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Chapter 18
Revenue Recognition
Recognize revenue in the accounting period when the performance obligation is satisfied
Step #1: Identify contract with customer Must apply Rev. Guidance to contract if: a.) contract has commercial substance b.) Parties have approved the contract and are committed to perform c.) Company can identify each party's rights (regarding goods & services transferred) d.) Company can identify payment terms e.) It is probable that the company will collect DO NOT apply Rev. Guidance if: 1.) Contract is wholly unperformed AND, 2.) Each party can terminate contract w/o cost Treat as a new contract if BOTH:
- Distinct
- Standalone price Step #2: Identify performance obligations Performance obligation: A promise in a contract to provide a product or service to a customer Distinct within the contract? Yes - separate P.O. No - Not separate P.O. Step #3: Determine transaction price Transaction Price: The amount of consideration we receive for providing goods/service 4 types of transaction price
- Variable consideration 3. Non-cash consideration
- time value of money 4. Consideration paid/payable to customers
Variable consideration Price dependent on future events. May include price increases, volume discounts 2 Methods for variable consideration
- Expected Value - probability weighted amount
- Most likely amount Expected Value: Probability-weighted amount in a range of possible consideration amounts. Most Likely Amount: The single most likely amount in a range of possible consideration outcomes. Only recognize variable consideration if: 1.) Company has experience with similar contracts and is able to estimate the amount of revenue 2.) Based on prior experience, it is highly probable that there will not be a significant reversal of For example: Peabody Construction Company enters into a contract with a customer to build a warehouse for $100,000, with a performance bonus of $50,000 that will be paid based on the timing of completion. The amount of the performance bonus decreases by 10% per week for every week beyond the agreed-upon completion date. The contract requirements are similar to contracts that Peabody has performed previously, and management believes that such experience is predictive for this contract. Management estimates that there is a 60% probability that the contract will be completed by the agreed- upon completion date, a 30% probability that it will be completed 1 week late, and only a 10% probability that it will be completed 2 weeks late. Question: How should Peabody account for this revenue arrangement? Management has concluded that the probability-weighted method is the most predictive approach: On time: 60% chance of $150,000 = $ 90, 1 week late: 30% chance of $145,000 = 43, 2 weeks late: 10% chance of $140,000 = 14, $147, Most likely outcome, if management believes they will meet the deadline and receive the $50,000 bonus, the total transaction price would be? $150,000 (the outcome with 60% probability) Time Value of Money When contract (sales transaction) involves a significant financing component. ► Interest accrued on consideration to be paid over time. ► Fair value determined either by measuring the consideration received or by discounting the payment using an imputed interest rate. ► Company reports as interest expense or interest revenue. For example: On July 1, 2019, SEK Company sold goods to Grant Company for R$900, in exchange for a 4-year, zero-interest-bearing note with a face amount of R$1,416,163. The goods have a cost on SEK’s books of R$590,000.
Questions: (a) How much revenue should SEK Company record on July 1, 2019? (b) How much revenue should it report related to this transaction on December 31, 2019?
Entry to record SEK’s sale to Grant Company on July 1, 2019, is as follows. Notes Receivable 900, Sales Revenue 900,
If no clear standalone price, what are other approaches? 1.) Adjusted Market Assessment Approach 2.) Expected Cost plus Margin Approach 3.) Residual approach Adjusted Market Assessment Approach Evaluate market and estimate what customers are willing to pay. Expected cost plus margin approach Estimate your expected cost and add an appropriate profit margin. Residual approach Residual - (transaction price) - (known standalone prices) *use if standalone price is either:
- highly variable
- Uncertain
Allocation of Discounts:Usually allocate proportionally across all P.O.s In some cases we may allocate only to one or more but not all P.O.s if ALL of the following:
- Regularly sells each distinct good/service on a standalone basis
- Regularly sell on a standalone basis a bundle at a discount
- Discount in (2) must be substantially the same as the discount in the contract If there is more than one performance obligation, how should the payment of $2,000,000 be allocated to various components? The total revenue of $2,000,000 should be allocated to the three components based on their relative standalone selling prices. In this case, the standalone selling price of the equipment is $2,000,000, the installation fee is $20,000, and the training is $50,000. The total standalone selling price therefore is $2,070,000 ($2,000,000 + $20,000 + $50,000). The allocation is as follows. Equipment $1,932,367 [($2,000,000 ÷ $2,070,000) × $2,000,000] Installation $19,324 [($20,000 ÷ $2,070,000) × $2,000,000] Training $48,309 [($50,000 ÷ $2,070,000) × $2,000,000] Handler makes the following entry on November 1, 2019, to record both sales revenue and service revenue on the installation, as well as unearned service revenue. November 1, 2019 Cash 2,000, Service Revenue (installation) 19, Unearned Service Revenue 48, Sales Revenue 1,932, Handler recognizes the training revenues on a straight-line basis starting on November 1, 2019, or $4,026 ($48,309 ÷ 12) per month for 1 year (unless a more appropriate method such as the percentage-of-completion method—discussed in the next section—is warranted). The journal entry to recognize the training revenue for 2 months in 2019 is as follows. December 31, 2019 Unearned Service Revenue 8, Service Revenue (training) ($4,026 × 2) 8, Therefore, Handler recognizes revenue at December 31, 2019, in the amount of $1,959, ($1,932,367 + $19,324 + $8,052). Handler makes the following journal entry to recognize the remaining training revenue in 2020, assuming adjusting entries are made at year-end.
December 31, 2020 Unearned Service Revenue 40, Service Revenue (training) ($48,309 − $8,052) 40,
Step #5 Recognize revenue when performance obligation is satisfied When is a P.O. satisfied? When a customer obtains control of the asset
When does a customer obtain control of the asset? 1.) Customer has the ability to direct use of and obtain substantially all remaining benefits 2.) Customer has ability to prevent others from doing the same
Indicators of transfer of control 1.) company has a right to payment 2.) company has transferred legal title 3.) company has transferred physical possession 4.) customer has significant risks/rewards of ownership 5.) customer has accepted the asset
Recognize revenue over a period of time if:
- Customer receives benefits as the seller performs
- Either of the following a.) customer controls the asset as it is created b.) company does not have an alternative use for the asset
Right of Return Sale that gives the customer the right to:
- a full or partial refund
- a credit to their account
- another product in exchange
Company would recognize
- revenue in the amount reasonably assured
- refund liability
- an asset for the company's right to recover the product
What if a company cannot estimate returns? Cannot recognize revenue until returns are predictable or return period expires. Repurchase agreement types
- Forward --> must buy it back
- Call option --> right to buy it back
- Put option --> must buy it back at the customer's request
How do you account for Forwards & Calls?
Returned Inventory 120 Cost of Goods Sold (2 × €60) 120
To record expected sales returns on January 31, 2019.
Sales Returns and Allowances 100
Allowance for Sales Returns and Allowances 100 To record the expected return of the one camera
Estimated Inventory Returns 60
Cost of Goods Sold (1 × €60) 60
Income statement
Statement of financial position
Cash Sales with Returns and Allowances
Illustration: Assume now that on January 12, 2019, Venden NV sells 100 cameras for €100 each for cash to Amaya SA. Venden allows Amaya to return any unused cameras within 45 days of purchase. The cost of each product is €60. Venden estimates that:
- Three products will be returned.
- The costs of recovering the products will be immaterial.
- The returned products are expected to be resold at a profit. To record the sale of the cameras January 12, 2019. Cash 10, Sales Revenue (100 × €100) 10, Cost of Goods Sold 6, Inventory (100 × €60) 6, Assuming that Venden did not pay cash at the time of the return of the two cameras to Amaya on January 24, 2019, the entries to record the return of the two cameras and related cost of goods sold are as follows. To record the return of the cameras January 24, 2019. Sales Returns and Allowances 200 Accounts Payable (2 × €100) 200 Returned Inventory 120
Cost of Goods Sold (2 × €60) 120 To record expected sales returns on January 31, 2019. Sales Returns and Allowances 100 Accounts Payable (1 × €100) 100 To record the expected return of the one camera Estimated Inventory Returns 60 Cost of Goods Sold (1 × €60) 60
Income statement
Statement of financial position
Repurchase agreements
Allows company to transfer an asset to a customer but have an unconditional (forward) obligation or unconditional right (call option) to repurchase the asset at a later date. If the obligation or right to repurchase is for an amount greater than or equal to selling price, then transaction is a financing transaction.
Facts: Morgan Ltd., an equipment dealer, sells equipment on January 1, 2019, to Lane Company for £100,000. It agrees to repurchase this equipment (an unconditional obligation) on December 31, 2020, for a price of £121,000.
Assuming an interest rate of 10% is imputed from the agreement, Morgan makes the following
entry to record the financing on January 1, 2019.
Cash 100,
Liability to Lane Company 100,
Morgan records interest on December 31, 2019, as follows.
Interest Expense 10,
Liability to Lane Construction (£100,000 x 10%) 10,
Morgan records interest and retirement of its liability to Lane on December 31, 2020, as follows.
Consignor (manufacturer or wholesaler) ships merchandise to the consignee
(dealer), who is to act as an agent for the consignor in selling the merchandise.
Consignor makes a profit on the sale.
► Carries merchandise as inventory.
Consignee makes a commission on the sale.
Warranties
Two types of warranties to customers:
- Product meets agreed-upon specifications in contract at time product is sold. a. Warranty is included in sales price (assurance-type warranty).
- Not included in sales price of product (service-type warranty). a. Recorded as a separate performance obligation.
For exampel: Maverick Company sold 1,000 Rollomatics on October 1, 2019, at total price of
$6,000,000, with a warranty guarantee that the product was free of defects. The cost of the Rollomatics is $4,000,000. The term of this assurance warranty is 2 years, with an estimated cost
of $80,000. In addition, Maverick sold extended warranties related to 400 Rollomatics for 3
years beyond the 2-year period for $18,000. On November 22, 2019, Maverick incurred labor
costs of $3,000 and part costs of $25,000 related to the assurance warranties. Maverick prepares
financial statements on December 31, 2019. It estimates that its future assurance warranty costs
will total $44,000 at December 31, 2019.
Question: What are the journal entries that Maverick Company should make should make in
2019 related to the sale of the Rollomatics and the assurance and extended warranties?
October 1, 2019 To record the sale of the Rollomatics and the related extended warranties:
Cash ($6,000,000 + $18,000) 6,018,
Sales Revenue 6,000, Unearned Warranty Revenue 18, To record the cost of goods sold and reduce the inventory of Rollomatics:
Cost of Goods Sold 4,000,
Inventory 4,000, November 22, 2019 To record the warranty costs incurred:
Warranty Expense 28,
Salaries and Wages Payable 3, Inventory (parts) 25, December 31, 2019
To record the adjusting entry related to its assurance warranty at year end:
Warranty Expense 44,
Warranty Liability 44,
For example: On March 1, 2019, Henly Company enters into a contract to transfer a product to
Propel Inc. on July 31, 2019. It is agreed that Propel will pay the full price of $10,000 in advance
on April 1, 2019. The contract is non-cancelable. Propel, however, does not pay until April 15,
2019, and Henly delivers the product on July 31, 2019. The cost of the product is $7,500.
No entry is required on March 1, 2019:
► Neither party has performed on the contract. ► Neither party has an unconditional right as of March 1, 2019. On receiving the cash on April 15, 2019, Henly records the following entry. Cash 10, Unearned Sales Revenue 10,
On satisfying the performance obligation on July 31, 2019, Henly records the following entry to
record the sale.
Unearned Sales Revenue 10, Sales Revenue 10, In addition, Henly records cost of goods sold as follows.
Cost of Good Sold 7, Inventory 7,
Contract Modifications
Change in contract terms while it is ongoing. Companies determine ► whether a new contract (and performance obligations) results or ► whether it is a modification of the existing contract.
For example, Crandall Co. has a contract to sell 100 products to a customer for $10,000 ($
per product) at various points in time over a six-month period. After 60 products have been
delivered, Crandall modifies the contract by promising to deliver 20 more products for an
additional $1,900, or $95 per product (which is the standalone selling price of the products at the time of the contract modification). Crandall regularly sells the products separately.
Given a new contract, Crandall recognizes an additional:
Original contract [(100 units - 60 units) x $100] = $4,
New product (20 units x $95) = 1,
Total revenue $5,
Prospective Modification
Company should ► account for effect of change in period of change as well as future periods if change affects both. ► not change previously reported results.
For Crandall, the amount recognized as revenue for each of the remaining products would be a
blended price of $98.33, computed as follows.
Products not delivered under original contract
($100 x $40) = $4,
Products to be delivered under contract modification ($95 x 20) = 1,
Total remaining revenue $5,
Revenue per remaining unit ($5,900 ÷ 60) = $98.
