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) Copyright 2000 by Harcourt Inc. All rights reserved. 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. Copyright 2000 by Harcourt Inc. All rights reserved. VI.4 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. Copyright 2000 by Harcourt Inc. All rights reserved. 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: 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. Copyright 2000 by Harcourt Inc. All rights reserved. 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) Copyright 2000 by Harcourt Inc. All rights reserved. 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 Copyright 2000 by Harcourt Inc. All rights reserved. VI.10 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. Copyright 2000 by Harcourt Inc. All rights reserved. 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 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 Copyright 2000 by Harcourt Inc. All rights reserved. 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 Copyright 2000 by Harcourt Inc. All rights reserved. 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. 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). Copyright 2000 by Harcourt Inc. All rights reserved. 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) Copyright 2000 by Harcourt Inc. All rights reserved. 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). Copyright 2000 by Harcourt Inc. All rights reserved. VI.17 3.b Allowance methods 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) Copyright 2000 by Harcourt Inc. All rights reserved. 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) Copyright 2000 by Harcourt Inc. All rights reserved. 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 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 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 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! Copyright 2000 by Harcourt Inc. All rights reserved. VI.25 Ordinary/extraordinary earnings/expenses 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: 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. Copyright 2000 by Harcourt Inc. All rights reserved.