Chapter 18: Revenue Recognition

Question 1

Criteria for recognizing revenue over time

Answer 1

At least one of the following:
1. The customer simultaneously receives and consumes the benefits of the seller’s performance as the seller performs.

2. The company’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
3. The company’s performance does not create an asset with an alternative use. (The asset cannot be used by another customer). Requires one of the following two criteria to be met as well:
   a. another company would not need to substantially re-perform the work the company has completed to date if that other company were to fulfill the remaining obligation to the customer
   b. the company has a right to payment for its performance completed to date, and it expects to fulfill the contract as promised.

Question 2

Percentage of completion method

Answer 2

recognizes revenues, costs, and gross profit as a company makes progress toward completion on a long-term project.

To defer recognition until completion would misrepresent efforts (costs) and accomplishments (revenues) of the period.

Must have methods for measuring extent of progress towards completion

Question 3

Methods of measuring extent of progress towards completion

Answer 3

Cost-to-cost method (most popular)
units-of-delivery method

can use both input and output measures

Question 4

Cost-to-cost basis

Answer 4

Measuring extent of progress towards completion by comparing costs incurred to date with the most recent estimate of the total costs required to complete the contract

costs incurred to date / most recent estimate of total costs = percentage complete

Question 5

Revenue recognition for percentage of completion method

Answer 5

Percent complete = cost incurred to date / most recent estimate of total costs

Revenue (or gross profit) to be recognized to date = percent complete x estimated total revenue (or gross profit)

current period revenue = revenue (or gross profit) to be recognized to date - Revenue (or gross profit) recognized in previous periods

Question 6

Revenues

Answer 6

Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations

Question 7

Five steps for revenue recognition

Answer 7

1) identify the contract with the customer (s)
2) identify the separate performance obligations in the contract
3) determine the transaction price
4) allocate the transaction price to the separate performance obligations
5) recognize revenue when each performance obligation is satisfied

Question 8

Determining when a performance obligation is satisfied

Answer 8

Determining factor is change in control of consideration

control = ability to direct the use of and obtain substantially all of the remaining benefits

Question 9

Contract assets

Answer 9

Two types

• unconditional rights to receive consideration because the company has satisfied its performance obligation with a customer (receivable on balance sheet)
• conditional rights to receive consideration because the company has satisfied one performance obligation, but must satisfy another performance obligation in the contract before it can bill the customer (contract asset on balance sheet)

Question 10

Contract liability

Answer 10

Company’s obligation to transfer goods or services to a customer for which the company has already received payment from the customer

Unearned sales (service) revenue

Question 11

Recognizing a contract asset

Answer 11

Journal entry when performance obligation is satisfied by right to receive payment is CONDITIONAL

Dr. Contract Asset
Cr. Sales Revenue

When right to receive payment is unconditional
Dr. Accounts Receivable
Cr. Contract Asset

Account tile must be clear between conditional and unconditional rights

Question 12

Contract modification

Answer 12

Change of terms to ongoing contract

Must determine if it is a new contract with separate performance obligation
or
modification of original contract and not separate obligation (prospective modification)

Question 13

Contract performance modification: Separate performance obligation

Answer 13

Meets BOTH of the following conditions:

• promised goals/ services are distinct
• company has the right to receive consideration that reflects the standalone selling price of the promised goods/ services

modification is effectively a new and separate contract with no affect on the accounting for the original contract

Question 14

Contract modification: Prospective modification

Answer 14

New products/ services are not distinct and/or not priced at a standalone price

Account for the effect of the change in the period of change and any future periods affected (no retrospective changes/ restatement)

Revise allocated portion of transaction price only based on what is not yet paid

Question 15

Treatment of costs to fulfill a contract

Answer 15

for contract periods over one year

• capitalized costs that give rise to an asset
  - incremental costs company would NOT incur if contract was not obtained
  - direct labor, materials, etc… relating directly to the contract
  - costs that generate/ enhance resources used to satisfy performance obligations

ONLY costs that are direct, incremental and recoverable. Everything else is expensed

Question 16

Collectibility

Answer 16

Risk that a customer will be unable to pay the amount of consideration in accordance with the contract.

As long as it is probable that customer will pay then contract exists and revenue is recognized and not adjusted for the credit risk

(just uses allowance for doubtful accounts/ bad debt

Question 17

Revenue recognition disclosures

Answer 17

Qualitative and quantitative information about

• contracts with customers
  - disaggregation of revenue
  - balances in contract assets and liabilities
  - performance obligations
• significant judgements
  
  • determination / allocation of transaction price
  • changes in judgements
• assets recognized from costs incurred to fulfill a contract
  - balances of capitalized costs
  
  • amortization amount and method

Question 18

Disaggregation of Revenue

Answer 18

Splitting revenue info into categories that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors

Question 19

Journal entry when contract is agreed upon/ entered into

Answer 19

No entry until performance is made by one side or the other

Payment received (promise not delivered) = unearned revenue
Promise delivered (no payment received)= sales revenue

Until performance occurs no net asset or net liability exists

Question 20

Contract

Answer 20

An agreement between parties that creates enforceable rights or obligations

components:

• commercial substance
• approved by both parties
• identification of the rights of the parties is established
• payment terms are identified
• is probable that the consideration will be collected

Can be written, oral, or implied from customary business practice

Gives rise to a net asset or net liability

Question 21

Allocation of the transaction price to separate performance obligations

Answer 21

Based on the relative standalone prices

If standalone pricing is unavailable base on best estimate of such

proportional method of allocation

Question 22

Estimation of standalone price

Answer 22

To estimate unknown standalone price use one of the following and THEN proportional method:

• adjusted market assessment approach: evaluate the market and estimate market price (adjusted for company costs
• Expected costs plus a margin
• residual approach: whatever remains of the transaction price after observable standalone prices are accounted for

Question 23

Transaction Price

Answer 23

Amount of consideration that a company expects to receive from a customer in exchange for transferring a good or service

May include multiple considerations:

• variable consideration
• time value of money
• non-cash consideration
• consideration paid, or payable, to the customer

Question 24

Variable consideration

Answer 24

When the price of a good or service is dependent on future events
(price increases, volume discounts, rebates, credits, performance bonuses, royalties)

Company estimates the amount of consideration it will receive from the contract to determine amount of revenue to recognize by either:
- expected value
or 
- most likely amount
(whichever better predicts results)

Question 25

Most likely amount variable consideration estimation

Answer 25

The single most likely amount in a range of possible consideration outcomes may be appropriate method if the contract only has two possible outcomes (if variable consideration is binary)

Question 26

Probability weighted method

Answer 26

sum of all possible transactions prices multiplied by their relative probability

Question 27

Expected value variable consideration estimation

Answer 27

Probability-weighted amount in a range of possible consideration amounts - appropriate method if a company has a large number of contracts with similar characteristics - can be based on a limited number of discrete outcomes and probabilities Estimate must be updated each report date

Question 28

Conditions that indicate revenue is constrained

Answer 28

- amount of consideration is highly susceptible to factors outside the company's influence (market volatility, weather, third party judgement) - uncertainty over amount of consideration unlikely to be restricted for a long time - company experience with similar obligations is limited - the contract has a large number/ broad range of possible consideration amounts

Question 29

Revenue constraint consideration

Answer 29

Company only allocates variable consideration if it is reasonably assured it will be entitled to that amount - have experience with similar contracts and can estimate the revenue - based on experience it is probable that there will not be significant reversal of revenue previously recognized if not then revenue recognition is constrained

Question 30

Imputed interest rate

Answer 30

The more clearly determinable of: 1) prevailing rate for a similar instrument of an issuer with a similar credit rating 2) a rate of interest that discounts the nominal amount of the instrument to the current sales price of the goods or services

Question 31

Time value of money and transaction price

Answer 31

Time value of money needs to be considered if the contract involves a significant financing component - the timing of payment does not match the timing of transfer of goods or services (at least if by over a year) Essentially notes receivable fair value should be determined by discounting the payment using an imputed interest rate any effects are reported as interest revenue

Question 32

Non-cash transactions

Answer 32

Revenue is generally recognized on the basis of the fair value of what is received - if that is not determinable then the selling price of the services performed

Question 33

Consideration paid or payable to customers

Answer 33

Discounts, volume rebates, coupons, free products or services these reduce consideration received / revenue to be recognized Gross (sales discount account) or net (sales discount forfeited account) methods

Question 34

Conditions for multiple performance obligations

Answer 34

1) obligations are a distinct product or service (could be purchased separately) 2) obligations are distinct within the contract - not highly dependent/ interrelated with other promises - if related products and obligation should be combined into one obligation

Question 35

Performance obligation

Answer 35

A promise to provide a product or service to a customer may be explicit, implicit, or based on customary business practice DISTINCT product or service that a customer is able to benefit from on its own or with other readily available resources

Question 36

Objective of new revenue recognition standard

Answer 36

Recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that the company receives or expects to receive in exchange for these goods or services

Question 37

Asset-liability approach for revenue recognition

Answer 37

Recognizes and measures revenue based on changes to assets and liabilities - assets and liabilities arising from contracts with customers Contracts: - initiate revenue transactions - indicate the terms of the transactions - specify promises by each party

Question 38

Revenue from contracts with customers

Answer 38

FASB and ISAB converged standard on revenue recognition - more robust framework - improves comparability - simplifying statement preparation - enhances disclosures Asset-liability approach for revenue recognition

Question 39

Returned inventory account

Answer 39

Used for returns to keep separate from other inventory - provides transparency combined with estimated inventory returns on balanced sheet subject to impairment testing separate from inventory

Question 40

Return within same period of sale

Answer 40

Dr. Sales Returns and Allowances Cr. Accounts Receivable (credit sales) or Cash/Payable (Cash sale) Dr. Returned inventory Cr. Cost of Goods Sold

Question 41

Adjusting entries for expected returns

Answer 41

Dr. Sales Returns and Allowances Cr. Allowance for sales returns and allowances (credit sale) (cash sale cr. accounts payable) Dr. Estimated inventory Returns Cr. Cost of goods sold

Question 42

Sales returns and allowances on income statement

Answer 42

``` Sales revenue Less sales returns and allowances = Net Sales Cost of Goods sold = Gross profit ```

Question 43

Sales Returns and Allowances on the balance sheet

Answer 43

``` Accounts Receivable Less; Allowance for sales returns and allowances Accounts receivable (net) Returned inventory (including estimated) ``` Accounts Payable (contains cash sales returned / est returned but not yet paid out)

Question 44

Repurchase agreements

Answer 44

Agreement to transfer an asset to a customer but have an unconditional (forward) obligation or unconditional right (call option) to repurchase the asset at a later date If the forward obligation/ call option to repurchase is at amount greater than or equal to the selling price then the transaction is a financing transaction If financing asset then asset not removed from books Sale depends on if control is really transferred

Question 45

Recording a financing transaction

Answer 45

Dr. Cash Cr. Liability to X company then accrue interest Dr. Interest Expense Cr. Liability to X company Pay financing Dr. Liability to X company Cr. Cash

Question 46

Put option (repurchase agreement)

Answer 46

Company holding an asset has the option to keep asset or to sell it back to originator (or third party) generally exercised if fair value < repurchase price (check this) recorded like financing transaction

Question 47

Bill and hold arrangement

Answer 47

A contract under which an entity bills a customer for a product but retains physical possession of the product until transferred to customer at a later date. For revenue recognition customer must have obtained control of product, plus: - bill & hold arrangement is substantive - product identified separately as belonging to customer - product is ready for physical transfer - seller does not have ability to use product or sell it to another customer

Question 48

Principal-Agent relationship

Answer 48

Principals performance obligation is to provide goods/ services Agents performance obligation is to arrange for principal to provide goods/ services to customers (ex: travel agents) agent does not recognize the full amount paid as revenue - only their commission (net approach) FASB has specific indicators for principal-agent relationship

Question 49

Consignments

Answer 49

Consignor ships merchandise to consignee who acts as an agent for the consignor in selling the merchandise Consignor retains title/ control of merchandise. Receives revenue from sale less any commission/ expenses Upon sale consignee has a liability for the net amount due to consignor

Question 50

Recording Consignment: Consignor Entries

Answer 50

Cost of finished goods/ Freight --> inventory (consignment) On notification of sales/ expenses & remittance Dr. Cash Dr. Expenses (by consignee, inc commission) Cr. Revenue from consignment sales Then move inventory (consignment) to cost of goods sold

Question 51

Recording Consignment: Consignee entries

Answer 51

Expenses: Dr. Receivable from consignor Cr. Cash Sale: Dr. Cash Cr. Payable to consignor Notification of sales/ expenses and remittance Dr. Payable to consignor Cr. Receivable from consignor Cr, Commission revenue (recognized on notification) Cr. Cash

Question 52

Assurance-type warranty

Answer 52

Warranty that the product meets agreed-upon specifications in the contract at the time the product is sold Included in sales price - no separate performance obligation is recorded Estimate warranty liability is expensed in the period the goods provided/ services performed

Question 53

Service-type warranty

Answer 53

Additional service beyond assurance-type warranty A separate performance obligation from the product (has a stand alone price) must allocate part of the transaction price to warranty performance obligation

Question 54

Assurance-type warranty journal entries

Answer 54

No entry at time of purchase Warranty costs in the same period as purchase: Dr. Warranty Expense Cr. Salaries and wages payable Cr. Inventory Adjusting entry for outstanding assurance warranty: Dr. Warranty expense Cr. Warranty liability

Question 55

Service-type warranty journal entries

Answer 55

At time of sale Cr. Unearned warranty revenue Then recognized revenue over period earned, usually on a straight line basis in adjusting entries Dr. Unearned warranty revenue Cr. Warranty Revenue

Question 56

Non-Refundable upfront fees

Answer 56

Payments received before delivery of service must determine if should be applied to current period if for future delivery it is not recorded as revenue till delivery made initiation fee recognized over service period if partial payment for later discounted price

Question 57

Recognizing revenue from performance obligation over time

Answer 57

Measured by progress to completion based on transfer of control the customer - straight line (satisfaction over whole contract period) - cost-to-cost or units-of-delivery: progress measured by a certain unit of input or output Cost-to-cost = costs to date as a percentage of expected total costs of completion

Question 58

Criteria for revenue recognized over period of time (vs at a point in time)

Answer 58

1) customer receives and consumes the benefits as the seller performs 2) customer controls the asset as it is created or enhanced 3) company does not have an alternative use for the asset created or enhanced and either: a) the customer receives benefits as the company performs (the task would not need to be re-performed or b) the company has a right to payment and the right is enforceable

Question 59

Indicators the customer has obtained control of an asset

Answer 59

(Assessment from customer perspective) 1) company has the right to payment for the asset 2) company has transferred the legal title to the asset 3) company has transferred physical possession of the asset 4) customer has all significant risks and rewards of ownership 5) customer has accepted the asset

Question 60

Control of assets

Answer 60

Defined by ability to direct the use of and obtain substantially the remaining benefits of the assets can prevent other companies from directing the use of / receiving the benefits of the assets - right to payment - transfer of legal title - transfer of physical possession - who holds risks and rewards of ownership

Question 61

Percentage of completion revenue entries

Answer 61

Accumulation of expenses: Dr. Construction in progress (inventory account) Cr. inventory/ payables/ cash etc... Billings: Dr. A/R Cr. Billings on Construction in process (contra-inventory account) To recognize revenues/ gross profit: Dr. Construction in Process (CIP)(Gross Profit) Dr. Construction Expenses Cr. Revenue from long term contracts Gross profit = total revenues less revenues recognized previously less current period costs On completion: Dr. billings on construction in process Cr. Construction in process

Question 62

Completed contract method

Answer 62

Same accumulation accounts as percentage of completion - inventory (construction in progress) - contra-inventory (billings or construction in progress) BUT revenue is not recognized until contract is completed may still bill and collect money from customers

Question 63

Completed contract revenue journal entry

Answer 63

When contract is completed need to close out inventory and billing accounts and recognize revenue Dr. Billings on construction in progress (close) Cr. Revenue from long term contracts Dr. Cost of construction Cr. Construction is progress (close)

Question 64

Cost-to-Cost basis calculation of revenue

Answer 64

Costs incurred to date/ Most recent estimate of total costs = percent complete percent complete x estimated total revenue (or gross profit) = revenue (or gross profit) to be recognized TO DATE Revenue (or gross profit) to be recognized to date - revenue (or gross profit) recognized in prior period = current period revenue (or gross profit)

Question 65

Cost-to-cost basis

Answer 65

Measuring percentage completion by comparing costs incurred to date with most recent estimate of total costs to complete the contract Cost of construction debited to construction in progress Progress billings credited to billings or construction in progress Recognize as revenue a percentage of estimated total price (or gross profit) less any previously recognized revenue (or gross profit)

Question 66

Measuring progress towards completion

Answer 66

cost-to-cost method units-of-delivery method identify measures as input or output and determine what measure of progress best suits the project

Question 67

Percentage of completion method

Answer 67

Recognizing revenues and gross profits each period based upon the progress of construction (the project) - only if it is possible to reasonable measure progress to completion - construction costs and gross profit for period recorded in inventory account (construction in progress) - progress billings go into a contra-inventory account (billings on construction in progress)

Question 68

Construction costs account

Answer 68

Inventory account Debited for all construction costs and construction gross profit credited full balance at completion of project to close

Question 69

Change in estimate percentage of completion - revenue recognition

Answer 69

Cumulative catch-up manner account for the change in estimate in the period of change so all subsequent periods are as if revised estimate was original estimate

Question 70

Percentage of completion accounts on balance sheet

Answer 70

Net construction in progress and billings on construction in progress Construction in progress > billings = current asset "costs and recognized profit in excess of billings" Construction in progress < billings = current liability "billings in excess of costs and recognized profit" if multiple projects do not net but segregate assets an liabilities

Question 71

Percentage of completion on income statement

Answer 71

Revenue from long-term contracts (less) costs of construction (=) gross profit

Question 72

Percentage of completion on balance sheet

Answer 72

Current assets Accounts receivable Inventory Construction in progress less: billings = costs and recognized profit in excess of billings (or a liability called billing in excess of costs and recognized profit if billings > construction) Inventory accounts close out and disappear when project is completed

Question 73

Percentage of completion disclosures

Answer 73

Disclose: - methods of accounting - measurement - costs included

Question 74

Loss in current period on a profitable contract

Answer 74

When a significant increase in estimated total contract costs does not eliminate all profits but does require a current period adjustment of excess gross profit recognized in prior periods (estimated costs mean that percentage complete goes backwards) Adjustment recorded as loss in current period (change in accounting estimates)

Question 75

Loss on an unprofitable contract

Answer 75

When cost estimates at the end of the current period indicate that a loss will result on completion of the project Must recognize entire expected contract loss in current period (both under percentage-of-completion and completed-contract method

Question 76

Recording loss in a current period on a profitable contract

Answer 76

done in the percentage-of-completion method ONLY - when percent complete math shows percentage complete dropped from previous period due to increased estimated costs Revenue to recognize is less than costs incurred = loss, effectively adjusts excessive gross profit previously recognized Dr. Construction Expense Cr. Construction in progress (loss) Cr. Revenue from long-term contracts loss recorded on balance sheets

Question 77

Recording loss on an unprofitable contract (Percentage-of-completion method)

Answer 77

Have to back out previously recognized profits - normal computation of revenue to be recognized in the current year Current year revenue + reversal of previous year(s) gross profit + total estimated contract loss = total construction expenses for current year loss entered as a debit to construction in progress account

Question 78

Recording loss on an unprofitable contract under completed contract method

Answer 78

Loss recognized in year loss becomes evident Dr. Loss from long-term contract Cr. Construction in progress (loss) Construction in progress account cannot excess contract price - if so must provide for loss if billings > accumulated costs show liability on balance sheet

Question 79

Types of franchising arrangements

Answer 79

Manufacturer-retailer Manufacturer- wholesaler Wholesaler-retailer Service sponsor - retailer (fastest growing/ most challenges)

Question 80

Services potentially provided by franchiser to franchisee

Answer 80

Depends on franchise arrangement - assistance in site selection (analyzing location/ negotiating lease) - evaluation of potential income - supervision of construction activity (inc. financing) - assistance with signs, fixtures, equipment - bookkeeping & advisory services (records and local regulations) - employee and management training - quality control - advertising and promotion

Question 81

Accounting for franchise agreements

Answer 81

Must determine what performance obligations are distinct vs. interrelated and when control is transferred / if it is transferred - if provides access to rights (not control) then franchise revenue recognized over time Royalties likely to be variable consideration, not recognized until uncertainty is resolved.