Revenue Recognition

Key Things To Know

Financial Accounting

Revenue Recognition

Key Things To Know

 

Recognize revenue:

1) when the customer controls the goods or services
2) at the amount the seller is entitled to and expects to receive

 

Revenue Recognition Process:

Step 1: Identify the contract with the customer (legal rights of the seller & buyer)

Step 2: Identify the performance obligations in the contract (single or multiple)

Step 3: Determine the transaction price the seller is entitled to receive from the buyer

Step 4: Allocate the transaction price to each performance obligation

Step 5: Recognize revenue when each performance obligation is satisfied

 

Multiple Distinct Performance Obligations?

A good or service is a distinct performance obligation if both:

The buyer could use the good or service on its own or in combination with other goods or service obtained elsewhere

The obligation is not highly interrelated with other goods or services in the contract

 

Recognize Revenue at One Point in Time:
Recognize revenue when control is likely to have passed at a given time

Evidenced by the buyer has control:

1) An obligation to pay seller
2) Legal title to the asset
3) Physical possession of the asset
4) The right to substantially all of the economic benefit from the good/service
5) Formally accepted the goods or services

 

Control may pass for the sale of goods at the point of delivery. The terms of shipment determine when title and risk of loss transfers:

FOB shipping: record revenue when the seller ships goods to the buyer.
FOB destination: record revenue when the buyer receives the goods.

 

Recognize Revenue Over a Period of Time when:

The buyer consumes the benefit of the sellers’ work as the seller performs the work over time (service contracts)
The buyer controls the asset as the seller creates the asset (LT contract)
An asset has no alternative use to the seller and the seller has legal right to receive progress payments

 

1 Price for Multiple Performance Obligations:

Allocate the total transaction price to each performance obligation based on the stand-alone price of each

Stand-alone   Price(FMV) % total x Total Price = Performance
Obligation Price
Perf Oblig 1    $X,XXX X % $ $
Perf Oblig 1    $X,XXX    X% $ $ ________
Total   $X,XXX 100% $ Total Price

If not sold separately, the seller must estimate the stand-alone price to the customer using one of the following approaches:

Adjusted market assessment approach:
estimate based on competitor prices

Expected cost plus margin approach:
estimate the cost to provide and add a reasonable profit margin

Residual approach:
the total selling price for all less the total of the other known stand-alone selling prices

 

For Public Companies:
The Securities Exchange Commission (SEC) currently also requires the following to record revenue:

Persuasive evidence that an arrangement exists.

Delivery has occurred or service has been rendered.

Seller’s price to the buyer is fixed and determinable.

Collectability is reasonably assured from the buyer and there is a demonstrated ability to pay.

 

Issues Related to Revenue Recognition

1) A contract must exist to recognize revenue

Contracts can be implicit based on the typical business practices of a company
Example: Providing goods in a retail store

A contract only exists if the seller believes it is probable the buyer will pay the price the seller is entitled to receive

The seller and the buyer cannot terminate at any time without penalty

 

Contract modifications:

Adding a distinct good or service is treated like a new, separate contract

The total price is reallocated to the new and all remaining performance obligations when a new performance obligation

Update the assessment of progress if performance occurs over time under a long-term contract

 

2) Is a promise a performance obligation?

Warranties

Quality Assurance (not sold separately):

Recognize in the period of the sale.
NOT a separate performance obligation.

 

Extended Warranty (sold separately, service type):

Recognize revenue over the time covered by the extended warranty.
A separate performance obligation

 

Option to Receive Additional Goods or Services:
Software upgrades, loyalty points, discounts on future purchases, contract renewal options

Separate performance obligation when the customer gets a material right they would not receive otherwise.

Allocate a portion of the transaction price to the option granted to the customer.

Estimating a stand-alone selling price for the option may be necessary.

Recognize revenue when the buyer exercises the deferred option (or expires).

 

Price depends on the outcome of future events:

Incentive payments, royalties, reimbursements, volume discounts, returns, rebates

Estimate the most likely amount that will be received using either:

1) The weighted average expected value using the percent probability of occurrence

2) The most likely amount (all or none)

Revise the estimate each period based on the most likely circumstances.

 

Right of Return

Estimate the value of returns and the cost of goods associated with returns if the seller can make a reliable estimate

Record estimated returns in the same period of the sale

(If it is not possible for a manufacturer who sells to distributors to make a reliable estimate — wait to recognize revenue until the distributor sells the products to the end user)

 

Payments by the Seller to the Customer for Floor Space or Advertising Cost Sharing:

If the seller pays fair market value:
Record a separate transaction for the purchase of goods and services

If the seller pays more than fair market value:
Record the separate transaction at fair market value
Record the excess over fair market value as a refund on the price to the customer

 

License Fees to use Intellectual Property (software, music, movies)

Types of licenses that allow the use of intellectual property:

Transfer a right of use:
Recognize revenue when the right transfers

Provide a right of access:
Recognize revenue over the access time

Part of a good or service:
Recognize revenue for the use when the revenue for the good or service is recognized

 

Franchisor / Franchisee

Franchisor grants the right to the franchisee to sell products or use the name Includes:

1) A license to use intellectual property
2) Initial start-up services (facilities, training, equipment)
3) Initial sales of products or services
4) Ongoing sales of products or services

 

General Franchise Revenue Rules:

Unearned revenue
Cash received prior to completing the performance obligation as

Recognize revenue when the obligation is satisfied.

Record initial franchise fees after performing substantially all the initial franchise services.

Recognize continuous support fees equally over the time the franchisor provides the support

Recognize revenue based on a percent of franchisee revenue in the period the franchisee reports revenues.

 

Bill and Hold Arrangements
The buyer requests the seller to ship the products on a later date.

Recognize revenue when upon delivery unless ALL of the following has occurred:

1) The customer controls the product.
2) There is good business reason for the hold arrangement.
3) The product is specifically identified as belonging to the customer
4) The produce is ready for shipment.

 

Principle
Controls the goods or service and is primarily responsible for delivering the goods or services to the customer. The principle assumes the risk of loss and receipt of payment.

Reports revenue at the GROSS amount

Reports Sales – Cost of Sales = Gross Profit on the income statement

Reports inventory on the balance sheet

 

Agent

       Facilitates the sale and earns a commission for matching buyers and sellers.

Report revenue for the NET amount received from facilitating the sale.

 

Footnote Disclosures Related to Revenue
Disclose the following significant components of revenue recognition in the footnotes:

The accounting methods used and the related details by category
Example: types of contracts, types of goods or services, types of customers

The amount of revenue previously reported as deferred revenue
A description of outstanding performance obligations
A description of contractual obligations: payment terms, returns, warranties
Any significant judgments used to make estimates
An explanation of significant changes in long-term contract assets and liabilities