Nyu Fsa 03

Financial Statement Analysis
Professor Julian Yeo
Class Notes 04: Revenue and Accounts Receivables
In this document, we examine the followings:

1. Revenue Recognition under GAAP
2. Exceptions to recognizing revenue at the time of delivery
2.1 Percentage-of-completion
2.2 Installment (collection) method (optional)
2.3 Cost recovery method (optional)
2.4 Completed contract method (optional)
2.5 Revenue recognition before delivery (optional)
3. Revenue from multiple element arrangements
3.1 Relative fair value approach
3.2 Customer Loyalty Program
4. Trading Revenue
5. Revenue Measurement
6. Quality Issues - revenue recognition and revenue measurement
7. Ways to detect manipulations of revenue recognition
8. Disclosure – Revenue Recognition
9. Changes in accounting estimates, principles and error corrections
10. Pledging, Assigning and Factoring Receivables
11. Interest Income on Receivables (optional)
12. Quality Issues – reported Receivables
13. Ways to detect manipulations of Receivables
14. Disclosure- Receivables
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1. Revenue Recognition under GAAP
For GAAP financial reporting purposes, revenue should be recognized at the first point at which
both of the following revenue-recognition criteria are satisfied:
1. The revenue is earned. The revenue-producing activity has been performed.
2. The revenue is either realized or realizable. (That is, the amount to be collected can be
estimated with reasonable accuracy.)
An entity can record revenue when it meets all of the following:

 The price is substantially fixed at the sale date.
 The buyer has either paid the seller or is obligated to make such payment.
 The payment is not contingent upon the buyer reselling the product.
 The buyer's obligation to pay does not change if the product is destroyed or damaged.
 The buyer has economic substance apart from the seller.
 The seller does not have any significant additional performance obligations related to the
sale.
 The seller can reasonably estimate the amount of future returns.
For product sale transactions, revenue is typically recognized when the purchaser is vested with
ownership rights (i.e., when title passes). For most firms, it is the time of delivery. Some firms
do not make the distinction between “the time of delivery” and “the time of sale,” and report (in
the summary of significant accounting policies) that revenue is recognized at the time of sale.
Conceptually, the firm performs only when it delivers the merchandise or provides the service,
so when there is a substantial gap between the time of sale and the (subsequent) time of delivery,
revenue should be recognized only at the time of delivery.
For service transactions, the most important question is to determine when a service transaction
has been completed is: has substantial performance occurred? Because of the intangibility of
services, it is often difficult to ascertain when a service consisting of more than a single act has
been satisfactorily performed to warrant the recognition of revenue.
2. Exceptions to recognizing revenue at the time of delivery

Long-term and Other Transactions
For many long-term transactions, the accounting period is “too short” to include a complete
business cycle. Furthermore, by their nature, these transactions are “big” projects, so a company
may only be involved in a small number of such projects. Consequently, recognition rules are
modified:
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2.1 Percentage-of-completion
This method is commonly used for long-term transactions (e.g., in the construction industry). It
requires a company to estimate total costs and total revenues as well as to measure progress.
Conceptually, the method recognizes the economic substance of a transaction by allocating
revenue to periods of work performed, so that revenue is recognized as it is earned.
Unlike the other exceptions to recognizing revenue at the time of delivery, the percentage of
completion method is quite common. In a recent survey of about 600 U.S. companies, 15%
indicated that they use this method.
Revenue and expense measurement

Current period income (gross profit) is calculated using the following steps:
 Total income from the project is estimated as the difference between the contract price
and estimated total costs.
 Income earned to date is calculated as the product of estimated total income and the
percentage of completion at the end of the year.
 Current period income is calculated as the difference between income earned to date and
cumulative income recognized in prior periods.1
Construction revenue is calculated as the product of the contact price and the change in the
percentage of completion during the year (current period progress).
Construction expense is calculated indirectly as the difference between construction revenue and
current period income.
Methods of assessing the percentage of completion:

i) Cost incurred method - Utilizing the incurred costs as an indicator of progress. As costs are
incurred, revenue is recognized according to a simple formula: current cost as a percentage of
expected total costs equals current revenue as a fraction of total revenue.
ii) Other methods. When progress is measured using physical units, either input units (e.g.,
hours of labor to date compared with estimated total labor hours needed for the project) or output
units (e.g., miles of road completed compared with total contract miles) are used.2
1 One exception is that an estimated loss should be fully recognized, independent of the percentage of completion.
2
Proportional recognition of costs - When a proportional method is based on costs incurred, all costs should be
charged against operations as incurred. When, on the other hand, performance is measured in some other way, it
may be appropriate to defer some portion of the cost, or accrue additional costs, to maintain a consistent profit
margin throughout the project life.
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Example: Percentage of Completion
On 3/3/2005 a firm signed a contract to build a house for $1,500.
2005 2006 2007
Costs incurred during the year 500 400 100
Estimated completion costs at the end of the year 500 100 0
Calculate revenue, expense and income in each of the years 2005-2007 assuming the firm uses
the percentage of completion method (more specifically, cost incurred method) for recognizing
revenue.
2005 2006 2007 Total
Contract price 1,500 1,500 1,500
Costs to date 500 900 1,000
Estimated completion costs 500 100 0
Estimated total costs (1,000) (1,000) (1,000)
Estimated total income 500 500 500
Estimated completion 50% 90% 100%
Income to date 250 450 500
Income previously recognized (0) (250) (450)
Income (i.e., gross profit) 250 200 50 500
2005 2006 2007 Total

Current period progress 50% 40% 10%
Revenue 750 600 150 1,500
Expense 500 400 100 1,000
It may seem that some of the steps are redundant. Each period, revenue, expense and income can
be calculated by multiplying the respective totals by the percentage of costs incurred during the
year (current period progress). This approach would indeed work for this example, but not for
more realistic examples. Consider Example 2.
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Question: What should we do in case there is a change in estimation of future costs?
It is extremely common to adjust the original estimates of the total revenue or cost of a contract,
as the contractor gathers more detailed information and the project progresses. These alterations
should be accounted for as changes in the accounting estimate (see later section), which only
require changes going forward; you should not make retroactive changes based on a revised
estimate on a construction project.
Example: Percentage of Completion with change of estimate

2005 2006 2007
the percentage of completion method for recognizing revenue.
2005 2006 2007 Total
Contract price 1,500 1,500 1,500
Costs to date 500 900 1,200
Estimated completion costs 500 400 0
Estimated total costs (1,000) (1,300) (1,200)
Estimated total income 500 200 300
Estimated completion 50% 69.23% 100%
Income to date 250 138 300
Income previously recognized (0) (250) (138)
Income (i.e., gross profit) 250 (112) 162 300
2005 2006 2007 Total

Current period progress 50% 19.23% 30.77%
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Revenue 750 288 462 1,500
Expense 500 400 300 1,200
If you attempt to use the simplified approach discussed above, you will get different (and
therefore incorrect) results. The reason is that in this example the estimate of total costs changes
over time. Of course, in reality, actual costs are almost always different from expectations, and
estimates of total costs change over time as new information becomes available. In addition,
companies may manipulate the expected amounts (e.g., they may use an estimate of completion
costs that is lower than the truly expected amount and consequently report high income for the
period). Therefore, understanding the above calculation is important for assessing “earnings
quality” and “earnings management.”
If the estimate of costs left to be incurred on a project plus actual costs already incurred exceeds
the total revenue to be expected from a contract, then you should recognize the full amount of the
difference in the current period as a loss, and present it on the balance sheet as a current liability.
If you used the percentage of completion method on the project, then the amount recognized will
be the total estimated loss on the project plus all project profits previously recognized. If, after
the loss estimate has been made, and the actual loss turns out to be a smaller number, then
recognize the difference in the current period as a gain.
In conclusion, if a company’s estimate of costs and related revenues are inaccurate, there may be
gain/loss recognized. Because of the significant flexibility to manage reported revenues, we
typically pay close scrutiny to reported numbers using percentage of completion.
Interesting question: Before the housing bust, WCI Communities (WCIC) and Toll Brothers
(TOL) began using percentage of completion for condo development sales based on a cost
incurred to total cost method. Why?
2.2 Installment (collection) method

Each period the firm calculates income as the product of cash collections and the gross profit
margin, and calculates expense as the difference between revenue and income. (One
complication, which we will ignore, is that each installment has an interest component).
The installment method can be used in most sales transactions for which payment is to be made
through periodic installments over an extended period of time and the collectibility of the sales
price cannot be reasonably estimated. This method is applicable to the sales of real estate, heavy
equipment, home furnishings, and other merchandise sold on an installment basis.
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Installment method revenue recognition is not in accordance with accrual accounting, because
revenue recognition is not normally based upon cash collection; however, its use is justified in
certain circumstances on the grounds that accrual accounting may result in “front-end loading”
(i.e., all of the revenue from a transaction being recognized at the point of sale with an improper
matching of related costs). For example, the application of accrual accounting to transactions that
provide for installment payments over periods of ten, twenty, or thirty years may underestimate
losses from contract defaults and other future contract costs.
2.3 Cost recovery method

Under the cost recovery method, income is zero (expense equals revenue) until the full cost is
recovered. After cost is recovered, income equals revenue (expense equals zero). The cost
recovery method is used when the uncertainty of collection of the sales price is so great that even
use of the installment method cannot be justified. In the U.S., the use of this method is very
uncommon.
Example: Installment and Cost Recovery Method

On 3/3/2005 a firm sold a product for $1,500 in three annual cash installments of $500 (in 2005),
$600 (in 2006), and $400 (in 2007). The product’s cost is $1,000.
Assume there is significant uncertainty about cash collections. Calculate revenue, expense and
income in each of the years 2005-2007 using (i) the installment method, and (ii) the cost
recovery method. Ignore present value considerations.
(i) The installment method:

2005 2006 2007 Total
Revenue 500 600 400 1,500
Expense (333) (400) (267) (1,000)
Income 167 200 133 500
(ii) The cost recovery method:

2005 2006 2007 Total
Revenue 500 600 400 1,500
Expense (500) (500) (0) (1,000)
Income 0 100 400 500
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Note: When use collection based-systems (installment method and cost recovery method), use
CASH received as revenue (not the amount in account receivable).
2.4 Completed contract method

When the uncertainty is about cash inflows, the firm should recognize revenue only when the
uncertainty is resolved. This method is generally not allowed under GAAP
Example: Completed Contract Method

2005 2006 2007
the completed contract method for recognizing revenue.
2005 2006 2007 Total

Revenue 0 0 1,500 1,500
Expense (0) (0) (1,200) (1,200)
Income 0 0 300 300
2.5 Revenue recognition before delivery

In certain situations, revenue can be recognized at the completion of production but prior to
delivery. The key criterion for using this method is that the sale will take place without any
doubt. The normal criteria for recognizing revenue before sale are:
 the sale and collection of proceeds must be assured;
 the product must be marketable immediately at quoted prices that cannot be influenced
by the producer;
 units of the product must be interchangeable; and
 there must be no significant costs involved in product sale or distribution.
Essentially, these criteria define a commodity. Inventory is valued at market value.
3 Revenue from multiple element arrangements
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A multiple-element arrangement contains several activities that independently generate revenue.
An arrangement with multiple deliverables is considered a separate unit of accounting if:
 The delivered item has value to the customer on a standalone basis. The items have
value on a standalone basis if it sold separately by any vendor or the customer could
resell the delivered item on a standalone basis
 If the arrangement includes a general right of return relative to the delivered item,
delivery or performance of the undelivered item is considered probable and
substantially in the control of the vendor
Examples of multiple element arrangements include: a contract covering the sale, servicing and
financing of equipment; sale of software with post-contract customer support; sale of a cell
phone with a phone service contract.
3.1 Relative fair value approach

Once it is established that the arrangement has multiple elements, there are two possible
treatments:
 Single element – only recognize revenue when all elements are delivered
 Multiple accounting units- recognizing revenue from each unit separately
o If there is Vendor Specific Objective Evidence (VSOE) or third-party evidence
of selling price for all units, the arrangement consideration is allocated based on
the relative fair value
o If the selling price of the delivered element is unknown, use the residual method.
Under the residual method, the delivered element selling price is the total
consideration minus the selling price of the undelivered unit. The residual
approach to determine the selling price of the undelivered unit is not allowed.
Vendors may offer many related and unrelated products and services together (“bundled”) or
separately. The prices assigned to the various elements of a particular transaction or series of
transactions on the seller's invoices and the timing of issuing those invoices are not always
indicative of the actual earning of revenue on the various elements of these transactions.
Example: Relative Fair Value Approach vs Residual Methods
Scenario A
A firm sells a TV with a three-year warranty for $2,000. The firm also sells the TV without a
warranty for $1,750. As an alternative to the firm’s warranty, a customer may purchase a
warranty from a competitor for $350
Using the relative fair value approach, when the TV is delivered the firm recognizes revenue
of 1750/(1750+350) * 2000 = $1,667. The revenues from the warranty are recognized either
straight line over the three years or proportional to the performance of the service.
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Dr Cash $2,000 (Assets ↑)
Cr Deferred Revenues $333 (Liabilities ↑)
Cr Revenues $1,667(Equity ↑)
Scenario B
In a slightly different example, a firm sells a TV with a three-year warranty for $2,000. The firm
does not sell the TV without a warranty. As an alternative to the firm’s warranty, a customer
may purchase a warranty from a competitor for $350.
Using the Residual Fair Value approach, when the TV is delivered the firm recognizes revenue
of 2000 – 350 = $1,650. The revenues from the warranty are recognized either straight line over
the three years or proportional to the performance of the service.
Dr Cash $2,000 (Assets ↑)

Cr Deferred Revenues $350 (Liabilities ↑)
Cr Revenues $1,650 (Equity ↑)
Scenario C
If the multiple unit sells for a different price than the combination of the individual units the
accounting recognition (revenue and therefore earnings) would not reflect the fundamental
economic transaction.
For example, a firm sells a TV with a three-year warranty for $2,000. The firm also sells the TV
without a warranty for $1,750. The firm also sells warranty, a customer may purchase a warranty
from a competitor for $350.
The firm’s calculations are as follows:

- The TV costs 1700 and is sold at a low margin
- The firm makes most of its profits from selling warranties, estimated to costs $100 to the firm
- The firm decides to lower the overall price of the warranty + TV when a customer purchases a
TV with warranty
When the TV is delivered, the firm recognizes the revenues from the TV based on the relative
fair value 350/(1750+350) * 2000 = $1,667. The firm will report a $33 loss from selling the TV.
Over time the firm will recognize a $233 profit from the sale of the warranty. Overall profit:
2000 – 1700 – 100 = 200 = 233 – 33.
In this example, discounts are reflected on profit margins not revenues.
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3.2 Customer Loyalty Program
For customer loyalty programs, company has the option to choose to recognize revenue using the
multiple-element model or incremental cost model.
Under the incremental cost model, revenue is recognized in full and the estimated cost of
fulfilling the awards is expensed and accrued.
Example: Customer Loyalty Program

A flight ticket is sold for $100 to a passenger who qualifies for free flight on the loyalty program.
Fair value of the ticket with no millage credit is $90. Fair value of the millage credit is $10. Cost
of fulfilling the credit is $5.
Multiple Element Model Incremental Cost Model

Revenue Now $90 $100
Expense Now - $5
Revenue Later $10 -
Expense Later $5 -
Under the multiple element model:

When the ticket is sold
Dr Cash $100
Cr Deferred Revenue $10
Cr Revenue $90
When points are redeemed

Dr Deferred Revenue $10
Cr Revenue $10
Dr Operating Expense $5
Cr Various assets $5
Under the incremental cost model:

When the ticket is sold
Dr Cash $100
Dr Operating Expense $5
Cr Sales $100
Cr Accrued Expense $5
4 Trading Revenue
Firms may opt to use of fair value to measure their financial assets/liabilities for trading
purposes. As a result, unrealized gains or losses will be recognized in the income statement for
trading investments. In establishing the fair value, SFAS No.157 provides the following fair
value hierarchy:

● Level 1 – observable inputs that reflect quoted market prices for identical assets or
liabilities in an active market. An example is publicly traded stock on an open market.
● Level 2 – observable inputs other than quoted market prices included within level 1 that
are observable either directly or indirectly. An example includes real estate property with
comparable listings.
● Level 3 – unobservable inputs reflect the reporting entity’s own assumptions about
market participant assumptions used in pricing an asset or liability. Examples include
private company stock that is not publicly traded on an open market, derivatives, or
impairment valuations.
The composition of financial instruments and the fair value level designations inform on the
quality of the fair value estimates and related unrealized gains and losses. In general, the quality
of fair values is higher for level 1 estimates, government-issued securities, and short-term
instruments.
Firms are required to provide relatively detailed information on level 3 unrealized gains and
losses. Unfortunately, no such disclosure is required for level 2 estimates, which are often as
subjective and problematic as level 3 estimates.
Unrealized gains/(losses) reflect current year changes in fair values, which in turn are affected by
measurement error and potential manipulation of the fair value estimates both in the current and
previous year. For example, if the previous year fair value estimates were understated and the
current estimates are correct, unrealized losses are understated.
5 Revenue Measurement
Possible measurement basis include:
- Cash sales: cash flow
- Open credit sales: undiscounted promised cash flows
- Credit sales with notes receivable (typically longer than one year): present value of
promised cash flows
- Sales in exchange for other assets or services: mostly fair value
- Gross vs net (depends on agency relation – see below)*
Revenues are reported net of actual and/or expected

- Discounts for prompt payment
- Returns
- Credits and Rebates
- Bad Debt Expense (limited cases)
See appendix A for examples of revenue deductions.

Gross vs Net Revenue*
This issue is particularly relevant for online retailing, advertisement transactions, mailing lists,
event tickets, travel tickets, auctions, magazine subscription brokers, catalog, consignment or
special order retail sales.
In deciding to report revenue using Gross or Net, first we need to establish whether the company
is an agent or principal. Even though the impact on net income is nil, the choice between gross
vs net has huge impact on reported revenue.
Primary indicator of principal is whether the entity is the primary obligor. Principal is the entity
who is originating the transaction, it must take on the risks of ownership, such as bearing the risk
of loss on product delivery, returns, and bad debts from customers. It must also obtain title to the
product being sold at some point during the sale transaction.
Primary Obligator – the primary obligator is the party responsible for providing the product or
service. The primary obligor is the party the customer will look to for fulfillment and for
ensuring its satisfaction.
Other indicators that the company is a principal include:

 The firm has general inventory risk
 The firm has the ability to establish selling price to the customer
 The firm changes the product or performs part of the service (adds value to the products
sold through alteration or added services, responsible for order fulfillment)
 The firm has discretion in supplier selection
 Credit risk for the amount billed
Indicators for net revenues

 The supplier is the primary obligator
 The amount the firm earns per transaction is fixed (dollars or percentages)
 The supplier has the credit risk
For consignment sales:

 The consignee does not record the merchandise on its books, when a sale occurs the
consignee recognizes the fee
 The consignor keeps the merchandise on its books until a sale occurs. Revenues are
usually the sales amount. The fee is usually a commission expense.
6 Quality Issues - revenue recognition and revenue measurement

There are potential issues with conditions that satisfy whether the transaction is realization and
earned.
– Persuasive evidence of an arrangement exists,

– Delivery has occurred or services have been rendered,
– The seller's price to the buyer is fixed or determinable, and
– Collectibility is reasonably assured.
Reported cases of manipulation of revenue recognition:

 Recognizing revenue when recourse obligation will nullify the sale
 Recognizing revenue without an agreement or customer acceptance
 Recognizing revenue when there is high uncertainty regarding cash collection
 Recognizing revenue when side agreements will nullify the sale
 Initiating bill and hold sales
 Recognizing revenue before delivery
 Rush to conclude many transactions before quarter end – improper sales cut-off
 Manipulating fair value estimates of revenue components in multiple element
transactions or ignoring some components
 Mischaracterizing revenue to accelerate its recognition (e.g., classify service
agreements as license sales)
 Manipulating unrealized gains and losses in mark-to-market revenues
 Inconsistent use of mark-to-market accounting
 Manipulating estimates of expected returns, discounts, rebates or other credits
 Manipulating terms of related party transaction and/or failing to disclose the nature of
related party transactions
 Recognizing revenue from “round tripping” transactions
 Reporting fictitious revenue
 Including gains or rebates in reported revenue
 Recognizing revenue from barter transactions with overstated value
 Manipulating the estimated fair value of assets or services received in noncash
transactions
 Manipulating the estimated value of unguaranteed residual value in sales-type leases
 Manipulating estimates of completion cost or progress under the percentage of
completion method
7 Ways to detect manipulations of revenue recognition

1. Gross Accounts Receivable/Sales
A high level or an increase in this ratio potentially suggests that revenue is overstated, the
company may be engaging in channel stuffing (note: accounts receivables may have to be
adjusted for securitization of receivables or for hidden or non-trade receivables)
Example: Channel Stuffing

A company approaches the end of year with the year to date revenue of $1,200. Its customers
are typically given 30 days credit, accordingly the balance of accounts receivable is $100.

To increase reported revenue (and earnings), the company ships $50 of additional
merchandise and reports it as revenue.
Normal ratio = 100/1200 = 0.083

Reported ratio when engaging in channel stuffing = 150/1250 = 0.12
To convert into days sales outstanding (DSO), simply multiply 365 by the Gross AR/Sales. A
high level or increase in DSO may suggest company granting extended payment terms to induce
sales. Note: If the AR has been factored/securitized, DSO will be deflated.
2. Unearned (deferred) Revenue/Sales or Order Backlog/Sales

- Low levels or decreases in these ratios may indicate revenue overstatement
- Understated ending balance implies recognition of future revenue; overstated beginning
balance implies recognition of past revenues
- To convert to days deferred revenue, simply multiply Unearned Revenue/Sales * 365.
- For an ongoing business with growing sales, we expect deferred revenue liability to grow
(as source of operating cash flow next period). Declining days deferred revenue may due
to a slowing overall business or improper draw down from this account to inflate sales.
3. Bill and Hold Sales/Sales

Revenue derived from related party transactions/Sales
Unbilled Receivables/Sales
- High levels or increases in these ratios may indicate revenue overstatement

- Commonly known as recognition of “soft” revenue
Example: Quality of Reported Revenue

Companies A & B are peer firms. Evaluate the quality of reported revenue.

In 2008, A had a large increase in Trade Receivables/Sales ratio and a large decline in Deferred Revenue/Sales ratio,
both suggesting that the company may be overstating its reported sales. In some cases, such changes could be due to
industry or economy-wide conditions rather than earnings management, but this alternative explanation is unlikely
since B did not experience similar changes in the ratios. A also had a decline in the allowance ratio, which is
consistent with an understatement of bad debt expense. The decline in the allowance ratio is relatively small, but the
increase in the receivables/sales ratio suggest that outstanding receivables at the end of 2008 are on average older
than at the end of 2007, which in turn implies that the allowance ratio should have increased not decreased (old
balances are more likely to be written off).
4. Additions or Deductions in Sales Return or Discount Reserves

- Companies may under-reserve for current sales or drawdown previously recorded
amounts
- When lower amount is deducted from gross sales to improve current period’s sales (and
earnings), when returns/discounts turn out to be higher in future period, the reserve will
have to be replenished (reducing sales and earnings) in future period.
- Schedule II of 10-K provides the breakdown of any sales return and discount reserves.
- Below please see the allowance for returns for Salix Pharmaceuticals. “Provision related
to prior period sales” represents amounts that were under-accrued that resulted in over-
stated revenues. “Deductions” may include reversals of previously recorded amounts that
increased the revenues in the current period.

5. Inventory/COGS
- A high level or increase in this ratio for customers for which the company is a major
vendor is often associated with company channel stuffing
- A high level or increase in this ratio may indicate “round tripping” transactions (inflated
inventory as a result of the round trip)
6. Change in revenue recognition policies

- Liberal return policies are often associated with channel stuffing
7. Gross Margin
A decrease in this ratio may indicate
- Revenue overstatement due to barter or agency transactions
- Sales pull-in activities that reduce sale prices and hence lower margin
8. Revenue/Gross Bookings (otherwise known as Revenue Margin)

- An increase in revenue margin concurrent with a decrease in gross margin may due to
revenue overstatement related to reporting gross versus net
9. Revenue Mix
- A high level or an increase in the relative magnitude of “soft revenues” may indicate
revenue overstatement
- Sources of “soft revenues” that are relatively easy to manipulate
o Percentage of completion income
o Mark-to-market income
- Changes in revenue mix may also indicate changes in revenue recognition from multiple
element arrangements
10. Growth in other receivables

- A high level or an increase may be signals of aggressive revenue recognition
11. Presence of related party transactions

- Historically, related party transactions have been linked to fictitious revenue recognition
involving other parties
12. Including one-time gains as revenue

Though this is not common, it has been done before. Prior to bankruptcy, General Motors (GM)
included a gain on sale of its defense business in revenues.
“Other Operations' total net sales and revenues include a pre-tax gain of approximately $814 million, or approximately
$505 million after-tax ($0.90 per diluted share), related to the sale of GM's Defense operations (light armored vehicle

business) to General Dynamics Corporation on March 1, 2003. The sale generated net proceeds of approximately $1.1
billion in cash.”
13. Quality of mark-to-market income (e.g., trading assets)

- Level 3 unrealized gains and losses
- Composition of instruments marked-to-market
- Reasonableness of the implied rates of return
8 Disclosure – Revenue Recognition
You will find typically find disclosure of the following information about an entity's revenue
recognition practices in the notes accompanying the financial statements:
Completed contract method: If this is used, the criteria used to determine contract completion, as
well as any departure from this policy.
Contract claims: The amounts of any revenue recognized from contract claims (amount in excess
of the agreed contract price)
Gross revenue: The gross transaction volume for those revenues reported net.
Incentive programs: The nature of any sales incentive programs and the amounts recognized in
the income statement for those programs.
Multiple-element arrangements: The nature of these arrangements and the significant

deliverables related to them, as well as the timing of delivery or performance. Also, their
performance, cancellation, termination, and refund provisions, as well as a discussion of the
factors used to determine selling prices, the timing of revenue recognition by unit of accounting,
the general timing of revenue recognition for significant units of accounting, and the effect of
changes in selling prices on the allocation of revenue to units of accounting.
Percentage of completion method: if this is used, the methods for measuring progress toward
completion, and also any departures from this policy.
Policies: The methods of determining revenue and the cost of earned revenue.
Revisions: The effect of estimate revisions, if material.
Shipping and handling: The classification of shipping and handling costs. (Typically, should not
be treated as a revenue deduction, should treat it as a SG&A)
Subsequent events: Any events occurring after the date of the financial statements that are
outside of the normal exposure and risk aspects of a contract.

9 Changes in accounting estimates, principles and error corrections
From time to time, a company will find that it must change its accounting to reflect a change in
accounting principle or estimate, or it may locate an accounting error that must be corrected.
Change in accounting estimate occurs when there is an adjustment to the carrying amount of an
asset or liability, or the subsequent accounting for it. Examples of changes in accounting
estimate include, changes in estimates for allowance for doubtful accounts, changes in the useful
life of depreciable assets, changes in the salvage values of depreciable assets, changes in the
amount of expected warranty obligations.
Since changes in accounting estimates occur relatively frequently, GAAP requires changes in
accounting estimates to be accounted for in the period of change and thereafter - accounted for
prospectively. No retrospective change is required or allowed. For example, if estimated
salvage value is increased by $50 and there are 5 years useful life remaining at the start of the
year. Depreciation for the current and next four years will be reduced by $10 each year using
straight line depreciation.
What is interesting is a prospective change to more aggressive revenue recognition can result in
substantially overstated revenue in the year of change.
Example: Change in Accounting Estimates
Timing of revenue recognition:

Old Method New Method
Year of Sale 50% 100%
(Contract signing)
Subsequent year 50% 0%
Assume:
(i) The accounting change is considered a change in estimate
(ii) The firm had $1,000 of new contracts two years prior to the year of change
(iii) Contract volume increases by $100 each year
Revenue is:
Old Method New Method Reported
Revenue
A year ago 500 + 550 = 1,050 1,100 1,050
The year of 550 +600 = 1,150 1,200 1,200+550 =
change 1,750
The following 600+650=1,250 1,300 1,300
year

Note: if the change is considered a change in accounting principle, reported revenue for the year
of change will be 1,200 and the comparative prior year numbers will be $1,100 a year ago and
$1,000 two years ago.
Change in accounting principle is a change from one accounting principle to another when
(i) The change is required by an update to GAAP, or
(ii) The use of an alternative principle is preferable.
Examples: a change from FIFO to average cost, a change from completed contracts to percentage
of completion.
A change in allowed only if it is required under a new standard or if the new principle is
preferable. A change in the method of applying an accounting principle also is considered a
change in accounting principle. An adoption or modification of an accounting principle due to
transactions or events that are either new or clearly different in substance from those previously
occurring is not considered a change in accounting principle.
Prior to 2006, cumulative effect of the change on equity as of the beginning of the year is
reported separately in income (below the income tax expense); prior year amounts are not
adjusted.
Since 2006, change in accounting principle is to be accounted retrospectively (similar to

restatement). The change is to be applied to prior accounting periods for comparative numbers
as if that principle had always been used. Steps include:
1. Alter the carrying amounts of assets and liabilities for the cumulative effect of the change in
principle as of the beginning of the first accounting period presented.
2. Adjust the beginning balance of retained earnings to offset the change noted in the first step.
3. Adjust the financial statements for each prior period presented to reflect the impact of the new
accounting principle.
If it is impracticable to make these changes, then do so as of the earliest reported periods for
which it is practicable to do so. Prospective approach can only be used if retrospective approach
is “impracticable”. It is considered impracticable to make a retrospective change when any of
the following conditions apply:
 Making a retrospective application calls for assumptions about what management
intended to do in prior periods, and those assumptions cannot be independently
substantiated.
 The company has made every reasonable effort to do so.
 Estimates are required, which are impossible to provide due to the lack of information
about the circumstances in the earlier periods.
Correction of an Error in Previously Issued Financial Statements


From time to time, firms may uncover error(s) in prior statements. When such an error is
discovered, the prior period statements to which the error applies must be restated. Restatement
requires steps similar to change in accounting principles applied retrospectively where financial
statements for each prior period are adjusted to reflect the impact of the error.
10 Pledging, Assigning and Factoring Receivables
Accounts Receivable (AR) are amounts due from customers for goods or services provided in the
normal course of business. Accounts receivable, open accounts, or trade accounts are
agreements by customers to pay for services rendered or merchandise received. Notes receivable
are formalized obligations evidenced by written promissory notes. Notes receivable generally
arise from cash advances but could result from sales of merchandise or the provision of services.
Reported Net Accounts Receivable is the difference between gross Accounts Receivable and
Allowance for Doubtful Accounts. Allowance for doubtful accounts can be estimated using:
● Percentage-of-sales method – the allowance is set as a percentage of overall sales
(Income Statement Approach)
● Percentage-of-Receivables method – the allowance is set as a percentage of overall
receivables (Balance Sheet Approach). It is common to use an aging schedule approach,
which assigns a higher allowance for older receivables.
A firm may use its accounts receivable as collateral for borrowings or by selling the receivables
outright. A wide variety of arrangements can be structured by the borrower and lender, but the
most common are pledging, assignment, and factoring.
Motivations for receivables-related funding include:

 Immediate cash needs
 The company is unwilling or unable to bear the cost of processing and collecting
receivables
 To reduce investment in working capital
 Loan covenants may preclude the company from borrowing
 To reduce perceived leverage and free up regulatory capital
 Earnings management (deliberate attempt to improve AR turnover or recognizing gains
from securitization)
Pledging Accounts receivable are used as collateral for loans. The customers whose accounts
have been pledged may not be aware of the pledge. Customer payments are still remitted to the
original entity to which the debt was owed. The accounts receivable, which remain assets of the
borrowing entity, continue to be shown as current assets in its financial statements but must be
identified as having been pledged.

Assignment Receivable assignment is a more formalized transfer of the receivables to the
lending institution. The lender selects specific receivables that it deems worthy as collateral.
Usually, customer payments are still remitted to the original entity to which the debt was owed.
Since the lender knows that not all the receivables will be collected on a timely basis by the
borrower, only a fraction of the face value of the receivables will be advanced as a loan to the
borrower.
Assigned accounts receivable remain on the balance sheet with appropriate disclosure of the
assignment similar to pledging. Prepaid finance charges would be recorded as a prepaid expense
and amortized to expense over the period to which the charges apply.
The borrower retains control of the receivables, and it is clear that the transaction is a secured
borrowing rather than a sale. If it is unclear whether the borrower has retained control of the
receivables, a determination must be made as to whether to account for the transfer as a sale or as
a secured borrowing (see factoring).
Example of disclosure for pledged receivables on the balance sheet:
Current assets:
Accounts receivable ($ 3,500,000 of which has been
pledged as collateral for bank loans), net of allowance
for doubtful accounts of $ 600,000 8,450,000
Current liabilities:
Bank loans payable (collateralized by pledged accounts receivable) 2,700,000
Factoring Accounts receivable factoring involves the outright sale of receivables. These
arrangements involve (1) notification to the customer to remit future payments to the factor
(finance company) and (2) the transfer of receivables to the factor without recourse to the
transferor. The factor assumes the risk of an inability to collect. Thus, once a factoring
arrangement is completed, the transferor has no further involvement with the accounts, except
for a return of merchandise. Receivables are sold and the difference between the cash received
and the carrying value is recognized as a gain or loss.
Recourse is the right of a transferee of a receivable to be paid by the transferor of the receivable
for the failure by a debtor to pay the receivable when due. A factoring arrangement can be done
with or without recourse.
Factored or securitized receivables are removed from the balance sheet if and only if the
company (transferor) has surrendered control over the receivables. Control is surrendered if all
following conditions are met:
1. The transferred asset has been isolated from the transferor. (Creditors no longer
have claim over the asset).

2. The transferees have obtained the right to pledge or exchange the asset (or the
interest on it)
3. The transferor does not maintain effective control over the transferred asset
through a repurchase agreement (repo)
These criteria may be satisfied even if the transferor “retains” (now known as “acquires”) some
interests, services the receivables or provides limited recourse.
Example: Factoring of Accounts Receivable with acquired interests
A company sells a pro rate nine-tenths interest (“participating interest”) in receivables with a
carrying amount of $1,020 for $910 cash. The company assumes a limited recourse obligation to
repurchase delinquent receivables. The estimated fair value of the recourse obligation is $10.
Dr Cash $910
Dr Loss on Securitization of AR (plug number) $18
Cr AR (net) $918*
Cr Recourse Obligation $10
*918 = 1,020 * 0.9
11. Interest Income on Receivables

If an entity has the contractual right to receive money on fixed or determinable dates that is
linked to a receivable, even if there is no stated provision in the associated contract for the
payment of interest, interest income must be recorded.
Imputed interest. To calculate interest income, interest rate at the date when the receivable is
created should be used. In many situations the interest rate commensurate with the risks
involved is the rate stated in the agreement between the payee and the debtor. However, if the
receivable is noninterest-bearing or if the rate stated in the agreement is not indicative of the
market rate for a debtor of similar creditworthiness under similar terms, interest is imputed at the
market rate.
Example: Interest Income on Receivables

A firm has difficulty collecting a receivable of $24,000 from a particular customer and agrees to
convert it in to a note, payable in $4,000 increments over six months. The note contains no
stated interest rate. The market rate is 6%.

Note: The discounted amount $23,586 of the note payments is less than the $24,000 amount of
the receivable by total interest of $414.
At the time of conversion
Dr Notes Receivable* $23,586

Dr SG&A Expense/Revenue Deduction $414
Cr Accounts Receivable $24,000
As each payment is received:
* Here, I have simplified it to one account. Typically the face value of $24,000 will be in Notes
Receivable accompanied by a contract account (i.e., some sort of valuation allowance account)
recording the negative $414.
Initial recording results in the recognition of an expense, typically (for customer receivables)
reported as selling expense or as a contra revenue item (sales discounts).
Interest income is recognized over the life of the agreement. Using the 1st payment as an
example:
Payment 1:
Dr Cash $4,000
Cr Notes Receivable $3,882
Cr Interest income $118
12. Quality Issues – reported AR
 Manipulation of allowances for uncollectible accounts, expected returns, discounts or

other credits
 Manipulation of the allowance for loan losses

 Distortion related to securitization or factoring of receivables
 using sale accounting inappropriately to hide receivables
 removing receivables from the balance sheet while retaining significant risk
 manipulating fair value estimates of acquired (formerly known as “retained”)
interests, servicing rights/obligations, or recourse obligations, thus the resulting
gain/loss, which in turn also results in overstatement of cash from operations and
understatement of accruals
 Overstated value of long-term receivables, especially if receivable-to-sales ratio is high,
time value of money is not accounted
 Aggregating allowances for non-AR credit losses with allowance for uncollectible
accounts
 Hiding receivables in “other assets”
 Reporting fictitious AR
13. Ways to detect manipulations in AR
1. Accounts Receivable/Sales
A high level or increase in this ratio may indicate revenue overstatement, inefficiencies or
difficulties in collecting receivables, high proportion of delinquent receivables
2. Significant securitization or factoring AR transactions

Beware if factoring results in material gains, retained interests, recourse obligations or
servicing rights or obligations
3. Delinquent (“past due”) Receivables/Accounts Receivable

Net Write-Offs/Sales
High levels or increases in these ratios may indicate low credit quality customers
4. Receivable-related Allowances/Gross Accounts Receivable

A low level or decrease in this ratio may indicate understatement of expected write-offs,
returns, or other credits, especially when receivables/sales is high or increasing
5. Allowance for Credit Losses/Delinquent Receivables

A low level or decrease in this ratio may indicate understatement of expected write-off
6. Bad Debt Expense/Net Write-Offs

A low level or decrease in this ratio may indicate understatement of expected write-offs. For
mature companies, this ratio should be close to one. As an illustration, take a look at HP’s
bade debt reserve disclosure. Identify signs of reserve draw down.

14. Disclosure – Accounts Receivables
You will typically find the following information about loans and trade receivables either on the
face of the financial statements or in the accompanying notes:
Allowances: The breakdown amount of the various loss allowances related to loans and
receivables.
Categories: The major categories of loans or trade receivables.
Collateral: The carrying amount of loans, trade receivables, standby letters of credit, securities
and financial instruments that is collateral for borrowings.
Impaired loans: The total period-end investment in impaired loans, the average such investment
during the period, the related interest income recognized during the period, and the policy for
recognizing interest income on impaired loans.
Loan credit losses: The activity in the allowance for credit losses related to loans, showing
beginning and ending balances and activity during the period.
Policies: The basis for accounting for the various types of receivables, as well as the methods for
determining the value of loans and recognizing related interest income.

Appendix A – Examples of Revenue Deductions
AMYLIN PHARMACEUTICALS INC (2008 10-K)
Revenue Recognition
We recognize revenue from the sale of our products when delivery has occurred, title has
transferred to the customer, the selling price is fixed or determinable, collectability is reasonably
assured and the Company has no further obligations. The Company records allowances for
product returns, rebates, wholesaler chargebacks, wholesaler discounts and prescription
vouchers. We are required to make significant judgments and estimates in determining some of
these allowances. If actual results differ from our estimates, we will be required to make
adjustments to these allowances in the future.
Product Returns
We do not offer our wholesale customers a general right of return. However, we will accept
returns of products that are damaged or defective when received by the wholesale customer or
for any unopened product during the period beginning six months prior to and up to 12 months
subsequent to its expiration date. We estimate product returns based on our historical returns
experience. Additionally, we consider several other factors in our estimation process including
our internal sales forecasts, the expiration dates of product shipped and third party data to assist
us in monitoring estimated channel inventory levels and prescription trends. Actual returns could
exceed our historical experience and our estimates of expected future returns due to factors such
as wholesaler and retailer stocking patterns and inventory levels and/or competitive changes. To
date actual returns have not differed materially from our estimates.
Rebates
Allowances for rebates include mandated discounts under the Medicaid Drug Rebate Program
and contracted discounts with commercial payors. Rebates are amounts owed after the final
dispensing of the product by a pharmacy to a benefit plan participant and are based upon
contractual agreements or legal requirements with private sector and public sector (e.g.
Medicaid) benefit providers. The allowance for rebates is based on contractual discount rates,
expected utilization under each contract and our estimate of the amount of inventory in the
distribution channel that will become subject to such rebates. Our estimates for expected
utilization for rebates are based on historical rebate claims and to a lesser extent third party
market research data. Rebates are generally invoiced and paid quarterly in arrears so that our
accrual consists of an estimate of the amount expected to be incurred for the current quarter's
activity, plus an accrual for prior quarters' unpaid rebates and an accrual for inventory in the
distribution channel.
Wholesaler Chargebacks
Wholesaler chargebacks are discounts that occur when contracted customers purchase directly
from an intermediary wholesale purchaser. Contracted customers, which currently consist

primarily of Federal government entities purchasing off the Federal Supply Schedule, generally
purchase the product at its contracted price, plus a mark-up from the wholesaler. The wholesaler,
in-turn, charges back to the Company the difference between the price initially paid by the
wholesaler and the contracted price paid to the wholesaler by the customer. The allowance for
wholesaler chargebacks is based on expected utilization of these programs and reported
wholesaler inventory levels. Actual rebates and wholesaler chargebacks could exceed historical
experience and our estimates of future participation in these programs. To date, actual rebate
claims and wholesaler chargebacks have not differed materially from our estimates.
Wholesaler Discounts
Wholesaler discounts consist of prompt payment discounts and distribution service fees. We
offer all of our wholesale customers a 2% prompt-pay discount within the first 30 days after the
date of the invoice. Distribution service fees arise from contractual agreements with certain of
our wholesale customers for distribution services they provide to us and are generally a fixed
percentage of their purchases of our products in a given period. Prompt payment discounts and
distribution service fees are recorded as a reduction to gross sales in the period the sales occur.
The allowance for wholesaler discounts is based upon actual data of product sales to wholesale
customers and not on estimates.
Prescription Vouchers
Prescription vouchers result in amounts owed to pharmacies that have redeemed vouchers for a
free prescription. We provide prescription vouchers to physicians, who in turn distribute them to
patients. Patients may redeem a voucher at a pharmacy for a free prescription. We reimburse the
pharmacy for the price it paid the wholesaler for the medicine and record this reimbursement as a
reduction to gross sales. The allowance for prescription vouchers is based on the number of
unredeemed vouchers in circulation, and the estimated utilization rate. The estimated utilization
rate is based on our historical utilization rates experience with prescription vouchers. The
allowance for prescription vouchers could exceed historical experience and our estimates of
future utilization rates. To date, actual prescription voucher utilization has not differed materially
from our estimates.

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Class Notes 04: Revenue and Accounts Receivables

In this document, we examine the followings:

An entity can record revenue when it meets all of the following:

2. Exceptions to recognizing revenue at the time of delivery

Revenue and expense measurement

Methods of assessing the percentage of completion:

2005 2006 2007 Total

Example: Percentage of Completion with change of estimate

2005 2006 2007 Total

2.2 Installment (collection) method

2.3 Cost recovery method

Example: Installment and Cost Recovery Method

(i) The installment method:

(ii) The cost recovery method:

2.4 Completed contract method

Example: Completed Contract Method

2005 2006 2007 Total

2.5 Revenue recognition before delivery

Essentially, these criteria define a commodity. Inventory is valued at market value.

3 Revenue from multiple element arrangements

3.1 Relative fair value approach

Example: Relative Fair Value Approach vs Residual Methods

Dr Cash $2,000 (Assets ↑)

The firm’s calculations are as follows:

In this example, discounts are reflected on profit margins not revenues.

Example: Customer Loyalty Program

Multiple Element Model Incremental Cost Model

Under the multiple element model:

When points are redeemed

Under the incremental cost model:

Revenues are reported net of actual and/or expected

Other indicators that the company is a principal include:

Indicators for net revenues

For consignment sales:

6 Quality Issues - revenue recognition and revenue measurement

Reported cases of manipulation of revenue recognition:

7 Ways to detect manipulations of revenue recognition

Example: Channel Stuffing

Normal ratio = 100/1200 = 0.083

2. Unearned (deferred) Revenue/Sales or Order Backlog/Sales

3. Bill and Hold Sales/Sales

- High levels or increases in these ratios may indicate revenue overstatement

Example: Quality of Reported Revenue

4. Additions or Deductions in Sales Return or Discount Reserves

6. Change in revenue recognition policies

8. Revenue/Gross Bookings (otherwise known as Revenue Margin)

10. Growth in other receivables

11. Presence of related party transactions

12. Including one-time gains as revenue

13. Quality of mark-to-market income (e.g., trading assets)

8 Disclosure – Revenue Recognition

Multiple-element arrangements: The nature of these arrangements and the significant

Revisions: The effect of estimate revisions, if material.

Example: Change in Accounting Estimates

Timing of revenue recognition:

Since 2006, change in accounting principle is to be accounted retrospectively (similar to

Correction of an Error in Previously Issued Financial Statements

10 Pledging, Assigning and Factoring Receivables

Motivations for receivables-related funding include:

Example of disclosure for pledged receivables on the balance sheet:

Example: Factoring of Accounts Receivable with acquired interests

11. Interest Income on Receivables

Example: Interest Income on Receivables