Transcript Financial Accounting

VI.1
Chapter 6 - Revenue recognition
- learning objectives
1. To understand (a) the economic consequences of accounting and (b) the
relations which readers of accounts must pay attention to in relation to a
company’s reported revenue/earnings. (The quality of earnings).
2. To understand the considerations that lie behind a company’s choice of
time for revenue recognition.
3. Recognition and measurement of revenues (and expenses) for various
types of companies.
4. To understand and be able to apply the two methods that are used in terms
of depreciation of uncollectible accounts (direct write-off method vs.
allowance method).
5. To understand and be able to apply the percentage of completion method
for contractors.
6. To be able to distinguish between ordinary and extraordinary expenses.
Copyright  2000 by Harcourt Inc. All rights reserved.
VI.2
1.a Economic consequences

Who is affected by the economic consequences of
financial accounting?
 Lenders and investors
 The reporting company, its management and
other users of financial accounts
 The standard setters (FASB, IASC, FSR)
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VI.3
1.a Economic consequences

What are the possible economic consequences?
 Financial statements are influenced by the the actual economic
circumstances of the reporting company (e.g. poor result due to
declining sales or increasing expenses) => falling share prices?
 Financial statements are influenced by the choice of accounting
principles, e.g. a change of method for accounting for inventories =>
changed purchase policies (and changed taxes?)
 Financial statements are influenced by change of good accounting
practice, e.g. a requirement to always expense R&D costs that
eliminates the possibility of capitalizing =>changed behavior?
 The reactions of companies on changes in good accounting practice
have for the standard setting organizations.
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VI.4
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1.b Quality of earnings
Managements can influence the economic result in a given
direction.
Examples:
 Choice of accounting principles, e.g. production
criterion vs. sales criterion.
 Estimates, e.g. expected useful life and thus depreciation
period for fixed tangible assets.
 Timing transactions to distort revenue / expense
recognition (“artificial” income smoothing).
 Quality is an analytical concept and cannot be
translated with a true and fair view.
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VI.5
2. Turnover and revenue
recognition?

The following criteria must be met:
1. The performance must have been basically
been accomplished (the company has
performed)
2. The amount received in return is fairly
precisely stated and can be measured with a
high degree of certainty (measurable)
It is important that both criteria are met!
Copyright  2000 by Harcourt Inc. All rights reserved.
VI.6
Income, accrual basis
Income is recognized on accrual basis of accounting, cf.
§49 and 29 in the DCAA:
 Income recognition principle (§ 49)

Matching principle (§ 29)
VI.7

2. Revenue registration/-recognition
Conditions for revenue recognition:
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The revenue has been earned
I.e. a company must have performed all, or at least
substantially all the services it must perform, and if it must
perform relatively “insignificant” future services (e.g. product
warranties) it must be able to forecast with reasonable
precision the cost of providing those future services.
The size of revenues must be measurable
I.e. the company must have received cash, a receivable, or some
other asset capable of reasonably precise value measurement.
This criterion requires for instance
that the company is able to make a reasonably precise
estimate of loss on debtor, return goods etc.
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VI.8
2. Expense recognition /matching
Expenses are matched to the revenue they were meant to generate:
 It is assumed that companies buy goods and services / invest in
assets with an intent to generate revenues. A true and fair statement
of the company’s income is achieved by matching expenses as good
as possible with the revenues they were meant to generate ( expenses
are related to “their” revenue)
I.E. Costs are recognized as expenses in the period when the revenue
they were intended to generate is actually generated.
(THE MATCHING PRINCIPLE IS A PRACTICAL
IMPLEMENTATION OF A CAUSE-AND-EFFECT REASONING
– AND ALSO A REFLECTION OF INTENTS BEHIND THE
WIILLINGNES TO INDULGE COSTS)
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VI.9
Figure 6.1 Operating process for a
manufacturing company
When can a company recognize revenue
and the matching expense?
(1)
Acquire
raw materials,
plant, and
equipment
(2)
(3)
Acquire labor Sell
and other
product
manufacturing
services and
convert raw
materials into
product
(4)
(5)
Period of
holding
receivable
Collect cash
time
(6)
Returns and
warranty
periods expire
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VI.10

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2.1. Invoice criterion
Revenue for most goods and their matching expenses are
recognized at the time of sale/delivery.
The general rule in terms of revenue recognition for goods
are:
DCAA’s definition of net turnover: The sales value of
products …….
The method has the advantage that it is easy to verify.
If the sold goods are distributed through a shipping agent
then the time of passing of title from seller to buyer will be
crucial for when the sale is recognized.
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VI.11

2.1. Construction contracts
Definition according to AS no. 6:
Contracts regarding plant, construction of one or more larger asset(s)
which combined make up a project
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Characteristics:
Firm contracts about construction of a larger asset/project
Sales price/price calculation agreed upon beforehand
Completion of the contract stretches over more than one accounting
year
Title normally passes to contractor concurrently with the completion of
the job
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VI.12
2.2 Production criterion
 Companies which carry out a piece of work that spans a
longer period of time (> 1 year) must recognize revenue
concurrently with the performance on the basis of the degree of
completion. Invoicing on account, if any, does not influence
income recognition.
 E.g. contractors, which make roads, build bridges and so on,
(auditors with a contract to carry out auditing work and the
likes should perhaps use the same method, but it is not
standard practice).
 Expenses are matched with earnings. They are recognized
concurrently with the revenue recognition – costs incurred in a
way generates their corresponding revenue recognition
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VI.13
2.2 Production criterion (continued)

The challenge with this method is to determine the
degree of completion. There are the following possible
solutions (sometimes in combination):
 To have an expert calculate the degree of
completion or
 To recognize such a proportion of the total price of
the project as revenues that accumulated revenues
recognized during construction divided by the total
price reflects costs incurred relative to total
expected cost (Accumulated cost incurred during
construction divided by the total budgeted costs is
seen as reflecting the portion of total price that can
be recognizes as accumulated revenues until now
(we use this method in our examples)
 Milestone-method
VI.14
After expiration of contract = Invoicing criterion.
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If it is not possible to calculate the percentage of completion, then
the revenue recognition will have to wait for the completion of the
job and its “final” hand over to the customer.
(One example would be a contract for development of software for
which the degree of completion is too difficult to determine).
Revenue is then recognized at the time of completion and costs are
accumulated to be expensed when the project is completed/handed
over. (The costs incurred are accumulated in an asset account for
works-in-progress as the project proceeds. This account is credited
in connection with the completion, and a corresponding amount is
charged as an expense, i.e. production costs, at that point in time).
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VI.15
Accounting standard no. 6
 Paragraph 37: Enterprise contracts are recommended
treated accounting-wise according to the production
criterion (i.e. the percentage of completion method). The
completed contract method should only be used when it is
regarded to give a true and fair view of the company’s assets
and liabilities, its economic position as well as profit of loss
(the completed contract method will not be allowed
according to more recent draft to a new accounting
standard, U 20)
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VI.16
3.a. Direct write-off method,
estimation of uncollectibles
Loss on debtors
Receivables, debtors

134,000
134,000
Shortcomings
 Misrepresents accounts actually collectible. If a company e.g. has
many uncollectibles (high rate of non-performance) future
payments will most likely be significantly lower than total
amount of accounts receivable.
 It does not meet the principle of revenue recognition. Revenue is
recognized at the time of sale at a higher amount than is actually
expected to be received as payment in return for this
performance.
 It gives management an incentive to manipulate earnings with
unfortunate intentions (sell to customers who are unlikely to pay
their bills in order to generate some ”paper” revenues).
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VI.17
3.b Allowance methods
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Meets the requirement of correct asset valuation and allocation.
Revenue recognition is reduced (debited) with an amount corresponding
to the expected loss on receivables i.e. an estimate of that part of the
credit sales that is estimated not to be paid for.
The set-off to this revenue reduction is a credit to the account for
uncollectible accounts receivable, “provisions” for loss on receivables
(asset regulating account).
The method does not dim completely up for the possibility of
manipulating with earnings.
Loss on debtors
“Provisions” for loss on debtors
134,000
134,000
Copyright  2000 by Harcourt Inc. All rights reserved.
VI.18
How to estimate loss
Two basic approaches:
 Percentage of credit sales (credit sales -%method)
The turnover deduction is determined on the basis of many
years’ experience of average loss on credit sales
 Estimated loss on gross receivables at the time of the balance
sheet (balance method):The part of receivables that is not
expected to be paid is “charged” on the basis of agings of
accounts receivable at the balance sheet date (previous
experiences with loss on (1) receivables not yet due and (2) age
segments of receivables that are past due)
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VI.19
3.b.1. On the basis of credit sales
1. Settle credit sales of the period
1. Calculate expected loss on accounts receivable for the period:
as a % of credit sales on the basis of experience
2. The estimated loss from credit sales is debited in the income
statement as a deduction to turnover or as cost)
4. The provision account (“provisions for uncollectible accounts
receivable”, which is a negative asset correction account) is
credited a corresponding amount (+ check for adequate
provisions)
5. When it turns out that a specific debtor definitely cannot pay:
 The loss is credited accounts receivable (the company has
realized that payments will not be received)
 the amount is set off in the provision account for expected
losses, i.e. the loss reduces the the provision account (once
a loss has occurred it is no longer an
expected loss)
Copyright  2000 by Harcourt Inc. All rights reserved.
VI.20
3.b.2. On the basis of aging-of-accounts receivable (1/2)
1. The expected loss on accounts receivable at the time of the opening
balance is known from last year’s ending balance.
2. Actual, established losses are deducted continuously during the year
from accounts receivables from the “provisions for uncollectible
accounts receivables” (The result is that the provision account may
temporarily become quite mad!)
3. The necessary ending amount for provisions is calculated on the basis
of experience and a “gross list” over accounts receivable (e.g. divided
as follows: non yet due, 1-30 days past due, 31-60 days past due etc. the longer an accounts receivable has been past due the higher the
percentage of expected losses)
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VI.21
3.b.2. On the basis of aging-of-accounts receivable (2/2)
4. The necessary additions to provisions for the year is
calculated from the calculated necessary year amount for
provisions for uncollectible receivables. If for example
DKK -100 (!) is the book value of provisions at year end
(before the uncollectible amount is estimated) and the
amount of uncollectible accounts receivable at year end
has been estimated to be DKK300 then the account is
credited with DKK400
3. The years additions provisions are set off (debited) in the
income statement as a deduction from turnover or
charged as an expense
Copyright  2000 by Harcourt Inc. All rights reserved.
VI.22
2.4 Revenue recognition: Installment method
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Profits are recognized proportionately with the percentage
of payments received.
Costs for goods sold are identical to the revenues recognized
by sale (the sale does not itself generate profit/net income)
The method is only acceptable in exceptional cases with
extreme risk on accounts receivable
Copyright  2000 by Harcourt Inc. All rights reserved.
VI.23
2.5 Cost settlement method
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A more cautious version of the installment method.
Revenue recognition is made in much the same way.
In stead of recognizing earnings proportional to the payments received
earnings is however not recognizes until payments received exceeds
costs of goods sold – from that point of time all consecutive payments
are considered earnings.
The method implies a significant delay in recognition of net earnings.
Use of this method can only be justified in cases where there is a
completely undecidable risk of non-performance from the customer
(and the seller has ownership reservations until the entire purchase sum
has been paid).
Copyright  2000 by Harcourt Inc. All rights reserved.
VI.24
Ordinary/extraordinary earnings/expenses
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Basically there are two dimensions when deciding
whether a transaction is extraordinary: frequency and
operating subsidiarity.
If a transaction/event occurs seldom and it has low
affinity to operations => extraordinary
But it takes a lot!
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VI.25
Ordinary/extraordinary earnings/expenses
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DCAA § 30. Revenue and expenses that originate from events that are not
included in ordinary operations and which cannot be expected to be recurring
must be classified as extraordinary revenue and expenses
Accounting standard no. 5, extraordinary items. Examples of extraordinary
items:
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compensation by expropriation
loss by a fire as a result of under insurance
rarely occurring sale of shares or buildings that are plant investments
sale of subsidiary companies or parts of company activities
The underlying requirement is that the triggering events occur very seldom, that they
have significant effects, and that they are clearly distinguishable from the
“operation events” in the company.
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