Generally Accepted Accounting Principles rely on the concept of a critical event to determine when revenue is recognized.  Most commonly the critical event is when, 1) the sale takes place, 2) when the goods or services are transferred (delivered) and 3) when all the production efforts are completed.  Note that the exchange of cash is not a critical event to revenue recognition.  Not surprisingly there are a number of exceptions to this basic concept.  Your author reviews some important variations to the basic rule.

Looking at the illustration 5 –1 on page 118.  Note that the operating cycle takes substantial time from cash to finally collecting the cash from a sale.  What if we are building a bridge or a jetliner and this cycle takes several years.  Should we report that we have made no revenue or profit to our shareholders over the years it takes to build a large asset.  We argue no, we should be entitled to recognize revenue as we are completing the project and therefore estimate to our owners how well our project is doing.

Accounts Receivable and Bad Debts:

Accounting recognizes the asset Accounts Receivable when we believe the buyer is committed to purchase our goods and services.  Bad Debts arise when we estimate that some of the buyers will not follow through on their commitment and we must recognize an expense for the lost Receivable.  The key is that Bad Debts should be recognized when the sale is made not when we later discover who is not going to pay.  Therefore, we set up an Allowance for Doubtful Accounts to reduce the gross Receivable to our best estimate of what we will really collect.

Review the discussion of Accounts Receivable and Bad Debts don’t worry about the entries to calculate the amount I am more interested in you understanding the concept.

Accounting for Warranty Costs:

Normally the costs of a warranty should be separated from the sale of the product. In the case of a car if $1000 is a fair value for the three-year warranty, then a portion of the $20,000 sales price should be matched with the estimated effort to keep the car.

            Cash                        $20,000

                        Revenue                              $19,000

                        Unearned Revenue            $  1,000

Then over the warranty period revenue is recognized as the services are performed.

Yr. 1.

            Unearned Revenue            $333

                        Warranty Revenue             $333

Note that this method creates a separate business, which managers can evaluate success or failure.

Bonds: Contracts between a company and an investor. The contract specifies that the company will pay a coupon rate (semi annual payments of interest) and a principal payment X number of years from contract date.

Example: Coupon rate: $40 every six months

Principle: $1000 at the end of 10 years.

Problem: How does an investor value these sets of promises

What is the value of $40 every six month for 10 years?

What is the value of $1000 paid ten years from today.

Unknown: What is the require rate of return on the investment. Investors will not be forced to pay $1000 for the bond just described.

If they pay more then the money is issued at a premium and the yield is less than 8%

Conversely, if they pay less than face value then the bond is sold at a discount and the yield is greater than 8%.

Bonds are direct financing agreements, the moneys can be used for any purchase leases are financing arrangements linked directly to the use of an asset. Lease arrangements do often advantages to direct purchases.

1. Risk Transfer

2. Low down payment financing

3. Tax benefits

4. Reporting advantages

Disadvantages

1. You may never own the asset and therefore can not resell without permission.

2. Usually more expensive than purchase transaction since lessor is absorbing risk.

3. Must re-lease if asset necessary part of operations.

Are leases essentially purchases or simply short term rights to use assets for a monthly payment?

Accounting principles have developed a set of rules that govern the treatment of leases. Essentially short-term agreements are expenses when accrued while long-term contracts require the capitalization of an asset and a corresponding obligation is reported on the balance sheet.

Pensions: We will discuss long term deferred compensation agreements at the end of the semester.

Note that your author now discusses ratio analysis.  I have mentioned some of these ratios in an earlier section, so refer back to chapter 1 (part 2) notes to refresh your memory.  Chapter 13 is fully devoted to financial statement analysis and we will get into the concepts of how to use these tools when we cover Chapter 13.  At this stage I want you to be aware of them and get comfortable with how they are calculated.