Chapter 4

KNOWLEDGE CHECK 4.1

 What two approaches have accountants devised for recognizing revenue?

The two approaches for recognizing revenue are the critical-event approach and
gradual approach.

 What are the five criteria for recognizing revenue under IFRS? Explain each
criterion.

The five revenue recognition criteria under IFRS are:

1. Significant risks and rewards of ownership have been transferred from the
seller to the buyer.
2. The seller has no involvement or control over the goods sold.
3. Collection of payment is reasonably assured.
4. The amount of revenue can be reasonably measured.
5. Costs of earning the revenue can be reasonably measured.

 What is the “sixth” criterion for revenue recognition and why is it so important?

The sixth criterion is that the revenue recognition point selected should provide a
reasonable and fair representation of the entity’s activities, given the needs of the
people who will be using the accounting information. This criterion is so
important because accounting information must provide useful information about
an entity to stakeholders so that they can make informed decisions.

KNOWLEDGE CHECK 4.2

 What is the gradual approach to recognizing revenue?

The gradual approach recognizes revenue bit by bit over the entire earnings
process rather than when a particular critical event occurs. It applies to long-term
contracts for activities like services and construction contracts.
 How do you determine the percentage of a project that has been completed?

Percentage of completion can be estimated by estimating the proportion of total

costs incurred to date on the contract. There are other ways as well such as
completion of certain milestones in a project or completion of measurable
components of a project such as the number of miles in a highway project
completed.

 Under what circumstances is the zero-profit method use?

The zero-profit method is used when percentage of completion can’t be used. It

isn’t appropriate to use the percentage of completion method if the total costs that
will be incurred over the contract, the amount of revenue that will be earned, or
the percentage of the project that has been completed on the financial statement
date can’t be reasonably estimated, or if there isn’t a reasonable expectation of
payment.

 Plato Inc. (Plato) recently entered into a three-year contract to build a small office
building for a growing law firm. The law firm will pay Plato $7,000,000 for the
building. Plato is required to pay all costs. Plato estimates its total cost of
construction will be $5,200,000 with costs of $1,700,000 in the first year,
$2,500,000 in the second year, and $1,000,000 in the third year. Assuming that
Plato’s cost estimates are correct, how much revenue will it recognize in each year
of the contract using (1) the percentage-of-completion method and (2) the zero-
profit method?

Percentage of completion method

Year 1 $1,700,000  $7,000,000 = $2,288,462
$5,200,000

Year 2 $2,500,000  $7,000,000 = $3,365,385

$5,200,000

Year 3 $1,000,000  $7,000,000 = $1,346,154

$5,200,000
 Zero-profit method (the amount recognized in years 1 and 2 equals the costs
incurred in the year.

Year 1 $1,700,000

Year 2 $2,500,000

Year 3 $2,800,000

KNOWLEDGE CHECK 4.3

 Identify and explain the two factors that influence managers’ accounting choices.
Why do these two factors often conflict?

The two factors that influence managers’ accounting choices are providing for the
information needs of stakeholders and self-interest. Providing relevant
information means that managers make choices that provide information that’s
most useful for the decisions stakeholders have to make. Pursuing their self-
interests means that managers make choices that serve their own needs and
interests rather than those of stakeholders. These factors often conflict because the
information that best serves the information needs of stakeholders isn’t
necessarily the same information or presentation that serves the interests of
stakeholders.

 What are some of the factors that limit the choices that managers can make?

The constraints managers could face include IFRS and ASPE, securities laws, tax
laws, corporations’ laws, and the terms of contracts.