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Chapter 18: Q3CA (page 1047)

CA18-3 (Recognition of Revenue鈥擳heory) Revenue is usually recognized at the point of sale (a point in time). Under special circumstances, however, bases other than the point of sale are used for the timing of revenue recognition.

Instructions

(a) Why is the point of sale usually used as the basis for the timing of revenue recognition?

(b) Disregarding the special circumstances when bases other than the point of sale are used, discuss the merits of each of the following objections to the point-of-sale basis of revenue recognition:

(1) It is too conservative because revenue is earned throughout the entire process of production.

(2) It is not conservative enough because accounts receivable do not represent disposable funds, sales returns and allowances may be made, and collection and bad debt expenses may be incurred in a later period.

(c) Revenue may also be recognized over time. Give an example of the circumstances in which revenue is recognized over time and accounting merits of its use instead of the point-of-sale basis.

Short Answer

Expert verified
  1. Point of saleprovides evidence that performance obligations are satisfied. Therefore, it is used as a base for the timing of revenue.
  2. Business entity must recognize the revenue over time because a portion of the project gets completed each year, and bad debt expenses must be matched in the same period when receivables are reported.
  3. The business entities generating revenue from long-term construction projects will recognize revenue over time. This method will provide more relevant information than the point of sale.

Step by step solution

01

Definition of Allowance For Bad Debts

The reserve created by the business entity for adjusting the uncollectible debts is known as the allowance for bad debts. This allowance is made based on estimations.

02

Point of sale as a base for timing of revenue

All business entities generally use the point of sale as a base for the timing of revenue because it provides evidence regarding the transfer of assets and its control to the customers.

03

Step 3:Merits of objections to the point of sale as basis of revenue recognition

1. It is too conservative because revenue is earned throughout the entire process of production: It is stated that the revenue is earned during the whole production process, but it is not convenient for the business entity to determine revenue based on operating activity. It is impossible to determine the revenue to be recognized for the period.

In general, the sale is said to be the point at which the performance obligations are satisfied. Revenue estimated before sales are just prospective revenue. It gets realized after the actual sale only. Therefore, the sale cannot be considered a conservative basis for revenue recognition.

2. Point of sale does not prove to be conservative because the accounts receivables reported by the business entity do not reflect the amount that can be collected from the sale because some of the receivables might be uncollectible. Therefore, the revenue and net income must depend upon the cash collection made by the business entity. The business entity must match the cost of managing receivables (bad debts) with the sales made on account in the same period.

Adjustments to revenue such as returns and bad debts can be measured with high accuracy and, therefore, do not degrade the information reported in the financial statement.

04

Recognizing revenue over time

The business entities engaged in long-term construction projects will recognize their revenue over time. For such business entities, point of sale does not prove significant in recognizing revenue.

Suppose the business entity defers the revenue from the project until it is completed. In that case, it will affect the usefulness of the intermediate annual financial statements because a portion of the contract will get completed each period, and proportionate revenue must be recognized for it.

Recognizing revenue over the period will provide more relevant information than the point-of-sale information.

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Most popular questions from this chapter

Stengel Co. enters into a 3-year contract to perform maintenance service for Laplante Inc. Laplante promises to pay \(100,000 at the beginning of each year (the standalone selling price of the service at contract inception is \)100,000 per year). At the end of the second year, the contract is modified, and the fee for the third year of service, which reflects a reduced menu of maintenance services to be performed at Laplante locations, is reduced to \(80,000 (the standalone selling price of the services at the beginning of the third year is \)80,000 per year). Briefly describe the accounting for this contract modification.

Tablet Tailors sells tablet PCs combined with Internet service, which permits the tablet to connect to the Internet anywhere and set up a Wi-Fi hot spot. It offers two bundles with the following terms.

1. Tablet Bundle A sells a tablet with 3 years of Internet service. The price for the tablet and a 3-year Internet connection service contract is \(500. The standalone selling price of the tablet is \)250 (the cost to Tablet Tailors is \(175). Tablet Tailors sells the Internet access service independently for an upfront payment of \)300. On January 2, 2017, Tablet Tailors signed 100 contracts, receiving a total of \(50,000 in cash.

2. Tablet Bundle B includes the tablet and Internet service plus a service plan for the tablet PC (for any repairs or upgrades to the tablet or the Internet connections) during the 3-year contract period. That product bundle sells for \)600. Tablet Tailors provides the 3-year tablet service plan as a separate product with a standalone selling price of \(150. Tablet Tailors signed 200 contracts for Tablet Bundle B on July 1, 2017, receiving a total of \)120,000 in cash.

Instructions

(c) Repeat the requirements for part (a), assuming that Tablet Tailors has no reliable data with which to estimate the stand-alone selling price for the Internet service.

Describe the conditions when contract assets and liabilities are recognized and presented in financial statements.

How should a franchisor account for continuing franchise fees and routine sales of equipment and supplies to franchisees?

Shaw Company sells goods that cost \(300,000 to Ricard Company for \)410,000 on January 2, 2017. The sales price includes an installation fee, which has a standalone selling price of \(40,000. The standalone selling price of the goods is \)370,000. The installation is considered a separate performance obligation and is expected to take 6 months to complete.

Instructions

(a) Prepare the journal entries (if any) to record the sale on January 2, 2017.

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