Chapter 4--Learning Objectives 4 1.Understand the concept of recognition.
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Transcript of Chapter 4--Learning Objectives 4 1.Understand the concept of recognition.
Chapter 4--Learning Objectives
1. Understand the concept of recognition
Recognition
Recognition is the process of formally recording or incorporating an item into the financial statements of an entity
ex. Area development fees
Recognition includes
depiction of an item in both words and numbers, with the amount included in the
totals of the financial statementsnot the footnotes
Accounting recognition must
Identify and measureevents, transactions and circumstances
that should be capturedin the accounting information system
Chapter 4--Learning Objectives
2. Interpret the recognition criteria for assets and liabilities
To be included,an item must... 1. Possess the characteristics of an
element of the financial statements
Asset
Liability
Revenue
Expense
Gain
Loss
To be included,an item must... 2. Be measurable, relevant and
reliable
Cash versus accrualbased accounting
Cash receipts and disbursements are recognized when they occur
and in CASH BASED accountingrevenues and expenses are recognized when
the cash changes hands
Cash versus accrualbased accounting
In accrual based accounting, changes in financial statement elements are recorded in
the period in which the events occurrather than when the cash changes hands
An event should be recognized when four criteria are met: 1. The item must meet the
definition of an asset or a liability 2. The item must be relevant 3. The item must be reliable 4. The item must be measurable
Chapter 4--Learning Objectives
3. Interpret the recognition criteria for revenues
Revenues
Inflows or enhancements of assets (or settlement of liabilities) from delivering goods or providing services in the entity’s ongoing major or central
operations
To be recognized...
Revenues must be:1. Realized or realizable2. Earned
Realized
Products or services are exchanged for cash or claims to cash
Realizable
When related assets received or held are readily convertible to known amounts of cash or claims to cash
Revenues are EARNED
Revenues are EARNED
when the entity has substantially completed
Revenues are EARNED
when the entity has substantially completed what it must do to be entitled to the benefits
Revenues are EARNED
when the entity has substantially completed what it must do to be entitled to the benefits represented by the revenues
The value-adding process(a black box)
The inputs include:
?
Material
Labor
Capital
The value-adding process(a black box)
At the end of the process the product is sold
and cash is received
?Product
Conservatism
Recognize losses as incurred Recognize Revenues when realized or
realizable
Chapter 4--Learning Objectives
4. Apply various revenue recognition points to appropriate situations
Revenue recognition points
Time of sale
Usually operationalized as time of deliveryChange in ownership--transfer of title
At production or delivery
If sale and cash receipt precedes production and delivery, revenue is recognized at the point of production and / or deliveryex. Airline ticketsex. commodities
During production
If product is contracted before production, collection is probable, and production requires an extended period of timeex. building
As the service is rendered
If contracted for in advance for continuously rendered servicesex. rent
When asset prices change
For assets which are readily salable without significant effort, revenues may be recognized at completion of production or when the prices of the assets changeex. Net realizable value of farm products
At the point of exchange
If products or services are exchanged for nonmonetary assets not readily convertible to cash, revenue may be recognized at the time of exchange if fair market values are determinable
Cycle completion
If collection of receivables is doubtful, revenues are deferred and recognized based on cash received
When right of return expires
If significant returns are likely (such as with college textbooks) revenue is recognized when the goods can no longer be returned
Percentage-of-completionrevenue recognition1. Determine costs incurred to date2. Estimate costs to complete3. Calculate percentage complete4. Apply percentage to projected profit5. Subtract previously recognized profit
Long-term project example
Contract price is $10,000,000 Original estimated cost is $9,000,000 Actual first year costs are $2,000,000 Estimated cost to complete at end of first year is
$7,000,000 Portion completed is: $2,000,000 $9,000,000 = .222222
Long-term project--year 1
Estimated total profit is $1,000,000 (contract price less est. total cost) Profit to recognize is $222,222 ($1,000,000 x .222222)
Long-term project--year 2
Total costs incurred are $6,500,000 Est. cost to complete is $2,700,000 Completion portion is .706522 ($6,500,000 / $9,200,000) Estimated total profit is $800,000 Profit recognizable is $565,217 Previous profit is $222,222 Year 2 profit is $342,995
Long-term project--year 3
Total costs incurred are $9,300,000 Project is complete Total profit is $700,000 Previous profit is $565,217 Year 3 profit is $134,783
Additional project features
Progress billings for first year are $1,000,000 Cash collections are $700,000 “Construction in Progress (CIP)” is treated as
an inventory account “Billings on Construction” is treated as a
contra account to CIP If “Billings” exceed CIP, the accounts become
a liability
Project entries--year 1
Const. in Progress 2,000,000 Cash, etc. 2,000,000 Accts. Receivable 1,000,000 Billings on Const. 1,000,000 Cash 700,000 Accts. Receivable 700,000 Const. in Progress 222,222 Cost of C I P 2,000,000 Const. Revenue 2,222,222
Year 2 project features
Additional project billings are $5,000,000 Total billings at year end are $6,000,000 Additional cash collections are $3,300,000 Total collections at year end are $4,000,000
Project entries--year 2
Const. in Progress 4,500,000 Cash, etc. 4,500,000 Accts. Receivable 5,000,000 Billings on Const. 5,000,000 Cash 3,300,000 Accts. Receivable 3,300,000 Const. in Progress 342,995 Cost of C I P 4,500,000 Const. Revenue 4,842,995
Year 3 project features
Project is completed during year Additional project billings are $4,000,000 Total billings at year end are $10,000,000
(contract price) Additional cash collections are $6,000,000 Total collections at year end are
$10,000,000
Project entries--year 3
Const. in Progress 2,800,000 Cash, etc. 2,800,000 Accts. Receivable 4,000,000 Billings on Const. 4,000,000 Cash 6,000,000 Accts. Receivable 6,000,000 Const. in Progress 134,783 Cost of C I P 2,800,000 Const. Revenue 2,934,783
A final entry--year 3
Billings on Const. 10,000,000 Const. in Progress 10,000,000
Closes out the inventory account and the related contra account
Installment Sale
42 tents @ $3,600 $300 per month plus 12% Cost $1800
Installment Sale (cont.)
Accounts Receivable 151,200
Inventory 75,600
Deferred Installment Revenue75,600
Installment Sale (cont.)
Cash 336
Interest Revenue 36
Accounts Receivable 300
Deferred Installment Revenue 150
Installment Revenue 150
Chapter 4--Learning Objectives
5. Understand the concepts of income and capital maintenance
Comprehensive income
The change in equity of a business
during a period
from transactions and other events
from non-owner sources
Maintenance of capital
Need to separate
Return on capitalfrom
Return of capital
Chapter Objectives
Understand the concept of recognition Interpret the recognition criteria for assets and
liabilities Interpret the recognition criteria for revenues Apply various revenue-recognition points to
appropriate situations. Understand the concepts of income and capital
maintenance.