Question

1.Discuss what was viewed as the major criticisms of Generally Accepted Accounting Principles as it relates to Revenue Recognition. In addition, identify the five steps in the revenue recognition process.

2. Discuss how companies satisfy a performance obligation? In addition, identify the indicators of satisfaction of a performance obligation.

Answer 1

Answer.1

Revenue irecognition iis ia igenerally iaccepted iaccounting iprinciple i(GAAP) ithat iidentifies ithe ispecific iconditions iin iwhich irevenue iis irecognized iand idetermines ihow ito iaccount ifor iit. iTypically, irevenue iis irecognized iwhen ia icritical ievent ihas ioccurred, iand ithe idollar iamount iis ieasily imeasurable ito ithe icompany.

Generally iaccepted iaccounting iprinciples i(GAAP) irefer ito ia icommon iset iof iaccounting iprinciples, istandards, iand iprocedures iissued iby ithe iFinancial iAccounting iStandards iBoard i(FASB). iPublic icompanies iin ithe iUnited iStates imust ifollow iGAAP iwhen itheir iaccountants icompile itheir ifinancial istatements. iGAAP iis ia icombination iof iauthoritative istandards i(set iby ipolicy iboards) iand ithe icommonly iaccepted iways iof irecording iand ireporting iaccounting iinformation. iGAAP iaims ito iimprove ithe iclarity, iconsistency, iand icomparability iof ithe icommunication iof ifinancial iinformation.

For iexample, irevenue iaccounting iis ifairly istraightforward iwhen ia iproduct iis isold, iand ithe irevenue iis irecognized iwhen ithe icustomer ipays ifor ithe iproduct. iHowever, iaccounting ifor irevenue ican iget icomplicated iwhen ia icompany itakes ia ilong itime ito iproduce ia iproduct. iAs ia iresult, ithere iare iseveral isituations iin iwhich ithere ican ibe iexceptions ito ithe irevenue irecognition iprinciple.

1. Revenue irecognition iis ia igenerally iaccepted iaccounting iprinciple i(GAAP) ithat istipulates ihow iand iwhen irevenue iis ito ibe irecognized.

2. The irevenue irecognition iprinciple iusing iaccrual iaccounting irequires ithat irevenues iare irecognized iwhen irealized iand iearned–not iwhen icash iis ireceived.

3. The irevenue irecognition istandard, iASC i606, iprovides ia iuniform iframework ifor irecognizing irevenue ifrom icontracts iwith icustomers.

Revenue iis iat ithe iheart iof iall ibusiness iperformance. iEverything ihinges ion ithe isale. iAs isuch, iregulators iknow ihow itempting iit iis ifor icompanies ito ipush ithe ilimits ion iwhat iqualifies ias irevenue, iespecially iwhen inot iall irevenue iis icollected iwhen ithe iwork iis icomplete. iFor iexample, iattorneys icharge itheir iclients iin ibillable ihours iand ipresent ithe iinvoice iafter iwork iis icompleted.

As ia iresult, ianalysts iprefer ithat ithe irevenue irecognition ipolicies ifor ione icompany iare ialso istandard ifor ithe ientire iindustry. iHaving ia istandard irevenue irecognition iguideline ihelps ito iensure ithat ian iapples-to-apples icomparison ican ibe imade ibetween icompanies iwhen ireviewing iline iitems ion ithe iincome istatement. iRevenue irecognition iprinciples iwithin ia icompany ishould iremain iconstant iover itime ias iwell, iso ihistorical ifinancials ican ibe ianalyzed iand ireviewed ifor iseasonal itrends ior iinconsistencies.

Within ithe inew istandards ithere iare ifive isteps ioutlined ifor irevenue irecognition.

Step i1: iIdentify ithe icontract iwith ia icustomer.

This istep iwill itypically ibe istraightforward ifor ifranchisors ibecause ithey ihave ia iwritten ifranchise iagreement iin iplace ithat ispecifies ithe iparties, ieach iparty's irights iand iobligations, iand ithe ipayment iterms. iThe iagreement iwill ialso ihave i"commercial isubstance," imeaning ithe icash iflows iof iboth iparties iare iexpected ito ichange ias ia iresult iof ithe icontract. iFranchisors imust itake ithe iadditional istep iof idetermining icollectability ibased ion iits icredit iunderwriting iof ithe ifranchisee.

Step i2: iIdentify ithe iperformance iobligations iin ithe icontract.

Franchisors imust idetermine iif ithe iservices i-- isuch ias ipre-opening iactivities, isite iselection iand itraining i-- iit iprovides ito ithe ifranchisee iat ithe ionset iof ithe ifranchise iagreement ican ibe iidentified ias i"distinct" ifrom ithe iintellectual iproperty ithat ithe ifranchisee iis ilicensing. iThis idetermination ishould ibe imade ibased ion iprofessional ijudgment iand iindustry ibest ipractices. i(In imany iareas, iincluding ithis ione, iprivately iheld ifranchisors ican ilook iat ithe ifilings iof ipublicly iheld ifranchisors ito isee ihow ithose ibusinesses ihandled ia idetermination.)

step i3: iDetermine ithe itransaction iprice.

For ifranchisors, ithis istep iinvolves ilisting iall ithe irevenue istreams i-- iincluding ithose ithat iwill ibe ireceived iup ifront, iand ithose ithat iwill ibe ireceived iover itime i-- iit iwill icollect ifrom ithe ifranchisee, iincluding ithe iinitial ifranchise ifee, iroyalties, irenewal ifees, itransfer ifees, irelocation ifees iand iso ion. iAll irevenue istreams ishould ibe ioutlined iin ithe ifranchise iagreement.

Franchisors imay ialso ineed ito inote isignificant ifinancing icomponents iin iarrangements iin iwhich ithe itiming iof ipayment iis iextended ior isignificantly ilater ithan iwhen ithe igoods ior iservices iare iprovided, isuch ias iarea idevelopment irights ior imaster ifranchise irights. iAdditionally, inon-cash iservices imust ibe ivalued ias ipart iof ithe itransaction iprice iat ithe iinception iof ithe iagreement.

Step i4: iAllocate ithe iprices ito ithe iperformance iobligations

For ithis istep, ifranchisors imust itake ieach idistinct igood ior iservice idetermined iin istep i2 iand iassign ia itransaction iprice iat ithe iinception iof ithe iagreement. iOne ior imore iapproved imethods imay ibe iused ito imake ithese ideterminations, iincluding ithe iadjusted imarket iassessment iapproach, ithe iexpected icost iplus ia imargin iapproach, iand ithe iresidual iapproach. iThe ioutcome ifor ieach iitem imust ibe ia istand-alone ivalue, imeaning ithe ivalue iat iwhich ithe igood ior iservice icould ibe isold ion iits iown.

Step i5: iRecognize irevenue.

For ifranchisors ito irecognize irevenue ifor ia iparticular igood ior iservice, ithat igood ior iservice imust ibe itransferred ito ithe ifranchisee, ieither iat ia ipoint iin itime, ior iover itime i(over ithe iperiod iof ithe ifranchise icontract). iRoyalties ihave ia icarve-out iexception ias isales-based iroyalties; itherefore ithe ifranchisor icontinues ito irecognize ithem ias ithe iunderlying isales ioccur, iand iaccrues ifor iroyalties iearned ibut inot iyet ireceived.

Answer.2

In isimple iterms iperformance iobligation iis ia i“Promise” ito ideliver igoods ior iservices iin ilieu iof ipayment i(in iadvance ior iotherwise).

As iper ithe iguidelines:

At ithe iinception iof ia icontract, ian ientity ishall iassess ithe ipromises imade iin ithe icontract ito ia icustomer iand ishall iidentify ithem ias iperformance iobligations. iThese imay iinclude:

1. A igood ior ia iservice i(or ia ibundle iof igoods ior iservices) ithat iis idistinct.

2. A iseries iof idistinct igoods ior iservices ithat iare isubstantially ithe isame iand ithat ihave ithe isame ipattern iof itransfer ito ithe icustomer.

. iA iperformance iobligation iis ia ipromise ito ideliver ia igood ior iprovide ia iservice i(or ia iseries iof idistinct igoods ior iservices ithat iare isubstantially ithe isame iand ithat ihave ithe isame ipattern iof itransfer ito ithe icustomer). iIt ican ibe iimplicit ior iexplicit.

Depending ion ithe icontract, ipromised igoods ior iservices imay iinclude, ibut iare inot ilimited ito, ithe ifollowing:

1. Sale iof igoods iproduced iby ian ientity i(for iexample, iinventory iof ia imanufacturer)

2. Resale iof igoods ipurchased iby ian ientity i(for iexample, imerchandise iof ia iretailer)

3. Resale iof irights ito igoods ior iservices ipurchased iby ian ientity i(for iexample, ia iticket iresold iby ian ientity iacting ias ia iprincipal)

4. Performing ia icontractually iagreed-upon itask i(or itasks) ifor ia icustomer

5. Providing ia iservice iof istanding iready ito iprovide igoods ior iservices i(for iexample, iunspecified iupdates ito isoftware ithat iare iprovided ion ia iwhen-and-if-available ibasis) ior iof imaking igoods ior iservices iavailable ifor ia icustomer ito iuse ias iand iwhen ithe icustomer idecides

6. Providing ia iservice iof iarranging ifor ianother iparty ito itransfer igoods ior iservices ito ia icustomer i(for iexample, iacting ias ian iagent iof ianother iparty)

7. Granting irights ito igoods ior iservices ito ibe iprovided iin ithe ifuture ithat ia icustomer ican iresell ior iprovide ito iits icustomer i(for iexample, ian ientity iselling ia iproduct ito ia iretailer ipromises ito itransfer ian iadditional igood ior iservice ito ian iindividual iwho ipurchases ithe iproduct ifrom ithe iretailer)

8. Constructing, imanufacturing, ior ideveloping ian iasset ion ibehalf iof ia icustomer

9. Granting ioptions ito ipurchase iadditional igoods ior iservices

In iorder ito iidentify iperformance iobligations iin ieach icontract, ia icompany ineeds ito idetermine iwhether ior inot ithe igoods ior iservices iare idistinct. iIf idistinct, ia icustomer ican ibenefit ifrom ithe igood ior iservice ion iits iown i(the igood ior iservice iis iseparable ifrom ithe iother igoods ior iservices iin ia icontract). iA igood ior iservice iis idistinct iif:

1. The icustomer ican ibenefit ifrom ithe igood ior iservice ieither ion iits iown ior itogether iwith iother iresources ithat iare ireadily iavailable ito ithe icustomer i(that iis, ithe igood ior iservice iis icapable iof ibeing idistinct).

2. The ientity’s ipromise ito itransfer ithe igood ior iservice ito ithe icustomer iis iseparately iidentifiable ifrom iother ipromises iin ithe icontract i(that iis, ithe ipromise ito itransfer ithe igood ior iservice iis idistinct iwithin ithe icontext iof ithe icontract).

Example; iAn iauto idealer isells ia icar ito ia icustomer ifor ian iall-inclusive iprice ithat iincludes ithe icar iand ithree iyears iof ifree ioil ichanges. iThis icontract iwould iinclude itwo iperformance iobligations. iThe ifirst iperformance iobligation iwould ibe ifor ithe isale iof ithe icar. iThe isecond iperformance iobligation iwould ibe ifor ithe ioil ichanges. iThe icar iperformance iobligation irevenue iwould ibe irecognized iupon idelivery ito ithe icustomer. iThe ioil ichange iperformance iobligation iwould ibe irecognized iover ithe ithree-year ioil ichange iobligation.

Determining ithe idistinct inature iof igoods iand iservices iwill irequire ijudgment. iASC i606-10-25-21 iprovides ia ilist iof ifactors ifor ia icompany ito iconsider iwhen idetermining iwhether ithere iare iseparate, idistinct igoods ior iservices iin ieach icontract. iThe icompany iwill ineed ito ievaluate ieach icontract ito idetermine iwhether ithere iis imore ithan ione iperformance iobligation.

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iEntities irecognize irevenue iat ia ipoint iin itime iwhen itheir iperformance iobligation idoes inot imeet ithe icriteria ito ibe imeasured iover itime iand icontrol iof ithe iasset ihas ibeen itransferred ito ithe icustomer. iTo idetermine iat iwhich ipoint iin itime ito irecognize irevenue, ientities imust iconsider ifactors ithat iindicate icontrol iof ia igood ior iservice ihas itransferred. iTopic i606 iprovides ifive iindicators iright ito ipayment, ilegal ititle, iand iphysical ipossession, iliability ifor irisks iand ir