1. TENTH CANADIAN EDITION INTERMEDIATE ACCOUNTING Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto 6 CHAPTER 6 Revenue Recognition Kieso Weygandt Warfield Young Wiecek McConomy

2. CHAPTER Copyright © John Wiley & Sons Canada, Ltd. 6 After studying this chapter, you should be able to: Understand the economics and legalities of selling transactions from a business perspective. Analyze and determine whether a company has earned revenues. Discuss issues relating to measurement and measurement uncertainty. Understand how to account for sales where there is collection uncertainty. Prepare journal entries for consignment sales and long-term contracts. Understand how to present sales transactions in the income statement and prepare basic disclosures. Discuss current trends in standard setting for revenue recognition including the contract-based approach. Identify differences in accounting between ASPE and IFRS. Revenue Recognition 2

3. 3 Copyright © John Wiley & Sons Canada, Ltd. Revenue Recognition Understanding the nature of sales transactions from a business perspective Economics of business transactions Legalities Information for decision-making Presentation and disclosure Presentation Disclosure Contract- based revenue recognition model Core principle Five steps Other issues regarding the contract- based approach Recognition and Measurement Earnings process Measurability Collectibility Mechanics IFRS / ASPE comparison Comparison of IFRS and ASP Looking ahead

4. 4 Copyright © John Wiley & Sons Canada, Ltd. Understanding Sales Transactions Accounting for revenues is often very complex Much of complexity is caused by the structure of the sales transactions To properly account for sales transactions, accountants must understand the business of the entity and the nature of the transaction Key questions for understanding the sales transactions from a business perspective are: –What is being given up? –What is being received? Normally specified in sales agreements

5. 5 Copyright © John Wiley & Sons Canada, Ltd. What is being sold? Sales transactions often involve transfer of goods, services, or both (known as deliverables) Accounting is different under each situation –Sale of goods: physical assets with finite point when control transfers to buyer (generally with transfer of legal title and possession) –Sale of services: legal title and possession irrelevant –Sale of goods and/or services combinations: complexity in measuring each component of bundled sales or multiple deliverables 5

6. 6 Copyright © John Wiley & Sons Canada, Ltd. What is being received? Consideration being received for goods and/or services sold is either: –Cash or cash-like (monetary) –Non-monetary (another good/service, also known as barter) Generally assume that the transaction is at arm’s length (between unrelated parties) such that Value of deliverables sold Value of consideration received =

7. 7 Copyright © John Wiley & Sons Canada, Ltd. Concessionary Terms It is critical to understand if sales are done under normal terms, or are special/unusual and contain concessionary terms such as: –Lenient return/payment policy –More accommodating credit policy –“Bill and hold” transactions –Inclusion of “extras” Concessionary terms may create additional obligations, or may indicate that control has not passed to the buyer

8. 8 Copyright © John Wiley & Sons Canada, Ltd. Legalities Rights and obligations of sales transactions are described and governed by law Contract law is most relevant as each sales transaction represents a contract with the customer Contract creates enforceable obligations and establishes the terms of the deal Sales contract generally determines the point when legal title and possession of goods sold pass on to the customer: –FOB shipping point –FOB destination Implicit obligations not specifically outlined in the sales contract (i.e. constructive obligation) may also be enforced under common or other law

9. 9 Copyright © John Wiley & Sons Canada, Ltd. Sales Transactions Revenue/sales is described as: –inflow of economic benefits (e.g. Cash, receivables, etc) –arising from ordinary activities There are two main conceptual views on how to account for revenues/sales: –Earnings approach –Contract-based approach

10. 10 Copyright © John Wiley & Sons Canada, Ltd. Earnings Approach Revenues for the sale of goods are recognized when the following criteria are met: 1.Risks and rewards of ownership are transferred to the buyer 2.Seller has no continuing involvement in, nor effective control over the sold goods 3.Costs and revenues can be reliably measured; and 4.Collectibility is probable

11. 11 Copyright © John Wiley & Sons Canada, Ltd. Earnings Approach – Selling Goods Two indicators of whether risk and rewards transfer from seller to buyer: –Who has the legal title to the goods sold? –Who has the possession of the goods sold? In some situations, risks and rewards may be considered to transfer even if legal title and/or possession don’t pass to the buyer –Example: forestry and agricultural products with assured prices and available markets

12. 12 Copyright © John Wiley & Sons Canada, Ltd. Earnings Approach - Services and Long-Term Contracts The earnings process for services is different than for the sale of goods For the sale of goods, delivery of the goods is the generally critical event For services, the performance of the service (which may be on-going or continuous) is the determination of revenue recognition Recognize revenue at each critical event, as long as it is collectible

13. 13 Copyright © John Wiley & Sons Canada, Ltd. Earnings Approach - Services and Long-Term Contracts There are two main ways of accounting for long-term contracts and other service contracts: –Percentage-of-Completion Method recognizes revenues and gross profit each period based on progress or contract completion –Completed-Contract Method recognizes revenue and gross profit only after the whole contract is completed When performance consists of many ongoing acts (i.e. continuous earnings process), then percentage-of-completion is preferred, as long as the company can measure the transaction When performance consists of a single act (i.e. discrete earnings process) or progress cannot be measured, then completed-contract method may be used IFRS makes no mention of completed-contract method and allows recognition of recoverable revenues equal to costs incurred if outcome is not reliably measurable (i.e. “zero-profit method”).

14. 14 Copyright © John Wiley & Sons Canada, Ltd. Measurability Sales are generally measured at fair value (reflecting also time value of money for consideration paid over extended period of time) Measurement uncertainty generally arises when: –we cannot measure the consideration –we cannot measure related costs, or –we cannot measure the outcome of the transaction There are two main options for revenue recognition under measurement uncertainty: –Do not recognize revenues until measurement uncertainty resolved –Recognize revenues but measure and accrue amount relating to uncertainty as a cost or reduced revenues (preferred)

15. 15 Copyright © John Wiley & Sons Canada, Ltd. Measuring Parts of a Sale More complex when sale creates multiple deliverables (e.g., a product and a service-a telephone company would sell a phone and a monthly service) GAAP says to separate each deliverable, if possible Overall price can be allocated using two methods: –Relative fair value method –Residual value method Timing of recognition for each deliverable is determined individually with reference to GAAP If components cannot be measured individually, then revenue recognition criteria are applied to the bundled sale as a whole (as if one product/service)

16. 16 Copyright © John Wiley & Sons Canada, Ltd. Collectibility In order to recognize revenues at time of sale, it is necessary to establish ultimate collectibility If collectibility cannot be reasonably assured, then revenues cannot be recognized at the time of sale –Accounting treatment defaults to cash basis (i.e. recognize income as cash is received)

17. 17 Copyright © John Wiley & Sons Canada, Ltd. Consignment Sales Consignor ships inventory to the consignee The consignee acts as an agent to sell the inventory Possession has transferred; however legal title remains with the seller Risks and rewards have not transferred Goods are held by seller as “Inventory on Consignment” Not held as inventory on consignee’s books When merchandise sold, the consignee remits cash to the consignor (after deducting commission and other chargeable expenses)

18. 18 Copyright © John Wiley & Sons Canada, Ltd. Consignment Sales – Earnings Goods shipped to Consignee Inventory on Consignment $$$ Finished Goods Inventory $$$ Payment of Freight Inventory on Consignment $$$ Cash $$$ Notification of Sale Accounts Receivable $$$ Relevant Expenses $$$ Consignment Sales $$$ Cost of Goods Sold $$$ Inventory on Consignment $$$ (Note: cost includes freight) Receipt of Cash from Sale Cash $$$ Accounts Receivable $$$ No Entry Notification/Payment of Sale Cash$$$ Payable to Consignor $$$ Remittance to Consignor Payable to Consignor $$$ Commission Revenue $$$ Cash $$$ Consignor’s BooksConsignee’s Books

19. 19 Copyright © John Wiley & Sons Canada, Ltd. Percentage-of-Completion: Earnings Approach The amount of revenues, costs and gross profit recognized on long term contracts depends upon the percentage of work done Application of percentage-of-completion method requires a basis for measuring the progress toward completion at interim dates, and is based on significant judgement Can use input measures (e.g. costs incurred — which is the most popular method — or labour hours worked) Can use output measures (e.g. storeys of a building completed, tonnes produced)

20. 20 Copyright © John Wiley & Sons Canada, Ltd. Percentage-of-Completion: Steps Costs incurred to date = Percent complete Most recent estimated total costs 1 Percent complete x Estimated total revenue (or GP) = Revenue to be recognized to date 2 Revenue (or GP) to be recognized to date – Revenue (or GP) recognized in prior periods = Current period revenue (or GP)* *Current period revenue – Current costs = Gross Profit 3 4

21. 21 Copyright © John Wiley & Sons Canada, Ltd. Percentage-of-Completion: Cost-to-Cost Basis Data: Contract price: $4,500,000 Estimated cost: $4,000,000 Start date: July, 2014 Finish: October, 2016 Balance sheet date: December 31 st Given: 2014 2015 2016 Costs to date$1,000,000 $2,916,000 $4,050,000 Estimated costs to complete $3,000,000 $1,134,000 $ -0- Progress billings during year$ 900,000 $2,400,000 $1,200,000 Cash collected during year$ 750,000 $1,750,000 $2,000,000

22. 22 Copyright © John Wiley & Sons Canada, Ltd. Percentage-of-Completion: Cost-to-Cost Basis 2014 2015 2016 $4,500,000 $4,500,000 $4,500,000 Contract Price (a) 1,000,000 2,916,000 4,050,000 3,000,000 1,134,000 -0- 4,000,000 4,050,000 4,050,000 Less: Estimated Costs Costs to Date Est. Cost to Complete Est. Total Costs (b) 25% 72% 100% 1,000,000 2,916,000 4,050,000 4,000,000 4,050,000 4,050,000 Percent Complete $ 500,000 $ 450,000 $ 450,000 Estimated Total Gross Profit (a – b)

23. 23 Copyright © John Wiley & Sons Canada, Ltd. Percentage-of-Completion: Cost-to-Cost Basis 1,750,000750,000 Accounts Receivable 1,750,000750,000 Cash To record collections: 2,400,000900,000 Billings on Construction in Process 2,400,000900,000 Accounts Receivable To record progress billings: 1,916,0001,000,000 Materials, Cash, Payables 1,916,0001,000,000 Construction in Process To record cost of construction: 20152014 Note: Journal entries for 2016 are not shown due to space limitations

24. 24 Copyright © John Wiley & Sons Canada, Ltd. Percentage-of-Completion: Cost-to-Cost Basis 2014 2015 2016 $4,500,000 $4,500,000 $4,500,000 Contract Price (a) 25% 72% 100% Percent complete (b) $1,125,000 $3,240,000 $4,500,000 -0- 1,125,000 3,240,000 $1,125,000 $2,115,000 $1,260,000 Revenue recognized: Revenue to date (a x b) Less: Prior years revenue Current year revenue $ 125,000 $ 324,000 $ 450,000 -0- 125,000 324,000 $ 125,000 $ 199,000 $ 126,000 Gross profit recognized: G.P. to date (Total x %) Less: G.P. in prior years Current year G. P.

25. 25 Copyright © John Wiley & Sons Canada, Ltd. Percentage-of-Completion: Cost-to-Cost Basis 199,000125,000Construction in Process 1,916,0001,000,000Construction Expenses 4,500,000Construction in Process 4,500,000Billings on Construction in Process To record completion of contract (recorded on completion date in 2016): 2,115,0001,125,000Revenue from Long-Term Contract To recognize revenue and gross profit: 20152014 Note: Some journal entries for 2016 are not shown due to space limitations

26. 26 Copyright © John Wiley & Sons Canada, Ltd. Percentage-of-Completion: Financial Statement Presentation The difference between “Construction in process” and “Billings on construction in process” is recorded on the Balance Sheet as either: –Current asset* (with Inventories) if difference is a debit balance or –Current liability* if difference is a credit balance *May be non-current depending on length of contract

27. 27 Copyright © John Wiley & Sons Canada, Ltd. Percentage-of-Completion: Financial Statement Presentation The balance in the Construction in Process account represents the costs incurred + gross profit recognized to date The balance in the Billings on Construction in process represents the billings made to customers to date

28. 28 Copyright © John Wiley & Sons Canada, Ltd. Completed-Contract Method: Earnings Approach Revenue and gross profit are recognized on the completion of the contract Advantage: reported revenue is based on actual results, not estimates Disadvantage: does not reflect current performance; creates distortion of earnings All journal entries are the same as the percentage-of- completion method except that no entry is recorded at the end of the period to recognize revenue and gross profit IFRS does not address this method explicitly (unlike ASPE)

29. 29 Copyright © John Wiley & Sons Canada, Ltd. Comparison of Results (Gross Profit Recognition) $450,000 Total 450,000126,0002016 0199,0002015 $ 0$125,0002014 Completed- Contract Percentage-of- Completion Year

30. 30 Copyright © John Wiley & Sons Canada, Ltd. Long-Term Contract Losses A long-term contract may produce either: an interim loss on a profitable contract or an overall loss on unprofitable contract Under the percentage-of-completion method, all losses are immediately recognized Under the completed-contract method, losses are recognized only when overall losses result

31. 31 Copyright © John Wiley & Sons Canada, Ltd. Recognizing Current and Overall Losses on Long-Term Contracts Current Loss on an otherwise overall profitable contract Completed Method: No adjustment needed Percentage Method: Recognize loss currently Loss on an overall unprofitable contract Percentage Method: Recognize entire loss now Completed Method: Recognize entire loss now

32. 32 Percentage Method: Interim Loss on Profitable Contract–Example 2014 2015 2016 $4,500,000 $4,500,000 $4,500,000 Contract Price 1,000,000 2,916,000 4,384,962 3,000,000 1,468,962 -0- 4,000,000 4,384,962 4,384,962 Costs to date Est. Cost to Complete Est. Total Costs 25% 66.5% 100% 1,000,000 2,916,000 4,384,962 4,000,000 4,384,962 4,384,962 Percent Complete Data as previously given, except for the 2015 cost estimate Revenue recognized to date in 2015: $4,500,000 x 66.5% = $2,992,500 Less: Amount recognized in 2014 1,125,000 Revenue recognized in 2015 1,867,500 Less: Actual costs incurred in 2015 1,916,000 Loss recognized in 2015 $48,500

33. 33 Copyright © John Wiley & Sons Canada, Ltd. Percentage Method: Interim Loss on Profitable Contract–Example 33 Record loss for 2015 : Construction Expenses 1,916,000 Construction in Process (loss) 48,500 Revenue from Long-Term Contract 1,867,500 Under the percentage-of completion method the Loss of $48,500 is reported on the Income Statement in 2015 Under the completed-contract method, no loss recognized in 2015

34. 34 Copyright © John Wiley & Sons Canada, Ltd. Percentage Method: Interim Loss on Overall Unprofitable Contract–Example 2014 2015 2016 $4,500,000 $4,500,000 $4,500,000 (a) Contract Price 1,000,000 2,916,000 4,556,250 3,000,000 1,640,250 -0- 4,000,000 4,556,250 4,556,250 (b) Costs To Date Est. Cost to Complete Est. Total Costs 25% 64% 100% 1,000,000 2,916,000 Gross Loss 4,000,000 4,556,250 (56,250)* Percent Complete Data as previously given, except for the 2015 cost estimate Losses recognized in 2015: Gross profit recognized in 2014(needs to be reversed)$125,000 Expected total loss on unprofitable contract (a – b) *56,250 Total loss to be recognized in 2015$181,250

35. 35 Copyright © John Wiley & Sons Canada, Ltd. Percentage Method: Interim Loss on Overall Unprofitable Contract–Example Record loss in 2015 for percentage-of-completion method: Construction Costs expensed in 2015: Revenue recognizable to date: (4,500,000 X 64%) $2,880,000 Less: Revenue recognized before 2015 1,125,000 Revenue recognized in 2015 1,755,000 Less: Loss recognized in 2015 (see previous slide) 181,250 Construction Cost Expense1,936,250 Construction Expenses 1,936,250 Construction in Process (Loss) 181,250 Revenue from Long-Term Contract 1,755,000

36. 36 Copyright © John Wiley & Sons Canada, Ltd. Completed-Contract Method: Interim Loss on Overall Unprofitable Contract–Example Record overall loss in 2015 for completed-contract method: Loss from Long-Term Contract56,250 Construction in Process (Loss)56,250 The loss is recognized in the year it first becomes evident.

37. 37 Copyright © John Wiley & Sons Canada, Ltd. Revenues vs. Gains Revenues: sales that are part of normal earnings process (e.g. sale of manufactured inventory) Gains: sales that are not part of the normal earnings process (e.g. sale of capital assets used in production of inventory) –Gains commonly result from transactions that do not involve an earnings process, and so realization is key

38. 38 Copyright © John Wiley & Sons Canada, Ltd. Repo Reporting Gross vs. Net Revenues Revenues can be recorded as the gross amount billed or as the net amount retained Consideration should be given to the following factors: –whether company acts as a principal or as an agent/broker –whether company takes title to the goods sold –whether company has risks and rewards of ownership of goods sold

39. 39 Copyright © John Wiley & Sons Canada, Ltd. Contract-Based Approach Proposed by IASB and FASB Contract defined as agreement between parties that creates enforceable rights and obligations Standard applies when contract –has commercial substance –is approved by both parties –has identified rights and obligations (including payment terms) Standard doesn’t apply to contracts that can be cancelled by either party at no cost, if –Goods/services have not been transferred; and –Payment has not been received and no right to receive payments exists Standard proposes increased disclosures

40. 40 Copyright © John Wiley & Sons Canada, Ltd. Contract-Based Approach 5 steps in determining when/how to recognize revenues: 1.Identify contract 2.Identify separate (enforceable) performance obligations in contract 3.Determine transaction price 4.Allocate transaction price 5.Recognize revenues when performance obligation satisfied

41. 41 Copyright © John Wiley & Sons Canada, Ltd. COPYRIGHT Copyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.