Accounting Chapter 5 Homework Lets Assume That Truetech Bases The Estimate

RECOGNIZING REVENUE FOR CONTRACTS

WITH MULTIPLE PERFORMANCE OBLIGATIONS

➢ Goal: Separate complex contracts into parts that can be viewed on a stand-alone

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

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

 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.

 A good or service is distinct if it is both:

▪ Capable of being distinct. The customer could use the good or service on

➢ Step 4: Allocate the transaction price to each performance obligation.

 Allocate based on relative stand-alone selling prices. If stand-alone selling

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CONTRACT CONTAINING

MULTIPLE PERFORMANCE OBLIGATIONS

TrueTech Industries manufactures the Tri-Box System, a multiplayer gaming

system allowing players to compete with each other over the Internet.

• The Tri-Box System includes the physical Tri-Box module as well as a one-year

subscription to the Tri-Net multi-user platform of Internet-based games and

other applications.

Illustration 5-7

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DETERMINING WHETHER GOODS AND SERVICES ARE DISTINCT

Assume the same facts as in Illustration 5-7. Do the Tri-Box module and the Tri-

Net subscription qualify as performance obligations in TrueTech’s contract with

CompStores?

Which of the goods and services promised in the contract are distinct? Both

the Tri-Box module and the Tri-Net subscription can be used on their own by a

Illustration 5-8

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ALLOCATING TRANSACTION PRICE TO PERFORMANCE OBLIGATIONS BASED ON RELATIVE

SE LLING PRICES

Assume the same facts as in Illustration 5–7. Because the stand-alone price of the

Tri-Box module ($240) represents 80% of the total of all the stand-alone selling

prices ($240 ÷ [$240 + 60]), and the Tri-Net subscription comprises 20% of the

Illustration 5-9

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RECOGNIZING REVENUE FOR MULTIPLE PERFORMANCE OBLIGATIONS

Assume the same facts as in Illustration 5–7. TrueTech records the following

journal entry at the time of the sale to CompStores (ignoring any entry to record

the reduction in inventory and the corresponding cost of goods sold):

January 1, 2016:

In each of the 12 months following the sale, TrueTech records the following entry

to recognize Tri-Net subscription revenue:

January 31, 2016:

Illustration 5-10

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Deferred

Revenue

Service

Revenue

SUMMARY OF REVENUE RECOGNITION CONCEPTS

COVERED IN PART A

Illustration 5-11

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STEP 1: WHEN DOES A CONTRACT EXIST

FOR PURPOSES OF REVENUE RECOGNITION?

➢ A contract is an agreement that creates legally enforceable rights and

obligations.

 Can be explicit or implicit.

➢ A contract exists for purposes of revenue recognition only if all of the following

are true:

 it has commercial substance, affecting the risk, timing or amount of the

seller’s future cash flows,

➢ A contract also does not exist if both of the following are true.

 neither the seller nor the customer has performed any obligations under

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DETERMINING WHETHER A CONTRACT EXISTS

FOR REVENUE RECOGNITION PURPOSES

Recall from Illustration 5-7 that CompStores ordered 1,000 Tri-Box systems on

December 20, 2015, at a price of $250 per unit. Assume that CompStores and

TrueTech can cancel the order without penalty prior to delivery. TrueTech made

delivery on January 1, 2016, and received $250,000 on January 25, 2016. When

does TrueTech’s arrangement with CompStores qualify as a contract for purposes

of revenue recognition?

Illustration 5-12

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STEP 2: IDENTIFY THE PERFORMANCE OBLIGATION(S)

➢ Examples of common parts of contracts that are not performance obligations:

 Prepayments (it’s part of the transaction price).

➢ Examples of common parts of contracts that are performance obligations:

 Extended warranties (it’s a separate obligation distinct from delivering

acceptable goods and services). A warranty is an extended warranty if either

▪ the customer has the option to purchase the warranty separately, or

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CUSTOMER OPTIONS

FOR ADDITIONAL GOODS AND SERVICES

• As a promotion, TrueTech Industries offers a 50% coupon for a gaming headset

with the purchase of a Tri-Box for its normal price of $240. The headset costs

$120 without a coupon (and $60 with a coupon), and the coupon must be

exercised within one year of the Tri-Box purchase. TrueTech estimates that

80% of customers will take advantage of the coupon. How would TrueTech

account for the cash sale of 100 Tri-Boxes sold under this promotion on January

1, 2016?

• The coupon provides a material right to the customer, because it provides a

obligations: the Tri-Box and the coupon.

• Because TrueTech expects only 80% of the coupons to be used, it estimates the

stand-alone selling price of a coupon to be $60 × 80% = $48. The sum of the

Illustration 5-13

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STEP 3: DETERMINE THE TRANSACTION PRICE:

VARIABLE CONSIDERATION

➢ Occurs when some of the contract price depends on the outcome of a future

event.

➢ Examples:

Incentive payments Royalties Volume discounts

➢ Constraint: 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.

 Intended to avoid severe revenue overstatements.

 Indicators that a significant reversal could occur:

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ACCOUNTING FOR VARIABLE CONSIDERATION

• TrueTech enters into a contract with ProSport Gaming to add ProSport’s online

games to the Tri-Net network. ProSports offers popular games like Brawl of

Bands, and wants those games offered on the Tri-Net so ProSports can sell

gems, weapons, health potions, and other game features that allow players to

advance more quickly in a game.

• On January 1, 2016, ProSport pays TrueTech an upfront fixed fee of $300,000

• TrueTech would record the following entry for the receipt of the cash on

January 1, 2016:

Cash …………………………... 300,000

Alternative 1: Expected Value

• The expected value would be calculated as a probability-weighted transaction

price:

Possible Amounts Probabilities Expected

Amounts

$480,000 ($300,000 fixed fee + 180,000 bonus) × 75% = $360,000

Illustration 5-14

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ACCOUNTING FOR VARIABLE CONSIDERATION

(continued)

Alternative 2: Most Likely Amount

• Because there is a greater chance of qualifying for the bonus than of not

• Let’s assume that TrueTech bases the estimate on the most likely amount,

$480,000. In each successive month TrueTech would recognize one month’s

3/31

5/31

6/30

3/31

30,000

4/30

30,000

5/31

30,000

6/30

30,000

6/30

-0-

• After six months, TrueTech’s deferred revenue account would have been

reduced to a zero balance, and the bonus receivable account would have a

If TrueTech

receives the bonus:

If TrueTech

does not receive bonus:

Illustration 5-14 (cont.)

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Service Revenue

1/1

-0-

1/31

80,000

2/28

80,000

Bonus Receivable

1/1

-0-

1/31

30,000

2/28

30,000

ACCOUNTING FOR VARIABLE CONSIDERATION: CHANGES IN ESTIMATES

• Assume the same facts as in Illustration 5-14, but that after three months

TrueTech concludes that, due to low usage of ProSport’s games, the most likely

outcome is that TrueTech will not receive the $180,000 bonus. TrueTech

would record the following entry in April to reduce its bonus receivable to zero

and reflect the adjustment in revenue:

• For the remainder of the contract, TrueTech only recognizes $50,000 of revenue

in each of the six months associated with the upfront fixed payment of

$300,000.

Illustration 5-15

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CONSTRAINT ON VARIABLE CONSIDERATION

• Assume the same facts as in Illustration 5-14, but that TrueTech initially concludes that it is

not probable that a significant revenue reversal will not occur in the future. In that case,

TrueTech is constrained from recognizing revenue associated with variable consideration. It

includes only the upfront fixed payment of $300,000 in the transaction price, and recognizes

revenue of $50,000 each month.

• On March 31, after three months of the contract have passed, TrueTech concludes it can

make an accurate enough bonus estimate for it to be probable that a significant revenue

reversal will not occur. TrueTech estimates a 75% likelihood it will receive the bonus and

bases its estimate on the “most likely amount” of $180,000. Since the contract is one-half

• In the final three months of the contract, TrueTech recognizes the remaining revenue

assuming a transaction price of $480,000, exactly as if it had included an estimate of variable

consideration in the transaction price all along:

Illustration 5-16

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OTHER TRANSACTION PRICE COMPLICATIONS

Principal v. Agent:

➢ 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.

➢ 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 seller has

 primary responsibility for delivering a product or service and

 is vulnerable to risks associated with

Time Value of Money:

➢ If payment happens before or after delivery, transaction has a financing

component. If that is significant, have to account for it.

 If payment before delivery, seller is getting a loan, so recognize interest

expense.

Payments by the Seller to the Customer:

➢ 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.

REVENUE RECOGNITION BY

PRINCIPALS AND AGENTS

Mike buys a Tri-Box module from an online retailer for $290. Let’s consider

accounting for that sale by two retailers: PrinCo and AgenCo:

• PrinCo purchases Tri-Box modules directly from TrueTech for $240, has the

modules shipped to its distribution center in Kansas, and then ships individual

modules to buyers when a sale is made. PrinCo offers occasional price

• AgenCo serves as a web portal by which multiple game module manufacturers

like trueTechcan offer their products for sale. The manufacturers ship directly

to buyers when a sale is made. AgenCo receives a $50 commission on each sale

The first part of the income statement for each retailer is shown below. Notice that

the same amount of gross profit, $50, is recognized by the principal and the agent.

What differ are the amounts of revenue and expense that are recognized and

reported.

A Principal Records Gross Revenue

(PrinCo)

An Agent Records Net Revenue

(AgenCo)

Illustration 5-18

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STEP 4: ALLOCATE THE TRANSACTION PRICE

TO PERFORMANCE OBLIGATIONS:

ESTIMATING STAND–ALONE SELLING PRICES

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

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–

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ALLOCATING TRANSACTION PRICE

TO PERFORMANCE OBLIGATIONS

USING THE RESIDUAL APPROACH

• Assume the same facts as Illustration 5-7, except that the stand-alone selling

price of the one-year Tri-Net subscription is highly uncertain because TrueTech

hasn’t sold that service previously and hasn’t established a price for it. Under

the residual approach, the value of the subscription would be estimated as

follows:

• Based on these relative stand-alone selling prices, if CompStores orders 1,000

Tri-Box Systems at the normal wholesale price of $250 each, TrueTech records

the following journal entry (ignoring any entry to record the reduction in

inventory and corresponding cost of goods sold):

Illustration 5-19

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STEP 5: RECOGNIZE REVENUE WHEN (OR AS)

EACH PERFORMANCE OBLIGATION IS SATISFIED

➢ Licenses

 Right of use: Transfer a right to use the seller’s intellectual property as it

exists when the license is granted. Revenue recognized at the point in time

the right is transferred.

➢ Franchises

 In franchise arrangements, the franchisor grants the right to sell the

franchisor’s products and use its name for a specified period of time.

➢ Bill-and-hold sales

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

the product until a later date.

➢ Consignment arrangements

 Exist when a “consignor” physically transfers the goods to the consignee but

➢ Gift Cards

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

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