Chapter 18

Revenue Recognition

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1. Revenue Recognition Basic ConceptsRevenue recognition

◦most difficult issue facing accounting◦most prevalent reason for accounting

restatements◦most common way financial statements are

fraudulently presented◦revenue is one of most important measures

used by inventors to assess a company’s performance

◦revenue recognition is the cornerstone of accrual accounting

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1. Revenue Recognition Basic ConceptsDefinition of revenue (SFAC 6)

◦ Inflows or other enhancements of assets or settlement of liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

General recognition criteria (SFAC 5)◦ meets definition of an element◦ measurability◦ relevance◦ faithful representation

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1a. Revenue Recognition Basic ConceptsAPB Statement 4

◦Revenue is recognized when the earnings process is complete or virtually

complete an exchange has taken place

Realization principle (SFAC 5)◦Revenue is recognized when

the earnings process is judged to be complete or virtually complete

there is reasonable certainty as to the collectability of the asset to be received

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1a. Revenue Recognition Basic ConceptsSEC SAB No. 101

◦persuasive evidence of an arrangement exists

◦delivery has occurred or services have been rendered

◦the seller’s price to the buyer is fixed or determinable

◦collectability is reasonably assured

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1b. Revenue from Contracts with Customers New standard adopted by FASB and IASB

◦ issued May 28, 2014◦ entities required to apply the new standard for reporting

periods beginning on or after Jan. 1, 2017

◦ the issuing boards agreed that this unusual length of time is appropriate because of the impact of this project

◦ this gives entities time to update their software systems and processes in order to capture data for comparatives

◦ the boards tentatively stated that entities could use an alternative transition method that would recognize the cumulative effect of initially applying the new standard

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1b. Revenue from Contracts with CustomersNew standard adopts an asset-liability

approach to revenue recognition◦ companies account for revenue based on

the asset or liability arising from contracts with customers

New revenue recognition principle:◦ revenue is recognized when the

performance obligation is satisfiedFollows a five-step process

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1b. Revenue from Contracts with CustomersThe five steps of revenue recognition

are:1. Identify the contract with customers.2. Identify the separate performance

obligations in the contract.3. Determine the transaction price.4. Allocate the transaction price to the

separate performance obligations.5. Recognize revenue when each

performance obligation is satisfied.ACCT-3030 8

1b. Revenue from Contracts with Customers1. Identifying the Contract with Customers

◦ a contract is an agreement between two or more parties that creates enforceable rights or obligations

◦ requirements for a contract the contract has commercial substance (future cash flows

change as a result of the contract) the parties to the contract have approved the contract and

are committed to perform their respective obligations. the company can identify each party’s rights regarding the

goods or services to be provided, and the company can identify the payment terms for the goods

and services to be transferred.

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1b. Revenue from Contracts with Customers1. Identifying the Contract with

Customers

◦Revenue from a contract with a customer cannot be recognized until a contract exists.

◦Do not recognize contract assets or liabilities until one or both parties to the contract perform.

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1b. Revenue from Contracts with Customers1. Identifying the Contract with Customers

◦ Contract modification - determine if a new contract and performance obligation results or whether it is a modification of the existing contract Treated as a new contract if both of the following

conditions are met: the promised goods or services are distinct, and the company has the right to receive an amount of

consideration that reflects the standalone selling price of the promised goods or services

If either or both of the above conditions not met, account for modification using a prospective approach under this approach, revenue is recognized using a blended price

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1b. Revenue from Contracts with Customers2. Identify the separate performance obligations in the

contract. A company must provide a distinct product or service

for a performance obligation to exist. If a single product or service is provided there is only

one performance obligation. If multiple products/services are provided and they are

interdependent and interrelated, they are combined and reported as a single performance obligation.

If the products/services are not highly dependent or interrelated with other promises, then each performance obligation should be accounted for separately.

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1b. Revenue from Contracts with Customers3. Determine the transaction price.

◦ Transaction price is amount company expects to receive from a customer in exchange for transferring goods/services

◦ In some contracts, may need to consider: variable consideration (such as discounts, rebates, bonuses, royalties)

use expected value (if more than two possible outcomes) or,

most likely amount (if only two possible outcomes)

time value of money m/b used if contract has significant financing component and time period greater than

one year

noncash consideration measure as fair value of what received

consideration paid or payable to the customer items that will reduce the consideration received (e.g., free products, volume

discounts)

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1b. Revenue from Contracts with Customers4. Allocate the transaction price to the separate

performance obligations.

◦ If more than one performance obligation exists, an allocation of the transaction price should be based on the relative fair values of the various performance obligations

◦ When a bundle of goods/services is sold, the bundle’s selling price may be less than the sum of the individual standalone prices. If so

the discount should be allocated to the product(s) causing the discount, not to the entire bundle

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1b. Revenue from Contracts with Customers5. Recognize revenue when each performance

obligation is satisfied.◦ A company satisfies its performance obligation

when the customer obtains control of the good/service.

◦ Performance obligations may be satisfied at a point in time or over a period of time.

◦ Companies recognize revenue over a period of time if: the customer controls the asset as it is created or the

company does not have an alternative use for the asset, and the company has a right to payment.

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2. General Rule When applying Revenue from Contracts with

Customers, revenue usually recognized at the point of sale

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Activity Revenue recognized when

Selling products Point of sale (date of delivery; when title passes)

Providing services Services have been performed and amounts are billable

Permitting others to use the firm’s assets

As time passes

Disposing of assets Date of sale

3. Possible Points to Recognize Revenue Most significant event Recognition before point of sale

◦ prior to starting production customer advances

◦ during production long-term construction contracts

◦ at completion of production precious metals, ag products

Recognition at point of sale◦ but if right of return exists or sale with buyback

Recognition after point of sale◦ cash collection methods

installment sales, cost recovery basis

◦ consignmentsACCT-3030 17

4. Expense RecognitionExpense – expired economic benefits

Outflows or other using up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. (SFAC 6)

Expenses to be recognized can be identified by◦matching◦direct expensing (period costs)◦systematic allocation

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5. Revenue Frauds Obvious accounting violations

◦ Fictitious sales or fake customers◦ Premature recording of sales◦ Inflated sales

Transactions sometimes lacking integrity◦ Roundtrip transactions◦ Channel stuffing and trade loading◦ Bill and hold transactions◦ Repurchase agreements◦ Related party transactions◦ Principle-agent (grossing up revenue)

Contracts, agreements and side lettersACCT-3030 19

6. Long-term Construction ContractsPercentage of completion method

◦ revenue recognized each period based on progress of construction

◦ this method required if company’s performance creates or enhances an

asset that the customer controls, or company’s performance does not create an asset

with an alternate use, and costs to complete and extent of progress toward

completion are reasonably dependable

If criteria not met use completed contract method

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6a. Long-term Construction ContractsMethods to estimate percentage of

completion◦cost-to-cost method (input method)

costs to date ÷ total estimated costs to complete most common method

◦machine hours or labor hours (input measure)

◦project milestones (output method)◦units of production (output method)◦engineer’s or architect’s estimates

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6b. Long-term Construction ContractsRevenue and GP recognized per period

◦percentage completed this period x total revenue or GP

◦new accounts construction in progress (inventory account) progress billings (contra acct to CIP)

◦financial statement presentation net both accounts – could be debit or credit

balance

◦exampleACCT-3030 22

7. Completed contract methodRevenues and gross profit recognized

when project finishedEntries

◦same entries to record costs and billings◦do not recognize revenue and gross profit

each yearThe two methods are not acceptable

alternativesExample

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8. Right of ReturnOnly recognize revenue if all of following are

met sellers price is fixed◦ buyer has paid or is obligated to pay

◦ buyer’s obligation would not be changed by the theft or destruction of the product

◦ buyer has economic substance apart from that provided by the seller

◦ seller doesn’t have future significant obligations

◦ amount of future returns can be reasonably estimated

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