This page covers new revenue recognition standard, percentage of completion method, completed contract method, and other topics covered in intermediate accounting and CPA exam.
Financial Accounting and Reporting (FAR) section of the CPA exam
This page covers new revenues recognition, percentage of completion method, completed contract method that’s are covered in intermediate accounting and CPA exam.
One of the most difficult issues facing accountants concerns the recognition of revenue. Chapter 18 presents the new standard for revenue recognition, Revenue from Contracts with Customers. Attention should be focused following how the five-step process for revenue recognition is used to measure and report revenue. In addition, revenue recognition issues concerning long-term contracts and franchises are discussed in the appendices.
Fundamentals of Revenue Recognition
Most revenue transactions pose few problems for revenue recognition. However, as contracts are becoming more complex, the revenue recognition process has also become increasingly more complex to manage. In addition, GAAP, with its multitude of revenue recognition standards, and IFRS, with its basic standard and limited guidance on certain minor topics, had a number of weaknesses and deficiencies.
The converged standard, Revenue from Contracts with Customers, will be an improvement by:
- Providing a more robust framework for addressing revenue recognition issues.
- Improving comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets.
- Simplifying the preparation of financial statements by reducing the number of requirements to which companies must refer.
- Requiring enhanced disclosures to help financial statement users better understand the amount, timing, and uncertainty of revenue that is recognized.
The 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. Companies analyze the contracts to determine the terms of the transaction and the measurement of the consideration. Without contracts, companies cannot know whether promises will be met.
The new standard identifies the key objective of revenue recognition, specifies a five-step process that companies should use to ensure that revenue is measured and reported correctly, and culminates by stating the revenue recognition principle, i.e., revenue is recognized when the performance obligation is satisfied.
Overview of the Five-Step Process
The five steps of revenue recognition are:
- Identify the contract with customers.
- Identify the separate performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the separate performance obligations.
- Recognize revenue when each performance obligation is satisfied.
Step 1 – Identifying the Contract with Customers
A contract is an agreement between two or more parties that creates enforceable rights or obligations. A valid contract exists when:
- The contract has commercial substance.
- The parties have approved the contract.
- The contract identifies the rights of the parties
- Payment terms are identified.
- It is probable that the consideration will be collected.
Revenue is recognized only when a valid contract exists. A company obtains rights to receive consideration from the customer and assumes obligations to transfer goods or services to the customer (performance obligations).
If the contract is wholly unperformed and each party can unilaterally terminate the contract without compensation, then revenue should not be recognized until one or both of the parties has performed. Until performance occurs, no net asset or net liability occurs.
Step 2 – Identifying Separate Performance Obligations
A company must provide a distinct product or service to a customer for a performance obligation to exist. A product or service is distinct when a customer is typically able to benefit from a good or service on its own or together with other readily available resources. This occurs when the company can sell a good or service on a standalone basis (good or service can be sold separately).
To determine whether a company has to account for multiple performance obligations, the company’s promise to sell the good or service to the customer must be separately identifiable from other promises within the contract.
Step 3 – Determining the Transaction Price
The transaction price is the amount of consideration a company expects to receive from a customer in exchange for transferring goods/services, generally a fixed amount over a short period of time. In other contracts, companies must consider such factors as variable consideration, the time value of money, noncash consideration, and consideration paid or payable to the customer.
Variable consideration includes such future events occurring such as price concessions, volume discounts, rebates, credits, performance bonuses, or royalties. A company estimates the amount of variable consideration it will receive from a contract to determine the amount of revenue to recognize.
Expected value: a probability-weighted amount in a range of possible consideration amounts. May be appropriate if the company has a number of contracts with similar characteristics. It can also be based on a limited number of discrete outcomes and probabilities.
Most likely amount: the single most likely amount in a range of possible consideration outcomes. It may be appropriate if there are only two possible outcomes.
A company only allocates variable consideration if it is reasonably assured that it will be entitled to that amount. Companies may only recognize variable consideration if:
They have experience with similar contracts and are able to estimate the cumulative amount of revenue, and
Based on experience, it is highly probable that there will not be a significant reversal of previously recognized revenue.
The time value of money must be accounted for if the contract has a significant financing component and the time period for payment is greater than a year. Revenue is determined by measuring either the fair value of the consideration received or by discounting the payment using an imputed interest rate. The imputed interest rate is the more clearly determinable of either:
The prevailing rate for a similar instrument of an issuer with a similar credit rating, or A rate of interest that discounts the nominal amount of the instrument to the current sales price of the goods/services.
If a company receives a form of noncash consideration in exchange for the sale of their goods/services, revenue should be measured using the fair value of what was received. If that cannot be determined, the selling price of the services performed/goods sold should be estimated and used to measure the revenue.
Consideration paid or payable may include discounts, volume rebates, coupons, free products or services. In general, such items will reduce the consideration received and the revenue recognized.
Step 4 – Allocating the Transaction Price to Separate Performance Obligations
If more than one performance obligation exists in a contract, an allocation of the transaction price is needed. The allocation should be based on the relative fair values of the various performance obligations, referred to as the standalone selling price. If this information is not available, companies should use their best estimate of what the goods/services might sell for as a standalone unit using one of the following:
Adjusted market assessment approach: Evaluate the market in which it sells goods/services and estimate the price that customers in that are market are willing to pay for those goods/services.
Expected cost plus a margin approach: Forecast expected costs of satisfying a performance obligation and then add an appropriate margin for that good/service.
Residual approach: If the standalone selling price of a good/service is highly variable or uncertain, then estimate the standalone selling price by reference to the total transaction price less the sum of the observable standalone selling prices of other goods/services in the contract.
Step 5 – Recognizing Revenue When (or as) 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 and this right is enforceable.
Accounting for Major Revenue Recognition Transactions
Sales returns and allowances involve a return of a product by a customer due to dissatisfaction in exchange for refunds, a credit or another product in exchange. The seller recognizes (a) an adjustment to revenue for products expected to be returned, (b) a refund liability, and (c) an asset for the right to recover the product.
In repurchase agreements, the company has an obligation or right to repurchase the asset at a later date. If the repurchase price is equal to, or greater than, the selling price, then the transaction is a financing transaction and not a sale.
In a bill and hold arrangement, the buyer is not yet ready to take delivery but does take title and accept billing. Revenue is recognized depending on when the buyer obtains control of the product.
In principal-agent relationships, the principal’s performance obligation is to provide goods/services to a customer. The agent’s performance obligation is to arrange for the principal to provide these goods/services to a customer. The principal recognizes revenue when the goods/services are sold to a customer. The agent recognizes revenue in the amount of the commission that it receives.
Consignments are a form of principal-agent relationship. The consignor is the principal and the consignee is the agent. The consignor recognizes revenue after receiving notification of a sale and the cash remittance from the consignee. The consignee records commission revenue after the sale is made.
Warranties can be assurance-type or service-type. A separate performance obligation is not recorded for assurance-type warranties. Service-type warranties are a separate performance obligation.
Nonrefundable upfront fees are generally related to initiation, activation, or setup activities for a good/service to be delivered in the future. The upfront fee should be allocated over the periods benefitted.
Presentation and Disclosure
Contract assets are (a) unconditional rights to receive consideration because the company has satisfied its performance obligation and are reported as a receivable, and (b) conditional rights to receive consideration because the company has satisfied one performance obligation but must satisfy another one before it can bill the customer. These latter rights are reported as contract assets. A contract liability is a company’s obligation to provide goods/services to a customer for which the company has received consideration. A contract liability is usually reported as Unearned Sales Revenue.
Companies only capitalize costs incurred to fulfill a contract that are direct, incremental, and recoverable, provided that the contract period is more than one year.
Collectibility is not a consideration in determining revenue recognition. Companies record revenue at gross without considering credit risk, and then recognize bad debt expense in accordance with the their bad debt estimates.
Disclosure requirements for revenue recognition are designed to help statement readers understand the nature, timing, amount, and uncertainty of revenue and cash flows arising from contracts with customers. To achieve this companies disclose qualitative and quantitative information about (a) contracts with customers, (b) significant judgments, and (c) assets recognized from costs incurred to fulfill a contract.
Long-term Construction Contracts
In most circumstances, revenue is recognized at the point of sale because most of the uncertainties related to the earnings process are removed and the exchange price is known. One of the exceptions to the general rule of recognition at point of sale is caused by long-term construction-type projects. The accounting measurements associated with long-term construction projects are difficult because events and amounts must be estimated for a period of years.
Revenue is recognized over time if (a) the company’s performance creates or enhances an asset and that the customer controls as the asset is created or enhanced, or (b) the company’s performance does not create an asset with an alternative use.
Two basic methods of accounting for long-term construction contracts are recognized by the accounting profession. They are: (a) the percentage-of completion method, and (b) the completed-contract method.
The percentage-of-completion method is used when a company can reasonably estimate its progress toward satisfaction of the performance obligations.
The rationale for using percentage-of-completion method is that under most of the contracts the buyer and seller have enforceable rights.
A continuous sale occurs as the work progresses and companies recognize revenue according to that progression.
The contractor can be expected to perform contractual obligations.
Percentage-of-Completion Method
Under the percentage-of-completion method, revenue on long-term construction contracts is recognized as construction progresses. Costs pertaining to the contract along with gross profit earned to date are accumulated in a Construction in Process account. The amount of revenue recognized in each accounting period is based on a percentage of the total revenue to be recognized on the contract. The most popular method of estimating the amount of revenue to recognize is based on the costs incurred on the contract to date divided by the most recent estimated total costs (cost-to-cost basis).
- The journal entry to recognize revenue under the percentage-of-completion method is as follows:
Dr Construction in Process
Dr Construction Expenses
Cr Revenue from Long-Term Contracts
In any subsequent year, total revenue to be recognized is estimated based on the current cost-to-cost basis, and any revenue recognized in prior years is subtracted, resulting in incremental revenue being recognized each year.
The Billings on Construction in Process account is subtracted from the Construction in Process accounts; if the amount is a debit, it is reported as a current asset; if the amount is a credit, it is reported as a current liability.
Completed-Contract Method
Under the completed-contract method, revenue and gross profit are recognized when the contract is completed. The principal advantage of the completed-contract method is that reported revenue is based on final results rather than on estimates of unperformed work. Its major disadvantage is the distortion of earnings that may occur. The accounting entries made under the completed-contract method are the same as those made under the percentage-of-completion method, with the notable exception of periodic income recognition.
Contract Losses
Two types of losses can occur on long-term contracts.
A loss in the current period on a profitable contract occurs when estimated total contract costs increase significantly, but the company still expects a profit on the overall contract. This is treated as a change in estimate and recognized only under the percentage-of-completion method.
An overall loss on an unprofitable contract occurs when a loss will result on the entire contract. In these circumstances, a loss is recognized under both the percentage-of-completion and completed-contract methods.
Revenue Recognition for Franchises (Appendix 18B)
A franchise arrangement grants a franchisee the right to open a business, use of a trade name or other intellectual property of the franchisor, continuing business services, and in some cases, supplying inventory and inventory management.
Four types of franchise arrangements have evolved in practice: (a) manufacturer-retailer, (b) manufacturer-wholesaler, (c) service sponsor-retailer, and (d) wholesaler-retailer.
Franchise companies derive their revenue from two sources: (a) initial franchise fees for providing the franchise relationship and some initial services, and (b) continuing franchise fees for continuing rights granted by the franchise contract and for providing continuing services.
Franchisors must analyze the franchise contract to determine if the various performance obligations are individually distinct or not. In the typical franchise contract they are, so the transaction price must be allocated between them. Revenue is then recognized as the performance obligations are satisfied. In some cases that may be at a point in time and in others over time. If over time, revenue is usually recognized on a straight-line basis