Illinois Installment Sales Contract by fic16203

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									 FINANCIAL REPORTING & ANALYSIS
                BY
  REVSINE – COLLINS – JOHNSON
            2nd Edition


CHAPTER 3
ADDITIONAL TOPICS
IN INCOME
DETERMINATION
         Slides Authored by
           Brian Leventhal
   University of Illinois at Chicago
                                       1
I. Revenue Recognition
   Prior to Sale
       A. A closer look at the revenue
       recognition criteria.
   1. The ―critical event‖---
    (―Condition 1” Revenue has
    been earned)
    varies from industry
    to industry.



                                         2
I. Revenue Recognition
   Prior to Sale
       A. A closer look at the revenue
       recognition criteria.
   2. Measurability of Revenue
    (―Condition 2‖) must be based on
    objective and verifiable
    evidence.




                                         3
I. Revenue Recognition
   Prior to Sale
          B. A closer look at the revenue recognition
          criteria.
   3. In most instances the point of sale is the earliest
    moment in time that the critical event(Earned) in
    the process of earning the revenue has taken
    place.
   The amount that will be collected
    is reasonably assured and is
    measurable with a reasonable
    degree of reliability.

   This is the dominant practice in
    most retail and manufacturing industries.         4
      Figure 2.2 The Revenue Recognition Process: Industries Recognizing Revenue at Indicated Phases

Revenues may also be recognized at other times besides the
point of sale.
I. Revenue Recognition
   Prior to Sale
      A. A closer look at the revenue
      recognition criteria.
1. Under the percentage-of-completion method
Conditions 1 and 2 are satisfied prior to the point of sale
(i.e., transfer of title).

a. Condition 1 - (critical event: Revenue is EARNED) is
satisfied over time as the project progresses.

b. Condition 2 (Revenue is measurable) is satisfied
since a firm contract with a known buyer at a set price exists.

                                                           6
I. Revenue Recognition
   Prior to Sale
        A. A closer look at the revenue
        recognition criteria.
     Normally, once gross revenues for the period are
    determined, the next step in determining income
    is to accumulate and record the costs associated
    with generating those revenues.

   However, under the
    percentage-of-completion method,
    it is the recognition of expenses
    that drives the recognition
    of revenues.
                                                    7
I. Revenue Recognition
   Prior to Sale
    1. Percentage-of-completion method
     recognizes:
     revenue, cost, and thus gross profit:

     as progress toward
     completion is made
     and is used primarily for
     long-term
     construction
     contracts.                          8
I. Revenue Recognition
   Prior to Sale
         1. Percentage-of-completion method
recognizes: revenue, cost, and thus gross profit as
progress toward completion is made and is used
primarily for long-term construction contracts.

    a. This method
     requires fairly good
     estimates
     of progress.

                                                9
I. Revenue Recognition
   Prior to Sale
             1. Percentage-of-completion method
    recognizes: revenue, cost, and thus gross profit as
    progress toward completion is made and is used
    primarily for long-term construction contracts.

   b. Cost-to-cost ratio:


     % complete = costs incurred to date
                 estimate of total costs

                                                   10
I. Revenue Recognition
   Prior to Sale
          1. Percentage-of-completion method
 recognizes: revenue, cost, and thus gross profit as
 progress toward completion is made and is used
 primarily for long-term construction contracts.

c.   Calculation Gross Profit:

     Gross Profit  % complete
 -   Gross Profit recognized in previous years
      Gross Profit recognized in Current Year
                                                 11
I. Revenue Recognition
   Prior to Sale
             1. Percentage-of-completion method
    recognizes: revenue, cost, and thus gross profit as
    progress toward completion is made and is used
    primarily for long-term construction contracts.
   d. A change in cost estimate is
    accounted for in a cumulative
    catch-up manner,
   i.e., accounted for such that the
    balance sheet is as it would have
    been if the revised estimate had
    been the original estimate.
                                                   12
I. Revenue Recognition
   Prior to Sale
          1. Percentage-of-completion method
 recognizes: revenue, cost, and thus gross profit as
 progress toward completion is made and is used
 primarily for long-term construction contracts.

     e. A current asset
      results when
      total costs and
      recognized profit
      exceed billings.
This will make more sense after going over example.
                                                      13
I. Revenue Recognition
   Prior to Sale
          1. Percentage-of-completion method
 recognizes: revenue, cost, and thus gross profit as
 progress toward completion is made and is used
 primarily for long-term construction contracts.

     f. A current liability
      results when billings
      exceed total costs
      and
      recognized profit.
This will make more sense after going over example.
                                                      14
   Authors’ Note……
 Consulting firms use the
percentage-of-completion
method for fixed price, fixed
period contracts.

The Information Technology
Professional Services sector,
for example, uses this method
to record approximately 30
percent of its revenues.

                                15
I. Revenue Recognition
   Prior to Sale


         Let’s look

           At an

          Example

                         16
I. Revenue Recognition
   Prior to Sale
        Percentage of Completion Example:
    Solid Construction Corp. signs a contract with
     the City of Springfield on JAN 1st 2001 to build
     a highway bridge over Stony Creek.
    The contract price is $1,000,000
    Construction costs are estimated to be
     $800,000
    The project is scheduled to be completed by
     DEC. 31st , 2003.
    Periodic cash payments are to be made by the
     City of Springfield as construction progresses.
                                                   17
I. Revenue Recognition
   Prior to Sale
         Percentage of Completion Example:

        Actual experience on the project as of DEC 31st
                          2001        2002         2003
Costs incurred to date $240,000    $544,000      $850,000
Estimated future costs   560,000    306,000        ------
Billings to date         280,000    650,000     1,000,000
Cash collections to date 210,000    600,000     1,000,000




                                                        18
Percentage of Completion Example:
Step 1: Compute the % Complete ratio for Year 1

 % complete = costs incurred to date
             estimate of total costs

 % complete = costs incurred to date
                     $240,000
                                                   =    30%
             estimate of total costs
                     $800,000
               $240,000 + $560,000

                        Actual experience on the project as of
                            DEC 31st             2001
                        Costs incurred to date     $240,000
                        Estimated future costs      560,000
                        Billings to date            280,000
                        Cash collections to date    210,000
                         Actual experience on the project as of
Percentage of                DEC 31st             2001
Completion               Costs incurred to date $240,000
                         Estimated future costs    560,000
Example:                 Billings to date         280,000
                         Cash collections to date 210,000
                         Contract Price          1,000,000

Step 2: Determine the estimated total profit on
        the contract for ALL YEARS.
Estimated
Total = Contract Price – Estimated Total Costs
profit
Estimated
Total = Contract Price – Estimated Total Costs
          $1,000,000            $800,000
                           $240,000 + $560,000
profit = $200,000
Step 3: Compute the estimated total gross profit
earned for the contract for Year 1.
     Calculation of Gross Profit:
 % complete  estimated Gross Profit
 - Gross Profit recognized in previous years
     Gross Profit for year 1 recognized

     Calculation of Gross Profit:
 % complete  estimated Gross Profit
    30%             $200,000
 - Gross Profit recognized in previous years
                      $0
     Gross Profit $60,0001 recognized
                  for year
Step 3: Or instead :Compute the estimated total
revenue earned for the contract for Year 1.
     Calculation of Revenue:
  % complete  Total Revenue
 - Revenue recognized in previous years
     Revenue for year 1 recognized

     Calculation of Revenue:
  % complete  Total Revenue
     30%         $300,000
                     $1,000,000
 - Revenue recognized in previous years
                    $0
      Revenue for year 1 recognized
               $300,000
Now let’s figure out how this information appears on the
                  Financial Statements!
Percentage of                 Actual experience on the project as
                                  of DEC 31st          2001
Completion                    Costs incurred to date $240,000
                              Estimated future costs    560,000
Example:                      Billings to date         280,000
                              Cash collections to date 210,000
Step 1: Record Customer       Contract Price          1,000,000
Billings for Year 1           Gross Profit Recognized    60,000


Dr.     Accounts Receivable                $280,000
        Cr.   Billings                                 $280,000

            Accounts
           Receivable                Billings

      $280,000                               $280,000
Percentage of                          Actual experience on the project as
                                           of DEC 31st          2001
Completion                 Costs incurred to date $240,000
                           Estimated future costs  560,000
Example:                   Billings to date        280,000
                                                   210,000
Step 1: Record Customer Cash collections to date 1,000,000
What type of account is Billings and why?
                           Contract Price
Billings for Year 1        Gross Profit Recognized  60,000

    Billings is really a deferred revenue account
         Accounts Receivable
Dr. ( Liability) because you don’t know the revenue
                                               $280,000
         Cr.
    recognizedBillings end of the period using an adjusting
                until the                               $280,000
    entry! Accounts
            Receivable                         Billings
  Usually for financial reporting purposes,
     is reclassified
  it$280,000                                          $280,000      ????
  As a Contra-Asset to
  Inventory: Construction in Progress.
  But it’s meaning has not changed!
Percentage of                       Actual experience on the project as
                                        of DEC 31st          2001
Completion                          Costs incurred to date $240,000
                                    Estimated future costs    560,000
Example:                            Billings to date         280,000
                                    Cash collections to date 210,000
Step 2: Record                      Contract Price          1,000,000
Construction costs Year 1           Gross Profit Recognized    60,000


Dr.     Inventory: Construction in Progress      $240,000
        Cr.   Accounts Payable, Cash, Etc,                   $240,000
            Inventory:
          Construction in             Accounts Payable,
             Progress                     Cash, Etc.


      $240,000                                     $240,000
Percentage of                   Actual experience on the project as
                                    of DEC 31st          2001
Completion                      Costs incurred to date $240,000
                                Estimated future costs    560,000
Example:                        Billings to date         280,000
Step 3: Record                  Cash collections to date 210,000
                                Contract Price          1,000,000
gross profit recognized         Gross Profit Recognized    60,000
for Year 1
Dr.   Inventory: Construction in Progress   $60,000
      Cr.   Income on long-term construction K      $60,000
                Inventory:
              Construction in          Income on long-
                 Progress            term construction K

Costs Yr 1 $240,000                                 $60,000
            $60,000
Percentage of
       Why is this Gross Profit also being recorded to
            Inventory:Construction in Progress?
Completion
This entry makes sense because we defer all billings as
Example:
Unearned Revenue but it is reclassified as a Contra-Asset to
Step 3: Record
Inventory:Construction in Progress.
gross profit recognized are reducing your deferred
So what’s really happening is you
for Year when you realize Revenue!
revenue 1
Dr.     Inventory: Construction in Progress  $60,000
This is Cr. instead of reducing Billings directly, but it $60,000
        done Income on long-term construction K           has the
same effect!
                                     Income on long-term
Inventory:Construction in Progress      construction K
   $240,000                                    $60,000
     $60,000    ????
Percentage of                 Actual experience on the project as
                                    of DEC 31    st      2001
                                       look after this $240,000
Notice how the Income Statement willincurred to date entry:
Completion                    Costs
                              Estimated future costs    560,000
Example:
Income on long-term construction K to date
                              Billings      $60,000 280,000
Step 3: Record                    Cash collections to date 210,000
                                  Contract Price
This is the Net Method of recording REVENUES!             1,000,000
gross profit recognized           Gross Profit Recognized    60,000
for Year 1
Dr.     Inventory: Construction in Progress   $60,000
        Cr.   Income on long-term construction K      $60,000
            Inventory:
          Construction in              Income on long-
             Progress                term construction K

      $240,000                                        $60,000
       $60,000
Percentage of                       Actual experience on the project as
                                        of DEC 31st          2001
Completion                          Costs incurred to date     $240,000
                                    Estimated future costs      560,000
Example:                            Billings to date            280,000
Step 3: Or Record                   Cash collections to date    210,000
                                    Gross Profit                  60,000
Revenue recognized                  Revenue Recognized           300,000
for Year 1
Dr.      Inventory: Construction in Progress   $ 60,000
Dr.      Construction Expense                  $240,000
         Cr.   Income on long-term construction K     $300,000
        Inventory:       Revenue on long-           Construction
      Construction in   term construction K           Expense
         Progress
$240,000                          $300,000 $240,000
 $60,000
Percentage of                 Actual look after this entry:
Notice how the Income Statement will experience on the project as
                                       of DEC 31st        2001
Completion
      Revenues
                                 Costs incurred to date $240,000
                           $300,000
                                 Estimated future costs  560,000
Example:
Less: Construction Expenses 240,000 to date
                                 Billings                280,000
      Gross Record
Step 3: OrProfit            $60,000 collections to date 210,000
                                 Cash
                                 Gross Profit              60,000
Revenue recognized               Revenue Recognized       300,000
This is the Gross Method of recording REVENUES!
for Year 1
Dr.      Inventory: Construction in Progress   $ 60,000
Dr.      Construction Expense                  $240,000
         Cr.   Income on long-term construction K     $300,000
        Inventory:       Revenue on long-            Construction
      Construction in   term construction K            Expense
         Progress
$240,000                          $300,000 $240,000
 $60,000
Percentage of                       Gross Method
Completion                        Revenue on long-
Example:                         term construction K

    Net Method                             $300,000

   Income on long-
 term construction K

             $60,000
                                    Construction
                                      Expense

                                $240,000

   Either way you do it , it still means
   the same thing!
Percentage of                      Actual experience on the project as
                                       of DEC 31st          2001
Completion                         Costs incurred to date $240,000
                                   Estimated future costs    560,000
Example:                           Billings to date         280,000
Step 4: Record                     Cash collections to date 210,000
                                   Contract Price          1,000,000
Cash Received for Year 1           Revenue Recognized        300,000


Dr.     Cash                           $ 210,000
        Cr.  Accounts Receivable                    $210,000

                                           Accounts
            Cash                          Receivable

      $210,000         Billings Yr 1 $280,000      $210,000

                           End Yr 1 $70,000
Percentage of
              Let’s see how the Balance Sheet would
Completion    look for 2001 Year 1
Example:
           Current Assets
      Accounts
     Receivable
  $70,000

    Inventory:
  Construction in                         Net Asset
     Progress
                  Less     Billings   = Carrying Value
$240,000 Costs Yr 1
 $60,000   GP Yr1
$300,000                 Yr 1   $280,000 = $20,000
Percentage of
              Let’s see how the Balance Sheet would
Completion    look for 2001 Year 1
Example:
           Current Assets
      Accounts           Since theoretically more work
     Receivable          has been performed than Billed,
  $70,000                you have a Asset.


    Inventory:
  Construction in                          Net Asset
     Progress
                  Less      Billings =   Carrying Value

$300,000                        $280,000      $20,000
Percentage of
              Let’s see how the Balance Sheet would
Completion    look for 2001 Year 1
Example:
           Current Assets
       Accounts
      Ending             Since theoretically more work
      Receivable
    Unearned             has been performed than Billed,
     Revenues
  $70,000                you have an Asset.
               Here’s another way to see the $20,000
    Inventory:
  Construction in                        Net Asset
     Progress
                  Less      Billings = Carrying Value
                                          Beg. Unearned
    Costs   Realized
            Revenues   $60,000 $280,000      Revenues


$240,000                        $220,000 = $20,000
Percentage of Completion Example:
Step 1: Compute the % Complete ratio for Year 2

 % complete = costs incurred to date
             estimate of total costs

  % complete = costs incurred to date
                      $544,000
                                                           =    64 %
Notice Total  estimate of total costs
                      $850,000
                $544,000 + $306,000
Estimated Costs
has changed from       Actual experience on the project as of DEC 31st
Yr 1 ($800,000)                                  2001         2002
                       Costs incurred to date $240,000     $544,000
So the new %           Estimated future costs   560,000     306,000
reflects the updated   Billings to date         280,000     650,000
information.           Cash collections to date 210,000     600,000
                     Actual experience on the project as of DEC 31st
Percentage of                                   2001         2002
Completion           Costs incurred to date $240,000      $544,000
                     Estimated future costs    560,000     306,000
Example:             Billings to date           280,000    650,000
                     Cash collections to date 210,000      600,000
                     Contract Price          $1,000,000

Step 2: Determine the estimated total profit on
        the contract for ALL YEARS.
Estimated
Total = Contract Price – Estimated Total Costs
profit
Estimated
Total = Contract Price – Estimated Total Costs
          $1,000,000                $850,000
                           $544,000 + $306,000
profit = $150,000 Noticed Profit has changed from 1st Year
                               of $200,000!
                     Actual experience on the project as of DEC 31st
Percentage of                         2001                  2002
Completion Since the profit has
              Costs incurred to date $240,000            $544,000
         changed the new costs 560,000
              Estimated future estimate                   306,000
Example:      Billings to date        280,000             650,000
                    be collections update
               will Cash used toto date 210,000           600,000
          the information in the records.
                    Contract Price     $1,000,000

Step 2: Determine the estimated total profit on
        the contract for ALL YEARS.
Estimated
Total = Contract Price – Estimated Total Costs
profit
Estimated
Total = Contract Price – Estimated Total Costs
          $1,000,000                $850,000
                           $544,000 + $306,000
profit = $150,000 Noticed Profit has changed from 1st Year
                               $200,000!
Step 3: Compute the estimated total gross profit
earned for the contract for Year 2.
     Calculation of Gross Profit:                 New
                                                estimate
 % complete Gross Profit                         used
 - Gross Profit recognized in previous years
     Gross Profit for year 2 recognizedTotal using
                                         new estimate

     Calculation of Gross Profit:
 % complete  estimated Gross Profit =
    64%             $150,000                     $96,000
                         Old estimate
 - Gross Profit recognized in previous years     ($60,000)
     Gross Profit for year 2 recognized          $36,000
                      Updated estimate
Step 3: Or instead :Compute the estimated total
revenue earned for the contract for Year 2.
     Calculation of Revenue:
  % complete  Total Revenue
 - Revenue recognized in previous years
     Revenue for year 2 recognized

     Calculation of Revenue:
  % complete  Total Revenue
     64%          $1,000,000       =         $640,000
 - Revenue recognized in previous years      ($300,000)
      Revenue for year 2 recognized         $340,000

Now let’s figure out how this information appears on the
                  Financial Statements!
Percentage of           Actual experience on the project as of DEC 31st
                                                   2001         2002
Completion              Costs incurred to date $240,000      $544,000
                        Estimated future costs    560,000     306,000
Example:                Billings to date           280,000    650,000
                        Cash collections to date 210,000      600,000
                        Contract Price          $1,000,000

Step 1: Record Customer Billings for Year 2
Dr.     Accounts Receivable               $370,000
        Cr.   Billings                                  $370,000
                Accounts
               Receivable                    Billings

      Yr 1 $280,000   $210,000 Yr1                  $280,000 Yr 1
 End Yr 1 $70,000                                   $370,000 Yr 2

      Yr 2 $370,000                                 $650,000 End Yr 2
Percentage of           Actual experience on the project as of DEC 31st
                                                   2001         2002
Completion              Costs incurred to date $240,000      $544,000
                        Estimated future costs    560,000     306,000
Example:                Billings to date           280,000    650,000
                        Cash collections to date 210,000      600,000
                        Contract Price          $1,000,000

Step 2: Record Construction costs Year 2
Dr.   Inventory: Construction in Progress         $304,000
      Cr.   Accounts Payable, Cash, Etc,                      $304,000
             Inventory:                Accounts Payable,
       Construction in Progress            Cash, Etc.

Costs Yr 1 $240,000
                                                    $304,000
 GP Yr 1    $60,000
End Yr 1 $300,000
 Costs Yr2 $304,000
Percentage of           Actual experience on the project as of DEC 31st
                                                  2001         2002
Completion              Costs incurred to date $240,000     $544,000
                        Estimated future costs   560,000     306,000
Example:                Billings to date         280,000     650,000
                        Cash collections to date 210,000     600,000
                        Gross Profit             $60,000     $36,000

Step 3: Record gross profit recognized for Year 2
Dr.   Inventory: Construction in Progress   $36,000
      Cr.   Income on long-term construction K      $36,000
             Inventory:
       Construction in Progress        Income on long-
Costs Yr 1 $240,000                  term construction K
GP    Yr 1 $60,000
                                                    $36,000
End Yr 1 $300,000
Costs Yr 2 $304,000
GP Yr 2     $36,000
End Yr 2 $640,000
Percentage of            Actual experience on the project as of DEC 31st
                                              2001      2002
                      Statement will look after this entry:
Notice how the IncomeCosts incurred to date $240,000 $544,000
Completion
                     Estimated future costs  560,000  306,000
Example:             construction
Income on long-term Billings to date K       $36,000 650,000
                                             280,000
                       Cash collections to date 210,000       600,000
This is the Net Method Gross Profit
                        of recording REVENUES!  $60,000       $36,000

Step 3: Record gross profit recognized for Year 2
Dr.    Inventory: Construction in Progress   $36,000
       Cr.   Income on long-term construction K      $36,000
             Inventory:
       Construction in Progress         Income on long-
Costs Yr 1 $240,000                   term construction K
Gr Prt Yr 1 $60,000
                                                     $36,000
End Yr 1 $300,000
Costs Yr 2 $304,000
Gr Prt Yr 2 $36,000
End Yr 2 $640,000
Percentage of                Actual experience on the project as of DEC 31st
                                                      2001          2002
Completion                   Costs incurred to date $240,000     $544,000
                             Estimated future costs  560,000      306,000
Example:                     Billings to date         280,000      650,000
                             Gross Profit              60,000       36,000
                             Revenue                $300,000      $340,000

Step 3: Or Record Revenue recognized for Year 2
Dr.       Inventory: Construction in Progress   $ 36,000
Dr.       Construction Expense                  $304,000
          Cr.   Income on long-term construction K     $340,000
        Inventory:           Revenue on long-            Construction
      Construction in       term construction K            Expense
         Progress
                                        $340,000 $304,000
$300,000       End Yr 1
$304,000      Costs Yr 2
$36,000       Gr Prt Yr 2

$640,000        End Yr 2
Percentage of Statement Year 2 project as of DEC 31
Notice how the IncomeActual experience on the will look after thisst
                                              2001          2002
entry:
Completion             Costs incurred to date $240,000    $544,000
                       Estimated future costs  560,000     306,000
Example:
   Revenues                   $340,000
                       Billings to date         280,000     650,000
                       Gross 304,000
Less: Construction Expenses Profit               60,000      36,000
      Gross Profit     Revenue 36,000
                               $              $300,000     $340,000

Step 3: Or Record Revenue recognized for Year 2
This is the Gross Method of recording REVENUES!
Dr.     Inventory: Construction in Progress   $ 36,000
Dr.     Construction Expense                  $304,000
        Cr.   Income on long-term construction K     $340,000
     Inventory:            Revenue on long-        Construction
   Construction in        term construction K        Expense
      Progress
                                    $340,000 $304,000
$300,000    End Yr 1
$304,000   Costs Yr 2
$36,000     Gr Prt Yr 2

$640,000      End Yr 2
Percentage of                       Gross Method
Completion                        Revenue on long-
Example:                         term construction K

    Net Method                             $340,000

   Income on long-
 term construction K

             $36,000
                                    Construction
                                      Expense

                                $304,000

   Either way you do it , it still means
   the same thing!
Percentage of          Actual experience on the project as of DEC 31st
                                                 2001         2002
Completion             Costs incurred to date $240,000     $544,000
                       Estimated future costs   560,000     306,000
Example:               Billings to date         280,000     650,000
                       Cash collections to date 210,000     600,000
                       Gross Profit             $60,000     $36,000

Step 4: Record Cash Received for Year 2
Dr.     Cash                            $ 390,000
        Cr.  Accounts Receivable                      $390,000

                                             Accounts
            Cash                            Receivable

      $390,000              End Yr 1 $70,000
                        Billings Yr 2 $370,000
                                                    $390,000
                           End Yr 2 $50,000
Percentage of
              Let’s see how the Balance Sheet would
Completion    look for 2002 Year 2
Example:
           Current Assets
        Accounts
       Receivable
   $50,000
                                                         Net
                       Current Liabilities             Liability
              Inventory:
        Construction in Progress Less Billings       = Carrying
Costs Yr 1 $240,000                  Yr 1   $280,000    Value
Gr Prt Yr 1 $60,000                   Yr 2  $370,000
End Yr 1 $300,000
Costs Yr 2 $304,000
Gr Prt Yr 2 $36,000
End Yr 2 $640,000        -     End Yr 2 $650,000= $10,000
Percentage of
              Let’s see how the Balance Sheet would
Completion    look for 2002 Year 2
Example:
           Current Assets
                             Since theoretically less work
        Accounts
                             has been performed than Billed,
       Receivable
                             you have a Liability.
   $50,000
                                                         Net
                       Current Liabilities             Liability
              Inventory:
        Construction in Progress Less Billings       = Carrying
Costs Yr 1 $240,000                  Yr 1   $280,000    Value
Gr Prt Yr 1 $60,000                   Yr 2  $370,000
End Yr 1 $300,000
Costs Yr 2 $304,000
Gr Prt Yr 2 $36,000
End Yr 2 $640,000        -     End Yr 2 $650,000= $10,000
Percentage of
              Let’s see how the Balance Sheet would
Completion    look for 2001 Year 2
Example:
              Here’s
           Currentanother way to see the $10,000
                      Assets
                         Since theoretically less work
      Accounts
     Ending              has been performed than Billed,
     Receivable
    Unearned             you have a Liability.
     Revenues
  $70,000
                  Current Liabilities
            Costs
    Inventory:
  Construction in                          Net Liability
     Progress
                  Less      Billings = Carrying Value
                                 $220,000    Beg. Unearned
$240,000    Realized
                                                Revenues
$304,000    Revenues   $36,000
                                  $370,000
$544,000                        $554,000= $10,000
Percentage of Completion Example:
Step 1: Compute the % Complete ratio for Year 3

 % complete = costs incurred to date
             estimate of total costs

 % complete = costs incurred to date=
                     $850,000                             100 %
             estimate of total costs
                     $850,000
               $544,000 + $306,000

                  Actual experience on the project as of DEC 31st
                                2001          2002            2003
        Costs incurred to date $240,000    $544,000        $850,000
        Estimated future costs   560,000    306,000          ------
        Billings to date         280,000    650,000       1,000,000
        Cash collections to date 210,000    600,000       1,000,000
                       Actual experience on the project as of DEC 31st
Percentage
                                     2001          2002            2003
of
             Costs incurred to date $240,000    $544,000        $850,000
Completion
             Estimated future costs   560,000    306,000          ------
Example:
             Billings to date         280,000    650,000       1,000,000
             Cash collections to date 210,000    600,000       1,000,000

Step 2: Determine the estimated total profit on
        the contract for ALL YEARS.
Estimated
Total = Contract Price – Estimated Total Costs
profit
Estimated
Total = Contract Price – Estimated Total Costs
          $1,000,000                  $850,000
                            $544,000 + $306,000
profit = $150,000 Noticed Profit has not changed from 2nd Year
Step 3: Compute the estimated total gross profit
earned for the contract for Year 3.
     Calculation of Gross Profit:
 % complete Gross Profit
 - Gross Profit recognized in previous years
     Gross Profit for year 3 recognized

     Calculation of Gross Profit:
 % complete  estimated Gross Profit =
   100%             $150,000                   $150,000
 - Gross Profit recognized in previous years
       $60,000 + $36,000                =      ($96,000)
     Gross Profit for year 3 recognized        $54,000
Step 3: Or instead :Compute the estimated total
revenue earned for the contract for Year 3.
     Calculation of Revenue:
  % complete  Total Revenue
 - Revenue recognized in previous years
     Revenue for year 3 recognized

     Calculation of Revenue:
  % complete  Total Revenue
    100%          $1,000,000       =        $1,000,000
 - Revenue recognized in previous =
        $300,000 + $340,000       years     ($640,000)
      Revenue for year 3 recognized         $360,000

Now let’s figure out how this information appears on the
                  Financial Statements!
                       Actual experience on the project as of DEC 31st
Percentage                           2001          2002            2003
of           Costs incurred to date $240,000    $544,000        $850,000
Completion   Estimated future costs   560,000    306,000          ------
Example:     Billings to date         280,000    650,000       1,000,000
             Cash collections to date 210,000    600,000       1,000,000


Step 1: Record Customer Billings for Year 3
Dr.   Accounts Receivable                 $350,000
      Cr.   Billings                                   $350,000
              Accounts                     Billings
             Receivable
End Yr 2 $50,000                                   $280,000 Yr 1
                                                   $370,000 Yr 2
    Yr 3 $350,000
                                                  $650,000 End Yr 2
                                                  $350,000
                                                 $1,000,000 End Yr 3
                       Actual experience on the project as of DEC 31st
Percentage                           2001          2002            2003
of           Costs incurred to date $240,000    $544,000        $850,000
Completion   Estimated future costs   560,000    306,000          ------
Example:     Billings to date         280,000    650,000       1,000,000
             Cash collections to date 210,000    600,000       1,000,000

Step 2: Record Construction costs Year 3
Dr.   Inventory: Construction in Progress          $306,000
      Cr.   Accounts Payable, Cash, Etc,                      $306,000
             Inventory:
       Construction in Progress         Accounts Payable,
                                            Cash, Etc.
 Costs Yr 1 $240,000
GP Yr 1      $60,000
                                                    $306,000
End Yr 1 $300,000
 Costs Yr 2 $304,000
 GP Yr 2     $36,000
End Yr 2 $640,000
 Costs Yr 3 $306,000
                         Actual experience on the project as of DEC 31st
Percentage                             2001          2002            2003
of             Costs incurred to date $240,000    $544,000        $850,000
Completion     Estimated future costs   560,000    306,000           ------
Example:       Billings to date         280,000    650,000       1,000,000
               Gross Profit Recognized   60,000    36,000           54,000
Step 3: Record gross profit recognized for Year 3
Dr.   Inventory: Construction in Progress $54,000
      Cr.      Income on long-term construction K               $54,000
                  Inventory:
            Construction in Progress
 Costs Yr 1 $240,000
GP Yr 1      $60,000                       Income on long-
End Yr 1 $300,000                        term construction K
 Costs Yr 2 $304,000
 GP Yr 2     $36,000                                   $54,000
End Yr 2 $640,000
 Costs Yr 3 $306,000
 GP Yr 3     $54,000
End Yr 2 $1,000,000
                      Actual experience on the project as of DEC 31st
Percentage                          2001          2002           2003
Notice how the Income Statement will look after this entry:
of          Costs incurred to date $240,000    $544,000       $850,000
Completion Estimated future costs    560,000    306,000          ------
Example: on long-term construction K
Income      Billings to date         280,000     $54,000 1,000,000
                                                650,000
            Gross Profit Recognized   60,000    36,000          54,000
Step 3: Record gross of recording REVENUES!
This is the Net Methodprofit recognized for Year 3
Dr.    Inventory: Construction in Progress          $54,000
       Cr.     Income on long-term construction K             $54,000
                 Inventory:
           Construction in Progress
 Costs Yr 1 $240,000
GP Yr 1      $60,000                      Income on long-
End Yr 1 $300,000                       term construction K
 Costs Yr 2 $304,000
 GP Yr 2     $36,000                                 $54,000
End Yr 2 $640,000
 Costs Yr 3 $306,000
 GP Yr 3     $54,000
End Yr 3 $1,000,000
                     Actual experience on the project as of DEC 31st
Percentage                           2001        2002           2003
of           Costs incurred to date $240,000  $544,000       $850,000
Completion   Estimated future costs   560,000  306,000          ------
Example:     Revenue                  300,000  340,000        360,000
             Gross Profit Recognized   60,000  36,000          54,000
Step 3: Or Record Revenue recognized for Year 3
Dr.   Inventory: Construction in Progress            $ 54,000
Dr.   Construction Expense                           $306,000
      Cr.      Income on long-term construction K               $360,000
         Inventory:Construction in Progress

 Costs Yr 1 $240,000
GP Yr 1      $60,000                Revenue on long-        Construction
End Yr 1 $300,000                  term construction K        Expense
 Costs Yr 2 $304,000
 GP Yr 2     $36,000                          $360,000 $306,000
End Yr 2 $640,000
 Costs Yr 3 $306,000
 GP Yr 3     $54,000
End Yr 3 $1,000,000
                  Actual experience Year project as after 31
Notice how the Income Statement on the 3 will lookof DECthisst
Percentage                      2001        2002          2003
entry:
of          Costs incurred to date $240,000           $544,000       $850,000
Completion Estimated future costs   560,000            306,000          ------
      Revenues
Example:    Revenue             $360,000
                                    300,000            340,000        360,000
Less: Construction Expenses 306,000
            Gross Profit Recognized   60,000           36,000          54,000
      Gross Profit       $ 54,000
Step 3: Or Record Revenue recognized for Year 3
Dr.       Inventory: Construction in Progress         $ 54,000
This
Dr.       the Gross Method of recording REVENUES!
       is Construction Expense                        $306,000
          Cr.      Income on long-term construction K          $360,000
            Inventory:Construction in Progress

 Costs Yr 1 $240,000
GP Yr 1      $60,000                   Revenue on long-          Construction
End Yr 1 $300,000                     term construction K          Expense
 Costs Yr 2 $304,000
 GP Yr 2     $36,000                             $360,000 $306,000
End Yr 2 $640,000
 Costs Yr 3 $306,000
 GP Yr 3     $54,000
End Yr 3 $1,000,000
Percentage of                       Gross Method
Completion                        Revenue on long-
Example:                         term construction K

    Net Method                             $360,000

   Income on long-
 term construction K

             $54,000
                                    Construction
                                      Expense

                                $306,000

   Either way you do it , it still means
   the same thing!
                           Actual experience on the project as of DEC 31st
Percentage                               2001          2002            2003
of               Costs incurred to date $240,000    $544,000        $850,000
Completion       Estimated future costs   560,000    306,000          ------
Example:         Billings to date         280,000    650,000       1,000,000
                 Cash collections to date 210,000    600,000       1,000,000


Step 4: Record Cash Received for Year 3
Dr.     Cash                                  $ 400,000
        Cr.  Accounts Receivable                           $400,000

                                                  Accounts
            Cash                                 Receivable

      $400,000                    End Yr 2 $50,000
                                 Billings   $350,000      $400,000

                                 End Yr 3       $0
Percentage of Completion Example:
Step 5: Record Completion of Project
Dr.   Billings                      $ 1,000,000
      Cr.     Inventory: Construction in Progress $1,000,000
             Inventory:                 Billings
       Construction in Progress
 Costs Yr 1 $240,000
                       Notice how the          $280,000 End Yr 1
GP Yr 1      $60,000
End Yr 1 $300,000      Inventory &              $370,000 Yr 2
 Costs Yr 2 $304,000   Billings Account        $650,000 End Yr 2
 GP Yr 2     $36,000   equal the Contract      $350,000 Yr 3
End Yr 2 $640,000      Price.
 Costs Yr 3 $306,000             $ 1,000,000   $1,000,000 End Yr3
 GP Yr 3     $54,000
                       $ 1,000,000                   $0
End Yr 3 $1,000,000
           $0
I. Revenue Recognition
   Prior to Sale
         2. Completed Contract Method is
    used when interim estimates of progress
    cannot be made.
   a. Therefore, NO interim
    revenue, costs, or gross profit
    are recorded.

   b. These items are accumulated
    on the balance sheet, but
    not reflected on the income
    statement until the project is
    completed.
                                              65
I. Revenue Recognition
   Prior to Sale

       Let’s look at an
          Example
               of
         Completed
          Contract
           Method
                          66
I. Revenue Recognition
   Prior to Sale
       Completed Contract Method Example:
    Solid Construction Corp. signs a contract with
     the City of Springfield on JAN 1st 2001 to build
     a highway bridge over Stony Creek.
    The contract price is $1,000,000
    Construction costs are estimated to be
     $800,000
    The project is scheduled to be completed by
     DEC. 31st , 2003.
    Periodic cash payments are to be made by the
     City of Springfield as construction progresses.
                                                   67
I. Revenue Recognition
   Prior to Sale
       Completed Contract Method Example:

        Actual experience on the project as of DEC 31st
                          2001        2002         2003
Costs incurred to date $240,000    $544,000      $850,000
Estimated future costs   560,000    306,000        ------
Billings to date         280,000    650,000     1,000,000
Cash collections to date 210,000    600,000     1,000,000




                                                        68
Completed Contract              Actual experience on the project as
                                    of DEC 31st          2001
Method Example:                 Costs incurred to date $240,000
                                Estimated future costs    560,000
                                Billings to date         280,000
                                Cash collections to date 210,000
Step 1: Record Customer         Contract Price          1,000,000
Billings for Year 1

Dr.     Accounts Receivable                  $280,000
        Cr.   Billings                                   $280,000

            Accounts
           Receivable                  Billings

      $280,000      Same as Percentage         $280,000
                   of Completion Method
Completed Contract                  Actual experience on the project as
                                        of DEC 31st          2001
Method Example:                     Costs incurred to date $240,000
                                    Estimated future costs    560,000
                                    Billings to date         280,000
                                    Cash collections to date 210,000
Step 2: Record                      Contract Price          1,000,000
Construction costs Year 1

Dr.     Inventory: Construction in Progress      $240,000
        Cr.   Accounts Payable, Cash, Etc,                   $240,000
            Inventory:
          Construction in             Accounts Payable,
             Progress                     Cash, Etc.


      $240,000       Same as Percentage            $240,000
                    of Completion Method
Completed Contract                 Actual experience on the project as
                                       of DEC 31st          2001
Method Example:                    Costs incurred to date $240,000
                                   Estimated future costs    560,000
                                   Billings to date         280,000
Step 3: Record                     Cash collections to date 210,000
                                   Contract Price          1,000,000
Cash Received for Year 1

Dr.     Cash                           $ 210,000
        Cr.  Accounts Receivable                    $210,000
                    Same as Percentage
                   of Completion Method    Accounts
            Cash                          Receivable

      $210,000         Billings Yr 1 $280,000      $210,000

                            End Yr 1 $70,000
Completed
            Let’s see how the Balance Sheet would
Contract    look for 2001 Year 1
Method
Example:  Current Assets
      Accounts
     Receivable
  $70,000
              Current Liability
    Inventory:
  Construction in                        Net Liability
     Progress
                  Less     Billings   = Carrying Value
$240,000 Costs Yr 1

$240,000                 Yr 1   $280,000 = $40,000
Completed               Actual experience on the project as of DEC 31st
                                                   2001         2002
Contract                Costs incurred to date $240,000      $544,000
                        Estimated future costs    560,000     306,000
Method                  Billings to date           280,000    650,000
Example:                Cash collections to date 210,000
                        Contract Price          $1,000,000
                                                              600,000


Step 1: Record Customer Billings for Year 2
Dr.     Accounts Receivable               $370,000
        Cr.   Billings                                  $370,000
                Accounts
               Receivable                    Billings

      Yr 1 $280,000   $210,000 Yr1                  $280,000 Yr 1
 End Yr 1 $70,000                                   $370,000 Yr 2
                       Same as Percentage
      Yr 2 $370,000   of Completion Method          $650,000 End Yr 2
Completed                Actual experience on the project as of DEC 31st
                                                    2001          2002
Contract                 Costs incurred to date $240,000       $544,000
                         Estimated future costs    560,000      306,000
Method                   Billings to date           280,000     650,000
Example:                 Cash collections to date 210,000
                         Contract Price          $1,000,000
                                                                600,000


Step 2: Record Construction costs Year 2
Dr.     Inventory: Construction in Progress        $304,000
        Cr.   Accounts Payable, Cash, Etc,                      $304,000

                  Inventory:                   Accounts Payable,
            Construction in Progress               Cash, Etc.

      Costs Yr 1 $240,000
                               Same as Percentage             $304,000
      Costs Yr2 $304,000      of Completion Method

Costs End Yr2 $304,000
Completed              Actual experience on the project as of DEC 31st
                                                 2001         2002
Contract               Costs incurred to date $240,000     $544,000
                       Estimated future costs   560,000     306,000
Method                 Billings to date         280,000     650,000
Example:               Cash collections to date 210,000     600,000


Step 3: Record Cash Received for Year 2
Dr.     Cash                            $ 390,000
        Cr.  Accounts Receivable                      $390,000
                    Same as Percentage
                   of Completion Method      Accounts
            Cash                            Receivable

      $390,000              End Yr 1 $70,000
                        Billings Yr 2 $370,000
                                                    $390,000
                           End Yr 2 $50,000
Completed
            Let’s see how the Balance Sheet would
Contract    look for 2002 Year 2
Method
Example:  Current Assets
        Accounts
       Receivable
   $50,000
                                                        Net
                      Current Liabilities             Liability
              Inventory:
       Construction in Progress Less Billings       = Carrying
Costs Yr 1 $240,000                 Yr 1   $280,000    Value
Costs Yr 2 $304,000                  Yr 2  $370,000
End Yr 2 $544,000              End Yr 2 $650,000 =$106,000
Completed          Actual experience on the project as of DEC 31st
Contract                         2001          2002            2003
          Costs incurred to date $240,000   $544,000        $850,000
Method    Estimated future costs  560,000    306,000          ------
Example: Billings to date         280,000    650,000       1,000,000
             Cash collections to date 210,000   600,000    1,000,000


Step 1: Record Customer Billings for Year 3
Dr.    Accounts Receivable                 $350,000
       Cr.   Billings                                 $350,000
               Accounts                    Billings
              Receivable
End Yr 2 $50,000                                  $280,000 Yr 1
                       Same as Percentage         $370,000 Yr 2
    Yr 3 $350,000
                      of Completion Method       $650,000 End Yr 2
                                                 $350,000
                                                $1,000,000 End Yr 3
Completed          Actual experience on the project as of DEC 31st
Contract                         2001          2002            2003
          Costs incurred to date $240,000   $544,000        $850,000
Method    Estimated future costs  560,000    306,000          ------
Example: Billings to date         280,000    650,000       1,000,000
              Cash collections to date 210,000     600,000      1,000,000

Step 2: Record Construction costs Year 3
Dr.     Inventory: Construction in Progress          $306,000
        Cr.   Accounts Payable, Cash, Etc,                      $306,000
                  Inventory:
            Construction in Progress             Accounts Payable,
                                                     Cash, Etc.
      Costs Yr 1 $240,000
      Costs Yr 2 $304,000       Same as Percentage
                               of Completion Method          $306,000
      Costs Yr 3 $306,000

Costs End Yr 3 $850,000
Completed          Actual experience on the project as of DEC 31st
Contract                         2001          2002            2003
          Costs incurred to date $240,000   $544,000        $850,000
Method    Estimated future costs  560,000    306,000          ------
Example: Billings to date         280,000    650,000       1,000,000
                 Cash collections to date 210,000        600,000   1,000,000


Step 3: Record Cash Received for Year 3
Dr.     Cash                                   $ 400,000
        Cr.  Accounts Receivable                              $400,000

                        Same as Percentage
                       of Completion Method          Accounts
            Cash                                    Receivable

      $400,000                    End Yr 2 $50,000
                                 Billings    $350,000        $400,000

                                 End Yr 3           $0
Completed          Actual experience on the project as of DEC 31st
Contract                         2001          2002            2003
          Costs incurred to date $240,000   $544,000        $850,000
Method    Estimated future costs  560,000    306,000          ------
Example: Billings to date         280,000    650,000       1,000,000
             Cash collections to date 210,000   600,000    1,000,000


Step 4: Determine the Actual total profit on
the contract for ALL YEARS.
Actual
Total = Contract Price –Actual Total Costs
profit
Actual
Total = Contract Price – Actual Total Costs
          $1,000,000            $850,000
profit = $150,000
Notice how Contract Example:
Completedthe Income Statement Year 3 will look after this
entry: 3: Record Completion of Project
Step
Dr.   Billings
      Revenues                 1,000,000
                           $$1,000,000
      Cr.     Inventory: Construction in Progress $850,000
Less: Construction Expenses 850,000
      Cr.     Income on long-term construction $150,000
      Gross Profit           $ 150,000
                Inventory:                Billings
       Construction in Progress
Costs Yr 1 $240,000                                 $280,000 End Yr 1
Costs Yr 2 $304,000
Costs Yr 3 $306,000                                  $370,000 Yr 2
                                                    $650,000 End Yr 2
End Yr 3   $850,000 $ 850,000                       $350,000 Yr 3
            $0                      $ 1,000,000 $1,000,000 End Yr3
                 Income on long-term construction
                                                          $0
                                $150,000
 Yearly Income Comparison on 2
 Long-Term Contract Actg Methods

             Completed      % of
                 K        Completion
  Year        Method        Method
  2001          - 0-        $60,000
  2002           - 0-       $36,000
  2003        $150,000      $54,000
Total Income  $150,000     $150,000

                                       82
I. Revenue Recognition
   Prior to Sale

    3. Long-term contract losses:

    a. Cost increases require current period
     adjustment of excess gross profit recognized
     in earlier periods.
     (We saw this in the % completion example)
    b. With unprofitable contracts, the entire
     expected loss must be recognized in the
     current period (as well as the recovery of
     previously recognized revenue and gross
     profit).
                      Follows Conservatism Principle   83
I. Revenue Recognition
   Prior to Sale

    4. Revenue recognition on commodities:

    a. The completed-transaction method
     recognizes income when the commodities are
     sold.

    b. The market price method
     recognizes income when the
     agricultural commodities are
     harvested or when the natural
     resources are extracted.
                                              84
I. Revenue Recognition
   Prior to Sale
      4. Revenue recognition on commodities:
              Market Price Method
 i.
    This alternative assumes that well-organized
 markets exist for the commodities.

 ii. Changes in the market value
 of the commodities while they are
 held in storage are reflected on both
 the balance sheet and income statement.


                                               85
I. Revenue Recognition
   Prior to Sale
          4. Revenue recognition on commodities:
Market Price Method & Completed Transaction
   c. Comparisons of these two methods:

   i. The completed transaction method merges
    the results of speculative and operating activity and
    does not reflect the separate results of either.

   ii. The market price method has the advantage of
    explicitly recognizing the separate results arising
    from operating and speculative activities.
                                                        86
I. Revenue Recognition
   Prior to Sale
    B. Revenue recognition Subsequent to
        Sale—
               Conditions 1 (earned) and
                         2 (measurable)
                   are both satisfied
                   after to the time of
                   the sale.

                                      87
I. Revenue Recognition
   Prior to Sale
       B. Revenue recognition Subsequent
          to Sale—
   1. This treatment is acceptable only under highly
                             unusual circumstances.


                         For example, when a
                             lengthy collection period
                             considerably increases
                             the risk of
                                   nonpayment.
                                                   88
I. Revenue Recognition
   Prior to Sale
        B. Revenue recognition Subsequent
            to Sale—
   2. Installment Sales Method
    recognizes Revenue and Income
    proportionately as Cash is collected based
    on the :

   Installment sales gross profit %
    and
   The amount of Cash collected.

                                                 89
I. Revenue Recognition
   Prior to Sale
          B. Revenue recognition Subsequent
             to Sale—
    2. Installment Sales Method recognizes
    Revenue and Income proportionately as Cash is
    collected.
     a. Installment accounts receivable are shown typically shown
     on the balance sheet as a current asset, even amounts that
     will be collected beyond the next 12 months.

     b. Industry practice typically classifies the deferred gross
     profit account as a contra-asset.

     c. Selling, general, & administrative costs of
     installment sales are treated as period costs.           90
B. Revenue recognition
Subsequent to Sale—


     Let’s look at an
        Example
          of the
       Installment
          Sales
         Method
                         91
B. Revenue recognition
Subsequent to Sale—
         Installment Sales Method Example:

       Actual experience on the project as of DEC 31st
                                  2001           2002
Installment Sales              $1,200,000      $1,300,000
Cost of installment goods sold    840,000         884,000
Gross Profit                   $ 360,000       $ 416,000
Gross Profit %                     30%              32%

Cash Collections
   On 2001 installment sales   $ 300,000       $ 600,000
   On 2002 installment sales                   $ 340,000

                                                       92
Installment Sales Method Example:
Step 1: Compute the Gross Profit % for Year 1

 Gross Profit % = Gross Profit   $$
                 Installment Sales $$

                         Profit
 Gross Profit % = Gross$360,000 $$ = 30%
                 Installment Sales $$
                      $ 1,200,000

              Actual experience on the project as of DEC 31st
                                               2001
              Installment Sales              $1,200,000
              Cost of installment goods sold    840,000
              Gross Profit                   $ 360,000
              Gross Profit %                   30%
              Cash Collections
                  On 2001 installment sales $ 300,000
               Actual experience on the project as of DEC 31st
Installment                                     2001
 Sales         Installment Sales              $1,200,000
Method         Cost of installment goods sold    840,000
               Gross Profit                   $ 360,000
 Example:      Gross Profit %                   30%
               Cash Collections
                   On 2001 installment sales $ 300,000

Step 2: Determine the Gross Profit recognized on
installment sales for Year 1.

Gross =Cash Collected * Gross Profit % Year 1
profit

Gross =Cash Collected * Gross Profit % Year 1
          $300,000                30%
profit = $90,000
Step 3: Compute the Gross Profit deferred for
        Year 1.
     Calculation of Deferred Gross Profit:
     Total Yearly Installment Gross Profit
 -   Installment Gross Profit recognized Year 1
      Installment Gross Profit deferred Year 1

     Calculation of Deferred Gross Profit:
     Total Yearly Installment Gross Profit
                    $360,000
 -                 $ 90,000
     Installment Gross Profit recognized Year 1
      Installment$ 270,000 deferred Year 1
                 Gross Profit
      Let’s see how this information looks on the
                 Financial Statements!
                            Actual experience on the project as of DEC 31st
Installment Sales                                              2001
Method Example:             Installment Sales              $1,200,000
                            Cost of installment goods sold    840,000
Step 1: Record              Gross Profit
                            Gross Profit %
                                                           $ 360,000
                                                                 30%
Installment Sales for       Cash Collections
                                 On 2001 installment sales $ 300,000
Year 1                      Gross Profit Recognized         $ 90,000
                            Gross Profit Deferred           $ 270,000

Dr.Accounts Receivable- 2001 Installment Sales $1,200,000
       Cr.   Installment Sales Revenue               $1,200,000
          Accounts                 Installment Sales
         Receivable                    Revenue

   $1,200,000                                     $1,200,000
                               Actual experience on the project as of DEC 31st
Installment Sales                                                 2001
Method Example:                Installment Sales              $1,200,000
                               Cost of installment goods sold    840,000
Step 2: Record                 Gross Profit                   $ 360,000
                               Gross Profit %                       30%
Installment Cost of            Cash Collections
Good Sold for Year 1                On 2001 installment sales $ 300,000
                               Gross Profit Recognized         $ 90,000
                               Gross Profit Deferred           $ 270,000

Dr.     Cost of Installment Goods Sold              $840,000
        Cr.    Inventory                                          $840,000
        Cost of Installment
            Goods Sold                       Inventory

      $840,000                                        $840,000
                             Actual experience on the project as of DEC 31st
Installment Sales                                               2001
Method Example:              Installment Sales              $1,200,000
                             Cost of installment goods sold    840,000
Step 3: Record               Gross Profit                   $ 360,000
Cash Collections for         Gross Profit %
                             Cash Collections
                                                                  30%

Year 1                            On 2001 installment sales $ 300,000
                             Gross Profit Recognized         $ 90,000
                             Gross Profit Deferred           $ 270,000


Dr.     Cash                            $ 300,000
        Cr.  Accounts Receivable                       $300,000
                                             Accounts
            Cash                            Receivable

      $300,000           Yr 2001 $1,200,000           $300,000

                       End Yr 2001 $900,000
                             Actual experience on the project as of DEC 31st
Installment Sales                                               2001
Method Example:              Installment Sales              $1,200,000
                             Cost of installment goods sold    840,000
Step 3: Record               Gross Profit                   $ 360,000
 Deferred gross              Gross Profit %
                             Cash Collections
                                                                  30%

profit                            On 2001 installment sales $ 300,000
                             Gross Profit Recognized         $ 90,000
for Year 1                   Gross Profit Deferred           $ 270,000

Dr. Deferred Gross Profit on Income Statement $270,000
      Cr.    Deferred Gross Profit- Adj. To A/R      $270,000

Gross Profit Deferred Gross Profit on           Deferred Gross
  on I/S       Income Statement               Profit- Adj. To A/R
           $1,200,000
$840,000                     Notice the I/S now                $270,000

           $360,000 $270,000 shows $90,000
                             Gross Profit!
                Income Statement will look after this as of DEC 31
Notice how the Sales            Actual experience on the project entry:   st
Installment                                                        2001
Method Example:                 Installment Sales              $1,200,000
       Installment Sales                       $1,200,000
                                Cost of installment goods sold    840,000
Step 3: Record                  Gross Profit
       Cost of Installment Goods Sold             (840,000) $ 360,000
              gross
 Deferred Profit
       Gross
                                Gross Profit %
                                Cash Collections 360,000
                                               $
                                                                     30%

profit Less: Deferred GP on Installment installment sales $ 300,000
                                     On 2001
for Year 1                      Gross            (270,000) $ 90,000
              Sales of current year Profit Recognized
                                Gross Profit Deferred           $ 270,000
       Total Gross Profit recognized
         this Gross
Dr. Deferred year Profit on Income Statement $270,000
                                                 $ 90,000
       Cr.    Deferred Gross Profit- Adj. To A/R                    $270,000

Gross Profit Deferred Gross Profit on              Deferred Gross
  on I/S       Income Statement                  Profit- Adj. To A/R
           $1,200,000
$840,000                     Notice the I/S now                 $270,000

           $360,000 $270,000 shows $90,000
                             Gross Profit!
Installment Sales Method Example:

What type of account is Deferred GP – Adj. To
A/R really?
It is is really a deferred revenue account
( Liability) because you don’t know the revenue
recognized until the cash is collected using an adjusting
entry!              Current Assets
Usually for financial reporting     Deferred Gross
purposes, it is reclassified      Profit- Adj. To A/R
As a Contra-Asset to
Accounts Receivable.
But it’s meaning has not                     $270,000   ????
changed!
                                 Actual experience on the project as of DEC 31st
Installment Sales                                                   2001
Method Example:                  Installment Sales              $1,200,000
                                 Cost of installment goods sold    840,000
How would this                   Gross Profit                   $ 360,000
information look on              Gross Profit %
                                 Cash Collections
                                                                      30%

the Balance Sheet?                    On 2001 installment sales $ 300,000
                                 Gross Profit Recognized         $ 90,000
                                 Gross Profit Deferred           $ 270,000

                     Current Assets
           Accounts
       Receivable-2001
       Installment Sales - Profit- Adj. Gross
                             Deferred
                                        To A/R
Yr 2001 $1,200,000    $300,000
                                                $270,000 = $630,000
End Yr $900,000
2001
Installment Sales Method Example:
Step 1: Compute the Gross Profit % for Year 2

 Gross Profit % = Gross Profit   $$
                 Installment Sales $$

                         Profit
 Gross Profit % = Gross$416,000 $$ = 32%
                 Installment Sales $$
                      $ 1,300,000

                        Actual experience on the project as of DEC 31st
                                              2001               2002
            Installment Sales              $1,200,000        $1,300,000
            Cost of installment goods sold    840,000            884,000
            Gross Profit                   $ 360,000         $ 416,000
            Gross Profit %                       30%              32%
            Cash Collections
                 On 2001 installment sales $ 300,000           $ 600,000
                 On 2002 installment sales                     $ 340,000
                          Actual experience on the project as of DEC 31st
Installment                                     2001               2002
 Sales        Installment Sales              $1,200,000        $1,300,000
              Cost of installment goods sold    840,000            884,000
Method        Gross Profit                   $ 360,000         $ 416,000
 Example:     Gross Profit %                       30%              32%
              Cash Collections
                   On 2001 installment sales $ 300,000           $ 600,000
                   On 2002 installment sales                     $ 340,000

Step 2: Determine the Gross Profit recognized on
installment sales from Year 1 collected in Year 2.

Gross =     Cash Collected               *        GP % Year 1
Profit    in Yr 2 from 2001 Sales


Gross = Cash Collected
             $600,000       *                     GP % Year 1
                                                     30%
Profit = in Yr 2$180,000 Sales
                from 2001
                          Actual experience on the project as of DEC 31st
Installment                                     2001               2002
 Sales        Installment Sales              $1,200,000        $1,300,000
              Cost of installment goods sold    840,000            884,000
Method        Gross Profit                   $ 360,000         $ 416,000
 Example:     Gross Profit %                       30%              32%
              Cash Collections
                   On 2001 installment sales $ 300,000           $ 600,000
                   On 2002 installment sales                     $ 340,000
              Gross Profit recognized in 2002 from 2001 Sales    $ 180,000

Step 3: Determine the Gross Profit recognized on
installment sales from Year 2 collected in Year 2.
Gross =     Cash Collected               *        GP % Year 2
Profit    in Yr 2 from 2002 Sales


Gross = Cash Collected
             $340,000       *                     GP % Year 2
                                                     32%
Profit = in Yr 2$108,800 Sales
                from 2002
Step 4: Compute the Gross Profit deferred for
        Year 2.
     Calculation of Deferred Gross Profit:
     Total Yearly Installment Gross Profit
 -   Installment Gross Profit recognized Year 2
      Installment Gross Profit deferred Year 2

     Calculation of Deferred Gross Profit:
     Total Yearly Installment Gross Profit
                    $416,000
 -                 $ 108,800
     Installment Gross Profit recognized Year 2
      Installment$ 307,200 deferred Year 2
                 Gross Profit
      Let’s see how this information looks on the
                 Financial Statements!
                            Actual experience on the project as of DEC 31st
Installment                                       2001               2002
Sales           Installment Sales              $1,200,000        $1,300,000
Method          Cost of installment goods sold    840,000            884,000
                Gross Profit                   $ 360,000         $ 416,000
Example:        Gross Profit %                       30%              32%
                Cash Collections
Step 1:              On 2001 installment sales $ 300,000           $ 600,000
Record               On 2002 installment sales                     $ 340,000
Installment     Gross Profit recognized in 2002 from 2001 Sales    $ 180,000
                Gross Profit recognized in 2002 from 2002 Sales    $ 108,800
Sales for       Gross Profit Deferred in 2002 from 2002 Sales      $ 307,200
Year 2
Dr.Accounts Receivable- 2002 Installment Sales $1,300,000
       Cr.   Installment Sales Revenue               $1,300,000
          Accounts
      Receivable-2002                  Installment Sales
      Installment Sales                    Revenue

   $1,300,000                                        $1,300,000
                              Actual experience on the project as of DEC 31st
Installment                                         2001               2002
Sales             Installment Sales              $1,200,000        $1,300,000
Method            Cost of installment goods sold    840,000            884,000
                  Gross Profit                   $ 360,000         $ 416,000
Example:          Gross Profit %                       30%              32%
                  Cash Collections
Step 2:                On 2001 installment sales $ 300,000           $ 600,000
Record                 On 2002 installment sales                     $ 340,000
Installment       Gross Profit recognized in 2002 from 2001 Sales    $ 180,000
                  Gross Profit recognized in 2002 from 2002 Sales    $ 108,800
Cost of Good      Gross Profit Deferred in 2002 from 2002 Sales      $ 307,200
Sold for
Year 2
Dr.     Cost of Installment Goods Sold                 $884,000
        Cr.    Inventory                                           $884,000
        Cost of Installment
            Goods Sold                         Inventory

      $884,000                                           $884,000
                              Actual experience on the project as of DEC 31st
Installment
                                                    2001               2002
Sales             Installment Sales              $1,200,000        $1,300,000
Method            Cost of installment goods sold    840,000            884,000
Example:          Gross Profit                   $ 360,000         $ 416,000
Step 3:           Gross Profit %                       30%              32%
                  Cash Collections
Record                 On 2001 installment sales $ 300,000           $ 600,000
Cash                   On 2002 installment sales                     $ 340,000
Installment Sales from different
Collections                                               years must
                  Gross Profit recognized in 2002 from 2001 Sales    $ 180,000
                  Gross Profit recognized in 2002 from 2002 Sales    $ 108,800
for Year 2 track of separately!
be kept           Gross Profit Deferred in 2002 from 2002 Sales      $ 307,200

Dr.   Cash                          $ 940,000
      Cr.  Accounts Receivable-2001           $600,000
      Cr.  Accounts Receivable-2002           $340,000
          Accounts                                 Accounts
      Receivable-2002                          Receivable-2001
      Installment Sales                        Installment Sales
  $1,300,000 $340,000              End Yr
                                   2001 $900,000         $600,000
   $960,000
                                         $300,000
                               Actual experience on the project as of DEC 31st
Installment
                                                      2001              2002
Sales               Cash Collections
Method                  On 2001 installment sales $ 300,000           $ 600,000
Example:                On 2002 installment sales                     $ 340,000
Step 3: Record      Gross Profit recognized in 2002 from 2001 Sales   $ 180,000
                    Gross Profit recognized in 2002 from 2002 Sales   $ 108,800
 Deferred
                    Gross Profit Deferred in 2002 from 2002 Sales     $ 307,200
gross profit
for Year 2

Dr. Deferred Gross Profit on Income Statement $307,200
      Cr.    Deferred Gross Profit- Adj. To A/R      $307,200

Gross Profit Deferred Gross Profit on               Deferred Gross Profit-
               Income Statement                       Adj. To A/R-2002
  on I/S
           $1,300,000
                                           From 2002 Sales $307,200
$884,000
           $416,000 $307,200
                               Actual experience on the project as of DEC 31st
Installment
                                                      2001              2002
Sales               Cash Collections
Method                  On 2001 installment sales $ 300,000           $ 600,000
Example:                On 2002 installment sales                     $ 340,000
Step4: Record       Gross Profit recognized in 2002 from 2001 Sales   $ 180,000
gross profit        Gross Profit recognized in 2002 from 2002 Sales   $ 108,800
In Year 2 from      Gross Profit Deferred in 2002 from 2002 Sales     $ 307,200
2001 Installment
Sales

Dr. Deferred Gross Profit –Adj. To A/R-2001      $180,000
    Cr. Recognized GP on Installment Sales-prior yr.    $180,000
  Gross Profit Deferred Gross Profit on             Deferred Gross Profit-
  on I/S- 2002 Income Statement-2002                  Adj. To A/R-2001

           $1,300,000
                                            From 2001 Sales $270,000
$884,000
                                                    $180,000
           $416,000 $307,200
           $180,000                                               $90,000
           $596,000
                      Actual experience look project as entry:
Notice how the Income Statement willon the after this of DEC 31st
Installment
                                                  2001                2002
Sales            Cash Collections
Method               On 2001 installment sales $ 300,000            $ 600,000
Example:             On 2002 installment sales                      $ 340,000
Step4: Record    Gross Profit recognized in 2002 from 2001 Sales    $ 180,000
gross profit                                          2002
                 Gross Profit recognized in 2002 from 2002 Sales    $ 108,800
                                                 $1,300,000
In YearInstallment Sales Deferred in 2002 from 2002 Sales
        2 from   Gross Profit                                       $ 307,200
       Cost of
2001 Installment Installment    Goods Sold   (884,000)
Sales
        Gross Profit                       $ 416,000
        Less: Gross Profit –Adj. To A/R-2001
Dr. DeferredDeferred GP on Installment             $180,000
               Sales of on Installment
    Cr. Recognized GP current year Sales-prior yr.
                                            (307,200)      $180,000
        Total Gross Profit recognized
   Gross Profit Deferred Gross Profit on      Deferred Gross Profit-
           2002 Income Statement-2002 $ 108,800 A/R-2001
  on I/S-on current years sales                 Adj. To
        Plus: Gross Profit recognized
                                       From 180,000
         on installment sales of prior years 2001 Sales $270,000
          $1,300,000
$884,000
    Total $416,000 $307,200                  $180,000
          Gross Profit recognized this yr.$ 288,800
          $180,000                                                 $90,000
          $596,000
Installment Sales Method Example:
How would this information look on the
Balance Sheet?
                  Current Assets
          Accounts
      Receivable-2001
      Installment Sales - Profit- Adj. Gross
                            Deferred
                                       To A/R
End Yr $900,000
2001            $600,000
End
Yr2002 $300,000                     $90,000 = $210,000
Installment Sales Method Example:
How would this information look on the
Balance Sheet?
                  Current Assets
          Accounts
      Receivable-2002
      Installment Sales - Profit- Adj. Gross
                            Deferred
                                       To A/R
    $1,300,000
                  $340,000
End
Yr2002 $960,000                     $307,200 = $652,800
II. Earnings Management

   A. Managers sometimes exploit the
    flexibility in GAAP to manipulate
    reported earnings
    in ways that mask
    the underlying
    performance of
    the company.


                                        115
II. Earnings Management
           1.    Arthur Levitt, former SEC
           Chairman warned in a 1998 speech
           delivered at the NYU Center for
           Law and Business: ―As a result, I
           fear that we are witnessing an
           erosion in the quality of
           earnings, and therefore, the
           quality of financial reporting.
           Managing may be giving way to
           manipulation; integrity may be
           losing to illusion.‖




                                          116
II. Earnings Management

    2. Figure 3.1 shows the discontinuity in
     the number of firms reporting slightly
     negative earnings
     versus slightly
     positive earnings.

    Weighted toward more
     positive
                                            117
II. Earnings Management

     2. Figure 3.1 shows the discontinuity in
       the number of firms reporting slightly
       negative earnings versus slightly
       positive earnings.
 a. This suggests that managers
 try to avoid reporting losses,
 since investors often penalize
 companies that fail to meet
 analysts’ earnings
 expectations.
                                          118
II. Earnings Management

    2. Figure 3.1 shows the discontinuity in
      the number of firms reporting slightly
      negative earnings versus slightly
      positive earnings.
 b.    One way of avoiding
 the reporting of small
 losses and to push earnings
 into the positive range is to
 exploit the flexibility in
 GAAP.
                                         119
II.Earnings Management

        2. Figure 3.1 shows the discontinuity in
        the number of firms reporting slightly
        negative earnings versus slightly
        positive earnings.
   c. There are a large number of
    forecast errors
    (e.g., actual earnings minus
    analysts’ consensus earnings)
    clustered around zero, with a
    disproportionate number of
    small negative forecast errors.
                                             120
II.Earnings Management

      2. Figure 3.1 shows the discontinuity in
      the number of firms reporting slightly
      negative earnings versus slightly
      positive earnings.
   d. One explanation is
    that some companies
    manage earnings
    upward to meet or beat
    analysts’ earnings
    projections.
                                           121
II.Earnings Management

      B. Popular earnings management ploys:

                   1. “Big Bath”
                   restructuring charges
                   may be used to boost
                   earnings in future years.




                                          122
II.Earnings Management

      B. Popular earnings management ploys
      1. “Big Bath” restructuring charges
       may be used to boost earnings in future
       years.
              a. Restructurings include the
              consolidation of operations through
              plant closures, labor force
              reductions, and the sale of non-core
              business units.
                                                123
II.Earnings Management

      B. Popular earnings management ploys
      1. “Big Bath” restructuring charges
       may be used to boost earnings in future
       years.
                 b. The associated estimated costs
                  are charged to expenses and are
                  offset by a liability.



                                               124
II.Earnings Management

      B. Popular earnings management ploys
      1. “Big Bath” restructuring charges
       may be used to boost earnings in future
       years.
               c. Managers may have an incentive to
                overstate the charges by including
                recurring future operating expenses.
               The boost to income results when the
                operating expenses are charged
                against the reserve, bypassing the
                income statement.
                                                 125
II.Earnings Management
      B. Popular earnings management
       ploys
      1. “Big Bath” restructuring charges
       may be used to boost earnings in future
       years.
                  d. There is a prevailing belief
                   that investors look beyond one-
                   time special charges and write-
                   offs, and instead focus on
                   sustainable operating
                   earnings.
                                               126
II.Earnings Management

B.      Popular earnings management ploys
          2. Creative acquisition accounting
          and purchased R&D:

     a. A significant portion of the
        purchase price in purchase
        business combinations
        may be allocated to
        purchased R&D and
        immediately expensed.
                                               127
II.Earnings Management

B.       Popular earnings management ploys
          2. Creative acquisition accounting
          and purchased R&D:
   b. This accounting avoids the charge for
    goodwill amortization that lowers future
    earnings.
   This issue will be mitigated by the FASB’s
    forthcoming business combinations
    project that will eliminate goodwill
    amortization.                                128
II.Earnings Management

B.       Popular earnings management ploys
           2. Creative acquisition accounting
           and purchased R&D:

   c. There is also concern that
    firms are recording excess
    reserves at the time of the
    acquisition that future operating
    expenses are charged against.

                                                129
II.Earnings Management

B.      Popular earnings management ploys
     3.   Miscellaneous “cookie jar reserves” are a
     convenient income smoothing device.

 a. Accrual accounting allows
    companies to estimate and
    accrue for obligations that will
    be paid in future periods as a
    result of transactions or events
    in the current period.
                                                 130
II.Earnings Management

B.      Popular earnings management ploys
     3.   Miscellaneous “cookie jar reserves” are a
     convenient income smoothing device.

    b. Some companies over-
     reserve in good times and
     cut back on estimated
     charges, or even reverse
     previous charges, in bad
     times.

                                                 131
II.Earnings Management

B.      Popular earnings management ploys
    4. Intentional errors deemed to be
     ―immaterial‖ might be used to inflate
     earnings.

    a. Companies may intentionally
     misapply GAAP , arguing that the
     incorrect treatment has an
     immaterial effect on earnings.

                                             132
II.Earnings Management

B.      Popular earnings management ploys
    4. Intentional errors deemed to be
     ―immaterial‖ might be used to inflate
     earnings.

    b. The cumulative total of
     these items may have a material
     effect on bottom line earnings.


                                             133
II.Earnings Management

B.       Popular earnings management ploys
        5. Premature or aggressive
         revenue recognition may also lead to
         the overstatement of earnings.
 a. Revenue is recognized when it is
    earned (critical event criterion) and
    realized or realizable (measurability
    criterion).
 • This occurs when the following
    criteria are met:
                                            134
II.Earnings Management
         5. Premature or aggressive revenue
          recognition may also lead to the
          overstatement of earnings.
•     This occurs when the following
      criteria are met:
    i.     Persuasive evidence of an
    arrangement exists,
    ii.    Delivery has occurred or services
    have been rendered,
    iii.   The seller’s price to the buyer is
    fixed or determinable, and
    iv.    Collectibility is reasonably
    assured.                                    135
II.Earnings Management

B.       Popular earnings management ploys
        5. Premature or aggressive
         revenue recognition may also lead to
         the overstatement of earnings.

        b. SEC Staff Accounting
         Bulletin illustrates several
         troublesome areas of
         revenue recognition.

                                            136

								
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