Lec 4 Notes

Why Do We Care About Revenue Recognition?
- Revenue has BIG impact on bottom-line profitability ==>

managers may be tempted to manage revenue
- Statistical Evidence: over 40% of SEC enforcement actions on

accounting issues deal with Revenue Recognition
- Anecdotal Evidence: Recent experience of Bristol-Myers

• In another setback for the beleaguered drug maker, Bristol-
Myers Squibb Co. confirmed that the Securities and Exchange
Commission has opened an inquiry into whether it improperly
inflated revenue last year by as much as $1 billion through use
of sales incentives...Drug makers, like many other
manufacturers, can boost near-term sales by extending lower
prices to wholesalers, encouraging them to load up. But such
"channel-stuffing" hurts later sales. --from WSJ, 7/12/2002
15.514 2003
Session 4
Criteria For Revenue Recognition
- Under accrual accounting, a firm recognizes revenue when it has:
- Performed all, or a substantial portion of, the services to be

provided.
- Incurred a substantial majority of the costs, and the remaining

costs can be reasonably estimated.
- Received either cash, a receivable, or some other asset for which

• a reasonably precise value can be measured
• collectibility is reasonably assured.
15.514 2003
Session 4
Importance Of Accounts Receivables
Receivables
Industry Total Assets
Eating Places 1.6%
Family Clothing Stores (The GAP) 3.0
Race Track Operations 3.1
Grocery Stores 4.9
Intel 8.6
Semiconductors 11.3
Advertising Agencies 42.7
Trans. Freight/Cargo 43.1
Computer Software Wholesale 45.5
Overall Median 13.0%
Source: 5,933 industrial firms from 2000 Global Vantage
15.514 2003
Session 4
Allowance For Bad Debts (Uncollectibles)
- Methods
• Direct Method
• Percentage of Sales
• Aging
- How might a firm’s choice of method evolve over

time?
15.514 2003
Session 4
I/S and B/S Relationships
Accounts Receivable (A) - Allowance for doubtful

Accounts (XA)
Beginning Balance Beginning Balance
+ Credit Sales + Amounts Recorded as Bad

Debt Expense
- Cash Collected
- Amounts Written Off - Amounts Written Off
+ Reinstatements + Reinstatements
= Ending Balance = Ending Balance

15.514 2003
Session 4
Parallels Between Bad Debt And Other Accrued Expenses
Cash + A/R - ADA Acc. Ret.

= Liab. + Earn
Accrue 50 K (50)K
Expense
Pay Liability (50)K (50)K
Accrue Bad 50 K (50)K

Debts
Write Off (50)K (50)K
Accounts
15.514 2003
Session 4
Problem E6-7
See Problem E6-7 on pages 272-3 of the course textbook.
15.514 2003
Session 4
Problem E6-7 (Cont’d)
AR -ADA L + CC + RE
BB
Sales
Write-Off
Bad Debt
Expense
EB
15.514 2003
Session 4
Allowance For Returns
- If customer has the right to return the product, the seller must
estimate the dollar value of returns.
- Revenue is reported net of the amount expected to be returned.
- Typically, seller sets up a contra-asset account, Allowance for
Returns:
• Analogous to Allowance for Doubtful Accounts
• When return actually occurs, reduce both Allowance and face
value of Accounts Receivable (or Cash) by the invoice
amount.
• Return has no effect on Net Income, nor on Net Assets, just as
Write-off of Uncollectible has no effect on these amounts.
• BSE: AR - Allowance for Returns = RE
- Intel takes a slightly different approach: Deferred Income
Liability.
15.514 2003
Session 4
Deferred Income: An Example
Shipments on 3/1 to OEMs and Distributors:

Total Billings $ 350,000
Direct to OEMs 280,000
To Distributors (PP) 70,000
COGS $ 90,000
Direct to OEMs 72,000
To Distributors (PP) 18,000
• Return / Price Protection expires for $35K of sales on 3/31

• Invoice Price is reduced from $35K to $25K on the remainder
of shipment on 4/15
15.514 2003
Session 4
Deferred Income: An Example
AR + INV = Deferred Inc + RE
OEM sales
Distrib. Sales
PP Expires
for $35K
PP Applies
for 35K
15.514 2003
Session 4
Reverse Engineering: How Much Cash Did Intel
Collect From Customers In 2002?
Reverse Engineering process:

- Identify Relevant Balance Sheet Accounts: A/R, Allowance for
Doubtful Accounts, Deferred Income
- Identify the activities that affect these accounts:
• Recognizing sales revenue as A/R
• Recognizing bad debt expense
• Writing off uncollectible accounts
• Invoicing products that affect the Deferred Income Liability
- Obtain amounts from the Financial Statements, notes, other
• i.e., Intel’s Bad Debt Expense ($10M) and Write-offs ($21) are
disclosed in its 10-K report filed with the SEC, but not in the
annual report.
- Set up BSE template and “plug” the remaining numbers
15.514 2003
Session 4
Determining Intel’s Cash Collections
Cash +AR -ADA +OA =Def Inc +RE
Begin
Balance 2,675 68 418
Sales
Revenue
Bad Debt
Expense
Write-
Offs
Change in
Def Inc
Cash
Collected
End
Balance 2,631 57 475
15.514 2003
Session 4
Summary Points
- Criteria for recognizing revenue

• Collectibility: Match expected bad debts to the period in
which the sales occur
� Distinguish between Bad Debt Expense and Write-Offs
� Methods for estimating Bad Debts / Uncollectible
Accounts
• Right of Return: match expected returns to the sales
period, or more conservatively, defer revenue
recognition until return protection / price protection ends.
- Reverse Engineering: infer the activities that underlie a
firm’s reported financial results
15.514 2003
Session 4

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Why Do We Care About Revenue Recognition?

- Revenue has BIG impact on bottom-line profitability ==>

- Statistical Evidence: over 40% of SEC enforcement actions on

- Anecdotal Evidence: Recent experience of Bristol-Myers

- Under accrual accounting, a firm recognizes revenue when it has:

- Performed all, or a substantial portion of, the services to be

- Incurred a substantial majority of the costs, and the remaining

- Received either cash, a receivable, or some other asset for which

Source: 5,933 industrial firms from 2000 Global Vantage

- How might a firm’s choice of method evolve over

Accounts Receivable (A) - Allowance for doubtful

Beginning Balance Beginning Balance

+ Credit Sales + Amounts Recorded as Bad

- Amounts Written Off - Amounts Written Off

= Ending Balance = Ending Balance

Cash + A/R - ADA Acc. Ret.

Accrue Bad 50 K (50)K

See Problem E6-7 on pages 272-3 of the course textbook.

Shipments on 3/1 to OEMs and Distributors:

• Return / Price Protection expires for $35K of sales on 3/31

AR + INV = Deferred Inc + RE

Reverse Engineering process:

- Criteria for recognizing revenue

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