Question

Describe the basic concept of revenue recognition. What are the issues involved when there are multiple-element sales? What are the required disclosures in regard to revenue recognition.

Answer 1

Answer

The basic concept of revenue recognition.

Revenue recognition is that it's the principle that states that revenue is recorded when it is realized or realizable and earned, not necessarily when it is received.

The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. They both determine the accounting period, in whichrevenues and expenses are recognized. ... Accrued revenue: Revenue is recognized before cash is received.

Recognition principles in three parts:
1. Sale of goods

2. Provision of services

3. Interest, royalties and dividends

Multiple-element sales;

Many companies, large and small, offer a broad range of products and services to their customers. Often these product and service sales are negotiated at the same time with a single customer, resulting in a single contractually binding arrangement with multiple deliverables.

Consider the cell phone company that provides a free or discounted phone to a customer who signs up for a two-year contract. A product (the phone) has been delivered at the beginning of the contract with a current cash flow (including activation fees) and a reasonably certain guaranteed future cash flow.

The required disclosures in regard to revenue recognition.

To illustrate the complexities and potential problems that can arise, here is a quick look at some of the more challenging revenue-related issues affected by the new disclosure requirements:

• Performance obligations. Companies are required to disclose the portion of a transaction’s price that is allocated to “remaining performance obligations” (terms of the contract that have yet to be satisfied), and then explain when in the future the company expects to recognize the revenue associated with those unsatisfied obligations. For some companies, this may require estimates that extend years into the future.

• Significant judgments and estimates. Companies are required to disclose information about the methods, inputs, and assumptions they used to both (1) estimate the amount of “variable consideration” (rebates, performance bonuses, refunds, etc.) included in the transaction price, and (2) estimate the likelihood of significant revenue reversals when the uncertainty associated with some or all of the variable consideration is resolved.

• Changes in contract asset and liability balances. Companies are required to disclose and explain changes in contract asset and liability balances that occurred during the reporting period. Examples of such explanations include: changes due to business combinations or dispositions; impairment of contract assets; contract modifications; changes in the estimate of transaction price; and variations in expected progress.

• Out-of-period revenue adjustments. Companies are required to disclose revenue that is being recognized in the current reporting period but resulted from performance obligations that were satisfied in a previous period (due to changes in the transaction price, revision of variable consideration estimates, etc.). Consider, for example, a five-year construction contract that includes a performance bonus for completing the project on time. If work is far behind schedule at the end of year-one, the company’s reporting for the period might not include any revenue for the bonus since the bonus’ estimated value at that moment is zero. However, if the work gets back on track in the second year, the company would need to recognize two-fifths of the total bonus amount as revenue in its year-two reporting – but it would also need to estimate and disclose the portion of the bonus revenue recognized in year-two that was actually attributable to work done in year one.