FRANCHISE ARRANGEMENTS
• Assume that TrueTech starts selling TechStop franchises. TrueTech charges
franchisees an initial fee in exchange for (a) the exclusive right to operate the
only TechStop in a particular area for a five-year period, (b) the equipment
necessary to distribute and repair TrueTech products, and (c) training services
to be provided over a two-year period. Similar equipment and training can be
purchased elsewhere. What are the performance obligations in this
arrangement, and when would TrueTech recognize revenue for each of them?
• TrueTech would allocate the initial franchise fee to three separate performance
obligations based on their relative stand-alone prices: (1) the right to operate a
TechStop, (2) equipment, and (3) training. TrueTech would recognize revenue
for the right to operate a TechStop over the five-year period that TrueTech
provides the exclusive arrangement. TrueTech would recognize revenue for the
Illustration 5-20
T5-28
REVENUE DISCLOSURES
➢ Income Statement: Include
Revenue,
➢ Balance Sheet: Include
Accounts Receivable: Unconditional right to receive payment, depending
Contract Liabilties: Deferred revenue.
➢ Disclosure: Lots of it.
Goal, help investors understand the nature, amount, timing and uncertainty
T5-30
COMPANIES ENGAGED IN LONG-TERM CONTRACTS
Company Type of Industry or Product
Oracle Corp. Computer software, license and consulting fees
Lockheed Martin Corporation Aircraft, missiles and spacecraft
Hewlett-Packard Information technology
Illustration 5-23
T5–31
RECOGNIZING REVENUE FOR LONG-TERM
CONTRACTS
Applying the 5-step process to long-term contracts is complicated in two ways:
➢ Step 2, “Identify the performance obligation(s) in the contract,” is important
because long-term contracts typically include many products and services that
comprise a single performance obligation.
➢ Step 5, “Recognize revenue when (or as) each performance obligation is
satisfied,” is important because there can be a big 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
➢ 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.)
T5–32
RECOGNIZING REVENUE FOR LONG-TERM
CONTRACTS
AT A POINT IN TIME VS. OVER TIME
At the beginning of 2016, the Harding Construction Company received a contract to
build an office building for $5 million. The project is estimated to take three years to
complete. According to the contract, Harding will bill the buyer in installments over
the construction period according to a prearranged schedule. Information related to
the contract is as follows:
2016 2017 2018
Construction costs incurred
T5–33
JOURNAL ENTRIES
2016
2018
BOTH APPROACHES:
Construction in progress
1,500,000
1,600,000
Cash, materials, etc.
Accounts receivable
1,200,000
1,800,000
Billings on construction contract
Cash
1,000,000
2,600,000
Accounts receivable
1,000,000
2,600,000
To record cash collections.
REVENUE RECOGNIZED UPON
COMPLETION:
Construction in progress (gross profit)
900,000
Cost of construction
Revenue from long-term contracts
Billings on construction contract
Construction in progress
REVENUE RECOGNIZED OVER
TIME ACCORDING TO
PERCENTAGE-OF-COMPLETION:
Construction in progress (gross profit)
500,000
275,000
Cost of construction
1,500,000
1,600,000
Revenue from long-term contracts
To record gross profit.
Billings on construction contract
5,000,000
Construction in progress
To close accounts.
Illustrations 5-24a,b,e
T5–34
THE SAME TOTAL INCOME IS RECOGNIZED
REGARDLESS OF REVENUE TIMING
Over Time
Upon Completion
Gross profit recognized:
2016
$500,000
– 0 –
$900,000
T5–35
CALCULATING REVENUE
RECOGNIZED OVER TIME
2016
2017
2018
Construction costs:
Construction costs incurred during the year
$1,500,000
$1,000,000
$1,600,000
Construction costs incurred in prior years
Actual construction costs to date
$1,500,000
$2,500,000
$4,100,000
Estimated remaining costs to complete
Total cost (estimated + actual)
$3,750,000
$4,000,000
$4,100,000
Contract price
$5,000,000
$5,000,000
$5,000,000
Percentage-of-completion:
Actual costs to date divided by the
estimated total project cost
$1,500,000
$3,750,000
= 40%
$2,500,000
$4,000,000
= 62.5%
$4,100,000
$4,100,000
= 100%
Equals:
_________
__________
_________
Cumulative revenue earned to date
$2,000,000
$3,125,000
$5,000,000
Revenue recognized in prior periods
(2,000,000)
(3,125,000)
Equals:
$2,000,000
$1,875,000
(in thousands)
Construction in progress (CIP)
500
125
275
Cost of construction
1,500
1,000
1,600
Revenue from long-term contracts
2,000
1,125
1,875
Minus:
Ilustration 5-24c
T5–36
REVENUE AND COST OF CONSTRUCTION:
REVENUE RECOGNIZED OVER TIME
2016
Revenue recognized in 2016 ($5,000,000 x 40%)
Cost of construction
Gross profit
2017
Revenue recognized to date ($5,000,000 x 62.5%)
$3,125,000
Less: Revenue recognized in 2016
Revenue recognized in 2017
Cost of construction
2018
Revenue recognized to date ($5,000,000 x 100%)
$5,000,000
Less: Revenue recognized in 2016 and 2017
Revenue recognized in 2018
Cost of construction
Illustration 5-24d
T5–37
BALANCE SHEET PRESENTATION
Balance Sheet
(End of year)
2016
2017
Projects for which Revenue Recognized Upon Completion:
Current assets:
$ 200,000
$800,000
300,000
700,000
Projects for which Revenue Recognized Over Time
According to Percentage of Completion:
Current assets:
Accounts receivable
Costs and profit ($2,000,000) in excess of billings ($1,200,000)
Illustration 5-24f
T5–38
LONG-TERM CONTRACT LOSSES
➢ 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.
2016 2017 2018
Construction costs incurred
during the year $1,500,000 $1,260,000 $2,440,000
Comparison of Periodic Gross Profit (Loss)
Percentage-of–
completion
Completed Contract
Gross profit (loss) recognized:
T5–39
ACTIVITY RATIOS
➢ Activity ratios measure a company’s efficiency in managing its assets.
Asset turnover ratio = Net sales
Average total assets
T5–40
PROFITABILITY RATIOS
➢ Profitability ratios assist in evaluating various aspects of a company’s profit-making
activities.
Profit margin on sales = Net income
Net sales
T5–41
DUPONT FRAMEWORK
➢ The DuPont Framework helps identify how profitability, activity, and financial
leverage trade off to determine return to shareholders:
➢ Because profit margin and asset turnover combine to equal return on assets, the
DuPont framework can also be written as:
T5–42
HOW WAS GAAP CHANGED BY ASU 2014-09?
T5–43
Previous GAAP
New GAAP
Under ASU No. 2014-09
Key concept
underlying
revenue
recognition
The realization principle: Recognize revenue
when both the earnings process is complete
and there is reasonable certainty as to
collectibility of the asset(s) to be received.
The core revenue recognition principle: 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 and services.
whether revenue
is recognized.
revenue recognition to subsequent cash
collection.
Accounting for
multiple
performance
obligations
Depends on the industry. Sometimes
performance obligations are ignored (e.g.,
“free” smartphones in cell phone contracts);
sometimes revenue recognition is
constrained (e.g., software for which there
is not sufficient evidence of stand-alone
prices).
Regardless of industry, apply criteria for
determining whether goods and services are
distinct to identify performance obligations,
allocate transaction price to performance
obligations, and recognize revenue when each
performance obligation is satisfied.
REALIZATION PRINCIPLE
The realization principle requires that two criteria be satisfied before revenue can be
recognized:
➢ The earnings process is judged complete or virtually complete (the earnings
T5-44
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Revenue Recognition Concepts. IAS No. 18 governs most revenue recognition
under IFRS. Similar to U.S. GAAP, it defines revenue as “the gross inflow of economic
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