Chapter 18. Revenue Recognition

I. The Five Step Process

II. Long-term Contract (Very difficult but important! Read the textbook!)

III. Other Issues

New Revenue Recognition Standard

Overview of Revenue Recognition

In May 2013, the FASB and IASB issued a converged standard on revenue recognition entitled Revenue from Contracts with Customers

Revenue from Contracts with Customers, adopts an asset-liability approach. Companies:

Are required to analyze contracts with customers

Contracts indicate terms and measurement of consideration.

Without contracts, companies cannot know whether promises will be met.

Account for revenue based on the asset (right) and liability (obligation) arising from contracts with customers.

New Revenue Recognition Standard

Performance Obligation is Satisfied

The Five-Step Process

Boeing has signed a contract to deliverairplanes to Delta.

Boeing Co. signs a contract to sell airplanes to Delta Air Lines for $100 million.

Boeing has only one performance obligation—to deliver airplanes to Delta.

Step 2: Identify the separate performance obligations in the

contract.

Step 1: Identify the contract with customers.

Step 5: Recognize revenue wheneach performance obligation

is satisfied.

Boeing recognizes revenue of $100 million for the sale of the airplanes to

Delta when the delivery is made.

Step 3: Determine the transaction price.

Step 4: Allocate the transaction price to the separate

performance obligations.

The transaction price is $100 million.

Boeing allocates $100 million to delivering airplanes to Delta.

Description

A contract is an agreement that creates enforceable rights or obligations.

Implementation

• A company applies the revenue guidance to contracts with customers

• A company must determine if new performance obligations are created by a contract modification.

Step 1: Indentify Contract with Customers

Contract: Agreement between two or more parties that creates enforceable rights or obligations - Can be written, oral, or implied from customary business practice

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.

Contract asset = Rights received > Performance obligation Contract liability = Rights received < Performance obligation

However, a company does not recognize contract assets or liabilities until one or both parties to the contract perform.

Contract with Customers

• Contract Criteria for Revenue Guidance

7

Contract Criteria for Revenue Guidance

Apply Revenue Guidance to Contracts If:

Disregard Revenue Guidance to Contracts If:

The contract has commercial substance;

The parties to the contract have approved the contract and are committed to perform their respective obligations;

The company can identify each party’s rights regarding the goods or services to be transferred; and

The company can identify the payment terms for the goods and services to be transferred.

The contract is wholly unperformed, and

Each party can unilaterally terminate the contract without compensation.

Company applies the revenue guidance to a contract according to the criteria in the following Illustration

“Change in contract terms while it is ongoing”.

Companies determine – whether a new contract (and performance obligations) is created by a contract modification or – whether it is a modification of the existing contract.

Contract Modifications

Contract Modifications, cont’d

• Separate Performance Obligation Accounts for as a new contract if both of the following

conditions are satisfied:1) Promised goods or services are distinct (i.e., company sells

them separately and they are not interdependent with other goods and services), and

2) The company has the right to receive an amount of consideration that reflects the “standalone” selling price of the promised goods or services.

• Prospective Modification If Additions are not a Separate Performance Obligation i.e.,) If neither or both of the above conditions are not met,

• Account for effect of change in period of change as well as future periods if change affects both.

Separate Performance Obligation

Crandall 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, Crandall modifies the

contract by promising to additionally deliver 20 more products at $95 per

product (which is the standalone selling price of the products at the time

of the contract modification). Crandall regularly sells the products

separately.

Given a new contract, Crandall recognizes an additional:

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

New product (20 units x $95) = 1,900

Total revenue recognized after modification = $5,900

If Additions are not a Separate Performance

Obligation, they are recognized as revenue for each of the

remaining products would be a “blended price” of $98.33.

Prospective Modification

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) = $98.33Revenue recognized after modification $5,900 = $98.33*60

Comparison of Contract Modification Approaches

Under the separate performance obligation approach

• $5,900 = 40*100 + 20*$95

Under the prospective modification approach

• $5,900 = $98.33*60

Description

• A performance obligation is a promise in a contract to provide a product or service to a customer.

• A performance obligation exists if the customer can benefit from the good or service on its own or together with other readily available resources.

Implementation

• A contract may be comprised of multiple performance obligations.

• If each of the goods or services is distinct, but is interdependent and interrelated, these goods and services are combined and reported as one performance obligation.

Step 2: Identify Separate Performance Obligations

Separate Performance Obligations

Determine whether a company has to account for

multiple (i.e., more than one) performance obligations

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.

Separate Performance Obligations: Examples

Com. A licenses customer-relationship software to Com. B. In addition, Com. A promises to provide consulting services by extensively customizing the software to Com. B’s information technology environment, for a total consideration of $600,000:

Com. A’s license and the consulting services are distinct but interdependent, and therefore should be accounted for as

One single performance obligation

Com. A manufactures and sells computers that include a warranty to make good on any defect for 120 days (often referred to as an assurance warranty). In addition, it sells separately an extended warranty, which provides protection from defects for 3 years beyond the 120 days (often referred to as a service warranty):

Com. A’s sale of the computer and related assurance warranty are interdependent and interrelated with each other

One single performance obligation But, the extended warranty is separately sold and not interdependent.

Separate performance obligation

Separate Performance Obligations: Example

Description

Transaction price is “the amount of consideration that a company expects to receive from a customer” in exchange for transferring goods and services.

Implementation

1. In a contract, transaction price is often easily determined because customer agrees to pay a fixed amount.

2. In other contracts, companies must consider:

(1) variable consideration,

(2) time value of money,

(3) noncash consideration, and

(4) consideration paid or payable to customer.

Step 3: Determine Transaction Price

Companies estimate amount of revenue to recognize. 1. Expected value: Probability-weighted amount in a range of possible consideration amounts May be appropriate if a company has a large number of contracts with similar

characteristics. Can be based on a limited number of discrete outcomes and probabilities.2. Most likely amount: The single most likely amount in a range of possible consideration outcomes May be appropriate if the contract has only “two” possible outcomes.

Variable consideration: A word of caution Only allocate variable consideration if it is reasonably assured that it will be entitled to the amount. Companies only recognizes variable consideration if 1. they have experience with similar contracts and are able to estimate the cumulative amount of revenue, and 2. based on experience, they do not expect a significant reversal of revenue previously recognized. If these two criteria are not met, revenue recognition is constrained.

Variable Consideration:“Price dependent on future events”

Question: How should Peabody account for this revenue arrangement?

Variable Consideration: Example

Peabody Construction Co. enters into a contract with a customer to build a warehouse for $100,000, with a performance bonus of $50,000 that will be paid based on the timing of completion. The amount of the performance bonus decreases by 10% per week for every week beyond the agreed-upon completion date. The contract requirements are similar to contracts that Peabody has performed previously, and management believes that such experience is predictive for this contract. Management estimates that there is a 60% probability that the contract will be completed by the agreed-upon completion date, a 30% probability that it will be completed 1 week late, and only a 10% probability that it will be completed 2 weeks late.

1. Management has concluded that the probability-weighted method is the

most predictive approach:

60% chance of $150,000 = $ 90,000

30% chance of $145,000 = 43,500

10% chance of $140,000 = 14,000

$147,500

2. Most likely outcome, if management believes they will meet the

deadline and receive the $50,000 bonus, the total transaction price

would be?$150,000 (the outcome with 60% probability)

Variable Consideration : Example, cont’d

Other issues• Time Value of Money

- When contract (sales transaction) involves a significant financing component.

• Fair value determined either by measuring the consideration received or by discounting the payment using an imputed interest rate.

• Company reports interest expense or interest revenue.

• Noncash Consideration

- Companies generally recognize revenue on the basis of the fair value of what is received (transactions with commercial substance).

If that cannot be determined, the selling price of what was given up.

- Receive Donation: Contribution Revenue

• Consideration Paid or Payable to Customers

- May include discounts, volume rebates, coupons, or free products.

- In general, these elements reduce the consideration received and the revenue to be recognized.

Volume Discount: ExampleMinjun Company offers its customers a 3% volume discount if they purchase at least $2 million of its product during the calendar year. On March 31, 2014, Minjun has made sales of $700,000 to Artic Co. In the previous 2 years, Minjun sold over $3,000,000 to Artic in the period April 1 to December 31.

Q: How much revenue should Minjun recognize for the first 3 months of 2014?

March 31, 2014:Accounts Receivable 679,000

Sales Revenue 679,000Reduced by $21,000(=$700,000x3%) because it is probable that the rebate will be provided.

Cash Receipt: Assuming Minjun’s customer meets the discount threshold,

Cash 679,000Accounts Receivable 679,000

If Minjun’s customer fails to meet the discount threshold, Minjun makes the following entry upon payment.

Cash 700,000Accounts Receivable 679,000Sales Discounts Forfeited 21,000

Description

If more than one performance obligation exists, allocate the transaction price based on relative fair values.

Implementation

The best measure of fair value is what the good service could be sold for on a standalone basis (standalone selling price).

Estimates of standalone selling price can be based on

1) adjusted market assessment,

2) expected cost plus a margin approach, or

3) a residual approach.

Step 4: Allocate Transaction Price to Separate Performance Obligations

Allocating Transaction Price to Separate Performance Obligations

1. Best measure of fair value is what the company could sell the

good or service for on a standalone basis.

2. If not available, companies should use their best estimate of

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

Three allocation approach

1) adjusted market assessment,

2) expected cost plus a margin approach, or

3) a residual approach

If more than one performance

obligation exists in a contract, the

allocation should be based on their

relative fair values (Illustration 18-16, Example 2 on Textbook p. 1054)

Description

A company satisfies its performance obligation when the customer obtains control of the good or service.

Implementation

• Companies satisfy performance obligations either at a point in time or over a period of time.

• Companies recognize revenue over a period of

time if (1) or (2) (i) and (ii) either (a) or (b) Next slide

Step 5: Recognize Revenue When Each Performance Obligation Is Satisfied

Change in Control Indicators1.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.

Recognizing Revenue When Each Performance Obligation is Satisfied

• Recognize revenue over a period of time (in a more rigorous manner) if:

(1) The customer controls the asset as it is created or enhanced or

(2) (i) the company does not have an alternative use for the asset created or enhanced and

(ii) either (a) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (b) the company has a right to payment and this right is enforceable

• Recognizes revenue over time by measuring the progress toward completion

• Method for measuring progress should depict transfer of control from company to customer

• The most common method is the cost-to-cost method• percentage-of-completion method

Sale of productfrom inventory

Sale of productfrom inventory

Rendering a service

Rendering a service

Permitting use of an asset

Permitting use of an asset

Sale of asset other than inventory

Sale of asset other than inventory

Type of Transaction

Revenue from sales

Revenue from sales

Date of sale (date of delivery)

Date of sale (date of delivery)

Revenue from fees or services

Revenue from fees or services

Revenue from interest, rents, and

royalties

Revenue from interest, rents, and

royaltiesGain or loss on

disposition

Gain or loss on disposition

Services performed and

billable

Services performed and

billable

As time passes or assets are

used

As time passes or assets are

usedDate of sale or

trade-in

Date of sale or trade-in

Description of Revenue

Timing of Revenue

Recognition

Revenue Recognition Situations:

Typical cases

On March 1, 2014, Margo Company enters into a contract to transfer a product to Soon Yoon on July 31, 2014. The contract is structured such that Soon Yoon is required to pay the full contract price of $5,000 on August 31, 2014.The cost of the goods transferred is $3,000. Margo delivers the product to Soon Yoon on July 31, 2014.

Question: Assuming Margo uses perpetual inventory method, what journal entries should Margo Company make in regards to this contract in 2014?

July 31, 2014Accounts Receivable 5,000

Sales Revenue 5,000

Cost of Goods Sold 3,000

Inventory 3,000

Cash 5,000

Accounts Receivable 5,000

August 31, 2014

Most Product Sales: Revenue Recognition at Point of Delivery

Long-term contract

• Revenue may be recognized before delivery under certain circumstances

• Long-term construction contracts using the percentage-of-completion method, are a notable example

The percentage-of-completion method recognizes revenues at various points in the project based on the percentage of work done.

Percentage-of-Completion vs. Completed-Contract method

Long-Term ConstructionAccounting Methods

Percentage-of-CompletionMethod

Completed-ContractMethod

: Rev. is recognized according to percentage of completion (before delivery): To be used if -Terms of contract must be certain, enforceable and expected to be performed by both parties

: Rev. is recognized only when contract is completed (at the point of delivery): To be used only when the percentage method is inapplicable (uncertain)

Percentage-of-Completion:How to get gross profit for each

yr? Costs Incurred to Date = Percent CompleteMost Recent Estimated Total Costs

1

Percent Complete x Estimated Total Revenue = Revenue (to Be Recognized) to Date

2

Revenue to Date – Prior Revenues =Current Period RevenueCost to Date – Prior costs =Current Period Cost So,Revenue of the year – Costs of the year = Gross Profit

3

Revenue to date - Cost to Date = Gross profit to dateSo, Gross profit to date – prior gross profits = Gross Profit

3OR

An Example

Data: Contract price: $4,500,000

Start date: July, 2010 Finish: Oct, 2012

Balance sheet date: December 31st

Given: 2010 2011 2012

Progress billings during year $ 900,000 $2,400,000 $1,200,000

Cash collected during year $ 750,000 $1,750,000 $2,000,000

Costs to date $1,000,000 $2,916,000 $4,050,000

Estimated costs to complete $3,000,000 $1,134,000 $ -0-

Calculate gross profit for each year.

2010 2011 2012

$4,500,000 $4,500,000 $4,500,000 Contract Price

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

Costs To DateEst. Cost to CompleteEst. Total Costs

1,000,000 2,916,000 4,050,000 4,000,000 4,050,000 4,050,000 = 25% = 72% = 100%

Percent Complete

Percentage-of-Completion:Percent complete?

Percentage-of-Completion: current year gross profit?

2010 2011 2012

$4,500,000 $4,500,000 $4,500,000 Contract Price

$1,000,000 $ 2,916,000 $ 4,050,000- 0 - 1,000,000 - 2,916,000 $1,000,000 $1,916,000 $ 1,134,000

Cost to date - Prior years’ costs Current year cost

$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 to date - Prior years’ Revenues Current year revenue

$ 1,125,000 $ 2,115,000 $ 1,260,000 -1,000,000 -1,916,000 -1,134,000 $ 125,000 $ 199,000 $ 126,000

Current year Revenue - Current year CostCurrent year gross profit

1,000,000 2,916,000 4,050,000 4,000,000 4,050,000 4,050,000 =25% =72% =100%

Percent Complete

Percentage-of-Completion: current year gross profit? Alternative

way 2010 2011 2012

$4,500,000 $4,500,000 $4,500,000 Contract Price

$ 125,000 $ 324,000 $ 450,000- -0- - 125,000 - 324,000 $ 125,000 $ 199,000 $ 126,000

Gross profit to date - Prior Gross profits Current year gross profit

$1,125,000 $3,240,000 $4,500,000- 1,000,000 - 2,916,000 - 4,050,000 $ 125,000 $ 324,000 $ 450,000

Revenue to date - Cost to date Gross Profit to date

1,000,000 2,916,000 4,050,000 4,000,000 4,050,000 4,050,000 =25% =72% =100%

Percent Complete

Income Statement 2010 2011 2012

Revenue on contracts 1,125,000 2,115,000 1,260,000'Journal Entries'!J15

Cost of construction 1,000,000 1,916,000 1,134,000Gross profit 125,000 199,000 126,000

Balance Sheet (12/31)Current assets:

Accounts receivable 150,000 800,000 Cost & profits > billings 225,000

Current liabilities:Billings > cost & profits 60,000

Percentage-of-Completion: F/S Representation

Completed-Contract Method

• Companies recognize revenue and gross profit only at point of sale (Delivery) —that is, when the contract is completed.

• Under this method, companies accumulate costs of long-term contracts in process, but they make no interim charges or credits to income statement accounts for revenues, costs, or gross profit.

• Gross Profit in the example: 2010 0;

2011 0;

2012 450,000 (= $4,500,000 - $4,050,000)

Income Statement 2010 2011 2012

Revenue on contracts --- --- 4,500,000

Cost of construction --- --- 4,050,000Gross profit --- --- 450,000

Balance Sheet (12/31)Current assets:

Accounts receivable 150,000 800,000 Cost & profits > billings 100,000

Current liabilities:Billings > cost & profits 384,000

Completed-Contract Method: F/S Representation

Comparison of Results(Gross Profit Recognition)

Year Percentage-of- Completion

Completed- Contract

2010 $125,000 $ 0

2011 199,000 0

2012 126,000 450,000

Total $450,000 $450,000

Another Example

2010 2011 2012

$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 DateEst. Cost to CompleteEst. Total Costs

1,000,000 2,916,000 4,384,962 4,000,000 4,384,962 4,384,962 = 25% = 66.5% = 100%

Percent Complete

Data as previously given, except for the 2012 cost estimate

Percentage-of-completion method for 2010, gross profit (125,000) is the same as that of prior example.

Prior Example

$1,134,000

Another Example:Gross profit for the 2011?

Revenue to 2011 (= $4,500,000 x 66.5%) $2,992,500Less: Revenue to 2010 1,125,000Revenue recognized in 2011 $1,867,500Less: Actual costs incurred in 2011 1,916,000Gross Profit (Loss) recognized in 2011 (48,500)

Revenue to 2011 (= $4,500,000 x 66.5%) $2,992,500Less: Cost to 2011 2,916,000Gross profit to 2011 $ 76,500Less: Gross profit to 2010 125,000Gross profit (Loss) in 2011 (48,500)

OR

Percentage-of-completion method (2011)

Another Example:Gross profit for the 2012?

Percentage-of-completion method (2012)

• Revenue (2012) = 4,500,000 – 2,992,500

= 1,507,500• Cost (2012) = 4,384,962 – 2,916,000

= 1,468,962• Gross profit (2012) = 1,507,500 - 1,468,962

= 38,538

Another Example: Completed-contract method

As the contract is overall profitable, no loss isrecognized in 2011

Gross profit:

2010 0; 2011 0; 2012 115,038 (= $4,500,000 - $4,384,962)

Estimated Overall Loss Contract:

Different ApproachA long-term contract may produce an estimated overall loss for the project Loss should be immediately recognized in

the expected year.

- Under the percentage-of-completion method, overall estimated losses are immediately recognized after considering accumulated gross profits to the last year

- Under the completed-contract method, overall estimated losses are immediately recognized

Estimated Overall Loss Contract

2010 2011 2012

$4,500,000 $4,500,000 $4,500,000 Contract Price

1,000,000 2,916,000 4,556,250+3,000,000 +1,640,250 -0- 4,000,000 4,586,250 4,556,250

Costs To DateEst. Cost to CompleteEst. Total Costs

1,125,000 Anticipated total -) 1,000,000 Loss is $86,250 125,000 30,000 So,

-$86,250 = 125,000 + X

X= -$211,250

Gross profit for each yr

Data as previously given, except for the 2011 cost estimate

Prior examples:

$1,134,000 & $1,468,962

Estimated Overall Loss Contract

Losses (Gross profit) recognized in 2011 POC CCCumulated gross profit recognized to 2010 $125,000 $ N/AExpected loss on unprofitable contract (total) ($86,250) ($86,250)Total loss to be recognized in 2011 ($211,250) ($86,250)

Gross profit recognized in 2012 POC CCCumulated gross profit recognized to 2011 ($86,250) ($86,250)Actual gross profit on the contract (total) ($86,250) ($86,250)Total gross profit to be recognized in 2012 $ 0 $ 0

Gross profit (Losses) recognized in 2010 POC CCgross profit recognized in 2010 $125,000 $ N/A

Summary (A long-term contract)

First, Check if there is

an estimated overall loss for the project (each year)

1) If No (i.e., total Revenue ≥ total estimated costs),

Normal method

2) If Yes (i.e., total Revenue < total estimated costs),

Total loss should be immediately recognized in the expected year.

Other Revenue Recognition Issues

• Right of return • Repurchase agreements• Bill and hold• Warranties• Principal-agent relationships

e.g., Consignment sales

Right of Return

• Right of return is granted for product for various reasons (e.g., dissatisfaction with product).

• When sales are made with a right of return, the seller should recognize revenue adjusted for the products expected to be returned, a refund liability, and

an asset for the right to recover the product.• an asset account: Estimated Inventory Returns• corresponding adjustment to cost of goods sold

Right of Return: Example

Venden Company sells 100 products for $100 each to Amaya Inc. for

cash. Venden allows Amaya to return any unused product within 30

days and receive a full refund. The cost of each product is $60. To

determine the transaction price, Venden decides that the approach

that is most predictive of the amount of consideration to which it will

be entitled is the most likely amount. Using the most likely amount,

Venden estimates that:

1. Three products will be returned.

2. The costs of recovering the products will be immaterial.

3. The returned products are expected to be resold at a profit.

Question: How should Venden record this sale?

Right of Return: Example, Cont’d

Venden records the sale as follows with the expectation that 3 products will be returned:

Cash 10,000Sales Revenue [$9,700 (= $100 x 97)] 9,700Refund Liability ($100 x 3) 300

Cost of Goods Sold 5,820Estimated Inventory Returns ($60 x 3) 180

Inventory 6,000

When a return of 2 products actually occurs later:

Refund Liability (2 x $100) 200Accounts Payable (Cash) 200

Returned Inventory (2 x $60) 120Estimated Inventory Returns 120

Companies record the returned asset in a separate account from inventory to

provide transparency.

Repurchase Agreement

• Transfer control of (sell) an asset to a customer but have an obligation or right to repurchase the asset at a later date.

• If obligation or right to repurchase is for an amount greater than or equal to selling price, then the transaction is a financing transaction.

• Not a sale

Repurchase Agreement, Example

Morgan Inc., an equipment dealer, sells equipment on January 1, 2014,

to Lane Company for $100,000. It agrees to repurchase this equipment

on December 31, 2015, for a price of $121,000.

Question: How should Morgan record this transaction?

Assuming an interest rate of 10% is imputed from the agreement, Morgan

makes the following entry to record the financing on January 1, 2014.Cash 100,000

Liability to Lane Company 100,000

Morgan Inc. records interest on December 31, 2014, as follows.Interest Expense 10,000

Liability to Lane Company ($100,000 x 10%) 10,000

Morgan Inc. records interest and retirement of its liability to Lane Company

on December 31, 2015, as follows.Interest Expense 11,000

Liability to Lane Company ($110,000 x 10%) 11,000Liability to Lane Company 121,000

Cash ($100,000 + $10,000 + $11,000) 121,000

Bill-and-Hold Arrangements

• Contract under which an entity bills a customer for a product but the entity retains physical possession of the product until a point in time in the future.

- Result when buyer is not yet ready to take delivery but does take title and accepts billing.

• Recognize revenue, depending on when the buyer obtains control of the product.

- all of the following 4 criteria should be met:

1. The reason for the bill-and-hold arrangement must be substantive.

2. The product must be identified separately as belonging to the buyer.

3. The product currently must be ready for physical transfer to the buyer.

4. The buyer cannot have the ability to use the product or to direct it to another customer.

Bill-and-Hold Arrangements: ExampleButler Company sells $450,000 (cost $280,000) of fireplaces on March 1, 2014

to a local coffee shop, Baristo, which is planning to expand its locations.

Under the agreement, Baristo asks Butler to retain these fireplaces in its

warehouses until the new coffee shops that will house the fireplaces are

ready. Title passes to Baristo at the time the agreement is signed.

Q: When should Butler recognize the revenue from this bill-and-hold arrangement?

• In this case, it appears that the 4 criteria were met, and therefore revenue recognition should be permitted at the time the contract is signed.

Butler makes the following entry to record the sale.Accounts receivable 450,000

Sales Revenue 450,000

Butler makes an entry to record the related cost of goods sold as follows.

Cost of Goods Sold 280,000Inventory 280,000

Warranties

• Two types of warranties to customers:

1. Assurance-type warranty • Product meets agreed-upon specifications in contract at the time the

product is sold. • Warranty is included in sales price.• Expensed at the point of the sale• Record a warranty liability

o estimated costs that will occur after sale due to the correction of defects or deficiencies required under the warranty provisions.

2. Service-type warranty

• Provides an additional service beyond the assurance-type warranty

• Represent a separate service and are an additional performance obligation

• Not included in sales price of the product

• Recorded as a separate performance obligation.

• The company recognizes revenue in the period that the service-type warranty is in effect.

Warranties: Example

Maverick Company sold 1,000 Rollomatics during 2014 at a total price of

$6,000,000, with a warranty guarantee that the product was free of any

defects. The cost of Rollomatics sold is $4,000,000. The term of the

assurance warranty is two years, with an estimated cost of $30,000. In

addition, Maverick sold extended warranties related to 400 Rollomatics for

3 years beyond the 2-year period for $12,000.

Question: What are the journal entries that Maverick Company should make in

2014 related to the sale and the related warranties?

Cash ($6,000,000 + $12,000) 6,012,000

Warranty Expense 30,000

Warranty Liability 30,000

Unearned Warranty Revenue 12,000

Sales Revenue 6,000,000

Cost of Goods Sold 4,000,000

Inventory 4,000,000

Principal-Agent Relationships,

e.g., Consignment Sales• Principal’s performance obligation is to provide goods/services to a

customer, while agent’s performance obligation is to arrange for principal to provide goods or services to a customer.

• Examples:

• Travel Company (agent) facilitates booking of cruise for Cruise Company (principal).

• Priceline (agent) facilitates sale of various services such as car rentals at Hertz (principal).

• The principal recognizes revenue when the goods/services are sold to a customer.

• The agent recognizes revenue in the amount of the commission that it receives

• Amounts collected on behalf of the principal are not revenue of the agent.

Consignment Sales

• Consignments: A type of principal-agent relationships

• Consignor (manufacturer or wholesaler) ships merchandise to the consignee (dealer), who is to act as an agent for the consignor in selling the merchandise.

• Consignment sales

One party (consignor) ships goods to another party (consignee) for sale

• Consignor (e.g., manufacturer or wholesaler) earns a profit on consignment sales

• Consignee (e.g., dealer) earns a commission on consignment sales.

• Possession has transferred; however legal title remains with the consignor

Question: Goods on consignment should be reported as inventory by the consignor or consignee? Consignor

Revenue Recognition for Consignment Sales

• Consignor carries goods to consignee and makes a profit on the sale.

• Separately classified as Inventory (consignments)• The consignor recognizes revenue only after receiving

notification of sale and the cash remittance from the consignee.

• Consignee sells goods for consignor and makes a sales commission.

• The consignee does not record the product as an asset. • The consignee remits to the consignor cash received from

customers, after deducting a sales commission and any chargeable expense: recognizes commission revenue while notifying sales and remitting cash to consignor.

Consignment Sales: Example

• Dec 10: ABC Co. shipped $200 of merchandise on consignment to XYZ Co. and ABC paid freight cost of $10 in cash.

• Dec 15: XYZ paid $20 for local advertising, which is reimbursable from ABC. XYZ hasn’t notified ABC this fact yet.

• Dec 28: all merchandise has been sold for $300 in cash.

• Dec 31: XYZ notified ABC, retained a 10% as sales commission, and remitted cash due ABC.

Prepare relevant journal entries for both parties

Consignment Sales: Example

Goods shipped to Consignee (Dec10)Inventory on Consignment 200 Finished Goods Inventory 200Payment of Freight (Dec 10)Inventory on Consignment 10 Cash 10Payment of ad by consignee (Dec15)No entry until notifiedSale of merchandise (Dec 28)No entry until notifiedSales notice and cash remittance (Dec31)Cash 250Advertising Expense 20Commission Expense 30 Consignment Sales Rev. 300

Cost of Goods Sold 210 Inventory on Consignment 210

Goods shipped to Consignee (Dec10)No entry

Payment of Freight (Dec 10)No entry

Payment of ad by consignee (Dec15)Receivable from Consignor 20 Cash 20Sale of merchandise (Dec 28)Cash 300 Payable to consignor 300Sales notice and cash remittance (Dec31)Payable to consignor 300 Commission Revenue 30 Receivable from consignor 20 Cash 250

Consignor’s Books Consignee’s Books

Revenue Recognition- Summary

• Probably the most difficult single issue in accounting – complex modern business activities makes the issue challenging

• What have been examined in class are conceptual guidelines. Real world revenue recognition requires a great deal of professional judgment and involves many accounting estimates.

• Revenue recognition is a CASE BY CASE approach. • A relatively small change in revenue recognition can have

a major impact on net income• An area where firms use questionable and sometimes

improper accounting procedures (Earnings management)– Private firms often have tax minimization as objective, while

public firms often have profit maximization as objective – With deliberate attempts to mislead users

Ch18 Homework

E18-3, E18-5, E18-10, E18-11, E18-14, E18-16, E18-17, E18-19, E18-26 (a & c), E18-29 (a & b) P18-10, P18-11, P18-12

You must work on these problems for the quiz and exam!