KWW 13th ch18

Chapter
18-1
CHAPTER 18
REVENUE RECOGNITION
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
18-2
Learning Objectives
1. Apply the revenue recognition principle.

2. Describe accounting issues for revenue recognition at point
of sale.
3. Apply the percentage-of-completion method for long-term
contracts.
4. Apply the completed-contract method for long-term
contracts.
5. Identify the proper accounting for losses on long-term
contracts.
6. Describe the installment-sales method of accounting.
7. Explain the cost-recovery method of accounting.
Chapter
18-3
Revenue Recognition
Revenue Revenue Revenue

Current
Recognition at the Recognition Recognition after
Environment
Point of Sale before Delivery Delivery
Guidelines for Sales with Percentage-of- Installment-sales

revenue buyback completion method
recognition agreements method Cost-recovery
Departures from Sales when right Completed- method
sale basis of return exists contract method Deposit method
Trade loading Long-term Summary of
and channel contract losses bases
stuffing Disclosures Concluding
Completion-of- remarks
production basis
Chapter
18-4
The Current Environment
Revenue recognition has been the largest source of

public company restatements over the past decade.
One study noted restatements of revenue:
Result in larger drops in market capitalization than

other types of restatement.
Caused eight of the top ten market value losses in

a recent year.
Chapter
18-5
Guidelines for Revenue Recognition

The revenue recognition principle provides that
companies should recognize revenue
(1) when it is realized or realizable and
(2) when it is earned.
Chapter
18-6 LO 1 Apply the revenue recognition principle.
Revenue Recognition Classified by Type of Transaction
Chapter 18 Chapter 18 Illustration 18-1
Type of Sale of Sale of asset

Rendering a Permitting use
Transaction product from other than
service of an asset
inventory inventory
Description Revenue from Revenue from Gain or loss on

Revenue from
of Revenue fees or interest, rents, disposition
sales
services and royalties
Timing of Date of sale Services As time passes

Date of sale
Revenue (date of performed and or assets are
or trade-in
Recognition delivery) billable used
Chapter
Departures from the Sale Basis

Earlier recognition is appropriate if there is a high degree
of certainty about the amount of revenue earned.
Delayed recognition is appropriate if the
 degree of uncertainty concerning the amount of

revenue or costs is sufficiently high or
 sale does not represent substantial completion of

the earnings process.
Chapter
Illustration 18-2
Revenue
Recognition
Alternatives
Chapter
Revenue Recognition at Point of Sale (Delivery)
Departures from the Sale Basis

FASB’s Concepts Statement No. 5, companies usually
meet the two conditions for recognizing revenue by the
time they deliver products or render services to
customers.
Implementation problems,
 Sales with Buyback Agreements
 Sales When Right of Return Exists
 Trade Loading and Channel Stuffing
Chapter
18-10 LO 2 Describe accounting issues for revenue recognition at point of sale.
Sales with Buyback Agreements
When a repurchase agreement exists at a set price

and this price covers all cost of the inventory plus
related holding costs, the inventory and related
liability remain on the seller’s books. In other
words, no sale.
Chapter
Sales When Right of Return Exists

Recognize revenue only if 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.
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.
Chapter
Sales When Right of Return Exists

Recognize revenue only if six conditions have been met.
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.
Chapter
Trade Loading and Channel Stuffing
“Trade loading is a crazy, uneconomic, 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.”*
* “The $600 Million Cigarette Scam,” Fortune (December 4, 1989), p. 89.
Chapter
Trade Loading and Channel Stuffing
A similar practice is referred to as channel

stuffing. 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 software left the
loading
Chapter
Revenue Recognition Before Delivery
Most notable example is long-term construction

contract accounting.
Two Methods:
Percentage-of-Completion Method.
 Rationale is that the buyer and seller have
enforceable rights.
Completed-Contract Method.
Chapter
Must use Percentage-of-Completion method when estimates

of progress toward completion, revenues, and costs are
reasonably dependable and all of the following conditions
exist:
1. Contract clearly specifies the enforceable rights
regarding goods or services by the parties, the
consideration to be exchanged, and the manner and
terms of settlement.
2. Buyer can be expected to satisfy all obligations.
3. Contractor can be expected to perform under the
contract.
Chapter
Companies should use the Completed-Contract method when

one of the following conditions applies when:
1. Company has primarily short-term contracts, or

2. Company cannot meet the conditions for using the
percentage-of-completion method, or
3. There are inherent hazards in the contract beyond the
normal, recurring business risks.
Chapter
Percentage-of-Completion Method
Formula for Total Revenue to Be Recognized to Date
Illustration 18-3
Illustration 18-4
Illustration 18-5
Chapter
18-19 LO 3 Apply the percentage-of-completion method for long-term contracts.
Illustration: KC Construction Company has a contract to

construct a $4,500,000 bridge at an estimated cost of
$4,000,000. The contract is to start in July 2010, and the
bridge is to be completed in October 2012. The following
data pertain to the construction period.
Chapter
Illustration: Compute percentage complete.

Illustration 18-6
Solution on
notes page
Chapter
Illustration: KC would make the following entries to

record (1) the costs of construction, (2) progress billings,
and (3) collections.
Illustration 18-7
Solution on notes page

Chapter
Illustration: Percentage-of-Completion, Revenue and
Gross Profit, by Year Illustration 18-8
Solution on
notes page
Chapter
18-23
Illustration: KC’s entries to recognize revenue and gross

profit each year and to record completion and final
approval of the contract.
Illustration 18-9
Solution on notes page

Chapter
Illustration: Content of Construction in Process

Account—Percentage-of-Completion Method
Illustration 18-10
Chapter
Financial Statement Presentation—Percentage-of-

Completion
Computation of Unbilled Contract Price at 12/31/10
Illustration 18-11
Chapter
Financial Statement—Percentage-of-Completion
KC Construction Company Illustration 18-12
Chapter
Illustration: Casper Construction Co.
2010 2011 2012

Contract price $675,000 $675,000 $675,000
Cost incurred current year 150,000 287,400 170,100
Estimated cost to complete
in future years 450,000 170,100 0
Billings to customer current year 135,000 360,000 180,000
Cash receipts from customer
Current year 112,500 262,500 300,000
A) Prepare the journal entries for 2010, 2011, and 2012.
Chapter
Illustration: 2010 2011 2012

Costs incurred to date $ 150,000 $ 437,400 $ 607,500
Estimated cost to complete 450,000 170,100
Est. total contract costs 600,000 607,500 607,500
Est. percentage complete 25.0% 72.0% 100.0%
Contract price 675,000 675,000 675,000
Revenue recognizable 168,750 486,000 675,000
Rev. recognized prior year (168,750) (486,000)
Rev. recognized currently 168,750 317,250 189,000
Costs incurred currently (150,000) (287,400) (170,100)
Gross profit recognized $ 18,750 $ 29,850 $ 18,900
Chapter
Illustration:
2010 2011 2012
Construction in progress 150,000 287,400 170,100
Cash 150,000 287,400 170,100
Accounts receivable 135,000 360,000 180,000

Billings on contract 135,000 360,000 180,000
Cash 112,500 262,500 300,000


Construction expense 150,000 287,400 170,100
Construction revenue 168,750 317,250 189,000
Billings on contract 675,000

Construction in progress 675,000
Chapter
Illustration:
Income Statement 2010 2011 2012
Revenue on contracts $ 168,750 $ 317,250 $ 189,000
Cost of construction 150,000 287,400 170,100
Gross profit 18,750 29,850 18,900
Balance Sheet (12/31)

Current assets:
Accounts receivable 22,500 120,000 -
Cost & profits > billings 33,750
Current liabilities:
Billings > cost & profits 9,000
Chapter
Completed Contract Method
Companies recognize revenue and gross profit only at point of

sale—that is, when the contract is completed.
Under this method, companies accumulate costs of long-term

contracts in process, but they make no interim charges or
credits to income statement accounts for revenues, costs, or
gross profit.
Chapter
18-32 LO 4 Apply the completed-contract method for long-term contracts.
Illustration:
2010 2011 2012
Cash 150,000 287,400 170,100

Billings on contract 135,000 360,000 180,000
Cash 112,500 262,500 300,000


Construction expense 607,500
Construction revenue 675,000
Billings on contract 675,000

Chapter
Illustration:
Income Statement 2010 2011 2012
Revenue on contracts $ - $ - $ 675,000
Cost of construction - - 607,500
Gross profit - - 67,500
Balance Sheet (12/31)

Current assets:
Accounts receivable 22,500 120,000 -
Cost & profits > billings 15,000
Current liabilities:
Billings > cost & profits 57,600
Chapter
Long-Term Contract Losses

Loss in the Current Period on a Profitable Contract
 Percentage-of-completion method only, the estimated
cost increase requires a current-period adjustment
of gross profit recognized in prior periods.
Loss on an Unprofitable Contract

 Under both percentage-of-completion and completed-
contract methods, the company must recognize in the
current period the entire expected contract loss.
Chapter
18-35 LO 5 Identify the proper accounting for losses on long-term contracts.
Illustration: Loss on Profitable Contract
Casper Construction Co.

2010 2011 2012
Contract price $675,000 $675,000 $675,000
in future years 450,000 215,436 0
Current year 112,500 262,500 300,000
b) Prepare the journal entries for 2010, 2011, and 2012 assuming the
estimated cost to complete at the end of 2011 was $215,436 instead of
$170,100.
Chapter

2010 2011 2012
Contract price 675,000 675,000 675,000
Gross profit recognized $ 18,750 $ (3,900) $ 7,314
Chapter
2010 2011 2012
Construction in progress 18,750 7,314

Construction expense 150,000 215,436
Construction revenue 168,750 222,750

Chapter
Illustration: Loss on Unprofitable Contract

Casper Construction Co.
2010 2011 2012
Contract price $675,000 $675,000 $675,000
in future years 450,000 246,038 0
Current year 112,500 262,500 300,000
c) Prepare the journal entries for 2010, 2011, and 2012 assuming the
estimated cost to complete at the end of 2011 was $246,038 instead of
$170,100.
Chapter

2010 2011 2012
Contract price 675,000 675,000 675,000
Gross profit recognized $ 18,750 $ (27,188) $ -
$675,000 – 683,438 = (8,438) cumulative loss Plug

Chapter
2010 2011 2012
Construction in progress 18,750 -

Construction expense 150,000 243,000
Construction revenue 168,750 243,000

Chapter

For the Completed-Contract method, companies would
recognize the following loss :
2010 2011 2012
Loss on construction contract 8,438

Chapter
Disclosures in Financial Statements

Construction contractors should disclosure:
the method of recognizing revenue,
the basis used to classify assets and liabilities as
current (nature and length of the operating cycle),
the basis for recording inventory,
the effects of any revision of estimates,
the amount of backlog on uncompleted contracts, and
the details about receivables.
Chapter
Completion-of-Production Basis
In certain cases companies recognize revenue at the
completion of production even though no sale has been
made.
Examples are:
precious metals or
agricultural products.
Chapter
Revenue Recognition After Delivery
When the collection of the sales price is not

reasonably assured and revenue recognition is
deferred.
Methods of deferring revenue:

Installment-sales method Generally
Cost-recovery method Employed
Deposit method
Chapter
18-45 LO 6 Describe the installment-sales method of accounting.
Installment-Sales Method
Recognizes income in the periods of collection rather
than in the period of sale.
Recognize both revenues and costs of sales in the

period of sale, but defer gross profit to periods in
which cash is collected.
Selling and administrative expenses are not deferred.
Chapter
Acceptability of the Installment-Sales Method
The profession concluded that except in special

circumstances, “the installment method of recognizing
revenue is not acceptable.”
The rationale: because the installment method does not

recognize any income until cash is collected, it is not in
accordance with the accrual concept.
Chapter
Cost-Recovery Method
Recognizes no profit until cash payments by the buyer
exceed the cost of the merchandise sold.
A seller is permitted to use the cost-recovery method to

account for sales in which “there is no reasonable basis for
estimating collectibility.” In addition, use of this method is
required where a high degree of uncertainty exists related
to the collection of receivables.
Chapter
18-48 LO 7 Explain the cost-recovery method of accounting.
Illustration: In 2010, Fesmire Manufacturing sells inventory with

a cost of $25,000 to Higley Company for $36,000. Higley will
make payments of $18,000 in 2010, $12,000 in 2011, and $6,000
in 2012. If the cost-recovery method applies to this transaction
and Higley makes payments as scheduled, Fesmire recognizes cash
collections, revenue, cost, and gross profit as follows.
Illustration 18-28
Chapter
Illustration: Fesmire’s journal entry to record the

deferred gross profit on the Higley sale transaction (after
recording the sale and the cost of sale in the normal
manner) at the end of 2010 is as follows.
Sales 36,000
Cost of Sales 25,000
Deferred Gross Profit 11,000
Chapter
Illustration: In 2011 and 2012, the deferred gross profit

becomes realized gross profit as the cumulative cash
collections exceed the total costs, by recording the
following entries.
2011 Deferred Gross Profit 5,000

Realized Gross Profit 5,000
2012 Deferred Gross Profit 6,000

Realized Gross Profit 6,000
Chapter
Deposit Method
Seller reports the cash received from the buyer as a
deposit on the contract and classifies it on the balance
sheet as a liability.
The seller does not recognize revenue or income until

the sale is complete.
Chapter
Illustration 18-29
Summary of Product Revenue Recognition Bases
Chapter
18-53
 The IASB defines revenue to include both revenues and gains. U.S.
GAAP provides separate definitions for revenues and gains.
 Revenue recognition fraud is a major issue in U.S. financial
reporting. The same situation occurs overseas as evidenced by
revenue recognition breakdowns at Dutch software company Baan
NV, Japanese electronics giant NEC, and Dutch grocer AHold NV.
 A specific standard exists for revenue recognition under iGAAP
(IAS 18). U.S. GAAP uses concepts such as realized, realizable, and
earned as a basis for revenue recognition.
Chapter
18-54
 iGAAP prohibits the use of the completed-contract method of
accounting for long-term construction contracts (IAS 13).
Companies must use the percentage-of-completion method. If
revenues and costs are difficult to estimate, then companies
recognize revenue only to the extent of the cost incurred—a zero-
profit approach.
 In long-term construction contracts, iGAAP requires recognition of
a loss immediately if the overall contract is going to be
unprofitable. In other words, U.S. GAAP and iGAAP are the same
regarding this issue.
Chapter
18-55
Franchises
Four types of franchising arrangements have evolved:
1. manufacturer-retailer,
2. manufacturer-wholesaler,
3. service sponsor-retailer, and
4. wholesaler-retailer.
Chapter
18-56 LO 8 Explain revenue recognition for franchises and consignment sales.
Franchises
Fastest-growing category of franchising is service
sponsor-retailer:
 Soft ice cream/frozen yogurt stores (Tastee Freeze,
TCBY, Dairy Queen)
 Food drive-ins (McDonald’s, KFC, Burger King)
 Restaurants (TGI Friday’s, Pizza Hut, Denny’s)
 Motels (Holiday Inn, Marriott, Best Western)
 Auto rentals (Avis, Hertz, National)
 Others (H & R Block, Meineke Mufflers, 7-Eleven Stores)
Chapter
Franchises
Two sources of revenue:
1. Sale of initial franchises and related assets or

services, and
2. Continuing fees based on the operations of

franchises.
Chapter
Franchises
The franchisor normally provides the franchisee with:
1. Assistance in site selection
2. Evaluation of potential income
3. Supervision of construction activity
4. Assistance in the acquisition of signs, fixtures, and equipment
5. Bookkeeping and advisory services
6. Employee and management training
7. Quality control
8. Advertising and promotion
Chapter
Initial Franchise Fees
Franchisors record initial franchise fees as
 revenue only when and as they make “substantial
performance” of the services they are obligated to perform
and when collection of the fee is reasonably assured.
Substantial performance occurs when the franchisor has no

remaining obligation to refund any cash received or excuse any
nonpayment of a note and has performed all the initial services
required under the contract.
Chapter
Example of Entries for Initial Franchise Fee
Illustration: Tum’s Pizza Inc. charges an initial franchise fee of
$50,000 for the right to operate as a franchisee of Tum’s Pizza.
Of this amount, $10,000 is payable when the franchisee signs the
agreement, and the balance is payable in five annual payments of
$8,000 each. The credit rating of the franchisee indicates that
money can be borrowed at 8 percent. The present value of an
ordinary annuity of five annual receipts of $8,000 each discounted
at 8 percent is $31,941.68. The discount of $8,058.32 represents
the interest revenue to be accrued by the franchisor over the
payment period.
Chapter
Illustration: 1. If there is reasonable expectation that Tum’s
Pizza Inc. may refund the down payment and if substantial future
services remain to be performed by Tum’s Pizza Inc., the entry
should be:
Cash 10,000.00
Notes Receivable 40,000.00
Discount on Notes Receivable 8,058.32
Unearned Franchise Fees 41,941.68
Chapter
Illustration: 2. If the probability of refunding the initial
franchise fee is extremely low, the amount of future services to be
provided to the franchisee is minimal, collectibility of the note is
reasonably assured, and substantial performance has occurred, the
entry should be:
Cash 10,000.00
Revenue from Franchise Fees 41,941.68
Chapter
Illustration: 3. If the initial down payment is not refundable,
represents a fair measure of the services already provided, with a
significant amount of services still to be performed by Tum’s Pizza
in future periods, and collectibility of the note is reasonably
assured, the entry should be:
Cash 10,000.00
Chapter
Illustration: 4. If the initial down payment is not refundable and
no future services are required by the franchisor, but collection of
the note is so uncertain that recognition of the note as an asset is
unwarranted, the entry should be:
Cash 10,000.00
Chapter
Illustration: 5. Under the same conditions as those listed in case
4 above, except that the down payment is refundable or substantial
services are yet to be performed, the entry should be:
Cash 10,000.00
In cases 4 and 5 — where collection of the note is extremely uncertain—

franchisors may recognize cash collections using the installment-sales
method or the cost-recovery method.
Chapter
Continuing Franchise Fees
Continuing franchise fees are received in return for the

continuing rights granted by the franchise agreement and
for providing such services as management training,
advertising and promotion, legal assistance, and other
support.
Franchisors report continuing fees as revenue when they

are earned and receivable from the franchisee.
Chapter
Bargain Purchases
Sometimes the franchise agreement grants the franchisee the
right to make bargain purchases of equipment or supplies after
the franchisee has paid the initial franchise fee.
If the bargain price is lower than the normal selling price of the
same product, or if it does not provide the franchisor a
reasonable profit, then the franchisor should defer a portion of
the initial franchise fee. The franchisor would account for the
deferred portion as an adjustment of the selling price when the
franchisee subsequently purchases the equipment or supplies.
Chapter
Options to Purchase
As a matter of management policy, the franchisor may reserve
the right to purchase a profitable franchise outlet, or to
purchase one that is in financial difficulty.
If it is probable at the time the option is given that the

franchisor will ultimately purchase the outlet, then the
franchisor should
 not recognize the initial franchise fee as revenue but
 should instead record it as a liability.
Chapter
Franchisor’s Cost
Should ordinarily defer direct costs (usually incremental
costs) relating to specific franchise sales for which revenue
has not yet been recognized.
Should not defer costs without reference to anticipated

revenue and its realizability.
Indirect costs of a regular and recurring nature, such as

selling and administrative expenses that are incurred
irrespective of the level of franchise sales, should be
expensed as incurred.
Chapter
Disclosure of Franchisors
 All significant commitments and obligations resulting

from franchise agreements.
 Any resolution of uncertainties regarding the

collectibility of franchise fees.
 Where possible, revenues and costs related to

franchisor owned outlets should be distinguished
from those related to franchised outlets.
Chapter
Consignments
 Consignor recognizes revenue only after receiving
notification of sale and cash remittance from the consignee.
 Consignor carries the merchandise as inventory throughout

the consignment, separately classified as Merchandise on
Consignment.
 Consignee does not record the merchandise as an asset.

Upon sale of the merchandise, the consignee has a liability
for the net amount due the consignor.
 Revenue is then recognized by the consignor.
Chapter
Consignments
Illustration: 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
percent commission, and remits the cash due Nelba.
Chapter
Consignments
Chapter
Consignments
Chapter
Copyright
Copyright © 2009 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
in Section 117 of the 1976 United States Copyright Act without
the express written permission of the copyright owner is
unlawful. Request for further information should be addressed
to the Permissions Department, John Wiley & Sons, Inc. The
purchaser may make back-up copies for his/her own use only
and not for distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages, caused by the
use of these programs or from the use of the information
contained herein.
Chapter
18-76

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Chapter

1. Apply the revenue recognition principle.

Revenue Revenue Revenue

Guidelines for Sales with Percentage-of- Installment-sales

Revenue recognition has been the largest source of

One study noted restatements of revenue:

Result in larger drops in market capitalization than

Caused eight of the top ten market value losses in

Guidelines for Revenue Recognition

(1) when it is realized or realizable and

(2) when it is earned.

Type of Sale of Sale of asset

Description Revenue from Revenue from Gain or loss on

Timing of Date of sale Services As time passes

Departures from the Sale Basis

Delayed recognition is appropriate if the

 degree of uncertainty concerning the amount of

 sale does not represent substantial completion of

Departures from the Sale Basis

Sales with Buyback Agreements

When a repurchase agreement exists at a set price

Sales When Right of Return Exists

1. The seller’s price to the buyer is substantially fixed or

2. The buyer has paid the seller, or the buyer is obligated to

3. The buyer’s obligation to the seller would not be changed in

Sales When Right of Return Exists

4. The buyer acquiring the product for resale has economic

5. The seller does not have significant obligations for future

6. The seller can reasonably estimate the amount of future

Trade Loading and Channel Stuffing

“Trade loading is a crazy, uneconomic, insidious

* “The $600 Million Cigarette Scam,” Fortune (December 4, 1989), p. 89.

Trade Loading and Channel Stuffing

A similar practice is referred to as channel

Most notable example is long-term construction

Must use Percentage-of-Completion method when estimates

Companies should use the Completed-Contract method when

1. Company has primarily short-term contracts, or

Illustration: KC Construction Company has a contract to

Illustration: Compute percentage complete.

Illustration: KC would make the following entries to

Solution on notes page

Illustration: KC’s entries to recognize revenue and gross

Solution on notes page

Illustration: Content of Construction in Process

Financial Statement Presentation—Percentage-of-

Computation of Unbilled Contract Price at 12/31/10

Illustration: Casper Construction Co.

2010 2011 2012

A) Prepare the journal entries for 2010, 2011, and 2012.

Illustration: 2010 2011 2012

Accounts receivable 135,000 360,000 180,000

Cash 112,500 262,500 300,000

Construction in progress 18,750 29,850 18,900

Billings on contract 675,000

Balance Sheet (12/31)

Completed Contract Method

Companies recognize revenue and gross profit only at point of

Under this method, companies accumulate costs of long-term

Accounts receivable 135,000 360,000 180,000

Cash 112,500 262,500 300,000

Construction in progress 67,500

Billings on contract 675,000