Revenue Recognition

Question 1

According to IFRS 15, what are the 5 steps in the recognition and measurement of revenues process?

Answer 1

1. Identify the contract with customer
2. Identify the performance obligations
3. Determine the transaction price

4.allocate the transaction price to performance obligations

5. Recognize revenue in accordance with performance

Question 2

Describe the step 1 of revenue recognition: identify the contract

Answer 2

It is important ti identify the contract before going through the rest of the steps to make sure we actually have potential revenue to record. A contract exists when the following are true:

-both partie approved the contract

-possible to identify both partie rights

-payment terms can be identified

-transaction has commercial substance

-probable that consideration will be received

Question 3

Describe the step 2 of revenue recognition: identify the performance obligation

Answer 3

In simple transaction there is only one performance obligation. Sometimes a transaction will include different goods/services that should be considered separately - if the following conditions are met:

-the customer can benefit from the good or service on its own or together with other readily available resources

-the good or service is separately identifiable from the other promises in the contract

Question 4

Describe the step 3 of revenue recognition: determine the transaction price

Answer 4

If the situation where there is a fixed amount of consideration, this is a simple step. However, there are some situations where the transaction price is not fixed:

-non-cash consideration

-significant financing

-consideration payable to customer

-variable considerations

Question 5

What is non cash consideration

Answer 5

In the case where considerstion besides cash is received, the fair value of that asset should be estimated to arrive at the transaction price:

-total transaction price = cash received + fair value of non cash consideration

If the fair value of the non cash consideration cannot be reliably estimated, the selling price of the good/service in question can be used to infer it

Question 6

What is consideration payable to customer and what are the potential issues

Answer 6

Sometimes a company will provide an incentive for their customer to keep purchasing from them. This creates a couple of issues:

-should a company recognize 100% of the sale revenues on the day the sale is made?

-should they wait until the coupons have been redeemed to record sales revenues?

Look at the excel file we did in class for answers

Question 7

How do we record variable consideration

Answer 7

There are 2 options for recording income in that situation:

-expected value: multiplying probabilities by possible outcomes

-most likely amount

IFRS states that we should use whichever method is more conservative so that we dont end up in a situation where we need to reverse revenues, only record additional revenues once uncertainty has been resolved

Question 8

Describe the step 4 of revenue recognition: allocate the transaction price to performance obligations

Answer 8

Once the transaction price has been determined, we now need to allocate it between the performance obligations:

-IFRS states that price should be allocated based on the relatives stand alone selling price

-the stand alone selling price is the amount the entity would normally sell that good/service for

-if one of the goods/services does not have an established selling price, the transaction price should be allocated based on the residual values

Question 9

Describe step 5: recognize revenue

Answer 9

Once we have established the performance obligations and allocated the transaction price between them, we can determine when revenue should be recognized for each obligation. IFRS states that revenue should be recognized when the enterprise transfer the control of the asset. Indications that control has been transferred

-customer is obliged to pay for asset

-customer has legal title to the asset

-customer has taken physical possession

-customer bears significant risk and rewards of ownership

-customer has accepted the asset

Question 10

What are the criteria for revenue to be recognized over time?

Answer 10

-customer simultaneously received and consumes the benefits of good/service

-entitys performance creates or enhances an asset the customer controls

-performance does not create an asset with an alternative use and entity has an enforceable right to payment for performance to date

Question 11

What is a consignment sale?

Answer 11

one party provides goods to a second party yo sell (consignee). The consignee has a right to return the goods to the first party if they are not sold.

Question 12

What are installment sales?

Answer 12

An installment is an arrangement where the seller allowed the buyer to make payments over time, even though the product is received at the beginning. This typically means there is a higher degree of uncertainty regarding collection, so revenues are recognized as payments are received.

Question 13

What are the two types of warranties?

Answer 13

Assurance type
Service type

Question 14

What are assurance type warranties?

Answer 14

ensure customer receives goods as specified in contract.

Question 15

example of assurance type warranty and how it would be recorded

Answer 15

Guarantee against manufacturing defects
- company would record a liability (warranty liability based on an estimate of future warranty costs.

Question 16

Service type warranty

Answer 16

provides service beyond assurance type, unrelated to the quality of the product at the time of the sale
- This type of warranty is a separate performance obligation with revenues recognized over the term of the warranty

Question 17

What could service type warranty cover?

Answer 17

Could cover future brokerage

Question 18

Explain what are bill and hold arrangements and what they imply?

Answer 18

• when a buyer purchases a good but does not take delivery right away (ex: storage issues)
• in case where payment was made, customer has accepted the good and they are ready for departure, criteria to recog rev have been met
• can recognize revenue, even w/o physical transfer

Question 19

The two ways of recognizing revenue from long term contracts

Answer 19

• percentage of completion (required by IFRS)
• Completed contract (only allowable under ASPE)

Question 20

Explain the percentage of completion method

Answer 20

recognizing revenues and expenses based on the completeness of the long term project

Question 21

Explain completed contract and when it should be used

Answer 21

Revenues and exp only recognized when project is complete
- should only be used when % of completion cannot be estimated

Question 22

The two types of long term contract we cover and which one we focus on with which approach

Answer 22

Cost plus contracts
Fixed price contracts
–» fixed price with the percentage of completion method

Question 23

What are cost plus contracts?

Answer 23

typically means the transaction price will be equal to costs incurred + a profit margin

• Could result in a moral hazard situation where the seller is motivated to increase costs incurred to get a higher profit margin
• Simple to account for, revenues will be recognized based on the costs incurred in each year plus the profit margin

Question 24

Fixed price contracts:

Answer 24

obvious, price agreed upon at the beginning, in this case the risk is in the hands of the seller

Question 25

How do we recognize fixed price contracts’ revenues using the percentage of completion method?

Answer 25

• Percentage of completion is estimated based on the costs incurred to date
• generally will require an engineer/specialist to determine the % of completion
• These estimates will often change from one year to the next and must be applied on a prospective basis

Question 26

2 ways of measuring percentage of completion explained

Answer 26

• Engineer simply estimate the % of the project that was completed during the year
• cost to cost method: involves estimating the costs remaining to complete the project. The % of completion would be determined as follows:
  Percentage complete= costs incurred to date/est total costs

Question 27

The phases of recognizing revenue on long term contracts

Answer 27

1. project costs are incurred
   - record as costs are incurred
   dr. construction in progress
   cr. cash, Accounts payable, etc
2. billing the client
   - record when invoice is sent
   dr. accounts rec
   cr. billings on construction in progress
3. receiving payments from the client
   - when cash is received
   dr. cash
   cr. accounts receivable
4. revenue and expense recognition
   - once per period
   dr. Cost of sales
   dr. construction in progress
   Cr. revenue (% of completion minus prior year
   rev)
5. Project completion
   - once per contract
   dr. Billings on construction in progress
   Cr. construction in progress (at this point these two accounts should be equal and equal to contract price)

Question 28

What are onerous contracts?

Answer 28

When cost incurred and estimated costs to complete exceed contract price, onerous means contract will have a loss.
- entire amount of loss need to be recognized immediatly in an account called ‘provision for onerous contract’.
–» Gross Profit(Loss): 100%*estimated gross profit(loss)- gross profit(loss) previously recognized

Question 29

Explain the cost recovery method

Answer 29

May have uncertainty over contract outcome, revenues can’t be reliably estimated, IFRS says use cost recovery method:
- Record expenses as incurred
- record rev equal to exp in the case where they are expected to be recoverable
- 0$ gross margin until the project is complete and the revenues are certain

Question 30

How can long term contract measurements be used in earning management?

Answer 30

• using engineer’s approach vs cost to cost
• making estimates of future costs to underestimate the costs to complete to increase current year’s revenues
• another incentive to underestimate cost would be to win a contract in a bidding scenario

Question 31

IFRS vs ASPE in terms of revenue recognition and performance over time

Answer 31

IFRS:
- Must use 5 step process for rev recog
- Requires percentage of completion for long term

ASPE:
- General application of principles
- can choose between % of comp or completed contract method

Question 32

ASPE- Sale of Goods

Answer 32

Revenues should be recognized when these criteria are met:
- risk and reward of ownership transferred
- managerial involvement and control given up
- revenue amount measured reliably
- economic benefits transferred
- costs can be measured

Question 33

ASPE: provision of services

Answer 33

Revenue from sale of services when those criteria are met:
- revenue amount measured reliably
- economic benefits transferred
- stage of completion measured reliably
- cost can be measured

Question 34

Aspe Decision tree

Answer 34

• Identify the contract(s) that form the arrangement
• does the arrangement have separately identifiable deliverables?
• if no:
  Arrangement is one unit of account
• if yes:
• each separately identified component is a separate unit of account
• allocate revenue to multiple elements in each unit of account

Question 35

Go see slide 38 and draw it, give yourself a 5 if you are able to do it from memory