25B b: Describe general principles of revenue recognition and accrual accounting, specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, gross and net reporting of revenue), and implications of revenue recognition principles f Flashcards
Explain
Revenue is recognized when earned and expenses are recognized when incurred.
Methods for accounting for long-term contracts include:
Percentage-of-completion—recognizes revenue in proportion to costs incurred
Completed-contract—recognizes revenue only when the contract is complete
Revenue recognition methods for installment sales are:
Normal revenue recognition at time of sale if collectability is reasonably assured.
Installment sales method if collectability cannot be reasonably estimated.
Cost recovery method if collectability is highly uncertain.
Revenue from barter transactions can only be recognized if its fair value can be estimated from historical data on similar non-barter transactions.
Gross revenue reporting shows sales and cost of goods sold, while net revenue reporting shows only the difference between sales and cost of goods sold and should be used when the firm is acting essentially as a selling agent and does not stock inventory, take credit risk, or have control over supplier and price.
Guidance from the U.S. Securities and Exchange Commission regarding the criteria for revenue recognition least likely specifies that there must be:
reasonable assurance that the product will be delivered or the service will be rendered.
One of the SEC’s criteria for revenue recognition is that the product has been delivered or the service has been rendered. The other criteria are evidence of an arrangement between the buyer and seller; the price has been determined or is determinable; and the seller is reasonably assured of collecting money.
Steven: The product HAS BEEN DELIVERED is not = to ‘will be delivered.’
SEC requires that the product has been delivered in assurance of revenue recognition.
As a general rule, revenue is normally recognized when it is:
realizable and earned.
Under the accrual concept, revenue is recognized when the earnings process is completed (earned) and ultimate realization (cash receipt) is assured.
Walker Company received a letter in November 2003 indicating that Johnson, Inc. would purchase a specialty machine priced at $4,000,000. In February 2004, a binding contract was executed for the machine’s construction. Materials costing $2,000,000 were ordered in December 2003, arrived with an invoice in August 2004, and were used in the manufacturing process in the first quarter of 2005. Walker completed and delivered the machine in December 2006. Johnson received the first invoice in 2007 and paid the $4,000,000 purchase price in 2007. Walker Company uses the accrual method of accounting. Walker should record the materials used to construct the machine as expenses in the year:
2006.
Under the accrual concept, income is recognized when the earning activities are substantially completed, risk of ownership has transferred from buyer to seller, and payment is realizable and collectible. Under the matching principle, expenses incurred that directly relate to the sold item are expensed in the same period as the revenue is recognized.
Which of the following is NOT a requirement for revenue recognition to occur?
Cash must have been received.
Revenue from credit sales may be recognized when sales are on account.
Other conditions when revenues are also considered earned include when: revenue can be measured with reasonable accuracy, transactions are not subject to revocation, it is possible to measure the cost of provided goods (no significant contingent obligation), and there is assurance of payment (cash) or collectability.
Under U.S. GAAP, when an unreliable estimate of costs exists and ultimate payment is assured, which of the following revenue recognition methods should be used?
Completed contract method.
The key word is “unreliable.” The completed contract method is used under U.S. GAAP when cost estimates are unreliable. The percentage-of-completion method recognizes profit corresponding to the percentage of cost incurred to total estimated costs associated with long-term construction contracts. Percent-of-completion is used where contracts and cost estimates are reliable.
The cost recovery method is similar to the installment sales method but is more conservative. Sales are recognized when cash is received, but no gross profit is recognized until all of the cost of goods sold is collected.
Which, if any, of the following statements about the installment sales method and cost recovery method is correct?
Statement 1: The cost recovery method recognizes revenue and associated costs of goods sold only when cash is received, based on gross profit margin.
Statement 2: The installment sales method recognizes sales when cash is received, but no gross profit is recognized until all of the cost of goods sold is collected.
Neither statement is correct.
Neither statement is correct because the definitions are reversed.
The calculation of the income recognized in the third year of a five-year construction contract accounted for using the percentage-of-completion method includes the ratio of:
total costs incurred to total estimated cost.
The percentage of completion method recognizes revenues in proportion to the proportion of expenses incurred. Using only the current year’s costs produces an incorrect result if the estimated total cost has changed. Revenue recognized in any given year is costs to date divided by total estimated costs, times total estimated revenue for the project, minus revenue that has already been recognized.
