FinancialAcct-C06-v3 3/28/06 4:08 PM Page 355 PART3 THREE Doing 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 impor- tant 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 consider- ations 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 FinancialAcct-C06-v3 3/28/06 4:08 PM Page 356 FinancialAcct-C06-v3 3/28/06 4:08 PM Page 357 CHAPTER SIX Revenue 6 and Expense Recognition 6.1 Chapter Introduction: Revenue and Expense Recognition Every public company has an annual meeting at which top inventories because those products were available management reports on performance and prospects for the to sell but just did not move out the door. future, and shareholders are able to ask questions. Here’s some of what went on at a recent annual meeting. Shareholder A. Benoit: Have the product markets collapsed? If not, then having the products available is still a Chief executive officer (CEO): … and I hope you have found good thing. Unless you doubt you will sell them, my report useful. While the company faces many why not add them to revenue when you have challenges, there is much strength here too, and them ready to sell? Otherwise you make the we look forward to improved prosperity. I now company look worse than it is, which hurts the invite questions from shareholders present today. company’s share price and so the value of my shares. Shareholder A. Benoit: Thank you for your informative comments. My question is about the company’s Shareholder B. Hutchence: Please also tell us why the revenues. I note that revenues have failed to grow company’s accounts receivable are up along with much this year while inventories have risen. Can inventories. This doesn’t make sense when you explain what is going wrong? revenues have not grown. CEO: We are facing much stronger competition in some CEO: I’ll ask our chief financial officer (CFO) to address product lines, so products we expected to sell those questions. have not sold, depressing revenue and increasing NEL FinancialAcct-C06-v3 3/28/06 4:08 PM Page 358 358 PART THREE DOING FINANCIAL ACCOUNTING CFO: The company’s accounting policy is to record Shareholder J. Ranu: Money in the bank from customers revenue only when a legal customer order has who are slow to pay? Do any other companies been received, so we cannot show revenue for like ours do this? It sounds fishy. Since you products no one has yet ordered. The have not shipped the products yet, are they accounts receivable are up, I agree, and still in inventory? frankly it is because in the face of competition, we have taken orders from some lower-quality CFO: Well, of course they are still in inventory. We only customers than we used to, and some of those record the revenue when we get the order. We customers are slower to pay than we had record cost of goods sold when we ship the hoped. products, a few days later. Shareholder J. Ranu: Hold on, here! You record revenue Shareholder B. Hutchence: You guys are trying to pull the when you get an order? You don’t wait until wool over our eyes! You are showing revenue you fill the order? Sounds like even though you should not, and are not matching the this has not been a good revenue year, your expenses with the revenues. Sounds like the accounting has made it better than it should company’s books are a mess, and the income have been. Are you covering up a real decline figure is a fabrication! I’ll bet it helps you in revenue? make your bonuses, but it doesn’t help us! CFO: I don’t like your language. We’re not covering up Several shareholders shout: Are you cooking the books? anything. But once we receive an order, it is as good as money in the bank, so we mark it CEO: Order, please! All of this can be explained if you down as revenue. will be kind enough to listen…. Learning Objectives Most annual meetings are not this confrontational, though • How to determine when it is the appropriate time to controversy does erupt at many companies’ meetings from record revenues and related expenses (the company in time to time, but the vignette illustrates several important the vignette is recording revenues too soon, before goods points. In this chapter you will learn: are shipped); • How accrual accounting works to make sure that revenues • How to set good accounting policies for measuring and expenses are measured in the appropriate period so revenues and expenses so that the results are not “fishy” as that each period’s income is valid (so there is no impropri- in the vignette, and why users of financial statements need ety, “cooking the books” as in the vignette); to be vigilant just in case the company is using improper • How advancing or delaying the measurement of revenues accounting policies (most companies are quite scrupulous and expenses, done to get income right, affects past and about their accounting, but some that are not have been future income measures as well as the balance sheet (such prominent in recent years, to the embarrassment of all as the receivables and inventories in the vignette); principled accountants, auditors, and managers). NEL FinancialAcct-C06-v3 3/28/06 4:08 PM Page 359 CHAPTER 6 REVENUE AND EXPENSE RECOGNITION 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 intro- duced 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 “resid- ual” 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 Accrual accounting is all about choosing follow cash transactions only. With accrual accounting, revenues, expenses, assets, and when to recognize liabilities can be recorded (recognized, as accountants say) before or after cash transac- phenomena in the tions happen. This can be done by the familiar method of debiting something and cred- accounts. iting 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 appropri- ate 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. Accrual accounting involves estimates, It exists because cash flow information is simply not complete enough to assess financial judgments, and performance or financial position. Keeping track of cash flow is crucial for business subjectivity. 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 NEL FinancialAcct-C06-v3 3/28/06 4:08 PM Page 360 360 PART THREE DOING FINANCIAL ACCOUNTING answering machine, and the fancy calculator I got so that I might be able to pass accounting.