Welcome to Financial Accounting
Chapter 5
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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
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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
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Alternative Points of Revenue Recognition
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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
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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.
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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.
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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
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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:
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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.
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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.
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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.
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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.
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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
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Costs are recognized based on the percentage complete.
Revenue Recognition During ProductionDealer Pays Bills
Freeport Boats pays the amounts owed on account.
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Assets and liabilities decline when amounts on account are paid.
Revenue Recognition During Production2013 Activity
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2013 Income Statement amounts:Revenue $1,800,000Expenses 1,260,000Gross profit $ 540,000
Revenue Recognition During Production2014 Activity
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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
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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
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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
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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
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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
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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
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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
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2013 Profit$0
Revenue Recognition at Completion of Production2014 Activity
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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
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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
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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
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Percentage-of-Credit-Sales Method
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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
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Aging Method Example
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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
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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:
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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
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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
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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.
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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
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365Net sales ÷ Accounts receivable balance
Receivable Collection Period =
Receivable Collection Period For Google
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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
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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
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Appendix 5B
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END OF CHAPTER 5