Revenue Recognition: 5-Step Guide

• Companies recognize revenue when they transfer goods/services to customers, for the amount the company expects to receive.

5 Steps to Apply Revenue Recognition Principle

• Identify the contract with a customer.
• Identify performance obligations in the contract.
• Determine the transaction price.
• Allocate the transaction price to each performance obligation.
• Recognize revenue when each performance obligation is satisfied.

1. Identifying the Contract

• It establishes legal rights of seller/customer.
• Approval of all parties, must have commercial substance and payment terms.
• Probable seller collection.
• A contract does not exist if neither party has performed POS or either party can terminate without penalty.

2. Identifying Performance Obligations (PO)

• Separate if distinct and sold separately, or when separately identified when delivered separately/are not combined.
• Options such as material rights, discounts, or coupons can be performance obligations if they provide a material right.
• Extended warranties could be POs, particularly if sold separately, or cover longer periods.
• Upfront fees and quality insurance warranties are not POs.

Journal Entries for Performance Obligations

• For one PO recognized at a point in time: debit accounts receivable and credit sales revenue; debit cash and credit accounts receivable when paying off accounts receivable.
• For one PO recognized over time: debit cash and credit deferred revenue when an order is placed; debit deferred revenue and credit service revenue when the full term of the contract ends.

What Constitutes a Performance Obligation

• Distinct good or service that is both capable of being distinct and separately identifiable.
• Quality assurance warranties and customer prepayments do not qualify.
• Extended warranties and customer options that provide a material right do qualify.
• If a customer consumes benefits as the seller performs, customer controls the asset, or the seller is creating an asset with no alternative use and has right to payment, it is a PO.

Transaction Price Adjustments

• Adjustments may be necessary for variable conditions.
• The company must make sure no significant revenue reversal will occur in the future.
• Must determine whether the seller is acting as a principal or agent.

Allocating Transaction Price

• Allocation should be based on relative standalone selling prices of the goods or services in each performance obligation.
• If standalone selling prices are not directly observable, use: adjusted market assessment, expected cost plus margin, or residual approach.

Revenue Recognition Timing

• Recognize at a single point in time when control passes to the customer.
• Control is more likely if the customer has an obligation to pay, legal title, possession, and has assumed the risks and rewards of ownership.
• Recognize over a period of time if the customer consumes the benefit as the seller performs.

3. Transaction Price

• Use amount seller expects to receive.
• Revenue recognition occurs when goods/services are transferred (physical possession + transfer of risk/rewards).
• With FOB shipping point, the seller no longer owns the goods, and if shipping is an additional PO now.
• With FOB destination, the seller no longer owns once at the destination point.
• Allocation price occurs if each PO has standalone prices; the vacuum in the example is the AP.

Journal Entries for Issuing Coupons

• Debit cash, credit sales revenue for the vacuum allocation, and credit deferred revenue for the option allocation.
• When redeeming a coupon, debit cash, credit deferred revenue (option), and credit/debit the warranty.

Transaction Pricing

• Return policy does not constitute a separate PO.
• Consider if principal or agent, the time value of money, and variable consideration.

Principal

• Acts on own behalf and has risk/reward.
• Responsible for providing goods/services, and thus recognizes revenue for entire amount.

Agent

• Acts on behalf of the principal.
• Does not take own inventory, rather facilitates a sale.
• The commission fee earned is the revenue recognized.

Time Value of Money

• Credit sales can have two POs, one to deliver goods and another for financing, (30 days payback), which includes interest too.
• Short-term AR is immaterial, so don't consider time value of money.

Journal Entries for Prepayment

• For collection before delivery/revenue recognition: debit cash, credit deferred revenue; at delivery occurrence, debit deferred revenue, credit sales revenue.
• For receivable collection after delivery/revenue recognition: debit notes receivable, credit sales revenue and discount on notes receivable; then debit cash and discount on notes receivable, credit notes receivable and interest revenue upon collection.

Variable Consideration

• Portion of transaction price that depends on the outcome of future events.
• Transaction price is fixed fee + bonus.
• Bonus = rebate coupon.
• Either estimate most likely amount or expected value by probability percentage x $.

Journal Entries

• For valid consideration: debit accounts receivable and bonus receivable, credit sales revenue.
• For collection if bonus is cancelled: debit cash, sales revenue; credit AR and bonus receivable.

GAAP Market Approach

• Sales price
• Modified Market Value
• Cost Plus Approach
• Residual Approach

Licenses

• Other companies using your thing.
• Functional intellectual property: right to use at a point in time.
• Symbolic intellectual property: right to access over time.

Bill and Hold Agreements

• Customer wants to place order but wants a delayed delivery.
• Recognize revenue at delivery except if customer has control, then recognize revenue when order is placed.

Gift Cards

• Initially recognized as unearned revenue.
• Recognize revenue for unredeemed gift cards when there is a remote chance they will be used.

Long-Term Contracts

• Consists of plumbing, electrical, or construction supplies which are distinct.
• Needs to be allocated.
• Customer controls asset.
• Recognize revenue over time.
• Point in time when the asset is transferred and the contract completed.

Construction in Progress (CIP)

• Similar to work in progress.
• Inventory: if inventory is sold (physical), then AR or cash is debited and inventory is credited.

Billings

• Accumulate all billings to buyer.
• Credit to CIP.
• Part of CIP that asset transferred to buyer.
• If CIP > Billings, work done > billings = Net asset.
• If CIP < Billings, work done < billings = Net liability (like unearned revenue).

Journal Entries for Construction

• Record construction costs: Debit CIP, credit cash, materials.
• Record progress billings: Debit AR, credit billings.
• Record cash collections: Debit cash, credit AR.

Revenue Recognition on Collection

• Debit CIP
• Credit cost of construction and revenue from LT contracts. (last yr)

Revenue Recognition over Time

• Debit CIP and credit cost of construction and revenue from long-term contracts.
• If unprofitable, debit loss on construction, credit CIP; debit cost of construction and credit CIP and revenue.
• Over all years.

Profitable

• Contract price is greater than the estimated total cost.
• Revenue and profit based on percentage completed of the contract.
• Profit Margin = Net Income / Revenue
• ROA = Net Income / Avg total A
• ROE = Net Income / Avg SE

Unprofitable

• Contract price is less than estimated total cost.
• Recognize entire estimated loss right away due to conservatism.

Actual Costs Incurred Formula

• Actual costs incurred during the year + prior costs incurred to date = Costs incurred to date + estimated costs to complete = Total estimated costs.
• Estimated Total Profit/Loss = Contract price - total est costs
• % complete = costs incurred to date / total est costs
• Revenue = % complete x contract price - previous yr's revenue
• Profit = % complete x estimated profit - previous yr's profit
• Cost of Construction = rev - profit

Cash

• Amounts readily available for use.
• Consists of checking/savings accounts and underpaid checks.

Cash Equivalents

• Consists of low-risk investments.
• Amounts temporarily invested for short-term investments to earn interest.
• Includes treasury bills and commercial paper expiring in ≤ 3 months at the purchase date.

Restricted Cash

• Not included in cash balance.
• Restricted by contractual or managerial restriction.
• Either part of investments or categorized as "other assets".

Receivables

• Claim to cash or assets/services in the future.
• Trade = sale to customer, Dr. AR, Cr. Sales Rev
• Nontrade = other than AR, such as div rec, intr rec, or loan

Valuation

• Initial valuation: AR transaction amount for revenue recognition.
• Two POs: delivery product/sales revenue and financing/interest revenue.
• Under GAAP, recognize entire amount as sales revenue, no allocation.
• Typically has 30-60 days (ST).

Variable Consideration

• Trade discounts: encourage higher volume and report AR net of trade discount.
• Cash discounts: encourages early payment. Terms written as 2/10, n/30; discount % / days for discount; entire amount due in 30 days.
• Can use gross or net method.

Gross Method

• Sell merchandise: debit AR, credit sales revenue for full amount
• Payment in discount period: debit cash and sales discount, credit AR
• Remaining balance payment: debit cash, credit AR

Net Method

• Sell merchandise: debit AR, credit sales revenue
• Payment in discount period: debit cash, credit AR
• Remaining balance payment: debit cash, credit AR, credit sales discount forfeited.

Sales Returns

• Variable consideration, so extract it at end of period adjustment
• 1. Journal entry for returns during the current period sales debit sales returns, credit AR/cash -Debit inventory, credit COGS
• 2. Journal entry for year-end/adjusting revenue -Estimate future returns for current period sales & debit sales returns, credit refund liability -Debit inventory returns, credit COGS
• 3. Journal entry for sale in prior period -Debit refund liability, credit AR or Cash -Debit inventory, credit inventory-estimated returns.

Balance Sheet items

• AR and AFDA

Income Statement items

• Revenue
• Sales Discount
• Sales Discount Forfeited
• Sales Returns
• BDE

Subsequent Valuation of Receivables

1. Direct Write-Off -Debit BDE, credit AR -Not GAAP -Doesn't match rev & exp -Use if credit loss is immaterial
2. Allowance -Debit BDE, credit AFDA -Debit AFDA, credit AR -Debit AR, Credit AFDA

AR journal entries

End AR Income statement

• (AR + AFDA) + credit sales

Credit Sales

• AR+AFDA
• uncollectibles

Notes Payable

• Formal credit approval
• Trade (credit sale)
• Nontrade (loans, taxes)

JE of notes payable

1. Sales
   • Debit NR, credit sales revenue
2. Collection -Debit cash, credit NR -Debit intr rec, credit intr rev Discount Notes
3. Debit sale, debit NR
4. Financing * interest over time
   • debit disc, credit sale revenues discount earned overtime

Valuation in Notes payable

• Initial valuation (PV of future CFs) interest bearing note, (PV of future CF = FF) is initial

Efficient intr rate formula

intr earned Sale price (NR discount on NR) annualize 12month rate

Types of NR

1. Short term note

• recognize amort, recoznize and discount to exp

2. Annuity -equal cash cashinfrow
3. LT intr bearing -effective intr

Imp airment

• PV of what you shout get Vs Rv under New contractLoss PV under new E bde

1. NR Intial valuation -PV of future -subsequent Valuation is for Impairment
2. Troubles des restructuring
   • PV of what you Should get Vs PV under newcontract

Accounts receivable- factprinh

W/o Recourse -Buyer Credit cash Retained fact Amount-AR Lossed on loan

Credit AR Recourse Seller Credit cash

Credit. Amounted Ar Debit- lossed on Receivable