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1. Why I Became a CPAJournal of Accountancy – October 2005 No one can argue when you say, “I am a person who counts!” The opportunity to become a client’s #1 trusted advisor. Nobody gets an Academy Award until we say so. Your debits always equal your credits. You have Credentials People Admire. It’s the only profession directly connected to life’s inevitabilities: death and taxes. Mom wanted you to be a rock star and this is the way to rebel. You can work on Saturdays and Sundays while your friends are forced to watch the “March Madness” NCAA tournament. Only you know what a widget is. No one ever asks, “How do you spell that?” Red Sox wouldn’t give in to salary demand. All the free pencils you want.
2. Chapter 18 REVENUE RECOGNITIONSommers – Intermediate I
3. 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: When it is realized or realizable – there is reasonable certainty as to the collectibility of the asset to be received (usually cash). When it is earned– the earnings process is judged to be complete or virtually complete.
4. Discussion Question Q18-2 What is viewed as a major criticism of GAAP as regards to revenue recognition? GAAP has numerous standards related to revenue recognition, but many believe the standards are often inconsistent with one another.
5. 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.
6. 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.
7. 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
8. 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.
9. Revenue Recognition Standard - WSJ What recently happened? Who is affected? When will they be affected?
10. Revenue Recognition – CFO.com How long did this take? What issues do companies face?
11. 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. The percentage-of-completion method is preferable when estimates of costs to complete and extent of progress toward completion of long-term contracts are reasonably dependable. The percentage-of-completion method should be used in circumstances when reasonably dependable estimates can be made and: The contract clearly specifies the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement. The buyer can be expected to satisfy all obligations under the contract. The contractor can be expected to perform the contractual obligation.
12. 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. The completed-contract method is preferable when the lack of dependable estimates or inherent hazards cause forecasts to be doubtful.
13. 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.
14. Percentage-of-Completion Method Must use when estimates of progress toward completion, revenues, and costs are reasonably dependable and allof the following conditions exist: 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. Buyer can be expected to satisfy all obligations. Contractor can be expected to perform under the contract.
15. Percentage-of-Completion Method Formula for Total Revenue to Be Recognized to Date
16. 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: 20112012 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 Construction in progress 100,000 (300,000/1,500,000)*500,000 Construction expenses 300,000 Revenue from long-term contract 400,000 (300,000/1,500,000)*2,000,000
17. 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: 20112012 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 Costs and profit ($400,000*) in excess of billings ($380,000) 20,000 Net of construction in progress and Billings on construction contract accounts
18. 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: 20112012 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 Construction in progress 25,000 125,000 – 100,000 Construction expenses 1,575,000 Revenue from long-term contract 1,600,000 Billings on construction contract 2,000,000 Construction in progress 2,000,000
19. 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: 20112012 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
20. Completed-Contract Method Companies should use when one of the following conditions applies when: Company has primarily short-term contracts, or Company cannot meet the conditions for using the percentage-of-completion method, or There are inherent hazards in the contract beyond the normal, recurring business risks.
21. 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: 20112012 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
22. 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: 20112012 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 $130,000 Current liabilities: Billings ($380,000) in excess of costs ($300,000) $ 80,000 Net of construction in progress and Billings on construction contract accounts
23. 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: 20112012 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 Construction in progress 125,000 Construction expenses 1,875,000 Revenue from long-term contract 2,000,000 Billings on construction contract 2,000,000 Construction in progress 2,000,000
24. 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: 20112012 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
25. 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.
26. 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 12-31-11At 12-31-12At 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.
27. 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 12-31-11At 12-31-12At 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 2011: 4,000,000 – 350,000 – 3,150,000 = 500,000 Recognize $0 2012: 4,000,000 – 2,500,000 – 1,700,000 = (200,000) Recognize $(200,000) 2013: 4,000,000 – 4,250,000 – 0 = (250,000) Recognize $(50,000)
28. 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 12-31-11At 12-31-12At 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) 2011 – No journal entry since profit expected 2012 Loss on long-term contracts 200,000 Construction in progress 200,000 2013 Construction expenses 4,050,000 Revenue from long-term contracts 4,000,000 Construction in progress 50,000
29. 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 12-31-11At 12-31-12At 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.
30. 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 12-31-11At 12-31-12At 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!) 2011: 500,000 * 10% = 50,000 Recognize $50,000 2012: (200,000) Recognize $(250,000) 2013: (250,000) Recognize $(50,000)
31. 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 12-31-11At 12-31-12At 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: Billings ($720,000) in excess of costs and profit ($400,000) $320,000 2012 Current assets: Costs less loss ($2,300,000*) in excess of billings ($2,170,000) $130,000
32. 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 12-31-11At 12-31-12At 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) 2011 Construction expenses 350,000 Construction in progress 50,000 Revenue from long-term contracts 400,000 .35/(.35+3.15)*4 2012 Construction expenses 2,230,952 Plug Revenue from long-term contracts 1,980,952 2.5/(2.5+1.7)*4-0.4 Construction in progress 250,000 2013 Construction expenses 1,669,048 Plug Revenue from long-term contracts 1,619,048 The rest Construction in progress 50,000
33. Helpful Graphic from Another Book
34. Discussion Question Q18-20 Explain the differences between the installment-sales method and the cost-recovery method. Under the installment-sales method, income recognition is deferred until the period of cash collection. At the end of each year, the appropriate gross profit rate is applied to the cash collections from each year’s sales to determine the realized gross profit. Under the cost-recovery method, no income is recognized until cash payments by the buyer exceed the seller’s cost of the inventory sold. After all costs have been recovered, all additional cash collections are included in income.
35. 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
36. 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.
37. 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.
38. 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.
39. 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
40. 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 receivable300,000 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
41. 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 120,000 Deferred gross profit 180,000 Cash 75,000 Installment accounts receivable 75,000 July 1, 2012 Cash 75,000 Installment accounts receivable 75,000 Deferred gross profit 30,000 Realized gross profit 30,000 75 + 75 – 120 = 30
42. 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.
43. 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 principles-based (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.
44. 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.
45. 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.