Chapter 6

Revenue Recognition

Overview
Conceptual
Understanding sales transactions Accounting for sale transactions
Earnings process Measurability Collectibility

Computational (Mechanics)
Consignment sales Bundle sales
Relative fair value method Residual value method

Long-term service contract

%-of-completion method Completed contract method Contract with interim loss Contract with overall loss Presentation
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Presentation and disclosure

Gross vs. Net revenues

1. Conceptual Fundamentals
Understanding the nature of sales transactions from a business perspective Economics of business transactions Legalities Accounting for sales transactions recognition and measurement Earnings approach 1. Earnings process 2. Measurability

Accounting presentation and disclosure

Revenues vs. Gains Net income vs. OCI Gross vs. net revenues

IFRS/Private Entity GAAP Comparison Analysis Looking ahead

3. Collectibility
Contract-based approach (not required)

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Understanding Sales Transactions

Accounting for revenues is often very complex Much of complexity is caused by the structure of the sales transaction

Discuss: What are the sales structure of the following stores? 1. Dollarama 2. Walmart (or Canadian Tire) 3. Costco 4. Bell/Fido/Rogers/Virgin Mobile 5. Brick: No payment, no interest for three years 6. Brick: Bad credit history? Well take of it?
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Real World Sales Transactions Cash sales (with no exchange or return) Credit sales Sales with rights of return and/or warranty Credit sales with concessional terms Bundle sales Consignment sales Sales contract on long-term constructions Swap of two non-monetary assets Etc.
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Understanding Sales Transactions

To properly account for sales transactions, accountants must understand the business of the entity and the nature of the transaction Key questions for understanding the sales transactions from a business perspective are:
What is being given up? What is being received?

Normally specified in sales agreements

What is being Sold (Given Up)?

Goods
Generally with transfer of legal title and possession Legality: f.o.b. shipping point, f.o.b. destination Earnings process: discrete process

Services
legal title and possession irrelevant Legality: governed by service contract (explicit obligation) or constructive obligation (implicit obligation) Earnings process: continuous process

Bundled sales (combinations of sale of goods and/or services)

Also called multiple deliverables complexity in measuring each component e.g. sale of cell phone w/ three-year service contract

What is Being Received?

Consideration being received for goods and/or services sold is either:
Cash or cash-like (monetary) Non-monetary (another good/service, also known as barter) Ch10

Generally assume that the transaction is at arms length (between unrelated parties) such that Value of Value of deliverables consideration sold received

Concessionary Terms
In contrast to normal terms
i.e. a better-than-normal deal

Incurred when one party is in a better bargaining position than the other Example of concessionary terms (p.323-324)
Lenient return policy Lenient payment policy Extended trial period More accommodating credit policy (e.g. sales made to customers with inferior credit) Bill and hold transactions Inclusion of extras (additional services, continuing fees, etc.)

Whats the concern?

Create more complex revenue recognition problem Whether and When to recognize? For what amount?
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E6-6
DSI sold inventory to CSI on Dec 20, 2010. The sale was made at significant discount to induce CSI to switch from its regular supplier CSI asked DSI not to ship the inventory until Jan 2, 2011, because CSIs warehouse was closed during the holidays (i.e. bill and hold)

Discuss whether the sale should be recognized in 2010 under earnings approach.

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Revenue Recognition
Understanding the nature of sales transactions from a business perspective Economics of business transactions Legalities Accounting for sales transactions recognition and measurement Earnings approach Contract-based approach Comparison Measurability Collectibility Mechanics

Accounting presentation and disclosure

Revenues versus gains

IFRS/Private Entity GAAP Comparison

Analysis Looking ahead

Net income versus other comprehensive income

Gross versus net revenues

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How to Account for Revenue?

There are two main conceptual views on how to account for revenues/sales:
Earnings approach (Traditional approach) Revenues are recognized when 1.risks and rewards transferred and/or earnings process substantially complete, 2.measurability reasonably assured 3.Collectibility is reasonably assured Contract-based approach
Not required for this class since it is still in an exposure draft form
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Recognition Criteria #1: Earnings Process (1) Sale of goods

Two indicators of whether risk and rewards transfer from seller to buyer:
Who has the legal title to the goods sold? Who has the possession of the goods sold?

In some situations, risks and rewards may be considered to transfer even if legal title and/or possession dont pass to the buyer
Example: forestry and agricultural products with assured prices and available markets

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Recognition criteria #1: Earnings Process (b) Services and Long-term Contracts
The earnings process for services is different than for the sale of goods For the sale of goods, delivery of the goods is the critical event For services, the performance of the service (which may be ongoing or continuous) is the determination of revenue recognition Recognize revenue at each critical event, as long as it is measurable and collectible
E.g. %-of-completion method (preferred)
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Services and Long-Term Contracts

If outcome is not reliably measurable or if there is a concern on collectibility
IFRS: zero-profit method (allows recognition of recoverable revenues equal to costs incurred) calculation and accounting treatment not required PE GAAP: completed-contract method may be used IFRS makes no mention of completed-contract method

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Recognition criteria #2: Measurability

Sales are generally measured at fair value (reflecting also time value of money for consideration paid over extended period of time) Measurement uncertainty generally arises when: we cannot measure the consideration we cannot measure related costs, or we cannot measure the outcome of the transaction Recognition under measurement uncertainty (two options) Do not recognize revenues until measurement uncertainty resolved Recognize revenues but measure and accrue amount relating to uncertainty as a cost or reduced revenues (e.g. Accrual of warranty liability) (preferred)

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Sales with Warranty/Rights of Return

Three alternatives
1. Sale recorded only when right of return expired 2. Sale recorded but subtracting estimate of future returns - Only available if returns measurable 3. Sale and returns recorded when they occur Revenue NOT recognized even if title has passed WHEN 1. The price is not fixed 2. Buyer does not pay until product is resold/consumed/used 3. Buyers obligation changes when there is theft, damage or product is destroyed 4. Returns are not estimable
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Measuring Parts of a Sale

More complex when sale creates multiple deliverables (i.e. bundle sales)
e.g. A telephone company would sell a phone and a monthly service

GAAP says to separate each deliverable, if possible Overall price can be allocated using two methods:
Relative fair value method Residual value method

Timing of recognition for each deliverable is determined individually with reference to GAAP 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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Bundle Sales: Illustration

Rogers sold you today a smart phone at $100 with a three-year service contract. Monthly fee is $25. Without the contract, you need to pay $300 to get the phone, and same monthly fee to get the service. Decide how Rogers should record the sale, assuming the time value of money is ignored, using
(1) Relative fair value method (2) Residual value method

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 Relative fair value method (preferred)

Phone: fair value $300 Service: fair value $900 ($25*12m*3yrs) Bundle: fair value $1200; sold at $1000

Relative fair value of phone: 300/1200=25%

Relative fair value of service: 900/1200=75% Sales revenue for phone: $1000 * 25% = $250 (today) Sales revenue for service: $1000 * 75% = $750 (spread to 36 months)

Residual value method

Used only if the fair value of delivered is unknown, yet the fair value of undelivered is known The residual value is then used to value the delivered
Sales revenue (undelivered) for service: $900 (known) Sales revenue (delivered) for phone: $1000-$900 = 100 (residual)

The purpose is to ensure the upfront revenue is not 20 overstated

Recognition criteria #3: Collectibility

In order to recognize revenues at time of sale, it is necessary to establish ultimate collectibility If collectibility cannot be reasonably assured, then revenues cannot be recognized at the time of sale
Accounting treatment defaults to cash basis (i.e. recognize income as cash is received) or expense coverage basis (i.e. recoverable revenue may only be recognized equal to recognized expenses zero profit method). Computation not required Zero profit method is only used in IFRS
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Recognition vs. Realizaton

Revenue is recognized when: Risks and rewards have passed or the earnings process is substantially complete Measurability is reasonably certain and Collectibility is reasonably assured (realized or realizable) Revenue is realized when products (goods or services), are exchanged for cash (or claim to cash) Revenue can be recognized even if it is not realized Revenue could be realized even if it it not recognized

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E6-6 Solution
Under the earnings approach, revenue is generally recognized when risks and reward are transferred (i.e. normally delivery). Where a bill and hold policy is not a normal business practice, the transaction should be reviewed to ensure it is a bona bide sales transaction, and not just an aggressive sales strategy that will not be realizable. In order to assess whether or not the sale to CSI should be included as a sale as at December 2010, one must first look at the conditions under which the customer requested that the shipment be put on hold until a January 2, 2011 shipping date. Care must be taken to determine which party has the significant risks and rewards of ownership. An argument could be made to recognize the revenue in fiscal 2010, as long as there is a sound business reason for holding the goods, the customer acknowledges the delayed delivery, normal payment terms apply, and the goods are available, on hand, identified, and ready for delivery at the time of sale. The buyer has control on the delivery date. The sales revenue amount is measurable and collectible.
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Revenue Recognition
Understanding the nature of sales transactions from a business perspective Economics of business transactions Legalities Accounting for sales transactions recognition and measurement Earnings approach Contract-based approach Accounting presentation and disclosure

IFRS/Private Entity GAAP Comparison

Analysis Looking ahead

Revenues versus gains

Net income versus other comprehensive income Gross versus net revenues

Comparison
Measurability Collectibility Mechanics

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Presentation: Reporting Gross vs. Net Revenues

Revenues can be recorded as the gross amount billed or as the net amount retained Different presentation leads to different ratio calculations. e.g. priceline.com (p.350-351), BE6-21 Consideration should be given to the following factors: whether company acts as a principal or as an agent/broker whether company takes title to the goods sold whether company has risks and rewards of ownership of goods sold
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Mechanics

Consignment Sales
Consignment sales
One party (consignor) ship goods to another party (consignee)) Consignor earns a profit on the sales Consignee earns a commission on the sales.

Possession has transferred; however legal title remains with the consignor

Think: Goods on consignment should be reported as inventory by the consignor or consignee?

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Illustration
Dec 10: ABC Co. shipped $200 of merchandise on consignment to XYZ Co. Dec 10: ABC paid freight cost of $10 in cash. Dec 15: XYZ paid $20 for local advertising, which is reimbursable from ABC in accordance with the agreement by both parties Dec 28: all merchandise has been sold for $300 in cash. Dec 31: XYZ notified ABC, retained a 10% as sales commission, and remitted cash to XYZ. Prepare relevant journal entries for both parties
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Consignors Books
Goods shipped to Consignee (Dec10) Inventory on Consignment 200 Finished Goods Inventory 200 Payment of Freight (Dec 10) Inventory on Consignment 10 Cash 10 Payment of ad by consignee (Dec15) No entry until notified Sale of merchandise (Dec 28) No entry Remittance of cash (Dec31) Cash 250 Advertising Expense 20 Commission Expense 30 Revenue 300 Cost of Goods Sold 210 Inventory on Consignment 210

Consignees Books
Goods shipped to Consignee (Dec10) No entry Payment of Freight (Dec 10) No entry Payment of ad by consignee (Dec15) Receivable from Consignor 20 Cash 20 Sale of merchandise (Dec 28) Cash 300 Payable to consignor 300 Remittance of cash (Dec 31) Payable to consignor 300 Commission Revenue 30 Receivable from consignor 20 Cash 250 29

Long-Term Service Contracts

Percentage-of-Completion Method
recognizes revenues and gross profit each period based on progress or contract completion Used when
Terms of contract are certain and enforceable Certainty of performance by both parties

If above criteria are not satisfied

Completed-Contract Method (PE GAAP only)
recognizes revenue and gross profit only after the whole contract is completed

Zero-profit Method (IFRS)

allows recognition of recoverable revenues equal to costs incurred if outcome is not reliably measurable
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Percentage-of-Completion
The amount of revenues, costs and gross

profit recognized on long term contracts depends upon the percentage of work done Application of percentage-of-completion method requires a basis for measuring the progress toward completion at interim dates
- Can use input measures (e.g. costs incurred-

which is the most popular method, or labor hours worked) - Can use output measures (e.g. storeys of a building completed, metric tons produced)
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Completed-Contract Method
Revenue and gross profit are recognized on the completion of the contract Advantage: reported revenue is based on actual results, not estimates Disadvantage: does not reflect current performance; creates distortion of earnings

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Percentage-of-Completion: An Example
Data: Contract price: $4,500,000 Estimated cost: $4,000,000

Start date:

July, 2004

Finish:

Oct, 2006

Balance sheet date: Given:

December 31st 2004 2005 2006

Progress billings during year $ 900,000 $2,400,000 $1,200,000 Cash collected during year $ 750,000 $1,750,000 $2,000,000

Costs to date

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

-0-

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

For each year, calculate gross profit , make journal entries, and describe how to present on balance sheet 33

Percentage-of-Completion: Cost-to-Cost Basis

1 Costs Incurred to Date = Percent Complete Most Recent Estimated Total Costs

2 Percent Complete x Estimated Total Revenue = 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 Cost = Gross Profit
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Percentage-of-Completion: Cost-to-Cost Basis

2004
Percent Complete
1,000,000 4,000,000 =25%

2005
2,916,000 4,050,000

2006
4,050,000 4,050,000

=72% $4,500,000 $3,240,000 1,125,000 $2,115,000 $2,916,000 - 1,000,000 $1,916,000 $ 2,115,000 1,916,000 $ 199,000

=100% $4,500,000 $4,500,000 3,240,000 $1,260,000 $4,050,000 - 2,916,000 $1,034,000 $ 1,260,000 1,034,000 35 $ 226,000

Contract Price
Revenue to be recognized to date Less: Prior Year Revenue Current Year Revenue

$4,500,000 $1,125,000 -0$1,125,000 $1,000,000 -0$1,000,000 $ 1,125,000 1,000,000 $ 125,000

Current year expense

Current year gross profit

Comparison of Results (Gross Profit Recognition)

Year
2004 2005 2006 Total

Percentage-ofCompletion
$125,000 199,000 126,000 $450,000

CompletedContract
$ 0 0 450,000 $450,000
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Percentage-of-Completion: Journal Entries

To record costs of construction (000 omitted) 2004 Construction in Process 1,000 Inventory, Cash, Payables, etc. 1,000 To record progress billings Accounts Receivable Billings on Construction To record collections Cash Accounts Receivable To recognise revenue and gross profit Construction in Process Construction Expense Rev. from Long-Term Contracts To record completion of the contract Billings on Construction Construction in Process 4,500 4, 50037 2005 1916 1916 2006_ 1,134 1,134

900 900

2,400 2,400

1,200 1,200

750 750

1,750 1,750

2,000 2,000

125 1,000 1,125

199 1,916 2115

126 1,134 1,260

Percentage-of-Completion: Financial Statement Presentation

Construction in Process (CIP) To accumulate incurring construction costs To recognize gross profit if percentage-ofcompletion method is used Billings on Construction in Process (BOCIP) To accumulate billing incurred to date A contra account to Construction in Process (CIP) At the end of each period, the balances of both accounts are compared. Debit net balance is reported as an ASSET Credit net balance as a LIABILITY Review p. 343 Illustration 6-15 and 6-16 When project ends, both accounts are CLOSED. 38

Financial Statement Presentation: Percentage-of-Completion

2004 (in 000) CIP: 1,000+125=1,125 (Deserved Revenue) BOCIP: 900 (Billed to customer) 1,125 > 900 => $225 reported as Current Asset (to be collected from customer)

2005 (in 000) CIP: 1,125+(1,916+199) = 3,240 BOCIP: 900+2,400=3,300 3,240 < 3,300 => $60 reported as Current Liability 39 (Customer overbilled)

Completed-Contract Method: Journal Entries

To record costs of construction (000 omitted) 2004 Construction in Process 1,000 Inventory, Cash, Payables, etc. 1,000 To record progress billings Accounts Receivable Billings on Construction To record collections Cash Accounts Receivable To recognise revenue and gross profit No entry To record completion of the contract Billings on Construction Revenue from long-term Contracts Construction Expenses Construction in Process 4,500 4, 500 4,050
40 4,050

2005 1916 1916

2006__ 1,134 1,134

900 900

2,400 2,400

1,200 1,200

750 750

1,750 1,750

2,000 2,000

Journal Entries: CompletedContract vs. Percentage-ofCompletion Method

All journal entries are the same EXCEPT THAT
(1) no entry is recorded at the end of the period for completed-contract method to recognize revenue and gross profit; (2) closing entries also differ

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Financial Statement Presentation: Completed-Contract

2004 (in 000) CIP: 1,000 (Costs incurred to date; Revenue uncertain) BOCIP: 900 (Billed to customer) 1,000 > 900 => $100 reported as Current Asset (to be collected from customer)

2005 (in 000) CIP: 1,000+1,916 = 2,916 BOCIP: 900+2,400=3,300 2,916 < 3,300 => $384 reported as Current Liability 42 (Over-billed to customer)

Long-Term Contract Losses

A long-term contract may produce either:
an overall profit an interim loss but an overall profit or an overall loss for the project

Under the percentage-of-completion method, losses in any case are immediately recognized during the period of loss. Under the completed-contract method, losses are recognized during the period of loss only when overall losses result
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Recognizing Current and Overall Losses on Long-Term Contracts

Scenario 1: Current Loss on an otherwise overall profitable contract Scenario 2: Loss on an overall unprofitable contract

Percentage Method: Recognize loss currently

Completed Method: No adjustment needed Percentage Method: Recognize entire loss now Completed Method: Recognize entire loss now
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Scenario I: Interim Loss on Profitable Contract Prior Example

Data as previously given, except for the 2005 cost estimate $1,134,000
2004 2005 $4,500,000 2,916,000 1,468,962 4,384,962 2,916,000 4,384,962 2006 $4,500,000 4,384,962 -04,384,962 4,384,962 4,384,962 $4,500,000 1,000,000 3,000,000 4,000,000 1,000,000 4,000,000 = 25%

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

Percent Complete

= 66.5%

= 100%

Revenue to be recognized to 2005: $4,500,000 x 66.5% = $2,992,500 Less: Revenue recognized prior to 2005: 1,125,000 Revenue recognized in 2005 $1,867,500 Less: Actual costs incurred in 2005 1,916,000 Loss recognized in 2005 (48,500)

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Scenario I: Interim Loss on Profitable Contract

Percentage-of-completion method
In contrast to
Construction expense Construction in Process (gain) 1,916,000 199,000

Revenue from Long-Term Contract 2,115,000

Construction Expense 1,916,000 Construction in Process (loss) 48,500 Revenue from Long-Term Contract 1,867,500

Completed-contract method
As the contract is overall profitable, no loss is recognized in 2005

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Scenario II: Interim Loss on Prior examples: Unprofitable Contract

Data as previously given, except for the 2005 cost estimate
2004 Contract Price Costs To Date Est. Cost to Complete Est. Total Costs Gross profit/loss $4,500,000 1,000,000 3,000,000 4,000,000 1,125,000 -) 1,000,000 125,000 2005 $4,500,000 2,916,000 1,640,250 4,556,250 Anticipated Loss $56,250 $1,134,000 & $1,468,962 $4,500,000 4,556,250 -04,556,250 2006

Losses recognized in 2005 Reverse gross profit recognized prior to 2005 Expected loss on unprofitable contract Total loss to be recognized in 2005

POC $125,000 56,250 $181,250

CC $ N/A 56,250 $56,250

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Scenario II: Interim Loss on Unprofitable Contract

Percentage-of-completion method

A plug-in number; Why is it more than 1,916,000?

Construction Expense 1,936,250 Construction in Process (loss) 181,250 Revenue from Long-Term Contract 1,755,000
Total rev. recognized in 2005: (4,500,000 X 64%) $2,880,000 Less: Revenue recognized in 2004 1,125,000 Revenue recognized in 2005 $1,755,000

Completed-contract method

2916000/4556250=64%

Whenever the contract results in OVERALL loss, the loss is recognized in the year it is anticipated, NOT in the year it actually occurs. Loss from Long-Term Contract 56,250 Construction in Process (loss) 56,250

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OPTIONAL - Why the construction expense $1,936,250 is more than $1,916,000? (An alternate way to determine construction expense) Demonstration 1
Construction cost expenses = Costs incurred in 2005 + Estimated loss in 2006 to be recognized in 2005 = 1,916,000 + 20,250* = 1,936,250 Overall Reverse Actual Loss in loss 2004 GP 2005 *Estimated loss in 2006 = 56,250 + 125,000 (1,916,000-1755,000) = 181,250-161,000 = 20,250

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OPTIONAL - Why the construction expense is more than $1,916,000? (An alternate way to determine construction expense) Demonstration 2 Construction expense recognized in 2005 include two components 1. Cost recognized in 2005 on the basis of %-of-completion 2. Anticipated loss Cost recognized on the basis of % of completion 4,500,000*64% $ 2,880,000 Less: cost of construction recognized in 2004 (1,000,000) Cost recognized in 2005 on the basis of POC $ 1,880,000 Add: Anticipated loss 56,250 Construction expense recognized in 2005 $ 1,936,250
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