1. Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Chapter 6 Revenue Recognition Chapter 6 Revenue Recognition

2. 2 Revenue Recognition Understanding the nature of sales transactions from a business perspective Economics of business transactions Legalities Accounting – presentation and disclosure Revenues versus gains Net income versus other comprehensive income Gross versus net revenues IFRS/Private Entity GAAP Comparison Analysis Looking ahead Accounting for sales transactions – recognition and measurement Earnings approach Contract-based approach Comparison Measurability Collectibility Mechanics

3. 3 Revenue Recognition Understanding the nature of sales transactions from a business perspective Economics of business transactions Legalities Accounting – presentation and disclosure Revenues versus gains Net income versus other comprehensive income Gross versus net revenues IFRS/Private Entity GAAP Comparison Analysis Looking ahead Accounting for sales transactions – recognition and measurement Earnings approach Contract-based approach Comparison Measurability Collectibility Mechanics

4. 4 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 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

6. 6 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 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 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 Revenue Recognition Understanding the nature of sales transactions from a business perspective Economics of business transactions Legalities Accounting – presentation and disclosure Revenues versus gains Net income versus other comprehensive income Gross versus net revenues IFRS/Private Entity GAAP Comparison Analysis Looking ahead Accounting for sales transactions – recognition and measurement Earnings approach Contract-based approach Comparison Measurability Collectibility Mechanics

10. 10 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

11. 11 Earnings Approach Revenues are recognized when the following criteria are met: 1.Performance is achieved: risks and rewards transferred and/or earnings process substantially complete, and measurability reasonably assured 2.Collectibility is reasonably assured

12. 12 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

13. 13 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 critical event For services, the performance of the service (which may be ongoing or continuous) is the determination of revenue recognition Recognize revenue at each critical event, as long as it is collectible

14. 14 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. Earnings Approach - Services and Long-Term Contracts

15. 15 Key criticisms of the earnings approach include the following: –Multiple (and sometimes conflicting) guidance on revenue recognition –Difficult to apply –Difficult to determine definitively who has the risks and rewards –Too much subjective judgment Problems with the Earnings Approach

16. 16 Two main questions under contract-based approach are: 1.When should the sales contract be recognized on the balance sheet? 2.When should the revenue be recognized on the income statement? Contract is recognized when all of the following conditions are met: 1.The entity is party to the contract, 2.The contractual rights are collectible/measurable, and 3.The performance obligation is measurable Contract-Based Approach

17. 17 Net contract position represents the balance of contractual rights less contractual obligations –Initial balance of net contract position is generally nil due to reciprocity and assumed arm’s length transaction Revenues are recognized when –Control passes to the buyer (as indicated by legal title / possession), or –Services are performed Contract-Based Approach

18. 18 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) Measurability

19. 19 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)

20. 20 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)

21. 21 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 “Merchandise 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)

22. 22 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

23. 23 Contract Accounting Long-Term Construction Accounting Methods Percentage-of-Completion Method Completed-Contract Method Used when performance requires many events i.e. continuous earnings process; process; can be used if measurable transaction is measurable To be used only when the percentage method is inapplicable (uncertain) i.e. when performance consists single act of single act or continuous not measurable earnings process not measurable

24. 24 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 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)

25. 25 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

26. 26 Percentage-of-Completion: Cost-to-Cost Basis Data: Contract price: $4,500,000 Estimated cost: $4,000,000 Start date: July, 2011 Finish: October, 2013 Balance sheet date: December 31 st Given: 2011 2012 2013 Costs to date$1,000,000 $2,916,000 $4,050,000 Estimated costs to complete $3,000,000 $1,134,000 $ -0- Progress billings during year$ 900,000 $2,400,000 $1,200,000 Cash collected during year$ 750,000 $1,750,000 $2,000,000

27. 27 Percentage-of-Completion: Cost-to-Cost Basis 2011 2012 2013 $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)

28. 28 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: 20122011 Note: Journal entries for 2013 are not shown due to space limitations

29. 29 Percentage-of-Completion: Cost-to-Cost Basis 2011 2012 2013 $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.

30. 30 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 2013): 2,115,0001,125,000Revenue from Long-Term Contract To recognize revenue and gross profit: 20122011 Note: Journal entries for 2013 are not shown due to space limitations

31. 31 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

32. 32 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

33. 33 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 private entity GAAP)

34. 34 Comparison of Results (Gross Profit Recognition) $450,000 Total 450,000126,0002013 0199,0002012 $ 0$125,0002011 Completed- Contract Percentage-of- Completion Year

35. 35 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

36. 36 Recognizing Current and Overall Losses on Long-Term Contracts Current Loss on otherwise 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

37. 37 Percentage Method: Interim Loss on Profitable Contract–Example 2011 2012 2013 $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 2012 cost estimate Revenue recognized to date in 2012: $4,500,000 x 66.5% = $2,992,500 Less: Amount recognized in 2011 1,125,000 Revenue recognized in 2012 1,867,500 Less: Actual costs incurred in 2012 1,916,000 Loss recognized in 2012 $48,500

38. 38 Percentage Method: Interim Loss on Profitable Contract–Example Record loss for 2012 : 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 2012 Under the completed-contract method, no loss recognized in 2012

39. 39 Percentage Method: Interim Loss on Overall Unprofitable Contract–Example 2011 2012 2013 $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 2012 cost estimate Losses recognized in 2012: Gross profit recognized in 2011(needs to be reversed)$125,000 Expected total loss on unprofitable contract (a – b) *56,250 Total loss to be recognized in 2012$181,250

40. 40 Percentage Method: Interim Loss on Overall Unprofitable Contract–Example Record loss in 2012 for percentage-of-completion method: Construction Costs expensed in 2012: Revenue recognized in 2009: (4,500,000 X 64%) $2,880,000 Less: Revenue recognized before 2012 1,125,000 Revenue recognized in 2012 1,755,000 Less: Loss recognized in 2012 (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

41. 41 Completed-Contract Method: Interim Loss on Overall Unprofitable Contract–Example Record overall loss in 2012 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.

42. 42 Revenue Recognition Understanding the nature of sales transactions from a business perspective Economics of business transactions Legalities Accounting – presentation and disclosure Revenues versus gains Net income versus other comprehensive income Gross versus net revenues IFRS/Private Entity GAAP Comparison Analysis Looking ahead Accounting for sales transactions – recognition and measurement Earnings approach Contract-based approach Comparison Measurability Collectibility Mechanics

43. 43 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 Gains and losses could be presented as part of net income or other comprehensive income (covered in subsequent chapters)

44. 44 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

45. 45 Revenue Recognition Understanding the nature of sales transactions from a business perspective Economics of business transactions Legalities Accounting – presentation and disclosure Revenues versus gains Net income versus other comprehensive income Gross versus net revenues IFRS/Private Entity GAAP Comparison Analysis Looking ahead Accounting for sales transactions – recognition and measurement Earnings approach Contract-based approach Comparison Measurability Collectibility Mechanics

46. 46 Looking Ahead IASB and FASB are working on a new contract-based model for revenue recognition Significant issues are still being discussed resolved

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