Southwest Airlines Frequent Flyer Program Accounting Questions

read:

Case: Accounting for Revenues (Course Pack)

Reading: Revenue Recognition (pages. 4-10, 15-17, and 20-22) (Course Pack)

Reading: Assets and Expenses (pages 5-8) (Course Pack)

Q1: SWA

How does SWA account for its frequent flyer program? Does this accounting make sense to you?

In 2020, SWA recognized passenger revenues of $7,665m (noted in Case). What percentage of ticket sales for that year were deferred? Given your answer, how significant are the costs of the program?

Q2: MP

Please outline the principles of revenue recognition? List these in bullet points or in a table.

Drawing on these principles, when should MP be allowed to recognize revenue on the Amgen contract?

A. When it signs the contractB. When it receives cashC. During the contract term, orD. When the contract is completed

Why did you choose A, B, C or D above?

3. Given the method of reporting used, what transactions would have been recorded in relation to the contract when it was signed and at the end of 2018?

4. In 2019, the company announced that completion of the project would take longer than anticipated, and that it would use the percentage completion method to allocate the deferred revenues over time, rather than straight-line. Conceptually, how does each method work? Which method makes more sense to you? Why?

Financial Accounting
V.G. Narayanan and Dennis Campbell, Co-Series Editors
+ INTERACTIVE ILLUSTRATIONS
Assets and Expenses
DENNIS CAMPBELL
HARVARD BUSINESS SCHOOL
5071 | Published: July 24, 2018
Table of Contents
1 Introduction …………………………………………………………………………………………………………………………….3
2 Essential Reading ……………………………………………………………………………………………………………………4
2.1 Current Assets ………………………………………………………………………………………………………………….4
2.1.1 Cash and Cash Equivalents ……………………………………………………………………………………..4
2.1.2 Accounts Receivable ……………………………………………………………………………………………….4
2.1.3 Inventory…………………………………………………………………………………………………………………7
2.1.4 Other …………………………………………………………………………………………………………………… 14
2.2 Long-Lived Assets …………………………………………………………………………………………………………. 14
2.2.1 Long-Lived Fixed Assets………………………………………………………………………………………. 14
2.2.2 Deferred Tax Assets (and Liabilities) …………………………………………………………………….. 22
2.2.3 Investments …………………………………………………………………………………………………………. 22
2.2.4 Goodwill and Other Intangible Assets …………………………………………………………………… 24
2.3 Basis for Recording Assets ……………………………………………………………………………………………. 30
2.3.1 Revaluation …………………………………………………………………………………………………………. 30
2.3.2 Impairment…………………………………………………………………………………………………………… 30
2.3.3 Differences Between FASB and IASB on Recording Basis ……………………………………… 31
2.4 Relationship to Income Statement ………………………………………………………………………………….. 32
2.4.1 Expenditures vs. Expenses…………………………………………………………………………………… 32
2.4.2 Accounts Receivable and Revenues ……………………………………………………………………… 32
2.4.3 Inventory and Cost of Goods Sold ………………………………………………………………………… 32
2.4.4 PP&E and Depreciation ………………………………………………………………………………………… 33
2.4.5 Intangibles and Amortization ………………………………………………………………………………… 33
2.4.6 Other Changes in Asset Values …………………………………………………………………………….. 33
3 Key Terms ……………………………………………………………………………………………………………………………. 34
4 Endnotes……………………………………………………………………………………………………………………………… 36
5 Index …………………………………………………………………………………………………………………………………… 38
This reading contains links to online interactive illustrations, denoted by the icon above. To
access these exercises, you will need a broadband internet connection. Verify that your
browser meets the minimum technical requirements by visiting http://hbsp.harvard.edu/techspecs.
Dennis Campbell, Dwight P. Robinson, Jr. Professor of Business Administration, Harvard
Business School, developed this Core Reading with the assistance of writer Sarah Abbott.
Copyright © 2018 Harvard Business School Publishing Corporation. All rights reserved.
5071 | Core Reading: Assets and Expenses
2
1 INTRODUCTION
A
ssets are defined as “probable future economic benefits obtained or controlled
by a particular entity as a result of past transactions or events.”1 To be recorded
as an asset, an economic resource must have four key characteristics:
1 It has been obtained at a measurable cost.
2 It is likely to generate a future benefit, contributing to
a firm’s cash flow either directly or indirectly.
3 The entity on whose balance sheet it is recorded controls it.
4 The transaction that has given the entity control over the
asset has already occurred.
Assets, composed of liabilities and equity, are recorded on a company’s balance
sheet. They present a picture of a company’s financial condition at a specific
point in time.
Assets = liabilities + equity
There are many types of assets. Land, cash, and investments are examples, but
assets can also be intangible, such as an entity’s brand, trademark, and
intellectual property. On an entity’s balance sheet, assets are grouped into two
broad categories: current assets and long-lived assets.
Assets are generally recorded at cost and only when there is reasonable
certainty that they will yield a future benefit.
If a company has an expenditure (or cash outlay) that does not meet the
definition of an asset, then it will likely be recorded as an expense on the income
statement.
To illustrate these concepts, this reading includes selected information from
the Coca-Cola Company’s 2014 annual report.
5071 | Core Reading: Assets and Expenses
3
2 ESSENTIAL READING
2.1 Current Assets
Current assets are cash and other assets that are reasonably expected to
generate a benefit for an entity during either the subsequent year or the normal
operating cycle, whichever is longer. 2,3,a Under US GAAP, current assets are
sequenced from the most liquid —i.e., the most easily convertible, directly or
indirectly, into cash—to the least liquid.
2.1.1 Cash and Cash Equivalents4
Cash comprises cash on hand and demand deposits. Cash equivalents include
highly liquid short-term investments held for short-term cash commitments
rather than for investment or other purposes. Examples of cash equivalents
include money market funds, government securities, certificates of deposits
(CDs), and investment-grade commercial papers that are readily convertible to
known amounts of cash and are subject to an insignificant risk of value
change. An investment constitutes a cash equivalent only if it is high-quality,
highly liquid, and short-term (generally maturing in less than three months).
This asset category is meant to capture cash on hand that is available to fund a
firm’s day-to-day operations. However, managers will often shift cash into liquid
investments to improve returns while still maintaining liquidity.
2.1.2 Accounts Receivable
A sale is generally realized when a promise to pay is received in exchange for the
provision of goods or services. Sales to customers in which the company is
compensated with terms other than cash (i.e., credit sales or sales on account)
are recorded as accounts receivable —a current asset—when payment is
normally expected within the short term or within the operating cycle. Accounts
receivable are recorded as the amount the company expects to receive from
customers in the future, generally the gross selling price less any discounts or
rebates and adjusted by an allowance for doubtful accounts.
The allowance for doubtful accounts is a contra asset, an account related to a
specific asset account that is used to offset the balance of that asset account. It is
a A company’s operating cycle is the time between its cash outlay to acquire goods and services
and its realization in cash from selling a finished product.
5071 | Core Reading: Assets and Expenses
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used when it is unlikely that all customers will pay their outstanding amounts in
full, which often happens when a customer gets into financial difficulty and lacks
the means to pay his or her account. In this case, a portion of the accounts
receivables will become bad debts.
Although a firm will likely know the amount of any discounts at the time of the
sale, it cannot know the allowance for doubtful accounts in advance, so it will
need to reasonably estimate the probable uncollectible amount. Therefore, a
firm must establish credit policies to control and assess its accounts receivable
accounts, and it must set accounting policies to analyze and determine the
appropriate allowance for doubtful accounts. This is generally done by looking
at the firm’s historic experience with bad debts. For example:
•
The firm may estimate the allowance by looking at the percentage of
historic credit sales that became bad debts and then applying this
percentage to sales in the current period. The resulting amount is
charged to expenses in the income statement for that period.
•
To calculate the amount of the allowance for bad debts on the
balance sheet, the firm may also look at the percentage of receivables on
the balance sheet that historically became bad debts.
•
The firm may classify outstanding accounts receivables based on
the amount of time they have been outstanding. Using this aging
analysis, receivables can be placed into groups (e.g., current; 1–30 days
past due; 31–60 days past due) and applies a different allowance
percentage to each group of accounts receivables. These adjustments are
made to the class of accounts receivable in the aggregate rather than to
individual accounts.
Once the firm selects a particular approach, it can calculate the allowance for
doubtful accounts for each accounting period.
When the firm determines that a particular customer is not going to pay his or
her account, it will remove this account, and the value of that customer’s
accounts receivable will be written off, i.e., reduced to $0. For example, credit
card companies will write off a customer’s account once the account is 180 days
past due. When this happens, no expense is recorded on the income statement.
Instead, the allowance is reduced by the amount of the write-off as shown in
Exhibit 1.5 The basic equation for the allowance for bad debts reads as follows:
Beginning allowance + bad debt expense – write-offs = ending allowance
5071 | Core Reading: Assets and Expenses
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An illustrative example from Coca-Cola’s 2014 annual report is shown in
Exhibit 2.
EXHIBIT 1 Accounting for Bad Debts
EXHIBIT 2 Accounting for Bad Debts at the Coca-Cola Company
The following excerpt is from the 2014 annual report of the Coca-Cola Company:
We record trade accounts receivable at net realizable value. This value includes an
appropriate allowance for estimated uncollectible accounts to reflect any loss anticipated on
the trade accounts receivable balances and charged to the provision for doubtful accounts.
We calculate this allowance based on our history of write-offs, the level of past-due accounts
based on the contractual terms of the receivables, and our relationships with, and the
economic status of, our bottling partners and customers. We believe our exposure to
concentrations of credit risk is limited due to the diverse geographic areas covered by our
operations. Activity in the allowance for doubtful accounts was as follows (in millions):
Year Ended December 31
2014
2013
2012
Balance at beginning of year
$61
$53
$83
Net charges to costs and expenses*
$308
$30
$5
Write-offs
−$13
−$14
−$19
Other**
−$25
−$8
−$16
Balance at end of year
$331
$61
$53
* The increase in 2014 was primarily related to concentrate sales receivables from our bottling partner in Venezuela.
** “Other” includes foreign currency translation and the impact of transferring certain assets to assets held for sale.
5071 | Core Reading: Assets and Expenses
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Interactive Illustration 1 offers a visual display of how the allowance for
doubtful accounts is calculated. The vertical bars represent debts owed to a
company by its customers. These overdue accounts are grouped by how long the
debts have been overdue. You can adjust the assumed percentage of
uncollectibility of each group using the sliders at the top. The calculated estimate
for bad debt is then shown at the bottom as an accounting entry.
INTERACTIVE ILLUSTRATION 1 Estimating Bad Debts
Scan this QR code, click the image, or use this link to access the interactive illustration:
http://bit.ly/hbsp2GgbnxK
2.1.3 Inventory
Inventory includes items that are being held for sale or use in the ordinary
course of business, are in the process of being produced for sale, or are being
consumed to produce goods or services for sale. 6 Inventories generally fall into
the category of finished goods (goods that have been completed and are ready
for sale), goods in process (goods in the process of being manufactured) , and
raw materials or manufacturing supplies (both of which are goods used in the
manufacture of goods for sale) .
When inventory is purchased or manufactured, it is recorded on the balance
sheet primarily at cost. Inventory costs are calculated as “the sum of the
applicable expenditures and charges directly or indirectly incurred in bringing
an article to its existing condition and location.”7 These costs can include raw
5071 | Core Reading: Assets and Expenses
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materials, direct labor, and related overhead costs. They will differ depending on
the nature of the company’s business, e.g., manufacturing vs. retail.
Various methods can be used for allocating overhead costs to individual
inventory items. One approach is to apply a standard overhead rate to each unit
of inventory. Another is to allocate overhead based on measures of output
volume, such as the machine hours or hours of direct labor required to complete
the unit. Activity-based costing (ABC), an even more accurate method for
allocating overheads costs, involves identifying activities performed to produce
the product, accumulating the costs per activity, and then allocating those
activity costs to products based on cost driver measures that help explain what
drives the use of resources (including indirect costs) by each type of product.
While inventories are recorded at cost initially, they are maintained at the
lower of cost or market (LCM) on an ongoing basis. “Market” refers to the cost
of replacing inventory , either by purchasing it in the open market or by
reproducing it at a cost equal to or between net realizable value and that net
realizable value reduced by a normal profit margin. 8,b An item’s net realizable
value is its selling price less any costs associated with completing and selling it. 9
A market value below the net realizable value less a normal profit margin is a
floor value for inventory; a market value above the net realizable value is a
ceiling value for inventory.
Any decline in inventory value is recorded as a loss or a charge against
revenue in the entity’s income statement in the accounting period during which
that decline in value occurs. c
When inventory is sold, it is recorded as an expense (cost of goods sold) on
the income statement. The timing of this entry, and of the corresponding balance
sheet entry, depends on the inventory recordkeeping method the firm employs.
A firm can opt to use either the perpetual method or the periodic method of
inventory accounting. In the perpetual method, the inventory account is
immediately adjusted when inventory is purchased. When inventory is sold,
there is a direct adjustment to the income statement through the cost of goods
sold account and to the balance sheet through the inventory account. In the
periodic method, inventory is recorded in a purchases account when it is
purchased. Inventory sales are recorded in a separate accounting entry. The
b IFRS requires inventories to be measured at either cost and net realizable value, whichever is
lower (IAS2-9).
c According to Topic 330, Inventory, 330-10-35-2 and 330-10-50, FASB desires a charge
separately identified from the consumed inventory costs when there has been a substantial and
unusual inventory write-down. IFRS requires the inventory write-down to be recognized as an
expense for the period in which it occurred (IAS 2-34).
5071 | Core Reading: Assets and Expenses
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inventory and cost of goods sold accounts are updated at the end of the period to
reflect any activity.
Recent advances in technology have made inventory management easier. For
example, inventory items can be fitted with unique barcodes that are scanned
every time the item is moved, e.g., from the stock room to the sales floor, when
shipped to different locations, or when sold. This allows for more accurate
tracking. Additionally, wireless networks allow for easier access to inventory
data.
Basic Equation for Accounting for Inventories:
Beginning inventories + purchases – ending inventories = cost of goods sold
To determine the cost of goods sold, the value or cost of inventory can be
calculated using several assumptions about the flow of cost factors. One method
is to record the cost and sales of each inventory item as it is purchased and sold,
which makes sense if each inventory item is unique; however, it is not workable
if the inventory includes a large number of identical items. Three more methods
are: first-in, first-out (FIFO), average cost, and last-in, first-out (LIFO).d It is
important to select the method that will most clearly reflect periodic income for
a particular firm.
•
FIFO. A measure of inventory in which the oldest items are
assumed to be transferred into cost of goods sold first. The items
remaining in inventory are those purchased most recently, which
means that the inventory balance is likely to provide a good
measurement of replacement cost.
•
Average cost. The cost of beginning inventory plus inventory
purchased during a period is considered as the cost of goods
available for sale. This cost is divided by the number of units
available for sale to determine an average cost per unit. This unit
cost is then used to calculate ending inventory and the cost of
goods sold.
•
LIFO. A measure of inventory in which the most recent additions
to inventory are assumed to be transferred into cost of goods
sold first. Thus, the oldest inventory items remain in the
inventory account. Although LIFO is not permitted under IFRS in
d According to FASB, Topic 330, Inventory, 330-10-30-9, in the United States, the cost of inventory
may be determined under FIFO, average, or LIFO method. However, under IAS 2-25, the cost of
inventories is assigned by using FIFO or weighted average cost formula only.
5071 | Core Reading: Assets and Expenses
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some countries, 10 it is permitted—and is commonly used—in the
United States. However, in a period with positive inflation, using
LIFO will have the impact of higher cost of goods sold (as
compared to the average cost or FIFO methods), and therefore
lower income. This makes it popular with firms looking to
minimize taxable income and reduce ta xes. For this reason, firms
that use LIFO for US tax accounting are also required to use it for
financial reporting.
Using Interactive Illustration 2, observe how different inventory costing
methods affect accounting entries. Begin by clicking on the question marks and
choosing a series of sales to customers. Then make a selection between periodic
and perpetual, and between FIFO, LIFO, and Average. Click play to see how
inventory and cost of goods sold (COGS) would be calculated under those
assumptions. Once the animation is over, change the selections at the top to see
the immediate effect of the new selections on the calculations.
INTERACTIVE ILLUSTRATION 2 Inventory Costing Method
Scan this QR code, click the image, or use this link to access the interactive illustration:
http://bit.ly/hbsp2LqDdNy
5071 | Core Reading: Assets and Expenses
10
EXHIBIT 3 Inventory Accounting
Units
Unit Cost
Total
4
$15
$60
Unit A
1
$20
$20
Unit B
1
$28
$28
Unit C
1
$23
$23
Unit D
1
$24
$24
Unit E
1
$30
$30
Beginning-of-period inventory
Purchases:
$184
Units sold during the period
6
End-of-period inventory
3
Goods Sold
End-of-period
inventory
Specific identification: Inspection shows items A, B, and E
remain in inventory at period end
$107
$78
Last invoice price
$94
$90
Simple average
$115
$70
FIFO
$108
$77
LIFO
$139
$45
Cost of
Inventory Accounting Method
Note: In this example the change in the LIFO reserve for a company using LIFO accounting
would equal $31. LIFO COGS ($139) – FIFO COGS ($108) = $31.
Because the LIFO method of accounting can result in balance sheet inventory
values that do not reflect current market values, the SEC requires firms to
disclose in their notes what the value of inventory would have been if they had
used the FIFO method.
The LIFO reserve equals the ending inventory’s FIFO cost less the LIFO cost,
but it also equals the cumulative difference between LIFO COGS and FIFO COGS.
5071 | Core Reading: Assets and Expenses
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FIFO COGS – LIFO COGS = LIFO reserve for the period
LIFO reserve
for the period
+
LIFO reserves for
previous periods
=
LIFO reserve on
the balance sheet
To better understand how the use of LIFO instead of FIFO affects the
calculation of COGS in the presence of increasing raw material prices
(acquisition cost), see Interactive Illustration 3. The large display is a graph of
the acquisition cost of inventory items. Assume the company purchases items at
a rate of 1,000 per month. Using the slider on the right edge of the graph, change
the assumption that this cost increases, decreases, or stays the same over the
course of a year. Use the slider along the bottom of the graph to change the
number of items the company sells over the course of the year. In the output box
on the right, observe the impact of the LIFO inventory costing method over the
FIFO inventory costing method. In what conditions does LIFO result in higher
ending inventory and income? In what conditions does LIFO result in lower
ending inventory and income?
INTERACTIVE ILLUSTRATION 3 Impact of Inventory Costing Method
Scan this QR code, click the image, or use this link to access the interactive illustration:
http://bit.ly/hbsp2IT6qfU
5071 | Core Reading: Assets and Expenses
12
EXHIBIT 4 Inventory Accounting at the Coca-Cola Company
The following excerpt is from the 2014 annual report of the Coca-Cola Company:
Inventories consist primarily of raw materials and packaging (which includes ingredients and
supplies) and finished goods (which include concentrates and syrups in our concentrate
operations and finished beverages in our finished product operations). Inventories are
valued at the lower of cost or market. We determine cost on the basis of the average cost or
first-in, first out methods. Inventories consisted of the following (in millions):
Balance Sheet
Year ending
December 31
2013
2014
$1,615
$1,692
Finished goods
$308
$1,240
Other
$351
$345
$3,100
$3,277
2013
2014
$17,889
$18,421
Raw materials and packaging
Total inventories
Income Statement
Cost of goods sold
5071 | Core Reading: Assets and Expenses
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2.1.4 Other
Other assets often include prepaid expenses, expenditures made by a firm prior
to being recognized as an expense in the income statement. These prepaid
expenses can include rents, insurance premiums, and travel costs. When the
expense is recognized, the asset is reduced by the amount of that expense. These
types of assets exemplify the matching convention—because cash is paid before
an expense is recognized, an asset is temporarily created.
The current portion of an entity’s investments, as described in Section 2.2.2,
are also classified as current investment assets.
2.2 Long-Lived Assets
Long-lived assets are assets that are used to generate future benefits for an
entity, have a useful life of more than one year, are used in operations, and are
not intended for sale in the ordinary course of business. Long-lived fixed assets,
investments, and intangibles are among the most common types of long-lived
assets.
2.2.1 Long-Lived Fixed Assets
In most companies, long-lived fixed assets, also known as property, plant, and
equipment (PP&E), are defined as tangible assets that are used to produce
goods or services over more than one year or operating cycle. They generally fall
into one of three categories: assets subject to depreciation (such as a truck),
assets subject to depletion (such as natural resources), and assets that do not
decline in value over time (such as land).
The key issues to consider while examining accounting for long-lived fixed
assets are as follows:
•
What costs should be capitalized as assets (i.e., they are added to
the balance sheet as assets rather than being expensed)?
•
How should asset-related costs be allocated across accounting
periods as operating expenses to best match the benefits that
those assets provide?
•
How should asset-related expenditures made subsequent to
acquisition, changes in fair value of assets, and asset sales be
properly classified, accounted for, and reported?
5071 | Core Reading: Assets and Expenses
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Exhibit 5 shows how Coca-Cola accounts for PP&E.
Measurement of Cost
PP&E includes land, buildings, and equipment that are used in the ordinary
course of business activities, such as computers, machinery, automobiles, tools,
and furniture. PP&E is initially recorded on the balance sheet at cost when it is
probable that the item’s future economic benefits will flow to the entity and the
cost of the item can be measured reliably.11 PP&E may be acquired for cash or in
an exchange, or it may be manufactured. The historical cost of purchased assets
includes the costs necessarily incurred to bring those assets to the condition and
location required for their intended use.12 The cost of PP&E comprises its
purchase price (including import duties and nonrefundable purchase taxes after
deducting trade discounts and rebates) plus direct set-up costs (delivery,
installation, construction, and testing) and any estimated costs needed to retire
the asset (such as the cost of dismantling and restoring the site on which the
asset is located).13 The costs of manufactured assets include direct materials,
direct labor, and related overhead. To capitalize these asset-related costs, they
must be directly matched to a future benefit; capitalized costs cannot exceed the
estimated value of that future benefit, and the costs cannot exceed the fair
market value of the asset.e
The allocation of asset-related overhead expenses is not always
straightforward. For example, when constructing a fixed asset in a facility that is
operating below capacity, should an overhead allocation be capitalized? If a
facility is operating at capacity, utilizing it to manufacture an asset for internal
use may decrease the production of items for sale, possibly creating a lost
opportunity cost that should be accounted for. If, however, a facility is below
capacity and its overhead costs would have been incurred anyway, should those
overhead costs be allocated to the cost of manufacturing a fixed asset?
If funds are borrowed to construct or prepare an asset that requires a period
of time to carry out the preparation activities necessary to bring it to the state of
its intended use, interest cost resulting from the expenditures incurred during
this preparation period should be capitalized. 14 The borrowing cost to be
capitalized is the interest incurred during the asset’s acquisition period that
could have been avoided if the expenditures for the assets had not been made.15
e Under IAS 16-22, IFRS requires any internal profits to be eliminated when calculating the costs of
self-constructed assets and of abnormal amounts of wasted material, labor, or other resources
incurred in self-constructing an asset to be excluded from the cost of the asset.
5071 | Core Reading: Assets and Expenses
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Once a fixed asset has been acquired or manufactured, the asset can often
incur subsequent expenditures, which must be analyzed to determine whether
they should be expensed when they are incurred or capitalized and added to the
asset costs. This depends on the impact the expenditures will have on the
asset—will they generate a benefit over more than one year or operating cycle?
Maintenance and repair costs that keep the asset in working order should be
expensed as incurred, while expenditures that increase the asset’s useful life,
efficiency, or productivity should be capitalized.
Depreciation
Many long-lived fixed assets have a limited life. Depreciation is the systematic
allocation of the depreciable cost of the asset over its useful life. The entity can
choose the depreciation method based on the pattern in which it expects to
consume the asset’s future economic benefits.16 A periodic (at least annual)
depreciation charge is recorded in the income statement, and the net value of
the assets is reduced by that amount. This net book value appears on the balance
sheet as follows:
Asset cost − accumulated depreciation = net book value
5071 | Core Reading: Assets and Expenses
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EXHIBIT 5 PP&E Accounting at the Coca-Cola Company
The following excerpt is from the 2014 annual report of the Coca-Cola Company:
Property, Plant, and Equipment: Property, plant, and equipment are stated at cost.
Repair and maintenance costs that do not improve service potential or extend
economic life are expensed as incurred. Depreciation is recorded principally by
the straight-line method over the estimated useful lives of our assets, which are
reviewed periodically and generally have the following ranges: buildings and
improvements: 40 years or less; and machinery, equipment and vehicle fleet: 20
years or less. Land is not depreciated, and construction in progress is not
depreciated until ready for service.
Depreciation expense, including the depreciation expense of assets under capital
lease, totaled $1,716 million, $1,727 million and $1,704 million in 2014, 2013 and
2012, respectively.
Year ended
December 31
2013
2014
972
1,011
Buildings and improvements
5,539
5,605
Machinery, equipment, and vehicle fleet
18,225
17,551
522
865
$25,258
$25,032
Less accumulated depreciation
10,625
10,065
Property, Plant, and Equipment—net
$14,633
$14,967
Land
Construction in progress
Note: Table summarizes our property, plant and equipment (in millions).
The accumulated depreciation account is a contra asset, which is netted
against the asset’s gross carrying amount. Note that there are no cash flows
associated with these entries, except for the impact, if any, they have on annual
income taxes paid. Depreciation can be calculated as cost − residual value =
depreciable cost.
5071 | Core Reading: Assets and Expenses
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The key factors in determining depreciation are as follows:
•
Cost. As discussed in Section 2.2.1, this includes the purchase price
plus other applicable costs incurred in readying the asset for its
intended use.
•
Residual value. The asset’s net realizable value at the end of its useful
life. This may be sale value, trade-in value, or scrap proceeds. It is also
commonly known as the salvage value of an asset.
•
Useful life. The period over which the asset is expected to generate
benefits for the entity. This may be measured in time or in other units
such as operating hours, miles driven, or units produced.
Depreciation methods must be rational and systematic. The most common
methods in practice include the following:
•
Straight-line depreciation. Depreciable value is allocated equally
across an asset’s useful life. Depreciation expense is constant across
years and is equivalent to the asset’s depreciable cost divided by its
useful life.
•
Accelerated depreciation. Depreciation charges are front-loaded with
lower charges in later years. Two common methods for calculating
accelerated depreciation are double-declining balance depreciation and
sum-of-the-years’-digits depreciation (as shown in Exhibit 6, with
straight-line depreciation):
 Double-declining balance depreciation. In each year, the net book
value is multiplied by a depreciation rate to calculate the annual
depreciation charge. That depreciation rate is calculated as two
times the reciprocal of the asset’s useful life (expressed in years). For
example, if the useful life of an asset is five years, the depreciation
rate is 2 × 1/5, or 40%. The asset’s residual value is not incorporated
into this calculation. However, depreciation is not generally charged
once the net book value equals the residual value. Additionally, some
companies will switch from the double-declining method to the
straight-line method once the annual depreciation charge is lower
under the double-declining method than it would be under the
straight-line method.
 Sum-of-the-years’-digits depreciation. In each year, an asset’s
depreciable cost is multiplied by a fraction to calculate the annual
depreciation charge. That fraction is calculated as the remaining
useful life (expressed in years) divided by the sum of the years’
5071 | Core Reading: Assets and Expenses
18
digits. For example, if the asset’s useful life is five years, the fraction
in Year 1 would be 5 / (1 + 2 + 3 + 4 + 5).
•
Units of production depreciation. The asset’s depreciable value is
divided by its estimated life, in terms of output units, to calculate a cost
per unit. In each year, that cost per unit is multiplied by the number of
units produced to calculate a depreciation charge. This is also known as
activity depreciation.
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EXHIBIT 6 Depreciation Accounting
Purchase of machinery
$22,000
Estimated salvage value
$2,000
Depreciable cost
$20,000
Useful life
5 years
Depreciation
Expense
Ending
Asset Value
Year 1
$4,000
$18,000
Year 2
$4,000
$14,000
Year 3
$4,000
$10,000
Year 4
$4,000
$6,000
Year 5
$4,000
$2,000
Year 1
$8,800
$13,200
Year 2
$5,280
$7,920
Year 3
$3,168
$4,752
Year 4
$1,901
$2,851
Year 5
$851
$2,000
Year 1
$6,667
$15,333
Year 2
$5,333
$10,000
Year 3
$4,000
$6,000
Year 4
$2,667
$3,333
Year 5
$1,333
$2,000
Straight-Line Method
Double-Declining Balance Method
(Rate = 40%)
Sum-of-the-Years’-Digits Method
(Denominator = 15)
Interactive Illustration 4 demonstrates these three common depreciation
methods in a side-by-side comparison. Set the initial cost of an asset, in this case
a truck, and its estimated residual value. The interactive calculates depreciation
5071 | Core Reading: Assets and Expenses
20
expenses and ending book values of a truck over its useful life (five years), using
the assumptions for the truck’s initial cost and residual value.
INTERACTIVE ILLUSTRATION 4 Depreciation Methods
Scan this QR code, click the image, or use this link to access the interactive illustration:
http://bit.ly/hbsp2mubrS6
Subsequent Accounting Estimates and Sales
Estimates made in calculating depreciation expenses often change over time, e.g.
an asset’s useful life may prove to be longer than expected. In such cases, any
changes to depreciation are made on a go-forward basis. That is, prior period
accounts are not restated to amend past depreciation expense.
An impairment loss occurs when the carrying value (net book value) of the
fixed asset is not recoverable and exceeds its fair value.17 If it appears that an
asset may be impaired, a company must consider whether an impairment loss
should be recognized.
When a fixed asset is sold, a gain or loss on the sale is often recorded. The net
book value or carrying cost (capitalized acquisition cost less accumulated
depreciation) of the asset sold is removed from the balance sheet, and any gain
or loss is reported in income from operations before income taxes in the income
statement.18 However, if the entity routinely sells fixed assets in its ordinary
activities, the proceeds from the sale are recognized as revenue.19
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21
Gain or loss on sale = proceeds from sale − net book value of asset sold
Except for quarries or landfill sites, land is an asset that has an indefinite life
and therefore is not depreciated. It should be included on the balance sheet
separately at cost, or less than cost if impaired, from depreciable assets even
when land and building were acquired together.20
Wasting assets, such as mineral deposits, are used up in the revenue
generation process. Exploration costs incurred by companies in the minerals,
petroleum, or timber businesses can be expensed as either incurred or
capitalized costs. The general rule is that costs associated with discovering and
developing productive properties are capitalized; all other discovery and
development costs are expensed. Any capitalized costs are subject to annual
depletion charges. As with depreciation, the purpose of depletion is to spread
asset-related costs over the asset’s useful life.
2.2.2 Deferred Tax Assets (and Liabilities)
When reporting revenues and expenses for financial and tax purposes, timing
differences often exist due to differences in financial accounting (e.g., GAAP or
IFRS) and income tax accounting rules. Taxes may be paid before they are
recognized in a firm’s income statement, or they may be recognized prior to
being paid. These timing differences create a temporary asset or liability known
as a deferred tax asset or liability. For example, provisions for bad debts are
recognized as expenses for financial reporting purposes but not for tax
purposes. As such, when a provision for bad debt is created or added to, a
deferred tax asset, equivalent to the tax rate multiplied by the expense, is
created. When the bad debt is realized, it is a tax-deductible expense. When the
firm realizes a tax benefit, the deferred tax asset is reduced accordingly.
Deferred tax assets or liabilities can be recorded as either current or long-term
assets or liabilities depending on the expected length of the timing difference.
2.2.3 Investments
Investments include the debt and equity securities of another entity reported on
a company’s balance sheet as either a current or long-term asset. The accounting
method used for investments depends on the purpose of the investment, the
degree of influence or control the investor can exert over the investee, and the
expected holding period.
Debt securities represent a creditor relationship with an entity. These include
preferred stock, collateralized mortgage obligations, corporate bonds,
5071 | Core Reading: Assets and Expenses
22
commercial paper, and treasury bonds, among others. Debt investments are
generally classified as held-to-maturity securities, trading securities, or
available-for-sale securities. These types of securities are illustrated in Exhibit
7.
A held-to-maturity security is a debt security that the reporting entity
intends—and has the ability—to hold to maturity.21 These investments are
recorded on the balance sheet at amortized cost, which is the cost of the security
adjusted for any purchase discount or premium.22
An entity purchases a trading security with the intent of selling it within
hours or days.23 Trading securities are reported on the balance sheet at fair
market value. Any changes in its fair market value, referred to as unrealized
holding gains and losses, are reported in the income statement. 24 Accounting
Standards Codification Topic 320 defines fair value as “the price that would be
received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date.”25
Investments held by an entity that have not been classified as either trading
securities or held-to-maturity securities are called available-for-sale
securities.26 Similar to a trading security, an available-for-sale security is
recorded on the balance sheet at fair market value. However, any unrealized
holding gains or losses due to changes in its market value are excluded from
earnings and are reported in other comprehensive income until realized.27
Equity securities, on the other hand, represent an ownership interest in an
entity. Equity investments in which the entity controls less than 20% of the
equity are minority passive investments, as the investor entity cannot exert any
influence over the investee entity. Minority passive investments with readily
determinable fair values are classified as trading securities; otherwise, they may
be accounted for at cost but adjusted for any impairments or observable price
changes (such as a private company having a new funding round with an
observable valuation). Finally, investments in which the entity controls more
than 50% of the equity are majority active investments.
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EXHIBIT 7 Accounting for Passive Investments
Minority active investments are accounted for using the equity method. The
investment is recorded at cost and then increases in each accounting period by
the entity’s share of the investee’s increase in retained earnings.
Majority active investments are accounted for using consolidation accounting,
in which the assets, liabilities, revenues, and expenses of the investment are
combined with those in the entity’s accounts. The percentage of the investment
that is not owned is accounted for via a minority interest account (also known as
a noncontrolling interest account).
2.2.4 Goodwill and Other Intangible Assets
An intangible asset is an identifiable, nonmonetary asset without physical
substance. Intangibles include goodwill and intangible assets such as brand
names, franchises, and patents. 28, f
Goodwill
Goodwill is created when one entity acquires another and the purchase price
paid by the acquiring entity exceeds the fair market value of the target entity’s
net identifiable assets.29 It is an intangible asset that is not separately
transferable. To calculate goodwill, it is necessary to determine the fair market
value of the target’s assets and liabilities. At the time of an acquisition, each item
on the target’s balance sheet is analyzed and written up or down to market
value. The difference between the fair market value of these assets and liabilities
f The term “intangibles” is used to refer to intangible assets other than goodwill.
5071 | Core Reading: Assets and Expenses
24
is the entity’s net book value. The purchase price less the net book value equals
goodwill.
Fair market
value of
assets
−
fair market
value of
liabilities
=
net book value or fair
value of net identifiable
assets
Purchase price − net book value or fair value of net identifiable assets = goodwill
Under FAS 142,g issued in 2001, goodwill should be tested at least once a year
to determine if its value has been impaired.h This is done by calculating the fair
value of the reporting unit with which the goodwill is associated; if that value
has declined such that the reporting unit’s carrying value exceeds its fair market
value, then goodwill is considered impaired and must be reduced by an amount
equal to that decline in value. The amount of impairment loss is the difference
between the goodwill and the implied value of the goodwill. The implied value of
the goodwill equals the fair value of the reporting unit less the fair value of its
net identifiable assets, excluding goodwill.i If the fair value of the reporting unit
has increased or remains the same, goodwill is not adjusted. (In practice the
process of estimating the value of goodwill is quite complicated; this description
is meant to provide only a simple definition.)
In 2014, US GAAP accounting rules were amended to simplify goodwill
accounting for private (i.e., not publicly traded) c ompanies. Under the new rules,
private companies do not have to perform an annual impairment test, but can
opt instead to amortize goodwill on a straight-line basis over a period of no
more than 10 years.30 However under IFRS, all companies, including private
ones, must use the impairment-only approach to accounting for goodwill.31
Other Intangibles
Other intangibles are separately transferable “expenditures for special rights,
privileges, or competitive advantages which offer the prospect of increased
revenues or earnings. They include expenditures for brand names, franchises,
patents, and similar items that exist only on paper, but nevertheless can
g FAS 142 has since been superseded by ASC 350.
h Topic 350-20-35-1, Goodwill shall not be amortized. Instead, goodwill shall be tested for
impairment at a level of reporting referred to as a reporting unit.
i Topic 350-20-35-2, Impairment is the condition that exists when the carrying amount of goodwill
exceeds its implied fair value.
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25
reasonably be expected to contribute to earnings beyond the current accounting
period.”32
Accurately estimating the value and useful life of an intangible asset can be
difficult . However, the task of valuing the asset is easier if it has been purchased
rather than developed internally.
Accounting Standards Codification (ASC) Topic 350 stipulates that acquired
intangible assets with finite lives should be recorded at acquisition cost and then
amortized over their economic or legal lives, whichever is shorter, for a period
not to exceed 40 years. The straight-line amortization method should be used
unless the entity can show that an alternative method is superior. Acquired
intangible assets with indefinite lives are not amortized, but instead are
subjected to an annual impairment test via a process similar to that described
earlier for goodwill.33
Expenses for developing intangible assets internally are more commonly
expensed in the accounting period in which they are incurred rather than
capitalized on the balance sheet. A number of expenditure types are recognized
as intangible assets:
•
Research and development (R&D) costs. Under US GAAP, R&D costs
should be expensed as incurred because whether there will be a future
benefit is likely to be uncertain, costs are often unrelated to any future
earnings potential, and capitalizing these costs does not provide
helpful information in assessing the company’s future earnings
potential.34,j However, under IFRS, development costs should be
capitalized when the project can be shown to be technically and
economically feasible.
•
Software development costs. Early-stage costs associated with
internally developed software for internal use should be expensed as
incurred. However, software development costs incurred beyond the
preliminary development stages (i.e., after a working model has been
developed or economic feasibility has been established) should be
capitalized as an intangible asset and reported on the balance
sheet.35 , k Amortization of the asset should begin when development of
that asset is complete.
j Under IFRS, internally generated intangible assets are expensed during the research phase and
capitalized during the development phase when technical feasibility has been established,
according to IAS 38-51 to 59.
k Under US GAAP, capitalization of cost begins when both of the following occur: (a) The
preliminary project stage is completed, and (b) management, with the relevant authority,
implicitly or explicitly authorizes and commits to funding a computer software project and the
5071 | Core Reading: Assets and Expenses
26
•
Patents. If patents are acquired, the purchase price should be
capitalized. If a patent is developed internally, only the legal fees and
registration costs should be capitalized. All other costs should be
expensed as incurred.
Internally developed intangibles that are not being amortized should be
tested for impairment at least annually and written down in value as required.
The way in which Coca-Cola accounts for its intangibles is reproduced in
Exhibit 8.
project will probably be completed and the software will be used to perform the function
intended.
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27
EXHIBIT 8 Accounting for Intangibles at the Coca-Cola Company
The following excerpt is from the 2014 annual report of the Coca-Cola Company:
Goodwill, Trademarks and Other Intangible Assets: We classify intangible assets into three
categories: (1 ) intangible assets with definite lives subject to amortization, (2 ) intangible assets with
indefinite lives not subject to amortization and (3 ) goodwill. We determine the useful lives of our
identifiable intangible assets after considering the specific facts and circumstances related to each
intangible asset. Factors we consider when determining useful lives include the contractual term of
any agreement related to the asset, the historical performance of the asset, the Company’s longterm strategy for using the asset, any laws or other local regulations which could impact the useful
life of the asset, and other economic factors, including competition and specific market conditions.
Intangible assets that are deemed to have definite lives are amortized, primarily on a straight-line
basis, over their useful lives, generally ranging from 1 to 20 years.
When facts and circumstances indicate that the carrying value of definite-lived intangible assets may
not be recoverable, management assesses the recoverability of the carrying value by preparing
estimates of sales volume and the resulting profit and cash flows. These estimated future cash flows
are consistent with those we use in our internal planning. If the sum of the expected future cash
flows (undiscounted and without interest charges) is less than the carrying amount, we recognize an
impairment loss. The impairment loss recognized is the amount by which the carrying amount of the
asset or asset group exceeds the fair value. We use a variety of methodologies to determine the fair
value of these assets, including discounted cash flow models, which are consistent with the
assumptions we believe hypothetical marketplace participants would use.
We test intangible assets determined to have indefinite useful lives, including trademarks, franchise
rights, and goodwill, for impairment annually, or more frequently if events or circumstances indicate
that assets might be impaired. Our Company performs these annual impairment reviews as of the
first day of our third fiscal quarter. We use a variety of methodologies in conducting impairment
assessments of indefinite-lived intangible assets, including, but not limited to, discounted cash flow
models, which are based on the assumptions we believe hypothetical marketplace participants
would use. For indefinite-lived intangible assets, other than goodwill, if the carrying amount exceeds
the fair value, an impairment charge is recognized in an amount equal to that excess. The Company
has the option to perform a qualitative assessment of indefinite-lived intangible assets, other than
goodwill, prior to completing the impairment test described above. The Company must assess
whether it is more likely than not that the fair value of the intangible asset is less than its carrying
amount. If the Company concludes that this is the case, it must perform the testing described above.
Otherwise,
5071 | Core Reading: Assets and Expenses
28
(continued)
the Company does not need to perform any further assessment. During 2014, the Company
performed qualitative assessments on less than 10 percent of our indefinite-lived intangible assets
balance.
We perform impairment tests of goodwill at our reporting unit level, which is one level below our
operating segments. Our operating segments are primarily based on geographic responsibility,
which is consistent with the way management runs our business. Our operating segments are
subdivided into smaller geographic regions or territories that we sometimes refer to as “business
units.” These business units are also our reporting units. The Bottling Investments operating
segment includes all Company-owned or consolidated bottling operations, regardless of geographic
location, except for bottling operations managed by CCR, which are included in our North America
operating segment. Generally, each Company-owned or consolidated bottling operation within our
Bottling Investments operating segment is its own reporting unit. Goodwill is assigned to the
reporting unit or units that benefit from the synergies arising from each business combination. The
goodwill impairment test consists of a two-step process, if necessary. The first step is to compare
the fair value of a reporting unit to its carrying value, including goodwill. We typically use discounted
cash flow models to determine the fair value of a reporting unit.
The assumptions used in these models are consistent with those we believe hypothetical
marketplace participants would use. If the fair value of the reporting unit is less than its carrying
value, the second step of the impairment test must be performed in order to determine the amount of
impairment loss, if any. The second step compares the implied fair value of the reporting unit’s
goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit’s
goodwill exceeds its implied fair value, an impairment charge is recognized in an amount equal to
that excess. The loss recognized cannot exceed the carrying amount of goodwill. The Company has
the option to perform a qualitative assessment of goodwill prior to completing the two-step process
described above to determine whether it is more likely than not that the fair value of a reporting unit
is less than its carrying amount, including goodwill and other intangible assets. If the Company
concludes that this is the case, it must perform the two-step process. Otherwise, the Company will
forego the two-step process and does not need to perform any further testing. During 2014, the
Company performed qualitative assessments on less than 10 percent of our consolidated goodwill
balance. Impairment charges related to intangible assets are generally recorded in the line item
other operating charges or, to the extent they relate to equity method investees, in the line item
equity income (loss)—net in our consolidated statements of income.
Note: Depreciation, depletion and amortization are all methods of allocating the cost of an asset
over its useful life.
5071 | Core Reading: Assets and Expenses
29
2.3 Basis for Recording Assets
With limited exceptions, and in keeping with SFAC 8, l assets are initially
recorded at historical cost and must be reassessed periodically, or at least
annually, to determine whether their values need to be reduced.
An entity must ask the following questions: Are there assets whose benefit has
expired? Are there assets whose future benefits are no longer reasonably
certain? Has the estimated future benefit of a particular asset decreased? Should
we recognize a particular asset at cost or market value?
2.3.1 Revaluation
Revaluation of an asset involves adjusting its book value to reflect its current
market value. As a result of this revaluation, the asset’s carrying value may
increase or decrease. Although US GAAP does not allow for the upward
revaluation of PP&E, it is permitted under IFRS in limited circumstances.m
2.3.2 Impairment
An asset must be recorded as an impairment once it becomes known that its
value has been impaired.
A long-lived asset classified as held for use or held for sale must be tested for
impairment by comparing its current carrying value with the estimated future
undiscounted cash flows it is expected to generate. If the carrying value is
greater than the expected future benefit, the entity must record an impairment
charge and write down the carrying value of the asset to its fair value.36 Exhibit
9 shows how Coca-Cola accounts for impairments.
l Statement of Financial Accounting Concepts No. 8 September 2010, Conceptual Framework for
Financial Reporting.
m Under IFRS 16-39, if an asset’s carrying value decreases as a result of a revaluation, the decrease
is recognized as a loss in the income statement. However, for an upward revaluation, any gain is
not recognized in the income statement but rather in other comprehensive income.
5071 | Core Reading: Assets and Expenses
30
EXHIBIT 9 Impairment Accounting at the Coca-Cola Company
The following excerpt is from the 2014 annual report of the Coca-Cola Company:
Certain events or changes in circumstances may indicate that the recoverability of
the carrying amount of property, plant and equipment should be assessed,
including, among others, a significant decrease in market value, a significant
change in the business climate in a particular market, or a current period operating
or cash flow loss combined with historical losses or projected future losses. When
such events or changes in circumstances are present, we estimate the future cash
flows expected to result from the use of the asset or asset group and its eventual
disposition. These estimated future cash flows are consistent with those we use in
our internal planning. If the sum of the expected future cash flows (undiscounted
and without interest charges) is less than the carrying amount, we recognize an
impairment loss. The impairment loss recognized is the amount by which the
carrying amount exceeds the fair value. We use a variety of methodologies to
determine the fair value of property, plant and equipment, including appraisals and
discounted cash flow models, which are consistent with the assumptions we believe
hypothetical marketplace participants would use.
2.3.3 Differences Between FASB and IASB on Recording Basis
Although there is significant overlap in the accounting rules for assets under US
GAAP and IFRS, there are some noteworthy differences between the two
standards. Some of these differences are listed below:
•
Under US GAAP, upward valuation of PP&E is not allowed; it is
allowed under IFRS.
•
Under US GAAP, companies are allowed to record depreciation
for a piece of equipment using component depreciation (i.e.,
looking at the depreciation rates of different parts), but it is not
common to do so. However, component depreciation is required
in some instances under IFRS.
5071 | Core Reading: Assets and Expenses
31
•
US GAAP allows for LIFO accounting for inventory. LIFO is
prohibited under IFRS.
Development costs for intangibles are expensed as incurred under US GAAP
except in specific instances (e.g., certain software costs). Under IFRS, they
are capitalized as soon as a project is determined to be technically and
economically feasible.37
2.4 Relationship to Income Statement
2.4.1 Expenditures vs. Expenses
Expenses are outflows of economic resources to pay for the consumption of
goods or services for the purpose of generating revenue. They are incurred
when a product or service generates revenues, without regard to when that
product or service was purchased. An expenditure, on the other hand, is an
outlay of cash, but if it is not used to generate revenue for the entity in the
accounting period in which it is made, it is neither recorded as an expense nor
reported in the income statement. (Instead this timing difference between the
expenditure being made and the expense being recognized is accounted for as a
prepaid asset and reported on the balance sheet. For example, prepaid rent is an
asset created when rent is paid in advance.)
2.4.2 Accounts Receivable and Revenues
Revenues are income that a company receives from its normal business
activities. They usually create an asset or decrease a liability. If a sale is made for
cash, cash on the balance sheet will increase. If a sale is made on credit (with a
promise of payment in the future), accounts receivable will increase. If a
company received cash before the sale took place, an unearned revenue liability
is created. Upon the sale, this liability would decrease.
2.4.3 Inventory and Cost of Goods Sold
The purchase of an inventory item is an expenditure—an outlay of cash—but it
is neither recognized as an expense in the accounting records nor reported on
the income statement of an entity. Instead, the inventory is recorded in an
inventory account and reported on the entity’s balance sheet as an asset. Once
that inventory is sold, the asset is removed from the balance sheet and an
expense, in the form of cost of goods sold, is recognized.
5071 | Core Reading: Assets and Expenses
32
2.4.4 PP&E and Depreciation
Because a long-lived fixed asset is expected to generate benefits over its useful
life that cover multiple accounting periods, its cost should be spread over its
useful life in the appropriate accounting period. For this reason, when a longlived asset is purchased, no immediate expense is recorded in the income
statement. Instead the annual consumed or expired cost of that asset is reflected
in the annual depreciation charge.
2.4.5 Intangibles and Amortization
Any decrease in the value of intangible assets is reflected in the income
statement. This may occur systematically via an annual amortization charge or
as needed via an impairment charge.
2.4.6 Other Changes in Asset Values
Other changes in asset values that are recorded on the income statement include
unrealized gains or losses on trading securities, changes in the provision for bad
debts (which are added to the allowance for doubtful accounts), gains and losses
on the sale or disposal of PP&E, write-downs of inventory, and write-downs of
long-lived fixed assets.
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33
3 KEY TERMS
assets Resources that are owned and that provide a future economic benefit.
accounts receivable An asset that represents money owed to a company by
its customers for goods or services, for which payment is normally expected
either in the short term or within the operating cycle.
activity-based costing (ABC) A method for allocating direct, indirect, and
overhead costs to specific production activities.
allowance for doubtful accounts A contra asset account, often computed as
a percentage of sales, from which the bad debts expense is subtracted.
available-for-sale security An investment whose timeframe falls between
held-to-maturity securities and trading securities; that is, it is not intended to be
sold within hours or days of purchase, nor is it intended to be held to maturity.
bad debt An account receivable that is not expected to be collected.
cash An account on the balance sheet that comprises cash on hand and demand
deposits.
contra asset An account that adjusts the net value of an asset on the balance
sheet and chart of accounts. Assets typically have credit balances, while contra
asset accounts typically have debit balances.
current assets Cash and other assets that are reasonably expected to generate
a benefit for an entity during either the subsequent year or the normal operating
cycle (whichever is longer).
debt investments Debt securities, such as preferred stock, collateralized
mortgage obligations, corporate bonds, commercial paper, and treasury bonds,
that represent a creditor relationship with an entity.
deferred tax asset or liability A temporary asset or liability that is created
when there is a difference in timing between when taxes are paid and when they
are recognized in a firm’s income.
depreciation The systematic allocation of an asset’s depreciable cost, which
reflects the decrease in value over its useful life.
equity investments Equity securities that represent an ownership interest in
an entity.
5071 | Core Reading: Assets and Expenses
34
first-in, first-out (FIFO) A measure of inventory in which the oldest items in
inventory are assumed to be transferred into cost of goods sold first. The items
remaining in inventory are those purchased most recently, which means that the
inventory balance is likely to provide a good measurement of replacement cost.
goodwill A nontransferrable intangible asset that is created when one entity
acquires another and the purchase price paid by the acquiring entity exceeds the
fair market value of the target entity’s net identifiable assets.
held-to-maturity security A debt security that the reporting entity intends
(and has the ability) to hold to maturity.
inventory Assets that are held for sale or use in the ordinary course of
business, in the process of either being produced for sale or being consumed to
produce goods or services for sale.
last-in, last-out (LIFO) A measure of inventory in which the most recent
additions to inventory are assumed to be transferred into cost of goods sold
first. Thus, the oldest inventory items remain in the inventory account.
lower of cost or market (LCM) The reported value of an asset equal to the
smaller of two possible values: (a) the cost to create the asset, or (b) the cost to
purchase it.
net realizable value The selling price of an item less any costs associated with
completing and selling it.
periodic method An inventory recordkeeping method by which the inventory
purchased is recorded in a purchases account and inventory sales are recorded
via a separate accounting entry. The inventory and cost of goods sold accounts
are updated at the end of the period for activity during the period.
perpetual method An inventory recordkeeping method by which the
inventory account is immediately adjusted when inventory is purchased. When
inventory is sold, there is a direct adjustment to the income statement through
the cost of goods sold account and to the balance sheet through the inventory
account.
property, plant, and equipment (PP&E) Tangible assets that are used to
produce goods or services over more than one year or operating cycle.
trading security An investment intended to be sold within hours or days of
purchase.
wasting assets Assets, such as natural resources, that are depleted in the
revenue generation process.
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35
4 ENDNOTES
1 Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 6 (2008): CON
6-1, http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=
id&blobwhere=1175820901044&blobheader=application%2Fpdf, accessed January 24, 2018.
2 Financial Accounting Standards Board, Accounting Standards Update: Balance Sheet (Topic 210),
January 2017, ASC 210-10-20: Glossary, Current Assets,
https://asc.fasb.org/imageRoot/94/108336194.pdf, accessed January 24, 2018; European
Commission, International Accounting Standard 1: Presentation of Financial Statements, February 18,
2011, IAS 1-66, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias1_en.pdf,
accessed January 24, 2018.
3 Financial Accounting Standards Board, Accounting Standards Update: Balance Sheet (Topic 210),
January 2017, ASC 210-10-20: Glossary, Operating Cycle,
https://asc.fasb.org/imageRoot/94/108336194.pdf, accessed January 24, 2018; European
Commission, International Accounting Standard 1: Presentation of Financial Statements, February 18,
2011, IAS 1-68, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias1_en.pdf,
accessed January 24, 2018.
4 Financial Accounting Standards Board, Accounting Standards Update: Cash and Cash Equivalents,
(Topic 305), January 2013, ASC 305-10-20: Glossary, Cash and Cash Equivalents; European
Commission, International Accounting Standard 7: Statement of Cash Flows, March 24, 2010,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias7_en.pdf, IAS 7-6/7,
accessed January 24, 2018.
5 Financial Accounting Standards Board, Accounting Standards Update: Receivables (Topic 310), July
2010, ASC 310-35-41.
6 Financial Accounting Standards Board, Accounting Standards Update: Inventory (Topic 330), July
2015, ASC 330-10-20: Glossary, Inventory; European Commission, International Accounting Standard
2: Inventories, September 16, 2009,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias2_en.pdf, IAS 2-6, accessed
January 24, 2018.
7 Financial Accounting Standards Board, Accounting Standards Update: Inventory (Topic 330), July
2015, ASC 330-10-30-1.
8 Financial Accounting Standards Board, Accounting Standards Update: Inventory (Topic 330), July
2015, ASC 330-10-20: Glossary, Market.
9 Financial Accounting Standards Board, Accounting Standards Update: Inventory (Topic 330), July
2015, ASC 330-10-20: Glossary, Net Realizable Value.
10 European Commission, International Accounting Standard 2: Inventories, September 16, 2009,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias2_en.pdf, IAS 2-25, accessed
January 24, 2018.
11 European Commission, International Accounting Standard 16: Property, Plant and Equipment,
September 16, 2009,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias16_en.pdf, IAS 16-7,
accessed January 24, 2018.
12 Financial Accounting Standards Board, Accounting Standards Update: Property, Plant, and Equipment
(Topic 360), April 2014, ASC 360-10-30-1, https://asc.fasb.org/imageRoot/76/51742576.pdf,
accessed January 24, 2018.
13 European Commission, International Accounting Standard 16: Property, Plant and Equipment,
September 16, 2009,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias16_en.pdf, IAS 16-16,
accessed January 24, 2018.
5071 | Core Reading: Assets and Expenses
36
14 Financial Accounting Standards Board, Accounting Standards Update: Interest (Topic 835), 835-2005-01.
15 Financial Accounting Standards Board, Accounting Standards Update: Interest (Topic 835), 835-2030-2.
16 Financial Accounting Standards Board, Accounting Standards Update: Property, Plant, and Equipment
(Topic 360), April 2014, ASC 360-10-35-4; European Commission, International Accounting Standard
16: Property, Plant and Equipment, September 16, 2009,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias16_en.pdf, IAS 16-60,
accessed January 24, 2018.
17 Financial Accounting Standards Board, Accounting Standards Update: Property, Plant, and Equipment
(Topic 360), April 2014, ASC 360-10-20: Glossary, Impairment; European Commission, International
Accounting Standard 36: Impairment of Assets, March 24, 2010,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias36_en.pdf, IAS 36-8,
accessed January 24, 2018.
18 Financial Accounting Standards Board, Accounting Standards Update: Property, Plant, and Equipment
(Topic 360), April 2014, ASC 360-10-45-5; European Commission, International Accounting Standard
36: Impairment of Assets, March 24, 2010,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias36_en.pdf, IAS 36-68,
accessed January 24, 2018.
19 European Commission, International Accounting Standard 36: Impairment of Assets, March 24, 2010,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias36_en.pdf, IAS 36-68A,
accessed January 24, 2018.
20 European Commission, International Accounting Standard 16: Property, Plant and Equipment,
September 16, 2009,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias16_en.pdf, IAS 16-58,
accessed January 24, 2018.
21
Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity
(Topic 320), ASC 320-10-25-1(c).
22
Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity
(Topic 320), ASC 320-35-1(c).
23
Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity
(Topic 320), ASC 320-25-1(a).
24 Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity
(Topic 320), ASC 320-35-1(a).
25
Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity
(Topic 320): Glossary, Fair Value.
26
Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity
(Topic 320), ASC 320-25-1(b).
27
Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity
(Topic 320), ASC 320-35-1(b).
28 Financial Accounting Standards Board, Accounting Standards Update: Intangibles—Goodwill and
Other (Topic 350), January 2017, ASC 350-10-20: Glossary, Intangibles; European Commission,
International Accounting Standard 38: Intangible Assets, March 24, 2010,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias38_en.pdf, IAS 38-8,
accessed January 24, 2018.
29 Financial Accounting Standards Board, Accounting Standards Update: Business Combinations (Topic
805), January 2017, ASC 805-30-1, https://asc.fasb.org/imageRoot/94/108336194.pdf: accessed
January 24, 2018.
5071 | Core Reading: Assets and Expenses
37
30 Financial Accounting Standards Board, Accounting Standards Update: Intangibles—Goodwill and
Other (Topic 350), January 2017, ASC 350-20-15-4 and ASC 350-20-65-2, Transition Guidance.
31 European Financial Reporting Advisory Group, Should Goodwill Still Not Be Amortised? Accounting
and Disclosure For Goodwill,” 2014,
http://old.efrag.org/files/Goodwill%20Impairment%20and%20Amortisation/140725_Should_good
will_still_not_be_amortised_Research_Group_paper.pdf, accessed January 24, 2018.
32 David F. Hawkins, “Intangible Assets Other Than Goodwill: Accounting and Analysis,” HBS No. 194077 (Boston: Harvard Business School, 2011).
33 Financial Accounting Standards Board, Accounting Standards Update: Intangibles—Goodwill and
Other (Topic 350), January 2017, ASC 350-30-35-1.
34 Financial Accounting Standards Board, Accounting Standards Update: Intangibles—Goodwill and
Other (Topic 350), January 2017, ASC 350-30-25-3.
35 Financial Accounting Standards Board, Accounting Standards Update: Intangibles—Goodwill and
Other (Topic 350), January 2017, ASC 350-40-25-12.
36 Financial Accounting Standards Board, Accounting Standards Update: Property, Plant, and Equipment
(Topic 360), April 2014, ASC 360-10-35-16 and 360-10-35-17; European Commission, International
Accounting Standard 36: Impairment of Assets, March 24, 2010,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias36_en.pdf, IAS 36-8 and IAS
36-58-64, accessed January 24, 2018.
37
European Commission, International Accounting Standard 38: Intangible Assets, March 24, 2010,
http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias38_en.pdf, IAS 38-54
through 38-59, accessed January 24, 2018.
5 INDEX
accelerated depreciation, 18
Accounting Standards Codification
(ASC), 21, 24
accounts receivable, aging analysis of,
5
accounts receivable, credit and
accounting policies for, 5
accounts receivable, definition of, 4, 32
accounts receivable, income
statements recording, 30
accounts receivable, recording of, 4
acquired intangible assets, 24
activity-based costing (ABC), 8, 32
activity depreciation, 19
aging analysis, 5
5071 | Core Reading: Assets and Expenses
allowance for doubtful accounts,
accounting for, 5, 6
allowance for doubtful accounts,
calculation for each accounting period,
5
allowance for doubtful accounts, CocaCola’s accounting for, 6
allowance for doubtful accounts, credit
and accounting policies for, 5
allowance for doubtful accounts,
definition of, 4, 32
allowance for doubtful accounts,
Interactive Illustration on calculating, 7
assets, current, 4
assets, definition of, 3, 32
38
assets, four key characteristics of, 3
assets, as impairments, 28
assets, long-lived, 14
assets, other items included in, 14
assets, recording of, 3, 28
assets, revaluation of, 28
assets, types of, 3
assets, US GAAP and IFRS differences
in recording, 29
available-for-sale securities, 22, 22, 32
average cost, definition of, 9
average cost, Interactive Illustration
on, 10
bad debts, accounting for, 5, 6
bad debts, allowance on balance sheet
for, 5
bad debts, Coca-Cola’s accounting for, 6
bad debts, as deferred tax asset, 14
bad debts, definition of, 5, 32
bad debts, Interactive Illustration on
estimating, 7
balance sheets, assets recorded on, 3
balance sheets, bad debt allowances
on, 5
balance sheets, inventory recorded on,
7
balance sheets, land on, 21
cash, definition of, 4, 32
cash equivalents, 4
cash on hand, 4
Coca-Cola, bad debts accounting by, 6
Coca-Cola, goodwill accounting by, 27
Coca-Cola, impairments accounting by,
29
Coca-Cola, intangible assets accounting
by, 26
Coca-Cola, inventory accounting by, 13
Coca-Cola, property, plant, and
equipment (PP&E) accounting by, 17
contra asset, accumulated depreciation
account as, 17
contra asset, definition of, 4, 32
cost measurement, in property, plant,
and equipment (PP&E), 15, 18
cost of goods sold (COGS), costing
methods and, 10, 11
cost of goods sold (COGS), on income
statements, 30
5071 | Core Reading: Assets and Expenses
cost of goods sold (COGS), Interactive
Illustration on LIFO and FIFO on, 12
current assets, definition of, 4, 32
current assets, types of, 3
debt investments, 21, 32
deferred tax asset or liability,
definition of, 14, 32
deferred tax asset or liability,
recording of, 14
depletion charges, 21
depreciation, changes made on a go
forward basis, 20
depreciation, common methods used
in, 18, 19
depreciation, definition of,16, 32
depreciation, Interactive Illustrations
on methods of, 20
depreciation, key factors in
determining, 18
depreciation, long-lived fixed assets
and, 14, 16, 31
depreciation, net book value of, 16
depreciation, US GAAP and IFRS
differences in recording, 29
double-declining balance depreciation,
18, 19, 20
equity, assets composed of liabilities
and, 3
equity investments, 22, 32
exploration costs, 21
fair market value, goodwill and, 23
fair market value, trading securities
and, 21
first-in first-out (FIFO), definition of, 9,
33
first-in first-out (FIFO), Interactive
Illustrations on, 10, 12
goodwill, Coca-Cola’s accounting for,
27
goodwill, definition of, 23, 33
goodwill, periodic testing of, 23
held-to-maturity securities, 21, 22, 33
IFRS, assets recording under, 29
2
IFRS, deferred tax asset or liability
under, 13
IFRS, last-in last-out (LIFO) under, 9
IFRS, revaluation under, 28
impairments, assets as, 28, 31
impairments, Coca-Cola’s accounting
for, 29
income statements, accounts
receivable and revenue on, 30
income statements, expenditures vs.
expenses on, 30
income statements, intangibles and
amortization on, 31
income statements, inventory and
costs of goods sold on, 30
income statements, PP&E and
depreciation on, 31
intangible assets, acquired, 24
intangible assets, changes in on income
statements, 31
intangible assets, Coca-Cola’s
accounting for, 26
intangible assets, development costs
of, 25, 30
intangible assets, types of, 23, 24
inventory, accounting for, 7
inventory, categories of, 7
inventory, Coca-Cola’s accounting for,
13
inventory, definition of, 7, 33
inventory, on income statements, 30
inventory, Interactive Illustration on
impact of costing methods on, 12
inventory, Interactive Illustration on
different costing methods in, 10
inventory, overhead cost allocation
methods in, 8
investments, accounting for, 22
investments, items included in, 21
land, accounting for, 21
last-in last-out (LIFO), definition of, 9,
33
last-in last-out (LIFO), Interactive
Illustrations on, 10, 12
last-in last-out (LIFO), US GAAP and
IFRS differences in recording, 29
liabilities, assets composed of equity
and, 3
long-lived assets, definition of, 14
5071 | Core Reading: Assets and Expenses
long-lived assets, types of, 14
long-lived fixed assets, categories of,
14
long-lived fixed assets, Coca-Cola’s
accounting for, 17
long-lived fixed assets, definition of, 14
long-lived fixed assets, depreciation of,
16
long-lived fixed assets, income
statements recording, 31
long-lived fixed assets, key issues in
accounting for, 15
long-lived fixed assets, measurement
of cost for, 15
lower of cost or market (LCM), 8, 33
majority active investments, 22
minority active investments, 22
net realizable value, 8, 33
noncontrolling interest account, 22
overhead cost allocation, in inventory,
8
overhead cost allocation, in property,
plant, and equipment (PP&E), 15
patents, 25
periodic method, definition of, 8, 33
periodic method, Interactive
Illustration on, 10
perpetual method, definition of, 8, 33
perpetual method, Interactive
Illustration on, 10
prepaid expenses, 14, 30
property, plant, and equipment
(PP&E), categories of, 14
property, plant, and equipment
(PP&E), accounting of, 17
property, plant, and equipment
(PP&E), definition of, 14, 33
property, plant, and equipment
(PP&E), depreciation of, 16
property, plant, and equipment
(PP&E), on income statements, 31
property, plant, and equipment
(PP&E), key issues in accounting for,
15
property, plant, and equipment
(PP&E), measurement of cost for, 15
3
property, plant, and equipment
(PP&E), US GAAP and IFRS differences
in, 29
research and development costs (R&D)
costs, 24
residual price, in depreciation, 18
revaluation, 28
software development costs, 25
straight-line depreciation, acquired
intangible assets, 24
straight-line depreciation, definition of,
18, 19, 20
straight-line depreciation, goodwill
under, 24
sum-of-the-years’-digits depreciation, 18,
19, 20
taxation, deferred asset or liability in,
13
trading securities, 21, 22, 33
units of production depreciation, 18
unrealized holding gains and losses,
21, 22
useful life, in depreciation, 18
US GAAP, assets recording under, 29
US GAAP, deferred tax asset or liability
under, 13
US GAAP, goodwill under, 24
US GAAP, revaluation under, 28
wasting assets, 21, 33
write-offs of bad debts, accounting for,
5, 6
write-offs of bad debts, Coca-Cola’s
example of, 6
5071 | Core Reading: Assets and Expenses
4
For the exclusive use of A. Gohil, 2022.
9-121-022
REV: JULY 15, 2021
PAUL HEALY
MARSHAL HERRMANN
Accounting for Revenues
In early March 2020, Alessandra Morales, an experienced analyst at a large U.S. brokerage firm was
asked to provide an overview on accounting for revenues for the incoming cohort of new hires in the
firm’s research department, most of whom had only limited accounting background. Morales decided
to focus on four areas where she had observed there were opportunities for managers to exercise
judgement in revenue reporting: (i) allocating transaction prices to obligations performed in different
periods, (ii) allocating multi-year contract revenues over time, (iii) estimating customer return
allowances, and (iv) estimating revenue collections. To illustrate the four, she selected companies
where the issues were particularly relevant and constructed the following four cases.
Allocating performance obligations to current and deferred revenues at
Southwest Airlines
Under Southwest’s frequent flyer program, Rapid Rewards, loyal customers earned miles from
traveling with Southwest, and redeemed those awards for free, discounted or upgraded air travel and
non-travel awards. For financial reporting, Southwest recognized a portion of the ticket price as
revenue when a Rapid Rewards member traveled and earned miles for future flights. The remainder
was considered a separate performance obligation and was deferred, recorded as “air traffic liability”
on the balance sheet, similar to prepaid tickets. Air traffic liability related to the loyalty program was
recognized as revenue when the customer later redeemed miles. In its 2020 financial statement
footnotes, the company explained this accounting as follows:
The Company records a liability for the relative fair value of providing free travel
under its loyalty program for all points earned from flight activity or sold to companies
participating in the Company’s Rapid Rewards loyalty program as business partners that
are expected to be redeemed for future travel. The loyalty liability represents performance
obligations that will be satisfied when a Rapid Rewards loyalty member redeems points
for travel or other goods and services. Points earned from flight activity are valued at their
relative standalone selling price by applying fair value based on historical redemption
patterns. … The Company records passenger revenue related to air transportation when
the transportation is delivered. The marketing elements [other goods and services
different from travel received by members in exchange for their loyalty points] are
recognized as Other – net revenue when earned.
Professor Paul Healy and Teaching Fellow Marshal Herrmann prepared this exercise as the basis for class discussion rather than to illustrate either
effective or ineffective handling of an administrative situation.
Copyright © 2020, 2021 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-5457685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu. This publication may not be digitized,
photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
This document is authorized for use only by Abhishek Gohil in TGM 517 Global Accounting & Financial Management (MGM SP22) taught by Euvin Naidoo, Thunderbird School of Global
Management from Jan 2022 to Mar 2022.
For the exclusive use of A. Gohil, 2022.
121-022
Accounting for Revenues
Southwest reported Passenger revenues of $7,665m and $20,776m in 2020 and 2019, respectively. In
its footnotes, Southwest provided the following information on loyalty program (Exhibit 1, in $
millions):
Exhibit 1
Twelve Months Ended
December 31,
2020
2019
$3,385
$3,011
Amounts deferred associated with points awarded
2,125
2,941
Revenue recognized from points redeemed – Passenger
(1,003)
(2,487)
(60)
(80)
$4,447
$3,385
Air traffic liability – loyalty program – beginning balance
Revenue recognized from points redeemed – Other
Air traffic liability – loyalty program – ending balance
Source:
Southwest
Airlines,
2020
Annual
Report,
p.
115,
https://www.southwestairlinesinvestorrelations.com/~/media/Files/S/SouthwestIR/LUV_2020_Annual%20Report_.pdf, accessed May 2021.
Note
6
“Revenue,”
Allocating multi-year contract revenues at Molecular Partners
On December 19, 2018, Molecular Partners (MP), a Swiss clinical-stage biotech firm announced that
it had signed a multi-year collaboration and licensing agreement with Amgen (the U.S. biotech firm)
to develop and commercialize MP0310, a preclinical molecule designed to activate immune cells in a
tumor to allow a human body to fight the cancer. Under the agreement, Amgen received exclusive
global development and commercial rights for MP0310, whereas MP retained certain rights to develop
and commercialize its own proprietary pipeline of products in combination with MP0310.
The contract terms also specified that MP would receive an upfront payment of CHF49.625 million
to conduct future research on the project, and be eligible to receive up to CHF493.3 million in future
development, regulatory and commercial milestone payments, as well as double-digit, tiered royalties.
MP and Amgen agreed to share the clinical development costs in defined percentages for the first three
indications, with Amgen being responsible for all development costs for any additional clinical trials.
IFRS required MP to allocate any research revenue from the agreement to periods when the research
was actually conducted. MP initially reported that the work would be performed evenly throughout
the performance period, and recognized the revenues accordingly. As a result, the CHF49.625 million
upfront payment would be allocated to the contract period as follows: CHF0.915 million in 2018,
CHF27.834 million in 2019 and CHF20.876 million in 2020 (see exhibit below).
However, in 2019 the timing for the project’s completion was extended, and new information
became available about the remaining costs. MP determined that the inputs would no longer be evenly
expended throughout the performance period and changed its method of revenue recognition to the
ratio of actual costs incurred in the period to the best estimate of the total expected costs of completing
the project (known as the percentage completion method). Under the new method, the company
2
This document is authorized for use only by Abhishek Gohil in TGM 517 Global Accounting & Financial Management (MGM SP22) taught by Euvin Naidoo, Thunderbird School of Global
Management from Jan 2022 to Mar 2022.
For the exclusive use of A. Gohil, 2022.
Accounting for Revenues
121-022
reported that it expected to allocate the remaining deferred revenues to the contract period as follows:
CHF20.383 million in 2019, CHF18.310 million in 2020, CHF9.53 million in 2021, and CHF0.487 million
in 2022 (see Exhibit 2).
Exhibit 2
Allocation of revenue 12/31/2018
(CHF millions)
Allocation of revenue 12/31/2019
(CHF millions)
2018
0.915
0.915
2019
27.834
20.383
2020
20.876
18.310
2021
9.530
2022
0.487
49.625
Source:
49.625
Molecular Partners, Annual Report FY2019, https://investors.molecularpartners.com/~/media/Files/M/MolecularPartners/documents/annual-report-fy2019.pdf, accessed August 2020.
Estimating customer return allowances at Purple
In 2013, Tony and Terry Pearce invented and patented Mattress Max, a machine that allowed them
to create and mold large pieces of elastic polymers into mattresses. Using this proprietary “hyper-elastic
polymer” material the brothers constructed a mattress that provided support and also dissipated heat
for users. In September 2015, the company began selling its mattresses and launched a series of videos
to explain the underlying science to potential customers, promising a full refund to any customers who
were dissatisfied within their first 100 nights’ sleep. The videos went viral, attracting more than 100
million viewers, and sales soared, from $72 million in 2016 to $319 million in 2018.
Other web-based mattress companies, such as Casper, Helix, Leesa, Lull, Saatva, and Tuft and
Needle, also had a 100-day customer return policy. Under U.S. GAAP, if sales transactions provided
customers with a right of return, the seller was required to report revenues for the period net of the
value of products expected to be returned, as well as a liability for the expected refunds. If returned
assets were expected to have any value they should be recorded as an asset with an adjustment to cost
of sales. Since Purple discarded any returned mattresses, it would not have to make any adjustments
to assets or cost of sales upon receiving a return.
Purple provided the following information on net sales and sales returns from 2016 to 2018 in $m:
3
This document is authorized for use only by Abhishek Gohil in TGM 517 Global Accounting & Financial Management (MGM SP22) taught by Euvin Naidoo, Thunderbird School of Global
Management from Jan 2022 to Mar 2022.
For the exclusive use of A. Gohil, 2022.
121-022
Accounting for Revenues
Exhibit 3
2018
2017
2016
Annual sales, net
285,791
196,859
65,473
Gross Profit
112,600
85,020
21,480
Accrued sales returns, beginning balance
4,825
2,054
17
Additions that reduced net sales
33,543
19,779
7,278
Deductions for current year returns
(32,911)
(17,008)
(5,241)
Accrued sales returns, ending balance
5,457
4,825
2,054
Income Statement
Balance Sheet
Source:
Purple Innovation, Inc., 2018 Annual Report, p. 92, http://d18rn0p25nwr6d.cloudfront.net/CIK0001643953/03c8b587-0cb9-4ae6-99a8-13ef83b6c914.pdf, accessed August 2020.
Estimating revenue collections at Crocs, Inc
Crocs, Inc developed and marketed casual footwear for men, women and children. Its shoes were
known for being colorful, soft, comfortable, lightweight, non-marking and odor-resistant. From its
inception in 2002 to 2017, Crocs had sold more than 600 million pairs of shoes in more than 90 countries
around the world.
In 2015, Crocs experienced delayed payments and defaults from distributor partners in China, and
determined that it would need to increase its bad debt expense and allowance. The following (Exhibit
4) reports information on Croc’s gross receivables, allowances, write-offs and operating earnings for
the years ended December 31, 2014-17 in $m:
Exhibit 4
2017
2016
2015
2014
101.8
111.2
120.0
114.8
Allowance for doubtful accounts
?
32.9
36.4
13.6
Accounts receivable (net)
?
78.3
83.6
101.2
Write-offs
15.8
9.6
3.5
2.1
Operating earnings before bad debt expense
18.5
0.0
(46.1)
7.4
Accounts receivable (gross)
Source:
Crocs, Inc. 2015 Annual Report, p. 87, p. 120, https://d18rn0p25nwr6d.cloudfront.net/CIK-0001334036/8845619752b4-4096-94d8-02a4e90c26f7.pdf);
Crocs,
Inc.
2017
Annual
Report,
p.
67,
p.
97,
https://d18rn0p25nwr6d.cloudfront.net/CIK-0001334036/62c1d6b3-61df-4cc1-9ef1-1050640672f9.pdf,
accessed
August 2020.
4
This document is authorized for use only by Abhishek Gohil in TGM 517 Global Accounting & Financial Management (MGM SP22) taught by Euvin Naidoo, Thunderbird School of Global
Management from Jan 2022 to Mar 2022.
Financial Accounting
V.G. Narayanan and Dennis Campbell, Co-Series Editors
READING
+ INTERACTIVE ILLUSTRATIONS
Revenue Recognition
DAVID F. HAWKINS
Harvard Business School
5066 | Published: June 29, 2017
5066 | Revenue Recognition
2
Table of Contents
1 INTRODUCTION……………………………………………………………………………………………………………………….5
2 ESSENTIAL READING ……………………………………………………………………………………………………………..8
2.1 Five-Step Process ……………………………………………………………………………………………………………..8
2.1.1 Identify the Contract(s) with a Customer …………………………………………………………………..9
2.1.2 Identify the Performance Obligations in the Contract……………………………………………… 10
2.1.3 Determine the Transaction Price …………………………………………………………………………… 12
2.1.4 Allocate the Transaction Price to the Performance Obligations in the Contract ……….. 17
2.1.5 Recognize the Revenue When (or As) the Entity Satisfies a Performance Obligation .. 18
2.2 Implementation Guidance ………………………………………………………………………………………………. 20
2.2.1 Contract Costs …………………………………………………………………………………………………….. 20
2.2.2 Contract Combinations ………………………………………………………………………………………… 20
2.2.3 Contract Modifications …………………………………………………………………………………………. 20
2.2.4 Contract Satisfied over Time: Output and Input Methods ……………………………………….. 21
2.2.5 Stand-Alone Selling Price Estimates ……………………………………………………………………… 22
2.2.6 Rights of Return …………………………………………………………………………………………………… 22
2.2.7 Inappropriate Interest Rates …………………………………………………………………………………. 23
2.2.8 Warranties …………………………………………………………………………………………………………… 24
2.2.9 Noncash Considerations………………………………………………………………………………………. 24
2.2.10 Repurchase Agreements …………………………………………………………………………………….. 25
2.2.11 Disclosure …………………………………………………………………………………………………………. 26
2.2.12 Analytical Considerations …………………………………………………………………………………… 26
2.3 Summary ………………………………………………………………………………………………………………………. 28
3 SUPPLEMENTAL READING ………………………………………………………………………………………………….. 29
3.1 Understanding Changes in the Revenue Recognition Standard ……………………………………….. 29
3.1.1 Topic 605, Revenue Recognition …………………………………………………………………………… 30
3.2 Accounting for Bad Debts ………………………………………………………………………………………………. 33
3.2.1 Bad Debt Estimation Methods ………………………………………………………………………………. 34
3.2.2 Accounting Entries for Bad Debt…………………………………………………………………………… 36
4 KEY TERMS …………………………………………………………………………………………………………………………. 38
5 ENDNOTES ………………………………………………………………………………………………………………………….. 40
5066 | Revenue Recognition
3
This reading contains links to online interactive illustrations, denoted by the icons above. To
access these exercises, you will need a broadband Internet connection. Verify that your
browser meets the minimum technical requirements by visiting http://hbsp.harvard.edu/techspecs.
John C. Coates, Professor of Business Administration, Harvard Law School, and Suraj
Srinivasan, Professor of Business, Harvard Business School, developed this Core Reading
with the assistance of writer M. Penelope K. Rossano.
Copyright © 2018 Harvard Business School Publishing Corporation. All rights reserved.
5066 | Revenue Recognition
4
1 INTRODUCTION
Companies try to boost earnings by manipulating the
recognition of revenue. Think about a bottle of fine wine.
You wouldn’t pop the cork on that bottle before it was ready.
But some companies are doing this with their revenue—
recognizing it before a sale is complete, before the product is
delivered to a customer, or at a time when the customer still
has options to terminate, void or delay the sale.
—Arthur Levitt, former Securities and Exchange Commission Chairman,
1998
Decisions about how to measure and report revenue determine in large part
whether financial statements are an accurate representation of a company’s
financial health. Preparers of financial statements must have, of course, a
thorough understanding of the complexities of the reporting of revenue—known
as revenue recognition. Users of these statements must also be able to assess
whether a company’s approach to revenue recognition provides an accurate
picture of that company’s income and cash flows.
Management judgment and estimates play an important role in revenue
recognition. When reading and interpreting financial statements, analysts must
assess the reasonableness of those decisions given the company’s circumstances.
Analysts should never assume that a company is healthy because its accounting
revenue and profits appear to be robust. This could be an illusion. The sales could
be accounting fictions that do not have future beneficial cash flow consequences,
so the analyst’s job is to examine the actual business transactions behind…

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