1. McGraw-Hill/Irwin Chapter 5 Revenue and Monetary Assets Copyright © 2011. The McGraw-Hill Companies. All Rights Reserved.

2. 5-2 Two Questions of Revenue Recognition 1.When should revenue be recognized (i.e., what accounting period)? 2.How much revenue should be recognized?

3. 5-3 Operating Cycle Convert materials into product Inspect product Purchase materials Store product Receive order from customer Ship product to customer Customer receives product Collect cash from customer For objectivity, revenue is recognized at a single point in this cycle.

4. 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. 5-5 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. Costs of transaction can be reliably measured.

6. 5-6 Revenue Recognition: SEC Persuasive evidence of an order. Delivery occurred or services performed. –Customer has assumed risks and rewards of ownership. Fixed or determinable selling price. Collectibility of sale is reasonably assured.

7. 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?

8. 5-8 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.

9. 5-9 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.

10. 5-10 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.

11. 5-11 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.

12. 5-12 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.

13. 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. Conservative variation is cost recovery method. –Cost of sales is recorded at an amount equal to installment payment (until total is recovered). –No income reported until cost is recovered.

14. 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. –Cumulative payments equal to at least 10% of purchase price. –Seller has completed or is clearly capable of completing required improvements (e.g., roads).

15. 5-15 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.

16. 5-16 Bad Debts: Direct Write-Off Method Write-off when specific uncollectible account is identified. What accounting concept is violated under this method?

17. 5-17 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.

18. 5-18 Business makes $10,000 of sales on credit. Estimates 3% of credit sales will be uncollectible. Bad Debt Expense + - DebitCredit Allowance for Doubtful Accounts DebitCredit - + Accounts Receivable DebitCredit + - $10,000 Sales Revenues - + DebitCredit $10,000 $300 Adjusting Entry Original Entries Bad Debts: Allowance Method

19. 5-19 Business determines that a customer who owes $75 will be unable to pay. Accounts Receivable DebitCredit + - $10,000 Allowance for Doubtful Accounts DebitCredit - + $300 $75 Write-off Entry Bad Debts: Allowance Method $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.

20. 5-20 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.

21. 5-21 Credit Card Sales  Bank plan (e.g., MasterCard, Visa).  Does not create accounts receivable.  Sales discount is credit card fee.  Credit plan (e.g., American Express, Discover).  Creates accounts receivable.  Sales discount is credit card fee.  No bad debts because card company assumes risk of loss.

22. 5-22 Sales Returns & Allowances  Estimate percentage of revenues that will eventually result in returns or allowances.  Conceptually similar to bad debt expense. similar to Sales Returns and Allowances Bad Debt Expense Provision for Returns and Allowances Allowance for Doubtful Accounts similar to

23. Sales Returns & Allowances  Alternative:  Skip adjusting entry.  Write off as they occur.  Why is this acceptable?  Materiality vs. matching. 5-23

24. 5-24 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.

25. Warranty Costs  Estimates usually based as a percentage of sales (similar to bad debt expense). 5-25 similar to Warranty Expense Bad Debt Expense Allowance for Warranties Allowance for Doubtful Accounts similar to  Allowance account is debited for actual expenditures.  Warranty expense is part of cost of sales.

26. 5-26 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.

27. 5-27 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.

28. 5-28 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).

29. 5-29 Cash Funds available for disbursement. May include highly liquid short-term investments (e.g., certificate of deposit).

30. 5-30 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).

31. 5-31 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.

32. 5-32 Accounting for Marketable Securities 1.Held-to-maturity securities.  Debt securities entity intends to hold to maturity.  Reported at cost. 2.Trading securities.  Debt or equity held for current resale.  Reported at market value.  Realized and unrealized gains/losses included in current year’s income.

33. 5-33 Accounting for Marketable Securities 3.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.

34. 5-34 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.

35. 5-35 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.

36. 5-36 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.