Intermediate Accounting Exam 2

The Five Key Steps in Applying the Core Revenue Recognition Principle

1. Identify the contract with a customer 2. Identify the performance obligation in the contract 3. Determine the transaction price 4. Allocate the transaction price to each performance obligation 5. Recognize revenue when (or as) each performance obligation is satisfied

Determine whether a contract exists, and whether some frequently encountered features of contracts qualify as performance obligations.

A contract exists when it has commercial substance and all parties to the contract are committed to performing the obligations and enforcing the rights that it specifies. Performance obligations are promises by the seller to transfer goods or services to a customer. A promise to transfer a good or service is a separate performance obligation if it is DISTINCT, which is the case if it is both CAPABLE OF BEING DISTINCT (meaning that the customer could use the good or service on its own or in combination with other goods and services it could obtain elsewhere), and IT IS SEPARATELY IDENTIFIABLE (meaning that the good or service is not highly interrelated with other goods and services in the contract, so it is distinct in the context of the contract). Prepayments, rights to return merchandise, and normal quality-assurance warranties do not qualify as performance obligations, because they don't transfer a good or service to the customer. On the other hand, extended warranties and customer options to receive goods or services in some preferred manner (for example, at a discount) qualify as performance obligations.

Allocate a contract's transaction price to multiple performance obligations.

A contract's transaction price is allocated to its performance obligations. The allocation is based on the STAND-ALONE SELLING PRICES of the goods and services underlying those performance obligations. The stand-alone selling price must be estimated if a good or service is not sold separately.

State the Core Revenue Recognition Principle

Companies recognize revenue when goods or services are transferred to customers for the amount the company expects to be entitled to receive in exchange for those goods or services

Understand and apply rules for measurement of inventory at the end of the reporting period.

Companies that use FIFO, average cost, or any other method besides LIFO or the retail inventory method report inventory at the lower of cost or net realizable vale (NRV). Net realizable value is selling price less costs to sell. Companies that use LIFO or the retail inventory method report inventory at the lower of cost or market. Market equals replacement cost, except that market should not(a) be greater than NRV (ceiling) or(b) be less than NRV minus an approximately normal profit margin (floor)

Explain which physical units of goods should be included in inventory.

Generally, determining the physical quantity that should be included in inventory is a simple matter, because it consists of items in the possession of the company. However, at the end of a reporting period it's important to determine the ownership of goods that are in transit between the company and its suppliers. Also, goods on consignment should be included in inventory of the consignor even though the company doesn't not have physical possession of the goods. In addition, a company anticipating sales returns includes in inventory the cost of merchandise it estimates will be returned.

Distinguish between the gross and net methods of accounting for cash discounts.

Gross Method adds on the sales discount whenever the sale discount is applied but the total amount is first reported. Net Method adds on the sales discount when first shown and if discount is forfeited then the adjustment would be made

Explain the appropriate accounting treatment required when an inventory error is discovered.

Most changes in inventory methods are reported retrospectively. This means revising all previous periods' financial statements to appear as if the newly adopted inventory method had been applied all along. An exception is a change to the LIFO method. In this case, it usually is impossible to calculate the income effect on prior years. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. As a result, a company changing to LIFO usually does not report the change retrospectively. Instead, the LIFO method simply is used from that point on.

Differentiate between the specific identification, FIFO, LIFO, and average cost methods used to determine the cost of ending inventory and cost of goods sold.

Once costs are determined, the cost of goods available for sale must be allocated between costs of goods sold and ending inventory. Unless each item is specifically identified and traced through the system, the allocation requires an assumption regarding the flow of costs. First-in, first-out (FIFO) assumes that units sold are the first units acquired. Last-in, first-out (LIFO) assumes that the units sold are the most recent units purchased. The average cost method assumes that cost of goods sold and ending inventory consists of a mixture of all the goods available for sale.

Explain when it is appropriate to recognize revenue over a period of time.

Revenue is recognized over time if either: 1. The customer consumes the benefit of the seller's work as it is performed 2. The customer controls the asset as it is created 3. The seller is creating an asset that has no alternative use to the seller, and the seller has the legal right to receive payment for progress to date,

Explain when it is appropriate to recognize revenue at a single point in time.

Revenue will be recognized at a single point in time when there's an obligation to pay the seller, the legal title to the asset has been transferred, the physical possession of the asset is transferred, the buyer has assumed the risks and rewards of ownership, or had accepted the asset.

Account for transactions that affect net purchases and prepare a cost of goods sold schedule.

The cost of inventory includes all expenditures necessary to acquire the inventory and bring it to its desired condition and location for sale or use. Generally, these expenditures include the purchase price of the goods reduced by any returns and purchase discounts, plus freight-in charges.

Estimate ending inventory and cost of goods sold using the retail inventory method, applying the various cost flow methods.

The gross profit method estimates cost of goods sold which is then subtracted from cost of goods available for sale to estimate ending inventory. The estimate of cost of goods sold is determined by subtracting an estimate of gross profit from net sales. The estimate of cost of goods sold is determined by subtracting an estimate of gross profit form net sales. The estimate of gross profit is determined by multiplying the historical gross profit ratio times net sales.

Describe the accounting treatment for merchandise returns.

To avoid overstating the gross profit, We create an account for sales returns, which is debited, and a refund liability, which is credited, with the estimate of how much we expect our goods would be returned.

Understand how variable consideration and other aspects of contracts affect the calculation and allocation of the transaction price.

When a contract includes consideration that depends on the outcome of future events, sellers estimate that variable consideration and include it in the contract's transactions price. The seller's estimate is based either on the most likely outcome or the expected value of the outcome. However, a constraint applies - variable consideration only should be included in the transaction price to the extent it is probable that a significant revenue reversal will not occur. The estimate of variable consideration is updated each period to reflect changes in circumstances. A seller also needs to determine if it is a principal (and recognizes as revenue the amount received from the customer) or an agent (and recognizes its commission as revenue), consider time value of money, and consider the effect of any payments by the seller to the customer. Once the transaction price is estimated, we allocate it to performance obligations according to their stand-alone selling prices, which can be estimated using the adjusted market assessment approach, the expected cost plus margin approach, or the residual approach.