financial accounting I, test 2 review
Special Issues for Step 4: Allocate the Transaction Price to the Performance Obligations
*Adjusted market assessment approach*: The seller considers what it could sell the product or services for in the market in which it normally conducts business, perhaps referencing prices charged by competitors. *Expected cost plus margin approach:* The seller estimates its costs of satisfying a performance obligation and then adds an appropriate profit margin. *Residual approach:* The seller estimates an unknown (or highly uncertain) stand-alone selling price by subtracting the sum of the known or estimated stand-alone selling prices of other goods and services in the contract from the total transaction price of the contract. (The residual approach is allowed only if the stand-alone selling price is highly uncertain,)
Cash Discounts
*Gross method* - records sale at full amount and then if the discount is taken, it records it as a debit to cash, a debit to "sales discount" for the amount of the discount, and a credit to accounts receivable for the sum of both. --The gross method recognizes discounts not taken as revenue when the sale is made. *Net method* - records sale at the amount net of the discount offered. if the discount is taken, we debit cash and credit accounts receivable and credit "interest revenue" for the amount of the discount taken. --The net method recognizes them as revenue after the discount period has passed and the cash is collected. *By either method, net sales is reduced by discounts taken.*
Special Issues for step 2: Identify the performance obligation
*Prepayment* are not a performance obligation. The are added to the transaction price. *Warranties* - A quality-assurance warranty is not a performance obligation. ( it is a cost of satisfying the performance obligation to deliver products of acceptable quality. The seller recognizes this cost in the period of sale as a warranty expense and related contingent liability.) *Extended Warranties* - Because an extended warranty usually is priced and sold separately from the product, it constitutes a performance obligation and can be viewed as a separate sales transaction. The price is recorded as a deferred revenue liability and then recognized as revenue over the extended warranty period. *Customer option for additional goods and services* - An option for additional goods or services is a performance obligation if it confers a material right to the customer. An example would be if you purchase something and the retailer gives you a 20% off coupon for your next purchase. --When a contract includes an option that provides a material right, the seller must allocate part of the contract's transaction price to the option. Just like for other performance obligations, that allocation process requires the seller to estimate the stand-alone selling price of the option, taking into account the likelihood that the customer will actually exercise the option. The seller recognizes revenue associated with the option when the option is exercised or expires.
Special Issues for Step 3: Determine the Transaction Price
*VARIABLE CONSIDERATION* - Sometimes a transaction price is uncertain because some of the price depends on the outcome of future events. --Variable consideration is estimated as either the expected value or the most likely amount. - the *expected value* (calculated as the sum of each possible amount multiplied by its probability) --Sellers are limited to recognizing variable consideration to the extent that it is probable that a significant revenue reversal will not occur in the future. *RIGHT OF RETURN* - A right of return is not a performance obligation. - however, there is contra account to sales revenue where an estimate of returns is placed. -so the seller reduces revenue by the estimated returns and records a liability for cash the seller anticipates refunding to customers. Sales revenue Less: Sales returns Net sales -debit "sales returns" and credit "refund liability" *IS THE SELLER A PRINCIPAL OR AGENT?* - The distinction between a principal and an agent is important because it affects the amount of revenue that a company can record. -If the company is a principal, it records revenue equal to the total sales price paid by customers as well as cost of goods sold equal to the cost of the item to the company. -On the other hand, if the company is an agent, it records as revenue only the commission it receives on the transaction. *THE TIME VALUE OF MONEY* - We recognize A/R when payment is made after delivery and we recognize deferred revenue when payment is made before delivery. -Sellers must account for the financing component of transactions when it is significant.
Step 2: Identify the performance obligations
-Contracts between a seller and a customer contain one or more performance obligations -promises to transfer goods or services to a customer. -The seller recognizes revenue when it satisfies a performance obligation by transferring the promised good or service. -We consider transfer to have occurred when the customer has control of the good or service. ---Control means that the customer has direct influence over the use of the good or service and obtains its benefits.
Multiple performance obligations -Delivery of the good or service is a performance obligation. -Promises to provide goods and services are performance obligations when the goods and services are distinct.
-a good or service is distinct if it is both 1. capable of being distinct - The customer could use the good or service on its own or in combination with other goods and services it could obtain elsewhere, and 2. separately identifiable from other goods and services in the contract. - The good or service is distinct in the context of the contract because it is not highly interrelated with other goods and services in the contract. (see pg 237)
Determining Progress Towards Completion
-output based estimates- progress happens over a passage of time (subscriptions) -input based estimates - % of completion construction Input or output methods can be used to estimate progress toward completion when performance obligations are satisfied over time.
Internal Control Procedures—Cash Disbursements
1. All disbursements, other than very small disbursements from petty cash, should be made by check. This provides a permanent record of all disbursements. 2. All expenditures should be authorized before a check is prepared. For example, a vendor invoice for the purchase of inventory should be compared with the purchase order and receiving report to ensure the accuracy of quantity, price, part numbers, and so on. This process should include verification of the proper ledger accounts to be debited. 3. Checks should be signed only by authorized individuals.
5 indicators that control has transferred from seller to customer. (a customer is more likely to control a good or service if the customer has:)
1. An obligation to pay the seller 2. legal title to the asset 3. Physical possession of the asset 4. Assumed the risk and reward of ownership 5. Accepted the asset
Criteria for recognizing revenue over time: If a performance obligation meets one of these criteria we recognize revenue over time, in proportion to the amount of performance obligation that has been satisfied. *(Most long-term contracts qualify for revenue recognition over time.)*
1. the customer consumes the benefit of the seller's work as it is performed. (ex/ cleaning service, or subscription service) 2. The customer controls the asset as it is created. (ex/ contractor constructs an extension to a customers existing building) 3. The seller is creating an asset that has no alternative use to the seller, and the seller has legal right to receive payment for progress to date. (ex/company manufactures customized fighter jets for the U.S. Air force).
TopChop sells hairstyling franchises. TopChop receives $60,000 from a new franchisee for providing initial training, equipment and furnishings that have a standalone selling price of $60,000. TopChop also receives $38,000 per year for use of the TopChop name and for ongoing consulting services (starting on the date the franchise is purchased). Carlos became a TopChop franchisee on July 1, 2016, and on August 1, 2016, had completed training and was open for business. How much revenue in 2016 will TopChop recognize for its arrangement with Carlos?
Because Carlos had completed training and was open for business on August 1, 2016, TopChop apparently has satisfied its performance obligation with respect to the initial training, equipment and furnishings, so it would recognize $60,000 of revenue in 2016. In addition, since Carlos was a franchisee for the last six months of 2016, TopChop should recognize 6 ÷ 12 = 50% of a yearly fee of $38,000, or $19,000. In total, TopChop recognizes revenue from Carlos of $60,000 + 19,000 = $79,000 in 2016.
Video Planet ("VP") sells a big screen TV package consisting of a 60-inch plasma TV, a universal remote, and on-site installation by VP staff. The installation includes programming the remote to have the TV interface with other parts of the customer's home entertainment system. VP concludes that the TV, remote and installation service are separate performance obligations. VP sells the 60-inch TV separately for $1,910 and sells the remote separately for $180, and offers the entire package for $2,220. VP does not sell the installation service separately. VP is aware that other similar vendors charge $230 for the installation service. VP also estimates that it incurs approximately $180 of compensation and other costs for VP staff to provide the installation service. VP typically charges 50% above cost on similar sales.
Calculate the stand-alone price of the installation service using each of the following approaches. 1. Under the *adjusted market assessment approach*, VP would base its estimate of the stand-alone selling price of the installation service on the prices charged by other vendors for that service, adjusted as necessary. Given that the other vendors are similar to VP, no adjustment is necessary. Therefore, VP would estimate the stand-alone selling price of the installation service to be $230, the amount charged by competitors for that service. 2. Under the *expected cost plus margin approach*, VP would base its estimate of the stand-alone selling price of the installation service on the $180 cost it incurs to provide the service, plus its normal margin of 50% × $180 = $90. Therefore, VP would estimate the stand-alone selling price of the installation service to be $180 + 90 = $270. 3. Under the *residual approach*, VP would base its estimate of the stand-alone selling price of the installation service on the total selling price of the package ($2,220) less the observable stand-alone selling prices of the TV ($1,910) and universal remote ($180). Therefore, VP would estimate the stand-alone selling price of the installation service to be $2,220 − ($1,910 + 180) = $130.
Finerly Corporation sells cosmetics through a network of independent distributors. Finerly shipped cosmetics to its distributors and is considering whether it should record $270,000 of revenue upon shipment of a new line of cosmetics. Finerly expects the distributors to be able to sell the cosmetics, but is uncertain because it has little experience with selling cosmetics of this type. Finerly is committed to accepting the cosmetics back from the distributors if the cosmetics are not sold. How much revenue should Finerly recognize upon delivery to its distributors?
Finerly should recognize $0 of revenue upon delivery to distributors. Given the uncertainty about estimated returns, Finerly can't argue that it is probable that it won't have to reverse (adjust downward) a significant amount of revenue in the future because of a change in returns. Therefore, Finerly won't recognize revenue until it either can better estimate returns or sales to end consumers occur. Essentially, because Finerly can't estimate returns, it treats this transaction as if it is placing those goods on consignment with independent distributors.
Journal entry for revenue recognition over time. - on Jan 1, Seller sells 1,000 1 year service subscription for $60 each
Jan, 1 cash ($60x1000) $60,000 deferred revenue $60,000 Jan, 31 deferred rev ($60,000/12) $5000 subscription rev $5000 Feb 28 deferred rev $5000 subscription rev $5000 etc.
Single Performance obligation
Performance obligation is satisfied when control of the goods or services is transferred from the seller to the customer and usually it's obvious that transfer occurs at the time of delivery.
Step 5: Recognize Revenue When (Or As) Each Performance Obligation Is Satisfied
Revenue with respect to each performance obligation is recognized when (or as) that performance obligation is satisfied. ex with multiple performance obligations (see ex of product A and B above): 1. delivery of item A. goods. $200 recognized right away as a debit to A/R and credit to Sales Revenue. 2. 1 year service subscription Item B. service $50 is recognized as deferred revenue right away and $4.17/month is debited to deferred revenue and credited to service/subscription revenue *A prepayment is not a performance obligation.* it is added to the transaction price.
5 steps to recognizing revenue
Step 1: Identify the contract Step 2: Identify the performance obligation(s) Step 3: Determine the transaction price Step 4: Allocate the transaction price Step 5: Recognize revenue when or as each performance obligation is satisfied.
petty cash
The appropriate expense accounts are debited *when the petty cash fund is reimbursed.* The petty cash fund always should have cash and receipts that together equal the amount of the fund. The petty cash account is not debited when replenishing the fund. - If, however, the size of *the fund is increased* at time of replenishment, *the account is debited for the increase.* -Similarly, *petty cash would be credited if the size of the fund is decreased.*
Step 1: Identify a contract
The key is that, implicitly or explicitly, you entered into an arrangement that specifies the legal rights and obligations of a seller and a customer.
Step 3: determine the transaction price
The transaction price is the amount the seller expects to be entitled to receive from the customer in exchange for providing goods and services. -*prepayments* are added to the transaction price
bank reconciliation
Timing differences occur when the company and the bank record transactions at different times. Errors can be made either by the company or the bank. For example, a check might be written for $210 but recorded on the company's books as a $120 disbursement; a deposit of $500 might be processed incorrectly by the bank as a $50 deposit. In addition to serving as a safeguard of cash, the bank reconciliation also uncovers errors such as these and helps ensure that the proper cash balance is reported in the balance sheet. Bank balance + Deposits outstanding - Checks outstanding ± Errors Corrected balance Book balance + Collections by bank - Service charges - NSF checks ± Errors Corrected balance The two corrected balances must equal.
Step 4: Allocate the Transaction Price to Each Performance Obligation
We allocate the transaction price to performance obligations in proportion to their relative stand-alone selling prices. ex/ Product A and B. standalone prices: A- $240 B- $60 Package price with A and B - $250 A and B purchased separately cost $300 ($240+$60) A - $240/$300 = 80% B - $60/$300 = 20% -so 80% of the price of the package with A and B, $250, should be allocated to product A. ($250x.8=$200) -and 20% allocated to product B. ($250x.2=$50)
Revenue recognition - performance obligations are satisfied, but payment is not made yet but is promised.
We recognize revenue when performance obligations are met, not when cash is received.
Liquidity
a measure of a company's cash position and overall ability to obtain cash in the normal course of business A company is assumed to be liquid if it has sufficient cash or is capable of converting its other assets to cash in a relatively short period of time so that current needs can be met. The current ratio is one of the most common ways of measuring liquidity and is calculated by dividing current assets by current liabilities. We can refine the measure by adjusting for the implicit assumption of the current ratio that all current assets are equally liquid. In the acid-test or quick ratio, the numerator consists of "quick assets," which include only cash and cash equivalents, short-term investments, and accounts receivable. *Profitability, for instance, is perhaps the best long-run indication of liquidity.*
separation of duties
an internal control technique in which various functions are distributed amongst employees to provide cross-checking that encourages accuracy and discourages fraud. -employees who handle cash should not be involved in or have access to accounting records nor be involved in the reconciliation of cash book balances to bank balances. -Employees involved in recordkeeping should not also have physical access to the assets.
compensating balances
compensating balance results in the borrower's paying an *effective interest rate higher than the stated rate on the debt*. For example, suppose that a company borrows $10,000,000 from a bank at an interest rate of 12%. If the bank requires a compensating balance of $2,000,000 to be held in a noninterest-bearing checking account, the company really is borrowing only $8,000,000 (the loan less the compensating balance). This means an effective interest rate of 15% ($1,200,000 ($10mil*.12) interest divided by $8,000,000 cash available for use). -A material compensating balance must be disclosed regardless of the classification of the cash. -If the compensating balance arrangement is informal with no contractual agreement that restricts the use of cash, the compensating balance can be reported as part of cash and cash equivalents, with note disclosure of the arrangement.
Cash equivalents
money market funds, treasury bills, and commercial paper. To be classified as cash equivalents, these investments must have a maturity date no longer than three months from the date of purchase. -company's policy on what is included as cash equivalency should be in a disclosure note. -Credit and debit card receivables often are included in cash equivalents.
