accounts Receivable
Billings on Construction in Process
(3)Collections: Cash
Accounts Receivable
(4)Revenue/Gross Profit: No Entry

(5)Final approval: Billings on Construction in Process


Revenue from Long-term Contracts
Construction Expense (Costs)
Construction in Process (Costs

d. Accounting for losses on long-term contracts.


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(1) Recognize a loss in the current period when costs increase to the
extent that gross profit recognized in prior periods must be eliminated
(2) Only applies to percentage-of-completion method.
(3) If estimates indicate that the entire contract will be unprofitable, the
entire loss is recognized immediately under both methods.

Revenue Recognition After Delivery.

a. Installment sales method.


1. payment required in periodic installments over a period of time
2. Emphasizes cash collection rather than sale.
3. Revenue and cost of goods sold are recognized in the period of sale
4. Gross profit recognition is deferred until the period of cash collection.
5. Selling and administrative expenses are recognized in the period of the sale.
6. Accounting for Installment sales:
(1) Use separate installment sales accounts to record sales and cost of sales
(2) compute the rate of gross profit on installment sales
(3) end of year, apply rate of gross profit to cash collections = realized gross profit
(4) defer unrealized gross profit to future years
(5) Account for interest separately: interest income in the period received.
(6) Uncollectible installment accounts receivable: similar to credit sales
(7) Widespread use for tax accounting.
(8) Not acceptable for financial accounting except under special circumstances

Example:

Installment sales $226,000 $248,000 $261,000


Cost of installment sales 164,980 176,080 195,750
Gross profit $ 61,020 $ 71,920 $ 65,250
Rate of Gross Profit 27% 29% 25%
Cash Receipts
2009 Sales $ 85,000 $ 96,000 $ 45,000
2010 Sales 123,000 87,000
2011 Sales 147,000

Only the 2010 journal entries will be shown.


To record 2010 installment sales
Installment Accounts Receivable, 2010................... 248,000
Installment Sales................................................ 248,000
To record cash collected on
installment receivables
Cash......................................................................... 219,000
Installment Accounts Receivables, 2009........... 96,000
Installment Accounts Receivables, 2010........... 123,000
To record 2010 cost of goods sold
on installment
Cost of Installment Sales......................................... 176,080
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Inventory (or Purchases).................................... 176,080

To close installment sales and cost


of installment sales
Installment Sales...................................................... 248,000
Cost of Installment Sales.................................... 176,080
Deferred Gross Profit, 2010............................... 71,920

To record realized gross profit


Deferred Gross Profit, 2009..................................... 25,920 (a)
Deferred Gross Profit, 2010..................................... 35,670 (b)
Realized Gross Profit.......................................... 61,590

(a) ($96,000 x .27)


(b) ($123,000 x .29)

C. Cost recovery method.


1. No profit recognized until cash payments by the buyer exceed the seller’s cost of
merchandise sold.
2. After all the costs have been recovered; any additional cash collections are
included in income.
3. APB Opinion No. 10 allows a seller to use the cost recovery method to account for
sales in which “there is no reasonable basis for estimating collectibility.”
4. Required under FASB Statement No. 45 (franchises) and No. 66 (real estate) where
a high degree of uncertainty exists related to the collection of receivables.
5. More appropriate than the installment method when there is a greater degree of
uncertainty.

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