Chapter 4--Learning Objectives

1. Chapter 4--Learning Objectives • 1. Understand the concept of recognition

2. Recognition • Recognition is the process of formally recording or incorporating an item into the financial statements of an entity • ex. Area development fees

3. Recognition includes • depiction of an item in both words and numbers, with the amount included in the totals of the financial statements • not the footnotes

4. Accounting recognition must • Identify and measure • events, transactions and circumstances • that should be captured • in the accounting information system

5. Chapter 4--Learning Objectives • 2. Interpret the recognition criteria for assets and liabilities

6. To be included,an item must... • 1. Possess the characteristics of an element of the financial statements Asset Revenue Gain Expense Loss Liability

7. To be included,an item must... • 2. Be measurable, relevant and reliable

8. Cash versus accrualbased accounting • Cash receipts and disbursements are recognized when they occur • and in CASH BASED accounting • revenues and expenses are recognized when the cash changes hands

9. Cash versus accrualbased accounting • In accrual based accounting, changes in financial statement elements are recorded in the period in which the events occur • rather than when the cash changes hands

10. An event should be recognized when four criteria are met: • 1. The item must meet the definition of an asset or a liability • 2. The item must be relevant • 3. The item must be reliable • 4. The item must be measurable

11. Chapter 4--Learning Objectives • 3. Interpret the recognition criteria for revenues

12. Revenues • Inflows or enhancements of assets • (or settlement of liabilities) • from delivering goods or providing services • in the entity’s ongoing major or central operations

13. To be recognized... • Revenues must be: • 1. Realized or realizable • 2. Earned

14. Realized • Products or services are exchanged for cash or claims to cash • Realizable • When related assets received or held are readily convertible to known amounts of cash or claims to cash

15. Revenues are EARNED

16. Revenues are EARNED • when the entity has substantially completed

17. Revenues are EARNED • when the entity has substantially completed what it must do to be entitled to the benefits

18. Revenues are EARNED • when the entity has substantially completed what it must do to be entitled to the benefits represented by the revenues

19. The value-adding process(a black box) • The inputs include: Material Labor ? Capital

20. The value-adding process(a black box) • At the end of the process • the product is sold • and cash is received ? Product

21. Conservatism • Recognize losses as incurred • Recognize Revenues when realized or realizable

22. Chapter 4--Learning Objectives • 4. Apply various revenue recognition points to appropriate situations

23. Revenue recognition points

24. Time of sale • Usually operationalized as time of delivery • Change in ownership--transfer of title

25. At production or delivery • If sale and cash receipt precedes production and delivery, revenue is recognized at the point of production and / or delivery • ex. Airline tickets • ex. commodities

26. During production • If product is contracted before production, collection is probable, and production requires an extended period of time • ex. building

27. As the service is rendered • If contracted for in advance for continuously rendered services • ex. rent

28. When asset prices change • For assets which are readily salable without significant effort, revenues may be recognized at completion of production or when the prices of the assets change • ex. Net realizable value of farm products

29. At the point of exchange • If products or services are exchanged for nonmonetary assets not readily convertible to cash, revenue may be recognized at the time of exchange if fair market values are determinable

30. Cycle completion • If collection of receivables is doubtful, revenues are deferred and recognized based on cash received

31. When right of return expires • If significant returns are likely (such as with college textbooks) revenue is recognized when the goods can no longer be returned

32. Percentage-of-completionrevenue recognition • 1. Determine costs incurred to date • 2. Estimate costs to complete • 3. Calculate percentage complete • 4. Apply percentage to projected • profit • 5. Subtract previously recognized • profit

33. Long-term project example • Contract price is $10,000,000 • Original estimated cost is $9,000,000 • Actual first year costs are $2,000,000 • Estimated cost to complete at end of first year is $7,000,000 • Portion completed is: • $2,000,000 • $9,000,000 = .222222

34. Long-term project--year 1 • Estimated total profit is $1,000,000 • (contract price less est. total cost) • Profit to recognize is $222,222 • ($1,000,000 x .222222)

35. Long-term project--year 2 • Total costs incurred are $6,500,000 • Est. cost to complete is $2,700,000 • Completion portion is .706522 • ($6,500,000 / $9,200,000) • Estimated total profit is $800,000 • Profit recognizable is $565,217 • Previous profit is $222,222 • Year 2 profit is $342,995

36. Long-term project--year 3 • Total costs incurred are $9,300,000 • Project is complete • Total profit is $700,000 • Previous profit is $565,217 • Year 3 profit is $134,783

37. Additional project features • Progress billings for first year are $1,000,000 • Cash collections are $700,000 • “Construction in Progress (CIP)” is treated as an inventory account • “Billings on Construction” is treated as a contra account to CIP • If “Billings” exceed CIP, the accounts become a liability

38. Project entries--year 1 • Const. in Progress 2,000,000 • Cash, etc. 2,000,000 • Accts. Receivable 1,000,000 • Billings on Const. 1,000,000 • Cash 700,000 • Accts. Receivable 700,000 • Const. in Progress 222,222 • Cost of C I P 2,000,000 • Const. Revenue 2,222,222

39. Year 2 project features • Additional project billings are $5,000,000 • Total billings at year end are $6,000,000 • Additional cash collections are $3,300,000 • Total collections at year end are $4,000,000

40. Project entries--year 2 • Const. in Progress 4,500,000 • Cash, etc. 4,500,000 • Accts. Receivable 5,000,000 • Billings on Const. 5,000,000 • Cash 3,300,000 • Accts. Receivable 3,300,000 • Const. in Progress 342,995 • Cost of C I P 4,500,000 • Const. Revenue 4,842,995

41. Year 3 project features • Project is completed during year • Additional project billings are $4,000,000 • Total billings at year end are $10,000,000 (contract price) • Additional cash collections are $6,000,000 • Total collections at year end are $10,000,000

42. Project entries--year 3 • Const. in Progress 2,800,000 • Cash, etc. 2,800,000 • Accts. Receivable 4,000,000 • Billings on Const. 4,000,000 • Cash 6,000,000 • Accts. Receivable 6,000,000 • Const. in Progress 134,783 • Cost of C I P 2,800,000 • Const. Revenue 2,934,783

43. A final entry--year 3 • Billings on Const. 10,000,000 • Const. in Progress 10,000,000 • Closes out the inventory account and the related contra account

44. Installment Sale • 42 tents @ $3,600 • $300 per month plus 12% • Cost $1800

45. Installment Sale (cont.) Accounts Receivable 151,200 Inventory 75,600 Deferred Installment Revenue 75,600

46. Installment Sale (cont.) Cash 336 Interest Revenue 36 Accounts Receivable 300 Deferred Installment Revenue 150 Installment Revenue 150

47. Chapter 4--Learning Objectives • 5. Understand the concepts of income and capital maintenance

48. Comprehensive income The change in equity of a business during a period from transactions and other events from non-owner sources

49. Maintenance of capital • Need to separate • Return on capital • from • Return of capital

50. Chapter Objectives • Understand the concept of recognition • Interpret the recognition criteria for assets and liabilities • Interpret the recognition criteria for revenues • Apply various revenue-recognition points to appropriate situations. • Understand the concepts of income and capital maintenance.