Intermediate Accounting Exam
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106 Terms
What are the two primary issues in revenue recognition?
Timing (when to record revenue) and Measurement (how much.
Revenue is recognized when control of a good or service transfers to the customer, in the amount the company expects to be entitled to in exchange.
List the five steps of revenue recognition in order
You recognize revenue as you satisfy each performance obligation (a promise to the customer). Five steps;
Identify the contract with the customer
Identify the performance obligations
Determine the transaction price
Allocate the transaction price to the performance obligations
Recognize revenue when (or as) each obligation is satisfied.
Steps 2 and 3 both feed into Step 4
Example 8.1 (the pattern for everything else)
Access Unlimited sells a phone (standalone $350) and a 12-month service plan (standalone $40 x 12 = $480) as a bundle for $750, paid in full on January 1. The phone cost $150.
Step 1: There is a contract.
Step 2: Two obligations: the phone and the service.
Step 3: Transaction price is $750.
Step 4: Total standalone value is $830. Phone share is $350 / $830 = 42.2%; service share is 57.8%. Phone gets $316.50, service gets $433.50.
Step 5: Phone revenue is recognized at delivery (point in time). Service revenue is recognized over the 12 months.
What are the five criteria for a contract with a customer?
All parties approve the contract and commit to performing
Each party’s rights are identifiable
Payment terms are identifiable
The contract has commercial substance
Collection is probable.
The customer paying in full is NOT a criterion.
Memory aid for the five contract criteria:
The first three say the contract is clear and agreed to (approved, rights identifiable, payment identifiable).
The last two say it is worth recording (it changes cash flows, and you will actually get paid).
Define commercial substance:
The risk, timing, or amount of the entity’s future cash flows is expected to change as a result of the contract. It is a Step 1 test about whether the contract is real.
Do not confuse it with performance obligation, which is a Step 2 idea about what was promised.
Which two contract criteria use the word “identifiable”?
Criterion 2 (each party's rights are identifiable) and criterion 3 (payment terms are identifiable). Distractor words on exams include "negotiable" or "fixed."
Example 8.2 (JC): 5,000 cases at $75 ($375,000), expects a 20% price concession. Does a contract exist? What is the price?
Yes, because it is probable JC collects 80% of the price. Transaction price = 80% x $375,000 = $300,000.
The collection test is about the amount the seller expects to be entitled to, not the full stated price.
If the five criteria are NOT met, how is cash received recorded, and when is revenue recognized?
Record cash as a liability (deferred revenue). Recognize revenue when consideration has been received AND one of these is true:
No remaining obligations, and substantially all consideration received is nonrefundable.
The contract is terminated and the consideration received is nonrefundable.
Control has transferred, no further transfer is owed, and the consideration is nonrefundable.
Example 8.3 (SBA sells a $5 million building, collection not probable). What happens?
No contract, so cash is deferred: $500,000, then $225,000, then $225,000.
Margots defaults and the contract terminates June 30, 2026.
The $950,000 received is nonrefundable: Dr Deferred Revenue 950,000; Cr Revenue 950,000.
When are separate contracts combined into one?
If any one holds:
They were negotiated as a package with a single commercial objective.
The consideration in one depends on the price or performance of another.
The goods or services in them are all a single performance obligation.
IFRS vs. U.S. GAAP: what does “probable” mean?
IFRS: more likely than not (over 50%).
U.S. GAAP: likely to occur, often interpreted as about 70-75%. US GAAP sets the higher bar.
Performance obligation
A promise to transfer a good or service that is distinct. Two forms:
A distinct good or service (or bundle of them).
A series of distinct goods or services that are substantially the same with the same pattern of transfer.
What two conditions must a good or service meet to be distinct?
BOTH:
Capable of being distinct: the customer can benefit from it on its own or with readily available resources
Separately identifiable: the seller’s promise to deliver it is separately identifiable from the other promises in the contract.
What is a readily available resource?
Something sold separately by the seller or another entity, or something the customer has already obtained from the seller or elsewhere.
How are “free” goods or services in a contract treated?
They must still be considered as possible performance obligations. The “free” label does not remove them.
Example 8.4 vs. 8.5 (CRED software license and installation): why two obligations in one and one in the other?
8.4: installation does not customize the software and others could do it. Both conditions met, so two obligations.
8.5: installation customizes the software and the software cannot be used until installed. The items are interdependent, so Condition 2 fails and there is one combined obligation.
Does one contract mean one performance obligation?
No. Williams’ single licensing agreement covered three films, which is three obligations. Each film is useful on its own, and delivering one does not depend on the others.
What is the procedure for counting obligations on an exam question?
List every good or service promised, including anything labeled free.
Test whether the customer could use each alone or with readily available resources.
Test whether your promise to deliver it is separate from your other promises.
Bundle items that fail; count what remains
Transaction price
The amount of consideration the entity expects to be entitled to as a result of providing goods or services to the customer.
Not necessarily the price stated in the contract. It is the amount the seller expects to receive.
It does not include amounts collected that will be passed on to third parties, such as sales tax. Sales tax collected from a customer is not the seller’s revenue.
It is the amount the entity will ultimately recognize as revenue.
Name the four factors that can adjust the transaction price
Variable consideration:
Amounts that depend on future events (like discounts, rebates, refunds, or performance bonuses).
(Adjustment: Estimate and constrain the amount to avoid overstating revenue).Significant financing component:
When the timing of payment provides financing to either the customer or the entity (essentially acting like a loan).
(Adjustment: Discount or compound the cash flows to present/future value).Noncash consideration:
Payment made in a form other than cash (e.g., goods, services, or equity shares).
(Adjustment: Measure at the fair value of the noncash item at contract inception).Consideration payable to a customer:
Money or credits the seller gives back to the customer (e.g., coupons, rebates, or slotting fees).
(Adjustment: Generally treated as a reduction of the transaction price/revenue, unless it is for a distinct good or service).
Variable consideration: what it is
Variable consideration exists when the payment the seller will receive for a good or service is not a fixed amount. The amount may vary because of:
price concessions,
performance bonuses or penalties,
discounts,
refunds,
rebates, and
incentives.
These elements can be stated explicitly in the contract (a bonus schedule) or implied (a seller who has a history of granting price concessions to similar customers).
What counts as variable consideration?
Anything that makes the price uncertain: discounts, rebates, refunds, performance bonuses and penalties, price concessions, and rights of return. The amount must be estimated.
Expected-value approach: what is it and when is it best?
The sum of probability-weighted amounts across a range of outcomes. Best with many possible outcomes. Check that probabilities total 100%. The result may not be an amount the company can actually receive.
Most-likely approach: what is it and when is it best?
Use the single most likely outcome. Best when there are only two possible outcomes. The result is an amount the company could actually receive.
What is the constraint on variable consideration?
Include variable consideration only to the extent it is probable that a significant revenue reversal will not occur.
In the book, 55% is not probable; about 75% generally qualifies.
Method for any variable-consideration problem.
List the outcomes and total consideration under each (start from the fixed amount)
Estimate using the required approach
Apply the constraint only if asked.
Confirm the probabilities total 100%
Shortcut: weight only the variable piece and add the fixed amount.
Nullibug: $400,000 fixed plus a bonus of $15,000 / $5,000 / $4,000 at 22% / 64% / 14%. Find the price both ways.
Expected value: $400,000 + (0.22 x 15,000 + 0.64 x 5,000 + 0.14 x 4,000) = $400,000 + $7,060 = $407,060.
Most likely amount: the 64% outcome, so $400,000 + $5,000 = $405,000.
Walker Consulting: $60,000 flat fee plus $10,000 if a target is reached (20% chance). Expected value?
$60,000 + (0.20 x $10,000) = $62,000. Trap: $60,000 ignores the bonus.
White Labs: 1,700 microscopes at $330, 10% discount if sales exceed 2,500 (55% likely). Most likely amount?
Base = 1,700 x $330 = $561,000.
The 55% outcome is likelier, so the discount applies: $561,000 x 90% = $504,900.
(Expected value would be $530,145, an amount the company could not receive.)
Williams Film: $165,000 fixed fee, even reduction if the third film is late, 86% likely on time. Transaction price?
Two outcomes, so most-likely-amount. The most likely outcome is no reduction and 86% clears the constraint, so the price is $165,000. The unstated reduction amount never enters.
Spiller: 290,000 pins at $17 with a retroactive volume discount (0% at 15%, 9% at 60%, 12% at 25%). Expected-value price?
Base = $4,930,000.
Expected discount = 0.15 x 0% + 0.60 x 9% + 0.25 x 12% = 8.4%, or $414,120.
Transaction price = $4,515,880.
The free refurbishing adds nothing to the price
What is the true definition of a significant financing component, and when do you NOT need to apply it (even if the timing gap is long)?
It is when the timing of payment agreed upon by the parties provides either the customer or the entity with financing for the transfer of goods or services. In simple terms: one party is acting like a bank for the other. The entity must adjust the transaction price for the time value of money to reflect what the cash price would have been if the customer paid at the time of delivery.
When to IGNORE it (even if > 1 year):
You do not adjust for a financing component if the timing of payment is driven by reasons other than financing:
Advance payment for a reason: The customer pays early to secure an adequate supply of goods (e.g., paying a year in advance to guarantee a spot in a manufacturing queue).
Variable consideration: The timing of payment is at the discretion of the customer (e.g., a rebate or a price concession).
Practical expedient: The time between transfer and payment is 1 year or less (as noted in your other card).
When does a significant financing component exist?
When more than a year lies between payment and delivery (the book’s rule of thumb) and the financing is significant.
Factors: difference between contract price and cash selling price, length of time, market interest rate.
Contract size and contract validity are NOT factors
Financing: delivery BEFORE payment
Discount to present value.
Sales revenue = PV
The difference is interest REVENUE
Example 8.9: $1,000,000 due in 2 years at 10%. Sales revenue $826,446; interest revenue $173,554.
Financing: payment BEFORE delivery
Grow to future value.
Sales revenue = FV, larger than the cash received.
The difference is interest EXPENSE (the seller is borrowing from the customer).
Example 8.10: $1,000,000 now, delivery in 2 years at 10%. Sales revenue $1,210,000; interest expense $210,000.
What is the formula for Present Value (PV) and what does it mean?
Formula (Direct Method)
FV = Future Value (the cash amount paid/received in the future)
i = interest rate per period (discount rate)
n = Number of periods
Present Value answers the question: "What is a future amount of money worth to me today?"
Because of the time value of money (inflation and opportunity cost), $1,000 today is worth more than $1,000 a year from now. This formula discounts a future cash flow back to its current, present-day worth. You use this when you know the future payment amount, but need to record the value of it today (like in the KMR Enterprises example).
What is the formula for Future Value (FV) and what does it mean?
PV = Present Value (the cash amount you have today)
i = Interest rate per period
n = Number of periods
Future Value answers the question: "If I invest this money today, how much will it grow to be in the future?"
This formula compounds the interest. You take your current money (PV), and multiply it by the interest rate over a set number of periods to see how much it will accumulate to. You use this when you are calculating things like retirement savings, loan balances, or what an investment will be worth down the road. (Note: This formula is just the PV formula algebraically rearranged).
Shiver Beaver: $4,000,000 paid in 8 years, delivery now, 4%. Revenue and interest?
Scenario: Delivery happens NOW, payment happens LATER. (Entity is financing the customer).
What to use: Present Value (PV) Table because you are discounting a future cash amount back to today's value.
Calculation Steps:
Identify the type: Single amount, so use the PV of $1 table.
Find the Factor: Look up n=8, i=4% in the PV of $1 table. Factor = 0.73069.
Sales Revenue: $4,000,000 × 0.73069 = $2,922,760. (Record this on the delivery date).
Interest Revenue: Total Cash ($4,000,000) − Sales Revenue ($2,922,760) = $1,077,240. (Recognized over the 8 years).
Key Check: Sales Revenue + Interest Revenue must equal the total cash received ($4,000,000).
Clark Cookie: $6,100,000 paid now, delivery in 10 years, 5%. Revenue and interest?
Scenario: Payment happens NOW, delivery happens LATER. (Customer is financing the entity—the entity is "borrowing" from the customer).
What to use: Future Value (FV) Table because you are taking the cash received today and "growing" it to what it will be worth at the time of delivery.
Calculation Steps:
Identify the type: Single amount, so use the FV of $1 table.
Find the Factor: Look up n=10, i=5% in the FV of $1 table. Factor = 1.62889.
Sales Revenue: $6,100,000 × 1.62889 = $9,936,229. (Record this on the delivery date in Year 10).
Interest Expense: Sales Revenue ($9,936,229) − Cash Received ($6,100,000) = $3,836,229. (Recognized over the 10 years).
Key Check: Sales Revenue must be larger than the cash received. If you used the PV factor (0.61391) here, you would get a revenue number smaller than the cash, which is the classic mistake.
How do I remember when to use the Future Value (FV) factor vs. the Present Value (PV) factor for financing components?
The "Time Travel" Rule:
Look at the Delivery Date. That is the date you must record your Revenue. Now, look at where the Cash is.
Cash is in the FUTURE (Delivery first): You must discount that future cash back to today. Use the PV Factor (Factor is less than 1.0).
Mnemonic: "Delivery Now, Cash Later = Discount back (PV)."
Result: Revenue < Cash; Difference is Interest Revenue.
Cash is in the PAST (Payment first): You must compound that past cash forward to the delivery date. Use the FV Factor (Factor is greater than 1.0).
Mnemonic: "Cash Now, Delivery Later = Grow forward (FV)."
Result: Revenue > Cash; Difference is Interest Expense.
Explanation:
Revenue is always recognized at the delivery date. The financing component just adjusts the amount of cash to match the delivery date.
If you get paid later (Delivery First), the cash you receive in the future includes interest. You have to strip that interest out using PV to find the true revenue today.
If you get paid early (Payment First), the cash you received today is missing interest. You have to add that interest using FV to find the true revenue at delivery.
Sanity Check (The "Borrowing" logic):
Payment First: You are borrowing from the customer. You owe them more than they gave you. Therefore, Revenue (what you owe) > Cash (what you got). This means you must use the FV factor (multiplier > 1) to make the number bigger.
Delivery First: You are loaning to the customer. They owe you more than the cash price. You only get the cash later. Therefore, Revenue (cash price today) < Cash (what you get later). This means you must use the PV factor (multiplier < 1) to make the number smaller.
Which table do you use for a single payment?
The Present Value of $1 or Future Value of $1 table, not an annuity table. Ask who holds the cash and for how long: delivery first means PV, payment first means FV.
Noncash consideration: how is the price measured?
At the fair value of the noncash consideration. If that cannot be estimated, use the standalone selling price of what the seller promised. Example 8.11: $55,000 when the stock trades actively; $56,000 (SSP of the services) when the stock is private.
Noncash consideration
Consideration promised by a costumer in a form other than cash (e.g., goods, services, shares of stock, or advertising space) in exchange for the transfer of goods or services.
Measurement Rule:
An entity must measure the noncash consideration at fair value at contract inception and include that amount in the transaction price
Consideration payable to a customer: what is the rule?
It reduces the transaction price unless the payment is for a distinct good or service the seller receives. Example 8.12: $10,000,000 less a $250,000 slotting fee = $9,750,000.
What is consideration payable to a customer?
It is an amount of cash (or a credit, such as a coupon or rebate) that the seller pays or promises to pay to the customer.
Examples:
Slotting fees
Coupons
Rebates
Price concessions
Basic Rule: Generally, it is treated as a reduction of the transaction price (revenue), unless it is in exchange for a distinct good or service from the customer.
Exhibit 8.4: all four factors together
Factor | Rule |
|---|---|
Variable consideration | Include it when it is probable that a significant revenue reversal will not occur. Estimate by expected value or most likely amount. |
Financing component | Incorporate it when delivery and payment are far apart. Use the market interest rate. Delivery before payment produces interest revenue; delivery after payment produces interest expense. |
Noncash consideration | Measure at the fair value of the noncash consideration. |
Consideration payable to a customer | Deduct unless the payment is for a distinct good or service. |
Define standalone selling price (SSP)
The price at which the seller would sell the good or service separately to a similar customer in similar circumstances
General allocation rule and formula?
Allocate on relative SSPs.
Allocated price = (obligation’s SSP /total of all SSPs) x transaction price
If SSPs total more than the price, the discount is spread in proportion to SSPs.
Why can’t you use standalone values directly as revenue?
They only set each obligation’s share. Revenue comes from the transaction price. Using them directly overstates revenue (Lucroy Phases 1-2 would be $1,656,000 instead of $1,480,410)
Name the three ways to estimate a missing SSP
Adjusted market assessment: Focus on what the seller believes customers in the market are willing to pay for the good or service, by evaluating the market (competitor prices, for example).
Expected cost plus a margin: Focus on internal factors: forecast the costs of providing the goods or services and add an appropriate profit margin.
Residual approach: The seller can estimate one or more, but not all, of the SSPs. The remainder of the transaction price (the "residual") is allocated to the item that has no SSP estimate.
How does “Adjusted Market Assessment” approach a missing Standalone Selling Price (SSP)
The Concept: It is an outside-in approach. You look at the external market to see what customers are willing to pay for similar goods or services, and then adjust for your specific circumstances.
How to apply it:
Look at competitor prices for similar items.
Look at the price of the good/service when sold separately in your own past transactions.
Look at pricing trends in the industry.
When to use it: Best used when there is a highly active and observable market for the item (e.g., consumer electronics, retail goods).
Why it matters: It proves you are focusing on the perceived value to the customer rather than just your internal costs.
How does the “Expected Cost Plus a Margin” approach estimate a missing Standalone Selling Price (SSP)?
The Concept: It is an inside-out approach. You look at your internal costs to provide the good or service, and then add a standard profit margin.
How to apply it:
Forecast the total expected costs to fulfill the obligation (materials, labor, overhead).
Add an appropriate profit margin. (This margin should reflect the margin the entity typically earns for similar services, or the industry average).
When to use it: Best used when the item is highly customized or unique to the seller, meaning there is no observable market price (e.g., custom software development, highly specialized construction).
Why it matters: It ensures the seller is compensated for their effort and risk, even if no one else sells the exact same item.
How does the "Residual" approach estimate a missing Standalone Selling Price (SSP), and what are the strict criteria for using it?
The Concept: It is a subtraction approach. You take the total transaction price of the contract and subtract the known SSPs of all the other distinct goods/services. Whatever is left over is the SSP for the item with the missing price.
Strict Criteria (You can ONLY use this if one of these is true):
The entity sells the same good/service to different customers for a highly variable range of amounts (e.g., different prices for different customers based on discounts).
The entity has not yet established a price for that good/service and it has not been sold separately before.
Example: A contract is $100. Item A has a known SSP of $60. Item B has no SSP. The residual approach assigns an SSP of $40 to Item B.
Why it matters: It is considered the "last resort" method. Standard-setters don't want companies using this method for everything, because it can artificially distort the prices of the remaining items. You must exhaust the other two methods first.
Bord Industries Problem: How do you allocate the $650,000 transaction price using the Adjusted Market Assessment approach?
Concept: You pretend you have no internal SSPs. You look entirely at what competitors are charging for A, B, and C to find their relative value.
The Math:
Find Total Market Price: Add up the market prices for all three products.
$133,000 (A) + $312,000 (B) + $200,000 (C) = $645,000
Find Percentages: Divide each product's market price by the $645,000 total.
A: 133,000 / 645,000 = 20.62%
B: 312,000 / 645,000 = 48.37%
C: 200,000 / 645,000 = 31.01%
Allocate: Multiply those percentages by the actual contract price ($650,000).
A: 20.62% × $650,000 = $134,030
B: 48.37% × $650,000 = $314,405
C: 31.01% × $650,000 = $201,565
Key Takeaway: You are allocating based on relative market value, ignoring the internal "standalone selling price" column entirely.
Bord Industries Problem: How do you allocate the $650,000 transaction price using the Expected Cost Plus a Margin approach?
Concept: You build the SSP from the ground up using your internal costs, plus a profit margin.
The Math:
Find Total Cost: Add up the forecasted costs.
$120,000 (A) + $250,000 (B) + $130,000 (C) = $500,000
Find the Margin: Figure out what margin is needed to bridge the gap between total cost and the actual transaction price.
($650,000 Transaction Price - $500,000 Total Cost) / $500,000 Total Cost = 30% Margin
Calculate Estimated SSPs: Multiply each product's cost by 1.30 (Cost + 30% margin).
A: $120,000 × 1.30 = $156,000
B: $250,000 × 1.30 = $325,000
C: $130,000 × 1.30 = $169,000
(Notice that these estimated SSPs add up perfectly to the $650,000 contract).
Key Takeaway: You are allocating based on the relative costs to produce each item, marked up by a consistent percentage.
Bord Industries Problem: How do you allocate the $650,000 transaction price using the Residual approach?
Bord Industries Problem: How do you allocate the $650,000 transaction price using the Residual approach?
Back:
Concept: You use the known standalone selling prices (SSP) for the items that have them, and whatever is "left over" from the contract price belongs to the item with the missing SSP.
The Math:
Start with the Total Contract Price: $650,000
Subtract known SSPs: Look at the "Standalone selling price" column for A and B (Ignore competitor prices and costs).
Minus A's SSP: -$175,000
Minus B's SSP: -$300,000
What is left goes to C:
$650,000 - $175,000 - $300,000 = $175,000
Key Takeaway: Unlike the other two methods, the Residual method does not adjust the prices of A and B. They stay at their exact stated SSPs, and C absorbs all the "discount" or "premium" of the overall contract.
Allocation Exception 1: variable consideration to only one obligation. Conditions?
Both must hold:
The variable terms relate to specific obligations only.
Allocating the amount entirely to them is consistent with a reasonable allocation based on SSPs.
Allocation Exception 2: a discount to only some obligations. Conditions?
All three:
The entity regularly sells the goods or services separately.
It regularly sells a bundle of some of them at a discount.
That bundle discount is basically the same as the discount in this contract.
Exhibit 8.5: the whole allocation process
Ask: is the SSP of each performance obligation known?
If no, estimate it, maximizing observable inputs, using one of the three approaches (adjusted market assessment, expected cost plus a margin, residual).
Ask: is the sum of the SSPs (or estimates) greater than the transaction price?
If no, allocate the transaction price by relative SSP.
If yes, there is a discount: allocate it by relative SSP (subject to the exceptions above).
When does a customer have control of an asset?
When it can direct the use of the asset and receives all (or substantially all) of the remaining benefits. Revenue is recognized when control transfers.
State the three criteria for recognizing revenue over time (any one is enough).
The customer receives and consumes the benefits simultaneously (memberships, subscriptions)
The customer controls the asset as the seller creates or enhances it.
The asset has no alternative use to the seller AND the seller has an enforceable right to payment for performance completed to date.
If revenue is recognized over time but progress can’t be measured reasonably, what happens?
Recognize no revenue until progress can be reasonably estimated.
List the five indicators of control for a point-in-time transfer.
The seller has a present right to payment.
The customer has legal title.
The seller has transferred physical possession.
The customer has the significant risks and rewards of ownership.
The customer has accepted the asset.
H&L Health Clubs: 100 annual memberships at $120 cash on January 1, quarterly reporting. How is revenue recognized and what are the entries?
The "Why" (Step 5 - Over Time): This meets Criterion 1 for recognizing revenue over time (the customer receives and consumes the benefit simultaneously as the service is provided day-by-day).
The Math: 100 memberships × $120 = $12,000 total cash. Since statements are quarterly, recognize 1/4 of the revenue each quarter ($12,000 / 4 = $3,000 per quarter).
Journal Entries:
Jan 1 (Cash received, service not yet provided):
Dr Cash ................................................ 12,000
Cr Deferred Revenue (Liability) ......... 12,000
Each Quarter End (Mar 31, Jun 30, Sep 30, Dec 31):
Dr Deferred Revenue ........................ 3,000
Cr Sales Revenue ................................ 3,000
Check: By Dec 31, Deferred Revenue is $0, and total Sales Revenue is $12,000.
Pemco: 3,000 memberships at $280 cash on Jan 1. Monthly revenue? What is the revenue on Jan 1 itself?
The "Why": Same as H&L. The members consume the benefit over time (Criterion 1), so revenue is recognized over time.
The Math: 3,000 × $280 = $840,000 total cash. Spread over 12 months = $840,000 / 12 = $70,000 per month.
Key Concept (Exam Trap):
Revenue recognized on January 1 itself is $0. Even though cash was received, no service has been delivered yet on day one. The entire $840,000 is a liability (Deferred Revenue) on Jan 1.
Wrong choices to avoid: $84,000 (dividing by 10 instead of 12) or $35,000 (random math).
Rand: $12 million contract, $2 million up front, 15,000 of 25,000 labor hours in Year 1. How is revenue recognized and what are the entries?
The "Why": The customer controls the system as it is built (e.g., custom software). This meets the criteria for Over Time recognition. You must use the cost-to-cost (or hours) measure of progress.
The Math:
Year 1 Progress: 15,000 / 25,000 hours = 60%. Revenue = 60% × $12M = $7,200,000.
Year 2 Progress: Remaining 10,000 hours = 40%. Revenue = 40% × $12M = $4,800,000.
Journal Entries:
Year 1 (Recognize Revenue & Bill customer):
Dr Deferred Revenue ....................... 2,000,000 (clears the upfront cash)
Dr Accounts Receivable .................... 5,200,000 (the unbilled balance)
Cr Service Revenue ............................. 7,200,000
Year 2 (Collect cash and recognize final revenue):
Dr Cash ............................................. 10,000,000
Cr Accounts Receivable ...................... 5,200,000
Cr Service Revenue ............................. 4,800,000
Hannah Greenhouses: four trees, $1,000 on credit, cost $650, immediate delivery. What are the entries?
The "Why": This is a Point-in-Time obligation. The trees are tangible goods. Control transfers to the customer immediately upon delivery.
The Math:
Revenue = $1,000 (the transaction price).
COGS = $650 (the cost of the inventory).
Journal Entries:
At Delivery (Record Sale & Receivable):
Dr Accounts Receivable ..................... 1,000
Cr Sales Revenue ................................ 1,000
At Delivery (Record Cost of Goods Sold):
Dr Cost of Goods Sold ....................... 650
Cr Inventory ........................................ 650
(Note: Unlike the membership or Rand examples, you record the expense and revenue at the exact same moment).
Lucroy: $2.7M paid in advance. Phases 1 & 2 delivered this year. How do you record the entries? (Allocated prices: P1 $810k, P2 $670,410, etc.)
The "Why": This is a contract with multiple distinct phases (Point-in-Time). Because the customer pays upfront, you owe a liability until each phase is delivered.
The Math:
Total Cash = $2,700,000.
Revenue earned this year (Phases 1 & 2) = $810,000 + $670,410 = $1,480,410.
Remaining Liability = $2,700,000 - $1,480,410 = $1,219,590 (represents Phases 3, 4, 5).
Journal Entries:
Beginning of Contract (Receive cash):
Dr Cash ............................................. 2,700,000
Cr Deferred Network Revenue ........... 2,700,000
Year-End (Record revenue for delivered phases):
Dr Deferred Network Revenue ........... 1,480,410
Cr Revenue ......................................... 1,480,410
(Note: The problem gave no cost information, so you do not record Cost of Goods Sold).
What are the Five Steps of Revenue Recognition (ASC 606) and the main rule for each?
Identify the contract: All 5 criteria (approval, rights, payment terms, commercial substance, probable collection) must be met. If not, use alternative methods.
Identify performance obligations: Promises to transfer distinct goods/services. (Two criteria: Capable of being distinct & distinct within the context of the contract).
Determine the transaction price: The amount the entity expects to be entitled to (adjust for variable consideration, financing, noncash, etc.).
Allocate the price: Allocate based on relative Standalone Selling Price (SSP) (using market, cost-plus, or residual methods).
Recognize revenue: As or when each obligation is satisfied. Over time (3 criteria) or Point-in-Time (5 indicators of control).
Where does judgment enter each of the five steps?
Step 1: whether collection is probable; whether to combine contracts.
Step 2: whether items are distinct.
Step 3: estimating variable consideration and the discount rate.
Step 4: estimating standalone selling prices.
Step 5: over time vs. point in time.
What are the two methods for long-term contracts, and what stays the same under both?
Percentage-of-completion (POC) and zero-gross profit. Total revenue and total costs are the same under both. Only timing differs: POC recognizes gross profit over the production period, zero-gross profit only at the end.
When is the zero-gross-profit method used?
Only when the contract does not meet the criteria required to recognize revenue over time. In Example 8.23 the arrangement “does not meet any of the three criteria.”
What is the cost-to-cost formula?
Cumulative percent complete = actual (cumulative) costs incurred to date / estimated total costs.
It is an input measure. Output measures (miles of highway, square footage built) also exist.
How do you get estimated total costs when the problem gives costs to complete?
Estimated total costs = cumulative costs to date + estimated costs to complete. The estimate is updated every year, because costs to complete change as the job progresses. This matters: the percentage in any year uses that year's estimate of total costs.
List the three steps each year under Percentage of completion (POC).
Revenue. Compute cumulative revenue = total estimated contract revenue x cumulative percent complete. Revenue for the current period = cumulative revenue minus the revenue recognized in all prior periods.
Costs. Record the actual costs for the current period as they are incurred.
Costs = actual costs incurred this year
Gross profit for the year = the current period's revenue from step 1 minus the costs from step 2.
Gross profit = current- year revenue minus the year’s costs
Which number is “revenue recognized in prior years”?
The previous column’s CUMULATIVE revenue. not its current-year revenue. Musa’s 2027 prior revenue is $981,611 (the 2026 cumulative), not $544,871.
What are Construction in Progress and Billings on CIP?
CIP is an inventory-like asset that accumulates construction costs (and, under POC, recognized gross profit). Billings on Construction in Progress is a contra account to CIP that accumulates amounts billed to the customer.
What is a contra account, how does it behave, and what are the most common examples?
Definition: An account linked to a related "parent" account that has an opposite normal balance. It is used to reduce the parent account's balance to its true carrying value.
How it behaves (The Rules):
Opposite Balance: If the parent is a debit (Asset), the contra is a credit. If the parent is a credit (Revenue), the contra is a debit.
Presentation: It is never shown on the balance sheet/income statement by itself. It is netted against the parent account (e.g., "Accounts Receivable, net of allowance").
Common Examples:
Contra-Asset: Allowance for Doubtful Accounts (reduces A/R), Accumulated Depreciation (reduces Equipment).
Contra-Revenue: Sales Returns and Allowances, Sales Discounts (reduces Gross Sales).
Contra-Equity: Treasury Stock (reduces Total Equity).
Contra-Liability: Discount on Bonds Payable (reduces the bond's carrying value).
List the four journal entries each year under POC.
Costs: Dr Construction in Progress; Cr Cash, Materials Inventory, Supplies Inventory, etc. (the resources used).
Billings: Dr Accounts Receivable; Cr Billings on Construction in Progress.
Collections: Dr Cash; Cr Accounts Receivable.
Revenue, costs, and gross profit: Cr Revenue from Long-Term Contracts for the year's revenue; Dr Construction Costs for the year's costs; and Dr CIP for the gross profit (the difference). In a loss year, the difference is a credit to CIP.
At the end of the project: remove CIP with a credit and remove Billings on CIP with a debit, each for the full contract price.
Where does gross profit go in the POC revenue entry, and what changes in a loss year?
Gross profit is debited to Construction in Progress (CIP), so CIP holds costs plus recognized profit. In a loss year the loss is CREDITED to CIP instead.
How is the net of CIP and Billings reported on the balance sheet.
CIP greater than Billings: an asset, “costs and recognized profits in excess of billings.”
Billings greater than CIP: a liability, “billings in excess of costs and recognized profits.”
Cash collections never enter this comparison.
What is the closing entry in the final year for POC entries?
Dr Billings on Construction in Progress; Cr Construction in Progress, for the full contract price. Both accounts equal the contract price just before closing.
Allstar Software: Contract $1,540,000. 2025 costs $127,920 (Est. total $639,600). 2026 costs $845,000 (Est. total $972,920). What is the 2026 revenue math and the required journal entries (including the closing entry)?
The Math (Step 1):
2025: $127,920 / $639,600 = 20%. Revenue = $1,540,000 × 20% = $308,000.
2026: $972,920 / $972,920 = 100%.
Cumulative Revenue: $1,540,000 × 100% = $1,540,000.
Current-Year Revenue: $1,540,000 - $308,000 (prior year) = $1,232,000.
Current-Year Gross Profit: $1,232,000 - $845,000 (current costs) = $387,000.
Journal Entries (Step 2):
Costs: Dr CIP 845,000 | Cr Cash/Materials 845,000
Billings: Dr A/R 610,000 | Cr Billings on CIP 610,000
Collections: Dr Cash 770,000 | Cr A/R 770,000
Revenue:
Dr Construction Costs ................................ 845,000
Dr CIP ........................................................ 387,000 (Gross Profit plug)
Cr Revenue on Long-Term Contract .......... 1,232,000
Closing Entry (End of 2026):
Because the contract is now 100% complete, you must zero out the temporary contract accounts.
Dr Billings on CIP ................................ 1,540,000
Cr Construction in Progress .................. 1,540,000
(Note: At this point, total CIP and total Billings both equal $1,540,000, so they net to zero on the balance sheet).
When do companies use the zero-gross profit method, and what is it?
Only when they do not meet the criteria required to use the percentage-of-completion method.
Each year it recognizes revenue equal to the actual costs incurred that year.
It therefore reports zero gross profit until the project is complete.
At the conclusion of the project, it recognizes the total gross profit.
The contract's total revenue and total costs are still the same as under POC. Only the timing of the gross profit changes.
Accounts under the zero-gross profit method
The accounts are the same as in POC (Construction in Progress, Billings on Construction in Progress, Accounts Receivable, Revenue, Construction Costs). The procedures:
Costs: Dr Construction in Progress for actual costs.
Billings: Dr Accounts Receivable; Cr Billings on Construction in Progress.
Collections: Dr Cash; Cr Accounts Receivable.
Revenue and costs: Cr Revenue on Long-Term Contract and Dr Construction Costs for the same amount (the year's actual costs). Record the total gross profit only at the conclusion of the project, as a debit to CIP.
Balance sheet: report the net of CIP and Billings on CIP at each balance sheet date. If CIP is higher, the net is an asset called costs in excess of billings. If Billings is higher, it is a liability called billings in excess of costs.
At the end of the project, remove CIP with a credit and Billings on CIP with a debit.
One difference to notice in the account names: under POC the balance sheet items are costs and recognized profits in excess of billings and billings in excess of costs and recognized profits. Under zero-gross-profit there is no recognized profit inside CIP until the end, so the names are costs in excess of billings and billings in excess of costs.
How does zero-gross-profit recognize revenue and gross profit?
Revenue each year equals the actual costs incurred that year, so gross profit is zero until the contract is complete. All of the gross profit is recognized at the conclusion of the project.
Bronco Builders: $9,300,000 fixed fee over 3 years. It fails the criteria for "over time" recognition. How is revenue recognized, what are the entries for 2027, and how does the Balance Sheet position change?
The "Why" (Zero-Gross-Profit Method):
Because the contract does not meet the criteria to recognize revenue over time, you use the zero-gross-profit method (a variation of the completed-contract method).
Rule: Revenue recognized each year = Actual Costs incurred that year.
Result: Gross profit is $0 in Years 1 and 2. All profit ($300,000) is "dumped" into the final year (2027) when the contract is complete.
The Math (The 2027 Trick):
Total Contract: $9,300,000. Total Costs: $9,000,000. Total Profit: $300,000.
2027 Revenue is not just the costs ($500,000). It is the remaining contract price: $9,300,000 - $1,500,000 (2025) - $7,000,000 (2026) = $800,000.
2027 Gross Profit: $800,000 Revenue - $500,000 Costs = $300,000.
2027 Journal Entries (The Final Year):
Costs: Dr CIP 500,000 | Cr Cash 500,000
Billings: Dr A/R 2,300,000 | Cr Billings on CIP 2,300,000
Collections: Dr Cash 3,100,000 | Cr A/R 3,100,000
Revenue (Notice the 3 lines this year!):
Dr CIP ................................................ 300,000 (This is the profit plug)
Dr Construction Costs ....................... 500,000
Cr Revenue .......................................... 800,000
Closing Entry:
Dr Billings on CIP ............................. 9,300,000
Cr CIP ................................................. 9,300,000
The Balance Sheet "Flip" (Crucial Concept):
You must compare CIP (Costs + Profits) to Billings at year-end.
2025: Billings ($4M) > CIP ($1.5M) = Liability of $2.5M ("Billings in excess of costs").
2026: CIP ($8.5M) > Billings ($7M) = Asset of $1.5M ("Costs in excess of billings").
2027: CIP ($9.3M) = Billings ($9.3M) = $0 (After closing).
How do zero-gross-profit entries differ from POC?
The same four entries each year. In years before the last, the revenue entry has no CIP line: Dr Construction Costs; Cr Revenue, equal amounts. In the final year it includes Dr CIP for the total gross profit.
Compare the two methods (Percentage-of-Completion vs. Zero-Gross-Profit) regarding total gross profit, timing, and economic reality. What are the key takeaways?
The Rule: Regardless of the method chosen, Total Gross Profit over the life of the contract is always exactly the same. (e.g., Bronco's total profit is $300,000 either way).
The Difference (Timing):
Percentage-of-Completion (POC): Reports profit over the production period as the work is completed. It smooths the profit out year-by-year.
Zero-Gross-Profit: Reports $0 profit until the final year, then dumps the entire profit in the last year upon completion.
The "Why it matters" (Economic Reality):
POC is considered superior accounting because it best measures economic activity. If you build a mall over 3 years, you are creating value every single year. POC reflects that value creation as it happens, whereas Zero-Gross-Profit makes the company look unprofitable for years and then suddenly hyper-profitable at the very end.
How does using Percentage-of-Completion (POC) vs. Zero-Gross-Profit affect Profit Margin and Debt-to-Equity ratios during the contract? (And what is the exception?)
Under POC (Compared to Zero-Gross-Profit):
Profit Margin (Net Income / Revenue) is generally higher.
Why: Because you are recognizing revenue and profit every year, not just costs.
Debt-to-Equity is generally lower.
Why: Under POC, you usually have a "Contract Asset" (Costs in excess of billings) on the balance sheet, which increases Assets and Equity. Under the zero-profit method, you often have a "Contract Liability" (Billings in excess of costs), which artificially inflates your liabilities, making the company look riskier.
The Exception (POC Loss Year):
If a contract is expected to be unprofitable, POC rules force you to recognize the entire expected loss immediately (the "loss provision").
In this specific year, Profit Margin is lower than the zero-profit method.
Debt-to-Equity may be higher because that sudden massive loss eats into Equity, while your debt (liabilities) remains high.
Compare the two methods' total gross profit and timing. Which method best measures economic activity and the net asset position?
Total Gross Profit: It is exactly the same over the life of the contract no matter which method you use (e.g., Bronco's $300,000). The methods only change when you report it, not how much.
Timing:
POC (Percentage-of-Completion): Reports profit over the production period. It smooths profit out year-by-year as the work is completed.
Zero-Gross-Profit: Reports profit at the very end. It recognizes $0 profit until the final year, then dumps the entire profit in at completion.
The "Why it matters":
Economic Activity: POC best measures economic activity because building a mall creates value every year. POC captures that value creation as it happens, whereas the zero-profit method makes the company look unprofitable for years and then suddenly hyper-profitable at the end.
Net Asset Position: POC is better for the balance sheet. If you bill less than you've worked (Costs > Billings), POC allows you to show a Contract Asset ("Costs in excess of billings"). Under the zero-profit method, you often end up with a Contract Liability ("Billings in excess of costs"), which makes the company look more leveraged than it actually is.
What is the expected effect on Profit Margin and Debt-to-Equity when using POC vs. Zero-Gross-Profit? What is the exception?
Under POC (Compared to Zero-Gross-Profit):
Profit Margin (Net Income / Revenue) is generally higher.
Why: You are recognizing profit every year alongside your revenue, rather than just matching costs with zero profit.
Debt-to-Equity is generally lower.
Why: POC often results in a "Contract Asset" (Costs in excess of billings), which increases your total Assets and Equity. The zero-profit method often results in a "Contract Liability" (Billings in excess of costs), which artificially inflates your liabilities and makes the company look riskier.
The Exception (The POC Loss Year):
If a contract is expected to be unprofitable, POC rules force you to recognize the entire expected loss immediately (a "loss provision").
Profit Margin is lower: The massive one-time loss hits your net income hard.
Debt-to-Equity may be higher: That sudden massive loss eats into Equity, making your Debt-to-Equity ratio spike upward.
Profit margin =
Profit margin = net income / revenues
Right of return: is it a separate performance obligation?
No. It is part of variable consideration that affects the transaction price. Expected returns are recorded as a refund liability.
List the right-of-return accounting rules.
Record expected returns as a refund liability.
Don’t recognize revenue on expected returns until the constraint no longer applies.
Reduce cost of goods sold by the cost of products expected to be returned.
Still reduce inventory by the full cost of the sale.
Record the offset as a separate asset, Other Assets - Estimated Returns.
Haxbo, Inc.: Sells merch costing $100,000 for $140,000 cash. Expects 10% returns. On Dec 28, a customer returns goods for a $10,000 refund (cost of returned goods is $7,143). What are the entries for Dec 3 (Sale) and Dec 28 (Return)?
The Math (Dec 3):
Expected Refund Liability: 10% × $140,000 sales price = $14,000.
Revenue to Recognize: 90% × $140,000 = $126,000 (You don't keep revenue you might have to give back).
Expected Returned Inventory Cost: 10% × $100,000 cost = $10,000.
Cost of Goods Sold: 90% × $100,000 = $90,000.
Dec 3 Journal Entries (Record the Sale):
Record the cash, the liability, and net revenue:
Dr Cash ...................................................... 140,000
Cr Refund Liability ................................... 14,000
Cr Sales Revenue .................................... 126,000
Record the cost and the asset for expected returns:
Dr Cost of Goods Sold .......................... 90,000
Dr Other Assets - Estimated Returns ..... 10,000 (This is a holding account for the expected inventory)
Cr Inventory .............................................. 100,000
Dec 28 Journal Entries (Actual Return occurs):
Settle the refund liability with cash:
Dr Refund Liability ................................... 10,000
Cr Cash ...................................................... 10,000
Put the returned goods back into inventory:
Dr Inventory ............................................. 7,143
Cr Other Assets - Estimated Returns ...... 7,143
The Golden Rule (Exam Shortcut):
On the sale date, Revenue and COGS are each reduced by the expected-return percentage (10% here). When the actual return happens later, you NEVER touch Sales Revenue or COGS again. You only settle the Refund Liability and move the physical inventory back.
What is a consignment sale and who are the parties?
The consignor (seller) delivers goods to a third party, the consignee, who sells them to the customer. It is a principal-agent arrangement: the consignor is the principal and the consignee is the agent.
Three indicators of a consignment arrangement.
The seller controls the product until a specified event occurs (such as sale to the ultimate consumer).
The seller can require the product be returned or sent to another third party.
The third party has no unconditional obligation to pay for the product.
Consignment: what does each party record on delivery?
Consignor: Dr Inventory on Consignment; Cr Inventory (at cost), a reclassification.
Consignee: no entry, because it does not own the goods.