SESSION 2

Assets – Part 1
Revenue Recognition,
Accounts Receivable, Inventory

2.1
 Learning objectives

1. Understand major asset categories – Pre-class video

2. Apply the revenue recognition principle

3. Account for receivables and bad debt

4. Apply inventory cost flow assumptions – LIFO, FIFO, average cost

5. Account for inventory obsolescence

6. Describe the principles of sound A/R and inventory management

2.2
 Revenue Recognition
• Revenue definition: Inflows (increase in assets or decrease in liabilities or a
combination of both) from delivering or producing goods, rendering services, or
other activities involving customers, that constitute the entity’s ongoing major
or central operations.

• For non-financial firms, income from interest and dividends can arise in the
normal course of operations. But these are not considered revenue in because
they are not “customer” transactions.

• Revenue differs from income. Income includes gains and losses from activities
that are not central to the firm’s operations.

2.3
 Revenue recognition: Five-step approach
1. Revenue arises from a contract that contains a promise (or promises) to transfer goods or services to a customer.
2. The contract contains a performance obligation, a distinct promise (or a group of promises).
3. The transaction price is the amount of consideration an entity expects to be entitled to receive from a customer
in exchange for providing the goods or services.
4. In case of contracts with multiple performance obligations, the transaction price must be allocated to each
performance obligation separately.
5. Revenue is recognized when (or as) the performance obligations are satisfied.

2.4
 Illustration 2.1: ABC & XYZ Revenue
⚫ Case 1: ABC Corp. delivers ₹10,000 of goods to XYZ Inc now. XYZ Inc. promises to pay cash next month.
⚫ Case 2: ABC Corp. delivers ₹10,000 of goods to XYZ Inc now. XYZ Inc. promises to pay once their quality
control department approves of the quality within 30 days. Quality control approves the quality next month
after 20 days.
⚫ Case 3: ABC Corp. delivers ₹10,000 of goods to XYZ Inc now. ABC Corp. informs XYZ Inc. that invoice
for payment will be sent next month and XYZ must pay upon receipt of the invoice.
⚫ Case 4: ABC Corp. receives a purchase order from XYZ Inc. ordering goods valued at ₹10,000 to be
delivered next month. ABC Corp delivers the goods next month and XYZ Inc. pays cash next month.
⚫ Case 5: ABC Corp. receives a purchase order from XYZ Inc. ordering goods valued at ₹10,000 to be
delivered next month. ABC Corp requires that XYZ Inc. pay 20% of the purchase order value at the time of
ordering and XYZ Inc. pays ₹2,000 in cash.
⚫ Case 6: ABC Corp. contracts to deliver ₹10,000 of goods to XYZ Inc. over five months starting this month.
XYZ Inc. pays ₹2,000 and promises to pay the remaining amount in four equal monthly instalments.

2.5
 Illustration 2.1: ABC & XYZ Revenue
Case # Performance obligation Transaction value (What) When is Revenue recognized and how
(When) much?

2.6
 Illustration 2.1: ABC & XYZ Revenue
Consider an electronics retailer. One of the most lucrative lines of business is warranty
contracts. Typically, the company will sell a warranty contract on an electronic item (say a
TV) for a fixed period. During this period the customer is protected from failure of the
purchased product. The company will repair the item free of cost (parts + labor). Because
of consumers’ risk aversion and the aggressive selling by the sales agents at the stores,
many customers buy a warranty, especially for TV sets.

Assume that the company sells a TV with a 2-year warranty at the following terms.

TV Warranty contract Total

Sales price 1,000 100 1,100
Cost 900 20 920
Gross profit 100 80 180

How should the total REVENUE of 1,100 be recognized?

2.7
 Liquid assets
Companies hold liquid assets for several reasons including:

• To satisfy their daily working capital needs like paying suppliers, employees, etc.

• To be able to make payment in advance to get things at a discount

• Creating a cushion in case of an economic downturn

• To be able to respond to opportunity. If a profitable investment arises, a company with

ample cash can quickly take action to close the deal

• Because they have nothing better to do with their cash. See the balance sheet of the
tech companies, for example.

2.8
 Accounts Receivable (A/R)
A/R definition: amounts owed to the company
⚫ Trade receivables: amounts owed from customers. The company extends a line of
credit. Normally these receivables have terms that require payments within a
relatively short time period.
⚫ Other receivables: various and sundry amounts owed for transactions other than sales
to a customer

Need for Trade receivables

⚫ A/R facilitates B2B trade. It would be nearly impossible to transact business if the
buyer had to pay in cash (Who would collect? How would the cash be kept secure?
What about long-distance, intercontinental sales?)
⚫ A/R can increase sales for the company. If the customer is given time to pay, it
creates the opportunity for the customer to resell the goods and make repay the A/R.
Absent that, the customer might not be able to buy the goods in the first place.

2.9
 A/R Accounting Basics

Sales on account

Collect from
customers

1. During the month, a company provides services and bills customers 19,000

2. During the month, the company collects 15,000 cash from customers

2.10
 Illustration 2.2: Accounting for Bad Debts
• MLM Co made credit sales of $100,000 during the year.
• Of these sales the company collected $40,000 in cash from customers.
• Thereafter, MLM Co learns that two customers have filed for bankruptcy and will
very likely not pay $2,000.
• At what amount will accounts receivables be recorded on the balance sheet?

Use all three methods to record these transactions.

1. Direct write off method
2. Allowance method – percentage of sale [Assume 3% of all sales are uncollectible]
3. Allowance method – percentage of AR [Assume 5% of ending A/R is uncollectible]
2.11
 Method #1: Direct write-off

Initial sale 100,000 100,000 100,000 − = 100,000

AR Ret. Earn.

Collect cash 40,000 (40,000)

AR

Write offs (2,000) (2,000) − 2,000 = (2,000)

AR Ret, Earn. Bad debt
expense

• Assumes that all sales are fully collectible until proven otherwise
• When MLM learns that two customers have filed for bankruptcy and will not pay their dues, they
are “removed” from the books. This process of reducing receivables is called “write off” and the
resulting loss is recorded as “bad debt expense”
• This method is simple and inexpensive to use. If bad debts are small and infrequent then this
practice will not misstate the economic situation in a material way.
• Method #1 is NOT acceptable for financial reporting. Followed for tax reporting purposes.
2.12
 Method #2: Allowance method: % of sales
• Losses due to non-payments by certain (unknown) customers are bound to
happen at some point.
• Recognize expected losses as bad debt expense at the same time the revenue
is recognized.
• Bad debt expense is calculated as a % of sales using historic trends and / or
other relevant current information.
• Create a reserve / allowance / cushion to absorb those expected losses. Create
an allowance for bad debt, a contra-asset account attached to A/R.
• When specific A/R are written off, no loss is recognized when the allowance
was created. Instead, the allowance is reduced reflecting that the cushion that
was previously created for future losses is now reduced.

2.13
 Illustration 2.2
Applying Method #2 ASSUME Bad Debt Expense
= 3% of Sales

Initial sale 100,000 100,000 100,000 − = 100,000

A/R Ret. Earn.

Create allowance (3,000) (3,000) − 3,000 = (3,000)

Allowance Ret. Earn. Bad debt
for bad debts expense

Collect cash 40,000 (40,000)

A/R

Write offs 2,000

Allowance
for bad debt

(2,000)
A/R

2.14
 Method #3: Allowance method: % of A/R

• Same logic as Method #2 but expected losses during the period but the
reserve / allowance / cushion is based on the outstanding A/R (that is,
GROSS accounts receivable).
• The allowance is “reset” each period and the amount required to bring the
allowance to the appropriate balance, is recorded as bad debt expense.
• As for Method #2, when specific A/R are written off, no loss is recognized.
Instead, the allowance is reduced to reflect the fact that the cushion that was
previously created for future losses has now been used for the intended
purpose.

2.15
 Illustration 2.2
Applying Method #3 ASSUME Allowance
= 5% of A/R

Initial sale 100,000 100,000 100,000 − = 100,000

A/R Ret. Earn.

Create allowance (5,000) (5,000) − 5,000 = (5,000)

Allowance Ret. Earn. Bad debt
for bad debt expense

Collect cash 40,000 (40,000)

A/R

Write offs 2,000

Allowance
for bad debt

(2,000)
A/R

Adjust allowance 100 100 Income statement − 100 = 100

Allowance Ret. Bad
Earn. debt expense 4,900
Bad debt
for bad debt expense

2.16
 Variation of Method #3: Aging Schedule
Aging schedule
• A more precise way to estimate required allowance
• Instead of an average % of total A/R at period end, the aging schedule varies
the % by A/R age
• The older the A/R, the more likely the balance will not be paid

A/R Balances Total 1-30 days 31-60 days 61-90 days > 90 days
Customer A 5,000 5,000
Customer B 10,000 10,000
Customer C 15,000 10,000 5,000
Customer D 22,000 2,000 10,000 10,000
Customer E 6,000 4,000 2,000
Total A/R outstanding 58,000 27,000 15,000 14,000 2,000
Historic bad debt % 0.00% 2% 5% 100%
Allowance required 3,000 0 300 700 2,000

2.17
 Comparing the three methods
Direct write off Allowance as a % of sales Allowance as a % of AR
Description of the Ostrich approach: Income statement approach: Balance sheet approach:
method Don’t estimate anything Match bad debts expense to Create allowance that relates
sales in the same period directly to the AR balance

Initial sale Record sales and increase A/R Record sales and increase A/R Record sales and increase A/R

Estimate bad debts No estimate at all As % of sales No direct estimate

Cash collection Record cash and decrease A/R Record cash and decrease A/R Record cash and decrease A/R

Write off Record Bad debt expense Decrease bad debt allowance Decrease bad debt allowance
Decrease A/R, gross Decrease A/R. gross

Estimate allowance No estimate at all No direct estimate As % of ending A/R

2.18
 Recovery of an uncollectible account
Continuing from Illustration 2.2
• MLM wrote off $2,000 because two customers filed for bankruptcy.
• Suppose one of these customers, sold certain assets in the next year and was able to pay
MLM $500.
• How should we account for it?

Reverse (500)
What is the net impact
allowance Allowance of this transaction on
for bad debts the income statement?
500
A/R 0
Collect 500 (500)
cash A/R

2.19
 Reversal of an allowance
Continuing from Illustration 2.2.
• The ending balance of the allowance for bad debts was $2,900.
• Suppose MLM learns that the economy is picking up and that all customers have better
business prospects.
• The company determines that it requires an allowance of only $1,000.
• How would we account for this new information?

What is the net impact

of this transaction on
Reverse the income statement?
allowance Allowance Retained Bad debt
for bad debts Earnings Expense
+1900

2.20
 Illustration 2.3: Accounting for Bad Debts
During the year MM Co. reports the following for fiscal 2020

Instructions: Prepare a FSET to record bad debt expense assuming

MM Co. accounts for bad debts with the following methods:
(a) 1% of NET sales
(b) 5% of GROSS Accounts Receivable
2.21
Illustration # 2.3 MM Co. Bad Debts Expense

BREAKOUT
with your Group for 10 minutes

1) Use your shared XL OneDrive file

2) Appoint a Reporter for the Group

3) Prepare a FSET to record bad debt

expense assuming MM Co. accounts for
bad debts with the following methods:
i) 1% of net sales
ii) 5% of total accounts receivable

Deliverable: Reporters – be prepared to

enter bad debt expense as indicated

2.22
Enter BAD DEBT EXPENSE in your Group’s box

2.23
Other estimates that use similar methods

• Banking: Loan Loss Provisions

• Merchandising: Sales Returns; Sales Discounts
• Pharma: Rebates; Chargebacks
• Manufacturing: Warranty Expenses
• Airlines: Frequent Flyer Miles
• Allowances for Inventory Obsolescence
• Consumer Electronics: Service Agreements

2.24
 Ideas for managing A/R

BREAKOUT
with your Classmates for 10 minutes

1) Appoint a Reporter for the Group

2) Prepare a list of specific steps managers

can take to “manage” A/R, collect cash as
quickly as possible, and minimize bad
debt losses

Deliverable: Reporters – be prepared to

report ONE of the items on your list when
called on

2.25
 Inventory: Big picture
⚫ Definition: goods held for sale in the normal course of business or items used in the
manufacture of products that will be sold
⚫ Need for inventory
▪ By holding an inventory of finished product, a firm can fill more orders and fill them more
quickly to provide better customer service
▪ For manufacturing firms, available raw materials can speed up production to meet demand
▪ BUT: it is costly to hold inventory, it ties up capital and increases risk of obsolescence
⚫ Categories of inventory
▪ Merchandising company - finished goods
▪ Manufacturing company
i. raw materials
ii. work-in-progress (WIP)
iii. finished goods
2.26
 Inventory: Cost flow assumptions
• Goods are purchased at various points of time during the year.
• At each purchase, the unit price might be different.
• Hence, we must make certain assumptions in order to allocate “cost” between
ending inventory and COGS.
• Following are some common methods to determine cost:
► Specific identification
► First-in, first-out (FIFO)
Cost Flow
► Last-in, first-out (LIFO)
Assumptions
► Average-cost
• NB: Cost flow assumptions are ASSUMPTIONS to make accounting easier and
do not need to track the physical inventory flow
2.27
 Illustration 2.4 Specific identification
MLM TV Company purchases three identical 50-inch TVs on different dates at
costs of $700, $750, and $800. During the year ML TV Company sold two sets at
$1,200 each. These facts are summarized below.

Purchases
February 3 1 TV at $700
March 5 1 TV at $750
May 22 1 TV at $800
Sales
June 1 2 TVs for $2,400 ($1,200 x2)

2.28
 Illustration 2.4 Specific identification
• The TVs have serial numbers and thus, MLM TV Co can use specific identification method
• MLM TV Co. determines that it sold the TVs that were purchased on February 3 and May 22
• Cost of goods sold is $1,500 ($700 + $800)
• Ending inventory is $750.
Cost of goods sold = $700 + $800 = $1,500

Ending inventory = $750

• This practice is relatively rare

• COGS is consistent with the physical sale of specific goods
• No cost flow assumption is needed
2.29
 Illustration 2.5 Cost flow assumptions
Assume these facts
for MLM Mart.

Determine ending inventory and COGS using

i. FIFO method
ii. LIFO method
iii. Average cost method
2.30
 First-In, First-Out (FIFO)
▪ ASSUME: Costs of the earliest goods purchased are the first to be sold.
Physical Flow
▪ To imagine this assumption, think of a conveyor belt. of Goods

▪ FIFO cost flow assumption sometimes parallels the In

actual physical flow of the inventory (but not required). Out

100 sold
200 sold
250 sold

2.31
 Last-In, Last-Out (LIFO)
▪ ASSUME: Costs of the latest goods purchased are the first to be sold.
Physical Flow of
▪ To imagine this assumption, think of a cookie jar. Goods

▪ Note that this assumption seldom coincides with Out

In
the actual physical flow of goods. Exceptions include
goods stored in piles, such as coal or hay.

150 sold
400 sold

2.32
 Average Cost
Allocates cost of goods available for sale on the basis of
weighted-average unit cost incurred.

Cost per Unit Ending Inventory Cost of Goods Sold

$12,000/1,000 units 450 units × $12 $12,000 - $5,400
= $12 per unit = $5,400 = $6,600

2.33
Financial statement impact of cost flow assumptions

HOUSTON MLM Mart

ELECTRONICS
While the sales, opening
Income
Condensed Statement
Income Statements
inventory, and purchases are
Explanation FIFO LIFO Avg. Cost the same in all three cases,
Sales revenue $18,500 $18,500 $18,500 ending inventory, COGS, and
Beginning inventory 1,000 1,000 1,000 hence profit is going to be
different.
Purchases 11,000 11,000 11,000
Cost of goods available for sale 12,000 12,000 12,000
But are they really
Less: Ending inventory 5,800 5,000 5,400
ECONOMICALLY different?
Cost of goods sold 6,200 7,000 6,600
Gross profit 12,300 11,500 11,900
Operating expenses 9,000 9,000 9,000
Income before income taxes 3,300 2,500 2,900
Income tax expense (30%) 990 750 870
Net income $2,310 $1,750 $2,030

2.34
 A few observations about cost flow assumptions
• If prices are increasing, then the following are true (opposite if prices are decreasing)
• LIFO will show lower profit as more recent costs are matched to sales
• LIFO will show lower inventory values because it reflects older market prices.
• LIFO is permitted only under US GAAP.
• Because LIFO ending inventories can be significantly lower than replacement costs,
companies using LIFO are required to disclose the amount at which the inventories would
have been had the company used FIFO method.
• The difference between these two methods is called the LIFO reserve.

FIFO Inventory - LIFO Inventory = LIFO reserve

• LIFO reserve can be viewed as an ‘unrealized holding gain’ – a gain that results from
holding inventory as prices are rising

2.35
 Illustration 2.6
Data for MLM Equipment Retail Stores is as follows:

Determine ending inventory and COGS using

i. FIFO method
ii. LIFO method
iii. Average cost method
2.36
 Illustration 2.6
BREAKOUT
with your Group for 10 minutes

1) Use your shared XL file and follow the

method shown for Illustration 2.6.

2) Appoint a Reporter for the Group

3) Determine COGS and ending

inventory balance for all three
inventory costing methods

Deliverable: Reporters – be prepared to

enter COGS as indicated

2.37
Put COGS for the method indicated for your Group

2.38
 Lower of cost or market (LCM)
When the market value of inventory is lower than its cost, companies have to “write down”
the inventory to its market value in the period in which the price decline occurs..

Illustration 2.7 ABC Corp has inventory worth $100,000. At the end of the fiscal year, it
becomes clear that due to certain change in market trends those goods can only be sold at
$90,000. How would ABC Corp account for this change in the value of inventory?

Lower of cost (10,000) (10,000) − 10,000 (10,000)

or market Allowance Retained Loss on
adjustment
obsolescence (COGS)

The allowance (a contra asset) is netted against the inventory (asset)

and “Inventories, net” is shown on the balance sheet.
2.39
 What happens if inventory values rebound?
• Under US GAAP – do nothing. The gain will be realized when the inventory is eventually
sold
• Under the IFRS and Ind-AS – The allowance that was earlier created can be reversed, but
only to the extent of the existing allowance
• For example if at the end of year 2, when the book value of inventory is $90,000, the market
value increases to $105,000, there is a potential $15,000 gain on the value increase. But as
the allowance is only $10,000, only $10,000 can be reversed

LCM reversal

2.40
 Heads up!!

• Session 3:

o Wrap up inventory

o Property plant & equipment (PPE)

• Watch Session #4 asynchronous videos – this content will be covered

on the midterm

• Work on Group Assignment #1

2.41