Lecture 08 Revenue Recognition Flashcards
What is the revenue recognition principle?
Revenue should be recognized at the first point in time at which the revenue is both:
- Earned (for product sales: the risks and rewards of ownership have passed to the buyer, i.e., the buyer is vested with the ownership rights and title; for service sales: substantial performance has occurred); and
- Realized or realizable (i.e., payment has been made or is reasonably assured).
What are the five steps used to recognize revenue?
The core principle: recognize a revenue amount that reflects the expected consideration for the goods and services provided to the customer.
This core principle is implemented in five steps:
- Identify the contract(s) with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations.
- Recognize revenue as the performance obligations are fulfilled.
How to identify contracts for the purpose of revenue recognition?
Definition: A contract is an agreement between two or more parties that creates enforceable rights and obligations.
Contracts can be written, oral, or implied by business practices.
In order to treat our agreement with the customer as a contract, we need
1. approval and commitment of the parties;
2. identification of the rights of the parties;
3. identification of the payment terms;
4. the contract to have commercial substance; and
5. collection of consideration (payment) to be probable.
What are 4 important points to keep in mind for contract identification?
- If the contract criteria are not met, revenue can only be recognized after all obligations have been performed and the customer has paid.
- If facts and circumstances change during the contract period, we may need to reassess whether the criteria are still met.
- Simultaneous contracts with the same customer can be combined if they meet the same commercial objective, their pricing terms are interdependent, or they involve a single common performance obligation.
- A modification of the contract either is treated as a separate contract (if feasible) or leads to an updating of the revenue recognition scheme.
What are performance obligations for the purpose of revenue recognition?
Definition. A performance obligation is a promise in a contract with a customer to transfer a good or service to the customer.
A performance obligation can be either:
1. a good or service (or a bundle of goods and services) that is distinct; or
2. a series of distinct goods and services that are substantially the same and have the same pattern of transfer.
A right to acquire goods or services in the future at a discount may also qualify as a separate performance obligation (material right option).
Performance obligations can be satisfied at a point in time or gradually over time.
How can we tell if performance obligations are distinct or non-distinct?
If the contract involves the transfer of several distinct goods and services (and they do not qualify as a series), a performance obligation is recognized for each of them. ‘Distinct’ means that
- the customer can benefit from the good or service either on its own or together with other resources readily available to the customer, and
- the promise to transfer the good or service is separately identifiable from other promises in the contract.
Goods and services are not distinct if they are highly interrelated, customize or modify one another, or are integrated by the seller as part of the contract.
What is the transaction price in revenue recognition and what are some of the common complications in determining it?
The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.
Complicating aspects in determining the transaction price include…
* variable consideration: use the expected (i.e., probability-weighted) amount or the ‘most likely’ amount.
* uncertainty in estimates: only use amounts unlikely to lead to reversals (reductions) in cumulative revenue recognized during the contract period.
* financing components: adjust the price for the time value of money in case of long gaps (one year or more) between delivery and payment.
* non-cash consideration: measure according to its estimated fair value or, if fair value cannot be reasonably estimated, by the standalone selling price of the goods and services provided to the customer.
* consideration paid to the customer: consideration paid to the customer (credits, cash, reductions in amounts owed) reduces the transaction price.
How are sales discounts recognised in revenue recognition?
Discounts are recorded by reducing sales revenue and recognizing an allowance for the expected amount of discounts at the same time that revenue is recognized.
DR sales discounts xxx
CR allowance for discounts xxx
The account ‘sales discounts’ is a contra-revenue account. It reduces the sales revenue amount shown on the income statement.
The account ‘allowance for discounts’ is a contra-asset account and reduces the balance of accounts receivable shown on the balance sheet.
When the customer takes advantage of the discount later, the payment received is recorded as:
DR cash xxx
DR allowance for discounts xxx
CR accounts receivable xxx
How are sales returns recognized for revenue recognition?
Sales returns are recorded by reducing revenue and cost of goods sold (for the cost of the returned items). The journal entries at the time of sale are:
DR sales returns and allowances xxx
CR refund liability xxx
DR inventory – right of return xxx
CR cost of goods sold xxx
The account ‘sales returns and allowances’ is a contra-revenue account reducing the sales revenue amount shown on the income statement.
The account ‘inventory – right of return’ is an asset account that captures the expected value (if any) of the products returned by the customer.
When an actual return occurs later, the company records:
DR refund liability xxx
CR cash xxx
DR inventory xxx
CR inventory – right of return xxx
How do we identify principal or agent for revenue recognition?
Definition. An entity is a principal if the entity controls a promised good or service before the entity transfers the good or service to a customer.
An entity is an agent if the entity’s performance obligation is to arrange for the provision of goods or services by another party.
If our company acts an agent or broker for goods and services actually provided by someone else, we can only recognize revenue in the amount of the fee or commission we receive for our service.
In other words, we need to apply net revenue accounting.
How do we allocate transaction price to performance obligation for revenue recognition?
Goods and services are often sold together as a bundle.
For example, a sale of medical imaging equipment may include hardware, software, future software upgrades, technical support, and training.
For a contract that has multiple performance obligations:
* allocate an amount to each obligation that reflects the consideration the entity expects to be entitled to for fulfilling that obligation;
* the allocation should be in proportion to the standalone selling prices of the individual performance obligations where possible, with any residual given to obligations with no determinable standalone price;
* any later price changes should be allocated in the same proportion at the time of the change (even to obligations already fulfilled).
What are the recognition methods for recognizing revenue?
The performance obligation is met when (or as) the promised goods or services are transferred (i.e., the customer obtains control of them).
Transfers are deemed to occur gradually over time if
the customer consumes the benefits of the goods (or services) as they are delivered (or rendered); or
fulfilling the performance obligation creates an asset that the customer controls during the creation process; or
the asset created has no alternative use to the seller, and the seller has an enforceable right to be paid for the work completed to date.
Otherwise, the transfer is considered to occur at a point in time. Indicators that the transfer is complete include:
a present right to payment from the customer for the goods or services;
transfer of legal title to the customer;
transfer of physical possession to the customer;
transfer of the significant risks and rewards of ownership to the customer;
acceptance of delivery by the customer.
How is progress measured toward completion of a contract for revenue recognition?
Progress can be measured either by
output methods, e.g., surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed, and units produced or units delivered, or by
input methods, e.g., resources consumed, labor hours expended, costs incurred, time elapsed, or machine hours used.
What is the percentage of completion method for tracking contract progress in revenue recognition?
The cumulative revenue to be recognized to date is the completion percentage multiplied by the total revenue to be collected.
cumulative revenue this period = completion percentage × total revenue
The current period revenue is the difference between the cumulative revenue to date and the cumulative revenue last period (i.e., the revenue already recognized in prior periods).
revenue this period = cumulative revenue this period – cumulative revenue last period
Exception: If total expected cost ever exceeds total revenue (on the contract as a whole), then in the period we find out, revenue is set so that profit-to-date equals the expected loss on the contract.
The expense (cost of sales) recognized along with the revenue is the actual cost incurred during the period.
What is the cost recovery method for tracking contract progress in revenue recognition?
If no reliable measure of progress is available, the company can only recognize revenue
* up to the amount of costs incurred to date; and
* only if these costs are recoverable (i.e., the payments from the customer are expected to be at least enough to cover the costs).
This method is called the cost recovery method.
