Intermediate Accounting Revenue Recognition PDF

c18RevenueRecognition.indd Page 1064 1/21/11 4:42:47 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 CHAPTER 18 Revenue Recognition LEARNING OBJECTIVES After studying this chapter, you...

c18RevenueRecognition.indd Page 1064 1/21/11 4:42:47 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 CHAPTER 18 Revenue Recognition LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Apply the revenue recognition principle. 5 Identify the proper accounting for losses on long-term contracts. 2 Describe accounting issues for revenue recognition at point of sale. 6 Describe the installment-sales method of accounting. 3 Apply the percentage-of-completion method for long-term contracts. 7 Explain the cost-recovery method of accounting. 4 Apply the completed-contract method for long-term contracts. It’s Back Several years after passage, the accounting world continues to be preoccupied with the Sarbanes- Oxley Act of 2002 (SOX). Unfortunately, SOX did not solve one of the classic accounting issues—how to properly account for revenue. In fact, revenue recognition practices are the most prevalent reasons for accounting restatements. A number of the revenue recognition issues relate to possible fraudulent behavior by company executives and employees. As a result of such revenue recognition problems, the SEC has increased its enforcement actions in this area. In some of these cases, companies made significant adjustments to previously issued financial statements. As Lynn Turner, a former chief accountant of the SEC, indicated, “When people cross over the boundaries of legitimate reporting, the Commission will take appropriate action to ensure the fairness and integrity that investors need and depend on every day.” Consider some SEC actions: The SEC charged the former co-chairman and CEO of Qwest Communications International Inc. and eight other former Qwest officers and employees with fraud and other violations of the federal securities laws. Three of these people fraudulently characterized nonrecurring revenue from one-time sales as revenue from recurring data and Internet services. The SEC release notes that internal correspondence likened Qwest’s dependence on these transactions to fill the gap between actual and projected revenue to an addiction. The SEC filed a complaint against three former senior officers of iGo Corp., alleging that the defendants collectively caused iGo to improperly recognize revenue on consignment sales and products that were not shipped or that were shipped after the end of a fiscal quarter. The SEC filed a complaint against the former CEO and chairman of Homestore Inc. and its former executive vice president of business development, alleging that they engaged in a fraudulent scheme to overstate advertising and subscription revenues. The scheme involved a complex structure of “round-trip” transactions using various third-party companies that, in essence, allowed Homestore to recognize its own cash as revenue. The SEC claims that Lantronix deliberately sent excessive product to distributors and granted them generous return rights and extended payment terms. In addition, as part of its alleged channel c18RevenueRecognition.indd Page 1065 1/22/11 8:55:16 AM users-133 /Users/users-133/Desktop/Ramakant_04.05.09/WB00113_R1:JWCL170/New IFRS IN THIS CHAPTER C See the International stuffing and to prevent product returns, Lantronix loaned funds to a third party to Perspectives on purchase Lantronix products from one of its distributors. The third party later re- pages 1066, 1087, and 1103. turned the product. The SEC also asserted that Lantronix engaged in other im- C Read the IFRS Insights on proper revenue recognition practices, including shipping without a purchase order pages 1134–1140 for a and recognizing revenue on a contingent sale. discussion of: Though the cases cited involved fraud and irregularity, not all revenue recognition —Long-term contracts errors are intentional. For example, in April 2005 American Home Mortgage Invest- ment Corp. announced that it would reverse revenue recognized from its fourth-quarter —Cost-recovery method 2004 loan securitization and would recognize it in the first quarter of 2005 instead. As a result, American Home restated its financial results for 2004. So, how does a company ensure that revenue transactions are recorded properly? Some answers will become apparent after you study this chapter. Sources: Cheryl de Mesa Graziano, “Revenue Recognition: A Perennial Problem,” Financial Executive (July 14, 2005), www.fei.org/mag/articles/7-2005_revenue.cfm; and S. Taub, “SEC Accuses Ex-CFO of Channel Stuffing,” CFO.com (September 30, 2006). As indicated in the opening story, the issue of PREVIEW OF CHAPTER 18 when revenue should be recognized is complex. The many methods of marketing products and services make it difficult to develop guidelines that will apply to all situations. This chapter provides you with general guidelines used in most business transactions. The content and organization of the chapter are as follows. REVENUE RECOGNITION REVENUE RECOGNITION REVENUE RECOGNITION REVENUE RECOGNITION CURRENT ENVIRONMENT AT P O I N T O F S A L E BEFORE DELIVERY A F T E R D E L I V E RY Guidelines for revenue Sales with discounts Percentage-of-completion Installment-sales method recognition Sales with right of return method Cost-recovery method Departures from sale basis Sales with buybacks Completed-contract Deposit method method Bill and hold sales Summary of bases Long-term contract losses Principal-agent relationships Disclosures Trade loading and channel Completion-of- stuffing production basis Multiple-deliverable arrangements 1065 c18RevenueRecognition.indd Page 1066 1/21/11 4:42:57 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 1066 Chapter 18 Revenue Recognition CURRENT ENVIRONMENT Most revenue transactions pose few problems for revenue recognition. This is be- cause, in many cases, the transaction is initiated and completed at the same time. However, not all transactions are that simple. For example, consider a customer who enters into a mobile phone contract with a company such as Verizon. The customer is often provided with a package that may include a handset, free minutes of talk time, data downloads, and text messaging service. In addition, some providers will bundle that with a fixed-line broadband service. At the same time, customers may pay for these services in a variety of ways, possibly receiving a discount on the hand- set, then paying higher prices for connection fees, and so forth. In some cases, depending on the package purchased, the company may provide free applications in subsequent periods. How then should the various pieces of this sale be reported by Verizon? The answer is not obvious. It is therefore not surprising that a recent survey of financial executives noted that the revenue recognition process is increasingly more complex to manage, prone to error, and material to financial statements compared to any other area in financial reporting. The report went on to note that revenue recognition is a top fraud risk and that regard- less of the accounting rules followed (GAAP or IFRS), the risk or errors and inaccuracies in revenue reporting is significant.1 Indeed, both the FASB and the IASB indicate that the present state of reporting INTERNATIONAL for revenue is unsatisfactory. IFRS is criticized because it lacks guidance in a number PERSPECTIVE of areas. For example, IFRS has one basic standard on revenue recognition—IAS The FASB and IASB have a 18—plus some limited guidance related to certain minor topics. In contrast, GAAP joint project to improve the has numerous standards related to revenue recognition (by some counts over 100), accounting for revenue. but many believe the standards are often inconsistent with one another. Thus, the accounting for revenues provides a most fitting contrast of the principles-based (IFRS) and rules-based (GAAP) approaches. While both sides have their advocates, the FASB and IASB recognize a number of deficiencies in this area.2 Unfortunately, inappropriate recognition of revenue can occur in any industry. Products that are sold to distributors for resale pose different risks than products or services that are sold directly to customers. Sales in high-technology industries, where rapid product obsolescence is a significant issue, pose different risks than sales of inventory with a longer life, such as farm or construction equipment, auto- mobiles, trucks, and appliances.3 As a consequence, restatements for improper revenue recognition are relatively common and can lead to significant share price adjustments. 1 See www.prweb.com/releases/RecognitionRevenue/IFRS/prweb1648994.htm. 2 See, for example, “Preliminary Views on Revenue Recognition in Contracts with Customers,” IASB/FASB Discussion Paper (December 19, 2008). Some of the problems noted are that GAAP has so many standards that at times they are inconsistent with each other in applying basic principles. In addition, even with the many standards, no guidance is provided for service transactions. Conversely, IFRS has a lack of guidance in certain fundamental areas such as multiple-deliverable arrangements, which are becoming increasingly common. In addition, there is inconsistency in applying revenue recognition principles to long-term contracts versus other elements of revenue recognition. 3 Adapted from American Institute of Certified Public Accountants, Inc., Audit Issues in Revenue Recognition (New York: AICPA, 1999). c18RevenueRecognition.indd Page 1067 1/21/11 4:42:59 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 Current Environment 1067 Guidelines for Revenue Recognition Revenue arises from ordinary operations and is referred to by various names 1 LEARNING OBJECTIVE such as sales, fees, rent, interest, royalties, and service revenue. Gains, on the Apply the revenue recognition other hand, may or may not arise in the normal course of operations. Typical principle. gains are gains on sale of noncurrent assets or unrealized gains related to investments or noncurrent assets. The primary issue related to revenue recognition is when to recognize the revenue. In general, the guidelines for revenue recognition are quite broad. On top of the broad guidelines, certain industries have specific additional guidelines that provide further insight into when revenue should be recognized. The revenue recognition principle provides that companies should recognize revenue4 (1) when it is realized or realizable, and (2) when it is earned.5 Therefore, proper revenue recognition revolves around three terms: Revenues are realized when a company exchanges goods and services for cash or claims to cash (receivables). Revenues are realizable when assets a company receives in exchange are readily convertible to known amounts of cash or claims to cash. Revenues are earned when a company has substantially accomplished what it must do to be entitled to the benefits represented by the revenues—that is, when the earn- ings process is complete or virtually complete.6 Four revenue transactions are recognized in accordance with this principle: 1. Companies recognize revenue from selling products at the date of sale. This Underlying Concepts date is usually interpreted to mean the date of delivery to customers. Revenues are inflows of assets 2. Companies recognize revenue from services provided, when services have and/or settlements of liabilities from been performed and are billable. delivering or producing goods, 3. Companies recognize revenue from permitting others to use enterprise providing services, or other earning activities that constitute a company’s assets, such as interest, rent, and royalties, as time passes or as the assets are ongoing major or central operations used. during a period. 4. Companies recognize revenue from disposing of assets other than products at the date of sale. 4 Recognition is “the process of formally recording or incorporating an item in the accounts and financial statements of an entity” (SFAC No. 3, par. 83). “Recognition includes depiction of an item in both words and numbers, with the amount included in the totals of the financial statements” (SFAC No. 5, par. 6). For an asset or liability, recognition involves recording not only acquisition or incurrence of the item but also later changes in it, including removal from the financial statements previously recognized. Recognition is not the same as realization, although the two are sometimes used interchange- ably in accounting literature and practice. Realization is “the process of converting noncash resources and rights into money and is most precisely used in accounting and financial report- ing to refer to sales of assets for cash or claims to cash” (SFAC No. 3, par. 83). 5 “Recognition and Measurement in Financial Statements of Business Enterprises,” Statement of Financial Accounting Concepts No. 5 (Stamford, Conn.: FASB, 1984), par. 83. 6 Gains (as contrasted to revenues) commonly result from transactions and other events that do not involve an “earning process.” For gain recognition, being earned is generally less significant than being realized or realizable. Companies commonly recognize gains at the time of an asset’s sale, disposition of a liability, or when prices of certain assets change. c18RevenueRecognition.indd Page 1068 1/21/11 4:43:01 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 1068 Chapter 18 Revenue Recognition These revenue transactions are diagrammed in Illustration 18-1. Type of Sale of product Rendering a Permitting use Sale of asset other transaction from inventory service of an asset than inventory Description Revenue from Revenue from interest, Gain or loss on Revenue from sales of revenue fees or services rents, and royalties disposition Timing of Date of sale Services performed As time passes or Date of sale revenue (date of delivery) and billable assets are used or trade-in recognition ILLUSTRATION 18-1 Revenue Recognition The preceding statements are the basis of accounting for revenue transactions. Yet, Classified by Nature of in practice there are departures from the revenue recognition principle. Companies Transaction sometimes recognize revenue at other points in the earning process, owing in great mea- sure to the considerable variety of revenue transactions.7 Departures from the Sale Basis An FASB study found some common reasons for departures from the sale basis.8 One reason is a desire to recognize earlier than the time of sale the effect of earning activities. Earlier recognition is appropriate if there is a high degree of certainty about the amount of revenue earned. A second reason is a desire to delay recognition of revenue beyond the time of sale. Delayed recognition is appropriate if the degree of uncertainty concern- ing the amount of either revenue or costs is sufficiently high or if the sale does not represent substantial completion of the earnings process. This chapter focuses on two of the four general types of revenue transactions described earlier: (1) selling products and (2) providing services. Both of these are sales transactions. (In several other sections of the textbook, we discuss the other two types of revenue transactions—revenue from permitting others to use enterprise assets, and revenue from disposing of assets other than products.) Our discussion of product sales transactions in this chapter is organized around the following topics: 1. Revenue recognition at point of sale (delivery). 2. Revenue recognition before delivery. 3. Revenue recognition after delivery. 7 The FASB and IASB are now involved in a joint project on revenue recognition. The purpose of this project is to develop comprehensive conceptual guidance on when to recognize revenue. Presently, the Boards are evaluating a customer-consideration model. In this model, a company accounts for the contract asset or liability that arises from the rights and performance obligations in an enforceable contract with the customer. At contract inception, the rights in the contract are measured at the amount of the promised customer payment (that is, the customer consideration). That amount is then allocated to the individual performance obligations identified within the contract in proportion to the standalone selling price of each good or service underlying the performance obligation. It is hoped that this approach (rather than using the earned and realized or realized criteria) will lead to a better basis for revenue recognition. See www.fasb.org/project/ revenue_recognition.shtml. 8 Henry R. Jaenicke, Survey of Present Practices in Recognizing Revenues, Expenses, Gains, and Losses, A Research Report (Stamford, Conn.: FASB, 1981), p. 11. c18RevenueRecognition.indd Page 1069 1/21/11 4:43:02 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 Revenue Recognition at Point of Sale (Delivery) 1069 Illustration 18-2 depicts this organization of revenue recognition topics. ILLUSTRATION 18-2 Revenue Recognition Alternatives At point of sale Before delivery After delivery (delivery) Before During At As cash After “The General Rule” production production completion is costs of collected are production recovered LIABILITY OR REVENUE? Suppose you purchased a gift card for spa services at Sundara Spa for $300. The gift card expires at the end of six months. When should Sundara record the revenue? Here are two choices: What do the 1. At the time Sundara receives the cash for the gift card. numbers 2. At the time Sundara provides the service to the gift-card holder. mean? If you answered number 2, you would be right. Companies should recognize revenue when the obligation is satisfied—which is when Sundara performs the service. Now let’s add a few more facts. Suppose that the gift-card holder fails to use the card in the six-month period. Statistics show that between 2 and 15 percent of gift-card holders never redeem their cards. So, do you still believe that Sundara should record the revenue at the expiration date? If you say you are not sure, you are probably right. Here is why: Certain states do not recog- nize expiration dates, and therefore the customer has the right to redeem an otherwise expired gift card at any time. Let’s say for the moment we are in one of these states. Because the card holder may never redeem, when can Sundara recognize the revenue? In that case, Sundara would have to show statistically that after a certain period of time, the likelihood of redemption is remote. If it can make that case, it can recognize the revenue. Otherwise, it may have to wait a long time. Unfortunately, Sundara may still have a problem. It may be required to turn over the value of the spa services to the state. The treatment for unclaimed gift cards may fall under the abandoned- and-unclaimed-property laws. Most common unclaimed items are required to be remitted to the states after a five-year period. Failure to report and remit the property can result in additional fines and penalties. So if Sundara is in a state where unclaimed property must be sent state to the state, Sundara should report a liability on its balance sheet. Source: PricewaterhouseCoopers, “Issues Surrounding the Recognition of Gift Card Sales and Escheat Liabilities,” Quick Brief (December 2004). REVENUE RECOGNITION AT POINT OF SALE (DELIVERY) According to the FASB’s Concepts Statement No. 5, companies usually meet the two conditions for recognizing revenue (being realized or realizable and being 2 LEARNING OBJECTIVE Describe accounting issues for revenue earned) by the time they deliver products or render services to customers.9 There- recognition at point of sale. fore, companies commonly recognize revenues from manufacturing and selling 9 The SEC believes that revenue is realized or realizable and earned when all of the following criteria are met: (1) Persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been provided; (3) the seller’s price to the buyer is fixed or determinable; and See the FASB (4) collectibility is reasonably assured. The SEC provided more specific guidance because Codification section the general criteria were difficult to interpret. (page 1109). c18RevenueRecognition.indd Page 1070 1/21/11 4:43:04 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 1070 Chapter 18 Revenue Recognition activities at point of sale (usually meaning delivery).10 Implementation problems, how- ever, can arise. We discuss some of these problematic situations on the following pages. Sales with Discounts 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. In essence, the seller is financing the sale and should record interest revenue over the payment term. Illustrations 18-3 and 18-4 provide examples of transac- tions that illustrate these points. ILLUSTRATION 18-3 VOLUME DISCOUNT Revenue Measurement— Volume Discount Facts: Sansung Company has an arrangement with its customers that it will provide a 3% volume dis- count to its customers if they purchase at least $2 million of its product during the calendar year. On March 31, 2012, Sansung has made sales of $700,000 to Artic Co. In the previous two years, Sansung sold over $3,000,000 to Artic in the period April 1 to December 31. Question: How much revenue should Sansung recognize for the first three months of 2012? Solution: In this case, Sansung should reduce its revenue by $21,000 ($700,000 3 3%) because it is probable that it will provide this rebate. Revenue should therefore be reported at $679,000 ($700,000 2 $21,000). To not recognize this volume discount overstates Sansung’s revenue for the first three months of 2012. In other words, the realizable revenue is $679,000, not $700,000. In this case, Sansung makes the following entry on March 31, 2012. Accounts Receivable 679,000 Sales Revenue 679,000 Assuming that Sansung’s customers meet the discount threshold, Sansung makes the following entry. Cash 679,000 Accounts Receivable 679,000 If Sansung’s customers fail to meet the discount threshold, Sansung makes the following entry upon payment. Cash 700,000 Accounts Receivable 679,000 Sales Discounts Forfeited 21,000 As indicated in Chapter 7 (page 372), Sales Discounted Forfeited is reported in the other revenue and expense section of the income statement. In some cases, companies provide cash discounts to customers for a short period of time (often referred to as prompt settlement discounts). For example, assume that terms are payment due in 60 days, but if payment is made within 5 days, a 2 percent discount is given. These prompt settlement discounts should reduce revenues, if material. In most cases, companies record the revenue at full price (gross) and record a sales dis- count if payment is made within the discount period. When a sales transaction involves a financing arrangement, the fair value is deter- mined either by measuring the consideration received or by discounting the payment using an imputed interest rate. The imputed interest rate is the more clearly determinable of either (1) the prevailing rate for a similar instrument of an issuer with a similar credit 10 Statement of Financial Accounting Concepts No. 5, op. cit., par. 84. c18RevenueRecognition.indd Page 1071 1/22/11 9:30:02 AM users-133 /Users/users-133/Desktop/Ramakant_04.05.09/WB00113_R1:JWCL170/New Revenue Recognition at Point of Sale (Delivery) 1071 rating, or (2) a rate of interest that discounts the nominal amount of the instrument to the current sales price of the goods or services. This issue is addressed in Illustration 18-4. EXTENDED PAYMENT TERMS ILLUSTRATION 18-4 Revenue Measurement— Facts: On July 1, 2012, SEK Company sold goods to Grant Company for $900,000 in exchange for a Deferred Payment 4-year zero-interest-bearing note in the face amount of $1,416,163. The goods have an inventory cost on SEK’s books of $590,000. Questions: (a) How much revenue should SEK Company record on July 1, 2012? (b) How much revenue should it report related to this transaction on December 31, 2012? Solution: (a) SEK should record revenue of $900,000 on July 1, 2012, which is the fair value of the inventory in this case. (b) SEK is also financing this purchase and records interest revenue on the note over the 4-year period. In this case, the interest rate is imputed and is determined to be 12%. SEK records interest revenue of $54,000 (12% 3 1⁄2 3 $900,000) at December 31, 2012. The journal entry to record SEK’s sale to Grant Company is as follows (ignoring the cost of goods sold entry). July 1, 2012 Notes Receivable 1,416,163 Sales Revenue 900,000 Discount on Notes Receivable 516,163 SEK makes the following entry to record interest revenue. December 31, 2012 Discount on Notes Receivable 54,000 Interest Revenue (12% 3 ½ 3 $900,00) 54,000 Sales with Right of Return Whether cash or credit sales are involved, a special problem arises with claims for re- turns and allowances. In Chapter 7, we presented the accounting treatment for normal returns and allowances. However, certain companies experience such a high rate of returns—a high ratio of returned merchandise to sales—that they find it necessary to postpone reporting sales until the return privilege has substantially expired. For example, in the publishing industry, the rate of return approaches 25 percent for hardcover books and 65 percent for some magazines. Other types of companies that experience high return rates are perishable food dealers, distributors who sell to retail outlets, recording-industry companies, and some toy and sporting goods manufactur- ers. Returns in these industries are frequently made either through a right of contract or as a matter of practice involving “guaranteed sales” agreements or consignments. Three alternative revenue recognition methods are available when the right of re- turn exposes the seller to continued risks of ownership. These are (1) not recording a sale until all return privileges have expired; (2) recording the sale, but reducing sales by an estimate of future returns; and (3) recording the sale and accounting for the returns as they occur. The FASB concluded that if a company sells its product but gives the buyer the right to return it, the company should recognize revenue from the sales trans- actions at the time of sale only if all of the following six conditions have been met. 1. The seller’s price to the buyer is substantially fixed or determinable at the date of sale. 2. 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. c18RevenueRecognition.indd Page 1072 1/21/11 4:43:05 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 1072 Chapter 18 Revenue Recognition 3. The buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product. 4. The buyer acquiring the product for resale has economic substance apart from that provided by the seller. 5. The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer. 6. The seller can reasonably estimate the amount of future returns. What if the six conditions are not met? In that case, the company must recognize sales revenue and cost of sales either when the return privilege has substantially expired or when those six conditions subsequently are met, whichever occurs first. In the in- come statement, the company must reduce sales revenue and cost of sales by the amount of the estimated returns.11 An example of a return situation is presented in Illustration 18-5. ILLUSTRATION 18-5 SALES WITH RETURNS Recognition—Returns Facts: Pesido Company is in the beta-testing stage for new laser equipment that will help patients who have acid reflux problems. The product that Pesido is selling has been very successful in trials to date. As a result, Pesido has received regulatory authority to sell this equipment to various hospitals. Because of the uncertainty surrounding this product, Pesido has granted to the participating hospitals the right to return the device and receive full reimbursement for a period of 9 months. Question: When should Pesido recognize the revenue for the sale of the new laser equipment? Solution: Given that the hospital has the right to rescind the purchase for a reason specified in the sales contract and Pesido is uncertain about the probability of return, Pesido should not record rev- enue at the time of delivery. If there is uncertainty about the possibility of return, revenue is recognized when the goods have been delivered and the time period for rejection has elapsed. Only at that time have the risks and rewards of ownership transferred. Companies may retain only an insignificant risk of ownership when a refund or right of return is provided. For example, revenue is recognized at the time of sale (even though a right of return exists or refund is permitted), provided the seller can reliably estimate future returns. In this case, the seller recognizes an allowance for returns based on previous experience and other relevant factors. Returning to the Pesido example, assume that Pesido sold $300,000 of laser equip- ment on August 1, 2012, and retains only an insignificant risk of ownership. On October 15, 2012, $10,000 in equipment was returned. In this case, Pesido makes the following entries. August 1, 2012 Accounts Receivable 300,000 Sales Revenue 300,000 October 15, 2012 Sales Returns and Allowances 10,000 Accounts Receivable 10,000 At December 31, 2012, based on prior experience, Pesido estimates that returns on the remaining balance will be 4 percent. Pesido makes the following entry to record the expected returns. 11 Here is an example where GAAP provides detailed guidelines beyond the general revenue recognition principle. c18RevenueRecognition.indd Page 1073 1/22/11 9:30:24 AM users-133 /Users/users-133/Desktop/Ramakant_04.05.09/WB00113_R1:JWCL170/New Revenue Recognition at Point of Sale (Delivery) 1073 December 31, 2012 Sales Returns and Allowances [($300,000 2 $10,000) 3 4%] 11,600 Allowance for Sales Returns and Allowances 11,600 The Sales Returns and Allowances account is reported as contra revenue in the income statement, and Allowance for Sales Returns and Allowances is reported as a contra account to Accounts Receivable in the balance sheet. As a result, the net revenue and net accounts receivable recognized are adjusted for the amount of the expected returns. Sales with Buybacks If a company sells a product in one period and agrees to buy it back in the next period, has the company sold the product? As indicated in Chapter 8, legal title has transferred in this situation. However, the economic substance of this transaction is that the seller retains the risks of ownership. Illustration 18-6 provides an example of a sale with a buyback provision. SALE WITH BUYBACK ILLUSTRATION 18-6 Recognition—Sale with Facts: Morgan Inc., an equipment dealer, sells equipment to Lane Company for $135,000. The equipment Buyback has a cost of $115,000. Morgan agrees to repurchase the equipment at the end of 2 years at its fair value. Lane Company pays full price at the sales date, and there are no restrictions on the use of the equipment over the 2 years. Question: How should Morgan record this transaction? Solution: For a sale and repurchase agreement, the terms of the agreement need to be analyzed to ascertain whether, in substance, the seller has transferred the risks and rewards of ownership to the buyer. In this case, it appears that the risks and rewards of ownership are transferred to Lane Company and therefore a sale should be recorded. That is, Lane will receive fair value at the date of repurchase, which indicates Morgan has transferred risks of ownership. Furthermore, Lane has no restrictions on use of the equipment, which indicates that Morgan has transferred the rewards of ownership. Morgan records the sale and related cost of goods sold as follows. Cash 135,000 Sales Revenue 135,000 Cost of Goods Sold 115,000 Inventory 115,000 Now assume that Morgan requires Lane to sign a note with repayment to be made in 24 monthly payments. Lane is also required to maintain the equipment at a certain level. Morgan sets the payment schedule such that it receives a normal lender’s rate of return on the transaction. In addition, Morgan agrees to repurchase the equipment after two years for $95,000. In this case, this arrangement appears to be a financing transaction rather than a sale. That is, Lane is required to maintain the equipment at a certain level and Morgan agrees to repurchase at a set price, resulting in a lender’s return. Thus, the risks and rewards of ownership are to a great extent still with Morgan. When the seller has retained the risks and rewards of ownership, even though legal title has been transferred, the transaction is a financing arrangement and does not give rise to revenue.12 12 In essence, Lane is renting the equipment from Morgan for two years. We discuss the account- ing for such rental or lease arrangements in Chapter 21. c18RevenueRecognition.indd Page 1074 1/21/11 4:43:05 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 1074 Chapter 18 Revenue Recognition Bill and Hold Sales Bill and hold sales result when the buyer is not yet ready to take delivery but does take title and accept billing. For example, a customer may request a company to enter into such an arrangement because of (1) lack of available space for the product, (2) delays in its production schedule, or (3) more than sufficient inventory in its distribution channel.13 Illustration 18-7 provides an example of a bill and hold arrangement. ILLUSTRATION 18-7 BILL AND HOLD Recognition—Bill and Hold Facts: Butler Company sells $450,000 of fireplaces to a local coffee shop, Baristo, which is planning to expand its locations around the city. Under the agreement, Baristo asks Butler to retain these fireplaces in its warehouses until the new coffee shops that will house the fireplaces are ready. Title passes to Baristo at the time the agreement is signed. Question: Should Butler report the revenue from this bill and hold arrangement when the agreement is signed, or should revenue be deferred and reported when the fire- places are delivered? Solution: When to recognize revenue in a bill and hold situation depends on the circumstances. Butler should record the revenue at the time title passes, provided (1) the risks of ownership have passed to Baristo, that is, Butler does not have specific performance obligations other than storage; (2) Baristo makes a fixed commitment to purchase the goods, requests that the transaction be on a bill and hold basis, and sets a fixed delivery date; and (3) goods must be segregated, complete, and ready for ship- ment. Otherwise, if these conditions are not met, it is assumed that the risks and rewards of owner- ship remain with the seller even though title has passed. In this case, it appears that these conditions were probably met and therefore revenue recognition should be permitted at the time the agreement is signed. Butler makes the following entry to record the bill and hold sale. Accounts Receivable 450,000 Sales Revenue 450,000 If a significant period of time elapses before payment, the accounts receivable is discounted. In addition, it is likely that one of the conditions above is violated (such as the normal payment terms). In this case, the most appropriate approach for bill and hold sales is to defer revenue recognition until the goods are delivered because the risks and rewards of ownership usually do not transfer until that point. Principal-Agent Relationships 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 revenue). Classic Example An example of principal-agent relationships is an airline that sells tickets through a travel agent. For example, assume that Fly-Away Travels sells airplane tickets for British Airways (BA) to various customers. In this case, the principal is BA and the agent is Fly-Away Travels. BA is acting as a principal because it has exposure to the significant risks and rewards associated with the sale of its services. Fly-Away is acting as an agent because it does not have exposure to significant risks and rewards related to the tickets. Although Fly-Away collects the full airfare from the client, it then remits this amount to BA less a commission. Fly-Away therefore should not record the full amount of the fare as revenue on its books—to do so overstates its revenue. Its revenue is the commission—not 13 Proposed Accounting Standards Update, “Revenue from Contracts with Customers” (Stamford, Conn.: FASB, June 24, 2010), p. 54. c18RevenueRecognition.indd Page 1075 1/21/11 4:43:05 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 Revenue Recognition at Point of Sale (Delivery) 1075 the full fare price. The risks and rewards of ownership are not transferred to Fly-Away because it does not bear any inventory risk as it sells tickets to customers. This distinction is very important for revenue recognition purposes. Some might argue that there is no harm in letting Fly-Away record revenue for the full price of the ticket and then charging the cost of the ticket against the revenue (often referred to as the gross method of recognizing revenue). Others note that this approach overstates the agent’s rev- enue and is misleading. The revenue received is the commission for providing the travel services, not the full fare price (often referred to as the net approach). The profession be- lieves the net approach is the correct method for recognizing revenue in a principal-agent relationship. As a result, the FASB has developed specific criteria to determine when a principal-agent relationship exists.14 An important feature in deciding whether Fly-Away is acting as an agent is whether the amount it earns is predetermined, being either a fixed fee per transaction or a stated percentage of the amount billed to the customer. GROSSED OUT Consider Priceline.com, the company made famous by William Shatner’s ads about “naming your own price” for airline tickets and hotel rooms. In one quarter, Priceline reported that it What do earned $152 million in revenues. But, that included the full amount customers paid for tickets, the number hotel rooms, and rental cars. Traditional travel agencies call that amount “gross bookings,” not mean? revenues. And, much like regular travel agencies, Priceline keeps only a small portion of gross bookings—namely, the spread between the customers’ accepted bids and the price it paid for the merchandise. The rest, which Priceline calls “product costs,” it pays to the airlines and hotels that supply the tickets and rooms. However, Priceline’s product costs came to $134 million, leaving Priceline just $18 million of what it calls “gross profit” and what most other companies would call revenues. And, that’s before all of Priceline’s other costs—like advertising and salaries—which netted out to a loss of $102 million. The difference isn’t academic: Priceline shares traded at about 23 times its reported revenues but at a mind-boggling 214 times its “gross profit.” This and other aggressive recogni- tion practices explains the stricter revenue recognition guidance, indicating that if a company performs as an agent or broker without assuming the risks and rewards of ownership of the goods, the company should report sales on a net (fee) basis. Source: Jeremy Kahn, “Presto Chango! Sales Are Huge,” Fortune (March 20, 2000), p. 44. Consignments Another common principal-agent relationship involves consignments. In these cases, manufacturers (or wholesalers) deliver goods but retain title to the goods until they are sold. This specialized method of marketing certain types of products makes use of a device known as a consignment. Under this arrangement, the consignor (manufacturer or wholesaler) ships merchandise to the consignee (dealer), who is to act as an agent for the consignor in selling the merchandise. Both consignor and consignee are interested in selling—the former to make a profit or develop a market, the latter to make a commis- sion on the sale. 14 Common principal-agent arrangements include (but are not limited to) (1) arrangements with third-party suppliers to drop-ship merchandise on behalf of the entity, (2) services offered by a company that will be provided by a third-party service provider, (3) shipping and handling fees and costs billed to customers, and (4) reimbursements for out-of-pocket expenses (expenses often include, but are not limited to, expenses related to airfare, mileage, hotel stays, out-of-town meals, photocopies, and telecommunications and facsimile charges). Principal-agent accounting guidance is not limited to entities that sell products or services over the Internet but also to transactions related to advertisements, mailing lists, event tickets, travel tickets, auctions (and reverse auctions), magazine subscription brokers, and catalog, consignment, or special-order retail sales. c18RevenueRecognition.indd Page 1076 2/3/11 11:57:46 AM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 1076 Chapter 18 Revenue Recognition The consignee accepts the merchandise and agrees to exercise due diligence in car- ing for and selling it. The consignee remits to the consignor cash received from custom- ers, after deducting a sales commission and any chargeable expenses. In consignment sales, the consignor uses a modified version of the sale basis of reve- nue recognition. That is, the consignor recognizes revenue only after receiving notification of sale and the cash remittance from the consignee. The consignor carries the merchandise as inventory throughout the consignment, separately classified as Inventory (consign- ments). The consignee does not record the merchandise as an asset on its books. Upon sale of the merchandise, the consignee has a liability for the net amount due the con- signor. The consignor periodically receives from the consignee a report called 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. Analysis of a consignment arrangement is provided in Illustration 18-8. ILLUSTRATION 18-8 SALES ON CONSIGNMENT Entries for Consignment Sales Facts: Nelba Manufacturing Co. ships merchandise costing $36,000 on consignment to Best Value Stores. Nelba pays $3,750 of freight costs, and Best Value pays $2,250 for local advertising costs that are reimbursable from Nelba. By the end of the period, Best Value has sold two-thirds of the consigned merchandise for $40,000 cash. Best Value notifies Nelba of the sales, retains a 10% commission, and remits the cash due Nelba. Question: What are the journal entries that the consignor (Nelba) and the consignee (Best Value) make to record this transaction? Solution: NELBA MFG. CO. BEST VALUE STORES (CONSIGNOR) (CONSIGNEE) Shipment of consigned merchandise Inventory (consignments) 36,000 No entry (record memo of merchandise Finished Goods Inventory 36,000 received). Payment of freight costs by consignor Inventory (consignments) 3,750 No entry. Cash 3,750 Payment of advertising by consignee No entry until notified. Receivable from Consignor 2,250 Cash 2,250 Sales of consigned merchandise No entry until notified. Cash 40,000 Payable to Consignor 40,000 Notification of sales and expenses and remittance of amount due Cash 33,750 Payable to Consignor 40,000 Advertising Expense 2,250 Receivable from Commission Expense 4,000 Consignor 2,250 Revenue from Commission Revenue 4,000 Consignment Sales 40,000 Cash 33,750 Adjustment of inventory on consignment for cost of sales Cost of Goods Sold 26,500 No entry. Inventory (consignments) 26,500 [2/3 ($36,000 1 $3,750) 5 $26,500] c18RevenueRecognition.indd Page 1077 1/21/11 4:43:06 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 Revenue Recognition at Point of Sale (Delivery) 1077 Under the consignment arrangement, the consignor accepts the risk that the mer- chandise might not sell and relieves the consignee of the need to commit part of its working capital to inventory. Companies use a variety of different systems and account titles to record consignments, but they all share the common goal of postponing the recognition of revenue until it is known that a sale to a third party has occurred. Trade Loading and Channel Stuffing One commentator describes trade loading this way: “Trade loading is a crazy, uneco- nomic, insidious practice through which manufacturers—trying to show sales, profits, and market share they don’t actually have—induce their wholesale customers, known as the trade, to buy more product than they can promptly resell.” For example, the ciga- rette industry appears to have exaggerated a couple years’ operating profits by as much as $600 million by taking the profits from future years. In the computer software industry, a similar practice is referred to as channel stuff- ing. When a software maker needed to make its financial results look good, it offered deep discounts to its distributors to overbuy and then recorded revenue when the soft- ware left the loading dock. Of course, the distributors’ inventories become bloated and the marketing channel gets too filled with product, but the software maker’s current- period financials are improved. However, financial results in future periods will suffer, unless the company repeats the process. Trade loading and channel stuffing distort operating results and “window dress” financial statements. In addition, similar to consignment transactions or sales with buy- back agreements, these arrangements generally do not transfer the risks and rewards of ownership. If used without an appropriate allowance for sales returns, channel stuffing is a classic example of booking tomorrow’s revenue today. Business managers need to be aware of the ethical dangers of misleading the financial community by engaging in such practices to improve their financial statements. ABOUT NO TAKE-BACKS THOSE SWAPS Investors in Lucent Technologies were negatively affected when Lucent violated one of the fun- damental criteria for revenue recognition—the “no take-back” rule. This rule holds that revenue What do the should not be booked on inventory that is shipped if the customer can return it at some point in numbers the future. In this particular case, Lucent agreed to take back shipped inventory from its distribu- tors if the distributors were unable to sell the items to their customers. mean? In essence, Lucent was “stuffing the channel.” By booking sales when goods were shipped, even though they most likely would get them back, Lucent was able to report continued sales growth. However, Lucent investors got a nasty surprise when distributors returned those goods and Lucent had to restate its financial results. The restatement erased $679 million in revenues, turning an operating profit into a loss. In response to this bad news, Lucent’s share price declined $1.31 per share, or 8.5 percent. Lucent is not alone in this practice. Sunbeam got caught stuffing the sales channel with barbeque grills and other outdoor items, which contributed to its troubles when it was forced to restate its earnings. Investors can be tipped off to potential channel stuffing by carefully reviewing a company’s revenue recognition policy for generous return policies and by watching inventory and receivables levels. When sales increase along with receivables, that’s one sign that customers are not paying for goods shipped on credit. And growing inventory levels are an indicator that customers have all the goods they need. Both scenarios suggest a higher likelihood of goods being returned and revenues and income being restated. So remember, no take-backs! Source: Adapted from S. Young, “Lucent Slashes First Quarter Outlook, Erases Revenue from Latest Quarter,” Wall Street Journal Online (December 22, 2000); and Tracey Byrnes, “Too Many Thin Mints: Spotting the Practice of Channel Stuffing,” Wall Street Journal Online (February 7, 2002). c18RevenueRecognition.indd Page 1078 1/21/11 4:43:06 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 1078 Chapter 18 Revenue Recognition Multiple-Deliverable Arrangements One of the most difficult issues related to revenue recognition involves multiple- deliverable arrangements (MDAs). 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. These issues are particularly complex in the technology area. Many devices have contracts that typically include such multiple deliverables as hardware, software, pro- fessional services, maintenance, and support—all of which are valued and accounted for differently. A classic example relates to the Apple iPhone and its AppleTV product. Basically, until a recent rule change, revenues and related costs were accounted for on a subscription basis over a period of years. The reason was that Apple provides future unspecified software upgrades and other features without charge. It was argued that Apple should defer a significant portion of the cash received for the iPhone and recog- nize it over future periods. At the same time, engineering, marketing, and warranty costs were expensed as incurred. As a result, Apple reported conservative numbers related to its iPhone revenue. However, as a result of efforts to more clearly define the various services related to an item such as the iPhone, Apple is now able to report more revenue at the point of sale. In general, all units in a multiple-deliverable arrangement are considered separate units of accounting, provided that: 1. A delivered item has value to the customer on a standalone basis; and 2. The arrangement includes a general right of return relative to the delivered item; and 3. Delivery or performance of the undelivered item is considered probable and substantially in the control of the seller. Once the separate units of accounting are determined, the amount paid for the arrange- ment is allocated among the separate units based on relative fair value. A company determines fair value based on what the vendor could sell the component for on a standalone basis. If this information is not available, the seller may rely on third-party evidence or if not available, the seller may use its best estimate of what the item might sell for as a standalone unit. Illustration 18-9 identifies the steps in the evaluation process. ILLUSTRATION 18-9 Multiple-Deliverable Evaluation Process Multiple-Deliverable Arrangements Includes general right of return Value to Customer Yes Account for as Delivery of undelivered items Yes on Standalone Basis Separate Unit probable and substantially controlled by seller Do Not Account for Allocate Based on No Separate Unit No Fair Values c18RevenueRecognition.indd Page 1079 1/21/11 4:43:08 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 Revenue Recognition at Point of Sale (Delivery) 1079 Presented in Illustrations 18-10 and 18-11 are two examples of the accounting for MDAs. MULTIPLE DELIVERABLES ILLUSTRATION 18-10 MDA—Equipment and Facts: Lopez Company enters into a contract to build, run, and maintain a highly complex piece of elec- Maintenance tronic equipment for a period of 5 years, commencing upon delivery of the equipment. There is a fixed fee for each of the build, run, and maintenance deliverables, and any progress payments made are not refundable. In addition, there is a right of return in the arrangement. All the deliverables have a standalone value, and there is verifiable evidence of the selling price for the building and maintenance but not for running the equipment. Questions: Should Lopez separate and then measure and allocate the amounts paid for the MDA? Solution: Assuming delivery (performance) is probable and Lopez controls any undelivered items, Lopez determines whether the components have standalone value. The components of the MDA are the equipment, maintenance of the equipment, and running the equipment; each component has a standalone value. Lopez can determine standalone values of equipment and the mainte- nance agreement by third-party evidence of fair values. The company then makes a best esti- mate of the selling price for running of the equipment. Lopez next applies the relative fair value method at the inception of the MDA to determine the proper allocation to each component. Once the allocation is performed, the company recognizes revenue independently for each component using regular revenue recognition criteria. PRODUCT, INSTALLATION, AND SERVICE ILLUSTRATION 18-11 MDA—Product, Facts: Handler Company is an experienced manufacturer of equipment used in the construction industry. Installation, and Service Handler’s products range from small to large individual pieces of automated machinery to complex sys- tems containing numerous components. Unit selling prices range from $600,000 to $4,000,000 and are quoted inclusive of installation and training. The installation process does not involve changes to the features of the equipment and does not require proprietary information about the equipment in order for the installed equipment to perform to specifications. Handler has the following arrangement with Chai Company. Chai purchases equipment from Handler for a price of $2,000,000 and chooses Handler to do the installation. Handler charges the same price for the equipment irrespective of whether it does the installation or not. (Some companies do the installation themselves because they either prefer their own employees to do the work or because of relationships with other customers.) The price of the installation service is estimated to have a fair value of $20,000. The fair value of the training sessions is estimated at $50,000. Chai is obligated to pay Handler the $2,000,000 upon the delivery and installation of the equipment. Handler delivers the equipment on September 1, 2012, and completes the installation of the equip- ment on November 1, 2012. Training related to the equipment starts once the installation is completed and lasts for 1 year. The equipment has a useful life of 10 years. Questions: (a) What are the standalone units for purposes of accounting for the sale of the equipment? (b) If there is more than one standalone unit, how should the fee of $2,000,000 be allocated to various components? Solution: (a) The first condition for separation into a standalone unit for the equipment is met. That is, the equipment, installation, and training are three separate components. (b) The total revenue of $2,000,000 should be allocated to the three components based on their rela- tive fair values. In this case, the fair value of the equipment should be considered $2,000,000, the installation fee is $20,000, and the training is $50,000. The total fair value to consider is $2,070,000 ($2,000,000 1 $20,000 1 $50,000). The allocation is as follows. Equipment $1,932,367 ($2,000,000 4 $2,070,000) 3 $2,000,000 Installation 19,324 ($20,000 4 $2,070,000) 3 $2,000,000 Training 48,309 ($50,000 4 $2,070,000) 3 $2,000,000 c18RevenueRecognition.indd Page 1080 1/22/11 9:31:39 AM users-133 /Users/users-133/Desktop/Ramakant_04.05.09/WB00113_R1:JWCL170/New 1080 Chapter 18 Revenue Recognition Handler makes the following entries on November 1, 2012. November 1, 2012 Cash 2,000,000 Service Revenue (installation) 19,324 Unearned Service Revenue 48,309 Sales Revenue 1,932,367 The sale of the equipment should be recognized once the installation is completed on November 1, 2012, and the installation fee also should be recognized because these ser- vices have been provided. The training revenues should be allocated on a straight-line basis starting on November 1, 2012, or $4,026 ($48,309 4 12) per month for one year (unless a more appropriate method such as the percentage-of-completion method is warranted). The journal entry to recognize the training revenue for two months in 2012 is as follows. December 31, 2012 Unearned Service Revenue 8,052 Service Revenue (training) ($4,026 3 2) 8,052 Therefore, the total revenue recognized at December 31, 2012, is $1,959,743 ($1,932,367 1 $19,324 1 $8,052). Handler makes the following journal entry to recognize the training revenue in 2013, assuming adjusting entries are made at year-end. December 31, 2013 Unearned Service Revenue 40,257 Service Revenue (training) ($48,309 2 $8,052) 40,257 Summary of Revenue Recognition Methods ILLUSTRATION 18-12 Illustration 18-12 provides a summary of revenue recognition methods and related Revenue Recognition at accounting guidance. the Point of Sale General Principles Recognize revenue (1) when it is realized or realizable, and (2) when it is earned. In numerous cases, GAAP provides additional specific guidance to help determine proper revenue recognition. Specific Transactions Accounting Guidance Sales with discounts Trade, volume, and cash discounts reduce sales revenue. Sales with extended payment The fair value measurement of revenue is determined by using the fair value of the consideration terms received or by discounting the future payments using an imputed interest rate. Sales with right of return If there is uncertainty about the possibility of return, recognize revenue when the goods are delivered and the return period has lapsed. If the company can reliably estimate future returns, revenue (less estimated returns) is recognized at the point of sale. Sales with buyback Terms of the buyback agreement must be analyzed to determine if, in substance, the seller has transferred the risks and rewards of ownership. Bill and hold sales Recognition depends on the circumstances. Recognize revenue when title passes if (1) the risks of ownership have passed to the customer, and the seller does not have specific obligations other than storage; (2) the customer makes a fixed commitment to purchase the goods, requests that the trans- action be on a bill and hold basis, and sets a fixed delivery date; and (3) goods must be segregated, complete, and ready for shipment. Sales involving principal-agent Amounts collected by the agent on behalf of the principal are not revenue of the agent. Instead, relationship (general) revenue to the agent is the amount of commission it receives. Sales involving principal-agent Consignor recognizes revenue (sales and cost of goods sold) when goods are sold by consignee. relationship (consignments) Consignee recognizes revenue for commissions received. Trade loading and channel Unless returns can be reliably measured, revenue should not be recognized until the goods are stuffing sold (by the distributor) to third parties. Multiple-deliverable Apply general revenue recognition principles to each element of the arrangement that has stand- arrangements alone value. Once the separate units of accounting are determined, the amount paid for the arrangement is allocated among the separate units based on relative fair value. c18RevenueRecognition.indd Page 1081 1/21/11 4:43:08 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 Revenue Recognition before Delivery 1081 REVENUE RECOGNITION BEFORE DELIVERY For the most part, companies recognize revenue at the point of sale (delivery) be- cause at point of sale most of the uncertainties in the earning process are removed and the exchange price is known. Under certain circumstances, however, companies recognize revenue prior to completion and delivery. The most notable example is long- term construction contract accounting, which uses the percentage-of-completion method. Long-term contracts frequently provide that the seller (builder) may bill the pur- chaser at intervals, as it reaches various points in the project. Examples of long-term contracts are construction-type contracts, development of military and commercial air- craft, weapons-delivery systems, and space exploration hardware. When the project con- sists of separable units, such as a group of buildings or miles of roadway, contract provi- sions may provide for delivery in installments. In that case, the seller would bill the buyer and transfer title at stated stages of completion, such as the completion of each building unit or every 10 miles of road. The accounting records should record sales when installments are “delivered.”15 Two distinctly different methods of accounting for long-term construction contracts are recognized.16 They are: Percentage-of-completion method. Companies recognize revenues and gross profits each period based upon the progress of the construction—that is, the percentage of completion. The company accumulates construction costs plus gross profit earned to date in an inventory account (Construction in Process), and it accumulates progress billings in a contra inventory account (Billings on Construction in Process). Completed-contract method. Companies recognize revenues and gross profit only when the contract is completed. The company accumulates construction costs in an inventory account (Construction in Process), and it accumulates progress billings in a contra inventory account (Billings on Construction in Process). The rationale for using percentage-of-completion accounting is that under most of these contracts the buyer and seller have enforceable rights. The buyer has the legal right to require specific performance on the contract. The seller has the right to require progress payments that provide evidence of the buyer’s ownership interest. As a result, a continuous sale occurs as the work progresses. Companies should recognize revenue according to that progression. Companies must use the percentage-of-completion method when estimates of Underlying Concepts progress toward completion, revenues, and costs are reasonably dependable and The percentage-of-completion all of the following conditions exist. method recognizes revenue from long-term contracts in the periods in 1. The contract clearly specifies the enforceable rights regarding goods or ser- which the revenue is earned. The firm vices to be provided and received by the parties, the consideration to be contract fixes the selling price. And, exchanged, and the manner and terms of settlement. if costs are estimable and collection reasonably assured, the revenue 2. The buyer can be expected to satisfy all obligations under the contract. recognition concept is not violated. 3. The contractor can be expected to perform the contractual obligations. 15 Statement of Financial Accounting Concepts No. 5, par. 84, item c. 16 Accounting Trends and Techniques—2010 reports that of the 86 of its 500 sample companies that referred to long-term construction contracts, 63 used the percentage-of-completion method and 20 used the completed-contract method. c18RevenueRecognition.indd Page 1082 1/21/11 4:43:09 PM f-392 /Users/f-392/Desktop/Nalini 23.9/ch05 1082 Chapter 18 Revenue Recognition Companies should use the completed-contract method when one of the following conditions applies: When a company has primarily short-term contracts, or When a company cannot meet the conditions for using the percentage-of-completion method, or When there are inherent hazards in the contract beyond the normal, recurring business risks. The presumption is that percentage-of-completion is the better method. Therefore, companies should use the completed-contract