FAR CPA Practice Questions: Determining the Amount and Timing of Revenue

In this video, we walk through 5 FAR practice questions about determining the amount and timing of revenue. These questions are from FAR content area 3 on the AICPA CPA exam blueprints: Select Transactions.

The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.

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Determining the Amount and Timing of Revenue Recognition Using the Five-Step Model

Revenue recognition ensures businesses report income accurately and consistently. The five-step model outlined in ASC 606 provides a framework for determining when and how much revenue to recognize. Below, we explain the process, illustrate its application, and provide journal entry examples.

The Five-Step Revenue Recognition Model

1. Identify the Contract with the Customer
   A contract is an agreement between two or more parties that creates enforceable rights and obligations. Contracts can be written, verbal, or implied, but they must meet criteria such as approval by both parties and a clear promise of payment.
   • Example:
     On January 1, a company signs a $120,000 contract to manufacture and deliver a custom machine by March 15.
2. Identify the Performance Obligations in the Contract
   Performance obligations are distinct goods or services promised in the contract. A performance obligation is distinct if the customer can benefit from it on its own or with other resources.
   • Example:
     In the above scenario, the only performance obligation is the delivery of the custom machine.
3. Determine the Transaction Price
   The transaction price is the amount the seller expects to receive in exchange for fulfilling its performance obligations. This includes fixed amounts, variable consideration, and discounts, if applicable.
   • Example:
     The transaction price is $120,000 for the custom machine.
4. Allocate the Transaction Price to the Performance Obligations
   If the contract includes multiple performance obligations, allocate the transaction price to each based on their relative standalone selling prices.
   • Example:
     If the contract included installation services valued at $10,000 separately, the $120,000 would be allocated based on the relative standalone selling prices of the machine and installation.
5. Recognize Revenue as Performance Obligations Are Satisfied
   Revenue is recognized either at a point in time (e.g., delivery) or over time (e.g., construction projects).
   • Example:
     For the custom machine, revenue is recognized on March 15, when the machine is delivered, as control is transferred to the customer.
     • Journal Entry Example:
       • Debit Accounts Receivable $120,000
       • Credit Revenue $120,000

Applying the Five-Step Model: Key Scenarios

Revenue Recognized at a Point in Time

Revenue is recognized when control of the goods or services transfers to the customer. This is common for tangible goods, where delivery or customer acceptance marks the point of recognition.

Example: A travel agency arranges a vacation package for $10,000, earning a 12% commission ($1,200). The agency recognizes $1,200 as revenue when the booking is confirmed.

Journal Entry:

• Debit Accounts Receivable $1,200
• Credit Revenue $1,200

Revenue Recognized Over Time (Percentage-of-Completion Method)

For long-term projects, revenue is recognized based on progress toward completion, often measured by costs incurred relative to total estimated costs.

Example: A contractor signs a $4,000,000 contract with $3,400,000 estimated total costs. At the end of Year 1, $1,200,000 of costs are incurred, representing 35.29% of total estimated costs.

Calculation:
Total expected profit: $4,000,000 – $3,400,000 = $600,000
Profit recognized in Year 1: $600,000 × 35.29% = $211,764

Recognizing Losses on Long-Term Projects

When total estimated costs exceed the contract price, a loss is recognized immediately.

Example: A $5,000,000 project has total estimated costs of $5,400,000. The contractor recognizes a $400,000 loss in the first year.

Journal Entry:

• Debit Loss on Contract $400,000
• Credit Construction in Progress $400,000

Agent vs. Principal Revenue Recognition

An agent recognizes revenue for the commission or fee earned, not the gross transaction amount.

Example: A retailer acts as an agent for a supplier, facilitating $100,000 in sales with a 10% commission. The retailer recognizes $10,000 as revenue.

Journal Entry:

• Debit Accounts Receivable $10,000
• Credit Revenue $10,000

Unearned Revenue for Upfront Payments

Upfront payments are recorded as liabilities (e.g., Unearned Revenue) and recognized as revenue over time as services are provided.

Example: A company collects $12,000 per client from 40 clients for a total of $480,000 on April 1, covering services through March 31. At the end of April, $40,000 is recognized as revenue.

Initial Journal Entry (April 1):

• Debit Cash $480,000
• Credit Unearned Revenue $480,000

Subsequent Journal Entry (Monthly):

• Debit Unearned Revenue $40,000
• Credit Revenue $40,000

Key Takeaways

• Timing of Recognition: Revenue is recognized when control transfers (point in time) or as performance obligations are satisfied (over time).
• Agent vs. Principal: Agents only recognize their commission or fee, not the full transaction amount.
• Upfront Payments: Unearned revenue is recognized as a liability until services are provided.
• Percentage-of-Completion: This method ensures revenue and expenses are recognized proportionately for long-term projects.
• Recognizing Losses: When estimated costs exceed the contract price, losses are recognized immediately.