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Chapter 5

Revenue and
Monetary Assets

McGraw-Hill/Irwin Copyright © 2011. The McGraw-Hill Companies. All Rights Reserved.


Two Questions of
Revenue Recognition
1. When should revenue be recognized
(i.e., what accounting period)?
2. How much revenue should be
recognized?

5-2
Operating Cycle
Collect cash
Customer from
receives customer Purchase
product materials

Ship For objectivity, revenue Convert


product to is recognized at a single materials
customer into product
point in this cycle.

Receive Inspect
order from product
customer Store
product
5-3
The Current Environment
Revenue Recognition Classified by Nature of Transaction

Type of Sale of asset


Sale of product Rendering a Permitting use
Transaction other than
from inventory service of an asset
inventory

Description Revenue from Revenue from Gain or loss on


Revenue from
of Revenue fees or services interest, rents, disposition
sales
and royalties

Timing of Date of sale Services As time passes


Date of sale or
Revenue (date of performed and or assets are
trade-in
Recognition delivery) billable used

5-4
Revenue Recognition: GAAP

• Criteria:
– When?
• Substantial performance.
• Conservatism concept.
– How much?
• Revenue and expenses can
be reliably measured (i.e.,
collected or collectible).
• Realization concept (i.e.,
realized or realizable).

5-5
Revenue Recognition: IFRS

• Risks and rewards of


ownership are
transferred to buyer.
• Seller no longer has
managerial involvement.
• Amount of revenue can
be reliably measured.
• Probable that seller will
receive revenue.

5-6
Revenue Recognition: SEC
• Persuasive evidence of
an order.
• Delivery completed or
services performed.
– Customer has assumed
risks and rewards of
ownership.
• Price can be determined.
• Collectibility of sale is
reasonably assured.

5-7
Delivery Method
• Most common.
• Recognize revenue when
goods or services are
delivered.
• When should revenue be
recognized?
– Auto repair shop?
– Prepaid hotel room?
– Dealer sold auto to
customer on monthly
payment (installment)
plan?
5-8
Revenue Recognition at Point of Sale
Illustration 18-3

The journal entry to record SEK’s sale to Grant Company on


July 1, 2011, is as follows (ignoring cost of goods sold entry).

Notes receivable 900,000


Sales 900,000
Revenue Recognition at Point of Sale

SEK makes the following entry to record interest revenue.

Notes receivable 54,000


Interest revenue (12% x ½ x €900,000) 54,000
Revenue Recognition at Point of Sale

Bill and Hold Sales


Buyer is not yet ready to take delivery but does take title and
accept billing.

Illustration 18-4
Revenue Recognition at Point of Sale

Solution: Butler should record the revenue at the time title


passes, provided
1. it is probable that delivery will be made;
2. the item is on hand, identified, and ready for delivery at
the time the sale is recognized;
3. Baristo acknowledges the deferred delivery arrangement;
and
4. the usual payment terms apply.

It appears that these conditions were probably met and


therefore revenue recognition should be permitted at the time
the agreement is signed.
LO 2
Revenue Recognition at Point of Sale

Illustration 18-4

Butler makes the following entry to record the bill and hold sale.

Accounts receivable 450,000


Sales 450,000
Revenue Recognition at Point of Sale

Sales Subject to Installation or Inspection


Illustration 18-5
Revenue Recognition at Point of Sale

Layaway Sales
Illustration 18-6
Revenue Recognition at
Point of Sale
Sales with Right of Return
Two possible revenue recognition methods are available when
the right of return exposes the seller to continued risks of
ownership:

1. not recording a sale until all return privileges have expired


or

2. recording the sale, but reducing sales by an estimate of


future returns.
Revenue Recognition at Point of Sale

Illustration 18-7
Revenue Recognition at Point of Sale

Pesido sold $300,000 of laser equipment on August 1, 2011, and


retains only an insignificant risk of ownership. On October 15,
2011, $10,000 in equipment was returned.

August 1, 2011
Accounts receivable 300,000
Sales 300,000
October 15, 2011
Sales returns and allowances 10,000
Accounts receivable 10,000

LO 2
Revenue Recognition at Point of Sale

At December 31, 2011, based on prior experience, Pesido


estimates that returns on the remaining balance will be 4 percent.
Pesido makes the following entry to record the expected returns.

December 31, 2011


Sales returns and allowances 11,600
Allowance for sales returns and allowances 11,600

[($300,000 - $10,000) x 4% = 11,600]


Revenue Recognition at Point of Sale

Illustration 18-8
Revenue Recognition at Point of Sale

Illustration 18-8

Morgan records the sale and related cost of goods sold as follows.

Cash 135,000
Sales 135,000
Cost of Goods Sold 115,000
Inventory 115,000
Consignment Method
• Consignor ships goods to consignee (but
retains title until they are sold).
• Consignee attempts to sell goods.
• Revenue recognized when goods are sold.
• Why? Risks (and rewards) of ownership are
not yet transferred.

5-22
Consignment Method

5-23
Franchise Revenue

• Permits franchisee to use


name/product of
franchisor.
• Recognize when earned.
– Not necessarily when
agreement signed or fee
received.
– Usually after franchisee
commences operations.

5-24
Percentage-of-Completion Method

• Design/development and
construction/ production
projects that extends over
several years (e.g., high-rise
building, aircraft).
• Could be either fixed price
or cost reimbursement
contract.
• Need reasonable assurance
of profit margin and
ultimate realization.
• Revenue recognized based
on total percentage of
project work performed
during period.
5-25
Long-Term Contracts (Construction)

Illustration: KC Construction Company has a contract to


construct a €4,500,000 bridge at an estimated cost of
€4,000,000. The contract is to start in July 2010, and the
bridge is to be completed in October 2012. The following data
pertain to the construction period.
Long-Term Contracts (Construction)

Illustration: Compute percentage complete.


Illustration 18-6
Long-Term Contracts (Construction)

Percentage-of-Completion, Revenue and Gross Profit, by Year


Illustration 18-16
Completed Contract Method

• Alternative to
percentage-of-
completion.
• Used when amount of
income to be earned on
contract cannot be
reliably estimated.
• Costs incurred are held as
an asset (i.e., Contract
Work in Progress) until
revenue is recognized.

5-29
Production Method
• Permitted, but not
required by GAAP.
• Applies to certain
agricultural and mining
products.
• Recognize revenue at
harvest.
– Clear market determined
price.
– Performance substantially
complete.

5-30
Installment Method

• Customer pays a certain amount per


period.
• Installment payment is recognized as
revenue and a proportional part of
cost of sales is recorded.

5-31
Real Estate Sales
• Developer often finances over many years.
• Uncertainty of income due to uncertainty of
receipt of future payments.
• Conditions required for revenue recognition:
– Period allowing cancellation and refund to buyer
has expired.
– Cumulative payments equal to at least 10% of
purchase price.
– Seller has completed or is clearly capable of
completing required improvements (e.g., roads).
5-32
Amount of Revenue Recognized
• Net realizable value.
– Amount reasonably estimated to be collected.
• Adjustment for bad debts.
– Direct write-off method.
– Allowance method.
• % of sales.
• % of (analysis of) accounts receivable.

5-33
Bad Debts:
Direct Write-Off Method
• Write-off when
specific
uncollectible
account is
identified.
• What accounting
concept is violated
under this method?
5-34
Bad Debts:
Allowance Method
• Estimate amount of current period credit
sales that will not be collected.
– % of credit sales, or
– Aging accounts receivables (i.e., use higher
uncollectible % on older receivables).
– Percentages based on experience and
judgment.

5-35
Bad Debts:
Allowance Method
• Business makes $10,000 of sales on credit.
Estimates 3% of credit sales will be uncollectible.
Accounts Receivable Sales Revenues
Debit Credit Debit Credit
Original
Entries
+ - - +
$10,000 $10,000

Allowance for
Bad Debt Expense Doubtful Accounts

Adjusting Debit Credit Debit Credit


Entry + - - +
$300 $300
5-36
Bad Debts:
Allowance Method
• Business determines that a customer who owes $75
will be unable to pay.
Allowance for
Doubtful Accounts Accounts Receivable
Debit Credit Debit Credit
Write-off
Entry
- + + -
$75 $300 $10,000 $75

• Allowance for Doubtful Accounts → contra-asset


account.
• Collection of a bad debt previously written-off:
• Debit Cash and credit (reinstate) the Allowance for
Doubtful Accounts. 5-37
Revenue Recognition at Point of Sale
Revenue Recognition at Point of Sale

Illustration 18-2

Sansung makes the following entry on March 31, 2011.


Accounts receivable 679,000
Sales 679,000
Sales Discounts
• Cash discount to induce customers to pay bills quickly.
– E.g., “2/10 net 30” (i.e., customer gets 2% cash discount if
paid within 10. Otherwise, total amount is due within 30
days.).
• Methods of recording:
– As reduction from gross sales.
– As expense of the period.
– Record initial sale at net; discounts not taken recorded as
additional revenue.

5-40
Credit Card Sales
 Bank plan (e.g.,  Credit plan (e.g., American
MasterCard, Visa). Express, Discover).
 Does not create  Creates accounts
accounts receivable. receivable.
 Sales discount is credit  Sales discount is credit
card fee. card fee.
 No bad debts because
card company assumes
risk of loss.

5-41
Sales Returns & Allowances

 Estimate percentage of revenues that will


eventually result in returns or allowances.
 Conceptually similar to bad debt expense.

Sales Returns Bad Debt


similar to
and Allowances Expense

Provision for Allowance for


Returns and similar to Doubtful
Allowances Accounts
5-42
Sales Returns & Allowances

 Alternative:
 Skip adjusting
entry.
 Write off as they
occur.
 Why is this
acceptable?
 Materiality vs.
matching. 5-43
Adjustment to Revenue vs. Expense

• Realization concept suggests adjustment to


revenue.
• In practice both methods are found.
– Creates differences in revenue and gross
margin, but not income.
– But must follow consistency concept (i.e., same
handling from year-to-year).
 Allows same company results to be compared from
year-to-year.
 But comparisons between companies may be
distorted.

5-44
Interest Revenue

• Amount earned by lender during


the period.
• Interest paid at maturity.
• Creates interest earned, but not yet paid.
• Adjusting entry:
• Debit Interest Receivable.
• Credit Interest Revenue.
• Interest Receivable account is zeroed out when
loan and interest is paid off.

5-45
Interest Revenue

• Discounted loan.
• Interest is implicit.
• Creates liability account (i.e.,
Unearned Interest Revenue)
when loan is made.
• Adjusting entry:
• Debit Unearned Interest
Revenue.
• Credit Interest Revenue.

5-46
Monetary vs. Nonmonetary
Assets
 Monetary assets.
 Money or claims to receive fixed sums of money.
 Appear on balance sheet at “value.”
 Cash; face value.
 Accounts receivable; estimated realizable value.
 Marketable securities; fair value.
 Non-monetary assets.
 Items used in future production and sales of
goods and services.
 Appear on balance sheet at unexpired cost (i.e.,
book value).

5-47
Cash

• Funds available for


disbursement.
• May include highly
liquid short-term
investments (e.g.,
certificate of
deposit).

5-48
Receivables

• Accounts receivables.
– Called trade receivables for nonfinancial
institutions.
 Other receivables.
 E.g., advances or loans to employees for
travel expenses.
 Shown separately (e.g., Due from
Employees).
5-49
Factoring

Sales
Sales of
of Receivables
Receivables
Factors are finance companies or banks that buy receivables from
businesses for a fee.
Illustration 7-19

7-81 LO 8 Understand special topics related to receivables.

5-50
SalesFactoring
of Receivables
Illustration: Crest Textiles, Inc. factors €500,000 of accounts
receivable with Commercial Factors, Inc., on a non-guarantee (or
without recourse) basis. Commercial Factors assesses a finance
charge of 3 percent of the amount of accounts receivable and retains
an amount equal to 5 percent of the accounts receivable (for probable
adjustments). Crest Textiles and Commercial Factors make the
following journal entries for the receivables transferred without
recourse.

5-51
Sales of Receivables
Sale with Guarantee
Seller guarantees payment to purchaser.

Transfer is considered a borrowing—sometimes referred to


as a failed sale.

Assume Crest Textiles sold the receivables on a with guarantee basis.


Illustration 7-21

5-52
Summary of Transfers
Factoring

Determining whether receivables that are transferred can be derecognized and


accounted for as a sale is based on an evaluation of whether the seller has
transferred substantially all the risks and rewards of ownership of the financial asset.
5-53
Marketable Securities

 Also called “Temporary


Investments.”
 Must be marketable (i.e.,
able to readily sell).
 E.g., commercial paper,
treasury bills, publicly
traded stocks and bonds
issued by companies.
5-54
Accounting for Marketable Securities

11. Held-to-maturity securities.


 Debt securities entity intends to hold to maturity.
 Reported at cost.

H2. Trading Securities.


 Debt or equity held for current resale.
 Reported at market value.
 Realized and unrealized gains/losses included in
current year’s income.

5-55
Accounting for Marketable Securities

33. Available-for-sale securities.


 Debt or equity securities that do not fit either of
the other two categories.
 Reported at market value.
 Realized gains and losses go through current
period’s income.
 Unrealized gains (losses) are credited (debited) to
stockholders’ equity account.

5-56
Accounting for Marketable Securities

 Available-for-sale securities:
 Debt or equity securities that do not fit
either of the other 2 categories.
 Reported at market value.
 Realized gains and losses go through
income.
 Unrealized gains and losses directly
credited (or debited) to a stockholders’
equity account. 5-57
Analysis of Monetary Assets
 Current ratio.
 Current assets ÷ Current liabilities.
 Measures liquidity; margin of safety.
 Need to also look at make up of assets (e.g.,
cash vs. inventory).
 Acid-test ratio.
 Monetary current assets ÷ Current liabilities.
 Excludes inventories and prepaid items.

5-58
Analysis of Monetary Assets
 Days’ cash.
 Cash ÷ (Cash expenses  365).
 Rough approximation of cash expenses is total
expenses minus noncash expenses (e.g.,
depreciation).
 Shows how well company is managing cash.
 Days’ receivables.
 Also called collection period.
 Accounts receivable ÷ (Sales ÷ 365).
 If available, use credit sales.
 General rule: Should not exceed 133% of payment
terms.

5-59
Thank you

5-60

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