Chapter 4 - Revenue and Expense Recognit

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Chapter 4

Revenue and Expense Recognition

Copyright © 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

LEARNING OBJECTIVES

• L.O. 4.1 – Explain why a range of acceptable alternatives exist and the rationale for a smaller set of alternatives.

• L.O. 4.2 – Apply the general revenue and expense recognition criteria.

• L.O. 4.3 – Apply the specific revenue and expense recognition for construction contracts.

• L.O. 4.4 – Apply the principle of conservatism to construction contracts.

• L.O. 4.5 – Apply professional judgment to evaluate the risk of revenue misstatements and appropriateness of policies.

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• Wide range of alternatives exist

• Alternatives exist along the value creation process

• Revenue recognized earlier reduces the quality of the information

• Criteria established by accounting standards eliminates some of alternatives

A. RANGE OF CONCEPTUAL ALTERNATIVESFOR REVENUE RECOGNITION (L.O.4-1)



A business’s value creation process



B. GENERAL REVENUE RECOGNTION CRITERIA (L.O.4-2)

• IAS 18 provides general revenue recognition criteria

• Criteria provided for the:

– Sale of goods

– Provision of services

• Criteria for sale of goods vs. provision of services viewed differently

• Recommends point 5 on value creation process

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1. Sale of Goods

• ALL conditions must be met in order to recognize revenue:

– (a) Transfer of significant risks and rewards of ownership

– (b) Loss of continuing managerial involvement or control to the degree usually associated with ownership

– (c) Amount of revenue can be measured reliably

– (d) Economic benefits will flow to the entity

– (e) Costs incurred or to be incurred can be measured reliably



Sale of Goods from Seller to Buyer

• Requires a high degree of certainty

• Requires procurement, demand and price risk reduced to an acceptable level

• Allows acceptance of credit and indemnity risk

• Results in some subjectivity and application of professional judgment



2. Provision of Services

• Must reliably estimate the outcome

• If outcome can be estimated reliably use stage of completion to recognize revenue

• If outcome cannot be estimated reliably, revenue is recognized only to extent of recoverability of expenses recognized

– Known as the cost recovery method



Determining a Reliable Estimate for the Outcome

• ALL conditions must be met:– (a) amount of revenue can be measured reliably– (b) probable that economic benefits associated with

transaction will flow to entity– (c) stage of completion of transaction at end of

period can be measured reliably– (d) costs incurred and costs to complete transaction

can be measured reliably



Sale of Goods vs. Provision of Services

Sale of goods

• Risk and rewards of ownership transferred

• Managerial involvement and control given up

• Revenue amount measured reliably

• Economic benefits transferred

• Stage of completion not applicable

• Costs can be measured

Provision of Services

• Ownership not applicable for services

• Managerial involvement and control not applicable

• Revenue amount measured reliably


• Stage of completion measured reliably

• Costs can be measured



C. EXPENSE RECOGNTION (L.O.4-2)

• Limited guidance in IFRS

• Conceptual framework provides guidance

• Matching applies in the recognition of revenue and cost of sales

• Systematic and rational approach applies for other expenses, i.e., depreciation

• Expense applies if asset criteria not met



D. SPECIFIC REVENUE RECOGNITION SITUATIONS (L.O.4-2)

• Point of sale may not apply

• Other situations/arrangements :

– 1. Consignment sales

– 2. Installment sales

– 3. Franchise revenue

– 4. Barter Transactions

– 5. Revenue recognition at point of production

• Professional judgment applied



1. Consignment sales

• Consignor provides goods to a consignee who will try to sell goods

• Consignee has the right to return all or portion of goods if not sold

• Consignor retains risks of ownership • Consignor does not record revenue when goods are

delivered to consignee • Revenue recognized when right of return expires



2. Installment Sales

• Buyer makes payments over extended period of time

• Buyer receives product at beginning of installment period

• Legal title may not transfer to buyer until all payments made

• Uncertainty over amount ultimately collected• May recognize revenue in proportion to payments

received



Installment Sales Example

• Assume Durable Furnishings makes installment sales of products with a retail price of $1,000,000 in the month of January. The cost of the products sold amounts to $800,000, so the average gross margin on these products is 20%.

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(Continued)



Installment Sales Example (Continued)

• In February, Durable Furnishings receives $50,000 for these installment sales (after deducting amounts on account of interest).



3. Franchise Revenue

• Franchisor licenses to franchisee– Its trademarks– Business practices to franchisee

• Two revenue sources: initial fee and ongoing fee• Ongoing fee revenue recognition is simple• Initial fee: immediate recognition or deferral to

future periods• Professional judgment required



Franchise Revenue Example

• Assume Delicio Restaurants signs a franchise agreement to allow a franchisee to operate in northwest Calgary for a 10-year period. The agreement requires the franchisee to pay Delicio $200,000 initially, and a royalty of 2% of sales revenue thereafter. Sales at this franchise location for the first year are $2 million. The management of Delicio estimates that the value of services rendered to this franchisee—such as location and demographic analysis, initial staffing, and training—totalled $80,000. Management also believes that the remainder of the initial fee (i.e.,$120,000) relates to services to be provided evenly over the 10-year period.

(Continued)



Franchise Revenue Example (Continued)



4. Barter Transactions

• Barter transactions – exchange of goods or services – with little or no monetary consideration.

• Measurement needs to be established• Generally recorded using estimates of “fair value”

of goods or services exchanged • Fair value

– Prices used for cash – Similar monetary consideration



5. Revenue Recognition at Point of Production

• Limited circumstances • IAS 41 - revenue recorded for produce on date of

harvest• IAS 18 - recording of revenue from selling of

commodities using forward contracts for delivery in the future but at fixed sale prices– Risks and rewards are transferred to the buyer

prior to delivery of the commodity



E. ACCOUNTING FOR CONSTRUCTION CONTRACTS (L.O.4-3)

• Challenge: allocating revenue to reporting periods • IAS 11 – Construction Contracts provides

additional guidance• “Construction contracts” has broad application

- manufacturing, assembly, other creation• If outcome is measured reliably stage of

completion may apply• Costs matched to revenue recognized



Defining “Construction Contracts”

• Understanding definition is key in order to understand its applicability• A construction contract – contract specifically negotiated for construction

of an asset or a combination of assets closely interrelated or interdependent in terms of their design, technology and function or ultimate purpose or use

* defined in IAS 11



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Types of Contracts Covered in “Construction Contracts”



Fixed Price: Percentage of completion applied when all of the following are satisfied :

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• Contract revenue measured reliably• Economic benefits transferred • Costs to complete measured • Stage of completion measured• Contract costs clearly identified and measured

reliably– Actual can be compared with prior estimates



For Cost Plus: Percentage of completion applied when all of the following are satisfied :


• Costs can be clearly identified and measured reliably, whether or not reimbursed



1. Revenue Recognition for Cost-plus Contracts

• Amount of revenue determined by actual costs plus percentage margin



Revenue Recognition for Fixed-price ContractsAssume – accurate estimates

• Percentage of completion allocates revenue – not expenses



2. Revenue Recognition for Fixed-price ContractsAssume – actual costs differ from estimates

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Revenue Recognition for Fixed-price ContractsAssume – actual costs differ from estimates

(Continued)



3. Revenue Recognition for Fixed-price Contracts:Cost-to-Cost Approach

• Need to calculate the percentage complete• Alternative based on costs incurred compared to

estimated costs to complete



Gross Profit Under Percentage to Complete – Cost-to-Cost Approach



4. Accounting Cycle for Construction ContractsConsider 3 Elements (L.O. 4-4)



Accounting Cycle for Construction Contracts(Continued)



Accounting Cycle for Construction Contracts(Continued)



5. Application of prudence (conservatism) in accounting for construction contracts

• Recall: principle of prudence results in bad news reported earlier than good news

• Recall: only a portion of revenue and profits reported based on percentage of completion

• Result: IAS 11 - losses recognized immediately



6. Revenue recognition when outcome of construction contracts is uncertain: Cost recovery method

• Cost recovery method recognizes:

– (1) contract costs incurred in the period as an expense

– (2) an amount of revenue equal to the costs that are expected to be recoverable

• Expected losses recognized immediately



7. Alternative in ASPE: Completed contract method

• Prescribed method - Percentage of completion • Allows for cost recovery and early loss recognition• Alternative method - Completed contract method

– deferral of revenue and expenses to end of project

– performance consists of single act or progress not reasonably estimated

– Losses not deferred



F. RISK OF EARNINGS OVERSTATEMENT IN CONSTRUCTION CONTRACTS (L.O. 4-5)

• Long-term nature

• Results in high-risk accounting and auditing

• Allocation of revenue and judgment in estimates provides opportunity for

– Intentional earnings management

– Unintentional judgment errors



1. Intentional Overstatement:earnings management

• Many estimates are used

• Valid and acceptable estimates exist

• Underestimating costs increases current profit

• Management’s ethical responsibility is to choose the best approach



2. Unintentional Overstatement:the winner’s curse

• Unintentional errors

– In the estimation process

– In conversation calculations

– Due to complexity of long-term contracts

• The winner’s curse – underestimating costs to win a contract – higher likelihood of loss when input information is different



G. PRESENTATION AND DISCLOSURE

• 1. General presentation and disclosure

– Type of activity

– Activity from non-monetary exchanges

– Revenue recognition policies

– Stage of completion

• 2. Presentation and disclosure for construction contracts

– Amount of contract revenue recognized

– Method of revenue recognition

– Method of estimating the percentage completed



H. SUBSTANTIVE DIFFERENCES BETWEEN IFRS AND ASPE



I. SUMMARY

• L.O. 4.1 – Explain why a range of acceptable alternatives exist and the rationale for a smaller set of alternatives.

• L.O. 4.2 – Apply the general revenue and expense recognition criteria.

• L.O.4.3 – Apply the specific revenue and expense recognition for construction contracts.

• L.O. 4.4 – Apply the principle of conservatism to construction contracts.

• L.O. 4.5 – Apply professional judgment to evaluate the risk of revenue misstatements and appropriateness of policies.


Documents

Chapter 4 - Revenue and Expense Recognit