Question

1. A customer prepays a vendor for goods or services not yet delivered or provided.  When she receives the customer’s check, the vendor’s accountant records that “deposit” as a liability, called “Unearned Revenue.” In the following month, the vendor delivers the goods (or completes the services).  At that time, the vendor’s accountant removes the unearned revenue amount from the liability account and recognizes a sale in the vendor’s revenue account

Required:Is this the correct accounting for the transaction?  Please explain your answer, briefly.

2. When preparing the cash flow from operating activities under the indirect method, why does the company add back depreciation expense as a reconciling item in determining net cash provided or used for operating activities?  What other items might be included in that reconciliation?

Answer 1

1. The treatment of the transaction is correct. The revenue is to be recognized only on completion of the contract ( in general case for goods at the time of its delivery ). Thus the advance is to be treated as a liability and on completion of the same sale transaction is to be recorded.

2. Cash flow from operating activities under indirect method is calculated by adding all non cash transactions to the net profit or loss of the company. Depreciation is added back since it is a non cash expenditure and is an increase in cash flow but reduced from the net profit or loss earlier.

We would add back all other non cash expenditure in the profit and loss account and adjust working capital changes to arrive at the cash flow from operations. Eg: Taxation, provisional expenses, etc.