Chapter 10: Revenue Recognition and
Valuation of Receivables
The timing of revenue recognition
Valuation of receivables; VAT
Accounting for bad debt
Overview
z What are receivables
z Recognition of accounts receivable Treatment of sales discounts
• Gross method
• Net method
Valuation of accounts receivable
• Direct write-off method
• Allowance method
Percentage-of-sales approach
Percentage-of-receivables approach
• Recovery of accounts written-off
z Are bad debts really bad?
z Recognition of notes receivable
Receivables: definition and categorization
z Definition: revenues recognized but not yet received, revenues on account
only what the accounting entity collects on its own account, not on behalf of others
• net of VAT
• agent: only the commission
z Classification
current receivables: expected to be collected within a year or the current operating cycle (whichever is longer)
noncurrent receivables: all others
trade receivables: amounts owed by customers for goods sold and services rendered
nontrade receivables: arise from a variety of transactions
Treatment of VAT
z
Example
invoice: Gross amount: 1000, including 25% VAT
• usually VAT has to be separately shown in the invoice
Trade Receivables
z
Accounts receivable
oral promises of the purchaser to pay
usually collectible within 30-60 days
represent „open accounts“ (short-term extension of credit)
z
„accounts receivable“ account in general ledger
Æ control account
General Ledger Accounts Receivable Subsidiary Record Accounts Receivable Miller Bal. 6.300 Bal. 500 Meier Total € 6.300 Bal. 1.800 Mayor
adapted from Harrison/Horngren, p.228 Bal. 4.000
Summary of individual receivables
VAT
VAT: 80
VAT: 288
Importance of Accounts Receivable - I
Source: Dun and Bradstreet, Industry Norms and Ratios, 1993-94
Accounts Receivable as a Percentage of Total Assets for Selected Industries
Receivables / Total assets Receivables / Current assets
Manufacturing
General Electric (Manufacturer) 0,35 1,03* Chevron (Oil drilling and refining) 0,09 0,47
Retail
Supervalu (Grocery retail) 0,09 0,26 Tommy Hilfiger (Clothing retail) 0,09 0,26
Internet
Yahoo (Internet search engine) 0,04 0,07 Cisco (Internet systems) 0,07 0,21
General services
SBC Communications 0,10 0,03 (Telecommunications services) 0,04 0,24 Wendy's (Restaurant services)
Financial services
Revenue recognition revisited
z Accounting regulation (IAS 18: Revenues)
Revenue is to be recognized when all of the following conditions are met
it is probable that economic benefits will flow to the entity from the respective transaction
the amount of revenue and the related costs can be measured reliably
the significant risks and rewards of the transaction have been transferred to the buyer
z specific cases
goods sold on consignment: consignor recognizes revenue only
when consignee has sold to his customer
right of the customer to return the goods: recognition depends on the amount of risk that customer will exercise this right
(consignment on approval ... return only if defective)
Recognition of Accounts Receivable
z
usual way if a credit sale occurs
record the sale as revenue and record an increase in accounts receivable
basis for recognition Ö exchange price, i.e. the amount due from the debtor
z
exchange price can be found in the contract or on
the invoice
Discounts must be recognized
interest not recognized, no discounting (immaterial)
Accounts Receivable € XYZ
Discounts
z
Trade Discounts
used to avoid frequent changes in catalogues
allow for different prices for different quantities
hide true invoice price from competitors
revenue recognized is the net amount
z
Sales Discounts
offered to induce prompt payment
usually 2% - 3% if payment occurs within 10 days, net amount due within 30 days
foregoing the discount is expensive (in terms of opportunity costs!)
Î e.g. not using a 2% discount means incurring a 36.9% interest on the discounted balance!!
Note that discounts apply to VAT too
z both revenue and VAT amounts are reduced by the discount percentage z Example: Invoice: 1000 + 200 VAT 2% discount used • Customer pays: 1176 Journal entries:
• when revenue is recognized using the gross method
Two methods of accounting for sales
discounts
z
(1) Gross method
initially recognize gross amount
recognize sales discounts when they are taken
z
(2) Net method
initially recognize amount net of sales discount
make „correcting“ entries if sales discounts are forfeited
from an accounting point of view Ö net method preferable
why? amount recognized closer to net realizable value from a practical point of view Ö gross method preferable
Gross Method Net Method I Sale of € 4.000, terms 3/10, n/30
Accounts Receivable 4.000 Accounts Receivable 3.880
Sales 4.000 Sales 3.880
II Payment of € 1.940 received within discount period:
Cash 1.940 Cash 1.940
Sales Discounts 60 Accounts Receivable 1.940 Accounts Receivable 2.000
III Payment of € 2.000 received after discount period:
Cash 2.000 Accounts Receivable 60 Accounts Receivable 2.000 Sales Discounts
Forefeited 60 Cash 2.000
Accounts Receivable 2.000
Note: The payment of € 1.940 results in a reduction of € 2.000 in the accounts receivable account
Valuation of Accounts Receivable
important for financial statement presentation
important also for internal decision making
valuation at net realizable value
• not always equal to face value!
z Motivating examples 1. Installment sales
• allow purchase of goods too expensive to fully pay instantly in cash
• risk of default if consumers overestimate their financial capabilities
When and what amount of (expected) credit losses should be recognized?
2. Businesses with high return ratios
• credit sales as, say, books are delivered to stores
• unsold copies are returned
One important valuation aspect: payment
behavior
0 5 10 15 20 25 30How do German companies evaluate the payment habits of their customers?
Valuation of Receivables: Gross method
z From book value (face value) to net realizable value
z Face value: nominal amount recognized when credit sale transaction is recorded
z Net realizable value (NRV): amount estimated to be collectible from outstanding receivables
z adjustments necessary for
discounts
returns, and
expected losses from revenues (uncollectible accounts)
z NRV = face value – adjustments for discounts – adjustments for sales returns
Uncollectible Accounts Receivable
z
represent loss of revenue
expense due to selling on credit
uncollectible accounts expense (also called bad debt expense) is recorded
z
When uncollectible accounts expense should be
recognized?
either at the time when an account turns out to be „uncollectible“: direct write-off method
Direct Write-Off Method
z
no entries until a specific account is deemed
uncollectible
loss recorded as credit entry for Accounts Receivable and debit entry for Bad Debt Expense (or uncollectible accounts expense)
z
Discussion
facts are recorded, not estimates
however, no matching of revenues and costs
no net realizable value presentation of receivables on the balance sheet
Æ Apply only for individual amounts not material!
Bad Debt Expense
€ XYZ
Allowance Method
z
Bad Debt Expense recorded in the same period as
the sale
debit Bad Debt Expense and credit Allowance for Uncollectible (or Doubtful) Accounts
two approaches: sales or percentage-of-receivables
z
Discussion
involves estimates
better matching of revenues and costs
receivables recorded at their net realizable values
This is the method that should be used (and must be used
Bad Debt Expense € XYZ
Both direct write-off and allowance method
combined
z
debit Allowance for Uncollectible Accounts
z
credit Accounts Receivable
z
estimated net realizable value of Accounts
Receivable remains unchanged
exception: unexpected high write-offs (major customer goes bankrupt)
Allowance for Uncollectible Accounts
1.100
Accounts Receivable
1.100
Effect of write-off on NRV illustrated:
Balances Balances
Before After
Write-Offs Write-Offs
Accounts Receivable € 143.000 € 141.900
Less Allowance for Uncollectible Accounts 13.690 12.590
Estimated Net Realizable Value of
Accounts Receivable € 129.310 € 129.310
Percentage-of-Sales (Income Statement)
Approach
z
Bad Debt Expense as a percentage of credit sales
during the accounting period
percentage determined from past experience and future expectations
amount to be recognized = percentage uncollectible × sales
any previous balance in Allowance for Uncollectible Accounts is closed out:
• Journal entries: Dr.: Allowance for Uncollectible Accounts; Cr.: Uncollectible Accounts Expense
z
Example
Credit sales amounted to € 760.000 while 3%, on average, deemed uncollectible
Percentage-of-Receivables (Balance Sheet)
Approach
z allowances for doubtful accounts made depending on the aging schedule of outstanding receivables
percentages for different age categories determined from past experience and future expectations
NOTE:
z Percentage-of-receivable Æ focus on balance sheet account
z Percentage-of-sales Æ focus on income statement account
z Different focus of approaches Æ balance in allowance for
uncollectible accounts does matter (PoR) and does
Example of an aging schedule under the
percentage-of-receivables approach
The (uncollected) credit sales of Paper Company in
its first year of business amount to:
Month
Customer
Amount
Jan.
Holm
10.000
Feb.
Lowe
2.000
August
Miller
20.000
Nov.
Smith (I)
8.000
Dec.
Baker
6.000
Cooper
1.000
Gardener
3.000
Aging schedule for year 1
(prepared on December 31, year 1):
Age Amount Percentage Uncoll.
category uncollectible amount
0 – 30 days 10,000 (B,C,G) 5% 500
31 – 90 days 8,000 (M) 10% 800
91 – 180 days 20,000 (S I) 15% 3,000
>180 days 12,000 (H,L) 25% 3,000
7,300
Journal entries and accounts in year 1:
Uncollectible accounts expense
7,300
Allowance for uncollectible accounts
7,300
Accounts Receivable Allowance for uncoll. accounts
50,000
7,300
(uncollected) credit sales in year 2:
Month
Customer
Amount
Jan.
Koller
2,000
March
Deutsch
40,000
July
Franco
6,000
August
Weyer
1,000
Sept.
Hunger
12,000
Nov,
Smith (II)
9,000
Dec.
Camillo
4,000
Other information for year 2:
z
Payments received from outstanding year-1
receivables
Holm 10,000
Miller 20,000
Smith (I) 8,000
z
Write-offs of year-1 receivables
Cooper 1,000
Gardener 3,000
z
Open accounts from year 1
Baker 6,000
Aging schedule at the end of year 2:
Age Amount Percentage Uncoll.
category uncollectible amount
0 – 30 days 4,000 (C) 5% 200
31 – 90 days 9,000 (S II) 10% 900
91 – 180 days 19,000 (F,W,H) 15% 2,850
>180 days 50,000 (K,D,B,L) 25% 12,500
Determining bad debt expense for year 2:
Targeted balance for allowance for u.a.
16,450
less credit balance from prior year
– 7,300
plus debits due to write-offs
+ 4,000
13,150
Accounts Receivable Allowance for uncoll. accounts
Remarks
z Net realizable value of receivables at the end of year 2 82.000 – 16.450 = 65.550
z In year 2: net realizable value of year-1 receivables after write-offs but before collections is the same as at the end of year 1, i.e. is equal to
€ 42.700
z Accounts written-off in year 2 „accounted“ for just € 200 of allowance for uncollectible accounts in year 1
z Balance of € 7.300 in Allowance for Uncollectible Accounts
Example 2 of an aging schedule of receivables
Company XYZ Percentage Required
estimated to be Balance in
Age Amount uncollectible Allowance
less than 30 days old € 65.000 3% 1.950
31 - 60 days old 35.000 6% 2.100
61 - 90 days old 12.000 15% 1.800
91 - 120 days old 14.000 22% 3.080
over 120 days old 17.000 28% 4.760
targeted balance of the Allowance for Uncollectible Accounts account: € 13.690
z Determination of Uncollectible Accounts Expense ... subtract the current credit balance of Allowance for
Credit balance of € 2.400
Targeted Balance for Allowance for Uncollectible Accounts: € 13.690
Less Current Credit Balance of Allowance for Uncollectible Accounts 2.400
Uncollectible Accounts Expense € 11.290
Dec. 31 Uncollectible Accounts Expense 11.290
Allowance for Uncollectible Accounts 11.290 Allowance for Uncollectible Accounts
Dec. 31 2.400
Dec. 31 adjustment 11.290
Recovery of accounts receivable written-off
z
allowance method
reestablish the receivable written-off
debit Cash and credit Accounts Receivable
z
direct write-off method
debit Cash
Accounts Receivable 1.100
Allowance for Uncollectible Accounts 1.100
Cash 1.100
Economic evaluation of allowing for bad debt
z
Two contrasting views:
1. „In God we trust. All others pay cash.“ (anonymous) 2. If the percentage of uncollectibles is below some
percentage of all receivables, our credit policy is too tight and we forego business.
z
According to view #1, uncollectible accounts
expense represents unnecessary expenses that
reduce profits.
z
According to view #2, uncollectible accounts
expense is a „necessary evil “ associated with credit
sales but these credit sales are a means to increase
and repeat business.
Recognition of Notes Receivable
z A promissory note is a written promise to pay a certain sum of money at a specific future date.
payee – holder of note; regards it as note receivable Æ asset
maker – issuer of note; regards it as note payable Æ liability
terms are negotiable
stronger legal claim than accounts receivable
some notes are tradable
z short-term notes recorded at face value interest immaterial
z long-term notes recorded at present value of cash expected to be collected
z Accounting for notes receivable:
similar to accounting for accounts receivable
notable difference in recognition of interest
Disposition of Accounts Receivable and Notes
Receivable
z
growing popularity of credit sales soaked up cash of
the selling companies
z
mean to accelerate receipt of cash:
transfer accounts or notes receivable to another company, e.g. bank or factor
z
finance charge associated with these transactions
z
transfer of receivables via
secured borrowing
sales of receivables
Sale of Receivables
z
An account receivable that ZiscoSys holds is sold to
Deutsche Factors (a fictitious commercial factor).
The receivable amounts to € 15.000 and the factor
takes a 4% finance charge.
z
Journal entries that both companies would make as
a result of the transaction.
ZiscoSys Deutsche Factors
Cash 14.400 Accounts Receivable 15.000
Loss on Sale of Receivables 600 Financing Revenue _ _600
Receivables Turnover
z
Two equivalent ratios
1.
Turnover rate =
2.
