Recognition and Measurement Criteria Flashcards
Financial statements are prepared using the accrual basis of accounting. What is the accrual basis of accounting?
The accrual basis of accounting means that transactions affecting a company’s financial statements are recorded in the period in which the events occur, rather than when the company receives cash or pays cash.
Therefore accounting standards are necessary to help accountants answer two questions: 1) when should an event be recorded and 2) at what amount should it be recorded? Recognition criteria help determine when an event should be recorded in the financial statements. When an item is recorded in the financial statements, accountants say that it has been recognized. Measurement criteria provide guidance on what amount should be recorded for the event.
Generally an item will be included in the financial statements if it meets the definition of?
Of an asset, liability, equity, revenue, or expense; if it can be measured; and if a reasonable estimate of the amount can be made. The item is reported in the financial statements in a monetary amount. In Canada, the monetary unit used for financial reporting is generally the Canadian dollar.
What are two important concepts underlying the general criteria?
The first concept is that for an asset to be recorded, it must be probable that there will be a future economic benefit, and for a liability to be recognized, it must be probable that economic resources will be given up. For example, a company does not have to be 100% certain that it will collect an account receivable to record the receivable; it just has to be probable that cash will be collected. The second concept is that estimates may be used to record dollar amounts if the precise dollar amount is not known.
REVENUE RECOGNITION CRITERIA:
What does the revenue recognition criteria state?
The revenue recognition criteria state that revenue is recognized when there has been an increase in an asset or a decrease in a liability due to ordinary profit-generating activities that results in an increase in owner’s equity.
REVENUE RECOGNITION CRITERIA:
SALE OF GOODS:
Revenue from the sale of goods is recognized when all of the following conditions have been met: ?
For sales in a retail establishment, these conditions are generally met at?
- The seller has transferred to the buyer the significant risks and rewards of ownership
- The seller does not have control over the goods or continuing managerial involvement.
3The amount of the revenue can be reliably measured. - It is probable there will be an increase in economic resources (that is, cash will be collected).
- Costs relating to the sale of the goods can be reliably measured.
For sales in a retail establishment, these conditions are genereally met at the point of sale. Consider a sale ny Reitmans for an item that is a final sale and cannot be returned. At the point of sale, the customer pays the cash and takes the merchandise. The company records the sale by debiting Cash and crediting Sales Revenue. In this example, there is no uncertainty about when or how much revenue should be recorded. Cash has been received and the customer has taken ownership of the goods.
REVENUE RECOGNITION CRITERIA:
SALE OF GOODS:
WHEN GOODS ARE SHIPPED:
When does the legal title pass and when is revenue recognized when goods are shipped?
Typically, the risks and rewards of ownership are transferred when legal title passes and the customer is in possession of the goods. For goods that are shipped, the shipping terms determine when the legal title passes. Recall that if the terms of the sale are FOB shipping point, then legal titles passes when the goods are shipped and the seller recognizes revenue on the date the goods are shipped. If the terms of the sale are FOB destination, then legal title passes when the goods arrive at their destination and revenue is recognized on the date the goods are delivered.
REVENUE RECOGNITION CRITERIA:
SALE OF GOODS:
WHEN GOODS ARE SOLD ON CREDIT:
When is revenue recognized when goods are sold on credit?
When merchandise is sold on credit, revenue is recognized at the point of sale as long as it is reasonably sure that the cash will be collected. If the sale were on credit rather than for cash, the company would record the sale by debiting Accounts Receivable and crediting Sales Revenue. Of course, not all accounts are actually collected. However, revenue can be recognized as long as an estimate can be made of any possible uncollectible accounts. Bad debt expense is recorded for the estimated uncollectible accounts and matched against revenue in the appropriate period.
REVENUE RECOGNITION CRITERIA:
SALE OF GOODS:
WHEN GOODS MAY BE RETURNED FOR A REFUND:
When is revenue recognized if a company provides refunds to customers for goods returned?
If a company provides refunds to customers for goods returned, revenue is recognized at point of sale if the company is able to reliably estimate future returns. The company will report sales net of an allowance for the estimated returns and recognize a liability for the estimated returns in its financial statements. For example,
REVENUE RECOGNITION CRITERIA:
SALE OF GOODS:
WHEN FREE WARRANTY SERVICE IS PROVIDED:
When is revenue recognized when a company provides free warranty service?
If a company provides free warranty service on its merchandise, revenue is recognized at point of sale if the company is able to reliably estimate the future warranty costs. The estimated warranty expense is recorded and a warranty liability is recognized in its financial statements. if costs relating to the sale cannot be reliably measured, then the revenue cannot be recognized.
REVENUE RECOGNITION CRITERIA:
SALE OF GOODS:
WHEN THE SALES TRANSACTION INCLUDES THE SALE OF GOODS AND A SERVICE COMPONENT:
How is revenue recognized in the sale of goods and a service?
Some sales transactions may include both the sale of goods and a service component. For example, assume a customer pays $3,250 cash for a large screen television and an extended warranty. The extended warranty normally sells for $250 as a separate warranty. The transaction must be recorded in the accounting records to reflect that the customer has paid for two items: the television and the extended warranty. Sales revenue of $3,000 is recorded for the sale of the television and $250 is recorded as unearned warranty revenue to recognize that the store has an obligation (liability) to provide warranty service in the future. Warranty revenue will be recognized when the company satisfies its obligation by providing warranty service.
REVENUE RECOGNITION CRITERIA:
SERVICE CONTRACTS AND CONSTRUCTION CONTRACTS:
When is revenue recognized in businesses that provide service?
Generally, in businesses that provide services, revenue is recognized when the service has been provided and it is probable that the cash will be collected. To illustrate, assume your doctor gives you a routine checkup in September, bills the provincial health care plan in October, and receives payment in November. When should your doctor recognize the revenue? The revenue should be recognized in September because that was when the service was performed, the price would have been known, and the receivable was likely to be collected.
REVENUE RECOGNITION CRITERIA:
SERVICE CONTRACTS AND CONSTRUCTION CONTRACTS:
What is the percentage-of-completion method? List the three steps for this method.
If costs to complete a project (that may take a few years to complete) can be reasonably estimated, the percentage-of-completion method is typically used to recognize revenue. The percentage-of-completion method recognizes revenue on long-term projects as progress is made toward completion based on reasonable estimates of how much of the work has been performed to date.
There are three steps in the percentage-of-completion method:
- Progress toward completion is measured. One common method of measuring progress toward completion is to compare the costs incurred in a period with the total estimated costs for the entire project (divide costs incurred with total estimated costs for the entire project). This results in a percentage that indicates the percentage of the work that is complete. In the Warrior example, the project is 15% ( $54 million / $360 million) complete at the end of 2012.
- This percentage is multiplied by the total revenue for the project, to determine the amount of revenue to be recognized for the period. Warrior will recognize revenue of $60 million (15% x $400 million) in 2012.
- The costs incurred are then subtracted from the revenue recognized to arrive at the gross profit for the current period. Warrior will report gross profit of $6 million ($60 million - $54 million) for 2012.
REVENUE RECOGNITION CRITERIA:
SERVICE CONTRACTS AND CONSTRUCTION CONTRACTS:
The IASB has proposed a new standard for revenue recognition in consultation with the FASB in the U.S., which is it? Is this going to make a difference in companies with long-term service or construction contracts?
The proposed standard is a “contract”- based approach. Under the proposed standard, a company would recognize revenue when it has transferred a promised good or service to a customer, which is when the customer obtains control of that good or service.
The new standard is not expected to significantly change the way most companies recognize revenues but it may make a significant difference for those companies who have long-term service or construction contracts.
EXPENSE RECOGNITION CRITERIA:
What does the basic expense recognition criteria state? Is expense only recognized when cash is paid?
The basic expense recognition criteria state that expenses are recognized when there is a decrease in an asset or increase in a liability, excluding transactions with owners that result in a decrease in owner’s equity.
This is not necessarily when cash is paid. For example, as supplies are used, the asset Supplies is decreased and an expense is recognized. Alternatively, when a liability for salaries payable is recorded, salaries expense is recognized.
EXPENSE RECOGNITION CRITERIA:
Expense recognition is tied to revenue recognition when? What is matching?
Expense recognition is tied to revenue recognition when there is a direct association between costs incurred and the earning of revenue. For example, there is a direct association between cost of goods sold and sales revenue. This is commonly referred to as matching.
Under matching, revenues and expenses that relate to the same transaction are recorded in the same accounting period. Other examples of expenses that relate directly to revenue are bad debt expense, warranty expense, and sales salaries.
GOOGLE: The matching principle requires a company to match expenses with related revenues in order to report a company’s profitability during a specified time interval. Ideally, the matching is based on a cause and effect relationship: sales causes the cost of goods sold expense and the sales commissions expense. If no cause and effect relationship exists, accountants will show an expense in the accounting period when a cost is used up or has expired. Lastly, if a cost cannot be linked to revenues or to an accounting period, the expense will be recorded immediately. An example of this is Advertising Expense and Research and Development Expense.
