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ReceivablesandRevenue
Recognition
15.501/516Accounting
Spring2004
ProfessorS.Roychowdhury
SloanSchoolofManagement
MassachusettsInstituteofTechnology
Feb23and25,2004
WHYDOWECAREABOUT
REVENUERECOGNITION?
RevenuehasaBIGimpactonbottom-lineprofitability==>
managersmaybetemptedtomanagerevenue
LargeSampleEvidence:over40%ofSECenforcementactions
onaccountingissuesdealwithRevenueRecognition
SampleofheadlinesfromsearchingDowJonesNewswirefor
2004and2003:
CeridianResultsfor2000-2003torestated,Feb18
Wolf Popper files Securities Class Action against Sonus
Networks,Feb13,2004
Tripos postpones earnings release will revise revenue
recognitionpolicies,Feb12
Opsware expects 100% revenue growth, points out
transparent revenue recognition policies,Feb11
AgcoCorpfacesclassactionsuit,Feb6
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CRITERIAFORREVENUE
RECOGNITION
Underaccrualaccounting,afirmrecognizesrevenuewhen
ithas:
Performedall,orasubstantialportionof,theservicestobe
provided.
Incurredasubstantialmajorityofthecosts,andthe
remainingcostscanbereasonablyestimated.
Receivedeithercash,areceivable,orsomeotherassetfor
which
areasonablyprecisevaluecanbemeasured
collectibilityisreasonablyassured.
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RecognitionCriteria
CashBasisvsAccrualBasis
Accrual
Cash
Revenue
Expense
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CashBasisvsAccrualBasis
RecognitionCriteria
Accrual
Cash
Revenue when$recd
Expense when$paid
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CashBasisvsAccrualBasis
RecognitionCriteria
Accrual
Cash
Revenue when earned when$recd
andrealized
Expense when incurred when$paid
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EXAMPLESOFREVENUE
RECOGNITIONEVENTS
z Atthetimeofsale(Thisis,byfar,mostcommonly
encountered.)
z Titlepassestothebuyeranddeliverytakesplace
z Reasonableestimateofuncollectibles
z Reasonableestimateofsalesreturns
z Reasonableestimationofallothermaterialexpenses
representinguncertainfutureoutflows(e.g.,warranty
costs).
z Mostcommoninretail,wholesale&manufacturing
z Evenwhenrightofreturnexists?
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Bill&Hold
z Hardware
z Revenue from hardware sales or sales-type leases is recognized when the
productisshipped.
z RecentexperienceofSunbeam
..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
categorizedbillandholdsalesandneverevenleftSunbeamswarehouses.
-- fromBarrons,6/8/98
z AgcoCorp
.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
dealercanarrangeforitsowntransportationoftheequipment.
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SAB101
z Fuelledbyrecentaccountingscandals
z IssuedbySEC:SAB101tookeffectincalendaryear2000.
z In general, SEC said that the most common reasons for changes in revenue
recognitionpoliciestocomplywithSAB101were:
z Deferralofrevenueonproductsalesuntilsuchproductsaredelivered,andtitle
transferstothecustomer.
z Deferralofvariousup-front,orprepaid,feesforwhichthecompanyhadnotcompleted
aseparateearningsprocess.
z Deferralofrevenueuntilcertainnon-perfunctorysellerobligations(suchasequipment
installation)werecompleted.
z Deferralofrevenuethatiscontingentontheoccurrenceofsomefutureevent(suchas
theachievementbyalesseeofcertainminimumsalesthresholds)untilthatevent
occurs.
z DidtheSECover-reactwithSAB101?Altamuro,BeattyandWeber(2003)
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GlobalCrossingandQwest
Communications
z Traded fiber optic capacity and booked
revenues
z Say, the two companies traded capacity
worth$10,000
z GlobalCrossing:
z Revenues
z Costofnetworkingservice
z SameforQwest.
z Whydidtheydothis?
10,000
10,000
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Isthisaccountingmanipulation?
channelstuffing,pricediscounts!
z Sunbeam
...Sunbeamjammedasmanysalesasitcouldinto1997topumpboth
thetopandbottomlines....Sunbeameithersentmoregoodsthanhad
been ordered by customers or shipped goods even after an order had
beencancelled.
z RecentexperienceofBristol-Myers
z In another setback for the beleaguered drug maker, Bristol-Myers Squibb
Co.confirmedthattheSecuritiesandExchangeCommissionhasopenedan
inquiryintowhetheritimproperlyinflatedrevenuelastyearbyasmuchas$1
billion through use of sales incentives...Drug makers, like many other
manufacturers, can boost near-term sales by extending lower prices to
wholesalers,encouragingthemtoloadup.Butsuch"channel-stuffing"hurts
latersales. --fromWSJ,7/12/2002
z Recentstatusofthisinvestigation?
z Systematic evidence: Roychowdhury (2003), available on
www.ssrn.com
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EXAMPLESOFREVENUE
RECOGNITIONEVENTS(Uncommon
cases)
z Duringproduction
z Establishmentoffirmcontractprice
z Reasonableassuranceofcollection
z Reasonableestimateofcostofcompletion
z E.g.,defenseandconstructioncontracts.
z AtCompletionofProduction
z Existenceofdeterministicorstablesellingprice
z Nosubstantialcostofmarketing
z E.g.,preciousmetals,agriculturalproducts
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EXAMPLESOFREVENUE
RECOGNITIONEVENTS(Uncommon
cases)
z Atthetimeofcashcollection
z Impossibletovalueassetsreceivedwithfairdegreeof
accuracy.
z E.g.,somerealestatelanddevelopmentdeals.
z Installmentapproach
z Profitsrecognizedinproportiontocashcollected
z Costrecoveryapproach
z Noprofitrecognizeduntilallthecostshavebeen
recovered.
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IMPORTANCEOFACCOUNTS
RECEIVABLE
Receivables
Industry TotalAssets
EatingPlaces 1.6%
FamilyClothingStores(TheGAP) 3.0
RaceTrackOperations 3.1
GroceryStores 4.9
Intel 8.6
Semiconductors 11.3
AdvertisingAgencies 42.7
Trans.Freight/Cargo 43.1
ComputerSoftwareWholesale 45.5
OverallMedian 13.0%
Source:5,933industrialfirmsfrom2000GlobalVantage
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SearsRoebuck&Co.- sales
z Its Year 1: Sears makes sales of microwave ovens
for$10,000
z Saycustomerspaidfor$4,000ofthesesaleswith
cash,therestwiththeirSearscreditcards
z So
DrCash 4,000
DrAccountsreceivables 6,000
CrRevenue 10,000
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SearsRoebuck&Co.-
receivables
z When Sears makes its credit sales, it estimates from past experience
that5%ofitsaccountsreceivableswillneverberecoveredinmoney
z Whatdoesthisimply?
z Whatareitsaccountsreceivablesactuallyworth?
z Whatisthepartofthesaleitwillactuallysee?
z Oneoption:Searsrecognizesanexpenseof$300andwritesdown its
accountsreceivableto$5,700
DrBadDebtexpense 300
CrAccountsReceivable 300
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SearsRoebuck&Co.- ADA
z ProblemwhatdoesSearsnotknow?
z ItthereforerecognizesBadDebtexpenseandcreatesanAllowancefor
DoubtfulAccounts(ADA)
DrBadDebtexpense 300
CrADA 300
z OnBalanceSheet,accountsreceivablearereportednetofADA
AccountsReceivables 6,000
lessADA 0,300
NetAccountsReceivable 5,700
z ADAisacontra-assetaccount!
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IncomeStatementandBalance
SheetRelations
AccountsReceivable(A)
BegBalance=0
CreditSales=6,000
Endingbalance=6,000
Allowancefordoubtfulaccounts(XA)
BegBalance=0
AmountofBadDebtExpense=300
Endingbalance=300
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SearsRoebuck&Co.write-
offs
z Its Year 2 end of quarter 1: For simplicity, assume no credit sales
duringquarter1ofYear2
z Customershavepaidup$3,000
z DrCash 3,000
z CrAccountsreceivables 3,000
z Also,CustomerBillyJoedeclaresbankruptcy&defaultsfor$50
z Searshasnowidentifiedacustomerwhohasdefaulted:Itcanwriteoff
BillysAccountReceivable
z Oftheoriginal$300Searshadexpectedtoseeasadefault,whatisthe
amountitstillexpectstoneverrecoverinthefuture?
z Whichaccountshouldreflectthis?
z DrADA 50
z CrAccountsreceivables 50
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IncomeStatementandBalance
SheetRelations
AccountsReceivable(A)
BegBalance=6,000
Cashcollection=3,000
Write-offs=50
Endingbalance=2,950
Allowancefordoubtfulaccounts(XA)
BegBalance=300
Write-offs=50
Endingbalance=250
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IncomeStatementandBalance
SheetRelations
AccountsReceivable(A)
BegBalance
CreditSales
Cashcollected
Write-offs
Endingbalance
Allowancefordoubtfulaccounts(XA)
BegBalance
AmountofBadDebtExpense
Write-offs
Endingbalance
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IncomeStatementandBalance
SheetRelations
- Allowancefordoubtful
Accounts(XA)
BeginningBalance
+AmountsRecordedasBad
DebtExpense
- AmountsWrittenOff
=EndingBalance
AccountsReceivable(A)
BeginningBalance
+CreditSales
- CashCollected
- AmountsWrittenOff
=EndingBalance
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ALLOWANCEFORBADDEBTS
(UNCOLLECTIBLES)
Methods
DirectWrite-OffMethod
RequiredbyIRS
DisallowedunderGAAP
PercentageofSales
Aging
Howmightafirmschoiceofmethodevolveovertime?
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AGINGANALYSISOFACCOUNTS
RECEIVABLES
Cowens,alargedepartmentstorelocatedinametropolitan
area,hasbeenexperiencingdifficultyinestimatingitsbad
debts.
Thecompanyhasdecidedtoprepareanagingschedulefor
itsoutstandingaccountsreceivablesandestimatebaddebts
bythedatesofitsreceivables.
Thisanalysisdisclosesthefollowinginformation:
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AGINGANALYSISOFACCOUNTS
RECEIVABLES
Balance($) Age Estimated%
Uncollectible
198,000 <30days 0.8
114,000 30-60days 2.0
73,000 61-120days 5.0
39,000 121-240days 20.0
25,000 241-360days 35.0
20,000 Over360days 50.0
469,000
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AGINGANALYSISOFACCOUNTS
RECEIVABLES
Balance($) Age Estimated%
Uncollectible
198,000x
114,000x
73,000x
39,000x
25,000x
<30days
30-60days
61-120days
121-240days
241-360days
Over360days
0.8=
2.0=
5.0=
20.0=
35.0=
50.0=
$ 1,584
2,280
3,650
7,800
8,750
10,000 20,000x
469,000 Totalexpecteduncollectible $34,064
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AGINGANALYSISOFACCOUNTS
RECEIVABLES
1. ComputetheestimatedamountofuncollectibleAccounts
Receivable,i.e., thedesiredendingbalanceoftheADA.
2. GivenabeginningADAbalanceof$5,700,recordthe
BadDebtExpenserequiredtoachievethedesired
endingADAbalance.
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AGINGANALYSISOFACCOUNTS
RECEIVABLES
Ret.Earnings
Cash A/R(A) -ADA
BB 469,000 5,700
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AGINGANALYSISOFACCOUNTS
RECEIVABLES
Cash A/R(A) -ADA
Ret.Earnings
BB 469,000 5,700
Baddebts ?
EB 34,064
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AGINGANALYSISOFACCOUNTS
RECEIVABLES
Cash A/R(A) -ADA
Ret.Earnings
BB 469,000 5,700
Baddebts 28,364 (28,364)(exp.)
EB 34,064
5,700+Bdx=34,064
Bdx=28,364
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AGINGANALYSISOFACCOUNTS
Makecreditsales
RECEIVABLES
Cash A/R(A)
BB 469,000
Baddebts
EB
-ADA
Ret.Earnings
5,700
28,364 (28,364)(exp.)
34,064
time
FYE
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AGINGANALYSISOFACCOUNTS
Makecreditsales
Recognizerevenue
RECEIVABLES
Cash A/R(A) -ADA
Ret.Earnings
BB 469,000 5,700
Baddebts 28,364 (28,364)(exp.)
EB 34,064
Write-off (3,000) (3,000)
time
FYE
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AGINGANALYSISOFACCOUNTS
RECEIVABLES
Cash A/R(A) -ADA
Ret.Earnings
BB 5,700
Baddebts 28,364 (28,364)(exp.)
EB 34,064
Write-off (3,000) (3,000)
FYE
Makecreditsales
Recognizerevenue
CreditCustomergoes
bankrupt
time
469,000
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AGINGANALYSISOFACCOUNTS
RECEIVABLES
Cash A/R(A) -ADA
Ret.Earnings
BB 5,700
Baddebts 28,364 (28,364)(exp.)
EB 34,064
Write-off (3,000) (3,000)
FYE
Makecreditsales
Recognizerevenue
CreditCustomergoes
bankrupt
Recognizeexpense?
time
469,000
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AGINGANALYSISOFACCOUNTS
RECEIVABLES
Cash A/R(A) -ADA
Ret.Earnings
BB 5,700
Baddebts 28,364 (28,364)(exp.)
EB 34,064
Write-off (3,000) (3,000)
FYE
Makecreditsales
Recognizerevenue
CreditCustomergoes
bankrupt
Recognizeexpense
time
469,000