kieso

weygandt
warfield
INTERMEDIATE team for success

Intermediat
F I F T E E N T H E D I T I O N

Intermediat
ACCOUNTING
e e
Accounting
Accounting

Prepared by
Coby Harmon
Prepared by
University of California,
CobySanta Barbara
Harmon Prepared by
Westmont
University College SantaCoby
of California,
Harmon
Barbara
University of California, Santa Barbara
18-1 Westmont College
 PREVIEW OF CHAPTER 18

Intermediate Accounting
15th Edition
Kieso Weygandt Warfield
18-2
 18 Revenue Recognition

LEARNING
LEARNINGOBJECTIVES
OBJECTIVES
After studying this chapter, you should be able to:

1. Apply the revenue recognition principle. 4. Apply the completed-contract method for
long-term contracts.
2. Describe accounting issues for revenue
recognition at point of sale. 5. Identify the proper accounting for losses
on long-term contracts.
3. Apply the percentage-of-completion
method for long-term contracts. 6. Describe the installment-sales method of
accounting.
7. Explain the cost-recovery method of
accounting.

18-3
 Overview of Revenue Recognition

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.

18-4 LO 1
 Overview of Revenue Recognition

Guidelines for Revenue Recognition

The revenue recognition principle provides that companies
should recognize revenue
1)when it is realized or realizable and

2)when it is earned.

18-5 LO 1
 Guidelines for Revenue Recognition
Revenue Recognition Classified by Type of Transaction
Chapter 18 Chapter 18 Illustration 18-1

Type of Sale
Saleof
ofasset
asset
Sale
Saleof
ofproduct
product Rendering
Renderingaa Permitting
Permittinguse
useof
of other than
Transaction from inventory
from inventory service
service an asset
an asset
other than
inventory
inventory

Description Revenue
Revenuefromfrom
Revenue
Revenuefrom
from Revenue
Revenuefrom
from Gain
Gainor
orloss
losson
on
interest, rents,
interest, rents,
of Revenue sales
sales fees or services
fees or services
disposition
disposition
and
androyalties
royalties

Timing of Services As
Date Services Astime
timepasses
passes
Revenue Dateof
ofsale
sale(date
(date performed
Date
Dateof
ofsale
saleor
or
of delivery) performedand and or
or assetsare
assets are trade-in
Recognition of delivery) billable used trade-in
billable used

18-6 LO 1
 Overview of Revenue Recognition

Departures from the Sale Basis

Earlier recognition is appropriate if there is a high degree
of certainty about the amount of revenue earned.

Delayed recognition 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.

18-7 LO 1
 Departures from the Sale Basis

Revenue Recognition Alternatives

Illustration 18-2

18-8 LO 1
18-9 LO 1
 18 Revenue Recognition

LEARNING
LEARNINGOBJECTIVES
OBJECTIVES
After studying this chapter, you should be able to:

1. Apply the revenue recognition principle. 4. Apply the completed-contract method for
long-term contracts.
2. Describe accounting issues for revenue
recognition at point of sale. 5. Identify the proper accounting for losses
on long-term contracts.
3. Apply the percentage-of-completion
method for long-term contracts. 6. Describe the installment-sales method of
accounting.
7. Explain the cost-recovery method of
accounting.

18-10
 Revenue Recognition at Point of Sale

FASB’s Concepts Statement No. 5, companies usually

meet the two conditions for recognizing revenue by the time
they deliver products or render services to customers.

Implementation problems,
  Principal-Agent Relationships
Sales with Discounts
  Trade Loading and Channel
Sales with Right of Return
Stuffing
 Sales with Buybacks
 Multiple-Deliverable
 Bill and Hold Sales
Arrangements

18-11 LO 2
 Revenue Recognition at Point of Sale

Sales with Discounts

 Trade discounts or volume rebates should reduce
consideration received and reduce revenue earned.
 If payment is delayed, seller should impute an interest
rate for the difference between the cash or cash
equivalent price and the deferred amount.

18-12 LO 2
 Sales with Discounts

VOLUME DISCOUNT Illustration 18-3

Illustration 18-3

Facts: Sansung Company has an arrangement with its customers that

it will provide a 3% volume discount to its customers if they purchase
at least $2 million of its product during the calendar year. On March
31, 2014, Sansung has made sales of $700,000 to Artic Co. In the
previous two years, Sansung sold over $3,000,000 to Artic in the
period April 1 to December 31. Sansung makes the following entry on
March 31, 2014.

Accounts Receivable 679,000

Sales Revenue 679,000

18-13 LO 2
 Sales with Discounts

VOLUME DISCOUNT Illustration 18-3

Facts: Sansung Company has an arrangement with its customers that

it will provide a 3% volume discount to its customers if they purchase
at least $2 million of its product during the calendar year. On March
31, 2014, Sansung has made sales of $700,000 to Artic Co. In the
previous two years, Sansung sold over $3,000,000 to Artic in the
period April 1 to December 31. Assuming Sansung’s customers meet
the discount threshold, Sansung makes the following entry.

Cash 679,000
Accounts Receivable 679,000

18-14 LO 2
 Sales with Discounts

VOLUME DISCOUNT Illustration 18-3

Facts: Sansung Company has an arrangement with its customers that

it will provide a 3% volume discount to its customers if they purchase
at least $2 million of its product during the calendar year. On March
31, 2014, Sansung has made sales of $700,000 to Artic Co. In the
previous two years, Sansung sold over $3,000,000 to Artic in the
period April 1 to December 31. Sansung makes the following entry on
March 31, 2014. If Sansung’s customers fail to meet the discount
threshold, Sansung makes the following entry upon payment.

Cash 700,000
Accounts Receivable 679,000
Sales Discounts Forfeited 21,000
18-15 LO 2
 Revenue Recognition at Point of Sale

Sales with Right of Return

Three alternative revenue recognition methods are available
when the right of return exposes the seller to continued risks of
ownership. These are

1. not recording a sale until all return privileges have expired;

2. recording the sale, but reducing sales by an estimate of future

returns; and

3. recording the sale and accounting for the returns as they

occur.

18-16 LO 2
 Sales with Right of Return

Recognize revenue only if six conditions have been met.

1. The seller’s price to the buyer is substantially fixed or

determinable at the date of sale.

2. The buyer has paid the seller, or the buyer is obligated to

pay the seller, and the obligation is not contingent on resale
of the product.

3. The buyer’s obligation to the seller would not be changed in

the event of theft or physical destruction or damage of the
product.

18-17 LO 2
 Sales with Right of Return

Recognize revenue only if six conditions have been met.

3. The buyer acquiring the product for resale has economic

substance apart from that provided by the seller.

4. The seller does not have significant obligations for future

performance to directly bring about resale of the product by
the buyer.

5. The seller can reasonably estimate the amount of future

returns.

18-18 LO 2
 Sales with Right of Return

SALES WITH RETURNS Illustration 18-5

Illustration 18-5

Facts: Pesido Company is in the beta-testing stage for new laser

equipment that will help patients who have acid reflux problems. The
product that Pesido is selling has been very successful in trials to date. As
a result, Pesido has received regulatory authority to sell this equipment to
various hospitals. Because of the uncertainty surrounding this product,
Pesido has granted to the participating hospitals the right to return the
device and receive full reimbursement for a period of 9 months.
Question: When should Pesido recognize the revenue for the sale of the
new laser equipment?

Solution: Given that the hospital has the right to rescind the purchase for
a reason specified in the sales contract and Pesido is uncertain about the
probability of return, Pesido should not record revenue at time of delivery.

18-19 LO 2
 Sales with Right of Return

SALES WITH RETURNS

Pesido sold $300,000 of laser equipment on August 1, 2014, and

retains only an insignificant risk of ownership. On October 15, 2014,
$10,000 in equipment was returned.

August 1, 2014
Accounts Receivable 300,000
Sales 300,000

October 15, 2014

Sales Returns and Allowances 10,000
Accounts Receivable
10,000
18-20 LO 2
 Sales with Right of Return

SALES WITH RETURNS

At December 31, 2014, based on prior experience, Pesido estimates

that returns on the remaining balance will be 4 percent. Pesido
makes the following entry to record the expected returns.

Calculation of estimated return = [($300,000 - $10,000) x 4% = 11,600]

December 31, 2014

Sales Returns and Allowances 11,600
Allowance for Sales Returns and Allowances
11,600

18-21 LO 2
 Revenue Recognition at Point of Sale

Sales with Buybacks

If a company sells a product in one period and agrees to buy
it back in the next period, has the company sold the
product?

The economic substance of this transaction is that the seller

retains the risks of ownership.

18-22 LO 2
 Sales with Buybacks

SALES WITH BUYBACK

Facts: Morgan Inc., an equipment dealer, sells equipment to Lane

Company for $135,000. The equipment has a cost of $115,000.
Morgan agrees to repurchase the equipment at the end of 2 years at
its fair value. Lane Company pays full price at the sales date, and
there are no restrictions on the use of the equipment over the 2
years. Morgan records the sale and cost of goods sold as follows:

Cash 135,000
Sales Revenue
135,000
Cost of Goods Sold 115,000
Inventory LO 2
18-23
 Revenue Recognition at Point of Sale

Bill and Hold Sales

Buyer is not yet ready to take delivery but does take title.

BILL AND HOLD Illustration 18-7

Facts: Butler Company sells $450,000 of fireplaces to a local coffee18-4

Illustration

shop, Baristo, which is planning to expand its locations around the

city. Under the agreement, Baristo asks Butler to retain these
fireplaces in its warehouses until the new coffee shops that will
house the fireplaces are ready. Title passes to Baristo at the time the
agreement is signed.
Question: Should Butler report the revenue from this bill and hold
arrangement when the agreement is signed, or should revenue be
deferred and reported when the fireplaces are delivered?
18-24 LO 2
 Bill and Hold Sales

Solution: Butler should record the revenue at the time title

passes, provided

1. the risks of ownership have passed to Baristo, that is, Butler

does not have specific performance obligations other than
storage;

2. Baristo makes a fixed commitment to purchase the goods,

requests that the transaction be on a bill and hold basis, and
sets a fixed delivery date; and

3. goods must be segregated, complete, and ready for

shipment.

18-25 LO 2
 Bill and Hold Sales

BILL AND HOLD Illustration

Illustration 18-7
18-4

Facts: Butler Company sells $450,000 of fireplaces to a local coffee

shop, Baristo, which is planning to expand its locations around the
city. Under the agreement, Baristo asks Butler to retain these
fireplaces in its warehouses until the new coffee shops that will
house the fireplaces are ready. Title passes to Baristo at the time the
agreement is signed. Butler makes the following entry.

Accounts Receivable 450,000

Sales 450,000

18-26 LO 2
 Revenue Recognition at Point of Sale

Principal-Agent Relationships
 Amounts collected on behalf of the principal are not
revenue of the agent.
 Revenue for the agent is the amount of the commission
it receives.

18-27 LO 2
18-28 LO 2
 Revenue Recognition at Point of Sale

Principal-Agent Relationships
Consignments
 Manufacturers (or wholesalers) deliver goods but retain
title to the goods until they are sold.

 Consignor (manufacturer or wholesaler) ships

merchandise to the consignee (dealer), who is to act as
an agent for the consignor in selling the merchandise.

 Consignor makes a profit on the sale.

 Consignee makes a commission on the sale.

18-29 LO 2
 Revenue Recognition at Point of Sale

Trade Loading and Channel Stuffing

“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.

18-30 LO 2
18-31 LO 2
 Revenue Recognition at Point of Sale

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.

18-32 LO 2
 Multiple-Deliverable Arrangements

All units in a multiple-deliverable arrangement are

considered separate units of accounting, provided that:
1. A delivered item has value to the customer on a
standalone basis; and

2. The arrangement includes a general right of return

relative to the delivered item; and

3. Delivery or performance of the undelivered item is

considered probable and substantially in the control of the
seller.

18-33 LO 2
 Multiple-Deliverable Arrangements

Multiple-Deliverable Evaluation Process

Illustration 18-9

18-34 LO 2
 18 Revenue Recognition

LEARNING
LEARNINGOBJECTIVES
OBJECTIVES
After studying this chapter, you should be able to:

1. Apply the revenue recognition principle. 4. Apply the completed-contract method for
long-term contracts.
2. Describe accounting issues for revenue
recognition at point of sale. 5. Identify the proper accounting for losses
on long-term contracts.
3. Apply the percentage-of-completion
method for long-term contracts. 6. Describe the installment-sales method of
accounting.
7. Explain the cost-recovery method of
accounting.

18-35
 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.

18-36 LO 3
 Revenue Recognition Before Delivery

Must use Percentage-of-Completion method when estimates

of progress toward completion, revenues, and costs are
reasonably dependable and all of the following conditions
exist:

1. 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.

2. Buyer can be expected to satisfy all obligations.

3. Contractor can be expected to perform under the

contractual obligations.

18-37 LO 3
 Revenue Recognition Before Delivery

Companies should use the Completed-Contract method when

one of the following conditions applies when:

1. Company has primarily short-term contracts, or

2. Company cannot meet the conditions for using the

percentage-of-completion method, or

3. There are inherent hazards in the contract beyond the normal,

recurring business risks.

18-38 LO 3
 Revenue Recognition Before Delivery

Percentage-of-Completion Method
Formula for Total Revenue to Be Recognized to Date

Illustration 18-13

Illustration 18-14

Illustration 18-15

18-39 LO 3
 Percentage-of-Completion Method

Illustration: Hardhat Construction Company has a contract to

construct a $4,500,000 bridge at an estimated cost of
$4,000,000. The contract is to start in July 2014, and the bridge
is to be completed in October 2016. The following data pertain to
the construction period.

18-40 LO 3
 Percentage-of-Completion Method

Illustration 18-16

Advance slide in presentation

18-41 mode to reveal answers.
LO 3
 Percentage-of-Completion Method

Illustration 18-17

Advance slide in presentation

18-42 mode to reveal answers.
LO 3
 Percentage-of-Completion Method

Illustration: Percentage-of-Completion Revenue, Costs, and

Gross Profit by Year
Illustration 18-18

18-43 LO 3
 Illustration 18-18

Percentage-
of-
Completion
Method

Illustration 18-19

Advance slide in presentation

18-44 mode to reveal answers.
LO 3
 Percentage-of-Completion Method

Illustration: Content of Construction in Process Account—

Percentage-of-Completion Method
Illustration 18-20

18-45 LO 3
 Percentage-of-Completion Method

Financial Statement Presentation—Percentage-

of-Completion
Computation of Unbilled Contract Price at 12/31/14
Illustration 18-21

18-46 LO 3
 Percentage-of-Completion Method

Financial Statement Presentation—Percentage-

of-Completion Method 2014
Illustration 18-22

18-47 LO 3
 Percentage-of-Completion Method

Financial Statement Presentation—Percentage-

of-Completion Method 2015
Illustration 18-23

18-48 LO 3
 Percentage-of-Completion Method

Illustration: Casper Construction Co.

2014 2015 2016
Contract price $675,000 $675,000 $675,000
Cost incurred current year 150,000 287,400 170,100
Estimated cost to complete
in future years 450,000 170,100 0
Billings to customer current year 135,000 360,000 180,000
Cash receipts from customer
Current year 112,500 262,500 300,000

A) Prepare the journal entries for 2014, 2015, and 2016.

18-49 LO 3
 Percentage-of-Completion Method

Illustration:
2014 2015 2016
Costs incurred to date $ 150,000 $ 437,400 $ 607,500
Estimated cost to complete 450,000 170,100
Est. total contract costs 600,000 607,500 607,500
Est. percentage complete 25.0% 72.0% 100.0%
Contract price 675,000 675,000 675,000
Revenue recognizable 168,750 486,000 675,000
Rev. recognized prior year (168,750) (486,000)
Rev. recognized currently 168,750 317,250 189,000
Costs incurred currently (150,000) (287,400) (170,100)
Gross profit recognized $ 18,750 $ 29,850 $ 18,900

18-50 LO 3
 Percentage-of-Completion Method

Illustration: 2014 2015 2016

Construction in progress 150,000 287,400 170,100
Cash 150,000 287,400 170,100

Accounts receivable 135,000 360,000 180,000

Billings on contract 135,000 360,000 180,000

Cash 112,500 262,500 300,000

Accounts receivable 112,500 262,500 300,000

Construction in progress 18,750 29,850 18,900

Construction expense 150,000 287,400 170,100
Construction revenue 168,750 317,250 189,000

Billings on contract 675,000

Construction in progress 675,000

18-51 LO 3
 Percentage-of-Completion Method

Illustration:
Income Statement 2014 2015 2016
Revenue on contracts $ 168,750 $ 317,250 $ 189,000
Cost of construction 150,000 287,400 170,100
Gross profit 18,750 29,850 18,900

Balance Sheet (12/31)

Current assets:
Accounts receivable 22,500 120,000 -
Cost & profits > billings 33,750
Current liabilities:
Billings > cost & profits 9,000

18-52 LO 3
 18 Revenue Recognition

LEARNING
LEARNINGOBJECTIVES
OBJECTIVES
After studying this chapter, you should be able to:

1. Apply the revenue recognition principle. 4. Apply the completed-contract method for
long-term contracts.
2. Describe accounting issues for revenue
recognition at point of sale. 5. Identify the proper accounting for losses
on long-term contracts.
3. Apply the percentage-of-completion
method for long-term contracts. 6. Describe the installment-sales method of
accounting.
7. Explain the cost-recovery method of
accounting.

18-53
 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.

18-54 LO 4
 Completed-Contract Method

Illustration:
2014 2015 2016
Construction in progress 150,000 287,400 170,100
Cash 150,000 287,400 170,100

Accounts receivable 135,000 360,000 180,000

Billings on contract 135,000 360,000 180,000

Cash 112,500 262,500 300,000

Accounts receivable 112,500 262,500 300,000

Construction in progress 67,500

Construction expense 607,500
Construction revenue 675,000

Billings on contract 675,000

Construction in progress 675,000

18-55 LO 4
 Completed-Contract Method

Illustration:
Income Statement 2014 2015 2016
Revenue on contracts $ - $ - $ 675,000
Cost of construction - - 607,500
Gross profit - - 67,500

Balance Sheet (12/31)

Current assets:
Accounts receivable 22,500 120,000 -
Cost & profits > billings 15,000
Current liabilities:
Billings > cost & profits 57,600

18-56 LO 4
 18 Revenue Recognition

LEARNING
LEARNINGOBJECTIVES
OBJECTIVES
After studying this chapter, you should be able to:

1. Apply the revenue recognition principle. 4. Apply the completed-contract method for
long-term contracts.
2. Describe accounting issues for revenue
recognition at point of sale. 5. Identify the proper accounting for losses
on long-term contracts.
3. Apply the percentage-of-completion
method for long-term contracts. 6. Describe the installment-sales method of
accounting.
7. Explain the cost-recovery method of
accounting.

18-57
 Revenue Recognition Before Delivery

Long-Term Contract Losses

1. 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.

2. 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.

18-58 LO 5
 Long-Term Contract Losses

Illustration: Loss on Profitable Contract

2014 2015 2016
Casper Construction
Contract price Co. $675,000 $675,000 $675,000
Cost incurred current year 150,000 287,400 215,436
Estimated cost to complete
in future years 450,000 215,436 0
Billings to customer current year 135,000 360,000 180,000
Cash receipts from customer
Current year 112,500 262,500 300,000

b) Prepare the journal entries for 2014, 2015, and 2016 assuming the
estimated cost to complete at the end of 2015 was $215,436 instead of
$170,100.
18-59 LO 5
 Long-Term Contract Losses

Illustration: Loss on Profitable Contract

2014 2015 2016
Costs incurred to date $ 150,000 $ 437,400 $ 652,836
Estimated cost to complete 450,000 215,436
Est. total contract costs 600,000 652,836 652,836
Est. percentage complete 25.0% 67.0% 100.0%
Contract price 675,000 675,000 675,000
Revenue recognizable 168,750 452,250 675,000
Rev. recognized prior year (168,750) (452,250)
Rev. recognized currently 168,750 283,500 222,750
Costs incurred currently (150,000) (287,400) (215,436)
Gross profit recognized $ 18,750 $ (3,900) $ 7,314

18-60 LO 5
 Long-Term Contract Losses

Illustration: Loss on Profitable Contract

2014 2015 2016

Construction in progress 18,750 7,314

Construction expense 150,000 215,436
Construction revenue 168,750 222,750

Construction in progress 3,900

Construction expense 287,400
Construction revenue 283,500

18-61 LO 5
 Long-Term Contract Losses

Illustration: Loss on Un-Profitable Contract

2014 2015 2016
Casper Construction
Contract price Co. $675,000 $675,000 $675,000
Cost incurred current year 150,000 287,400 246,038
Estimated cost to complete
in future years 450,000 246,038 0
Billings to customer current year 135,000 360,000 180,000
Cash receipts from customer
Current year 112,500 262,500 300,000

c) Prepare the journal entries for 2012, 2013, and 2014 assuming the
estimated cost to complete at the end of 2013 was $246,038 instead of
$170,100.

18-62 LO 5
 Long-Term Contract Losses
Illustration: Loss on Unprofitable Contract
2014 2015 2016
Costs incurred to date $ 150,000 $ 437,400 $ 683,438
Estimated cost to complete 450,000 246,038
Est. total contract costs 600,000 683,438 683,438
Est. percentage complete 25.0% 64.0% 100.0%
Contract price 675,000 675,000 675,000
Revenue recognizable 168,750 432,000 675,000
Rev. recognized prior year (168,750) (432,000)
Rev. recognized currently 168,750 263,250 243,000
Costs incurred currently (150,000) (290,438) (243,000)
Gross profit recognized $ 18,750 $ (27,188) $ -

18-63 $675,000 – 683,438 = (8,438) cumulative loss LO 5

 Long-Term Contract Losses

Illustration: Loss on Un-Profitable Contract

2014 2015 2016

Construction in progress 18,750 -

Construction expense 150,000 243,000
Construction revenue 168,750 243,000

Construction in progress 27,188

Construction expense 290,438
Construction revenue 263,250

18-64 LO 5
 Long-Term Contract Losses

Illustration: Loss on Un-Profitable Contract

For the Completed-Contract method, companies would

recognize the following loss :

2014 2015 2016

Loss on construction contract 8,438

Construction in progress 8,438

18-65 LO 5
 Revenue Recognition Before Delivery

Disclosures in Financial Statements

Construction contractors should disclose:
 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.

18-66 LO 5
 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.

18-67 LO 5
 18 Revenue Recognition

LEARNING
LEARNINGOBJECTIVES
OBJECTIVES
After studying this chapter, you should be able to:

1. Apply the revenue recognition principle. 4. Apply the completed-contract method for
long-term contracts.
2. Describe accounting issues for revenue
recognition at point of sale. 5. Identify the proper accounting for losses
on long-term contracts.
3. Apply the percentage-of-completion
method for long-term contracts. 6. Describe the installment-sales method of
accounting.
7. Explain the cost-recovery method of
accounting.

18-68
 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 Generally

Employed
Cost-recovery method
 Deposit method

18-69 LO 6
 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.

18-70 LO 6
 Installment-Sales Method

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.

18-71 LO 6
 Installment-Sales Method

Procedure for Deferring Revenue and Cost of

Sales of Merchandise

18-72 LO 6
 Installment-Sales Method

Prepare the entry to record sales made on installment in 2014:

Installment Accounts Receivable, 2014 200,000

Installment Sales 200,000

18-73 LO 6
 Installment-Sales Method

Prepare the entry to record cash collected on installment receivables:

Cash 60,000
Installment Accounts Receivable, 2014 60,000

18-74 LO 6
 Installment-Sales Method

Prepare the entry to record cost of goods sold on installment in 2014

Cost of Installment Sales 150,000

Inventory (or Purchases) 150,000

18-75 LO 6
 Installment-Sales Method

Prepare the entry to close installment sales and cost of installment sales:

Installment Sales 200,000

Cost of Installment Sales 150,000
Deferred Gross Profit, 2014 50,000
18-76 LO 6
 Installment-Sales Method

Prepare the entry to remove from deferred gross profit the profit realized:

Deferred Gross Profit, 2014 15,000

Realized Gross Profit 15,000

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 Installment-Sales Method

Prepare the entry to close profits realized by collections:

Realized Gross Profit 15,000

Income Summary 15,000

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 Installment-Sales Method

Computation of Realized and Deferred Gross Profit, 2014:

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 Installment-Sales Method

Additional Problems of Installment-Sales

Accounting
These problems are related to:

1.Interest on installment contracts.

2.Uncollectible accounts.

3.Defaults and repossessions.

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 Installment-Sales Method

Financial Statement Presentation of Installment-

Sales Transactions
Illustration 18-38

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 18 Revenue Recognition

LEARNING
LEARNINGOBJECTIVES
OBJECTIVES
After studying this chapter, you should be able to:

1. Apply the revenue recognition principle. 4. Apply the completed-contract method for
long-term contracts.
2. Describe accounting issues for revenue
recognition at point of sale. 5. Identify the proper accounting for losses
on long-term contracts.
3. Apply the percentage-of-completion
method for long-term contracts. 6. Describe the installment-sales method of
accounting.
7. Explain the cost-recovery method of
accounting.

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 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.

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 Cost-Recovery Method

Illustration: In 2014, Fesmire Manufacturing sells inventory with a

cost of $25,000 to Higley Company for $36,000. Higley will make
payments of $18,000 in 2014, $12,000 in 2015, and $6,000 in 2016.
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

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 Cost-Recovery Method
Illustration 18-41

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 2014 is as follows.
Sales 36,000
Cost of Sales
25,000
LO 7
18-85 Deferred Gross Profit
 Cost-Recovery Method
Illustration 18-41

Prepare the entries to recognize gross profit to the extent that cash
collections in 2015 exceed costs.

Deferred Gross Profit 5,000

Realized Gross Profit
5,000
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 Cost-Recovery Method
Illustration 18-41

Prepare the entries to recognize gross profit to the extent that cash
collections in 2016 exceed costs.

Deferred Gross Profit 6,000

Realized Gross Profit
6,000
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 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.

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 Summary of Revenue Recognition Bases
Illustration 18-42

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

Franchises
Four types of franchising arrangements have evolved:
1. manufacturer-retailer,

2. manufacturer-wholesaler,

3. service sponsor-retailer, and

4. wholesaler-retailer.

18-90 LO 8 Explain the revenue recognition for franchises.

 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

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)

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

Franchises
Two sources of revenue:
1. Sale of initial franchises and related assets or services,
and

2. Continuing fees based on the operations of franchises.

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

Franchises
The franchisor normally provides the franchisee with:
1. Assistance in site selection.
2. Evaluation of potential income.
3. Supervision of construction activity.
4. Assistance in the acquisition of signs, fixtures, and equipment.
5. Bookkeeping and advisory services.
6. Employee and management training.
7. Quality control.
8. Advertising and promotion.

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

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.

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

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.

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

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

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

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
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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

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
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Unearned Franchise Fees
 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

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

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

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.

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

Continuing Franchise Fees

Continuing franchise fees are received in return for the
continuing rights granted by the franchise agreement and for
providing such services as management training, advertising
and promotion, legal assistance, and other support.

Franchisors report continuing fees as revenue when they

are earned and receivable from the franchisee.

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

Bargain Purchases
Sometimes the franchise agreement grants the franchisee the right
to make bargain purchases of equipment or supplies after the
franchisee has paid the initial franchise fee.

If the bargain price is lower than the normal selling price of the same
product, or if it does not provide the franchisor a reasonable profit,
then the franchisor should defer a portion of the initial franchise fee.
The franchisor would account for the deferred portion as an
adjustment of the selling price when the franchisee subsequently
purchases the equipment or supplies.

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

Options to Purchase
As a matter of management policy, the franchisor may reserve
the right to purchase a profitable franchise outlet, or to purchase
one that is in financial difficulty.

If it is probable at the time the option is given that the franchisor

will ultimately purchase the outlet, then the franchisor should
 not recognize the initial franchise fee as revenue but
 should instead record it as a liability.

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

Franchisor’s Cost
 Should ordinarily defer direct costs (usually incremental
costs) relating to specific franchise sales for which revenue has
not yet been recognized.
 Should not defer costs without reference to anticipated revenue
and its realizability.
 Indirect costs of a regular and recurring nature, such as
selling and administrative expenses that are incurred
irrespective of the level of franchise sales, should be expensed
as incurred.

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 APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES

Disclosure of Franchisors
 All significant commitments and obligations resulting from
franchise agreements.
 Any resolution of uncertainties regarding the collectibility of
franchise fees.
 Where possible, revenues and costs related to franchisor
owned outlets should be distinguished from those related to
franchised outlets.

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 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.

LO 9 Compare the accounting procedures related to

18-106 revenue recognition under GAAP AND 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.

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 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.

18-108 LO 9
 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.

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 ON THE HORIZON
The FASB and IASB are now involved in a joint project on revenue recognition..
In particular, the project is intended to improve financial reporting by (1)
converging U.S. and international standards on revenue recognition, (2)
eliminating inconsistencies in the existing conceptual guidance on revenue
recognition, (3) providing conceptual guidance that would be useful in
addressing future revenue recognition issues, (4) eliminating inconsistencies in
existing standards-level authoritative literature and accepted practices, (5) filling
voids in revenue recognition guidance that have developed over time, and (6)
establishing a single, comprehensive standard on revenue recognition.
Presently, the Boards proposed a “customer-consideration” model; under this
model, revenue is recognized when a performance obligation is satisfied. It is
hoped that this approach (rather than using the earned and realized or realized
criteria) will lead to a better basis for revenue recognition.

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 IFRS SELF-TEST QUESTION
The IASB:
a. has issued over 100 standards related to revenue recognition.
b. has issued one standard related to revenue recognition.
c. indicates that the present state of reporting for revenue is
satisfactory.
d. All of the above.

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 IFRS SELF-TEST QUESTION
Under IFRS, the revenue recognition principle indicates that revenue is
recognized when:
I. the benefits can be measured reliably.
II. the sales transaction is initiated and completed.
III. it is probable the benefits will flow to the company.
IV. the date of sale, date of delivery, and billing have all occurred.
a. I, II, and III.
b. II and III.
c. I and III.
d. I, II, III and IV.

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 Copyright

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18-113