ACCT MIS 3200: CH6 Questions for Review of Key Topics

Q 6-16 What are three methods for estimating stand-alone selling prices of goods and services that normally are not sold separately?

1. Adjusted market assessment approach: Under this approach, the seller estimates what it could sell the product or services for in the market in which it normally sells products. The seller likely would consider prices charged by competitors for similar products. 2. Expected cost plus margin approach: Under this approach, the seller estimates its costs of satisfying the performance obligation and then adds an appropriate profit margin to determine the revenue it would anticipate receiving for satisfying the performance obligation.3. Residual approach: Under this approach, the seller subtracts from the total transaction price the sum of the known or estimated stand-alone selling prices of the other performance obligations that are included in the contract to arrive at an estimate of an unknown or highly uncertain stand-alone selling price.

Q 6-19 When does a company typically recognize revenue for a bill-and-hold sale?

A bill-and-hold arrangement exists when a customer purchases goods but requests that the seller retain physical possession until a later date. The key indicator of whether control has passed from the seller to the customer for bill-and-hold arrangements is whether the customer has control of the asset. Since the customer doesn't have physical possession of the goods in a bill-and-hold arrangement, the customer isn't normally viewed as controlling the goods. However, if the customer goods are specifically identified as the customer's, and are ready for physical transfer, and the seller can't use the goods or sell them to another customer, then revenue would be recognized despite the customer not having taken physical possession of the goods.

Q 6-7 What must a contract include for the contract to exist for purposes of revenue recognition?

A contract specifies the legal rights and obligations of the seller and the customer. For a contract to exist for purposes of revenue recognition, it must: 1. Have commercial substance, affecting the risk, timing or amount of the seller's future cash flows, 2. Be approved by both the seller and the customer, indicating commitment to fulfilling their obligations, 3. Specify the seller and customer's rights regarding the goods or services to be transferred, and 4. Specify payment terms.5. Be probable that the seller will collect the amount it is entitled to receive. We normally think of a contract as being specified in a written document, but contracts can be oral rather than written. Contracts also can be implicit based on the typical business practices that a company follows. The key is that, implicitly or explicitly, the arrangement be substantive and specify the legal rights and obligations of a seller and a customer.

Q 6-2 What indicators suggest that a performance obligation has been satisfied at a single point in time?

A performance obligation is satisfied at a single point in time when control is transferred to the buyer at a single point in time. This often occurs at delivery. Five key indicators are used to decide whether control of a good or service has passed from the seller to the buyer. The customer is more likely to control a good or service if the customer has:1. An obligation to pay the seller. 2. Legal title to the asset.3. Physical possession of the asset. 4. Assumed the risks and rewards of ownership. 5. Accepted the asset. Management should evaluate these indicators individually and in combination to decide whether control has been transferred.

Q 6-3 What criteria determine whether a company can recognize revenue over time?

A performance obligation is satisfied over time if at least one of the following three criteria is met: 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, or3. The seller is creating an asset that has no alternative use to the seller, and the seller can receive payment for its progress even if the customer cancels the contract.

Q 6-13 What is the difference between a principal and an agent for determining the amount of revenue to recognize?

A principal has primary responsibility for delivering a product or service and obtains control of the goods or services before they are transferred to the customer. A principal recognizes as revenue the amount received from a customer. An agent doesn't primarily deliver goods or services, but acts as a facilitator that earns a commission for helping sellers to transact with buyers, and recognizes as revenue only the commission it receives for facilitating the sale.

Q 6-12 Is a customer's right to return merchandise a performance obligation of the seller? How should sellers account for a right of return?

A right to return merchandise is not a performance obligation. Rather, it represents a potential failure to satisfy the original performance obligation. We view a right of return as a particular type of variable consideration. A seller usually can estimate the returns that will result for a given volume of sales based on past experience. Accordingly, the seller usually recognizes revenue upon delivery, but then reduces revenue by the estimated returns. The seller reports net sales revenue in the income statement, and also reports a refund liability in the balance sheet for any additional amounts it expects to refund to customers who make returns. However, if the seller lacks sufficient information to be able to accurately estimate returns, the constraint on variable consideration applies, and the seller should recognize revenue only to the extent it is probable that a significant revenue reversal will not occur later if the estimate of returns changes. The seller might instead postpone recognizing any revenue until the uncertainty about returns is resolved.

Q 6-11 How are sellers constrained from recognizing variable consideration, and under what circumstances does the constraint apply?

A seller is constrained to recognize only the amount of revenue for which the seller believes it is probable that a significant amount of revenue won't have to be reversed (adjusted downward) in the future because of a change in that variable consideration. Indicators that variable consideration should be constrained include limited other evidence on which to base an estimate, dependence of the variable consideration on factors outside the seller's control, and a long delay between when the estimate must be made and when the uncertainty is resolved.

Q 6-27 When is an estimated loss on a long-term contract recognized, both for contracts that recognize revenue over time and those that recognize revenue at the point in time the contract is completed?

An estimated loss on a long-term contract must be fully recognized in the first period the loss becomes evident, regardless of the revenue recognition method used.

Q 6-23 Must bad debt expense be reported on its own line on the income statement? If not, how should it be disclosed?

Bad debt expense must be reported clearly either on its own line in the income statement or in the notes to the financial statements.

Q 6-17 When is revenue recognized with respect to licenses?

For licenses of symbolic intellectual property (IP), like trademarks, logos, brand names and franchise rights, sellers recognize revenue over time, because the license provides the customer with the right of access to the seller's IP with the understanding that the seller will undertake ongoing activities during the license period that benefit the customer. For licenses of functional IP, sellers typically recognize revenue at the point in time that the customer can first use the IP. Functional IP has significant standalone functionality that is not affected by the seller's ongoing activity. Examples include software, drug formulas, and media content. However, even for functional IP, sometimes sellers have to recognize revenue over time, because the seller is expected to change the functionality over the license period and the customer is required to use the updated version. In that case, even though the license involves functional IP, we view the license as transferring a right of access, and revenue must be recognized over the license period.

Q 6-25 Explain how to account for revenue on a long-term contract over time as opposed to at a point in time. Under what circumstances should revenue be recognized at the point in time a contract is completed?

If a long-term contract qualifies for revenue recognition over time, the seller recognizes a portion of the project's expected revenues and costs to each period in which construction occurs, according to the percentage of the project completed to date. If the contract does not qualify for revenue recognition over time, the seller recognizes revenue and costs when the project is complete.

Q 6-9 When a contract includes an option to buy additional goods or services, when does that option give rise to a performance obligation?

If a seller grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation only if the option provides a material right to the customer that the customer would not receive without entering into the contract. If the option provides a material right, the customer in effect pays the seller in advance for future goods or services, and the seller recognizes revenue when those future goods or services are transferred or when the option expires.

Q 6-15 When should a seller view a payment to its customer as a refund of part of the price paid by the customer for the seller's products or services?

If a seller purchases distinct goods or services from their customer and pays more than fair value for those goods or services, the excess payments are viewed as a refund of part of the price of the goods and services that the customer purchased from the seller. The excess payments are subtracted from the amount the seller is entitled to receive from the customer when calculating the transaction price of the sale to the customer.

Q 6-6 How does a seller allocate a transaction price to a contract's performance obligations?

If an arrangement has multiple performance obligations, the seller allocates the transaction price in proportion to the stand-alone selling prices of the goods or services underlying those performance obligations. If the seller can't observe actual stand-alone selling prices, the seller should estimate them.

Q 6-24 Explain the difference between contract assets, contract liabilities, and accounts receivable.

If the customer makes payment to the seller before the seller has satisfied performance obligations, the seller records a contract liability. If the seller satisfies a performance obligation before the customer has paid for it, the seller records either a contract asset or a receivable. The seller recognizes an accounts receivable if the seller has an unconditional right to receive payment, which is the case if only the passage of time is required before the payment is due. If instead the seller satisfies a performance obligation but its right to payment depends on something other than the passage of time (for example, the seller satisfying other performance obligations), the seller recognizes a contract asset.

Q 6-18 n a franchise arrangement, what are a franchisor's typical performance obligations?

In franchise arrangements, the franchisor typically has multiple performance obligations. The franchisor grants to the franchisee a right to sell the franchisor's products and services and use its name for a specified period of time. The franchisor also usually provides initial start-up services (such as identifying locations, remodeling or constructing facilities, and selling equipment and training to the franchisee). The franchisor also may provide ongoing products and services (such as franchise-branded products and advertising and administrative services). So, a franchise involves a license to use the franchisor's intellectual property, but also involves initial sales of products and services as well as ongoing sales of products and services.

Q 6-14 Under what circumstances should sellers consider the time value of money when recognizing revenue?

In general, the "time value of money" refers to the fact that money to be received in the future is less valuable than the same amount of money received now. If you have the money now, you can invest it to earn a return so the money can grow to a larger amount in the future. If payment occurs either before or after delivery, conceptually the arrangement includes a financing component. Prepayments include an element of interest expense (the seller is borrowing from the buyer between payment and delivery), while receivables include an element of interest revenue (the buyer is borrowing from the seller between payment and delivery). When delivery and payment occur relatively near each other, the financing component is not significant and can be ignored. As a practical matter, sellers can assume the financing component is not significant if the period between delivery and payment is less than a year.

Q 6-5 What characteristics make a good or service a performance obligation?

Sellers account for a promise to provide a good or service as a performance obligation if the good or service is distinct from other goods and services in the contract. The idea is to separate contracts into parts that can be viewed on a stand-alone basis. That way the financial statements can better reflect the timing of the transfer of separate goods and services and the profit earned on each one. Performance obligations that are not distinct are combined and treated as a single performance obligation. A performance obligation is distinct if it is both:1. Capable of being distinct. The customer could use the good or service on its own or in combination with other goods and services it could obtain elsewhere, and 2. Separately identifiable from other goods or services in the contract. The good or service is not highly interrelated with other goods and services in the contract.

Q 6-4 We recognize service revenue either at one point in time or over a period of time. Explain the rationale for recognizing service revenue using these two approaches.

Services typically qualify for revenue recognition over time because the customer consumes the benefit of the seller's work as it is performed. However, for convenience, even if the service qualifies for recognition of revenue over time, the seller might wait to recognize revenue until the service has been completed because it is more convenient to account for it that way. For example, if a service is delivered over days or even weeks, the seller might just wait to recognize revenue until delivery is complete rather than bothering with a more precise recognition of revenue over time. This departure from GAAP is appropriate only if the amount of revenue recognized under the departure is not materially different from the amount of revenue that would be recognized if revenue was recognized over time.

Q 6-21 When does a consignor typically recognize revenue for a consignment sale?

Sometimes a company arranges for another company to sell its product under consignment. The "consignor" physically transfers the goods to the other company (the consignee), but the consignor retains legal title. If the consignee can't find a buyer within an agreed-upon time, the consignee returns the goods to the consignor. However, if a buyer is found, the consignee remits the selling price (less commission and approved expenses) to the consignor. Because the consignor retains the risks and rewards of ownership of the product and title does not pass to the consignee, the consignor does not record revenue (and related costs) until the consignee sells the goods and title passes to the eventual customer.

Q 6-22 When does a company recognize revenue for a sale of a gift card?

Sometimes companies receive non-refundable prepayments from customers for some future good or service. That is what occurs when a company sells a gift card. The seller does not recognize revenue at the time the gift card is sold to the customer. Instead, the seller records a deferred revenue liability in anticipation of recording revenue when the gift card is redeemed. If the gift card isn't redeemed, the seller recognizes revenue when it expires or when, based on past experience, the seller has concluded that customers will not redeem it.

Q 6-26 Periodic billings to the customer for a long-term construction contract are recorded as billings on construction contract. How is this account reported in the balance sheet?

The billings on construction contract account is a contra account to the construction in progress asset. At the end of each reporting period, the balances in these two accounts are compared. If the net amount is a debit, it is reported in the balance sheet as a contract asset. Conversely, if the net amount is a credit, it is reported as a contract liability.

Q 6-1 What are the five key steps a company follows to apply the core revenue recognition principle?

The five key steps in applying the core revenue recognition principle are: 1. Identify the contract with a customer.2. Identify the performance obligation(s) in the contract.3. Determine the transaction price.4. Allocate the transaction price to the performance obligations.5. Recognize revenue when (or as) each performance obligation is satisfied.

Q 6-10 Is variable consideration included in the calculation of a contract's transaction price? If so, how is the amount of variable consideration estimated?

Variable consideration is included in the contract's transaction price when the seller believes it is probable that it won't have to reverse (adjust downward) a significant amount of revenue in the future because of a change in that variable consideration. The seller estimates the variable consideration as either the expected value or the most likely amount to be received, and includes that amount in the contract's transaction price.