Lecture 4 Revenue recognition

The total estimated contract costs in Year 2 are 0.925 million.

The progress towards completion in Year 2 is 100%.

The total costs recognized in the current year (Year 2) is 675,000.

The total amount recorded for contract liability is $1,025,000 and for contract asset is$1,025,000.

The key topics include:

• Revenue Recognition
• Repurchase
• Consignment
• Bill-and-hold
• Right of Return
• Warranties
• Sale of Non-financial Asset
• Contract Costs
• Transfer Over Time
• Construction Contract

A performance obligation is satisfied at a point in time when control of the good or service is transferred to the customer. This means the customer can direct the use of and obtain substantially all the remaining benefits from the asset, and the seller can prevent others from using it.

The indicators that control has passed to the customer include:

1. A present obligation to pay
2. Physical possession of the asset
3. Legal title to the asset
4. Risks and rewards of ownership
5. Acceptance of the asset by the customer

Control is significant in revenue recognition as it determines when an entity can recognize revenue. It refers to the ability to direct the use of and obtain substantially all the remaining benefits from an asset, as well as the ability to prevent others from using it.

The revenue standard provides guidance in areas beyond the five steps model to assist entities in applying the model effectively, addressing various issues that may arise during the revenue recognition process.

1. Forward: An entity's obligation to repurchase the asset.
2. Call Option: An entity's right to repurchase the asset.
3. Put Option: An entity's obligation to repurchase the asset at the customer's request.

If an entity has an obligation or a right to repurchase an asset, the customer does not have control of the asset. This means that despite physical possession, the customer is limited in their ability to direct the use of and obtain benefits from the asset.

The entity needs to consider:

• If the repurchase price is greater than the selling price.
• If the repurchase price is less than the selling price.

The entity accounts for the transaction as a financing arrangement. It continues to recognize the asset and recognizes a financial liability for any consideration received. The difference between the consideration received and the amount to be paid is recognized as interest and any applicable processing or holding costs.

The entity must account for the contract as a lease in accordance with HKFRS 16, unless it is part of a sales and leaseback. In this case, the entity can continue recognizing the asset and recognize a financial liability for any consideration received. If the option expires unexercised, the entity derecognizes the liability and the related asset, and recognizes revenue.

The difference between the consideration received from the customer and the amount of consideration to be paid to the customer is recognized as interest, along with any applicable processing or holding costs.

The entity derecognizes the liability and the related asset, and recognizes revenue.

Morgan Inc. should record the transaction as follows:

1. Record the cash received and liability on January 1, 2015:
   • Debit Cash £100,000
   • Credit Liability to Lane Company £100,000

This entry reflects the financing aspect of the repurchase agreement, where Morgan Inc. receives cash and recognizes a liability for the amount owed to Lane Company.

Morgan Inc. should record the following entries:

• Interest Expense: 10,000
• Liability to Lane Company (£100,000 x 10%): 10,000

On December 31, 2016, Morgan Inc. records:

• Interest Expense: 11,000
• Liability to Lane Company (£110,000 x 10%): 11,000

If Morgan exercises the right to repurchase the asset, the following entries will be made:

• Liability to Lane Company: 121,000
• Cash (£100,000 + £10,000 + £11,000): 121,000

If Morgan does not exercise the right to repurchase the asset, the entries will be:

• Liability to Lane Company: 121,000
• Revenue (£100,000 + £10,000 + £11,000): 121,000

A consignment arrangement is when an entity delivers goods to another party (like a dealer or distributor) but retains control of those goods, meaning it cannot recognize revenue upon delivery until certain conditions are met.

The indicators of a consignment arrangement include:

1. The entity controls the product until a specified event occurs (e.g., sale to a customer).
2. The entity can require the return of the product or transfer it to a third party.
3. The dealer does not have an unconditional obligation to pay for the products, although a deposit may be required.

Revenue is recognized when control of the product transfers to the intermediary (the dealer) or the end customer.

1. Inventory on consignment: Debit $36,000
2. Inventory: Credit $36,000

1. Bank: Debit $40,000
2. Commission expense: Debit $4,000
3. Payable to consignor: Credit $36,000

The consignee retains a 10% commission on the sales, which amounts to $4,000** from the total sales of **$40,000.

The consignor records the cost of sales as follows:

• Debit Cost of Sales: $24,000
• Credit Inventory on Consignment: $24,000

The consignee records the transaction as follows:

• Debit Payable to Consignor: $36,000
• Credit Bank: $36,000

The consignor records the cash received as follows:

• Debit Bank: $36,000
• Credit Receivable from Consignee: $36,000

A bill-and-hold arrangement occurs when an entity bills a customer for a product that it transfers at a point in time but retains physical possession of the product until it is transferred to the customer at a future point in time, often due to the customer's lack of available space or delays in production schedules.

The conditions that must be met for revenue recognition in a bill-and-hold arrangement include:

1. The reason for the bill-and-hold arrangement must be substantive.
2. The product must be identified separately as belonging to the customer.
3. The product must be ready for physical transfer to the customer.
4. The entity must not have the ability to use the product or direct it to another customer.

If any of the conditions for revenue recognition are not met, the customer has not obtained control of the product, and the entity may not recognize revenue until it concludes that the customer has obtained control of the product.

Butler Ltd should report the revenue at the time title passes, provided the following criteria are met:

1. The reason for the bill-and-hold arrangement must be substantive.
2. The product must be identified separately as belonging to Galaxy.
3. The product currently must be ready for physical transfer to Galaxy.
4. Butler cannot have the ability to use the product or to direct it to another customer.

When a sale includes a right of return, an entity must initially recognize:

1. Revenue: at the gross transaction price less the expected level of returns.
2. Refund liability: at the expected level of returns.
3. Estimated inventory return: by reference to the carrying amount of the products expected to be returned, less the expected recovery costs.
4. Cost of goods sold: as the carrying amount of goods sold less the estimated inventory return.
5. Reduction of inventory: as the carrying amount of goods transferred to the customer.

1. To recognize the sale excluding revenue on products expected to be returned:

   • Dr Bank $10,000
   • Cr Refund liability $300 (for 3 products at$100 each)
   • Cr Revenue $9,700 (for 97 products at$100 each)

2. To recognize the cost of sales and the right to recover products from customers:

   • Dr Estimated inventory returns $180 (for 3 products at$60 each)
   • Dr Costs of sales $5,820 (for 97 products at$60 each)
   • Cr Inventory $6,000 (for 100 products at$60 each)

Venden should record the following journal entries:

1. Refund Liability: $300 (for 3 units at$100 each)
2. Accounts Payable: $200
3. Revenue: $100
4. Inventory: $120 (for 2 units at$60 each)
5. COGS: $60 (for 1 unit at$60)
6. Estimated Inventory Returns: $180 (for 3 units at$60 each)

A warranty provides assurance to the customer that the product will function as intended and may also offer additional services related to compliance with agreed-upon specifications.

An assurance warranty is accounted for as part of the sale price of the entity's product.

A warranty is considered a performance obligation if: 1. The customer has the option to purchase the warranty separately; or 2. Additional services are provided as part of the warranty.

Service warranties are accounted for under existing guidance as a separate performance obligation.

A warranty may be considered a separate performance obligation if it provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.

An entity allocates a portion of the transaction price to a service warranty by applying the requirement in step 4 of the revenue recognition model.

If an entity cannot reasonably account for the assurance and service elements of a warranty separately, it accounts for both warranties together as a single performance obligation.

The set-up costs should be accounted for as follows:

1. Record the total transaction price:

   • Dr Bank/trade receivables $3,600

2. Record the warranty expense for the assurance warranty:

   • Dr Warranty expense $200

3. Record the accrued warranty costs for the assurance warranty:

   • Cr Accrued warranty costs (assurance warranty) $200

4. Record the contract liability for the service warranty:

   • Cr Contract liability (service warranty) $400

5. Recognize revenue for the sale of the computer:

   • Cr Revenue $3,200

An entity derecognizes a non-financial asset when control of that asset transfers to the recipient. The resulting gain or loss is calculated as the difference between the transaction price and the asset's carrying amount, and it is not presented as revenue.

The guidance applies to the following types of non-financial assets:

• Property, plant and equipment (HKAS 16)
• Intangible assets (HKAS 38)
• Investment property (HKAS 40)

The accounting entries for the disposal of a non-financial asset are as follows:

A contract asset is an entity's right to consideration in exchange for goods and services that the entity has transferred to a customer, where that right is conditional on something other than the passage of time.

A contract asset is conditional on something other than the passage of time, while a receivable is unconditional, meaning only the passage of time is required before payment is due.

An entity must present a contract as a contract asset if it satisfies a performance obligation by transferring goods or services to a customer before being entitled to payment, and if it is required to perform other obligations before payment is due.

An entity is required to assess a contract asset for impairment in accordance with HKFRS 9.

Dr Contract Asset 30,000

Cr Revenue 30,000

Dr Accounts Receivable 100,000

Cr Contract Asset 30,000

Cr Revenue 70,000

A contract asset is a right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditional on something other than the passage of time (e.g. invoice).

1. Costs of obtaining a contract
2. Costs of fulfilling a contract

If costs incurred to obtain a contract are expected to be recovered, they should be capitalised as an asset. However, if the amortisation period of the asset is one year or less, they can be expensed as incurred.

Costs incurred regardless of whether a contract is obtained, such as legal fees for due diligence, are expensed as they are incurred unless they meet the criteria to be capitalised as fulfilment costs.

If contract costs are not expected to be recovered, they should be recognised as an expense.

An entity recognizes an asset for contract fulfillment costs only if the costs:

1. Relate directly to an existing contract or specific anticipated contract;
2. Generate or enhance resources that will be used to satisfy performance obligations in the future;
3. Are expected to be recovered.

The criteria for transferring control over time are:

1. The customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs (e.g., cleaning services).
2. The entity's performance creates or enhances an asset that the customer continues to use as the asset is created or enhanced (e.g., building an asset on a customer's site).
3. The entity's performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date (e.g., building a specialized asset for a customer).

If none of the criteria for transferring control over time are met, control transfers to the customer at a point in time, and the entity recognizes revenue at that point in time.

Developer D can recognize revenue over time for Unit X if:

1. The contract has substantive terms that prevent D from directing Unit X to another customer.
2. Unit X does not have an alternative use due to contractual restrictions.
3. D has an enforceable right to all consideration promised under the contract if Customer Y defaults on its obligations.
   Since these conditions are met, revenue can be recognized over time.

Contract liabilities are obligations to transfer goods or services to a customer for which the entity has received consideration before the entity transfers a good or service to the customer.

Contract assets are rights to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditional on something other than the passage of time (e.g. invoice).

Receivables are unconditional rights to consideration if only the passage of time is required before payment of that consideration is due, unlike contract assets which are conditional.

Revenue and costs should be recognized according to the progress towards completion of the contract at the reporting date if:

1. The entity's performance does not create an asset with alternative use when restricted during creation/enhancement.
2. The entity has an enforceable right to payment that compensates for performance to date.

Revenue to be recognized to date = Estimated total revenue x Percentage complete

Current period revenue = Total revenue to be recognized to date - Revenue recognized in PRIOR periods

Gross profit = Current Period Revenue - Current Period Costs

Costs relating to future activity should be excluded, such as costs of materials delivered but not yet used.

Current period costs = Total costs to be recognized to date - Costs recognized in PRIOR periods

Calculate the percentage of completion.

Determine the amounts to be recognized as costs and revenue in the income statements.

Determine amounts or gross balances to be recognized in the statement of financial position, such as amounts to be billed to customers and owed to customers.

Prepare extracts of financial statements with respect to the construction contract.

The journal entry is:

• Dr Contract asset
• Cr Cash, inventory, A/P etc

The journal entry is:

• Dr AR on work billed
• Cr Contract liability

The journal entry is:

• Dr Cash (maybe after retention)
• Cr AR on work billed

The journal entries are:

• Dr Construction expense
• Dr Contract asset
• Cr Revenue on construction

The journal entry is:

• Dr Contract liability
• Cr Contract asset

The percentage of completion for Year 1 is calculated using the formula:

Progress towards completion = (Contract costs incurred to date) / (Total estimated contract costs)

In this case:

• Contract costs incurred to date = $250,000
• Total estimated contract costs = $750,000

Thus, the percentage of completion is:

Progress towards completion = $250,000 /$750,000 = 33 1/3%

The estimated profit for Year 2 is calculated as follows:

Estimated profit = Total contract revenue - Total estimated contract costs

For Year 2:

• Total contract revenue = $1,025,000
• Total estimated contract costs = $925,000

Thus, the estimated profit is:

Estimated profit = $1,025,000 -$925,000 = $100,000

The total estimated contract costs for Year 1 are calculated by adding the contract costs incurred to date and the estimated costs to complete:

Total estimated contract costs = Contract costs incurred to date + Contract costs to complete

For Year 1:

• Contract costs incurred to date = $250,000
• Contract costs to complete = $500,000

Thus, the total estimated contract costs are:

Total estimated contract costs = $250,000 +$500,000 = $750,000

The enforceable right to all consideration promised under the contract signifies that ABC Construction has a legal claim to receive payment for the work completed, regardless of the project's progress. This right ensures that ABC can recognize revenue based on the progress towards completion, as it indicates that the company will receive the full contract price of $1,025,000 upon completion of the project.

The total contract price is $1,025,000.

The progress towards completion percentage for Year 1 is 33 1/3%.

Revenue recognized to date in Year 1 is $341,667.

The total estimated contract costs are $750,000.

The costs recognized in the current year are $250,000.

The total cost incurred to date in Year 2 is $925,000.

Cash collections to date in Year 2 amount to $695,000.

The estimated cost to complete the project in Year 2 is $0.

The total contract price for the construction project is $1,025,000.

The progress billing to date in Year 2 is $775,000.

The total contract revenue recognized in Year 2 is 1,025,000.

The revenue recognized in the current year (Year 2) is 683,333.