chapter 4--learning objectives 4 1.understand the concept of recognition

Chapter 4--Learning Objectives

1. Understand the concept of recognition

Recognition

Recognition is the process of formally recording or incorporating an item into the financial statements of an entity

ex. Area development fees

Recognition includes

depiction of an item in both words and numbers, with the amount included in the

totals of the financial statementsnot the footnotes

Accounting recognition must

Identify and measureevents, transactions and circumstances

that should be capturedin the accounting information system

Chapter 4--Learning Objectives

2. Interpret the recognition criteria for assets and liabilities

To be included,an item must... 1. Possess the characteristics of an

element of the financial statements

Asset

Liability

Revenue

Expense

Gain

Loss

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

reliable

Cash versus accrualbased accounting

Cash receipts and disbursements are recognized when they occur

and in CASH BASED accountingrevenues and expenses are recognized when

the cash changes hands

Cash versus accrualbased accounting

In accrual based accounting, changes in financial statement elements are recorded in

the period in which the events occurrather than when the cash changes hands

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

Chapter 4--Learning Objectives

3. Interpret the recognition criteria for revenues

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

To be recognized...

Revenues must be:1. Realized or realizable2. Earned

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

Revenues are EARNED

Revenues are EARNED

when the entity has substantially completed

Revenues are EARNED

when the entity has substantially completed what it must do to be entitled to the benefits

Revenues are EARNED

when the entity has substantially completed what it must do to be entitled to the benefits represented by the revenues

The value-adding process(a black box)

The inputs include:

?

Material

Labor

Capital

The value-adding process(a black box)

At the end of the process the product is sold

and cash is received

?Product

Conservatism

Recognize losses as incurred Recognize Revenues when realized or

realizable

Chapter 4--Learning Objectives

4. Apply various revenue recognition points to appropriate situations

Revenue recognition points

Time of sale

Usually operationalized as time of deliveryChange in ownership--transfer of title

At production or delivery

If sale and cash receipt precedes production and delivery, revenue is recognized at the point of production and / or deliveryex. Airline ticketsex. commodities

During production

If product is contracted before production, collection is probable, and production requires an extended period of timeex. building

As the service is rendered

If contracted for in advance for continuously rendered servicesex. rent

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 changeex. Net realizable value of farm products

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

Cycle completion

If collection of receivables is doubtful, revenues are deferred and recognized based on cash received

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

Percentage-of-completionrevenue recognition1. Determine costs incurred to date2. Estimate costs to complete3. Calculate percentage complete4. Apply percentage to projected profit5. Subtract previously recognized profit

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

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)

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

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

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

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

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

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

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

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

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

Installment Sale

42 tents @ $3,600 $300 per month plus 12% Cost $1800

Installment Sale (cont.)

Accounts Receivable 151,200

Inventory 75,600

Deferred Installment Revenue75,600

Installment Sale (cont.)

Cash 336

Interest Revenue 36

Accounts Receivable 300

Deferred Installment Revenue 150

Installment Revenue 150

Chapter 4--Learning Objectives

5. Understand the concepts of income and capital maintenance

Comprehensive income

The change in equity of a business

during a period

from transactions and other events

from non-owner sources

Maintenance of capital

Need to separate

Return on capitalfrom

Return of capital

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.