Hey there. Welcome. Had breakfast yet?
First of all, before you tackle this accounting standard, know that you’re a step from perfecting your knowledge in yet another standard.
OBJECTIVES:
At the end of this lecture, the student should be able to
(a) Express a detailed conceptualization of what revenue recognition entails.
(b) Enforce the accounting treatment of revenue recognition.
WHAT IS REVENUE?
Revenue is any increase in equity, resulting from an increase in economic benefits flowing to a firm.
A contract is a legally enforceable agreement between parties, that give rise to obligations.
Conditions under which revenue is recognised:
(a) Risks and rewards should be transferred to the buyer.
(b) The seller must relinquish control over the asset.
(c) Payment by the buyer must be reasonably assured
(d) The amount of revenue from the use of the subject contracted on should be measurable.
(e) The cost of generating such revenue should also be measurable.
Exceptions: Lease, Insurance and Financial Instruments (LIF).
STEPS IN REVENUE RECOGNITION
IDENTIFY THE CONTRACT.
The following are ways to identify the contract:
(a) Both parties must give their consent.
(b) The place of transfer of title should be expressed in the contract.
(c) It should be probable that the buyer would settle considerations.
(d) The items under sale should have economic substance. (Substance over form).
(e) The terms of payment should be specified. e.g credit terms, etc.
IDENTIFY PERFORMANCE OBLIGATIONS.
Performance obligations must not only be specifically, but separately identified for discrete goods or services.
DETERMINE THE TRANSACTION PRICE.
The transaction price is often easily determined. Sometimes, the parties would require a third party (specialist) to estimate the contract’s price. It is the amount expected to be paid to the seller.
ALLOCATE CONTRACT PRICE TO PERFORMANCE OBLIGATIONS.
The aggregated consideration under is allocated to each separate performance obligation.
RECOGNIZE REVENUE IN ACCORDANCE TO PERFORMANCE.
Revene can be recognized at a point in time (usually related to goods), or over a period of time (usually related to services), in which case, part will be deferred.
Let us take a look at the following examples:
Q1:
Kantata Ltd Manufactures motor vehicles in Ghana. The company recently entered into a contract with Baiden Ltd to sell a fleet of motor vehicles. These motor vehicles are specially designed for Baiden Ltd, as such, has an integrated software system for functionalities such as voice recognitions, automatic steering and thumbprint activations. The sofware system comes with other contractual obligations. This includes software and license, installation service, technical support, and software updates. Also, the vehicles come with a 3 year warranty for major unforseen contigencies, and a free 1 year repairs and maintenance for minor unforseen contigencies.
Required:
Identify the performance obligations under the contract between Kantata Ltd and Baiden Ltd.
Solution
The software and license, and the installation service should be aggregated and made a single performance obligation in the allocation of the contract price. This is so because the software and license cannot be used without the installation service. Technical support and software updates should however be separately identified as performances obligations. The 3 year warranty and free 1 year repairs and maintenance are significant financing components. They should also be separately identified. Thus, the purchase consideration should be allocated separately as follows:
(a) Software and license, and installation service.
(b) Technical support.
(c) Software updates.
(d) 3 year warranty.
(e) 1 year repairs and maintenance.
The 3 year warranty, and the 1 year repair are services, the revenue of which is to be realized over a period of time (3 years and 1 year respectively), and not at a point in time.
Q2:
Coronavirus Ltd sells mobile phones to SARS Ltd under a written agreement. Under this agreement, Coronavirus Ltd is to provide a “free” mobile phone, when SARS Ltd signs up for their 12 month call and data bundles at $50.00 per month.
A similar mobile phone service provider, MERS Ltd, sells a mobile phone at $360.00 without a monthly contract. MERS charges $35.00 for its monthly call and data bundles.
Required:
Demonstrate the treatment of the transactions above in the books of both firms, assuming the cost of a mobile phone to both Coronavirus Ltd, and MERS Ltd is $700.00.
Solution
Though the mobile phone is said to be free, it is really not free. It is captured in the amount paid for the 12 month call and data bundles, the total amount of which is $50.00 X 12 = $600.00.
The mobile phone, and the call and data bundles should be separately identified.
Looking unto MERS Ltd, a mobile phone without a monthly contract sells at $360.00, and monthly call and data bundles sells at $35.00 per month, the total amount of which is $35.00 X 12 = $420.00.
The total package from MERS sells at $780.00.
Allocating the contract consideration to performance, we have:
Mobile phone: $360.00 X $600.00 ≈$277.00
$780.00
Call and data bundles: $420.00 X $600.00 ≈$323.00.
$780.00
Q3:
UVW Ltd sold an asset under a contract to XYZ Ltd. Since the principal driver at XYZ Ltd does not know how to drive a truck, UVW Ltd decided to throw in a complementary driving lesson, which is to last for 12 months, seeing how complicated the truck is, all of which cost $1,000,000.00. The stand alone price of the truck and complementary driving lesson is $950,000.00 and $250,000.00 respectively.
Required:
Show how the above transaction would be treated in the books of UVW Ltd, assuming it bought the truck at $750,000.00.
Solution
Total of stand-alone price of truck and complementary driving lesson = $950,000.00+$250,000.00
=$1,200,000.00.
Allocating consideration to performance:
Truck: $950,000.00 X $1,000,000.00 ≈ $791,667.00.
$1,200,000.00
Driving Lesson: $250,000.00 X $1,000,000.00 ≈$208,333.00.
$1,200,000.00
The amount of $208,333.00, as allocated to the complemetary driving lesson would be realized over a period of 12 months.
Q4:
In each of the following situations, state at which date, if any, revenue will be recognised:
1. A contract for the sale of goods is entered into on 1 May 2016. The goods are delivered on
15 May 2016. The buyer pays for the goods on 30 May 2016. The contract contains a
clause that entitles the buyer to rescind the purchase at any time. This is in addition to
normal warranty conditions.
2. A contract for the sale of goods is entered into on 1 May 2016. The goods are delivered on
15 May 2016. The buyer pays for the goods on 30 May 2016. The contract contains a
clause that entitles the buyer to return the goods up until 30 June 2016 if the goods do
not perform according to their specification.
3. A contract for the sale of goods is entered into on 1 May 2016. The goods are delivered
on 15 May 2016. The contract contains a clause that states that the buyer shall pay only
for those goods that it sells to a third party for the period ended 31 August 2016. Any
goods not sold to a third party by that date will be returned to the seller.
4. Retail goods are sold with normal provisions allowing the customer to return the goods
if the goods do not perform satisfactorily. The goods are invoiced on 1 May 2016 and
the customer pays cash for them on that date.
Solution
1. No revenue is recognised because the customer has the right to rescind the purchase at any
time – beyond normal warranty conditions. The cash is recorded on receipt with the credit
being recorded as a borrowing.
2. Revenue is recognised on 30 June 2016.This is the date at which the seller has no further
performance obligations.
3. Revenue is recognised only at the dates the buyer on-sells the goods to a third party.
4. Revenue is recognised on 1 May 2016. The right of return is a normal warranty clause and is
included in determining the measurement of the revenue.
ABOUT THE AUTHOR
Prince Kwesi Oklu-Darku is a Level 300 student at the University of Ghana, currently pursuing a Bachelor of Science degree in Administration, and Accounting as a major course of study. He attended the Saint Johns’ Senior High School where he won an academic award as the best student in Financial Accounting. Do not hesitate to make comments in the comment box below, and address your questions to: swagccounting@gmail.com for quicker reviews.
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