2/19/2021

Topic 6: Revenue
Recognition

Motivation

Summary of AAER* alleged misstatement activities

*Accounting and Auditing Enforcement Releases by the SEC

Revenue recognition
Premature 53.1%
Fictitious 38.8
Unclear 18.4
Any type 65.3

Overstate assets 24.5

Other income increasing 46.9
Capitalize expenses 22.5
Create (or use) hidden reserves 20.4
Off-balance sheet financing 6.1
Improper income statement classification 18.4
Illegal transactions 6.1
Related party 16.3

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Agenda

1. Journal entries associated with revenue recognition

2. New revenue recognition standards (primary focus)

3. Additional issues (~ Thursday)

• Sales returns
• Bill-and-hold arrangements
• Principal-agent relationships
• Consignments
• Warranties
• Nonrefundable upfront fees

4. Long-term contracts (~next week)

Scenarios

1) The firm receives cash and revenue is earned*

2) The firm earns* revenue, cash not yet received

Later when cash is received:

3) The firm receives cash, revenue is not yet earned*

Later when revenue is earned*:

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Revenue Recognition Standard ASC 606

On May 28, 2014, the FASB issued Accounting Standards Update
(ASU) No. 2014-09, and the IASB issued IFRS 15, Revenue from
Contracts with Customers

Annual reporting periods beginning after December 15, 2017 (for

public entities), but early adoption permitted

New ASC Topic 606 provides a single model that is to be applied by

all firms in determining when revenue may be recognized
− Provides a five-step model for evaluating how and when revenue should
be recognized, rather than providing detailed industry-by-industry
standards
− Is far more principles oriented than the existing standards, which tended
to be more rules based
− Focuses on when control of goods and services is transferred to the
customer, rather than when the firm has earned the consideration to
which it is entitled
− Account for revenue based on the asset or liability arising from contracts
with customers

Revenue Recognition Standard

Revenue Recognition Principal

− Recognize revenue in the accounting period when the
performance obligation is satisfied

5 Step Process for Revenue Recognition

1. Identify the contract with customers
2. Identify the separate performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the separate performance
obligations
5. Recognize revenue when each performance obligation is
satisfied

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Five Step Process

Transactions: Single/Multiple POs
Legal rights of seller and customer
1. Identify the contract
established

2. Identify performance
Single Multiple
obligation(s)

3. Determine the transaction Amount seller is entitled to receive

price from customer
4. Allocate the transaction
No allocation Allocate a portion
price to performance
obligations(s) required to each PO
5. Recognize revenue
when (or as) each At a Over a At whatever time
performance obligation point in period is appropriate for
is satisfied time of time each PO

Five Step Process Overview

Step in Process Description Implementation

1. Identify the A contract is an agreement A company applies the revenue

contract with that creates enforceable guidance to contracts with
customers. rights or obligations. customers.

2. Identify the A performance obligation is A contract may be comprised of

separate a promise in a contract to multiple POs.
performance provide a product or service Accounting is based on
obligations in to a customer. evaluation of whether the
the contract product or service is distinct
within the contract.
If each of the goods or services is
distinct, but is interdependent
and interrelated, these goods and
services are combined and
reported as one PO.

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Five Step Process Overview (cont’d)

Step in Process Description Implementation

3. Determine Transaction price is the In determining the transaction

the amount of consideration
transaction that a company expects
price. to receive from a
customer in exchange for
transferring goods and
services.
price, companies must
consider the following factors:
1. variable consideration,
2. time value of money,
3. noncash consideration, and
4. consideration paid or
payable to customer.

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Five Step Process Overview (cont’d)

Step in Process Description Implementation

4. Allocate the If more than one PO exists, The best measure of fair value
transaction allocate the transaction is what the good or service
price to the price based on relative fair could be sold for on a
separate PO. values. standalone basis (standalone
selling price).

5. Recognize A company satisfies its PO Companies satisfy performance

revenue when the customer obligations either at a point in
when each obtains control of the good time or over a period of time.
performance or service.
obligation is
satisfied.

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Boeing Example

Assume that Boeing Corporation signs a contract to sell airplanes

to Delta Air Lines for $100 million.
Step 1: Identify the
Boeing has signed a contract to deliver
contract
airplanes to Delta.
with customers.

Step 2: Identify the Boeing has only one performance obligation—to

separate performance deliver airplanes to Delta. If Boeing also agreed to
obligations in the maintain the planes, a separate performance
contract. obligation is established for this promise.

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Boeing Example (cont’d)

Step 3: Determine the The transaction price is straightforward,
transaction price. $100 million.

Step 4: Allocate the

transaction price to the Boeing has only one performance
separate performance obligation—to deliver airplanes to Delta.
obligations.

Step 5: Recognize Boeing recognizes revenue of $100 million for

revenue when each the sale of the airplanes to Delta when it
performance obligation satisfies its performance obligation—the
is satisfied. delivery of the airplanes to Delta.

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Step 1: Identify the Contract

Contract
− Agreement that creates enforceable rights
− Written, oral, or implied (customary business practice)

5 Requirements for Valid Contract

1. Contract has commercial substance
2. Parties have approved contract
3. Identification of the rights is established
4. Payment terms are identified
5. Probable that consideration will be collected

Revenue cannot be recognized until a contract

exists

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Step 1: Identify the Contract (Example 1)

Leno Computers manufactures Tablet computers for sale to

retailers such as Fallon Electronics. Recently, Leno sold and
delivered 200 tablet computers to Fallon for $20,000 on January 5,
2020. Fallon has agreed to pay for 200 tablet computers within 30
days. Fallon has a good credit rating and should have no difficulty
in making payment to Leno. Does a valid contract exist?

1.Commercial substance?
2.Approval?
3.Rights?
4.Payment terms?
5.Performance?

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Step 1: Identify the Contract (Example 2)

TrueTech Industries manufactures the Tri-Box System, a multiplayer

gaming system allowing players to compete with each other over the
Internet. CompStores orders 1,000 Tri-Box Systems at the
wholesale price of $270/system on May 10, 2017, promising
payment within 30 days after delivery. TrueTech or CompStores can
cancel the order at any time prior to delivery without penalty.
TrueTech delivers the Tri-Boxes to CompStores on May 20, 2017. Is
the TrueTech arrangement with CompStores a contract?

1.Commercial substance?
2.Approval?
3.Rights?
4.Payment terms?
5.Performance?

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Contract Modifications

Change in contract terms to existing contract

New Contract - if both of the following conditions are satisfied:
− Promised goods or services are distinct
• Regularly sells them separately
• Not interdependent with other goods and services
− Right to receive an amount of consideration that reflects the
standalone selling price of the promised goods or services

Modification to existing contract - account for using a

prospective approach
− Account for effect of change in period of change as well as future
periods if change affects both
− Not change previously reported results

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Contract Modification (Example)

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 deliver 20 more products for an additional $1,900, or $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. Prepare the journal entry to record sales revenue on the 40
remaining units under the initial order of 100 units using (1) the new
contract approach and (2) the prospective approach.

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Step 2: Identify Performance Obligation(s)

Performance Obligation (POs)

− Promise to provide a distinct product or service to a
customer

Distinct
− Customer is able to benefit from good/service on its own
or together with other readily available resources
− Separate each POs that are not highly dependent or
interrelated
− Combine goods / services interdependent or interrelated
into a single performance obligation

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Step 2: Identify the PO(s) (Example 1)

SoftTech Inc. licenses customer-relationship software to Lopez Company. In
addition to providing the software itself, SoftTech promises to provide
consulting services by extensively customizing the software to Lopez’s
information technology environment, for a total consideration of $600,000. In
this case, SoftTech is providing a significant service by integrating the goods
and services (the license and the consulting service) into one combined item
for which Lopez has contracted. In addition, the software is significantly
customized by SoftTech in accordance with specifications negotiated by Lopez.
Do these facts describe a single or separate performance obligation?

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Step 2: identify the PO(s) (example 2)

Chen Computer Inc. manufactures and sells computers that include a
warranty to make good on any defect in its computers for 120 days (often
referred to as an assurance warranty). In addition, it sells separately an
extended warranty, which provides protection from defects for three years
beyond the 120 days (often referred to as a service warranty). Identify the
performance obligations.

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Step 3: Determine the Transaction Price

Amount of consideration that a company expects to

receive from a customer

In a contract is often easily determined because

customer agrees to pay a fixed amount

Other complexities
− Variable consideration
− Time value of money (Significant financing component)
− Noncash consideration
− Consideration paid or payable to the customer

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Variable Consideration

Price may depend on future events

- Performance bonus
- Volume discounts, rebates, credits
- Royalties
Estimate amount of revenue to recognize
- Expected value – probability weighted amount
- Most likely amount – single most likely amount
Only recognize variable consideration if
- Experience with similar contracts and able to estimate the
cumulative amount of revenue
- Based on experience do not expect a significant reversal of
revenue previously recognized

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Variable Consideration
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.

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.

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Variable Consideration Example

Peabody Construction Company 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.

How should Peabody account for this revenue arrangement?

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Time Value of Money

• When timing of payment does not match transfer of

goods or services contract involves a significant financing
component

• Interest accrued on consideration to be paid over time

− Fair value determined either by measuring the consideration
received or
− Discounting the payment using an imputed interest rate

• Report as interest expense or interest revenue

− Not required to reflect the time value of money if the time
period for payment is less than a year

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Time Value of Money Example

On July 1, 2020, SEK Company sold goods to Grant Company for $900,000
in exchange for a 4-year, zero-interest-bearing note with a face amount of
$1,416,167. The goods have an inventory cost on SEK’s books of $590,000.
(a) How much revenue should SEK Company record on 7/1/2020?

(b) How much revenue should it report related to this transaction on 12/31/2020?

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Noncash Consideration

• Goods, services, or other noncash consideration

− Generally recognize revenue on the basis of the fair value of what is
received
− Estimate selling price

• Contributions received (donations and gifts)

− Recognize revenue based on fair value of consideration received

• Contributed goods or services (equipment or labor) as

consideration for goods provided or services performed
− Recognize revenue based on fair value of consideration received

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Consideration Paid to Customers

• Discounts, volume rebates, coupons, free products, or

services
− Generally reduce the consideration received and the revenue
to be recognized

Example: Sansung 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,
2020, Sansung has made sales of $700,000 to Artic Co. In the previous 2 years,
Sansung sold over $3,000,000 to Artic in the period April 1 to December 31.

How much revenue should Sansung recognize for the first 3 months of 2020?

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Step 4: Allocating Transaction Price to POs

• Based on relative fair values

• Best measure of fair value is what the company
could sell the good or service for on a standalone
basis
• If not available, best estimate of what the good or
service might sell for as a standalone unit

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Step 4: Allocating Transaction Price

Adjusted market assessment approach
− Estimate price customers are willing to pay in market
− May include referring to competitors prices for similar goods /
services and adjust for company’s costs / margins

Expected Cost plus a margin approach

− Forecast costs to satisfy performance obligation and add an
appropriate margin

Residual approach
− Remaining amount after total transaction price allocated to
observable standalone selling prices goods / services

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Allocating Transaction Price (Example)

Appliance Center sells ovens on a standalone basis and also sells installation services
and maintenance services for ovens. However, Appliance Center does not offer
installation or other maintenance services to customers who buy ovens from other
vendors. Pricing is as follows:
Oven only $800
Oven with installation $850
Oven with maintenance $975
Oven with installation and maintenance $1,000
The maintenance service is separately priced within the arrangement at $175.
Additionally, the incremental amount charged for installation approximates the
amount charged by independent third parties.
Assume that a customer purchases an oven with both installation and maintenance
services for $1,000, how should revenue be allocated to the oven, the installation
and the maintenance contract?

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Step 5: Recognize Revenue as POs are Satisfied

• Performance obligation is satisfied when the customer

obtains control of the good or service

• Change in Control Indicators

1. Right to payment for asset
2. Transferred legal title to asset
3. Transferred physical possession of asset
4. Significant risks and rewards of ownership
5. Customer has accepted the asset

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Step 5: Recognize Revenue

Timing of recognition depends on revenue type:

3
1 2
Revenue from
Revenue from Revenue from
permitting use
sale of goods Services
of an asset

When the When the

As time passes or
goods are services are
assets are used
delivered performed

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Step 5: Recognize Revenue – Over Time

Revenue is recognized over time if one of the following 3

criteria is met
Primarily service 1. The customer receives and consumes the
contracts – usually
recognized using benefits as the seller performs
straight-line
2. The customer controls the asset as it is created or
enhanced
Primarily
construction-type
contracts – usually
3. The company does not have an alternative use
recognized using for the asset created or enhanced and either (a)
percentage-of- the customer receives benefits as the company
completion (next
week) 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

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Comprehensive Example

Tablet Tailors sells tablet PCs combined with Internet service, which permits
the tablet to connect to the Internet anywhere and set up a Wi-Fi hot spot.
The “Tablet Bundle” is a tablet with 3 years of Internet service. The price for
the tablet and a 3-year Internet connection service contract is $500. The
standalone selling price of the tablet is $250 (the cost to Tablet Tailors is
$175). Tablet Tailors sells the Internet access service independently for
$300. On January 2, 2020, Tablet Tailors signed 100 contracts, received a
total of $50,000 in cash, and transferred control of the tablet PCs to the
customer. Assume that valid contracts exist and that the Internet access
service is distinct within the context of the contract. Prepare the required
journal entries for 2020.

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Questions?

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Revenue Recognition:
Special Issues

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Revenue Recognition Issues

1. Sales returns and allowances

2. Bill and hold

3. Principal-agent relationships

4. Consignments

5. Warranties

6. Nonrefundable upfront fees

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Sales Returns and Allowances

• Right of return is often granted for various reasons and

may allow full or partial refund for consideration paid

• Right of return is not considered a separate

performance obligation

• Revenue should be recognized for amount reasonable

assured to be entitled
− Needs to consider returns and allowances
− Establish contra revenue account for estimate of returns
− Asset and corresponding adjustment to COGS for good
returned

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Sales Return and Allowances Example

On March 10, 2020, Steele Company sold 200 tool sets to Barr
Hardware at a price of $50 each (cost of $30 per set). Steele allows
Barr to return any unused toolsets within 60 days of purchase.
Steele estimates that 10 sets will be returned. On March 25, 20, Barr
returns 6 toolsets. Prepare any necessary journal entries at (1)
March 10, 2020, (2) March 25, 2020, and (3) March 31, 2020 (when
Steele prepares F/S).

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Sales Return and Allowances (example cont’d)

Credit Transactions (A/R) Cash Transactions

(1)DR A/R 10,000 DR Cash 10,000

CR Revenue 10,000 CR Revenue 10,000

DR COGS 6,000 SAME

CR Inventory 6,000

(2) DR Sales Returns 300 DR Sales Returns 300

CR A/R 300 CR Refund Liability (or A/P) 300

DR Returned Inventory 180

CR COGS 180 SAME

(3) DR Sales Returns 200 DR Sales Returns 200

CR Allowance for Returns 200 CR Refund Liability (or A/P) 200

DR Estimated Inventory Returns 120

CR COGS 120 SAME

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Bill and Hold Sales

• Bills a customer for a product but retain physical

possession of the product until a point in time in the future

• Buyer is not yet ready to take delivery but does take title
and accepts billing

• Criteria to recognize revenue as long as other revenue

recognition criteria are also satisfied:
1. The reason for the bill-and-hold arrangement is substantive
2. The product is identified separately as belonging to the customer
3. The product currently must be ready for physical transfer to the
customer
4. The company cannot have the ability to use the product or direct it
to another customer

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Bill and Hold Sales (Example)

An entity enters into a contract with a customer on January 1, 2020, for the
sale of a machine and spare parts. The manufacturing lead time for the
machine and spare parts is two years. Upon completion of manufacturing,
the entity demonstrates that the machine and spare parts meet the agreed-
upon specifications in the contract. The promises to transfer the machine
and spare parts are distinct and result in two performance obligations that
each will be satisfied at a point in time.

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Principle-Agent Relationships

• Agent’s performance obligation is to arrange for principal to

provide goods or services to a customer
− 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)

• Amounts collected on behalf of the principal are not revenue

of the agent

• Revenue for agent is amount of commission received

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Principle-Agent Relationships (Example)

Groupon S1
June 2, 2011

Groupon S1
Amendment No.7
November 1, 2011

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Consignments

• Manufacturers (or wholesalers) deliver goods but retain title to

the goods until they are sold
• Consignor (manufacturer or wholesaler) ships merchandise to the
consignee (dealer), who is to act as an agent for the consignor in
selling the merchandise
• Consignor makes a profit on the sale
− Carries merchandise as inventory
• Consignee makes a commission on the sale
− Does not record asset / inventory
• Traditionally, consignment deals are made on artwork, clothing,
and books
− Boston Scientific (consignor)
− Second Art in Iowa City (consignee)

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Warranties

Two types of warranties to customers:

1. Assurance-type warranty
• Product meets agreed-upon specifications in contract at time product is
sold
• Warranty is included in sales price
• Not a separate performance obligation
• Record a warranty liability and expense in period goods /
service provided
2. Service-type warranty
• Customers have the option to purchase separately and
• Promised warranty services are in addition to the assurance provided
with purchase of good/service
− Not included in sales price of product
− Recorded as a separate performance obligation – allocate portion of
transaction price

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Warranties (Example)

On November 1, 2020, Grando Company sells

production equipment to Fargo Inc. for $50,000. Grando
includes a 90-day assurance warranty with the sale of all
its equipment (Nov 1, 2020 – Jan 31, 2021). In addition,
Grando sells an extended warranty (service-type) for an
additional 6 months for $800. During 2020, Grando
incurred costs related to the assurance warranty of $100
and estimates $150 of warranty costs will be incurred for
the remainder of the warranty. Perform the necessary
journal entries during 2020.

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Nonrefundable Upfront Fees

• Advance Payments from customers before delivery of

product or performance of service

• Upfront payments are usually nonrefundable

− Membership fee in a health club
− Activation fees for phone, Internet, or cable

• Determine whether upfront fee is considered to be a

separate performance obligation
− If not, account for as advanced payment and recognize as
revenue over time as goods and services are provided
− If a separate PO, recognize revenue in accordance with the
transfer of that promised good or service

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Nonrefundable Upfront Fees (Example)

Cable Company C enters into a one-year contract to

provide cable television to Customer A. In addition to a
monthly service fee of $100, Cable Company C charges
a one-time up-front installation fee of $24. Cable
Company C has determined that its installation services
do not transfer a promised good or service to the
customer, but are instead a set-up activity that is an
administrative task.

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Disclosure

Under the new standard, companies will disclose more information about its
contracts with customers than is currently required, including more
disaggregated information about revenue and more information about its
performance obligations remaining at the reporting date.

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Significant areas of Judgement

Step 1: Is the contract legally enforceable?

- Judgement examples #1

Step 2: Are the performance obligations distinct?

- Judgement examples #2 & 3

Step 3: Is variable consideration is reasonably assured?

- Judgement examples #4

Step 4: How to allocate selling price to different obligations?

- Judgement examples #5

Step 5: Has control been transferred?

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Judgement Example #1

Metro produces and sells custom leather bags. Metro receives a large order
on December 15 from Paulie’s Purses, an existing customer in good standing.
Metro’s normal and customary business practice for such transactions is to
receive a written sales agreement from the customer that requires the
signatures of authorized company representatives and approval from their
sales committee. Authorized representatives from both Metro and Paulie’s
Purses have signed the agreement. However, the sales committee for Paulie’s
Purses is currently on vacation and will not be able to formally approve the
order and sign the agreement until January. They did verbally approve the
contract on a phone call. Due to the size of the order and their existing
relationship with Paulie’s Purses, Metro decides to ship the bags the last week
in December. The bags arrive at Paulie’s Purses prior to December 31.

Can Metro recognize revenue at December 31, as it is highly unlikely that

Paulie’s Purses sales committee will not approve the order?

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Judgement Example #2

Manufacturer sells a product to a distributor (that is, its customer), who will then
resell it to an end customer.

CASE A: In the contract with the distributor, manufacturer promises to provide

maintenance services for no additional consideration (that is, “free”) to any party
(that is, the end customer) that purchases the product from the distributor.
Manufacturer outsources the performance of the maintenance services to the
distributor and pays the distributor an agreed-upon amount for providing those
services on its behalf. If the end customer does not use the maintenance
services, the entity is not obliged to pay the distributor.

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Judgement Example #2 (cont’d)

Manufacturer sells a product to a distributor (that is, its customer), who will then
resell it to an end customer.

CASE B: Manufacturer has historically provided maintenance services for no

additional consideration (that is, “free”) to end customers that purchase the
entity’s product from the distributor. Manufacturer does not explicitly promise
maintenance services during negotiations with the distributor, and the final
contract between the entity and the distributor does not specify terms or
conditions for those services.

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Judgement Example #2 (cont’d)

Manufacturer sells a product to a distributor (that is, its customer), who will then
resell it to an end customer.

CASE B: Manufacturer has historically provided maintenance services for no

additional consideration (that is, “free”) to end customers that purchase the
entity’s product from the distributor. Manufacturer does not explicitly promise
maintenance services during negotiations with the distributor, and the final
contract between the entity and the distributor does not specify terms or
conditions for those services.

However, on the basis of its customary business practice, manufacturer

determines at contract inception that it has made an implicit promise to
provide maintenance services as part of the negotiated exchange with the
distributor. That is, manufacturer’s past practices of providing these services
create valid expectations of the customers (that is, the distributor and end
customers). Consequently, manufacturer identifies the promise of maintenance
services as a performance obligation to which it allocates a portion of the
transaction price.

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Judgement Example #2 (cont’d)

Manufacturer, sells a product to a distributor (that is, its customer), who will then
resell it to an end customer.

CASE C: In the contract with the distributor, Manufacturer does not promise to
provide any maintenance services. In addition, the entity typically does not
provide maintenance services, and, therefore, manufacturer’s customary
business practices, published policies, and specific statements at the time of
entering into the contract have not created an implicit promise to provide goods
or services to its customers. Manufacturer transfers control of the product to the
distributor and, therefore, the contract is completed. However, before the sale to
the end customer, the entity makes an offer to provide maintenance services to
any party that purchases the product from the distributor for no additional
promised consideration.

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Judgement Example #3

Telco has a contract with Customer that includes the delivery of a handset and 24 months
of voice/data services. The handset is locked to Telco’s network and cannot be used on
a third-party network without modification – i.e., through an unlock code – but can be
used by a customer to perform certain functions – e.g., calendar, contacts list, email.
However, there is evidence of customers reselling the handset on an online auction site
and recapturing a portion of the selling price of the phone. Telco regularly sells its
services separately to customers, through renewals and sales to customers who acquire
their handset from an alternative vendor – e.g., a retailer. Is the handset a separate
performance obligation?

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Judgement Example #4

Dempsy Outsourcing provides call-center ordering services for Airmall

magazine. Dempsy receives an annual fee of $100,000 for providing such
services and is also eligible to receive a performance bonus up to $50,000, if
average customer wait times are below certain thresholds at the end of the
year. Using historical results as well as current expectations, Dempsy estimates
the chances of achieving the different performance bonuses are as follows:

Average Wait Time Performance Bonus % Chance of Achieving

< 1 minute $50,000 5%
< 2 minutes $40,000 20%
< 3 minutes $30,000 45%
< 4 minutes $20,000 20%
< 5 minutes $10,000 10%

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Judgement Example #5

An entity regularly sells Products A and B individually, thereby establishing the

following standalone selling prices:

Product Standalone Selling Price

Product A $40
Product B 60

The entity enters into a contract with a customer to sell Products A, B, and C.
The standalone selling price for Product C is highly variable. Consequently, the
entity decides to estimate the standalone selling price of Product C using the
residual approach. Total consideration in the contract is $105.

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Questions?

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Long-term Contracting

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Agenda

1. Overview

2. Percentage of Completion method

3. Completed Contract method

4. Long-Term Contract Losses

5. Disclosure Example UTX

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Step 5: Recognize Revenue Over Time

Revenue is recognized over time if one of the following 3

criteria is met
Primarily service 1. The customer receives and consumes the
contracts – usually
recognized using benefits as the seller performs
straight-line
2. The customer controls the asset as it is created or
enhanced
Primarily
construction-type
contracts – usually
3. The company does not have an alternative use
recognized using for the asset created or enhanced and either (a)
percentage-of- the customer receives benefits as the company
completion
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

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Percentage of Completion (POC)

• Recognize revenue/profits ratably based on %

complete

• Measurement issue is how to measure the % complete

− Cost-to-cost basis - costs incurred to date v. most current
estimate of total costs
− Input basis - labor hours worked
− Output basis - tons produced, stories of a building
completed

• Completed Contract Method if criteria to recognize over

time are not met

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Percentage of Completion: Cost-to-Cost Basis

Step 1
Compute the cost ratio to determine
percent complete

Step 2
Determine the estimated total profit

Step 3
Compute the cumulative estimated
revenue earned to date and the
cumulative estimated profit earned to date

Step 4
Compute the incremental revenue and the
incremental profit earned in the current
period

Step 5
Prepare journal entries

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Percentage of Completion JEs

1. Record costs of construction:

DR Construction in process (CIP)
CR Cash, payables, etc.
2. Progress billings: Recorded as needed, usually
multiple times per year
DR Accounts receivable
CR Billings
3. Collections:
DR Cash
CR Accounts receivable
4. To recognize revenue and gross profit:
Recorded as an adjusting entry
DR CIP (gross profit)
at each year-end or quarterly
DR Expense period
CR Revenue

5. To record completion of project: Recorded when project is

DR Billings complete
CR CIP

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POC JEs compared to Regular Revenue Recognition

General Revenue Recognition:
1. Record costs as incurred:
DR WIP / Finished Goods (Inventory)
CR Cash, payables, etc.
2. Progress billings:
DR Accounts receivable
CR Unearned Revenue
POC Revenue Recognition:
1. Record costs of construction:
DR Construction in process (CIP)
CR Cash, payables, etc.
2. Progress billings:
DR Accounts receivable
CR Billings

3. Collections: 3. Collections:
DR Cash DR Cash
CR Accounts receivable
CR Accounts receivable
4. To recognize revenue and gross profit:
4. Recognize Revenue when transfer control:
DR CIP (gross profit)
DR A/R or Cash or Unearned Revenue
CR Revenue DR Expense
CR Revenue

5. Recognize COGS (costs) when recognize

Revenue: 5. To record completion of project:
DR COGS (Expense) DR Billings
CR Inventory CR CIP

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Completed Contracts JEs

1. Record costs of construction:

DR Construction in process (CIP)
CR Cash, payables, etc.
Recorded as needed, usually
2. Progress billings: multiple times per year (same
DR Accounts receivable as Percentage-of-Completion
CR Billings method)

3. Collections:
DR Cash
CR Accounts receivable

4. To recognize all expenses:

DR Expense
CR CIP Recorded when project is
complete
5. To recognize all revenue:
DR Billings
CR Revenue

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Percentage of Completion (Example)

In 2020 Gurney Construction Company agreed to construct an apartment

building at a price of $1,200,000. Information relating to the costs and billings
for this contract is shown below. Determine amount of revenue and profit to
recognize and prepare journal entries.

2018 2019 2020

Costs incurred to date 280,000 600,000 785,000

Estimated future costs 520,000 200,000 0

Total Estimated Costs 800,000 800,000 785,000

Customer billings to 150,000 500,000 1,200,000

date
Collections to date 120,000 320,000 940,000

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Percentage of Completion
Step 1: Cost to Cost Basis 2018 2019 2020
Costs incurred to date

Estimated total costs

Percent complete

Step 2: Estimated total Profit

Total Revenue

Less: Estimated total costs

Estimated Profit

Step 3 / 4 :Revenue

Total Revenue

% complete

Cumulative revenue to date

Less: Revenue previously

recognized
Current period revenue

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Percentage of Completion
Step 3 / 4: Profit 2018 2019 2020
Total Revenue

Estimated total costs

Estimated Profit

% complete

Cumulative Profit

Profit previously
recognized
Current period profit

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CIP T-Account

A T-account analysis of the CIP account is very useful in answering

questions
Example: Daniels Construction incurred $1 million in construction costs on
a new contract this year. It expects to incur another $7 million to
complete the project. The balance in the CIP account at year end is $1.2
million. What is the total revenue they expect to earn on the contract?
• Answer: 1.2 – 1 = 200,000 in GP recognized
• Project is 1/(1+7) or 12.5% complete, so 200,000 / 0.125 = $1,600,000 in
total profit
• Since profit is revenues minus expenses, total revenues must be 1.6 + 8 =
$9.6 million

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Long-Term Contract Losses

1. Loss in current period on a profitable contract

• Increase in estimated total cost but project is still profitable overall
• Percentage-of-Completion method - Adjustment in current period to adjust
excess gross profit recognized on the project in prior periods
− Adjustment in the current period (no prior period adjustment) since change in
estimate
• Completed Contract method - No adjustment needed
− No revenue or expense is recorded until completion

2. Loss in current period on an unprofitable contract

Increase in estimated total costs that will result in a loss on the entire
contract
Record the ENTIRE expected contract loss in the current period under both
the Percentage-of-Completion method and the Completed Contract method

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Long-Term Contract Losses (Example 1)

1. Loss in current period on a profitable contract

Return to the Gurney example. Assume billings and collections are the same.

But, adjust the 2019 cost numbers as shown below:

2018 2019 2020

Costs incurred to date 280,000 600,000 980,000

Estimated future costs 520,000 380,000 (vs. 200,000) 0

Total Estimated Costs 800,000 980,000 980,000 (vs. 785,000)

% complete 35% 600 / 980 = 61.224% 100%

$380 not $200 Cumulative % complete = 600/980 = 61.224%

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Long-Term Contract Losses (Example 2)

2. Loss in current period on an unprofitable contract

Again, return to the Gurney example. Assume billings and collections are the
same.

But, adjust the 2019 cost numbers as shown below.

2018 2019 2020
Costs incurred to date 280,000 600,000 1,250,000

Estimated future costs 520,000 650,000 0

Total Estimated Costs 800,000 1,250,000 1,250,000

% complete 35% 600 /1,250 = 48% 100%

There are still $650 of costs remaining:

$1,250 > $1,200 => expected loss on contract as a whole

Cumulative % complete = 600/1,250 = 48%

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Disclosure Example: UTX

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Questions?

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