FINANCIAL ACCOUNTING

Topics: Revenue, Contract, Cost of goods sold Pages: 12 (1936 words) Published: October 16, 2014
Chapter 6: Revenue RecognitionRead: Chapter 6 and partly 13 on warrantyIn-class exercises: BE6-7, EX6-11, EX6-9, EX6-16, EX6-18 Practice exercises: EX6-7, BE6-11, P6-1, P6-2, E13-17
There are two main conceptual views on how to account for revenues/sales: Earnings approach
Contract-based approach

Earnings Approach
Revenues are recognized when the following criteria are met: 1. Performance is achieved:
a. risks and rewards transferred and/or earnings process substantially complete, and b. measurability reasonably assured
2. Collectibility is reasonably assured

“Earnings process” is substantially complete.
Operational functions firm that ADD VALUE in generation of revenue Varies across different firm
Eg. Produce goods→sale →collect cash→provide after sale service

Contract-Based Approach

Contract-Based Approach
Contract is recognized when all of the following conditions are met: 1. The entity is party to the contract,
2. The contractual rights are collectible/measurable, and
3. The performance obligation is measurable

Net contract position represents the balance of contractual rights less contractual obligations Initial balance of net contract position is generally nil due to reciprocity and assumed arm’s length transaction Revenues are recognized when

Control passes to the buyer (as indicated by legal title / possession), or Services are performed

Earnings Approach
Recognize revenue at different stages in the earnings process

1) DURING PRODUCTION

Many long term construction contracts

2) WHEN PRODUCTION IS COMPLETE (BEFORE SALE)

Product with guaranteed price and buyer (eg. Some agricultural products where gov’t agrees to purchase excess at set price)

3) AT SALE/DELIVERY

If revenue, cost, collection can be estimated
Buyer assumes risks & rewards at this date
Seller has no significant involvement/control of goods after this date

How should you treat goods in transit?
Risks & rewards are transferred where legal title passes
Fob shipping point →sale complete when leaves seller
Fob destination→ sale not complete until delivered
4) AFTER DELIVERY, WHEN CASH IS COLLECTED
if collectability can’t be estimated

5) LATER THAN DELIVERY & CASH COLLECTION
If seller has significant future obligations which can’t be estimated Trial period (allow returns)

Problems with the Earnings Approach

Multiple (and sometimes conflicting) guidance on revenue recognition Difficult to apply
Difficult to determine definitively who has the risks and rewards Too much subjective judgment

BE 6-7
Multiple deliverables
(e.g., a telephone company would sell a phone and a monthly service)

Separate each deliverable, if possible
Overall price can be allocated using two methods:
Relative fair value method
Residual value method
If components cannot be measured individually, then revenue recognition criteria are applied to the bundled sale as a whole (as if one product/service)

Bundle Sales
EX 6-6
Consignment Sales
Consignor ships inventory to the consignee
The consignee acts as an agent to sell the inventory
Possession has transferred; however legal title remains with the seller Risks and rewards have not transferred
Goods are held by seller as “Merchandise on Consignment” Not held as inventory on consignee’s books
When merchandise sold, the consignee remits cash to the consignor (after deducting commission and other chargeable expenses)

Example:

Nov 1, 2010 a manufacturer pays $500 to ship inventory costing $40,000 to a retailer who holds it on consignment. If the goods are sold, the retailer gets a 10% commission on the selling price. If the goods are not sold within 120 days, the retailer agrees to return them to the manufacturer. At Dec 31, 2010 half of the goods have been sold for $38,000. How will these transactions affect the manufacturer’s I/S for the year ended Dec 31, 2010?

Consigned inventory is still reported on manufacturer’s...
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