Tag Archives | revenue recognition

What is GAAP?

What is GAAP?

GAAP stands for Generally Accepted Accounting Principles. It is the set of rules and guidelines for U.S. companies to follow. GAAP regulates financial reporting for public companies, private businesses, non-profits, and government authorities. This means that GAAP outlines the procedures to make sure that businesses are recording their financials in the same way.

GAAP Principles

The principles in GAAP ensure transparency and consistency. This includes the following topics:

The overall philosophy behind these principles is to prevent deceptive recording.

What is IRFS?

While the United States follows the GAAP, most of the developed world follows the International Financial Reporting Standards (IFRS.) In 2008, the United States decided to move towards adopting the IFRS to be more consistent with the rest of the world. While the long term effects are only speculative, the short term changes will have an immediate impact on accountants, managers, and investors.

IFRS vs GAAP

What is the benefit of following the same set of guidelines as the rest of the world? One major advantage of having the same international financial reporting guidelines is the effect on investors. Investors will be able to compare and contrast investments between nations more accurately.

For example, if there is one startup in the United States and one in London, then they will likely use different methods for financial reporting. This could make the investor’s decision very difficult. If inventory and depreciation are valued differently, then the investor might not fully understand the true standing of these startups.

What is GAAP

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Percentage Completion Method

Percentage Completion Method Example

It is important to visually grasp the percentage completion method for full understanding. The following is a percentage of completion method example to help explain how the method works within a company. Bob is a project accountant for Whistle-at-You Construction Co. Because he is the primary project accountant for his company, this brings with it multiple additional responsibilities. He is responsible for all transactions and yearly revenue for a new tower project that is estimated to take 5 years to complete. Costs and revenues will be recorded at an accrual basis during this 5 year window of production. Whistle-at-You Construction uses the percentage of completion method of revenue recognition for all projects that will take over a year to complete. Bob has obtained and would account for the following information concerning the project over the five year period as follows:

General Information:

Estimated Project Cost = $500 million

Total Project Revenue = $750 million

Year 1:

Cost = $80 million

Percentage Complete = 16%

Revenue = $120 million

Income = $40 million

Year 2:

Cost = $100 million

Percentage Complete = 20%

Revenue = $150 million

Income = $50 million

Year 3:

Cost = $110 million

Percentage Complete = 22%

Revenue = $165 million

Income = $55 million

Year 4:

Cost = $90 million

Percentage Complete = 18%

Revenue = $135 million

Income = $45 million

Year 5:

Cost = $120 million

Percentage Complete = 24%

Revenue = $180 million

Income = $60 million

Percentage Completion Method

See Also: Percentage Completion (POC) Method

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Installment Sales Method

See Also:
Accounting Principles
Point of Sale Method (POS)
Collection Method
Percentage of Completion Method
Completed Contract Method

Installment Sales Definition

The Installment Method of revenue recognition under the revenue principle deals with sales that require periodic payments over a specified time period usually established within a contract called the installment sales contract.

Installment Sales Explanation

Due to conservative practices in business, the installment sales method of accounting finds the gross profit percentage associated with the total sale and recognizes this percentage as gross profit as the periodic or installment payments are received. Therefore, the company does not recover the cost of the goods sold or the gross profit until the last payment has been made by the customer. The installment method is generally used by real estate companies because the cost of land can be substantial and paying for the total cost up front is simply not possible.

Installment Sales Method Example

The following Installment sales method example explains how a company would use the Installment Sales method:

For example, Real Estate Company has just sold a large parcel of land to Case Co. at a price of $1 million. Case signed an installment sales contract that requires payments of $150,000 over the next 6 years and an up-front payment of $100,000. The cost of the land sold for Real Estate is $600,000. Thus the gross profit they will recognize under the method at the end of the installment sales agreement would be $400,000.

Gross Profit percentage = Gross Profit/Sale Price = $400,000/$1 Million = 40% Year 1 during the year:

Installment Accounts Receivable (A/R) ………………………$1,000,000
Installment Sales …………………………………………………………………………$1,000,000

Cost of Land Sold ………………………………………………………$600,000
Land………………………………………………………………………………………………$600,000

Cash…………………………………………………………………………….$250,000
(up-front payment of 100,000 + year 1 periodic of $150,000)
Installment A/R……………………………………………………………………………..$250,000

Year 1 end of year:

Installment Sales………………………………………………………..$1,000,000
Cost of Land ………………………………………………………………………………..$600,000
Deferred Gross Profit………………………………………………………………….$400,000

Deferred Gross Profit ……………………………………………….$100,000 (250,000*40%)
Realized gross profit on Installment Sales……………………………………$100,000

Year 2-6 end of year:

Deferred Gross Profit…………………………………………………$60,000
Realized gross profit on Installment Sales………………………………………..$60,000

Notice that the total amount at the year 6 end will show the total amount of gross profit.

Year 1 Gross Profit realized=$100,000
Year 2 Gross Profit realized=$60,000
Year 3 Gross Profit realized=$60,000
Year 4 Gross Profit realized=$60,000
Year 5 Gross Profit realized=$60,000
Year 6 Gross Profit realized=$60,000
Total Gross Profit realized =$400,000

Note: To simplify the transaction accounting, interest has been left out. There is also an assumption that the company has not made any other sale outside of this one. If the company had made any other installment sales, then the gross profit percentage would need to be recalculated each year and applied to the cash receipts.

Installment Sales method

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Freight on Board (FOB)

See Also:
Ex Works (EXW)
How to manage inventory
Just in Time Inventory System
Inventory Cost
Accounting Principles

Freight on Board (FOB) Definition

Freight on Board, known internationally as Free on Board, are the terms of a transaction within a contract. The terms are there to determine liability and when revenue recognition can take place between two parties. This becomes of interest to companies during the transportation of goods from one company to another. There are commonly two types of fob revenue recognition and liability, fob destination and fob shipping.

Freight on Board Destination

Freight or free on board destination means the terms of the transaction as it pertains to liabilities of the goods being delivered for a company will not pass on to the customer or the purchaser until it arrives on location of that customer. Therefore a company cannot and should not recognize revenue until the goods have arrived on location of the customer.

Freight on Board Shipping

Freight or free on board shipping point means that a company is allowing the purchaser or customer to assume the responsibility as soon as the goods have left the seller’s warehouse or business location. The seller is then allowed to recognize revenue as soon as the goods leave because the payment for these goods is certain as they leave the location.

Freight on Board Example

Acme inc. supplies TNT explosives and anvils to its various customers around the globe. Wile E. Coyote has hatched a plan to once and for all destroy the Road Runner. He orders some TNT explosives from Acme in order to set his plan in motion. Acme uses fob shipping point when it has to deliver goods. Therefore Acme recognizes the revenue immediately as the goods leave the warehouse. Even if the truck were to crash on its way the company can still expect payment because Wile. E Coyote is liable. If the terms had been fob destination and the truck had crashed on the way then Wile E. Coyote would not be expected to pay for that shipment of goods and Acme inc. would be required to accept the loss.

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freight on board

freight on board

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Earnings per Share (EPS)

See Also:
Price Earnings Growth Ratio Analysis
Price Earnings Ratio Analysis
Gross Profit Margin Ratio Analysis
Net Profit Margin Analysis
Financial Ratios

Earnings per Share (EPS) Definition

The earnings per share or EPS is the amount of profit that accrues to each shareholder based on their percentage ownerships or amount of shares owned within the company.

Earnings per Share (EPS) Explained

The earnings per share ratio is often a good measure of how a company is doing from year to year and is used by many investors in the market. However, companies know that the EPS is often a measure of how they are handling their businesses. This leads several companies to manipulate the EPS ratio. The ratio can be manipulated if the company were to buy or sell its own shares in the market, referred to as Treasury Stock. The net income aspect can also be manipulated through the recognition of revenue as well as other ways.

Earnings per Share (EPS) Formula

The EPS equation is as follows:
(Net Income – Preferred Dividends)/Shares Outstanding

Earnings per Share (EPS) Example

Tim is trying to calculate the EPS for Wawadoo Inc. He was given the following information to solve the problem.

Operating Income – $350,000
Interest expense – $20,000
Tax rate – 34%
Shares outstanding – 100,000 common (no preferred)

Tim will make the EPS calculation as follows:
$350,000 – (350,000 * .34) – $20,000 = $211,000 = Net Income
$211,000/100,000 = $2.11/share = EPS

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earnings per share

 

earnings per share

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Cost Recovery Method

See Also:
Accounting Principles
Point of Sale Method (POS)
Installment Method
Percentage of Completion Method
Completed Contract Method

Cost Recovery Method Definition

Also known as the collection method, cost recovery method accounting is a way of recognizing revenue under the revenue principle. The method is commonly used in conjunction with companies who do not believe that they will receive a future payment of cash or it is highly unlikely that they will.

Cost Recovery Method Explanation

When using collection method accounting a company will commonly reduce the accounts receivable account through the allowance for doubtful accounts. It will then only recognize the revenue upon the receipt of cash up to the inventory or service amount. In other words, if a company only receives cash of $20,000 for an inventory item costing $50,000, then the company will defer this recognition of revenue until the other $30,000 has been received in cash. Because the company has reduced the amount of revenue that it would normally recognize under the accounts receivable account, cost recovery accounting is the most conservative form of revenue recognition.

Cost Recovery Method Example

The following is a cost recovery method example. It shows when a company should adopt recovery cost to paint a better picture of what sort of condition the company is in:

For example, Steel Company is a company that supplies steel to customers who use that steel to make all sorts of items. These items range from beams to construct buildings to ship building companies. One of Steel’s long time customers Ship Builders R’ Us has recently been going through some trouble. It is becoming more and more likely that the company will need to file for bankruptcy. Because of this Steel Company has decided to use the cost recovery method of revenue recognition. The inventory that has been sold to Ship Builders is in total around $500,000 with a cost to Steel Company of $400,000.

The company is expected to pay Steel in installments of $100,000 in the next three years (2008, 2009 and 2010). They have already paid Steel $200,000 upon the sale in 2007. Thus the company needs to take the installments out of accounts receivable to reduce the amount of revenue. Then the company will not recognize revenue until the end of 2009 when the total cash paid is $400,000 or the cost to Steel Co. The last payment in 2010 is like any normal sale assuming that it occurs because the full cost was recovered in 2009.

Note: The above example does not account for interest.

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cost recovery method

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cost recovery method

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Completed Contract Method

See Also:
Accounting Principles
Percentage of Completion Method
Installment Method
Point of Sale Method (POS)
Cost Recovery Method

Completed Contract Method Definition

The completed contract method is also known as the contract completion method. It is a form of revenue recognition used for project based accounting such as construction. The completed contract method of accounting records all revenue earned on the project in the period when a project is done.

Completed Contract Method Meaning

The Completed Contract Method of revenue recognition is normally only used in the short-term. For example, projects that last less than a year are considered short-term. It is anything over a year, then most firms prefer the percentage of completion method because it paints a more realistic picture in the long term. However, for firms that are more conservative the complete contract method becomes appropriate because the revenue will not be recognized until the total cost has been accounted for and all the revenue has been received.

Completed Contract Method Example

The following represents an example to help explain completed contract method accounting:

Bob works for Whistle-at-You Construction Co. (WAY). He has obtained the following information via a contract with a company. This company is in need of refurbishing some office space. Whistle-at-You believes that they will be able to complete the project in 8 months. WAY uses the completed contract method of revenue recognition when it is dealing with projects that will only lasts under a year. The contract states that the company will pay WAY $5 million upon completion of the project. The estimated costs equal $4 million.

At the end of the construction, which ended up being 9 months instead of 8 months, the company pays the $5 million to WAY. But the actual cost for the project amounted to $4.5 million dollars. Because the project is completed Bob will recognize revenue in the amount of $5 million and the actual cost of construction of $4.5 million. Therefore, he will correctly state the income at $500,000.

Note: If Bob had used the percentage of completion method, then the company would have made some adjusting entries to correct for the extra costs and the extended month. This is one major advantage that completed contract method revenue recognition has over the percentage completion method.

completed contract method

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