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Canada (162,165)
BUS 251 (101)
Chapter 4

BUS 251 - Financial Accounting: A User Perspective SIXTH Canadian edition - Chapters 4, 6, 7

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Business Administration
BUS 251
Steve Gibson

Chapter 4 Revenue Recognition and Statement of Earnings CASH-TO-CASH CYCLE - Corporate managers engage in three general types of activities: financing, investing, and operating. We will focus on operating: the ones that generate most of the revenue. - Operating activities include all the normal, day-to-day activities of every business that almost always involve cash. - The typical business operations involves an outflow of cash that is followed by an inflow of cash, a process commonly called cash-to-cash cycle. Cash - The initial amount of cash in a company comes from the original investment by shareholders and from any loans that the company may have received as start-up financing. Acquisition of Inventory - Before the company acquires the inventory that it will sell to customers or will use to provide its services, it must undertake the investing activities of acquiring property, plant, and equipment. - Company hires labour and purchases the first shipments of inventory (or signs contracts to acquire them). Selling Activity - All activities that promote and sell the product. - Pricing, advertising, hiring and managing sales force, establishing retail sales outlets etc. Delivering of Product Collection - Collection of the sales price in cash or it could take place later in time called account receivable. - Credit risk: the risk that the buyer wont pay for the service/product. - There can be an interest charge (but usually not for shorter period) and sometimes the seller may ask for the product back (repossession) or may try other methods to collect on the account. - Goods may be returned, which means no cash collections. May be due to damaged in shipment or price allowance (adjustment). - Cash discount: less than the full amount will be accepted as full payment. Warranty Service - Some goods carry a written or implied guarantee of quality. Summary of the Cash-to-Cash Cycle - Net amount left in cash after this cycle is completed is then available to purchase more goods and services in the next cycle. - If the cash inflows are less than the cash outflows, the amount of cash available is reduces, and the company may be unable to begin a new cycle without getting additional cash from outside the company in form of an equity or debt. - If the cash inflows exceed cash outflows, the company can expand its volume of activity, add another type of productive activity, or return some of the extra cash to shareholders in the form of dividends. REVENUE RECOGNITION - To measure operating performance as accurately as possible, accountants divide normal operating activities in two groups, called revenues and expenses. - Revenues are inflows of cash or other benefits from the businesss normal operating activities when these inflows result in an increase in equity that did not come from contributions from equity holders. - Expenses are the costs incurred to earn revenues. - The difference between revenues and expense called net earnings (or net income). - Matching: requires the simultaneous recognition of all costs that are or will be incurred (in past, present, or future) to product the revenue. - Revenue can be easy to be recognized at a certain, but some are more difficult. - Revenue recognition criteria have been developed with IFRS to resolve this conflict and produce a measure of performance that is intended to balance the need for timely information with the need for timely and reliable information. Two basic criteria: Probability that economic benefits will flow to the company. (Normally met when the activity that generated the revenue (performance) is substantially completed. Requirement that the revenue can be reliably measured. When the goods or services are sold for cash or an agreed selling price (account receivable), the measurement is easy to determine. Earnings Management - Earnings Management: management deliberately chooses how and when to recognize revenues and costs so that net earnings are higher or lower in particular accounting periods. - External users usually have difficulties in determining whether earnings management takes place. - Sometimes, Ontario Securities Commission or Securities and Exchange Commission (SEC) in the United States, question a companys revenue recognition policy. - Users of financial statements rely on auditors to determine whether accounting standards have been applied appropriately or not. Applications of Revenue Recognition Revenue Recognition for the Sale of Goods - For the sales of goods, there are five specific revenue recognition criteria that must be met before revenue can be recognized: There has been a transfer of the risks and rewards to the buyer. The company no longer has managerial involvement or control over the goods sold. The revenue can be measured reliably. It is probable that economic benefits from the transaction will flow to the seller. The costs incurred or to be incurred with respect to the transaction can be measured reliably. - Recognition at the time of sale The most common point at which sales revenues are recognized is the time of sale and/or shipment of the goods to the customer. Usually the company has completed everything they have to do for the transaction. The title to the goods has been transferred, which transfers the risk and rewards to the buyer, and the company no longer has control over the goods. Cash: economic benefits, A/R: measurable. However, the company will have to be reasonably assured of collection of the A/R before revenue can be recognized. If doubtful, an estimate of potential uncollectability must be made and an allowance for uncollectable accounts established. Sometimes they might do a deposit, in that case, we call it unearned revenue Cash (A) 500 Unearned Revenue (L) 500 When goods are delivered, the deposit can then recognized as a revenue Unearned Revenue (L) 500 Sales Revenue (S/E) 500 - Recognition at the time of contract signing Usually retail land sales companies recognize revenue right wen they sign the contract. Now there must be certain minimum criteria. First, that there be only minimal costs yet to be incurred (that means that the seller has completed substantially all the things that have to be done to conclude the sale) , and second, that the receivables created in the transaction have a reasonable chance of being collected. - Recognition at the time of production Common for mining and long-term construction. Revenue is recognized using the percentage of completion method, which recognizes a portion of a projects revenues and expenses during the construction period based on the percentage of completion method, which recognizes a portion of a projects revenues and expenses during the construction period based on the percentage of completion. Expense for this period/total cost of project = percentage completed Percentage completed x total revenue = revenue to be recognized this period. - Recognition at the time of collection Except for cash sales, revenue criteria are almost always met before cash is collected. Revenue Recognition for Delivery of Services - The criteria for the recognition of service revenue The amount of revenue can be measured reliably. It is probable that economic benefits from the service will flow to the provider. The stage of completion of the service measured reliably. The costs incurred or to be incurred with respect to the transaction can be measured reliably. - Revenue from the provision of services is normally recognized in the period when the service is completed. Revenue from the Use by Others of a Companys Assets - Companies can also earn revenue by allowing others to use their assets. - The revenue is in the form of interest, dividends, or royalties. STATEMENT OF EARNINGS FORMAT - Multi-step format Earnings from Operation Revenue and expenses resulting from the sales of goods/services to customers.
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