ST.

VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]

COO – FORM 12
SUBJECT TITLE: Accounting for Special Transactions
INSTRUCTOR: Mary Jane A. Intao, CPA
SUBJECT CODE: ADV3

TOPIC 1: REVENUE RECOGNITION

Learning Objectives:
At the end of this topic, the students are expected to:

• Identify the evaluation criteria for a contract, the components of the transaction
price, and when a contract modification triggers treatment as a new contract.
• Recognize the accounting treatment pertaining to customer acceptance clauses,
rights to acquire additional goods, donations, asset repurchases, and breakage.
• Recognize the situations under which contract liabilities occur, and when
disaggregation is used.
• Specify the methods used to control which third parties are recognized as customers
• Identify other revenue recognition issues like non-refundable upfront fees and
licenses and royalties.
• Describe presentation and disclosure regarding revenue in non-refundable upfront
fees and licenses and royalties.

NOTES:

1.1 Concepts and 5 Steps Model Framework of Revenue Recognition from

Contracts with Customers

Overview

IFRS 15 specifies how and when an IFRS reporter will recognize revenue as well as
requiring such entities to provide users of financial statements with more
informative, relevant disclosures. The standard provides a single, principles based
five-step model to be applied to all contracts with customers.

IFRS 15 was issued in May 2014 and applies to an annual reporting period beginning
on or after 1 January 2018. On 12 April 2016, clarifying amendments were issued
that have the same effective date as the standard itself.

SCOPE

IFRS 15 Revenue from Contracts with Customers applies to all contracts with
customers except for: leases within the scope of IAS 17 Leases; financial
instruments and other contractual rights or obligations within the scope of IFRS 9
Financial Instruments, IFRS 10 Consolidated Financial Statements, IFRS 11 Joint
Arrangements, IAS 27 Separate Financial Statements and IAS 28 Investments in
Associates and Joint Ventures; insurance contracts within the scope of IFRS 4
Insurance Contracts; and non-monetary exchanges between entities in the same line
of business to facilitate sales to customers or potential customers. [IFRS 15:5]

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 ST. VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]
A contract with a customer may be partially within the scope of IFRS 15 and partially
within the scope of another standard. In that scenario: [IFRS 15:7]

a. if other standards specify how to separate and/or initially measure one or

more parts of the contract, then those separation and measurement
requirements are applied first. The transaction price is then reduced by the
amounts that are initially measured under other standards;
b. if no other standard provides guidance on how to separate and/or initially
measure one or more parts of the contract, then IFRS 15 will be applied.

Key definitions

Contract -An agreement between two or more parties that creates enforceable
rights and obligations.

Customer- A party that has contracted with an entity to obtain goods or services
that are an output of the entity’s ordinary activities in exchange for consideration.

Income- Increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases of liabilities that result in an increase
in equity, other than those relating to contributions from equity participants.

Performance obligation- A promise in a contract with a customer to transfer to the

customer either: a good or service (or a bundle of goods or services) that is distinct;
or a series of distinct goods or services that are substantially the same and that have
the same pattern of transfer to the customer.

Revenue - Income arising in the course of an entity’s ordinary activities.

Transaction price- the amount of consideration to which an entity expects to be

entitled in exchange for transferring promised goods or services to a customer,
excluding amounts collected on behalf of third parties.

ACCOUNTING REQUIREMENTS FOR REVENUE

The five-step model framework

The core principle of IFRS 15 is that an entity will recognize revenue to depict the
transfer of promised goods or services to customers in an amount that reflects the
consideration to which the entity expects to be entitled in exchange for those goods
or services. This core principle is delivered in a five-step model framework: [IFRS
15:IN7]

Identify the contract(s) with a customer Identify the performance obligations in the
contract Determine the transaction price Allocate the transaction price to the
performance obligations in the contract. Recognize revenue when (or as) the entity
satisfies a performance obligation.

Application of this guidance will depend on the facts and circumstances present in a
contract with a customer and will require the exercise of judgment.

Step 1: Identify the contract with the customer

A contract with a customer will be within the scope of IFRS 15 if all the following
conditions are met: [IFRS 15:9]
• The contract has been approved by the parties to the contract;
• Each party’s rights in relation to the goods or services to be transferred can be
identified;
• The payment terms for the goods or services to be transferred can be identified;
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 ST. VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]
• The contract has commercial substance;
• It is probable that the consideration to which the entity is entitled to in exchange for
the goods or services will be collected.

If a contract with a customer does not yet meet all of the above criteria, the entity
will continue to re-assess the contract going forward to determine whether it
subsequently meets the above criteria. From that point, the entity will apply IFRS 15
to the contract. [IFRS 15:14]

The standard provides detailed guidance on how to account for approved contract
modifications. If certain conditions are met, a contract modification will be accounted
for as a separate contract with the customer. If not, it will be accounted for by
modifying the accounting for the current contract with the customer. Whether the
latter type of modification is accounted for prospectively or retrospectively depends
on whether the remaining goods or services to be delivered after the modification are
distinct from those delivered prior to the modification. Further details on accounting
for contract modifications can be found in the Standard. [IFRS 15:18-21].

Step 2: Identify the performance obligations in the contract

At the inception of the contract, the entity should assess the goods or services that
have been promised to the customer, and identify as a performance obligation:
[IFRS 15.22]

• A good or service (or bundle of goods or services) that is distinct; or

• A series of distinct goods or services that are substantially the same and that have
the same pattern of transfer to the customer.

A series of distinct goods or services is transferred to the customer in the same

pattern if both of the following criteria are met: [IFRS 15:23]

• Each distinct good or service in the series that the entity promises to transfer
consecutively to the customer would be a performance obligation that is satisfied
over time (see below);
• And a single method of measuring progress would be used to measure the entity’s
progress towards complete satisfaction of the performance obligation to transfer
each distinct good or service in the series to the customer.

A good or service is distinct if both of the following criteria are met: [IFRS 15:27]

• The customer can benefit from the good or services on its own or in conjunction with
other readily available resources;
• And the entity’s promise to transfer the good or service to the customer is separately
identifiable from other promises in the contract.

Factors for consideration as to whether a promise to transfer goods or services to the

customer is not separately identifiable include, but are not limited to: [IFRS 15:29]

• the entity does provide a significant service of integrating the goods or services with
other goods or services promised in the contract;
• the goods or services significantly modify or customize other goods or services
promised in the contract; the goods or services are highly interrelated or highly
interdependent.

Step 3: Determine the transaction price

The transaction price is the amount to which an entity expects to be entitled in

exchange for the transfer of goods and services. When making this determination, an
entity will consider past customary business practices. [IFRS 15:47]

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 ST. VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]
Where a contract contains elements of variable consideration, the entity will estimate
the amount of variable consideration to which it will be entitled under the contract.
[IFRS 15:50] Variable consideration can arise, for example, as a result of discounts,
rebates, refunds, credits, price concessions, incentives, performance bonuses,
penalties or other similar items. Variable consideration is also present if an entity’s
right to consideration is contingent on the occurrence of a future event. [IFRS
15:51]

The standard deals with the uncertainty relating to variable consideration by limiting
the amount of variable consideration that can be recognized. Specifically, variable
consideration is only included in the transaction price if, and to the extent that, it is
highly probable that its inclusion will not result in a significant revenue reversal in
the future when the uncertainty has been subsequently resolved. [IFRS 15:56]

However, a different, more restrictive approach is applied in respect of sales or

usage-based royalty revenue arising from licenses of intellectual property. Such
revenue is recognized only when the underlying sales or usage occur. [IFRS 15:B63]

Step 4: Allocate the transaction price to the performance obligations in the

contracts

Where a contract has multiple performance obligations, an entity will allocate the
transaction price to the performance obligations in the contract by reference to their
relative standalone selling prices. [IFRS 15:74] If a standalone selling price is not
directly observable, the entity will need to estimate it. IFRS 15 suggests various
methods that might be used, including: [IFRS 15:79]

A. Adjusted market assessment approach

B. Expected cost plus a margin approach
C. Residual approach (only permissible in limited circumstances).

Any overall discount compared to the aggregate of standalone selling prices is

allocated between performance obligations on a relative standalone selling price
basis. In certain circumstances, it may be appropriate to allocate such a discount to
some but not all of the performance obligations. [IFRS 15:81]

Where consideration is paid in advance or in arrears, the entity will need to consider
whether the contract includes a significant financing arrangement and, if so, adjust
for the time value of money. [IFRS 15:60] A practical expedient is available where
the interval between transfer of the promised goods or services and payment by the
customer is expected to be less than 12 months. [IFRS 15:63]

Step 5: Recognize revenue when (or as) the entity satisfies a performance
obligation

Revenue is recognized as control is passed, either over time or at a point in time.

[IFRS 15:32]

Control of an asset is defined as the ability to direct the use of and obtain
substantially all of the remaining benefits from the asset. This includes the ability to
prevent others from directing the use of and obtaining the benefits from the asset.
The benefits related to the asset are the potential cash flows that may be obtained
directly or indirectly.

These include, but are not limited to: [IFRS 15:31-33]

a. using the asset to produce goods or provide services;
b. using the asset to enhance the value of other assets;
c. using the asset to settle liabilities or to reduce expenses;
d. selling or exchanging the asset; pledging the asset to secure a loan; and
holding the asset.

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 ST. VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]
An entity recognizes revenue over time if one of the following criteria is met: [IFRS
15:35]
• The customer simultaneously receives and consumes all of the benefits
provided by the entity as the entity performs;
• the entity’s performance creates or enhances an asset that the customer
controls as the asset is created;
• or the entity’s performance does not create an asset with an alternative use
to the entity and the entity has an enforceable right to payment for
performance completed to date.

If an entity does not satisfy its performance obligation over time, it satisfies it at a
point in time. Revenue will therefore be recognized when control is passed at a
certain point in time. Factors that may indicate the point in time at which control
passes include, but are not limited to: [IFRS 15:38]

• the entity has a present right to payment for the asset;

• the customer has legal title to the asset;
• the entity has transferred physical possession of the asset;
• the customer has the significant risks and rewards related to the ownership of
the asset; and
• the customer has accepted the asset.

Contract costs

The incremental costs of obtaining a contract must be recognized as an asset if the

entity expects to recover those costs. However, those incremental costs are limited
to the costs that the entity would not have incurred if the contract had not been
successfully obtained (e.g. ‘success fees’ paid to agents). A practical expedient is
available, allowing the incremental costs of obtaining a contract to be expensed if the
associated amortization period would be 12 months or less. [IFRS 15:91-94]

Costs incurred to fulfil a contract are recognized as an asset if and only if all of the
following criteria are met: [IFRS 15:95]

a. the costs relate directly to a contract (or a specific anticipated contract);

b. the costs generate or enhance resources of the entity that will be used in
satisfying performance obligations in the future;
c. and the costs are expected to be recovered.

These include costs such as direct labor, direct materials, and the allocation of
overheads that relate directly to the contract. [IFRS 15:97]

The asset recognized in respect of the costs to obtain or fulfil a contract is amortized
on a systematic basis that is consistent with the pattern of transfer of the goods or
services to which the asset relates. [IFRS 15:99]

Further useful implementation guidance in relation to applying IFRS 15

These topics include:

a. Performance obligations satisfied over time

b. Methods for measuring progress towards complete satisfaction of a
performance obligation
c. Sale with a right of return
d. Warranties
e. Principal versus agent consideration.
f. Customer options for additional goods or services
g. Customers’ unexercised rights
h. Non-refundable upfront fees
i. Licensing Repurchase arrangements
j. Consignment arrangements
k. Bill-and-hold arrangements
l. Customer acceptance

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 ST. VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]
m. Disclosures of disaggregation of revenue

These topics should be considered carefully when applying IFRS 15.

Presentation in financial statements

Contracts with customers will be presented in an entity’s statement of financial

position as a contract liability, a contract asset, or a receivable, depending on the
relationship between the entity’s performance and the customer’s payment. [IFRS
15:105]
A contract liability is presented in the statement of financial position where a
customer has paid an amount of consideration prior to the entity performing by
transferring the related good or service to the customer. [IFRS 15:106]

Where the entity has performed by transferring a good or service to the customer
and the customer has not yet paid the related consideration, a contract asset or a
receivable is presented in the statement of financial position, depending on the
nature of the entity’s right to consideration. A contract asset is recognized when the
entity’s right to consideration is conditional on something other than the passage of
time, for example future performance of the entity. A receivable is recognized when
the entity’s right to consideration is unconditional except for the passage of time.

Contract assets and receivables shall be accounted for in accordance with IFRS 9.
Any impairment relating to contracts with customers should be measured, presented
and disclosed in accordance with IFRS 9. Any difference between the initial
recognition of a receivable and the corresponding amount of revenue recognized
should also be presented as an expense, for example, an impairment loss. [IFRS
15:107-108]

Disclosures

The disclosure objective stated in IFRS 15 is for an entity to disclose sufficient

information to enable users of financial statements to understand the nature,
amount, timing and uncertainty of revenue and cash flows arising from contracts
with customers. Therefore, an entity should disclose qualitative and quantitative
information about all of the following: [IFRS 15:110]

• its contracts with customers;

• the significant judgments, and changes in the judgments, made in applying
the guidance to those contracts;
• and any assets recognized from the costs to obtain or fulfil a contract with a
customer.

Entities will need to consider the level of detail necessary to satisfy the disclosure
objective and how much emphasis to place on each of the requirements. An entity
should aggregate or disaggregate disclosures to ensure that useful information is not
obscured. [IFRS 15:111]

In order to achieve the disclosure objective stated above, the Standard introduces a
number of new disclosure requirements. Further details about these specific
requirements can be found at IFRS 15:113-129.

1.2 Concepts of Revenue Recognition for:

1.2.1 Right of return

Under IFRS 15 Revenue from contract with customers, when an entity makes a sale
with a right of return it recognizes revenue at the amount to which it expects to be
entitled by applying the variable consideration and constraint guidance set out in
Step 3 of the model (see Step 3 Determine the transaction price). The entity also
recognizes a refund liability and an asset for any goods or services that it expects to
be returned.

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 ST. VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]
• An entity applies the accounting guidance for a sale with a right of return
when a customer has a right to:
a full or partial refund of any consideration paid;
• a credit that can be applied against amounts owed, or that will be owed, to
the entity; or
• another product in exchange (unless it is another product of the same type,
quality, condition and price – e.g. exchanging a red sweater for a white
sweater). [IFRS 15.B20]

An entity does not account for its stand-ready obligation to accept returns as a
performance obligation. [IFRS 15.B21–B22]
In addition to product returns, the guidance also applies to services that are provided
subject to a refund.

The guidance does not apply to:

• exchanges by customers of one product for another of the same type, quality,
condition and price; and
• returns of faulty goods or replacements, which are instead evaluated under
the guidance on warranties. [IFRS 15.B26–B27]

When an entity makes a sale with a right of return, it initially recognizes the
following: [IFRS 15.B21, B23, B25]

REPORTING LINE MEASUREMENT

Measured at the gross transaction price, less the expected
REVENUE level of returns calculated using the guidance on estimating
variable consideration and the constraint (see Constraints
and variable consideration)

REFUND LIABILITY Measured at the expected level of returns – i.e. the

difference between the cash or receivable amount and the
revenue as measured above
The nature of such a refund liability is different from
contract liabilities and therefore it is not presented as such

Return asset Measured with reference to the carrying amount of the

products expected to be returned less the expected
recovery costs, including potential decreases in the value
to the entity of returned products
The nature of this return asset is different from trade and
other receivables and therefore it is not presented as such

Cost of goods sold Measured as the carrying amount of the products sold less
the return asset as measured above

Reduction of Inventory Measured as the carrying amount of the products

transferred to the customer

The entity updates its measurement of the refund liability and return asset at each
reporting date for changes in expectations about the amount of the refunds. It
recognizes adjustments to the:

• refund liability as revenue; and

• return asset as an expense. [IFRS 15.B24–B25]

Worked example – Sale with a right of return

Retailer B sells 100 products at a price of 100 each and receives a payment of
10,000.

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COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]

The sales contract allows the customer to return any undamaged products within 30
days and receive a full refund in cash. The cost of each product is 60. B estimates
that three products will be returned and a subsequent change in the estimate will not
result in a significant revenue reversal.

B estimates that the costs of recovering the products will not be significant and
expects that the products can be resold at a profit.

Within 30 days, two products are returned.

B records the following entries on:

• transfer of the products to the customer to reflect its expectation that three
products will be returned;
• return of the two products; and
• expiry of the right to return products.

Debit Credit
Sale
Cash 10,000
Refund Liability 300
Revenue 9,700

To recognize sale excluding revenue

On products expected to be returned

Return Asset 180

Cost of Sales 5820
Inventory 6000

To recognize cost of sales and right

To recover products from customers

TWO PRODUCTS RETURNED

Refund Liability 200
Cash 200

To recognize the refund for

Product returned

RIGHT OF RETURN
EXPIRATION
Refund Liability 100
Revenue 100

To recognize revenue on expiry of right of return

Cost of sales 60
Return 60

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 ST. VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]
Partial refunds

Partial refunds are measured based on the portion expected to be refunded[IFRS

15.55, B23–B25]

The measurement of a refund liability reflects the amount expected to be refunded to

the customer. Therefore, when a right of return allows the customer to return a
product for a partial refund (e.g. 95 percent of the sales price), the refund liability
(and the corresponding change in the transaction price) is measured based on the
portion of the transaction price expected to be refunded. For example, this would be
the number of products expected to be returned multiplied by 95 percent of the
selling price.

Restocking fees and costs

An entity sometimes charges a customer a restocking fee when a product is

returned. The restocking fee is generally intended to compensate the entity for costs
associated with the product return (e.g. shipping and repacking costs) or the
reduction in the selling price that an entity may achieve when reselling the product
to another customer.

A right of return with a restocking fee is similar to a right of return for a partial
refund. Therefore, a restocking fee is included as part of the estimated transaction
price when control transfers – i.e. the refund liability is based on the transaction
price less the restocking fee.

Similarly, the entity’s expected costs related to restocking are reflected in the
measurement of the return asset when control of the product transfers. This is
consistent with the guidance in the standard that any expected costs to recover
returned products should be included by reducing the carrying amount of the return
asset recorded for the right to recover those products.

Conditional right of return

The standard does not distinguish between conditional and unconditional rights of
return and both are accounted for similarly. However, for a conditional right of return
the probability that the return condition would be met is considered in determining
the expected level of returns. For example, a food production company only accepts
returns of its products that are past a sell-by date. Sale with a right of return

Based on historical experience, the company assesses the probability that the
products will become past their sell-by date and estimates their return rate.

1.2.2 Principal-agent relationship

Principal versus agent

Some arrangements involve two or more unrelated parties that contribute to
providing a specified good or service to a customer. In these instances, management
will need to determine whether the company has promised to provide the specified
good or service itself as a principal or to arrange for those specified goods or services
to be provided by another party as an agent. This determination often requires
judgment, and different conclusions can significantly impact the amount and timing
of revenue recognition.

Management first obtains an understanding (it is English, this means you need to
know all about it) of the relationships and contractual arrangements among the
various parties. This includes identifying the specified good or service being provided
to the end customer and determining whether the company controls that good or
service before it is transferred to the end customer.

9
 ST. VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]
A company is a principal in a transaction if it obtains control of the goods and
services of another party before it transfers control over those goods and services to
the customer. A company that is a principal obtains control of any one of the
following:

• A good from the other party that it then transfers to the customer
• A right to a service to be performed by the other party that gives the
company the ability to direct that party to provide the service to the customer
on the company’s behalf
• A good or service that the company then combines with others in providing
the specific good or service to a customer

If the determination of whether the company controls the specified good or service
(i.e., is a principal) is unclear, companies should evaluate the following indicators:
• Primary responsibility for fulfilling the promise
• Inventory risk
• Discretion in establishing price

The principal versus agent assessment is often required for arrangements in the
Entertainment & Media industry. For example:

• Determining whether a content owner or an online retailer is the principal

with respect to the sale of an electronic book, a movie or a song to a
consumer
• Determining whether a producer or distributing studio is the principal with
respect to film exploitation
• Determining which of many potential parties is the principal in an internet
advertising transaction
• Determining whether a video game company is the principal when hosting
third party gaming software on its platform

With the growth of digital business models, which often involve no physical goods
and little inventory risk, these judgments are expected to be more challenging in
significance and complexity.

Cases

These two cases show the difference in revenue recognition in a role as a principal or
agent:

Case 1 – Accounting for transportation costs: Entity is a principal

Retailer B enters into a contract with Customer C that involves the following two
performance obligations:

• transfer of Product P;
• and delivery service.

Based on its evaluation of whether it controls the goods and services before transfer
to C, B concludes that it is a principal for both performance obligations. B allocates
the total transaction price between the two performance obligations and recognizes
revenue and costs for each performance obligation as follows.

• Product P: Revenue is recognized when control transfers to C when P leaves

B’s premises. The cost of the inventory as determined under the inventory’s
standard is derecognized at the same point in time.
• Delivery service: Revenue is recognized over time as the shipping service is
performed. B considers that the shipping costs are not in the scope of another
standard and that they do not generate or enhance a resource controlled by B
10
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COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]
that will be used to satisfy a performance obligation in the future. Therefore,
B expenses the shipping costs as they are incurred.

Case 2– Accounting for transportation costs: Entity is an agent

Modifying the above case from principal to agent, Retailer B instead determines that
it acts as an agent for the shipping service, which is provided by a third party
shipping company.

The accounting for Product P is the same as above.

However, when B is an agent for the delivery service, revenue for arranging the
delivery service is recognized on a net basis – i.e. net of the amount payable to the
third party shipping company – when B satisfies its obligation of arranging for the
delivery service.

1.2.3 Gift Cards/certificates

Accounting for Gift Cards under IFRS-15

A gift card is a form of payment that can be used to make purchases at retail stores,
gas stations, restaurants, and other locations. You load money onto the card, which
you or the gift card’s recipient can then spend at accepted locations.

Gift cards can be open-loop or closed-loop. An open-loop gift card can be used
anywhere that brand of card is accepted. For example, if you have a gift card that’s
branded with the Visa logo, you could use it to make purchases anywhere Visa is
accepted.

A closed-loop card, on the other hand, can only be used at specific merchants. For
instance, if you purchase a gift card from Starbucks or Amazon, you or the gift
card’s recipient would be able to use them to make purchases only at the retailer
issuing the card.

When compared to IAS 18 ‘Revenue’, IFRS 15 ‘Revenue From Contracts With

Customers’ provides more significant guidance, that can be applied to various
situations retailers need to face, such as the treatment of gift cards (vouchers).

The core principle of IFRS 15 is that the timing of revenue recognition depends on
the timing of fulfilment of promises by the entity. In the case of goods, the fulfilment
of the promise happens when control of the goods is transferred to the customer.

In the case of gift cards, there are two dates to consider:

• The date of the purchase of the gift card (prepayment received by the entity).
• The date the gift card is redeemed (goods transferred to the customer).

IFRS 15, paras. B44 – B47 provide guidance on such situations, whereby the
customer may have paid, but may have not yet exercised their rights. The key points
that impact accounting for gift cards are:

• Upon customer prepayment, a contract liability is recognized, not revenue.

• Revenue is recognized when the promise is fulfilled.
• If the customer does not exercise the contractual rights, those rights are
referred to as breakage.
• In case of breakage, the entity may or may not be obliged to refund the
customer for the amount prepaid for those rights, depending on the contract.

11
 ST. VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]
• If the entity enjoys no refund obligation, the entity recognizes revenue based
on expected breakage, in proportion to the pattern of rights exercised by the
customer.
• If the entity does not expect to be entitled to a breakage amount, the entity
recognizes revenue from breakage when the likelihood of the customer
exercising its remaining rights becomes remote.
• If the entity needs to refund the prepayment in the event that the customer
does not exercise the rights, revenue from breakage is not recognized at any
point, but rather, the liability is refunded.

The following simple example illustrates accounting for typical gift card situations
that have an expiry date, and the entity is not obliged to refund the amount prepaid
for breakage.

Fragrant is a perfumery shop and began to offer gift cards to customers as from 1
July 2018. The company has a 31 December financial year-end.

Salient details:
• Gift card redemption period: 1 year.
• Gift cards issued on 1 July 2018: €300.
• Gift cards issued between 2 July 2018 and 31 December 2018: €0.
• Redemptions made up to 31 December 2018: €180.
• Expected breakage at 1 July 2018: 5% of the value of gift cards issued.
• Expected breakage at 31 December 2018: 5% of the value of gift cards
issued.

How is such a situation accounted for?

Upon receipt of consideration for the gift cards, that is, on 1st July in this case:

Once the expected breakages at reporting date is estimated, the estimated

breakages on consideration received during the period can be calculated.

Estimated breakages = Expected breakages * Consideration received

= 5% * €300
= €15

The release of revenue at year-end turns out to be as follows:

Why are we releasing €189 and not the amount redeemed (€180)? The reason is
that we need to take our expected breakages into account. As per IFRS 15, Para.
B46, “If the entity expects to be entitled to a breakage amount in a contract
liability, the entity shall recognize the expected breakage amount as revenue in
proportion to the pattern of rights exercised by the customer”.

The €189 of revenue released has two components:

€180 representing the selling price of goods redeemed.

€9 for expected breakages.

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Upon every redemption, the entity recognizes additional revenue to the selling price
of the goods redeemed, since there is an expectation that some of overall
consideration received during the period will not be redeemed. The €9 is computed
as per below:

Additional Revenue = [Estimated Breakages * (Total Redemptions Made / Total Gift

Cards Issued)
= 15 * 180/300

The breakages in this contract are those situations whereby the customer paid
consideration but did not follow up on his rights by redeeming the gift. To compute
the adjustment to contract liability and revenue representing expected breakages,
in this example we would calculate [Total Breakages * (Redemptions/Gift Cards
Issued)], which is equal to €15 * €180/€300.

The breakage estimate would typically need to be adjusted at every period-end,

and adjustments would need to be made accordingly.

1.2.5 Non-refundable upfront fees

An entity assesses whether the non-refundable upfront fee relates to the transfer of
a promised good or service to the customer. (IFRS 15.B40, B48–B51)
In many cases, even though a non-refundable upfront fee relates to an activity that
the entity is required to undertake to fulfil the contract, that activity does not result
in the transfer of a promised good or service to the customer. Instead, it is an
administrative task. For further discussion on identifying performance
obligations, use this link.

If the activity does not result in the transfer of a promised good or service to the
customer, then the upfront fee is an advance payment for performance obligations
to be satisfied in the future and is recognized as revenue when those future goods
or services are provided.

If the upfront fee gives rise to a material right for future goods or services, then the
entity attributes all of it to the goods and services to be transferred, including the
material right associated with the upfront payment.

The non-refundable upfront fee results in a contract that includes a customer option
that is a material right if it would probably impact the customer’s decision on
whether to exercise the option to continue buying the entity’s product or service
(e.g. to renew a membership or service contract or order an additional product).
(IFRS 15.BC387)

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Case – Non-refundable upfront fees: Annual contract

Cable Company C enters into a one-year contract to provide cable television to

Customer Z. In addition to a monthly service fee of 100, C charges a one-time
upfront fee of 50. C has determined that its set-up activity does not transfer a
promised good or service to Z, but is instead an administrative task.

At the end of the year, Z can renew the contract on a month-to-month basis at
the then-current monthly rate or can commit to another one-year contract at the
then-current annual rate. In either case, Z will not be charged another fee on
renewal. The average customer life for customers entering into similar contracts
is three years.

C considers both quantitative and qualitative factors to determine whether the

upfront fee provides an incentive for Z to renew the contract beyond the stated
contract term to avoid the upfront fee. If the incentive is important to Z’s
decision to enter into the contract, then there is a material right.

First, C compares the upfront fee of 50 with the total transaction price of 1,250
(the upfront fee of 50 plus the service fee of 1,200 (12 × 100)). It concludes that
the non-refundable upfront fee is not quantitatively material.

Second, C considers the qualitative reasons that Z might renew. These include,
but are not limited to, the overall quality of the service provided, the services and
related pricing provided by competitors and the inconvenience to Z of changing
service providers (e.g. returning equipment to C, scheduling installation by the
new provider).

C concludes that although avoidance of the upfront fee on renewal is a

consideration to Z, this factor alone does not influence Z’s decision over whether
to renew the service. C concludes based on its customer satisfaction research
data that the quality of service provided and its competitive pricing are the key
factors underpinning the average customer life of three years.

Overall, C concludes that the upfront fee of 50 does not convey a material right
to Z.

As a result, C treats the upfront fee as an advance payment on the contracted

one-year cable services and recognizes it as revenue over the one-year contract
term. This results in monthly revenue of 104 (1,250 / 12) for the one-year
contract.

Conversely, if C determined that the upfront fee results in a contract that

includes a customer option that is a material right, then it would allocate the total
transaction price including the upfront fee between the one-year cable service
and the material right to renew the contract (see Customer options for additional
goods or services).

Considerations:

• Quantitative and qualitative indicators are considered when assessing

upfront fees
• Determining whether a non-refundable upfront fee relates to the transfer
of a promised good or service.
• Upfront fee may need to be allocated
• Deferral period for non-refundable upfront fee depends on whether the fee
provides a material right
• Consideration of whether a non-refundable upfront fee gives rise to a
significant financing component
• Upfront fees in the funds and insurance industry

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1.2.6 Bill and Hold arrangements

Bill-and-hold arrangements occur when an entity bills a customer for a product

that it transfers at a point in time, but retains physical possession of the product
until it is transferred to the customer at a future point in time. This might occur
to accommodate a customer’s lack of available space for the product or delays in
production schedules. [IFRS 15.B79]

To determine when to recognize revenue, an entity needs to determine when the

customer obtains control of the product. Generally, this occurs at shipment or
delivery to the customer, depending on the contract terms (for discussion of the
indicators for transfer of control at a point in time, see Performance obligations
satisfied at a point in time from Step 5 IFRS 15 in the link). The new standard
provides criteria that have to be met for a customer to obtain control of a product
in a bill-and-hold arrangement. These are illustrated below. [IFRS 15.B80–B81]

A further explanation of these criteria is as follows:

• The product must be identified separately as belonging to the
customer. Even if the entity’s inventory is homogeneous, the customer’s
product must be segregated from the entity’s ongoing fulfilment
operations.

• The product currently must be ready for physical transfer to the

customer. In any revenue transaction recognized at a point in time,
revenue is recognized when an entity has satisfied its performance
obligation to transfer control of the product to the customer. If an entity
has remaining costs or effort to develop, manufacture or refine the
product, the entity may not have satisfied its performance obligation. This
criterion does not include the actual costs to deliver a product, which
would be normal and customary in most revenue transactions, or if the
entity identifies a separate performance obligation for custodial services,
as discussed below.
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• The entity cannot have the ability to use the product or to direct it to
another customer. If the entity has the ability to freely substitute goods to
fill other orders, control of the goods has not passed to the buyer. That is,
the entity has retained the right to use the customer’s product in a
manner that best suits the entity.

The reason for the bill-and-hold arrangement must be substantive

(e.g., the customer has requested the arrangement).

A bill-and-hold transaction initiated by the selling entity typically indicates

that a bill-and-hold arrangement is not substantive. In general it should be
the customer to request such an arrangement and the selling entity would
need to evaluate the reasons for the request to determine whether the
customer has a substantive business purpose. Judgement is required when
assessing this criterion. For example, a customer with an established buying
history that places an order in excess of its normal volume and requests that
the entity retains the product needs to be evaluated carefully because the
request may not appear to have a substantive business purpose.

If an entity concludes that it can recognize revenue for a bill-and-hold

transaction, IFRS 15.B82 states that the entity needs to further consider
whether it is also providing custodial services for the customer that would be
identified as a separate performance obligation in the contract.

A selling entity may utilize International Commerce Terms (Incoterms) to

clarify when delivery occurs. Incoterms are a series of pre-defined commercial
terms published by the International Chamber of Commerce (ICC) relating to
international commercial law. For example, the Incoterm ‘EXW’ or ‘Ex Works’
means that the selling entity ‘delivers’ when it places the goods at the
disposal of the customer, either at the seller’s premises or at another named
location (e.g., factory, warehouse). The selling entity is not required to load
the goods on any collecting vehicle, nor does it need to clear the goods for
export.

Under an Ex Works arrangement, the entity’s responsibility is to make

ordered goods available to the customer at the entity’s premises or another
named location. The customer is responsible for arranging, and paying for,
shipment of the goods to the desired location and bears all of the risks related
to them once they are made available.

As a result it makes sense to evaluate all Ex Works arrangements using the

bill-and-hold criteria discussed above to determine whether revenue
recognition is appropriate prior to shipment.

Example:

Company C enters into a contract to sell equipment to Customer A, who is

awaiting completion of a manufacturing facility and requests that Company C
hold the equipment until the manufacturing facility is completed.

Company C bills and collects the nonrefundable transaction price from

Customer A and agrees to hold the equipment until Customer A requests
delivery. The transaction price includes appropriate consideration for
Company C to hold the equipment indefinitely. The equipment is complete
and segregated from Company C’s inventory and is ready for shipment.
Company C cannot use the equipment or sell it to another customer.
Customer A has requested that the delivery be delayed, with no specified
delivery date.

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COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
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Company C concludes that Customer A’s request for the bill-and-hold basis is
substantive. It also concludes that control of the equipment has transferred to
Customer A and that it will recognize revenue on a bill-and-hold basis even
though Customer A has not specified a delivery date.

The obligation to warehouse the goods on behalf of Customer A represents a

separate performance obligation. Company C needs to estimate the stand-
alone selling price of the warehousing performance obligation based on its
estimate of how long the warehousing service will be provided. The amount of
the transaction price allocated to the warehousing obligation is deferred and
then recognized over time as the warehousing services are provided.

EXERCISE 1:

A. Allocating TOTAL TRANSACTION PRICE Using Adjusted Market Assessment

Approach

Rosmar Malakas, Inc. enters into a contract with a customer to transfer a software
license, perform installation, and provide software updates and technical support for
five years in exchange for P28,800,000. Rosmar has determined that each good or
service is a separate performance obligation. Rosmar sells the license, installation,
updates and technical support separately, so each has a directly observable stand-
alone selling price:

Software License P 18,000,000

Installation Service 7,200,000
Software Updates 4,800,000
Technical Support 6,000,000
Total P 36,000,000

B. Estimated Cost plus a Margin Approach

Marian Rivera sells a machine and one year’s free technical support for P100,000.
The sale of the machine and the provision of the technical support have been
identified as a separate performance obligations. Marian Rivera usually sells the
machine for P95,000 but it has not yet started selling technical support for this
machine as a stand-alone product. Other support services offered by Marian Rivera
attract a mark-up of 50%. It is expected that the technical support will cost Marian
Rivera P20,000.

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COLLEGE OF SCIENCE AND TECHNOLOGY
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Tel. # (033) 396-2291 ; Fax : (033) 5248081
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TOPIC 2: Long Term Construction Contracts

Learning Objectives:
At the end of this topic, the students are expected to:

1. Identify situations requiring recognition of revenue over time and demonstrate the
percentage-of-completion and completed contract methods of recognizing revenue
for long-term contracts.

Notes:

The general revenue recognition criteria described in the realization principle suggest that
revenue should be recognized when a long-term project is finished (that is, when the
earnings process is virtually complete). This is known as the completed contract method
of revenue recognition. The problem with this method is that all revenues, expenses, and
resulting income from the project are recognized in the period in which the project is
completed; no revenues or expenses are reported in the income statements of earlier
reporting periods in which much of the work may have been performed. Net income should
provide a measure of periodic accomplishment to help predict future accomplishments.
Clearly, income statements prepared using the completed contract method do not fairly
report each period’s accomplishments when a project spans more than one reporting period.
Much of the earnings process is far removed from the point of delivery.

The percentage-of-completion method of revenue recognition for long-term construction

and other projects is designed to help address this problem. By this approach, we recognize
revenues (and expenses) over time by allocating a share of the project’s expected revenues
and expenses to each period in which the earnings process occurs, that is, the con- tract
period. Although the contract usually specifies total revenues, the project’s expenses are
not known until completion. Consequently, it’s necessary for a company to estimate the
project’s future costs at the end of each reporting period in order to estimate total gross
profit to be earned on the project.

Because the percentage-of-completion method does a better job of recognizing revenue in

the periods in which revenue is earned, U.S. and international GAAP require the use of that
method unless it’s not possible to make reliable estimates of revenues, expenses, and
progress toward completion.16 Companies prefer the percentage-of-completion method as
well because it allows earlier revenue and profit recognition than does the completed con-
tract method. For both reasons, the percentage-of-completion method is more prevalent in
practice. However, much of the accounting is the same under either method, so we start by
discussing the similarities between the two methods, and then the differences. You’ll see
that we recognize the same total amounts or revenue and profit over the life of the contract
under either method. Only the timing of recognition differs.

Illustration 5–12 provides information to compare accounting for long-term contracts using
the completed contract and percentage-of-completion methods.

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Construction costs include the labor, materials, and overhead costs directly related to the
construction of the building. Notice how the total of estimated and actual construction costs
changes from period to period. Cost revisions are typical in long-term contracts in which
costs are estimated over long periods of time.

ACCOUNTING FOR THE COST OF CONSTRUCTION AND ACCOUNTS RECEIVABLE.

Summary journal entries for both the percentage-of-completion and completed contract
methods are shown in Illustration 5–12A for construction costs, billings, and cash receipts.

Accounting for costs, billings, and cash receipts are the same for both the
percentage- of-completion and completed contract methods.

With both the completed contract and percentage-of-completion methods, all costs incurred
in the construction process are initially recorded in an asset account called construction in
progress. This asset account is equivalent to work-in-process inventory in a manufacturing
company. This is logical since the construction project is essentially an inventory item in
process for the contractor.

Notice that periodic billings are credited to billings on construction contract. This
account is a contra account to the construction in progress asset. At the end of each period,
the balances in these two accounts are compared. If the net amount is a debit, it is reported
in the balance sheet as an asset. Conversely, if the net amount is a credit, it is reported as
a liability.

To understand why we use the billings on construction contract account (or billings for
short), consider a key difference between accounting for a long-term contract and
accounting for a typical sale in which revenue is recognized upon delivery. Recall our earlier
example in which Taft Company gives up its physical asset (inventory; in this instance a
supercomputer) and recognizes cost of goods sold at the same time it gets a financial asset

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Tel. # (033) 396-2291 ; Fax : (033) 5248081
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(an account receivable) and recognizes revenue. So, first a physical asset is in the balance
sheet, and then a financial asset, but the two are not in the balance sheet at the same time.

Now consider our Harding Construction example. Harding is creating a physical asset
(construction in progress) in the same periods it recognizes a financial asset (first
recognizing accounts receivable when the customer is billed and then recognizing cash when
the receivable is collected). Having both the physical asset and the financial asset in the
balance sheet at the same time constitutes double counting the same arrangement. The
billings account solves this problem. Whenever an account receivable is recognized, the
other side of the journal entry increases the billings account, which is contra to (and thus
reduces) construction in progress. As a result, the financial asset (accounts receivable)
increases and the physical asset (the net amount of construction in progress and billings)
decreases, and no double counting occurs.

GROSS PROFIT RECOGNITION—GENERAL APPROACH. Now let’s consider recognition

of gross profit. The top portion of Illustration 5–12B shows the journal entry to recognize
revenue, cost of construction (think of this as cost of goods sold), and gross profit under the
completed contract method, while the bottom portion shows the journal entries that achieve
this for the percentage-of-completion method. At this point focus on the structure of the
journal entries (what is debited and credited). We’ll discuss how to calculate the specific
amounts later in the chapter.

It’s important to understand two key aspects of Illustration 5–12B. First, the same amounts
of revenue, cost, and gross profit are recognized under both the completed contract and
percentage-of-completion methods. The only difference is timing. To check this, sum all of
the revenue recognized for both methods over the three years:

Second, notice that in both methods we add gross profit (the difference between revenue
and cost) to the construction in progress asset. That seems odd—why add profit to what is
essentially an inventory account? The key here is that, when Harding recognizes gross
profit, Harding is acting like it has sold some portion of the asset to the customer, but
Harding keeps the asset in Harding’s own balance sheet (in the construction in progress
account) until delivery to the customer. Putting recognized gross profit into the construction
in progress account just updates that account to reflect the total value (cost 1 gross profit 5
sales price) of the customer’s asset. However, don’t forget that the billings account is contra
to the construction in progress account. Over the life of the construction project, Harding
will bill the customer for the entire sales price of the asset. Therefore, at the end of the
contract, the construction in progress account (containing total cost and gross profit) and

20
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the billings account (containing all amounts billed to the customer) will have equal balances
that exactly offset to create a net value of zero.

The only task remaining is for Harding to officially transfer title to the finished asset to the
customer. At that time, Harding will prepare a journal entry that removes the con- tract
from its balance sheet by debiting billings and crediting construction in progress for the
entire value of the contract. As shown in Illustration 5–12C, the same journal entry is
recorded to close out the billings on construction contract and construction in progress
accounts under the completed contract and percentage-of-completion methods.

Now that we’ve seen how gross profit is recognized for long-term contracts, let’s consider
how the timing of that recognition differs between the completed contract and percentage-
of-completion methods.

TIMING OF GROSS PROFIT RECOGNITION UNDER THE COMPLETED CONTRACT

METHOD. The timing of gross profit recognition under the completed contract method is
simple. As the name implies, all revenues and expenses related to the proj- ect are
recognized when the contract is completed. As shown in Illustration 5–12B and in the T-
accounts below, completion occurs in 2015 for our Harding example. Prior to then,
construction in progress includes only costs, showing a balance of $1,500,000 and
$2,500,000 of cost at the end of 2013 and 2014, respectively, and including $4,100,000 of
cost when the project is completed in 2015. Harding includes an additional $900,000 of
gross profit in construction in progress when the project is completed in 2015 because the
asset is viewed as “sold” on that date. The company records revenue of $5,000,000, cost of
construction (similar to cost of goods sold) of $4,100,000, and the resulting $900,000 gross
profit on that date.

TIMING OF GROSS PROFIT RECOGNITION UNDER THE PERCENTAGE- OF-

COMPLETION METHOD. Using the percentage-of-completion method we recognize a
portion of the estimated gross profit each period based on progress to date. How should
progress to date be estimated?

One approach is to use output measures like units of production. For example, with a multi-
year contract to deliver airplanes we might recognize progress according to the number of
planes delivered. Another example of an output measure is recognizing portions of revenue
associated with achieving particular milestones specified in a sales contract. Accounting
guidance states a preference for output measures when they can be established, arguing
that they are more directly and reliably related to assessing progress than are input
measures.

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Another approach is to use an input measure like the “cost-to-cost ratio,” by which
progress to date is estimated by calculating the percentage of estimated total cost that has
been incurred to date. Similar input measures might be used instead, like the number of
labor hours incurred to date compared to estimated total hours. One advantage of input
measures is that they capture progress on long-term contracts that may not translate easily
into simple output measures. For example, a natural output measure for highway
construction might be finished miles of road, but that measure could be deceptive if not all
miles of road require the same effort. A highway contract for the state of Arizona would
likely pay the contractor more for miles of road blasted through the mountains than for
miles paved across flat des- sert, and a cost-to-cost approach reflects that difference.
Research suggests that the cost-to- cost input measure is most common in practice.19

Regardless of the specific approach used to estimate progress to date, under the
percentage- of-completion method we determine the amount of gross profit recognized in
each period using the following logic:

Illustration 5–12D shows the calculation of gross profit for each of the years for our Har-
ding Construction Company example, with progress to date estimated using the cost-to-cost
ratio. Refer to the bottom part of Illustration 5–12B to see the journal entries used to
recognize gross profit in each period, and the T-accounts on the next page to see that the
gross profit recognized in each period is added to the construction in progress account.

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Income statements are more informative if the sales revenue and cost
gross profit are reported rather than the net figure alone. So, the income statement for
each year will report the appropriate revenue and cost of construction amounts. For
example, in 2013, the gross profit of $500,000 consists of revenue of $2,000,000 (40% of
the $5,000,000 contract price) less the $1,500,000 cost of construction. In subsequent
periods, we calculate revenue by multiplying the percentage of completion by the contract
price and then subtracting revenue recognized in prior periods, similar to the way we
calculate gross profit each period. The cost of construction, then, is the difference between
revenue and gross profit. In most cases, cost of construction also equals the construction
costs incurred during the period. The table in Illustration 5–12E shows the revenue and cost
of construction recognized in each of the three years of our example. Of course, as you can
see in this illustration, we could have initially determined the gross profit by first calculating
revenue and then subtracting cost of construction.

A Comparison of the Completed Contract and Percentage-of-Completion Methods

INCOME RECOGNITION. Illustration 5–12B shows journal entries that would deter- mine
the amount of revenue, cost, and therefore gross profit that would appear in the income
statement under the percentage-of-completion and completed contract methods. Comparing
the gross profit patterns produced by each method of revenue recognition demonstrates the
essential difference between them:

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Although both methods yield identical gross profit of $900,000 for the entire 3-year period,
the timing differs. The completed contract method defers all gross profit to 2015, when the
proj- ect is completed. Obviously, the percentage-of-completion method provides a better
measure of the company’s economic activity and progress over the three-year period. That’s
why the percentage-of-completion method is preferred, and, as mentioned previously, the
completed contract method should be used only when the company is unable to make
dependable estimates of future revenue and costs necessary to apply the percentage-of-
completion method.

BALANCE SHEET RECOGNITION. The balance sheet presentation for the construction-
related accounts by both methods is shown in Illustration 5–12F. The balance in the
construction in progress account differs between methods because of the earlier gross profit
recognition that occurs under the percentage-of-completion method.

In the balance sheet, the construction in progress (CIP) account (containing costs and
profit) is offset against the billings on construction contract account, with CIP > Billings
shown as an asset and Billings > CIP shown as a liability. Because a company may have
some contracts that have a net asset position and others that have a net liability position,
we usually will see both net assets and net liabilities shown in a balance sheet at the same
time.

Construction in progress in excess of billings essentially represents an unbilled receivable.

Companies include it in their balance sheets as a component of accounts receivable, as part
of inventory, or on its own line. The construction company is incurring construction costs
(and recognizing gross profit using the percentage-of-completion method) for which it will
be paid by the buyer. If the construction company bills the buyer an amount exactly equal
to these costs (and profits recognized) then the accounts receivable balance properly
reflects the claims of the construction company. If, however, the amount billed is less than
the costs incurred (plus profits recognized) the difference represents the remaining claim to
cash—an asset.

On the other hand, Billings in excess of construction in progress essentially indicates that
the overbilled accounts receivable overstates the amount of the claim to cash earned to that
date and must be reported as a liability. This is similar to the unearned revenue liability that
is recorded when a customer pays for a product or service in advance. The advance is

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properly shown as a liability representing the obligation to provide the good or service in the
future.

LONG-TERM CONTRACT LOSSES. The Harding Construction Company example above

involves a situation in which a profit was realized on the construction contract.
Unfortunately, losses sometimes occur on long-term contracts.

Periodic loss occurs for profitable project. When using the percentage-of-completion
method, a loss sometimes must be recognized in at least one period over the life of the
project even though the project as a whole is expected to be profitable. We determine the
loss in precisely the same way we determined the profit in profitable years. For example,
assume the same $5 million contract for Harding Construction Company described in
Illustration 5–12 but with the following cost information:

At the end of 2013, gross profit of $500,000 (revenue of $2,000,000 less cost of
construction of $1,500,000) is recognized as previously determined.

At the end of 2014, the company now forecasts a total profit of $400,000 ($5,000,000 less
4,600,000) on the project and, at that time, the project is estimated to be 60% complete
($2,760,000 / 4,600,000). Applying this percentage to the anticipated gross profit of
$400,000 results in a gross profit to date of $240,000. But remember, a gross profit of
$500,000 was recognized in 2013.

This situation is treated as a change in accounting estimate because it resulted from a

change in the estimation of costs to complete at the end of 2013. Actual total costs to
complete—$4,600,000—were much higher than the 2013 year-end estimate of $3,750,000.
Recall from our discussion of changes in accounting estimates in Chapter 4 that we don’t go
back and restate the prior year’s gross profit. Instead, the 2014 income statement would
report a loss of $260,000 ($500,000 2 240,000) so that the cumulative amount recognized
to date totals $240,000 of gross profit. The loss consists of 2014 revenue of $1,000,000
(computed as $5,000,000 3 60% 5 $3,000,000 revenue to be recognized by end of 2014
less 2013 revenue of $2,000,000) less cost of construction of $1,260,000 (cost incurred in
2014). The following journal entry records the loss in 2014:

The 2015 gross profit comprises $2,000,000 in revenue ($5,000,000 less revenue of
$3,000,000 recognized in 2013 and 2014) and $1,840,000 in cost of construction (cost
incurred in 2015). The 2015 income statement would report a gross profit of $160,000:

Of course, when using the completed contract method, no profit or loss is recorded in 2013
or 2014. Instead, a $400,000 gross profit (revenue of $5,000,000 and cost of construction
of $4,600,000) is recognized in 2015.

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 ST. VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]
Loss is projected on the entire project. If an overall loss is projected on the entire
contract, the total loss must be recognized in the period in which that projection occurs,
regardless of whether the percentage-of-completion or completed contract method is being
used. Again consider the Harding Construction Company example but with the following cost
information:

At the end of 2014, revised costs indicate a loss of $100,000 for the entire project
($5,000,000 less 5,100,000). In this situation, the total anticipated loss must be recognized
in 2014 for both the percentage-of-completion method and the completed contract method.
As a gross profit of $500,000 was recognized in 2013 using the percentage-of-completion
method, a $600,000 loss is recognized in 2014 so that the cumulative amount recognized to
date totals a $100,000 loss. Once again, this situation is treated as a change in accounting
estimate, with no restatement of 2013 income. If the completed contract method is used,
because no gross profit is recognized in 2013, the $100,000 loss for the project is
recognized in 2014 by debiting loss from long-term contracts and crediting construction in
progress for $100,000.

Why recognize the estimated overall loss of $100,000 in 2014, rather than at the end of the
contract? If the loss was not recognized in 2014, construction in progress would be valued
at an amount greater than the company expects to realize from the contract. To avoid that
problem, the construction in progress account is reduced to $2,660,000 ($2,760,000 in
costs to date less $100,000 estimated total loss). This amount combined with the estimated
costs to complete of $2,340,000 equals the realizable contract price of $5,000,000.
Recognizing losses on long-term projects in the period the losses become known is
equivalent to measuring inventory at the lower of cost or market.

The pattern of gross profit (loss) over the contract period for the two methods is
summarized in the following table. Notice that an unanticipated increase in costs of
$100,000 causes a further loss of $100,000 to be recognized in 2015.

The table in Illustration 5–12G shows the revenue and cost of construction recognized in
each of the three years using the percentage-of-completion method.

Revenue is recognized in the usual way by multiplying a percentage of completion by the

total contract price. In situations where a loss is expected on the entire project, cost of
construction for the period will no longer be equal to cost incurred during the period. The
easiest way to compute cost of construction is to add the amount of the recognized loss to
the amount of revenue recognized. For example, in 2014 revenue recognized of $706,000 is
added to the loss of $600,000 to arrive at the cost of construction of $1,306,000.

26
 ST. VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]

The journal entries to record the losses in 2014 and 2015 are as follows:

Using the completed contract method, no revenue or cost of construction is recognized until
the contract is complete. In 2014, a loss on long-term contracts (an income statement
account) of $100,000 is recognized. In 2015, the income statement will report revenue of
$5,000,000 and cost of construction of $5,100,000, thus reporting the additional loss of
$100,000. The journal entries to record the losses in 2014 and 2015 are as follows:

You can see from this example that use of the percentage-of-completion method in this case
produces a large overstatement of income in 2013 and a large understatement in 2014
caused by a change in the estimation of future costs. These estimate revisions happen
occasionally. However, recall that if management believes they are unable to make
dependable forecasts of future costs, the completed contract method should be used.

27
 ST. VINCENT
COLLEGE OF SCIENCE AND TECHNOLOGY
Cagamutan Norte, Leganes, Iloilo - 5003
Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@[Link]
EXERCISES:

Reference:

1. Advanced Accounting, 10th Edition, by Joe B. Hoyle, Thomas F. Schaefer,

Timothy S. Doupnik

2. Advanced Accounting, Principles and Procedural Applications, Volume 2,

2017 Edition

3. [Link]
4. Advanced Financial Accounting, Tenth Edition, by Theodore E. Christensen,
et al
5. [Link]
6. [Link]
7. [Link]
[Link]

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