Chapter 10: Revenue Recognition and Valuation of Receivables

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Chapter 10: Revenue Recognition and

Valuation of Receivables

The timing of revenue recognition

Valuation of receivables; VAT

Accounting for bad debt

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Overview

z What are receivables

z Recognition of accounts receivable ΠTreatment of sales discounts

• Gross method

• Net method

ΠValuation of accounts receivable

• Direct write-off method

• Allowance method

ΠPercentage-of-sales approach

ΠPercentage-of-receivables approach

• Recovery of accounts written-off

z Are bad debts really bad?

z Recognition of notes receivable

(3)

Receivables: definition and categorization

z Definition: revenues recognized but not yet received, revenues on account

Πonly what the accounting entity collects on its own account, not on behalf of others

• net of VAT

• agent: only the commission

z Classification

Πcurrent receivables: expected to be collected within a year or the current operating cycle (whichever is longer)

Πnoncurrent receivables: all others

Πtrade receivables: amounts owed by customers for goods sold and services rendered

Πnontrade receivables: arise from a variety of transactions

(4)

Treatment of VAT

z

Example

Πinvoice: Gross amount: 1000, including 25% VAT

• usually VAT has to be separately shown in the invoice

(5)

Trade Receivables

z

Accounts receivable

Πoral promises of the purchaser to pay

Πusually collectible within 30-60 days

Œ represent „open accounts“ (short-term extension of credit)

z

„accounts receivable“ account in general ledger

Æ control account

(6)

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

(7)

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

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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

(9)

Revenue recognition revisited

z Accounting regulation (IAS 18: Revenues)

Revenue is to be recognized when all of the following conditions are met

Πit is probable that economic benefits will flow to the entity from the respective transaction

Πthe amount of revenue and the related costs can be measured reliably

Πthe significant risks and rewards of the transaction have been transferred to the buyer

z specific cases

Πgoods sold on consignment: consignor recognizes revenue only

when consignee has sold to his customer

Πright 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)

(10)

Recognition of Accounts Receivable

z

usual way if a credit sale occurs

Πrecord the sale as revenue and record an increase in accounts receivable

Œ 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

ΠDiscounts must be recognized

Πinterest not recognized, no discounting (immaterial)

Accounts Receivable € XYZ

(11)

Discounts

z

Trade Discounts

Πused to avoid frequent changes in catalogues

Πallow for different prices for different quantities

Πhide true invoice price from competitors

revenue recognized is the net amount

z

Sales Discounts

Πoffered to induce prompt payment

Πusually 2% - 3% if payment occurs within 10 days, net amount due within 30 days

Πforegoing 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!!

(12)

Note that discounts apply to VAT too

z both revenue and VAT amounts are reduced by the discount percentage z Example: Œ Invoice: 1000 + 200 VAT Œ 2% discount used • Customer pays: 1176 Œ Journal entries:

• when revenue is recognized using the gross method

(13)

Two methods of accounting for sales

discounts

z

(1) Gross method

Πinitially recognize gross amount

Πrecognize sales discounts when they are taken

z

(2) Net method

Πinitially recognize amount net of sales discount

Œ 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

(14)

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

(15)

Valuation of Accounts Receivable

Πimportant for financial statement presentation

Πimportant also for internal decision making

Πvaluation at net realizable value

• not always equal to face value!

z Motivating examples Π1. 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?

Π2. Businesses with high return ratios

• credit sales as, say, books are delivered to stores

• unsold copies are returned

(16)

One important valuation aspect: payment

behavior

0 5 10 15 20 25 30

How do German companies evaluate the payment habits of their customers?

(17)

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

Πdiscounts

Πreturns, and

Πexpected losses from revenues (uncollectible accounts)

z NRV = face value – adjustments for discounts – adjustments for sales returns

(18)

Uncollectible Accounts Receivable

z

represent loss of revenue

Πexpense due to selling on credit

Πuncollectible accounts expense (also called bad debt expense) is recorded

z

When uncollectible accounts expense should be

recognized?

Œ either at the time when an account turns out to be „uncollectible“: direct write-off method

(19)

Direct Write-Off Method

z

no entries until a specific account is deemed

uncollectible

Πloss recorded as credit entry for Accounts Receivable and debit entry for Bad Debt Expense (or uncollectible accounts expense)

z

Discussion

Πfacts are recorded, not estimates

Πhowever, no matching of revenues and costs

Πno net realizable value presentation of receivables on the balance sheet

Æ Apply only for individual amounts not material!

Bad Debt Expense

€ XYZ

(20)

Allowance Method

z

Bad Debt Expense recorded in the same period as

the sale

Πdebit Bad Debt Expense and credit Allowance for Uncollectible (or Doubtful) Accounts

Πtwo approaches: sales or percentage-of-receivables

z

Discussion

Πinvolves estimates

Πbetter matching of revenues and costs

Πreceivables recorded at their net realizable values

ΠThis is the method that should be used (and must be used

Bad Debt Expense € XYZ

(21)

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

Πexception: unexpected high write-offs (major customer goes bankrupt)

Allowance for Uncollectible Accounts

1.100

Accounts Receivable

1.100

(22)

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

(23)

Percentage-of-Sales (Income Statement)

Approach

z

Bad Debt Expense as a percentage of credit sales

during the accounting period

Πpercentage determined from past experience and future expectations

Œ amount to be recognized = percentage uncollectible × sales

Πany previous balance in Allowance for Uncollectible Accounts is closed out:

• Journal entries: Dr.: Allowance for Uncollectible Accounts; Cr.: Uncollectible Accounts Expense

z

Example

Œ Credit sales amounted to € 760.000 while 3%, on average, deemed uncollectible

(24)

Percentage-of-Receivables (Balance Sheet)

Approach

z allowances for doubtful accounts made depending on the aging schedule of outstanding receivables

Πpercentages 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

(25)

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

(26)

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

(27)

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

(28)

(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

(29)

Other information for year 2:

z

Payments received from outstanding year-1

receivables

ΠHolm 10,000

ΠMiller 20,000

ΠSmith (I) 8,000

z

Write-offs of year-1 receivables

ΠCooper 1,000

ΠGardener 3,000

z

Open accounts from year 1

ΠBaker 6,000

(30)

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

(31)

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

(32)

Remarks

z Net realizable value of receivables at the end of year 2 Π82.000 Р16.450 = 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

(33)

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 Π... subtract the current credit balance of Allowance for

(34)

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

(35)

Recovery of accounts receivable written-off

z

allowance method

Πreestablish the receivable written-off

Πdebit Cash and credit Accounts Receivable

z

direct write-off method

Πdebit Cash

Accounts Receivable 1.100

Allowance for Uncollectible Accounts 1.100

Cash 1.100

(36)

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.

(37)

Recognition of Notes Receivable

z A promissory note is a written promise to pay a certain sum of money at a specific future date.

Œ payee – holder of note; regards it as note receivable Æ asset

Œ maker – issuer of note; regards it as note payable Æ liability

Πterms are negotiable

Πstronger legal claim than accounts receivable

Πsome notes are tradable

z short-term notes recorded at face value Πinterest immaterial

z long-term notes recorded at present value of cash expected to be collected

z Accounting for notes receivable:

Πsimilar to accounting for accounts receivable

Πnotable difference in recognition of interest

(38)

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:

Πtransfer accounts or notes receivable to another company, e.g. bank or factor

z

finance charge associated with these transactions

z

transfer of receivables via

Πsecured borrowing

Πsales of receivables

(39)

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

(40)

Receivables Turnover

z

Two equivalent ratios

1.

Turnover rate =

2.

average credit period taken by customers

=

Sales on Account

average net accounts receivable

Figure

Updating...

References

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