MBA Module 3 PPT

Week 5
Recognition and
Revenue Recognition
Revenue recognition refers to the
recording of revenue by a company
GAAP has two revenue recognition
criteria that must be met for revenue to be
recognized (and recorded on the income
statement)—revenue must be:
1. Realized or realizable
2. Earned
Cisco’s Revenue Recognition Policy
SEC Guidelines for Revenue
SEC outlines its guidance for revenue
recognition in Staff Accounting Bulletin
(SAB) 101, where it states that revenue is
realized, or realizable, and earned when
each of the following criteria are met:
There is persuasive evidence that a sales agreement exists,
Delivery has occurred or services have been rendered,
Seller’s price to the buyer is fixed or determinable, and
Collectibility is reasonably assured.
Revenue Recognition Challenges
Some serious revenue recognition challenges are:
Revenue recognition upon delivery pending execution of
sales agreements.
Gross vs. Net.
Sales on consignment.
Failure to take delivery.
Nonrefundable fees.
Channel stuffing.
Mischaracterizing extraordinary or unusual transactions as
Mischaracterizing transactions as “arm’s-length.”
Selling undervalued assets.
For certain industries requiring long-term
contacts, revenue is recognized using the
percentage-of-completion method, which
recognizes revenue by determining the costs
incurred to date compared with the
project’s total expected costs.
 Percentage-of-completion method of
revenue recognition requires an estimate of
total anticipated costs.
 The
cash account is the first asset
listed in the current asset section of
the balance sheet.
 It consists of coin, checks, and bank
drafts received by the company.
Helpful Tip
Transpositions occur when you switch the
place of numbers (e.g., 79 becomes 97,
157 becomes 517, 6794 becomes 7649,
16945 becomes 61954)
 A simple trick can identify this as the
reason things do not reconcile
Proper Management of Cash
 Proper
management requires that
enough cash be available to meet the
needs of the company’s operations.
 Too much cash is undesirable as it
loses purchasing power in periods of
Accounts Receivable
Accounts receivable are reported on the balance
sheet of the seller at net realizable value, which is
the net amount the seller expects to collect.
 Gross amount less an allowance for uncollectable
Sellers realize that they will not be able to collect on
all of the accounts that are owed to them and they
must therefore match this bad debt expense with the
sales revenue.
Is it optimal to have no bad debts?
Allowance for Uncollectible
There are two widely accepted methods to
estimate the amount of accounts
receivable that will not be collected:
 Aging
 Percentage of sales
A third method, direct write-offs, is not
allowable per GAAP
Percentage of Sales
Estimate of bad debt expense is computed
as a percentage of credit sales.
 Example:
If sales are $100,000 and we
expect 2% will not be collected, then our
estimate of bad debt expense will be $2,000
The other side of this entry is to increase
the allowance for bad debt account.
Aging Schedule
When aging the accounts, an analysis is prepared of
the receivables as of the balance sheet date.
Each customer’s account balance is categorized by
the number of days or months the underlying
invoices have remained outstanding.
Based on prior experience or on other available
statistics, bad debts percentages are applied to each
of these categorized amounts, with larger
percentages being applied to older accounts.
Aging Analysis Example
Write-off of Uncollectible Accounts
The write-off of an uncollecitble account does not
affect income. The amount written-off is reflected as
a reduction of the account receivable balance and the
allowance for uncollectible accounts:
Reporting Accounts Receivable
Accounts receivable are reported on the balance
sheet at net realizable value, that is, the gross
amount owed to them less the allowance for
uncollectible accounts.
Given our gross balance of $100,000 and
estimated uncollectible accounts of $2,900,
accounts receivable will be reported as follows:
Bad Debt Expense
Bad Debt Expense is equal to the
increase in the allowance for
uncollectible accounts.
 In our previous example, if no previous
balance existed in the allowance for
uncollectible accounts, the company
would record a bad debt expense of
Analysis Implications: Adequacy of
Allowance Account
Companies are making two
representations by reporting the
accounts receivable (net) in the
current asset section of the balance
They expect to collect the total amount
reported on the balance sheet.
They expect to collect this amount within
the next year (because of the
classification as a current asset).
Analysis Implications: Adequacy of
Allowance Account
The first issue, from an analysis
viewpoint, is whether the company has
adequately provisioned for its
uncollectible accounts.
 Compare
with the percentage the company
reported in prior years.
 Compare with the percentage reported by
other companies in its industry.
Could be used for shifting income
between years.
Receivables Turnover Rate and
Days Sales in Receivables
The accounts receivables turnover (ART) rate is
defined as
A companion ratio is the Average Collection
Receivables management
When companies sell to other
companies, they offer credit terms,
which are called sales on credit (or
credit sales or sales on account).
 An example of a common credit term is
2/10, net 30.
 Why offer a discount for early
Receivables management (cont.)
 Pledging
 Securitization
Earnings management
Revenue recognition
 Receivables