CHAPTER 5

Revenue Recognition and Profitability Analysis

Overview

In Chapter 4 we discussed net income and its presentation in the incomestatement. In Chapter 5 we focus on revenue recognition, which determineswhen and how much revenue appears in the income statement. In Part Aof this chapter we discuss the general approach for recognizing revenue inthree situations—at a point in time, over a period of time, and for contractsthat include multiple parts that might require recognizing revenue at differenttimes. In Part B we see how to deal with special issues that affectthe revenue recognition process. In Part C we discuss how to account forrevenue in long-term contracts. In Part D we examine common ratios usedin profitability analysis. In an appendix we consider some aspects of GAAPthat were eliminated by recent changes in accounting standards but that stillwill be used in practice until the end of 2016.

Learning Objectives

●LO5-1State the core revenue recognition principle and the five key steps in applying it.

●LO5-2Explain when it is appropriate to recognize revenue at a single point in time.

●LO5-3Explain when it is appropriate to recognize revenue over a period of time.

●LO5-4Allocate a contract’s transaction price to multiple performance obligations.

●LO5-5Determine whether a contract exists, and whether some frequently encountered

features of contracts qualify as performance obligations.

●LO5-6Understand how variable consideration and other aspects of contracts affect the

calculation and allocation of the transaction price.

●LO5-7Determine the timing of revenue recognition with respect to licenses, franchises, and

other common arrangements.

●LO5-8Understand the disclosures required for revenue recognition, accounts receivable,

contract assets, and contract liabilities.

●LO5-9 Demonstrate revenue recognition for long-term contracts, both at a point in time

whenthe contract is completed and over a period of time according to the percentage completed.

●LO5–10 Identify and calculate the common ratios used to assess profitability.

Lecture Outline

Part A: Introduction to Revenue Recognition

I.Revenue Recognition in General

A.FASB definition: “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.(T5-1)

B. To determine how much revenue to recognize and when to recognize it, we apply the core revenue recognition principal: Companies recognize revenue when goods or services are transferred to customers for the amount the company expects to be entitled to receive in exchange for those goods or services. (T5-2)

  1. Key concept: the seller has one or more performance obligations.
  2. Performance obligations are promises to transfer goods or services to the customer.
  3. Revenue recognition is tied to satisfaction of performance obligations.

C.Five steps are used to apply the principle:(T5-2)

  1. Identify the contract with a customer.
  2. Identify the performance obligation(s) in the contract.
  3. Determine the transaction price.
  4. Allocate the transaction price to each performance obligation.
  5. Recognize revenue when (or as) each performance obligation is satisfied.

D.Key considerations for each of the five steps that we will learn about: (T5-3)

  1. A contract establishes the legal rights and obligations of the seller and the customer.
  2. Contracts can indicate that the seller has one or more performance obligations.
  3. The transaction price is the amount the seller is entitled to receive from the customer.
  4. If there are multiple performance obligations, the contract price must be allocated among them.
  5. Recognize revenue for each performance obligation at a point in time or over time, depending on how that performance obligation is satisfied.

II.Revenue Recognition at a Point in Time

A. We recognize revenue at a point in time when we don’t qualify for recognizing revenue over time.

B. The performance obligation is satisfied when control of the goods or services is transferred from the seller to the customer.

C.Usually transfer of control is obvious, and coincides with delivery.

D. Other indicators of transfer of control: the customer has(T5-4, T5-5)

  1. An obligation to pay the seller.
  2. Legal title to the asset.
  3. Physical possession of the asset.
  4. Assumed the risks and rewards of ownership.
  5. Accepted the asset.

III.Revenue Recognition over a Period of Time

A. Revenue should be recognized over time if goods and services are transferred over time to the customer.

B. Revenue can be recognized over time if one of the following conditions hold:(T5-6, T5-7)

  1. The customer consumes the benefit of the seller’s work as it is performed, or
  2. The customer controls the asset as it is created, or
  3. The seller is creating an asset that has no alternative use to the seller, and the seller has the legal right to receive payment for progress to date.

C. If revenue is recognized over time, we can measure progress towards completion by using:

  1. Input measures. The most common approach is to use the “cost-to-cost” ratio, which is equal to cost incurred to date divided by estimated total costs.
  2. Output measures. Examples include the passage of time and the amount of finished product delivered.

IV.Revenue Recognition for Contracts with Multiple Performance Obligations

A. The objective is to separate complex contracts into parts that can be viewed on a stand-alone basis. Steps 2 and 4 are critical to this process.(T5-8 – T5-12)

B. Step 2: Identify the performance obligation(s) in the contract.

  1. A promise to provide a good or service is a performance obligation if the good or service is distinct from other goods and services in the contract.
  2. A good or service is distinct if it is both:
  1. Capable of being distinct. The customer could use the good or service on its own or in combination with other goods and services it could obtain elsewhere, and
  2. Separately identifiable from other goods or services in the contract. The good or service also is distinct in the context of the contract because it is not highly interrelated with other goods and services in the contract.

C. Step 4: Allocate the transaction price to each performance obligation based on relative stand-alone selling prices. If stand-along selling pricesaren’t observable, estimate them.

V. Illustration 5-11 Sumarizes the Revenue Recognition Concepts Covered in Part A(T5-13)

Part B: Special Topics in Revenue Recognition

I.Special Issues for Step 1: Identify the Contract (T5-14, T5-15)

  1. A contract is an agreement that creates legally enforceable rights and obligations.
  1. Can be explicit or implicit.
  2. Can be oral or written.
  1. A contract exists for purposes of revenue recognition only if it
  1. has commercial substance, affecting the risk, timing or amount of the seller’s future cash flows,
  2. has been approved by both the seller and the customer, indicating commitment to fulfilling their obligations,
  3. specifies the seller’s and customer’s rights regarding the goods or services to be transferred,
  4. specifies payment terms, and
  5. is probable that the seller will collect the amount it is entitled to receive.
  1. A contract does not exist if both of the following are true.
  1. neither the seller nor the customer has performed any obligations under the contract, and
  2. both the seller and the customer can terminate the contract without penalty.

II.Special Issues for Step 2: Identify the Performance Obligation(s) (T5-16, T5-17)

  1. Examples of common parts of contracts that are not performance obligations:
  1. Prepayments (it’s part of the transaction price).
  2. Quality-assurance warranties (it’s part of the performance obligation to deliver goods and services that are free of defects).
  3. Right of return (it’s part of the performance obligation to deliver acceptable goods and services).
  1. Examples of common parts of contracts that are performance obligations:
  1. Extended warranties (it’s a separate obligation distinct from delivering acceptable goods and services). A warranty is an extended warranty if either
  1. the customer has the option to purchase the warranty separately, or
  2. the warranty provides a service to the customer beyond quality assurance.
  1. Options that provide a material right (a material right is something the customer wouldn’t get otherwise, so the seller is obligated to provide it).

III.Special Issues for Step 3: Determine the Transaction Price

  1. Variable Consideration: (T5-18 – T5-22)
  1. Occurs when some of the contract price depends on the outcome of a future event. Examples:
  1. Incentive payments.
  2. Royalties.
  3. Volume discounts.
  4. Rebates.
  5. Right of return.
  1. Estimate variable consideration using either
  1. Expected value, calculated as the sum of each possible amount multiplied by its probability (more likely to be used when several outcomes are possible).
  2. Most likely amount (more likely to be used when two outcomes are possible).
  1. Sellers only include an estimate of variable consideration in the transaction price to the extent it is probable that a significant revenue reversal will not occur when the uncertainty associated with the variable consideration is resolved.
  1. Intended to avoid severe revenue overstatements due to estimation error.
  2. Indicators that a significant reversal could occur:
  3. poor evidence on which to base an estimate,
  4. dependence of the estimate on factors outside the seller’s control,
  5. a history of the seller changing payment terms on similar contracts,
  6. a broad range of outcomes that could occur, and
  7. a long delay before uncertainty resolves.
  1. The seller should update estimates of variable consideration (and of whether the constraint is required) prospectively, adjusting revenue and other accounts as necessary in the period in which the estimate is revised.
  2. Regarding sales with a right of return,
  1. If sales are for cash, companies record estimated returns by debiting a contra-revenue account called “sales returns” and crediting a refund liability.
  2. If sales are for credit, companies record estimated returns by debiting a contra-revenue account called “sales returns” and crediting a contra-receivables account called “allowance for sales returns.
  3. We’ll discuss accounting for returns more in Chapter 7.
  1. Principal or Agent (T5-23, T5-24)
  1. If the company is a principal, it records revenue equal to the total sales price paid by customers as well as cost of goods sold equal to the cost of the item to the company.
  2. If the company is an agent, it records as revenue only the commission it receives on the transaction.
  3. We view the seller as a principal if it obtains control of the goods or services before they are transferred to the customer. Control is evident if the principal has primary responsibility for delivering a product or service and is vulnerable to risks associated with holding inventory, delivering the product or service, and collecting payment from the customer.
  1. Time Value of Money(T5-23)
  1. If payment happens before or after delivery, the transaction has a financing component. If the financing component is significant, the seller has to account for it.
  1. If payment before delivery, seller is getting a loan, so recognizes interest expense.
  2. If payment after delivery, seller is giving a loan, so recognizes interest revenue.
  1. We presume the financing component is not significant if payment and delivery are separated by less than one year.
  1. Payments by the Seller to the Customer (T5-23)
  1. If the seller is purchasing distinct goods or services from the customer at the fair value of those goods or services, we account for that purchase as a separate transaction.
  2. If a seller pays more for distinct goods or services purchased from their customer than the fair value of those goods or services, those excess payments are viewed as a refund. They are subtracted from the amount the seller is entitled to receive from the customer when calculating the transaction price of the sale to the customer.

IV.Special Issues for Step4: Allocate the Transaction Price to the Performance Obligations

  1. Three methods are recommended for estimating stand-alone selling prices that are not observable: (T5-25, T5-26)
  1. Adjusted market assessment approach: The seller considers what it could sell the product or services for in the market in which it normally conducts business, perhaps referencing prices charged by competitors.
  2. Expected cost plus margin approach: The seller estimates its costs of satisfying a performance obligation and then adds an appropriate profit margin.
  3. Residual approach: The seller estimates an unknown (or highly uncertain) stand-alone selling price by subtracting the sum of the known or estimated stand-alone selling prices from the total transaction price. The residual approach is allowed only if the stand-alone selling price is highly uncertain, either because
  1. the seller hasn’t previously sold the good or service and hasn’t yet determined a price for it, or
  2. the seller provides the same good or service to different customers at substantiallydifferent prices.

V. Special Issues for Step 5: Recognize Revenue When (Or As) Each Performance Obligation Is Satisfied(T5-27, T5-28)

  1. Licenses
  1. Right of use: Some licenses transfer a right to use the seller’s intellectual property as it exists when the license is granted. Revenue for those licenses is recognized at the point in time the right is transferred.
  2. Right of access: Some licenses provide the customer with access to the seller’s intellectual property with the understanding that the seller will undertake ongoing activities during the license period that affect the benefit the customer receives. Revenue for those licenses is recognized over the period of time for which access is provided.
  1. Franchises
  1. The franchisor grants to the franchisee the right to sell the franchisor’s products and use its name for a specified period of time.
  2. A franchise typically involves a license to use the franchisor’s intellectual property, but also involves initial sales of products and services as well as ongoing sales of products and services.
  3. The franchisor must evaluate each part of the franchise arrangement to identify the performance obligations and account for them accordingly.
  1. Bill-and-hold sales
  1. Exist when a customer purchases goods but requests that the seller not ship the product until a later date.
  2. Sellers usually conclude that control has not been transferred and revenue should not be recognized until actual delivery to the customer occurs.
  3. Sellers can recognize revenue prior to delivery only if (a) they conclude that the customer controls the product, (b) there is a good reason for the bill-and-hold arrangement, and (c) the product is specifically identified as belonging to the customer and is ready for shipment.
  1. Consignment arrangements
  1. Exist when a “consignor” physically transfers the goods to the other company (the consignee), but the consignor retains legal title.
  2. The consignor retains control so it postpones recognizing revenue until sale to an end customer occurs.
  1. Gift Cards
  1. Seller records a deferred revenue liability when the card is sold.
  2. Seller recognizes revenue when the card is used and at the point when it concludes there is only a “remote likelihood” that customer will use the card.

VI. Disclosures(T5-29)

  1. Income Statement reports revenue, bad debt expense, and interest revenue and interest expense associated with significant finance components.
  2. Balance Sheet
  1. Accounts Receivable: Unconditional right to receive payment, depending only on the passage of time.
  2. Contract Assets: Conditional right to receive payment for performance obligations already performed.
  3. Contract Liabilities: Deferred revenue.
  1. Disclosure:
  1. The objective is to help investors understand the nature, amount, timing and uncertainty of revenues and cash flows.
  2. Required disclosures include:
  1. Separation of revenue into meaningful categories (product lines, geographic regions, types of customers, types of contracts).
  2. Outstanding performance obligations.
  3. Important contractual provisions.
  4. Significant judgments.
  5. Significant changes in contract assets and liabilities.

VII. Illustration 5-22 Sumarizes the Revenue Recognition Special Topics Covered in Part B(T5-30)

Part C: Accounting for Long-Term Contracts (T5-31)

I. Two of the five revenue recognition steps are especially critical for long-term contracts:(T5-32)

  1. Step 2, “Identify the performance obligation(s) in the contract,” is important because long-term contracts typically include many products and services that could be viewed as separate performance obligations. These products and services are capable of being distinct, but they are not separately identifiable, because the seller’s role is to combine those products and services for purposes of delivering a completed product. Therefore, these contracts are viewed as a bundle of products and services that comprise a single performance obligation.
  2. Step 5, “Recognize revenue when (or as) each performance obligation is satisfied,” is important because there can be a considerable difference for long-term contracts between recognizing revenue over time and recognizing revenue only when the contract has been completed. Most long-term contracts qualify for revenue recognition over time, either because
  1. the seller is creating an asset that the customer controls as it is completed, or
  2. the seller is creating an asset that is customized for the customer, so the seller has no other use for the asset and has the right to be paid for progress even if the customer cancels the contract.
  1. If a contract doesn’t qualify for revenue recognition over time, revenue is recognized upon completion of the contract. (In prior GAAP, this was called the completed contract method.)
  2. If a contract qualifies for revenue recognition over time, revenue is recognized over the term of the contract according to the percentage of completion. (In prior GAAP, this was called the percentage-of-completion method.)

II.Much of the accounting is the same, regardless of whether revenue is recognized over time or upon contract completion. (T5-33 – T5-37)

  1. All costs of construction are recorded in an asset (inventory) account called construction in progress.
  2. Period billings are credited to billings on construction contract, a contra account to the construction in progress account.This serves to reduce the book value of the physical asset (construction in progress) when a financial asset (accounts receivable) is also recognized; otherwise the project would be double-counted on the balance sheet.
  3. Construction in progress is debited for the amount of gross profit recognized. The same total amount of gross profit is recognizedover the life of the contract regardless of the timing of revenue recognition – the only difference is timing.
  4. Recognizing revenue at a point in time is equivalent to recognizing revenue at the point of delivery, that is, when the project is complete.
  1. No revenues or expenses are recognized until the project is complete.
  2. Exception: overall losses on the contract (see below).
  1. Recognizing revenue over time allocates a fair share of a project's revenues and expenses to each reporting period during construction. How is that fair share determined? (T5-13)
  1. The allocation of project profit is accomplished by estimating progress to date.
  2. Progress to date (the percentage of completion) can be estimated as the proportion of the project's cost incurred to date divided by total estimated costs, by project milestones, or by relying on an engineer's or architect's estimate. The “cost-to-cost” approach is most common.
  3. To determine revenue, the percentage of completion is multiplied by estimated total revenue to determine revenue that should be recognized to date, and then the current period's revenue is determined by subtracting from this amount the revenue recognized in previous periods.

Revenue recognized this period / = / (
/ Total
estimated
revenue / × / Percentage
completed
to date / ) / − / Revenue
recognized in prior periods
Cumulative revenue to be
Recognized to date
  1. In most cases, the cost of construction equals the construction costs incurred during the period. Therefore, the same approach used to estimate revenue can be used to estimate gross profit.

III. Balance sheet effects: Construction in progress is compared to billings on construction contract. (T5-38)