Chapter 6 Revenue Recognition Notes
Chapter 6 Revenue Recognition Notes Understanding the Nature of Sales Transactions from a Business Perspective Economics of Business Transactions Reciprocal Nature—What is being received? • by assuming that the transactions are at arm’s length, i.e., they are between unrelated parties, then it may also be assumed that the value of what is given up usually approximates the value of what is received in the transaction • sales agreements normally specify what is being given up and what is being acquired as follows: o acquired—consideration or rights to the consideration; the amount, nature, and timing are normally agree upon o given up—goods/services (now or in the future); delivery details (quantities, nature, timing, shipping terms) are agreed upon • consideration that s non-monetary (as with barter transactions) presents greater challenges for accounting purposes • barter or non-monetary transactions are where few or no monetary assets are received as consideration when goods/services are sold • generally, a barter transaction is seen as a sale if the transaction has commercial substance • commercial substance means that the transaction is a bona fide purchase and sae and that the entity has entered into the transaction for business purposes, exchanging one type of asset or service for another different asset or service (dissimilar) • after the transaction, the entity will be in a different position and its future cash flows are expected to change significantly as a result of the transaction (in terms of timing, amount, and/or riskiness) • the risk that the price of an asset will change is referred to as a price risk Concessionary Terms—Are the terms of sale normal or is this a special deal? • in some cases, one party is in a better bargaining position than the other • care must be taken to identify concessionary (or abnormal) terms in any deal as they may complicate the accounting • concessionary terms are terms that are more lenient than usual and are meant to induce sales • concessionary or abnormal terms may create additional obligations or may reflect the fact that the risks and rewards or control has not yet passed to the customer; some of these situations may even indicate that no sale has taken place at all Normal Selling Terms Concessionary Selling Terms Payment terms Sell for cash or on credit. If credit, payment is Terms that are more lenient than this; e.g., usually expected within 30 to 60 days. o selling on credit where the buyer does not have to pay for 90 days or more, or o instalment sales where these are not normal industry practice Extension of credit Sell to customers that are creditworthy Sales to customers that are riskier than the existing customer base. Shipping terms including bill and Ship when ordered and ready to ship. Ship at later date; e.g., entity may hold inventory hold in its warehouse for extended period. Additional services or continuing Once shipped and legal title passes, no Extended right of return/warranty period, cash involvement in assets sold continuing involvement except for normal rights flow guarantee on future rental of building sold, of return and/or standard warranties. profit guarantees on future resale or buyback provisions.
Legalities Contract Law • a contract with customers is an agreement that creates enforceable obligations and establishes the terms of the deal • there is a promissor (the seller), a promissee (the customer), and an agreement • thus, the act of entering into a sales agreement creates legal rights and obligations • in addition, the contract establishes the point in time when legal title passes (entitlement/ownership under law) • when the customer takes physical possession of the goods straight away, legal title would normally pass at this point • if the goods are shipped, the point at which legal title passes is often evidenced by the shipping terms as follows: o FOB shipping point—means title passes at the point of shipment o FOB destination—means title passes when the asset reaches the customer Other • in many cases, entity may have an implicit obligation even if it is not explicitly noted in a selling contract—constructive obligation • a constructive obligation is an obligation that is created through past practice or by signalling something to potential customers • constructive obligations are often enforceable under common or other law • any enforceable promise that results from the sale (whether explicit or implicit) may create a performance obligation that needs to be recognized in the balance sheet; this includes both contractual and other promises
Accounting for Sales Transactions—Recognition and Measurement • • • • •
realization is the process of converting noncash resources and rights into money from an accounting perspective, there are 2 conceptual views of how to account for revenues: earnings, and contract-based approach the earnings approach focuses on the earnings process and how a company adds value for its customers the contract-based approach focuses on the contractual rights and obligations created by sales contracts in all cases, in order to properly account for the transaction, there should be persuasive evidence of the sales arrangement
•
evidence might consist of a contract (written or verbal), an invoice, or both
Earnings Approach General Principle • under this approach, revenues are recognized when: performance is substantially complete, and collection is reasonably assured • performance occurs when an entity can measure the revenue (and costs) and when it has substantially accomplished what it must do to be entitled to the benefits of the revenues—that is, the earnings process must be complete or substantially complete • revenues are recognized when the following criteria are met: 1) Performance is achieved, which means a) the risks and rewards are transferred and/or the earnings process is substantially complete (normally when a product is delivered or services are provided), and b) measurability is reasonably assured (price is fixed/determinable) 2) Collectability is reasonably assured • earnings process is a term that refers to the actions that a company takes to add value • the concept of risks and rewards (benefits) of ownership is a core concept in the earnings approach to revenue recognition • it helps to establish ownership and to indicate when ownership passes from one party to another
•
in determining who has the risks and rewards of ownership and, therefore, whether a sale has occurred at the point of delivery, it is important to look at who has possession of the goods and who has legal title • when services are provided, the focus is on performance of the service • the accounting is more complex where the earnings process has numerous significant events (continuous earnings process) • two methods of accounting for long-term construction and other service contracts are generally recognized: 1) Percentage-of-Completion Method. Revenues and gross profit are recognized each period based on construction progress—in other words, the percentage of completion. This makes the most sense in long-term service contracts when it is the service that is being provided to build something or work on something that is owned by the customer (numerous significant events). 2) Completed-Contract Method. Revenues and gross profit are recognized only when the contract is completed. This makes the most sense when the service consists of a single significant event or the item being built/constructed is owned by the company building/constructing it. In this latter case, it is more like building/constructing inventory and then selling it and recognizing revenues when it is complete. It may also make sense to use this method when there are measurement problems. Problems with the Earnings Approach • the following points reflect some of the problems with the earnings approach: o Multiple and sometimes conflicting guidance. o The earnings approach is difficult to apply, since there are different views on what the earnings process is and when revenues are earned. Both the OSC and SEC review financial statements regularly and find that there are problems with how revenues are accounted for. In addition, many large corporate frauds have involved revenue recognition. o In many cases, the risks and rewards are split between the buyer and the seller. So it is difficult to determine definitively just who has the risks and rewards. o It is felt that this approach requires too much subjective judgment. o This approach does not deal with when receivables should be booked if the revenues are not yet earned.
Contract-Based Approach General Principle • the emphasis is on the balance sheet, although it is not exclusively a balance sheet approach; this approach focuses on measuring the rights and obligations under sales contracts and recognizes revenues when these rights and obligations change • model focuses on contractual and other rights and obligations created by the sales contract and analyzes the performance criteria for revenue recognition from the perspective of the customer considering whether the obligations under the contract have been fulfilled • under this approach, the contract is recognized when: (1) the entity becomes party to the contract, (2) the contractual rights are collectible/measurable, and (3) the performance obligation is measurable • the net amount of the contractual rights and obligations is known as the net contract position • because of reciprocity and assuming an arm’s-length transaction, the initial value of the net contract position should normally be nil • the net contract position is recognized when the entity becomes party to the contract and when the contractual rights and performance obligations are measurable (including credit risk) • revenues are recognized when control of the related assets passes (for assets sold) and when performance occurs for services
Measurability
General Principle • under either method, revenues should only be recognized if the transaction is measurable • sales are generally measured at fair value, which is represented by the value of the consideration received or receivable • where the sale is on credit and the repayment term extends over a longer period (and the receivable is non-interest-bearing or the interest rate is below market rate), the receivable should be discounted to reflect the time value of money • for barter transactions, if the fair value of the consideration is not available, the fair value of the product/service sold is used as long as the sale has commercial substance and is reciprocal Measurement Uncertainty • measurement uncertainty results from an inability to measure the transaction or parts of the transaction
• • • •
this might arise for the following reasons—(1) inability to measure the consideration; (2) inability to measure related costs; and (3) inability to measure the outcome of the transaction itself care should be taken to analyze external factors such as obsolescence, business or economic cycles, the financial health of customers, and the arrival of a competitor’s products that may cause the company’s products to become obsolete two alternative revenue recognition treatments are available where there is measurement uncertainty—(1) do not record a sale if it is not measurable; and (2) record sale, but attempt to measure and accrue amount relating to uncertainty as cost or reduced revenues the second treatment is preferred under accrual accounting
Collectibility General Principle • at the point of sale, if it is reasonably sure that collection of the receivable will ultimately occur (or it is probable that economic benefits will flow to the entity), revenues are recognized under both methods • as long as it is possible to estimate uncollectible amounts at the point of sale (perhaps based on historical data), the sale is booked and the potential uncollectible amount is accrued • alternatively, when collectibility cannot be reasonably assured, revenues cannot be recognized • in these cases, it is presumed that if collectibility is not established at the time of sae, then in substance no real sale has been made
Mechanics
Percentage-of-Completion Method • percentage-of-completion method recognizes revenues, costs, and gross profit as progress is made toward completion on LT contract • measuring progress toward completion requires significant judgment • the various measures are identified and classified as either input measures (efforts that have been devoted to a contract) or output measures (measures results), but neither can be applied to all long-term projects • one of most popular input measures used to determine progress toward completion is cost, sometimes referred to as cost-to-cost basis • under the cost-to-cost basis, the percentage of completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract percent complete = costs incurred to date / most recent estimate of total costs • the percentage of cost incurred out of total estimated costs is then applied to the total revenue or the estimated total gross profit on the contract to arrive at the revenue or the gross profit amounts to be recognized to date percent complete × estimated total revenue (or gross profit) = revenue (or gross profit) to be recognized to date • to find the amount of revenue and gross profit that will be recognized in each period: revenue (or gross profit) to be recognized to date – revenue (or gross profit) recognized in prior periods = current period revenue (or gross profit) Losses on Long-Term Contracts • two types of losses an occur under long-term contracts: 1) Loss in Current Period on a Profitable Contract. This condition occurs when there is a significant increase in the estimated total contracts cost during construction but the increase does not eliminate all profit on the contract. Under the percentage-ofcompletion method only, the increase in the estimated cost requires an adjustment in the current period for the excess gross profit that was recognized on the project in prior periods. This adjustment is recorded as a loss in the current period because it is a change in accounting estimate. 2) Loss on an Unprofitable Contract. Cost estimates at the end of the current period may indicate that a loss will result once the contract is completed. Under both the percentage-of-completion and completed-contract methods, the entire loss that is expected on the contract must be recognized in the current period.
IFRS/Private Entity GAAP Comparison Analysis • • • • • •
biased reporting is possible under both a principles-based accounting standards system (because there is less specific guidance) and a rules-based accounting standards system (by finding loopholes in the rules) revenues are a key number used to judge management’s job performance and they are signal in marketplace of sustainable growth revenue recognition is one of the main areas of misrepresentation it is often difficult to spot such misrepresentation in financial statements, since the note disclosures are often very general it is therefore important to carefully understand the company’s underlying business and business model and to ensure that any changes in the business model are reflected appropriately in the statements care should also be taken to ensure that large and unusual transactions are entered into for bona fide business reasons rather than to make the company’s performance look better than it really is
Summary of Learning Objectives 1. Understand the economics and legalities of selling transactions from a business perspective.
2.
It is critical to understand a transaction from a business perspective before attempting to account for it. The analysis should begin with what is being sold to the customer (goods or services) and note also the nature and amount of the consideration. When one party is in a better bargaining position than the other, it may be able to negotiate concessions such as more lenient payment terms. These concessions often complicate the accounting as they introduce measurement uncertainty in many cases. Selling transactions are based on contractual arrangements between a buyer and a seller. Contracts create rights and obligations under law that must be considered when accounting for the transactions. In addition to contractual law, rights and obligations may exist under other forms of the law, e.g., common law or statutory law. These should also be considered. Understand the conceptual difference between an earnings approach and a contract-based approach for accounting purposes.
3. 4.
5.
6.
7.
8.
9.
10.
11.
The earnings approach focuses on the earnings process and how a company adds value whereas the contract-based approach focuses on the creation of contractual rights and obligations created by sales contracts. Identify and apply revenue recognition principles under the earnings approach. Under this approach, revenue is recognized when performance is substantially complete (risks and rewards have passed and the earnings process sis substantially complete and measurable) and collection is reasonably assured. Identify and apply revenue recognition principles under the contract-based approach. Under this approach, there are two recognition points: (1) when to recognize the net contract position, and (2) when to recognize the related revenue in the income statement. The net contract position is first recognized when the contract is entered into. Revenue is recognized when performance occurs. This is when control passes if goods are involved or when the service is provided/performance obligation is extinguished. The accounting should also take into account measurement and collection uncertainty. Discuss issues relating to measurement and measurement uncertainty. Revenue may only be recognized when measurable. There are many reasons that measurement uncertainty exists including inability to measure the revenue itself (e.g., barter transactions or price protection clauses) and inability to measure costs or uncertainty relating to the outcomes of the contract itself (contingencies). In the latter case, extreme uncertainty may indicate that the contract or business deal has not yet been completed. Where the sale involves more than one element, e.g., goods and services, then the selling price must be allocated to the respective parts of the sale using an allocation method such as the relative fair value method or residual method. Understand how to account for sales where there is collection uncertainty. Collectibility issues also create measurement uncertainty and must be considered when recognizing and measuring sales transactions. When collectibility cannot be assured and/or the related revenue is not measurable in terms of collection or credit risk, then no sale is booked. Prepare journal entries for consignment sales under the earnings and contract-based approaches. Under the earnings approach, the risks and rewards remain with the seller and, therefore, a real sale does not occur until the goods are sold to a third party. Special accounts separate inventory on consignment. Under the contract-based approach, the consigner contracts with the consignee for selling services. The consignee would book the net contract position and recognize revenues when the services are provided (upon sale to the customer). The consigner would book the sales contract when the contract is entered into by the customer and the revenues when the control to the goods passes to the customer. This would likely result in the same journal entries as under the earnings approach, assuming that the contract is entered into at the same time as when control over the goods sold is passed to the customer. Apply the percentage-of-completion method under the earnings and contract-based approaches. To apply the percentage-of-completion method to long-term contracts, a basis is needed for measuring the progress toward completion at particular interim dates. One of the most popular input measures that is used to determine the progress toward completion is the cost-to-cost basis. Using this basis, the percentage of completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract. The percentage of the total estimated costs that the costs incurred amount to is applied to the total revenue or the estimated total gross profit on the contract to arrive at the revenue or the gross profit amounts to be recognized to date. The journal entries would differ under the earnings approach as compared with the contract-based approach since the net contract position would be recognized when the contract is initially entered into the latter. There is no need to separately account for billings under the contract-based approach. Apply the completed-contract method under the earnings and contract-based approaches. Under the earnings approach, revenue and gross profit are recognized only when the contract is completed. Costs of long-term contracts in process and current billings are accumulated, but there are no interim charges or credits to income statement accounts for revenues, costs, and gross profit. The annual entries to record costs of construction, progress billings, and collections from customers would be identical to those for the percentage-of-completion method, with one significant exception: revenue and gross profit are not recognized until the end of the contract. Under the contract-based approach, this method is not relevant since the net contract would be booked when the contract is entered into and if a customer has been identified, the revenues would be recognized as the services were performed and control over the asset was passed to the customer. Where legal title to the asset being constructed is not passed over to the customer until the end o the contract, the transaction is treated like a sale of goods, with revenue being booked at the end when the goods are “sold”. Therefore, the journal entries would be essentially the same as under the percentage-of-completion method (contract-based approach) except for the revenue recognition entries. Understand how to prevent sales transactions in the income statement. Transactions where the seller is acting as principal in the sale should be accounted for on a gross basis. Where the seller is acting as an agent (putting buyers and sellers together), the transaction should be booked on a net basis. Consideration should be given to whether the seller has the risks and rewards of ownership of the product being sold. Transactions are treated as revenues when they relate to ordinary activities of the entity. They are treated as gains when they deal with ancillary activities. In general, revenues and gains are booked to net income except in very limited circumstances. Understand the impact of accounting choices on key numbers/ratios. “Revenues” is a key number on the financial statements. It is used to judge management’s job performance and is an indicator of sustainable growth potential. For this reason, revenues are sometimes manipulated in the financial statements. Care should be taken to ensure that the revenues recognized reflect economic reality. Having said this, there are differing conceptual views on when and how revenues should be recognized.
12. Discuss current trends in standard setting for revenue recognition. IASB and FASB are currently studying a new model for revenue recognition—the contract-based model, which is felt to be conceptually superior.
Legalities Contract Law • a contract with customers is an agreement that creates enforceable obligations and establishes the terms of the deal • there is a promissor (the seller), a promissee (the customer), and an agreement • thus, the act of entering into a sales agreement creates legal rights and obligations • in addition, the contract establishes the point in time when legal title passes (entitlement/ownership under law) • when the customer takes physical possession of the goods straight away, legal title would normally pass at this point • if the goods are shipped, the point at which legal title passes is often evidenced by the shipping terms as follows: o FOB shipping point—means title passes at the point of shipment o FOB destination—means title passes when the asset reaches the customer Other • in many cases, entity may have an implicit obligation even if it is not explicitly noted in a selling contract—constructive obligation • a constructive obligation is an obligation that is created through past practice or by signalling something to potential customers • constructive obligations are often enforceable under common or other law • any enforceable promise that results from the sale (whether explicit or implicit) may create a performance obligation that needs to be recognized in the balance sheet; this includes both contractual and other promises
Accounting for Sales Transactions—Recognition and Measurement • • • • •
realization is the process of converting noncash resources and rights into money from an accounting perspective, there are 2 conceptual views of how to account for revenues: earnings, and contract-based approach the earnings approach focuses on the earnings process and how a company adds value for its customers the contract-based approach focuses on the contractual rights and obligations created by sales contracts in all cases, in order to properly account for the transaction, there should be persuasive evidence of the sales arrangement
•
evidence might consist of a contract (written or verbal), an invoice, or both
Earnings Approach General Principle • under this approach, revenues are recognized when: performance is substantially complete, and collection is reasonably assured • performance occurs when an entity can measure the revenue (and costs) and when it has substantially accomplished what it must do to be entitled to the benefits of the revenues—that is, the earnings process must be complete or substantially complete • revenues are recognized when the following criteria are met: 1) Performance is achieved, which means a) the risks and rewards are transferred and/or the earnings process is substantially complete (normally when a product is delivered or services are provided), and b) measurability is reasonably assured (price is fixed/determinable) 2) Collectability is reasonably assured • earnings process is a term that refers to the actions that a company takes to add value • the concept of risks and rewards (benefits) of ownership is a core concept in the earnings approach to revenue recognition • it helps to establish ownership and to indicate when ownership passes from one party to another
•
in determining who has the risks and rewards of ownership and, therefore, whether a sale has occurred at the point of delivery, it is important to look at who has possession of the goods and who has legal title • when services are provided, the focus is on performance of the service • the accounting is more complex where the earnings process has numerous significant events (continuous earnings process) • two methods of accounting for long-term construction and other service contracts are generally recognized: 1) Percentage-of-Completion Method. Revenues and gross profit are recognized each period based on construction progress—in other words, the percentage of completion. This makes the most sense in long-term service contracts when it is the service that is being provided to build something or work on something that is owned by the customer (numerous significant events). 2) Completed-Contract Method. Revenues and gross profit are recognized only when the contract is completed. This makes the most sense when the service consists of a single significant event or the item being built/constructed is owned by the company building/constructing it. In this latter case, it is more like building/constructing inventory and then selling it and recognizing revenues when it is complete. It may also make sense to use this method when there are measurement problems. Problems with the Earnings Approach • the following points reflect some of the problems with the earnings approach: o Multiple and sometimes conflicting guidance. o The earnings approach is difficult to apply, since there are different views on what the earnings process is and when revenues are earned. Both the OSC and SEC review financial statements regularly and find that there are problems with how revenues are accounted for. In addition, many large corporate frauds have involved revenue recognition. o In many cases, the risks and rewards are split between the buyer and the seller. So it is difficult to determine definitively just who has the risks and rewards. o It is felt that this approach requires too much subjective judgment. o This approach does not deal with when receivables should be booked if the revenues are not yet earned.
Contract-Based Approach General Principle • the emphasis is on the balance sheet, although it is not exclusively a balance sheet approach; this approach focuses on measuring the rights and obligations under sales contracts and recognizes revenues when these rights and obligations change • model focuses on contractual and other rights and obligations created by the sales contract and analyzes the performance criteria for revenue recognition from the perspective of the customer considering whether the obligations under the contract have been fulfilled • under this approach, the contract is recognized when: (1) the entity becomes party to the contract, (2) the contractual rights are collectible/measurable, and (3) the performance obligation is measurable • the net amount of the contractual rights and obligations is known as the net contract position • because of reciprocity and assuming an arm’s-length transaction, the initial value of the net contract position should normally be nil • the net contract position is recognized when the entity becomes party to the contract and when the contractual rights and performance obligations are measurable (including credit risk) • revenues are recognized when control of the related assets passes (for assets sold) and when performance occurs for services
Measurability
General Principle • under either method, revenues should only be recognized if the transaction is measurable • sales are generally measured at fair value, which is represented by the value of the consideration received or receivable • where the sale is on credit and the repayment term extends over a longer period (and the receivable is non-interest-bearing or the interest rate is below market rate), the receivable should be discounted to reflect the time value of money • for barter transactions, if the fair value of the consideration is not available, the fair value of the product/service sold is used as long as the sale has commercial substance and is reciprocal Measurement Uncertainty • measurement uncertainty results from an inability to measure the transaction or parts of the transaction
• • • •
this might arise for the following reasons—(1) inability to measure the consideration; (2) inability to measure related costs; and (3) inability to measure the outcome of the transaction itself care should be taken to analyze external factors such as obsolescence, business or economic cycles, the financial health of customers, and the arrival of a competitor’s products that may cause the company’s products to become obsolete two alternative revenue recognition treatments are available where there is measurement uncertainty—(1) do not record a sale if it is not measurable; and (2) record sale, but attempt to measure and accrue amount relating to uncertainty as cost or reduced revenues the second treatment is preferred under accrual accounting
Collectibility General Principle • at the point of sale, if it is reasonably sure that collection of the receivable will ultimately occur (or it is probable that economic benefits will flow to the entity), revenues are recognized under both methods • as long as it is possible to estimate uncollectible amounts at the point of sale (perhaps based on historical data), the sale is booked and the potential uncollectible amount is accrued • alternatively, when collectibility cannot be reasonably assured, revenues cannot be recognized • in these cases, it is presumed that if collectibility is not established at the time of sae, then in substance no real sale has been made
Mechanics
Percentage-of-Completion Method • percentage-of-completion method recognizes revenues, costs, and gross profit as progress is made toward completion on LT contract • measuring progress toward completion requires significant judgment • the various measures are identified and classified as either input measures (efforts that have been devoted to a contract) or output measures (measures results), but neither can be applied to all long-term projects • one of most popular input measures used to determine progress toward completion is cost, sometimes referred to as cost-to-cost basis • under the cost-to-cost basis, the percentage of completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract percent complete = costs incurred to date / most recent estimate of total costs • the percentage of cost incurred out of total estimated costs is then applied to the total revenue or the estimated total gross profit on the contract to arrive at the revenue or the gross profit amounts to be recognized to date percent complete × estimated total revenue (or gross profit) = revenue (or gross profit) to be recognized to date • to find the amount of revenue and gross profit that will be recognized in each period: revenue (or gross profit) to be recognized to date – revenue (or gross profit) recognized in prior periods = current period revenue (or gross profit) Losses on Long-Term Contracts • two types of losses an occur under long-term contracts: 1) Loss in Current Period on a Profitable Contract. This condition occurs when there is a significant increase in the estimated total contracts cost during construction but the increase does not eliminate all profit on the contract. Under the percentage-ofcompletion method only, the increase in the estimated cost requires an adjustment in the current period for the excess gross profit that was recognized on the project in prior periods. This adjustment is recorded as a loss in the current period because it is a change in accounting estimate. 2) Loss on an Unprofitable Contract. Cost estimates at the end of the current period may indicate that a loss will result once the contract is completed. Under both the percentage-of-completion and completed-contract methods, the entire loss that is expected on the contract must be recognized in the current period.
IFRS/Private Entity GAAP Comparison Analysis • • • • • •
biased reporting is possible under both a principles-based accounting standards system (because there is less specific guidance) and a rules-based accounting standards system (by finding loopholes in the rules) revenues are a key number used to judge management’s job performance and they are signal in marketplace of sustainable growth revenue recognition is one of the main areas of misrepresentation it is often difficult to spot such misrepresentation in financial statements, since the note disclosures are often very general it is therefore important to carefully understand the company’s underlying business and business model and to ensure that any changes in the business model are reflected appropriately in the statements care should also be taken to ensure that large and unusual transactions are entered into for bona fide business reasons rather than to make the company’s performance look better than it really is
Summary of Learning Objectives 1. Understand the economics and legalities of selling transactions from a business perspective.
2.
It is critical to understand a transaction from a business perspective before attempting to account for it. The analysis should begin with what is being sold to the customer (goods or services) and note also the nature and amount of the consideration. When one party is in a better bargaining position than the other, it may be able to negotiate concessions such as more lenient payment terms. These concessions often complicate the accounting as they introduce measurement uncertainty in many cases. Selling transactions are based on contractual arrangements between a buyer and a seller. Contracts create rights and obligations under law that must be considered when accounting for the transactions. In addition to contractual law, rights and obligations may exist under other forms of the law, e.g., common law or statutory law. These should also be considered. Understand the conceptual difference between an earnings approach and a contract-based approach for accounting purposes.
3. 4.
5.
6.
7.
8.
9.
10.
11.
The earnings approach focuses on the earnings process and how a company adds value whereas the contract-based approach focuses on the creation of contractual rights and obligations created by sales contracts. Identify and apply revenue recognition principles under the earnings approach. Under this approach, revenue is recognized when performance is substantially complete (risks and rewards have passed and the earnings process sis substantially complete and measurable) and collection is reasonably assured. Identify and apply revenue recognition principles under the contract-based approach. Under this approach, there are two recognition points: (1) when to recognize the net contract position, and (2) when to recognize the related revenue in the income statement. The net contract position is first recognized when the contract is entered into. Revenue is recognized when performance occurs. This is when control passes if goods are involved or when the service is provided/performance obligation is extinguished. The accounting should also take into account measurement and collection uncertainty. Discuss issues relating to measurement and measurement uncertainty. Revenue may only be recognized when measurable. There are many reasons that measurement uncertainty exists including inability to measure the revenue itself (e.g., barter transactions or price protection clauses) and inability to measure costs or uncertainty relating to the outcomes of the contract itself (contingencies). In the latter case, extreme uncertainty may indicate that the contract or business deal has not yet been completed. Where the sale involves more than one element, e.g., goods and services, then the selling price must be allocated to the respective parts of the sale using an allocation method such as the relative fair value method or residual method. Understand how to account for sales where there is collection uncertainty. Collectibility issues also create measurement uncertainty and must be considered when recognizing and measuring sales transactions. When collectibility cannot be assured and/or the related revenue is not measurable in terms of collection or credit risk, then no sale is booked. Prepare journal entries for consignment sales under the earnings and contract-based approaches. Under the earnings approach, the risks and rewards remain with the seller and, therefore, a real sale does not occur until the goods are sold to a third party. Special accounts separate inventory on consignment. Under the contract-based approach, the consigner contracts with the consignee for selling services. The consignee would book the net contract position and recognize revenues when the services are provided (upon sale to the customer). The consigner would book the sales contract when the contract is entered into by the customer and the revenues when the control to the goods passes to the customer. This would likely result in the same journal entries as under the earnings approach, assuming that the contract is entered into at the same time as when control over the goods sold is passed to the customer. Apply the percentage-of-completion method under the earnings and contract-based approaches. To apply the percentage-of-completion method to long-term contracts, a basis is needed for measuring the progress toward completion at particular interim dates. One of the most popular input measures that is used to determine the progress toward completion is the cost-to-cost basis. Using this basis, the percentage of completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract. The percentage of the total estimated costs that the costs incurred amount to is applied to the total revenue or the estimated total gross profit on the contract to arrive at the revenue or the gross profit amounts to be recognized to date. The journal entries would differ under the earnings approach as compared with the contract-based approach since the net contract position would be recognized when the contract is initially entered into the latter. There is no need to separately account for billings under the contract-based approach. Apply the completed-contract method under the earnings and contract-based approaches. Under the earnings approach, revenue and gross profit are recognized only when the contract is completed. Costs of long-term contracts in process and current billings are accumulated, but there are no interim charges or credits to income statement accounts for revenues, costs, and gross profit. The annual entries to record costs of construction, progress billings, and collections from customers would be identical to those for the percentage-of-completion method, with one significant exception: revenue and gross profit are not recognized until the end of the contract. Under the contract-based approach, this method is not relevant since the net contract would be booked when the contract is entered into and if a customer has been identified, the revenues would be recognized as the services were performed and control over the asset was passed to the customer. Where legal title to the asset being constructed is not passed over to the customer until the end o the contract, the transaction is treated like a sale of goods, with revenue being booked at the end when the goods are “sold”. Therefore, the journal entries would be essentially the same as under the percentage-of-completion method (contract-based approach) except for the revenue recognition entries. Understand how to prevent sales transactions in the income statement. Transactions where the seller is acting as principal in the sale should be accounted for on a gross basis. Where the seller is acting as an agent (putting buyers and sellers together), the transaction should be booked on a net basis. Consideration should be given to whether the seller has the risks and rewards of ownership of the product being sold. Transactions are treated as revenues when they relate to ordinary activities of the entity. They are treated as gains when they deal with ancillary activities. In general, revenues and gains are booked to net income except in very limited circumstances. Understand the impact of accounting choices on key numbers/ratios. “Revenues” is a key number on the financial statements. It is used to judge management’s job performance and is an indicator of sustainable growth potential. For this reason, revenues are sometimes manipulated in the financial statements. Care should be taken to ensure that the revenues recognized reflect economic reality. Having said this, there are differing conceptual views on when and how revenues should be recognized.
12. Discuss current trends in standard setting for revenue recognition. IASB and FASB are currently studying a new model for revenue recognition—the contract-based model, which is felt to be conceptually superior.
