MAC 710 Final

Two Primary Issues with Revenue Recognition

Timing
Measurement

Timing

when to recognize revenue. Main principle: when CONTROL of the asset has been transferred

Measurement

how much revenue to recognize. Main principle: use the amount that the seller EXPECTS to be entitled to receive in exchange for the good/service

Five Steps of Revenue Recognition

Step 1: Identify the contract(s) with the customer
Step 2: Identify the performance obligation(s) in the contract
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the performance obligation(s)
Step 5: Recognize revenue when (or as) each performance obligation is satisfied

Contract

an agreement between two or more parties that creates enforceable rights and obligations

Five criteria to be considered a Contract

1. All parties to the contract have AGREED to the contract and are COMMITTED to performing under the contract
2. Each party's RIGHTS with respect to the goods or services that are being transferred are IDENTIFIABLE
3. The PAYMENT TERMS for the goods or services that are being transferred are IDENTIFIABLE
4.The contract has COMMERCIAL SUBSTANCE, meaning that the risk, timing, or amount of the entity's future cash flows is expected to change as a result of the contract
5. It is PROBABLE that the seller will COLLECT the consideration to which it is entitled in exchange for the goods or services

How is collectability assessed?

Collectability is assessed on EXPECTED CONSIDERATION, not contract price (e.g., discount amount would not be part of collectability)
-US GAAP: probable- likely to occur
-IFRS: probable- more likely than not

Probable Collectability under GAAP and IFRS

-US GAAP: probable- likely to occur
-IFRS: probable- more likely than not

Combining Contracts

Multiple contracts should be combined if one of the following criteria is met:
-the contracts are negotiated as a package and have a single commercial objective
-the amount of consideration to be received by the seller related to one contract depends on the price or performance of another contract
-the goods or services promised in the separate contracts are all part of one performance obligation

When to recognize revenue if a contract has not be identified

The company will recognize revenue when it has received the consideration and ONE of the following holds:
-it has no remaining obligations to transfer goods/services and substantially all of the consideration has been received and is nonrefundable, OR
-the contract has been terminated and any consideration received is nonrefundable, OR
-the entity has transferred control of the goods or services, is no longer transferring the goods or services, and has no obligation to transfer additional goods/services, and the consideration received is nonrefundable

If cash is received but it is NOT appropriate to recognize revenue yet:

Credit a liability account (don't remove inventory)

Performance Obligation

A promise to transfer a distinct good/service (or bundle of goods/services) OR
A promise to transfer a series of distinct goods/services that are substantially the same and have the same pattern of transfer to the customer

In order to be distinct, must meet 2 conditions:

-the customer can benefit from the good or service on its own or in conjunction with other readily available resources (sold separately by the seller, or another entity, or the seller already possesses it) to the customer
-AND: the promise of the seller to deliver that good/service is separately identifiable from other promises in the contract. If a promise to deliver is separable from another promise, then the two promises are not highly dependent or interrelated

Transaction Price

it is the amount of consideration that the entity EXPECTS to be entitled to as a result of providing goods or services to the customer. This is NOT NECESSARILY THE CONTRACT PRICE, it is the amount the seller expects to receive and the amount we will ultimately recognize as revenue

Complex cases for Transaction Prices

-Variable consideration and constraining estimates of variable consideration
-Significant financing component in the contract
-Noncash consideration
-Consideration payable to the customer

Variable Consideration (definition and examples)

When payment received is not a fixed amount (ex: price concessions, performance bonuses or penalties, discounts, refunds, rebates, incentives, etc.)

Transaction price must take into account ____________

The transaction price must take into account the variable consideration; thus, the transaction price might not be the stated contract price

Approaches to determining Transaction Price

Most-likely-amount approach
Expected-value approach

Most-likely-amount approach

use the single most likely amount in the range of possibilities as the estimate of the transaction price

Expected-Value approach

sum the probability weighted amounts in a range of possible consideration amounts

Consideration could be ______

constrained

Constraining Estimates of variable consideration

Before we can include variable consideration in the transaction price, we must ensure that it is not probable that there will be a significant revenue reversal
-US GAAP: uses the term probable. IFRS uses the term highly probable
-It is not defined, but 70-75% is in the ballpark

Method for Constraining Estimates of variable consideration

1. Based on your tentative answer to the problem, compute the probability that revenue will be reversed -- that is the probability that, ultimately, revenue will be less than what you just computed
2. If that number is more than 25-30% you need to lower the amount of revenue you are about to recognize

Significant Financing Component (determining transaction price)

-If payment happens before delivery, the customer is providing financing to the seller
-If delivery happens before payment, the seller is providing financing to the customer
-If the time between delivery and payment is MORE THAN ONE YEAR, then we need to separate the revenue from providing the good/service from the interest revenue/expense-- if the financing component is significant

To determine if financing component is significant, consider....

-difference between contract price and cash selling price (if payment is on the same date as delivery)
-length of time between delivery and payment
-market rate of interest

If financing component is significant -->

Use TVM to determine the financing component.
-if delivery occurs before payment (interest revenue), determine sales/service revenue by taking the PV of consideration; the rest is interest revenue (PV = FV/(1+r)^n)
-if payment occurs before delivery (interest expense), determine sales/service revenue by taking the FV of consideration; the difference is interest expense (FV= PV * (1+r)^n)

Noncash consideration

Seller may be paid in something other than cash
-Record the transaction price at the fair value at contract inception of the noncash consideration received (if this amount cannot be reasonably estimated, use the standalone selling price of the good/service)

Consideration Payable to a Customer

A seller may pay the buyer, if it is trying to incentivize the buyer to purchase its goods/services (pay customer to put merchandise on a stand at front of store)
-Unless this payment is in exchange for a distinct good/service, the consideration should be deducted from the transaction price

Standalone Selling Price (SSP)

price the seller would charge for the same goods/services if it sold them on a standalone basis to similar customers under similar circumstances

Steps in Allocating the Transaction Price to the Performance Obligation

1. Determine the standalone selling price of the goods/services related to each performance obligation
2. Sum up the standalone selling prices. If the sum is greater than the transaction price, allocate the discount on the basis of the relative standalone selling prices (allocate the transaction price to each separate performance obligation based on the proportion of the SSP of each performance obligation to the sum of the SSPs)

Must estimate the SSP if the seller doesn't ____________

sell the goods/service separately.
FASB/IFRS doe snot stipulate a method for estimating SSP. It should maximize the use of observable inputs and should be used consistently for similar circumstances.

3 Methods suggested by FASB/IASB in estimating SSPs

-Adjusted market assessment approach
-Expected cost plus margin approach
-Residual approach

Adjusted market assessment approach (for estimating SSPs)

Using the "market" rate for the good/service. Use a competitor's prices and adjust as necessary

Expected cost plus margin approach (for estimating SSPs)

Forecast cost of providing good/service and add a profit margin

Residual Approach (for estimating SSPs)

Determine standalone selling price for everything possible and then allocate the remainder to the good/service for which it doesn't have an SSP

General Rule for when to Recognize Revenue

-Recognize when goods/services are TRANSFERRED. Transfer is defined as occurring when CONTROL has been given to the customer.
-Control: if you have the ability to direct the use of the asset and receive all (substantially all) of the benefits of owning the asset
-May be transferred over time or as of a point in time

Criteria to Meet Revenue over Time

Only need to meet ONE:
-the customer receives and consumes the benefits of the goods/services simultaneously
-The customer controls the asset as the seller creates it or enhances it over time
-The asset the seller is creating does NOT have an alternative use to the seller, and the seller has an enforceable right to payment for the performance completed to date

HOWEVER, seller must be able to measure progress towards completion

Transfer over Time

Recognize revenue over time as long as seller can measure progress towards completion
-If progress is not estimable, then recognize once fully delivered
-Can measure progress toward completion using OUTPUT or INPUT measures

Transfer at a Point in Time

Must transfer control in order to recognize revenue.
Five indicators (these are NOT criteria):
1. The seller has a present right to payment for the asset
2. The customer has a legal title to the asset
3. The seller has transferred physical possession of the asset
4. The customer has the significant risks and rewards of ownership of the asset
5. The customer has accepted the asset

Criteria to be considered a contract

1. Approval and commitment
2. Identification of the rights of the parties
3. Identification of payment terms
4. The contract has commercial substance
5. It is probable that the consideration will be collected

Are warranties a separate performance obligation?

Codification has stated that warranties can be benefited from separately --> potential to be their own performance obligation

Implications of Long Term Contracts on Revenue Recognition

Recognizing revenue at the end of the contract may NOT provide the most accurate portrayal of the company

Approaches to recognizing LT Contracts

-Percentage of completion: recognize revenue and gross profit before delivery
-Completed Contract

DIFFERENCE BETWEEN THESE TWO: is all about TIMING (but, you get the same revenue and expenses in the end)

Criteria to Recognize Percentage of Completion (POC)

Must meet one of these:
-the customer receives and consumes the benefits of the goods or services simultaneously
-the customer controls the asset as the seller creates it or enhances it over time
-the asset the seller is creating does NOT have an alternative use to the seller, and the seller has an enforceable right to payment for the performance completed to date

(also must be able to estimate progress towards completion)

SAME CRITERIA FOR RECOGNIZING REVENUE OVER TIME

POC Steps

1. Initially accumulate costs by debiting an asset account called CONSTRUCTION IN PROGRESS
2. As bills are sent to the customer throughout the project, increase accounts receivable with a debit and increase with a credit the account BILLINGS ON CONSTRUCTION CONTRACT
3. When cash is received from the customer, increase cash with a debit and decrease accounts receivable with a credit
4. Recognize the revenue and the associated costs each year, basing the amount of gross profit in a given year on the progress to date (Credit revenue from LT contracts, debit the cost of construction, and debit/credit the difference between revenue and the cost of the contract (i.e., the gross profit) to the CIP account
5. At the end of the project, remove the CIP account (for this particular project) from the books with a credit and remove the billings on construction contract account with a debit

Costs in excess of billings

the CIP account netted with the billing on construction contract account. Is reported as an asset on the balance sheet

Billings in Excess of Costs and Recognized Profits

A liability on the balance sheet that occurs when the billings account is larger than the CIP account (this account is the net of the billings and CIP account)

Cost to Cost approach for estimating completion

the firm estimates the cumulative percentage of completion by dividing the total cost incurred to date by total estimated costs

Cumulative revenue under POC

The total estimated revenue multiplied by the percentage complete. Revenue for the current period is equal to the cumulative revenue less revenue recognized in all prior periods

Completed Contract Method

Waits to recognize profit until the contract is complete. Recognizes revenue and costs throughout the project, but profit equals zero

Steps in Completed Contract Method

1. Initially accumulate costs by debiting CIP
2. As bills are sent to the customer throughout the project, increase accounts receivable with a debit and increase billings on construction contract with a credit
3. When cash is received from the customer, increase cash with a debit and decrease accounts receivable with a credit
4. RECOGNIZE THE ACTUAL COSTS INCURRED AND THE SAME AMOUNT OF REVENUE EACH YEAR (forcing GP to be 0). Report any gross profit at the end of the project
5. At the end of the project, remove the CIP account from the books with a credit and remove the billings on construction contract account with a debit

Sales with Right of Return

Sales returns are common and usually not a significant problem for most companies. However, in certain industries, such as publishing, high sales returns cause companies to postpone revenue recognition until the product can no longer be returned
-RIGHT OF RETURN IS NOT A SEPARATE PERFORMANCE OBLIGATION-- it is variable consideration

Accounting for Sales with Right of Return

-Liability: amount of expected return (Refund Liability account)
-COGS: reduced by the COGS attributable to the products estimated to be returned
-Inventory: should be reduced by full amount
-Difference between debit to COGS and credit to inventory goes to Other Assets- Estimated Returns account

Consigned Goods

A consignment sale is an arrangement where a seller (consignor) delivers goods to a third party (consignee), who sells the goods to the customer.

A consignment sale is an example of a principal-agent arrangement

Accounting for Consigned Goods

On delivery date: Consignor credits inventory and debits INVENTORY ON CONSIGNMENT. Consignee makes no entry
Upon sale of inventory: Consignee records cash, COMMISSIONS EARNED, and an AMOUNT DUE TO CONSIGNOR for the sale. Consignor makes no entry
Upon transfer of cash to consignor: Consignor records cash, revenue, COMMISSIONS EXPENSE, and COGS, and removes inventory. Consignee removes liability and records reduction in cash

Bill and Hold Transactions

transactions where a buyer accepts title and billings but delays the physical receipt of the goods.

Must meet 4 criteria to recognize revenue:
-the reason for the bill and hold must be substantive
-the product must be separately identified as belonging to the customer
-the product must be ready for physical transfer to the customer
-the entity cannot have the ability to use the product in any way, including delivering it to another customer

Channel Stuffing

aka Trade Loading. A practice in which a company induces wholesale distributors to buy more inventory than they can sell in the current period, thus "stuffing" the distribution channel. Firms should NOT recognize revenue from a channel stuffing arrangement because the risks and rewards of ownership have not passed to the buyer, given the buyer's ability to return the product.

Matter of judgement in determining when line is crossed into channel stuffing.

Cash

Coins, currency, bank deposits, and negotiable instruments (e.g., checks and money orders)

Cash equivalents

Short-term, highly liquid investments with original maturities of THREE MONTHS OR LESS (e.g., treasury bills, commercial paper, certificates of deposit, money market funds)

Restricted cash

cash balances that may involve restrictions on withdrawal, limiting use in current operating cycle (e.g., foreign bank accounts, escrow accounts, collateral for certain obligations, and long-term debt sinking funds)

Report as current (<1 year) or noncurrent (>1 year)
Often part of other assets

Compensating balances

minimum cash balances that debtors must keep on deposit as support for existing credit agreements (often part of other assets)

Report as current or noncurrent based on underlying agreement

Accounts receivable

-Trade accounts (when customers buy on account)
-Amounts due to an entity from its customers or clients that originated from the sale of goods/services

Generally recorded at amount of the sale

Trade discounts

reduction of the catalog or list price whenever a company sells to a reseller in the same industry

lowers sales revenue and A/R

Volume discount

reduces the list price for customers purchasing a large quantity of merchandise

Lowers sales revenue and A/R

Sales Discounts

Reductions companies grant to customers for early cash payment

2/10 n 30 (read as 2 10 net 30--> get 2% discount if you pay in 10 days, otherwise it is due in 30 days)

2 approaches to Sales Discounts

-Most-likely amount
-Expected value

Most likely amount method (Sales Discounts)

Book A/R at gross amount if it is most likely that customer will not take the discount and at net amount if it is most likely that the customer will take the discount

Most likely amount method (Sales Discounts) --> Gross approach

a company initially records accounts receivable at the full (gross) sales amount
-if the customer pays within the discount period, then the difference is a debit to SALES DISCOUNT (contra revenue)

Most likely amount method (Sales Discounts) --> Net approach

the company assumes that the customer will take the sales discount and initially records sales and accounts receivable at the net amount
-if the customers pays after the discount period, then SALES DISCOUNTS FORFEITED (revenue) is credited

Expected Value Method (Sales discounts)

-Assign probabilities to both possible outcomes and take the weighted probability

Again- you may have to use the SALES DISCOUNT and/or SALES DISCOUNTS FORFEITED accounts

Subsequent Measurement of A/R

Must measure the realizability of A/R
-Measure at amount expected to collect

Allowance method
conceptual framework
-future economic benefit
-match expense to reveneu

Aging of Accounts Receivable (steps)

1. Determine the aging category by separating the A/R balances based on the age of the receivable
2. Multiply the balance in each aging category by an estimated percentage of uncollectible accounts for that specific category
3. Add the subtotals of each aging category to determine the required balance in the allowance for uncollectible accounts (you must then calculate what entry needs to be made to get to this balance in the Allowance account --> often there is a beginning balance in the Allowance account that you must consider)

Write-off of Uncollectible accounts

To write off a specific account: reduce the allowance for uncollectible accounts and also reduce the accounts receivable (No effect on NRV of A/R. No Income statement effect)

This is done at specific customer account level

NRV of A/R

Gross A/R less Allowance for Bad debt

Subsequent Recovery (of bad debt)

A recovery occurs when a company receives payment on an account it had previously written off

2 Steps to account for subsequent recovery of accounts previously written off

1. Reinstate the account receivable and restore the allowance account
2. Record the cash collection

3 Ways to Obtain Cash Immediately from A/R

1. Pledging and Assigning
2. Factoring
3. Securitizations

Pledging

receivables are collateral for a financing arrangement

A/R remains on balance sheet (receivables are classified as current or noncurrent according to classification of underlying loan)

Assigning

receivables are collateral for a loan, but company MUST USE RECEIPTS ON COLLECTION OF RECEIVABLES TO REPAY DEBT

A/R remains on balance sheet (receivables are classified as current or noncurrent according to classification of underlying loan)

Factoring Accounts Receivable

when a company sells its accounts receivable to a third party (the factor) at a discount

Must determine if arrangement qualifies as a sale or if it is a secured borrowing

What qualifies as a sale under US GAAP (for Factoring purposes)

Centered on CONTROL of receivables
Companies must meet the following conditions to record transaction as a sale:
-receivables must be isolated from the company
-factor has the ability to pledge or exchange the receivables
-selling company does NOT maintain effective control over the receivables

What qualifies as a sale under IFRS (for Factoring purposes)

Centers on TRANSFER OF RISKS AND REWARDS OF OWNERSHIP
Companies must meet 3 conditions to classify transaction as a sale
-Company does NOT have to pay the factor unless it collects the receivables
-Company cannot use receivables as collateral for other transactions
-Company has to pay the factor the cash it collects without a long delay

If transaction is secured borrowing...

treat the transaction as if the receivables were pledged/assigned

Receivables sold without recourse

meaning the seller does NOT guarantee collectability
Steps to Record:
1. Record cash proceeds
2. Remove A/R
3. Record receivable from factor for holdback amount
4. Record gain/loss computed as the difference between net proceeds (adjusted for hold back) and the carrying amount of the receivables

Receivables sold with recourse

meaning the seller does guarantee collectability
Steps to record:
1. Record cash proceeds
2. Remove A/R
3. Record receivable from factor for holdback amount
4. Record gain/loss computed as the difference between net proceeds (adjusted for holdback) and the carrying amount of the receivables
5. Record recourse obligation
6. Record loss related to recourse obligation (often netted with gain/loss)

Factoring without recourse process

-Selling company removes A/R from books and records related gain or loss on the transaction
-Gain/loss is the difference between the net proceeds on the sale and the face amount of the receivables factored (less the factor's fee, less any holdback)

Holdback

an amount of cash that the buyer does NOT remit to the seller but retains as security; holdback is a type of receivable on the seller's books (After receivables are fully collected, buyer returns the holdback amount to seller)

Factoring with recourse process

Similar to factoring without recourse, EXCEPT seller recognizes liability by recording RECOURSE LIABILITY and ESTIMATED EXPENSE FOR POSSIBLE LOSSES DUE TO GUARANTEE (generally wrap up expense of recourse obligation and include it in our loss)

Securitization

A financing technique that involves taking many separate, often diverse financial assets and combining them into a single pool or bundle
-investors purchase interests in the pool of assets instead of an individual asset or group of assets
-DIVERSIFIES risk for buyers

Note Receivable

a formal, written promise to receive a fixed sum of money at a specified date (or dates) in the future with a stated interest rate (UNLIKE WITH A/R, there is a CONTRACT and they almost always carry interest)

Companies report a note receivable on the balance sheet at present value of future cash flows

Recording a Note Receivable when Stated Rate = Market Rate

-Company records the note at face value
-Interest accrues over the life of the note

Recording a Note Receivable when Stated Rate < Market Rate

Company records the note at present value, which is done by:
-if note is received in exchange for goods/services, assume note's present value is the fair value of the goods/services provided
-if company cannot determine fair value, compute present value of the note discounted at the market rate of interest

Difference between face value and fair or present value represents deferred interest over the life of the loan

Deferred interest revenue is initially recorded as a DISCOUNT ON NOTES RECEIVABLE and amortized to interest revenue over the loan term

Required Disclosures for A/R

-accounting policies and methodology used to estimate allowance for uncollectible accounts
-gross receivable and allowance
-reconciliation of accounts
-factoring: amounts, terms, collateral

Operating Cycle

Days Sales Outstanding + Days Inventory on Hand

A/R Turnover Ratio

Credit sales / Average Accounts Receivable

Average A/R

(Beginning A/R + Ending A/R) / 2

Days Sales Outstanding

365 / accounts receivable turnover ratio

Inventory Turnover Ratio

COGS / average inventory

Avg. Inventory

(Beginning Inventory + Ending Inventory) / 2

Days Inventory on Hand

365/inventory turnover ratio