Question

What three conceptual factors affect the decision as to when to recognize revenue.

What are the three revenue recognition alternatives?

Under what circumstances does a company recognize revenue prior to the completion of the earnings process?

Under what circumstances does a company use the percentage of completion method for long term contracts?

How may the departure from the principle of recognizing revenue only at the completion of the earnings process be justified when a company uses the percentage of completion method.

Describe input ad output measures used in the percentage of completion method. Give an example of each.

How does a company account for losses under the two methods of accounting for long term construction contracts?

How does a company classify the following accounts in its financial statements: Construction in Progress, Partial billings, Construction Revenue, and Construction Expense?

Describe the difference between the cost recovery method and the installment method of revenue recognition.

When a contract has multiple elements (multiple deliverables), how does GAAP determine if one of the elements should be considered a separate unit of accounting?

Distinguish between the initial franchise fee and continuing franchise fee. When is each recognized as revenue?

How is revenue recognized for real estate sales?

In a consignment, does consignee or consignor retain title to the property? When is revenue recognized by the consignor? The consignee?

Answer 1

1- What are the three factors affects the decision when to recignize revenue. What are the three revenue re ognization alternatives? Ans. -  Factors Affecting Financing Decisions:

While taking financing decisions the finance manager keeps in mind the following factors:

1. Cost: The cost of raising finance from various sources is different and finance managers always prefer the source with minimum cost.

2. Risk:

More risk is associated with borrowed fund as compared to owner’s fund securities. Finance manager compares the risk with the cost involved and prefers securities with moderate risk factor.

3. Cash Flow Position:

The cash flow position of the company also helps in selecting the securities. With smooth and steady cash flow companies can easily afford borrowed fund securities but when companies have shortage of cash flow, then they must go for owner’s fund securities only.

There are several revenue recognition methods that may be used:

Sales Basis Method

With the sales basis revenue recognition methods, revenue is recorded at the time of sale. Sale is defined as the period of time where goods and services change hands, which may or may not be at the same time as payment.

Percentage of Completion Method

The percentage of completion method for recognizing revenue is typically used in large or long-term projects. Firms that provide construction services, engineering services or other services with long projects are most likely to use this method. Providers of these services need to be able to demonstrate that they are generating revenue even though projects are not yet complete.

Installment Method

When companies cannot rely on their customer’s ability to pay in a timely manner, the installment revenue recognition method may be best suited for the organization. With the installment method, revenue is only recorded once the organization has received payment.

2- Under what circumstances does a company recognize revenue prior to the completion of the earnings process?

Answer -   The revenue recognition principle, a feature of accrual accounting, requires that revenues are recognized on the income statement in the period when realized and earned—not necessarily when cash is received.

The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. They both determine the accounting period in which revenues and expenses are recognized. According to the principle, revenues are recognized when they are realized or realizable, and are earned (usually when goods are transferred or services rendered), no matter when cash is received. In cash accounting – in contrast – revenues are recognized when cash is received no matter when goods or services are sold.

Cash can be received in an earlier or later period than obligations are met (when goods or services are delivered) and related revenues are recognized that results in the following two types of accounts:

• Accrued revenue: Revenue is recognized before cash is received.
• Deferred revenue: Revenue is recognized when cash is received.

Revenue realized during an accounting period is included in the income.

3- How may be departure from the principle of recognizing revenue..............

The percentage of completion method is an accounting method in which the revenues and expenses of long-term contracts are recognized as a percentage of the work completed during the period. This is in contrast to the completed contract method, which defers the reporting of income and expenses until a project is completed. The percentage-of-completion method of accounting is common for the construction industry, but companies in other sectors also use the method.

• The percentage of completion method reports revenues and expenses in terms of the work completed to date.
• This method can only be used if payment is assured and estimating completion is relatively straightforward.
• The percentage of completion method has been misused by some companies to boost short-term results. 4- Describe input and output measures used in percentage of completion method.............

Answer -- While using the percentage of completion method, companies can calculate the percentage of completion using either the input or output measures.

The input method measures the materials and labor required to satisfy an obligation. The two methods of measuring input are:

COST-TO-COST METHOD

Percentage of completion method is commonly measured through the cost-to-cost method which compares costs incurred to total estimated costs. To estimate the percentage of completion, you divide the total expenditure incurred from inception to date with the total estimated costs of the contract.

Example:

If the estimated costs of a long-term project are $50,000 and you have incurred $10,000 in the current period, then the percentage of completion is calculated as follows:

Percentage Completion = 10,000/50,000
% Completion = 20%

If the estimated revenue of the project is $80,000, the revenue recognized is:

Revenue Recognized = 20% x 80,000
Revenue Recognized = $16,000

EFFORTS EXPENDED METHOD

The completion of work is measured by the percentage of efforts expended till date as compared to estimated total effort expected to be expended for each contract. The percentage of completion is based on labor hours, machine hours or material.

THE OUTPUT METHOD

The output method compares the results achieved till date to the total expected results of the contract. This method uses direct measurement of value to the customer of the goods or services transferred to date. This includes units produced/delivered, milestones and appraisal of results achieved.

The method you choose to calculate the percentage of completion should be based on the nature of the contract and the terms of the delivery obligation.

5- How does a company classify accounts in its financial............

An accountancy term, construction in progress (CIP) asset or capital work in progress entry records the cost of construction work, which is not yet completed (typically, applied to capital budget items). A CIP item is not depreciated until the asset is placed in service. Normally, upon completion, a CIP item is reclassified, and the reclassified asset is capitalized and depreciated.

Progress billings are invoices requesting payment for work completed to date. Progress billings are prepared and submitted for payment at different stages in the process of a major project.

Where the result or outcome of any contract for construction can be projected, the related contract revenue and contract costs shall be recognized by taking into account the stage of completion of such contract. Expected losses shall be recognized immediately as expenses.

6- Describe the difference between the cost method and...............

The cost recovery method is used in much more uncertain transactions, in which accountants are either unable to assume payment confidently or if the value of the sale is difficult to estimate. When a sale is made, but payments are delayed over a period of time, the transaction is called an installment sale.

Cost Recovery Method

Cost recovery is an even more conservative method of revenue recognition. Here, all gross profit is deferred until the cost of the item sold is recovered. The initial journal entry, however, is identical to installment method.

Installment method

When a sale is made, but payments are delayed over a period of time, the transaction is called an installment sale. Accountants do not want to recognize the full amount of the sale on the outset, because there is a sufficient risk of not collecting that makes the receivables questionable.

7- When a contract has multiple elements...........

New GAAP for multiple-deliverable arrangements will provide a clearer picture of the economic realities of such arrangements. Whether an element has an objective and reliable fair value, as previous GAAP requires for separation, is no longer important. The economic reality is that if the service is being offered to the customer, that element has value and, if appropriate, should be recognized accordingly. In addition, the more robust disclosure requirements will give financial statement users a better picture of how a company is earning its money.

This article presents the major GAAP revisions affecting multiple deliverables along with brief examples of how the changes will affect practice.

8- Distinguish between initial franchise fee and continuing......

The initial fee they pay when entering into the successor agreement is generally referred to as a renewal or successor fee. Similar to the transfer fee, the renewal fee usually is a lower amount than charged to new franchisees.An initial franchise fee refers to the amount of money you pay to the franchisor when you sign your franchise agreement. Fees vary by organization and typically reflect the size and scope of the franchise you're buying.

The continuing franchisee will also be expected to pay the franchisor an ongoing fee, sometimes referred to as a franchise fee, management service fee, service fee or royalty. This payment is for the ongoing use of the franchisor's goodwill, brand reputation and the established brand name and/or trademarks.

9- How is revenue recognized for real estate sales.......

The guidance, found in Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, supersedes existing revenue recognition rules and makes significant changes to the rules for accounting for real estate sales.

Here’s a look at each step and its associated issues particular to revenue recognition for real estate companies:

1. Identify the contract. The guidance applies to each contract that a company has with a customer. In some cases, two or more contracts might be combined for financial reporting purposes

Identify the company’s performance obligations. Sellers often remain involved in property that they’ve sold.

Determine the transaction price. The company must determine the amount that it expects to be entitled to in exchange for transferring promised goods or services to a customer.

Allocate the transaction price to performance obligations under the contract. The business will typically allocate the transaction price to each performance obligation based on the relative “standalone selling price” of each distinct good or service promised.

Recognize revenue as performance obligations are satisfied. A company must recognize revenue when it satisfies a performance obligation by transferring the promised good or service to a customer.

10- In a consignment does consignee...............

Consigned goods are recognized as revenues by the consignor, when it receives payment from the consignee for goods sold.

The two parties to a consignment contract are the consignor and consignee. The consignor is the person who owns the property that the consignee, who is a retailer, agrees to sell. The consignor retains title to the goods until they sell.