CHAPTER 6 REVENUE RECOGNITION 1. Apply the ...
CHAPTER 6 REVENUE RECOGNITION 1. Apply the revenue recognition principle •
Revenue is recognized when performance is substantially complete and when collection is reasonably assured o
Performance occurs when the entity can measure the revenue and when the earnings process must be complete or substantially complete Persuasive evidence of an arrangement exists (following factors to be considered) o Customary business practice—refers to how and when the entity considers that the terms of the arrangement are finalized o Side arrangements—sometimes an entity enters into additional agreements with the customer which may modify the original transactions o Economic substance—transaction may be a consignment or financing type of transaction, in which case no revenue will be recognized, initially Delivery has occurred; seller’s price to the buyer is fixed and determinable
•
Revenues recognized: o
Performance is achieved which means Risks and rewards are transferred and/or the earnings process is substantially complete, and Measurability is reasonably assured
o
Collectability is reasonably assured
2. Describe the accounting issues associated with revenue recognition for sales of goods •
Earnings process refers to the actions that a company takes to add value
•
Often, there is one main act or critical event in the earnings process that signals substantial completion or performance o
In business that sell goods, it’s normally at point of delivery
o
•
Discrete earnings process is referred to as if the earnings process has a critical event, whether a sale has occurred at the point of delivery, it’s important to look at who has possession of the goods and who has legal title
Risks and rewards of ownership o
o
o
o
In determining who has the risks and rewards of ownership
FOB shipping point—legal title belongs to the buyer when the goods leave the shipping docks
FOB destination—legal title does not pass until the goods reach the customer’s location
Sales with buyback
if company sells inventory in one period and agrees to buy it back in the next accounting period, has the company sold the products, then 100% return
when there’s a repurchase agreement at a set price and this price covers all costs of the inventory plus related holding costs, the inventory and related liability remain on the seller’s books since the seller retains the price risk
Bill and hold transactions
Sometimes a company will sell inventory to a customer but not ship it
Why? Perhaps the customer doesn’t have room in its warehouse in the short-term, or perhaps the customer’s receiving department is on strike
EIC 141 requires that certain additional analysis be completed before recognizing revenues in this situation: •
the customer must be the one who requests it;
•
there must be a fixed commitment (written or electronic) including a delivery schedule;
•
goods must be segregated from other inventory in the warehouse and be ready to ship
Transactions with customer acceptance provisions
Customer has the right to accept or reject the inventory
o
Types: trial or evaluation basis; right of return based on subjective criteria; right of return based on seller’s or customer’s objective spcifications
Disposition of assets other than inventory
Applies to items that are disposed of through sales that are not part of the normal earnings process—e.g. sales of income-producing or capital assets
If the purchaser does not pay, legal title to the asset may return to the vendor at little or no loss to the purchaser
3. Explain the accounting for consignment sales •
The risks and rewards remain with the seller in this case, and thus, a real sale does not occur until the goods are sold to a third party
•
Special accounts separate inventory on consignment
•
Under this arrangement, the consignor (e.g., manufacturer) ships merchandise to the consignee (e.g., a dealer), who acts as an agent for the consignor in selling the merchandise o
Consignor make a profit or develop a market, consignee to make a commission on the sales
o
The company selling the goods will often use this type of distribution mechanism to encourage consignees to take their goods and sell them
•
Non-refundable fees—fees that are paid up front shouldn’t be recognized as revenues unless the earnings process is substantially complete, that it, unless the company has earned them
•
Continuing managerial involvement—the vendor retains some involvement in the product sold, such as the responsibility to fix the product if it breaks or to provide ongoing product support to the customer
•
Completion of production—revenue recognized when the sales price is reasonably assured, the units are interchangeable, and no significant costs are involved in distributing the product
4. Describe the accounting issues related to revenue recognition for services and long-term contracts
•
When services are provided, the focus is on performance of the service, and the earnings process often has numerous significant events instead of just one critical event or discrete act
•
The earnings process = ongoing or continuing earnings process
•
Businesses that provide services that are different from businesses that sell goods, since the customer is usually identified before the services are performed
•
Two different accounting methods for long-term construction contracts are recognized: o
Percentage-of-completion method—revenues and gross profit are recognized each period based on the construction progress
o
Completed-contract method—revenues and gross profit are recognized only when the contract is completed
o
Used when there is a continuous earnings process
Used when there’s a discrete earnings process or a continuous earnings process but the revenues are not measurable
Debit inventory account (construction in process) and credit contra inventory account (billings on construction in process)
5. Apply the percentage-of-completion method for long-term contracts •
Its method recognizes revenues, costs, and gross profit as progress is made toward completion on a long-term contract
•
Measuring process toward completion requires significant judgment
•
o
Input measures—costs incurred, labor hours worked
o
Output measures—tons produced, storeys of a building completed, km of a high way completed
Input measure method—cost-to-cost method—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 o
•
(cost incurred to date/most recent estimate of total costs) = % complete
Formula for total revenue to be recognized to date:
o •
Formula for amount of current period revenue, cost-to-cost basis: o
•
% complete X estimated total revenue (or gross profit) = revenue (or gross profit)
Revenue (gross profit) to be recognized to date – revenue recognized in prior periods = current period revenue (or gross profit)
Pg.300 s
6. Apply the completed-contract method for long-term contracts •
Under this method, 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 bit recognized until the end of the contract
7. Account for losses on long-term contracts (pg.303) •
•
Two types of losses: o
Loss in current period on a profitable contract—this condition occurs when there’s a significant increase in the estimated total contract costs during construction but the increase does not eliminate all profit on the contract
o
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
Pg. 305 to see the journal entries
8. Understand when to book sales net versus gross •
Although net income doesn’t change if a company chooses to report revenues as the gross amount billed to the customer (as well as the related cost of goods sold) instead of the net amount retained, the revenues number changes
•
In analyzing this issue (a presentation issue), these should be considered: o
Whether the company acts as a principal in the transaction or an agent or broker (who is buying and selling an item for commission)
o
Whether the company takes title to the goods being sold
o
Whether the company has the risks and rewards of ownership of the goods being sold
9. Discuss how to deal with measurement uncertainty •
This results from an inability to measure the consideration itself—in some barter transactions—or an inability to measure returns
•
Sales with right of return o Whether cash or credit, returns in many industries are frequently done either trough a right of contract or as a matter of practice, involving guaranteed sales agreement or consignments o Certain situations prevent revenue recognition when there’s a right of return even though title to the goods has passed (e.g., if the price is not fixed or determinable, if the buyer’s obligation to pay is excuse until the buyer resells, consumes, or uses the product, if the returns are not estimable) o Price protection—if the purchase price goes down before the customer has resold the product, the vendor will provide a cash refund o Fully refundable fees—recognized as revenues as long as the entity is able to estimate the amount of refunds and the estimates are being made for a large pool of homogeneous items o Revenues related to cancellable sales arrangement shouldn’t be recognized until the cancellation privileges have expired, because the cancellation period is seen as a trial period
•
Trade loading and channel stuffing o
Overstates sales in one period and distort operating results
o
Producers induce their wholesale customers (a.k.a. trade) to buy more product than they could resell—as a result, the wholesalers would return significant amounts of product in the following period
•
Bundled sales (a.k.a. multiple element arrangements) o
When the sale creates multiple deliverables, such as a product and service or several products and/or services, the revenue should be allocated between the deliverables
o
Deliverable treated as separate unit of accounting if:
o
10.
Each deliverable has value to the customer on a stand-alone basis
Undelivered deliverable has a value that can be determined objectively
Completion of the contract is probable and within the control of the vendor (if there’s a general right of return)
If separate units, then allocate the overall price to each unit using:
Relative fair value method—the fair value of each item is determined and then the purchase price is allocated based on the relative fair values
Residual value method—the fair value of the undelivered item would be subtracted from the overall purchase price; residual value used to value the delivered item
Discuss how to deal with collection uncertainty
•
When collectability cannot be reasonably assured, revenues cannot be recognized
•
If collectability is established but the uncollectible amounts cannot be estimated, use: o
Installment sales method
o
Cost recovery method
•
These methods allow revenue recognition upfront but gross profits are deferred
•
Because of the greater risk to collectability, various devices are used to protect the seller: o
The use of a conditional sales contract that provides that title to the item sold doesn’t pass to the purchaser until all payments have been made
o
Use of notes secured by a chattel (personal property) mortgage on the article sold
11.
Explain and apply the installment sales method of accounting
•
It emphasizes collection rather than a sale, recognizing income in the collection periods rather than the sale period
•
When there’s no reasonable approach for estimating the degree of collectability, income should not be recognized until cash is collected
•
Record operating expenses without considering that a portion of the year’s gross profit will be deferred
•
Pg. 313
12.
Explain and apply the cost recovery method of accounting
•
No profit is recognized until cash payments by the buyer add up to more than the seller’s cost for the merchandise sold
•
Under the cost recovery method, total revenue and cost of goods sold are reported in the period of sale, similar to the installment sales method. However, unlike the installment sales method, which recognizes income as cash is collected, the cost recovery method recognizes profit only when cash collections exceed the total cost of the goods sold
•
Pg.319
Revenue is recognized when performance is substantially complete and when collection is reasonably assured o
Performance occurs when the entity can measure the revenue and when the earnings process must be complete or substantially complete Persuasive evidence of an arrangement exists (following factors to be considered) o Customary business practice—refers to how and when the entity considers that the terms of the arrangement are finalized o Side arrangements—sometimes an entity enters into additional agreements with the customer which may modify the original transactions o Economic substance—transaction may be a consignment or financing type of transaction, in which case no revenue will be recognized, initially Delivery has occurred; seller’s price to the buyer is fixed and determinable
•
Revenues recognized: o
Performance is achieved which means Risks and rewards are transferred and/or the earnings process is substantially complete, and Measurability is reasonably assured
o
Collectability is reasonably assured
2. Describe the accounting issues associated with revenue recognition for sales of goods •
Earnings process refers to the actions that a company takes to add value
•
Often, there is one main act or critical event in the earnings process that signals substantial completion or performance o
In business that sell goods, it’s normally at point of delivery
o
•
Discrete earnings process is referred to as if the earnings process has a critical event, whether a sale has occurred at the point of delivery, it’s important to look at who has possession of the goods and who has legal title
Risks and rewards of ownership o
o
o
o
In determining who has the risks and rewards of ownership
FOB shipping point—legal title belongs to the buyer when the goods leave the shipping docks
FOB destination—legal title does not pass until the goods reach the customer’s location
Sales with buyback
if company sells inventory in one period and agrees to buy it back in the next accounting period, has the company sold the products, then 100% return
when there’s a repurchase agreement at a set price and this price covers all costs of the inventory plus related holding costs, the inventory and related liability remain on the seller’s books since the seller retains the price risk
Bill and hold transactions
Sometimes a company will sell inventory to a customer but not ship it
Why? Perhaps the customer doesn’t have room in its warehouse in the short-term, or perhaps the customer’s receiving department is on strike
EIC 141 requires that certain additional analysis be completed before recognizing revenues in this situation: •
the customer must be the one who requests it;
•
there must be a fixed commitment (written or electronic) including a delivery schedule;
•
goods must be segregated from other inventory in the warehouse and be ready to ship
Transactions with customer acceptance provisions
Customer has the right to accept or reject the inventory
o
Types: trial or evaluation basis; right of return based on subjective criteria; right of return based on seller’s or customer’s objective spcifications
Disposition of assets other than inventory
Applies to items that are disposed of through sales that are not part of the normal earnings process—e.g. sales of income-producing or capital assets
If the purchaser does not pay, legal title to the asset may return to the vendor at little or no loss to the purchaser
3. Explain the accounting for consignment sales •
The risks and rewards remain with the seller in this case, and thus, a real sale does not occur until the goods are sold to a third party
•
Special accounts separate inventory on consignment
•
Under this arrangement, the consignor (e.g., manufacturer) ships merchandise to the consignee (e.g., a dealer), who acts as an agent for the consignor in selling the merchandise o
Consignor make a profit or develop a market, consignee to make a commission on the sales
o
The company selling the goods will often use this type of distribution mechanism to encourage consignees to take their goods and sell them
•
Non-refundable fees—fees that are paid up front shouldn’t be recognized as revenues unless the earnings process is substantially complete, that it, unless the company has earned them
•
Continuing managerial involvement—the vendor retains some involvement in the product sold, such as the responsibility to fix the product if it breaks or to provide ongoing product support to the customer
•
Completion of production—revenue recognized when the sales price is reasonably assured, the units are interchangeable, and no significant costs are involved in distributing the product
4. Describe the accounting issues related to revenue recognition for services and long-term contracts
•
When services are provided, the focus is on performance of the service, and the earnings process often has numerous significant events instead of just one critical event or discrete act
•
The earnings process = ongoing or continuing earnings process
•
Businesses that provide services that are different from businesses that sell goods, since the customer is usually identified before the services are performed
•
Two different accounting methods for long-term construction contracts are recognized: o
Percentage-of-completion method—revenues and gross profit are recognized each period based on the construction progress
o
Completed-contract method—revenues and gross profit are recognized only when the contract is completed
o
Used when there is a continuous earnings process
Used when there’s a discrete earnings process or a continuous earnings process but the revenues are not measurable
Debit inventory account (construction in process) and credit contra inventory account (billings on construction in process)
5. Apply the percentage-of-completion method for long-term contracts •
Its method recognizes revenues, costs, and gross profit as progress is made toward completion on a long-term contract
•
Measuring process toward completion requires significant judgment
•
o
Input measures—costs incurred, labor hours worked
o
Output measures—tons produced, storeys of a building completed, km of a high way completed
Input measure method—cost-to-cost method—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 o
•
(cost incurred to date/most recent estimate of total costs) = % complete
Formula for total revenue to be recognized to date:
o •
Formula for amount of current period revenue, cost-to-cost basis: o
•
% complete X estimated total revenue (or gross profit) = revenue (or gross profit)
Revenue (gross profit) to be recognized to date – revenue recognized in prior periods = current period revenue (or gross profit)
Pg.300 s
6. Apply the completed-contract method for long-term contracts •
Under this method, 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 bit recognized until the end of the contract
7. Account for losses on long-term contracts (pg.303) •
•
Two types of losses: o
Loss in current period on a profitable contract—this condition occurs when there’s a significant increase in the estimated total contract costs during construction but the increase does not eliminate all profit on the contract
o
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
Pg. 305 to see the journal entries
8. Understand when to book sales net versus gross •
Although net income doesn’t change if a company chooses to report revenues as the gross amount billed to the customer (as well as the related cost of goods sold) instead of the net amount retained, the revenues number changes
•
In analyzing this issue (a presentation issue), these should be considered: o
Whether the company acts as a principal in the transaction or an agent or broker (who is buying and selling an item for commission)
o
Whether the company takes title to the goods being sold
o
Whether the company has the risks and rewards of ownership of the goods being sold
9. Discuss how to deal with measurement uncertainty •
This results from an inability to measure the consideration itself—in some barter transactions—or an inability to measure returns
•
Sales with right of return o Whether cash or credit, returns in many industries are frequently done either trough a right of contract or as a matter of practice, involving guaranteed sales agreement or consignments o Certain situations prevent revenue recognition when there’s a right of return even though title to the goods has passed (e.g., if the price is not fixed or determinable, if the buyer’s obligation to pay is excuse until the buyer resells, consumes, or uses the product, if the returns are not estimable) o Price protection—if the purchase price goes down before the customer has resold the product, the vendor will provide a cash refund o Fully refundable fees—recognized as revenues as long as the entity is able to estimate the amount of refunds and the estimates are being made for a large pool of homogeneous items o Revenues related to cancellable sales arrangement shouldn’t be recognized until the cancellation privileges have expired, because the cancellation period is seen as a trial period
•
Trade loading and channel stuffing o
Overstates sales in one period and distort operating results
o
Producers induce their wholesale customers (a.k.a. trade) to buy more product than they could resell—as a result, the wholesalers would return significant amounts of product in the following period
•
Bundled sales (a.k.a. multiple element arrangements) o
When the sale creates multiple deliverables, such as a product and service or several products and/or services, the revenue should be allocated between the deliverables
o
Deliverable treated as separate unit of accounting if:
o
10.
Each deliverable has value to the customer on a stand-alone basis
Undelivered deliverable has a value that can be determined objectively
Completion of the contract is probable and within the control of the vendor (if there’s a general right of return)
If separate units, then allocate the overall price to each unit using:
Relative fair value method—the fair value of each item is determined and then the purchase price is allocated based on the relative fair values
Residual value method—the fair value of the undelivered item would be subtracted from the overall purchase price; residual value used to value the delivered item
Discuss how to deal with collection uncertainty
•
When collectability cannot be reasonably assured, revenues cannot be recognized
•
If collectability is established but the uncollectible amounts cannot be estimated, use: o
Installment sales method
o
Cost recovery method
•
These methods allow revenue recognition upfront but gross profits are deferred
•
Because of the greater risk to collectability, various devices are used to protect the seller: o
The use of a conditional sales contract that provides that title to the item sold doesn’t pass to the purchaser until all payments have been made
o
Use of notes secured by a chattel (personal property) mortgage on the article sold
11.
Explain and apply the installment sales method of accounting
•
It emphasizes collection rather than a sale, recognizing income in the collection periods rather than the sale period
•
When there’s no reasonable approach for estimating the degree of collectability, income should not be recognized until cash is collected
•
Record operating expenses without considering that a portion of the year’s gross profit will be deferred
•
Pg. 313
12.
Explain and apply the cost recovery method of accounting
•
No profit is recognized until cash payments by the buyer add up to more than the seller’s cost for the merchandise sold
•
Under the cost recovery method, total revenue and cost of goods sold are reported in the period of sale, similar to the installment sales method. However, unlike the installment sales method, which recognizes income as cash is collected, the cost recovery method recognizes profit only when cash collections exceed the total cost of the goods sold
•
Pg.319
