DEFINITION OF REVENUE

According to the FASB, Accounting Standards Update (ASU) No. 2014–09: “Revenues are inflows or
other enhancements of assets of an entity or settlements of its liabilities (or a combination of both)
from delivering or producing goods, rendering services, or other activities that constitute the entity’s
ongoing major or central operations.”

Measuring (how much?) and reporting revenue is a critical aspect of financial reporting

Revenue recognition (when?) criteria ensure appropriateness of the timing and amount of revenue
reported

Core Principle: Companies recognize revenue when goods or services are transferred to customers for
the amount the company expects to be entitled to receive in exchange for those goods and services

How much: amount the seller is entitled to receive

When: upon transfer to customers

Application of the core revenue recognition principle can be summarized in five steps.

Step 1: Identify the contract between a seller and a customer.

Step 2: Identify the performance obligation or obligations, i.e. promises by the seller to transfer goods
or services to a customer.

Step 3: Determine the transaction price for the contract.

Step 4: If the contract contains multiple performance obligations the transaction price is allocated to
those performance obligations.

Step 5: Recognize revenue when (or as) each performance obligation is satisfied. That happens when
the seller transfers control of the promised goods or services underlying each performance obligation.

Key concept: The seller has one or more performance obligations

Performance obligations are promises to transfer goods or services to the customer.

Revenue recognition is tied to satisfaction of performance obligations.

Note 1: Revenue is recognized at a point in time or over a period of time depending on whether the
transfer of control happens either at a single point in time or over a period of time.

Note 2: If a contract contains multiple performance obligations, the timing of revenue recognition is
determined separately for each performance obligation depending on when that performance
obligation is satisfied.

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 RECOGNIZING REVENUE AT A SINGLE POINT IN TIME

We recognize revenue at a point in time when we don’t qualify for recognizing revenue over time.

The performance obligation is satisfied when control of the goods or services is transferred from the
seller to the customer.

Usually transfer of control is obvious, and coincides with delivery.

Criteria for Recognizing Revenue at a Point in Time

The customer is more likely to control a good or service if the customer has:

• An obligation to pay the seller.

• Legal title to the asset.

• Physical possession of the asset.

• Assumed the risks and rewards of ownership.

• Accepted the asset.

Example: On July 1, 2017, ABC Real Estate Company sold a parcel of land for $6,000,000 to construction
company XYZ. The book value of the land in ABC’s books was $2,400,000. The terms of sale required a
down payment of $300,000 and 19 annual payments of $300,000 plus interest at 8% per annum due on
each July 1 beginning in 2018. How much revenue will ABC recognize in 2017 for the sale (ignore
interest)? Provide the related journal entry.

ABC has one performance obligation, the transfer of the land. On July 1, 2017, ABC has transferred the
land (the word “sold” implies transfer), and the construction company has an obligation to pay ABC.
ABC’s performance obligation has been satisfied, and revenue of $6,000,000 can be recognized.

Note: Under accrual accounting, revenue is recorded when goods or services are transferred to
customers, i.e. on July 1, 2017, not necessarily when cash changes hands in future periods.

Journal entry on July 1, 2017:

Dr. Cash $300,000

Dr. Note Receivable 5,700,000
Cr. Revenue 6,000,000

Dr. Cost of land sold 2,400,000

Cr. Land 2,400,000

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 RECOGNIZING REVENUE OVER TIME

We recognize revenue over time when performance obligations are satisfied over time. That is the case
if we transfer goods and services over time.

Criteria for Recognizing Revenue over Time

Revenue is recognized over time if either:

• The customer consumes the benefit of the seller’s work as it is performed, as when a company
provides cleaning services to a customer for a period of time, or

• The customer controls the asset as it is created, as when a contractor builds an extension onto
a customer’s existing building, or

• The seller is creating an asset that has no alternative use to the seller, and the seller has the
legal right to receive payment for progress to date, as when a company manufactures customized
fighter jets for the U.S. Airforce.

Example 1: Mary signed up and paid $1,200 for a 6 month ceramics course on June 1, 2017, with ABC
Ceramics. How much revenue will ABC recognize as of July 31, 2017? Provide the required journal
entries on June 1 and July 31.

ABC has one performance obligation, to teach the course. This case qualifies for revenue recognition
over time because the customer consumes the benefit of the seller's service as the seller provides it
(the first criterion above is met).

On June 1 Mary (the customer) prepays for the course (service). No revenue has been earned at that
point because no service has been provided yet. Therefore, all revenue is deferred:
Dr. Cash $1,200
Cr. Deferred (or Unearned) revenue $1,200

On July 31 ABC would recognize revenue of $400 ($1,200 × 2/6 of the contract duration):

Dr. Deferred revenue $400

Cr. Revenue 400

Example 2: ABC Co. signed a contract to make bumper cars for XYZ Parks. The contract indicates that
XYZ will pay ABC a total of $60,000, and XYZ can cancel the contract if it so chooses but must pay ABC for
work completed. ABC believes that, if XYZ cancelled the contract, ABC could sell the bumper cars to
another park and still make a profit. The contract is expected to last six months, and as of December 31,
2017, the job is 80% complete. How much revenue should ABC recognize in 2017 for this contract?

ABC has one performance obligation, to make the bumper cars. This arrangement does not qualify for revenue
recognition over time because the asset the seller is creating has an alternative use to it. Thus, ABC must wait
until completion of the contract before recognizing revenue (none of the above three criteria is met).

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 RECOGNIZING REVENUE FOR CONTRACTS WITH MULTIPLE PERFORMANCE OBLIGATIONS

Goal: Separate complex contracts into parts that can be viewed on a stand-alone basis. Steps 2 and 4
are critical to this process.

Step 2: Identify the performance obligation(s) in the contract.

A promise to provide a good or service is a performance obligation if the good or service is

distinct from other goods and services in the contract.

A good or service is distinct if it is both:

 Capable of being distinct. The customer could use the good or service on its own or in
combination with other goods and services it could obtain elsewhere, and

 Separately identifiable from other goods or services in the contract. The good or service also is
distinct in the context of the contract because it is not highly interrelated with other goods and
services in the contract.

Step 4: Allocate the transaction price to each performance obligation.

 Allocate based on relative stand-alone selling prices. If stand-alone selling prices aren’t
observable, estimate them.

 Then treat each performance obligation separately, recognizing revenue when appropriate for
that performance obligation.

Example 1: KLM Electronics sells computers and provides hardware maintenance services. On April 1,
2017, KLM sold a package deal containing a computer and a one-year unlimited maintenance/repair
service for the computer at a bundle price of $1,000. If sold separately, the computer costs $840 and the
one-year unlimited maintenance/repair service costs $360. How much revenue would KLM recognize for
the month of April assuming that revenue is accrued monthly? Provide the required journal entries.

The computer and maintenance services are distinct, because they are both capable of being distinct (they could
be sold separately) and are separately identifiable (they are not highly interrelated, i.e. the customer does not
need the computer and the maintenance continuously all the time). Therefore, they qualify as performance
obligations (both criteria are met). The total bundle price of $1,000 would be allocated to each of them:

$1,000 × ($840 ÷ (840 + 360))=$700 allocated to the computer

$1,000 × ($360 ÷ (840 + 360))=$300 allocated to the maintenance contract

April 1, 2017: Dr. Cash $1,000

Cr. Revenue 700
Cr. Deferred revenue 300

Since KLM delivered the computer on April 1, the related revenue of $700 is recognized at that point.

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April 30, 2017: Dr. Deferred revenue $25 (300 x 1/12)
Cr. Revenue 25

By the end of April KLM has delivered one month of maintenance and so it should recognize revenue for one
month. Thus, revenue from the maintenance performance obligation is recognized over time.

Example 2: On July 15, 2017, ABC Co. signed a contract to provide XYZ Bakery with an ingredient-
weighing system for a price of $90,000. The system included finely tuned scales that fit into XYZ's
automated assembly line, ABC's proprietary software modified to allow the weighing system to function
in XYZ's automated system, and a one-year contract to calibrate the equipment and software on an as-
needed basis. (ABC competes with other vendors who offer ongoing calibration contracts for ABC's
systems.) If ABC was to provide these goods or services separately, it would charge $60,000 for the
scales, $10,000 for the software, and $30,000 for the calibration contract. ABC delivered and installed
the equipment and software on August 1, 2017, and the calibration service commenced on that date.
Assume that the scales, software and calibration service are viewed as one performance obligation. How
much revenue will ABC recognize by the end of 2017 for this contract? Provide the required journal
entries.

Since the contract has only one performance obligation, revenue will be recognized over time given
that ABC provides the combination of scales, software and calibration service. No revenue can be
recognized upon delivery of the scales or software. Since the contract has a one-year duration and
commenced on August 1, revenue for five months has been earned in 2017, equal to $37,500 ($90,000
× 5/12).
August 1: Dr. Cash or A/R $90,000
Cr. Deferred revenue 90,000

December 31: Dr. Deferred revenue $37,500

Cr. Revenue 37,500

Exercise: In the previous example, assume that the scales, software and calibration service are all
separate performance obligations. How much revenue will ABC recognize in 2017 for this contract?
Provide the required journal entries.

The revenue for the scales and software should be recognized upon delivery (at a point in time) on
August 1, 2017, because ABC delivered and installed (transferred) both on that date. Since the
calibration contract has a one-year duration and commenced on August 1, 2017, revenue from it
should be recognized over the next 12 months (over a period of time).

August 1: Dr. Cash or A/R $90,000

Cr. Revenue (scales) 54,000 [$90,000 × ($60,000 ÷ ($60,000 + 10,000 + 30,000))]
Cr. Revenue (software) 9,000 [$90,000 × ($10,000 ÷ ($60,000 + 10,000 + 30,000))]
Cr. Deferred revenue 27,000 [$90,000 × ($30,000 ÷ ($60,000 + 10,000 + 30,000))]

December 31: Dr. Deferred revenue $11,250

Cr. Revenue 11,250 ($27,000 × 5/12)