1. Income Measurement and Profitability Analysis
Chapter 5
Chapter 5: Income Measurement and Profitability Analysis
The focus of this chapter is revenue recognition. We first discuss the general circumstance in which revenue is recognized when a good or service is delivered. Then we discuss circumstances in which revenue should be deferred until after delivery or should be recognized prior to delivery. The chapter also includes an appendix describing requirements for interim financial reporting and a Where We’re Headed Supplement explaining in detail a proposed Accounting Standards Update (hereafter, “proposed ASU”) that the FASB and IASB plan to issue in 2012 that substantially changes how we account for revenue recognition.

2. Realization Principle
Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.
Record revenue when:
What is revenue? According to the FASB, “Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.” In other words, revenue tracks the inflow of net assets that occurs when a business provides goods or services to its customers.
Revenue recognition criteria help ensure that an income statement reflects the actual accomplishments of a company for the period. In other words, revenue should be recognized in the period or periods that the revenue-generating activities of the company are performed.
The realization principle requires that two criteria be satisfied before revenue can be recognized:
The earnings process is complete or virtually complete and
There is reasonable certainty as to the collectibility of the asset to be received (usually cash).
Premature revenue recognition reduces the quality of reported earnings and can cause serious problems for the reporting company.
AND
there is reasonable certainty as to the collectibility of the asset to be received (usually cash).
the earnings process is complete or virtually complete.

3. SEC Staff Accounting Bulletin No. 101 and 104
Additional criteria for judging whether or not the realization principle is satisfied:
Persuasive evidence of an arrangement exists.
Delivery has occurred or services have been performed.
The seller’s price to the buyer is fixed or determinable.
Collectibility is reasonably assured.
As part of its crackdown on earnings management, the SEC issued additional guidance, summarized in Staff Accounting Bulletin (SAB) No. 101 and later in SAB 104, indicating the SEC’s views on revenue. The SABs provide additional criteria for judging whether or not the realization principle is satisfied:
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.
Collectibility is reasonably assured.
In addition to these four criteria, the SABs also pose a number of revenue recognition questions relating to each of the criteria. The questions provide the facts of the scenario and then the SEC offers its interpretive response. These responses and supporting explanations provide guidance to companies with similar revenue recognition issues.
Soon after SAB No. 101 was issued, many companies changed their revenue recognition methods. In most cases, the changes resulted in a deferral of revenue recognition.
In addition to these four criteria, the SABs also pose a number of revenue recognition questions relating to each of the criteria.

4. Realization Principle
Revenue recognition is often tied to delivery of the product from the seller to the buyer.
This illustration relates various revenue-recognition methods to critical steps in the earnings process. Recall that the realization principle indicates that the central issues for recognizing revenue are (a) judging when the earnings process is substantially complete and (b) whether there is reasonable certainty as to the collectibility of the cash to be received. Often this decision is straightforward and tied to delivery of the product from the seller to the buyer. At delivery, the earnings process is virtually complete and the seller receives either cash or a receivable. At other times, though, recognizing revenue upon delivery may be inappropriate. It may be that revenue should be deferred to a point after delivery because the seller is unable to estimate whether the buyer will return the product or pay the receivable. Or, sometimes revenue should be recognized at a point prior to delivery because the earnings process occurs over multiple reporting periods and the company can better inform financial statement users by making reliable estimates of revenue and cost prior to delivery.

5. Revenue recognition criteria for U.S. GAAP and IFRS include:
U. S. GAAP vs. IFRS
Revenue recognition criteria for U.S. GAAP and IFRS include:
Earnings process is complete or virtually complete.
Reasonable certainty as to the collectibility of the asset to be received.
Revenue and costs can be measured reliably.
Probable that economic benefits will flow to the seller.
Risk and rewards are transferred to buyer and seller does not manage or control the goods.
Stage of completion can be measured reliably.
IAS No. 18 governs most revenue recognition under IFRS. Similar to U.S. GAAP, it defines revenue as “the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.” IFRS allows revenue to be recognized when the following conditions have been satisfied:
The amount of revenue and costs associated with the transaction can be measured reliably.
It is probable that the economic benefits associated with the transaction will flow to the seller.
(For sales of goods) the seller has transferred to the buyer the risks and rewards of ownership, and doesn't effectively manage or control the goods.
(For sales of services) the stage of completion can be measured reliably.
These general conditions typically will lead to revenue recognition at the same time and in the same amount as would occur under U.S. GAAP, but there are exceptions. For example, later in this chapter we discuss differences between IFRS and U.S. GAAP that may affect the timing of revenue recognition with respect to multiple-deliverable contracts. More generally, IFRS has much less industry-specific guidance than does U.S. GAAP, leading to fewer exceptions to applying these revenue recognition conditions.

6. Revenue Recognition at Delivery
Recognize Revenue
When the product or service has been delivered to the customer and cash has been received or a receivable has been generated that has reasonable assurance of collectibility.
While revenue usually is earned during a period of time, it often is recognized at one specific point in time when both revenue recognition criteria are satisfied, that is, when the product or service has been delivered to the customer and cash has been received or a receivable has been generated that has reasonable assurance of collectibility. Revenue from the sale of products usually is recognized at the point of product delivery. The product delivery date occurs when legal title to the goods passes from seller to buyer, which depends on the terms of the sales agreement.
For service revenue, if there is one final service that is crucial to the earnings process, revenues and costs are deferred and recognized after this service has been performed. For example, a moving company will pack, load, transport, and deliver household goods for a fixed fee. Although packing, loading, and transporting all are important to the earning process, delivery is the culminating event of the earnings process. So, the entire service fee is recognized as revenue after the goods have been delivered.

7. Is the Seller a Principal or Agent?
Has primary responsibility for delivering product or service and is vulnerable to risks associated with delivery and collection.
Agent
Does not have primary responsibility for delivering product or service but acts as a facilitator that earns a commission
Regardless of whether we are dealing with a product or a service, an important consideration is whether the seller is acting as a “principal” or as an “agent.” Here’s the difference. A principal has primary responsibility for delivering a product or service, and typically is vulnerable to risks associated with delivering the product or service and collecting payment from the customer. In contrast, an agent doesn’t primarily deliver goods or services, but acts as a facilitator that earns a commission for helping sellers transact with buyers.
If the company is a principal, the company should recognize as revenue the gross (total) amount received from a customer. If instead the company is an agent, it recognizes as revenue only the net commission it receives for facilitating the sale.
Recognizes as revenue the gross (total) amount received from a customer.
Recognizes as revenue the net commission it receives for facilitating the sale.

8. Revenue Recognition after Delivery
Recognizing revenue at delivery of the product or service assumes we are able to make reasonable estimates of amounts due from customers that potentially might be uncollectible and amounts not collectible due to customers returning the products they purchased.
Recognizing revenue when goods and services are delivered assumes we are able to make reasonable estimates of amounts due from customers that potentially might be uncollectible. For product sales, this also includes amounts not collectible due to customers returning the products they purchased. Otherwise, we would violate one of the requirements of the revenue realization principle we discussed earlier—that there must be reasonable certainty as to the collectibility of cash from the customer. In this section we address a few situations in which uncertainties are so severe that they could cause a delay in recognizing revenue from a sale of a product or service. For each of these situations, notice that the accounting is essentially the same—deferring recognition of the gross profit arising from a sale of a product or service until uncertainties have been resolved.
Installment sales can be accounted for using the installment sales method or the cost recovery method.
The installment sales method recognizes the gross profit by applying the gross profit percentage on the sale to the amount of cash actually collected.
The cost recovery method defers all gross profit recognition until cash equal to the cost of the item sold has been collected.
Installment Sales Method
Cost Recovery Method

9. Installment Sales Method
On November 1, 2013, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, The land cost $560,000 to develop. The company’s fiscal year ends on December 31.
To deal with the uncertainty of collection, the installment sales method recognizes revenue and costs only when cash payments are received. Each payment is assumed to be composed of two components: (1) a partial recovery of the cost of the item sold and (2) a gross profit component. These components are determined by the gross profit percentage applicable to the sale.
On November 1, 2013, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, The land cost $560,000 to develop. The company’s fiscal year ends on December 31.
Let’s see how Belmont Corporation will account for this sale using the installment sales method. One of the first things we need to do is to calculate the gross profit percentage as shown on the slide.
Gross Profit $240,000 ÷ $800,000 = 30%

10. Installment Sales Method
During 2013, Belmont Corporation collected $200,000 on its installment sales.
In the first entry, installment sales receivable is debited for $800,000. Inventory is credited for the portion of the receivable that represents the cost of the land sold. The difference is deferred gross profit. Deferred gross profit is a contra account to the installment sales receivable.
When payments are received, gross profit is recognized. The second set of entries records the collection of the first installment and recognizes the gross profit component of the payment, $60,000. Realized gross profit gets closed to income summary as part of the normal year-end closing process and is included in net income in the income statement.
The income statement for 2013 would report a gross profit from installment sales of $60,000. Sales and cost of goods sold usually are not reported in the income statement under the installment method, just the resulting gross profit. Journal entries to record the remaining three payments on November 1, 2014, 2015, and 2016, are identical.
This entry records the realized gross profit by adjusting the deferred gross profit account.

11. Cost Recovery Method
On November 1, 2013, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, The land cost $560,000 to develop. The company’s fiscal year ends on December 31.
In situations where there is an extremely high degree of uncertainty regarding the ultimate cash collection on an installment sale, an even more conservative approach, the cost recovery method, can be used. This method defers all gross profit recognition until the cost of the item sold has been recovered. The gross profit recognition pattern applying the cost recovery method to the Belmont Corporation situation is illustrated on this slide.
Now, let’s use the same data for Belmont Corporation and use the cost recovery method. One of the first things to notice is that under this method, gross profit will not be recognized until 2015.

12. Cost Recovery Method
This slide summarizes all the entries using the cost recovery method. Notice that the first entry is exactly the same and that the other entries have the same structure as the entries we just did using the installment sales method, but the timing of the gross profit realization differs between the two methods.
In the first entry, installment sales receivable is debited for $800,000. Inventory is credited for the portion of the receivable that represents the cost of the land sold. The difference is deferred gross profit.
The second entry records the $200,000 Belmont Corporation collected on its installment sales. The entry is to debit cash and credit installment sales receivable. Belmont Corporation will make this same entry on November 1, 2013, 2014, 2015, and 2016.
The third entry on November 1, 2015, records the realized gross profit by adjusting the deferred gross profit account. The amount of the entry is $40,000, which is the amount of the cost recovered at this payment date.
The fourth entry on November 1, 2016, records the remainder of the realized gross profit of $200,000 and adjusts the deferred gross profit account.

13. Reduce both sales and cost of goods sold
Right of Return
In most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery.
Estimate the returns
Retailers usually give their customers the right to return merchandise if they are not satisfied. In most situations, even though the right to return merchandise exists, revenues and expenses can be appropriately recognized at point of delivery. Based on past experience, a company usually can estimate the returns that will result for a given volume of sales. These estimates are used to reduce both sales and cost of goods sold in anticipation of returns. The purpose of the estimates is to avoid overstating gross profit in the period of sale and understating gross profit in the period of return. Because the return of merchandise can negate the benefits of having made a sale, the seller must meet specific criteria before revenue is recognized in situations when the right of return exists. The most critical of these criteria is that the seller must be able to make reliable estimates of future returns. In some situations, these criteria are not satisfied at the point of delivery of the product. For example, manufacturers of semiconductors like Intel Corporation and Motorola Corporation usually sell their products through independent distributor companies. Economic factors, competition among manufacturers, and rapid obsolescence of the product motivate these manufacturers to grant the distributors the right of return if they are unable to sell the semiconductors. So, revenue recognition often is deferred beyond the delivery point to the date the products actually are sold by the distributor to an end user.
Reduce both sales and cost of goods sold

14. Consignment Sales
Sometimes a company arranges for another company to sell its product under consignment.
Because the consignor retains the risks and rewards of ownership of the product and title does not pass to the consignee, the consignor does not record a sale until the consignee sells the goods and title passes to the eventual customer.
Sometimes a company arranges for another company to sell its product under consignment. The “consignor” physically transfers the goods to the other company (the consignee), but the consignor retains legal title. If the consignee can’t find a buyer within an agreed-upon time, the consignee returns the goods to the consignor. However, if a buyer is found, the consignee remits the selling price (less commission and approved expenses) to the consignor. Because the consignor retains the risks and rewards of ownership of the product and title does not pass to the consignee, the consignor does not record a sale (revenue and related expenses) until the consignee sells the goods and title passes to the eventual customer. Of course, that means goods on consignment still are part of the consignor’s inventory.

15. Revenue Recognition Prior to Delivery
Completed Contract Method
Long-term Contracts
Percentage-of-Completion Method
The types of companies that make use of long-term contracts are many and varied. A recent survey of reporting practices of 600 large public companies indicates that approximately one in every four companies engages in long-term contracts. And they are not just construction companies. In fact, even services such as research, installation, and consulting often are contracted for on a long-term basis.
The general revenue recognition criteria described in the realization principle suggest that revenue should be recognized when a long-term project is finished (that is, when the earnings process is virtually complete). This is known as the completed contract method of revenue recognition. The problem with this method is that all revenues, expenses, and resulting income from the project are recognized in the period in which the project is completed; no revenues or expenses are reported in the income statements of earlier reporting periods in which much of the work may have been performed. Net income should provide a measure of periodic accomplishment to help predict future accomplishments. Clearly, income statements prepared using the completed contract method do not fairly report each period’s accomplishments when a project spans more than one reporting period. Much of the earnings process is far removed from the point of delivery.
The percentage-of-completion method of revenue recognition for long-term construction and other projects is designed to help address this problem. By this approach, we recognize revenues (and expenses) over time by allocating a share of the project’s expected revenues and expenses to each period in which the earnings process occurs, that is, the contract period. Although the contract usually specifies total revenues, the project’s expenses are not known until completion. Consequently, it’s necessary for a company to estimate the project’s future costs at the end of each reporting period in order to estimate total gross profit to be earned on the project.

16. Completed Contract and Percentage-of-Completion Methods Compared
At the beginning of 2013, the Harding Construction Company received a contract to build an office building for $5 million. The project is estimated to take three years to complete. According to the contract, Harding will bill the buyer in installments over the construction period according to a prearranged schedule. Information related to the contract is as follows:
At the beginning of 2013, the Harding Construction Company received a contract to build an office building for $5 million. The project is estimated to take three years to complete. According to the contract, Harding will bill the buyer in installments over the construction period according to a prearranged schedule. Information related to the contract is shown on this slide. Construction costs include the labor, materials, and overhead costs directly related to the construction of the building. Notice how the total of estimated and actual construction costs changes from period to period. Cost revisions are typical in long-term contracts in which costs are estimated over long periods of time.

17. Accounting for the Cost of Construction and Accounts Receivable
With both the completed contract and percentage-of-completion methods, all costs of construction are recorded in an asset account called construction in progress.
With both the completed contract and percentage-of-completion methods, all costs of construction are recorded in an asset account called construction in progress. This account is equivalent to the asset work-in-process inventory in a manufacturing company. This is logical since the construction project is essentially an inventory item in process for the contractor. Notice that periodic billings are credited to billings on construction contract. This account is a contra account to the construction in progress asset. At the end of each period, the balances in these two accounts are compared. If the net amount is a debit, it is reported in the balance sheet as an asset. Conversely, if the net amount is a credit, it is reported as a liability.

18. Gross Profit Recognition—General Approach
The top portion shows the journal entries to recognize revenue, cost of construction (think of this as cost of goods sold), and gross profit under the completed contract method, while the bottom portion shows the journal entries that achieve this for the percentage-of-completion method.
It’s important to understand two key aspects of these journal entries. First, the same amounts of revenue, cost, and gross profit are recognized under both the completed contract and percentage-of-completion methods. The only difference is timing. Second, notice that in both methods we add gross profit (the difference between revenue and cost) to the construction in progress asset. That may seem odd—why add profit to what is essentially an inventory account? The key here is that, when the Harding Construction Company recognizes gross profit, Harding Construction is acting like it has sold some portion of the asset to the customer, but Harding Construction keeps the asset in Harding Construction’s own balance sheet (in the construction in progress account) until delivery to the customer. Putting recognized gross profit into the construction in progress account just updates that account to reflect the total value (cost + gross profit = sales price) of the customer’s asset. However, don’t forget that the billings on construction contract account is contra to the construction in progress account. Over the life of the construction project, Harding Construction will bill the customer for the entire sales price of the asset. Therefore, at the end of the contract, the construction in progress account (containing total cost and gross profit) and the billings on construction contract account (containing all amounts billed to the customer) will have equal balances that exactly offset to create a net value of zero.
In both methods the same amounts of revenue, cost, and gross profit are recognized.
In both methods we add gross profit to the construction in progress asset.

19. Gross Profit Recognition—General Approach
The same journal entry is recorded to close out the billings on construction contract and construction in progress accounts under the completed contract and percentage-of-completion methods.
When title officially passes to the customer, Harding Construction will prepare a journal entry that removes the contract from its balance sheet by debiting billings on construction contract and crediting construction in progress for the entire value of the contract. As shown on this slide, the same journal entry is recorded to close out the billings on construction contract and construction in progress accounts under the completed contract and percentage-of-completion methods.

20. Timing of Gross Profit Recognition Under the Completed Contract Method
Under the completed contract method, all revenues and expenses related to the project are recognized when the contract is completed.
The timing of gross profit recognition under the completed contract method is simple. As the name implies, all revenues and expenses related to the project are recognized when the contract is completed. As shown earlier and in the T-accounts provided here, completion occurs in 2015 for the Harding Construction example. Prior to then, construction in progress includes only costs, showing a balance of $1,500,000 and $2,500,000 of cost at the end of 2013 and 2014, respectively, and including $4,100,000 of cost when the project is completed in Harding includes an additional $900,000 of gross profit in construction in progress when the project is completed in 2015 because the asset is viewed as “sold” on that date. The company records revenue of $5,000,000, cost of construction (similar to cost of goods sold) of $4,100,000, and the resulting $900,000 gross profit on that date.

21. Timing of Gross Profit Recognition Under the Percentage-of-Completion Method
Under the percentage-of-completion method, profit is recognized over the life of the project as the project is completed.
We determine the amount of gross profit recognized in each period using the following logic:
Under the percentage-of-completion method, profit is recognized over the life of the project as the project is completed. Progress to date can be estimated as the proportion of the project’s cost incurred to date divided by total estimated costs, or by relying on an engineer’s or architect’s estimate. Regardless of the specific approach used to estimate progress to date, under the percentage-of-completion method we determine the amount of gross profit recognized in each period using the following logic:
Gross profit recognized this period = (total estimated gross profit × percentage completed to date) − gross profit recognized in prior periods, where total estimated gross profit = total estimated revenue – total estimated cost.

22. Percentage-of-Completion Method Allocation of Gross Profit
This slide illustrates the calculation of gross profit for each of the years for our Harding Construction Company example, with progress to date estimated using the cost-to-cost ratio. Earlier we showed the journal entries used to recognize gross profit in each period.

23. Percentage-of-Completion Method Allocation of Gross Profit
Notice that the gross profit recognized in each period is added to the construction in progress account.
The T-accounts for the percentage-of-completion method are illustrated on this slide. Notice that the gross profit recognized in each period is added to the construction in progress account.

24. Percentage-of-Completion Method Allocation of Gross Profit
The income statement for each year will report the appropriate revenue and cost of construction amounts.
Income statements are more informative if the sales revenue and cost components of gross profit are reported rather than the net figure alone. So, the income statement for each year will report the appropriate revenue and cost of construction amounts. For example, in 2013, the gross profit of $500,000 consists of revenue of $2,000,000 (40% of the $5,000,000 contract price) less the $1,500,000 cost of construction. In subsequent periods, we calculate revenue by multiplying the percentage of completion by the contract price and then subtracting revenue recognized in prior periods, similar to the way we calculate gross profit each period. The cost of construction, then, is the difference between revenue and gross profit. In most cases, cost of construction also equals the construction costs incurred during the period. The table on this slide shows the revenue and cost of construction recognized in each of the three years of our example. Of course, as you can see in this illustration, we could have initially determined the gross profit by first calculating revenue and then subtracting cost of construction.

25. Income Recognition
The same total amount of profit or loss is recognized under both the completed contract and the percentage-of-completion methods, but the timing of recognition differs.
Earlier we illustrated the journal entries that would determine the amount of revenue, cost, and therefore gross profit that would appear in the income statement under the percentage-of-completion and completed contract methods. Comparing the gross profit patterns produced by each method of revenue recognition demonstrates the essential difference as shown on this slide. Although both methods yield identical gross profit of $900,000 for the entire three-year period, the timing differs. The completed contract method defers all gross profit to 2015, when the project is completed. Obviously, the percentage-of-completion method provides a better measure of the company’s economic activity and progress over the three-year period. That’s why the percentage-of-completion method is preferred, and, as mentioned previously, the completed contract method should be used only when the company is unable to make dependable estimates of future costs necessary to apply the percentage-of-completion method.

26. Balance Sheet Recognition
The balance in the construction in progress account differs between methods because of the earlier gross profit recognition that occurs under the percentage-of-completion method.
The balance sheet presentation for the construction-related accounts by both methods is shown on this slide. The balance in the construction in progress account differs between methods because of the earlier gross profit recognition that occurs under the percentage-of-completion method.

27. Balance Sheet Recognition
Billings on construction contract are subtracted from construction in progress to determine balance sheet presentation.
CIP > Billings
Asset
In the balance sheet, the construction in progress (CIP) account (containing costs and profit) is offset against the billings on construction contract account, with CIP > Billings shown as an asset and Billings > CIP shown as a liability. Because a company may have some contracts that have a net asset position and others that have a net liability position, we usually will see both net assets and net liabilities shown in a balance sheet at the same time.
Construction in progress in excess of billings essentially represents an unbilled receivable. Companies include it in their balance sheets as a component of accounts receivable, as part of inventory, or on its own line. The construction company is incurring construction costs (and recognizing gross profit using the percentage-of-completion method) for which it will be paid by the buyer. If the construction company bills the buyer an amount exactly equal to these costs (and profits recognized) then the accounts receivable balance properly reflects the claims of the construction company. If, however, the amount billed is less than the costs incurred (plus profits recognized) the difference represents the remaining claim to cash—an asset.
On the other hand, billings in excess of construction in progress essentially indicates that the overbilled accounts receivable overstates the amount of the claim to cash earned to that date and must be reported as a liability. This is similar to the unearned revenue liability that is recorded when a customer pays for a product or service in advance. The advance is properly shown as a liability representing the obligation to provide the good or service in the future.
Billings > CIP
Liability

28. Long-term Contract Losses
Periodic Loss for Profitable Projects
Determine periodic loss and record loss as a credit to the construction in progress account.
Loss Projected for Entire Project
Estimated loss is fully recognized in the first period the loss is anticipated and is recorded by a credit to construction in progress account.
Unfortunately, losses sometimes occur on long-term contracts. Losses are recognized in the period in which they are determined, regardless of the revenue recognition method used.
For a periodic loss on an overall profitable project, the loss is recorded as a credit to the construction in progress account if the project is accounted for under the percentage-of-completion method. No entry is made under the completed contract method.
For an overall loss on the entire project, the estimated loss is fully recognized in the first period the loss is anticipated and is recorded by a credit to the construction in progress account.

29. U. S. GAAP vs. IFRS
There are similarities and differences between IFRS and U.S. GAAP when considering revenue recognition for long-term construction contracts.
Requires percentage-of-completion when reliable estimates can be made.
Requires completed contract method when reliable estimates can’t be made.
IAS No. 11 governs revenue recognition for long-term construction contracts. Like U.S. GAAP, that standard requires the use of the percentage-of-completion method when reliable estimates can be made. However, unlike U.S. GAAP, IAS No. 11 requires the use of the cost recovery method rather than the completed contract method when reliable estimates can’t be made. Under the cost recovery method, contract costs are expensed as incurred, and an offsetting amount of contract revenue is recognized to the extent that it is probable that costs will be recoverable from the customer. No gross profit is recognized until all costs have been recovered, which is why this method is also sometimes called the “zero-profit method.” Note that under both the completed contract and cost recovery methods no gross profit is recognized until the contract is essentially completed, but revenue and construction costs will be recognized earlier under the cost recovery method than under the completed contract method. Also, under both methods an expected loss is recognized immediately.
Requires percentage-of-completion when reliable estimates can be made.
Requires cost recovery method when reliable estimates can’t be made.

30. U. S. GAAP vs. IFRS
Notice that revenue recognition occurs earlier under the cost recovery method than under the completed contract method, but gross profit recognition occurs at the end of the contract for both methods.
To see the difference between the completed contract and cost recovery methods, this slide shows a comparison of the revenue, cost, and gross profit recognition under the two methods. Notice that revenue recognition occurs earlier under the cost recovery method than under the completed contract method, but gross profit recognition occurs at the end of the contract for both methods. As a result, gross profit as a percentage of revenue differs between the two methods at various points in the life of the contract.

31. Software and Other Multiple Deliverable Arrangements
If a sale includes multiple elements (software, future upgrades, post contract customer support, etc.), the revenue should be allocated to the various elements based on ‘vendor-specific objective evidence’ (VSOE) of fair values of the individual elements.
The software industry is a key economic component of our economy. Microsoft alone reported revenues in excess of $70 billion for its 2011 fiscal year. Yet, the recognition of software revenues has been a controversial accounting issue. The controversy stems from the way software vendors typically package their products. It is not unusual for these companies to sell multiple software deliverables in a bundle for a lump-sum contract price. The bundle often includes product, upgrades, post contract customer support, and other services. The critical accounting question concerns the timing of revenue recognition.
The American Institute of Certified Public Accountants (AICPA) issued authoritative guidance in this area. The AICPA position indicates that if an arrangement includes multiple elements, the revenue from the arrangement should be allocated to the various elements based on ‘Vendor-Specific Objective Evidence’ (VSOE) of fair values of the individual elements. It doesn’t matter what separate prices are indicated in the multiple-element contract. Rather, the VSOE of fair values are the sales prices of the elements when sold separately by that vendor. If VSOE doesn’t exist, revenue recognition is deferred until VSOE is available or until all elements of the arrangement are delivered.

32. Software and Other Multiple Deliverable Arrangements
The FASB’s Emerging Issues Task Force (EITF) issued guidance to broaden the application of this basic perspective to other arrangements that involve “multiple deliverables,” such as sales of appliances with maintenance contracts, cellular phone contracts that come with a “free phone,” and even painting services that include sales of paint as well as labor.
Sellers offering other multiple-deliverable contracts now are allowed to estimate selling prices when they lack VSOE from stand-alone sales prices. Using estimated selling prices allows earlier revenue recognition than would be allowed if sellers had to have VSOE in order to recognize revenue.
More recently, the FASB’s Emerging Issues Task Force (EITF) issued guidance to broaden the application of this basic perspective to other arrangements that involve “multiple deliverables.” Examples of such arrangements are sales of appliances with maintenance contracts, cellular phone contracts that come with a “free phone,” and even painting services that include sales of paint as well as labor. Other examples are products that contain both hardware and software essential to the functioning of the product, such as computers and smart phones that are always sold with an operating system. Now, as with software-only contracts, sellers allocate total revenue to the various parts of a multiple-deliverable arrangement on the basis of the relative stand-alone selling prices of the parts. Sellers must defer revenue recognition for parts that don’t have stand-alone value, or whose value is contingent upon other undelivered parts. However, unlike software-only arrangements, sellers offering other multiple-deliverable contracts now are allowed to estimate selling prices when they lack VSOE from stand-alone sales prices. Using estimated selling prices allows earlier revenue recognition than would be allowed if sellers had to have VSOE in order to recognize revenue.
For some sellers this change had a huge effect. As an example, consider and the highly successful iPhone. Apple used to defer revenue on iPhones and other products because it didn’t have VSOE of the sales price of future software upgrades included with the phones. This practice resulted in over $12 billion of deferred (unearned) revenue as of the end of fiscal The adoption of the new accounting principles increased the Company’s net sales by $6.4 billion, $5.0 billion, and $572 million for 2009, 2008 and 2007, respectively. After this accounting change, Apple recognizes almost all of the revenue associated with an iPhone at the time of sale. The only amount deferred is the small amount of revenue estimated for future software upgrade rights.

33. U. S. GAAP vs. IFRS
IFRS contains very little guidance about multiple-deliverable arrangements.
Revenue should be allocated to the various elements based on ‘vendor-specific objective evidence’ (VSOE) of fair values of the individual elements.
May be necessary to apply the recognition criteria to the separately identifiable components of a single transaction.
Allocation of total revenue to individual components are based on fair value, with no requirements to focus on VSOE.
IFRS contains very little guidance about multiple-deliverable arrangements. IAS No. 18 simply states that: ”. . . in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction” and gives a couple of examples. Allocations of total revenue to individual components are based on fair value, with no requirements to focus on VSOE. Also, IFRS tends to encourage focus on the underlying economics of revenue transactions, so particular contractual characteristics like contingencies may matter less under IFRS than they do under U.S. GAAP.

34. Franchise Sales Initial Franchise Fees Continuing Franchise Fees
Generally are recognized at a point in time when the earnings process is virtually complete.
Continuing Franchise Fees
Recognized over time as the services are performed.
The use of franchise arrangements has become increasingly popular in the United States over the past 30 years. In the franchise arrangement, the franchisor grants to the franchisee the right to sell the franchisor’s products and use its name for a specified period of time. The fees paid by the franchisee to the franchisor usually comprise the initial franchise fee and the continuing franchise fee.
Continuing franchise fees are paid to the franchisor for continuing rights as well as for advertising and promotion and other services provided over the life of the franchise agreement. These fees sometimes are a fixed annual or monthly amount, a percentage of the volume of business done by the franchise, or a combination of both. Continuing franchise fees are recognized over time as the services are performed.
The challenging revenue recognition issue pertains to the initial franchise fee. The initial franchise fee is usually a fixed amount that may be payable in installments. In many cases, the initial franchise fee covers significant services to be performed in the future. And, if the fee is payable in installments over an extended period of time, it creates an additional concern of collectibility. Specific guidance for revenue recognition of the initial franchise fee is provided in U.S. GAAP, which requires that substantially all of the initial services of the franchisor required by the franchise agreement be performed before the initial franchise fee can be recognized as revenue. In situations where the initial franchise fee is collectible in installments, the installment sales method or cost recovery method should be used for profit recognition, if a reasonable estimate of uncollectibility cannot be made.

35. The Boards appear committed to improving accounting in this area.
U. S. GAAP vs. IFRS
The FASB and IASB are currently working on a new, comprehensive approach to revenue recognition.
Has over 100 revenue-related standards that sometimes contradict each other.
Has two primary standards that also sometimes contradict each other and that don’t offer guidance in some important areas (like multiple deliverables).
The FASB and IASB are in the process of finalizing an Accounting Standards Update (ASU) that provides a new, comprehensive approach to revenue recognition. Why? Currently, the FASB has over 100 revenue-related standards that sometimes contradict each other and that treat similar economic events differently. The IASB has two primary standards (IAS No. 11 and IAS No. 18) that also sometimes contradict each other and that don’t offer guidance in some important areas (like multiple deliverables). And, although both the FASB and IASB define revenue in terms of flows of assets and liabilities, the FASB guidance typically bases revenue recognition on the earnings process, while the IASB standards base it on the transfer of the risks and rewards of ownership, which can lead to different outcomes. So, the accounting guidance on revenue recognition could use some improvement.
The Boards’ new approach is similar in many ways to the current U.S. guidance for recognizing revenue on multiple-deliverable contracts. The focus is on contracts between a seller and a buyer. A seller identifies all of its distinct performance obligations under a contract, determines the transaction price of the contract, and then allocates that price to the various performance obligations according to the estimated stand-alone selling prices of those obligations. The seller then recognizes revenue as each of those performance obligations is satisfied.
For many types of sales arrangements, adopting the ASU will not change current practice. However, it will create consistency in revenue recognition across industries, and in some areas it will change practice considerably. For example, estimates of variable future payments will be included in revenue to a greater extent than exists currently, affecting revenue recognition on many contracts that peg future payments to future outcomes. Also, while companies still will estimate bad debts, an inability to estimate bad debts will not prevent revenue recognition, so the installment and cost-recovery methods will not exist.
The Boards appear committed to improving accounting in this area.

36. Activity Ratios
Activity ratios measure a company’s efficiency in managing its assets. Although, in concept, the activity or turnover can be measured for any asset, activity ratios are most frequently calculated for accounts receivable, inventory, and total assets.
The asset turnover ratio is calculated as net sales divided by average total assets. This ratio measures how efficiently a company utilizes all of its assets to generate revenue.
The receivables turnover ratio is calculated as net sales divided by average accounts receivable. Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. The denominator is determined by adding beginning and ending net accounts receivable and dividing by two. This ratio measures how many times a company converts its receivables into cash each year. The higher the ratio, the shorter the average time between credit sales and cash collection.
The average collection period is calculated as 365 divided by the receivables turnover ratio. This ratio is an approximation of the number of days the average accounts receivable balance is outstanding.
The inventory turnover ratio is calculated as cost of goods sold divided by average inventory. The denominator is determined by adding beginning and ending inventory and dividing by two. This ratio measures the number of times merchandise inventory is sold and replaced during the year. A relatively high ratio, say compared to a competitor, usually is desirable. However, as with most ratios, care must be taken in interpretation. For example, a high ratio could indicate comparative strength in a company’s sales force or it could indicate a relatively low inventory level, which could lead to stockouts and lost sales.
The average days in inventory is calculated as 365 divided by the inventory turnover ratio. This ratio indicates the number of days it normally takes to sell inventory.
Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.

37. Return on Equity Key Components
Profitability Ratios
Return on Equity Key Components
Profitability
Activity
Financial Leverage
Profitability ratios attempt to measure a company’s ability to earn an adequate return relative to sales or resources devoted to operations. Three common profitability ratios are the profit margin on sales, the return on assets, and the return on shareholders’ equity.
Profit margin on sales is calculated as net income divided by net sales. This ratio indicates the portion of each dollar of revenue that is available to cover expenses.
Return on assets is calculated as net income divided by average total assets. Profit margin and asset turnover combine to yield return on assets , which measures the return generated by a company’s assets.
Return on equity is calculated as net income divided by average shareholders’ equity. This ratio measures the ability of management to generate net income from the resources the owners provide. In addition to monitoring return on equity, investors want to understand how that return can be improved.
There are three key components to the return on equity:
Profitability is measured by the profit margin (Net Income divided by Sales). A higher profit margin indicates that a company is generating more profit from each dollar of sales.
Activity is measured by asset turnover (Sales divided by Average Total Assets). A higher asset turnover indicates that a company is using its assets efficiently to generate more sales from each dollar of assets.
Financial Leverage is measured by the equity multiplier (Average Total Assets divided by Average Total Equity). A high equity multiplier indicates that relatively more of the company’s assets have been financed with debt. Leverage can provide additional return to the company’s equity holders.

38. DuPont Framework
The DuPont framework helps identify how profitability, activity, and financial leverage trade off to determine return to shareholders:
Return on
equity =
Profit margin X
Asset
turnover
Equity
multiplier
Net income
Avg. total
Total sales
Avg. total assets
Avg. total equity
Because profit margin and asset turnover combine to equal return on assets, the DuPont framework can also be written as:
Part I
The DuPont framework shows that return on equity depends on profitability, activity, and financial leverage. In equation form, the DuPont framework is profit margin times asset turnover times the equity multiplier. Notice that total sales and average total assets appear in the numerator of one ratio and the denominator of another. Although the DuPont framework computations use the term “total sales,” it refers to “net sales,” which is sales net of sales returns and allowances.
Part II
So, they cancel to yield net income divided by average total equity, or return on assets. This provides another way to compute ROE as return on assets times the equity multiplier.
This is called the DuPont framework because the DuPont Company was a pioneer in emphasizing this relationship.
Return on equity =
Return on assets X
Equity
multiplier
Net income
Avg. total equity
Avg. total assets

39. Appendix 5: Interim Reporting
Issued for periods of less than a year, typically as quarterly financial statements.
Serves to enhance the timeliness of financial information.
Appendix 5: Interim Reporting
Financial statements covering periods of less than a year are called interim reports. Companies registered with the SEC, which includes most public companies, must submit quarterly reports. Though there is no requirement to do so, most also send quarterly reports to their shareholders and typically include abbreviated, unaudited interim reports as supplemental information within their annual reports.
For accounting information to be useful to decision makers, it must be available on a timely basis. One of the objectives of interim reporting is to enhance the timeliness of financial information. In addition, quarterly reports provide investors and creditors with additional insight on the seasonality of business operations that might otherwise get lost in annual reports.
However, the downside to these benefits is the relative unreliability of interim reporting. With a shorter reporting period, questions associated with estimation and allocation are magnified. The fundamental debate regarding interim reporting centers on the choice between the discrete and integral part approaches.
Fundamental debate centers on the choice between the discrete and integral part approaches.

40. Interim Reporting Reporting Revenues and Expenses
With only a few exceptions, the same accounting principles applicable to annual reporting are used for interim reporting.
Reporting Unusual Items
Discontinued operations and extraordinary items are reported entirely within the interim period in which they occur.
Earnings Per Share
Quarterly EPS calculations follow the same procedures as annual calculations.
Part I
With only a few exceptions, the same accounting principles applicable to annual reporting are used for interim reporting of revenues and expenses. For example, costs and expenses subject to year-end adjustments, such as depreciation and bad debt expense, are estimated and allocated to interim periods in a systematic way.
Part II
On the other hand, discontinued operations and extraordinary items should be reported separately in the interim period in which they occur. That is, these amounts should not be allocated among individual quarters within the fiscal year. The same is true for items that are unusual or infrequent but not both. Notice that treatment of these items is more consistent with the discrete view than the integral part view.
Part III
Quarterly EPS calculations follow the same procedures as annual calculations, which is consistent with the discrete view.
Part IV
Accounting changes made in an interim period are reported by retrospectively applying the changes to prior interim financial statements. Then in financial reports of subsequent interim periods of the same fiscal year, we disclose how that change affected income from continuing operations, net income, and related per share amounts for the postchange interim period.
Reporting Accounting Changes
Accounting changes made in an interim period are reported by retrospectively applying the changes to prior financial statements.

41. U. S. GAAP vs. IFRS
IAS No. 34 requires that a company apply the same accounting policies in its interim financial statements as it applies in its annual financial statements.
Costs for repairs, property taxes, and advertising that do not meet the definition of an asset at the end of an interim period are accrued or deferred and then charged to each of the periods they benefit.
Costs for repairs, property taxes, and advertising that do not meet the definition of an asset at the end of an interim period are expensed entirely in the period in which they occur.
IAS No. 34 requires that a company apply the same accounting policies in its interim financial statements as it applies in its annual financial statements. Therefore, IFRS takes much more of a discrete-period approach than does U.S. GAAP. For example, costs for repairs, property taxes, and advertising that do not meet the definition of an asset at the end of an interim period are expensed entirely in the period in which they occur under IFRS, but are accrued or deferred and then charged to each of the periods they benefit under U.S. GAAP. This difference would tend to make interim period income more volatile under IFRS than under U.S. GAAP. However, as in U.S. GAAP, income taxes are accounted for based on an estimate of the tax rate expected to apply for the entire year.
This difference would tend to make interim period income more volatile under IFRS than under U.S. GAAP.

42. Appendix 5: Interim Reporting
Minimum Disclosures
Sales, income taxes, and net income
Earnings per share
Seasonal revenues, costs, and expenses
Significant changes in estimates for income taxes
Discontinued operations, extraordinary items, and unusual or infrequent items
Contingencies
Changes in accounting principles or estimates
Information about fair value of financial instruments and the methods and assumptions used to estimate fair values
Significant changes in financial position
Appendix 5: Interim Reporting
Complete financial statements are not required for interim reporting, but certain minimum disclosures are required as follows:
sales, income taxes, and net income
earnings per share
seasonal revenues, costs, and expenses
significant changes in estimates for income taxes
discontinued operations, extraordinary items, and unusual or infrequent items
contingencies
changes in accounting principles or estimates
information about fair value of financial instruments and the methods and assumptions used to estimate fair values
significant changes in financial position.

43. Revenue Recognition: A Chapter Supplement
Core Revenue Recognition Principle
A company must recognize revenue when goods or services are transferred to customers in an amount that reflects the consideration the company expects to receive in exchange for those goods or services.
Key Steps in Applying the Principle
Identify a contract with a customer.
Identify the performance obligation(s) in the contract.
Determine the transaction price.
Allocate the transaction price to the performance obligations.
Recognize revenue when each performance obligation is satisfied.
Revenue Recognition: A Chapter Supplement
The FASB and the IASB are collaborating on several major new standards designed in part to move U.S. GAAP and IFRS closer together (convergence). This reading is based on their joint Exposure Draft of a new revenue recognition Accounting Standards Update (proposed ASU) and “tentative decisions” of the Boards after receiving feedback from the Exposure Draft as of the date this text went to press.
In June 2010 the FASB and IASB issued identical Exposure Drafts (ED) for a new ASU entitled “Revenue from Contracts with Customers,” and followed up with another Exposure Draft in 2011.  The purpose of the proposed ASU is to improve revenue recognition guidance and in the process to eliminate current revenue recognition differences among industries and between U.S. GAAP and IFRS. It appears likely that the proposed ASU will become effective for fiscal years starting no sooner than 2015.
The core revenue recognition principle and key application steps of the proposed ASU are as follows:
Core Revenue Recognition Principle: A company must recognize revenue when goods or services are transferred to customers in an amount that reflects the consideration the company expects to receive in exchange for those goods or services.
Key Steps in Applying the Principle
Identify a contract with a customer.
Identify the performance obligation(s) in the contract.
Determine the transaction price.
Allocate the transaction price to the performance obligations.
Recognize revenue when each performance obligation is satisfied.

44. Step 1: Identify the Contract
Under the proposed ASU, we recognize revenue associated with contracts that are legally enforceable.
Step 1: Identify the Contract
Under the proposed ASU, we recognize revenue associated with contracts that are legally enforceable. We normally think of a contract as being specified in a written document, but that doesn’t have to be the case for revenue recognition to occur. Contracts can be oral rather than written. They can be explicit, but they also can be implicit based on the typical business practices that a company uses to sell products or services.
An enforceable contract exists for purposes of revenue recognition when the contract meets five criteria.
Commercial substance. The contract is expected to affect the seller’s future cash flows.
Approval. Each party to the contract has approved the contract and is committed to satisfying their respective obligations.
Rights and obligations. Each party’s rights and obligations are specified.
Payment terms. The terms and manner of payment are specified.
Performance. A contract does not exist if both parties can terminate the contract without penalty before any obligations are performed.

45. Step 2: Identify the Performance Obligation(s)
Performance obligations are promises to transfer goods or services to the buyer and are accounted for separately if they are distinct.
A performance obligation is accounted for separately from other performance obligations if it is distinct, which is the case if either:
The seller regularly sells the good or service separately, or
The seller could sell it separately (the customer can use the good or service on its own or together with other readily available resources).
Step 2: Identify the Performance Obligation(s)
Once a contract is identified, the next step is to determine what performance obligation(s) the seller must satisfy to fulfill the contract. A contract could obligate a seller to provide multiple goods and services. For example, when Verizon signs up a new cell phone customer, the sales contract could require delivery of a smart phone, delivery of the related software, and provision of a warranty on the phone, ongoing network access, and optional future upgrades.
For purposes of revenue recognition, the key consideration is whether promises to transfer goods and services constitute distinct performance obligations. A performance obligation is accounted for separately from other performance obligations if it is distinct, which is the case if either:
The seller regularly sells the good or service separately, or
The seller could sell it separately (the customer can use the good or service on its own or together with other readily available resources).
Performance obligations are accounted for separately if they are distinct.

46. Step 2: Identify the Performance Obligation(s)
If a seller integrates goods and services into one asset, they are viewed as providing an integration service that qualifies as a single performance obligation.
A bundle of goods or services is viewed as a single performance obligation if both of the following are true:
The goods or services in the bundle are highly interrelated and the seller provides a significant service of integrating them into a combined item.
The bundle is significantly modified or customized for the customer.
Sometimes, though, a seller provides the service of integrating a bundle of promised goods or services into a single item that is delivered to a customer. In that case, we view the seller as providing a single integration service that we consider to be a single performance obligation. For example, when a construction company integrates many goods and services to provide a finished building, we view the construction company as providing an integration service that is a single performance obligation.
A bundle of goods or services is viewed as a single performance obligation if both of the following are true:
The goods or services in the bundle are highly interrelated and the seller provides a significant service of integrating them into a combined item.
The bundle is significantly modified or customized for the customer.

47. Step 3: Determine the Transaction Price
Determining the transaction price is simple if the buyer pays a fixed amount immediately or in the near future.
Variable Consideration
Time Value of Money
Collectability of the Transaction Price
Complications in Determining Transaction Price
Step 3: Determine the Transaction Price
Determining the transaction price is simple if the buyer pays a fixed amount immediately or in the near future. However, in some contracts this determination is more difficult. Specific complications include variable consideration, time value of money, and collectability of the transaction price.
Variable consideration: Variable consideration exists when a transaction price is uncertain because some of the price is to be paid to the seller is dependent on future events. Such variable consideration occurs in many industries, including construction (incentive payments), entertainment and media (royalties), healthcare (Medicare and Medicaid reimbursements), manufacturing (volume discounts), and telecommunications (rebates). If a reasonable estimate of variable consideration can be made, the seller should include it in the transaction price. The seller should estimate the variable consideration as either the probability-weighted amount or the most likely amount, depending on which better predicts the amount that the seller will receive.
Time value of money: If delivery and payment occur relatively near each other, the time value of money is not significant and it can be ignored. However, if the time value of money is significant, a sales transaction is viewed as including two parts: a delivery component (for goods or services) and a financing component (either interest paid to the buyer in the case of a prepayment or to the seller in the case of a receivable).
Collectability of the transaction price: Whenever sales are made on credit, there is some potential for bad debts. Under the proposed ASU, an estimate is made of the amount of bad debts, and that amount is treated as a contra-revenue, similar to how sales returns are treated in current GAAP. The estimated amount of bad debts, which the proposed ASU refers to as an “impairment resulting from credit risk,” is presented in the income statement as a separate line item immediately below gross revenue that reduces gross revenue to a net amount.

48. Accounting for Variable Consideration When it Can be Reasonably Estimated
TrueTech enters into a contract with ProSport Gaming to add ProSport’s online games to the Tri-Net network. ProSport will pay TrueTech an up-front $300,000 fixed fee for six months of featured access, as well as a $200,000 bonus if Tri-Net users access ProSport products for at least 15,000 hours during the six month period. TrueTech estimates a 75% chance that it will achieve the usage target and earn the $200,000 bonus.
Using the probability-weighted amount process, TrueTech would calculate the expected amount of each possible outcome by multiplying the possible amount times the probability. In this example, TrueTech would multiple $500,000 times 75% and $300,000 times 25% to arrive at the expected contract price at inception of $450,000.

49. Accounting for Variable Consideration When it Can be Reasonably Estimated
If TrueTech used the most likely amount approach, it would take the most likely amount of bonus of $200,000 and add it to the $300,000 fixed fee to arrive at $500,000.
In this TrueTech example, the company would use the estimate based on the most likely amount, $500,000, because only two outcomes are possible, and it is likely that the bonus will be received. In each successive month, TrueTech would recognize one month’s revenue based on a total transaction price of $500,000, reducing unearned revenue and recognizing bonus receivable as shown here.
After six months, TrueTech’s unearned revenue account would be reduced to a zero balance, and the bonus receivable would have a balance of $200,000. At that point TrueTech would know if the usage of ProSport products had reached the bonus threshold and would make of the the two journal entries shown at the bottom of this slide, depending on whether TrueTech receives the bonus or not.

50. The Time Value of Money
If the time value of money is significant, a sales transaction is viewed as including two parts: a delivery component and a financing component.
It is common for contracts to specify that payment occurs before or after delivery. If the time value of money is significant, a sales transaction is viewed as including two parts: a delivery component and a financing component.
On January 1, 2013, TrueTech enters into a contract with GameStop Stores to deliver four Tri-Box modules that have a fair value of $1,000.
Prepayment Case: GameStop pays TrueTech $907 on January 1, 2013 and TrueTech agrees to deliver the modules on December 31, GameStop pays significantly in advance of delivery, such that TrueTech is viewed as borrowing money from GameStop and TrueTech incurs interest expense.
Receivable Case: TrueTech delivers the modules on January 1, 2013 and GameStop agrees to pay TrueTech $1,000 on December 31, TrueTech delivers the modules significantly in advance of payment, such that TrueTech is viewed as loaning money to GameStop and TrueTech earns interest revenue.
The fiscal year-end for both companies is December 31. The time value of money in both cases is 5%.

51. The Time Value of Money
When TrueTech receives payment before delivery, on January 1, 2013, TrueTech credits unearned revenue for the present value of the contract, $907. Then on December 31, 2013, TrueTech will record accrued interest expense of $45 by debiting interest expense and crediting unearned revenue. When delivery occurs December 31, 2014, TrueTech will debit interest expense for $48 and unearned revenue for $952 and credit revenue for $1,000.
When TrueTech receives payment after delivery, on January 1, 2013, TrueTech debits accounts receivable and credits revenue for $1,000. Then on December 31, 2013, TrueTech will record accrued interest revenue of $50 by debiting accounts receivable crediting interest revenue. When the payment occurs on December 31, 2014, TrueTech will debit cash for $1,013 and credit interest revenue for $53 and accounts receivable for $1,050.

52. Step 4: Allocate the Transaction Price to the Performance Obligations
If an arrangement has more than one distinct performance obligation, the seller allocates the transaction price to the separate performance obligations in proportion to the standalone selling price of the goods or services underlying those performance obligations.
Step 4: Allocate the Transaction Price to the Performance Obligations
If an arrangement has more than one distinct performance obligation, the seller allocates the transaction price to the separate performance obligations in proportion to the standalone selling price of the goods or services underlying those performance obligations. If the seller can’t observe actual standalone selling prices, the seller should estimate them.

53. Step 4: Allocate the Transaction Price to the Performance Obligations
TrueTech Industries manufactures the Tri-Box System, a multiplayer gaming system allowing players to compete with each other over the Internet.
The Tri-Box System has a wholesale price of $270, which includes the physical Tri-Box console as well as a one-year subscription to the Tri-Net of Internet-based games and other applications.
Owners of Tri-Box modules as well as other game consoles can purchase one-year subscriptions to the Tri-Net from TrueTech for $50.
TrueTech does not sell a Tri-Box module without the initial one-year Tri-Net subscription, but estimates that it would charge $250 per unit if it chose to do so.
CompStores orders 1,000 Tri-Boxes at the normal wholesale price of $270. Because the standalone price of the Tri-Box module ($250) represents 5/6  of the total fair values ($250 ÷ [$ ]), and the Tri-Net subscription comprises 1/6  of the total ($50 ÷ [$ ]), we allocate 5/6  of the transaction price to the Tri-Boxes and 1/6  of the transaction price to the Tri-Net subscriptions. Accordingly, TrueTech would recognize the following journal entry (ignoring any entry to record the reduction in inventory and the corresponding cost of goods sold): debit accounts receivable for $270,000 and credit revenue for $225,000 and unearned revenue for $45,000.
TrueTech then converts the unearned revenue to revenue over the one-year term of the Tri-Net subscription as that revenue is earned.

54. Step 5: Recognize Revenue When Each Performance Obligation Is Satisfied
In general, a seller recognizes revenue allocated to each performance obligation when it satisfies the performance obligation.
Step 5: Recognize Revenue When Each Performance Obligation Is Satisfied
In general, a seller recognizes revenue allocated to each performance obligation when it satisfies the performance obligation.
A performance obligation is satisfied over time if at least one of the following two criteria is met:
The seller is creating or enhancing an asset that the buyer controls as the service is performed. OR
The seller is not creating an asset that the buyer controls or that has alternative use to the seller, and at least one of the following conditions hold:
The buyer simultaneously receives and consumes a benefit as the seller performs.
Another seller would not need to reperform the tasks performed to date if that other seller were to fulfill the remaining obligation.
The seller has the right to payment for performance even if the buyer could cancel the contract, and it expects to fulfill the contract.
If a performance obligation meets at least one of the criteria above, we recognize revenue over time, in proportion to the amount of the performance obligation that has been satisfied. For example, if one-third of the service has been performed, one-third of performance obligation has been satisfied, so one-third of the revenue should be recognized.

55. Step 5: Recognize Revenue When Each Performance Obligation Is Satisfied
If a performance obligation is not satisfied over time, it is satisfied at a single point in time, when the seller transfers control of goods to the buyer. Often transfer of control is obvious and coincides with delivery. In other circumstances, though, transfer of control is not as clear.
If a performance obligation is not satisfied over time, it is satisfied at a single point in time, when the seller transfers control of goods to the buyer. Often transfer of control is obvious and coincides with delivery. In other circumstances, though, transfer of control is not as clear.
There are five key indicators that should be considered when judging whether control of a good has passed from the seller to the buyer, but sellers also should consider whether other indicators are appropriate.
The five key indicators that control of a good has passed from the seller to the buyer are:
Buyer has an unconditional obligation to pay.
Buyer has legal title.
Buyer has physical possession.
Buyer assumes risks and rewards of ownership.
The buyer has accepted the asset.

56. End of Chapter 5
End of Chapter 5.