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CHAPTER 6: Revenue and Expense Recognition CHAPTER 6 Revenue and Expense Recognition Main topics in Chapter 6: Conceptual foundation of accrual accounting; Accounting policy choice, including the fiscal period; Revenue recognition criteria and methods;

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chapter 6
CHAPTER 6:

Revenue and Expense Recognition

© 2007 by Nelson, a division of Thomson Canada Limited.

slide2
CHAPTER 6Revenue and Expense Recognition

Main topics in Chapter 6:

  • Conceptual foundation of accrual accounting;
  • Accounting policy choice, including the fiscal period;
  • Revenue recognition criteria and methods;
  • Related expense recognition and matching;
  • Prepaid and accrued expenses.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide3
Book’s Coverage of Financial Accounting

Standards Principles Ch. 5, 6, 7, 8, 9

Plugged Into the Economic Events of the World

Methods Ch. 1, 2, 3, 4, 6, 7, 8, 9

Accounting System Ch 1, 2, 3, 7

Ch. 1,2,3,4,5,10

Ch. 1, 4, 10

Management

Cash Flow

Ch. 7

Ch. 1, 3, 6, 8, 9

Internal Control

Ch. 2, 3, 4, 5, 10

Ch. 2, 6, 8, 9

Income

Ch. 2, 3, 4, 5, 8, 9, 10

Financial Analysis

Financial Position

Disclosure

slide4
Event #1

Event #2

Event #3

Event #4

Event #5

Event #6

Income Measurement

Events, projects and sales occur all the time

© 2007 by Nelson, a division of Thomson Canada Limited.

slide5
Period 1

Period 2

Event #1

Event #2

Event #3

Event #4

Event #5

Event #6

Income Measurement

Period 3

Some events cross periods thus how can we properly account for the revenues and expenses at over any period?

© 2007 by Nelson, a division of Thomson Canada Limited.

slide6
Conceptual Foundation of Accrual Accounting
  • Accrual accounting is based on the idea that events, estimates, and judgments important to the measurement of financial performance and position should be recognized by entries, whether or not cash has been received or paid out.
  • The result affects income, through the revenue and expense figures, and also affects the balance sheet, through accounts like accounts receivable and accounts payable.
  • Bottom Line: the income statement and balance sheet articulate through accrual accounting.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide7
Conceptual Foundation of Accrual Accounting
  • Revenues are inflows of economic resources from customers.
  • Expenses are outflows of economic resources to employees, suppliers, tax authorities, and others (incurred to generate revenue).
  • Net income is the difference between revenues and expenses over a period of time.
  • Matching is the logic of income measurement, ensuring that revenues and expenses are measured comparably.
  • Timing of the recognition of revenues and expenses is the heart of accrual accounting’s measurement of income.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide8
Accrual Accounting – Recognizing Cash Revenue and Expenses
  • In a transaction directly involving cash, there is an obvious exchange where cash is debited or credited directly.
  • Example: Cash sales or expenses paid for with cash

Journal Entry:

Expenses: DR Expense CR Cash

Revenues: DR Cash CR Revenue

  • These transactions rely on a cash basis

© 2007 by Nelson, a division of Thomson Canada Limited.

slide9
EXPENSE

REVENUE

1) Recognition

2) Cash Transactions

Accrual Accounting – Recognizing Cash Revenue and Expenses

  • Often, cash is not directly exchanged when a product or service is sold or an expense is incurred.
  • For example, when you use a credit card, there is no direct cash exchange until a later time – this is accrual revenue or expense recognition
  • Stretch the time out so that revenues and expenses are recognized beforecash transactions

DR A/R CR Revenue

DR Expense CR A/P

DR Cash CR A/R

DR A/P CR Cash

© 2007 by Nelson, a division of Thomson Canada Limited.

slide10
EXPENSE

REVENUE

1) Cash Transactions

2) Recognition

Accrual Accounting – Recognizing Accrual Revenue and Expenses

  • Sometimes, the opposite occurs, and the revenue is received in cash before it should be recognized
  • For example, a deposit on a contract is not truly revenue for the company until the project is complete
  • Stretch the time out so that revenues and expenses are recognized aftercash transactions

DR Cash CR Def. Rev

DR Prepaid exp. (Asset) CR A/P

DR Deferred Rev. CR Revenue

DR Expenses CR Prepaid Exp.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide11
Current accounting period

Next accounting period

A/R

A/R

Revenue

Revenue

Cash

Cash

Revenue and Expense Recognition Scenarios

  • Revenue recognition prior to cash collection

Revenue recognized

DR Accounts receivable

CR Revenue

Cash collected

DR Cash

CR Accounts receivable

© 2007 by Nelson, a division of Thomson Canada Limited.

slide12
Recognition Prior to Cash Flow – J/E Example

Revenue

Company XYZ made a sale on credit

DR Accounts receivable 2,464

CR Revenue 2,464

Cash

The customer pays off what is owing

DR Cash 2,464

CR Accounts receivable 2,464

© 2007 by Nelson, a division of Thomson Canada Limited.

slide13
Past accounting period

Current accounting period

Revenue

Revenue

Cash

Cash

Revenue and Expense Recognition Scenarios

B. Revenue recognition after cash collection

Cash collected

DR Cash

CR Deferred revenue / deposits liability

  • Revenue recognized
  • DR Deferred revenue /
  • deposits liability
    • CR Revenue

Deferred Revenue

Deferred Revenue

© 2007 by Nelson, a division of Thomson Canada Limited.

slide14
Recognition After Cash Flow – J/E Example

Cash

A customer placed a deposit on a widget.

DR Cash 25,000

CR Deferred revenue liab. 25,000

Revenue

The customer purchases the widget.

DR Deferred revenue liab. 25,000

CR Revenue 25,000

© 2007 by Nelson, a division of Thomson Canada Limited.

slide15
Current accounting period

Next accounting period

A/P

A/P

Expense

Expense

Cash

Cash

Revenue and Expense Recognition Scenarios

C. Expense recognition prior to cash payment

Expense recognized

DR Expense

CR Accounts Payable

or other liability

Cash paid

DR Accounts payable or

other liability

CR Cash

© 2007 by Nelson, a division of Thomson Canada Limited.

slide16
Recognition Prior to Cash Flow – J/E Example

Expense

XYZ had maintenance done on a machine

DR Maintenance expense 85,000

CR Accounts payable 85,000

Cash

XYZ paid for the maintenance

DR Accounts payable 85,000

CR Cash 85,000

© 2007 by Nelson, a division of Thomson Canada Limited.

slide17
Past accounting period

Current accounting period

Asset

Expense

Expense

Cash

Cash

Revenue and Expense Recognition Scenarios

D. Expense recognition after cash payment

Cash paid

DR Asset(inventory,

equipment , etc.)

CR Cash

  • Expense recognized
  • DR Expense (COGS,
  • amortization, etc.)
    • CR Asset(inventory, equipment , etc.)

Asset

© 2007 by Nelson, a division of Thomson Canada Limited.

slide18
Recognition After Cash Flow – J/E Example

Cash

XYZ bought a new piece of equipment

DR Property & Equipment 158,000

CR Cash 158,000

Expense

XYZ amortizes the equipment over 10 years (expense is 15,800 in each year)

DR Amortization expense 158,000

CR Accumulated amortization 158,000

© 2007 by Nelson, a division of Thomson Canada Limited.

slide19
Straight Cash Revenues and Expenses

Cash revenue

A customer made a minor purchase

DR Cash 9,000

CR Revenue 9,000

Cash expense

XYZ made a donation to charity

DR Donation expense 10,000

CR Cash 10,000

© 2007 by Nelson, a division of Thomson Canada Limited.

slide20
Basic Event Format for Oil Sands Inc. Example:

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

© 2007 by Nelson, a division of Thomson Canada Limited.

slide21
1.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Sell crude oil for $40,000 cash.

Revenue

Cash

Operating Revenues

© 2007 by Nelson, a division of Thomson Canada Limited.

slide22
2.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Buy inventory for $24,000 on credit.

No

Inventories

Accounts Payable

© 2007 by Nelson, a division of Thomson Canada Limited.

slide23
3.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Sell sulphur for $10,000 on credit.

Revenue

Accounts Receivable

Operating Revenues

© 2007 by Nelson, a division of Thomson Canada Limited.

slide24
4.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Goods sold cost $5,200.

Expense

COGS of Crude Oil and Products

Inventories

© 2007 by Nelson, a division of Thomson Canada Limited.

slide25
5.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Buy truck for $250,000 on credit.

No

Capital Assets

Accounts payable

© 2007 by Nelson, a division of Thomson Canada Limited.

slide26
6.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Pay $100,000 on truck.

No

Accounts payable

Cash

© 2007 by Nelson, a division of Thomson Canada Limited.

slide27
7.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Use $20,000 of truck value.

Expense

Amortization Expense

Accumulated Amortization (balance sheet)

© 2007 by Nelson, a division of Thomson Canada Limited.

slide28
8.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Pay for the inventory in 2.

No

Accounts Payable

Cash

© 2007 by Nelson, a division of Thomson Canada Limited.

slide29
9.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Collect for the sulphur sold in 3.

No

Cash

Accounts Receivable

© 2007 by Nelson, a division of Thomson Canada Limited.

slide30
10.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Buy 3 years’ insurance for $60,000.

No

Prepaid Expenses

Cash

© 2007 by Nelson, a division of Thomson Canada Limited.

slide31
11.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Use one year’s insurance.

Expense

Operating Expenses

Prepaid Expenses

© 2007 by Nelson, a division of Thomson Canada Limited.

slide32
12.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Donate $4,000 cash to charity.

Expense

Operating Expenses

Cash

© 2007 by Nelson, a division of Thomson Canada Limited.

slide33
13.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Receive customer deposit of $8,000.

No

Cash

Customer deposits liability

© 2007 by Nelson, a division of Thomson Canada Limited.

slide34
14.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Deliver $8,000 goods to customer.

Revenue

Customer deposits liability

Operating Revenues

© 2007 by Nelson, a division of Thomson Canada Limited.

slide35
15.

Event:

Revenue or Expense?

Before Cash

Same Time

After Cash

Entry:

DR:

CR:

Auditor sends a bill for $5,000.

Expense

Operating Expenses

Accounts Payable

© 2007 by Nelson, a division of Thomson Canada Limited.

slide36
Accrual Connections:
  • Revenue recognition #3 (Sell sulphur for $10,000 on credit) anticipates collection #9 (Collect for the sulphur sold in 3).
  • Expense recognition #4 (Goods sold cost $5,200) follows acquisition #2 (Buy inventory for $24,000 on credit).
  • Expense recognition #7 (Use $20,000 of truck value) follows acquisition #5 (Buy truck for $250,000 on credit).

© 2007 by Nelson, a division of Thomson Canada Limited.

slide37
Accrual Connections:
  • Expense recognition #11 (Use one year’s insurance) follows acquisition #10 (Buy 3 years’ insurance for $60,000).
  • Revenue recognition #14 (Deliver $8,000 goods to customer) follows collection #13 (Receive customer deposit of $8,000).
  • Expense recognition #15 (Auditor sends a bill for $5,000) anticipates a later payment.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide38
Balance Sheet

Income Statement

Revenue

Liabilities

Assets

Expenses

Equity

Net Income

What Accrual Accounting Adjustments Do

  • Accrual adjustments affect both balance sheet (assets and liabilities) and income statement (revenues and expenses)
  • There are four kinds of accrual accounting connections:

© 2007 by Nelson, a division of Thomson Canada Limited.

slide39
1)Assets and Revenues,

2)Assets and Expenses,

3)Liabilities and Revenues, and

4)Liabilities and Expenses.

Balance Sheet

Income Statement

Revenue

Liabilities

Assets

Expenses

Equity

Net Income

slide40
Articulation

The resulting net income goes into equity (retained earnings), completing the articulation of the statements.

Balance Sheet

Income Statement

Revenue

Liabilities

Assets

Expenses

Equity

Net Income

© 2007 by Nelson, a division of Thomson Canada Limited.

slide41
Accounting Policies

What are they?

  • Decisions made in advance about how to account for a type of event, transaction, or accrual
  • Top-management’s judgment about appropriate accounting

© 2007 by Nelson, a division of Thomson Canada Limited.

slide42
Accounting Policies

What is their purpose?

  • Companies differ, so not all rules affect everyone
  • There can’t be an accounting rule for everything that could happen
  • A choice may be informative itself (a “signal”)
  • By its nature, accrual accounting requires choices about fairness and timing, especially for revenues and expenses.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide43
General Criteria for Accounting Policy Choices
  • Fairness- (objectivity, lack of bias, correspondence with economic substance)
  • Matching- (fitting expense recognition to the revenue)
  • Consistency- over time
  • Comparability- to other companies (especially same industry)
  • Authoritative standards- conformance with GAAP, etc.
  • Materiality- significant errors that alter decisions
  • Conservatism- taking anticipated losses into account before they occur, but only taking anticipated gains when they happen
  • Additional criteria include the cost of implementing the policy, and tax considerations

© 2007 by Nelson, a division of Thomson Canada Limited.

slide44
Accounting Policies

DANGERS!

  • Management may be self-serving in its choices
  • Potential for accounting “manipulation” such as:
    • Income smoothing
    • “Big Bath”
    • Abuses such as “aggressive accounting”
    • Even fraud
  • Too much choice may reduce inter-company comparability
  • Pressure on auditors to agree

© 2007 by Nelson, a division of Thomson Canada Limited.

slide45
Implementing Policy Choices: The Fiscal Period
  • Economic and business events are continuously ongoing – whether a single day or stretching for decades
  • Problem: How do we create concise financial statements and reports out of this mess of periods?
  • Answer: By the accounting policy choices employed by the company
  • Let’s take a closer look at a common problem:

How to recognize revenue and matching expenses?

© 2007 by Nelson, a division of Thomson Canada Limited.

slide46
Revenue Recognition: A Policy Choice

a) Cutting continuous events into fiscal periods

  • Whole issue is timing of revenue and expense recognition:
  • Company success is usually a long-term matter
  • But reports for shorter periods are needed
  • So we’re forced to make judgment, estimates, and choices
  • How do we “cut-off” events to measure performance?

© 2007 by Nelson, a division of Thomson Canada Limited.

slide47
Revenue Recognition: A Policy Choice

b) Accuracy versus decision relevance

HIGH

Relevance

Reliability

Amount of relevance or reliability

LOW

Early

Time when recognized in accounts

Late

slide48
Revenue Recognition: A Policy Choice

c) Balance Sheet and Income Statement Articulation

  • Every revenue and expense recognition entry affects both I/S and B/S
  • Therefore the entry should make sense from both sides:
  • Income measurement
  • Balance sheet valuation

© 2007 by Nelson, a division of Thomson Canada Limited.

slide49
Revenue Recognition: A Policy Choice

d) Balance Sheet and Income Statement Articulation

Two Examples:

DR: Accounts Receivable

CR: Revenue

Has the revenue been earned? Is the accounts receivable a valid asset?

DR: Expense

CR: Accounts Payable

Has the expense been incurred? Is the liability what is really owed?

© 2007 by Nelson, a division of Thomson Canada Limited.

slide50
Revenue Recognition: Solutions

a) Choose a fiscal period

  • Companies select a fixed fiscal period of one year for annual reporting (divided into 4 even interim or quarterly reports)
  • Attempt to accommodate the business cycle
  • Creates comparability to other companies (especially in industry)
  • Date may depend on tax or legal reasons
  • December 31 year-end is by far the most common

© 2007 by Nelson, a division of Thomson Canada Limited.

slide51
Revenue Recognition: Solutions

b) Critical event versus multiple-event recognition

  • Critical event is usually easier (one entry per revenue event)
  • But which critical event? Usually point of delivery of goods or service to customer: “we’ve done our job”
  • For longer-term revenue activities, it is normal to choose several in-between stages

© 2007 by Nelson, a division of Thomson Canada Limited.

slide52
Presumed value generation and discrete accounting entries

Over-recognition area

Presumed real growth in value

Value (Income) Generated Over Time

Value increase recognized through a single critical event

Under-recognition area

Revenue Recognition: Solutions

c) Choose a critical event

Start business

Acquire inventory

Market & sell

Deliver goods

Bill customer

Collect money

Provide warranty

Time

slide53
Revenue Recognition: Solutions

d) Impact on the Balance Sheet and Income Statement

  • Utilizing the critical event method of revenue recognition causes over and under recognition errors
  • The critical event method is a compromise
  • As long as the event matches the criteria (next slide), it will give a consistent portrayal of the company on the financial statements

© 2007 by Nelson, a division of Thomson Canada Limited.

slide54
Criteria for Revenue Recognition

Four Criteria:

  • Goods or services have been provided;
  • Costs have been incurred or are estimable;
  • Revenue is measurable in dollars;
  • Cash or promise to pay has been received.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide55
Five Revenue Recognition Methods
  • At delivery (point of sale or shipment);
  • During production (e.g. percentage of completion);
  • Completion of production;
  • When cash is received (e.g. installment sales);
  • After cash has been received.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide56
Revenue Recognition Examples

In each of the following independent cases, indicate when you think the company should recognize revenue. Support your answer with reference to the generally accepted criteria for revenue recognition.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide57
Revenue Recognition Examples

P & C’s is a soft drink manufacturer, producing beverages that are shipped across Canada upon receipt of a purchase order. Sales are billed immediately after a shipment is made. The company estimates that approx. 1.5% of credit sales will prove to be uncollectible.

At shipment (method 1): all 4 criteria are met.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide58
Revenue Recognition Examples

S & G Construction Ltd. undertakes long-term construction contracts. The company only accepts contracts that pay a fixed fee for services provided. There has never been a problem collecting from customers in the past, and costs can be estimated with reasonable accuracy.

Throughout (method 2): all 4 criteria are met at various stages throughout the contract.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide59
Revenue Recognition Examples

Crazy Carl’s Hi-Fi Stereo Company sells state of the art stereo equipment on an installment plan. Customers take delivery once the first payment is made. Since Crazy Carl’s has no screening process of applicants for the installment plan, over 50% of payments end up in default.

At cash receipt (method 4): criterion 1 is met early, but the other 3 are not met until cash is in hand.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide60
Revenue Recognition Examples

The Rock Oil Co. mines and refines oil and gas. The company usually waits to sell their inventory when the market price is favourable. Given the current market conditions, the company is able sell all of its inventory.

At production (method 3): no further selling activity required (criterion 1), costs are known, revenue is measurable (but fluctuates), promises unnecessary (ready market). But most companies would wait until shipment (method 1).

© 2007 by Nelson, a division of Thomson Canada Limited.

slide61
Revenue Recognition and Expense Matching
  • Revenues or Expenses first?
    • Usually revenue recognition policy is created first, then expense recognition policy is matched to it
  • Importance of Matching
    • Proper revenue-expense matching is important to good income measurement
    • Early revenue recognition without corresponding expenses inflates income while the opposite depresses income
    • Certain items don’t match well, including “period” costs, “discretionary” expenses, and gains/losses on disposal

© 2007 by Nelson, a division of Thomson Canada Limited.

slide62
Construction Example
  • Construction companies and others who perform long-term projects use a ‘percentage of completion’ method of revenue recognition
  • Revenue is recognized during fiscal periods for the percentage that the project has been completed
  • Corresponding expenses are matched to the proportional revenue to help maintain consistency
  • This approach smoothes out income and prevents large swings depending on when projects are completed.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide63
Construction Example:

Dino’s Construction Ltd. has several contracts to construct buildings:

© 2007 by Nelson, a division of Thomson Canada Limited.

slide64
Completed Contracts Basis

1) Assuming all revenues, collections, expenses, and payments are as expected, calculate income before income tax for 2006:

a) Using the completed contracts basis to recognize contract revenues and expenses.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide65
Contract #27 Expected Income $120,000

Contract #29 Expected Income $250,000

Expected Income $370,000

Completed Contracts Basis

Contracts #27 and #29 are 100% completed. Thus, we recognize their revenues and expenses.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide66
Completed Contracts Basis

1) Assuming all revenues, collections, expenses, and payments are as expected, calculate income before income tax for 2006:

b) Using the percentage of completion basis to recognize contract revenues and expenses.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide67
Percentage of Completion Basis

48,000

140,000

250,000

72,000

204,000

$714,000

Income Earned = Expected Income * %age Completed

© 2007 by Nelson, a division of Thomson Canada Limited.

slide68
Percentage of Completion Basis

2) Which of these two bases is the more conservative? Why?

The completed contract basis is the more conservative. All revenues and expense are deferred until the end with this method. Under the percentage of completion method, some revenues and expenses are recognized earlier.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide69
Percentage of Completion Basis

3) No revenue has yet been collected on Contract #29. It has been learned that Contract #29 has run into legal trouble. The $610,000 expected expense has been incurred. Now it is learned that revenue of only $100,000 will be received so there is an expected loss of $510,000.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide70
Converts the already recorded gain of $150,000 to the expected loss of $610,000

Write down A/R to the $100,000 now expected

Correcting Contract #29

On contract #29, revenue of $860,000 and expense of $610,000 have already been recognized, for an income of $250,000.

Now it will be a loss of $510,000 instead.

ANSWER

DR Loss expense $760,000

CR Accounts receivable $760,000

© 2007 by Nelson, a division of Thomson Canada Limited.

slide71
Another Example

Lobo’s Emporium (Lobo’s) is a franchise of dessert food outlets. Franchises are available for five years, with a renewal option of three more five year periods. Each franchise sells for $60,000 with the franchisee paying $20,000 down in cash, and the remainder in four equal annual installments. The franchiser is also the sole distributor of supplies, etc. to the franchisee.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide72
Here is the data for Lobo’s first year, ended August 31st, 2006:

Franchise agreements signed 21

Down Payments received 17

Fast-food outlets opened 12

Franchise-related costs $340,000

Other general expenses $ 70,000

Two of the franchises have already gone out of business (having paid only the initial $20,000), three others who have opened are under severe financial distress and don’t look like they are going to make it, and one of the unopened franchises looks like it will never open its doors.

slide73
List as many methods as you can think of for recognizing revenue from franchise sales.
  • As cash is received;
  • After the outlets have opened, recognize all revenue;
  • At the signing of the contract, recognize all revenue;
  • After receiving the down payment, recognize all revenue;
  • On some other basis.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide74
Rank those methods from least conservative to most conservative.

Least conservative

  • As cash is received;
  • After the outlets have opened, recognize all revenue;
  • At the signing of the contract, recognize all revenue;
  • Recognize the full revenue after the down payment is received.

c

d

b

a

Most conservative

© 2007 by Nelson, a division of Thomson Canada Limited.

slide75
List as many methods as you can think of for recognizing expenses from franchise-related costs.
  • All general and franchise-related costs immediately;
  • All general expenses, but only 12/21 of the franchise-related costs;
  • All general expenses, but only 17/21 of the franchise-related costs;
  • In proportion to the cash received;
  • Some other formula.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide76
Match each expense recognition method to the revenue recognition method that seems most appropriate.
  • All general and franchise-related costs immediately;
  • All general expenses, but only 12/21 of the franchise-related costs;
  • All general expenses, but only 17/21 of the franchise-related costs;
  • In proportion to the cash received.
  • As cash is received;
  • After the outlets have opened, recognize all revenue;
  • At the signing of the contract, recognize all revenue;
  • Recognize the full revenue after the down payment is received.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide77
Prepaid and Accrued Expenses

Prepaid and Accrued Expenses are very common devices of accrual accounting: to line expenses such as insurance, interest, rent, and property taxes up with the fiscal period to which they apply, whether or not they were paid for before, during, or after that period.

Basic to accrual accounting’s attempt to timerevenues and expense appropriately.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide78
Prepaid and accrued expenses result from two factors:

1. Matching expense recognition to the fiscal period over which the expense is incurred (and during which revenue is recognized); and

2. Cash flow for paying the expense not coinciding with the expense recognition.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide79
Only two journal entries are needed to implement the two factors:
  • Expense recognition:
  • An annual, or more usually, monthly adjustment to the accounts to create an expense account and recognize that either a prepaid asset has been consumed or that an accrued liability has been incurred:
  • Dr Some expense account
  • Cr Some balance sheet account (prepaid expense or accrued liability)
  • Cash payment:
  • Recorded whenever the payment is made for the expense:
  • Dr The balance sheet account (prepaid expense or accrued liability)
  • Cr Cash
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Prepaid and Accrued Expenses:
  • Prepaid expenses are assets that arise because an expenditure has been made, but there is still value extending into the future
  • Accrued expenses are liabilities, usually current, that arise from exactly the same timing difference as do prepaid expenses

© 2007 by Nelson, a division of Thomson Canada Limited.

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Features of a Prepaid Expense:

Prepaid Asset

x

y

z

Accrued Liability

Fiscal year

Cash outlays

  • Prepaid expenses arise when expenses are paid prior to the period to which the expenses apply
  • Prepaid expenses have value in reducing future cash payouts
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Features of an Accrued Liability:

Prepaid Asset

x

y

z

Accrued Liability

Fiscal year

  • The cash flow happens after the economic value has been obtained
  • Accrued liabilities have value in increasing future cash payouts. The expense is created by building up the accrual to expense over the period to which it applies.
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Prepaid Asset

Accrued Liability

x

y

z

Fiscal year

A mixed case is also common, in that sometimes the cash paid is prior to the incurrence of the expense, and sometimes follows it.

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Prepaid Asset

Accrued Liability

x

y

z

Fiscal year

The cash payment times X, Y, and Z are now not regular: X and Y are made before the whole expense has been incurred, and then there is a long delay before Z is made.

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The balance sheet account varies from being an accrued liability to being a prepaid expense. A single balance sheet account could be used, and it could be put in the current assets if its balance is a debit, and in the current liabilities if its balance is a credit.

Prepaid Asset

Accrued Liability

x

y

z

Fiscal year

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Let’s try an example:

Tyler Inc.

Prepaid and Accrued Expenses:

Therefore, accrued (unpaid) expenses and prepaid expenses are just opposite sides of the same coin, reflecting a mismatch between the cash payment and the expense (use of the economic value).

© 2007 by Nelson, a division of Thomson Canada Limited.

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Tyler Inc.

Tyler Inc. obtained financing from a foreign bank near the end of last year. Due to the way the loan contract was designed, the company paid a small amount of interest in advance, so at the end of last year, the company’s balance sheet showed a Prepaid Interest asset of $1,000. During this year, the loan interest, calculated according to the contract, amounted to $24,570, and the company paid the bank $22,000 on account on interest.

© 2007 by Nelson, a division of Thomson Canada Limited.

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Prepaid or accrued interest, end of last year?
  • Interest expense for this year?
  • Prepaid or accrued interest, end of this year?

24,570

1,000

24,570

22,000

22,000

Tyler Inc.

What are the:

Prepaid/Accrued Interest

Interest Expense

Cash

1,570

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Tyler Inc.

Entries:

DR Interest Exp. 24,570

CR Prepaid/Accrued Int. 24,570

DR Prepaid/Accrued Int. 22,000

CR Cash 22,000

© 2007 by Nelson, a division of Thomson Canada Limited.

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