Revenue Recognition Notes 3

Receivables and Revenue Recognition Accounting WHY DO WE CARE ABOUT REVENUE RECOGNITION? ƒ Revenue has a BIG impact on bottom-line profitability ==> managers may be tempted to manage revenue ƒ Large Sample Evidence: over 40% of SEC enforcement actions on accounting issues deal with Revenue Recognition ƒ Sample of headlines from searching Dow Jones Newswire for 2004 and 2003: ƒ Ceridian Results for 2000-2003 to restated, Feb 18 ƒ Wolf Popper files Securities Class Action against Sonus Networks, Feb 13, 2004 ƒ Tripos postpones earnings release – will revise revenue recognition policies, Feb 12 ƒ Opsware expects 100% revenue growth, points out transparent revenue recognition policies, Feb 11 ƒ Agco Corp faces class action suit, Feb 6 CRITERIA FOR REVENUE RECOGNITION ƒ Under accrual accounting, a firm recognizes revenue when it has: ƒ Performed all, or a substantial portion of, the services to be provided. ƒ Incurred a substantial majority of the costs, and the remaining costs can be reasonably estimated. ƒ Received either cash, a receivable, or some other asset for which ƒ a reasonably precise value can be measured ƒ collectibility is reasonably assured. Cash Basis vs Accrual Basis Recognition Criteria Accrual Revenue Expense Cash Cash Basis vs Accrual Basis Recognition Criteria Accrual Cash Revenue when $ rec’d Expense when $ paid Cash Basis vs Accrual Basis Recognition Criteria Accrual Cash Revenue when earned and realized when $ rec’d Expense when incurred when $ paid EXAMPLES OF REVENUE RECOGNITION EVENTS z At the time of sale (This is, by far, most commonly encountered.) z z z z z Title passes to the buyer and delivery takes place Reasonable estimate of uncollectibles Reasonable estimate of sales returns Reasonable estimation of all other material expenses representing uncertain future outflows (e.g., warranty costs). Most common in retail, wholesale & manufacturing z Even when right of return exists? Bill & Hold z Hardware z Revenue 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.” -- from Barron’s, 6/8/98 z Agco Corp “….Farm equipment company Agco announced that the Securities and Exchange Commission has launched an informal inquiry into its 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. 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 z z z z Deferral of revenue on product sales until such products are delivered, and title transfers to the customer. Deferral of various up-front, or prepaid, fees for which the company had not completed a separate earnings process. Deferral of revenue until certain non-perfunctory seller obligations (such as equipment installation) were completed. 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. Did the SEC over-react with SAB 101? Altamuro, Beatty and Weber (2003) Global Crossing and Qwest Communications z z z Traded fiber optic capacity and booked revenues Say, the two companies traded capacity worth $10,000 Global Crossing: z z z z Revenues Cost of networking service Same for Qwest. Why did they do this? 10,000 10,000 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. … z Recent experience of Bristol-Myers z z z In another setback for the beleaguered drug maker, Bristol-Myers Squibb Co. confirmed that the Securities and Exchange Commission has opened an inquiry into 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. --from WSJ, 7/12/2002 Recent status of this investigation? Systematic evidence: www.ssrn.com Roychowdhury (2003), available on EXAMPLES OF REVENUE RECOGNITION EVENTS (Uncommon cases) z During production z z z z z Establishment of firm contract price Reasonable assurance of collection Reasonable estimate of cost of completion E.g., defense and construction contracts. At Completion of Production z z z Existence of deterministic or stable selling price No substantial cost of marketing E.g., precious metals, agricultural products EXAMPLES OF REVENUE RECOGNITION EVENTS (Uncommon cases) z At the time of cash collection z z z Installment approach z z Impossible to value assets received with fair degree of accuracy. E.g., some real estate land development deals. Profits recognized in proportion to cash collected Cost recovery approach z No profit recognized until all the costs have been recovered. IMPORTANCE OF ACCOUNTS RECEIVABLE Receivables 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: 5,933 industrial firms from 2000 Global Vantage Sears Roebuck & Co. - sales z Its Year 1: Sears makes sales of microwave ovens for $ 10,000 z Say customers paid for $4,000 of these sales with cash, the rest with their Sears credit cards z So Dr Cash Dr Accounts receivables Cr Revenue 4,000 6,000 10,000 Sears Roebuck & Co. receivables z When Sears makes its credit sales, it estimates from past experience that 5% of its accounts receivables will never be recovered in money 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: Sears recognizes an expense of $300 and writes down its accounts receivable to $ 5,700 Dr Bad Debt expense Cr Accounts Receivable 300 300 Sears Roebuck & Co. - ADA z Problem – what does Sears not know? z It therefore recognizes Bad Debt expense and creates an Allowance for Doubtful Accounts (ADA) Dr Bad Debt expense Cr ADA 300 300 z On Balance Sheet, accounts receivable are reported net of ADA Accounts Receivables 6,000 0,300 less ADA Net Accounts Receivable 5,700 z ADA is a contra-asset account! 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 Sears Roebuck & Co. – writeoffs 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 Dr Cash Cr Accounts receivables z z z z z z z z 3,000 3,000 Also, Customer Billy Joe declares bankruptcy & defaults for $50 Sears has now identified a customer who has defaulted: It can write off Billy’s Account Receivable Of the original $300 Sears had expected to see as a default, what is the amount it still expects to never recover in the future? Which account should reflect this? Dr ADA 50 Cr Accounts receivables 50 Income Statement and Balance Sheet Relations Accounts Receivable (A) Beg Balance = 6,000 Cash collection = 3,000 Write-offs = 50 Ending balance = 2,950 Allowance for doubtful accounts (XA) Beg Balance = 300 Write-offs = 50 Ending balance = 250 Income Statement and Balance Sheet Relations Accounts Receivable (A) Beg Balance Credit Sales Cash collected Write-offs Ending balance Allowance for doubtful accounts (XA) Beg Balance Amount of Bad Debt Expense Write-offs Ending balance Income Statement and Balance Sheet Relations Accounts Receivable (A) - Allowance for doubtful Accounts (XA) Beginning Balance Beginning Balance + Credit Sales + Amounts Recorded as Bad - Cash Collected - Amounts Written Off = Ending Balance Debt Expense - Amounts Written Off = Ending Balance ALLOWANCE FOR BAD DEBTS (UNCOLLECTIBLES) ƒ Methods ƒ Direct Write-Off Method ƒ Required by IRS ƒDisallowed under GAAP ƒ ƒ ƒ Percentage of Sales Aging How might a firm’s choice of method evolve over time? AGING ANALYSIS OF ACCOUNTS RECEIVABLES Cowen’s, a large department store located in a metropolitan area, has been experiencing difficulty in estimating its bad debts. The company has decided to prepare an aging schedule for its outstanding accounts receivables and estimate bad debts by the dates of its receivables. This analysis discloses the following information: AGING ANALYSIS OF ACCOUNTS RECEIVABLES Balance ($) Age Estimated % Uncollectible 198,000 < 30 days 0.8 114,000 30-60 days 2.0 73,000 61-120 days 5.0 39,000 121-240 days 20.0 25,000 241-360 days 35.0 20,000 Over 360 days 50.0 469,000 AGING ANALYSIS OF ACCOUNTS RECEIVABLES Balance ($) Age Estimated % Uncollectible 198,000 x < 30 days 0.8 = $ 1,584 114,000 x 30-60 days 2.0 = 2,280 73,000 x 61-120 days 5.0 = 3,650 39,000 x 121-240 days 20.0 = 7,800 25,000 x 241-360 days 35.0 = 8,750 20,000 x Over 360 days 50.0 = 10,000 469,000 Total expected uncollectible $ 34,064 AGING ANALYSIS OF ACCOUNTS RECEIVABLES 1. Compute the estimated amount of uncollectible Accounts Receivable, i.e., the desired ending balance of the ADA. 2. Given a beginning ADA balance of $5,700, record the Bad Debt Expense required to achieve the desired ending ADA balance. AGING ANALYSIS OF ACCOUNTS RECEIVABLES Cash BB A/R (A) 469,000 -ADA 5,700 Ret.Earnings AGING ANALYSIS OF ACCOUNTS RECEIVABLES Cash BB Bad debts EB A/R (A) 469,000 -ADA 5,700 ? 34,064 Ret.Earnings AGING ANALYSIS OF ACCOUNTS RECEIVABLES Cash BB A/R (A) 469,000 -ADA Ret.Earnings 5,700 Bad debts 28,364 EB 34,064 5,700 + Bdx =34,064 Bdx =28,364 (28,364) (exp.) AGING ANALYSIS OF ACCOUNTS RECEIVABLES Cash A/R (A) -ADA 469,000 BB Ret.Earnings 5,700 Bad debts 28,364 EB 34,064 (28,364) (exp.) Make credit sales time FYE AGING ANALYSIS OF ACCOUNTS RECEIVABLES Cash A/R (A) -ADA 469,000 BB 5,700 Bad debts 28,364 EB 34,064 Write-off (3,000) Ret.Earnings (28,364) (exp.) (3,000) Make credit sales time Recognize revenue FYE AGING ANALYSIS OF ACCOUNTS RECEIVABLES Cash A/R (A) -ADA 469,000 BB 5,700 Bad debts 28,364 EB 34,064 Write-off (3,000) Ret.Earnings (28,364) (exp.) (3,000) Credit Customer goes bankrupt Make credit sales time Recognize revenue FYE AGING ANALYSIS OF ACCOUNTS RECEIVABLES Cash A/R (A) 469,000 BB -ADA 5,700 Bad debts 28,364 EB 34,064 Write-off (3,000) Make credit sales Ret.Earnings (28,364) (exp.) (3,000) Credit Customer goes bankrupt time Recognize revenue FYE Recognize expense? AGING ANALYSIS OF ACCOUNTS RECEIVABLES Cash A/R (A) -ADA 469,000 BB 5,700 Bad debts 28,364 EB 34,064 Write-off (3,000) Ret.Earnings (28,364) (exp.) (3,000) Make credit sales FYE Credit Customer goes bankrupt time Recognize revenue Recognize expense