Revenue Recognition

1
Revenue Recognition

• Overview
• Return on Investment
• Revenue Recognition
• Cash-to-Cash Cycle

2
Return on Investment

• Investors generally want to know how well their
  investments are performing.
• The most simple example is the return on your
  bank account or a bond that you have purchased.

3
Return on Investment

• How do you determine or calculate
  the return on your bank account?

4
Return on Investment

• How might you suggest that shareholders of a
  business calculate or measure their
  return on investment?

5
Return on Investment

• For the investment number, refer to the Balance
  Sheet

6
Return on Investment

• To determine the return number, what
  transactions impact Shareholders Equity?

7
Revenue Recognition

• Accountants have developed and established
  concepts and guidelines to guide how estimates of
  changes in value of assets and liabilities can be
  determined. These are sometimes called revenue
  recognition principles.
• These principles address the transactions within
  the normal day-to-day activities of the business
  (operating activities).

8
Revenue Recognition

• The typical operation of a business involves an
  outflow of cash followed by an inflow of
  cash. This is called the cash-to-cash cycle.
• (see Exhibit 4-1, page 223)
• The revenue recognition principles provide
  guidelines to businesses regarding the timing of
  revenue recognition in the cash-to-cash cycle.

9
Cash-to-Cash Cycle

• Cash
• Initial investment by shareholders.
  (Also loans from lenders but, for simplicity,
  assume investment by shareholders.)

10
Cash-to-Cash Cycle

• Acquisition of Materials/Inventory
• At start-up Property, buildings and equipment.
• Then, labour is hired and inventory is purchased
  (or contracts are signed for acquisition).
• These costs are generally greater in a retail
  operation vs. a service-oriented operation.
• These costs are generally greater, again, in a
  manufacturing operation (since production
  activity is added to the cycle).

11
Cash-to-Cash Cycle

• Selling Activity
• All activities incurred to promote and sell the
  product. (e.g. pricing, advertising, hiring and
  managing a sales force, retail sales outlets,
  etc.)
• The end result are sales contracts between buyer
  and seller either verbal or written.

12
Cash-to-Cash Cycle

• Delivery of Product
• Delivery to the customer.
• Length of time depends on the nature of the
  product. (e.g. groceries, building of a car)

13
Cash-to-Cash Cycle

• Collection
• Collection of sales price in cash. Can be
  immediate or later (an account receivable).
• If later, like a loan to the buyer. There is a
  risk that the buyer wont pay (credit risk).
  Interest may be charged if payment is not made
  within a specified period of time. Also, the
  seller may try to take back the product or enlist
  a collection agency in the event of overdue
  payment.

14
Cash-to-Cash Cycle

• Collection (contd)
• Other events that affect collection of cash
• Returns - no cash collection.
• Price adjustment or price allowance (possibly due
  to damage in shipment).
• Cash discount - an incentive to the customer to
  pay promptly. (e.g. 2/10, net 30 means
  a 2 discount if the account is paid in 10 days.
  Otherwise, the total amount is due in 30 days.)
  

15
Cash-to-Cash Cycle

• Warranty Service
• Some goods carry a written or implied guarantee
  of quality.
• During the warranty period, the seller is
  responsible for replacement or repair of the
  product.
• This can reduce the amount of cash available at
  the end of the cycle.

16
Cash-to-Cash Cycle

• Summary
• When the cycle is complete, the net amount of
  cash left is available to start the next cycle.
• If the cash inflows exceed outflows, the business
  can expand its activities and/or return some of
  the extra cash to the shareholders (through
  dividends).
• If the cash inflows are less than outflows, the
  business may not be able to begin a new cycle.

17
Cash-to-Cash Cycle

• Summary (contd)
• The sequence of phases in the cycle may differ
  for different businesses (large contractors may
  do most selling at or near the beginning of the
  cycle) or may take place simultaneously (e.g. a
  grocery store - delivery and collection of cash).
• Different businesses may be able to recognize
  revenue at different stages in the cash-to-cash
  cycle (as long as they adhere to revenue
  recognition principles).