CHAPTER QUESTIONS The two general revenue recognition criteria are that revenue should be recognized when it is realized or realizable and it has been earned through substantial completion of the activities involved in the earnings process inventory to the extent that they cannot be used to fill other orders The presumption is that customer acceptance provisions are important to the buyer or else they wouldn’t have been included in the sales agreement in the first place Accordingly, the seller has not completed the earnings process until the customer acceptance provisions have been satisfied The four revenue recognition criteria identified in SOP 972 are: a Persuasive evidence of an arrangement exists b Delivery has occurred c The vendor's fee is fixed or determinable d Collectibility is probable The first two items relate to whether revenue has been earned, and the last two relate to the realizability of the revenue Up-front, non-refundable fees are not recognized as revenue immediately because the earnings process is not complete The buyer is not paying for the initiation of the service, but instead is paying for the service itself Revenue shouldn’t be recognized until the transaction price can be definitely determined because it is less likely that an arm’s-length market transaction has occurred when the parties have not even agreed upon the final price and because the associated measurement uncertainty means that the information is not reliable enough for recognition and inclusion in the financial statements SAB 101 was issued by the SEC to curtail specific abuses in revenue recognition practices Question of SAB 101 emphasizes the proper signing of sales agreements to encourage companies to implement good internal controls surrounding revenue recognition If a company does not have good internal controls in place for processing customer contracts, it becomes much easier for company executives to manipulate the reported amount of revenue 10 A refundable fee can be recognized as revenue month-by-month before the refund period is over when the seller can make a reliable estimate about the number of refunds that will be requested Reliable estimates are possible when the seller has at least two years’ past experience with a large pool of similar transactions A sale can be turned into a consignment through a liberal return policy that does not require the buyer to pay for the product until the buyer in turn sells it to a customer A sale can also be turned into a consignment if the seller agrees to repurchase the product at the same price and provides interest-free financing to the buyer 11 Contingent rent can’t be estimated and recognized on a straight-line basis over the course of a year because to so would involve recognizing the future impact of future events No contingent rent should be recognized until the contingency threshold has been reached In a bill-and-hold arrangement, the seller “sells” goods to the buyer but holds the goods for later shipment, either in the seller’s own warehouse or in a third-party warehouse A bill-and-hold arrangement is a sale when the arrangement comes about upon the written request of the buyer, the goods are ready to ship, and the goods are separated from other 12 A company can reliably estimate product returns if the company has substantial past experience with a large pool of similar transactions Also, the return period should be short and demand for the product should be fairly stable Also, a 49 50 company can reliably estimate product returns when there have been no large inventory increases for either the company or its customers 13 A company would prefer gross revenue reporting over net revenue reporting because the larger total revenue number increases the apparent size of the company’s economic activity If investors use a price-to-sales relationship in valuing the company, gross revenue reporting can lead to a higher stock price 14 If percentage-of-completion accounting is to be used by construction contractors, the following elements should be present in the transaction a Dependable estimates can be made of the extent of progress toward completion, contract revenues, and contract costs b The contract should clearly specify 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 buyer can be expected to satisfy obligations under the contract d The contractor can be expected to perform the contractual obligation Because most contractors with significant contract obligations have the experience to make the necessary estimates, it is recommended that they use percentageof-completion accounting rather than the completed-contract method 15 The cost-to-cost method of measuring the percentage of completion is an input method and is computed by relating the costs incurred to date to the total estimated costs The efforts-expended methods are also input methods, but they are based on the ratio of the efforts expended by labor or machines on the contract to the total effort expected to be expended They include labor hours, labor dollars, machine hours, or even material quantities The percentage computed is then applied to revenue and costs to determine the amount reported for the period 16 Output measures of percentage of completion include units produced, contract milestones reached, and values added to the contract Particular examples Chapter of output measures include miles of roadway, cubic yards of dirt removed, or architects' and engineers' estimates of job completion 17 The construction in progress account is used to accumulate all costs directly chargeable to a contract, including a share of indirect overhead costs and the recognized gross profit earned to date if the company is using the percentage-ofcompletion method The progress billings on construction contracts account is used to accumulate the total progress billings made on a contract, including any billed retainer fees These accounts are offset against each other on the balance sheet If Construction in Progress is the larger of the two accounts, both are reported in the Current Asset section If Progress Billings on Construction Contracts is larger, both are reported in the Current Liability section 18 A minority of the members of the Construction Contractor Guide Committee of the AICPA feels that the costs reported under the percentage-of-completion method should always be the costs incurred to date If the method of arriving at the percentage of completion is other than the cost-to-cost method, the only way this could occur would be to compute revenue as the sum of costs incurred and the computed gross profit rather than by applying the percentage of completion to the total contract price 19 Under percentage-of-completion accounting, the difference between recognized revenue and recognized costs, or the recognized gross profit, is added to the costs incurred in arriving at the balance reported in the construction in progress account 20 The major reason for a fluctuating gross profit percentage under the percentage-ofcompletion method is the revision of estimates that is inherent in this type of contract As costs incurred differ from those anticipated, and as expectations of future costs change over the contract time period, the total gross profit to be earned on the project also changes When some profit has already been recognized, these adjustments can create large changes in the reported gross profit percentage from 21 22 23 24 year to year These fluctuations would also increase if a measure of completion other than cost-to-cost was used and if the minority position of the AICPA Construction Contractor Guide Committee was followed If a loss is anticipated on a contract, the entire loss should be recognized in the period when the loss is first anticipated This is true under both the completedcontract and the percentage-of-completion methods Under the completed-contract method, the amount of the expected loss is charged to a loss account and credited to Construction in Progress Under the percentage-of-completion method, however, the amount of the loss plus any profit recognized in prior periods on the contract must be recognized and reported as a loss Under either method, the balance reported in Construction in Progress will be the same The measures used to compute a percentage of performance in long-term service contracts depend on the nature of the acts of service to be performed If the acts of service are identical or similar in nature, an output measure derived by relating the number of acts performed to the total number of acts to be performed over the contract life is recommended If the acts are defined, but are not identical, the sales value of the acts performed to date related to the total contract sales value is used When a service company is organized and its activities grow rapidly in the early years of its life, the deferral of all revenue over the service life fails to recognize any profit on the sale of the contracts Because the sale is the critical event in many service companies, failure to recognize profit in the early years of a company results in both direct and indirect costs being charged against very little revenue Thus, in a newly formed company, large losses will often be shown even if the company may be profitable over time The deferred revenue recognition method may not an acceptable job of predicting the pattern of future cash flows The three methods of revenue recognition that await the receipt of cash are (a) installment sales, (b) cost recovery, and (c) cash Under the installment sales method, a portion of recognized 51 each cash receipt is 52 Chapter as income Under the cost recovery method, no income is recognized until all costs are recovered Under the cash method, all costs incurred are expensed immediately, and all cash receipts are recognized as revenue Costs incurred are deferred and matched against cash received under both the installment sales and cost recovery methods As indicated previously, under the cash method all costs are expensed immediately 25 The installment sales method of accounting is preferred over the full accrual method if cash collection is highly uncertain and if the amount of loss due to uncollectible accounts cannot be reasonably estimated This can occur if the sales transaction is unusual in nature and involves a customer in a way that default carries little cost or penalty 26 Installment sales accounting requires recognition of gross profit as the cash is collected The amount to be recognized is based on the gross profit percentage of the sales year Because these percentages can vary from year to year, it is necessary to maintain records that identify sales and collections by year and to maintain a record of each year's gross profit percentage 27 Interest on installment sales contracts should be recognized each period as earned Each cash collection, therefore, should be reduced by the interest earned before the gross profit percentage is applied to the balance of the collection to determine the gross profit earned 28 The cash method of recognizing revenue would be acceptable for reporting purposes only if the probability of recovery of product or service costs is slight Seldom would the method be appropriate for product or real estate sales because of repossession rights held by the seller However, in service contracts with high initial costs and great uncertainty as to collection, the cash method might be appropriate PRACTICE EXERCISES PRACTICE 81 BASIC JOURNAL ENTRIES FOR REVENUE RECOGNITION Cash 1,000 Unearned Service Revenue 1,000 Unearned Service Revenue Service Revenue PRACTICE 82 1,000 1,000 JOURNAL ENTRIES FOR A CONSIGNMENT Inventory on Consignment Inventory 10,000 Accounts Receivable Sales 16,000 Cost of Goods Sold Inventory on Consignment 10,000 10,000 PRACTICE 83 16,000 10,000 JOURNAL ENTRIES FOR A LAYAWAY Cash (2  $50) Deposits Received from Customers 100 Cash Deposits Received from Customers Sales 300 50 Cost of Goods Sold Inventory 200 100 350 200 Deposits Received from Customers Revenue from Layaway Forfeitures 50 50 PRACTICE 84 JOURNAL ENTRIES FOR AN UP-FRONT, NONREFUNDABLE FEE Cash (200  $360) Unearned Initial Sign-up Fees 72,000 Cash (200  $50) Monthly Service Revenue 10,000 72,000 10,000 Unearned Initial Sign-up Fees ($72,000/36 months) Initial Sign-up Fee Revenue PRACTICE 85 2,000 2,000 JOURNAL ENTRIES FOR AN UP-FRONT, REFUNDABLE FEE Cash (1,500  $1,000) 1,500,000 Customers’ Refundable Fees (30%) 450,000 Unearned Membership Fees (70%) 1,050,000 Unearned Membership Fees ($1,050,000/12 months) 87,500 Membership Fee Revenue 87,500 Cost of Membership Fee Revenue (70%) 10,500 Administrative Expense (30%) 4,500 Cash [($120/12 months)  1,500 customers] 15,000 Unearned Membership Fees ($1,050,000/12 months)87,500 Membership Fee Revenue 87,500 Cost of Membership Fee Revenue (70%) 10,500 Administrative Expense (30%) 4,500 Cash [($120/12 months)  1,500 customers] 15,000 Customers’ Refundable Fees Cash PRACTICE 86 450,000 450,000 JOURNAL ENTRIES FOR CONTINGENT RENT Cash 40,000 Rent Revenue Cash 40,000 40,000 Rent Revenue 40,000 Contingent Rent Receivable 100,000 Contingent Rent Revenue 100,000 ($55,000,000  $50,000,000)  0.02 = $100,000 Chapter 55 PRACTICE 86 (Concluded) Cash 40,000 Rent Revenue Contingent Rent Receivable Contingent Rent Revenue $12,000,000  0.02 = $240,000 40,000 240,000 240,000 Cash 600,000 Contingent Rent Receivable 600,000 ($80,000,000  $50,000,000)  0.02 = $600,000 PRACTICE 87 REPORTING REVENUE GROSS AND NET Cash ($300,000  0.02) Commission Revenue Cash 6,000 6,000 300,000 Sales Cost of Goods Sold Inventory Commission Expense Cash PRACTICE 88 300,000 210,000 210,000 6,000 6,000 COST-TO-COST METHOD Percentage of completion: [$100,000/($100,000 + $450,000)] = 18.182% Cumulative revenue to be recognized: $800,000  0.18182 Revenue recognized in previous years Revenue to be recognized in Year $145,456 $145,456 Percentage of completion: [($100,000 + $150,000)/($100,000 + $150,000 + $280,000)] = 47.170% Cumulative revenue to be recognized: $800,000  0.47170 Revenue recognized in previous years Revenue to be recognized in Year $377,360 145,456 $231,904 Percentage of completion: 100.000% Cumulative revenue to be recognized: $800,000  1.00000 Revenue recognized in previous years $800,000 377,360 Revenue to be recognized in Year $422,640 Chapter PRACTICE 89 57 EFFORTS-EXPENDED METHOD Percentage of completion: [150/(150 + 850)] = 15.000% Cumulative revenue to be recognized: $800,000  0.15000 $120,000 Revenue recognized in previous years Revenue to be recognized in Year $120,000 Percentage of completion: [(150 + 300)/(150 + 300 + 520)] = 46.392% Cumulative revenue to be recognized: $800,000  0.46392 Revenue recognized in previous years Revenue to be recognized in Year $371,136 120,000 $251,136 Percentage of completion: 100.000% Cumulative revenue to be recognized: $800,000  1.00000 Revenue recognized in previous years Revenue to be recognized in Year PRACTICE 810 $800,000 371,136 $428,864 PERCENTAGE OF COMPLETION BASED ON OUTPUT MEASURES Percentage of completion: [3,000/(3,000 + 15,200)] = 16.484% Cumulative revenue to be recognized: $800,000  0.16484 Revenue recognized in previous years Revenue to be recognized in Year $131,872 $131,872 Percentage of completion: [(3,000 + 7,500)/(3,000 + 7,500 + 8,200)] = 56.150% Cumulative revenue to be recognized: $800,000  0.56150 Revenue recognized in previous years Revenue to be recognized in Year $449,200 131,872 $317,328 Percentage of completion: 100.000% Cumulative revenue to be recognized: $800,000  1.00000 Revenue recognized in previous years Revenue to be recognized in Year $800,000 449,200 $350,800 PRACTICE 811 BASIC CONSTRUCTION JOURNAL ENTRIES Construction in Progress Materials, Cash, etc 100,000 Accounts Receivable Progress Billings 200,000 Cash 180,000 100,000 200,000 Accounts Receivable 180,000 Construction in Progress Materials, Cash, etc 150,000 Accounts Receivable Progress Billings 200,000 Cash 170,000 150,000 200,000 Accounts Receivable 170,000 Construction in Progress Materials, Cash, etc 250,000 Accounts Receivable Progress Billings 400,000 Cash 450,000 250,000 400,000 Accounts Receivable PRACTICE 812 450,000 COMPLETED-CONTRACT JOURNAL ENTRIES Progress Billings 800,000 Revenue on Construction Contracts 800,000 Cost of Construction Contracts Construction in Progress PRACTICE 813 500,000 500,000 PERCENTAGE-OF-COMPLETION JOURNAL ENTRIES Cost of Construction Contracts 100,000 Construction in Progress 45,456 Revenue on Construction Contracts 145,456 Cost of Construction Contracts 150,000 Construction in Progress 81,904 Revenue on Construction Contracts 231,904 Cost of Construction Contracts 250,000 Construction in Progress 172,640 Revenue on Construction Contracts 422,640 98 Chapter DISCUSSION CASES Discussion Case 8–52 This case is designed to contrast the point of revenue recognition with respect to the completedcontract method of accounting and the percentage-of-completion method The discussion should focus on the appropriateness and advantages and disadvantages of each method in terms of reporting a realistic income figure The previous accountant's policy of deferring all expenses and revenues to the period of completion conforms to the concept that revenue is not recognized until an actual exchange has taken place The argument is that revenue emerges from sales, not production Actually, revenue is earned continuously The question is when to recognize it If there are significant uncertainties involved as to the actual sales price or collectibility, the completed-contract method followed by the previous accountant has merit By contrast, the percentage-of-completion method recognizes revenues as they are earned over the period of the projects instead of at completion This method is acceptable, and generally preferable, when a firm contract for a sale exists, and the costs remaining to be incurred on the project can be estimated with reasonable accuracy Discussion Case 8–53 This case can be used to discuss the rationale underlying percentage-of-completion accounting and to explore areas not specifically included in the identified questions It should be emphasized that the tax method used does not have to coincide with the book method and that the completed-contract method is available for tax purposes with some limitations Income tax allocation procedures would be necessary if the methods not agree This topic is covered in a later chapter The requirement to recognize losses entirely in the period when first identified is the same regardless of the accounting method used It is based on the valuation principle that inventory should not be valued at more than its net realizable value If the costs to date plus expected future costs exceed the contract price, the excess must be deducted from the cost incurred to date if the net realizable value principle is to be followed Discussion could include rationale for this approach, including the historical tendency to be conservative in applying the percentage-of-completion method The discussion could also focus on the uncertainty that often arises when applying this method and the extreme care that is necessary in computing the percentage of completion and the estimation of future costs Discussion Case 8–54 The revenue recognized on a long-term contract under the percentage-of-completion method is determined by applying a percentage representing the degree of completion to the total contract price at the end of the accounting period The percentage is derived by dividing the costs incurred to date by the total estimated costs of the entire contract based on the most recent information The percentage may also be derived by other input or output measures of progress, such as engineering or architectural estimates, the ratio of direct labor costs incurred to date to total estimated labor costs, or the ratio of direct labor hours incurred to estimated total direct labor hours If the cost-to-cost method is used, the costs incurred are deducted from the recognized revenue to determine the recognized gross profit If another measure is used, the percentage of completion is applied to the total estimated costs to determine the costs to be recognized in the current period As an alternative, the costs incurred may be increased by the gross profit earned on the contract in the period to determine total revenues If it is anticipated that a loss will occur on the contract, the full amount of the expected loss is recognized in the period it is first determined In subsequent periods, because the percentage-of-completion method described produces cumulative results, gross profit recognized in prior periods must be subtracted to obtain current earnings to be recognized Chapter 99 Discussion Case 8–54 (Concluded) Under the completed-contract method, no earnings are recognized until the contract is substantially completed For the period in which completion occurs, gross revenues include the total contract price Total job costs incurred are deducted from gross revenues, resulting in recognition of the entire amount of gross profit in the completion period If it is expected that a loss will occur on the contract, a provision for loss should be recognized immediately The percentage-of-completion method is preferable when estimates of the bases upon which progress is measured are reasonably dependable The completed-contract method is preferable when inherent hazards or lack of dependable estimates cause the forecasts to be of doubtful value Interim billings on long-term contracts are not generally accepted as a method of recognizing earnings because such billings often not bear a meaningful relationship to the work performed on the contract Typically, billings may be accelerated in the early stages of the contract to provide the contractor with the working capital needed to begin performance If earnings were recognized on a billings basis, it would be possible for a contractor to materially distort the contractor's earnings merely by rendering billings without regard to any degree of progress on the contract Discussion Case 8–55 This case can be used to introduce the very difficult revenue recognition problems that face companies in service industries The membership fee should not be recognized immediately because there has not been substantial completion of the earnings process In addition, no separate chunk of revenue should be allocated to the initial sign-up process and recognized immediately because customers are not willing to pay merely to be signed up for a membership; they are paying the initial fee to receive future membership services Instead, the membership fee should be recognized on a straight-line basis for the economic life of the agreement A very difficult question is whether some of the initial fee revenue should be separately deferred and allocated to the special courses and programs that a customer is expected to take, at a discount, during the term of the membership Doing this would require reliable historical data on which to base the estimates This case is based on the experience of an actual company In the actual case situation, the studios recognized the entire membership fee as revenue at the time of the initial contract Little or no provision was made for future membership services In the initial promotion, memberships were sold easily to those most interested in the services rendered by such institutions This made the revenue and income for newly opened studios high As the particular studios matured and settled into more normal operations, the revenue and income slowed down to a more stable state The overall company statements continued to show increasing revenue and income by opening new studios at an accelerated rate This had its eventual limits The sale of the company was near completion when the impact of these facts was understood by the prospective purchaser Preparation of revised statements disclosed the real conditions existing and led to a withdrawal, with penalty, of the offer to buy Although not part of the revenue recognition problem, further analysis indicated that some mortgages, especially second mortgages, had not been properly recorded, which added to the unattractiveness of the studios to potential buyers Discussion Case 8–56 This case provides a basis for a class discussion on the difficulty of being precise in determining when revenue is to be recognized The following points concerning each of the four methods enumerated in the case will be helpful in conducting a discussion of this case Method 1: Recognize revenue when advance billing is made Strengths The advertising contract stresses the development of the advertising copy as a principal service Because of past experience, it apparently has been possible to estimate the costs to develop the copy, the media cost, and possible loss from uncollectible accounts at the time the contract is signed 100 Chapter Discussion Case 8–56 (Concluded) The critical event under this revenue recognition method is signing the contract Adjustments to the estimates are small, and thus a very early revenue recognition point is possible Weaknesses The revenue recognition criteria state that there should be substantial performance of all services before revenue is recognized At the signing of the contract, the service to be performed is still in the future Being able to estimate costs is only one of the prerequisites for revenue recognition Accurate past estimates not guarantee accurate future estimates It is unacceptable to recognize revenue for services to be rendered on the basis of only a signed contract Method 2: Recognize revenue when payment is received from the client Strengths The receipt of payment from the client adds one objective dimension to recognizing revenue One less item must be estimated: the possible uncollectible accounts Receipt of cash in this case assures the agency that the contract is firm and that there is no misunderstanding as to the contractual payment terms Weaknesses Depending on what services are performed before the payment is received, this method has many of the same weaknesses as the first method There is not necessarily a connection between the timing of cash receipts and the performance of advertising services The services may be substantially performed prior to cash collection, in which case collection may be too late to properly recognize revenue On the other hand, collection may be made before the services are rendered, in which case cash collection is too early Method 3: Recognize revenue in the month when advertising appears in the media Strengths By the time the advertisement appears in the media, there is no doubt that the agency has delivered the contracted services The advertisement has been designed and has been placed in the media This point of revenue recognition is more closely aligned with traditional revenue recognition practices Students who like to follow a majority position will probably favor this method Weaknesses Even though services have been rendered, there is still uncertainty as to the cost of the media services This may or may not be serious, depending on the variability and predictability of the media costs Contingent on payment timing, bad debt expense may still have to be estimated under this method Method 4: Recognize revenue when the bill for advertising is received from the media Strengths At this point, all costs and revenues should be known in amount, and revenue recognition should be free of estimates and uncertainties, especially if the client paid the advance billing as has been the practice This method should lead to high verifiability of the revenue and cost to be reported Weaknesses This method may defer recognition of revenue too far beyond the critical performance of services The revenue recognition principle does not require 100% certainty before revenue and costs are recognized Income statements should reflect the efforts expended in the period of reporting, not in some later period when all uncertainties are resolved Estimates and judgments must be applied to enhance relevance and timeliness It is usually interesting to have students vote for their preference after all four methods have been discussed This case could also be used in a debate format One or more students could defend each method, and the class could then identify the most convincing presentation Chapter 101 Discussion Case 8–57 This case illustrates that the use of differing revenue recognition methods can affect materially a firm’s reported performance When the uncertainty of cash collection is high and there is little penalty to the customer when default occurs, revenue recognition may be more appropriate at the point of cash collection rather than at the point of sale In this case, there appears to be substantial doubt as to the collectibility of receivables If in sales dollars is not being collected, it appears the earnings process is not complete at the point of sale While it is unfortunate that the restated financial statements result in a significantly lower net income, the independent auditor has a responsibility to the users of the financial statements to ensure that those financial statements accurately reflect the financial position of the company Discussion Case 8–58 Numerous possibilities exist for recognizing revenue, though not all are acceptable One possibility is to recognize revenue when the agreement is made with partnerships to purchase the plant Another is to recognize some revenue at the point of sale and to recognize the remainder as the notes are paid off Midwestern elected to recognize all the revenue at the point of sale As mentioned in the case, on a cash basis, Midwestern actually had negative cash flows from operations Thus, while the income statement reported a profit margin of 66%, the firm was actually losing cash In this case, there was substantial doubt as to whether the $45,000 partnership notes would be collected Although the plant was guaranteed to be profitable, Midwestern was overly optimistic as to the demand for ethanol gas Midwestern should have used a revenue recognition method that related revenue recognition with cash collection Either the installment sales method or the cost recovery method would have been appropriate Discussion Case 8–59 If the loan origination fee relates to work done in processing the loan, such as title and credit checks and other loan-related efforts, the firm might argue that the services related to that fee are complete once the loan is made In 1986, the FASB released SFAS No 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.” In paragraph of this Statement, the FASB clearly states that “Loan origination fees shall be deferred and recognized over the life of the loan.” If the collectibility of the loans is questionable, the accrual method of accounting would not be appropriate As discussed in the text, the likelihood of cash collections dictates whether the installment sales, cost recovery, or cash method would be most appropriate In the case of savings and loans, the deposits were federally insured by the government Thus, investors could make deposits in the high-risk investments knowing that they stood a chance of reaping a large return with very little downside risk The government would make sure that they received their original investment back Whether or not external auditors are responsible for evaluating a firm's lending practices is to be decided by the courts The Federal Savings and Loan Insurance Corporation (FSLIC) filed suit against of the then largest CPA firms in the late 1980s, alleging negligence in conducting their audits At least one of the major firms, Ernst & Young, settled its case out of court The settlement was for $400 million 102 Chapter Discussion Case 8–60 For money received by home office from test centers, the journal entry to book the receipt of cash as revenue would be: Cash xxx Revenue xxx However, if that money was subsequently "churned" back to the test site, a second journal entry would have to be made The credit would be to Cash and the debit should be made to a receivable account Any subsequent receipts of cash from the test center would then have to be analyzed to determine if the cash is revenue or a repayment of the receivable One can see that if "churning" is occurring, the receivables account will continue to increase as revenue increases If the test center site transferring the money has an established receivable with the home office, the accountant at the home office would have to determine if the money received was a payment on the receivable or the recognition of revenue The answer would depend on supporting documentation However, if the remittances increase and no payments are being made to reduce the receivable, then the accountant at the home office should begin to question why loans are not being repaid Discussion Case 8–61 This case examines the issue of shipping inventory in anticipation of an order The revenue recognition criteria require the customer to provide an asset (an accounts receivable) in order for revenue to be realizable In the instance where the customer has not ordered the inventory, it would be difficult to claim that the customer has provided an asset The situation could be different if the customer has issued an open purchase order to Datarite In this case, Datarite could argue that an open purchase order results in an accounts receivable once inventory is shipped Such an arrangement should be very carefully scrutinized by the company’s auditor If the company president includes the extra inventory shipments as revenue, then the debt covenants will be satisfied Thus, in this instance, the existence of debt covenants will have resulted in the company’s performing business activities only to satisfy debt restrictions If the sales are subsequently returned by dealers, the company will have, in effect, violated its debt covenants but will have avoided disclosing this fact to debt holders Discussion Case 8–62 This case describes a typical franchise arrangement An initial fee is involved that covers services to be rendered before the franchise outlet is opened and some services to be recognized subsequent to the opening Because this franchise arrangement involves installment payments, the interest implicit in the initial fee must be removed and recognized over the period of payment, in this case years Thus, the notes receivable, face value $20,000, should be reported at $15,163, the net present value of the notes at 10% interest rate The management of Magleby would argue that because at least $5,000 worth of services are rendered at the time the contract is signed, at least this amount should be recognized as revenue at the time of opening In fact, Magleby’s management would argue that at the time that a franchise opens, only two steps remain before Magleby Inn will have fully earned the entire franchise fee First, it must provide expert advice over the 5-year period Second, it must wait until the end of each of the next years so that it may collect each of the $4,000 notes Because collection has not been a problem and the advice may consist largely of manuals and periodical service tip fliers, it could be maintained that a substantial portion of the $15,163, the present value of the notes, should be recognized as revenue when a franchisee begins operation The revenue recognition practice described in the previous paragraph is acceptable only if Magleby can demonstrate that the initial services provided in supervising construction, arranging financing, and so forth are a separate product If Magleby can demonstrate that these services are a separate product, the earnings process for this separate product is substantially complete when a franchise opens A portion of the initial fee could be allocated to this separate product and recognized as revenue at that time Magleby would have to show that it, or some other firm in the same industry, offers these initial setup services as a separate product, independent of the continuing advisory services over the 5- Chapter 103 year period Discussion Case 8–62 (Concluded) Even if it can be demonstrated that the initial services are a separate product, there is still the issue of collectibility to be considered Although there have been no defaults on the notes, the extent of Magleby Inn’s experience may be so limited that there may in fact be a substantial collection problem in the future (as has been the actual experience of many franchisers in the recent past) At some time in the future, after Magleby Inn has experienced a large number of franchises that have opened and operated for years or more, it should be possible to develop probability measures so that the earned portion of the present value of the notes may be recognized as revenue at the time the franchise begins operation For the present, however, it might be necessary to recognize the $4,000 revenue only as the notes are collected The monthly fee of 2% of sales should be recorded as revenue at the end of each month This fee is for current services rendered and should be recognized as the services are performed Discussion Case 8–63 The sales being made by Rain-Soft are in reality consignments and, as such, are not generally recognized as sales until they have been sold to an outside party This case is an example of a situation in which a transaction might be labeled a sale but the terms of the side agreements between the “seller” and the “buyer” convert the transaction into a consignment arrangement Using past experience as a guide is risky because a change in economic conditions can make past experience irrelevant to actual experience Class discussion could focus on the legal differences between a consignment sale to a dealer, who is in reality an agent of the selling company, and an actual arm’slength sale Uncertainties, such as the probability of cash collection and the possibility of return, still exist in arm’s-length sales, but a presumption exists under these conditions that an exchange has taken place and the revenue can be recognized A change in accounting policy is probably required in the case as described for the company to be keeping its records in accordance with GAAP As part of this case, it is instructive to look at SFAS No 48, “Revenue Recognition when Right of Return Exists.” 104 Chapter SOLUTIONS TO STOP & THINK Stop & Think (p 436): How would a contract's percentage of completion be measured? What methods can you come up with to determine how complete a contract is? There is a variety of methods for determining a contract's percentage of completion This text will discuss the cost-to-cost method, engineer's estimates, and other input and output measures Before students read on to find out what the answer is, they should spend a little time thinking about it They will soon realize that they will come up with the same methods that are commonly used Stop & Think (p 439): Progress Billings on Construction Contracts is offset against the construction in progress account What does the resulting net figure represent? When the progress billings on construction contracts account is netted against the construction in progress account, the resulting net figure represents the amount of the construction (which includes costs as well as a portion of expected profits) for which the customer has not yet been billed Stop & Think (p 443): What circumstances would give rise to a loss being reported on a profitable contract? In other words, what does a loss being reported for this period tell us about last year's profit? If our estimates in prior periods were off by a significant amount, we could end up recording too much revenue (and profit) in the early periods This error would require us to record a loss for this period so that the revenue (and profit) recognized to date would be correct Stop & Think (p 449): If the collection of cash is uncertain, when and how should revenue and profits be recognized? There are several methods available for recognizing revenue when the receipt of cash is uncertain The text will soon discuss several of those methods This question is inserted at this point to cause students to realize that, if they stop and think for just a minute, they will come up with the same methods that are actually employed in practice Stop & Think (p 451): What does the $80,000 net amount represent? This amount represents the cost of the inventory associated with the $120,000 in sales that is reflected in the accounts receivable balance Because collection of the receivable balance is uncertain, it is recorded at a lesser amount This $80,000 number assumes that if worse came to worst and customers didn't pay, the seller could at least get the inventory back Chapter 105 SOLUTIONS TO STOP & RESEARCH Stop & Research (p 423): MicroStrategy isn’t the only company that has been subjected to unpleasant public scrutiny because of a restatement associated with SAB 101 In fact, in 2002 a contract management company called diCarta was sponsoring a Web site specifically devoted to SAB 101 issues The Web address is http:// www.sab101.org Access this Web site and compile a list of three additional companies impacted by SAB 101 The following summaries come from the “News & Analysis” section of http:// www.sab101.org: MAR 9, 2001Teradyne Hurting (MotleyFool.com) Semiconductor testing equipment manufacturer Teradyne warned that first-quarter results would be lower than expected, due in part to SAB 101, an accounting change Teradyne recently made, dictating it recognize revenue once a customer accepts a machine Prior to the change, Teradyne recognized revenue once a machine was shipped http://www.biz.yahoo.com/mf/010309/news01_010309.html MAR 15, 2001SCI, Stewart Still On Life Support (CBS MarketWatch.com) Service Corp International and Stewart Enterprises, two of the country's largest funeral home/cemetery operators, have reported significant losses due to SAB 101, designed primarily to curb the funeral industry's tendency to immediately book 100 percent of revenue from sales of multi-year installment plans http://www.cbs.marketwatch.com/news/story.asp?guid=%7B0F041FAD %2DBE08%2D4968%2D99B9%2D380392E540AE%7D&siteid=mktw APR 23, 2001Covad Receives Nasdaq Delisting Notice (Yahoo! Technology News, Reuters) Nasdaq has threatened to delist Covad Communications for not yet filing its earnings report for the quarter ending Dec 31 The company has said a new federal accounting regulation, known as SAB 101, would result in reduced revenue for 2000 of about $52 million http://www.dailynews.yahoo.com/h/nm/20010423/tc/tech_covad_dc_1.html Stop & Research (p 435): Access the FASB’s Web site at http:// www.fasb.org, and determine the current status of the revenue recognition project On June 21, 2002, the FASB posted the following update on the progress of the revenue recognition project: “The Board anticipates that this project will take two to three years to complete The Board is exploring the possibility of working jointly on this project with the International Accounting Standards Board The staff has also begun the ‘top-down’ development of conceptual guidance and the ‘bottom-up’ inventory of accounting literature The AICPA’s Accounting Standards Executive Committee has agreed to assist the Board in developing the inventory of relevant AICPA literature.” 106 Chapter SOLUTIONS TO BOXED ITEMS McKesson Accounting Scandals: 1937 and 1999 (pp 446–447) At first glance, the 47.5% stock price drop, resulting in lost market value of $8.8 billion, seems out of proportion to the $42 million revenue overstatement However, this announcement probably caused investors to doubt the integrity of McKesson’s management Accordingly, the stock price would drop in anticipation of the uncovering of even more bad news And in this case, that skepticism turned out to be justified The fact that the overstatement of revenue at HBO & Company coincided with the period in which the company was an acquisition target is probably not a coincidence When a company is preparing to issue stock, to apply for a major loan, or to be acquired, it is very important for the company’s reported financial performance to look as solid as possible In this case, the reported financial performance of HBO & Company directly impacted the acquisition price Thus, there is a temptation to overstate revenues in order to fluff up reported performance Both the 1937 McKesson & Robbins case and the 1999 McKesson HBOC case involved collusion among top managers Because top managers can circumvent internal control systems, fraud perpetrated by top managers is difficult to detect In fact, a determined set of top managers can almost always get away with fraud, at least in the short run The difficulty is in continuing to hide the fraud as it grows larger, which always seems to happen Soft Revenue for Software Companies (pp 452–453) The primary difficulty associated with allocating a software package’s purchase price over the earnings process is in determining the amount and timing of revenue recognition For example, how much of the $500 selling price would be recognized at the point of sale, how much would be recognized at installation, how much revenue should be associated with the upgrade, and are there other points in the earnings process to which should be attributed a portion of the revenue? While these issues may be difficult to address, other industries have faced similar issues The health fitness industry, for example, must allocate initial membership fees over the life of a fitness contract The software industry has had to develop revenue recognition methods for allocating revenue Microsoft’s revenues have increased at a substantial rate over the past several years The company does not need to use accounting methods to accelerate sales Microsoft’s competitors, on the other hand, need all the help they can get as they try to compete against Microsoft Thus, Microsoft would support a rule that slows the recognition of revenue because such a rule would affect Microsoft’s competitors more than it would Microsoft itself In addition, Microsoft has been accused of deferring revenue in boom years just in case the company needs to bolster sagging revenues in future years Chapter 107 COMPETENCY ENHANCEMENT OPPORTUNITIES Deciphering 8–1 (The Walt Disney Company) Revenue Recognition (from Note Description of the Business and Summary of Significant Accounting Policies) Revenues from the theatrical distribution of motion pictures are recognized when motion pictures are exhibited Revenues from video sales are recognized on the date that video units are made widely available for sale by retailers Revenues from the licensing of feature films and television programming are recorded when the material is available for telecasting by the licensee and when certain other conditions are met Broadcast advertising revenues are recognized when commercials are aired Revenues from television subscription services related to the Company's primary cable programming services are recognized as services are provided Internet advertising revenues are recognized on the basis of impression views in the period the advertising is displayed, provided that no significant obligations remain and collection of the resulting receivable is probable Direct marketing and Internet-based merchandise revenues are recognized upon shipment to customers Merchandise licensing advance and guarantee payments are recognized when the underlying royalties are earned Revenues from advance theme park ticket sales are recognized when the tickets are used Revenues from participants at the theme parks are generally recorded over the period of the applicable agreements commencing with the opening of the related attraction One possibility would be when the videos were shipped to retailers and a promise of payment was received from retailers One possibility would be when Disney contracted with theaters to release the motion picture and the theaters gave a promise to pay for the right to exhibit the motion picture However, until the movie is exhibited, the promised service has not been delivered by Disney Deciphering 8–2 (Siskon Gold Corporation) Siskon recognizes revenue from its gold operations when it pours the gold—not when the gold is sold This is an exception to the general rule of revenue recognition, but it is acceptable because of the readily available market for gold This method of revenue recognition might be a problem if the market for gold were highly volatile As long as the price of gold is fairly stable, this method of revenue recognition should result in a fairly stated picture of a firm's income If the market for gold were to suddenly drop and gold went from selling for $400 an ounce to $150 an ounce, then revenues could be greatly overstated 108 Chapter Deciphering 8–3 (Ben & Jerry’s Homemade, Inc.) Ben & Jerry's recognizes revenue on its ice cream when the product is shipped Ben & Jerry's sells two different types of franchises The first is a franchise for an individual store, and the second is a franchise for a geographical area Revenue from franchise fees for an individual store is recognized when the services outlined in the franchise agreement have been substantially performed and the store has opened for business Revenue relating to area franchises is recognized based on the proportion of the number of stores opened in the geographical area relative to the number of stores expected to be opened Deciphering 8–4 (Lockheed Martin Corporation) Lockheed measures the percentage of a contract completed using achievement of performance milestones or the cost-to-cost method When the cost-to-cost method is used, revenues and profits are recorded based on the ratio of costs incurred to estimated total costs—just as is illustrated in the chapter For cost-reimbursed-type contracts, costs are recorded as incurred, and profits are estimated and included based on a cost-to-cost-type estimate If changes are made to long-term contracts, those changes are reflected in the current and future periods Prior period financial statements are not restated Again, any changes in estimates are reflected in the current period Students should realize that a loss for the period is accounted for differently from a loss for the contract Lockheed accounts for losses on contracts in the period in which that loss is identified Sample CPA Exam Questions The correct answer is a To calculate the income in the fourth and final year of a contract accounted for by the percentage-of-completion method, the total profit would first be calculated by comparing the contract price to actual total costs The amount would then be reduced by the income previously recognized to give the amount to be recognized in the fourth year The correct answer is d A nonrefundable lease bonus should be recognized as revenue over the lease term The receipt of the lease bonus creates deferred revenue Writing Assignment: Credit terms and revenue recognition Students should address the following issues as they deal with this revenue recognition assignment: Has Mitsubishi substantially completed its part of the revenue recognition process? Has Mitsubishi received a valid promise of payment? If Mitsubishi has received a valid promise, should it include the entire selling price as revenue in the period of the sale, or should part of the selling price be allocated to interest and recognized over time? Ford Motor Company disclosed the following about the accounting for its 0.0% financing program: “Costs for customer and dealer cash incentives and costs for special financing and leasing programs that we sponsor through Ford Credit (e.g., 0.0% financing program) are recognized as sales reductions at the later of the date the related vehicle sales are recorded or at the date the incentive program is both approved and communicated In general, the amount of financing cost that we provide to Ford Credit is the difference between the amounts offered to retail customers and a market-based interest or lease rate.” Chapter 109 Research Project: Revenue recognition for the medical profession The medical profession has traditionally had a hard time with recognizing revenue because of the difficulty of collecting after a service has been provided As a result of this research experience, students should learn that the profession now goes to great lengths to ensure that a customer will be able to pay prior to the service being provided Because hospitals deal with more patients than small medical practices, it is more likely that hospitals have a formalized method for ensuring that payment will be made The Debate: Health clubs and revenue recognition The point of this exercise is to help students realize that there are incentives that can affect one's perspective An investor, an auditor, and a creditor can look at the same set of facts and reach different conclusions based on their motivation This experience should help students to realize that there may not always be friendly agreement about the answer to an accounting question The current and the potential investors might make arguments like the following: Current Investors  Signing up new members is an important part of our business In fact, one of our most important economic assets is our membership base  Recall that this accounting issue revolves around how to classify cash that we have already received This is not a question of inventing fictitious transactions  The proper revenue recognition policy should reflect the economics of our business  We think that deferring all of the up-front fee, as is required in many cases under SAB 101, is overly conservative  In order to be able to recognize a substantial portion of the up-front fee, we intend to restructure the sign-up process so that customers get an extensive physical examination and evaluation as part of the initial sign-up We will also sell this examination separately By so doing, we can immediately recognize as revenue the portion of the up-front fee that can be allocated to the evaluation Note: The final bullet point sounds like manipulation of the accounting rules in order to accelerate the recognition of revenue The health club owners would have to demonstrate that actual customers were willing to pay the stated amount for the physical examination and evaluation without also receiving club membership Potential Investors  We really don’t care how the up-front fee is accounted for in terms of revenue recognition  What we care about is the future growth prospects of the health club  To us, the most important information is week-by-week data on how many people sign up for membership and how heavily new and old members use the club facilities  The week-by-week sign-up data will allow us to see the trend in whether the number of new members is increasing or decreasing This will help us forecast future revenues  The club usage data will help us more accurately forecast the future operating costs of the clubs Ethical Dilemma The point of this exercise is to drive home the two basic revenue recognition criteria—realizability and substantial completion For most companies, the substantial completion criterion is not satisfied until the point of sale because significant effort must occur to sell the product Because gold is a commodity and has a rather sophisticated market associated with it, the substantial completion criterion has been determined to be satisfied when the gold has been mined and processed and is ready for sale But prior to this point, substantial completion has not been achieved As a result of this case, students should realize that events can occur, over which a firm may have no control, that can significantly affect the firm's financial performance 110 Chapter Chapter 111 Cumulative Spreadsheet Analysis See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual Internet Search a “MAX overstated sales for the first two quarters of fiscal year 2000 by 98% These inflated sales figures prompted a 600% spike in MAX's stock price in only three months (from $4.44 to more than $28).” b “This order came in after MAX Brazil was formed and shipped just before [its fiscal first] quarter end, on September 29, 1999 However, the product only shipped to MAX Brazil, not to the ultimate customer… On November 17, 1999, only two days after [a] glowing press release about MAX's first quarter results, the Brazilian customer cancelled the entire transaction and returned what units it had MAX did not disclose this fact to the public until May 2000, when it restated the first quarter financial statements.” c “On December 28, 1999, MAX received a supposed order from a Chilean company The goods for this order never left Dallas On December 29, 1999, a shipment to fill the order was prepared and picked up by MAX's Dallas-based shipping agent However, MAX directed the shipping agent to hold the goods until payment was received MAX never received payment and the goods remained at the shipping agent's Dallas warehouse until many months later, when MAX finally retook possession… GAAP generally precludes recognizing revenue from a sale of goods until delivery to the ultimate customer has occurred Delivery of this order had not occurred by December 31, 1999; indeed, MAX always retained title to and constructive possession of the goods Nevertheless, MAX's second quarter 10-Q and accompanying press release misrepresented that the Chilean sale was complete.” a “In the summer of 1998, Telxon negotiated a sale to a company that operated a chain of hardware stores Telxon's competitors were also seeking the business, and it was well known at the time that the hardware chain was in very poor financial condition On September 30, 1998, Telxon shipped the product to the hardware chain and recognized revenue of approximately $7 million Title to the goods transferred to a leasing company, and the hardware chain signed a long-term lease with the leasing company Without the hardware chain's knowledge, however, Telxon also signed a separate agreement with the leasing company on September 29, by which Telxon guaranteed the hardware chain's lease payments to the leasing company (a ‘credit enhancement agreement’) The leasing company paid cash to Telxon for the product, pursuant to the lease contract with the hardware chain The hardware chain filed a bankruptcy petition and defaulted on the lease within months, and the leasing company demanded full payment on the lease from Telxon… Telxon's recognition of this revenue was not in conformity with GAAP, which require that ‘the sale of property [subject to a lease] shall not be treated as a sale if the seller retains substantial risks of ownership in the leased property.’ See, SFAS No 13, Accounting for Leases (November 1976), ¶¶ 21-22 Since Telxon guaranteed the lease payments to the leasing company, Telxon retained substantial risks of ownership.” b “One of Telxon's biggest customers was a company that operated a nationwide chain of retail stores In late September 1998, James Cleveland and Telxon's chief technical officer proposed a sale of customized ‘AirBeam’ software to the retail chain The software was designed to upgrade existing software and to provide a ‘Y2K fix.’ The retail chain agreed to the purchase in principle and negotiated a price of $2 million, but first required that its technicians prepare detailed specifications for upgrades that would be needed to Telxon's base software The retail chain provided those specifications to Telxon by facsimile dated October 2, 1998; Telxon agreed to the specifications and the retail chain issued a purchase order (‘p/o’) for the software on October 5, 1998 The p/o stated that the price included all future updates and maintenance, and that payment was contingent upon (i) ‘fault free performance,’ (ii) ‘complete installation 112 Chapter in all [chain] business units,’ and (iii) ‘the requirements noted in Attachment 'A' [that is, the specifications dated October 2].’ Telxon's chief technical officer estimated that his department needed three to six months to write the software code for the upgrades specified by the retail chain Cleveland, Haver, Grand and others met shortly after the retail chain's p/o arrived on October 5, 1998 At the meeting, the group discussed the state of completion of the software and, at or following the meeting, it was decided that Telxon would recognize the full $2 million in revenue as of September 30, 1998 Telxon assigned no related cost-of-goods-sold to the revenues and its pre-tax profits were thereby increased by the entire $2 million Telxon delivered the AirBeam product to the retail chain without the requested modifications, and the retail chain did not pay Recognition of this revenue was not in conformity with GAAP For software sales GAAP require, inter alia, ‘persuasive evidence of an arrangement’ and delivery of the software as of the date of recognition Also, if ‘uncertainty exists about customer acceptance’ after delivery, revenue should not be recognized.” ... gross revenue reporting can lead to a higher stock price 14 If percentage-of-completion accounting is to be used by construction contractors, the following elements should be present in the transaction... percentageof-completion accounting rather than the completed-contract method 15 The cost-to-cost method of measuring the percentage of completion is an input method and is computed by relating the costs... incurred and the computed gross profit rather than by applying the percentage of completion to the total contract price 19 Under percentage-of-completion accounting, the difference between recognized