CORPORATE FINANCIAL REPORTING

MODULE 4

POWERPOINT SLIDES
 Revenue recognition and related
concepts
• The general rule is that a company recognizes
(earns) revenue when goods are transferred or
services are completed
• Note that cash is not the key issue

• However, there are complicating factors…

Issues with revenue recognition

• Multiple-element contracts (e.g., software,

hardware and services all sold for one price)
require estimates of the value of each piece

• Sales allowance issues must be estimated and

held back from total sales
• Return rates (for items that allow return)
• Incentives and discounts offered to customers

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 Multiple-element contracts
(Bundled transactions)

Sales allowance example

ABC Company has a historical return rate of 5%.
The estimated gross profit margin is 50%.What are
the December entries related to revenue and
sales allowance?

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 Revenue and sales allowance
Assets Liabilities Equity Income Statement
Cash Non-cash Liabilities Contrib. Retained Revenue Expenses
Capital Earnings
(50,000) 50,000 100,000 (50,000)
Inventory

(5,000) (5,000) (5,000)

Allowance for Est.
Returns Returns
2,500 2,500 2,500 Inv.
Inventory Adj. Adjust.
for Allowance

Deferred revenue
Deferred revenue (or unearned revenue) occurs
when a firm receives cash before providing
goods/services. It is a liability because the firms
owes their side of the contract (goods/services).

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 Deferred revenue
Firm XYZ receives 100 in cash, then provides the services to earn the revenue
the next month (at no additional cost to XYZ).

Assets Liabilities Equity Income Statement

Cash Non-cash Liabilities Contrib. Retained Revenue Expenses
Capital Earnings
100 100
Deferred
Revenue
(100) 100 100

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 Long-term contract accounting

• A contract is generally defined to be a long term

contract if it is not expected to be completed in
the year that the contract is entered into.

Long-term contract accounting

• A contract is generally defined to be a long term

contract if it is not expected to be completed in
the year that the contract is entered into.

• Completed Contract vs Percentage of

completion (i.e. cost to cost method)

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3

Example
ABC Company has a contract to build a custom test
chamber for a client at a price of $100,000. ABC
Corporation uses the percentage-of-completion
contract method and estimates that the total cost
will be approximately $80,000. ABC has promised to
complete the project in three years. At year end, the
total costs to date are $40,000. The income reported
for the first year of this project will be:
a. $(10,000)
b. $20,000
c. $10,000

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 Accounts Receivable Review
Pfizer Example
1. Pfizer sells $200K of drugs to customer on account. The
drugs cost Pfizer $70K to produce

Assets Liabilities Equity Income Statement

Cash Non-cash Liabilities Contrib. Retained Revenue Expenses
Capital Earnings
+200k A/R +130K +200k -70k
-70K Inv. COGS

Accounts Receivable Review

Pfizer Example
1. Pfizer sells $200K of drugs to customer on account. The
drugs cost Pfizer $70K to produce
2. The customer pays $125K on account to Pfizer.
Assets Liabilities Equity Income Statement
Cash Non-cash Liabilities Contrib. Retained Revenue Expenses
Capital Earnings
+200k A/R +130K +200k -70k
-70K Inv. COGS
+125K -125K A/R

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 Collectibility of accounts
receivable
COLGATE-PALMOLIVE COMPANY
Consolidated Balance Sheets
As of December 31,
(Dollars in Millions Except Share and Per Share Amounts)

2016 2015
Assets
Current Assets

Cash and cash equivalents $ 1,315 $ 970

Receivables (net of allowances of

$73 and $59, respectively) 1,411 1,427
Inventories 1,171 1,180

Other current assets 441 807

Total current assets 4,338 4,384

Collectibility of accounts
receivable
COLGATE-PALMOLIVE COMPANY
Consolidated Balance Sheets Note: Gross receivables at
As of December 31, December 31, 2016 equal
(Dollars in Millions Except Share and Per Share Amounts) $1,411 + 73 = $1,484 million.
That is, CP is legally entitled to
$1,484 million, but its balance
2016 2015 sheet only reports $1,411
Assets million of receivables.
Current Assets

Cash and cash equivalents $ 1,315 $ 970

Receivables (net of allowances of

$73 and $59, respectively) 1,411 1,427
Inventories 1,171 1,180

Other current assets 441 807

Total current assets 4,338 4,384

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 Accounts Receivable –
estimating risk
• Sellers expect that some buyers will not be able
to pay their accounts.

• Accounts receivable are reported on the balance

sheet of the seller at net realizable value.

• Frequently done on an aging basis

Allowance for Uncollectible /

Doubtful Accounts

Aging of Accounts Receivable

Estimated Estimated
Age of Accounts Receivable Percent Uncollectible
Receivable Balance Uncollectible Accounts
Current $100,000 2% $2,000
1-60 days past due 30,000 3 900
61-90 days past due 15,000 4 600
Over 90 days past due 5,000 8 400
Total $150,000 $3,900

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 Allowance for Uncollectible /
Doubtful Accounts
Suppose existing allowance account is $5,000

Accounts receivable, gross $105,000

Allowance (5,000)
Accounts receivable, net $100,000

An aging (update) indicates that the allowance

should actually be $7,900. That is accounts
receivable should be (adjusted):

Accounts receivable, gross $105,000

Allowance (7,900)
Accounts receivable, net $97,100

Adjusting Allowance account

Need to increase the allowance account by $2,900
to get to $7,900. It is a contra‐asset account
(modifies an existing asset)

This is charged as an expense (bad debt expense)

Assets Liabilities Equity Income Statement
Cash Non-cash Liabilities Contrib. Retained Revenue Expenses
Capital Earnings
-2,900 -2,900 -2,900
Allowance for Bad Debt
doubtful acct. Exp

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 Adjusting Allowance account
Suppose next year a customer owing $3,000 goes
bankrupt

This is not an expense – and the balance sheet will

not change if it reports net receivables only.
Assets Liabilities Equity Income Statement
Cash Non-cash Liabilities Contrib. Retained Revenue Expenses
Capital Earnings
No Effect on
Net A/R

Allowance for Uncollectible /

Doubtful Accounts
The allowance account will reflect this change,
but notice net receivables does not change.

Accounts receivable, gross $105,000 – 3,000 = $102,000

Allowance (7,900) + 3,000 = (4,900)

Accounts receivable, net $97,100 $97,100

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 Income Shifting?
• Be aware that companies have used the
allowance to shift income from one year into
another.
• By overestimating the bad debt expense for the
current year, expense is increased in the current
period.
• However, in future periods, when actual write-
offs are less than provisioned earlier, it can
decrease the bad debt expense of that period.

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HERE IS A CONVENIENT WAY TO REMEMBER THE ACCOUNTING FOR AN ALLOWANCE:

Remember the relation to track

the allowance for doubtful
accounts
Beginning allowance for uncollectible accounts xxx
Add: Bad debt expense +xx
Less: write-offs of accounts receivable (xx)
Equals: Ending allowance for uncollectible xxx
accounts

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 Dell footnote for allowance

Balance at Charged to Write-Offs Balance

Fiscal Beginning Bad Debt Charged to at End of
Year Description of Period Expense Allowance Period

(in millions)
2005 Allowance for doubtful
accounts $ 84 $ 31 $ 37 $ 78
2004 Allowance for doubtful
accounts $ 71 $ 48 $ 35 $ 84
2003 Allowance for doubtful
accounts $ 68 $ 39 $ 36 $ 71

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 Financial analysis ratio:

Accounts Receivable Turnover

Accounts Receivable Turnover

ୗୟ୪ୣୱ
AR Turnover ൌ
୅୴ୣ୰ୟ୥ୣ ୅ୡୡ୭୳୬୲ୱ ୖୣୡୣ୧୴ୟୠ୪ୣ ሺ୬ୣ୲ሻ

Gives you a sense of how quickly the company is

collecting its receivables

ଷ଺ହ ஽௔௬௦
Days sales outstanding ൌ
஺ோ ்௨௥௡௢௩௘௥

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 Accounts Receivable Turnover
ଷ଻,ଶ଺଺
AR Turnover ൌ ൌ 9.73
ሺଷ଻ଽଵାଷ଺଼ହሻ/ଶ

ଷ଻,ଶ଺଺
AR Turnover ൌ ൌ 9.73
ሺଷ଻ଽଵାଷ଺଼ହሻ/ଶ

ଷ଺ହ
Days Sales Outstanding ൌ ൌ 37.5 days
ଽ.଻ଷ

GM%=0.20
GM%=0.47
GM% =0.15

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 Analyzing AR turnover can help:
• Determine if a company is getting more lenient
with credit terms

• Identify deteriorating credit quality

• Predict likelihood of fraud