<< Cost of Goods Sold and Inventory

The Revenue Principle of GAAP requires Revenue to be recorded in the period it is Earned regardless of when it is billed or when cash is received.

In some cases, it is simple to determine the timing for Revenues Earned, once ownership of a product is transferred or a service is complete, revenue is considered to have been earned. But if revenue recognition were delayed until the end of a long term contract, the Matching Principle of tying revenues and their direct costs to each other would be violated. The solution to this problem is the Percentage of Completion method of Revenue Recognition.

Contract Revenues are tied to Costs, but Billings on Contracts are not always tied to Costs. Sometimes elements of a contract are billed in advance or sometimes they are delayed by mutual agreement (or disagreement). This mismatch between actual billed revenue and earned revenue will require an adjusting entry but since the Percentage of Completion method adjusts billed revenue to reflect earned revenue, billings are posted to revenues and adjusted later to reflect the correct earned revenue amount. (Debit Accounts Receivable, Credit Sales).

Long Term Contracts will have estimates for both sides of a contract, Costs and Revenues. Calculating Percentage of Completion requires both total actual and total estimated numbers to calculate a percentage so it uses the side where both the actual and estimated numbers can be known, Costs.

• Percent Complete = Actual Costs to Date / Total Estimated Costs

The Percent Complete is then applied to the Total Estimated Revenue to determine Earned Revenue to Date.

• Earned Revenue to Date = Percent Complete * Total Estimated Revenue

Finally, the Earned Revenue to Date is compared to the Billings on Contract to Date. The difference is either added to or subtracted from the Revenue.

• Earned Revenue to Date – Total Billings on Contract = Over/Under Billed Revenue

The Over/Under Billed Revenue accounts are Balance Sheet Accounts and they are often called either Billings in Excess of Costs (liability account that reflects over-billings) or Costs in Excess of Billings (asset account that reflects under-billings).

Work In Progress Statement:

<< Cost of Goods Sold and Inventory

**disclaimer: All information posted on this blog is from my own experience and training. The guidelines I present are general and in my experience, standard practice. I do not write with authority from any Accounting Standards Boards.

<< Financials – Statement of Cash Flows

WIP Statement and Percent Complete>>

The purpose of an Inventory System in Financial Accounting is to account for resources and to match costs to their related sales as closely as possible.  Management Accounting is more concerned with the details of inventory management but for Financial Accounting, when inventory is purchased or sold, the objective is to satisfy the Matching Principle and to accurately represent the financial position of the entity.

The Matching Principle requires that revenues and their related costs be matched up and posted into the same accounting period.  When Inventory is purchased and before it is sold, there are no revenues to match it to so it cannot be considered a cost until it is sold.

The inventory examples assume that the entity has ownership of products purchased and that they are purchased and manufactured for sale as finished goods.  There are cases where the entity purchasing materials for and accounting for a project are not the owners of the product even as it is in the process of construction or manufacturing.  In these cases, purchases are debited directly to Income Statement Cost accounts.  The key concept is ownership.

There are two systems used to account for Inventory, the Periodic System and the Perpetual System.  Each has its own accounting methods and I’ll demonstrate those methods here.  I will not be explaining Inventory Valuation methods (FIFO, LIFO, Specific Identification etc.)

Periodic Inventory System – Assumes Entity Owns Inventory until Sale:

The first system I’ll demonstrate is the Periodic System.  The Periodic System may work well for companies where changes in sales can be tied closely to changes in inventory purchases. Under this system, as inventory is purchased, it is debited to the Income Statement Account “Purchases” and the Balance Sheet Account “Inventory” is adjusted at the end of the year when the available inventory is counted and valued.  At this time, the balances of the Inventory and Purchase Accounts are transferred to Cost of Goods Sold Account and the value of the Ending Inventory is transferred back from Cost of Goods Sold to Ending Inventory.

Entry for purchases throughout the year.

*In the entry above, the credit entry could be cash, I chose Accounts Payable because it will be the most common account used in this situation.

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