Revenue Recognition: Completed Contract Method

1. PART II: Corporate Accounting Concepts and Issues Lecture 21 Revenue Recognition: Completed Contract Method Instructor Adnan Shoaib

2. Learning Objectives • Apply the completed-contract method for long-term contracts. • Identify the proper accounting for losses on long-term contracts. • Describe the installment-sales method of accounting. • Explain the cost-recovery method of accounting.

3. Revenue Recognition Current Environment Revenue Recognition at the Point of Sale Revenue Recognition before Delivery Revenue Recognition after Delivery Guidelines for revenue recognition Departures from sale basis Sales with discounts Sales with right of return Sales with buybacks Bill and hold sales Principal-agent relationships Trade loading and channel stuffing Multiple-deliverable arrangements Percentage-of-completion method Completed-contract method Long-term contract losses Disclosures Completion-of-production basis Installment-sales method Cost-recovery method Deposit method Summary of bases

4. Revenue Recognition Before Delivery Completed Contract Method Companies recognize revenue and gross profit only at point of sale—that is, when the contract is completed. Under this method, companies accumulate costs of long-term contracts in process, but they make no interim charges or credits to income statement accounts for revenues, costs, or gross profit. LO 1 Apply the completed-contract method for long-term contracts.

5. Completed Contract Method Illustration: Casper Construction Co. A) Prepare the journal entries for 2010, 2011, and 2012. LO 3 Apply the percentage-of-completion method for long-term contracts.

6. Completed Contract Method Illustration: LO 3 Apply the percentage-of-completion method for long-term contracts.

7. Completed Contract Method Illustration: LO 1 Apply the completed-contract method for long-term contracts.

8. Completed Contract Method Illustration: LO 1 Apply the completed-contract method for long-term contracts.

9. Completed Contract and Percentage-of-Completion Methods Compared

10. Accounting for the Cost of Construction and Accounts Receivable With both the completed contract and percentage-of-completion methods, all costs of construction are recorded in an asset account called construction in progress.

11. Gross Profit Recognition—General Approach In both methods the same amounts of revenue, cost, and gross profit are recognized. In both methods we add gross profit to the construction in progress asset.

12. Gross Profit Recognition—General Approach The same journal entry is recorded to close out the billings on construction contract and construction in progress accounts under the completed contract and percentage-of-completion methods.

13. Timing of Gross Profit Recognition Under the Completed Contract Method Under the completed contract method, all revenues and expenses related to the project are recognized when the contract is completed.

14. Timing of Gross Profit Recognition Under the Percentage-of-Completion Method Using the percentage-of-completion method, we recognize a portion of the estimated gross profit each period based on progress to date. We determine the amount of gross profit recognized in each period using the following logic:

15. Percentage-of-Completion Method Allocation of Gross Profit

16. Percentage-of-Completion Method Allocation of Gross Profit Notice that the gross profit recognized in each period is added to the construction in progress account.

17. Percentage-of-Completion Method Allocation of Gross Profit The income statement for each year will report the appropriate revenue and cost of construction amounts.

18. Income Recognition The same total amount of profit or loss is recognized under both the completed contract and the percentage-of-completion methods, but the timing of recognition differs.

19. Balance Sheet Recognition Billings on construction contract are subtracted from construction in progress to determine balance sheet presentation. CIP > Billings Asset Billings > CIP Liability

20. Balance Sheet Recognition The balance in the construction in progress account differs between methods because of the earlier gross profit recognition that occurs under the percentage-of-completion method.

21. Revenue Recognition Before Delivery 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 completed-contract methods, the company must recognize in the current period the entire expected contract loss. LO 2 Identify the proper accounting for losses on long-term contracts.

22. Long-Term Contract Losses Illustration:Loss on Profitable Contract Casper Construction Co. b) Prepare the journal entries for 2010, 2011, and 2012 assuming the estimated cost to complete at the end of 2011 was $215,436 instead of $170,100. LO 2 Identify the proper accounting for losses on long-term contracts.

23. Long-Term Contract Losses Illustration: Loss on Profitable Contract LO 2 Identify the proper accounting for losses on long-term contracts.

24. Long-Term Contract Losses Illustration: Loss on Profitable Contract LO 2 Identify the proper accounting for losses on long-term contracts.

25. Long-Term Contract Losses Illustration: Loss on Unprofitable Contract Casper Construction Co. c) Prepare the journal entries for 2010, 2011, and 2012 assuming the estimated cost to complete at the end of 2011 was $246,038 instead of $170,100. LO 2 Identify the proper accounting for losses on long-term contracts.

26. Long-Term Contract Losses Illustration: Loss on Unprofitable Contract Plug $675,000 – 683,438 = (8,438) cumulative loss LO 2 Identify the proper accounting for losses on long-term contracts.

27. Long-Term Contract Losses Illustration: Loss on Unprofitable Contract LO 2 Identify the proper accounting for losses on long-term contracts.

28. Long-Term Contract Losses Illustration: Loss on Unprofitable Contract For the Completed-Contract method, companies would recognize the following loss : LO 2 Identify the proper accounting for losses on long-term contracts.

29. Revenue Recognition Before Delivery Disclosures in Financial Statements • Construction contractors should disclosure: • the method of recognizing revenue, • the basis used to classify assets and liabilities as current (nature and length of the operating cycle), • the basis for recording inventory, • the effects of any revision of estimates, • the amount of backlog on uncompleted contracts, and • the details about receivables. LO 2 Identify the proper accounting for losses on long-term contracts.

30. Revenue Recognition Before Delivery Completion-of-Production Basis In certain cases companies recognize revenue at the completion of productioneven though no sale has been made. • Examples are: • precious metals or • agricultural products. LO 2 Identify the proper accounting for losses on long-term contracts.

31. Revenue Recognition After Delivery 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 LO 3 Describe the installment-sales method of accounting.

32. Revenue Recognition After Delivery 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. LO 3 Describe the installment-sales method of accounting.

33. Revenue Recognition After Delivery 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. LO 3 Describe the installment-sales method of accounting.

34. Revenue Recognition After Delivery 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. LO 4 Explain the cost-recovery method of accounting.

35. Cost-Recovery Method Illustration: In 2012, Fesmire Manufacturing sells inventory with a cost of $25,000 to Higley Company for $36,000. Higley will make payments of $18,000 in 2012, $12,000 in 2013, and $6,000 in 2014. If the cost-recovery method applies to this transaction and Higley makes payments as scheduled, Fesmire recognizes cash collections, revenue, cost, and gross profit as follows. Illustration 18-41 LO 7

36. Cost-Recovery Method Illustration: Fesmire’s journal entry to record the deferred gross profit on the Higley sale transaction (after recording the sale and the cost of sale in the normal manner) at the end of 2012 is as follows. Sales 36,000 Cost of Sales 25,000 Deferred Gross Profit 11,000 LO 4 Explain the cost-recovery method of accounting.

37. Cost-Recovery Method Illustration: In 2013 and 2014, the deferred gross profit becomes realized gross profit as the cumulative cash collections exceed the total costs, by recording the following entries. Deferred Gross Profit 5,000 Realized Gross Profit 5,000 2013 Deferred Gross Profit 6,000 Realized Gross Profit 6,000 2014 LO 4 Explain the cost-recovery method of accounting.

38. Revenue Recognition After Delivery Deposit Method Seller reports the cash received from the buyer as a deposit on the contract and classifies it on the balance sheet as a liability. The seller does not recognize revenue or income until the sale is complete. LO 4 Explain the cost-recovery method of accounting.

39. Summary of Product Revenue Recognition Illustration 18-42 LO 7

40. REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS Franchises • Four types of franchising arrangements have evolved: • manufacturer-retailer, • manufacturer-wholesaler, • service sponsor-retailer, and • wholesaler-retailer. LO 5 Explain the revenue recognition for franchises.

41. REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS Franchises • Fastest-growing category is service sponsor-retailer: • Soft ice cream/frozen yogurt stores (Tastee Freeze, TCBY, Dairy Queen) • Food drive-ins (McDonald’s, KFC, Burger King) • Restaurants (TGI Friday’s, Pizza Hut, Denny’s) • Motels (Holiday Inn, Marriott, Best Western) • Auto rentals (Avis, Hertz, National) • Others (H & R Block, Meineke Mufflers, 7-Eleven Stores) LO 5 Explain the revenue recognition for franchises.

42. REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS Franchises • Two sources of revenue: • Sale of initial franchises and related assets or services, and • Continuing fees based on the operations of franchises. LO 5 Explain the revenue recognition for franchises.

43. REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS Franchises • The franchisor normally provides the franchisee with: • Assistance in site selection. • Evaluation of potential income. • Supervision of construction activity. • Assistance in the acquisition of signs, fixtures, and equipment. • Bookkeeping and advisory services. • Employee and management training. • Quality control. • Advertising and promotion. LO 5 Explain the revenue recognition for franchises.

44. REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS Initial Franchise Fees • Franchisors record initial franchise fees as • revenue only when and as they make “substantial performance” of the services they are obligated to perform and when collection of the fee is reasonably assured. • Substantial performance occurs when the franchisor has no remaining obligation to refund any cash received or excuse any nonpayment of a note and has performed all the initial services required under the contract. LO 5 Explain the revenue recognition for franchises.

45. REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS Example of Entries for Initial Franchise Fee Illustration: Tum’s Pizza Inc. charges an initial franchise fee of $50,000 for the right to operate as a franchisee of Tum’s Pizza. Of this amount, $10,000 is payable when the franchisee signs the agreement, and the balance is payable in five annual payments of $8,000 each. The credit rating of the franchisee indicates that money can be borrowed at 8 percent. The present value of an ordinary annuity of five annual receipts of $8,000 each discounted at 8 percent is $31,941.68. The discount of $8,058.32 represents the interest revenue to be accrued by the franchisor over the payment period. LO 5 Explain the revenue recognition for franchises.

46. REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS Example of Entries for Initial Franchise Fee Illustration:1. If there is reasonable expectation that Tum’s Pizza Inc. may refund the down payment and if substantial future services remain to be performed by Tum’s Pizza Inc., the entry should be: Cash 10,000.00 Notes Receivable 40,000.00 Discount on Notes Receivable 8,058.32 Unearned Franchise Fees 41,941.68 LO 5 Explain the revenue recognition for franchises.

47. REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS Example of Entries for Initial Franchise Fee Illustration:2. If the probability of refunding the initial franchise fee is extremely low, the amount of future services to be provided to the franchisee is minimal, collectibility of the note is reasonably assured, and substantial performance has occurred, the entry should be: Cash 10,000.00 Notes Receivable 40,000.00 Discount on Notes Receivable 8,058.32 Revenue from Franchise Fees 41,941.68 LO 5 Explain the revenue recognition for franchises.

48. REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS Example of Entries for Initial Franchise Fee Illustration:3. If the initial down payment is not refundable, represents a fair measure of the services already provided, with a significant amount of services still to be performed by Tum’s Pizza in future periods, and collectibility of the note is reasonably assured, the entry should be: Cash 10,000.00 Notes Receivable 40,000.00 Discount on Notes Receivable 8,058.32 Revenue from Franchise Fees 10,000.00 Unearned Franchise Fees 31,941.68 LO 5 Explain the revenue recognition for franchises.

49. REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS Example of Entries for Initial Franchise Fee Illustration:4. If the initial down payment is not refundable and no future services are required by the franchisor, but collection of the note is so uncertain that recognition of the note as an asset is unwarranted, the entry should be: Cash 10,000.00 Revenue from Franchise Fees 10,000.00 LO 5 Explain the revenue recognition for franchises.

50. REVENUE RECOGNITION FOR SPECIAL SALES TRANSACTIONS Example of Entries for Initial Franchise Fee Illustration:5. Under the same conditions as those listed in case 4 above, except that the down payment is refundable or substantial services are yet to be performed, the entry should be: Cash 10,000.00 Unearned Franchise Fees 10,000.00 In cases 4 and 5 — where collection of the note is extremely uncertain—franchisors may recognize cash collections using the installment-sales method or the cost-recovery method. LO 5 Explain the revenue recognition for franchises.