USCPA (FAR) – (4) Revenue Recognition

I would like to record about the key points of the US CPA exam content.

<Create and note the points based on mainly Becker’s workbook>

Five-step approach to recognizing revenue from contracts with customers.

• Step 1: Identify the Contract: Companies must identify contracts with customers that are legally enforceable and have commercial substance. The contract must specify the payment terms and identify the rights and obligations of each party, and there must be a probable benefit that the company will collect the revenue.
• Step 2: Identify the Performance Obligations : Identify the performance obligations (promised goods or services) within the contract. A performance obligation is a good or service that can provide benefit to the customer on its own, or in conjunction with other readily available resources. It involves the transfer of goods or provision of services. When the services are all very similar in nature and can be provided to the buyer in a similar manner, this would indicate that the services can be combined into a single performance obligation.
• Step 3: Determine the Transaction Price : Determine the total amount of consideration (transaction price) that is expected to be received from the customer under the contract. The transaction price may include variable considerations such as bonuses, discounts, and refunds. Any discount that exists in a contract (based on the total value of the contract versus the stand-alone value of each obligation summed within the contract) should be allocated proportionally across all obligations within the contract.
• Step 4: Allocate the Transaction Price to the Performance Obligations: Allocate the transaction price to each performance obligation in the contract. This is typically based on the standalone selling prices of each obligation. If a standalone selling price is not readily determinable, estimates must be used.
• Step 5: Recognize Revenue: Recognize revenue when the customer obtains control of the good or service, or as the performance obligations are satisfied. This often corresponds to the point at which ownership of goods transfers or services are rendered.

Step4: Revenue allocation for contracts containing multiple services

<Step-by-Step Allocation Method>

• Identification of Performance Obligations: Identify each distinct promised good or service (performance obligation) within the contract.
• Determination of Standalone Selling Prices: Determine the standalone selling price for each performance obligation. This is the price at which the good or service would be sold separately.
• Allocation of the Transaction Price: Allocate the total transaction price to each performance obligation based on their standalone selling prices. This is usually done by dividing the SSP of each obligation by the total SSPs and applying these ratios to the total transaction price.

<Estimating Standalone Selling Prices>

• Adjusted Market Assessment Approach: Estimate the SSP by adjusting the market price of similar goods or services.
• Expected Cost Plus Margin Approach: Calculate the SSP by adding a profit margin to the expected costs of the goods or services.
• Residual Approach: Use the remaining amount of the total transaction price, after subtracting the standalone selling prices of other performance obligations, as the SSP for a specific obligation. This approach is used only if SSP cannot be reasonably estimated by other methods.

According to ASC 606, the allocation of revenue is made at the time of contract inception, and subsequent changes are generally not permitted. This ensures that the contract with the customer is accurately reflected, and revenue recognition is transparent and consistent.

Step5: Revenue Recognition (the input method and the output method)

• These methods are used to determine the timing of revenue recognition in transactions with customers based on contracts.
• Input Method: The input method recognizes revenue based on the inputs (such as costs or labor hours) into the production or progress of the goods or services being provided. This method evaluates the performance obligation progress by measuring the resources consumed.
• Output Method: The output method recognizes revenue based on the outcomes resulting from the goods produced or services provided (e.g., the number of products completed or units of service delivered). This method assesses the performance obligation progress by measuring the output produced or the value of the services delivered.
• Selection and Application : Companies must choose one of these methods and apply it consistently. The choice often depends on the nature of the contract, the method of performance, as well as the actual business processes and capabilities of the accounting information system. ASC 606 mandates that the chosen method should reliably depict the performance toward the completion of the contract.
• Both methods are means to accurately reflect the progress of contract fulfillment and ensure transparency and accuracy in revenue recognition.
• When a company recognizes revenue over time for a four-year construction contract, income previously recognized would be used to calculate the income recognized in the second year (but not progress billings to date).
• Because the company cannot reasonably estimate returns at the time of sale, it cannot recognize revenue on the day of the sale.

A contract modification

• A contract modification represents a change in the price or scope or both of a contract approved by both parties. The modification is treated as a new contract if the scope increases because of the addition of distinct goods or services and the change in contract price represents stand-alone prices.

A genuine Sale or Service as a financing arrangement

Criteria for Determining a Genuine Sale

• Transfer of Control: Whether control of the goods (ownership or rights of use) has been transferred to the customer. If control is transferred, the transaction is often considered a genuine sale.
• Terms of the Repurchase Option: (1) Exercise Price of the Option: If the exercise price of the option is significantly lower than the current market price or expected future price, the transaction may be considered a financing arrangement. Conversely, if the option price is equal to or higher than the fair market value, it is more likely to be a genuine sale. (2) Probability of Exercise: The likelihood of the option being exercised. If it is high, the transaction may be treated as a financing arrangement.
• Contract Duration and Economic Life: How the period of repurchase relates to the economic life of the goods. For example, if the repurchase is to occur over a significant portion of the economic life of the goods, it may exhibit characteristics of a financing transaction.
• Overall Economic Substance of the Transaction: At the end of the transaction, who essentially bears the risks and rewards. If the seller retains significant risks or rewards, it may be considered a financing transaction.

Revenue recognition

• Cash receipts represent an increase to the liability while recognized revenues represent a decrease to the liability. The beginning and ending balances of the liability are known and the cash receipts are known. Place the known amounts in the BASE(Beg, Add, Sub, End) mnemonic and squeeze the solution.