FA2 Module 4. Revenue and expense recognition 1.Revenue recognition 2.Expense recognition 3.Revenue recognition by critical event 4.Revenue recognition by effort expended 5.The percentage-of-completion method 6.Long-term contract losses 7.The instalment method

1. Revenue recognition IFRS definition of revenue Revenue arises from (1) inflows of cash, increases in accounts receivable, or other increases in a business’s assets, (2) settlement of its liabilities, or (3) a combination of the two. These inflows must be derived from delivering or producing goods, rendering service, or performing other activities that constitute a company’s business operations over a specific period of time.

1. Revenue recognition Revenue/expense vs. gains/losses Revenues/expenses arise from central operating activities of company, while gains/losses can be peripheral or from central activities. Practical differences: Gains and losses are typically either net amounts (e. g., cash inflow less carrying value of disposed asset) or recorded changes in value (e. g., remeasurement of inventory to NRV).

1. Revenue recognition Earnings process The earnings process consists of all activities and events an entity engages in to earn revenue: Purchasing/manufacturing inventory Marketing/advertising Granting credit Delivering merchandise Collecting cash

1. Revenue recognition Earnings process (continued) Each step in the earnings process represents effort necessary to earn revenue, but the value of each step is impossible to measure reliably. Instead, accountants tend to identify one critical event in the earnings process, an event which can be reliably identified and at which time earnings can be said to be earned.

Identifying the critical event: Revenue recognition criteria (sale of goods) Seller transfers significant risks and rewards of ownership to buyer Amount of revenue is reasonably measurable and collectibility is reasonably assured Economic benefits of transaction will flow to seller Seller can reliably measure all costs of transaction, past and future Seller retains no continuing control

Identifying the critical event: Revenue recognition criteria (sale of goods) The short version: Seller has completed its part of agreement (performance is achieved, most costs incurred and remaining costs can be estimated, risks and rewards of ownership have transferred to buyer) The amount of revenue can be measured Collection of revenue is reasonably assured

Critical events: Examples 1.When service or good is delivered to customer 2.When production is complete, but before delivery to customer (e. g., bill-and-hold) 3.Some time after delivery to customer (e. g., returns policy where number of returns is unknown) 4.When cash is received

Revenue recognition exercise In each of the cases below, determine an appropriate revenue recognition policy. 1.Subbway sells sandwiches to customers for cash. 2.Life sells magazine subscriptions; subscribers pay cash up front and the magazines are delivered monthly. 3.Tymex sells watches with a one-year warranty.

Revenue recognition exercise In each of the cases below, determine an appropriate revenue recognition policy. 4.Buy-now-pay-later sells merchandise on credit. Customers pay within 90 days of receipt of the merchandise. 5.Big Construction builds vacation cruise ships on a contract basis for major cruise line companies. Ship construction normally takes three years.

2. Expense recognition Expense arises from outflows of assets or increases in liabilities that result from delivering or producing goods, rendering services or performing other activities that constitute a company’s business operations over a specific period of time. How to account for a cost incurred? If the cost will generate a future benefit – ASSET If the cost will generate a current benefit (or future benefit is not sufficiently certain) – EXPENSE Asset becomes expense as benefits are realized.

Revenue and expense recognition Revenues should be recognized when revenue recognition criteria are met. Expenses are recognized as follows: 1.Matching: Costs that are clearly associated with specific sales or service revenue (e. g., cost of goods sold, sales commissions) should be expensed when the associated sale or service revenue is recognized, even if the cost in question has not yet been incurred (e. g., warranty costs). 2.Costs that are not clearly associated with specific sales or service revenue, should be expensed when incurred (e. g., CEO salary) or when the related good (e. g., insurance) is used.

3. Revenue recognition – critical event Under the critical event approach, a single event in the earnings process is identified as the point at which revenue is recognized. The event is usually one which is clearly and objectively identifiable (a reliability concern), and is one at which the revenue recognition criteria are clearly met. Relevance vs. representational faithfulness Relevance usually favours earlier revenue recognition based on effort expended, but representational faithfulness favours later recognition based on the critical event.

3. Revenue recognition – critical event Perhaps the most common critical event is the point at which merchandise or service is delivered to the customer. Once the revenue is recognized, related expenses are recognized as well (matching principle). Related costs incurred prior to revenue recognition (e. g., purchase of inventory) are assets that are expensed at the critical event. Related costs that will be incurred after the critical event (e. g., warranty costs) are estimated and accrued at the critical event. Example: A6-7

4. Revenue recognition – effort expended Recognizing revenue on the basis of effort expended in the earnings process generally leads to more relevant revenue and earnings information, but reliability problems favour the use of the critical event approach. In certain industries (e. g., construction), earnings on individual projects are earned over several years. In this case, the critical event approach discourages recognition of revenue until the project is complete, potentially leading to a distorted picture of a firm’s economic performance.

Revenue and long-term contracts Under a long-term contract, a contractor formally agrees to undertake a project that will require several months or years to complete. Usually, selling price, billings, delivery dates, etc. are specified. Revenue: When is performance achieved? Long-term contract: Performance is “achieved” as long as the amount of consideration to be received for the work performed (effort expended) can be measured with reasonable reliability.

5. The percentage-of-completion method Revenues and related expenses are recognized during each period during which work is accomplished on a long-term contract. To use this method: It must be possible to measure the amount of work done as percentage of total (performance is achieved) Revenue is known and collectibility is reasonably assured It is possible to measure expenses related to the revenue earned this period

Percentage-of-completion: How to measure the amount of work done? The most popular method is the cost-to-cost method. Percentage of work completed = 100 X Costs incurred to end of current period Most recent estimate of total costs Note that the estimate of total costs is likely to change from period to period.

Percentage-of-completion: How much revenue to recognize? Percentage of work completed (to end of current period) X Total revenue (or gross profit*) expected from contract - Total contract-related revenue (or gross profit*) recognized in prior periods = This year’s revenue (or gross profit*) *Note: This approach usually works for gross profit, but sometimes fails if losses must be recognized!

Percentage-of-completion: How much expense to recognize? On a cost-to-cost basis, the amount of contract expense each year is generally the actual contract-related cost incurred. = percentage of work completed this year X most current estimate of total cost = cost incurred this year

Percentage-of-completion: Bookkeeping To record costs incurred Dr. Construction in process (inventory) Cr. Cash, payables, etc. To record revenue and expenses Dr. Construction expense Cr. Revenue Dr. Construction in process (cr. if loss) Note that the amount of gross profit for the year is added to the inventory account.

Percentage-of-completion: Bookkeeping To record progress billings to client Dr. Accounts receivable Cr. Billings on construction in process To record collection of cash Dr. Cash Cr. Accounts receivable To record completion of project Dr. Billings on construction in process Cr. Construction in process

Percentage-of-completion: Balance sheet Presentation of inventory and billings (contract by contract basis) 1.Inventory > billings In current assets, inventory is presented net of billings (billings is an inventory contra account). 2.Billings > inventory The amount by which billings exceeds inventory is presented among current liabilities. Example: Cornet

Example: Cornet Construction In 20x1, Cornet Construction accepted a three-year construction project for a building that was to be ready by the end of 20x4. Contract revenue was fixed at $24,000,000 and total construction costs were estimated to be $18,000,000. Information regarding this project for the years 20x1 – 20x4 is presented below (all amounts in millions of dollars): 20x120x220x320x4 Total cost to date Estimated cost to complete Billings to client Cash collected from client

6. Long-term contract losses If cost estimates change during the execution of the contract, it is likely that the gross profit from the contract will change. This might lead to an inappropriate amount of (usually excess) gross profit being recognized in earlier periods. There are two cases: 1.Contract is still profitable, but too much gross profit has been recognized in prior years. 2.Contract is unprofitable.

6. Long-term contract losses 1. Contract is still profitable, but too much gross profit has been recognized in prior years. Percentage-of-completion An adjustment is made this year so that total gross profit recognized since start of contract is consistent with new cost estimates. Example: Cornet (20x2)

7. Long-term contract losses 2.Contract is no longer profitable. Percentage-of-completion All contract-related profit recognized in earlier years must be eliminated in the current period. In addition, total expected loss on the contract must be recognized in the current period (prudence). Example: Cornet (20x3)

7. The instalment method An instalment sale is any type of sale for which a series of payments is required of the customer over an extended period of time. The instalment method is a revenue recognition policy that defers recognition of income until the period in which the cash is collected. The instalment method is not appropriate for all instalment sales, only those for which estimates of uncollectible amounts are impossible.

The instalment method: Bookkeeping Delivery of goods/services to customer Dr. Instalment accounts receivable mkt val Cr. Inventorycost Cr. Deferred gross margin (liab)profit

The instalment method: Bookkeeping When cash is collected Dr. Cash Cr. Instalment accounts receivable To recognize revenue and matching expense Dr. Deferred gross marginprofit* Dr. Cost of goods soldcost** Cr. Revenuecash collected *(**) = proportion of total cash collected X total deferred gross margin (cost of product service) Example: A6-13

The recovery method The recovery method is a revenue recognition policy that defers recognition of income until the total cost of the sale is recovered. This method is used: 1.For credit sales where the uncertainty is too high, even for the instalment method 2.For long-term contracts when it is impossible to estimate the total cost to complete the contract (IFRS)

The cost recovery method: Bookkeeping Delivery of goods/services to customer Dr. Instalment accounts receivable mkt val Cr. Inventorycost Cr. Deferred gross margin (liab)profit

The cost recovery method: Bookkeeping When cash is collected Dr. Cash Cr. Instalment accounts receivable To recognize revenue and matching expense Dr. Deferred gross margin* Dr. Cost of goods sold** Cr. Revenuecash collected ** = cash collected until full cost is recovered * = 0 until full cost is recovered Example: A6-13