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Measurement Revenue Recognition

Questions for the Day


What are the rules for revenue recognition? How do different options for revenue recognition affect the financial statements?

Notes 6: Income

ACCT 5011 Financial Accounting Notes 6

Income Statement tells us


What have we earned (revenues) What was the cost of those earnings (expenses)

Revenues
Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entitys ongoing major or central operations (SFAC6)
Must be Related to our basic operations
Inflows not related to our basic operations are gains (though for our purposes, the distinction is fairly unimportant)

Timing of revenue recognition is NOT determined by the timing of cash (accrual concept) Revenue is recognized when it is earned and realizable (Revenue Principle)

ACCT 5011 Financial Accounting Notes 6

Revenue Principle requires recognition when


Earned
The firm has fulfilled all, or essentially all of its obligations.

Realized (or realizable)


There is persuasive evidence of an arrangement for customer payment The price is fixed or determinable. Collection is reasonably assured.

NOT THE SAME AS A CASH RECEIPT For most firms, recognition occurs
on delivery of goods or services
Completed Contract Method

Other possibilities include


Production
Percentage of Completion Method

Cash Collection
Installment Method

Others

The method used must be disclosed in the footnotes if the method has a material impact. Usually in the first footnote.

ACCT 5011 Financial Accounting Notes 6

5.11 Revenue Recognition Neiman Marcus, a U.S. retailer, uses the accrual basis of accounting and follows U.S. GAAP. It recognizes revenue at the time is sells merchandise. Indicate the amount of revenue (if any) the firm recognizes during the months of February, March, and April in each of the following hypothetical transactions.
a. Collects $800 cash from a customer during March for a custom-

made suit that the firm will make and deliver to the customer in April.
b. Collects $2,160 cash from customer for meals served in the firms

restaurant during March.


c. Collects $39,200 cash from customers during March for

merchandise sold and delivered in February.


d. Sells merchandise to customers during March on account, for

which the firm will collect $59,400 cash from customers during April.
e. Rents space in its store to a travel agency for $9,000 a month,

effective March 1. Receives $18,000 cash on March 1 for two months rent.
f. Same as part e, except that it receives the check for the March and

April rent on April 1.


x. Lends $10,000 to a supplier on February 1. After one year, the

supplier will repay the $10,000 principal plus $1,200 simple interest.

ACCT 5011 Financial Accounting Notes 6

There are only three types of revenue transactions


Depending on which happens first the cash or the revenue

1. Cash is received before revenue is recognized When cash is received Cash (+A) $100 Advance from Cust (+L) $100 When revenue is recognized Advance from Cust (-L) $100 Revenue (+R, +SE) $100 Example: Southwest sells a plane ticket six months before the flight. 2. Cash is received at the same time revenue is recognized When cash is received & rev. is recognized Cash (+A) $100 Revenue (+R, +SE) $100 Example: The Muny sells tickets at the box office for tonights performance. 3. Cash is received after revenue is recognized When revenue is recognized Accounts Receivable (+A) $100 Revenue (+R, +SE) $100 When cash is received Cash (+A) $100 Accounts Receivable (-A) $100 Example: Charter Cable sends out bills for May services on June 1.

ACCT 5011 Financial Accounting Notes 6

Accounting for Bad Debt (somewhat simplified)


Problem
For proper matching, we try to assign bad debt expense to period of sale, yet we dont know then which specific debts will go bad!

Solution GAAP generally requires the Allowance Method (2 steps) Step 1. Estimate bad debt expense & reduce A/R Bad debt expense (+E, -SE) Allowance for Bad Debts (+XA) (*)
Note that this entry affects net income and current assets, but not cash flow! (*) This is a contra-asset which is included as a reduction of accounts receivable. So this could be:

Accounts Receivable, net (-A) 2. Write-off when specific account determined to be uncollectible Allowance for Bad Debts (-XA) Accounts Receivable, gross (-A)
Note that this entry does not affect net income, current assets, or cash flow! In fact, as both affect parts of Accounts Receivable, net, there is NO effect on the financial statements

We can estimate bad debt expense in step 1 using various methods. Well look only at one: Percentage of credit sales - compute amount of expense each period

ACCT 5011 Financial Accounting Notes 6

An example of Bad Debts Expense


At the start of 2013, Prince, Inc. had gross A/R of $5.2m, and an allowance of $300,000. Total 2013 credit sales were $20m. In 2013 Prince collected $18m in cash from credit customers and wrote-off $150,000 worth of accounts. Prince assumes that 1% of credit sales will prove uncollectible.
Accounts Receivable, gross (+A) 20,000 Sales Revenue (+R, +SE) Bad Debt Expense (+E, -SE) 200(*) Allowance for bad debts (+XA)
(*) Computed as $20m credit sales x 1%

20,000
200

Cash (+A) 18,000 Accounts Receivable, gross (-A) Allowance for bad debts (-XA) 150 Accounts Receivable, gross (-A)
Accounts Receivable, gross (A) ($,000) BB Sales $5,200 $20,000 $18,000 Collections $150 Write-offs EB $7,050 Write-offs $150

18,000 150

Allowance for Bad Debts (A) ($,000) $300 BB $200 Bad Debts

$350 EB

OR
Accounts Receivable, net (A) ($,000) BB Sales $4,900 $20,000 $200 Bad Debts $18,000 Collections

EB

$6,700

ACCT 5011 Financial Accounting Notes 6

Percentage of Completion Method (8.34)

Shannon agreed to build a warehouse for $6,000,000. Expected and actual costs to construct the warehouse were as follows: 2012, $1,200,000; 2013, $3,000,000; 2014, $600,000. The firm completed the warehouse in 2014. In addition, assume that the $6,000,000 contract price is paid as follows: $1,000,000 on signing (in 2012), $2,000,000 at July 30, 2013 and the remaining $3,000,000 upon completion in February, 2014.

Sometimes waiting until the end of a project (i.e., delivery) in order to recognize revenue may be misleading
Long-term construction projects Long-term consulting projects

Under completed contract:


Revenues Expenses Income 2012 0 0 0 2013 0 0 0 2014 6,000 4,800 1,200

Under percentage of completion:


2012 (25%) 1,500 1,200 300 2013 (62.5%) 3,750 3,000 750 2014 (12.5%) 750 600 150

Percentage Revenues Expenses Income

ACCT 5011 Financial Accounting Notes 6

Percentage of Completion Method (cont)


Percentage of Completion 2012 Journal Entries Cash (+A) Unbilled Services (+A) Revenue (+R,+SE) Cost of Sales (+E,-SE) Cash (-A) 2013 Journal Entries Cash (+A) Unbilled Services (-A) Revenue (+R,+SE) Cost of Sales (+E,-SE) Cash (-A) 2014 Journal Entries Cash (+A) Revenue (+R,+SE) Unbilled Services (-A) Cost of Sales (+E,-SE) Cash (-A)

Completed Contract 2012 Journal Entries Cash (+A) 1000 Advance from Cust (+L) 1000 Inventory (+A) 1200 Cash (-A) 1200 2013 Journal Entries Cash (+A) 2000 Advance from Cust (+L) 2000 Inventory (+A) 3000 Cash (-A) 3000 2014 Journal Entries Cash (+A) 3000 Advance from Cust (+L) 3000 Advance from Cust (-L) 6000 Revenue (+R,+SE) 6000 Inventory (+A) 600 Cash (-A) 600 Cost of Sales (+E,-SE) 4800 Inventory (-A) 4800

1000 500 1500 1200 1200 2000 1750 3750 3000 3000 3000 750 2250 600 600

Comparing the 2012 statements under the two methods, we see that under Percentage Completion:
Revenue, expense and NI are all higher (by 1500, 1200 and 300 respectively) Inventory (A) is lower by 1200 Unbilled Services (A) is higher by 500 Advance from customer (L) is lower by 1000 Retained earnings (SE) is higher by 300

ACCT 5011 Financial Accounting Notes 6

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