Chapter 4: Revenue Recognition and Statement of Income Flashcards
Income is composed of two elements:
revenue and gains
Ordinary activities
A company’s normal, ongoing major business activities
Revenues
defined as increases in economic benefits from a company’s ordinary operating activities
gains
result in increases in economic benefits from activities that are outside the course of ordinary operating activities.
Revenue is often referred to with other terms
such as sales, fees, interest, dividends, royalties, or rent.
economic benefit
there does not have to be a receipt of cash in order for a company to recognize revenue. This is why the term economic benefit is used when defining revenue.
company reports net income
When total revenues exceed total expenses
if total expenses exceed total revenues
a company reports a net loss.
When assessing revenues, financial statement users evaluate
both quantity and quality
Quantity
the amount of revenue and whether or not the trend shows an increase or decrease over a number of accounting periods.
Quality
refers to the source(s) of revenue and the company’s ability to sustain the revenue over the longer term.
higher quality earnings
high quality, high-quality
If these two amounts are moving together (both up or both down) and if the cash flow from operating activities is greater than the net income,
(cash flow from operations (from the statement of cash flows) with net income (or net earnings))
lower quality earnings
If the two amounts do not move together and if the cash flow from operating activities is less than the net income
The revenue recognition approach also differs depending on whether a company is using
IFRS or ASPE
There are two revenue recognition approaches
1) the contract-based approach (which is also known as the asset-liability approach)
2) the earnings-based approach
Companies preparing their financial statements using IFRS must use:
the contract-based approach
companies preparing their financial statements using ASPE must use:
the earnings-based approach
Contract-Based Approach
the contract-based approach focuses on the contracts a company has with its customers
Contract
an agreement between two or more parties that creates a combination of rights (the right to be paid by customers, which is also known as the right to receive consideration) and performance obligations (the requirement to provide goods or services to customers).
Net position in a contract
An entity’s position in a contract that it is party to. Determined by comparing the entity’s rights under the contract with its performance obligations under the contract. May result in a contract asset, contract liability, or net nil position
Under the contract-based approach revenues are recognized when:
a company’s net position in the contract increases; that is, when a company’s rights under the contract increase or when its performance obligations under the contract decrease.
5 step model of Revenue Recognition
1) Identify the contract.
2) Identify the performance obligations.
3) Determine the transaction price.
4) Allocate the transaction price to performance obligations.
5) Recognize revenue when each performance obligation is satisfied.
Identify the contract
A contract exists when all five of the following criteria are met:
There is a legally enforceable agreement between two or more parties.
It has been approved and the parties are committed to their obligations.
Each party’s rights to receive goods or services or payment for those goods and services can be identified.
The contract has commercial substance, meaning that the risk, timing, or amount of the company’s future cash flows is expected to change as a result of the contract.
Collection is considered probable.
Commercial substance
meaning that the risk, timing, or amount of the company’s future cash flows is expected to change as a result of the contract.
Identify the performance obligations
The contract must be analyzed to determine the performance obligation(s) contained in it.
These are the goods and/or services to be delivered to the customer and are sometimes referred to as the contract deliverables.
There may be a single performance obligation to provide goods or services, or multiple performance obligations in which goods or services will be delivered over a period of time.
Distinct good or services
Goods or services are considered to be distinct if both of the following criteria are met:
The customer can benefit from the good or service (by using, consuming, or selling it) on its own or with other resources it possesses or can obtain from a third party.
The promise to transfer the goods or services is separate from other promised goods or services in the contract. That is, these goods or services are being purchased as separate items under the contract, rather than forming part of a larger good or service.
Determine the transaction price
The transaction price is the amount of consideration the company expects to receive in exchange for providing the goods or services.
Variable consideration
can result if there are discounts, refunds, rebates, price concessions, incentives, performance bonuses, penalties, and so on.
sales discounts (or prompt payment discounts):
which provide the customer with a discount off the purchase price if they pay within a shorter period of time
A typical sales discount is “2/10, n/30,”
which means that the customer could take a 2% discount if they paid within 10 days of purchase or, if this was not done, the net (or full) amount of the account would be due within 30 days.
Allocate the transaction price to performance obligations.
If, in Step 2, only a single performance obligation was identified, then this step is not required. However, if multiple performance obligations were identified, then a portion of the transaction price determined in Step 3 must be allocated to each of them.
stand-alone selling price
This is the price that the company would sell each good or service (that is, each performance obligation) for separately.
Recognize revenue when each performance obligation is satisfied.
As each performance obligation is satisfied, the company recognizes revenue equal to the portion of the transaction price that has been allocated to it in Step 4.
Performance obligations are satisfied when _______ of the goods or services are transferred to the customer.
control
Control is transferred
if the customer has the ability to direct the use of the asset and obtain substantially all of the remaining benefits from it through its use, consumption, sale, and so on.
Indicators that control has been transferred include the customer having:
physical possession legal title the risks and rewards of ownership accepted the goods or received the services an obligation to pay
Private companies using ASPE to prepare their financial statements use an earnings-based approach rather that the contract-based approach to determine when revenue should be recognized.
Under the earnings-based approach, revenue is recognized when the earnings process is substantially complete.
Revenue recognition criteria: Sale of goods
Revenue from the sale of goods can be recognized when all of the following criteria are met:
- The risks and rewards of ownership have been transferred to the customer.
- The seller has no continuing involvement or control over the goods.
- The amount of consideration to be received can be measured with reasonable assurance.
- Collection is reasonably assured.
Revenue recognition criteria: Provision of services
Revenue from the provision of services can be recognized when all of the following criteria are met:
- The service has been performed.
- The amount of consideration to be received can be measured with reasonable assurance.
- Collection is reasonably assured.
The contract-based approach focuses on the
statement of financial position,
Right of Returns
Many companies provide a period in which customers can return goods for a variety of reasons (such as they were the wrong goods or they arrived damaged).
If a company makes sales with a right of return, management must estimate the extent of expected returns because they affect the estimated transaction price (Step 3 of the five-step model).
Types of Warranties
Assurance warranty
Service warranty
Assurance warranty
Sometimes warranty coverage is included in the price of the product
Service warranty
Customers may also be given the option to purchase separate warranty coverage
Key points to warranties
Assurance warranties are not considered to be a separate performance obligation.
Service warranties are considered to be a separate performance obligation.
Service warranties are purchased separately, generally have a long term, and the seller is not legally required to provide them.
Factors that indicate that the warranty is a service warranty include:
The warranty is priced or negotiated separately.
The warranty coverage period is longer. The longer it is, the more likely the warranty is a service warranty.
The warranty is not required by law.
Consignment
The selling of goods on behalf of another party, usually for comission
Consignor
The owner of goods sold on consignment by a consignee
Consignee
A entity that sells goods on commission on behalf of consignors, receiving a commission when the goods are sold
Factors that would indicate a consignment arrangement include:
The company transferring the goods continues to control them until a future sale occurs.
The company transferring the goods is able to require them to be returned.
The company receiving the goods does not have an obligation to pay for them until a future sale occurs.
Third-Party Sales
Sometimes a company is involved in third-party sales, either selling goods on behalf of a third party or using a third party to sell its goods. Travel sites like Expedia are an example of this.
Principal
The initial amount lent or borrower
Agent
A company that arranges for a third party to provide a good or service to its customer. Agents receive a commission or fee for arranging the sale
If the company is considered to be a principal,
then the transaction price (Step 3 of the five-step model) would be the gross amount.
If the company is considered to be an agent
then the transaction price (Step 3 of the five-step model) would be the net amount.
Factors that would indicate that a company is serving as agent rather than principal include:
A third party is responsible for providing the goods or services.
The company receives consideration in the form of a commission.
The company does not establish the prices of the goods or services.
The company has no risk related to holding inventory.
There are two main formats that can be used to prepare a statement of income:
the single-step format and the multi-step format
single-step format
A statement of income in which all revenues are listed in one section and all expense (except income tax) are listed in as second section
Order: Revenue, expenses,
Multi-step statement of income
A statement of income in which revenues and expenses from different sources are shown in separate sections
The Five Steps of the Multi-Step Statement of Income
1) Sales revenue (or revenue)
2) Gross profit (or gross margin)
3) Profit from operations (or operating income)
4) Profit before income tax expense
5) Net income (loss) or profit
Statements of income prepared using a multi-step format present key measures
including gross profit and profit from operating activities, making analysis easier for decision makers.
Comprehensive income
is the total change in the shareholders’ equity (or net assets) of the enterprise from non-owner sources. It is equal to net income plus other comprehensive income.
Statement of comprehensive income
Financial statement showing net income plus other components of other comprehensive income, combined to produce the total comprehensive income
Other comprehensive income
Changes in net asset values representing unrealized gains and losses, which are not included in net earnings but are included in comprehensive income
Comprehensive income = Net income + other comprehensive income
Equation
Comprehensive income includes gains and losses from revaluing financial statement items to fair value or from changes in foreign exchange rates.
Stated again
Accounting standards offer companies the choice of presenting their expenses
by function or by nature
Function
A method of organizing expenses on the statement of income by way of the activity (business function) for which they were incurred (such as cost of goods sold, administrative, and selling)
If chosen, must include the nature in notes to financial statements
Nature
A method of organizing expenses on the statement of income by way of their natural classification (such as salaries, transportation, depreciation, and advertising)
Earnings per share (EPS)
A ratio calculated by dividing the earnings for the period by the average number of shares outstanding during the period.
basic earnings per share ratio
Net income−Preferred dividends
_________________________
Weighted average number of
common shares outstanding
Gross margin
Sales revenue - cost of goods sold = Gross margin
Operating expense
Things such as utilities expense, insurance expense, administration expense, distribution expense (do not include interest expense or interest revenue, or financing activities)
Operating income =
Gross margin - operating expense
In a single-step statement of income, interest collected on investments is reported as a non-operating revenue. True or flase?
False
Which statement of income format(s) do/does accounting standards allow?
Both ASPE and IFRS allow either format.
Under the ________, accounting revenues are recognized when they are earned regardless of whether the related cash was received by the company.
accrual basis
Financial statement users can find information about a company’s approach to revenue recognition in the ________ to its financial statements
Notes
