Intermediate Accounting IFRS Edition Chapter 18 Revenue

Volume 2

18-1

CHAPTER

18

REVENUE

Intermediate Accounting IFRS Edition Kieso, Weygandt, and Warfield 18-2

Learning Objectives

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1.

Apply the revenue recognition principle.

2.

Describe accounting issues for revenue recognition at point of sale.

3.

Apply the percentage-of-completion method for long-term contracts.

4.

Apply the cost-recovery method for long-term contracts.

5.

Identify the proper accounting for losses on long-term contracts.

6.

Describe the accounting issues for service contracts.

7.

Identify the proper accounting for multiple-deliverable arrangements.

Revenue

Current Environment

Guidelines for revenue recognition Departures from sale basis

Revenue Recognition (At Point of Sale) Measurement Recognition Summary

Revenue Recognition (LongTerm Contracts) Percentage-ofcompletion method Cost-recovery method Long-term contract losses

Disclosures

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Revenue Recognition (Other) Service contracts Multipledeliverable arrangements Other Summary of methods

The Current Environment Revenue recognition is a top fraud risk and regardless of the accounting rules followed (IFRS or U.S. GAAP), the risk or errors and inaccuracies in revenue reporting is significant. Restatements for improper revenue recognition are relatively common and can lead to significant share price adjustments.

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The Current Environment Guidelines for Revenue Recognition Revenue recognition principle: Revenue is recognized (1) when it is probable that the economic benefits will flow to the company and

(2) when the benefits can be measured reliably.

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LO 1 Apply the revenue recognition principle.

The Current Environment Revenue Recognition Classified by Nature of Transaction Illustration 18-1

Type of Transaction

Sale of product from inventory

Rendering a service

Permitting use of an asset

Sale of asset other than inventory

Description of Revenue

Revenue from sales

Revenue from fees or services

Revenue from interest, rents, and royalties

Gain or loss on disposition

Timing of Revenue Recognition

Date of sale (date of delivery)

Services performed and billable

As time passes or assets are used

Date of sale or trade-in

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The Current Environment Departures from the Sale Basis Earlier recognition is appropriate if there is a high degree of certainty about the amount of revenue earned. Delayed recognition is appropriate if the 

degree of uncertainty concerning the amount of revenue or costs is sufficiently high or



sale does not represent substantial completion of the earnings process.

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Revenue Recognition at Point of Sale Measurement of Sale Revenue Revenue should be measured at the fair value of consideration received or receivable.

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

Trade discounts or volume rebates should reduce consideration received or receivable and the related revenue.



If payment is delayed, seller should impute an interest rate for the difference between the cash or cash equivalent price and the deferred amount.

LO 2 Describe accounting issues for revenue recognition at point of sale.

Revenue Recognition at Point of Sale Illustration 18-2

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Sansung makes the following entry on March 31, 2011. Accounts receivable Sales

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679,000 679,000



Assuming Sansung’s customers meet the discount threshold, Sansung makes the following entry. Cash

679,000

Accounts receivable

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679,000



If Sansung’s customers fail to meet the discount threshold, Sansung makes the following entry upon payment. Cash

700,000

Accounts receivable Sales discounts forfeited

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679,000 21,000


Revenue Recognition at Point of Sale Measurement of Sale Revenue When a sales transaction involves a financing arrangement, the fair value is determined by discounting the payment using an imputed interest rate. Imputed interest rate is the more clearly determinable of either 1. the prevailing rate for a similar instrument of an issuer with a similar credit rating, or 2. a rate of interest that discounts the nominal amount of the instrument to the current sales price of the goods or services.

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The journal entry to record SEK’s sale to Grant Company on July 1, 2011, is as follows (ignoring cost of goods sold entry). Notes receivable Sales

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900,000 900,000



SEK makes the following entry to record interest revenue. Notes receivable Interest revenue (12% x ½ x €900,000)

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54,000 54,000


Revenue Recognition at Point of Sale Recognition of Sale Revenue Revenue from the sale of goods is recognized when all the following conditions are met: 1. Company has transferred to the buyer the significant risks and rewards of ownership of the goods; 2. Company retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; 3. The amount of revenue can be measured reliably; 4. It is probable that the economic benefits will flow to the company; and 5. The costs incurred or to be incurred can be estimated reliably. 18-18

LO 2

Revenue Recognition at Point of Sale Bill and Hold Sales Buyer is not yet ready to take delivery but does take title and accept billing. Illustration 18-4

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Revenue Recognition at Point of Sale Solution: Butler should record the revenue at the time title passes, provided 1. it is probable that delivery will be made; 2. the item is on hand, identified, and ready for delivery at the time the sale is recognized; 3. Baristo acknowledges the deferred delivery arrangement; and 4. the usual payment terms apply. It appears that these conditions were probably met and therefore revenue recognition should be permitted at the time the agreement is signed. 18-20

LO 2


Butler makes the following entry to record the bill and hold sale. Accounts receivable

Sales

18-21

450,000

450,000


Revenue Recognition at Point of Sale Sales Subject to Installation or Inspection Illustration 18-5

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Revenue Recognition at Point of Sale Layaway Sales Illustration 18-6

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Revenue Recognition at Point of Sale Sales with Right of Return Two possible revenue recognition methods are available when the right of return exposes the seller to continued risks of ownership: 1. not recording a sale until all return privileges have expired or 2. recording the sale, but reducing sales by an estimate of future returns.

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Revenue Recognition at Point of Sale

Pesido sold $300,000 of laser equipment on August 1, 2011, and retains only an insignificant risk of ownership. On October 15, 2011, $10,000 in equipment was returned. August 1, 2011

Accounts receivable

300,000

Sales

300,000 October 15, 2011

Sales returns and allowances Accounts receivable 18-26

10,000 10,000 LO 2

Revenue Recognition at Point of Sale

At December 31, 2011, based on prior experience, Pesido estimates that returns on the remaining balance will be 4 percent. Pesido makes the following entry to record the expected returns. December 31, 2011

Sales returns and allowances Allowance for sales returns and allowances

11,600 11,600

[($300,000 - $10,000) x 4% = 11,600] 18-27



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Morgan records the sale and related cost of goods sold as follows. Cash

135,000

Sales Cost of Goods Sold Inventory

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135,000 115,000 115,000


Revenue Recognition at Point of Sale Principal-Agent Relationships

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

Amounts collected on behalf of the principal are not revenue of the agent.



Revenue for the agent is the amount of the commission it receives.


Revenue Recognition at Point of Sale Consignments

18-31



Manufacturers (or wholesalers) deliver goods but retain title to the goods until they are sold.



Consignor (manufacturer or wholesaler) ships merchandise to the consignee (dealer), who is to act as an agent for the consignor in selling the merchandise.



Consignor makes a profit on the sale.



Consignee makes a commission on the sale.


Revenue Recognition at Point of Sale Trade Loading and Channel Stuffing Trade loading - a crazy, uneconomic, insidious practice through which manufacturers—trying to show sales, profits, and market share they don’t actually have—induce their wholesale customers, known as the trade, to buy more product than they can promptly resell. Channel stuffing. When a software maker needed to make its financial results look good, it offered deep discounts to its distributors to overbuy, and then recorded revenue when the software left the loading dock.

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Long-Term Contracts (Construction) Two methods of accounting for long-term construction contracts:

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

Percentage-of-completion method.



Cost-recovery (zero-profit) method.

Long-Term Contracts (Construction) Rationale for using percentage-of-completion accounting is that under most of these contracts, the

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

Buyer and seller have enforceable rights.



Buyer has the legal right to require specific performance on the contract.



Seller has the right to require progress payments that provide evidence of the buyer’s ownership interest.



As a result, a continuous sale occurs as the work progresses and companies should recognize revenue according to that progression.

Long-Term Contracts (Construction) Companies must use the percentage-of-completion method when all of the following conditions exist. 1. Total contract revenue can be measured reliably; 2. It is probable that the economic benefits associated with the contract will flow to the company; 3. Both the contract costs to complete the contract and the stage of contract completion at the end of the reporting period can be measured reliably; and 4. The contract costs attributable to the contract can be clearly identified and measured reliably so the actual contract costs incurred can be compared with prior estimates. 18-35

Long-Term Contracts (Construction) Companies should use the cost-recovery method when one of the following conditions applies: 1. When a company cannot meet the conditions for using the percentage-of-completion method, or 2. When there are inherent hazards in the contract beyond the normal, recurring business risks.

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Long-Term Contracts (Construction) Percentage-of-Completion Method Calculation for Revenue to Be Recognized Illustration 18-11

Illustration 18-12

Illustration 18-13

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LO 3 Apply the percentage-of-completion method for long-term contracts.

Long-Term Contracts (Construction) Illustration: KC Construction Company has a contract to construct a €4,500,000 bridge at an estimated cost of €4,000,000. The contract is to start in July 2010, and the bridge is to be completed in October 2012. The following data pertain to the construction period.

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Long-Term Contracts (Construction) Illustration: Compute percentage complete. Illustration 18-6

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Long-Term Contracts (Construction) Illustration: KC would make the following entries to record (1) the costs of construction, (2) progress billings, and (3) collections. Illustration 18-7

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Long-Term Contracts (Construction) Percentage-of-Completion, Revenue and Gross Profit, by Year Illustration 18-16

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Long-Term Contracts (Construction) Illustration: KC’s entries to recognize revenue and gross profit each year and to record completion and final approval of the contract. Illustration 18-17

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Long-Term Contracts (Construction) Illustration: Content of Construction in Process Account— Percentage-of-Completion Method Illustration 18-18

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Long-Term Contracts (Construction) Financial Statement Presentation—Percentage-ofCompletion Computation of Unbilled Contract Price at 12/31/10 Illustration 18-19

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Long-Term Contracts (Construction) Financial Statement—Percentage-of-Completion Illustration 18-20

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LO 3

Cost-Recovery (Zero-Profit) Method Illustration: For the bridge project illustrated on the preceding pages, Hardhat Construction would report the following revenues and costs. Illustration 18-21

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LO 4 Apply the cost-recovery method for long-term contracts.

Cost-Recovery (Zero-Profit) Method Illustration: Hardhat’s entries to recognize revenue and gross profit each year and to record completion and final approval of the contract. Illustration 18-22

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Cost-Recovery (Zero-Profit) Method Illustration: Comparison of gross profit recognized under different methods. Illustration 18-23

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Long-Term Contracts (Construction) Financial Statement—Cost-Recovery Method Illustration 18-24

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Long-Term Contracts (Construction) Illustration: Casper Construction Co. Contract price Cost incurred current year Estimated cost to complete in future years Billings to customer current year Cash receipts from customer Current year

2010 €675,000 150,000

2011 €675,000 287,400

2012 €675,000 170,100

450,000 135,000

170,100 360,000

0 180,000

112,500

262,500

300,000

A) Prepare the journal entries for 2010, 2011, and 2012.

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Long-Term Contracts (Construction) Illustration:

2010

2011

2012

€ 150,000

€ 437,400

€ 607,500

Estimated cost to complete

450,000

170,100

Est. total contract costs

600,000

607,500

Costs incurred to date

Est. percentage complete

25.0%

72.0%

607,500 100.0%

Contract price

675,000

675,000

675,000

Revenue recognizable

168,750

486,000

675,000

(168,750)

(486,000)

Rev. recognized prior year Rev. recognized currently

168,750

317,250

189,000

Costs incurred currently

(150,000)

(287,400)

(170,100)

Gross profit recognized

€ 18,750

€ 29,850

€ 18,900

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Long-Term Contracts (Construction) Illustration:

2010 150,000 150,000

2011 287,400 287,400

2012 170,100 170,100

Accounts receivable Billings on contract

135,000

360,000

180,000

Cash Accounts receivable

112,500

Construction in progress Construction expense Construction revenue

18,750 150,000

Construction in progress Cash

Billings on contract Construction in progress

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135,000

360,000 262,500

112,500

300,000 262,500

29,850 287,400 168,750

180,000

300,000 18,900 170,100

317,250

189,000 675,000 675,000


Long-Term Contracts (Construction) Illustration: Income Statement Revenue on contracts Cost of construction Gross profit

Balance Sheet (12/31) Current assets: Accounts receivable Cost & profits > billings Current liabilities: Billings > cost & profits

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2010

2011

2012

$ 168,750 150,000 18,750

$ 317,250 287,400 29,850

$ 189,000 170,100 18,900

22,500 33,750

120,000

-

9,000


Long-Term Contracts (Construction) Cost-Recovery Method Companies recognize revenue only to the extent of costs incurred that are expected to be recoverable. Only after all costs are incurred is gross profit recognized.

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Cost-Recovery Method Illustration: 2010 150,000 150,000

2011 287,400 287,400

2012 170,100 170,100

Accounts receivable Billings on contract

135,000

360,000

180,000

Cash Accounts receivable

112,500

Construction in progress Cash

135,000 262,500 112,500


150,000

180,000 300,000

262,500

300,000 67,500 170,100

287,400 150,000

Billings on contract Construction in progress 18-55

360,000

287,400

237,600 675,000 675,000


Cost-Recovery Method Illustration: Income Statement Revenue on contracts Cost of construction Gross profit

Balance Sheet (12/31) Current assets: Accounts receivable Cost & profits > billings Current liabilities: Billings > cost & profits

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2010

2011

€0 -

€0 -

22,500 15,000

120,000

2012 € 675,000 607,500 67,500

-

57,600


Long-Term Contracts (Construction) Long-Term Contract Losses 

Loss in the Current Period on a Profitable Contract ►



Loss on an Unprofitable Contract ►

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Percentage-of-completion method only, the estimated cost increase requires a current-period adjustment of gross profit recognized in prior periods.

Under both percentage-of-completion and completedcontract methods, the company must recognize in the current period the entire expected contract loss.

LO 5 Identify the proper accounting for losses on long-term contracts.

Long-Term Contract Losses Illustration: Loss in Current Period Casper Construction Co. Contract price Cost incurred current year Estimated cost to complete in future years Billings to customer current year Cash receipts from customer Current year

2010 €675,000 150,000

2011 €675,000 287,400

2012 €675,000 215,436

450,000 135,000

215,436 360,000

0 180,000

112,500

262,500

300,000

b) Prepare the journal entries for 2010, 2011, and 2012 assuming the estimated cost to complete at the end of 2011 was €215,436 instead of €170,100.

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Long-Term Contract Losses Illustration: Loss in Current Period 2010

2011

2012

€ 150,000

€ 437,400

€ 652,836


450,000

215,436


600,000

652,836

Costs incurred to date


25.0%

67.0%

652,836 100.0%

Contract price

675,000

675,000

675,000


168,750

452,250

675,000

(168,750)

(452,250)


168,750

283,500

222,750


(150,000)

(287,400)

(215,436)


€ 18,750

(€ 3,900)

€ 7,314

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Long-Term Contract Losses Illustration: Loss in Current Period 2010 Construction in progress Construction expense Construction revenue Construction in progress Construction expense Construction revenue

18-60

2011

2012

18,750 150,000

7,314 215,436 168,750

222,750 3,900 287,400 283,500


Long-Term Contract Losses Illustration: Loss on Unprofitable Contract Casper Construction Co. Contract price Cost incurred current year Estimated cost to complete in future years Billings to customer current year Cash receipts from customer Current year

2010 €675,000 150,000

2011 €675,000 287,400

2012 €675,000 246,038

450,000 135,000

246,038 360,000

0 180,000

112,500

262,500

300,000

c) Prepare the journal entries for 2010, 2011, and 2012 assuming the estimated cost to complete at the end of 2011 was € 246,038 instead of € 170,100. 18-61


Long-Term Contract Losses Illustration: Loss on Unprofitable Contract 2010 Costs incurred to date

2011

€ 150,000

€ 437,400


450,000

246,038


600,000

683,438


25.0%

2012 € 683,438 683,438

64.0%

100.0%

Contract price

675,000

675,000

675,000


168,750

432,000

675,000

(168,750)

(432,000)


168,750

263,250

243,000


(150,000)

(290,438)

(243,000)


€ 18,750

(€ 27,188)

€0

$675,000 – 683,438 = (8,438) cumulative loss 18-62

Plug LO 5

Long-Term Contract Losses Illustration: Loss on Unprofitable Contract 2010 Construction in progress Construction expense Construction revenue Construction in progress Construction expense Construction revenue

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2011

2012

18,750 150,000

243,000 168,750

243,000 27,188 290,438 263,250


Long-Term Contract Losses Illustration: Loss on Unprofitable Contract For the Cost-Recovery method, companies would recognize the following loss: 2010 Loss on construction contract

2011 8,438


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8,438 287,400 287,400


Long-Term Contract Losses Disclosures in Financial Statements Construction contractors should disclosure: 

Revenue recognized during the period and the methods used to determine the contract revenue and stage of completion.



For contracts in progress, ►



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aggregate amount of costs incurred and recognized net income, amount of advances received, and amount of retentions.

Any contingent assets or liabilities related to these contracts.


Other Revenue Recognition Issues Service Contracts Follow the same criteria as long-term contracts. To recognize revenue:

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

It must be reliably measurable;



Economic benefits are probable;



Stage of completion must be reliably measurable; and



Costs must be reliably measurable.

LO 6 Describe the accounting issues for service contracts.

Other Revenue Recognition Issues Service Contracts Single Act: Revenue recognized at the time of the act. More Than One Act: Revenue recognized as various acts occur.

Three circumstances: 1. Specified number of identical or similar acts. 2. Specified number of defined but not identical acts. 3. Unspecified number of identical acts or similar acts with a fixed period for performance. 18-67


Other Revenue Recognition Issues

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Assuming R&D services are provided according to the contract in 2011, Jackson makes the following entries in 2011 to recognized revenue on the Andes contract. January 1, 2011

Cash

1,000,000

Unearned R&D service revenue

1,000,000

December 31, 2011

Cash

400,000

Unearned R&D Service Revenue

200,000

R&D Service Revenue 18-69

600,000 LO 6


18-70



18-71



18-72



SeniorLife makes the following entries related to the contract. January 1, 2011

Cash

300,000

Unearned service revenue

300,000

December 31, 2011

Unearned service revenue

60,000

Service Revenue

60,000 December 31, 2012

Unearned service revenue Service Revenue 18-73

105,000 105,000

Other Revenue Recognition Issues Multiple-Deliverable Arrangements (MDAs) MDAs provide multiple products or services to customers as part of a single arrangement. Major accounting issues

18-74



how to allocate the revenue to the various products and services and



how to allocate the revenue to the proper period.

LO 7 Identify the proper accounting for multiple-deliverable arrangements.

Other Revenue Recognition Issues Multiple-Deliverable Arrangements (MDAs) All units in a MDA are considered separate units of accounting, provided that: 1. A delivered item has value to the customer on a standalone basis; and 2. The arrangement includes a general right of return relative to the delivered item; and 3. Delivery or performance of the undelivered item is considered probable and substantially in the control of the seller. 18-75


Other Revenue Recognition Issues Multiple-Deliverable Arrangements (MDAs) Illustration 18-33

18-76


Illustration 18-34

18-77


Other Revenue Recognition Issues Other Revenue Situations

18-78



Interest, Royalties, and Dividends



Accretion



Completion-of-Production Basis


18-79



The IASB defines revenue to include both revenues and gains. U.S. GAAP provides separate definitions for revenues and gains.



Revenue recognition fraud is a major issue in revenue recognition. The same situation occurs in the United States as evidenced by revenue recognition breakdowns at telecom company Global Crossing (USA), technology company Lucent Technologies (USA), and utility company Enron (USA).

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

A specific standard exists for revenue recognition under IFRS (IAS 18). In general, the standard is based on the probability that the economic benefits associated with the transaction will flow to the company selling the goods, rendering the service, or receiving investment income. In addition, the revenues and costs must be capable of being measured reliably. U.S. GAAP uses concepts such as realized or realizable, and earned as a basis for revenue recognition.



U.S. GAAP permits the use of the completed-contract method of accounting for long-term construction contracts (IAS 11). Companies generally use the percentage-of-completion method. If revenues and costs are difficult to estimate, then companies recognize revenue only to the extent of the cost incurred—a zero-profit approach under IFRS.

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

U.S. GAAP does not allow the percentage-of-completion method for service contracts. Under IFRS, costs can be deferred if the company is using percentage-of-completion. Under GAAP, costs are generally expensed as incurred.



U.S. GAAP provides detailed guidance in multiple-deliverable arrangements. IFRS guidance is more general.

Franchises Two sources of revenue: 1. Sale of initial franchises and related assets or services, and 2. Continuing fees based on the operations of franchises.

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LO 8 Explain revenue recognition for franchises sales.

Franchises The franchisor normally provides the franchisee with: 1. Assistance in site selection. 2. Evaluation of potential income. 3. Supervision of construction activity. 4. Assistance in the acquisition of signs, fixtures, and equipment. 5. Bookkeeping and advisory services. 6. Employee and management training. 7. Quality control. 8. Advertising and promotion. 18-83


Initial Franchise Fees Franchisors record initial franchise fees as 

revenue only when and as they make “substantial performance” of the services they are obligated to perform and when collection of the fee is reasonably assured.

Substantial performance occurs when the franchisor has no remaining obligation to refund any cash received or excuse any nonpayment of a note and has performed all the initial services

required under the contract.

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Example of Entries for Initial Franchise Fee Illustration: Tum’s Pizza Inc. charges an initial franchise fee of

$50,000 for the right to operate as a franchisee of Tum’s Pizza. Of this amount, $10,000 is payable when the franchisee signs the agreement, and the balance is payable in five annual payments of $8,000 each. The credit rating of the franchisee indicates that money can be borrowed at 8 percent. The present value of an ordinary annuity of five annual receipts of $8,000 each discounted at 8 percent is $31,942. The discount of $8,058 represents the interest revenue to be accrued by the franchisor over the payment period.

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Example of Entries for Initial Franchise Fee Illustration: 1. If there is reasonable expectation that Tum’s Pizza Inc.

may refund the down payment and if substantial future services remain to be performed by Tum’s Pizza Inc., the entry should be: Cash

10,000

Notes Receivable

31,942

Unearned Franchise Fees

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41,942


Example of Entries for Initial Franchise Fee Illustration: 2. If the probability of refunding the initial franchise fee is

extremely low, the amount of future services to be provided to the franchisee is minimal, collectibility of the note is reasonably assured, and substantial performance has occurred, the entry should be: Cash

10,000

Notes Receivable

31,942

Revenue from Franchise Fees

18-87

41,942


Example of Entries for Initial Franchise Fee Illustration: 3. If the initial down payment is not refundable,

represents a fair measure of the services already provided, with a significant amount of services still to be performed by Tum’s Pizza in future periods, and collectibility of the note is reasonably assured, the entry should be: Cash

10,000

Notes Receivable

31,942

Revenue from Franchise Fees Unearned Franchise Fees

18-88

10,000.00 31,942


Example of Entries for Initial Franchise Fee Illustration: 4. If the initial down payment is not refundable and no

future services are required by the franchisor, but collection of the note is so uncertain that recognition of the note as an asset is unwarranted, the entry should be: Cash

10,000

Revenue from Franchise Fees

18-89

10,000


Example of Entries for Initial Franchise Fee Illustration: 5. Under the same conditions as those listed in case 4

above, except that the down payment is refundable or substantial services are yet to be performed, the entry should be:

Cash

10,000

Unearned Franchise Fees

10,000

In cases 4 and 5 — where collection of the note is extremely uncertain— franchisors may recognize cash collections using the cost-recovery method.

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Continuing Franchise Fees Continuing franchise fees are received in return for the

continuing rights granted by the franchise agreement and for providing such services as management training, advertising and promotion, legal assistance, and other support. Franchisors report continuing fees as revenue when they are earned and receivable from the franchisee.

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Intermediate Accounting IFRS Edition Chapter 18 Revenue

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