revenue recognition

why do we care about revenue?

users care
& rev. recog. is a top fraud risk

• rev is important for valuation

• value influences compensation

• compensation influences managers

  • revenue —> valuation (stock price) —> compensation —> managers

revenue definition

inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combo) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations

revenue incentives

most revenue transactions do not pose problems for revenue recognition. however, some transactions are very complex (may take more than a year to complete)

standard change: asc 605 → asc 606

• 606 is more principles-based

• effective FY starting post 12/15/2017

• started as “harmonization” project with IFRS

• criticisms of asc 605: too many/inconsistent “rules” (differ by industry, etc)

• 606 improves comparability of rev. rec. across entities, industries, jurisdictions

asc 606 five step process to recognize revenue: step one

identify contract with the customer

• “contract w customer”: an agreement b/w two parties that creates enforceable rights or obligations

• ensure contract has substance

• can be explicit or implicit

• in our class, we will always assume this occurs

step two

identify separate performance obligations

• “performance obligation”: promise to provide a (distinct) product or service to a customer

• how to identify separate performance obligations:

  • can the customer benefit from the good or service on its own?

    • think of the pizza and salad vs salad and croutons example

  • can seller sell the goods or services separately?

  • are they highly interdependent or interrelated?

step 3

determine the transaction price

• “transaction price”: amount of consideration that a company expects to receive from a customer in exchange for transferring a good or service

• types of consideration:

  • fixed consideration

  • variable consideration

  • non-cash consideration

fixed consideration

price is known upfront (i.e. going into a store and buying a good w a price tag on it)

variable consideration

price is dependent on future events (ex: potential bonus for good performance)

• company estimates the amount of variable consideration it will receive from the contract using one of two approaches:

  • expected value: probability-weighted approach

  • most likely amount: single most likely amount in range or possible outcomes (most commonly used for binary outcomes)

a company can only recognize variable consideration if they have experience with similar contracts, and it is highly probable there will not be a significant reversal

non-cash consideration

receipt of goods, services, or other noncash consideration in exchange for delivery of goods/provision of services (ex: receiving company stock rather than cash)

• recognize revenue on the basis of the fair value of what is received

• if not easily determined, recognize revenue based on estimated selling price of services performed

step four

allocate transaction price

• if the transaction includes more than one performance obligation, allocate to various performance obligations based on their relative fair values

• best for allocation is the standalone selling price

  • if not available, use in this order: market value, cost-plus, residual approach

  • will use standalone and market in this class

step five

satisfy performance obligation & recognize revenue

• performance obligation is satisfied when customer obtains control of the good or service

  • indicators of this: seller has right to payment, transferred legal title, transfers possession, customer accepts the asset, customer has significant risks and rewards of ownership

1. bill-and-hold sales: the buyer is not ready to take delivery of the goods, but does take title and accept billing

2. long term construction projects

bill and hold sales

• reasons the bill and hold: production delays/lack of space

• should the seller get to recognize revenue in this circumstance? yes, when the title passes - which is before delivery actually takes place - if:

  • the reason the bill and hold arrangement must be substantive (there is economic substance)

  • the product must be identified separately as belonging to the customer

  • the product currently must be ready for physical transfer to the customer, and

  • the seller cannot have the ability to use the product or to direct it to another customer

two methods for recognizing revenue for long-term projects

1. percentage of completion method (poc/overtime) (more relevant)

2. completed contract method (ccm/point in time) (more reliable)

percentage of completion method

• the company satisfies their performance obligation and recognizes revenue over the life of the contract based on the progress of the job (i.e. the percentage that is complete)

• the use the poc method, one of the following critieria must be met

  • the customer simultaneously receives and consumes the benefits of the seller’s performance

    • ex: 2-year cleaning service contract; still receive benefits over the 2 years before the contract is up

  • the company’s performance creates or enhances an asset that the customer controls as it is created

    • ex: adding on section to sanford. use new video boards in season before full add on is done (UGA controls what is on the board)

  • the company’s performance does not create an asset with an alternative use. In addition, EITHER:

    • another company would not need to substantially re-perform the work completed to date if that other company were to fulfill the remaining obligation to the customer OR

    • the company has a right to payment for its performance completed to date, and it expects to fulfill the contract as promised

      • i.e. we’ll pay them as they go, but we expect them to complete the full job

total estimated income formula

revenue - total estimated costs

percent complete formula

costs to date / total estimated costs

current period income formula

(percent complete x total estimated income) - prior period(s) income

• if the total estimated income calculated earlier was negative, the formula is instead:

  • (total loss) - prior period(s) income/loss already recognized

    • fasb does this so you recognize as much loss as possible when it occurs

current period revenue formula

(percent complete x total revenue) - prior period(s)

current expenses

plug

JE 1

as costs are incurred

dr. CIP

cr. construction materials

• these entries are done as the work is done

• there are various credits that could go here, such as RM, wages payable, or overhead. we call them construction materials

• CIP is an asset account, kind of like WIP. typically this would be COGS

JE 2

as firm bills the customer

dr. A/R

cr. billings

• the billings account is a contra-asset account (contra to the CIP account). it avoids double counting of assets. revenue and A/R do not necessarily match, plus it is used to offset CIP

• billing points are set up throughout the contract. the billings account is a running total of how much has been billed to date. A/R represents how much still needs to be paid

JE 3

as cash is collected

dr. cash

cr. A/R

• the buyer must pay throughout, not at the end. cash is collected throughout the contract reducing A/R

• the billings account is unaffected by the collection of cash. the billings account is a running total of how much has been billed to date

JE 4 (projects w/ profit)

on 12/31/CY (time to book income)

dr. construction expense (plug)

dr. CIP

cr. construction revenue

• the number for construction expense, cip, and revenue come from equations 3, 4, and 5 above

JE 4 (projects w/ a loss)

on 12/31/CY (time to book loss)

dr. construction expense

cr. cip

cr. construction revenue

• the number for construction expense, cip, and revenue come from equations 3, 4, and 5 above

• the number for construction expense is a plug

note: JE 1, 2, 3, and 4 happen every year, including the last year of the project

JE 5

one time journal entries at the end of the project

dr. billings

cr. CIP

• the number for billings is the total revenue booked throughout the contract, which is also the total contract price. billings - revenue

• the number for CIP is the same as billings because CIP goes up for all expenses, and for all income. CIP equals expenses + income. therefore, billings = CIP

on the financial statements, the project is presented as follows

1. cash (asset)

• “billed and collected”

2. A/R (asset)

• “billed, but not yet collected”

3. CIP and billings

• if CIP > billings, then it’s a current asset

• if CIP < billings, then it’s a current liability

• billings avoids double-counting

• see more on this in the notes packet

CCM

see in notes packet