Question

Diversified Industries manufactures sump-pumps. Its most popular product is called the Super Soaker, which has a retail price of \(1,200 and costs \)540 to manufacture. It sells the Super Soaker on a standalone basis directly to businesses. Diversified also provides installation services for these commercial customers, who want an emergency pumping capability (with regular and back-up generator power) at their businesses. Diversified also distributes the Super Soaker through a consignment agreement with Menards. Income data for the first quarter of 2017 from operations other than the Super Soaker are as follows.

Revenues: \(9,500,000

Expenses: \)7,750,000

Diversified has the following information related to two Super Soaker revenue arrangements during the first quarter of 2017.

1. Diversified sells 30 Super Soakers to businesses in flood-prone areas for a total contract price of \(54,600. In addition to the pumps, Diversified also provides installation (at a cost of \)150 per pump). On a standalone basis, the fair value of this service is \(200 per unit installed. The contract payment also includes a \)10 per month service plan for the pumps for 3 years after installation (Diversified’s cost to provide this service is \(7 per month). The Super Soakers are delivered and installed on March 1, 2017, and full payment is made to Diversified. Any discount is applied to the pump/installation bundle.

2. Diversified ships 300 Super Soakers to Menards on consignment. By March 31, 2017, Menards has sold two-thirds of the consigned merchandise at the listed price of \)1,200 per unit. Menards notifies Diversified of the sales, retains a 5% commission, and remits the cash due Diversified.

Principles

Explain how the five-step revenue recognition process, when applied to Diversified’s two revenue arrangements, reflects the concept of control in the definition of an asset and trade-offs between relevance and faithful representation.

Short answer

To recognize revenue, the business entity mustdetermine the terms of the contract, obligations, transaction price, allocation base of different obligations, and satisfaction of the obligations.

Step-by-step solution

Definition of Faithful Representation

A concept of accounting states that the business entity must report information that will accurately reflect the position and performance of the business entity.

Five-Step Revenue Recognition Process

Five Steps:

1. Identification of contract with the customer.

2. Identification of Separate performance obligations.

3. Determination of Transaction price.

4. Allocating transaction prices to different obligations.

5. The revenue is recognized when the obligations are fulfilled.

Concept of control in assets: The asset is said to be controlled when the individual can use the asset and derive benefits from using it.

Control help in determining the relevance because it determines the cash flow that a business entity can generate from sale and thus help in the prediction of the revenue information.

The business entity must sacrifice faithful representation when there is more than one performance obligation. Under such a situation, the contract price is allocated based on their fair value. Faithful representation is also affected while estimating returns, warranty obligations, and other items affecting the transaction price.