1

Chapter 2 Module 1: Revenue Recognition Part I

Accrual Accounting vs Cash Accounting:
When financial statements are prepared under United States Generally Accepted Accounting
Principles (GAAP), they will need to use the accrual basis of accounting. The cash basis
method of accounting is the method of accounting that is used for tax reporting purposes.
The cash basis method of accounting will recognize revenue when cash is received and
expenses when cash is paid, regardless of the period in which they have been earned. For
financial reporting purposes you must know that accrual accounting is the method that
indicates:

Revenue Recognition:
For financial statement reporting purposes, revenue is recognized when it has been earned
(performance has occurred). This is representative of the accrual method of accounting.
Revenues should be recognized when an exchange of services or a sale of goods have been
provided.

© Universal Review, LLC. All rights reserved.

2

Five Steps of Revenue Recognition:

ASC 606 is the standard for revenue recognition under US. GAAP. Under ASC 606, revenue
recognition applies a five-step approach that you should understand:

Step 1: Identify the Contract with a Customer:

Contracts represent an agreement that creates an
enforceable right or obligation between two or more parties.
Depending on the circumstances of the business transaction,
contracts can be written, made orally, or may simply be
implied by an entity’s customary business practices. The
contracts may depend on the class of customer or the nature
of the promised goods or service which should be considered
in determining whether the agreement is enforceable and
should be considered binding.

Criteria of a Contract - A contract should be accounted for when it meets the following
criteria:

© Universal Review, LLC. All rights reserved.

3

© Universal Review, LLC. All rights reserved.

4

Criteria Not Enforceable—A contract does not exist if each of the parties may cancel the
contract before any goods or services are transferred to the customer and before any
consideration (e.g., cash payments) have been made to the seller without paying the party
within the deal. The cancellation will exist when the contract is considered to have not been
performed.

Combination of Contracts:
Contracts will be combined when two or more are agreed upon simultaneously or nearly
simultaneously with the same customer (or related parties of the customer) should be
combined and accounted for as one singular contract. This should occur if any of the
following criteria are met:

• The contracts are negotiated as a package with a single commercial objective.

• The amount of consideration to be paid in one contract depends on the other price or
performance of the other contract.
• The goods and services promised in the contracts (or some goods or services
promised in the contracts) are a single performance obligation, in accordance with
the standard.

© Universal Review, LLC. All rights reserved.

5

Contract Modifications:
A modification made to a contract may sometimes be necessary if approved by both parties.
This is sometimes referred to as a change order, a variation, or an amendment made to the
contract. The modification of a contract can either create a new contract or even change
existing enforceable rights and obligations of the parties to a contract. The approval of a
contract modification can be made in writing, orally, or can be implied by most customary
business practices.

Step 2: Identify the Performance Obligations in the Contract:

A performance obligation is a promise to
transfer a distinct good or service, or a series of
distinct goods or services that are substantially
the same and have the same pattern of
transfer, to a given customer.

© Universal Review, LLC. All rights reserved.

6

© Universal Review, LLC. All rights reserved.

7

Single Performance Obligation - A contract with a single performance obligation is one in

which only one distinct good or service is being provided to the customer. A good or service
is distinct if a customer can benefit from the good or service on its own or together with
other resources that the customer has readily available and the seller's promise to transfer
the good or provide the service can be identified separately from other promises in the
contract.

Multiple Performance Obligations - When a contract has more than one performance
obligation, an entity will be required to allocate the respective portion of the transaction
price and account for it separately.

Step 3: Determine the Transaction Price:

The transaction price will almost always be defined as the price point in
which the buyer of goods or services has agreed to pay in exchange for
those goods or services. Additionally, there are other considerations
that might be included within the terms of the contract:

© Universal Review, LLC. All rights reserved.

8

1) Variable consideration –consideration is considered variable if the amount in which

an organization is receiving is contingent on a future event either occurring or not
occurring. Bonuses are a common example of variable consideration.

© Universal Review, LLC. All rights reserved.

9

2) Noncash consideration – consideration will not

always be valued in cash. Often, organizations will
barter transactions and essentially trade tangible
property in exchange for services rendered or other
goods.

3) Financing components – components can also be financed

with debt or equity. Often interest income will be associated
with debt interesting components.

© Universal Review, LLC. All rights reserved.

10

4) Consideration payable to the customers – If the consideration paid

or payable to a customer is a discount or a refund for goods or
services provided to a customer, the reduction of the transaction
price should be recognized.

Step 4: Allocate the Transaction Price to the Performance Obligation:

Once the transaction price has been determined, the referenced price should be allocated
to its performance obligation within the terms of the contract. Performance obligations may
either be one single performance obligation or multiple performance obligations.

Single performance obligations – should be apportioned to one single performance

obligation.

Multiple performance obligations – should be allocated proportionately to the performance

obligation that is based on deemed standalone prices.

Standalone Selling Price:

Companies will often be requested to fulfill multiple performance obligations. The allocation
of transaction prices to the performance obligations requires the allocation of the
transaction price to each performance obligation in proportion to its standalone selling price.
This reflects the overall price in which a company can sell goods or services individually to a

© Universal Review, LLC. All rights reserved.

11

customer. Generally, this may consist of the customers quoted price that may also consist of
additional or separate transactions with the customer (e.g., a car dealership offering
additional services such as future maintenance or upgrades).

Discounted Price:
Transactions involving goods or services frequently be bundled together and sold at a
discounted price. This will be lower than each respective price had they been sold
individually. For financial reporting purposes, the total discount must be applied to each
respective product or service and allocated based on its proportional value to the total
consideration received.

© Universal Review, LLC. All rights reserved.

12

Variable consideration:
Similarly described in Step 3, determining the transaction price, variable consideration will
consist of the organization receiving a contingent amount based on a future event. As
previously stated, bonuses are a common example of variable consideration.

Step 5: Revenue Recognition Once Obligation Has Been Performed:

Revenue should be recognized once the obligation has been satisfied and the customer has
retained possession of the goods or services. These transactions will be referred to as
prepaid cash in exchange for the performance of the obligation at a later date. This is a very
common theme within accrual accounting and should be recorded by recognizing cash and
unearned revenue. Once revenue has been earned, the liability will be reversed, and
revenue will be recognized.

© Universal Review, LLC. All rights reserved.

13

Satisfaction of the performance - A performance obligation is satisfied in its entirety when

goods or services are transferred to the customer or client, or when goods or services have
been received by the customer or they obtain control of the asset.

Control of the asset – Can be acknowledged based on the consumers ability to put the
purchased goods to use or offset liabilities (aka offer the consumer an economic benefit).
The seller of goods or services can satisfy performance obligations either periodically or in a
one-time lump sum payment. To determine that control has passed to the customer and the
entity has satisfied the performance obligation, the organization will consider the following:

© Universal Review, LLC. All rights reserved.

14

Contract Liabilities and Contract Assets:

Contract liabilities and contract assets will be reflected on the organizations balance sheet
when agreed upon contracts are entered into. Generally, contract liabilities will be reported
by the entity that has entered into the agreement and will perform the terms of the contract.

Contract liabilities – When organizations agree to perform goods and services and receives
payment prior to doing so, they will report a contract liability until the obligation to perform
services has been fulfilled.

© Universal Review, LLC. All rights reserved.

15

Contract asset – If on the other hand, the organization delivers the goods or services prior to
receiving payment, it will book a contract asset on its balance sheet. Contract assets will
reflect the organizations future right to compensation (think of this as accounts receivable).
Additionally, contract assets can either be conditional or unconditional rights.

Conditional – conditional rights to a contract asset will exist if a company completes a

performance obligation prior to receiving compensation, however, it will be required to
complete another performance obligation prior to being entitled to consideration from that
customer.

Unconditional – unconditional rights to a contract asset will occur when an organization has
fulfilled the performance obligation and is awaiting payment.

© Universal Review, LLC. All rights reserved.

16

© Universal Review, LLC. All rights reserved.

17

© Universal Review, LLC. All rights reserved.

18

Long-Term Contracts:
In certain situations, revenue is recognized over a long-term period of time. In which case,
firms may recognize revenue over the life of the contract. The two methods that will be used
to recognize revenue over a contract period consist of:
1. The completed contract method
2. The percentage-of-completion method

Complete Contract Method:

The completed-contract method is allowed under U.S. GAAP for recognizing revenue from
long-term construction contracts if the percentage-of-completion method can’t be applied.
This method will recognize revenue at the end of the contract (i.e., when it is complete). This
is different from the percentage-of-completion method in that the percentage-of-completion
method will recognize revenue throughout the life of the long-term construction project.

© Universal Review, LLC. All rights reserved.

19

Companies will use the completed contract method when any of the following conditions
exist:
1. The company has short-term contracts
2. The company cannot meet the conditions for using the percentage-of-completion
method.
3. There are inherent risk hazards in the contract beyond the normal recurring business
risks.

Percentage-of-Completion Method:
The percentage of completion method is the more heavily tested method for recognizing
revenue over the life of a contract. While the completed contract method will recognize
revenue at the end of a project, where the percentage-of-completion method is different is it
will recognize revenue throughout the life of the contract over time.

The percentage of completion method must be used when estimates of progress toward
completion, revenues, and costs are all reasonably dependable and if all of the following
conditions exist:
1. The contract clearly specifies the enforceable rights regarding goods or services by
the parties.
2. The buyer can be expected to satisfy all obligations
3. The contractor can be expected to perform under the contractual obligations.

© Universal Review, LLC. All rights reserved.

20

Balance sheet recognition – will have specific requirements for recognizing both assets and
liabilities. Construction in progress will be presented as an inventory account on the balance
sheet that recognizes the total amount of gross profit earned from construction completed
to date. Whereas the progress billings account will represent a contra inventory account for
all construction costs that have been accumulated to date.

Current Assets:
If construction in progress (i.e., total accumulated costs to date) plus estimated earnings
exceed progress billings (i.e., total amount billed to date), the discrepancy will be recorded
by the company as a current asset on the balance sheet.

© Universal Review, LLC. All rights reserved.

21

Due on accounts – will be recognized as a current asset on the balance sheet for the
amount billed on the construction project that is yet to be collected.

Current Liabilities:
If construction in progress (i.e., total accumulated costs to date) plus estimated earnings is
less than progress billings (i.e., total amount billed to date), the discrepancy will be recorded
by the company as a current liability on the balance sheet.

© Universal Review, LLC. All rights reserved.

22

© Universal Review, LLC. All rights reserved.

23

© Universal Review, LLC. All rights reserved.

24

© Universal Review, LLC. All rights reserved.