Receivables and Revenue Recognition
Receivables and Revenue Recognition
Revenue Recognition
15.511 Corporate
Accounting Summer 2004
Professor SP Kothari
Sloan School of Management
Massachusetts Institute of Technology
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.
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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 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.
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Cash Basis vs Accrual Basis
Recognition Criteria
Cash
Accrual
Revenue
Expense
5
Cash Basis vs Accrual Basis
Recognition Criteria
Cash
Accrual
Revenue when $ rec’d
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Cash Basis vs Accrual Basis
Recognition Criteria
Cash
Accrual
Revenue when earned when $ rec’d
and realized
Expense when incurred when $ paid
7
Examples of revenue recognition events
(common cases)
8
Revenue manipulation:
Bill & Hold
z Hardware
zRevenue from hardware sales or sales-type leases is recognized when the
product is shipped.
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.
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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.
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Nuts & Bolts Hardware - sales
z Its Year 1: Nuts & Bolts makes sales of microwave
ovens for $ 10,000
z So
Dr Cash 4,000
Dr Accounts receivables 6,000
Cr Revenue 10,000
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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 One option: Nuts & Bolts recognizes an expense of $300 and writes
down its accounts receivable to $ 5,700
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Nuts & Bolts Hardware - ADA
z Problem – what does Nuts & Bolts not know? – Specific accounts
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Income Statement and
Balance Sheet Relations
Accounts Receivable (A)
Beg Balance = 0
Credit Sales = 6,000
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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
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Income Statement and
Balance Sheet Relations
Accounts Receivable (A)
Beg Balance = 6,000
Cash collection = 3,000
Write-offs = 50
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Income Statement and
Balance Sheet Relations
Accounts Receivable (A)
Beg Balance
Credit Sales
Cash collected
Write-offs
Ending balance
Ending balance
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Income Statement and
Balance Sheet Relations
20
ALLOWANCE FOR BAD
DEBTS (UNCOLLECTIBLES)
Methods
Direct Write-Off Method
Required by IRS
Disallowed under GAAP
Percentage of Sales
Aging