Intermediate Accounting 3 16 edition, Schemes and Mind Maps of Accounting

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Intermediate Accounting

I F R S E d i t i o n – 2 n d

Donald E. Kieso, Jerry J. Weygandt , Terry D. Warfield

C h a p t e r - 1 8

Revenue Recognition

ANSWERS TO QUESTIONS

1. Most revenue transactions pose few problems for revenue recognition. This is because, in many cases, the transaction is initiated and completed at the same time. However, due to the complexity of some transactions, many believe the revenue recognition process is increasingly complex to manage, more prone to error, and more material to financial statements compared to any other area of financial reporting. As a result, the FASB and IASB have indicated that the present state of reporting for revenue is unsatisfactory and the Boards issued a standard, “Revenue from Contracts with Customers,” in 2013. This new standard provides a new approach for how and when companies should report revenue. The standard is comprehensive and applies to all companies. As a result, comparability and consistency in reporting revenue should be enhanced.
2. IFRS lacked guidance in a number of areas because it had only one standard for revenue recognition.
3. The revenue recognition principle indicates that revenue is recognized in the accounting period when a performance obligation is satisfied. That is, a company recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services.
4. The five steps in the revenue recognition process are:
5. Identify the contract with customers.
6. Identify the separate performance obligations in the contract.
7. Determine the transaction price.
8. Allocate the transaction price to the separate performance obligations.
9. Recognize revenue when each performance obligation is satisfied.
10. Change in control is the deciding factor in determining when a performance obligation is satisfied. Control is transferred when the customer has the ability to direct the use of and obtain substantially all the remaining benefits from the asset or service. Control is also indicated if the customer has the ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service.
11. Revenues are recognized generally as follows:

(a) Revenue from selling products—date of delivery to customers. (b) Revenue from services performed—when the services have been performed (performance obligation satisfied) and are billable. (c) Revenue from permitting others to use company assets—as time passes or as the assets are used. (d) Revenue from disposing of assets other than products—at the date of sale.

7. The first step in the revenue recognition process is the identification of a contract or contracts with the customer. A contract is an agreement between two or more parties that creates enforceable rights or obligations. That is, the contract identifies the performance obligations in a revenue arrangement. Contracts can be written, oral, or implied from customary business practice. In some cases, there may be multiple contracts related to the transaction, and accounting for each contract may or may not occur, depending on the circumstances. These situations often develop when not only a product is provided but some type of service is performed as well.

Questions Chapter 18 (Continued)

14. Variable consideration (when the price of a good or service is dependent on future events), includes such elements as discounts, rebates, credits, performance bonuses, or royalties. A company estimates the amount of variable consideration it will receive from the contract to determine the amount of revenue to recognize. Companies use either (1) the expected value, which is a probability weighted amount, or (2) the most likely amount in a range of possible amounts to estimate variable consideration. Companies select among these two methods based on which approach better predicts the amount of consideration to which a company is entitled.
15. The transaction price should include management’s estimate of the amount of consideration to which the entity will be entitled. Given the multiple outcomes and probabilities available based on prior experience, the probability-weighted method is the most predictive approach for estimating the variable consideration. In this situation: 25% chance of £421,000 if by February 1 (25% X £421,000) = £ 105, 25% chance of £414,000 if by February 8 (25% X £414,000) = 103, 25% chance of £407,000 if by February 15 (25% X £407,000) = 101, 25% chance of £400,000 if after February 15 (25% X £400,000) = 100, £ 410, Thus, the total transaction price is £410,500 based on the probability-weighted estimate.
16. Allee should not allocate variable consideration to the performance obligation, unless it is reasonably assured it is entitled to that amount. In this case, it does not have experience with similar contracts and therefore is not able to estimate the cumulative amount of revenue. Allee is constrained in recognizing variable consideration if there might be a significant reversal of revenue previously recognized.
17. In measuring the transaction price, companies make the following adjustment for:

(a) Time value of money - When a sales transaction involves a significant financing component (that is, interest is accrued on consideration to be paid over time), the fair value (transaction price) is determined either by measuring the consideration received or by discounting the payment using an imputed interest rate. The imputed interest rate is the more clearly determinable of either (1) the prevailing rate for a similar instrument of an issuer with a similar credit rating, or (2) a rate of interest that discounts the nominal amount of the instrument to the current sales price of the goods or services. The company will report the effects of the financing either as interest expense or interest revenue. (b) When non-cash consideration is involved, revenue is generally recognized on the basis of the fair value of what is received. If the fair value cannot be determined, then the company should estimate the selling price of the goods delivered or services performed and recognize this amount as revenue. In addition, companies sometimes receive contributions (donations, gifts). A contribution is often some type of asset (such as securities, land, buildings or use of facilities) but it could be the forgiveness of debt. Similarly, this consideration should be recognized as revenue based on the fair value of the consideration received.

18. Any discounts or volume rebates should reduce consideration received and reduce revenue recognized.
19. If an allocation of the transaction price to various performance obligations is needed, the allocation is based on their relative fair value. The best measure of fair value is what the company could sell the good or service on a standalone basis (referred to as the standalone selling price). If this information is not available, companies should use their best estimate of what the good or service might sell for as a standalone unit. The three approaches for estimating stand-alone selling price are (1) Adjusted market assessment approach; (2) Expected cost plus a margin approach, and (3) Residual approach.

Questions Chapter 18 (Continued)

20. Since each element sells separately and has a separate standalone value, the equipment, installation, and training are three separate performance obligations. The total revenue of $80,000 should be allocated to the three performance obligations based on their relative fair values. Thus, the total estimated fair value is $100,000) ($90,000 + $7,000 + $3,000). The allocation is as follows. Equipment ($90,000 ÷ $100,000) X $80,000 = $72,000. Installation ($7,000 ÷ $100,000) X $80,000 = $5,600. Training ($3,000 ÷ $100,000) X $80,000 = $2,400.
21. A company satisfies its performance obligation when the customer obtains control of the good or service. Indications that the customer has obtained control are:
22. The company has a right to payment for the asset.
23. The company transferred legal title to the asset.
24. The company transferred physical possession of the asset.
25. The customer has the significant risks and rewards of ownership.
26. The customer has accepted the asset.
27. Companies recognize revenue over a period of time if one of the following two criteria is met.
    1. The customer controls the asset as it is created or enhanced.
    2. The company does not have an alternative use for the asset created or enhanced and either (1) the customer receives benefits as the company performs and therefore, the task would not need to be re-performed, or (2) The company has a right to payment and this right should be enforceable.
28. A company recognizes revenue from a performance obligation over time by measuring the progress toward completion. The method selected for measuring progress should depict the transfer of control from the company to the customer. The most common are the cost-to-cost and units-of-delivery methods. The objective of all these methods is to measure the extent of progress in terms of costs, units, or value added. Companies identify the various measures (costs incurred, labor hours worked, tons produced, floors completed, etc.) and classify them as input or output measures. Input measures (costs incurred, labor hours worked) are efforts devoted to a contract. Output measures (with units of delivery measured as tons produced, floors of a building completed, miles of a highway completed) track results. Neither is universally applicable to all long-term projects. Their use requires the exercise of judgment and careful tailoring to the circumstances. The most popular input measure used to determine the progress toward completion is the cost-to-cost basis. Under this basis, a company measures the percentage of completion by comparing costs incurred to date with the most recent estimate of the total costs required to complete the contract.
29. To account for sales with rights of return, (and for some services that are provided subject to a refund), companies generally recognize all of the following.

a. Revenue for the transferred products in the amount of consideration to which seller is reasonably assured to be entitled (considering the products expected to be returned). b. A refund liability. c. An asset (and corresponding adjustment to cost of sales) for its right to recover inventory from the customer. Thus, at the time of sale, only the revenue not subject to estimated refund is recognized. The remaining revenue is recognized when the refund provision expires.

Questions Chapter 18 (Continued)

31. Under the asset-liability model for recognizing revenue, companies recognize assets and liabilities according to the definitions of assets and liabilities in a revenue arrangement. For example, when a company has a right to consideration for meeting a performance obligation, it has a right to consideration from the customer and therefore has a contract asset. A contract liability is a company’s obligation to transfer goods or services to a customer for which the company has received consideration from the customer. Thus, if the customer performs first, by prepaying for the product, then the seller has a contract liability. Companies must present these contract assets and contract liabilities on their balance sheet. Contract assets are of two types: (a) Unconditional rights to receive consideration because the company has satisfied its performance obligation with customer, and (b) Conditional rights to receive consideration because the company has satisfied one performance obligation, but must satisfy another performance obligation in the contract before it can bill the customer. Companies should report unconditional rights to receive consideration as a receivable on the balance sheet. Conditional rights on the balance sheet should be reported separately as contract assets.
32. (a) Companies divide fulfillment costs (contract acquisition costs) into two categories: (1) those that give rise to an asset, and (2) those that are expensed as incurred. Companies recognize an asset for the incremental costs, if these costs are incurred to obtain a contract with a customer. In other words, incremental costs are costs that a company would not incur if the contract had not been obtained (for example, selling commissions). Other examples are: (a) Direct labor, direct materials, and allocation of costs that relate directly to the contract (such as costs of contract management and supervision, insurance, and depreciation of tools and equipment), and (b) Costs that generate or enhance resources of the company that will be used in satisfying performance obligations in the future. Costs include intangible design or engineering costs that will continue to benefit in the future. Companies capitalize costs that are direct, incremental, and recoverable (assuming that the contract period is more than one year).

(b) Collectibility – whether a company will get paid for satisfying a performance obligation is not a consideration in determining revenue recognition. That is, the amount recognized is not adjusted for customer credit risk. Rather, companies report the revenue gross and then present an allowance for any impairment due to bad debts (recognized initially and subsequently in accordance with the respective bad debt guidance) prominently as an expense in the income statement. If significant doubt exists at contract inception about collectability, it often indicates that the parties are not committed to their obligations. As a result, conditions for the existence of a contract are not met and therefore revenue is not recognized.

33. Quantitative disclosures include: (a) Contracts with customers – These disclosures include the disaggregation of revenue, presentation of opening and closing balances in contract assets and contract liabilities, and significant information related to its performance obligations; (b) Qualitative disclosures include information on significant judgments. These disclosures include judgments and changes in these judgments that affect the determination of the transaction price, the allocation of the transaction price and the determination of the timing of revenue; (c) Assets recognized from costs incurred to fulfill contract—these disclosures include the closing balances of assets recognized to obtain or fulfill a contract, the amount of amortization recognized and the method used for amortization.

Questions Chapter 18 (Continued)

*34. The two basic methods of accounting for long-term construction contracts are: (1) the percentage- of-completion method and (2) the cost-recovery method. The percentage-of-completion method is preferable when estimates of costs to complete and extent of progress toward completion of long-term contracts are reasonably dependable. The percentage-of-completion method should be used in circumstances when reasonably dependable estimates can be made and: (1) The contract clearly specifies the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement. (2) The buyer can be expected to satisfy all obligations under the contract. (3) The contractor can be expected to perform the contractual obligations. The cost-recovery method is preferable when the lack of dependable estimates or inherent hazards cause forecasts to be doubtful.

*35. Under the percentage-of-completion method, income is reported to reflect more accurately the production effort. Income is recognized periodically on the basis of the percentage of the job completed rather than only when the entire job is completed. The principal disadvantage of the cost-recovery method is that it may lead to distortion of earnings because no attempt is made to reflect current performance when the period of the contract extends into more than one accounting period.

*36. The methods used to determine the extent of progress toward completion are the cost-to-cost method and units-of-delivery method. Costs incurred and labor hours worked are examples of input measures, while tons produced, stories of a building completed, and miles of highway completed are examples of output measures.

*37. The two types of losses that can become evident in accounting for long-term contracts are:

(1) A current period loss involved in a contract that, upon completion, is expected to produce a profit. (2) A loss related to an unprofitable contract. The first type of loss is actually an adjustment in the current period of gross profit recognized on the contract in prior periods. It arises when, during construction, there is a significant increase in the estimated total contract costs but the increase does not eliminate all profit on the contract. Under the percentage-of-completion method, the estimated cost increase necessitates a current period adjustment of previously recognized gross profit; the adjustment results in recording a current period loss. No adjustment is necessary under the cost-recovery method because gross profit is only recognized upon completion of the contract. Cost estimates at the end of the current period may indicate that a loss will result upon com- pletion of the entire contract. Under both methods, the entire loss must be recognized in the current period.

*38. It is improper to recognize the entire franchise fee as revenue at the date of sale when many of the services of the franchisor are yet to be performed.

*39. Continuing franchise fees should be reported as revenue when the performance obligations related to those fees have been satisfied by the franchisor. These revenues are generally recognized over time as the related product and services are provided. Continuing product sales would be accounted for in the same manner as would any other product sales.

BRIEF EXERCISE 18-

Ismail accounts for the bundle of goods and services as a single performance obligation because the goods or services in the bundle are highly interrelated. Ismail also provides a significant service by integrating the goods or services into the combined item (that is, the hospital) for which the customer has contracted. In addition, the goods or services are significantly modified and customized to fulfill the contract. Revenue for the performance obligation would be recognized over time by selecting an appropriate measure of progress toward satisfaction of the performance obligation.

BRIEF EXERCISE 18-

The performance obligations relate to the license and the consulting services. They are distinct.

(a) If interdependent, the contract is accounted for as a single revenue amount of £200,000.

(b) If not interdependent, service revenue is £75,000 and the license revenue is £125,000, based on estimated standalone values.

BRIEF EXERCISE 18-

The transaction price should include management’s estimate of the amount of consideration to which the entity will be entitled. Given the multiple outcomes and probabilities available based on prior experience, the probability-weighted method is the most predictive approach for estimating the variable consideration in this situation:

Completion Date Probability Expected Value

August 1 70% chance of $1,150,000 = $ 805, August 8 20% chance of $1,100,000 = 220, August 15 5% chance of $1,050,000 = 52, After August 15 5% chance of $1,000,000 = 50, $1,127,

Thus, the total transaction price is $1,127,500 based on the probability- weighted estimate.

BRIEF EXERECISE 18-

(a) In this situation, Nair uses the most likely amount as the estimate - $1,150,000.

(b) When there is limited information with which to develop a reliable estimate of completion, then no revenue related to the incentive should be recognized until the uncertainty is resolved. Therefore, no revenue is recognized until the completion of the contract.

BRIEF EXERCISE 18-

January 2, 2015

Notes Receivable ...................................................... 11, Discount on Notes Receivable ......................... 1, Sales Revenue ................................................... 10,

Cost of Goods Sold ................................................. 6, Inventory ........................................................... 6,

Revenue Recognized in 2015

Sales revenue ............................................................ R$10, Interest revenue (R$11,000 – R$10,000) .................. 1, Total revenue ..................................................... R$11,

BRIEF EXERCISE 18-

Parnevik should record revenue of €660,000 on March 1, 2015, which is the fair value of the inventory in this case. Parnevik is also financing this purchase and records interest revenue on the note over the 4-year period. In this case, the interest rate is imputed to be 10% ([€660,000/€1,062,937] = .6209, which is the PV of €1 factor for n = 5, I = 10%). Parnevik records interest revenue of €55,000 (10% X €660,000 X 10/12) at December 31, 2015

BRIEF EXERCISE 18-

July 1, 2015

No entry – neither party has performed under the contract.

On September 1, 2015, Geraths has two performance obligations: (1) the delivery of the windows and (2) the installation of the windows.

Windows £2, Installation 600 Total £2,

Allocation

Windows (£2,000 ÷ £2,600) X £2,400 = £1, Installation (£600 ÷ £2,600) X £2,400 = 554 Revenue recognized £2, (rounded to nearest dollar)

Geraths makes the following entries for delivery and installation.

September 1, 2015

Cash ........................................................................... 2, Accounts Receivable ................................................ 400 Unearned Service Revenue ............................. 554 Sales Revenue .................................................. 1,

Cost of Goods Sold .................................................. 1, Inventory ............................................................ 1,

(Windows delivered, performance obligation for installation recorded)

October 15, 2015

Cash ........................................................................... 400 Unearned Service Revenue ...................................... 554 Service Revenue (Installation) ......................... 554 Accounts Receivable ........................................ 400

The sale of the windows is recognized once delivered. The installation fee is recognized when the windows are installed.

BRIEF EXERCISE 18-

(a) July 1, 2015

No entry – neither party has performed under the contract.

On September 1, 2015, Geraths has two performance obligations: (1) the delivery of the windows and (2) the installation of the windows.

Windows £2, Installation (£400 + (20% X £400)] 480 Total £2,

Allocation

Windows (£2,000 ÷ £2,480) X £2,400 = £1, Installation (£480 ÷ £2,480) X £2,400 = 465 Revenue recognized £2, (rounded to nearest dollar)

Geraths makes the following entries for delivery and installation.

September 1, 2015

Cash ........................................................................... 2, Accounts Receivable ............................................... 400 Unearned Service Revenue ............................ 465 Sales Revenue ................................................. 1,

Cost of Goods Sold .................................................. 1, Inventory............................................................ 1,

(Windows delivered, performance obligation for installation recorded)

October 15, 2015

Cash ........................................................................... 400 Unearned Service Revenue ..................................... 465 Service Revenue (Installation) ......................... 465 Accounts Receivable ........................................ 400

The sale of the windows is recognized once delivered. The installation is fee is recognized when the windows are installed.

BRIEF EXERCISE 18-13 (continued)

October 11, 2015

(b) Refund Liability ............................................... 78, Accounts Receivable ............................... 78, Returned Inventory .......................................... 62,400* Estimated Inventory Returns .................. 62,

*(€560,000 ÷ €700,000) X €78,

BRIEF EXERCISE 18-

Upon transfer of control of the products, Kristin would recognize:

(a) Revenue of $5,800 ($20 X 290 [300-10]) products expected not to be returned) (b) A refund liability for $200 ($20 refund X 10 products expected to be returned) (c) An asset of $120 ($12 X 10 products) for its right to recover products from customers on settling the refund liability.

Hence, the amount recognized in cost of goods sold for 290 products is $3,480 ($12 X 290). The journal entries to record the sale and related cost of goods sold are as follows:

Cash ........................................................................... 6, Sales Revenue .................................................. 5, Refund Liability ................................................. 200

Cost of Goods Sold .................................................. 3, Estimated Inventory Returns................................... 120 Inventory (300 X $12) ........................................ 3,

If the company is unable to estimate the level of returns with any reliability, it should not report any revenue until the returns are predictable.

BRIEF EXERCISE 18-

When to recognize revenue in a bill-and-hold arrangement depends on the circumstances. Mills determines when it has satisfied its performance obligation to transfer a product by evaluating when ShopBarb obtains control of that product. For ShopBarb to have obtained control of a product in a bill-and-hold arrangement, all of the following criteria should be met:

(a) The reason for the bill-and-hold arrangement must be substantive. (b) The product must be identified separately as belonging to the ShopBarb. (c) The product currently must be ready for physical transfer to ShopBarb. (d) Mills cannot have the ability to use the product or to direct it to another customer.

In this case, the criteria are assumed to be met. As a result, revenue recognition should be permitted at the time the contract is signed. Mills makes the following entry to record the bill and hold sale.

June 1, 2015

Accounts Receivable ................................................ 200, Sales Revenue ................................................... 200,

Cost of Goods Sold .................................................. 110, Inventory ............................................................ 110,

Mills makes the following entry to record the cash received.

September 1, 2015

Cash ........................................................................... 200, Accounts Receivable ........................................ 200,

If a significant period of time elapses before payment, the accounts receivable is discounted. In addition, if one of the four conditions is violated, revenue recognition should be deferred until the goods are delivered to ShopBarb.

BRIEF EXERCISE 18-18 (continued)

Talarczyk reduces the Warranty Liability account over the first two years

as the actual warranty costs are incurred The company also recognizes

revenue related to the service type warranty over the two-year period that

extends beyond the assurance warranty period (two years). In most cases,

the unearned warranty revenue is recognized on a straight line basis and

the costs associated with the service type warranty are expensed as

incurred.

BRIEF EXERCISE 18-

No entry is required on May 1, 2015 because neither party has performed on the contract. On June 15, 2015, Eric agreed to pay the full price and therefore Mount has an unconditional right to those funds on that date.

On receiving the cash on June 15, 2015, Mount records the following entry.

June 15, 2015

Cash ........................................................................... 25, Unearned Sales Revenue ................................. 25,

On satisfying the performance obligation on September 30, 2015, Mount records the following entry

September 30, 2015

Unearned Sales Revenue ......................................... 25, Sales Revenue ................................................... 25,

BRIEF EXERCISE 18-

The initiation fee may be viewed as separate performance obligation

because it provides a renewal option at a lower price than normally

charged. As a result, BlueBox is providing a discounted price in the

subsequent years. This should be reflected in the revenue recognized in all

four periods. In this situation, in the total transaction price is $

([($5 X 12) X 3] + $100). In the first year, BlueBox would report revenue of

$70 ($280 ÷ 4). The initiation fee is allocated over the entire four year

period.

BRIEF EXERCISE 18-20 (continued)

Another approach is to assume that the initiation fee is a separate

performance obligation because it provides a renewal option at a lower

price than normally charged. As a result the initiation fee would be

allocated to years two through four, unless forfeited earlier.

* BRIEF EXERCISE 18-

Construction in Process .......................................... 1,700, Materials, Cash, Payables. ............................... 1,700,

Accounts Receivable ............................................... 1,200, Billings on Construction in Process ............... 1,200,

Cash ........................................................................... 960, Accounts Receivable ........................................ 960,

Construction in Process [£1,700,000 ÷ (£1,700,000 + £3,300,000)] X £2,000,000 ............................................................. 680, Construction Expenses ........................................... 1,700, Revenue from Long-Term Contracts (£7,000,000 X 34%) ......................................... 2,380,

* BRIEF EXERCISE 18-

Current Assets Accounts receivable ......................................... $240, Inventories Construction in process ........................... $1,715, Less: Billings ............................................ 1,000, Costs in excess of billings .......................... 715,

* BRIEF EXERCISE 18-

(a) Construction Expenses .................................... 278, Construction in Process........................... 20,000* Revenue from Long-Term Contracts ....... 258,