THE UNIVERSITY OF NEW SOUTH WALES

SchoolofAccounting ACCT3563:IssuesinFinancialReportingandAnalysis Session2,2013

Week5

Revenuerecognition

Website:http://telt.unsw.edu.au

Topics&LearningObjectives
Topics: Revenuerecognition o Saleofgoods o Renderingofservices o Interest,royaltiesanddividends o Constructioncontracts

Thistopicslearningobjectives(LO)aretounderstandandexplain: 1. whentorecogniserevenuefromsaleofgoodsorfromrenderingofservices; 2. accountingforconstructioncontractactivityusingthepercentageof completionmethod; 3. theimplicationsofagencytheorytorevenue/profitrecognition.

RequiredReadings
RequiredReadings: DeeganChapter15(15.115.9) Accountingstandards:AASB118,AASB111

PracticeQuestions:Textbookquestions
DeeganChapter15: Reviewquestions1,6,9,19 Suggestedsolutions Deegan15.1 FirstconsidertherelevantrequirementsofAASB118Revenue:

14.Revenue from the sale of goods shall be recognised when all the following conditionshavebeensatisfied: (a) the entity has transferred to the buyer the significant risks and rewards of ownershipofthegoods; (b) the entity retains neither continuing managerial involvement to the degree usuallyassociatedwithownershipnoreffectivecontroloverthegoodssold;

(c) theamountofrevenuecanbemeasuredreliably; (d) it is probable that the economic benefits associated with the transaction will flowtotheentity;and (e) the costs incurred or to be incurred in respect of the transaction can be measuredreliably. 15.The assessment of when an entity has transferred the significant risks and rewardsofownershiptothebuyerrequiresanexaminationofthecircumstances of the transaction. In most cases, the transfer of the risks and rewards of ownership coincides with the transfer of the legal title or the passing of possessiontothebuyer.Thisisthecaseformostretailsales.Inothercases,the transfer of risks and rewards of ownership occurs at a different time from the transferoflegaltitleorthepassingofpossession. 16.If the entity retains significant risks of ownership, the transaction is not a sale and revenue is not recognised. An entity may retain a significant risk of ownership in a number of ways. Examples of situations in which the entity may retainthesignificantrisksandrewardsofownershipare: (a) when the entity retains an obligation for unsatisfactory performance not coveredbynormalwarrantyprovisions; (b) when the receipt of the revenue from a particular sale is contingent on the derivationofrevenuebythebuyerfromitssaleofthegoods; (c) when the goods are shipped subject to installation and the installation is a significant part of the contract which has not yet been completed by the entity;and (d) whenthebuyerhastherighttorescindthepurchaseforareasonspecifiedin thesalescontractandtheentityisuncertainabouttheprobabilityofreturn. 17.Ifanentityretainsonlyaninsignificantriskofownership,thetransactionisasale and revenue is recognised. For example, a seller may retain the legal title to the goodssolelytoprotectthecollectabilityoftheamountdue.Insuchacase,ifthe entity has transferred the significant risks and rewards of ownership, the transaction is a sale and revenue is recognised. Another example of an entity retaining only an insignificant risk of ownership may be a retail sale when a refund is offered if the customer is not satisfied. Revenue in such cases is recognised at the time of sale provided the seller can reliably estimate future returns and recognises a liability for returns based on previous experience and otherrelevantfactors. 18.Revenue is recognised only when it is probable that the economic benefits associated with the transaction will flow to the entity. In some cases, this may not be probable until the consideration is received or until an uncertainty is removed. For example, it may be uncertain that a foreign governmental authoritywillgrantpermissiontoremittheconsiderationfromasaleinaforeign country. When the permission is granted, the uncertainty is removed and revenue is recognised. However, when an uncertainty arises about the collectability of an amount already included in revenue, the uncollectable amountortheamountinrespectofwhichrecoveryhasceasedtobeprobableis recognised as an expense, rather than as an adjustment of the amount of revenueoriginallyrecognised.

19.Revenue and expenses that relate to the same transaction or other event are recognisedsimultaneously;thisprocessiscommonlyreferredtoasthematching of revenues and expenses. Expenses, including warranties and other costs to be incurred after the shipment of the goods can normally be measured reliably when the other conditions for the recognition of revenue have been satisfied. However,revenuecannotberecognisedwhentheexpensescannotbemeasured reliably;insuchcircumstances,anyconsiderationalreadyreceivedforthesaleof thegoodsisrecognisedasaliability. Where there is an agreement in place that all production will be acquired by a particular consumer, and it is probable that the inflow of resources will occur, then in principle it would be appropriateto recognise revenue atthe point of production. This would particularly be the case if there was a legal arrangement in place that all production must be purchased. In the absence of such an arrangement, revenue wouldnottypicallyberecogniseduntilthesalestransactionhadtakenplace.

It should also be noted that AASB 118 does not apply to revenue arising from some sourcessuch as the initial recognition of revenue from agricultural produce (AASB 141 Agriculture would apply and allows agricultural produce to be valued at fair valuelessestimatedpointofsalecosts).Hence,forsomegoods,suchasagricultural produce, it can be possible to recognise revenue in advance of a binding sales agreementandtotheextentthatafairvaluecanbereliablydetermined. Deegan15.6 FOB stands for free on board. An item may be sold FOB shipping point, or FOB destination. Destination or shipping point refers to the point at which title of the goods passes to the purchaser. If the goods are shipped FOB destination, title does not pass until the buyer receives the goods at the destination. In this case, revenue wouldnottypicallyberecogniseduntilthegoodsreachtheirdestination. Another description for contracts that are FOB destination is Cartage, Insurance Freight(CIF)meaningthatthesellerbearsresponsibilityforthegoodsuntiltheyare deliveredintostores. Deegan15.9 Aputoptiongivesitsholdertherighttosellanasset,ataspecifiedexerciseprice,on or before a specified date. The writer (or seller) of the put option agrees to buy the asset at a future date, for the exercise price, if the put option holder (buyer) should request it. The holder of the put option (who may also be in possession of the underlying asset) would typically only exercise the option (that is, require the other partytobuytheunderlyingasset)iftheexercisepricewasabovethemarketprice. In considering whetherto recognise revenue when thereare associatedoptions, the probability of the exercise of the options must be considered. Where it is probable that the put option will be exercised and Eddie is required to repurchase the equipment, revenues should not be recognised by Eddie since the requisite degree of certainty that the inflow of economic benefits has occurred will not have been attained.Thehigherthepricerecordedontheputoption,thegreatertheprobability

thatMassMarketerwillrequireEddietoreacquiretheassets.Hencethegreaterthe price recorded on the option (which increases the differential between the fair value, and the option price at the exercise date) the lower the justification for recordingthesalesrevenue. Atissueiswhetherthetransactionhasresultedinatransferoftherisksandrewards ofownershiptothebuyer.Asparagraph5ofAppendixAtoAASB118states: For a sale and repurchase agreement on an asset other than a financial asset the terms of the agreementneed to beanalysed toascertain whether,in substance, the seller has transferred the risks and rewards of ownership to the buyer and hence revenue is recognised. When the seller has retained the risks and rewards of ownership, even though legal title has been transferred, the transaction is a financingarrangementanddoesnotgiverisetorevenue. Additionalcomments Suppose a company sold land at the end of year and booked a substantial gain on sale and then in the subsequent period the land reappeared on its balance sheet as theresultofthepurchaserexercisingaputoption.Ofcourse,ifthelandisrevalued by the gain on revaluation would be recognised in reserves and there would be no profit on sale. Accounting for the saleandputback as if they were separate independent transactions has the effect of crystallising an unrealised gain in the profitandloss. Agency theory indicates that managers may be on the lookout for oneoff profits to give performance a boost especially around the end of the year. Transactions such asthosereferredtointhisquestionshouldbecarefullyscrutinisedbytheauditor. Deegan15.19 (a) 2013 2014 2015 Contractprice $40000000 $40000000 $40000000 Lessestimatedcost: Coststodate 10000000 26000000 32000000 Estimatedcoststo 22000000 6000000 __________ complete Estimatedtotalcost 32000000 32000000 32000000 $8000000 $8000000 Estimatedtotalgrossprofit/(loss) $8000000 Percentcomplete 31.25% 81.25% 100% Note:Themethodareweusingtomeasurestageofcompletionistheproportion thatcontractcostsincurredforworkperformedtodatebeartotheestimatedtotal contractcosts.

ContractRevenuesrecognisedusingstageofcompletion 2013:Totalexpectedrevenue$4000000031.25% $12500000 2014:Totalexpectedrevenue$4000000081.25% $32500000 Less:Revenuerecognised2010 12500000 Revenuerecognised2011 20000000 2015:$40000000100% $40000000 Less:Revenuerecognised2010and2011 32500000 Revenuerecognised2012 $7500000 ContractExpensesrecognisedusingstageofcompletion 2013:Totalexpectedcosts$3200000031.25% $10000000 2014:Totalexpectedcosts$3200000081.25% $26000000 Less:Expensesrecognised2010 10000000 Expensesrecognised2011 16000000 2015:$32000000100% $32000000 Less:Expensesrecognised2010and2011 26000000 Expensesrecognised2012 $6000000 Grossprofitrecognisedusingstageofcompletion: 2013:$800000031.25% $2500000 2014:$800000081.25% $6500000 Less:Profitrecognised2010 2500000 Profitrecognised2011 4000000 2015:$8000000100% $8000000 Less:Profitrecognised2010and2011 6500000 Profitrecognised2012 $1500000 (b) Wherestageofcontractcompletioncannotbereliablydetermined,whichmeans thatcontractrevenuesarerecognisedonlytoextentofcontractcostsincurred for2013and2014. 2013 2014 2015 (i) Torecordcostsincurred: DrConstructioninprogress 10.0 16.0 6.0 CrCash,accountspayable 10.0 16.0 6.0 (ii) Torecordbillingstocustomers: DrAccountsreceivable 8.0 20.0 12.0 CrBillingsoncontractsinprogress 8.0 20.0 12.0 (iii) Torecordcashcollections:

 (iv)

(v) 40.0 40.0 Financialstatementextracts 2013 2014 2015 $m $m $m Balancesheet Constructioninprogress 10 26 Less:Billingsoncontractsinprogress (8) (28) 2 (2) Incomestatement Revenuefromlongtermcontracts 10 16 14 Less:Constructionexpenses (10) (16) (6) Includedinprofit 8 ***Itshouldbenotedthatinthiscaseitisonlywhenthecontractiscompletethat theprofitemerges. (c) Journalentriesassumingthestageofcompletioncanbereliablydetermined whichmeanscontractrevenuesandcontractexpensesarerecognisedby referencetothestageofcompletionofthecontractfor2010and2011. 2013 2014 2015 $m $m $m (i) Torecordcostsincurred: DrConstructioninprogress 10.0 16.0 6.0 CrCash,accountspayable,etc. 10.0 16.0 6.0 (ii) Torecordbillingstocustomers: DrAccountsreceivable 8.0 20.0 12.0 CrBillingsoncontractsinprogress 8.0 20.0 12.0 (iii) Torecordcashcollections: DrCash 8.0 20.0 12.0 CrAccountsreceivable 8.0 20.0 12.0 (iv) Torecordperiodicincomerecognised:

DrCash CrAccountsreceivable Torecordperiodicincomerecognised: DrConstructioninprogress DrConstructionexpenses CrRevenuefromlongterm contracts Torecordfinalapprovalandacceptance: DrBillingsoncontractsinprogress CrConstructioninprogress

20.0 8.0 20.0 10.0 16.0 10.0 16.0

8.0

12.0 12.0 8.0 6.0 14.0

(v) 40.0 40.0 Financialstatementextracts 2013 2014 2015 $m $m $m Balancesheet Constructioninprogress 12.5 32.5 Less:Billingsoncontractsinprogress (8) (28) 4.5 4.5 Incomestatement Revenuefromlongtermcontracts 12.5 20 7.5 Less:Constructionexpenses (10) (16) (6) Includedinprofit 2.5 4 1.5 ***Itshouldbenotedthatinthiscasetheprofitemergesoverthelifeofthecontact activity.

DrConstructioninprogress DrConstructionexpenses CrRevenuefromlongterm contracts Torecordfinalapprovalandacceptance: DrBillingsoncontractsinprogress CrConstructioninprogress

2.5 4.0 1.5 10.0 16.0 6.0 12.5 20.0 7.5

PracticeQuestions:Pastexamquestions
1. Constructioncontract Bridge Ltd signs a contract on 1 January 20X7 to build a bridge for a customer over three years at an agreed contact price of $80m. The estimated construction costs foreachyearareasfollows: 20X7 $20m 20X8 $20m 20X9 $10m $50m Due to weather delays, Bridge Ltd has only incurred actual costs to build the bridge of $10m by the end of 20X7 but it still expects to complete the project on time for total construction costs of around $50m. Bridge Ltd has invoiced the customer $15 millionduring20X7ofwhich$8mhasbeenreceivedby31December20X7. REQUIRED In accordance with AASB 111 Construction Contracts, prepare the journal entries of BridgeLtdinrespectoftheconstructioncontractfortheyearto31December20X7.