Chapter 4--Learning Objectives 4 1.Understand the concept of recognition

Recognition 4 Recognition is the process of formally recording or incorporating an item into the financial statements of an entity 4 ex. Area development fees

Recognition includes 4 depiction of an item in both words and numbers, with the amount included in the totals of the financial statements 4 not the footnotes

Accounting recognition must 4 Identify and measure 4 events, transactions and circumstances 4 that should be captured 4 in the accounting information system

Chapter 4--Learning Objectives 4 2.Interpret the recognition criteria for assets and liabilities

To be included, an item must Possess the characteristics of an element of the financial statements Asset Liability Revenue Expense Gain Loss

To be included, an item must Be measurable, relevant and reliable

Cash versus accrual based accounting 4 Cash receipts and disbursements are recognized when they occur 4 and in CASH BASED accounting 4 revenues and expenses are recognized when the cash changes hands

Cash versus accrual based accounting 4 In accrual based accounting, changes in financial statement elements are recorded in the period in which the events occur 4 rather than when the cash changes hands

An event should be recognized when four criteria are met: 4 1.The item must meet the definition of an asset or a liability 4 2.The item must be relevant 4 3.The item must be reliable 4 4.The item must be measurable

Chapter 4--Learning Objectives 4 3.Interpret the recognition criteria for revenues

Revenues 4 Inflows or enhancements of assets 4 (or settlement of liabilities) 4 from delivering goods or providing services 4 in the entity’s ongoing major or central operations

To be recognized... 4 Revenues must be: 4 1.Realized or realizable 4 2.Earned

Realized 4 Products or services are exchanged for cash or claims to cash 4 Realizable 4 When related assets received or held are readily convertible to known amounts of cash or claims to cash

Revenues are EARNED

4 when the entity has substantially completed

Revenues are EARNED 4 when the entity has substantially completed what it must do to be entitled to the benefits

Revenues are EARNED 4 when the entity has substantially completed what it must do to be entitled to the benefits represented by the revenues

The value-adding process (a black box) 4 The inputs include: ? Material Labor Capital

The value-adding process (a black box) 4 At the end of the process 4 the product is sold 4 and cash is received ? Product

Conservatism 4 Recognize losses as incurred 4 Recognize Revenues when realized or realizable

Chapter 4--Learning Objectives 4 4.Apply various revenue recognition points to appropriate situations

Revenue recognition points

Time of sale 4 Usually operationalized as time of delivery 4 Change in ownership--transfer of title

At production or delivery 4 If sale and cash receipt precedes production and delivery, revenue is recognized at the point of production and / or delivery 4 ex. Airline tickets 4 ex. commodities

During production 4 If product is contracted before production, collection is probable, and production requires an extended period of time 4 ex. building

As the service is rendered 4 If contracted for in advance for continuously rendered services 4 ex. rent

When asset prices change 4 For assets which are readily salable without significant effort, revenues may be recognized at completion of production or when the prices of the assets change 4 ex. Net realizable value of farm products

At the point of exchange 4 If products or services are exchanged for nonmonetary assets not readily convertible to cash, revenue may be recognized at the time of exchange if fair market values are determinable

Cycle completion 4 If collection of receivables is doubtful, revenues are deferred and recognized based on cash received

When right of return expires 4 If significant returns are likely (such as with college textbooks) revenue is recognized when the goods can no longer be returned

Percentage-of-completion revenue recognition 4 1.Determine costs incurred to date 4 2.Estimate costs to complete 4 3.Calculate percentage complete 4 4.Apply percentage to projected 4 profit 4 5.Subtract previously recognized 4 profit

Long-term project example 4 Contract price is $10,000,000 4 Original estimated cost is $9,000,000 4 Actual first year costs are $2,000,000 4 Estimated cost to complete at end of first year is $7,000,000 4 Portion completed is: 4 $2,000,000 4 $9,000,000 =

Long-term project--year 1 4 Estimated total profit is $1,000,000 4 (contract price less est. total cost) 4 Profit to recognize is $222,222 4 ($1,000,000 x )

Long-term project--year 2 4 Total costs incurred are $6,500,000 4 Est. cost to complete is $2,700,000 4 Completion portion is ($6,500,000 / $9,200,000) 4 Estimated total profit is $800,000 4 Profit recognizable is $565,217 4 Previous profit is $222,222 4 Year 2 profit is $342,995

Long-term project--year 3 4 Total costs incurred are $9,300,000 4 Project is complete 4 Total profit is $700,000 4 Previous profit is $565,217 4 Year 3 profit is $134,783

Additional project features 4 Progress billings for first year are $1,000,000 4 Cash collections are $700,000 4 “Construction in Progress (CIP)” is treated as an inventory account 4 “Billings on Construction” is treated as a contra account to CIP 4 If “Billings” exceed CIP, the accounts become a liability

Project entries--year 1 4 Const. in Progress2,000,000 4 Cash, etc.2,000,000 4 Accts. Receivable1,000,000 4 Billings on Const.1,000,000 4 Cash700,000 4 Accts. Receivable700,000 4 Const. in Progress222,222 4 Cost of C I P2,000,000 4 Const. Revenue2,222,222

Year 2 project features 4 Additional project billings are $5,000,000 4 Total billings at year end are $6,000,000 4 Additional cash collections are $3,300,000 4 Total collections at year end are $4,000,000

Project entries--year 2 4 Const. in Progress4,500,000 4 Cash, etc.4,500,000 4 Accts. Receivable5,000,000 4 Billings on Const.5,000,000 4 Cash3,300,000 4 Accts. Receivable3,300,000 4 Const. in Progress342,995 4 Cost of C I P4,500,000 4 Const. Revenue4,842,995

Year 3 project features 4 Project is completed during year 4 Additional project billings are $4,000,000 4 Total billings at year end are $10,000,000 (contract price) 4 Additional cash collections are $6,000,000 4 Total collections at year end are $10,000,000

Project entries--year 3 4 Const. in Progress2,800,000 4 Cash, etc.2,800,000 4 Accts. Receivable4,000,000 4 Billings on Const.4,000,000 4 Cash6,000,000 4 Accts. Receivable6,000,000 4 Const. in Progress134,783 4 Cost of C I P2,800,000 4 Const. Revenue2,934,783

A final entry--year 3 4 Billings on Const.10,000,000 4 Const. in Progress10,000,000 4 Closes out the inventory account and the related contra account

Installment Sale 4 42 $3,600 4 $300 per month plus 12% 4 Cost $1800

Installment Sale (cont.) Accounts Receivable151,200 Inventory75,600 Deferred Installment Revenue75,600

Installment Sale (cont.) Cash336 Interest Revenue 36 Accounts Receivable 300 Deferred Installment Revenue150 Installment Revenue 150

Chapter 4--Learning Objectives 4 5.Understand the concepts of income and capital maintenance

Comprehensive income The change in equity of a business during a period from transactions and other events from non-owner sources

Maintenance of capital 4 Need to separate 4 Return on capital 4 from 4 Return of capital

Chapter Objectives 4 Understand the concept of recognition 4 Interpret the recognition criteria for assets and liabilities 4 Interpret the recognition criteria for revenues 4 Apply various revenue-recognition points to appropriate situations. 4 Understand the concepts of income and capital maintenance.