18 Revenue Recognition

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1 Understand the fundamental concepts 3 Apply the five-step process to major

related to revenue recognition and revenue recognition issues.
measurement.
4 Describe presentation and disclosure
2 Understand and apply the five-step regarding revenue.
revenue recognition process.

GAAP IN MOTION
The recent standard on revenue recognition was the result of joint work by the FASB and IASB. As a result, the
Boards issued a converged standard with few differences between GAAP and IFRS.

IT’S BACK
Several years after passage, the accounting world continues to be preoccupied with the Sarbanes-Oxley Act of 2002
(SOX). Unfortunately, SOX did not solve one of the classic accounting issues—how to properly account for revenue.
In fact, revenue recognition practices are the most prevalent reason for accounting restatements. A number of
revenue recognition issues relate to possible fraudulent behavior by company executives and employees.
As a result of such revenue recognition problems, the SEC has increased its enforcement actions in this
area. In some of these cases, companies made significant adjustments to previously issued financial statements.
As Lynn Turner, a former chief accountant of the SEC, indicated, “When people cross over the boundaries of
legitimate reporting, the Commission will take appropriate action to ensure the fairness and integrity that
investors need and depend on every day.”
Consider some SEC actions:

• The SEC charged the former co-chairman and CEO of Qwest Communications International Inc. and
eight other former Qwest officers and employees with fraud and other violations of the federal securities laws.
Three of these people fraudulently characterized nonrecurring revenue from one-time sales as revenue from
recurring data and Internet services. The SEC release notes that internal correspondence likened Qwest’s
dependence on these transactions to fill the gap between actual and projected revenue to an addiction.
• The SEC filed a complaint against three former senior officers of iGo Corp., alleging that the defendants
collectively caused iGo to improperly recognize revenue on consignment sales and products that were not
shipped or that were shipped after the end of a fiscal quarter.
• The SEC filed a complaint against the former CEO and chairman of Homestore Inc. and its former executive
vice president of business development, alleging that they engaged in a fraudulent scheme to overstate
advertising and subscription revenues. The scheme involved a complex structure of “round-trip” transactions
using various third-party companies that, in essence, allowed Homestore to recognize its own cash as revenue.
• The SEC claims that Lantronix deliberately sent excessive product to distributors and granted them gener-
ous return rights and extended payment terms. In addition, as part of its alleged channel stuffing and to
prevent product returns, Lantronix loaned funds to a third party to purchase Lantronix products from one of
its distributors. The third party later returned the products. The SEC also asserted that Lantronix engaged in
other improper revenue recognition practices, including shipping without a purchase order and recognizing
revenue on a contingent sale.
 Revenue numbers are attracting more attention from investors these days. In a recent survey, financial
executives noted that the revenue recognition process is increasingly more complex to manage, more prone to
error, and more material to financial statements compared to any other area in financial reporting. The report
went on to note that revenue recognition is a top fraud risk and that regardless of the accounting rules followed
(GAAP or IFRS), the risk of errors and inaccuracies in revenue reporting is significant.
In response, the FASB and IASB issued a new standard on revenue recognition that hopefully will improve
the reporting of revenue transactions. This new standard provides a set of guidelines to follow in determining
when revenue should be reported and how it should be measured. The new standard is comprehensive and
applies to all companies. As a result, comparability and consistency in reporting revenue should be enhanced.
After studying this chapter, you should have a good understanding of the new revenue recognition concepts.
Sources: Cheryl de Mesa Graziano,“Revenue Recognition: A Perennial Problem,” Financial Executive (July 14, 2005), www.fei.
org/mag/articles/7-2005_revenue.cfm; S. Taub,“SEC Accuses Ex-CFO of Channel Stuffing,”CFO.com (September 30, 2006); and
www.softrax.com/resources/pdf/intlriskrevreporting and Accounting Standards Update No. 2014-09, Revenue from Contracts with
Customers (Topic 606) (Norwalk, Conn.: FASB, May 2014).

PREVIEW OF CHAPTER 18 As indicated in the opening story, the issue of

when revenue should be recognized is complex. The many methods of marketing products
and services make it difficult to develop guidelines that will apply to all situations. This This chapter also includes
chapter provides you with general guidelines used in most business transactions. The numerous conceptual
discussions.
content and organization of the chapter are as follows.

REVENUE RECOGNITION

FUNDAMENTALS OF THE FIVE-STEP PROCESS REVENUE RECOGNITION PRESENTATION AND

REVENUE RECOGNITION REVISITED ISSUES DISCLOSURE
• Background • Identifying the contract • Sales returns and • Presentation
• New revenue recognition with customers allowances • Disclosure
standard • Identifying separate • Repurchase agreements
• Overview of five-step performance • Bill-and-hold
process: Boeing obligations arrangements
example • Determining the • Principal-agent
• Extended example of transaction price relationships
five-step process: BEAN • Allocating the • Consignments
transaction price
• Warranties
• Satisfying performance
obligations • Nonrefundable upfront
fees

REVIEW AND PRACTICE

Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary review
and practice problem with solution. Multiple-choice questions with annotated solutions as well as
additional exercises and practice problem with solutions are also available online.

979
980 Chapter 18 Revenue Recognition

LEARNING OBJECTIVE 1 FUNDAMENTALS OF REVENUE RECOGNITION

Understand the funda-
mental concepts related
Background
to revenue recognition Revenue is one of, if not the most, important measures of financial performance that a
and measurement. company reports. Revenue provides insights into a company’s past and future perfor-
mance and is a significant driver of other performance measures, such as EBITDA, net
income, and earnings per share. Therefore, establishing robust guidelines for recogniz-
ing revenue is a standard-setting priority.
Most revenue transactions pose few problems for revenue recognition. That is,
most companies initiate and complete transactions at the same time. However, not all
transactions are that simple. For example, consider a cell phone contract between a
company such as Verizon and a customer. Verizon often provides a customer with a
package that may include a handset, free minutes of talk time, data downloads, and
text messaging service. In addition, some providers will bundle that with a fixed-line
broadband service. At the same time, the customer may pay for these services in a
variety of ways, possibly receiving a discount on the handset and then paying higher
prices for connection fees and so forth. In some cases, depending on the package
purchased, the company may provide free upgrades in subsequent periods. How,
then, should Verizon report the various pieces of this sale? The answer is not
obvious.
Both the FASB and the IASB have indicated that the state of reporting for revenue
INTERNATIONAL
was unsatisfactory. IFRS was criticized because it lacked guidance in a number of areas.
PERSPECTIVE
For example, IFRS had one general standard on revenue recognition—IAS 18—plus
The converged revenue some limited guidance related to certain minor topics. In contrast, GAAP had numerous
recognition standard standards related to revenue recognition (by some counts, well over 100), but many
represents a significant believed the standards were often inconsistent with one another. Thus, the accounting
milestone in the FASB/ for revenue provided a most fitting contrast of the principles-based (IFRS) and rules-
IASB convergence
based (GAAP) approaches.1
project.
Recently, the FASB and IASB issued a converged standard on revenue recognition
entitled Revenue from Contracts with Customers. [1] To address the inconsistencies and
See the FASB weaknesses of the previous approaches, a comprehensive revenue recognition standard
Codification now applies to a wide range of transactions and industries. The Boards believe this new
References standard will improve GAAP and IFRS by:
(page 1050).
(a) Providing a more robust framework for addressing revenue recognition issues.
(b) Improving comparability of revenue recognition practices across entities, indus-
tries, jurisdictions, and capital markets.
(c) Simplifying the preparation of financial statements by reducing the number of
requirements to which companies must refer.
(d) Requiring enhanced disclosures to help financial statement users better under-
stand the amount, timing, and uncertainty of revenue that is recognized. [2]

New Revenue Recognition Standard

The new standard, Revenue from Contracts with Customers, adopts an asset-liability
approach as the basis for revenue recognition. The asset-liability approach recognizes

1
See, for example, “Preliminary Views on Revenue Recognition in Contracts with Customers,” IASB/FASB
Discussion Paper (December 19, 2008). Some noted that GAAP has so many standards that at times they are
inconsistent with each other in applying basic principles. In addition, even with the many standards, no
comprehensive guidance was provided for service transactions. Conversely, IFRS lacked guidance in
certain fundamental areas such as multiple-deliverable arrangements. In addition, there were inconsisten-
cies in applying revenue recognition principles to long-term contracts versus other elements of revenue
recognition.
 Fundamentals of Revenue Recognition 981

and measures revenue based on changes in assets and liabilities. The Boards decided
that focusing on (a) the recognition and measurement of assets and liabilities and
(b) changes in those assets or liabilities over the life of the contract brings more disci-
pline to the measurement of revenue, compared to the ”earned and realized” criteria in
prior standards.
Under the asset-liability approach, companies account for revenue based on the
UNDERLYING
asset or liability arising from contracts with customers. Companies analyze contracts CONCEPTS
with customers because contracts initiate revenue transactions. Contracts indicate the
terms of the transaction, provide the measurement of the consideration, and specify the The asset-liability
approach is consistent
promises that must be met by each party.
with the conceptual
Illustration 18-1 shows the key concepts related to this new standard on revenue
framework approach to
recognition. The new standard first identifies the key objective of revenue recognition, recognition.
followed by a five-step process that companies should use to ensure that revenue is
measured and reported correctly.

ILLUSTRATION 18-1
KEY OBJECTIVE Key Concepts of Revenue
Recognition
Recognize revenue to depict the transfer of goods or services to customers in an amount that reflects
the consideration that the company receives, or expects to receive, in exchange for these goods or
services.

FIVE-STEP PROCESS FOR REVENUE RECOGNITION

1. Identify the contract with customers.

2. Identify the separate performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the separate performance obligations.
5. Recognize revenue when each performance obligation is satisfied.

REVENUE RECOGNITION PRINCIPLE

Recognize revenue in the accounting period when the performance obligation is satisfied.

The culmination of the process is the revenue recognition principle, which states
that revenue is recognized when the performance obligation is satisfied. We examine all
steps in more detail in the following section.

Overview of the Five-Step Process—Boeing Example

Assume that Boeing Corporation signs a contract to sell airplanes to Delta Air Lines for
$100 million. Illustration 18-2 (page 982) shows the five steps that Boeing follows to
recognize revenue.
As indicated, Step 5 is when Boeing recognizes revenue related to the sale of the
airplanes to Delta. At this point, Boeing delivers the airplanes to Delta and satisfies its
performance obligation. In essence, a change in control from Boeing to Delta occurs.
Delta now controls the assets because it has the ability to direct the use of and obtain
substantially all the remaining benefits from the airplanes. Control also includes
Delta’s ability to prevent other companies from directing the use of, or receiving the
benefits from, the airplanes.
982 Chapter 18 Revenue Recognition

A contract is an agreement between two parties

Step 1: Identify the contract that creates enforceable rights or obligations. In
with customers. this case, Boeing has signed a contract to deliver
airplanes to Delta.
A contract

Boeing has only one performance obligation—to

Step 2: Identify the separate
deliver airplanes to Delta. If Boeing also agreed to
performance obligations in
maintain the planes, a separate performance
the contract.
obligation is recorded for this promise.

Transaction price is the amount of consideration

that a company expects to receive from a customer
Step 3: Determine the transaction
in exchange for transferring a good or service. In
price.
this case, the transaction price is
straightforward—it is $100 million.

Step 4: Allocate the transaction In this case, Boeing has only one performance
price to the separate obligation—to deliver airplanes to Delta.
performance obligations.

Boeing recognizes revenue of $100 million for the

Step 5: Recognize revenue when
sale of the airplanes to Delta when it satisfies its
each performance obligation
performance obligation—the delivery of the
is satisfied.
airplanes to Delta.

ILLUSTRATION 18-2
Five Steps of Revenue
Recognition

Extended Example of the Five-Step

Process: BEAN
To provide another application of the basic principles of the five-step revenue recogni-
tion model, we use a coffee and wine business called BEAN. BEAN is located in the
Midwest and serves gourmet coffee, espresso, lattes, teas, and smoothies. It also sells
various pastries, coffee beans, other food products, wine, and beer.

Identifying the Contract with Customers—Step 1

Assume that Tyler Angler orders a large cup of black coffee costing $3 from BEAN.
Tyler gives $3 to a BEAN barista, who pours the coffee into a large cup and gives it to
Tyler.
 Fundamentals of Revenue Recognition 983

Question: How much revenue should BEAN recognize on this transaction?

Step 1 We first must determine whether a valid contract exists between BEAN and Tyler. Here are the
components of a valid contract and how it affects BEAN and Tyler.

1. The contract has commercial substance: Tyler gives cash for the coffee.
2. The parties have approved the contract: Tyler agrees to purchase the coffee and BEAN agrees to sell it.
3. Identification of the rights of the parties is established: Tyler has the right to the coffee and BEAN
has the right to receive $3.
4. Payment terms are identified: Tyler agrees to pay $3 for the coffee.
5. It is probable that the consideration will be collected: BEAN has received $3 before it delivered the
coffee. [3]2

From this information, it appears that BEAN and Tyler have a valid contract with one another.

Step 2 The next step is to identify BEAN’s performance obligation(s), if any. The answer is straightfor-
ward—BEAN has a performance obligation to provide a large cup of coffee to Tyler. BEAN has no other
performance obligation for any other good or service.
Step 3 BEAN must determine the transaction price related to the sale of the coffee. The price of the cof-
fee is $3, and no discounts or other adjustments are available. Therefore, the transaction price is $3.
Step 4 BEAN must allocate the transaction price to all performance obligations. Given that BEAN has
only one performance obligation, no allocation is necessary.
Step 5 Revenue is recognized when the performance obligation is satisfied. BEAN satisfies its perfor-
mance obligation when Tyler obtains control of the coffee. The following conditions are indicators that
control of the coffee has passed to Tyler:
a. BEAN has the right to payment for the coffee.
b. BEAN has transferred legal title to the coffee.
c. BEAN has transferred physical possession of the coffee.
d. Tyler has significant risks (e.g., he might spill the coffee) and rewards of ownership (he gets to drink
the coffee).
e. Tyler has accepted the asset.

Solution: BEAN should recognize $3 in revenue from this transaction when Tyler receives the coffee.

Identifying Separate Performance Obligations—Step 2

The following day, Tyler orders another large cup of coffee for $3 and also purchases
two bagels at a price of $5. The barista provides these products and Tyler pays $8.

Question: How much revenue should BEAN recognize on the purchase

of these two items?

Step 1 A valid contract exists as it meets the five conditions necessary for a contract to be enforceable
as discussed in the previous example.

Step 2 BEAN must determine whether the sale of the coffee and the sale of the two bagels involve one or
two performance obligations. In the previous transaction between BEAN and Tyler, this determination was
straightforward because BEAN provided a single distinct product (a large cup of coffee) and therefore
only one performance obligation existed. However, an arrangement to purchase coffee and bagels may
have more than one performance obligation. Multiple performance obligations exist when the following
two conditions are satisfied:
1. BEAN must provide a distinct product or service. In other words, BEAN must be able to sell the coffee
and the bagels separately from one another.

2
BEAN disregards revenue guidance for a contract that is wholly unperformed and for which each party can
unilaterally terminate the contract without compensation.
984 Chapter 18 Revenue Recognition

2. BEAN’s products are distinct within the contract. In other words, if the performance obligation is not
highly dependent on, or interrelated with, other promises in the contract, then each performance obli-
gation should be accounted for separately. Conversely, if each of these products is interdependent
and interrelated, these products are combined and reported as one performance obligation. [4]
The large cup of coffee and the two bagels appear to be distinct from one another and are not highly
dependent or interrelated. That is, BEAN can sell the coffee and the two bagels separately, and Tyler
benefits separately from the coffee and the bagels.
BEAN should therefore record two performance obligations—one for the sale of the coffee and one for
the sale of the bagels.

Step 3 The transaction price is $8 ($3 + $5).

Step 4 BEAN has two performance obligations: to provide (1) a large cup of coffee and (2) the two
bagels. Each of these obligations is distinct and not interrelated (and priced separately); no allocation of
the transaction price is necessary. That is, the coffee sale is recorded at $3 and the sale of the bagels is
priced at $5.
Step 5 BEAN has satisfied both performance obligations when the coffee and bagels are given to Tyler
(control of the product has passed to the customer).

Solution: BEAN should recognize $8 ($3 + $5) of revenue when Tyler receives the coffee and
bagels.

Determining the Transaction Price—Step 3

BEAN decides to provide an additional incentive to its customers to shop at its store.
BEAN roasts its own coffee beans and sells the beans wholesale to grocery stores, restau-
rants, and other commercial companies. In addition, it sells the coffee beans at its retail
location. BEAN is interested in stimulating sales of its Smoke Jumper coffee beans on
Tuesdays, a slow business day for the store. Normally, these beans sell for $10 for a
12-ounce bag, but BEAN decides to cut the price by $1 when customers buy them on
Tuesdays (the discounted price is now $9 per bag). Tyler has come to the store on a
Tuesday, decides to purchase a bag of Smoke Jumper beans, and pays BEAN $9.

Question: How much revenue should BEAN recognize on this transaction?

Step 1 As in our previous examples, with the sale of a large cup of coffee or the sale of a large cup
of coffee and two bagels, a valid contract exists. The same is true for the sale of Smoke Jumper beans
as well.
Step 2 The identification of the performance obligation is straightforward. BEAN has a performance
obligation to provide a bag of Smoke Jumper coffee beans to Tyler. BEAN has no other performance
obligation to provide a product or service.

Step 3 The transaction price for a bag of Smoke Jumper beans sold to Tyler is $9, not $10. The transac-
tion price is the amount that a company expects to receive from a customer in exchange for transferring
goods and services. [5] The transaction price in a contract is often easily determined because the cus-
tomer agrees to pay a fixed amount to the company over a short period of time. In other contracts,
companies must consider adjustments such as when they make payments or provide some other
consideration to their customers (e.g., a coupon) as part of a revenue arrangement.3

Step 4 BEAN allocates the transaction price to the performance obligations. Given that there is only one
performance obligation, no allocation is necessary.
Step 5 BEAN has satisfied the performance obligation as control of the product has passed to Tyler.

Solution: BEAN should recognize $9 of revenue when Tyler receives the Smoke Jumper coffee
beans.

3
We provide expanded discussion and examples of variation in transaction price, including variable
consideration, later in the chapter.
 Fundamentals of Revenue Recognition 985

Allocating the Transaction Price to Separate Performance

Obligations—Step 4
For revenue arrangements with multiple performance obligations, BEAN might be
required to allocate the transaction price to more than one performance obligation in the
contract. If an allocation is needed, the transaction price is allocated to the various
performance obligations based on their relative standalone selling prices. If this infor-
mation is not available, companies should use their best estimate of what the good or
service might sell for as a standalone unit. [6]
BEAN wants to provide even more incentive for customers to buy its coffee beans,
as well as purchase a cup of coffee. BEAN therefore offers customers a $2 discount on
the purchase of a large cup of coffee when they buy a bag of its premium Motor Moka
beans (which normally sell for $12) at the same time. Tyler decides this offer is too good
to pass up and buys a bag of Motor Moka beans for $12 and a large cup of coffee for $1.
As indicated earlier, a large cup of coffee normally retails for $3 at BEAN.

Question: How much revenue should BEAN recognize on the purchase of these two items?

Step 1 In our previous situations, valid contracts have existed. The same is also true for the sale of a bag
of Motor Moka beans and the large cup of coffee.
Step 2 The bag of Motor Moka beans and the large cup of coffee are distinct from one another and are
not highly dependent on or highly interrelated with the other. BEAN can sell a bag of the Motor Moka beans
and a large cup of coffee separately. Furthermore, Tyler benefits separately from both the large cup of
coffee and the Motor Moka coffee beans.
Step 3 BEAN’s transaction price is $13 ($12 for the bag of Motor Moka beans and $1 for the large cup
of coffee).

Step 4 BEAN allocates the transaction price to the two performance obligations based on their relative
standalone selling prices. The standalone selling price of a bag of Motor Moka beans is $12 and the large
cup of coffee is $3. The allocation of the transaction price of $13 is as follows.

Product Standalone Selling Price Percentage Allocated Amount

Motor Moka beans (one bag) $12 80% ($12 ÷ $15) $10.40 ($13 × 80%)
Large cup of coffee 3 20 ($3 ÷ $15) 2.60 ($13 × 20%)
Total $15 100% $13.00

As indicated, the total transaction price ($13) is allocated $10.40 to the bag of Motor Moka beans and
$2.60 to the large cup of coffee.

Step 5 BEAN has satisfied both performance obligations as control of the bag of Motor Moka beans and
the large cup of coffee has passed to Tyler.

Solution: BEAN should recognize revenue of $13, comprised of revenue from the sale of the Motor
Moka beans at $10.40 and the sale of the large cup of coffee at $2.60.

Recognizing Revenue When (or as) Each Performance

Obligation Is Satisfied—Step 5
As indicted in the examples presented, BEAN satisfied its performance obligation(s)
when Tyler obtained control of the product(s). Change in control is the deciding factor in
determining when a performance obligation is satisfied. A customer controls the product
or service when the customer has the ability to direct the use of and obtain substantially
all the remaining benefits from the product. Control also includes Tyler’s ability to pre-
vent other companies from directing the use of, or receiving benefits from, the coffee or
986 Chapter 18 Revenue Recognition

coffee beans. As discussed earlier, the indicators that Tyler has obtained control are
as follows:
a. BEAN has the right to payment for the coffee.
b. BEAN has transferred legal title to the coffee.
c. BEAN has transferred physical possession of the coffee.
d. Tyler has significant risks and rewards of ownership.
e. Tyler has accepted the asset.4

LEARNING OBJECTIVE 2 THE FIVE-STEP PROCESS REVISITED

Understand and apply The Boeing and BEAN examples provide a basic understanding of the five-step process
the five-step revenue used to recognize revenue. We now discuss more technical issues related to the imple-
recognition process. mentation of these five steps.

Identifying the Contract with Customers—Step 1

A contract is an agreement between two or more parties that creates enforceable rights or
obligations. Contracts can be written, oral, or implied from customary business practice
(such as the BEAN contract with Tyler). Revenue is recognized only when a valid contract
exists. On entering into a contract with a customer, a company obtains rights to receive
consideration from the customer and assumes obligations to transfer goods or services to
the customer (performance obligations). The combination of those rights and performance
obligations gives rise to an (net) asset or (net) liability.
In some cases, there are multiple contracts related to an arrangement; accounting
for each contract may or may not occur, depending upon the circumstances. These situ-
ations often develop when not only a product is provided but some type of service is
performed as well. To be valid, a contract must meet the five conditions illustrated in the
BEAN example. If the contract is wholly unperformed and each party can unilaterally
terminate the contract without compensation, then revenue should not be recognized
until one or both of the parties has performed. A basic contract where these issues are
discussed is presented in Illustration 18-3.
ILLUSTRATION 18-3 CONTRACTS AND RECOGNITION
Basic Revenue Transaction
Facts: On March 1, 2017, Margo Company enters into a contract to transfer a product to Soon Yoon on
July 31, 2017. The contract is structured such that Soon Yoon is required to pay the full contract price of
$5,000 on August 31, 2017. The cost of the goods transferred is $3,000. Margo delivers the product to
Soon Yoon on July 31, 2017. Either party can unilaterally terminate the contract without compensation.

Question: What journal entries should Margo Company make in regards to this contract in 2017?

Solution: No entry is required on March 1, 2017, because neither party has performed on the contract.
On July 31, 2017, Margo delivers the product and therefore should recognize revenue on that date as
it satisfies its performance obligation by delivering the product to Soon Yoon.
The journal entry to record the sale and related cost of goods sold is as follows.
July 31, 2017
Accounts Receivable 5,000
Sales Revenue 5,000
Cost of Goods Sold 3,000
Inventory 3,000
After receiving the cash payment on August 31, 2017, Margo makes the following entry.
August 31, 2017
Cash 5,000
Accounts Receivable 5,000

4
While in the BEAN example recognition occurred at a point in time, in certain cases, companies satisfy
performance obligations over a period of time. We address the criteria for determining point-in-time versus
over-time recognition later in the chapter.
 The Five-Step Process Revisited 987

A key feature of the revenue arrangement is that the contract between the two
parties is not recorded (does not result in a journal entry) until one or both of the
parties perform under the contract. Until performance occurs, no net asset or net
liability occurs.5

Identifying Separate Performance Obligations—Step 2

A performance obligation is a promise to provide a product or service to a customer.
This promise may be explicit, implicit, or possibly based on customary business prac-
tice. To determine whether a performance obligation exists, the company must provide
a distinct product or service to the customer.
A product or service is distinct when a customer is able to benefit from a good
or service on its own or together with other readily available resources. This situa-
tion typically occurs when the company can sell a good or service on a standalone
basis (can be sold separately). For example, BEAN provided a good (a large cup of
coffee) on a standalone basis to Tyler. Tyler benefited from this cup of coffee by con-
suming it.
To determine whether a company has to account for multiple performance obligations,
the company’s promise to sell the good or service to the customer must be separately
identifiable from other promises within the contract (that is, the good or service must be
distinct within the contract). In other words, the objective is to determine whether the
nature of a company’s promise is to transfer individual goods and services to the cus-
tomer or to transfer a combined item (or items) for which individual goods or services
are inputs.
For example, when BEAN sold Tyler a large cup of coffee and two bagels, two per-
formance obligations occurred. In that case, the large cup of coffee had a standalone
selling price and the two bagels had a standalone selling price—even though the two
promises may be part of one contract.
Conversely, assume that BEAN sold a large latte (comprised of coffee and milk) to
Tyler. In this case, BEAN sold two distinct products (coffee and milk), but these two
goods are not distinct within the contract. That is, the coffee and milk in the latte are
highly interdependent or interrelated within the contract. As a result, the products are
combined and reported as one performance obligation.
To illustrate another situation, assume that General Motors sells an automobile
to Marquart Auto Dealers at a price that includes six months of telematics services
such as navigation and remote diagnostics. These telematics services are regularly
sold on a standalone basis by General Motors for a monthly fee. After the six-month
period, the consumer can renew these services on a fee basis with General Motors.
The question is whether General Motors sold one or two products. If we look at
General Motors’ objective, it appears that it is to sell two goods, the automobile and
the telematic services. Both are distinct (they can be sold separately) and are not
interdependent.
As another example, SoftTech Inc. licenses customer-relationship software to Lopez
Company. In addition to providing the software itself, SoftTech promises to perform
consulting services by extensively customizing the software to Lopez’s information

5
Recall a valid contract exists when (1) the contract has commercial substance, (2) the parties have
approved the contract, (3) the contract identifies the rights of the parties, (4) payment terms are identified,
and (5) it is probable that the consideration will be collected. The FASB included this last criterion (which
acts like a collectibility threshold) because the Board concluded that the assessment of a customer’s credit
risk was important to determine whether a contract is valid. That is, under the revenue standard (and
discussed later in the chapter), collectibility is not a consideration for determining whether revenue is
recognized. However, collectibility may be a consideration in assessing whether parties to the contract are
committed to perform. In determining whether it is probable that a company will collect the amount of
consideration to which it is entitled, the company assesses both the customer’s ability and intent to pay as
amounts become due. [7]
988 Chapter 18 Revenue Recognition

technology environment, for total consideration of $600,000. In this case, the objective of
SoftTech appears to be to transfer a combined product and service for which indi-
vidual goods and services are inputs. In other words, SoftTech is providing a sig-
nificant service by integrating the goods and services (the license and the consulting
service) into one combined item for which Lopez has contracted. In addition, the soft-
ware is significantly customized by SoftTech in accordance with specifications negoti-
ated by Lopez. As a result, the license and the consulting services are distinct but
interdependent, and therefore should be accounted for as one performance
obligation.6

Determining the Transaction Price—Step 3

The transaction price is the amount of consideration that a company expects to receive
from a customer in exchange for transferring goods and services. The transaction price
in a contract is often easily determined because the customer agrees to pay a fixed
amount to the company over a short period of time. In other contracts, companies must
consider the following factors. [8]

• Variable consideration
• Time value of money
• Noncash consideration
• Consideration paid or payable to the customer

Variable Consideration
In some cases, the price of a good or service is dependent on future events. These
future events might include price increases, volume discounts, rebates, credits, perfor-
mance bonuses, or royalties. In these cases, the company estimates the amount of
UNDERLYING
variable consideration it will receive from the contract to determine the amount of
CONCEPTS
revenue to recognize. Companies use either the expected value, which is a probability-
The expected value weighted amount, or the most likely amount in a range of possible amounts to esti-
approach is also illus- mate variable consideration. Companies select among these two methods based on
trated in Chapter 6 to
which approach better predicts the amount of consideration to which a company is
determine the liability for
warranties.
entitled. [9] Illustration 18-4 highlights the issues to be considered in selecting the
appropriate method.

ILLUSTRATION 18-4 Expected Value: Probability-weighted amount Most Likely Amount: The single most likely amount
Estimating Variable in a range of possible consideration amounts. in a range of possible consideration outcomes.
Consideration
• May be appropriate if a company has a large • May be appropriate if the contract has only two
number of contracts with similar characteristics. possible outcomes.
• Can be based on a limited number of discrete
outcomes and probabilities.

Illustration 18-5 provides an application of the two estimation methods.

6
In practice, determining whether multiple performance obligations exist can be complex. For homework
purposes, you need to determine the objective of the transaction. If the objective is to transfer individual goods
or services, then account for these performance obligations separately. Indicators that help to understand
whether performance obligations should be accounted for separately are (1) the performance obligations
have a standalone selling price and (2) the goods or services are not highly interdependent or
interrelated.
 The Five-Step Process Revisited 989

ILLUSTRATION 18-5
ESTIMATING VARIABLE CONSIDERATION
Transaction Price—Variable
Facts: Peabody Construction Company enters into a contract with a customer to build a warehouse for Consideration
$100,000, with a performance bonus of $50,000 that will be paid based on the timing of completion. The
amount of the performance bonus decreases by 10% per week for every week beyond the agreed-upon
completion date. The contract requirements are similar to contracts that Peabody has performed previously,
and management believes that such experience is predictive for this contract. Management estimates that there
is a 60% probability that the contract will be completed by the agreed-upon completion date, a 30% probability
that it will be completed 1 week late, and only a 10% probability that it will be completed 2 weeks late.

Question: How should Peabody account for this revenue arrangement?

Solution: The transaction price should include management’s estimate of the amount of consideration
to which Peabody will be entitled. Management has concluded that the probability-weighted method
is the most predictive approach for estimating the variable consideration in this situation:
On time: 60% chance of $150,000 [$100,000 + ($50,000 × 1.0)] = $ 90,000
1 week late: 30% chance of $145,000 [$100,000 + ($50,000 × .90)] = 43,500
2 weeks late: 10% chance of $140,000 [$100,000 + ($50,000 × .80)] = 14,000
$147,500

Thus, the total transaction price is $147,500 based on the probability-weighted estimate. Management
should update its estimate at each reporting date. Using a most likely outcome approach may be more
predictive if a performance bonus is binary (Peabody either will or will not earn the performance bonus),
such that Peabody earns either $50,000 for completion on the agreed-upon date or nothing for
completion after the agreed-upon date. In this scenario, if management believes that Peabody will
meet the deadline and estimates the consideration using the most likely outcome, the total transaction
price would be $150,000 (the outcome with 60% probability).

A word of caution—a company only allocates variable consideration if it is reason-

ably assured that it will be entitled to that amount. Companies therefore may only
recognize variable consideration if (1) they have experience with similar contracts and
are able to estimate the cumulative amount of revenue, and (2) based on experience, it
is highly probable that there will not be a significant reversal of revenue previously
recognized.7 If these criteria are not met, revenue recognition is constrained. [11]
Illustration 18-6 provides an example of how the revenue constraint works.
ILLUSTRATION 18-6
REVENUE CONSTRAINT
Transaction Price—
Facts: On January 1, Shera Company enters into a contract with Hornung Inc. to perform asset-management Revenue Constraint
services for 1 year. Shera receives a quarterly management fee based on a percentage of Hornung’s assets
under management at the end of each quarter. In addition, Shera receives a performance-based incentive
fee of 20% of the fund’s return in excess of the return of an observable index at the end of the year.
Shera accounts for the contract as a single performance obligation to perform investment-management
services for 1 year because the services are interdependent and interrelated. To recognize revenue for
satisfying the performance obligation over time, Shera selects an output method of measuring progress
toward complete satisfaction of the performance obligation. Shera has had a number of these types of
contracts with customers in the past.

Question: At what point should Shera recognize the management fee and the
performance-based incentive fee related to Hornung?

Solution: Shera should record the management fee each quarter as it performs the management of the
fund. However, Shera should not record the incentive fee until the end of the year. Although Shera has
experience with similar contracts, that experience is not predictive of the outcome of the current contract
because the amount of consideration is highly susceptible to volatility in the market. In addition, the incentive
fee has a large number and high variability of possible consideration amounts. Thus, revenue related to the
incentive fee is constrained (not recognized) until the incentive fee is known at the end of the year.

7
Conditions such as one of the following would indicate that the revenue is constrained (or not recognized):
1. The amount of consideration is highly susceptible to factors outside the company’s influence. Factors
include volatility in a market, the judgment of third parties, weather conditions, and a high risk of
obsolescence of the promised good or service.
2. The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
3. The company’s experience (or other evidence) with similar types of performance obligations is limited.
4. The contract has a large number and broad range of possible consideration amounts. [10]
990 Chapter 18 Revenue Recognition

Time Value of Money

Timing of payment to the company sometimes does not match the transfer of the goods
or services to the customer. In most situations, companies receive consideration after the
product is provided or the service performed. In essence, the company provides financ-
ing for the customer.
Companies account for the time value of money if the contract involves a signifi-
cant financing component. When a sales transaction involves a significant financing
component (i.e., interest is accrued on consideration to be paid over time), the fair value
is determined either by measuring the consideration received or by discounting the
payment using an imputed interest rate. The imputed interest rate is the more clearly
determinable of either (1) the prevailing rate for a similar instrument of an issuer with a
similar credit rating, or (2) a rate of interest that discounts the nominal amount of the
instrument to the current sales price of the goods or services. The company will report
the effects of the financing either as interest expense or interest revenue. Illustration 18-7
provides an example of a financing transaction.

ILLUSTRATION 18-7
EXTENDED PAYMENT TERMS
Transaction Price—
Extended Payment Terms Facts: On July 1, 2017, SEK Company sold goods to Grant Company for $900,000 in exchange for a
4-year, zero-interest-bearing note with a face amount of $1,416,163. The goods have an inventory cost
on SEK’s books of $590,000.

Questions: (a) How much revenue should SEK Company record on July 1, 2017? (b) How
much revenue should it report related to this transaction on December 31, 2017?

Solution:
(a) SEK should record revenue of $900,000 on July 1, 2017, which is the fair value of the inventory in
this case.
(b) SEK is also financing this purchase and records interest revenue on the note over the 4-year
period. In this case, the interest rate is imputed and is determined to be 12%. SEK records interest
revenue of $54,000 (12% × ½ × $900,000) at December 31, 2017.

The entry to record SEK’s sale to Grant Company is as follows.

July 1, 2017
Notes Receivable 1,416,163
Discount on Notes Receivable 516,163
Sales Revenue 900,000

The related entry to record the cost of goods sold is as follows.

July 1, 2017
Cost of Goods Sold 590,000
Inventory 590,000

SEK makes the following entry to record (accrue) interest revenue at the end of the year.
December 31, 2017
Discount on Notes Receivable 54,000
Interest Revenue (12% × ½ × $900,000) 54,000

As a practical expedient, companies are not required to reflect the time value of money
to determine the transaction price if the time period for payment is less than a year. [12]

Noncash Consideration
Companies sometimes receive consideration in the form of goods, services, or other
noncash consideration. When these situations occur, companies generally recognize
revenue on the basis of the fair value of what is received. For example, assume that
Raylin Company receives common stock of Monroe Company in payment for consult-
ing services. In that case, Raylin Company recognizes revenue in the amount of the fair
 The Five-Step Process Revisited 991

value of the common stock received. If Raylin cannot determine this amount, then it
should estimate the selling price of the services performed and recognize this amount as
revenue.
In addition, companies sometimes receive contributions (e.g., donations and gifts).
A contribution is often some type of asset (e.g., securities, land, buildings, or use of
facilities) but it could be the forgiveness of debt. In these cases, companies recognize
revenue for the fair value of the consideration received. Similarly, customers sometimes
contribute goods or services, such as equipment or labor, as consideration for goods
provided or services performed. This consideration should be recognized as revenue
based on the fair value of the consideration received.

Consideration Paid or Payable to Customers

Companies often make payments to their customers as part of a revenue arrangement.
Consideration paid or payable may include discounts, volume rebates, coupons, free
products, or services. In general, these elements reduce the consideration received and
the revenue to be recognized. Illustration 18-8 provides an example of this type of
transaction.

ILLUSTRATION 18-8
VOLUME DISCOUNT
Transaction Price—
Facts: Sansung Company offers its customers a 3% volume discount if they purchase at least $2 million Volume Discount
of its product during the calendar year. On March 31, 2017, Sansung has made sales of $700,000 to Artic
Co. In the previous 2 years, Sansung sold over $3,000,000 to Artic in the period April 1 to December 31.
Assume that Sansung prepares financial statements quarterly.

Question: How much revenue should Sansung recognize for the first 3 months of
2017?

Solution: In this case, Sansung should reduce its revenue by $21,000 ($700,000 × 3%) because it is
probable that it will provide this rebate. Revenue is therefore $679,000 ($700,000 − $21,000). To not
recognize this volume discount overstates Sansung’s revenue for the first 3 months of 2017. In other
words, the appropriate revenue is $679,000, not $700,000.
Given these facts, Sansung makes the following entry on March 31, 2017, to recognize revenue.
Accounts Receivable 679,000
Sales Revenue 679,000

Assuming that Sansung’s customer meets the discount threshold, Sansung makes the following
entry to record collection of accounts receivable.
Cash 679,000
Accounts Receivable 679,000

If Sansung’s customer fails to meet the discount threshold, Sansung makes the following entry to
record collection of accounts receivable.
Cash 700,000
Accounts Receivable 679,000
Sales Discounts Forfeited 21,000

As indicated in Chapter 7 (pages 331–332), Sales Discounts Forfeited is reported in the “Other
revenues and gains” section of the income statement.

In many cases, companies provide cash discounts to customers for a short period
of time (often referred to as prompt settlement discounts). For example, assume
that terms are payment due in 60 days, but if payment is made within five days, a two
percent discount is given (referred to as 2/5, net 60). These prompt settlement dis-
counts should reduce revenues, if material. In most cases, companies record the rev-
enue at full price (gross) and record a sales discount if payment is made within the
discount period.
992 Chapter 18 Revenue Recognition

Allocating the Transaction Price to Separate

Performance Obligations—Step 4
Companies often have to allocate the transaction price to more than one performance
obligation in a contract. If an allocation is needed, the transaction price allocated to the
various performance obligations is based on their relative fair values. The best measure
of fair value is what the company could sell the good or service for on a standalone
basis, referred to as the standalone selling price. If this information is not available,
companies should use their best estimate of what the good or service might sell for as a
standalone unit. Illustration 18-9 summarizes the approaches that companies follow (in
preferred order of use).

ILLUSTRATION 18-9
Allocation Approach Implementation
Transaction Price—
Allocation Evaluate the market in which it sells goods or services
and estimate the price that customers in that market
are willing to pay for those goods or services. That
Adjusted market assessment approach approach also might include referring to prices from
the company’s competitors for similar goods or
services and adjusting those prices as necessary to
reflect the company’s costs and margins.
Forecast expected costs of satisfying a performance
Expected cost plus a margin approach obligation and then add an appropriate margin for that
good or service.
If the standalone selling price of a good or service is
highly variable or uncertain, then a company may
estimate the standalone selling price by reference to
Residual approach
the total transaction price less the sum of the observ-
able standalone selling prices of other goods or
services promised in the contract.8

To illustrate, Travis Company enters into a contract with a customer to sell Products
A, B, and C in exchange for $100,000. Travis Company regularly sells Product A sepa-
rately, and therefore the standalone selling price is directly observable at $50,000. The
standalone selling price of Product B is estimated using the adjusted market assessment
approach and is determined to be $30,000. Travis Company decides to use the residual
approach to value Product C as it has confidence that Products A and B are valued cor-
rectly. The selling price for the products is allocated as shown in Illustration 18-10.

ILLUSTRATION 18-10
Product Price Rationale
Residual Value Allocation
A $ 50,000 Directly observable using standalone selling price.
B 30,000 Directly observable using adjusted market assessment approach.
C 20,000 [$100,000 − ($50,000 + $30,000)]; using the residual approach given
reliability of the two above measurements.
Total trans-
action price $100,000

Illustrations 18-11 and 18-12 are additional examples of the measurement issues
involved in allocating the transaction price.
8
A selling price is highly variable when a company sells the same good or service to different customers
(at or near the same time) for a broad range of amounts. A selling price is uncertain when a company
has not yet established a price for a good or service and the good or service has not previously been
sold. [13]
 The Five-Step Process Revisited 993

ILLUSTRATION 18-11
MULTIPLE PERFORMANCE OBLIGATIONS—EXAMPLE 1
Allocation—Multiple
Facts: Lonnie Company enters into a contract to build, run, and maintain a highly complex piece of electronic Performance Obligations
equipment for a period of 5 years, commencing upon delivery of the equipment. There is a fixed fee for each
of the build, run, and maintenance deliverables, and any progress payments made are nonrefundable. It is
determined that the transaction price must be allocated to the three performance obligations: building,
running, and maintaining the equipment. There is verifiable evidence of the selling price for the building and
maintenance but not for running the equipment.

Question: What procedure should Lonnie Company use to allocate the transaction
price to the three performance obligations?

Solution: The performance obligations relate to building the equipment, running the equipment, and
maintaining the equipment. As indicated, Lonnie can determine verifiable standalone selling prices for
the equipment and the maintenance agreements. The company then can make a best estimate of the
selling price for running the equipment, using the adjusted market assessment approach or expected
cost plus a margin approach. Lonnie next applies the proportional standalone selling price method at
the inception of the transaction to determine the proper allocation to each performance obligation.
Once the allocation is performed, Lonnie recognizes revenue independently for each performance
obligation using regular revenue recognition criteria.
If, on the other hand, Lonnie is unable to estimate the standalone selling price for running the
equipment because such an estimate is highly variable or uncertain, Lonnie may use a residual approach.
In this case, Lonnie uses the standalone selling prices of the equipment and maintenance agreements and
subtracts these prices from the total transaction price to arrive at a residual value for running the equipment.

ILLUSTRATION 18-12
MULTIPLE PERFORMANCE OBLIGATIONS—EXAMPLE 2
Multiple Performance
Facts: Handler Company is an established manufacturer of equipment used in the construction industry. Obligations—Product,
Handler’s products range from small to large individual pieces of automated machinery to complex systems Installation, and Service
containing numerous components. Unit selling prices range from $600,000 to $4,000,000 and are quoted
inclusive of installation and training. The installation process does not involve changes to the features of
the equipment and does not require proprietary information about the equipment in order for the installed
equipment to perform to specifications. Handler has the following arrangement with Chai Company.
• Chai purchases equipment from Handler for a price of $2,000,000 and chooses Handler to do the
installation. Handler charges the same price for the equipment irrespective of whether it does the
installation or not. (Some companies do the installation themselves because they either prefer their
own employees to do the work or because of relationships with other customers.) The installation
service included in the arrangement is estimated to have a standalone selling price of $20,000.
• The standalone selling price of the training sessions is estimated at $50,000. Other companies can
also perform these training services.
• Chai is obligated to pay Handler the $2,000,000 upon the delivery and installation of the equipment.
• Handler delivers the equipment on September 1, 2017, and completes the installation of the equipment
on November 1, 2017 (transfer of control is complete). Training related to the equipment starts once
the installation is completed and lasts for 1 year. The equipment has a useful life of 10 years.

Questions: (a) What are the performance obligations for purposes of accounting for
the sale of the equipment? (b) If there is more than one performance obligation,
how should the payment of $2,000,000 be allocated to various components?

Solution:
(a) Handler’s primary objective is to sell equipment. The other services (installation and training) can
be performed by other parties if necessary. As a result, the equipment, installation, and training are
three separate products or services. Each of these items has a standalone selling price and is not
interdependent.
(b) The total revenue of $2,000,000 should be allocated to the three components based on their relative
standalone selling prices. In this case, the standalone selling price of the equipment is $2,000,000, the
installation fee is $20,000, and the training is $50,000. The total standalone selling price therefore is
$2,070,000 ($2,000,000 + $20,000 + $50,000). The allocation is as follows.
Equipment $1,932,367 [($2,000,000 ÷ $2,070,000) × $2,000,000]
Installation $19,324 [($20,000 ÷ $2,070,000) × $2,000,000]
Training $48,309 [($50,000 ÷ $2,070,000) × $2,000,000]

(continued)
994 Chapter 18 Revenue Recognition

ILLUSTRATION 18-12
Multiple Performance Handler makes the following entry on November 1, 2017, to record both sales revenue and service
Obligations—Product, revenue on the installation, as well as unearned service revenue.
Installation, and Service November 1, 2017
(Continued) Cash 2,000,000
Service Revenue (installation) 19,324
Unearned Service Revenue 48,309
Sales Revenue 1,932,367
Assuming the cost of the equipment is $1,500,000, the entry to record cost of goods sold is as follows.
November 1, 2017
Cost of Goods Sold 1,500,000
Inventory 1,500,000
As indicated by these entries, Handler recognizes revenue from the sale of the equipment once the
installation is completed on November 1, 2017. In addition, it recognizes revenue for the installation fee
because these services have been performed.
Handler recognizes the training revenues on a straight-line basis starting on November 1, 2017,
or $4,026 ($48,309 ÷ 12) per month for 1 year (unless a more appropriate method such as the
percentage-of-completion method—discussed in the next section—is warranted). The journal entry to
recognize the training revenue for 2 months in 2017 is as follows.
December 31, 2017
Unearned Service Revenue 8,052
Service Revenue (training) ($4,026 × 2) 8,052
Therefore, Handler recognizes revenue at December 31, 2017, in the amount of $1,959,743 ($1,932,367
+ $19,324 + $8,052). Handler makes the following journal entry to recognize the remaining training
revenue in 2018, assuming adjusting entries are made at year-end.
December 31, 2018
Unearned Service Revenue 40,257
Service Revenue (training) ($48,309 − $8,052) 40,257

Recognizing Revenue When (or as) Each

Performance Obligation Is Satisfied—Step 5
A company satisfies its performance obligation when the customer obtains control of the
good or service. As indicated in the Handler example (in Illustration 18–12) and the BEAN
example, the concept of change in control is the deciding factor in determining when a
performance obligation is satisfied. The customer controls the product or service when it
has the ability to direct the use of and obtain substantially all the remaining benefits from
the asset or service. Control also includes the customer’s ability to prevent other compa-
nies from directing the use of, or receiving the benefits, from the asset or service. Illustra-
tion 18-13 summarizes the indicators that the customer has obtained control. [14]

ILLUSTRATION 18-13
1. The company has a right to payment for the asset.
Change in Control
2. The company has transferred legal title to the asset.
Indicators
3. The company has transferred physical possession of the asset.
4. The customer has significant risks and rewards of ownership.
5. The customer has accepted the asset.

This is a list of indicators, not requirements or criteria. Not all of the indicators need
to be met for management to conclude that control has transferred and revenue can be
recognized. Management must use judgment to determine whether the factors collec-
tively indicate that the customer has obtained control. This assessment should be
focused primarily on the customer’s perspective.
Companies satisfy performance obligations either at a point in time or over a
period of time. Companies recognize revenue over a period of time if one of the follow-
ing three criteria is met.

1. The customer receives and consumes the benefits as the seller performs.
 The Five-Step Process Revisited 995

2. The customer controls the asset as it is created or enhanced (e.g., a builder constructs
a building on a customer’s property).
3. The company does not have an alternative use for the asset created or enhanced (e.g.,
an aircraft manufacturer builds specialty jets to a customer’s specifications) and either
(a) the customer receives benefits as the company performs and therefore the task
would not need to be re-performed, or (b) the company has a right to payment and
this right is enforceable.

Illustration 18-14 provides an example of the point in time when revenue should be
recognized.

ILLUSTRATION 18-14
TIMING OF REVENUE RECOGNITION
Satisfying a Performance
Facts: Gomez Software Company enters into a contract with Hurly Company to develop and install Obligation
customer relationship management (CRM) software. Progress payments are made upon completion of
each stage of the contract. If the contract is terminated, then the partly completed CRM software
passes to Hurly Company. Gomez Software is prohibited from redirecting the software to another
customer.

Question: At what point should Gomez Software Company recognize revenue

related to its contract with Hurly Company?

Solution: Gomez Software does not create an asset with an alternative use because it is prohibited
from redirecting the software to another customer. In addition, Gomez Software is entitled to payments
for performance to date and expects to complete the project. Therefore, Gomez Software concludes
that the contract meets the criteria for recognizing revenue over time.

A company recognizes revenue from a performance obligation over time by mea-

suring the progress toward completion. The method selected for measuring progress
should depict the transfer of control from the company to the customer. For many ser-
vice arrangements, revenue is recognized on a straight-line basis because the perfor-
mance obligation is being satisfied ratably over the contract period. In other settings
(e.g., long-term construction contracts), companies use various methods to determine
the extent of progress toward completion. The most common are the cost-to-cost and
units-of-delivery methods. The objective of all these methods is to measure the extent of
progress in terms of costs, units, or value added. Companies identify the various mea-
sures (costs incurred, labor hours worked, tons produced, floors completed, etc.) and
classify them as input or output measures.
Input measures (e.g., costs incurred and labor hours worked) are efforts devoted to
a contract. Output measures (with units of delivery measured as tons produced, floors
of a building completed, miles of a highway completed, etc.) track results. Neither is
universally applicable to all long-term projects. Their use requires the exercise of judg-
ment and careful tailoring to the circumstances.
The most popular input measure used to determine the progress toward comple-
tion is the cost-to-cost basis. Under this basis, a company measures the percentage of
completion by comparing costs incurred to date with the most recent estimate of the
total costs required to complete the contract. The percentage-of-completion method is
discussed more fully in Appendix 18A, which examines the accounting for long-term
contracts.

Summary
Illustration 18-15 (on page 996) provides a summary of the five-step revenue recognition
process.
996 Chapter 18 Revenue Recognition

ILLUSTRATION 18-15
Summary of the Five-Step
Revenue Recognition Process
Step in Process Description Implementation

1. Identify the contract A contract is an agreement that creates enforceable A company applies the revenue guidance to
with customers. rights or obligations. contracts with customers.

2. Identify the separate A performance obligation is a promise in a contract A contract may be comprised of multiple
performance to provide a product or service to a customer. performance obligations. The accounting for
obligations in A performance obligation exists if the customer can multiple performance obligations is based on
the contract. benefit from the good or service on its own or together evaluation of whether the product or service is
with other readily available resources. distinct within the contract. If each of the goods
or services is distinct, but is interdependent and
interrelated, these goods and services are combined
and reported as one performance obligation.

3. Determine the The transaction price is the amount of consideration In determining the transaction price, companies
transaction price. that a company expects to receive from a customer must consider the following factors: (1) variable
in exchange for transferring goods and services. consideration, (2) time value of money,
(3) noncash consideration, and (4) consideration
paid or payable to customer.

4. Allocate the If more than one performance obligation exists, allocate The best measure of fair value is what the good or
transaction price to the the transaction price based on relative fair values. service could be sold for on a standalone basis
separate performance (standalone selling price). Estimates of standalone
obligations. selling price can be based on (1) adjusted market
assessment, (2) expected cost plus a margin
approach, or (3) a residual approach.

5. Recognize revenue A company satisfies its performance obligation Companies satisfy performance obligations either
when each perfor- when the customer obtains control of the good at a point in time or over a period of time. Companies
mance obligation or service. recognize revenue over a period of time if one of
is satisfied. the following criteria is met: (1) the customer
receives and consumes the benefits as the seller
performs, (2) the customer controls the asset as it
is created, or (3) the company does not have an
alternative use for the asset.

LEARNING OBJECTIVE 3 ACCOUNTING FOR REVENUE

Apply the five-step RECOGNITION ISSUES
process to major revenue
recognition issues. This section addresses revenue recognition issues found in practice. Most of these issues
relate to determining the transaction price (Step 3) and evaluating when control of the
product or service passes to the customer (Step 5). The revenue recognition principle
and the concept of control are illustrated for the following situations.
• Sales returns and allowances • Consignments
• Repurchase agreements • Warranties
• Bill and hold • Nonrefundable upfront fees
• Principal-agent relationships

Sales Returns and Allowances

Sales returns and allowances are very common for many companies that sell goods to
customers. For example, assume that Fafco Solar sells solar panels to customers on
account. Fafco grants customers the right of return for these panels for various reasons
(e.g., dissatisfaction with the product) and to receive any combination of the following.

1. A full or partial refund of any consideration paid.

2. A credit that can be applied against amounts owed, or that will be owed, to the seller.
3. Another product in exchange.
 Accounting for Revenue Recognition issues 997

To account for these sales returns and allowances, Fafco should recognize the
following:

(a) Revenue for the transferred solar panels in the amount of consideration to which
Fafco is reasonably assured to be entitled (considering the products to be returned
or allowance granted).
(b) An asset (and corresponding adjustment to cost of goods sold) for the goods
returned from customers.

Credit Sales with Returns and Allowances

To illustrate the accounting for a return situation in more detail, assume that on January
12, 2017, Venden Company sells 100 cameras for $100 each on account to Amaya Inc.
Venden allows Amaya to return any unused cameras within 45 days of purchase. The
cost of each product is $60. Venden estimates that:

1. Three products will be returned.

2. The cost of recovering the products will be immaterial.
3. The returned products are expected to be resold at a profit.

On January 24, Amaya returns two of the cameras because they were the wrong
color. On January 31, Venden prepares financial statements and determines that it is
likely that only one more camera will be returned. Venden makes the following entries
related to these transactions.

To record the sale of the cameras and related cost of goods sold on January 12, 2017

Accounts Receivable 10,000

Sales Revenue (100 × $100) 10,000
Cost of Goods Sold 6,000
Inventory (100 × $60) 6,000

To record the return of the two cameras on January 24, 2017

Sales Returns and Allowances 200

Accounts Receivable (2 × $100) 200
Returned Inventory 120
Cost of Goods Sold (2 × $60) 120

The Sales Returns and Allowances account is a contra-account to Sales Revenue.

The Returned Inventory account is used to separate returned inventory from regular
inventory.
On January 31, 2017, Venden prepares financial statements. As indicated earlier,
Venden originally estimated that the most likely outcome was that three cameras would
be returned. Venden believes the original estimate is correct and makes the following
adjusting entries to account for expected returns at January 31, 2017.

To record expected sales returns on January 31, 2017

Sales Returns and Allowances 100

Allowance for Sales Returns and Allowances (1 × $100) 100

To record the expected return of the one camera and related reduction in Cost of Goods Sold

Estimated Inventory Returns 60

Cost of Goods Sold (1 × $60) 60
998 Chapter 18 Revenue Recognition

The Allowance for Sales Returns and Allowances account is a contra-account to

Accounts Receivable. The Estimated Inventory Returns account will generally be added
to the Returned Inventory account at the end of the reporting period.9
For the month of January, Venden’s income statement reports the information pre-
sented in Illustration 18-16.

ILLUSTRATION 18-16
Sales revenue (100 × $100) $10,000
Income Statement
Less: Sales returns and allowances ($200 + $100) 300
Reporting
Net sales 9,700
Cost of goods sold (97 × $60) 5,820
Gross profit $ 3,880

As a result, at the end of the reporting period, the net sales reflects the amount that
Venden is entitled to collect.
Venden reports the following information in the balance sheet as of January 31,
2017.

ILLUSTRATION 18-17
Accounts receivable ($10,000 – $200) $9,800
Balance Sheet Reporting
Less: Allowance for sales returns and allowances 100
Accounts receivable (net) $9,700
Returned inventory (including estimated) (3 × $60) $ 180

Cash Sales with Returns and Allowances

Assume now that Venden sold the cameras to Amaya for cash instead of on account. In
this situation, Venden makes the following entries related to these transactions.

To record the sale of the cameras and related cost of goods sold on January 12, 2017

Cash 10,000
Sales Revenue (100 × $100) 10,000
Cost of Goods Sold 6,000
Inventory (100 × $60) 6,000

Assuming that Venden did not pay cash at the time of the return of the two cameras
to Amaya on January 24, 2017, the entries to record the return of the two cameras and
related cost of goods sold are as follows.

9
As indicated, at the date of sale, both sales revenue and accounts receivable are recorded at their gross
amounts without consideration of sales returns and allowances. Then, at the end of the reporting period,
adjusting entries are made, resulting in both sales revenues and accounts receivable being reported at net
amounts and which reflect actual and estimated returns and allowances. As discussed in Chapter 7, most
companies follow this adjusting entry approach because estimating net sales at the date of sale is often
difficult and time-consuming. In addition, recording accounts receivables net at the sale date may lead to a
lack of correspondence between the control account and the subsidiary ledger related to accounts receivable.
By waiting to make the necessary adjusting entries at the end of the reporting period, information related to
actual sales returns and allowances is available, and a company still achieves the FASB’s objective of
reflecting accounts receivable and sales revenue at the amount the company is entitled to receive (and
inventories and cost of goods sold at cost).
 Accounting for Revenue Recognition issues 999

To record the return of two cameras on January 24, 2017

Sales Returns and Allowances 200

Accounts Payable (2 × $100) 200
Returned Inventory 120
Cost of Goods Sold (2 × $60) 120

Venden records an accounts payable to Amaya to recognize that it owes Amaya for
the return of two cameras. As indicated earlier, the Sales Returns and Allowances
account is a contra-revenue account. The Returned Inventory account is used to sepa-
rate returned inventory from regular inventory.
On January 31, 2017, Venden prepares financial statements. As indicated earlier,
Venden estimates that the most likely outcome is that one more camera will be returned.
Venden therefore makes the following adjusting entries.

To record expected sales returns on January 31, 2017

Sales Returns and Allowances 100

Accounts Payable (1 × $100) 100
To record the expected return of the one camera and related Cost of Goods Sold

Estimated Inventory Returns 60

Cost of Goods Sold (1 × $60) 60

At January 31, 2017, Venden records an accounts payable to recognize its estimated
additional liability to Amaya for expected future returns. The Estimated Inventory
Returns account will generally be added to the Returned Inventory account at the end
of the reporting period to identify returned and estimated inventory returns.
Illustration 18-18 presents the information related to these sales that will be reported
on Venden’s income statement for the month of January.
ILLUSTRATION 18-18
Sales revenue (100 × $100) $10,000
Income Statement
Less: Sales returns and allowances (3 × $100) 300
Reporting Sales Returns
Net sales 9,700
and Allowances
Cost of goods sold (97 × $60) 5,820
Gross profit $ 3,880

On Venden’s balance sheet as of January 31, 2017, the following information is reported.
ILLUSTRATION 18-19
Cash (assuming no cash payments to date to Amaya) $10,000
Balance Sheet Reporting
Returned inventory (including estimated) (3 × $60) 180
Sales Returns and
Accounts payable ($200 + $100) 300 Allowances

Companies record the returned asset in a separate account from inventory to provide
transparency. The carrying value of the returned asset is subject to impairment testing,
separate from the inventory. If a company is unable to estimate the level of returns with
any reliability, it should not report any revenue until the returns become predictive.

Repurchase Agreements
In some cases, companies enter into repurchase agreements, which allow them to trans-
fer an asset to a customer but have an unconditional (forward) obligation or uncondi-
tional right (call option) to repurchase the asset at a later date. In these situations, the
question is whether the company sold the asset.10 Generally, companies report these
10
Beyond financing motivations, a company may transfer inventory to another party on a short-term basis
to avoid inventory taxes. If the counterparty is able to use the inventory during the transfer period, the
transaction may more appropriately be accounted for as a rental agreement.
1000 Chapter 18 Revenue Recognition

transactions as a financing (borrowing). That is, if the company has a forward obligation
or call option to repurchase the asset for an amount greater than or equal to its selling
price, then the transaction is a financing transaction by the company.11 Illustration 18-20
examines the issues related to a repurchase agreement.

ILLUSTRATION 18-20
REPURCHASE AGREEMENT
Recognition—Repurchase
Agreement Facts: Morgan Inc., an equipment dealer, sells equipment on January 1, 2017, to Lane Company for
$100,000. It agrees to repurchase this equipment (an unconditional obligation) from Lane Company on
December 31, 2018, for a price of $121,000.

Question: Should Morgan Inc. record a sale for this transaction?

Solution: For a sale and repurchase agreement, the terms of the agreement need to be analyzed to
determine whether Morgan Inc. has transferred control to the customer, Lane Company. As indicated
earlier, control of an asset refers to the ability to direct the use of and obtain substantially all the
benefits from the asset. Control also includes the ability to prevent other companies from directing the
use of and receiving the benefit from a good or service. In this case, Morgan Inc. continues to have
control of the asset because it has agreed to repurchase the asset at an amount greater than the
selling price. Therefore, this agreement is a financing transaction and not a sale. Thus, the asset is not
removed from the books of Morgan Inc.
Assuming that an interest rate of 10% is imputed from the agreement, Morgan Inc. makes the
following entries to record this agreement. Morgan Inc. records the financing on January 1, 2017, as
follows.
January 1, 2017
Cash 100,000
Liability to Lane Company 100,000

Morgan Inc. records interest on December 31, 2017, as follows.

December 31, 2017

Interest Expense 10,000
Liability to Lane Company ($100,000 × 10%) 10,000

Morgan Inc. records interest and retirement of its liability to Lane Company as follows.

December 31, 2018

Interest Expense 11,000
Liability to Lane Company ($110,000 × 10%) 11,000
Liability to Lane Company 121,000
Cash ($100,000 + $10,000 + $11,000) 121,000

Rather than Morgan Inc. having a forward or call option to repurchase the asset,
assume that Lane Company has the option to require Morgan Inc. to repurchase the
asset at December 31, 2018. This option is a put option; that is, Lane Company has the
option to put the asset back to Morgan Inc. In this situation, Lane Company has control
of the asset as it can keep the equipment or sell it to Morgan Inc. or to some other third
party. The value of a put option increases when the value of the underlying asset (in this
case, the equipment) decreases. In determining how to account for this transaction,
Morgan Inc. has to determine whether Lane Company will have an economic incentive
to exercise this put option at the end of 2018.
Specifically, Lane Company has a significant economic incentive to exercise its put
option if the value of the equipment declines. In this case, the transaction is generally
reported as a financing transaction as shown in Illustration 18-20. That is, Lane Com-
pany will return (put) the equipment back to Morgan Inc. if the repurchase price exceeds

11
If the repurchase price is less than the selling price, then the transaction is accounted for as a lease. [15]
The accounting for leases is discussed in Chapter 21.
 Accounting for Revenue Recognition issues 1001

the fair value of the equipment. For example, if the repurchase price of the equipment is
$150,000 but its fair value is $125,000, Lane Company is better off returning the equip-
ment to Morgan Inc.
Conversely, if Lane Company does not have a significant economic incentive to
exercise its put option, then the transaction should be reported as a sale of a product
with a right of return.

Bill-and-Hold Arrangements
A bill-and-hold arrangement is a contract under which an entity bills a customer for a
product but the entity retains physical possession of the product until it is transferred to
the customer at a point in time in the future. Bill-and-hold sales result when the buyer
is not yet ready to take delivery but does take title and accepts billing. For example, a
customer may request a company to enter into such an arrangement because of (1) lack
of available space for the product, (2) delays in its production schedule, or (3) more than
sufficient inventory in its distribution channel. [16] Illustration 18-21 provides an
example of a bill-and-hold arrangement.

ILLUSTRATION 18-21
BILL AND HOLD
Recognition—Bill and Hold
Facts: Butler Company sells $450,000 (cost $280,000) of fireplaces on March 1, 2017, to a local coffee
shop, Baristo, which is planning to expand its locations around the city. Under the agreement, Baristo
asks Butler to retain these fireplaces in its warehouses until the new coffee shops that will house the
fireplaces are ready. Title passes to Baristo at the time the agreement is signed.

Question: When should Butler recognize the revenue from this bill-and-hold
arrangement?

Solution: When to recognize revenue in a bill-and-hold arrangement depends on the circumstances.

Butler determines when it has satisfied its performance obligation to transfer a product by evaluating
when Baristo obtains control of that product. For Baristo to have obtained control of a product in a
bill-and-hold arrangement, it must meet all of the conditions for change in control plus all of the
following criteria:
(a) The reason for the bill-and-hold arrangement must be substantive.
(b) The product must be identified separately as belonging to Baristo.
(c) The product currently must be ready for physical transfer to Baristo.
(d) Butler cannot have the ability to use the product or to direct it to another customer.
In this case, assuming that the above criteria were met in the contract, revenue recognition should be
permitted at the time the contract is signed. Butler has transferred control to Baristo; that is, Butler has
a right to payment for the fireplaces and legal title has transferred.
Butler makes the following entry to record the bill-and-hold sale and related cost of goods sold.
March 1, 2017
Accounts Receivable 450,000
Sales Revenue 450,000
Cost of Goods Sold 280,000
Inventory 280,000

Principal-Agent Relationships
In a principal-agent relationship, the principal’s performance obligation is to provide
goods or perform services for a customer. The agent’s performance obligation is to
arrange for the principal to provide these goods or services to a customer. Examples of
principal-agent relationships are as follows.

• Preferred Travel Company (agent) facilitates the booking of cruise excursions by

finding customers for Regency Cruise Company (principal).
• Priceline (agent) facilitates the sale of various services such as car rentals for Hertz
(principal).
1002 Chapter 18 Revenue Recognition

In these types of situations, amounts collected on behalf of the principal are not
revenue of the agent. Instead, revenue for the agent is the amount of the commission it
receives (usually a percentage of total revenue). Illustration 18-22 provides an example
of the issues related to principal-agent relationships.

ILLUSTRATION 18-22
PRINCIPAL-AGENT RELATIONSHIP
Recognition—Principal-
Agent Relationship Facts: Fly-Away Travel sells airplane tickets for British Airways (BA) to various customers.

Question: What are the performance obligations in this situation and how should
revenue be recognized for both the principal and agent?

Solution: The principal in this case is BA and the agent is Fly-Away Travel. Because BA has the
performance obligation to provide air transportation to the customer, it is the principal. Fly-Away Travel
facilitates the sale of the airline ticket to the customer in exchange for a fee or commission. Its
performance obligation is to arrange for BA to provide air transportation to the customer.
Although Fly-Away collects the full airfare from the customer, it then remits this amount to BA less
the commission. Fly-Away therefore should not record the full amount of the fare as revenue on its
books—to do so overstates revenue. Its revenue is the commission, not the full price. Control of per-
forming the air transportation is with BA, not Fly-Away Travel.

Some might argue that there is no harm in letting Fly-Away record revenue for the
full price of the ticket and then charging the cost of the ticket against the revenue (often
referred to as the gross method of recognizing revenue). Others note that this approach
overstates the agent’s revenue and is misleading. The revenue received is the commis-
sion for providing the travel services, not the full fare price (often referred to as the net
approach). The profession believes the net approach is the correct method for recogniz-
ing revenue in a principal-agent relationship. As a result, the FASB has developed spe-
cific criteria to determine when a principal-agent relationship exists.12 An important
feature in deciding whether Fly-Away is acting as an agent is whether the amount it
earns is predetermined, being either a fixed fee per transaction or a stated percentage of
the amount billed to the customer.

Consignments
A common principal-agent relationship involves consignments. In these cases, manu-
facturers (or wholesalers) deliver goods but retain title to the goods until they are sold.
This specialized method of marketing certain types of products makes use of an agree-
ment known as a consignment. Under this arrangement, the consignor (manufacturer
or wholesaler) ships merchandise to the consignee (dealer), who is to act as an agent for
the consignor in selling the merchandise. Both consignor and consignee are interested in
selling—the former to make a profit or develop a market, the latter to make a commis-
sion on the sale.
The consignee accepts the merchandise and agrees to exercise due diligence in
caring for and selling it. The consignee remits to the consignor cash received from
customers, after deducting a sales commission and any chargeable expenses. In con-
signment sales, the consignor uses a modified version of the point-of-sale basis of
revenue recognition. That is, the consignor recognizes revenue only after receiving
notification of the sale.

12
Indicators that the company’s performance obligation is to arrange for the providing of goods or the
performing of services by another party (i.e., the company is an agent and should recognize revenue in the
net amount) include the following: (a) the other party is primarily responsible for fulfilling the contract;
(b) the company does not have inventory risk before or after the customer order, during shipping, or on
return; (c) the company does not have latitude in establishing prices for the other party’s goods or services
and, hence, the benefit that the company can receive from those goods or services is constrained; (d) the
company’s consideration is in the form of a commission; and (e) the company does not have customer credit
risk for the amount receivable in exchange for the other party’s goods or services. [17]
 Accounting for Revenue Recognition issues 1003

The consignor carries the merchandise as inventory throughout the consignment,

separately classified as Inventory (consignments). The consignee does not record the
merchandise as an asset on its books. Upon sale of the merchandise, the consignee has
a liability for the net amount due the consignor. The consignor periodically receives
from the consignee a report called account sales that shows the merchandise received,
merchandise sold, expenses chargeable to the consignment, and the cash remitted.
Revenue is then recognized by the consignor. Analysis of a consignment arrangement is
provided in Illustration 18-23.

ILLUSTRATION 18-23
SALES ON CONSIGNMENT
Recognition—Sales on
Facts: Nelba Manufacturing Co. ships merchandise costing $36,000 on consignment to Best Value Consignment
Stores. Nelba pays $3,750 of freight costs, and Best Value pays $2,250 for local advertising costs that are
reimbursable from Nelba. By the end of the period, Best Value has sold two-thirds of the consigned
merchandise for $40,000 cash. Best Value notifies Nelba of the sales, retains a 10% commission, and
remits the cash due Nelba.

Question: What are the journal entries that the consignor (Nelba) and the consignee
(Best Value) make to record this transaction?

Solution:
NELBA MFG. CO. BEST VALUE STORES
(CONSIGNOR) (CONSIGNEE)
Shipment of consigned merchandise

Inventory (consignments) 36,000 No entry (record memo of merchandise

Finished Goods Inventory 36,000 received).

Payment of freight costs by consignor

Inventory (consignments) 3,750 No entry.

Cash 3,750

Payment of advertising by consignee

No entry until notified. Receivable from Consignor 2,250

Cash 2,250

Sales of consigned merchandise

No entry until notified. Cash 40,000

Payable to Consignor 40,000

Notification of sales and expenses and remittance of amount due

Cash 33,750 Payable to Consignor 40,000

Advertising Expense 2,250 Receivable from
Commission Expense 4,000 Consignor 2,250
Revenue from Commission Revenue 4,000
Consignment Sales 40,000 Cash 33,750

Adjustment of inventory on consignment for cost of sales

Cost of Goods Sold 26,500 No entry.

Inventory (consignments) 26,500
[2/3 ($36,000 + $3,750) = $26,500]

Under the consignment arrangement, the consignor accepts the risk that the mer-
chandise might not sell and relieves the consignee of the need to commit part of its
working capital to inventory. Consignors use a variety of systems and account titles to
record consignments, but they all share the common goal of postponing the recognition
of revenue until it is known that a sale to a third party has occurred. Consignees only
recognize commission revenue.
1004 Chapter 18 Revenue Recognition

WHAT DO THE NUMBERS MEAN? GROSSED OUT

As you learned in Chapter 4, many corporate executives your own price” for airline tickets and hotel rooms. In one quar-
obsess over the bottom line. However, analysts on the outside ter, Priceline reported that it earned $152 million in revenues.
look at the big picture, which includes examination of both the But, that included the full amount customers paid for tickets,
top line and the important subtotals in the income statement, hotel rooms, and rental cars. Traditional travel agencies call
such as gross profit. Not too long ago, the top line caused that amount “gross bookings,” not revenues. And, much like
some concern, with nearly all companies in the S&P 500 report- regular travel agencies, Priceline keeps only a small portion of
ing a 2 percent decline in the bottom line while the top line saw gross bookings—namely, the spread between the customers’
revenue decline by 1 percent. This was troubling because it was accepted bids and the price it paid for the merchandise. The
the first decline in revenues since we crawled out of the reces- rest, which Priceline calls “product costs,” it pays to the airlines
sion following the financial crisis. McDonald’s gave an ominous and hotels that supply the tickets and rooms.
preview—it saw its first monthly sales decline in nine years. And However, Priceline’s product costs came to $134 million,
the United States, rather than foreign markets, led the drop. leaving Priceline just $18 million of what it calls “gross profit”
What about income subtotals like gross margin? These and what most other companies would call revenues. And
metrics too have been under pressure. There is concern that that’s before all of Priceline’s other costs—like advertising and
struggling companies may employ a number of manipulations to salaries—which netted out to a loss of $102 million. The differ-
mask the impact of gross margin declines on the bottom line. In ence isn’t academic. Priceline shares traded at about 23 times
fact, Rite Aid prepares an income statement that omits the its reported revenues but at a mind-boggling 214 times its
gross margin subtotal. Rite Aid has used a number of suspect “gross profit.” This and other aggressive recognition practices
accounting adjustments related to tax allowances and inventory explain the stricter revenue recognition guidance, indicating
gains to offset its weak gross margin. that if a company performs as an agent or broker without
Or, consider the classic case of Priceline.com, the com- assuming the risks and rewards of ownership of the goods, the
pany made famous by William Shatner’s ads about “naming company should report sales on a net (fee) basis.

Sources: Jeremy Kahn, “Presto Chango! Sales Are Huge,” Fortune (March 20, 2000), p. 44; A. Catanach and E. Ketz, “RITE AID: Is Management Selling
Drugs or Using Them?” Grumpy Old Accountants (August 22, 2011); and S. Jakab, “Weak Revenue Is New Worry for Investors,” Wall Street Journal
(November 25, 2012).

Warranties
As discussed in Chapter 13, companies often provide one of two types of warranties to
customers:

1. Warranties that the product meets agreed-upon specifications in the contract at the
time the product is sold. This type of warranty is included in the sales price of a
company’s product and is often referred to as an assurance-type warranty.
2. Warranties that provide an additional service beyond the assurance-type warranty.
This warranty is not included in the sales price of the product and is referred to as a
service-type warranty. As a consequence, it is recorded as a separate performance
obligation.

Companies do not record a separate performance obligation for assurance-type

warranties. This type of warranty is nothing more than a quality guarantee that the
good or service is free from defects at the point of sale. In this case, the sale of the prod-
uct and the related assurance warranty are one performance obligation as they are inter-
dependent of and interrelated with each other. The objective for companies that issue an
assurance warranty is to provide a combined item (product and a warranty).
These types of obligations should be expensed in the period the goods are provided or
services performed. In addition, the company should record a warranty liability. The esti-
mated amount of the liability includes all the costs that the company will incur after sale
due to the correction of defects or deficiencies required under the warranty provisions.
In addition, companies sometimes provide customers with an option to purchase a
warranty separately. In most cases, these extended warranties provide the customer a
service beyond fixing defects that existed at the time of sale. For example, when you
purchase a TV, you are entitled to the company’s warranty. You will also undoubtedly
 Accounting for Revenue Recognition issues 1005

be offered an extended warranty on the product at an additional cost. These service-

type warranties represent a separate service and are an additional performance obliga-
tion. The service-type warranty is sold separately and therefore has a standalone selling
price. In this case, the objective of the company is to sell an additional service to custom-
ers. As a result, companies should allocate a portion of the transaction price to this per-
formance obligation, if provided. The company recognizes revenue in the period that
the service-type warranty is in effect. Illustration 18-24 presents an example of both an
assurance-type and a service-type warranty.

ILLUSTRATION 18-24
WARRANTIES
Recognition—Performance
Facts: Maverick Company sold 1,000 Rollomatics on October 1, 2017, at total price of $6,000,000, with Obligations and Warranties
a warranty guarantee that the product was free of defects. The cost of the Rollomatics is $4,000,000. The
term of this assurance warranty is 2 years, with an estimated cost of $80,000. In addition, Maverick sold
extended warranties related to 400 Rollomatics for 3 years beyond the 2-year period for $18,000. On
November 22, 2017, Maverick incurred labor costs of $3,000 and part costs of $25,000 related to the
assurance warranties. Maverick prepares financial statements on December 31, 2017. It estimates that its
future assurance warranty costs will total $44,000 at December 31, 2017.

Question: What are the journal entries that Maverick Company should make in 2017
related to the sale of the Rollomatics and the assurance and extended warranties?

Solution: Maverick makes the following entries in 2017 related to Rollomatics sold with warranties.
October 1, 2017

To record the sale of the Rollomatics and the related extended warranties:
Cash ($6,000,000 + $18,000) 6,018,000
Sales Revenue 6,000,000
Unearned Warranty Revenue 18,000

To record the cost of goods sold and reduce the inventory of Rollomatics:
Cost of Goods Sold 4,000,000
Inventory 4,000,000
November 22, 2017

To record the warranty costs incurred:

Warranty Expense 28,000
Salaries and Wages Payable 3,000
Inventory (parts) 25,000
December 31, 2017

To record the adjusting entry related to its assurance warranty at the end of the year:
Warranty Expense 44,000
Warranty Liability 44,000

Maverick Company makes an adjusting entry to record a liability for the expected
warranty costs related to the sale of the Rollomatics. When actual warranty costs are
incurred in 2018, the Warranty Liability account is reduced.
In most cases, Unearned Warranty Revenue (related to the service-type warranty) is
recognized on a straight-line basis as Warranty Revenue over the three-year period to
which it applies. Revenue related to the extended warranty is not recognized until the
warranty becomes effective on October 1, 2019. If financial statements are prepared on
December 31, 2019, Maverick makes the following entry to recognize revenue:
Unearned Warranty Revenue 1,500
Warranty Revenue [($18,000 ÷ 36) × 3] 1,500

Similar to that illustrated in Chapter 13 (pages 677–678), Maverick Company

reduces the Warranty Liability account over the warranty period as the actual warranty
1006 Chapter 18 Revenue Recognition

costs are incurred.13 The company also recognizes revenue related to the service-type
warranty over the three-year period that extends beyond the assurance warranty period
(two years). In most cases, the unearned warranty revenue is recognized on a straight-
line basis. The costs associated with the service-type warranty are expensed as incurred.

Nonrefundable Upfront Fees

Companies sometimes receive payments (upfront fees) from customers before they
deliver a product or perform a service. Upfront payments generally relate to the initia-
tion, activation, or setup of a good or service to be provided or performed in the future.
In most cases, these upfront payments are nonrefundable. Examples include fees paid
for membership in a health club or buying club, and activation fees for phone, Internet,
or cable.
Companies must determine whether these nonrefundable advance payments are
for products or services in the current period. In most situations, these payments are for
future delivery of products and services and should therefore not be recorded as reve-
nue at the time of payment. In some cases, the upfront fee is viewed similar to a renewal
option for future products and services at a reduced price. An example would be a
health club where once the initiation fee is paid, no additional fee is necessary upon
renewal. Illustration 18-25 provides an example of an upfront fee payment.

ILLUSTRATION 18-25
UPFRONT FEE CONSIDERATIONS
Transaction Price—Upfront
Fee Considerations Facts: Erica Felise signs a 1-year contract with Bigelow Health Club. The terms of the contract are that
Erica is required to pay a nonrefundable initiation fee of $200 and a membership fee of $50 per month.
Bigelow determines that its customers, on average, renew their annual membership two times before
terminating their membership.

Question: What is the amount of revenue Bigelow Health Club should recognize in
the first year?

Solution: In this case, the membership fee arrangement may be viewed as a single performance
obligation (similar services are provided in all periods). That is, Bigelow is providing a discounted price
in the second and third years for the same services, and this should be reflected in the revenue
recognized in those periods. Bigelow determines the total transaction price to be $2,000—the upfront
fee of $200 and the three years of monthly fees of $1,800 ($50 × 36)—and allocates it over the three
years. In this case, Bigelow would report revenue of $55.56 ($2,000 ÷ 36) each month for three years.
Unless otherwise instructed, use this approach for homework problems.14

Summary
Illustration 18-26 provides a summary of the additional issues related to transfer of con-
trol and revenue recognition.

13
As with the accounting for sales returns and allowances, the entries shown here reflect a gross (as opposed
to net) treatment of the warranty obligation. That is, at the date of sale, Maverick recorded sales with an
assurance warranty at the gross amount, without adjustment for expected warranty costs (sometimes
referred to as the expense warranty approach). Then at the end of the accounting period when financial
statements are prepared, Maverick prepares adjusting entries to record a liability for any remaining
estimated warranty expenses (after accounting for actual warranty expenditures). Companies generally do
not use the net method because it requires additional analysis and bookkeeping to adjust the warranty
liability for unused warranty claims.
14
The initiation fee might be viewed as a separate performance obligation (it provides a renewal option at a
lower price than normally charged, perhaps with different services). In this situation, in the first period,
Bigelow would report revenue of $600 ($50 × 12). The initiation fee would then be allocated to years two
and three ($100 in each year) unless forfeited earlier.
 Presentation and Disclosure 1007

ILLUSTRATION 18-26
Summary—Other Revenue
Recognition Issues

Issue Description Implementation

Sales returns and Return of product by customer (e.g., due to Seller may recognize (a) an adjustment to revenue
allowances dissatisfaction with the product) in exchange for for products expected to be returned, and (b) an asset
refunds, a credit against amounts owed or that will be (and corresponding adjustment to cost of goods
owed, and/or another product in exchange. sold) for the goods returned from customers.

Repurchase Seller has an obligation or right to repurchase Generally, if the company has an obligation or right
agreements the asset at a later date. to repurchase the asset for an amount greater than
its selling price, then the transaction is a financing
transaction.

Bill and hold Result when the buyer is not yet ready to take Revenue is recognized depending on when the
delivery but does take title and accept billing. customer obtains control of that product.

Principal-agent Arrangement in which the principal’s performance Amounts collected on behalf of the principal are
obligation is to provide goods or perform services not revenue of the agent. Instead, revenue for the
for a customer. The agent’s performance obligation agent is the amount of the commission it receives.
is to arrange for the principal to provide these goods The principal recognizes revenue when the goods
or services to a customer. or services are sold to a third-party customer.

Consignments A principal-agent relationship in which the consignor The consignor recognizes revenue only after
(manufacturer or wholesaler) ships merchandise to receiving notification of the sale and the cash
the consignee (dealer), who is to act as an agent for remittance from the consignee (consignor carries
the consignor in selling the merchandise. the merchandise as inventory throughout the
consignment). The consignee records commission
revenue (usually some percentage of the selling
price).

Warranties Warranties can be assurance-type (product meets A separate performance obligation is not recorded
agreed-upon specifications) or service-type (provides for assurance-type warranties (considered part of
additional service beyond the assurance-type the product). Service-type warranties are recorded
warranty). as a separate performance obligation. Companies
should allocate a portion of the transaction price to
service type-warranties, when present.

Nonrefundable Upfront payments generally relate to initiation, The upfront payment should be allocated over the
upfront fees activation, or setup activities for a good or service periods benefited.
to be delivered in the future.

PRESENTATION AND DISCLOSURE LEARNING OBJECTIVE 4

Describe presentation
Presentation and disclosure regarding
Companies use an asset-liability approach to recognize revenue. For example, when revenue.
General Mills delivers cereal to Whole Foods Market (satisfying its performance obli-
gation), it has a right to consideration from Whole Foods and therefore has a contract
asset. If, on the other hand, Whole Foods Market performs first, by prepaying for this
cereal, General Mills has a contract liability. Companies must present these contract
assets and contract liabilities on their balance sheets.

Contract Assets and Liabilities

Contract assets are of two types: (1) unconditional rights to receive consideration
because the company has satisfied its performance obligation with a customer, and
(2) conditional rights to receive consideration because the company has satisfied one
performance obligation but must satisfy another performance obligation in the contract
before it can bill the customer. Companies should report unconditional rights to receive
consideration as a receivable on the balance sheet. Conditional rights on the balance
sheet should be reported separately as contract assets. Illustration 18-27 (on page 1008)
provides an example of the accounting and reporting for a contract asset.
1008 Chapter 18 Revenue Recognition

ILLUSTRATION 18-27
CONTRACT ASSET
Contract Asset Recognition
and Presentation Facts: On January 1, 2017, Finn Company enters into a contract to transfer Product A and Product B to
Obermine Co. for $100,000. The contract specifies that payment of Product A will not occur until Product
B is also delivered. In other words, payment will not occur until both Product A and Product B are
transferred to Obermine. Finn determines that standalone selling prices are $30,000 for Product A and
$70,000 for Product B. Finn delivers Product A to Obermine on February 1, 2017. On March 1, 2017, Finn
delivers Product B to Obermine.

Question: What journal entries should Finn Company make in regards to this
contract in 2017?

Solution: No entry is required on January 1, 2017, because neither party has performed on the contract.
On February 1, 2017, Finn records the following entry.
February 1, 2017
Contract Asset 30,000
Sales Revenue 30,000

On February 1, Finn has satisfied its performance obligation and therefore reports revenue of $30,000.
However, it does not record an accounts receivable at this point because it does not have an
unconditional right to receive the $100,000 unless it also transfers Product B to Obermine. In other
words, a contract asset occurs generally when a company must satisfy another performance obligation
before it is entitled to bill the customer. When Finn transfers Product B on March 1, 2017, it makes the
following entry.
March 1, 2017
Accounts Receivable 100,000
Contract Asset 30,000
Sales Revenue 70,000

As indicated above, a contract liability is a company’s obligation to transfer goods

or services to a customer for which the company has received consideration from the
customer. A contract liability is generally referred to as Unearned Sales Revenue,
Unearned Service Revenue, or another appropriate account title. Illustration 18-28 pro-
vides an example of the recognition and presentation of a contract liability.

ILLUSTRATION 18-28
CONTRACT LIABILITY
Contract Liability
Recognition and Facts: On March 1, 2017, Henly Company enters into a contract to transfer a product to Propel Inc. on
Presentation July 31, 2017. It is agreed that Propel will pay the full price of $10,000 in advance on April 15, 2017. Henly
delivers the product on July 31, 2017. The cost of the product is $7,500.

Question: What journal entries are required in 2017?

Solution: No entry is required on March 1, 2017, because neither party has performed on the contract.
On receiving the cash on April 15, 2017, Henly records the following entry.
April 15, 2017
Cash 10,000
Unearned Sales Revenue 10,000

On satisfying the performance obligation on July 31, 2017, Henly records the following entry to record
the sale.
July 31, 2017
Unearned Sales Revenue 10,000
Sales Revenue 10,000

In addition, Henly records cost of goods sold as follows.

Cost of Goods Sold 7,500
Inventory 7,500
 Presentation and Disclosure 1009

Companies are not required to use the terms “contract assets” and “contract liabilities”
on the balance sheet. For example, contract liabilities are performance obligations and
therefore more descriptive titles (as noted earlier) such as unearned service revenue,
unearned sales revenue, repurchase liability, and return liability may be used where appro-
priate. For contract assets, it is important that financial statement users can differentiate
between unconditional and conditional rights through appropriate account presentation.

Contract Modifications
Companies sometimes change the contract terms while it is ongoing; this is referred to
as a contract modification. When a contract modification occurs, companies determine
whether a new contract (and performance obligations) results or whether it is a modifi-
cation of the existing contract.

Separate Performance Obligation. A company accounts for a contract modification as

a new contract if both of the following conditions are satisfied:

• The promised goods or services are distinct (i.e., the company sells them separately
and they are not interdependent with other goods and services), and
• The company has the right to receive an amount of consideration that reflects the
standalone selling price of the promised goods or services. [18]

For example, Crandall Co. has a contract to sell 100 products to a customer for
$10,000 ($100 per product) at various points in time over a six-month period. After
60 products have been delivered, Crandall modifies the contract by promising to deliver
20 more products for an additional $1,900, or $95 per product (which is the standalone
selling price of the products at the time of the contract modification). Crandall regularly
sells the products separately. In this situation, the contract modification for the addi-
tional 20 products is, in effect, a new and separate contract because it meets both of the
conditions above. That is, it does not affect the accounting for the original contract.
Given a new contract, Crandall recognizes an additional $4,000 [(100 units – 60 units)
× $100] related to the original contract terms and $1,900 (20 units × $95) related to the
new products. Total revenue after the modification is therefore $5,900 ($4,000 + $1,900).

Prospective Modification. What if Crandall Co. determines that the additional prod-
ucts are not a separate performance obligation? This might arise if the new products are
not priced at the proper standalone selling price or if they are not distinct. In this situa-
tion, companies generally account for the modification using a prospective approach.
Under the prospective approach, Crandall should account for the effect of the
change in the period of change as well as future periods if the change affects both. Cran-
dall should not change previously reported results. Thus, for Crandall, the amount rec-
ognized as revenue for each of the remaining products would be a blended price of
$98.33, computed as shown in Illustration 18-29.

ILLUSTRATION 18-29
Consideration for products not yet delivered under original contract ($100 × 40) $4,000 Revenue Under Prospective
Consideration for products to be delivered under the contract modification ($95 × 20) 1,900
Modification
Total remaining revenue $5,900

Revenue per remaining unit ($5,900 ÷ 60) = $98.33

Therefore, under the prospective approach, this computation differs from that in the
separate performance obligation approach in that revenue on the remaining units is
recognized at the blended price. Total revenue after the modification is therefore $5,900
(60 units × $98.33). Illustration 18-30 (on page 1010) shows the revenue reported under
the two contract modification approaches for Crandall Co.
1010 Chapter 18 Revenue Recognition

ILLUSTRATION 18-30
Revenue Recognized Revenue Recognized Total Revenue
Comparison of Contract
Prior to Modification After Modification Recognized
Modification Approaches
Separate performance obligation $6,000 $5,900 $11,900

No separate performance
obligation—prospectively $6,000 $5,900 $11,900

As indicated, whether a modification is treated as a separate performance obliga-

tion or prospectively, the same amount of revenue is recognized before and after the
modification. However, under the prospective approach, a blended price ($98.33) is
used for sales in the periods after the modification.15

Costs to Fulfill a Contract

Companies may also report assets associated with fulfillment costs related to a revenue
arrangement. Companies divide fulfillment costs (contract acquisition costs) into two
categories:

1. Those that give rise to an asset.

2. Those that are expensed as incurred.

Companies recognize an asset for the incremental costs if these costs are incurred to
obtain a contract with a customer. In other words, incremental costs are those that a
company would not incur if the contract had not been obtained (e.g., selling commis-
sions). Additional examples that give rise to an asset are as follows.

(a) Direct labor, direct materials, and allocation of costs that relate directly to the con-
tract (e.g., costs of contract management and supervision, insurance, and deprecia-
tion of tools and equipment).
(b) Costs that generate or enhance resources of the company that will be used in satisfy-
ing performance obligations in the future. Such costs include intangible design or
engineering costs that will continue to give rise to benefits in the future.

Other costs that are expensed as incurred include general and administrative costs
(unless those costs are explicitly chargeable to the customer under the contract) as well
as costs of wasted materials, labor, or other resources to fulfill the contract that were
not reflected in the price of the contract. That is, companies only capitalize costs that
are direct, incremental, and recoverable (assuming that the contract period is more
than one year). Illustration 18-31 provides an example of costs capitalized to fulfill a
contract.
As a practical expedient, a company recognizes the incremental costs of obtaining a
contract as an expense when incurred if the amortization period of the asset that the
company otherwise would have recognized is one year or less.

15
Another approach to account for a contract modification is to report the information in a cumulative
catch-up manner. In other words, assuming that these new products are part of the original contract,
companies adjust the revenue account to reflect the cumulative effect for periods prior to when the
modification occurred. An example of a catch-up situation is a long-term construction contract, which is
discussed in more detail in Appendix 18A. Use of the prospective approach avoids the complexity of
opening up the accounting for previously satisfied performance obligations. However, it ignores any
adjustments to revenue that have already been recognized. [19] For homework purposes, unless instructed
otherwise, use the prospective approach for modifications that do not result in a separate performance obligation.
Expanded discussion of the prospective and cumulative catch-up (retrospective) approaches to accounting
changes is provided in Chapter 22.
 Presentation and Disclosure 1011

ILLUSTRATION 18-31
CONTRACT COSTS
Recognition—Contract
Facts: Rock Integrators enters into a contract to operate Dello Company’s information technology data Costs
center for 5 years. Rock Integrators incurs selling commission costs of $10,000 to obtain the contract.
Before performing the services, Rock Integrators designs and builds a technology platform that interfaces
with Dello’s systems. That platform is not transferred to Dello. Dello promises to pay a fixed fee of $20,000
per month. Rock Integrators incurs the following additional costs: design services for the platform
$40,000, hardware for the platform $120,000, software $90,000, and testing of data center $100,000.

Question: What are Rock Integrators’ costs for fulfilling the contract to Dello
Company?

Solution: The $10,000 selling commission costs related to obtaining the contract are recognized as an
asset. The design services cost of $40,000 and the hardware for the platform of $120,000 are also
capitalized. As the technology platform is independent of the contract, the pattern of amortization of
this platform may not be related to the terms of the contract. The testing costs are expensed as
incurred; in general, these costs are not recoverable.

Collectibility
As indicated earlier, if it is probable that the transaction price will not be collected, this
is an indication that the parties are not committed to their obligations. As a result, one
of the criteria for the existence of a contract is not met and therefore revenue is not
recognized.
Any time a company sells a product or performs a service on account, a collectibility
issue occurs. Collectibility refers to a customer’s credit risk, that is, the risk that a cus-
tomer will be unable to pay the amount of consideration in accordance with the contract.
Under the revenue guidance—as long as a contract exists (it is probable that the customer
will pay)—the amount recognized as revenue is not adjusted for customer credit risk.
Thus, companies report the revenue gross (without consideration of credit risk) and
then present an allowance for any impairment due to bad debts (recognized initially
and subsequently in accordance with the respective bad debt guidance). An impairment
related to bad debts is reported as an operating expense in the income statement. As a
result, whether a company will get paid for satisfying a performance obligation is not a
consideration in determining revenue recognition. [20]

Disclosure
The disclosure requirements for revenue recognition are designed to help financial
statement users understand the nature, amount, timing, and uncertainty of revenue and
cash flows arising from contracts with customers. To achieve that objective, companies
disclose qualitative and quantitative information about all of the following:
• Contracts with customers. These disclosures include the disaggregation of revenue,
presentation of opening and closing balances in contract assets and contract liabili-
ties, and significant information related to their performance obligations.
• Significant judgments. These disclosures include judgments and changes in these
judgments that affect the determination of the transaction price, the allocation of the
transaction price, and the determination of the timing of revenue.
• Assets recognized from costs incurred to fulfill a contract. These disclosures in-
clude the closing balances of assets recognized to obtain or fulfill a contract, the
amount of amortization recognized, and the method used for amortization.
To implement these requirements and meet the disclosure objectives, companies pro-
vide a range of disclosures, as summarized in Illustration 18-32 (on page 1012). [21]16

16
See PricewaterhouseCoopers Dataline 2013–2014.
1012 Chapter 18 Revenue Recognition

ILLUSTRATION 18-32
Revenue Disclosures

Disclosure Type Requirements

Disaggregation of revenue Disclose disaggregated revenue information in categories that depict how the nature, amount,
timing, and uncertainty of revenue and cash flows are affected by economic factors. Reconcile
disaggregated revenue to revenue for reportable segments.
Reconciliation of contract Disclose opening and closing balances of contract assets (e.g., unbilled receivables) and liabilities
balances (e.g., deferred revenue) and provide a qualitative description of significant changes in these amounts.
Disclose the amount of revenue recognized in the current period relating to performance obligations
satisfied in a prior period (e.g., from contracts with variable consideration). Disclose the opening and
closing balances of trade receivables if not presented elsewhere.
Remaining performance Disclose the amount of the transaction price allocated to remaining performance obligations not
obligations subject to significant revenue reversal. Provide a narrative discussion of potential additional revenue
in constrained arrangements.
Costs to obtain or fulfill Disclose the closing balances of capitalized costs to obtain and fulfill a contract and the amount of
contracts amortization in the period. Disclose the method used to determine amortization for each reporting
period.
Other qualitative Disclose significant judgments and changes in judgments that affect the amount and timing of
disclosures revenue from contracts with customers. Disclose how management determines the minimum
amount of revenue not subject to the variable consideration constraint.

EVOLVING ISSUE REVENUE: “IT’S LIKE AN OCTOPUS”

As you have learned in this chapter, the recently issued revenue issues that could arise when companies, institutions, and other
recognition standard provides a comprehensive and general organizations implement the revenue recognition standard.
framework for recognizing revenue and should result in improve- The transition group is comprised of specialists representing
ments in the reporting of revenue. However, these new rules financial statement preparers, auditors, regulators, users, and
reflect significant change relative to the prior revenue guidance. other stakeholders, as well as members of the FASB and IASB.
As one senior accountant noted, “Revenue touches everything The resource group solicits, analyzes, and discusses
. . . It’s like an octopus. . . It has tentacles all over the income stakeholder issues that apply to common transactions that
statement.” The new rules—to be adopted by most companies could reasonably create diversity in practice. In addition to pro-
in 2018—are expected to create implementation challenges, viding a forum to discuss the application of the requirements,
especially for companies that: the transition group provides information that will help the
Boards determine what, if any, action will be needed to resolve
• Currently recognize revenue using industry-specific that diversity. The group itself will not issue guidance.
guidance. As noted by Russ Golden, chairman of the FASB:
• Have customer contracts with diverse terms and conditions.
“Effective implementation of the revenue recognition
• Have arrangements with goods or services delivered over standard is critical to its success in providing financial
long periods.
statement users with the information they need to make
• Have systems or processes that do not easily provide the right decisions about how to allocate their capital.
new data requirements. The Boards are committed to ensuring a smooth transi-
tion to the new standard, and the transition resource
Among the companies that are likely to experience significant
group is an important tool for determining any areas that
changes are those in the telecommunications, aerospace, con-
will need additional guidance before the standard
struction, asset management, real estate, and software industries.
becomes effective.”
In the months after issuance of the new guidance, the
FASB and IASB have issued documents that will address com- So change is necessary to achieve improvements in revenue
mon questions posed by these industries. In addition, the recognition accounting. Hopefully, the extended transition
Boards have created a joint transition resource group that is period and expanded support by the transition group will make
responsible for informing the FASB and IASB about interpretive the change a bit less painful.

Sources: Executive Accounting Update: “Changes to Revenue Recognition,” KPMG (January 22, 2014); Defining Issues No. 14-9: “Implementing the
Forthcoming Revenue Recognition Standard,” KPMG (February 2014); and E. Chasen, “Revenue Recognition Accounting Changes Could Have Long
Tentacles,” Wall Street Journal (November 16, 2015).
 Appendix 18A: Long-Term Construction Contracts 1013

APPENDIX 18A LONG-TERM CONSTRUCTION CONTRACTS

REVENUE RECOGNITION OVER TIME LEARNING OBJECTIVE *5

Apply the percentage-of-
For the most part, companies recognize revenue at the point of sale because that is when completion method for
the performance obligation is satisfied. However, as indicated in the chapter, under cer- long-term contracts.
tain circumstances companies recognize revenue over time. The most notable context in
which revenue is recognized over time is long-term construction contract accounting.
Long-term contracts frequently provide that the seller (builder) may bill the pur-
chaser at intervals, as it reaches various points in the project. Examples of long-term
contracts are construction-type contracts, development of military and commercial air-
craft, weapons-delivery systems, and space exploration hardware. When the project
consists of separable units, such as a group of buildings or miles of roadway, contract
provisions may provide for delivery in installments. In that case, the seller would bill
the buyer and transfer title at stated stages of completion, such as the completion of each
building unit or every 10 miles of road. The accounting records should record sales
when installments are “delivered.”
A company satisfies a performance obligation and recognizes revenue over time if
at least one of the following three criteria is met: [22]

1. The customer simultaneously receives and consumes the benefits of the seller’s
performance as the seller performs.
2. The company’s performance creates or enhances an asset (for example, work in
process) that the customer controls as the asset is created or enhanced; or
3. The company’s performance does not create an asset with an alternative use. For
example, the asset cannot be used by another customer. In addition to this alterna-
tive use element, at least one of the following criteria must be met:
(a) Another company would not need to substantially re-perform the work the
company has completed to date if that other company were to fulfill the remain-
ing obligation to the customer.
(b) The company has a right to payment for its performance completed to date, and
it expects to fulfill the contract as promised.17

Therefore, if criterion 1, 2, or 3 is met, then a company recognizes revenue over time

if it can reasonably estimate its progress toward satisfaction of the performance obli-
gations. That is, it recognizes revenues and gross profits each period based upon the
progress of the construction—referred to as the percentage-of-completion method. The
company accumulates construction costs plus gross profit recognized to date in an
inventory account (Construction in Process), and it accumulates progress billings in a
contra inventory account (Billings on Construction in Process).
The rationale for using percentage-of-completion accounting is that under most of
these contracts the buyer and seller have enforceable rights. The buyer has the legal
right to require specific performance on the contract. The seller has the right to require
progress payments that provide evidence of the buyer’s ownership interest. As a result,
a continuous sale occurs as the work progresses. Companies should recognize revenue
according to that progression.

17
The right to payment for performance completed to date does not need to be for a fixed amount. However,
the company must be entitled to an amount that would compensate the company for performance com-
pleted to date (even if the customer can terminate the contract for reasons other than the company’s failure
to perform as promised). Compensation for performance completed to date includes payment that approxi-
mates the selling price of the goods or services transferred to date (for example, recovery of the company’s
costs plus a reasonable profit margin).
1014 Chapter 18 Revenue Recognition

Alternatively, if the criteria for recognition over time are not met (e.g., the company
does not have a right to payment for work completed to date), the company recognizes
revenues and gross profit at a point in time, that is, when the contract is completed. This
approach is referred to as the completed-contract method.18 The company accumulates
construction costs in an inventory account (Construction in Process), and it accumulates
progress billings in a contra inventory account (Billings on Construction in Process).

Percentage-of-Completion Method
The percentage-of-completion method recognizes revenues, costs, and gross profit as a
company makes progress toward completion on a long-term contract. To defer recogni-
tion of these items until completion of the entire contract is to misrepresent the efforts
(costs) and accomplishments (revenues) of the accounting periods during the contract.
In order to apply the percentage-of-completion method, a company must have some
basis or standard for measuring the progress toward completion at particular interim
dates.

Measuring the Progress Toward Completion

As one practicing accountant wrote, “The big problem in applying the percentage-of-
completion method . . . has to do with the ability to make reasonably accurate estimates
of completion and the final gross profit.” Companies use various methods to determine
the extent of progress toward completion. The most common are the cost-to-cost and
units-of-delivery methods.
As indicated in the chapter, the objective of all these methods is to measure the
extent of progress in terms of costs, units, or value added. Companies identify the vari-
ous measures (costs incurred, labor hours worked, tons produced, floors completed,
etc.) and classify them as input or output measures. Input measures (costs incurred,
labor hours worked) are efforts devoted to a contract. Output measures (with units of
delivery measured as tons produced, floors of a building completed, miles of a highway
completed) track results. Neither measure is universally applicable to all long-term
projects. Their use requires the exercise of judgment and careful tailoring to the
circumstances.
Both input and output measures have certain disadvantages. The input measure is
based on an established relationship between a unit of input and productivity. If ineffi-
ciencies cause the productivity relationship to change, inaccurate measurements result.
Another potential problem is front-end loading, in which significant upfront costs result
in higher estimates of completion. To avoid this problem, companies should disregard
some early-stage construction costs—for example, costs of uninstalled materials or costs
of subcontracts not yet performed—if they do not relate to contract performance.
Similarly, output measures can produce inaccurate results if the units used are not
comparable in time, effort, or cost to complete. For example, using floors (stories) com-
pleted can be deceiving. Completing the first floor of an eight-story building may
require more than one-eighth the total cost because of the substructure and foundation
construction.
The most popular input measure used to determine the progress toward comple-
tion is the cost-to-cost basis. Under this basis, a company like EDS measures the
percentage of completion by comparing costs incurred to date with the most recent
estimate of the total costs required to complete the contract. Illustration 18A-1 shows the
formula for the cost-to-cost basis.

18
Accounting Trends and Techniques reports that of the 83 of its 500 sample companies that referred to
long-term construction contracts, 75 used the percentage-of-completion method and 8 used the completed-
contract method. In some circumstances (e.g., in the early stages of a contract), a company may not be able
to reasonably measure the outcome of a performance obligation, but it expects to recover the costs incurred
in satisfying the performance obligation. In these situations, companies recognize revenue only to the extent
of the costs incurred until such time that they can reasonably measure the outcome of the performance
obligation. This is referred to as the cost-recovery method. [23]
 Appendix 18A: Long-Term Construction Contracts 1015

ILLUSTRATION 18A-1
Costs Incurred to Date
= Percent Complete Formula for Percentage-
Most Recent Estimate of Total Costs of-Completion, Cost-to-
Cost Basis

Once EDS knows the percentage that costs incurred bear to total estimated costs, it
applies that percentage to the total revenue or the estimated total gross profit on the
contract. The resulting amount is the revenue or the gross profit to be recognized to
date. Illustration 18A-2 shows this computation.

ILLUSTRATION 18A-2
Estimated Revenue (or Gross
Percent Formula for Total Revenue
× Total Revenue = Profit) to Be
Complete (or Gross Profit) to Be
(or Gross Profit) Recognized to Date
Recognized to Date

To find the amounts of revenue and gross profit recognized each period, EDS subtracts
total revenue or gross profit recognized in prior periods, as shown in Illustration 18A-3.

ILLUSTRATION 18A-3
Revenue (or Gross Revenue (or Gross Current-Period
Formula for Amount of
Profit) to Be − Profit) Recognized = Revenue
Recognized to Date in Prior Periods (or Gross Profit) Current-Period Revenue
(or Gross Profit) Cost-to-
Cost Basis

Because the cost-to-cost method is widely used (without excluding other bases for
measuring progress toward completion), we have adopted it for use in our examples.

Example of Percentage-of-Completion Method—Cost-to-Cost Basis

To illustrate the percentage-of-completion method, assume that Hardhat Construction
Company has a contract to construct a $4,500,000 bridge at an estimated cost of
$4,000,000. The contract is to start in July 2017, and the bridge is to be completed in
October 2019. The following data pertain to the construction period. (Note that by the
end of 2018, Hardhat has revised the estimated total cost from $4,000,000 to $4,050,000.)

2017 2018 2019

Costs to date $1,000,000 $2,916,000 $4,050,000
Estimated costs to complete 3,000,000 1,134,000 —
Progress billings during the year 900,000 2,400,000 1,200,000
Cash collected during the year 750,000 1,750,000 2,000,000

Hardhat would compute the percent complete as shown in Illustration 18A-4.

ILLUSTRATION 18A-4
2017 2018 2019
Application of Percentage-
Contract price $4,500,000 $4,500,000 $ 4,500,000
of-Completion Method,
Less estimated cost: Cost-to-Cost Basis
Costs to date 1,000,000 2,916,000 4,050,000
Estimated costs to complete 3,000,000 1,134,000 —
Estimated total costs 4,000,000 4,050,000 4,050,000
Estimated total gross profit $ 500,000 $ 450,000 $ 450,000

Percent complete 25% 72% 100%

( $4,000,000 ($4,050,000 ($4,050,000

$1,000,000
( $2,916,000
( $4,050,000
(

On the basis of the data above, Hardhat would make the following entries to record
(1) the costs of construction, (2) progress billings, and (3) collections. These entries
appear as summaries of the many transactions that would be entered individually as
they occur during the year.
1016 Chapter 18 Revenue Recognition

ILLUSTRATION 18A-5
2017 2018 2019
Journal Entries—
To record costs of construction:
Percentage-of-Completion Construction in Process 1,000,000 1,916,000 1,134,000
Method, Cost-to-Cost Materials, Cash,
Basis Payables, etc. 1,000,000 1,916,000 1,134,000
To record progress billings:
Accounts Receivable 900,000 2,400,000 1,200,000
Billings on Construction
in Process 900,000 2,400,000 1,200,000
To record collections:
Cash 750,000 1,750,000 2,000,000
Accounts Receivable 750,000 1,750,000 2,000,000

In this example, the costs incurred to date are a measure of the extent of progress
toward completion. To determine this, Hardhat evaluates the costs incurred to date as a
proportion of the estimated total costs to be incurred on the project. The estimated rev-
enue and gross profit that Hardhat will recognize for each year are calculated as shown
in Illustration 18A-6.

ILLUSTRATION 18A-6
Recognized in Recognized in
Percentage-of-Completion
To Date Prior Years Current Year
Revenue, Costs, and Gross
2017
Profit by Year
Revenues ($4,500,000 × 25%) $1,125,000 $1,125,000
Costs 1,000,000 1,000,000
Gross profit $ 125,000 $ 125,000

2018
Revenues ($4,500,000 × 72%) $3,240,000 $1,125,000 $2,115,000
Costs 2,916,000 1,000,000 1,916,000
Gross profit $ 324,000 $ 125,000 $ 199,000

2019
Revenues ($4,500,000 × 100%) $4,500,000 $3,240,000 $1,260,000
Costs 4,050,000 2,916,000 1,134,000
Gross profit $ 450,000 $ 324,000 $ 126,000

Illustration 18A-7 shows Hardhat’s entries to recognize revenue and gross profit
each year and to record completion and final approval of the contract.

ILLUSTRATION 18A-7
2017 2018 2019
Journal Entries to
To recognize revenue and
Recognize Revenue and gross profit:
Gross Profit and to Record Construction in Process
Contract Completion— (gross profit) 125,000 199,000 126,000
Percentage-of-Completion Construction Expenses 1,000,000 1,916,000 1,134,000
Method, Cost-to-Cost Revenue from Long-Term
Basis Contracts 1,125,000 2,115,000 1,260,000
To record completion of
the contract:
Billings on Construction
in Process 4,500,000
Construction in Process 4,500,000

Note that Hardhat debits gross profit (as computed in Illustration 18A-6) to Con-
struction in Process. Similarly, it credits Revenue from Long-Term Contracts for the
amounts computed in Illustration 18A-6. Hardhat then debits the difference between
the amounts recognized each year for revenue and gross profit to a nominal account,
 Appendix 18A: Long-Term Construction Contracts 1017

Construction Expenses (similar to Cost of Goods Sold in a manufacturing company). It

reports that amount in the income statement as the actual cost of construction incurred
in that period. For example, in 2017 Hardhat uses the actual costs of $1,000,000 to com-
pute both the gross profit of $125,000 and the percent complete (25 percent).
Hardhat continues to accumulate costs in the Construction in Process account, in
order to maintain a record of total costs incurred (plus recognized gross profit) to date.
Although theoretically a series of “sales” takes place using the percentage-of-completion
method, the selling company cannot remove the inventory cost until the construction is
completed and transferred to the new owner. Hardhat’s Construction in Process account
for the bridge would include the following summarized entries over the term of the
construction project.

ILLUSTRATION 18A-8
Construction in Process
Content of Construction
2017 construction costs $1,000,000 12/31/19 to close in Process Account—
2017 recognized gross profit 125,000 completed
Percentage-of-Completion
2018 construction costs 1,916,000 project $4,500,000
Method
2018 recognized gross profit 199,000
2019 construction costs 1,134,000
2019 recognized gross profit 126,000
Total $4,500,000 Total $4,500,000

Recall that the Hardhat Construction Company example contained a change in

estimated costs: In the second year, 2018, it increased the estimated total costs from
$4,000,000 to $4,050,000. The change in estimate is accounted for in a cumulative catch-
up manner, as indicated in the chapter. This is done by first adjusting the percent com-
pleted to the new estimate of total costs. Next, Hardhat deducts the amount of revenues
and gross profit recognized in prior periods from revenues and gross profit computed
for progress to date. That is, it accounts for the change in estimate in the period of
change. That way, the balance sheet at the end of the period of change and the account-
ing in subsequent periods are as they would have been if the revised estimate had been
the original estimate.

Financial Statement Presentation—Percentage-of-Completion

Generally, when a company records a receivable from a sale, it reduces the Inventory
account. Under the percentage-of-completion method, however, the company continues
to carry both the receivable and the inventory. Subtracting the balance in the Billings
account from Construction in Process avoids double-counting the inventory. During the
life of the contract, Hardhat reports in the balance sheet the difference between the Con-
struction in Process and the Billings on Construction in Process accounts. If that amount
is a debit, Hardhat reports it as a current asset; if it is a credit, it reports it as a current
liability.
At times, the costs incurred plus the gross profit recognized to date (the balance in
Construction in Process) exceed the billings. In that case, Hardhat reports this excess as
a current asset entitled “Costs and recognized profit in excess of billings.” Hardhat can
at any time calculate the unbilled portion of revenue recognized to date by subtracting
the billings to date from the revenue recognized to date, as illustrated for 2017 for
Hardhat Construction in Illustration 18A-9.

ILLUSTRATION 18A-9
$1,000,000 Computation of Unbilled
Contract revenue recognized to date: $4,500,000 × $1,125,000
$4,000,000 Contract Price at 12/31/17
Billings to date (900,000)
Unbilled revenue $ 225,000
1018 Chapter 18 Revenue Recognition

At other times, the billings exceed costs incurred and gross profit to date. In that
case, Hardhat reports this excess as a current liability entitled “Billings in excess of costs
and recognized profit.”
What happens, as is usually the case, when companies have more than one project
going at a time? When a company has a number of projects, costs exceed billings on
some contracts and billings exceed costs on others. In such a case, the company segre-
gates the contracts. The asset side includes only those contracts on which costs and
recognized profit exceed billings. The liability side includes only those on which billings
exceed costs and recognized profit. Separate disclosures of the dollar volume of billings
and costs are preferable to a summary presentation of the net difference.
Using data from the bridge example, Hardhat Construction Company would report
the status and results of its long-term construction activities in 2017 under the percent-
age-of-completion method as shown in Illustration 18A-10.

ILLUSTRATION 18A-10
HARDHAT CONSTRUCTION COMPANY
Financial Statement
Presentation—Percentage- Income Statement (from Illustration 18A-6) 2017
of-Completion Method Revenue from long-term contracts $1,125,000
(2017) Costs of construction 1,000,000
Gross profit $ 125,000

Balance Sheet (12/31) 2017

Current assets
Accounts receivable ($900,000 – $750,000) $ 150,000
Inventory
Construction in process $1,125,000
Less: Billings 900,000
Costs and recognized profit
in excess of billings 225,000

In 2018, its financial statement presentation is as follows.

ILLUSTRATION 18A-11
HARDHAT CONSTRUCTION COMPANY
Financial Statement
Presentation—Percentage- Income Statement (from Illustration 18A-6) 2018
of-Completion Method Revenue from long-term contracts $2,115,000
(2018) Costs of construction 1,916,000
Gross profit $ 199,000

Balance Sheet (12/31)

Current assets
Accounts receivable ($150,000 + $2,400,000 – $1,750,000) $ 800,000
Current liabilities
Billings $3,300,000
Less: Construction in process 3,240,000
Billings in excess of costs and
recognized profit 60,000

In 2019, Hardhat’s financial statements only include an income statement because

the bridge project was completed and settled.

ILLUSTRATION 18A-12
HARDHAT CONSTRUCTION COMPANY
Financial Statement
Presentation—Percentage- Income Statement (from Illustration 18A-6) 2019
of-Completion Method Revenue from long-term contracts $1,260,000
(2019) Costs of construction 1,134,000
Gross profit $ 126,000
 Appendix 18A: Long-Term Construction Contracts 1019

In addition, Hardhat should disclose the following information in each year.

ILLUSTRATION 18A-13
Note 1. Summary of significant accounting policies.
Percentage-of-Completion
Long-Term Construction Contracts. The company recognizes revenues and reports profits from long-
term construction contracts, its principal business, under the percentage-of-completion method of Method Note Disclosure
accounting. These contracts generally extend for periods in excess of one year. The amounts of revenues
and profits recognized each year are based on the ratio of costs incurred to the total estimated costs.
Costs included in construction in process include direct materials, direct labor, and project-related
overhead. Corporate general and administrative expenses are charged to the periods as incurred and are
not allocated to construction contracts.

Completed-Contract Method LEARNING OBJECTIVE *6

Under the completed-contract method, companies recognize revenue and gross Apply the completed-
profit only at point of sale—that is, when the contract is completed. Under this contract method for
method, companies accumulate costs of long-term contracts in process, but they long-term contracts.
make no interim charges or credits to income statement accounts for revenues, costs,
or gross profit.
The principal advantage of the completed-contract method is that reported revenue
reflects final results rather than estimates of unperformed work. Its major disadvantage
is that it does not reflect current performance when the period of a contract extends into
more than one accounting period. Although operations may be fairly uniform during
the period of the contract, the company will not report revenue until the year of comple-
tion, creating a distortion of earnings.
Under the completed-contract method, the company would make the same annual
entries to record costs of construction, progress billings, and collections from customers
as those illustrated under the percentage-of-completion method (see Illustration 18A-5
on page 1016). The significant difference is that the company would not make entries to
recognize revenue and gross profit.
For example, under the completed-contract method for the bridge project illustrated
on the preceding pages, Hardhat Construction Company would make the following
entries in 2019 to recognize revenue and costs and to close out the inventory and billing
accounts.
Billings on Construction in Process 4,500,000
Revenue from Long-Term Contracts 4,500,000
Costs of Construction 4,050,000
Construction in Process 4,050,000

Illustration 18A-14 compares the amount of gross profit that Hardhat Construction
Company would recognize for the bridge project under the two revenue recognition
methods.

ILLUSTRATION 18A-14
Percentage-of-Completion Completed-Contract
Comparison of Gross
2017 $125,000 $ 0 Profit Recognized under
2018 199,000 0
Different Methods
2019 126,000 450,000

Under the completed-contract method, Hardhat Construction would report its

long-term construction activities as follows.
1020 Chapter 18 Revenue Recognition

ILLUSTRATION 18A-15
HARDHAT CONSTRUCTION COMPANY
Financial Statement
Presentation—Completed- 2017 2018 2019
Contract Method Income Statement
Revenue from long-term contracts — — $4,500,000
Costs of construction — — 4,050,000
Gross profit — — $ 450,000

Balance Sheet (12/31)

Current assets
Accounts receivable $150,000 $800,000 $ –0–
Inventory
Construction in process $1,000,000
Less: Billings 900,000
Costs in excess of billings 100,000 –0–
Current liabilities
Billings ($3,300,000) in excess of
costs ($2,916,000) 384,000 –0–

Note 1. Summary of significant accounting policies.

Long-Term Construction Contracts. The company recognizes revenues and reports profits from long-
term construction contracts, its principal business, under the completed-contract method. These con-
tracts generally extend for periods in excess of one year. Contract costs and billings are accumulated
during the periods of construction, but no revenues or profits are recognized until completion of the
contract. Costs included in construction in process include direct material, direct labor, and project-
related overhead. Corporate general and administrative expenses are charged to the periods as incurred.

LEARNING OBJECTIVE *7 Long-Term Contract Losses

Identify the proper Two types of losses can become evident under long-term contracts:
accounting for losses on
long-term contracts. 1. Loss in the current period on a profitable contract. This condition arises when, dur-
ing construction, there is a significant increase in the estimated total contract costs
but the increase does not eliminate all profit on the contract. Under the percentage-
of-completion method only, the estimated cost increase requires a current-period
adjustment of excess gross profit recognized on the project in prior periods. The
company records this adjustment as a loss in the current period because it is a
change in accounting estimate (discussed in Chapter 22).
2. Loss on an unprofitable contract. Cost estimates at the end of the current period may
indicate that a loss will result on completion of the entire contract. Under both the
percentage-of-completion and the completed-contract methods, the company must
recognize in the current period the entire expected contract loss.

The treatment described for unprofitable contracts is consistent with the accounting
custom of anticipating foreseeable losses to avoid overstatement of current and future
income (conservatism). [24]

Loss in Current Period

To illustrate a loss in the current period on a contract expected to be profitable upon
completion, we’ll continue with the Hardhat Construction Company bridge project.
Assume that on December 31, 2018, Hardhat estimates the costs to complete the bridge
contract at $1,468,962 instead of $1,134,000 (refer to page 1015). Assuming all other data
are the same as before, Hardhat would compute the percent complete and recognize
the loss as shown in Illustration 18A-16. Compare these computations with those for
2018 in Illustration 18A-4 (page 1015). The “percent complete” has dropped, from 72
percent to 661⁄2 percent, due to the increase in estimated future costs to complete the
contract.
 Appendix 18A: Long-Term Construction Contracts 1021

ILLUSTRATION 18A-16
Cost to date (12/31/18) $2,916,000
Computation of
Estimated costs to complete (revised) 1,468,962
Recognizable Loss, 2018—
Estimated total costs $4,384,962
Loss in Current Period
Percent complete ($2,916,000 ÷ $4,384,962) 661⁄2%
Revenue recognized in 2018
($4,500,000 × 661⁄2%) – $1,125,000 $1,867,500
Costs incurred in 2018 1,916,000
Loss recognized in 2018 $ (48,500)

The 2018 loss of $48,500 is a cumulative adjustment of the “excessive” gross profit
recognized on the contract in 2017. Instead of restating the prior period, the company
absorbs the prior period misstatement entirely in the current period. In this illustration,
the adjustment was large enough to result in recognition of a loss.
Hardhat Construction would record the loss in 2018 as follows.

Construction Expenses 1,916,000

Construction in Process (loss) 48,500
Revenue from Long-Term Contracts 1,867,500

Hardhat will report the loss of $48,500 on the 2018 income statement as the differ-
ence between the reported revenue of $1,867,500 and the costs of $1,916,000.19 Under the
completed-contract method, the company does not recognize a loss in 2018. Why not?
Because the company still expects the contract to result in a profit, to be recognized in
the year of completion.

Loss on an Unprofitable Contract

To illustrate the accounting for an overall loss on a long-term contract, assume that at
December 31, 2018, Hardhat Construction Company estimates the costs to complete the
bridge contract at $1,640,250 instead of $1,134,000. Revised estimates for the bridge con-
tract are as follows.

2017 2018
Original Revised
Estimates Estimates
Contract price $4,500,000 $4,500,000
Estimated total cost 4,000,000 4,556,250*
Estimated gross profit $ 500,000
Estimated loss $ (56,250)

*($2,916,000 + $1,640,250)

Under the percentage-of-completion method, Hardhat recognized $125,000 of

gross profit in 2017 (see Illustration 18A-6 on page 1016). This amount must be offset in
2018 because it is no longer expected to be realized. In addition, since losses must be
recognized as soon as estimable, the company must recognize the total estimated loss of
$56,250 in 2018. Therefore, Hardhat must recognize a total loss of $181,250 ($125,000 +
$56,250) in 2018.

19
In 2019, Hardhat Construction will recognize the remaining 33½ percent of the revenue ($1,507,500), with
costs of $1,468,962 as expected, and will report a gross profit of $38,538. The total gross profit over the three
years of the contract would be $115,038 [$125,000 (2017) – $48,500 (2018) + $38,538 (2019)]. This amount is
the difference between the total contract revenue of $4,500,000 and the total contract costs of $4,384,962.
1022 Chapter 18 Revenue Recognition

Illustration 18A-17 shows Hardhat’s computation of the revenue to be recognized in

2018.

ILLUSTRATION 18A-17
Revenue recognized in 2018:
Computation of Revenue
Contract price $4,500,000
Recognizable, 2018— Percent complete × 64%*
Unprofitable Contract
Revenue recognizable to date 2,880,000
Less: Revenue recognized prior to 2018 1,125,000
Revenue recognized in 2018 $1,755,000

*Cost to date (12/31/18) $2,916,000

Estimated cost to complete 1,640,250
Estimated total costs $4,556,250
Percent complete: $2,916,000 ÷ $4,556,250 = 64%

To compute the construction costs to be expensed in 2018, Hardhat adds the total
loss to be recognized in 2018 ($125,000 + $56,250) to the revenue to be recognized in
2018. Illustration 18A-18 shows this computation.

ILLUSTRATION 18A-18
Revenue recognized in 2018 (computed above) $1,755,000
Computation of
Total loss recognized in 2018:
Construction Expense, Reversal of 2017 gross profit $125,000
2018—Unprofitable Total estimated loss on the contract 56,250 181,250
Contract
Construction cost expensed in 2018 $1,936,250

Hardhat Construction would record the long-term contract revenues, expenses, and
loss in 2018 as follows.
Construction Expenses 1,936,250
Construction in Process (loss) 181,250
Revenue from Long-Term Contracts 1,755,000

At the end of 2018, Construction in Process has a balance of $2,859,750 as shown

below.20

ILLUSTRATION 18A-19
Construction in Process
Content of Construction
in Process Account at End 2017 Construction costs 1,000,000
2017 Recognized gross profit 125,000
of 2018—Unprofitable
2018 Construction costs 1,916,000 2018 Recognized loss 181,250
Contract
Balance 2,859,750

Under the completed-contract method, Hardhat also would recognize the contract
loss of $56,250 through the following entry in 2018 (the year in which the loss first
became evident).

20
If the costs in 2019 are $1,640,250 as projected, at the end of 2019 the Construction in Process account will
have a balance of $1,640,250 + $2,859,750, or $4,500,000, equal to the contract price. When the company
matches the revenue remaining to be recognized in 2019 of $1,620,000 [$4,500,000 (total contract price)
– $1,125,000 (2017) – $1,755,000 (2018)] with the construction expense to be recognized in 2019 of $1,620,000
[total costs of $4,556,250 less the total costs recognized in prior years of $2,936,250 (2017, $1,000,000; 2018,
$1,936,250)], a zero profit results. Thus, the total loss has been recognized in 2018, the year in which it first
became evident.
 Appendix 18B: Revenue Recognition for Franchises 1023

Loss from Long-Term Contracts 56,250

Construction in Process (loss) 56,250

Just as the Billings account balance cannot exceed the contract price, neither can the
balance in Construction in Process exceed the contract price. In circumstances where
the Construction in Process balance exceeds the billings, the company can deduct the
recognized loss from such accumulated costs on the balance sheet. That is, under both
the percentage-of-completion and the completed-contract methods, the provision for
the loss (the credit) may be combined with Construction in Process, thereby reducing
the inventory balance. In those circumstances, however (as in the 2018 example above),
where the billings exceed the accumulated costs, Hardhat must report separately on the
balance sheet, as a current liability, the amount of the estimated loss. That is, under both
the percentage-of-completion and the completed-contract methods, Hardhat would
take the $56,250 loss, as estimated in 2018, from the Construction in Process account and
report it separately as a current liability titled “Estimated liability from long-term
contracts.”

APPENDIX 18B REVENUE RECOGNITION FOR FRANCHISES

In this appendix, we cover a common yet unique type of business transaction—fran- LEARNING OBJECTIVE *8
chises. As indicated throughout this chapter, companies recognize revenue when per- Explain revenue recogni-
formance obligations in a revenue arrangement are satisfied. Franchises represent a tion for franchises.
challenging area because a variety of performance obligations may exist in a given fran-
chise agreement. As a result, companies must carefully analyze franchise agreements to
identify the separate performance obligations, determine when performance obliga-
tions are met, and, therefore, when revenue should be recognized.21
Four types of franchising arrangements have evolved: (1) manufacturer-retailer,
(2) manufacturer-wholesaler, (3) service sponsor-retailer, and (4) wholesaler-retailer.
The fastest-growing category of franchising, and the one that has given rise to account-
ing challenges, is the third category, service sponsor-retailer. Included in this category
are such industries and businesses as:

• Soft ice cream/frozen yogurt stores (Tastee Freez, TCBY, Dairy Queen)
• Food drive-ins (McDonald’s, KFC, Burger King)
• Restaurants (TGI Friday’s, Pizza Hut, Denny’s)
• Motels (Holiday Inn, Marriott, Best Western)
• Auto rentals (Avis, Hertz, National)
• Others (H & R Block, Meineke Mufflers, 7-Eleven Stores, Kelly Services)

Franchise companies derive their revenue from one or both of two sources: (1) from
the sale of initial franchises and related assets or services, and (2) from continuing fees
based on the operations of franchises. The franchisor (the party who grants business

21
Franchises are an example of a license or similar rights to use intellectual property. In such arrangements,
a company grants a customer the right to use, but not own, intellectual property of the company. Other
examples of intellectual property include (1) software and technology; (2) motion pictures, music, and other
forms of media and entertainment; and (3) patents, trademarks, and copyrights. Generally, revenue is
recognized in these situations when the customer obtains control of the rights. In some cases, a license is a
promise to provide a right, which transfers to the customer at a point in time. In other cases, a license is a
promise to provide access to an entity’s intellectual property, which transfers benefits to the customer over
time. [25]
1024 Chapter 18 Revenue Recognition

rights under the franchise) normally provides the franchisee (the party who operates
the franchised business) with the following services.

1. Assistance in site selection: (a) analyzing location and (b) negotiating lease.
2. Evaluation of potential income.
3. Supervision of construction activity: (a) obtaining financing, (b) designing building,
and (c) supervising contractor while building.
4. Assistance in the acquisition of signs, fixtures, and equipment.
5. Bookkeeping and advisory services: (a) setting up franchisee’s records; (b) advising
on income, real estate, and other taxes; and (c) advising on local regulations of the
franchisee’s business.
6. Employee and management training.
7. Quality control.
8. Advertising and promotion.

In the past, it was standard practice for franchisors to recognize the entire franchise
fee at the date of sale, whether the fee was received then or was collectible over a long
period of time. Frequently, franchisors recorded the entire amount as revenue in the
year of sale, even though many of the services were yet to be performed and uncertainty
existed regarding the collection of the entire fee. (In effect, the franchisors were counting
their fried chickens before they were hatched.) However, a franchise agreement may
provide for refunds to the franchisee if certain conditions are not met, and franchise fee
profit can be reduced sharply by future costs of obligations and services to be rendered
by the franchisor.

FRANCHISE ACCOUNTING
As indicated, the performance obligations in a franchise arrangement relate to the right
to open a business, use of the trade name or other intellectual property of the franchisor,
and continuing services, such as marketing help, training, and in some cases supplying
inventory and inventory management. Franchisors commonly charge an initial fran-
chise fee as well as continuing franchise fees. The initial franchise fee is payment for
establishing the franchise relationship and providing some initial services. Continuing
franchise fees are received in return for the continuing rights granted by the franchise
agreement and for providing such services as management training, advertising and
promotion, legal assistance, and other support. Illustration 18B-1 provides an example
of a franchise arrangement.

ILLUSTRATION 18B-1
FRANCHISE
Recognition—Franchise
Arrangement Facts: Tum’s Pizza Inc. enters into a franchise agreement on December 31, 2017, giving Food Fight Corp.
the right to operate as a franchisee of Tum’s Pizza for 5 years. Tum’s charges Food Fight an initial franchise
fee of $50,000 for the right to operate as a franchisee. Of this amount, $20,000 is payable when Food
Fight signs the agreement, and the note balance is payable in five annual payments of $6,000 each on
December 31. As part of the arrangement, Tum’s helps locate the site, negotiate the lease or purchase of
the site, supervise the construction activity, and provide employee training and the equipment necessary
to be a distributor of its products. Similar training services and equipment are sold separately.
Food Fight also promises to pay ongoing royalty payments of 1% of its annual sales (payable each
January 31 of the following year) and is obliged to purchase products from Tum’s at its current standalone
selling prices at the time of purchase. The credit rating of Food Fight indicates that money can be
borrowed at 8%. The present value of an ordinary annuity of five annual receipts of $6,000 each discounted
at 8% is $23,957. The discount of $6,043 represents the interest revenue to be accrued by Tum’s over the
payment period.

(continued)
 Appendix 18B: Revenue Recognition for Franchises 1025

ILLUSTRATION 18B-1
Question: What are the performance obligations in this arrangement and the point Recognition—Franchise
in time at which the performance obligations for Tum’s are satisfied and revenue is Arrangement (Continued)
recognized?

Solution: To identify the performance obligations, Tum’s must determine whether the promised rights,
site selection and construction services, training services, and equipment are distinct.
• Rights to the trade name, market area, and proprietary know-how for 5 years are not individually
distinct because each one is not sold separately and cannot be used with other goods or services
that are readily available to the franchisee. Therefore, those combined rights give rise to a single
performance obligation. Tum’s satisfies the performance obligation to grant those rights at the point
in time when Food Fight obtains control of the rights. That is, once Food Fight begins operating the
store, Tum’s has no further obligation with respect to these rights.
• Training services and equipment are distinct because similar services and equipment are sold
separately. Tum’s satisfies those performance obligations when it transfers the services and
equipment to Food Fight.
• Tum’s cannot recognize revenue for the royalty payments because it is not reasonably assured to be
entitled to those sales-based royalty amounts. That is, these payments represent variable consideration.
Therefore, Tum’s recognizes revenue for the royalties when (or as) the uncertainty is resolved.

Tum’s promise to stand ready to provide products to the franchisee in the future at standalone selling
prices is not accounted for as a separate performance obligation in the contract because it does not
provide Food Fight with a material right. Thus, revenue from those sales is recorded in the future when
the sales are made.

To illustrate the accounting for this franchise, consider the following values for allo-
cation of the transaction price at December 31, 2017.

Rights to the trade name, market area,

and proprietary know-how $20,000
Training services 9,957
Equipment (cost of $10,000) 14,000
Total transaction price $43,957

Training is completed in January 2018, the equipment is installed in January 2018,

and Food Fight holds a grand opening on February 2, 2018. The entries for the Tum’s
franchise arrangement are summarized in Illustration 18B-2.

ILLUSTRATION 18B-2
Tum’s signs the agreement and receives upfront payment and note on December 31, 2017 Franchise Entries—
Inception and
Cash 20,000 Commencement of
Notes Receivable 30,000 Operations
Discount on Notes Receivable 6,043
Unearned Franchise Revenue 20,000
Unearned Service Revenue (training) 9,957
Unearned Sales Revenue (equipment) 14,000

Franchise opens; Tum’s satisfies the performance obligations related to the franchise rights,
training, and equipment (that is, Tum’s has no further obligations related to these elements
of the franchise) on February 2, 2018

Unearned Franchise Revenue 20,000

Franchise Revenue 20,000

(continued)
1026 Chapter 18 Revenue Recognition

ILLUSTRATION 18B-2
Unearned Service Revenue (training) 9,957
Franchise Entries—
Service Revenue (training) 9,957
Inception and
Commencement of Unearned Sales Revenue (equipment) 14,000
Operations (Continued) Sales Revenue 14,000

Cost of Goods Sold 10,000

Inventory 10,000

As indicated, when Food Fight begins operations, Tum’s satisfies the performance obli-
gations related to the franchise rights, training, and equipment under the franchise agree-
ment. That is, Tum’s has no further obligations related to these elements of the franchise.
During 2018, Food Fight does well, recording $525,000 of sales in its first year of
operations. The entries for Tum’s related to the first year of operations of the franchise
are summarized in Illustration 18B-3.

ILLUSTRATION 18B-3
Franchise Entries—First To record continuing franchise fees on December 31, 2018
Year of Franchise Accounts Receivable ($525,000 × 1%) 5,250
Operations Franchise Revenue 5,250

To record payment received and interest revenue on note on December 31, 2018

Cash 6,000
Notes Receivable 6,000

Discount on Notes Receivable ($23,957 × 8%) 1,917

Interest Revenue 1,917

Tum’s will make similar entries in subsequent years of the franchise agreement.

RECOGNITION OF FRANCHISE
RIGHTS REVENUE OVER TIME
In the franchise example presented in Illustration 18B-1, Tum’s transferred control of the
franchise rights at a point in time—that is, when the franchisee began operations and
could benefit from control of the rights—with no further involvement by Tum’s. In other
situations, depending on the economic substance of the rights, the franchisor may be
providing access to the right rather than transferring control of the franchise rights. In
this case, the franchise revenue is recognized over time, rather than at a point in time.
The franchise arrangement presented in Illustration 18B-4 provides an example of a
franchise agreement with revenue recognized over time.

ILLUSTRATION 18B-4
FRANCHISE REVENUE OVER TIME
Revenue Recognition over
Time—Franchise Facts: Tech Solvers Corp. is a franchisor in the emerging technology consulting service business. Tech
Solvers’ stores provide a range of computing services (hardware/software installation, repairs, data
backup, device syncing, and network solutions) on popular Apple and PC devices. Each franchise
agreement gives a franchisee the right to open a Tech Solvers store and sell Tech Solvers’ products and
services in the area for 5 years. Under the contract, Tech Solvers also provides the franchisee with a
number of services to support and enhance the franchise brand, including (a) advising and consulting on
the operations of the store; (b) communicating new hardware and software developments, and service
techniques; (c) providing business and training manuals; and (d) advertising programs and training. As an
almost entirely service operation (all parts and other supplies are purchased as needed by customers),
Tech Solvers provides few upfront services to franchisees. Instead, the franchisee recruits service

(continued)
 Appendix 18B: Revenue Recognition for Franchises 1027

ILLUSTRATION 18B-4
technicians, who are given Tech Solvers’ training materials (online manuals and tutorials), which are
updated for technology changes, on a monthly basis at a minimum.
Revenue Recognition over
Tech Solvers enters into a franchise agreement on December 15, 2017, giving a franchisee the rights to Time—Franchise
operate a Tech Solvers franchise in eastern Indiana for 5 years. Tech Solvers charges an initial franchise fee (Continued)
of $5,000 for the right to operate as a franchisee, payable upon signing the contract. Tech Solvers also
receives ongoing royalty payments of 7% of the franchisee’s annual sales (payable each January 15 of the
following year). The franchise began operations in January 2018 and recognized $85,000 of revenue in 2018.

Question: What are the performance obligations in this arrangement and the point in
time at which the performance obligations will be satisfied and revenue will be
recognized?

Solution: To identify the performance obligations, Tech Solvers must determine whether the promised
rights and the ongoing franchisee technology support and training services are distinct.
• Rights to the trade name, market area, and proprietary know-how for 5 years are not individually
distinct because each one is not sold separately and cannot be used with other goods or services
that are readily available to the franchisee. In addition, these licensed rights have a close connection
with the underlying Tech Solvers’ intellectual property (its ability to keep its service and training ma-
terials up-to-date). Therefore, those combined rights and the ongoing training materials are a single
performance obligation. Tech Solvers satisfies the performance obligation over time. That is, once
the franchisee begins operating a Tech Solvers franchise, Tech Solvers is providing access to the
rights and must continue to perform updates and services.
• Tech Solvers cannot recognize revenue for the royalty payments because it is not reasonably as-
sured to be entitled to those revenue-based royalty amounts. That is, these payments represent
variable consideration. Therefore, Tech Solvers recognizes revenue for the royalties when (or as) the
uncertainty is resolved.

The entries for Tech Solvers related to the franchise are summarized in Illustration
18B-5.

ILLUSTRATION 18B-5
Franchise agreement signed and receipt of upfront payment and note on December 15, 2017 Franchise Entries—
Cash 5,000 Revenue Recognized
Unearned Franchise Revenue 5,000 over Time

Franchise begins operations in January 2018 and records $85,000 of revenue for the year ended
December 31, 2018 on December 31, 2018

Unearned Franchise Revenue 1,000

Franchise Revenue ($5,000 ÷ 5) 1,000

Accounts Receivable 5,950

Franchise Revenue ($85,000 × 7%) 5,950

To record payment received from franchisee on January 15, 2019

Cash 5,950
Accounts Receivable 5,950

As indicated, Tech Solvers satisfies the performance obligation related to the

franchise rights and training materials over time (in this case, on a straight-line basis).
Continuing franchise fees are recognized when uncertainty related to the variable con-
sideration is resolved.
In summary, analysis of the characteristics of the Tech Solvers franchise indicates
that it does not reflect a right that is transferred at a point in time. That is, Tech Solvers
has a continuing obligation to provide updated materials and ongoing support, sug-
gesting the control of the right has not been transferred to the franchisee. Thus, revenue
from the franchise rights is recognized over time.
 1028 Chapter 18 Revenue Recognition

REVIEW AND PRACTICE

KEY TERMS REVIEW
asset-liability approach, 980 consignment, 1002 *franchises, 1023 principal-agent relationship,
assurance-type consignor, 1002 *franchisor, 1023 1001
warranty, 1004 *continuing franchise fees, *initial franchise fee, repurchase agreements,
bill-and-hold 1024 1024 999
arrangement, 1001 contract, 986 *input measures, 1014 revenue recognition
*Billings account, 1017 contract assets, 1007 *output measures, 1014 principle, 981
collectibility, 1011 contract liability, 1008 *percentage-of-completion service-type warranty, 1004
*completed-contract method, contract modification, 1009 method, 1014 transaction price, 988
1019 *cost-to-cost basis, 1014 performance obligation, upfront fees, 1006
consignee, 1002 *franchisee, 1024 987 warranties, 1004

LEARNING OBJECTIVES REVIEW

1 Understand the fundamental concepts related to revenue recognition and measurement. Most revenue transac-
tions pose few problems for revenue recognition. This is because, in many cases, the transaction is initiated and completed at
the same time. Increasing complexity of business and revenue arrangements have resulted in revenue recognition practices
being identified as the most prevalent reasons for accounting restatements. A number of the revenue recognition issues relate
to possible fraudulent behavior by company executives and employees, but are also due to sometimes incomplete and incon-
sistent accounting guidelines for revenue recognition. A recent new standard provides a set of guidelines to follow in deter-
mining when revenue should be reported and how it should be measured. The standard is comprehensive and applies to all
companies. As a result, comparability and consistency in reporting revenue should be enhanced.
The five steps in the revenue recognition process are (1) identify the contract with customers, (2) identify the separate
performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the separate
performance obligations, and (5) recognize revenue when each performance obligation is satisfied.
2 Understand and apply the five-step revenue recognition process. Identify the contract with customers. A contract is an
agreement that creates enforceable rights or obligations. A company applies the revenue guidance to contracts with customers.
Identify the separate performance obligations in the contract. A performance obligation is a promise in a contract to
provide a product or service to a customer. A contract may be comprised of multiple performance obligations. The accounting
for multiple performance obligations is based on evaluation of whether the product or service is distinct within the contract.
If each of the goods or services is distinct, but is interdependent and interrelated, these goods and services are combined and
reported as one performance obligation.
Determine the transaction price. The transaction price is the amount of consideration that a company expects to
receive from a customer in exchange for transferring goods and services. In determining the transaction price, companies
must consider the following factors: (1) variable consideration, (2) time value of money, (3) noncash consideration, and (4)
consideration paid or payable to a customer.
Allocate the transaction price to the separate performance obligations. If more than one performance obligation exists
in a contract, allocate the transaction price based on relative standalone selling prices. Estimates of standalone selling price can
be based on (1) adjusted market assessment, (2) expected cost plus a margin approach, or (3) a residual approach.
Recognize revenue when the company satisfies its performance obligation. A company satisfies its performance
obligation when the customer obtains control of the good or service. Companies satisfy performance obligations either at
a point in time or over a period of time. Companies recognize revenue over a period of time if one of the following criteria
is met: (1) the customer receives and consumes the benefits as the seller performs, (2) the customer controls the asset as it is
created, or (3) the company does not have an alternative use for the asset.
3 Apply the five-step process to major revenue recognition issues. Refer to Illustration 18-26 (page 1007) for a sum-
mary of the accounting for (a) sales returns and allowances, (b) repurchase agreements, (c) bill-and-hold sales, (d) principal-
agent relationships, (e) consignments, (f) warranties, and (g) nonrefundable upfront fees.
4 Describe presentation and disclosure regarding revenue. Under the asset-liability approach, to recognize revenue,
companies present contract assets and contract liabilities on their balance sheets. Contract assets are rights to receive consideration.
A contract liability is a company’s obligation to transfer goods or services to a customer for which the company has received
 Practice Problem 1029

consideration from the customer. Companies must determine if new performance obligations are created by a contract modification
and may also report assets associated with fulfillment costs and contract acquisition costs related to a revenue arrangement.
Companies disclose qualitative and quantitative information about (a) contracts with customers with disaggregation of revenue,
presentation of opening and closing balances in contract assets and contract liabilities, and significant information related to their
performance obligations; (b) significant judgments that affect the determination of the transaction price, the allocation of the trans-
action price, and the determination of the timing of revenue; and (c) assets recognized from costs incurred to fulfill a contract.

*5 Apply the percentage-of-completion method for long-term contracts. To apply the percentage-of-completion
method to long-term contracts, a company must have some basis for measuring the progress toward completion at particular
interim dates. One of the most popular input measures used to determine the progress toward completion is the cost-to-cost
basis. Using this basis, a company measures the percentage of completion by comparing costs incurred to date with the most
recent estimate of the total costs to complete the contract. The company applies that percentage to the total revenue or the
estimated total gross profit on the contract, to arrive at the amount of revenue or gross profit to be recognized to date.

*6 Apply the completed-contract method for long-term contracts. Under this method, companies recognize revenue
and gross profit only at a point in time—that is, when the company completes the contract. The company accumulates costs
of long-term contracts in process and current billings. It makes no interim charges or credits to income statement accounts for
revenues, costs, and gross profit. The annual journal entries to record costs of construction, progress billings, and collections
from customers would be identical to those for the percentage-of-completion method—with the significant exclusion of the
recognition of revenue and gross profit.

*7 Identify the proper accounting for losses on long-term contracts. Two types of losses can become evident under
long-term contracts. (1) Loss in current period on a profitable contract: Under the percentage-of-completion method only, the
estimated cost increase requires a current-period adjustment of excess gross profit recognized on the project in prior periods.
The company records this adjustment as a loss in the current period because it is a change in accounting estimate. (2) Loss on
an unprofitable contract: Under both the percentage-of-completion and the completed-contract methods, the company must
recognize the entire expected contract loss in the current period.

*8 Explain revenue recognition for franchises. In a franchise arrangement, the franchisor satisfies its performance obliga-
tion for a franchise license when control of the franchise rights is transferred, generally when the franchisee begins operations
of the franchise. In situations where the franchisor provides access to the rights rather than transferring control of the franchise
rights, the franchise rights’ revenue is recognized over time rather than at a point in time. Franchisors recognize continuing
franchise fees over time (as uncertainty related to the variable consideration is resolved).

ENHANCED REVIEW AND PRACTICE

Go online for multiple-choice questions with solutions, review exercises with solutions, and a full
glossary of all key terms.

PRACTICE PROBLEM
Outback Industries manufactures emergency power equipment. Its most popular generator is a model called the E-Booster, which
has a retail price of $1,500 and costs Outback $740 to manufacture. It sells the E-Booster on a standalone basis directly to businesses,
as well as provides installation services. Outback also distributes the E-Booster through a consignment agreement with Home
Depot. Income data for Outback’s first quarter of 2017 from operations other than the E-Booster generator are as follows.
Revenues $6,500,000
Expenses 4,350,000
Outback has the following information related to four E-Booster revenue arrangements during the first quarter of 2017.
1. Outback entered into an arrangement with the Grocers Co-op in eastern Minnesota to deliver E-Boosters for the meat lock-
ers in the grocers’ stores. Outback provides a 5% volume discount for E-Boosters purchased by Grocers Co-op if at least
$450,000 of E-Boosters are purchased during 2017. By March 31, 2017, Outback has made sales of $360,000 ($1,500 × 240
generators) to Grocers Co-op. Based on prior experience with this promotion in two neighboring states, the discount
threshold is met for the year if more than one-half of the target had been met by mid-year.
2. On January 1, 2017, Outback sells 20 E-Boosters to Nick’s Liquors. Nick’s signs a 6-month note due in 6 months at an annual
interest rate of 12%. Outback allows Nick’s to return any E-Boosters that it cannot use within 120 days and receive a full refund.
Based on prior experience, Outback estimates that three units will be returned (using the most likely outcome approach). Out-
back‘s costs to recover the products will be immaterial, and the returned generators are expected to be resold at a profit. No
E-Boosters have been returned as of March 31, 2017, and Outback still estimates that three units will be returned in the future.
1030 Chapter 18 Revenue Recognition

3. Outback sells 30 E-Boosters to a community bank in the Florida Keys, to provide uninterrupted power for bank branches
with ATMs, for a total contract price of $50,000. In addition to the E-Boosters, Outback also provides installation at a stand-
alone selling price of $200 per E-Booster; the cost to Outback to install is $150 per E-Booster. The E-Boosters are delivered
and installed on March 1, 2017, and full payment is made to Outback.
4. Outback ships 300 E-Boosters to Home Depot on consignment. By March 31, 2017, Home Depot has sold three-fourths of
the consigned merchandise at the listed price of $1,500 per unit. Home Depot notifies Outback of the sales, retains an 8%
commission, and remits the cash due to Outback.
Instructions
(a) Determine net income for Outback Industries for the first quarter of 2017. (Ignore taxes.)
(b) In reviewing the credit history of Nick’s Liquors, Outback has some concerns about the collectibility of the full amount due
on the note. Briefly discuss how collectibility of the note affects revenue recognition and income measurement for Outback.

SOLUTION

(a) The amount of revenue and expense recognized on each of the arrangements is as follows.
1. Sales revenue [95% × ($1,500 × 240)] $342,000
Cost of goods sold ($740 × 240) 177,600
Gross profit $164,400

2. Sales revenue (20 × $1,500) 30,000

Less: Estimated returns (3 × $1,500) 4,500
Net sales 25,500
Cost of goods sold (17 × $740) 12,580
Gross profit 12,920
Interest revenue ($30,000 × 12% × 3/12) 900
Net income on this arrangement 13,820

3. The total transaction price of $50,000 is allocated between the equipment and
installation. The transaction price for the equipment and installation is
allocated based on relative standalone selling prices:
Equipment: $44,118 = ($45,000 ÷ $51,000*) × $50,000
Installation: $5,882 = ($6,000 ÷ $51,000) × $50,000
*$45,000 + $6,000
Sales revenue $44,118
Cost of goods sold (30 × $740) 22,200
Gross profit 21,918
Installation revenue 5,882
Installation expense (30 × $150) 4,500
Net profit 1,382
Net income on this arrangement 23,300
4. Sales revenue (225* × $1,500) 337,500
Cost of goods sold (225 × $740) 166,500
Gross profit 171,000
Commission expense ($337,500 × 8%) 27,000
Net income on this arrangement 144,000
Net income on E-Booster $345,520
*300 × 75%
Outback Industries’ net income for the quarter: $6,500,000 − $4,350,000 + $345,520 = $2,495,520.
(b) Whether a company will get paid for satisfying a performance obligation is not a consideration in determining revenue
recognition. That is, the amount recognized is not adjusted for customer credit risk. If significant doubt exists at contract
inception about collectibility, Outback reports the revenue gross and then presents an allowance for any impairment due
to bad debts, which will reduce net income and which is reported as an operating expense in the income statement.

Exercises, Problems, Problem Solution Walkthrough Videos, and many more assessment
tools and resources are available for practice in WileyPLUS.

Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.
 Questions 1031

QUESTIONS
1. Explain the current environment regarding revenue approach should Allee use to determine the transaction
recognition. price for this contract? Explain.
2. What was viewed as a major criticism of GAAP as it 15. Refer to the information in Question 14. Assume that
relates to revenue recognition? Allee has limited experience with a construction project
3. Describe the revenue recognition principle. on the same scale as the 10 speedboats. How does this
affect the accounting for the variable consideration?
4. Identify the five steps in the revenue recognition process.
16. In measuring the transaction price, explain the accounting
5. Describe the critical factor in evaluating whether a per-
for (a) time value of money, and (b) noncash consideration.
formance obligation is satisfied.
17. What is the proper accounting for volume discounts on
6. When is revenue recognized in the following situations?
sales of products?
(a) Revenue from selling products, (b) revenue from ser-
vices performed, (c) revenue from permitting others to use 18. On what basis should the transaction price be allocated to
company assets, and (d) revenue from disposing of assets various performance obligations? Identify the approaches
other than products. for allocating the transaction price.
7. Explain the importance of a contract in the revenue rec- 19. Fuhremann Co. is a full-service manufacturer of surveil-
ognition process. lance equipment. Customers can purchase any combina-
tion of equipment, installation services, and training as
8. On October 10, 2017, Executor Co. entered into a contract
part of Fuhremann’s security services. Thus, each of
with Belisle Inc. to transfer Executor’s specialty products
these performance obligations are separate with individ-
(sales value of $10,000, cost of $6,500) on December 15,
ual standalone selling prices. Laplante Inc. purchased
2017. Belisle agrees to make a payment of $5,000 upon
cameras, installation, and training at a total price of
delivery and signs a promissory note to pay the remain-
$80,000. Estimated standalone selling prices of the equip-
ing balance on January 15, 2018. What entries does Exec-
ment, installation, and training are $90,000, $7,000, and
utor make in 2017 on this contract? Ignore time value of
$3,000, respectively. How should the transaction price be
money considerations.
allocated to the equipment, installation, and training?
9. What is a performance obligation? Under what condi-
20. When does a company satisfy a performance obligation?
tions does a performance obligation exist?
Identify the indicators of satisfaction of a performance
10. When must multiple performance obligations in a reve- obligation.
nue arrangement be accounted for separately?
21. Under what conditions does a company recognize reve-
11. Engelhart Implements Inc. sells tractors to area farmers. nue over a period of time?
The price for each tractor includes GPS positioning service
22. How do companies recognize revenue from a perfor-
for 9 months (which facilitates field settings for planting
mance obligation over time?
and harvesting equipment). The GPS service is regularly
sold on a standalone basis by Engelhart for a monthly fee. 23. Explain the accounting for sales with right of return.
After the 9-month period, the consumer can renew the ser- 24. What are the reporting issues in a sale with a repurchase
vice on a fee basis. Does Engelhart have one or multiple agreement?
performance obligations? Explain. 25. Explain a bill-and-hold sale. When is revenue recognized
12. What is the transaction price? What additional factors in these situations?
related to the transaction price must be considered in 26. Explain a principal-agent relationship and its signifi-
determining the transaction price? cance to revenue recognition.
13. What are some examples of variable consideration? What are 27. What is the nature of a sale on consignment?
the two approaches for estimating variable consideration?
28. What are the two types of warranties? Explain the account-
14. Allee Corp. is evaluating a revenue arrangement to ing for each type.
determine proper revenue recognition. The contract is for
29. Campus Cellular provides cell phones and 1 year of cell ser-
construction of 10 speedboats for a contract price of
vice to students for an upfront, nonrefundable fee of $300 and
$400,000. The customer needs the boats in its showrooms
a usage fee of $5 per month. Students may renew the service
by February 1, 2018, for the boat purchase season; the
for each year they are on campus (on average, students renew
customer provides a bonus payment of $21,000 if all
their service one time). What amount of revenue should
boats are delivered by the February 1 deadline. The bonus
Campus Cellular recognize in the first year of the contract?
is reduced by $7,000 each week that the boats are deliv-
ered after the deadline until no bonus is paid if the boats 30. Describe the conditions when contract assets and liabili-
are delivered after February 15, 2018. Allee frequently ties are recognized and presented in financial statements.
includes such bonus terms in it contracts and thus has 31. Explain the accounting for contract modifications.
good historical data for estimating the probabilities of 32. Explain the reporting for (a) costs to fulfill a contract and
completion at different dates. It estimates an equal prob- (b) collectibility.
ability (25%) for each full delivery outcome. What
 1032 Chapter 18 Revenue Recognition

33. What qualitative and quantitative disclosures are measures” and some “output measures” that might be
required related to revenue recognition? used to determine the extent of progress.
* 34. What are the two basic methods of accounting for long- * 37. What are the two types of losses that can become evident
term construction contracts? Indicate the circumstances in accounting for long-term contracts? What is the nature
that determine when one or the other of these methods of each type of loss? How is each type accounted for?
should be used. * 38. Why in franchise arrangements may it be improper to
* 35. For what reasons should the percentage-of-completion recognize the entire franchise fee as revenue at the date
method be used over the completed-contract method of sale?
whenever possible? * 39. How should a franchisor account for continuing fran-
* 36. What methods are used in practice to determine the extent chise fees and routine sales of equipment and supplies to
of progress toward completion? Identify some “input franchisees?

BRIEF EXERCISES
BE18-1 (L01) Leno Computers manufactures tablet computers for sale to retailers such as Fallon Electronics. Recently, Leno
sold and delivered 200 tablet computers to Fallon for $20,000 on January 5, 2017. Fallon has agreed to pay for the 200 tablet com-
puters within 30 days. Fallon has a good credit rating and should have no difficulty in making payment to Leno. (a) Explain
whether a valid contract exists between Leno Computers and Fallon Electronics. (b) Assuming that Leno Computers has not yet
delivered the tablet computers to Fallon Electronics, what might cause a valid contract not to exist between Leno and Fallon?
BE18-2 (L01) On May 10, 2017, Cosmo Co. enters into a contract to deliver a product to Greig Inc. on June 15, 2017. Greig
agrees to pay the full contract price of $2,000 on July 15, 2017. The cost of the goods is $1,300. Cosmo delivers the product to
Greig on June 15, 2017, and receives payment on July 15, 2017. Prepare the journal entries for Cosmo related to this contract.
Either party may terminate the contract without compensation until one of the parties performs.
BE18-3 (L02) Hillside Company enters into a contract with Sanchez Inc. to provide a software license and 3 years of customer
support. The customer-support services require specialized knowledge that only Hillside Company’s employees can perform.
How many performance obligations are in the contract?
BE18-4 (L02) Destin Company signs a contract to manufacture a new 3D printer for $80,000. The contract includes installa-
tion which costs $4,000 and a maintenance agreement over the life of the printer at a cost of $10,000. The printer cannot be oper-
ated without the installation. Destin Company as well as other companies could provide the installation and maintenance agree-
ment. What are Destin Company’s performance obligations in this contract?
BE18-5 (L02) Ismail Construction enters into a contract to design and build a hospital. Ismail is responsible for the overall
management of the project and identifies various goods and services to be provided, including engineering, site clearance, foun-
dation, procurement, construction of the structure, piping and wiring, installation of equipment, and finishing. Does Ismail have
a single performance obligation to the customer in this revenue arrangement? Explain.
BE18-6 (L02) 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 provides a performance bonus of $150,000 to be paid if the
building is ready for rental beginning August 1, 2018. 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 Probability
August 1, 2018 70%
August 8, 2018 20
August 15, 2018 5
After August 15, 2018 5

Determine the transaction price for this contract.

BE18-7 (L02) Referring to the revenue arrangement in BE18-6, determine the transaction price for the contract, assuming
(a) Nair is only able to estimate whether the building can be completed by August 1, 2018, or not (Nair estimates that there is a
70% chance that the building will be completed by August 1, 2018), and (b) Nair has limited information with which to develop
a reliable estimate of completion by the August 1, 2018, deadline.
BE18-8 (L02) Presented below are three revenue recognition situations.
(a) Groupo sells goods to MTN for $1,000,000, payment due at delivery.
(b) Groupo sells goods on account to Grifols for $800,000, payment due in 30 days.
(c) Groupo sells goods to Magnus for $500,000, payment due in two installments, the first installment payable in 18 months
and the second payment due 6 months later. The present value of the future payments is $464,000.
Indicate the transaction price for each of these situations and when revenue will be recognized.
 Brief Exercises 1033

BE18-9 (L02) On January 2, 2017, Adani Inc. sells goods to Geo Company in exchange for a zero-interest-bearing note with
face value of $11,000, with payment due in 12 months. The fair value of the goods at the date of sale is $10,000 (cost $6,000).
Prepare the journal entry to record this transaction on January 2, 2017. How much total revenue should be recognized in 2017?
BE18-10 (L02) On March 1, 2017, Parnevik Company sold goods to Goosen Inc. for $660,000 in exchange for a 5-year, zero-
interest-bearing note in the face amount of $1,062,937 (an inputed rate of 10%). The goods have an inventory cost on Parnevik’s
books of $400,000. Prepare the journal entries for Parnevik on (a) March 1, 2017, and (b) December 31, 2017.
BE18-11 (L02,3) Telephone Sellers Inc. sells prepaid telephone cards to customers. Telephone Sellers then pays the telecom-
munications company, TeleExpress, for the actual use of its telephone lines related to the prepaid telephone cards. Assume that
Telephone Sellers sells $4,000 of prepaid cards in January 2017. It then pays TeleExpress based on usage, which turns out to be
50% in February, 30% in March, and 20% in April. The total payment by Telephone Sellers for TeleExpress lines over the 3 months
is $3,000. Indicate how much income Telephone Sellers should recognize in January, February, March, and April.
BE18-12 (L02,3) Manual Company sells goods to Nolan Company during 2017. It offers Nolan the following rebates based
on total sales to Nolan. If total sales to Nolan are 10,000 units, it will grant a rebate of 2%. If it sells up to 20,000 units, it will grant
a rebate of 4%. If it sells up to 30,000 units, it will grant a rebate of 6%. In the first quarter of the year, Manual sells 11,000 units
to Nolan at a sales price of $110,000. Manual, based on past experience, has sold over 40,000 units to Nolan, and these sales nor-
mally take place in the third quarter of the year. What amount of revenue should Manual report for the sale of the 11,000 units
in the first quarter of the year?
BE18-13 (L03) On July 10, 2017, Amodt Music sold CDs to retailers on account and recorded sales revenue of $700,000 (cost
$560,000). Amodt grants the right to return CDs that do not sell in 3 months following delivery. Past experience indicates that
the normal return rate is 15%. By October 11, 2017, retailers returned CDs to Amodt and were granted credit of $78,000. Prepare
Amodt’s journal entries to record (a) the sale on July 10, 2017, and (b) $78,000 of returns on October 11, 2017, and on October 31,
2017. Assume that Amodt prepares financial statement on October 31, 2017.
BE18-14 (L03) Kristin Company sells 300 units of its products for $20 each to Logan Inc. for cash. Kristin allows Logan to
return any unused product within 30 days and receive a full refund. The cost of each product is $12. To determine the transaction
price, Kristin decides that the approach that is most predictive of the amount of consideration to which it will be entitled is the
probability-weighted amount. Using the probability-weighted amount, Kristin estimates that (1) 10 products will be returned
and (2) the returned products are expected to be resold at a profit. Indicate the amount of (a) net sales, (b) estimated liability for
refunds, and (c) cost of goods sold that Kristen should report in its financial statements (assume that none of the products have
been returned at the financial statement date).
BE18-15 (L03) On June 1, 2017, Mills Company sells $200,000 of shelving units to a local retailer, ShopBarb, which is planning
to expand its stores in the area. Under the agreement, ShopBarb asks Mills to retain the shelving units at its factory until the new
stores are ready for installation. Title passes to ShopBarb at the time the agreement is signed. The shelving units are delivered to
the stores on September 1, 2017, and ShopBarb pays in full. Prepare the journal entries for this bill-and-hold arrangement
(assuming that conditions for recognizing the sale as a bill-and-hold sale have been met) for Mills on June 1 and September 1,
2017. The cost of the shelving units to Mills is $110,000.
BE18-16 (L03) Travel Inc. sells tickets for a Caribbean cruise on ShipAway Cruise Lines to Carmel Company employees. The
total cruise package price to Carmel Company employees is $70,000. Travel Inc. receives a commission of 6% of the total price.
Travel Inc. therefore remits $65,800 to ShipAway. Prepare the journal entry to record the remittance and revenue recognized by
Travel Inc. on this transaction.
BE18-17 (L03) Jansen Corporation shipped $20,000 of merchandise on consignment to Gooch Company. Jansen paid freight
costs of $2,000. Gooch Company paid $500 for local advertising, which is reimbursable from Jansen. By year-end, 60% of the
merchandise had been sold for $21,500. Gooch notified Jansen, retained a 10% commission, and remitted the cash due to Jansen.
Prepare Jansen’s journal entry when the cash is received.
BE18-18 (L03) Talarczyk Company sold 10,000 Super-Spreaders on December 31, 2017, at a total price of $1,000,000, with a
warranty guarantee that the product was free of any defects. The cost of the spreaders sold is $550,000. The assurance warranties
extend for a 2-year period and are estimated to cost $40,000. Talarczyk also sold extended warranties (service-type warranties)
related to 2,000 spreaders for 2 years beyond the 2-year period for $12,000. Given this information, determine the amounts to
report for the following at December 31, 2017: sales revenue, warranty expense, unearned warranty revenue, warranty liability,
and cash.
BE18-19 (L04) On May 1, 2017, Mount Company enters into a contract to transfer a product to Eric Company on September
30, 2017. It is agreed that Eric will pay the full price of $25,000 in advance on June 15, 2017. Eric pays on June 15, 2017, and Mount
delivers the product on September 30, 2017. Prepare the journal entries required for Mount in 2017.
BE18-20 (L03) Nate Beggs signs a 1-year contract with BlueBox Video. The terms of the contract are that Nate is required to
pay a nonrefundable initiation fee of $100. No annual membership fee is charged in the first year. After the first year, member-
ship can be renewed by paying an annual membership fee of $5 per month. BlueBox determines that its customers, on average,
renew their annual membership three times after the first year before terminating their membership. What amount of revenue
should BlueBox recognize in its first year?
 1034 Chapter 18 Revenue Recognition

BE18-21 (L04) Stengel Co. enters into a 3-year contract to perform maintenance service for Laplante Inc. Laplante promises
to pay $100,000 at the beginning of each year (the standalone selling price of the service at contract inception is $100,000 per
year). At the end of the second year, the contract is modified and the fee for the third year of service, which reflects a reduced
menu of maintenance services to be performed at Laplante locations, is reduced to $80,000 (the standalone selling price of the
services at the beginning of the third year is $80,000 per year). Briefly describe the accounting for this contract modification.
* BE18-22 (L05) Turner, Inc. began work on a $7,000,000 contract in 2017 to construct an office building. During 2017, Turner,
Inc. incurred costs of $1,700,000, billed its customers for $1,200,000, and collected $960,000. At December 31, 2017, the esti-
mated additional costs to complete the project total $3,300,000. Prepare Turner’s 2017 journal entries using the percentage-of-
completion method.
* BE18-23 (L06) Guillen, Inc. began work on a $7,000,000 contract in 2017 to construct an office building. Guillen uses the
completed-contract method. At December 31, 2017, the balances in certain accounts were Construction in Process $1,715,000,
Accounts Receivable $240,000, and Billings on Construction in Process $1,000,000. Indicate how these accounts would be
reported in Guillen’s December 31, 2017, balance sheet.
* BE18-24 (L07) Archer Construction Company began work on a $420,000 construction contract in 2017. During 2017, Archer
incurred costs of $278,000, billed its customer for $215,000, and collected $175,000. At December 31, 2017, the estimated addi-
tional costs to complete the project total $162,000. Prepare Archer’s journal entry to record profit or loss, if any, using (a) the
percentage-of-completion method and (b) the completed-contract method.
* BE18-25 (L08) Frozen Delight, Inc. charges an initial franchise fee of $75,000 for the right to operate as a franchisee of Frozen
Delight. Of this amount, $25,000 is collected immediately. The remainder is collected in four equal annual installments of $12,500
each. These installments have a present value of $41,402. As part of the total franchise fee, Frozen Delight also provides training
(with a fair value of $2,000) to help franchisees get the store ready to open. The franchise agreement is signed on April 1, 2017,
training is completed, and the store opens on July 1, 2017. Prepare the journal entries required by Frozen Delight in 2017.

EXERCISES
E18-1 (LO1) (Fundamentals of Revenue Recognition) Presented below are five different situations. Provide an answer to
each of these questions.
1. The Kawaski Jeep dealership sells both new and used Jeeps. Some of the Jeeps are used for demonstration purposes; after 6
months, these Jeeps are then sold as used vehicles. Should Kawaski Jeep record these sales of used Jeeps as revenue or as a gain?
2. One of the main indicators of whether control has passed to the customer is whether revenue has been earned. Is this state-
ment correct?
3. One of the five steps in determining whether revenue should be recognized is whether the sale has been realized. Do you
agree?
4. One of the criteria that contracts must meet to apply the revenue standard is that collectibility of the sales price must be
reasonably possible. Is this correct?
5. Many believe the distinction between revenue and gains is important in the financial statements. Given that both revenues
and gains increase net income, why is the distinction important?
E18-2 (LO1) (Fundamentals of Revenue Recognition) Respond to the questions related to the following statements.
1. A wholly unperformed contract is one in which the company has neither transferred the promised goods or services to the
customer nor received, or become entitled to receive, any consideration. Why are these contracts not recorded in the
accounts?
2. Performance obligations are the unit of account for purposes of applying the revenue recognition standard and therefore
determine when and how revenue is recognized. Is this statement correct?
3. Elaina Company contracts with a customer and provides the customer with an option to purchase additional goods for
free or at a discount. Should Elaina Company account for this option?
4. The transaction price is generally not adjusted to reflect the customer’s credit risk, meaning the risk that the customer will
not pay the amount to which the entity is entitled to under the contract. Comment on this statement.
E18-3 (LO1,2) (Existence of a Contract) On May 1, 2017, Richardson Inc. entered into a contract to deliver one of its specialty
mowers to Kickapoo Landscaping Co. The contract requires Kickapoo to pay the contract price of $900 in advance on May 15,
2017. Kickapoo pays Richardson on May 15, 2017, and Richardson delivers the mower (with cost of $575) on May 31, 2017.

Instructions
(a) Prepare the journal entry on May 1, 2017, for Richardson.
(b) Prepare the journal entry on May 15, 2017, for Richardson.
(c) Prepare the journal entry on May 31, 2017, for Richardson.
 Exercises 1035

E18-4 (LO2) (Determine Transaction Price) Jupiter Company sells goods to Danone Inc. by accepting a note receivable on
January 2, 2017. The goods have a sales price of $610,000 (cost of $500,000). The terms are net 30. If Danone pays within 5 days,
however, it receives a cash discount of $10,000. Past history indicates that the cash discount will be taken. On January 28, 2017,
Danone makes payment to Jupiter for the full sales price.

Instructions
(a) Prepare the journal entry(ies) to record the sale and related cost of goods sold for Jupiter Company on January 2, 2017,
and the payment on January 28, 2017. Assume that Jupiter Company records the January 2, 2017, transaction using the
net method.
(b) Prepare the journal entry(ies) to record the sale and related cost of goods sold for Jupiter Company on January 2, 2017,
and the payment on January 28, 2017. Assume that Jupiter Company records the January 2, 2017, transaction using the
gross method.

E18-5 (LO2) (Determine Transaction Price) Jeff Heun, president of Concrete Always, agrees to construct a concrete cart
path at Dakota Golf Club. Concrete Always enters into a contract with Dakota to construct the path for $200,000. In addition,
as part of the contract, a performance bonus of $40,000 will be paid based on the timing of completion. The performance
bonus will be paid fully if completed by the agreed-upon date. The performance bonus decreases by $10,000 per week for
every week beyond the agreed-upon completion date. Jeff has been involved in a number of contracts that had performance
bonuses as part of the agreement in the past. As a result, he is fairly confident that he will receive a good portion of the per-
formance bonus. Jeff estimates, given the constraints of his schedule related to other jobs , that there is 55% probability that
he will complete the project on time, a 30% probability that he will be 1 week late, and a 15% probability that he will be 2
weeks late.

Instructions
(a) Determine the transaction price that Concrete Always should compute for this agreement.
(b) Assume that Jeff Heun has reviewed his work schedule and decided that it makes sense to complete this project on
time. Assuming that he now believes that the probability for completing the project on time is 90% and otherwise it will
be finished 1 week late, determine the transaction price.

E18-6 (LO2) (Determine Transaction Price) Bill Amends, owner of Real Estate Inc., buys and sells commercial properties.
Recently, he sold land for $3,000,000 to the Blackhawk Group, a developer that plans to build a new shopping mall. In addi-
tion to the $3,000,000 sales price, Blackhawk Group agrees to pay Real Estate Inc. 1% of the retail sales of the mall for 10
years. Blackhawk estimates that retail sales in a typical mall project is $1,000,000 a year. Given the substantial increase in
online sales that are occurring in the retail market, Bill had originally indicated that he would prefer a higher price for the
land instead of the 1% royalty arrangement and suggested a price of $3,250,000. However, Blackhawk would not agree to
those terms.

Instructions
What is the transaction price for the land and related royalty payment that Real Estate Inc. should record?

E18-7 (LO2) (Determine Transaction Price) Blair Biotech enters into a licensing agreement with Pang Pharmaceutical for
a drug under development. Blair will receive a payment of $10,000,000 if the drug receives regulatory approval. Based on
prior experience in the drug-approval process, Blair determines it is 90% likely that the drug will gain approval and a 10%
chance of denial.

Instructions
(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 January 15, 2018, prepare the journal entries for Blair. The license meets the criteria for point-in-time revenue
recognition.

E18-8 (LO2,3) (Determine Transaction Price) Aaron’s Agency sells an insurance policy offered by Capital Insurance
Company for a commission of $100 on January 2, 2017. In addition, Aaron will receive an additional commission of $10
each year for as long as the policyholder does not cancel the policy. After selling the policy, Aaron does not have any
remaining performance obligations. Based on Aaron’s significant experience with these types of policies, it estimates that
policyholders on average renew the policy for 4.5 years. It has no evidence to suggest that previous policyholder behavior
will change.

Instructions
(a) Determine the transaction price of the arrangement for Aaron, assuming 100 policies are sold.
(b) Determine the revenue that Aaron will recognize in 2017.
1036 Chapter 18 Revenue Recognition

E18-9 (LO2,3) (Determine Transaction Price) Taylor Marina has 300 available slips that rent for $800 per season. Pay-
ments must be made in full by the start of the boating season, April 1, 2018. The boating season ends October 31, and the
marina has a December 31 year-end. Slips for future seasons may be reserved if paid for by December 31, 2018. Under a new
policy, if payment for 2019 season slips is made by December 31, 2018, a 5% discount is allowed. If payment for 2020 season
slips is made by December 31, 2018, renters get a 20% discount (this promotion hopefully will provide cash flow for major
dock repairs).
On December 31, 2017, all 300 slips for the 2018 season were rented at full price. On December 31, 2018, 200 slips were
reserved and paid for the 2019 boating season, and 60 slips were reserved and paid for the 2020 boating season.

Instructions
(a) Prepare the appropriate journal entries for December 31, 2017, and December 31, 2018.
(b) Assume the marina operator is unsophisticated in business. Explain the managerial significance of the above account-
ing to this person.

E18-10 (LO2,3) (Allocate Transaction Price) Geraths Windows manufactures and sells custom storm windows for three-
season 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 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 irrespective of whether it does the installation or not. The
installation service is estimated to have a standalone selling price of $600. The customer pays Geraths $2,000 (which
equals the standalone selling price 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 September 1, 2017, Geraths completes installation on
October 15, 2017, and the customer pays the balance due. Prepare the journal entries for Geraths in 2017. (Round amounts
to nearest dollar.)

E18-11 (LO2,3) (Allocate Transaction Price) Refer to the revenue arrangement in E18-10. Repeat the requirements, assum-
ing (a) Geraths estimates the standalone selling price of the installation based on an estimated cost of $400 plus a margin of 20%
on cost, and (b) given uncertainty of finding skilled labor, Geraths is unable to develop a reliable estimate for the standalone
selling price of the installation. (Round amounts to nearest dollar.)

E18-12 (LO3) (Allocate Transaction Price) Shaw Company sells goods that cost $300,000 to Ricard Company for $410,000 on
January 2, 2017. The sales price includes an installation fee, which has a standalone selling price of $40,000. The standalone sell-
ing price of the goods is $370,000. The installation is considered a separate performance obligation and is expected to take
6 months to complete.

Instructions
(a) Prepare the journal entries (if any) to record the sale on January 2, 2017.
(b) Shaw prepares an income statement for the first quarter of 2017, ending on March 31, 2017 (installation was completed
on June 18, 2017). How much revenue should Shaw recognize related to its sale to Ricard?

E18-13 (LO3) (Allocate Transaction Price) 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 and does not require proprietary information about the equipment in order for the installed equipment to
perform to specifications. 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 installation service is estimated to have a standalone selling price of $50,000.
The cost of the equipment is $600,000.
• Winkerbean is obligated to pay Crankshaft the $1,000,000 upon the 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
which should be accounted for separately.

Instructions
(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 on June 1, 2017 and September 30, 2017, assum-
ing Crankshaft receives payment when installation is completed.
 Exercises 1037

E18-14 (LO3) (Allocate Transaction Price) Refer to the revenue arrangement in E18-13.

Instructions
Repeat requirements (a) and (b) assuming Crankshaft does not have market data with which to determine the standalone 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.
E18-15 (LO3) (Allocate Transaction Price) Appliance Center is an experienced home appliance dealer. Appliance Center
also offers a number of services for the home appliances that it sells. Assume that Appliance Center sells ovens on a standalone
basis. Appliance Center also sells installation services and maintenance services for ovens. However, Appliance Center does not
offer installation or maintenance services to customers who buy ovens from other vendors. Pricing for ovens is as follows.
Oven only $ 800
Oven with installation service 850
Oven with maintenance services 975
Oven with installation and maintenance services 1,000

In each instance in which maintenance services are provided, the maintenance service is separately priced within the
arrangement at $175. Additionally, the incremental amount charged by Appliance Center for installation approximates the
amount charged by independent third parties. Ovens are sold subject to a general right of return. If a customer purchases an
oven with installation and/or maintenance services, in the event Appliance Center does not complete the service satisfactorily,
the customer is only entitled to a refund of the portion of the fee that exceeds $800.

Instructions
(a) Assume that a customer purchases an oven with both installation and maintenance services for $1,000. Based on its
experience, Appliance Center believes that it is probable that the installation of the equipment will be performed satis-
factorily to the customer. Assume that the maintenance services are priced separately (i.e., the three components are
distinct). Identify the separate performance obligations related to the Appliance Center revenue arrangement.
(b) Indicate the amount of revenue that should be allocated to the oven, the installation, and to the maintenance contract.

E18-16 (LO3) EXCEL (Sales with Returns) On March 10, 2017, Steele Company sold to Barr Hardware 200 tool sets at a price
of $50 each (cost $30 per set) with terms of n/60, f.o.b. shipping point. Steele allows Barr to return any unused tool sets within
60 days of purchase. Steele estimates that (1) 10 sets will be returned, (2) the cost of recovering the products will be immaterial,
and (3) the returned tools sets can be resold at a profit. On March 25, 2017, Barr returned six tool sets and received a credit to its
account.

Instructions
(a) Prepare journal entries for Steele to record (1) the sale on March 10, 2017, (2) the return on March 25, 2017, and (c) any
adjusting entries required on March 31, 2017 (when Steele prepares financial statements). Steele believes the original
estimate of returns is correct.
(b) Indicate the income statement and balance sheet reporting by Steele at March 31, 2017, of the information related to the
Barr sales transaction.

E18-17 (LO3) EXCEL (Sales with Returns) Refer to the revenue arrangement in E18-16. Assume that instead of selling the
tool sets on credit, that Steele sold them for cash.

Instructions
(a) Prepare journal entries for Steele to record (1) the sale on March 10, 2017, (2) the return on March 25, 2017, and (c) any
adjusting entries required on March 31, 2017 (when Steele prepares financial statements). Steele believes the original
estimate of returns is correct.
(b) Indicate the income statement and balance sheet reporting by Steele at March 31, 2017, of the information related to the
Barr sale.
E18-18 (LO3) EXCEL (Sales with Allowances) On October 2, 2017, Laplante Company sold $6,000 of its elite camping gear
(with a cost of $3,600) to Lynch Outfitters. As part of the sales agreement, Laplante includes a provision that if Lynch is dissatis-
fied with the product, Laplante will grant an allowance on the sales price or agree to take the product back (although returns are
rare, given the long-term relationship between Laplante and Lynch). Lynch expects total allowances to Lynch to be $800. On
October 16, 2017, Laplante grants an allowance of $400 to Lynch because the color for some of the items delivered was a bit dif-
ferent than what appeared in the catalog.

Instructions
(a) Prepare journal entries for Laplante to record (1) the sale on October 2, 2017, (2) the granting of the allowance on
October 16, 2017, and, (c) any adjusting required on October 31, 2017 (when Laplante prepares financial statements).
Laplante now estimates additional allowances of $250 will be granted to Lynch in the future.
1038 Chapter 18 Revenue Recognition

(b) Indicate the income statement and balance sheet reporting by Laplante at October 31, 2017, of the information related
to the Lynch transaction.

E18-19 (LO3) EXCEL (Sales with Returns) On June 3, 2017, Hunt Company sold to Ann Mount merchandise having a sales
price of $8,000 (cost $6,000) with terms of n/60, f.o.b. shipping point. Hunt estimates that merchandise with a sales value of $800
will be returned. An invoice totaling $120 was received by Mount on June 8 from Olympic Transport Service for the freight cost.
Upon receipt of the goods, on June 8, Mount returned to Hunt $300 of merchandise containing flaws. Hunt estimates the returned
items are expected to be resold at a profit. The freight on the returned merchandise was $24, paid by Hunt on June 8. On July 16,
the company received a check for the balance due from Mount.

Instructions
Prepare journal entries for Hunt Company to record all the events in June and July.

E18-20 (LO3) (Sales with Returns) 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 to five of its largest customers the unconditional right of
return to these products if not fully satisfied. The right of return extends for 4 months. Organic Growth estimates returns of 20%.
Organic Growth sells these seeds on account for $1,500,000 (cost $750,000) on January 2, 2017. Customers are required to pay the
full amount due by March 15, 2017.

Instructions
(a) Prepare the journal entry for Organic Growth at January 2, 2017.
(b) Assume that one customer returns the seeds on March 1, 2017, due to unsatisfactory performance. Prepare the journal
entry to record this transaction, assuming this customer purchased $100,000 of seeds from Organic Growth.
(c) Assume Organic Growth prepares financial statements quarterly. Prepare the necessary entries (if any) to adjust Organic
Growth’s financial results for the above transactions on March 31, 2017, assuming remaining expected returns of
$200,000.

E18-21 (LO3) (Sales with Returns) Uddin Publishing Co. publishes college textbooks that are sold to bookstores on the fol-
lowing terms. Each title has a fixed wholesale price, terms f.o.b. shipping point, and payment is due 60 days after shipment. The
retailer may return a maximum of 30% of an order at the retailer’s expense. Sales are made only to retailers who have good credit
ratings. Past experience indicates that the normal return rate is 12%. The costs of recovery are expected to be immaterial, and the
textbooks are expected to be resold at a profit.

Instructions
(a) Identify the revenue recognition criteria that Uddin could employ concerning textbook sales.
(b) Briefly discuss the reasoning for your answers in (a) above.
(c) On July 1, 2017, Uddin shipped books invoiced at $15,000,000 (cost $12,000,000). Prepare the journal entry to record this
transaction.
(d) On October 3, 2017, $1.5 million of the invoiced July sales were returned according to the return policy, and the remain-
ing $13.5 million was paid. Prepare the journal entries for the return and payment.
(e) Assume Uddin prepares financial statements on October 31, 2017, the close of the fiscal year. No other returns are
anticipated. Indicate the amounts reported on the income statement and balance related to the above transactions.

E18-22 (LO3) (Sales with Repurchase) Cramer Corp. sells idle machinery to Enyart Company on July 1, 2017, for $40,000.
Cramer agrees to repurchase this equipment from Enyart on June 30, 2018, for a price of $42,400 (an imputed interest rate of 6%).
Instructions
(a) Prepare the journal entry for Cramer for the transfer of the asset to Enyart on July 1, 2017.
(b) Prepare any other necessary journal entries for Cramer in 2017.
(c) Prepare the journal entry for Cramer when the machinery is repurchased on June 30, 2018.
E18-23 (LO3) (Repurchase Agreement) Zagat Inc. enters into an agreement on March 1, 2017, to sell Werner Metal Company
aluminum ingots. As part of the agreement, Zagat also agrees to repurchase the ingots on May 1, 2017, at the original sales price
of $200,000 plus 2%.

Instructions
(a) Prepare Zagat’s journal entry necessary on March 1, 2017.
(b) Prepare Zagat’s journal entry for the repurchase of the ingots on May 1, 2017.

E18-24 (LO3) (Bill and Hold) Wood-Mode Company is involved in the design, manufacture, and installation of various
types of wood products for large construction projects. Wood-Mode recently completed a large contract for Stadium Inc., which
 Exercises 1039

consisted of building 35 different types of concession counters for a new soccer arena under construction. The terms of the con-
tract are that upon completion of the counters, Stadium would pay $2,000,000. Unfortunately, due to the depressed economy, the
completion of the new soccer arena is now delayed. Stadium has therefore asked Wood-Mode to hold the counters for
2 months at its manufacturing plant until the arena is completed. Stadium acknowledges in writing that it ordered the counters
and that they now have ownership. The time that Wood-Mode Company must hold the counters is totally dependent on when
the arena is completed. Because Wood-Mode has not received additional progress payments for the counters due to the delay,
Stadium has provided a deposit of $300,000.

Instructions
(a) Explain this type of revenue recognition transaction.
(b) What factors should be considered in determining when to recognize revenue in this transaction?
(c) Prepare the journal entry(ies) that Wood-Mode should make, assuming it signed a valid sales contract to sell the coun-
ters and received at the time the $300,000 deposit.

E18-25 (LO3) (Consignment Sales) On May 3, 2017, Eisler Company consigned 80 freezers, costing $500 each, to Remmers
Company. The cost of shipping the freezers amounted to $840 and was paid by Eisler Company. On December 30, 2017, a report
was received from the consignee, indicating that 40 freezers had been sold for $750 each. Remittance was made by the con-
signee for the amount due after deducting a commission of 6%, advertising of $200, and total installation costs of $320 on the
freezers sold.

Instructions
(a) Compute the inventory value of the units unsold in the hands of the consignee.
(b) Compute the profit for the consignor for the units sold.
(c) Compute the amount of cash that will be remitted by the consignee.

E18-26 (LO3) (Warranty Arrangement) On January 2, 2017, Grando Company sells production equipment to Fargo Inc. for
$50,000. Grando includes a 2-year assurance warranty service with the sale of all its equipment. The customer receives and pays
for the equipment on January 2, 2017. During 2017, Grando incurs costs related to warranties of $900. At December 31, 2017,
Grando estimates that $650 of warranty costs will be incurred in the second year of the warranty.

Instructions
(a) Prepare the journal entry to record this transaction on January 2, 2017, and on December 31, 2017 (assuming financial
statements are prepared on December 31, 2017).
(b) Repeat the requirements for (a), assuming that in addition to the assurance warranty, Grando sold an extended war-
ranty (service-type warranty) for an additional 2 years (2019–2020) for $800.

E18-27 (LO3) (Warranties) Celic Inc. manufactures and sells computers that include an assurance-type warranty for
the first 90 days. Celic offers an optional extended coverage plan under which it will repair or replace any defective part
for 3 years from the expiration of the assurance-type warranty. Because the optional extended coverage plan is sold sepa-
rately, Celic determines that the 3 years of extended coverage represents a separate performance obligation. The total
transaction price for the sale of a computer and the extended warranty is $3,600 on October 1, 2017, and Celic determines
the standalone selling price of each is $3,200 and $400, respectively. Further, Celic estimates, based on historical experi-
ence, it will incur $200 in costs to repair defects that arise within the 90-day coverage period for the assurance-type war-
ranty. The cost of the equipment is $1,440. Assume that the $200 in costs to repair defects in the computers occurred on
October 25, 2017.

Instructions
(a) Prepare the journal entry(ies) to record the October transactions related to sale of the computers.
(b) Briefly describe the accounting for the service-type warranty after the 90-day assurance-type warranty period.

E18-28 (LO4) (Existence of a Contract) On January 1, 2017, Gordon Co. enters into a contract to sell a customer a wiring base
and shelving unit that sits on the base in exchange for $3,000. The contract requires delivery of the base first but states that pay-
ment for the base will not be made until the shelving unit is delivered. Gordon identifies two performance obligations and
allocates $1,200 of the transaction price to the wiring base and the remainder to the shelving unit. The cost of the wiring base is
$700; the shelves have a cost of $320.

Instructions
(a) Prepare the journal entry on January 1, 2017, for Gordon.
(b) Prepare the journal entry on February 5, 2017, for Gordon when the wiring base is delivered to the customer.
1040 Chapter 18 Revenue Recognition

(c) Prepare the journal entry on February 25, 2017, for Gordon when the shelving unit is delivered to the customer and
Gordon receives full payment.

E18-29 (LO4) (Contract Modification) In September 2017, Gaertner Corp. commits to selling 150 of its iPhone-compatible
docking stations to Better Buy Co. for $15,000 ($100 per product). The stations are delivered to Better Buy over the next 6 months.
After 90 stations are delivered, the contract is modified and Gaertner promises to deliver an additional 45 products for an addi-
tional $4,275 ($95 per station). All sales are cash on delivery.

Instructions
(a) Prepare the journal entry for Gaertner for the sale of the first 90 stations. The cost of each station is $54.
(b) Prepare the journal entry for the sale of 10 more stations after the contract modification, assuming that the price for the
additional stations reflects the standalone selling price at the time of the contract modification. In addition, the addi-
tional stations are distinct from the original products as Gaertner regularly sells the products separately.
(c) Prepare the journal entry for the sale of 10 more stations (as in (b)), assuming that the pricing for the additional products
does not reflect the standalone selling price of the additional products and the prospective method is used.

E18-30 (LO4) (Contract Modification) Tyler Financial Services performs bookkeeping and tax-reporting services to startup
companies in the Oconomowoc area. On January 1, 2017, Tyler entered into a 3-year service contract with Walleye Tech. Walleye
promises to pay $10,000 at the beginning of each year, which at contract inception is the standalone selling price for these ser-
vices. At the end of the second year, the contract is modified and the fee for the third year of services is reduced to $8,000. In
addition, Walleye agrees to pay an additional $20,000 at the beginning of the third year to cover the contract for 3 additional
years (i.e., 4 years remain after the modification). The extended contract services are similar to those provided in the first 2 years
of the contract.

Instructions
(a) Prepare the journal entries for Tyler in 2017 and 2018 related to this service contract.
(b) Prepare the journal entries for Tyler in 2019 related to the modified service contract, assuming a prospective
approach.
(c) Repeat the requirements for part (b), assuming Tyler and Walleye agree on a revised set of services (fewer bookkeeping
services but more tax services) in the extended contract period and the modification results in a separate performance
obligation.

E18-31 (LO4) (Contract Costs) Rex’s Reclaimers entered into a contract with Dan’s Demolition to manage the processing of
recycled materials on Dan’s various demolition projects. Services for the 3-year contract include collecting, sorting, and trans-
porting reclaimed materials to recycling centers or contractors who will reuse them. Rex’s incurs selling commission costs of
$2,000 to obtain the contract. Before performing the services, Rex’s also designs and builds receptacles and loading equipment
that interfaces with Dan’s demolition equipment at a cost of $27,000. These receptacles and equipment are retained by Rex’s and
can be used for other projects. Dan’s promises to pay a fixed fee of $12,000 per year, payable every 6 months for the services
under the contract. Rex’s incurs the following costs: design services for the receptacles to interface with Dan’s equipment $3,000,
loading equipment controllers $6,000, and special testing and OSHA inspection fees $2,000 (some of Dan’s projects are on gov-
ernment property).

Instructions
(a) Determine the costs that should be capitalized as part of Rex’s Reclaimers revenue arrangement with Dan’s
Demolition.
(b) Dan’s also expects to incur general and administrative costs related to this contract, as well as costs of wasted materials
and labor that likely cannot be factored into the contract price. Can these costs be capitalized? Explain.

E18-32 (LO4) (Contract Costs, Collectibility) Refer to the information in E18-31.

Instructions
(a) Does the accounting for capitalized costs change if the contract is for 1 year rather than 3 years? Explain.
(b) Dan’s Demolition is a startup company; as a result, there is more than insignificant uncertainty about Dan’s ability to
make the 6-month payments on time. Does this uncertainty affect the amount of revenue to be recognized under the
contract? Explain.

*E18-33 (LO5,6) (Recognition of Profit on Long-Term Contracts) During 2017, Nilsen Company started a construction job
with a contract price of $1,600,000. The job was completed in 2019. The following information is available.
 Problems 1041

2017 2018 2019

Costs incurred to date $400,000 $825,000 $1,070,000
Estimated costs to complete 600,000 275,000 –0–
Billings to date 300,000 900,000 1,600,000
Collections to date 270,000 810,000 1,425,000

Instructions
(a) Compute the amount of gross profit to be recognized each year, assuming the percentage-of-completion method is
used.
(b) Prepare all necessary journal entries for 2018.
(c) Compute the amount of gross profit to be recognized each year, assuming the completed-contract method is used.
*E18-34 (LO5) (Analysis of Percentage-of-Completion Financial Statements) In 2017, Steinrotter Construction Corp. began
construction work under a 3-year contract. The contract price was $1,000,000. Steinrotter uses the percentage-of-completion
method for financial accounting purposes. The income to be recognized each year is based on the proportion of cost incurred to
total estimated costs for completing the contract. The financial statement presentations relating to this contract at December 31,
2017, are shown below.

Balance Sheet
Accounts receivable $18,000
Construction in process $65,000
Less: Billings 61,500
Costs and recognized profit in excess of billings 3,500
Income Statement
Income (before tax) on the contract recognized in 2017 $19,500

Instructions
(a) How much cash was collected in 2017 on this contract?
(b) What was the initial estimated total income before tax on this contract?
(AICPA adapted)
*E18-35 (LO5) EXCEL (Gross Profit on Uncompleted Contract) On April 1, 2017, Dougherty Inc. entered into a cost plus
fixed fee contract to construct an electric generator for Altom Corporation. At the contract date, Dougherty estimated that it
would take 2 years to complete the project at a cost of $2,000,000. The fixed fee stipulated in the contract is $450,000. Dougherty
appropriately accounts for this contract under the percentage-of-completion method. During 2017, Dougherty incurred costs of
$800,000 related to the project. The estimated cost at December 31, 2017, to complete the contract is $1,200,000. Altom was billed
$600,000 under the contract.

Instructions
Prepare a schedule to compute the amount of gross profit to be recognized by Dougherty under the contract for the year ended
December 31, 2017. Show supporting computations in good form.
(AICPA adapted)
*E18-36 (LO5,6) (Recognition of Revenue on Long-Term Contract and Entries) Hamilton Construction Company uses the
percentage-of-completion method of accounting. In 2017, Hamilton began work under contract #E2-D2, which provided for a
contract price of $2,200,000. Other details follow:
2017 2018
Costs incurred during the year $640,000 $1,425,000
Estimated costs to complete, as of December 31 960,000 –0–
Billings during the year 420,000 1,680,000
Collections during the year 350,000 1,500,000

Instructions
(a) What portion of the total contract price would be recognized as revenue in 2017? In 2018?
(b) Assuming the same facts as those above except that Hamilton uses the completed-contract method of accounting, what
portion of the total contract price would be recognized as revenue in 2018?
(c) Prepare a complete set of journal entries for 2017 (using the percentage-of-completion method).
*E18-37 (LO5,6) (Recognition of Profit and Balance Sheet Amounts for Long-Term Contracts) Yanmei Construction Com-
pany began operations on January 1, 2017. During the year, Yanmei Construction entered into a contract with Lundquist Corp.
to construct a manufacturing facility. At that time, Yanmei estimated that it would take 5 years to complete the facility at a total
cost of $4,500,000. The total contract price for construction of the facility is $6,000,000. During the year, Yanmei incurred $1,185,800
 1042 Chapter 18 Revenue Recognition

in construction costs related to the construction project. The estimated cost to complete the contract is $4,204,200. Lundquist
Corp. was billed and paid 25% of the contract price.

Instructions
Prepare schedules to compute the amount of gross profit to be recognized for the year ended December 31, 2017, and the amount
to be shown as “costs and recognized profit in excess of billings” or “billings in excess of costs and recognized profit” at Decem-
ber 31, 2017, under each of the following methods. Show supporting computations in good form.
(a) Completed-contract method.
(b) Percentage-of-completion method.
(AICPA adapted)
*E18-38 (LO8) (Franchise Entries) Pacific Crossburgers Inc. charges an initial franchise fee of $70,000. Upon the signing of the
agreement (which covers 3 years), a payment of $28,000 is due. Thereafter, three annual payments of $14,000 are required. The
credit rating of the franchisee is such that it would have to pay interest at 10% to borrow money. The franchise agreement is
signed on May 1, 2017, and the franchise commences operation on July 1, 2017.

Instructions
Prepare the journal entries in 2017 for the franchisor under the following assumptions. (Round to the nearest dollar.)
(a) No future services are required by the franchisor once the franchise starts operations.
(b) The franchisor has substantial services to perform, once the franchise begins operations, to maintain the value of the
franchise.
(c) The total franchise fee includes training services (with a value of $2,400) for the period leading up to the franchise open-
ing and for 2 months following opening.
*E18-39 (LO8) (Franchise Fee, Initial Down Payment) On January 1, 2017, Lesley Benjamin signed an agreement, covering
5 years, to operate as a franchisee of Campbell Inc. for an initial franchise fee of $50,000. The amount of $10,000 was paid when
the agreement was signed, and the balance is payable in five annual payments of $8,000 each, beginning January 1, 2018. The
agreement provides that the down payment is nonrefundable and that no future services are required of the franchisor once the
franchise commences operations on April 1, 2017. Lesley Benjamin’s credit rating indicates that she can borrow money at 11%
for a loan of this type.

Instructions
(a) Prepare journal entries for Campbell for 2017-related revenue for this franchise arrangement.
(b) Prepare journal entries for Campbell for 2017-related revenue for this franchise arrangement, assuming that in addition
to the franchise rights, Campbell also provides 1 year of operational consulting and training services, beginning on the
signing date. These services have a value of $3,600.
(c) Repeat the requirements for part (a), assuming that Campbell must provide services to Benjamin throughout the fran-
chise period to maintain the franchise value.

PROBLEMS
P18-1 (LO2,3) (Allocate Transaction Price, Upfront Fees) Tablet Tailors sells tablet PCs combined with Internet service, which
permits the tablet to connect to the Internet anywhere and set up a Wi-Fi hot spot. It offers two bundles with the following terms.
1. Tablet Bundle A sells a tablet with 3 years of Internet service. The price for the tablet and a 3-year Internet connection
service contract is $500. The standalone selling price of the tablet is $250 (the cost to Tablet Tailors is $175). Tablet Tailors
sells the Internet access service independently for an upfront payment of $300. On January 2, 2017, Tablet Tailors signed
100 contracts, receiving a total of $50,000 in cash.
2. Tablet Bundle B includes the tablet and Internet service plus a service plan for the tablet PC (for any repairs or upgrades
to the tablet or the Internet connections) during the 3-year contract period. That product bundle sells for $600. Tablet
Tailors provides the 3-year tablet service plan as a separate product with a standalone selling price of $150. Tablet Tailors
signed 200 contracts for Tablet Bundle B on July 1, 2017, receiving a total of $120,000 in cash.

Instructions
(a) Prepare any journal entries to record the revenue arrangement for Tablet Bundle A on January 2, 2017, and December
31, 2017.
(b) Prepare any journal entries to record the revenue arrangement for Tablet Bundle B on July 1, 2017, and December 31, 2017.
(c) Repeat the requirements for part (a), assuming that Tablet Tailors has no reliable data with which to estimate the stand-
alone selling price for the Internet service.
 Problems 1043

P18-2 (LO2,3,4) (Allocate Transaction Price, Modification of Contract) Refer to the Tablet Bundle A revenue arrangement
in P18-1. In response to competitive pressure for Internet access for Tablet Bundle A, after 2 years of the 3-year contract, Tablet
Tailors offers a modified contract and extension incentive. The extended contract services are similar to those provided in the
first 2 years of the contract. Signing the extension and paying $90 (which equals the standalone selling of the revised Internet
service package) extends access for 2 more years of Internet connection. Forty Tablet Bundle A customers sign up for this offer.

Instructions
(a) Prepare the journal entries when the contract is signed on January 2, 2019, for the 40 extended contracts. Assume the
modification does not result in a separate performance obligation.
(b) Prepare the journal entries on December 31, 2019, for the 40 extended contracts (the first year of the revised 3-year
contract).

P18-3 (LO2,3,4) (Allocate Transaction Price, Discounts, Time Value) Grill Master Company sells total outdoor grilling
solutions, providing gas and charcoal grills, accessories, and installation services for custom patio grilling stations.

Instructions
Respond to the requirements related to the following independent revenue arrangements for Grill Master products and services.
(a) Grill Master offers contract GM205, which is comprised of a free-standing gas grill for small patio use plus installation
to a customer’s gas line for a total price $800. On a standalone basis, the grill sells for $700 (cost $425), and Grill Master
estimates that the standalone selling price of the installation service (based on cost-plus estimation) is $150. (The selling
of the grill and the installation services should be considered two performance obligations.) Grill Master signed 10
GM205 contracts on April 20, 2017, and customers paid the contract price in cash. The grills were delivered and installed
on May 15, 2017. Prepare journal entries for Grill Master for GM205 in April and May 2017.
(b) The State of Kentucky is planning major renovations in its parks during 2017 and enters into a contract with Grill
Master to purchase 400 durable, easy maintenance, standard charcoal grills during 2017. The grills are priced at $200
each (with a cost of $160 each), and Grill Master provides a 6% volume discount if Kentucky purchases at least 300
grills during 2017. On April 17, 2017, Grill Master delivered and received payment for 280 grills. Based on prior expe-
rience with the State of Kentucky renovation projects, the delivery of this many grills makes it certain that Kentucky
will meet the discount threshold. Prepare the journal entries for Grill Master for grills sold on April 17, 2017. Assume
the company records sales transaction net.
(c) Grill Master sells its specialty combination gas/wood-fired grills to local restaurants. Each grill is sold for $1,000 (cost $550) on
credit with terms 3/30, net/90. Prepare the journal entries for the sale of 20 grills on September 1, 2017, and upon payment,
assuming the customer paid on (1) September 25, 2017, and (2) October 15, 2017. Assume the company records sales net.
(d) On October 1, 2017, Grill Master sold one of its super deluxe combination gas/charcoal grills to a local builder. The
builder plans to install it in one of its “Parade of Homes” houses. Grill Master accepted a 3-year, zero-interest-bearing
note with face amount of $5,324. The grill has an inventory cost of $2,700. An interest rate of 10% is an appropriate
market rate of interest for this customer. Prepare the journal entries on October 1, 2017, and December 31, 2017.

P18-4 (LO2,3,4) (Allocate Transaction Price, Discounts, Time Value) Economy Appliance Co. manufactures low-price, no-
frills appliances that are in great demand for rental units. Pricing and cost information on Economy’s main products are as follows.

Standalone
Item Selling Price (Cost)
Refrigerator $500 ($260)
Range 560 (275)
Stackable washer/dryer unit 700 (400)

Customers can contract to purchase either individually at the stated prices or a three-item bundle with a price of $1,800. The
bundle price includes delivery and installation. Economy also provides installation (not a separate performance obligation).

Instructions
Respond to the requirements related to the following independent revenue arrangements for Economy Appliance Co.
(a) On June 1, 2017, Economy sold 100 washer/dryer units without installation to Laplante Rentals for $70,000. Laplante is
a newer customer and is unsure how this product will work in its older rental units. Economy offers a 60-day return
privilege and estimates, based on prior experience with sales on this product, 4% of the units will be returned. Prepare
the journal entries for the sale and related cost of goods sold on June 1, 2017.
(b) YellowCard Property Managers operates upscale student apartment buildings. On May 1, 2017, Economy signs a con-
tract with YellowCard for 300 appliance bundles to be delivered and installed in one of its new buildings. YellowCard
pays 20% cash at contract signing and will pay the balance upon installation no later than August 1, 2017. Prepare
journal entries for Economy on (1) May 1, 2017, and (2) August 1, 2017, when all appliances are installed.
1044 Chapter 18 Revenue Recognition

(c) Refer to the arrangement in part (b). It would help YellowCard secure lease agreements with students if the installation
of the appliance bundles can be completed by July 1, 2017. YellowCard offers a 10% bonus payment if Economy can
complete installation by July 1, 2017. Economy estimates its chances of meeting the bonus deadline to be 90%, based on
a number of prior contracts of similar scale. Repeat the requirement for part (b), given this bonus provision. Assume
installation is completed by July 1, 2017.
(d) Epic Rentals would like to take advantage of the bundle price for its 400-unit project; on February 1, 2017, Economy
signs a contract with Epic for 400 bundles. Under the agreement, Economy will hold the appliance bundles in its ware-
houses until the new rental units are ready for installation. Epic pays 10% cash at contract signing. On April 1, 2017,
Economy completes manufacture of the appliances in the Epic bundle order and places them in the warehouse. Econ-
omy and Epic have documented the warehouse arrangement and identified the units designated for Epic. The units are
ready to ship, and Economy may not sell these units to other customers. Prepare journal entries for Economy on
(1) February 1, 2017, and (2) April 1, 2017.

P18-5 (LO2,3,4) (Allocate Transaction Price, Returns, and Consignments) Ritt Ranch & Farm is a distributor of ranch and farm
equipment. Its products range from small tools, power equipment for trench-digging and fencing, grain dryers, and barn winches.
Most products are sold direct via its company catalog and Internet site. However, given some of its specialty products, select farm
implement stores carry Ritt’s products. Pricing and cost information on three of Ritt’s most popular products are as follows.

Standalone
Item Selling Price (Cost)
Mini-trencher $ 3,600 ($2,000)
Power fence hole auger 1,200 (800)
Grain/hay dryer 14,000 (11,000)

Instructions
Respond to the requirements related to the following independent revenue arrangements for Ritt Ranch & Farm.
(a) On January 1, 2017, Ritt sells 40 augers to Mills Farm & Fleet for $48,000. Mills signs a 6-month note at an annual interest
rate of 12%. Ritt allows Mills to return any auger that it cannot use within 60 days and receive a full refund. Based on
prior experience, Ritt estimates that 5% of units sold to customers like Mills will be returned (using the most likely
outcome approach). Ritt’s costs to recover the products will be immaterial, and the returned augers are expected to be
resold at a profit. Prepare the journal entry for Ritt on January 1, 2017.
(b) On August 10, 2017, Ritt sells 16 mini-trenchers to a farm co-op in western Minnesota. Ritt provides a 4% volume dis-
count on the mini-trenchers if the co-op has a 15% increase in purchases from Ritt compared to the prior year. Given the
slowdown in the farm economy, sales to the co-op have been flat, and it is highly uncertain that the benchmark will be
met. Prepare the journal entry for Ritt on August 10, 2017.
(c) Ritt sells three grain/hay dryers to a local farmer at a total contract price of $45,200. In addition to the dryers, Ritt pro-
vides installation, which has a standalone selling price of $1,000 per unit installed. The contract payment also includes
a $1,200 maintenance plan for the dryers for 3 years after installation. Ritt signs the contract on June 20, 2017, and
receives a 20% down payment from the farmer. The dryers are delivered and installed on October 1, 2017, and full pay-
ment is made to Ritt. Prepare the journal entries for Ritt in 2017 related to this arrangement.
(d) On April 25, 2017, Ritt ships 100 augers to Farm Depot, a farm supply dealer in Nebraska, on consignment. By June 30,
2017, Farm Depot has sold 60 of the consigned augers at the listed price of $1,200 per unit. Farm Depot notifies Ritt of
the sales, retains a 10% commission, and remits the cash due Ritt. Prepare the journal entries for Ritt and Farm Depot
for the consignment arrangement.

P18-6 (LO3) (Warranty, Customer Loyalty Program) Hale Hardware takes pride as the “shop around the corner” that can
compete with the big-box home improvement stores by providing good service from knowledgeable sales associates (many of
whom are retired local handymen). Hale has developed the following two revenue arrangements to enhance its relationships
with customers and increase its bottom line.
1. Hale sells a specialty portable winch that is popular with many of the local customers for use at their lake homes (putting
docks in and out, launching boats, etc.). The Hale winch is a standard manufacture winch that Hale modifies so the winch
can be used for a variety of tasks. Hale sold 70 of these winches during 2017 at a total price of $21,000, with a warranty
guarantee that the product was free of any defects. The cost of winches sold is $16,000. The assurance warranties extend
for a 3-year period with an estimated cost of $2,100. In addition, Hale sold extended warranties related to 20 Hale winches
for 2 years beyond the 3-year period for $400 each.
2. To bolster its already strong customer base, Hale implemented a customer loyalty program that rewards a customer with
1 loyalty point for every $10 of purchases on a select group of Hale products. Each point is redeemable for a $1 discount
on any purchases of Hale merchandise in the following 2 years. During 2017, customers purchased select group products
for $100,000 (all products are sold to provide a 45% gross profit) and earned 10,000 points redeemable for future purchases.
The standalone selling price of the purchased products is $100,000. Based on prior experience with incentives programs
 Problems 1045

like this, Hale expects 9,500 points to be redeemed related to these sales (Hale appropriately uses this experience to esti-
mate the value of future consideration related to bonus points).

Instructions
(a) Identify the separate performance obligations in the Hale warranty and bonus point programs, and briefly explain the
point in time when the performance obligations are satisfied.
(b) Prepare the journal entries for Hale related to the sales of Hale winches with warranties.
(c) Prepare the journal entries for the bonus point sales for Hale in 2017.
(d) How much additional sales revenue is recognized by Hale in 2018, assuming 4,500 bonus points are redeemed?

P18-7 (LO3) (Customer Loyalty Program) Martz Inc. has a customer loyalty program that rewards a customer with 1 cus-
tomer loyalty point for every $10 of purchases. Each point is redeemable for a $3 discount on any future purchases. On July 2,
2017, customers purchase products for $300,000 (with a cost of $171,000) and earn 30,000 points redeemable for future purchases.
Martz expects 25,000 points to be redeemed. Martz estimates a standalone selling price of $2.50 per point (or $75,000 total) on
the basis of the likelihood of redemption. The points provide a material right to customers that they would not receive without
entering into a contract. As a result, Martz concludes that the points are a separate performance obligation.

Instructions
(a) Determine the transaction price for the product and the customer loyalty points.
(b) Prepare the journal entries to record the sale of the product and related points on July 2, 2017.
(c) At the end of the first reporting period (July 31, 2017), 10,000 loyalty points are redeemed. Martz continues to expect
25,000 loyalty points to be redeemed in total. Determine the amount of loyalty point revenue to be recognized at
July 31, 2017.

P18-8 (LO2,3) (Time Value, Gift Cards, Discounts) Presented below are two independent revenue arrangements for Colbert
Company.

Instructions
Respond to the requirements related to each revenue arrangement.
(a) Colbert sells 3D printer systems. Recently, Colbert provided a special promotion of zero-interest financing for 2 years
on any new 3D printer system. Assume that Colbert sells Lyle Cartright a 3D system, receiving a $5,000 zero-interest-
bearing note on January 1, 2017. The cost of the 3D printer system is $4,000. Colbert imputes a 6% interest rate on this
zero-interest note transaction. Prepare the journal entry to record the sale on January 1, 2017, and compute the total
amount of revenue to be recognized in 2017.
(b) Colbert sells 20 nonrefundable $100 gift cards for 3D printer paper on March 1, 2017. The paper has a standalone selling
price of $100 (cost $80). The gift cards expiration date is June 30, 2017. Colbert estimates that customers will not redeem
10% of these gift cards. The pattern of redemption is as follows.

Redemption Total
March 31 50%
April 30 80
June 30 85

Prepare the 2017 journal entries related to the gift cards at March 1, March 31, April 30, and June 30.

*P18-9 (LO5,6) EXCEL (Recognition of Profit on Long-Term Contract) Shanahan Construction Company has entered into
a contract beginning January 1, 2017, to build a parking complex. It has been estimated that the complex will cost $600,000 and
will take 3 years to construct. The complex will be billed to the purchasing company at $900,000. The following data pertain to
the construction period.
2017 2018 2019
Costs to date $270,000 $450,000 $610,000
Estimated costs to complete 330,000 150,000 –0–
Progress billings to date 270,000 550,000 900,000
Cash collected to date 240,000 500,000 900,000

Instructions
(a) Using the percentage-of-completion method, compute the estimated gross profit that would be recognized during each
year of the construction period.
(b) Using the completed-contract method, compute the estimated gross profit that would be recognized during each year
of the construction period.
 1046 Chapter 18 Revenue Recognition

*P18-10 (LO5,6,7) (Long-Term Contract with Interim Loss) On March 1, 2017, Pechstein Construction Company contracted
to construct a factory building for Fabrik Manufacturing Inc. for a total contract price of $8,400,000. The building was completed
by October 31, 2019. The annual contract costs incurred, estimated costs to complete the contract, and accumulated billings to
Fabrik for 2017, 2018, and 2019 are given below.
2017 2018 2019
Contract costs incurred during the year $2,880,000 $2,230,000 $2,190,000
Estimated costs to complete the
contract at 12/31 3,520,000 2,190,000 –0–
Billings to Fabrik during the year 3,200,000 3,500,000 1,700,000

Instructions
(a) Using the percentage-of-completion method, prepare schedules to compute the profit or loss to be recognized as a
result of this contract for the years ended December 31, 2017, 2018, and 2019. (Ignore income taxes.)
(b) Using the completed-contract method, prepare schedules to compute the profit or loss to be recognized as a result of
this contract for the years ended December 31, 2017, 2018, and 2019. (Ignore incomes taxes.)

*P18-11 (LO5,6,7) EXCEL (Long-Term Contract with an Overall Loss) On July 1, 2017, Torvill Construction Company Inc.
contracted to build an office building for Gumbel Corp. for a total contract price of $1,900,000. On July 1, Torvill estimated that
it would take between 2 and 3 years to complete the building. On December 31, 2019, the building was deemed substantially
completed. Following are accumulated contract costs incurred, estimated costs to complete the contract, and accumulated bill-
ings to Gumbel for 2017, 2018, and 2019.
At 12/31/17 At 12/31/18 At 12/31/19
Contract costs incurred to date $ 300,000 $1,200,000 $2,100,000
Estimated costs to complete the contract 1,200,000 800,000 –0–
Billings to Gumbel 300,000 1,100,000 1,850,000

Instructions
(a) Using the percentage-of-completion method, prepare schedules to compute the profit or loss to be recognized as a
result of this contract for the years ended December 31, 2017, 2018, and 2019. (Ignore income taxes.)
(b) Using the completed-contract method, prepare schedules to compute the profit or loss to be recognized as a result of
this contract for the years ended December 31, 2017, 2018, and 2019. (Ignore income taxes.)

*P18-12 (LO8) (Franchise Revenue) Amigos Burrito Inc. sells franchises to independent operators throughout the northwest-
ern part of the United States. The contract with the franchisee includes the following provisions.
1. The franchisee is charged an initial fee of $120,000. Of this amount, $20,000 is payable when the agreement is signed, and
a $100,000 zero-interest-bearing note is payable with a $20,000 payment at the end of each of the 5 subsequent years. The
present value of an ordinary annuity of five annual receipts of $20,000, each discounted at 10%, is $75,816.
2. All of the initial franchise fee collected by Amigos is to be refunded and the remaining obligation canceled if, for any rea-
son, the franchisee fails to open his or her franchise.
3. In return for the initial franchise fee, Amigos agrees to (a) assist the franchisee in selecting the location for the business,
(b) negotiate the lease for the land, (c) obtain financing and assist with building design, (d) supervise construction,
(e) establish accounting and tax records, and (f) provide expert advice over a 5-year period relating to such matters as
employee and management training, quality control, and promotion. This continuing involvement by Amigos helps main-
tain the brand value of the franchise.
4. In addition to the initial franchise fee, the franchisee is required to pay to Amigos a monthly fee of 2% of sales for menu plan-
ning, recipe innovations, and the privilege of purchasing ingredients from Amigos at or below prevailing market prices.
Management of Amigos Burrito estimates that the value of the services rendered to the franchisee at the time the contract is signed
amounts to at least $20,000. All franchisees to date have opened their locations at the scheduled time, and none have defaulted on
any of the notes receivable. The credit ratings of all franchisees would entitle them to borrow at the current interest rate of 10%.

Instructions
(a) Discuss the alternatives that Amigos Burrito Inc. might use to account for the franchise fees.
(b) Prepare the journal entries for the initial and continuing franchise fees, assuming:
(1) Franchise agreement is signed on January 5, 2017.
(2) Amigos completes franchise startup tasks and the franchise opens on July 1, 2017.
(3) The franchisee records $260,000 in sales in the first 6 months of operations and remits the monthly franchise fee on
December 31, 2017.
(c) Briefly describe the accounting for unearned franchise fees, assuming that Amigos has little or no involvement with the
franchisee related to expert advice on employee and management training, quality control, and promotion, once the
franchise opens.
 Concepts for Analysis 1047

CONCEPTS FOR ANALYSIS

CA18-1 (Five-Step Revenue Process) Revenue is recognized based on a five-step process that is applied to a company’s revenue
arrangements.
Instructions
(a) Briefly describe the five-step process.
(b) Explain the importance of contracts when analyzing revenue arrangements.
(c) How are fair value measurement concepts applied in implementation of the five-step process?
(d) How does the five-step process reflect application of the definitions of assets and liabilities?
CA18-2 (Satisfying Performance Obligations) Judy Schaeffer is getting up to speed on the new guidance on revenue recogni-
tion. She is trying to understand the revenue recognition principle as it relates to the five-step revenue recognition process.
Instructions
(a) Describe the revenue recognition principle.
(b) Briefly discuss how the revenue recognition principle relates to the definitions of assets and liabilities. What is the
importance of control?
(c) Judy recalls that previous revenue recognition guidance required that revenue not be recognized unless the revenue
was realized or realizable (also referred to as collectibility). Is collectibility a consideration in the recognition of reve-
nue? Explain.
CA18-3 (Recognition of Revenue—Theory) Revenue is usually recognized at the point of sale (a point in time). Under special
circumstances, however, bases other than the point of sale are used for the timing of revenue recognition.
Instructions
(a) Why is the point of sale usually used as the basis for the timing of revenue recognition?
(b) Disregarding the special circumstances when bases other than the point of sale are used, discuss the merits of each of
the following objections to the point-of-sale basis of revenue recognition:
(1) It is too conservative because revenue is earned throughout the entire process of production.
(2) It is not conservative enough because accounts receivable do not represent disposable funds, sales returns and
allowances may be made, and collection and bad debt expenses may be incurred in a later period.
(c) Revenue may also be recognized over time. Give an example of the circumstances in which revenue is recognized over
time and accounting merits of its use instead of the point-of-sale basis.
(AICPA adapted)
CA18-4 (Recognition of Revenue—Theory) Revenue is recognized for accounting purposes when a performance obligation is
satisfied. In some situations, revenue is recognized over time as the fair values of assets and liabilities change. In other situations,
however, accountants have developed guidelines for recognizing revenue at the point of sale.
Instructions
(Ignore income taxes.)
(a) Explain and justify why revenue is often recognized at time of sale.
(b) Explain in what situations it would be appropriate to recognize revenue over time.

CA18-5 (Discounts) Fahey Company sells Stairmasters to a retailer, Physical Fitness, Inc., for $2,000,000. Fahey has a history of
providing price concessions on this product if the retailer has difficulty selling the Stairmasters to customers. Fahey has experience
with sales like these in the past and estimates that the maximum amount of price concessions is $300,000.
Instructions
(a) Determine the amount of revenue that Fahey should recognize for the sale of Stairmasters to Physical Fitness, Inc.
(b) According to GAAP, in some situations, the amount of revenue recognized may be constrained. Explain how the
accounting for the Stairmasters sales might be affected by the revenue constraint due to variable consideration or
returns.
(c) Some believe that revenue recognition should be constrained by collectibility. Is such a view consistent with GAAP?
Explain.

CA18-6 (Recognition of Revenue from Subscriptions) Cutting Edge is a monthly magazine that has been on the market for
18 months. It currently has a circulation of 1.4 million copies. Negotiations are underway to obtain a bank loan in order to update
the magazine’s facilities. Cutting Edge is producing close to capacity and expects to grow at an average of 20% per year over the next
3 years.
After reviewing the financial statements of Cutting Edge, Andy Rich, the bank loan officer, had indicated that a loan could
be offered to Cutting Edge only if it could increase its current ratio and decrease its debt to equity ratio to a specified level.
Jonathan Embry, the marketing manager of Cutting Edge, has devised a plan to meet these requirements. Embry indicates that
 1048 Chapter 18 Revenue Recognition

an advertising campaign can be initiated to immediately increase circulation. The potential customers would be contacted after
the purchase of another magazine’s mailing list. The campaign would include:
1. An offer to subscribe to Cutting Edge at three-fourths the normal price.
2. A special offer to all new subscribers to receive the most current world atlas whenever requested at a guaranteed price of $2.
3. An unconditional guarantee that any subscriber will receive a full refund if dissatisfied with the magazine.
Although the offer of a full refund is risky, Embry claims that few people will ask for a refund after receiving half of their sub-
scription issues. Embry notes that other magazine companies have tried this sales promotion technique and experienced great
success. Their average cancellation rate was 25%. On average, each company increased its initial circulation threefold and in the
long run increased circulation to twice that which existed before the promotion. In addition, 60% of the new subscribers are
expected to take advantage of the atlas premium. Embry feels confident that the increased subscriptions from the advertising
campaign will increase the current ratio and decrease the debt to equity ratio.
You are the controller of Cutting Edge and must give your opinion of the proposed plan.
Instructions
(a) When should revenue from the new subscriptions be recognized?
(b) How would you classify the estimated sales returns stemming from the unconditional guarantee?
(c) How should the atlas premium be recorded? Is the estimated premium claims a liability? Explain.
(d) Does the proposed plan achieve the goals of increasing the current ratio and decreasing the debt to equity ratio?

CA18-7 (Recognition of Revenue—Bonus Points) Griseta & Dubel Inc. was formed early this year to sell merchandise credits to
merchants, who distribute the credits free to their customers. For example, customers can earn additional credits based on the dol-
lars they spend with a merchant (e.g., airlines and hotels). Accounts for accumulating the credits and catalogs illustrating the mer-
chandise for which the credits may be exchanged are maintained online. Centers with inventories of merchandise premiums have
been established for redemption of the credits. Merchants may not return unused credits to Griseta & Dubel.
The following schedule expresses Griseta & Dubel’s expectations as to the percentages of a normal month’s activity that will
be attained. For this purpose, a “normal month’s activity” is defined as the level of operations expected when expansion of
activities ceases or tapers off to a stable rate. The company expects that this level will be attained in the third year and that sales
of credits will average $6,000,000 per month throughout the third year.

Actual Merchandise Credit

Credit Sales Premium Purchases Redemptions
Month Percent Percent Percent
6th 30% 40% 10%
12th 60 60 45
18th 80 80 70
24th 90 90 80
30th 100 100 95

Griseta & Dubel plans to adopt an annual closing date at the end of each 12 months of operation.
Instructions
(a) Discuss the factors to be considered in determining when revenue should be recognized.
(b) Apply the revenue recognition factors to the Griseta & Dubel Inc. revenue arrangement.
(c) Provide balance sheet accounts that should be used and indicate how each should be classified.
(AICPA adapted)
CA18-8 ETHICS (Revenue Recognition—Membership Fees) Midwest Health Club (MHC) offers 1-year memberships. Mem-
bership fees are due in full at the beginning of the individual membership period. As an incentive to new customers, MHC adver-
tised that any customers not satisfied for any reason could receive a refund of the remaining portion of unused membership fees.
As a result of this policy, Richard Nies, corporate controller, recognized revenue ratably over the life of the membership. MHC is in
the process of preparing its year-end financial statements. Rachel Avery, MHC’s treasurer, is concerned about the company’s lack-
luster performance this year. She reviews the financial statements Nies prepared and tells Nies to recognize membership revenue
when the fees are received.
Instructions
Answer the following questions.
(a) What are the ethical issues involved?
(b) What should Nies do?

*CA18-9 WRITING (Long-Term Contract—Percentage-of-Completion) Widjaja Company is accounting for a long-term con-
struction contract using the percentage-of-completion method. It is a 4-year contract that is currently in its second year. The latest
estimates of total contract costs indicate that the contract will be completed at a profit to Widjaja Company.
 Using Your Judgment 1049

Instructions
(a) What theoretical justification is there for Widjaja Company’s use of the percentage-of-completion method?
(b) How would progress billings be accounted for? Include in your discussion the classification of progress billings in
Widjaja Company financial statements.
(c) How would the income recognized in the second year of the 4-year contract be determined using the cost-to-cost
method of determining percentage of completion?
(d) What would be the effect on earnings per share in the second year of the 4-year contract of using the percentage-of-
completion method instead of the completed-contract method? Discuss.
(AICPA adapted)

USING YOUR JUDGMENT

As the new revenue recognition guidance is not yet implemented, note that the financial statements and notes for Procter &
Gamble, Coca-Cola, PepsiCo, and Westinghouse reflect revenue recognition under prior standards.

Financial Reporting Problem

The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix B. The company’s complete annual report, including the notes to
the financial statements, is available online.

Instructions
Refer to P&G’s financial statements and the accompanying notes to answer the following questions.
(a) What were P&G’s net sales for 2014?
(b) What was the percentage of increase or decrease in P&G’s net sales from 2013 to 2014? From 2012 to 2013? From 2012 to
2014?
(c) In its notes to the financial statements, what criteria does P&G use to recognize revenue?
(d) How does P&G account for trade promotions? Does the accounting conform to accrual accounting concepts? Explain.

Comparative Analysis Case

The Coca-Cola Company and PepsiCo, Inc.
The financial statements of Coca-Cola and PepsiCo are presented in Appendices C and D, respectively. The companies’ com-
plete annual reports, including the notes to the financial statements, are available online.

Instructions
Use the companies’ financial information to answer the following questions.
(a) What were Coca-Cola’s and PepsiCo’s net revenues (sales) for the year 2014? Which company increased its revenue
more (dollars and percentage) from 2013 to 2014?
(b) Are the revenue recognition policies of Coca-Cola and PepsiCo similar? Explain.
(c) In which foreign countries (geographic areas) did Coca-Cola and PepsiCo experience significant revenues in 2014?
Compare the amounts of foreign revenues to U.S. revenues for both Coca-Cola and PepsiCo.

Financial Statement Analysis Case

Westinghouse Electric Corporation
The following note appears in the “Summary of Significant Accounting Policies” section of the Annual Report of Westinghouse
Electric Corporation.

Note 1 (in part): Revenue Recognition. Sales are primarily recorded as products are shipped and services are rendered. The percentage-
of-completion method of accounting is used for nuclear steam supply system orders with delivery schedules generally in excess of five
years and for certain construction projects where this method of accounting is consistent with industry practice.
WFSI revenues are generally recognized on the accrual method. When accounts become delinquent for more than two payment
periods, usually 60 days, income is recognized only as payments are received. Such delinquent accounts for which no payments are re-
ceived in the current month, and other accounts on which income is not being recognized because the receipt of either principal or inter-
est is questionable, are classified as nonearning receivables.
1050 Chapter 18 Revenue Recognition

Instructions
(a) Identify the revenue recognition methods used by Westinghouse Electric as discussed in its note on significant account-
ing policies.
(b) Under what conditions are the revenue recognition methods identified in the first paragraph of Westinghouse’s note
above acceptable?
(c) From the information provided in the second paragraph of Westinghouse’s note, identify the type of operation being
described and defend the acceptability of the revenue recognition method.

Accounting, Analysis, and Principles

Diversified Industries manufactures sump-pumps. Its most popular product is called the Super Soaker, which has a retail price
of $1,200 and costs $540 to manufacture. It sells the Super Soaker on a standalone basis directly to businesses. Diversified also
provides installation services for these commercial customers, who want an emergency pumping capability (with regular and
back-up generator power) at their businesses. Diversified also distributes the Super Soaker through a consignment agreement
with Menards. Income data for the first quarter of 2017 from operations other than the Super Soaker are as follows.

Revenues $9,500,000
Expenses 7,750,000

Diversified has the following information related to two Super Soaker revenue arrangements during the first quarter of 2017.

1. Diversified sells 30 Super Soakers to businesses in flood-prone areas for a total contract price of $54,600. In addition to
the pumps, Diversified also provides installation (at a cost of $150 per pump). On a standalone basis, the fair value of this
service is $200 per unit installed. The contract payment also includes a $10 per month service plan for the pumps for 3
years after installation (Diversified’s cost to provide this service is $7 per month). The Super Soakers are delivered and
installed on March 1, 2017, and full payment is made to Diversified. Any discount is applied to the pump/installation
bundle.
2. Diversified ships 300 Super Soakers to Menards on consignment. By March 31, 2017, Menards has sold two-thirds of the
consigned merchandise at the listed price of $1,200 per unit. Menards notifies Diversified of the sales, retains a 5% com-
mission, and remits the cash due Diversified.

Accounting
Determine Diversified Industries’ 2017 first-quarter net income. (Ignore taxes.)

Analysis
Determine free cash flow (see Chapter 5) for Diversified Industries for the first quarter of 2017. In the first quarter, Diversified
had depreciation expense of $175,000 and a net increase in working capital (change in accounts receivable and accounts payable)
of $250,000. In the first quarter, capital expenditures were $500,000; Diversified paid dividends of $120,000.

Principles
Explain how the five-step revenue recognition process, when applied to Diversified’s two revenue arrangements, reflects the
concept of control in the definition of an asset and trade-offs between relevance and faithful representation.

BRIDGE TO THE PROFESSION

FASB Codification References

[1] FASB ASC 606. [Predecessor literature: None.]
[2] FASB Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) (May 2014), Summary.
[3] FASB ASC 606-10-25-1 to 4. [Predecessor literature: None.]
[4] FASB ASC 606-10-25-15. [Predecessor literature: None.]
[5] FASB ASC 606-10-32-2 to 4. [Predecessor literature: None.]
[6] FASB ASC 606-10-32-31 to 35. [Predecessor literature: None.]
[7] FASB ASC 606-10-25-1 (e). [Predecessor literature: None.]
[8] FASB ASC 606-10-32-2 to 4. [Predecessor literature: None.]
[9] FASB ASC 606-10-32-5 to 9. [Predecessor literature: None.]
 Bridge to the Profession 1051

[10] FASB ASC 606-10-32-12. [Predecessor literature: None.]

[11] FASB ASC 606-10-32-11. [Predecessor literature: None.]
[12] FASB ASC 606-10-32-18. [Predecessor literature: None.]
[13] FASB ASC 606-10-32-12. [Predecessor literature: None.]
[14] FASB Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) (May 2014), pp. 5–6.
[15] FASB ASC 606-10-55-72. [Predecessor literature: None.]
[16] FASB ASC 606-10-25-30 and 606-10-55-408. [Predecessor literature: None.]
[17] FASB ASC 606-10-55-38 to 39. [Predecessor literature: None.]
[18] FASB ASC 606-10-25-12. [Predecessor literature: None.]
[19] FASB ASC 606-10-25-13. [Predecessor literature: None.]
[20] FASB Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) (May 2014), par. BC261.
[21] FASB ASC 606-10-50-1 to 21. [Predecessor literature: None.]
[22] FASB ASC 606-10-25-27 to 29. [Predecessor literature: None.]
[23] FASB ASC 606-10-25-27. [Predecessor literature: None.]
[24] FASB ASC 450 (Contingencies).
[25] FASB ASC 606-10-55-54 to 64. [Predecessor literature: None.]

Codification Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to
the following. Provide Codification references for your responses.
CE18-1 Access the glossary (“Master Glossary”) to answer the following.
(a) What is the definition of a customer?
(b) What is a performance obligation?
(c) How is standalone selling price defined?
(d) What is a transaction price?

CE18-2 Briefly explain the conditions when a contract modification shall be accounted for as a separate performance obligation.
CE18-3 Describe the accounting for refund liabilities.
CE18-4 What procedures are followed in the allocation of a discount?

Codification Research Case

Employees at your company disagree about the accounting for sales returns. The sales manager believes that granting more
generous return provisions can give the company a competitive edge and increase sales revenue. The controller cautions that,
depending on the terms granted, loose return provisions might lead to non-GAAP revenue recognition. The company CFO
would like you to research the issue to provide an authoritative answer.

Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to
the following. Provide Codification references for your responses. (Provide paragraph citations.)
(a) What is the authoritative literature addressing revenue recognition when right of return exists?
(b) What is meant by “right of return”? “Bill and hold”?
(c) Describe the accounting when there is a right of return.
(d) When goods are sold on a bill-and-hold basis, what conditions must be met to recognize revenue upon receipt of the
order?

ADDITIONAL PROFESSIONAL RESOURCES

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