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MGCR 211 (10)
Chapter 4

Accounting (MCGR 211) - Chapter 4 Revenue Recognition

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Management Core
MGCR 211
Walter Moschella

Chapter 4 – Revenue Recognition and Statement of Earnings Revenue Recognition: Revenue  inflows of cash or other benefits from the business’s normal operating activities when these inflows result in an increase in equity that did not come from contributions from equity holders  Revenues result from normal operating activities o Other activities that result in increased equity that are not from ordinary operating activities are not called revenues  Revenues  usually involved sale of goods, provision of services or allowing the use of the company’s assets in exchange for interest, dividends or royalties Expenses  costs incurred to earn revenues Revenues – Expenses = net earnings (or net income)  Matching is used to produce accurate measurement of net operating performance  earnings of revenues are matched to their cost  Inverse relationship between how early in the cash-to-cash cycle the company wants to recognize revenues vs. how accurate the company’s estimate of future events is Revenue recognition criteria: 1. Probable that economic benefits will flow to the company a. Criteria is met when the activity generating the revenue is substantially complete b. Performance has been achieved 2. Revenues can be reliably measured a. There must be reasonable assurance that the amounts earned can be realized or collected from the buyer b. If the amount of revenue cannot be measured, it cannot be recognized c. Ex. hard to measure when g&s are exchanged for g&s *criteria is usually met at the time of delivery (when goods are given to the shipping company) Earnings Management  When management deliberately chooses to recognize revenues and costs to make net earnings higher or lower during certain accounting period or smoother over time Revenue Recognition for Sale of Goods For sale of goods, 5 revenue recognition criteria must be met: 1. Transfer of risks and rewards to the buyer 2. Company no longer has managerial involvement or control over the goods sold 3. Revenue can be measured reliably 4. Probable that economic benefits from the transaction will flow to the seller 5. Costs incurred or to be incurred w/ respect to the transaction can be measured reliably Recognition at the time of sale:  Most common time of recognition = time of sale/and or shipment of the goods to customer o After shipment, company has typically finished its end of the transaction  Ex. title to goods has been transferred, risk and rewards are transferred, company no longer has control over the good  Ex. at time of sale, the amount earned is known and measurable by the company (regardless of cash or credit)  Companies sometime have allowance for uncollectible accounts *companies are required to state revenue recognition policy F.O.B.  free on board  legal term that describes the point in which title to the goods passes from the seller to the buyer  F.O.B shipping point, title of goods is passed once the goods leave the seller’s loading dock  F.O.B. Goods remain property of the seller until they reach the buyer’s receiving dock *Way the goods are shipped affects revenue recognition point EX. revenue recognition at time of sale includes warranty expense because it is related to the generation of revenue  When warranty expense is recognized, it is recognized as a liability on the balance sheet Revenue recognition excludes deposit for a product to be delivered  revenue recognition criteria has not been met yet  title has not been passed yet  recorded as unearned revenue, deferred revenue, revenue received in advance (liability) + deposit is recorded as cash (asset) Sales returns:  when sales return periods are short, the income is not materially misstated due to returns  for companies where returns can substantially affect revenues (ex. B2B) they should estimate the amount of returns when revenue is recognized o ex. online clothing sales have a much higher return rate than physical clothing stores Recognition at the time of contract signing  some situations it is better to recognize revenue when contract is signed instead of when goods are delivered o ex. retail land sales  retail land sale companies usually recognize revenue at the date of contract signing o Caveat  usually sell before land has been developed; development costs have not been incurred yet  Future development costs are not matched to revenues, can only be matched if they can be accurately estimated Current industry standards:  Revenue is recognized at contract signing if certain criteria is met 1) minimal costs are yet to be incurred 2) receivables created in the transaction have a reasonable chance of being collected Recognition at the time of production:  common industries: mining, long-term construction  if product’s market value and sale are fairly common at the time of production, then inventories produced can be valued at their net realizable value (selling price) and resulting revenues can be recognized immediately  MINING: the critical event in mining is not the sale of ore, but production o Market is established with stable prices o Many companies manage risk of changing prices through future contracts  Sale and amount of revenue is certain  LONG TERM CONSTRUCTION: o Has long production period o Revenue recognized through percentage of completion method:  Recognizes a portion of projects revenues and expenses based on percentage of completion (Expenses for this period/total cost of project)= percentage completed percentage completed X Total revenue = revenue to be recognized this period Percentage Completion and Revenue Recognition  Total revenue can be reliably measured  Contract makes it likely that economic benefits will be received by seller  Costs incurred to date are known  reliable measure  Period billing + collection = gives ability to estimate collectability  Co
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