SPECIAL ISSUES IN STEP 1: WHEN DOES A CONTRACT EXIST FOR PURPOSES

OF REVENUE RECOGNITION?

A contract is an agreement that creates legally enforceable rights and obligations.

 Can be explicit or implicit.

 Can be oral or written.

A contract exists for purposes of revenue recognition only if all of the following are true:

 it has commercial substance, affecting the risk, timing or amount of the seller’s future cash
flows,
 it has been approved by both the seller and the customer, indicating commitment to fulfilling
their obligations,
 it specifies the seller’s and customer’s rights regarding the goods or services to be transferred,
 it specifies payment terms, and
 it is probable that the seller will collect the amount it is entitled to receive.

A contract does not exist if both of the following are true.

 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.

Example 1: ABC Stores ordered 1,000 cell phones on December 20, 2016, at a price of $250 per unit
from XYZ Instruments. ABC and XYZ can cancel the order without penalty prior to delivery. XYZ made
delivery on January 1, 2017, and received $250,000 on January 25, 2017. When does XYZ’s arrangement
with ABC qualify as a contract for purposes of revenue recognition?

The arrangement qualifies as a contract on January 1, 2017. That is the date XYZ makes delivery to
ABC. Prior to delivery, neither XYZ nor ABC had performed an obligation under the contract, and both
parties could cancel the order without penalty, so the arrangement didn’t qualify as a contract for
purposes of revenue recognition.

Example 2: KLM Associates received a written, approved contract to deliver economic consulting
services, with service and payment commencing in one month. The contract specifies the services that
KLM is to perform, and the payment terms. KLM and the customer both can cancel the contract without
penalty prior to commencing service. Does KLM have a contract for purposes of revenue recognition on
the day the contract is received?

a. Yes, because KLM has a written approved contract.

b. No, because KLM and the customer can cancel without penalty, and neither has performed an
obligation under the contract.
c. Maybe, depending on whether KLM can estimate collectability of the receivable.
d. There is insufficient data on which to base an answer.

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 SPECIAL ISSUES IN STEP 2: IDENTIFY THE PERFORMANCE OBLIGATION(S)

Examples of common parts of contracts that are NOT performance obligations:

 Prepayments (it’s part of the transaction price).

 Quality-assurance warranties (it’s part of the performance obligation to deliver goods and
services that are free of defects).
 Right of return (it’s part of the performance obligation to deliver acceptable goods and
services).

Examples of common parts of contracts that are performance obligations:

 Extended warranties (it’s a separate obligation distinct from delivering acceptable goods and
services). A warranty is an extended warranty if either
o the customer has the option to purchase the warranty separately, or
o The warranty provides a service to the customer beyond quality assurance.

 Options that provide a material right (a material right is something the customer wouldn’t get
otherwise, so the seller is obligated to provide it).

Example 1: Which of the following is an example of an extended warranty?

a. XYZ Headphones, Inc. provides assurance that its headphones are defect-free after purchase.
b. ABC's Flowers assures clients that its flowers will stay fresh for at least a week.
c. KLM Electronics offers a warranty at an affordable price that provides additional protection after
the customer takes possession of the product.
d. Alpha Electronics promises to make repairs or replace any product found to be defective within a
week of purchase.

Answer choices a, b, and d are examples of quality assurance warranties. They are promises to fulfill
the performance obligation to provide goods of acceptable quality, rather than being performance
obligations in their own right.

Example 2: In which of the following is the option described not a performance obligation?

a. Customers accumulate points for every dollar spent at KLM's Book Store. The points can be redeemed
for books once certain levels are met.
b. Customers can get 5% cash back for every $100 spent on eco-friendly products.
c. Customers can "buy two, get one free" at a menswear store.
d. Upon purchase of any name-brand TV, customers can purchase a 5-year extended warranty at a 25%
discount.

5% cash back is an adjustment of list price, and therefore must be considered when calculating the
transaction price. It is not a performance obligation.

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 SPECIAL ISSUES IN STEP 3: DETERMINE THE TRANSACTION PRICE

1. Estimating variable consideration and determining whether it is constrained

2. Offering the customer the right to return merchandise to the seller
3. Identifying whether the seller is acting as a principal or an agent
4. Considering the time value of money
5. Accounting for payments by the seller to the customer

1. VARIABLE CONSIDERATION

Occurs when some of the contract price depends on the outcome of a future event.

Examples:

Entertainment and media - Royalties

Health care - Medicare and Medicaid reimbursements

Manufacturing - Volume discounts and product returns

Construction - Incentive payments

Telecommunications - Rebates

Estimate variable consideration using either

 Expected value
 Most likely amount

Constraint: Sellers 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.

Intended to avoid severe revenue overstatements (conservatism).

Indicators that a significant reversal could occur:

 poor evidence on which to base an estimate,

 dependence on factors outside the seller’s control,
 history of the seller changing payment terms on similar contracts,
 a broad range of outcomes that could occur, and
 a long delay before uncertainty resolves

The seller should update estimates of variable consideration (and whether the constraint is required)
prospectively, adjusting revenue and other accounts as necessary in the period in which the estimate is
revised.

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Example: Thomas Consultants provided Bran Construction with assistance in implementing various cost-
savings initiatives. Thomas' contract specifies that it will receive a flat fee of $50,000 and an additional
$20,000 if Bran reaches a pre-specified target amount of cost savings. Thomas estimates that there is a
20% chance that Bran will achieve the cost-savings target.

a) Assuming Thomas uses the expected value as its estimate of variable consideration, calculate
the transaction price.

$70,000 ($50,000 fixed fee + 20,000 bonus) × 20% = $14,000

$50,000 ($50,000 fixed fee + 0 bonus) × 80% = 40,000

Expected contract price at inception $54,000

Or, alternatively: $50,000 + ($20,000 × 20%) = $54,000

b) Assuming Thomas uses the most likely value as its estimate of variable consideration, calculate
the transaction price.

The most likely amount is the flat fee of $50,000, because there is a greater chance of not
qualifying for the bonus than of qualifying for the bonus, so that is the transaction price.

c) Assume Thomas uses the expected value as its estimate of variable consideration, but is very
uncertain of that estimate due to a lack of experience with similar consulting arrangements.
Calculate the transaction price.

Because Thomas is very uncertain of its estimate, Thomas can’t argue that it is probable that it
won’t have to reverse (adjust downward) a significant amount of revenue in the future because of
a change in returns. Therefore, Thomas would not include the bonus estimate in the transaction
price, and the transaction price would be the flat fee of $50,000.

2. RIGHT OF RETURN
 Exists when the customer can return the good if not satisfied or unable to resell it
 Viewed as a failure to satisfy the original performance obligation
 The seller reduces revenue by the estimated returns, and either:
o records a liability for cash the seller anticipates refunding to customers, or
o reduces accounts receivable if the seller has not yet been paid

Example: Finerly Corporation sells cosmetics through a network of independent distributors. Finerly
shipped cosmetics to its distributors and is considering whether it should record $300,000 of revenue
upon shipment of a new line of cosmetics. Finerly expects the distributors to be able to sell the
cosmetics, but is uncertain because it has little experience with selling cosmetics of this type. Finerly is
committed to accepting the cosmetics back from the distributors if the cosmetics are not sold. How
much revenue should Finerly recognize upon delivery to its distributors?

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Finerly should recognize $0 of revenue upon delivery to distributors. Given the uncertainty about
estimated returns, Finerly can’t argue that it is probable that it won’t have to reverse (adjust
downward) a significant amount of revenue in the future because of a change in returns. Therefore,
Finerly won’t recognize revenue until it either can better estimate returns or sales to end consumers
occur. Essentially, because Finerly can’t estimate returns, it treats this transaction as if it is placing
those goods on consignment with independent distributors.

3. SELLER IS ACTING AS A PRINCIPAL OR AN AGENT

Principal: providing the good or service to the customer
Agent: only arranging for another company to provide the good or service.
 If the company is a principal, it records revenue equal to the total sales price paid by
customers as well as cost of goods sold equal to the cost of the item to the company.

 If the company is an agent, it records as revenue only the commission it receives on the
transaction.

 We view the seller as a principal if it obtains control of the goods or services before they are
transferred to the customer. Control is evident if the seller has
o primary responsibility for delivering a product or service and
o is vulnerable to risks associated with
 holding inventory,
 delivering the product or service, and
 collecting payment from the customer.

Example: Assume that Amazon.com sells the MacBook Pro, a computer brand produced by Apple, for a
retail price of $1,500. Amazon arranges its operations such that customers receive products directly
from Apple Stores rather than Amazon. Customers purchase from Amazon using credit cards, and
Amazon forwards cash to Apple equal to the retail price minus a $150 commission that Amazon keeps.
In this arrangement, how much revenue will Amazon recognize for the sale of one MacBook Pro?

Amazon will recognize revenue of $150, its commission on the sale. In this transaction, Amazon never
has primary responsibility for delivering a product or service, and it is not vulnerable to risks
associated with holding inventory or delivering the product or service. Therefore, Amazon serves as
an agent, and will only recognize revenue on the transaction equal to the amount of the commission it
receives.

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 4. TIME VALUE OF MONEY

If payment happens before or after delivery, transaction has a financing component. In that case, the
contract contains:

 The cash price of the good or service, and

 A financing component that if significant is accounted for as follows:
o If payment before delivery, seller is getting a loan, so recognize interest expense.
o If payment after delivery, seller is giving a loan, so recognize interest revenue.

Sellers can assume the financing component is not significant if the period between delivery and
payment is less than a year.

Example: On January 1, 2016, Wright Transport sold four school buses to the Elmira School District. In
exchange for the buses, Wright received a note requiring payment of $515,000 by Elmira on December
31, 2018. The effective interest rate is 8%.

How much sales revenue would Wright recognize on January 1, 2016, for this transaction?

Sales revenue = present value of the note receivable = $515,000 × 0.79383* = $408,822
* Present value of $1: n = 3, i = 8%

Prepare journal entries to record the sale of merchandise on January 1, 2016 (omit any entry that might
be required for the cost of the goods sold), the December 31, 2016, interest accrual, the December 31,
2017, interest accrual, and receipt of payment of the note on December 31, 2018.

January 1, 2016

Note receivable 515,000

Discount on note receivable 106,178

Sales revenue* 408,822

December 31, 2016

Discount on note receivable 32,706

Interest revenue ($408,822 × 8%) 32,706

December 31, 2017

Discount on note receivable 35,322

Interest revenue (($408,822 + 32,706) × 8%) 35,322

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December 31, 2018

Cash 515,000

Discount on note receivable 38,150

Interest revenue (($408,822+32,706+35,322) × 8%) 38,150

Note receivable 515,000

* $515,000 × Present value of $1; n = 3, i = 8%

5. PAYMENTS BY THE SELLER TO THE CUSTOMER

If the seller is purchasing distinct goods or services from the customer at the fair value of those goods or
services, we account for that purchase as a separate transaction.

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

Example: Lewis Co. sold merchandise to AdCo for $60,000 and received $60,000 for that sale one month
later. One week prior to receiving payment from AdCo, Lewis made a $10,000 payment to AdCo for
advertising services that have a fair value of $7,500. After accounting for any necessary adjustments,
how much revenue should Lewis Co. record for the merchandise sold to AdCo?

If a seller is purchasing distinct goods or services from a customer at the fair value of those goods or
services, we account for that purchase as a separate transaction. Otherwise, excess payments by the
seller are treated as a refund of the customer’s purchase. If the payments are made (or are expected
to be made) at the time of the original sale, the transaction price of the customer’s purchase is
reduced immediately by the refund. If payment is not expected at the time of the sale, revenue is
recorded based on the full transaction price, and any subsequent payment by the seller above fair
value results in a reduction of the transaction price at that time.

There is no indication that Lewis’ payment to AdCo for $10,000, which is $2,500 more than the fair
value of those services ($7,500), was expected at the time of the original sale. Therefore, the original
sale would be recorded based on the full transaction price of $60,000. The overpayment of $2,500
reduces the $60,000 transaction price of the goods sold by Lewis to AdCo at the time the $10,000 is
paid, resulting in a downward adjustment of revenue of $2,500 at that time and net revenue over the
period of $60,000 – 2,500 = $57,500.

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 SPECIAL ISSUES IN STEP 4: ALLOCATE THE TRANSACTION PRICE TO PERFORMANCE OBLIGATIONS:
ESTIMATING STAND-ALONE SELLING PRICES

Three methods are recommended for estimating stand-alone selling prices that are not observable:

1. Adjusted market assessment approach: The seller considers what it could sell the product or services
for in the market in which it normally conducts business, perhaps referencing prices charged by
competitors.

Example: O'Hara Associates sells golf clubs and, with each sale of a full set of clubs, provides
complementary club-fitting services. A full set of clubs with the fitting services sells for $1,500. Similar
club-fitting services are offered by other vendors for $110, and O'Hara generally charges approximately
10% more than do other vendors for similar services. Estimate the stand-alone selling price of the club-
fitting services using the adjusted market assessment approach.

Under the adjusted market assessment approach, O’Hara would base its estimate of the stand-alone
selling price of the club-fitting services on the prices charged by other vendors for those services,
adjusted as necessary. Because O’Hara typically charges 10% more than what other vendors charge,
O’Hara would estimate the stand-alone selling price of the club-fitting service to be $110 × 1.10= $121.

2. Expected cost plus margin approach: The seller estimates its costs of satisfying a performance
obligation and then adds an appropriate profit margin.

Example: Same as above but now O'Hara estimates that it incurs $60 of staff compensation and other
costs to provide the fitting services, and normally earns 30% over cost on similar services. Assuming that
the golf clubs and the club fitting services are separate performance obligations, estimate the stand-
alone selling price of the club-fitting services using the expected cost plus margin approach.

Under the expected cost plus margin approach, O’Hara would base its estimate of the stand-alone
selling price of the club-fitting service on the $60 cost it incurs to provide the services, plus its normal
margin of $60 × 30% = $18. Therefore, O’Hara would estimate the stand-alone selling price of the
club-fitting services to be $60 + 18 = $78.

3. Residual approach: The seller estimates an unknown (or highly uncertain) stand-alone selling price by
subtracting the sum of the known or estimated stand-alone selling prices from the total transaction
price. Only allowed if the stand-alone selling price is highly uncertain, either because

 the seller hasn’t previously sold the good or service and hasn’t yet determined a price for it, or
 because the seller provides the same good or service to different customers at substantially
different prices.

Example: Same as above but now O'Hara sells the same clubs without the fitting service for $1,400.
Assuming that the golf clubs and the club-fitting services are separate performance obligations, estimate
the stand-alone selling price of the club fitting services using the residual approach.

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Under the residual approach, O’Hara would base its estimate of the stand-alone selling price of the
club-fitting services on the total selling price of the contract ($1,500) minus the observable stand-
alone selling price of clubs ($1,400). Therefore, O’Hara would estimate the stand-alone selling price of
the club-fitting services to be $1,500 – 1,400 = $100.

SPECIAL ISSUES IN STEP 5: RECOGNIZE REVENUE WHEN (OR AS)

EACH PERFORMANCE OBLIGATION IS SATISFIED

Licenses

Right of use: Transfer a right to use the seller’s intellectual property as it exists when the license
is granted, e.g. a music download. Revenue recognized at the point in time the right is transferred.

Right of access: Provide access to the seller’s intellectual property with the understanding that
the seller will undertake ongoing activities during the license period that affect the benefit the customer
receives, e.g. an NFL trademark granted to the company over a period of time. Revenue recognized over
the period of time for which access is provided.

Example: Saar Associates sells two licenses to Kim & Company on September 1, 2016. First, in exchange
for $100,000, Saar provides Kim with a copy of its proprietary investment management software, which
Saar does not anticipate updating and which Kim can use permanently. Second, in exchange for $90,000,
Saar provides Kim with a three-year right to market Kim's financial advisory services under the name of
Saar Associates, which Saar advertises on an ongoing basis. How much revenue will Saar recognize in
2016 under this arrangement?

The software license is a right of use, since Saar’s activities during the license period (which for this
software does not have an end date) will not affect the value of the software to Kim. Therefore, Saar
can recognize the entire $100,000 upon transfer of the right. However, the license to use the Saar
name is an access right, with Saar’s ongoing activity affecting the benefit that Kim receives, so Saar
should recognize revenue as that access is consumed over 36 months. Since Kim uses the Saar name
for four months in 2016 (September through December), Saar should recognize revenue of 4 ÷ 36 =
1/9 of $90,000, or $10,000, for that access right in 2016. In total, Saar recognizes revenue of $100,000
+ 10,000 = $110,000 in 2016.

Franchises

In franchise arrangements, the franchisor grants the right to sell the franchisor’s products and
use its name for a specified period of time.

Typically involves a license to use the franchisor’s intellectual property, but also initial sales of
products and services and ongoing sales of products and services.

The franchisor identifies the performance obligations and follows the 5-step process.

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Example: TopChop sells hairstyling franchises. TopChop receives $50,000 from a new franchisee for
providing initial training, equipment and furnishings that have a stand-alone selling price of $50,000.
TopChop also receives $30,000 per year for use of the TopChop name and for ongoing consulting
services (starting on the date the franchise is purchased). Carlos became a TopChop franchisee on July 1,
2016, and on August 1, 2016, had completed training and was open for business. How much revenue in
2016 will TopChop recognize for its arrangement with Carlos?

Because Carlos had completed training and was open for business on August 1, 2016, TopChop
apparently has satisfied its performance obligation with respect to the initial training, equipment and
furnishings, so it would recognize $50,000 of revenue in 2016. In addition, since Carlos was a
franchisee for the last six months of 2016, TopChop should recognize 6 ÷ 12 = 50% of a yearly fee of
$30,000, or $15,000. In total, TopChop recognizes revenue from Carlos of $50,000 + 15,000 = $65,000
in 2016.

Bill-and-hold sales

Exist when a customer purchases goods but requests that the seller not ship the product until a
later date.

Sellers usually conclude that control has not been transferred so revenue not recognized until
delivery.

Sellers can recognize revenue prior to delivery only if (a) they conclude that the customer
controls the product, (b) there is a good reason for the bill-and-hold arrangement, and (c) the product is
specifically identified as belonging to the customer and is ready for shipment.

Example: Dowell Fishing Supply, Inc., sold $50,000 of Dowell Rods on December 15, 2016, to
Bassadrome. Because of a shipping backlog, Dowell held the inventory in Dowell's warehouse until
January 12, 2017 (having assured Bassadrome that it would deliver sooner if necessary). How much
revenue should Dowell recognize in 2016 for the sale to Bassadrome?

$0. Prior to delivery, Dowell maintains control of the inventory and should not recognize revenue.

Consignment arrangements

Exist when a “consignor” physically transfers the goods to the consignee but retains legal title.

The consignor retains control so postpone recognizing revenue until sale to an end customer
occurs.

Example: Kerianne paints landscapes, and in late 2016 placed four paintings with a retail price of $250
each in the Holmstrom Gallery. Kerianne's arrangement with Holmstrom is that Holmstrom will earn a
20% commission on paintings sold to gallery patrons. As of December 31, 2016, one painting had been
sold by Holmstrom to gallery patrons. How much revenue with respect to these four paintings should
Kerianne recognize in 2016?

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$250, equal to revenue for the sale of one painting. Kerianne has a consignment arrangement with
Holmstrom, so should not recognize transfer of paintings to Holmstrom as sales. Kerianne would
recognize Holmstrom’s commission of $250 × 20% = $50 as an expense.

Gift Cards

Seller records a deferred revenue liability when the card is sold.

Seller recognizes revenue when a gift card is redeemed or the likelihood of redemption is
viewed as remote.

Example: GoodBuy sells gift cards redeemable for GoodBuy products either in store or online. During
2016, GoodBuy sold $1,000,000 of gift cards, and $840,000 of the gift cards were redeemed for
products. As of December 31, 2016, $30,000 of the remaining gift cards had passed the date at which
GoodBuy concludes that the cards will never be redeemed. How much gift card revenue should
GoodBuy recognize in 2016?

GoodBuy should not recognize revenue when it sells the $1,000,000 of gift cards, because it has not
yet satisfied its performance obligation to deliver goods upon redemption of the cards. GoodBuy
should recognize revenue of $840,000 for redemptions, as well as $30,000 for gift cards that it
estimates will never be redeemed, totaling $870,000.

REVENUE DISCLOSURES

Income Statement: Include Revenue, Bad debt expense, and Interest revenue and expense associated
with significant finance components.

Balance Sheet: Include, Accounts Receivable: Unconditional right to receive payment, depending only
on the passage of time. Contract Assets: Conditional right to receive payment for performance
obligations already performed. Contract Liabilities: Deferred revenue.

Disclosure: Lots of it. Goal, help investors understand the nature, amount, timing and uncertainty of
revenues and cash flows.

Required disclosures include:

 Meaningful categories of revenue.

 Outstanding performance obligations.
 Important contractual provisions.
 Significant judgments.
 Significant changes in contract assets and liabilities.

For homework work on E5-2, E5-3, E5-5, E5-6, E5-7, E5-10, E5-11, E5-15, P5-1, P5-2, P5-4, P5-6, P5-7, P5-8

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