lecture6revenue recognition.pdf

8/10/2019 lecture6Revenue Recognition.pdf

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Receivables and Revenue

Recognition

15.501/516AccountingSpring2004

Professor S. RoychowdhurySloan School of Management

Massachusetts Institute of Technology

Feb 23 and 25, 2004


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WHY DO WE CARE ABOUT

REVENUE RECOGNITION?Revenue has a BIG impact on bottom-line profitability ==>

managers may be tempted to manage revenue

Large Sample Evidence: over 40% of SEC enforcement actionson accounting issues deal with Revenue Recognition

Sample of headlines from searching Dow Jones Newswire for2004 and 2003:

Ceridian Results for 2000-2003 to restated, Feb 18

Wolf Popper files Securities Class Action against SonusNetworks, Feb 13, 2004

Tripos postpones earnings release will revise revenuerecognition policies, Feb 12Opsware expects 100% revenue growth, points out

transparent revenue recognition policies, Feb 11

Agco Corp faces class action suit, Feb 6 2


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CRITERIA FOR REVENUE

RECOGNITION

Underaccrualaccounting,afirmrecognizesrevenuewhen

ithas:

Performedall,orasubstantialportionof,theservicestobeprovided.

Incurredasubstantialmajorityofthecosts,andtheremainingcostscanbereasonablyestimated.

Receivedeithercash,areceivable,orsomeotherassetforwhich

areasonablyprecisevaluecanbemeasured

collectibilityisreasonablyassured.

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Recognition Criteria

Cash Basis vs Accrual Basis

Accrual Cash

Revenue

Expense

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Cash Basis vs Accrual Basis

Recognition Criteria

Accrual Cash

Revenue when earned when $ recd

and realized

Expense when incurred when $ paid

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EXAMPLES OF REVENUE

RECOGNITION EVENTS

z At the time of sale (Thisis,byfar,mostcommonly

encountered.)z Titlepassestothebuyeranddeliverytakesplace

z Reasonableestimateofuncollectibles

z Reasonableestimateofsalesreturns

z Reasonableestimationofallothermaterialexpensesrepresentinguncertainfutureoutflows(e.g.,warrantycosts).

z Mostcommoninretail,wholesale&manufacturing

z Evenwhenrightofreturnexists?

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Bill & Hold

z Hardware

z Revenuefromhardwaresalesorsales-typeleasesisrecognized whenthe

productisshipped.

z RecentexperienceofSunbeam..InthefourthquarteroflastyearSunbeamrecorded$50millioninsalesofcooking grills under an early buy program [some $35 million] werecategorizedbillandholdsalesandneverevenleftSunbeamswarehouses.

-- fromBarrons,6/8/98

z AgcoCorp.Farm equipment company Agco announced that the Securities andExchange Commission has launched an informal inquiry into its accounting

practicesAgcostated that insome instances it recognizes revenuewhenequipment remains on its premises after having been invoiced to the dealer.These transactions occur at a dealer's request, added Agco, usually so thedealercanarrangeforitsowntransportationoftheequipment.

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SAB 101

z Fuelledbyrecentaccountingscandals

z IssuedbySEC:SAB101tookeffectincalendaryear2000.

z In general, SECsaid that themost common reasons for changes in revenuerecognitionpoliciestocomplywithSAB101were:z Deferralofrevenueonproductsalesuntilsuchproductsaredelivered,andtitle

transferstothecustomer.z Deferralofvariousup-front,orprepaid,feesforwhichthecompanyhadnotcompleted

aseparateearningsprocess.z Deferralofrevenueuntilcertainnon-perfunctorysellerobligations(suchasequipment

installation)werecompleted.z Deferralofrevenuethatiscontingentontheoccurrenceofsomefutureevent(suchas

theachievementbyalesseeofcertainminimumsalesthresholds)untilthatevent

occurs.

z DidtheSECover-reactwithSAB101?Altamuro,BeattyandWeber(2003)

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Global Crossing and Qwest

Communications

z Traded fiber optic capacity and booked

revenuesz Say, the two companies traded capacity

worth$10,000

z GlobalCrossing:z

Revenues

z Costofnetworkingservice

z SameforQwest.

z Whydidtheydothis?

10,000

10,000

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Is this accounting manipulation? channel stuffing, price discounts!

z Sunbeam...Sunbeamjammedasmanysalesasitcouldinto1997topumpboththetopandbottomlines....Sunbeameithersent more goods than hadbeen ordered bycustomersorshippedgoodsevenafteranorderhadbeencancelled.

z Recent experience of Bristol-Myersz

Inanother setback for the beleaguereddrugmaker, Bristol-Myers SquibbCo.confirmedthattheSecuritiesandExchangeCommissionhasopenedaninquiryintowhetheritimproperly inflated revenue last year by as much as $1billion through use of sales incentives...Drug makers, like many othermanufacturers, can boost near-term sales by extending lower prices towholesalers,encouragingthemtoloadup.Butsuch"channel-stuffing"hurts

latersales. --fromWSJ,7/12/2002z Recentstatusofthisinvestigation?

z Systematic evidence: Roychowdhury (2003), available onwww.ssrn.com

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EXAMPLES OF REVENUE

RECOGNITION EVENTS (Uncommoncases)

z During production

z Establishmentoffirmcontractprice

z

Reasonableassuranceofcollection

z

Reasonableestimateofcostofcompletion

z E.g.,defenseandconstructioncontracts.

z At Completion of Production

z Existenceofdeterministicorstablesellingprice

z

Nosubstantialcostofmarketingz E.g.,preciousmetals,agriculturalproducts

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EXAMPLES OF REVENUE

RECOGNITION EVENTS (Uncommoncases)

z At the time of cash collection

z Impossibletovalueassetsreceivedwithfairdegreeofaccuracy.

z

E.g.,somerealestatelanddevelopmentdeals.

z Installment approach

z Profitsrecognizedinproportiontocashcollected

z Cost recovery approach

z

Noprofitrecognizeduntilallthecostshavebeenrecovered.

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IMPORTANCE OF ACCOUNTS

RECEIVABLEReceivables

Industry Total Assets

Eating Places 1.6%Family Clothing Stores (The GAP) 3.0

Race Track Operations 3.1

Grocery Stores 4.9

Intel 8.6

Semiconductors 11.3

Advertising Agencies 42.7

Trans. Freight/Cargo 43.1

Computer Software Wholesale 45.5

Overall Median 13.0%

Source:5,933industrialfirmsfrom2000GlobalVantage

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Sears Roebuck & Co. - sales

z ItsYear1:Searsmakessalesofmicrowaveovens

for$10,000

z Saycustomerspaidfor$4,000ofthesesaleswithcash,therestwiththeirSearscreditcards

z SoDrCash 4,000

DrAccountsreceivables 6,000CrRevenue 10,000

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Sears Roebuck & Co.

receivables

z WhenSearsmakesitscreditsales,itestimatesfrompastexperiencethat5%ofitsaccountsreceivableswillneverberecoveredinmoney

z Whatdoesthisimply?

z Whatareitsaccountsreceivablesactuallyworth?

z Whatisthepartofthesaleitwillactuallysee?

z Oneoption:Searsrecognizesanexpenseof$300andwritesdown itsaccountsreceivableto$5,700

DrBadDebtexpense 300CrAccountsReceivable 300

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Sears Roebuck & Co. - ADA

z ProblemwhatdoesSearsnot know?

z ItthereforerecognizesBadDebtexpenseandcreatesanAllowanceforDoubtfulAccounts(ADA)

DrBadDebtexpense 300CrADA 300

z OnBalanceSheet,accountsreceivablearereportednetofADAAccounts Receivables 6,000less ADA 0,300

Net Accounts Receivable 5,700

z ADAisacontra-assetaccount!

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Income Statement and Balance

Sheet RelationsAccounts Receivable (A)

Beg Balance = 0Credit Sales = 6,000

Ending balance = 6,000

Allowance for doubtful accounts (XA)

Beg Balance = 0

Amount of Bad Debt Expense = 300

Ending balance = 300

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Sears Roebuck & Co. write-

offsz Its Year 2 end of quarter 1: For simplicity, assume no credit sales

duringquarter1ofYear2

z Customershavepaidup$3,000z DrCash 3,000z CrAccountsreceivables 3,000

z Also,CustomerBillyJoedeclaresbankruptcy&defaultsfor$50z Searshasnowidentifiedacustomerwhohasdefaulted:Itcanwriteoff

BillysAccountReceivablez Oftheoriginal$300Searshadexpectedtoseeasadefault,whatisthe

amountitstillexpectstoneverrecoverinthefuture?z Whichaccountshouldreflectthis?z DrADA 50z CrAccountsreceivables 50

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Beg Balance = 6,000Cash collection = 3,000

Write-offs = 50

Ending balance = 2,950


Beg Balance = 300

Write-offs = 50

Ending balance = 250

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Beg BalanceCredit Sales

Cash collected Write-offs

Ending balance


Beg Balance

Amount of Bad Debt ExpenseWrite-offs

Ending balance

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Sheet Relations

- Allowancefordoubtful

Accounts(XA)

BeginningBalance

+AmountsRecordedasBad

DebtExpense

- AmountsWrittenOff

=EndingBalance

AccountsReceivable(A)

BeginningBalance

+CreditSales

- CashCollected

- AmountsWrittenOff

=EndingBalance

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ALLOWANCE FOR BAD DEBTS

(UNCOLLECTIBLES)

Methods DirectWrite-OffMethod

RequiredbyIRS

DisallowedunderGAAP

PercentageofSales

Aging

Howmightafirmschoiceofmethodevolveovertime?

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AGING ANALYSIS OF ACCOUNTS

RECEIVABLES

Cowens,alargedepartmentstorelocatedinametropolitanarea,hasbeenexperiencingdifficultyinestimatingitsbaddebts.

Thecompanyhasdecidedtoprepareanagingscheduleforitsoutstandingaccountsreceivablesandestimatebaddebtsbythedatesofitsreceivables.

Thisanalysisdisclosesthefollowinginformation:

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RECEIVABLESBalance($) Age Estimated%

Uncollectible198,000


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RECEIVABLESBalance ($) Age Estimated %

Uncollectible

198,000 x

114,000 x

73,000 x

39,000 x

25,000 x

< 30 days

30-60 days

61-120 days

121-240 days

241-360 days

Over 360 days

0.8 =

2.0 =

5.0 =

20.0 =

35.0 =

50.0 =

$ 1,584

2,280

3,650

7,800

8,750

10,00020,000 x

469,000 Total expected uncollectible $ 34,064

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RECEIVABLES

1. ComputetheestimatedamountofuncollectibleAccounts

Receivable,i.e., thedesiredendingbalanceoftheADA.

2. GivenabeginningADAbalanceof$5,700,recordthe

BadDebtExpenserequiredtoachievethedesiredendingADAbalance.

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RECEIVABLESRet.EarningsCash A/R(A) -ADA

BB 469,000 5,700

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RECEIVABLESCash A/R(A) -ADA Ret.Earnings

BB 469,000 5,700

Baddebts ?

EB 34,064

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BB 469,000 5,700

Baddebts 28,364 (28,364)(exp.)

EB 34,064

5,700 + Bdx =34,064Bdx =28,364

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Makecreditsales

RECEIVABLESCash A/R(A)

BB 469,000

Baddebts

EB

-ADA Ret.Earnings

5,700

28,364 (28,364)(exp.)

34,064

time

FYE

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Makecreditsales

Recognize revenue


BB 469,000 5,700

Baddebts 28,364 (28,364)(exp.)

EB 34,064

Write-off (3,000) (3,000)

time

FYE

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BB 5,700

Baddebts 28,364 (28,364)(exp.)

EB 34,064

Write-off (3,000) (3,000)

FYE

Makecreditsales

Recognize revenue

CreditCustomergoesbankrupt

time

469,000

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BB 5,700

Baddebts 28,364 (28,364)(exp.)

EB 34,064

Write-off (3,000) (3,000)

FYE

Makecreditsales

Recognize revenue


Recognize expense?

time

469,000

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BB 5,700

Baddebts 28,364 (28,364)(exp.)

EB 34,064

Write-off (3,000) (3,000)

FYE

Makecreditsales

Recognize revenue


Recognize expense

time

469,000

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