Understand the economics and legalities of selling transactions from a business perspective Analyze and determine whether a company has earned revenues Discuss issues relating to measurement and measurement uncertainty ID: 244891
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After studying this chapter, you should be able to:Understand the economics and legalities of selling transactions from a business perspective.Analyze and determine whether a company has earned revenues.Discuss issues relating to measurement and measurement uncertainty.Understand how to account for sales where there is collection uncertainty.Prepare journal entries for consignment sales and long-term contracts.Understand how to present sales transactions in the income statement and prepare basic disclosures.Discuss current trends in standard setting for revenue recognition including the contract-based approach.Identify differences in accounting between ASPE and IFRS.
Revenue Recognition
2Slide3
Revenue Recognition
Understanding the nature of sales transactions from a business perspectiveEconomics of business transactionsLegalities
Information for decision-making
Presentation and disclosure
Presentation
Disclosure
Contract-based revenue recognition model
Core principle
Five steps
Other issues regarding the contract-based approach
Recognition and Measurement
Earnings process
Measurability
Collectibility
Mechanics
IFRS / ASPE comparison
Comparison of IFRS and ASP
Looking aheadSlide4
Understanding Sales Transactions
Accounting for revenues is often very complexMuch of complexity is caused by the structure of the sales transactionsTo 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 agreementsSlide5
What is being sold?
Sales transactions often involve transfer of goods, services, or both (known as deliverables)Accounting is different under each situationSale of goods: physical assets with 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
5Slide6
What is being 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
=Slide7
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 policyMore 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 buyerSlide8
Legalities
Rights and obligations of sales transactions are described and governed by lawContract law is most relevant as each sales transaction represents a contract with the customerContract 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 pointFOB destination
Implicit obligations not specifically outlined in the sales contract (i.e. constructive obligation) may also be enforced under common or other lawSlide9
Sales Transactions
Revenue/sales is described as:inflow of economic benefits (e.g. Cash, receivables, etc)arising from ordinary activities
There are two main conceptual views on how to account for revenues/sales:
Earnings approach
Contract-based approachSlide10
Earnings Approach
Revenues for the sale of goods are recognized when the following criteria are met:Risks and rewards of ownership are transferred to the buyerSeller has no continuing involvement in, nor effective control
over the sold goods
Costs and revenues can be
reliably measured; and
Collectibility
is probableSlide11
Earnings Approach – Selling Goods
Two indicators of whether risk and rewards transfer from seller to buyer:Who has the legal title to the goods sold?
Who has the possession of the goods sold?
In some situations, risks and rewards may be considered to transfer even if legal title and/or possession don’t pass to the buyer
Example: forestry and agricultural products with assured prices and available marketsSlide12
Earnings Approach - Services and Long-Term Contracts
The earnings process for services is different than for the sale of goodsFor the sale of goods, delivery of the goods is the generally critical eventFor services, the performance of the service (which may be on-going or continuous) is the determination of revenue recognition
Recognize revenue
at each critical event
, as long as it is collectibleSlide13
Earnings Approach - Services and Long-Term Contracts
There are two main ways of accounting for long-term contracts and other service contracts: Percentage-of-Completion Method recognizes revenues and gross profit each period based on progress or contract completionCompleted-Contract Method recognizes revenue and gross profit only after the whole contract is completed
When performance consists of many ongoing acts (i.e. continuous earnings process), then percentage-of-completion is preferred, as long as the company can measure the transaction
When performance consists of a single act (i.e.
discrete earnings process
) or progress cannot be measured, then completed-contract method may be used
IFRS makes no mention of completed-contract method and allows recognition of recoverable revenues equal to costs incurred if outcome is not reliably measurable (i.e. “zero-profit method”).Slide14
Measurability
Sales are generally measured at fair value (reflecting also time value of money for consideration paid over extended period of time)Measurement uncertainty generally arises when: we cannot measure the consideration
we cannot measure related costs, or
we cannot measure the outcome of the transaction
There are two main options for revenue recognition under measurement uncertainty:
Do not recognize revenues
until measurement uncertainty resolvedRecognize revenues but
measure and accrue amount relating to uncertainty as a cost or reduced revenues (preferred)Slide15
Measuring Parts of a Sale
More complex when sale creates multiple deliverables (e.g., a product and a service-a telephone company would sell a phone and a monthly service)GAAP says to separate each deliverable, if possibleOverall price can be allocated using two methods:
Relative fair value method
Residual value method
Timing of recognition for each deliverable is determined
individually
with reference to GAAPIf components cannot be measured individually, then revenue recognition criteria are applied to the bundled sale as a whole (as if one product/service)Slide16
Collectibility
In order to recognize revenues at time of sale, it is necessary to establish ultimate collectibilityIf collectibility cannot be reasonably assured, then revenues cannot be recognized at the time of saleAccounting treatment defaults to cash basis (i.e. recognize income as cash is received)Slide17
Consignment Sales
Consignor ships inventory to the consignee The consignee acts as an agent to sell the inventoryPossession 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)Slide18
Consignment Sales – Earnings
Goods shipped to ConsigneeInventory on Consignment $$$ Finished Goods Inventory $$$
Payment of Freight
Inventory on Consignment $$$
Cash $$$
Notification of Sale
Accounts Receivable $$$
Relevant Expenses $$$
Consignment Sales $$$
Cost of Goods Sold $$$
Inventory on Consignment $$$
(Note: cost includes freight)Receipt of Cash from SaleCash $$$
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 BooksSlide19
Percentage-of-Completion: Earnings Approach
The amount of revenues, costs and gross profit recognized on long term contracts depends upon the percentage of work doneApplication of percentage-of-completion method requires a basis for measuring the progress toward completion at interim dates, and is based on significant judgementCan 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)Slide20
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
4Slide21
Percentage-of-Completion:
Cost-to-Cost BasisData: Contract price: $4,500,000 Estimated cost: $4,000,000
Start date: July, 2014 Finish: October, 2016
Balance sheet date: December 31
st
Given:
2014 2015
2016
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 $2,000,000Slide22
Percentage-of-Completion:
Cost-to-Cost Basis 2014 2015 2016 $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 4,050,000Less: 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)Slide23
Percentage-of-Completion:
Cost-to-Cost Basis1,750,000
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:
2015
2014
Note: Journal entries for 2016 are not shown due to space limitationsSlide24
Percentage-of-Completion:
Cost-to-Cost Basis 2014 2015 2016
$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 $1,260,000Revenue recognized:Revenue to date (a x b)Less: Prior years revenueCurrent 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.Slide25
Percentage-of-Completion:
Cost-to-Cost Basis199,000
125,000
Construction in Process
1,916,000
1,000,000
Construction Expenses
4,500,000
Construction in Process
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:
2015
2014
Note: Some journal entries for 2016 are not shown due to space limitationsSlide26
Percentage-of-Completion: 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 orCurrent liability* if difference is a credit balance
*May be non-current depending on length of contractSlide27
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 dateSlide28
Completed-Contract Method: Earnings Approach
Revenue and gross profit are recognized on the completion of the contractAdvantage: reported revenue is based on actual results, not estimatesDisadvantage: 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)Slide29
Comparison of Results
(Gross Profit Recognition)$450,000$450,000
Total
450,000
126,000
2016
0
199,000
2015
$ 0
$125,000
2014
Completed- Contract
Percentage-of- Completion
YearSlide30
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 recognizedUnder the completed-contract method, losses are recognized only when overall losses resultSlide31
Recognizing Current and Overall
Losses on Long-Term ContractsCurrent Loss onan otherwiseoverall 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 nowSlide32
32
Percentage Method: Interim Loss on Profitable Contract–Example
2014 2015 2016
$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 CompleteEst. Total Costs 25% 66.5% 100%
1,000,000
2,916,000
4,384,962 4,000,000 4,384,962 4,384,962Percent Complete
Data as previously given, except for the 2015 cost estimate
Revenue recognized to date in 2015: $4,500,000 x 66.5% = $2,992,500
Less: Amount recognized in 2014
1,125,000
Revenue recognized in 2015 1,867,500
Less: Actual costs incurred in 2015
1,916,000
Loss recognized in 2015
$48,500Slide33
Percentage Method: Interim Loss on Profitable Contract–Example
33Record loss for 2015:
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 2015
Under the
completed-contract method
, no lossrecognized in 2015Slide34
Percentage Method: Interim Loss on Overall Unprofitable Contract–Example
2014 2015 2016
$4,500,000 $4,500,000 $4,500,000 (a)
Contract Price
1,000,000 2,916,000 4,556,250
3,000,000
1,640,250
-0- 4,000,000 4,556,250 4,556,250 (b)Costs To Date
Est. Cost to Complete
Est. Total Costs
25% 64% 100% 1,000,000 2,916,000 Gross Loss 4,000,000 4,556,250 (56,250)*
Percent Complete
Data as previously given, except for the 2015 cost estimate
Losses recognized in 2015:
Gross profit recognized in 2014 (needs to be reversed) $125,000
Expected total loss on unprofitable contract (a – b) *
56,250
Total loss to be recognized in 2015
$181,250Slide35
Percentage Method: Interim Loss on Overall Unprofitable Contract–Example
Record loss in 2015 for percentage-of-completion method:Construction Costs expensed in 2015:
Revenue recognizable to date: (4,500,000 X 64%) $2,880,000
Less: Revenue recognized before 2015
1,125,000
Revenue recognized in 2015 1,755,000
Less: Loss recognized in 2015 (see previous slide) 181,250
Construction Cost Expense 1,936,250
Construction Expenses 1,936,250
Construction in Process (Loss) 181,250
Revenue from Long-Term Contract 1,755,000Slide36
Completed-Contract Method: Interim Loss on Overall Unprofitable Contract–Example
Record overall loss in 2015 for completed-contract method:Loss from Long-Term Contract 56,250
Construction in Process (Loss) 56,250
The loss is recognized in the year it first becomes
evident.Slide37
Revenues vs. Gains
Revenues: sales that are part of normal earnings process (e.g. sale of manufactured inventory)Gains: sales that are not part of the normal earnings process (e.g. sale of capital assets used in production of inventory)Gains commonly result from transactions that do not involve an earnings process, and so realization is keySlide38
Repo
rting Gross vs. Net RevenuesRevenues can be recorded as the gross amount billed or as the net amount retainedConsideration should be given to the following factors:
whether company acts as a
principal
or
as an agent/broker
whether company takes title to the goods sold
whether company has
risks and rewards of ownership of goods soldSlide39
Contract-Based Approach
Proposed by IASB and FASBContract defined as agreement between parties that creates enforceable rights and obligationsStandard applies when contract
has commercial substance
is approved by both parties
has identified rights and obligations (including payment terms)
Standard
doesn’t apply to contracts that can be cancelled by either party at no cost, if Goods/services have not been transferred; and
Payment has not been received and no right to receive payments exists
Standard proposes increased disclosuresSlide40
Contract-Based Approach
5 steps in determining when/how to recognize revenues:Identify contractIdentify separate (enforceable) performance obligations in contract
Determine transaction price
Allocate transaction price
Recognize revenues when performance obligation satisfiedSlide41
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