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Chapter 6

Chapter 6 Notes

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Financial Accounting

Chapter 6 Revenue Recognition Notes Understanding the Nature of Sales Transactions from a Business Perspective Economics of Business Transactions Reciprocal NatureWhat is being received? by assuming that the transactions are at arms length, i.e., they are between unrelated parties, then it may also be assumed that the value of what is given up usually approximates the value of what is received in the transaction sales agreements normally specify what is being given up and what is being acquired as follows: o acquiredconsideration or rights to the consideration; the amount, nature, and timing are normally agree upon o given upgoods/services (now or in the future); delivery details (quantities, nature, timing, shipping terms) are agreed upon consideration that s non-monetary (as with barter transactions) presents greater challenges for accounting purposes barter or non-monetary transactions are where few or no monetary assets are received as consideration when goods/services are sold generally, a barter transaction is seen as a sale if the transaction has commercial substance commercial substance means that the transaction is a bona fide purchase and sae and that the entity has entered into the transaction for business purposes, exchanging one type of asset or service for another different asset or service (dissimilar) after the transaction, the entity will be in a different position and its future cash flows are expected to change significantly as a result of the transaction (in terms of timing, amount, and/or riskiness) the risk that the price of an asset will change is referred to as a price risk Concessionary TermsAre the terms of sale normal or is this a special deal? in some cases, one party is in a better bargaining position than the other care must be taken to identify concessionary (or abnormal) terms in any deal as they may complicate the accounting concessionary terms are terms that are more lenient than usual and are meant to induce sales concessionary or abnormal terms may create additional obligations or may reflect the fact that the risks and rewards or control has not yet passed to the customer; some of these situations may even indicate that no sale has taken place at all Normal Selling Terms Concessionary Selling Terms Payment terms Sell for cash or on credit. If credit, payment is Terms that are more lenient than this; e.g., usually expected within 30 to 60 days. o selling on credit where the buyer does not have to pay for 90 days or more, or o instalment sales where these are not normal industry practice Extension of credit Sell to customers that are creditworthy Sales to customers that are riskier than the existing customer base. Shipping terms including bill and Ship when ordered and ready to ship. Ship at later date; e.g., entity may hold inventory hold in its warehouse for extended period. Additional services or continuing Once shipped and legal title passes, no Extended right of return/warranty period, cash involvement in assets sold continuing involvement except for normal rights flow guarantee on future rental of building sold, of return and/or standard warranties. profit guarantees on future resale or buyback provisions. Legalities Contract Law a contract with customers is an agreement that creates enforceable obligations and establishes the terms of the deal there is a promissor (the seller), a promissee (the customer), and an agreement thus, the act of entering into a sales agreement creates legal rights and obligations in addition, the contract establishes the point in time when legal title passes (entitlement/ownership under law) when the customer takes physical possession of the goods straight away, legal title would normally pass at this point if the goods are shipped, the point at which legal title passes is often evidenced by the shipping terms as follows: o FOB shipping pointmeans title passes at the point of shipment o FOB destinationmeans title passes when the asset reaches the customer Other in many cases, entity may have an implicit obligation even if it is not explicitly noted in a selling contractconstructive obligation a constructive obligation is an obligation that is created through past practice or by signalling something to potential customers constructive obligations are often enforceable under common or other law any enforceable promise that results from the sale (whether explicit or implicit) may create a performance obligation that needs to be recognized in the balance sheet; this includes both contractual and other promises Accounting for Sales TransactionsRecognition and Measurement realization is the process of converting noncash resources and rights into money from an accounting perspective, there are 2 conceptual views of how to account for revenues: earnings, and contract-based approach the earnings approach focuses on the earnings process and how a company adds value for its customers the contract-based approach focuses on the contractual rights and obligations created by sales contracts in all cases, in order to properly account for the transaction, there should be persuasive evidence of the sales arrangement evidence might consist of a contract (written or verbal), an invoice, or both Earnings Approach General Principle under this approach, revenues are recognized when: performance is substantially complete, and collection is reasonably assured performance occurs when an entity can measure the revenue (and costs) and when it has substantially accomplished what it must do to be entitled to the benefits of the revenuesthat is, the earnings process must be complete or substantially complete revenues are recognized when the following criteria are met: 1) Performance is achieved, which means a) the risks and rewards are transferred and/or the earnings process is substantially complete (normally when a product is delivered or services are provided), and b) measurability is reasonably assured (price is fixed/determinable) 2) Collectability is reasonably assured earnings process is a term that refers to the actions that a company takes to add value the concept of risks and rewards (benefits) of ownership is a core concept in the earnings approach to revenue recognition it helps to establish ownership and to indicate when ownership passes from one party to another in determining who has the risks and rewards of ownership and, therefore, whether a sale has occurred at the point of delivery, it is important to look at who has possession of the goods and who has legal title when services are provided, the focus is on performance of the service the accounting is more complex where the earnings process has numerous significant events (continuous earnings process) two methods of accounting for long-term construction and other service contracts are generally recognized: 1) Percentage-of-Completion Method. Revenues and gross profit are recognized each period based on construction progressin other words, the percentage of completion. This makes the most sense in long-term service contracts when it is the service that is being provided to build something or work on something that is owned by the customer (numerous significant events). 2) Completed-Contract Method. Revenues and gross profit are recognized only when the contract is completed. This makes the most sense when the service consists of a single significant event or the item being built/constructed is owned by the company building/constructing it. In this latter case, it is more like building/constructing inventory and then selling it and recognizing revenues when it is complete. It may also make sense to use this method when there are measurement problems. Problems with the Earnings Approach the following points reflect some of the problems with the earnings approach: o Multiple and sometimes conflicting guidance. o The earnings a
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