Supplement: GAAP in Effect Prior to ASU No. 2014-09
I. Summary of GAAP Changes
A. ASU No. 2014-09 replaced over 200 specific items of revenue recognition guidance.
Illustration 5–S1 summarizes some important changes in GAAP that occurred.
II. The Realization Principle
A. The realization principle requires that two criteria be satisfied before revenue can be
recognized:
1. The earnings process is judged to be complete or virtually complete.
2. There is reasonable certainty as to the collectibility of the asset to be received.
B. Staff Accounting Bulletin Nos. 101 and 104 summarized the SEC’s views on revenue
recognition. The bulletins provide additional criteria for judging whether or not the
realization principle is satisfied:
1. Persuasive evidence of an arrangement exists.
2. Delivery has occurred or services have been rendered.
3. The seller’s price to the buyer is fixed or determinable.
4. Collectibility is reasonably assured.
C. IFRS revenue recognition concepts focus on transfer of economic benefits. IFRS
allows revenue to be recognized when the following conditions have been satisfied:
1. The amount of revenue and costs associated with the transaction can be
measured reliably.
2. It is probable that the economic benefits associated with the transaction will flow
to the seller.
3. (For sales of goods) the seller has transferred to the buyer the risks and rewards
of ownership and doesn’t effectively manage or control the goods.
4. (For sales of services) the stage of completion can be measured reliably.
5. These requirements are similar to U.S. GAAP, and revenue typically is
recognized at a similar point under IFRS and U.S. GAAP.
D. Under prior GAAP, it was useful to characterize revenue from the perspective of the
point of delivery.
E. Revenue recognition prior to delivery is covered in the main chapter (that is, revenue
recognition over time for long-term contracts).
1. Under prior GAAP, use of the percentage-of-completion method was required
unless accurate estimates of revenue, cost, and percentage complete could not be
made.
2. IFRS used the cost recovery method rather than the completed contract method.
III. Installment Sales
A. Significant uncertainties about cash collection could cause a delay in recognizing
revenue from the sale of a product or a service.
B. Installment sales
1. Revenue recognition for most installment sales takes place at the point of
delivery because reliable estimates of potential uncollectible amounts can be
made.
2. When exceptional uncertainty exists, two accounting methods are available:
a. The installment sales method.
b. The cost recovery method.
3. The installment sales method recognizes gross profit by applying the gross profit
percentage on the sale to the amount of cash actually received.
4. The cost recovery method defers all gross profit recognition until cash equal to
the cost of the item sold has been received.
IV. Industry-Specific Revenue Issues
A. Software and other multiple-element arrangements
1. If a software arrangement (sale) includes multiple elements, the revenue from the
arrangement should be allocated to the various elements based on the relative fair
values of the individual elements (“vendor-specific objective evidence”).
2. More generally, if an arrangement contains multiple elements, revenue should be
allocated to individual deliverables if they qualify for separate revenue
recognition (e.g., they must have value on a stand-alone basis). Otherwise,
revenue is delayed until completion of later deliverables. The revenue is
allocated based on relative selling prices, and those prices can be estimated if
they are not available.
3. IAS No. 18 is the general revenue recognition standard in IFRS. There is not
much guidance about multiple-element contracts or industry-specific revenue
recognition in IFRS.
B. Franchise sales
1. In a franchise sale, the fees to be paid by the franchisee to the franchisor usually
comprise (1) the initial franchise fee, and (2) continuing franchise fees.
2. GAAP requires that the franchisor has substantially performed the services
promised in the franchise agreement and that the collectibility of the initial
franchise fee is reasonably assured before the fee can be recognized.
3. Continuing franchise fees are paid to the franchisor for continuing rights as well
as for advertising and promotion and other services over the life of the agreement
and are recognized by the franchisor as revenue in the period received, which
corresponds to the periods the services are performed.
V. Additional Differences Between U.S. GAAP and IFRS
A. Under IFRS, IAS No. 11 governs revenue recognition for long-term construction
contracts.
1. Like U.S. GAAP, the international standard requires the use of
percentage-of-completion accounting when estimates can be made precisely.
2. Unlike U.S. GAAP, the international standard requires the use of the cost
recovery method rather than the completed contract method when estimates
cannot be made precisely enough to allow percentage-of-completion accounting.
a. Under the cost recovery method, contract costs are expensed as incurred,
and an exactly offsetting amount of contract revenue is recognized, such
that no gross profit is recognized until all costs have been incurred.
b. Under both the cost recovery and completed contract methods, no gross
profit is recognized until the contract is essentially completed, but revenue
and construction costs will be recognized earlier under the cost recovery
method than under the completed contract method.
PowerPoint Slides
Three PowerPoint presentations of the chapter are available in the Connect
Library:
1. With “Concept Checks” useful for classroom presentation, permitting the
instructor to intersperse in the presentation short exercises students can be
asked to solve individually or in small groups before the solution is
“revealed” by the instructor. {These are available only within Instructor
Resources.}
2. Without the “Concept Checks” so students don’t have the solutions before
being asked to solve individually or in small groups.
3. Accessible PowerPoint Presentations. Accessibility is becoming even
more important in the education marketplace. Students and instructors with
disabilities use many different assistive technologies, and McGraw-Hill
Education is working to increase compatibility and access that will not only
help those with disabilities achieve better learning outcomes, but also serve
the institutions that are teaching these students. Accessible PowerPoint
allows slide content to be read by a screen reader and provides alternative
text descriptions for any image files used that enrich the learning experience.
Accessible PowerPoint is also designed with high-contrast color palettes and
uses texture when possible, instead of color to denote different aspects of the
imagery used within the slide.
Note: The slides are intended to provide comprehensive coverage of the chapter,
but they can be easily edited to allow instructors to change numbers
and content in illustrations or to delete slides pertaining to topics they
choose to omit or deemphasize. (Using your students’ names for company
names in the Concept Checks or Illustrations can be fun.)
Suggestions for Class Activities
1. Real World Scenario
The following is an excerpt from an article that appeared in the August 25, 2002, edition of The
Seattle Times:
When Cutter & Buck revealed two weeks ago that it padded sales figures
in 2000 by recording $5.8 million in shipments that were mostly returned,
the news came as a surprise to many investors. But it wasn’t the first time
the Seattle sportswear retailer’s shipping and accounting practices have
been called into question. Shortly before co-founder Joey Rodolfo left in
1997, he accused the company of shipping orders months before
customers were expecting them, a method of prematurely booking sales.
Some customers and former employees say early shipments persisted for
years after Rodolfo raised the issue. And late last week, Chief Executive
Fran Conley said an internal investigation has found that early shipments
were “more extensive than I had known” and may force the company to
further restate sales figures.
Shipping and booking orders ahead of schedule to meet short-term sales
goals — a practice sometimes called channel stuffing — is not, by
definition, illegal. But by essentially borrowing from future sales to claim
bigger current sales and profit, it can be used to boost a company’s bottom
line and create a misleading appearance of growth for investors.
Suggestions:
This article provides a good way to introduce the topic of channel stuffing. When a company
stuffs the channel, it ships inventory ahead of schedule, filling its distribution channels with more
product than is needed. Since companies often record sales as soon as they ship products,
channel stuffing can make it appear that business is booming. Is this practice legal? Is it an
acceptable practice according to GAAP? Is it an ethical practice?
Points to Note:
Channel stuffing is not an uncommon practice. There are many examples you can find for
your students. The text references the Sunbeam incident that occurred in the late ’90s. More
recent examples include Microsoft, Novell, Network Associates, and AOL.
GAAP do not address channel stuffing specifically. The key is whether or not the practice
leads to excessive future sales returns that are not adequately provided for by the seller. There
may be an issue with respect to the legality of the practice if it can be shown that the practice
resulted in misleading the investing public. And there are ethical dimensions to the practice as
well.
2. Research Activity
Most of your students probably have purchased merchandise via the Internet. You can buy the
products of many companies online. Some of these companies, such as Amazon, often act
merely as intermediaries between the manufacturer and the consumer. Revenue recognition
for this type of transaction has been controversial. If Amazon sells something to a customer
for $100 that costs $80, the profit on the transaction is clearly $20. But should Amazon
recognize $100 in revenue and $80 in cost of goods sold (the gross method), or should it
recognize only the $20 in gross profit (the net method)?
Suggestions:
Discuss with your class the implications of one reporting method versus the other. Why should
it make a difference? What factors might dictate whether or not Amazon should recognize the
transaction gross versus net? Have them access Amazon’s most recent financial statements using
Edgar (www.sec.gov). Or you can show them Amazon’s disclosure note and discuss the contents
of the note. The following is a portion of the company’s revenue recognition disclosure note that
appeared in its 2013 financial statements:
We evaluate whether it is appropriate to record the gross amount of product sales and related
costs or the net amount earned as commissions. Generally, when we are primarily obligated in
a transaction, are subject to inventory risk, have latitude in establishing prices and selecting
suppliers, or have several but not all of these indicators, revenue is recorded at the gross sales
price. We generally record the net amounts as commissions earned if we are not primarily
obligated and do not have latitude in establishing prices. Such amounts earned are determined
using a fixed percentage, a fixed-payment schedule, or a combination of the two.
3. Professional Skills Development Activities
The following are suggested assignments from the end-of-chapter material that will help your
students develop their communication, research, analysis, and judgment skills.
Communication Skills. In addition to Communication Cases 5–7 and 5–13, Judgment Case
5–12 can be adapted to ask students to choose one of the two alternatives and write a memo
supporting their position. Judgment Case 5–3 and Ethics Case 5–4 do well as group
assignments. Judgment Cases 5–5 and 5–6 and Ethics Case 5–4 create good class
discussions and are suitable for short student presentation(s).
Research Skills. In their careers, our graduates will be required to locate and extract relevant
information from available resource material to determine the correct accounting practice,
perhaps identifying the appropriate authoritative literature to support a decision. Research
Cases 5–1 and 5–10 and Real World Case 5–9 provide an excellent opportunity to help
students develop this skill, as does the Air France–KLM case.
Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct
students to gather, assemble, organize, process, or interpret data to provide options for
making business and investment decisions. Exercises 5–22, 5–25, and 5–26 and Problems
5–15, 5–16, and 5–17 provide opportunities to develop and sharpen analytical skills.
Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that
require students to critically analyze issues to apply concepts learned to business situations
in order to evaluate options for decision making and provide an appropriate conclusion. In
addition to Judgment Cases 5–2, 5–3, 5–5, 5–6, 5–8, and 5–12, Real World Case 5–9 also
requires students to exercise judgment.
4. Ethical Dilemma
The chapter contains the following ethical dilemma:
ETHICAL DILEMMA
The Precision Parts Corporation manufactures automobile parts. The company has reported a
profit every year since the company’s inception in 1980. Management prides itself on this
accomplishment and believes one important contributing factor is the company’s incentive plan
that rewards top management a bonus equal to a percentage of operating income if the
operating income goal for the year is achieved. However, 2018 has been a tough year, and
prospects for attaining the income goal for the year are bleak.
Tony Smith, the company’s chief financial officer, has determined a way to increase
December sales by an amount sufficient to boost operating income over the goal for the year
and earn bonuses for all top management. A reputable customer ordered $120,000 of normally
stocked parts to be shipped on January 15, 2019. Tony told the rest of top management, “I
know we can get that order ready by December 31. We can then just leave the order on the
loading dock until shipment. I see nothing wrong with recognizing the sale in 2018, since the
parts will have been manufactured and we do have a firm order from a reputable customer.”
The company’s normal procedure is to ship goods f.o.b. destination and to recognize sales
revenue when the customer receives the parts.
You may wish to discuss this in class. If so, discussion should include these elements.
Step 1—The Facts:
Precision Parts Corporation has reported a profit since its inception and given top management
bonuses when the operating income goal is achieved. In 2018, however, the company does not
expect to achieve its profit goal. Tony Smith, the CFO, wants to record a sale in 2018 that will
not be shipped until January 2019 so that management will receive bonuses for achieving the
profit goal. The CFO is attempting to manipulate the recognition of revenue. The company’s
normal procedure is to recognize sales revenue when goods are shipped f.o.b. destination.
Although sales revenue may be recognized when production ends if certainty of collection exists,
nothing in the case indicates that there is reasonable certainty as to the collectibility of the
revenue at the end of production.
Step 2—The Ethical Issue and the Stakeholders:
The ethical issue or dilemma is whether Tony Smith’s obligation to top management to show a
profit is greater than his obligation to provide information that is not misleading to users of
financial statements.
Stakeholders include CFO Tony Smith, other corporate managers, auditors, present and future
creditors, and current and future investors.
Step 3—Values:
Values include competence, honesty, integrity, objectivity, loyalty to the company, and
responsibility to users of financial statements.
Step 4—Alternatives:
1. Record the parts sales revenue in 2018.
2. Record the parts sales revenue in 2019, when the goods are shipped.
Step 5—Evaluation of Alternatives in Terms of Values:
1. Alternative 1 illustrates loyalty to the company and other top managers.
2. Alternative 2 exhibits the values of competence, honesty, integrity, objectivity, and
responsibility to users of the financial statements.
Step 6—Consequences:
Alternative 1
Positive consequences: Tony would enable other top managers to receive bonuses and permit
the company to meet its operating income goal.
Negative consequences: Users of the financial statements would be misinformed. Users of the
financial statements may sue the company upon learning the truth if the amount of revenue is
material and affects their financial decisions. Auditors may refuse to give a positive opinion on
the fair presentation of the financial statements. Tony may lose the respect of the rest of top
management and his job.
Alternative 2
Positive consequences: Users of the financial statements would receive more relevant and
reliable reported revenue. Tony would maintain his integrity. He may receive praise for being
honest and keep his job.
Negative consequences: Tony may incur the disfavor of the rest of top management for not
enabling others to receive a bonus. He may lose the trust of other managers and lose his job.
Step 7—Decision:
Student(s) must decide their course of action.
Assignment Chart
Brief
Exercises
Learning
Objective(s
) Topic
Est.
time
(min.)
5–1 2 Revenue recognition at a point in time 5
5–2 3 Timing of revenue recognition 5
5–3 3 Timing of revenue recognition 5
5–4 4 Allocating the transaction price 5
5–5 5 Existence of a contract 5
5–6 5,10 Existence of a contract; IFRS 5
5–7 5 Performance obligations; prepayments 5
5–8 5 Performance obligations; warranties 5
5–9 5 Performance obligations; warranties 5
5–10 5 Performance obligations; options 5
5–11 5 Performance obligations; construction 5
5–12 5Performance obligations; construction 5
5–13 5,6 Performance obligations; right of return 5
5–14 6 Variable consideration 5
5–15 6 Variable consideration 5
5–16 6 Right of return 5
5–17 6 Principal or agent 10
5–18 6 Payments by the seller to the customer 10
5–19 6 Estimating stand-alone selling prices; adjusted market
assessment approach
10
5–20 6 Estimating stand-alone selling prices; expected cost plus
margin approach
10
5–21 6 Estimating stand-alone selling prices; residual approach 10
5–22 7 Timing of revenue recognition; licenses 10
5–23 7 Timing of revenue recognition; licenses 10
5–24 7,10 Timing of revenue recognition; licenses 10
5–25 7 Timing of revenue recognition; franchises 10
5–26 7 Timing of revenue recognition; bill-and-hold 5
5–27 7Timing of revenue recognition; consignment 5
5–28 7Timing of revenue recognition; gift cards 5
5–29 8Contract assets and contract liabilities 5
5–30 8,9 Contract assets and contract liabilities 5
5–31 9 Long-term contract; revenue recognition over time; profit
recognition
10
5–32 9 Long-term contract; revenue recognition over time; balance
sheet
10
5–33 9 Long-term contract; revenue recognition upon completion 15
5–34 9 Long-term contract; revenue recognition; loss on entire
project
5
Exercises
Learning
Objective(s
) Topic
Est.
time
(min.)
5–1 1,2,3 FASB codification research 15
5–2 3 Service revenue 15
5–3 4 Allocating transaction price 15
5–4 4,5 FASB codification research 15
5–5 2,4,5 Performance obligations 20
5–6 2,4,5 Performance obligations; customer option for additional
goods or services
15
5–7 3,4,5 Performance obligations; customer option for additional
goods or services; prepayment
15
5–8 4,5 Performance obligations; customer option for additional
goods or services
20
5–9 6 Variable consideration; estimation and constraint 15
5–10 3,6 Variable consideration—most likely amount; change in
estimate
15
5–11 3,6 Variable consideration—expected value; change in estimate 20
5–12 2,5,6 Consideration payable to customer; collectability of
transaction price
10
5–13 6 Approaches for estimating stand-alone selling prices 10
5–14 6,7 FASB codification research 15
5–15 6,7 Franchises; residual method 20
5–16 8 FASB codification research 15
5–17 9 Long-term contract; revenue recognition over time and at a
point in time
25
5–18 9Long-term contract; revenue recognition over time vs. upon
project completion
30
5–19 9Long-term contract; revenue recognition over time; loss
projected on entire project
30
5–20 8,9 Long-term contract; revenue recognition upon project
completion; loss projected on entire project
20
5–21 9 Income (loss) recognition; long-term contract; revenue
recognition over time vs. upon project completion
50
5–22 9 Long-term contract; revenue recognition over time; solve for
unknowns
25
Problems
Learning
Objective(s) Topic
Est.
time
(min.)
5–1 4,5 Upfront fees; performance obligations 25
5–2 2,4,5 Performance obligations; warranties; option 30
5–3 2,4,5 Performance obligations; warranties; option 35
5–4 2,4,5 Performance obligations; customer options for additional
goods and services 30
5–5 3,6 Variable consideration 25
5–6 3,6 Variable consideration; change of estimate 25
5–7 3,6 Variable consideration; constraint and change of estimate 20
5–8 3,6 Variable transaction price 40
5–9 3,6,7 Variable transaction price 45
5–10 8,9 Long-term contract; revenue recognition over time 55
5–11 9Long-term contract; revenue recognition upon completion 40
5–12 9Long-term contract; revenue recognized over time; loss
projected on entire project 25
5–13 9Long-term contract; revenue recognition over time vs. upon
project completion 45
Star Problems\
Learning
Cases Objective(s) Topic
Research Case 5–1 1 Earnings management with respect to revenues
Judgment Case 5–2 2 Satisfaction of performance obligations
Judgment Case 5–3 2 Satisfaction of performance obligations
Ethics Case 5–4 2 Revenue recognition
Judgment Case 5–5 2,3 Satisfying performance obligations
Judgment Case 5–6 5,7 Performance obligation; licensing
Communication Case 5–7 5 Performance obligations; loyalty program
Judgment Case 5–8 6 Principal or agent
Real World Case 5–9 6 Principal agent considerations
Research Case 5–10 6 FASB codification; locate and extract relevant
information and authoritative support for a
financial reporting issue; reporting revenue as a
principal or as an agent
Real World Case 5–11 7 Chainsaw Al; revenue recognition and earnings
management
Judgment Case 5–12 9 Revenue recognition; long-term construction
contracts
Communication Case 5–13 9 Long-term contract; revenue recognition over
time vs. upon project completion
Target Case 2,6,7 Target
Air France–KLM Case 2,4,5 Air France–KLM