Chapter 6

Revenue Recognition

Revenue Recognition

Revenue recognition is the largest

cause of earnings restatements in
the last 10 years.
Definition of Revenue:
inflow of economic benefits (Cash, A/R)
arising from ordinary activities

Two conceptual views on how to

account for revenues/sales:
Earnings approach
Contract-based approach (last 2 slides)
2

Earnings Approach
Revenues are recognized:
When risks and rewards have passed
When services are rendered,
measurable and collectible
In addition under IFRS there is no
continuing involvement

Earnings Approach Selling

Goods
Revenue typically recognized at point of

delivery (if earnings process is discrete)

If not discrete, transfer of risk and
rewards from seller to buyer is
determined by:
Who has the legal title to the goods sold
Who has the possession of the goods sold

Earlier recognition may be appropriate

if risks and rewards transfer even if
legal title and/or possession do not
pass to the buyer.
Ex. Agricultural products with assured
prices and available markets
4

Collectibility &
Measurability
As long as collectibility is reasonably assured revenue is
recognized and estimate of uncollectible amount is
accrued.
If collectability cannot be reasonably assured, then
revenues are recognized as cash is received
Measurement uncertainty arises when:
we cannot measure the consideration
we cannot measure related costs, or
we cannot measure the outcome of the transaction
When measurement uncertainty exists:
Do not recognize revenues until measurement
uncertainty resolved, or
Recognize revenues but measure and accrue amount
relating to uncertainty as a cost or reduced revenues
(preferred)
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Bundled Sale

Ex. Rogers sells a phone and a monthly service

IFRS and ASPE requires separation of each
deliverable, if possible
Price can be allocated using:

Relative fair value method

Residual value method

Revenue recognition for each part is

determined separately
If components cannot be measured
individually, then revenue recognition criteria
are applied to the bundled sale as a whole (as
if one product/service)
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Bundled Sale
Relative Fair Value Method-similar to a Lump-Sum
purchase of PP&E (chapter 10). Allocate sales price
based on relative fair value.
Residual Value method-value what hasnt been
delivered at its fair value. Value what has been
delivered at residual amount(whats left).
Example: Rogers sells an iPad mini(with retina
display) and a 2 year service agreement for $1,400.
Assume the iPad has a fair value of $600 and the
service has a fair value of $40/month. How does
Rogers record the revenue under the Relative Fair
Value Method and the Residual Method.
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Earnings Approach - Services and

Long-Term Contracts
Recognize revenue at each critical event, as long as it is
collectible using 2 approaches
1. Percentage-of-Completion Method
Used when performance has several ongoing acts and
Transactions are measurable
recognizes revenues and gross profit each period
based on progress or contract completion.
2. Completed-Contract Method
Used when performance is a single act or not
measurable
recognizes revenue and gross profit only after the
whole contract is completed
IFRS does not explicitly mention this method but does
not prevent this method if its appropriate.
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Percentage-of-Completion: Earnings
Approach
Revenues, costs and gross profit
recognized depends upon the
percentage of work done
The percentage-of-completion method
requires a basis for measuring the
progress toward completion at interim
dates
Input measures (e.g. costs incurred, or
labour hours worked)
Output measures (e.g. storeys of a building
completed, tonnes produced)
9

BE6-18
Pennfield Construction began work on a
$5,020,00 construction contract in 20120.
During 2010, the company incurred costs of
$1,600,000, billed its customer for
$1,750,000, and collected $1,500,000. At
December 31, 210, the estimated future
costs to complete the project total
$2,500,000. Assume that Pennfield uses the
percentage-of-completion method. Prepare
all journal entries required for the year ended
December 31, 2010.
10

BE6-18 addition
A. Assume in 2011 costs were $1,500,000, future
costs were estimated to be $1,100,000, Billings
were $1,300,000, and Cash collected was
$1,300,000.
B. Instead assume in 2011 costs were $1,700,000,
future costs were estimated to be $1,500,000,
and Billings and Cash collected were the same as
in A.
C. Instead assume in 2011 costs $1,900,000, future
costs were estimated to be $1,550,000, and
Billings and Cash collected were the same as in A.
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Percentage-of-Completion:
Steps
1

Costs incurred to date

= Percent complete
Most recent estimated total costs

2 Percent complete x Estimated total revenue (or GP) =

Revenue (or GP) to be recognized to date
3 Revenue (or GP) to be recognized to date
Revenue (or GP) recognized in prior periods =
Current period revenue (or GP)*
4 *Current period revenue Current costs = Gross Profit
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Percentage-of-Completion:
Cost-to-Cost Basis
Data: Contract price: $4,500,000 Estimated cost: $4,000,000
Start date:

July, 2011

Balance sheet date:

Given:
Costs to date

Finish: October, 2013

December 31st
2011

2012

2013

$1,000,000 $2,916,000 $4,050,000

Estimated costs to complete $3,000,000 $1,134,000 $

-0-

Progress billings during year $ 900,000 $2,400,000 $1,200,000

Cash collected during year

$ 750,000 $1,750,000 $2,000,000

13

Percentage-of-Completion:
Cost-to-Cost Basis
Contract Price (a)
Less: Estimated Costs
Costs to Date
Est. Cost to Complete
Est. Total Costs (b)
Estimated Total Gross
Profit (a b)

Percent Complete

2011

2012

$4,500,000

$4,500,000

$4,500,000

1,000,000
3,000,000
4,000,000

2,916,000
1,134,000
4,050,000

4,050,000
-04,050,000

$ 500,000

$ 450,000

25%
1,000,000
4,000,000

72%
2,916,000
4,050,000

2013

$ 450,000
100%
4,050,000
4,050,000
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Percentage-of-Completion:
Cost-to-Cost Basis
2011

2012

To record cost of construction:

Construction in Process

1,000,000

Materials, Cash, Payables

1,916,000
1,000,000

1,916,000

To record progress billings:

Accounts Receivable

900,000

Billings on Construction in
Process

2,400,000

900,000

2,400,000

To record collections:
Cash
Accounts Receivable

750,000

1,750,000
750,000

1,750,000

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Percentage-of-Completion:
Cost-to-Cost Basis
2011
Contract Price (a)
Percent complete (b)
Revenue recognized:
Revenue to date (a x b)
Less: Prior years revenue
Current year revenue

Gross profit recognized:

G.P. to date (Total x %)
Less: G.P. in prior years
Current year G. P.

$4,500,000
25%

2012
$4,500,000
72%

2013
$4,500,000
100%

$1,125,000
-0$1,125,000

$3,240,000
1,125,000
$2,115,000

$4,500,000
3,240,000
$1,260,000

$ 125,000
-0$ 125,000

$ 324,000
125,000
$ 199,000

$ 450,000
324,000
$ 126,000
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Percentage-of-Completion:
Cost-to-Cost Basis
2011

2012

To recognize revenue and gross profit:

Construction in Process

125,000

199,000

Construction Expenses

1,000,000

1,916,000

Revenue from Long-Term

Contract

1,125,000

2,115,000

To record completion of contract

(recorded on completion date in 2013):
Billings on Construction in
Process
Construction in Process

4,500,000
4,500,000

17

Percentage-of-Completion:
Financial Statement
Presentation

The difference between Construction

in process and Billings on
construction in process is recorded
on the Balance Sheet as either:
Current asset* (with Inventories) if
difference is a debit balance or
Current liability* if difference is a credit
balance
*May be non-current depending on length
of contract
18

Percentage-of-Completion:
Financial Statement
Presentation
The balance in the Construction in
Process account represents the costs
incurred + gross profit recognized to
date
The balance in the Billings on
Construction in Process represents
the billings made to customers to
date
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Long-Term Contract Losses

A long-term contract may produce either:

an interim loss on a profitable contract or
an overall loss on unprofitable contract
Under the percentage-of-completion method,
all losses are immediately recognized
Under the completed-contract method,
losses are recognized only when overall
losses result

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Percentage Method: Interim Loss

on Profitable ContractExample
Data as previously given, except for the 2012 cost estimate
Contract Price
Costs to date
Est. Cost to Complete
Est. Total Costs
Percent Complete

2011
$4,500,000

2012
$4,500,000

2013
$4,500,000

1,000,000
3,000,000
4,000,000

2,916,000
1,468,962
4,384,962

4,384,962
-04,384,962

25%

66.5%

100%

2,916,000
4,384,962

4,384,962
4,384,962

1,000,000
4,000,000

Revenue recognized to date in 2012: $4,500,000 x 66.5% = $2,992,500

Less: Amount recognized in 2011
1,125,000
Revenue recognized in 2012
1,867,500
Less: Actual costs incurred in 2012
1,916,000
Loss recognized in 2012
$48,500
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Percentage Method: Interim Loss on

Profitable ContractExample
Record loss for 2012:
Construction Expenses
1,916,000
Construction in Process (loss)
48,500
Revenue from Long-Term Contract
1,867,500
Under the percentage-of completion method the Loss
of $48,500 is reported on the Income Statement in 2012
Under the completed-contract method, no loss
recognized in 2012
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Percentage Method: Interim Loss on

Overall Unprofitable ContractExample
Data as previously given, except for the 2012 cost estimate
2011
$4,500,000

2012
$4,500,000

2013
$4,500,000 (a)

Costs To Date
Est. Cost to Complete
Est. Total Costs

1,000,000
3,000,000
4,000,000

2,916,000
1,640,250
4,556,250

4,556,250
-04,556,250 (b)

Percent Complete

25%
1,000,000
4,000,000

64%
2,916,000
4,556,250

100%
Gross Loss
(56,250)*

Contract Price

Losses recognized in 2012:

Gross profit recognized in 2011 (needs to be reversed) $125,000
Expected total loss on unprofitable contract (a b)
*56,250
Total loss to be recognized in 2012
$181,250
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Percentage Method: Interim Loss on

Overall Unprofitable ContractExample
Record loss in 2012 for percentage-of-completion method:
Construction Costs expensed in 2012:
Revenue to date: (4,500,000 X 64%)
$2,880,000
Less: Revenue recognized before 2012
1,125,000
Revenue recognized in 2012
1,755,000
Less: Loss recognized in 2012 (see previous slide) 181,250
Construction Cost Expense
1,936,250
Construction Expenses
1,936,250
Construction in Process (Loss)
Revenue from Long-Term Contract

181,250
1,755,000

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Completed-Contract Method: Interim Loss

on Overall Unprofitable ContractExample
Record overall loss in 2012 for
completed-contract method:
Loss from Long-Term Contract
56,250
Construction in Process (Loss)

56,250

The loss is recognized in the year it first becomes

evident.

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Completed-Contract Method:
Earnings Approach
Revenue and gross profit are recognized
when the contract is completed
Advantage: reported revenue is based on
actual results, not estimates
Disadvantage: distorts current performance
All journal entries are the same as the
percentage-of-completion method except
that no entry is recorded at the end of the
period to recognize revenue and gross profit
IFRS does not address the completedcontract method but allows for recognition
of recoverable revenues equal to costs
incurred if outcome is not reliably
measurable (Zero-Profit method)
26

Comparison of Results
(Gross Profit Recognition)
Year
2011

Percentage-ofCompletion

CompletedContract

$125,000 $

2012

199,000

2013

126,000

450,000

Total

$450,000

$450,000
27

Zero Profit Method

If outcome or profitability becomes
undeterminable
IFRS-recognize recoverable revenues
equal to costs incurred (dont record
gross profit)
ASPE-use completed contract method

28

Gross vs Net Method of

Revenue Recognition
How do intermediaries such as
Priceline or Groupon record revenue?
Is the company a principal or agent?
Principal if
Takes title of goods
Has risks and rewards of ownership
Record Revenues at Gross

Otherwise Agent
Record Revenues at Net
29

Consignment Sales
When Consignor ships inventory to the
consignee, possession has transferred; but
legal title remains with the seller
Risks and rewards have not transferred
Goods are held by seller as Merchandise on
Consignment, not held as inventory
When merchandise sold, the consignee
remits cash to the consignor (after
deducting commission and other chargeable
expenses)

30

Consignment Sales Earnings

Consignors Books
Goods shipped to Consignee
Inventory on Consignment $$$
Finished Goods Inventory
$$$
Payment of Freight
Inventory on Consignment $$$
Cash
$$$
Notification of Sale
Accounts Receivable
$$$
Relevant Expenses
$$$
Consignment Sales
$$$
Cost of Goods Sold
$$$
Inventory on Consignment
$
$$
(Note: cost includes freight)
Receipt of Cash from Sale
Cash
$$$
Accounts Receivable
$$$

Consignees Books
No Entry

No Entry
Notification/Payment of Sale
Cash
$$$
Payable to Consignor $$$
Remittance to Consignor
Payable to Consignor $$$
Cash
$$$
Commission Revenue $$
$
31

BE6-11
Finch Industries shipped $550,000 of
merchandise on consignment to Royal Crown
Company. Finch paid freight cost of $5,000.
Royal Crown Company paid $1,500 for local
advertising, which is reimbursable from Finch.
By year end, 75% of the merchandise had
been sold for $618,750. Royal Crown notified
Finch, retained a 10% commission and
remitted the cash due to Finch. Prepare the
journal entries required by Finch for this
transaction under the earnings approach.
32

Problems with the Earnings

Approach
Multiple and conflicting guidance on
revenue recognition
Difficult to apply
Difficult to determine definitively
who has the risks and rewards
Very subjective judgment

33

Contract-Based Approach

Recognises revenue when there is a

change in rights/responsibilities
Asks the questions:
1. When should the sales contract be recognized on
the balance sheet?
2. When should revenue be recognized on the
income statement?

Contract is recognized when all of the following

conditions are met:
1. The entity is party to the contract,
2. The contractual rights are collectible/measurable,
and
3. The performance obligation is measurable
34

Contract-Based Approach
Net contract position equals contractual rights
minus contractual obligations
Initial balance of net contract position is generally
zero
Revenues are recognized when
Legal title or possession passes to the buyer, or
Services are performed

Advantage of Contract-Based Approach

Conceptually sound

Problems with Contract-Based Approach

New model that needs to be tested
Does not cover revenue that is not contract based
35