Chapter 9 Lecture and Notes

Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions

Three accounting issues:

1. Recognizing accounts receivable.
2. Valuing accounts receivable.
3. Disposing of accounts receivable.

 

 

Revenue recognition principle: states that companies must recognize revenue in the period in which it is earned, i.e., when a four-step process is completed. Remember, this may not necessarily be when cash is collected.

1. 1. 1. 1. 1. 1. 1. 1. 1. 1. 1. There is credible evidence that an arrangement exists.
                              2. Goods have been delivered or services have been performed.
                              3. The selling price or fee to the buyer is fixed or can be reasonably determined.
                              4. There is reasonable assurance that the amount owed to the seller is collectible.

 

Accrual accounting also incorporates the matching principle (otherwise known as the expense recognition principle), which instructs companies to record expenses related to revenue generation in the period in which they are incurred.

 

Recognizing Accounts Receivable

• Service organization records a receivable when it performs service on account.
• Merchandiser records accounts receivable at the point of sale of merchandise on account.

 

 

 

Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches

Valuing Accounts Receivables

• Current asset.
• Valuation (cash realizable value).

   

 

Uncollectible Accounts Receivable

• Sales on account raise the possibility of accounts not being collected.
• Companies record credit losses as debits to Bad Debt Expense.

Bad debts are uncollectible amounts from customer accounts and are  a necessary aspect of allowing customers to use credit to pay for goods and services. You will sometimes see Bad Debt Expense called Uncollectible Accounts Expense.

• Bad debt negatively affects accounts receivable.
• When future collection of receivables cannot be reasonably assumed, companies must estimate the amount of expected nonpayment.
• Methods a company may use to recognize bad debt:
• The direct write-off method
• The allowance method
• Aging of accounts receivable method

 

Direct Write-off Method

• A bad debt is written off when the company is fairly certain that collection is not possible.
• This method is not acceptable under GAAP because it violates the matching principle.
  • For example, a sale that occurs in January is not written off until November.
    • January’s income includes the sale.
    • November’s income includes bad debt expense.

 

NOTE: An exception to using the direct write-off method is if the results would not be substantially different than the company would get if they used the allowance method. Thus, a company that has very few credit sales could use the direct write-off method.

 

Allowance Method

The allowance method estimates bad debt during a period, based on past experience and industry standards.

• Matches bad debt with related sales during the period
• Three steps to this process

  1. Companies estimate uncollectible accounts receivable. Two approaches to calculate amount of bad debt expense:

     • • Income statement approach
       • Balance sheet approach

  2. Debit Bad Debt Expense and credit Allowance for Doubtful Accounts (a contra-asset account).

  3. Companies debit Allowance for Doubtful Accounts and credit Accounts Receivable at the time the specific account is written off as uncollectible.

• Two approaches to calculate amount of bad debt expense:
  • Income statement approach
  • Balance sheet approach

 

Income Statement Method

The income statement method (also known as the percentage of sales method) estimates bad debt expenses based on the assumption that at the end of the period, a certain percentage of sales during the period will not be collected. The estimation is typically based on credit sales only, not total sales.

 

  

 

Balance Sheet Method

The balance sheet method (also known as the percentage of accounts receivable method) estimates bad debt expenses based on the balance in accounts receivable. The method looks at the balance of accounts receivable at the end of the period and assumes that a certain amount will not be collected.

 

 

 

Disposing of Accounts Receivables: Reasons to Sell Receivables

Companies sell receivables for two major reasons.

1. Receivables may be the only reasonable source of cash.
2. Billing and collection are often time-consuming and costly.

 Sale of Receivables to a Factor

• Finance company or bank.
• Buys receivables from businesses and then collects the payments directly from the customers.
• Typically charges a commission to the company that is selling the receivables.
• Fee ranges from 1 to 3% of the receivables purchased.

Determine the Efficiency of Receivables Management Using Financial Ratios

Stakeholders, such as investors, lenders, and management, use financial statement data to make informed decisions about a company’s financial position.

• They will look at each statement—as well as ratio analysis—for trends, industry comparisons, and past performance to help make financing determinations.

 

Accounts receivable turnover ratio: determines how many times (i.e., how often) accounts receivable are collected during an operating period and converted to cash

Number of days’ sales in receivables ratio: is similar to accounts receivable turnover in that it shows the expected days it will take to convert accounts receivable into cash. The reflected outcome is in number of days, rather than in number of times.

 

Example: In 2019 Vader's Star Systems had net sales of $37,750 million for the year. It had a beginning accounts receivable (net) balance of $5,157 million and an ending accounts receivable (net) balance of $5,344 million. Assuming that Vader’s sales were all on credit, its accounts receivable turnover is computed as follows.

 

 

Discuss the Role of Accounting for Receivables in Earnings Management

Earnings management works within GAAP constraints to improve stakeholders’ views of the company’s financial position.

Earnings manipulation is noticeably different in that it typically ignores GAAP rules to alter earnings significantly. Carried to an extreme, manipulation can lead to fraudulent behavior by a company

A company may be enticed to manipulate earnings for several reasons. It may want to show a healthier income level, meet or exceed market expectations, and receive management bonuses. This can produce more investment interest from potential investors. An increase to receivables and inventory can help a business to secure more borrowed funds.

 

 

 

Apply Revenue Recognition Principles to Long-Term Projects

In some types of sales and service transactions, revenue recognition and expense recognition are less clear cut. Examples include the following:

• Long-term construction-company projects
• Real estate installment sales
• Multi-year magazine subscriptions
• A combined equipment sale with an accompanying service contract

These types of transactions have special reporting requirements to meet revenue recognition and matching principles.

 

Long-term construction-company projects

• Percentage of completion: recognizes revenue based on the percentage of the work that has been done
• Completed contract: recognizes all revenue at the time the project is completed

Real estate installment sales

• Recognizes revenue using the gross profit percentage each time the buyer makes a payment to the seller.

Multi-year magazine subscriptions

• These are typically paid for in advance, and revenue is recognized as the service is performed.

A combined equipment sale with an accompanying service contract

• The sale portion of the contract is recognized immediately, but the revenue allocated to the service portion is recognized over the service period.

 

NOTE Percentage of completion—the assumption is that if 40 percent of the work has been done, then 40 percent of the costs have been incurred, so 40 percent of the revenue can be recognized. Completed contract—improper matching because costs are being recognized as incurred, but revenues are only recognized at the end of the project, even if that is years later. The installment method accounts for risk and defers revenue using a gross profit percentage. These types of plans are typically for commercial real estate and have the effect of deferring revenue until collections (installments) are received. Subscriptions, of any sort, would use this method; other examples include gym memberships and airline tickets. Cell phones with service contracts are an example of equipment sale with accompanying service contract.

 

Explain How Notes Receivable and Accounts Receivable Differ

Companies may grant credit in exchange for a promissory note.  A promissory note is a written promise to pay a specified amount of money on demand or at a definite time.

Promissory notes may be used

1. when individuals and companies lend or borrow money,
2. when amount of transaction and credit period exceed normal limits, or
3. in settlement of accounts receivable.

 

Notes receivable has several defining characteristics:

• Principal of a note is the initial loan amount, not including interest.
• Issue date is the date on which the security agreement is initially established.
• Maturity date is the date at which the principal and interest become due and payable.
• The maturity date is established in the initial note contract.
• Interest is a monetary incentive to the lender that justifies loan risk.
• Interest rate is the part of a loan charged to the borrower, expressed as an annual percentage of the outstanding loan amount.

 

Key Feature Comparison of Accounts Receivable and Notes Receivable

Accounts Receivable	Notes Receivable
•An informal agreement between customer and company •Receivable in less than one year or within a company’s operating cycle •Does not include interest	•A legal contract with established payment terms •Receivable beyond one year and outside of a company’s operating cycle •Includes interest

 

Determining the Maturity Date

• On demand
• At the end of a stated period of time
• On a stated date

 

Computing Interest

 

When counting days, omit the date the note is issued, but include the due date. The interest rate specified in the annual rate.

 

   

 

 

 

More Examples on journalizing Notes Receivable

 

Valuing Notes Receivable

• Report short-term notes receivable at their cash (net) realizable value .
• Estimation of cash realizable value and bad debt expense are done similarly to accounts receivable.
• Allowance for Doubtful Accounts is used.

Disposing of Notes Receivable

1. Notes may be held to their maturity date.
2. Maker may default and payee must make an adjustment to the account.
3. Holder speeds up conversion to cash by selling the note receivable.

Dishonor of Notes Receivable

• Not paid in full at maturity.
• No longer negotiable.

• According to the revenue recognition principle, a company will recognize revenue when a product or service is provided to a client. The revenue must be reported in the period when the earnings process completes.
• According to the matching principle, expenses must be matched with revenues in the period in which they are incurred. A mismatch in revenues and expenses can lead to financial statement misreporting.
• When a customer pays for a product or service on a line of credit, the Accounts Receivable account is used. Accounts receivable must satisfy the following criteria: the customer owes money and has yet to pay, the amount is due in less than a company’s operating cycle, and the account usually does not incur interest.
• Bad debt is a result of unpaid and uncollectible customer accounts. Companies are required to record bad debt on financial statements as expenses.
• The direct write-off method records bad debt only when the due date has passed for a known amount. Bad Debt Expense increases (debit) and Accounts Receivable decreases (credit) for the amount uncollectible.
• The income statement method estimates bad debt based on a percentage of credit sales. Bad Debt Expense increases (debit) and Allowance for Doubtful Accounts increases (credit) for the amount estimated as uncollectible.
• The balance sheet method estimates bad debt based on a percentage of outstanding accounts receivable. Bad Debt Expense increases (debit) and Allowance for Doubtful Accounts increases (credit) for the amount estimated as uncollectible.
• The balance sheet aging of receivables method estimates bad debt based on outstanding accounts receivable, but it considers the time period that an account is past due. Bad Debt Expense increases (debit) and Allowance for Doubtful Accounts increases (credit) for the amount estimated as uncollectible.
• The accounts receivable turnover ratio shows how many times receivables are collected during a period and converted to cash. The ratio is found by taking net credit sales and dividing by average accounts receivable for the period.
• The number of days’ sales in receivables ratio shows the expected number of days it will take to convert accounts receivable into cash. The ratio is found by taking 365 days and dividing by the accounts receivable turnover ratio.
• Earnings management can occur in several ways, including changes to bad debt estimation methods, percentage uncollectible figures, and category distribution within the balance sheet aging method.
• Some revenue transactions cannot be recognized instantly examples include Long-term construction projects, Real estate installment sales, multi-year magazine subscriptions, and a combined equipment purchase with accompanying service contract.
• Accounts receivable is an informal agreement between customer and company, with collection occurring in less than a year, and no interest requirement. In contrast, notes receivable is a legal contract, with collection occurring typically over a year, and interest requirements.
• The terms of a note contract establish the principal collection amount, maturity date, and annual interest rate.
• Interest is computed as the principal amount multiplied by the part of the year, multiplied by the annual interest rate. The entry to record accumulated interest increases interest receivable and interest revenue.