Chapter McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Revenue and Monetary Assets 5

5-2 Operating Cycle Cash-to-cash. –Receive cash from customer –Purchase materials/services & pay cash –Convert materials/services to salable product –Store product –Sell product –Receive cash from customer

5-3 Revenue recognition: When? (Timing) & How much? (Amount) At one point in revenue cycle (objectivity). Criteria: –When? Earned (Conservatism) Normally, goods shipped. Service performed. –How much? Realized or realizable (Realization). Already collected or collectible. Amount can be measured reliably. Next step: matching costs.

5-4 SEC SAB 101: Criteria for Revenue Realized & Earned Persuasive evidence of an order. Delivery occurred or services performed. Fixed or determinable selling price. Reasonably assured collectibility.

5-5 Delivery Method Recognize revenue when goods or services are delivered. For goods: when title transfers. –FOB shipping point (when goods are given to carrier). Examples: –Order is received for $900. Sales entry? –Goods are produced. Sales entry? –Goods are shipped. Sales entry?

5-6 Consignment Method Consignor ships goods to consignee. Inventory on consignment1,000 Merchandise inventory1,000  Consignor retains title until goods are sold to customer. At sale: Accounts receivable1,400 Sales revenue1,400 COGS1,000 Inventory on consignment 1,000

5-7 Franchise Revenue Recognize: –When earned. –Not necessarily when agreement signed or fee received.

5-8 Franchise Revenue First Example Ben & Jerry’s charges a franchise fee primarily for identifying the site, designing the store, training management and staff, and otherwise helping to get the franchise started in business. Assume the initial fee is $100,000. When should this $100,000 be recorded as revenue?

5-9 Franchise Revenue Second Example Lakers, Inc. receives $6,000 from a franchisee for the right to use its trademark and have access to its “know- how” for a period of 5 years. This know- how includes training sessions, and some one available to answer questions. When should the $6,000 be recognized as revenue?

5-10 Percentage-of-Completion Method Design/development and construction/production projects that extends over several years. Customer pays either fixed price or cost reimbursement contract. Reasonable assurance of profit margin and ultimate realization. Revenue recognized based on total percentage of project work performed during period.

5-11 Completed Contract Method Percentage of completion method required unless: –Amount of income to be earned on contract cannot reasonably be determined. Alternative is completed contract method. –Costs incurred are an asset/inventory (Contract Work in Progress) until revenue is recognized.

5-12 Production Method Applies to agricultural and mining. Criteria: –Clear market determined price. –Performance substantially complete. Minimal remaining costs. Permitted but not required by GAAP.

5-13 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. Under cost recovery method, cost is recorded equal to installment payment until total cost of sales is covered.

5-14 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. –Cum payments equal to 10% of purchase price. –Seller has completed or is clearly capable of completing required improvement.

5-15 Amount of Revenue Recognized Net realizable value (amount reasonably estimated to be collected). 2 approaches: –Direct write-off method. –Allowance method. % of sales. % of (analysis of) AR.

5-16 Bad Debts Direct Write-Off Method Write-off when specific account that is uncollectible is identified. Why is this not acceptable under GAAP?

5-17 Allowance Method Estimate amount of current period credit sales that will not be collected. –Historical % of sales tempered by judgment. –Historical % of aged receivables (+ judgment). Adjusting entry at end of period.  When an uncollectible account is identified, it is written off.

5-18 First Bad Debt Exercise Amount of revenue recognized: –Sales for the year were $2,000 for cash and $6,000 on credit. –Historically we don’t collect about 5% of our credit sales due to customer bankruptcies or unable to locate customer. –A customer, The XYZ Company went bankrupt. They owed us $175. Entry for revenue? Entry for bad debts - direct write-off (not- GAAP)? Entries for bad debts (allowance method)?

5-19 Second Bad Debt Exercise Balances in Accounts –Accounts receivable dr 3,000. Consisting of 2,000 current and 1,000 overdue. –Allowance for doubtful accounts cr 50. Estimated amount of accounts that are uncollectible: –2% for current and 10% for non-current accounts. What entry do we make at the end of the year to accrue for bad debts?

5-20 Allowance Method (continued)  Allowance… is a contra-asset account.  Collection of a bad debt that was written- off:  Cash  Allowance for Doubtful Accounts

5-21 Sales Discounts Sales terms are “2/10 net 30” –Customer gets 2% cash discount if paid within 10 days. –Otherwise, total amount is due within 30 days. What does “1/15 net 45” mean? What is the effective annual rate of savings by taking advantage of terms of “2/10 net 30”?

5-22 Alternative methods of accounting for sales discounts Record initial sale at gross. –At collection of net amount record discount as a reduction from gross sales. Record initial sale at gross. –At collection of net amount record discount as an expense of the period. Record initial sale at net. –Record amounts not taken as discounts as additional revenue.

5-23 Sales Discount Exercise We sold $10,000 of mdse. Sales terms are 2/10, n/30. Customers paid us for $8,000 of the merchandise billed within 10 days. The remaining $2,000 was paid within 30 days. –Record at gross. –Record at net.

5-24 Credit Card Sales  If cash received by merchant immediately (Bank plan, MC, Visa): Cash970 Sales discount30 Sales revenue1000

5-25 Credit Card Sales (continued)  If cash received by merchant in 30 days (American Express, Discover): Accounts receivable970 Sales discount30 Sales revenue1000

5-26 Sales Returns & Allowances  Similar to bad debt expense,  Estimate percentage of revenues that will eventually result in returns or allowances.  Adjusting entry at end of period.  Actual return or allowance.

5-27 Sales Return Exercise  On average 2% of our $10,000 of sales is returned. Adjusting entry at end of period?  Entry for return of $80 of goods?  Same for direct write-off method?

5-28 Sales Returns & Allowances (Continued)  Provision for Returns and Allowances is a liability account.  Alternative:  Not accrue for returns and allowances but write them off as they occur.  Is this GAAP?

5-29 Adjustment vs. expense Realization concept suggests adjustment to revenue.  In practice both methods are found.  Consistency:  Same handling from year to year.  Allows same company results to be compared from year to year.  Comparisons between companies may be distorted.

5-30 Warranty Costs  Amounts are estimated (usually as a percentage of sales).  Part of Cost of goods sold.  Record accrual (adjusting entry)  Record the actual expenditures.  Allowance… is a liability account. Estimated warranty expense is part of costs of sales.

5-31 Warranty Expenses Exercise We estimate that warranty expenses will be 4% of our $10,000 of sales. Entry? We spent $120 on parts and $250 on labor for repairs under warranty. Entry?

5-32 Interest Revenue Amount earned by lender during the period. 2 approaches –Interest paid at maturity. Interest is explicit. –Discounted loan. Interest is implicit. Accounted for separately from sale.

5-33 Exercise: Interest Revenue On January 1, 19x1 sold a customer $1,000 of mdse. We received a promissory note for $1,000 plus 8% interest to be paid in one year. –Entry for sale? –Entry for accrual of interest on December 31, 19x1? –Entry for receipt of payment on note on January 1, 19x2? On January 1, 19x1, we sold mdse. and received a promissory note for $5,000 with no interest. The note is due in one year. The market rate of interest on such a note is 9%. –Entry at sale: –Year end adjusting entry (12/31/19x1) –Entry when customer pays note (1/1/19x2)

5-34 Monetary& Non-monetary Assets  Monetary assets are money or claims to receive fixed sums of money.  Non-monetary assets are items used in future production and sales of goods and services.  Balance sheet distinction  Current and non-current assets.  Not monetary and non-monetary.  Non-monetary assets (except inventory) on BS at unexpired cost. (Cost less depreciation)  Monetary assets: Cash reported at face. AR at NRV. Other at fair value.

5-35 Cash Funds available for disbursement. May include liquid short term investments. –Highly liquid debt instruments with original maturities of 90 days or less.

5-36 Receivables Trade receivables –Accounts receivables from usual sales of products or services for non-financial institutions.  Other receivables are shown separately.  E.g. due from employees, advances or loans.

5-37 Marketable Securities  Must be marketable.  E.g. commercial paper, treasury bills, publicly traded stocks and bonds issued by companies.  Also called “Temporary Investments.”

5-38 Accounting for Marketable Securities  Three categories  Held-to-maturity: debt securities,  Valued at cost.  Trading securities: debt or equity held for current resale, valued at market.  Realized (i.e. if sold during period) and unrealized (not yet sold but market price has changed) gain or loss included in current year’s income.

5-39 Accounting for Marketable Securities (Continued)  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.

5-40 Analysis of Monetary Assets  Current ratio = CA/CL  Acid-test ratio = quick ratio = monetary CA/CL= (CA - inventories - prepaid items) /CL.  Days cash = cash/(annual cash expenses  365)  Cash expenses  total expenses - depreciation.  Days receivable = average collection period = Receivables/(Sales  365)  Ratios differ by industry.

Chapter McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. End of Chapter 5 5