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Revenue

recognizing rules,
and Working
Capital

Learning Objectives
In this lecture, you will learn more specific topics within
the general framework of what was discussed
earlier:
1. Understand and apply the criteria for recognizing
revenue other than at the time of sales:

Percentage of completion method


Completed contract method
Installment sales method
Cost recovery method

2. Understand inventory components, inventory cost


flows, and the accounting for inventory in
merchandising and manufacturing firms: LIFO vs
FIFO.
3. Learn how to calculate cash conversion cycle: How
Accounting
and Financial
2 it needs in
much
cashReporting
a firm needs and how long

Review and Application of


Income Recognition Principles
Revenue recognition requirements under
U.S. GAAP:
1.The seller must have substantially
performed its obligations to the
customer.
2.The seller must have obtained an
asset from the customer that it can
reliably measure. If the asset is not
cash, the seller must be reasonably
certain of converting it into cash.
Accounting and Financial Reporting

Revenue Recognition
Rules

The
Company
receives
$100 Cash
from a
customer
Accounting and Financial Reporting

The
Company
pays $50
Cash to a
vendor.
4

Percentage-ofCompletion
Long-term construction
companies may earn revenue
as they go.
For example, a contract to
pave a road is earned as the
Expenses can be matched
against
final pavement isThe
laid.
customer
this revenue and recognized in
Company
proportion.
pays $50
The difficulty lies in measuring the
Cash to a
percentage of completing:
vendor.
Engineering estimates or
percentage of the budgeted costs
incurred
Accounting and Financial Reporting
5

Percentage-of-Completion
Example
Srinisan Group agrees to build a large
warehouse for a customer, with an
estimate of 3 years to complete. The
customer agreement with Srinisan
provides for an upfront fee of 10
million and equal payments of 30
million at the end of the first, the
second and third years of the project.
Srinisan expects to incur costs of 15
million, 25 million, and 10 million in
the first, second, and third years,
respectively. Using the percentage-ofAccounting
and Financial Reporting method, determine how
6
completion

Percentage-of-Completion Example
Based
ondegree
the contract
information,
To figure
of completion:
the
table
Costfollowing
incurred per
yearpresents
= 15/50 income
recognition
for the three-year
= 30%
30% x 100 million
period. Total Costs
Costs total revenue = 30
The Incurr Degree
million of The
Company
ed
Company
Yea
Completi Reven
(in
Expens Inco
receives
pays
$50 me
r
on
ue
million)
es
$100 Cash
Cash 15
to a 15
1
15
30%
30
from a
vendor.
2
25
50%
50
25
25
customer
3
10
20%
20
10
10
Totaand Financial Reporting
Accounting
7

Journal Entries for the Percentageof-Completion


-At the time of signing:
Cash
Advances from Customers
-End of first year:
Cash

10
10
30

Advances from Customers

30

Advances from Customers


30
Cost of Goods Sold
15
Sales Revenue
Inventory (construction in progress)
-End of second year:
Cash
30
Advances from Customers

30
15

customer

Account Receivable
10
Advances from Customers
40
Cost of Goods Sold
25
Sales Revenue
Inventory (construction in progress)
-End of third year:
Cash
30
Account Receivable
10
Advances from Customers
Advances from Customers
20
Cost of Goods Sold
10
Sales Revenue
Inventory (construction in progress)
Accounting and Financial Reporting

20

The30
Company
pays50 $50
25
Cash
to a
vendor.
20
10

Completed Contract
If the percentage of completion
cannot reasonably be estimated, then
recognition of revenues should be
delayed until the contract is
completed and accepted by the
customer.

The
An example would be a contract to
customer
develop a computer program; it either
Company
works satisfactorily or it doesnt; there
pays $50
is little meaning to a percentage of
Cash to a
completion.

In these cases, revenue is vendor.


recognized
upon completion of the contract.

Accounting and Financial Reporting

Completed Contract
(continued)
Expenses are matched; i.e., they
are recognized upon completion,
also.

So where are cash (and other


The
asset)
outflows
that
are made
customer
Company
before completion recorded?
pays $50
* Such outflows are debited to an
Cash to a
asset.
vendor.

* This asset is credited (to remove


it) and an expense is debited upon
completion.
Accounting and Financial Reporting
10

Installment Sales
Recognizes revenue as the
seller collects cash from
periodic payments.

A common example is a rent-to-own


store, in which the customer takes
possession of an asset and pays The
customer
periodic
payments like rent.
Company

pays
In these cases, revenue may
be$50
Cash
to a
recognized on a cash basis,
as the
cash is received. Matchingvendor.
of
expenses calls for recognition of a
proportional
amount of the total cost
Accounting and Financial Reporting
11

Installment Sales: An
Example
Assume a customer agrees to pay
$20,000 over the next three years in
three installments of $7,500, $8,750,
and $3,750. The retailers cost of the
item purchased is $14,000.
The
Immediately
after
the
sale,
the
customer
Companyof
customer has physical possession
pays
$50
the inventory, and the seller
has
a
At
the time with
of sale,
theuncertainty.
seller
receivable
great
Cash to a
recognizes an account receivable
vendor. and
credits inventory and defers the gross
margin on the sale until it collects
Accounting and Financial Reporting
12
cash.

Installment Sales: An Example


cont.
At the time of sale:
AR
20,000
Inventory
14,000
customer

The
Company
Deferred
Gross Margin
Deferred
gross margin,
unlike
pays $50
6,000
deferred revenue, is not aCash
liability.
to a It
is a contra asset account. vendor.
However,
many firms display it among the
current liabilities or between
Accounting and Financial Reporting
liabilities
and shareholders equity. 13

Installment Sales: An Example


cont.
At the time of the first installment
payment:
Cash
7,500
Deferred
Gross Margin
customer
COGS (plug)

The 2,250
Company
5,250
pays $50
Cash to a
vendor.

AR
7,500
Deferred gross
Revenue
margin=(7,500/20,000)*6,000=2,250
7,500
Accounting and Financial Reporting

14

Installment Sales: An Example


cont.
At the time of the second installment
payment:
Cash
8,750
Deferred
Gross Margin
customer
COGS (plug)

The 2,625
Company
6,125
pays $50
Cash to a
vendor.

AR
8,750
Deferred gross
Revenue
margin=(8,750/20,000)*6,000=2,625
8,750
Accounting and Financial Reporting

15

Installment Sales: An Example


cont.
At the time of the third installment
payment:
Cash
3,750
Deferred
Gross Margin
customer
COGS (plug)

The 1,125
Company
2,625
pays $50
Cash to a
vendor.

AR
3,750
Deferred gross
Revenue
margin=(3,750/20,000)*6,000=1,125
3,750
Accounting and Financial Reporting

16

Installment Sales: An Example


cont.
If the customer fails to make all the
promised payments, the seller can
repossess the sold item and include
that item in its inventory at its net
realizable value. The seller also need
The
to customer
write off the remain balances
in
Company
AR, Deferred Gross Margin,
and
recognize any gain or losspays
on $50
reposession.
Cash to a
vendor.
Accounting and Financial Reporting

17

Cost Recovery
This is a more conservative form
of installment sales method that
has the same revenue
recognition rule.
However, it recognizes expenses
equal to revenue until
the entire
The
cost of the asset is covered.
customer

Company
pays
Income appears to be zero until
the$50
cost is
Cash
to a
recovered and then is equal to
revenue
vendor.
until the payments are completed.
Accounting and Financial Reporting

18

Cost Recovery:
Example
In the previous example, if the seller follows the cost recovery
method, the journal entries would look like the following:
At the time of the first installment payment:
Cash
7,500
COGS
7,500 (same as the cash
received)
AR
7,500
Revenue
7,500
At the time of the second payment:
Cash
8,750
Deferred Goss Margin
2,250
COGS
6,500 (14,000-7500)
AR
8,750
Revenue
8,750
At the time of the third payment:
Cash
3,750
Deferred Gross Margin
3,750
AR
3,750
Revenue
3,750

customer

Accounting and Financial Reporting

The
Company
pays $50
Cash to a
vendor.

19

Working Capital:
Underlying Concepts & Terminology
Net working capital (Working capital or
capital ratio) is the difference between
a firms current assets and its current
liabilities.
The current ratio, also called the
working capital ratio, is current assets
divided by current liabilities.

Accounting and Financial Reporting

20

Underlying Concepts &


Terminology
Both working capital and the current
ratio provide information about liquidity
a firms ability to meet short-term
obligations as they come due.
Although most firms have positive
working capital, negative working capital
does not mean a firm cannot meet its
near-term obligations.

Accounting and Financial Reporting

21

Principal Current Asset


Accounts
Cash and cash
equivalents
Account Receivables
Prepayments (or
prepaid assets)
Inventory
Of the working capital accounts,
Inventory is the most complex.

Accounting and Financial Reporting

22

Principal Current Asset


Accounts
Inventory
Three issues are key to inventory
accounting:
1. Types of costs included in
acquiring inventory.
2. Market value changes of
inventories after acquisition.
3. Cost-flow assumptions used to
trace the movement of costs into and
out of inventory, including the effects
of per-unit inventory costs changing
Accounting and Financial Reporting
23

Inventory Terminology
Inventory
is the stock of goods a firm holds for
sale or for further processing.

Merchandise inventory
denotes goods held for sale by a retail
or wholesale business.

Raw materials inventory


is the inventory of materials stored that
are used in production.
Accounting and Financial Reporting

24

24

Inventory Terminology
(cont.)

Work-in-process
is an inventory of partially completed goods.

Finished goods inventory


denotes goods held for sale by a
manufacturing firm.

Cost of Goods Sold


denotes the transfer costs Finished Goods
Inventory account to this expense account
reducing net income and ultimately retained
earnings.
Accounting and Financial Reporting

25

25

Inventory Equation
Inventories fluctuate in size, growing
by additions and shrinking by
withdrawals. The following equations
describe the change in inventory
measured in physical units.
Beginning Inv. + Additions Withdrawals =
Ending Inv.

Goods available for Use or Sale


OR

Beginning Inv. + Additions Ending Inv. =


Withdrawals
Accounting and Financial Reporting

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Goods available for Use or Sale

26

What costs are included


in the purchase of
inventory?
Inventory should include all costs incurred
to acquire goods and prepare them for
sale.
The purchase price includes ordering
goods, receiving, inspecting, and
recording the purchase.
Recorded when title passes to the firm.
Merchandise purchase adjustments
such as transportation and special handling,
cash discounts, returns, and other
adjustments are part of costs included in
inventory.
Accounting and Financial Reporting

27

27

What costs are included in the


manufacturing inventory?
A manufacturing firm
incurs three types of
costs to convert raw
materials into finished
goods.

Accounting and Financial Reporting

28

Diagram of Cost Flows

(Figure

8.1)

Accounting and Financial Reporting

29

29

Cost-Flow Assumptions
Neither U.S. GAAP nor IFRS requires firms to use
specific identification; both allow firms to select a
cost-flow assumption. That cost-flow
assumption need not match the actual physical
flow of units within the firm. Typical cost-flow
assumptions are as follows:

Accounting and Financial Reporting

30

30

Appendix 8.1: LIFOs


Effects on the Financial
Statements

LIFO usually presents a cost of goods sold


figure that reflects current costs.
In periods of rising prices, it also generally
results in reporting lower taxable income
and incurring lower income tax payments.
LIFO usually leads to a balance sheet amount
for inventory that is far below the current cost
of that inventory.
SEC registrants using LIFO must disclose LIFO
reserve, or the excess of FIFO or current

cost over LIFO cost of inventories.


Accounting and Financial Reporting

31

31

Appendix 8.1: LIFOs Effects On the


Financial Statements

U.S. firm using LIFO must consider


issues of dipping into old LIFO layers of
inventory, also called LIFO liquidation.
Reducing end-of-period physical
The
inventory quantities below The
beginning-ofCompany
period quantities causes cost
of goods
Company
receives
sold to reflect the current periods
pays $50
$100
Cashplus a portion ofCash
purchases
the older
to a
from
a lower costs) in thevendor.
(usually
beginning
customer
inventorythe results are larger
reported income and larger income
Accounting and Financial Reporting
32
taxes.

Inventory Costs Using FIFO


and LIFO
Now lets look at the following data
regarding the inventory purchases
of Carlisle Toys for the years ended
December 31, 2009, 2010, and
2011.

In this problem we will:

Determine Carlisles costs of goods sold and


ending inventory value for each year using
FIFO and LIFO.

Accounting and Financial Reporting

33

Inventory Costs Using FIFO


and LIFO
Below are the inventory purchases of Carlisle
Toys for the years ended December 31, 2009,
2010, and 2011.

2009
Begin year: 0
units
1/1: Buy 1 unit
@$5
2/1: Buy 1 unit
@$8
4/1: Buy 1 unit
@$13

6/1: Buy 1 unit at

Accounting and Financial Reporting

2010

2011

4/1: Buy 2
units @$12
each

34

Inventory Costs Using


FIFO

Below are the inventory purchases of Carlisle


Toys for the years ended December 31, 2009,
2010, and 2011.

2009
Begin year: 0
units
1/1: Buy 1 unit
@$5
2/1: Buy 1 unit
@$8
4/1: Buy 1 unit
@$13

6/1: Buy 1 unit at

Accounting and Financial Reporting

2009 FIFO
2010
2011
Cost of Goods = $5 + 8 =
$13

Sold
(These were the
first
two units purchased

and are therefore


considered to be the

sold
first two units
4/1:
Buy 2
on 12/1/09.)
units @$12
each

35

Inventory Costs Using


FIFO

Below are the inventory purchases of Carlisle


Toys for the years ended December 31, 2009,
2010, and 2011.

2009
Begin year: 0
units
1/1: Buy 1 unit
@$5
2/1: Buy 1 unit
@$8
4/1: Buy 1 unit
@$13

6/1: Buy 1 unit at

Accounting and Financial Reporting

2009 FIFO
2010
2011
Ending Inventory = $13 +
14 = $27

(The last two units


purchased
are
considered to
be remaining
in the FIFO inventory on
12/31/09.)
4/1: Buy 2
units @$12
each

36

Inventory Costs Using


FIFO
LIKEWISE:

Using the sameEnding


logic,2010
we complete our FIFO
Ending
calculations
forInventory
2010 and 2011.
Becomes 2011
Begin. Inventory

Cost of Goods
NOTIC
E:
FIFO
Sold
Ending
2010
13+14=27
2009
Invento
2011
12+12=24
2009
2010
ry
Begin
year: 0 units (1 x $13) + (1 x $14)
Become
1/1:
Buy 1 unit
s 2010
@$5

Begin.
2/1:
Inv. Buy 1 unit
@$8

4/1: Buy 1 unit


4/1: Buy 2 units @$12
@$13
each
Accounting
and1Financial
Reporting
6/1:
Buy
unit at

Ending
Inventory
12+12=24
0
2011
(2 x $12)

37

Inventory Costs Using


LIFO

Now, lets calculate Cost of


Goods Sold and Ending Inventory
under
LIFO.
2009
2010
2011

Begin year: 0
units
1/1: Buy 1 unit
@$5
2/1: Buy 1 unit
@$8
4/1: Buy 1 unit
@$13
6/1: Buy 1 unit at

Accounting and Financial Reporting

4/1: Buy 2
units @$12
each

38

Inventory Costs Using


LIFO

Below are the inventory purchases of Carlisle


Toys for the years ended December 31, 2009,
2010, and 2011.

2009
Begin year: 0
units
1/1: Buy 1 unit
@$5
2/1: Buy 1 unit
@$8
4/1: Buy 1 unit
@$13

6/1: Buy 1 unit at

Accounting and Financial Reporting

2009 LIFO
2010
2011
Cost of Goods = $13 + 14
= $27

Sold
(These were the
last
two units purchased

and are therefore


considered to be the

sold
first two units
4/1:
Buy 2
on 12/1/09.)
units @$12
each

39

Inventory Costs Using


LIFO

Below are the inventory purchases of Carlisle


Toys for the years ended December 31, 2009,
2010, and 2011.

2009
Begin year: 0
units
1/1: Buy 1 unit
@$5
2/1: Buy 1 unit
@$8
4/1: Buy 1 unit
@$13

6/1: Buy 1 unit at

Accounting and Financial Reporting

2009 LIFO
2010
2011
Ending Inventory = $5 + 8
= $13

(The first two units


purchased
are
considered to
be remaining
in the LIFO inventory on
12/31/09.)
4/1: Buy 2
units @$12
each

40

Inventory Costs Using


LIFO
LIKEWISE:

Using the sameEnding


logic,2010
we complete our LIFO
Ending
calculations
forInventory
2010 and 2011.
Becomes 2011
Begin. Inventory

NOTICE
Cost of Goods
: Ending
2009
LIFO
Sold
Inventor 2010
12+12=24
y
2011
5+82010
= 13
Become
2009
s 2010
Begin.year: 0 units (1 x $5) + (1 x $8)
Begin
Inv. Buy 1 unit
1/1:

Ending
Inventory
5+8 = 13
0
2011
(1 x $5) + (1 x
$8)

@$5

2/1: Buy 1 unit


@$8

4/1: Buy 1 unit


4/1: Buy 2 units @$12
Accounting and Financial Reporting
@$13
each
41

Working Capital
Net Working Capital - Current assets
minus current liabilities. Often called
working capital.
Cash Conversion Cycle - Period
between firms payment for materials
and collection on its sales.
Carrying Costs - Costs of maintaining
current assets, including opportunity
cost of capital.
Shortage Costs - Costs incurred from
shortages in current assets.
Accounting and Financial Reporting

42

Working Capital
Simple Cycle of operations
Cash

Raw materials
inventory

Receivables

Finished goods
inventory
Accounting and Financial Reporting

43

Working Capital
Cash conversion cycle

Accounting and Financial Reporting

44

Working Capital
inventory
Inventory period =
annual COGS/365
accounts receivable
Accounts receivable s period =
annual sales/365
accounts payable
Accounts payable period =
annual COGS/365

Accounting and Financial Reporting

45

Working Capital
Example - Cash Conversion Cycle
Given the aggregate balance sheet
and income statement for US
Manufacturing firms, calculate the
cash conversion cycle.
Income

Sales
COGS

Statement
2007
5,887
5,305

Accounting and Financial Reporting

Balance

Sheet

Inventory
A/R

2007
613
703

A/P

471
46

Working Capital
Example - Cash Conversion Cycle
Given the aggregate balance sheet and
income statement for US Manufacturing
firms, calculate the cash conversion cycle.

inventory
Inventory period =
annual COGS/365
613
=
5,305/365
42.2 days
Accounting and Financial Reporting

47

Working Capital
Example - Cash Conversion Cycle
Given the aggregate balance sheet and
income statement for US Manufacturing
firms, calculate the cash conversion cycle.

accounts receivable
Receivables period =
annual sales/365
703
=
5,887/365
= 43.6 days
Accounting and Financial Reporting

48

Working Capital
Example - Cash Conversion Cycle
Given the aggregate balance sheet and
income statement for US Manufacturing
firms, calculate the cash conversion cycle.

accounts payable
Payable period =
annual COGS/365
471
=
5,305 / 365
= 32.4 days
Accounting and Financial Reporting

49

Working Capital
Example - Cash Conversion Cycle
Given the aggregate balance sheet and
income statement for US Manufacturing
firms, calculate the cash conversion
Inventory period 42.2 days
cycle.

Receivable s period = 43.6 days

Payable period = 32.4 days


Cash conversion cycle = (42.2+43.6) 32.4 = 53.4

Accounting and Financial Reporting

50