#06 – Revenue and Expense Recognition (2.1, 2.2, 2.3, 2.4, 2.5) Flashcards
TIMING ISSUES
F2.1
I - DEFINITIONS
II – REVENUE RECOGNITION
III -
Definitions –Assets and Liabilities
Assets are probable future economic benefits that are obtained or controlled by a particular entity as a result of past events or transactions
Liabilities are probable future sacrifices of economic benefits that an entity faces for obligations to provide services or transfer assets due to past events or transactions
Definitions –Revenues
Revenues are increases of assets and/or reductions of liabilities doing a period of time. They stem from the rendering of services, delivery of goods, or any other activities that may constitute the major ongoing or central operations of an entity
Definitions –Revenue Recognition under US GAAP
Revenue is recognized when it is realized (or realizable) and earned
4 criteria must be met before any revenue can be recognized
- Persuasive evidence of an arrangement exists
- Delivery has occurred or services have been rendered
- The price is fixed and determinable, and
- Collection is reasonably assured
Revenue from the sales of products or the disposal of all the assets is recognized on the date of sale of the product or other assets. The following criteria apply
- Delivery of goods or setting aside goods, and/or
- Transfer of legal title
Revenue from allowing others the use of the entity’s assets is recognized when the assets are used
Revenue from the performance of services is recognized in the period the services have been rendered and are able to be billed by the entity
The reason for waiting for the sale to take place is objectivity.
Definitions –Revenue Recognition under IFRS
Under IF S, revenue transactions are divided into the following four categories
- Sale of goods
- Rendering of services
- Revenue from interest, royalties, and dividends
- Construction contracts
Each category has its own revenue recognition rules
Definitions –Revenue Recognition under IFRS: Sale of Goods
Revenue from the sale of goods is recognized when
- Revenue and costs incurred for the transaction can be measured reliably
- It is probable that economic benefits of the transaction will flow to the entity
- The entity has transferred to the buyer the significant risks and rewards of ownership
- The entity does not retain managerial involvement to the degree associated with ownership or control over the goods sold
Definitions –Revenue Recognition under IFRS: Rendering of Services
Revenue from the rendering of services is recognized using the percentage of completion method when the outcome of the transaction can be estimated reliably
The outcome of the transaction can be estimated reliably when:
- Revenue and costs incurred for the transaction can be measured reliably
- It is probable that economic benefits from the transaction will flow to the entity
- The stage of completion of the transaction at the end of the reporting period can be measured reliably
Definitions –Revenue Recognition under IFRS: Revenue from Interest, Royalties, and Dividends
Revenue from interest, royalties, and dividends that arise from the use by others of the entity’s assets is recognize when:
- Revenue can be measured reliably
- It is probable economic benefits of the transaction will flow to the entity
Interest revenue is recognized using the effective interest method
Royalties are recognized on the uproar basis
Dividends are recognized when the shareholders’ right to receive payments are established
Definitions –Revenue Recognition under IFRS: construction Contracts
Contract revenue and contract costs are recognized as revenue and expenses using the percentage of completion method when the outcome of the construction contract can be estimated reliably
The outcome of the construction contract can be estimated reliably when
- The contract revenue and contract costs attributable to the transaction can be measured reliably
- It is probable that economic benefits from the transaction will flow to the entity
- The contract costs to compete the contract and the stage of of contract completion at the end of the reporting period can be measured reliably
Expected loss on the construction contract is recognized immediately as an expense.
Definitions – Multiple Element Arrangements
When a sales contract includes multiple products and services, the fair value of the contract must be allocated to the separate contract elements. Revenue is then recognize separately for each element based on the revenue recognition criteria appropriate for each element
Definitions – Exceptions and Other Special Accounting Treatments
- Deferred credits
- Installment sales
- Cost recovery method
- Nonmonetary exchanges
- Involuntary conversions
- Net method of accounting for trade (sales) discounts
- Percentage of completion contract accounting
Definitions – Exceptions and Other Special Accounting Treatments: Deferred Credits, Installment Sales, and Cost Recovery Method
Deferred credit is reported when cash is received before it is earned.
– A deferred credits is recognized as revenue as it is earned
Installment sales
– Revenue is recognized the collections are made. – Used when ultimate realization of collection is in doubt
Cost recovery method
– No profit is recognized on a sale until all costs have been recovered
Nonmonetary exchanges
– The recognition of revenue depends upon the type of exchange
Definitions –Exceptions and Other Special Accounting Treatments: Involuntary Conversions, Net method of Accounting for Trade (Sales) Discounts, and Percentage-of-completion contract accounting
Involuntary conversions
– Involuntary conversions of a non-monetary asset to cash would result in a gain or lost for financial accounting purposes
Net method of accounting for trade (sales) discounts
– Sales are recorded net of any discounts, therefore Accounts Receivable at year and does not include the discount offered
– If the discount is not earned, the sales discount amount is recorded as “other income”, and cash or Accounts Receivable is debited at that time
Percentage-of-completion contract accounting
– Revenue is recognized as production takes place for long-term construction contracts having costs that can be reasonably estimated
– If costs cannot be reasonably estimated, then the completed contract method must be used
Definitions – Expenses
Expenses are reduction of assets and/or increases of liabilities during a period of time.
They stem from the rendering of services, delivering of goods, or any other activities that may constitute the major ongoing or central operations of an entity
Expenses should be recognized according to the matching principle
Definitions – Realization and Recognition
Realization occurs when the entity obtains cash or the right to receive cash or has converted a non-cash resource into cash
Recognition is the actual recording of transactions and events in the financial statements
Definitions – Matching Principle
Expense must be recognized in the same period in which the related revenues is recognized.
Matching revenues and costs is the simultaneous or combined recognition of the revenues and expenses that results directly and jointly from the same transactions or events
For those expenses that do not have a cause effect relationship to revenues, another systematic and rational approach to expense recognition should be used (e.g. amortization and depreciation of long-lived assets, and the immediate expensing of certain administrative costs, referred to as period costs)
Definitions – Accrual Accounting
Accrual accounting is required by GAAP
Accrual accounting is the process of employing the revenue recognition rule and the matching principle to the recognition of revenues and expenses.
Accrual accounting records the transactions and events as they occur, not when the cash is received or expended.
Definitions – Deferral
Deferral of revenues or expenses occurs when cash is received or expended but is not recognizable for financial statement purposes.
Deferral typically results in the recognition of a liability or a prepaid expense
Deferred Credits = Unearned Revenue
Definitions – Accrued Assets and Liabilities
Accrued assets (or accrued revenues) – Revenue recognized or earned through the passage of time (or other criteria) but not yet paid to the entity
Accrued liabilities (or a crude expenses) – Expenses recognized or encourage through the passage of time (or other criteria) but not yet paid by the entity
Estimated liabilities
– Probable future changes that result from a prior act (e.g. estimated liability for warranties)
Definitions – Expired and Unexpired Costs
Expired costs (expenses) are costs that expired during the period and have no future benefit
– Insurance expense is an indirect expense and is systematically allocated to the period for which benefit is received
– Cost of goods sold are directly allocated to the periods in which the sales take place, which matches the cause and effect of the transaction
– Period costs are costs expiring in the period incurred
Unexpired costs (e.g. fixed assets and inventory) should be capitalized and matched against future revenues. – If future revenues are not certain or there is no residual value, then these costs should be expensed as expired costs
Definitions – Prepaid Expenses
Prepaid expenses relates to expenditures with a residual value (e.g. prepaid insurance with a cancellation value)
Prepaid expenses may also occur where there exists a future rights to services
Definitions – Deferred Charges
Deferred charges result from expenditures or accruals that cannot be charged the tangible assets, but that do pertain to future operations (e.g. bond issue costs)
Deferred charges may include tangible assets and noncurrent prepaid items
Revenue Recognition – Royalty Revenue
Royalty Revenue is recognized when earned.
Reporting royalty revenue requires accrual of a provision for revenues based on estimated sales
– Provision for revenues = % estimated sales
Journal Entries
DR Cash XXX
CR Unearned royalty XXX
DR Unearned royalty XXX
CR Earned royalty XXX
Revenue Recognition – Unearned Revenue
Revenue received in advance is recorded as a liability
Journal Entries
DR Cash XXX
CR Unearned Revenue XXX
DR Unearned Revenue XXX
CR Revenue XXX
Revenue Recognition – Revenue Recognition when the Right of Return Exists
Revenue from a sales transactions where the buyer has the right to return the product will be recognized at the time of sale if:
1. The sales price is substantially fixed at the date of sale
2. The buyer assumes all risks of loss because the goods are considered in the buyer’s possession
3. The buyer has paid some form of consideration
and
5. The amount of future returns can be reasonably estimated
Revenue Recognition – Franchises: Fees
Franchise operations include a franchisee that receives the right to operate one or more units of a franchisor’s business.
Franchise accounting involves two types of these
– Initial franchise fees
– Continuing franchisees
Initial franchise fees = fees paid by the franchisee for initial for receiving initial services from the franchise or e.g. site selection, supervision of construction, bookkeeping services, and quality control
Continuing franchise fees = ongoing services provided by the franchisor franchisee e.g. management training, promotion, and legal assistance
– Fees are usually calculated based on a percentage of franchise revenues.
Revenue Recognition – Franchises: Revenue
The present value of any contract amounts relating to future services to be performed should be recorded as unearned revenue
Unearned revenue is recognized as as revenue once “substantial performance” on such future services has occurred
Substantial performance
– Franchisor has no obligation to refund any payment (cash or otherwise) received
– Initial services required of the franchisor have been performed
and
– All other conditions of the sale have been met
Revenue Recognition – Franchises: Other Recognition Methods
Installment of cost recovery percentages methods may be used under certain circumstances
These methods can be used for earlier recognition of the in initial franchise fee revenue only when:
– Revenue is collectible over an extended period of time, and
– There’s no reasonable basis for estimating collectibility
Long-term Construction Contract – Completed Contract Method: US GAAP vs IFRS
US GAAP Only
Completed contract method is not permitted under IFRS
– Use percentage of completion method is final outcome of the project can be reliably estimated
– Use cost recovery method when the final outcome of the project can NOT be reliably estimated
Long-term Construction Contract – Completed Contract Method: Requirements
The completed contract method recognizes income only on completion (or substantial completion) of the contract
A contract is regarded as substantially complete the remaining costs are significant
User completed contract method when:
– It is difficult to estimate of the costs of a contract in progress
– There are many contracts in progress so that about an equal number are completed each year and an unequal recognition of income does not result
– The projects out of short duration, and collections are not assured
Long-term Construction Contract – Completed Contract Method: Balance Sheet Presentation
On balance sheet, report:
–Costs (billings) of uncompleted contracts in excess of related billings (costs) ››› a CURRENT asset
or
– Progress billings on uncompleted contracts in excess of cost ››› a CURRENT liability
“Costs (billings) of uncompleted contracts in excess of related billings (costs)” sometimes called “construction in progress”
“Progress billings on uncompleted contracts in excess of cost” sometimes called “Progress Billings”
Long-term Construction Contract – Completed Contract Method: Accounting
Applicable overhead and direct costs charged to a Construction in Progress account
Billings and/or cash received should be credited to advances on construction progress account
At completion, gross profit or loss recognized
Gross Profit/Loss
= Contract Price – Total Costs
Losses recognized in full in the year they are discovered i.e. once a loss is EXPECTED.
– Don’t wait till the end of the contract
Long-term Construction Contract – Completed Contract Method: Advantages and Disadvantages
Advantage = completed contract method based on final results rather than on estimates
Disadvantage = doesn’t properly reflect matching principle.
Long-term Construction Contract – Percentage of Completion Method
Permitted under IFRS and US GAAP
Used when
1. Can reasonably estimate profitability
and
2. Can provide reliable measure of progress towards completion
Long-term Construction Contract – Percentage of Completion Method: Revenue Recognition
Recognized income as work progresses on the contract
Income recognized
= (costs incurred/total estimated cost) x estimated total income
May also use other progress measures than cost
Long-term Construction Contract – Percentage of Completion Method: Expense Recognition
Provision for loss is made once it is expected that a loss will occur.
Long-term Construction Contract – Percentage of Completion Method: Balance Sheet Presentation
Construction in Progress (current asset) and Progress Billings (current liability) accounts
Long-term Construction Contract – Percentage of Completion Method: Advantages and Disadvantages
Advantage = matching principle followed
Disadvantage = relies on estimates
Installment Sales – Installment Method
Revenue recognized when cash is collected
Installment method used when there is no reasonable basis for estimating the degree of collectibility
Revenue recognized i.e. Earned Gross Profit
= Gross Profit % x Cash collections
Deferred gross profit
= Gross Profit % x Installment receivables
Gross Profit % = Gross Profit ÷ Sales Price
Gross Profit = Sales – COGS
Installment Sales – Cost Recovery Method
Revenue recognized only when cash collected exceeds costs
- cash collections first applied to the recovery of product costs
- collections after all costs have been recovered are recognized as profit.
Use cost recovery method when receivable collected over extended period and there is not reasonable basis for estimating their collectibility
Most conservative method of revenue recognition
Accounting for Nonmonetary Exchanges: US GAAP vs. IFRS
US GAAP – Exchanges of nonmonetary assets categorized as
1. Have commercial substance,
or
2. Lack commercial substance
Have commercial substance = future cash flows change as a result of the transaction
– Change can be in areas of risk, timing, or amount of cash flows.
Lacking commercial substance = future cash flows not expected to change significantly
Accounting for Nonmonetary Exchanges – US GAAP: Exchanges Having Commercial Substance
Fair value approach is used
Fair value of assets given up assumed to be equal to fair value of asset received, including and cash given or received in the transaction
i.e.
Old Asset’s NBV (Historical Cost – Accumulated Depreciation) + Cash given ± Gain/Loss recognized = FV of new asset + Cash received
Journal entries to recognize exchange DR New Asset @ FV DR Cash received DR Old Asset Accumulated Deprecition DR Recognized Loss (if any) on old asset CR Old Asset @ Historical cost CR Cash received CR Recognized Gain (if any)
Note: gains and losses fully recognized for exchanges having commercial substance
Accounting for Nonmonetary Exchanges – US GAAP: Exchanges Lacking Commercial Substance
Loss on old asset ALWAYS recognized
Gains on old asset recognized depending on whether boot is received
- No boot received = no gain recognized (even if boot is paid)
- Boot is received, and is < 25% of total consideration received = recognize a portion of gain
– % Gain recognized = Boot received ÷ Total consideration received - Boot is received and it is ≥ 25% of total consideration = recognized all gains
Accounting for Nonmonetary Exchanges – IFRS
IFRS – Exchanges of nonmentary assets categorized as
- Exchanges of similar assets
- Exchanges of dissimilar assets
Exchange of similar assets treated in the same way as having commercial substance under US GAAP i.e. gain and loss recognized
Exchanges of dissimilar assets = no gain recognized
Accounting for Nonmonetary Exchanges – Involuntary Conversions
Involuntary conversion = loss due to fire, theft, or condemnation
When non-monetary assets are involuntary converted to cash, entire gain or loss is recognized for financial accounting purposes
– Different treatment for tax purpose can lead to inter period tax allocation
Correcting and Adjusting Accounts
Used to ensure expenses are correctly matched against revenue
