Chapter 8
Revenue Recognition
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1. Revenue Recognition Basic Concepts
Revenue recognitionmost difficult issue facing accountingmost prevalent reason for accounting restatementsmost common way financial statements are fraudulently presentedrevenue is one of most important measures used by inventors to assess a company’s performancerevenue recognitionis thecornerstone of accrual accounting
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1. Revenue Recognition Basic Concepts
Definition of revenue (SFAC 6)Inflows or other enhancements of assets or settlement of liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.General recognition criteria (SFAC 5)meets definition of an elementmeasurabilityrelevancefaithful representation
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1a. Revenue Recognition Basic Concepts
APB Statement 4Revenue is recognized whenthe earnings process is complete or virtually completean exchange has taken placeRealization principle (SFAC 5)Revenue is recognized whenthe earnings process is judged to be complete or virtually completethere is reasonable certainty as to the collectability of the asset to be received
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1a. Revenue Recognition Basic Concepts
SEC SAB No. 101persuasive evidence of an arrangement existsdelivery has occurred or services have been renderedthe seller’s price to the buyer is fixed or determinablecollectability is reasonably assured
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1b. Revenue from Contracts with Customers
New standard adopted by FASB and IASBissued May 28,2014entities requiredto apply the new standard for reporting periods beginning on or after Jan.1, 2017 (now 2018)the issuing boardsagreed that this unusual length of time is appropriate because of the impact of thisprojectthis gives entitiestime to update their software systems and processes in order to capture data forcomparativesthe boards tentativelystated that entities could useanalternativetransition method that wouldrecognizethe cumulative effect of initially applying the newstandard
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1b. Revenue from Contracts with Customers
Newstandard adopts anasset-liability approachto revenuerecognitioncompaniesaccount for revenue based on the asset or liability arising from contracts withcustomersNew revenue recognition principle:revenue is recognized when the performance obligation issatisfiedFollows a five-step process
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1b. Revenue from Contracts with Customers
The five steps of revenue recognition are:Identifythe contract with customers.Identifythe separate performance obligations in the contract.Determinethe transaction price.Allocatethe transaction price to the separate performanceobligations.Recognizerevenue when each performance obligation issatisfied.
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1b. Revenue from Contracts with Customers
Identifying the Contract withCustomersacontract is an agreement between two or more parties that creates enforceable rights orobligationsrequirements for a contractthecontract has commercialsubstance(future cash flows change as a result of the contract)theparties to the contract have approved the contract and are committed to perform their respective obligations.thecompany can identify each party’s rights regarding the goods or services to be provided,andthecompany can identify the payment terms for the goods and services to be transferred.
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1b. Revenue from Contracts with Customers
Identifying the Contract withCustomersRevenue from a contract with a customer cannot be recognized until a contract exists.Donot recognize contract assets or liabilities until one or both parties to the contract perform.
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1b. Revenue from Contracts with Customers
Identifying the Contract with CustomersContractmodification -determine if a new contract and performance obligation results or whether it is a modification of the existing contractTreatedas a new contract ifbothof the following conditions are met:the promised goods or services are distinct, andthe company has the right to receive an amount of consideration that reflects the standalone selling price of the promised goods orservicesIfeitheror both of the aboveconditionsnot met,accountformodificationusing a prospectiveapproachunderthis approach, revenue is recognized using a blendedprice
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1b. Revenue from Contracts with Customers
Identify the separate performance obligations in the contract.A company must provide a distinct product or service for aperformance obligationto exist.Ifa single product or service is provided there is only one performance obligation.Ifmultiple products/services are provided and they are interdependent and interrelated, they are combined and reported as a single performance obligation.Ifthe products/services are not highly dependent or interrelated with other promises, then each performance obligation should be accounted for separately.
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1b. Revenue from Contracts with Customers
Determine the transaction price.Transactionpriceisamountcompanyexpects to receive from a customer in exchange for transferringgoods/servicesInsomecontracts,may need to consider:variableconsideration (such as discounts, rebates, bonuses,royalties)use expected value (if more than two possible outcomes) or,most likely amount (if only two possibleoutcomes)timevalue ofmoneym/b used if contract has significant financing component and time period greater than one yearnoncash considerationmeasure as fair value of what receivedconsiderationpaid or payable to thecustomeritems that will reduce the consideration received(e.g., free products, volume discounts)
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1b. Revenue from Contracts with Customers
Allocate the transaction price to the separate performance obligations.Ifmore than one performance obligationexists,an allocation of the transaction priceshouldbe based on the relative fair values of the various performanceobligationsWhen a bundle of goods/services is sold, the bundle’s selling price may be less than the sum of the individual standalone prices.If sothediscount should be allocated to the product(s) causing the discount, not to the entire bundle
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1b. Revenue from Contracts with Customers
Recognize revenue when each performance obligation is satisfied.A company satisfies its performance obligation when the customer obtains control of the good/service.Performanceobligations may be satisfied at a point in time or over a period of time.Companiesrecognize revenue over a period of time if:thecustomer controls the asset as it is created or the company does not have an alternative use for the asset,andthecompany has a right to payment.
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2. General Rule
When applying Revenue from Contracts with Customers, revenueis usuallyrecognized at the point of sale
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3. Possible Points to Recognize Revenue
Most significant eventRecognition before point of saleprior to starting productioncustomer advancesduring productionlong-term construction contractsat completion of productionprecious metals, ag productsRecognition at point of salebut if right of return exists or sale with buybackRecognition after point of salecash collection methodsinstallment sales, cost recovery basisconsignments
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4. Expense Recognition
Expense – expired economic benefitsOutflows or other using up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. (SFAC 6)Expenses to be recognized can be identified bymatchingdirect expensing (period costs)systematic allocation
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5. Revenue Frauds
Obvious accounting violationsFictitious sales or fake customersPremature recording of salesInflated salesTransactions sometimes lacking integrityRoundtrip transactionsChannel stuffing and trade loadingBill and hold transactionsRepurchase agreementsRelated party transactionsPrinciple-agent (grossing up revenue)Contracts, agreements and side letters
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6. Long-term Construction Contracts
Percentage of completion methodrevenue recognized each period based on progress of constructionthis method required ifcompany’s performance creates or enhances an asset that the customer controls,orcompany’s performance does not create an asset with an alternateuse,andcosts to complete and extent of progress toward completion are reasonably dependableIf criteria not met use completed contract method
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6a. Long-term Construction Contracts
Methods to estimate percentage of completioncost-to-cost method (input method)costs to date ÷ total estimated costs to completemost common methodmachine hours or labor hours (input measure)project milestones (output method)units of production (output method)engineer’s or architect’s estimates
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6b. Long-term Construction Contracts
Revenue and GP recognized per periodpercentage completed this period x total revenue or GPnew accountsconstruction in progress (inventory account)progress billings (contra acct to CIP)financial statement presentationnet both accounts – could be debit or credit balanceexample
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7.Completed contract method
Revenues and gross profit recognized when project finishedEntriessame entries to record costs and billingsdo not recognize revenue and gross profit each yearThe two methods are not acceptable alternativesExample
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8. Right of Return
Only recognize revenue if all of following are met sellers price is fixedbuyer has paid or is obligated to paybuyer’s obligation would not be changed by the theft or destruction of the productbuyer has economic substance apart from that provided by the sellerseller doesn’t have future significant obligationsamount of future returns can be reasonably estimated
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