Chapter 8 8-27
8
Revenue Recognition
Overview
Revenue recognition, on the surface, seems to be a straightforward topic, and so you may be wondering why an entire chapter is devoted to it. As mentioned in Chapter 6, revenue recognition, or rather improper revenue recognition in some instances, is one of the main methods of earnings management. While there are some basic guidelines for revenue recognition, there are also many kinds of transactions that don’t easily fall under these fundamental rules; there are fuzzy areas and exceptions for certain types of transactions.
Typically revenue should be recognized when two criteria are met. The first is that payment has been received or is collectible. The second is that the earnings process needs to be substantially complete, which generally means that a product has been delivered or a service has been performed.
SAB 101provides additional guidance and specific examples related to the above two criteria. The SEC released these standards to combat specific revenue recognition abuses that had come to their attention.
For companies in the construction industry, there are two permissible methods to recognizing revenue. The more common method is known as the percentage-of-completion method. Under this method, the company providing the construction recognizes revenue as they complete the work. The other method is more conservative and is known as the completed-contract method. Revenue isn’t recognized until the contract is completed, as the name indicates, under this second method. Similar methods are available for long-term service contracts as there are for construction contracts.
Under the typical revenue recognition system, payment needs to be realizable. What happens when the realizability is in question? Under this scenario, another method known as the installment sales method comes into play. In more extreme instances, cost recovery or a pure cash method can be the correct method to use in recognizing revenue.
Learning Objectives
Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that this section of the chapter is second nature to you before you attempt the homework, a quiz, or exam. This important piece of the chapter serves as your CliffsNotes or “cheat sheet” to the basic concepts and principles that must be mastered.
If after reading this section of the chapter you still don’t feel comfortable with all of the Learning Objectives covered, you will need to spend additional time and effort reviewing those concepts that you are struggling with.
The following “Tips, Hints, and Things to Remember” are organized according to the Learning Objectives (LOs) in the chapter and should be gone over after reading each of the LOs in the textbook.
Tips, Hints, and Things to Remember
LO1 – Identify the primary criteria for revenue recognition.
How? Typical revenue recognition is based on a two-prong approach. Both prongs must be met before revenue should usually be recognized. The product should change hands (or if it is a service, it should have been performed), and the cash should be realized (in hand) or realizable (an accounts receivable or other receivable expected to be collected).
The most common method of revenue recognition is referred to as point-of-sale recognition. This is the method that you have experienced up until now, which usually includes a debit to Accounts Receivable or Cash and a credit to Sales when the merchandise is handed over or shipped. Don’t forget this method just because others are covered in this chapter as it is, by far, the most common for most companies.
LO2 – Discuss the revenue recognition issues, and abuses, underlying the examples used in SAB 101.
Why? Why is SAB 101 necessary given that criteria has already been established for revenue recognition? There are many fuzzy areas when it comes to revenue recognition. Many transactions are not black and white when it comes to meeting both of the criteria required for revenue recognition. Companies sometimes took advantage of their circumstances to book revenue earlier or book larger amounts. The SEC issued this SAB to clarify these fuzzy areas and limit revenue recognition policies that they deemed to be too aggressive.
Why? Don’t skip reading the details in LO2. Understanding the whys of SAB 101 and the underlying themes that the SEC illustrates will help enable you to be able to see when it is appropriate to record revenue in nearly any given fact pattern—even if it isn’t one specifically addressed in the Staff Accounting Bulletin gone over in this learning objective.
LO3 – Describe the contract approach to revenue recognition that is currently being considered by the FASB and IASB.
Why? The focus of this section is a contract approach to revenue recognition which contains three basic steps: identify the performance obligations accepted by a seller in its contracts with its buyers; for multiple-element transactions, allocate transaction prices based on relative separate selling prices; and recognize revenue when performance obligations are satisfied. In essence, revenue is recognized when the seller satisfies the obligation to the buyer.
LO4 – Record journal entries for long-term construction-type contracts using percentage-of-completion and completed-contract methods.
How? Note the journal entries for percentage-of-completion and completed-contract methods are the same with the exception of the entry that debits both Cost of Long-Term Construction Contracts and Construction in Progress accounts and credits Revenue from Long-Term Construction Contracts each year. For the completed-contract method, this entry is made only in the year in which the contract is completed, and Construction in Progress does not receive a debit. Under the completed-contract method, the Construction in Progress account never “stores” a profit component associated with the project.
LO5 – Record journal entries for long-term service contracts using the proportional performance method.
How? Although the journal entries look a bit different (mostly because of differing account names) than those encountered in LO4, the theory behind this method is similar to the percentage-of-completion method. Revenue is recognized over the period of the contract based on the services performed, not on the timing of the cash collections.
LO6 – Explain when revenue is recognized after delivery of goods or services through installment sales, cost recovery, and cash methods.
How? Be very careful when performing an installment sales calculation. Students frequently get them confused with the percentage-of-completion calculations since they are covered in the same chapter. The methods couldn’t be more different. A couple of things to remember:
· Installment sales apply to sales for which the product has usually been delivered, but the payments are coming in installments, and there is uncertainty of cash collections. Contrast this with the percentage-of-completion method in which the product is being delivered in “installments” and the payments are reasonably expected to be collected.
· The installment sales method recognizes revenue based, in large part, on when cash is received. Contrast this with the percentage-of-completion method in which the calculation for revenue recognition completely ignores when cash is received.
The following sections, featuring various multiple choice questions, matching exercises, and problems, along with solutions and approaches to arriving at the solutions, is intended to develop your problem-solving and critical-thinking abilities. While learning through trial and error can be effective for improving your quiz and exam scores, and it can be a more interesting way to study than merely re-reading a chapter, that is only a secondary objective in presenting this information in this format.
The main goal of the following sections is to get you thinking, “How can I best approach this problem to arrive at the correct solution—even if I don’t know enough at this point to easily come up with the proper results?” There is not one simple approach that can be applied to all questions to arrive at the right answer. Think of the following approaches as possibilities, as tools that you can place in your problem-solving toolkit—a toolkit that should be consistently added to. Some of the tools have yet to even be created or thought of. Through practice, creative thinking, and an ever expanding knowledge base, you will be the creator of the additional tools.
Multiple Choice
MC8-1 (LO1) Revenues and gains are generally recognized when
a. / cash has been received.b. / cash has been received and they have been earned through substantial completion.
c. / they are realized or realizable and a contract has been signed.
d. / they are realized or realizable and have been earned through substantial completion.
MC8-2 (LO2) In accounting for sales on consignment, sales revenue and the related cost of goods sold should be recognized by the
a. / consignor when the goods are shipped to the consignee.b. / consignor when the consignee has sold the goods.
c. / consignee when the goods are shipped to the third party.
d. / consignee when cash is received from the customer.
MC8-3 (LO4) Lena Construction Company’s projects extend over several years, and collection of receivables is reasonably certain. Each project has a contract that specifies a price and the rights and obligations of all parties. Both the contractor and the customer are expected to fulfill their contractual obligations on each project. Reliable estimates can be made of the extent of progress and cost to complete each project. Which of the following methods should the company use to account for construction revenue?
a. / Installment sales methodb. / Percentage-of-completion method
c. / Completed-contract method
d. / Cost recovery method
MC8-4 (LO4) How should the balances of Progress Billings on Construction Contracts and Construction in Progress be shown at reporting dates prior to the completion of a long-term contract?
a. / Progress Billings on Construction Contracts as income, Construction in Progress as inventory.b. / Progress Billings on Construction Contracts as deferred income, Construction in Progress as a current asset.
c. / Net—as income from construction if credit balance and loss from construction if debit balance.
d. / Net—as a current asset if debit balance and current liability if credit balance.
MC8-5 (LO4) If the percentage-of-completion method is used, what is the basis for determining the gross profit to be recognized in the second year of a three-year contract?
b. / incremental cost for the second year only
c. / cumulative actual costs and estimated costs to complete
d. / No gross profit would be recognized in year 2.
MC8-6 (LO4) Cooper Construction Company uses the completed-contract method for long-term construction contracts. The information for a specific contract as of January 1, 2013, is shown below.
Costs incurred to date / $ 700,000Contract price / 1,900,000
Estimated remaining cost to complete / 800,000
Cost of $600,000 was incurred during 2013, and on December 31, 2013, the estimated remaining cost to complete was still $800,000. The correct balance for the Construction in Progress account at December 31, 2013, is
a. / $600,000.b. / $700,000.
c. / $1,100,000.
d. / $1,300,000.
MC8-7 (LO4) COF Construction, Inc., uses the percentage-of-completion method of recognizing income. In 2013, COF started work on a $4,500,000 construction contract, which will be completed in 2014. The accounting records disclosed the following data as of the end of last year:
Progress billings / $1,650,000Costs incurred (actual costs during 2013 on the contract) / 1,350,000
Collections / 1,050,000
Estimated cost to complete (during 2014) / 2,700,000
How much income should COF have recognized on this contract in 2013?
a. / $105,000b. / $150,000
c. / $300,000
d. / $350,000
MC8-8 (LO5) SamSolutions enters into a $15,000 service contract with Denver Corp. on July 1, 2013. The contract allows Denver Corp. to obtain technical support on their SamSolutions software at no cost over the next three years beginning on July 1, 2013. SamSolutions receives $10,000 on July 1, 2013, and $5,000 on July 1, 2014, under the contract agreement. How much revenue should SamSolutions recognize for this long-term service contract for the six-month period ending December 31, 2013?
b. / $2,500
c. / $10,000
d. / $15,000
MC8-9 (LO6) The cost recovery method is
a. / used only when circumstances surrounding a sale are so uncertain that earlier recognition is impossible.b. / the most common method of accounting for real estate sales.
c. / similar to percentage-of-completion accounting.
d. / never acceptable under generally accepted accounting principles.
MC8-10 (LO6) When using the installment sales method,
a. / gross profit is deferred until all cash is received, but revenues and costs are recognized in proportion to the cash collected from the sale.b. / gross profit is recognized only after the amount of cash collected exceeds the cost of the item sold.
c. / total revenues and costs are recognized at the point of sale, but gross profit is deferred in proportion to the cash that is uncollected from the sale.
d. / revenue, costs, and gross profit are recognized proportionally as the cash is received from the sale of product.
MC8-11 (LO6) Graven Company began operations on January 1, 2013, and uses the installment sales method of accounting. The company has the following information available for 2013 and 2014: