CHAPTER FIVE

Revenue recognition

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 OVERVIEW OF REVENUE RECOGNITION

New Revenue Recognition Standard

Revenue from Contracts with Customers, adopts an
asset-liability approach. Companies:
◆ Account for revenue based on the asset or liability arising
from contracts with customers.

◆ Are required to analyze contracts with customers

► Contracts indicate terms and measurement of
consideration.

► Without contracts, companies cannot know whether

promises will be met.
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 New Revenue Recognition Standard

ILLUSTRATION 1 Key Concepts of Revenue Recognition

3
Performance Obligation is Satisfied
Recognizing Revenue When (or as) Each
Performance Obligation Is Satisfied-Step 5
Step in Process Description Implementation

1. Identify the A contract is an A company applies the revenue

contract with agreement that creates guidance to contracts with
customers. enforceable rights or customers and must determine
obligations. if new performance obligations
are created by a contract
modification.

ILLUSTRATION 20
Summary of the
Five-Step Revenue
Recognition Process

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Recognizing Revenue When (or as) Each
Performance Obligation Is Satisfied-Step 5
Step in Process Description Implementation

2. Identify the A performance obligation A contract may be comprised of

separate is a promise in a contract multiple performance
performance to provide a product or obligations.
obligations service to a customer. Accounting is based on
in the A performance obligation evaluation of whether the
contract exists if the customer can product or service is distinct
benefit from the good or within the contract.
service on its own or If each of the goods or services
together with other readily is distinct, but is interdependent
available resources. and interrelated, these goods
and services are combined and
ILLUSTRATION 20
Summary of the reported as one performance
Five-Step Revenue obligation.
Recognition Process

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Recognizing Revenue When (or as) Each
Performance Obligation Is Satisfied-Step 5
Step in Process Description Implementation

3. Determine Transaction price is the In determining the transaction

the amount of consideration price, companies must consider
transaction that a company expects to the following factors:
price. receive from a customer 1. variable consideration,
in exchange for
2. time value of money,
transferring goods and
services. 3. Non-cash consideration, and
4. consideration paid or
payable to customer.

ILLUSTRATION 20
Summary of the
Five-Step Revenue
Recognition Process

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Recognizing Revenue When (or as) Each
Performance Obligation Is Satisfied-Step 5
Step in Process Description Implementation

4. Allocate the If more than one The best measure of fair value
transaction performance obligation is what the good service could
price to the exists, allocate the be sold for on a standalone
separate transaction price based basis (standalone selling price).
performance on relative fair values. Estimates of standalone selling
obligation. price can be based on
1. adjusted market
assessment,
2. expected cost-plus a margin
approach, or
ILLUSTRATION 20 3. a residual approach.
Summary of the
Five-Step Revenue
Recognition Process

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Recognizing Revenue When (or as) Each
Performance Obligation Is Satisfied-Step 5
Step in Process Description Implementation

5. Recognize A company satisfies its Companies satisfy performance

revenue performance obligation obligations either at a point in
when each when the customer time or over a period of time.
performance obtains control of the Companies recognize revenue
obligation is good or service. over a period of time if
satisfied. 1. the customer controls the
asset as it is created or
2. the company does not have
an alternative use for the
asset.
ILLUSTRATION 20
Summary of the
Five-Step Revenue
Recognition Process

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 THE FIVE-STEP PROCESS

Assume that Airbus (FRA) Corporation signs a contract to sell

airplanes to Ethiopian Airlines for €100 million.
ILLUSTRATION 2
Five Steps of Revenue Recognition

A contract is an agreement between two parties

Step 1: Identify the
that creates enforceable rights or obligations. In
contract with
this case, Airbus has signed a contract to deliver
customers.
airplanes to Ethiopian airlines.

Airbus has only one performance obligation—to

Step 2: Identify the
deliver airplanes to Ethiopian airlines. If Airbus
separate performance
also agreed to maintain the planes, a separate
obligations in the
performance obligation is recorded for this
contract.
promise.

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 THE FIVE-STEP PROCESS

ILLUSTRATION 2 Five Steps of Revenue Recognition

Transaction price is the amount of consideration

Step 3: Determine that a company expects to receive from a
the transaction customer in exchange for transferring a good or
price. service. In this case, the transaction price is
straightforward—it is €100 million.

Step 5: Allocate the

transaction price to In this case, Airbus has only one performance
the separate obligation—to deliver airplanes to Ethiopian
performance airlines.
obligations.

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 THE FIVE-STEP PROCESS

ILLUSTRATION 2 Five Steps of Revenue Recognition

Step 5: Recognize
Airbus recognizes revenue of €100 million for the
revenue when
sale of the airplanes to Ethiopian airlines when it
each performance
satisfies its performance obligation—the delivery
obligation
of the airplanes to Ethiopian airlines.
is satisfied.

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 Identify Contract with Customers—Step 1

Contract:
◆ Agreement between two or more parties that creates
enforceable rights or obligations.

◆ Can be
► written,
► oral, or
► implied from customary business practice.

Company applies the revenue guidance to a contract

according to the following criteria in Illustration 3.

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 Contract with Customers—Step 1

ILLUSTRATION 3 Contract Criteria for Revenue Guidance

Disregard Revenue
Apply Revenue Guidance to Contracts If:
Guidance to Contracts If:

▪ The contract has commercial substance; ▪ The contract is wholly

▪ The parties to the contract have approved the unperformed, and
contract and are committed to perform their ▪ Each party can unilaterally
respective obligations; terminate the contract
▪ The company can identify each party’s rights without compensation.
regarding the goods or services to be
transferred; and
▪ The company can identify the payment terms
for the goods and services to be transferred.
▪ It is probable It is probable that the company
will collect the consideration to which it will be
entitled.

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 Contract with Customers—Step 1

Basic Accounting
◆ Revenue cannot be recognized until a contract exists.
◆ Company obtains rights to receive consideration and
assumes obligations to transfer goods or services.
◆ Rights and performance obligations gives rise to an (net)
asset or (net) liability.
◆ Company does not recognize contract assets or liabilities until
one or both parties to the contract perform.

Contract asset = Rights received > Performance obligation

Contract liability = Rights received < Performance obligation

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 Contract with Customers—Step 1

Contract Modifications
◆ Change in contract terms while it is ongoing.

◆ Companies determine
► whether a new contract (and performance
obligations) results or

► whether it is a modification of the existing contract.

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 Contract Modifications

Separate Performance Obligation

◆ Account for as a new contract if both of the following
conditions are satisfied:
► Promised goods or services are distinct (i.e.,
company sells them separately and they are not
interdependent with other goods and services), and

► The company has the right to receive an amount of

consideration that reflects the standalone selling
price of the promised goods or services.

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 Separate Performance Obligation

For example, Crand Co. has a contract to sell 100 products to a

customer for $10,000 (€100 per product) at various points in time
over a six-month period. After 60 products have been delivered,
Crand modifies the contract by promising to deliver 20 more
products for an additional €1,900, or €95 per product (which is the
standalone selling price of the products at the time of the contract
modification). Crand regularly sells the products separately.

Given a new contract, Crand recognizes an additional:

Original contract [(100 units - 60 units) x €100] = €4,000

New product (20 units x €95) = 1,900
Total revenue €5,900

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 Contract Modifications

Prospective Modification
◆ Company should
► account for effect of change in period of change as
well as future periods if change affects both.

► not change previously reported results.

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 Prospective Modification

For Crand, the amount recognized as revenue for each of the

remaining products would be a blended price of €98.33, computed
as shown in Illustration 5.
Products not delivered under original contract

($100 x €40) = €4,000

Products to be delivered under contract
modification (€95 x 20) = 1,900
Total remaining revenue €5,900

Revenue per remaining unit (€5,900 ÷ 60) = €98.33

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 Separate Performance Obligations—Step 2

Revenue Recognition Situations

ILLUSTRATION 7

Sale of asset
Type of Sale of product Performing a Permitting use of
other than
Transaction from inventory service an asset
inventory

Description Revenue from

Revenue from Revenue from Gain or loss on
interest, rents,
of Revenue sales fees or services disposition
and royalties

Timing of Services As time passes

Date of sale (date Date of sale or
Revenue performed and or assets are
of delivery) trade-in
Recognition billable used

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Separate Performance Obligations—Step 2

◆ To determine whether a company has to account for

multiple performance obligations, it evaluates a second
condition.

◆ Whether the product is distinct within the contract.

► If performance obligation is not highly dependent on,
or interrelated with, other promises in the contract,
then each performance obligation should be
accounted for separately.

► If each of these services is interdependent and

interrelated, these services are combined and
reported as one performance obligation.
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 Determining Transaction Price—Step 3

Transaction price
◆ Amount of consideration that company expects to
receive from a customer.

◆ In a contract is often easily determined because

customer agrees to pay a fixed amount.

◆ Other contracts, companies must consider:

► Variable consideration
► Time value of money
► Non-cash consideration
► Consideration paid or payable to customers
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 Determining Transaction Price—Step 3

Variable Consideration
◆ Price dependent on future events.
► May include discounts, rebates, credits, performance
bonuses, or royalties.

◆ Companies estimate amount of revenue to recognize.

► Expected value
► Most likely amount

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 Determining Transaction Price—Step 3

Non-Cash Consideration
Goods, services, or other non-cash consideration.
◆ Companies sometimes receive contributions (e.g.,
donations and gifts).

◆ Customers sometimes contribute goods or services,

such as equipment or labor, as consideration for goods
provided or services performed.

◆ Companies generally recognize revenue on the basis

of the fair value of what is received.

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Allocating Transaction Price to Separate
Performance Obligations—Step 5
◆ Based on their relative fair values.

◆ Best measure of fair value is what the company could

sell the good or service for on a standalone basis.

◆ If not available, companies should use their best

estimate of what the good or service might sell for as a
standalone unit.

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Recognizing Revenue When (or as) Each
Performance Obligation Is Satisfied-Step 5
Company satisfies its performance obligation when the
customer obtains control of the good or service.

Change in Control Indicators

1. Company has a right to payment for asset.
2. Company has transferred legal title to asset.
3. Company has transferred physical possession of asset.
4. Customer has significant risks and rewards of ownership.
5. Customer has accepted the asset.

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Recognizing Revenue When (or as) Each
Performance Obligation Is Satisfied-Step 5
Recognizing revenue from a performance obligation over
time
◆ Measure progress toward completion
► Method for measuring progress should depict transfer
of control from company to customer.

► Most common are cost-to-cost and units-of-delivery

methods.

► Objective of methods is to measure extent of progress

in terms of costs, units, or value added.

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 LONG-TERM CONSTRUCTION CONTRACTS

REVENUE RECOGNITION OVER TIME

Under certain circumstances companies recognize
revenue over time.

The most notable context in which revenue may be

recognized over time is long-term construction contract
accounting.

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 LONG-TERM CONSTRUCTION CONTRACTS

REVENUE RECOGNITION OVER TIME

Long-term contracts frequently provide that seller (builder)
may bill purchaser at intervals.
► Examples:
▪ Development of military and commercial aircraft
▪ Weapons-delivery systems
▪ Space exploration hardware

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 LONG-TERM CONSTRUCTION CONTRACTS

REVENUE RECOGNITION OVER TIME

A company recognizes revenue over time if at least one of
the following two criteria is met:
1. Company’s performance creates or enhances an asset
(e.g., work in process) that the customer controls as the
asset is created or enhanced; or

2. Company’s performance does not create an asset with

an alternative use. In addition…

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 LONG-TERM CONSTRUCTION CONTRACTS

REVENUE RECOGNITION OVER TIME

In addition at least one of the following criteria must be met:
a. The customer simultaneously receives and consumes the
benefits of the entity’s performance as the entity performs.

b. Another company would not need to substantially re-perform

the work the company has completed to date if that other
company were to fulfill the remaining obligation to the
customer.

c. The company has a right to payment for its performance

completed to date, and it expects to fulfill the contract as
promised.
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 LONG-TERM CONSTRUCTION CONTRACTS

REVENUE RECOGNITION OVER TIME

If criterion 1 or 2 is met, then a company recognizes
revenue over time if it can reasonably estimate its progress
toward satisfaction of the performance obligations.
◆ Company recognizes revenues and gross profits each
period based upon the progress of the construction—
referred to as the percentage-of-completion method.

◆ If criteria are not met, the company recognizes revenues

and gross profit when the contract is completed, referred
to as the cost-recovery (zero-profit) method.

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 LONG-TERM CONSTRUCTION CONTRACTS

Percentage-of-Completion Method
Measuring the Progress Toward Completion
Most popular input measure used to determine the progress
toward completion is the cost-to-cost basis.

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 LONG-TERM CONSTRUCTION CONTRACTS

Percentage-of-Completion Method
Revenue to Recognized Cost-to-Cost Basis
ILLUSTRATION 1

ILLUSTRATION 2

ILLUSTRATION 3

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 PERCENTAGE-OF-COMPLETION METHOD

Illustration: Hardhat Construction Company has a contract to

construct a £5,500,000 bridge at an estimated cost of
£5,000,000. The contract is to start in July 2015, and the bridge
is to be completed in October 2017. The following data pertain to
the construction period.

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 PERCENTAGE-OF-COMPLETION METHOD

ILLUSTRATION 5

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 PERCENTAGE-OF-COMPLETION METHOD

ILLUSTRATION 5

37
 PERCENTAGE-OF-COMPLETION METHOD

Illustration: Percentage-of-Completion Revenue, Costs, and

Gross Profit by Year
ILLUSTRATION 6

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 ILLUSTRATION 6

PERCENTAGE-OF-
COMPLETION
METHOD

ILLUSTRATION 7

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 PERCENTAGE-OF-COMPLETION METHOD

Illustration: Content of Construction in Process Account—

Percentage-of-Completion Method
ILLUSTRATION 8

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 PERCENTAGE-OF-COMPLETION METHOD

Financial Statement Presentation—Percentage-

of-Completion
Computation of Unbilled Contract Price at 12/31/15

ILLUSTRATION 9

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 PERCENTAGE-OF-COMPLETION METHOD

Financial Statement Presentation—Percentage-

of-Completion Method (2015)
ILLUSTRATION 10

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 PERCENTAGE-OF-COMPLETION METHOD

Financial Statement Presentation—Percentage-

of-Completion Method (2016)
ILLUSTRATION 11

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 LONG-TERM CONSTRUCTION CONTRACTS

Cost-Recovery (Zero-Profit) Method

This method recognizes revenue only to the extent of costs
incurred that are expected to be recoverable. Only after all costs
are incurred is gross profit recognized.

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 COST-RECOVERY (ZERO-PROFIT) METHOD

Illustration: Hardhat Construction would report the following

revenues and costs for 2015–2017. ILLUSTRATION 15

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 COST-RECOVERY (ZERO-PROFIT) METHOD

ILLUSTRATION 15
Cost-Recovery Method
Revenue, Costs, and
Gross Profit by Year

ILLUSTRATION 15
Journal Entries—
Cost-Recovery Method

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 COST-RECOVERY (ZERO-PROFIT) METHOD

ILLUSTRATION 15
Cost-Recovery Method
Revenue, Costs, and
Gross Profit by Year

ILLUSTRATION 16
Comparison of Gross
Profit Recognized under
Different Methods

47
COST-RECOVERY (ZERO-PROFIT) METHOD

ILLUSTRATION 17
48 Financial Statement Presentation—Cost- Recovery Method
 LONG-TERM CONSTRUCTION CONTRACTS

Long-Term Contract Losses

1. Loss in Current Period on a Profitable Contract
► Percentage-of-completion method only, the estimated
cost increase requires a current-period adjustment of
gross profit recognized in prior periods.

2. Loss on an Unprofitable Contract

► Under both percentage-of-completion and cost-
recovery methods, the company must recognize in the
current period the entire expected contract loss.

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 LONG-TERM CONTRACT LOSSES

Illustration: Loss in Current Period

2014 2015 2016
Contract price
Casper Construction Co. $675,000 $675,000 $675,000
Cost incurred current year 150,000 287,400 215,436
Estimated cost to complete
in future years 450,000 215,436 0
Billings to customer current year 135,000 360,000 180,000
Cash receipts from customer
Current year 112,500 262,500 300,000

Prepare the journal entries to record revenue and expense for 2015, 2015, and
2016 assuming the estimated cost to complete at the end of 2015 was
$215,536.

50 Advance slide in presentation mode to reveal answers.

 LONG-TERM CONTRACT LOSSES

Illustration: Loss in Current Period

2014 2015 2016
Costs incurred to date $ 150,000 $ 437,400 $ 652,836
Estimated cost to complete 450,000 215,436
Est. total contract costs 600,000 652,836 652,836
Est. percentage complete 25.0% 67.0% 100.0%
Contract price 675,000 675,000 675,000
Revenue recognizable 168,750 452,250 675,000
Rev. recognized prior year (168,750) (452,250)
Rev. recognized currently 168,750 283,500 222,750
Costs incurred currently (150,000) (287,400) (215,436)
Gross profit recognized $ 18,750 $ (3,900) $ 7,314

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 LONG-TERM CONTRACT LOSSES

Illustration: Loss in Current Period

2014 2015 2016

Construction in Process 18,750 7,314

Construction Expenses 150,000 215,436
Revenue from LT Contracts 168,750 222,750

Construction in Process 3,900

Construction Expenses 287,400
Revenue from LT Contracts 283,500

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 LONG-TERM CONTRACT LOSSES

Illustration: Loss on Unprofitable Contract

2014 2015 2016
Contract price
Casper Construction Co. $675,000 $675,000 $675,000
Cost incurred current year 150,000 287,400 246,038
Estimated cost to complete
in future years 450,000 246,038 0
Billings to customer current year 135,000 360,000 180,000
Cash receipts from customer
Current year 112,500 262,500 300,000

Prepare the journal entries for 2015, 2015, and 2016 assuming the estimated
cost to complete at the end of 2015 was $256,038 instead of $170,100.

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 LONG-TERM CONTRACT LOSSES

Illustration: Loss on Unprofitable Contract

2014 2015 2016
Costs incurred to date $ 150,000 $ 437,400 $ 683,438
Estimated cost to complete 450,000 246,038
Est. total contract costs 600,000 683,438 683,438
Est. percentage complete 25.0% 64.0% 100.0%
Contract price 675,000 675,000 675,000
Revenue recognizable 168,750 432,000 675,000
Rev. recognized prior year (168,750) (432,000)
Rev. recognized currently 168,750 263,250 243,000
Costs incurred currently (150,000) (290,438) (243,000)
Gross profit recognized $ 18,750 $ (27,188) $ -

54 $675,000 – 683,538 = (8,538) cumulative loss

 LONG-TERM CONTRACT LOSSES

Illustration: Loss on Unprofitable Contract

2014 2015 2016

Construction in Process 18,750 -

Construction Expenses 150,000 243,000
Revenue from LT Contracts 168,750 243,000

Construction Expenses 290,438

Construction in Process 27,188
Revenue from LT Contracts 263,250

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 LONG-TERM CONTRACT LOSSES

Illustration: Loss on Unprofitable Contract

For the Cost-Recovery method, companies would recognize the

following loss :

2014 2015 2016

Loss on LT Contracts 8,438

Construction in Process 8,438

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 REVENUE RECOGNITION FOR FRANCHISES

Franchises
Four types of franchising arrangements have evolved:
1. Manufacturer-retailer

2. Manufacturer-wholesaler

3. Service sponsor-retailer

4. Wholesaler-retailer

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 REVENUE RECOGNITION FOR FRANCHISES

Franchises
Two sources of revenue:
1. Sale of initial franchises and related assets or services,
and

2. Continuing fees based on the operations of franchises.

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 REVENUE RECOGNITION FOR FRANCHISES

Franchises
The franchisor normally provides the franchisee with:
1. Assistance in site selection
2. Evaluation of potential income
3. Supervision of construction activity
4. Assistance in the acquisition of signs, fixtures, and equipment
5. Bookkeeping and advisory services
6. Employee and management training
7. Quality control
8. Advertising and promotion

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 REVENUE RECOGNITION FOR FRANCHISES

FRANCHISE ACCOUNTING
Performance obligations relate to:

◆ Right to open a business.

◆ Use of trade name or other intellectual property of the

franchisor.

◆ Continuing services, such as marketing help, training, and

in some cases supplying inventory and inventory
management.

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 REVENUE RECOGNITION FOR FRANCHISES

FRANCHISE ACCOUNTING
Franchisors commonly charge an initial franchise fee and
continuing franchise fees:

► Initial franchise fee (payment for establishing the relationship

and providing some initial services).

► Continuing franchise fees received

▪ In return for continuing rights granted by the agreement.
▪ For providing management training, advertising and
promotion, legal assistance, and other support.

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 REVENUE RECOGNITION FOR FRANCHISES

Consider the following for allocation of the transaction price at

December 31, 2015.

Training is completed in January 2016, the equipment is installed in

January 2016, and Food Fight holds a grand opening on February 2,
2016.

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 REVENUE RECOGNITION FOR FRANCHISES

On December 31, 2015, Tum’s signs the agreement and receives

upfront payment and note.

Cash 20,000
Notes Receivable 30,000
Discount on Notes Receivable 6,053
Unearned Franchise Revenue 20,000
Unearned Service Revenue (training) 9,957
Unearned Sales Revenue (equipment) 15,000

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 REVENUE RECOGNITION FOR FRANCHISES

On February 2, 2016, franchise opens. Tum’s satisfies the

performance obligations related to the franchise rights, training, and
equipment.

Unearned Franchise Revenue 20,000

Franchise Revenue 20,000
Unearned Service Revenue (training) 9,957
Service Revenue (training) 9,957
Unearned Sales Revenue (equipment) 15,000
Sales Revenue 15,000
Cost of Goods Sold 10,000
Inventory 10,000

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 REVENUE RECOGNITION FOR FRANCHISES

RECOGNITION OF FRANCHISE RIGHTS

REVENUE OVER TIME
Depending on the economic substance of the rights, the
franchisor may be providing access to the right rather than
transferring control of the franchise rights.

In this case, the franchise revenue is recognized over

time, rather than at a point in time.

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 FRANCHISE REVENUE OVER TIME

Identify the performance obligations and the point in time when the
performance obligations are satisfied and revenue is recognized.

Rights to the trade name, market area, and proprietary know-how

for 5 years are not individually distinct.

◆ Each one is not sold separately and cannot be used with other
goods or services that are readily available to the franchisee.

◆ Licensed rights and the ongoing training materials are a single

performance obligation.

◆ Tech Solvers is providing access to the rights and must continue

(over time) to perform updates and services.

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 FRANCHISE REVENUE OVER TIME

Identify the performance obligations and the point in time when the
performance obligations are satisfied and revenue is recognized.

Tech Solvers cannot recognize revenue for the royalty payments

◆ Not reasonably assured to be entitled to those revenue-based

royalty amounts.

◆ Payments represent variable consideration.

◆ Recognize revenue for royalties when (or as) uncertainty is

resolved.

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 FRANCHISE REVENUE OVER TIME

Franchise agreement signed and receipt of upfront payment and note,

December 15, 2015:

Cash 5,000
Unearned Franchise Revenue 5,000

Franchise begins operations in January 2016 and records €85,000 of

revenue for the year ended December 31, 2016.

Unearned Franchise Revenue 1,000

Franchise Revenue (€5,000 ÷ 5) 1,000
Accounts Receivable 5,950
Franchise Revenue (€85,000 x 7%) 5,950

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 Thank you!!!

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