Chapter 6 - Handout - Mervat Saleh, CA CHAPTER 6 REVENUE...

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Unformatted text preview: Mervat Saleh, CA CHAPTER 6 REVENUE RECOGNITION |- Sales transactions: Revenue Recognition - Earnings Approach: Current GAAP and lFRS — Revenue is recognised when: a. Performance is achieved which means: i. risks and rewards are transferred and/or the earnings process is substantially complete; and ii. Measurability is reasonably assured; b. Collectability is reasonably assured. ll- Earnings Approach versus Contract-based approach Revenues can be accounted for using either: A. Earnings approach: Focuses on how a company adds value for its customers, or B. Contract-based approach: Focuses on the contractual rights and obligations created by sales contracts A. Earnings Approach 2. The earnings approach is current GAAP and lFRS. - It is primarily an IIS approach and revenues are recognized when: 1. Performance is achieved which means: (a) risks and rewards are transferred and/or the earnings process is substantially complete (who has legal title) ; and (b) Measurability is reasonably assured; 2. Collectability is reasonably assured. 1. Sales of Goods 0 A contract to sell merchandise in the future is not recorded as a sale until the merchandise is delivered and the transaction is complete. 0 Critical event - the point of goods delivery 1 Mervat Saleh, CA 0 Sales with buybacks and bill and hold transactions. - A buyback agreement is classified as a loan with the items transferred being held as collateral. -'Bill and hold transactions - bona fide business reasons for structuring a sale this way, such as lack of space at the purchaser’s warehouse. 0 Sales contracts with provisions to return any or all of the goods purchased. - It will likely be appropriate to recognize the sale as long as the amount of returns can be reasonably estimated. 2. Rendering of Services and Long-Term Contracts 0 The critical event - the performance of the service. 0 The earnings process sometimes has numerous significant events as opposed to one critical event. 0 Long-term construction - events and amounts must be estimated for a period of years. 0 Two basic methods of accounting for long-term construction contracts: (a) The percentage-of-completion method, and (b) The completed-contract method. 0 Choosing the Appropriate Method - The method that best matches the revenues to be recognized to the work performed. 0 The percentage-of—completion method - It should be used when estimates of progress toward completion, revenues, and costs are reasonably ascertainable. - Cost to cost base 0 The completed-contract method — It should be used when performance consists of the execution of a single act or when the co. cannot reasonably estimate the progress toward completion. 2 Mervat Saleh, CA B. Contract-Based Approach 1. This approach is based more on the BIS. 2. The revenue is recognized when control passes (legal title) /performance occurs. o It focuses on measuring the rights and obligations under sales contracts and recognizes revenues when these rights and obligations change. 0 This method asks two questions: (a) When should the sales contract be recognized on the 8/8? (b) When should the revenue be recognized on the US? 0 Under this approach, the contract is recognized when: (a) the entity becomes party to the contract, (b) the contractual rights are collectible/measurable, and (c) the performance obligation is measurable. lll - Consignment Sales A- Earnings Approach: 0 The vendor (consignor) retains the risks of ownership, namely that the merchandise might not sell, and relieves the dealer (consignee) of the need to commit part of its working capital to inventory. 0 The consignor retains legal title to the goods and the goods are carried on the consignor’s inventory. 0 It is not recorded as an asset by the consignee. When the merchandise is sold, the consignee has a liability for the net amount that it must remit to the consignor B- Contract-based Approach: 0 Both parties have rights and obligations when the consignment arrangement is first entered. o The consignee would record a net contract position of zero. As measurement uncertainty exists (i.e. there is no guarantee the consignee will sell any of the consigned merchandise) then no sales revenue is yet earned. ' 3 Mervat Saleh, CA 0 The consignor would be essentially the same under both the earnings and contract-based approach. lll — Long — Term Contracts A- Earnings Approach 1. Percentage-of-Completion Method 0 Rrevenue on long-term contracts is recognised as construction progresses (i.e., before delivery). 0 The method is preferable when estimates of costs to complete and the extent of progress toward completion of long-term contracts are reasonably reliable. o The amount of revenue recognised in each accounting period is based on a percentage of the total revenue to be recognised on the contract. 0 This percentage may be based on input measures (costs incurred), or output measures (tons produced, stories of a building completed, miles of highway Completed). 0 One of the measures used to determine the progress toward completion is cost - the percentage of completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract, calculated as follows: cost incurred to date = % complete most recent estimate of total costs Revenues to be recognised to date = % complete >< estimated total revenue 0 No recognition is given to the contract when it is first entered into. 0 A receivable is set up over the earnings period based on progress billings. o The account “Billings on Construction in Process” is offset against the “Construction in Process” account. 0 The Construction in Process account accumulates all the costs and profit recognized over the earnings period, so that at the end of the contract, the balance in both accounts completely offsets each other and a final entry is recorded to close both accounts. 2. Completed Contract Method 0 Revenue, expenses and gross profit are recognized when the contract is completed. 0 Reported revenue is based on final results rather than on estimates regarding unperformed work. lts major disadvantage is the distortion of earnings that may occur over the periods during which the work is done. 4 Mervat Saleh, CA 0 The accounting entries made under the completed—contract method is the same as those made under the percentage-of-completion method, with the notable exception of periodic income recognition. 0 The completed contract method is not allowed under IFRS. B— Contract-Based Approach 1. Percentage-of-Completion Method 0 The contractual rights and obligations are both recorded when the contract is first entered into - one as an asset, one as a liability so that at inception of the contract, the net value would be zero. 0 The same method of determining percent complete is used as in the earnings based approach. 0 However there will be no need for a billings account or construction in process account because the contractual rights have already been recorded. 0 Many of the entries will be the same, but rather than using construction in process, billings and accounts receivable, the expenses incurred draw down the “obligation” and the payments received from the customer draw down the “rights”. 2. Completed Contract Method 0 It is not used for services being provided in the contract-based approach because revenues are recognized as the service is provided/earned. 0 Where the construction of real estate or similar assets is involved and the legal title of the asset is not passed to the customer until the end of the contract, the transaction would be treated like any other inventory transaction with the costs being accumulated in an inventory account and o The sale of the asset recorded at the end of the contract. Mervat Saleh, CA IV - Long Term Contract Losses Long term contract losses can occur: a. As a loss in the current period on a profitable contract. - Under the percentage of completion method, a current period adjustment of any excess gross profit recognised in a prior period is necessary. b. As a loss on an unprofitable contract. - Under both the percentage of completion and the completed contract method, the entire contract loss must be recognised in the current period. Example 1: PERCENTAGE-OF-COMPLETION METHOD DATA Buildmore Construction Limited received a contract for $6,000,000 in Year 1 to build a parking complex for the federal government. The following data was accumulated during the construction period: Year 1 Year 2 __Y_<fl§__ Total costs to date $ 1,800,000 $ 2,090,000 $ 5,000,000 Estimated cost to complete 2,700,000 3,410,000 —- Progress billings during year 2,000,000 2,000,000 2,000,000 Cash collected during year 1,500,000 2,000,000 2,500,000 1. To record costs of construction (000 omitted) Year1—-— - Year 2 Year 3 Construction in Process 1,800 290 2,910 Materials, Cash, Payables, etc. 1,800 290 2,910 2. To record progress billings Accounts Receivable 2,000 2,000 2,000 Billings on Construction 2,000 2,000 2,000 3. To record collections Cash 1,500 2,000 2,500 Accounts Receivable 1,500 2,000 2,500 6 , Mervat Saleh, CA 4. To recognise revenue and gross grofit Construction in Process 600 410 810 Construction Expense 1,800 290 2,910 Rev. from Long-Term Contracts 2,400 120 3,720 1,800 2,090 5,000 Percentage of completion 4,500 5,500 5,000 = 40% = 38% = 100% Revenue to be recognised 6,000 X 40% 6,000 X 38% 6,000 X 100% = 2,400 = 2,280 = 6,000 - 2,400 - 2,280 1120) 3,720 Profit to be recognised 1,500 x 40% 500 x 38% 1,000 x 100% = g = 190 = 1,000 - 600 - 190 (410) 51 0 To record final apgroval of the contract Year 3 Billings on Construction 6,000 Construction in Process 6,000 Note: Loss on contract is recognised, in full, immediately under either the percentage-of- completion method or the completed—contract method. Mervat Saleh, CA Example 2: COMPLETED-CONTRACT METHOD DATA Buildmore Construction Limited received a contract for $6,000,000 in Year 1 to build a parking complex for the federal government. The following data was accumulated during the construction period: Year 1 Year 2 Year 3 Total costs to date $1,800,000 $2,090,000 $5,000,000 Estimated cost to complete 2,700,000 3,410,000 -- Progress billings during year 2,000,000 2,000,000 2,000,000 Cash collected during year 1,500,000 2,000,000 2,500,000 1. To record costs of construction (, 000 omitted) Year 1 Year 2 Year 3 Construction in Process 1,800 290 2,910 Materials, Cash, Payables, etc. 1,800 290 2,910 2. To record progress billings - Accounts Receivable 2,000 2,000 2,000 Billings on Construction . 2,000 2,000 2,000 3. To record collections - Cash 1,500 2,000 2,500 Accounts Receivable 1,500 2,000 2,500 STEP # 4 IS NOT REQUIRED 5. To record final approval of the contract Billings on Construction 6,000 Revenue from Long-Term Contracts 6,000 Construction Expenses 5,000 Construction in Progress 5,000 ...
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This note was uploaded on 01/17/2012 for the course ACCOUNTING 310 taught by Professor Ily during the Spring '11 term at Concordia Canada.

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Chapter 6 - Handout - Mervat Saleh, CA CHAPTER 6 REVENUE...

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