Chapter 4

Chapter 4
Revenue and Expense Recognition
Copyright 2012 Pearson Canada Inc.
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Lo/Fisher, Intermediate Accounting Vol.1
LEARNING OBJECTIVES L.O. 4.1 Explain why a range of acceptable alternatives exist and the rationale for a smaller set of alternatives. L.O. 4.2 Apply the general revenue and expense recognition criteria. L.O. 4.3 Apply the specific revenue and expense recognition for construction contracts. L.O. 4.4 Apply the principle of conservatism to construction contracts. L.O. 4.5 Apply professional judgment to evaluate the risk of revenue misstatements and appropriateness of policies.
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A. RANGE OF CONCEPTUAL ALTERNATIVES FOR REVENUE RECOGNITION (L.O.4-1)
Wide range of alternatives exist Alternatives exist along the value creation process Revenue recognized earlier reduces the quality of the information Criteria established by accounting standards eliminates some of alternatives
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A businesss value creation process
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B. GENERAL REVENUE RECOGNTION CRITERIA (L.O.4-2)
IAS 18 provides general revenue recognition criteria Criteria provided for the: Sale of goods Provision of services Criteria for sale of goods vs. provision of services viewed differently Recommends point 5 on value creation process
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1. Sale of Goods
ALL conditions must be met in order to recognize revenue: (a) Transfer of significant risks and rewards of ownership (b) Loss of continuing managerial involvement or control to the degree usually associated with ownership (c) Amount of revenue can be measured reliably (d) Economic benefits will flow to the entity (e) Costs incurred or to be incurred can be measured reliably
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Sale of Goods from Seller to Buyer
Requires a high degree of certainty Requires procurement, demand and price risk reduced to an acceptable level Allows acceptance of credit and indemnity risk Results in some subjectivity and application of professional judgment
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2. Provision of Services
Must reliably estimate the outcome If outcome can be estimated reliably use stage of completion to recognize revenue If outcome cannot be estimated reliably, revenue is recognized only to extent of recoverability of expenses recognized Known as the cost recovery method
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Determining a Reliable Estimate for the Outcome
ALL conditions must be met: (a) amount of revenue can be measured reliably (b) probable that economic benefits associated with transaction will flow to entity (c) stage of completion of transaction at end of period can be measured reliably (d) costs incurred and costs to complete transaction can be measured reliably
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Sale of Goods vs. Provision of Services Sale of goods

Risk and rewards of ownership transferred Managerial involvement and control given up Revenue amount measured reliably Economic benefits transferred Stage of completion not applicable Costs can be measured
Provision of Services
Ownership not applicable for services Managerial involvement and control not applicable Revenue amount measured reliably Economic benefits transferred Stage of completion measured reliably Costs can be measured
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C. EXPENSE RECOGNTION (L.O.4-2)
Limited guidance in IFRS Conceptual framework provides guidance Matching applies in the recognition of revenue and cost of sales Systematic and rational approach applies for other expenses, i.e., depreciation Expense applies if asset criteria not met
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D. SPECIFIC REVENUE RECOGNITION SITUATIONS (L.O.4-2)
Point of sale may not apply Other situations/arrangements : 1. Consignment sales 2. Installment sales 3. Franchise revenue 4. Barter Transactions 5. Revenue recognition at point of production Professional judgment applied
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1. Consignment sales
Consignor provides goods to a consignee who will try to sell goods Consignee has the right to return all or portion of goods if not sold Consignor retains risks of ownership Consignor does not record revenue when goods are delivered to consignee Revenue recognized when right of return expires
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2. Installment Sales
Buyer makes payments over extended period of time Buyer receives product at beginning of installment period Legal title may not transfer to buyer until all payments made Uncertainty over amount ultimately collected May recognize revenue in proportion to payments received
Installment Sales Example

Assume Durable Furnishings makes installment sales of products with a retail price of $1,000,000 in the month of January. The cost of the products sold amounts to $800,000, so the average gross margin on these products is 20%.
(Continued)
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Installment Sales Example (Continued)

In February, Durable Furnishings receives $50,000 for these installment sales (after deducting amounts on account of interest).
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3. Franchise Revenue
Franchisor licenses to franchisee Its trademarks Business practices to franchisee Two revenue sources: initial fee and ongoing fee Ongoing fee revenue recognition is simple Initial fee: immediate recognition or deferral to future periods Professional judgment required
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Franchise Revenue Example Assume Delicio Restaurants signs a franchise agreement to allow a franchisee to operate in northwest Calgary for a 10year period. The agreement requires the franchisee to pay Delicio $200,000 initially, and a royalty of 2% of sales revenue thereafter. Sales at this franchise location for the first year are $2 million. The management of Delicio estimates that the value of services rendered to this franchiseesuch as location and demographic analysis, initial staffing, and trainingtotalled $80,000. Management also believes that the remainder of the initial fee (i.e.,$120,000) relates to services to be provided evenly over the 10-year period.
(Continued)
Franchise Revenue Example (Continued)
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4. Barter Transactions
Barter transactions exchange of goods or services with little or no monetary consideration. Measurement needs to be established Generally recorded using estimates of fair value of goods or services exchanged Fair value Prices used for cash Similar monetary consideration
5. Revenue Recognition at Point of Production
Limited circumstances IAS 41 - revenue recorded for produce on date of harvest IAS 18 - recording of revenue from selling of commodities using forward contracts for delivery in the future but at fixed sale prices Risks and rewards are transferred to the buyer prior to delivery of the commodity
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E. ACCOUNTING FOR CONSTRUCTION CONTRACTS (L.O.4-3)
Challenge: allocating revenue to reporting periods IAS 11 Construction Contracts provides additional guidance Construction contracts has broad application - manufacturing, assembly, other creation If outcome is measured reliably stage of completion may apply Costs matched to revenue recognized
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Defining Construction Contracts
Understanding definition is key in order to understand its applicability A construction contract contract specifically negotiated for construction of an asset or a combination of assets closely interrelated or interdependent in terms of their design, technology and function or ultimate purpose or use
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Types of Contracts Covered in Construction Contracts
Fixedprice contracts Costplus contracts

the contractor/ builder agrees to a price before construction begins
the price dependent on amount spent on the project plus a profit margin
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Fixed Price: Percentage of completion applied when all of the following are satisfied :
Contract revenue measured reliably Economic benefits transferred Costs to complete measured Stage of completion measured Contract costs clearly identified and measured reliably Actual can be compared with prior estimates
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For Cost Plus: Percentage of completion applied when all of the following are satisfied :
Economic benefits transferred Costs can be clearly identified and measured reliably, whether or not reimbursed
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1. Revenue Recognition for Cost-plus Contracts
Amount of revenue determined by actual costs plus percentage margin
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Revenue Recognition for Fixed-price Contracts Assume accurate estimates
Percentage of completion allocates revenue not expenses
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2. Revenue Recognition for Fixed-price Contracts Assume actual costs differ from estimates
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Revenue Recognition for Fixed-price Contracts Assume actual costs differ from estimates (Continued)
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3. Revenue Recognition for Fixed-price Contracts: Cost-to-Cost Approach
Need to calculate the percentage complete Alternative based on costs incurred compared to estimated costs to complete
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Gross Profit Under Percentage to Complete Cost-to-Cost Approach
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4. Accounting Cycle for Construction Contracts Consider 3 Elements (L.O. 4-4)
Phase
Timing
Journal entry
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Accounting Cycle for Construction Contracts (Continued)

Costs for materials, labour, overhead Incurring Capitalized in Construction in Progress Cost Invoice based on contract Accounts receivable recorded Contra account Billings on Construction in Progress
Billing Client
Cash recorded for amount received Receiving Record cash and reduce accounts receivable payments
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Accounting Cycle for Construction Contracts (Continued)

Once per period per contract Revenue recorded and cost of sales recorded in the same entry Constructions in progress adjusted for the difference
Revenue and expense recognition
Complete the project
Remove all balances relating to the contract Construction in progress account has accumulated all the costs and net income affect The billings on construction in progress = all invoices Balance in accounts = the contract price
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5. Application of prudence (conservatism) in accounting for construction contracts
Recall: principle of prudence results in bad news reported earlier than good news Recall: only a portion of revenue and profits reported based on percentage of completion Result: IAS 11 - losses recognized immediately
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6. Revenue recognition when outcome of construction contracts is uncertain: Cost recovery method
Cost recovery method recognizes: (1) contract costs incurred in the period as an expense (2) an amount of revenue equal to the costs that are expected to be recoverable Expected losses recognized immediately
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7. Alternative in ASPE: Completed contract method
Prescribed method - Percentage of completion Allows for cost recovery and early loss recognition Alternative method - Completed contract method deferral of revenue and expenses to end of project performance consists of single act or progress not reasonably estimated Losses not deferred
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F. RISK OF EARNINGS OVERSTATEMENT IN CONSTRUCTION CONTRACTS (L.O. 4-5)
Long-term nature Results in high-risk accounting and auditing Allocation of revenue and judgment in estimates provides opportunity for Intentional earnings management Unintentional judgment errors
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1. Intentional Overstatement: earnings management
Many estimates are used Valid and acceptable estimates exist Underestimating costs increases current profit Managements ethical responsibility is to choose the best approach
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2. Unintentional Overstatement: the winners curse
Unintentional errors In the estimation process In conversation calculations Due to complexity of long-term contracts The winners curse underestimating costs to win a contract higher likelihood of loss when input information is different
G. PRESENTATION AND DISCLOSURE 1. General presentation and disclosure Type of activity Activity from non-monetary exchanges Revenue recognition policies Stage of completion 2. Presentation and disclosure for construction contracts Amount of contract revenue recognized Method of revenue recognition Method of estimating the percentage completed
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H. SUBSTANTIVE DIFFERENCES BETWEEN IFRS AND ASPE
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I. SUMMARY L.O. 4.1 Explain why a range of acceptable alternatives exist and the rationale for a smaller set of alternatives. L.O. 4.2 Apply the general revenue and expense recognition criteria. L.O.4.3 Apply the specific revenue and expense recognition for construction contracts. L.O. 4.4 Apply the principle of conservatism to construction contracts. L.O. 4.5 Apply professional judgment to evaluate the risk of revenue misstatements and appropriateness of policies.
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Chapter 4 - Revenue and Expense Recognit

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Chapter 4 - Revenue and Expense Recognit

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Revenue and Expense Recognition

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

A. RANGE OF CONCEPTUAL ALTERNATIVES FOR REVENUE RECOGNITION (L.O.4-1)

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

A businesss value creation process

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

B. GENERAL REVENUE RECOGNTION CRITERIA (L.O.4-2)

Lo/Fisher, Intermediate Accounting Vol.1

Lo/Fisher, Intermediate Accounting Vol.1

Sale of Goods from Seller to Buyer

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Determining a Reliable Estimate for the Outcome

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Sale of Goods vs. Provision of Services Sale of goods

Lo/Fisher, Intermediate Accounting Vol.1

C. EXPENSE RECOGNTION (L.O.4-2)

Lo/Fisher, Intermediate Accounting Vol.1

D. SPECIFIC REVENUE RECOGNITION SITUATIONS (L.O.4-2)

Lo/Fisher, Intermediate Accounting Vol.1

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Lo/Fisher, Intermediate Accounting Vol.1

Installment Sales Example

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Installment Sales Example (Continued)

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Lo/Fisher, Intermediate Accounting Vol.1

Franchise Revenue Example (Continued)

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Lo/Fisher, Intermediate Accounting Vol.1

5. Revenue Recognition at Point of Production

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

E. ACCOUNTING FOR CONSTRUCTION CONTRACTS (L.O.4-3)

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Defining Construction Contracts

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Types of Contracts Covered in Construction Contracts

Fixedprice contracts Costplus contracts

the contractor/ builder agrees to a price before construction begins

Lo/Fisher, Intermediate Accounting Vol.1

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

Copyright 2012 Pearson Canada Inc.

Lo/Fisher, Intermediate Accounting Vol.1

1. Revenue Recognition for Cost-plus Contracts