Revenue Recognition

LOVETTE JAM PRADA JACOSALEM

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Operating Cycle
• Cash-to-cash.
▫ Receive cash from customer
▫ Purchase materials/services & pay cash
▫ Convert materials/services to salable product
▫ Inspect the product
▫ Store product
▫ Receive an order for the product
▫ Sell product
▫ Receive cash from customer
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Revenue Recognition:
When? (Timing) & How much? (Amount)
• At one point in revenue cycle (objectivity).
• Criteria:
▫ When? Earned (Conservatism)
 Normally, goods shipped.
 Service performed.
▫ How much? Realized or realizable (Realization).
 Already collected or collectible.
 Amount can be measured reliably.
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Basic Revenue Recognition Criteria

• Recognize revenue in earliest period in which:
▫ Entity has substantially performed what is
required in order to earn income;
▫ Amount of income can be reliably measured;
▫ Related assets received can readily be converted
to cash or claims for cash
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Timing of Revenue Recognition

Event Revenue Typical Revenue
Recognition at This Recognition Method
Time
1. Sales order received No None
2.Deposit or advanced No None
payment received
3. Goods are produced For certain long-term Percentage of
contracts completion
4. Production For precious metals and Production
completed; goods are certain agricultural
stored products
5. Goods shipped or Usually Delivery
services provided
6. Customer pays Collection is uncertain Installment
account receivable
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DELIVERY METHOD
• Recognize revenue when goods or services are
delivered.
• For goods: when title transfers.
▫ FOB shipping point (when goods are given to
carrier, the sale occurred at the shipping point).
▫ FOB destination (sale doesn’t occur until the
goods reach the destination)
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Consignment Method
• Consignor ships goods to consignee.
Inventory on consignment 1,000
Merchandise inventory 1,000
· Consignor retains title until goods are sold to
customer. At sale:
Accounts receivable 1,400
Sales revenue 1,400
COGS 1,000
Inventory on consignment 1,000
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Franchise Revenue
• Recognize:
▫ When earned.
▫ Not when agreement signed or fee received.

Cash 100,000
Unearned Revenue 100,000
Unearned Revenue 100,000
Revenue 100,000
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PERCENTAGE-OF-COMPLETION
METHOD
• Design/development and
construction/production projects that extends
over several years.
• Customer pays either fixed price or cost
reimbursement contract.
• Reasonable assurance of profit margin and
ultimate realization.
• Revenue recognized based on total percentage of
project work performed during period.
 5-10

Completed Contract Method

• Percentage of completion method required
unless:
▫ Amount of income to be earned on contract
cannot reasonably be determined.
• Alternative is completed contract method.
▫ Costs incurred are an asset (Contract Work in
Progress) until revenue is recognized.
Long-Term Contract Accounting Method
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PRODUCTION METHOD
• Applies to agricultural and mining.
• Criteria:
▫ Clear market determined price.
▫ Performance substantially complete.
 Minimal remaining costs.
• Permitted but not required by GAAP.
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INSTALLMENT METHOD
• Customer pays a certain amount per period.
• In pure installment method, installment
payment is recognized as revenue and a
proportional part of cost of sales is recorded.
• Under cost recovery method, cost is recorded
equal to installment payment until total cost of
sales is covered.
 5-14

Real Estate Sales

• Developer often finances over many years.
• Uncertainty of income due to uncertainty of
receipt of future payments.
• Conditions required for revenue recognition:
▫ Period allowing cancellation and refund to buyer has
expired.
▫ Cum payments equal to 10% of purchase price.
▫ Seller has completed or is clearly capable of
completing required improvement.
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AMOUNT OF REVENUE
RECOGNIZED
• Net realizable value (amount reasonably
estimated to be collected).
• 2 approaches:
▫ Direct write-off method.
▫ Allowance method.
 % of sales.
 % of (analysis of) AR.
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Direct Write-Off Method

• Write-off when specific account that is
uncollectible is identified.
• Requires that the specific uncollectible accounts
be identified.

Bad debt expense

Accounts receivable
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Allowance Method
• Estimate amount of current period credit sales
that will not be collected.
▫ Historical % tempered by judgment.
▫ Historical % of aged receivables (+judgment).
• Adjusting entry at end of period.
· When an uncollectible account is identified, it is
written off.
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Allowance Method (continued)

· Allowance for Doubtful Accounts is a contra-
asset account.
Bad debt expense
Allowance for Doubtful Accounts

· Collection of a bad debt that was written-off:

Cash
Allowance for Doubtful Accounts
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Sales Discounts
• Sales terms are “2/10 net 30”

▫ Customer gets 2% cash discount if paid within 10

days.
▫ Otherwise, total amount is due within 30 days.
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Alternative Methods of Accounting

for Sales Discounts
· Record initial sale at gross.
· At collection of net amount record discount as a
reduction from gross sales.
· Record initial sale at gross.
· At collection of net amount record discount as an
expense of the period.
· Record initial sale at net.
· Record amounts not taken as discounts as
additional revenue.
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Credit Card Sales

· If cash received by merchant immediately (Bank
plan, MC, Visa):

Cash 970
Sales discount 30
Sales revenue 1,000
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Credit Card Sales (continued)

· If cash received by merchant in 30 days
(American Express, Discover):

Accounts receivable 970

Sales discount 30
Sales revenue 1,000
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Sales Returns & Allowances

· Similar to bad debt expense,
· Estimate percentage of revenues that will
eventually result in returns or allowances.
· Adjusting entry at end of period.
· Actual return or allowance.
 5-24

Sales Returns & Allowances

(Continued)
· Provision for Returns and Allowances is a
liability account.
· Alternative:
· Not accrue for returns and allowances but write
them off as they occur.
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Adjustment vs. Expense

• Realization concept suggests adjustment to
revenue.
· In practice both methods are found.
· Consistency:
· Same handling from year to year.
· Allows same company results to be compared from
year to year.
· Comparisons between companies may be distorted.
 5-27

Warranty Costs
· Amounts are estimated (usually as a percentage
of sales).

Estimated Warranty Expense

Allowance for Warranties

· Allowance for warranties is a liability account.

Estimated warranty expense is part of costs of
sales.
 5-28

Interest Revenue
• Amount earned by lender during the period.
• 2 approaches
▫ Interest paid at maturity.
 Interest is explicit.
▫ Discounted loan.
 Interest is implicit.
• Accounted for separately from sale.