Chapter 7: Revenue Recognition
1
Chapter 7
Revenue Recognition
TABLE OF CONTENTS
Framing the Issues 3
Revenue Recognition Criteria 3
Risks and Risk Sharing
5
Credit Risk
5
Customer Preference Risk and Demand Risk
9
Foreign Currency Risk
Accounting Implication of Risks
Exercise 7.01
12
15
18
Deferred Revenue
19
Example 19
Exercise 7.02
Receivables Discounts for Early Payments
24
25
26
Example
27
Interest Income
33
Exercise 7.03
34
Writing off Bad Debts
35
Example
35
Recovering Write-offs
39
Replenishing the Bad Debts Allowance
40
Example
40
Exercise 7.04
44
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Analyzing Bad Debts 45
Searching for Bad Debt Information
45
Interpreting Disclosed Numbers
47
Measuring and Calibrating Credit Risk
48
Exercise 7.05
51
Exercise 7.06
52
Warranties
Standard Warranties
Example
53
54
55
Extended Warranties
58
Exercise 7.07
59
Exercise 7.08
60
Exercise 7.09
61
Product Returns
62
Returns Allowances
63
Recording Product Returns
66
Example 67
Exercise 7.10
76
Exercise 7.11
77
Exercise 7.12
78
Exercise 7.13
79
Exercise 7.14
82
Exercise 7.15
84
Sales Incentives
88
Exercise 7.16
89
Exercise 7.17
90
Exercise 7.18
91
Exercise 7.19
92
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition
3
FRAMING THE ISSUES
This chapter takes a deeper look into revenue recognition and related
risks and consequences for accounting. In particular, we will go beyond
the examples studied earlier, such as Starbucks recognizing revenue when
it sells coffee for cash, but deferring revenue when it sells Value Cards
for cash until customers use the cards to purchase coffee. In contrast,
for many companies, the judgements around revenue recognition
are extremely more complex. Importantly, these issues often involve
challenging business and accounting decisions users of financial
statements need to understand when interpreting related disclosures.
Revenue Recognition Criteria
Revenue must be deferred until four criteria are met:
1. Persuasive evidence of an arrangement: This criteria was put in place
to stop opportunistic managers from devising sham transactions to
increase revenues, which occurred frequently prior to the accounting
scandals in 2002. For example, some opportunistic managers under
pressure to make sales targets near the end of the quarter would
enter arrangements called round-trip sales whereby they would sell
products to third-parties prior to the quarter-end with a promise to
buy them back for a higher price early the next quarter. The third
parties really did not need the products, but they saw an opportunity
to make a quick profit. Concerned about round-trip sales and other
illegal sales gimmicks, the SEC mandated companies can only
recognize revenue when there is persuasive evidence the related sales
arrangement and documentation follows normal business practice
for the industry. In some industries, this means the buyer must have
a purchase order approved by the appropriate level of management.
In other cases, such as selling coffee to customers for cash, formal
purchase orders are not required to establish a legitimate sale
occurred.
2. Delivery has occurred or service has been rendered: This criteria was put
in place to stop opportunistic managers from recognizing revenues
before they fulfilled their obligations to customers and, in particular,
before they transferred the risks of ownership to customers. For
example, some managers entered bill and hold arrangements where
they would offer customers a bargain price near the end of the quarter
to purchase products before they needed them, or even had storage
space for them. The seller would “bill” the customer and recognize
revenue, but agree to “hold” the products in their warehouse for
future delivery. Recognizing there are very rare circumstances where
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customers can actually assume the risks of ownership in bill and
hold arrangements, the SEC still permits revenue recognition in
these arrangements when several stringent criteria are met. However,
these criteria are rarely met and thus most companies must defer
recognition until delivery occurs. Furthermore, the delivery criteria
aims to restrict revenue recognition associated with several other
questionable sales transactions besides bill and hold arrangements.
Importantly, in applying this criteria, the SEC generally requires
customer acceptance: it is not enough for sellers to deliver goods
or services, customers must accept them. Additionally, sellers must
have sufficient information to reliably estimate product returns and
establish related allowances before revenue can be recognized (as
discussed later in this chapter).
3. Fixed or determinable sales price: This criteria aims to prevent
revenue recognition when the ultimate price of a product or service
is unknown or can not be estimated reliably. For example, before
this criteria was recognized, discount retailers would recognize
revenues when they received up-front annual membership fees from
customers, even when these fees were fully reimbursable if customers
subsequently decided to terminate the arrangements. The SEC argued
the price of the product could essentially change during the period
covered by the contract (from the initial fee to $0 if it was fully
reimbursed). There are numerous other situations where the SEC
does not believe the price is fixed or determinable and thus, where
revenue recognition must be deferred, including many arrangements
where sellers offer customers price protection (which we will study
later).
4. Collectibility is reasonably assured: This criteria differs from the other
three in that it centers on the customer’s performance obligation in a
sales arrangement — to pay for the good or service — rather than on
the seller’s performance obligations.
These criteria apply to a broad range of sales arrangements; but they do
not apply to contexts where revenue recognition is guided by specific
GAAP such as banking, leasing, and motion picture productions. In
fact, U.S. GAAP has over 160 standards that guide revenue recognition.
Moreover, applying the four criteria often requires considerable judgment
because the SEC recognizes they can not always be interpreted literally.
For example, retailers often allow customers to return products for a full
refund for a specified return period. Thus, strictly speaking, prices are
not fixed at sales dates (they may end up being $0 if a customer returns
products) and thus, customers have not really accepted them. The
SEC permits companies to recognize revenue at the sales date in these
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Chapter 7: Revenue Recognition
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situations, providing they can reliably estimate returns, which can require
considerable judgment, as do many of the revenue recognition criteria.
Risks and Risk Sharing
Applying the four revenue recognition criteria or industry-specific
revenue recognition GAAP is often considerably more complex than
suggested by the Starbucks’ examples at the start of this chapter because
the underlying sales agreements are more complex. Generally, this
complexity is due to provisions in sales arrangements specifying how
sellers and buyers assume risks, share risks, or try to protect themselves
from bearing risks.
This section focuses primarily on two risks particularly important to
revenue recognition and related balance sheet accounts (receivables,
deferred revenues and various allowances discussed later in this chapter):
credit risk and customer preference or demand risk.
We will also briefly discuss risk associated with foreign currency
fluctuations, which can significantly affect the U.S. dollar value of
revenue and related financial-statement items, but does not affect when
revenue is recognized in a foreign currency or how much foreign-currency
revenue is recognized.
Credit Risk
In addition to being one of the four criteria for revenue recognition,
reasonable assurance of collectibility is a necessary condition for staying
in business: a business could quickly find itself in bankruptcy if it failed
to collect a big chunk of its receivables.
While few companies are driven to bankruptcy by customers failing to
pay their bills, companies with significant receivables can suffer large
decreases in profitability if a relatively small portion of their customers
stop paying their bills.
For example, General Motors reports approximately $245 billion of gross
receivables on its balance sheet at the end of 2004, which represents
slightly more than 50% of its assets. Some of these receivables are
associated with product sales: GM bills dealerships when it sells them
cars. Revenues associated with these sales should only be recognized when
GM is reasonably certain it will collect the related receivables and can
reliably estimate the amounts that will not be collected — the bad debts.
The biggest portion of GM’s receivables are related to loans or leases on
a wide array of assets sold by other companies, but financed by GM. For
these receivables, GM should only recognize related interest revenue if
it is reasonably assured it will collect the interest and principal on these
loans and can reliably estimate the related bad debts.
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GM also recognized approximately $2 billion of bad debt expense for
2004. We will discuss this expense in great detail later in the chapter. For
now, all you need to know is bad debt expense tends to increase when
customers are less likely to pay their bills.
• GM’s $2 billion bad debt expense was very significant
relative to its $1.2 billion of pretax income for 2004.
To put this in perspective, bad debt expense could have
wiped out GM’s $1.2 billion of pretax income if it had
increased by less than 1/2% of GM’s $245 billion of
ending accounts receivable.
• Thus, an outsider valuing GM’s stock or an insider
managing its receivables should carefully assess the risk of
this occurring, which is called credit risk.
• Additionally, GM must carefully assess credit risk when
deciding whether to recognize revenue.
Credit risk refers to the possibility a debtor — usually a customer for a
receivable — will not make payments on time, fail to meet covenants,
or default on the debt altogether. When these events occur, creditors can
usually take one or more legal actions to try and minimize their losses.
For example, they can take the debtor to court or seize the collateral,
providing the expected benefits from these actions exceed the expected
costs. Credit risk depends on two factors that can offset or aggravate each
other, depending on the context:
• Collateral risk: the risk the value of the collateral will decline. By
definition, this risk pertains to the asset serving as collateral.
• General credit risk: the risk associated with the debtor’s overall
capacity to meet an obligation from its combined assets. This risk is
less severe for agreements where the creditor has seniority — is paid
earlier in the event of bankruptcy.
To understand how these risks can offset or aggravate one another,
consider a car loan from General Motors, which is reported as a financing
receivable on GM’s balance sheet. If the value of the car appreciates
dramatically during the loan period, GM’s credit risk is essentially zero,
regardless of the debtor-customer’s general credit risk: GM can avoid
losses by repossessing the car, if the customer is foolish enough to default
on the loan (rather than sell the car, pay the loan, and keep the balance).
Similarly, if the value of the car depreciates completely, GM will not be
overly concerned if the customer has low general credit risk with several
other valuable assets and few other obligations: GM can threaten to take
the customer to court if the customer tries to default on the loan.
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Chapter 7: Revenue Recognition
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Both of these examples illustrate that these two risks can offset each other
in some contexts. However, they can also aggravate each other if the value
of the debtors’ assets are correlated.
Credit risk is more problematic for some companies than others,
depending on the portion of total assets that are receivables or other
debtor-creditor arrangements such as debt investment securities, the
length of these agreements, the nature of the collateral, and the debtors’
financial circumstances.
For example, to illustrate the magnitude of this risk for some companies,
consider that General Electric, General Motors, and Ford collectively
recognized nearly $700 billion of receivables at the end of 2004, which
was slightly more than 50% of their combined total assets, but receivables
comprise less than 5% of the assets of many other well known companies,
including Wal-Mart and Home Depot.
Also collectively, GE, GM, and Ford recognized over $12.6 billion of
bad debts allowance at the end of 2004. The allowance for bad debts
is a contra asset to gross accounts receivables, reflecting the credit risk
associated with these assets. It is intended to be management’s best
estimate at the balance-sheet date of the gross receivables recognized at
that date not expected to be collected in the future (net of recoveries
associated with repossessed collateral).
For companies with large receivables balances, estimating the allowance
for bad debts requires considerable judgment and slight changes in
the assumptions can have dramatic financial-statement consequences.
You will know a company’s estimates for bad debts require significant
judgment if this is identified and discussed in the company’s Management
Discussion and Analysis (MD&A) sections of their annual reports.
In response to the 2002 accounting scandals, the SEC requires companies
to identify and discuss their most critical accounting estimates in their
MD&A, where two criteria must be met for an estimate to be deemed
critical:
• The estimate requires the company to make assumptions about issues
that are highly uncertain at the time when the estimates are made.
This criterion directly relates critical accounting estimates to risks.
• Different estimates the company reasonably could have used for
the current reporting period, or changes in accounting estimates
reasonably likely to occur from period to period have a material
impact on the company’s financial statements and disclosures.
Not surprisingly, GE, GM, and Ford include bad debts estimation as
one of their 4-8 critical accounting estimates. In deed, over 30% of the
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Fortune 100 companies (largest 100 companies measured by sales) and
over 50% of Fortune 900-950 companies include bad debt estimation as a
critical accounting estimate in their 2004 annual reports.
There are three key lessons here:
• Get in the habit of studying the critical accounting
estimates in the management discussion and analysis
sections of annual reports (and 10-Ks, which are expanded
versions of annual reports filed with the SEC) to identify
where the accounting might be suspect because it requires
considerable judgment, which provides opportunities for
honest errors or manipulation.
• Estimating the allowance for bad debt is frequently listed
as a critical accounting estimate and the uncertainty
associated with these estimates depends directly on the
company’s exposure to credit risk.
• The more you understand the underlying credit risk, the
better prepared you will be to assess the reliability of the
allowance for bad debts and bad debt expense (defined
later in this chapter).
Companies can take several steps to manage credit risk including:
• Screening customers carefully before extending credit.
• Setting credit limits, preventing sales persons from selling customers
more goods and services on account once their outstanding receivables
hit pre specified limits.
• Monitoring outstanding receivables and refusing to sell additional
products to customers who do not pay their current balances in a
reasonable amount of time.
• Outsourcing customer financing to third parties, who assume the
related credit risk.
• Selling receivables to banks and other financial institutions, which is
called factoring.
• Selling receivables to special purpose entities (SPE) — legal
entities created for a single purpose — buying receivables with cash
raised by issuing mostly debt securities. The receivables are said to be
securitized because the SPE’s investors have debt and equity security
claims on only one asset — the SPE’s receivables.
To assess the costs and benefits of taking these actions, insiders and
outsiders must understand the accounting issues discussed in this chapter.
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Chapter 7: Revenue Recognition
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Customer Preference Risk and Demand Risk
Have you ever found yourself conflicted when trying to decide whether
to purchase a big-ticket item such as a television, computer, automobile,
or house? On the upside, you are beginning to get emotionally attached
to the product, believing it has the potential to make a big difference
in the quality of your life. On the downside, you are not sure you can
afford it and even if you can, you are not sure it is the best way to spend
your money or assume debt. Maybe you can get a better deal on the
product elsewhere, find a close substitute from a competitor at a lower
price, or find a completely different use for your money that gives you
more satisfaction, including investing it because you are concerned about
the economy or otherwise want to ensure you can consume more in the
future.
Your uncertainty about this product versus other alternatives for the same
or less money reflects your preference risk — uncertainty about your
preference for a product or service. From the perspective of the person
trying to sell you the product and more generally the supply chain he or
she represents, the way you resolve this uncertainty has an upside — you
buy the product — and a downside — you take your business elsewhere.
From the seller’s perspective, your preference risk combined with other
customers’ preference risk increases demand risk — uncertainty about
the quantity of products that can be sold at various prices.
For the most part, we will not be concerned about subtle distinctions
between demand risk (that directly affects sellers but only affects buyers
indirectly through prices) and customer preference risk (that directly
affects both customers and sellers) and will use the terms interchangeably
to mean the risk customers will prefer another alternative to a company’s
products, or buy its products and return them at a later date for a refund.
Customer preference (demand) risk either encompasses or is affected by
several other risks companies can manage to varying degrees. Some of
these risks, such as downturns in the economy, commodity price increases,
and increasing competition, are largely beyond companies’ control. They
can take actions to mitigate their consequences; but they can not control
them at the source.
Regardless of whether companies respond pro actively or
reactively, their success depends largely on their ability to
manage risks better than their competitors.
In the long-term companies can devise strategies to mitigate customer
preference risk including, among other things, designing innovative
products and/or cutting costs and passing some of the savings along to
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customers. Companies also frequently take shorter-term actions, which is
the focus herein, including offering customers:
• Generous return policies, allowing customers to purchase products
they are uncertain about, knowing they can return them at a later
date if the products fail to meet their expectations, they find better
substitutes, or they find themselves strapped for cash.
• Comprehensive warranties to alleviate customers’ concerns about
defects and product quality.
• Price protection, rebates, and volume discounts to mitigate
customers’ concerns about finding lower prices elsewhere.
• Customer loyalty programs such as frequent flyer programs to
encourage repeat business.
• Below market interest rates and attractive payment terms to address
customers’ concerns about financing.
• Competitive prices for all of the above features. Another way companies manage customer preference risk is advertising,
which we discussed extensively in earlier chapters. By advertising
companies can provide information about products, which reduces
customers’ concerns as to whether the products will meet their needs.
Advertising can also provide emotional comfort. Let’s face it, ads
frequently tell us very little about products but still strengthen our
emotional bond to them.
Companies must understand and manage customer preference risk
to achieve sales growth —a key driver of shareholder value. However,
establishing return policies, credit terms, warranty policies, and taking
other actions to stimulate sales growth entails taking on costs and risks
that can affect the other two key determinants of shareholder value
— return on equity and the cost of capital — favorably or adversely
depending on how companies forecast and manage these costs and risks
and implement related policies.
For example, if a company were to offer lifetime warranties and return
privileges for products only expected to last a few years, it would
stimulate considerable sales growth in the short term, but ultimately it
would likely go out of business. By contrast, if a company were to set
return periods too short, restocking fees too high, or offer exchanges
rather than refunds, it would run the risk customers would take their
business to competitors offering more generous terms.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 11
Companies often shift risk from customers to themselves
to lower customer preference risk. For example, this
risk is generally lowered when companies offer return
policies superior to their competitors. As indicated earlier,
customers feel more comfortable purchasing products
knowing they can return them for refunds. However,
companies are then stuck with the risk returned products
will become obsolete or otherwise become impaired and
bear costs to process, hold, and resale returned products.
Similarly, warranties shift customer preference risks associated with
product quality from customers to sellers and price protection shifts the
risk prices will decline after purchases from customers to sellers (or the
risk customers will find lower prices elsewhere).
In other situations where companies take actions to mitigate customer
preference risk such as offering coupons, sales rebates, or reward points,
risk is not shifted from customers to sellers, but sellers still incur risks. For
example, companies run the risk of offering costly rebates to customers
who would have purchased the products without rebates or offering
more generous rebates than are needed to attract sales. Similarly, offering
generous credit terms to customers to alleviate financing concerns can be
risky because sellers assume not only credit risk, but also interest rate risk,
and in some cases foreign currency risk.
Many of the actions companies take to manage customer preference
risk affect revenue recognition. For example, companies must estimate
product returns and warranty costs when they make related sales. When
these estimates are not reliable because a company does not have enough
historical experience to establish reliable benchmarks, they can not
recognize revenue on these sales when products are delivered.
Thus, in assessing a company’s performance, outsiders need to not only
understand the financial-statement consequence of actions taken to
manage customer preference risks, outsiders should also consider the
extent to which the benefits from these actions more than compensate
for the costs and risks. To this end, outsiders rely greatly on numbers
reported in financial statement and footnotes. However, many of these
numbers are based on estimates affected by the underlying risks and can
require considerable judgment when these risks are severe.
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Foreign Currency Risk
Growth in revenues associated with sales in foreign currencies can change
dramatically from year to year because of changes in foreign-currency
exchange rates. For example, the Management Discussion and Analysis
section of Wal-Mart’s 2005 annual report states:
Net sales increased by 11.7% from fiscal 2004 to $285 billion in
fiscal 2005, and income from continuing operations increased
15.9% to $10.8 billion. Foreign currency exchange rates favorably
impacted sales by $3.2 billion in 2005.
Page 24, Wal-Mart’s 2005 Annual Report
Based solely on this quote, the $3.2 billion increase associated with
foreign currency exchange rates would seem imperceptible relative to WalMart’s $285 billion of revenues (approximately 1/10 %). However, users
of Wal-Mart’s financial statements are concerned about the company’s
revenue growth which was $28.89 billion for fiscal 2005. The $3.2 billion
revenue increase associated with foreign exchange gains is 13% of this
growth.
Stated alternatively, revenue growth would have been 10% rather than
the 11.7% stated in the above quote. This may not seem like much of
a difference, but in fact it could have a significant effect on valuation
models widely used by equity analysts to value shareholder value.
Moreover, regardless of what model or procedure an analyst uses to value
a company, they must estimate future revenue growth and these estimates
become more problematic when exchange rates fluctuate widely from year
to year.
When predicting revenue growth, a key determinant of its
share price, analysts must identify revenue gains and losses
associated with foreign exchange rates and decide how
they will deal with them in their analysis.
Accounting for foreign currencies is beyond the scope of this chapter.
Still, we are going to discuss foreign currency risk briefly to raise your
awareness to its increasing importance as companies expand globally.
If you are a foreign student in the U.S. or a student who has studied
abroad as a foreign student, you likely purchased part of your education
in what for you was a foreign currency and you are likely already well
aware of foreign-currency-exchange-rate risk.
For a foreign student in the U.S., this risk would be realized, for example,
if the student kept her savings in a home-country currency, planning
to convert it to pay tuition in U.S. dollars in the future, and her homecurrency devalued dramatically in the interim (relative to U.S. dollars). It
would now take more of her home-country currency to cover her tuition.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 13
To avoid, or at least mitigate, this risk prior to arriving in the U.S., she
could convert enough of her home-country savings to U.S. dollars (at
the current exchange rates) to meet her expected future tuition, housing
payments, and other U.S. dollar denominated obligations.
For example, if she was from Germany, had euro savings and expected her
future U.S. obligations to be US$10,000, and the exchange rate was 1.25
US$ per 1€ (euro) prior to arriving in the U.S., she could convert €8,000
of her savings to US$10,000 of savings.
Keeping in mind that U.S. dollars are a foreign currency for her, in this
situation we say she has hedged an anticipated foreign currency liability
(tuition payable) with a foreign currency asset (bank deposit). Hedges
occur when one exposure to a risk (her US$ savings, an asset) offsets an
opposite exposure to the risk (her anticipated US$ obligations, a future
liability). For example, if the euro appreciates relative to the dollar, the
increase in the value of her US$ asset measured in euros will offset the
decrease in the value of her expected US$ liability measured in euros.
Alternatively, at least in principal, she could use a foreign-currency
forward purchase contract to hedge the risk, which is what companies
often do on a much larger scale when entering these contracts is
financially feasible. For example, prior to arriving in the U.S. she could
enter a contract that would allow her to purchase US$ in the future at
the current exchange rates. These contracts are part of a broader class of
financial agreements called derivatives.
Virtually all companies doing significant business outside their home
countries enter foreign-currency contracts and these are discussed
extensively in annual reports. For example, the Derivative Financial
Instruments section of the Accounting Policies section of HarleyDavidson’s 2005 annual report states:
The company sells its products internationally and in most
markets those sales are made in the foreign country’s local
currency. As a result, the company’s earnings can be affected by
fluctuations in the value of the U.S. dollar relative to the foreign
currency. The company uses foreign currency contracts to mitigate
the effect of these fluctuations on earnings. The foreign currency
contracts are entered into with banks and allow the company to
exchange a specified amount of foreign currency for U.S. dollars
at a future date, based on a fixed exchange rate.
Page 54, Harley-Davidson’s 2005 Annual Report
Harley-Davidson reports the impact of foreign-currency exchange rates
on revenues in the Management Discussion and Analysis section of its
2005 annual report:
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Changes in foreign currency exchange rates, related to European
currencies, resulted in approximately $7 million of higher revenue
during 2005 when compared to 2004.
Page 37, Harley-Davidson’s 2005 Annual Report
The $7 million of revenues associated with exchange rate changes is less
than 1/10% of Harley-Davidson’s revenues and only 2% of its revenue
growth for 2005. However, the comparable number for 2004 was $46
million and represented 18% of the company’s revenue growth. This
big difference between 2004 and 2005 underscores that the financialstatement consequences of foreign currency exchange rates can fluctuate
greatly from year to year.
This fluctuation in revenues also raises a few questions an investor
analyzing Harley-Davidson would want to pursue:
• Were Harley-Davidson’s revenues affected by the hedges discussed in
the earlier quote?
• If so, why did they fluctuate so much?
• Were revenues hedged but the hedge offsets affected other incomestatement line items besides revenues?
• Were other income-statement line items such as cost of sales hedged?
The answers to these questions can sometimes be determined from
annual report disclosures, but often you need to understand accounting
is beyond the scope of this chapter to interpret them appropriately. Still,
hopefully you have learned enough about foreign currency risk from the
brief discussion here to recognize situations where your analyses could be
greatly affected by foreign exchange rates.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 15
Accounting Implication of Risks
The remainder of this chapter focuses primarily on record keeping and
reporting associated with events and circumstances greatly influenced by
credit risk, customer preference risk, and companies’ efforts to manage
these risks. We will briefly discuss a few accounting implications of these
risks to help you recognize the similarities in the measurements and
entries in the subsequent sections.
Credit risks and customer preference risks definitely have important
income statement consequences. However, the measurement focus is
primarily on balance sheets and, in particular, on ensuring the end-ofperiod balances in allowances are adequate to cover future costs associated
with these risks or efforts to mange them.
For example, the GAAP measurement goal associated with bad debts is
to ensure the ending balance in the allowance for bad debts represents
management’s best estimate of future bad debts associated with the
outstanding receivables on the balance-sheet date or, equivalently, net
accounts receivable is management’s best estimate of the expected future
collections.
To this end, companies typically record an adjusting entry
at the end of the reporting period ensuring the allowance
has the right balance. Thus, the amount recorded in
this entry is determined by the target ending balance:
the accountant first estimates the ending balance and
then determines how much must be recorded to ensure
this balance. This balance-sheet measurement approach
contrasts with the accounting we have studied thus far,
where ending balances simply totaled entries and did not
influence the amounts recorded.
Like bad debts, the measurement goal for warranties is to ensure the
balance sheet records a warranty liability, also called a warranty allowance
or warranty reserve, that is management’s best estimate of the future
warranty claims associated with products sold in the current and prior
periods still under warranty. Also similar to bad debts, an adjusting entry
is recorded at the end of the period to ensure this balance.
Similarly, the accounting for sales returns, price protection, rebates,
loyalty programs, and other sales incentives generally centers on getting
the appropriate balances in allowances that are either contra assets (like
the allowance for bad debts) or liabilities (like the warranty allowance).
Another common concept of the accounting in this chapter is the
adjusting entries ensuring the correct balance sheet numbers also affect
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income. For example, the adjusting entry to ensure the correct ending
balance for the allowance for bad debts also increases bad debt expense.
As you study the subsequent sections pay particular
attention to which income statement line items are
affected by these entries. Some increase contra revenues
and thus reduce net revenues while others increase
expenses.
You do not need to understand much about credit risk and customer
preference risk to understand the entries herein, their financial-statement
consequences, and the underlying events and circumstances they aim to
measure. However, you do need to calibrate the extent to which these
risks are present to assess how reliably the numbers in these entries
measure what they are intended to measure. Several factors affect the
reliability of reported numbers, but three are particularly important: the
extent to which the underlying events and circumstances are risky, the
extent to which there are reliable measurement benchmarks — market
prices, historical measures of comparable activity, or other companies’
measures of comparable activity — and the extent to which managers are
motivated to report honestly.
Generally, the riskier the activity being estimated (such as future bad
debts, product returns, or warranty claims) and the less reliable the
available benchmarks, the greater the possibility of measurement errors
for all managers and the more opportunities there are for dishonest
managers to manipulate measures.
Historically, the measures we will be studying in this chapter have
frequently been associated with earnings manipulation, with numerous
managers facing the SEC’s wrath for under reporting allowances to boost
income or recognizing revenue when there was too much uncertainty
about future returns or collections.
The measures in this chapter can be particularly suspect since they require
the most judgment and are recorded at the end of the period, when
managers are feeling particularly pressured to make their performance
targets and know how close they are to making them. At this time, if they
know they are going to fall short of their targets, they may be tempted
to reduce allowances below what they should be to comply with GAAP
and thus increase reported income. By contrast, if they know they will
otherwise exceed their targets, they may be tempted to build a cushion
for the future by increasing allowances above what they should be to
comply with GAAP.
Concerned about such manipulations, the SEC issued standards in
1999 and 2001 that tightened the guidelines for revenue recognition
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 17
and measuring allowances. For example, prior to the 1999 standard,
companies could decide when they had enough historical experience
to reliably estimate returns, a prerequisite for recognizing revenue at
the time of a sale. However, the SEC narrowed the latitude of these
judgments:
In general, the [SEC] staff typically expects a start-up company,
a company introducing new services, or a company introducing
services to a new class of customer to have at least two years of
experience to be able to make reasonable and reliable estimates.
Footnote 40, SEC Staff Accounting Bulletin No. 101, December 1999
Similarly, the 2001 standard tightened the guidelines for estimating
allowances and, in particular, required companies to establish consistent
policies, methodologies, and processes for estimating allowances and to
document that they are following them consistently each year.
Notwithstanding these tighter guidelines, you still
need to exercise healthy skepticism when assessing the
reliability of most of the numbers in disclosures related
to topics discussed in this chapter. While completing
these assessments is beyond the scope of this chapter, you
will learn how to identify situations where the numbers
require the most judgment — are critical accounting
estimates — and the places where you should be most
skeptical about reliability.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
18
Navigating Accounting
®
Exercise 7.01
The questions in this exercise center on Cisco’s revenue recognition
policies, as discussed in its 2005 annual report. The exercise aims to help
you learn how to search for and interpret related information.
Search Icon
This exercise requires you
to search for information.
(a) Where does Cisco discuss revenue recognition extensively in its 2005
annual report?
(b) How do you know many of Cisco’s revenue recognition decisions
require considerable judgment?
(c) Estimate the sales for which Cisco had billed customers but not yet
recognized revenues by the end of 2005?
Usage Icon
This exercise
helps you learn
how accounting
reports are used
by investors,
creditors, and other
stakeholders.
(d) Revenue must be deferred when one or more of the four criteria
discussed earlier are not met. Based on the way Cisco ultimately
recognizes previously deferred technical services revenue, which of the
four criteria is likely preventing earlier revenue recognition?
(e) Multiple element sales arrangements pertain to situations when a
company sells a bundle of goods and/or services for a package price.
Revenue recognition challenges frequently arise when the elements in
these arrangements are delivered in different reporting periods. Based
on Cisco’s discussion of these arrangements:
(1) What are the related revenue recognition issues?
(2)Which revenue recognition assumption seems to require the most
judgment?
(3) Absent GAAP restrictions, how might an unscrupulous manager
try to accelerate revenue recognition by exercising this judgment
opportunistically?
(4)What does GAAP seem to require to mitigate opportunistic
revenue recognition?
(f ) Cisco has taken actions to increase sales that essentially transfer
customer preference risk from customers to Cisco. Which of these
actions have lead to accounting requiring considerable judgment?
(g) Briefly compare and contrast the degree to which judgment is
required in revenue recognition for Cisco, Coca Cola, and Disney.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 19
DEFERRED REVENUE
In earlier chapters, we have been assuming revenue is recognized when
products are delivered to customers and customers were either billed or
paid cash at this time. There were two entries:
• Recognizing revenue by increasing (debiting) accounts receivable or
cash and increasing (crediting) revenues.
• Recognizing cost of sales by decreasing (crediting) inventories and
increasing (debiting) cost of sales.
Companies deferring revenue on some of their sales, as discussed shortly,
will generally not defer revenues on most sales and thus will record the
above entries when they deliver products to customers.
When one or more of the four revenue recognition criteria are not
met, revenues and cost of sales are both deferred until the criteria are
subsequently met. We will use an example to demonstrate the related
entries.
Example
Assumptions
• ABC company delivers inventories costing $10 to DEF company, a
retailer, on December 1, 2007. ABC bills DEF for $25 on this date,
the sales price before consideration of possible future discounts.
• Prior to agreeing to the sale, DEF was concerned about failing to
recognize a fair return on its investment in these inventories because
of obsolescence risk. There were rumors one of ABC’s competitors
was about to introduce a new product that would decrease the retail
price DEF could charge for ABC’s product.
• To facilitate the sale, ABC agrees to absorb this risk and includes a
price-protection clause in the sales contract specifying ABC would
rebate DEF for any decline in the retail price (up to the amount DEF
was billed by ABC) between December 1, 2007 (the delivery date)
and March 1, 2008. The expected price decrease is highly uncertain
and can not be estimated reliably.
• DEF agrees it will notify ABC when and if it sells inventories prior to
March 1, 2008.
• ABC decided to defer revenue associated with the sale until March 1,
2008 unless DEF sells the inventories sooner.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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®
• On December 25, 2007, DEF notified ABC it had sold products it
had purchased from ABC for $5. DEF did not seek price protection
on these sales and ABC had recorded $2 of related inventoried costs.
• ABC’s financial statements have the same line items as Cisco’ 2005
financial statements.
• ABC uses the accounts below for related entries.
Abbreviation
Account
ASSETS
AR
accounts receivable (gross)
FGI
finished goods inventory
SDelInv
segregated delivered inventories related to deferred revenues
LIABILITIES
Drev
deferred revenue liability
TEMPORARY OWNERS' EQUITY
CGS
GrSalesR
cost of good sold
gross sales revenues
Note, consistent with Cisco, ABC transfers inventoried costs to
segregated inventories (SDelInv) when goods are delivered and revenue is
deferred.
GAAP seems to be silent regarding the accounting for inventoried costs.
However, the Accounting Research Manager, a widely used GAAP
reference that also provides interpretations in places where GAAP is
silent or imprecise, recommends the approach used here and opposes the
only other logical alternative — recognizing these inventoried costs in a
contra liability to deferred revenue:
In addition, it would generally not be appropriate to offset
against deferred revenue any related deferred costs.
Accounting Research Manager, Interpretations and Examples/18
Still, Intel reports a deferred income liability rather than a deferred
revenue liability, which, interpreted literally would mean Intel nets the
related inventoried costs against its deferred revenues.
Required
(a) Record the entries ABC records on December 1, 2007.
(b) Identify line items on ABC’s balance sheet, income statement, and
cash-flow statement directly affected by the part (a) entries.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 21
(c) Record the entries ABC records on December 25, 2007.
(d) Identify line items on ABC’s balance sheet, income statement, and
cash-flow statement directly affected by the part (c) entries.
Solution
Part (a) — Delivery Date Entries
• On December 1, 2007, ABC will record the following entry to
recognize billing DEF:
+
+
AR
+ $25
= +
= +
Drev
+ $25
or
AR
Drev
Debit
$25
Credit
$25
• On December 1, 2007, ABC will also record the following entry to
transfer inventoried costs associated with the deferred revenues to
segregated inventoried costs:
+
+
FGI
-$10
+ SDelInv =
+ + $10 =
or
SDelInv
FGI
Debit
$10
Credit
$10
Part (b) — Delivery Date Entries’ Effects
The captions for the financial-statement items are based on those used in
Cisco’s 2005 annual report (pages 40-42).
Balance Sheet
• Accounts receivable, net of allowance for doubtful accounts increases
by the $25 billings, reflecting the benefit associated with the expected
future collections.
• There would be no net change in inventories. More precisely, using
the captions in the table near the middle of page 54 of Cisco’s 2005
annual report, $10 of inventoried costs would be shifted from
Manufacturing finished goods to Distributor inventory and deferred
cost of sales.
• The Deferred revenue liability recognized in the current liabilities
would increase by $25 (because the liability will be removed on or
before the price-protection period ends in the very near future).
Note, Cisco also reports a non-current liability likely associated with
deferred revenues on service contracts extending for more than a year.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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®
Income Statement
• The income statement is not affected by the part (a) entries.
Statement of Cash Flows
• The accounts receivable adjustment helps reconcile net income
to cash from operations decreases by $25. Strictly speaking this
adjustment is not needed because the part (a) entries do not affect
income or cash from operations. Thus, this adjustment must be offset
by another, as discussed next.
• The deferred revenue adjustment increases by $25, offsetting the
receivables adjustment for the reason indicated above.
• There is no net effect on the inventories adjustment because the two
inventory effects in the second entry in part (a) offset each other.
Part (c) — Revenue Recognition Entries
• On December 25, 2007, ABC records the following entry to
recognize $5 of previously deferred revenue:
= +
= +
Drev
- $5
+ GrSalesR
+
+ $5
or
Drev
GrSalesR
Debit
$5
Credit
$5
• On December 25, 2007, ABC also records the following entry to
recognize $2 cost of sales associated with the revenues in the above
entry:
+ SDelInv =
+
- $2
=
-
CGS
+ $2
or
CGS
SDelInv
Debit
$2
Credit
$2
Part (d) — Revenue Recognition Effects
The captions for the financial-statement items are based on those used in
Cisco’s 2005 annual report (pages 40-42).
Balance Sheet
• Inventories decreases by $2, signifying previously deferred
inventoried costs in segregated inventories are no longer deferred.
• The current Deferred revenue liability decreases by $5, indicating
ABC is no longer obligated to protect DEF against related price
declines and can thus recognize revenue.
• Retained earnings increases by the $3 of pretax profit recognized in
the above entries.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 23
Income Statement
• Net sales: product increases by $5, signifying ABC has met all four
criteria for revenue recognition.
• Cost of sale: product increases by $2, matching the inventoried cost
of the products to the recognized revenues.
Statement of Cash Flows
• Net income increases by the $3 pretax affect of the part (c) entries.
• The inventories adjustment increases by $2, offsetting the $2 noncash effect recognized in net income as cost of sales.
• The deferred revenues adjustment decreases by $5, offsetting the $5
non-cash effect recognized in net income as revenues.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
24
Navigating Accounting
R
E
C
O
R
D
K
E
E
P
I
N
G
A
ssets
R
E
P
O
R
T
I
N
G
=
iabilities
+O
wners'
liabilities + permanent OE+
E
quities
temporary OE
Exercise 7.02
Zero
Background
E
n
t
r
i
e
s
Tr Bal
Cls IS
Cls RE
End Bal
Direct Cash Flows
Operating
=L
cash +other assets
Beg Bal
®
Zero
Balance Sheets
Income Statements
Assets
Revenue
Investing
Liabilities
Expenses
Financing
Owners' Equity
Gains & Losses
Net Income
Cash change
Reconciliations
Net Income
Adjustments
Operating Cash
Record Keeping
and Reporting
Icon
This exercise helps
you meet the insider
record keeping and
reporting challenge.
This exercise is based on Mighty Mascot Software, Inc. (MMS). Like
Cardinal and Eagle, MMS is a fictitious company with an Excel model,
MMS8.xls. Similar to Eagle, MMS is a manufacturing company and
the MMS8.xls is a budgeting model with a one year planning horizon.
However, many of the entries in the MMS model are considerably more
complex than those in Eagle.
Like many companies, MMS sells products in two markets: (1) a stable
market where revenues are recognized when goods are delivered because
there is a reasonably high probability products will be paid for at the
agreed upon price shortly after delivery (and thus not returned) and all
revenue recognition criteria met at the time of the sale, and (2) a risky
market where revenues are recognized later because there is a higher risk
goods will be returned or price discounts will be shared with distributors.
MMS sells two products; product 1 and product 2. Both products are
sold in the stable market but only product 2 is sold in the riskier market.
Similar to the Cardinal and Eagle models, you can learn more about the
entries you will be recording in the EntryInputs sheet. Similarly, you can
learn about the accounts you can use in these entries in the Accts sheet.
Required
(a) Record MMS 19-23 on a blank piece of paper using information in
the Entryinputs and Accts sheets. You may use the balance-sheetequation or debits-credits approach.
Notes:
• You will likely find the more complex entries in MMS easier to
record if you divide them into the simpler entries recommended
in the Entryinputs sheets (for select entries that are particularly
complex)
• MMS 29-30 recognize previously deferred revenues and related
costs. We will record them after you learn about sales discounts in
the next section
(b) Identify the line items on MMS’s balance sheet, income statement,
and statement of cash flows affected by MMS 19-23.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 25
RECEIVABLES
We have already seen receivables are increased (debited) when customers
are billed and are decreased (credited) when cash is subsequently
collected. These entries typically explain most of the change in gross
accounts receivable.
We have also seen receivables generally increases when a company
acquires another company and decreases when it disposes of one of its
segments or divisions. These are non-operating events.
This section examines record keeping and reporting associated with:
• Discounts for early payments
• Interest earned on accounts receivable
• Bad debts
Writing off receivables associated with bad debts
 Recoveries — reinstating previously written off receivables
 Establishing and replenishing allowances for bad debts
 Most companies record entries for discounts and interest associated with
receivables, so we will quickly cover the related entries. However, with
one exception, these entries are usually relatively immaterial compared to
other events affecting net accounts receivable. The exception is accruing
interest can be very important to companies such as GE, GM, and Ford
with extensive financing receivables and to banks and other financial
institutions with loans (which are essentially financing receivables).
Similar to discounts and accrued interest, most companies also record
the three events associated with bad debts: write-offs, recoveries, and
establishing or replenishing allowances. While these entries can also
be relatively immaterial for some companies, understanding them and
their financial-statement consequences is very important when analyzing
companies particularly susceptible to credit risk.
Some companies include an allowance for product returns. We will
discuss the reasons they do so and an alternative approach when we study
product returns.
In addition, we will introduce an increasingly important receivables
related activity: the financial-statement consequences of transferring
receivables to other companies by factoring or securitizing them. This
accounting is very challenging and we are only going to touch the
surface.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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Navigating Accounting
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As you study this section keep in mind receivables, like revenues, can be
significantly affected by fluctuations in foreign currency exchange rates.
Discounts for Early Payments
Customers can sometimes receive discounts for paying their bills quickly.
For example, if a company permits its customers to pay their bills within
sixty days to avoid an interest penalty, it might offer a 2% discount to
customers who pay within ten days of being billed.
Here is an overview of the entries illustrated in the following example:
• Recording a discounted collection when revenue has already been
recognized by the collection date:
Increase (debit) cash for the cash received — the sales price, or
equivalently the amount billed, less the discount.
 Decrease (credit) gross accounts receivable for the amount billed
and thus the amount that would have been collected if there was
no discount.
 Increase (debit) a contra revenue for the discount, which ensures
net revenues equals the amount collected.
 • Recording a discounted collection when revenue is deferred at the
collection date:
Increase (debit) cash for the cash received — same as above.
 
Decrease (credit) gross accounts receivable for the amount
billed— same as above.
Decrease (debit) the deferred revenue liability for the discount,
which ensures the related revenue recognized in the future will
equal the amount collected. Another alternative is to increase
(debit) a contra liability to deferred revenue. This alternative
makes it easier to keep track of the information needed to record
the next entry.
 • Recognizing previously deferred revenue associated with an early
payment discount.
Decrease (debit) the deferred revenue liability for the amount
collected — the net revenue to be recognized. If the discount
was recorded to a contra liability in the previous entry, decrease
(debit) the deferred revenue liability for the sales price — the
gross revenues to be recognized — and decrease (credit) the
contra liability for the discount.
 © 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 27
• Increase (credit) gross revenues for the sales price.
• Increase (debit) a contra revenue for the discount.
Example
Note: This example ignores the inventory/cost of sales associated with the
events to focus on the revenue recognition and receivables aspect of this
example.
Assumptions
• ABC company offers customers a discount for paying their bills
within ten days of the billing date.
• On December 1, 2007, ABC sells goods to DEF, bills DEF $100, and
recognizes $100 of revenues.
• On December 10, 2007, ABC collects $98 from DEF, having given
DEF a $2 discount for early payment.
• On December 15, 2007, ABC bills XYZ $300 and defers $300 of
revenue.
• On December 24, 2007, ABC collects $294 from XYZ, having given
XYZ a $6 discount for early payment. ABC had not recognized any of
the revenue associated with the collection at this time.
• On January 15, 2008, ABC recognizes $300 of gross revenues and $6
of discount associated with the XYZ sale.
• ABC records discounts directly to its deferred revenue liability (rather
than to a contra liability) and documents deferred gross revenues and
discounts in notes (rather than accounts).
• ABC’s financial statements have the same line items as Cisco’ 2005
financial statements.
• ABC closes its fiscal year on December 31.
• ABC uses the accounts at the top of the next page for related entries.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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Navigating Accounting
®
Abbreviation
Account
ASSETS
AR
C
accounts receivable (gross)
cash
LIABILITIES
Drev
deferred revenue liability
TEMPORARY OWNERS' EQUITY
GrSalesR
gross sales revenues
SalesDis
sales discounts for early payment (contra revenue)
Required
(a) Record the entry ABC records on December 1, 2007 to recognize the
revenue on the sale to DEF and the subsequent entry it records on
December 10 to record the related collection.
(b) Identify line items on ABC’s balance sheet, income statement, and
cash-flow statement directly affected by the part (a) entries.
(c) Record the entry ABC records on December 15, 2007 to record
the deferred revenue on the sale to XYZ, the entry it records on
December 24 to record the related collection, and the entry it records
on January 15, 2008, to recognize related revenue.
(d) Identify line items on ABC’s 2007 balance sheet, income statement,
and cash-flow statement directly affected by the part (c) entries.
Solution
Part (a) — Discount Entries, No Deferrals
• On December 1, 2007, ABC will record the following entry to
recognize gross revenues:
+
AR
= + GrSalesR
+ + $100 = + + $100
AR
or
GrSalesR
Debit
$100
Credit
• On December 10, 2007, ABC will record the following entry to
recognize collection of the amount billed less an early payment
discount:
+
+
C
+ $98
+
+
AR
=
- $100 =
or
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
-
SalesDis
+ $2
$100
Chapter 7: Revenue Recognition 29
C
SalesDis
AR
Debit
$98
$2
Credit
$100
Part (b) — Discount Entries’ Effects, No Deferral
The captions for the financial-statement items are based on those used in
Cisco’s 2005 annual report (pages 40-42).
Balance Sheet
• Cash and cash equivalents increases when ABC collects $98 from
DEF on December 10, 2007.
• The two entries in part (a) have a $0 net effect on Accounts
receivable, net of allowance for doubtful accounts:


Net accounts receivable increases by $100 when DEF is billed on
December 1, 2007.
Net accounts receivable decreases by $100 when ABC collects $98
from DEF on December 10, 2007. • Retained earnings increases by the $98 increase in net revenues:

The $100 increase in gross revenues on December 1, 2007.

Less the $2 discount recognized on December 10, 2007.
Income Statement
• Combined, the two entries in part (a) increase Net sales: product by
$98:

The $100 increase in gross revenues on December 1, 2007.

Less the $2 discount recognized on December 10, 2007.
Statement of Cash Flows
• The combined effect of the entries in part (a) is Net income increases
by $98:

The $100 increase in gross revenues on December 1, 2007.

Less the $2 discount recognized on December 10, 2007.
• Net cash provided by operating activities increased by the $98
collected on December 10, 2007.
• Strictly speaking, no adjusting entry is needed because Net income
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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Navigating Accounting
®
and Net cash provided by operating activities both increased by $98 as
a result of the two entries in part (a).
• The entries have a $0 net effect on the Accounts receivable
adjustment:


Net accounts receivable increases by $100 when DEF is billed
on December 1, 2007, resulting in a -$100 Accounts receivable
adjustment on the cash flow statement.
Net accounts receivable decreases by $100 when ABC collects $98
from DEF on December 10, 2007, resulting in a +$100 Accounts
receivable adjustment on the cash flow statement.
Part (c) — Discount Entries, Deferrals
• On December 15, 2007, ABC will record the following entry to
recognize deferred revenues: +
AR
= +
+ + $300 = +
Drev
+ $300
AR
Debit
$300
Drev
Credit
$300
• On December 24, 2007, ABC will record the following entry to
recognize discounted collections associated with deferred revenues:
+
C
+
AR
= +
or
+ + $294 + - $300 = +
Drev
- $6
or
Debit
$294
$6
C
Drev
AR
Credit
$300
• On January 15, 2008, ABC will record the following entry to
recognize previously deferred revenues net of early payment
discount:
= +
= +
Drev
- $294
+ GrSalesR + + $300
-
SalesDis
+ $6
or
Drev
SalesDis
GrSalesR
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Debit
$294
$6
Credit
$300
Chapter 7: Revenue Recognition 31
Part (d) — Discount Entries’ Effects, Deferral
The captions for the financial-statement items are based on those used in
Cisco’s 2005 annual report (pages 40-42).
Balance Sheet
• Cash and cash equivalents increases when ABC collects $294 from
XYZ on December 24, 2007.
• The two 2007 entries in part (c) have a $0 net effect on Accounts
receivable, net of allowance for doubtful accounts:


Net accounts receivable increases by $300 when XYZ is billed on
December 15, 2007.
Net accounts receivable decreases by $300 when ABC collects
$294 from XYZ on December 24, 2007.
• The two 2007 entries in part (c) have a $294 net effect on the current
Deferred revenue liability:


Deferred revenues increases by $300 when customers are billed on
December 15, 2007.
Deferred revenues decreases by $6 when ABC collects $294 from
XYZ on December 24, 2007. Income Statement
• There is no effect in 2007.
Statement of Cash Flows
• Net cash provided by operating activities increased by the $294
collected on December 24, 2007.
• Income is not affected in 2007 so a $294 adjustment is needed to
reconcile the $0 effect on Net income to the $294 effect on Net cash
provided by operating activities.
• The 2007 entries in part (c) have a $0 net effect on the Accounts
receivable adjustment:


Net accounts receivable increases by $300 when XYZ is billed
on December 15, 2007, resulting in a -$300 Accounts receivable
adjustment on the cash flow statement.
Net accounts receivable decreases by $300 when ABC collects
$294 from XYZ on December 24, 2007, resulting in a +$300
Accounts receivable adjustment on the cash flow statement.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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• The 2007 entries in part (c) have a $294 net effect on the Deferred
revenue adjustment:


The deferred revenue liability increases by $300 when XYZ
is billed on December 15, 2007, resulting in a $300 Deferred
revenue adjustment on the cash flow statement.
The deferred revenue liability decreases by the $6 discount
when ABC collects $294 from DEF on December 24, 2007,
resulting in a -$6 Deferred revenues adjustment on the cash flow
statement.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 33
Interest Income
The entry to accrue interest income earned on accounts receivables when
customers do not pay their bills on time is straightforward and described
here for completeness:
• Increase (debit) accounts receivable, or a related account such as
interest receivable, for the interest earned during the reporting
period.
• Increase (credit) interest income for the same amount.
This entry has the following financial-statement consequences for a
company with financial statements similar to those in Cisco’s 2005
annual report:
Balance Sheet
• Would likely increase Accounts receivable, net of allowance for
doubtful accounts and Retained earnings.
Income Statement
• Would increase Interest income
Statement of Cash Flows
• Would increase Net income but would not affect Net cash provided
by operating activity.
• A negative adjustment would be needed to reconcile the income and
cash effects. It would likely be included in the Accounts receivable
adjustment: Recall that an increase in this account corresponds to a
negative adjustment on the cash flow statement.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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Navigating Accounting
R
E
C
O
R
D
K
E
E
P
I
N
G
A
ssets
=
iabilities
+O
wners'
liabilities + permanent OE+
E
quities
temporary OE
Exercise 7.03
Zero
Required
E
n
t
r
i
e
s
Tr Bal
Cls IS
Cls RE
End Bal
Direct Cash Flows
R
E
P
O
R
T
I
N
G
=L
cash +other assets
Beg Bal
®
Zero
Balance Sheets
Income Statements
Operating
Assets
Revenue
Investing
Liabilities
Expenses
Financing
Owners' Equity
Gains & Losses
Net Income
Cash change
Reconciliations
Net Income
(a) Record MMS 24, 25, and 29-31 a on a blank piece of paper using
information in the Entryinputs and Accts sheets. You may use the
balance-sheet-equation or debits-credits approach.
Adjustments
Operating Cash
Record Keeping
and Reporting
Icon
This exercise helps
you meet the insider
record keeping and
reporting challenge.
(b) Identify the line items on MMS’s balance sheet, income statement,
and statement of cash flows directly affected by MMS 24, 25, and 2931.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 35
Writing off Bad Debts
Most companies have policies specifying when they will write off bad
debts. For example, the Management Discussion and Analysis section
of General Electric’s annual report indicates GE writes off receivables
past due by either 120 or 180 days, depending on the nature of the
receivables:
We write off unsecured closed-end installment loans at 120
days contractually past due and unsecured openended revolving
loans at 180 days contractually past due. We write down loans
secured by collateral other than real estate to the fair value of the
collateral, less costs to sell, when such loans are 120 days past
due. Consumer loans secured by residential real estate (both
revolving and closed-end loans) are written down to the fair value
of collateral, less costs to sell, no later than when they become
360 days past due. Unsecured loans in bankruptcy are written off
within 60 days of notification of filing by the bankruptcy court
or within contractual write-off periods, whichever occurs earlier.
Page 72, General Electric’s 2005 Annual Report
An important lesson is there is typically no judgment
involved with write-offs once a company’s policy is
established.
The entry to record write-offs is decrease (debit) the allowance for
bad debts contra asset and decrease (credit) gross accounts receivable.
However, as indicated in the following example, when a receivable with
collateral is written off, a second entry is required to record the receipt of
the collateral when, and if, the company receives this property.
Example
Assumptions
• On January 31, 2007, ABC’s allowance for doubtful accounts has a
$25 balance and ABC will not replenish the allowance until February
28, 2007.
The next few assumptions indicate ABC will write
off more than $25 of receivables prior to replenishing
the allowance. This will cause the allowance to have
a negative balance prior to being replenished. An
important lesson here, and the only reason we included
this assumption, is it is not unreasonable nor unusual for
allowances to have negative balances during the reporting
period. The adjusting entry replenishing the account
(discussed later) ensures a positive balance at the end of
the period.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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• On February 1, 2007, ABC writes off a $10 receivable owed by XYZ.
There is no collateral associated with this receivable.
• On February 3, 2007, ABC writes off a $100 receivable owed by
DEF.



The collateral is products ABC previously sold to DEF.
ABC fully expects to repossess the collateral without incurring
significant costs and to reinstate it to finished goods inventories.
ABC values the collateral at $70 when it writes off the receivable
on February 3, 2007. This is the replacement cost of comparable
products ABC holds in inventory at that time: what it would cost
to replace them.
• On February 15, 2007, DEF turns over the collateral associated with
the February 3, 2007 write-off to ABC.


The replacement cost of comparable products in inventory is still
$70.
ABC reinstates the collateral to finished goods inventory at this
$70 replacement cost.
• ABC’s financial statements have the same line items as Cisco’ 2005
financial statements.
• ABC uses the accounts below for related entries.
Abbreviation
Account
ASSETS
AR
accounts receivable (gross)
AllowBD
allowance for bad debts
FGI
finished goods inventory
Required
(a) Record the write-off of the XYZ receivable on February 1, 2007.
(b) Identify line items on ABC’s balance sheet, income statement, and
cash-flow statement directly affected by the part (a) entry.
(c) Record the write-off of the DEF receivable on February 3, 2007.
(d) Record the receipt of collateral associated with the DEF write-off on
February 15, 2007.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 37
(e) Identify the combined effect of the entries in parts (c) and (d) on
ABC’s balance sheet, income statement, and cash-flow statement.
(f ) The allowance for bad debts is associated with credit risk. How do
write-off entries relate to credit risk?
Solution
Part (a) — Write-offs Entries, No Collateral
• On February 1, 2007, ABC will record the following entry to writeoff the XYZ receivable:
+
+
AR
-$10
-
AllowBD =
- $10 =
or
AllowBD
AR
Debit
$10
Credit
$10
Part (b) — Write-offs Entries Effects, No Collateral
The captions for the financial-statement items are based on those used in
Cisco’s 2005 annual report (pages 40-42).
Balance Sheet
• There is a $0 net effect on Accounts receivable, net of allowance for
doubtful accounts:


Gross accounts receivable decreases by $10, indicating ABC can
no longer expect to collect $10 from XYZ.
The allowance for bad debts decreases by $10, signifying $10 of
the allowance was used to write off the XYZ receivable.
Recording write-offs decreases gross accounts receivable
and the allowance for bad debts, but it does not change
net accounts receivable and has no visible effect on the
balance sheet. Still, banks and companies such as GE,
GM, and Ford with extensive financing receivables
typically report write-offs in their footnotes. Income Statement
• There is no effect.
Statement of Cash Flows
• There is no income effect and no cash effect, so no adjustments are
required.
• There is a $0 net effect on the Accounts receivable adjustment.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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You might be thinking this entry is not very important
because it has no net effect on any of the financial
statements. This is true, but the entry can have a very
important indirect effect: To the extent receivables were
written off during the current period that were not
anticipated when the allowance was replenished at the end
of the last reporting period, the more the allowance will
need to be replenished at the end of the current period
and the related adjusting entry decreases net income (as
we shall see shortly).
Part (c) — Write-offs Entries, with Collateral
• On February 3, 2007, ABC will record the following entry to writeoff the DEF receivable:
+
+
AR
-$30
-
AllowBD =
- $30 =
or
AllowBD
AR
Debit
$30
Credit
$30
After this entry, ABC continues to recognize a $70
receivable, signifying the value of the collateral it expects
to receive from DEF in the near future.
Part (d) — Receipt of Collateral Entries
• On February 15, 2007, ABC will record the following entry when it
receives collateral associated with the DEF write-off:
+
+
AR
-$70
+
+
FGI
+ $70
=
=
or
FGI
AR
Debit
$70
Credit
$70
Part (e) — Effects of Write-offs with Collateral Received
The captions for the financial-statement items are based on those used in
Cisco’s 2005 annual report (pages 40-42).
Balance Sheet
• The combined effect of the entries in parts (c) and (d) is a $70
decrease in Accounts receivable, net of allowance for doubtful
accounts:


Gross accounts receivable decreases by $100 ($30 + $70).
The allowance for bad debts decreases by $30. When there is
collateral, the allowances can be set lower because the collateral
reduces the downside of write-offs.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 39
Income Statement
• There is no effect.
Statement of Cash Flows
• Combined, the entries in parts (c) and (d) do not effect net income
or cash from operations and thus the adjustments must net to $0, as
indicated below.
• There is a + $70 net effect on the Accounts receivable adjustment:


Recording the $30 write-off has a $0 effect on net accounts
receivable and thus does not alter the adjustment.
Reinstating the collateral to inventory decreases accounts
receivable, which is associated with a positive adjustment.
• There is a - $70 net effect on the Inventories adjustment, which is
associated with the $70 increase in inventories.
Part (f) — Connection to Credit Risk
All risks, including credit, are forward looking, centering on the
possibility that something could go wrong. Write-offs are realizations
of credit risk. Something did go wrong: customers did not keep their
promises.
The important accounting issue is whether these
realizations were anticipated on the balance sheet. The
ending balance in the allowance always reflects the
consequences of current-period write-offs. The critical
issue that insiders and outsiders must assess is whether
the company also anticipates future losses: to what extent
does the allowance reflect credit risk.
Recovering Write-offs
Occasionally, previously written off accounts receivable are reinstated
(recovered) either because customers or other debtors pay their bills to
maintain their credit standing or renegotiate the outstanding balance.
Recoveries are recorded by reversing all or part of the prior write-off:
• Increase (debit) gross accounts receivable for the amount the
customer will owe going forward.
• Increase (credit) the allowance for bad debts for the same amount.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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Replenishing the Bad Debts Allowance
At the end of each accounting period, prior to creating financial
statements, companies replenish the allowance for bad debts. The
GAAP goal is to ensure that the allowance‘s ending balance reflects
management’s best estimate of the expected future write-offs (net of
recoveries) associated with the outstanding gross receivables at the
balance sheet date.
As we shall soon see, the adjusting entry that aims to ensure the ending
allowance balance meets this goal is reported as an expense on the
income statement. Anticipating this financial-statement consequence,
companies have been known to abandon the GAAP goal of reporting the
number that reflects their best estimate of the future write-offs in favor of
manipulating income through the expense associated with the entry. The
SEC has taken several steps to try to curb such opportunistic behavior,
but there is still plenty of room for dishonest managers to play games.
The following adjusting entry to replenish the allowance will be
illustrated in the example that follows:
• Increase (credit) the allowance for bad debts for the amount needed
to ensure the target ending balance.
• Increase (debit) the provision for bad debts, also called the bad debts
expense for the same amount.
Example
Assumptions
• ABC starts fiscal 2007 with $100 of gross accounts receivable and
a $5 allowance for bad debts, or $95 of net accounts receivable.
Thus, assuming ABC was following GAAP, at the end of fiscal
2006 management expected it would write off $5 of its $100 of its
outstanding receivables at that time.
• During fiscal 2007, ABC:



Billed customers $60 when it sold goods and services
Collected $75 from customers related to previous sales on
account
Wrote off $7 of accounts receivable.
• ABC’s credit department expects to collect $71 of the outstanding
receivables at the end of 2007.
• ABC’s financial statements have the same line items as Cisco’ 2005
financial statements.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 41
• ABC uses the accounts below for related entry.
Abbreviation
Account
ASSETS
AllowBD
allowance for bad debts
TEMPORARY OWNERS' EQUITY
ProvBD
provision for bad debts
Required
(a) Determine the bad debts provision to be recorded at the end of 2007.
(b) Record the 2007 provision for bad debts.
(c) Identify line items on ABC’s balance sheet, income statement, and
cash-flow statement directly affected by the part (b) entry.
(d) How does recording the provision for bad debts relate to credit risk?
Solution
Part (a) — Determining the provision for bad debts
The first step towards determining the provision is to derive the trial
balances for gross accounts receivable and the allowance for bad debts
immediately prior to recording the provision:
Gross accounts
receivable
Allowance for
doubtful
accounts
Beginning balance
$100
$5
Sales on account
$60
Collections
($75)
Write-offs
($7)
($7)
Trial balance
$78
($2)
ABC’s credit department expects $71 of the $78 gross accounts receivable
ending balance to be collected, which means they expect $7 of these
receivables to be written off ($78 - $71).
Prior to recording the provision, the allowance is -$2 (as indicated above).
The allowance must be increased by $9 to take it from -$2 to the $7
target ending balance. Thus, the provision is $9.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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Part (b) — Provision for Bad Debts Entry
Here is the adjusting entry ABC records at the end of fiscal 2007 to
recognize the provision for bad debts and ensure the allowance for bad
debts target balance :
-
AllowBD =
+ $9
=
-
ProvBD
+ $9
or
ProvBD
AllowBD
Debit
$9
Credit
$9
Part (c) — Effects of Provision for Bad Debts
The captions for the financial-statement items are based on those used in
Cisco’s 2005 annual report (pages 40-42).
Balance Sheet
• The provision increases the allowance for bad debts and thus
decreases Accounts receivable net of the allowance for bad debts,
reducing the future benefits associated with this asset — expected
future collections.
• The provision decreases income and thus decreases Retained
earnings.
Income Statement
• Cisco does not report the provision for bad debts separately on its
income statement, which is not unusual. The provision is typically
included in an operating expense. Based on the captions on
Cisco’s income statement, the most likely candidate is General and
administrative expenses. Thus, we conclude recording the provision
increases this expense.
Statement of Cash Flows
• Recording the provision decreases net income by $9 but does not
affect cash from operations. Thus, a +$9 adjustment is needed to
reconcile Net income to Net cash provided by operations.
• Cisco discloses this adjustment separately as Provision for doubtful
accounts.
Banks and other companies with large receivables
generally report a separate adjustment for the provision
but in contrast to Cisco, most companies with relatively
small receivables balances do not disclose a separate
adjustment. Instead, the provision adjustment is included
in the Accounts receivable adjustment.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 43
Recall, by convention the net effects of all operating
entries affecting working capital accounts such as
accounts receivable are included in the adjustments. As a
result, we typically can interpret the accounts receivable
adjustment as the net effects of the operating entries
affecting accounts receivable, or more precisely as the
negative of these effects.
When a separate adjustment is provided for the provision
for bad debts, this adjustment must be combined with
the accounts receivable adjustment to determine the net
effects of operating entries on accounts receivable.
Part (d) — Connection to Credit Risk
In contrast to write-offs net of recoveries, which reflects realizations of
credit risk, recording the provision for bad debts reflects three aspects of
credit risk:
(1) Measurement error: More or less realizations of risk during the
current period — write-offs net of recoveries — than was anticipated
in the allowance at the start of the period.
(2) Revisions to the allowance associated with the arrival of new
information during the period about receivables outstanding at the
start of the period. For example, suppose part of ABC’s $5 allowance
at the start of 2007 had pertained to non-current receivables not
due until 2008. If the credit quality of these receivables deteriorated
during 2007 because of previously unforeseen circumstances, the
allowance at the end of 2007 would need to be increased through the
provision to reflect the increased credit risk.
(3) Management’s estimate at the end of the period of the expected
future write-offs (net of recoveries) associated with new receivables
added during the period.
Note, the first aspect of credit risk looks back at unanticipated risk
realizations and the second and third look forward to expected future
losses.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
44
Navigating Accounting
R
E
C
O
R
D
K
E
E
P
I
N
G
A
=L
=
iabilities
+O
wners'
liabilities + permanent OE+
E
quities
temporary OE
Exercise 7.04
Zero
Required
E
n
t
r
i
e
s
Tr Bal
Cls IS
Cls RE
End Bal
Direct Cash Flows
R
E
P
O
R
T
I
N
G
ssets
cash +other assets
Beg Bal
®
Zero
Balance Sheets
Income Statements
Operating
Assets
Revenue
Investing
Liabilities
Expenses
Financing
Owners' Equity
Gains & Losses
Net Income
Cash change
Reconciliations
Net Income
(a) Record MMS 35-36 on a blank piece of paper using information in
the Entryinputs and Accts sheets. You may use the balance-sheetequation or debits-credits approach.
Adjustments
Operating Cash
Record Keeping
and Reporting
Icon
This exercise helps
you meet the insider
record keeping and
reporting challenge.
(b) Identify the line items on MMS’s balance sheet, income statement,
and statement of cash flows directly affected by MMS 35-36.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 45
Analyzing Bad Debts
This section discusses where you can search for information that will
help you assess bad debts and related credit risk, ways you can use it to
assess a company’s credit risk associated with receivables, and calibrate
the relative importance of this risk in assessing a company’s overall
financial position.
This discussion and the exercises at the end of the section will help
you begin to assess companies’ exposure to credit risk associated with
receivables. However, you will still have a good deal to learn to become
an expert.
Searching for Bad Debt Information
Before you start creating ratios and comparing them across companies
and time, it is important to analyze a company’s exposure to credit risk
qualitatively.
For example, knowing Boeing sells a good deal of airplanes to airlines
and many of these customers were in dire financial condition at the
end of 2005, we would start an analysis of Boeing’s credit risk knowing
qualitatively it was likely severe.
More generally, the first step in analyzing the credit risk associated with
a company’s receivables is to understand its business and the general
health of its customers. If you are not already knowledgeable about a
company and its customers, you can usually gain a pretty good general
understanding from the Business and Risks sections of companies’ 10-Ks
filings to the SEC (Sections I and IA, respectively).
Another qualitative assessment you should make early on is the extent
to which the company’s receivables are concentrated in a few customers.
Companies with concentrated receivables discuss the extent of this
concentration in footnotes. For example, the Credit Risk section of the
Significant Group Concentration of Risks footnote (Note 22) of Boeing’s
2005 annual report states:
Of the $15,252 in Accounts receivable and Customer financing
included in the Consolidated Statements of Financial Position
as of December 31, 2005, $9,711 related to commercial aircraft
customers ($221 of Accounts receivable and $9,490 of Customer
financing) and $2,797 related to the U.S. Government. Of
the $9,490 of aircraft customer financing $8,917 related to
customers we believe have less than investment grade credit. Air
Tran Airways, United, and AMR Corporation were associated
with 18%, 11% and 12%, respectively, of our aircraft financing
portfolio. Financing for aircraft is collateralized by security in the
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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related asset, and historically we have not experienced a problem
in accessing such collateral.
Page 77, Boeing’s 2005 Annual Report
This quote also suggests another path you could follow at this
point: analyze (at least qualitatively) customers’ financial statements
and footnotes, especially those under financial duress. Customer
concentration is not the only type of concentration you should assess
up front. From the previous section, we know relatively small assets
associated with retained interests in receivables transferred to SPEs are
highly concentrated sources of credit risk. You should qualitatively gauge
the extent to which this type of concentration is likely to be problematic
early in your analysis.
Once you have completed a qualitative assessment of a company’s bad
debts and credit risk, you should search for the numbers in bad debts
entries. As we shall see, these can be useful for creating ratios reflecting
credit risk that can be compared across companies and time.
When can you locate the numbers we recorded in an earlier section
for bad debts entries? The short answer is we can generally locate or
reliably estimate write-offs, recoveries, and bad debt expense when
they are important and, in particular, when companies include bad
debts estimation as a Critical Accounting Estimate in the Management
Discussion and Analysis section of their annual reports (or 10-K SEC
filings). By contrast, you can typically not estimate these items reliably
for companies with relatively small receivables balances. Between these
extremes, you may or may not locate these numbers.
The best place to start a search for this information is Schedule II in 10Ks, “Valuation and Qualifying Accounts.” The SEC requires companies
to include Schedule II when the numbers reported in the last few sections
are material.
For example, the drug store chain Walgreens, the 45th largest U.S.
company by sales in 2005, includes estimating doubtful accounts as
a Critical Accounting Policy in its 2005 annual report (page 21). To
determine if Walgreens includes Schedule II in its 10-K, we downloaded
its 2005 10-K from the investor relations section of its web site.
Most companies post their SEC filings or a link to them. You can also
download 10-Ks and other SEC filings from the SEC web site:
SEC.gov > Filings and Forms (Edgar) > Search for company filings
> General purpose searches > Companies and other filers >Company
name
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 47
Searching for “Schedule II” in this file, we soon find the table at the
bottom of the page.
Interpreting Disclosed Numbers
Knowing the entries we recorded earlier, we are tempted to conclude the
$50.4 million “Additions Charged to costs and expenses” for 2005 is the
provision for bad debts.
However, when we study product returns later in the chapter, you are
going to learn many companies combine their allowances for returns and
bad debts. This is appropriate when products are typically returned before
customers pay their bills. By contrast, when customers tend to purchase
products with third party credit cards or cash, the returns allowance
is classified as a liability, rather than as a contra asset. Unfortunately,
it is usually impossible to determine how companies classify returns
allowances.
WALGREEN CO. AND SUBSIDIARIES
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED AUGUST 31, 2005, 2004 AND 2003
(Dollars in Millions)
Classification
Additions
Balance at Charged to
Beginning Costs and
of Period
Expenses
Deductions
Balance at
End of
Period
Allowances deducted from
receivables
for doubtful accounts Year Ended August 31, 2005
$28.3
$50.4
$(33.4)
$45.3
Year Ended August 31, 2004
$27.1
$31.2
$(30.0)
$28.3
Year Ended August 31, 2003
$20.1
$30.4
$(23.4)
$27.1
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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The adjusting entry to replenish the allowance for returns differs from
the one to replenish the allowance for bad debts. The entries are similar
in they both increase (credit) an allowance (and perhaps the same
allowance), but the offset is an increase to an expense for bad debts and
an increase to a contra revenue for product returns (as discussed in detail
later in this chapter).
Thus, based solely on the above table, all we can reasonably conclude is
the $50.4 million Additions charged to costs and expenses could very well
be explained by two adjusting entries (there could be other entries but
they will usually have a much smaller impact on the allowance):
(1) Recording bad debts expense and/or
(2) Recording the provision for returns (a contra revenue).
For Walgreens, we can likely eliminate the hypothesis the returns
provision explains much, if any, of the $50.4 million because the
company’s 2005 Summary of Accounting Policies footnote states:
Customer returns are immaterial.
Page 27, Walgreens’ 2005 Annual Report
Thus, we are pretty confident the following entry is a reasonable estimate
of the combined quarterly entries Walgreens recorded during 2005 to
replenish its bad debt allowance:
-
AllowBD =
+ $50.4 =
-
ProvBD
+ $50.4
or ProvBD
AllowBD
Debit
$50.4
Credit
$50.4
Similarly, we are also confident the $33.4 million reported as
“Deductions” is a good estimate of the annual write-offs net of recoveries.
Measuring and Calibrating Credit Risk
The importance of credit risk and related bad debts information for
assessing a company’s overall performance and financial position can vary
greatly from one company to another and can vary significantly over time
for the same company.
Assuming for now the allowance for bad debts is a reasonably reliable
estimate of future bad debts, one way to measure credit risk is to express
the allowance as a percent of gross accounts receivable at each balance
sheet date. This measure reflects credit risk concerns going forward.
Similarly, we can measure credit risk realizations, which can be a good
indicator of future realizations, by expressing write-offs as a percent of the
average gross receivables balances during the reporting period.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 49
These measures can then be compared to those of comparable companies,
to the same company over time, or to changes in economy wide or
industry wide measures tending to correlate with credit risk. To illustrate
how to locate information in these ratios and their limitations, we will
derive Walgreens’ allowance to gross receivables ratios at the ends of fiscal
2004 and 2005.
We could derive Walgreens’ gross receivables by adding the allowance
balances in the earlier table to the net receivables on the balance sheet.
Alternatively, we can get it directly from the table reported in Walgreens’
Supplementary Financial Information footnote.
Supplementary Financial Information
Included in the Consolidated Balance Sheets captions are the following assets
and liabilities (In Millions):
Accounts receivable –
Accounts receivable
Allowance for doubtful accounts
2005
2004
$1,441.6
(45.3)
$1,197.4
(28.3)
$1,396.3
$1,169.1
Accrued expenses and other liabilities – Page 31, Walgreens’ 2005 Annual Report
Accrued salaries
$ 516.6
$ 465.3
Taxes other than income taxes
261.7
222.9
We see the allowance
increased from 2.4% of gross
receivables194.0
at the end
Profit sharing
143.4
of fiscal 2004
(2.4% = $28.3/$1,197.4) to 3.1% 570.2
at the end of488.3
fiscal 2005.
Other
These percents are nearly twice those GM and $1,491.9
Ford typically
report,
$1,370.5
suggesting a few hypotheses an analyst might examine:
(1) Walgreens’ receivables are riskier than GM’s and Ford’s receivables.
(2) Walgreens’ receivables’ risk is more concentrated because it retains
more credit risk associated with securitizations than GM or Ford.
(3) GM and Ford either unintentionally or intentionally understate their
allowances.
(4) Walgreens either intentionally or unintentionally overstate its
allowance.
Subject to the caveats below, the first hypothesis likely explains most of
the difference between Walgreens and the two automobile manufacturers.
We would expect Ford’s and GM’s receivables to be less risky than
Walgreens’ because theirs are collateralized while Walgreens’ are likely not
collateralized. The exercises at the end of this section compare Walgreens
to other retailers, which are better comparables than GM and Ford. These
exercises also suggest ways to extend the discussion here.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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However, before starting the exercises, we want to warn you about three
caveats to accepting the first hypothesis above — Walgreens’ receivables
are riskier than GM’s and Ford’s:
• There are plenty of situations in the past where companies either
understated or overstated allowances so the third and fourth
hypotheses are usually worthy of serious consideration.
• Credit risk retained through securitizations must be taken into
account when comparing companies (second hypothesis).
• Walgreens’ receivables may be riskier per dollar of gross receivables,
but this widely used measure of credit risk has an important
limitation: it does not account for the amount of gross receivables on
companies’ balance sheets. For example, GM’s receivables are nearly
50% of its assets while Walgreens’ receivables are only 7% of its assets.
The most important lesson of this section is analyzing a company’s
exposure to credit risk involves analyzing qualitative and quantitative
information from several sources, and comparing this information for the
same company across time and for comparable companies.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 51
Exercise 7.05
This exercise is based largely on Target’s fiscal 2005 annual report,
which has general merchandise discount stores throughout the U.S.
Additionally, one question asks you to compare Walgreens and Target.
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(a) True or False: We can reasonably conclude Target’s customers or other
debtors owed Target $5,666 at the end of fiscal 2005.
(b) Which line item on Target’s income statement includes the provision
for bad debts and how much is the provision?
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(c) Locate three places in the annual report where the bad debts expense
can be found.
(d) True or False: We can reasonably conclude the amount reported in
Schedule II as “Additions charged to costs, expenses, and revenues”
for the Accounts receivable reserves in 2005 does not include any
revenues.
(e) Record an entry that combines the quarterly entries Target likely
recorded during fiscal 2005 to recognize bad debts expense.
(f ) What line items on Target’s balance sheet, income statement, and
statement of cash flows are directly affected by the entry in part (e).
(g) Record an entry that combines the quarterly entries Target likely
recorded during fiscal 2005 to recognize write-offs, net of recoveries.
(h) What line items on Target’s balance sheet, income statement, and
statement of cash flows are directly affected by the entry in part (g).
(i) Compare Walgreens’ and Target’s exposure to credit risk and suggest
possible reasons they might differ.
(j) If you were participating in a conference call with Target’s CEO
and CFO, what questions might you ask them to advance your
understanding of Target’s exposure to credit risk?
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Exercise 7.06
This exercise compares credit risk and related disclosures for Walgreens
and two other drug store chains: CVS and Rite Aid. Fiscal 2005 10-ks for
Walgreens and CVS and a fiscal 2006 10-Ks for Rite Aid.
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Companies are free to choose how they designate fiscal years. Rite Aid
refers to the year ending March 4, 2006 as fiscal 2006. This is a bit
unusual. Companies with year-ends in January-May generally use the
prior calendar year as their fiscal year. For example, CVS refers to the year
ending March 14, 2006 as fiscal 2005 (even though it ends 10 days after
Rite Aid’s fiscal 2006 year). Similarly, Walgreens refers to the year ending
August 31, 2005 as fiscal 2005.
For the purpose of this question, you should compare Rite Aid’s fiscal
2006 disclosures to those reported by CVS and Walgreens for fiscal 2005.
Required
(a) Compute the allowance as a percent of gross accounts receivable at
the ends of the most recent two fiscal years for the three companies.
(b) Compute net write-offs as a percent of average gross receivables for
the most recent fiscal year only.
(c) Compute net accounts receivable as a percent of total assets at the
ends of the most recent two fiscal years for the three companies.
(d) Based solely on the ratios in parts (a) - (c), what conclusions might
you draw about the three companies’ exposure to credit risk?
(e) For which of the three companies does it seem particularly
inappropriate to use the ratios in parts (a) - (c) to assess exposure
to credit risk? Adjust the ratios for this company so they are more
comparable to those of the other companies.
(f ) Taking into account the ratios from parts (a) - (e) and other
information you might glean from the companies 10-K’s, briefly
compare their exposure to credit risk. What else would you like
to know about the companies if you had time to conduct a more
thorough analysis and where might you search for this information?
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Chapter 7: Revenue Recognition 53
WARRANTIES
Companies providing warranties promise customers their products are
free from defects and work as intended. Companies’ warranty policies
state what types of problems are covered under warranty, the time period,
and what remedies the company will provide and pay for, such as repairs
or replacement of defective products.
If you have purchased electronic equipment, home appliances, or big
ticket items such as a car, you likely already know there are two types
of warranties: standard and extended. Standard warranties come with
the product and are typically short-term like one year, and extended
warranties are optional and sold separately, usually when products are
purchased and can cover many years.
Warranties are similar to bad debts in they are a risky future cost
companies incur to mitigate customer preference risk and increase current
sales. However, while credit risk centers on problems with customers,
warranty risk centers on problems with products.
Warranty risk is typically larger for extended warranties because they
cover longer periods. Also, extended warranty costs can be riskier
because the further out in the future the warranty claims occur, the more
uncertainty there is about the costs of parts and labor to honor them.
Both types of warranties affect revenue recognition, but their effects
differ significantly. For standard warranties, the revenue recognition
issue is similar to the one arising with bad debts: revenue associated
with sale of a product with a standard warranty can be recognized
when warranty claims can be forecasted reliably and the four criteria for
revenue recognition have been met. Also similar to bad debts, a warranty
allowance is maintained to cover the cost of expected claims. However, as
we shall see in the next section, the entries differ.
Importantly, there are not separate revenue disclosures for standard
warranties under current GAAP. However, the FASB is considering
recognizing separate revenues as part of a broader revenue recognition
project. We will briefly discuss one of the proposed revenue recognition
alternatives for standard warranties here because it is similar to the
current GAAP for extended warranties.
The rationale behind the proposed alternative is the price of a product
with a standard warranty implicitly includes a price for future services
associated with the standard warranty. Under the proposed alternative
the portion of the price associated with standard warranty would be
deferred at the time of the sale and recognized ratably over the standard
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warranty period as service is delivered. The opponents to this approach
have argued determining the portion of the sales prices associated with
standard warranties would be problematic. This contrasts with extended
warranties, which are typically priced separately from products and often
sold separately (not bundled with product sales). However, if the price a
customer pays for an extended warranty is bundled with a product sale
it may not be the fair value of the extended warranty — the price that
would be paid to purchase the warranty in a separate transaction.
To summarize, there are three significant differences between extended
and standard warranties that explain differences in the related accounting:
1. Extended warranties are riskier and, in particular, forecasting the costs
of future warranty claims reliably is more difficult.
2. Extended warranty prices can generally be determined more reliably.
3. The services associated with extended warranties are delivered further
in the future from the dates products are sold.
Because of these differences, revenue recognition is deferred at the time
customers purchase extended warranties and subsequently recognized
ratably during the extended warranty period as service is delivered. Also
in contrast to standard warranties, allowances for extended warranty costs
are not accrued.
Thus, accounting for extended warranties is conceptually the same as
accounting for Starbucks Value Cards. Recall, revenue is deferred when
customers purchase value cards and subsequently recognized as customers
use the cards to purchase coffee, along with the cost to deliver the coffee.
Standard Warranties
Accounting for standard warranties and bad debts are similar in that an
allowance is used up during the reporting period and replenished at the
end of the period with an adjusting entry ensuring the ending balance
will cover expected future costs.
Also, similar to bad debts, estimating the allowance for warranties can
require considerable judgment: over 10% of the Fortune-100 companies
and 6% of the Fortune 900-950 listed warranty allowance estimation as
a critical accounting estimate in their 2004 annual reports. As with all
critical accounting estimates, this provides opportunities for honest errors
or manipulation.
Similarities aside, accounting for standard warranties and bad debts differ
in two ways:
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Chapter 7: Revenue Recognition 55
• The adjusting entry replenishing the allowance impacts the income
statement differently and typically increases cost of sales for standard
warranties and selling, general, and administrative expenses for bad
debts provisions.
• On the balance sheet, the allowance is a liability for extended
warranties and a contra asset (to gross accounts receivable) for bad
debts.
Here is an overview of the entries associated with standard warranties,
which are illustrated in the following example:
• Using the allowance during the period when warranty claims are met:
decrease (debit) the allowance for the total cost incurred for parts
and labor, decrease (credit) inventories for parts costs, and increase
(credit) accrued liabilities or decrease (credit) cash for labor costs (and
possibly other costs).
• Replenishing the allowance at the end of reporting periods: increase
(credit) the allowance and increase (debit) cost of sales.
Example
Assumptions
• ABC provides a standard warranty with its products and maintains an
allowance with a $1,000 balance on January 1, 2007.
• During 2007, ABC incurs parts and labor costs of $400 and $900,
respectively, to meet warranty claims.
• On December 31, 2007, ABC estimates it will cost $1,100 to meet
future claims associated with products under standard warranty at
that time.
• ABC’s financial statements have the same line items as Cisco’ 2005
financial statements.
• ABC uses the accounts below for related entries.
Abbreviation
Account
ASSETS
FGI
finished goods inventory -- parts
LIABILITIES
AcrWag
WarAll
accrued wages
Warranty allowance
TEMPORARY OWNERS' EQUITY
CGS
cost of good sold
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Required
(a) Record the costs associated with 2007 warranty claims.
(b) Identify line items on ABC’s balance sheet, income statement, and
cash-flow statement directly affected by the part (a) entries.
(c) Determine the adjustment required at the end of 2007 to ensure the
allowance will cover expected future warranty claims.
(d) Record the adjusting entry at the end of 2007 to ensure the allowance
will cover the expected future warranty claims.
(e) Identify line items on ABC’s balance sheet, income statement, and
cash-flow statement directly affected by the part (d) entries.
Solution
Part (a) — Meeting Warranty Claims Entry
Here is the entry to record the warranty claims during 2007:
+
+
FGI
- $400
= +
= +
AcrWag
+ $900
+
+
WarAll
- $1,300
or
WarAll
FGI
AcrWag
Debit
$1,300
Credit
$400
$900
Part (b) — Meeting Warranty Claims Effects
Balance Sheet
• Inventories decreases by $400, reflecting the use of parts.
• Accrued compensation (current liability) increases by $900, reflecting
the obligation to employees associated with labor costs.
• Other accrued liabilities decreases by $1,300. Cisco indicates this
line item includes its warranty allowance (page 21 of its 2005 annual
report). This decrease indicates ABC’s warranty obligations have
partly been met by settling claims.
Income Statement
• No effect
Statement of Cash Flows
• The entry does not affect net income or cash from operations, thus
the adjustments must net to $0:
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 57
$400 increase in Inventories adjustment.
 $900 increase in Accrued compensation adjustment.
 $1,300 decrease in Other accrued liabilities adjustment.
 Part (c) — Determining Allowance Adjustment
The table below explains how the $1,400 adjustment is determined. First,
a ($300) trial balance is determined to assess the allowance prior to the
entry. A $1,400 adjustment is needed to ensure the allowance has the
$1,100 target ending balance:
Warranty
Allowance
Beginning balance
$1,000
Used during year to cover warranty claims
($1,300)
Trial balance before replenishing allowance
($300)
Target ending balance needed to cover future claims
$1,100
Adjustment needed to get from trial balance to target balance
$1,400
Part (d) — Replenishing the Allowance
Here is the adjusting entry recorded at the end of 2007 to replenish the
allowance:
= + WarAll
= + + $1,400
-
CGS
+ $1,400
or
CGS
WarAll
Debit
$1,400
Credit
$1,400
Part (e) — Replenishing Allowance Effects
Balance Sheet
• Other accrued liabilities increases by $1,400, reflecting an increase in
ABC’s obligation to meet customers’ future warranty claims.
• Retained earnings decreases (pretax) by the $1,400 recognized in cost
of sales, indicating the owners’ equity decreases in anticipation of
future warranty costs.
Income Statement
• Cost of sales increases by $1,400. Thus, the higher the warranty
provision, the lower the company’s gross margin. The warranty
provision is not necessarily consistent with the matching principle.
Rather, it can be affected by the size of the allowance at the beginning
of the period, the cost of current and prior period warranty claims,
and expected future warranty claims.
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Statement of Cash Flows
• Net income decreases by $1,400 but Net cash provided by operating
activities is not affected by the entry.
• The Other accrued liabilities adjustment increases by $1,400 to
reconcile the -$1,400 income effect to the $0 cash effect.
Extended Warranties
Accounting for extended warranties involves three entries similar to
entries we covered extensively earlier in the chapter:
• Defer revenue when extended warranties are sold: increase (debit)
accounts receivable or cash and increase (credit) a deferred revenue
liability.
• Recognize revenue ratably during the extended warranty period:
increase (credit) service revenue and decrease (debit) deferred
revenues.
• Recognize costs to meet warranty claims as they are incurred during
the extended warranty period: increase (debit) cost of sales, decrease
(credit) inventories for parts costs, and increase (credit) accrued wages
for labor costs (and possibly other costs).
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Chapter 7: Revenue Recognition 59
Exercise 7.07
This exercise pertains to warranty-related questions on the 2003 final
exam, which was based on a supplement from Gateway’s fiscal 2002
annual report.
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Required
Answer final exam 2003 questions 2(f ), 2(g), 2(h) and 4(d). Be sure to
read the directions for exam question 4 which specifies how account
names should be chosen.
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Exercise 7.08
This exercise pertains to warranty-related questions on the 2004 final
exam, which was based on a supplement from AMD’s fiscal 2003 annual
report.
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Required
Answer final exam 2004 questions 2(g) and 4(d). Be sure to read the
directions for exam question 4, which specifies how account names
should be chosen.
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Chapter 7: Revenue Recognition 61
Exercise 7.09
This exercise pertains to warranty-related questions on the 2005 midterm exam, which was based on a supplement from York’s fiscal 2004
annual report.
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Answer mid-term exam 2005 questions 5(f ) and 7.
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PRODUCT RETURNS
Like warranties and bad debts, product returns are a risky future cost
companies incur to reduce customer preference risk and increase current
sales. Also, similar to bad debts and warranties, revenue recognition
on product sales must be deferred at the time of sale if returns can not
be estimated reliably and when returns can be estimated reliably, an
allowance must be maintained.
Accounting for product returns is also similar to the accounting for bad
debts and warranties in that the allowance is used during the reporting
period and replenished at the end of the period. However, the entries
are quite different than those for bad debts and warranties, and there are
several variations depending on whether:
• revenues associated with returned products have been deferred or
alternatively, have been recognized,
• customers have paid for returned products and are due a refund or,
alternatively, have not yet paid and their receivables are forgiven,
• the company reports the allowance for product returns as a contra
asset to accounts receivable or, alternatively, reports it as a liability,
• the company maintains separate allowances for revenues and
inventoried costs or, alternatively, nets these allowances into a single
allowance.
The entries for situations where products are returned after revenues
have been recognized are quite different from those where products
are returned when revenues are deferred — have yet to be recognized.
However, you should not have difficulty with the other variations once
you see a few illustrations. For this reason, rather than put you to sleep
going through all of these variations, the examples in this section assume:
• Customers have not yet paid when they return products, so their
receivables are forgiven. If they had already paid, they would receive
a cash refund. Thus, cash would decrease (be credited) rather than
receivables.
• The company uses separate allowances for revenues and inventoried
costs associated with returns. It is straightforward to net the
allowances into a single allowance once you know the entries for
separate allowances.
• The allowances are liabilities rather than contra assets. The entries are
identical for these two alternatives and it is very easy to understand
how to derive one balance-sheet-equation entry once you know the
other.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 63
Returns Allowances
As products are returned during the period, companies use return
allowances to offset the net effect of giving customers refunds (or
forgiving receivables) and reinstating returned products to inventory.
Income is not affected by these entries in the same ways it is not affected
when companies write off bad debts or incur costs associated with
warranty claims. Rather, similar to bad debts and warranties, the income
effects of product returns are recognized through adjusting entries at the
end of reporting periods.
There are three issues that cause product return allowances to be more
complicated than those for warranties and bad debts:
1. Companies can report return allowances as liabilities or contra assets.
2. There are two return allowances rather then one (unless the two are
netted, which tends to complicate rather then simplify matters).
3. Returns associated with deferred revenues affects one of these
allowances but not the other.
To the lay a foundation for the following entries, we will briefly discuss
each of these issues.
Allowance can be a Liability or Contra Asset
Conceptually, the allowance for returns is a liability, representing a
company’s legal obligation to honor its sales agreement with customers by
accepting returned products. However, in situations where return periods
ends before most customers are expected to pay their bills, companies
generally net the returns allowance “liability” against accounts receivable
as a contra asset.
To understand the intuition here, consider what happens when a
customer returns a product prior to paying for the product. The company
meets its obligation to the customer by taking back the product and
forgiving the receivable. The receivable is never collected. In anticipation
of these situations, the company creates an allowance for doubtful
accounts that includes expected product returns and expected bad debts
associated with credit risk. More generally, the allowance for doubtful
accounts can pertain to both bad debts and product returns or just to bad
debts.
Reporting the returns allowance as a contra asset rather than a liability
is an example of a more general concept called netting assets and
liabilities. Generally, GAAP does not permit companies to net assets and
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liabilities because doing so shrinks the balance sheet and reduces financial
leverage. Instead, it mandates reporting assets and liabilities at gross
amounts.
The exception to this general rule occurs when the assets and liabilities
are with the same party or group — such as customers — and will be
settled at the same time. When these conditions are met, assets and
liabilities can be netted with the net effect being reported as an asset or
liability depending on the relative sizes of the netted items. This exception
applies to returns allowances and receivables when customers (as a group)
generally return products before paying bills.
Two allowances
To understand why two allowances are used for product returns, consider
what happens when customers return products. The customer gives the
company the product, which is returned to inventory, and the company
either gives the customer a cash refund or forgives a receivable. Hence, the
two allowances are the revenue portion of the returns allowance and the
inventoried cost portion of the returns allowance.
The revenue portion of the returns allowance represents the gross cost
of expected returns – the foregone revenues that will be realized by paying
refunds or forgiving receivables associated with expected future returns.
Here, to facilitate the discussion, we will assume the revenue portion of
the returns allowance is a liability rather than a contra asset.
The inventoried cost portion of the returns allowance, when
no revenues have been deferred, represents the foregone cost of
sales (inventoried costs) associated with the expected future returns.
Alternatively stated, it is the gross benefits the company expects to receive
when customers return products – the returned products measured at
their inventoried costs. Here we assume the inventoried cost portion of
the returns allowance is a contra liability rather than a contra-contra asset.
Notably, when revenues have been deferred, no inventoried cost portion
of the returns allowance is needed because there is no need to reinstate
inventories when products with deferred revenues are returned. When
companies defer revenues, they continue to recognize the related
inventories on their balance sheets even though they have delivered
products to customers, classifying them as segregated delivered inventories
associated with deferred revenues. Thus, if customers return products
when revenue is still deferred, there is no need to reinstate the products
to inventories — they are already there. They just need to be reclassified
from segregated inventories to finished goods inventories.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 65
Importantly, the gross benefits are the same when
companies defer revenues, but the inventoried cost
portion of the allowance does not include all of these
benefits. In particular, it does not include the inventoried
costs associated with products expected to be returned
when revenues are deferred.
The reinstated inventory is recorded at the lower of its inventoried
cost when it was sold or its replacement cost on the date it is returned
— what it would cost the company to produce or otherwise acquire
comparable inventory on the return date. If the replacement cost is lower
than the original inventoried cost, the return can be recorded at the
original inventoried costs, as illustrated in the examples, with a follow-up
impairment entry to write the inventory down to its replacement cost.
For this reason, to simplify the subsequent discussion and examples, we
will assume replacement costs are the same as the original inventoried
costs in this chapter.
We are also going to ignore restocking fees customers might incur when
they return products. When there are restocking fees or when customers
otherwise receive partial refunds, customers essentially share the risk
associated with returns. As a result the net cost associated with refunds,
discussed below, is smaller and a smaller allowance is needed.
To summarize, given the above assumptions, the net cost of a product
return is the foregone gross margin on the sale: foregone revenue (sales
price) less foregone cost of sales (measured at inventoried costs). Stated
alternatively, the company’s net obligation to customers who are eligible
to return products in the future is its expected gross obligation to them as
a group — the estimated future refunds or forgiven receivables, measured
at sales prices (foregone revenues) — less the benefits it expects to
receive from them — the returned products, measured at their expected
inventoried costs (foregone cost of sales). For companies not deferring
revenue, this net obligation to customers is the net product return
allowance it reports as a liability on its balance sheet (or net contra asset
when allowances are classified this way).
Deferred Revenues Issues
Two features of deferred revenues accounting affect product return
entries: First, as indicated above, the inventoried cost portion of the
returns allowance does not include inventoried costs associated with
future returns for which revenue is expected to still be deferred when the
products are returned.
Second, the SEC has indicated the deferred revenue liability should
represent revenues expected to be recognized in the future and thus
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should be reported net of expected returns and price discounts. As
we shall see, this is accomplished by decreasing deferred revenues for
expected future returns and increasing the revenue portion of the
allowance for bad debts.
Recording Product Returns
The entries recorded when products are returned depend on whether
revenue has been recognized on the returned product or deferred. Here is
a broad overview of the entries, which will be illustrated in the example
that follows.
When revenues have previously been recognized:
• Decrease (debit) the revenue portion of the returns allowance for the
revenue associated with the returned product.
• Decrease (credit) cash or accounts receivable for the revenue
associated with the returned product, depending on whether the
customer receives a refund or a forgiven receivable.
• Decrease (credit) the inventoried cost portion of the returns
allowance for the inventoried costs associated with the returned
product.
• Increase (debit) finished goods inventory for the inventoried costs
associated with the returned product.
When revenues have not been recognized (are deferred):
• Decrease (debit) the revenue portion of the returns allowance for
the revenue associated with the returned product. (This is the same
as above and thus does not depend on whether revenues have been
deferred or previously recognized when products are returned.)
• Decrease (credit) cash or accounts receivable for the revenue
associated with the returned product, depending on whether the
customer receives a refund or a forgiven receivable. (This part of the
entry also does not depend on whether revenues have been deferred
or previously recognized when products are returned.)
• Decrease (credit) segregated delivered inventories associated with
deferred revenues for the inventoried costs associated with the
returned product. (This is the only part of the entry depending on
whether revenues have been recognized or deferred when products are
returned.)
• Increase (debit) finished goods inventory for the inventoried costs
associated with the returned product. (This part of the entry
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 67
also does not depend on whether revenues have been deferred or
previously recognized when products are returned.)
Example
Assumptions
• ABC Company classifies the net allowance for product returns
as a liability and maintains separate revenue and inventoried cost
portions.
• ABC had not yet collected any cash from customers who returned
products during 2007. Receivables balances were forgiven in
exchange for returned products.
• The replacement costs of products returned during 2007 were the
same as the original inventoried costs recognized when the products
were sold.
• At January 1, 2007, the revenue and inventoried costs portions of the
allowance are $125 and $20, respectively, with the revenue portion
split as follows:


$100 associated with products expected to be returned after
revenue has been recognized.
$25 associated with products expected to be returned before
revenue is recognized (and thus is deferred)
• During 2007, customers return products for which $150 of revenues
and $30 of costs of sales have previously been recognized.
• During 2007, customers return products associated with $40 of
deferred revenues and $8 of inventoried costs.
• On December 31, 2007, ABC expects customers to return products
in the future currently associated with $60 of the deferred revenues
recognized on its balance sheet.
• On December 31, 2007, ABC expects customers to return products
in the future associated with $200 of previously recognized revenues
and $40 of previously recognized cost of sales (inventoried costs).
• ABC uses the accounts at the top of the next page:
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Abbreviation
Account
ASSETS
AR
accounts receivable (gross)
FGI
finished goods inventory
SDelInv
segregated delivered inventories related to deferred revenues
LIABILITIES
Drev
deferred revenue liability
RetAlRev
Returns allowance: revenues portion
RetAlInv
Returns allowance: inventoried cost portion (contra liability)
TEMPORARY OWNERS' EQUITY
CGS
SalesRet
cost of good sold
sales returns (contra revenue)
Required
(a) Record the 2007 product returns for which revenues had previously
been recognized when products were returned.
(b) Describe in general terms how the entry in part (a) directly affects
ABC’s balance sheet, income statement, and statement of cash flows.
(c) Record the 2007 product returns for which revenues were deferred
when products were returned.
(d) Describe in general terms how the entry in part (c) directly affects
ABC’s balance sheet, income statement, and statement of cash flows.
(e) Complete the table at the top of the next page to determine the
adjustments needed to ensure the correct ending balances in the
portions of the return allowance associated with revenues and
inventoried costs.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 69
Allowance for Returns
Inventoried
cost portion
Revenues portion
Associated
with
recognized
revenues
Associated
with
recognized
revenues
only
Associated
with
deferred
revenues
Beginning balances
Products with recognized revenues returned
Products with deferred revenues returned
Trial balances
Target balances
Required adjustments
(f ) Record the adjusting entry to replenish the allowances.
(g) Describe in general terms how the entry in part (f ) directly affects
ABC’s balance sheet, income statement, and statement of cash flows.
Solution
Part (a) — Returns Entry: Revenue Recognized
To facilitate the discussion, we are going to parse this entry into two
parts: what the company gives the customer — forgives a receivable —
and what the customer gives the company — the product.
Forgiving the receivable:
+
+
AR
- $150
= + RetAlRev
= +
- $150
or
RetAlRev
AR
Debit
$150
Credit
Debit
$30
Credit
$150
Reinstating the returned product to inventories:
+
+
FGI
+ $30
=
=
-
RetAlInv
- $30
or
FGI
RetAlInv
$30
Combining the above entries, we see the net effect of the return:
+
+
AR
- $150
+
+
FGI
+ $30
= + RetAlRev
= +
- $150
-
RetAlInv
- $30
or
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
70
Navigating Accounting
®
RetAlRev
FGI
AR
RetAlInv
Debit
$150
$30
Credit
$150
$30
Part (b) — Returns Entry Effects: Revenue Recognized
Balance Sheet
• Assets decrease by $120, with a $150 receivables decrease offset by
a $30 inventories increase. This $120 net decrease in assets reflects
the realized customer preference risk associated with the return
— foregone gross margin on a prior sale.
• Liabilities decrease by $120, with a $150 decrease in the revenue
portion of the allowance offset by a $30 decrease in the inventoried
cost portion (its contra liability). This $120 decrease in liabilities
signifies ABC has met an obligation to a customer by accepting the
returned product in exchange for forgiving a receivable.
• Owners’ equity is not affected by the entry, at least directly. Similar
to writing off bad debts, using the allowances during the reporting
period does not directly affect owners’ equity. Moreover, if the return
was anticipated earlier when the allowances were replenished at the
end of the prior period, it is already reflected in owners’ equity. By
contrast, if the return was not anticipated in the allowance, it will
affect owners’ equity when the allowance is replenished at the end of
the current period.
Income Statement
• No direct effect.
Statement of Cash Flows
• There is no income effect and no cash-flow effect, but the following
reconciling adjustments offset each other:

$150 increase in receivables adjustment (this asset decreased)

$30 decrease in the inventories adjustment (this asset increased)

$120 decrease in accrued liabilities or other liabilities, reflecting
the net decrease in the returns allowances ($150 decrease in
the revenues portion less a $30 decrease in the inventoried cost
portion).
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 71
Part (c) — Returns Entry: Revenue Deferred
Once again, to facilitate the discussion, we are going to parse this entry
into two parts: what the company gives the customer — forgives a
receivable — and what the customer gives the company — the product.
The entry associated with forgiving the receivable is the same as it is
when a customer returns a product where revenue has been recognized.
The entry associated with the returned product differs. When revenues
have already been recognized, the returned product is reinstated to
inventory. However, if revenue is still deferred when the product
is returned, the inventoried costs are reclassified from segregated
inventories to finished goods inventories.
Forgiving the receivable:
+
+
AR
- $40
= + RetAlRev
= +
- $40
or
RetAlRev
AR
Debit
$40
Credit
Debit
$8
Credit
$40
Reclassifying segregated inventories:
+
+
FGI
+ $8
+
+
SDelInv
- $8
=
=
or
FGI
+
+
SDelInv
- $8
SDelInv
$8
Net effect of the return:
+
+
AR
- $40
+
+
FGI
+ $8
= + RetAlRev
= +
- $40
or
RetAlRev
FGI
AR
SDelInv
Debit
$40
$8
Credit
$40
$8
Part (d) — Returns Entry Effects: Revenue Deferred
Balance Sheet
• Assets decrease by the $40 receivables decrease. There is no net effect
on inventories.
• Liabilities decrease by the $40 decrease in the revenue portion of the
allowance.
• Owners’ equity is not directly affected by the entry.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
72
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Income Statement
• No direct effect.
Statement of Cash Flows
• There is no income effect and no cash-flow effect, but the following
reconciling adjustments offset each other:


$40 increase in receivables adjustment (this asset decreased)
$40 decrease in accrued liabilities or other liabilities, reflecting
the decrease in the revenue portion of the returns allowances.
Part (e) — Determining the allowance adjustments
There are two keys to understanding the adjustments to the allowances:
• Split the revenue portion of the allowance into two parts: the part
associated with products returned when revenues are deferred and
the part associated with products returned when revenues have
previously been recognized.
• Base the allowances on the end-of-period revenue status of previously
sold products still within the return period (and thus can be returned
in the future):


The ending balance in the deferred revenue part (of the revenue
portion of the returns allowance) should reflect the expected
returns associated with the deferred revenues liability at the end
of the period. This will ensure the deferred revenue liability
reported on the balance sheet satisfies the SEC requirement it be
net of expected returns and thus reflects revenues expected to be
recognized in the future.
The ending balance in the previously recognized revenue part (of
the revenue portion of the returns allowance) should reflect the
expected returns associated with revenues recognized prior to the
end of the period.
You might be thinking there is a disconnect here: The allowances are
determined based on the revenue status of products at the end of the
period, but are used up based on the revenue status when products are
returned. No problem: the adjusting entries at the end of the next period
automatically adjust for status changes. In particular, they adjust for
products returned next period that are associated with deferred revenues
at the end of the current period and recognized in revenue before they
are returned.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 73
The derivations in the completed table below are comparable to those for
adjustments for bad debts and warranties:
Allowance for Returns
Revenues portion
Beginning balances
Products with recognized revenues returned
Inventoried
cost portion
Associated
with
recognized
revenues
Associated
with
deferred
revenues
Associated
with
recognized
revenues
only
$100
$25
$20
($150)
Products with deferred revenues returned
($30)
($40)
Trial balances
($50)
($15)
($10)
Target balances
$200
$60
$40
Required adjustments
$250
$75
$50
Part (f) — Replenishing Allowances Entry
To facilitate the discussion, we will parse this entry into three parts: one
for each allowance in the above table.
Adjusting the previously recognized revenues part of the revenue portion
of the returns allowance:
= + RetAlRev
= +
+ $250
-
SalesRet
+ $250
or
SalesRet
RetAlRev
Debit
$250
Credit
$250
Adjusting the inventoried cost portion of the returns allowance, which
only pertains to cost of sales associated with previously recognized
revenues. In particular, this allowance is not affected by inventoried costs
associated with deferred revenues:
=
=
-
RetAlInv
+ $50
-
CGS
- $50
or
RetAlInv
CGS
Debit
$50
Credit
$50
Adjusting the deferred revenues part of the revenue portion of the returns
allowance:
= +
= +
Drev
- $75
+
+
RetAlRev
+ $75
or
Drev
RetAlRev
Debit
$75
Credit
$75
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
74
Navigating Accounting
®
Here is the combined effects of the three entries:
= +
= +
Drev
- $75
+
+
RetAlRev
+ $325
-
RetAlInv
+ $50
-
SalesRet
+ $250
-
CGS
- $50
or
SalesRet
RetAlInv
Drev
RetAlRev
CGS
Debit
$250
$50
$75
Credit
$325
$50
Part (g) — Replenishing Allowances Entry Effects
As you study the financial statement consequences of this entry, keep
in mind that, regardless of whether prior sales have been previously
recognized or are deferred at year end, this entry:
1. Adjusts for differences between expected returns at the beginning of
the current period (associated with prior period sales) and realized
returns during the current period associated with prior period sales.
2. Recognizes realized returns associated with current period sales,
which can not be anticipated in the beginning allowance.
3. Recognizes anticipated future returns associated with current period
sales.
Balance Sheet
• Liabilities increase by $200: This represents a $275 net increase in
the combined returns allowances, offset by a $75 decrease in deferred
revenues. More specifically:


Accrued liabilities or other liabilities increases by $275,
depending on how the allowances are classified on the balance
sheet. This reflects the additional costs ABC incurs for the three
reasons listed above.
Deferred revenues decreases by $75, ensuring it only reflects
expected future revenues.
• Owners’ equity decreases by $200, reflecting the $200 reduction in
gross margin recognized in income (discussed next).
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 75
Income Statement
Gross margin decreases by $200, reflecting the net cost of returns
associated with current or prior period sales not recognized in income in
prior periods. It nets two effects:
• $250 decrease in net sales, ensuring reported revenues are net of
revenues associated with product returns.
• $50 decrease in cost of sales, ensuring reported cost of sales are net of
cost of sales associated with product returns.
Cash Flow Statement
The following adjustments reconcile the entry’s -$200 income effect to
its $0 effect on operating cash flows:
• $275 increase in the accrued liabilities or other liabilities adjustment,
reflecting the combined effect of the adjustment on the allowances.
• $75 decrease in the deferred revenues adjustment.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
76
Navigating Accounting
R
E
C
O
R
D
K
E
E
P
I
N
G
A
ssets
R
E
P
O
R
T
I
N
G
=
iabilities
+O
wners'
liabilities + permanent OE+
E
quities
temporary OE
Exercise 7.10
Zero
Required
E
n
t
r
i
e
s
Tr Bal
Cls IS
Cls RE
End Bal
Direct Cash Flows
Operating
=L
cash +other assets
Beg Bal
®
Zero
Balance Sheets
Income Statements
Assets
Revenue
Investing
Liabilities
Expenses
Financing
Owners' Equity
Gains & Losses
Net Income
Cash change
Reconciliations
Net Income
(a) Record MMS 26-28 on a blank piece of paper using information in
the Entryinputs and Accts sheets. You may use the balance-sheetequation or debits-credits approach.
Adjustments
Operating Cash
Record Keeping
and Reporting
Icon
This exercise helps
you meet the insider
record keeping and
reporting challenge.
Here are some facts you need to know to record these entries:
• MMS defers revenues on sales to the riskier market (at the time of
the sale when customers are billed and products are shipped).
• MMS offers price protection to customers in the riskier market
and establishes an allowance for price protection to ensure the
deferred revenues liability reflects expected revenues.
• Similar to returns, price-protection realizations either decrease
cash (if customers who receive price protection have already paid
MMS) or forgiven receivables.
• MMS recognizes a royalty in cost of sales associated with one
of its products. MMS is only obligated to pay royalties when it
recognizes revenues and accrues a related liability at this time.
• MMS is not obligated to pay a refund on returned products
for which it has previously recognized revenues (because it only
permits customers in the riskier market to return products and
revenues are deferred in the riskier market at the time of sale). For
this reason, MMS maintains an allowance for the royalty costs
previously recognized in cost of sales associated with expected
returns.
(b) Identify the line items on MMS’s balance sheet, income statement,
and statement of cash flows directly affected by MMS 26-28.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 77
Exercise 7.11
The questions in this exercise center on Nordstrom’s return policies, as
discussed in its 2005 annual report and 10-K:
Search Icon
This exercise requires you
to search for information.
The exercise aims to help you learn how to search for and interpret
related information.
Required
(a) What is Nordstrom’s return policy?
Usage Icon
This exercise
helps you learn
how accounting
reports are used
by investors,
creditors, and other
stakeholders.
(b) What was the total amount of the adjusting entries Nordstrom
recorded during fiscal 2005 to replenish the allowance for sales
returns?
(c) True or False: Ignoring other adjustments to gross revenues (besides
returns), based on the information in the 10-K and annual report,
we can reasonably conclude Nordstrom had $8,528,148 of gross
revenues in fiscal 2005: $7,722,860 net revenues (reported on the
income statement) + $805,288 (from Schedule II).
(d) Estimate the gross profit Nordstrom’s would have reported in fiscal
2005 if Nordstrom’s could have stopped allowing customers to return
products without affecting sales. This is not a realistic assumption
because Nordstrom’s generous return policy is thought to be very
important to customers. So, what do we learn from this exercise and
what is it we would like to know when analyzing Nordstrom we do
not learn from this exercise and probably can not determine?
(e) Estimate the percent decrease in the returns adjusting entries for the
year that would have been needed to increase basic earnings per share
by one cent. State your assumptions and consider whether they are
reasonable.
(f ) Companies are frequently accused, rightfully or wrongfully, of
managing earnings per share a few cents to meet analysts’ forecasts.
We have no reason to believe Nordstrom did so during fiscal 2005
and do not mean to imply they might have done so. Still, as a healthy
skeptic of reported numbers you should know how to calibrate the
likelihood management could increase earnings per share (eps) by
a few cents through the allowance adjustment either intentionally
or inadvertently (by honest errors). What is your assessment of the
possibility Nordstrom could have increased or decreased eps a few
cents to meet analyst expectations at the end of fiscal 2005?
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
78
Navigating Accounting
®
Exercise 7.12
The questions in this exercise center on Nordstrom’s and Cisco’s return
policies, as discussed in their 2005 annual reports and 10-Ks:
Search Icon
This exercise requires you
to search for information.
Required
(a) Identify a fundamental difference in the ways the two companies
report the allowance for sales returns?
(b) What difference(s) in the companies’ businesses likely explain the
difference in the way they report the returns allowance?
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 79
R
E
C
O
R
D
K
E
E
P
I
N
G
A
ssets
=
iabilities
+O
wners'
liabilities + permanent OE+
E
quities
temporary OE
Zero
E
n
t
r
i
e
s
Tr Bal
Cls IS
Cls RE
End Bal
Direct Cash Flows
R
E
P
O
R
T
I
N
G
=L
cash +other assets
Beg Bal
Zero
Balance Sheets
Income Statements
Operating
Assets
Investing
Liabilities
Expenses
Financing
Owners' Equity
Gains & Losses
Revenue
Net Income
Cash change
Reconciliations
Net Income
Adjustments
Operating Cash
Record Keeping
and Reporting
Icon
This exercise helps
you meet the insider
record keeping and
reporting challenge.
Exercise 7.13
This exercise has two objectives. First, it gives you an opportunity to
review the entries associated with bad debts, warranties, and product
returns. Second, it develops a template you can use for reverse
engineering related entries for real companies, assuming they report
returns allowances as a liability. (The next exercise builds a template for
situations where the returns allowance is a contra asset).
You will be recording entries into the following Excel file: Ex_07.14.xls.
Ex_07.14.xls contains numerous comments to help you intrepret the
numbers in cells:
• To learn about cells with red triangles in their upper-right corner,
place your mouse over them to view the associated comment.
• Comments are a feature of Excel; Use Excel’s Help to learn how to
resize or move the comment for better viewing, if needed, such as
right clicking the cell to “Show comment” or “Hide Comment”.
Accounts
ABC company uses the following accounts:
Accounts Legend
Assets
ALLBD
C
GrAR
Invent
OthAs
SDelInv
Allowance for bad debts
Cash
Gross accounts receivable
Inventories (not yet delivered)
Other assets
Segregated delivered inventories
Permanent Equities
DefRev
OthEq
RetALLRev
RetALLInv
SIALL
WarALL
Deferred revenues liability
Other equities
Returns allowance: revenue portion
Returns allowance: inventoried costs portion
Sales incentive allowance
Warranties allowance
Temporary Owners' Equity
CGS
GrRev
OthExp
SalesIn
SalesR
Cost of goods sold
Gross revenues
Other expenses
Sales incentive contra revenue
Sales return contra revenue
Year-1 Events
ABC’s year-1 events start at the top of the next page. We are assuming
ABC defers revenues when there is considerable uncertainty about returns
and there are no collections, write-offs, warranty claims, or product
returns during year 1.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
80
Navigating Accounting
®
E1.1 $1,000 of revenue is recognized when goods are shipped and
customers are billed. There are $200 of related inventoried costs.
E1.2 $400 of revenue is deferred when goods are shipped and
customers are billed. There are $80 of related inventoried costs.
E1.3 At year-end, management estimates products with $35 of
recognized revenues and $7 of recognized cost of sales will be
returned and products with $15 of deferred revenues and $3 of
inventoried costs will also be returned.
E1.4 At year-end, management estimates there will be $60 of warranty
costs associated with the revenues recognized in year 1.
E1.5 At year-end, management estimates $20 of the year-end gross
receivables will not be collected because of bad debts.
Year-2 Events
E2.1 $1,600 is collected from customers (represents several collections
during year-2, including collections of year-1 and year-2 sales).
E2.2 Paid customers associated with $20 of deferred revenues and $4
of related inventoried costs return products that can be resold.
Unpaid customers associated with $30 of deferred revenues and
$6 of related inventoried costs return products that can be resold.
E2.3 Paid customers associated with $20 of the previously recognized
revenues and $4 of related inventoried costs return products
that can be resold. Unpaid customers associated with $20 of the
previously recognized revenues and $4 of related inventoried
costs return products that can be resold.
E2.4 $350 of previously deferred revenues are recognized. There are
$70 of related inventoried costs.
E2.5 $1,500 of revenue is recognized when goods are shipped and
customers are billed. There are $300 of related inventoried costs.
E2.6 $600 of revenue is deferred when goods are shipped and
customers are billed. There are $150 of related inventoried costs.
E2.7 $15 of bad debts are written off.
E2.8 Warranty claims for year 2 cost $20: $15 for inventoried parts
and $5 cash for labor.
E2.9 At year-end, management estimates there will be $120 of future
warranty costs associated with years 1 and 2 revenues.
E2.10 At year-end, management estimates products with $70 of
recognized revenues and $14 of recognized cost of sales will be
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 81
returned and also products with $30 of deferred revenues and $6
of inventoried costs will be returned. See the table below to get
the required adjustments.
Allowances for Returns
$150
Revenues portion
Inventoried
costs portion
Associated with Associated with Associated with
recognized
deferred
recognized
revenues
revenues
revenues only
Yr-1 ending balances
E2.2
E2.3
E2.10
$35
$15
Paid customers return products for
which revenues are still deferred
($20)
Unpaid customers return products for
which revenues are still deferred
($30)
$7
Paid customers return products for
which revenues were recognized
($20)
($4)
Unpaid customers return products for
which revenues were recognized
($20)
($4)
Trial balances prior to replenishing
allowances
($5)
($35)
($1)
Target trial balances
$70
$30
$14
Required adjustments to ensure
target balances
$75
$65
$15
E2.11 At year-end, management estimates $40 of the year-end gross
receivables will not be collected. A $35 provision is needed to
ensure this ending balance.
E2.12 At year-end, management establishes a $10 allowance for rebates
associated with recognized revenues offered near the end of year
2. No rebates were paid in year 2.
Required
Record the year-1 and year-2 entries in the Blank_BSE_Matrix
worksheet of Ex_07.14.xls.
When you have completed the exercise, take a few moments to study
the template in the General Structure worksheet Ex_07.14.xls. This
worksheet provides a good template for reverse engineering companies
related entries to the extent this is possible.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
82
Navigating Accounting
R
E
C
O
R
D
K
E
E
P
I
N
G
A
ssets
=
iabilities
+O
wners'
liabilities + permanent OE+
E
quities
temporary OE
Zero
E
n
t
r
i
e
s
Tr Bal
Cls IS
Cls RE
End Bal
Direct Cash Flows
R
E
P
O
R
T
I
N
G
=L
cash +other assets
Beg Bal
Zero
Balance Sheets
Income Statements
Operating
Assets
Investing
Liabilities
Expenses
Financing
Owners' Equity
Gains & Losses
Revenue
Net Income
Cash change
Reconciliations
®
Exercise 7.14
This exercise modifies Exercise 7.14 such that return allowances are
recorded to contra assets rather than liabilities. In the process, it develops
a template you can use for reverse engineering related entries for real
companies, assuming they report returns allowances as a contra asset.
Net Income
Adjustments
Operating Cash
Record Keeping
and Reporting
Icon
This exercise helps
you meet the insider
record keeping and
reporting challenge.
You will be recording entries into the following Excel file: Ex_07.15.xls.
Accounts
The accounts names are the same as they were in Ex7.14. However, those
associated with the returns allowance are now classified as contra assets
rather than liabilities as indicated below:
Accounts Legend
Assets
ALLBD
C
GrAR
Invent
OthAs
RetALLInv
RetALLRev
SDelInv
Allowance for bad debts
Cash
Gross accounts receivable
Inventories (not yet delivered)
Other assets
Returns allowance: revenue portion
Returns allowance: inventoried costs portion
Segregated delivered inventories
Permanent Equities
DefRev
OthEq
SIALL
WarALL
Deferred revenues liability
Other equities
Sales incentive allowance
Warranties allowance
CGS
GrRev
OthExp
SalesIn
SalesR
Cost of goods sold
Gross revenues
Other expenses
Sales incentive contra revenue
Sales return contra revenue
Temporary Owners Equity
Required
Record the following entries in the Blank_BSE_Matrix worksheet of
Ex_07.15.xls.
E1.3 At year-end, management estimates products with $35 of
recognized revenues and $7 of recognized cost of sales will be
returned and products with $15 of deferred revenues and $3 of
inventoried costs will also be returned.
E2.2 Paid customers associated with $20 of deferred revenues and $4
of related inventoried costs return products that can be resold.
Unpaid customers associated with $30 of deferred revenues and
$6 of related inventoried costs return products that can be resold.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 83
E2.3 Paid customers associated with $20 of the previously recognized
revenues and $4 of related inventoried costs return products
that can be resold. Unpaid customers associated with $20 of the
previously recognized revenues and $4 of related inventoried costs
return products that can be resold.
E2.10 At year-end, management estimates products with $70 of
recognized revenues and $14 of recognized cost of sales will be
returned and also products with $30 of deferred revenues and $6
of inventoried costs will be returned. See the table below to get
the required adjustments.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
84
Navigating Accounting
R
E
C
O
R
D
K
E
E
P
I
N
G
A
ssets
=
iabilities
+O
wners'
liabilities + permanent OE+
E
quities
temporary OE
Zero
E
n
t
r
i
e
s
Tr Bal
Cls IS
Cls RE
End Bal
Direct Cash Flows
R
E
P
O
R
T
I
N
G
=L
cash +other assets
Beg Bal
Zero
Balance Sheets
Income Statements
Operating
Assets
Investing
Liabilities
Expenses
Financing
Owners' Equity
Gains & Losses
Revenue
Net Income
Cash change
Reconciliations
Net Income
®
Exercise 7.15
The questions in this exercise center on Cisco’s return policies, as
discussed in its 2005 annual report and 10-K. You will be recording
entries into the following Excel file:
Chapter_07 > Ex_07.16.xls.
Adjustments
Operating Cash
Record Keeping
and Reporting
Icon
This exercise
helps you meet
the outsider record
keeping and reporting
challenge — recreate
companies entries
from disclosed
information.
The exercise aims to help you learn how to search for and interpret
related information, and reverse engineer related entries when this is
possible. There are five parts that build on each other.
Each part has a worksheet based on the balance-sheet-equation-matrix
template developed in Exercise 7.15.
(a) The goals and directions are at the top of the Part (a) worksheet and
reproduced or paraphrased below for your convenience:
Goal
• Help you learn how to locate revenue-related disclosures found
in one or more cells in the template for part (a). These cells are
identified with specific entries or account balances.
Search Icon
This exercise requires you
to search for information.
Directions
• Replace as many of the yellow cells in the template as possible
with numbers from Cisco’s fiscal 2005 Annual Report or 10-K.
• Do not try to derive other numbers in Part (a).
• To learn about an account, place your mouse over its abbreviation
in the fist row of the template’s balance-sheet equation.
• More generally, to learn about cells with red triangles in their
upper-right corner, place your mouse over them.
Usage Icon
This exercise
helps you learn
how accounting
reports are used
by investors,
creditors, and other
stakeholders.
• Cisco classifies the returns allowance as a contra asset to accounts
receivable rather than as a liability. Cisco’s annual report states the
allowance is “recorded as a reduction of our accounts receivable.”
We are interpreting this to mean Cisco deducts the allowance
for returns separately from the allowance for doubtful accounts
reported on its balance sheet. Alternatively, we could have
interpreted the reported amount to be the combined allowances
for bad debts and returns.
(b)The goals and directions are at the top of the Part (b) worksheet
and reproduced or paraphrased below for your convenience:
Goal
• Help you learn how to locate revenue-related disclosures
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 85
identified with groups of cells in the template for part (b) and
thus with more than one underlying entry or account balance.
This will help you interpret revenue-related numbers aggregating
qualitatively different types of information: you will learn how
to identify reported numbers’ key components, their relative
magnitudes, and how they relate to underlying events and
circumstances.
Directions
• Form groups of related cells: Locate numbers in Cisco’s 2005
Annual Report or 10-K aggregating information related to two or
more template cells.
• For example, if Cisco had reported the decrease in gross accounts
receivable associated with returns, you would have grouped cells
F20 and F22 (GrAR column for events E2 and E3).
• For each of these groups, assign variables to cells (in the group)
you have not yet located and derive an equation. For example, if
Cisco had reported a $10 decrease in gross accounts receivable
associated with returns, the related equation would be:
-X1 - X2 = -$10,
where X1 and X2 are the decreases in gross accounts receivable
associated with returns of deferred and recognized revenues,
respectively.
• If two or more cells represent the same concept (e.g. gross
revenues), use the same variable for both cells. For example, if you
had already designated X3 as the decrease in accounts receivable
associated with collections, you would use X3 again for the related
increase in cash.
(c) The goals, assumptions, and directions are at the top of the Part
(c) worksheet and reproduced or paraphrased below for your
convenience:
Goal
• Help you learn how to: (1) specify assumptions allowing you
to estimate customer collections, which companies generally do
not disclose, (2) assess the validity of these assumptions, and (3)
estimate collections. Knowing the extent to which collections
differ from net revenues can help you assess the reliability of
revenues: A large gap between revenues and collections can signal
aggressive revenue recognition.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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Assumptions
• The effects of “other operating events” are negligible relative
to cash collections and can be ignored in your analysis (X5 =
X6 = X10 =X14 = X20 = X21 = X24 = $0, as indicated in the
template).
• The effects of sales incentives entries are negligible relative to cash
collections and can be ignored in your analysis (X4 = X13 = X17
= X19 = $0, as indicated in the template).
Directions
• Use the assumptions above to simplify the equations for net
revenues, the deferred revenue liability, and net accounts
receivable (see the notes for Steps 15, 17 and 19, respectively).
• Solve these three equations. Hints: (1) Adding two of these
equations together (by adding the left sides to get a new left
side and the right sides to get a new right side) will get you an
equation with only four variables, X2, X3, X11 and X12. Next,
determine a way to combine the new equation with the third
equation (the one you haven’t used yet) to eliminate everything
except X15 — the collections.
• Assess the validity of the above assumptions. Use information
in Cisco’s annual report to assess (in general terms) the extent to
which it is reasonable to assume away sales incentives, and other
operating entries when estimating collections. Hint: Assuming
these assumptions are not correct, given what you learn about
Cisco in general and its events and circumstances during fiscal
2005, how big (in absolute value) could the related variables likely
get relative to the cash collections estimate?
(d) The goals and directions are at the top of the Part (d) worksheet and
reproduced or paraphrased below for your convenience:
Goal
• Help you learn a short-cut to estimate customer collections and
appreciate its limitations.
Directions
• Now that you have suffered through the equations in Part (c)
to estimate customer collections, we are going to show you a
short-cut that is much more intuitive and will give you the same
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 87
estimate. You may be wondering why we didn’t just skip the
equations and go straight to the shortcut. Good, that is essentially
the second question for this part of the exercise: What did you
learn from parts (b)-(c) you would not have learned if we had
started with the shortcut?
• Here is the first question: What is the shortcut?
Hints
(1) Each of the three equations in Part (c) had one number. Two
of these numbers are disclosed in one of the three primary
financial statements, the third is a component of a prominent
number disclosed in this statement, and customer collections
is a component of another prominent number disclosed in
this statement. Which statement is this?
(2) Given what you know about this statement, and, in particular,
the purpose of the section of the statement where collections
and the three numbers in the equations are located, how
is this purpose related to the way we combined the three
equations to derive the collections estimate?
(e) The goals and directions are at the top of the Part (e) worksheet and
reproduced or paraphrased below for your convenience:
Goal
• Help you learn how to: (1) specify assumptions allowing you
to estimate warranty claim costs, which companies generally do
not disclose, (2) assess the validity of these assumptions, and
(3) estimate warranty claim costs. Knowing the extent to which
warranty claim costs differ from the warranty provision can help
you assess the reliability of the provision: A large gap between the
provision and costs can signal income manipulation through the
provision.
Directions
• Estimate the warranty claim costs for fiscal 2005.
• State and defend your assumptions.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
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SALES INCENTIVES
Similar to warranties, bad debts, and product returns, sales incentives are
risky future costs companies incur to reduce customer preference risk and
increase current sales.
Sales incentives can include cash consideration given to customers such
as rebates, volume discounts, price discounts, or slotting fees paid to
retailers to ensure shelf space or non-cash consideration such as products
associated with buy-one-get-one-free promotions, trips associated with
frequent flyer programs, or gifts.
Accounting for sales incentives is similar to the accounting for bad debts,
warranties, and product returns in that an allowance is used during the
reporting period and replenished at the end of the period.
Sales incentive allowances are typically liabilities, but like returns
allowances, they can be contra assets to accounts receivable. They are used
up during reporting periods when customers receive the cash or non-cash
consideration.
With few exceptions, the end-of-period adjusting entries replenishing
allowances increase a contra revenue for sales incentives where customers
receive cash consideration, and increase cost of sales for sales incentives
where customers receive non-cash consideration.
From the above overview and prior sections, we expect you already know
enough about the accounting for sales incentives to interpret related
disclosures. The exercise on the next page will reinforce your learning.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 89
R
E
C
O
R
D
K
E
E
P
I
N
G
A
ssets
=
iabilities
+O
wners'
liabilities + permanent OE+
E
quities
temporary OE
Zero
E
n
t
r
i
e
s
Tr Bal
Cls IS
Cls RE
End Bal
Direct Cash Flows
R
E
P
O
R
T
I
N
G
=L
cash +other assets
Beg Bal
Zero
Balance Sheets
Income Statements
Operating
Assets
Investing
Liabilities
Expenses
Financing
Owners' Equity
Gains & Losses
Revenue
Net Income
Cash change
Reconciliations
Net Income
Exercise 7.16
The questions in this exercise center on Merck’s indirect discounts, as
discussed in its 2005 10-K:
The exercise aims to help you learn how to search for and interpret
related information, and reverse engineer related entries.
Adjustments
Operating Cash
Record Keeping
and Reporting
Icon
This exercise
helps you meet
the outsider record
keeping and reporting
challenge — recreate
companies entries
from disclosed
information.
Merck’s 10-K discusses an allowance for indirect customer discounts.
Merck provides a table similar to those normally reported in Schedule II
for this indirect allowance, showing the aggregate flows into and out of
the allowance and its beginning and ending balances.
Merck does not report the indirect allowance in Schedule II. However,
Merck believes accounting for indirect discounts requires considerable
judgment that can materially impact its financial statements.
Merck also discusses two components of the indirect allowance
(chargebacks and rebates) and provides beginning and ending balances
for these component allowances. However, Merck does not provide the
flows into and out of the component allowances.
Thus, Merck provides the flows for the combined indirect allowance, but
does not provide them for its two component allowances.
Search Icon
This exercise requires you
to search for information.
For the following questions, assume the flows in and out of the allowances
for chargebacks and rebates are proportionate to these allowances’ ending
balances.
Required
(a) How do Merck’s indirect and direct discounts differ?
(b) Record an entry to summarize the entries Merck recorded during
fiscal 2005 to replenish the allowance for indirect discounts.
Usage Icon
This exercise
helps you learn
how accounting
reports are used
by investors,
creditors, and other
stakeholders.
(c) What line items in Merck’s fiscal 2005 balance sheet, income
statement, and statement of cash flows are likely directly affected by
the entry in part (b)?
(d) Record an entry to summarize the entries Merck recorded during
fiscal 2005 to replenish the allowance for indirect discounts.
(e) What line items in Merck’s fiscal 2005 balance sheet, income
statement, and statement of cash flows are likely directly affected by
the entry in part (d)?
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
90
Navigating Accounting
R
E
C
O
R
D
K
E
E
P
I
N
G
A
ssets
=
iabilities
+O
wners'
liabilities + permanent OE+
E
quities
temporary OE
Zero
E
n
t
r
i
e
s
Tr Bal
Cls IS
Cls RE
End Bal
Direct Cash Flows
R
E
P
O
R
T
I
N
G
=L
cash +other assets
Beg Bal
Zero
Balance Sheets
Income Statements
Operating
Assets
Investing
Liabilities
Expenses
Financing
Owners' Equity
Gains & Losses
Revenue
Net Income
Cash change
Reconciliations
Net Income
Adjustments
Operating Cash
Record Keeping
and Reporting
Icon
This exercise
helps you meet
the outsider record
keeping and reporting
challenge — recreate
companies entries
from disclosed
information.
Search Icon
®
Exercise 7.17
The questions in this exercise center on Church and Dwight’s sales
incentives, as discussed in its 2005 10-K:
The exercise aims to help you learn how to search for and interpret
related information, and reverse engineer related entries when possible.
Required
(a) True or False: Based on information in its 2005 10-K, we can
reasonably conclude Church and Dwight recognizes costs associated
with cooperative advertising promotions with customers as
advertising expense when Church and Dwight reimburses customers
for placing advertisements for Church and Dwight products.
(b) Record an entry to summarize the entries Church and Dwight
recorded during fiscal 2004 to reverse prior promotion liabilities.
(c) Companies have been accused, rightfully or wrongfully, of building
up a “cookie jar” for future use by recognizing excessive allowances in
good years, knowing they can reverse them in the future. We have no
reason to believe Church and Dwight did this. Still, a healthy skeptic
should at least calibrate the effect of a reversal on earnings per share.
What was this effect in 2004?
This exercise requires you
to search for information.
Usage Icon
This exercise
helps you learn
how accounting
reports are used
by investors,
creditors, and other
stakeholders.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
Chapter 7: Revenue Recognition 91
Exercise 7.18
This exercise pertains to revenue-recognition questions on the 2006 final
exam, which was based on a supplement from HP’s fiscal 2005 annual
report.
Search Icon
This exercise requires you
to search for information.
Required
Answer final exam 2006 questions 1e, 1f, 1g, 1i, 4f and 4g. Be sure to
read the directions for exam question 4, which specifies how account
names should be chosen.
Usage Icon
This exercise
helps you learn
how accounting
reports are used
by investors,
creditors, and other
stakeholders.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson
92
Navigating Accounting
®
Exercise 7.19
This exercise pertains to revenue-recognition questions on the 2007 final
exam, which was based on a supplement from Motorola’s fiscal 2006
annual report.
Search Icon
This exercise requires you
to search for information.
Required
Answer final exam 2007 questions 1a, 1k, 3h, and 3i.
Usage Icon
This exercise
helps you learn
how accounting
reports are used
by investors,
creditors, and other
stakeholders.
© 1991–2009 NavAcc LLC, G. Peter & Carolyn R. Wilson