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Intermediate Accounting November 16 th , 2010

Intermediate Accounting November 16 th , 2010. General Course Questions Columbia Sportswear Annual Report Project Questions Chapter 18 Revenue Recognition (using assigned homework) A. Two Conditions for Revenue Recognition (question 2)

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Intermediate Accounting November 16 th , 2010

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  1. Intermediate AccountingNovember 16th, 2010 • General Course Questions • Columbia Sportswear Annual Report Project Questions • Chapter 18 Revenue Recognition (using assigned homework) A. Two Conditions for Revenue Recognition (question 2) B. Departures from the Point of Sale Basis (question 6) C. Long term Construction Contracts (?7 & 9, BE 2,3,4,Prob 6) D. Installment Sales & Cost Recovery (BE 7,8,9, 10) E. Cost Recovery (BE 10) 4. Discussion Question #4 Revenue Recognition 5. Return and Review Ch 7 quiz – cash & receivables

  2. Revenue Recognition Revenue should be recognized at the soon as what TWO conditions are met: 1. 2. Revenue should be recognized when you have ______ the W______ & P_______ is assured. Question 2

  3. Revenue Recognition Classified by Type of Transaction Chapter 18 Chapter 18 Chapter 14 & others Chapter 10 Sale of product from inventory Sale of asset other than inventory Type of Transaction Rendering a service Permitting use of an asset Revenue from fees or services Revenue from interest, rents, and royalties Description of Revenue Gain or loss on disposition Revenue from sales Timing of Revenue Recognition Date of sale (date of delivery) Services performed and billable As time passes or assets are used Date of sale or trade-in

  4. Timing of Revenue Recognition • I. Revenue is normally recognized at the point of sale, provided: • A. Revenue can be reasonably ___________, collectibility of the sales price is reasonably assured or the amount uncollectible can be ___________ reasonably. • B. The earnings process is _______; the seller is not obligated to perform significant activities after the sale. • II. Earlier recognition is appropriate if there is a high degree of certainty about the amount of revenue earned. • III. Delayedrecognition is appropriate if the • degree of uncertainty concerning the amount of revenue or costs is sufficiently high or • sale does not represent substantial completion of the earnings process.

  5. Timing of Revenue Recognition • I. Revenue is normally recognized at the point of sale, provided: • A. Revenue can be reasonably measured,collectibility of the sales price is reasonably assured or the amount uncollectible can be estimated reasonably. • B. The earnings process is complete; the seller is not obligated to perform significant activities after the sale. • II. Earlierrecognition is appropriate if there is a high degree of certainty about the amount of revenue earned. • III. Delayedrecognition is appropriate if the • degree of uncertainty concerning the amount of revenue or costs is sufficiently high or • sale does not represent substantial completion of the earnings process.

  6. Revenue Recognition Alternatives

  7. Departures from the Point of Sale Basis Departures from the Sale Basis • A. Sales with Buyback Agreements - even though title has transferred, if the seller still has the risk of ownership it is not a sale. • B. Sales When Right of Return Exists - do not record the sale unless all of the following six provisions are met: (question 6) • 1. Sellers _____ is known (fixed or determinable at the date of sale) • 2. Buyer's payment is not contingent upon the ______ of product • 3. The buyer's obligation is not altered if product is _____/______ • 4. Buyer is a separate ______ from seller • 5. Seller is not obligated to help buyer _______the product • 6. Future returns can be _________ • C. Trade Loading and Channel Stuffing - practices to book tomorrows revenues today, need to be discouraged.

  8. Departures from the Point of Sale Basis Departures from the Sale Basis • A. Sales with Buyback Agreements - even though title has transferred, if the seller still has the risk of ownership it is not a sale. • B. Sales When Right of Return Exists - do not record the sale unless all of the following six provisions are met: • 1. Sellers price is known (fixed or determinable at the date of sale) • 2. Buyer's payment is not contingent upon the resale of product • 3. The buyer's obligation is not altered if product is stolen/damaged • 4. Buyer is a separate entity from seller • 5. Seller is not obligated to help buyer resell the product • 6. Future returns can be estimated • C. Trade Loading and Channel Stuffing - practices to book tomorrows revenues today, need to be discouraged.

  9. Percentage-of-Completion Method Completed Contract Method 1) Terms of contract must be certain, enforceable. 2) Certainty of performance by both parties 3) Estimates of completion can be made reliably • For short-term contracts • Used for long-term • contracts only when • conditions for percentage • completion are not met • 3) Abnormal contract risks Revenue Recognition Before Delivery Long-Term Construction Accounting Methods Question 7 & 9

  10. Basic Idea of Percentage of Completion • Reflect the economic substance of the activities of the company • I/S: Revenues earned and expenses incurred to reflect the efforts and accomplishments each period. They are not all deferred until the final year of project completion. • B/S: Value of asset being constructed is adjusted at the end of each period to reflect the amount of revenue recognized on the contract • Requires the use of estimates • What information do we need? • Contract revenue • Expenses incurred (or other input or output measures) • Estimated remaining expenses (or other input or output measures) • Billing and cash from customer

  11. Percentage-of-Completion: Balance Sheet Accounts “Construction in Process” (CIP) • An Inventory account used to accumulate the amount recognized as Revenue throughout the contract (Similar to a Work-In-Process inventory account, but includes not only cost, but also the gross profit to date) • First the construction costs are recorded in this account as they are incurred • Then the gross profit is added to this account at the end of each period when Revenue is recognized. Thus, the balance in this account then equals the total revenue recognized on the contract to date. • This inventory account is not removed until the construction is complete and title is transferred to the new owner. Then it is offset against Billings on Construction in Process. “Billings on Construction in Process” • A Contra-Inventory account to CIP, used to accumulate the amount that a customer has been billed and thus recorded in Cash or Accts Rec. • Interim billings are not usually based upon percentage of costs or completion. Thus, the amount billed and recorded in Billings on CIP is not likely to be equal to the revenue recognized, which is the balance in the CIP account.

  12. Percentage-of-Completion: Balance Sheet Accounts • “Construction in Process” (CIP) An Inventory account which equals the total revenue recognized on the contract to date. • “Billings on Construction in Process” A Contra-Inventory account to CIP, used to accumulate the amount that a customer has been billed and thus recorded in Cash or Accts Rec. • Interim billings are not usually based upon percentage of costs or completion. Thus, the amount billed and recorded in Billings on CIP is not likely to be equal to the revenue recognized, which is the balance in the CIP account. • At the end of any accounting period, the difference between the balance in “CIP” and “Billings on CIP” will appear on the balance sheet. • If “CIP” > “Billings on CIP”, the difference will be reported as an asset • If “Billing on CIP” > “CIP”, the difference will appear as a liability. • The two accounts (CIP and Billings on CIP) will equal at the end of the contract. They are closed out against each other when construction is complete and title is transferred to the new owner.

  13. Percentage-of-Completion: Financial Statements Balance Sheet Cash Accounts Receivable Inventory: Construction in Process (Cost + Gross Profit = Revenue recognized to-date on the contract) Less Billings on Construction in Process (amount billed; amount of cash received and/or still in A/R) Total amount in Current assets related to the contract will equal the amount of Revenue Recognized to date on the contract (the amount in cash and/or A/R will be offset against Billings on CIP) Income Statement Construction Revenue Construction Costs s Gross profit on Construction efforts

  14. Percentage-of-Completion: Journal Entries During the period to record costs of construction: DR: Construction in process (CIP) CR Cash, Raw Materials, A/P, Acc. Depr, Wages Payable When contract says you can make progress billings to customer: DR: Accounts receivable CR Billings on CIP To record cash collections: DR: Cash CR Accounts receivable End of the Accounting Period to recognize Revenue, cost & Gross Profit DR: CIP (gross profit adjustment for current year) DR. Construction Costs (Expense account) CR Construction Revenue

  15. Percentage-of-Completion: Journal Entries End of Construction when construction is complete and title is transferred to the new owner: DR: Billings on Construction in process CR Construction in Process The total amount invoiced in Billings on CIP will equal the total revenue recognized to-date on the contract at the end which has been captured in the CIP account. Thus the two accounts are closed out against each other as the construction company no longer has title to the asset and the amount invoiced has been recorded in cash and/or Accounts Receivable.

  16. Computing the Revenue & Gross Profit to recognize at the end of each period using Percentage-of-Completion 1 Costs incurred to date = Percent complete Most recent estimated total costs 2 Estimated total revenue x Percent complete = Revenue to be recognized to date 3 Total revenue to be recognized to date less Revenue recognized in PRIOR periods = Current period revenue 4 Current Period Revenue less current costs = Gross profit

  17. Percentage-of-Completion: Homework Problem 6 Data: Contract price: $8,400,000 Estimated cost: $4,000,000 Start date: July, 2003 Finish: October, 2005 Balance sheet date: Dec. 31 Given: 201020112012 Costs incurred during the year $2,880,000 $2,230,000 $2,190,000 Estimated costs to complete $3,530,000 $2,190,000 $ -0- total estimated costs Progress Billings during year $3,200,000 $3,500,000 $1,700,000 Cash collected during year What is the percent complete, revenue, and gross profit recognized each year? 17

  18. Percentage-of-Completion: Homework Problem 6 Data: Contract price: $8,400,000 Estimated cost: $4,000,000 Start date: July, 2003 Finish: October, 2005 Balance sheet date: Dec. 31 Given: 201020112012 Costs incurred during the year $2,880,000 $2,230,000 $2,190,000 Estimated costs to complete $3,530,000 $2,190,000 $ -0- total estimated costs $6,400,000 $7,300,000 $7,300,000 Progress Billings during year $3,200,000 $3,500,000 $1,700,000 Cash collected during year What is the percent complete, revenue, and gross profit recognized each year? 18

  19. % complete to-date 2,880,000 ___% 2,880k + 2230K = $7,300,000 $6,400,000 $5,110,000=___% $7,300,000 $7,300,000 100 % 8,400,000 * ___% 8,400,000 *__% 8,400,000 = 3,780,000 less 3,780,000 less 5,880,000 = 2,100,000 = 2,520,000 Revenue recognized Gross Profit (loss) recognized $3,780,000 less 2,100,000 less 2,520,000 $2,880,000 2,230,000 less 2,190,000 $________ = $_________ = $_______ Percentage-of-Completion: Homework Problem 6 2010 2011 2012 Contract to date Revenue Costs Gross Profit $3,780,000 $5,880,000 8,400,000 $2,880,000 5,110,000 7,300,000 $900,000 $ 770,000 $1,100,000

  20. % complete to-date 2,880,000 45% 2,880k + 2230K = $7,300,000 $6,400,000 $5,110,000=70% $7,300,000 $7,300,000 100 % 8,400,000 * 45% 8,400,000 * 70% 8,400,000 = 3,780,000 less 3,780,000 less 5,880,000 = 2,100,000 = 2,520,000 Revenue recognized Gross Profit (loss) recognized $3,780,000 less 2,100,000 less 2,520,000 $2,880,000 2,230,000 less 2,190,000 $900,000 = (130,000) = 330,000 Percentage-of-Completion: Homework Problem 6 2010 2011 2012 Contract to date Revenue Costs Gross Profit $3,780,000 $5,880,000 8,400,000 $2,880,000 5,110,000 7,300,000 $900,000 $ 770,000 $1,100,000

  21. Percentage-of-Completion: the Construction in Progress Account Note that Gross Profit is stored in the CIP Account – this is very different from “ordinary” sales transactions, where gross profit is not in any specific account • A T-account analysis of the CIP account is very useful in answering questions • For example, you could be told that Daniels Construction incurred $1 million in construction costs on a new contract this year. They expect to incur another $7 million to complete the project. The balance in the CIP account at year end is $1.2 million. What is the total revenue they expect to earn on the contract? • Answer: 1.2 – 1 = 200,000 in GP recognized • Project is 1/(1+7) or 12.5% complete, so 200,000 / 0.125 = $1,600,000 in total profit • Since profit is revenues minus expenses, total revenues must be 1.6 + 8 = $9.6 million

  22. Completed Contract Method • Use For Short Term Construction Contracts • Or when does not meet criteria for % Completion: • Terms of contract not certain, or enforceable • Certainty of Performance by either party is in question • Realiable estimates to measure % complete are not available (cost, input or output measures) • No revenue, no expense, no gross profit recognized until the project is actually completed. • Journal entries prepared during the life of contract are the same as those prepared under the percentage-of-completion method with the exception of the last journal entry that recognizes periodic revenue, expense and gross profit. • Instead, the entire revenue, expense and gross profit are recorded at the end of the project.

  23. CompletedContract • Assuming the same numbers as example before, what are the journal entries under the completed contract method? • All journal entries for 2010, 2011, and 2012 would appear exactly as before, except that there would be no revenue recognition journal entry in each year • Therefore, the balance in CIP at the end of each year would represent only the inventoried construction costs

  24. Losses on Contracts Need to determine if the loss is for the current period or if for the contract overall. • If on overall profitable contract, recognize the loss in the period incurred via “negative gross profit” (see example Problem 6 year 2011) • Overall unprofitable contract • Percentage of completion: Recognize entire contract loss now by “backing out” previous gross profit • Completed contract: Recognize the entire loss now. What is the theoretical justification for this?

  25. Disclosures in Construction Company 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.

  26. Revenue Recognition Before Delivery Completion-of-Production Basis In certain cases companies recognize revenue at the completion of production even though no sale has been made. • Examples are: • precious metals or • agricultural products. • What is the theoretical justification for this?

  27. Revenue Recognition After Delivery Revenue recognition is deferred when collection of sales price is not reasonably assured and no reliable estimates can be made. Methods of deferring revenue: • Installment-sales method • Cost-recovery method • Deposit method – cash received prior to delivery or transfer of property. Thus sale is not complete, and cash is recorded as a customer deposit (current liability). Generally Employed

  28. The Installment Sales Method • Recognize income in periods of cash collection rather than at the point of sale. • Title typically does not pass to the buyer until all cash payments have been made to the seller. • Recognize both Revenue and Cost of Sales in period of sale, but Gross profit is deferred to the periods of collection. • Selling and administrative expenses are not deferred.

  29. The Installment Sales Method • Installment sales must be kept separate from regular sales • Gross profit on installment sales must be determinable • The amount of cash collected from installment accounts by year sold must be known • Provision must be made to carry forward each year’s deferred gross profit separately

  30. Steps to Record Installment Sales Record initial Installment sale, keeping track of A/R by year sold and noting revenue as “Installment Sales”. Cost of sales and inventory reduction recorded normally, using information to compute Gross Profit rate each year. When closing “Installment Sales and COGS, defer the Gross Profit by year of sale. Record cash collections reducing A/R by year of original sale. Realize Gross profit on cash collected, taking Cash times gross profit rate in year of original sale, and reducing deferred gross profit for the corresponding year.

  31. The Installment Sales Method: Example Given:2003 2004 2005 • Installment sales $200,000 $250,000 $240,000 • Cost of sales $150,000 $190,000 $168,000 • Gross Profit $ 50,000 $ 60,000 $ 72,000 Cash received in: • from 2003 sales $ 60,000 $ 100,000 $ 40,000 • from 2004 sales $ -0- $ 100,000 $125,000 • from 2005 sales $ -0- $ -0- $ 80,000 • Determine the realized and deferred gross profit.

  32. The Installment Sales Method: Example 2003 2004 2005 Gross profit rate 25% 24% 30% Realized Gross Profit: From 2003 sales (e.g., 60,000 x 25%) ($100,000 x 25%) ($40,000 x 25%) Realized in $ 15,000 $ 25,000 $ 10,000 From 2004 sales:($100,000 x 24%) ($125,000 x 24%) Realized in: $ -0- $ 24,000 $ 30,000 From 2005 sales: ($80,000 x 30%) Realized in: $ -0- $ -0- $ 24,000 32

  33. The Installment Sales Method: 2003 Journal Entries for Gross Profit 1. When the 2003 installment sale is made: Installment A/R (2003) 200,000 Installment Sales 200,000 2. Cost of Sales 150,000 Inventory 150,000 3. Installment Sales 200,000 Cost of Sales 150,000 Deferred Gross Profit, 2003 50,000 When cash is received, some deferred GP is recognized as revenue: 4. Cash 60,000 Installment A/R (2003) 60,000 5. Deferred Gross Profit, 2003 15,000 Realized Gross Profit (I/S) 15,000 (Realized: $60,000 x 25%) 33

  34. The Installment Sales Method: 2004 Journal Entries for Gross Profit 1. Installment A/R (2004) 250,000 Installment Sales 250,000 2. Cost of Sales 190,000 Inventory 190,000 3. Installment Sales 250,000 Cost of Sales 190,000 Deferred Gross Profit, 2004 60,000 4. When cash is received, some deferred GP is recog’d as revenue: Cash 200,000 Installment A/R (2003) 100,000 Installment A/R (2004) 100,000 5. Deferred Gross Profit, 2003 25,000 Deferred Gross Profit, 2004 24,000 Realized Gross Profit (I/S) 49,000 (Realized: ’03: $100K x 25% + ’04 $100K X 24%)

  35. Installment Sales Method: 2005 Journal Entries 1. 2. 3. 4. When cash is received, some deferred GP is recognized as revenue: Cash 245,000 5. 35

  36. Installment Sales Method: 2005 Journal Entries 1. Installment A/R (2005) 240,000 Installment Sales 240,000 2. Cost of Sales 168,000 Inventory 168,000 3. Installment Sales 240,000 Cost of Sales 168,000 Deferred Gross Profit, 2005 72,000 4. When cash is received, some deferred GP is recognized as revenue: Cash 245,000 Installment A/R (2003) 40,000 Installment A/R (2004) 125,000 Installment A/R (2005) 80,000 5. Deferred Gross Profit, 2003 10,000 Deferred Gross Profit, 2004 30,000 Deferred Gross Profit, 2005 24,000 Realized Gross Profit (I/S) 64,000 (Realized: ’03: $40K x 25% + ’04 $125K X 24% + ’05 80K X 30%)

  37. The Cost Recovery Method • Used when no reasonable basis for estimating collectibility as in franchises and real estate. • Seller recognizes no profit until cash payments by buyer exceed seller’s cost of merchandise. • After recovering all costs, seller includes additional cash collections in income. • The income statement reports the amount of gross profit recognized and the amount deferred.

  38. The Original Example – Cost Recovery Method Given:2003 2004 2005 • Installment sales $200,000 $250,000 $240,000 • Cost of sales $150,000 $190,000 $168,000 • Gross Profit $ 50,000 $ 60,000 $ 72,000 • Cash received in: • from 2003 sales $ 60,000 $ 100,000 $ 40,000 • from 2004 sales $ -0- $ 100,000 $125,000 • from 2005 sales $ -0- $ -0- $ 80,000 • Determine the realized and deferred gross profit.

  39. The Cost Recovery Method: 2003 Journal Entries 2003: (J/E’s for sales and deferral of GP are same as in installment method) 1. When the 2003 installment sale is made: Installment A/R (2003) 200,000 Installment Sales 200,000 2. Cost of Sales 150,000 Inventory 150,000 3. Installment Sales 200,000 Cost of Sales 150,000 Deferred Gross Profit, 2003 50,000 Cash collection J/E’s: 4. Cash 60,000 Installment A/R (2003) 60,000 • No Gross Profit realized until cost of Sales recovered by cash collections Note: costs remaining to recover = 150,000 – 60,000 = 90,000 before any recognition of profit 39

  40. The Cost Recovery Method 2004: J/E’s for sales and deferral of GP are same as in installment method Cash 200,000 Installment A/R (2003) 100,000 Installment A/R (2004) 100,000 • 2003 GP can be recognized: 150,000 – 60,000 – 100,000 = 10,000 to be recognized • No 2004 GP to be recognized: 190,000 – 100,000 = 90,000 Deferred GP, 2003 sales 10,000 Recognized GP 10,000

  41. The Cost Recovery Method 2005: J/E’s for sales and deferral of GP are same as in installment method Entry to record Cash Collections: Cash 245,000 Entry to record Realized Gross Profit:

  42. The Cost Recovery Method 2005: J/E’s for sales and deferral of GP are same as in installment method Cash 245,000 Installment A/R (2003) 40,000 Installment A/R (2004) 125,000 Installment A/R (2005) 80,000 • All cash collected in 2003 can be recognized as GP because costs covered in 2004 • 2004 GP to be recognized: 190,000 – 100,000 – 125,000 = 35,000 • No GP for 2005: 168,000 – 80,000 = 88,000 Deferred GP, 2003 sales 40,000 Deferred GP, 2004 sales 35,000 Recognized GP 75,000

  43. Installment Sales Issues - Interest and Repossessions • Interest: recognize at time of receipt (do not defer) • Repossessions: • Be sure to account for all payments and recognition of gross profit until the repossession date • Set up repossessed goods at their fair value at repossession (not what they were worth when originally sold) • Write off any remaining A/R and deferred Gross Profit; recognizing the gain/loss to make the journal entry balance

  44. Franchise Revenue (Appendix 18A) Basic Idea: • Various types of franchise arrangements, we will focus on service sponsor-retailer • Franchisor sells (1) right to operate business and (2) provides on-going support activities. • Revenue streams (1) initial sale of franchise and related assets/services (2) fees based on the operation of the franchise So how does franchisor record this revenue?

  45. Franchise Revenue • Initial Franchise fee • Revenue recorded when there is: • Substantial performance • No remaining obligation to refund any cash or excuse any non-payment of note. Generally assumed to be when franchisee commences operations • Collection of fee is reasonably assured • If terms not met, then Unearned Franchise Fees • Often payment is in cash and a LT note receivable • Continuing Fees • When earned and receivable. • Often amount must be verified

  46. Franchise Revenue Example On 3/31/09 the Red Hot Chicken Wing Corp. entered into a franchise agreement with Thomas Keller. In exchange for an initial franchise fee of $50,000, Red Hot will provide initial services to include the selection of location, construction of building, employee training and consulting services over several years. $10,000 is payable on 3/31/09, with the remaining $40,000 payable in annual installments. 10% interest on the note (at market rate) is payable annually. In addition, the franchisee will pay continuing franchise fees of $1000 per month for advertising and promotion provided by Red Hot, beginning immediately after the franchise begins operations. Thomas Keller opened his Red Hot franchise for business on 9/30/09

  47. Franchise Revenue Example Initial Franchise fee 3/31/09 Cash 10,000 Note Receivable 40,000 Unearned franchise fee revenue 50,000 9/30/09 Unearned franchise fee revenue 50,000 Franchise fee revenue 50,000 Continuing Fees 10/31/09 Cash 1000 (& monthly) Service Revenue 1000 Debt Service 3/31/10 Cash 4000 Interest revenue 4000

  48. Consignments (Appendix 18A) Basic idea: • Consignor “gives” merchandise to a a reseller to sell on your behalf to an end user. • Can’t recognize revenue until sold to end user Entries: Ships to consignee Inventory on consignment xxx Finished good inventory xxx Notified of sale to end user Cash xxx Commission expense xxx Revenue from consigned sales xxx COGS xxx Inventory on consignment xxx

  49. Revenue Recognition: US GAAP vs. IFRS • Long-term construction contracts when outcomes cannot be reasonably estimated: • US GAAP: must use Completed Contract Method (No revenue or expense is recognized until the end of the contract) • IFRS: must use the zero-profit method (revenues are recognized only to the extent of costs) • Service Revenue • US GAAP: follow specific industry guidance for revenue recognition • IFRS: typically use the % Completion method (or straight-line if services are specified over a period of time)

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