Chapter 18 Revenue recognition

Revenue recognition is a top fraud risk and that regardless of the accounting rules
followed GAAP or IFRS.
New revenue recognition standard:
Asset-liability approach recognized and measures revenue based on changes in
assets and liabilities.
1
the recognition and measurement of assets and liabilities and 2)
changes in those asstes or liabilities over the life of the contract brings more
discipline to the measurement of revenue, compared to the earned and
realized criteria in prior standards.
Contracts are the lifeblood of most business .
Contracts : the terms of the transaction, measurement of the considerartion, and
specify the promises that must be met by each party.
The culmination of the process is the revenue recognition principle,
Recognition of revenue when the performance obligation is satisfied.
The give-step process
Step 1. Identify the contract with customers. boeing has signed a conract to
deliver airplanes to Detla

Step 2. Identify the separate performance obligation in the contract for example,
deliver airplanes to Detla is one performance obligation.
Step3: Determine the transaction price.
Step 4: Allocate the transaction price to the separate performance obligations
(deliver airplanes to Detla is only one performance obligation)
Step 5: recognize revenue when each performance obligation is satisfied ( boeing
recoginzies revenue of 100 million for the sale of the airplanes to detla when it
satisfies its performance obligation the delivery of the airplanes to detla. (
)

The cost of goods sold has debit accounts and when products sold out,
Cost of Goods Sold 500
Inventory

500

() Accounts Receivable
Sales Revenue

400

400

A key feature of the revenue arrangement is that the signing of the contract by the
two parties is not recorded (does not result in a journal entry) until one or both of
the parties perform under the contract. Until performance occurs, no net asset or
net liability occurs.
Contract Modifications
Companies sometimes change the contract terms while it is ongoing; this is
referred to as a contract modification.

Separate performance obligation: A company accounts for a contract modification

as a new contract if both of the following conditions as satisfied :
1. The promised goods or services are distinct (company sells them separately
and they are not interdependent with other goods and services ) and
2. The company has the right to receive an amount of consideration that
reflects the standalone selling price of the promised goods or services.
Prospective Modification ( blended price)
As indicated, whether a modification is treated as a separate performance obligation or prospectively, the same amount of revenue is recognized before and after
the modification. However, under the prospective approach, a blended price
($98.33) is used for sales in the periods after the modification.4
Step 2 : A performance obligation is a promise in a contract to provide a product
or serviceto a customer. This promise may be explicit, implicit, or possibly based
on custom-ary business practice. This promise may be explicit, implicit, or
possibly based on custom-ary business practice. To determine whether a
performance obligation exists, the company must provide a distinct product or
service. Variable consideration Time value of money Noncash consideration
Consideration paid or payable to the customer
.
Determining the Transaction PriceStep 3
The transaction price is the amount of consideration that a company expects to
receive from a customer in exchange for transferring goods and services. Variable
consideration
Time value of money
Noncash consideration
Consideration paid or payable to the customer

Variable Consideration

In some cases, the price of a good or service is dependent on future events.These

future events might include discounts, rebates, credits, performancebonuses, or
royalties. In these cases,Companies use either the expected value,which is a
probability-weighted amount, or the most likely amount in arange of possible
amounts to estimate variable consideration. Companiesselect among these two
methods based on which approach better predicts the amount of consideration to
which a company is entitled.

TIME VALUE OF MONEY :

consideration ( )
Companies account for the time value of money if the contract involves a significant financing component. When a sales transaction involves a significant
financing component (i.e., interest is accrued on consideration to be paid over
time), the fair value is determined either by measuring the consideration received
or by discounting the payment using an imputed interest rate. The imputed interest
rate is the more clearly determinable of either (1) the prevailing rate for a similar
instrument of an issuer with a similar credit rating, or (2) a rate of interest that
discounts the nominal amount of the instrument to the current sales price of the
goods or services. The company
eQuestions: (a) How much revenue should SEK Company record on July 1,
2014? (b) How m example: Facts: On July 1, 2014, SEK Company sold goods to
Grant Company for $900,000 in exchange for a 4-year, zero-interest-bearing note
with a face amount of $1,416,163. The goods have an inventory cost on SEKs

books of $590,000. this transaction on December 31, 2014?

Solution:
(a) SEK should record revenue of $900,000 on July 1, 2014, which is the fair value
of the inventory in this case.
(b) SEK is also financing this purchase and records interest revenue on the note
over the 4-year period. In this case, the interest rate is imputed and is determined to
be 12%. SEK records interest revenue of $54,000 (12% 3 12 3 $900,000) at
December 31, 2014.
The entry to record SEKs sale to Grant Company is as follows.
July 1, 2014
Notes Receivable

1,416,163

Discount on Notes Receivable

516,163

Sales Revenue

9,00,000

The related entry to record the cost of goods sold is as follows.

July 1, 2014
Cost of Goods Sold

590,000

Inventory

590,000

SEK makes the following entry to record interest revenue at the end of the year.
December 31, 2014
Discount on Notes Receivable
Interest Revenue

54,000
(12% * 12 * $900,000) 54,000

As a practical expedient, companies are not required to reflect the time value of
money to determine the transaction price if the time period for payment is less than
a year. [11]
Noncash Consideration
Companies sometimes receive consideration in the form of goods, services, or

other noncash consideration. When these situations occur, companies generally

recognize revenue on the basis of the fair value of what is received
Consideration Paid or Payable to Customers
Companies often make payments to their customers as part of a revenue
arrangement. Consideration paid or payable may include discounts, volume
rebates, coupons, free products, or services. In general, these elements reduce the
consideration received and the revenue to be recognized. These prompt settlement
discounts should reduce revenues, if material. In most cases, companies record the
revenue at full price (gross) and record a sales discount if payment is made within
the discount period.
For example, assume that terms are payment due in 60 days, but if payment is
made within five days, a two per- cent discount is given (referred to as 2/5, net 60).
Allocating the Transaction Price to Separate Performance ObligationsStep
4
ifanallocationisneeded,thetransactionpriceallocatedtothevariousperformance
obligationsisbasedontheirrelativefairvalues.

Recognizing revenue when ( or as) each performance obligation is satisfied

step 5
Company satisfies its performance obligation when the customer obtains control of
the good or service
Change in control indicators:
1.
2.
3.
4.
5.

Company has a right to payment for asset

C Has transferred legal title to asset
C Has transferred physical possession of asset
Customer Has significant risks and rewards of ownership
Customer Has accepted the asset.
Companiesrecognizerevenueoveraperiodoftimeifthecustomerreceivesand
consumesthebenefitsasthesellerperformsandoneofthefollowingtwocriteria
ismet.

1.

Thecustomercontrolstheassetasitiscreatedorenhanced(e.g.,abuilderconstructsa

buildingonacustomersproperty).
2.

Thecompanydoesnothaveanalternativeusefortheassetcreatedorenhanced(e.g.,an
aircraftmanufacturerbuildsspecialtyjetstoacustomersspecications)andeither(a)the
customerreceivesbenetsasthecompanyperformsandthereforethetaskwouldnotneed
tobereperformed,or(b)thecompanyhasarighttopaymentandthisrightis
enforceable.

Other revenue recognition issues:

Right of return
Consignments
Repurchase agreements ( book store)
Warranties ( iphone 6 )
Bill and hold (
Non refundable upfront fees
Principal agent relationships
Right of return

Is granted for product for various reasons

Full of partial refund of any consideration paid
Credit that can be applied against amounts owed, or that wilbe owed to the
seller
Another product in exchange.
If repurchase price >= original selling price = no revenue is recorded
When sell occurs

cash

##

Liability to company

End of period

interest expense

##

##

Liability to company

When repurchase occurs liability to company

##

##

Cash

Entry to record an actual return

Sales returns and allowances ##
A?R ( or ap or cash )
Returned inventory

##
##

Cost of goods sold

##

Entry at end of period to record estimated future returns

Sals returns and allowance
Allowance for sales R and A

##
##

##

Estimated inventory returns ##

Cost of goods sold

##

Sales ( optional to disclose on I/S)

- Sales returns +allowanve
-sales discounts
net sales ( not optional disclose )
-cos
gp
-sga
NI

A/R allowance for DA allownce for sales R and A =net A/R

Inventory estimate inventory returns = net

Bill and hold arrangements

a.Contract under which an entity bills a customers for a pridcut but the entity
retians ohysical possession of the product until a point in time in the future
b.Result when buyer is not yet ready to take delivery but does take title and
aceptes bullings
c.Record revenue when buyer obtains control of the product
1
2

Reasons for bill and hodl to be substantive ( important considerable

big)
Product must be separately identified as belonging to customers

3
4

Product has to be physically ready to ship transfer to customers

Seller cannot use them or direct them to another customer

Principle Agent relationships

Agents performance obligation is to arrange for principla to provide goods or
services to a customer

NonrefundableUpfrontFees
Companiessometimesreceivepayments(upfrontfees)fromcustomersbeforethey
deliveraproductorperformaservice.Upfrontpaymentsgenerallyrelatetotheinitia
tion,activation,orsetupofagoodorservicetobeprovidedorperformedinthefuture.In
mostcases,theseupfrontpaymentsarenonrefundable.
Inmostsituations,thesepaymentsareforfuturedeliveryofproductsandservicesand
shouldthereforenotberecordedasrevenueatthetimeofpayment.

PRESENTATIONANDDISCLOSURE
Presentation
Asindicatedabove,acontractliabilityisacompanysobligationtotransfergoodsor
servicestoacustomerforwhichthecompanyhasreceivedconsiderationfromthe
customer.AcontractliabilityisgenerallyreferredtoasUnearnedSalesRevenue,
UnearnedServiceRevenue,oranotherappropriateaccounttitle.Illustration1830
providesanexampleoftherecognitionandpresentationofacontractliability.

Companiesarenotrequiredtousethetermscontractassetsandcontractliabilities
onthebalancesheet.

Consignments
Warranties:(notestonthesecondwarranties)
Twotypesofwarranties1.

incremental cost ()
disclosure:
appendix 18 A long-term construction contacts
revenue recognition over time
occurs when one of two conditions exist:
1. Customers controls asset as itt is created or
enhanced