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BUS 251 (92)
Chapter 4

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Simon Fraser University
Business Administration
BUS 251
Steve Gibson

Chapter 4: Revenue Recognition and Statement of Earnings  Revenue must be large enough to cover all the expenses oCompany is viable when we see that the Revenues > Expenses, but when the company incurred a loss, we would want to know what was the cause behind it and how decisions are reflected in the predictable earnings oHigh quality net earnings: cash flow is more than the net earnings oLow quality net earnings: cash flow is less than the net earnings  Cash-to-cash cycle oOperating cycles: all normal, day-to-day activities that mostly involve cash oBuying and selling of inventory (outflow and inflow of cash) - cash to cash cycle oCash  Cash from shareholders through the issuance of shares and loans oAcquisition of Inventory  (Investing activities) buying property, plant and equipment  Filling the shelf by buying inventories and labor oSelling activity  All the activities designed to promote products then sell them  Sales contract between buyer and seller is established  Payments are due at the same time they are purchase oDelivery of the product  Delivery of the product depends on the contract oCollection  Some of the cash collection process should almost be immediately or it can be recorded has accounts receivable and cash will be collected in another day  But there is a risk associated with the accounts receivable payment so there are interest charges (for long period of time)  Price allowance: price adjustment are allowed for those buyers who received the goods damaged  Cash discounts are issued to encourage buyer to pay the shipment in shorter period of time (2/10 net 30) oWarranty service  During the warranty time the seller is still responsible for the product  There is also additional coverage to let the seller collect additional revenue when no repair is needed oSummary of cash-to-cash cycle  The amount left over from the cash to cash cycle is extra cash that can be used to purchase more inventories in the future  Expand volume and capacity of the company and more dividends can be paid  Revenue Recognition oAdjustment must be made to recognize revenue for materiality oRevenues: inflow of cash from operating activities and not from the shareholders oIncrease in retained earning = increase in entity oExpenses: costs incurred to earn the revenues oNet earnings/net income: Revenues - Expenses oProfit can be earned by charging higher prices and/or controlling costs oMatching (accrual accounting): all costs related to the earning of revenues are matched to the revenues they helped earned oThere is a conflict between measuring timely and reliability of performance oRevenue recognition criteria: resolve conflict and measure performance to balance the information needed for timely and reliable information o2 criteria needed to be met before revenue can be recognized  Probable that economic benefits will flow to the company (cash)  Revenue is generated (performance) = most costs have been paid or can now be estimated, very little left to do for the seller  The risks and rewards are transferred/the earning process is substantially complete with the respect to the sale  Revenue can be reliably measured  Measurement is easy to determine (both the buyer and the seller agreed on one price)  Credit checks on the buyer are needed to assure that the owing amount will be collected in the future  Earning management oManagement deliberately chooses how and when to recognize revenue so then the process would be smoother over time oEarning management can be related to early or late recognition of revenue and expenses oThis can affect the market value of the company oApplications of revenue recognition  Revenue recognition for the sale of goods  5 Specific revenue recognition criteria a) Transfer of risks and rewards to the buyer b) The company no longer has control over the goods sold c) Revenue can be measure reliably d) The goods sold will generate economic benefits in the future e) The costs incurred or estimate will be measured reliably  Recognition at the time of sale oMost common point at which revenue are recognized are when the delivery of the product has been completed oThe title of the good is immediately transferred to the buyer, the company has no control over it whatsoever, cash are paid in the posted amount so then revenue are measured and increase economic benefit to the company (estimate and allowance for uncollectable amount must be established at this time) oSome of the company’s revenue recognition criteria can be found in the notes to financial statements section oF.O.B: free-on-board products indicates that revenue is recognized when the shipment of the product has been dispatched and the transfer of title from seller to buyer is complete oRecognizing warranty expense is important because it must be recognized in the same time as the revenue that is generated so we can estimate the net income and liabilities for the future oDeposits: When company receives deposits cannot be recorded as revenue because the title, rewards, and risks have not passed to the buyer  Deposit amount are recorded as liability in the name of unearned revenue  After delivery deposit amount then can be transferred into revenue  Recorded in the footnote of revenue recognition in the notes to FS oReturns: estimate the amount of returns is important because we don’t want overstate income  After allowed-return period then revenue can be recognized without the estimation of return products  Recognition at time of contract signing oMany problem such as collectability and uncertain future costs oWhen a contract is signed and revenue is recognized the company has not transfer the rewards and risks of the product yet so then the seller needs to continue control and manage the product until development time oThe second problem is that we don’t know how much the matching cost in the future for the revenue and buyer may want to back out and cancel the contract so the seller will not receive sufficient cash net flow oSo, in order for recognition of revenue at the time of contract signing it must meet the following 2 criteria:  Only minimal costs yet to incurred (seller done almost everything to conclude sale)  Receivables must have a reasonable chance of being collected  Recognition at the time of production oRecognizing revenue ASAP the company has timely information to make decisions oBut prices of production fluctuate so some company has forward contract to sell at a fixed price to the seller oWe have unknown amount earn if forward/option contracts are used oPercentage of completion method: recognize expenses and revenue at a portion based on the percentage
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