acct5011notes 6

1ACCT 5011 Financial Accounting – Notes 6

Notes 6: Notes 6: Income Income Measurement – Measurement –

Revenue Revenue RecognitionRecognition

• What are the rules for revenue recognition?

• How do different options for revenue recognition affect the financial statements?

Questions for the Day


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 entity’s 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)


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.


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 firm’s 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.

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.


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


Example: The Muny sells tickets at the box office for tonight’s performance.

3. Cash is received after revenue is recognized

When revenue is recognized

Accounts Receivable (+A) $100


When cash is received

Cash (+A) $100

Accounts Receivable (-A) $100

Example: Charter Cable sends out bills for May services on June 1.


Accounting for Bad Debt (somewhat simplified) Problem

» For proper matching, we try to assign bad debt expense to period of sale, yet we don’t 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/RBad 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. We’ll look only at one:

Percentage of credit sales - compute amount of expense each period


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) 20,000

Bad Debt Expense (+E, -SE) 200(*)

Allowance for bad debts (+XA) 200

(*) Computed as $20m credit sales x 1%

Cash (+A) 18,000

Accounts Receivable, gross (-A) 18,000

Allowance for bad debts (-XA) 150

Accounts Receivable, gross (-A) 150

OR

Accounts Receivable, gross (A) ($,000)

BB $5,200

Sales $20,000

$18,000 Collections

$150 Write-offs

EB $7,050

Allowance for Bad Debts (A) ($,000)

Write-offs $150

$300 BB

$200 Bad Debts

$350 EB

Accounts Receivable, net (A) ($,000)

BB $4,900

Sales $20,000 $200 Bad Debts

$18,000 Collections

EB $6,700


Percentage of Completion Method (8.34)

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:

Under percentage of completion:

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.

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

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


Percentage of Completion Method (cont)

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

Completed Contract

2012 Journal Entries

Cash (+A) 1000

Advance from Cust (+L) 1000

“Inventory” (+A) 1200

Cash (-A) 1200


Cash (+A) 2000



Cash (-A) 3000


Cash (+A) 3000


Advance from Cust (-L) 6000

Revenue (+R,+SE) 6000


Cash (-A) 600

Cost of Sales (+E,-SE) 4800

“Inventory” (-A) 4800

Percentage of Completion


Cash (+A) 1000

Unbilled Services (+A) 500



Cash (-A) 1200


Cash (+A) 2000

Unbilled Services (-A) 1750



Cash (-A) 3000


Cash (+A) 3000


Unbilled Services (-A) 2250


Cash (-A) 600

acct5011notes 6

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