Rev. Recog - 2 DEFINITIONS Revenues Inflows of assets or settlements of liabilities during a period from delivering or producing goods or services. Expenses Outflows of assets or incurrence of liabilities during a period from delivering or producing goods or services. ○ Incurred in an attempt to produce revenues
Revenue and Expenses The price for goods sold and services rendered during a given accounting period. Increases owner’s equity. The costs of goods and services used up in the process of earning revenue. Decreases owner’s equity.
Debits and Credits for Revenue and ExpenseEQUITIES Debit for Decrease Credit for Increase REVENUES Debit for Decrease Credit for Increase EXPENSES Credit for Decrease Debit for Increase Expenses decrease owner’s equity. Revenues increase owner’s equity.
Rev. Recog - 5 REVENUE PRINCIPLE Revenue should be recognized in the financial statement when... It is earned, and It is realized or realizable (Measurable)
Rev. Recog - 6 REVENUE PRINCIPLE Revenue is earned when the earnings process is completed or virtually completed. Revenue is realized when cash is received. Revenue is realizable when claims to cash are received that can be converted into a known amount of cash.
Rev. Recog - 7 REVENUE PRINCIPLE Revenue is typically recognized: ○ ○ At delivery (point of sale) ○ After delivery ○ Before delivery of product or service
Rev. Recog - 8 REVENUE RECOGNITION POINTS Design and production, construction in progress, minerals discovered Goods completed and ready for sale, contract complete Delivery of product or service Cash collected for goods or services Right of return expires Recognition before delivery Recognition after delivery Recognition at delivery Percentage-of completion method Production method Completed contract method Point of sale method Installment method Cost recovery method Right of return expiration method RELEVANCERELIABILITY
Rev. Recog - 9 Revenue is earned and realized at the point of sale. The product or service has been delivered to the customer and cash has been received or is receivable. This method is sometimes called the “sales method,” or “delivery method.” REVENUE RECOGNITION Point of Sale
Rev. Recog - 10 Uncertainties about collectibility or future performance by seller. Sale with right of return. Product-financing arrangements. REVENUE RECOGNITION After Delivery
Rev. Recog - 11 INSTALLMENT SALES When we are uncertain about the collectibility of the sales revenue or the ability of the seller to deliver futures services, we should defer revenue recognition. Two commonly used accounting methods are the... Installment sales method. Cost recovery method.
Rev. Recog - 12 INSTALLMENT SALES Installment Sales Method ¶ Sale and cost of sale recorded as usual. · Compute gross margin rate on the installment sales. ¸ Recognize gross margin as cash is received. ¹ Gross margin not realized is deferred until a future period.
Rev. Recog - 13 INSTALLMENT SALES Example Sam’s Appliances made sales of $200,000 in 20xx that qualified for the installment sales method of accounting. The items sold have a cost to Sam’s of $130,000. During 20xx, Sam’s collected cash from installment customers of $90,000. The remaining amount will be collected in 20xx. Prepare the journal entries to record the installment sales transactions during 20xx.
Rev. Recog - 23 COST RECOVERY METHOD Like the installment sales method, cost recovery is used when we are uncertain about the collectibility of the sales revenue or the ability of the seller to complete future performance. UNCERTAINTY IS GREATER! No profit is recognized until cost of item sold is fully recovered.
Rev. Recog - 24 COST RECOVERY Sam’s Appliances made sales of $200,000 in 20xx that qualified for the cost recovery method of accounting. The items sold have a cost to Sam’s of $130,000. During 20xx, Sam’s collected cash from installment customers of $90,000. The remaining amount will be collected in 20xx. Prepare the journal entries to record the installment sales transactions during 20xx.
Rev. Recog - 28 COST RECOVERY No profit is recognized in 20xx because the cost of the item sold ($130,000) has not been recovered in the form of cash receipts. Once we collect $130,000 in cash, profit recognition begins.
Rev. Recog - 29 COST RECOVERY All gross profit has been deferred until we recover the $130,000 cost of the item sold. Balance Sheet
Rev. Recog - 30 RIGHT OF RETURN In some industries it is common practice that the sales terms allow customers the right to return goods under specified conditions and over long periods of time. Book Publishing Equipment Manufacturing
Rev. Recog - 31 RIGHT OF RETURN Recognize revenue at point of sale if, ¶ Selling price is fixed or determinable. · Buyer is obligated to pay the seller and payment is not contingent upon resale of the product. ¸ Buyer is obligated even in case of theft or physical destruction. ¹ Buyer has economic substance apart from that provided by the seller. º Seller has no obligation for future performance. » Future returns can be estimated.
Rev. Recog - 32 PRODUCT-FINANCING ARRANGEMENTS An agreement in which a sponsoring company sells a product to another company and in a related transaction agrees to repurchase the product. The sponsoring company Records a liability when the proceeds are received. No sale is recorded and inventory is not adjusted. Wait for a sale to outside party.
Rev. Recog - 33 REVENUE RECOGNITION Before Delivery Accounting for long-term construction contracts Completed-Contract Method Percentage-of-Completion Method
Rev. Recog - 34 REVENUE RECOGNITION Before Delivery Percentage-of-completion method is appropriate when... ¶ Contract specifies the amount of consideration to be exchanged and the terms of settlement. · Buyer is expected to satisfy the obligation. ¸ Contractor can perform according to the terms of the contract.
Rev. Recog - 35 MEASURING PROGRESS TOWARD COMPLETION Input Measures Effort devoted to project compared to total effort expected (cost incurred to date compared to total estimated costs) Output Measures Results to date compared to total results
Rev. Recog - 36 MEASURING PROGRESS TOWARD COMPLETION Cost-to-Cost Method Total costs incurred to date Percent complete = Most recent estimate of total costs of the project
Rev. Recog - 37 MEASURING PROGRESS TOWARD COMPLETION Cost-to-Cost Method Current Period Revenue Total Revenue from Contract × Percent Complete Total Revenue to Recognize - Revenue Recognized in Prior Periods = Revenue Recognized in Current Period
Rev. Recog - 38 LONG-TERM CONTRACTS Example During 20xx, West, Inc. enters into a contract with Putnam County to build a bridge over Cane River. The project will take 3 years to complete and has a fixed price of $4,500,000. West’s engineers estimate the total cost of the bridge to be $3,000,000. At the end of 20xx, the information on the next page was gathered by West’s accountant.
Rev. Recog - 39 LONG-TERM CONTRACTS Example West uses the percentage-of-completion method to account for all long-term construction projects. Prepare the necessary 20xx journal entries for this project.
Rev. Recog - 44 LONG-TERM CONTRACTS Example If West uses the Completed-Contract method, no revenue is recognized during 19X6. All revenue and profit is recognized at the end of the contract when delivery of the bridge to Putnam County is made.
Rev. Recog - 45 REVENUE RECOGNITION Before Delivery Completion of Production Accretion Basis Discovery Basis
Rev. Recog - 47 SPECIFIC PERFORMANCE Used to account for revenue that is earned by performing a single act. Franchise revenue (SFAS No. 45) Bob’s Burgers
Rev. Recog - 48 PROPORTIONAL PERFORMANCE Used to recognize service revenue that is earned by more than a single act and when the service is rendered in more than one accounting period. ¶ Similar performance acts - equal amount for each act · Dissimilar performance acts - in proportion to direct costs of each act ¸ Similar acts with a fixed period for performance
Rev. Recog - 49 COMPLETED PERFORMANCE Used when revenue is earned by performing a series of acts, and the last act is so important that revenue is only considered earned if it is performed.
Rev. Recog - 50 COLLECTION Used to account for service revenue when the uncertainty of collection is very high. Revenue recognized when cash is received.
Rev. Recog - 51 EXPENSE RECOGNITION Expenses are outflows of assets or incurrences of liabilities during a period from delivery or producing goods or rendering services.
Rev. Recog - 52 MATCHING Once revenues are determined, the expenses incurred in generating the revenue should be recognized. As revenues are earned, certain assets are consumed and services are used.
53 expenses What is expenses? The costs associated with producing revenue. expenses What impact do expenses have on equity? Expenses Expenses represent a decrease in equity resulting from the cost of producing revenue. Examples???? Expenses
Rev. Recog - 54 EXPENSES Recognition Methods Direct Period Allocated
55 A company pays wages of $250. Before using expense accounts: Expenses Dr. Owner’s Equity$250 Cr. Cash$250 Using expense accounts: Dr. Wages Expense$250 Cr. Cash$250
Rev. Recog - 56 GAINS AND LOSSES Gains and losses result from peripheral or incidental transactions, events, or circumstances. Most gains and losses are recognized when the transaction is completed. Estimated losses are recognized before realization if they are probable and can be reasonably estimated.
TIME PERIOD ASSUMPTION The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods — generally a month, a quarter, or a year. Periods of less than one year are called interim periods. The accounting time period of one year in length is usually known as a fiscal year.
REVENUE RECOGNITION PRINCIPLE The revenue recognition principle states that revenue should be recognized in the accounting period in which it is earned. In a service business, revenue is usually considered to be earned at the time the service is performed. In a merchandising business, revenue is usually earned at the time the goods are delivered.
THE MATCHING PRINCIPLE The practice of expense recognition is referred to as the matching principle. The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues). Revenues earned this month are offset against.... expenses incurred in earning the revenue
ACCRUAL BASIS OF ACCOUNTING Adheres to the Revenue recognition principle Matching principle Revenue recorded when earned, not only when cash received. Expense recorded when services or goods are used or consumed in the generation of revenue, not only when cash paid. GAAP
Revenue recorded only when cash received. Expense recorded only when cash paid. NOT GAAP CASH BASIS OF ACCOUNTING
Adjusting entries make the revenue recognition and matching principles HAPPEN! ADJUSTING ENTRIES
TRIAL BALANCE The Trial Balance is analysed to determine the need for adjusting entries.
Adjusting entries are required each time financial statements are prepared. Adjusting entries can be classified as 1. prepayments (prepaid expenses or unearned revenues), 2. accruals (accrued revenues or accrued expenses), or 3. estimates (amortization). ADJUSTING ENTRIES
TYPES OF ADJUSTING ENTRIES Prepayments 1. Prepaid Expenses — Expenses paid in cash and recorded as assets before they are used or consumed. 2. Unearned Revenues — Revenues received in cash and recorded as liabilities before they are earned.
TYPES OF ADJUSTING ENTRIES Accruals 1. Accrued Revenues — Revenues earned but not yet received in cash or recorded. 2. Accrued Expenses — Expenses incurred but not yet paid in cash or recorded.
TYPES OF ADJUSTING ENTRIES Estimates 1. Amortization — Allocation of the cost of capital assets to expense over their useful lives.
PREPAYMENTS Prepayments are either prepaid expenses or unearned revenues. Adjusting entries for prepayments are required to record the portion of the prepayment that represents 1. the expense incurred or, 2. the revenue earned in the current accounting period.
Prepaid expenses are expenses paid in cash and recorded as assets before they are used or consumed. Prepaid expenses expire with the passage of time or through use and consumption. An asset-expense account relationship exists with prepaid expenses. PREPAID EXPENSES
Prior to adjustment, assets are overstated and expenses are understated. The adjusting entry results in a debit to an expense account and a credit to an asset account. Examples of prepaid expenses include supplies, rent, insurance, and property tax. PREPAID EXPENSES
Unearned revenues are revenues received and recorded as liabilities before they are earned. Unearned revenues are subsequently earned by performing a service or providing a good to a customer. A liability-revenue account relationship exists with unearned revenues. UNEARNED REVENUES
Prior to adjustment, liabilities are overstated and revenues are understated. The adjusting entry results in a debit to a liability account and a credit to a revenue account. Examples of unearned revenues include rent, magazine subscriptions, airplane tickets, and tuition. UNEARNED REVENUES
ACCRUALS A different type of adjusting entry is accruals. Adjusting entries for accruals are required to record revenues earned and expenses incurred in the current period. The adjusting entry for accruals will increase both a balance sheet and an income statement account.
Accrued revenues may accumulate with the passing of time or through services performed but not billed or collected. An asset-revenue account relationship exists with accrued revenues. Prior to adjustment, assets and revenues are understated. The adjusting entry requires a debit to an asset account and a credit to a revenue account. Examples of accrued revenues include accounts receivable, rent receivable, and interest receivable. ACCRUED REVENUES
Accrued expenses are expenses incurred but not yet paid. A liability-expense account relationship exists. Prior to adjustment, liabilities and expenses are understated. The adjusting entry results in a debit to an expense account and a credit to a liability account. Examples of accrued expenses include accounts payable, rent payable, salaries payable, and interest payable. ACCRUED EXPENSES
FORMULA TO CALCULATE INTEREST Face Value of Note Annual Interest Rate Time (in Terms of One Year) xx Interest $5,000 x 6% x 1/12 = $25 =
Amortization is the process of allocating the cost of certain capital assets to expense over their useful life in a rational and systematic manner. Amortization attempts to match the cost of a long-term, capital asset to the revenue it generates each period. AMORTIZATION
Amortization is an estimate rather than a factual measurement of the cost that has expired. We’re not attempting to reflect the actual change in value of an asset!
Accumulated Amortization Amortization Expense AMORTIZATION In recording amortization, Amortization Expense is debited and a contra asset account, Accumulated Amortization, is credited. The difference between the cost of the asset and its related accumulated amortization is referred to as the net book value of the asset. xxxxxx
AMORTIZATION Balance Sheet Presentation Office equipment $5,000 Less: Accumulated amortization 83 Net book value $4,917
SUMMARY OF ADJUSTING ENTRIES 1.Prepaid Assets andAssets overstated Dr. Expenses expensesexpensesExpenses understated Cr. Assets 2.UnearnedLiabilities andLiabilities overstated Dr. Liabilities revenues revenues Revenues understated Cr. Revenues 3.AccruedAssets andAssets understated Dr. Assets revenuesrevenuesRevenues understated Cr. Revenues 4.AccruedExpenses andExpenses understated Dr. Expenses expensesliabilitiesLiabilities understated Cr. Liabilities 5.AmortizationExpense andExpenses understated Dr. Amort. Exp contra assetAssets overstated Cr. Accum. Amortization 1.Prepaid Assets andAssets overstated Dr. Expenses expensesexpensesExpenses understated Cr. Assets 2.UnearnedLiabilities andLiabilities overstated Dr. Liabilities revenues revenues Revenues understated Cr. Revenues 3.AccruedAssets andAssets understated Dr. Assets revenuesrevenuesRevenues understated Cr. Revenues 4.AccruedExpenses andExpenses understated Dr. Expenses expensesliabilitiesLiabilities understated Cr. Liabilities 5.AmortizationExpense andExpenses understated Dr. Amort. Exp contra assetAssets overstated Cr. Accum. Amortization Type of AccountAccounts beforeAdjusting Adjustment RelationshipAdjustmentEntry
ADJUSTED TRIAL BALANCE An Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted. It shows the balances of all accounts at the end of the accounting period and the effects of all financial events that have occurred during the period. It proves the equality of the total debit and credit balances in the ledger after all adjustments have been made. Financial statements can be prepared directly from the adjusted trial balance.
TRIAL BALANCE AND ADJUSTED TRIAL BALANCE COMPARED
PREPARING FINANCIAL STATEMENTS Financial statements can be prepared directly from an adjusted trial balance. 1. The income statement is prepared from the revenue and expense accounts. 2. The statement of owner’s equity is derived from the owner’s capital and drawings accounts and the net income (or net loss) shown in the income statement. 3. The balance sheet is then prepared from the asset and liability accounts and the ending owner’s capital balance as reported in the statement of owner’s equity.
PREPARATION OF THE INCOME STATEMENT AND THE STATEMENT OF OWNER’S EQUITY FROM THE ADJUSTED TRIAL BALANCE
PREPARATION OF THE BALANCE SHEET FROM THE ADJUSTED TRIAL BALANCE From Statement of Owner’s Equity
1. Analyse transactions 2. Journalize the transactions 3. Post to ledger accounts 4. Prepare a trial balance 5. Journalize and post adjusting entries 6. Prepare adjusted trial balance 7. Prepare financial statements 8. Coming next chapter 9. Coming next chapter STEPS IN THE ACCOUNTING CYCLE