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Chapter 18 Learning Objective 2

Understand and apply the five-step
Revenue Recognition revenue recognition process.

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Learning Objectives Five Steps of Revenue Recognition

Steps 1 and 2
After studying this chapter, you should be able to:
Assume that Airbus (FRA) Corporation signs a contract to sell
LO 2 Understand and apply the five-step revenue recognition airplanes to Cathay Pacific Airlines (HKG) for €100 million.
process.
VAS highlights

ILLUSTRATION 18.2

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Five Steps of Revenue Recognition The Five-Step Process Revisited

Steps 3 and 4 Identifying the Contract with Customers—Step 1
Assume that Airbus (FRA) Corporation signs a contract to sell
Contract:
airplanes to Cathay Pacific Airlines (HKG) for €100 million.
• Agreement between two or more parties that creates
enforceable rights or obligations.
• Can be
o written,
o oral, or
o implied from customary business practice.

ILLUSTRATION 18.2

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Five Steps of Revenue Recognition Identifying the Contract with

Step 5 Customers—Step 1
Assume that Airbus (FRA) Corporation signs a contract to sell
Accounting
airplanes to Cathay Pacific Airlines (HKG) for €100 million.
• Revenue cannot be recognized until a contract exists.
• Company obtains rights to receive consideration and
assumes obligations to transfer goods or services.
• Rights and performance obligations give rise to a (net)
asset or (net) liability.
ILLUSTRATION 18.2
• Company does not recognize contract assets or
liabilities until one or both parties perform under the
contract.

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Basic Revenue Recognition Identifying Separate Performance

Obligations—Step 2
Illustration
Assume that Tata 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 Tata Motors for a monthly fee.
After the six-month period, the consumer can renew these services
on a fee basis with Tata Motors.
The question is whether Tata Motors sold one or two products?

If we look at Tata 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.
ILLUSTRATION 18.3

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Identifying Separate Performance Identifying Separate Performance Obligations—

Another Illustration
Obligations—Step 2
SoftTech Inc. licenses customer-relationship software to Lopez Company. In
A performance obligation is a promise to provide a distinct addition to providing the software itself, SoftTech promises to provide
product or service to a customer. consulting services by extensively customizing the software to Lopez’s
A product or service is distinct when a customer is able to information technology environment, for a total consideration of $600,000.
In this case, the objective of SoftTech appears to be to transfer a combined
• benefit from a good or service on its own or product and service for which individual goods and services are inputs. In
• together with other readily available resources. other words, SoftTech is providing a significant service by integrating the
goods and services (the license and the consulting service) into one
The objective is to determine whether the nature of a combined item for which Lopez has contracted. In addition, the software is
company’s promise is to transfer individual goods and significantly customized by SoftTech in accordance with specifications
services to the customer or to transfer a combined item (or negotiated by Lopez.
items) for which individual goods or services are inputs. As a result, the license and the consulting services are distinct but
interdependent, and therefore should be accounted for as one performance
obligation.
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Determining the Transaction Price—Step 3 Determining the Transaction Price—

Transaction Price Step 3
• Amount of consideration that company expects to receive
Estimating Variable Consideration
from a customer. Expected Value: Probability- Most Likely Amount: The single most
• In a contract is often easily determined because customer weighted amount in a range of likely amount in a range of possible
possible consideration amounts. consideration outcomes.
agrees to pay a fixed amount.
• May be appropriate if a • May be appropriate if the contract
• Companies must consider if any: company has a large number of has only two possible outcomes.
o Variable consideration contracts with similar
characteristics.
o Time value of money • Can be based on a limited
o Non-cash consideration number of discrete outcomes
and probabilities
o Consideration paid or payable to customers
ILLUSTRATION 18.4

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Determining the Transaction Price—Step 3 Transaction Price—Variable Consideration

Variable Consideration

• Price dependent on future events.

o May include price increases, volume discounts, rebates,
credits, performance bonuses, or royalties.
• Companies estimate amount of revenue to recognize.
o Expected value
o Most likely amount

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ILLUSTRATION 18.5
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Transaction Price—Variable Consideration Determining the Transaction Price—Step 3

Time Value of Money
• When contract (sales transaction) involves a significant
financing component.
o Interest accrued on consideration to be paid over time.
o Fair value determined either by measuring the
consideration received or by discounting the payment using
an imputed interest rate.
o Company reports as interest expense or interest revenue.

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ILLUSTRATION 18.5
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Variable Consideration Time Value of Money

A Word of Caution Transaction Price—Extended Payment Terms
• Companies only allocate variable consideration if it is
reasonably assured that it will be entitled to the amount.
• Companies 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, they do not expect a significant
reversal of revenue previously recognized.
If these criteria are not met, revenue recognition is
constrained.

ILLUSTRATION 18.7

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Time Value of Money Determining the Transaction Price—Step 3

Transaction Price—Extended Payment Terms Consideration Paid or Payable to Customers
• 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 18.7

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Determining the Transaction Price—Step 3 Consideration Paid or Payable to Customers

Non-Cash Consideration Transaction Price—Volume Discount (read by your self)

Goods, services, or other non-cash consideration.

• Companies sometimes receive contributions (e.g., donations
and gifts).
• Customers sometimes contribute goods or services, such as
equipment or labor, as consideration for goods provided or
services performed.
• Companies generally recognize revenue on the basis of the
fair value of what is received.

ILLUSTRATION 18.8

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Allocating the Transaction Price to Allocating the Transaction Price

Multiple Performance Obligations—Product,
Separate Performance Obligations—Step 4 Installation, and Service (for your reference only)
• Based on their relative fair values. Handler Company is an established manufacturer of equipment used in the construction industry. Handler’s
products range from small to large individual pieces of automated machinery to complex systems containing
• Best measure of fair value is what the company could sell 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
the good or service for on a standalone basis (standalone 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.
selling price)
• Chai purchases equipment from Handler for a price of $2,000,000 and chooses Handler to do the
• If not available, companies should use their best estimate 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
of what the good or service might sell for as a standalone 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.
unit
• 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 and completes installation of the equipment on November 1, 2022. 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
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Allocating Transaction Price to Separate Recognizing Revenue When (or as) Each
Performance Obligations—Step 4 Performance Obligation Is Satisfied—Step 5
Transaction Price—Allocation
Company satisfies its performance obligation when the
customer obtains control of the good or service.
Change in Control Indicators
1. Company has a right to payment for asset.
2. Company has transferred legal title to asset.
3. Company has transferred physical possession of asset.
4. Customer has significant risks and rewards of ownership.
5. Customer has accepted the asset.

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Recognizing Revenue When (or as) Each Summary of the Five-Step Revenue
Performance Obligation Is Satisfied—Step 5 Recognition Process
Step 2
Companies satisfy performance obligations either: Step in Process Description Implementation
• at a point in time or 2. Identify the separate A performance obligation is a A contract may be comprised of
performance promise in a contract to multiple performance obligations.
• over a period of time, by measuring progress toward obligations in the provide a product or service The accounting for multiple
completion contract. to a customer. performance obligations is based
o Method for measuring progress should depict transfer of A performance obligation on evaluation of whether the
control from company to customer. exists if the customer can product or service is
benefit from the good or distinct within the contract. If
o Most common are cost-to-cost and units-of-delivery methods. service on its own or together each of the goods or services is
with other readily available distinct, but are all
resources. interdependent and interrelated,
these goods and services are
combined and reported as one
ILLUSTRATION 18.15
performance obligation.

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Summary of the Five-Step Revenue Summary of the Five-Step Revenue

Recognition Process Recognition Process
Step 1 Step 3
Step in Process Description Implementation Step in Process Description Implementation
1. Identify the A contract is an A company applies the 3. Determine the The transaction price is the In determining the transaction
contract with agreement that creates revenue guidance to contracts transaction price. amount of consideration that price, companies must consider
customers. enforceable rights or with customers. a company expects to receive the following factors: (1) variable
obligations. from a customer in exchange consideration, (2) time value of
for transferring goods and money, (3) non-cash
ILLUSTRATION 18.15 services. consideration, and (4)
consideration paid or payable to
customer.
ILLUSTRATION 18.15

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Summary of the Five-Step Revenue

Recognition Process VAS highlights
Step 4

Step in Process Description Implementation

4. Allocate the If more than one The best measure of fair value is
transaction price to performance obligation what the good or service could be
the separate exists, allocate the sold for on a standalone basis
performance transaction price based on (standalone selling price).
obligations. elative fair values. Estimates of standalone
selling price can be based on (1)
adjusted market assessment, (2)
expected cost plus a margin
ILLUSTRATION approach, or (3) a residual
18.15
approach.

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Summary of the Five-Step Revenue

VAS highlights
Recognition Process
Step 5 Revenue Recognition for sales of goods:
Step in Process Description Implementation The following revenue recognition criteria must be ALL satisfied:
5. Recognize revenue A company satisfies its Companies satisfy performance
when each performance obligation when obligations either at a point in a) The seller has transferred most of risks and
performance the customer obtains control time or over a period of time. rewards of ownership
obligation is satisfied. of the good or service. Companies recognize revenue
over a period of time if one of the
b) The seller doesn’t effectively manage or
following criteria is met: (1) the control the goods
customer receives and consumes c) The amount of revenue can be measured
the benefits as the seller reliably
performs, (2) the customer
controls the asset as it is created, d) The seller have received or will received
or (3) the company does not have economic benefits from the sale transaction.
an alternative use for the asset. e) Costs related could be determined
ILLUSTRATION 18.15

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VAS highlights Practice exercises

Revenue Recognition for services rendered: BE18.4 (LO 2) Destin Company signs a contract to manufacture a
new 3D printer for $80,000. The contract includes installation which
The following revenue recognition criteria must be ALL satisfied: costs $4,000 and a maintenance agreement over the life of the printer
at a cost of $10,000. The printer cannot be operated without
a) The amount of revenue can be measured reliably the installation. Destin Company as well as other companies could
b) The seller have received or will received economic provide the installation and maintenance agreement.
benefits from the sale transaction. What are Destin Company’s performance obligations in this contract?
c) The stage of completion can be measured
reliably.
d) Costs related could be determined

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Practice exercises Practice exercises

BE18.3 (LO 2) Hillside Company enters into a contract with Sanchez BE18.5 (LO 2) Ismail Construction enters into a contract to design
Inc. to provide a software license and 3 years of customer support. The and build a hospital. Ismail is responsible for the overall management
customer support services require specialized knowledge that only of the project and identifies various goods and services to be provided,
Hillside Company’s employees can provide. including engineering, site clearance, foundation, procurement,
How many performance obligations are in the contract? 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.

Solution: this is a special case. Ismail accounts for the bundle of goods
and services as a single performance obligation because the goods or
services in the bundle are highly interrelated

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Practice exercises
BE18.6 (LO 2) Nair A.G. 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,
2023. 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:

Determine the transaction price for this contract.

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