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11 CHAPTER 5

REVENUE RECOGNITION

Accounting Standards Update (ASU) No. 2014–09: “Revenue from Contracts with Customers”

Core revenue recognition principal: Companies recognize revenue when goods or services are
transferred to customers for the amount the company expects to be entitled to receive in
exchange for those goods or services.
 When: upon transfer to customers
 How much: amount the seller is entitled to receive

I. Contracts with only one performance obligation:

Case A: Revenue recognized at a single point in time

Revenue is recognized at one specific point in time when control has transferred from the seller
to the customer.

Key indicators that control of a good or service has passed from the seller to the buyer
• Buyer has an unconditional obligation to pay.
• Buyer has legal title to the asset.
• Buyer has physical possession of the asset.
• Buyer assumes the risks and rewards of ownership.
• Buyer has accepted the asset.

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Example: On February 4, 2016 Meyers sold $800 of merchandise on account. The merchandise
cost Meyers $600. On February 16, 2016 Meyers received $800 from the customer.

Case B: Revenue recognized over a period of time

Revenue is recognized over a period of time if one of the following three conditions hold:
• The customer consumes the benefit of the seller’s work as it is performed
• The customer controls the asset as it is created
• The seller is creating an asset that has no alternative use to the seller and the seller has the
legal right to receive payment for progress to date even if the contract is cancelled

On January 1, 2016, a health club signed up a new customer. The customer paid a $2,400
membership fee. It is expected that the customer will use the club for the next 2 years.

While revenue usually is earned during a period of time, revenue often is recognized at one
specific point in time.

Goods in transit (Record revenues or not?) - It depends on the shipping agreement.

If the goods are shipped f.o.b (free on board) shipping point, then legal title of the goods are
transferred to be buyer once the goods are shipped so the seller can record revenues when the
items are shipped.

If the goods are shipped f.o.b. destination, legal title is transferred once the goods are delivered
so the seller has to wait until the products are delivered before revenues can be recorded.

II. Contracts with multiple performance obligations:

The goal is to separate the contract into parts that can be viewed on a stand-alone basis.

Goods and services are viewed as separate performance obligations if they are distinct:
 Capable of being distinct
 Separately identifiable from other goods or services in the contract

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SPECIAL ISSUES

Step 1: Identify the contract

A contract only exists if it:


• has commercial substance
• has been approved by the seller and customer
• specifies the rights of the seller and customer
• specifies payment terms
• is probable that the seller will collect the amount it is entitled to receive under the
contract
A contract does not exist if:
• neither the seller nor the customer has performed any obligations under the contract, and
• both the seller and the customer can terminate the contract without penalty

Step 2: Identify the performance obligation(s)

Prepayments: Not considered as POs. They are accounted for as deferred revenue initially and
later recognized as revenue as each performance obligation is satisfied.

Warranties:
 Quality-assurance warranties - Not considered as POs. The seller recognizes this cost in
the period of sale as a warranty expense and related contingent liability.
 Extended warranties - Considered as POs. The seller recognizes the extended warranties
as a deferred revenue liability and then recognizes as revenue over the extended warranty
period.

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Options for additional goods or services: Considered as PO if they provide a material right to
the customer that the customer would not receive otherwise.

Example: As a promotion, TrueTech Industries offers a 50% coupon for a gaming headset with
the purchase of a Tri-Box at its normal price of $240. The headset costs $120 without a coupon
(and $60 with a coupon), and the coupon must be exercised within one year of the Tri-Box
purchase. TrueTech estimates that 80% of customers will take advantage of the coupon. How
would TrueTech account for the cash sale of 100 Tri-Boxes sold under this promotion on
January 1, 2016?

Right of return: Not considered as POs. in most retail situations revenue can be recognized at
the point of delivery if the seller is able to make reliable estimates of future returns. The
estimated returns reduce both sales and cost of goods sold.

Example: TrueTech sold 1,000 Tri-Boxes to CompStores for $240 for cash. Each Tri-box costs
TrueTech $200. TrueTech estimates that CompStores will return 5% of the Tri-Boxes purchased.

Step 3: Determine the transaction price

 Variable consideration: estimated as either the expected value or the most likely amount.

Example: Siddhi entered into a contract offering variable consideration on January 1, 2016. The
contract paid Siddhi $12,000 upfront for six months of continuous consulting services. In
addition, there was a 60% chance the contract would pay an additional bonus of $4,000 and a
40% chance the contract would pay an additional bonus of $6,000, depending on the outcome of
the consulting contract. This contract qualified for revenue recognition over time. After three
months, Siddhi changed its assessment and expected the chance to receive $4,000 to be 30% and
the chance to receive $4,000 to be 70%. On July 1, 2016 Siddhi received the $6,000 bonus from
the client.

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1) Expected Value

2) Most Likely Amount

 Constraint on recognizing variable consideration: sellers are constrained to only include


an estimate of variable consideration in the transaction price to the extent it is probable
that a significant revenue reversal will not occur when the uncertainty associated with the
variable consideration is resolved.

 Right of return:

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 Is the seller a principal or agent?

Principal Agent

Performance • To deliver goods and • To facilitate a


obligation services (so is transaction between a
vulnerable to risks principal and a
associated with holding customer
inventory)
Recording • Total sales price paid by • Only the commission it
revenue customers receives on the
• Also recognizes cost of transaction
goods sold

Example: MobileGo purchases Iphone X directly from Apple for $500. The phones are shipped
to MobileGo's warehouse and held there until a sale is made. MobileGo sells Iphone X to a
customer for $725 and ships individual phones to customers from its warehouse.

Example: Mobile-Online is a web portal on which mobile phone manufacturers sell their
products. When an Ipone X is sold through Mobile-Online for $725, the phone is shipped
directly from Apple's warehouse and Mobile-Online charges $50 commission.

 Time value of money:


o if the period between delivery and payment is less than a year, the time value of
money can be ignored
o if payment and delivery occur relatively far apart, the time value of money should
be accounted for. In that case, the seller views the transaction price as consisting
of (a) the cash price of the good or service and (b) a “financing component”
representing the interest for the time between the sale and the cash payment.

 Payments by the seller to the customer: if the seller purchases distinct goods or services
from the customer:
 At the fair value of those goods or services, the seller accounts for that purchase as a
separate transaction
 Pays more than the fair value of those goods or services, those excess payments are
viewed as a refund

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Step 4: Allocate the transaction price

Example: On January 1, 2016, TrueTech delivers 1,000 Tri-Box Systems to CompStores at a


price of $270 per system. The Tri-Box System includes the physical Tri-Box module as well as a
one-year subscription to the Tri-Net multiuser platform of internet-based games and other
applications. The Tri-Box modules have a stand-alone selling price of $250, but TrueTech does
not sell one-year subscriptions separately. Other vendors charge $50 for similar one-year
subscriptions to internet games and applications. TrueTech estimates that it incurs approximately
$10 of cost by providing one-year subscription to Tri-Net multiuser platform and usually the
margin for similar services is 50% above cost.

1) Adjusted market assessment approach

2) Expected cost plus margin approach

3) Residual approach

Step 5: Recognize revenue when each performance obligation is satisfied

1) Licenses
 A license is said to transfer a right of use if the seller’s activities during the license period
are not expected to affect the intellectual property being licensed to the customer. For
example, think of a music download. In that case revenue is recognized at the start of the
license period, that is, when the right is transferred.
 A license provides a right of access to the seller’s intellectual property if the seller’s
ongoing activities affect the benefit the customer receives from the intellectual property.
For example, think of an NFL trademark granted to a company over a period of time. In
that case revenue is recognized over the period of time for which access is provided.

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2) Franchises: In a franchise sale, the fees to be paid by the franchisee to the franchisor usually
comprise (1) the initial franchise fee, and (2) continuing franchise fees.
 GAAP require that the franchisor has substantially performed the services promised in
the franchise agreement and that the collectibility of the initial franchise fee is reasonably
assured before the fee can be recognized.
 Continuing franchise fees are paid to the franchisor for continuing rights as well as for
advertising and promotion and other services over the life of the agreement and are
recognized by the franchisor as revenue in the period received, which corresponds to the
periods the services are performed.

Example: On March 31, 2016, the Red Hot Chicken Wing Corporation entered into a franchise
agreement with Thomas Keller. In exchange for an initial franchise fee of $50,000, payable on
March 31, 2016, Red Hot grants Thomas Keller the exclusive right to operate Red Hot in Reston,
Virginia for a five-year period and will provide initial services including the construction
assistance, training of employees, and consulting services over five years. In addition, the
franchisee will pay continuing franchise fees of $1,000 per month for advertising and promotion
provided by Red Hot, beginning immediately after the franchise begins operations. Thomas
Keller opened his Red Hot franchise for business on September 30, 2016.

3) Bill-and-hold arrangements: since the customer doesn’t have physical possession of the
asset until the seller has delivered it, transfer of control has not occurred, so revenue typically
should not be recognized until actual delivery to the customer occurs.

4) Consignment arrangements: given that the consignor retains the risks of ownership, it
postpones revenue recognition until sale to a third party occurs.

5) Gift cards: sales of gift cards are recognized as deferred revenue, and then revenue is
recognized when a gift card is redeemed or the likelihood of redemption is viewed as remote.

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ACCOUNTING FOR LONG-TERM CONTRACTS

Revenue may be recognized before delivery when the products takes years to deliver (e.g., long-
term contact on buildings, highways, spacecraft) to provide timely information to investors.

In these situations, there are two methods of accounting for revenue and expense recognition:
 Recognizing revenue upon the completion of the contract
 Recognizing revenue over time according to % of completion.

If a contract doesn’t qualify for revenue recognition over time, revenue recognition is delayed
until the contract is completed.

1. No revenues or expenses are recognized until the project is complete.


2. Not properly portray a company's performance over the construction period and should
only be used in unusual situations (when forecasts of costs to complete the project are
highly uncertain).
3. During the project, construction costs are recorded as “Construction in progress” (an
inventory account) and billings are recorded as “Billings on construction contract” (a
contra inventory account).

Construction in Progress Construction in Progress


- Billings on Construction Contract - Billings on Construction Contract
Debit Balance (Unbilled Receivable) Credit Balance (Overbilled Receivable)

Classified as Classified as
an asset a liability

4. At completion of the project, all accounts are closed and the entire gross profit from the
construction project is recognized.

Dr. Cost of construction…………………………..XX


Dr. Construction in progress……………………...XX (gross profit)
Cr. Revenue from long-term contract………………………………..XX

Dr. Revenue from long-term contract…………….XX


Cr. Cost of construction……………………………………………...XX
Cr. R/E……………………………………………………………….XX

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Example: Geller Construction entered into a three-year contract to build a containment vessel for
Southeast Power Company for a contract price of $1,400,000. Presented below is information
about the contract.

2016 2017 2018


Construction costs incurred during the year $ 250,000 $ 550,000 $ 400,000
Construction costs incurred in prior years - 250,000 800,000
Construction costs to date 250,000 800,000 1,200,000
Estimated costs to complete at end of year 1,000,000 425,000 -
Total estimated (actual) construction costs $1,250,000 $1,225,000 $1,200,000

Billings made during the year $ 250,000 $ 525,000 $ 625,000


Cash collections during year 225,000 470,000 405,000

How will Geller account for the revenues and cost of this project if revenue is recognized upon
completion?

2016:

2017:

Construction in progress
Cash, materials, etc.
A/R
Billing on construction contract
Cash
A/R

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2018:

Construction in process
Cash, materials, etc.
A/R
Billing on construction contract
Cash
A/R

To recognize gross profit:

Construction in Progress Billings on Construction Contract


2016 250,000 250,000 2016
2017 550,000 525,000 2017
2018 400,000 625,000 2018
2018 200,000
1,400,000 1,400,000

Entry to transfer title to the customer.

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If a contract qualifies for revenue recognition over time, revenue is recognized over time by
allocating a fair share of a project's revenues and expenses to each reporting period during
construction.

1 Costs incurred to date = Percent complete


Most recent estimated total costs

2 Estimated total revenue x Percent complete


= Revenue to be recognized to date

3 Revenue to be recognized to date – Revenue


recognized in PRIOR periods = Current period revenue

4 Current Period Revenue – current period costs = Gross profit

Example: Geller Construction entered into a three-year contract to build a containment vessel for
Southeast Power Company for a contract price of $1,400,000. Presented below is information
about the contract.

2016 2017 2018


Construction costs incurred during the year $ 250,000 $ 550,000 $ 400,000
Construction costs incurred in prior years - 250,000 800,000
Construction costs to date 250,000 800,000 1,200,000
Estimated costs to complete at end of year 1,000,000 425,000 -
Total estimated (actual) construction costs $1,250,000 $1,225,000 $1,200,000

Billings made during the year $ 250,000 $ 525,000 $ 625,000


Cash collections during year 225,000 470,000 405,000

2016:

Dr. Construction in progress 250K


Cr. Cash, material, wage payable, etc. 250K
Dr. Account Receivable 250K
Cr. Billings on construction contract (BCC (+XA) 250K
Dr. Cash 250K
Cr. A/R 250K

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2017:

Construction in progress 250K


Cash, materials, etc. 250K
A/R 250K
Billing on construction contract (contra asset to CIP) 250K
Cash 225K
A/R 225K

Cost of construction
Construction in progress
Revenue from long-term contract
Revenue from long-term contract
Cost of construction
R/E

2018:

Construction in progress 400K


Cash, materials, etc. 400K
A/R 625K
Billing on construction contract 625K
Cash 405K
A/R 405K

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To recognize gross profit
Cost of construction (Total cost incurred) 1.2M
Construction in progress (to recognize gross profit) 0.2M
Revenue from long-term contract 1.4M
Revenue from long-term contract
Cost of construction
R/E

Construction in Progress Billings on Construction Contract


2016 250,000 250,000 2016
30,000
2017 550,000 525,000 2017
84,286
2018 400,000 625,000 2018
85,714
1,400,000 1,400,000

Entry to transfer title to the customer.


Dr. BCC 1.4M
Cr. CIP 1.4M

A comparison of two methods:

Revenue Recognition
Over Time Upon Completion
Gross profit recognized:
2016
2017
2018
Total gross profit

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Example – Periodic loss for profitable project

2016 2017 2018


Contract price $1,400,000 $1,400,000 $1,400,000

Actual costs to date $ 250,000 $ 800,000 $1,350,000


Estimated costs to complete 1,000,000 550,000 0
Total estimated construction cost $1,250,000 $1,350,000 $1,350,000
Total gross profit (Contract price - total costs) $ 150,000 $ 50,000 $ 50,000

Billings made during the year $ 250,000 $ 525,000 $ 625,000

Revenue recognition upon completion:

2018:

Cost of construction
Construction in progress (Gross profit)
Revenue from long-term contracts

Construction in Progress Billings on Construction Contract

2017

2017
2018

Revenue recognition over time:

2016:

Cost of construction
Construction in progress (Gross profit)
Revenue from long-term contracts

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2017:

Cost of construction
Construction in progress (Loss)
Revenue from long-term contracts

2018:

Cost of construction
Construction in progress (Gross profit)
Revenue from long-term contracts

Construction in Progress Billings on Construction Contract


30K

2017 550K

2018 550K 370K 2017


20.37K
1.4M

1.4M

A comparison of two methods:

Revenue Recognition
Over Time Upon Completion
Gross profit recognized:
2016 30K 0
2017 -370 0
2018 20.37K 50K
Total project loss 50K 50K

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If Overall loss on the entire project:

Dr. Cost of Construction…………………………..X+Y


Cr. Construction in Process (loss)…………………………….X
Cr. Revenue from long-term contracts………………………..Y

Example: Overall loss

2016 2017 2018


Contract price $1,400,000 $1,400,000 $1,400,000

Actual costs to date $ 250,000 $ 910,000 $1,520,000


Estimated costs to complete 1,000,000 540,000 0
Total estimated construction cost $1,250,000 $1,450,000 $1,520,000
Total gross profit (Contract price - total costs) $ 150,000 $ (50,000) $ (120,000)

Billings made during the year $ 250,000 $ 525,000 $ 625,000

Revenue recognition upon completion:


*If you have an overall loss, you need to recognize the loss amount first, then you back out the
cost of construction.*  start with the loss amount Commented [AM1]: Do this because of accounting
conservatism requires you to recognize loss first
2017:

Dr. Loss on Long Term Contract 50K


Cr. CIP (Loss) 50K
2018:

Dr. Cost of Construction 1.47M Commented [AM2]: Not 1.52M because the 50K was already
recognized in the previous years
Cr. CIP (Loss) (120K-70K from last year) 70K Commented [AM3]: Cannot double count an expense that has
already been counted
Cr. Revenue from Long Term Contract 1.4M

Construction in Progress Billings on Construction Contract


2016 250K 250K 2016
30K Commented [AM4]: 30K should only be under construction
completion method
2017 660K 525K 2017
50K 2017
2018 610K 625K 2018
70K 2018
1.4M 1.4M

2017: CIP 860K – BCC 775K= 85K (Untitled Receivable)


2018: CIP 0 - BCC 0 = 0K

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Revenue recognition over time:

% of completion:
2016: 250K/1.250K = 20%
2017: 910K - 250K/1450K = 62.76% - 20% = 42.76% Commented [AM5]: Want to always use the cumulative values
 DO NOT SUBTRACT OUT PREVIOUS YEAR
2018:100% - 62.76% = 37.24%

2016:

Cost of construction 250K


Construction in progress 30K
Revenue from long-term contracts 280K

2017:

660K Commented [AM6]: 910K-250K=660K


Cost of construction
678,640 Commented [AM7]: Fix cost of construction in order to make
the journal entry even and match credits and debits
61.36K
Construction in progress
80K Commented [AM8]: Recognize 30K profit from last year in
addition to the 50K
Revenue from long-term contracts 598,649 Commented [AM9]: Need to only recognize 42% of revenue
rather than 100%
Commented [AM10R9]: 42.76% x 1.4M
2018:

Cost of construction 591,360 Commented [AM11]: 70K + 521,360

Construction in progress 70K Commented [AM12]: 120K – 50K

Revenue from long-term contracts 521,360 Commented [AM13]: 37.24% x 1.4M

Construction in Progress Billings on Construction Contract


2016 250K 250K 2016
30K
2017 660K 525K 2017
80K 2017
2018 610K 625K 2018
70K 2018
1.4M 1.4M

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A comparison of two methods:

Revenue Recognition
Over Time Upon Completion
Gross profit recognized:
2016 30K 0
2017 -80K -50K
2018 -70K -70K
Total project loss -120K -120K
Commented [AM14]: Gives a more volatile earning  goes
from a strong positive number to a strong negative number within
one year

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