Revenue Recognition

FASB updated revenue recognition standards to address confusion caused by multiple, industry-specific standards. The new standards are almost identical to IFRS.

Five-Step Revenue Recognition Model

Identify the contract with the customer.
Identify the performance obligations in the contract.
Determine the transaction price.
Allocate the transaction price to the performance obligations.
Recognize revenue when (or as) each performance obligation is satisfied.

Revenue recognition errors are a primary reason for financial statement restatements required by the SEC.

Step 1: Identify the Contract

A customer is a person or entity that has contracted with the company to obtain goods or services in exchange for consideration.
Consideration is typically money, but can also be other forms of payment.

Contract Requirements

A contract must meet all of the following criteria:

All parties approve the contract and are legally obligated.
Each party's obligations are clearly identified.
Payment terms are identified.
The contract has commercial substance (leads to future cash flows).
- Commercial substance can include non-cash transactions where the company saves money.
Collection is probable.

These requirements prevent the use of false contracts to record revenue that will not be collected.

Contract Combinations and Modifications

Two or more contracts entered into at or near the same time with the same customer should be combined into one contract.
Modifications to a contract may require adjustments or creation of a new contract.

Contract Modification Examples

Example 1

P agrees to sell 500 t-shirts to J for $14$ each. After 400 shirts are delivered, the contract is modified to add 200 sweatshirts at $5$ each (below normal selling price).
The original agreement has not been fully satisfied, so the new agreement is a modification, not a new contract.
Remaining obligation: 100 t-shirts @ $14$ each, plus 200 sweatshirts @ $5$ each.
Total remaining revenue: $(100 \times 14) + (200 \times 5) = 1400 + 1000 = 2400$
Total remaining items: $100 + 200 = 300$
Revenue per item: $2400 / 300 = 8$
Revenue is recognized at $8$ per item as they are delivered.
Impact: changes in revenue recognition impact financial reporting, impacting revenue in different months, quarters, or even fiscal years.

Example 2

P sells 500 t-shirts to J at $14$ per shirt. After 400 shirts, the price of the remaining 100 shirts is reduced to $9$ each.
The average revenue per shirt is $\frac{(400 \times 14)+(100 \times 9)}{500} = \frac{5600+900}{500} = \frac{6500}{500} = 13$
The average price per shirt is now $13$ .
Revenue already recorded (400 shirts at $14$ ) is $5,600$ , but should have been $5,200$ (400 shirts at $13$ ).
A revenue reduction of $400$ is needed to correct the previous revenue recognition.
This example demonstrates the complexity of contract modifications and their impact on revenue recognition.

Types of Contracts

Contracts do not have to be written; they can be verbal or implied.
All contracts must be legally enforceable.
An implied contract example is a patient going to a doctor for treatment. The patient implies that they, or their insurance, will pay for the service.

Enforceability

If neither party has fulfilled their part of the contract, and both parties have the right to cancel without penalty, then there is no enforceable contract.

Hospital Example: Collectability

A hospital treats an uninsured patient in the emergency room.
The hospital then reassesses whether a contract exists based on the patient's ability to pay.
If the hospital determines the patient can likely pay $1,000 of a $10,000 bill, the transaction price is $1,000$ .
The remaining $9,000$ is treated as a discount or price concession.
If the patient cannot pay anything, it's labeled as charitable services.
Contracts can only exist when you know the standing of all parties involved.

Step 2: Identify Performance Obligations

Performance obligations are the promises to transfer goods or services to a customer.
A single contract can have multiple performance obligations.

Painting Contract Example

A painter is contracted to paint a building over the Christmas holiday.
The painter buys and delivers the paint on December 30 and begins painting on January 1, finishing on January 3.
If the paint and supplies are listed separately in the contract with a price, the painter can recognize revenue for the paint in December and the painting services in January.
If the contract is generic (painting and supplies), no revenue can be recognized until January 3.

Printer Contract Example

A company orders a printer with installation and a service contract.
If the customer can pay someone else for installation and service, each is a separate performance obligation.
Revenue from the printer is recognized upon delivery, installation upon completion, and service revenue over the contract period.
If no one else can install or service the printer, it's one performance obligation, and all revenue is recognized upfront.

Warranties

Implicit warranties (included with the product) are not separate performance obligations.
Extended warranties (customer buys separately) are separate performance obligations, with revenue recognized over the warranty period.

Step 3: Determine the Transaction Price

The transaction price is the amount of consideration a firm expects to receive, less amounts collected on behalf of third parties (e.g., sales taxes).
If payment is in non-cash form, it is valued at fair value.

Variable Consideration

Variable consideration includes items like rebates, refunds, and volume discounts.
These are estimated upfront, but may change over time.

Financing Component

If there is a financing component, the transaction price should separate the interest revenue from the revenue from goods or services.

Principal vs. Agent

Principals recognize revenue related to the cost of goods sold.
Agents recognize revenue only for their commission.
Consignment sales are a common example of a principal-agent relationship.

Right of Return

If a customer has the right to return goods, revenue cannot be recognized until the return right expires.
However, if returns can be reasonably estimated, revenue can be recognized with an allowance for estimated returns.

Step 4: Allocate Transaction Price

With multiple performance obligations, the transaction price must be allocated to each.

Allocation Example

Performance obligation 1: $20$ , performance obligation 2: $10$ , amount paid: $25$ .
The total of performance obligations is $30$ .
Allocate $20/30$ (two-thirds) of the $25$ to performance obligation 1 and $10/30$ (one-third) to performance obligation 2.
Even if allocated properly, you can only record revenue equal to the amount received, namely $25$ .

Step 5: Recognize Revenue

Revenue is recognized when (or as) a performance obligation is satisfied.
Satisfaction occurs when control of the goods or services has been transferred to the customer.
Control is not always the same as physical possession.

Satisfaction Over Time

For performance obligations satisfied over time (e.g., long-term construction contracts), two methods exist in the U.S.

Completed Contract Method

Recognize revenue only when the contract is complete.
Not permitted under IFRS.

Percentage of Completion Method

Recognize revenue as the project progresses.

Example

Three-year contract for $2,000,000$ to build a building, total estimated cost $1,400,000$ , expected profit $600,000$ .
In year 1, $350,000$ in costs are incurred.
Percentage of completion: $350,000 / 1,400,000 = 25\%$ .
Revenue recognized in year 1: $25\% \times 2,000,000= 500,000$
Profit recognised in year 1: $25\% \times 600,000 = 150,000$

Other Revenue Situations

Licenses

If a patent is sold, it is treated like any other sale.
If it's a license, revenue recognition can be at the inception or over time, depending on contract specifics.

Franchise Agreements

Upfront payments may be recognized immediately or over time, depending on what they cover (e.g., training, site selection).
Ongoing franchise revenue (percentage of sales) is recognized as received.

Consignment Arrangements

The purpose is to facilitate a sale to a third party.
The company transferring goods still controls them.
The consignee (consignment shop) is not obligated to pay until the goods are sold and when that happens, the cosignor will get the revenue.

Bill-and-Hold Arrangements

A customer is billed for goods, but the seller retains physical possession.
Revenue can be recognized if the goods are distinct, set aside, and cannot be used for other customers.

Gift Cards

Revenue is not recognized until the gift card is used.
Breakage (unused gift cards) can be recognized to the extent that it can be reasonably estimated, and once cards begin to be redeemed.

Disclosures

Extensive footnote disclosures are required related to revenue recognition because misstated revenue can have significant financial statement impact.

Revenue Recognition

FASB updated revenue recognition standards to address confusion caused by multiple, industry-specific standards. The new standards are almost identical to IFRS. This update ensures consistency and comparability in financial reporting across different industries and jurisdictions.

Five-Step Revenue Recognition Model

The core of the updated standards is a five-step model that provides a structured approach to recognizing revenue:

Identify the contract with the customer.
Identify the performance obligations in the contract.
Determine the transaction price.
Allocate the transaction price to the performance obligations.
Recognize revenue when (or as) each performance obligation is satisfied.

Revenue recognition errors are a primary reason for financial statement restatements required by the SEC. Accurate revenue recognition is crucial for maintaining investor confidence and regulatory compliance.

Step 1: Identify the Contract

A customer is a person or entity that has contracted with the company to obtain goods or services in exchange for consideration. Identifying the customer is the first step in determining whether a contract exists.
Consideration is typically money, but can also be other forms of payment. Consideration can include goods, services, or other non-cash items.

Contract Requirements

To be recognized under the revenue recognition standard, a contract must meet all of the following criteria:

All parties approve the contract and are legally obligated. This ensures that the contract is binding and enforceable.
Each party's obligations are clearly identified. Clear identification of obligations ensures that all parties understand their responsibilities.
Payment terms are identified. The payment terms, including the amount, timing, and form of payment, must be clearly defined.
The contract has commercial substance (leads to future cash flows).
- Commercial substance can include non-cash transactions where the company saves money. The contract must have an economic impact on the company.
Collection is probable. The company must have a reasonable expectation of collecting the consideration to be received under the contract.

These requirements prevent the use of false contracts to record revenue that will not be collected, ensuring that revenue is recognized only when it is reasonably certain to be realized.

Contract Combinations and Modifications

Two or more contracts entered into at or near the same time with the same customer should be combined into one contract if they are so closely related that they should be accounted for as a single contract. This prevents companies from artificially splitting contracts to manipulate revenue recognition.
Modifications to a contract may require adjustments or creation of a new contract. A contract modification is a change in the scope or price of a contract. It may be accounted for as a separate contract, a termination of the existing contract and creation of a new contract, or a cumulative catch-up adjustment to revenue.

Contract Modification Examples

Example 1

P agrees to sell 500 t-shirts to J for $14$ each. After 400 shirts are delivered, the contract is modified to add 200 sweatshirts at $5$ each (below normal selling price).
The original agreement has not been fully satisfied, so the new agreement is a modification, not a new contract.
Remaining obligation: 100 t-shirts @ $14$ each, plus 200 sweatshirts @ $5$ each.
Total remaining revenue: $(100 \times 14) + (200 \times 5) = 1400 + 1000 = 2400$
Total remaining items: $100 + 200 = 300$
Revenue per item: $2400 / 300 = 8$
Revenue is recognized at $8$ per item as they are delivered.
Impact: changes in revenue recognition impact financial reporting, impacting revenue in different months, quarters, or even fiscal years. Accurate accounting for contract modifications is essential for ensuring that financial statements reflect the true economic substance of the underlying transactions.

Example 2

P sells 500 t-shirts to J at $14$ per shirt. After 400 shirts, the price of the remaining 100 shirts is reduced to $9$ each.
The average revenue per shirt is $\frac{(400 \times 14)+(100 \times 9)}{500} = \frac{5600+900}{500} = \frac{6500}{500} = 13$
The average price per shirt is now $13$ .
Revenue already recorded (400 shirts at $14$ ) is $5,600$ , but should have been $5,200$ (400 shirts at $13$ ).
A revenue reduction of $400$ is needed to correct the previous revenue recognition.
This example demonstrates the complexity of contract modifications and their impact on revenue recognition. Careful consideration must be given to the terms of the modification and its impact on the overall transaction price.

Types of Contracts

Contracts do not have to be written; they can be verbal or implied. While written contracts are preferred for clarity and enforceability, verbal and implied contracts can also be recognized under the revenue recognition standard.
All contracts must be legally enforceable. To be recognized, a contract must be legally binding and enforceable in the relevant jurisdiction.
An implied contract example is a patient going to a doctor for treatment. The patient implies that they, or their insurance, will pay for the service. This creates an implied contract for the provision of medical services.

Enforceability

If neither party has fulfilled their part of the contract, and both parties have the right to cancel without penalty, then there is no enforceable contract. In this situation, there is no binding agreement and no obligation to perform.

Hospital Example: Collectability

A hospital treats an uninsured patient in the emergency room.
The hospital then reassesses whether a contract exists based on the patient's ability to pay. The hospital must evaluate the patient's financial situation to determine whether collection is probable.
If the hospital determines the patient can likely pay $1,000 of a $10,000 bill, the transaction price is $1,000$ . The remaining portion of the bill is not considered part of the transaction price.
The remaining $9,000$ is treated as a discount or price concession. This represents the amount that the hospital does not expect to collect.
If the patient cannot pay anything, it's labeled as charitable services. In this case, the hospital provides services without the expectation of payment.
Contracts can only exist when you know the standing of all parties involved. This ensures that the contract is based on a clear understanding of each party's rights and obligations.

Step 2: Identify Performance Obligations

Performance obligations are the promises to transfer goods or services to a customer. A performance obligation is a distinct promise to provide a specific item or service to the customer.
A single contract can have multiple performance obligations. Each performance obligation should be accounted for separately.

Painting Contract Example

A painter is contracted to paint a building over the Christmas holiday.
The painter buys and delivers the paint on December 30 and begins painting on January 1, finishing on January 3.
If the paint and supplies are listed separately in the contract with a price, the painter can recognize revenue for the paint in December and the painting services in January. This allows for revenue recognition that aligns with the transfer of control of the goods and services.
If the contract is generic (painting and supplies), no revenue can be recognized until January 3. In this case, the performance obligation is the complete painting service, and revenue is recognized upon completion.

Printer Contract Example

A company orders a printer with installation and a service contract.
If the customer can pay someone else for installation and service, each is a separate performance obligation. This means that the customer can obtain these services from another provider.
Revenue from the printer is recognized upon delivery, installation upon completion, and service revenue over the contract period. Each performance obligation is recognized as it is satisfied.
If no one else can install or service the printer, it's one performance obligation, and all revenue is recognized upfront. In this case, the installation and service are integral to the printer, and the entire revenue is recognized when the printer is delivered and ready for use.

Warranties

Implicit warranties (included with the product) are not separate performance obligations. These warranties are included as part of the product and do not represent a distinct service.
Extended warranties (customer buys separately) are separate performance obligations, with revenue recognized over the warranty period. Extended warranties provide additional coverage and are considered a distinct service for which revenue is recognized over time.

Step 3: Determine the Transaction Price

The transaction price is the amount of consideration a firm expects to receive, less amounts collected on behalf of third parties (e.g., sales taxes). This represents the total amount of revenue that the company expects to earn from the contract.
If payment is in non-cash form, it is valued at fair value. Non-cash consideration should be measured at its fair value as of the contract inception.

Variable Consideration

Variable consideration includes items like rebates, refunds, and volume discounts. These items can cause the transaction price to fluctuate.
These are estimated upfront, but may change over time. Companies must estimate variable consideration and reassess their estimates at each reporting period.

Financing Component

If there is a financing component, the transaction price should separate the interest revenue from the revenue from goods or services. This ensures that interest revenue is recognized separately from the revenue associated with the underlying goods or services.

Principal vs. Agent

Principals recognize revenue related to the cost of goods sold. Principals are responsible for providing the goods or services to the customer.
Agents recognize revenue only for their commission. Agents act on behalf of the principal and do not bear the risk of loss or damage to the goods.
Consignment sales are a common example of a principal-agent relationship. In a consignment arrangement, the consignor (principal) transfers goods to the consignee (agent) for sale to a third party.

Right of Return

If a customer has the right to return goods, revenue cannot be recognized until the return right expires. This prevents companies from recognizing revenue on goods that may be returned by the customer.
However, if returns can be reasonably estimated, revenue can be recognized with an allowance for estimated returns. This allows companies to recognize revenue while accounting for the possibility of returns.

Step 4: Allocate Transaction Price

With multiple performance obligations, the transaction price must be allocated to each. The allocation should be based on the relative standalone selling prices of the performance obligations.

Allocation Example

Performance obligation 1: $20$ , performance obligation 2: $10$ , amount paid: $25$ .
The total of performance obligations is $30$ .
Allocate $20/30$ (two-thirds) of the $25$ to performance obligation 1 and $10/30$ (one-third) to performance obligation 2.
Even if allocated properly, you can only record revenue equal to the amount received, namely $25$ . The allocation ensures that each performance obligation is recognized in proportion to its relative standalone selling price.

Step 5: Recognize Revenue

Revenue is recognized when (or as) a performance obligation is satisfied. Revenue should be recognized when the company has transferred control of the goods or services to the customer.
Satisfaction occurs when control of the goods or services has been transferred to the customer. Control is the ability to direct the use of and obtain substantially all of the remaining benefits from the asset.
Control is not always the same as physical possession. The customer may have control of the asset even if the seller retains physical possession.

Satisfaction Over Time

For performance obligations satisfied over time (e.g., long-term construction contracts), two methods exist in the U.S.

Completed Contract Method

Recognize revenue only when the contract is complete. Under this method, revenue is not recognized until all work has been completed.
Not permitted under IFRS. IFRS requires that revenue be recognized as the work progresses.

Percentage of Completion Method

Recognize revenue as the project progresses. Under this method, revenue is recognized based on the percentage of work completed.

Example

Three-year contract for $2,000,000$ to build a building, total estimated cost $1,400,000$ , expected profit $600,000$ .
In year 1, $350,000$ in costs are incurred.
Percentage of completion: $350,000 / 1,400,000 = 25\%$ .
Revenue recognized in year 1: $25\% \times 2,000,000= 500,000$
Profit recognised in year 1: $25\% \times 600,000 = 150,000$

Other Revenue Situations

Licenses

If a patent is sold, it is treated like any other sale. Revenue is recognized when control of the patent is transferred to the buyer.
If it's a license, revenue recognition can be at the inception or over time, depending on contract specifics. The specific terms of the license agreement will determine the timing of revenue recognition.

Franchise Agreements

Upfront payments may be recognized immediately or over time, depending on what they cover (e.g., training, site selection). The nature of the upfront payment will determine the timing of revenue recognition.
Ongoing franchise revenue (percentage of sales) is recognized as received. Ongoing revenue is typically recognized as it is earned.

Consignment Arrangements

The purpose is to facilitate a sale to a third party. The consignor transfers goods to the consignee for sale to a third party.
The company transferring goods still controls them. The consignor retains control of the goods until they are sold to the third party.
The consignee (consignment shop) is not obligated to pay until the goods are sold and when that happens, the cosignor will get the revenue.

Bill-and-Hold Arrangements

A customer is billed for goods, but the seller retains physical possession.
Revenue can be recognized if the goods are distinct, set aside, and cannot be used for other customers. This allows the seller to recognize revenue even though they have not yet delivered the goods to the customer.

Gift Cards

Revenue is not recognized until the gift card is used. The seller does not recognize revenue until the gift card is redeemed.
Breakage (unused gift cards) can be recognized to the extent that it can be reasonably estimated, and once cards begin to be redeemed. Breakage represents the amount of gift card value that is not expected to be redeemed.

Disclosures

Extensive footnote disclosures are required related to revenue recognition because misstated revenue can have significant financial statement impact. These