J. REVENUE RECOGNITION

Question 1

_{J. REVENUE RECOGNITION}

Two main criteria for recognizing revenue:

Answer 1

• The revenue is earned, meaning the goods or services have been provided to the customer
• There is reasonable assurance that the receivables will be collected

Question 2

_{J. REVENUE RECOGNITION}

ASC 606 - Revenue from Contracts with Customers

Answer 2

This standard is now the main framework for revenue recognition

Except for specific items such as:

• leases
• nonmonetary exchanges
• insurance contracts, and
• specifics of different financial instruments.

This standard aims to clarify the principles for recognizing revenue and simplify previous industry-specific revenue recognition.

Question 3

_{J. REVENUE RECOGNITION}

The main idea behind ASC 606 is the “5 steps”:

Answer 3

1. Identify the contract with the customer.
2. Identify the performance obligations in the contract. If there are different performance obligations (products) in the contract, these are accounted for separately.
3. Determine the transaction price. This is the amount that the providing entity expects to be entitled to in exchange for providing the goods or services to the customer.
4. Allocate the transaction price to the performance obligations in the contract.
   
   1. The price is allocated on the basis of standalone prices of the goods or services promised in the contract.
   2. If standalone prices are not observable, the entity estimates them.
5. Recognize revenue when (or as) the entity satisfies the performance obligation.

Question 4

_{J. REVENUE RECOGNITION}

A few notes to this before we do examples:

Answer 4

• If a contract includes a significant financing component, whether it’s explicitly stated or not as “financing”, then interest income or expense should be recognized separately from the revenue from the contract with customers. This can be ignored if the time between payment and performance of the contract is less than a year, or if the performance of the contract is highly variable and not within control of the entity or customer.
  
  • The idea is that the revenue recognized should reflect what the customer would pay right when the goods or services were available to be transferred to the customer.
  • When it’s determined that a contract does include a significant financing component, then the effective interest method is used.
• The transaction price is the final amount expected to be exchanged for providing goods or services to a customer, and it excludes amounts collected for third parties such as taxes. Also, sales discounts or volume discounts – if they are expected to be hit, are subtracted from the transaction price.
  
  • A restaurant contracts to cater a sports team’s dinners through the season for $1,000 per dinner for 30 dinners. The restaurant offers a discount of $100 per dinner if the total dinners hit 20, then the transaction price of the contract is $900 x 30 which equals $27,000.
• If there is a contract modification that entails distinctly different goods or services at their standalone price, then this is considered a separate contract.
• The performance obligation is fully satisfied when the good or service is transferred to the customer, and a good or service is “transferred” when the customer obtains control of that good or service.

Question 5

_{J. REVENUE RECOGNITION}

Example- Identifying Performance Obligations

Answer 5

Example- Identifying Performance Obligations

An HVAC business contracts with a customer to sell and install an air conditioning unit in the customer’s home. This is two separate performance obligations:

• The sale of an air conditioning unit, and
• the installation of the unit.

The contract price will be allocated to these two separate obligations.

Question 6

_{J. REVENUE RECOGNITION}

Example - Allocating the Transaction Price to Multiple Products

Answer 6

ABC contracts with XYZ to sell XYZ its three most popular products, Alpha, Beta, and Omega. The total contract price is $100,000. ABC normally sells Alpha for $30,000, Beta for $75,000, and Omega for $45,000. To determine how much revenue ABC will allocate to each product based on the contract, you take the percentage of each item relative to the total:

Alpha is 30/150 = 20%,

Beta is 75/150 = 50%,

Omega is 45/150 = 30%

ABC would recognize the following revenue per product:

Alpha = $20,000

Beta = $50,000

Omega = $30,000

Question 7

_{J. REVENUE RECOGNITION}

Recognizing Revenue Over Time

Answer 7

When recognizing revenue over time, there is the input method and the output method. The input method is the most common and is very similar to the percentage of completion approach. The input method recognizes revenue based on satisfying the performance obligation relative to the total performance obligation to be performed, such as recognizing revenue on construction project as costs are incurred relative to the total estimated cost to finish the project.

For example, if the contract is to build a house, the customer has control of the house as it’s being completed, so revenue is recognized as the construction is completed.The input method is used when the costs being tracked are things like costs incurred, labor hours, machine hours, etc.

The output method recognizes revenue based on the value transferred to the customer relative to the total value to be transferred. These are things such as units produced or delivered, milestones reached, etc.

Example:

ABC corp contracts to construct a building for XYZ for $1,000,000. The building will be completed by the end of year 2. ABC uses the input method using costs incurred. ABC estimates that the total costs will be $500,000. These are first year’s results:

Costs incurred: $300,000

Costs remaining: $200,000

Based on this, in year 1 ABC incurred 60% of the total cost of the project (300,000 / 500,000 = 60%), so it will recognize 60% of the revenue in year 1, which is $600,000. Gross profit recognized would be $300,000(total gross profit in project = 500,000 x 60%).

In year 2, as long as nothing major changes, ABC completes the remaining 40% of the project and will recognize $400,000 of revenue in year 2.

*Revenue, gross profit, and costs are essentially based on the percentage complete approach as illustrated in this example.

Question 8

_{J. REVENUE RECOGNITION}

Not-For-Profit Revenue from Contributed Services

Answer 8

An NFP can recognize revenue from donated services if:

1. The services provided require special skills
2. The services are provided by someone who has the skills
3. Such skills would be paid for if they hadn’t been donated

Example:

A dentist spends a Saturday doing dental cleanings for free for an NFP organization. The dentist would have charged $200 per hour and he volunteered for 8 hours that day. The NFP would recognize $1,600 in contribution revenue. If the dentist had volunteered but simply volunteered to wash cars with other volunteers, there would be no revenue recognized.