Chapter 7. Revenue Recognition

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TABLE OF CONTENTS

Framing the Issues 3

Revenue Recognition Criteria 3

Risks and Risk Sharing 5

Credit Risk 5

Customer Preference Risk and Demand Risk 9

Foreign Currency Risk 12

Accounting Implication of Risks 15

Exercise 7.01 18

Deferred Revenue 19

Example 19

Exercise 7.02 24

Receivables 25

Discounts for Early Payments 26

Example 27

Interest Income 33

Exercise 7.03 34

Writing off Bad Debts 35

Example 35

Recovering Write-offs 39

Replenishing the Bad Debts Allowance 40

Example 40

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Analyzing Bad Debts 45

Searching for Bad Debt Information 45

Interpreting Disclosed Numbers 47

Measuring and Calibrating Credit Risk 48

Exercise 7.05 51

Exercise 7.06 52

Warranties 53

Standard Warranties 54

Example 55

Extended Warranties 58

Exercise 7.07 59

Exercise 7.08 60

Exercise 7.09 61

Product Returns 62

Returns Allowances 63

Recording Product Returns 66

Example 67

Exercise 7.10 76

Exercise 7.11 77

Exercise 7.12 78

Exercise 7.13 79

Exercise 7.14 82

Exercise 7.15 84

Sales Incentives 88

Exercise 7.16 89

Exercise 7.17 90

Exercise 7.18 91

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FRAMING THE ISSUES

This chapter takes a deeper look into revenue recognition and related risks and consequences for accounting. In particular, we will go beyond the examples studied earlier, such as Starbucks recognizing revenue when it sells coffee for cash, but deferring revenue when it sells Value Cards for cash until customers use the cards to purchase coffee. In contrast, for many companies, the judgements around revenue recognition are extremely more complex. Importantly, these issues often involve challenging business and accounting decisions users of financial statements need to understand when interpreting related disclosures.

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riteria

Revenue must be deferred until four criteria are met:

1. Persuasive evidence of an arrangement: This criteria was put in place to stop opportunistic managers from devising sham transactions to increase revenues, which occurred frequently prior to the accounting scandals in 2002. For example, some opportunistic managers under pressure to make sales targets near the end of the quarter would enter arrangements called _{round-trip sales}whereby they would sell products to third-parties prior to the quarter-end with a promise to buy them back for a higher price early the next quarter. The third parties really did not need the products, but they saw an opportunity to make a quick profit. Concerned about round-trip sales and other illegal sales gimmicks, the SEC mandated companies can only recognize revenue when there is persuasive evidence the related sales arrangement and documentation follows normal business practice for the industry. In some industries, this means the buyer must have a purchase order approved by the appropriate level of management. In other cases, such as selling coffee to customers for cash, formal purchase orders are not required to establish a legitimate sale occurred.

2. Delivery has occurred or service has been rendered: This criteria was put in place to stop opportunistic managers from recognizing revenues before they fulfilled their obligations to customers and, in particular, before they transferred the risks of ownership to customers. For example, some managers entered _{bill and hold} arrangements where they would offer customers a bargain price near the end of the quarter to purchase products before they needed them, or even had storage space for them. The seller would “bill” the customer and recognize revenue, but agree to “hold” the products in their warehouse for future delivery. Recognizing there are very rare circumstances where

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customers can actually assume the risks of ownership in bill and hold arrangements, the SEC still permits revenue recognition in these arrangements when several stringent criteria are met. However, these criteria are rarely met and thus most companies must defer recognition until delivery occurs. Furthermore, the delivery criteria aims to restrict revenue recognition associated with several other questionable sales transactions besides bill and hold arrangements. Importantly, in applying this criteria, the SEC generally requires customer acceptance: it is not enough for sellers to deliver goods or services, customers must accept them. Additionally, sellers must have sufficient information to reliably estimate product returns and establish related allowances before revenue can be recognized (as discussed later in this chapter).

3. Fixed or determinable sales price: This criteria aims to prevent revenue recognition when the ultimate price of a product or service is unknown or can not be estimated reliably. For example, before this criteria was recognized, discount retailers would recognize revenues when they received up-front annual membership fees from customers, even when these fees were fully reimbursable if customers subsequently decided to terminate the arrangements. The SEC argued the price of the product could essentially change during the period covered by the contract (from the initial fee to $0 if it was fully reimbursed). There are numerous other situations where the SEC does not believe the price is fixed or determinable and thus, where revenue recognition must be deferred, including many arrangements where sellers offer customers price protection (which we will study later).

4. Collectibility is reasonably assured: This criteria differs from the other three in that it centers on the customer’s performance obligation in a sales arrangement — to pay for the good or service — rather than on the seller’s performance obligations.

These criteria apply to a broad range of sales arrangements; but they do not apply to contexts where revenue recognition is guided by specific GAAP such as banking, leasing, and motion picture productions. In fact, U.S. GAAP has over 160 standards that guide revenue recognition. Moreover, applying the four criteria often requires considerable judgment because the SEC recognizes they can not always be interpreted literally. For example, retailers often allow customers to return products for a full refund for a specified return period. Thus, strictly speaking, prices are not fixed at sales dates (they may end up being $0 if a customer returns products) and thus, customers have not really accepted them. The

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situations, providing they can reliably estimate returns, which can require considerable judgment, as do many of the revenue recognition criteria.

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Applying the four revenue recognition criteria or industry-specific revenue recognition GAAP is often considerably more complex than suggested by the Starbucks’ examples at the start of this chapter because the underlying sales agreements are more complex. Generally, this complexity is due to provisions in sales arrangements specifying how sellers and buyers assume risks, share risks, or try to protect themselves from bearing risks.

This section focuses primarily on two risks particularly important to revenue recognition and related balance sheet accounts (receivables, deferred revenues and various allowances discussed later in this chapter): credit risk and customer preference or demand risk.

We will also briefly discuss risk associated with foreign currency fluctuations, which can significantly affect the U.S. dollar value of revenue and related financial-statement items, but does not affect when

revenue is recognized in a foreign currency or howmuch foreign-currency revenue is recognized.

Credit Risk

In addition to being one of the four criteria for revenue recognition, reasonable assurance of collectibility is a necessary condition for staying in business: a business could quickly find itself in bankruptcy if it failed to collect a big chunk of its receivables.

While few companies are driven to bankruptcy by customers failing to pay their bills, companies with significant receivables can suffer large decreases in profitability if a relatively small portion of their customers stop paying their bills.

For example, General Motors reports approximately $245 billion of gross receivables on its balance sheet at the end of 2004, which represents slightly more than 50% of its assets. Some of these receivables are associated with product sales: GM bills dealerships when it sells them cars. Revenues associated with these sales should only be recognized when GM is reasonably certain it will collect the related receivables and can reliably estimate the amounts that will not be collected — the bad debts. The biggest portion of GM’s receivables are related to loans or leases on a wide array of assets sold by other companies, but financed by GM. For these receivables, GM should only recognize related interest revenue if it is reasonably assured it will collect the interest and principal on these

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GM also recognized approximately $2 billion of bad debt expense for 2004. We will discuss this expense in great detail later in the chapter. For now, all you need to know is bad debt expense tends to increase when customers are less likely to pay their bills.

• GM’s $2 billion bad debt expense was very significant relative to its $1.2 billion of pretax income for 2004. To put this in perspective, bad debt expense could have wiped out GM’s $1.2 billion of pretax income if it had increased by less than 1/2% of GM’s $245 billion of ending accounts receivable.

• Thus, an outsider valuing GM’s stock or an insider managing its receivables should carefully assess the risk of this occurring, which is called credit risk.

• Additionally, GM must carefully assess credit risk when deciding whether to recognize revenue.

Credit risk refers to the possibility a debtor — usually a customer for a receivable — will not make payments on time, fail to meet covenants, or default on the debt altogether. When these events occur, creditors can usually take one or more legal actions to try and minimize their losses. For example, they can take the debtor to court or seize the collateral, providing the expected benefits from these actions exceed the expected costs. Credit risk depends on two factors that can offset or aggravate each other, depending on the context:

• Collateral risk: the risk the value of the collateral will decline. By definition, this risk pertains to the asset serving as collateral. • General credit risk: the risk associated with the debtor’s overall

capacity to meet an obligation from its combined assets. This risk is less severe for agreements where the creditor has seniority — is paid earlier in the event of bankruptcy.

To understand how these risks can offset or aggravate one another,

consider a car loan from General Motors, which is reported as a financing receivable on GM’s balance sheet. If the value of the car appreciates dramatically during the loan period, GM’s credit risk is essentially zero, regardless of the debtor-customer’s general credit risk: GM can avoid losses by repossessing the car, if the customer is foolish enough to default on the loan (rather than sell the car, pay the loan, and keep the balance). Similarly, if the value of the car depreciates completely, GM will not be overly concerned if the customer has low general credit risk with several other valuable assets and few other obligations: GM can threaten to take the customer to court if the customer tries to default on the loan.

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Both of these examples illustrate that these two risks can offset each other in some contexts. However, they can also aggravate each other if the value of the debtors’ assets are correlated.

Credit risk is more problematic for some companies than others, depending on the portion of total assets that are receivables or other debtor-creditor arrangements such as debt investment securities, the length of these agreements, the nature of the collateral, and the debtors’ financial circumstances.

For example, to illustrate the magnitude of this risk for some companies, consider that General Electric, General Motors, and Ford collectively recognized nearly $700 billion of receivables at the end of 2004, which was slightly more than 50% of their combined total assets, but receivables comprise less than 5% of the assets of many other well known companies, including Wal-Mart and Home Depot.

Also collectively, GE, GM, and Ford recognized over $12.6 billion of bad debts allowance at the end of 2004. The allowance for bad debts is a contra asset to gross accounts receivables, reflecting the credit risk associated with these assets. It is intended to be management’s best estimate at the balance-sheet date of the gross receivables recognized at that date not expected to be collected in the future (net of recoveries associated with repossessed collateral).

For companies with large receivables balances, estimating the allowance for bad debts requires considerable judgment and slight changes in the assumptions can have dramatic financial-statement consequences. You will know a company’s estimates for bad debts require significant judgment if this is identified and discussed in the company’s Management Discussion and Analysis (MD&A) sections of their annual reports. In response to the 2002 accounting scandals, the SEC requires companies to identify and discuss their most critical accounting estimates in their MD&A, where two criteria must be met for an estimate to be deemed critical:

• The estimate requires the company to make assumptions about issues that are highly uncertain at the time when the estimates are made. This criterion directly relates critical accounting estimates to risks. • Different estimates the company reasonably could have used for

the current reporting period, or changes in accounting estimates reasonably likely to occur from period to period have a material impact on the company’s financial statements and disclosures. Not surprisingly, GE, GM, and Ford include bad debts estimation as one of their 4-8 critical accounting estimates. In deed, over 30% of the

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Fortune 100 companies (largest 100 companies measured by sales) and over 50% of Fortune 900-950 companies include bad debt estimation as a critical accounting estimate in their 2004 annual reports.

There are three key lessons here:

• Get in the habit of studying the critical accounting estimates in the management discussion and analysis sections of annual reports (and 10-Ks, which are expanded versions of annual reports filed with the SEC) to identify where the accounting might be suspect because it requires considerable judgment, which provides opportunities for honest errors or manipulation.

• Estimating the allowance for bad debt is frequently listed as a critical accounting estimate and the uncertainty associated with these estimates depends directly on the company’s exposure to credit risk.

• The more you understand the underlying credit risk, the better prepared you will be to assess the reliability of the allowance for bad debts and bad debt expense (defined later in this chapter).

Companies can take several steps to manage credit risk including: • Screening customers carefully before extending credit.

• Setting credit limits, preventing sales persons from selling customers more goods and services on account once their outstanding receivables hit pre specified limits.

• Monitoring outstanding receivables and refusing to sell additional products to customers who do not pay their current balances in a reasonable amount of time.

• Outsourcing customer financing to third parties, who assume the related credit risk.

• Selling receivables to banks and other financial institutions, which is called factoring.

• Selling receivables to special purpose entities (SPE) — legal entities created for a single purpose — buying receivables with cash raised by issuing mostly debt securities. The receivables are said to be

securitized because the SPE’s investors have debt and equity security

claims on only one asset — the SPE’s receivables.

To assess the costs and benefits of taking these actions, insiders and outsiders must understand the accounting issues discussed in this chapter.

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Customer Preference Risk and Demand Risk

Have you ever found yourself conflicted when trying to decide whether to purchase a big-ticket item such as a television, computer, automobile, or house? On the upside, you are beginning to get emotionally attached to the product, believing it has the potential to make a big difference in the quality of your life. On the downside, you are not sure you can afford it and even if you can, you are not sure it is the best way to spend your money or assume debt. Maybe you can get a better deal on the product elsewhere, find a close substitute from a competitor at a lower price, or find a completely different use for your money that gives you more satisfaction, including investing it because you are concerned about the economy or otherwise want to ensure you can consume more in the future.

Your uncertainty about this product versus other alternatives for the same or less money reflects your preference risk — uncertainty about your preference for a product or service. From the perspective of the person trying to sell you the product and more generally the supply chain he or she represents, the way you resolve this uncertainty has an upside — you buy the product — and a downside — you take your business elsewhere. From the seller’s perspective, your preference risk combined with other customers’ preference risk increases _{demand risk} — uncertainty about the quantity of products that can be sold at various prices.

For the most part, we will not be concerned about subtle distinctions between demand risk (that directly affects sellers but only affects buyers indirectly through prices) and customer preference risk (that directly affects both customers and sellers) and will use the terms interchangeably to mean the risk customers will prefer another alternative to a company’s products, or buy its products and return them at a later date for a refund. Customer preference (demand) risk either encompasses or is affected by several other risks companies can manage to varying degrees. Some of these risks, such as downturns in the economy, commodity price increases, and increasing competition, are largely beyond companies’ control. They can take actions to mitigate their consequences; but they can not control them at the source.

Regardless of whether companies respond pro actively or reactively, their success depends largely on their ability to manage risks better than their competitors.

In the long-term companies can devise strategies to mitigate customer preference risk including, among other things, designing innovative products and/or cutting costs and passing some of the savings along to

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customers. Companies also frequently take shorter-term actions, which is the focus herein, including offering customers:

• Generous return policies, allowing customers to purchase products they are uncertain about, knowing they can return them at a later date if the products fail to meet their expectations, they find better substitutes, or they find themselves strapped for cash.

• Comprehensive warranties to alleviate customers’ concerns about defects and product quality.

• Price protection, rebates, and volume discounts to mitigate customers’ concerns about finding lower prices elsewhere. • Customer loyalty programs such as frequent flyer programs to

encourage repeat business.

• Below market interest rates and attractive payment terms to address customers’ concerns about financing.

• Competitive prices for all of the above features.

Another way companies manage customer preference risk is advertising, which we discussed extensively in earlier chapters. By advertising companies can provide information about products, which reduces customers’ concerns as to whether the products will meet their needs. Advertising can also provide emotional comfort. Let’s face it, ads frequently tell us very little about products but still strengthen our emotional bond to them.

Companies must understand and manage customer preference risk to achieve sales growth —a key driver of shareholder value. However, establishing return policies, credit terms, warranty policies, and taking other actions to stimulate sales growth entails taking on costs and risks that can affect the other two key determinants of shareholder value — return on equity and the cost of capital — favorably or adversely depending on how companies forecast and manage these costs and risks and implement related policies.

For example, if a company were to offer lifetime warranties and return privileges for products only expected to last a few years, it would stimulate considerable sales growth in the short term, but ultimately it would likely go out of business. By contrast, if a company were to set return periods too short, restocking fees too high, or offer exchanges rather than refunds, it would run the risk customers would take their business to competitors offering more generous terms.

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Companies often shift risk from customers to themselves to lower customer preference risk. For example, this risk is generally lowered when companies offer return policies superior to their competitors. As indicated earlier, customers feel more comfortable purchasing products knowing they can return them for refunds. However, companies are then stuck with the risk returned products will become obsolete or otherwise become impaired and bear costs to process, hold, and resale returned products. Similarly, warranties shift customer preference risks associated with product quality from customers to sellers and price protection shifts the risk prices will decline after purchases from customers to sellers (or the risk customers will find lower prices elsewhere).

In other situations where companies take actions to mitigate customer preference risk such as offering coupons, sales rebates, or reward points, risk is not shifted from customers to sellers, but sellers still incur risks. For example, companies run the risk of offering costly rebates to customers who would have purchased the products without rebates or offering more generous rebates than are needed to attract sales. Similarly, offering generous credit terms to customers to alleviate financing concerns can be risky because sellers assume not only credit risk, but also interest rate risk, and in some cases foreign currency risk.

Many of the actions companies take to manage customer preference risk affect revenue recognition. For example, companies must estimate product returns and warranty costs when they make related sales. When these estimates are not reliable because a company does not have enough historical experience to establish reliable benchmarks, they can not recognize revenue on these sales when products are delivered.

Thus, in assessing a company’s performance, outsiders need to not only understand the financial-statement consequence of actions taken to manage customer preference risks, outsiders should also consider the extent to which the benefits from these actions more than compensate for the costs and risks. To this end, outsiders rely greatly on numbers reported in financial statement and footnotes. However, many of these numbers are based on estimates affected by the underlying risks and can require considerable judgment when these risks are severe.

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Foreign Currency Risk

Growth in revenues associated with sales in foreign currencies can change dramatically from year to year because of changes in foreign-currency exchange rates. For example, the Management Discussion and Analysis section of Wal-Mart’s 2005 annual report states:

Net sales increased by 11.7% from fiscal 2004 to $285 billion in fiscal 2005, and income from continuing operations increased 15.9% to $10.8 billion. Foreign currency exchange rates favorably impacted sales by $3.2 billion in 2005.

Page 24, Wal-Mart’s 2005 Annual Report Based solely on this quote, the $3.2 billion increase associated with foreign currency exchange rates would seem imperceptible relative to Wal-Mart’s $285 billion of revenues (approximately 1/10 %). However, users of Wal-Mart’s financial statements are concerned about the company’s revenue growth which was $28.89 billion for fiscal 2005. The $3.2 billion revenue increase associated with foreign exchange gains is 13% of this growth.

Stated alternatively, revenue growth would have been 10% rather than the 11.7% stated in the above quote. This may not seem like much of a difference, but in fact it could have a significant effect on valuation models widely used by equity analysts to value shareholder value.

Moreover, regardless of what model or procedure an analyst uses to value a company, they must estimate future revenue growth and these estimates become more problematic when exchange rates fluctuate widely from year to year.

When predicting revenue growth, a key determinant of its share price, analysts must identify revenue gains and losses associated with foreign exchange rates and decide how they will deal with them in their analysis.

Accounting for foreign currencies is beyond the scope of this chapter. Still, we are going to discuss foreign currency risk briefly to raise your awareness to its increasing importance as companies expand globally. If you are a foreign student in the U.S. or a student who has studied abroad as a foreign student, you likely purchased part of your education in what for you was a foreign currency and you are likely already well aware of foreign-currency-exchange-rate risk.

For a foreign student in the U.S., this risk would be realized, for example, if the student kept her savings in a home-country currency, planning to convert it to pay tuition in U.S. dollars in the future, and her home-currency devalued dramatically in the interim (relative to U.S. dollars). It would now take more of her home-country currency to cover her tuition.

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To avoid, or at least mitigate, this risk prior to arriving in the U.S., she could convert enough of her home-country savings to U.S. dollars (at the current exchange rates) to meet her expected future tuition, housing payments, and other U.S. dollar denominated obligations.

For example, if she was from Germany, had euro savings and expected her future U.S. obligations to be US$10,000, and the exchange rate was 1.25 US$ per 1€ (euro) prior to arriving in the U.S., she could convert €8,000 of her savings to US$10,000 of savings.

Keeping in mind that U.S. dollars are a foreign currency for her, in this situation we say she has hedged an anticipated foreign currency liability (tuition payable) with a foreign currency asset (bank deposit). _Hedges occur when one exposure to a risk (her US$ savings, an asset) offsets an opposite exposure to the risk (her anticipated US$ obligations, a future liability). For example, if the euro appreciates relative to the dollar, the increase in the value of her US$ asset measured in euros will offset the decrease in the value of her expected US$ liability measured in euros. Alternatively, at least in principal, she could use a foreign-currency

forward purchase contract to hedge the risk, which is what companies often do on a much larger scale when entering these contracts is

financially feasible. For example, prior to arriving in the U.S. she could enter a contract that would allow her to purchase US$ in the future at the current exchange rates. These contracts are part of a broader class of financial agreements called derivatives.

Virtually all companies doing significant business outside their home countries enter foreign-currency contracts and these are discussed extensively in annual reports. For example, the Derivative Financial Instruments section of the Accounting Policies section of Harley-Davidson’s 2005 annual report states:

The company sells its products internationally and in most markets those sales are made in the foreign country’s local currency. As a result, the company’s earnings can be affected by fluctuations in the value of the U.S. dollar relative to the foreign currency. The company uses foreign currency contracts to mitigate the effect of these fluctuations on earnings. The foreign currency contracts are entered into with banks and allow the company to exchange a specified amount of foreign currency for U.S. dollars at a future date, based on a fixed exchange rate.

Page 54, Harley-Davidson’s 2005 Annual Report Harley-Davidson reports the impact of foreign-currency exchange rates on revenues in the Management Discussion and Analysis section of its 2005 annual report:

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Changes in foreign currency exchange rates, related to European currencies, resulted in approximately $7 million of higher revenue during 2005 when compared to 2004.

Page 37, Harley-Davidson’s 2005 Annual Report The $7 million of revenues associated with exchange rate changes is less than 1/10% of Harley-Davidson’s revenues and only 2% of its revenue growth for 2005. However, the comparable number for 2004 was $46 million and represented 18% of the company’s revenue growth. This big difference between 2004 and 2005 underscores that the financial-statement consequences of foreign currency exchange rates can fluctuate greatly from year to year.

This fluctuation in revenues also raises a few questions an investor analyzing Harley-Davidson would want to pursue:

• Were Harley-Davidson’s revenues affected by the hedges discussed in the earlier quote?

• If so, why did they fluctuate so much?

• Were revenues hedged but the hedge offsets affected other income-statement line items besides revenues?

• Were other income-statement line items such as cost of sales hedged? The answers to these questions can sometimes be determined from annual report disclosures, but often you need to understand accounting is beyond the scope of this chapter to interpret them appropriately. Still, hopefully you have learned enough about foreign currency risk from the brief discussion here to recognize situations where your analyses could be greatly affected by foreign exchange rates.

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isks

The remainder of this chapter focuses primarily on record keeping and reporting associated with events and circumstances greatly influenced by credit risk, customer preference risk, and companies’ efforts to manage these risks. We will briefly discuss a few accounting implications of these risks to help you recognize the similarities in the measurements and entries in the subsequent sections.

Credit risks and customer preference risks definitely have important income statement consequences. However, the measurement focus is primarily on balance sheets and, in particular, on ensuring the end-of-period balances in allowances are adequate to cover future costs associated with these risks or efforts to mange them.

For example, the GAAP measurement goal associated with bad debts is to ensure the ending balance in the allowance for bad debts represents management’s best estimate of future bad debts associated with the outstanding receivables on the balance-sheet date or, equivalently, net accounts receivable is management’s best estimate of the expected future collections.

To this end, companies typically record an adjusting entry at the end of the reporting period ensuring the allowance has the right balance. Thus, the amount recorded in this entry is determined by the target ending balance: the accountant first estimates the ending balance and then determines how much must be recorded to ensure this balance. This balance-sheet measurement approach contrasts with the accounting we have studied thus far, where ending balances simply totaled entries and did not influence the amounts recorded.

Like bad debts, the measurement goal for warranties is to ensure the balance sheet records a warranty liability, also called a warranty allowance or warranty reserve, that is management’s best estimate of the future warranty claims associated with products sold in the current and prior periods still under warranty. Also similar to bad debts, an adjusting entry is recorded at the end of the period to ensure this balance.

Similarly, the accounting for sales returns, price protection, rebates, loyalty programs, and other sales incentives generally centers on getting the appropriate balances in allowances that are either contra assets (like the allowance for bad debts) or liabilities (like the warranty allowance). Another common concept of the accounting in this chapter is the adjusting entries ensuring the correct balance sheet numbers also affect

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income. For example, the adjusting entry to ensure the correct ending balance for the allowance for bad debts also increases bad debt expense.

As you study the subsequent sections pay particular attention to which income statement line items are affected by these entries. Some increase contra revenues and thus reduce net revenues while others increase expenses.

You do not need to understand much about credit risk and customer preference risk to understand the entries herein, their financial-statement consequences, and the underlying events and circumstances they aim to measure. However, you do need to calibrate the extent to which these risks are present to assess how reliably the numbers in these entries measure what they are intended to measure. Several factors affect the reliability of reported numbers, but three are particularly important: the extent to which the underlying events and circumstances are risky, the extent to which there are reliable measurement benchmarks — market prices, historical measures of comparable activity, or other companies’ measures of comparable activity — and the extent to which managers are motivated to report honestly.

Generally, the riskier the activity being estimated (such as future bad debts, product returns, or warranty claims) and the less reliable the available benchmarks, the greater the possibility of measurement errors for all managers and the more opportunities there are for dishonest managers to manipulate measures.

Historically, the measures we will be studying in this chapter have frequently been associated with earnings manipulation, with numerous managers facing the SEC’s wrath for under reporting allowances to boost income or recognizing revenue when there was too much uncertainty about future returns or collections.

The measures in this chapter can be particularly suspect since they require the most judgment and are recorded at the end of the period, when managers are feeling particularly pressured to make their performance targets and know how close they are to making them. At this time, if they know they are going to fall short of their targets, they may be tempted to reduce allowances below what they should be to comply with GAAP and thus increase reported income. By contrast, if they know they will otherwise exceed their targets, they may be tempted to build a cushion for the future by increasing allowances above what they should be to comply with GAAP.

Concerned about such manipulations, the SEC issued standards in 1999 and 2001 that tightened the guidelines for revenue recognition

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and measuring allowances. For example, prior to the 1999 standard, companies could decide when they had enough historical experience to reliably estimate returns, a prerequisite for recognizing revenue at the time of a sale. However, the SEC narrowed the latitude of these judgments:

In general, the [SEC] staff typically expects a start-up company, a company introducing new services, or a company introducing services to a new class of customer to have at least two years of experience to be able to make reasonable and reliable estimates.

Footnote 40, SEC Staff Accounting Bulletin No. 101, December 1999 Similarly, the 2001 standard tightened the guidelines for estimating allowances and, in particular, required companies to establish consistent policies, methodologies, and processes for estimating allowances and to document that they are following them consistently each year.

Notwithstanding these tighter guidelines, you still need to exercise healthy skepticism when assessing the reliability of most of the numbers in disclosures related to topics discussed in this chapter. While completing these assessments is beyond the scope of this chapter, you will learn how to identify situations where the numbers require the most judgment — are critical accounting estimates — and the places where you should be most skeptical about reliability.

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Exercise 7.01

The questions in this exercise center on Cisco’s revenue recognition policies, as discussed in its 2005 annual report. The exercise aims to help you learn how to search for and interpret related information.

(a) Where does Cisco discuss revenue recognition extensively in its 2005 annual report?

(b) How do you know many of Cisco’s revenue recognition decisions require considerable judgment?

(c) Estimate the sales for which Cisco had billed customers but not yet recognized revenues by the end of 2005?

(d) Revenue must be deferred when one or more of the four criteria discussed earlier are not met. Based on the way Cisco ultimately recognizes previously deferred technical services revenue, which of the four criteria is likely preventing earlier revenue recognition?

(e) Multiple element sales arrangements pertain to situations when a company sells a bundle of goods and/or services for a package price. Revenue recognition challenges frequently arise when the elements in these arrangements are delivered in different reporting periods. Based on Cisco’s discussion of these arrangements:

(1) What are the related revenue recognition issues?

(2) Which revenue recognition assumption seems to require the most judgment?

(3) Absent GAAP restrictions, how might an unscrupulous manager try to accelerate revenue recognition by exercising this judgment opportunistically?

(4) What does GAAP seem to require to mitigate opportunistic revenue recognition?

(f) Cisco has taken actions to increase sales that essentially transfer customer preference risk from customers to Cisco. Which of these actions have lead to accounting requiring considerable judgment? (g) Briefly compare and contrast the degree to which judgment is

required in revenue recognition for Cisco, Coca Cola, and Disney.

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This exercise requires you to search for information.

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This exercise helps you learn how accounting reports are used by investors, creditors, and other stakeholders.

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DEFERRED REVENUE

In earlier chapters, we have been assuming revenue is recognized when products are delivered to customers and customers were either billed or paid cash at this time. There were two entries:

• Recognizing revenue by increasing (debiting) accounts receivable or cash and increasing (crediting) revenues.

• Recognizing cost of sales by decreasing (crediting) inventories and increasing (debiting) cost of sales.

Companies deferring revenue on some of their sales, as discussed shortly, will generally not defer revenues on most sales and thus will record the above entries when they deliver products to customers.

When one or more of the four revenue recognition criteria are not met, revenues and cost of sales are both deferred until the criteria are subsequently met. We will use an example to demonstrate the related entries.

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xample

Assumptions

• ABC company delivers inventories costing $10 to DEF company, a retailer, on December 1, 2007. ABC bills DEF for $25 on this date, the sales price before consideration of possible future discounts. • Prior to agreeing to the sale, DEF was concerned about failing to

recognize a fair return on its investment in these inventories because of obsolescence risk. There were rumors one of ABC’s competitors was about to introduce a new product that would decrease the retail price DEF could charge for ABC’s product.

• To facilitate the sale, ABC agrees to absorb this risk and includes a price-protection clause in the sales contract specifying ABC would rebate DEF for any decline in the retail price (up to the amount DEF was billed by ABC) between December 1, 2007 (the delivery date) and March 1, 2008. The expected price decrease is highly uncertain and can not be estimated reliably.

• DEF agrees it will notify ABC when and if it sells inventories prior to March 1, 2008.

• ABC decided to defer revenue associated with the sale until March 1, 2008 unless DEF sells the inventories sooner.

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• On December 25, 2007, DEF notified ABC it had sold products it had purchased from ABC for $5. DEF did not seek price protection on these sales and ABC had recorded $2 of related inventoried costs. • ABC’s financial statements have the same line items as Cisco’ 2005

financial statements.

• ABC uses the accounts below for related entries.

Abbreviation Account

AR accounts receivable (gross)

FGI finished goods inventory

SDelInv segregated delivered inventories related to deferred revenues

Drev deferred revenue liability

CGS cost of good sold

GrSalesR gross sales revenues

ASSETS

LIABILITIES

TEMPORARY OWNERS' EQUITY

Note, consistent with Cisco, ABC transfers inventoried costs to

segregated inventories (SDelInv) when goods are delivered and revenue is deferred.

GAAP seems to be silent regarding the accounting for inventoried costs. However, the Accounting Research Manager, a widely used GAAP reference that also provides interpretations in places where GAAP is silent or imprecise, recommends the approach used here and opposes the only other logical alternative — recognizing these inventoried costs in a contra liability to deferred revenue:

In addition, it would generally not be appropriate to offset against deferred revenue any related deferred costs.

Accounting Research Manager, Interpretations and Examples/18 Still, Intel reports a deferred income liability rather than a deferred revenue liability, which, interpreted literally would mean Intel nets the related inventoried costs against its deferred revenues.

Required

(a) Record the entries ABC records on December 1, 2007.

(b) Identify line items on ABC’s balance sheet, income statement, and cash-flow statement directly affected by the part (a) entries.

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• On December 1, 2007, ABC will also record the following entry to transfer inventoried costs associated with the deferred revenues to segregated inventoried costs:

(c) Record the entries ABC records on December 25, 2007.

(d) Identify line items on ABC’s balance sheet, income statement, and cash-flow statement directly affected by the part (c) entries.

Solution

Part (a) — Delivery Date Entries

• On December 1, 2007, ABC will record the following entry to recognize billing DEF:

or

+ AR = + Drev + + $25 = + + $25

Debit Credit

AR $25

Drev $25

+ FGI + SDelInv = + -$10 + + $10 = or

Debit Credit

SDelInv $10

FGI $10

Part (b) — Delivery Date Entries’ Effects

The captions for the financial-statement items are based on those used in Cisco’s 2005 annual report (pages 40-42).

Balance Sheet

• Accounts receivable, net of allowance for doubtful accounts increases by the $25 billings, reflecting the benefit associated with the expected future collections.

• There would be no net change in inventories. More precisely, using the captions in the table near the middle of page 54 of Cisco’s 2005 annual report, $10 of inventoried costs would be shifted from Manufacturing finished goods to Distributor inventory and deferred cost of sales.

• The Deferred revenue liability recognized in the current liabilities would increase by $25 (because the liability will be removed on or before the price-protection period ends in the very near future). Note, Cisco also reports a non-current liability likely associated with deferred revenues on service contracts extending for more than a year.

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Income Statement

• The income statement is not affected by the part (a) entries.

Statement of Cash Flows

• The accounts receivable adjustment helps reconcile net income to cash from operations decreases by $25. Strictly speaking this adjustment is not needed because the part (a) entries do not affect income or cash from operations. Thus, this adjustment must be offset by another, as discussed next.

• The deferred revenue adjustment increases by $25, offsetting the receivables adjustment for the reason indicated above.

• There is no net effect on the inventories adjustment because the two inventory effects in the second entry in part (a) offset each other. Part (c) — Revenue Recognition Entries

• On December 25, 2007, ABC records the following entry to recognize $5 of previously deferred revenue:

or

= + Drev + GrSalesR = + - $5 + + $5

Debit Credit

Drev $5

GrSalesR $5

• On December 25, 2007, ABC also records the following entry to recognize $2 cost of sales associated with the revenues in the above entry:

+ SDelInv = - CGS

+ - $2 = - + $2 or

Debit Credit

CGS $2

SDelInv $2

Part (d) — Revenue Recognition Effects

Balance Sheet

• Inventories decreases by $2, signifying previously deferred

inventoried costs in segregated inventories are no longer deferred. • The current Deferred revenue liability decreases by $5, indicating ABC is no longer obligated to protect DEF against related price declines and can thus recognize revenue.

• Retained earnings increases by the $3 of pretax profit recognized in the above entries.

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• Net sales: product increases by $5, signifying ABC has met all four criteria for revenue recognition.

• Cost of sale: product increases by $2, matching the inventoried cost of the products to the recognized revenues.

• Net income increases by the $3 pretax affect of the part (c) entries. • The inventories adjustment increases by $2, offsetting the $2

non-cash effect recognized in net income as cost of sales.

• The deferred revenues adjustment decreases by $5, offsetting the $5 non-cash effect recognized in net income as revenues.

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Exercise 7.02

Background

This exercise is based on Mighty Mascot Software, Inc. (MMS). Like Cardinal and Eagle, MMS is a fictitious company with an Excel model, MMS8.xls. Similar to Eagle, MMS is a manufacturing company and the MMS8.xls is a budgeting model with a one year planning horizon. However, many of the entries in the MMS model are considerably more complex than those in Eagle.

Like many companies, MMS sells products in two markets: (1) a _stable

market where revenues are recognized when goods are delivered because there is a reasonably high probability products will be paid for at the agreed upon price shortly after delivery (and thus not returned) and all revenue recognition criteria met at the time of the sale, and (2) a risky

market where revenues are recognized later because there is a higher risk goods will be returned or price discounts will be shared with distributors. MMS sells two products; product 1 and product 2. Both products are sold in the stable market but only product 2 is sold in the riskier market. Similar to the Cardinal and Eagle models, you can learn more about the entries you will be recording in the EntryInputs sheet. Similarly, you can learn about the accounts you can use in these entries in the Accts sheet. Required

(a) Record MMS 19-23 on a blank piece of paper using information in the Entryinputs and Accts sheets. You may use the balance-sheet-equation or debits-credits approach.

Notes:

• You will likely find the more complex entries in MMS easier to record if you divide them into the simpler entries recommended in the Entryinputs sheets (for select entries that are particularly complex)

• MMS 29-30 recognize previously deferred revenues and related costs. We will record them after you learn about sales discounts in the next section

(b) Identify the line items on MMS’s balance sheet, income statement, and statement of cash flows affected by MMS 19-23.

E nt r i e s Operating Investing Financing Beg Bal Tr Bal Cls IS Cls RE End Bal Zero Zero Revenue Expenses Gains & Losses Assets Liabilities Owners' Equity

Net Income Cash change

cash +other assets = liabilities + permanent OE+ temporary OE

Assets = Liabilities + Owners' Equities

R E C O R D K E E P I N G R E P O R T I N G Adjustments Operating Cash Reconciliations Net Income

Direct Cash Flows Balance Sheets Income Statements

Record Keeping and Reporting Icon

This exercise helps you meet the insider record keeping and reporting challenge.

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RECEIVABLES

We have already seen receivables are increased (debited) when customers are billed and are decreased (credited) when cash is subsequently

collected. These entries typically explain most of the change in gross accounts receivable.

We have also seen receivables generally increases when a company acquires another company and decreases when it disposes of one of its segments or divisions. These are non-operating events.

This section examines record keeping and reporting associated with: • Discounts for early payments

• Interest earned on accounts receivable • Bad debts

 Writing off receivables associated with bad debts

 Recoveries — reinstating previously written off receivables  Establishing and replenishing allowances for bad debts

Most companies record entries for discounts and interest associated with receivables, so we will quickly cover the related entries. However, with one exception, these entries are usually relatively immaterial compared to other events affecting net accounts receivable. The exception is accruing interest can be very important to companies such as GE, GM, and Ford with extensive financing receivables and to banks and other financial institutions with loans (which are essentially financing receivables). Similar to discounts and accrued interest, most companies also record the three events associated with bad debts: write-offs, recoveries, and establishing or replenishing allowances. While these entries can also be relatively immaterial for some companies, understanding them and their financial-statement consequences is very important when analyzing companies particularly susceptible to credit risk.

Some companies include an allowance for product returns. We will discuss the reasons they do so and an alternative approach when we study product returns.

In addition, we will introduce an increasingly important receivables related activity: the financial-statement consequences of transferring receivables to other companies by factoring or securitizing them. This accounting is very challenging and we are only going to touch the surface.

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As you study this section keep in mind receivables, like revenues, can be significantly affected by fluctuations in foreign currency exchange rates.

d

isCounts for

e

arly

p

ayments

Customers can sometimes receive discounts for paying their bills quickly. For example, if a company permits its customers to pay their bills within sixty days to avoid an interest penalty, it might offer a 2% discount to customers who pay within ten days of being billed.

Here is an overview of the entries illustrated in the following example: • Recording a discounted collection when revenue has already been

recognized by the collection date:

 Increase (debit) cash for the cash received — the sales price, or

equivalently the amount billed, less the discount.

 Decrease (credit) gross accounts receivable for the amount billed

and thus the amount that would have been collected if there was no discount.

 Increase (debit) a contra revenue for the discount, which ensures

net revenues equals the amount collected.

• Recording a discounted collection when revenue is deferred at the collection date:

 Increase (debit) cash for the cash received — same as above.  Decrease (credit) gross accounts receivable for the amount

billed— same as above.

 Decrease (debit) the deferred revenue liability for the discount,

which ensures the related revenue recognized in the future will equal the amount collected. Another alternative is to increase (debit) a contra liability to deferred revenue. This alternative makes it easier to keep track of the information needed to record the next entry.

• Recognizing previously deferred revenue associated with an early payment discount.

 Decrease (debit) the deferred revenue liability for the amount

collected — the net revenue to be recognized. If the discount was recorded to a contra liability in the previous entry, decrease (debit) the deferred revenue liability for the sales price — the gross revenues to be recognized — and decrease (credit) the contra liability for the discount.

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• Increase (credit) gross revenues for the sales price. • Increase (debit) a contra revenue for the discount.

Example

Note: This example ignores the inventory/cost of sales associated with the events to focus on the revenue recognition and receivables aspect of this example.

Assumptions

• ABC company offers customers a discount for paying their bills within ten days of the billing date.

• On December 1, 2007, ABC sells goods to DEF, bills DEF $100, and recognizes $100 of revenues.

• On December 10, 2007, ABC collects $98 from DEF, having given DEF a $2 discount for early payment.

• On December 15, 2007, ABC bills XYZ $300 and defers $300 of revenue.

• On December 24, 2007, ABC collects $294 from XYZ, having given XYZ a $6 discount for early payment. ABC had not recognized any of the revenue associated with the collection at this time.

• On January 15, 2008, ABC recognizes $300 of gross revenues and $6 of discount associated with the XYZ sale.

• ABC records discounts directly to its deferred revenue liability (rather than to a contra liability) and documents deferred gross revenues and discounts in notes (rather than accounts).

• ABC’s financial statements have the same line items as Cisco’ 2005 financial statements.

• ABC closes its fiscal year on December 31.

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C cash

Drev deferred revenue liability

GrSalesR gross sales revenues

SalesDis sales discounts for early payment (contra revenue)

LIABILITIES

TEMPORARY OWNERS' EQUITY ASSETS

Required

(a) Record the entry ABC records on December 1, 2007 to recognize the revenue on the sale to DEF and the subsequent entry it records on December 10 to record the related collection.

(b) Identify line items on ABC’s balance sheet, income statement, and cash-flow statement directly affected by the part (a) entries. (c) Record the entry ABC records on December 15, 2007 to record

the deferred revenue on the sale to XYZ, the entry it records on December 24 to record the related collection, and the entry it records on January 15, 2008, to recognize related revenue.

(d) Identify line items on ABC’s 2007 balance sheet, income statement, and cash-flow statement directly affected by the part (c) entries.

Solution

Part (a) — Discount Entries, No Deferrals

• On December 1, 2007, ABC will record the following entry to recognize gross revenues:

or

+ AR = + GrSalesR + + $100 = + + $100

Debit Credit

AR $100

GrSalesR $100

• On December 10, 2007, ABC will record the following entry to recognize collection of the amount billed less an early payment discount:

or

+ C + AR = - SalesDis + + $98 + - $100 = - + $2

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Debit Credit

C $98

SalesDis $2

AR $100

Part (b) — Discount Entries’ Effects, No Deferral

Balance Sheet

• Cash and cash equivalents increases when ABC collects $98 from DEF on December 10, 2007.

• The two entries in part (a) have a $0 net effect on Accounts receivable, net of allowance for doubtful accounts:

 Net accounts receivable increases by $100 when DEF is billed on

December 1, 2007.

 Net accounts receivable decreases by $100 when ABC collects $98

from DEF on December 10, 2007.

• Retained earnings increases by the $98 increase in net revenues:

 The $100 increase in gross revenues on December 1, 2007.  Less the $2 discount recognized on December 10, 2007.

• Combined, the two entries in part (a) increase Net sales: product by $98:

• The combined effect of the entries in part (a) is Net income increases by $98:

• Net cash provided by operating activities increased by the $98 collected on December 10, 2007.

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and Net cash provided by operating activities both increased by $98 as a result of the two entries in part (a).

• The entries have a $0 net effect on the Accounts receivable adjustment:

 Net accounts receivable increases by $100 when DEF is billed

on December 1, 2007, resulting in a -$100 Accounts receivable adjustment on the cash flow statement.

 Net accounts receivable decreases by $100 when ABC collects $98

from DEF on December 10, 2007, resulting in a +$100 Accounts receivable adjustment on the cash flow statement.

Part (c) — Discount Entries, Deferrals

• On December 15, 2007, ABC will record the following entry to recognize deferred revenues:

or

+ AR = + Drev + + $300 = + + $300

Debit Credit

AR $300

Drev $300

• On December 24, 2007, ABC will record the following entry to recognize discounted collections associated with deferred revenues:

+ C + AR = + Drev

+ + $294 + - $300 = + - $6

or

Debit Credit

C $294

Drev $6

AR $300

• On January 15, 2008, ABC will record the following entry to recognize previously deferred revenues net of early payment discount:

= + Drev + GrSalesR - SalesDis = + - $294 + + $300 - + $6

Debit Credit

Drev $294

SalesDis $6

GrSalesR $300

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Part (d) — Discount Entries’ Effects, Deferral

Balance Sheet

• Cash and cash equivalents increases when ABC collects $294 from XYZ on December 24, 2007.

• The two 2007 entries in part (c) have a $0 net effect on Accounts receivable, net of allowance for doubtful accounts:

 Net accounts receivable increases by $300 when XYZ is billed on

December 15, 2007.

 Net accounts receivable decreases by $300 when ABC collects

$294 from XYZ on December 24, 2007.

• The two 2007 entries in part (c) have a $294 net effect on the current Deferred revenue liability:

 Deferred revenues increases by $300 when customers are billed on

December 15, 2007.

 Deferred revenues decreases by $6 when ABC collects $294 from

XYZ on December 24, 2007.

• There is no effect in 2007.

• Net cash provided by operating activities increased by the $294 collected on December 24, 2007.

• Income is not affected in 2007 so a $294 adjustment is needed to reconcile the $0 effect on Net income to the $294 effect on Net cash provided by operating activities.

• The 2007 entries in part (c) have a $0 net effect on the Accounts receivable adjustment:

 Net accounts receivable increases by $300 when XYZ is billed

on December 15, 2007, resulting in a -$300 Accounts receivable adjustment on the cash flow statement.

 Net accounts receivable decreases by $300 when ABC collects

$294 from XYZ on December 24, 2007, resulting in a +$300 Accounts receivable adjustment on the cash flow statement.

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• The 2007 entries in part (c) have a $294 net effect on the Deferred revenue adjustment:

 The deferred revenue liability increases by $300 when XYZ

is billed on December 15, 2007, resulting in a $300 Deferred revenue adjustment on the cash flow statement.

 The deferred revenue liability decreases by the $6 discount

when ABC collects $294 from DEF on December 24, 2007, resulting in a -$6 Deferred revenues adjustment on the cash flow statement.

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i

nterest

i

nCome

The entry to accrue interest income earned on accounts receivables when customers do not pay their bills on time is straightforward and described here for completeness:

• Increase (debit) accounts receivable, or a related account such as interest receivable, for the interest earned during the reporting period.

• Increase (credit) interest income for the same amount.

This entry has the following financial-statement consequences for a company with financial statements similar to those in Cisco’s 2005 annual report:

Balance Sheet

• Would likely increase Accounts receivable, net of allowance for doubtful accounts and Retained earnings.

• Would increase Interest income

• Would increase Net income but would not affect Net cash provided by operating activity.

• A negative adjustment would be needed to reconcile the income and cash effects. It would likely be included in the Accounts receivable adjustment: Recall that an increase in this account corresponds to a negative adjustment on the cash flow statement.

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Exercise 7.03

Required

(a) Record MMS 24, 25, and 29-31 a on a blank piece of paper using information in the Entryinputs and Accts sheets. You may use the balance-sheet-equation or debits-credits approach.

(b) Identify the line items on MMS’s balance sheet, income statement, and statement of cash flows directly affected by MMS 24, 25, and 29-31. E n t r i e s Operating Investing Financing Beg Bal Tr Bal Cls IS Cls RE End Bal Zero Zero Revenue Expenses Gains & Losses Assets Liabilities Owners' Equity

Net Income Cash change

cash +other assets = liabilities + permanent OE+ temporary OE

Assets = Liabilities + Owners' Equities

R E C O R D K E E P I N G R E P O R T I N G Adjustments Operating Cash Reconciliations Net Income

Direct Cash Flows Balance Sheets Income Statements

Record Keeping and Reporting Icon

This exercise helps you meet the insider record keeping and reporting challenge.

(35)

W

riting off

B

ad

d

eBts

Most companies have policies specifying when they will write off bad debts. For example, the Management Discussion and Analysis section of General Electric’s annual report indicates GE writes off receivables past due by either 120 or 180 days, depending on the nature of the receivables:

We write off unsecured closed-end installment loans at 120 days contractually past due and unsecured openended revolving loans at 180 days contractually past due. We write down loans secured by collateral other than real estate to the fair value of the collateral, less costs to sell, when such loans are 120 days past due. Consumer loans secured by residential real estate (both revolving and closed-end loans) are written down to the fair value of collateral, less costs to sell, no later than when they become 360 days past due. Unsecured loans in bankruptcy are written off within 60 days of notification of filing by the bankruptcy court or within contractual write-off periods, whichever occurs earlier.

Page 72, General Electric’s 2005 Annual Report An important lesson is there is typically no judgment

involved with write-offs once a company’s policy is established.

The entry to record write-offs is decrease (debit) the allowance for bad debts contra asset and decrease (credit) gross accounts receivable. However, as indicated in the following example, when a receivable with collateral is written off, a second entry is required to record the receipt of the collateral when, and if, the company receives this property.

Example

Assumptions

• On January 31, 2007, ABC’s allowance for doubtful accounts has a $25 balance and ABC will not replenish the allowance until February 28, 2007.

The next few assumptions indicate ABC will write off more than $25 of receivables prior to replenishing the allowance. This will cause the allowance to have a negative balance prior to being replenished. An important lesson here, and the only reason we included this assumption, is it is not unreasonable nor unusual for allowances to have negative balances during the reporting period. The adjusting entry replenishing the account (discussed later) ensures a positive balance at the end of the period.

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• On February 1, 2007, ABC writes off a $10 receivable owed by XYZ. There is no collateral associated with this receivable.

• On February 3, 2007, ABC writes off a $100 receivable owed by DEF.

 The collateral is products ABC previously sold to DEF.  ABC fully expects to repossess the collateral without incurring

significant costs and to reinstate it to finished goods inventories.

 ABC values the collateral at $70 when it writes off the receivable

on February 3, 2007. This is the replacement cost of comparable products ABC holds in inventory at that time: what it would cost to replace them.

• On February 15, 2007, DEF turns over the collateral associated with the February 3, 2007 write-off to ABC.

 The replacement cost of comparable products in inventory is still

$70.

 ABC reinstates the collateral to finished goods inventory at this

$70 replacement cost.

• ABC’s financial statements have the same line items as Cisco’ 2005 financial statements.

• ABC uses the accounts below for related entries.

AllowBD allowance for bad debts

FGI finished goods inventory

ASSETS

Required

(a) Record the write-off of the XYZ receivable on February 1, 2007. (b) Identify line items on ABC’s balance sheet, income statement, and

cash-flow statement directly affected by the part (a) entry. (c) Record the write-off of the DEF receivable on February 3, 2007. (d) Record the receipt of collateral associated with the DEF write-off on

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(e) Identify the combined effect of the entries in parts (c) and (d) on ABC’s balance sheet, income statement, and cash-flow statement. (f) The allowance for bad debts is associated with credit risk. How do

write-off entries relate to credit risk? Solution

Part (a) — Write-offs Entries, No Collateral

• On February 1, 2007, ABC will record the following entry to write-off the XYZ receivable:

or

+ AR - AllowBD = + -$10 - - $10 =

Debit Credit

AllowBD $10

AR $10

Part (b) — Write-offs Entries Effects, No Collateral

Balance Sheet

• There is a $0 net effect on Accounts receivable, net of allowance for doubtful accounts:

 Gross accounts receivable decreases by $10, indicating ABC can

no longer expect to collect $10 from XYZ.

 The allowance for bad debts decreases by $10, signifying $10 of

the allowance was used to write off the XYZ receivable. Recording write-offs decreases gross accounts receivable and the allowance for bad debts, but it does not change net accounts receivable and has no visible effect on the balance sheet. Still, banks and companies such as GE, GM, and Ford with extensive financing receivables typically report write-offs in their footnotes.

• There is no effect.

• There is no income effect and no cash effect, so no adjustments are required.

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You might be thinking this entry is not very important because it has no net effect on any of the financial statements. This is true, but the entry can have a very important indirect effect: To the extent receivables were written off during the current period that were not

anticipated when the allowance was replenished at the end of the last reporting period, the more the allowance will need to be replenished at the end of the current period and the related adjusting entry decreases net income (as we shall see shortly).

Part (c) — Write-offs Entries, with Collateral

• On February 3, 2007, ABC will record the following entry to write-off the DEF receivable:

or

+ AR - AllowBD = + -$30 - - $30 =

Debit Credit

AllowBD $30

AR $30

After this entry, ABC continues to recognize a $70 receivable, signifying the value of the collateral it expects to receive from DEF in the near future.

Part (d) — Receipt of Collateral Entries

• On February 15, 2007, ABC will record the following entry when it receives collateral associated with the DEF write-off:

or

+ AR + FGI =

+ -$70 + + $70 =

Debit Credit

FGI $70

AR $70

Part (e) — Effects of Write-offs with Collateral Received The captions for the financial-statement items are based on those used in Cisco’s 2005 annual report (pages 40-42).

Balance Sheet

• The combined effect of the entries in parts (c) and (d) is a $70 decrease in Accounts receivable, net of allowance for doubtful accounts:

 Gross accounts receivable decreases by $100 ($30 + $70).  The allowance for bad debts decreases by $30. When there is

collateral, the allowances can be set lower because the collateral reduces the downside of write-offs.