Chapter 5Chapter 5

Revenue and Monetary Revenue and Monetary AssetsAssets

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved.

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Operating CycleOperating Cycle

Cash-to-cash.Cash-to-cash. Receive cash from customerReceive cash from customer Purchase materials/services & pay cashPurchase materials/services & pay cash Convert materials/services to salable productConvert materials/services to salable product Store productStore product Sell productSell product Receive cash from customerReceive cash from customer

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Revenue Recognition: Revenue Recognition: When? (Timing) & How much? (Amt.)When? (Timing) & How much? (Amt.)

At one point in revenue cycle (objectivity).At one point in revenue cycle (objectivity). Criteria:Criteria:

When? Earned (Conservatism)When? Earned (Conservatism)• Normally, goods shipped.Normally, goods shipped.• Service performed.Service performed.

How much? Realized or realizable (Realization).How much? Realized or realizable (Realization).• Already collected or collectible.Already collected or collectible.• Amount can be measured reliably.Amount can be measured reliably.

Next step: matching costs.Next step: matching costs.

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Basic Revenue Recognition CriteriaBasic Revenue Recognition Criteria

Recognize revenue in earliest period in Recognize revenue in earliest period in which:which: Entity has substantially performed what is Entity has substantially performed what is

required in order to earn income andrequired in order to earn income and Amount of income can be reliably measured.Amount of income can be reliably measured.

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Delivery MethodDelivery Method

Recognize revenue when goods or Recognize revenue when goods or services are delivered.services are delivered.

For goods: when title transfers.For goods: when title transfers. FOB shipping point (when goods are given to FOB shipping point (when goods are given to

carrier).carrier). Example 1:Example 1:

Order is received for $900. Sales entry?Order is received for $900. Sales entry? Goods are produced. Sales entry?Goods are produced. Sales entry? Goods are shipped. Sales entry?Goods are shipped. Sales entry?

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Consignment MethodConsignment Method

Consignor ships goods to consignee.Consignor ships goods to consignee.• Inventory on consignmentInventory on consignment 1,0001,000

• Merchandise inventoryMerchandise inventory 1,0001,000

Consignor retains title until goods are Consignor retains title until goods are sold to customer. At sale:sold to customer. At sale:

• Accounts receivableAccounts receivable 1,4001,400

• Sales revenueSales revenue 1,4001,400

• COGSCOGS 1,0001,000

• Inventory on consignment Inventory on consignment 1,0001,000

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Franchise RevenueFranchise Revenue

Recognize:Recognize: When earned. When earned. Not when agreement signed or fee Not when agreement signed or fee

received.received.

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Franchise Revenue First Franchise Revenue First Example Example

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

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Franchise Revenue Second Franchise Revenue Second ExampleExample

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

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Percentage-of-Completion MethodPercentage-of-Completion Method

Design/development and Design/development and construction/production projects that extends construction/production projects that extends over several years.over several years.

Customer pays either fixed price or cost Customer pays either fixed price or cost reimbursement contract.reimbursement contract.

Reasonable assurance of profit margin and Reasonable assurance of profit margin and ultimate realization.ultimate realization.

Revenue recognized based on total percentage Revenue recognized based on total percentage of project work performed during period.of project work performed during period.

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Completed Contract MethodCompleted Contract Method

Percentage of completion method required Percentage of completion method required unless:unless: Amount of income to be earned on contract Amount of income to be earned on contract

cannot reasonably be determined.cannot reasonably be determined. Alternative is completed contract method.Alternative is completed contract method.

Costs incurred are an asset (Contract Work in Costs incurred are an asset (Contract Work in Progress) until revenue is recognized.Progress) until revenue is recognized.

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Production MethodProduction Method

Applies to agricultural and mining.Applies to agricultural and mining. Criteria:Criteria:

Clear market determined price.Clear market determined price. Performance substantially complete.Performance substantially complete.

• Minimal remaining costs.Minimal remaining costs.

Permitted but not required by GAAP.Permitted but not required by GAAP.

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Installment MethodInstallment Method

Customer pays a certain amount per Customer pays a certain amount per period.period.

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

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

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Real Estate SalesReal Estate Sales

Developer often finances over many years.Developer often finances over many years. Uncertainty of income due to uncertainty of Uncertainty of income due to uncertainty of

receipt of future payments.receipt of future payments. Conditions required for revenue recognition:Conditions required for revenue recognition:

Period allowing cancellation and refund to buyer has Period allowing cancellation and refund to buyer has expired.expired.

Cum payments equal to 10% of purchase price.Cum payments equal to 10% of purchase price. Seller has completed or is clearly capable of Seller has completed or is clearly capable of

completing required improvement.completing required improvement.

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Amount of Revenue Amount of Revenue RecognizedRecognized

Net realizable value (amount Net realizable value (amount reasonably estimated to be collected).reasonably estimated to be collected).

2 approaches:2 approaches: Direct write-off method.Direct write-off method. Allowance method.Allowance method.

• % of sales.% of sales.• % of (analysis of) AR.% of (analysis of) AR.

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Direct Write-Off MethodDirect Write-Off Method

Write-off when specific account that is Write-off when specific account that is uncollectible is identified.uncollectible is identified.

Why is this not acceptable under GAAP?Why is this not acceptable under GAAP?

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Allowance MethodAllowance Method

Estimate amount of current period credit Estimate amount of current period credit sales that will not be collected.sales that will not be collected. Historical % tempered by judgment.Historical % tempered by judgment. Historical % of aged receivables (+judgment).Historical % of aged receivables (+judgment).

Adjusting entry at end of period.Adjusting entry at end of period. When an uncollectible account is When an uncollectible account is

identified, it is written off.identified, it is written off.

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ExampleExample Amount of revenue recognized:Amount of revenue recognized:

Sales for the year were $2,000 for cash and Sales for the year were $2,000 for cash and $6,000 on credit. $6,000 on credit.

Historically we don’t collect about 5% of our Historically we don’t collect about 5% of our credit sales due to customer bankruptcies or credit sales due to customer bankruptcies or unable to locate customer. unable to locate customer.

A customer, The XYZ Company went bankrupt. A customer, The XYZ Company went bankrupt. They owed us $175. They owed us $175.

Entry for revenue?Entry for revenue? Entry for bad debts - direct write-off (not-Entry for bad debts - direct write-off (not-

GAAP)?GAAP)? Entries for bad debts (allowance method)?Entries for bad debts (allowance method)?

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ExampleExample

Balances in AccountsBalances in Accounts Accounts receivable dr 3,000.Accounts receivable dr 3,000.

• Consisting of 2,000 current and 1,000 overdue.Consisting of 2,000 current and 1,000 overdue. Allowance for doubtful accounts cr 50.Allowance for doubtful accounts cr 50.

Estimated amount of accounts that are Estimated amount of accounts that are uncollectible: uncollectible: 2% for current and 10% for non-current accounts.2% for current and 10% for non-current accounts.

What entry do we make at the end of the year What entry do we make at the end of the year to accrue for bad debts?to accrue for bad debts?

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Allowance Method (continued)Allowance Method (continued)

Allowance… is a contra-asset account.Allowance… is a contra-asset account. Collection of a bad debt that was written-Collection of a bad debt that was written-

off:off: CashCash

Allowance for Doubtful AccountsAllowance for Doubtful Accounts

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Sales DiscountsSales Discounts

Sales terms are “2/10 net 30”Sales terms are “2/10 net 30” Customer gets 2% cash discount if paid within Customer gets 2% cash discount if paid within

10 days.10 days. Otherwise, total amount is due within 30 days.Otherwise, total amount is due within 30 days.

What does “1/15 net 45” mean?What does “1/15 net 45” mean? What is the effective annual rate of What is the effective annual rate of

savings by taking advantage of terms of savings by taking advantage of terms of “2/10 net 30”?“2/10 net 30”?

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Alternative Methods of Alternative Methods of Accounting for Sales DiscountsAccounting for Sales Discounts

Record initial sale at gross. Record initial sale at gross. At collection of net amount record discount as At collection of net amount record discount as

a reduction from gross sales.a reduction from gross sales. Record initial sale at gross. Record initial sale at gross.

At collection of net amount record discount as At collection of net amount record discount as an expense of the period.an expense of the period.

Record initial sale at net. Record initial sale at net. Record amounts not taken as discounts as Record amounts not taken as discounts as

additional revenue.additional revenue.

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ExampleExample

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

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Credit Card SalesCredit Card Sales

If cash received by merchant immediately If cash received by merchant immediately (Bank plan, MC, Visa):(Bank plan, MC, Visa):

• CashCash 970 970• Sales discountSales discount 30 30• Sales revenueSales revenue 10001000

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Credit Card Sales (continued)Credit Card Sales (continued)

If cash received by merchant in 30 days If cash received by merchant in 30 days (American Express, Discover):(American Express, Discover):

• Accounts receivableAccounts receivable 970 970• Sales discountSales discount 30 30• Sales revenueSales revenue 1000 1000

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Sales Returns & AllowancesSales Returns & Allowances

Similar to bad debt expense,Similar to bad debt expense, Estimate percentage of revenues that will Estimate percentage of revenues that will

eventually result in returns or allowances. eventually result in returns or allowances.

Adjusting entry at end of period.Adjusting entry at end of period. Actual return or allowance.Actual return or allowance.

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ExampleExample

On average 2% of our $10,000 of sales is On average 2% of our $10,000 of sales is returned. Adjusting entry at end of period?returned. Adjusting entry at end of period?

Entry for return of $80 of goods?Entry for return of $80 of goods? Same for direct write-off method? Same for direct write-off method?

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Sales Returns & Allowances Sales Returns & Allowances (Continued)(Continued)

Provision for Returns and Allowances is a Provision for Returns and Allowances is a liability account.liability account.

Alternative:Alternative: Not accrue for returns and allowances but Not accrue for returns and allowances but

write them off as they occur.write them off as they occur. Is this GAAP?Is this GAAP?

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Adjustment vs. ExpenseAdjustment vs. Expense

Realization concept suggests adjustment Realization concept suggests adjustment to revenue.to revenue.

In practice both methods are found.In practice both methods are found. Consistency:Consistency:

Same handling from year to year.Same handling from year to year. Allows same company results to be compared Allows same company results to be compared

from year to year.from year to year. Comparisons between companies may be Comparisons between companies may be

distorted.distorted.

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Warranty CostsWarranty Costs

Amounts are estimated (usually as a Amounts are estimated (usually as a percentage of sales).percentage of sales).

Part of Cost of goods sold.Part of Cost of goods sold. Record accrual (adjusting entry)Record accrual (adjusting entry) Record the actual expenditures.Record the actual expenditures. Allowance… is a liability account. Est. Allowance… is a liability account. Est.

warranty exp. Is part of costs of sales.warranty exp. Is part of costs of sales.

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Warranty Expenses ExampleWarranty Expenses Example

We estimate that warranty expenses will We estimate that warranty expenses will be 4% of our $10,000 of sales. Entry?be 4% of our $10,000 of sales. Entry?

We spent $120 on parts and $250 on labor We spent $120 on parts and $250 on labor for repairs under warranty. Entry?for repairs under warranty. Entry?

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Interest RevenueInterest Revenue

Amount earned by lender during the Amount earned by lender during the period.period.

2 approaches2 approaches Interest paid at maturity.Interest paid at maturity.

• Interest is explicit.Interest is explicit. Discounted loan.Discounted loan.

• Interest is implicit.Interest is implicit.

Accounted for separately from sale.Accounted for separately from sale.

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Example: Interest RevenueExample: Interest Revenue On January 1, 19x1 sold a customer $1,000 of On January 1, 19x1 sold a customer $1,000 of

mdse. We received a promissory note for $1,000 mdse. We received a promissory note for $1,000 plus 8% interest to be paid in one year. plus 8% interest to be paid in one year.

Entry for sale?Entry for sale? Entry for accrual of interest on December 31, 19x1?Entry for accrual of interest on December 31, 19x1? Entry for receipt of payment on note on January 1, Entry for receipt of payment on note on January 1,

19x2?19x2? On January 1, 19x1, we sold mdse. and received a On January 1, 19x1, we sold mdse. and received a

promissory note for $5,000 with no interest. The promissory note for $5,000 with no interest. The note is due in one year. The market rate of note is due in one year. The market rate of interest on such a note is 9%.interest on such a note is 9%.

Entry at sale:Entry at sale: Year end adjusting entry (12/31/19x1)Year end adjusting entry (12/31/19x1) Entry when customer pays note (1/1/19x2)Entry when customer pays note (1/1/19x2)

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Monetary& Non-monetary Monetary& Non-monetary AssetsAssets

Monetary assets are money or claims to Monetary assets are money or claims to receive fixed sums of money.receive fixed sums of money.

Non-monetary assets are items used in future Non-monetary assets are items used in future production and sales of goods and services.production and sales of goods and services.

Balance sheet distinctionBalance sheet distinction Current and non-current assets.Current and non-current assets. Not monetary and non-monetary.Not monetary and non-monetary.

Non-monetary assets (except inventory) on Non-monetary assets (except inventory) on BS at unexpired cost. (Cost less depreciation)BS at unexpired cost. (Cost less depreciation)

Monetary assets: Cash reported at face. AR Monetary assets: Cash reported at face. AR at NRV. Other at fair value.at NRV. Other at fair value.

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CashCash

Funds available for disbursement.Funds available for disbursement. May include liquid short term investments.May include liquid short term investments.

Highly liquid debt instruments with original Highly liquid debt instruments with original maturities of 90 days or less.maturities of 90 days or less.

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ReceivablesReceivables

Trade receivablesTrade receivables Accounts receivables from usual sales of Accounts receivables from usual sales of

products or services for non-financial products or services for non-financial institutions.institutions.

Other receivables are shown separately.Other receivables are shown separately. E.g., Due from employees, advances or loans.E.g., Due from employees, advances or loans.

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Marketable SecuritiesMarketable Securities

Must be marketable.Must be marketable. E.g., commercial paper, treasury bills, E.g., commercial paper, treasury bills,

publicly traded stocks and bonds issued publicly traded stocks and bonds issued by companies.by companies.

Also called “Temporary Investments.”Also called “Temporary Investments.”

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Accounting for Marketable Accounting for Marketable SecuritiesSecurities

Three categoriesThree categories Held-to-maturity: debt securities,Held-to-maturity: debt securities,

Valued at cost.Valued at cost. Trading securities: debt or equity held for Trading securities: debt or equity held for

current resale, valued at market. current resale, valued at market. Realized (i.e., if sold during period) and unrealized Realized (i.e., if sold during period) and unrealized

(not yet sold but market price has changed) gain or (not yet sold but market price has changed) gain or loss included in current year’s income.loss included in current year’s income.

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Accounting for Marketable Accounting for Marketable Securities (Continued)Securities (Continued)

Available-for-sale securities: Available-for-sale securities: Debt or equity securities that do not fit either Debt or equity securities that do not fit either

of the other 2 categories. of the other 2 categories. Reported at market value. Reported at market value. Realized gains and losses go through income.Realized gains and losses go through income. Unrealized gains and losses directly credited Unrealized gains and losses directly credited

(or debited) to a stockholders’ equity account.(or debited) to a stockholders’ equity account.

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Analysis of Monetary AssetsAnalysis of Monetary Assets

Current ratio = CA/CLCurrent ratio = CA/CL Acid-test ratio = quick ratio = monetary Acid-test ratio = quick ratio = monetary

CA/CL= (CA - inventories - prepaid items) CA/CL= (CA - inventories - prepaid items) /CL./CL.

Days cash = cash/(cash expenses Days cash = cash/(cash expenses 365) 365) Cash expenses Cash expenses total expenses - depreciation. total expenses - depreciation.

Days receivable = average collection period = Days receivable = average collection period = Receivables/(Sales Receivables/(Sales 365) 365)

Ratios differ by industry.Ratios differ by industry.