CHAPTER 6:

1. CHAPTER 6: Revenue and Expense Recognition © 2007 by Nelson, a division of Thomson Canada Limited.

2. CHAPTER 6Revenue and Expense Recognition Main topics in Chapter 6: • Conceptual foundation of accrual accounting; • Accounting policy choice, including the fiscal period; • Revenue recognition criteria and methods; • Related expense recognition and matching; • Prepaid and accrued expenses. © 2007 by Nelson, a division of Thomson Canada Limited.

3. Book’s Coverage of Financial Accounting Standards Principles Ch. 5, 6, 7, 8, 9 Plugged Into the Economic Events of the World Methods Ch. 1, 2, 3, 4, 6, 7, 8, 9 Accounting System Ch 1, 2, 3, 7 Ch. 1,2,3,4,5,10 Ch. 1, 4, 10 Management Cash Flow Ch. 7 Ch. 1, 3, 6, 8, 9 Internal Control Ch. 2, 3, 4, 5, 10 Ch. 2, 6, 8, 9 Income Ch. 2, 3, 4, 5, 8, 9, 10 Financial Analysis Financial Position Disclosure

4. Event #1 Event #2 Event #3 Event #4 Event #5 Event #6 Income Measurement Events, projects and sales occur all the time © 2007 by Nelson, a division of Thomson Canada Limited.

5. Period 1 Period 2 Event #1 Event #2 Event #3 Event #4 Event #5 Event #6 Income Measurement Period 3 Some events cross periods thus how can we properly account for the revenues and expenses at over any period? © 2007 by Nelson, a division of Thomson Canada Limited.

6. Conceptual Foundation of Accrual Accounting • Accrual accounting is based on the idea that events, estimates, and judgments important to the measurement of financial performance and position should be recognized by entries, whether or not cash has been received or paid out. • The result affects income, through the revenue and expense figures, and also affects the balance sheet, through accounts like accounts receivable and accounts payable. • Bottom Line: the income statement and balance sheet articulate through accrual accounting. © 2007 by Nelson, a division of Thomson Canada Limited.

7. Conceptual Foundation of Accrual Accounting • Revenues are inflows of economic resources from customers. • Expenses are outflows of economic resources to employees, suppliers, tax authorities, and others (incurred to generate revenue). • Net income is the difference between revenues and expenses over a period of time. • Matching is the logic of income measurement, ensuring that revenues and expenses are measured comparably. • Timing of the recognition of revenues and expenses is the heart of accrual accounting’s measurement of income. © 2007 by Nelson, a division of Thomson Canada Limited.

8. Accrual Accounting – Recognizing Cash Revenue and Expenses • In a transaction directly involving cash, there is an obvious exchange where cash is debited or credited directly. • Example: Cash sales or expenses paid for with cash Journal Entry: Expenses: DR Expense CR Cash Revenues: DR Cash CR Revenue • These transactions rely on a cash basis © 2007 by Nelson, a division of Thomson Canada Limited.

9. EXPENSE REVENUE 1) Recognition 2) Cash Transactions Accrual Accounting – Recognizing Cash Revenue and Expenses • Often, cash is not directly exchanged when a product or service is sold or an expense is incurred. • For example, when you use a credit card, there is no direct cash exchange until a later time – this is accrual revenue or expense recognition • Stretch the time out so that revenues and expenses are recognized beforecash transactions DR A/R CR Revenue DR Expense CR A/P DR Cash CR A/R DR A/P CR Cash © 2007 by Nelson, a division of Thomson Canada Limited.

10. EXPENSE REVENUE 1) Cash Transactions 2) Recognition Accrual Accounting – Recognizing Accrual Revenue and Expenses • Sometimes, the opposite occurs, and the revenue is received in cash before it should be recognized • For example, a deposit on a contract is not truly revenue for the company until the project is complete • Stretch the time out so that revenues and expenses are recognized aftercash transactions DR Cash CR Def. Rev DR Prepaid exp. (Asset) CR A/P DR Deferred Rev. CR Revenue DR Expenses CR Prepaid Exp. © 2007 by Nelson, a division of Thomson Canada Limited.

11. Current accounting period Next accounting period A/R A/R Revenue Revenue Cash Cash Revenue and Expense Recognition Scenarios • Revenue recognition prior to cash collection Revenue recognized DR Accounts receivable CR Revenue Cash collected DR Cash CR Accounts receivable © 2007 by Nelson, a division of Thomson Canada Limited.

12. Recognition Prior to Cash Flow – J/E Example Revenue Company XYZ made a sale on credit DR Accounts receivable 2,464 CR Revenue 2,464 Cash The customer pays off what is owing DR Cash 2,464 CR Accounts receivable 2,464 © 2007 by Nelson, a division of Thomson Canada Limited.

13. Past accounting period Current accounting period Revenue Revenue Cash Cash Revenue and Expense Recognition Scenarios B. Revenue recognition after cash collection Cash collected DR Cash CR Deferred revenue / deposits liability • Revenue recognized • DR Deferred revenue / • deposits liability • CR Revenue Deferred Revenue Deferred Revenue © 2007 by Nelson, a division of Thomson Canada Limited.

14. Recognition After Cash Flow – J/E Example Cash A customer placed a deposit on a widget. DR Cash 25,000 CR Deferred revenue liab. 25,000 Revenue The customer purchases the widget. DR Deferred revenue liab. 25,000 CR Revenue 25,000 © 2007 by Nelson, a division of Thomson Canada Limited.

15. Current accounting period Next accounting period A/P A/P Expense Expense Cash Cash Revenue and Expense Recognition Scenarios C. Expense recognition prior to cash payment Expense recognized DR Expense CR Accounts Payable or other liability Cash paid DR Accounts payable or other liability CR Cash © 2007 by Nelson, a division of Thomson Canada Limited.

16. Recognition Prior to Cash Flow – J/E Example Expense XYZ had maintenance done on a machine DR Maintenance expense 85,000 CR Accounts payable 85,000 Cash XYZ paid for the maintenance DR Accounts payable 85,000 CR Cash 85,000 © 2007 by Nelson, a division of Thomson Canada Limited.

17. Past accounting period Current accounting period Asset Expense Expense Cash Cash Revenue and Expense Recognition Scenarios D. Expense recognition after cash payment Cash paid DR Asset(inventory, equipment , etc.) CR Cash • Expense recognized • DR Expense (COGS, • amortization, etc.) • CR Asset(inventory, equipment , etc.) Asset © 2007 by Nelson, a division of Thomson Canada Limited.

18. Recognition After Cash Flow – J/E Example Cash XYZ bought a new piece of equipment DR Property & Equipment 158,000 CR Cash 158,000 Expense XYZ amortizes the equipment over 10 years (expense is 15,800 in each year) DR Amortization expense 158,000 CR Accumulated amortization 158,000 © 2007 by Nelson, a division of Thomson Canada Limited.

19. Straight Cash Revenues and Expenses Cash revenue A customer made a minor purchase DR Cash 9,000 CR Revenue 9,000 Cash expense XYZ made a donation to charity DR Donation expense 10,000 CR Cash 10,000 © 2007 by Nelson, a division of Thomson Canada Limited.

20. Basic Event Format for Oil Sands Inc. Example: Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: © 2007 by Nelson, a division of Thomson Canada Limited.

21. 1. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Sell crude oil for $40,000 cash. Revenue Cash Operating Revenues © 2007 by Nelson, a division of Thomson Canada Limited.

22. 2. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Buy inventory for $24,000 on credit. No Inventories Accounts Payable © 2007 by Nelson, a division of Thomson Canada Limited.

23. 3. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Sell sulphur for $10,000 on credit. Revenue Accounts Receivable Operating Revenues © 2007 by Nelson, a division of Thomson Canada Limited.

24. 4. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Goods sold cost $5,200. Expense COGS of Crude Oil and Products Inventories © 2007 by Nelson, a division of Thomson Canada Limited.

25. 5. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Buy truck for $250,000 on credit. No Capital Assets Accounts payable © 2007 by Nelson, a division of Thomson Canada Limited.

26. 6. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Pay $100,000 on truck. No Accounts payable Cash © 2007 by Nelson, a division of Thomson Canada Limited.

27. 7. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Use $20,000 of truck value. Expense Amortization Expense Accumulated Amortization (balance sheet) © 2007 by Nelson, a division of Thomson Canada Limited.

28. 8. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Pay for the inventory in 2. No Accounts Payable Cash © 2007 by Nelson, a division of Thomson Canada Limited.

29. 9. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Collect for the sulphur sold in 3. No Cash Accounts Receivable © 2007 by Nelson, a division of Thomson Canada Limited.

30. 10. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Buy 3 years’ insurance for $60,000. No Prepaid Expenses Cash © 2007 by Nelson, a division of Thomson Canada Limited.

31. 11. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Use one year’s insurance. Expense Operating Expenses Prepaid Expenses © 2007 by Nelson, a division of Thomson Canada Limited.

32. 12. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Donate $4,000 cash to charity. Expense Operating Expenses Cash © 2007 by Nelson, a division of Thomson Canada Limited.

33. 13. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Receive customer deposit of $8,000. No Cash Customer deposits liability © 2007 by Nelson, a division of Thomson Canada Limited.

34. 14. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Deliver $8,000 goods to customer. Revenue Customer deposits liability Operating Revenues © 2007 by Nelson, a division of Thomson Canada Limited.

35. 15. Event: Revenue or Expense? Before Cash Same Time After Cash Entry: DR: CR: Auditor sends a bill for $5,000. Expense Operating Expenses Accounts Payable © 2007 by Nelson, a division of Thomson Canada Limited.

36. Accrual Connections: • Revenue recognition #3 (Sell sulphur for $10,000 on credit) anticipates collection #9 (Collect for the sulphur sold in 3). • Expense recognition #4 (Goods sold cost $5,200) follows acquisition #2 (Buy inventory for $24,000 on credit). • Expense recognition #7 (Use $20,000 of truck value) follows acquisition #5 (Buy truck for $250,000 on credit). © 2007 by Nelson, a division of Thomson Canada Limited.

37. Accrual Connections: • Expense recognition #11 (Use one year’s insurance) follows acquisition #10 (Buy 3 years’ insurance for $60,000). • Revenue recognition #14 (Deliver $8,000 goods to customer) follows collection #13 (Receive customer deposit of $8,000). • Expense recognition #15 (Auditor sends a bill for $5,000) anticipates a later payment. © 2007 by Nelson, a division of Thomson Canada Limited.

38. Balance Sheet Income Statement Revenue Liabilities Assets Expenses Equity Net Income What Accrual Accounting Adjustments Do • Accrual adjustments affect both balance sheet (assets and liabilities) and income statement (revenues and expenses) • There are four kinds of accrual accounting connections: © 2007 by Nelson, a division of Thomson Canada Limited.

39. 1)Assets and Revenues, 2)Assets and Expenses, 3)Liabilities and Revenues, and 4)Liabilities and Expenses. Balance Sheet Income Statement Revenue Liabilities Assets Expenses Equity Net Income

40. Articulation The resulting net income goes into equity (retained earnings), completing the articulation of the statements. Balance Sheet Income Statement Revenue Liabilities Assets Expenses Equity Net Income © 2007 by Nelson, a division of Thomson Canada Limited.

41. Accounting Policies What are they? • Decisions made in advance about how to account for a type of event, transaction, or accrual • Top-management’s judgment about appropriate accounting © 2007 by Nelson, a division of Thomson Canada Limited.

42. Accounting Policies What is their purpose? • Companies differ, so not all rules affect everyone • There can’t be an accounting rule for everything that could happen • A choice may be informative itself (a “signal”) • By its nature, accrual accounting requires choices about fairness and timing, especially for revenues and expenses. © 2007 by Nelson, a division of Thomson Canada Limited.

43. General Criteria for Accounting Policy Choices • Fairness- (objectivity, lack of bias, correspondence with economic substance) • Matching- (fitting expense recognition to the revenue) • Consistency- over time • Comparability- to other companies (especially same industry) • Authoritative standards- conformance with GAAP, etc. • Materiality- significant errors that alter decisions • Conservatism- taking anticipated losses into account before they occur, but only taking anticipated gains when they happen • Additional criteria include the cost of implementing the policy, and tax considerations © 2007 by Nelson, a division of Thomson Canada Limited.

44. Accounting Policies DANGERS! • Management may be self-serving in its choices • Potential for accounting “manipulation” such as: • Income smoothing • “Big Bath” • Abuses such as “aggressive accounting” • Even fraud • Too much choice may reduce inter-company comparability • Pressure on auditors to agree © 2007 by Nelson, a division of Thomson Canada Limited.

45. Implementing Policy Choices: The Fiscal Period • Economic and business events are continuously ongoing – whether a single day or stretching for decades • Problem: How do we create concise financial statements and reports out of this mess of periods? • Answer: By the accounting policy choices employed by the company • Let’s take a closer look at a common problem: How to recognize revenue and matching expenses? © 2007 by Nelson, a division of Thomson Canada Limited.

46. Revenue Recognition: A Policy Choice a) Cutting continuous events into fiscal periods • Whole issue is timing of revenue and expense recognition: • Company success is usually a long-term matter • But reports for shorter periods are needed • So we’re forced to make judgment, estimates, and choices • How do we “cut-off” events to measure performance? © 2007 by Nelson, a division of Thomson Canada Limited.

47. Revenue Recognition: A Policy Choice b) Accuracy versus decision relevance HIGH Relevance Reliability Amount of relevance or reliability LOW Early Time when recognized in accounts Late

48. Revenue Recognition: A Policy Choice c) Balance Sheet and Income Statement Articulation • Every revenue and expense recognition entry affects both I/S and B/S • Therefore the entry should make sense from both sides: • Income measurement • Balance sheet valuation © 2007 by Nelson, a division of Thomson Canada Limited.

49. Revenue Recognition: A Policy Choice d) Balance Sheet and Income Statement Articulation Two Examples: DR: Accounts Receivable CR: Revenue Has the revenue been earned? Is the accounts receivable a valid asset? DR: Expense CR: Accounts Payable Has the expense been incurred? Is the liability what is really owed? © 2007 by Nelson, a division of Thomson Canada Limited.

50. Revenue Recognition: Solutions a) Choose a fiscal period • Companies select a fixed fiscal period of one year for annual reporting (divided into 4 even interim or quarterly reports) • Attempt to accommodate the business cycle • Creates comparability to other companies (especially in industry) • Date may depend on tax or legal reasons • December 31 year-end is by far the most common © 2007 by Nelson, a division of Thomson Canada Limited.