Chapter 6 Flashcards

Revenue Recognition

1
Q

revenues

A

inflows or other enhancements of assets (of an entity or settlements of its liabilities or both)

from delivering g/s, from business main ops

important not only know how much rev to recognize (record) but WHEN

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2
Q

five steps to rev recognition

A

1) identify the contract

2) identify the performance obligations

3) determine the transaction price

4) allocate the transaction price

5) recognize rev when (or as) each performance obligation is satisfied

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3
Q

1) identify the legal contract

A

legal rights of seller and customer

contract establishes the legal rights and obligations of the s/c with respect to one or more performance obligations

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4
Q

2) identify the performance obligations

A

can be single or multiple

it is a promise to transfer a g/s that is distinct (which if g/s is capable of being distinct and separately identifiable)

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5
Q

3) determine the transaction price

A

the amount seller is entitled to receive from customer (for both single and multiple)

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6
Q

4) allocate the transaction price

A

if single - no allocation required

if multiple - allocate a portion to each performance obligation

seller allocates the transaction price to performance obligations based on the relative stand alone selling prices of the g/s in each performance obligation

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7
Q

5) recognize rev when (or as) each performance obligation is satisfied

A

if single - at one point in time or over a period of time (refer back to reasons)

if multiple - at whatever time is appropriate for each performance obligation (over a period to time) –> because of three things (refer back to slide)

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8
Q

recognizing rev at a single point in time BREAK DOWN (5 things)

A

indicators are used to determine when control has transferred from seller to customer

customer more likely to control a g/s if customer has

  • an obligation to pay the seller
  • legal title to the asset
  • physical possession of the asset
  • assumed the risks/rewards of ownership
  • accepted the asset
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9
Q

example for recognizing rev at a single point in time

A

Corp A sells stuff to Corp B

when should Corp A recognize revenue?

1) Dec 20, 2023 Corp A sells 1,000 things at price of 240 each promising payment in 30 days
- NOOOO

2) Jan 1, 2024 Corp A delivers 1,000 things at 240 each to Corp B
- YESSSS

Journal entry
Debit: AR 240,000
Credit: Sales Rev 240,000

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10
Q

for recognizing rev at a single point in time example, what would Corp journal entry be once receive payment from Corp B

A

Debit: cash
Credit: AR

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11
Q

recognizing rev over a period of time

A

1) the customer consumes the benefit of the seller’s work as it is performed
ex: cleaning service

2) the customer controls the asset as it is created
ex: constructing a building extension

3) seller is creating an asset that has no alternative use to the seller and the seller has the legal right to receive payment for progress to date
ex: order of jets customized for US Air Force

NOTE: recv is recognized in proportion to amt of performance obligation that has been satisfied

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12
Q

recognizing rev over a period of time

A

example: TrueTech Industries sells one year subscriptions to the Tri Net multisuer platform of Internet based games

TrueTech sells 1,000 subscriptions for $60 each on Jan 1, 2024

Journal entry: Jan 1, 2024
Debit: Cash 60,000
Credit: Deferred Rev 60,000

at the end of each 12 months what will be the journal entry

Journal entry each month
Debit: Deferred Rev 5,000
Credit: SR 5,000

5,000 –> 60,000/12

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13
Q

Recognizing Rev when the three criteria do not apply when recognizing a revenue over a point in time

A

if a performance obligation does not meet any three of the criteria for recognizing rev over time then…

  • revenue must be recognized at the point in time when the performance obligation has been completely satisfied
  • usually occurs at the end of contract
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14
Q

determining progress towards completion

A

to recognize rev over time the seller needs to estimate progress towards completion

1) out-based estimate
- measured as the proportion of the g/s transferred to date

2) input-based estimate
- measured as the proportion of effort expended thus far relative to the total effort expected to satisfy the performance obligation

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15
Q

recognizing rev for contracts that contain multiple performance obligations

A

steps 2 and 4 are VERY important

step 1: identify the contract

step 2: identify the performance obligation(s)

step 3: determine the transaction price

step 4: allocate the transaction price to each performance obligation

step 5: recognize rev when (or as) each performance obligation is satisfied

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16
Q

BREAKDOWN of step 2 for recognizing rev for contracts that contain multiple performance obligations

A

step 2: identify the performance obligation(s)

sellers account for a promise to provide a good or service as a performance obligation if the good/service is distinct from other g/s in the contract

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17
Q

in step 2, what makes something distinct

A

1) capable of being distinct
2) seperately identifiable from other g/s in the contract

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18
Q

special issues in revenue recognition (steps)

A

step one: specific requirements for contract existence

step 2: prepayments, warranties, customer options for additional g/s

step 3: variable consideration, right of return, seller as principal or agent, time value of money, payments by seller to customer

step 4: various approaches to estimating stand alone selling prices

step 5: licenses, franchises, bill-and-hold arrangements, consignment arrangements, gift cards

disclosure: lots of it

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19
Q

special issues for step 1: identify the contract (5 things must happen) and what is NOT supported

A

can be explicit, implicit, oral and written

contract can only exist if:
- has commercial substance (meaningful change in co. finances)
- has been approved by the s/c
- specifies the rights of the s/c
- specifies payment terms
- is probable that the seller will collect the amount it is entitled to receive under the contract

a contract does NOT exist if:
- neither the s/c has performed any obligations under the contract
- s/c can terminate the contract without penalty

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20
Q

determining whether a contract exsits for rev recognition purposes

A

CompStores orders 1,000 TriBox systems on Dec 20, 2023 at price of $250 per unit

assume CompStores and TrueTech can cancel order wihtout penalty prior to delivery

TrueTech made delivery on Jan 1, 2024 and received $250,000 on Jan 25, 2024

When does True Tech’s arrangement with CompStores qualify as a contract for purposes of rev recognition?

A: Jan 1 2024

21
Q

special issues for step 2: identify things that are NOT performance obligations

A

prepayments:
part of the transaction price (paid in advance, not a distinct promise, not going to be purchased separately)

quality assurance warranties:
part of performance obligation to deliver products of acceptable quality
(NOTE: extended warranty is part of PO)

right of return:
represents a potential failure to satisfy original performance obligation to provide goods that the customer wants to keep

22
Q

special issues for step 2: identify things that are performance obligations

A

1) extended warranties:
warranty is an extended if:
- customer has option to purchase the warranty separately
- the warranty provides a service to customer beyond quality assurance

2) options provide a material right (is something the customer would not receive otherwise, so the seller is obligated to provide it)
- a discount is a type of option

23
Q

special issues for step 3: determine the transaction price

A

1) variable consideration and the constraint on its recognition

2) sales with a right of return (a particular type of variable consideration)

3) identifying whether the seller is acting as a principal or an agent

4) time value of money

5) payments by the seller to the customer

24
Q

step 3 special issues

A

variable consideration: portion of transaction price depends on the outcome of future events

examples:
- construction (incentive payments)
- entertainment and media (royalties)
- health care - Medicare and Medicaid (reimbursements)
- Manufacturing (volume discounts and product returns)
- telecommunications (rebates)

25
Q

variable consideration

A

portion of a transaction price depends on the outcome of future events

26
Q

what are two methods of estimation for determining the transaction price

A
  • expected value:
    used in situations where contracts contains large number of possible outcomes
  • most likely amount:
    used where a contract has only two possible outcomes (outcome you believe has highest liklehood of occuring)

these methods are based on ability to best predict the amount the seller will receive

27
Q

expected value - determining the transaction price

A

journal entry for receipt of cash:
Debit: Cash or AR
Credit: Deferred Rev

so if have 300,000 up front fixed fee for 6m, 180,000 bonus, 75% chance

possible amounts:
480,000
probabilities:
75%
Expected Amounts:
360,000

possible amounts:
300,000
probabilties:
25%
expected amounts:
75,000

expected amounts = 435,000

so every 6ms:

debit: DR 50,000
Debit: BR 22,500
Service Revenue 72,500

135,000/6 = 22,500
435,000/6 = 72,500

28
Q

special amounts for step 3: alternative 2 –> most likely amount

A

journal entry each month:
Debit: DR 50,000
Debit: BR 30,000
Credit: SR 80,000

300,000 + 180,000 = 480,000

480,000/6 = 80,000
300,000/6 = 50,000
180,000/6 = 30,000

at the end of month: will need to

Debit: Cash
Credit: BR (is this supposed to be AR)

Debit: Service Rev
Credit: BR

NOTE: after three months (NOT receive 180,000 bonus)
Debit: SR 90,000
Credit: BR 90,000

NOTE:
Debit: DR 50,000
Credit: SR 50,000

29
Q

special issues for step 3: constraint on recognizing variable considerations

A

sellers only include an estimate variable consideration in the transaction price to the extent it is “probably” that a significant revenue reversal will not occur when the uncertainty associated with the variable consideration is resolved –> they are only estimating if slight uncertainty –> there are factors/indicators of poor uncertainty for revenue reversal

30
Q

what are indicators that a significant revenue reversal could occur include:

A
  • poor evidence on which to base an estimate
  • dependence of estimate on factors outside the seller’s control
  • history of the seller changing payment terms on similar contracts
  • broad range of outcomes that could occur
  • long delay before uncertainty resolves
31
Q

slide 60-61 –> constraint on recognizing variable consideration

A

Journal entry every months 4-6

Debit: DR 50,000
Credit: SR 50,000

company constrained from recognizing revenue associated with variable consideration –> company includes only the up-front fixed payment of 300,000 in the transaction price and recognizes revenue of 50,000 each month

300,000/6 = 50,000

(going back and recognizing the BR and the revenue that would be recognized in Jan-Mar, that you would have recognized, but then have to estimate it)

now assume April 1st, after three months of the contract passed, company concludes it now can make an accurate enough bonus estimate for it to be probable that a significant revenue reversal will not occur: assume 75% likelihood will receive bonus

Debt: Bonus R 90,000
Credit: SR 90,000

Debit DR: 50,000
Debit: BR 30,000
Credit: 80,000

(the second part of the entry is recognizing the DR of 50,000 for the month of April + BR, gives you a total of 80,000

32
Q

special issues for step 3: right of return

A

right of return

exists when the customer can return the good if not satisfied or unable to resell it

viewed as a failure to satisfy the original performance obligation

sellers report net sales revenue in the income statement, equal to gross sales revenue less actual and estimated returns

33
Q

example of right of return

A

assume company sold 1,000 for $240 each; estimates will 5% will be returned

Debit: estimated returns 12,000
Credit: Return or Refund Liability 12,000

income statement presentation:
Sales Rev (240x1000) 240,000
Less: estimated returns (5%) (12000)
Net Sales rev 228,000

34
Q

special issues: is the seller principal or agent (performance obligation)

A

performance obligation:

Principal: to provide g/s (so is vulnerable to risks associated with holding inventory)

Agent: to facilitate a transaction between a principal and a customer

35
Q

special issues: is the seller principal or agent (recording revenue)

A

principal:
total sales price paid by customers; also recognizes cost of goods sold

agent: recognizes only the commission it receives on the transaction

36
Q

special issues for step 3: time value of money

A

if time value of money is a significant part of the contract, seller should view the transaction price as consisting of two components:

1) delivery component: equal to the cash price of the g/s

2) financing component: interest considered paid to the customer (in case of prepayment) or to the seller (in the case of a receivable)

sellers can assume the financing component is NOT significant if the period between delivery and payment is less than a year

37
Q

journal entries for time value of money PREPAYMENT

A

when gives price in beginning this is FV

journal entry when issued:
Debit: Cash
Credit: DR

subsequent delivery
Debit: Interest Exp (PV x i)
Debit: DR
Credit: Sales Revenue

38
Q

journal entries for special issues for step 3 - time value of money RECEIVABLES

A

value given is FV

entry on delivery:
Debit: NR 1,056
Credit: Discount on NR 96
Credit: Sales Revenue 960

when subsequent collection occurs:
Debit: cash 1056
Debit: disct on NR 96
Credit: Interest Rev 96
Credit: Notes Receivable 1,056

39
Q

special issues for step 3: payments by the seller to the customer

A

if the seller purchases distinct goods/services from the customer

  • at the fair value of those g/s, seller accounts for that purchase as a separate transaction
  • pays more than the fair value of those g/s, thos excess payments are viewed as a refund
    (subtracted from the amount the seller is entitled to receive when calculating the transaction price to the sale of the customer
40
Q

special issues for step 4: allocate the transaction rice to the performance obligations

A

estimating the stand alone selling prices:

1) adjusted market assessment approach: price if product or services were sold in the market

2) expected cost plus margin approach: estimate the costs of satisfying a performance obligation and then add an appropriate profit margin

3) residual approach: subtract the sum of the known or estimated stand-alone selling prices of others goods and services in the contract from the total transaction price of the contract

41
Q

residual approach for step 4 (special issues)

A

total price
stand alone (______)
estimated stand alone

JE:
Debit: AR 250,000
Credit: SR 240,000
Credit: SR 10,000

42
Q

special issues for step 5: recognize revenue when each performance obligation is satisfied

A

licenses
franchises
bill-and-hold arrangements
consignment arrangements
gift cards

43
Q

licenses

A

allow the customer to access the seller’s intellectual property (IP)

  • licenses of functional intellectual property transfer a right of use, so sellers typically recognize revenue at a point in time

(1) has a significant stand-alone functionality (can perform a task, or be played or aired)
(2) the benefit the customer receives from the license isn’t affected by the seller’s ongoing activity
(3) therefore viewed as transferring a right of use (ex: a music download)
(4) revenue is recognized at the point in time that the customer can start using the IP

44
Q

symbolic IP

A

transfer seller’s IP with the understanding that the seller will undertake ongoing activities

(1) lacks significant stand-alone functionality
(2) the benefit the customer receives from the license affected by the seller’s ongoing activity
(3) license transfers a right of access to the seller’s IP
(example: trademarks, logos, brand names, franchise rights)

45
Q

what is the exception for licenses

A
  • functional IP: viewed as transferring a right of access (and requiring revenue recognition over time) if both

(1) the seller is expected to change the functionality over time
(2) the customer is required to use the updated version
example: virus protection software

46
Q

franchises

A

franchisor grants to the franchisee right to sell the franchisor’s products and use its name for a specified time period

franchises often include a license to use intellectual property, as well as initial sales of products and services transferred at the start of the franchise as well as on going sales over the life of the franchise

franchisor must evaluate each part of the franchise agreement to identify the performance obligations

47
Q

bill-and-hold arrangement

A

exists when customer purchases goods but requests that the seller retain physical possession of the goods until a later date

since the customer does not have physical possession of the asset until the seller has delivered it, transfer of control has not occured, so revenue typically should not be recognized until actual delivery to the customer occurs

48
Q

consignment arrangements

A

“consignor” physically transfers the goods to the other company (the consignee) but the consignor retains the legal title

if a buyer is found, the consignee remits the selling price (less commission and approved expenses) to the consignor

if the consignee cannot find a buyer within an agreed upon time, the consignee returns the goods to the consignor

given that the consignor retains the risk of ownership, it postpones revenue recognition until sale to a third party occurs

49
Q

gift cards

A

sales of gift cards are recognized as DR liability

rev is recognized when a gift card is redeemed or the likelihood of redemption is viewed as remote