Chapter 18 Intermediate Accounting: Questions

34. What are the two basic methods of accounting for long-term construction contracts? Indicate the circumstances that determine when one or the other of these methods should be used.

*34. For the most part, companies recognize revenue at the point of sale because that is when the performance obligation is satisfied. Under certain circumstances, companies recognize revenue over time. The most notable context in which revenue is recognized over time is long-term construction contract accounting. Long-term contracts frequently provide that the seller (builder) may bill the purchaser at intervals, as it reaches various points in the project. A company satisfies a performance obligation and recognizes revenue over time if at least one of the following three criteria is met: 1. The customer simultaneously receives and consumes the benefits of the entity's performance as the entity performs. 2. The company's performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced; or 3. The company's performance does not create an asset with an alternative use. For example, the asset cannot be used by another customer. In addition to this alternative use element, at least one of the following criteria must be met: (a) Another company would not need to substantially re-perform the work the company has completed to date if that other company were to fulfill the remaining obligation to the customer. (b) The company has a right to payment for its performance completed to date, and it expects to fulfill the contract as promised. Therefore, if criterion 1 or 2 is met, then a company recognizes revenue over time if it can reasonably estimate its progress toward satisfaction of the performance obligations. That is, it recognizes revenues and gross profits each period based upon the progress of the construction—referred to as the percentage-of-completion method. The rationale for using percentage-of-completion accounting is that under most of these contracts the buyer and seller have enforceable rights. The buyer has the legal right to require specific performance on the contract. The seller has the right to require progress payments that provide evidence of the buyer's ownership interest. As a result, a continuous sale occurs as the work progresses. Companies should recognize revenue according to that progression. The right to payment for performance completed to date does not need to be for a fixed amount. However, the company must be entitled to an amount that would compensate the company for performance completed to date (even if the customer can terminate the contract for reasons other than the company's failure to perform as promised). Alternatively, if the criteria for recognition over time are not met (e.g., the company does not have a right to payment for work completed to date), the company recognizes revenues and gross profit at a point in time, that is, when the contract is completed. This approach is referred to as the completed-contract method.

35. For what reasons should the percentage-of-completion method be used over the completed-contract method whenever possible?

*35. Under the percentage-of-completion method, income is reported to reflect more accurately the production effort. Income is recognized periodically on the basis of the percentage of the job completed rather than only when the entire job is completed. The principal disadvantage of the completed-contract method is that it may lead to distortion of earnings because no attempt is made to reflect current performance when the period of the contract extends into more than one accounting period. The percentage-of-completion method recognizes revenues, costs, and gross profit as a company makes progress toward completion on a long-term contract. To defer recognition of these items until completion of the entire contract is to misrepresent the efforts (costs) and accomplishments (revenues) of the accounting periods during the contract.

36. What methods are used in practice to determine the extent of progress toward completion? Identify some "input measures" and some "output measures" that might be used to determine the extent of progress.

*36. The methods used to determine the extent of progress toward completion are the cost-to-cost method and units-of-delivery method. Costs incurred and labor hours worked are examples of input measures, while tons produced, stories of a building completed, and miles of highway completed are examples of output measures.

37. What are the two types of losses that can become evident in accounting for long-term contracts? What is the nature of each type of loss? How is each type accounted for?

*37. The two types of losses that can become evident in accounting for long-term contracts are: (1) A current period loss involved in a contract that, upon completion, is expected to produce a profit. (2) A loss related to an unprofitable contract. The first type of loss is actually an adjustment in the current period of gross profit recognized on the contract in prior periods. It arises when, during construction, there is a significant increase in the estimated total contract costs but the increase does not eliminate all profit on the contract. Under the percentage-of-completion method, the estimated cost increase necessitates a current period adjustment of previously recognized gross profit; the adjustment results in recording a current period loss. No adjustment is necessary under the completed-contract method because gross profit is only recognized upon completion of the contract. Cost estimates at the end of the current period may indicate that a loss will result upon completion of the entire contract. Under both percentage-of-completion and completed contract methods, the entire loss must be recognized in the current period.

38. Why in franchise arrangements may it be improper to recognize the entire franchise fee as revenue at the date of sale?

*38. It is improper to recognize the entire franchise fee as revenue at the date of sale when many of the services of the franchisor are yet to be performed.

39. How should a franchisor account for continuing franchise fees and routine sales of equipment and supplies to franchisees?

*39. Continuing franchise fees should be reported as revenue when the performance obligations related to those fees have been satisfied by the franchisor. These revenues are generally recognized over time as the related product and services are provided. Continuing product sales would be accounted for in the same manner as would any other product sales.

1. Explain the current environment regarding revenue recognition.

1. Most revenue transactions pose few problems for revenue recognition. This is because, in many cases, the transaction is initiated and completed at the same time. However, due to the complexity of some transactions, many believe the revenue recognition process is increasingly complex to manage, more prone to error, and more material to financial statements compared to any other area of financial reporting. In addition, even with the many standards, no comprehensive guidance was provided for service transactions. As a result, the FASB and IASB have indicated that the present state of reporting for revenue is unsatisfactory and the Boards issued a standard, "Revenue from Contracts with Customers". This new standard provides a new approach for how and when companies should report revenue. The standard is comprehensive and applies to all companies. As a result, comparability and consistency in reporting revenue should be enhanced.

10. When must multiple performance obligations in a revenue arrangement be accounted for separately?

10. To determine whether a performance obligation exists, the company must provide a distinct product or service to the customer. To determine whether a company has to account for multiple performance obligations, the company's promise to sell the good or service to the customer must be separately identifiable from other promises within the contract (that is, the good or service must be distinct within the contract). In other words, the objective is to determine whether the nature of a company's promise is to transfer individual goods and services to the customer or to transfer a combined item (or items) for which individual goods or services are inputs.

11. Engelhart Implements Inc. sells tractors to area farmers. The price for each tractor includes GPS positioning service for 9 months (which facilitates field settings for planting and harvesting equipment). The GPS service is regularly sold on a standalone basis by Engelhart for a monthly fee. After the 9-month period, the consumer can renew the service on a fee basis. Does Engelhart have one or multiple performance obligations? Explain.

11. In this situation, it appears that Engelhart has two performance obligations: (1) one related to providing the tractor and (2) the other related to the GPS services. Both are distinct (they can be sold separately) and are not interdependent.

12. What is the transaction price? What additional factors related to the transaction price must be considered in determining the transaction price?

12. The transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring goods and services. The transaction price in a contract is often easily obtained because the customer agrees to pay a fixed amount to the company over a short period of time. In other contracts, companies must consider the following factors (1) Variable consideration, (2) Time value of money, (3) Noncash consideration, and (4) Consideration paid or payable to customer.

13. What are some examples of variable consideration? What are the two approaches for estimating variable consideration?

13. Variable consideration (when the price of a good or service is dependent on future events), includes such elements as price or volume discounts, rebates, credits, performance bonuses, or royalties. A company estimates the amount of variable consideration it will receive from the contract to determine the amount of revenue to recognize. Companies use either (1) the expected value, which is a probability weighted amount, or (2) the most likely amount in a range of possible amounts to estimate variable consideration. Companies select among these two methods based on which approach better predicts the amount of consideration to which a company is entitled.

14. Allee Corp. is evaluating a revenue arrangement to determine proper revenue recognition. The contract is for construction of 10 speedboats for a contract price of $400,000. The customer needs the boats in its showrooms by February 1, 2018, for the boat purchase season; the customer provides a bonus payment of $21,000 if all boats are delivered by the February 1 deadline. The bonus is reduced by $7,000 each week that the boats are delivered after the deadline until no bonus is paid if the boats are delivered after February 15, 2018. Allee frequently includes such bonus terms in it contracts and thus has good historical data for estimating the probabilities of completion at different dates. It estimates an equal probability (25%) for each full delivery outcome. What approach should Allee use to determine the transaction price for this contract? Explain.

14. The transaction price should include management's estimate of the amount of consideration to which the entity will be entitled. Given the multiple outcomes and probabilities available based on prior experience, the probability-weighted method is the most predictive approach for estimating the variable consideration. In this situation: 25% chance of $421,000 if by February 1 (25% X $421,000) = $ 105,250 25% chance of $414,000 if by February 8 (25% X $414,000) = 103,500 25% chance of $407,000 if by February 15 (25% X $407,000) = 101,750 25% chance of $400,000 if after February 15 (25% X $400,000) = 100,000 $ 410,500 Thus, the total transaction price is $410,500 based on the probability-weighted estimate.

15. Refer to the information in Question 14. Assume that Allee has limited experience with a construction project on the same scale as the 10 speedboats. How does this affect the accounting for the variable consideration?

15. Allee should only allocate variable consideration to the performance obligation if it is reasonably assured that it will be entitled to that amount. In this case, it does not have experience with similar contracts and is not able to estimate the cumulative amount of revenue. Allee should not recognize revenue at this time. Allee is constrained in recognizing variable consideration as there might be a significant reversal of revenue previously recognized.

16. In measuring the transaction price, explain the accounting for (a) time value of money, and (b) noncash consideration.

16. In measuring the transaction price, companies make the following adjustment for: (a) Time value of money - When a sales transaction involves a significant financing component (that is, interest is accrued on consideration to be paid over time), the fair value (transaction price) 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 will report the effects of the financing either as interest expense or interest revenue.

17. What is the proper accounting for volume discounts on sales of products?

17. Any discounts or volume rebates should reduce consideration received and reduce revenue recognized.

18. On what basis should the transaction price be allocated to various performance obligations? Identify the approaches for allocating the transaction price.

18. If an allocation of transaction price to various performance obligations is needed, the allocation is based on what the company could sell the good or service on a standalone basis (referred to as the standalone selling price). If this information is not available, companies should use their best estimate of what the good or service might sell for as a standalone unit. The three approaches for estimating standalone selling price are (1) Adjusted market assessment approach; (2) Expected cost plus a margin approach, and (3) Residual approach.

19. Fuhremann Co. is a full-service manufacturer of surveillance equipment. Customers can purchase any combination of equipment, installation services, and training as part of Fuhremann's security services. Thus, each of these performance obligations are separate with individual standalone selling prices. Laplante Inc. purchased cameras, installation, and training at a total price of $80,000. Estimated standalone selling prices of the equipment, installation, and training are $90,000, $7,000, and $3,000, respectively. How should the transaction price be allocated to the equipment, installation, and training?

19. Since each element sells separately and has a separate standalone selling price, the equipment, installation, and training are three separate performance obligations. The total revenue of $80,000 should be allocated to the three performance obligations based on their relative standalone selling price. Thus, the total estimated selling price is $100,000 ($90,000 + $7,000 + $3,000). The allocation is as follows. Equipment ($90,000 ÷ $100,000) X $80,000 = $72,000. Installation ($7,000 ÷ $100,000) X $80,000 = $5,600. Training ($3,000 ÷ $100,000) X $80,000 = $2,400.

2. What was viewed as a major criticism of GAAP as it relates to revenue recognition?

2. GAAP had numerous standards related to revenue recognition, but many believed the standards were often inconsistent with one another.

20. When does a company satisfy a performance obligation? Identify the indicators of satisfaction of a performance obligation.

20. A company satisfies its performance obligation when the customer obtains control of the good or service. Indications that the customer has obtained control are: 1. The company has a right to payment for the asset. 2. The company transferred legal title to the asset. 3. The company transferred physical possession of the asset. 4. The customer has the significant risks and rewards of ownership. 5. The customer has accepted the asset.

21. Under what conditions does a company recognize revenue over a period of time?

21. Companies satisfy performance obligations either at a point in time or over a period of time. Companies recognize revenue over a period of time if one of the following three criteria is met: 1. The customer receives and consumes the benefits as the seller performs. 2. The customer controls the asset as it is created or enhanced (e.g., a builder constructs a building on a customer's property). 3. The company does not have an alternative use for the asset created or enhanced (e.g., an aircraft manufacturer builds specialty jets to a customer's specifications) and either (a) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (b) the company has a right to payment and this right is enforceable.

22. How do companies recognize revenue from a performance obligation over time?

22. A company recognizes revenue from a performance obligation over time by measuring the progress toward completion. The method selected for measuring progress should depict the transfer of control from the company to the customer. The most common are the cost-to-cost and units-of-delivery methods. The objective of these methods is to measure the extent of progress in terms of costs, units, or value added. Companies identify the various measures (costs incurred, labor hours worked, tons produced, floors completed, etc.) and classify them as input or output measures. Input measures (costs incurred, labor hours worked) are efforts devoted to a contract. Output measures (with units of delivery measured as tons produced, floors of a building completed, miles of a highway completed) track results. Neither is universally applicable to all long-term projects. Their use requires the exercise of judgment and careful tailoring to the circumstances. The most popular input measure used to determine the progress toward completion is the cost-to-cost basis. Under this basis, a company measures the percentage of completion by comparing costs incurred to date with the most recent estimate of the total costs required to complete the contract.

23. Explain the accounting for sales with right of return.

23. To account for sales with rights of return, (and for some services that are provided subject to a refund), companies generally recognize all of the following. a. Revenue for the transferred products in the amount of consideration to which seller is reasonably assured to be entitled considering the products expected to be returned or allowances granted. b. An asset (and corresponding adjustment to cost of goods sold) for its right to recover inventory from the customer. If the company is unable to reliably estimate the level of returns, it should not report revenue until the returns are predictable.

24. What are the reporting issues in a sale with a repurchase agreement?

24. If a company sells a product in one period and agrees to buy it back in the next period, legal title may have transferred, but the economic substance of the transaction is that the seller retains the risks of ownership. When companies enter into repurchase agreements, they are allowed to transfer an asset to a customer but have an unconditional (forward) obligation or unconditional right (call option) to repurchase the asset at a later date. In these situations, the question is whether the company sold the asset. Generally, companies report these transactions as a financing (borrowing). That is, if the company has a forward obligation or call option to repurchase the asset for an amount greater than or equal to its selling price, then the transaction is a financing transaction.

25. Explain a bill-and-hold sale. When is revenue recognized in these situations?

25. Bill-and-hold sales result when the buyer is not yet ready to take delivery but the buyer takes title and accepts billing. Revenue is recognized at the time title passes, if all of the following criteria are met and the control provisions related to revenue recognition are met: (a) The reason for the bill-and-hold arrangement must be substantive. (b) The product must be identified separately as belonging to the customer. (c) The product currently must be ready for physical transfer to the customer. (d) The seller cannot have the ability to use the product or to direct it to another customer.

26. Explain a principal-agent relationship and its significance to revenue recognition.

26. In a principal-agent relationship, the principal's performance obligation is to provide goods or perform services for a customer. The agent's performance obligation is to arrange for the principal to provide these goods or services to a customer. In a principal-agent relationship, amounts collected on behalf of the principal are not revenue of the agent. The revenue for the agent is the amount of the commission it receives (usually a percentage of the selling price or total revenue).

27. What is the nature of a sale on consignment?

27. A sale on consignment is the shipment of merchandise from a manufacturer (or wholesaler) to a dealer (or retailer) with title to the goods and the risk of sale being retained by the manufacturer who becomes the consignor. The consignee (dealer) is expected to exercise due diligence in caring for the merchandise and the dealer has full right to return the merchandise. The consignee receives a commission upon the sale and remits the balance of the cash collected to the consignor. The consignor recognizes a sale and the related revenue upon notification of sale from the consignee and receipt of the cash. The consigned goods are carried in the consignor's inventory, not the consignee's, until sold.

28. What are the two types of warranties? Explain the accounting for each type.

28. The two types of warranties are: a. Warranties that the product meets agreed-upon specifications in the contract at the time the product is sold. This type of warranty is included in the sale price of the company's product and is often referred to as an assurance-type warranty. b. Warranties that provide an additional service beyond the assurance-type warranty. This warranty is not included in the sale price of the product and is referred to as a service-type warranty. Companies do not record a separate performance obligation for assurance-type warranties. These types of warranties are nothing more than a quality guarantee that the good or service is free from defects at the point of sale. These types of obligations should be expensed in the period the goods are provided or services performed. In addition, the company should record a warranty liability. The estimated amount of the liability includes all the costs that the company will incur after sale and that are incident to the correction of defects or deficiencies required under the warranty provisions. Warranties that provide the customer a service beyond fixing defects that existed at the time of sale represent a separate service and are an additional performance obligation. As a result, companies should allocate a portion of the transaction price to this performance obligation. The company recognizes revenue in the period that the service type warranty is in effect.

29. Campus Cellular provides cell phones and 1 year of cell service to students for an upfront, nonrefundable fee of $300 and a usage fee of $5 per month. Students may renew the service for each year they are on campus (on average, students renew their service one time). What amount of revenue should Campus Cellular recognize in the first year of the contract?

29. The total transaction price is $420 [$300 + ($5 X 24)]. That is, Campus Cellular is providing a service in the second year without receiving an upfront fee. Thus the upfront fee should be recognized as revenue over two periods. As a result, Campus Cellular recognizes revenue of $210 ($420 ÷ 2) in both year 1 and year 2.

3. Describe the revenue recognition principle.

3. The revenue recognition principle indicates that revenue is recognized in the accounting period when a performance obligation is satisfied. That is, a company recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services.

30. Describe the conditions when contract assets and liabilities are recognized and presented in financial statements.

30. Under the asset-liability model for recognizing revenue, companies recognize assets and liabilities according to the definitions of assets and liabilities in a revenue arrangement. For example, when a company has a right to consideration for meeting a performance obligation, it has a right to consideration from the customer and therefore has a contract asset. A contract liability is a company's obligation to transfer goods or services to a customer for which the company has received consideration from the customer. Thus, if the customer performs first, by prepaying for the product, then the seller has a contract liability. Companies must present these contract assets and contract liabilities on their balance sheet. Contract assets are of two types: (a) Unconditional rights to receive consideration because the company has satisfied its performance obligation with the customer, and (b) Conditional rights to receive consideration because the company has satisfied one performance obligation, but must satisfy another performance obligation in the contract before it can bill the customer. Companies should report unconditional rights to receive consideration as a receivable on the balance sheet. Conditional rights on the balance sheet (e.g., unbilled receivables) should be reported separately as contract assets.

31. Explain the accounting for contract modifications.

31. A contract modification occurs if a company changes the contract terms during the term of the contract. When a contract is modified, the company must determine whether a new performance obligation has occurred or whether it is a modification of the existing performance obligation. If it is a modification of an existing performance obligation, then the change is generally reported prospectively or as a cumulative effect adjustment to revenue, depending on the circumstances. If the modification results in a separate performance obligation, then this performance obligation should be accounted for separately.

32. Explain the reporting for (a) costs to fulfill a contract and (b) collectibility

32. (a) Companies divide fulfillment costs (contract acquisition costs) into two categories: (1) those that give rise to an asset, and (2) those that are expensed as incurred. Companies recognize an asset for the incremental costs, if these costs are incurred to obtain a contract with a customer. In other words, incremental costs are costs that a company would not incur if the contract had not been obtained (for example, selling commissions). Other examples are: (a) Direct labor, direct materials, and allocation of costs that relate directly to the contract (such as costs of contract management and supervision, insurance, and depreciation of tools and equipment), and (b) Costs that generate or enhance resources of the company that will be used in satisfying performance obligations in the future. Costs include intangible design or engineering costs that will continue to benefit in the future. Companies capitalize costs that are direct, incremental, and recoverable (assuming that the contract period is more than one year). (b) Collectibility - Any time a company sells a product or performs a service on account, a collectibility issue occurs. Collectibility refers to a customer's credit risk, that is, the risk that a customer will be unable to pay the amount of consideration in accordance with the contract. Under the revenue guidance—as long as a contract exists (it is probable that the customer will pay)—the amount recognized as revenue is not adjusted for customer credit risk. Thus, companies report the revenue gross (without consideration of credit risk) and then present an allowance for any impairment due to bad debts recognized initially and subsequently in accordance with the respective bad debt guidance). An impairment related to bad debts is reported as an operating expense in the income statement. Whether a company will get paid for satisfying a performance obligation is not a consideration in determining revenue recognition.

33. What qualitative and quantitative disclosures are required related to revenue recognition?

33. The disclosure requirements for revenue recognition are designed to help financial statement users understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. To achieve that objective, companies disclose qualitative and quantitative information about all of the following: • Contracts with Customers - These disclosures include the disaggregation of revenue, presentation of opening and closing balances in contract assets and contract liabilities, and significant information related to their performance obligations. • Significant judgments. These disclosures include judgments and changes in these judgments that affect the determination of the transaction price, the allocation of the transaction price, and the determination of the timing of revenue. • Assets recognized from costs incurred to fulfill a contract. These disclosures include the closing balances of assets recognized to obtain or fulfill a contract, the amount of amortization recognized, and the method used for amortization.

4. Identify the five steps in the revenue recognition process.

4. The five steps in the revenue recognition process are: 1. Identify the contract(s) 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.

5. Describe the critical factor in evaluating whether a performance obligation is satisfied.

5. Change in control is the deciding factor in determining when a performance obligation is satisfied. Control is transferred when the customer has the ability to direct the use of and obtain substantially all the remaining benefits from the asset or service. Control is also indicated if the customer has the ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service.

6. When is revenue recognized in the following situations? (a) Revenue from selling products, (b) revenue from services performed, (c) revenue from permitting others to use company assets, and (d) revenue from disposing of assets other than products.

6. Revenues are recognized generally as follows: (a) Revenue from selling products—date of delivery to customers. (b) Revenue from services performed—when the services have been performed (performance obligation satisfied). (c) Revenue from permitting others to use company assets—as time passes or as the assets are used. (d) Revenue from disposing of assets other than products—at the date of sale.

7. Explain the importance of a contract in the revenue recognition process.

7. The first step in the revenue recognition process is the identification of a contract or contracts with the customer. A contract is an agreement between two or more parties that creates enforceable rights or obligations. That is, the contract identifies the performance obligations in a revenue arrangement. Contracts can be written, oral, or implied from customary business practice. In some cases, there may be multiple contracts related to the transaction, and accounting for each contract may or may not occur, depending on the circumstances. These situations often develop when not only a product is provided but some type of service is performed as well.

8. On October 10, 2017, Executor Co. entered into a contract with Belisle Inc. to transfer Executor's specialty products (sales value of $10,000, cost of $6,500) on December 15, 2017. Belisle agrees to make a payment of $5,000 upon delivery and signs a promissory note to pay the remaining balance on January 15, 2018. What entries does Executor make in 2017 on this contract? Ignore time value of money considerations.

8. No entry is required on October 10, 2017, because neither party has performed on the contract. That is, neither party has an unconditional right as of October 10, 2017. On December 15, 2017, Executor delivers the product and therefore should recognize revenue on that date as it satisfied its performance obligation on that date. The journal entry to record the sales revenue and related cost of goods sold is as follows. December 15, 2017 Notes Receivable 5,000 Cash 5,000 .....Sales Revenue 10,000 Cost of Goods Sold 6,500 .....Inventory 6,500

9. What is a performance obligation? Under what conditions does a performance obligation exist?

9. A performance obligation is a promise in a contract to provide a product or service to a customer. This promise may be explicit, implicit, or possibly based on customary business practice. To determine whether a performance obligation exists, the company must determine whether the customer can benefit from the good or service on its own or together with other readily available resources.