#06 – Revenue and Expense Recognition (2.1, 2.2, 2.3, 2.4, 2.5)

Question 1

TIMING ISSUES

Answer 1

F2.1
I - DEFINITIONS
II – REVENUE RECOGNITION
III -

Question 2

Definitions –Assets and Liabilities

Answer 2

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

Question 3

Definitions –Revenues

Answer 3

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

Question 4

Definitions –Revenue Recognition under US GAAP

Answer 4

Revenue is recognized when it is realized (or realizable) and earned

4 criteria must be met before any revenue can be recognized

1. Persuasive evidence of an arrangement exists
2. Delivery has occurred or services have been rendered
3. The price is fixed and determinable, and
4. 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

1. Delivery of goods or setting aside goods, and/or
2. 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.

Question 5

Definitions –Revenue Recognition under IFRS

Answer 5

Under IF S, revenue transactions are divided into the following four categories

1. Sale of goods
2. Rendering of services
3. Revenue from interest, royalties, and dividends
4. Construction contracts

Each category has its own revenue recognition rules

Question 6

Definitions –Revenue Recognition under IFRS: Sale of Goods

Answer 6

Revenue from the sale of goods is recognized when

1. Revenue and costs incurred for the transaction can be measured reliably
2. It is probable that economic benefits of the transaction will flow to the entity
3. The entity has transferred to the buyer the significant risks and rewards of ownership
4. The entity does not retain managerial involvement to the degree associated with ownership or control over the goods sold

Question 7

Definitions –Revenue Recognition under IFRS: Rendering of Services

Answer 7

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:

1. Revenue and costs incurred for the transaction can be measured reliably
2. It is probable that economic benefits from the transaction will flow to the entity
3. The stage of completion of the transaction at the end of the reporting period can be measured reliably

Question 8

Definitions –Revenue Recognition under IFRS: Revenue from Interest, Royalties, and Dividends

Answer 8

Revenue from interest, royalties, and dividends that arise from the use by others of the entity’s assets is recognize when:

1. Revenue can be measured reliably
2. 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

Question 9

Definitions –Revenue Recognition under IFRS: construction Contracts

Answer 9

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

1. The contract revenue and contract costs attributable to the transaction can be measured reliably
2. It is probable that economic benefits from the transaction will flow to the entity
3. 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.

Question 10

Definitions – Multiple Element Arrangements

Answer 10

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

Question 11

Definitions – Exceptions and Other Special Accounting Treatments

Answer 11

1. Deferred credits
2. Installment sales
3. Cost recovery method
4. Nonmonetary exchanges
5. Involuntary conversions
6. Net method of accounting for trade (sales) discounts
7. Percentage of completion contract accounting

Question 12

Definitions – Exceptions and Other Special Accounting Treatments: Deferred Credits, Installment Sales, and Cost Recovery Method

Answer 12

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

Question 13

Definitions –Exceptions and Other Special Accounting Treatments: Involuntary Conversions, Net method of Accounting for Trade (Sales) Discounts, and Percentage-of-completion contract accounting

Answer 13

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

Question 14

Definitions – Expenses

Answer 14

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

Question 15

Definitions – Realization and Recognition

Answer 15

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

Question 16

Definitions – Matching Principle

Answer 16

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)

Question 17

Definitions – Accrual Accounting

Answer 17

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.

Question 18

Definitions – Deferral

Answer 18

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

Question 19

Definitions – Accrued Assets and Liabilities

Answer 19

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)

Question 20

Definitions – Expired and Unexpired Costs

Answer 20

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

Question 21

Definitions – Prepaid Expenses

Answer 21

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

Question 22

Definitions – Deferred Charges

Answer 22

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

Question 23

Revenue Recognition – Royalty Revenue

Answer 23

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

Question 24

Revenue Recognition – Unearned Revenue

Answer 24

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

Question 25

Revenue Recognition – Revenue Recognition when the Right of Return Exists

Answer 25

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

Question 26

Revenue Recognition – Franchises: Fees

Answer 26

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.

Question 27

Revenue Recognition – Franchises: Revenue

Answer 27

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

Question 28

Revenue Recognition – Franchises: Other Recognition Methods

Answer 28

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

Question 29

Long-term Construction Contract – Completed Contract Method: US GAAP vs IFRS

Answer 29

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

Question 30

Long-term Construction Contract – Completed Contract Method: Requirements

Answer 30

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

Question 31

Long-term Construction Contract – Completed Contract Method: Balance Sheet Presentation

Answer 31

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”

Question 32

Long-term Construction Contract – Completed Contract Method: Accounting

Answer 32

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

Question 33

Long-term Construction Contract – Completed Contract Method: Advantages and Disadvantages

Answer 33

Advantage = completed contract method based on final results rather than on estimates

Disadvantage = doesn’t properly reflect matching principle.

Question 34

Long-term Construction Contract – Percentage of Completion Method

Answer 34

Permitted under IFRS and US GAAP

Used when
1. Can reasonably estimate profitability
and
2. Can provide reliable measure of progress towards completion

Question 35

Long-term Construction Contract – Percentage of Completion Method: Revenue Recognition

Answer 35

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

Question 36

Long-term Construction Contract – Percentage of Completion Method: Expense Recognition

Answer 36

Provision for loss is made once it is expected that a loss will occur.

Question 37

Long-term Construction Contract – Percentage of Completion Method: Balance Sheet Presentation

Answer 37

Construction in Progress (current asset) and Progress Billings (current liability) accounts

Question 38

Long-term Construction Contract – Percentage of Completion Method: Advantages and Disadvantages

Answer 38

Advantage = matching principle followed

Disadvantage = relies on estimates

Question 39

Installment Sales – Installment Method

Answer 39

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

Question 40

Installment Sales – Cost Recovery Method

Answer 40

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

Question 41

Accounting for Nonmonetary Exchanges: US GAAP vs. IFRS

Answer 41

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

Question 42

Accounting for Nonmonetary Exchanges – US GAAP: Exchanges Having Commercial Substance

Answer 42

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

Question 43

Accounting for Nonmonetary Exchanges – US GAAP: Exchanges Lacking Commercial Substance

Answer 43

Loss on old asset ALWAYS recognized

Gains on old asset recognized depending on whether boot is received

1. No boot received = no gain recognized (even if boot is paid)
2. Boot is received, and is < 25% of total consideration received = recognize a portion of gain
   – % Gain recognized = Boot received ÷ Total consideration received
3. Boot is received and it is ≥ 25% of total consideration = recognized all gains

Question 44

Accounting for Nonmonetary Exchanges – IFRS

Answer 44

IFRS – Exchanges of nonmentary assets categorized as

1. Exchanges of similar assets
2. 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

Question 45

Accounting for Nonmonetary Exchanges – Involuntary Conversions

Answer 45

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

Question 46

Correcting and Adjusting Accounts

Answer 46

Used to ensure expenses are correctly matched against revenue