Preclass 2 - Revenue Recognition PDF

MGT2250 Revenue Recognition Copyright ©2022 John Wiley & Sons, Canada, Ltd. Topics Covered Multiple Sale of Good Sale of Service Performance Obligations Bill and Hold Principal/Agent Consignment The Physical...

MGT2250 Revenue Recognition Copyright ©2022 John Wiley & Sons, Canada, Ltd. Topics Covered Multiple Sale of Good Sale of Service Performance Obligations Bill and Hold Principal/Agent Consignment The Physical Nature of Sales Transactions Sales transactions involve the transfer of goods, services, or both (known as deliverables) Sales of goods and sales of services are different Sales of Goods Sales of Service Tangible assets Not tangible assets Definite point when control passes— Possession, legal title are irrelevant— indicated by transfer of legal title and depends on when the service is rendered possession Usually viewed as “one-time” Often spans more than one period Revenue Recognition: An Overview There are two approaches to recognizing revenue: o IFRS 15: The asset-liability approach (or contracts- based approach) ▪ Accounts for revenue based on the asset or liability arising from contracts with customers or changes to assets and liabilities o ASPE: The earnings approach as followed under A SPE ▪ Recognizes and measures revenue based on whether it has been earned ▪ The performance obligation is satisfied when there is a change in control from the seller to the customer IFRS 15 5 Step Criteria  Key Concepts of Revenue Recognition (IFRS 15) FIVE-STEP PROCESS FOR REVENUE RECOGNITION 1. Identify the contract with customers. KEY OBJECTIVE 2. Identify the separate performance obligations Recognize revenue to depict the in the contract. transfer of goods or services to 3. Determine the transaction price. customers in an amount that reflects 4. Allocate the transaction price to the separate the consideration that the company performance obligations. receives, or expects to receive, in 5. Recognize revenue when each performance exchange for these goods or obligation is satisfied. services. REVENUE RECOGNITION PRINCIPLE Recognize revenue in the accounting period when the performance obligation is satisfied.  IFRS 15: Handbook Goods: tangible assets. Control: entity has access to beneifts Possession & Legal title Services: tangible assets Step 1 - Identifying the Contract with Customers A contract is an agreement between two or more parties that creates enforceable rights or obligations The combination of the rights and performance obligations set out in a contract gives rise to a (net) asset or (net) liability A company does not recognize contract assets or liabilities, nor is a journal entry prepared, until one or both parties perform their contracted obligations Contract Criteria for Revenue Guidance Apply IFRS 15 to Contract if: Disregard IFRS 15 if: The contract has commercial substance. The contract is wholly The parties in the contract have approved unperformed and the contract and are committed to perform Each party can their respective obligations. unilaterally terminate The company can identify each party's rights the contract without regarding the goods or services to be compensation. transferred. The company can identify the payment terms for the goods and services to be transferred. It is probable that the company will collect the consideration to which it will be entitled. EXAMPLE: Accounting for a Basic Revenue Transaction—Step 1 PiP 6.7 On March 1, 2023, Margo Company enters into a contract to transfer a product to Soon Yoon on July 31, 2023. Soon Yoon is required to pay the full contract price of $5,000 on August 31, 2023. The cost of goods transferred is $3,000. Margo delivers the product to Soon Yoon on July 31, 2023. On March 1: contract is identified; no journal entry On July 31: sale is recorded to accounts receivable, COGS Step 1: Identify the A contract is an agreement between two parties that contract with creates enforceable rights or obligations. In this case, customers Margo Company has a contract to deliver a product to Soon Yoon. Step 2 - Identifying Separate Performance Obligations Performance obligation is a promise to provide a product or service to the customer o Promise may be explicit, implicit or possibly based on customary business practice o The product or service must be distinct (the customer can separately benefit from it) If a performance obligation in a multi-obligation contract is distinct within the contract, then it should be accounted for separately Types of Separate Performance Obligations Loyalty Programs Warranties Upfront Fees Initiation Fees EXAMPLE: Multiple Goods and Services— Multiple Performance Obligations PiP 6.9 Genus Motors sells an automobile to Marquart Auto Dealers at a price that includes six months of telematics services such as navigation and remote diagnostics. These telematics services are regularly sold on a stand- alone basis by Genus Motors for a monthly fee. After the six-month period, the consumer can renew these services on a fee basis with Genus Motors. Step 2: Identify the There are two performance obligations in this separate performance contract that are distinct and not interdependent. obligations in the The customer can benefit from the use of both the contract car and the service on their own. EXAMPLE: Multiple Goods and Services—One Performance Obligation PiP 6.10 Soft Tech Inc. sells customer-relationship software to Lopez Company. In addition to providing the software itself, Soft Tech promises to perform consulting services, extensively customizing the software to Lopez’s information technology environment, for a total consideration of $600,000. Step 2: Identify the In this case, the customized software and consulting separate performance services have been integrated into one combined obligations in the item. Even though they are distinct, they are contract interdependent (one cannot be sold without the other) so should be accounted for as one performance obligation. Multiple Goods and Services—Customer Loyalty Programs PiP 6.11 An airline offers 1,000 points on a prepaid flight for $1,000. Redemption is estimated to be 90%. The stand-alone value of the points is $50 (taking into account breakage) and the value for the flight is $980. Step 2: Identify the The airline is offering two services: the current separate performance flight and the future flight. The material right is the obligations in the discount on the future flight. The flight and the contract points represent separate performance obligations. The $1,000 is allocated proportionately. Warranties Companies often provide two types of warranties: Warranty Type Description Accounting Treatment Assurance Provides assurance that the Represents a cost of product meets agreed-upon selling the product specifications in the contract at Recognize a warranty the time the product is sold liability for after-sale (quality guarantee) expenses Service Provides an additional service Represents a separate beyond the assurance-type performance obligation warranty Recognizes revenue in Service type can't recognize rev until expires, or after work the period the warranty is in effect Upfront Fees Do they provide with material right? Upfront fees are payments received before a product is delivered or a service is performed (e.g., a membership fee that provides a significant discount on future annual fees) Theoretically, this is a material right to future benefits and would be considered a separate obligation Under IFRS 15, treated as one performance obligation— because it is difficult to determine the stand-alone value of the future benefit Multiple Goods and Services—Initiation Fees as One Performance Obligation PiP 6.14 A customer signs a one-year contract with a health club. There is an initiation fee of $200 plus an monthly membership fee of $50. From experience, the club knows members usually renew twice before cancelling their membership. Step 2: Identify the The membership fee would be viewed as a single separate performance performance obligation to be delivered over a obligations in the period of three years. The single obligation consists contract of providing the same services each month for three years. Step 3 - Determining the Transaction Price Transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring goods or services o Transaction price is usually stated within the contract o In other contracts consider variable consideration time value of money non-cash consideration consideration paid or payable to customers o Factors addressed in IFRS; little guidance from ASPE Variable Consideration: Right of Return Right of return obligates the seller to allow the customer to return goods for a refund, a credit or an exchange Seller must recognize o Revenue from the sale of the product (considering the possibility of future returns) o A refund liability COGS, Inventory o An asset (and adjustment to cost of sales) to recognize recovery to inventory Accounting treatment differs between I FRS and ASPE Transaction Price—Right of Return PiP 6.16 Venden Company sells 100 products for $100 each to Amaya Inc. payable in 30 days. Venden allows Amaya to return any unused product within 30 days and receive a full refund. The cost of each product is $60. Based on past experience, Venden estimates three products will be returned. only recognize revenue on products you know are not gonna be returned The amounts used are the same under IFRS and ASPE Revenue: $9,700 ($100 x 97)—products that will not be returned Cost of sales: $5,820 ($60 x 97)—cost of the products that will not be returned Refund liability: $300 ($100 x 3)—products expected to be returned An asset: $180 ($60 x 3)—products that will be recovered and returned to inventory Transaction Price—Right of Return Journal Entries (IFRS) IFRS: revenue is only the ones that are not gonna be returned Transaction Price—Right of Return Journal Entries (ASPE) Step 4 - Allocating the Transaction Price to Separate Performance Obligations Transaction prices are allocated to more than one performance obligation in a contract based on their relative fair values o The best measure of fair value is what the company could sell the good or service for on a stand-alone basis (stand-alone selling price) o If this information is not available, best estimates are used o All information that is available (like market conditions and type of customer) should be used; in particular, observable information Best measure of value: amount that the company could sell the good or service for on a stand-alone basis Estimating Stand-Alone Selling Price How to calculate stand-alone prices (in preferred order of use) Allocation Approach Implementation Adjusted market assessment Estimate the price that customers purchasing the approach goods or services will pay. The company might also look at competitor prices for similar goods or services. Expected cost plus a margin Forecast expected costs and add a reasonable profit margin. Residual approach Use where the selling price is highly variable or uncertain. Estimate the stand-alone selling price by starting with the total price for the contract and deducting the observable selling prices of other items being sold. Allocation of Transaction Price—Bundled Sale (1) When the sum of the value of each good/service in a bundle is greater than the transaction price … o the total revenue (transaction price) should be allocated to the separate performance obligations based on their relative value PiP 6.23  Allocation of Transaction Price—Bundled Sale (2) When the selling price of a bundle is less than the individual stand-alone prices due to a specific component … o the discount should be allocated to the performance obligation that is causing the discount, and not to the entire bundle PiP 6.24 Comparing the two separate bundles 1&2&3 2&3 (one with the performing obligation 1 and one Bundled Bundled without) we can determine the $100 discount Bundled Purchased Price $ 650.00 $ 550.00 applies to performance obligations 2 & 3. Stand-alone prices: Allocation of $650 would be: Performance Obligation 1 100.00 Performance obligation 1, $100 Performance Obligation 2 525.00 525.00 Performance obligations 2 & 3, $550 Performance Obligation 3 125.00 125.00 $ 750.00 $ 650.00 Step 5 - Recognizing Revenue when (or As) Each Performance Obligation is Satisfied A company satisfies its performance obligation when the customer obtains control of the good or service Indicators of control: o The company has a right to payment for the asset o The company has transferred legal title to the asset o The company has transferred physical possession of the asset o The customer has significant risks and rewards of ownership o The customer has accepted the asset When to Recognize Revenue Companies satisfy performance obligations either at a point in time or over a period of time (IFRS) Companies recognize revenue over a period of time if one or more of the following criteria are met: o The customer receives and consumes the benefits as the seller performs o The customer controls the asset as it is being created or enhanced o The company does not have an alternative use for the asset created or enhanced, and the amount is collectible Recognizing Revenue—Progress Towards Completion A company recognizes revenue from a performance obligation over time by measuring the progress towards completion Method should depict the transfer of control Objective is to measure the extent of progress of costs, units or value added Input measures: efforts devoted to a contract Output measures: track results Most popular input measure is cost-to-cost basis Comparing costs incurred to date with the most recent estimate of total contract costs  Recognition—Satisfying a Performance Obligation over Time PiP 6.26 Two-year contract for cleaning services on a monthly basis: On January 1, Dandy signed a two-year contract for $30,000 with $6,000 being paid January 31 and the rest monthly at $1,000 per month (end of month). One performance Up-front payment required $ 6,000 obligation over time Monthly payments (24 x $1,000) 24,000 Total cost of the contract $ 30,000 Total contract price is divided evenly over the two Revenue per month ($30,000/24) $ 1,250 years Journal entry on January 31: Summary of the Five Step Revenue Recognition Process—Steps 1, 2 Step in Process Description Implementation 1. Identify the A contract is an agreement that A company applies the revenue guidance to contract creates enforceable rights or contracts with customers and must determine with obligations. if new performance obligations are created by customers. a contract modification. 2. Identify the A performance obligation is a promise A contract may be composed of multiple separate in a contract to provide a product or performance obligations. The accounting for performance service to a customer. A performance multiple performance obligations is based on obligations obligation exists if the customer can evaluation of whether the product or service is in the benefit from the good or service on its distinct within the contract. If each of the contract. own or together with other readily goods or services is distinct, but is available resources. interdependent and interrelated, these goods and service are combined and reported as one performance obligation.  Summary of the Five Step Revenue Recognition Process—Steps 3, 4, 5 Step in Process Description Implementation LO 7 3. Determine the The transaction price is the amount of ln determining the transaction price, companies transaction price. consideration that a company expects to must consider the following factors: (1) variable receive from a customer in exchange for consideration, (2) time value of money, (3) non- transferring goods and services. cash consideration, and (4) consideration paid or payable to the customer. 4. Allocate the If more than one performance obligation The best measure of value is what the good or transaction price to exists, allocate the transaction price service could be sold for on a stand-alone basis (the the separate based on relative fair values. stand-alone selling price). Estimates of stand-alone performance selling price can be based on (1) adjusted market obligations. assessment (2) expected cost plus a margin approach. or (3) a residual approach. 5. Recognize revenue A company satisfies its performance Companies satisfy performance obligations either when each obligation when the customer obtains at a point in time or over a period of time. performance control of the good or service. Companies recognize revenue over a period of time obligation is if (1) the customer controls the asset as it is created satisfied. or (2) the company does not have an alternative use for the asset. Earnings Approach to Revenue Recognition Used under ASPE Revenues for sale of goods must meet all of the following conditions 1. Risks and rewards of ownership are transferred to the buyer or revenues are earned 2. Seller has no continuing involvement in, nor effective control over, the goods sold 3. Costs and revenues can be reliably measured; and 4. Collectibility is probable Other Revenue Recognition Issues There are several situations where revenue recognition issues arise o bill and hold o principal-agent relationships o consignments This discussion is based on I FRS 15 as ASPE has little specific guidance in these areas  Bill-and-Hold Arrangements Issue Description Implementation Bill and hold Results when the buyer is not yet Revenue is recognized depending ready to take delivery but takes on when the customer obtains title and accepts billing control of that product To establish transfer of control, and therefore recognize revenue, all of these criteria have to be met a. The reason to hold the inventory must be substantive. b. The product must be identified separately and belong to the customer. c. The product must be ready to ship. d. The company cannot use the product nor sell it to another customer. Principal-Agent Relationships Performance obligations in a principal-agent relationship Principal Agent To provide goods or perform To arrange for the principal to services for a customer e.g., an provide goods or perform services airline for a customer e.g., travel agency How much to recognize? Amounts collected on behalf of the principal are not revenue of the agent; revenue for the agent is the amount of commission it receives The principal recognizes revenue when the goods and services are sold to a third party Consignment Sales Manufacturers or wholesalers (consignors) deliver goods to the dealer (consignee) but retain title until the goods are sold Accounting for consignment sales o The consignee does not record the merchandise as an asset on its books; inventory is carried on books of consignor o Once the merchandise is sold, consignee has a liability for the net amount due o Consignee remits proceeds from sales to consignor after deducting commission and chargeable expenses o Consignor recognizes revenue when the remittance from the consignee is received  A Comparison of IFRS and ASPE: Recognition IFRS 15 A SPE Contract-based approach/Asset-Liability approach with Earnings approach five steps (1) Identify contract; (2) Identify separate performance obligations; (3) Determine transaction price; (4) Allocate transaction price; (5) Recognize revenue when performance obligation is satisfied (when control passes) Recognition when performance is achieved (risks and rewards have passed and services are rendered and measurable) and collectible Recognize revenue for each distinct performance Recognize over time for long-term obligation at a point in time or over time contracts If providing goods and services together, must consider if performance obligations are interrelated (If they are, treat as one performance obligation) A Comparison of IFRS and ASPE: Recognition IFRS 15 A SPE Percentage-of-completion acceptable; may use Use percentage of completion method or zero-profit method completed contract if no percentages available Assurance-type warranties are accrued as Warranty costs have historically been costs/liabilities and service-type warranties are accrued as costs/ obligations when treated as separate performance obligations (if revenues recognized. More recently, these sold separately). may have been accounted for as bundled sales (unearned revenues). A Comparison of IFRS and ASPE: Measurement IFRS 15 A SP E Transaction price is the amount that the entity Recognize at transaction or consideration expects to receive. price, which is generally assumed to be fair value Greater emphasis is placed on using measurement models to quantify risk/ uncertainty Guidance is provided as to how to calculate Where payment is received over time, ASPE discount rate where the sale is financed. If the notes that the amount should be discounted term is less than one year, there is no need to using a prevailing market rate. separate out the financing component. Where variable consideration exists, revenue is recognized only if it is highly probable that a future reversal will not occur. A Comparison of IFRS and ASPE: Measurement IFRS 15 A SP E The transaction price for transactions with The transaction price for transactions with multiple elements is allocated using relative multiple elements is allocated using relative value (although may estimate where not value or residual value method (choice). available and may use residual method to estimate). Specific guidance is given. Where a right of return exists, a refund Where a right of return exists, sales returns and liability is recognized. allowances are recognized as contra accounts to revenues and accounts receivable. IAS 41 deals with biological assets. It still Accounting for biological assets is dealt with in stands because the proposed standard does ASPE 3041. not cover these areas. Issue HG needs guidance on how to properly account for the Green Basket subscriptions. Customers pay in advance for 12 monthly deliveries, and there is a potential for returns within 45 days. Olive is unsure how to recognize revenue and account for the possibility of customer returns. GAAP/Analysis Identify the contract with customers - MET – When a customer purchases the annual subscription, a contract is created between HG and the customer, and HG has an obligation to transfer 12 monthly baskets to the customer. Identify the separate performance obligations in the contract - MET - Each basket is distinct, the customer can benefit from each one as a standalone basket, and the baskets have the same pattern of transfer to the customer, since they are received monthly. In addition, each of the 12 baskets purchased in the subscription is separately identifiable from the other baskets in the subscription. Therefore, the delivery of each basket represents a distinct performance obligation. Determine the transaction price - MET – 12 baskets will be delivered to the customer for $1,200. Allocate the transaction price to the separate performance obligations - MET – The allocation should be based on a relative standalone selling price, being what HG could expect to receive if each individual basket were sold separately to a customer. Each monthly basket will be of roughly the same value, which is $100 per Green Basket ($1,200 ÷ 12 baskets). Recognize revenue when each performance obligation is satisfied - MET –when each monthly basket is delivered, HG can recognize it as revenue for $100. Recommendation/Impact Therefore, the entries to credit revenue for the $60,000 collected in November 2022 and the $36,000 collected in December 2022 will need to be reversed, and those amounts will need to be recognized as follows: Dr. Cash $96,000 Cr. Unearned revenue $96,000 Accordingly, for the December 1, 2022, delivery date, HG can recognize $5,000 (50 subscriptions × $100/basket) because the performance obligation of the first month of the annual subscription has been satisfied. A corresponding cost of sales (COS) will also be recognized for 60% of the revenue (so $3,000 for December 2022). BRIEF EXERCISE 6.9 The membership renewal option gives the customer a material right that cannot be obtained without first paying the non-refundable initiation fee of $100. In these cases, the customer is in effect paying in advance for services and the transaction price must be allocated between the services currently purchased and the services to be purchased in the future under the membership renewal option. IFRS 15 allows the entity to treat this as one performance obligation. The total transaction price is $100 + ($5 x 12 x 3) = $280. BlueBox would recognize $280/4 = $70 revenue per year. BRIEF EXERCISE 6.15 a. July 10, 2023 Accounts Receivable 700,000 Sales Revenue 595,000 Refund Liability (15% X $700,000) 105,000 To record sale on account Cost of Goods Sold 476,000 Estimated Inventory Returns1 84,000 Inventory 560,000 1 (15% X $560,000) To record cost of goods sold b. October 10, 2023 Refund Liability 78,000 Accounts Payable 78,000 To record returns from customers Returned Inventory2 62,400 Estimated Inventory Returns 62,400 2 ($560,000 ÷ $700,000) X $78,000 To record return of inventory Refund Liability…………………………… 27,000 Sales Revenue……………………… 27,000 To adjust refund liability for end of right of return Cost of Goods Sold………………………. 21,600 Estimated Inventory Returns……. 21,600 To adjust cost of goods sold for end of right of return BRIEF EXERCISE 6.32 No entry is required on May 1, 2023, because neither party has performed on the contract. On June 15, 2023, Eric agreed to pay the full price and therefore Mount has an unconditional right to those funds on that date. On receiving the cash on June 15, 2023, Mount records the following entry. June 15, 2023 Cash 25,000 Unearned Revenue 25,000 On satisfying the performance obligation on September 30, 2023, Mount records the following entries September 30, 2023 Unearned Revenue 25,000 Sales Revenue 25,000 To record sales revenue Cost of Goods Sold 18,000 Inventory 18,000 To record cost of goods sold EXERCISE 6.5 a. The sale of the equipment and the assurance warranty are one performance obligation because they are interdependent and interrelated with each other b. Cash ($48,800 + $1,200) 50,000 Warranty Expense 1,200 Warranty Liability 1,200 Sales Revenue 50,000 c. Grando should recognize $400 of warranty revenue in 2025 and 2026. Cash ($48,800 + $1,200 + $800) 50,800 Warranty Expense 1,200 Warranty Liability 1,200 Sales Revenue 50,000 Unearned Revenue 800 EXERCISE 6.16 a. Steps Analysis Step 1: Identify the Both parties have agreed to enter into a contract with contract. The quantity, price, and payment customers. terms have been agreed to and each party’s rights under the contract are clear. The contract has commercial substance. There are no indications of any concerns regarding collectibility. Step 2: Identify the The contract includes two performance separate performance obligations: the sale of the goods and the obligations in the installation of the goods. contract. Step 3: Determine the $400,000 transaction price. Step 4: Allocate the Schedule 1 below transaction price to the separate performance obligations. Step 5: Recognize The first performance, the sale of goods, is revenue when each satisfied on March 1, 2023, when the goods performance are delivered to Ricard. The revenue obligation is satisfied. related to this performance obligation would be recognized at this point. The second performance obligation related to the installation of the goods is satisfied and the revenue is recognized on June 18, 2023, when the installation is completed.  Stand- Alone (SA) % of Total Allocation of Performance Selling SA Selling Contract Contract obligation Price Price Price Price Deliver goods $370,000 90.24% X $400,000 $360,960 Installation 40,000 9.76% X $400,000 39,040 $410,000 100 % $400,000 b. Jan. 2, 2023 No entry – neither party has performed under the contract. March 1, 2023 Cash 270,000 Contract Asset 90,960 Sales Revenue 360,960 To record sales Cost of Goods Sold 300,000 Inventory 300,000 To record cost of goods sold June 18, 2023 Cash ($400,000 - $270,000) 130,000 Service Revenue - Installation 39,040 Contract Asset 90,960 The sale of the goods is recognized once delivered. The installation fee is recognized when the goods are installed.