Chapter 5 (Unit 4) Revenue Recognition

Question 1

What are the Five Steps of Revenue Recognition?

Answer 1

Step 1 - Identify the contract with a customer
Step 2 - Identify the performance obligation(s) in the contract
Step 3 - Determine the transaction price
Step 4 - Allocate the transaction price to the performance obligation(s) in the contract.
Step 5 - Recognize Revenue when the entity satisfies the performance obligation.

Question 2

What are indicators that control has transferred from seller to customer? (5)

Answer 2

• Seller has present right to payment
• Customer has legal title to asset
• Physical possession transferred to customer
• Risks and rewards of ownership transferred to customer
• Customer has accepted the asset

Question 3

Performance Obligation Satisfied at Point in Time

O’Hara Corp. sold goods for $5,000 that had a cost of $3,000. The customer immediately accepted and took possession of the goods and paid for the goods using cash. What are the journal entries O’Hara will need to record the sale?

Answer 3

D: Cash 5,000
C: Sales Revenue 5,000

D: COGS 3,000
C: Inventory 3,000

Question 4

What are the two revenue recognition approaches for performance obligations satisfied over a period of time?

Answer 4

Output Method - recognize revenue based on value of goods transferred relative to remaining goods

Input Method - measure revenue based on proportion of expected inputs (e.g., costs incurred/total expected costs (aka cost to total cost approach)

Question 5

A company expects to incur $100,000 in total project costs on a contract with a sales price of $200,000.

If the company has incurred $25,000 of the $100,000 total costs, then the company would recognize 25% of the revenue.

What would be the journal entry to recognize the revenue using the input method?

Answer 5

25,000 / 100,000 = 25%
200,000 x 25% = 50,000

D: Accounts Receivable 50,000
C: Sales Revenue 50,000

Question 6

Define Contract Liabilities.

Answer 6

A liability that is created when a customer pays in advance.

(e.g., Unearned Revenue - a liability account)

Question 7

Gator Company entered into a contract with Croc Company to transfer product to Croc Company for a sales price of $50,000. The product has a cost of $35,000. Croc Company paid Gator Company the full $50,000 price in advance.

a) What is the journal entry on the date cash is received and before transfer of product?

b) What is the journal entry on the date the performance obligation is satisfied?

Answer 7

a)
D: Cash 50,000
C: Unearned Sales Revenue 50,000

b)
D: Unearned Sales Revenue 50,000
C: Sales Revenue 50,000
D: Cost of Goods Sold 35,000
C: Inventory 35,000

Question 8

Define Contract Assets.

Answer 8

Entity performs before customer pays.

Two types:
Unconditional - entity has a right to payment (e.g., Accounts Receivable)

Conditional - entity must complete another performance obligation before it has a right to consideration

Question 9

Burr Company is buying 2 products from Hamilton for a sales price of $950,000. The contract requires the delivery of Product 2 (P2) before payment on Product 1 (P1) will be remitted. P1 has a sales price of $600,000 and P2 has a sales price of $350,000. Hamilton delivers P1 to Burr on April 2, 20x9, and delivers P2 to Burr on June 30, 20x9.

a) What is Hamilton’s journal entry on April 2, 20x9?

b) What is Hamilton’s journal entry on June 30, 20x9?

Answer 9

a)
D: Contract Asset 600,000
C: Sales Revenue 600,000

A contract asset is recorded; payment is conditional on P2 delivery.

b)
D: Accounts Receivable 950,000 (moves from conditional to unconditional)
C: Contract Asset 600,000 (remove contract asset now that both PO are done)
C: Sales Revenue 350,000 (recognize the remaining revenue)

Because P2 has been delivered, Hamilton now has an unconditional right to consideration for both P1 and P2.

Question 10

Define Variable Consideration in regards to a contract.

Answer 10

Pricing terms impacted by a future event, such as earning a performance bonus for delivering by a certain date.

Question 11

Define Variable Consideration in regard to a contract. What are the two methods of Variable Consideration?

Answer 11

Pricing terms impacted by a future event, such as earning a performance bonus for delivering by a certain date.

1) Expected Value Method
2) Most Likely Amount Method

Question 12

When is the Expected Value Method used for Variable Consideration in a contract?

Answer 12

Generally more than two outcomes possible.

Use when entity has other contract with similar characteristics and can probability-weight the possible outcomes.

Question 13

When is the Most Likely Amount Method used for Variable Consideration in a contract?

Answer 13

Use when there are two possible outcomes

Ex. either you are or you aren’t going to get the performance bonus

Question 14

Craig Co. engages Wesley to build a large piece of manufacturing equipment. The sales price of the equipment is $75,000.

If Wesley delivers the equipment by:
- June 30th, then there is a bonus of $10,000 (60% probability)
- July 5th, then there is a bonus of $7,000 (20% probability)
- July 10th, then there is a bonus of $5,000 (10% probability)
- No bonus if delivery is July 15th or later (10% probability)

Wesley frequently enters into contracts with similar terms and can set a probability rate based on past experience. Determine the transaction price.

Answer 14

Because there are more than two outcomes possible, use the Expected Value Method.

June 30th delivery: 60% ($75,000 + $10,000) = $51,000
July 5th delivery: 20% ($75,000 + $7,000) = $16,400
July 10th delivery: 10% ($75,000 + $5,000) = $ 8,000
July 15th delivery: 10% ($75,000 + $0.00) = $ 7,500

Estimated total transaction price = $82,900

OR

June 30th delivery: 60% x $10,000 = $6,000
July 5th delivery: 20% x $7,000 = $1,400
July 10th delivery: 10% x $5,000 = $500
July 15th delivery: 10% x $0.00 = $0.00

Estimated variable consideration = $7,900
Estimated total transaction price = $7,900 + $75,000 = $82,900

Question 15

Craig Co. engages Wesley to build a large piece of manufacturing equipment. The sales price of the equipment is $75,000.

If Wesley delivers the equipment by June 30th, then Craig will pay Wesley a bonus of $10,000 (70% probability).

Otherwise, no bonus will be paid and the equipment is expected to be delivered by July 15th (30% probability).

Determine the transaction price.

Answer 15

Because there are two possible outcomes, use the Most Likely Amount Method.

Based on prior experience, the most likely outcome is that Wesley will deliver the equipment by June 30th (70% probability) and earn the bonus.

Wesley should include the performance bonus of $10,000 in the transaction price.

The transaction price is $85,000 ($75,000 for the equipment + $10,000 for the bonus).

Question 16

Define Significant Financing Compnent.

Answer 16

Contract allows the buyer to pay at a much later date - effectively seller provides financing.

Question 17

On October 1, 20x9, Jordan Company sold (and transferred control of) equipment to Curry Company for $1,000,000 and accepted a 5-year note with an interest rate of 5% and monthly installments of $18,871. The equipment costs Jordan $750,000.

a) How much revenue should Jordan recognize on October 1, 20x9?

b) What are the journal entries for October 1, 20x9?

c) What is the journal entry for October 31, 20x9?

Answer 17

a) 1,000,000

b)
D: Notes Receivable 1,000,000
C: Sales Revenue 1,000,000

D: Cost of Goods Sold 750,000
C: Inventory 750,000

c)
D: Cash 18,871
C: Interest Revenue (1,000 x 0.05/12) 4,167
C: Notes Receivable (plug) 14,704

Question 18

Wolf Company sold goods to Frank Company for the rights to a patent. The fair value of the patent is $75,000. The inventory cost Wolf $40,000.

What journal entries are recorded associated with the sale?

Answer 18

D: Patent 75,000
C: Sales Rev 75,000

D: Cost of Goods Sold 40,000
C: Inventory 40,000

Question 19

What are examples of Consideration Payable to Customer? (3)

Answer 19

Volume Discounts
Rebates
Discount for Quick Payment

Question 20

Fritz Company offers a 2.5% discount for purchasing more than $1,000,000 of goods during the year. Mike Company regularly exceeds $1,000,000 of goods during the year. In March, Mike Company purchases $450,000 of goods. The inventory costs $370,000.

a) What journal entries are recorded in March?

b) What journal entry is recorded if Mike meets the volume discount threshold and pays Fritz?

c) What journal entry is recorded if Mike does not meet the volume discount threshold and pays Fritz?

Answer 20

a)
D: Accounts Receivable 438,750 (450,000 x 0.975
C: Sales Revenue 438,750

D: Cost of Goods Sold 370,000
C: Inventory 370,000

b)
D: Cash 438,750
C: Accounts Receivable 438,750

c)
D: Cash 450,000
C: Accounts Receivable 438,750
C: Sales Discounts Forfeited 11,250

Sales Discounts Forfeited is a revenue account considered “other revenue.”

Question 21

How do you identify Performance Obligations?

Answer 21

Performance obligations - distinct good or service

Two criteria to be distinct
1) Customer can benefit from the good or service on its own or with other readily available resources.
2) The good or service is separate from other promises in the contract.

Question 22

How is the transaction price of a contract allocated when there are multiple performance obligations?

Answer 22

Allocate based on the relative proportion of total standalone prices.

If standalone prices are not directly observable, then estimate standalone selling prices.

Question 23

Smith Company produces equipment and offers installation and training services to its customers.

Westbrook Company enters into a contract with Smith Company to purchase a piece of equipment, have the equipment installed, and receive training on the equipment. Westbrook Company has the expertise to install the equipment and train its employees on the equipment but has chosen to contract Smith to complete those tasks.

The total contract price is $1,200,000. The equipment cost is $900,000.

Smith sells the equipment alone for $1,100,000 and offers installation services for $70,000 and training for $130,000. Installation and training services are performed when the equipment is delivered.

a) Allocate the transaction price.

b) What are the journal entries if delivery, installation, and training POs are satisfied at the same time?

c) What are the journal entries if delivery and installation are completed at the same time, and training occurs over the next six months?

d) Following the scenario in C, what is the monthly adjustment JE?

Answer 23

a) Three separate performance obligations.

Calculate total standalone price.

1,100,000 + 70,000 + 130,000 = $1,300,000

Equipment = 84.62%
Installation = 5.38%
Training = 10.00%

Equipment = 1,200,000 x 84.62% = $1,015,400
Installation = 1,200,000 x 5.38% = $64,560
Training = 1,200,000 x 10% = 120,000

b)
D: Cash 1,200,000
C: Sales Revenue 1,015,440
C: Service Revenue (Installation) 64,560
C: Service Revenue (Training) 120,000

D: Cost of Goods Sold 900,000
C: Inventory 900,000

c)
D: Cash 1,200,000
C: Sales Revenue 1,015440
C: Sales Revenue (Installation) 64,560
C: Unearned Service Revenue (Training) 120,000

d)
D: Unearned Service Revenue 20,000 (120,000/6)
C: Service Revenue 20,000

Question 24

What are the conditions that cause Contract Modifications to create a new separate contract, and how does it impact the accounting for the original contract?

Answer 24

If
- additional goods or services are distinct
AND
- consideration for additional goods or services reflects proper standalone pricing.
THEN
this is accounted for as a new, separate contract.

This does not impact the accounting for the existing contract.

Question 25

What are the conditions that cause Contract Modifications to just modify the existing contract (instead of creating a new separate contract) and how does it impact the accounting for the original contract?

Answer 25

If
-additional goods or services are not distinct
OR
-additional goods or services are not priced at proper standalone pricing.
THEN
account for the contract modification using a prospective approach.

Question 26

Herring Company promises to sell 80 products to a customer for a contract price of $12,000 ($150 per product).

After transferring 40 products, the contract is modified to include the delivery of an additional 25 products.

Additional 25 products are priced at $140 each.

Modification of existing contract or new separate contract created?

Answer 26

The additional goods are distinct with appropriate standalone pricing. This is a new, separate contract.

Question 27

Herring Company promises to sell 80 products to a customer for a contract price of $12,000 ($150 per product).

After transferring 40 products, the contract is modified to include the delivery of an additional 25 products.

Herring agrees to sell the additional products to the customer for $80.

Modification of existing contract or new separate contract created?

Answer 27

The additional goods do not have an appropriate standalone price. This is a modification to the existing contract.

The price of the remaining products (40 + 25) will have a blended price of $123.08 per product moving forward.

Question 28

When are costs to fulfill a contract expensed vs. amortized?

Answer 28

Expense as incurred:
- General and administrative costs
- Costs with an amortization period of less than one year
-ex: Manager’s salary expense for time spent reviewing the contract

Amortized over the life of the contract:
-Costs that give rise to an asset
-Benefit period is greater than one year
-Direct, incremental costs
-ex: Real estate agent’s commission to secure tenant’s lease

Question 29

The beginning balance of a retailer’s gift card liability for the current year is $4,600,000.

What are the journal entries for the following transactions:

a) $32,000,000 of gift cards were sold

b) $28,000,000 of cards were used by customers.

c) 60% average gross margin on goods purchased

d) From past experience, the firm estimates that customers have forfeited 20% of the beginning gift card liability balance.

Answer 29

a)
D: Cash 32,000,000
C: Gift Card Liability (Unearned Rev) 32,000,000

b)
D: Gift Card Liability 28,000,000
C: Sales Revenue 28,000,000

c)
D: COGS 11,200,000 (28,000,000 x 0.4)
C: Inventory 11,200,000

d)
D: Gift Card Liability 920,000 (4,600,000 x .2)
C: Forfeited Card Revenue 920,000

Question 30

A tenant pays a building management firm $24,000 for two years’ rent on August 1, 20x3.

The rental period begins on that date, and the building management firm has a calendar year-end.

a) Provide the journal entries for August 1, 20x3 and December 31, 20x3.

b) Determine the effects on the 20x3 Income Statement and Balance Sheet.

Answer 30

a)
August 1, 20x3
D: Cash 24,000
C: Unearned Rent 24,000

December 31, 20x3
D: Unearned Rent 5,000
C: Rent Revenue 5,000

b)
Income Statement Effect:
$5,000 of Rent Revenue recognized

Balance Sheet Effect:
$19,000 Unearned Rent remaining

Question 31

A firm’s sales totaled $3,000,000 for the year.

This figure includes $150,000 for two-year extended service-type warranty contracts covering the goods sold.

a) Record the journal entry for the sale.

The firm expects to incur a total of $120,000 cost to service the warranty claims. During year 1, $20,000 of warranty costs were incurred.

b) Record the journal entries for the warranty in Year 1.

Answer 31

a)
D: Cash 3,000,000
C: Sales Revenue 2,850,000
C: Unearned Warranty Rev 150,000

b)
D: Warranty Expense 20,000
C: Cash/Inventory/etc. 20,000

D: Unearned Warranty Revenue 25,000 ([20,000/120,000]150,000)
C: Warranty Revenue 25,000
Firms may also use a straight-line approach.

Question 32

Dave Inc. sells 200 phones for $50 each to a buyer on credit. Each phone costs Dave $30. Dave allows the buyer to return the phones for any reason and expects the buyer to return 10 phones.

a) What are the journal entries on the date of the sale?

Two weeks later the buyer returns four phones.

b) What are the journal entries to record?

At the end of the reporting period, Dave must make an adjusting journal entry to record the additional six phones expected to be returned.

c) What are the journal entries to record?

Answer 32

a)
D: Accounts Receivable 10,000
C: Sales Revenue 10,000

D: Cost of Goods Sold 6,000
C: Inventory 6,000

b)
D: Sales Returns and Allowances 200
C: Accounts Receivable 200

D: Returned Inventory 120
C: Cost of Goods Sold 120

c)
D: Sales Returns and Allowances 300
C: Allowance for Sales Returns and Allowances 300

D: Estimated Inventory Returns 180
C: Cost of Goods Sold 180

Question 33

Define Bill-and-Hold Arrangements

Answer 33

Seller retains physical possession of goods for a substantive reason. If the seller sets the distinct goods aside ready for immediate delivery, the seller can recognize that revenue.

ex. Buyer wants the goods and pays for the goods but their facility is not ready to take delivery.

Question 34

When using the Percentage-of-Completion Method to recognize revenue, what formulas are used in determining Cost-to-Cost Basis?

Answer 34

Costs incurred to date / Most recent estimate of total costs = Percentage complete

Percentage complete x Estimated total revenue (gross profit) = Revenue (or gross profit) to be recognized to date

Revenue to be recognized to date - Revenue recognized in prior periods = Current period revenue

Question 35

On April 1, 2014, Martin Corporation entered into a cost-plus-fixed-fee contract to construct an electric generator for Kelly Corporation. At the contract date, Martin estimated that it would take 2 years to complete the project at a cost of $950,000. The fixed fee stipulated in the contract is $200,000. Martin appropriately accounts for this contract under the percentage-of-completion method. During 2014, Martin incurred costs of $450,000 related to the project. The estimated cost at December 31, 2014, to complete the contract is $550,000. Kelly was billed $320,000 under the contract.

What is the amount of gross profit to be recognized by martin under the contract for the year ended December 31, 2014.

Answer 35

Costs incurred to date / Most recent estimate of total costs = Percentage complete
450,000 / 1,000,000 (450,000 + 550,000) = 45%

Percentage complete x Estimated total revenue (gross profit) = Revenue (or gross profit) to be recognized to date

Total contract price = 950,000 + 200,000 = 1,150,000
45% x (1,150,000 - 1,000,000) = 67,500

Question 36

Nair Corp. enters into a contract with a customer to build an apartment building for $1,028,000. The customer hopes to rent apartments at the beginning of the school year and provides a performance bonus of $186,000 to be paid if the building is ready for rental beginning August 1, 2015. The bonus is reduced by $62,000 each week that completion is delayed. Nair commonly includes these completion bonuses in its contracts and, based on prior experience, estimates the following completion outcomes:

August 1 - 70%
August 8 - 20%
August 15 - 5%
After 15th - 5%

Determine the transaction price for this contract.

Answer 36

1,186,100

Question 37

Mauer Company licenses customer-relationship software to Hedges Inc. for 3 years. In addition to providing the software, Mauer promises to provide consulting services over the life of the license to maintain operability within Hedges’ computer system. The total transaction price is $200,000. Based on standalone values, Mauer estimates the consulting services have a value of $75,000 and the software license has a value of $125,000. Upon installation of the software on July 1, 2014, Hedges pays $100,000; the contract balance is due on December 31, 2014.

Identify the performance obligations and the revenue in 2014, assuming:

a) the performance obligations are interdependent

b) the performance obligations are not interdependent

Answer 37

a) Revenue = 33,333 ([200,000 / 3 years] 6/12)

b) Service Revenue = 12,500 ([75,000 / 3 years] 6/12)
License Revenue = 125,000

Question 38

Travel Inc. sells tickets for a Caribbean cruise on ShipAway Cruise Lines to Carmel Company employees. The total cruise package price to Carmel Company employees is $75,500. Travel Inc. receives a commission of 5% of the total price. Travel Inc., therefore, remits $71,725 to ShipAway. Prepare the journal entry to record the remittance and revenue recognized by Travel Inc. on this transaction.

Answer 38

D: Accounts Payable 75,500
C: Sales Revenue 3,775
C: Cash 71,725

The agent recognizes their income on a net basis rather than a gross basis. Recognizing 75,500 worth of income and taking the remittance of 71,725 as a cost against that revenue would make their Income Statement misleading.