intermediate accounting exam 2 chapter 8 conceptual

Revenue recognition: TIMING issue

When revenue is recognized: when the company transfers control of an asset (good or service) to the customer.

Revenue recognition: MEASUREMENT issue

How much revenue is recognized: the amount the company expects to be entitled to receive in exchange for the goods or services.

Core principle of ASC 606

Revenue must match the actual transfer of goods or services to the customer; revenue is recognized as each performance obligation is satisfied.

The five steps of revenue recognition (ASC 606)

1) Identify the contract; 2) Identify the performance obligations; 3) Determine the transaction price; 4) Allocate the transaction price to the performance obligations; 5) Recognize revenue when (or as) each performance obligation is satisfied.

Step 1 of revenue recognition

Identify the contract(s) with the customer (a valid, approved agreement; focus on commercial substance and collectibility).

Step 2 of revenue recognition

Identify the performance obligations: break the contract into distinct promises to transfer goods or services.

Step 3 of revenue recognition

Determine the transaction price: the total amount the entity expects to be entitled to (considers discounts, bonuses, refunds, financing, etc.).

Step 4 of revenue recognition

Allocate the transaction price to the performance obligations, generally based on relative standalone selling prices (SSP).

Step 5 of revenue recognition

Recognize revenue when (or as) each performance obligation is satisfied, either over time or at a point in time.

Why do companies need judgment in applying the five steps?

Many steps require estimates: collectability, whether goods/services are distinct, variable consideration probabilities, discount rate for financing, SSP estimates, and over-time vs. point-in-time.

Contract (revenue recognition definition)

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

Five criteria to identify a contract with a customer

1) All parties approve and are committed to perform; 2) Each party's rights are identifiable; 3) Payment terms are identifiable; 4) The contract has commercial substance; 5) Collection of consideration is probable.

Commercial substance

The risk, timing, or amount of the entity's future cash flows is expected to change as a result of the contract.

Collectibility criterion: does it require collecting the full stated price?

No. It must be probable the entity will collect the consideration it expects to be entitled to, which can be less than the stated price (e.g., if it expects to grant a price concession).

If the five contract criteria are NOT met, when can the seller recognize revenue?

Only when consideration has been received AND one of these occurs: (1) no remaining obligations and substantially all consideration received is nonrefundable; (2) the contract is terminated and consideration received is nonrefundable; or (3) control has transferred, the seller is no longer transferring goods/services, and consideration received is nonrefundable.

How is cash received recorded when the five contract criteria are not met?

As a liability (deferred revenue) until one of the conditions for recognizing revenue is met; the seller also does not derecognize the asset being sold.

When must multiple contracts be combined into one?

If any ONE applies: (1) negotiated as a package with a single commercial objective; (2) consideration in one contract depends on the price or performance of another; or (3) the goods/services promised in the contracts are all one performance obligation.

IFRS vs. U.S. GAAP: definition of 'probable' for collectability

IFRS: 'more likely than not' (over 50%). U.S. GAAP: 'likely to occur' (significantly higher than 50%, often interpreted as about 70-75%).

Which standard sets a higher collectability threshold, IFRS or U.S. GAAP?

U.S. GAAP (probable = likely to occur) is higher than IFRS (probable = more likely than not).

IFRS vs. FASB: third condition for recognizing revenue when contract criteria are not met

IFRS does not explicitly include it (the 'control transferred, no further obligation, nonrefundable' condition) because the IASB felt the first two conditions already cover those cases.

Performance obligation

A promise to transfer a good or service (or bundle) that is distinct.

Why must a seller identify the performance obligations?

To allocate the transaction price to each one and to recognize revenue when or as each individual obligation is satisfied.

Two conditions for a good or service to be 'distinct'

1) The customer can benefit from it on its own or with other readily available resources; AND 2) The promise to deliver it is separately identifiable from other promises in the contract.

Readily available resource

A good or service that is sold separately by the seller or another entity, or that the customer has already obtained from the seller or in another transaction.

Are 'free' goods or services in a contract possible performance obligations?

Yes. Even if labeled free of charge, they must be considered as possible performance obligations.

When are a software license and its installation TWO separate performance obligations?

When installation doesn't modify/customize the software and could be performed by another entity (the customer can benefit from the license alone and the promises are separately identifiable).

When are a software license and its installation ONE performance obligation?

When installation significantly customizes/modifies the software so it can't be used until installed; the promises are interdependent and not separately identifiable.

What does 'separately identifiable' mean in determining distinct goods/services?

The promise to deliver the good or service is not interdependent with, or significantly modified by, the other promises in the contract.

Transaction price

The amount of consideration the entity expects to be entitled to for providing goods or services to the customer; the amount ultimately recognized as revenue.

Is the transaction price always the price stated in the contract?

No. It is the amount the seller expects to receive, which may differ from the stated price.

Are sales taxes included in the transaction price?

No. Amounts collected on behalf of third parties (such as sales tax) are excluded.

Four factors considered in determining the transaction price

1) Variable consideration (and the constraint); 2) Significant financing component; 3) Noncash consideration; 4) Consideration payable to a customer.

Variable consideration

Consideration that is not a fixed amount, e.g., price concessions, performance bonuses or penalties, discounts, refunds, rebates, and incentives; may be explicit or implicit in the contract.

Two approaches for estimating variable consideration

1) Expected-value approach; 2) Most-likely-amount approach. Use whichever better predicts the amount the entity will receive, and apply it consistently.

Expected-value approach

Sums the probability-weighted amounts in a range of possible consideration amounts.

When is the expected-value approach best suited?

When the entity has a large number of contracts with similar characteristics or a range of possible outcomes.

Most-likely-amount approach

Uses the single most likely amount in a range of possible consideration amounts.

When is the most-likely-amount approach best suited?

When a contract has only two possible outcomes (e.g., earn a bonus or not).

Constraint on variable consideration

Variable consideration is included in the transaction price only if it is probable (highly probable under IFRS) that a significant revenue reversal will not occur when the uncertainty is resolved.

How is the constraint assessed?

Using a cumulative probability level to determine whether the 'probable' (likely to occur) threshold is met; if it isn't met for an amount, include a lower amount that does meet it.

Factors that increase the risk of a significant revenue reversal (constraint indicators)

1) Amount is highly susceptible to factors outside the entity's control (market, weather); 2) Uncertainty won't be resolved for a long time; 3) Limited experience or historical evidence with similar contracts.

When must variable consideration estimates be re-evaluated?

At the end of every reporting period; if the constraint is lifted, update the transaction price and record a cumulative catch-up adjustment.

U.S. GAAP vs. IFRS wording for the variable consideration constraint

U.S. GAAP says 'probable'; IFRS says 'highly probable.' The two are essentially the same threshold.

When does a significant financing component exist?

When the time between payment and delivery is more than one year and the financing effect is significant at the individual contract level.

Why separate a significant financing component from revenue?

Revenue should reflect the price a buyer would pay if payment occurred on the same date as delivery (the cash selling price).

Three factors used to decide whether a significant financing component exists

1) Difference between the contract price and the cash selling price; 2) Length of time between delivery and payment; 3) Prevailing market interest rate.

Discount rate used for a significant financing component

The rate the entity would use in a separate financing arrangement with the customer (reflects the customer's credit risk).

Delivery BEFORE payment (financing component): who is financed and how is it measured?

The seller finances the customer. Transaction price = present value of the promised payment (discount it back). Difference is recognized as interest income over time.

Delivery AFTER payment (financing component): who is financed and how is it measured?

The customer finances the seller. Transaction price = future value of the payment received. Difference is recognized as interest expense; the contract liability accretes.

Balance sheet account at inception: delivery before payment vs. delivery after payment

Before payment: contract asset / receivable. After payment: contract liability (deferred revenue).

Revenue vs. cash received: delivery before payment vs. delivery after payment

Before payment: revenue recognized is LESS than cash eventually received. After payment: revenue recognized is MORE than cash received.

Effect on profit: interest income vs. interest expense from financing

Delivery before payment produces interest income (increases profit). Delivery after payment produces interest expense (decreases profit).

Noncash consideration: how is the transaction price measured?

At the fair value of the noncash consideration received (e.g., stock).

Noncash consideration when fair value can't be reasonably estimated

Measure the transaction price at the standalone selling price of the goods or services promised to the customer.

Consideration payable to a customer

Payments from the seller to the customer (e.g., slotting fees) to entice purchases. Deduct from the transaction price unless the payment is for a distinct good or service received from the customer.

General rule for allocating the transaction price

Allocate to each performance obligation based on its relative standalone selling price (SSP) at contract inception.

Standalone selling price (SSP)

The price the seller would charge for the same good or service if sold separately to similar customers under similar circumstances.

Contract discount (in allocation)

The amount by which the sum of the standalone selling prices exceeds the transaction price.

Default treatment of a contract discount

Allocate it proportionally to all performance obligations based on relative SSP.

Three methods for estimating SSP when not directly observable

1) Adjusted market assessment approach; 2) Expected-cost-plus-a-margin approach; 3) Residual approach.

Adjusted market assessment approach

Estimates SSP based on what customers in the market are willing to pay (e.g., competitor prices), then allocates on a relative basis.

Expected-cost-plus-a-margin approach

Forecasts the costs of providing the good or service and adds an appropriate profit margin (focuses on internal factors).

Residual approach

Estimates SSP for one or more (but not all) obligations from observable prices, then allocates the remaining transaction price (residual) to the item with no SSP estimate.

Two exceptions to relative-SSP allocation

1) When the contract includes variable consideration; 2) When a discount is not related to all of the contract's performance obligations.

Exception 1: criteria to allocate variable consideration to only some performance obligations

BOTH: 1) the variable payment terms relate to one or more (not all) specific performance obligations; AND 2) allocating it entirely to those obligations is consistent with a reasonable allocation based on standalone selling prices.

When must variable consideration be allocated to ALL performance obligations on a relative-SSP basis?

When the two criteria aren't both met, e.g., allocating all variable consideration to one obligation would be significantly out of line with that item's standalone selling price.

Exception 2: criteria to allocate a discount to only some performance obligations

ALL three: 1) the entity regularly sells each good/service on a standalone basis; 2) it regularly sells a bundle of some of them at a discount; 3) the bundle's discount is basically the same as the discount in this contract.

When is a good or service considered transferred?

When the customer obtains control of it.

Control of an asset

The ability to direct the use of the asset and receive all (or substantially all) of its remaining benefits.

Three criteria for transfer over time (any ONE qualifies)

1) Customer receives and consumes benefits simultaneously as the seller performs; 2) Customer controls the asset as the seller creates or enhances it; 3) Asset has no alternative use to the seller AND the seller has an enforceable right to payment for performance to date.

Example of over-time criterion 1 (simultaneous receipt and consumption)

Health club memberships or magazine subscriptions.

Example of over-time criterion 2 (customer controls asset as it's created)

Software updates; an IT system the customer controls during creation.

How is revenue recognized for obligations satisfied over time?

Over the same time period, based on progress toward completion.

What if progress toward completion can't be reasonably measured?

Recognize no revenue until progress can be reasonably estimated.

Five indicators that control has transferred at a point in time

1) Seller has a present right to payment; 2) Customer has legal title; 3) Seller transferred physical possession; 4) Customer has significant risks and rewards of ownership; 5) Customer has accepted the asset.

How is cash received before the service is performed recorded?

As deferred (unearned) revenue, a liability; revenue is recognized as the obligation is satisfied.

Long-term contract (revenue recognition)

A transaction where the firm reports revenue, costs, and gross profit over time rather than at a point in time.

Two methods of revenue recognition for long-term contracts

1) Percentage-of-completion method; 2) Zero-gross-profit method.

How do the two long-term contract methods differ?

Total revenue, costs, and gross profit over the contract are the same; only timing differs. Percentage-of-completion recognizes gross profit over the production period; zero-gross-profit recognizes it only at completion.

Percentage-of-completion method

Recognizes revenue, costs, and gross profit each period based on progress toward completion.

Cost-to-cost approach

An input measure: cumulative percent complete = total costs incurred to date / total estimated costs.

Input vs. output measures of progress

Input measures use resources consumed (e.g., costs incurred, labor hours); output measures use results achieved (e.g., miles of highway or square footage completed).

Steps to compute each year's results under percentage-of-completion

1) Cumulative revenue = total estimated contract revenue x cumulative % complete; current-period revenue = cumulative minus prior revenue; 2) Record actual costs incurred in the period; 3) Gross profit = current revenue minus current costs.

Zero-gross-profit method: when is it used?

Only when the criteria for percentage-of-completion (over-time recognition) are not met.

Zero-gross-profit method: how is revenue measured each year?

Revenue each year equals the actual costs incurred, so gross profit is zero until the project is complete; total gross profit is recognized at completion.

Construction in progress (CIP)

An inventory-type asset account that accumulates construction costs (and, under percentage-of-completion, recognized gross profit).

Billings on construction in progress

A contra account to CIP that increases (credit) when the contractor bills the customer; it reduces the net carrying value of CIP.

Net CIP vs. billings: when is it an asset vs. a liability? (percentage-of-completion)

If CIP > billings: asset called 'costs and recognized profits in excess of billings.' If billings > CIP: liability called 'billings in excess of costs and recognized profits.'

Net CIP vs. billings: when is it an asset vs. a liability? (zero-gross-profit)

If CIP > billings: asset called 'costs in excess of billings.' If billings > CIP: liability called 'billings in excess of costs.'

Basic accounting procedures during a long-term contract

Debit CIP for costs incurred; bill customer (debit A/R, credit Billings on CIP); collect cash (debit Cash, credit A/R); recognize revenue and costs; at completion, close out CIP and Billings on CIP.

Which long-term contract method best measures economic activity and the contractor's net asset (liability) position?

Percentage-of-completion, because it reports gross profit as production takes place.

Profit margin: percentage-of-completion vs. zero-gross-profit

Generally higher under percentage-of-completion (earlier revenue and gross profit), unless there is a loss on the contract. Zero-gross-profit shows 0% margin until completion.

Debt-to-equity ratio: percentage-of-completion vs. zero-gross-profit

Generally lower under percentage-of-completion (higher assets and equity from earlier profit), unless there is a loss on the contract. Ratios are equal at completion.

Conceptual framework connection to revenue recognition

Information must be relevant (predictive value) and faithfully represent the underlying economic events; recognizing revenue over time as work progresses supports both.

Right-of-return sale: is the right of return a separate performance obligation?

No. It is a component of variable consideration that affects the transaction price.

Right-of-return sale: accounting for expected returns (revenue side)

Do not recognize revenue for the amount of expected returns (until no longer constrained); record a refund liability for that amount.

Right-of-return sale: accounting for cost of goods sold and inventory

Reduce inventory by the full cost of sales, reduce COGS for the cost of products expected to be returned, and record that amount as a separate asset (not in inventory).

Consignment sale

The seller (consignor) delivers goods to a third party (consignee) who sells them to the customer; control stays with the consignor until sale to the end customer.

Principal vs. agent in a consignment

The consignor is the principal; the consignee is the agent selling on the principal's behalf.

Three indicators of a consignment arrangement

1) Seller controls the product until a specified event occurs (e.g., sale to the consumer); 2) Seller can require return of the product or transfer to another party; 3) The third party has no unconditional obligation to pay.