Chapter 18: Revenue Recognition Flashcards
Criteria for recognizing revenue over time
At least one of the following:
1. The customer simultaneously receives and consumes the benefits of the seller’s performance as the seller performs.
- 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.
- 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.
Percentage of completion method
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
Methods of measuring extent of progress towards completion
Cost-to-cost method (most popular)
units-of-delivery method
can use both input and output measures
Cost-to-cost basis
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
Revenue recognition for percentage of completion method
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
Revenues
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
Five steps for revenue recognition
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
Determining when a performance obligation is satisfied
Determining factor is change in control of consideration
control = ability to direct the use of and obtain substantially all of the remaining benefits
Contract assets
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)
Contract liability
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
Recognizing a contract asset
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
Contract modification
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)
Contract performance modification: Separate performance obligation
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
Contract modification: Prospective modification
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
Treatment of costs to fulfill a contract
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
Collectibility
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
Revenue recognition disclosures
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
Disaggregation of Revenue
Splitting revenue info into categories that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors
Journal entry when contract is agreed upon/ entered into
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
Contract
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
Allocation of the transaction price to separate performance obligations
Based on the relative standalone prices
If standalone pricing is unavailable base on best estimate of such
proportional method of allocation
Estimation of standalone price
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
Transaction Price
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
Variable consideration
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)
Most likely amount variable consideration estimation
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)
Probability weighted method
sum of all possible transactions prices multiplied by their relative probability
Expected value variable consideration estimation
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
Conditions that indicate revenue is constrained
- 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
Revenue constraint consideration
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
Imputed interest rate
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
Time value of money and transaction price
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
Non-cash transactions
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
Consideration paid or payable to customers
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
Conditions for multiple performance obligations
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
Performance obligation
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
Objective of new revenue recognition standard
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
Asset-liability approach for revenue recognition
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
Revenue from contracts with customers
FASB and ISAB converged standard on revenue recognition
- more robust framework
- improves comparability
- simplifying statement preparation
- enhances disclosures
Asset-liability approach for revenue recognition
Returned inventory account
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
Return within same period of sale
Dr. Sales Returns and Allowances
Cr. Accounts Receivable (credit sales) or Cash/Payable (Cash sale)
Dr. Returned inventory
Cr. Cost of Goods Sold
Adjusting entries for expected returns
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
Sales returns and allowances on income statement
Sales revenue Less sales returns and allowances = Net Sales Cost of Goods sold = Gross profit
Sales Returns and Allowances on the balance sheet
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)
Repurchase agreements
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
Recording a financing transaction
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
Put option (repurchase agreement)
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
Bill and hold arrangement
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
Principal-Agent relationship
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
Consignments
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
Recording Consignment: Consignor Entries
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
Recording Consignment: Consignee entries
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
Assurance-type warranty
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
Service-type warranty
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
Assurance-type warranty journal entries
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
Service-type warranty journal entries
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
Non-Refundable upfront fees
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
Recognizing revenue from performance obligation over time
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
Criteria for revenue recognized over period of time (vs at a point in time)
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
Indicators the customer has obtained control of an asset
(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
Control of assets
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
Percentage of completion revenue entries
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
Completed contract method
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
Completed contract revenue journal entry
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)
Cost-to-Cost basis calculation of revenue
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)
Cost-to-cost basis
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)
Measuring progress towards completion
cost-to-cost method
units-of-delivery method
identify measures as input or output and determine what measure of progress best suits the project
Percentage of completion method
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)
Construction costs account
Inventory account
Debited for all construction costs and construction gross profit
credited full balance at completion of project to close
Change in estimate percentage of completion - revenue recognition
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
Percentage of completion accounts on balance sheet
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
Percentage of completion on income statement
Revenue from long-term contracts
(less) costs of construction
(=) gross profit
Percentage of completion on balance sheet
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
Percentage of completion disclosures
Disclose:
- methods of accounting
- measurement
- costs included
Loss in current period on a profitable contract
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)
Loss on an unprofitable contract
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
Recording loss in a current period on a profitable contract
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
Recording loss on an unprofitable contract (Percentage-of-completion method)
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
Recording loss on an unprofitable contract under completed contract method
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
Types of franchising arrangements
Manufacturer-retailer
Manufacturer- wholesaler
Wholesaler-retailer
Service sponsor - retailer (fastest growing/ most challenges)
Services potentially provided by franchiser to franchisee
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
Accounting for franchise agreements
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.
