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1
Chapter 17
Income
Recognition and
Measurement of
Net Assets
2
Objectives
1. Understand the revenue recognition
alternatives.
2. Explain revenue recognition at the time of
sale, during production, and at time of
cash receipt.
3. Explain the conceptual issues regarding
revenue recognition alternatives.
4. Describe the alternative revenue
recognition methods.
3
Objectives
5. Account for revenue recognition prior to
the period of sale, including the percentage-
of-completion and completed contract
methods.
6. Account for revenue recognition after the
period of sale, including the installment and
cost recovery methods.
7. Account for revenue recognition delayed
until a future event occurs.
4
Objectives
8. Understand software revenue recognition,
franchises, real estate sales, retail land
sales, and consignment sales.
9. Understand accounting for changes in
prices (Appendix).
5
Revenue Recognition
Example 1: Revenue Recognition at Time of Sale
1. Ringwood Company manufactures the inventory.
Inventory 100
Cash 100
2. Ringwood sells the inventory for $150.
Accounts Receivable 150
Revenue 150
Cost of Goods Sold 100
Inventory 100
6
Revenue Recognition
Example 1: Revenue Recognition at Time of Sale
3. Ringwood collects cash of $60.
Cash 60
Accounts Receivable 60
Income Statement
Revenue $150
Cost of goods sold (100)
Gross profit $ 50
7
Revenue Recognition
Example 2: Revenue Recognition During Production
1. Ringwood Company manufactures the inventory.
Inventory 100
Cash 100
2. Ringwood recognizes the revenue during production.
Production Expense 100
Inventory 50
Revenue 150
8
Revenue Recognition
Example 2: Revenue Recognition During Production
3. The company bills the customer for a partial billing
of $130.
Accounts Receivable 130
Partial Billings 130
4. Ringwood collects cash of $60.
Cash 60
Accounts Receivable 60
9
Revenue Recognition
Example 2: Revenue Recognition During Production
Income Statement
Revenue $150
Production expense (100)
Gross profit $ 50
The balance sheet shows Inventory of
$150, less Partial Billings of $130.
10
Revenue Recognition
Example 3: Revenue Recognition at Time of Cash Receipt
1. Ringwood Company manufactures the inventory.
Inventory 100
Cash 100
2. Ringwood “sells” the inventory and defers the
recognition of revenue.
Accounts Receivable 150
Inventory 100
Deferred Gross Profit 50
11
Revenue Recognition
Example 3: Revenue Recognition at Time of Cash Receipt
3. Ringwood collects cash of $60.
Cash 60
Accounts Receivable 60
($60 ÷ $150) x
basis
4. The company recognizes revenue on the$100 of the
cash received.
Cost of Goods Sold 40
Deferred Gross Profit Cash 20
Revenue Receive 60
d
12
Revenue Recognition
Example 3: Revenue Recognition at Time of Cash Receipt
Income Statement
Revenue $ 60
Cost of goods sold (40)
Gross profit $ 20
The balance sheet shows Accounts Receivable of
$90, less Deferred Gross Profit of $30.
13
Conceptual Issues
The decision as to when to recognize revenue
focuses on three factors:
• The economic substance of the event takes
precedence over the legal form of the
transaction.
• The risks and benefits of ownership have been
transferred to the buyer.
• The collectibility of the receivable from the
sale is reasonably assured.
14
Alternative Revenue
Recognition Methods
Revenue recognition in the period of sale.
Revenue recognition prior to the period of
sale.
Revenue recognition at the completion of
production.
Revenue recognition after the period of
sale.
Revenue recognition delayed until a future
event.
15
Revenue Recognized
Earned and Realizable
Not Sufficient Economic Substance Collectibility is Collectibility is
Transfer of Risks and Transfer of Risks Reasonably Not Reasonably
and Benefits of and Benefits of Assured Assured
Ownership Ownership
Deposit Recognition before Recognition at Installment Cost
Method Physical Transfer Physical Transfer Method Recovery
Method
Percentage-of- Completed- Accrual Method:
Completion Method Contract Method “Normal” Revenue
(for Long-Term (for Long-Term Recognition at Sale
Contracts) Contracts)
16
Revenue Recognition Prior
to the Period of Sale
Percentage-of-Completion Method
It achieves the goals of accrual
accounting.
It is consistent with the argument
that revenue is earned continuously
over the entire earning process.
It results in a more relevant measure
of periodic income.
17
Percentage-of-Completion Method
AICPA Statement of Position No. 81-1 requires that
a construction company use the percentage-of-
completion method for long-term contracts when all
the following conditions are met:
18
Percentage-of-Completion Method
1. The company can make reasonably dependable
estimates of the extent of progress toward
completion, contract revenue, and contract costs.
2. The contract clearly specifies the enforceable
rights regarding goods or services to be provided
and received by both the company and the buyer,
the consideration to be exchanged, and the manner
and terms of settlement.
3. The buyer can be expected to satisfy its obligations
under the contract.
4. The company expects to perform its contractual
obligations.
19
Percentage-of-Completion Method
…for short-term contract, and
The Statement inherent hazards in
when there are also requires
that a company use the
the contract beyond the normal
business risks method
completed-contractfor which
only when at least one of
reasonably dependable estimates
cannot is made.
these conditions be not met...
20
Percentage-of-Completion Method
2000 2001 2002
Construction costs incurred during
the year $100,000 $186,000 $314,000
Estimated costs to complete the
contract 400,000 264,000 ---
Partial billing to customer 80,000 350,000 270,000
Collections from customer 50,000 330,000 320,000
Total contract price: $700,000
Example
21
Percentage-of-Completion Method
2000
1. To record construction costs:
Construction in Progress 100,000
Accounts Payable, etc. 100,000
2. To record partial billings:
Accounts Receivable 80,000
Partial Billings 80,000
3. To record collections:
Cash 50,000
Accounts Receivable 50,000
22
Percentage-of-Completion Method
2000
4. To record gross profit:
Construction Expense 100,000
Construction in Progress 40,000
Construction Revenue 140,000
($100,000 ÷ $500,000) x $700,000
23
Percentage-of-Completion Method
2001
1. To record construction costs:
Construction in Progress 186,000
Accounts Payable, etc. 186,000
2. To record partial billings:
Accounts Receivable 350,000
Partial Billings 350,000
3. To record collections:
Cash 330,000
Accounts Receivable 330,000
24
Percentage-of-Completion Method
2001
4. To record gross profit:
Construction Expense 186,000
Construction in Progress 38,000
Construction Revenue 224,000
[($286,000 ÷ $550,000) x $700,000] - $140,000
Construction costs
Revised cost = Previous year’s
$286,000
incurred to date + $264,000 construction revenue
25
Percentage-of-Completion Method
2002
1. To record construction costs:
Construction in Progress 314,000
Accounts Payable, etc. 314,000
2. To record partial billings:
Accounts Receivable 270,000
Partial Billings 270,000
3. To record collections:
Cash 320,000
Accounts Receivable 320,000
26
Percentage-of-Completion Method
2002
4. To record gross profit and close out accounts:
Construction Expense 314,000
Construction in Progress 22,000
Construction Revenue 336,000
Partial Billings 700,000
Construction in Progress 700,000
$700,000 - $140,000 - $224,000
Recognized in 2000 in 2001
Recognized
27
Completed-Contract Method
Entries 1, 2, and 3 are the same as those used
for the percentage-of-completion method.
The completed-contract method does not
recognize revenue until the project is
completed, so there is no Entry 4 until 2002.
28
Completed-Contract Method
2002
4. To record gross profit and close out accounts:
Partial Billings 700,000
Construction Revenue 700,000
Construction Expense 600,000
Construction in Progress 600,000
$100,000 + $186,000 + $314,000
29
Capitalized Interest
If interest cost is associated with
the funds used in the construction,
the firm should include this cost
in the Construction in Process
account.
30
Installment Method
…and agrees involve
Installment sales to make a
financing agreement
periodic payments over an ...makes a small
whereby the customer
extended period, often down payment,...
signs a contract,...
several years.
31
Installment Method
Total sales, cost of goods sold, and collections are
recorded in the normal manner during the year.
At the end of the year, installment sales are identified.
The revenue and the related cost of goods sold are
“reversed,” and the deferred gross profit is recognized.
At the end of the year, the gross profit rate on
installment sales is computed.
A portion of the deferred gross profit is recognized as
gross profit.
In future years the remaining deferred gross profit is
reduced and the gross profit is recognized based on the
cash collected on the installment sales.
32
Installment Method
Consider the following information for Lee for 2001:
Total credit sales $500,000
Total cost of goods sold 390,000
Installment method sales 100,000
Installment method cost of goods sold 75,000
Gross profit rate on installment method sales 25%
Cash receipts on installment method sales 20,000
Cash receipts on other credit sales 300,000
Lee Company uses a perpetual inventory method.
33
Installment Method
Credit sales during the year:
Accounts Receivable 500,000
Sales 500,000
Cost of Goods Sold 390,000
Inventory 390,000
Collected $300,000; $20,000 related to installment sales:
Cash 320,000
Accounts Receivable 320,000
Continued
34
Installment Method
Installment sales and related cost of goods sold
identified and “reversed”:
Sales 100,000
Cost of Goods Sold 75,000
Deferred Gross Profit, 2001 25,000
Recognized a gross profit of 25% of cash collected on
installment sales:
Deferred Gross Profit, 2001 5,000
Gross Profit Realized on Installment
Method Sales 5,000
35
Installment Method
Consider the following information for Lee for 2002:
Total credit sales $600,000
Total cost of goods sold 430,000
Installment method sales 150,000
Installment method cost of goods sold 105,000
Gross profit rate on installment method sales 30%
Cash receipts on installment method sales:
2001 sales 30,000
2002 sales 40,000
Cash receipts on other credit sales 480,000
36
Installment Method
Credit sales during the year:
Accounts Receivable 600,000
Sales 600,000
Cost of Goods Sold 430,000
Inventory 430,000
Collected $550,000; $70,000 related to installment sales:
Cash 550,000
Accounts Receivable 550,000
Continued
37
Installment Method
Installment sales and related cost of goods sold
identified and “reversed”:
Sales 150,000
Cost of Goods Sold 105,000
Deferred Gross Profit, 2002 45,000
Recognized a gross profit of 25% of cash collected on
installment sales for 2001 and 30% for 2002:
Deferred Gross Profit, 2001 7,500
Deferred Gross Profit, 2002 12,000
Gross Profit Realized on Installment
Method Sales 19,500
38
Cost Recovery Method
Consider the following information for the Parken
Company:
Sale of property under cost recovery
method $20,000
Cost of property sold (net) 12,000
Cash collections:
2001 5,000
2002 9,000
2003 6,000
39
Cost Recovery Method
During 2001
Accounts Receivable 20,000
Deferred Gross Profit 8,000
Property (net) 12,000
Collected $5,000
Cash 5,000
Accounts Receivable 5,000
Continued
40
Cost Recovery Method
During 2002
Cash 9,000
Accounts Receivable 9,000
December 31, 2002
Deferred Gross Profit 2,000
Gross Profit Realized on Cost
Recovery Transactions 2,000
($5,000 + $9,000) minus
property cost of $12,000
Continued
41
Cost Recovery Method
During 2003
Cash 6,000
Accounts Receivable 6,000
December 31, 2003
Deferred Gross Profit 6,000
Gross Profit Realized on Cost
Recovery Transactions 6,000
The cash collected in 2003 results in the
recognition of an equal amount of gross profit.
42
Revenue Recognition Delayed Until a
Future Event Occurs (Deposit Method)
Oscar Company sells a subsidiary to the
Pet Company and accepts a $500,000
down payment and a 10% note for the
balance of the sale of $7 million. The net
assets of the subsidiary are $5 million
and Pet Company has the right to cancel
the agreement for the next year.
43
Revenue Recognition Delayed Until a
Future Event Occurs (Deposit Method)
Upon receipt of down payment (Oscar Company):
Cash 500,000
Deposit from Purchaser 500,000
When circumstances allow the revenue to be recognized:
Interest Receivable 650,000 liability
Note Receivable 6,500,000
Deposit from Purchaser 500,000
Interest Revenue 10% x $6,500,000 650,000
Gain 2,000,000
Net Assets of Subsidiary 5,000,000
44
Software Revenue Recognition
Guidelines of AICPA Statement of
Position No. 97-2
If a company has an agreement to deliver
software that requires significant production,
modification, or customization of software, it
uses contract accounting for the agreement.
45
Software Revenue Recognition
Guidelines of AICPA Statement of
Position No. 97-2
If a company has an agreement to deliver
software that does not require significant
production, modification, or customization
of software, it recognizes revenue when (a)
persuasive evidence of an agreement exists,
(b) delivery has occurred, (c) the seller’s fee
is fixed or determinable, and (d)
collectibility is probable.
46
Software Revenue Recognition
Guidelines of AICPA Statement of
Position No. 97-2
A company separately accounts for a service
element if (a) the services are not essential
to the functionality of any other element of
the transaction, and (b) the services are
stated separately in the contract such that the
total price of the agreement would be
expected to vary as the result of inclusion or
exclusion of the service.
47
Software Revenue Recognition
Guidelines of AICPA Statement of
Position No. 97-2
Software arrangements may consist of
multiple elements such as additional
software products, upgrades and/or
enhancements, rights to exchange or return
software, and customer support. If contract
accounting does not apply, a company must
allocate its fee to the various elements based
on fair values.
48
Software Revenue Recognition
Guidelines of AICPA Statement of
Position No. 97-2
A company must allocate any discounts
proportionately to all the elements, except
that none can be allocated to upgrade
rights.
49
Franchise
A franchise agreement involves
the granting of business rights
by the franchisor to a franchisee
who will operate the franchised
business.
50
Franchise
Castle Company sells a franchise that
requires an initial franchise fee of
$70,000. A down payment of $20,000
cash is required, with the balance covered
by the issuance of a $50,000, 10% note,
payable by the franchisee in five equal
annual installments.
51
Franchise
Situation 1: Castle has substantially performed all
material services, the refund period has expired, and
the collectibility of the note is reasonably assured.
Cash 20,000
Notes Receivable 50,000
Franchise Revenue 70,000
52
Franchise
Situation 2: The refund period has expired and the
collectibility of the note is reasonably assured, but
Castle has not substantially performed all material
services.
Cash 20,000
Notes Receivable 50,000
Unearned Franchise Fees 70,000
Castle will recognize the unearned franchise fees as
revenue when it has performed all material services.
53
Franchise
Situation 3: Castle has substantially performed all
material services and the collectibility of the note is
reasonably assured, but the refund period has not
expired.
Cash 20,000
Notes Receivable 50,000
Unearned Franchise Fees 70,000
Castle will recognize the unearned franchise fees as
revenue when the refund period expires.
54
Franchise
Situation 4: Castle has substantially performed all
material services and the refund period has expired,
but the collectibility of the note is not reasonably
assured.
Cash 20,000
Notes Receivable 50,000
Unearned Franchise Fees 50,000
Franchise Revenue 20,000
Each year revenue of $10,000 is
recognized as cash is collected.
55
Franchise
Situation 5: The refund period has expired, but Castle
has not substantially performed all material services
and there is no basis for estimating the collectibility
of the note.
Cash 20,000
Unearned Franchise Fees 20,000
Castle recognizes revenue either under the accrual
method (if collectibility is reasonably assured) or the
installment method (if it has no basis for estimating
the collectibility of the note).
56
Franchise
Situation 6: Castle has earned only $30,000 from
providingCastle recognizes the unearned being a
initial services, with the balance
franchise continuing services. The
down payment forfees as revenue when it refund
performs the continuing services.
period has expired and collectibility of the note is
reasonably assured.
Cash 20,000
Notes Receivable 50,000
Franchise Revenue 30,000
Unearned Franchise Fees 40,000
57
Retail Land Sales
The selling company recognizes revenue and the
related expenses in the period of the sale on the accrual
basis if all of the following conditions are met:
The buyer has made the down payment and each
required subsequent payment until the period of
cancellation with refund has expired.
The cumulative payments of principal and
interest equal or exceed 10% of the contract sales
price.
Continued
58
Retail Land Sales
Collection experience for the project indicates
that at least 90% of the contracts will be collected
in full (a down payment of 20% is an acceptable
indication of collectibility).
The receivable from the sale is not subject to
subordination to new loans on the property.
The seller is not obligated to complete
improvements of lots sold or to construct
amenities or other facilities applicable to lots
sold.
59
Consignment Sales
Accounting for consignments may be summarized--
1. Since title remains with the consignor, when the
goods are transferred from the consignor to the
consignee, the consignor does not record the sale
of inventory.
2. The consignor recognizes revenue only when the
sale to the third party occurs.
3. The consignee uses a Consignment-in account.
4. The consignor uses a Consignment-out account,
which is a special inventory account.
60
Chapter 17
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