CHAPTER # 09

Revenue and Revenue Recognition

Revenue represents the gross income (economic benefits) earned by a company from its
principal business activities. It includes income from sales of goods and services, royalty
income and dividends from its investments.

Revenue is different from gains in that gains represent increase in value not related to
the company's principal business activities. For example, if a company is engaged in
manufacturing and sales of PCs, any income from sale of PCs or sale of after-sale service
contracts is revenue and so is any royalty received on any patented technology.
However, if the same company sells some of its property, plant and equipment for more
than its book value there is an increase in value but that is a gain and not revenue
because it is not related to the company's principal business activity.

IAS 18 Revenue contains IFRS principles for revenue recognition while ASC 605 Revenue
recognition is the US GAAP equivalent of IAS 18. Both standards are quite similar in their
approach to revenue recognition but the US GAAP provides more specificity.

Since revenue recognition involves considerable judgment by management of a

company, the accounting standards adopt a substance-over-form perspective. Revenue
is recognized when risk and rewards inherent in the goods (or services) is transferred to
the other entity, the consideration for the transfer is measurable and is realized (or
realizable).

Accounting for Cash Sales

Cash sales are sales made against cash. It is where the seller receives the cash
consideration at the time of delivery. Unlike credit sales, cash sales do not result in
accounts receivable. It is not necessary that the seller must receive the currency notes to
qualify a sale as cash sale. Sales involving direct immediate transfer to the seller bank
account or payments through credit cards are also cash sales.
Accounting for cash sales depends on whether any sales tax or value-added tax (VAT) or
any other indirect tax is applicable to the products sold. If sales tax or VAT is not
applicable, the sale is recorded as follows:

Cash A

Sales A

If any indirect tax is applicable, the seller is required to collect a certain percentage of
the retail price as sales tax or VAT and pay it to the government. Cash received from
cash sales to which sales tax or VAT applies is sum of the actual retail price and the sales
tax collected on the behalf of the government. This transaction results in increase in
cash, recognition of revenue and also gives rise to a liability, sales tax payable. A taxable
credit sale is recorded as follows:

Cash A

Sales B

Sales tax payable C

Where A is the actual cash received, B is the retail price before sales tax, C is the sales
tax collected on the sale and D is the percentage rate applicable on the transaction.

C and A are given by:

C = B × D%
A=B+C

Example
Havana Refreshments (HR) sells hand-rolled cigars and rich fresh cocktails. A pack of
cigar is sold at $25 and each glass of cocktail juice has a price of $10. 50% tobacco tax
(which is an indirect tax) applies to cigars. On 29 August 2014, HR sold 150 packs of
cigars and 500 glasses of cocktail juices all on cash.

Required: Journalize the transactions.

Solution

Since juices don’t carry any taxes, recording juice sale is pretty straightforward. Total
amount of juice sales is $5,000 [= 500 × $10]. The following journal entry is required.

Cash $5,000
 Juice sales $5,000

Cigars carry 50% tobacco tax. Total value of sales is $3,750 [= 150 × $25]. Amount of
tobacco tax is $1,875. Cash to be collected from customers is $5,625 [= $3,750 +
$1,875]. This would be journalized as follows:

Cash $5,625

Cigar sales $3,750

Tobacco tax payable $1,875

Accounting for Credit Sales

Credit sales are sales in which a company expects the buyer to pay the price within a
certain period. Unlike cash sales, in which the buyer has to pay the cash on spot, credit
sales are flexible in respect of the actual payment of the invoice.

Credit Terms
Credit sales carry a certain time period in which the invoice is due. Further, they normally
offer a cash discount if the payment is made within a certain period of the actual sale
date. The credit terms are expressed as a/b, net z where a is the percentage cash
discount offered when the payment is made within the discount period, b is the
discount period in days, and z is the credit period i.e. the time period till the due date of
the invoice.

Journal Entries
A sale is recorded when the risk and rewards inherent in the product transfers to the
buyers. This involves creation of account receivable.

Accounts receivable A

Sales A

When the buyer pays the invoice within the discount period, a cash discount is recorded.
Cash discount equals the product of invoice value and the percentage cash discount
included in the credit terms. This is journalized as follows:

Cash (C = A – B) C
 Cash discount (discount % × A) B

Accounts receivable A

Credit sales involve a risk that the buyer might not eventually pay when the amount is
due. This results in bad debts expense, which is estimated based on the creditworthiness
of the buyer and the company’s past experience.

Example
On 1 July 2014, Woodworks, Inc. sold 5 office desks, 5 revolving chairs and 10 visitor
chairs to A2Z Real Estate Solutions (ARES), for $3,000 with credit terms of 2/10, net 30.

On 10 July 2014, ARES paid $980. On 30 July 2014, it paid $1,800 more. A week late a
court ordered the company to be wound up. Woodworks, Inc. wants to write off the
uncollected credit sales as bad debts expense.

Required: Journalize the transactions.

Solution

The credit sale is recorded as follows:

Accounts receivable—ARES $3,000

Sales $3,000

$980 paid on 10 July 2014 is after adjustment for cash discount equal to $20 [=2% ×
$1,000]. This payment discharges $1,000 worth of accounts receivable. The payment will
be recorded as follows:

Cash [= $1,000 - $20] $980

Cash discount [= 2% × $1,000] $20

Accounts receivable—
$1,000
ARES

$1,800 paid on 30 July 2014 is not entitled to the 2 % discount. It is recorded as follows:

Cash $1,800

Accounts receivable—
$1,800
ARES
After winding up of ARES, the outstanding balance on ARES account is not recoverable.
It is charged to income statement as a direct write off of bad debts expense.

Bad debts expense [= 3,000 - 1,000

$200
- 1,800]

Accounts receivables—
$200
ARES

Accounting for Sales Returns

Customers are normally entitled to return the products they purchase from a company
when they are not satisfied, usually within a specified duration after the sale. When a
sales return occurs, the customer physically returns the product and receives his cash
back.

Accounting for a sales return involves reversing (a) the revenue recorded at the time of
original sale, and (b) the related cost of goods sold.

Revenue is reversed by debiting the sales returns and allowances account (which is
a contra-account to sales) by the amount of original sale and crediting accounts
receivable account or cash account (depending on whether it was a credit sale or a cash
sale).

Sales returns and allowances A

Accounts receivable/cash A

Net sales equal gross sales minus sales returns and allowances.

Some companies do not use the contra-account for the purpose of sales return. Instead,
they debit the sales account directly and credit accounts receivable or cash.

Sales B

Accounts receivable/cash B

When a product is physically returned, it increases inventory and decreases related cost

of goods sold recognized at the time of sale. The following journal entry is made.

Inventory C
 Cost of goods sold C

Example
Brazuca, Inc. is a football manufacturer and distributor. On 1 July 2014, it sold 500
footballs each to Club A and Club B at a price of $20 per football. Club A paid the total
amount due (which was $10,000) on 10 July 2014. The receivable from Club B was
outstanding as at the end of July, when Club A returned 5 and Club B returned 10
footballs. Each football costs $15.

Record the return of footballs by each club. How will the journal entries be different if
no contra-account is used?

Solution
Sales return from Club A:

Sales returns and allowances [= 5 × $20] $100

Cash $100

Related cost of goods sold adjustment:

Inventory [= 5 × $15] $75

Cost of goods sold $75

Sales returns from Club B:

Sales returns and allowances [= 10 × $20] $200

Accounts receivable $200

Related cost of goods sold adjustment:

Inventory [= 10 × $15] $150

Cost of goods sold $150

Please note that accounts receivable is credited in case of Club B because the amount
was still outstanding at the time of the sales return.

If no sales returns and allowances account is there, the revenue reversal entries will be

different (as shown below). The cost of goods adjustment is same under both the
methods.
 Sales [= Club A + B = 100 + 200] $300

Accounts receivable [for Club B] $200

Cash [for Club A] $100

Accrued Revenue
Accrued revenue is the amount of revenue that is earned but not yet billed to the client.
Revenue is accrued in order to properly match revenue with expenses. It normally arises
in case of sales that occur over a period of time and/or where the issue of invoice is
delayed.

Accrued revenue is also referred to as unbilled revenue. The concept of accrued revenue
is opposite to unearned revenue (also called deferred revenue) in which cash is received
before the products giving rise to the revenue are transferred.

Following are few of the examples in which revenue is accrued.

 A professional association that allows payment of membership fees in arrears records

accrued revenue, which increases as the payment date approaches.
 Revenue is accrued on a construction contract according to the percentage of
completion method when the contract price is billed at the end of the contract.
 A building maintenance company accrues revenue over the period of maintenance
contract.
 An equipment leasing company accrues revenue over the lease term if it bills the lease
receivable at the end of the contract.

Example
M & A Solutions (MAS) provides corporate finance and investment banking services. On
1 January 2014, government of a South Asian country hired it to provide financial advice
related to privatization of state entities. Under the contract, the firm had to do a
preliminary review of government-owned entities and come up with a list of four ideal
candidates for privatization by end of March 2014. The second phase of the contract
involved carrying out valuations of the entities by end of June 2014. They agreed upon a
contract price of $25 million, payable in July 2014. $5 million of the fee related to
preliminary review and $5 million related to each second-phase review.

Illustrate revenue recognition in the given scenario and write down necessary journal
entries.
Journal entries
Since the fee is payable after the completion of the contract, MAS will bill review by end
of June 2014. In the meanwhile, in accordance with the matching concept, it has to
accrue revenue at completion of each milestone.

The required journal entries are as follows:

 On completion of the preliminary study, MAS will record accrued revenue because the
firm has completed its obligations under the first phase of the contract.

Accrued revenue $5 M

$5
Revenue
M

 On completion of each valuation, revenue must be recorded

Accrued revenue $5 M

$5
Revenue
M

 On completing the preliminary study and the four valuations, MAS can bill the
government and record a receivable.

Accounts receivable $25 M

$25
Accrued revenue
M

Unearned Revenue
Unearned revenue (also called deferred revenue) is a liability which represents the
consideration received by a company for performance obligations which it has yet to
satisfy.

Under the prevailing revenue accounting standards, a company identifies performance

obligations under each contract, allocates the contract price to each obligation and
recognizes revenue as and when it satisfies the performance obligations regardless of
when the cash is received.
When a performance obligation has been satisfied (i.e. when goods/services have been
provided) but cash is not yet received, a company records a receivable. On the other
hand, when cash has been received but the company has yet to satisfy the performance
obligations, the company books the receipt of cash by recording a corresponding
unearned revenue. In this sense, the unearned revenue is just the opposite of accounts
receivable. The receipt of cash is recognized as a liability because the company must
either provide the underlying goods or services or refund the consideration.

The unearned revenue is recognized at an amount equal to the consideration received.

If the contract has a significant financing component or foreign currencies are involved,
the unearned revenue may be subject to finance cost, exchange differences until the
performance obligations have been satisfied.

On satisfaction of the performance obligation, the unearned revenue is adjusted and

revenue is recognized. Examples of entities whose books may contain significant
unearned revenues include newspaper publishers, entertainment companies,
telecommunication operators, etc. because the nature of their business is such that cash
is received before goods and/or services are provided.

Example
Voice is a VoIP company which provides innovative voice calling solutions. Assume that
during the month of January 20X2 its users purchased talk time worth $10 million. This
must be utilized by the subscribers by the end of March 20X2.

Voice would record this purchase as follows:

Cash 10 million

10
Unearned Revenue
million

The purchase of talk time is just an advance payment for services which Voice has yet to
provide. Since there is a cash inflow and an increase in cash there is an offsetting
increase in liabilities.

Let’s assume Voice has a single performance obligation which is satisfied over time.

If the users consumed $8 million of the talk time purchased in January by the end of
February, the company can recognize an equivalent amount of revenue.

Unearned Revenue 8 million

 8
Cash
million

$2 million worth of revenue is still unearned at the end of February (assuming no

additional purchase of credit). If the users had purchased $9 million worth of talk time
the balance in the unearned revenue at the end of February would have been $11
million ($2 million opening unearned revenue plus $9 additional talk time purchased).

Revenue Recognition: Percentage of

Completion Method
Percentage of completion method is a basis for revenue recognition in long-term
construction contracts which span over more than one accounting periods. In case of
long-term contracts, accountants need a basis to apportion the total contract revenue
between the multiple accounting periods. Percentage of completion method provides
one of those bases, other being full-contract method.

It determines revenue recognized in one accounting period in accordance with the

following formula:

Revenue Recognized

Percentage of Work Completed in the Period

= 
Total Contract Value

Total contract value is the total revenue from the long-term contract.

Percentage of work completed is the proportion of work completed in a period to total

work for the contract. It is usually estimated using the following formula:

Percentage of Work Completed

Expenditures Incurred from Inception to Date

= 
Total Estimated Costs for the Contract

Expenditures incurred from inception to date represent costs incurred from the start of
the project to the date of estimation.
Total estimated expenditures for the contract represent the total budgeted cost for the
project. It includes costs that have been incurred to date and costs that are expected to
be incurred in future periods.

There is another method for estimating percentage of completion called survey method
which is based on the physical progress of the contract. Under this method engineers
and other experts observe the activities and determine their judgment of the percentage
of work completed.

Example
Construction Inc. is engaged in constructing a massive bridge in Wonderland. The
contract is worth $200 million and the company is expected to complete it in 3 years. In
Year 1 the company has incurred an amount of $50 million on the contract and the
engineers estimate that in the next 2 years the company is expected to expend $110
million more. Based on the physical progress of the project the engineers also estimate
that 40% of the work has been carried out.

Solution:

Under the survey method the engineers have provided their judgment of the
percentage of work completed and it is 40%.

Based on costs incurred to date and total costs the percentage of completion comes out
to be:

Percentage of work completed = $50 million ÷ ($50 million + $110 million) = 31.25%.

Total costs include costs incurred to date and costs expected to be incurred over the
remaining period.

Based on the percentage of completion calculated using cost date we determine than
revenue of $62.5 million has been earned (31.25% multiplied by $200 million total
contract value). On the other hand based on the engineer's survey the revenue
recognized should be $80 million (40% multiplied by $200 million).

Completed Contract Method of Revenue

Recognition
Completed contract method is an approach used for construction contract accounting in
which the revenue is recognized only when the contract is 100% complete. In contrast to
the percentage of completion method, which records estimated revenue in each period
based on the percentage of completion of the contract, the completed contract method
defers contract revenue. However, even the completed contract method does not defer
recognition of related costs and expenses.

Gross profit on a completed contract = total contract price – contract costs

Total revenue and total gross profit recorded under both the methods are same. The
methods differ in the inter-period distribution of revenue and gross profit.

Example and Journal Entries

Metro Structures, Inc. is a diverse construction group. On 1 January 2011, it won a 3-year
contract to construct an intra-city dedicated bus tracks for a total price of $300 million.

Following is a summary of the costs incurred, amounts billed and amounts collected.

201
2012 2013
1

Amounts in million

Costs incurred $80 $100 $40

$15
Estimated cost to complete $100 0
0

$10
Amount billed $100 $100
0

Amount collected $90 $130 $80

Solution

Total gross profit on the contract

= $300 million – ($80 million + $100 million + $40 million)
= $80 million.

2011

Following journal entries are made:

 1. To record the cost incurred:

Work-in-progress $80 M

Accounts payable and $80

others M

2. To record the amount billed:

Accounts receivable $100 M

$100
Billings
M

3. To record the collections:

Cash $90 M

$90
Account receivable
M

2012

The journal entries will be similar to those in previous period.

1. To record the cost incurred:

Work-in-progress $40 M

Accounts payable and $40

others M

2. To record the amount billed:

Accounts receivable $100 M

$100
Billings
M

3. To record the collections:

Cash $80 M
 $80
Account receivable
M

2013

In addition to the journal entries to record costs, billings and collection, in the last year
of the contract, a journal entry is recorded to recognize the gross profit.

1. To record the cost incurred:

Work-in-progress $100 M

Accounts payable and $100

others M

2. To record the amount billed:

Accounts receivable $100 M

$100
Billings
M

3. To record the collections:

Cash $130 M

$130
Accounts receivable
M

4. To record the revenue:

Billings (100 + 100 + 100) $300 M

Contruction Contracts $300

Revenue M

5. To expense out the work-in-progress:

Cost of construction $220 M

Work-in-progress (80 + 100 $220

+ 40) M
 6. The difference i.e. $80 million is the gross profit on the contract ($300 million - $220
million).

Installment Method of Revenue

Recognition
Installment method is a method of revenue recognition in which gross profit is deferred
until cash from the sale is received. Unlike the cost recovery method, which defers the
profit till the cash collections exceeds the costs; installment method recognizes
proportionate profit at receipt of each installment.

Installment method is a conservative method of revenue recognition. It is only applied in

situations, for example in real estate, when the risks and rewards are not completely
transferred at the time of sale. It differs from cost recovery method because in
installment method there is less doubt about collectability of the installments.

Journal entries
Accounting for installment sales include the following steps:

 At the time of sale, recognize the revenue and related cost of goods sold.
 Defer the gross profit on the sale.
 At the end of each period, make a journal entry to recognize profit equal to the product
of the gross profit rate on the installment sale and the actual cash collection.

The journal entries are illustrated in the following example.

Example
You work as an accounting analyst at Goldberg, LLC. On 1 January 20X2, your company
sold some real estate costing $120,000 for $200,000. After reviewing the terms of the
sale, the CFO concluded that the company would recognize the revenue using
installment sales method. He asked you to post the journal entries required at the time
of sale.

Just to help you understand the subsequent accounting treatment of the sale, he asked
you to write down the journal entries you will make if you receive an installment of
$50,000 in 20X2 and $70,000 in 20X3.

Solution
Following journal entries are required at the time of sale.
 Installment receivables $200,000

Installment sales $200,000

Cost of goods sold $120,000

Inventory $120,000

The related revenue is deferred as follows.

Installment sales $200,000

Cost of goods sold $120,000

Deferred gross profit $80,000

Deferred gross profit is a contra-account to installment receivables, i.e. it is subtracted

from installment receivables.

The amount of revenue recognized at the receipt of each installment equals the product
of the gross profit rate on the installment sale and the amount of installment received.

$200,000 −
Gross Profit on Sale $120,000 = 40%
=
$200,000

The collections are accounted for as follows.

20X2:

Cash $50,000

Installment receivables $50,000

20X3:

Cash $70,000

Installment receivables $70,000

Following adjusting journal entries are needed to recognize the deferred revenue.

20X2:
 Deferred gross profit $20,000

Gross profit on installment sales $20,000

Where, $20,000 = 40% × $50,000.

20X3:

Deferred gross profit $28,000

Gross profit on installment sales $28,000

Where, $28,000 = 40% × $70,000.

Cost Recovery Method of Revenue

Recognition
Cost recovery method (also known as cost recoverability method) is one of the methods
of revenue recognition others being installment method, percentage of completion
method and completed contract method. Under this method revenue from a sale is
recognized only to the extent of receipts from the buyer.

In periods in which the initial payments are received no gross profit is reported because
the revenue recognized equals the amounts received and a cost equal to the revenue
recognized is charged to the income statement. Once all the cost has been recovered
the final payments consist of the gross profit earned on the sale.

Cost recovery method is used to account for revenue in situations when the
recoverability of revenue is not certain or the value of the sale cannot be determined
accurately. IAS 18 Revenue requires companies to recognize revenue only when the
consideration is measurable. In this scenario since total revenue is not determined it is
more prudent to record revenue equal to the receipts and match costs. Recording the
total sales value as revenue would overstate gross profit.

Example
Prudence Inc. is engaged in manufacture and sale of specialized manufacturing
equipment. It has excess capacity of 30% so on 1 January 2011 the company's
management sold equipment worth $20 million to Uncertainty Inc. a company which is
facing a liquidity crunch. The equipment cost $10 million in manufacturing costs. The
receipts from Uncertainty in FY 2011 we as follows:

 First Quarter $3 million

 Second Quarter $6 million
 Third Quarter 4 million
 Fourth Quarter 7 million

Determine the gross profit earned in each quarter under cost recovery method.

Solution

Under cost recovery method revenue is recognized only to the extent of receipts. So in
Q1 revenue recognized is $3 million which is matched with cost of $3 million resulting in
zero gross profit. In Q2 revenue recognized is $6 million matched with $6 million cost
resulting in zero gross profit. In Q3 revenue recognized is $4 million matched with the
remaining cost of $1 million ($10 million - $3 million - $6 million) resulting in a gross
profit of $3 million. In Q4 no cost is left and the revenue recognized is $7 million so
gross profit is $7 million.

Total revenue recognized and total gross profit earned under cost recovery method
would equal all other methods but its distribution among various periods would be
different.