Chapter 18
Revenue Recognition
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1. Revenue Recognition Basic Concepts
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Revenue recognition
◦ most difficult issue facing accounting
◦ most prevalent reason for accounting
restatements
◦ most common way financial statements are
fraudulently presented
◦ revenue is one of most important measures used
by inventors to assess a company’s performance
◦ revenue recognition is the cornerstone of accrual
accounting
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1. Revenue Recognition Basic Concepts

Definition of revenue (SFAC 6)
◦ Inflows or other enhancements of assets or
settlement of liabilities during a period from delivering
or producing goods, rendering services, or other
activities that constitute the entity’s ongoing major or
central operations.
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General recognition criteria (SFAC 5)
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meets definition of an element
measurability
relevance
faithful representation
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1a. Revenue Recognition Basic Concepts
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APB Statement 4
◦ Revenue is recognized when
 the earnings process is complete or virtually complete
 an exchange has taken place
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Realization principle (SFAC 5)
◦ Revenue is recognized when
 the earnings process is judged to be complete or
virtually complete
 there is reasonable certainty as to the collectability of
the asset to be received
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1a. Revenue Recognition Basic Concepts

SEC SAB No. 101
◦ persuasive evidence of an arrangement exists
◦ delivery has occurred or services have been
rendered
◦ the seller’s price to the buyer is fixed or
determinable
◦ collectability is reasonably assured
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1b. Revenue from Contracts with Customers

New standard adopted by FASB and IASB
◦ issued May 28, 2014
◦ entities required to apply the new standard for reporting
periods beginning on or after Jan. 1, 2017
◦ the issuing boards agreed that this unusual length of time is
appropriate because of the impact of this project
◦ this gives entities time to update their software systems and
processes in order to capture data for comparatives
◦ the boards tentatively stated that entities could use an
alternative transition method that would recognize the
cumulative effect of initially applying the new standard
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1b. Revenue from Contracts with Customers

New standard adopts an asset-liability
approach to revenue recognition
◦ companies account for revenue based on the asset or
liability arising from contracts with customers

New revenue recognition principle:
◦ revenue is recognized when the performance
obligation is satisfied
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Follows a five-step process
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1b. Revenue from Contracts with Customers

The five steps of revenue recognition are:
1. Identify the contract with customers.
2. Identify the separate performance obligations in the
contract.
3. Determine the transaction price.
4. Allocate the transaction price to the separate
performance obligations.
5. Recognize revenue when each performance
obligation is satisfied.
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1b. Revenue from Contracts with Customers
1.
Identifying the Contract with Customers
◦ a contract is an agreement between two or more
parties that creates enforceable rights or obligations
◦ requirements for a contract
 the contract has commercial substance (future cash flows change
as a result of the contract)
 the parties to the contract have approved the contract and
are committed to perform their respective obligations.
 the company can identify each party’s rights regarding the
goods or services to be provided, and
 the company can identify the payment terms for the goods
and services to be transferred.
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1b. Revenue from Contracts with Customers
1.
Identifying the Contract with Customers
◦ Revenue from a contract with a customer
cannot be recognized until a contract exists.
◦ Do not recognize contract assets or liabilities
until one or both parties to the contract
perform.
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1b. Revenue from Contracts with Customers
1.
Identifying the Contract with Customers
◦ Contract modification - determine if a new contract
and performance obligation results or whether it is a
modification of the existing contract
 Treated as a new contract if both of the following
conditions are met:
 the promised goods or services are distinct, and
 the company has the right to receive an amount of
consideration that reflects the standalone selling price of the
promised goods or services
 If either or both of the above conditions not met,
account for modification using a prospective approach
 under this approach, revenue is recognized using a blended price
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1b. Revenue from Contracts with Customers
Identify the separate performance obligations in the contract.
2.
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A company must provide a distinct product or service for a
performance obligation to exist.
If a single product or service is provided there is only one
performance obligation.
If multiple products/services are provided and they are
interdependent and interrelated, they are combined and
reported as a single performance obligation.
If the products/services are not highly dependent or interrelated
with other promises, then each performance obligation should
be accounted for separately.
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1b. Revenue from Contracts with Customers
3.
Determine the transaction price.
◦ Transaction price is amount company expects to receive from a
customer in exchange for transferring goods/services
◦ In some contracts, may need to consider:
 variable consideration (such as discounts, rebates, bonuses, royalties)
 use expected value (if more than two possible outcomes) or,
 most likely amount (if only two possible outcomes)
 time value of money
 m/b used if contract has significant financing component and time period greater than
one year
 noncash consideration
 measure as fair value of what received
 consideration paid or payable to the customer
 items that will reduce the consideration received (e.g., free products, volume discounts)
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1b. Revenue from Contracts with Customers
4.
Allocate the transaction price to the separate
performance obligations.
◦ If more than one performance obligation exists, an
allocation of the transaction price should be based on
the relative fair values of the various performance
obligations
◦ When a bundle of goods/services is sold, the bundle’s
selling price may be less than the sum of the individual
standalone prices. If so
 the discount should be allocated to the product(s) causing the
discount, not to the entire bundle
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1b. Revenue from Contracts with Customers
5.
Recognize revenue when each performance
obligation is satisfied.
◦ A company satisfies its performance obligation when
the customer obtains control of the good/service.
◦ Performance obligations may be satisfied at a point in
time or over a period of time.
◦ Companies recognize revenue over a period of time
if:
 the customer controls the asset as it is created or the
company does not have an alternative use for the asset, and
 the company has a right to payment.
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2. General Rule

When applying Revenue from Contracts with Customers,
revenue usually recognized at the point of sale
Activity
Revenue recognized when
Selling products
Point of sale (date of delivery;
when title passes)
Providing services
Services have been performed
and amounts are billable
Permitting others to use the
firm’s assets
As time passes
Disposing of assets
Date of sale
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3. Possible Points to Recognize Revenue
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Most significant event
Recognition before point of sale
◦ prior to starting production
 customer advances
◦ during production
 long-term construction contracts
◦ at completion of production
 precious metals, ag products

Recognition at point of sale
◦ but if right of return exists or sale with buyback

Recognition after point of sale
◦ cash collection methods
 installment sales, cost recovery basis
◦ consignments
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4. Expense Recognition

Expense – expired economic benefits
Outflows or other using up of assets or incurrence of liabilities
during a period from delivering or producing goods, rendering
services, or other activities that constitute the entity’s ongoing
major or central operations. (SFAC 6)

Expenses to be recognized can be identified
by
◦ matching
◦ direct expensing (period costs)
◦ systematic allocation
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5. Revenue Frauds

Obvious accounting violations
◦ Fictitious sales or fake customers
◦ Premature recording of sales
◦ Inflated sales
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Transactions sometimes lacking integrity
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Roundtrip transactions
Channel stuffing and trade loading
Bill and hold transactions
Repurchase agreements
Related party transactions
Principle-agent (grossing up revenue)
Contracts, agreements and side letters
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6. Long-term Construction Contracts
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Percentage of completion method
◦ revenue recognized each period based on
progress of construction
◦ this method required if
 company’s performance creates or enhances an asset
that the customer controls, or
 company’s performance does not create an asset with
an alternate use, and
 costs to complete and extent of progress toward
completion are reasonably dependable

If criteria not met use completed contract
method
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6a. Long-term Construction Contracts
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Methods to estimate percentage of
completion
◦ cost-to-cost method (input method)
 costs to date ÷ total estimated costs to complete
 most common method
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machine hours or labor hours (input measure)
project milestones (output method)
units of production (output method)
engineer’s or architect’s estimates
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6b. Long-term Construction Contracts

Revenue and GP recognized per period
◦ percentage completed this period x total
revenue or GP
◦ new accounts
 construction in progress (inventory account)
 progress billings (contra acct to CIP)
◦ financial statement presentation
 net both accounts – could be debit or credit balance
◦ example
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7. Completed contract method
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Revenues and gross profit recognized when
project finished
Entries
◦ same entries to record costs and billings
◦ do not recognize revenue and gross profit each
year
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The two methods are not acceptable
alternatives
Example
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8. Right of Return

Only recognize revenue if all of following are met
sellers price is fixed
◦ buyer has paid or is obligated to pay
◦ buyer’s obligation would not be changed by the theft
or destruction of the product
◦ buyer has economic substance apart from that
provided by the seller
◦ seller doesn’t have future significant obligations
◦ amount of future returns can be reasonably estimated
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