Objectives

• Apply revenue recognition principles to various types of transaction.    

• Demonstrate an understanding of revenue recognition for contracts with customers using the five steps required to recognize revenue.

• Demonstrate an understanding of the matching principle with respect to revenues and expenses and be able to apply it to a specific situation

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Topic Outline

• Revenue Recognition, New Standard

• Identify the contract with a customer

• Identify separate performance obligations in the contract

• Determine the transaction price

• Allocate the transaction price to the performance obligation(s) identified in the contract

• Recognize revenue for each performance obligation

 

Key Definitions

• Revenue- is recorded as or when performance obligations under contracts with customers are completed.

 

         I. Revenue Recognition, New Standard

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A. As part of the Convergence Project, the FASB and IASB jointly issued a unified standard for recognizing revenue from contracts with customers. This standard applies to all companies for fiscal periods starting after December 15, 2018, ensuring that there are no major discrepancies in revenue recognition between U.S. GAAP and IFRS.

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B. The converged standard requires organizations to recognize revenue  using the following steps.

○   Identify the contract with a customer.

○   Identify separate performance obligations in the contract.

○   Determine the transaction price.

○ Allocate the transaction price to the performance obligation(s) identified in the contract.

○   Recognize revenue for each performance obligation.

C. Each of these five steps must be completed before effective revenue recognition may occur. 

 

II. Identify the Contract with a Customer

Before recognizing revenue, the organization needs to ascertain the existence of a contract. The following factors should be taken into account when identifying a contract with a customer.

1. The contract must be approved by all parties and can be written, oral, or simply implied by normal business practice.

2. Relevant rights and obligations of each party (generally the seller's performance obligations and the buyer's payment terms) are clear.

3. The contract has commercial substance.

4. Some situations may indicate that no contract exists for purposes of revenue recognition. In these cases, revenue would not be recognized before it is determined that a contract does exist. 

1. If each party has the unilateral right to terminate the contract without compensating the other party, then no contract exists until either

a. The entity has transferred goods or services to the customer.

b. The entity has received or is entitled to receive consideration for goods or services. 

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2. If it is uncertain that substantially all of the consideration for goods or services will be collected, there is no contract, and revenue will not be recognized until nonrefundable consideration is received and the organization has met its performance requirements.

 

III. Identify Separate Performance Obligations in the Contract

A. A performance obligation is a promise to transfer distinct goods and/or services to the customer.

B. Identification of performance responsibilities should be done from the customer's standpoint. As a result, performance responsibilities may be explicitly stated in the contract or simply assumed by usual business practices if those activities create reasonable expectations on the side of the customer.

C. Contracts may contain more than one performance obligation.

Illustration: An organization sells equipment with installation and an attached warranty agreement; the selling organization would recognize revenue independently for the three distinct performance obligations:

1. Delivery of the equipment

2. Installation of the equipment

3. Fulfillment of the warranty obligation

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D. Organizations are not obligated to identify separate, immaterial performance obligations. For this purpose, materiality is determined by referencing the individual contract rather than the organization as a whole.

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Illustration: An organization sells equipment and provides a technician to set up the machine; the setup may or may not be deemed a separate performance obligation based on materiality.

a. If the machine price is $2,000 and the cost of sending out a technician is $200, the setup is likely to be considered material in the context of the contract and would be considered a separate performance obligation.

b. If the machine price is $2,000,000 and the cost of sending out a technician is $200, the setup is likely to be considered immaterial in the context of the contract and the contract would have a single performance obligation: delivery of the machine.

 

IV. Determine the Transaction Price

A. The transaction price is the amount of consideration the organization expects to receive.

B. If a customer pays noncash consideration (goods, services, stock, etc.), the fair value of the noncash consideration is included in the transaction price.

C. If the contract contains a provision for variable consideration, the organization must estimate the amount of consideration it expects to receive under the contract. Variable consideration can come from:

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a. Cash discounts: Generally regarded as a decrease of the initial transaction price.

b. Volume discounts: The organization must forecast the number of units expected to be sold and calculate the average selling price per unit based on the contract pricing schedule at the anticipated volume. The transaction price would be set using this approximated figure.

c.  Rebates: Typically recognized as a decrease in the initial transaction amount; however, if the rebate is paid in exchange for anything from the client, such as marketing services, it has no effect on the transaction amount and is recorded as an expense.

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Illustration: Company Z sells Product A to all consumers for $100 per unit. Company Z also provides a $5 discount on Product A to clients who suggest another purchasing customer to them. This refund is most likely classified as a marketing expense rather than a transaction price deduction because Company Z receives a marketing service in exchange for the reimbursement.

 

d. Right of return: Returns must be anticipated and incorporated into the transaction price using an estimate. It is permissible to merge similar contracts throughout this estimating process.

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Illustration: Company Z sells Product A to all consumers for $100 per unit, with a 30-day return policy. According to historical data, approximately 1% of all Product A purchases are returned within 30 days. In October, Company Z sold 4,000 units of Product A. Because the contracts for Product A are identical, Company Z can combine them to predict returns. The transaction price for October sales, adjusted for the 1% return rate, is $396,000 (4,000 units × $100 per unit × 99%).

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V. Allocate the Transaction Price to the Performance Obligation(S) Identified in the Contract

A. Where multiple goods or services are included in the same contract, the transaction price is allocated to each performance obligation based on their relative individual selling prices.

B. Individual selling prices should be based upon observable stand-alone selling prices used when the organization sells the item separately. When stand-alone selling prices are not observable, individual selling prices can be estimated using the following methods.

a.  Adjusted market price: The price of the commodity or service that the market is willing to pay for. Can be calculated by comparing the observable price of a comparable competitor product and making the necessary adjustments for discrepancies.

b.  Expected cost plus margin: The estimated cost of producing the good or providing the service plus an amount for reasonable margin.

c.  Residual approach: The residual amount obtained by subtracting the observable standalone prices of other obligations in the contract from the total transaction price. This approach is only applicable when:

1. The organization sells the good or service at highly varied prices or    
2. The organization does not have an established price for that good or service and the good or service has not been previously sold individually.

 

VI.Recognize Revenue for each Performance Obligation

A. Revenue should be recognized when, or as, each performance obligation is satisfied by transferring control of the good or service to the customer.

B.  Each performance obligation is reviewed to determine if the control over the good or service is transferred over time or at a point in time.

C. If the transfer of control of the good or service happens over time, revenue is recognized over the same period. Control is transferred over time if

1. The customer simultaneously receives and consumes the benefit of the performance obligation.

2. The satisfaction of the performance obligation creates or enhançes an asset already controlled by the customer.

3. The good or service has no alternative future use to the selling organization and the organization has a right to payment for work completed.

D. Revenue recognition for contracts that cover a length of time entails evaluating the progress toward completion. This evaluation can use either output or input methods, depending on the individual contract circumstances.

1. Output methods measure the results, actually achieved or value actually transferred to a customer.

a. Initially, the company must estimate the amount of output required to meet the performance obligation.

b. The progress towards completion ratio is computed by dividing the outputs obtained so far by the total output required to complete the contract.

2. Input methods measure how much effort or cost has been expended to satisfy a performance obligation.

a. Initially, the business must estimate the amount of input required to complete the contract.

b. The progress towards completion ratio is computed by dividing the input achieved so far by the total input required to complete the contract.

c. The revenue recognized today should be the completion ratio multiplied by the transaction price for the performance obligation.

d. Input metrics may include hours performed, money incurred, machine hours, or the passage of time.

E. If control is transferred at a single point in time rather than progressively over time, income is recognized correspondingly. Several variables indicate when control has effectively shifted, and income should be recognized.
   1. The entity has an enforceable right to payment.
   2. Title to the asset has transferred to the customer.
   3. Physical possession of the asset has transferred to the customer.
   4. Risks and rewards of ownership have transferred to the customer.
   5. The customer has formally accepted the good or service.

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Practice Questions

Part 1: Theories 

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All of the following are conditions for recognizing revenue at a point in time under the FASB's revenue recognition standard except:

a. The entity has an enforceable right to payment.

b. Title to the asset transfers to the customer when they pay for the asset in full.

c. The customer has formally accepted the good or service.

d. Risks and rewards of ownership have transferred to the customer.

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All of the following are steps of the five recognition steps to recognizing revenue except:

a. Select an output method for estimating stand-alone selling price.

b. Determine the transaction price.

c. Identify the contract with a customer.

d. Identify Identify separate performance obligations in the contract.

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Which of the following statements concerning performance obligations for revenue recognition purposes is not correct?

a. Materiality of a performance obligation is measured based on an individual contract, not on the organization as a whole.

b. Identification of performance obligations is done from the perspective of the customer.

c. The existence of multiple performance obligations means revenue could be recognized at multiple times

d. Performance obligations must be explicitly stated in a contract.

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Which of the following is correct concerning performance obligations?

a. A single contract can contain multiple performance obligations.

b. Performance obligations must be explicitly stated in the contract.

c. Identification of performance obligations is done from the perspective of the seller.

d. Materiality of a performance obligation is measured based on the organization’s total sales revenue.

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A retail company shipped two orders of the same product on the same day. Shipment A was shipped FOB Destination and Shipment B was shipped FOB Shipping Point. Which of the following statements concerning the recognition of cost of goods sold is correct?

a. Cost of goods sold is recorded for both Shipment A and Shipment B when the shipments arrive at the buyer

b. Cost of goods sold is recognized for Shipment A when the shipment leaves the seller and for Shipment B when the shipment arrives at the buyer.

c. Cost of goods sold is recognized for Shipment A when the shipment arrives at the buyer and for Shipment B when the shipment leaves the seller.

d. Cost of goods sold is recorded for both Shipment A and Shipment B when the shipments leave the seller.

 

 

 

Part 2: Problem Solving 

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1. Rachel, Inc. has a $500,000 airport construction project contract. The estimated total costs are $400,000. In the first year, incurred costs are $200,000 and the project is 45% complete. Rachel will be recognizing revenue over time. What amount of revenue will Rachel recognize if the company utilizes the following to recognize revenue: output method based on percentage completed and input method based on costs incurred, respectively?

a. $0 ; 225,000

b. $250, 000 ; 0

c. $225,000 ; 250,000

d. $250,000 ; 225,000

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2. Big Seller Co. sells a TV and Speaker combination for $510 dollars. The TV is delivered immediately, and the speakers are shipped to the customer later that week. The TV sells alone for $380 dollars, and the speakers sell alone for $190 dollars. How much revenue should Big Seller Co. recognize from the TV when sold as part of the combo?

a. $340

b. $170

c. $400

d. $380

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3. Filmore Construction has a 5-year construction contract to build 300 miles of highway for $2,000,000. The estimated total cost to complete the project is $900,000. During Year 1, Filmore incurred costs of $270,000 and completed 75 miles of highway. At the end of Year 2, Filmore incurred total costs of $540,000 and completed a total of 180 miles of highway. How much revenue would Jackson report in Year 1 and Year 2 assuming the contract does not qualify for revenue recognition over time?$120,000

a. $600,000 and $600,000

b. $400,000 and $400,000

c. $500,000 and $700,000

d. $0 and $0

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4. A builder is charging a client $100 million for a four-year construction project. The builder is expecting to spend $60 million on the project. The project is considered a single performance obligation and the builder appropriately uses an input method based on total costs to recognize revenue over time. Below is a table of costs incurred during the project:

Year                            Costs
   1                                  $6 million
   2                                  $12 million
   3                                  $18 million
   4                                  $24 million

How much revenue should the builder recognize in Year 2?

a. $0

b. $12 million

c. $25 million

d. $20 million

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5. The UAM Company sells three distinct products as part of a single contract. Each product meets the definition of a separate performance obligation under the contract. It has sold Products 1 and 2 individually in the past and a competitor sells Products 2 and 3 individually. Information on the three products is shown below:

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  Product Observable Stand-Alone Price Adjusted Market Price
   1                                  $500                            Not available
   2                                  $900                            $800
   3                                  Not available               $400 

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If the transaction price is determined to be $1,710, how much revenue should be allocated to each product?

a. $510 for Product 1, $800 for Product 2, and $400 for Product 3

b. $475 for Product 1, $855 for Product 2, and $380 for Product 3  

c. $570 for Product 1, $570 for Product 2, and $570 for Product 3

d. $500 for Product 1, $900 for Product 2, and $310 for Product 3
 

Answer Key

Part 1: Theories 

1. B.  Title to the asset transfers to the customer when they pay for the asset in full
   Revenue recognition implies transferring asset title to the client. However, total payment is not required for title transfer if it is extremely likely that the majority of the payment would be received.
    

2. A. Select an output method for estimating stand-alone selling price.
   This stage is not involved in the revenue recognition process. Step four, allocating the transaction price to the performance responsibilities, allows for the estimation of stand-alone selling prices. However, output methods are not used in this work.
    

3. D. Performance obligations must be explicitly stated in a contract.
   According to GAAP, the second prerequisite for revenue recognition is to identify unique performance commitments. Revenue is recognized when the seller fulfills these commitments. Even if not explicitly mentioned in the contract, behaviors that reasonably cause the consumer to expect products or services can trigger revenue recognition.
    

4. A. A single contract can contain multiple performance obligations.
   In GAAP, the second stage of revenue recognition requires identifying distinct performance obligations. Revenue is recognized when the seller fulfills these duties for the customer. Contracts might have several obligations, such as delivering and installing machines. In such cases, revenue would be recognized separately for each completed commitment.
    

5. C. Cost of goods sold is recognized for Shipment A when the shipment arrives at the buyer and for Shipment B when the shipment leaves the seller
   When a product is sold, the cost of goods sold is recognized alongside the revenue. The shipping terms specify when title to the goods is transferred from the vendor to the customer. Under "FOB Destination," title changes hands when the items arrive at the buyer's location, whereas "FOB Shipping Point" occurs when the goods leave the seller. This has an impact on when revenue and cost of products sold are recognized: under "FOB Destination," it is upon the buyer's receipt, whereas under "FOB Shipping Point," it is upon the seller's dispatch.

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Part 2: Problem Solving 

1. C. $225,000 ; 250,000 

Output Method                                Input Method
=500,000 x 45%                                  =200,000/400,000 = 50%
=225,000                                             =500,000 x 50%
                   =250,000

2. A. $340 

= ($380) ÷ ($380 + $190) = 66.67%
= 66.67% x $510
=$340

3. D. $0 and $0 

(No revenue is recognized in Year 1 or Year 2 since the contract does not meet the criteria for revenue recognition over time, and all revenue is recognized only upon project completion.)

4. D. $20 million

= ($6M + $12M+ $18M + $24M) = $60M
= Year 2 ($12M / $60M) = 20%
= ($100M x 20%)
= $20 million

5. B. $475 for Product 1, $855 for Product 2, and $380 for Product 

= ($500 + $900 + $400) = $1800
= P1 ($500/$1800) = 27.78% ; P2 ($900/$1800) = 50% ; P3 ($400/$1800) = 22.22%
= P1 (27.78% × $1,710) = $475
= P2 (50% × $1,710) = $855
= P3 (22.22% × $1,710) = $380

 

Reference

Wiley. (2023). Wiley CMA Exam Review 2023 Study Guide Part 1: Financial Planning, Performance, and Analytics. Wiley.