Chapter 5

Revenue and
Monetary Assets

McGraw-Hill/Irwin

Copyright 2011. The McGraw-Hill Companies. All Rights Reserved.

Two Questions of
Revenue Recognition
1. When should revenue be recognized
(i.e., what accounting period)?
2. How much revenue should be
recognized?

5-2

Operating Cycle
Customer
receives
product

Ship
product to
customer

Collect cash
from
customer

For objectivity, revenue

is recognized at a single
point in this cycle.

Receive
order from
customer

Purchase
materials

Convert
materials
into product

Inspect
product
Store
product
5-3

Revenue Recognition: GAAP

Criteria:
When?
Substantial performance.
Conservatism concept.

How much?
Revenue and expenses can be reliably
measured (i.e., collected or collectible).
Realization concept (i.e., realized or realizable).
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Revenue Recognition: IFRS

Risks and rewards of ownership are
transferred to buyer.
Seller no longer has managerial involvement.
Amount of revenue can be reliably measured.
Probable that seller will receive revenue.
Costs of transaction can be reliably measured.

5-5

Revenue Recognition: SEC

Persuasive evidence of an order.
Delivery occurred or services performed.
Customer has assumed risks and rewards of
ownership.

Fixed or determinable selling price.

Collectibility of sale is reasonably
assured.
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Delivery Method
Most common.
Recognize revenue when goods or
services are delivered.
When should revenue be recognized?
Auto repair shop?
Prepaid hotel room?
Dealer sold auto to customer on monthly
payment (installment) plan?
5-7

Consignment Method
Consignor ships goods to consignee
(but retains title until they are sold).
Consignee attempts to sell goods.
Revenue recognized when goods are
sold.
Why? Risks (and rewards) of
ownership are not yet transferred.
5-8

Franchise Revenue
Permits franchisee to use name/product
of franchisor.
Recognize when earned.
Not necessarily when agreement signed or
fee received.
Usually after franchisee commences
operations.
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Percentage-of-Completion
Method
Design/development and construction/
production projects that extends over several
years (e.g., high-rise building, aircraft).
Could be either fixed price or cost
reimbursement contract.
Need reasonable assurance of profit margin
and ultimate realization.
Revenue recognized based on total
percentage of project work performed during
period.
5-10

Completed Contract Method

Alternative to percentage-of-completion.
Used when amount of income to be
earned on contract cannot be reliably
estimated.
Costs incurred are held as an asset (i.e.,
Contract Work in Progress) until revenue
is recognized.
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Production Method
Permitted, but not required by GAAP.
Applies to certain agricultural and mining
products.
Recognize revenue at harvest.
Clear market determined price.
Performance substantially complete.

5-12

Installment Method
Customer pays a certain amount per
period.
Installment payment is recognized as
revenue and a proportional part of cost of
sales is recorded.
Conservative variation is cost recovery
method.
Cost of sales is recorded at an amount equal to
installment payment (until total is recovered).
No income reported until cost is recovered.
5-13

Real Estate Sales

Developer often finances over many years.
Uncertainty of income due to uncertainty of
receipt of future payments.
Conditions required for revenue recognition:
Period allowing cancellation and refund to buyer
has expired.
Cumulative payments equal to at least 10% of
purchase price.
Seller has completed or is clearly capable of
completing required improvements (e.g., roads).
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Amount of Revenue Recognized

Net realizable value.
Amount reasonably estimated to be
collected.

Adjustment for bad debts.

Direct write-off method.
Allowance method.
% of sales.
% of (analysis of) accounts receivable.
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Bad Debts:
Direct Write-Off Method
Write-off when specific uncollectible
account is identified.
What accounting concept is violated
under this method?

5-16

Bad Debts:
Allowance Method
Estimate amount of current period credit
sales that will not be collected.
% of credit sales, or
Aging accounts receivables (i.e., use higher
uncollectible % on older receivables).
Percentages based on experience and
judgment.

5-17

Bad Debts:
Allowance Method
Business makes $10,000 of sales on credit.
Estimates 3% of credit sales will be uncollectible.

Original
Entries

Adjusting
Entry

Accounts Receivable
Debit Credit

$10,000

Sales Revenues
Debit Credit

$10,000

Bad Debt Expense

Allowance for
Doubtful Accounts

Debit Credit

Debit Credit

$300

$300
5-18

Bad Debts:
Allowance Method
Business determines that a customer who owes $75
will be unable to pay.
Allowance for
Doubtful Accounts

Write-off
Entry

Debit Credit

$75

$300

Accounts Receivable
Debit Credit

$10,000

$75

Allowance for Doubtful Accounts contra-asset

account.
Collection of a bad debt previously written-off:
Debit Cash and credit (reinstate) the Allowance for
Doubtful Accounts.

5-19

Sales Discounts
Cash discount to induce customers to pay
bills quickly.
E.g., 2/10 net 30 (i.e., customer gets 2% cash
discount if paid within 10. Otherwise, total
amount is due within 30 days.).

Methods of recording:
As reduction from gross sales.
As expense of the period.
Record initial sale at net; discounts not taken
recorded as additional revenue.
5-20

Credit Card Sales

Bank plan (e.g., MasterCard, Visa).
Does not create accounts receivable.
Sales discount is credit card fee.

Credit plan (e.g., American Express, Discover).

Creates accounts receivable.
Sales discount is credit card fee.
No bad debts because card company assumes risk
of loss.
5-21

Sales Returns & Allowances

Estimate percentage of revenues that will
eventually result in returns or allowances.
Conceptually similar to bad debt expense.
Sales Returns
and Allowances

Provision for
Returns and
Allowances

similar to

Bad Debt
Expense

similar to

Allowance for
Doubtful
Accounts
5-22

Sales Returns & Allowances

Alternative:
Skip adjusting entry.
Write off as they occur.
Why is this acceptable?
Materiality vs. matching.

5-23

Adjustment to Revenue
vs. Expense
Realization concept suggests adjustment to
revenue.
In practice both methods are found.
Creates differences in revenue and gross
margin, but not income.
But must follow consistency concept (i.e., same
handling from year-to-year).
Allows same company results to be compared from
year-to-year.
But comparisons between companies may be
distorted.

5-24

Warranty Costs
Estimates usually based as a percentage of sales
(similar to bad debt expense).
Warranty
Expense

similar to

Bad Debt
Expense

Allowance for
similar to
Doubtful
Accounts
Allowance account is debited for actual expenditures.
Warranty expense is part of cost of sales.
Allowance for
Warranties

5-25

Interest Revenue
Amount earned by lender during the period.
Interest paid at maturity.
Creates interest earned, but not yet paid.
Adjusting entry:
Debit Interest Receivable.
Credit Interest Revenue.

Interest Receivable account is zeroed out when

loan and interest is paid off.

5-26

Interest Revenue
Discounted loan.
Interest is implicit.
Creates liability account (i.e., Unearned Interest
Revenue) when loan is made.
Adjusting entry:
Debit Unearned Interest Revenue.
Credit Interest Revenue.

5-27

Monetary vs. Nonmonetary

Assets
Monetary assets.

Money or claims to receive fixed sums of money.

Appear on balance sheet at value.
Cash; face value.
Accounts receivable; estimated realizable value.
Marketable securities; fair value.

Non-monetary assets.

Items used in future production and sales of

goods and services.
Appear on balance sheet at unexpired cost (i.e.,
book value).
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Cash
Funds available for disbursement.
May include highly liquid short-term
investments (e.g., certificate of deposit).

5-29

Receivables
Accounts receivables.
Called trade receivables for nonfinancial
institutions.

Other receivables.
E.g., advances or loans to employees for
travel expenses.
Shown separately (e.g., Due from
Employees).
5-30

Marketable Securities
Also called Temporary Investments.
Must be marketable (i.e., able to readily
sell).
E.g., commercial paper, treasury bills,
publicly traded stocks and bonds issued
by companies.

5-31

Accounting for Marketable

Securities
1. Held-to-maturity securities.
Debt securities entity intends to hold to maturity.
Reported at cost.

2. Trading securities.
Debt or equity held for current resale.
Reported at market value.
Realized and unrealized gains/losses included in
current years income.
5-32

Accounting for Marketable

Securities
3. Available-for-sale securities.
Debt or equity securities that do not fit either of
the other two categories.
Reported at market value.
Realized gains and losses go through current
periods income.
Unrealized gains (losses) are credited (debited) to
stockholders equity account.
5-33

Accounting for Marketable

Securities
Available-for-sale securities:
Debt or equity securities that do not fit
either of the other 2 categories.
Reported at market value.
Realized gains and losses go through
income.
Unrealized gains and losses directly
credited (or debited) to a stockholders
equity account.
5-34

Analysis of Monetary Assets

Current ratio.
Current assets Current liabilities.
Measures liquidity; margin of safety.
Need to also look at make up of assets (e.g.,
cash vs. inventory).

Acid-test ratio.
Monetary current assets Current liabilities.
Excludes inventories and prepaid items.

5-35

Analysis of Monetary Assets

Days cash.

Cash (Cash expenses 365).

Rough approximation of cash expenses is total
expenses minus noncash expenses (e.g.,
depreciation).
Shows how well company is managing cash.

Days receivables.

Also called collection period.

Accounts receivable (Sales 365).
If available, use credit sales.
General rule: Should not exceed 133% of payment
terms.
5-36