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REVENUE RECOGNITION
Accounting Standards Update (ASU) No. 2014–09: “Revenue from Contracts with Customers”
Core revenue recognition principal: Companies 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 or services.
When: upon transfer to customers
How much: amount the seller is entitled to receive
Revenue is recognized at one specific point in time when control has transferred from the seller
to the customer.
Key indicators that control of a good or service has passed from the seller to the buyer
• Buyer has an unconditional obligation to pay.
• Buyer has legal title to the asset.
• Buyer has physical possession of the asset.
• Buyer assumes the risks and rewards of ownership.
• Buyer has accepted the asset.
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Example: On February 4, 2016 Meyers sold $800 of merchandise on account. The merchandise
cost Meyers $600. On February 16, 2016 Meyers received $800 from the customer.
Revenue is recognized over a period of time if one of the following three conditions hold:
• The customer consumes the benefit of the seller’s work as it is performed
• The customer controls the asset as it is created
• The seller is creating an asset that has no alternative use to the seller and the seller has the
legal right to receive payment for progress to date even if the contract is cancelled
On January 1, 2016, a health club signed up a new customer. The customer paid a $2,400
membership fee. It is expected that the customer will use the club for the next 2 years.
While revenue usually is earned during a period of time, revenue often is recognized at one
specific point in time.
If the goods are shipped f.o.b (free on board) shipping point, then legal title of the goods are
transferred to be buyer once the goods are shipped so the seller can record revenues when the
items are shipped.
If the goods are shipped f.o.b. destination, legal title is transferred once the goods are delivered
so the seller has to wait until the products are delivered before revenues can be recorded.
The goal is to separate the contract into parts that can be viewed on a stand-alone basis.
Goods and services are viewed as separate performance obligations if they are distinct:
Capable of being distinct
Separately identifiable from other goods or services in the contract
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SPECIAL ISSUES
Prepayments: Not considered as POs. They are accounted for as deferred revenue initially and
later recognized as revenue as each performance obligation is satisfied.
Warranties:
Quality-assurance warranties - Not considered as POs. The seller recognizes this cost in
the period of sale as a warranty expense and related contingent liability.
Extended warranties - Considered as POs. The seller recognizes the extended warranties
as a deferred revenue liability and then recognizes as revenue over the extended warranty
period.
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Options for additional goods or services: Considered as PO if they provide a material right to
the customer that the customer would not receive otherwise.
Example: As a promotion, TrueTech Industries offers a 50% coupon for a gaming headset with
the purchase of a Tri-Box at 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?
Right of return: Not considered as POs. in most retail situations revenue can be recognized at
the point of delivery if the seller is able to make reliable estimates of future returns. The
estimated returns reduce both sales and cost of goods sold.
Example: TrueTech sold 1,000 Tri-Boxes to CompStores for $240 for cash. Each Tri-box costs
TrueTech $200. TrueTech estimates that CompStores will return 5% of the Tri-Boxes purchased.
Variable consideration: estimated as either the expected value or the most likely amount.
Example: Siddhi entered into a contract offering variable consideration on January 1, 2016. The
contract paid Siddhi $12,000 upfront for six months of continuous consulting services. In
addition, there was a 60% chance the contract would pay an additional bonus of $4,000 and a
40% chance the contract would pay an additional bonus of $6,000, depending on the outcome of
the consulting contract. This contract qualified for revenue recognition over time. After three
months, Siddhi changed its assessment and expected the chance to receive $4,000 to be 30% and
the chance to receive $4,000 to be 70%. On July 1, 2016 Siddhi received the $6,000 bonus from
the client.
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1) Expected Value
Right of return:
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Is the seller a principal or agent?
Principal Agent
Example: MobileGo purchases Iphone X directly from Apple for $500. The phones are shipped
to MobileGo's warehouse and held there until a sale is made. MobileGo sells Iphone X to a
customer for $725 and ships individual phones to customers from its warehouse.
Example: Mobile-Online is a web portal on which mobile phone manufacturers sell their
products. When an Ipone X is sold through Mobile-Online for $725, the phone is shipped
directly from Apple's warehouse and Mobile-Online charges $50 commission.
Payments by the seller to the customer: if the seller purchases distinct goods or services
from the customer:
At the fair value of those goods or services, the seller accounts for that purchase as a
separate transaction
Pays more than the fair value of those goods or services, those excess payments are
viewed as a refund
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Step 4: Allocate the transaction price
3) Residual approach
1) Licenses
A license is said to transfer a right of use if the seller’s activities during the license period
are not expected to affect the intellectual property being licensed to the customer. For
example, think of a music download. In that case revenue is recognized at the start of the
license period, that is, when the right is transferred.
A license provides a right of access to the seller’s intellectual property if the seller’s
ongoing activities affect the benefit the customer receives from the intellectual property.
For example, think of an NFL trademark granted to a company over a period of time. In
that case revenue is recognized over the period of time for which access is provided.
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2) Franchises: In a franchise sale, the fees to be paid by the franchisee to the franchisor usually
comprise (1) the initial franchise fee, and (2) continuing franchise fees.
GAAP require that the franchisor has substantially performed the services promised in
the franchise agreement and that the collectibility of the initial franchise fee is reasonably
assured before the fee can be recognized.
Continuing franchise fees are paid to the franchisor for continuing rights as well as for
advertising and promotion and other services over the life of the agreement and are
recognized by the franchisor as revenue in the period received, which corresponds to the
periods the services are performed.
Example: On March 31, 2016, the Red Hot Chicken Wing Corporation entered into a franchise
agreement with Thomas Keller. In exchange for an initial franchise fee of $50,000, payable on
March 31, 2016, Red Hot grants Thomas Keller the exclusive right to operate Red Hot in Reston,
Virginia for a five-year period and will provide initial services including the construction
assistance, training of employees, and consulting services over five years. In addition, the
franchisee will pay continuing franchise fees of $1,000 per month for advertising and promotion
provided by Red Hot, beginning immediately after the franchise begins operations. Thomas
Keller opened his Red Hot franchise for business on September 30, 2016.
3) Bill-and-hold arrangements: since the customer doesn’t have physical possession of the
asset until the seller has delivered it, transfer of control has not occurred, so revenue typically
should not be recognized until actual delivery to the customer occurs.
4) Consignment arrangements: given that the consignor retains the risks of ownership, it
postpones revenue recognition until sale to a third party occurs.
5) Gift cards: sales of gift cards are recognized as deferred revenue, and then revenue is
recognized when a gift card is redeemed or the likelihood of redemption is viewed as remote.
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ACCOUNTING FOR LONG-TERM CONTRACTS
Revenue may be recognized before delivery when the products takes years to deliver (e.g., long-
term contact on buildings, highways, spacecraft) to provide timely information to investors.
In these situations, there are two methods of accounting for revenue and expense recognition:
Recognizing revenue upon the completion of the contract
Recognizing revenue over time according to % of completion.
If a contract doesn’t qualify for revenue recognition over time, revenue recognition is delayed
until the contract is completed.
Classified as Classified as
an asset a liability
4. At completion of the project, all accounts are closed and the entire gross profit from the
construction project is recognized.
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Example: Geller Construction entered into a three-year contract to build a containment vessel for
Southeast Power Company for a contract price of $1,400,000. Presented below is information
about the contract.
How will Geller account for the revenues and cost of this project if revenue is recognized upon
completion?
2016:
2017:
Construction in progress
Cash, materials, etc.
A/R
Billing on construction contract
Cash
A/R
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2018:
Construction in process
Cash, materials, etc.
A/R
Billing on construction contract
Cash
A/R
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If a contract qualifies for revenue recognition over time, revenue is recognized over time by
allocating a fair share of a project's revenues and expenses to each reporting period during
construction.
Example: Geller Construction entered into a three-year contract to build a containment vessel for
Southeast Power Company for a contract price of $1,400,000. Presented below is information
about the contract.
2016:
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2017:
Cost of construction
Construction in progress
Revenue from long-term contract
Revenue from long-term contract
Cost of construction
R/E
2018:
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To recognize gross profit
Cost of construction (Total cost incurred) 1.2M
Construction in progress (to recognize gross profit) 0.2M
Revenue from long-term contract 1.4M
Revenue from long-term contract
Cost of construction
R/E
Revenue Recognition
Over Time Upon Completion
Gross profit recognized:
2016
2017
2018
Total gross profit
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Example – Periodic loss for profitable project
2018:
Cost of construction
Construction in progress (Gross profit)
Revenue from long-term contracts
2017
2017
2018
2016:
Cost of construction
Construction in progress (Gross profit)
Revenue from long-term contracts
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2017:
Cost of construction
Construction in progress (Loss)
Revenue from long-term contracts
2018:
Cost of construction
Construction in progress (Gross profit)
Revenue from long-term contracts
2017 550K
1.4M
Revenue Recognition
Over Time Upon Completion
Gross profit recognized:
2016 30K 0
2017 -370 0
2018 20.37K 50K
Total project loss 50K 50K
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If Overall loss on the entire project:
Dr. Cost of Construction 1.47M Commented [AM2]: Not 1.52M because the 50K was already
recognized in the previous years
Cr. CIP (Loss) (120K-70K from last year) 70K Commented [AM3]: Cannot double count an expense that has
already been counted
Cr. Revenue from Long Term Contract 1.4M
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Revenue recognition over time:
% of completion:
2016: 250K/1.250K = 20%
2017: 910K - 250K/1450K = 62.76% - 20% = 42.76% Commented [AM5]: Want to always use the cumulative values
DO NOT SUBTRACT OUT PREVIOUS YEAR
2018:100% - 62.76% = 37.24%
2016:
2017:
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A comparison of two methods:
Revenue Recognition
Over Time Upon Completion
Gross profit recognized:
2016 30K 0
2017 -80K -50K
2018 -70K -70K
Total project loss -120K -120K
Commented [AM14]: Gives a more volatile earning goes
from a strong positive number to a strong negative number within
one year
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