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Chapter 3: Additional Topics in Income Determination (Source: ACCT303 Textbook)

Chapter 3: Additional Topics in Income Determination (Source: ACCT303 Textbook). When can revenue be recognized before or after the point of sale? Revenue recognition for long-term construction contracts, agricultural commodities, and installment sales.

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Chapter 3: Additional Topics in Income Determination (Source: ACCT303 Textbook)

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  1. Chapter 3: Additional Topics in Income Determination (Source: ACCT303 Textbook) • When can revenue be recognized before or after the point of sale? • Revenue recognition for long-term construction contracts, agricultural commodities, and installment sales. • Revenue principles for franchise sales, sales with right of return, and “bundled” software sales with multiple deliverables.. 3-1

  2. Chapter 3: Additional Topics in Income Determination • How GAAP income determination invites “earnings management”. • The various techniques used to manage earnings. • The SEC guidance intended to curtail earnings management. • Key differences between IFRS and U.S. GAAP rules for revenue recognition. 3-2

  3. The criteria for revenue recognition Time of sale is used in most industries Condition 1: The critical event in the process of earning the revenue has taken place. (Earned) Condition 2: The amount of revenue that will be collected is reasonably assured and is measurable with a reasonable degree of reliability. (Measurability)

  4. Timing of Revenue Recognition • Time of sale • During production • Percentage of completion Method • Completed contract Method • On completion of production ( Prior to the sale) • After sale

  5. Learning Objective : Time of sale

  6. May 1 June 1 July 1 Buy 3 TV sets ($160 each) Sells and delivers 2 sets ($200 each) One customer pays cash The other customer pays 1. Revenue Recognition: Time of sale • Time of sale is the dominant practice in most industries. • Revenue is recognized at the time of sale (June 1) because that’s when the two critical conditions are met. • Example: Howard’s TV and Appliance Store

  7. Example: Accounting for Howard’s TV and Appliance Store • May 1 Inventory ($160*3) 480 Cash 480 • June 1 ( Time of Sale) Cash 200 Account Receivable 200 Sales 400 • July 1 Cash 200 Account Receivable 200

  8. Learning Objective : During the production phase

  9. Revenue Recognition: during production Criteria for recognizing revenue during production: • A customer must be identified and an exchange price agrees upon (i.e., a contract signed). • A significant portion of the agreed services has been performed ,and the expected costs of future services can be reliably estimated. • Future payments from customers are expected (i.e., reasonably assured).

  10. Revenue Recognition: during production (contd.) • In addition: • The 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. • The buyer can be expected to satisfy all obligations. • The contractor can be expected to perform under the contract.

  11. Revenues recognize during production phase Case Study:Long-term Construction Projects • Two Methods: • 1. Percentage-of-completion method • 2. Completed contract method ( Not allowed for IFRS) • If all the criteria listed above are met, the Percentage-of-completion method must be applied; otherwise the Completed contract method would be used.

  12. Method 1: Percentage-of-completion • Percentage-of-completion method: revenue is recognized in proportion to the “work done” each period. • What journal entries are needed to record? • 1. Gross profit. • 2. Inventory costs. • 3. Billings. • 4. Cash collections.

  13. Example: Solid Construction Corp. • Contract price is $1,000,000 and construction costs are estimated to be $800,000. Actual Experience on the Project as of December 31 Original estimate was $800,000 How much gross profit must be recognized each year?

  14. Estimated total contract profit Step 2: $200,000 = $1,000,000 - $800,000 Estimated profit earned to date Step 3: $60,000 = $200,000 x 30% Percentage-of-completion for 2011 (Year 1) Actual Experience on the Project as of December 31 $240,000 Cost incurred Percentage of completion ratio Step 1: 30% = = $800,000 Estimated total costs

  15. $544,000 64% = 30% $850,000 $200,000 $60,000 Incremental profit earned Step 4: $36,000 = $96,000 - $60,000 Percentage-of-completion for 2012 (Year 2) Actual Experience on the Project as of December 31 Percentage of completion ratio Step 1: 30% 30% Estimated total contract profit Step 2: $150,000 = $1,000,000 - $850,000 $200,000 $200,000 Estimated profit earned to date Step 3: $60,000 $60,000 $96,000 = $150,000 x 64%

  16. Percentage-of-completion for 2013 (Year 3) Actual Experience on the Project as of December 31 Percentage of completion ratio Step 1: 100% 30% 64% Estimated total contract profit Step 2: $200,000 $150,000 $150,000 Estimated profit earned to date $60,000 Step 3: $96,000 $150,000 Incremental profit earned Step 4: $54,000 $36,000

  17. Percentage-of-completion:Balance sheet presentation Construction in progress > Billings on construction in progress - record -- Current Assets Construction in progress < Billings on construction in progress - record -- Current Liabilities

  18. Journal Entries for 2011:Percentage-of-completion method • 1. To record costs incurred: Inventory: Construction in progress $240,000 Account payable, cash, etc. 240,000 • 2. To record net profit: Inventory: Construction in progress $60,000 Income on L-term construction contract $60,000 • 2. To record customer billings Accounts receivable $280,000 Billings on construction in progress $280,000 • 4. To record cash received Cash $210,000 Account receivable $210,000

  19. An Alternative to record 2Percentage-of-completion method • 2. To record construction revenue, expense and net profit: Construction Expense $240,000 Inventory: Construction in progress $60,000 Construction Revenue $300,000

  20. Percentage-of-completion: Journal entries 2011 2012 2013

  21. Method 2: Completed-contract method:Long-term construction projects • Suppose it is not possible to determine expected costs with a high degree of reliability. • Percentage-of-completion then becomes inappropriate because “matching” fails. • Completed-contract method postpones all revenue recognition (and expenses) until the period of project completion.

  22. Completed-contract Method: Journal entries 2011 2012 2013 No entry needed for completed contract method a. Construction in Progress 150,000 b. Billing on construction in progress 1,000,000 Income on L-T Cons. Contract 150,000 Construction in progress 1,000,000

  23. 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.

  24. Learning Objective : On completion of production Prior to Sale: Revenue recognition on Commodities

  25. 3. Revenue Recognition on Completion of Production (Prior to Sale) Criteria for recognizing revenue on completion of production or prior to sale: The product is immediately saleable at quoted market prices. Units are homogeneous. No significant uncertainty exists regarding the cost of distributing the product.

  26. Revenue recognition prior to sale: • Both revenue recognition conditions need to be met to recognize revenues. Take “commodities” for instance: • Condition 1 :The critical event is extraction (mining) or harvesting (agriculture). • Condition 2:Open to some dispute. • Thus, revenue recognition could occur when the sales transaction is completed, or earlier at extraction or harvest (i.e., when the critical event is satisfied).

  27. Revenue recognition prior to sale: Case study: Commodities • Two Methods for Commodities revenue recognition: • 1.Completed-transaction (sales) method • 2. Market-price (production) method Critical Event A farmer harvests 110,000 bushels of corn on September 30, 2011. On this date, the posted market price per bushel was $3.50. The total cost of growing the crop was $220,000 or $2.00 per bushel. The farmer decides to sell 100,000 bushels for cash on September at the posted price of $3.50 and stores the remaining 10,000 bushels. On January 2, 2012 the market price drops to $3.00. Fearing further price declines, the farmer immediately sells the bushels in storage at a price of $3.00 per bushel. Time of Sale

  28. Commodities:1. Completed-transaction (sales) method • Condition 2 is not satisfied until the eventual selling price is known. • Accordingly, only the 100,000 bushels sold on Sept. 30, 2011 are included in 2011 revenue. • Revenue (and related expenses) for the remaining 10,000 bushels is postponed to 2012 when those bushels are sold.

  29. Commodities:2. Market-price (production) method • Because producers face an established market price for the commodity, Condition 2 is satisfied continuously. • Accordingly, all 110,000 bushels produced in 2011 are included in 2011 revenue under the production method. • As a result, the inventory of 10,000 bushels is shown at market value of $35,000. DR Crop inventory $15,000 CR Market gain on unsold inventory $15,000 Recognition Matching Net realizable value

  30. Method 2 - Market-price (production) method • Assumption: The farmer is engaging in two activities: corn production and commodity speculation (10,000 bushels held in inventory). • Subsequent changes in the market price give rise to speculative gains and losses, called inventory holding gains and losses. • At the start of 2012, the market price drops from $3.50 to $3.00. The inventory is “marked-to-market” to reflect the loss: DR Inventory (holding) loss on speculation $5,000 CR Crop inventory $5,000 = 10,000 x ($3.50 - $3.00)

  31. Commodities:Market-price (production) method (continued) • Fearing a further market price decline, the farmer immediately sells all 10,000 bushels at $3.00: DR Cost of goods sold $30,000 CR Crop inventory $30,000 DR Cash $30,000 CR Crop revenue $30,000 The inventory book value is $30,000 at the time of sale: Production cost (10,000 x $2.00) $20,000 Market gain at harvest (10,000 x $1.50) 15,000 Inventory holding loss (10,000 x $0.50) ( 5,000) $30,000

  32. Commodities:Comparison of revenue recognition methods

  33. Commodities:Comparison of revenue recognition methods • In practice, the sales method is more prevalent. • However, the production conforms to GAAP when readily determinable prices are continuously available. • Two advantages of the production method: • Recognizes two income streams—one from farming and another from commodity speculation. • Conforms more closely to the income recognition conditions (critical event and measurability).

  34. Learning Objective : Revenue Recognition After the Sale

  35. Revenue recognition after the sale:Method 1: Installment sales method • Sometimes revenue is not recognized at the point of sale even though a valid sale has taken place, because. • Cash collection extends to a long period of time, • High risk of not receiving cash from the buyer. • No reasonable basis for estimating uncollectible accounts. • Conditions 1 and 2 are both satisfied over time as cash collections take place and revenue is recognized as cash is collected.

  36. Revenue recognition after the sale:Installment sales method example • The amount of revenue recognized each period depends on two things: • Installment-sales gross-profit percentage • Amount of cash collected on installment accounts receivable. 3-36

  37. $600,000 30% $180,000 $340,000 Gross-profit % 32% Income recognized $108,800 Total income recognized $288,800 Revenue recognition after the sale:Installment sales calculations Cash collections from 2011 sales $300,000 $300,000 Gross-profit % 30% 30% Income recognized $90,000 Cash collections from 2012 sales 3-37

  38. Revenue recognition after the sale:Installment sales income statement 3-38

  39. Revenue recognition afterthe sale: Installment sales journal entries 2011 2012 Note: GAAP requires that the interest component of the periodic cash receipts must be recorded separately.

  40. Revenue recognition after the sale:Method 2: Cost recovery method • GAAP allows this approach when: • Collections on installment sales occur over an extended period. • Highly unlikely the collection will be realized (i.e., with high default rate). • There is no reasonable basis for estimating collectability. • Under the cost recovery method: • No profit is recognized until cash payments from the buyer exceed the seller’s cost of goods sold. • After the seller’s cost has been recovered, any excess cash collected is recorded as recognized gross profit.

  41. $800,000 -600,000 $200,000 Revenue recognition after the sale:Method 2: Cost recovery method (skip)

  42. Revenue recognition after the sale:Method 2: Cost recovery method (skip) $1,200,000 -600,000 -200,000 $400,000 Note: The cost recovery method is very conservative because profit is recognized only when the cumulativecash collections exceed the total cost of land sold.

  43. Learning Objective : Specialized transactions 1. Franchise sales 2. Sales with Significant Return 3. “bundled” software sales with multiple deliverables

  44. Specialized transactions:Franchised sales Exercise right to sell product or service • Continuing franchise fees are recorded as revenue in the period they are earned and received. • The initial franchise fee is comprised of two elements: • Payment for the right to operate a franchise in a given area. • Payment for services to be performed later by the franchisor. • The issue: How much of the initial franchise fee should be recognized as revenue up front by the franchisor? Franchisor Franchisee Customer Seller Buyer 1. Initial franchisee fee 2. Continuing fees 3-44

  45. Specialized transactions:Franchise sales example • GAAP specifies: • recognize revenue for the initial franchise fee only when all material services and conditions have been substantially performed by franchisor. On January 1, 2011, Diet Right sells a dieting/weight loss franchise for an initial fee of $25,000 with $10,000 due at the signing of the franchise agreement and the remainder due in three annual installments (due December 31) of $5,000 each plus interest at 8% on the unpaid balance. The $10,000 up-front payment gives the franchisee the right to use Diet Right’s name and sell prepackaged healthy meals prepared at Diet Right’s corporate headquarters. In return for the initial franchise fee, Diet Right agrees to train employees, set up a recordkeeping system, maintain a Web site with online dietary counseling by a registered dietician, and provide advertising and various promotional materials. In addition to the initial franchise fee, Diet Right will receive 2% of the franchise’s annual sales for allowing the franchisee to purchase prepackaged meals at below market prices. 3-45

  46. Franchise Sales (contd.) • 1/1/2011 (when contract is signed) • Cash 10,000 • Note receivable 15,000* • Earned franchise Fees 10,000** • Unearned franchise fees 15,000 • *payments for the service to be performed later. • ** amount received for right to use Diet Right name and to sell Diet Right’s prepackaged meals. • Assuming half of the deferred payment ($7,500)is for employee training and recordkeeping system installation and both tasks have been completed by Diet Right on 3/1/2011, the following entry will be recorded on 3/1/2011: • Unearned franchise fees 7,500 • Earned franchise Fees 7,500

  47. Franchise Sales (contd.) • The remaining $7,500 initial franchise fees will be recognized as earned fees when services are performed. • Recording Continuing Franchise Fees: • Assuming franchisee sales were $100,000 in 2011, the following entry will be recorded for the franchisor: • Cash (2% x 100,000) 2,000 • Earned franchise fees 2,000

  48. Specialized transactions:Sales with Significant Return Sell with significant return • SFAS No. 45 says the following six criteria must be met for a seller to record revenue at the time of sale: • Seller’s price to buyer is substantially fixed at the date of sale. • Buyer has paid seller, or is obligated to pay and the obligation is not contingent on resale. • Buyer’s obligation does not change in the event of theft, destruction, or damage of the product. • Buyers and sellers are two separate economic entities; • Seller does not have significant obligations for future performance to directly bring about resale of the product to the buyer. • The amount of future returns can be reasonably estimated. Seller Buyer Customer Resale Cash payment or obligation to pay

  49. Specialized transactions:Sales with Significant Return (contd.) • If all six conditions are met, revenue can be recognized at time of sale. • However, the amount of potential returns need to be estimated and recognized at the end of a period. • If conditions are not met, revenue cannot be recognized until the return period expired.

  50. Specialized transactions:Bundled (Multi-element) sales –Software only and it does not require any modification or additional development • Oracle sells a database software “bundle” for $1 million. The “bundle” includes: • Customer support for five years. • Software upgrades • Staff training • Software • Revenue recognition for each element is based on the relative selling price of each element: • Cus. Support: $150/1,500=10% • Upgrades: $300/1,500=20% • Training:$450/1,500=30% • Software: $600/1,500=40% VSOE of selling price Revenue recognized: Over 5-year period Customer support $150 Upgrades $300 As installed Training $450 When completed Software $600 When delivered and installed Oracle’s software and services bundle 3-50

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