REVENUE RECOGNITION STEPS

Chapter : Revenue Recognition
After studying this chapter, you should be able to:
1. Understand the economics and legalities of selling transactions from a business perspective.
2. Identify the five steps in the revenue recognition process
3. Identify the contract with customers
4. Identify the separate performance obligations in the contract
5. Determine the transaction price
6. Allocate the transaction price to the separate performance obligations
7. Understand how to recognize revenue when the company satisfies its performance obligation
8. Analyze and determine whether a company has earned revenues under the earnings approach.
9. Identify other revenue recognition issues
10. Describe presentation and disclosure regarding revenue
11. Identify differences in accounts between IFRS and ASPE and potential changes
2

Understanding Sales Transactions
• Accounting for revenues is often very complex
• Much of complexity is caused by the structure of the
sales transactions
• To properly account for sales transactions,
accountants must understand the business of the
entity and the nature of the transaction
• Key questions for understanding the sales
transactions from a business perspective are:
– What is being given up?
– What is being received?
• Normally specified in sales agreements
4

What is being sold?
• Sales transactions often involve transfer of
goods, services, or both (known as deliverables)
• Accounting is different under each situation
– Sale of goods: tangible assets with a finite point when
control transfers to buyer (generally with transfer of
legal title and possession)
– Sale of services: legal title and possession irrelevant
– Sale of goods and/or services combinations:
complexity in measuring each component of bundled
sales or multiple deliverables
5

What is being received?
• Most business transactions are reciprocal, something is given
up and something is received
• Consideration being received for goods and/or services sold
is either:
– Cash or cash-like (monetary)
– Non-monetary (another good/service, also known as
barter)
• Generally assume that the transaction is at arm’s length
(between unrelated parties) such that
Value of
deliverables
sold
Value of
consideration
received
=
6

Concessionary Terms
• It is critical to understand if sales are done under
normal terms, or are special/unusual and contain
concessionary terms such as:
– Lenient return/payment policy
– Selling price is deeply discounted
– Continued involvement by the seller
– More accommodating credit policy
– “Bill and hold” transactions
– Inclusion of “extras”
• Concessionary terms may create additional
obligations, or may indicate that control has not
passed to the buyer
7

Legalities
• Rights and obligations of sales transactions are described and
governed by law
• Contract law is most relevant as each sales transaction represents a
contract with the customer
• Contract creates enforceable obligations and establishes the terms
of the deal
• Sales contract generally determines the point when legal title and
possession of goods sold pass on to the customer:
– FOB shipping point
– FOB destination
• Implicit obligations not specifically outlined in the sales contract (i.e.
constructive obligation) may also be enforced under common or
other law
8

Sales Transactions
• Revenue/sales is described as:
– inflow of economic benefits (e.g. Cash,
receivables, etc)
– arising from ordinary activities
• There are two approaches to recognizing
sales/revenues:
– Asset-liability approach (contract based
approach)
– Earnings approach
9

Five-Step Process to Revenue Recognition
Continued… 11

12
Five-Step Process to Revenue Recognition

Identifying the Contract with
Customers – Step 1
• A contract is an agreement between two or more parties that
creates enforceable rights or obligations.
– Can be written, oral or implied
13

Identifying the Contract with
Customers – Step 1
• Upon entering into a contract with a customer, a
company obtains rights to receive consideration
from the customer and assumes obligations to
transfer goods or services to the customer.
• A company does not recognize contract assets
or liabilities, nor is a journal entry performed,
until one or both parties perform their contracted
obligations
14

Identifying Separate Performance
Obligations – Step 2
• Performance obligation is a promise to provide a
product or service
– Promise may be explicit, implicit or possibly based on
customary business practice
15

16
Identifying Separate Performance
Obligations – Step 2

Determining the Transaction Price –
Step 3
• Transaction price is the amount of consideration
that a company expects to receive from a
customer in exchange for transferring goods or
services
– Transaction price is usually stated within the contract
– Must consider the following:
• Variable consideration
• Time value of money
• Noncash consideration
• Consideration paid or payable to the customer
17

Allocating the Transaction Price to Separate
Performance Obligations –
Step 4
• Transaction prices are allocated to performance
obligations based on relative fair values
– Fair value is what the company could sell the
good or service for on a standalone basis
(standalone selling price)
– If this information is not available, best estimates
are used
18

Recognizing Revenue when each
Performance Obligation is Satisfied – Step 5
• A company satisfies its performance obligation
when the customer obtains control of the good
or service
• Indicators of control:
– The company has a right to payment for the asset
– The company has transferred legal title to the asset
– The company has transferred physical possession of the asset
– The customer has significant risks and rewards of ownership
– The customer has accepted the asset
19

Summary of the five step revenue
recognition process
20
Continued…

21
Summary of the five step revenue
recognition process

Earnings Approach
• Revenues for the sale of goods are
recognized when the following criteria are
met:
1. Risks and rewards of ownership are
transferred to the buyer
2. Seller has no continuing involvement in, nor
effective control over the sold goods
3. Costs and revenues can be reliably
measured; and
4. Collectibility is probable
22

Other Revenue Recognition Issues
• There are several situations where revenue
recognition issues arise.
• This is based on IFRS 15 as ASPE has little
specific guidance in these areas
• The situations are:
– Right of return
– Repurchase agreements
– Bill and Hold
– Principal-agent relationships
– Consignments
– Warranties
– Non-refundable upfront fees
23

Right of Return
• Sales with rights of return have long been a
challenge in the area of revenue recognition
• If there is an expectation that items may be
returned, an estimate must be made and accounted
for the initial transaction
24

25
Right of Return
Continued…

Repurchase Agreements
• If a company enters into a repurchase agreement, it
will allow them to transfer an asset to customer but
have an obligation or right to repurchase the asset
at a later date
• Raises the question, “did the company actually sell
the asset?”
• Generally reported as a financing transaction
(borrowing)
27

Bill-and-Hold Arrangements
• A contract under which one entity bills a customer
for a product but the entity retains physical
possession of the product until it is transferred to the
customer at a point in the future
• May occur when the purchasing company has
limited available space for the product, delays in
their production schedule, more than sufficient
inventory in its distribution channel
28

Principal-Agent Relationships
• Principals obligation = provide goods or services to
the customer
• Agents obligation = arrange for the principal to
provide goods or services to the customer
• In these situations, amounts collected on behalf of
the principal are not revenue of the agent
– Usually commission is paid and the agent would record
this as their revenue
29

Consignment Sales
• Consignor ships inventory to the consignee
• The consignee acts as an agent to sell the inventory
• Possession has transferred; however legal title
remains with the seller
• Risks and rewards have not transferred
• Goods are held by seller as “Inventory on
Consignment”
• Not held as inventory on consignee’s books
• When merchandise sold, the consignee remits cash
to the consignor (after deducting commission and
other chargeable expenses)
30

Consignment Sales – Earnings
Goods shipped to Consignee
Inventory on Consignment $$$
Finished Goods Inventory $$$
Payment of Freight
Cash $$$
Notification of Sale
Accounts Receivable $$$
Relevant Expenses $$$
Consignment Sales $$$
Cost of Goods Sold $$$
(Note: cost includes freight)
Receipt of Cash from Sale
Cash $$$
Accounts Receivable $$$
No Entry
No Entry
Notification/Payment of Sale
Cash $$$
Payable to Consignor $$$
Remittance to Consignor
Payable to Consignor $$$
Commission Revenue $$$
Cash $$$
Consignor’s Books Consignee’s Books
31

Warranties
• Companies often provide one of two types of warranties to
customers:
– Warranties that the product meets agreed-upon
specifications in the contract at the time the product is sold
• This type of warranty is included in the sales price of a
company’s product (assurance type warranty)
– Warranties that provide an additional service beyond the
assurance-type warranty
• This type of warrant is not included in the sales price of
a company’s product (service type warranty)
32

Non-refundable Upfront Fees
• Companies sometimes receive payments
(upfront fees) from customers before they deliver
a product or perform a service
– Generally relate to the initiation, activation or
setup of a good or service to be provided or
performed in the future
– In most cases the upfront payment is non-
refundable
33

Presentation and Disclosure
• Contract assets and contract liabilities must be recorded on the balance
sheet
– There are two types of contract assets
• Unconditional rights to receive consideration
• Conditional rights to receive consideration
– 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
• If it is probable that the transaction price will not be collected, this is an
indication that the parties are not committed to their obligations
– As long as a contract exists the amount recognized as revenue is not
adjusted for customer credit risk
34

Presentation and Disclosure
• The disclosure requirements for revenue recognition are
designed to help financial statement users understand
the nature, amount, timing and uncertainty of revenue
and cash flows arising from contracts with customers
• To achieve this, companies disclose quantitative and
qualitative information about the following:
• Contracts with customers
• Significant judgements
• Assets recognized from costs incurred to fulfil a
contract
35

Percentage-of-Completion: Earnings
Approach
• The amount of revenues, costs and gross profit
recognized on long term contracts depends upon the
percentage of work done
• Application of percentage-of-completion method requires
a basis for measuring the progress toward completion at
interim dates, and is based on significant judgement
• Can use input measures (e.g. costs incurred—which is
the most popular method—or labour hours worked)
• Can use output measures (e.g. storeys of a building
completed, tonnes produced)
41

Percentage-of-Completion:
Steps
Costs incurred to date = Percent complete
Most recent estimated total costs
1
Percent complete x Estimated total revenue (or GP) =
Revenue to be recognized to date
2
Revenue (or GP) to be recognized to date –
Revenue (or GP) recognized in prior periods =
Current period revenue (or GP)*
*Current period revenue – Current costs = Gross Profit
3
4
42

Cost-to-Cost Basis
Data: Contract price: $4,500,000 Estimated cost: $4,000,000
Start date: July, 2017 Finish: October, 2019
Balance sheet date: December 31st
Given: 2017 2018 2019
Costs to date $1,000,000 $2,916,000 $4,050,000
Estimated costs to complete $3,000,000 $1,134,000 $ -0-
Progress billings during year $ 900,000 $2,400,000 $1,200,000
Cash collected during year $ 750,000 $1,750,000 $2,000,000
43

Cost-to-Cost Basis
2017 2018 2019
$4,500,000 $4,500,000 $4,500,000
Contract Price (a)
1,000,000 2,916,000 4,050,000
3,000,000 1,134,000 -0-
4,000,000 4,050,000 4,050,000
Less: Estimated Costs
Costs to Date
Est. Cost to Complete
Est. Total Costs (b)
25% 72% 100%
1,000,000 2,916,000 4,050,000
4,000,000 4,050,000 4,050,000
Percent Complete
$ 500,000 $ 450,000 $ 450,000
Estimated Total Gross
Profit (a – b)
44

Cost-to-Cost Basis
1,750,000
750,000
Accounts Receivable
1,750,000
750,000
Cash
To record collections:
2,400,000
900,000
Billings on Construction in
Process
2,400,000
900,000
Accounts Receivable
To record progress billings:
1,916,000
1,000,000
Materials, Cash, Payables
1,916,000
1,000,000
Construction in Process
To record cost of construction:
2018
2017
Note: Journal entries for 2016 are not shown due to space limitations
45

Cost-to-Cost Basis
2017 2018 2019
$4,500,000 $4,500,000 $4,500,000
Contract Price (a)
25% 72% 100%
Percent complete (b)
$1,125,000 $3,240,000 $4,500,000
-0- 1,125,000 3,240,000
$1,125,000 $2,115,000 $1,260,000
Revenue recognized:
Revenue to date (a x b)
Less: Prior years revenue
Current year revenue
$ 125,000 $ 324,000 $ 450,000
-0- 125,000 324,000
$ 125,000 $ 199,000 $ 126,000
Gross profit recognized:
G.P. to date (Total x %)
Less: G.P. in prior years
Current year G. P.
46

Cost-to-Cost Basis
199,000
125,000
1,916,000
1,000,000
Construction Expenses
4,500,000
4,500,000
Billings on Construction in
Process
To record completion of contract
(recorded on completion date in 2016):
2,115,000
1,125,000
Revenue from Long-Term
Contract
To recognize revenue and gross profit:
2018
2017
Note: Some journal entries for 2016 are not shown due to space
limitations
47

Financial Statement Presentation
• The difference between “Construction in
process” and “Billings on construction in
process” is recorded on the Balance
Sheet as either:
– Current asset* (with Inventories) if difference
is a debit balance or
– Current liability* if difference is a credit
balance
*May be non-current depending on length of
contract
48

Percentage-of-Completion: Financial
Statement Presentation
• The balance in the Construction in Process
account represents the costs incurred + gross
profit recognized to date
• The balance in the Billings on Construction in
process represents the billings made to
customers to date
49

Completed-Contract Method:
Earnings Approach
• Revenue and gross profit are recognized on the
completion of the contract
• Advantage: reported revenue is based on actual results,
not estimates
• Disadvantage: does not reflect current performance;
creates distortion of earnings
• All journal entries are the same as the percentage-of-
completion method except that no entry is recorded at
the end of the period to recognize revenue and gross
profit
• IFRS does not address this method explicitly (unlike
ASPE)
50

Comparison of Results
(Gross Profit Recognition)
$450,000
$450,000
Total
450,000
126,000
2019
0
199,000
2018
$ 0
$125,000
2017
Completed-
Contract
Percentage-of-
Completion
Year
51

Long-Term Contract Losses
• A long-term contract may produce either:
• an interim loss on a profitable contract or
• an overall loss on unprofitable contract
• Under the percentage-of-completion method,
all losses are immediately recognized
• Under the completed-contract method, losses
are recognized only when overall losses result
52

Recognizing Current and Overall
Losses on Long-Term Contracts
Current Loss on
an otherwise
overall profitable
contract
Completed Method:
No adjustment needed
Percentage Method:
Recognize loss currently
Loss on an
overall unprofitable
contract
Percentage Method:
Recognize entire loss now
Completed Method:
Recognize entire loss now
53

Percentage Method: Interim Loss on
Profitable Contract–Example
54
2017 2018 2019
$4,500,000 $4,500,000 $4,500,000
Contract Price
1,000,000 2,916,000 4,384,962
3,000,000 1,468,962 -0-
4,000,000 4,384,962 4,384,962
Costs to date
Est. Cost to Complete
Est. Total Costs
25% 66.5% 100%
1,000,000 2,916,000 4,384,962
4,000,000 4,384,962 4,384,962
Percent Complete
Data as previously given, except for the 2017 cost estimate
Cost to date (12/31/2018) $2,916,000
Estimated costs to complete (revised) 1,468,962
Estimated total costs 4,384,962
Percent complete (2,916,000 / 4,384,962) 66 ½%
Revenue recognized in 2018
(4,500,000 x 66 ½% ) – 1,125,000 $1,867,500
Costs incurred in 2018 1,916,000
Loss recognized in 2018 $48,500

Percentage Method: Interim Loss on
Profitable Contract–Example
55
Record loss for 2018:
Construction Expenses 1,916,000
Construction in Process (loss) 48,500
Revenue from Long-Term Contract 1,867,500
Under the percentage-of completion method the Loss
of $48,500 is reported on the Income Statement in 2017
Under the completed-contract method, no loss would be
recognized in 2017

Bundled Contracts
• Bundled Contracts means those
Contracts pursuant to which the
Company sells to third parties products
or services of the Business together
with other products or services of the
Company not included in the Business,
including those set forth in Section 5.13 of
the Company Disclosure Schedule.
56

Accounting for Sales Return
• Sales return is the return of products or commodities by customers
to the seller due to many reasons, but usually within some agreed
time period and due to the condition of the product and customer
satisfaction. This sales return is accounted for differently from the
seller and buyer’s perspectives. There may be countless reasons for
sales return, but some of the common reasons are:
1. Goods are defective
2. Goods are not according to the customer’s needs
3. Goods are shipped too late to the customer
4. Wrong Products sent to the buyer
5. Products are not according to the specifications
57

Description Dr Cr
Sales Return Allowance /
Revenue Account
XXX
Cr – Cash/Accounts
Receivable
XXX
58
Accounting for sales return is mainly concerned with revising revenue and cost of goods sold
previously recorded. Account receivable or cash and cash equivalents should also affect
whether it is the cash sale or credit sales.
For the seller, revenue can be revised by debiting the sales return account (A contra account
by nature) and crediting cash/accounts receivable with the invoice amount.
Here is the sale return journal entry:
As we can see from the journal entries above, the seller should debit the exact amount of
return to the revenue account or the sales return allowance account once the sale is returned.
This sales return allowance account is the contra account to the sales revenue account.
Related article How Do You Calculate Aging Accounts Receivable?

Description Dr Cr
Inventory / Stock XXX
Cost of Goods Sold XXX
59
Now we have to deal with inventory/goods that customers just returned. These
inventory/goods need to be stored and recorded in the warehouse.
So when the company’s warehouse physically receives the goods, the inventory account
will be debited to increase the asset, and the cost of goods sold will be credited.
Here is the entry to recognize inventory and derecognition of the cost of goods sold.
So once this entry is posted, inventory will be increased, and the cost of goods sold will be
derecognized.

Warranty Obligations
• Warranty Obligations means all liabilities
and obligations arising out of or relating to
the repair, rework, replacement or return
of, or any claim for breach of warranty in
respect of or refund of the purchase price
of, any Business Products.
60

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