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Revenue Recognition

LOVETTE JAM PRADA JACOSALEM

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5-2

Operating Cycle

Cash-to-cash.

Receive cash fromcustomer Purchase materials/services & paycash

Convertmaterials/services to salable product

Inspectthe product

Store product Receive anorder for the product

Sell product

Receive cash fromcustomer

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5-3

Revenue Recognition:When? (Timing) & How much? (Amount)

Atone point in revenue cycle (objectivity).

Criteria: When? Earned (Conservatism)

x Normally, goods shipped.

x Service performed.

Howmuch? Realizedor realizable (Realization).x Alreadycollectedor collectible.

x Amountcan be measured reliably.

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Timing of Revenue RecognitionEvent Revenue

Recognition at ThisTime

Typical RevenueRecognition Method

1. Sales order received No None

2.Dep

osi

to

r adva

nce

dpayment received

No None

3. Goods are produced For certain long-termcontracts

Percentage ofcompletion

4. Production

completed; goods arestored

For precious metals and

certain agriculturalproducts

Production

5. Goods shippedorservices provided

Usually Delivery

6. Customer pays

account receivable

Collection is uncertain Installment

5-5

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DELIVERY METHOD

Recognize revenuewhen goods or services are

delivered. For goods:whentitle transfers.

FOB shipping point (when goods are giventocarrier, the sale occurred atthe shipping point).

FOB destination (sale doesntoccur until thegoods reach the destination)

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Consignment Method Consignor ships goods toconsignee.

Inventoryonconsignment 1,000

Merchandise inventory 1,000y Consignor retains title until goods are soldto

customer. At sale:Accounts receivable 1,400

Sales revenue 1,400COGS 1,000

Inventoryonconsignment 1,000

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Franchise Revenue

Recognize:

When earned.

Notwhen agreement signedor fee received.

Cash 100,000

Unearned Revenue 100,000

Unearned Revenue 100,000

Revenue 100,000

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PERCENTAGE-OF-COMPLETIONMETHOD Design/development and

construction/production projects that extendsover several years.

Customer pays either fixed price or costreimbursementcontract.

Reasonable assurance of profitmargin andultimate realization.

Revenue recognized basedontotal percentage ofprojectwork performedduring period.

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Completed Contract Method

Percentage ofcompletionmethod required

unless: Amountof income to be earnedoncontractcannot reasonably be determined.

Alternative is completedcontractmethod.

Costs incurred are an asset (Contract Work inProgress) until revenue is recognized.

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Long-Term Contract Accounting Method

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PRODUCTION METHOD

Applies to agricultural andmining.

Criteria: Clear marketdetermined price.

Perf ormance substantiallycomplete.

x Minimal remaining costs.

Permitted butnot required by GAAP.

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INSTALLMENT METHOD

Customer pays a certain amount per period.

Inpure installment method, installmentpayment is recognized as revenue and aproportional partofcostof sales is recorded.

Under cost recovery method, cost is recorded

equal to installment paymentuntil total costofsales is covered.

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5-14

Real Estate Sales

Developer often finances over many years.

Uncertaintyof income due touncertaintyofreceiptof future payments.

Conditions required for revenue recognition: Period allowing cancellation and refundto buyer has

expired. Cum payments equal to10% of purchase price.

Seller has completedor is clearlycapable ofcompleting required improvement.

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5-15

AMOUNT OF REVENUE

RECOGNIZED

Net realizable value (amount reasonablyestimatedto be collected).

2 approaches:

Directwrite-offmethod.

Allowance method.

x % of sales.

x % of (analysis of) AR.

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Direct Write-Off Method

Write-offwhen specific accountthat is

uncollectible is identified. Requires thatthe specificuncollectible accountsbe identified.

Baddebt expenseAccounts receivable

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Allowance Method

Estimate amountofcurrent periodcredit sales

thatwill not be collected. Historical % tempered by judgment.

Historical % of aged receivables (+judgment).

Adjusting entry at endof period.

yWhen anuncollectible account is identified, it iswrittenoff.

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Allowance Method (continued)

yAllowance for Doubtful Accounts is a contra-

asset account.Baddebt expense

Allowance for Doubtful Accounts

y Collectionof a baddebtthatwaswritten-off:

Cash

Allowance for Doubtful Accounts

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5-19

Sales Discounts

Sales terms are 2/10 net30

Customer gets 2% cash discount if paidwithin10days.

Otherwise, total amount is due within30 days.

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Alternative Methods of Accountingfor Sales Discounts

y Record initial sale at gross.

yAtcollectionofnet amount recorddiscount as areduction from gross sales.

y Record initial sale at gross.

yAtcollectionofnet amount recorddiscount as an

expense ofthe period.

y Record initial sale atnet.

y Record amounts nottaken as discounts asadditional revenue.

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Credit Card Sales (continued)

y Ifcash received bymerchant in30 days

(Am

erica

nExpress, Dis

cover):

Accounts receivable 970

Sales discount 30

Sales revenue 1,000

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Sales Returns & Allowances

y Similar to baddebt expense,

y Estimate percentage of revenues thatwilleventually result in returns or allowances.

yAdjusting entry at endof period.

yActual returnor allowance.

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Sales Returns & Allowances(Continued)

y

Provision for Returns and Allowances is aliability account.

yAlternative:

y Not accrue for returns and allowances butwrite

themoff as theyoccur.

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Adjustment vs. Expense

Realizationconcept suggests adjustmenttorevenue.

y In practice both methods are found.

y Consistency:

y Same handling from year to year.

yAllows same company results to be compared fromyear to year.

y Comparisons betweencompanies may be distorted.

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Interest Revenue

Amount earned by lender during the period.

2 approaches Interest paid atmaturity.x Interest is explicit.

Discounted loan.

x

Interest is implicit. Accounted for separately from sale.