 Hello and welcome to this session in which we would look at step three in the revenue recognition process and that is transaction price. In the prior recordings we looked at identifying the contract that was step one. In step two we identified the separate performance obligation or obligations. Here we're going to determine the transaction price and obviously we're going to work part four and part five in future recording. What is the transaction price which is part three or five of the revenue recognition process? Well it's how much you're going to be going to record for the revenue. So you did the work, you have a contract with someone, what is the price? Well oftentimes most of the time it's a pretty straightforward transaction. For example you want to buy a car they will tell you what the price is you pay it and that's the transaction price. So it's the consideration expected to be received from a customer. How much do you expect to be received? Now this amount is easy to figure out if the price is fixed. The price is clearly stated and there's no contingencies nothing else. Now bear in mind the price does not have to be specific. In the real world you can put conditions, you can put considerations, variable consideration, other things but you have enough information to assign a price. It doesn't have to be specific but you have enough information to determine a price. So some contract will have those conditions, will have those variable consideration, will have some sort of a factor that's going to influence the price. And those factors are variable considerations one, time value of money two, non-cash consideration three, consideration paid or payable to customer. And if you know anything about Professor Farhad once you have a list and I numbered that list I'm going to go over each aspect of this list. Let's start with variable consideration. Well what is a variable consideration? It means the price is dependent upon some future event. So you don't know what the final price is but the final price is dependent upon some event happening or not happening. An example would be a good example performance bonus. For example your bonus you're going to get a bonus but that bonus is dependent upon some delivery criteria. So the company can estimate the amount of the variable consideration to determine the revenue. So what you will do you would say okay I don't know what that final price is because it's depending about it's it's depending about some future event but I can estimate the amount of this variable consideration to determine my transaction price. Specifically we use two methods in determining the variable consideration. One is called the expected value and the other one is called the most likely method. Before we proceed any further explaining the expected value and the most likely method I would like to remind you whether you are a student or a CPA candidate to take a look at my website farhatlectures.com. I don't replace your CPA review course I don't replace your accounting course. My motto is saving helping CPA candidate and accounting student one at a time by providing you with resources lectures detailed lectures multiple choice through false questions. This is a partial list of my accounting courses advance intermediate governmental managerial auditing you name it. My CPA resources are aligned with your Becker, Roger, Lewily and Gleam so it's very important to go back and forth between my material and your CPA review course. I give you access in addition to the multiple choice questions for each course to 1500 previously released AI CPA original questions with the detailed solution. Those questions appeared on prior exams. If you have not connected with me on LinkedIn please do so take a look at my LinkedIn recommendation like this recording share it with other it helps me tremendously connect with me on Instagram I'm trying to grow my Instagram Facebook Twitter and Reddit. So what is the expected value? Well the expected value is the probability weighted amount and the range of possible considerations so simply put we can estimate different probabilities for the outcome and we're going to go ahead and calculate that probability that weighted amount probability. When do we use this method? We use this method the expected value when the company have past experience with similar work so they have past experience with similar contract and the company in the past they had many they did many work with similar characteristic what does that mean? It means when they estimate when they estimate those probabilities before they weigh them when they estimate them they have good experience with that they can rely on that experience and simply put the probabilities can be based on limited number of discrete outcome and probabilities simply put you're just going to have to assign probabilities percentages and they should add up to 100%. This is when you would use the expected value the most likely method it's the single most likely amount in a range of possible consideration outcome so you have consideration outcomes more than one and what's the most likely outcome? When do we use this method? Well when we have actually binary outcome two outcome the contract has only two possible outcome either this outcome or that outcome now each outcome will have a different possibility for example outcome A you're going to get the bonus 70% outcome B you're going to get the bonus 30% will go with the higher probability but it has only two outcome if that's the case if it's a binary outcome you go with the higher consideration. So let's take a look at this example maze enters into a contract with a customer to hold the website a website for 20,000 and within that contract there's a performance bonus of $2,000 that will be paid based on the timing of the completion we know the contract is 20,000 but that's not the final price the final price you might have a bonus and that bonus could be up to 2,000 depending on when you would complete the project the amount of the performance bonus decreases by 10% for every 10 days beyond the agreed upon completion date so if you don't deliver on time for every 10 days it's delayed you'd lose 10% of the bonus now maze the company that's performing this work is familiar with this type of work they do websites all the time they have this type sorts of contract and they know the time and the required based on prior experience and based on their prior experience based on the amount of the work required based on their staffing availability they can estimate how long it's going to take them so therefore what they would do is they will build this table there's a 60% possibility they're going to be on time there's a 30% possibility they're going to be 10 days late and there's a 10% possibilities they're going to be 20 days late now what we do is we're going to compute the outcome we'll take 20,000 which is the contract price plus under 60% outcome we're going to receive 100% of the bonus which is $2,000 therefore the gross contract is 22,000 for the 30% if you are 30 if you are late 10 days you're only going to you're going to lose 10% so it's the count you're going to get the contract amount plus 2,000 times 90% so it's 1,800 the total is 21,800 if that materializes and there's a 10% chance you're going to be 20 days late if you're 20 days late you're going to get your 20,000 plus you're going to lose another 10% of the bonus which we're going to make it 1,600 so you would get 21,600 now we're going to weigh the amount based on the probability the 22,000 there is a 60% we're going to get this amount that's equivalent to 13,200 30% chance we're going to get 21,800 and 10% chance we're going to get 21,600 now what we do is we add them all up and the weighted probability is 21,900 now if the performance bonus is binary what does that mean binary binary means we have two outcome either we will we will or will not earn the bonus so what we do is go with we'll go with the most likely outcome so if the most likely outcome okay so maze earns either the 2,000 for the completion of the agreed upon date or get nothing if they don't complete it and there's a 60% chance we are going to complete this okay there's a 60% chance it means there's a higher probability we are going to get this on time we're going to go with that higher the highest probability 60% 60% will give us exactly 22,000 if that's the case so if the most likely outcome is yes we will so the most likely outcome we will earn it either we will okay if that's the case we'll go with we will because it's 60% chance we will therefore we'll go with 22,000 most likely outcome when variable consideration is not allowed when can you not compute this variable consideration and include it in your revenue it's only let's see when it's only allowed it's only allowed when you have experience we already talked about this with similar contract and you are able to estimate the cumulative amount of revenue based on that experience okay so what does that mean it's it means there's a high probability you are not going to back out revenue there's a high probability that you will not have to reverse revenue because what happened is you estimate you estimated 60% you will be on time what happened if you are not on you booked the 60% that based on that probability you booked 22,000 then when I end up happening you were pretty late if you already booked 22,000 you have to go back and reverse revenue and they don't want you to do that if the if those two criterias are not met it means you have experience and you can estimate this amount then revenue recognition is constrained what does that mean it means you wait until the project is done the best way to illustrate this is to work an example but the example that would work it's going to have to be a long example we'll do it in another recording now let's talk about the time value of money what happened if you sold something and you don't get the money immediately you sold it and you're going to be receiving either one payments or many payments at future dates in these contract when you have future payment future receipts of payment what you have is you have a significant financing component because now the contract it might be stated directly or not it's going to have two components one there's going to be one price for the delivery component for the item that you sold and that's going to be the present value of the payments discounted which is the present value should reflect should approximate the fair value of the component then you have a financing component because whatever you're paying the payments will be broken down by a principal amount for the price of the item and an interest component so interest component is accounted for separately now let's take a look at an example Adam company performed consulting services for Ryan company in the amount of eight hundred thousand dollar in exchange for three years zero interest bearing note with a face value of a million so here's what happened Adam did some work for Ryan consulting work Ryan says okay I'm going to give you this piece of paper promising to pay you a million dollar three years from now that's it so how would Adam account for this transaction because Adam is getting the is will need to record the revenue now but get the payment later so Ryan will debit notes receivable for a million dollar this is how much we are waiting to receive the sales amount is only eight hundred thousand because the sales amount we did the work eight hundred thousand worth of work so the difference is discount on notes receivable so the difference here is this two hundred thousand is future interest revenue so the two hundred thousand the difference is the future interest revenue we're going to be accounting for so a year later what's going to happen is we're going to account for some of the revenue and it's going to be eight hundred thousand times seven point seven two what did I get the seven point seven two based on this deal if you compute the interest rate at seven point seven two seven point one five to seven point seven two five so I just put seven point seven two so if you did for three years you're going to be like a few dollars difference it doesn't matter this is just to illustrate the point simply put you're going to start to turn this discount this discount into interest revenue so two hundred thousand of the deal although I'm going to be receiving a million dollar two hundred thousand of it will be interest revenue and the sales revenue only eight hundred thousand so I have to split the deal into the delivery component which is eight hundred thousand and the finance component is two hundred thousand and the finance component I'm going to account for this over the years now bear in mind here you have to know what's the time value of money also you need to know how to discount how to amortize note whether it's a notes receivable or a notes payable this is the assumption here the third item that we have to discuss when we are looking at revenue recognition transaction price is non-cash non-cash consideration what is non-cash consideration is when the company receive like gifts donations contribution or contribution of goods and services like labor equipment a piece of land as a consideration for goods and services provided so so you provided a service the customer don't have money to pay you so what they do they give you something in return how do you account for that transaction well under those circumstances the the transaction price is the fair value of what is received you look at what you are what you are receiving the fair value of it is how much you're going to be accounted for the fourth item we have to be aware of is consideration paid or payable to customers what is this what is the purpose of this why would we pay the customer or give the customer some consideration well the reason is simple you want to offer the customer incentive to do what maybe to pay early or to purchase more so this might include discount a volume rebate if you buy enough we will give you a rebate coupons for future purposes free product along the sale or some service along the sale free why are we doing so we are doing so to encourage you to buy more from us well what would that gonna do to your sales revenue it's going to reduce your consideration received simply put i remember one time i purchased a uh a computer and i don't remember exactly how much i paid i believe it was around a thousand dollar a thousand dollar then if i fill a rebate those are no longer you know they don't longer do that i still remember that's long time ago i'll get a one hundred dollar back so what happened is initially they recorded the sale for a thousand dollar i filled out the rebate i send it they send me a check for a hundred dollar therefore their total sales now is 900 so why did they do that they they wanted they wanted to encourage me to buy the computer so they did not give me the rebate up front they said okay buy it and they were hoping the customer will not fill out the rebate the best way to illustrate this is to work with an example with journal entries adam company offer its customers a two percent volume discount if they purchase at least a million dollar worth of merchandise in any particular year so i'll give you two percent discount you purchase one million from me on march 31st adam had made sales of 550 000 to ryan company so the first quarter they already made 550 000 in the previous two years adam sold over a million dollar to ryan in the period from april to december so what what are we saying here i'm reinforcing the idea that you have to know your customers you have to know that ryan for sure will exceed the million dollar if they exceeded a million dollar in the first quarter companies would know adam would know based on past experience based on the nature of the business that maybe the first quarter was a slow season for ryan ryan will be buying more therefore we're comfortable saying look ryan will get the two percent discount therefore what we do is when we debit the receivable we debit the receivable for only 98 percent of it so we'll get we'll take two percent off so the account receivable is debited for 539 000 which is if we take 550 times two percent that's going to be 11 000 so this is we take it out we assume we assume that ryan is qualify for this therefore we record the the journal entry upfront let's assume this is the case how much would ryan pay us well ryan will pay us only 539 000 if ryan did indeed exceeded the threshold so for this sale they would only pay us 539 let's assume ryan for some reason their business slowed down there was a slowdown in the economy and what they did is they did not purchase a million dollar for the rest of the year they're gonna have to pay us 550 000 will credit the receivable for only 539 now we have sales discounts forfeited because they forfeited the discount of 11 000 basically this is other revenue this is if they did not end up getting the million dollar so this is how it works the best way to illustrate this concept and to learn to learn more about them is to go to farhatlectures.com and work multiple choice questions go to my website invest in yourself get a subscription right for a month it will help you tremendously in the next recording we're going to look at allocating the price to separate performance obligation once again don't shortchange yourself invest in your career 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