chapter 10: revenue recognition and valuation of receivables · 2018. 11. 2. · accounts...
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Chapter 10: Revenue Recognition and Valuation of Receivables
The timing of revenue recognitionValuation of receivables; VAT
Accounting for bad debtRefinancing receivables before the due date
Receivables turnover
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Overview
What are receivablesRecognition of accounts receivable
Treatment of sales discounts• Gross method• Net method
Valuation of accounts receivable• Direct write-off method• Allowance method
Percentage-of-sales approachPercentage-of-receivables approach
• Recovery of accounts written-offAre bad debts really bad?Recognition of notes receivableDisposition of accounts receivable and notes receivable
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Receivables: definition and categorization
Definition: revenues recognized but not yet received, revenues on account
receivables include any taxes the seller collects on behalf of the government• gross of VAT
Classification current receivables: expected to be collected within a year noncurrent receivables: all others
trade receivables: amounts owed by customers for goods sold and services renderednontrade receivables: arise from a variety of transactions• e.g. interest, royalties, dividends, compensation for damages
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Treatment of VAT
Exampleinvoice: Gross amount: 1000, including 25% VAT• usually VAT has to be separately shown in the invoice
revenue × (1 + 25%) = 1000• revenue = 1000/1.25 = 800
Journal entries:Dr.: Customer 1000
Cr.: revenue 800VAT 200
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Trade Receivables
Accounts receivableoral promises of the purchaser to payusually collectible within 30-60 daysrepresent „open accounts“ (short-term extension of credit)
„accounts receivable“ account in general ledger control account
summarizes total amount receivable
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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 Bank of America (Banking services) 0,61 0,87 Merril Lynch (Investment services) 0,47 0,52
* includes note receivable
Importance of Accounts Receivable
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Revenue recognition revisited
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 transactionthe amount of revenue and the related costs can be measured reliablythe significant risks and rewards of the transaction have been transferred to the buyer
specific casesgoods sold on consignment: consignor recognizes revenue only when consignee has sold to his customerright 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)warranty claims do not prevent revenue recognition but they lead to a provision (a separate debt item)
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Recognition of Accounts Receivable
usual way if a credit sale occursrecord the sale as revenue and record
an increase in accounts receivable
basis for recognition exchange price,i.e. the amount due from the debtor
exchange price can be found in the contract or on the invoice
Discounts must be recognizedinterest not recognized, no discounting (immaterial)
Accounts Receivable € XYZ Revenue € XYZ
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Discounts
Trade Discountsused to avoid frequent changes in cataloguesallow for different prices for different quantitieshide true invoice price from competitors
revenue recognized is the net amountSales Discounts
offered to induce prompt paymentusually 2% - 3% if payment occurs within 10 days, net amount due within 30 days foregoing the discount is expensive (in terms of opportunity costs!)
e.g. not using a 2% discount means incurring a 36.9% interest on the discounted balance!!
100)360201(98 =+ r
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Note that discounts apply to VAT too
both revenue and VAT amounts are reduced by the discount percentageExample:
Invoice: 1000 + 200 VAT2% discount used• Customer pays: 1176
Journal entries:• when revenue is recognized using the gross method• Dr. Accounts receivable: 1200
Cr. Sales Revenue: 1000VAT: 200
• payment:• Dr. Cash: 1176
Sales discount: 20VAT: 4
Cr.: Accounts receivable: 1200
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Two methods of accounting for sales discounts
(1) Gross methodinitially recognize gross amountrecognize sales discounts when they are taken
(2) Net methodinitially recognize amount net of sales discountmake „correcting“ entries if sales discounts are forfeited
from an accounting point of view net method preferablewhy? amount recognized closer to net realizable value
from a practical point of view gross method preferablewhy? easy to apply, no additional calculation necessary
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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 1.940Sales 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 60Cash 2.000 Accounts Receivable 2.000
Note: The payment of € 1.940 results in a reduction of € 2.000 in the accounts receivable accountunder the gross method.
forfeited
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Valuation of Accounts Receivableimportant for financial statement presentationimportant also for internal decision makingvaluation at net realizable value • not always equal to face value!
Motivating examples1. 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
should general allowances be made upfront?
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One important valuation aspect: payment behavior
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5
10
15
20
25
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How do German companies evaluate the payment habits of their customers?
Bad 11,5 26,6 12,9 15Good 27,4 21,4 23,9 26,9
Manufact-uring Construction Wholesale /
RetailersService
Industries
Source: Creditreform
, Figures from 2000
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Valuation of Receivables: Gross method
From book value (face value) to net realizable valueFace value: nominal amount recognized when credit sale transaction is recordedNet realizable value (NRV): amount estimated to be collectible from outstanding receivablesadjustments necessary for
discountsreturns, andexpected losses from revenues (uncollectible accounts)
NRV = face value – adjustments for discounts– adjustments for sales returns– allowance for uncollectible accounts
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Uncollectible Accounts Receivable
represent loss of revenue expense due to selling on credituncollectible accounts expense (also called bad debt expense) is recorded
When should uncollectible accounts expense be recognized?
either at the time when an account turns out to be „uncollectible“: direct write-off methodor in the period of the sales: estimate of uncollectible accounts: allowance method
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Direct Write-Off Method
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)
Discussionfacts are recorded, not estimateshowever, no matching of revenues and costsno net realizable value presentation of receivables
on the balance sheetApply only for individual amounts not material!
Bad Debt Expense € XYZ Accounts Receivable € XYZ
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Allowance Method
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: percentage-of-sales or percentage-of-receivables
Discussioninvolves estimatesbetter matching of revenues and costs receivables recorded at their net realizable valuesThis is the method that should be used (and must be used in many countries)
Bad Debt Expense € XYZ Allowance for Doubtful Accounts € XYZ
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Treatment of direct write-offs when the allowance method is applied
debit Allowance for Uncollectible Accountscredit Accounts Receivableestimated net realizable value of Accounts Receivable remains unchanged
exception: unexpected high write-offs (major customer goesbankrupt)
Allowance for Uncollectible Accounts 1.100 Accounts Receivable 1.100
a specific account is written-off
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Effect of write-off on NRV illustrated:
Balances BalancesBefore After
Write-Offs Write-Offs
Accounts Receivable € 143.000 € 141.900Less Allowance for Uncollectible Accounts 13.690 12.590
Estimated Net Realizable Value of Accounts Receivable € 129.310 € 129.310
No effect on net realizable value of Accounts Receivable
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Percentage-of-Sales (Income Statement) Approach
Bad Debt Expense as a percentage of credit sales during the accounting period
percentage determined from past experience and future expectationsamount to be recognized = percentage uncollectible × credit sales
ExampleCredit sales amounted to € 760.000 while 3%, on average,deemed uncollectible
Uncollectible Accounts Expense 22.800 Allowance for Uncollectible Accounts 22.800
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Percentage-of-Receivables (Balance Sheet) Approach
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:Percentage-of-receivable focus on balance sheet accountPercentage-of-sales focus on income statement
accountDifferent focus of approaches:
Percentage -of-sales approach implicitly assumes that annual credit sales are linearly related to bad debt amount!Percentage –of-receivables approach assumes that a linear relationship exists between the amount of credit sales outstanding at the balance sheet date and the amount of bad debt
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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 AmountJan. Holm 10.000Feb. Lowe 2.000August Smith (I) 8.000Nov. Miller 20.000Dec. Baker 6.000
Cooper 1.000Gardener 3.000
50.000
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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 20,000 (M) 10% 2,000
91 – 180 days 8,000 (S I) 15% 1,200
>180 days 12,000 (H,L) 25% 3,0006,700
Targeted balance for Allowance for Uncollectible Accounts
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Journal entries and accounts in year 1:
Uncollectible accounts expense 6,700
Allowance for uncollectible accounts 6,700
Accounts Receivable Allowance for uncoll. accounts50,000 6,700
Net realizable value of accounts receivable: 43,300
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(uncollected) credit sales in year 2:
Month Customer AmountJan. Koller 2,000March Deutsch 40,000July Franco 6,000August Weyer 1,000Sept. Hunger 12,000Nov, Smith (II) 9,000Dec. Camillo 4,000
74,000
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Other information for year 2:
Payments received from outstanding year-1 receivables
Holm 10,000Miller 20,000Smith (I) 8,000
Write-offs of year-1 receivablesCooper 1,000Gardener 3,000
Open accounts from year 1Baker 6,000Lowe 2,000
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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% 12,50016,450
Targeted balance for Allowance for Uncollectible Accounts
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Determining bad debt expense for year 2:
Targeted balance for allowance for u.a. 16,450less credit balance from prior year – 6,700plus debits due to write-offs + 4,000
13,750Accounts Receivable
50.000
1.000 3.000 10.000 20.000 8.000
74.000
82.000
Red – write-offs; blue – collections yr.1; green – adj. yr.2
Allowance for uncoll. Accounts
1.000 6.7003.000
13.750
16.450
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Remarks
Net realizable value of receivables at the end of year 282.000 – 16.450 = 65.550
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€ 43.300
Accounts written-off in year 2 „accounted“ for just € 200 of allowance for uncollectible accounts in year 1
Balance of € 6.700 in Allowance for Uncollectible Accounts account from year 1 matters for determining bad debt expense (uncollectible accounts expense) in year 2
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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% 1.95031 - 60 days old 35.000 6% 2.10061 - 90 days old 12.000 15% 1.80091 - 120 days old 14.000 22% 3.080over 120 days old 17.000 28% 4.760
targeted balance of the Allowance for Uncollectible Accounts account: € 13.690
Determination of Uncollectible Accounts Expense... subtract the current credit balance of Allowance for Uncollectible Accounts to determine Uncollectible Accounts Expense for the corresponding accounting period
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Credit balance of € 2.400
Targeted Balance for Allowance for Uncollectible Accounts: € 13.690Less 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 2.400Dec. 31 adjustment 11.290
Dec. 31 balance 13.690
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Recovery of accounts receivable written-off
allowance methodreestablish the receivable written-offdebit Cash and credit Accounts Receivable
direct write-off methoddebit Cashcredit Uncollectible Amounts Recovered
Accounts Receivable 1.100 Allowance for Uncollectible Accounts 1.100
Cash 1.100 Accounts Receivable 1.100
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Economic evaluation of allowing for bad debt
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.
According to view #1, uncollectible accounts expense represents unnecessary expenses that reduce profits.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.
in advance it is not known which accounts will turn bad
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Recognition of Notes Receivable
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 assetmaker – issuer of note; regards it as note payable liabilityterms are negotiablestronger legal claim than accounts receivablesome notes are tradable
short-term notes recorded at face valueinterest immaterial
long-term notes recorded at present value of cash expected to be collectedAccounting for notes receivable:
similar to accounting for accounts receivablenotable difference in recognition of interest• topic will be dealt with under „liabilities“, i.e. notes payable
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Disposition of Accounts Receivable and Notes Receivable
growing popularity of credit sales soaked up cash of the selling companiesmeans to accelerate receipt of cash:
transfer accounts or notes receivable to another company, e.g. bank or factor
finance charge associated with these transactionstransfer of receivables via
secured borrowingsales of receivables
differ in some legal aspects and accounting treatment
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Sale of Receivables
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.Journal entries that both companies would make as a result of the transaction.
ZiscoSys Deutsche Factors
Cash 14.400 Accounts Receivable 15.000Loss on Sale of Receivables 600 Financing Revenue _ _600 Accounts Receivable 15.000 Cash 14.400