Receivables and Revenue Recognition

Receivables and
Revenue Recognition
15.511 Corporate
Accounting Summer 2004
Professor SP Kothari
Sloan School of Management
Massachusetts Institute of Technology
June 21, 2004

1
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 actions

on accounting issues deal with Revenue Recognition
2
Criteria for revenue recognition
Under accrual accounting, a firm recognizes revenue
when it has:
Delivered goods and the title is transferred to the
buyer
Performed all, or a substantial portion of, the services
to be provided.
Incurred a substantial majority of the costs, and the
remaining costs can be reasonably estimated.
Received either cash, a receivable, or some other
asset for which
a reasonably precise value can be assigned collectibility is reasonably assured.

3
Guidance on revenue recognition in SAB 101 (Details
to those interested on the next slide)
Some Details of SAB 101
z Fuelled by recent accounting scandals
z Issued by SEC: SAB 101 took effect in calendar year 2000.
z In general, SEC said that the most common reasons for changes in revenue
recognition policies to comply with SAB 101 were:
z Deferral of revenue on product sales until such products are delivered, and title
transfers to the customer.
z Deferral of various up-front, or prepaid, fees for which the company had not completed
a separate earnings process.
z Deferral of revenue until certain non-perfunctory seller obligations (such as equipment
installation) were completed.
z Deferral of revenue that is contingent on the occurrence of some future event (such
as the achievement by a lessee of certain minimum sales thresholds) until that event
occurs.
z Did the SEC over-react with SAB 101? Altamuro, Jennifer, Anne Beatty, and
Joseph Weber. “Motives for Early Revenue Recognition: Evidence from SEC
Staff Accounting Bulletin (SAB) 101.” 1 August 2002.
4
Cash Basis vs Accrual Basis
Recognition Criteria
Cash
Accrual
Revenue
Expense
5
Cash
Accrual
Revenue when $ rec’d
Expense when $ paid
6
Cash
Accrual
Revenue when earned when $ rec’d
and realized
Expense when incurred when $ paid
7
Examples of revenue recognition events
(common cases)
z At the time of sale

z Title passes to the buyer and delivery takes place
z Reasonable estimate of uncollectibles
z Reasonable estimate of sales returns
z Reasonable estimation of all other material expenses
representing uncertain future outflows (e.g., warranty
costs).
z Most common in retail, wholesale & manufacturing
z Even when right of return exists?
8
Revenue manipulation:
Bill & Hold
z Hardware
zRevenue from hardware sales or sales-type leases is recognized when the
product is shipped.
z Recent experience of Sunbeam

“…. In the fourth quarter of last year Sunbeam recorded $50 million in sales of
cooking grills under an ‘early buy’ program … some $35 million were categorized
‘bill and hold’ sales and never even left Sunbeam’s warehouses.”
- Laing, Jonathan R. “Dangerous Games: Did “Chainsaw Al” Dunlap Maunfacture Sunbeam’s Earnings Last
Year?” Barron’s, 8 June 1998, 17.
z Agco Corp – SEC investigating their accounting practices

“Agco stated that in some instances it recognizes revenue when equipment
remains on its premises after having been invoiced to the dealer. These
transactions occur at a dealer's request, added Agco, usually so the dealer can
arrange for its own transportation of the equipment.”
- Taub, Stephen. “SEC Digs Into Agco’s Accounting.” CFO.com, 6 February 2004,
http://www.cfo.com/article/1,5309,12099%7C%7CT%7C121,00.html?f=TodayInFinance_Inside (accessed July 9,
2004).
9
Is this accounting manipulation? –
channel stuffing & price discounts
z Sunbeam
“... Sunbeam jammed as many sales as it could into 1997 to pump both the
top and bottom lines. ... Sunbeam either sent more goods than had been
ordered by customers or shipped goods even after an order had been
cancelled. …”
- Laing, Jonathan R. “Dangerous Games: Did “Chainsaw Al” Dunlap Maunfacture
Sunbeam’s Earnings Last Year?” Barron’s, 8 June 1998, 17.
z Recent experience of Bristol-Myers Squibb Co.

z SEC investigating “whether it improperly inflated revenue last year by as
much as $1 billion through use of sales incentives...Drug makers, like
many other manufacturers, can boost near-term sales by extending lower
prices to wholesalers, encouraging them to load up. But such "channel-
stuffing" hurts later sales.”
- Harris, Gardiner. “Bristol-Myers Faces Inquiry By SEC Into Revenue Problem.” The
Wall Street Journal, 12 July 2002, B6.
z Systematic evidence: Roychowdhury, Sugata. "Management of Earnings through

the Manipulation of Real Activities that Affect Cash Flow from Operations.” MIT Sloan School of
Management working paper, 25 November 2003.
10
http://ssrn.com/abstract=477941 (last accessed July 9, 2004)

Examples of revenue recognition
events (Uncommon cases)
z During production
z Establishment of firm contract price
z Reasonable assurance of collection
z Reasonable estimate of cost of completion
z E.g., defense and construction contracts.
z At Completion of Production
z Existence of deterministic or stable selling price
z No substantial cost of marketing
z E.g., precious metals, agricultural products
11
Examples of revenue recognition
events (Uncommon cases)
z At the time of cash collection
z Impossible to value assets received with fair degree of
accuracy.
z E.g., some real estate land development deals.
z Installment approach
z Profits recognized in proportion to cash collected
z Cost recovery approach
z No profit recognized until all the costs have been
recovered.
12
Nuts & Bolts Hardware - sales
z Its Year 1: Nuts & Bolts makes sales of microwave
ovens for $ 10,000
z Say customers paid $4,000 for these purchases with

cash, the rest with their Nuts & Bolts credit cards
z So
Dr Cash 4,000
Dr Accounts receivables 6,000
Cr Revenue 10,000
13
Nuts & Bolts Hardware -
receivables
z When Nuts & Bolts makes its credit sales, it estimates from past
experience that 5% of its accounts receivables will never be collected
z What does this imply?
z What are its accounts receivables actually worth?
z What is the part of the sale it will actually see?
z One option: Nuts & Bolts recognizes an expense of $300 and writes
down its accounts receivable to $ 5,700
Dr Bad Debt expense 300

Cr Accounts Receivable 300
14
Nuts & Bolts Hardware - ADA
z Problem – what does Nuts & Bolts not know? – Specific accounts
z It therefore recognizes Bad Debt expense and creates an Allowance

for Doubtful Accounts (ADA)
Dr Bad Debt expense 300

Cr ADA 300
z On Balance Sheet, accounts receivable are reported net of ADA

Accounts Receivables 6,000
less ADA 0,300
Net Accounts Receivable 5,700
z ADA is a contra-asset account!
15
Income Statement and
Balance Sheet Relations
Accounts Receivable (A)
Beg Balance = 0
Credit Sales = 6,000
Ending balance = 6,000
Allowance for doubtful accounts (XA)

Beg Balance = 0
Amount of Bad Debt Expense = 300
Ending balance = 300
16
Nuts & Bolts Hardware
– write-offs
z Its Year 2 end of quarter 1: For simplicity, assume no credit sales
during quarter 1 of Year 2
z Customers have paid up $ 3,000

z Dr Cash 3,000
z Cr Accounts receivables 3,000
z Also, Customer Smith declares bankruptcy & defaults for $50

z Nuts & Bolts has now identified a customer who has defaulted: It can
write off Smith’s Account Receivable
z Of the original $300 Nuts & Bolts had expected to see as a default,
what is the amount it still expects to never recover in the future?
z Which account
? should reflect this?
z Dr ADA 50
z Cr Accounts receivables 50
17
Beg Balance = 6,000
Cash collection = 3,000
Write-offs = 50
Ending balance = 2,950

Beg Balance = 300
Write-offs = 50
Ending balance = 250
18
Beg Balance
Credit Sales
Cash collected
Write-offs
Ending balance

Beg Balance
Amount of Bad Debt Expense
Write-offs
Ending balance
19
Accounts Receivable (A) - Allowance for doubtful

Accounts (XA)
Beginning Balance Beginning Balance

+ Credit Sales + Amounts Recorded as Bad
- Cash Collected Debt Expense
- Amounts Written Off - Amounts Written Off
= Ending Balance = Ending Balance
20
ALLOWANCE FOR BAD
DEBTS (UNCOLLECTIBLES)
Methods
Direct Write-Off Method
Required by IRS
Disallowed under GAAP
Percentage of Sales
Aging
How might a firm’s choice of method evolve over time?

21

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Receivables and

June 21, 2004

 Large Sample Evidence: over 40% of SEC enforcement actions

z Issued by SEC: SAB 101 took effect in calendar year 2000.

Expense when $ paid

z At the time of sale

z Recent experience of Sunbeam

z Agco Corp – SEC investigating their accounting practices

z Recent experience of Bristol-Myers Squibb Co.

z Systematic evidence: Roychowdhury, Sugata. "Management of Earnings through

http://ssrn.com/abstract=477941 (last accessed July 9, 2004)

z Say customers paid $4,000 for these purchases with

z What does this imply?

z What are its accounts receivables actually worth?

z What is the part of the sale it will actually see?

Dr Bad Debt expense 300

z It therefore recognizes Bad Debt expense and creates an Allowance

Dr Bad Debt expense 300

z On Balance Sheet, accounts receivable are reported net of ADA

z ADA is a contra-asset account!

Ending balance = 6,000

Allowance for doubtful accounts (XA)

Ending balance = 300

z Customers have paid up $ 3,000

z Also, Customer Smith declares bankruptcy & defaults for $50

Ending balance = 2,950

Allowance for doubtful accounts (XA)

Ending balance = 250

Allowance for doubtful accounts (XA)

Accounts Receivable (A) - Allowance for doubtful

Beginning Balance Beginning Balance

 How might a firm’s choice of method evolve over time?

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Large Sample Evidence: over 40% of SEC enforcement actions

How might a firm’s choice of method evolve over time?