Chapter 6: Revenue Recognition

Process of capturing info for financial purposes involves deciding when to recognize

the transaction and how to measure and present it; must therefore understand the business the entity is engaged in (in order to account for transactions properly)

[Economics of Business Transactions] Basics- Are we selling goods, services, or both? What is the physical nature of the transaction?

Important to focus on whether goods or services or both are being transferred (referred to as deliverables)

Why does this matter for accounting purposes? Sales of goods and of services are different

o Goods are tangible assets; therefore at one point in time control over the goods or item being sold passes to the buyer (coincides w transfer of possession and legal title)

o With services, transfer of possession & legal title is irrelevant Many contracts involve both goods and services (known as multiple

deliverable or bundled sales) Understanding what the company is selling will help determine when to recognize

revenues Reciprocal nature- what Is being received?

Most business transactions are reciprocal; the entity gives smth up and receives smth in return

Consideration is what the entity receives in return for the provision of goods or services

Why does the reciprocal nature of transactions matter for accounting purposes? We assume transactions are at arms length (value of what is given up usually

approximates the value of what is received in the transaction) and reciprocal Sales agreements specify what is being given up and what is being acquired

o Acquired: consideration or rights to them; the amount, nature, and timing agreed upon

o Given up: goods or services (now or in future); details regarding delivery (quantities, nature of goods/services, timing, shipping terms) are agreed upon

If entity sells on credit, there is a risk that customer will not pay (credit risk) o Consideration that is non monetary (like w barter transactions) presents

challenges for accounting purposes; generally seen as a sale if the transaction has commercial substance (bona fide purchase and sale and the company

UNDERSTANDING THE NATURE OF SALES TRANSACTIONS FROM A BUSINESS PERSPECTIVE

entered into it for business purposes- exchanging one asset or service for another)

The risk that the price of an asset will change: price risk Concessionary terms- are the terms of sale normal or is this a special deal?

Examples include: o Selling price discounted o The entity agrees to a more lenient return or payment policy (paying in

installments or using contingent sales) o Loosens its credit policy o Transfers legal title but allows the customer to take delivery at a later date

(bill and hold) o Goods are shipped subject to customer acceptance conditions o Agrees to provide ongoing or additional services beyond the main goods or

services agreed to in order to make the sale o Seller continues to have some involvement, including a guarantee of resale

(or permission to return) or guarantee of profit Why does this matter for accounting purposes?

Care must be taken to identify concessionary (or abnormal) terms in any deal as they may complicate accounting

o These terms are more lenient than usual and meant to induce sales Should also ask if the selling terms are normal business practices for the company

or special/unusual in some way o Pg 320

[Legalities]

Companies operate within environments governed by law (contract law, common law, securities law etc)

[Contract Law]

when entity sells smth, both enter into a contract An agreement that creates enforceable obligations and establishes the terms of the

deal The two parties have promised to exchange assets and this creates a contract Therefore entering this creates legal rights and obligations Contract establishes the point when legal title passes (entitlement/ownership under

law) o When customer takes physical possession, legal title would pass at this point o If goods are shipped, point t which legal title passes is by shipping terms:

FOB shipping point- title passes at point of shipment FOB destination- title passes when the asset reaches the customer

[Constructive Obligation] Constructive obligation: an entity may have an implicit obligation even if its not

explicitly noted in a selling contract o Created through past practice or by signaling smth to potential customers

o If enforceable (under common or other law) it creates an obligation which needs to be recognized on BS

Information for Decision Making

Trend analysis most important showing changes in revenues from year to year Biased reporting is possible under principles and rules based accounting standards

Revenue is an inflow of economic benefits and arises from ordinary activities Revenues are realized when goods and services are exchanged for cash Realization is the process of converting non cash resources and rights into money

(cash to cash cycle) How to account for revenues (recognized)

o Earnings approach: focuses on the earning process and how a company adds value for its customers

Under ASPE and IFRS Revenues for sale of goods and related costs are recognized when

1. The risks and rewards of ownership are transferred 2. Vendor has no continuing involvement in nor effective control

over the goods sold 3. Costs and revenues can be measured reliably and 4. Collectability is probable

o Contract based approach: focuses on contractual rights and obligations creates by sales contracts

[Earnings Approach] General Principle

Earnings approach historically placed under Canadian GAAP and IFRS Seen as an IS approach to accounting for revenues and focus is on measuring

revenues and costs and recognizing revenues when earned; recognized when o Performance is substantially complete: can measure the revenue and

costs when it has substantially accomplished what must do to e entitled to the benefits of the revenue- earnigns process must be complete or sub. Complete

The risks and rewards are transferred and or the earnings process is sub. Complete (normally when product delivered or services are provided)

Measurability is reasonably assured o Collection is reasonable assured

ACCOUNTING FOR SALES TRANSACTIONS – RECOGNITION AND MEASUREMENT

Earnings Process Earnings process: a term that refers to the actions that a company takes to add value

o Focuses on operating activities Selling Goods

o When sell goods, there is often one main act or critical event in the earnings process that signals sub completion or performance

o Can recognize under accrual accounting even though some uncertainty remains

Sub. Completion normally occurs at the point of delivery (when risks and rewards of ownership including legal title and possession pass)

If has a critical event, referred to as a discrete earnings process o Concept or risks and rewards of ownership is important in the earnings

approach to rev reco; helps to establish ownership and to indicate when ownership passes from one party to another (who has the risks and rewards treats the goods as an asset)

o In some cases can recognize revenue before completion of production even though there is no specific customer for the asset at that point when the products have assured prices and ready markets; rev is recognized over time as the assets mature

The critical event is the appreciation in value of the asset Selling services

The focus is on the performance of the service Long term contracts

//Problems with the earnings approach

Multiple and sometimes conflicting guidance Diff views on what the earnings process is and when revs are earned The risks and rewards are split btwn the buyer and the seller in many cases Require too much subjective judgment Does not deal w when receivables should be booked if revs are not yet earned

//[Contract Based Approach] General Principle

Emphasis on BS and focuses on measuring the rights and obligation under sales contracts and recognizes rev when these rights and obligations change

Asks 2 questions o When should the sales contract be reco on the BS? o When should the rev be reco on the IS?

Contract is reco when: o The entity becomes party to the contract o The contractual rights are collectible/measureable o The performance obligation is measurable

Rev are reco when control passes or performance occurs Net contract position: the net amount of the contractual rights and obligations

o Initial value should be nil (value = what is being received) No receivables exits until the service is performed- company is now owed anything

till they perform and the customer does not pay til the service is received (unless contract says otherwise)

If the sale relates to goods (not services) performance occurs when the customer obtains control over the goods

This approach puts emphasis on control as opposed to who has risks and rewards of ownership

The net contract position is reco when the entity becomes party to the contract and when the contractual rights and performances obligations are measurable

Rev are reco when control of the related assets passes (for assets sold) and when performance occurs for services

Problems: does not deal w rev that are not contract based //[Comparison of the two approaches]

Pg 334 [Measurability] General principle

Under either method, rev should only be reco if the transaction is measurable Sales generally measured at FV Where the sale is on credit and the repayment term extends over a longer period the

receivable should be discounted to reflect the time value of money o To calculate the interest rate, IFRS says it should be whichever of the

following is more determinable The prevailing rate for a similar NR or The imputed rate that discounts the cash flows to the current cash

selling price of the item sold If FV not available for barter transactions, the FV of the product or service sold is

use as long as the sale has commercial substance and is reciprocal Measurement uncertainty

Results from an inability to measure the transaction or parts of the transaction; may arise from

o Inability to measure the consideration o Inability to measure related costs o Inability to measure the outcome of the transaction itself

Concessionary terms: often involve longer time horizons, are unique or one time, and include more lenient return and other policies

2 alternative rev reco treatments are available where there is measurement uncertainty:

o Do not record a sale if it is not measurable o Record the sale but attempt to measure and accrue an amount relating to the

uncertainty as a cost or reduced revs

This is preferred under accrual acc Measuring parts of a sale

Sales involving more than one product or service create additional measurement challenges; dealt w diff than sales of products

Diff services may also be accounted for differently depending on when the related revs are earned so therefore need to separate the sales into units

o If there are separate units, then allocate the overall price to each unit o The relative FV method would be used; the FV of each item is determined

(stand alone value) and then the purchase price is allocated based on the relative FVs

o The residual value method could be used alternatively; the FV of the undelivered item is subtracted from the overall purchase price

The residual value is then used to value the delivered item Ensures that upfront revs are not overstated If not possible to measure each part, then rev reco criteria must be

applied to the whole bundled sale as tho it were one product/service Onerous contracts: the contract is no longer profitable to the company;

consideration should be given to remeasuring the contract and reflecting a loss in the IS

Payments to customers

Volume rebates: made to encourage customers to buy more (the more they do the lower the price per unit)

o DR revenue, CR inventory Reimbursement of costs: occur when the customer incurs a cost such as advertising

that benefits both the customer and the company o DR expense, CR expense

As long as vendor receives an identifiable benefit in exchange for the payment like advertising, as long as payment received is reimbursement or costs incurred by the customer to sell the vendors product like advertising

Acquisition of assets to facilitate sales: may be made to acquire assets from the customer that are needed to sell the products

[Collectability] General principle

At the point of sale, if it is reasonably sure that collection of the receivable will ultimately occur then rev are reco

Applies under both approaches; as long as it Is possible to est the uncollectible amounts at point of sale, the sale is booked and potential uncollectible amount is accrued

If not, then defaults to a cash basis (reco when cash is received) instalment sales method and cost recovery method

[Mechanics] Consignment

In some arrangements, the vendor retains legal title to the goods; the point of delivery is not proof of full performance

The consignor ships merc to the consignee who acts as an agent for the consignor in selling the merc

Revenue reco by consignor only once notified of the sale o In their inventory though

Separate account: merchandise on consignment

Long term contracts Billings: long term contracts frequently provide that the seller may invoice the

purchaser at intervals, as various points in the project are reached; 2 methods reco under ASPE

Either reco the rev over the life of contract or at end o Percentage of completion method: rev, costs, and GP recognized as process

is made toward completion on a long term contract (IFRS only mentions this) Measuring progress requires good judgement

Input measures measure the efforts that have been devoted to a contract

o Can be bad method to use because inefficiencies or front end loading (higher ests in beginning) cause inaccurate info

o Popular input measure: cost to cost basis (% of completion is measured by comparing costs incurred to date w the most recent est of the total costs to complete the contract)

Costs incurred to date/most recent estimate of total costs = % complete to date

% complete to date x est total rev (or gp) = rev (or gp) to be reco to date

rev (or gp) to be reco to date – rev (or gp) reco in prior periods = current period rev (or gp)

Output measures measure results o Can be inaccurate if units that are used are not

comparable in time, effort, or cost to complete Depends on circumstances so need judgment

o Completed contract method: rev and GP are recognized only when the contract is completed

Advanatage is that reported rev is based on final results not estimates

Disadvantage is that it does not reflect current performance when te period of contract is longer than one accounting period; distorts earnings

The method that best matches the rev to be recognized t the work performed should be used

o If performance requires many ongoing acts (eg it’s a continuous earning process), the % of completion method should be used as long as the company is able to measure the transaction

o The completed contract method should be used when performance consists of a single act (discrete earnings process) or as a default method for continuous earnings process when the progress toward completion is not measurable

Zero profit method IFRS allows recognition of recoverable revs equal to costs incurred where the

outcome is not reliably measurable Under ASPE, if not determinable outcome then accounting would default to the

completed contract method Losses on long term contracts

Two types can occur o Loss in current period on a profitable contract

Significant increase in the estimated total contract costs during construction but increase does not eliminate all profit on the contract

Under % comp method: adjust current period for excess GP that was reco in prior periods and then record as a loss in current period

o Loss on an unprofitable contract Under both methods, entire loss that is expected on contract must be

reco in current period Earnings approach

The consignee accepts the merc and agrees to look after inventory and sell it; when its sold the money is then given to consignor after deducting a sales commission and any chargeable exps

o Rev is reco only after the consignor receives notification of the sale Inventory recorded for consignor not the consignee

Contract based approach

The net contract position would be 0 on the consignees books once the contract is agreed upon

o Must measure the vale of the rights and obligations up front o Uncertainty about rev since it depends (contingent) on sales so no entry

ACCOUNTING – PRESENTATION AND DISCLOSURE

[Revenue vs Gains]

Not only sales of assets but also items that are disposed of through sales that are not part of the normal earnings process

o In this case, a gain is generated [Net income vs OCI]

Following factors must be considered o Whether the company acts as a principal in the transaction or an agent or

broker (buying and selling the item for commission) o Whether the company takes title to the goods being sold o Whether the company has risks and rewards of ownership of the goods being

sold IFRS/PRIVATE ENTITY GAAP COMPARISON- PG 352