Revenue Recognition

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 Learning Objectives
After studying this chapter, you will understand:

1. The five-step revenue recognition model under the newly issued

standard.
2. What constitutes a contract and a performance obligation.
3. How transaction prices are determined and allocated among
performance obligations.
4. How revenue is recognized at a point in time or over time.
5. How to determine whether the firm is a principal or an agent, and
the accounting implications of the determination.

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 AASB 15 Revenue Recognition
(AASB 15 Revenue from Contracts with Customers)

The main issue in accounting for revenue is in determining when the

revenue is to be recognised.

AASB 15 will apply to all contracts with customers, except for contracts
covered by other Standards, such as leases, insurance and financial
instruments.

What is required?

AASB 15 stipulates how and when revenue is recorded, requiring entities to

provide users of financial statements with more information and reporting
disclosures.
Its core principle is the recognition of revenue for the transfer of goods or services, at a value that
reflects the consideration to which the entity expects to be entitled, in return for meeting
performance obligations.
 The Five-step Revenue Recognition
Model
 The revenue recognition model provides a five-step method for
evaluating contracts with customers to determine when revenue
may be recognized.
 The five steps:
1. Identify the contract(s) with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in
the contract.
5. Recognize revenue when (or as) the entity satisfies a
performance obligation.

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 Step 1: Identify the Contract(s) with a Customer

 All of the following conditions must be met for a firm to account

for a contract with a customer:
 All parties to the contract have approved the contract and are legally
obligated to perform their obligations under the contract.
 Each party’s rights regarding the goods or services being exchanged can be
identified.
 Payment terms can be identified.
 The contract has commercial substance.
 Collection is probable.

 if neither party has yet performed under the contract and both parties have
the right to cancel the contract without penalty, then for purposes of the
revenue recognition standard, no contract exists.

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 Collectibility versus Price
Concessions
 If a firm believes it will not ultimately receive the full, stated
contract price, judgment may be necessary to determine if the
shortfall is due to a collectibility problem or a price concession.
For example:
 A hospital immediately treats an uninsured patient in the emergency
room; later, the hospital determines the patient is uninsured and does
not expect to collect in full.
 Initially, the hospital cannot determine that the patient is committed to
perform its obligation; therefore, no revenue may yet be recognized.
 The hospital will reassess whether a contract can be identified as
circumstances change.

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 Consideration Received before a
Contract Exists
 Sometimes a payment is received before a contract can be
identified. When that is the case, revenue may be recognized
when (1) the consideration is nonrefundable and (2) any one of
the following events has occurred:
 There are no remaining obligations to transfer goods or services to
the customer.
 The contract has been terminated.
 The entity has transferred the goods or services to which the
consideration received relates, and it has no further obligation to
transfer goods or services.
 Any discrepancy between when the payment is received and
when the obligation(s) is (are) satisfied would be considered a
significant financing component. (Step 2 of the model.)

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 Step 2: Identify the Performance
Obligations in the Contract
 At the inception of a contract, a firm must determine its
performance obligations.
 Each performance obligation is a promise to provide goods or
services.
 Judgment may be required to determine if:
 The elements of a set of promised goods or services are distinct from
one another, and therefore constitute separate performance
obligations, or
 They are not distinct.

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 Step 2: Identify the Performance
Obligations in the Contract,
concluded
 Factors that indicate two or more promises to transfer goods or
services are not separately identifiable include:
 The entity provides a significant service of integrating the

goods or services with other goods or services promised in the

contract.
 One or more of the goods or services significantly modifies or

is significantly modified by other goods or services promised in

the contract.
 The goods or services are highly interdependent or

interrelated.

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 Warranties
 Warranties provide repair services for goods sold to a customer.
 Warranties can serve two purposes.
1. They can be used to assure the customer that the product it is
purchasing is free of defect at the time of the purchase. Such
defects cannot always be detected immediately.
2. They act as a sort of insurance policy against future repair and
maintenance costs.
 A warranty is considered a separate performance obligation if:
 The customer has the option to purchase the warranty separately, or
 The warranty provides services beyond what is required to assure
the product is free of defects at the time of sale.

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 Warranties, concluded
 The cost of providing the warranty is estimated and expensed in
the period in which revenue is recognized for the good whose
quality it assures.
 Warranties that provide services beyond assuring the product is
defect-free at the time of sale are separate performance
obligations.
 Answers to the following questions will be useful in distinguishing
between an assurance warranty and a warranty providing
additional services:
 Is the warranty required by law?
 What is the length of the warranty?
 What are the services required under the warranty?

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 Step 3: Determine the Transaction
Price
 The transaction price:
 Is the amount of consideration the firm expects to be entitled

to receive.
 Excludes amounts collected on behalf of third parties, such as

for sales taxes.

 Noncash consideration is to be valued at fair value.
 The transaction price may have both fixed and variable
components.

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 Assessing Whether the Firm Is a
Principal or an Agent
 For transactions involving more than two parties, a firm may need
to determine whether it is a(n):
 Principal (providing goods or services) – A firm is considered a
principal if it obtains control of the goods or services and then
transfers that control to another party.
 Agent (facilitating the sale of goods or services by another party).
 The principal–agent determination affects whether a firm
recognizes revenue on a gross or a net basis.
 A principal recognizes revenue for the gross amount paid by the
customer and reports as an expense its cost of goods sold.
 An agent reports revenue only for the net amount retained (e.g., its
commission).

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 Assessing Whether the Firm Is a
Principal or an Agent, concluded
 The principal–agent determination also affects the timing of the
revenue recognition:
 An agent may recognize revenue when its performance

obligation to the principal is satisfied.

 A principal may not recognize revenue until the goods or

services promised to the end customer have been transferred.

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 Right of Return

 A right of return exists when the customer is entitled to a full or

partial refund, a credit against amounts owed, or another product
in exchange (unless it is only for another product that is
essentially the same).
 In these situations, the amount the firm will be entitled to collect
depends on the extent to which customers exercise their rights to
refunds.
 When a right of return exists, the variable consideration analysis
is applied.

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 Right of Return, continued

 A retailer sells goods at a selling price of $10,000 (and a $8,000

cost). Customers have a right of return within 30 days.
 The store estimates that 4% of the units sold will be returned.
 Revenue recognized in the period is 96% × $10,000 = $9,600.
 The journal entry is as follows:
DR Cash $10,000
CR Sales revenue $9,600
CR Refund liability 400

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 Right of Return, concluded
 A retailer sells goods at a selling price of $10,000 (and a $8,000
cost). Customers have a right of return within 30 days.
 The store estimates that 4% of the units sold will be returned.
 Cost of goods sold is only recognized on the portion of the total
sale for which revenue has been recognized.
 Cost of goods sold is $8,000 × 96% = $7,680.
 The journal entry is as follows:

DR Cost of goods sold $7,680

CR Inventory recovery asset $ 320
CR Inventory 8,000

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 Step 4: Allocate the Transaction
Price to the Performance
Obligations in the Contract
 The allocation of the transaction price should be based on the
stand-alone prices for the goods and services comprising each
performance obligation.
When the sum of the The allocation of the consideration should
stand-alone prices be based on the proportion of the sum of
is not equal to the the stand-alone prices represented by
total consideration each performance obligation.

 Stand-alone prices are straightforward when the goods and

services in the contract are also sold separately; otherwise,
estimates must be made using a(n):
 Adjusted market approach
 Expected cost plus margin approach
 Residual approach

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 Step 5: Recognize Revenue When
(or as) the Entity Satisfies a
Performance Obligation
 A performance obligation is considered satisfied when control
over the goods and services that comprise the performance
obligation is transferred to the customer.
 Control has transferred when:
 The customer has a legal obligation to pay the firm.
 The customer has legal title (in the case of goods).
 The customer has physical possession (in the case of goods).
 The customer is subject to the risks and rewards generally
associated with ownership.
 The customer has indicated its acceptance of the goods and
services.
 These are indicators of control; no single item above is decisive.

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 Licenses
 Some transactions involving intellectual property represent a sale
of intellectual property, whereas others represent licenses.
 The approach to be used for revenue recognition depends on
whether the transaction is considered a sale or a license.
 If the transaction represents a sale, then it is treated like any

other sale and the five-step model is applied to determine the

point in time that sales revenue may be recognized.
 If the transaction is a license, then revenue recognition may

be entirely at the inception of the license or over time during

the period of the license, depending on the circumstances.

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 Licenses, continued
 First, the firm must determine whether the transaction is a sale, or
a license, of intellectual property.
 If the customer’s right to use the intellectual property is somehow
limited, for example by time or geographic area, then the contract is a
license.
 If the customer’s use of the property is unlimited, the contract is a
sale.
 If a contract is determined to be a license, then the firm must
determine if the license is a distinct performance obligation.
 If it is not distinct, the firm applies the five-step model for a combined
bundle that represents a single performance obligation.
 If it is distinct, then the firm must assess whether the customer has a
right to access the firm’s intellectual property.

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 Consignment Arrangements
 A consignment arrangement exists when a firm delivers goods to
another party but retains control over them.
 The purpose of the arrangement is typically to facilitate a sale to a
third party.
 Indicators that a consignment agreement exists are as follows:
 The firm transferring possession of the product still controls it

until some event occurs, such as the sale of the product to a

third party.
 The firm transferring possession of the product has the right to

require the product to be returned or transferred elsewhere.

 The entity that has received the product is not obligated to pay

for it (unless it is sold).

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 Bill-and-Hold Arrangements
 A bill-and-hold arrangement exists when the firm bills a customer
for goods but retains physical possession at the customer’s
request.
 Revenue is recognized when control is transferred to the
customer; all of the following criteria must be met:
 The reason for the bill-and-hold arrangement is substantive.
 The product is identified separately as belonging to the customer.
 The product is ready for physical transfer to the customer.
 The firm does not have the ability to use the product itself or to
transfer it to another customer.
 If any of the criteria are not met, the customer has not yet
obtained control and the seller may not recognize revenue.

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 Long-Term Construction Projects:
Percentage-of-Completion Method
 Long-term construction projects are generally undertaken only
after a buyer has been found and has obligated itself
contractually.
 When that is the case:
 The cost of the project can be reasonably estimated, and

collection is reasonably certain, perhaps because of progress

payments that are made as construction progresses, and
 The percentage-of-completion method is permitted under rules

in effect through 2017.

 Percentage-of-completion method – Revenue is recognized in
proportion to the “work done” each period.

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 Example: Solid Construction Corp.
 Contract price is $1,000,000 and construction costs
are estimated to be $800,000.

Original estimate
was $800,000

 How much revenue should be recognized each year?

2014 2015 2016 Total

Gross Profit ? ? ? $1,000,000

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 Percentage-of-Completion for 2014
(Year 1)

Percentage of $240,000 Cost incurred

30% = =
completion ratio $800,000 Estimated total costs

Revenue recognized in
current period $1,000,000 x 30% = $300,000

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 Percentage-of-Completion for 2015
(Year 2)

Percentage of $544,000
30% 64% =
completion ratio $850,000
Cumulative revenue
to date $200,000
$0 $1,000,000 x 64%= $640,000

Cumulative revenue at $60,000

$300,000
$60,000 $300,000 (in 2014)
prior 12/31

Revenue recognized $640,000 - $300,000 = $340,000

in current period

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 Percentage-of-Completion for 2016
(Year 3)

Percentage of $850,000
30% 100% =
completion ratio $850,000
Cumulative revenue
to date $200,000
$0 $1,000,000 x 100%= $1,000,000

Cumulative revenue $60,000

$300,000
$60,000 $300,000 (in 2014) +
at prior 12/31 $340,000 (in 2015)
Revenue recognized $1,000,000 - $640,000 = $360,000
in current period

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 Long-Term Construction Projects:
Completed-Contract Method
 In some cases, it is not possible to determine expected costs with
a high degree of reliability.
 In these situations, the completed-contract method is used
instead.
 The completed-contract method postpones recognition of

income until the project is completed.

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 Summary

 The model provides a five-step method for evaluating contracts with

customers to determine when revenue may be recognized.
1. Identify the contract(s) with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.

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