ACCT Test #3 Chp. 8 Revenue Recognition

Completed-Contract Method Accounting Procedures

1. Accumulate construction costs by debiting an asset (inventory) account called construction in progress (CIP) The CIP account is an asset account because, as project costs are incurred, the contractor has the right to bill the buyer. 2. When the contractor sends bills to the customer throughout the project, increase accounts receivable with a debit and credit an account called billings on construction in progress, a contra account to the construction in progress account that reduces the net carrying value of the asset, CIP. In effect, this transaction replaces the physical asset(inventory) with a financial asset (accounts receivable). Using the contra account avoids double counting the total asset value. 3. When the contractor receives cash from the customer, increase cash with a debit and decrease accounts receivable with a credit 4. Recognize the actual costs incurred and the same amount of revenue each year. Thus, the firm reports no gross profit. Only record the total gross profit at the conclusion of the project. 5. At the end of the project, remove from the books the CIP account with a credit and the billings on construction in progress account with a debit.

Overview of 5 steps in Revenue Recognition

1. Identity the contract(s) with a customer 2. Identity the performance obligations in the contract 3. Determine the transaction price 4. Allocate the transaction price to the performance obligations 5. Recognize revenue when, or as, it satisfies each performance obligation We do not actually record a journal entry until the 5th step. The point of the 5-step approach is to determine when to recognize revenue and how much revenue to recognize. Thus, we will not know the proper journal entry to record the sale until we complete the entire process

2 Accounting Methods for revenue recognition for long-term contracts

1. Percentage-of completion method 2. Completed-contract method Total revenue and costs for a long-term contract are the same under both methods. The difference between the two approaches is the timing of revenue and gross profit recognition on the contract: Percentage-of-completion method recognizes gross profit over the production period while the completed-contract method only recognizes gross profit at the end of the contract. An entity should use percentage-of-completion method when it meets one of the three criteria for goods and services transferred over time: 1. The customer receives and consumes the benefits of the goods or services simultaneously (ex. health club memberships, and magazine subscriptions) 2. The customer controls the asset as the seller creates it or enhances it over time (ex. software updates) 3. The asset the seller is creating does not have an alternative use to the seller, and the seller has an enforceable right to payment for the performance completed to date. and it can reasonably measure progress toward completion. If these conditions are met, the financial statements are more accurately presented under the percentage-of-completion method because the entity's economic activities are reported on the income statement. If the contract does not meet any of the three criteria or if the entity cannot reasonably measure progress toward completion, then it uses the completed-contract method.

Input measures

A common method used in practice, the cost-to-cost approach, estimates the cumulative percentage of completion by dividing the total cost incurred to date by total estimated costs as follows: Cumulative Percentage Complete = Total Costs Incurred to Date/Estimated Total Cost of the Project The estimated total cost of the project equals the total actual costs incurred to date plus the estimated costs to complete the project. The estimated total cost of the project is likely to change throughout the contract period. This does not create a problem because the ratio is computed each period using the current costs to date and estimated total cost.

Consignment Sales

A consignment sale is an arrangement where a seller (referred to as the consignor) delivers goods to a third party (the consignee), who sells the goods to the customer. A consignment sale is an example of a principal-agent arrangement (where one party (the agent) acts on behalf of another party (the principal).) In this case, the consignor is the principal and the consignee is the agent. Consignment sales-for goods such as books, furniture, musical instruments, toys, automobiles, and sporting goods - are quite common in practice. For example, a retailer of musical instruments can hold a piano from a manufacturer that it will sell on consignment basis. Determining whether a particular arrangement is a consignment arrangement is based on whether the seller passes control to the other party. If so, then it is a normal sale. If not, then it qualifies as a consignment arrangement. 3 indicators that an arrangement is a consignment arrangement: 1. The seller controls the product until a specified event occurs, such as the sale to the ultimate consumer. 2. The seller can require that the product be returned to it or sent to another third party 3. The third party does not have an unconditional obligation to pay for the product. The parties must use judgement to determine whether control has passed based on these indicators. If an arrangement is classified as a consignment arrangement, the consignee does not record the inventory on its books, and the consignor does not record revenue when the goods are delivered, Rather, on the delivery date, the consignor credits inventory and debits inventory on consignment while the consignee makes not entry. The consignor records revenue, along with the commission expense and receivable or cash, upon notification that the consignee has sold the inventory. The consignor will also record cost of goods sold and remove the inventory on consignment from its books. When the consignee sells the inventory, it records commissions revenue and an amount that is due to the consignor for the sale

1. Identity the contract(s) with a customer

A contract is an agreement between two or more parties that creates enforceable rights and obligations.

2. Identify the Performance Obligations in the Contract

A seller needs to identify the various performance obligations in a contract to allocate the transaction price to these different performance obligations and to recognize revenue when or as it satisfies each individual one. Conceptually, a performance obligation is a promise to transfer a good or service that is distinct. A performance obligation is either: 1. A promise to transfer a good or service, or a bundle of goods or services, that is distinct, or 2. A promise to transfer a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer

Consideration Payable to a Customer

At times, a seller makes payments to a customer if the seller is providing incentives to entice the buyer to purchase, or continue to purchase, its goods. Unless the payment to the customer is in exchange for a distinct good or service, the seller should deduct the amount of the consideration payable to the customer from the transaction price.

Step 5: Recognize Revenue When, or As, Each Performance Obligation is Satisfied

Companies determine when to recognize revenue in Step 5 based on when the goods or services are transferred to the customer. A good or service is transferred when the customer obtains control. A customer has control of the asset if has the ability to direct the use of the asset and receives all (or substantially all) of the remaining benefits of owning the asset.

Completed-Contract Method

Companies only utilize the completed-contract method when they do not meet the criteria required to use percentage-of-completion.

Constraining estimates of variable consideration

Entities must also assess the contract to determine if there are any constraints to variable consideration. For the entity to include variable consideration in the estimated transaction price (and thus the amount of revenue recognized), it has to conclude that is probable that a significant revenue reversal will not occur in future periods. Requires the use of a cumulative probability level to determine if the definition of probable (likely to occur) is met. * In estimating the constraint on variable consideration, U.S. GAAP uses the term "probable" whereas IFRS uses the term "highly probable" The definitions of "probable" under US GAAP and "highly probable" under IFRS are essentially the same

Determining the Estimated Percentage of Completion

Firms estimate the degree of completion by using input measures (costs incurred, direct labor hours used, and such), output measures (miles of highway, the number of cell towers installed, and such) or engineering estimates.

Transfer over Time

Goods and services may be transferred to the customer over time or at a point in time. If the goods or services are transferred over time, then the seller recognizes revenue over that time period. However, if the goods or services are transferred to the customer at a point in time, then the seller recognizes the revenue at that point in time. Companies must determine whether the goods/services are transferred over time or as of a point in time at the inception of the contract. Goods or services are transferred over time if the seller meets any one of the following 3 criteria: 1. The customer receives and consumes the benefits of the goods or services simultaneously (ex. health club memberships, and magazine subscriptions) 2. The customer controls the asset as the seller creates it or enhances it over time (ex. software updates) 3. The asset the seller is creating does not have an alternative use to the seller, and the seller has an enforceable right to payment for the performance completed to date. If a good or service is transferred over time, then the seller recognizes revenue over that same time period, based on the progress that is has made toward completion. However, if the seller does not have a reasonable way to measure its progress toward completion, then it should not recognize ANY revenue until it can reasonably estimate progress. Progress towards completion can be measured using either output methods or input methods. Examples of output methods include units produced or delivered, progress such as floors or miles completed, and time elapsed. Examples of input methods include labor hours expended, machine hours used, and costs incurred.

Failure to Meet Contract Criteria

If a seller does not satisfy all of the five Step 1 criteria, then it should recognize revenue when either: 1. The seller has no remaining obligations to transfer goods or services and substantially all (or all) of the consideration has been received by the seller and is nonrefundable or 2. The contract has been terminated and any consideration already received from the customer is nonrefundable. If the seller receives cash before the appropriate time to recognize revenue, it should report the consideration as a liability. In addition, the entity should not remove the inventory from its balance sheet.

4. Allocate the Transaction Price to the Performance Obligations

If the determination from step 2 is that there is only one performance obligation, then step 4 is not required.

Transfer at a Point in Time

If the seller does not meet the three criteria to recognize revenue, then it assumes that the goods or services are transferred at a point in time. It is often straightforward to determine when control is transferred. For example, consider a retailer that sells computers. Control is transferred when a customer purchases a computer at the retailer, takes delivery at the register,and pays for a computer at the point of sale. However, other times it is more difficult to make this determination. In these cases, the entity should consider a number of indicators of control: 1. The seller has a present right to payment for the asset 2. The customer has legal title to the asset 3. The seller has transferred physical possession of the asset. 4. The customer has the significant risks and rewards of ownership of the asset 5. The customer has accepted the asset. These 5 conditions indicate that control may have transferred , but any of them does not determine whether control has actually passed to the customer. The entity should consider all of the facts and circumstances to make this determination.

Contract Criteria

If the seller meets the following five criteria related to the contract, then it continues through the remaining four steps to determine the timing and measurement of revenue recognition. 1. All parties in the contract have agreed to the contract and are committed to performing under the contract. (The approval by the parties can be in writing, provided orally, or implied by an entity's customary business practices) 2. Each party's rights with respect to the goods or services that are being transferred are identifiable. 3. The payment terms for the goods or services that are being transferred are identifiable. 4. The contract has commercial substance (meaning that the risk, timing, or amount of the entity's future cash flows is expected to change as a result of the contract.) 5. It is probable that the seller will collect the consideration to which it is entitled in exchange for the goods or services. (To assess the probability of collection, the seller considers the customer's ability and intention to pay this specific amount of consideration when it is due.

Output Measures

In addition to the cost-cost approach, which is an input measure of the degree completion, firms also use output measures in practice. Output measures include measures such as highway completed or square footage completed of a building.

Significant financing component

In contracts when delivery of the goods or services occurs in advance of the payment, the seller is providing financing to the buyer. Alternatively, in contracts when delivery occurs well after payment, the buyer is providing financing to the seller. When the time lapse between payment and delivery is more than one year, entities are required to separate the revenue generated from the contract from the financing component if the financing component is significant at the individual contract level. The rationale is that the seller should recognize revenue at the amount that properly reflects the price that buyer would pay, if payment occurred on the same date as delivery. In determining whether a significant financing component exists, the entity considers three factors: 1. The difference between the contract price and the cash selling price of the goods or services 2. The length of time between delivery and payment 3. The prevailing interest rate in the market Once an entity concludes that there is a significant financing component, it determines the transaction price by using the time value of money: If the delivery occurs BEFORE payment, the entity discounts the promised consideration amount back to the present value, using the same discount rate it would use if it entered into a separate financing arrangement. If the delivery occurs AFTER the payment, the entity determines the future value of the payment, using the same discount rate it would use if it entered into a separate financing arrangement. The entity ultimately recognizes the transaction price as sales or service revenue and records the difference between the total contract price and the present or future value as interest revenue if the payment occurs before delivery.

Noncash Consideration

In some contracts, instead of paying cash for the good or service, customers compensate the seller with goods, services, or other noncash items such as shares of stock in the customer's corporation. In this case, the transaction price should be measured at the fair value of the noncash consideration received by the seller. If the seller cannot reasonably estimate the fair value of the noncash consideration received, then it should measure the transaction price at the standalone selling price of the goods or services promised to the customer.

Multiple Contracts

It is not uncommon for vendors to enter into multiple contracts with the same customer. Under certain circumstances, the seller should combine these contracts and account for them as a single contract. Specifically, if one of the following criteria is met, the seller should combine multiple individual contracts for purposes of determining the timing and measurement of revenue: 1. The contracts are negotiated as a package and have a single commercial objective. 2. The amount of consideration to be received by the seller related to one contract depends on the price or performance of another contract. 3. The goods or services promised in the separate contracts are all part of one performance obligation.

Overview of Long-Term Contracts

Long-Term contracts are a type of transaction where firms report revenue, costs, and gross profit over time, as opposed to at a point in time. They are prevalent in industries such as communications, homebuilding, software development, aircraft, shipbuilding, and construction. Consider a company that enters into a contract to manufacture or build a product for the customer when the manufacturing process will take a period of time substantially longer than a year. If the firm recognized revenue at a point in time, it would not recognize the revenue (and associated gross profit) attributable to the long-term contract until it completed the product and delivered it to the customer. However, this approach may not provide the most accurate presentation of the company's financial position and economic performance.

Other Principal-Agent Transactions

Other common principal-agent transactions - such as travel agency transactions, transactions related to advertisements and mailing lists, and auction transactions - require special accounting.

Percentage-of-Completion Method

Percentage-of-Completion Method Accounting Procedures: 1. Accumulate construction costs by debiting an asset (inventory) account called construction in progress (CIP) The CIP account is an asset account because, as project costs are incurred, the contractor has the right to bill the buyer. 2. When the contractor sends bills to the customer throughout the project, increase accounts receivable with a debit and credit an account called billings on construction in progress, a contra account to the construction in progress account that reduces the net carrying value of the asset, CIP. In effect, this transaction replaces the physical asset(inventory) with a financial asset (accounts receivable). Using the contra account avoids double counting the total asset value. 3. When the contractor receives cash from the customer, increase cash with a debit and decrease accounts receivable 4. Recognize the revenue and the associated costs each year, basing the amount of gross profit in a given year on the progress to date (that is, the percentage of the project that has been completed). Credit revenue from long-term contracts, debit the construction costs, and debit the difference between the revenue and the cost of construction (the gross profit) to the CIP account 5. At the end of the project, remove the CIP account from the books with a credit and remove the billings on construction in progress account with a debit. At the end of each year, the firm reports accounts receivable and costs and recognized profits in excess of billings on the balance sheet. If CIP is larger than the billings account, the net amount is called costs and recognized profits in excess of billings, and is reported as an asset on the balance sheet. If, however, the billings account is larger than the CIP account, then the firm reports the net of the two accounts, billings in excess of costs and recognized profits, as a liability on the balance sheet. The measurement of the net asset or net liability position of each contract has implications for financial statement users: - If the company reports a net asset position, the contract has unbilled receivables. That is, the contractor has an asset, giving the firm the right to bill the buyer for the work performed. - If the company reports a significant amount of unbilled receivables, the buyer may have little capital at risk and can easily abandon the project - If the company reports a significant net liability position, it implies that the contractor has received cash in advance and has the obligation to perform on the contract. However, if the contractor expends cash received for alternative uses, there may be insufficient resources to complete the project.

Special Issues in Revenue Recognition

Right-to-return sales, consignment sales, principal-agent transactions, bill-and-hold transactions pg. 396

Standalone Selling Price

To allocate the transaction price, the entity first determines the standalone selling price of the goods or services related to each performance obligation. Then, if the sum of the standalone selling prices is greater than the transaction price, the seller typically allocates the discount to separate performance obligations on the basis of the relative standalone selling prices. The standalone selling price of each performance obligation is the price the seller would charge for the same goods or services if it sold them on a standalone basis to similar customers under similar circumstances. Companies can often determine the standalone selling price using this method because they typically sell their goods or services on a standalone basis. However, in practice, the seller sometimes does not sell the same goods or services separately. In this case, the seller must estimate the standalone selling price. The authoritative literature does not stipulate an exact method but states that the company should use a method that maximizes the use of observable inputs. Whatever method the entity chooses for estimating the standalone selling price, it should use the same method consistently in similar circumstances.

3. Determine the Transaction Price

Transaction Price: the amount of consideration that the entity expects to be entitled to as a result of providing goods or services to the customer. It is the amount that an entity will ultimately recognize as revenue. Not necessarily the price stated in the contract - rather, it is the amount the seller expects to receive. (does not include amounts collected that will be remitted to third parties (such as sales tax) Sellers consider the effects of a number of different factors when determining the transaction price, including: 1. Variable consideration and constraining estimates of variable consideration 2. Any significant financing component in the contract 3. Noncash consideration 4. Consideration payable to a customer

Completed-Contract Method Implementation

Under the completed-contract method, the firm reports income from the contract only in the final year of the project. At the end of each year, the firm reports accounts receivable as well as costs in excess of billings on the balance sheet. When the CIP is larger than the billings on construction in progress, the net amount, which is called costs in excess of billings, is reported as an asset on the balance sheet. If however, the billings account is larger than the CIP account, then the firm reports the net of the two accounts, billings in excess of costs, as a liability on the balance sheet.

Percentage-of-Completion Method Implementation

Under the percentage-of-completion method, firms recognize both revenues and gross profits based on the project's stage of completion. Specifically, firms recognize revenue, costs, and gross profit each year by: 1. Computing cumulative revenue by multiplying the total estimated contract revenue times the percentage complete. Revenue for the current period is cumulative revenue less revenue recognized in all prior periods. 2. Actual costs for the current period will be known or given. 3. Computing gross profit for the year as the revenue recognized in the current period in (1) less the costs recognized in the period in (2). If the reported costs exceed the reported revenues in a given year for an otherwise profitable contract, then the gross profit is negative. In this case, the firm credits construction in progress in the journal entry made to record revenues, costs, and gross profit.

Variable Consideration and Constraining Estimates of Variable Consideration

Variable Consideration: when the payment received for providing a good or service is not a fixed amount. The amount of consideration may vary from a fixed amount due to price concessions, performance bonuses or penalties, discounts, refunds, rebates, and incentives. Elements of variable consideration may be stated explicitly or implicitly in the contract. Ex. a discount for early payment typically offered by a seller is considered an element of variable consideration, even though it may not be specified explicitly in the contract. If variable consideration is included in the contract, then the entity must estimate the consideration that it expects to receive using one of two acceptable approaches: 1. the expected-value approach or the 2. most-likely amount approach. The entity should use the approach that provides the best estimate of the amount of consideration it will receive.

Right-to-Return Sales

When a company makes a right-to-return sale, it is providing customers with the ability to return a product that has been transferred to them. The seller is obligated to accept the returned product, if the buyer chooses to return it. The right to return does not represent a separate performance obligation, but rather is a component of variable consideration affecting the transaction price. Recognize the amount of expected returns as a refund liability, which represents the seller's obligation to the customer to stand ready to receive the returned product and refund the customers consideration. Recognize revenue when no longer subject to the constraint, such as at the end of the returns periods.

3 Standalone Selling Price Determination Methods

While the authoritative literature does not specify a particular method, it does provide three suggestions suitable to determine a standalone selling price specific to a good or service: the adjusted market assessment approach, the expected-cost-plus-a-margin approach, and the residual approach. 1. Adjusted market assessment approach - Evaluate the market and estimate the price that it believes customers would pay. (Might include using prices from the seller's competitors and adjusting those prices as necessary) 2. Expected-cost-plus-a-margin approach - focuses on internal factors by forecasting the costs associated with providing the goods or services and adding an appropriate profit margin. 3. Residual approach - allows an entity to estimate one or more, but not all, of the standalone selling prices, and then allocate the remainder of the transaction price, or the residual amount, to the goods and services for which it does not have a standalone selling price estimate. Specifically, when using the residual approach, the entity estimates the residual standalone selling price by subtracting the standalone selling prices of the goods or services that underlie the other performance obligations from the total transaction price. Once the entity has estimated all of the standalone selling prices, it allocates any discount (that is, any amount by which the sum of the standalone selling prices is greater than the transaction price) to separate performance obligations on the basis of relative standalone selling prices. In other words, the entity allocates the transaction price to each separate performance obligation based on the proportion of the standalone selling prices of each performance obligation to the sum of the standalone selling price of all of the performance obligations in the contract.

Standalone Selling Price Exceptions

While the general rule is that the transaction price should be allocated based on the relative standalone selling prices, there are two possible exceptions. 1. When the contract includes variable consideration 2. When the discount is not related to all of the contract's performance obligations The seller should allocate variable consideration to one or more, but not all performance obligations if 2 criteria are met: 1. The terms of the variable amount relate to one or more, but not all, of the specific performance obligations. 2. Allocating the variable amount entirely to one or more, but not all, of the specific performance obligations is consistent with the objective of performing the allocation in a way that reflects a reasonable allocation of the transaction price on the basis of the standalone selling prices. 2nd exception: discount is not related to all of the contract's performance obligations Involves the allocation of a discount measured as the difference between the sum of the standalone selling prices and the transaction price. Typically, any discount should be allocated proportionately to the performance obligations based on the relative standalone selling prices. However, if an entity determines that the discount is not related to all of the performance obligations, it should only allocate the discount to the performance obligations to which it relates. Specifically, if the following three criteria are met, then the seller should allocate the discount to one or more, but not all, of the performance obligations. 1. The entity regularly sells the goods/services in the contract on a standalone basis. 2. The entity regularly sells a bundle of some of those goods/services at a discount to the sum of the standalone selling prices of the separate goods/services 3. The discount in the bundle of goods/services described in (2) is basically the same as the discount in this contract

Revenue recognition

involves issues dealing with timing (when revenue is recognized) and measurement (how much revenue is recognized). With regard to timing, the fundamental principle of revenue recognition is that a company should recognize revenue when it transfers CONTROL of an asset (either a good or service) to the customer. With regard to measurement, the fundamental principle is that a company should recognize the amount of revenue that it expects to be entitled to receive in exchange for the goods and services. Finally, the company recognizes revenue as it satisfies each performance obligation.

Expected Value Approach

the entity sums the probability-weighted amounts in a range of possible consideration amounts. This method is best suited when the entity has a large number of contracts with similar characteristics.

Most-likely amount Approach

uses the single most likely amount in a range of possible consideration amounts as the estimate. Best suited when there are only two possible outcomes.