Transcript Chapter 6, Receivables and Revenue Recognition

Chapter 6 -- Receivables
and Revenue Recognition
FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS,
METHODS, AND USES
12th Edition
Clyde P. Stickney and Roman L. Weil
Learning Objectives
1. Develop an introductory understanding of the
quality of earnings as a concept of evaluating
generally accepted accounting principles
discussed in Chapters 6 to 12.
2. Understand why the allowance method for
uncollectible accounts matches bad debts with
revenues better than the direct write-off method.
3. Apply the allowance method for uncollectible
accounts.
4. Analyze information on accounts receivable to
evaluate a firm’s management of its credit
operation.
Learning Objectives
5. Develop a sensitivity to issues in recognizing
and measuring revenues and expenses for
various types of businesses.
6. Cement an understanding of the concept that
net income over sufficiently long periods
equals cash inflows minus cash outflows other
than transactions with owners (a
measurement issue), regardless of when firms
recognize the revenues and expenses (a
timing issue).
Chapter Outline
1. Financial Reporting Environment
2. Quality of Earnings
3. Review of revenue recognition principles
4. Application of income recognition
principles
5. Revenue recognition at time of sale
6. Analyzing information on accounts
receivable
Chapter Outline
7. Income recognition at times different from sale
8. Summary illustration of income recognition
methods
9. Format and classification with the Income
Statement
10. An International Perspective
Chapter Summary
Appendix 6.1 – Effects on the Statement of Cash
Flows of Transactions Involving Accounts
Receivable
Quality of Earnings


Refers to the ability managers have to use discretion
in measuring and reporting earnings
This discretion may involve:
– Choosing among alternative accounting principles
– Making estimates
– Timing transactions in order to control recognition

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High quality earnings are presumed to be fair
representations of the economic performance of the
firm
Low quality earnings overstate fair earnings
Income Recognition Principle

Revenue is recognized (recorded) when both:
– The firm has performed all, or a substantial
portion of, the services; that is, the revenue
has been earned, and
– The firm has received cash, a receivable or
some asset capable of reasonable
measurement; that is, the revenue is
measurable.
Income Recognition Principle

Expenses are matched to the revenues that
they generate
– Since the firm only expends assets (causing
expenses) in anticipation of revenue, fair
measurement of net income calls for
matching those expenses against revenue.
– Expenses are recognized in the period in
which the revenue is recognized.
Figure 6.1: Operating Process for
a Manufacturing Firm
When has the firm earned revenue?
When is the expense incurred?
Revenue Recognition Rules

Different recognition rules may be
appropriate for different situations
1. At time of sale
2. Percentage of completion
3. Completed contract
4. Installment sales
5. Cost recovery first
Revenue Recognition Rules
 Different
industries or situations
1. Long-term contractors
2. Forestry products
3. Insurance
4. Franchisors
Discuss Earning Revenue At Time
of Sale

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Merchandising firms earn revenue when the
sale is made.
Revenue is then recognized at the time of the
sale.
And expenses that contributed to that revenue
are recognized at the same time.
This method is the general rule for sales of
goods.
It has the advantage of being easily verified.
At Time of Sale (Cont.)


A more technical version of this rule
recognizes revenue when the title to the
goods passes from seller to buyer. This
may occur when the goods are moved from
the seller’s loading dock to a shipper.
Management has incentives to recognize
revenues as early as the account will allow.
Explain Recognition for
Percentage of Completion

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Long-term construction companies may earn
revenue as they go
For example, a contract to pave a road is earned as
the final payment is laid
Expenses can be matched against this revenue and
recognized in proportion
The difficulty lies in measuring the percentage of
completing
– Engineering estimates, or
– Percentage of the budgeted costs incurred
Explain Recognition for Completed
Contract
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If the percentage of completion cannot
reasonably be estimated, then recognition of
revenues should be delayed until the contract is
completed and accepted by the customer.
An example would be a contract to develop a
computer program; it either works satisfactorily
or it doesn’t; there is little meaning to a
percentage of completion.
In these cases, revenue is recognized upon
completion of the contract.
Completed Contract (Cont.)
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And expenses are matched; that is, they are
recognized upon completion also.
So where are cash (and other asset) outflows
that are made before completion?
– Such outflows are capitalized; that is, they
are debited to an asset
– This asset is credited (removing it) and an
expense is debited upon completion
Revenue Recognition for Installment
Sales
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Recognized revenue as the seller collects
cash from periodic payments.
A common example is a rent-to-own store
in which the customer takes possession of
an asset and pays periodic payments like
rent. The customer may return the asset
and stop payments at any time. After a
set number of payments is ownership of
the asset is given. Some rent-to-own
stores have been criticized because the
implicit rate of interest in many such
contracts is so high.
Installment Sales (Cont.)
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In these cases,
revenue may be
recognized on a cash
basis, as the cash is
received.
Matching of expenses
calls for recognition of
a proportional
amount of the total
cost of the asset.
Review Revenue Recognition for
Cost Recovery First
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A more conservative form of installment sales
method has the same revenue recognition
rule.
But recognized expenses equal to revenue
(and so zero income).
Until the entire cost of the asset is covered.
Income appears to be zero until the cost is
recovered and then is equal to revenue until
the payments are completed.
Cost Recovery First (Cont.)
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This method front-end loads expenses but
results in a greatly delayed recognition of
income.
This method is justified in sales where the
probability of default by the customer is very
high.
Since income in these cases is very uncertain,
no income is recognized until the cost is
recovered.
Different Industries -- What is the
appropriate revenue recognition rule?
1. Long term contractors –
Projects take several years to complete and
cash inflows and outflows may be made during
the project.
2. Forestry products –
Similar to a long term contract, forests take
many years to mature but cash inflow is
typically at the sale.
Different Industries -- What is the
Appropriate Revenue Recognition
Rule?
3. Insurance –
What is a prepaid asset to the insured is a
deposit paid in advance of services to the
insurance company. Revenue is earned when
the service is provided.
4. Franchisors–
A franchisor sells rights to a franchisee who
pays for them. These payments may be
deferred until the franchisee earns revenue.
How does uncollectible accounts affect
revenue recognition?
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For credit sales, revenue is recognized (credited) at
the time of the sale even thought the customer has
not paid cash.
Instead, an account receivable is established
(debited).
An account receivable is an asset that represents a
promise to pay.
Not all customers are able or willing to fulfill their
promise.
When a customer defaults, the account becomes
valueless and must be credited and removed.
Uncollectible Accounts (Cont.)

The offsetting debit could be considered a
reversal of revenue:
– Most consider this a necessary and
unpleasant expense of doing business.
– In these cases, an expense could be
debited and the revenue would remain.

The timing of the recognition of this expense
depends on the accounting method.
Uncollectible Accounts (Cont.)
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An uncollectible account is written-off (the asset is
removed) and an expense is recognized
When the expense is recognized depends on the
method of accounting for uncollectible accounts
There are two basic methods for accounting for
uncollectible accounts:
a. Direct write-off
The
expense is recognized when the account
is written-off
This
method is required for most tax purposes
Uncollectible Accounts (Cont.)
b. Allowance method
The
expense is matched to the
revenue by recognizing an estimate
of the expense in the same period
as the credit sale
Two
variants:
1. Credit sales basis
2. Net receivables or aging of A.R.
basis
Explain Direct Write-Off

Recognizes losses from uncollectible accounts
in the period in which the account is
determined to be uncollectible:
Bad debt expense
134,000
Accounts receivable
To record losses from know uncollectible accounts
134,000
Explain Direct Write-Off (cont.)
Shortcomings:
Fails to match bad debt expense with revenue,
the revenue is recognized at the time of the sale
but the expense is delayed until the account is
determined to be uncollectible.
Provides an opportunity to manipulate earnings
each period by strategically writing-off accounts.
The amount of accounts receivable is not the best
estimate of the expected cash inflow; that is, if
the firm and one million dollars in accounts
receivable but a high default rate, the expected
cash inflow may be much less than one million
dollars.
Discuss the Allowance Method
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GAAP requires that bad debts expense be matched
against the revenue to which it gives rise.
When revenue is recognized, a bad debts expense is also
recognized as an estimate of the amount of revenue
which may eventually prove uncollectible.
The offset to this expense is called the allowance for
uncollectible accounts:
Bad debt expense
134,000
Allowance for uncollectible accounts
To record losses from estimated uncollectible accounts
134,000
The allowance is a contra asset with a credit balance. And
when it is subtracted from accounts receivable, the difference
(net accounts receivable) represents an estimate of the cash
value of accounts receivable.
Credit Sales Basis
1. Begin with credit sales for the period.
2. Estimate the amount of uncollectible sales,
– Typically as a percentage of sales.
– This percentage may be based on
experience coupled with current economic
conditions.
3. Debit an expense (sometimes called loss or
provision for bad debts) for this amount.
Credit Sales Basis
4. Credit the allowance account for the same
amount
5. When specific accounts are determined to be
uncollectible:
– Credit the specific account receivable
removing it,
– Debit the allowance for uncollectible
accounts reducing it.
Net Receivables & Aging of A.R.
Basis
1. Estimate the net amount of receivables
expected.
2. Take this amount as the ending balance in
the allowance for uncollectible accounts.
3. Credit the allowance account for the amount
needed to bring the current balance up to the
amount that was estimated in step 1.
Net Receivables & Aging of A.R. Basis
(Cont.)
4. Offset this credit with a debit to bad debt
expense for the same amount.
5. When specific accounts are determined to be
uncollectible:
– Credit the specific account receivable
removing it,
– Debit the allowance for uncollectible
accounts reducing it.
Aging of Accounts Receivable
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
How do you estimate the net amount of
receivables?
One method is to analyze the accounts
receivable and apply the assumption that
overdue accounts are more likely to eventually
prove uncollectible and the more overdue the
account, the more likely it will prove
uncollectible.
Aging of Accounts Receivable
(cont.)

An aging schedule separates the accounts
receivable into layers.
– The base layer is comprised of all the
accounts that are current or not overdue
– Layers are added at intervals of perhaps 30
days separating accounts according to their
age
– Different percentages are applied to each
layer with higher percentages being assigned
to the older accounts
Aging of Accounts Receivable
(cont.)

The sum of the
product of the
balance in a layer
with its associated
percentage gives an
estimate of the net
amount of
uncollectible
receivables.
An Illustration of the Allowance
Account
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Joe, a customer charges $5 of merchandise in year
1.
In year 1, we do not know whether a specific
account may eventually prove uncollectible, so we
recognize revenue for the amount of the credit sale
to Joe.
At the end of year 1, we have to estimate the bad
debt expense associated with that year’s sales. We
may use either the percentage of sales method or
the net receivables method. Consider this amount
to be estimated to be $100.
An Illustration of the Allowance
Account (cont.)
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In year 2, we determine that the customer’s
$5 receivable is uncollectible. We write this
account off but do not recognize an expense
here. The expense was anticipated by the
journal entry at the end of year 1.
Instead, we reduce the allowance account.
An Illustration of the Allowance
Account
year 1
year 1
year 2
account receivable -- Joe
sales revenue
bad debts expense
allowance for uncollectible accounts
allowance for uncollectible accounts
accounts receivable -- Joe
5
5
100
100
5
5
An Illustration of the Allowance
Account
A.R. -- Joe
5
sales revenue
5
bad debts exp.
allow for u.a.
100
5
100
5
An International Perspective

The International Accounting Standards Committee
(IASC) says that the firm should recognize revenue
when:
1. The seller has transferred significant risks and
rewards of ownership to the buyer
2. Managerial involvement and control has passed from
seller to the buyer
3. The seller can reliably measure the amount of
revenue
4. It is probable that the seller will receive economic
benefit
5. The seller can reliably measure the costs (including
future costs) of the transactions
An International Perspective
(cont.)

In addition, the IASC recommends
– The allowance method for uncollectibles
– The percentage of completing method for
services
– The matching principle for timing of
expense recognition
Chapter Summary
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This chapter has presented concepts of
measurement of receivables and revenue.
Quality of earnings was defined as choosing those
measurement methods that fairly present the
economic performance of the firm.
The income recognition principle was presented
along with some income recognition rules.
Uncollectible accounts were presented including:
allowance and direct-write-off methods of
matching bad debt expense and aging of accounts
receivable.
Chapter Summary (Cont.)
The
accrual basis of accounting
provides measures of operating
performance that are superior to
those provided by cash flow basis:
 recognizing
revenues when earned
and measurable rather than when
cash is received,
 matching
expenses to revenues
without regard for when the timing of
the cash outflow.
Appendix 6.1 – Effects on the
Statement of Cash Flows of
Transactions Involving Accounts
Receivable


Transactions changing accounts receivable
are operating activities.
Under indirect method, to compute cash flow
from operations:
– Increase in accounts receivable is
subtracted from net income.
– Decrease in accounts receivable is added
to net income.
Appendix 6.1 (Cont.)
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Most firms report changes in accounts
receivable net of allowance for uncollectible
accounts as a single line in Operating
Activities….
With no further adjustments in that section for
uncollectible accounts to derive cash flow
from operations.
Firms with significant uncollectibles may
disclose separately. If they report gross
changes in accounts receivable in the
Operating Activities section, they must addback to net income for bad debt expense.