Chapter 6- rsm220.docx

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University of Toronto St. George
Rotman Commerce
Dragan Stojanovic

Chapter 6: Revenue Recognition UNDERSTANDING THE NATURE OF SALES TRANSACTIONS FROM A BUSINESS PERSPECTIVE  Process of capturing info for financial purposes involves deciding when to recognize the transaction and how to measure and present it; must therefore understand the business the entity is engaged in (in order to account for transactions properly) [Economics of Business Transactions] Basics- Are we selling goods, services, or both? What is the physical nature of the transaction?  Important to focus on whether goods or services or both are being transferred (referred to as deliverables) Why does this matter for accounting purposes?  Sales of goods and of services are different o Goods are tangible assets; therefore at one point in time control over the goods or item being sold passes to the buyer (coincides w transfer of possession and legal title) o With services, transfer of possession & legal title is irrelevant  Many contracts involve both goods and services (known as multiple deliverable or bundled sales)  Understanding what the company is selling will help determine when to recognize revenues Reciprocal nature- what Is being received?  Most business transactions are reciprocal; the entity gives smth up and receives smth in return  Consideration is what the entity receives in return for the provision of goods or services Why does the reciprocal nature of transactions matter for accounting purposes?  We assume transactions are at arms length (value of what is given up usually approximates the value of what is received in the transaction) and reciprocal  Sales agreements specify what is being given up and what is being acquired o Acquired: consideration or rights to them; the amount, nature, and timing agreed upon o Given up: goods or services (now or in future); details regarding delivery (quantities, nature of goods/services, timing, shipping terms) are agreed upon  If entity sells on credit, there is a risk that customer will not pay (credit risk) o Consideration that is non monetary (like w barter transactions) presents challenges for accounting purposes; generally seen as a sale if the transaction has commercial substance (bona fide purchase and sale and the company entered into it for business purposes- exchanging one asset or service for another)  The risk that the price of an asset will change: price risk Concessionary terms- are the terms of sale normal or is this a special deal?  Examples include: o Selling price discounted o The entity agrees to a more lenient return or payment policy (paying in installments or using contingent sales) o Loosens its credit policy o Transfers legal title but allows the customer to take delivery at a later date (bill and hold) o Goods are shipped subject to customer acceptance conditions o Agrees to provide ongoing or additional services beyond the main goods or services agreed to in order to make the sale o Seller continues to have some involvement, including a guarantee of resale (or permission to return) or guarantee of profit Why does this matter for accounting purposes?  Care must be taken to identify concessionary (or abnormal) terms in any deal as they may complicate accounting o These terms are more lenient than usual and meant to induce sales  Should also ask if the selling terms are normal business practices for the company or special/unusual in some way o Pg 320 [Legalities]  Companies operate within environments governed by law (contract law, common law, securities law etc) [Contract Law]  when entity sells smth, both enter into a contract  An agreement that creates enforceable obligations and establishes the terms of the deal  The two parties have promised to exchange assets and this creates a contract  Therefore entering this creates legal rights and obligations  Contract establishes the point when legal title passes (entitlement/ownership under law) o When customer takes physical possession, legal title would pass at this point o If goods are shipped, point t which legal title passes is by shipping terms:  FOB shipping point- title passes at point of shipment  FOB destination- title passes when the asset reaches the customer [Constructive Obligation]  Constructive obligation: an entity may have an implicit obligation even if its not explicitly noted in a selling contract o Created through past practice or by signaling smth to potential customers o If enforceable (under common or other law) it creates an obligation which needs to be recognized on BS Information for Decision Making  Trend analysis most important showing changes in revenues from year to year  Biased reporting is possible under principles and rules based accounting standards ACCOUNTING FOR SALES TRANSACTIONS – RECOGNITION AND MEASUREMENT  Revenue is an inflow of economic benefits and arises from ordinary activities  Revenues are realized when goods and services are exchanged for cash  Realization is the process of converting non cash resources and rights into money (cash to cash cycle)  How to account for revenues (recognized) o Earnings approach: focuses on the earning process and how a company adds value for its customers  Under ASPE and IFRS  Revenues for sale of goods and related costs are recognized when 1. The risks and rewards of ownership are transferred 2. Vendor has no continuing involvement in nor effective control over the goods sold 3. Costs and revenues can be measured reliably and 4. Collectability is probable o Contract based approach: focuses on contractual rights and obligations creates by sales contracts [Earnings Approach] General Principle  Earnings approach historically placed under Canadian GAAP and IFRS  Seen as an IS approach to accounting for revenues and focus is on measuring revenues and costs and recognizing revenues when earned; recognized when o Performance is substantially complete: can measure the revenue and costs when it has substantially accomplished what must do to e entitled to the benefits of the revenue- earnigns process must be complete or sub. Complete  The risks and rewards are transferred and or the earnings process is sub. Complete (normally when product delivered or services are provided)  Measurability is reasonably assured o Collection is reasonable assured Earnings Process  Earnings process: a term that refers to the actions that a company takes to add value o Focuses on operating activities Selling Goods o When sell goods, there is often one main act or critical event in the earnings process that signals sub completion or performance o Can recognize under accrual accounting even though some uncertainty remains  Sub. Completion normally occurs at the point of delivery (when risks and rewards of ownership including legal title and possession pass)  If has a critical event, referred to as a discrete earnings process o Concept or risks and rewards of ownership is important in the earnings approach to rev reco; helps to establish ownership and to indicate when ownership passes from one party to another (who has the risks and rewards treats the goods as an asset) o In some cases can recognize revenue before completion of production even though there is no specific customer for the asset at that point when the products have assured prices and ready markets; rev is recognized over time as the assets mature  The critical event is the appreciation in value of the asset Selling services  The focus is on the performance of the service  Long term contracts //Problems with the earnings approach  Multiple and sometimes conflicting guidance  Diff views on what the earnings process is and when revs are earned  The risks and rewards are split btwn the buyer and the seller in many cases  Require too much subjective judgment  Does not deal w when receivables should be booked if revs are not yet earned //[Contract Based Approach] General Principle  Emphasis on BS and focuses on measuring the rights and obligation under sales contracts and recognizes rev when these rights and obligations change  Asks 2 questions o When should the sales contract be reco on the BS? o When should the rev be reco on the IS?  Contract is reco when: o The entity becomes party to the contract o The contractual rights are collectible/measureable o The performance obligation is measurable  Rev are reco when control passes or performance occurs  Net contract position: the net amount of the contractual rights and obligations o Initial value should be nil (value = what is being received)  No receivables exits until the service is performed- company is now owed anything till they perform and the customer does not pay til the service is received (unless contract says otherwise)  If the sale relates to goods (not services) performance occurs when the customer ob
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