978-1259722660 Chapter 5 Lecture Note Part 1

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CHAPTER 5

REVENUE RECOGNITION

Overview

In Chapter 4, we discussed net income and its presentation in the income statement. In Chapter 5,

we focus on revenue recognition, which determines when and how much revenue appears in the

income statement. In Part A of this chapter, we discuss the general approach for recognizing revenue

in three situations—at a point in time, over a period of time, and for contracts that include multiple

parts that might require recognizing revenue at different times. In Part B, we see how to deal with

special issues that affect the revenue recognition process. In Part C, we discuss how to account for

revenue in long-term contracts. In an appendix, we consider some aspects of GAAP that were

eliminated by recent changes in accounting standards but that still will be used in practice until the

end of 2017.

Note to Instructors: Using Chapter 5 to Teach Revenue Recognition

Given the FASB’s new approach to revenue recognition, Chapter 5 was completely revised and

carefully structured to facilitate instruction, starting off by making clear to students how the five-step

revenue recognition process works and then discussing how various business arrangements affect the

five-step process.

Part A is designed to provide a simple introduction to the five-step revenue recognition process.

Part A can be covered on its own by instructors who desire to provide single-session coverage of

the basics of the new revenue recognition approach, or used as the foundation for additional topics

covered later in the chapter.

Part B follows Part A with in-depth coverage applying the revenue recognition process in various

circumstances. Part B is structured to maximize flexibility by allowing instructors to cover

whatever subset of these topics they prefer. Topics include estimating variable consideration,

determining stand-alone selling prices of performance obligations, and understanding how

revenue recognition under ASU No. 2014-09 handles common arrangements such as prepayments,

customer options to buy additional goods and services, quality-assurance and extended

warranties, rights of return, licenses, franchises, bill-and-hold sales, consignment arrangements,

and gift cards. A key feature of Part B is that each of these special issues is presented according to

which step in the revenue recognition process is being affected. Organizing topics this way allows

students to build a stronger framework for understanding each step in the FASB’s new revenue

recognition process.

Part C likewise maximizes instructor flexibility as it covers accounting for long-term contracts

under ASU No. 2014-09. Given the importance of long-term contracts, we continue to include this

topic in the body of the chapter, but instructors who don’t wish to cover long-term contracts can

skip Part C. Alternatively, instructors can cover the basics of recognizing revenue over time

(according to percentage of completion) and at a point in time (upon contract completion) but not

cover accounting for contract losses.

The appendix is provided for instructors who want to cover aspects of GAAP that are eliminated

by ASU No. 2014-09 but that will be used in practice until the end of 2017. Topics include the

realization principle, the installment method, the cost recovery method, industry-specific

accounting for software and franchises, and the differences between U.S. GAAP and IFRS prior

to ASU No. 2014-09.

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Learning Objectives

LO5–1State the core revenue recognition principle and the five key steps in applying it.

LO5–2Explain when it is appropriate to recognize revenue at a single point in time.

LO5–3Explain when it is appropriate to recognize revenue over a period of time.

LO5–4Allocate a contract’s transaction price to multiple performance obligations.

LO5–5 Determine whether a contract exists, and whether some frequently encountered features

of contracts qualify as performance obligations.

LO5–6 Understand how variable consideration and other aspects of contracts affect the

calculation and allocation of the transaction price.

LO5–7 Determine the timing of revenue recognition with respect to licenses, franchises, and

other common arrangements.

LO5–8 Understand the disclosures required for revenue recognition, accounts receivable,

contract assets, and contract liabilities.

LO5–9 Demonstrate revenue recognition for long-term contracts, both at a point in time when the

contract is completed and over a period of time according to the percentage completed.

LO5–10 Discuss the primary differences between U.S. GAAP and IFRS with respect to revenue

recognition.

Lecture Outline

Part A: Introduction to Revenue Recognition

I. Revenue Recognition in General

A. FASB definition: “Revenues are inflows or other enhancements of assets of an entity or

settlements of its liabilities (or a combination of both) from delivering or producing goods,

rendering services, or other activities that constitute the entity’s ongoing major or central

operations.” In other words, revenue is the inflow of net assets that occurs when a business

provides goods or services to its customers.

B. To determine how much revenue to recognize and when to recognize it, we apply the core

revenue recognition principle: companies recognize revenue when goods or services are

transferred to customers for the amount the company expects to be entitled to receive in

exchange for those goods or services.

1. Key concept: the seller has one or more performance obligations.

a. Performance obligations are promises to transfer goods or services to the

customer.

b. Revenue recognition is tied to satisfaction of performance obligations.

C. Five steps are used to apply the principle:

1. Identify the contract with a customer.

2. Identify the performance obligation(s) in the contract.

3. Determine the transaction price.

4. Allocate the transaction price to each performance obligation.

5. Recognize revenue when (or as) each performance obligation is satisfied.

D. Key considerations for each of the five steps that we will learn about:

1. A contract establishes the legal rights and obligations of the seller and the customer.

2. Contracts can indicate that the seller has one or more performance obligations.

3. The transaction price is the amount the seller is entitled to receive from the customer.

4. If there are multiple performance obligations, the contract price must be allocated

among them.

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5. Recognize revenue for each performance obligation at a point in time or over time,

depending on how that performance obligation is satisfied.

II. Recognizing Revenue at a Single Point in Time

A. We recognize revenue at a point in time when we don’t qualify for recognizing revenue over

time.

B. The performance obligation is satisfied when control of the goods or services is transferred

from the seller to the customer.

C. Usually transfer of control is obvious and coincides with delivery.

D. The customer is more likely to control a good or service if the customer has:

1. An obligation to pay the seller.

2. Legal title to the asset.

3. Physical possession of the asset.

4. Assumed the risks and rewards of ownership.

5. Accepted the asset.

III. Recognizing Revenue over a Period of Time

A. Revenue should be recognized over time if goods and services are transferred over time to

the customer.

B. Revenue can be recognized over time if one of the following conditions holds:

1. The customer consumes the benefit of the seller’s work as it is performed, or

2. The customer controls the asset as it is created, or

3. The seller is creating an asset that has no alternative use to the seller, and the seller

has the legal right to receive payment for progress to date.

C. If revenue is recognized over time, we can measure progress toward completion by using:

1. Input measures. The most common approach is to use a “cost-to-cost ratio,” which

compares total cost incurred to date to the total estimated cost to complete the project.

2. Output measures. Examples include the passage of time and the amount of finished

product delivered.

IV. Recognizing Revenue for Contracts that Contain Multiple Performance Obligations

A. The objective is to separate complex contracts into parts that can be viewed on a stand-alone

basis. Steps 2 and 4 are critical to this process.

B. Step 2: Identify the performance obligation(s) in the contract.

1. A promise to provide a good or service is a performance obligation if the good or

service is distinct from other goods and services in the contract.

2. A good or service is distinct if it is both:

a. Capable of being distinct. The customer could use the good or service on its own

or in combination with other goods and services it could obtain elsewhere, and

b. Separately identifiable from other goods or services in the contract. The good or

service also is distinct in the context of the contract because it is not highly

interrelated with other goods and services in the contract. The goal is to

determine whether the seller’s performance obligation is to transfer individual

goods and services or to transfer an item that uses those as inputs to provide

some output.

C. Step 4: Allocate the transaction price to each performance obligation based on relative

stand-alone selling prices. If stand-alone selling prices aren’t observable, estimate them.

V. Illustration 5-11 Summary of Fundamental Issues Related to Recognizing Revenue

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Part B: Special Topics in Revenue Recognition

I. Special Issues for Step 1: Identify the Contract

A. A contract is an agreement that creates legally enforceable rights and obligations.

1. Can be explicit or implicit.

2. Can be oral or written.

B. A contract exists for purposes of revenue recognition only if it

1. Has commercial substance, affecting the risk, timing, or amount of the seller’s future

cash flows,

2. Has been approved by both the seller and the customer, indicating commitment to

fulfilling their obligations,

3. Specifies the seller’s and customer’s rights regarding the goods or services to be

transferred,

4. Specifies payment terms, and

5. Is probable that the seller will collect the amount it is entitled to receive.

C. Even if a contract doesn’t exist, the seller still can recognize an amount of revenue equal to

any nonrefundable payments it has received, so long as it has transferred control of the

goods and services and it does not have any further obligations to transfer goods or services

to the customer.

D. A contract does not exist if both of the following are true:

1. Neither the seller nor the customer has performed any obligations under the contract,

and

2. Both the seller and the customer can terminate the contract without penalty.

II. Special Issues for Step 2: Identify the Performance Obligation(s)

A. Examples of common parts of contracts that are not performance obligations:

1. Prepayments (part of the transaction price).

2. Quality-assurance warranties (part of the performance obligation to deliver goods and

services that are free of defects).

3. Right of return (part of the performance obligation to deliver acceptable goods and

services).

B. Examples of common parts of contracts that are performance obligations:

1. Extended warranties (separate obligations distinct from delivering acceptable goods

and services). A warranty is an extended warranty if either:

a. The customer has the option to purchase the warranty separately, or

b. The warranty provides a service to the customer beyond quality assurance.

2. Options that provide a material right (a material right is something the customer

wouldn’t get otherwise, so the seller is obligated to provide it).

III. Special Issues for Step 3: Determine the Transaction Price

A. Variable consideration

1. Occurs when some of the contract price depends on the outcome of a future event.

Examples:

a. Incentive payments.

b. Royalties.

c. Volume discounts and product returns.

d. Rebates.

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2. Estimate variable consideration using either:

a. Expected value, calculated as the sum of each possible amount multiplied by its

probability (more likely to be used when several outcomes are possible), or

b. Most likely amount (more likely to be used when two outcomes are possible).

3. Sellers only include an estimate of variable consideration in the transaction price to

the extent it is “probable” that a significant revenue reversal will not occur when the

uncertainty associated with the variable consideration is resolved.

a. Intended to avoid severe revenue overstatements due to estimation error.

b. Indicators that a significant reversal could occur:

i. Poor evidence on which to base an estimate,

ii. Dependence of the estimate on factors outside the seller’s control,

iii. A history of the seller changing payment terms on similar contracts,

iv. A broad range of outcomes that could occur, and

v. A long delay before uncertainty resolves.

4. The seller should update estimates of variable consideration (and of whether the

constraint is required) prospectively, adjusting revenue and other accounts as

necessary in the period in which the estimate is revised.

B. Right of return

1. If sales are for cash, companies record estimated returns by debiting a contra revenue

account called “sales returns” and crediting a refund liability.

2. If sales are for credit, companies record estimated returns by debiting a contra

revenue account called “sales returns” and crediting a contra receivables account

called “allowance for sales returns.”

3. We’ll discuss accounting for returns more in Chapter 7.

C. Is the seller a principal or agent?

1. If the company is a principal, it records revenue equal to the total sales price paid by

customers as well as cost of goods sold equal to the cost of the item to the company.

2. If the company is an agent, it records as revenue only the commission it receives on

the transaction.

3. We view the seller as a principal if it obtains control of the goods or services before

they are transferred to the customer. Control is evident if the principal has primary

responsibility for delivering a product or service and is vulnerable to risks associated

with holding inventory, setting prices, and delivering an acceptable product or service

to the customer.

D. The time value of money

1. If payment happens before or after delivery, the transaction has a financing

component. If the financing component is significant, the seller has to account for it.

a. If payment before delivery, seller is getting a loan, so recognizes interest

expense.

b. If payment after delivery, seller is giving a loan, so recognizes interest revenue.

2. We presume the financing component is not significant if payment and delivery are

separated by less than one year.

E. Payments by the seller to the customer

1. If the seller is purchasing distinct goods or services from the customer at the fair

value of those goods or services, we account for that purchase as a separate

transaction.

2. If a seller pays more for distinct goods or services purchased from their customer than

the fair value of those goods or services, those excess payments are viewed as a

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refund. They are subtracted from the amount the seller is entitled to receive from the

customer when calculating the transaction price of the sale to the customer.

IV. Special Issues for Step 4: Allocate the Transaction Price to the Performance Obligations

A. Three methods are recommended for estimating stand-alone selling prices that are not

observable:

1. Adjusted market assessment approach: The seller considers what it could sell the

product or services for in the market in which it normally conducts business, perhaps

referencing prices charged by competitors.

2. Expected cost plus margin approach: The seller estimates its costs of satisfying a

performance obligation and then adds an appropriate profit margin.

3. Residual approach: The seller estimates an unknown (or highly uncertain)

stand-alone selling price by subtracting the sum of the known or estimated

stand-alone selling prices from the total transaction price. The residual approach is

allowed only if the stand-alone selling price is highly uncertain, either because:

a. The seller hasn’t previously sold the good or service and hasn’t yet determined a

price for it, or

b. The seller provides the same good or service to different customers at

substantially different prices.

V. Special Issues for Step 5: Recognize Revenue When (Or As) Each Performance Obligation

Is Satisfied

A. Licenses

1. Functional intellectual property: Some licenses involve IP (intellectual property) that

has standalone functionality because it can perform a task (like software) or be played

(like media). Licenses of functional IP transfer a right to use the seller’s intellectual

property as it exists when the license is granted. Revenue for those licenses is

recognized at the point in time the right is transferred. An exception is when the seller

is expected to change the IP during the license period and the customer has to use the

new version. In that case, the license is viewed as providing an access right and

revenue is recognized over time.

2. Symbolic intellectual property: Some licenses involve symbolic IP like brands, team

or trade names, or logos. It is understood that the seller will undertake ongoing

activities during the license period that affect the benefit the customer receives. A

license to access symbolic intellectual property is an access right for which revenue

must be recognized over time. Revenue for those licenses is recognized over the

period of time for which access is provided.

B. Franchises

1. The franchisor grants to the franchisee the right to sell the franchisor’s products and

use its name for a specified period of time.

2. A franchise typically involves a license to use the franchisor’s intellectual property

but also involves initial sales of products and services as well as ongoing sales of

products and services.

3. The franchisor must evaluate each part of the franchise arrangement to identify the

performance obligations and account for them accordingly.

C. Bill-and-hold arrangements

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1. Exist when a customer purchases goods but requests that the seller not ship the

product until a later date.

2. Sellers usually conclude that control has not been transferred and revenue should not

be recognized until actual delivery to the customer occurs.

3. Sellers can recognize revenue prior to delivery only if:

a. They conclude that the customer controls the product,

b. There is a good reason for the bill-and-hold arrangement, and

c. The product is specifically identified as belonging to the customer and is ready

for shipment.

D. Consignment arrangements

1. Exist when a “consignor” physically transfers the goods to the other company (the

consignee), but the consignor retains legal title.

2. The consignor retains control so it postpones recognizing revenue until sale to an end

customer occurs.

E. Gift Cards

1. Seller records a deferred revenue liability when the card is sold.

2. Seller recognizes revenue when the card is used and at the point when it concludes

there is only a “remote likelihood” that customer will use the card.

VI. Disclosures

A. Income statement disclosure

1. Reports revenue, bad debt expense, and any interest revenue or interest expense

associated with significant finance components.

B. Balance sheet disclosure

1. Accounts receivable: Unconditional right to receive payment, depending only on the

passage of time.

2. Contract assets: Conditional right to receive payment for performance obligations

already performed.

3. Contract liabilities: Deferred revenue.

C. Disclosure notes

1. The objective is to help investors understand the nature, amount, timing, and

uncertainty of revenues and cash flows.

2. Required disclosures include:

a. Separation of revenue into meaningful categories (product lines, geographic

regions, types of customers, types of contracts).

b. Outstanding performance obligations.

c. Important contractual provisions.

d. Significant judgments.

e. Significant changes in contract assets and liabilities.

VII. Illustration 5-22 Summary of Fundamental and Special Issues Related to Recognizing

Revenue

Part C: Accounting for Long-Term Contracts

I. Two Steps Critical for Long-Term Contracts

A. Step 2, “Identify the performance obligation(s) in the contract,” is important because

long-term contracts typically include many products and services that could be viewed as

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separate performance obligations. These products and services are capable of being distinct,

but they are not separately identifiable because the seller’s role is to combine those

products and services for purposes of delivering a completed product. Therefore, these

contracts are viewed as a bundle of products and services that comprise a single

performance obligation.

B. Step 5, “Recognize revenue when (or as) each performance obligation is satisfied,” is

important because there can be a considerable difference for long-term contracts between

recognizing revenue over time and recognizing revenue only when the contract has been

completed. Most long-term contracts qualify for revenue recognition over time, either

because:

1. The seller is creating an asset that the customer controls as it is completed, or

2. The seller is creating an asset that is customized for the customer, so the seller has no

other use for the asset and has the right to be paid for progress even if the customer

cancels the contract.

C. If a contract doesn’t qualify for revenue recognition over time, revenue is recognized upon

completion of the contract. (In prior GAAP, this was called the completed contract

method.)

D. If a contract qualifies for revenue recognition over time, revenue is recognized over the

term of the contract according to the percentage of completion. (In prior GAAP, this was

called the “percentage-of-completion method.”)

II. Accounting for a Profitable Long-Term Contract

A. All costs of construction are recorded in an asset (inventory) account called construction in

progress.

B. Period billings are credited to billings on construction contract, a contra account to the

construction in progress account. This serves to reduce the book value of the physical asset

(construction in progress) when a financial asset (accounts receivable) is also recognized;

otherwise the project would be double counted on the balance sheet.

C. Construction in progress is debited for the amount of gross profit recognized. The same

total amount of gross profit is recognized over the life of the contract regardless of the

timing of revenue recognition—the only difference is timing.

D. Recognizing revenue at a point in time is equivalent to recognizing revenue at the point of

delivery, that is, when the project is complete.

1. No revenues or expenses are recognized until the project is complete.

2. Exception: overall losses on the contract (see below).

E. Recognizing revenue over time allocates a fair share of a project’s revenues and expenses to

each reporting period during construction. How is that fair share determined?

1. The allocation of project profit is accomplished by estimating progress to date.

2. Progress to date (the percentage of completion) can be estimated as the proportion of

the project’s cost incurred to date divided by total estimated costs, by project

milestones, or by relying on an engineer’s or architect’s estimate. The “cost-to-cost

ratio” is most common.

3. To determine revenue, the percentage of completion is multiplied by estimated total

revenue to determine revenue that should be recognized to date, and then the current

period’s revenue is determined by subtracting from this amount the revenue

recognized in previous periods.

Revenue

recognized

this period

= Total

estimated

revenue

× Percentage

completed

to date

− Revenue

recognized in

prior periods

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( )

Cumulative revenue to be

recognized to date

4. In most cases, the cost of construction equals the construction costs incurred during

the period. Therefore, the same approach used to estimate revenue can be used to

estimate gross profit.

III. A Comparison of Revenue Recognized Over the Term of the Contract and at the

Completion of Contract

A. A debit balance indicates costs (plus profits if revenue is recognized over time according to

percentage of completion) in excess of billings and is reported as an asset.

B. A credit balance indicates billings in excess of costs (plus profits if revenue is recognized

over time according to percentage of completion) and is reported as a liability.

IV. Long-Term Contract Losses

A. A loss could occur on a profitable project if the estimated costs to complete were

underestimated in prior periods.

B. An estimated loss on a long-term contract is fully recognized in the first period that the loss

is anticipated, regardless of the revenue recognition method used.

C. Recognized losses on long-term contracts reduce the construction in progress account.

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