Chapter 6

Revenue Recognition
Preview
• Revenue Recognition Rules
• Four criteria
• Gross Sales, Returns and Discounts, and Net Sales
• Three contra-revenue accounts
• What to do when receivables are old or dying?
• Aging of receivables
• Bad debts
• What happens after receiving cash?
• Safeguarding cash
• Important ratios related to sales
• Gross profit margin, Net profit margin
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• Assets turnover, Receivables turnover
Revenue Recognition Rules

• Four criteria
• An example for the first criteria
• A simple example for all criteria
• A book exercise
• An example for why following GAAP does not guarantee truthful 3
reporting
Revenue Principle
• Revenues are recognized when:
(A) Goods have been delivered; services have been provided
(B) Persuasive evidence of customer payment arrangement
(C) Price is known or can be reasonably determined
(D) Collection is reasonably assured.

• Compare:
• During the period (Ch.3): a sale that meets all criteria: recognize
right on the spot.
• At the end of the period (Ch.4): a continuous sale that meets all
criteria: recognize at the end of the period.
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Revenue Principle: (A)
• A company sells a machine. The sales contract with the
customer includes the following:
• Machine has to be delivered. (Goods)
• Machine has to be installed on site. (Goods)
• The company has to conduct an on-site demonstration. (Service)
• A written customer acceptance has to be obtained.
• When can we recognize revenues?
• Day -5: the customer pays 1/3 of the price.
• Day 1: machine is delivered.
• Day 3: machine is installed on site.
• Day 6 to 10: a five-day demonstration was performed.
• Day 30: customer signs the acceptance form.
• Day 45: customer pays the rest 2/3 of the price. 5
Revenue Principle: (A) to (D)
• Sogo department store orders 1,000 men’s shirts from Giorgio
Armani S.p.A. today. The delivery date is next month.
• Today: (A) goods are not delivered yet. No revenues for Armani.
• Armani delivers 1,000 men’s shirts to Sogo today, but the color of
the clothes is not what Sogo wanted. Sogo is not happy and asks to
renegotiate the price.
• Today: (C) Price is not known yet. No revenues.
• Armani agrees at a lower price. But now Sogo encounters a problem
with its bank and is temporarily unable to arrange payments.
• Today: (B) customer payments are not arranged. No revenues.
• Sogo finally resolves the payment problem and is able to pay within
30 days.
• Today: (A) goods are delivered. (B) Customer payments have been
arranged. (C) Price is known. (D) Customer is likely to pay.
Armani recognizes revenues. 6
In-class Exercise: P6-1
• Case A: firm sells a coupon book. Customer prepaid. Coupons
can be used for the next 12 months.
• (A) (B) (C) (D) which is not fulfilled yet? (A)
• Recognize revenues when customer redeems coupons or when
the coupons expire.
• Case B: firm sold a product for $50K. Customer paid $250 first.
Then the firm finds that the customer has bad credit history.
• (A) (B) (C) (D) which is not fulfilled yet? (D)
• Recognize revenues when customer finally able and willing to pay.
• Case C: firm sells products and then promises to do repair for
7 years
• (A) (B) (C) (D) which is not fulfilled yet? All are fulfilled.
• Matching principle: when revenues are recorded, record 7
expenses (estimate future repair expenses) at the same time.
Play around the rule
• Buffalo buffalo Buffalo buffalo buffalo buffalo Buffalo buffalo.
• Grammatically correct! (check it up on Wikipedia if you like)
• But makes no sense!
• Channel stuffing
• Ship a lot more products to customers than they can sell, and
recognize revenues
• Create the illusion that the company’s sale is strong
• Not absolutely violating GAAP:
• (A) Goods are delivered. (B) Customer payments have been
arranged. (C) Price is known. (D) Customer is likely to pay.
• But does not fairly present the performance!
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Discounts, Returns, and
Net Sales

• Discounts: credit card

• Discounts: receive cash early
• Returns and Allowances
• Explain why record contra revenue accounts instead of reducing sales
• A book exercise
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Discounts: B2C (credit card)
• Discounts example 1: credit card sales to customers
• Not the discounts you receive in store!
• Credit card companies charge merchants a fee per transaction.
• For example, Paypal: 2.9%+$0.30 per transaction
Visa, Master, etc.: 1.5% to 3%
• So the actual money the merchant receives is 97% ~ 98.5% of the
money you pay
• Ex. A G2000 shirt was first sold for $500. There is a 20% sale now
and the shirt is $400 after discounts. You bought it and paid by
credit. G2000 recognizes $400 revenues AND $12 discounts.
• Red discounts is what we are talking about here, not green discounts
Sales Revenue $400
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Less: Credit Card Discounts ($400*3%) 12
Net Sales $388
Discounts: B2B (early receipt)
• Discounts example 2: sales to business
• If you pay in 30 days, you have to pay $10 million. But if you pay
in 5 days, you only need to pay $9 million. Would you pay earlier?
• To encourage customers to pay earlier, companies usually provide
discounts.
• Payment terms are usually like this:
2%/5 net 30:
2% discount if pay in 5 days, full payment due in 30 days.
• Ex. “Cisco offers expedited, discounted payment terms of 1%/20 net
60 to U.S. and Canadian suppliers”: if you sell a computer to Cisco for
US$1,000, it will try its best to pay you in 20 days and your revenues
will be the following:
Sales Revenue $1,000
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Less: Sales Discounts ($1000*1%) 10
Net Sales $990
Returns and Allowances
• A customer is not satisfied with the purchase and returns the
goods.
• The company gives a refund and records Sales Returns and
Allowances.

Sales Revenue $2,000

Less: Sales returns and allowances 500
Net Sales $1,500

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Why not reduce sales directly?
• If we reduce sales directly, we only see the following
information at the end:
Net Sales $****

• If we don’t reduce sales directly, we record the contra-revenue

accounts and see the following information at the end:

Sales Revenue $**** More useful

Less: Credit card discounts *** information
for managers
Sales discounts ***
Sales returns and allowances ***
Net Sales $**** 13
In-class Exercise: P6-2
(b) Sold merchandise for $11,500 (on credit).
• All criteria fulfilled? Yes.
• Revenue recognition journal entry:
Accounts Receivable 11,500
Revenue 11,500
• Sales revenue +11,500; A/R +11,500. Should also
increase
(d) Customer returned one unit (unit price is $500). inventory and
• Sales returns and allowances, contra-revenue account reduce cost of
Sales returns and allowances 500 goods sold
Accounts Receivable 500
• Sales revenue no change; returns +500; A/R -500.
(f) Customer paid in full within discount period.
• Sales discount, contra-revenue account, (11,500-500)*2%
Cash 10,780
Sales discount 220
Accounts Receivable 11,000
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• Sales revenue no change; discounts +220; A/R -11000.
In-class Exercise: P6-2
(c) Sold merchandise for $26,500 (on credit).
• All criteria fulfilled? Yes.
• Revenue recognition journal entry:
Accounts Receivable 26,500
Revenue 26,500
• Sales revenue +26,500; A/R +26,500.
(h) Customer paid in full within discount period
• Sales discount, contra-revenue account, 26500*2%
Cash 25,970
Sales discount 530
Accounts Receivable 26,500
• Sales revenue no change; discount +530; A/R -26500.
(j) Customer returned seven units (unit price is $500).
• Sales returns and allowances, contra-revenue account
Sales returns and allowances 3,500
Sales discount (!!) 70
Cash 3,430 15
• Sales revenue no change; discount -70; returns +3500.
In-class Exercise: P6-2

Sales Revenue Sales Discounts (taken) Sales Returns and

Allowances

(b) +11,500 NE NE
(c) +26,500 NE NE
(d) NE NE +500
(f) NE +220 NE
(h) NE +530 NE
(j) NE –70 +3,500

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Receivables
• Aging of A/R
• Dying of A/R
• Death of A/R Becomes Bad Debt
• A Simple Example for Bad Debt 17
• Three book exercises
Aging of Accounts Receivables
• Suppose payment term is net 30.
• January 1: sells for $100 on credit.
• January 20: sells for $200 on credit.
• February 4: sells for $300 on credit.
• February 20: sells for $400 on credit.
• What’s the age of the above sales by February 28?
January 1 59 days old 29 days past due

January 20 39 days old 9 days past due

February 4 24 days old Not yet due

February 20 8 days old Not yet due 18

Dying of Accounts Receivables
• As A/R get older…
• Less and less likely to get money back
(More and more likely dead)
• Example:
• Not due yet: 1% uncollectible

• Past due for 30 days: 10% uncollectible

• Past due for 90 days: 50% uncollectible

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Bad Debt Expense
• When we suspect that some A/R might have died, we record
(a) Bad debt expense ↑ (b) Allowance of doubtful accounts ↑

• When we are confirmed that A/R is really dead, we record

(c) Allowance of doubtful accounts ↓ (d) Accounts Receivable ↓
• Officially write-off A/R, i.e., declare that A/R is dead.

• When we find that A/R rises from the dead, don’t panic.
Reverse the death record first:
(p) Accounts Receivable ↑ (ɔ) Allowance of doubtful accounts ↑
Then record the cash receipt as usual:
Cash xxx
Accounts Receivable xxx 20
A Simple Example
• 11/3/2013: Sale for $10,000 on credit. Net 30.
• 12/1/2014: customer pays $4,000 cash.
• 12/2/2014: $6,000 A/R due; no receipt of cash.
• No action. We wait until the end of the period.
• 12/31/2013: $6,000 A/R past due. Likely dead.
• Bad Debt Expense 6000
Allowance of doubtful accounts 6000
• 3/31/2014: $6,000 A/R still there; customer went bankrupt
• Allowance of doubtful accounts 6,000
Accounts Receivable 6,000
• 11/30/2014: Customer’s parent company pays the A/R.
• Accounts Receivable 6,000
Allowance of doubtful accounts 6,000
Cash 6,000 21
Accounts Receivable 6,000
In-class Exercise: P6-5
• By 12/31/2014:
• Brown: $6,200 A/R past due for over one year.
• Strothers: $20,500 A/R past due for less than one year
$4,000 A/R not due yet
• So total Allowance for doubtful accounts by 12/31/2014:
• Brown: $6,200 A/R * 28% = $1,736
• Strothers: $20,500 * 9% = $1,845; $4,000 * 3% = $120
• $1,736+$1,845+$120 = $3,701
• We cannot kill A/R twice.
• The Allowance for doubtful account already has a balance of $900
from 2013, i.e., $900 A/R had been claimed to be likely dead in 2013.
• $3701 – $900 = $2,801 (new A/R likely dead in 2014)
• Bad Debt Expense 2,801 22
Allowance of doubtful accounts 2,801
In-class Exercise: E6-15
• Bad debt expense: increased by new likely dead A/R $14
• Allowance for doubtful accounts: 333 – 375 = -42
• Increased by new likely dead A/R $14
• Reduced by new confirmed dead A/R X
• Also may be increased by A/R rises from the dead 0
• A/R:
• Increased by new sales $69,943
• Reduced by collection of cash Y
• Also may be reduced by confirmed death X
• Also may be increased by A/R rises from the dead 0

Gross A/R: (14,987+333) – (13,014+375) = 1,931

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-42 = +14 – X + 0  X = 56 1931 = +69943 – Y – X + 0  Y = 67956
In-class Exercise: E6-18
• A/R of $550 is uncollectible:
• Allowance of doubtful accounts 550
Accounts Receivable 550
• 2% of credit sales may not be collectible:
• Bad Debt Expense 500
Allowance of doubtful accounts 500
Income statement:
Operating expenses:
Bad debt expense........................................................ $500
Balance sheet:
Current assets
Accounts receivable ($3,500 + $25,000
- $18,000 - $550) ........................................ $9,950
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Less: Allowance for doubtful accounts
($300 - $550 + $500) .................................. 250 $9,700
Cash
• Safeguarding cash (internal controls)
• Management of cash

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Internal Control of Cash
• Employee A receives checks from everyone, including
customers
• He records how much amount is received from whom.
• What if employee A also records cash collections for A/R?
• He records which customer’s which A/R is reduced.
• So if he puts customer X’s checks into his pockets, and then
records customer Y’s checks as collection for X’s A/R, and then
records customer Z’s checks as collection for Y’s A/R, …
How can you find out that he stole money?
• Aging of A/R: critical for finding out fraud.
• Appropriate separation of jobs is an important element of
internal control. 26
Management of Cash
• Cash is an unproductive resource. Why?
• If a company receives $1 million cash from customers and then
puts them in the safe lock, how much cash would the company
have after one year?
• $1 million.
• What if the company puts the cash in its savings account in a
bank?
• $1 million + $1 million * interest rate.
• What if the company uses the cash to buy more assets and
generate more sales?
• $1 million of assets + $1 million * ________________
• Careful planning of cash receipts and disbursements is critical
for lowering liquidity risk
• Chapter 3, operating cycle: pay cash earlier and receive cash later 27
means that you are always short of cash.
Important ratios related to sales
• Gross profit margin, net profit margin
• The meaning of receivables turnover
• Assets turnover, receivables turnover, and average A/R days
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Gross and Net Profit Margin
Starbucks, Corp. Apple, Inc.
For the year ended …
(in millions)
9/28/2014 9/27/2014
Net Revenues 16,447.80 182,795.00
Cost of sales 6,858.00 112,258.00
Operating expenses 6,796.40 18,034.00
Operating income 3,081.10 52,503.00
Net Income 2,068.10 39,510.00

• Gross profit margin = gross profit / net revenues

• Gross profit = Net revenues – cost of sales
• Net profit margin = net income / net revenues 29
• Compare Starbucks and Apple. What do you find?
Receivables Turnover
Net Sales A/R
• Day 1: Sales of $100 on credit……………………………… $100 $100
• Day 2: Sales of $100 on credit……………………………… $200 $200
• Day 3: Collect $100 cash……………………………………… $200 $100
• Net sales/Accounts receivable = $200/$100 = 2
• For every 2 sales on credit, one is not collected.

• Day 4: Sales of $100 on credit………………………………. $300 $200

• Net sales/Accounts receivable = $300/$200 = 1.5
• For every 1.5 sales on credit, one is not collected.
• Day 5: Collect $100 cash………………………………. $300 $100
• Net sales/Accounts receivable = $300/$100 = 3
30
• For every 3 sales on credit, one is not collected.
Assets Turnover and Receivables Turnover

(in millions) Starbucks, Corp. Apple, Inc.

9/28/2014 9/29/2013 9/27/2014 9/28/2013
Net revenues 16,448 14,867 182,795 170,910
Total Assets 10,753 11,517 231,839 207,000
Net A/R 631 561 17,460 13,102
Assets turnover 1.48 0.83
A/R turnover 28 12

• Assets turnover = Net revenues / average total assets

• For every $100 total assets, how much revenues can be earned?
• Receivables turnover = Net revenues / average AR
• Speed of collecting A/R !!
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• Average collection period = 365 / receivables turnover
Summary quiz – true or false?
1. When a real estate company sells a $1 million house to a
customer with a poor credit record, the company cannot
recognize revenues upon sale.
2. When a customer returns a $50 mug to Starbucks, Starbucks
debits revenues by $50.
3. Earlier sales on credit would result in younger A/R at the
end of the period.
4. When A/R likely become bad debt, we debit bad debt
expense and credit allowance for doubtful accounts.
5. Bad debt expense is never reduced.
6. Whenever A/R due unpaid, we write-off A/R.
7. Given two years of financial statements, we can calculate
how fast a company collects A/R. 32