CHAPTER LEARNING OBJECTIVES

18 Revenue Recognition CHAPTER LEARNING OBJECTIVES 1. Describe and apply the revenue recognition principle. 2. Describe accounting issues for revenue recognition at point of sale. 3. Apply the percentage-of-completion method for long-term contracts. 4. Apply the completed-contract method for long-term contracts. 5. Identify the proper accounting for losses on long-term contracts. 6. Describe the installment method of accounting. 7. Explain the cost recovery method of accounting. *8. Explain revenue recognition for franchises. *9. Compare the accounting procedures related to revenue recognition under GAAP and IFRS. CHAPTER REVIEW 1. One of the most difficult issues facing accountants concerns the recognition of revenue by a business organization. Although general rules and guidelines exist, the significant variety of marketing methods for products and services make it difficult to apply the rules consistently in all situations. Chapter 18 is devoted to a discussion and illustration of revenue transactions that result from the sale of products and the rendering of services. Throughout the discussion, attention is focused on the theory behind the accounting methods used to recognize revenue. Revenue transactions that result from leasing and the sale of assets other than inventory are discussed in other sections of the text. Revenue Recognition 2. (L.O. 1) The revenue recognition principle provides that revenue is recognized when (1) it is realized or realizable and (2) it is earned. Revenues are realized when goods and services are exchanged for cash or claims to cash (receivables). Revenues are realizable when assets received in exchange are readily convertible to known amounts of cash or claims to cash. Revenues are earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues, that is, when the earnings process is complete or virtually complete. *Note: All asterisked (*) items relate to material contained in the Appendix to the chapter. 18-2 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ 3. The conceptual nature of revenue as well as the basis of accounting for revenue transactions are described in the following four statements. (a) (b) (c) (d) Revenue from selling products is recognized at the date of sale, usually interpreted to mean the date of delivery to customers. Revenue from services rendered is recognized when services have been performed and are billable. Revenue from permitting others to use enterprise assets, such as interest, rent, and royalties, is recognized as time passes or as the assets are used. Revenue from disposing of assets other than products is recognized at the date of sale. Point of Sale 4. (L.O. 2) According to the FASB, revenue is recognized when the product is delivered or the service is rendered. This time of recognition is normally at the time of sale when the product or service is delivered to the customer. Some problems in implementing these basic principles arise when (a) sales are made with discounts, (b) sales are made with right of return, (c) sales have buyback agreements, (d) sales are made as bill and hold sales, (e) a principal-agent relationship exists, (f) trade loading or channel stuffing is present, and (g) sales are made with multiple-deliverable arrangements. 5. Any trade discounts or volume rebates should reduce consideration received and reduce revenue earned. In addition, if the payment is delayed, the seller should impute an interest rate for the difference between the cash or cash equivalent price and the deferred amount. 6. In most business enterprises, a far greater proportion of total sales volume is handled on a credit basis than on an ordinary cash sale basis. In situations where the seller gives the buyer the right to return the product, the FASB concluded that the transactions should not be recognized currently as sales unless all of the following six conditions are met: a. b. c. d. e. f. The seller’s price to the buyer is substantially fixed or determinable at the date of sale. The buyer has paid the seller, or the buyer is obligated to pay and the obligation is not contingent on resale of the product. The buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product. The buyer has economic substance apart from that provided by the seller. The seller does not have significant future performance obligations to directly bring about the resale of the product by the buyer. The amount of future returns can be reasonably estimated. 7. If a company sells a product in one period and agrees to buy it back in the next period this is known as a sales with buyback and sometimes the arrangement should be recognized as a financing transaction rather than a sale. 8. Bill and hold sales result when the buyer is not yet ready to take delivery but does take title and accept billing. If a significant period of time elapses before payment, the accounts receivable is discounted. 9. In a principal-agent relationship, amounts collected on behalf of the principal are not revenue of the agent. Instead, revenue for the agent is the amount of the commission it receives (usually a percentage of the total revenues). Chapter 18: Revenue Recognition 18-3 ____________________________________________________________________________________ Consignments 10. Another common principal-agent relationship involves consignments. In a consignment sales arrangement, merchandise is shipped by the consignor to the consignee, who acts as an agent for the consignor in selling the merchandise. The merchandise shipped to the consignee remains the property of the consignor until a sale is made. When a sale is made, the consignee remits the proceeds, less any related expenses plus a sales commission, to the consignor. When the consignor receives word that a sale has been made, revenue is recognized and inventory is appropriately reduced. 11. In accounting for consignment sales arrangements, the consignor periodically receives from the consignee an account sales that shows the merchandise received, merchandise sold, expenses chargeable to the consignment, and the cash remitted. Revenue is then recognized by the consignor. 12. Even when revenues are recorded at date of delivery, with neither buyback or return provisions, some companies are recognizing revenues and earnings prematurely. This occurs in situations where trade loading or channel stuffing are present. Trade loading is an attempt to show sales, profits, and market share an entity does not have by inducing wholesale customers to buy more product then they can promptly sell. Channel stuffing is a similar tactic found mostly in the computer software industry. In channel stuffing, the software maker offers deep discounts to its distributors to overbuy and records revenue when the software leaves its loading dock. When this process takes place, the distributors’ inventories become bloated and the marketing channel gets stuffed, but the software maker’s financial statements are improved. 13. Multiple deliverable arrangements (MDAs) provide multiple products or services to customers as part of a single arrangement. The major accounting issues related to this type of arrangement are how to allocate the revenue to the various products and services and how to allocate the revenue to the proper period. Revenue Recognition Before Delivery and Long-term Contracts 14. In most circumstances, revenue is recognized at the point of sale because most of the uncertainties related to the earning process are removed and the exchange price is known. One of the exceptions to the general rule of recognition at point of sale is caused by long-term construction-type projects. The accounting measurements associated with long-term construction projects are difficult because events and amounts must be estimated for a period of years. Two basic methods of accounting for long-term construction contracts are recognized by the accounting profession: (a) the percentage-of completion method and (b) the completed-contract method. 15. The percentage-of-completion method must be used when estimates of progress toward completion, revenues, and costs are reasonably dependable and all the following conditions exist: a. b. c. The contract clearly specifies the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement. The buyer can be expected to satisfy all obligations under the contract. The contractor can be expected to perform contractual obligations. The completed-contract method should be used only when (a) an entity has primarily short-term contracts, (b) the conditions for using the percentage-of-completion method cannot be met, or (c) there are inherent hazards in the contract beyond normal, recurring business risks. 18-4 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ Percentage-of-Completion Method 16. (L.O. 3) Under the percentage-of-completion method, revenue on long-term construction contracts is recognized as construction progresses. Costs pertaining to the contract plus gross profit earned to date are accumulated in a Construction in Process account. The amount of revenue recognized in each accounting period is based on a percentage of the total revenue to be recognized on the contract. This percentage is the costs incurred on the contract to date divided by the most recent estimated total costs (cost-to-cost basis). Income recognized before completion is recorded by debiting Construction in Process and crediting Revenue from Long-term Contracts. Use of this method is dependent upon the seller’s ability to provide a reliable estimate of both the cost to complete and the percentage of contract performance completed. When such estimates are considered reasonably dependable, the accounting profession has considered the percentage-of-completion method preferable. Completed-Contract Method 17. (L.O. 4) Under the completed-contract method, revenue and gross profit are recognized when the contract is completed. The principal advantage of the completed-contract method is that reported revenue is based on final results rather than on estimates of unperformed work. Its major disadvantage is the distortion of earnings that may occur. The accounting entries made under the completed-contract method are the same as those made under the percentage-of-completion method, with the notable exception of periodic income recognition. Contract Losses 18. (L.O. 5) When the current estimates of total contract revenue and contract cost indicate a loss is expected, the entire expected contract loss must be recognized in the period in which it becomes evident under both the percentage-of-completion and the completed-contract-methods. 19. In addition to normal financial statement disclosures, construction contractors should disclose (a) the method of recognizing revenue, (b) the basis used to classify assets and liabilities as current, (c) the basis for recording inventory, (d) the effects of any revisions of estimates, (e) the amount of backlog on incomplete contracts, and (f) the details about receivables. Installment Method 20. (L.O. 6) In some cases revenue is recognized after delivery of the product to the buyer. This is due to the fact that, in certain sales situations, the sales price is not reasonably assured and revenue recognition is deferred. The methods generally used to account for the deferral of revenue recognition until cash is received are (a) the installment method and (b) the cost recovery method. 21. In 1966, the accounting profession concluded that, except in special circumstances, the installment method of recognizing revenue is not acceptable. Use of the installment method is justified in situations where receivables are collectible over an extended period of time and there is no reasonable basis for estimating the degree of collectibility. The method is used extensively in tax accounting and has relevance because of the increased emphasis on cash flows. 22. The term installment sale describes any type of sale for which payment is required in periodic installments over an extended period of time. The installment method places emphasis on collection, as installment sales lead to income realization in the period of collection rather than the period of sale. This does not mean that revenue is considered unrealized until the entire sale price has been collected but rather that income realization is proportionate to collection. This is due to the fact that the ultimate profit is more uncertain in installment sales than in ordinary sales because collection is more doubtful. Chapter 18: Revenue Recognition 18-5 ____________________________________________________________________________________ 23. Under the installment sales method of accounting, the gross profit (sales less cost of goods sold) on installment sales is deferred to those periods in which cash is collected. Operating expenses, such as selling and administrative expenses, are treated as expenses in the period incurred. For installment sales in any one year, the following procedures apply under the installment sales method: a. b. c. During the year, record both sales and cost of sales in the regular way using separate installment sales accounts and compute the rate of gross profit on installment sales transactions. At the end of the year, apply the rate of gross profit to the cash collections of the current year’s installment sales to arrive at the realized gross profit. The gross profit not realized should be deferred to future years. In any year in which collections from prior years’ installment sales are received, the gross profit rate of each year’s sales must be applied against cash collections of accounts receivable resulting from that year’s sales to arrive at the realized gross profit. 24. To illustrate the installment sales method of accounting assume the following facts: Installment sales Cost of installment sales Gross profit Rate of Gross Profit Cash Receipts 2014 Sales 2015 Sales 2016 Sales 2014 $226,000 164,980 $ 61,020 27% 2015 $248,000 176,080 $ 71,920 29% 2016 $261,000 195,750 $ 65,250 25% $ 85,000 $ 96,000 123,000 $ 45,000 87,000 147,000 Only the 2015 journal entries will be shown. The entries for 2014 and 2016 are the same, but the entire set of entries for the installment method are demonstrated by the 2015 entries. To record 2015 installment sales Installment Accounts Receivable, 2015 Installment Sales 248,000 To record cash collected on installment receivables Cash Installment Accounts Receivables, 2014 Installment Accounts Receivables, 2015 219,000 To record 2015 cost of goods sold on installment Cost of Installment Sales Inventory (or Purchases) To close installment sales and cost of installment sales Installment Sales Cost of Installment Sales Deferred Gross Profit, 2015 248,000 96,000 123,000 176,080 176,080 248,000 176,080 71,920 18-6 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ To record realized gross profit Deferred Gross Profit, 2014 Deferred Gross Profit, 2015 Realized Gross Profit (a) (b) 25,920 (a) 35,670 (b) 61,590 ($96,000 X .27) ($123,000 X .29) 25. When interest is involved in installment sales, it should be accounted for separately as interest income in the period received. Uncollectible installment accounts receivable should be accounted for in a manner similar to that used for such losses on other credit sales if repossessions do not normally compensate for uncollectible balances. Repossessions 26. The accounting for repossessions recognizes that the related installment receivable account is not collectible and that it should be written off. Also, the applicable deferred gross profit must be removed from the ledger. 27. Repossessed merchandise should be recorded in the Repossessed Merchandise Inventory account. The item repossessed should be recorded at its fair value. The objective should be to put any asset acquired on the books at its fair value or, when fair value is not ascertainable, at the best possible approximation of fair value. If installment sales transactions represent a significant part of total sales, full disclosure of installment sales, the cost of installment sales, and any expenses allocable to installment sales is desirable. Deferred gross profit on installment sales is generally treated as unearned revenue and classified as a current liability. Cost Recovery Method 28. (L.O. 7) Under the cost recovery method, no profit is recognized until cash payments by the buyer exceed the seller’s cost of the merchandise sold. After all the costs have been recovered, any additional cash collections are included in income. The accounting profession allows a seller to use the cost recovery method to account for sales in which “there is no reasonable basis for estimating collectibility.” The cost recovery method is required under GAAP where a high degree of uncertainty exists related to the collection of receivables. The cost recovery method is more appropriate than the installment method when there is a greater degree of uncertainty. Franchises *29. (L.O. 8) Appendix 18A includes a presentation of franchise sales transactions. In franchise operations a franchisor grants business rights under a franchise agreement to a franchisee. Four types of franchise arrangements have evolved in practice: (a) manufacturer-retailer, (b) manufacturer-wholesaler, (c) service sponsor-retailer (McDonald’s, Pizza Hut, etc.), and (d) wholesaler -retailer. Franchise companies derive their revenue from one or both of two sources: (a) the sale of initial franchises and related assets or services and (b) continuing fees based on the operations of franchises. Chapter 18: Revenue Recognition 18-7 ____________________________________________________________________________________ *30. Initial franchise fees are to be recorded as revenue only when and as the franchisor makes substantial performance of the services it is obligated to perform and collection of the fee is reasonably assured. Continuing franchise fees should be reported as revenue when they are earned and receivable from the franchisee, unless a portion of them has been designated for a particular purpose, such as providing a specified amount for building maintenance or local advertising. When a franchisee is given an option to purchase equipment or supplies by a franchisor at a bargain purchase price (lower than the normal selling price), a portion of the initial franchise fee should be deferred and accounted for as an adjustment to the selling price of equipment or supplies. A franchisor should disclose all significant commitments and obligations resulting from franchise agreements, including a description of services that have not yet been substantially performed. IFRS Insights *31. (L.O. 9) The IASB defines revenue to include both revenues and gains. GAAP provides separate definitions for revenues and gains. IFRS has one basic standard on revenue recognition. GAAP has numerous standards related to revenue recognition. Accounting for revenue provides a most fitting contract of the principles-based (IFRS) and rules-based (GAAP) approaches. GLOSSARY Account sales. A document a consignor periodically receives from the consignee that shows the merchandise received, merchandise sold, expenses chargeable to the consignment, and the cash remitted. Completion of production basis. The recognition of revenue at the completion of production even though no sale has been made (examples include precious metals or agricultural products with assured prices). Completed-Contract Method. The accounting for long-term construction contracts where revenues and gross profit are recognized only when the contract is completed. Consignment. A contractual arrangement whereby a consignor ships merchandise to a consignee, who is to act as an agent for the consignor in selling the merchandise. The consignor retains title to the goods until the goods are sold. Consignor. The party (generally a manufacturer) that sends goods to a consignee under consignment. Consignee. The party (generally a dealer) that receives goods from a consignor under consignment. 18-8 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ *Continuing franchise fees. The payments made by a franchisee to a franchisor for the continuing rights granted by the franchise agreement and for providing such services as management training, advertising and promotion, legal assistance, and other support. Cost recovery method. Income is not recognized until cash payments by the buyer exceed the seller’s cost of the merchandise sold. Cost-to-cost basis. The method used under the percentage-of-completion method whereby the percentage of completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract. Deposit method. The seller reports cash received in advance as a deposit on the contract and classifies it as a liability (refundable deposit or customer advance). Earned. Revenues are earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues, that is, when the earnings process is complete or virtually complete. *Franchise. A contractual arrangement whereby a franchisor grants business rights and provides services to a franchisee who in return agrees to pay an initial franchise fee to operate a business and pay continuing fees based on the operations of the business. *Franchisee. The party who operates the franchised business. *Franchisor. The party who grants business rights under the franchise. *Initial franchise fee. Consideration for establishing the franchise relationship and providing some initial services. Installment sales method. Income is recognized when it is collected rather than in the period of sale. Percentage-of-Completion Method. The accounting for long-term construction contracts where revenues and gross profit are recognized each period based upon the progress of the construction, that is, the percentage of completion. Realizable. Revenues are realizable when assets received in exchange are readily convertible to known amounts of cash or claims to cash. Realized. Revenues are realized when goods and services are exchanged for cash or claims to cash (receivables). Revenue recognition principle. The principle that provides that revenue is recognized when (1) it is realized or realizable and (2) it is earned. *Substantial performance. When the franchisor has no remaining obligation to refund any cash received or excuse any nonpayment of a note and has performed all the initial services required under the contract. Chapter 18: Revenue Recognition 18-9 ____________________________________________________________________________________ CHAPTER OUTLINE Fill in the outline presented below. (L.O. 1) The Revenue Recognition Principle (L.O. 2) Revenue Recognition at Point of Sale (Delivery) Sales with Discounts Sales When Right of Return Exists Sales with Buyback Agreements Bill and Hold Sales Principal-agent Relationship Trade Loading and Channel Stuffing Multiple-Deliverable Arrangements Revenue Recognition Before Delivery Revenue Recognition During Production (L.O. 3) Percentage-of-Completion Method (L.O. 4) Completed-Contract Method (L.O. 5) Losses on Long-Term Contracts 18-10 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ Chapter Outline (continued) (L.O. 6) Installment Sales Method Uncollectible Accounts Defaults and Repossessions (L.O. 7) Cost Recovery Method Deposit Method *(L.O. 8) Franchises *Initial Franchise Fees *Continuing Franchise Fees *Bargain Purchases *Options to Purchase Chapter 18: Revenue Recognition 18-11 ____________________________________________________________________________________ REVIEW QUESTIONS AND EXERCISES TRUE-FALSE Indicate whether each of the following is true (T) or false (F) in the space provided. _____ 1. (L.O. 1) FASB Concepts Statement No. 5 provides that revenue is recognized when (a) it is collected and (b) the earning process is complete. _____ 2. (L.O. 2) Transactions for which sales recognition is postponed because of a high ratio of returned merchandise should not be recognized as sales until the return privilege has substantially expired. _____ 3. (L.O. 2) In consignment sales accounting, merchandise shipped on consignment remains the property of the consignor until sold. _____ 4. (L.O. 2) Expenses paid by the consignor in a consignment arrangement are normally deducted from any commission earned by the consignee. _____ 5. (L.O. 2) Consignment accounting represents a method of postponing the recognition of revenue until it is known that a sale to a third party has occurred. _____ 6. (L.O. 2) Trade loading and channel stuffing are management and marketing policy decisions and actions that hype sales, distort operating results, and window dress financial statements. _____ 7. (L.O. 3) The accounting profession indicates that the percentage-of-completion method is preferred in accounting for long-term construction contracts only when estimates of costs to complete and extent of progress toward completion are verified by an independent certified public accountant. _____ 8. (L.O. 3) Under the cost-to-cost basis, the percentage of completion is measured by comparing costs incurred to date with the most recent estimate of revenues collected to date. _____ 9. (L.O. 3) Under the percentage-of-completion method, the difference between the Construction in Process and the Billings on Construction in Process accounts is reported in the balance sheet as a current asset if a debit, and as a contra asset if a credit. _____ 10. (L.O. 4) The principal advantage of the completed-contract method in accounting for longterm construction contracts is that reported income is based on final results rather than on estimates of unperformed work. _____ 11. (L.O. 4) The major disadvantage of the completed-contract method as compared with the percentage of-completion method is that total net income over the life of the construction contract is normally smaller under the completed-contract method. 18-12 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ _____ 12. (L.O. 4) The annual entries to record costs of construction, progress billings, and collections from customers under the completed-contract method would be identical to those illustrated under the percentage-of-completion method with the significant exclusion of the recognition of revenue and gross profit. _____ 13. (L.O. 4) When there is a loss in the current period on a profitable contract, under both the percentage-of-completion and the completed-contract methods, the estimated cost increase requires a current period adjustment of excess gross profit recognized on the project in prior periods. _____ 14. (L.O. 5) The completion of production basis is permitted by GAAP. _____ 15. (L.O. 6) Because payment for a product sold on an installment basis is spread over a relatively long period, the risk of loss resulting from uncollectible accounts is greater in installment sales transactions than in ordinary sales. _____ 16. (L.O. 6) Under the installment sales method, emphasis is placed on collection rather than on sale, and revenue is considered unrealized until the entire sales price has been collected. _____ 17. (L.O. 6) The difference between realized gross profit and deferred gross profit on installment sales is based on the cash collections related to the installment sales. _____ 18. (L.O. 6) Repossessed merchandise as a result of a defaulted installment sales contract should be recorded at the best possible estimate of what the item can ultimately be resold for in the second-hand market. _____ 19. (L.O. 6) Deferred gross profit on installment sales is generally treated as consisting entirely of unearned revenue and is classified as a current liability. _____ 20. (L.O. 6) According to the APB, the installment method of recognizing revenue is restricted to those cases in which receivables are collectible over an extended period of time and there is no reasonable basis for estimating the degree of collectability. _____ 21. (L.O. 6) When interest is involved in installment sales, it should be accounted for as an addition to gross profit recognized on the installment sales collections during the period. _____ 22. (L.O. 7) Under the cost recovery method, deferred gross profit is offset against the related receivable—reduced by collections—on the balance sheet. _____ 23. (L.O. 7) The deposit method postpones recognizing a sale until a determination can be made as to whether a sale has occurred for accounting purposes. _____*24. (L.O. 8) A franchiser must disclose all significant commitments and obligations resulting from franchise agreements, including a description of services that have not yet been substantially performed. _____*25. (L.O. 8) Franchise companies derive their income almost exclusively from the collection and amortization of initial franchise fees. Chapter 18: Revenue Recognition 18-13 ____________________________________________________________________________________ MULTIPLE CHOICE Select the best answer for each of the following items and enter the corresponding letter in the space. _____ 1. (L.O. 1) Which of the following is not an accurate representation concerning revenue recognition? A. B. C. D. _____ 2. Revenue from selling products is recognized at the date of sale, usually interpreted to mean the date of delivery to customers. Revenue from services rendered is recognized when cash is received or when services have been performed. Revenue from permitting others to use enterprise assets is recognized as time passes or as the assets are used. Revenue from disposing of assets other than products is recognized at the date of sale. (L.O. 2) Which of the following is not a condition that must be present for a company to recognize revenue at the time of sale when the company gives the buyer the right to return the product? A. B. C. D. The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product. The present value of the future returns can be reasonably estimated. The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer. The seller’s price to the buyer is substantially fixed or determinable at the date of sale. _____ 3. (L.O. 2) Which of the following is not an accurate statement regarding consignment arrangements? A. The merchandise shipped on consignment remains the property of the consignor until sold. B. Since the merchandise shipped remains the property of the consignor, the consignee has no legal obligation regarding any damage to the merchandise. C. The consignee is entitled to reimbursement from the consignor for expenses paid in connection with selling the goods and is generally entitled to a commission at an agreed rate on sale actually made. D. The consignor accepts the risk that the goods on consignment might not sell and thus relieves the consignee of the need to commit working capital to inventory. _____ 4. (L.O. 2) Theoretically, freight costs incurred in the transfer of consigned goods from the consignor to the consignee should be considered: A. B. C. D. an expense by the consignee. an expense by the consignor. inventoriable by the consignee. inventoriable by the consignor. 18-14 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ _____ 5. (L.O. 3) The profession requires that the percentage-of-completion method be used when estimates of progress toward completion, revenues, and costs are reasonably dependable and three specific conditions exist. Which of the following is not one of the three required conditions? A. The buyer can be expected to satisfy all obligations under the contract. B. The contract clearly specifies the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement. C. The asset being constructed is a tangible asset to be used in the production of the purchasing entity’s product or the rendering of its service. D. The contractor can be expected to perform the contractual obligation. _____ 6. (L.O. 3) One of the more popular input measures used to determine the progress toward completion in the percentage-of-completion method is: A. B. C. D. revenue-percentage basis. cost-percentage basis. progress completion basis. cost-to-cost basis. The following information relates to questions 7 and 8. Cushing Corporation recently received a long-term contract to construct a luxury liner. The contract will take 3 years to complete at a cost of $3,500,000. The price of the liner is set at $5,000,000. The cost estimates at the end of the first year are in line with original estimates, and $1,050,000 of costs were incurred during the first year. _____ 7. (L.O. 3) The amount of income recognized during the first year using the percentage-ofcompletion method is: A. B. C. D. _____ 8. $1,500,000. $1,050,000. $ 735,000. $ 450,000. (L.O. 3) At the end of the first year which of the following entries would be made to recognize revenue on the contract? A. B. C. D. Accounts Receivable - Construction Contract Revenue on Long-Term Contract Billings on Construction Contract Revenue on Long-Term Contract Construction in Process Revenue on Long-Term Contract Billings on Construction Contract Construction in Process Chapter 18: Revenue Recognition 18-15 ____________________________________________________________________________________ The following information relates to questions 9 and 10. Bretts Construction Company had a contract starting April 2013, to construct a $6,000,000 building that is expected to be completed in September 2015, at an estimated cost of $5,500,000. At the end of 2013, the costs to date were $2,530,000 and the estimated total costs to complete had not changed. The progress billings during 2013 were $1,200,000 and the cash collected during 2013 was $800,000. _____ 9. (L.O. 3) For the year ended December 31, 2013, Bretts would recognize gross profit on the building of: A. $210,833 B. $230,000 C. $270,000 D. $ 0 _____ 10. (L.O. 3) At December 31, 2013, Bretts would report Construction in Process in the amount of: A. B. C. D. _____ 11. (L.O. 4) In accounting for long-term construction-type contracts construction costs are accumulated in an inventory account called Construction in Process under the: A. B. C. D. _____ 12. Percentage-ofCompletion Method Yes Yes No No CompletedContract Method Yes No Yes No (L.O. 4) Under the completed-contract method of accounting for long-term construction contracts, interim charges and/or credits to the income statement are made for: A. B. C. D. _____ 13. $ 230,000 $2,530,000 $2,760,000 $2,360,000 Revenues Yes No No Yes Costs No No Yes Yes Gross Profit No No No Yes (L.O. 4) The principal advantage of the completed-contract method is that: A. B. C. D. reported revenue is based on final results rather than estimates of unperformed work. it reflects current performance when the period of a contract extends into more than one accounting period. it is not necessary to recognize revenue at the point of sale. a greater amount of gross profit and net income is reported then is the case when the percentage-of-completion method is used. 18-16 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ _____ 14. (L.O. 4) The Nathan Company is involved in the construction of an asset under a long-term construction contract. At the end of the third year of the five year contract, the cost estimates indicate that a loss will result on the completion of the entire contract. In accounting for this contract, the entire expected loss must be recognized in the current period under the: A. B. C. D. _____ 15. B. C. D. Under both the percentage-of-completion and the completed contract methods, the estimated cost increase requires a current period adjustment of excess gross profit recognized on the project in prior periods. Under the percentage-of-completion method only, the estimated cost increase requires a current period adjustment of excess gross profit recognized on the project in prior periods. Under the completed contract method only, the estimated cost increase requires a current period adjustment of excess gross profit recognized on the project in prior periods. No current period adjustment is required. (L.O. 7) Which of the following methods or bases is used when the collectibility of the receivable is so uncertain that gross profit (or income) is not recognized until cash is received? A. B. C. D. _____ 18. Automobiles. Large appliances. Single family residential units. Precious metals. (L.O. 5) When there is a significant increase in the estimated total contract costs but the increase does not eliminate all profit on the contract, which of the following is correct? A. _____ 17. CompletedContract Method No Yes Yes No (L.O. 4) For which of the following products is it appropriate to recognize revenue at the completion of production even though no sale has been made? A. B. C. D. _____ 16. Percentage-ofCompletion Method Yes Yes No No Percentage-of-completion method. Completed-contract method. Installment sales method. Deposit method. (L.O. 6) Under the installment sales accounting method certain items related to the sale are recognized in the period of the sale and certain items are recognized in the period in which cash is collected. Of the following items, which are recognized in the period of sale and which are recognized in the period in which the cash is collected? A. B. C. D. Revenues Sale Sale Sale Cash Cost of Sales Sale Cash Sale Cash Gross Profit Cash Sale Cash Sale Other Expenses Cash Cash Sale Cash Chapter 18: Revenue Recognition 18-17 ____________________________________________________________________________________ _____ 19. (L.O. 6) The realization of income on installment sales transactions involves: A. B. C. D. recognition of the difference between the cash collected on installment sales and the cash expenses incurred. deferring the net income related to installment sales and recognizing the income as cash is collected. deferring gross profit while recognizing operating or financial expenses in the period incurred. deferring gross profit and all additional expenses related to installment sales until cash is ultimately collected. The following information relates to questions 20-22. During 2014, Trang Corporation sold merchandise costing $500,000 on an installment basis for $800,000. The cash receipts related to these sales were collected as follows: 2014, $250,000; 2015, $450,000; 2016, $100,000. _____ 20. (L.O. 6) What is the rate of gross profit on the installment sales made by Trang Corporation during 2014? A. B. C. D. _____ 21. (L.O. 6) If expenses, other than the cost of the merchandise sold, related to the 2014 installment sales amounted to $60,000, by what amount would Trang’s net income for 2014 increase as a result of installment sales? A. B. C. D. _____ 22. $240,000. $190,000. $ 71,250. $ 33,750. (L.O. 6) What amounts would be shown in the December 31, 2015 financial statements for realized gross profit on 2014 installment sales, and deferred gross profit on 2014 installment sales, respectively? A. B. C. D. _____ 23. 37.5%. 50%. 60%. 62.5%. $168,750 and $37,500. $262,500 and $37,500. $131,250 and $50,000. $0 and $0. (L.O. 6) Deferred gross profit on installment sales is generally treated as: A. B. C. D. an owners’ equity account until collection. unearned revenue and is classified as a current liability. unearned revenue and is classified as a deferred charge on the balance sheet. unearned revenue and is allocated between income tax liability, allowance for bad debts, and net income. 18-18 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ _____ 24. (L.O. 7) Some companies defer the recognition of revenue because the collection of the sales price is not reasonably assured. One method employed to defer revenue recognition is the cost recovery method. Under the cost recovery method profit is not recognized until: A. B. C. D. _____*25. the entire sales price is collected. the seller is convinced that collection is assured beyond a reasonable doubt. the buyer formally accepts delivery of the merchandise involved in the sale. cash payments by the buyer exceed the seller’s cost of the merchandise sold. (L.O. 8) Initial franchise fees, are recorded as revenue only when and as the franchisor makes substantial performance of the services it is obligated to perform and: A. B. C. D. the franchise agreement will last for 5 years or more. the franchisee has the financial support of a local bank. collection of the fee is reasonably assured. the franchisee maintains a specified minimum profit level. Chapter 18: Revenue Recognition 18-19 ____________________________________________________________________________________ REVIEW EXERCISES 1. (L.O. 1, 2, 3, 4, 6 and *8) Match the revenue transaction listed on the left with the point of revenue realization generally considered appropriate listed on the right. ____ ____ ____ 1. 2. 3. ____ 4. ____ ____ 5. 6. Revenue Transaction Cash sales of merchandise Sales of merchandise on account Percentage-of-completion method on long-term construction project Completed-contract method on long-term construction project Installment sales Consignment sales Point of Realization A. When accounts receivable are collected B. When the designated agent collects the purchase price C. Date of delivery to customer D. When the designated agent submits an “account sales” E. As completion of the agreement by the seller progresses 2. (S. O. 3) Melanie Construction Company entered into a contract to construct a building for Steve Elbert. The contract called for a flat fee of $900,000, and specified that a progress report be given periodically as to percentage of completion. Construction activities for the first two years are summarized below: 2014: 2015: Construction costs incurred during the year amounted to $172,800; estimated cost to complete, $547,200. Construction costs incurred during the year amounted to $385,450; estimated cost to complete, $166,750. Instructions: Using the percentage-of-completion method, compute the amount of gross profit Melanie Construction Company should recognize in 2014 and 2015 as a result of this contract. ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 18-20 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ 3. (S. O. 3 and 4) Meyer Corporation uses the percentage-of-completion method to account for work performed under long-term construction contracts. Meyer began work under contract #7031-21, which provided for a contract price of $3,645,000. Additional data is as follows: Costs incurred during the year................................... Estimated costs to complete, as of December 31....... Billings during the year ............................................. Collections during the year........................................ 2012 $563,000 1,500,000 580,000 525,000 2013 $1,764,000 -02,875,000 2,670,000 Instructions: a. b. What portion of the total contract price would be recognized as revenue in 2014 and in 2015? Prepare a complete set of journal entries for 2014 under the (1) percentage-of completion method, and (2) the completed-contract method. a. ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ Chapter 18: Revenue Recognition 18-21 ____________________________________________________________________________________ b. General Journal Date Account Title J1 Debit Credit 18-22 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ 4. (L.O. 7) The following information was taken from the records of Locken Corporation for the years indicated. The company’s year end is December 31. Sales (on installment) Cost of sales Gross Profit Cash receipts: 2014 sales 2015 sales 2016 sales 2014 $450,000 342,000 $108,000 2015 $500,000 360,000 $140,000 2016 $620,000 434,000 $186,000 $125,000 $280,000 210,000 $ 45,000 230,000 250,000 Instructions: Calculate the amount of realized gross profit on installment sales and deferred gross profit to be reported in the year-end financial statements of Locken Corporation for the three years noted. ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ Chapter 18: Revenue Recognition 18-23 ____________________________________________________________________________________ 5. (L.O.7) Gardin Company uses the installment sales method to account for its installment sales. On January 1, 2014, Gardin Company had an installment account receivable from Silverman Company in the amount of $2,300. Silverman paid a total of $500 on the account during 2014. However, late in 2012 Silverman discontinued payments and the merchandise was repossessed. When the merchandise was repossessed it had a fair market value of $720. Gardin Company spent an additional $75 to recondition the merchandise. When the repossessed merchandise was originally sold, it was to yield a 45% gross profit rate. Instructions: Prepare the journal entries on the books of Gardin Company to record all transactions with Silverman Company during 2014. General Journal Date Account Title J1 Debit Credit 18-24 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES TRUE-FALSE 1. (F) 2. (T) 3. (T) 4. (F) 5. (T) 6. (T) 7. (F) The accounting profession considers the percentage-of-completion method preferable when estimates of cost to complete and extent of progress toward completion of long-term contracts are reasonably dependable. There is no necessity to have these estimates verified by an independent third party. In 1981, the AICPA recommended that the completedcontract method and the percentage-of-completion method be used in specified circumstances and that these two methods not be viewed as acceptable alternatives in the same circumstances. 8. (F) Under the cost-to-cost basis, the percentage-of-completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract. 9. (F) Under the percentage-of-completion method, the difference between the Construction in Process and the Billings on Construction in Process accounts is reported in the balance sheet as a current asset if a debit, and as a current liability if a credit. 10. (T) 11. (F) 12. (T) 13. (F) 14. (T) 15. (T) The revenue recognition principle adopted by the FASB has revenue recognized when (1) it is realized or realizable and (2) it is earned. Revenues are realized when goods and services are exchanged for cash or claims to cash (receivables). Revenues are realizable when assets received in exchange are readily convertible to known amounts of cash or claims to cash. Revenues are earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. The consignee acts as an agent for the consignor in selling merchandise. The consignee earns a commission upon the sale of the consigned merchandise. However, expenses incurred by the consignor are not deducted from the commissions earned by the consignee. The total net income or gross profit over the life of a construction contract is the same under both the percentage-of-completion method and the completed-contract method. The major difference between the methods is the timing of the recognition of gross profit during the life of the contract. When there is a loss in the current period on a profitable contract, under the percentage-ofcompletion method only, the estimated cost increase requires a current period adjustment of excess gross profit recognized on the project in prior periods. Chapter 18: Revenue Recognition 18-25 ____________________________________________________________________________________ 16. (F) This statement is false because each time a portion of the revenue from an installment sale is collected, it is recognized as revenue. The statement in this question reads “...until the entire sales price is collected” which makes it false. 17. (T) 18. (F) 19. (T) 20. (T) 21. (F) 22. (T) 23. (T) *24. (T) *25. (F) The objective with respect to repossessed merchandise is to put it on the books at its fair value or, when fair value is not ascertainable, at the best possible approximation of fair value. When interest is involved in installment sales, it should be accounted for separately as interest revenue distinct from the gross profit recognized on the installment sales collections during the period. Franchise companies derive their revenue from one or both of two sources: (1) from the sale of initial franchise and related assets or services and (2) from continuing fees based on the operations of franchises. MULTIPLE CHOICE 1. (B) Revenues from services rendered is recognized when services have been performed and are billable. The receipt of cash does not necessarily signal the recognition of revenue. 2. (B) The FASB has concluded that if a company sells its product but gives the buyer the right to return it, then revenue from the sales transaction shall be recognized at the time of sale only if all of the following six conditions have been met: 1. 2. 3. 4. 5. 6. The seller’s price to the buyer is substantially fixed or determinable at the date of sale. The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product. The buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product. The buyer acquiring the product for resale has economic substance apart from that provided by the seller. The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer. The amount of future returns can be reasonably estimated. 18-26 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ 3. (B) When a consignee accepts merchandise on a consignment arrangement, he or she agrees to exercise due diligence in caring for and selling the merchandise. If the consignee does not exercise due diligence in caring for the merchandise, he or she will be liable for damages sustained. 4. (D) Freight costs are necessary costs incurred in bringing consigned goods to the condition and location required for sale. This is the responsibility of the consignor and should be recognized as an inventoriable cost. 5. (C) The specific conditions make no mention of the asset which is the subject of the contract. The other three alternatives include conditions which must be met for mandatory use of the percentage-of-completion method. 6. (D) The cost-to-cost basis is a popular input method and is often used to determine the progress toward completion when the percentage-of-completion method is used. Under the cost-to-cost basis, the percentage of completion is measured by dividing the costs incurred to date by the most recent estimate of the total costs to complete the contract. 7. (D) Total cost................................................................ ............ Cost incurred............................................ .......................... . $3,500,000 $1,050,000 % of total cost incurred $1,050,000 ÷ $3,500,000 =.30 Estimated income: $5,000,000 - $3,500,000 = $1,500,000 Income recognized in the first year $1,500,000 x .30 = $450,000 8. (C) Under the percentage-of-completion method, the Construction in Process account is used to record revenue throughout the contract period. 9. (B) Bretts would calculate the estimated total gross profit and the percentage completed on the building as follows: Contract price Less estimated cost: Costs to date $2,530,000 Estimated costs to complete 2,970,000 Estimated total costs Estimated total gross profit Percent complete ($2,530,000/$5,500,000): $6,000,000 5,500,000 $ 500,000 46% Therefore the gross profit recognized in 2013 would be $230,000 (46 % of $500,000). 10. (C) $2,530,000 of costs are accumulated in the Construction in Process account to maintain a record of the total costs incurred. In addition, the gross profit of $230,000 computed in 9. above would also be debited to Construction in Process. Therefore at December 31, 2013, the account Construction in Process would have an ending balance of $2,760,000 ($2,530,000 + $230,000). Chapter 18: Revenue Recognition 18-27 ____________________________________________________________________________________ 11. (A) Both the percentage-of-completion method and the completed-contract method use the Construction in Process account to accumulate construction costs during the period of the contract. In addition to construction costs, gross profit earned to date is included in the Construction in Process account under the percentage-of-completion method. 12. (B) Under the completed-contract method, costs of long-term contracts in process and current billings are accumulated, but there are no interim changes or credits to income statement accounts for revenues, costs, and gross profit. 13. (A) The completed-contract method recognizes revenue and gross profit only at the point of sale, that is, when the contract is completed. Thus, reported revenue is based on final results rather than estimates of unperformed work as is the case with the percentage-ofcompletion method. The final amount of gross profit is the same under the completedcontract method as it is under the percentage-of-completion method. The major difference is the pattern of recognition. 14. (B) Cost estimates at the end of the current period may indicate that a loss will result on completion of the entire contract. Under both the percentage-of-completion method and the completed-contract method, the entire expected contract loss must be recognized in the current period. 15. (D) In the case of precious metals with assured prices, revenue is recognized at the completion of production even though no sale has been made. Revenue is recognized when these metals are mined because the sales price is reasonably assured, the units are interchangeable, and no significant costs are involved in distributing the product. The other three products noted in alternatives A, B, and C do not meet all these characteristics. 16. (B) When there is a significant increase in the estimated total contract costs but the increase does not eliminate all profit on the contract, under the percentage-of-completion method only, the estimated cost increase requires a current period adjustment of excess gross profit recognized on the project in the prior periods. 17. (C) The installment sales method is used when the collectibility of the receivable is so uncertain that gross profit (or income) is not recognized until cash is received. (A) The percentage-of-completion method is used for long-term contracts when estimates of progress toward completion, revenues, and costs are reasonably dependable and (1) the contract clearly specifies certain enforceable rights, (2) the buyer can be expected to satisfy all obligations under the contract, and (3) the contractor can be expected to perform the contractual obligation. (B) The completed-contract method is used when (1) an entity has primarily short-term contracts, or (2) when the conditions for using the percentage-of-completion method cannot be met, or (3) when there are inherent hazards in the contract beyond the normal, recurring business risks. (D) The deposit method is used when there is not sufficient transfer of the risks and rewards of ownership. 18. (C) Both revenues and cost of sales are recognized in the period of sale but the related gross profit is deferred to those periods in which cash is collected. Thus, instead of the sale being deferred to the future periods of anticipated collection and then related costs and expenses being deferred, only proportional gross profit is deferred. Other expenses, that is, selling expense, administrative expense, and so on, are not deferred. 19. (C) Under the installment method of accounting, gross profit recognition is deferred until the period of cash collection. Both revenues and cost of sales are recognized in the 18-28 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ period of sale, but the related gross profit is deferred to those periods in which cash is collected. Thus, instead of the sale being deferred to the future periods of anticipated collection and then related costs and expenses being deferred, only the proportional gross profit is deferred, which is equivalent to deferring both sales and cost of sales. Other expenses such as selling expense and administrative expense are not deferred. 20. (A) Rate of gross profit is computed by dividing the gross profit by the sales price. G.P. ($800,000 - $500,000)...................... Sales Price ................................................ Rate of G.P. ($300,000 ÷ $800,000) ........ $300,000 800,000 37.5% 21. (D) Realized gross profit ($250,000 x 37.5%) Less expenses Increase in net income $ 93,750 60,000 $33,750 22. (A) Total gross profit ($800,000 - $500,000) Gross profit realized in: 2014 ($250,000 x 37.5%) 2015 ($450,000 x 37.5%) 2016 ($100,000 x 37.5%) $300,000 $ 93,750 168,750 37,500 The December 31, 2015, financial statements will show realized gross profit of $168,750 and deferred gross profit of $37,500 resulting from 2014 installment sales. 23. (B) Deferred gross profit on installment sales is generally treated as unearned revenue and is classified as a current liability. Theoretically, deferred gross profit consists of three elements: (1) income tax liability to be paid when the sales are reported as realized revenue; (2) allowance for collection expense, bad debts, and repossession losses; and (3) net income. Because of the difficulty in allocating deferred gross profit among these three elements, however, the whole amount is frequently reported as unearned revenue. 24. (D) Under the cost recovery method, after all costs have been recovered, any additional cash collections are included in income. Thus, profit is not recognized until cash payments by the buyer exceed the seller’s cost of merchandise sold. This method is used where a high degree of uncertainty exists related to collection of receivables. *25. (C) The initial franchise fee is considered for establishing the franchise relationship and providing some initial services. Such fees are recorded as revenue only upon substantial performance by the franchiser and when collection of the initial franchise fee is reasonably assured. Chapter 18: Revenue Recognition 18-29 ____________________________________________________________________________________ REVIEW EXERCISES 1. 1. 2. 3. 2. C C E 4. 5. 6. C A D 2014: Contract price ....................................................... Less: Cost to date ..................................................... Estimated cost to complete ............................. Estimated total cost ............................................... Estimated total income .......................................... Income recognized in 2014: ($172,800 ÷ 720,000) X $180,000 $900,000 $172,800 547,200 720,000 $180,000 $43,200 2015: Contract price............................................................................ Less: Cost to date ($172,800 + $385,450) ................................. Estimated cost to complete ............................................... Estimated total cost ................................................................... Estimated total income.............................................................. Income recognized in 2015: ($558,250 ÷725,000) X $175,000 $134,750 Less 2014 recognized income 43,200 $ 91,550 3. a. 2014: $558,250 166,750 725,000 $175,000 $563, 000 X $3,645,000 = $994,733 $2, 063, 000 2015: b. $900,000 Contract Price Revenue Recognized in 2014 Revenue Recognized in 2015 $3,645,000 994,733 $2,650,266 (1) Percentage-of-Completion Method - 2014 Construction in Process Materials, Cash, Payable, etc. Accounts Receivable Billings on Construction in Process Cash Accounts Receivable Construction in Process Construction Expense Revenue-Long-Term Contracts (see a) *[$3,645,000 - ($563,000 + $1,500,000) x ($563,000/($563,000 + $1,500,000))] 563,000 563,000 580,000 580,000 525,000 525,000 431,733* 563,000 994,733 18-30 Student Study Guide for Intermediate Accounting, 15th Edition ____________________________________________________________________________________ (2) Completed-Contract Method - 2014 Under the completed-contract method, all the above entries are made except for the last entry. No income is recognized until the contract is completed. 4. Rate of Gross Profit on sales ......................... Realized Gross Profit 2014 sales .............................................. 2015 sales .............................................. 2016 sales .............................................. Realized Gross Profit 12-31 .......................... Deferred Gross Profit: 2014 sales .............................................. 2015 sales .............................................. 2016 sales .............................................. Deferred Gross Profit 12-31 .......................... 5. 2014 24% 2015 28% 2016 30% $30,000 $67,200 58,800 $30,000 $126,000 $10,800 64,400 75,000 $150,200 $78,000 $ 10,800 81,200 $ 16,800 111,000 $127,800 $ 92,000 $78,000 Cash Accounts Receivable (To record collection of cash on installment receivables) 500 Deferred Gross Profit ($500 X 45%) Realized Gross Profit (To recognize gross profit on installment sale) 225 Repossessed Merchandise Deferred Gross Profit (45% X $1,800) Loss on Repossession Installment Accounts Receivable (To record default and repossessed merchandise) 720 810 270 Repossessed Merchandise Cash (To record cash spent on reconditioning) 75 500 225 1,800 75