Chapter 17 - INT 2

When a company delivers a product before receiving cash, what is the journal entry to record the sale and cost of goods sold?

To record the sale:
Dr Accounts Receivable
Cr Sales Revenue

To record cost of goods sold:
Dr Cost of Goods Sold
Cr Inventory

When a customer pays cash after a sale was previously recorded on account, what is the journal entry?

Dr Cash
Cr Accounts Receivable

five step revenue recognition model

1. identify the contract with the customer

2. identify the performance obligations- must be able to sell goods separately from one another( distinct)

3. determine transaction price

4. allocate transaction price to the performance obligation

5. recognize revenue when (or as) each performance obligation is satisfied - record when control transfers to the customer

new rule: revenue from contracts with customers

You should recognize revenue when you've actually transferred control of a good or service to a customer, in an amount that reflects what you expect to get paid.

Company has performed work but has not been paid

• Debit: Accounts Receivable

• Credit: Service/Sales Revenue

Company has been paid but has not delivered yet

1. When the Cash is Received

• Debit: Cash

• Credit: Contract Liability (or Unearned Revenue)

2. When the Work is Finally Done

• Debit: Unearned Revenue

• Credit: Service/Sales Revenue

To be distinct a good or service must be:

• capable of being distinct

• distinct within the context of the contract

Criteria	The Simple Test
Capable?	Can the customer use it "as is" or with stuff they already have?
Separately Identifiable?	Is the company selling a specific item or a combined result?

Step 3: Determine Transaction Price

1. Expected Value Method ( probability-weighted amount)

2. Most Likely Amount Method

Method	Best For...	Logic
Expected Value	Portfolio of contracts / Multiple outcomes	Probability-weighted average
Most Likely Amount	Single contract / "Binary" (Yes/No) outcomes	The single highest probability

Expected Value Method ( probability-weighted amount)

you take every possible outcome, multiply it by its probability, and add them all together.

• When to use it: When a company has a large number of contracts with similar characteristics or many different possible outcomes.

Most Likely Amount Method

You simply pick the single outcome that is the most probable.

• When to use it: When the contract has only two possible outcomes (e.g., you either get the bonus or you don't).

Variable Consideration

• The part of a contract price that isn't fixed. It’s any portion of the payment that depends on future events or outcomes.

You have to estimate it upfront using the two methods:

1. Estimate: Use either the Expected Value (probability-weighted) or Most Likely Amount (the single best bet).

2. Apply the Constraint: you only include the estimate in the transaction price if it is "highly probable" that you won't have to "reverse" (take back) that revenue later.

Companies only recognize variable consideration IF:

1. they have experience with similar contracts and are able to estimate the cumulative(total) amount of revenue

2. based on experience it is highly probable there will be no significant reversal of revenue previously recognized

IF these conditions are not met the revenue recognition is constrained

Time value of money

If the gap between delivery and payment is significant (usually more than one year), you must split the total cash received into:

• Revenue: The "Fair Value" (Cash price today).

• Interest Revenue: The extra money earned because the customer took time to pay.

To do this: Use Imputed rate

2. Choosing the Imputed Interest Rate

• pick the one that is easiest to prove (more clearly determinable):

Method	What it means
Market Rate	What would a bank charge this specific customer for a similar loan? (Based on their credit rating).
Discounted Price Rate	The math that bridges the gap. If the "Cash Price" is $900 today but the "Pay Later" price is $1,000, the rate is whatever makes $1,000 discount back to $900.

significant financing component

Exists when the timing of payments in a contract provides either the customer or the seller with a benefit of financing the transaction.

1. The Company finances the Customer (Payment is LATE)

The company is essentially giving the customer a loan so they can buy the product.

• The Accounting: The company must pull the "interest" out of the price and record it as Interest Revenue, not Sales Revenue.

2. The Customer finances the Company (Payment is EARLY)

The customer is essentially "loaning" the company money to fund their operations.

• The Accounting: The company must record Interest Expense because they are benefiting from having that cash early.

How is a sale recorded when it contains a significant financing component?

The sale is recorded at its Fair Value (the cash selling price) by discounting the future payment using an imputed interest rate. The difference between the cash price and the future payment is recognized over time as Interest Revenue.

What is the journal entry at the time of sale for a $1,100 note due in one year, if the current cash price of the good is $1,000?

Debit: Notes Receivable $1,100

• Credit: Sales Revenue $1,000

• Credit: Discount on Notes Receivable $100

A company enters a contract for a $100,000 base fee plus a performance bonus. There is a 60% chance of a $20,000 bonus and a 40% chance of a $10,000 bonus. What is the calculated Transaction Price?\

• Base: $100,000$

• Bonus A: $20,000 \times 0.60 = 12,000$

• Bonus B: $10,000 \times 0.40 = 4,000$

• Total: $100,000 + 12,000 + 4,000 = \mathbf{116,000}$

A contractor signs a $500,000 contract. If they are late, they must pay a $50,000 penalty. Management estimates a 70% chance of finishing on time and a 30% chance of being late. What is the Expected Value of the transaction price?

• On time (Full Price): $500,000 \times 0.70 = 350,000$

• Late (Price - Penalty): $450,000 \times 0.30 = 135,000$

• Total: $350,000 + 135,000 = \mathbf{485,000}$

If a company sells goods in exchange for a long-term zero-interest-bearing note, what amount is recorded as Sales Revenue on the date of the transaction?

The Fair Value of the goods (or the Present Value of the note). Any amount in the "Face Value" of the note above this Fair Value is considered interest to be earned over time, not sales revenue today.

What is the standard journal entry to record a sale with a long-term note containing a financing component?

Debit: Notes Receivable (at Face Value)

Debit: Cost of Goods Sold

• Credit: Sales Revenue (at Fair Value/PV)

• Credit: Discount on Notes Receivable (the difference)

• Credit: Inventory

What is the journal entry to recognize interest earned on a note that was originally recorded with a Discount on Notes Receivable?

Debit: Discount on Notes Receivable

• Credit: Interest Revenue

If a company offers a volume discount based on annual purchases, and it is probable the customer will meet the threshold, how is revenue recorded for early-year sales?

Revenue is recorded net of the discount (Total Sales − Estimated Discount).

A company sells $700,000 of goods in Q1. They offer a 3% discount if the customer hits $2M in annual sales. Based on history, it is probable the customer will hit the target. What is the recorded Sales Revenue for Q1?

• Gross Sale: $700,000$

• Estimated Discount: $700,000 \times 3\% = \$21,000$

• Net Revenue: $700,000 - 21,000 = \mathbf{679,000}$

What is the journal entry for a $700,000 sale where a 3% volume discount is expected to be taken by the customer?

• Debit: Accounts Receivable $679,000$

• Credit: Sales Revenue $679,000$

If a customer was expected to take a volume discount (and revenue was recorded net), but they fail to meet the purchase threshold, how is the extra cash recorded?

Debit: Cash (Full Gross Amount)

• Credit: Accounts Receivable (The Net Amount)

• Credit: Sales Discounts Forfeited (The difference)

In Step 4 of the revenue model, what is the Residual Approach?

A method used to estimate a standalone selling price by taking the Total Transaction Price and subtracting the sum of the observable standalone selling prices of all other items in the contract.

A company sells Products A, B, and C for a total of $100,000.

• Product A (Observable): $50,000

• Product B (Estimated Market Price): $30,000 Question: What is the allocated value of Product C using the Residual Approach?

Total Price ($100,000) - Product A ($50,000) - Product B ($30,000) = $20,000 (The "leftover" or residual amount).

Under what conditions is a company allowed to use the Residual Approach to value a performance obligation?

Only if the standalone selling price is highly variable (the company sells the same item to different customers for a wide range of prices) or uncertain (the company hasn't established a price for the item yet).

The 3 Ways to Guess a Price

Method	The "Simple" Explanation	Example
1. Adjusted Market Assessment	The "Look Around" Method: Look at what your competitors charge for the same thing and adjust it for your own brand.	"Competitors charge $35 for this, so we’ll value ours at $30."
2. Expected Cost Plus Margin	The "Build It" Method: Figure out exactly how much it costs you to make the item, then add a fair profit on top.	"It costs us $10 to make, and we usually want a 50% profit, so the price is $15."
3. Residual Approach	The "Leftovers" Method: If you know the price of Item A and Item B, whatever is left over from the total bundle price belongs to Item C.	"The total bundle is $100. Item A is $50. Item B is $30. That leaves $20 for Item C."

What is the Residual Approach in accounting?

The "Leftovers" method. You take the Total Price and subtract the known values of the other items to find the value of the "mystery" item.

When is a company allowed to use the Adjusted Market Assessment?

When they don't have their own price tag, so they "look around" at what competitors are charging for similar products.

If a company knows exactly what it costs to make a product, which estimation method should they use?

Expected Cost Plus Margin. (Cost + Profit = Price).

Which allocation method involves looking at competitor prices for similar goods or services and adjusting them to estimate a standalone price?

The Adjusted Market Assessment Approach.

Relative Standalone Selling Price (The "Market" Math)

A company bundles Product A and Service B for a total contract price of $1,500.

• Standalone Price of A: $1,200

• Estimated Market Price of B: $400 Question: How much of the $1,500 is allocated to Service B?

• Find the Total Standalone Value: $1,200 (A) + 400 (B) =1,600

• Find the Percentage for B: $400 \1,600 = 25%

• Allocate the actual Price: $1,500 x 25% = $375

  (Note: Because the bundle is a "deal," both items are reduced proportionally.)

Residual Approach (The "Leftover" Math)

A firm sells a "Tech Bundle" for $5,000. It includes:

• Hardware (Observable price): $4,200

• Software (Price is highly variable/unknown) Question: Using the Residual Approach, what is the value of the Software?

1. Start with the Total Price: $5,000

2. Subtract all known Standalone Prices: $5,000 - 4,200 = 800

   (Note: You only use this if the Software price cannot be reliably estimated any other way.)

Allocation with Three Performance Obligations

A $2,000,000 contract includes Equipment, Installation, and Training.

• Equipment/Install (Combined): $2,000,000 standalone.

• Training: $50,000 standalone. Question: What is the math to find the revenue for the Equipment portion?

The Math Step-by-Step:

1. Total Standalone Value: $2,000,000 + 50,000 = 2,050,000

2. Calculate the Weight (Ratio): $2,000,000 \2,050,000 = 0.97561

3. Apply to Transaction Price: $2,000,000 x 0.97561 = $1,951,220

Cost Plus a Margin (The "Markup" Math)

A company needs to estimate the price of a custom service.

• Labor/Material Cost: $8,000

• Standard Profit Margin: 20%

• What is the estimated standalone price used for allocation?

• Calculate the Margin amount: $8,000 x 20% = 1,600$ (This is a 20% markup on cost).

Add to Cost: $8,000 + 1,600 = 9,600

Alternatively, if the margin is 20% of the Selling Price:

$8,000 \(1 - 0.20) = 10,000

When is the Most Likely Amount method preferred over the Expected Value method for estimating variable consideration?

When the contract has only two possible outcomes

If a company has a large number of similar contracts with a range of possible outcomes, which estimation method should they use?

The Expected Value method (the probability-weighted amount).

How do you calculate Interest Revenue for the first year of a zero-interest-bearing note?

Multiply the Present Value (the carrying amount) by the Imputed Interest Rate.

Math: PV X Rate = Interest Revenue

Revenue Recognition Over Time: The Three Criteria

Criterion	Example
1. The customer simultaneously receives and consumes the benefits as the seller performs.	Routine or recurring services, such as monthly accounting, cleaning, or a 1-year gym membership.
2. The customer controls the asset as it is created or enhanced.	Building an asset on a customer’s site, such as constructing a warehouse on land the customer already owns.
3. The company’s performance does not create an asset with an alternative use AND:
* The customer receives benefits as the company performs (task would not need to be re-performed).	Specialized services where the work done to date is specific to that client's needs.
OR
* The company has an enforceable right to payment for performance completed to date.	An aircraft manufacturer building specialty jets to a customer’s unique specifications that cannot be sold to anyone else.

Sales Returns and Allowances

involves a return of a product by a customer in exchange for refunds, a credit, or another product in exchange.

The Seller Recognizes:

• an adjustment to revenue for products expected to be returned

• a refund liability

• an asset for the right to recover the product

When a company allows returns, it cannot record full revenue upfront if some might be returned later. They only record what they expect to keep

Refund Liability

represents the money the company may have to give back for expected returns

Return Asset

represents the inventory expected to be returned, recorded at the cost of the good (not sale price)

• reduce COGS bc they are expected to come back

Sales Returns and Allowances - JE to record sale of product and cogs

Accounts receivable xx

sales revenue xx

COGS xx

inventory xx

Sales Returns and Allowances - JE to record return of product

Sales returns and allowances xx

accounts receivable xx

Returned Inventory xx

COGS. xx

Sales Returns and Allowances - JE to record return of last products (not included in the first return)

Sales returns and allowances xx

refund liability xx

Estimated inventory return xx

COGS xx

Repurchase Agreements

companies enter into these agreements, which allows them to transfer an asset to a customer but have an unconditional (forward) obligation or an unconditional right (call option) to repurchase the asset at a later date

• if the company has a forward obligation or call option to repurchase the asset for greater than or equal to its selling price, then the transaction is a financing transaction by the company

Financing Transaction

1. company continues to recognize the asset and also recognizes a financial liability for any cash received

2. interest is recognized for the difference between the amount received by the company from the original transfer for the asset and the amount to be paid when the asset is repurchased

Repurchase Agreement - JE for the Initial Receipt of Cash

Debit: Cash

• Credit: Liability to [Customer]

Repurchase Agreement - The Accrual of Interest (Year-End)

Debit: Interest Expense

• Credit: Liability to [Customer]

Repurchase Agreement - The Final Repurchase (Maturity)

Debit: Liability to [Customer]

• Credit: Cash

Bill and Hold Arrangements

a contract under which a company bills a customer for a product, but retains the physical possession of the product until it is transferred to the customer in the future

• results when the buyer is not ready to take the delivery but does not take the title and accepts billing

Bill-and-Hold Arrangement - The 4 Conditions

Initial	Condition	Description
S	Substantive Reason	The customer (not the seller) must request the arrangement for a valid business reason (e.g., they don't have warehouse space yet).
I	Identified Separately	The product must be specifically identified as belonging to the customer (e.g., tagged with their name or order number).
R	Ready for Shipment	The product must be complete and ready for immediate transfer. No more assembly or testing can be required.
E	Excluded Use	The seller cannot have the ability to use the product or direct it to another customer to fill a different order.

Bill-and-Hold Arrangement - At the time of the "Bill" (When control transfers)

• Debit: Accounts Receivable (Total Price)

• Credit: Sales Revenue (Product portion)

• Credit: Unearned Revenue (Storage portion)

To record the Cost of Goods Sold:

• Debit: Cost of Goods Sold

• Credit: Inventory

principal - agent relationship

the principal’s performance obligation is to provide goods/services to a customer. the agent’s performance obligation is to arrange for the principal to provide these goods/services to a customer

Principal (main seller)

• actually provides goods/services

• records full revenue

Agent (middleman)

• just arranges the sale

• does not own/provide the products

• only earns commission

Consignments

form of principal - agent relationship, the consignor delivers goods but retains the title to the goods until they are sold.

• the consigner ships products to the consignee, who is to act as an agent for the consignor in selling the product

Consignor (owner)

• sends goods to store

• still owns inventory

• waits until item is sold to recognize revenue

Consignee (seller)

• holds and sells goods

• does not own inventory

• only earns commission

Journal Entries for the CONSIGNOR (The Owner) - When shipping goods to the Consignee:

• Debit: Inventory (Consigned)

• Credit: Finished Goods Inventory

Journal Entries for the CONSIGNOR (The Owner) - When paying for shipping/freight costs

• Debit: Inventory (Consigned)

• Credit: Cash

Journal Entries for the CONSIGNOR (The Owner) - When the Consignee reports a sale

• Debit: Cash (Amount received)

• Debit: Commission Expense

• Debit: Advertising/Other Expenses (if reimbursed)

• Credit: Sales Revenue (Gross amount)

Journal Entries for the CONSIGNEE - When paying for expenses to be reimbursed (e.g., local ads)

• Debit: Receivable from Consignor

• Credit: Cash

Journal Entries for the CONSIGNEE - When selling the goods to a customer:

• Debit: Cash

• Credit: Payable to Consignor

Journal Entries for the CONSIGNEE - When settling up with the Consignor (Taking their cut):

• Debit: Payable to Consignor (Full sales amount)

• Credit: Commission Revenue (Their profit)

• Credit: Receivable from Consignor (Reimbursement for ads/shipping)

• Credit: Cash (The check they send to the Consignor)

Warranties

obligations that arise when a company provides a guarantee to a customer that a product will meet certain specifications or perform as promised for a specific period after the sale.

• two types assurance and service

1. Assurance-Type Warranty (The "Quality" Promise)

• included for free with the product

• not a separate performance obligation

• just guarantees no defects at the time of sale

Accounting:

• It is not a separate performance obligation. You do not allocate any of the transaction price to it.

• Method: You use the Accrual Method. You record an estimated warranty liability and a corresponding expense in the same period the product is sold (Matching Principle).

Service-Type Warranty (The "Extra" Protection)

This provides a service that goes beyond simply assuring that the product is functional at the time of sale (e.g., an "extended warranty").

• Nature: It is a distinct service provided to the customer.

• Accounting: It is a separate performance obligation. You must allocate a portion of the transaction price to this warranty.

• Method: You record the allocated amount as Unearned Warranty Revenue and recognize it as revenue over the life of the warranty period.

Assurance-Type Warranty - At the Time of Sale (Year 1)

You record the sale normally. At year-end, you estimate the future costs of fixing those products.

• Debit: Warranty Expense

• Credit: Warranty Liability

Assurance-Type Warranty - When a Customer Brings an Item for Repair (Year 2)

When you actually spend money to fix a product under an assurance warranty:

• Debit: Warranty Liability

• Credit: Cash, Inventory (parts), or Wages Payable

Concept: You are "using up" the liability you set aside in Year 1.

Service-Type Warranty (The "Deferral" Method) - At the Time of Sale

You split the cash between the product and the warranty.

• Debit: Cash (Total Price)

• Credit: Sales Revenue (Product portion)

• Credit: Unearned Warranty Revenue (Warranty portion)

Concept: You haven't "earned" the warranty money yet because you haven't provided the years of coverage promised.

Service-Type Warranty (The "Deferral" Method) - Over the Life of the Warranty (Adjusting Entries)

Every year the warranty is active, you "earn" a portion of that revenue.

• Debit: Unearned Warranty Revenue

• Credit: Warranty Revenue

Concept: This moves the money from the Balance Sheet (Liability) to the Income Statement (Revenue) as time passes.

Service-Type Warranty (The "Deferral" Method) - When a Repair Occurs under a Service Warranty

Unlike the assurance type, costs here are usually expensed as they happen.

• Debit: Warranty Expense

• Credit: Cash, Inventory, or Wages Payable

Nonrefundable upfront fees

sometimes companies receive payments (upfront fees) from customers before they deliver goods or perform a service

• relate to the initiation, activation, or setup of a good/service to be provided in the future

• usually nonrefundable

• only record revenue when you actually provide the good/service

Presentation (what goes on the balance sheet)

1. Contract Assets

2. Contract Liabilities

Contract Assets

company has done work but hasn’t been paid yet

two types:

• Unconditional

• conditional

Unconditional Right: Accounts Receivable

has satisfied its performance obligation

• recorded at accounts receivable

Conditional Right: Contract Asset

has satisfied one performance obligation but must satisfy another before they can bill the customer

• recorded as a contract asset

Contract Liabilities

• This is the technical term for Unearned Revenue or Deferred Revenue.

• It is reported when a customer pays before the company performs the work.

Costs to fulfill a contract

1. Incremental Costs of Obtaining a Contract

These are costs you only incur because you got the contract (e.g., sales commissions).

• Rule: Capitalize as an asset if you expect to recover them.

• Exception: If the contract is one year or less, you can choose to expense them immediately for simplicity.

2. Costs to Fulfill a Contract

These are setup or mobilization costs (e.g., moving heavy equipment to a site or coding a basic platform).

• Rule: Capitalize as an asset ONLY IF they:

  1. Relate directly to a specific contract.

  2. Generate or enhance resources that will be used to satisfy future performance.

  3. Are expected to be recovered.

• Note: General overhead or costs of wasted materials must be expensed immediately.

Disclosure (what goes in the notes)

1. contracts with customers: breakdown revenue, show beg and contract assets/liabilities, explain performance obligations

2. significant judgements: explain decisions like how revenue is measured, timing of revenue recognition, allocation of transaction price

3. costs to obtain/fulfill contract: Companies must disclose the closing balances of the assets recognized from these costs and the amount of amortization (expense) recognized during the period.

Contract Asset - When you finish the first part of a project (The Condition)

• Debit: Contract Asset

• Credit: Sales Revenue

Contract Asset - When you finish the rest of the project

• Debit: Accounts Receivable — 40,000

• Credit: Contract Asset — 30,000

• Credit: Sales Revenue — 10,000

Contract Asset - When the customer pays

• Debit: Cash — 40,000

• Credit: Accounts Receivable — 40,000

Contract Liability - When the customer pays upfront (The "Advance")

• Debit: Cash — 1,200

• Credit: Contract Liability — 1,200

Contract Liability - When the Performance Obligation is Satisfied

Account	Debit	Credit
Unearned Sales Revenue	10,000
Sales Revenue		10,000

Account	Debit	Credit
Cost of Goods Sold	7,500
Inventory		7,500

The "Over Time" Criteria - Long-Term Construction Contracts

• Simultaneous Benefit: Customer consumes the benefit as the work is done (e.g., a cleaning service).

• Customer Control: The work enhances an asset the customer already controls (e.g., building an addition on the customer’s existing house).

• No Alternative Use + Right to Pay: The asset is so specialized it can't be sold to anyone else, AND the seller has a legal right to be paid for work done so far.

Revenue is recognized over time if ANY ONE of these 3 hurdles is cleared:

Long-Term Construction Contracts - The Two Methods of Accounting

• Percentage-of-Completion method

• completed contract method

When should a company use the Percentage-of-Completion method?

When the company can reasonably estimate progress toward finishing the project and at least one of the "Over Time" criteria is met.

The Percentage-of-Completion Math

two approaches to measure:

1. cost to cost method

2. output measures

cost to cost method

• measures based on costs incurred so far

percent complete = costs incurred to date/total est costs

revenue recognized = percent complete x total contract revenue

gross profit = revenue - costs

What is Construction in Process (CIP) and what type of account is it?

It is an Inventory (Asset) account. It stores all the actual costs of the build (labor, materials) PLUS any gross profit recognized to date.

JE to recognize revenue under the percentage of completion method

dr: construction in progress xx

dr: construction expenses. xx

cr: revenue from long term contracts xx

What is the primary advantage of the Completed-Contract method over Percentage-of-Completion?

It is based on final results rather than estimates. There is no risk of having to "reverse" profit later if estimates were wrong.

Percentage-of-Completion Method - The "Two Buckets" (Accounts)

• Construction in Process (CIP)

• Billings on Construction in Process

Construction in Process (CIP)

An inventory asset account that accumulates all actual costs incurred (materials, labor) plus all recognized gross profit to date.

Billings on Construction in Process

• A contra-inventory account that tracks the total amount of progress invoices sent to the customer throughout the project.

Net Construction Asset

The balance sheet position when CIP exceeds Billings; reported as "Costs and Recognized Profit in Excess of Billings."