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
Custome
r
receives
product

Collect
cash
from
custome
r

Purchas
e
material
s

For objectivity, revenue Convert

Ship
product is recognized at a single
material
to
s into
point
in
this
cycle.
custome
product
r
Receive
Inspect
order
product
from
Store
custome
product
r
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).
5-4

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.
5-6

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.
5-9

Percentage-ofCompletion 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-ofcompletion.
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.
5-11

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).
5-14

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.
5-15

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.
Origina
l
Entries

Adjusti
ng
Entry

Sales
Accounts
Revenues
Receivable
Credit
Debit
Credit Debit

+
$10,000

$10,000

Allowance for
Doubtful Accounts

Bad Debt
Expense
Debit
Credit Debit

$300

Credit

$300
5-18

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

Writeoff
Entry

Debit

Accounts
Receivable
Credit
Credit Debit

$75

$300

$10,000

$75

Allowance for Doubtful Accounts contraasset account.

Collection of a bad debt previously writtenoff:
Debit Cash and credit (reinstate) the

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

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).
5-28

Cash
Funds available for
disbursement.
May include highly liquid shortterm 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