Question

In: Accounting

On January 10, KH sold a mixer it purchased from MU for $80 cash and delivered...

On January 10, KH sold a mixer it purchased from MU for $80 cash and delivered it to a customer. KH has a 45-day return policy under which a customer can exchange a product for another product of the same type, quality, condition and price. The exchange policy requires that all returned products must be like new. Based on extensive historical experience, KH estimates that 2% of its products will be exchanged by customers for another product of the same price, condition, quality and type. KH estimates the cost of recovering any products will be insignificant. KH does not record any potential volume discounts until they are earned.

Requirements

? Record all initial accounting entries for KH for January 10 based on the current guidance on revenue recognition in ASC 605. Include references to the guidance to support your proposed accounting. Show any calculations you make to support your journal entries.

? Prepare a detailed explanation of each of the five steps of revenue recognition. Record all initial accounting entries for MU for January 10 based on the new guidance on revenue recognition in ASC 606. Include references to the guidance to support your proposed accounting. Show any calculations you make to support your journal entries.

? What, if anything, is the difference in revenue recognized for the month of January under ASC 605 and ASC 606?

Solutions

Expert Solution

Under ASC 605, a right of return that was generally available to all customers made it difficult to conclude that consideration was fixed or determinable, which made it difficult to recognize revenue on some transactions. ASC 605-15-25-1 required entities to meet each of five criteria to recognize any revenue at the point of sale, or recognize no revenue whatsoever until the return provision expires or until all of the criteria were met, whichever came first. An entity was required to:

  • Determine the price at the date of sale,
  • Receive payment, or have the right to receive payment,
  • Have no obligation to replace products in the event of theft or destruction,
  • Meet certain economic substance tests,
  • Be able to estimate the returns to be received.

These criteria, and particularly the criterion to be able to estimate the returns to be received, frequently led to companies being required to defer revenue that had substantially been earned.

In comparison, ASC 606 takes a more principles-based approach and treats general rights of return as variable consideration. In many cases, this will lead to similar treatment under both standards. However, entities who have previously determined they could not make an estimate accurate enough to meet the requirements for earlier recognition under ASC 605 may find that they will recognize revenue earlier as they apply the new revenue model to these transactions. It should be noted that transactions that were deemed too uncertain to reliably estimate under ASC 605 will likely need to have some of their variable consideration constrained, but it would be rare that the uncertainty would be so great as to constrain the estimated revenue to $0. These transactions will recognize some revenue upfront, which was not permitted under ASC 605.

Companies that currently have too much uncertainty to recognize revenue upfront under ASC 605 will probably see the most significant changes to their financial statements as they will generally recognize much more revenue upfront under ASC 606 than is currently allowed. The accounting for customer-specific rights of return, or customer acceptance provisions, is not expected to undergo any major change.

Five Steps of Revenue Recognition :-

An entity recognizes revenue in accordance with that core principle by applying the following steps:

Step 1: Identify the contract(s) with a customer—A contract is an agreement between two or more parties that creates enforceable rights and obligations. The guidance in this Topic applies to each contract that has been agreed upon with a customer and meets specified criteria. In some cases, this Topic requires an entity to combine contracts and account for them as one contract. This Topic also provides requirements for the accounting for contract modifications. (See paragraphs 606-10-25-1 through 25-13.)

Step 2: Identify the performance obligations in the contract—A contract includes promises to transfer goods or services to a customer. If those goods or services are distinct, the promises are performance obligations and are accounted for separately. A good or service is distinct if the customer can benefit from the good or service on its own or together with other resources that are readily available to the customer and the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract. (See paragraphs 606-10-25-14 through 25-22.)

Step 3: Determine the transaction price—The transaction price is the amount of consideration in a contract to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer. The transaction price can be a fixed amount of customer consideration, but it may sometimes include variable consideration or consideration in a form other than cash. The transaction price also is adjusted for the effects of the time value of money if the contract includes a significant financing component and for any consideration payable to the customer. If the consideration is variable, an entity estimates the amount of consideration to which it will be entitled in exchange for the promised goods or services. The estimated amount of variable consideration will be included in the transaction price only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. (See paragraphs 606-10-32-2 through 32-27.)

Step 4: Allocate the transaction price to the performance obligations in the contract—An entity typically allocates the transaction price to each performance obligation on the basis of the relative standalone selling prices of each distinct good or service promised in the contract. If a standalone selling price is not observable, an entity estimates it. Sometimes, the transaction price includes a discount or a variable amount of consideration that relates entirely to a part of the contract. The requirements specify when an entity allocates the discount or variable consideration to one or more, but not all, performance obligations (or distinct goods or services) in the contract. (See paragraphs 606-10-32-28 through 32-41.)

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation—An entity recognizes revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer (which is when the customer obtains control of that good or service). The amount of revenue recognized is the amount allocated to the satisfied performance obligation. A performance obligation may be satisfied at a point in time (typically for promises to transfer goods to a customer) or over time (typically for promises to transfer services to a customer). For performance obligations satisfied over time, an entity recognizes revenue over time by selecting an appropriate method for measuring the entity’s progress toward complete satisfaction of that performance obligation. (See paragraphs 606-10-25-23 through 25-30.)


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