630 $84,300

On October 31, 20X5, the fiscal year end of the accounting firm, the following hours had been spent on
the audit, which is not due to be completed until January 31, 20X6.

Staff Hours

Junior 120

Senior 45

Manager 4

Partner 2

These amounts are all within budget. None of the work to date has been invoiced. Costs incurred to date
and costs to complete the work can be measured reliably.

Required:

Prepare the journal entry to recognize revenue for the public accounting firm as at October 31, 20X5.

Solution to Example 2.2b

Staff Hours Charge-out rate Total

Junior 120 $110 $13,200

Senior 45 $160 7,200

Manager 4 $240 960

Partner 2 $350 700

$22,060

DR Accrued revenue (a current asset) 22,060

CR Assurance revenue 22,060

Recognition of expenses (contract costs)

According to the expense recognition requirements of the IFRS conceptual framework, all costs
pertaining to a sale — past, present and future — must be recognized at the same time revenue is
recognized (a process commonly referred to as matching). Therefore, expenses are recognized at the
point in time that performance obligations are satisfied.

Expenses — performance obligations satisfied over a period of time

When performance obligations are satisfied over a period of time, there are multiple revenue
recognition points, and therefore multiple expense recognition points. While the standard applies
equally to performance obligations satisfied at a point in time and over a period of time, much of the
guidance is more relevant to accounting obligations satisfied over a period of time. Pertinent points
from IFRS 15 are as follows:

• The costs incurred in fulfilling the contract that are not within the scope of another standard are
recognized as an asset, provided that the costs meet all three criteria below:

o The costs related directly to a specific contract — for example, the engine purchased to power
the yacht that is being constructed under contact.

o The costs generate or enhance the entity’s resources that will be used to satisfy the
performance obligation — for example, the payment made to varnish the deck of the yacht.

o The costs are expected to be recovered.

• The costs incurred in fulfilling the contract that are within the scope of another standard are to
be accounted for in accordance with that standard. For example, the accounting treatment for direct
materials and labour used in manufacturing goods is accounted for in accordance with the governing
inventory standard, rather than the revenue recognition standard.

• General and administrative expenses are normally expensed when incurred. For example, the
salaries of the office staff of a construction company will be expensed when earned by the employees,
rather than being expensed to reflect the stage of completion of the various contracts that the company
is working on.

• The cost of wasted resources (such as material and labour) of an abnormally high amount are
expensed when squandered. This means that if a crate containing 100 windows is inadvertently dropped
and 10 of the windows break, then the cost of the broken windows would be immediately expensed,
rather than being accounted for as a contract cost.

• Costs that will be reimbursed by the customer, irrespective of whether the contract is obtained,
are recognized as an asset.

• An entity recognizes an asset for the incremental costs of obtaining a contract if it expects to
recover those costs, and the asset is then amortized on a systematic basis over the life of the contract.
For example, an asset would be created for the sales commission paid to a broker who arranged a five-
year contract. The cost would then be expensed over the fiveyear life of the contract. Note that the
expense cannot be capitalized (recognized as an asset) if the cost would have been incurred regardless
of whether or not the contract had been obtained.
o As a practical matter, the standard permits an entity to immediately expense any incremental
costs that would have been amortized over a period of one year or less.

o According to the standard, an entity should recognize an impairment loss if it no longer expects
to recover the full amount of the asset over the remainder of the contract.

The mechanics of recognizing expenses related to performance obligations satisfied over time will be
discussed in Week 3.

2.2-2 Initial and subsequent measurement

The standard asserts that, as performance obligations are satisfied, the amount of the transaction price
shall be recognized as revenue. It also states how the transaction price for a contract is determined,
though this can be a difficult process in more complex situations. For most common transactions,
though, it’s fairly straightforward, with the transaction price normally being the net amount that the
entity expects to receive for transferring the goods or services to the customer. Additional
considerations in determining the transaction price are discussed below.

Amounts collected on behalf of third parties

The transaction price excludes amounts collected on behalf of third parties, such as sales taxes.

Variable consideration

When the contract includes a variable amount, such as a performance bonus, the entity estimates the
amount of the variable consideration to be received using either expected value techniques or the most
likely amount, and must use the same method over the life of the contract. Variable consideration is
reassessed at the end of each reporting period. An entity will include the variable consideration in its
transaction price to the extent that it is highly probable that a significant reversal of the consideration
will not occur. Following are some of the factors that could increase the likelihood that a significant
reversal of the variable consideration will occur:

• The amount of consideration is highly susceptible to factors outside the entity’s influence. • The
uncertainty about the amount of consideration is not expected to be resolved for a long period of time.

• The entity has limited experience with similar types of contracts. • The contract has a large
number and broad range of possible consideration amounts.

If any of these factors are present, the variable consideration is not included in the transaction price
until it is resolved. Examples 2.2c and 2.2h demonstrate how variable consideration is accounted for.

The standard requires that the change in transaction price be allocated to all performance obligations
(promises made in the contract) on the same basis (proportion) as when the contract was first
recognized. If the performance obligation has been satisfied, then any adjustments to the amount of
variable consideration should be immediately reported as an increase or decrease in revenue on the
statement of comprehensive income. More simply, the proportion of the additional revenue earned to
date is recorded in the current period.

Note that some contracts represent a series of distinct goods or services that are substantially the same
(for example, providing a daily office-cleaning service under a one-year contract or providing sales and
marketing support for the duration of a franchise agreement). If the terms of a variable payment relate
specifically to the entity satisfying a specific performance obligation, then the change in consideration is
not allocated to the different performance obligations on a proportionate basis. Rather, 100% of the
change in transaction price is allocated to the specific performance obligation to which it pertains and is
reported as an increase or decrease in revenue on the statement of comprehensive income. Using the
example above, if the office wanted a deep clean done one day instead of the usual clean, the cost for
this would be higher. This higher cost would be accounted for at the time of service, and recorded as an
increase in revenues immediately by the service company.

An expected value is the probability-weighted average of the possible outcomes, whereas the most
likely amount is, as the name suggests, the most likely amount of consideration to be received in a range
of possible outcomes.

Example 2.2c: Determining the transaction price

Bridge Over Water Inc. has a $4 million fixed-price contract with Water City to construct a bridge. The
contract contains a provision for an additional early-completion bonus payable to Bridge Over Water, as
follows:

Completion date Bonus payment Estimated probability

July 31, 20X6, or before $1,000,000 5%

August 31, 20X6 800,000 10%

September 30, 20X6 600,000 10%

October 31, 20X6 300,000 15%

November 30, 20X6 100,000 40% December 31, 20X6, or later 0 20%

Required:

a) Determine the transaction price of the contract assuming that Bridge Over Water estimates the
variable consideration using expected value techniques.

b) Independent of part a) above, determine the transaction price of the contract assuming that
Bridge Over Water estimates the variable consideration using the most likely amount.
Solution to Example 2.2c

a)

Amount — Weight —

Completion date Bonus payment Estimated probability Contribution

July 31, 20X6, or before $1,000,000 5% $ 50,000

August 31, 20X6 800,000 10% 80,000

September 30, 20X6 600,000 10% 60,000

October 31, 20X6 300,000 15% 45,000

November 30, 20X6 100,000 40% 40,000

December 31, 20X6, or

later 0 20% 0

100% $275,000

Variable consideration (early-completion bonus) $ 275,000

Fixed contract price 4,000,000 Transaction price for contract $4,275,000

b) The $100,000 payment is the most likely amount, as the probability of this occurrence (40%) is higher
than any of the other possible outcomes.

Variable consideration (early-completion bonus) $ 100,000

Fixed contract price 4,000,000

Transaction price for contract $4,100,000

Significant financing component

IFRS 15 normally requires that when a contract specifies payment terms over a long period of time, the
consideration received must be adjusted for the time value of money. The discount rate to be used at
inception should reflect the underlying credit risk. Once established, the rate is not amended to reflect
subsequent changes in the interest rate or other circumstances. Interest revenue arising from the
financing component of the transaction is reported separately from the contract revenue in the
statement of comprehensive income.
However, entities can ignore the time value of money if the customer pays the full amount due within
one year of the asset transfer date.

Example 2.2d: Financing component

On January 1, 20X5, Marvel Motors Ltd. accepted an $88,200, two-year, interest-free note receivable
from a customer as full consideration for the purchase of a car. The customer could have opted to
purchase the car for $80,000 cash.

Marvel, whose fiscal year end is December 31, 20X5, prepares its financial statements in accordance
with IFRS. The original cost of the car to Marvel was $72,000. The note receivable was paid in full by the
customer on January 1, 20X7.

Required:

Prepare Marvel’s journal entries pertaining to the sale of the car for the following dates: January 1,
20X5, December 31, 20X5, December 31, 20X6, and January 1, 20X7.

Solution to Example 2.2d

Use the cash equivalent price to determine the effective interest rate to account for this transaction.
Assume that Marvel would implicitly charge a (market) rate of interest that reflects the underlying credit
risk of the customer.

Market rate of interest would be calculated as follows (using a financial calculator):

N (number of payments) = 2

PV (present value) = –$80,000

FV (future value) = $88,200

PMT (payment) = $0

CPT I/Y (compute interest rate) = 5%

The following journal entries would need to be made by Marvel:

January 1, 20X5

DR Notes receivable 80,000

CR Sales revenue 80,000

DR Cost of goods sold 72,000

CR Inventory 72,000

December 31, 20X5

DR Notes receivable 4,000

CR Interest revenue 4,000

($80,000 × 5%)

December 31, 20X6

DR Notes receivable 4,200

CR Interest revenue 4,200

[($80,000 + $4,000) × 5%]

January 1, 20X7

DR Cash 88,200

CR Notes receivable 88,200

($80,000 + $4,000 + $4,200)

Note: This is an example of the application of the effective interest rate method that is required by IFRS.
The effective interest rate method will be discussed in more detail in Week 5.

Non-cash consideration

Entities sometimes enter into a sales transaction where the consideration is not cash — for example, a
company may barter products instead of transacting in cash. From an accounting perspective, the first
task is to determine whether the asset given up represents a transaction that is in keeping with its
ordinary activities, or if it is outside the company’s main revenuegenerating activity.

If a company normally sells office furnishings and it agrees to accept a motor vehicle as payment for
office furniture, the asset received (the motor vehicle) represents income arising from an entity’s
ordinary business activities. Transactions of this nature are accounted for in the same manner as other
sales. The selling entity measures the non-cash consideration received at its fair value. This amount will
in turn be recorded as revenue, with the book value of the goods or services sold charged to cost of
goods sold in the normal fashion.
If a pizza restaurant gives up a used pizza oven in exchange for the same motor vehicle, however, the
sale of the oven is outside the company’s main revenue-generating activities (the company does not sell
pizza ovens to generate revenue; it sells pizzas). It is thus accounted for as a disposal of plant and
equipment. This type of transaction is discussed in detail in Week 4.

Consideration payable to a customer

Sometimes a contract provides that an entity will either pay (or promise to pay) a customer a sum of
money or provide the customer with some form of a credit (for example, a voucher that entitles the
customer to a future or current discount) that can be applied against the amount owed. This is
structured legally as a separate item, rather than deducted from the selling price for the current sale.
The economic reality, however, is that the current item was sold at a discount.

Other contracts can provide a commitment for the company to purchase a distinct good or service from
the customer at a future date (essentially requiring the seller and purchaser to buy from each other). In
this situation, two separate sales are occurring between the parties and must be accounted for on that
basis.

The accounting treatment depends on the underlying nature of the transaction that gave rise to the
payment or credit:

• If payment is made to the customer for something other than a distinct good or service, the economic
reality is that a discount has been given, and the transaction price (and hence revenue) is reduced by the
amount of the consideration given up.

Example 2.2e: Consideration payable to a customer

All Things Mechanical Corp. (ALMC) enters into a contract with We Need It Inc. (WNII) to provide it with
a custom-built machine. Pertinent details are as follows:

• The contract price is $3 million due at time of delivery of the completed machine.

• Terms of the contract require that, upon completion, ALMC must provide WNII with a
transferable coupon that can be used by WNII to acquire $100,000 of goods from ALMC on a no-charge
basis (for no cash payment). • ALMC determines that this contract represents a single performance
obligation.

Required:

Determine the transaction price of the contract to construct the machine and prepare the journal entry
for the ultimate sale of the machine to WNII.

Solution to Example 2.2e

In this example, ALMC is selling a machine to WNII, but is also paying WNII by providing it with a
$100,000 coupon. The coupon provided by ALMC to WNII gives WNII a discount on a future purchase,
which is for something other than distinct goods and services, and so the economic reality is that this is
actually a reduction of the proceeds on the current sale. The value of the coupon must be deducted
from the transaction price in accordance with IFRS 15. The transaction price for the contract to construct
the machine is thus $2,900,000 ($3,000,000 – $100,000).

DR Accounts receivable 3,000,000 CR Sales revenue 2,900,000

CR Redeemable voucher liability coupons* 100,000

*This is a liability account, similar to a deferred revenue account.

• If an entity makes a fair value payment to its customer for a distinct good or service, then the
purchase is accounted for in the same way as for a transaction with any other supplier. A distinct good
or service is one in which there is an identifiable benefit to the purchaser, and the entity could have
entered into an exchange transaction with someone other than the customer to receive that benefit.
More simply, the entity bought something from its customer that it wanted and which had value. Had
the entity not purchased it from the customer, the entity could have purchased the item elsewhere.

• If the amount paid for a distinct good or service exceeds the fair value of the item, the fair value
amount is accounted for in the normal manner for a transaction of this nature and the excess is
accounted for as a reduction in the transaction price.

Example 2.2f: Consideration payable to a customer

Engines Unlimited Ltd. (EUL) enters into a contract with Love To Race Inc. (LTR) to sell racing equipment.
Pertinent details of the contract are as follows:

• The contract price provides that LTR will pay $1 million to EUL upon delivery of the racing
equipment.

• A condition of the contract requires EUL to purchase a number of high-performance engines

from LTR for $150,000. The goods acquired from LTR are required to complete a different contract with
another customer. EUL could have bought these items from LTR or another supplier whether or not LTR
was awarded the racingequipment contract.

• The fair value of the goods purchased by EUL from LTR was $125,000. • EUL determines that
this contract represents a single performance obligation.

Required:

Determine the transaction price of the contract to provide the racing equipment and prepare the journal
entries EUL would record for the transaction above.
a) Revised transaction price ($4,000,000 fixed contract + $300,000 earlycompletion bonus)
$4,300,000

Initially estimated transaction price, per Example 2.2c part a) solution 4,275,000

Incremental transaction price to be allocated to performance obligations

$ 25,000

Bridge — allocation of change in consideration 80% × $25,000 $ 20,000

Approaches — allocation of change in 20% × $25,000

consideration 5,000

Total — change in consideration $ 25,000

b) Bridge — revised transaction price 80% × $4,300,000 $3,440,000

Approaches — revised transaction price 20% × $4,300,000 860,000

Total — revised transaction price $4,300,000

Customer loyalty programs — own-party awards

Many companies use marketing incentives such as customer loyalty programs to increase sales. These
programs generally award points that the customer can later redeem for something of value. Accounting
for the revenue from customer loyalty programs for own-party awards , is governed by IFRS 15, because
a vendor that awards points when it sells a product has two performance obligations: delivering the
good or service that was sold and meeting the loyalty plan commitment.

Accounting for customer loyalty plans and other sales/marketing-related inducements can be very
complex. To illustrate this concept, assume Jasmeet went out of town on business for two days. The
hotel she stayed at offered its own reward program that awards one point for each stay of two nights or
longer. When guests have accumulated five points, they can exchange those points for one night’s free
accommodations.

• Using Jasmeet’s hotel stay as an example, the hotel must allocate the transaction price (the
price charged for Jasmeet’s room stay) to the two parts of the room booking:

o Jasmeet’s right to stay at the hotel for the two days reserved
 CR Accounts receivable 9,900

Receipt on payment of $40,000 received after the discount period:

DR Cash 40,000

CR Accounts receivable 39,600

CR Other revenue (forfeited 400 cash discounts)

Both methods are seen in practice, although valuing receivables at the gross amount is more common.
From a theoretical perspective the net method should be used, as $49,500 is the amount of revenue
arising from the sale of the goods and $500 is the interest revenue earned from customers who pay on
or after the 11th day. From a practical perspective, though, it is much easier administratively to record
receivables at their face value (the gross amount).

2.4-3 Subsequent measurement

Accounts receivable are reported on the statement of financial position at their transaction price, less an
allowance for expected losses (doubtful accounts). This method of subsequently valuing receivables is
commonly referred to as the “lower of cost or net realizable value” approach. Net realizable value refers
to the net amount that a company expects to collect from its trade receivables. The most common
methods of determining the net realizable value of accounts receivable are described below.

2.4-4 Methods of accounting for bad debts

An unfortunate by-product of selling on credit terms is that not everyone pays you back! Recall that one
criterion of revenue recognition is that “it is probable that the economic benefits associated with the
transaction will flow to the entity.” To satisfy this requirement, companies estimate the amount of
accounts receivable that they will not collect and then charge this amount to bad debt expense. By
taking this step, companies can recognize revenue on credit sales at the time of delivery. Methods used
to account for bad debts include the direct write-off method and an allowance for doubtful accounts.

Direct write-off method

This approach is used only for accounts known to be uncollectible, rather than estimated to be
uncollectible using expected value or other accepted techniques. When it is determined that a customer
is not going to pay the amount owing, the accounts receivable balance is derecognized (removed from
the financial statements). The offsetting entry for the write-off is a debit to bad debt expense. The
following is an example of an entry to record the direct write-off of an account receivable with a balance
of $8,341.

DR Bad debt expense 8,341