As we continue forward, revenues are inflows of enhancements and/or settlements (assets and/or liabilities). They constitute the central ongoing operations, and follow a “Contract with Customers” standard, led by the “Core Principle” (substituted the Realization Principle of “recognizing earnings when they were “virtually complete” and collections were “reasonably certain”), which helps form a more unified approach cross industries, helps manage complex arrangements, and better aligns to FASB’s conceptual framework. The five steps of the “Contracts with Customers” standards are identifying the contract, identifying the performance obligation, determining the transaction price, allocating the transaction price, and recognizing revenue when the performance obligation has been satisfied.
A contract is said to be a contract when there is commercial substance, approval from the parties, rights have been specified, repayment terms have been determined, and probable that customers will collect (in a contract, it requires a performance obligation and a penalty to leave). And a customer is known to own the good when there is an obligation to pay, legal title exists, physical possession, rights and rewards have been transferred, and accepted. A performance obligation is set to be multiple, it is capable of being unique and separately identifiable. Prepayments, Quality Assurance, and Rights of Returns are not performance obligations, but Extended Warranties and Options are. Therefore, this leads us to the next step, being determining the transaction price, and variable consideration. Before determining the transaction price, quick note on principal or seller agent, as it plays into step 3. Performance obligation for a principal is vulnerable to the risk of holding inventory, where the agent facilitates the transaction. The Revenue recording for a principal, however, is the total sales price and COGS (records gross revenue), where the agent records only the commission on a Net Revenue Basis. Onto variable consideration. Variable consideration states that part of the transaction price is determined on future events, and can be estimated used the “Expected Value” or “Most Likely Amount” methods. Variable consideration goes to the extent of how probable a revenue reversal will not occur, and indicators that shows potential revenue reversals (using the POHBL trick) are POOR EVIDENCE, estimate dependence on OUTSIDE SELLER’S CONTROL, a HISTORY of changing payment terms, BROAD RANGE of outcomes, and LONG DELAYS in resolutions. And when determining the transaction price, you will have to note the implications of Rights of Return. Ultimately, here, a company will have to reduce the estimated revenues by the return (estimated) by either reducing accounts receivables (via allowances if cash has not been paid) or a contra revenue account in the revenue account via sales return (a liability). Therefore, if you sell 100K worth of services, and expect to return 10% of it, you will debit sales return of 10K and credit refund liability of 10K. Let’s take an example of Expected Value and Most Likely Amount Methods, where Company “A” Contracts Company “B” to do social media services, with a onetime upfront fee of $100K. There is a bonus incentive of $50K for hitting a specific target. Company B believes there is a 60% chance that it will hit the target. Under the expected value there is a 40% chance that Company B will collect just the 100K, which is a 40K product and 60% that they will collect 150K, which is a 90K product, meaning there is an expected value on the contract price of $130K ($30K more than the $100K without the bonus). Therefore, in the 12 months (presumably), if they are to make their quota, they will have deferred revenue straight-lined out with $8.3K, a bonus receivable at 2.5K, and a credit of servicing the revenue of $10.8K. If the bonus does come through, a debit on cash for 50K, an additional service revenue credit of 20K, and you credit out the 30K of bonus receivable. Under the “Most Likely Amount”, Cash will be debited at 100K and the deferred revenue will be credited at $100K, where monthly, there will be reduction of $8.3K for deferred revenue, an increase in bonus receivable of $4.2K, and a service revenue credit of $12.5K. And with all of this said, if you go into a full 6 months and realize that you will not be able to hit the bonus, you will effectively debit out the sales revenue (meaning a reduction in your P&L and equity) and you will be crediting bonus receivable, meaning a reduction in your assets. Knowing Step 3 is Step 8.
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