Chapter 5 PP

Welcome to Financial Accounting

Chapter 5

@Cambridge Business Publishers, 2013

1

Operating Cycle, Revenue Recognition, and Receivable Valuation

Operating Cycle of a Business

What is an operating cycle?A repetitive cycle of events that occur in the ongoing operations of a business

© Cambridge Business Publishers, 2013

Recognizing Revenue

What is revenue? The inflow of assets to a business that occurs as a

direct consequence of providing goods or services to customers

Conditions required to recognize revenue1. Revenue must be earned

Seller must satisfy obligations under sale agreement

2. Revenue must be realized or realizable Seller must have been paid or reasonably expect

to be paid Recognize means report on the income

statement © Cambridge Business Publishers, 2013

Staff Accounting Bulletin (SAB) 101

Issued by the U.S. Securities and Exchange Commission To combat the large number of inaccurate, usually

aggressive revenue recognition practices Requires the following revenue recognition

criteria to be met before recognizing revenue1. Persuasive evidence of a sales arrangement must

exist2. Delivery of the product or service must occur3. The seller’s price to the buyer is fixed or

determinable4. Collectibility of any unpaid cash is reasonably

assured© Cambridge Business Publishers, 2013

Controversial Revenue Issues

Exactly what constitutes persuasive evidence of a sales arrangement

Consignment sales A right-of-product-return policy exists A product is complete and paid for but not

yet delivered The seller receives non-refundable fees The seller acts as a middleman The sale involves a barter transaction


Alternative Points of Revenue Recognition


Retail and Service Companies

Revenue recognition limited to Point of sale Point of cash collection

Exception to point of sale Significant doubt regarding the debt-paying

ability of a customer Requires the company to wait until the point of

cash collection Referred to as the installment method


Installment Method of Revenue Recognition

Used when significant doubt of cash collection exists

Revenue is recognized only to the extent of any cash received

Customer signs a promissory note receivable Seller/dealer has a hidden opportunity cost

Interest on the amount financed Reduces the real profit Dealer’s money could have been invested to earn

interest Seller/dealer often charges interest on unpaid

balances to recover opportunity costs© Cambridge Business Publishers, 2013

Installment Method Example

A dealer sells a 56” plasma TV for $4,200 with a cost of $2,700, for an installment note to be paid in 12 equal monthly installments with the first payment due on the date the TV is delivered.


Cash to be received each month:$4,200 ÷ 12 = $350

Cost allocation each month:$2,700 ÷ 12 = $225

Monthly gross profit recognized:$350 – $225 = $125

Monthly Revenue Recognized

Monthly Cost of Goods Sold Recognized

Installment Method Example continued

A dealer sells a 56” plasma TV for $4,200 with a cost of $2,700, for an installment note to be paid in 12 equal monthly installments . Assume the cost of interest is 1% per month.


Amount financed ($4,200 – $350) $3,850Less: Present value of 11 payments @1%

($350 × 10.368) 3,629Opportunity cost $ 221

Manufacturing Companies

Use raw materials to produce products Typically sell to retailers who distribute

products Recognize revenue at

The point of product delivery, or The point of cash collection if collection is

uncertain During production or after production

If goods are produced under contract when production spans several periods


Revenue Recognition During Production Example

Freeport Boats signed a $6 million contract to build a charter boat for Cruising Time. Freeport estimates the cost of boat to be $4,200,000. Additional data:


2013 2014 2015 Percentage of work complete 30% 70% Costs incurred during the year $1,300,000 $2,900,000 Progress billings during the year 1,500,000 4,500,000 Cash collected during the year 1,000,000 3,000,000 2,000,000

Percentage-of-completion method is used.i.e., revenue is recognized in proportion to the

percentage of work completed each year.

Revenue Recognition During ProductionContract Signing

The contract to build the boat was signed on January 2, 2013.


No transaction is recordedWhy?Because no exchange has taken place .

Revenue Recognition During ProductionProduction Items Acquired

Freeport Boats acquires production items with a cost of $1,300,000 on account.


Production-in-progress is an asset representing the cost of production not yet

recognized as an expense.

Revenue Recognition During ProductionCustomer Billings

Freeport Boats bills the customer $1,500,000 on account.


Revenue to be recognized= % Complete × Contract Amount= 30% × $6,000,000 = $1,800,000

Unbilled Accounts Receivable is an asset account representing the amount earned but not yet billed.

Revenue Recognition During ProductionCustomer Payment Collected

Freeport Boats collects a payment of $1,000,000 from the customer.


No changes to the amount billed have occurred. One asset (cash) replaces another asset (Account Receivable).

Revenue Recognition During ProductionProduction Costs Used

Freeport Boats recognizes production costs on the contract.% complete × Estimated Costs30% × $4,200,000 = $1,260,000


Costs are recognized based on the percentage complete.

Revenue Recognition During ProductionDealer Pays Bills

Freeport Boats pays the amounts owed on account.


Assets and liabilities decline when amounts on account are paid.

Revenue Recognition During Production2013 Activity


2013 Income Statement amounts:Revenue $1,800,000Expenses 1,260,000Gross profit $ 540,000

Revenue Recognition During Production2014 Activity


Income Statement amounts for 2014: Revenue ($6,000,000 - $1,800,000) $4,200,000 Expenses ($4,200,000 - $1,260,000) 2,940,000 Gross profit $1,260,000

Revenue Recognition At Completion of Production


Revenue, costs of production, and gross profit are recognized when the project is complete

No income statement effects are reported until completion

Deferred revenue Represents amounts billed or collected but not

yet earned A liability account

Production-in-progress Represents the cost incurred on the project not

yet recognized as an expense

Revenue Recognition at Completion of ProductionExample


Freeport Boats signed a $6 million contract to build a charter boat for Cruising Time. Freeport estimates the cost of boat to be $4,200,000. Additional data:

2013 2014 2015 Costs incurred during the year $1,300,000 $2,900,000 Progress billings during the year 1,500,000 4,500,000 Cash collected during the year 1,000,000 3,000,000 $2,000,000

The completed contract method recognizes revenue at the completion of production.

Revenue Recognition at Completion of ProductionProduction Items Acquired


Freeport Boats acquired items for production costing $1,300,000 on account.

Production-in-progress is used to hold the cost of production that has been incurred but not yet recognized as an expense.

Revenue Recognition at Completion of ProductionCustomer Billings


Freeport Boats billed the customer $1,500,000.

The revenue is deferred (not recognized on the income statement) by recording it in a liability account, Deferred Revenue.

Revenue Recognition at Completion of ProductionCollecting Cash from Customers


Freeport Boats collected $1,000,000 of the amount due from customers.

The collection has no effect on revenue

or expenses.

Revenue Recognition at Completion of ProductionPayment of Amounts Owed


Freeport Boats paid $1,300,000 of the amount owed for production items previously acquired.

The payment of amounts previously charged on account has no effect on revenue or expenses.

Revenue Recognition at Completion of Production2013 Activity


2013 Profit$0

Revenue Recognition at Completion of Production2014 Activity


2014Profit

$1,800,000

Extending Credit to Customers

Done when the expected revenues from incremental sales exceed the costs associated with extending the credit

Costs of extending credit Time value of money Potential cost on uncollectible accounts

Reducing the risk of uncollectible accounts Acquire customer information from credit

information intermediaries Past credit history Credit scoring techniques


Methods of Estimating Uncollectible Accounts

Two widely used methods Percentage-of-credit-sales method Aging method

Both methods match the cost of uncollectible accounts against the related revenue

Estimates are based on historical information Historical credit losses Historical credit sales


Allowance for Uncollectible Accounts

Contra asset Balance represents the amount the company

believes it will not collect Considered to be a reserve for expected future

losses Appears on the balance sheet as a reduction

from Accounts Receivable Often called

Allowance for doubtful accounts Reserve for doubtful accounts


Percentage-of-Credit-Sales Method


1.5% × $80,000 = $1,200

In 2013, Granger Lumber sold carpentry supplies for $80,000 to contractors on account during May.

Bad debt expense is recognized in

the same year as the revenue.

Granger estimates that 1.5% of its credit sales will be uncollectible.

Aging Method

Most widely used approach of estimating uncollectible accounts

Involves categorizing receivables according to how much time has elapsed since the credit sale occurred

Each aging group is assigned a different percentage of collectibility with the older receivables considered less likely to be collected


Aging Method Example


Granger Lumber sold carpentry supplies for $80,000 to contractors on account during May of 2013. At the end of May, accounts outstanding less than 30 days are $11,000, those between 31 and 60 days are $7,800, between 61 and 90 days are $3,200, and over 90 days are $4,000. Granger provides the following estimate of uncollectible accounts: 0-30 days, 0.3%; 31-60 days, 0.6%; 61-90 days, 1.8%; and over 90 days, 28.0%. Calculation of uncollectible accounts expense:

0-30 days 0.3% × $11,000 = $ 33 31-60 days 0.6% × 7,800 = 47 61-90 days 1.8% × 3,200 = 57 Over 90 days 28.0% × 4,000 = 1,120

$26,000 $1,257

Aging Method Example continued


Assume the Allowance for Uncollectible Accounts balance at the beginning of the period was $140, and that Granger collected $54,000 from customers during May.

The spreadsheet is not in balance is because only selected items are shown.

$140 + Bad debt expense = $1,257Bad debt expense = $1,117

Bad debt expense

is recognized in the same year

as the revenue.

Receivables on the Balance Sheet

Reported as part of current assets:


Current AssetsAccounts receivable $26,000 Less allowance for uncollectible accounts (1,117)Accounts receivable, net $24,883

Net Realizable Value

Writing Off Uncollectible Accounts

Occurs when a specific account is determined to be uncollectible

Remove the customer’s account balance and reduce the allowance for uncollectible accounts


Example:Assume Michael Jackson, a past customer of Granger Lumber, still owes Granger $700. After repeated attempts to collect, Granger determined that Michael’s financial situation would not allow him to pay. Granger wrote off the account.

The spreadsheet is not in balance is because only selected items are shown.

Notice net receivables does not change after the write-off

Sales Discounts

Offered to customers to shorten the duration of receivables

Reduces the ‘interest-free’ loan the receivable provides to customers (i.e., the opportunity cost)

Credit terms Specify sales discounts allowed and time allowed

until payment is due Example: 2/10, n/30

A 2 percent discount is allowed if paid within 10 days of the invoice date; otherwise the full invoice amount is due in 30 days


Sales Discount Example Granger Lumber offered terms of 1/15, n/30 on

a credit sale made on May 12 totaling $90,000. The customer paid on May 23.


Invoice amount $90,000 Discount ($90,000 × 1%) 900 Cash received $89,100

The receivable is reduced for the entire amount.

Receivable Collection Period

The time period it takes for a company to collect, on average, each receivable owed

Timely collection reduces the opportunity cost of the time value of money


365Net sales ÷ Accounts receivable balance

Receivable Collection Period =

Receivable Collection Period For Google


Data from Google, Inc. (in millions) 2012

Accounts receivable $ 9,729 Net sales 50,175

Receivable Collection Period for 2012365

Net sales ÷ Accounts receivable balance

365$50,175 ÷ $9,729

=

= = 70.8 days

It took Google 70.8 days, on average, to collect each receivable in 2012.

Sales Returns

Occur when customers return unwanted and/or defective products for cash, credit refund or store credit

Estimated on the basis of recent historical business experience

Financial statement reporting Sales Returns, a contra-revenue account on the

income statement, and Allowance for Sales Returns, a contra-asset

account on the balance sheet


Revenue Recognition under SAB No. 101

Revenue should be recognized when all of the following are met: Persuasive evidence of a sales arrangement

exists Delivery has occurred or services have been

rendered Seller’s price to the buyer is fixed or

determinable, and Cash collectibility is reasonable assured


Appendix 5B


44

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END OF CHAPTER 5

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Chapter 5 PP