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Chapter 3Revenue Recognition — Contract withCustomersIntroductionIn financial reporting, confusion arises when to agree what revenue is and what it isn't. One can be able to decide that the issues associated with revenue recognition can get relatively problematical. In this chapter we focus on the c...

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Chapter 3 Revenue Recognition — Contract with Customers Introduction In financial reporting, confusion arises when to agree what revenue is and what it isn't. One can be able to decide that the issues associated with revenue recognition can get relatively problematical. In this chapter we focus on the complexities associated with revenue recognition and the conceptual nature of revenue and as the basis of accounting for revenue recognition decision. In practice, there are departures from the revenue recognition principle (the accrual method). Revenue is sometimes recognized at other points in the earning process, attributing in great measure to the significant diversity of revenue transactions. until most recently revenue recognition was exactly one of the biggest gaps between IFRS (PFRS) and US GAAP. Finally, these two standards came closer and tried to solve all these differences on May 28, 2014 when new revenue recognition standard was IFRS (PFRS) 15 Revenue from Contracts with Customers and it should fill the gap between IFRS and US GAAP. Effect of IFRS (PFRS) 15: What Type of Business will be the most affected? For some companies, the impact of the new rules for revenue recognition will be minimal and they will simply continue recognizing revenue just as before. Still, on the other hand, some companies might face difficult challenges in order to apply with the new rules. The biggest challenges will be mainly in the areas that are not very precisely arranged by superseded IAS (PAS) 18 and other related standards. IFRS (PFRS) 75 has a lesser room for accounting decisions and specifies a lot more things depending on the transaction involved. The major areas of impact that are probably affected: Is the revenue recognized: a. over time (spread between the periods during contract duration) or at the point of time (upon completion)? b. If the revenue is to be recognized over time, how should the company measure the progress towards completion (in the previous standards the phrase "stage of completion" were used)? c. How shall companies account for revenue from bundled offers (with multiple deliverables)? Should they split the contract into several components? d. How shall companies deal with contract modifications? e. How shall companies treat the contract costs, including cost of obtaining the contract? Shall they expense these costs in profit or loss, or capitalize and defer?

f.

Are there any financing components in the contract? If it is in the affirmative, how to deal with the time value of money? g. What disclosures do companies. need to make? Do they have all the appropriate and relevant information? Different sectors or industries are affected in many different ways along the 5-step model as introduced by IFRS (PFRS) 15. There are four (4) important industries that will face probably the biggest challenges: 1. Telecommunications: Identifying individual performance obligations and allocating transaction price 2. Manufacturers: Contract modifications Software development and technology: Splitting the contract into two (2) separate obligations 3. Real estate and property development: Revenue over time/at the point of time IFRS (PFRS) 15 will replace the following standards and interpretations: PAS 18 Revenue, PAS I I Construction Contracts SIC 31 Revenue — Barter Transaction Involving Advertising Services a. PFRIC 13 Customer Loyalty Programs PFRIC 15 Agreements for the Construction of Real Estate and b. PFRIC 18 Transfer of Assets from Customers The core principle of IFRS (PFRS) 75 is that an entity will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration (payment) to which the entity expects to be entitled in exchange for those goods or services. c. P FRS 15 contains guidance for transactions not previously addressed (service revenue, contract modifications); PFRS 15 improves guidance for multiple-element arrangements; PFRS 15 requires enhance disclosures about revenue

Overview of Revenue Recognition in Relation to PFRS 15

l. Contract with customers 2. Separate performance obligations 3. Determining the transaction price 4. Allocating the transaction price

5.

Satisfying performance obligations (installment sales, construction contracts, and franchises)

1. 2. 3.

4. 5.

Right of return Bill-and-hold arrangements Principal-agent relationships Warranties

Non-refundable upfront fees Repurchase agreements 7. Licensing 8. Gift Cards 9. Franchise (Chapter 5) 10. Consignments (Chapter 5) Revenue from Contracts with Customers adopts an asset-liability approach. Companies: d. Account for revenue based on the asset or liability arising from contracts with customers. Are required to analyze contracts with customers - Contracts indicate terms and measurement of consideration. - Without contracts, companies cannot know whether promises will be met. 6.

However, IFRS (PFRS) 15 requires capitalizing them and recognizing them in profit or loss in line with revenue recognition.

The Revenue Recognition Principle Recognize revenue to depict the transfer of goods or services to customers in amount that reflects the consideration that the company receives, or expects to receive, in exchange for these goods or services. Recognize revenue in the accounting period when the performance obligation is satisfied. • Revenue Recognition at a (Single) Point in Time in Summary Form:

a) We recognize revenue at a point in time when we don't qualify for recognizing revenue over time.

b) The performance obligation is satisfied when control of the goods or services is transferred from the seller to the customer.

c) Usually transfer of control is obvious, and coincides With delivery. d) Other indicators of transfer of control: the customer has -

An obligation to pay the seller.

-

Legal title to the asset. Physical possession of the asset. Assumed the risks and rewards of ownership accepted the asset.

The indicators as mentioned in letter "D" above indicates that control has been transferred from the seller to the customer (the customer is more likely to control a good or service if the customer has those indicators). Sellers should evaluate these indicators individually and in combination to decide whether control has been transferred and revenue can be recognized.

• Revenue Recognition Over a Period of Time (Over Time) In Summary Form: a Revenue should be recognized over time if goods and services are transferred over time to the customer. b Revenue can be recognized over time if one of the following conditions hold: - The customer consumes the benefit of the seller's work as it is performed, or The customer controls the asset as it is created, as when a contractor builds an extension into a customer's existing school building, or The seller is creating an asset that has no alternative usesto the seller, and the seller has the legal right to receive payment for progress to date, as when a company manufactures customized product.

The S-Step Process STEP 1: WHEN DOES A CONTRACT EXIST FOR PURPOSES OF REVENUE RECOGNITION?  A contract is an agreement that creates legally enforceable rights and obligations. - Can be explicit or implicit. - Can be oral or written. A contract exists for purposes of revenue recognition only if all of the following are true: - it has commercial substance, affecting the risk, timing or amount of the seller's future cash flows, -

it has been approved by both the seller and the customer, indicating commitment to fulfilling their obligations,

-

it specifies the seller's and customer's rights regarding the goods or services to be transferred,

-

it specifies payment terms, and

-

it is probable that the seller will collect the amount it is entitled to receive.

 A contract also does not exist if both of the following are true. - Neither the seller nor the customer has performed any obligations under the contract and -

Both the seller and the customer can terminate the contract without penalty.

STEP 2: IDENTIFY THE PERFORMANCE OBLIGATION(S)  Examples of common parts of contracts that are not performance obligations: - Prepayments (it's part of the transaction price). - Quality-assurance warranties (its part of the performance obligation to deliver goods and services that are free of defects). - right of return (it's part of the performance obligation to deliver acceptable goods and services).  Examples of common parts of contracts that are performance obligations: Extended warranties (it's a separate obligation distinct from delivering acceptable goods and services). A warranty is an extended warranty if either the customer has the option to purchase the warranty separately, or the warranty provides a service to the customer beyond quality assurance. - Options that provide a material right (a material right is something the customer wouldn't get otherwise, so the seller is obligated to provide it). STEP 3: DETERMINE THE TRANSACTION PRICE: VARIABLE CONSIDERATION Occurs when some of the contract price depends on the outcome of a future Examples: - Incentive payments Royalties ÉVolume discountsÉRebates ÉRight of return Estimate variable consideration using either - Expected value - Most likely amount  Constraint: Sellers only include an estimate of variable consideration in the transaction price fo the extent it is probable that a significant revenue reversal will not occur when the uncertainty associated with the variable consideration is resolved. Intended to avoid severe revenue overstatements. Indicators that a significant reversal could occur: poor evidence on which to base an estimate, dependence on factors outside the seller's control, history of the seller changing payment terms on similar contracts, a broad range of outcomes that could occur, and a long delay before uncertainty resolves The seller should update estimates of variable consideration (and whether the constraint is required) prospectively, adjusting revenue and other accounts as necessary in the period in which the estimate is revised.

STEP 4: ALLOCATE THE TRANSACTION PRICE TO PERFORMANCE OBLIGATIONS: ESTIMATING STAND-ALONE SELLING PRICES Three methods are recommended for estimating stand-alone selling prices that are not observable: 1. Adjusted market assessment approach: The seller considers what it could sell the product or services for in the market in which it normally conducts business, perhaps referencing prices charged by competitors. 2. Expected cost plus margin approach: The seller estimates its costs of satisfying a performance obligation and then adds an appropriate profit margin 3. Residual approach: The seller estimates an unknown (or highly uncertain) standalone selling price by subtracting the sum of the known or estimated stand-alone selling prices from the total transaction price. Only allowed if the stand-alone selling price is highly uncertain, either because the seller hasn't previously sold the good or service and hasn't yet determined a price for it, or because the seller provides the same good or service to different customers at substantiallydifferent prices. STEP 5: RECOGNIZE REVENUE WHEN (OR AS) EACH PERFORMANCE OBLIGATION IS SATISFIED.

Statement of Financial Position Presentation: A contract asset or contract liability should be presented in the statement of financial position when either party has performed in a contract. Contract asset -Rights received > Performance obligation Contract liability =Rights received < Performance obligation PFRS (IFRS) 15 is not prescriptive about the treatment of contract assets/liabilities. Contract Assets Contract asset — an entity's right to consideration in exchange for goods or services that the entity has transferred to the customer (i.e. the entity performs before the customer pays). Contract assets are of two types: Unconditional Conditional rights As alternatives to the term "contract asset", the standard also allows the terms receivable and work-in-progress to be used. If revenue exceeds cash received, this could be included within trade receivables. If costs to date exceed cost of sales, this could be included within inventory, as work-in-progress. Contract Liabilities

Contract Liability — oncompany's obligation to transfer goods or services to a customer for which the company has received consideration from the customer or consideration is due from the customer (i.e. the customer pays or owes payment before the entity performs). If the cash received exceeds the revenue recognized to date, there will be a contract liability (acting effectively as deferred income). A contract liability is generally referred to as Unearned Sales Revenue. Unearned Service Revenue, or any appropriate account title. If a contract is loss making, there will be a provision recorded to recognise the full loss under the onerous contract, as per PAS (IAS) 37. This can either be termed as a contract liability or a provision. V. A Review: Key Considerations When Applying the Five Steps to Revenue Recognition

MULTIPLE CHOICE PROBLEMS Items 1 to 5 are based on the following information: Globemartr Inc. a telecommunications operator, entered into a contract with Kim Dorothy on March l , 20x7. In line with the contract, Kim Dorothy subscribes for Globemart's monthly plan for 12 months and in return Kim Dorothy receives a free Apple I-Phone handset from Globemart. Kim Doroth will pay a monthly fee of P I ,200. Kim Dorothy gets the handset immediately after contract signature. Globemart sells the same handsets for P3,600 and the same monthly plans for P800 per month without handset. 1.

Identify the contract with a customer - what kind of contract between Globemart, Inc. and Kim Dorothy? a b

Oral Contract Written contract

c. Customary business practice d. No contract

2. Identify the performance obligations (PO) — how many performance obligations a. I-Performance Obligation: Network services (monthly/installment plan) b. I-Performance Obligation: Apple I-Phone Handset. c. 2 Performance Obligations: Network services (monthly/ installment plan) and Apple I-Phone Handset. d. No performance obligation since there is no existing contract. 3. Determine the transaction price -- the total transaction price? a. P3, 600 c. PI 3,200 b. P9,600 d. p 14,400 4.

Allocate the transaction price to the performance obligations: the allocated transaction price to each performance obligations? a. None, since there is no contract P9,600 network service and P3,600 for Apple I-Phone Handset b. c.

5.

PO for network service and PI 3,200 for Apple I-Phone Handset P 10,473 network service and P3,927 for Apple I-Phone Handset

Recognize revenue when (or as) an entity satisfies a performance obligation: timing of revenue recognition? a. None, since there is no contract b. Network service and for Apple I-Phone Handset -- both overtime c. Network service — over time and for Apple I-Phone handset — paint in time d. Network service — paint in time and for Apple I-Phone Handset —

Items 6 to 10 are based on the following information: Globemart, Inc. a telecommunications operator, entered into a contract with Kim Dorothy on March l , In line with the contract, Kim Dorothy subscribes for Globemart's monthly plan for 12 months and in return Kim Dorothy receives fee a free of P Apple I ,200. Kim I-Phone Dorothy handset gets the from handset Globemart. immediately Kim Doroth after contract will pay a signature.monthly Globemart sells the same handsets for P3,600 and the same monthly plans for P800 per month without handset.

6.

On March l , 20x7, the amount of accounts receivable to be recorded a. None c. P 8,727.50 b. P3,927.OO d. PI 2,654.50

7.

On March 1, a. b.

the revenue from sales of goods amounted to: None c. P 8,727.50 P3,927.OO d. PI 2,654.50

8.

On March 31, 20x7, the amount of accounts receivable to be recorded a. None c. PI 200.00 b. P872.75 d. P8,727.50

9.

On March 31 , 20x7, the revenue from network services amounted to: a. None c. P 1,200.00 b. P872.50 d. PI 2,654.50

10.

On December 31 , 20x7, the total revenue amounted to: a. None c. P 1,200.00 b. P872.50 d. PI 2,654.50

Contract Assets and Receivable Items 11 to 15 are based on the following information: On January I , Conrad Company enters into a contract to transfer Product X and Product Y to Piolo Co. for P200,000. The contract specifies that payment of Product X will not occur until Product Y is also delivered. In other words' payment will not occur until both Product X and Product Y are transferred to Piolo. Conrad determines that standalone prices are P60,000 for Product X and PI 40,000 for Product Y. Conrad delivers Product X to Piolo on February I 20x9• On March l , Conrad delivers Product Y to Piolo. 11. On January l , the amount of accounts receivable to be recorded: a. b.

None c. PI 40,000 P60,OOOd. P200,OOO

12. On February I , 20x9, the amount of accounts receivable to be recorded: a. None c. P140,ooo b. P60,OOO d. P200,OOO

13. February l, 20x9, the amount of revenue to be recorded: a. None c. P140,OOO b. P60,OOO d. P200,OOO 14. On March l, 20x9, the amount of accounts receivable to be recorded: a. None c. P140,OOO b. P60,OOO d, pmo,ooo 15. On Marchthe amount of revenue to be recorded: a. None c. P140.OOO b. P60,OOO d. pmo,ooo

Contract Assets and Receivable Items 16 to 21 are based on the following information: On January 1 , 20x9, Castano enters into a non-cancellable contract with Recio for the sale of an excavator for P700,OOO, the excavator will be delivered to Recio on April 1, mx9. The contract requires. Recio to pay the P700,OOO in advance on Febn.jary l, 20x9 and Recio makes the payment on March 1 , 20x9. 16. On January 1, the amount of accounts receivable to be recorded: a. None C. P 70000 b. P350,000 d. PI40,000 17. On January 208, the amount of revenue to be recorded: a. None c. P 700,000 b. P350,000 d. 140,000 18. On February 1, 20x9, the amount of accounts receivable to be recorded: a. None c. P 700,000 b. P350,000 d. 140,000 19. On February 1, 20x9, the amount of revenue to be recorded: a. None c. P 700,000 b. P350,000 d. 140,000 20. On March 1 , 20x9, the amount of revenue to be recorded: a. None c. P 700,000 b. P350,000 d. 140,000 21.

*April l, the amount of revenue to be recorded: a. None c. P 700,000 b. P350,000 d. 140,000

Contract Liability Evelyn Company enters into a contract to transfer a product »July 31 , 20x9, it is agreed that Chua will pay the full price of e on April l, The contract is non-cancellable. Chua, pay until April 15, 20x9, and Evelyn delivers the product on of the product is PI 5.0m,, the amount of revenue to be recorded;

23. On April 2, 20x9, the amount of revenue to be recorded: a. None c. 15,000 b. 1,000 d. 20,000 24. On April t 15, the amount of revenue to be recorded: c. None d. 1,000 25. On July 31, e. None f. 1,000

c. 15,000 d. 20,000 the amount of revenue to be recorded: c. 15,000 d. 20,000

Contract Assets/Contract Liabilities 26. Gupta Industries received a P300,000 prepayment from Packard Associates for the sale of new equipment. Gupta will bill Packard an additions PI 00,000 upon delivery of the equipment. Upon receipt of the P300,000 prepayment, how much should Holt recognize for a contract asset, a contract liability, and accounts receivable? a. Contract asset: PO; contract liability: P300,OOO, accounts receivable, PO. b. Contract asset: P300,000; contract liability: PO, accounts receivable, PO. c. Contract asset: PO; contract liability: P300,OOO, accounts receivable, P 100.000. d. Contract asset: P300,000; contract liability: PO, accounts receivable, P 100,000. 27. Holt Industries received a P2,00...