Revenue Recognition Flashcards
According to IFRS 15, what are the 5 steps in the recognition and measurement of revenues process?
- Identify the contract with customer
- Identify the performance obligations
- Determine the transaction price
4.allocate the transaction price to performance obligations
- Recognize revenue in accordance with performance
Describe the step 1 of revenue recognition: identify the contract
It is important ti identify the contract before going through the rest of the steps to make sure we actually have potential revenue to record. A contract exists when the following are true:
-both partie approved the contract
-possible to identify both partie rights
-payment terms can be identified
-transaction has commercial substance
-probable that consideration will be received
Describe the step 2 of revenue recognition: identify the performance obligation
In simple transaction there is only one performance obligation. Sometimes a transaction will include different goods/services that should be considered separately - if the following conditions are met:
-the customer can benefit from the good or service on its own or together with other readily available resources
-the good or service is separately identifiable from the other promises in the contract
Describe the step 3 of revenue recognition: determine the transaction price
If the situation where there is a fixed amount of consideration, this is a simple step. However, there are some situations where the transaction price is not fixed:
-non-cash consideration
-significant financing
-consideration payable to customer
-variable considerations
What is non cash consideration
In the case where considerstion besides cash is received, the fair value of that asset should be estimated to arrive at the transaction price:
-total transaction price = cash received + fair value of non cash consideration
If the fair value of the non cash consideration cannot be reliably estimated, the selling price of the good/service in question can be used to infer it
What is consideration payable to customer and what are the potential issues
Sometimes a company will provide an incentive for their customer to keep purchasing from them. This creates a couple of issues:
-should a company recognize 100% of the sale revenues on the day the sale is made?
-should they wait until the coupons have been redeemed to record sales revenues?
Look at the excel file we did in class for answers
How do we record variable consideration
There are 2 options for recording income in that situation:
-expected value: multiplying probabilities by possible outcomes
-most likely amount
IFRS states that we should use whichever method is more conservative so that we dont end up in a situation where we need to reverse revenues, only record additional revenues once uncertainty has been resolved
Describe the step 4 of revenue recognition: allocate the transaction price to performance obligations
Once the transaction price has been determined, we now need to allocate it between the performance obligations:
-IFRS states that price should be allocated based on the relatives stand alone selling price
-the stand alone selling price is the amount the entity would normally sell that good/service for
-if one of the goods/services does not have an established selling price, the transaction price should be allocated based on the residual values
Describe step 5: recognize revenue
Once we have established the performance obligations and allocated the transaction price between them, we can determine when revenue should be recognized for each obligation. IFRS states that revenue should be recognized when the enterprise transfer the control of the asset. Indications that control has been transferred
-customer is obliged to pay for asset
-customer has legal title to the asset
-customer has taken physical possession
-customer bears significant risk and rewards of ownership
-customer has accepted the asset
What are the criteria for revenue to be recognized over time?
-customer simultaneously received and consumes the benefits of good/service
-entitys performance creates or enhances an asset the customer controls
-performance does not create an asset with an alternative use and entity has an enforceable right to payment for performance to date
What is a consignment sale?
one party provides goods to a second party yo sell (consignee). The consignee has a right to return the goods to the first party if they are not sold.
What are installment sales?
An installment is an arrangement where the seller allowed the buyer to make payments over time, even though the product is received at the beginning. This typically means there is a higher degree of uncertainty regarding collection, so revenues are recognized as payments are received.
What are the two types of warranties?
Assurance type
Service type
What are assurance type warranties?
ensure customer receives goods as specified in contract.
example of assurance type warranty and how it would be recorded
Guarantee against manufacturing defects
- company would record a liability (warranty liability based on an estimate of future warranty costs.
Service type warranty
provides service beyond assurance type, unrelated to the quality of the product at the time of the sale
- This type of warranty is a separate performance obligation with revenues recognized over the term of the warranty
What could service type warranty cover?
Could cover future brokerage
Explain what are bill and hold arrangements and what they imply?
- when a buyer purchases a good but does not take delivery right away (ex: storage issues)
- in case where payment was made, customer has accepted the good and they are ready for departure, criteria to recog rev have been met
- can recognize revenue, even w/o physical transfer
The two ways of recognizing revenue from long term contracts
- percentage of completion (required by IFRS)
- Completed contract (only allowable under ASPE)
Explain the percentage of completion method
recognizing revenues and expenses based on the completeness of the long term project
Explain completed contract and when it should be used
Revenues and exp only recognized when project is complete
- should only be used when % of completion cannot be estimated
The two types of long term contract we cover and which one we focus on with which approach
Cost plus contracts
Fixed price contracts
–» fixed price with the percentage of completion method
What are cost plus contracts?
typically means the transaction price will be equal to costs incurred + a profit margin
- Could result in a moral hazard situation where the seller is motivated to increase costs incurred to get a higher profit margin
- Simple to account for, revenues will be recognized based on the costs incurred in each year plus the profit margin
Fixed price contracts:
obvious, price agreed upon at the beginning, in this case the risk is in the hands of the seller
How do we recognize fixed price contracts’ revenues using the percentage of completion method?
- Percentage of completion is estimated based on the costs incurred to date
- generally will require an engineer/specialist to determine the % of completion
- These estimates will often change from one year to the next and must be applied on a prospective basis
2 ways of measuring percentage of completion explained
- Engineer simply estimate the % of the project that was completed during the year
- cost to cost method: involves estimating the costs remaining to complete the project. The % of completion would be determined as follows:
Percentage complete= costs incurred to date/est total costs
The phases of recognizing revenue on long term contracts
- project costs are incurred
- record as costs are incurred
dr. construction in progress
cr. cash, Accounts payable, etc - billing the client
- record when invoice is sent
dr. accounts rec
cr. billings on construction in progress - receiving payments from the client
- when cash is received
dr. cash
cr. accounts receivable - revenue and expense recognition
- once per period
dr. Cost of sales
dr. construction in progress
Cr. revenue (% of completion minus prior year
rev) - Project completion
- once per contract
dr. Billings on construction in progress
Cr. construction in progress (at this point these two accounts should be equal and equal to contract price)
What are onerous contracts?
When cost incurred and estimated costs to complete exceed contract price, onerous means contract will have a loss.
- entire amount of loss need to be recognized immediatly in an account called ‘provision for onerous contract’.
–» Gross Profit(Loss): 100%*estimated gross profit(loss)- gross profit(loss) previously recognized
Explain the cost recovery method
May have uncertainty over contract outcome, revenues can’t be reliably estimated, IFRS says use cost recovery method:
- Record expenses as incurred
- record rev equal to exp in the case where they are expected to be recoverable
- 0$ gross margin until the project is complete and the revenues are certain
How can long term contract measurements be used in earning management?
- using engineer’s approach vs cost to cost
- making estimates of future costs to underestimate the costs to complete to increase current year’s revenues
- another incentive to underestimate cost would be to win a contract in a bidding scenario
IFRS vs ASPE in terms of revenue recognition and performance over time
IFRS:
- Must use 5 step process for rev recog
- Requires percentage of completion for long term
ASPE:
- General application of principles
- can choose between % of comp or completed contract method
ASPE- Sale of Goods
Revenues should be recognized when these criteria are met:
- risk and reward of ownership transferred
- managerial involvement and control given up
- revenue amount measured reliably
- economic benefits transferred
- costs can be measured
ASPE: provision of services
Revenue from sale of services when those criteria are met:
- revenue amount measured reliably
- economic benefits transferred
- stage of completion measured reliably
- cost can be measured
Aspe Decision tree
- Identify the contract(s) that form the arrangement
- does the arrangement have separately identifiable deliverables?
- if no:
Arrangement is one unit of account - if yes:
- each separately identified component is a separate unit of account
- allocate revenue to multiple elements in each unit of account
Go see slide 38 and draw it, give yourself a 5 if you are able to do it from memory
