THREE
3
Doing PART Financial Accounting
C6 Revenue and Expense Recognition C7 Recordkeeping and Control C8 Assets Accounting C9 Liabilities, Equity, and Corporate Groups The four chapters in this group delve into various practices important to anyone preparing financial statements. These practices are presented to show their importance both to future accountants and to people not planning to become accountants. Chapter 6 focuses on the way accrual accounting measures income, accounting's "bottom line," as the difference between revenues and expenses. Chapter 7 outlines recordkeeping and internal control considerations that exist separately from the financial statements but significantly influence those statements. Chapters 8 and 9 examine the accounts on the two sides of the balance sheet in more detail. Chapter 8 focuses on the left "assets" side and Chapter 9 on the right "liabilities and equity" side.
NEL
CHAPTER SIX
Revenue and Expense Recognition
6
6.1 Chapter Introduction: Revenue and Expense Recognition
Every public company has an annual meeting at which top management reports on performance and prospects for the future, and shareholders are able to ask questions. Here's some of what went on at a recent annual meeting. Chief executive officer (CEO): ... and I hope you have found my report useful. While the company faces many challenges, there is much strength here too, and we look forward to improved prosperity. I now invite questions from shareholders present today. Shareholder A. Benoit: Thank you for your informative comments. My question is about the company's revenues. I note that revenues have failed to grow much this year while inventories have risen. Can you explain what is going wrong? CEO: We are facing much stronger competition in some product lines, so products we expected to sell have not sold, depressing revenue and increasing inventories because those products were available to sell but just did not move out the door. Shareholder A. Benoit: Have the product markets collapsed? If not, then having the products available is still a good thing. Unless you doubt you will sell them, why not add them to revenue when you have them ready to sell? Otherwise you make the company look worse than it is, which hurts the company's share price and so the value of my shares. Shareholder B. Hutchence: Please also tell us why the company's accounts receivable are up along with inventories. This doesn't make sense when revenues have not grown. CEO: I'll ask our chief financial officer (CFO) to address those questions.
NEL
358
PART T HREE
D OING F INANCIAL A CCOUNTING
CFO: The company's accounting policy is to record revenue only when a legal customer order has been received, so we cannot show revenue for products no one has yet ordered. The accounts receivable are up, I agree, and frankly it is because in the face of competition, we have taken orders from some lower-quality customers than we used to, and some of those customers are slower to pay than we had hoped. Shareholder J. Ranu: Hold on, here! You record revenue when you get an order? You don't wait until you fill the order? Sounds like even though this has not been a good revenue year, your accounting has made it better than it should have been. Are you covering up a real decline in revenue? CFO: I don't like your language. We're not covering up anything. But once we receive an order, it is as good as money in the bank, so we mark it down as revenue.
Shareholder J. Ranu: Money in the bank from customers who are slow to pay? Do any other companies like ours do this? It sounds fishy. Since you have not shipped the products yet, are they still in inventory? CFO: Well, of course they are still in inventory. We only record the revenue when we get the order. We record cost of goods sold when we ship the products, a few days later. Shareholder B. Hutchence: You guys are trying to pull the wool over our eyes! You are showing revenue you should not, and are not matching the expenses with the revenues. Sounds like the company's books are a mess, and the income figure is a fabrication! I'll bet it helps you make your bonuses, but it doesn't help us! Several shareholders shout: Are you cooking the books? CEO: Order, please! All of this can be explained if you will be kind enough to listen....
Learning Objectives
Most annual meetings are not this confrontational, though controversy does erupt at many companies' meetings from time to time, but the vignette illustrates several important points. In this chapter you will learn: How accrual accounting works to make sure that revenues and expenses are measured in the appropriate period so that each period's income is valid (so there is no impropriety, "cooking the books" as in the vignette); How advancing or delaying the measurement of revenues and expenses, done to get income right, affects past and future income measures as well as the balance sheet (such as the receivables and inventories in the vignette); How to determine when it is the appropriate time to record revenues and related expenses (the company in the vignette is recording revenues too soon, before goods are shipped); How to set good accounting policies for measuring revenues and expenses so that the results are not "fishy" as in the vignette, and why users of financial statements need to be vigilant just in case the company is using improper accounting policies (most companies are quite scrupulous about their accounting, but some that are not have been prominent in recent years, to the embarrassment of all principled accountants, auditors, and managers).
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
359
6.2 What Is Accrual Accounting?
This chapter begins four chapters on doing financial accounting by focusing on how accrual accounting's measures of revenue and expense are constructed and matched to provide the measure of income. It is all based on double-entry accounting and on the concepts of revenue and expense, and the ways of adjusting accounts that were introduced in Chapter 3. With the conceptual and technical background provided by the first five chapters, this whole chapter is devoted to revenue and expense recognition, because accrual accounting is at the heart of financial accounting and is absolutely essential to understanding the income statement. Also, in many ways, the balance sheet is a "residual" of the measurement of revenues, expenses, and income, so this chapter extends your understanding of the balance sheet as well. Later chapters examine various parts of the balance sheet in more depth, using this chapter's explanation of accrual accounting. The key to accrual accounting is that it frees financial accounting from having to follow cash transactions only. With accrual accounting, revenues, expenses, assets, and liabilities can be recorded (recognized, as accountants say) before or after cash transactions happen. This can be done by the familiar method of debiting something and crediting something. The big question is when to recognize these income statement and balance sheet amounts by recording them in the accounts. For example, if revenue can be recorded at another time than when cash changes hands, such as by debiting accounts receivable and crediting revenue before the customer pays, when is it appropriate to do that? What evidence, principles, or assumptions support recognition before the cash changes hands, or after? Accrual accounting is the dominant form of financial accounting in the world today. It exists because cash flow information is simply not complete enough to assess financial performance or financial position. Keeping track of cash flow is crucial for business success, but it is not enough. We have to go beyond cash flow to assess economic performance more broadly and to assess noncash resources and obligations. We do this even though it forces us to make estimates, judgments, and other accounting choices that, in turn, make the results less precise than we would wish, and more subjective than transaction-based cash flow figures. As a reminder of the ideas about accrual accounting introduced in Chapters 1 and 3, let's imagine the following conversation between a student and a relative who is also a professional accountant: Accountant: Well, you spent the summer working at High-Class Boutique. How did you do? Student: I had a great time. Met some great people, learned a lot about retailing, and so decided to major in marketing. Accountant: No, I meant how did you do financially? Student: Let's see. I received $6,460 over the four months. I have $4,530 left in the bank; so, I guess I must have spent $1,930. Gee, $4,530 doesn't make me rich after a summer's work! But the Boutique still owes me for my last week of work. Accountant: What did you spend the $1,930 on? Student: I blew some of the money on burgers and evening entertainment, and on that trip to the lake. But also, I bought clothes for the fall term, and I have the
Accrual accounting is all about choosing when to recognize phenomena in the accounts.
Accrual accounting involves estimates, judgments, and subjectivity.
NEL
360
PART T HREE
D OING F INANCIAL A CCOUNTING
answering machine, and the fancy calculator I got so that I might be able to pass accounting. Accountant: Don't forget you have to pay your Uncle Al back the money he lent you in May. That's in your bank account too, so it looks as if you spent more than $1,930. You promised to pay him, plus interest, at the end of the summer. There's also your university tuition for next year, and didn't you say once that you owed a friend something for gas for that trip to the lake? Student: I don't think we should count the tuition because it doesn't really apply until I register. Although I guess that is why I was working. Now I'm not sure if I had a good summer or not! Accrual accounting incorporates many phenomena besides the period's cash flows. This example illustrates many of the issues accrual accounting tries to deal with, including: 1. The more you think about it, the more Illustrative Accrual Issues complex measuring per formance and position seems to be, and the less satisfacWhy accrual accounting? tory cash by itself seems to be as a 1. Complexity leads to a demand measure. for accrual basis rather than cash Some of the revenue earned may not yet basis. have been received in cash (payment for Some complexities: the last week of work). Similarly, some costs incurred may not yet 2. Uncollected revenues. 3. Unpaid expenses. have been paid (the gas for the lake trip). 4. Asset values extending beyond Some cash payments result in resources this period. still having economic value at the end of 5. Some cash receipts that have to the period (the answering machine, the be repaid. calculator, and maybe the clothes). 6. Deterioration of asset values Some cash receipts result in obligations during this period. still outstanding at the end of the period 7. Obligations that build up during (Uncle Al's loan). this period. The longer-term resources may have deteIt's not straightforward. riorated during the period (not all the clothes purchased during the summer will 8. Judgments and decisions are still be valuable because fashions change, often required. and the answering machine and calculator are now used items). Obligations may build up during the period (the interest on Uncle Al's loan). There is often doubt about whether some things should be included in measuring performance for a given period or position at a given point in time (the university tuition), leading to necessary judgments and decisions that make accrual accounting's measurements often subjective and even controversial.
2.
3. 4.
5.
6.
7. 8.
Accrual accounting's tradeoff: aiming for relevance without losing too much reliability.
Think of accrual accounting as an attempt Relevance-Reliability Tradeoff to measure economic performance and finanMore relevance Less reliability cial position in a more complete way than just More reliability Less relevance using cash. There is always a tradeoff here: the closer to cash, the more precise the measure is, but also the more limited and less informative it is. The more accountants try to make the financial statements economically relevant, the more they must include estimates and other sources of imprecision or error. Referring back to the relevance-reliability tradeoff diagram in Section 5.3, accrual accounting aims for more relevance but the price paid
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
361
is less reliability. To minimize the damage to reliability, there are many rules and standards surrounding accrual accounting, as we saw already in Chapter 5, and considerable evidence is normally required to back up the accrual figures. Companies are expected to choose sensible policies for doing their accrual accounting, and to stay with those policies over the years unless there is good reason for changing them.
Mini-Demonstration Problem
We're about to launch into conceptual material you might find difficult. Remembering that it is all based on the accrual accounting examples we already saw might help you with it. So let's make sure you have the earlier examples straight. If you have any trouble with this little demonstration, please look back to Chapter 1, Sections 1.10 to 1.12, and Chapter 4, Section 4.9. In its first year, new company Affleck Inc. collected cash from its customers of $85,000, paid cash bills of $74,000, and bought a truck for $50,000, borrowing $40,000 from the bank in order to do that and so ending the year with $1,000 in the bank. At the end of the year, the company had uncollected revenues of $13,000 and unpaid expenses of $4,000, and $5,000 of the truck's value was thought to have been used (amortization). a. What was the company's accrual income for the year? The accrual income figure incorporates some cash figures (cash collections and payments) adjusted for some noncash or not-yet-cash figures (uncollected revenues, unpaid expenses, and amortization), and does not incorporate some cash figures (the truck purchase and the bank loan). So accrual income = $85,000 $74,000 + $13,000 $4,000 $5,000 = $15,000.
b. What was the company's cash income for the year? Just the day-to-day cash flows: $85,000 $74,000 = $11,000. c. What was cash from operations for the year? Accrual income adjusted for noncash revenues and expenses and noncash working capital changes: $15,000 + $5,000 amortization $13,000 uncollected revenue + $4,000 unpaid expenses = $11,000, which is cash income.
figure 6.1
Overlap
Cash income
Accrual income
Accrual and Cash Income are Different but Overlap
NEL
362
PART T HREE
D OING F INANCIAL A CCOUNTING
how's your understanding?
Here are two questions you should be able to answer based on what you have just read. If you can't answer them, it would be best to reread the material. 1. If accrual accounting produces less precise figures than just using cash transactions would, why is accrual accounting used? 2. Suppose it was discovered that Affleck Inc. had inventories costing $9,000 on hand at the end of its first year. This amount had been included in the $74,000 of cash bills paid. What are the revised figures for (a) accrual income, (b) cash income, and (c) cash from operations? (a) Accrual income will be $9,000 higher because there is an asset that had been recorded as an expense, so $15,000 + $9,000 = $24,000. Calculating it the long way, income = $85,000 $74,000 + 13,000 + $9,000 4,000 $5,000 = $24,000. (b) Cash income is unaffected, still being $11,000. Nothing has happened to cash. (c) Cash from operations will now have a $9,000 inventory increase to deduct from accrual income, so it will be $24,000 + $5,000 $13,000 $9,000 + $4,000 = $11,000, unchanged from before. This confirms that cash income is unaffected.
6.3 Conceptual Foundation of Accrual Accounting
Accrual accounting recognizes economic phenomena whether or not realized in cash. 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 in the accounts (and therefore reflected in the financial statements), whether they have not yet, or have already, been realized by cash received or paid out. Adapting the diagram in Section 6.2 (Figure 6.1), we might say in Figure 6.2 that the objective is to recognize economic flows separately from cash flows. The result affects income, through the revenue and expense figures, but also affects the balance sheet, through accounts like accounts receivable and accounts payable that are used to create the appropriate revenues and expenses. The income statement and balance sheet articulate through accrual accounting.
figure 6.2
Economic Versus Cash Flows
Some current cash flows are also in current economic flows Some current cash flows are not in current economic flows Some current economic flows are not current cash flows
Overlap
Cash flows
Economic flows
Accrual accounting focuses on the economic flows
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
363
Let's build the accrual accounting approach from some basics. These four cornerstones (which are shown in Figure 6.3) have come up already in this book, but we'll give them brief definitions again and build from there: Revenues: economic inflows. Expenses: economic outflows. Net income: economic success. Matching revenues and expenses is supposed to produce a logical net income measure. Revenues and expenses are economic concepts extending beyond transactions. Properly measured revenues and expenses should lead to proper net income. Many criteria besides matching help ensure that revenues, expenses, and income are proper. Revenues are inflows of economic resources from customers. We might say that earning revenues is the reason a company is in business. Expenses are outflows of economic resources to employees, suppliers, taxation authorities, and others, resulting from business activities to generate revenue and serve customers. We might say that incurring expenses is the cost of earning revenues. Net income is the difference between revenues and expenses over a period of time, such as a month, a quarter, or a year. We might say that net income is the measure of success in generating more revenues than it costs to generate those revenues. Matching is the logic of income measurement, ensuring that revenues and expenses are measured comparably, so that deducting the expenses from the revenues to calculate net income produces a meaningful result. We might say that matching ties accrual accounting together into a coherent system.
Note some features of these cornerstones: Revenues and expenses refer to inflows and outflows of economic resources. These flows may be represented by the kinds of events recognized by the transactional recordkeeping system, but they may also involve nontransactional phenomena. In particular, they may involve phenomena that arise before or after cash changes hands, as well as at the time of the cash flow. Net income depends on how revenues and expenses are measured, and is not well defined separately from revenues and expenses. Accountants don't, or shouldn't, choose the income number first and force the calculation of revenues and expenses to result in that income. Instead, they measure revenues and expenses as properly as they can. Net income then is just the difference between these revenues and expenses. Matching involves trying to line up measures of economic inflows with those of economic outflows. It is logical, but not the only logic one could imagine applying. For example, if revenues are overestimated and then expenses are overestimated to match, the net income figure may be about right because the overestimations roughly cancel out, but the figures for revenues and expenses will be misleading, as will any balance sheet accounts related to them, such as accounts receivable and accounts payable. If the method of recognizing revenue is poor, it hardly makes sense to argue for a poor expense recognition method for the sake of matching. So, many other criteria enter into revenue and expense recognition and income measurement to fine-tune the system and ensure that the matched measures are sensible. Examples of such criteria are fairness, comparability, consistency, conservatism, and other concepts in Chapter 5, plus various detailed methods for determining how much revenue has been earned and how much expense has been incurred, which we will see.
Matching
figure 6.3
The Four Cornerstones of Accrual Accounting Revenues
Expenses
Net Income
NEL
364
PART T HREE
D OING F INANCIAL A CCOUNTING
FYI
Revenue-expense matching gives income measurement priority over balance sheet valuation.
T
he discussion above indicates that matching is a central criterion in accrual accounting, used to get the income right by lining up the revenues and expenses properly. The balance sheet is a sort of residual of the matching process: you record whatever receivables, payables, amortization, etc., you need to get the income right,
so the balance sheet figures are secondarily important to getting a valid income number. Matching's central place is increasingly challenged by people who argue that this is wrong. They have two primary arguments. One is that putting things on the balance sheet, or leaving them off, to get the income statement right is improper because financial statement users then may be misled by the balance sheet.
Using fair values for the balance sheet is gaining popularity, including for measuring income.
Accrual accounting can handle matching or fair value accounting, or a mixture.
The second argument is that a better way to measure income is to measure changes in the fair values of the balance sheet assets and liabilities, and take the net of those changes as the income for the period. Comparing your assets and debts, if you are better off at the end of the period than at the beginning, you have made an income; if you're worse off, you've made a loss. You then focus on getting the balance sheet right, in fair values, and the income statement becomes the residual, the resultant of getting the balance sheet right. Fair value accounting is gaining popularity worldwide, and although it is not close to replacing the matching principle yet, there is some possibility it will win out some time in the future. It is used already in some areas of accounting, as we will see in later chapters. The accrual accounting model given below can accommodate either the matching principle or the fair value approach, or a mixture of the two: the difference is in how the numbers used in the various entries are calculated, with matching emphasizing the income statement side of entries, and fair value emphasizing the balance sheet side. In any case, the income statement and balance sheet must still articulate somehow.
A Conceptual System for Accrual Income Measurement
Accrual accounting includes cash flows plus both earlier and later economic phenomena. Accrual accounting's purpose is to extend the measurement of financial performance and position by recognizing phenomena prior to and subsequent to cash flows, as well as at the point of cash flows, making accrual accounting more complete than just using transactions, especially just cash transactions. (In sophisticated companies, many of the routine noncash parts of accrual accounting, such as recognizing uncollected revenue as accounts receivable, are handled with transactional records, but those are still based on the principles explained in this chapter.) Let's work through how this is done, focusing on revenues and expenses for the time being. Exhibit 6.1 summarizes accrual revenue and expense recognition and shows how that fits with the cash flows that are also happening. It is important to remember that accrual accounting does not ignore cash flows; it just permits revenues and expenses to be recognized earlier or later than the related cash receipts and payments. Cash flow is still part of the picture. Parts 2 and 3 of Exhibit 6.1 can be rearranged to show the four possible revenue and expense recognition scenarios other than just recognizing revenues and expenses when the cash flow happens (which was Part 1 of Exhibit 6.1). Exhibit 6.2 does this, showing how accrual accounting implements different timing than that of the cash flows through eight general kinds of journal entries that allow revenue and expense recognition
NEL
Accrual accounting is all about timing of revenue and expense recognition.
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
365
E
X
H IBI
61
T
Summary of Accrual Accounting Revenue and Expense Recognition
Revenues (1) Start with cash transactions DR Cash CR Revenues Expenses DR Expenses CR Cash
(2) Stretch the time out so that revenues and expenses are recognized before the cash transactions (a) Recognition (b) Cash transactions DR Accounts receivable CR Revenues DR Cash CR Accounts receivable DR Expenses CR Accounts payable# DR Accounts payable# CR Cash
Note that the sums of entries 2(a) and 2(b) equal the entries in (1). The accounts receivable and payable accounts are temporary accounts used to allow earlier recognition of revenues and expenses and are eliminated when the cash flows. (3) Stretch the time out the other way so that revenues and expenses are recognized after the cash transactions (a) Cash transactions (b) Recognition DR Cash CR Deferred revenue** DR Deferred revenue** CR Revenues DR Assets* CR Cash DR Expenses CR Assets*
Note that the sums of entries 3(a) and 3(b) equal the entries in (1). The assets* and deferred revenue** accounts are temporary accounts used to allow later recognition of revenues and expenses and are eliminated by that recognition.
Other liabilities than accounts payable may be involved, such as accrued interest, income tax payable, warranty liability, pension liability, and deferred income tax. * Example asset accounts that might be debited at the cash transaction stage include inventories, prepaid insurance, and factory. These are eliminated (over time) by entries that credit such accounts and debit cost of goods sold, insurance expense, and amortization expense. ** Deferred revenue is a temporary liability account used to record cash received before the revenue has been earned, such as with customer deposits.
#
to happen before or after the cash transactions. In this exhibit, the "current accounting period" is the one in which the accounting is now being done--the "past" period has already finished and the "next" period has not started. "Period" can be any period over which income is being measured: a year, a quarter, a month, or whatever. The arrows indicate accounts used to allow the revenue or expense recognition to diverge from the cash flow. As noted in Exhibit 6.1, these accounts are temporary in concept, and eventually are eliminated by later cash flow or later recognition.
NEL
366
X
PART T HREE
D OING F INANCIAL A CCOUNTING
H IBI
T
E
62
The Four General Scenarios When Revenue or Expense Recognition Does Not Coincide with Cash Flow
A. Revenue recognition prior to cash collection Current accounting period Revenue recognized DR Accounts receivable asset CR Revenues Next accounting period Cash collected DR Cash CR Accounts receivable asset
B. Revenue recognition after cash collection Past accounting period Cash collected DR Cash CR Deferred revenue/ deposits liability Current accounting period Revenue recognized DR Deferred revenue/deposits liability CR Revenue
C. Expense recognition prior to cash payment Current accounting period Expense recognized DR Expense CR Accounts payable or other liability Next accounting period Cash paid DR Accounts payable or other liability CR Cash
D. Expense recognition after cash payment Past accounting period Cash paid DR Asset (inventory, equipment, etc.) CR Cash Current accounting period Expense recognized Dr Expense (COGS, amortization, etc.) CR Asset (inventory, accum. amort., etc.)
Accrual accounting separates recognition from cash flow, incorporating both in a logical system of entries.
Accrual accounting reflects practical complexity as well as its conceptual base.
Following in Exhibit 6.3 are some examples to help you see how the accrual accounting system works. We'll use types of entries you've already seen in earlier chapters. The example entries involve manufacturer Northern Gear Ltd. Now you should be able to see how the records and adjustments you already know how to do aggregate into an overall structure that makes accrual accounting a system. As you know, Canada has a system of GST and provincial sales taxes in most provinces. To make the examples in Exhibit 6.3 more realistic, some such taxes are also included in the example entries; the basic idea is that when tax is charged to customers, it has to be paid to the government and so is a liability, and when tax is incurred on the company's purchases, it can be claimed back from the government and so reduces the liability. Companies also must deduct income taxes and other deductions from employees' pay, so the examples include that too. Don't get hung up on them now. In Chapter 7, more time will be devoted to how these practical tax considerations work. They are included to illustrate that accrual accounting adapts to whatever the business and legal requirements are, and so can become quite complex. Some modern accounting procedures are very complex indeed. But the conceptual structure in Exhibits 6.1 and 6.2 underlies whatever complex procedures an enterprise uses.
NEL
C HAPTER 6
H IBI
R EVENUE
AND
E XPENSE R ECOGNITION
367
E
X
63
T
Recognition prior to cash flow Revenue Northern Gear made a sale on credit DR Accounts receivable CR Revenue CR Sales taxes due DR Wages expense CR Deductions due CR Wages payable DR Interest expense CR Interest payable DR Legal advice expense DR Sales taxes due CR Accounts payable 2,464 2,200 264 1,860 340 1,520 240 240 500 35 535
Expense Employees worked for wages paid later
Interest was due on a bank loan Legal advice was obtained, plus GST
Cash flows related to prior recognition Collection A customer made a payment on DR Cash account CR Accounts receivable Payment The company paid a supplier The company remitted employee deductions Cash revenues and expenses Cash revenue A customer made a minor purchase DR Accounts payable CR Cash DR Deductions due CR Cash
1,100 1,100 775 775 825 825
DR Cash CR Sales taxes due CR Revenue DR Donations expense CR Cash DR Supplies expense DR Sales taxes due CR Cash
90 10 80 100 100 210 15 225
Cash expense Northern Gear made a donation to charity The company bought supplies, plus GST
Cash flows related to later recognition Collection A customer paid for an order in advance DR Cash CR Deferred revenue Payment Northern Gear bought new machinery The company bought inventory, plus GST The company paid for insurance in advance DR Machinery asset CR Cash DR Inventory asset DR Sales taxes due CR Cash DR Prepaid insurance asset CR Cash
784 784 5,200 5,200 2,300 161 2,461 840 840
NEL
Exhibit 6.3 continues on next page
368
X
PART T HREE
D OING F INANCIAL A CCOUNTING
H IBI
T
E
63
(continued)
Recognition after cash flow Revenue The customer's prepaid order was shipped Expense Cost of goods sold on a week's sales Amortization for a year Insurance used during a month
DR Deferred revenue CR Sales taxes due CR Revenue DR COGS expense CR Inventory asset DR Amort. expense CR Accum. amort. DR Insurance expense CR Prepaid insurance
784 84 700 23,611 23,611 41,500 41,500 70 70
Accrual accounting is a flexible system that can handle many phenomena.
These entries don't cover quite everything accrual accounting can do, and you might be able to think of events that combine some of the above entries. An example is buying inventory on credit. That is a debit to Inventory and a credit not to Cash, but to Accounts payable. This entry allows both recognition of the expense later and payment of the cash later. Buying machinery or other noncurrent assets on credit would work the same way. Accrual accounting is quite flexible and can handle all sorts of events and adjustments. All you need to do is figure out what to debit and what to credit.
FYI
D
oes accrual accounting matter? Here are some comments about research results: "Accrual accounting can be viewed as one potentially cost-effective compromise between merely reporting cash flows and a 1 more ambitious system of fuller disclosure." ("Fuller disclosure" might include reporting all the company's transactions and other events and just letting the user of the information construct his/her own version of income, assets, etc., in whatever way that person thinks appropriate. You can think of accounting principles as decisions on behalf of presumed users of what they would like to know, so there is always, at
least conceptually, the possibility of not making such a decision and just reporting everything.) "There is a significant, positive correlation between (share) price changes and earn2 ings changes." "Price changes appear to be more highly correlated with earnings changes than with changes in `cash 3 flow'." "The research provides clear evidence that investors and creditors can use accounting information to predict 4 many phenomena of interest." (So the principles, entries, and other efforts by accountants do make a difference. A good thing for accountants!)
how's your understanding?
Here are two questions you should be able to answer based on what you have just read. If you can't answer them, it would be best to reread the material. 1. How do accrual accounting entries work to separate the earning of revenue from the receipt of cash, and is it always necessary to separate them, or can they happen at the same time? 2. In what way can it be said that amortization expense and cost of goods sold expense are examples of the same thing?
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
369
6.4 Accounting Policy Choices
There are complications, but we have seen that the general pattern behind accrual accounting's revenue and expense recognition system is: Recognition of revenue prior to cash collection: Create an asset, usually called accounts receivable, to hold the economic value gained through the revenue until the cash is collected. Recognition of revenue after cash collection: Create a liability, usually called customer deposits or deferred revenue, to hold the cash value until the revenue has been earned. Recognition of expense prior to cash payment: Create a liability account, such as accounts payable, wages payable, pension liability, or future income tax liability, to hold the economic value lost through the expense until the cash is paid. Recognition of expense after cash payment: Create an asset account, such as inventory or buildings and equipment, to hold the economic value until it is consumed, when it is then transferred to an expense such as cost of goods sold or amortization expense.
Accrual accounting uses a variety of accounts to represent noncash economic values.
Since accrual accounting is a system, decisions about when and how to record the various recognition and other entries described above and in the previous section should not be made in an unorganized way. Instead, the enterprise should make accounting policy choices about how its accrual accounting is to be conducted.
What Is an Accounting Policy?
Management needs to provide direction about how the accounting is to be done. Imagine the following scenario: the bookkeeper for MegaMega Stores Inc. has to decide whether or not each sales invoice should be recorded as revenue (credit revenue, debit cash, or accounts receivable) and so, each time, phones the president and asks whether that invoice should be recorded. Pretty silly, eh? What the company needs to do is decide, in advance and in general, what sort of transaction constitutes a sale that is to be recorded as revenue. Then this decision can be communicated to the bookkeeper, who can apply the criteria to each invoice and so decide what to record without phoning the president. The president can run the company instead of talking to the bookkeeper every few minutes. An accounting policy is a decision made in advance about how, when, and whether to record or recognize something. Typically, companies make policy choices in many areas. The following are only a few examples: when and how to recognize revenue how to compute amortization on plant and equipment assets how to value inventories and calculate cost of goods sold how to value receivables, including how to estimate the effects of bad debts which expenditures on noncurrent assets should be added to the asset accounts and which should be included with expenses such as repairs and maintenance
Accounting policies apply to everything in the financial statements.
Many choices are needed in assembling meaningful financial statements. When you choose the location of an account in the financial statements (such as putting it in current liabilities rather than noncurrent liabilities), you are making an accounting policy choice! Accounting policy choices are very important to the interpretation and analysis of the financial statements. Without knowing how the statements were assembled, it is difficult to use them intelligently. For this reason, the first of the notes following the financial statements is usually a summary of the company's significant accounting policies. These
NEL
370
PART T HREE
D OING F INANCIAL A CCOUNTING
are the topics covered in CPR's year 2004 "Summary of significant accounting policies 5 note: Consolidation method List of principal subsidiaries How revenue is recognized What are cash and short-term investments How foreign currencies are translated Accounting for pensions, other benefits What is in inventories What kinds of property are owned How property is depreciated Accounting for financial instruments Accounting for restructuring charges Accounting for income taxes Calculation of earnings per share Accounting for stock options
In an immediately following note, CPR also describes changes in the company's accounting policies for hedging transactions, legal obligations arising from asset retirement, stock-based compensation, guarantees that require payment contingent on specified types of future events, impairment of the value of long-lived assets, and the cost of severance and termination benefits.6 The company stated that all these changes were made to comply with changes in the CICA accounting guidelines. Details of the effect of the changes on the financial statements are also provided. Other notes to CPR's statements provide further details on important policies. Companies do not overwhelm the reader with descriptions about every accounting policy: those that are obvious or that follow standard rules that an informed reader (you're becoming one!) should know about are usually not described. For example, the definitions of current assets and current liabilities are well known and would be mentioned only if something unusual was being done.
Why Is There a Choice?
Accrual accounting requires that accounting policy choices be made. Accrual accounting forces the preparers of financial statements to make choices, whether they like it or not. 1. The basis of accrual accounting is to augment the transactional records to produce a more complete economic picture of the enterprise's performance and position. How to do this is a matter of judgment and of criteria such as fairness and matching. Accrual accounting therefore necessitates choices about accounting figures, notes, and methods. Even the basic transactional records of accounting require decisions about what is a transaction, which accounts to use, and how and when transactions are to be recorded. In Canada, the United States, Britain, Why Is There a Choice Among Australia, New Zealand, and many other Accounting Policies? countries, governments and professional 1. Accrual accounting makes it accounting standard-setters (such as the necessary. CICA and the FASB) have been reluctant to 2. Even recording transactions try to specify all solutions and require all requires policies. enterprises to follow them. Such authorities 3. Accounting standards do not specify all possible solutions. appear to believe that choices in accounting 4. Format and disclosure also are appropriate to fit the accounting to each involve choices and policies. enterprise's circumstances, and perhaps inevitable in our free enterprise economic system. Stock market participants, financial analysts, and others who rely on financial statements are expected to attain sufficient knowledge of accounting and the enterprise to make informed decisions, just as they would when buying the enterprise's products or having other interactions with the enterprise.
2.
3.
Not all countries give as much policy choice to companies as Canada does.
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
371
Recording something in the accounts, having a narrative disclosure, or both, is a choice.
4.
Authorities in many countries (such as China, France, Germany, and Japan) specify accounting methods more strictly than in Canada. In such countries, the material covered in this chapter would put more emphasis on how to implement the approved accounting methods and less on how to choose among a variety of acceptable methods. Because the complete financial statements include the titles and classifications of figures and the footnotes and other narrative disclosures, there is frequently a decision to be made as to whether to adjust the figures for something or to disclose it in the narrative material instead, or give it a special title, or even all of these. For example, if the company has been sued by a disgruntled customer, should that be recorded as a liability? If recorded, should it be listed separately in the balance sheet? Should it instead just be disclosed in the notes, or perhaps in a note even if it is recorded?
General Criteria for Accounting Policy Choices
When deciding how to account for revenues, inventories, amortization, and other matters (including what to say in footnote disclosures), companies have to consider the following kinds of criteria and work out how they apply to the specific policy choice situation. These criteria were examined in depth in Sections 5.2 and 5.3. The principles in Chapter 5 are essential to making accounting policy choices. 1. 2. 3. 4. 5. 6. 7. Fairness (objectivity, lack of bias, correspondence with economic substance). Matching (fitting revenue recognition to the economic process, fitting expense recognition to the economic process and to the revenue). Consistency over time. Comparability to other companies (especially in the same industry). Conformance with authoritative standards, and less formal aspects of GAAP. Materiality to (significance to decisions of) known or presumed users of the information. Conservatism (taking anticipated losses into account before the transaction happens, but not taking anticipated gains into account until the transaction happens).
In addition, various criteria specific to the particular accounting policy choice issue must be considered. Examples are the cost of implementing the policy, tax effects, internal control considerations, and other business implications and consequences. These criteria will be indicated as topics are covered in this and later chapters.
How Much Freedom of Choice Is There?
Accounting policy choices are constrained by authoritative standards and broader GAAP. Accounting policy choices are made within the standards set out by the CICA Handbook, the FASB, and other standard-setters and regulators as described in Chapter 5. While companies ordinarily do not have to follow these standards, or the less-formal parts of GAAP, they can get into considerable trouble if they do not. Stock markets may refuse to list their shares. Taxation authorities may refuse to accept their financial statements as evidence of income for tax purposes. Shareholders and creditors may sue for alleged misrepresentation. Embarrassing newspaper articles may be written about them. So many policy choices are highly constrained, and are expected to be made with reference to standard criteria. There are some areas of accounting that are new or controversial enough that there is no or little guidance from standard-setters, and then the company is a little more free to make its own policy decisions. Even when there is an authoritative standard or a clear tradition, the necessity of fitting the accounting policy to the particular circumstances of the enterprise necessitates, in turn, the exercise of professional judgment by the preparers and auditors of the information. As the CICA Handbook's Introduction to Accounting Standards says:
NEL
372
Standards cannot cover everything, so people still have to use their heads.
PART T HREE
D OING F INANCIAL A CCOUNTING
"Accounting Handbook Sections emphasize principles rather than detailed rules and, therefore, cannot be phrased to suit all circumstances or combinations of circumstances that may arise."7
FYI
D
oes accounting policy choice provide a way for company management to alter the picture presented in the financial statements--to present the story they want to tell rather than the "truth"? The short answer is yes. The whole idea of accrual accounting is to permit a company to choose how its performance and position are to be depicted. There is a fine line between choosing the accounting policies that suit the company's circumstances and therefore produce fair reporting, and choosing policies that tell a desired story that may not be fair. The vast majority of companies and their managers are scrupulous about their accounting and consider producing fair financial statements to be both ethical and good business practice. But we do learn of companies that have stepped over the line and "doctored" their accounts to make themselves look better or to hide some embarrassing result. The following shows some types of doctoring: What accountants and the business press often call aggressive accounting: seeking out accounting methods and policy choices that serve management's objectives
for growth, financing, bonuses, or other purposes that seem to violate fairness or conservatism. The examples of income manipulation in Chapter 3, Section 3.10: earnings management, the Big Bath and income smoothing. The recent high-profile examples of following accounting standards in a way that confuses more than informs--a contributing factor to Enron's downfall was strong negative stock market reaction to perceived self-serving accounting policy choices. Manipulation dangers can be overrated. Few managers are crooked in their accounting; most are honest and anxious that their accounting be fair and truthful. Most believe that good financial reporting is important to the company's reputation and ability to borrow, raise share capital, and generally do business. Most consider good financial reporting to be part of good business and professional ethics. However, the danger of manipulation is always there, so accountants, auditors, and users who rely on financial statements for their decisions must be vigilant.
A Few Technical Points
Accounting policy choices generally do not affect cash and cash flow. 1. Cash flow. Generally, accounting policy choice does not affect cash flow. Policy choices are made by accrual accounting entries, which are intended to go beyond cash and so seldom affect cash directly. There may be indirect or eventual effects, especially through income tax. But, at the instant an accounting policy choice is implemented, there is no cash or cash flow effect except in the rare case where a cash account is involved. The cash flow statement is useful partly because its analysis helps to identify accounting policy choices that may have taken the income a little too far from cash flow. Dual effects of changes. Because the financial statements are fundamentally connected through double-entry accounting, most accounting policy changes affect both the balance sheet and the income statement. They must affect both if they are to affect net income. This is financial statement articulation. Here are some examples:
Accounting policy choices that affect income must also affect the balance sheet.
2.
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
373
Balance Sheet Accounts Temporary investments Accounts receivable Inventories Prepaid and accrued expenses Property and plant assets Intangible and leased assets Liabilities Equity
Main Income Statement Accounts Nonoperating revenue or expense Revenue, bad debts expense Cost of goods sold expense Various expense accounts Amortization expense Amortization expense Various expense accounts None*
* Transactions with owners, such as share capital issues and redemptions and dividends, are ordinarily not considered part of the measurement of income. However, there are some technicalities in which this may be violated--this book will not cover such technicalities.
Classification and disclosure choices are part of accounting policy choice.
3.
Classification and disclosure. There are accounting policy choices in three areas, besides the example of Equity accounts above, that are important even though they do not directly affect the current period's income: Classification policies (decisions about where within the balance sheet or where within the income statement to show accounts) do not affect income because they do not involve both the balance sheet and income statement, as do recognition policies, but instead affect only one statement or the other. Disclosure policies relate to what is said about the figures in the words used in the statements and in the notes to the statements. Changes in accounting policies are also disclosed, including a description of the change and a calculation of the effect the change has had on the financial statements. Many changes have to be given retroactive effect; for example, if the revenue recognition method is changed, past years' financial statements have to be recalculated to show them on the new basis. Therefore, if a company has changed its accounting policy in some area, the prior years' figures in this year's annual report may not be the same as the ones you would have seen in last year's annual report.
how's your understanding?
Here are two questions you should be able to answer based on what you have just read. If you can't answer them, it would be best to reread the material. 1. Sue Wong, an experienced investor, reacted in frustration on having difficulty comparing the financial statements of two companies she was considering investing in, because the companies had made different choices about accounting for some items. Why do enterprises make choices, and why might they be different choices? 2. The president of Burning Issues Ltd., a political polling firm, is concerned about how to account for large expenditures on developing mailing and phone lists. The question is whether these expenditures should be included in the assets of the firm or deducted as expenses. What criteria should the president use in deciding how to account for the expenditures?
NEL
374
PART T HREE
D OING F INANCIAL A CCOUNTING
6.5 The Fiscal Period
Measuring financial performance and position requires defined fiscal periods. Financial statements all have a time dimension. Balance sheets are prepared as at specific points in time, and the other three statements cover specified periods of time. Business and other economic activities go on continuously, so if the financial statements are to be at or begin and end at particular dates, financial accounting must somehow find a way to separate all those activities into fiscal periods. Accrual accounting is the method, because it is designed to incorporate economic phenomena that happen before or after the cash transactions. You could say that without the need for periodic reporting for fiscal periods, accrual accounting would be unnecessary. But how does accrual accounting separate the records and adjustments into periods? Here's an example of the problem. Quantum Inc. earns its revenue through a series of projects, done one at a time. Cash receipts for revenues happen once or twice during each project, and cash payments for expenses happen about a month after expenses are incurred. To calculate net income for, say, 2006 using accrual accounting, we can use the various categories of entries set out in Section 6.3. We can recognize revenues and expenses before or after cash inflows and outflows. But how much of these apply to 2006 rather than to other years? We need to find a way to "cut off" the accounting records of what are continuous activities, so that 2006 can be separated from 2005 and 2007. The 2006 net income is a measure of the economic value added by the projects during that year. By the matching criterion, that measure is produced by calculating the increase in resources (revenues) minus the decrease in resources (expenses), determined using comparable methods so that their difference is a meaningful income figure. Exhibit 6.4 and Figure 6.4 show Quantum's projects affecting 2006:
Accrual accounting must cut continuous business activities into fiscal periods.
E
X
H IBI
64
Project #39 Work began on the project Some cash received from the customer Disbursements for expenses began Work completed on the project Disbursements for expenses ended Remaining cash received from the customer Project #40 Work began on the project Disbursements for expenses began All cash received from the customer Work completed on the project Disbursements for expenses ended Project #41 Some cash received from the customer Work began on the project Disbursements for expenses began Work completed on the project Disbursements for expenses ended Remaining cash received from the customer
T
Receipts
Payments Nov. 05
Dec. 05 Dec. 05 Feb. 06 Mar. 06 Apr. 06 Mar. 06 Apr. 06 Sep. 06 Oct. 06 Nov. 06 Nov. 06 Nov. 06 Dec. 06 Mar. 07 Apr. 07 Apr. 07
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
375
figure 6.4
2005
Quantum's Projects
2006 #39 #40 #41 J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O N D 2007
Let's try to do this project by project. Project 40 is easiest. The project began and ended in 2006. All the receipts and payments happened in 2006, and all the revenue was earned (and collected) and expenses were incurred (and paid) in 2006. The cash basis works fine here because there is no "cut off" needed between 2006 and any other year. Project 39 is more awkward. There were two cash inflows, Dec. 2005 and Apr. 2006. The project was completed in 2006, so there is no problem at the end of 2006. The accounting problem arises at the beginning of 2006, in the transition from 2005. For the project revenues, the accounting depends on whether the cash inflows to the end of Dec. 2005 coincided with the revenue earned to that point: a. If the Dec. 2005 inflow was less than the amount of revenue earned by the end of the year, then there should be a Dec. 31, 2005, account receivable created for the rest of the revenue earned but not collected. b. If the Dec. 2005 inflow was greater than the amount of revenue earned by the end of the year, then there should be a Dec. 31, 2005, deferred revenue liability created for the unearned portion. c. If the Dec. 2005 inflow equalled the amount of revenue earned by the end of the year, then there is no problem: cash and accrual accounting coincide. For the Project 39 expenses, there are two problems. 1. 2. The expenses incurred in December would not be paid until January, so a Dec. 31, 2005, account payable should be created for those. The amount of expenses recognized in 2005 should match the revenue recognized for 2005, so that the revenue-expense difference, net income, is meaningful.
Income measurement requires that revenues and expenses be cut off in appropriate and matching ways.
Allocation of revenues and expenses to a period affects other periods too.
Project 41 has the same sort of awkwardness as Project 39, except that since it extends into 2007, it has to be cut off properly at the end of 2006, in the transition to 2007. So 2006 revenues, expenses, and resulting net income will be a combination of the part of Project 39's revenues and expenses not recognized in 2005, all of Project 40's revenues and expenses, and the part of Project 41's revenues and expenses recognized in 2006. You can see that both the cut off at the end of 2005 and the one at the end of 2006 have to be appropriate if the 2006 revenues, expenses, and net income are to be fair. Because of this, the 2006 results involve estimates on Projects 39 and 41 that also affect the fairness of the results for 2005 and 2007. The revenues and expenses for those projects have to be properly allocated among the years they involve, and the results for all those years will be affected by the quality of the allocations. Lots of work for accountants!
NEL
376
Making appropriate revenue and expense cut offs can be a difficult task.
PART T HREE
D OING F INANCIAL A CCOUNTING
Making effective cut offs for revenues and expenses is a major task for accrual accounting. Much effort is put into determining whether revenues are placed in the appropriate years, whether there are bills outstanding for expenses that should be taken into account, whether inventories of goods and supplies are actually on hand, and so on. Generally, the larger and less frequent an enterprise's revenue and expense transactions are, the harder it is to do this, and for enterprises that have many short and simple transactions, the easier it gets. But even there it can be difficult if there are thousands of transactions in process across a year-end.
Choice of Fiscal Period
Most companies have a December 31 fiscal year-end, but many other dates are used too. When should the fiscal (accounting) year begin and end? Companies have an initial choice, but once they make it, reasons of habit and legal and tax rules usually force them to stay with that choice indefinitely. They may select a fiscal year-end that is a relatively quiet time, so that there aren't many unfinished transactions in process and the revenue and expense cut offs can be made more cleanly. However, in practice, most companies select December 31 as their fiscal year-end. In Chapters 69 of this book, frequent references will be made to statistics about Canadian companies included in Financial Reporting in Canada 2005, the 30th edition of a survey of company annual reports published by CICA. The sample of 200 companies is taken from the Toronto Stock Exchange, and it changes every edition as companies start up, merge, and go out of business. The publication includes not only statistics, but also many examples of how these companies did their accounting and wrote their footnote disclosures. For example, the samples of 200 companies included 126 December 31 year-ends in 2001, 124 in 2002 and 133 in 2003 and 2004. The popularity of 8 December 31 declined slightly in the companies sampled. Every other month-end was represented in the sample, and sometimes a date other than a month-end was used (such as 52 or 53 week fiscal periods). Though history, tradition, and income tax reasons make December 31 the majority choice, the minority, still a substantial number, choosing other fiscal periods has many reasons for other dates, including a better fit with the company's "natural" business year (some food companies choose dates just before or after the harvest season, and some retailers prefer dates other than December 31 because they like to avoid the hectic Christmas season), but choosing other dates may just be traditional too. "Regardless of the reasons for odd fiscal years, this much is certain for many firms. The business calendar quickly becomes engraved in stone. Procter & Gamble, for example, closes its books at the end of June. 9 No one remembers why. Is a change likely? Not on your life."
how's your understanding?
Here are two questions you should be able to answer based on what you have just read. If you can't answer them, it would be best to reread the material. 1. Why is the fiscal period an important issue in financial accounting? 2. Sheaf Farm Products Ltd. is considering changing its accounting policy for revenue recognition, to match the revenue better to expenses. It is now 2006. The policy being considered would increase revenue in 2006 by $53,200. Accounts receivable at the end of 2005 would increase by $38,900 and at the end of 2006 would increase by $92,100, the difference being the $53,200 revenue effect in 2006. If the policy change were made, how much revenue would be moved from 2006 to 2005, and how much from 2007 to 2006?
Revenue changes: $38,900 moved from 2006 to 2005; $92,100 moved from 2007 to 2006.
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
377
6.6 Revenue Recognition
Accuracy Versus Decision Relevance
Income for the life of the enterprise can be determined from cash flows, without accruals. Income over the life of an enterprise is based on cash flows. At the end of the enterprise's life, all expenses have resulted in cash outflows and all the revenue earned has resulted in cash inflows. There is no need for accrual accounting, or for estimates of any kind; the results are known with certainty. Income over the life of the enterprise is simply the sum of the cash on hand at the end plus any cash withdrawn by the owners over the enterprise's life (such as dividends), minus any cash contributed by the owners over that time (such as share capital). Decision makers want information about performance earlier than at the end of the enterprise's life. It is difficult, though, to cut the essentially continuous operations of a company into discrete time periods. Income determined before the end of the company's life, so that it is relevant for evaluating the enterprise's performance over shorter decision periods, is unavoidably subject to estimates and judgments because the whole story is never known until the end. This takes us back to the ever-present tradeoff between reliability and relevance in income measurement, illustrated in Section 5.3 as relevance versus reliability of estimates, and mentioned in Section 6.2 also. If revenues and expenses are recognized earlier, so that they are more relevant for decision making, then they will not be as reliable (accurately measured) as they would be if recognition were delayed until later, when outcomes of the various economic activities are better known. Because the tradeoff is very important to accrual accounting, Figure 6.5 illustrates it again, now relating it to when phenomena are recognized in the accounts.
Decision making cannot wait until the firm's life ends, so we have accrual accounting.
Critical Event Simplification
If we are to describe the firm's operations for a given period by calculating the income for that period, we must define a means by which to measure the amount of income that can be attributed to that period. We accomplish this by defining how much revenue can be recognized in that period; and, then matching to that revenue the expenses which were incurred to generate the revenue.
figure 6.5
Relevance Amount of relevance or reliability Reliability
Time when recognized in accounts Early Late
NEL
378
Income is the result of revenue recognition matched by expense recognition.
PART T HREE
D OING F INANCIAL A CCOUNTING
Income, the value added by the activities of the firm, is just the difference between the recognized revenue and the recognized expenses. Revenue recognition is important because, by the matching criterion, expense recognition and therefore income measurement should correspond with the revenue. This can get rather messy in practice, as you might imagine. For example, some expenses, often called period expenses, are only indirectly related to revenue, being incurred as time passes (interest is an example). Others, often called discretionary expenses, arise more haphazardly or as other business decisions are made by management (such as donations, research and development, or maintenance). But for simplicity, let's assume that revenue recognition is the primary driver of income measurement. What are the revenues, or the expenses, for a period? From an economic and business point of view, income is earned by a wide variety of actions taken by the enterprise. There is a whole sequence of activities intended to help generate income, which therefore generate revenue and incur expenses, including, for example: 1 2. 3. 4. 5. Organizing the firm in the first place Building the factory Buying or making inventory Advertising Selling 6. 7. 8. 9. Delivering to a customer Billing Collecting cash Providing warranty service
How should we recognize revenue when there is such a series of activities as those listed above? Recognizing it a bit at a time as each activity is carried out would approximate the economic process underlying the business. This would be relevant, all right, but by the same token it would be very subjective and imprecise, because it is difficult to say what each activity actually adds. How do you tell, when the company is just being organized, what revenue that form of organization will help to generate, for example? It would also be expensive to implement, with armies of accountants scurrying about measuring the small value change generated by each of the various activities and writing masses of journal entries to recognize each value change. The upward-sloping solid line in Figure 6.6 illustrates the presumed increase in value generated by the sorts of activities listed above.
figure 6.6
Presumed Value Generated over a Series of Activities
Value (income) generated over time
Presumed real growth in value Value increase recognized through a single critical event
Activities
Start Acquire business inventory
Market & sell
Deliver goods
Bill Collect customer money
Provide warranty
Time
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
379
Recognizing revenue at a single critical event is practical, but theoretically awkward.
Delivery of goods or services is the most common critical event for recognizing revenue.
Instead, for greater objectivity and verifiability and less accounting cost, accountants usually choose one activity in the sequence of value-producing activities above as the critical event in the revenue generation sequence that can be readily documented, and recognize all of the revenue at that point. This is a simplification, because clearly some revenue could have been recognized when earlier activities were carried out, and probably some should be recognized when later activities take place. In theory, revenue is under-recognized prior to that point and over-recognized after it. Figure 6.6 also illustrates this. The critical event is designated by the vertical dotted line at the end of the delivery activity. Income earned prior to this event is not recognized by the accounting system, so the value produced by the activities to the left of it is not recognized until, all at once, 100% of the value is recognized. Until the rest of the activities are completed, the result (to the right of the dotted line) is over-recognition of the value because there are still things to be done. Using the critical event simplification is an accounting policy choice, a fairly obvious and practical one made by most companies, but still a choice. The most common critical event used is the point of completing delivery of the goods or services to the customer. To recognize the earning of revenue when that event has taken place, we make a recognition entry to record the asset (or liability reduction) obtained for the revenue:
DR Accounts receivable, or Cash, or Deferred revenue liability CR Revenue
XXXX XXXX
For some companies, such as those building big projects like power stations or pipelines, or project-based companies such as Quantum Inc. in Section 6.5, it is worthwhile and fair to make a different accounting policy choice: to estimate revenue at several points along the sequence illustrated in Figure 6.6. That means chopping the amount of revenue up into pieces and recording each piece with an entry like the one above, instead of all at once. Later, we'll see examples of how to recognize revenue, and therefore income, in smaller steps that more closely fit the continuously increasing value. However, most companies use the practical simplification of the critical event.
Criteria for Revenue Recognition
Revenue recognition, then, is the usual first step in Revenue Recognition Criteria determining income for the period. The revenue All four should be met: recognition criteria discussed here have been 1. Goods/services provided formulated for the purpose of making sure 2. Related costs known that revenue will be recognized only when 3. Revenue measurable there is objective evidence that revenue has 4. Revenue receipt promised indeed been earned. This is an attempt to ensure that the result is reliable. The following four criteria must normally all be met in order that revenue may be recognized. For most enterprises, the activity nearest to fitting these criteria is chosen as the critical event, and for most of them that is delivery. However, as we'll see, there are exceptions (as usual!). These four criteria must normally all be met before revenue is recognized. 1. 2. 3. All or substantially all of the goods or services to be provided to customers have been provided or performed (the "delivery" criterion mentioned above). Most of the costs to generate the revenue have been incurred, and those remaining can be measured with reasonable accuracy. The amount of the revenue can be reasonably measured in dollar terms (for example, if some customers are likely to return goods for a refund, such returns can be reasonably estimated).
NEL
380
PART T HREE
D OING F INANCIAL A CCOUNTING
4.
Cash, a promise of cash (a receivable), or another asset that can be measured with reasonable precision has been received.
Although the above criteria seem fairly clear, there are still many judgments to be made about when the criteria are met. For instance, how should the "delivery" criterion be defined? Is it when 100% of the services have been performed? 90%? 80%? People must use their heads and exercise good judgment. In the vignette at the beginning of this chapter, the company was not following good practice, because it recognized revenue when an order was received, not waiting for delivery.
how's your understanding?
Here are two questions you should be able to answer based on what you have just read. If you can't answer them, it would be best to reread the material. 1. Why is the "critical event" a simplification and why is it used anyway? 2. Suppose Friendly Construction earned $1,000,000 revenue from a building contract, progressively, as follows: 10% when the contract was signed, 20% when the foundation was finished, 40% when the building exterior was finished, 20% when the interior was finished, and 10% after the owner had moved in and final adjustments and corrections were made. The company's expenses on the contract were $850,000, incurred according to the same progression as the revenue. If delivery were used as the critical event, how much revenue, expense, and net income would be recognized at that point, and how much would really have been earned/incurred then?
100% of revenue, expense, and income would be recognized: $1,000,000; $850,000; $150,000. Assuming delivery was when the owner moved in, only 90% of all the above would really have been earned/incurred: $900,000 revenue earned, $765,000 expenses incurred, $135,000 income earned. Using a single critical event would have understated income until that event and then overstated it after the event.
6.7 Revenue Recognition Methods
Look again at the journal entry to recognize revenue shown just above the revenue recognition criteria in Section 6.6. With this entry in mind, let's take a closer look at five commonly used methods of revenue recognition.
Revenue recognition: DR Receivables, Cash or other balance sheet account, CR Revenue, on the income statement
1. At Delivery (Point of Sale or Shipment)
Point of delivery usually meets the revenue recognition criteria given in Section 6.6. For most retail, service, and manufacturing businesses, revenue is recognized when the product or service is sold. "Sold" is usually defined as being when the goods or services have been delivered, or at least shipped to the purchaser, when legal title passes to the purchaser. It's a single critical event. At that point substantially all of the service has been performed, terms and price have been set, and cash has either been received, or is reasonably certain to be received. Even though there is some risk involved in extending credit, this can usually be adequately estimated and adjusted for by creating an allowance for doubtful accounts receivable and a corresponding bad debts expense. More about this is in Chapter 7. Another risk at the point of sale is the possibility of returns and the likely service obligation under the warranties for the product or service sold. These can usually be
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
381
adequately estimated and recognized as an expense of the business and matched against the revenue of that period. Delivery (point of sale) is so common a revenue recognition method that most companies do not mention in their financial statements that they are using it. You are expected to assume it is the one being used if you are not told otherwise. In accordance with this, you should be told if one of the other methods below is being used. CPR's year 2004 annual report has a revenue recognition policy note stating: "Railway freight revenues are recognized based on the percentage of completed service method. Other revenue is 10 recognized as service is performed or contractual obligations are met." (More about CPR's method is under heading 2 below.) Here are two other examples: From Canadian Tire's 2004 annual report: "The Corporation's shipments of merchandise to Associate Dealers (retail store owner-operators) are recorded as revenue when delivered. Revenue on the sale of petroleum products is recorded 11 upon sale to the consumer." From the Bombardier Inc. 200405 annual report: "Revenues from the sale of commercial aircraft and narrow-body business aircraft (Learjet) are recognized 12 upon final delivery of products and presented in manufacturing revenues."
2. During Production
Recognizing revenue only once for multiperiod projects distorts income in all periods. Sometimes the earnings process extends well beyond one fiscal period, as is the case in building construction, road building, shipbuilding, and other lengthy processes. In such situations, if a company waited until the point of delivery to recognize revenue, it might report no revenue for one or more years, and then, when the project was complete, would report all the revenue. This would distort the performance picture for the duration of the project: some years with no revenue, then one year with huge revenue, even though the company was working faithfully on the contract all along. The "How's Your Understanding?" item above illustrated this. In the case of construction and similar operations, there are not likely many projects going on at once (few, anyway, in comparison to the number of hamburgers making up a burger bar's revenue), and these projects include enough documentation that the value added can usually be estimated and verified. Therefore, in an attempt to provide users with relevant information and reflect the economics of what is happening, revenue may be recognized during production. (With matching, this also means recognizing expenses and therefore income during production.) A typical description of this is from the 2004 annual report of Aecon Group Inc., Canada's largest public construction and infrastructure development company: "Revenue and income from fixed price construction contracts, including contracts in which the Company participates through joint ventures, are determined on the percentage of completion 13 method, based on the ratio of costs incurred to date over estimated total costs." We saw above that CPR uses the "percentage of completed services method" to recognize its main kind of revenues, railway freight revenues. This early-recognition approach is applied in a conservative way: if a project looks as if it will make money (project revenues greater than expenses), a portion of that income is recognized in the period in which the portion seems to have been earned, but if a project looks as if it will lose money (project revenues less than expenses), the whole anticipated loss is recognized right away. Percentage of completion, mentioned by Aecon Group and CPR, is the most common method of recognizing revenue during production. This method entails determining what proportion of the project, or in CPR's case, promised freight shipments, has been completed during the year and recognizing that proportion of total expected revenue, expenses (costs), and, therefore, income, as was done in the "How's Your
Recognizing revenue during production is fair if applied conservatively.
Recognizing revenue during production requires a great deal of judgment.
NEL
382
PART T HREE
D OING F INANCIAL A CCOUNTING
Understanding?" item above. Often, this is done by measuring the proportion of expected total costs incurred during the period (Aecon Group's method). It may also be done by using physical estimates of completion, shipping records (for CPR), architects' estimates of project completion, and similar methods using evidence other than the proportion of total estimated costs spent so far. In order to recognize revenue using percentage of completion, the contract price (total revenue) must be reasonably certain, total costs must be reasonably determinable, and there must be reasonable assurance of payment. The frequent use of the word "reasonable" here shows that a lot of judgment is required in using this method!
Example of Percentage of Completion Method
Percentage of completion spreads revenues and income out over several fiscal periods. Let's assume Greenway Construction had a large, three-year project with total revenue of $4,000,000 and total costs of $3,400,000. (Prior to expense recognition, project costs are charged to an inventory account for costs of construction in process. Like other inventories, this account holds costs until they are matched to revenues.) Total estimated income for the project over the three years was therefore $600,000. The project was 20% completed at the end of the first year, 65% completed at the end of the second year, and 100% completed at the end of the third year. Ignoring complications that arise when revenues and costs do not work out as expected, Exhibit 6.5 shows journal entries to implement percentage of completion revenue (and matched expense) recognition during production. (All amounts are in thousands of dollars.)
E
X
H IBI
65
Percentage of contract done in the year Revenue recognition: DR Accounts receivable CR Revenue Percentage earned each year. Expense recognition: DR Cost of goods sold expense CR Construction in process inventory Percentage matched to revenue. Resulting income each year
This method defers all revenue and income until the end of the process.
T
Year 1
Year 2
Year 3
20% 800 800 1,800
45% 1,400 1,800
35%
1,400
680 680
1,530 1,530
1,190 1,190
$120
$270
$210
You can see the timing effect of accrual accounting here. The annual entries have the effect of spreading the $600,000 project income out over the three years: 20% to the first year, 45% to the second, 35% to the third.
3. Completion of Production
In the percentage of completion method, revenue is recognized as the work proceeds. But it is also possible to wait until the work is all done and recognize the revenue then. Waiting until the end is like the point-of-sale method, except if the work takes a long time, perhaps several accounting periods, then it is very conservative because no revenue would be recognized for a long time, then all of it at once. The distortion mentioned
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
383
above would be implemented deliberately, because it is believed that no revenue or income can be said to be earned until everything is done, even if that takes a long time. It would be like not getting any grades for your years of courses until the last day of the last class, when you'd get all the grades at once and find out if your four years had been a success or a failure.
Example of Completion of Production Method
In the Greenway Construction example above, if revenue and the associated expenses were recognized on the completion of production, the project income would be: This method differs greatly from the more economically appropriate percentage of completion method. $0 in Year 1; $0 in Year 2; and $600,000 in Year 3.
Compared to the percentage of completion method, income would be: $120,000 lower in Year 1; $270,000 lower in Year 2; and $390,000 higher in Year 3.
If there is no customer yet, even the completed contract method is likely inappropriate.
So if Greenway wanted to know "what if" it changed to the completion of production (or completed contract) method, there's the answer, ignoring income tax. If there is no customer yet, but the production is done, is that a legitimate time to recognize revenue? That is appropriate only under very limited circumstances, such as when there are ready or guaranteed markets for the product, stable prices, and minimal marketing costs. It would not be appropriate for a construction company building houses in standard styles and selling them later. Revenue recognition should wait until the sale happens, so that the criteria listed in Section 6.6 are met. Historically, revenue from gold mines was recognized at the point of completion of production; producers could expect to sell all they produced since there was a world price for gold and Western governments provided a ready market. This is no longer the case for all gold mines, and today almost the only time revenue is recognized at time of completion when there is no customer yet is in agricultural concerns that produce within government quotas.
4. When Cash Is Received
Waiting for the cash to recognize revenue is an exception, not the rule. If there is serious doubt as to the collectibility of cash from a revenue-generating transaction, revenue recognition is delayed until the collection has taken place. This does not mean that revenue recognition is delayed every time a business extends credit to a customer. In the vast majority of cases, revenue is recognized before the cash is received. Most businesses have accounts receivable, which are recognized but uncollected revenue. Revenue recognition is only delayed when the risk is great and the amount collectible cannot be reasonably determined, or is not sufficiently predictable. Delay is proper until the revenue recognition criteria have been met.
Examples of Revenue Recognition on a Cash Received Basis
Particular business circumstances may require cash basis revenue recognition. An example of waiting for the cash is in the case of certain real estate transactions that are speculative in nature and/or for which the collection of cash is contingent upon some future condition (such as the purchasers of a shopping mall successfully leasing a certain percentage of the space). Another example of revenue recognition at time of collection is the "Installment sales" method. When the majority of the revenue will come in over a long series of installments, and there is substantial uncertainty that a given customer will actually make all the payments, the revenue is recognized in stages as the cash comes in. The Installment sales method has some complexities, but in principle it is just a way of recognizing revenue on a cash received basis.
NEL
384
PART T HREE
D OING F INANCIAL A CCOUNTING
A final example is that many businesses do not extend credit to their customers, but deal only on a cash basis. Fast-food restaurants, coffee shops, some movie theatres, and numerous other "cash only" businesses recognize revenue on a cash basis because that is the only basis they have. (By the way, if customers pay with credit cards, those payments are normally treated as cash. If there is any receivable, it is a bulk one with the credit card company related to delays in processing the credit card slips, not resulting from extending credit to individual customers.)
5. At Some Point After Cash Has Been Received
Circumstances may require delaying revenue recognition past when cash is received. Revenue recognition methods 1, 2, and 3 use accrual accounting, while method 4 essentially uses the cash basis for recognizing revenue. It is also possible to defer recognition for some time after the cash has been collected. Even though cash has been received, all revenue may not be recognized immediately because of some circumstance, such as a guaranteed deposit refund policy or a policy of "satisfaction guaranteed or money back." Here's how this method works: 1. A current liability account (Deferred revenue) is credited when the cash is collected:
DR Cash CR Deferred revenue or Deposits received liability
2.
Revenue will be recognized at a point in the future, normally after the refund time has expired or the required after-delivery service has been performed:
DR Deferred revenue or Deposits received liability CR Revenue
Customer deposits are not revenue until the goods or services are delivered.
(We saw this pair of entries in the conceptual discussion in Section 6.3.) Deferring revenue recognition to a point after cash has been received is standard practice if, for some reason, a customer has paid in advance. Examples are magazine subscriptions or fitness club memberships, which are prepayments by the customers for service to be received later. This is a very conservative method, but that is really not the reason it is used. It is used because until the services or goods have been delivered, the revenue and therefore the income have not yet been earned. The revenue recognition criteria have not been met. Fairness requires waiting until they have been met.
how's your understanding?
Here are two questions you should be able to answer based on what you have just read. If you can't answer them, it would be best to reread the material. 1. What circumstances make each of the five revenue recognition methods appropriate? 2. During the year, Smokey Inc. completed and billed projects having total revenue of $150,000, one of which had a $10,000 "return if not satisfied" promise. At the end of the year, one more project with revenue of $14,000 was complete but it had not been billed because the client had not yet taken possession of the goods. At the end of the year, further projects with eventual revenue of $45,000 were 60% complete. Cash of $150,000 had been collected on the billed projects, $10,000 on the completed but undelivered project, and $20,000 on the incomplete ones. What would be the revenue for the year on each of the five methods in this section?
1. Delivery: $150,000; 2. Percentage completion: $191,000 ($150,000 + $14,000 + 0.60 $45,000); 3. Completion of production: $164,000 ($150,000 + $14,000); 4. Cash received: $180,000 ($150,000 + $10,000 + $20,000) or just a conservative $132,000; 5. After cash was received: $140,000 ($150,000 $10,000). This is quite a variety of revenue figures, and more combinations of the given data could be imagined!
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
385
6.8 Expense Recognition and Matching
Usually, expenses incurred in a period are assumed to match revenues for that period. According to the "matching" criterion, expense recognition should be timed to match the revenue recognition method. The basic idea is that expense accounts should be debited in parallel to the crediting of revenue accounts. In practice, this is done quite routinely for most expenses. When expenses such as wages, interest, heat, property taxes, or advertising are incurred, they are recognized as expenses on the assumption that they were incurred to help earn revenues in the same period. Sometimes this assumption is a bit strained; for example, advertising may stimulate revenue over more than the current period, but the subjectivity of estimating multi-period effects and the simplicity of just expensing such costs when incurred lead most companies to just expense them, matching them to current revenues. There are cases, however, when the accounting has to be more refined. We saw expense matching to the revenue recognized during production in the Greenway Construction example above. Just to help you see the potential accrual accounting offers for fine-tuning revenue and expense recognition, here's another example, from the diverse field of franchising. WonderBurgers Ltd. is a franchiser, which means it sells the right to sell its products in particular geographic areas. For example, a franchisee might pay $25,000 for the right to set up a WonderBurgers fast-food restaurant in Sudbury, and no one else would be able to use the WonderBurgers brand name and other features, such as its recipes, in Sudbury. Revenue from selling franchises is recognized over time, like construction revenue. Let's suppose that the management of WonderBurgers estimates that it takes three years for a franchise to become viable and knows that during that time it will have to provide a lot of help. Suppose the sort of schedule of cash flows and economic activity that WonderBurgers has experienced for a typical $25,000 franchise fee is much like the one shown in Exhibit 6.6 below. The "percent-of-fee-earned" amounts could have been determined by how much revenue was collected or how much support cost was spent, but because of the kinds of effort the company and its franchisees go through in getting a franchise going, management has worked out a general policy of recognizing 40% of the revenue in the first year of a franchise and 30% in each of the next two years. (It's a lot like the percentage of completion method we saw above, which is no accident. Franchise accounting is a form of the percentage of completion method.)
A franchisee buys the right to use the franchiser's brand, etc., under specified conditions.
E
X
H IBI
66
Year 1 2 3
T
Cash Paid by Franchisee $15,000 5,000 5,000 $25,000
Cash Cost to Help Franchisee $4,000 3,000 1,000 $8,000
Percent of Fee Earned 40% 30% 30% 100%
Using management's estimates of percent of fee earned as the basis of revenue recognition, the revenue recognized from the typical franchise sale would be Year 1, $10,000 (40%); and Years 2 and 3, $7,500 each (30% each).
NEL
386
Expenses related to the franchise are recognized so as to match the revenue. Expense matching produces income that follows the same pattern as revenue.
PART T HREE
D OING F INANCIAL A CCOUNTING
According to the matching criterion, the expense of helping the franchisee should be recognized on the same schedule, so the expense recognized would be Year 1, $3,200 (40%); and Years 2 and 3, $2,400 each (30% each).
This matching process means that the income from the contract follows the same pattern. The total expected income is $17,000 ($25,000 minus $8,000), and the matching process produces an income pattern of Year 1, $6,800 (40% of $17,000, which is $10,000 revenue recognized minus $3,200 expense recognized); and Years 2 and 3, $5,100 (30% of $17,000 each, which is $7,500 revenue minus $2,400 expense).
The resulting income schedule and differences between the accrual basis (percentage of completion) and cash basis income are in Exhibit 6.7 below.
X
H IBI
T
E
67
Accrual Basis Income (a) Revenue $10,000 7,500 7,500 $25,000 (b) Expense $3,200 2,400 2,400 $8,000 (c) Income $ 6,800 5,100 5,100 $17,000 Difference Year 1 2 3 (a)(d) $(5,000) 2,500 2,500 0 (b)(e) $ (800) (600) 1,400 0
Cash Basis Income (d) Received $15,000 5,000 5,000 $25,000 (e) Spent $4,000 3,000 1,000 $8,000 (f) Income $11,000 2,000 4,000 $17,000
Year 1 2 3
(c)(f) $(4,200) 3,100 1,100 0
The accrual and cash bases eventually produce the same total income, by different routes.
You can see the point again about accrual accounting being a matter of timing. Both the accrual and the cash basis get to the same point, $17,000 income over the three years, but they take different routes to get there. In Year 1, the accrual income is $4,200 less than the net cash inflow of $11,000, but in Years 2 and 3, the accrual income is greater than the net cash inflows. The cash flow statement's Operations section reconciles accrual income to cash flow. To refresh your knowledge of the cash flow statement and show how the accrual and cash bases reconcile, the Operations section of WonderBurgers Ltd.'s cash flow statements would show the following (ignoring tax and other complications):
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
387
$ 6,800 5,000 (800) $11,000 $ 5,100 (2,500) (600) $ 2,000 $ 5,100 (2,500) 1,400 $ 4,000
Year 1
Accrual income Add increase in deferred revenue ($15,000 collected minus $10,000 recognized as revenue) Deduct increase in prepaid expense ($4,000 spent minus $3,200 recognized as expense) Cash from operations (cash income) Accrual income Deduct decrease in deferred revenue ($5,000 collected minus $7,500 recognized as revenue) Deduct increase in prepaid expense ($3,000 spent minus $2,400 recognized as expense) Cash from operations (cash income) Accrual income Deduct decrease in deferred revenue ($5,000 collected minus $7,500 recognized as revenue) Add decrease in prepaid expense ($1,000 spent minus $2,400 recognized as expense) Cash from operations (cash income)
Year 2
Year 3
If you look back to the Difference section of Exhibit 6.7 above, you will see that the cash flow statement's adjusting items are those same differences. All methods of managing the accounts, so that the accrual income can be different from the cash flow, involve creating balance sheet accounts to hold the differences until they disappear. Accounts for doing this have names like accounts receivable, inventory, contract work in process, deferred revenue liability, and accounts payable. The details of their workings are often complicated, and each company has its own system.
FYI
ccrual accounting's purpose is to move beyond cash flows toward a broader economic concept of earnings and financial position. From a manager's point of view, this has several implications: As a more inclusive way of measuring performance and position, accrual accounting reflects more of what a manager is trying to do than cash flow can. This should make accrual accounting attractive to managers who want to be evaluated fairly and who are interested in comparing their companies to others. Financial accounting reports the results of actions, not the reasons for them (except by implication). Managers may therefore feel that the accounting statements are incomplete because they miss the "why" behind the revenues, expenses, assets, and liabilities. To many people, earnings should be defined as changes in the market value of the company. Managers may be compensated using market-value mechanisms like bonuses and stock options. The evidence-based accounting procedures for revenue recognition, expense recognition, and matching them to measure income may not
A
relate very well to managers' efforts to increase the market value of their companies. Accrual accounting's procedures require evidence to support entries and conservatism in estimating the effects of future events (provide for expected losses, but not for expected gains until they occur). To managers seeking an even-handed evaluation of their performance, accounting may seem overly skeptical about the future and downwardly biased in its measures. Managers may wish that accrual accounting recognized their optimism about the future more than it does. The criteria as to when and how to recognize revenues and expenses are inescapably judgmental and, therefore, to many managers' tastes, are both arbitrary and subjective. Many managers find accrual accounting too loose and flexible and would prefer less estimation and subjectivity. Managers should take financial accounting seriously so that they can know when the accounting measures seem appropriate and when they do not. Accrual accounting has many advantages and is very widely used, but managers should not accept it uncritically.
NEL
388
PART T HREE
D OING F INANCIAL A CCOUNTING
how's your understanding?
Here are two questions you should be able to answer based on what you have just read. If you can't answer them, it would be best to reread the material. 1. Why is matching revenues and expenses important? 2. Suppose everything was the same in the WonderBurgers example except that the percentages of fees earned and expenses incurred over the three years were determined by how much revenue was collected or how much support cost was spent. Calculate the following for both methods: accrual income for Years 1, 2, 3, and total; difference from cash basis income for Years 1, 2, 3, and total.
Based on revenue collected Year 1 Accrual incomes (60%, 20%, 20% of $17,000) Cash incomes (as before) Differences Based on support cost spent Year 1 Accrual incomes (50%, 37.5%, 12.5% of $17,000) Cash incomes (as before) Differences $ 8,500 11,000 $ (2,500) Year 2 $ 6,375 2,000 $ 4,375 Year 3 $ 2,125 4,000 $(1,875) Total $17,000 17,000 $ 0 $10,200 11,000 $ (800) Year 2 $3,400 2,000 $1,400 Year 3 $ 3,400 4,000 $ (600) Total $17,000 17,000 $ 0
6.9 Demonstration Problem: Revenue and Expense Recognition
Nakiska Fabricating Inc. produces large pressure vessels, pipeline pumping stations, and related equipment for the oil and gas industry. Its products are all made to order and can cost its customers millions of dollars. The company keeps its accounts on a project basis, grouping a set of items ordered by one customer and due at a similar time into a single project account. For each project, there are extensive initial design costs, then the costs of producing the items ordered, then large delivery costs (delivering its largest vessels involves closing highways, paying for police escorts, cutting overhead electrical wires, etc.), and finally significant on-site service costs to make sure the items are installed properly and work to specifications. A major project can therefore take several years from the receipt of the order to the end of the on-site service, and to maintain its reputation and learn from any mistakes, Nakiska always responds to customer complaints even if they arise years later. All contracts specify payment to Nakiska of 25% of the contract price when project work begins, upon 60% delivery, and 15% when onsite service is finished. The company's fiscal year-end is April 30. Here is information about the company's recent projects (ignoring income taxes and nonproject revenues and expenses). "Costs" are those incurred to the date given.
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
389
Projects
N38 Order received Project work begun Project delivered to site On-site service finished Contract price (millions) Costs to Apr 30, 2006 Costs to Apr 30, 2007 Costs to Apr 30, 2008 May 05 Jun 05 Mar 06 May 06 $3.2 2.5 2.6 2.7
N39 Sep 05 Nov 05 May 06 Jun 06 $1.9 1.2 1.6 1.6
N40 Oct 05 Dec 05 Aug 06 Oct 06 $5.4 2.1 4.8 4.8
N41 Mar 06 May 06 Oct 06 Jul 07 $4.5 0.0 4.6 4.9
N42 Jul 06 Sep 06 May 07 Jul 07 $2.3 0.0 1.7 2.0
N43 Dec 06 Feb 07 Oct 07 Apr 08 $4.2 0.0 0.7 3.5
1.
2.
Assuming the future costs are known or can be estimated, and that customers pay on time, calculate the company's project income for the year ended April 30, 2004, on the a. delivery basis; b. percentage of completion basis; c. finishing of on-site service basis; d. cash received basis. After attending an accounting workshop at which prudent accounting was emphasized, Nakiska's project accountant wondered if the company should postpone revenue and expense recognition until all possible customer complaints had been dealt with. Contracts N38 and N41, for example, had continued to cost the company money after the on-site service had been completed. Address the accountant's concern.
Answers: 1. Project incomes for year ended April 30, 2007 (in millions): a. Delivery basis:
N38 N39 N40 N41 N42 N43 All in previous year 100% because delivered during year ($1.9 $1.6) 100% because delivered during year ($5.4 $4.8) Anticipate the eventual loss ($4.5 $4.9) Not delivered during year Not delivered during year Total project income for the year $0.0 0.3 0.6 (0.4) 0.0 0.0 $0.5
b. Percentage of completion basis:
N38 N39 N40 N41 N42 N43 ($2.6 $2.5)/$2.7 ($3.2 $2.7) ($1.6 $1.2)/$1.6 ($1.9 $1.6) ($4.8 $2.1)/$4.8 ($5.4 $4.8) Anticipate the eventual loss ($4.5 $4.9) ($1.7 $0.0)/$2.0 ($2.3 $2.0) ($0.7 $0.0)/$3.5 ($4.2 $3.5) Total project income for the year $0.0185 0.075 0.3375 (0.4) 0.255 0.14 $0.426
c.
Finishing of on-site service basis:
N38 N39 N40 N41 N42 N43 100% because completed during year ($3.2 $2.7) 100% because completed during year ($1.9 $1.6) 100% because completed during year ($5.4 $4.8) Anticipate the eventual loss ($4.5 $4.9) Not completed during year Not completed during year Total project income for the year $0.5 0.3 0.6 (0.4) 0.0 0.0 $1.0
NEL
390
PART T HREE
D OING F INANCIAL A CCOUNTING
d. Cash received basis:
N38 N39 N40 N41 N42 N43 15% of contract price received: 15% x ($3.2 $2.7) 75% of contract price received: 75% x ($1.9 $1.6) 75% of contract price received: 75% x ($5.4 $4.8) Anticipate the eventual loss ($4.5 $4.9) 25% of contract price received: 25% x ($2.3 $2.0) 25% of contract price received: 25% x ($4.2 $3.5) Total project income for the year $0.075 0.225 0.45 (0.4) 0.075 0.175 $0.6
Note that these incomes differ because of the facts of the situations. The four bases do not necessarily line up in any particular order in any particular year.
(2) Postponing all recognition of revenues and expenses (and therefore income) until all possible complaints have been dealt with is unnecessarily conservative. As long as the company has carried out the terms of the contract and can estimate possible future "warranty" costs, the revenue recognition criteria have been met and project revenues and expenses, including a provision for estimated warranty costs, should be recognized and used to calculate project incomes. Postponing the whole because of uncertainty about a small part would seriously under-report the company's earnings.
how's your understanding?
Here are two questions you should be able to answer based on what you have just read. If you can't answer them, it would be best to reread the material. 1. Generally, under which of the four recognition bases shown above would income be affected by (a) a delay in the project work that delayed delivery but not completion of on-site service, or (b) a delay in payments by customers? 2. Which basis would show the highest accumulated income to any date (say April 30, 2004) for Nakiska, and which would show the lowest accumulated income?
(a) Income would be affected under the delivery basis if delivery is delayed, and probably under the percentage of completion basis because it uses the proportion of costs incurred to any point. (b) Income would be affected only under the cash received basis.
The highest accumulated income in this example would be shown by the delivery basis, because the other three all postpone some revenue and expense recognition past the delivery date. The lowest accumulated income in this example would be shown by the percentage of completion basis, because some costs continue to be incurred past the finishing of on-site service (which is also the date of the last customer payment) and so percentage of completion would postpone some revenues and income past that date.
6.10 Prepaid and Accrued Expenses
Prepaid and accrued expenses serve to line expense recognition up with the fiscal period. This section is about a very common use of accrual accounting: to line up expenses such as insurance, interest, rent, and property taxes with the fiscal period to which they apply, whether or not they were paid for before, during, or after that period. The ideas in this section apply most usually to current assets and liabilities, adjusting for fairly short-term differences between the expense and the cash payment, but they can also apply to longer-term deferred assets and liability accruals. Prepaid and accrued expenses result from two factors (which we saw in the conceptual discussion in Sections 6.2 and 6.3):
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
391
1. 2.
Matching expense recognition to the fiscal period over which the expense is incurred (and during which revenue is recognized); and Cash flow for paying the expense not coinciding with the expense recognition.
Only two journal entries are needed to implement the two factors: 1. Expense recognition: An annual or more usually monthly adjustment to the accounts to create an expense account and recognize that either a prepaid asset has been consumed or an accrued liability has been incurred:
DR Some expense account CR Some balance sheet account (prepaid expense or accrued liability)
2.
Cash payment: Recorded whenever the payment is made for the expense:
DR The balance sheet account (prepaid expense or accrued liability) CR Cash
Prepaid Expenses Asset
Prepaid expenses arise when expenses are paid prior to the period to which the expenses apply. Prepaid expenses are assets that arise because expenditures have been made, but there is still value extending into the future, so that the expenditure isn't all an expense yet. They are usually classified as current assets because the future value usually continues only into the next year. But sometimes the value extends beyond a year, and the company may then appropriately show a noncurrent prepaid expense or "deferred charge" if it is a significant enough amount to warrant such classification. Prepaid expenses arise whenever the payment schedule for an expense is ahead of the company's fiscal period, such as for annual insurance premiums when the policy's ending date is past the fiscal year-end, or property taxes that are based on the municipality's tax assessment schedule and cover a period past the company's fiscal period. Prepaid expenses are not assets in the same way as are receivables (to be collected in cash) or inventories (to be sold for cash). They arise from accrual accounting, in cases where the expense recognition follows the cash flow. As was indicated earlier in this chapter, this is conceptually the same reason inventories and factory assets are on the balance sheet: something of value exists and therefore its cost should not yet be deducted as an expense. Here, the value is in the fact that, having spent the money already, the company will not have to spend it in the next period. They have an economic value because future resources will not have to be expended.
Prepaid expense assets have value in reducing future cash payouts.
Pure Prepaid Expenses Asset Case
The purest case of a prepaid expense arises where entry #1 above always follows entry #2: payment is always in advance. In Figure 6.7, the horizontal arrow is fiscal periods and the vertical axis has prepaid expense asset above the arrow and accrued liability below it. The cash payments are made at times X, Y, and Z, and after each of those times, the prepaid expense is transferred to expense by entries like #1 over the period to which it applies. In this pure prepaid case, there is no accrued expenses liability.
figure 6.7
Pure Prepaid Expenses Asset Case
Prepaid Asset
X
Y
Z
Accrued Liability
NEL
392
PART T HREE
D OING F INANCIAL A CCOUNTING
Accrued Expenses Liability
Accrued expenses arise when expenses are paid after the period to which the expenses apply. Accrued expenses are liabilities, usually current, that arise from exactly the same timing difference as do prepaid expenses, but in their case the cash flow happens after the economic value has been obtained. An example is accruing interest that is building up on a bank loan. Another is paying for an audit only after the work has been done for the present fiscal year.
Pure Accrued Expenses Liability Case
The purest case of an accrued expense arises where entry #1 above always precedes entry #2: payment is always afterwards ("in arrears"). In Figure 6.8, the horizontal arrow is still fiscal periods, with prepaid expense asset above it and accrued liability below it. The cash payments are still made at times X, Y, and Z, and prior to each of those times, the expense is created by building up the accrual to expense over the period to which it applies. In this pure accrued expenses case there is no prepaid expense.
figure 6.8
Prepaid Asset
Pure Accrued Expenses Liability Case
X
Y
Z
Accrued Liability
The Balance Sheet Account Can Vary Between Being an Asset and a Liability
Mixed AssetLiability Case
A mixed case is also common, in which sometimes the cash paid is prior to the incurrence of the expense, and sometimes follows it. Suppose a company has a June 30 fiscal year-end and pays property taxes to the local municipality. Property taxes apply to the calendar year: Prepaid property taxes at the fiscal year-end of June 30 arise if property taxes for the whole of the calendar year are paid in June, before the end of the fiscal year. Accrued property taxes at the fiscal year-end of June 30 arise if property taxes for the calendar year are not paid until July, after the fiscal year-end.
Figure 6.9 is an illustration of the mixed case. The cash payment times X, Y, and Z are now not regular: X and Y are made before the whole expense has been incurred, and then there is a long delay before Z is made. The balance sheet account varies from being an accrued liability to being a prepaid expense. A single balance sheet account could be used, and it could be put in the current assets if its balance is a debit, and in the current liabilities if its balance is a credit. (This happens with other accounts, too. If an account payable is overpaid, it would have a debit balance and would be included with the
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
393
accounts receivable, on the assumption the overpayment would be refunded or used to purchase more goods. Conversely, if an account receivable is overpaid by the customer, it would have a credit balance and would be shown with the accounts payable, on the same assumption.)
figure 6.9
Mixed AssetLiability Case
Prepaid Asset
X
Y
Z
Accrued Liability
Depending on payment timing, an expense may be either accrued or prepaid.
Therefore, accrued (unpaid) expenses and prepaid expenses are just opposite sides of the same coin, reflecting a mismatch between the cash payment and the expense (use of the economic value). They arise as accrual accounting tries to arrange the expenses to reflect economic use rather than cash flow. They are assets or liabilities depending on how the cash flow and the expense recognition happen to mismatch, so you often see similar kinds of items as prepaid expense assets and as accrued expense liabilities, or even as an asset one year and a liability the next. Common examples include insurance, property taxes, sales commissions, interest, licences, and current income taxes (payable if owing, or refundable if overpaid).
Example
Here is an example. Day and Night Inc. has ten local corner stores that are part of a national chain. Each year, it pays a franchise fee to the chain for use of the chain's logo and other rights during the calendar year. No matter when the fee is paid, its economic value applies to the calendar year. The company's fiscal year-end is September 30, however, so it is measuring expenses over the period October 1 to September 30, not the calendar year to which the payments apply. This is the kind of mismatch of periods that gives rise to prepaid and accrued expenses. The expense is allocated to fiscal periods regardless of when it is paid.
Illustration 1: The fee is paid on August 31 every year.
The diagram of this case in Figure 6.10 shows the payment made at A (end of August) each year. This pays off an accrued expense that had been building up since the beginning of the year and creates a prepaid expense for the rest of the year. By S (end of September), there is still some prepaid expense, and by D (end of December) there is neither a prepaid expense nor an accrued liability. The expense for any fiscal year is a combination of the consumption of the three-month prepaid existing at the end of September last year, the eight-month January to August accrual for this year, and one month's consumption of the prepaid existing at the end of August this year.
NEL
394
PART T HREE
D OING F INANCIAL A CCOUNTING
figure 6.10
Prepaid Asset
AS
D
AS Accrued Liability
D
AS
D
IIllustration 2: The fee is paid on November 30 every year.
The diagram of this case (Figure 6.11) shows the payment made at N (end of November) each year. This pays off an accrued expense that had been building up since the beginning of the year and creates a prepaid expense for only one month. By S (end of September), there is an accrued expense, and by D (end of December) there is neither a prepaid expense nor an accrued liability. The expense for any fiscal year is a combination of the two-month accrual from the end of September to the end of November last year, the consumption of the one-month prepaid existing at the end of November last year, and the nine-month January to September accrual for this year.
figure 6.11
Prepaid Asset
S
ND
S
ND
S
ND
Accrued Liability
The expense is independent of payment timing; together expense and payment make an asset or liability.
Accrual accounting has used a prepaid expense asset in the first case and an accrued expense liability in the second case to produce the same calculation of expense: 3/12 of last year's fee (the October to December part) plus 9/12 of this year's (the January to September part). The happenstance of the payment date does not affect the expense, but it does affect the balance sheet. The balance sheet's asset or liability accounts arise as a consequence of accrual accounting's method of measuring expenses (and therefore income) properly, in combination with the timing of the payment of the fee. For such prepaid and accrued accounts, we could say that the balance sheet values are just residu-
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
395
als of the particular combination of expense incurrence and cash payment and don't have any deeper meaning.
Mini-Demonstration Case: Prepaid and Accrued Expenses
Let's put some numbers into the Day and Night Inc. example used in the charts above. The company's fiscal year-end is September 30. Suppose the annual franchise fee, which applies to the calendar year, is $12,000 the first year, $15,000 the second year and $18,000 the third year.
Illustration 1: The fee is paid on August 31 every year.
Prepaid asset Sept. 30 Year 1: 3/12 $12,000 = $3,000 Expense for year ended Sept. 30 Year 2: 3/12 $12,000 + 9/12 $15,000 = $14,250 (This equals the last 3 months of the previous calendar year's fee plus the first 9 months of this calendar year's fee, to fit the annual fees to the company's fiscal year.) Prepaid asset Sept. 30 Year 2: 3/12 $15,000 = $3,750 Expense for year ended Sept. 30 Year 3: 3/12 $15,000 + 9/12 $18,000 = $17,250 (Again, this equals the last 3 months of the previous calendar year's fee plus the first 9 months of this calendar year's fee, to fit the annual fees to the company's fiscal year.) Prepaid asset Sept. 30 Year 3: 3/12 $18,000 = $4,500
Illustration 2: The feel is paid on November 30 every year.
Accrued liability Sept. 30 Year 1: 9/12 $12,000 = $9,000 Expense for year ended Sept. 30 Year 2: 3/12 $12,000 + 9/12 $15,000 = $14,250 (Same as Illustration 1: expense is unaffected by payment date.) Accrued liability Sept. 30 Year 2: 9/12 $15,000 = $11,250 Expense for year ended Sept. 30 Year 3: 3/12 $15,000 + 9/12 $18,000 = $17,250 (Again, same Illustration 1: expense is unaffected by payment date.) Accrued liability Sept. 30 Year 3: 9/12 $18,000 = $13,500
how's your understanding?
Here are two questions you should be able to answer based on what you have just read. If you can't answer them, it would be best to reread the material. 1. Why might the balance sheet account related to a particular expense be a prepaid expense asset at the end of one year and an accrued expense liability at the end of another year? 2. Mah Stores Inc. pays its insurance premium in advance every year on September 30 for the year beginning that date. This year, the premium (paid last September) was $5,280 and next year it is estimated to be $5,400. If the company's fiscal year-end is July 31, what is the prepaid insurance asset or accrued insurance liability at this July 31? If the company failed to pay its premium for next year until November 1, what would be the prepaid insurance asset or accrued insurance liability on its quarterly balance sheet at October 31? July 31: Asset = $880 (2/12 $5,280); Oct. 31: Liability = $450 (1/12 $5,400).
NEL
396
PART T HREE
D OING F INANCIAL A CCOUNTING
6.11 Terms to Be Sure You Understand
Here is this chapter's list of terms introduced or emphasized. Make sure you know what they mean in accounting, and if any are unclear to you, check the chapter again or refer to the glossary of terms at the back of the book. Accounting policy choices Accrual accounting Accrued expenses Aggressive accounting Articulate Articulation Authoritative standards Big Bath Cash received basis Classification Comparability Completed contract Conservatism Conservative Consistency Critical event Cut off Delivery (point of sale) Disclosure Discretionary expenses Earnings management Expense recognition Expenses Fair value accounting Fairness Fiscal periods Franchising GAAP Income Income smoothing Matching Materiality Net income Percentage of completion Period expenses Prepaid expenses Realized Recognition Recognized Revenue recognition Revenues Significant accounting policies
NEL
6. 2 1
CONTINUING DEMONSTRATION CASE
D ATA
FOR
Installment 6
I N S TA L L M E N T 6
The Continuing Case is intended to give you a little extra practice, mostly on preparation of accounting information. It has been a while since sets of journal entries were illustrated, so this installment presents the entries for the second six months of Mato's operation. You can see that the ideas behind accrual accounting, especially cutting the business's activities into fiscal periods, are present in the standard entries to record revenues and expenses. Later installments will deal with the company's accounting policy choices and analysis of its first year's financial statements. Here again is the August 31, 2006, general ledger trial balance produced in Installment 3 and used to produce the financial statements for the first six months of the company's existence.
Debit balance accounts
Cash Accounts receivable Inventory Automobile Leasehold improvements Equipment and furniture Computer Software Incorporation costs Cost of goods sold expense Salary--Mavis Salary--Tomas Salary--other Travel expense Telephone expense Rent expense Utilities expense Office and general expenses Amort. expense--auto. Amort. expense--leasehold imp. Amort. expense--equipment Amort. expense--computer Amort. expense--software $ 4,507 18,723 73,614 10,000 63,964 29,740 14,900 4,800 1,100 28,202 15,000 9,280 1,200 8,726 2,461 12,000 1,629 3,444 1,000 6,396 744 1,490 480 $313,400 $313,400
Credit balance accounts
Bank loan Accounts payable Loan payable Share capital Revenues Accum. amort.--auto. Accum. amort.--leasehold imp. Accum. amort.--equip. Accum. amort.--computer Accum. amort.--software $ 75,000 45,616 15,000 125,000 42,674 1,000 6,396 744 1,490 480
Alarmed by the company's loss for the six months ($49,378 per Installment 3) and negative cash generation (decrease in cash of $125,493 per Installment 4), Mavis and Tomas took strong action over the next six months. They put extra effort into sales, pressed the boutiques for collection as much as they could without damaging their new relationships with these customers, reduced inventory levels, and generally tried to run "a lean shop," as Tomas put it.
NEL
397
Here are events for the six months ended February 28, 2007, grouped and identified for later reference: a. Revenue for the six months totalled $184,982, all on credit. (It will turn out later that they had been collecting and paying GST during this time--that will be dealt with in a later installment, to avoid complicating this one.) Collections from customers during the six months were $189,996. Purchases for the six months were $71,004, all on credit. Payments to suppliers during the six months came to $81,276. (To conserve cash, the company continued to rely on the patience of its suppliers more than Tomas liked. But doing so did save interest expense, because the suppliers did not charge interest while the bank did!) Cost of goods sold for the six months was $110,565. An inventory count on February 28, 2007, revealed inventory on hand costing $33,612. (This allowed Tomas to deduce that there had been a shortage in inventory, because there was a little less on hand than expected based on the cost of what had been sold. There was inventory of $73,614 on hand at the end of August, $71,004 more was purchased, and the cost of goods sold was $110,565. $73,614 + $71,004 $110,565 = $34,053 which should have been on hand. The count showed $33,612 so there was a shortage of $441.) Tomas decided to combine the three salary expense accounts into one, effective September 1, 2006. Salaries for the six months to February 28, 2007, totalled $42,000. The company had paid all of this, except that it owed the government $2,284 in income tax and other deductions, and the employees $2,358 in net salaries at the end of February. Various operating expenses for the six months were: travel, $1,376; phone, $1,553; rent, $12,000; utilities, $1,956; office and general expenses, $2,489. All of these were paid by February 28, except for $1,312. The company bought further necessary equipment at a cost of $2,650 cash on November 3, 2006. The company's bank loan rose and fell during the period. A total of $32,000 in further borrowing was incurred, and $59,500 was repaid. Bank loan interest of $4,814 was paid during the six months (including a portion for the period prior to August 31, 2006, that had not been included in the accounts to that date). Unfortunately (personally and financially), Tomas's father's health had deteriorated over the autumn and so he requested that his loan be repaid. The company did that on December 15, 2006, including interest of $1,425.
b. c. d.
e. f.
g. h.
i.
j. k. l.
m.
The employee (mentioned in an earlier installment) had been hired in August and looked after the bookkeeping for the company. The above events were made up of hundreds of individual transactions recorded by the employee, but they are summarized by the journal entries that follow. See if you can do them before you look at the results!
R E S U LT S
FOR
I N S TA L L M E N T 6
Journal entries for the period September 1, 2006, to February 28, 2007, follow, corresponding with the events listed previously. To save clutter, they are not accompanied by explanations or DR and CR indications, other than in the placement of the figures (the debits to the left). Since they are summary entries, their dates are also omitted.
398
NEL
a. Accounts receivable Revenue b. Cash Accounts receivable c. Inventory Accounts payable d. Accounts payable Cash e. Cost of goods sold expense Inventory f. Inventory shortage expense Inventory ($73,614 + $71,004 $110,565 $33,612) g. Salaries Expense Salary--Mavis Salary--Tomas Salary--Other h. Salaries expense Deductions payable Salaries payable Cash (deduced) i. Travel expense Phone expense Rent expense Utilities expense Office and general expense Accounts payable Cash (deduced) j. Equipment and furniture Cash k. Cash Bank loan Bank loan Cash l. Interest expense Cash m. Loan payable Interest expense Cash
184,982 184,982 189,996 189,996 71,004 71,004 81,276 81,276 110,565 110,565 441 441 25,480 15,000 9,280 1,200 42,000 2,284 2,358 37,358 1,376 1,553 12,000 1,956 2,489 1,312 18,062 2,650 2,650 32,000 32,000 59,500 59,500 4,814 4,814 15,000 1,425 16,425
Posting these journal entries results in the following general ledger account balances at February 28, 2007 (arranged in balance sheet order, as is usually, but certainly not always, done in a trial balance). Credits are shown in brackets.
NEL
399
Account
Cash
Balance Aug. 31/06
4,507
Transactions for period to February 28, 2007
189,996 (81,276) (37,358) (18,062) (2,650) 32,000 (59,500) (4,814) (16,425)
Balance Feb. 28/07
6,418 13,709 33,612 10,000 (1,000) 63,964 (6,396) 32,390 (744) 14,900 (1,490) 4,800 (480) 1,100 (47,500) (36,656) (2,284) (2,358) 0 (125,000) (227,656) 138,767 0 0 0 67,480 10,102 4,014 24,000 3,585 5,933 6,239 441 1,000 6,396 744 1,490 480 0
Accounts receivable Inventory Automobile Accum. amort.--auto Leasehold improvements Accum. amort.--leasehold imp. Equipment and furniture Accum. amort.--equip. Computer Accum. amort.--computer Software Accum. amort.--software Incorporation cost Bank loan Accounts payable Deductions payable Salaries payable Loan payable Share capital Revenue Cost of goods sold expense Salary--Mavis Salary--Tomas Salary--other Salaries expense Travel expense Phone expense Rent expense Utilities expense Office and general expense Interest expense Inventory shortage expense Amortization expense--auto. Amortization expense--leasehold Amortization expense--equipment Amortization expense--computer Amortization expense--software Net Sums
18,723 73,614 10,000 (1,000) 63,964 (6,396) 29,740 (744) 14,900 (1,490) 4,800 (480) 1,100 (75,000) (45,616) 0 0 (15,000) (125,000) (42,674) 28,202 15,000 9,280 1,200 0 8,726 2,461 12,000 1,629 3,444 0 0 1,000 6,396 744 1,490 480 0
184,982 (189,996) 71,004 (110,565) (441) 0 0 0 0 2,650 0 0 0 0 0 0 (32,000) 59,500 (71,004) 81,276 (1,312) (2,284) (2,358) 15,000 0 (184,982) 110,565 (15,000) (9,280) (1,200) 25,480 42,000 1,376 1,553 12,000 1,956 2,489 4,814 1,425 441 0 0 0 0 0 0
400
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
401
6.13 Homework and Discussion to Develop Understanding
The problems roughly follow the outline of the chapter. Three main categories of questions are presented. Asterisked problems (*) have an informal solution provided in the Student Solutions Manual. EXTENDED TIME problems involve a thorough examination of the material and may take longer to complete. CHALLENGING problems are more difficult.
For further explanation, please refer to Section 1.15.
Accrual Accounting Sections 6.26.3
What Is It and Why Do We Use It? * PROBLEM 6.1 Discuss the basis of accrual accounting
Discuss the following: 1. Speaking positively, it might be said that accrual accounting improves on the cash flow information. Speaking negatively, it might be said that accrual accounting messes up the picture by introducing noncash flow factors. Whether or not you like the result they achieve, how do accrual accounting entries work to alter the cash flow story? Why can it be said that timing is at the centre of accrual accounting?
2.
PROBLEM 6.2 Explain why accrual accounting diverges from cash flow
Respond in point form to the following complaint by a businessperson: "I find modern financial accounting really annoying. The basis of financial strength is the availability and use of real resources, like cash and machinery, yet accrual accounting produces an income measure that is deliberately different from the cash return earned by the business. Why is this so? Why should accrual accounting diverge from the measurement of cash flow?"
PROBLEM 6.3 Why accrual accounting is needed
Discuss the following statement: "Over the life of a business entity, it matters little which basis of revenue recognition is used. It is only because investors and others such as taxation authorities demand periodic income measurement that problems of revenues and expense recognition arise."
C hallenging PROBLEM 6.4 Is accrual accounting a tool of management?
A professor recently said that accrual accounting was invented because managers wanted something they could manipulate to their own purposes more than was possible with transaction-based, cash-based data. Accrual accounting, the professor continued, is a tool of management and has driven accounting away from the goal of producing information that is representative of any real phenomena and toward fanciful reports largely devoid of real meaning. 1. What do you think of the professor's views? Are there any better reasons for accrual accounting?
NEL
402
PART T HREE
D OING F INANCIAL A CCOUNTING
2. 3.
The professor said that academics and practitioners tend to differ in their responses to his views. What do you think the differences would be? If the professor is right, what does that say about the dictum that management bears the responsibility for providing financial information about an enterprise?
Conceptual Foundation * PROBLEM 6.5 Explain how revenues and expenses differ from cash flows
1. 2.
3. 4.
Explain the difference between a revenue and a cash receipt. Give examples of items that are revenue of a given period but not receipts of that period, items that are receipts but not revenue, and items that are both revenue and receipts. Explain the difference between an expense and a cash disbursement (payment). Give examples of items that are expenses of a given period but not disbursements of that period, items that are disbursements but not expenses, and items that are both expenses and disbursements.
PROBLEM 6.6 Match accrual accounting terms
Match the terms on the left with the most appropriate phrases on the right. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Accounts receivable Inventory Cash Prepaid expense Deferred revenue Pension liability Future tax liability Accrued expense liability Income tax payable Amortization a. Consumption of long-term assets b. Revenue recognized after collection c. An estimate of what the government wants soon d. Goods waiting to be expensed e. Revenue recognized before collection f. Usually unaffected by accounting policy choice g. Expense paid before being consumed h. An estimate of what the government wants much later i. Promises to employees expensed already j. Expense paid after economic value has been obtained
PROBLEM 6.7 Examine some accrual accounting phenomena
1.
2.
On December 31, the end of the accounting period of Major Corp., the company accountant is about to make some adjustments. Describe a set of circumstances where, in making the typical year-end adjustments a. an expense is debited and a liability is credited b. an expense is debited and an asset contra account is credited c. an asset is debited and a revenue is credited d. a liability is credited and a revenue is debited A business executive remarked, "Accountants use a dual standard for measuring assets. Some are on the balance sheet because they have real future economic value. Others are there only because they're left over from the income measurement process ... sort of expenses waiting to be deducted. Similarly with liabilities: some are really owed but some are just leftovers of the accrual accounting process for measuring income."
Discuss the remark, citing examples of assets and liabilities that might fit the executive's four categories.
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
403
C hallenging and E xtended time
PROBLEM 6.8 Conversion from cash to accrual basis
Temporary Help Ltd. is a company offering specialized personal services (for example, secretarial assistance, delivery of advertising, errands, shopping for gifts). The company's accounts have been kept on a cash basis, but its banker has asked that the accounting be changed to the accrual basis. Income for 2006 on the cash basis was $169,000. Using the following figures (note the order of the years), calculate the company's 2006 income on the accrual basis.
Assets 2006 Cash basis: Current Noncurrent Accrual basis: Current Noncurrent 2005 Liabilities 2006 2005
$ 96,000 -- 174,000 30,000
$ 83,000 -- 144,000 36,000
$37,000 -- 78,000 16,000
$37,000 -- 55,000 --
C hallenging
PROBLEM 6.9 Explain accrual concepts to a businessperson
A businessperson you know has just received the financial statements of a company in which that person owns shares. Answer the following questions asked by the person. Try to answer without jargon and use examples that will make your answers clear. 1. 2. 3. I've been told that these accrual accounting numbers are "mainly a matter of timing." What does that mean? I see the company has a note in its financial statements describing its "revenue recognition" method. Why would I want to know that? I know from my business experience that sometimes you collect cash sooner or later than you expect. Customers may have cash, or not, for all sorts of reasons that have nothing to do with you. I understand that accrual accounting takes this into account so that it doesn't matter when cash is collected; you get the same revenue figure anyway. Is this true? I understand that accountants try to be sure that revenues and expenses "match" each other so that the income you get by subtracting expenses from revenues makes sense. Seems quite appropriate. But what effect, if any, does this matching procedure have on the balance sheet figures?
4.
Accounting Policy Choices Section 6.4
* PROBLEM 6.10 Can the auditor prevent unfair accounting policies?
A commentator on the accounting scene remarked, "Management makes its accounting choices to serve its own interests, and there's no way the poor lonely auditor can hold the fort of fairness when you consider how vague and judgmental accrual accounting's criteria for accounting policy choices are." What are your views on the commentator's remarks?
PROBLEM 6.11 Whose role should it be to choose accounting policies?
Should management have the responsibility and authority to choose companies' accounting policies, or should that role be someone else's (for example, the
NEL
404
PART T HREE
D OING F INANCIAL A CCOUNTING
government's, the auditor's, an independent board's)? If you think it should be management's role, why? If you think it should be someone else's role, whose? Why?
PROBLEM 6.12 Comment on various remarks about accounting policies
Comment briefly on the following remarks by a businessperson: 1. 2. "No one cares what our accounting policy choices are because they have no effect on the price of the company's shares." "Our accounting policies are mainly a signal about the kind of company we are (conservatively managed, careful to follow authoritative rules) and so they are fairly consistent overall." "Once we have established proper accounting policies, all those notes at the end of the financial statements are really an irrelevant nuisance."
3.
* PROBLEM 6.13 Discuss the conflict between flexible and standard accounting
As you have seen, there is a general conflict between two financial reporting objectives. The first objective is to fit the accounting to each company's circumstances so that the resulting reports are relevant to understanding or evaluating that company. The second is to make accounting consistent from company to company so that intercompany comparisons may be facilitated and the overall credibility of the information maintained. Give your views on how important this conflict is and how (if at all) it should be dealt with.
PROBLEM 6.14 Issues about the significant accounting policies note
1. 2. 3.
What is the purpose of the significant accounting policies note that usually is the first note to a company's financial statements? How should a company decide what to include in that note? A business commentator suggested that, when a company uses an accounting policy that is unusual, its significant accounting policies note should include a calculation of the effect on income of using that policy as compared to the more usual practice. What do you think of that idea?
C hallenging
PROBLEM 6.15 Questions on auditors, judgment, and accounting policies
Write a paragraph on each of the following topics, using the perspective on accounting policy choice and methods provided in this chapter: 1. 2. 3. Why the auditor's report refers to whether the company's financial statements have been prepared in accordance with GAAP. Why professional judgment is needed in preparing financial statements. Whether it is justifiable to use an aggressive revenue recognition policy (recognizing revenue early in the production-sale-collection cycle process).
C hallenging and E xtended time
PROBLEM 6.16 Comment on a newspaper article critical of accounting
On page 405 there is a newspaper article critical of managing earnings through aggres14 sive accounting. The article does not talk about revenue and expense recognition directly, but implies it through the techniques it mentions: The Big Bath, which we have seen before, which depresses current income by moving expenses forward from the future in order to make the future income higher. Immediately writing off part of the costs of acquiring another company, rather than keeping them on the balance sheet and amortizing them against future income.
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
405
Paying managers with stock options; giving them cheap shares instead of cash and thereby not showing the real cost of employing them, because instead of an expense that reduces income, there is just a lower amount of share capital in the equity section of the balance sheet. Capitalizing research and development costs as assets to be amortized instead of deducting them as expenses now, which has the opposite effect to those of the first two income management methods.
Comment on the issues raised in the article. Some of these are: Do you think the problems are particularly serious in high-tech companies that rely on R&D, give big incentives to creative people, and sell ideas more than goods? Would it solve anything to have Canadian companies follow American practices more closely, even though there are problems in the United States too? Is it possible for a company to use aggressive accounting practices and still be conservative?
Tech firms' accounting methods assailed
Aggressive practices boost earnings, but may not be sustainable in long term: report
SIMON TUCK Technology Reporter, Ottawa
S
ome of Canada's largest technology companies are boosting their earnings through the use of aggressive accounting practices, according to a report from Merrill Lynch Canada Inc. The report warns that earnings created by the aggressive methods, which are far more widespread in the United States, are not sustainable in the long term. That would be especially perilous for the companies if the economy weakens and investors become more skittish. "In these times of turbulent markets," the report says, "we feel this may be the time to take a more critical look at earnings quality issues in the sector." The report says Canadian technology heavyweights Northern Telecom Ltd., Newbridge Networks Corp., JDS Fitel Inc., ATI Technologies Inc. and Mitel Corp. were the companies reviewed and "almost all could see a reduction to their reported and estimated [earnings] after adjusting for some accounting practices." The report is careful to point out that the accounting practices are not illegal, or even inappropriate. But it does state that such methods are "a red flag worth monitoring." However, many analysts and investors are ignoring the red flag, said Tom Astle, senior technology analyst at Torontobased Merrill Lynch Canada. "Technology companies have discovered
that Wall Street and Bay Street tend to ignore writeoffs." The report points out four areas of concern: "Big-bath accounting" that loads writeoffs onto quarters where a company would record a loss in any case. That increases expenses in one quarter, but boosts income in future quarters, creating the impression of a brightening financial picture. Writing off "research and development in process" from acquisitions. That also has the effect of transferring costs from future quarters to the current one, and boosting earnings in subsequent periods. Unrecorded costs for employee stock options. The report says that such options have a value that should be recorded as an expense at the time of issue, but rarely is. Recording expenditures on research and development as assets that are then subject to amortization, rather than as expenses. This pracitce increases profit in the short term, but reduces it in subsequent quarters as the asset is amortized. Such expenditures should be recorded as expenses as they occur, the report says. Tim Saunders, Mitel's vice-president and corporate controller, said the report
addresses an important and timely issue, but he said his Kanata, Ont.-based firm uses conservative accounting practices. Marc Ren de Cotret, a spokesman for Nepean, Ont.-based JDS Fitel, said his company uses "very clean" accounting methods. "We have very, very conservative accounting practices." ATI's accounting practices are also conservative, said spokeswoman Jo-Anne Chang, adding that Canadian high-tech firms are not as aggressive as their U.S. counterparts. Northern Telecom, of Brampton, Ont., and Newbridge, of Kanata, Ont., did not comment. However, the report itself states that all the firms are operating within the law and within generally accepted accounting principles. But the report says that just obeying the rules does not provide an entirely clear picture for investors. "Simply complying with generally accepted accounting principles in either Canada or the United States does not guarantee earnings quality." The silver lining for Canada's technology industry is the report's even heavier criticism of the accounting practices of U.S. firms. The report suggests that Canadian companies begin following accepted American accounting practices "so that we can compare apples to apples."
Reprinted from The Globe and Mail, 29 March 1999, by Simon Tuck.
NEL
406
PART T HREE
D OING F INANCIAL A CCOUNTING
Revenue Recognition Sections 6.66.7
* PROBLEM 6.17 Recommend revenue recognition policies
What revenue recognition policy would you recommend for each of the following companies? Why? a. Harry's Hamburgers, an all-night fast-food joint on the highway. b. EngSoft, a designer and installer of high-priced, custom-fitted software for engineering and other high-tech companies. c. Nevada Gold, a miner of gold in northern Nevada. d. Fast Furniture, a seller of cheap furniture, which has the slogan "buy now and pay nothing until a year from now." e. Goldenrod Construction, which does building contracts with governments and large corporations. f. Handsome Homes, which builds homes in the new part of town and hires agents to sell the homes upon completion.
E xtended time PROBLEM 6.18 Likely revenue recognition policies for various cases
For each of the following independent cases, identify at what point revenue should be recognized: Case 1. Tim Hortons sells coupon books for ten dollars. Each of the two-dollar coupons can be used in the restaurant at any time during the next 12 months. The customer must pay cash for the coupon book. Case 2. In 2005 Snowdon Construction Company started a long-term construction project to build a large office block. The project was completed in 2007. At the end of 2007 the building had still not been sold as Snowdon was seeking a premium price. Snowdon is confident that it will be able to sell the building for the full asking price given the high demand and short supply of office space in the area. Case 3. The Korean Kar Kompany has always recognized revenue at the point of sale of its vehicles. Recently, it extended its warranties to cover its vehicles for a period of ten years. A recent B.Comm. graduate working in the accounting department now questions whether Korean Kar has completed the earnings process at the time of sale. She suggests that the warranty obligation for ten years means that a significant amount of additional work must be carried out in the future. Korean Kar's engineers estimate the cost of warranty work will average about 5% of the vehicle's selling price. Case 4. Allan Alls has just opened his real estate brokerage business, Allsold, and is unsure when he should recognize revenue for the business. It is his opinion that he has earned at least half of the commission when the sale listing is signed since he receives this amount even if another agent sells the property. He argues the remainder of the commission revenue should be recognized when an offer of purchase and sale is accepted by the owner of the property. His accountant has told Allan that the proper timing of revenue recognition for this business is when the real estate sale has closed; that is, when the new owner takes title to the property.
PROBLEM 6.19 Choose suitable revenue recognition policies
In each of the following independent cases, indicate when you think the company in question should recognize revenue. Support your decision with reference to the generally accepted criteria for revenue recognition.
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
407
a.
Alaska Gold Co. mines and refines gold. The company waits to sell the gold until it feels the market price is favourable. The company can, if it wishes, sell its entire inventory of gold at any time at the prevailing market price. b. Crazy Freddie sells cheap, ugly furniture on the installment plan. His customers take delivery of the furniture after making a down payment. In the course of the past year, Crazy Freddie has had to repossess over 50% of the furniture that he sold, due to customers defaulting on payments. c. Tom and Mark's Construction Co. undertakes long-term construction contracts. The company only accepts contracts that will pay a fixed fee. Costs can be estimated with reasonable accuracy, and there has never been a problem collecting from customers. d. Cecily Cedric Co. is a toy manufacturer, producing toys that are shipped to various retail customers upon receipt of their purchase order. Sales are billed after shipment. The company estimates that approximately 2% of credit sales prove to be uncollectible.
* PROBLEM 6.20 Revenue recognition policy for a fashion house
Molloy House Inc. makes and sells high-priced made-to-order clothing. All sales are onetime-only designs, made to the buyer's specifications after much consultation and demonstrations of fabrics and styles. Prices average over $10,000 for a dress and more than that for gowns, suits, and other larger items. Sales volumes are not high, but profit margins are: gross margin is usually over 60% and net income is usually over 20% of sales. Customers are promised absolute satisfaction, and about 10% of sales are returned or need costly adjustment. Customers pay about 25% of the price before work begins and are billed for the rest upon delivery, which is normally some weeks or months later. Most customers pay within a month or two of delivery, but some long-time customers are slower than that. Occasionally, due to death or bankruptcy, the remaining 75% is never paid--this happens in about one in 50 sales. a. Specify the revenue recognition policy that you would recommend Molloy House use and explain why that policy is appropriate. b. Most deliveries are made during three periods: the spring (coming out balls, graduations, and horse races), the summer (weddings), and the fall (opera and charity balls), but the company's staff are busy all year filling orders, which are often made far in advance and so allow the company to maintain fairly steady production. All fabric and other materials and supplies are purchased only as each order requires them; the company has no significant general inventory. (i) An unfilled order is both an asset and a liability for Molloy House. Explain why this is true. (ii) When would be a good date for the company's fiscal year-end? Why?
PROBLEM 6.21 Accounting for a health club
Carrot Club is a local health club, with exercise machines, a health food bar, and other features. The club offers a membership package of $400 for 100 visits. The package has to be paid for $100 down plus $100 per month over the next three months. A few new members fail to pay the $300 they owe. The company uses accrual accounting, and therefore its financial statements have accounts receivable for unpaid memberships and deferred revenue liability for members' unused visits. At the end of the 2005 fiscal year, members' unused visits totalled 85,000. At that date, members owed $22,000. During the 2006 fiscal year, the club sold 1,200 new memberships and experienced 140,000 visits by members. Bad debts of $1,400 were written off against the accounts receivable.
NEL
408
PART T HREE
D OING F INANCIAL A CCOUNTING
1.
At the end of the 2006 fiscal year, the club estimated that $1,500 of the $17,500 members' accounts owing then were doubtful. Ignoring the possibility that some members may never use visits they've paid for, calculate: a. Revenue for the 2006 fiscal year. b. Deferred revenue liability for unused visits, as at the end of the 2006 fiscal year. The company's auditor suggested that the financial statements should take into account the fact that some paid-up members move, lose interest, or otherwise end up never using all the visits they have paid for. If the company adopted this accounting policy, indicate the effect (up, down, or no effect) on each of the following, and say why you chose the answer you did. a. Accounts receivable at the end of 2006. b. Revenue for 2006.
2.
PROBLEM 6.22 Franchise revenue amounts and policies
Clucky Chicken Corp. (CC) and Poulet Chicken Inc. (PC) are competitors. Both sell franchises for their chicken restaurants. The purchaser of the franchise (the franchisee) receives the right to use CC's and PC's products and benefit from national training and advertising programs for ten years. The buyers agree to pay $750,000 for a franchise. Of this amount, $150,000 is paid upon signing the agreement and the remainder is payable in five equal annual installments of $120,000 each. Clucky Chicken recognizes all franchise revenue when franchise agreements are signed. Poulet Chicken recognizes franchise revenue as cash is received. In 2004 the companies each sold eight franchises. In 2005 they each sold six. In 2006 and 2007 neither company sold a franchise. 1. 2. Determine the amount of franchise revenue recognized by each company in 2004, 2005, 2006, and 2007. Do you think that revenue should be recognized when the franchise agreement is signed, when cash is received, or over the life of the franchise agreement? Why? Fully support your answer.
* PROBLEM 6.23 Answer a question about revenues
The Rosemead Nursery raises trees intended for sale to landscape suppliers and contractors. The trees normally take five years to reach saleable size. What special problems of income determination does Rosemead face if it is to prepare annual financial statements?
* PROBLEM 6.24 Revenue recognition for an airline
Redneck Airlines recognizes revenue when transportation is provided. Passengers who cancel tickets prior to the day of departure are given nonrefundable credits for future flights. The airline then charges a $20.00 change fee when another flight is booked. Passengers who miss a flight or cancel on the day of departure forfeit their fare. On January 2, 2005, John purchased a round-trip ticket from Edmonton to Victoria for $300.00 and paid for it three days later. The flight was to leave Edmonton on January 24, 2005, and return on January 26, 2005. On January 17, John learned that he would have to work on the following weekend so he cancelled his ticket. On February 7, 2005, John called and booked a round-trip flight to Winnipeg, departing February 21, 2005, and returning February 23, 2005. John used his credit towards the fare of $400.00 and paid cash for the change fee and difference in fares. John caught the flight on the 21st but slept in on the 23rd and missed his return flight. He arrived at the airport that afternoon and paid $200.00 cash for a one-way ticket on a plane leaving immediately. Prepare journal entries to record Redneck's revenue from John.
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
409
C hallenging
PROBLEM 6.25 Accounting versus economic view of revenue
An economist might argue that revenue is created or earned continuously by a wide variety of the firm's activities (such as production, sales, delivery), yet the accountant in a typical case selects only one of these steps (the "critical event") to signal the time at which all revenues are to be recognized. a. Assuming that the economist's view is correct, under what circumstances would the accountant's method lead to an undistorted measure of periodic income? In other words, under what conditions will the opinion that income is continuously earned agree with income as determined by accountants? b. What are the obstacles to the practical implementation of the economist's view as the basis for accounting income determination?
Fiscal Period, Expense Recognition and Matching Sections 6.5, 6.8, 6.9
* PROBLEM 6.26 Revenues, expenses, and income for a construction contract
Rockheads Inc. is a construction contractor specializing in roads and other large constructions of earthworks, rocks, and concrete. Here is information about one of its multi-year contracts, Job 48.
Total revenue agreed in the contract: $5,200,000 Rockheads' estimate of its total costs over the life of the contract: $4,300,000 Year 1: Spent $900,000, billed $1,300,000, collected $1,000,000 Year 2: Spent $1,990,000, billed $1,800,000, collected $2,030,000 Year 3: Spent $1,410,000, billed $2,100,000, collected $2,170,000
Calculate the revenue, expense, and income from Job 48 for each year and for the whole contract on each of the following bases: a. Completed contract basis. b. Percentage completion basis (using proportion of cost spent as the measure of percentage completed and rounding percentages to the nearest whole percent). c. Cash received basis (hint: match expense recognition to the proportion of total cash received each year).
PROBLEM 6.27 Construction accounting
Rimrock Construction Ltd. has several contracts to construct buildings:
Contract No. 48 49 50 51 52 Expected Revenue $1,000,000 1,500,000 860,000 2,430,000 1,600,000 Expected Expense $ 800,000 1,300,000 710,000 1,950,000 1,320,000 Expected Income $200,000 200,000 150,000 480,000 280,000 Percentage Completed End of 2005 60% 20% 0% 0% 0% End of 2006 100% 80% 100% 90% 20%
1.
2.
NEL
Assuming all revenues, collections, expenses, and payments are as expected, calculate income before income tax for 2006: a. Using the completed contracts basis to recognize contract revenues and expenses. b. Using the percentage of completion basis to recognize contract revenues and expenses. Which of these two bases is the more conservative? Why?
410
PART T HREE
D OING F INANCIAL A CCOUNTING
3.
No revenue has yet been collected on Contract #50, but all expenses related to it have been paid. Contract #50 has run into legal trouble. Rimrock now expects to receive only $100,000 of the expected revenue. Write the journal entry, if any is needed, to recognize this information. (Assume the completed contract basis if necessary.)
PROBLEM 6.28 Revenue, expenses, and income for a construction contract.
The information below relates to an individual long-term construction contract of Tamarack Construction Ltd.
Year 2004 2005 2006 Total Costs Incurred $1,500,000 2,750,000 1,600,000 $5,850,000 Cash Received $2,025,000 3,150,000 2,325,000 $7,500,000
Assume that the contract price was $7,500,000 and that the original cost estimate on the contract was $6,000,000. Calculate the revenue, expenses, and income for each year 2004 to 2006 and for the whole contract on each of the following bases: a. Completed contract basis b. Percentage of completion basis (using proportion of cost spent as the measure of percentage completed and rounding percentages to the nearest whole percent). c. Cash received basis (hint: match expense recognition to the proportion of total cash received each year). d. How would your answer to b. change if the contract were not yet completed?
* PROBLEM 6.29 Answer a question about expenses
In 2006, Flimsy Construction Ltd. has recognized 38% of the total expected revenue from a contract to build a garage onto Professor Blotz's house. The total contract price is $43,000 and Flimsy expects its costs for the contract to be $29,500. Costs so far have been in line with expectations. How much contract expense should Flimsy recognize for 2006 and what would be the resulting contract income for 2006?
* PROBLEM 6.30 Calculate accrual net income from various accounts
Pottery Galore Ltd. has just finished its 2006 fiscal year. From the following data, calculate net income or loss for 2006:
Collections from customers during 2006 Accounts receivable, end of 2005 Accounts receivable, end of 2006 Bad debts (written off to expense directly from accounts receivable in 2006) Payments to suppliers and employees during 2006 Accounts and wages payable, end of 2005 Accounts and wages payable, end of 2006 Inventory of unsold goods, end of 2005 Inventory of unsold goods, end of 2006 Bank loan, end of 2006 (The loan was taken out a month before the end of 2006 at an interest rate of 8%. No interest has yet been paid.) Income tax payable, end of 2006 (none end of 2005) Income tax paid during 2006 Future income tax liability, end of 2006 (none end of 2005) $174,320 11,380 9,440 520 145,690 12,770 15,510 21,340 24,650 12,000
2,340 3,400 1,230
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
411
C hallenging
PROBLEM 6.31 Contract cash flow and income calculations
The Swazy Construction Company has secured a contract with the Alberta government for the construction of 15 km of highway at a contract price of $125,000 a kilometre. Payments for each kilometre of highway are to be made according to the following schedule: 35% at the time the concrete is poured 45% when all work on that kilometre is completed 20% when all 15 km of highway have been completed, inspected, and approved
At the end of the first period of operation, 5 km of highway have been entirely completed and approved, concrete has been poured on a second stretch of 5 km, and preliminary grading has been done on the third 5-km stretch. The job was originally estimated to cost $100,000 a kilometre. Costs to date have coincided with these original estimates and have totalled the following amounts: on the completed stretch, $100,000 a kilometre; on the second stretch, $80,000 a kilometre; and on the third stretch, $12,500 a kilometre. It is estimated that each unfinished stretch will be completed at the costs originally estimated. 1. 2. How much should the Alberta government have paid Swazy during or at the end of the first period of operation under the terms of the contract? Show computations. How much income would you report for this period? Show your calculations and justify your method.
C hallenging and E xtended time
PROBLEM 6.32 Income on various revenue recognition bases
The Latanae Company produces a single product at a cost of $8 each, all of which is paid in cash when the unit is produced. Selling expenses of $4 a unit are paid at the time of shipment. The sale price is $15 a unit; all sales are on account. No customer defaults are expected, and no costs are incurred at the time of collection. During 2005, the company produced 150,000 units, shipped 120,000 units, and collected $900,000 from customers. During 2006, it produced 120,000 units, shipped 135,000 units, and collected $1,425,000 from customers. 1. Ignoring income tax for now, determine the amount of income that would be reported for each of these two years: a. If revenue and expense are recognized at the time of production. b. If revenue and expense are recognized at the time of shipment. c. If revenue and expense are recognized at the time of collection. Would the asset total shown on the December 31, 2006, balance sheet be affected by the choice among the three recognition bases used in part 1? What would be the amount of any such difference? Redo part 1, assuming that the company's income tax rate is 30%.
2.
3.
C hallenging and E xtended time
PROBLEM 6.33 Real company's revenue, expense recognition
Using the financial statements, MD&A, and other information of any company you are interested in, write a comprehensive review of the company's revenue and expense recognition policies. (This information can be found on the Web page of most public companies, or check www.sedar.com for the companies' filings.) Cover such points as a. What the nature of the company's business is and how it earns its revenue and incurs its expenses; b. What the company's financial statements and notes disclose about its important revenue and expense recognition policies; c. Based on (a) and (b) and on your own thinking about the company, the appropriateness of the company's revenue and expense policies and what questions or concerns you have about them; and
NEL
412
PART T HREE
D OING F INANCIAL A CCOUNTING
d. What the company's cash flow statement tells you about how close the company's accrual net income is to cash income.
Prepaid and Accrued Expenses Section 6.10
* PROBLEM 6.34 Calculate prepaid and accrued expense
A local company pays its property taxes on a rather erratic basis. Here is a schedule of its property tax bills and payments over the last few years: Was billed in April 2004 for the calendar 2004 taxes of $4,500. Paid those taxes September 20, 2004. Was billed in April 2005 for the calendar 2005 taxes of $4,800. Paid those taxes November 30, 2005. Was billed in April 2006 for the calendar 2007 taxes of $5,100. Paid those taxes August 15, 2007.
Calculate the prepaid or accrued property taxes and the property tax expense for the fiscal years 2005 and 2006, if the company had each of the following fiscal year-ends: a. b. c. d. April 30 June 30 September 30 December 31
PROBLEM 6.35 Prepaid and accrued expenses
For each of these examples, calculate whether the company had a prepaid asset or an accrued liability at the end of 2005, what the amount of that was, and what the related expense for 2005 was. 1. Westridge Manufacturing Inc. has significant costs for worker training. These costs are sometimes paid in advance and sometimes after they have been incurred. At the beginning of 2005, the company had paid $148,560 in advance. During 2005, the company incurred training costs of $960,370 and paid $808,760. In addition, the company suffered injury costs totalling $127,530 in spite of the training. Athabasca Eco-Tours pays for some of the costs of its tours in advance, some during the tours, and some later, after the tours have occurred. At the beginning of 2005, the company owed $62,380 on prior tours. During 2005, the company incurred $875,320 in tour costs and paid $814,630.
2.
PROBLEM 6.36 Prepaid and accrued expenses
Papa Jack's Pizza has an account with a local media company for television and radio advertisements. On January 1, 2006, Papa Jack's Pizza had a positive balance of $8,000 in its advertising account. Papa Jack's Pizza ran ads costing $11,000 in January and made a payment of $13,000 at the end of the month. February's ads cost $16,000 and a payment of $9,000 was made at the end of the month. Prepare journal entries for these transactions and a chart to reflect the account activity for the first two months of 2006. (Use the format of Figures 6.10 and 6.11 in Section 6.10.)
Integrated
* PROBLEM 6.37 Discuss some terms
Discuss what each of the following terms has to do with income measurement and related balance sheet valuation:
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
413
a. b. c. d. e. f.
aggressive accounting articulation deferred revenue matching period expenses conservatism
* PROBLEM 6.38 Adjusting journal entries
It is the end of International Fabrics Inc.'s fiscal year. You are working on the company's financial statements, and have discovered the items listed below. For each item: 1. 2. a. State whether or not the item requires that an adjustment be made in the company's accounts according to the principles of accrual accounting; and If the answer to part 1 is yes, write a journal entry to adjust the company's accounts.
Sales of $3,200 made on account just before the end of the fiscal year were not recorded until the beginning of the next year. b. The cost of goods sold for those sales, totalling $1,900, has not yet been recognized. c. During the year, deposits of $5,300 were made by customers on special orders and were credited to the deposit liability account. Deposits of $1,400 are still being held, but all the other special orders have been completed and the customers have paid the rest of the price for those orders (those payments are included in sales revenue). d. Maintenance expenses seemed rather high, and on investigation it turned out that an addition to the company's store, constructed over a period of several months at a cost of $62,320, had been included in the maintenance expenses. e. Just before the year-end, the company was sued by a customer whose expensive curtains lost their colour as soon as they were exposed to sunlight. The lawsuit was for $4,300 to replace the curtains and $50,000 in pain and suffering damages. Legal advice indicates that the curtains should be replaced (which would cost the company about what it is being sued for) but that the customer will not succeed with the pain and suffering damages. f. The company's auditors sent a bill for $2,350 for the year's audit work. g. Just before the year-end, the company bought an automobile from a major shareholder for $17,220, agreeing to pay in three months. h. At the beginning of the year, the company had paid $2,000 for the exclusive right to distribute in Canada fabrics made by Silk Dreams Inc. of Pennsylvania. The exclusive distributorship is for a period of four years.
* PROBLEM 6.39 Explain some accrual accounting topics
Explain to a businessperson who is not an accountant and is impatient with jargon what each of the following topics has to do with accrual accounting, what impact it has on companies' financial statements, and how important it is in understanding the financial statements. a. Recognizing revenue when it has been earned. b. Using the balance sheet to hold the "residual" effects of income measurement. c. Matching expense recognition to the fiscal period in which the expense was incurred.
E xtended time PROBLEM 6.40 Calculation of accrual income from cash records
Mike Stammer is a private investigator. He keeps his accounting records on a cash basis and has produced the following income statement, as he calls it.
NEL
414
PART T HREE
D OING F INANCIAL A CCOUNTING
Mike Stammer Income Statement for the Year Ended June 30, 2006
Fees collected in cash Less cash expenses Net income $85,000 34,600 $50,400
An examination of Mike's records shows these balances at the beginning and end of fiscal 2006:
July 1, 2005 Fees receivable Client deposits on continuing investigations Accrued expenses Prepaid expenses $12,460 -- 4,250 1,900 June 30, 2006 $ 3,900 1,800 5,250 2,500
1.
a.
2.
3. 4. 5.
What amount of the fees Mike collected in fiscal 2006 were received for investigations he actually completed in fiscal 2005? b. What amount of the fees received in 2006 will he earn in 2007? c. How much in fees did he earn in 2006, but not collect? a. What amount of the expenses Mike paid in fiscal 2006 should be matched with his efforts in fiscal 2005 or 2007? b. What amount of expenses paid in previous years should be matched with revenues Mike earned in 2006? Use your answers to parts 1 and 2 to prepare an accrual basis income statement for Mike Stammer for the year ended June 30, 2006. Add or subtract whichever adjustments to the cash income statement are necessary to reconcile Mike's $50,400 "income" to your figure. Compare the two income statements. Why might Mike Stammer (or others using his financial information) prefer to use the cash basis of accounting? Why might he (or others) prefer the accrual basis?
PROBLEM 6.41 Recommend revenue and expense recognition policy
Bob Basquit Productions Ltd. (BBPL) acquired the rights to use the names of a number of basketball players on life-sized stuffed dolls it purchases from a toy manufacturer. The dolls are marketed through mail order advertisements in the TV-listings inserts of large newspapers. When an order is received (with a money order, cheque, or credit card number), BBPL contacts the toy manufacturer. The toy manufacturer is responsible for manufacturing and shipping the doll to the lucky boy or girl. BBPL is notified at the time of shipment. The customer has the option of returning the doll within two weeks of the day it is received. BBPL pays the toy manufacturer within 30 days after delivery. Response to the dolls this Christmas has been overwhelming. In fact, the toy manufacturer is working extra shifts to try to keep up with the demand. 1. 2. Identify three points in time that BBPL could recognize revenue on the dolls. Which would you recommend? Why? Identify two different points in time that the toy manufacturer could recognize revenue on the dolls.
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
415
3.
Discuss how BBPL should account for its payments to basketball players for the right to use their names. (Assume that each player is paid a lump sum initially and a royalty on each doll sold that uses his name.)
C hallenging
PROBLEM 6.42 Accounting methods for a frequent buyer program
Heather, the owner of Blue Books, has been struggling with the competition from big bookstore chains and has decided to offer customers a reward points plan to encourage repeat business. The plan is free, and if a customer joins, every dollar spent on a book earns the customer 5 cents toward future books. This is not a discount on future purchases, but has to be used to obtain books just on points. For example, if a customer wants to get a $20.00 book on points, she would have to have spent $400.00 before then. If she has only spent, say, $350.00, she cannot use the points accumulated so far to get a discount on the book but must wait until she has spent another $50.00, and then she will get the book free. 1. Ignoring the possibility that some customers may never redeem their points, describe the accounting policy you would recommend the company use for this new points plan. Your policy should be the one you think is conceptually sound--don't worry here about the practical implications of your policy, such as keeping track of needed information. Answer in two parts: a. How would you account for points earned by customers before they redeem any free books? b. How would you account for the redemption of points for free books? Bert observed that some customers will never redeem their points. Explain how, if at all, you would modify the policy you recommended above in accounting for this factor. The bookstore's auditor observed that both conservatism and matching are important to the policy choice. Explain why both are important in this case.
2.
3.
C hallenging and E xtended time
PROBLEM 6.43 Revenue and expense recognition for a franchiser
The Pie Place, Inc. (TPP) was started in 2005 to franchise a chain of fast-food outlets that would sell only pies: meat, mince, pecan, sugar, and the like. A specialty was to be "pi-pie," a recipe made from various roots (ginger, ginseng, etc.) and invented by Janet Randolph, the founder and owner of TPP. Janet has divided each major city into population sectors of about 200,000 each and plans to sell one franchise per sector. For smaller cities, franchises will cover rural areas as well. The franchises will be good for ten years, renewable for at least two more tenyear periods, and will sell for $20,000 each. Each franchisee must pay TPP $5,000 down in cash, pay the remainder in three equal annual installments (with no interest charges), and agree to buy various ingredients from TPP. In return, TPP will provide expert advice (Janet's), recipes, help with locating and constructing the food outlet, management training, and some national advertising. (Most advertising costs will be charged back to the franchises on a pro rata basis.) Here are data for TPP's first year, ended August 31, 2006:
Franchise agreements signed Down payments received Fast-food outlets opened Franchise-related costs Other general expenses 28 26 18 $230,000 $55,000
One of the franchises has already gone out of business (having paid only the initial $5,000), two others of those that have opened do not look as if they are going to make it, and one of the unopened franchises looks as if it will never get going.
NEL
416
PART T HREE
D OING F INANCIAL A CCOUNTING
1. 2. 3. 4. 5. 6. 7.
List as many methods as you can think of for recognizing revenue from franchise sales. Rank those methods from least conservative to most conservative. List as many methods as you can think of for recognizing expenses from franchiserelated costs. Match each expense recognition method to the revenue recognition method that seems most appropriate. Compare the income before tax for 2006 that would be produced by two or three of the more reasonable matched methods of recognizing revenue and expense. Choose a matched method that you think would be most appropriate for TPP. Draft an "accounting policy" footnote describing your chosen revenue/ expense recognition method for TPP's August 31, 2006, financial statements.
C hallenging and E xtended time
PROBLEM 6.44 Comprehensive revenue and expense issues
Programs Plus Inc. (PPI) is engaged in developing a computerized scheduling, shipping, maintenance, and operations system for the North American logistics industry. PPI has spent the last five years conducting systems development work and this year (ended November 30, 2006) sold its first systems. Initial funding of $3,000,000 came from the founder, who invested $1,500,000 for shares and $1,500,000 in the form of a loan. In the past, the company was not very concerned about accounting issues and financial statements, but now it is seeking external financing and is required to prepare financial statements to obtain this financing. It is now December 19, 2006. The president is very concerned about how the company's results for the year ended November 30, 2006, will appear to investors. She understands that GAAP allow choices to be made regarding accounting policies and is interested in the choices available for the following two issues: Costs totalling $2,500,000 have been incurred evenly over the last five years in developing systems. Of these costs, $1,000,000 relate to failed efforts on a system that was found this year to be unmarketable. The rest of the costs are attributable to the development of a system that is currently being sold. The company expects to be able to sell the system for five years before it becomes technologically obsolete. The system is expected to become more obsolete and therefore, harder to market as the five years progress. Right now, the company anticipates selling the system as follows:
Fiscal year ended Nov. 30, 2006 Fiscal year ended Nov. 30, 2007 Fiscal year ended Nov. 30, 2008 Fiscal year ended Nov. 30, 2009 Fiscal year ended Nov. 30, 2010 2 systems already sold 4 systems expected to be sold 3 systems expected to be sold 2 systems expected to be sold 1 system expected to be sold
Sales commenced in the last half of 2006. Each sales contract is priced to provide a $250,000 margin over estimated contract costs. Sales arise as follows: a contract is negotiated covering the services to be provided; a nonreturnable deposit of 15% of the negotiated price is required before work commences; as work continues, regular billings are made at specific stages of completion of the system. To November 30, 2006, the following sales have occurred:
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
417
Cash Rec'd Including Completed Deposit So Far $600,000 337,500 $937,500 40% Nil Cash Paid for Costs So Far $500,000 Nil $500,000
Sold To Co. A Co. B
Total Contract Price $2,000,000 2,250,000 $4,250,000
Deposit $300,000 337,500 $637,500
Contract Billings So Far $750,000 Nil $750,000
Prior to making any accounting decisions involved in the above issues, the company's account balances at November 30, 2006, are:
Debit Cash Contract costs paid Contract receipts Development costs Share capital Shareholder loan $ 937,500 500,000 $ 937,500 2,500,000 1,500,000 1,500,000 $3,937,500 $3,937,500 Credit
The following additional information is relevant: a. Of the costs to date, $500,000 has been paid in cash and an additional $200,000 has been incurred but not paid. The only cash inflow this year has been from contract deposits and billings. b. The company is still in the development stage and is not required to pay income tax for 2006 or prior years. c. The founding shareholder's loan is interest-free and due on demand, but the shareholder has signed a letter confirming that he will not withdraw the funds over the course of the next year. Given all of the above information, answer the following: 1. 2. 3. 4. 5. 6. Suggest two different methods of recognizing revenue from sales of the systems. (No calculations are needed--just describe the methods.) Choose a revenue recognition method for CompCom and state why you prefer it. Based on the method you chose in part 2, calculate the company's revenue and contract cost expense for the year ended November 30, 2006. The president wants to capitalize the development costs. How much would you recommend be capitalized, and why? Explain to the president why amortization of any such development cost asset is necessary. Choose a method of amortizing the development cost asset that makes sense to you and calculate the amortization expense for 2006 and the accumulated amortization at November 30, 2006. Based on your answers to the previous parts, prepare an income statement and statement of retained earnings for 2006 and a balance sheet as at November 30, 2006, with appropriate notes. If you're not exhausted, also prepare a cash flow statement for 2006.
7.
8.
NEL
418
PART T HREE
D OING F INANCIAL A CCOUNTING
CASE 6A
A VARIETY OF REVENUE AND EXPENSE RECOGNITION PROBLEMS IN
REAL COMPANIES
M
1.
uch of this book has involved large companies in the public eye. But income measurement is important in all kinds of enterprises. Discuss the accounting methods, ethics, and business practices in the following examples, all real companies with their identities disguised. In each example, try to figure out which accounts in the income statement and balance sheet are involved so that you can say what the effects are on the financial statements. Great Chicken was founded to sell fast-food franchises using the name of a well-known entertainer. Quite a few retired couples and other hopeful people signed up to buy franchises, usually putting up their savings and promising to pay the rest out of the profits of their franchise. Great Chicken recorded the total value of each franchise as revenue on the day the deal was signed. The company had no expenses to speak of at the beginning (except advertising and promotion), so its income statement showed high profits, which encouraged more people to sign up for franchises, which produced more profits. The company's profit growth was huge. But then it became apparent that the franchisees had not chosen good locations, didn't know much about running a chicken shop, couldn't cook and ser ve the food properly, and so couldn't pay their promised franchise payments. It also became apparent that Great Chicken really didn't know how to help them. To the despair of everyone, the whole operation, franchiser and franchisees, went out of business. Intensive Research Inc., located next to a major university, raised funding to develop some drugs for treating serious illnesses. During several years of research and development, the company had very small revenues (interest and some research grants and fees for consulting to other companies) and very large R&D expenses. The president believed it would be inappropriate accounting to match the high R&D to zero revenues yet from the drugs, and bad for the company's image to have losses all this time, so the company capitalized R&D (removed it from expense and put it on the balance sheet as a long-term asset). Enough was capitalized each
3.
4.
2.
year to bring the company's net income to just above zero. Central Community Association rented out its hall on weekends for weddings and other functions. The money earned by these rentals was a major part of the association's funding, largely paying the salary of the association's manager. However, a fair number of renters managed to disappear from town or otherwise avoid paying, so the association instituted a policy of payment in advance. In the first year of this policy, the association showed a large increase in income, because rental reservations often well into future months had been included in the revenue. An argument broke out at the association's regular board of directors meeting when an accountant suggested that each function's reservation revenue be deferred until the function had been held. It turned out that the association's manager, flush with cash, had spent a lot more on repairs and cleaning than usual, and if the revenue was deferred, the association would show a loss for the year, contrary to its by-laws. The manager argued that the deferral of revenue was unnecessary because after the first year of the new policy, things would pretty much even out, revenues coming in at about the same rate as expenses, and so the policy of requiring payment in advance brought in effect a permanent gain for the association. The president of Morgan Lumber always kept the results of the annual inventory count secret. Even the company's chief accountant was not told how much inventory was on hand until a preliminary income figure had been determined for the year. Then the president would consult the records of the inventory count and provide a year-end inventory cost figure, from which the chief accountant deduced the cost of goods sold (beginning inventory plus purchases minus ending inventory equals the cost of what must have been sold). Each year, the final income turned out to be just about what the president wanted, in line with indications given to the bank and with installments paid on the company's income tax.
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
419
5.
6.
Western Business Bank had a large portfolio of loans receivable, all secured by property mortgages. Some of these loans were not being repaid very well, or at all, but the bank did not worry about this much as long as the market values of the mortgaged properties exceeded the loans amounts. So each month, the bank added interest on the loans to interest revenue and to the loans receivable, which therefore continued to rise because many were not being repaid by borrowers. Therefore, the bank's reported assets and revenue (and income) grew even if the borrowers were not keeping up their payments. The bank reasoned that it could always seize the mortgaged properties, sell them, and recover its money. Then, to everyone's horror, the real estate market collapsed, driving market values of mortgaged properties down below the accumulated "loans plus accrued interest" receivables. The bank went out of business soon after, leaving many shareholders and depositors without their money. Brilliant Software had a small but innovative set of software to be sold in the educational market.
Having made promises to investors that the company would succeed, the president was disappointed at the great competition the company faced and resultant slow sales. The company's sales force was therefore issued with "sales call reports" that looked just like sales invoices. When a salesperson made a call, the report was filled in with the number of software packages the potential customer had expressed an interest in, though not actually agreed to buy. These reports came back to head office, where signatures were forged onto them to turn them into sales orders, which were then booked as revenue. To complete the process, the software had to be shipped, but to where? The so-called customer had not actually ordered it. So Brilliant Software quietly rented a warehouse in an obscure part of town, and "shipped" the software there. Somehow no one seemed to question the consequent growth in accounts receivable, and the "shipped" software gathered dust in the warehouse until the whole mess was 15 uncovered.
NEL
420
PART T HREE
D OING F INANCIAL A CCOUNTING
CASE 6B
"LESSONS OF THE '90S"
D
iscuss the lessons for preparing and using accrual accounting information that are suggested in the article below, "Lessons of the '90s."16 As some "disaster stories" mentioned in
the article (Enron, Global Crossing, and WorldCom) will continue to unfold after this book has gone to press, your discussion could be updated by events that have happened since the article was written.
LESSONS OF THE '90S
If there is anything Wall Street and the rest of us should have learned from the '90s, it's that the fixation on earnings reports is what got us into this mess in the first place.
By Harris Collingwood
I
nvestors, pummelled financially by a two-year drop in stocks and psychologically by the atrocities of Sept. 11, 2001, are said to be chastened now. A newly sober Wall Street shudders when recalling the stock market bubble, as a groggy party-goer regrets the excesses of the night before. The day traders have taken their optimism and margin accounts and chat-board rants and disappeared down the same hole that swallowed the age of irony. That's what we're told. But then we get a day like May 8. After the close of trading the previous day, Cisco Systems, the former Internet titan, disclosed a modest profit of $729 million, or 10 cents a share, and the markets went wild. The Nasdaq composite index, thick with technology stocks, soared 7.8 per cent, its biggest gain in more than a year and the eighth-biggest ever. The Dow Jones industrial average posted its best performance since September. And why? Because Cisco beat its modest earnings-growth target by a slim two cents a share. Never mind that Cisco's quarterly revenue was basically flat, and that analysts and Cisco's own management attributed the profits to cost cutting rather than to an upturn in business.
Cisco beat its forecast, and that's all that matters. If there is anything Wall Street and the rest of us should have learned from the '90s, it's that the fixation on earnings reports is what got us into this mess in the first place. It's not by coincidence that the bull market's disaster stories--Enron, Global Crossing and WorldCom, to name just three--concern the companies that were most adept at conjuring market-pleasing numbers. Their handsome earnings statements disguised enterprises too rotten to stand unsupported, and their collapse took lives, businesses and portfolios down with them. It would be comforting to think that the damage was confined to Enron and a handful of other companies that got up to tricks no respectable corporation would even consider.
Public companies and investors alike were obsessed with earnings growth
Yet during the stock market boom, nearly every public company, from the most admired to the most reviled, was gripped by an unhealthy obsession with earnings growth. In its early phases this fixation
may have stimulated corporate innovation and efficiency, but by the time the bull market was in full cry, the pressure for endless growth was driving corporations to fudge the facts, mortgage the future and work against their own best interests and those of their customers, employees and shareholders. Obsessions die hard. As the market's one-day frenzy over Cisco illustrates, the earnings fixation withstood the bursting of the stock market bubble, and it will withstand whatever reform measures eventually emerge from Washington. It is a matter of some urgency, then, to figure out how business fell under this corrosive spell--before it undoes another big company, obliterates billions more dollars in shareholder wealth and throws thousands more people out of work. A little like the Public Broadcasting System, the earnings game owes its survival to corporate sponsorship, as well as to the support of viewers (or investors) like you. Corporate executives, for their part, are almost compelled to play. Continued earnings growth ensures their company's access to affordable sources of capital. It also lets executives keep their jobs and
NEL
C HAPTER 6
R EVENUE
AND
E XPENSE R ECOGNITION
421
collect stock options and other earnings-related incentives. But executives aren't the only ones playing the earnings game. Over the years, an entire earnings infrastructure has developed, including corporate executives and directors, accountants and analysts, fund managers and kitchen-table stock players. These interested parties play mutually reinforcing roles in sustaining the fiction that continuous profit growth is either possible or desirable. And it is a fiction. Even in the 1990s, an exceptionally good period for business, only one in eight large companies managed to achieve continuous, year-upon-year earnings growth. According to a recent report by Credit Suisse First Boston, average earnings growth during the '90s, the up years and the down years taken together, was little better than seven per cent. Nonetheless, most large companies currently predict that their earnings will grow by about 15 per cent a year, every year. And no company in the CSFB study forecasts even a single year of declining profits. The companies that do achieve continual growth aren't necessarily better off for it, nor are their investors. Over the years, economists have come to two widely shared conclusions about corporate earnings: First, higher earnings this quarter do not presage higher earnings next quarter. The second conclusion is that rapidly growing profits are not necessarily a symptom of robust corporate health. They're just as likely to indicate a corporate management that is more adept at fancy accounting tricks than at running a business. In recent years, earnings have so dominated the financial conversation that it's hard to remember that there are other ways to judge and compare corporate performance.
Some professional investors, the legendary Warren Buffet among them, evaluate companies by their return on invested capital. Others, like the mutual fund manager Robert Olstein, consistently make money by focusing on the cash generated by a company's continuing operations. Baruch Lev, an accounting professor at New York University's Stern School of Business, argues against relying on any single data point. He advocates ranking companies on everything from patent filings to the amount they invest in employee training. But in a sound-bite era, the subtle and complex lose out to the simple and obvious every time. As the long bull market recouped the losses of the early-'90s downturn, a single, stark equation took firm hold in the minds of the mass of investors: More earnings equals more shareholder value. All business news was reduced to earnings news, and growth forecasting emerged as an industry in its own right. Left to their own devices, corporate managers during the boom weren't about to abandon the earnings game. The rewards for playing were too great and the penalties for nonparticipation too severe. But in theory at least, two groups of professionals--audit firms and securities analysts--had a duty to investors to restrain corporate managers' most self-serving impulses and subject their actions to skeptical scrutiny. Instead, far too many analysts and auditors connived with management to conceal the true condition of some of the market's most dysfunctional companies. The litany of the professionals' failures has been well chronicled, so regular readers of the business pages will recognize a few of the more egregious examples.
Watchdogs lost their effectiveness trying to serve two masters
As early as February 2001, auditors from Arthur Andersen were aware that Andrew Fastow, Enron's chief financial officer, was serving two masters: Enron and the partnerships with which the company had an ostensibly arm'slength relationship. The auditors discussed the blatant conflict among themselves but did nothing to check it. Auditors at another firm, KPMG, supposedly allowed Xerox to produce a deceptively cheery picture of its revenue growth. The company's European, Latin American and Canadian units booked all the revenue from the long-term copier leases up front, even though customers paid over several years. The pressures that drove the accounting firms to bend their principles are clear enough. In the 1980s and 1990s, the firms aggressively sold consulting services to their existing audit clients. Consulting revenue soon surpassed audit revenue at the Big Five firms, leading them to regard auditing not as a function in its own right but as a marketing tool. Aware that corporate clients could simply fire an unco-operative auditor--as Xerox did when KPMG refused to certify the company's 2000 financial report--audit firms became more and more lenient toward their clients. Like the accounting firms, analysts suffer from hopelessly divided loyalties. Although in theory analysts' primary task is to provide reliable information to investors, their primary constituency is actually their colleagues in investment banking, who earn multimillion-dollar fees for underwriting and distributing securities of corporate clients. None of these conflicts of interest should come as news to reasonably informed investors. It was not exactly a
NEL
422
PART T HREE
D OING F INANCIAL A CCOUNTING
secret in the 1990s that many corporations were straining the limits of acceptable accounting, and that several of the companies with the most questionable accounting, including Waste Management and Sunbeam, were clients of Arthur Andersen. The standards that govern corporate accounting--known as generally accepted accounting principles--are far more flexible than the public would imagine. In general, this is a desirable and necessary quality. It brings, say, an airline, which collects its payment as soon as it sells a ticket, and a software company, where payment lags far behind the sale, into the same financial universe.
The trouble is, that same flexibility gives corporate managers the latitude to summon earnings out of this air if they're so inclined. It enabled companies like Xerox to claim most of their revenue all at once, even though their clients usually paid over a period of several years. For now, at least, investors do seem to be scrutinizing earnings reports with a new diligence. But it will be interesting to see if their caution survives the next stock market rally, and whether they can resist the hype of ratings-starved financial channels spewing earnings reports by the minute, all day every working day. In the end, corporate managers are probably the best hope for break-
ing the grip of the earnings obsession. Gillette's chief executive, James Kilts, has disavowed his predecessor's promises of 18 per cent annual earnings growth, saying it led the company to increase prices, cut ad spending and otherwise cripple its own long-term prospects. The stock market and human nature being what they are, such realism isn't likely to become the majority view. But even a sizable minority could help ensure that the next boom doesn't end as badly as the last one. Harris Collingwood, a former senior editor of The Harvard Business Review, writes frequently on business and finance. Copyright 2002 Harris Collingwood.
NOTES
1. W.H. Beaver, Financial Reporting: An Accounting Revolution, 2nd ed. (Englewood Cliffs: Prentice-Hall, 1989), 8. Ibid., 105. Ibid., 105. P.A. Griffin, ed., Usefulness to Investors and Creditors of Information Provided by Financial Reporting, 2nd ed. (Stamford: Financial Accounting Standards Board, 1987), 14. CPR notes to consolidated financial statements, 2004 Annual Report, 4851. Ibid., 5153. Canadian Institute of Chartered Accountants, "Introduction to Accounting Standards," in CICA Handbook (Toronto: Canadian Institute of Chartered Accountants, revised to April 2005), as posted on the Handbook Web site http://www.knotia.ca. 8. C. Byrd, I. Chen, and J. Smith, Financial Reporting in Canada, 2005 (Toronto: Canadian Institute of Chartered Accountants, 2005), 6. (The 2005 30th edition surveys annual reports of 200 Toronto Stock Exchange companies for 2004, 2003, 2002 and 2001.)
2. 3. 4.
9. Christopher Power, "Let's Get Fiscal," Forbes (April 30, 1984): 103. 10. CPR, 2004 Annual Report, 48. 11. Canadian Tire 2004 Annual Report, 87. 12. Bombardier Inc. 200405 Annual Report, 97. 13. Aecon Group Inc. 2004 Annual Report, 34. 14. S. Tuck, "Tech Firms' Accounting Methods Assailed," The Globe and Mail (29 March 1999): B1, B9. 15. Based on the article "Anatomy of a Fraud," by M. Maremont, Business Week (16 September 1996): 9092, 94. 16. H. Collingwood, "Lessons of the '90s," The Edmonton Journal (June 16, 2002): D5. Reprinted from The New York Times Magazine.
5. 6. 7.
NEL