COMM 320 Chapter 4 Notes PDF

COMM 320 Chapter Four Revenue Recognition and the Statement of Income As previously noted, users follow an entity’s revenue very closely. Increasing revenues allow companies to expand and lead to increasing share prices. There is tremendous pressure on management of public companies to...

COMM 320 Chapter Four Revenue Recognition and the Statement of Income As previously noted, users follow an entity’s revenue very closely. Increasing revenues allow companies to expand and lead to increasing share prices. There is tremendous pressure on management of public companies to reach targeted revenue forecasts. Such pressure unfortunately leads to manipulation of revenue amounts. Recall from Chapter 2 that entities must use the accrual basis of accounting and recognize (i.e. record) revenue when earned. In many situations, determining whether revenue is earned is not easy as one may think. There are two issues to address with revenue recognition. First when should an amount be recognized in the financial statements (recognition) and second at what amount (measurement)? As the method of revenue recognition needs to be understood, all entities must disclose their revenue recognition policies in the notes to their financial statements. Watch for news stories identifying companies that have fraudulently overstated income by prematurely recognizing revenue or recording fictitious revenue. When discovered, these entities must restate their previously released financial statements and often face fines, sanctions and class-action lawsuits. Having to restate a financial statement may negatively affect the reputation of that entity - i.e. shareholders may question the reliability of any of the entity’s financial information and the integrity of management. © Scott M. Sinclair, FCPA, FCA 2022 1  COMM 320 Companies reporting under ASPE use an earnings-based approach: For Sale of Goods Revenue should be recorded when all of the following conditions are have been satisfied: The entity has transferred to the buyer the significant risks and rewards of ownership of the goods? This is usually the transfer of legal title. The seller has no continuing involvement or control over the goods. The amount of consideration to be received can be measured with reasonable assurance. Collection is reasonably assured. For provision of services: Revenue should be recorded when all of the following conditions are have been satisfied: The service has been performed. The amount of consideration to be received can be measured with reasonable assurance. Collection is reasonably assured. © Scott M. Sinclair, FCPA, FCA 2022 2  COMM 320 Companies reporting under IFRS use a contract-based approach: The standard setters have adopted a contract-based approach that focuses on the contracts a company has with its customers. The contract creates a combination of rights – rights to receive consideration and performance obligations. Management uses the following steps to determine when to recognize revenue: Identify the contract Identify the performance obligations Determine the transaction price Allocate the transaction price to the performance obligations Recognize revenue when the performance obligation is satisfied. Pages 4-5 to 4-12 provide further detail and examples that I encourage you to review. Rights of Returns In many sales transactions, the entity allows customers the right to return goods within a certain time frame. As a result, the entity must attempt to estimate the amount of refunds in the same period as the sale is recognized. Failure to make an estimate at the time of recognition would overstate sales. © Scott M. Sinclair, FCPA, FCA 2022 3  COMM 320 Warranties When an entity provides a warranty against defects of its products and the warranty is part of the sales transaction, the entity has a performance obligation (i.e. a liability) which must be established when the sale is recognized (assurance warranty). As with rights of return, significant judgment is required in establishing the amount to record. Usually, the amount is based on historical warranty claims history. Actual claims would reduce the liability established. If the entity sells an extended warranty which is not a part of the initial sales transaction (service warranty) then this transaction would be considered a separate transaction. In most cases the amount charged to the customer would be set up as deferred revenue and recognized as revenue over the period of the warranty. Actual claims would be recorded as received. The Income Statement Recall that an income statement is prepared to measure the operating performance of an entity for a period of time. Revenues, gains, expenses and losses are recorded on this statement. While management does have flexibility in the format of the statement, there are generally two basis approaches: Single-step – the most simplistic format in which all revenues regardless of source are listed first followed by all expenses. Multiple-step – a more refined approach in which there are multiple sub totals that provide the reader with key measures including gross profit, operating profit and income before income taxes. There are good examples in Exhibits 4.4 & 4.5 of the textbook. © Scott M. Sinclair, FCPA, FCA 2022 4  COMM 320 Captions commonly found items on an Income Statement Revenue – revenue earned from the normal operations of the entity. When there are many different lines of business the revenue may be divided even further. Cost of Goods sold – the cost of the products sold Gross Margin (Profit) is the difference between Sales and Cost of goods sold. This is an important item for most retail operations. Management watches this line very closely. Note that a service organization would not have a cost of goods sold nor a gross margin. Operating costs represent the expenses incurred in the normal course of business – e.g. salary expense, hydro, rent etc. Companies have flexibility in presenting this information. Operating profit equals gross margin less operating expenses. Other Income/Expenses - Items that are not central to continuing operations such as investment income, rental income, or interest expense are usually shown after operating profit. Interest expense – finance and borrowing costs Profit before income taxes - sum or all income minus expenses except taxes and results of investments in associated companies. Income tax expense - this is a cost of running a business and therefore properly shown on the income statement. Profit for the year - profit from continuing operations © Scott M. Sinclair, FCPA, FCA 2022 5  COMM 320 Captions commonly found items on an Income Statement continued Earnings per share - another closely monitored ratio, calculates the amount of profit earned by each share. = (Net income – Preferred dividends)/ the weighted average number of common shares outstanding during the year. Discontinued Operations If an entity discontinues a segment of its business, the income or loss from that segment should be shown as a separate line item on the income statement. Why? Because a reader should understand that this amount is not expected to occur in the future. Such information is relevant – it has predictive value! Public Companies – Statement of Comprehensive Income Public companies prepare a Statement of Comprehensive Income. This statement includes the Income Statement as described above and a second component known as Other Comprehensive Income. This second component includes gains and losses from revaluing financial statement items to fair value or from changes in foreign currency rates. The details of discontinued operations and comprehensive income are discussed in Intermediate Accounting. © Scott M. Sinclair, FCPA, FCA 2022 6  COMM 320 Appendix A Recording of Sales In many situations revenue is recognized when title to the product is transferred from the seller to the buyer. There are two shipping terms you will often encounter and need to understand: FOB shipping point – title to the goods passes to the buyer when the goods are shipped FOB destination – title to the goods passes to the buyer when the goods are delivered (FOB means “free on board”) The selling price of the product is often dependent on the quantity ordered by a customer. Those who buy more are often afforded lower unit prices. The ultimate sales price times quantity sold is referred to/recorded as gross sales. Some customers may be granted credit (i.e. the ability to pay their account after 30 or 60 days) while others may have to pay cash or settle their account with a credit card. When the textbook discusses credit sales or sales on account they are referring to situations where credit has been granted. It is not referring to sales settled with credit cards. We will address sales on account in Chapter 6. © Scott M. Sinclair, FCPA, FCA 2022 7  COMM 320 The journal entry to record a sale with cash is: Dr Cash Cr Sales The journal entry to record a sale on account is: Dr Accounts (Trade) Receivables Cr Sales The journal entry to record a sale paid with a credit card is: Dr Cash Dr Credit card charge (*) Cr Sales (*) Remember from the seller’s point of view, the bank charges a fee when a customer uses their credit card. As discussed, cash flow is the lifeblood of an entity. If management cannot collect it accounts receivables quickly the entity will be required to borrow funds to finance operations. To entice customers to pay quickly some companies offer a sales discount – a discount for early payment. You will often see the following notation on the bottom of a sales invoice: Terms 30 days – this means the amount is due within 30 days of the invoice date Terms 2/10, n/30 – this means the seller will grant a 2% discount if the invoice is paid within 10 days. Should the discount not be taken, the full amount of the invoice is due within 30 days. Terms vary among industries- some grant generous terms while others offer no discounts. © Scott M. Sinclair, FCPA, FCA 2022 8  COMM 320 Sales discounts, returns & allowances Sales discounts are offered to encourage customers to pay their accounts promptly. When a customer takes a sales discount (i.e., a discount for early payment) the seller would record the following entry: Dr Cash Dr Sales Discount Cr Accounts (Trade) Receivables The Sales Discount account is a contra account - an account that offsets the sales account in the Income Statement. After purchasing a product, a customer may wish to return a product they have purchased or ask for a reduction in price because the product is either damaged or not exactly what was ordered. Each scenario will be discussed separately. Sales Returns arise when a customer returns a product. The seller would record the transaction as follows: Dr Sale returns Cr Accounts (Trade) Receivables Notice that the debit goes to Sales Returns (another contra account) not the Sales account. Management usually sets up a Sales Returns account so they can monitor the level of returns. Sales Allowances arise when a customer requests and is granted an allowance (i.e., a reduction in the initial sales price), the entry recorded by the seller is: Dr Sales Allowances Cr Accounts (Trade) Receivables The Sales Allowance account is another contra account. © Scott M. Sinclair, FCPA, FCA 2022 9