Chapter 6Revenue Recognition

*Revenue RecognitionRevenue recognition is the largest cause of earnings restatements in the last 10 years.Definition of Revenue:inflow of economic benefits (Cash, A/R)arising from ordinary activitiesTwo conceptual views on how to account for revenues/sales:Earnings approachContract-based approach (last 2 slides)

*Earnings ApproachRevenues are recognized:When risks and rewards have passedWhen services are rendered, measurable and collectibleIn addition under IFRS there is no continuing involvement

*Earnings Approach Selling GoodsRevenue typically recognized at point of delivery (if earnings process is discrete)If not discrete, transfer of risk and rewards from seller to buyer is determined by:Who has the legal title to the goods soldWho has the possession of the goods soldEarlier recognition may be appropriate if risks and rewards transfer even if legal title and/or possession do not pass to the buyer. Ex. Agricultural products with assured prices and available markets

*As long as collectibility is reasonably assured revenue is recognized and estimate of uncollectible amount is accrued.If collectability cannot be reasonably assured, then revenues are recognized as cash is receivedMeasurement uncertainty arises when: we cannot measure the considerationwe cannot measure related costs, orwe cannot measure the outcome of the transactionWhen measurement uncertainty exists:Do not recognize revenues until measurement uncertainty resolved, orRecognize revenues but measure and accrue amount relating to uncertainty as a cost or reduced revenues (preferred)Collectibility & Measurability

*Bundled SaleEx. Rogers sells a phone and a monthly serviceIFRS and ASPE requires separation of each deliverable, if possiblePrice can be allocated using:Relative fair value methodResidual value methodRevenue recognition for each part is determined separatelyIf components cannot be measured individually, then revenue recognition criteria are applied to the bundled sale as a whole (as if one product/service)

Bundled SaleRelative Fair Value Method-similar to a Lump-Sum purchase of PP&E (chapter 10). Allocate sales price based on relative fair value.Residual Value method-value what hasnt been delivered at its fair value. Value what has been delivered at residual amount(whats left).Example: Rogers sells an iPad mini(with retina display) and a 2 year service agreement for $1,400. Assume the iPad has a fair value of $600 and the service has a fair value of $40/month. How does Rogers record the revenue under the Relative Fair Value Method and the Residual Method. *

*Earnings Approach - Services and Long-Term Contracts Recognize revenue at each critical event, as long as it is collectible using 2 approachesPercentage-of-Completion MethodUsed when performance has several ongoing acts andTransactions are measurable recognizes revenues and gross profit each period based on progress or contract completion.Completed-Contract Method Used when performance is a single act or not measurablerecognizes revenue and gross profit only after the whole contract is completedIFRS does not explicitly mention this method but does not prevent this method if its appropriate.

*Percentage-of-Completion: Earnings ApproachRevenues, costs and gross profit recognized depends upon the percentage of work doneThe percentage-of-completion method requires a basis for measuring the progress toward completion at interim datesInput measures (e.g. costs incurred, or labour hours worked)Output measures (e.g. storeys of a building completed, tonnes produced)

BE6-18Pennfield Construction began work on a $5,020,00 construction contract in 20120. During 2010, the company incurred costs of $1,600,000, billed its customer for $1,750,000, and collected $1,500,000. At December 31, 210, the estimated future costs to complete the project total $2,500,000. Assume that Pennfield uses the percentage-of-completion method. Prepare all journal entries required for the year ended December 31, 2010.*

BE6-18 additionAssume in 2011 costs were $1,500,000, future costs were estimated to be $1,100,000, Billings were $1,300,000, and Cash collected was $1,300,000.Instead assume in 2011 costs were $1,700,000, future costs were estimated to be $1,500,000, and Billings and Cash collected were the same as in A.Instead assume in 2011 costs $1,900,000, future costs were estimated to be $1,550,000, and Billings and Cash collected were the same as in A.*

*Percentage-of-Completion:Steps

*Percentage-of-Completion:Cost-to-Cost BasisData: Contract price: $4,500,000 Estimated cost: $4,000,000

Start date: July, 2011 Finish: October, 2013

Balance sheet date: December 31st Given: 2011 2012 2013

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

*Percentage-of-Completion: Cost-to-Cost Basis

*Percentage-of-Completion: Cost-to-Cost Basis

*Percentage-of-Completion: Cost-to-Cost Basis 2011 2012 2013

$ 125,000 $ 324,000 $ 450,000 -0- 125,000 324,000 $ 125,000 $ 199,000 $ 126,000Gross profit recognized:G.P. to date (Total x %)Less: G.P. in prior yearsCurrent year G. P.

*Percentage-of-Completion: Cost-to-Cost Basis

*Percentage-of-Completion: Financial Statement PresentationThe 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 contract

*Percentage-of-Completion: Financial Statement PresentationThe 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

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

*Percentage Method: Interim Loss on Profitable ContractExample 2011 2012 2013Data as previously given, except for the 2012 cost estimateRevenue recognized to date in 2012: $4,500,000 x 66.5% = $2,992,500Less: Amount recognized in 2011 1,125,000 Revenue recognized in 2012 1,867,500Less: Actual costs incurred in 2012 1,916,000Loss recognized in 2012 $48,500

*Percentage Method: Interim Loss on Profitable ContractExampleRecord loss for 2012:Construction Expenses 1,916,000 Construction in Process (loss) 48,500 Revenue from Long-Term Contract 1,867,500Under the percentage-of completion method the Loss of $48,500 is reported on the Income Statement in 2012Under the completed-contract method, no lossrecognized in 2012

*Percentage Method: Interim Loss on Overall Unprofitable ContractExample 2011 2012 2013Data as previously given, except for the 2012 cost estimateLosses recognized in 2012:Gross profit recognized in 2011(needs to be reversed)$125,000Expected total loss on unprofitable contract (a b) *56,250Total loss to be recognized in 2012$181,250

*Percentage Method: Interim Loss on Overall Unprofitable ContractExampleRecord loss in 2012 for percentage-of-completion method:Construction Costs expensed in 2012:Revenue to date: (4,500,000 X 64%) $2,880,000Less: Revenue recognized before 2012 1,125,000Revenue recognized in 2012 1,755,000Less: Loss recognized in 2012 (see previous slide) 181,250Construction Cost Expense1,936,250Construction Expenses 1,936,250 Construction in Process (Loss) 181,250 Revenue from Long-Term Contract 1,755,000

*Completed-Contract Method: Interim Loss on Overall Unprofitable ContractExampleRecord overall loss in 2012 for completed-contract method:Loss from Long-Term Contract56,250Construction in Process (Loss)56,250The loss is recognized in the year it first becomesevident.

*Completed-Contract Method: Earnings ApproachRevenue and gross profit are recognized when the contract is completedAdvantage: reported revenue is based on actual results, not estimatesDisadvantage: distorts current performanceAll 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 profitIFRS does not address the completed-contract method but allows for recognition of recoverable revenues equal to costs incurred if outcome is not reliably measurable (Zero-Profit method)

*Comparison of Results(Gross Profit Recognition)$450,000$450,000Total450,000126,00020130199,0002012$ 0$125,0002011Completed- ContractPercentage-of- CompletionYear

Zero Profit MethodIf outcome or profitability becomes undeterminableIFRS-recognize recoverable revenues equal to costs incurred (dont record gross profit)ASPE-use completed contract method*

Gross vs Net Method of Revenue RecognitionHow do intermediaries such as Priceline or Groupon record revenue?Is the company a principal or agent?Principal if Takes title of goodsHas risks and rewards of ownershipRecord Revenues at Gross Otherwise AgentRecord Revenues at Net*

*Consignment SalesWhen Consignor ships inventory to the consignee, possession has transferred; but legal title remains with the sellerRisks and rewards have not transferredGoods are held by seller as Merchandise on Consignment, not held as inventoryWhen merchandise sold, the consignee remits cash to the consignor (after deducting commission and other chargeable expenses)

*Consignment Sales EarningsGoods shipped to ConsigneeInventory on Consignment $$$ Finished Goods Inventory $$$Payment of FreightInventory on Consignment $$$ Cash $$$Notification of SaleAccounts 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 SaleCash$$$ Payable to Consignor $$$

Remittance to ConsignorPayable to Consignor $$$ Cash $$$ Commission Revenue $$$

Consignors BooksConsignees Books

BE6-11Finch Industries shipped $550,000 of merchandise on consignment to Royal Crown Company. Finch paid freight cost of $5,000. Royal Crown Company paid $1,500 for local advertising, which is reimbursable from Finch. By year end, 75% of the merchandise had been sold for $618,750. Royal Crown notified Finch, retained a 10% commission and remitted the cash due to Finch. Prepare the journal entries required by Finch for this transaction under the earnings approach.*

*Multiple and conflicting guidance on revenue recognitionDifficult to applyDifficult to determine definitively who has the risks and rewardsVery subjective judgment Problems with the Earnings Approach

*Recognises revenue when there is a change in rights/responsibilitiesAsks the questions:When should the sales contract be recognized on the balance sheet? When should revenue be recognized on the income statement?Contract is recognized when all of the following conditions are met: The entity is party to the contract, The contractual rights are collectible/measurable, and The performance obligation is measurableContract-Based Approach

*Net contract position equals contractual rights minus contractual obligationsInitial balance of net contract position is generally zeroRevenues are recognized whenLegal title or possession passes to the buyer, orServices are performed Advantage of Contract-Based ApproachConceptually soundProblems with Contract-Based ApproachNew model that needs to be testedDoes not cover revenue that is not contract basedContract-Based Approach

****************************