Deegan5e SM Ch16

Chapter 16
Revenue recognition issues

16.1
The AASB Framework does not provide a great deal of guidance in relation to when revenue
should be recognised. The former Australian conceptual framework provided guidance which
is not inconsistent with the contents of the AASB Framework. Specifically, paragraph 130 of
SAC 4 provided a number of tests which would be useful in determining whether to
recognise revenue. These were:
(a)
an agreement for the provision of goods and services exists between the entity and
one or more parties external to the entity;
(b)
cash has been received, or the entity has a claim against an external party or parties
that:
(i)
is for a specified consideration, in the form of cash, other assets, or a

reduction in a liability of the entity;
(ii)
cannot be avoided by the external party or parties without the incurrence of a

penalty set sufficiently large as, in normal circumstances, to defer avoidance;
(c)
all acts of performance necessary to establish a valid claim against the external party
or parties have been completed; and
(d)
it is possible to estimate reliably the collectability of debts or the return of goods sold.
Where the above tests are met, revenue would generally be recognised, because it will be
probable that an inflow of service potential or future economic benefits have occurred.
Where there is an agreement in place that all production will be acquired by a particular
consumer, and it is probable that the inflow of resources will occur, then in principle it would
be appropriate to recognise revenue at the point of production. This would particularly be the
case if there was a legal arrangement in place that all production will be purchased. In the
absence of such an arrangement, revenue would not typically be recognised until a sales
transaction had taken place. However, we need to consider the requirements of AASB 118
Revenue, which can act to limit the application of this general principle. Paragraph 14 of
AASB 118 states:
Revenue from the sale of goods shall be recognised when all the following conditions
have been satisfied:
(a) the entity has transferred to the buyer the significant risks and rewards of
ownership of the goods;
(b) the entity retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold;
(c) the amount of revenue can be measured reliably;
(d) it is probable that the economic benefits associated with the transaction will flow to
the entity; and
(e) the costs incurred or to be incurred in respect of the transaction can be measured
reliably.
In most cases, control will not pass at the completion of production, hence AASB 118
excludes revenue recognition at point of production. AASB 118, however, does not apply to
Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan
161
revenue arising from some sourcessuch as the initial recognition of revenue from
agricultural produce (AASB 141 Agriculture would apply and allows agricultural produce
to be valued at fair value less estimated point-of-sale costs). Hence, for some goods, such as
agricultural produce, it can be possible to recognise revenue in advance of a binding sales
agreement and to the extent that a fair value can be reliably determined.
16.2
If there was a constant and repetitive series of transactions then once a point was chosen in
the production/sales cycle, the revenue to be recognised each year at that point would be
equivalent to the revenue recognised at any other pointthat is, there is a constant flow
though the system.
16.3
A bad debt occurs when a specific debtor is deemed unlikely to pay its debts and as a result
the reporting entity recognises a bad debts expense and also reduces the balance of the
debtors ledger (with a corresponding reduction in the debtors subsidiary ledger). It is also
possible that a debtor that goes bad was anticipated and that a sufficient amount was
previously recognised as a doubtful debts expense, with a corresponding increase in the
provision for doubtful debts. If this is the case, there would be a debit to the provision for
doubtful debts and a credit to accounts receivable (also called debtors).
A doubtful debt is recognised when it is considered, perhaps on the basis of past experience,
that not all debtors will pay the amounts that are due. No specific debtors are identified as
being unlikely to pay. Rather, a general provision is created (a provision for doubtful debts)
which is offset against accounts receivable. That is, the provision for doubtful debts is a
contra account. When a doubtful debts expense is recognised, no adjustments are made
directly to the debtors ledger or the associated subsidiary ledgers.
16.4
What it means is that different approaches to asset and revenue recognition and measurement
will directly impact the quantum of revenues reported by an entity. For example, if an entity
values its assets at market value, then the increase in the value of the assets could be treated
as revenue. Alternatively, if an entity strictly applies historical cost accounting then, although
there may be an increase in the market value of its assets, this increase may be ignored until
such time as a sale occurs. Consequently, prior to the sale, less revenue will be reported by
the historical cost organisation relative to an entity that adopts a mark to market approach
to valuation.
As a further example, some forms of current cost accounting value all assets at market value,
but where the increase in market value is simply due to changing price levels in the economy,
the change in value is treated as a capital reserve, rather than as part of profits.
Some entities adopt a modified version of historical cost in which, consistent with AASB 116
Property, Plant and Equipment, they elect to perform asset revaluations. However, under
the AASB 116 approach to revaluing property, plant and equipment, any gain is not treated
as revenue, but is to be treated as part of the reserves of the reporting entity (as part of the
asset revaluation reserve). Superannuation plans, life insurers and general insurers, however,
are not to apply AASB 116. Rather, all the assets of superannuation plans, and the
investments held by general and life insurers are, pursuant to specific Accounting Standards,
to be valued at net-market value with any changes therein to be directly taken to profits.
Hence, as can be seen from the above discussion, how assets are measured will have direct
implications for the reported profits of an entity.
162
16.5
FOB stands for free on board. An item may be sold FOB shipping point, or FOB destination.
Destination or shipping point refer to the point at which title of the goods passes to the
purchaser. If the goods are shipped FOB destination, title does not pass until the buyer
receives the goods at the destination. In this case, revenue would not typically be recognised
until the goods reach their destination.
16.6
A put option gives its holder the right to sell an asset, at a specified exercise price, on or
before a specified date. The writer (or seller) of the put option agrees to buy the asset at a
future date, for the exercise price, if the put option holder (buyer) should request it. The
holder of the put option (who may also be in possession of the underlying asset) would
typically only exercise the option (that is, require the other party to buy the underlying asset)
if the exercise price was above the market price.
Where a transaction involves the use of a financial instrument such as an option, it is
necessary to evaluate the conditions attaching to the transaction to establish whether, in
substance, the transaction is a financing arrangement rather than a sale.
In considering whether to recognise revenue when there are associated options, the
probability of the exercise of the options must be considered. Where it is probable that the
put option will be exercised and Eddie is required to repurchase the equipment, revenues
should not be recognised by Eddie since the requisite degree of certainty that the inflow of
economic benefits has occurred will not have been attained. The higher the price recorded on
the put option, the greater the probability that Mass Marketer will require Eddie to re-acquire
the assets. Hence the greater the price recorded on the option (which increases the
differential between the fair value, and the option price at the exercise date) the lower the
justification for recording the sales revenue.
At issue is whether the transaction has resulted in a transfer of the risks and rewards of
ownership to the buyer. As paragraph 5 of Appendix A to AASB 118 states:
For a sale and repurchase agreement on an asset other than a financial asset the terms
of the agreement need to be analysed to ascertain whether, in substance, the seller has
transferred the risks and rewards of ownership to the buyer and hence revenue is
recognised. When the seller has retained the risks and rewards of ownership, even
though legal title has been transferred, the transaction is a financing arrangement and
does not give rise to revenue.
16.7
The percentage-of-completion method would be considered to be less conservative. A

conservative approach to profit recognition would be to wait until such time that all
necessary requirements pertaining to the construction have occurred. This would ensure, with
high certainty, that all expected revenue has actually been earned. Generally, such high levels
of certainty are not required.
16.8
To the extent that the benefactor does not have any rights to make a claim to have the
donation returned, then the donation would be treated as income, as it would satisfy the
definition and recognition criteria of income as provided in the AASB Framework. The
donation represents an inflow of economic benefits in the form of an increase in assets, which
is not a contribution from the owners of the entity. Further, the inflow has occurred and is for
a specific amounthence the inflow satisfies the probable test as well as being capable of
reliable measurement. Whether it would be treated as revenue or a gain (remember, the
AASB Framework divides income into revenues and gains) would be dependent upon the
nature of the business. If the entity was the sort of entity that relied upon donations to
163
support its business (for example, it is a registered charity) then the donation might be treated
as revenue. Otherwise it might be treated as a gain. As paragraph 74 of the AASB
Framework states:
The definition of income encompasses both revenue and gains. Revenue arises in
the course of the ordinary activities of an entity and is referred to by a variety of
different names, including sales, fees, interest, dividends, royalties and rent.
Paragraph 75 of the AASB Framework further provides:
Gains represent other items that meet the definition of income and may, or may
not, arise in the course of the ordinary activities of an entity. Gains represent
increases in economic benefits and as such are no different in nature from revenue.
Hence they are not regarded as constituting a separate element in the Framework.
16.9
Pursuant to AASB 111, the aggregate billings on a construction contract shall be deducted
from the asset account, construction in progress (or construction in progress might also be
referred to as contract costs incurred). If progress billings exceed the gross amount of
construction in progress, the net amount should be shown as a liability, otherwise the net
amount is shown as an asset.
16.10 Paragraph 30 of AASB 111 provides guidance in determining the percentage of completion.
It states:
The stage of completion of a contract may be determined in a variety of ways. The
entity uses the method that measures reliably the work performed. Depending on the
nature of the contract, the methods may include:
(a) the proportion that contract costs incurred for work performed to date bear to
the estimated total contract costs;
(b) surveys of work performed; or
(c) completion of a physical proportion of the contract work.
Progress payments and advances received from customers often do not reflect the
work performed.
The former accounting standard in place within Australia had allowed, in certain
circumstances, the use of the billings basis for determining percentage of completionthis
method involves calculating the proportion that progress billings to date bear to the total
estimated billings for the contract. AASB 111 excludes the use of the billings basis.
The cost basis is commonly used by reporting entities that are involved in construction
contracts.
16.11 (a)
If management was rewarded in terms of accounting profits then it would be

reasonable to assume that the management would prefer to have non-volatile profits
such that they would receive a more uniform series of cash flows. Also, it would be
reasonable to assume that they would prefer that accounting profits not be deferred to
future periods, given that the present value of the future receipts would be lower than
those received in earlier years. With this in mind, management rewarded by profitbased schemes would probably prefer to adopt the percentage-of-completion method.
In adopting this accounting method they would necessarily need to ensure that the
requirements associated with the percentage of completion, as noted in AASB 111
(such as the requirement that for a fixed-price contract the future contract revenue
164
can be reliably measured and the contract costs to complete the contract and the stage
of completion can be measured reliably), are satisfied.
(b)
If a firm is subject to a debt-to-asset constraint, a debt-to-equity constraint, or an

interest coverage constraint then we may expect that the management would prefer
to adopt the percentage-of-completion method. As we know, under the percentageof-completion method we take the income to the income statement and we increase
the asset, construction in progress by the amount of profit recognised. This has the
effect of loosening the aforementioned accounting ratios.
16.12 The choice of accounting method should be dictated by considerations of what method is
appropriate in given circumstances and not by what method will provide management with
their preferred results. That is, a reporting entity should adopt accounting methods on an
objective basis. With that said, if a firm is currently being examined because of its high
accounting profits (perhaps by employee unions attempting to secure increased wages for
their members), then researchers adopting the central tenets of Positive Accounting Theory
(for example, that all individual action is driven by self-interest and not issues such as
objectivity, fairness, etc.) would argue that the firm may prefer to adopt a method which
defers income recognition to future periods. This could be accomplished by demonstrating
that the organisation cannot reliably measure the stage of completion on a particular project,
and consistent with AASB 111, the firm will then only recognise revenue to an amount equal
to the costs incurred. That is, no net profit would be recognised until the project is complete.
16.13 (a)
Contract price
Less estimated cost:
Costs to date
Estimated costs to complete
Estimated total cost
Estimated total gross profit
Per cent complete
2006
$10 000 000
2007
$10 000 000
2008
$10 000 000
2 500 000
5 500 000
8 000 000
$ 2 000 000
31.25%
6 500 000
1 500 000
8 000 000
$ 2 000 000
81.25%
8 000 000
_________
8 000 000
$2 000 000
100%
Gross profit recognised pursuant to the percentage-of-completion method (assuming

that the stage of completion can be reliably estimated).
2006 $2 000 000 31.25%
$625 000
2007 $2 000 000 81.25%

Less gross profit already recognised
Gross profit in 2007
$ 1 625 000
625 000
$ 1 000 000
2008 $2 000 000 100%

Less gross profit already recognised
Gross profit in 2008
$ 2 000 000
1 625 000
$ 375 000
Journal entries: POC method

2006
2007
2008
165
(i)
(ii)
(iii)
(iv)
(v)
(b)
To record costs incurred:

Dr Construction in progress
Cr Cash, accounts payable, accum. deprec.
2.5
To record billings to customers

Dr Accounts receivable
Cr Billings on contracts in progress
2.0
To record cash collections:

Dr Cash
Cr Accounts receivable
2.0
To record periodic income recognised:

Dr Construction expenses
Cr Revenue from long-term contracts
To record final approval and acceptance:
Dr Billings on contracts in progress
Cr Construction in progress
4.0
2.5
1.5
4.0
5.0
2.0
1.5
3.0
5.0
5.0
2.0
3.0
3.0
5.0
3.0
0.625
1.0
0.375
2.500
4.0
1.500
3.125
5.0
1.875
1.0
1.0
Stage of completion cannot be reliably determined. In this case, contract costs must
be recognised as an expense in the financial year in which they are incurred and where
it is probable that the costs will be recovered, revenue must be recognised only to the
extent of costs incurred.
2006
(i)
(ii)
(iii)
(iv)
(v)
(vi)

Cr Cash, accounts payable, etc.
2.5
To record billings to customers:

2.0

Dr Cash
2.0
To record periodic expenses and revenues:

2.5
To record the profit on the project:

To record final approval and acceptance of

contract and income:
2007
4.0
2.5
1.5
4.0
5.0
2.0
2.0
3.0
3.0
3.0
5.0
4.0
2.5
3.0
1.5
4.0
1.5
5.0
5.0
2008
1.5
2.0
2.0
10.0
166
Cr Construction revenue
16.14 (a)
10.0
Assuming stage of completion can be reliably determined.
Contract price
Costs to date
Estimated total gross profit/(loss)
Per cent complete
2006
$10 000 000
2007
$ 10 000 000
2008
$10 000 000
2 500 000
5 500 000
8 000 000
$ 2 000 000
31.25%
8 000 000
3 000 000
11 000 000
$(1 000 000)
72.73%
11 000 000
__________
11 000 000
$(1 000 000)
100%
Gross profit recognised in:

2006 $2 000 000 31.25%
$625 000
2007 expected loss

Less profit already recognised
Loss recognised in 2007
$ (1 000 000)
625 000
$ (1 625 000)
2008 expected loss

Less profit (loss) already recognised
Profit/loss recognised in 2008
$(1 000 000)

(1 000 000)
$
nil
Journal entries: POC method

2006
(i)
(ii)
(iii)
(iv)
(v)

2.5

2.0

Dr Cash
2.0

2007
5.5
2.5
2008
3.0
5.5
5.0
2.0
3.0
3.0
5.0
5.0
2.0
3.0
3.0
5.0
3.0
0.625
2.5
5.5
3.0
3.125
3.875
3.0
1.625
10.0
10.0
Following the above journal entries, the total expenses recognised on the contract will be
$11m, and the total revenues will be $10m, giving a total loss on the contract of $1m. The
167
asset construction in progress will be valued at $10m, which is its recoverable amount.
These numbers are reconciled as follows:
Construction
expenses
Construction
revenues
Construction
in progress
2006
2.5
3.125
3.125
2007
5.5
3.875
3.875
2008
3.0
3.0
3.0
11.0
10.0
10.0
(b)
Assuming stage of contract completion cannot be reliably determined.

2006
(i)
(ii)
(iii)
(iv)
(v)

2.5

2.0

Dr Cash
2.0
To recognise revenues and expenses and

forseeable losses:
Dr Construction in expense
Cr Construction revenue
2.5
Contract price
Costs to date
Per cent complete
5.5
2.5
3.0
5.0
2.0
3.0
3.0
5.0
5.0
3.0
3.0
5.0
5.5
2.5
2008
5.5
2.0
To record final approval and acceptance of

contractandincome:
16.15 (a)
2007
3.0
4.5
1.0
3.0
10.0
10.0
3.0
2010
$40 000 000
2011
$40 000 000
2012
$40 000 000
10 000 000
22 000 000
32 000 000
$ 8 000 000
31.25%
26 000 000
6 000 000
32 000 000
$ 8 000 000
81.25%
32 000 000
__________
32 000 000
$ 8 000 000
100%

2010 $8 000 000 31.25%
$2 500 000
168
(b)
2011 $8 000 000 81.25%

Profit recognised in year
$6 500 000
2 500 000
4 000 000
2012 $8 000 000 100%

$8 000 000
6 500 000
$1 500 000
Where stage of contract completion cannot be reliably determined.

2010
(i)
(ii)
(iii)
(iv)
(v)
(c)

Cr Cash, accounts payable
8.0

Dr Cash
8.0

2012
10.0
16.0
6.0
10.0
16.0
6.0


2011
20.0
12.0
8.0
20.0
12.0
8.0
20.0
12.0
20.0
12.0
8.0
10.0
16.0
6.0
10.0
16.0
14.0
40.0
40.0
Journal entries assuming stage of completion can be reliably determined.

2010
(i)
(ii)
(iii)
(iv)
(v)

2012
10.0
16.0
6.0
10.0
16.0
6.0

8.0

Dr Cash
8.0

2011
20.0
12.0
8.0
20.0
12.0
8.0
20.0
12.0
20.0
12.0
2.5
4.0
1.5
10.0
16.0
6.0
12.5
20.0
7.5
169

16.16 (a)
Contract price
Costs to date
Per cent complete
2010
$40 000 000
10 000 000
22 000 000
32 000 000
$ 8 000 000
31.25%
2011
$40 000 000
40.0
40.0
2012
$ 40 000 000
31 000 000
46 000 000
15 000 000 ___________
46 000 000
46 000 000
($ 6 000 000) ($ 6 000 000)
67.39%
100%

2010 $8 000 000 31.25%
$2 500 000
2011 Expected loss

Loss recognised in year
$(6 500 000)

2 500 000
(8 500 000)
2012 Expected loss

Less loss already recognised [2 500 000 + (8 500 000)]
$(6 000 000)

(6 000 000)
0
1610
(b)
Where stage of contract completion cannot be reliably determined.

2010
(i)
(ii)
(iii)
(iv)
(v)
(c)

8.0

Dr Cash
8.0

Cr Construction in Progress
20.0
12.0
8.0
20.0
12.0
8.0
20.0
12.0
20.0
12.0
10.0
21.0
15.0
10.0
15.0
15.0
6.0
40.0
40.0
Journal entries assuming stage of completion can be reliably determined.

2010
(i)
(ii)
(iii)
(iv)
(v)
16.17 (a)
2012
10.0
21.0
15.0
10.0
21.0
15.0


2011

8.0

Dr Cash
8.0

2012
10.0
21.0
15.0
10.0
21.0
15.0


2011
20.0
12.0
8.0
20.0
12.0
8.0
20.0
12.0
20.0
12.0
2.5
10.0
21.0
15.0
12.5
12.5
15.0
8.5
40.0
40.0
To provide the journal entries for part (b), we need to determine the interest
component of each $6000 payment. The easiest way to do this is to draw up a table,
as shown below. The interest element is calculated by multiplying the opening
receivable for a period by the rate of interest implicit in the arrangement.
1611
To determine the interest rate, we can divide the fair value of the asset at the date of
sale by the periodic payment.
$19 019 $6000 = 3.1699. Reviewing our present value tables, we find that this
equates to an interest rate of 10 per cent.
Date
1 July 2009
30 June 2010
30 June 2011
30 June 2012
30 June 2013
Cash
payment
Interest
revenue
6 000
6 000
6 000
6 000
24 000
1 902
1 492
1 041
545
4 981
Principal
reduction
4 098
4 508
4 959
5 455
19 019
Outstanding
balance
19 019
14 921
10 413
5 454
0
Interest revenue equals the outstanding liability at the beginning of the financial
period, multiplied by the interest rate implicit in the agreement, which in this question
is 10 per cent.
The reduction in the principal is calculated by subtracting the interest revenue from
the cash payment.
(b)
Journal entries using the net-interest method:

Journalentrytorecordtheinitialsaleon 1 July 2009
Dr
Note receivable
Cr
Sales
19 019
19 019
Journal entry to record the receipt of $6000 on 30 June 2010

Dr
Cr
Cr
Cash
Note receivable
Interest revenue
6 000
4 098
1 902

Dr
Cr
Cr
Cash
Note receivable
Interest revenue
6 000
4 508
1 492
Journal entries using the gross method:

Journalentrytorecordthe initial sale on 1 July 2009
Dr
Cr
Cr
Note receivable
Sales
Unearned interest
24 000
19 019
4 981
1612

Dr
Cr
Dr
Cr
Cash
Note receivable
Unearned interest
Interest revenue
6 000
6 000
1 902
1 902
Journal entry to record the receipt of $6 000 on 30 June 2011

Dr
Cr
Dr
Cr
Cash
Note receivable
Unearned interest
Interest revenue
6 000
6 000
1 492
1 492
16.18 At issue here is whether the claim against Allgas should be recorded as a receivable and as
income in the accounts of SSB. If the claim was agreed to by Allgas, or the court rules that
Allgas must pay, then there would be an inflow of future economic benefits which did not
relate to a contribution of owners and which increased equity during the reporting period
consistent with the definition of income. However, at issue is the probability that the inflow
of future economic benefits has occurred or whether the inflow can be measured reliably. As
the court case had not been settled, and as there seems no strong evidence that SSB will be
successful, or otherwise, the inflow is too uncertain to warrant recognition as income.
Nevertheless, the notes to the accounts of SSB (and Allgas) should provide a description of
the claim, and the companys assessment of the probability than an amount will be received,
as well as an estimate of the expected receipt.
16.19 Because the painting has been given irrevocably as a gift, and not as a loan, it becomes an
asset of the National Gallery of Victoria. Because there has been an inflow of economic
benefits which is not of the nature of a contribution by an owner, the donation is to be treated
as income. In determining the amount to be recorded for the asset, and therefore for the
income, the inflow should be recorded at its fair value. Because it did not go to sale, the
amount will need to be determined by somebody with expertise in valuing such works of art.
Perhaps if Sothebys auction reserves have been reliable estimates of market value in past
auctions, then the amount placed on the painting by Sothebys might be used as the basis of
measuring the asset. Otherwise, a valuation might be obtained from an independent market
analyst.
1613

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Chapter 16

Revenue recognition issues

is for a specified consideration, in the form of cash, other assets, or a

cannot be avoided by the external party or parties without the incurrence of a

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

The percentage-of-completion method would be considered to be less conservative. A

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

If management was rewarded in terms of accounting profits then it would be

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

If a firm is subject to a debt-to-asset constraint, a debt-to-equity constraint, or an

Gross profit recognised pursuant to the percentage-of-completion method (assuming

2007 $2 000 000 81.25%

2008 $2 000 000 100%

Journal entries: POC method

To record costs incurred:

To record billings to customers

To record cash collections:

To record periodic income recognised:

To record costs incurred:

To record billings to customers:

To record cash collections:

To record periodic expenses and revenues:

To record the profit on the project:

To record final approval and acceptance of

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

Assuming stage of completion can be reliably determined.

Gross profit recognised in:

2007 expected loss

2008 expected loss

$(1 000 000)

Journal entries: POC method

To record costs incurred:

To record billings to customers:

To record cash collections:

To record periodic income recognised:

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

Assuming stage of contract completion cannot be reliably determined.

To record costs incurred:

To record billings to customers:

To record cash collections:

To recognise revenues and expenses and

To record final approval and acceptance of

Gross profit recognised in:

2011 $8 000 000 81.25%

2012 $8 000 000 100%

Where stage of contract completion cannot be reliably determined.

To record costs incurred:

To record cash collections:

To record final approval and acceptance:

To record billings to customers:

To record periodic income recognised:

Journal entries assuming stage of completion can be reliably determined.

To record costs incurred:

To record billings to customers:

To record cash collections:

To record periodic income recognised:

To record final approval and acceptance:

Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan

Dr Billings on contracts in progress

Gross profit recognised in:

2011 Expected loss

$(6 500 000)

2012 Expected loss