lecture6revenue recognition.pdf
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Receivables and Revenue
Recognition
15.501/516AccountingSpring2004
Professor S. RoychowdhurySloan School of Management
Massachusetts Institute of Technology
Feb 23 and 25, 2004
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WHY DO WE CARE ABOUT
REVENUE RECOGNITION?Revenue has a BIG impact on bottom-line profitability ==>
managers may be tempted to manage revenue
Large Sample Evidence: over 40% of SEC enforcement actionson accounting issues deal with Revenue Recognition
Sample of headlines from searching Dow Jones Newswire for2004 and 2003:
Ceridian Results for 2000-2003 to restated, Feb 18
Wolf Popper files Securities Class Action against SonusNetworks, Feb 13, 2004
Tripos postpones earnings release will revise revenuerecognition policies, Feb 12Opsware expects 100% revenue growth, points out
transparent revenue recognition policies, Feb 11
Agco Corp faces class action suit, Feb 6 2
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CRITERIA FOR REVENUE
RECOGNITION
Underaccrualaccounting,afirmrecognizesrevenuewhen
ithas:
Performedall,orasubstantialportionof,theservicestobeprovided.
Incurredasubstantialmajorityofthecosts,andtheremainingcostscanbereasonablyestimated.
Receivedeithercash,areceivable,orsomeotherassetforwhich
areasonablyprecisevaluecanbemeasured
collectibilityisreasonablyassured.
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Recognition Criteria
Cash Basis vs Accrual Basis
Accrual Cash
Revenue
Expense
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Cash Basis vs Accrual Basis
Recognition Criteria
Accrual Cash
Revenue when earned when $ recd
and realized
Expense when incurred when $ paid
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EXAMPLES OF REVENUE
RECOGNITION EVENTS
z At the time of sale (Thisis,byfar,mostcommonly
encountered.)z Titlepassestothebuyeranddeliverytakesplace
z Reasonableestimateofuncollectibles
z Reasonableestimateofsalesreturns
z Reasonableestimationofallothermaterialexpensesrepresentinguncertainfutureoutflows(e.g.,warrantycosts).
z Mostcommoninretail,wholesale&manufacturing
z Evenwhenrightofreturnexists?
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Bill & Hold
z Hardware
z Revenuefromhardwaresalesorsales-typeleasesisrecognized whenthe
productisshipped.
z RecentexperienceofSunbeam..InthefourthquarteroflastyearSunbeamrecorded$50millioninsalesofcooking grills under an early buy program [some $35 million] werecategorizedbillandholdsalesandneverevenleftSunbeamswarehouses.
-- fromBarrons,6/8/98
z AgcoCorp.Farm equipment company Agco announced that the Securities andExchange Commission has launched an informal inquiry into its accounting
practicesAgcostated that insome instances it recognizes revenuewhenequipment remains on its premises after having been invoiced to the dealer.These transactions occur at a dealer's request, added Agco, usually so thedealercanarrangeforitsowntransportationoftheequipment.
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SAB 101
z Fuelledbyrecentaccountingscandals
z IssuedbySEC:SAB101tookeffectincalendaryear2000.
z In general, SECsaid that themost common reasons for changes in revenuerecognitionpoliciestocomplywithSAB101were:z Deferralofrevenueonproductsalesuntilsuchproductsaredelivered,andtitle
transferstothecustomer.z Deferralofvariousup-front,orprepaid,feesforwhichthecompanyhadnotcompleted
aseparateearningsprocess.z Deferralofrevenueuntilcertainnon-perfunctorysellerobligations(suchasequipment
installation)werecompleted.z Deferralofrevenuethatiscontingentontheoccurrenceofsomefutureevent(suchas
theachievementbyalesseeofcertainminimumsalesthresholds)untilthatevent
occurs.
z DidtheSECover-reactwithSAB101?Altamuro,BeattyandWeber(2003)
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Global Crossing and Qwest
Communications
z Traded fiber optic capacity and booked
revenuesz Say, the two companies traded capacity
worth$10,000
z GlobalCrossing:z
Revenues
z Costofnetworkingservice
z SameforQwest.
z Whydidtheydothis?
10,000
10,000
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Is this accounting manipulation? channel stuffing, price discounts!
z Sunbeam...Sunbeamjammedasmanysalesasitcouldinto1997topumpboththetopandbottomlines....Sunbeameithersent more goods than hadbeen ordered bycustomersorshippedgoodsevenafteranorderhadbeencancelled.
z Recent experience of Bristol-Myersz
Inanother setback for the beleaguereddrugmaker, Bristol-Myers SquibbCo.confirmedthattheSecuritiesandExchangeCommissionhasopenedaninquiryintowhetheritimproperly inflated revenue last year by as much as $1billion through use of sales incentives...Drug makers, like many othermanufacturers, can boost near-term sales by extending lower prices towholesalers,encouragingthemtoloadup.Butsuch"channel-stuffing"hurts
latersales. --fromWSJ,7/12/2002z Recentstatusofthisinvestigation?
z Systematic evidence: Roychowdhury (2003), available onwww.ssrn.com
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EXAMPLES OF REVENUE
RECOGNITION EVENTS (Uncommoncases)
z During production
z Establishmentoffirmcontractprice
z
Reasonableassuranceofcollection
z
Reasonableestimateofcostofcompletion
z E.g.,defenseandconstructioncontracts.
z At Completion of Production
z Existenceofdeterministicorstablesellingprice
z
Nosubstantialcostofmarketingz E.g.,preciousmetals,agriculturalproducts
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EXAMPLES OF REVENUE
RECOGNITION EVENTS (Uncommoncases)
z At the time of cash collection
z Impossibletovalueassetsreceivedwithfairdegreeofaccuracy.
z
E.g.,somerealestatelanddevelopmentdeals.
z Installment approach
z Profitsrecognizedinproportiontocashcollected
z Cost recovery approach
z
Noprofitrecognizeduntilallthecostshavebeenrecovered.
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IMPORTANCE OF ACCOUNTS
RECEIVABLEReceivables
Industry Total Assets
Eating Places 1.6%Family Clothing Stores (The GAP) 3.0
Race Track Operations 3.1
Grocery Stores 4.9
Intel 8.6
Semiconductors 11.3
Advertising Agencies 42.7
Trans. Freight/Cargo 43.1
Computer Software Wholesale 45.5
Overall Median 13.0%
Source:5,933industrialfirmsfrom2000GlobalVantage
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Sears Roebuck & Co. - sales
z ItsYear1:Searsmakessalesofmicrowaveovens
for$10,000
z Saycustomerspaidfor$4,000ofthesesaleswithcash,therestwiththeirSearscreditcards
z SoDrCash 4,000
DrAccountsreceivables 6,000CrRevenue 10,000
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Sears Roebuck & Co.
receivables
z WhenSearsmakesitscreditsales,itestimatesfrompastexperiencethat5%ofitsaccountsreceivableswillneverberecoveredinmoney
z Whatdoesthisimply?
z Whatareitsaccountsreceivablesactuallyworth?
z Whatisthepartofthesaleitwillactuallysee?
z Oneoption:Searsrecognizesanexpenseof$300andwritesdown itsaccountsreceivableto$5,700
DrBadDebtexpense 300CrAccountsReceivable 300
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Sears Roebuck & Co. - ADA
z ProblemwhatdoesSearsnot know?
z ItthereforerecognizesBadDebtexpenseandcreatesanAllowanceforDoubtfulAccounts(ADA)
DrBadDebtexpense 300CrADA 300
z OnBalanceSheet,accountsreceivablearereportednetofADAAccounts Receivables 6,000less ADA 0,300
Net Accounts Receivable 5,700
z ADAisacontra-assetaccount!
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Income Statement and Balance
Sheet RelationsAccounts Receivable (A)
Beg Balance = 0Credit Sales = 6,000
Ending balance = 6,000
Allowance for doubtful accounts (XA)
Beg Balance = 0
Amount of Bad Debt Expense = 300
Ending balance = 300
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Sears Roebuck & Co. write-
offsz Its Year 2 end of quarter 1: For simplicity, assume no credit sales
duringquarter1ofYear2
z Customershavepaidup$3,000z DrCash 3,000z CrAccountsreceivables 3,000
z Also,CustomerBillyJoedeclaresbankruptcy&defaultsfor$50z Searshasnowidentifiedacustomerwhohasdefaulted:Itcanwriteoff
BillysAccountReceivablez Oftheoriginal$300Searshadexpectedtoseeasadefault,whatisthe
amountitstillexpectstoneverrecoverinthefuture?z Whichaccountshouldreflectthis?z DrADA 50z CrAccountsreceivables 50
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Income Statement and Balance
Sheet RelationsAccounts Receivable (A)
Beg Balance = 6,000Cash collection = 3,000
Write-offs = 50
Ending balance = 2,950
Allowance for doubtful accounts (XA)
Beg Balance = 300
Write-offs = 50
Ending balance = 250
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Income Statement and Balance
Sheet RelationsAccounts Receivable (A)
Beg BalanceCredit Sales
Cash collected Write-offs
Ending balance
Allowance for doubtful accounts (XA)
Beg Balance
Amount of Bad Debt ExpenseWrite-offs
Ending balance
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Income Statement and Balance
Sheet Relations
- Allowancefordoubtful
Accounts(XA)
BeginningBalance
+AmountsRecordedasBad
DebtExpense
- AmountsWrittenOff
=EndingBalance
AccountsReceivable(A)
BeginningBalance
+CreditSales
- CashCollected
- AmountsWrittenOff
=EndingBalance
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ALLOWANCE FOR BAD DEBTS
(UNCOLLECTIBLES)
Methods DirectWrite-OffMethod
RequiredbyIRS
DisallowedunderGAAP
PercentageofSales
Aging
Howmightafirmschoiceofmethodevolveovertime?
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AGING ANALYSIS OF ACCOUNTS
RECEIVABLES
Cowens,alargedepartmentstorelocatedinametropolitanarea,hasbeenexperiencingdifficultyinestimatingitsbaddebts.
Thecompanyhasdecidedtoprepareanagingscheduleforitsoutstandingaccountsreceivablesandestimatebaddebtsbythedatesofitsreceivables.
Thisanalysisdisclosesthefollowinginformation:
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AGING ANALYSIS OF ACCOUNTS
RECEIVABLESBalance($) Age Estimated%
Uncollectible198,000
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AGING ANALYSIS OF ACCOUNTS
RECEIVABLESBalance ($) Age Estimated %
Uncollectible
198,000 x
114,000 x
73,000 x
39,000 x
25,000 x
< 30 days
30-60 days
61-120 days
121-240 days
241-360 days
Over 360 days
0.8 =
2.0 =
5.0 =
20.0 =
35.0 =
50.0 =
$ 1,584
2,280
3,650
7,800
8,750
10,00020,000 x
469,000 Total expected uncollectible $ 34,064
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AGING ANALYSIS OF ACCOUNTS
RECEIVABLES
1. ComputetheestimatedamountofuncollectibleAccounts
Receivable,i.e., thedesiredendingbalanceoftheADA.
2. GivenabeginningADAbalanceof$5,700,recordthe
BadDebtExpenserequiredtoachievethedesiredendingADAbalance.
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AGING ANALYSIS OF ACCOUNTS
RECEIVABLESRet.EarningsCash A/R(A) -ADA
BB 469,000 5,700
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AGING ANALYSIS OF ACCOUNTS
RECEIVABLESCash A/R(A) -ADA Ret.Earnings
BB 469,000 5,700
Baddebts ?
EB 34,064
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AGING ANALYSIS OF ACCOUNTS
RECEIVABLESCash A/R(A) -ADA Ret.Earnings
BB 469,000 5,700
Baddebts 28,364 (28,364)(exp.)
EB 34,064
5,700 + Bdx =34,064Bdx =28,364
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AGING ANALYSIS OF ACCOUNTS
Makecreditsales
RECEIVABLESCash A/R(A)
BB 469,000
Baddebts
EB
-ADA Ret.Earnings
5,700
28,364 (28,364)(exp.)
34,064
time
FYE
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AGING ANALYSIS OF ACCOUNTS
Makecreditsales
Recognize revenue
RECEIVABLESCash A/R(A) -ADA Ret.Earnings
BB 469,000 5,700
Baddebts 28,364 (28,364)(exp.)
EB 34,064
Write-off (3,000) (3,000)
time
FYE
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AGING ANALYSIS OF ACCOUNTS
RECEIVABLESCash A/R(A) -ADA Ret.Earnings
BB 5,700
Baddebts 28,364 (28,364)(exp.)
EB 34,064
Write-off (3,000) (3,000)
FYE
Makecreditsales
Recognize revenue
CreditCustomergoesbankrupt
time
469,000
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AGING ANALYSIS OF ACCOUNTS
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AGING ANALYSIS OF ACCOUNTS
RECEIVABLESCash A/R(A) -ADA Ret.Earnings
BB 5,700
Baddebts 28,364 (28,364)(exp.)
EB 34,064
Write-off (3,000) (3,000)
FYE
Makecreditsales
Recognize revenue
CreditCustomergoesbankrupt
Recognize expense?
time
469,000
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AGING ANALYSIS OF ACCOUNTS
RECEIVABLESCash A/R(A) -ADA Ret.Earnings
BB 5,700
Baddebts 28,364 (28,364)(exp.)
EB 34,064
Write-off (3,000) (3,000)
FYE
Makecreditsales
Recognize revenue
CreditCustomergoesbankrupt
Recognize expense
time
469,000