CHAPTER 5 Revenue Recognition and Profitability Analysis 233 All revenue recognition starts with a contract between a seller and a customer. You may not have realized it, but you have been a party to several such contracts very recently. Maybe you bought a cup of Starbucks coffee or a breakfast biscuit at McDonalds this morning. Or maybe you bought this textbook through Amazon or had a checkup at your doctor’s office. Even though these transactions weren’t accompanied by written and signed agreements, they are considered contracts for purposes of revenue recognition. The key is that, implicitly or explicitly, you entered into an arrangement that specifies the legal rights and obligations of a seller and a customer. Contracts between a seller and a customer contain one or m ore p erformance obligations , which are promises by the seller to transfer goods or services to a customer. The seller recognizes revenue when it satisfies a performance obligation by transferring the promised good or service. We consider transfer to have occurred when the customer has control of the good or service. Control means that the customer has direct influence over the use of the good or service and obtains its benefits. For many contracts, following this approach is very straightforward. In particular, if a contract includes only one performance obligation, we typically just have to decide when the seller delivers the good or provides the service to a customer, and then make sure that the seller recognizes revenue at that time. As a simple example, assume Macy’s sells a skirt to Susan for $75 that Macy’s previously purchased from a wholesaler for $40. How would Macy’s account for the sale to Susan? 1. Identify the contract with a customer: In this case, the contract may not be written, but it is clear—Macy’s delivers the skirt to Susan, and Susan agrees to pay $75 to Macy’s. 2. Identify the performance obligation(s) in the contract: Macy’s has only a single performance obligation—to deliver the skirt. 3. Determine the transaction price: Macy’s is entitled to receive $75 from Susan. 4. Allocate the transaction price to each performance obligation: With only one performance obligation, Macy’s allocates the full transaction price of $75 to delivery of the skirt. 5. Recognize revenue when (or as) each performance obligation is satisfied: Macy’s satisfies its performance obligation when it delivers the skirt to Susan, so Macy’s records the following journal entries at that time: Performance obligations are promises to transfer goods or services to a customer. Performance obligations are satisfied when the seller transfers control of goods or services to the customer. Cash ..................................................................................................... 75 Sales revenue .................................................................................. 75 Cost of goods sold6 ............................................................................ 40 Inventory ......................................................................................... 40 Revenue recognition gets more complicated when a contract contains more than one performance obligation. For example, when Verizon signs up a new cell phone customer, the sales contract might require Verizon to provide (1) a smartphone, (2) related software, (3) a warranty on the phone, (4) ongoing network access, and (5) optional future upgrades. Verizon must determine which of these goods and services constitute performance obligations, allocate the transaction price to those performance obligations, and recognize revenue when (or as) each performance obligation is satisfied. In Part A of this chapter, we apply the five steps for recognizing revenue to various types of contracts. First we’ll focus on contracts that have only one performance obligation to deliver a good or service at a single point in time, like Macy’s sale of a skirt to Susan. Then we’ll consider situations in which one performance obligation to deliver goods and services is satisfied over time, like a landlord renting an apartment or a bank lending money. For those contracts, we recognize revenue over a period of time. After that, we’ll consider contracts that contain multiple performance obligations, like the Verizon example we just discussed. Illustration 5–2 summarizes some key considerations we will return to throughout this chapter. 6This second journal entry assumes that Macy’s uses a “perpetual” inventory system, by which we record increases and decreases in inventory as they occur (“perpetually”). We reviewed this method briefly in Chapter 2 and explore it in more depth in Chapter 8.
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