Operating Cycle

1. Revenue and Monetary AssetsJOIN KHALID AZIZCOACHING CLASSESICMAP STAGE 1,2,3,4,5ICAP MODULE A,B,C,DPIPFABBA & MBAB.COM & M.COMACCOUNTING OF O/A LEVELMA-ECONOMICS0322-3385752KARACHI, PAKISTAN

2. Operating Cycle • Cash-to-cash. • Receive cash from customer • Purchase materials/services & pay cash • Convert materials/services to salable product • Store product • Sell product • Receive cash from customer

3. Revenue Recognition: When? (Timing) & How much? (Amt.) • At one point in revenue cycle (objectivity). • Criteria: • When? Earned (Conservatism) • Normally, goods shipped. • Service performed. • How much? Realized or realizable (Realization). • Already collected or collectible. • Amount can be measured reliably. • Next step: matching costs.

4. Basic Revenue Recognition Criteria • Recognize revenue in earliest period in which: • Entity has substantially performed what is required in order to earn income and • Amount of income can be reliably measured.

5. Delivery Method • Recognize revenue when goods or services are delivered. • For goods: when title transfers. • FOB shipping point (when goods are given to carrier). • Example 1: • Order is received for Rs900. Sales entry? • Goods are produced. Sales entry? • Goods are shipped. Sales entry?

6. Consignment Method • Consignor ships goods to consignee. • Inventory on consignment 1,000 • Merchandise inventory 1,000 • Consignor retains title until goods are sold to customer. At sale: • Accounts receivable 1,400 • Sales revenue 1,400 • COGS 1,000 • Inventory on consignment 1,000

7. Franchise Revenue • Recognize: • When earned. • Not when agreement signed or fee received.

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

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

10. Percentage-of-Completion Method • Design/development and construction/production projects that extends over several years. • Customer pays either fixed price or cost reimbursement contract. • Reasonable assurance of profit margin and ultimate realization. • Revenue recognized based on total percentage of project work performed during period.

11. Completed Contract Method • Percentage of completion method required unless: • Amount of income to be earned on contract cannot reasonably be determined. • Alternative is completed contract method. • Costs incurred are an asset (Contract Work in Progress) until revenue is recognized.

12. Production Method • Applies to agricultural and mining. • Criteria: • Clear market determined price. • Performance substantially complete. • Minimal remaining costs. • Permitted but not required by GAAP.

13. Installment Method • Customer pays a certain amount per period. • Installment payment is recognized as revenue and a proportional part of cost of sales is recorded. • Under cost recovery method, cost is recorded equal to installment payment until total cost of sales is covered.

14. Real Estate Sales • Developer often finances over many years. • Uncertainty of income due to uncertainty of receipt of future payments. • Conditions required for revenue recognition: • Period allowing cancellation and refund to buyer has expired. • Cum payments equal to 10% of purchase price. • Seller has completed or is clearly capable of completing required improvement.

15. Amount of Revenue Recognized • Net realizable value (amount reasonably estimated to be collected). • 2 approaches: • Direct write-off method. • Allowance method. • % of sales. • % of (analysis of) AR.

16. Direct Write-Off Method • Write-off when specific account that is uncollectible is identified. • Why is this not acceptable under GAAP?

17. Allowance Method • Estimate amount of current period credit sales that will not be collected. • Historical % tempered by judgment. • Historical % of aged receivables (+judgment). • Adjusting entry at end of period. • When an uncollectible account is identified, it is written off.

18. Example • Amount of revenue recognized: • Sales for the year were Rs2,000 for cash and Rs6,000 on credit. • Historically we don’t collect about 5% of our credit sales due to customer bankruptcies or unable to locate customer. • A customer, The XYZ Company went bankrupt. They owed us Rs175. • Entry for revenue? • Entry for bad debts - direct write-off (not-GAAP)? • Entries for bad debts (allowance method)?

19. Example • Balances in Accounts • Accounts receivable dr 3,000. • Consisting of 2,000 current and 1,000 overdue. • Allowance for doubtful accounts cr 50. • Estimated amount of accounts that are uncollectible: • 2% for current and 10% for non-current accounts. • What entry do we make at the end of the year to accrue for bad debts?

20. Allowance Method (continued) • Allowance… is a contra-asset account. • Collection of a bad debt that was written-off: • Cash • Allowance for Doubtful Accounts

21. Sales Discounts • Sales terms are “2/10 net 30” • Customer gets 2% cash discount if paid within 10 days. • Otherwise, total amount is due within 30 days. • What does “1/15 net 45” mean? • What is the effective annual rate of savings by taking advantage of terms of “2/10 net 30”?

22. Alternative Methods of Accounting for Sales Discounts • Record initial sale at gross. • At collection of net amount record discount as a reduction from gross sales. • Record initial sale at gross. • At collection of net amount record discount as an expense of the period. • Record initial sale at net. • Record amounts not taken as discounts as additional revenue.

23. Example • We sold Rs10,000 of mdse. Sales terms are 2/10, n/30. Customers paid us for Rs8,000 of the merchandise billed within 10 days. The remaining Rs2,000 was paid within 30 days. • Record at gross. • Record at net.

24. Credit Card Sales • If cash received by merchant immediately (Bank plan, MC, Visa): • Cash 970 • Sales discount 30 • Sales revenue 1000

25. Credit Card Sales (continued) • If cash received by merchant in 30 days (American Express, Discover): • Accounts receivable 970 • Sales discount 30 • Sales revenue 1000

26. Sales Returns & Allowances • Similar to bad debt expense, • Estimate percentage of revenues that will eventually result in returns or allowances. • Adjusting entry at end of period. • Actual return or allowance.

27. Example • On average 2% of our Rs10,000 of sales is returned. Adjusting entry at end of period? • Entry for return of Rs80 of goods? • Same for direct write-off method?

28. Sales Returns & Allowances (Continued) • Provision for Returns and Allowances is a liability account. • Alternative: • Not accrue for returns and allowances but write them off as they occur. • Is this GAAP?

29. Adjustment vs. Expense • Realization concept suggests adjustment to revenue. • In practice both methods are found. • Consistency: • Same handling from year to year. • Allows same company results to be compared from year to year. • Comparisons between companies may be distorted.

30. Warranty Costs • Amounts are estimated (usually as a percentage of sales). • Part of Cost of goods sold. • Record accrual (adjusting entry) • Record the actual expenditures. • Allowance… is a liability account. Est. warranty exp. Is part of costs of sales.

31. Warranty Expenses Example • We estimate that warranty expenses will be 4% of our Rs10,000 of sales. Entry? • We spent Rs120 on parts and Rs250 on labor for repairs under warranty. Entry?

32. Interest Revenue • Amount earned by lender during the period. • 2 approaches • Interest paid at maturity. • Interest is explicit. • Discounted loan. • Interest is implicit. • Accounted for separately from sale.

33. Example: Interest Revenue • On January 1, 19x1 sold a customer Rs1,000 of mdse. We received a promissory note for Rs1,000 plus 8% interest to be paid in one year. • Entry for sale? • Entry for accrual of interest on December 31, 19x1? • Entry for receipt of payment on note on January 1, 19x2? • On January 1, 19x1, we sold mdse. and received a promissory note for Rs5,000 with no interest. The note is due in one year. The market rate of interest on such a note is 9%. • Entry at sale: • Year end adjusting entry (12/31/19x1) • Entry when customer pays note (1/1/19x2)

34. Monetary& Non-monetary Assets • Monetary assets are money or claims to receive fixed sums of money. • Non-monetary assets are items used in future production and sales of goods and services. • Balance sheet distinction • Current and non-current assets. • Not monetary and non-monetary. • Non-monetary assets (except inventory) on BS at unexpired cost. (Cost less depreciation) • Monetary assets: Cash reported at face. AR at NRV. Other at fair value.

35. Cash • Funds available for disbursement. • May include liquid short term investments. • Highly liquid debt instruments with original maturities of 90 days or less.

36. Receivables • Trade receivables • Accounts receivables from usual sales of products or services for non-financial institutions. • Other receivables are shown separately. • E.g., Due from employees, advances or loans.

37. Marketable Securities • Must be marketable. • E.g., commercial paper, treasury bills, publicly traded stocks and bonds issued by companies. • Also called “Temporary Investments.”

38. Accounting for Marketable Securities • Three categories • Held-to-maturity: debt securities, • Valued at cost. • Trading securities: debt or equity held for current resale, valued at market. • Realized (i.e., if sold during period) and unrealized (not yet sold but market price has changed) gain or loss included in current year’s income.

39. Accounting for Marketable Securities (Continued) • Available-for-sale securities: • Debt or equity securities that do not fit either of the other 2 categories. • Reported at market value. • Realized gains and losses go through income. • Unrealized gains and losses directly credited (or debited) to a stockholders’ equity account.

40. Analysis of Monetary Assets • Current ratio = CA/CL • Acid-test ratio = quick ratio = monetary CA/CL= (CA - inventories - prepaid items) /CL. • Days cash = cash/(cash expenses  365) • Cash expenses  total expenses - depreciation. • Days receivable = average collection period = Receivables/(Sales  365) • Ratios differ by industry.