Establish and maintain accrual accounting system

REVENUE RECOGNITON

INTRODUCTION.

One of the most difficult issues facing accountants concerns the recognition of revenue and
expenses by a business enterprise. Although general rules and guidelines exist, the significant
variety of marketing methods for products and services make it difficult to apply the rules
consistently in all situations.

The recognition issue refers to the difficulty of deciding when a business transaction should be
recorded. The recognition issue is not always solved easily. Consider the case of an advertising
agency that is asked by a client to prepare a major advertising campaign. People may work on
the campaign several hours a day for a number of weeks. Value is added to the plan as the
employees develop it.

REVENUE RECOGNITION.

The objective of any business enterprise is to generate income that will provide owners with a
return on their investment. The major source of income for most enterprises is from its operation
- the process of generating revenue by providing goods and services to outsiders. Operations
involve the incurring of costs and expenses, and unless a satisfactory level of revenue is
generated a loss or a low level of income will result, no matter how carefully costs and expenses
are controlled. Consequently, the meaning of revenue and the criteria for its recognition are
important not only to accountants but also to enterprise and to the users of its financial
statements.
In today’s more complex and uncertain business environment, accountants are faced with two
tasks relating to revenue i.e. to determine when revenue is realized and the birr amount at which
it is recognized in the accounting records. Because of new and frequently complex ways of
structuring business transactions, and because of the many new products and services developed
in recent years, revenue recognition has become one of the most challenging problems in
financial accounting.

Recognition as the recording of an item in the accounts and financial statements as an asset,
liability, revenue, expense, gain, or loss. Recognition includes depiction of an item in both
words and numbers, with the amount included in the summarized figures reported in the
financial statements
Four fundamental criteria must be met before an item can be recognized. These are definition
(the item or the event must meet the definition of one of the financial statement elements (asset,
revenue, expense etc), measurability (the item or event must have a relevant attribute that is
reliably measurable, that is, a characteristic, trait, or aspect that can be quantified and measured.
Examples are historical cost, current cost, market value etc), Relevance (information about the
item or event is capable of making a difference in users decisions), Reliability (information
about the item is representational faithful, verifiable, and neutral).
In addition to the above four general recognition criteria, the revenue principle provides that
revenue should be recognized in the financial statements when it is earned and it is realized or
realizable.
Revenues are earned when the company has substantially accomplished all that it must do to be
entitled to receive the associated benefits of the revenue. In general, revenue is recognizable
when the earning process is completed or virtually completed.
Earning process is the profit – directed activities of a business enterprise through which revenue
is earned; such activities may include purchasing, manufacturing, selling, rendering services,
delivering and servicing products sold, allowing others to use enterprise resources, etc.
Revenue is realized when cash is received for the goods or services sold. Revenue is considered
realizable when claims to cash (for example, non-cash assets such as accounts or notes
receivable) are received that are determined to be readily comfortable into known amount of
cash. This criteria is also met if the product is a commodity, such as gold or wheat, for which
there is a public market in which essentially unlimited amounts of the product can be bought or
sold at the known market price. In the measurement of revenue, realization generally means that
a measurable transaction (such as sale) or an event (such as the rendering of services) has been
completed or is sufficiently finalized to warrant the recording of earned revenue in the
accounting records. The selection of the critical event indicating that revenue has been realized
(earned) is the foundation of the revenue realization principle. In addition, revenue to be
recognized collection of the claims from customers and clients who have purchased goods and
services should be reasonably assured.
In general, revenues are recognized (formally recorded in the accounting records) as soon as all
criteria are met. An accounting issue is to determine when the criteria are met for different types
of revenue – generating transactions.
In making many revenue & expense recognition decisions, accountants may rely on estimates
and professional judgments. For example, the amount spent for material, labor, and other
services may be measured objectively, however, the continuous transformation of these cost
inputs into more valuable outputs is an internal process that requires estimates based on
subjective judgment. In tracing the effect of this process and portraying it in terms of birr,
accountants do not have objective external evidence supporting market transactions as a basis for
measurement and recording.
However, generally accepted accounting principles provide few guidelines for making estimates
and for exercising professional judgment in specific revenue & expense recognition situations.
Stages at which revenues are recognized.
The delivery of goods or services to a customer is a significant event that occurs in virtually all
revenue – generating transitions. Given this fact, three broad timing categories of revenue
recognition can be identified:
1. Revenue recognized on delivery of the product or service (the point of sale)
2. Revenue recognized before delivery of the product or service.
3. Revenue recognized after delivery of the product or service.
For most companies and for most goods and services, however, revenue is recognized at the time
of delivery of the goods or services to the customer: Revenue is them considered both earned and
realized or realizable when the product or service is delivered.
Revenue is sometimes recognized before delivery when the earning process extends over several
accounting periods and it is considered important (i.e. relevant) to provide revenue information
before the earning process is complete. For example, when there is a contract to produce a
product for a known birr amount that will be received when the product is delivered (i.e. it is
realizable), revenue can be recognized as it is earned, before the product is delivered to the
customer.
Revenue is sometimes recognized after delivery when there are concerns about the amount of
revenue that will be realized. Revenue has been earned, but recognition is delayed until the
amount realizable is determined. In these situations, providing reliable revenue information is
considered more important than early, potentially more relevant but less reliable, revenue
information.
Revenue Recognized at Delivery (Point of Sale)
The conditions for revenue recognition are usually met at the time goods or services are
delivered. Thus, revenue from the sale of goods is usually recognized at the date of sale, which
is the date the goods are delivered to the customer. Revenue from services rendered is likewise
recognized when the services have been performed. This is the point – of – sale method,
sometimes called the sales method or the delivery methods of revenue recognition.
Some costs associated with servicing a product or service sold with a guarantee or warranty may
be incurred after delivery. When these cost can be reasonably estimated, revenue is still
recognized at the date of sale, with a provision made for future warranty cost. In this case,
revenue is considered earned and realizable.
One may question why accountants choose so late a stage in the earning process to recognize
revenue and thus net income.
The answer comes in two parts: (1) At any point prior to sale, the expected selling price of a
product and the ability to sell it at a profit may be so uncertain that they do not constitute
sufficient evidence to justify an upward valuation of the product, and (2) for most business
enterprises the actual sale of a product is the most important step – the critical event – in the
earning process. Until a sale is made and the product is delivered to and accepted by the
customer, the future stream of revenue is both uncertain and unearned.
5.1.1. Revenue Recognition Before Delivery
In some instances the earning process extends over several accounting periods. Delivery of the
final products may occur years after the initiation of the product. Examples are construction of
large ships, bridges, office buildings, and development of space exploration equipment.
Contracts for these projects often provide for progress billings at various points in the
construction process.
If the builder (seller) waits until the construction is completed to recognize revenue, the
information on revenue and expense included in the financial statements will be reliable, but may
not be relevant for decision making because the – information is not timely. In such instances, it
often is worthwhile to trade – off reliability in order to provide more timely, relevant earnings
information. This is the case for a company engaging in long – construction contracts.
There are two methods of accounting for revenue on long – term constructs:
1. Completed – contract method: under this method revenues, expenses, and gross profit are
recognized only when the contract is completed. As construction costs are incurred they are
accumulated in an inventory account (construction in progress). Progress billings are not
recorded as revenues but are accumulated in a contra inventory account (billings on
construction progress. At the completion of the contract, all the accounts are closed and the
entire gross profit from the construction project is recognized.
2. Percentage – of – completion method: Under this method revenue, expenses and gross profit
are recognized each accounting period based on the estimate of the percentage of completion
of the construction project.

The percentage - -of – completion method recognizes revenue on a long – term project as the
contract is being completed, thus timely information is provided. However, it contains estimates
and is not as reliable as information in the completed – contract method.
Management of a company has little freedom of choice in deciding between these alternative
methods of accounting for long – term contracts. When estimate of costs to complete and extent
of progress toward completion of long-term construction contracts are reasonably dependable,
the percentage – of - completion method is preferable. When lack of dependable estimates or
inherent hazards cause forecasts to be doubtful, the completed – contract method is preferable.
the percentage – of - completion method measures the percentage completed by the ratio of the
costs incurred to date to the current estimate of the total cost required to complete the project:
total costs incurred to date
Percent complete = -------------------------------------------------
Most recent estimate of total costs of the project
The most recent estimate of total project costs is the sum of the total costs incurred to date plus
the estimated costs yet to be incurred to complete the project. Once the percentage completed
has been computed, the amount of revenue to be recognized in the current period is determined
as:
Current
Period= (percent complete X total revenue from contract) – total revenue Recognized in prior
periods revenue
Illustration: FENOTE construction company engaged into contract with a municipality to
construct a 10 kilometer highway. Total contract price is Br. 900,000.
Additional data: Year 1 year 2 year 3

Construction costs incurred during the year ...........Br.125,000 Br. 495,000 Br. 145,000
Estimated cost to complete the project

at the end of the year ............................................. Br.625,000 Br. 155,000 0

Operating costs incurred (selling , Administrative)Br. 15,000 Br. 30,000 12,000

Required : using the above data compute the realized profit on contract revenue for each year
under the following methods of accounting for construction – type contracts:
(a) Percentage - of –completion method (cost – to cost)
(b) Completed – contract method.
Solution:
(a) Percentage – of – completion method
 Revenue recognized to date = Actual cost incurred to date X contract price- rev. recognized in prev
Newly estimated total cost to complete the projects
Therefore,
Revenue recognized for year 1 =125,000 X 900,000
750,000
= Br. 150,000

Revenue recognized for year 2 =620,000 X 900,000 - 150,000

775,000
= 720,000 – 150,000
= Br. 570,000
Revenue recognized for year 3 = 765,000 X 900,000 - (150,000 X 570,000)
765,000
= Br. 180,000
 Fenote Construction Company
Realized Gross Profit On Contract Revenue – Percentage Of Completion Method.

For Years 1,2 And3

YEAR 1YEAR 2YEAR 3

Contract Revenue Br. 150,000 Br. 570,000 Br. 180,000

Costs Incurred125,000495,000145,000

Realized Gross Profit On Contract Revenue Br. 25,000 Br. 75,000 Br. 35,000

Operating Expenses 15,00030,000 12,000

Net Income Br.10,000 Br. 45,000 Br.23,000

(B) Completed – contract method.

YEAR 1 YEAR 2YEAR 3
Contract revenue … Br.0 Br.0 Br. 0
construction costs incurred.................................... 0 0 0

Gross profit Br. 0 Br. 0 Br. 0

Operating expenses Br. 15,000 Br. 30,000 Br.12,000

Net income Br. (15,000) Br. (30,000) Br.(123,000)

Revenue Recognition After Delivery (installment sales)

Under some circumstances the revenue recognition criteria are not met until sometime after

delivery of the goods or service to the customer. Such is the case when The ultimate

collectability of the sales price is highly uncertain, such as with some long – term installment

sales In such instance revenue may be recorded under the installment method, the cost recovery

method , or some other method based on cash collection.

Special Characteristics of Installment Sales

An installment sale is a sale of real or personal property or services which provides for a service
of payments over a period of months or years. A down payment usually, but not always, is
required. Since, the seller must wait a considerable period of time to collect the full sales price, it
is customary to provide interest on the unpaid balances and to add carrying charges to the listed
selling price.

The risk of non-collection to the seller is greatly increased when sales are made on the
installment plan. Customers generally are in weaker financial condition then those who buy or
open account; furthermore, the credit rating of the customers and their ability to pay may change
significantly during the period covered by installment contract. The risk of non-collection is
guaranteed by security agreement which enables them to repossess the property if the buyer falls
to make payments.

The seller's right to protect their security interest (uncollected balance of a sale contract) and to
repossess the property varies by type of industry, the form of the contractual arrangement, and
the statutes relating to repossessions. For the service-type business, repossession obviously is not
available as a safeguard against the failure to collect. In reality, for many types of personal
property as well, the sellers' right to repossess may be more a threat than a real assurance against
loss. The product sold may have been damaged or may have depreciated to a point that it is
worth less than the balance due on the installment contract. A basic rule designed to minimize
losses from non-payments of installment contracts is to require a sufficient down payment,
payment to cover the loss of value when property moves out of the "new Merchandise" category.
A corollary rule is that the payment schedule should not be outstripped by the projected decline
in value of the property. For example, if a customer buying an automobile on the installment plan
finds after a year or so that the car is currently worth less than the balance still owed on the
contract, the customer's motivation to continue the payments may be reduced.

Competitive pressures within an industry often will not permit a business to adhere to these
standards. Furthermore, repossession may be a difficult and expensive process, especially if the
customer is non-cooperative or necessary to make the merchandise salable, and the resale of such
merchandise may be difficult. For these reasons, doubtful accounts expense is likely to be
significantly higher on installment sales than regular credit sales.
A related problem is the increased collection expenses when payments are spread over an
extended period. Accounting expenses also are multiplied by the use of installment sales, and
large amounts of working capital are tied up in installment receivables. In recognition of these
problems, many business executives have concluded that the handling of installment receivables
is a separate business, and they therefore sell their installment receivable to finance companies
which specialize in credit and collection activities.

From the above discussion, it is understood that installment sales pose some challenging
problems. The most basic problems are:

 Difficulty of matching costs with related revenue

 Greater risk of non-collection or higher doubtful accounts expense
 Repossession of highly damaged or depreciated property
 Higher collection expenses
 Reconditioning and repairing costs for repossessed property
 Substantial amount of working capital is tied up in receivables
Methods for Recognition of Profits on Installment Sales

The determination of net income on installment sales is complicated by the fact that the amounts
of revenue and related costs and expenses are infrequently known in the period when the sale is
made. Substantial expenses such as collection, accounting, repairs, and repossession are likely to
be incurred in subsequent periods. In some business, the risk of non-collection may be go great
as to raise doubts as to the recognition of any revenue or profit at the point of sale. The first
objective in development of accounting policies for installment sales should be reasonable
matching of costs and revenue. However, in recognition of the diverse business conditions under
which installment sales are made, three approaches are used:

1. Cost Recovery method; and

2. Recognition of Gross Profit through the use of installment method of accounting.

The Installment Method of Accounting

Under the installment method of accounting, each cash collection on the contract is regarded as
including both a return of costs and a realization of gross profit in the ratio in which these two
elements were included in the selling price. The gross profit is deferred and credited to Deferred
Gross Profit. At each collection the gross profit is realized and the realization is debited and
credited to Deferred Gross Profit and Realized Gross Profit, respectively.
The installment method is acceptable under income tax regulations. In fact, the opportunity to
postpone the recognition of taxable income has been responsible for the popularity of the
installment method of accounting for income tax purposes. Although the income tax advantages
are readily apparent, the theoretical support for the installment method of accounting is less
imperative.

1. Cost Recovery Method Gross Profit Recognition

In some cases accounts receivable may be collectible over a long period of time. In addition the
terms of sale may not be definite, and the financial position of customers may be extremely
unpredictable, thus making it virtually impossible to find a reasonable basis for estimating the
degree of collectability of the receivable. In such cases, either the installment method or the cost
recovery method of accounting may be used for installment sales. Under the cost recovery
method, no profit is recognized unit all costs of the item sold have been fully recovered. After all
costs have been recovered, additional collections on the installment receivables would be
recognized as revenue (profit), and only current collection expenses would be charged to such
revenue. The cost recovery method of accounting is rarely used.
Example 3.1: At the beginning of Year 3, SANCHO Company sold merchandise on installment
basis for Br 200,000 that have cost of Br 130,000. The first payment is to be collected at the end
of Year 3. The cash collection performances are as follows:

Year 1.......................................................................................... Br 90,00 0

Year 2.......................................................................................... Br 60,00 0

Year 3.......................................................................................... Br 50,00 0

Instruction: Determine the realized gross profit to be reported each year under Cost Recovery
Method; and Installment Method

1. Cost Recovery Method

The gross profit to be realized is the difference between the cash collection and unrecovered
cost:

C o l l e c t i o nC o s tRealized GPR e m a r k

Year 1 9 0 , 0 0 0 130,000 B r 0 40,000 cost is not recovered (90,000-130,000)

Y e a r 2 6 0 , 0 0 0 4 0 , 0 0 0 Br20,000 20,000 profit after the cost is fully recovered

Year 3 5 0 , 0 0 0 0 Br50,000 The entire collection is a profit

T o t a l 200,000 Br70,000

2. Installment Method
Under installment method of gross profit and revenue recognition, each cash collection consists
of certain percentage of gross profit and certain percentage of cost recovery

C o l l e c t i o n Gross Profit %age R e a l i z e d G r o s s P r o f i t

Year 1 9 0 , 0 0 0 3 5 % 90,000 @ 35% = 31,500

Year 2 6 0 , 0 0 0 3 5 % 60,000 @ 35% = 21,000

Year 3 5 0 , 0 0 0 3 5 % 50,000 @ 35% = 17,500

T o t a l 200,000 7 0 , 0 0 0

Illustration3.1:SingleSaleofRealEstateontheinstallmentplan

OnNovember1,Year1 ,ZF. Real Estate, which maintained accounting records on a calendar year
basis sold a building for Br 215,000 whose construction cost was Br140,000. Commission and
other expenses pertaining to the sale was Br 15,000. The Br 15,000 was an expense treated as
deductions in determining the gross profit on the sale rather than as charges to specific expense
accounts. Then et amount of receivable from the sale was therefore Br200,000 of which 70%
represented the cost i.e.there turn on the investment and 30% represented deferred gross
gain.Allcollectionsfromthebuyerincludingthedownpaymentwereregardedasconsistingof70%costr
ecoveryof30%realizationofGrossProfitorgain.The contract of sale called for adown payment of
Br 65,000 and a promissory note,with payment every six months in the amount of Br30,000 plus
interest (financecharges) of the annual interest rate of 10% on the un paid
balance.Instruction:Recordthetransactionundertheinstallmentmethod.

TransactionofYear1:
Z F R e a l E s t a t e

JournalEntriestoRecordSaleofBuildingonInstallmentPlan

Y e a r 1 Cash.............................................................................................. 50,000

Nov.1 NotesReceivable......................................................................... 150,000

Building................................................................... 140,000

DeferredGainonSaleofBuilding............................60,000
Recordingbuildingoninstallmentplan.NetcashisthedifferencebetweentheBr65,000downpaymentandtheBr15,000commissionexpense(65,000-15,000)

D e c . 3 1 DeferredGainonsaleofBuilding................................................. 15,000

RealizedGainonsaleofbuilding..................................15,000

RealizedGainComputedat30%ofcashcollectedonthecontractduringYear1

D e c . 3 1 InterestReceivables........................................................................2,500
InterestRevenue.............................................................2,500

Toaccrueinterestfortwomonthsat10%onnotesreceivablesofBr150,000. Br150,000@10
%@2/12=2,500

TransactionofYear2:
Y e a r 2 Cash...............................................................................................37,500

May.1 InterestReceivable........................................................2,500

InterestRevenue...........................................................5,000

NotesReceivable..........................................................30,000

CollectedSemiannualinstallmentonnotesreceivableplusinterestforsixmonthsat10%onBr
150,000

N o v . 1 Cash...............................................................................................36,000

InterestRevenue...........................................................6,000

NotesReceivable..........................................................30,000

CollectedSemiannualinstallmentonnotesreceivableplusinterestforsixmonthsat10%onun
paidbalanceofBr120,000(Br150,000-30,000)

D e c . 3 1 DeferredGainonsaleofBuilding......................................................18,000

RealizedGainonsaleofbuilding......................................18,000

RealizedGainComputedat30%ofcashcollectedonthecontractduringYear2(Br60,000@3
0%=Br18,000)

D e c . 3 1 InterestReceivables........................................................................1,500

InterestRevenue.............................................................1,500

Toaccrueinterestfortwomonthsat10%onnotesreceivablesofBr90,000.Br90,000@10%@
2/12=1,500

TransactionofYear3:
Y e a r 3 Cash.............................................................................................. 34,500

May.1 InterestReceivable..................................................... 1,500

InterestRevenue......................................................... 3,000

NotesReceivable........................................................ 30,000

CollectedSemiannualinstallmentonnotesreceivableplusinterestforsixmonthsat10
%onBr90,000

N o v . 1 Cash.............................................................................................. 33,000

InterestRevenue......................................................... 3,000

NotesReceivable........................................................ 30,000

CollectedSemiannualinstallmentonnotesreceivableplusinterestforsixmonthsat10
%onunpaidbalanceofBr60,000(Br90,000-30,000)

D e c . 3 1 DeferredGainonsaleofBuilding................................................. 18,000

RealizedGainonsaleofbuilding..................................18,000

RealizedGainComputedat30%ofcashcollectedonthecontractduringYear2(Br60,000@3
0%=Br18,000)

D e c . 3 1 InterestReceivables..................................................................... 500

InterestRevenue.......................................................... 500

Toaccrueinterestfortwomonthsat10%onnotesreceivablesofBr30,000.Br30,000@
10%@2/12=500

TransactionofYear-4:

Y e a r 4 Cash...............................................................................................31,500

May1 InterestReceivable........................................................500

InterestRevenue...........................................................1,000

NotesReceivable..........................................................30,000

CollectionofthefinalSemiannualinstallmentplusinterestforsixmonthsat10%onBr30,000