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CMA(USA) Part-1 Unit No.1

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Notes on External Financial Statements & Revenue Recognition

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Teaches: Accountancy: Management, Bookkeeping, Finance: Corporate, Quantitative Analysis, Finance, Accounting, Business, ACCA, CPA, CMA

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Certified Management Accountant â€” Unit-I CMA(USA) Part-I EXTERNAL NCIAL STATEMENTS AND REVENUE GNITION
O O O Things To Learn Concepts of Financial Accounting Statement of Financial Position (Bal nce Sheet) Income Statement and Statement of Comprehensive Income O O O O Statement of Changes in Equity and Equity Transactions Statement of Cash Flows Revenue Recognition -- Revenue Recognition after Delivery Revenue Recognition -- Long-Term onstruction Contracts
CONCEPTS OF FINANCIAL ACCOUNTING The Objective of General-Purpose Financial Reporting The objective of general-purpose financial reporting is to report financial information that is USefUI in making decisions about providing resources to the reporting entity. Users need to differentiate between changes in economic resources and claims arising from (1) the entitVs performance (income tatement) and (2) other events and transactions, such as issuing debt and equity (balance sheet). Information about financial performance is USefUI or: Understanding the return on economic resources, its variability, and its O Evaluating management; and O Predicting future returns. O Financial accounting differs from management accounting. Management accounting assists management decision making, planning, and control. Management accounting information ist erefore primarily directed to specific internal users, and it ordinarily need not f Ilow GAAP. 3
CONCEPTS OF FINANCIAL ACCOUNTING External users use financial statements to deter ine whether doing business with the firm will be beneficial. 1) Investors need information to decide whether to increase, decrease, or obtain an investment in a firm. 2) Creditors need information to determine whether to extend credit and under what terms. 3) Financial advisors and analysts need financial statements to help investors evaluate particular investments. 4) Stock exchanges need financial statements to e aluate whether to accept a firm's stock for listing or whether to suspend the stock's trading. 5) Regulatory agencies may need financial statements to evaluate the firm's conformity with regulations and to determine price levels in regulated industries. Internal users use financial statements to make decisions affecting the operations of the business. These users include management/ employees, and the board of directors. 5
CONCEPTS OF FINANCIAL ACCOUNTING Users of Financial Statements Users with direct interests include a) Investors or potential investors b) Suppliers and creditors c) Employees d) Management Users having indirect interests include a) Financial advisors and analysts b) Stock markets or exchanges c) Regulatory authorities 6
CONCEPTS OF FINANCIAL ACCOUNTING Features of Financial Statements A full set of financial statements includes the following statements: 1) Statement of financial position (also called a balance sheet) 2) Income statement 3) Statement of comprehensive income 4) Statement of changes in equity 5) Statement of cash flows To be useful/ information presented in the financi I statements must be relevant and faithfully represented. To enhance the usefulness, the information should be comparable with similar information for (1) other entities and (2) the same entity for another period or date. Thus, comparability allows Users to understand similarities and differences. 7
CONCEPTS OF FINANCIAL ACCOUNTING Financial Statement Relationships Financial statements complement each other. The describe different aspects of the same transactions, and more than one statement is necessary to provide information for a specific economic decision. The components (elements) of one statement relate to those of other statements. Among the relationships are those listed below: 1) Net income or loss from the statement of inco e is reported and accumulated in the retained earnings account/ a component of he equity section of the statement of financial position. 2) The components of cash and equivalents from t e statement of financial position are reconciled with the corresponding items in the statement of cash flows. 3) Items of equity from the statement of financial position are reconciled with the beginning balances on the statement of changes in equity. 8
CONCEPTS OF FINANCIAL ACCOUNTING Accrual Basis of Accounting Financial statements are prepared under the accr al basis of accounting. Accrual accounting records the financial effects of transac ions and other events and circumstances when they OCCUr rather than when their associated cash is paid or received. 1) Revenues are recognized in the period in which hey were earned even if the cash will be received in a future period. 2) Expenses are recognized in the period in which hey were incurred even if the cash will be paid in a future period. 9
STATEMENT OF FINANCIAL POSITION (BALANCE SHEET) Overview The statement of financial position, also called th balance sheet/ reports the amounts of assets, liabilities, equity, and their relationships at a moment in time, such as at the end of the fiscal year. It helps users to assess liquidity, financial flexibility, and risk. Assets = Liabilities + Equi ty Elements of Balance Sheet Assets are resources controlled by the entity as a result of past events. They represent probable future economic benefits to the entity. Examples include inventory; accounts receivable; investments; and property, plant/ and equipment. Liabilities are present obligations of the entity ari ing from past events. Their settlement is expected to result in an outflow Ofe onomic benefits from the entity. Examples include loans, bonds issued by the entity, and accounts payable. 10
STATEMENT OF FINANCIAL POSITION (BALANCE SHEET) Equity is the residual interest in the assets of the ntity after subtracting all its liabilities. Examples include a companVs common stock/ preferred stock/ and retained earnings. Equity is affected not only by operations but also by transactions with owners, such as dividends and contributions. Investments by owners are increases in equity of a business entity. They result from transfers of something of value to increase ownership interests. Assets are the most commonly transferred item, Ut services also can be exchanged for equity interests. 2) Distributions to owners are decreases in equity. They result from transferring assets, providing services, or incurrin liabilities. A distribution to owners decreases the ownership interest in the co pany. 11
STATEMENT OF FINANCIAL POSITION (BALANCE SHEET) Current and Noncurrent Assets An asset is classified as current on the statement of financial position if it is expected to be realized in cash or sold or consum d within the entitVs operating cycle or 1 year, whichever is longer. Noncurrent assets are those not qualifying as current. Major Categories Of Noncurrent Assets: Investments and funds include nonoperating items intended to be held beyond the longer of 1 year or the operating cycle. The following assets are typically included: a) Investments in securities made to control or influence another entity and other noncurrent securities. b) Certain individual trading, available-for-sale, and held-to-maturity securities may be noncurrent. c) Funds restricted as to withdrawal or use for other than current operations, or example, to (1) retire long-term debt/ (2) satisfy p nsion obligations, or (3) pay for the acquisition or construction of noncurrenta sets. 12
STATEMENT OF FINANCIAL POSITION (BALANCE SHEET) Property, plant, and equipment (PPE) are tangible operating items recorded at cost and reported net of any accumulated depreci tion. They include a) Land and natural resources subject to depletion e.g., oil and gas b) Buildings, equipment/ furniture, fixtures, leasehold improvements, land improvements, assets held under capital leases, n ncurrent assets under construction, and other depreciable assets 3) Intangible assets are nonfinancial assets without physical substance. Examples are patents and goodwill. 13
STATEMENT OF FINANCIAL POSITION (BALANCE SHEET) Current and Noncurrent Liabilities: Current Liabilities are expected to be settled or liquidated in the ordinary course of business during the longer of the next year ort e operating cycle. Major Categories Of Current Liabilities: Trade payables for items entering into the operat ng cycle Other payables arising from operations, such as accrued wages, salaries Unearned revenues arising from collections in ad ance Other obligations expected to be liquidated in th ordinary course of business during the longer of the next year or the operatin cycle. These include a) Short-term notes given to acquire capital assets b) Payments required under sinking-fund provisions c) Payments on the current portion of serial bonds or other noncurrent debt d) Long-term obligations that are or will become callable by the creditor because of the debtor's violation of a provision of the debt Ã…greement at the balance sheet date 14
STATEMENT OF FINANCIAL POSITION (BALANCE SHEET) Current liabilities do not include short-term debt if an entity: 1) Intends to refinance them on a noncurrent basis and 2) Demonstrates an ability to do so. a) The ability to refinance may be demonstrated b entering into a refinancing agreement before the balance sheet is issued. Noncurrent Liabilities are those not qualifying as current. 1) Noncurrent notes and bonds 2) Liabilities under capital leases 3) Most postretirement benefit obligations 4) Deferred tax liabilities arising from interperiod tax allocation 5) Obligations under product or service warranty fgreements 6) Advances for noncurrent commitments to pro ide goods or services 7) revenue 15
STATEMENT OF FINANCIAL POSITION (BALANCE SHEET) Equity Any recognized transaction that does not have equal and offsetting effects on total assets and total liabilities changes equity. Capital contributions by owners Retained earnings are the accumulated net inco e not yet distributed Treasury stock is the firm's own stock that has been repurchased. Accumulated other comprehensive income item not included in net income. Balance Sheet Elements Are Permanent ACCOUn s Assets, liabilities, and equity are recorded in permanent (real) accounts. Their balances at the end of one accounting period (the alance sheet date) are carried forward as the beginning balances of the next accounting period. 16
STATEMENT OF FINANCIAL POSITION (BALANCE SHEET) Major Note Disclosures a. The first footnote accompanying any set of complete financial statements is generally one describing significant accounting policies, such as the Use of estimates and rules for revenue recognition. b. Footnote disclosures and schedules specifically elated to the balance sheet include 1) Investment securities 2) Property, plant/ and equipment holdings 3) Maturity patterns of bond issues 4) Significant uncertainties, such as pending litigation 5) Details of capital stock issues Limitations of Balance Sheet The balance sheet shows a companVs financial potition at a single point in time; accounts may vary significantly a few days before pr after the publication of the balance sheet. Many balance sheet items, such as fixed assets, are valued at historical costs, which may bear no resemblance to the current value of those items.
INCOME STATEMENT AND STATEMENT OF COMPREHENSIVE INCOME Income Statement Elements The Income Equation Revenues + Gains sâ€” Expenses Losses Jncome (Loss) Revenues are inflows or other enhancements of aSsets or settlements of liabilities. Gains are increases in equity (or net assets) other than from revenues or investments by owners. Expenses are outflows or other usage of assets or incurrences of liabilities Losses are decreases in equity (or net assets) other than from expenses or distributions to owners. All transactions affecting the net change in equity during the period are included in income except: 1) Transactions with owners 2) Prior-period adjustments (such as error correction or a change in accounting principle) 3) Items reported initially in other comprehensive ncome 18
INCOME STATEMENT AND STATEMENT OF COMPREHENSIVE INCOME Revenues, expenses, gains, and losses are recorded in temporary (nominal) accounts because they record the transactions, e ents, and other circumstances during a period of time. These accounts are closed (reduced to zero) at the end of each accounting period, and their balances are tra sferred to real accounts. 1) For example, income or loss for the period (a nooninal account) is closed to retained earnings (a real account) at the end of the reporting period. Typical Items of Cost and Expense The expense recognition principles are associatin catJSe and effect/ systematic and rational allocation, and immediate recognition. Matching is essentially synonymous with associat ng cause and effect. Such a direct relationship is found when the cost of good sold is recognized in the same period as the revenue from the sale of the goods. 19
INCOME STATEMENT AND STATEMENT OF COMPREHENSIVE INCOME Other Expenses 1) General and administrative expenses are incurred for the benefit of the enterprise as a whole and are not related wholly t a specific function, e.g., selling or manufacturing. a) They include accounting, legal/ and other fees for professional services; officers' salaries; insurance; wages of office staff; miscellaneous supplies; and office occupancy costs. 2) Selling expenses are those incurred in selling or marketing. a) Examples include sales representatives/ salaries commissions, and traveling expense; advertising; sales department salaries and expenses, including rent; and credit and collection costs. b) Shipping costs are also often classified as sellin costs. d. Interest expense is recognized based on the passage of time. In the case of bonds, notes, and capital leases, the effective inte est method is Used. 20
INCOME STATEMENT AND STATEMENT OF COMPREHENSIVE INCOME Income Statement Formats The single-step income statement provides one rouping for revenue items and one for expense items. The multiple-step income statement matches o erating revenues and expenses in a section separate from non-operatin items. Reporting Irregular Items Discontinued operations, if reported/ may have two components: Olncome or loss from operations of the compone t Gain or loss on the disposal of this component O Extraordinary items are income statement items that meet the following two criteria: Unusual in nature O Olnfrequent in occurrence in the environment in hich the entity operates 21
INCOME STATEMENT AND STATEMENT OF COMPREHENSIVE INCOME EXAMPLE Sales Cost of goods sold Gross profit General and administrative expenses Income before taxes Income taxes Income from continued operations Discontinued operations: Loss from operations of component X, net of taxes Gain on disposal of component X, net of taxes Loss on discontinued operations Income before extraordinary items Extraordinary item: Loss from volcanic eruption, net of taxes Net income $ 500,000 (200,000) $ 300,000 (120,000) $ 180,000 (40,000) $ 140,000 $ (60,000) 10,000 $ (50,000) $ 90,000 (20,000) $ 70,000 22
INCOME STATEMENT AND STATEMENT OF COMPREHENSIVE INCOME Limitations of the Income Statement The income statement does not always show all it ms of income and expense. Some item are reported in Other Comprehensive ncome. The financial statements report accrual-basis resu ts for the period. Statement of Comprehensive Income Comprehensive income includes all changes ine Uity (net assets) of a business during a period except those from investments by and distributions to owners. The effective portion of a gain or loss on a hedging instrument O Unrealized gains and losses due to changes in the fair value of available-for-sale O securities Translation gains and losses for financial statem nts of foreign operations O Certain amounts associated with accounting for defined benefit O postretirement plans 23
INCOME STATEMENT AND STATEMENT OF COMPREHENSIVE INCOME All items of comprehensive income are recognize for the period in either 1) One continuous financial statement that hast o sections, net income and 2) Two separate but consecutive statements. a) The first statement (the income statement) pre ents the components of net income and total net income. b) The second statement (the statement of OCI) is presented immediately after the first. It presents a total of OCI with its compon nts and a total of comprehensive income. c. The following is an example of a separate statement of comprehensive Net income Other comprehensive income (net of tax): Loss on defined benefit postretirement plans Gains on foreign currency translation Gains on remeasuring available-for-sale securities Effective portion of losses on cash flow hedges Other comprehensive income (loss) Total comprehensive income $ 70,000 6,000 4,000 (3,000) (8,000) s 62 000
STATEMENT OF CHANGES IN EQUITY AND EQUITY TRANSACTIONS Statement of Changes in Equity A statement of changes in equity presents a reconciliation for the accounting period of the beginning balance for each compon nt of equity to the ending balance. Each change is disclosed separately in the statem nt. The following are the common changes in the equity component balances during the accounting period: 1) Net income (loss) for the period, which increase (decreases) the retained earnings balance. 2) Distributions to owners (dividends paid)/ which ecreases the retained earnings balance. 3) Issuance of common stock/ which increases the common stock balance. If the amount paid for the stock is above the par value o stock/ the balance of additional paid-in capital is also increased. 4) Total change in other comprehensive income d ring the period. 25
STATEMENT OF CHANGES IN EQUITY AND EQUITY TRANSACTIONS Statement of Retained Earnings A statement of retained earnings reconciles the b ginning and ending balances of the account. This statement is reported as part f the statement of changes in equity in a separate column. Retained earnings beginning balance + Net income (loss) for the period â€” Dividends distributed during the period + Positive (neaative) prior-period adjustments Retained earninqs endinq balance Prior-period adjustments include the cumulative effect of changes in accounting principle and corrections of prior-period financial statement errors. These items require retrospective application, i.e., adjustment of the beginning balance of retained earnings for the prior period's cumulative effect on the income statement. 26
STATEMENT OF CHANGES IN EQUITY AND EQUITY TRANSACTIONS Retained earnings are sometimes appropriated (restricted) to a special account to disclose that earnings retained in the business ( ot paid out in dividends) are being used for special purposes. An appropriation Ust be clearly displayed within equity. 1) Purposes include (a) compliance with a bond in enture (bond contract)/ b) retention of assets for internally financed expansion, (c) anticipation of losses, or (d) adherence to legal restrictions. 2) The appropriation does not set aside assets. It imits the availability of dividends. A formal entry (debit retained earnings credit retained earnings appropriated) or disclosure in a note may be mad 3) Transfers to and from an appropriation do not a fect net income. 27
STATEMENT OF CHANGES IN EQUITY AND EQUITY TRANSACTIONS Common and Preferred Stock The most widely used classes of stock are common and preferred. The following basic terminology is related to stock. 1) Stock authorized is the maximum amount of st ckthat a corporation is legally allowed to issue. 2) Stock issued is the amount of stock authorized hat has actually been issued by the corporation. 3) Stock outstanding is the amount of stock issued that has been purchased and is held by shareholders. The common shareholders are the owners of the firm. They have voting rights, and they select the firm's board of directors and vote on resolutions. Common shareholders are not entitled to dividends unless so declared by the board of directors. A firm may choose not to declare any. 28
STATEMENT OF CHANGES IN EQUITY AND EQUITY TRANSACTIONS 1) Common shareholders are entitled to receive Ii uidating distributions only after all other claims have been satisfied/ includin those of preferred shareholders. 2) Common shareholders ordinarily have preemptive rights. Preemptive rights give current common shareholders the right to PU chase any additional stock issuances in proportion to their ownership percen ages. This way the preemptive rights safeguard a common shareholder's proportionate interest in the firm. Preferred stock has features of debt and equity. I is classified as an equity instrument and presented in the equity section of the firm's balance sheet. Preferred stock has a fixed charge, but payment o dividends is not an obligation. The payment of dividends is at the firm's discretio . Preferred shareholders tend not to have voting rights. 29
STATEMENT OF CHANGES IN EQUITY AND EQUITY TRANSACTIONS Equity Transactions â€” Issuance of Stock Cash is increased (debited)/ the appropriate stock ccount is increased (credited) for the total par value of stock issued/ and additional paid-in capital (paid-in capital in excess of par) is increased (credited) for the difference. EXAMPLE A company issued 50,000 shares of its $1 par-value common stock. The market price of the stock was $17 per share on the day of issue. Cash (50,000 shares x $17 market price) Common stock (50,000 shares x $1 par value) Additional paid-in capital -- common (difference) $850,000 $ 50,000 800,000 The balances of cash, common stock, and additional paid-in capital were increased by $850,000, $50,000, and $800,000, respectively. 30
STATEMENT OF CHANGES IN EQUITY AND EQUITY TRANSACTIONS Equity Transactions â€” Cash Dividend On the date of declaration, the board of director formally approves a dividend. A declaration of a dividend decreases (debits) the retained earnings account. b. All holders of the stock on the date of record are legally entitled to receive the dividend. c. The date of payment is the date on which the di idend is paid. EXAMPLE On September 12, a company's board of directors declared a $3 per-share dividend to be paid on October 15 to all holders of common stock. On the date of declaration, 40,000 shares of common stock were outstanding. September 12 -- Declaration date Retained earnings (40,000 x $3) Dividends payable $120,000 $120,000 October 15 -- Payment date Dividends payable Cash $120,000 $120,000 31
STATEMENT OF CHANGES IN EQUITY AND EQUITY TRANSACTIONS Equity Transactions â€” Property Dividend 1) First/ the property is re-measured to fair value softhe date of declaration, and any gain or loss on the re-measurement is recognized in the statement of income 2) Second/ the carrying amount of retained earnin sis decreased for the fair value of the property to be distributed 3) Third/ the property is distributed as a dividend EXAMPLE On August 1, a company's board of directors declared a property dividend (land) to be distributed on December 1 to holders of common stock. On August 1, the carrying amount of the land to be distributed is $50,000 and its fair value is $80,000. The journal entries to record the declaration and distribution of the property dividend are as follows: August 1 -- Declaration date Land ($80,000 - $50,000) $30,000 $30,000 Gain on land remeasurement $80,000 Retained earnings $80,000 Property dividend payable December 1 -- Payment date Property dividend payable Land $80,000 $80,000
STATEMENT OF CHANGES IN EQUITY AND EQUITY TRANSACTIONS Equity Transactions â€” Stock Dividend and Stock Split a. A stock dividend involves no distribution of cash or other property. Stock dividends are accounted for as a reclassification o different equity accounts, not as liabilities. 1) The recipient does not recognize income. It has he same proportionate interest in the entity and the same total carrying amount as before the stock dividend. b. The accounting for stock dividends depends on he percentage of new shares to be issued. 1) An issuance of shares less than 20% to 25% oft e previously outstanding common shares should be recognized as a stock dividend. 2) An issuance of more than 20% to 25% of the previously outstanding common shares should be recognized as a stock split in the form of a dividend. c. In accounting for a stock dividend, the fair value of the additional shares issued is reclassified from retained earnings to co mon stock (at par value) and the difference to additional paid-in capital. 33
STATEMENT OF CASH FLOWS The primary purpose of the statement of cash flows is to provide relevant information about the cash receipts and cash pay ents of an entity during the period. Operating Activities Operating activities are all transactions and other events that are not financing or investing activities. The following are examples of cash inflows from operating activities: Cash receipts from the sale of goods and service O Cash receipts from royalties, fees, commissions, and other revenue O Cash received in the form of interest or dividends O The following are examples of cash outflows from operating activities: Cash payments to suppliers for goods and services O Cash payments to employees O Cash payments to government for taxes, duties, fines O Payments of interest on debt O 34
STATEMENT OF CASH FLOWS Investing Activities Cash flows from investing activities represent the xtent to which expenditures have been made for resources intended to genera e future income and cash flows. The following are examples of cash outflows (and inflo s) from investing activities: Cash payments to acquire (cash receipts from sa e of) property plant. O Cash payments to acquire equity and debt instruments O Cash advances and loans made to other parties O Financing Activities Cash flows from financing activities generally invo ve the cash effects of transactions and other events that relate to the is uance, settlement/ or reacquisition of the entitVs debt and equity instru ents. For example: Cash proceeds from issuing shares and other equity instruments Cash proceeds from issuing loans, notes, bonds. 35
STATEMENT OF CASH FLOWS Noncash Investing and Financing Activities Information about all investing and financing act vities that affect recognized assets or liabilities but not cash flows must be disclosed in the notes, outside the body of the statement of cash flows. For example: Conversion of debt to equity O Acquisition of assets either by assuming directly related liabilities or by means O of a capital lease Exchange of a noncash asset or liability for anot er O Indirect Method of Presenting Operating Cash F ows Under the indirect method/ the net cash flow from operating activities is determined by adjusti g the net income of a business for the effect of the following: Noncash revenue and expenses O Gains or losses on sales of PPE items O All deferrals of past operating cash flows O All accruals of expected future operating cash flows O 36
STATEMENT OF CASH FLOWS Direct Method of Presenting Operating Cash Flows Under the direct method/ the entity presents majJr classes of actual gross operating cash receipts and payments and theirs m (net cash flow from operating activities). At a minimum, the following must be presented: 1) Cash collected from customers 2) Interest and dividends received 3) Other operating cash receipts, if any 4) Cash paid to employees and other suppliers of goods and services 5) Interest paid 6) Income taxes paid 7) Other operating cash payments, if any 37
REVENUE RECOGNITION -- REVENUE RECOGNITION AFTER DELIVERY According to the revenue recognition principle, re enues and gains should be recognized when (1) realized or realizable and (2) earned. 1) Revenues and gains are realized when goods or ervices have been exchanged for cash or claims to cash. Revenues and gains are realizable when goods or services have been exchanged for assets that are readily convertible into cash or claims to cash. 2) Revenues are earned when the earning process has been substantially completed/ and the entity is entitled to the resulting benefits or revenues. a) Thus, revenue on sales can be recognized in the statement of income even if the cash from sales is not received yet. 38
REVENUE RECOGNITION -- REVENUE RECOGNITION AFTER DELIVERY The Installment Method a. The installment method is only acceptable w en receivables are collectible over an extended period and no reasonable basis exists for estimating the degree of collectability. b. The installment method recognizes a partial rofit on a sale as each installment is collected. 1) This approach differs from the ordinary procedure, that is, recognition of revenue when a transaction is complete. Thus, when collection problems (bad debts) can be reasonably estimated/ thef Il profit is usually recognized in the period of sale. c. The amount recognized each period under the installment method is the realized gross profit. This amount equals the c sh collected on installment sales for the period times the gross profit perce tage on installment sales for the period (a separate gross profit percentage is calculated for each period). 39
REVENUE RECOGNITION -- REVENUE RECOGNITION AFTER DELIVERY The Installment Method Metro sells its inventory to Jingle Co. for $750,000 signs an installments sales contract requiring that it pay $100,000 down payment and $130,000 per year for the next five years, with the first payment also due at signing. So the initial payment is $230,000 ($100,000 + $130,000). Metro cost of inventory sold is $400,000. Metro's gross profit on the whole is $350,000 ($750/ooo-$400/ooo). Metro also has to figure out ross profit percentage, which is 46.67%. So to record these transaction on instal ment sales; 39
REVENUE RECOGNITION -- REVENUE RECOGNITION AFTER DELIVERY The Installment Method Entries to recorded for this installment sales would be, Installments Accounts Receivables (A/R) Installment Sales Cost of Goods Sold Inventory Cash Installments Accounts Receivables (A/R) Installment Sales Cost of Goods Sold Deferred Gross Profit Deferred Gross Profit(46.67%) Realized Gross Profit $750,000 7501000 $400,000 400/000 $230,000 230/000 $750,000 $400,000 $350,000 $108,100 $108,100 39
REVENUE RECOGNITION -- REVENUE RECOGNITION AFTER DELIVERY Cost-Recovery Method The cost-recovery method may be used only in the same circumstances as the installment method. However, no profit is recognized until collections exceed the cost of the item sold. Subsequent receipts are treated entirely as revenues. Example Prudence Inc. is engaged in manufacture and sale of specialized manufacturing equipment. It has excess capacity of 30% so on 1 January 2011 the company's management sold equipment worth $20 million to Uncertainty Inc. a company which is facing a liquidity crunch. The equipment cost $10 million in manufacturing costs. Th receipts from Uncertainty in FY 2011 we as follows: First Quarter $3 million Second Quarter $6 million Third Quarter 4 million Fourth Quarter 7 million Determine the gross profit earned in each quarter und r cost recovery method. 40
REVENUE RECOGNITION -- REVENUE RECOGNITION AFTER DELIVERY Cost-Recovery Method The cost-recovery method may be used only in the same circumstances as the installment method. However, no profit is recognized until collections exceed the cost of the item sold. Subsequent receipts are treated entirely as revenues. Solution Under cost recovery method revenue is recognized onl to the extent of receipts. So in QI revenue recognized is $3 million which is matched with cost of $3 million resulting in zero gross profit. In Q2 revenue recognized is $6 million matched with $6 million cost resulting in zero gross profit. In Q3 revenue recognized is $4 millio matched with the remaining cost of $1 million ($10 million - $3 million - $6 million) resultin in a gross profit of $3 million. In Q4 no cost is left and the revenue recognized is $7 million so gross profit is $7 million. 40
REVENUE RECOGNITION -- REVENUE RECOGNITION AFTER DELIVERY Deposit Method This method is used when cash is received/ but the criteria for a sale have not been met. Thus, the seller continues to account for the property in the same way as an owner. No revenue or profit is recognized because it has not been e rned/ e.g. / by transferring the property. The entry is: Cash Deposit liability $xxx $xxx To illustrate, assume that a franchiser charges new franchisees a fee consisting of $10,000 payable in cash when the agreement is signed foll wed by four annual payments of $3,750 each. Assuming the franchisee could borrow mo ey at 10%, the present value of the four annual payments is $11,887 ($3,750 x 3.1699).17 The agreement provides that the franchiser will assist in locating the site for a buildi g, conduct a market survey to estimate potential income, supervise the construction o a building, and provide initial training to employees. If the down payment is refundable and no services have been rendered at the time the arrangement is made, the deposit method would be used as long as collection on the note is reasonably certain. The following entry woul be made to record the transaction: 40
REVENUE RECOGNITION -- REVENUE RECOGNITION AFTER DELIVERY Deposit Method This method is used when cash is received/ but the criteria for a sale have not been met. Thus, the seller continues to account for the property in the same way as an owner. No revenue or profit is recognized because it has not been e rned/ e.g. / by transferring the property. The entry is: Cash 10,000 Notes Receivable 11,887 Deposit on Franchise (or Unearned Franchise Fee) 21,887 When the initial services are determined to be substantia ly performed, the revenue recognition method to be used and the resulting journal ntries depend on the probability of future cash collection. If the collection of the note is re sonably assured, the full accrual method would be used. Assume that substantial performance of the initial services by the franchiser costs $14,000. The entries to record this event using the full accrual method would be as follows: Cost of Franchise Fee Revenue 14,000 Cash 14,000 Deposit on Franchise (or Unearned Franchise Fee) Franchise Fee Revenue 21,887 21,887 40
REVENUE RECOGNITION -- LONG-TERM CONSTRUCTION CONTRACTS The Completed-Contract Method The completed-contract method is used to account for a long-term project when the percentage-of-completion method is inappropriate. Example Construction Corporation enters into a contract on January 1, 19A, with the Department of City Development to build a small building for $100,000. T e project is estimated to take 3 years. The following information presents the transactions hat took place over this time: Construction Cost Billings Cash collections Estimated Completion cost As of 31st Dec Total 19A 19B 19C $20,000 $25,000 $25,000 $70,000 $25,000 $35,000 $40,000 $100,000 $20,000 $20,000 $60,000 $100,000 $45,000 $25,000 The final profit is $30,000 ($100,000 ? $70,000). Also notice that the estimate of what the final profit would be changed between 19A and 19B. In 19A it w s $35,000 (selling price of $100,000 ? $20,000 of costs incurred so far ? $45,000 of es imated completion costs). In 19B it changed to $30,000 ($100,000 ? $20,000 ? $25,000 ? $25,000). The journal entries for the three years would be as follows: 41
REVENUE RECOGNITION -- LONG-TERM CONSTRUCTION CONTRACTS The Completed-Contract Method The completed-contract method is used to account for a long-term project when the percentage-of-completion method is inappropriate. Example The journal entries for the three years would be as follows: 25, oo 35, oo 1.Construction in Process Miscellaneous 2.Accounts Rec 19A 20,000 20,000 25,000 Biilings on Construction 25,000 3.Cash Accounts Rec 4. No Recognition of Profit 20,000 20,000 19B 25,000 35,000 20,000 20,000 19C 25,000 25,000 40,000 40,000 60,000 60,000 41
REVENUE RECOGNITION -- LONG-TERM CONSTRUCTION CONTRACTS The Percentage-of-Completion Method Percentage-of-completion is the preferable method. It records (1) all contract costs in construction in progress and (2) all amounts billed in progr ss billings. The amount of gross profit recognized in a period is calculated as follows: Calculate the estimated total gross profit on the project. EXAMPLE A contractor is constructing an office complex for a real estate developer. The agreed-upon contract price was $75 million. As of the close of Year 4 of the project, the contractor had incurred $44 million of costs. By its best estimates as of that date, costs remaining to finish the project were $19 million. Contract price Minus: costs incurred to date Minus: estimated costs to complete Estimated total gross profit 41
REVENUE RECOGNITION -- LONG-TERM CONSTRUCTION CONTRACTS Calculate the percentage of the project completed aso the reporting date, determined by the ratio of costs incurred thus far to estimated total costs. EXAMPLE Total estimated costs for the project as of the end of Year 4 are calculated as follows: Costs incurred to date Estimated costs to complete Total estimated costs The project is therefore 69.8% complete + Subtract the gross profit recognized so far. EXAMPLE The contractor will recognize $2,151 ,000 in gross profit for Year 4, calculated as follows: Estimated total gross profit Times: percentage complete Gross profit earned to date Minus: gross profit recognized in prior periods (given) Gross profit for current period 69.8%
REVENUE RECOGNITION -- LONG-TERM CONSTRUCTION CONTRACTS Progress Billings Ordinarily, progress billings are made and payments ar received during the term of the contract. The entries are: The customer is billed: Accounts receivable Progress billings The customer pays: Cash Accounts receivable $xxx $xxx $xxx $xxx Neither billing nor the receipt of cash affects gross profit. Moreover, billing, receipt of payment/ and incurrence of cost have the same effects Jnder both accounting methods. 43
REVENUE RECOGNITION -- LONG-TERM CONSTRUCTION CONTRACTS The difference between construction in progress (costs and recognized gross profit) and progress billings to date is reported as Ã¥ current asset if construction in progress exceeds total billings and as a current iiability if billings exceed construction in progress. Closing entry: $xxx Progress billings $xxx Construction in progress 44
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