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March 21
Class 18 Handout
Recognize Revenue When Seller Satisfies a Performance Obligation
[Q13] Example 1: Revenue recognized at a point in time
A Seller, Rita Inc. enters a contract to deliver customized ski equipment to a customer for $500
(cost is $250). The customer pays a $100 deposit upfront on October 15, 2020, while the remaining
$400 ($500-$100) is due on deliver, expected in three weeks. Prepare the journal entries required
on Oct 15 and on Nov 7, 2020 (the date that the customized ski equipment is picked up by the
customer and balance is paid in full).
Step 1: Is there a contract?
Step 2: How many distinct performance obligations?
Step 3: Transaction price determined?
Step 4: Allocation of transaction price
Step 5: At what point will performance obligation be satisfied? Once performance obligation is
satisfied, we can recognize revenues.
– Performance obligation is satisfied when goods is delivered and when the customer has
control.
Solution:
Revenue is recognized on delivery of the ski equipment because that is the point at which control
of the product is transferred to the customer. This means that only at this point is the fifth step of
the revenue recognition process complete. The $100 was received in advance of the delivery of the
product, Rita Inc. will recognize a liability (i.e., unearned revenue). Unearned revenue will be
reduced and recognized as revenue when delivery of the customized product takes place.
October 15, 2020 – to record customer prepayment
Dr. Cash …………………………………………………………………… 100
Cr. Unearned revenue…………………………………………….
100
Nov 7, 2020 – to recognize revenue and reduce inventory
Dr. Unearned revenue ………………………………………………… 100
Dr. Cash ………………………………………………………………….. 400
Cr. Sales revenue ……………………………………………………
500
Dr. Cost of goods sold ……………………………………………….. 250
Cr. Inventory ………………………………………………………….
250
[Q14] Example 2: Revenue recognized at a point in time
Gapp Inc. sponsors a customer loyalty point program where customers earn one loyalty point for
every $5 spent on clothing and accessories at any Gapp Inc. store or through online purchases.
Loyalty program members can exchange accumulated loyalty points for free products at Gapp Inc.
(such as one loyalty point equals $1 of free products). It is common for loyalty program members
to accumulate and redeem loyalty points for free products. During June of 2020, customers
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purchased products with a sales value of $20,000, earning 4,000 in loyalty points. Based on past
history of promotional programs, Gapp Inc. estimates a standalone selling price of $0.75 per loyalty
point or $3,000 in total. The standalone selling price of the products purchased is $20,000.
Required:
a. assuming that there are two performance obligations (product sales and loyalty points), allocate
the transaction price to the products and loyalty points.
Note: There are two distinct performance obligations in this contract.
– A good/service is distinct if a customer can benefit from the good/service on its own or
together with other resources that the customer has readily available and the seller’s promise to
transfer the good or provide the service can be identified separately from other promises in the
contract.
– When a contract has more than one performance obligation, each performance obligation
should be allocated a portion of the transaction price and accounted for separately.
– If the standalone selling price is available, the transaction price is allocated using the relative
proportion of the total standalone pricing.
The transaction price would be allocated as follows (Step 4):
Performance
Obligation
Sale of product
Loyalty points
Transaction Price Standalone
as Stated
Selling price
$20,000
$20,000

3,000
$20,000
$23,000
Selling price ratio Allocated
transaction price
20/23
$17,391
(20,000×20/23)
3/23
2,609
(20,000×3/23)
$20,000
b. Record the entry for sales for the month of June (ignore the cost entries).
Gapp Inc. records the following journal entry for the month of June for the transfer of control of
product to the customer (point in time sale). Revenue allocated to the loyalty points is deferred until
the rewards are redeemed for additional product.
June 30, 2020 – To record sale transaction
Dr. Cash ………………………………………………………………. 20,000
Cr. Unearned revenue ……………………………………………..
Cr. Sales revenue ……………………………………………………
2,609
17,391
c. Assuming that 1,600 loyalty points were redeemed in June, and Gapp Inc. still expects 4,000
points to be redeemed in total, record the entry to recognize revenue on the redeemed loyalty points
(ignore the cost entries).
Gapp Inc. would recognize revenue related to the customer options for June for $1,044 or (1,600
points/4,000 pts) x 2,609. Gapp Inc. records the following entry:
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June 30, 2020 – to record customers’ redemption of loyalty points
Dr. Unearned revenue ……………………………………………… 1,044
Cr. Sales revenue ……………………………………………………
1,044
[Q15] Example 3: Revenue recognized at a point in time
A contractor enters into a three-year construction contract with Dental Inc. to build an office
building. The contract has the following conditions.
– The office building plan is based upon a standard model frequently built by the contractor.
– Non-refundable payments are required including a payment equal to 10% of the contract price
up front, interim billing totaling 50% of the contract at the end of 18 months, and 40% at
the end of the contract if the project meets the prescribed requirements.
– Dental Inc. can cancel the contract at any time (with a termination penalty); any work in
process is the property of the contractor. Any payments made to the contractor before the
cancellation date remain with the contractor.
– Physical possession and title do not pass until the completion of the contract.
– Total estimated contract revenue is $300 million and total estimated contract cost is $200
million.
– Year one cost is $120 million (including $20 million related to contractor-caused
inefficiencies)
Determine the amount of revenue that the contractor should recognize during the first year of the
contract.
Solution:
First, the contractor must evaluate whether revenue should be recognized at a point in time or over
time. This situation does not warrant revenue recognition over time. In other word, this situation
does not allow the contractor to recognize revenue at the end of each year as the construction
progresses. In order to recognize revenue, the contractor has to determine if the performance
obligation is satisfied. In this situation, performance obligation is to build an office building. Due
to the following reasons, the performance obligation is not satisfied during the construction period:
1. During the construction period, Dental Inc. does not enjoy use of the building or have control of
the building, as it does not own the work in process.
2. Physical possession and title do not pass until the completion of the contract.
3. The building has alternative uses (is not customized).
4. The contractor does not have an enforceable right of payment for work to date. Payments are not
based upon performance but on a pre-set schedule, thus, at any point in time, the contractor may not
have been compensated for the work completed.
Therefore, no revenue (or expense) is recorded in 2020. Instead, revenue (and expense) would be
recognized at the completion of the project when control of the building is transferred to Dental Inc.
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The following are a set of practice problems for Revenues from Contract to Customers
– The five-step model application
[Question 1] Recognize Revenue at a point in time
Coffee Co. enters into a contract to delivery coffee to the House of Commons on July 1, 2020. The
House agrees to pay the full price of $ 3,000 on August 1, 2020. The cost of goods is $ 1,400.
Coffee Co. delivers the coffee to the House on July 1, 2020 and receives payment on August 1,
2020.
Instructions
Prepare the journal entries for Coffee Co. related to this contract.
Solution
On July 1, 2020, Coffee Co. delivers and therefore should recognize the revenue on that date
because it satisfies the performance obligation by delivering the coffee to the House. There is now
an unconditional right to receive the payment (and therefore an accounts receivable)
The journal entry to record the sale and related cost of goods sold is as follows:
July 1, 2020
Accounts Receivable ……………………………………………………
Sales Revenue ………………………………………………………
Costs of Goods Sold…………………………………………………….
Inventory ……………………………………………………………..
3,000
3,000
1,400
1,400
After receiving payment on August 1, 2020, Coffee Co makes the following entry:
August 1, 2020
Cash…………………………………………………………………………..
Accounts Receivable……………………………………………..
3,000
3,000
[Question 2] Performance Obligation
Trikonasana Inc. enters into a contract to design and build a bridge connecting a busy downtown
core to a shoreline across the way that is home to many commuters. Trikonasana is responsible for
overall management of the project and identifies various goods and services to be provided,
including engineering, site clearance, foundation, procurement, construction of the structure, and
so on.
Instructions
Under IFRS, does Trikonasana have a single performance obligation to the city in this revenue
arrangement?
Solution
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The overall management of the bridge construction project and the construction itself are
interdependent, and therefore should be accounted for as one performance obligation.
[Question 3] Performance Obligation
Island Foods Inc. has a promotional program whereby for every $10 spent in store, customers
receive stamps which can later be redeemed for knives and cookware.
Instructions
Under IFRS does Island Foods have a single performance obligation to its customers in this
revenue arrangement?
Solution
For the items customers buy in store, Island Foods has fulfilled its performance obligation. The
rights associated with the stamps are essentially giving the customer future items for free and
should be treated as separate performance obligations as they provide the customer with a right
they would otherwise not be entitled to (i.e., Without the stamps they would need to pay for such
knives and cookware). A portion of the customer’s bill is hence advance payment for future goods
and services, and the transaction price must be allocated accordingly, between the two separate
performance obligations.
[Question 4] Allocate transaction price
Periwinkle Company manufactures equipment. Periwinkle’s products range form simple
automated machinery to complex systems containing numerous components. Unit selling prices
range from $ 140,000 to $1,200,000 and are quoted inclusive of installation. The installation
process does NOT involve changes to the features of the equipment to perform specifications.
Periwinkle has the following relationship with Rose Inc.
•
•
Rose can purchase equipment from Periwinkle for a price of $200,000 and contracts with
Periwinkle to install the equipment. Using market data, Rose determines installation service
is estimated to have a fair value of $ 20,000. The cost of the equipment is $78,000.
Rose is obligated to pay Periwinkle the $ 200,000 upon delivery and installation of the
equipment.
Periwinkle delivers the equipment on August 1, 2020, and completes the installation of the
equipment on October 1, 2020. The equipment has a useful life of 7 years. Assume the equipment
and the installations are two distinct performance obligations that should be accounted for
separately.
Instructions
a) How should the transaction price of $ 200,000 be allocated among the service obligations?
b) Prepare the journal entries for Periwinkle for this revenue arrangement for 2020, assuming
Periwinkle receives payment when installation is completed.
Solution
a)
The transaction price would be allocated as follows (Step 4):
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Performance
Transaction Price Standalone
Obligation
as Stated
Selling price
Sale of Equipment $200,000
$200,000
Installation

20,000
$200,000
$220,000
b) Journal Entries
August 1, 2020: Equipment Delivery
Accounts Receivable……………………………………………..
Sales Revenue ………………………………………………..
Unearned installation revenue ………………………….
Cost of Equipment Sold …………………………………………
Equipment Inventory ………………………………………
October 1, 2020: Equipment Installation
Cash ……………………………………………………………………
Unearned installation revenue ………………………………..
Installation Revenue ……………………………………….
Accounts Receivable ………………………………………
Selling price ratio Allocated
transaction price
20/22
$181,818
(200,000×20/22)
2/22
$18,182
(200,000×2/22)
$20,000
200,000
181,818
18,182
78,000
78,000
200,000
18,182
18,182
200,000
If there was a cost of labour associated with installation, we would record that here, too; however,
this information was not provided in the question.
[Question 5] Timing of revenue recognition
Asana Inc. enters into a contract with Modo Company to develop and install a customized
enterprise resource planning system (ERP). Progress payments are made upon completion of each
stage of the contract. If the contract is terminated, the partly completely ERP will pass to Modo
Company. Asana is prohibited from directing the software to another customer (and besides, it is
likely too customized to do so, anyway). Asana Inc. prepares its financial statements in accordance
with IFRS.
Instructions
At what point should Asana recognize revenue related to its contract with Modo Company?
Solution
Asana creates an asset with no alternative use because it is prohibited from redirecting the software.
In addition, Asana is entitled to payments for performance to date and expects to complete the
project. Therefore, Asana concludes that the contract meets the criteria for recognition of revenue
over time.
[Question 6] Identify transaction price – Sales with a right to return
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The Martino Corporation, in attempt to raise revenues, begins selling goods with an automatic
right to return within six months if not completely satisfied. On November 1, $35,000 worth of
goods with a cost of $22,000 are sold. Company officials expect that 15% of the goods sold will
be returned before the expiration date in the following year. How much gross profit should be
recognized on this sale in the current year?
Solution: $11,050
Sales revenue to be booked = 85% x $35,000 = $29,750
Cost of goods sold to be booked = 85% x $22,000 = $18,700
Gross profit = $11,050
Journal entries will be recorded on November 1 as follows:
Dr. Accounts receivables (Cash)
Cr. Sales revenue
Cr. Refund Liability
$35,000
$29,750
$5,250
Dr. Cost of goods sold
Dr. Right to recover asset
Cr. Inventory
$18,700
$3,300
$22,000
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March 28 Class 19 Handout
Long Term Construction Contracts
Example – A small building contractor commences three projects in year 1. The project
is completed in year 3.
Problem – If no profit is recognized in years 1 and 2, the income statement will show
no revenue in years 1 and 2 and the entire amount will be recognized in year 3.
However, the contractor did enegage in earnings activities in each of the three years.
Solution – Recognize revenue on long-term construction contract as the contract
progresses, if one of the following criteria is met:
1. The customer receives and consumes the benefits simultaneously
2. The customer controls the asset under construction
3. The asset created has no alternative use for the seller
If none of the above criteria is not met, defer revenue recognition until the contract is
completed (use the completed contract method):
Percentage-of-completion method
â–ª Recognize revenue and profit as contract progresses.
â–ª Percentage of completion, at any one point in time, is determined by the costs
incurred to date divided by the total estimated costs of the contract.
o Percentage of completion =
Cost incurred to date
Total estimated cos t
Completed contract method
â–ª Recognize revenue and profit until the contract is fully completed.
â–ª Construction costs are accumulated in an inventory account (Construction in
Progress Inventory), and progress billings are accumulated in the Contract
Liability Account.
â–ª
If it becomes apparent that a loss is expected on a contract, recognize the expected
contract loss immediately.
1
In accounting for construction contracts, new accounts are introduced:
1) Contract Costs (or Construction in Progress (CIP) inventory) – This is similar to
the work in progress inventory account for a manufacturing firm. This is a current
asset account and shows up on Balance Sheet.
2) Contract Liability (or Billings on contracts) – It includes amounts billed to the
customer (progress billings) over the contract period. This is a current liability
account and shows up on Balance Sheet.
3) Contract Assets: This is a current asset account. In a given year, if revenue
recognized to date is greater than the amount billed to date, the extra amount will be
carried in Contract Assets. It represents the contractor’s financial interest in the
construction contract – that is, the value of the revenue recognized but not yet
billed. This is a current asset account and shows up on Balance sheet.
4) Costs of Construction – By the end of a given year, if percentage of completion
method is used, you will need to close the costs incurred in the current year into
Costs of Construction account. Think about this account as the “Construction
Expense” account which is used to be matched with “Revenues” recognized during
the construction. This is an expense account and shows up on Income
Statement.
2
Example 1 – An Overall Profitable Contract
This is three-year construction contract. The overall contract price is $8,500
thousands.
We are given information relating to costs incurred within each year, costs estimated
to complete the remaining of the project at the end of each year, billings made in
each year, and cash collection within each year:
Contract price: $8,500 thousands
2004
Costs incurred in year
3,200
Estimated costs to
3,200
complete
Billings in year
3,200
Cash collected in year
2,800
2005
2,600
1,450
2006
1,450
-0-
3,500
2,500
1,800
3,200
Total
7,250
First of all, determine if it is an overall profit or an overall loss contract:
Total revenue of the contract = $8,500
Total costs of construction = $7,250 (3,200 + 2,600 + 1,450)
Since total revenue > total costs of construction, it is an overall profit contract.
Second, based on the given information, we could figure out the revenues and expenses to
be recognized by the end of each year using the percentage of completion method:
A. Costs incurred in year
B. Costs incurred to date
C. Estimated costs to complete
D. Total estimated cost (=B+C)
2004
3,200
3,200
3,200
6,400
2005
2,600
5,800
1,450
7,250
2006
1,450
7,250
-07,250
E. Percentage complete (=B/D)
F. Contract price
G. Revenue recognized to date (=E*F)
H. Revenue previously recognized
50%
8,500
4,250
-0-
80%
8,500
6,800
4,250
100%
8,500
8,500
6,800
I. Revenue recognition -current year (G)-(H) 4,250
J. Profit recognition – current year (I) – (A) 1,050
K. Billings made in year
3,200
L. Cash collected in year
2,800
2,550
(50)
3,500
2,500
1,700
250
1,800
3,200
3
TOTAL
7,250
8,500
1,250
8,500
8,500
The following journal entries are required to account for the construction contract, under the
Percentage of Completion method, for the three years:
Year 2004
1. Dr. Contract Costs
Cr. Cash (accounts payable)
3,200
3,200
To record construction costs incurred during 2004.
2. Dr. Accounts receivable
Cr. Contract Liability
3,200
3,200
To record progress billings made in 2004
3. Dr. Cash
Cr. Accounts receivable
2,800
2,800
To record cash collected from customer during 2004.
4. Dr. Contract liabilities
Dr. Contract Asset
Cr. Revenue
3,200
1,050
4,250
To record revenue recognized in 2004.
Contract Assets: This is a current asset account. In 2004, revenue recognized to date
($4,250) is greater than the amount billed to date ($3,200), the extra amount ($1,050)
will be carried in Contract Assets. It represents the contractor’s financial interest in the
construction contract – that is, the value of the revenue recognized but not yet
billed. This is a current asset account and shows up on Balance sheet.
5. Dr. Costs of Construction
Cr. Contract costs
3,200
3,200
To record expense recognized in 2004.
Costs of Construction – By the end of a given year, if percentage of completion
method is used, you will need to close the costs incurred in the current year into Costs
of Construction account. Think about this account as the “Construction Expense”
account which is used to be matched with “Revenues” recognized during the
construction. This is an expense account and shows up on Income Statement.
4
Balance Sheet presentation by the end of 2004
Current Assets:
Accounts receivable
Contract Assets
$400
$1,050
Income Statement presentation by the end of 2004
Revenue
Costs of Construction
Gross profit
$4,250
$3,200
$1,050
Year 2005
1. Dr. Contract costs
2,600
Cr. Cash (accounts payable)
2,600
To record construction costs incurred during 2005.
2. Dr. Accounts receivable
3,500
Cr. Contract liability
3,500
To record progress billings made during 2005.
3. Dr. Cash
Cr. Accounts receivable
To record cash collected in 2005.
2,500
2,500
4. Dr. Contract liability
3,500
Cr. Revenue
2,550
Cr. Contract Asset
950
To record construction revenue recognized in 2005.
5. Dr. Costs of Construction
Cr. Contract costs
To record expense recognized in 2005.
2,600
2,600
Balance Sheet presentation by the end of 2005
Current Assets:
Accounts receivable
Contract Assets
$1,400 ($400 + 3,500 – 2,500)
$100 ($1,050 – 950)
Income Statement presentation by the end of 2005
Revenue
Costs of Construction
$2,550
$2,600
5
Gross profit
($50)
Note that the company has sustained a loss in 2005 (costs exceed revenues by $50). The
overall contract is expected to be profitable.
Year 2006
1. Dr. Contract Costs
Cr. Cash (accounts payable)
1,450
1,450
To record construction costs incurred in 2006.
2. Dr. Accounts receivable
Cr. Contract liability
1,800
1,800
To record progress billings made in 2006.
3. Dr. Cash
Cr. Accounts receivable
3,200
3,200
To record cash collected in 2006.
4. Dr. Contract liability
Cr. Revenue
Cr. Contract Asset
1,800
1,700
100
To record construction revenue recognized in 2006.
5. Dr. Costs of Construction
Cr. Contract costs
1,450
1,450
To record construction expense recognized in 2006.
Balance Sheet presentation by the end of 2006
Current Assets:
Accounts receivable
Contract Assets
$0 ($1,400+1,800-3,200)
$0 ($100-$100)
By the end of the contract, the entire amount of the contract price has been recognized as
revenue and also billed, so the contract asset will be zero by the end of the contract.
Income Statement presentation by the end of 2006
Revenue
$1,700
6
Costs of Construction
Gross profit
$1,450
$250
As double check, the total profit of the contract = total contract price – total costs
incurred = $8,500 – $7,250 = $1,250
And the total profit of $1,250 is indeed recognized in the three years:
Income Statement
2004
2005
2006
Revenue
Cost of construction
(Contract expense)
Gross profit (loss)
4,250
2,550
1,700
(3,200)
1,050
(2,600)
(50)
(1,450)
250
The following journal entries are required to account for the construction contract, under the
Completed Contract method, for the three years:
Year 2004
1. Dr. Construction in progress Inventory
Cr. Cash (accounts payable)
3,200
3,200
To record construction costs incurred during 2004.
2. Dr. Accounts receivable
Cr. Contract liability
3,200
3,200
To record progress billings made in 2004
3. Dr. Cash
Cr. Accounts receivable
2,800
2,800
To record cash collected from customer during 2004.
Balance Sheet presentation by the end of 2004
Current Assets:
Accounts receivable
Construction in progress inventory
$400
3,200
Current Liabilities:
7
Contract Liability
$3,200
Income Statement presentation by the end of 2004
Revenue
Costs of Construction
Gross profit
$0
$0
$0
Note that under the completed contract method, we do NOT recognize any
revenue, construction expense, and gross profit/gross loss until the completion
of the contract.
Year 2005
1. Dr. Construction in progress Inventory
2,600
Cr. Cash (accounts payable)
2,600
To record construction costs incurred during 2005.
2. Dr. Accounts receivable
3,500
Cr. Contract liability
3,500
To record progress billings made during 2005.
3. Dr. Cash
Cr. Accounts receivable
To record cash collected in 2005.
2,500
2,500
Balance Sheet presentation by the end of 2005
Current Assets:
Accounts receivable
Construction in progress inventory
$1,400
5,800
Current Liabilities:
Contract Liability
$6,700
Income Statement presentation by the end of 2004
Revenue
Costs of Construction
Gross profit
$0
$0
$0
Again, no revenue, no expenses, and no gross profit is recognized in 2005.
Year 2006
8
1. Dr. Construction in progress inventory
1,450
Cr. Cash (accounts payable)
1,450
To record construction costs incurred in 2006.
2. Dr. Accounts receivable
Cr. Contract Liability
To record progress billings made in 2006.
1,800
3. Dr. Cash
Cr. Accounts receivable
To record cash collected in 2006.
3,200
1,800
3,200
Finally:
4. Dr. Contract liability
Cr. Revenue
8,500
5. Dr. Cost of construction
Cr. Construction-in-progress inventory
7,250
8,500
7,250
To recognize revenue and expense when the contract is completed.
1. To close out the Construction in progress inventory into Cost of construction account
2. To close out the Contract liability account to Revenue
Balance Sheet presentation by the end of 2006
Current Assets:
Accounts receivable
Construction in progress inventory
$0
$0
Current Liabilities:
Contract Liability
$0
Income Statement presentation by the end of 2004
Revenue
Costs of Construction
Gross profit
$8,500
$7,250
$1,250
As double check, the total profit of the contract = total contract price – total costs
incurred = $8,500 – $7,250 = $1,250
And the total profit of $1,250 is completely recognized in the last year:
9
Income Statement
2004
2005
2006
Revenue
Costs of construction
Gross profit
-0-0-0-
-0-0-0-
8,500
(7,250)
1,250
Overall Loss Contracts
When it becomes apparent in a period that a loss is expected on the entire contract, the
entire amount of the expected loss is recognized in that period under both the percentage of
completion method and the completed contract method.
Example 2 – An Overall Loss Contract
This is three-year construction contract. The overall contract price is $8,500
thousands.
We are given information relating to costs incurred within each year, costs estimated
to complete the remaining of the project at the end of each year, billings made in
each year, and cash collection within each year:
Contract price: $8,500 thousands
2004
Costs incurred in year
3,200
Estimated costs to
3,200
complete
Billings in year
3,200
Cash collected in year
2,800
2005
2,600
4,200
2006
4,500
-0-
3,500
2,500
1,800
3,200
Total
10,300
First of all, determine if it is an overall profit or an overall loss contract:
Total revenue of the contract = $8,500
Total costs of construction = $10,300 (3,200 + 2,600 + 4,500)
Since total revenue < total costs of construction, it is an overall loss contract. 10 A. Costs incurred in year B. Costs incurred to date C. Estimated costs to complete D. Total estimated cost (=B+C) E. Percentage complete (=B/D) F. Contract price 2004 3,200 3,200 3,200 6,400 50% 8,500 2005 2,600 5,800 4,200 10,000 ------8,500 2006 4,500 10,300 -010,300 100% 8,500 H. Revenue recognized to date (=E*F) 4,250 4,300*** 8,500 I. Revenue previously recognized -0J. Revenue recognition -current year (H)-(I) 4,250 K. Profit (loss) recognized, current year(J-A) 1,050 L. Billings made in year 3,200 M. Cash collected in year 2,800 4,250 50 (2,550) 3,500 2,500 4,300 4,200 (300) 1,800 3,200 11 TOTAL 10,300 8,500 (1,800) 8,500 8,500 *** For year 2005, once we realize that the contract is going to lose money starting from this year, revenue recognized to date can no longer be calculated as E*F. Instead, revenue recognized to date = total contract revenue ($8,500) – Estimated costs to complete ($4,200) = $4,300. Journal entries: the Percentage of Completion Method Year 2004 1. Dr. Contract costs Cr. Cash (accounts payable) 3,200 3,200 To record construction costs incurred during 2004. 2. Dr. Accounts receivable Cr. Contract Liability 3,200 3,200 To record progress billings made in 2004. 3. Dr. Cash Cr. Accounts receivable 2,800 2,800 To record cash collected from customer during 2004. 4. Dr. Contract liability Dr. Contract Asset Cr. Revenue 3,200 1,050 4,250 To record contract revenue recognized in 2004. 5. Dr. Costs of construction Cr. Contract costs 3,200 3,200 To record contract expense recognized in 2004. Balance Sheet presentation by the end of 2004 Current Assets: Accounts receivable Contract Assets $400 $1,050 Income Statement presentation by the end of 2004 Revenue Costs of Construction Gross profit $4,250 $3,200 $1,050 12 Year 2005 1. Dr. Contract costs Cr. Cash (accounts payable) 2,600 2,600 To record construction costs incurred during 2005. 2. Dr. Accounts receivable Cr. Contract liability 3,500 3,500 To record progress billings made during 2005. 3. Dr. Cash Cr. Accounts receivable 2,500 2,500 To record cash collected in 2005. 4. Dr. Contract liability Cr. Contract Asset Cr. Revenue 3,500 3,450 50 To record construction revenue recognized in 2005. In this year, total cost increases to $10,000, resulting in an overall loss on the contract of $1,500. Therefore, (G) Revenue recognized to date is limited to $4,300 (Revenue of $8,500 – Estimated costs to complete $4,200). Revenue to be recognized in 2005 = $4,300 - $4,250 (already recognized in 2004) = $50 5. Dr. Costs of Construction Cr. Contract costs 2,600 2,600 To record construction expense recognized in 2005. Balance Sheet presentation by the end of 2005 Current Assets: Accounts receivable Contract Assets $1,400 ($400 + 3,500 – 2,500) ($2,400) ($1,050 – 3,450) Income Statement presentation by the end of 2005 Revenue Costs of Construction $50 $2,600 13 Gross profit ($2,550) Year 2006 1. Dr. Contract costs Cr. Cash (accounts payable) 4,500 4,500 To record construction costs incurred in 2006. 2. Dr. Accounts receivable Cr. Billings on contracts 1,800 1,800 To record progress billings made in 2006. 3. Dr. Cash Cr. Accounts receivable 3,200 3,200 To record cash collected in the year. 4. Dr. Contract Liability Dr. Contract Asset Cr. Revenue 1,800 2,400 4,200 To record construction revenue recognized in 2006. 5. Dr. Cost of construction Cr. Contract costs 4,500 4,500 To record construction expense recognized in 2006. Balance Sheet presentation by the end of 2006 Current Assets: Accounts receivable Contract Assets $0 ($1,400+1,800-3,200) $0 ($2,400-$2,400) By the end of the contract, the entire amount of the contract price has been recognized as revenue and also billed, so the contract asset will be zero by the end of the contract. Income Statement presentation by the end of 2006 Revenue Costs of Construction Gross profit $4,200 $4,500 ($300) 14 As double check, the total profit (loss) of the contract = total contract price – total costs incurred = $8,500 - $10,300 = ($1,800) And the total loss of $1,800 is indeed recognized in the three years: Income Statement 2004 2005 2006 Revenue Cost of construction Gross profit (loss) 4,250 (3,200) 1,050 50 (2,600) (2,550) 4,200 (4,500) (300) 15 Journal entries: the Completed Contract Method Year 2004 1. Dr. Construction in progress (CIP) inventory 3,200 Cr. Cash (accounts payable) 3,200 To record construction costs incurred during the year. 2. Dr. Accounts receivable Cr. Contract Liability 3,200 3,200 To record progress billings made in the year 3. Dr. Cash Cr. Accounts receivable 2,800 2,800 To record cash collected from customer during the year. Balance Sheet presentation by the end of 2004 Current Assets: Accounts receivable Construction in progress inventory $400 $3,200 Current Liabilities: Contract Liability $3,200 Income Statement presentation by the end of 2004 Revenue Costs of Construction Gross profit $0 $0 $0 Note that under the completed contract method, we do NOT recognize any revenue, construction expense, and gross profit/gross loss until the completion of the contract. Year 2005 1. Dr. Construction in progress inventory Cr. Cash (accounts payable) 2,600 2,600 16 To record construction costs incurred during the period. 2. Dr. Accounts receivable Cr. Contract Liability 3,500 3,500 To record progress billings made during the year. 3. Dr. Cash Cr. Accounts receivable 2,500 2,500 To record cash collected in the year. 4. Dr. Contract loss Cr. Construction in progress Inventory 1,500 1, 500 To record loss expected on the contract. Balance Sheet presentation by the end of 2005 Current Assets: Accounts receivable Construction in progress inventory $1,400 $4,300 Current Liabilities: Contract Liability $6,700 Income Statement presentation by the end of 2005 Revenue Costs of Construction Gross profit $0 $0 $0 Contract Loss $1,500 Year 2006 1. Dr. Construction in progress inventory Cr. Cash (accounts payable) 4,500 4,500 To record construction costs incurred in the year. 2. Dr. Accounts receivable 1,800 17 Cr. Contract Liability 1,800 To record progress billings made in the year. 3. Dr. Cash Cr. Accounts receivable 3,200 3,200 To record cash collected in the year. Finally: Dr. Contract Liability Cr. Revenue 8,500 Dr. Cost of construction Cr. Construction in progress inventory 8,800 8,500 8,800 To recognize revenue and expense for the entire contract under the completed contract method. To close out the construction in progress inventory and the billings on contracts accounts. Balance Sheet presentation by the end of 2006 Current Assets: Accounts receivable Construction in progress inventory $0 $0 Current Liabilities: Contract Liability $0 Income Statement presentation by the end of 2004 Revenue Costs of Construction Gross loss $8,500 $8,800 $300 As double check, the total profit (loss) of the contract = total contract price – total costs incurred = $8,500 - $10,300 = ($1,800) And the total gross loss of $1,800 is recognized in the 2005 and 2006: 18 Income Statement 2004 2005 2006 Revenue Costs of construction Gross profit -0-0-0- -0-0-0- 8,500 (8,800) (300) Contract loss (1,500) 19 Extra examples for long-term construction contract revenue recognition PERCENTAGE-OF-COMPLETION METHOD DATA Buildmore Construction Limited received a contract for $6,000,000 in Year 1 to build a parking complex for the federal government. The following data was accumulated during the construction period: Year 1 Year 2 Year 3 Total costs to date Estimated cost to complete Progress billings during year Cash collected during year $ 1,800,000 2,700,000 2,000,000 1,500,000 $ 2,090,000 3,410,000 2,000,000 2,000,000 $ 5,000,000 -2,000,000 2,500,000 Year 1 1. Dr. Contract costs Cr. Cash (A/P) $1,800,000 $1,800,000 To record costs incurred in Year 1. 2. Dr. Accounts receivable Cr. Contract liability $2,000,000 $2,000,000 To record billing in Year 1. 3. Dr. Cash Cr. Accounts receivable $1,500,000 $1,500,000 To record cash collection in Year 1. 4. Dr. Contract liability Dr. Contract asset Cr. Revenue $2,000,000 $400,000 $2,400,000* Percentage of completion = costs incurred to date / Total costs for the contract = $1,800,000 / (1,800,000 + 2,700,000) = 40% Revenue to date = 40% x $6,000,000 = $2,400,000 Revenue recognized previously = $0 (this is year 1) Revenue to be recognized in Year 1 = $2,400,000 To record revenue in Year 1 based on percentage of completion. 20 5. Dr. Costs of Construction Cr. Contract costs $1,800,000 $1,800,000 To record contract expense in Year 1. Balance Sheet presentation by the end of Year 1 Current Assets Accounts receivable Contract asset $500,000 $400,000 Income Statement presentation for Year 1 Revenue Costs of Construction Gross profit $2,400,000 $1,800,000 $600,000 Year 2 1. Dr. Contract costs Cr. Cash (A/P) $290,000* $290,000 To record costs incurred in Year 2. *Cost incurred in Year 2 = Cost incurred to date – Cost incurred in Year 1 = 2,090,000 – 1,800,000 = $290,000 2. Dr. Accounts receivable Cr. Contract liability $2,000,000 $2,000,000 To record billing in Year 2. 3. Dr. Cash Cr. Accounts receivable $2,000,000 $2,000,000 To record cash collection in Year 2. 4. Dr. Contract liability Dr. Revenue Cr. Contract Asset $2,000,000 $120,000* $2,120,000 Percentage of completion = costs incurred to date / Total costs for the contract = $2,090,000 / (2,090,000+3,410,000) = 38% Revenue to date = 38% x $6,000,000 = $2,280,000 21 Revenue recognized previously = $2,400,000 in year 1 Revenue to be recognized in Year 2 = ($120,000)* To record revenue in Year 2 based on percentage of completion. *We overbooked revenue in Year 2, therefore, it is corrected in Year 2. 5. Dr. Costs of Construction Cr. Contract costs $290,000 $290,000 To record contract expense in Year 2. Balance Sheet presentation by the end of Year 2 Current Assets Accounts receivable Contract asset $500,000 ($1,720,000) Income Statement presentation for Year 2 Revenue Costs of Construction Gross profit ($120,000) $290,000 ($410,000) Year 3 1. Dr. Contract costs Cr. Cash (A/P) $2,910,000 $2,910,000 To record costs incurred in Year 3. 2. Dr. Accounts receivable Cr. Contract liability $2,000,000 $2,000,000 To record billing in Year 3. 3. Dr. Cash Cr. Accounts receivable $2,500,000 $2,500,000 To record cash collection in Year 3. 4. Dr. Contract liability Dr. Contract asset Cr. Revenue $2,000,000 $1,720,000 $3,172,000* Percentage of completion = costs incurred to date / Total costs for the contract 22 = 100% Revenue to date = 100% x $6,000,000 = $6,000,000 Revenue recognized previously = $2,280,000 Revenue to be recognized in Year 1 = $3,720,000 To record revenue in Year 3 based on percentage of completion. 5. Dr. Costs of Construction Cr. Contract costs $2,910,000 $2,910,000 To record contract expense in Year 3. Balance Sheet presentation by the end of Year 3 Current Assets Accounts receivable Contract asset $0 $0 Income Statement presentation for Year 3 Revenue Costs of Construction Gross profit $3,720,000 $2,910,000 $810,000 As double check, the total profit (loss) of the contract = total contract price – total costs incurred = $6,000,000 - $5,000,000 = $1,000,000 And the total profit of $1,000,000 is indeed recognized in the three years: Income Statement Year 1 Year 2 Revenue Cost of construction Gross profit (loss) 2,400,000 (1,800,000) 600,000 (120,000) (290,000) (410,000) 23 Year 3 3,720,000 (2,910,000) 810,000 COMPLETED-CONTRACT METHOD DATA Buildmore Construction Limited received a contract for $6,000,000 in Year 1 to build a parking complex for the federal government. The following data was accumulated during the construction period: Total costs to date Estimated cost to complete Progress billings during year Cash collected during year Year 1 Year 2 Year 3 $1,800,000 2,700,000 2,000,000 1,500,000 $2,090,000 3,410,000 2,000,000 2,000,000 $5,000,000 -2,000,000 2,500,000 Year 1 1. Dr. CIP Inventory Cr. Cash (A/P) $1,800,000 $1,800,000 To record costs incurred in Year 1. 2. Dr. Accounts receivable Cr. Contract liability $2,000,000 $2,000,000 To record billing in Year 1. 3. Dr. Cash Cr. Accounts receivable $1,500,000 $1,500,000 To record cash collection in Year 1. Balance Sheet presentation by the end of Year 1 Current Assets Accounts receivable CIP Inventory $500,000 $1,800,000 Current Liabilities Contract Liability $2,000,000 Income Statement presentation for Year 1 Revenue Costs of Construction $0 $0 24 Gross profit $0 Year 2 1. Dr. CIP Inventory Cr. Cash (A/P) $290,000* $290,000 To record costs incurred in Year 2. *Cost incurred in Year 2 = Cost incurred to date – Cost incurred in Year 1 = 2,090,000 – 1,800,000 = $290,000 2. Dr. Accounts receivable Cr. Contract liability $2,000,000 $2,000,000 To record billing in Year 2. 3. Dr. Cash Cr. Accounts receivable $2,000,000 $2,000,000 To record cash collection in Year 2. Balance Sheet presentation by the end of Year 2 Current Assets Accounts receivable CIP Inventory $500,000 $2,090,000 Current Liabilities Contract Liability $4,000,000 Income Statement presentation for Year 2 Revenue Costs of Construction Gross profit $0 $0 $0 Year 3 1. Dr. CIP Inventory Cr. Cash (A/P) $2,910,000 $2,910,000 To record costs incurred in Year 3. 2. Dr. Accounts receivable $2,000,000 25 Cr. Contract liability $2,000,000 To record billing in Year 3. 3. Dr. Cash Cr. Accounts receivable $2,500,000 $2,500,000 To record cash collection in Year 3. 4. Dr. Contract Liability Cr. Revenue $6,000,000 $6,000,000 To close contract liability to Revenue. 5. Dr. Costs of Construction Cr. CIP Inventory $5,000,000 $5,000,000 To Close CIP Inventory to Costs of construction. Balance Sheet presentation by the end of Year 3 Current Assets Accounts receivable CIP Inventory $0 $0 Current Assets Current liability $0 Income Statement presentation for Year 3 Revenue Costs of Construction Gross profit $6,000,000 $5,000,000 $1,000,000 As double check, the total profit (loss) of the contract = total contract price – total costs incurred = $6,000,000 - $5,000,000 = $1,000,000 And the total profit of $1,000,000 is indeed recognized in the three years: Income Statement Year 1 Year 2 Revenue Cost of construction Gross profit (loss) 0 (0) 0 (0) (0) (0) 26 Year 3 6,000,000 (5,000,000) 1,000,000 Percentage Completion Accounting as an Example of a Change in Estimate We recognize revenue under the percentage of completion method by going through two steps: (1) determining revenue recognized to date (2) deducting revenue already recognized This method automatically corrects inaccurate estimates of prior years’ total costs, and accounts for the change in estimate prospectively (that is, by charging the correction to the current year’s operations). We must use the above two-stage method to account for changes in estimates. To see why, consider the following example, where the information is taken from the last example we cover in class (loss contract example). If we allocate revenue to each period based on current period costs/estimated total costs, we end up allocating 120% of the contract value to revenue, which is obviously incorrect: Calculations Current period cost / Estimated total costs Year 1: 3,200/6,400 50% Year 2: 2,600/10,000 26% Year 3: 4,500/10,300 44% Total 120% Our problem in the above example is that total costs as estimated in periods 1 and 2 understate actual total costs. Therefore, each time we calculate costs as a percentage of estimated total costs, we calculate a percentage of a different denominator. We can correctly allocate 100% of the revenue using a non-cumulative approach only if we can estimate costs with 100% accuracy in the first accounting period. Since we cannot know for sure that cost estimates are correct, we must assign revenue to periods by the two-stage process of deducing revenue previously recognized from the total revenue earned to date. 27 Exercise 1 During 2007, Houston Corporation started a construction job with a contract price of $4.2 million. Houston ran into severe technical difficulties during construction but managed to complete the job in 2009. The following information is available: Costs incurred to date Estimated costs to complete 2007 600,000 3,150,000 2008 2,000,000 2,000,000 2009 4,250,000 -0- Required: (a) Calculate the amount of gross profit that should be recognized each year under the percentage-of-completion method. Solution: 2007: Percentage of completion = 600,000 / (600,000 + 3,150,000) = 600,000 / 3,750,000 = 16% Revenue to be recognized to date = 16% x $4,200,000 = $672,000 Revenue recognized previously = $0 (This is the first year.) Revenue to be recognized in 2007 = $672,000 – $0 = $672,000 Costs of Construction = $600,000 Gross profit for 2007 = Revenue – Costs of Construction = $672,000 - $600,000 = $72,000 2008: Percentage of completion = 2,000,000 / (2,000,000 + 2,000,000) = 50% Revenue to be recognized to date = 50% x $4,200,000 = $2,100,000 Revenue recognized previously = $672,000 Revenue to be recognized in 2008 = $2,100,000 – $672,000 = $1,428,000 Costs of Construction = $2,000,000 - $600,000 = $1,400,000 Gross profit for 2008 = Revenue – Costs of Construction = $1,428,000 - $1,400,000 = $28,000 2009: Percentage of completion = 100% [This is the last year and the contract is 100% completed by the end of year 3.] Revenue to be recognized to date = 100% x $4,200,000 = $4,200,000 Revenue recognized previously = $672,000 + $1,428,000 = $2,100,000 Revenue to be recognized in 2009 = $4,200,000 – $2,100,000 = $2,100,000 28 Costs of Construction = $4,250,000 - $2,000,000 = $2,250,000 Gross loss for 2009 = Revenue – Costs of Construction = $2,100,000 - $2,250,000 = ($150,000) (b) Calculate the amount of gross profit or loss that should be recognized each year under the completed-contract method. Solution: Under the Completed contract method: Gross profit to be recognized in 2007 = $0 Gross profit to be recognized in 2008 = $0 Gross loss to be recognized in 2009 = $4,200,000 - $4,250,000 = ($50,000) 29 Exercise 2 On March 1, 2008. Whellan Limited signed a contract to construct a factory building for Vottero Manufacturing Inc. for a total contract price of $9.4 million. The building was completed by October 31, 2010. The annual contract costs that were incurred, the estimated costs to complete the contract, and the accumulated billings to Vottero for 2008, 2009, and 2010 were as follows: Contract costs incurred during the year Estimated costs to complete the contract Billings to Vottero during the year Cash collections from Vottero during the year 2008 1,600,000 2009 5,000,000 2010 2,200,000 4,800,000 2,084,000 -0- 2,000,000 5,100,000 2,300,000 1,950,000 4,900,000 2,550,000 Required: (a) Using the percentage-of-completion method, prepare schedules to calculate the profit or loss that should be recognized from this contract for the years ended December 31, 2008, 2009, and 2010. Solution: 2008: Percentage of completion = 1,600,000 / (1,600,000 + 4,800,000) = 1,600,000 / 6,400,000 = 25% Revenue to be recognized to date = 25% x $9,400,000 = $2,350,000 Revenue recognized previously = $0 (This is the first year.) Revenue to be recognized in 2007 = $2,350,000 – $0 = $2,350,000 Costs of Construction = $1,600,000 Gross profit for 2008 = Revenue – Costs of Construction = $2,350,000 - $1,600,000 = $750,000 2009: Percentage of completion = 6,600,000 / (6,600,000 + 2,084,000) = 76% Revenue to be recognized to date = 76% x $9,400,000 = $7,144,000 Revenue recognized previously = $2,350,000 Revenue to be recognized in 2009 = $7,144,000 – $2,350,000 = $4,794,000 30 Costs of Construction = $5,000,000 Gross loss for 2009 = Revenue – Costs of Construction = $4,794000 - $5,000,000 = ($206,000) 2010: Percentage of completion = 100% [This is the last year and the contract is 100% completed by the end of year 3.] Revenue to be recognized to date = 100% x $9,400,000 = $9,400,000 Revenue recognized previously = $2,350,000+ $4,794,000 = $7,144,000 Revenue to be recognized in 2010 = $9,400,000 – $7,144,000 = $2,256,000 Costs of Construction = $2,200,000 Gross Profit for 2010 = Revenue – Costs of Construction = $2,256,000- $2,200,000 = $56,000 (b) Using the completed-contract method, prepare schedules to calculate the profit or loss that should be recognized from this contract for the years ended December 2008, 2009, and 2010. Solution: Under the Completed contract method: Gross profit to be recognized in 2008 = $0 Gross profit to be recognized in 2009 = $0 Gross profit to be recognized in 2010 = $9,400,000 - $8,800,000 = $600,000 (c) Prepare all necessary journal entries for 2008, 2009 and 2010 using the completed-contract method. Solution: 2008: 1. Dr. CIP Inventory Cr. Cash (A/P) $1,600,000 $1,600,000 2. Dr. Accounts receivable Cr. Contract liability $2,000,000 $2,000,000 3. Dr. Cash $1,950,000 31 Cr. Accounts receivable $1,950,000 2009: 1. Dr. CIP Inventory Cr. Cash (A/P) $5,000,000 $5,000,000 2. Dr. Accounts receivable Cr. Contract liability $5,100,000 $5,100,000 3. Dr. Cash Cr. Accounts receivable $4,900,000 $4,900,000 2010: 1. Dr. CIP Inventory Cr. Cash (A/P) $2,200,000 $2,200,000 2. Dr. Accounts receivable Cr. Contract liability $2,300,000 $2,300,000 3. Dr. Cash Cr. Accounts receivable $2,550,000 $2,550,000 4. Dr. Contract liability Cr. Revenue $9,400,000 $9,400,000 5. Dr. Costs of Construction Cr. Contract Costs $8,800,000 $8,800,000 (d) Prepare any necessary entry to accrue contract losses for the year ending December 31, 2009 using the percentage-of-completion method. Solution: 2008: 1. Dr. CIP Inventory Cr. Cash (A/P) $1,600,000 $1,600,000 2. Dr. Accounts receivable Cr. Contract liability $2,000,000 $2,000,000 3. Dr. Cash Cr. Accounts receivable $1,950,000 $1,950,000 32 4. Dr. Contract Asset Dr. Contract Liability Cr. Revenue $350,000 $2,000,000 $2,350,000 5. Dr. Costs of Construction Cr. Contract Costs $1,600,000 $1,600,000 2009: 1. Dr. CIP Inventory Cr. Cash (A/P) $5,000,000 $5,000,000 2. Dr. Accounts receivable Cr. Contract liability $5,100,000 $5,100,000 3. Dr. Cash Cr. Accounts receivable $4,900,000 $4,900,000 4. Dr. Contract Liability Cr. Revenue Cr. Contract Asset $5,100,000 $4,794,000 $306,000 5. Dr. Costs of Construction Cr. Contract Costs $5,000,000 $5,000,000 2010: 1. Dr. CIP Inventory Cr. Cash (A/P) $2,200,000 $2,200,000 2. Dr. Accounts receivable Cr. Contract liability $2,300,000 $2,300,000 3. Dr. Cash Cr. Accounts receivable $2,550,000 $2,550,000 4. Dr. Contract Liability Dr. Contract Asset Cr. Revenue $2,300,000 $44,000 $2,256,000 5. Dr. Costs of Construction Cr. Contract Costs $2,200,000 $2,200,000 33 More Practice on Long-term Contract Revenue Recognition Please complete the following questions: Question 1: On February 1, 2014, Jonathon Contractors agreed to construct a building at total contract price of $3,000,000. Jonathon estimated total construction costs would be $2,000,000 and the project would be finished in 2016. Information relating to the costs and billings for this contract is as follows: Total costs incurred to date Estimated costs to complete Customer billings to date Collections to date 2014 $750,000 1,250,000 1,100,000 1,000,000 2015 $1,320,000 880,000 2,000,000 1,750,000 2016 $2,300,000 -03,000,000 2,950,000 Required 1. Using the percentage-of-completion method, calculate the gross profit that should be reported for 2014 and 2015. Solution: In year 2014, percentage of completion = 750,000 / (750,000 + 1,250,000) = 37.5% Revenue recognized to date = 37.5% x 3,000,000 = 1,125,000 Revenue recognized previously = 0 Revenue to be recognized in 2014 = 1,125,000 – 0 = 1,125,000 Costs of construction recognized in 2014 = 750,000 Gross profit for 2014 = revenue in 2014 – costs of construction in 2014 = 1,125,000 – 750,000 = 375,000 In year 2015, percentage of completion = 1,320,000 / (1,320,000 + 880,000) = 60% Revenue recognized to date = 60% x 3,000,000 = 1,800,000 Revenue recognized previously = 1,125,000 Revenue to be recognized in 2015 = 1,800,000 – 1,125,000 = 675,000 Costs of construction recognized in 2015 = 1,320,000 - 750,000 = 570,000 Gross profit for 2015 = revenue in 2015 – costs of construction in 2015 = 675,000 – 570,000 = 105,000 Required 2. Indicate the amount reported as A/R relating to this contract as of the end of 2014 and 2015. Solution: In 2014, Accounts receivable should have an ending balance of $100,000 as per the following two transactions and journal entries: 34 Dr. Accounts receivable 1,100,000 Cr. Contract Liability 1,100,000 Dr. Cash 1,000,000 Cr. Accounts receivable 1,000,000 In 2015, Accounts receivable should have an ending balance of $250,000 ($100,000 was carried from 2014) as per the following two transactions during 2015 and journal entries: Dr. Accounts receivable 900,000 Cr. Contract Liability 900,000 Dr. Cash 750,000 Cr. Accounts receivable 750,000 Required 3. Assume that Jonathon was unable to accurately estimate costs to complete this project, starting in 2014. Since Jonathon follows ASPE, it was decided that the Completed Contract method was therefore going to be used to account for this contract. With this in mind, indicate the amount of gross profit that Jonathon would report for 2014, 2015, and 2016. Solution: Under the completed contract method, no gross profit will be recognized in 2014 and 2015. In 2016, the overall gross profit of the contract will be recognized at $700,000 (3,000,000 – 2,300,000). Question 2: Danny Inc. signed a contract to build a plant for a customer. Construction covered a three-year period. Data concerning the construction were as follows (in thousands): Year 1 Year 2 Year 3 Contract Price Costs to date 1,000 1,000 1,000 350 850 1,100 Additional costs to complete 600 200 0 Progress Billing In year 250 450 300 Collection In year 200 500 300 Required 1: Provide all journal entries in year 3 under the completed contract method. Solution: Dr. CIP inventory 250 Cr. Cash (A/P) 250 Dr. A/R 300 Cr. Contract Liability 300 35 Dr. Cash 300 Cr. A/R 300 Dr. Contract Liability 1,000 Cr. Revenue 1,000 Dr. Costs of construction Cr. CIP inventory 1,050 1,050 Please note that the total loss for this contract is $100 ($1,000 - $1,100). In Year 2, total costs estimated to complete the project is $1,050 ($850 + $200) which already exceeded the total revenue of the contract $1,000. Thus, $50 of Contract Loss would have been recognized in Year 2 already. In the last year, gross profit appears to be $50 ($1,000 - $1,050). That is, the overall loss was recognized in Year 2 (Contract loss of $50) and Year 3 (Gross profit of $50). Required 2: Provide all journal entries in year 3 under the percentage of completion method. Solution: Dr. Contract costs 250 Cr. Cash (A/P) 250 Dr. A/R 300 Cr. Contract liability 300 Dr. Cash 300 Cr. A/R 300 Dr. Contract Liability Cr. Revenue Cr. Contract Asset 300 Dr. Costs of Construction Cr. Contract costs 250 200 100 250 Required 3: Complete the following balance sheet and income statement if completed contract method is used. 36 Year 1 Year 2 Year 3 Balance Sheet Accounts receivable Construction in Progress (CIP) Contract Liability 50 350 250 0 800 700 0 0 0 Income Statement Revenue Costs of construction Gross profit (loss) Contract Loss 0 0 0 0 0 0 0 (50) 1,000 1,050 (50) 0 The following journal entries are recorded for your reference: Under the completed contract method Year 1 1. Dr. CIP inventory $350 Cr. Cash (A/P) 350 2. Dr. Accounts receivable $250 Cr. Contract liabilities 250 3. Dr. Cash $200 Cr. Accounts receivable 200 Year 2 1. Dr. CIP Inventory $500 Cr. Cash (A/P) $500 2. Dr. Accounts receivable 450 Cr. Contract liability 450 3. Dr. Cash $500 Cr. Accounts receivable 500 *In Year 2, total costs of the contract (850+200) is greater than the total revenue (1,000). We start anticipating this contract to be a loss contract. We need to recognize a contract loss immediately. 4. Dr. Contract loss Cr. CIP inventory 50 50 37 Year 3 1. Dr. Contract costs Cr. Cash (A/P) 250 250 2. Dr. Accounts receivable 300 Cr. Contract liability 300 3. Dr. Cash 300 Cr. Accounts receivable 300 4. Dr. Contract liability Cr. Revenue 1,000 1,000 5. Dr. Costs of Construction Cr. Contract costs 1,050 1,050 Required 4: Complete the following balance sheet and income statement if percentage of completion method is used. Year 1 Year 2 Year 3 Balance Sheet Accounts receivable Contract Asset 50 118.4 0 100 0 0 Income Statement Revenue from long-term contracts Cost of construction Gross profit (loss) 368.4 350 18.4 431.6 500 (68.4) 200 250 (50) The following journal entries are recorded for your reference: Under the percentage of completion method Year 1 1. Dr. Contract costs $350 Cr. Cash (A/P) 350 2. Dr. Accounts receivable $250 Cr. Contract liabilities 250 3. Dr. Cash $200 Cr. Accounts receivable 200 38 4. Dr. Contract asset $118.4 Dr. Contract liabilities 250 Cr. Revenue 368.4* Percentage of completion = 350/950 = 36.84% Revenue to date = 1,000 x 36.84% = 368.4 Revenue recognized previously=$0 Revenue to be recognized in Year 1 = 368.4 – 0 = 368.4 5. Dr. Costs of Construction 350 Cr. Contract costs 350 Year 2 1. Dr. Contract costs $500 Cr. Cash (A/P) $500 2. Dr. Accounts receivable 450 Cr. Contract liability 450 3. Dr. Cash $500 Cr. Accounts receivable 500 4. Dr. Contract liability Cr. Revenue Cr. Contract Asset 431.6** 18.4 450 **In Year 2, total costs of the contract (850+200) is greater than the total revenue (1,000). We start anticipating this contract to be a loss contract. We can no longer use % of completion x Total revenue to calculate the revenue to be recognized to date. We have to use the following: Revenue recognized to date = Total revenue – Estimated future costs = 1,000 – 200 = 800 Revenue recognized previously= 800 – 368.4 = 431.6 5. Dr. Costs of construction 500 Cr. Contract costs 500 Year 3 1. Dr. Contract costs Cr. Cash (A/P) 250 250 2. Dr. Accounts receivable 300 Cr. Contract liability 3. Dr. Cash 300 300 39 Cr. Accounts receivable 4. Dr. Contract liability Cr. Revenue Cr. Contract Asset 300 300 200*** 100 ***Revenue recognized to date = 100% x 1,000 = 1,000 Revenue recognized previously = 368.4 + 431.6 Revenue to be recognized in year 3 = 1,000 – 368.4 – 431.6 = 200 5. Dr. Costs of Construction Cr. Contract costs 250 250 Question 3: Southwest Edmonton Construction Inc (“SECI”) won a contract bidding for a new apartment building with a bid of $5.115 million. At the start of construction, SECI estimated that the construction would cost $4 million and take three years to complete. Work commenced on January 1, 2007. SECI has provided you with the following information relating to the project: Year 2007 2008 2009 Costs incurred in the current year $ 2,001,000 1,483,000 1,916,000 Estimated costs to complete $ 2,599,000 1,716,000 0 Estimated total costs $ 4,600,000 5,200,000 5,400,000 Billings sent during the year $ 1,500,000 1,500,000 2,115,000 Cash received on billings $ 0 1,700,000 3,300,000 Required: a. Compute the total profit or loss for each of the three years assuming that SECI uses the completed contract method. 2007: nothing 2008: contract loss 2009: contract loss b. 5,115,000-5,200,000 = 85,000 5,115,000-5,400,000+85,000 = 200,000 Compute the revenue, cost of construction and gross profit or loss to be recognized on the contract in each of the three years, assuming that SECI uses the percentage completion method. Year 2007 Percentage of completion = 2,001,000 / 4,600,000 = 43.5% Revenue 2007 = 43.5% x 5,115,000 = 2,225,025 Cost of construction 2007 = 2,001,000 Gross profit = 2,225,025 – 2,001,000 = 224,025 40 Year 2008 By the end of 2008, total costs > total revenue ➔ overall loss expected.
Revenue that can be recognized is limited to = 5,115,000 -1,716,000 = 3,399,000
Revenue 2008 = 3,399,000 – 2,225,025 = 1,173,975
Cost of construction 2008 = 1,483,000
Gross loss = 1,173,975 – 1,483,000 = (309,025)
Year 2009
Revenue 2009 = 5,115,000 – 2,225,025 – 1,173,975 = 1,716,000
Cost of construction 2009 = 1,916,000
Gross loss = 1,716,000 – 1,916,000 = (200,000)
c.
Dr
Dr
Dr
Dr
Prepare all the necessary the journal entries required to account for the contract
for the year 2008 only, assuming SECI uses the percentage completion method.
Contract costs
CR
Cash ( or A/P)
1,483,000
A/R
Cr
1,500,000
Cash
Cr
1,483,000
Contract liability
1,500,000
1,700,000
A/R
1,700,000
Contract liability
1,500,000
Cr
Revenue
Cr
Contract Asset
41
1,173,975
326,025
Class 16 Handout Revenue Recognition
Identify Performance Obligation: Once the contract has been identified, an entity will need to
evaluate the terms and customary business practices to identify which promised goods or services,
or a bundle of promised goods or services, would be accounted for as separate performance
obligations.
[Q1] The following are independent situations that require professional judgement for determining
when to recognize revenue from the transactions.
1.
2.
3.
4.
5.
6.
Volkswagen sells all its vehicles with the promise that any service required in the first year of
ownership will be free of charge.
Walmart sells you a new wardrobe online. The wardrobe is shipped and arrives in November,
and you charge it to your Walmart credit card. In December, you receive your Walmart credit
card statement and pay the amount due.
Norwegian Cruise lines sells you a 10-day Mediterranean cruise. The cost includes your
transportation (of course), room and board, and meals and entertainment on the ship. Shore
excursions are an additional cost.
You go back to Walmart and buy some hangers and socks to go in your new wardrobe. You
pay with cash.
Students pre-register for online classes at Royal Roads University year round, one month in
advance of their course start-date.
In February, Splashes sells dishwashers with 3 year extended warranties. The dishwashers are
delivered in April, and payment is due upon delivery. Warranty plans are normally sold
separately.
Required: For each scenario, identify what is being “sold”: goods, services, or a combination.
Solution:
1. Combination. The car is a goods, while the promised service is a service.
2. Combination. The wardrobe is a good. By using Walmart’s credit card, you have also used their
credit-lending services.
3. Combination. The room is a good (though if cleaned, part of the room is a service). The food is
part good/part service. Entertainment is a service. Transportation is a service.
4. Good
5. Service
6. Combination
Determining the Transaction Price:
[Q2] Indicate the transaction price for each of these transactions and when revenue will be
recognized.
(a). Grupo sells goods to MTN for $1,000,000, payment due at delivery.
(b). Grupo sells goods on account to Grifols for $800,000, payment due in 30 days.
1
(c). Grupo sells goods to Magnus for $500,000, payment due in two instalments: the first
instalment payable in 18 months, and the second payment due 6 months later. The present value
of the future payments is $464,000.
Solution:
(a)
(b)
(c)
Grupo would recognize revenue of $1,000,000 at delivery.
Grupo would recognize revenue of $800,000 at the point of sale.
Grupo would recognize revenue of $464,000 at the point of sale. Interest revenue of $36,000
will be earned over the next 2 years.
Variable Consideration: variable consideration should be estimated using either a probabilityweighted expected value or the most likely amount, whichever better predicts the amount of
consideration to which the entity will be entitled.
[Q3] Example 1 (probability-weighted approach): Nair Corp. enters into a contract with a
customer to build an apartment building for $1,000,000. The customer hopes to rent apartments at
the beginning of the school year and offers a performance bonus of $150,000 to be paid if the
building is ready for rental beginning August 1, 2017. The bonus is reduced by $50,000 each week
that completion is delayed. Nair commonly includes these completion bonuses in its contracts and,
based on prior experience, estimates the following completion outcomes:
Completed by
August 1, 2017
August 8, 2017
August 15, 2017
After August 15, 2017
Probability
70%
20%
5%
5%
Determine the transaction price for this contract under IFRS.
Solution:
The transaction price should include management’s estimate of the amount of consideration to
which the entity will be entitled. Given the multiple outcomes and probabilities available based on
prior experience, the probability-weighted method is the most predictive approach for estimating
the variable consideration in this situation:
Completion Date
August 1
August 8
August 15
After August 15
Probability
Expected Value
70% chance of $1,150,000 = $ 805,000
20% chance of $1,100,000 = 220,000
5% chance of $1,050,000 =
52,500
5% chance of $1,000,000 =
50,000
$1,127,500
Thus, the total transaction price is $ 1,127,500 based on the probability-weighted estimate.
2
[Q4] Example 2 (most likely approach): Blair Biotech enters into a licensing agreement with
Pang Pharmaceutical for a drug under development. Blair will receive a payment of $10,000 if the
drug receives regulatory approval. Based on prior experience with the drug-approval process, Blair
determines it is 90% likely that the drug will gain approval, with a 10% chance of denial.
Required:
(a) Determine the transaction price of the arrangement for Blair Biotech.
(b) Assuming that regulatory approval was granted on December 20, 2017, and that Blair received
the payment from Pang on Jan 15, 2018, prepare the journal entries for Blair.
Solution:
(a)
Because the arrangement only has two possible outcomes (regulatory approval is achieved
or not), Blair determines the transaction price based on the most likely approach. Thus, the
best measure for the transaction price is $10,000.
(b)
December 20, 2017
Accounts Receivable ………………………………………………………..
Revenue ……………………………………………………………….
January 15, 2018
Cash ……………………………………………………………………………
Accounts Receivable ……………………………………………..
10,000
10,000
10,000
10,000
Sales with right of return
[Q5] Example 1: Organic Growth Company is presently testing a number of new agricultural
seeds that it has recently harvested. To stimulate interest, it has decided to grant five of its largest
customers the unconditional right to return these products if not fully satisfied. The right of return
extends for four months. Organic Growth sells these seeds on account for $1,500,000 (cost
$800,000) on April 2, 2017. Customers are required to pay the full amount due by June 15, 2017.
The company follows IFRS.
(a) Prepare the journal entry for Organic Growth at April 2, 2017, assuming Organic Growth
estimates returns of 20% based on prior experience.
(b) Assume that one customer returns the seeds on June 1, 2017. Prepare the journal entry to record
this transaction, assuming this customer purchased $100,000 of seeds from Organic Growth.
(c) Briefly describe the accounting for these sales if Organic Growth is unable to reliably estimate
returns.
Solution:
(a)
April 2, 2017
3
Accounts Receivable ………………………………………………………..
Refund Liability ($1,500,000 X 20%) ……………………..
Sales Revenue ………………………………………………………
1,500,000
Right to recover asset ……………………………………………………….
Cost of Goods Sold ………………………………………………………….
Inventory ……………………………………………………………….
* (20% X 800,000)
160,000*
640,000
(b)
300,000
1,200,000
800,000
June 1, 2017
Refund Liability ………………………………………………………………
Accounts Receivable ………………………………………………
100,000
Inventory ………………………………………………………………………..
Right to recovery asset…………………………………………….
53,333*
100,000
53,333
* ($800,000 ÷ $1,500,000) X $100,000
(c)
If Organic Growth is unable to estimate returns, it defers recognition of revenue until the return
period expires on August 2, 2017.
[Q6] Example 2: On June 3, 2017, Hunt Company sold to Ann Mount merchandise having a sales
price of $8,000 (cost $5,600) with terms of 2/10, n/60, f.o.b. shipping point. Hunt estimates that
merchandise with a sales value of $800 will be returned. An invoice totalling $120, terms n/30,
was received by Mount on June 8 from Olimpic Transport Service for the freight cost. Upon receipt
of the goods, on June 5, Mount notified Hunt that $300 of merchandise contained flaws. The same
day, Hunt issued a credit memo covering the defective merchandise and asked that it be returned
at Hunt’s expense. Hunt estimated the returned items to have a fair value of $120. The freight on
the returned merchandise was $24, paid by Hunt on June 7. On June 12, the company received a
cheque for the balance due from Mount.
Required:
(a) Prepare journal entries for Hunt Company to record all the events noted above, assuming sales
and receivables are entered at gross selling price.
(b) Prepare the journal entry, assuming that Ann Mount did not remit payment until August 5.
Solution:
(a) The journal entries to record sales and related cost of goods sold are as follows.
June 3, 2017
Accounts Receivable ………………………………………………………..
8,000
Refund Liability ……………………………………………………..
800
4
Sales Revenue ………………………………………………………..
Right to recovery asset ……………………………………………………..
Cost of Goods Sold ………………………………………………………….
Inventory ……………………………………………………………..
7,200
560*
5,040
5,600
* ($5,600 ÷ $8,000) X $800
The journal entries to record the return is as follows.
June 5, 2017
Refund Liability ………………………………………………………………
Accounts Receivable ……………………………………………..
Returned Inventory * ……………………………………………………….
Loss due to Damaged Inventory ………………………………………..
Right to recovery asset…………………………………………….
300
300
120
90
210
* Because these goods were damaged they likely will be separated from other inventory.
The journal entry to record delivery cost is as follows.
June 7, 2017
Delivery Expense …………………………………………………………….
Cash ……………………………………………………………………..
24
24
The journal entry to record payment within the discount period is as follows.
June 12, 2017
Cash …………………………………………………………………… 7,546
Sales Discounts (2% X $7,700*) ……………………………………….
Accounts Receivable ……………………………………………..
*$8,000 – $300
154
7,700
(b) August 5, 2017
Cash
…………………………………………………………………… 7,700
Accounts Receivable …………………………………………….
7,700
Allocating the Transaction Price to Separate Performance Obligation:
An entity must allocate the transaction price to each separate performance obligation on a relative
stand-alone selling price basis.
[Q7] Example 1: Total Standalone selling price equals total transaction price
A customer enters into a contract with Ali Buys Inc. to purchase a computer and computer services
for a combined price of $1,200 (stated to the customer as $1,000 for the computer and $200 for
the computer services). The sale of the computer and the services are considered separate
5
performance obligations. Ali Buys Inc. sells the same computers to other customers for $1,000
each and provides computer services (technical assistance) to other customers for $200 per year.
This means that the standalone selling price for the computer is $1,000 and the standalone selling
price for computer services is $200.
In this case, the total transaction price of $1,200 equals the total standalone selling price of
$1,200.
Allocate the total $1,200 transaction price to each distinct performance obligation.
Solution:
Performance
Obligation
Computer
Services
Transaction Price as Standalone
Stated
Price
$1,000
200
$1,200
Selling Allocated Transaction
Price
$1,000
$1,000
200
200
$1,200
$1,200
The transaction price of $1,200 is the amount recognized as revenue in Sept 5, with $1,000
allocated to the computer and $200 to the computer services (unearned service revenue).
[Q8] Example 2: Total Standalone selling price Does NOT equal total transaction price
Assume the same circumstances as in Example 1 except that the customer pays a combined
discounted selling price of $900 (stated to the customer as $800 for the computer and $100 for the
service).
In this case, the total transaction price of $900 does not equal the total standalone selling
price of $1,200.
Allocate the total $900 transaction price to each distinct performance obligation.
Solution:
Performance
Obligation
Computer
Services
Transaction
Price as Stated
$800
100
$900
Standalone
Selling Price
$1,000
200
$1,200
Selling
Ratio
price Allocated
Transaction
Price
1,000/1,200
$750
200/1,200
150
$900
[Q9] Example 3: Adjusted Market Assessment Approach and Expected Cost Plus a Margin
Approach
Alex Inc. enters into a contract with a customer to sell three products in exchange for $200, the
total transaction price (stated to the customer as $75 for Product A, $100 for Production B, and
$25 for Product C). Alex regularly sells Product A, so the market price is directly observable at
$75 per product. The standalone selling price of Products B and C are not observable. Alex Inc.
6
gathers additional information regarding Products B and C. Two competitors sell an item similar
to Product B for an average selling price of $100. The estimated cost of Product C is $36 and the
company has a typical profit margin of 40%. Allocate the total $200 transaction price to each
distinct performance obligation.
Solution:
The standalone selling prices of Products A, B, and C are estimated as follows:
Product A
$75
Directly observable – known standalone selling price
Product B
100
Adjusted market assessment approach – estimated based upon competitor’s
Price
Product C
50
Expected cost plus a margin – estimated based on cost plus margin
($36×1.40)
The customer received a discount because the combined price of the bundled goods was $200,
which was less than the estimated standalone selling prices of the individual products, which total
$225. Because there is no observable evidence of where to allocate the $25 ($225 – $200) discount,
the discount is allocated proportionately as follows.
Performance
Obligation
Product A
Product B
Product C
Transaction Price Standalone
as Stated
Selling Price
$75
$75
100
100
25
50
$200
$225
Selling Price
Ratio
75/225
100/225
50/225
Allocated
Transaction Price
$69 (200 x 75/225)
89 (200 x 100/225)
44 (200 x 50/225)
$200
The $200 transaction price is the amount recognized as revenue in Sept 5, with $69 allocated to
Product A, $89 to Product B, and $44 to Product C.
[Q10] Example 4: Residual Approach
Alex Inc. enters into a contract with a customer to sell three products in exchange for $200, the
total transaction price. Alex Inc. regularly sells Product A for $75 and Product B for $95 on a
standalone basis. The standalone selling price of Product C is not observable because it is a new
product and is currently not sold by competitors. Because Product C has not been sold before and
does not have an established price, the residual approach can be used to estimate the selling price
of Product C. Allocate the total $200 transaction price to each distinct performance obligation.
Solution:
The standalone selling prices of Product A, B, and C are summarized as follows.
Performance obligation
Product A
Standalone Selling Price
$75 (observable)
Allocated Transaction Price
$75
7
Product B
Product C
$95 (observable)
$95
$30*
$200
*$200 – 75 – 95 = $30
The $200 transaction price is the amount recognized as revenue in Sept 5, with $75 allocated to
Product A, $95 to Product B, and $30 to Product C.
[Q11] Example 5: Crankshaft Company manufactures equipment. Crankshaft’s products range
from simple automated machinery to complex systems containing numerous components. Unit
selling prices range from $200,000 to $1,500,000, and are quoted inclusive of installation. The
installation process does not involve changes to the features of the equipment to perform to
specification. Crankshaft has the following arrangement with Winkerbean Inc.


Winkerbean purchases equipment from Crankshaft for a price of $1,000,000 and contracts
with Crankshaft to install the equipment. Crankshaft charges the same price for the
equipment irrespective of whether it does the installation or not. Using market data,
Crankshaft determines that the installation service is estimated to have a fair value of
$50,000. The cost of the equipment is $600,000.
Winkerbean is obligated to pay Crankshaft the $1,000,000 upon delivery and installation
of the equipment.
Crankshaft delivers the equipment on June 1, 2017, and completes the installation of the equipment
on September 30, 2017. The equipment has a useful life of 10 years. Assume that the equipment
and the installation are two distinct performance obligations that should be accounted for
separately.
Required:
(a). How should the transaction price of $1,000,000 be allocated among the service obligations?
(b). Prepare the journal entries for Crankshaft for this revenue arrangement in 2017, assuming
Crankshaft receives payment when installation is completed.
Solution:
(a)
The total revenue of $1,000,000 should be allocated to the two performance obligations
based on their relative fair values. In this case, the fair value of the equipment should be
considered $1,000,000 and the fair value of the installation fee is $50,000. The total fair
value to consider is $1,050,000 ($1,000,000 + $50,000). The allocation is as follows.
Equipment ($1,000,000 / $1,050,000) X $1,000,000 = $952,381
Installation ($50,000 / $1,050,000) X $1,000,000= $ 47,619
(b)
Crankshaft makes the following entries.
8
June 1, 2017
Cash
…………………………………………………………….. 1,000,000
Unearned Service Revenue – Installation ………………….
Sales Revenue ………………………………………………………
Cost of Goods Sold ……………………………………………… 600,000
Inventory ……………………………………………………………..
(Equipment delivered, performance obligation for installation recorded)
Sept 30, 2017
Unearned Revenue ………………………………………………… 47,619
Service Revenue – Installation ………………………………….
47,619
952,381
600,000
47,619
The sale of the equipment is recognized once delivered.
The installation fee is recognized when the equipment is installed.
As a practical expedient, if a company has two or more distinct performance obligations, it
may bundle these performance obligations if they have the same revenue recognition pattern.
That is they are recognized immediately or they are recognized over time using the same
revenue recognition pattern.
Repeat requirements (a) and (b), assuming Crankshaft does not have market data with which to
determine the stand-alone selling price of the installation services. As a result, an expected cost
plus margin approach is used. The cost of installation is $36,000; Crankshaft prices these services
with a 25% margin relative to cost.
Solution:
(a)
The total revenue of $1,000,000 should be allocated to the two performance obligations
based on their relative fair values. In this case, the fair value of the equipment should be
considered $1,000,000 and the fair value of the installation fee, assuming a cost plus
approach is $45,000 ($36,000 + [25% X $36,000]). The total fair value to consider is
$1,045,000 ($1,000,000 + $45,000). The allocation is as follows.
Equipment ($1,000,000 /$1,045,000) X $1,000,000 = $956,938
Installation ($45,000 /$1,045,000) X $1,000,000 = $ 43,062
(b)
Crankshaft makes the following entries.
June 1, 2017
Cash
…………………………………………………………….. 1,000,000
Unearned Service Revenue – Installation ………………….
Sales Revenue ………………………………………………………
(Equipment delivered, performance obligation for installation recorded)
43,062
956,938
9
Cost of Goods Sold ………………………………………………………….
Inventory ……………………………………………………………..
600,000
Sept 30, 2017
Unearned Revenue ………………………………………………… 43,062
Service Revenue – Installation ………………………………….
600,000
43,062
The sale of the equipment is recognized once delivered.
The installation fee is recognized when the equipment is installed.
[Q12] Example 6: Geraths Windows manufactures and sells custom storm windows for threeseason porches. Geraths also provides installation service for the windows. The installation process
does not involve changes in the windows, so this service can be performed by other vendors.
Geraths enters into the following non-cancellable contract on July 1, 2017, with a local homeowner.
The customer purchases windows for a price of $2,400 and chooses Geraths to do the installation.
Geraths charges the same price for the windows regardless of whether it does the installation or
not. The price of the installation service is estimated to have a fair value of $600. The customer
pays Geraths $2,000 (which equals the fair value of the windows, which have a cost of $1,100)
upon delivery and the remaining balance upon installation of the windows. The windows are
delivered on Sep 1, 2017, Gerath completes installation on Oct 15, 2017, and the customer pays
the balance due. Prepare the journal entries for Geraths in 2017.
Solution:
July 1, 2017
No entry – neither party has performed under the contract.
On September 1, 2017, Geraths has two performance obligations: (1) the delivery of the windows
and (2) the installation of the windows.
Windows
Installation
Total
Allocation
Windows ($2,000 ÷ $2,600) X $2,400 =
Installation ($600 ÷ $2,600) X $2,400 =
Revenue recognized
(rounded to nearest dollar)
$2,000
600
$2,600
$1,846
554
$2,400
Geraths makes the following entries for delivery and installation.
September 1, 2017
Cash ………………………………………………………………… 2,000
Accounts Receivable ………………………………………………….. 400
10
Unearned Revenue …………………………………………………
Sales Revenue ……………………………………………………….
554
1,846
Cost of Goods Sold …………………………………………………. 1,100
Inventory ……………………………………………………………….
1,100
(Windows delivered, performance obligation for installation recorded)
October 15, 2017
Cash ……………………………………………………………………… 400
Unearned Revenue …………………………………………………….. 554
Service Revenue – Installation ………………………………….
Accounts Receivable ……………………………………………….
554
400
The sale of the windows is recognized once delivered. The installation fee is recognized when
the windows are installed.
Repeat the requirements, assuming (a) Geraths estimates the stand-alone value of the installation
based on an estimated cost of $400 plus a margin of 20% on cost, and (b) given the uncertainty of
finding skilled labor, Geraths is unable to develop a reliable estimate for the fair value of the
installation.
Solution:
(a)
July 1, 2017
No entry – neither party has performed under the contract.
On September 1, 2017, Geraths has two performance obligations: (1) the delivery of the windows
and (2) the installation of the windows.
Windows
Installation [$400 + (20% X $400)]
Total
Allocation
Windows ($2,000 ÷ $2,480) X $2,400 =
Installation ($480 ÷ $2,480) X $2,400 =
Revenue recognized
(rounded to nearest dollar)
$2,000
480
$2,480
$1,935
465
$2,400
Geraths makes the following entries for delivery and installation.
September 1, 2017
Cash
…………………………………………………………………… 2,000
11
Accounts Receivable ………………………………………………………..
Unearned Revenue – Installation ……………………………….
Sales Revenue ……………………………………………………….
400
Cost of Goods Sold ………………………………………………………….
Inventory ……………………………………………………………….
1,100
465
1,935
1,100
(Windows delivered, performance obligation for installation recorded)
October 15, 2017
Cash ……………………………………………………………………… 400
Unearned Revenue – Installation ………………………………………..
Service Revenue – Installation ………………………………….
Accounts Receivable ……………………………………………….
465
465
400
The sale of the windows is recognized once delivered. The installation is fee is recognized when
the windows are installed.
b)
If Garaths cannot estimate the costs for installation, then the residual approach is used. In
this approach, the total fair value of the contract is $2,400. Given that the windows have a
standalone fair value of $2,000, then $400 ($2,400 – $2,000) is allocated to the installation.
Geraths makes the following entries for delivery and installation.
September 1, 2017
Cash …………………………………………………………………… 2,000
Accounts Receivable ………………………………………………….. 400
Unearned Revenue – Installation ……………………………….
Sales Revenue ……………………………………………………….
Cost of Goods Sold ………………………………………………………….
Inventory ……………………………………………………………….
400
2,000
1,100
1,100
(Windows delivered, performance obligation for installation recorded)
October 15, 2017
Cash ……………………………………………………………………… 400
Unearned Revenue – Installation ………………………………….. 400
Service Revenue – Installation ………………………………….
Accounts Receivable ……………………………………………….
400
400
12
Recognize Revenue When Seller Satisfies a Performance Obligation
[Q13] Example 1: Revenue recognized at a point in time
A Seller, Rita Inc. enters a contract to deliver customized ski equipment to a customer for $500
(cost is $250). The customer pays a $100 deposit upfront on October 15, 2020, while the remaining
$400 ($500-$100) is due on deliver, expected in three weeks. Prepare the journal entries required
on Oct 15 and on Nov 7, 2020 (the date that the customized ski equipment is picked up by the
customer and balance is paid in full).
Solution:
Revenue is recognized on delivery of the ski eequipment because that is the point at which control
of the product is transferred to the customer. This means that only at this point is the fifth step of
the revenue recognition process complete. Because the $100 was received in advance of the delivery
of the product, Rita Inc. will recognize unearned revenue. Unearned revenue will be reduced and
recognized as revenue when delivery of the customized product takes place.
October 15, 2020 – to record customer prepayment
Dr. Cash …………………………………………………………………… 100
Cr. Unearned revenue…………………………………………….
100
Nov 7, 2020 – to recognize revenue and reduce inventory
Dr. Unearned revenue ………………………………………………… 100
Dr. Cash ………………………………………………………………….. 400
Cr. Sales revenue ……………………………………………………
500
Dr. Cost of goods sold ……………………………………………….. 250
Cr. Inventory ………………………………………………………….
250
[Q14] Example 2: Revenue recognized at a point in time
Gapp Inc. sponsors a customer loyalty point program where customers earn one loyalty point for
every $5 spent on clothing and accessories at any Gapp Inc. store or through online purchases.
Loyalty program members can exchange accumulated loyalty points for free products at Gapp Inc.
(such as one loyalty point equals $1 of free products). It is common for loyalty program members
to accumulate and redeem loyalty points for free products. During June of 2020, customers
purchased products with a sales value of $20,000, earning $4,000 in loyalty points. Based on past
history of promotional programs, Gapp Inc. estimates a standalone selling price of $0.75 per loyalty
point or $3,000 in total. The standalone selling price of the products purchased is $20,000.
Required:
a. assuming that there are two performance obligations (product sales and loyalty points), allocate
the transaction price to the products and loyalty points.
b. Record the entry for sales for the month of June (ignore the cost entries).
c. Assuming that 1,600 loyalty points were redeemed in June, and Gapp Inc. still expects 3,000
points to be redeemed in total, record the entry to recognize revenue on the redeemed loyalty points
(ignore the cost entries).
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Solution:
a. the transaction price would be allocated as follows (Step 4)
Performance
Obligation
Sale of product
Loyalty points
Transaction Price Standalone
Selling price ratio Allocated
as Stated
Selling price
transaction price
$20,000
$20,000
20/23
$17,391
3,000
3/23
2,609
$20,000
$23,000
$20,000
b. Gapp Inc. records the following journal entry for the month of June for the transfer of control of
product to the customer (point in time sale). Revenue allocated to the customer option (loyalty
points) is deferred until the rewards are redeemed for additional product.
June 30, 2020 – To record sale transaction
Dr. Cash ………………………………………………………………. 20,000
Cr. Unearned revenue ……………………………………………..
Cr. Sales revenue ……………………………………………………
2,609
17,391
c. Gapp Inc. would recognize revenue related to the customer options for June for $1,391 or (1,600
points/3,000 pts) x 2,609. Gapp Inc. records the following entry:
June 30, 2020 – to record customer redemption of loyalty points
Dr. Unearned revenue ……………………………………………… 1,391
Cr. Sales revenue ……………………………………………………
1,391
[Q15] Example 3: Revenue recognized at a point in time
A contractor enters into a three-year construction contract with Dental Inc. to build an office
building. The contract has the following conditions.
– The office building plan is based upon a standard model frequently built by the contractor.
– Non-refundable payments are required including a payment equal to 10% of the contract up
front, interim billing totaling 50% of the contract at the end of 18 months, and 40% at the
end of the contract if the project meets the prescribed requirements.
– Dental Inc. can cancel the contract at any time (with a termination penalty); any work in
process is the property of the contractor. Any payments made to the contractor before the
cancellation date remain with the contractor.
– Physical possession and title do not pass until completion of the contract.
– Total estimated contract revenue is $300 million and total estimated contract cost is $200
million.
– Year one cost is $120 million (including $20 million related to contractor-caused
inefficiencies)
Determine the amount of revenue that the contractor should recognize during the first year of the
contract.
Solution:
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First, the contractor must evaluate whether revenue should be recognized at a point in time or over
time. This situation does not warrant revenue recognition over time.
– Dental Inc. does not enjoy use of the building or have control of the building over its life, as
it does not own the work in process.
– The building has alternative uses (is not customized)
– The contractor does not have an enforceable right of payment for work to date. Payments are
not based upon performance but on a preset schedule, thus, at any point in time, the
contractor may not have been compensated for the work completed.
Therefore, no revenue (or expense) is recorded in 2020. Instead, revenue (and expense) would be
recognized in income at the completion of the project when control of the building is transferred to
Dental Inc.
Bill-and-Hold Arrangement
[Q16] Brow Inc. enters into a contract during August of 2020 to supply 1,000 units of product to a
retailer. Brow Inc. must deliver the units in 2020 at a date to be specified by the retailer. The retailer
expects to have sufficient shelf space at the time of delivery but does not currently have the shelf
space to hold the order. Brow Inc. has inventory of 200,000 units of product, excluding the 1,000
units relating to the contract with the retailer. Even though the 1,000 units of product are
interchangeable with other units, the 1,000 units are ready for immediate shipment at the request of
the customer, segregated from inventory (beginning on Sept 1, 2020) and will not be used to fulfill
other orders. Payment for the 1,000 units is due Sept 30, 2020. The units are sold at $50 per unit
while the cost to Brow Inc. is $30 per unit. Record the entry for Brow Inc. on Sept 1, 2020.
Solution:
Brow Inc. should recognize revenue on Sep 1, 2020, when the 1,000 units are segregated from the
rest of the inventory because the inventory cannot be used to fulfill other orders and is ready for
transfer to the customer. The reason for the bill-and-hold transaction is substantive (lack of shelf
space). Brow Inc. records the following entry on Sept 1, 2020.
Sept 1, 2020 – To record sale of units in bill-and-hold arrangement
Dr. Accounts receivable …………………………………………. 50,000
Cr. Sales revenue ……………………………………………………
50,000
Dr. Cost of goods sold …………………………………………… 30,000
Cr. Inventory (1,000 x $30) ……………………………………..
30,000
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