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Chapter 6

Chapter 6 Notes

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Department
Financial Accounting
Course Code
MGAC01H3
Professor
Daga

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Chapter 6 Revenue Recognition Notes
Understanding the Nature of Sales Transactions from a Business Perspective
Economics of Business Transactions
Reciprocal Nature—What is being received?
by assuming that the transactions are at arm’s 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:
oacquired—consideration or rights to the consideration; the amount, nature, and timing are normally agree upon
ogiven up—goods/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 Terms—Are 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
usually expected within 30 to 60 days.
Terms that are more lenient than this; e.g.,
oselling on credit where the buyer does not
have to pay for 90 days or more, or
oinstalment 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
hold
Ship when ordered and ready to ship. Ship at later date; e.g., entity may hold inventory
in its warehouse for extended period.
Additional services or continuing
involvement in assets sold
Once shipped and legal title passes, no
continuing involvement except for normal rights
of return and/or standard warranties.
Extended right of return/warranty period, cash
flow guarantee on future rental of building sold,
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:
oFOB shipping point—means title passes at the point of shipment
oFOB destination—means 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 contract—constructive 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 Transactions—Recognition 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 revenues—that 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 progress—in
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:
oMultiple and sometimes conflicting guidance.
oThe earnings approach is difficult to apply, since there are different views on what the earnings process is and when revenues
are earned. Both the OSC and SEC review financial statements regularly and find that there are problems with how revenues are
accounted for. In addition, many large corporate frauds have involved revenue recognition.
oIn many cases, the risks and rewards are split between the buyer and the seller. So it is difficult to determine definitively just
who has the risks and rewards.
oIt is felt that this approach requires too much subjective judgment.
oThis approach does not deal with when receivables should be booked if the revenues are not yet earned.
Contract-Based Approach
General Principle
the emphasis is on the balance sheet, although it is not exclusively a balance sheet approach; this approach focuses on measuring the
rights and obligations under sales contracts and recognizes revenues when these rights and obligations change
model focuses on contractual and other rights and obligations created by the sales contract and analyzes the performance criteria for
revenue recognition from the perspective of the customer considering whether the obligations under the contract have been fulfilled
under this approach, the contract is recognized when: (1) the entity becomes party to the contract, (2) the contractual rights are
collectible/measurable, and (3) the performance obligation is measurable
the net amount of the contractual rights and obligations is known as the net contract position
because of reciprocity and assuming an arm’s-length transaction, the initial value of the net contract position should normally be nil
the net contract position is recognized when the entity becomes party to the contract and when the contractual rights and
performance obligations are measurable (including credit risk)
revenues are recognized when control of the related assets passes (for assets sold) and when performance occurs for services
Measurability
General Principle
under either method, revenues should only be recognized if the transaction is measurable
sales are generally measured at fair value, which is represented by the value of the consideration received or receivable
where the sale is on credit and the repayment term extends over a longer period (and the receivable is non-interest-bearing or the
interest rate is below market rate), the receivable should be discounted to reflect the time value of money
for barter transactions, if the fair value of the consideration is not available, the fair value of the product/service sold is used as long
as the sale has commercial substance and is reciprocal
Measurement Uncertainty
measurement uncertainty results from an inability to measure the transaction or parts of the transaction

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Description
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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