Revenue and Monetary Revenue and Monetary AssetsAssets

JOIN KHALID AZIZJOIN KHALID AZIZCOACHING CLASSESCOACHING CLASSES

ICMAP STAGE 1,2,3,4,5ICMAP STAGE 1,2,3,4,5ICAP MODULE A,B,C,DICAP MODULE A,B,C,D

PIPFAPIPFABBA & MBABBA & MBA

B.COM & M.COMB.COM & M.COMACCOUNTING OF O/A LEVELACCOUNTING OF O/A LEVEL

MA-ECONOMICSMA-ECONOMICS0322-33857520322-3385752

KARACHI, PAKISTANKARACHI, PAKISTAN

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Operating CycleOperating Cycle Cash-to-cash.Cash-to-cash.

• Receive cash from customerReceive cash from customer• Purchase materials/services & pay cashPurchase materials/services & pay cash• Convert materials/services to salable Convert materials/services to salable

productproduct• Store productStore product• Sell productSell product• Receive cash from customerReceive cash from customer

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Revenue Recognition: Revenue Recognition: When? (Timing) & How much? (Amt.)When? (Timing) & How much? (Amt.)

At one point in revenue cycle (objectivity).At one point in revenue cycle (objectivity). Criteria:Criteria:

• When? Earned (Conservatism)When? Earned (Conservatism) Normally, goods shipped.Normally, goods shipped. Service performed.Service performed.

• How much? Realized or realizable How much? Realized or realizable (Realization).(Realization).

Already collected or collectible.Already collected or collectible. Amount can be measured reliably.Amount can be measured reliably.

Next step: matching costs.Next step: matching costs.

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Basic Revenue Recognition CriteriaBasic Revenue Recognition Criteria

Recognize revenue in earliest period Recognize revenue in earliest period in which:in which:• Entity has substantially performed what Entity has substantially performed what

is required in order to earn income andis required in order to earn income and• Amount of income can be reliably Amount of income can be reliably

measured.measured.

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Delivery MethodDelivery Method Recognize revenue when goods or Recognize revenue when goods or

services are delivered.services are delivered. For goods: when title transfers.For goods: when title transfers.

• FOB shipping point (when goods are given FOB shipping point (when goods are given to carrier).to carrier).

Example 1:Example 1:• Order is received for Rs900. Sales entry?Order is received for Rs900. Sales entry?• Goods are produced. Sales entry?Goods are produced. Sales entry?• Goods are shipped. Sales entry?Goods are shipped. Sales entry?

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Consignment MethodConsignment Method Consignor ships goods to consignee.Consignor ships goods to consignee.

Inventory on consignmentInventory on consignment 1,0001,000 Merchandise inventoryMerchandise inventory 1,0001,000

Consignor retains title until goods are Consignor retains title until goods are sold to customer. At sale:sold to customer. At sale:

Accounts receivableAccounts receivable 1,4001,400 Sales revenueSales revenue 1,4001,400 COGSCOGS 1,0001,000 Inventory on consignment Inventory on consignment 1,0001,000

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Franchise RevenueFranchise Revenue

Recognize:Recognize:• When earned. When earned. • Not when agreement signed or fee Not when agreement signed or fee

received.received.

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Franchise Revenue First Franchise Revenue First Example Example

Tariq & Tariq’s charges a franchise fee Tariq & Tariq’s charges a franchise fee primarily for identifying the site, primarily for identifying the site, designing the store, training designing the store, training management and staff, and otherwise management and staff, and otherwise helping to get the franchise started in helping to get the franchise started in business. Assume the initial fee is business. Assume the initial fee is Rs100,000. When should this Rs100,000. When should this Rs100,000 be recorded as revenue?Rs100,000 be recorded as revenue?

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Franchise Revenue Second Franchise Revenue Second ExampleExample

• Golden, Inc. receives Rs6,000 from a Golden, Inc. receives Rs6,000 from a franchisee for the right to use its franchisee for the right to use its trademark and have access to its “know-trademark and have access to its “know-how” for a period of 5 years. This know-how” for a period of 5 years. This know-how includes training sessions, and how includes training sessions, and some one available to answer questions. some one available to answer questions. When should the Rs6,000 be recognized When should the Rs6,000 be recognized as revenue?as revenue?

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Percentage-of-Completion MethodPercentage-of-Completion Method

Design/development and Design/development and construction/production projects that construction/production projects that extends over several years.extends over several years.

Customer pays either fixed price or cost Customer pays either fixed price or cost reimbursement contract.reimbursement contract.

Reasonable assurance of profit margin and Reasonable assurance of profit margin and ultimate realization.ultimate realization.

Revenue recognized based on total Revenue recognized based on total percentage of project work performed percentage of project work performed during period.during period.

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Completed Contract MethodCompleted Contract Method Percentage of completion method Percentage of completion method

required unless:required unless:• Amount of income to be earned on contract Amount of income to be earned on contract

cannot reasonably be determined.cannot reasonably be determined. Alternative is completed contract Alternative is completed contract

method.method.• Costs incurred are an asset (Contract Work Costs incurred are an asset (Contract Work

in Progress) until revenue is recognized.in Progress) until revenue is recognized.

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Production MethodProduction Method Applies to agricultural and mining.Applies to agricultural and mining. Criteria:Criteria:

• Clear market determined price.Clear market determined price.• Performance substantially complete.Performance substantially complete.

Minimal remaining costs.Minimal remaining costs. Permitted but not required by GAAP.Permitted but not required by GAAP.

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Installment MethodInstallment Method Customer pays a certain amount per Customer pays a certain amount per

period.period. Installment payment is recognized as Installment payment is recognized as

revenue and a proportional part of cost revenue and a proportional part of cost of sales is recorded.of sales is recorded.

Under cost recovery method, cost is Under cost recovery method, cost is recorded equal to installment payment recorded equal to installment payment until total cost of sales is covered.until total cost of sales is covered.

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Real Estate SalesReal Estate Sales Developer often finances over many years.Developer often finances over many years. Uncertainty of income due to uncertainty Uncertainty of income due to uncertainty

of receipt of future payments.of receipt of future payments. Conditions required for revenue Conditions required for revenue

recognition:recognition:• Period allowing cancellation and refund to Period allowing cancellation and refund to

buyer has expired.buyer has expired.• Cum payments equal to 10% of purchase price.Cum payments equal to 10% of purchase price.• Seller has completed or is clearly capable of Seller has completed or is clearly capable of

completing required improvement.completing required improvement.

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Amount of Revenue Amount of Revenue RecognizedRecognized

Net realizable value (amount Net realizable value (amount reasonably estimated to be reasonably estimated to be collected).collected).

2 approaches:2 approaches:• Direct write-off method.Direct write-off method.• Allowance method.Allowance method.

% of sales.% of sales. % of (analysis of) AR.% of (analysis of) AR.

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Direct Write-Off MethodDirect Write-Off Method Write-off when specific account that Write-off when specific account that

is uncollectible is identified.is uncollectible is identified.

Why is this not acceptable under Why is this not acceptable under GAAP?GAAP?

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Allowance MethodAllowance Method Estimate amount of current period Estimate amount of current period

credit sales that will not be collected.credit sales that will not be collected.• Historical % tempered by judgment.Historical % tempered by judgment.• Historical % of aged receivables Historical % of aged receivables

(+judgment).(+judgment). Adjusting entry at end of period.Adjusting entry at end of period. When an uncollectible account is When an uncollectible account is

identified, it is written off.identified, it is written off.

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ExampleExample Amount of revenue recognized:Amount of revenue recognized:

• Sales for the year were Rs2,000 for cash Sales for the year were Rs2,000 for cash and Rs6,000 on credit. and Rs6,000 on credit.

• Historically we don’t collect about 5% of Historically we don’t collect about 5% of our credit sales due to customer our credit sales due to customer bankruptcies or unable to locate customer. bankruptcies or unable to locate customer.

• A customer, The XYZ Company went A customer, The XYZ Company went bankrupt. They owed us Rs175.bankrupt. They owed us Rs175.

Entry for revenue?Entry for revenue? Entry for bad debts - direct write-off (not-Entry for bad debts - direct write-off (not-

GAAP)?GAAP)? Entries for bad debts (allowance Entries for bad debts (allowance

method)?method)?

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ExampleExample Balances in AccountsBalances in Accounts

• Accounts receivable dr 3,000.Accounts receivable dr 3,000. Consisting of 2,000 current and 1,000 overdue.Consisting of 2,000 current and 1,000 overdue.

• Allowance for doubtful accounts cr 50.Allowance for doubtful accounts cr 50. Estimated amount of accounts that are Estimated amount of accounts that are

uncollectible: uncollectible: • 2% for current and 10% for non-current accounts.2% for current and 10% for non-current accounts.

What entry do we make at the end of the year to What entry do we make at the end of the year to accrue for bad debts?accrue for bad debts?

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Allowance Method (continued)Allowance Method (continued) Allowance… is a contra-asset Allowance… is a contra-asset

account.account. Collection of a bad debt that was Collection of a bad debt that was

written-off:written-off: CashCash

Allowance for Doubtful AccountsAllowance for Doubtful Accounts

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Sales DiscountsSales Discounts Sales terms are “2/10 net 30”Sales terms are “2/10 net 30”

• Customer gets 2% cash discount if paid Customer gets 2% cash discount if paid within 10 days.within 10 days.

• Otherwise, total amount is due within 30 Otherwise, total amount is due within 30 days.days.

What does “1/15 net 45” mean?What does “1/15 net 45” mean? What is the effective annual rate of What is the effective annual rate of

savings by taking advantage of terms savings by taking advantage of terms of “2/10 net 30”?of “2/10 net 30”?

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Alternative Methods of Alternative Methods of Accounting for Sales DiscountsAccounting for Sales Discounts

Record initial sale at gross. Record initial sale at gross. At collection of net amount record At collection of net amount record

discount as a reduction from gross sales.discount as a reduction from gross sales. Record initial sale at gross. Record initial sale at gross.

At collection of net amount record At collection of net amount record discount as an expense of the period.discount as an expense of the period.

Record initial sale at net. Record initial sale at net. Record amounts not taken as discounts Record amounts not taken as discounts

as additional revenue.as additional revenue.

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ExampleExample We sold Rs10,000 of mdse. Sales We sold Rs10,000 of mdse. Sales

terms are 2/10, n/30. Customers terms are 2/10, n/30. Customers paid us for Rs8,000 of the paid us for Rs8,000 of the merchandise billed within 10 merchandise billed within 10 days. The remaining Rs2,000 days. The remaining Rs2,000 was paid within 30 days.was paid within 30 days.• Record at gross.Record at gross.• Record at net.Record at net.

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Credit Card SalesCredit Card Sales If cash received by merchant If cash received by merchant

immediately (Bank plan, MC, Visa):immediately (Bank plan, MC, Visa):

CashCash 970 970 Sales discountSales discount 30 30 Sales revenueSales revenue 1000 1000

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Credit Card Sales (continued)Credit Card Sales (continued) If cash received by merchant in 30 If cash received by merchant in 30

days (American Express, Discover):days (American Express, Discover):

Accounts receivableAccounts receivable 970 970 Sales discountSales discount 30 30 Sales revenueSales revenue 1000 1000

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Sales Returns & AllowancesSales Returns & Allowances

Similar to bad debt expense,Similar to bad debt expense, Estimate percentage of revenues that Estimate percentage of revenues that

will eventually result in returns or will eventually result in returns or allowances. allowances.

Adjusting entry at end of period.Adjusting entry at end of period. Actual return or allowance.Actual return or allowance.

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ExampleExample

On average 2% of our Rs10,000 of sales On average 2% of our Rs10,000 of sales is returned. Adjusting entry at end of is returned. Adjusting entry at end of period?period?

Entry for return of Rs80 of goods?Entry for return of Rs80 of goods? Same for direct write-off method? Same for direct write-off method?

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Sales Returns & Allowances Sales Returns & Allowances (Continued)(Continued)

Provision for Returns and Allowances Provision for Returns and Allowances is a liability account.is a liability account.

Alternative:Alternative: Not accrue for returns and allowances Not accrue for returns and allowances

but write them off as they occur.but write them off as they occur. Is this GAAP?Is this GAAP?

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Adjustment vs. ExpenseAdjustment vs. Expense

Realization concept suggests Realization concept suggests adjustment to revenue.adjustment to revenue.

In practice both methods are found.In practice both methods are found. Consistency:Consistency:

Same handling from year to year.Same handling from year to year. Allows same company results to be Allows same company results to be

compared from year to year.compared from year to year. Comparisons between companies may be Comparisons between companies may be

distorted.distorted.

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Warranty CostsWarranty Costs Amounts are estimated (usually as a Amounts are estimated (usually as a

percentage of sales).percentage of sales). Part of Cost of goods sold.Part of Cost of goods sold. Record accrual (adjusting entry)Record accrual (adjusting entry) Record the actual expenditures.Record the actual expenditures. Allowance… is a liability account. Allowance… is a liability account.

Est. warranty exp. Is part of costs of Est. warranty exp. Is part of costs of sales.sales.

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Warranty Expenses ExampleWarranty Expenses Example

We estimate that warranty expenses We estimate that warranty expenses will be 4% of our Rs10,000 of sales. will be 4% of our Rs10,000 of sales. Entry?Entry?

We spent Rs120 on parts and Rs250 We spent Rs120 on parts and Rs250 on labor for repairs under warranty. on labor for repairs under warranty. Entry?Entry?

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Interest RevenueInterest Revenue Amount earned by lender during the Amount earned by lender during the

period.period. 2 approaches2 approaches

• Interest paid at maturity.Interest paid at maturity. Interest is explicit.Interest is explicit.

• Discounted loan.Discounted loan. Interest is implicit.Interest is implicit.

Accounted for separately from sale.Accounted for separately from sale.

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Example: Interest RevenueExample: Interest Revenue On January 1, 19x1 sold a customer Rs1,000 On January 1, 19x1 sold a customer Rs1,000

of mdse. We received a promissory note for of mdse. We received a promissory note for Rs1,000 plus 8% interest to be paid in one Rs1,000 plus 8% interest to be paid in one year. year. • Entry for sale?Entry for sale?• Entry for accrual of interest on December 31, 19x1?Entry for accrual of interest on December 31, 19x1?• Entry for receipt of payment on note on January 1, Entry for receipt of payment on note on January 1,

19x2?19x2? On January 1, 19x1, we sold mdse. and On January 1, 19x1, we sold mdse. and

received a promissory note for Rs5,000 with received a promissory note for Rs5,000 with no interest. The note is due in one year. The no interest. The note is due in one year. The market rate of interest on such a note is 9%.market rate of interest on such a note is 9%.• Entry at sale:Entry at sale:• Year end adjusting entry (12/31/19x1)Year end adjusting entry (12/31/19x1)• Entry when customer pays note (1/1/19x2)Entry when customer pays note (1/1/19x2)

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Monetary& Non-monetary Monetary& Non-monetary AssetsAssets

Monetary assets are money or claims to Monetary assets are money or claims to receive fixed sums of money.receive fixed sums of money.

Non-monetary assets are items used in future Non-monetary assets are items used in future production and sales of goods and services.production and sales of goods and services.

Balance sheet distinctionBalance sheet distinction Current and non-current assets.Current and non-current assets. Not monetary and non-monetary.Not monetary and non-monetary.

Non-monetary assets (except inventory) on Non-monetary assets (except inventory) on BS at unexpired cost. (Cost less depreciation)BS at unexpired cost. (Cost less depreciation)

Monetary assets: Cash reported at face. AR at Monetary assets: Cash reported at face. AR at NRV. Other at fair value.NRV. Other at fair value.

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CashCash Funds available for disbursement.Funds available for disbursement. May include liquid short term May include liquid short term

investments.investments.• Highly liquid debt instruments with Highly liquid debt instruments with

original maturities of 90 days or less.original maturities of 90 days or less.

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ReceivablesReceivables Trade receivablesTrade receivables

• Accounts receivables from usual sales of Accounts receivables from usual sales of products or services for non-financial products or services for non-financial institutions.institutions.

Other receivables are shown Other receivables are shown separately.separately. E.g., Due from employees, advances or E.g., Due from employees, advances or

loans.loans.

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Marketable SecuritiesMarketable Securities Must be marketable.Must be marketable. E.g., commercial paper, treasury E.g., commercial paper, treasury

bills, publicly traded stocks and bills, publicly traded stocks and bonds issued by companies.bonds issued by companies.

Also called “Temporary Also called “Temporary Investments.”Investments.”

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Accounting for Marketable Accounting for Marketable SecuritiesSecurities

Three categoriesThree categories Held-to-maturity: debt securities,Held-to-maturity: debt securities,

Valued at cost.Valued at cost. Trading securities: debt or equity held Trading securities: debt or equity held

for current resale, valued at market. for current resale, valued at market. Realized (i.e., if sold during period) and Realized (i.e., if sold during period) and

unrealized (not yet sold but market price has unrealized (not yet sold but market price has changed) gain or loss included in current changed) gain or loss included in current year’s income.year’s income.

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Accounting for Marketable Accounting for Marketable Securities (Continued)Securities (Continued)

Available-for-sale securities: Available-for-sale securities: Debt or equity securities that do not fit Debt or equity securities that do not fit

either of the other 2 categories. either of the other 2 categories. Reported at market value. Reported at market value. Realized gains and losses go through Realized gains and losses go through

income.income. Unrealized gains and losses directly Unrealized gains and losses directly

credited (or debited) to a stockholders’ credited (or debited) to a stockholders’ equity account.equity account.

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Analysis of Monetary AssetsAnalysis of Monetary Assets

Current ratio = CA/CLCurrent ratio = CA/CL Acid-test ratio = quick ratio = monetary Acid-test ratio = quick ratio = monetary

CA/CL= (CA - inventories - prepaid CA/CL= (CA - inventories - prepaid items) /CL.items) /CL.

Days cash = cash/(cash expenses Days cash = cash/(cash expenses 365) 365) Cash expenses Cash expenses total expenses - total expenses -

depreciation.depreciation. Days receivable = average collection Days receivable = average collection

period = Receivables/(Sales period = Receivables/(Sales 365) 365) Ratios differ by industry.Ratios differ by industry.

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