FINANCIAL ACCOUNTINGFINANCIAL ACCOUNTING

AN INTRODUCTION TO CONCEPTS,AN INTRODUCTION TO CONCEPTS,METHODS, AND USESMETHODS, AND USES

12th Edition12th Edition

FINANCIAL ACCOUNTINGFINANCIAL ACCOUNTING

AN INTRODUCTION TO CONCEPTS,AN INTRODUCTION TO CONCEPTS,METHODS, AND USESMETHODS, AND USES

12th Edition12th Edition

Chapter 6 -- Receivablesand Revenue Recognition

Clyde P. Stickney and Roman L. Weil

Learning ObjectivesLearning Objectives

1.1. Develop an introductory understanding of Develop an introductory understanding of the quality of earnings as a concept of the quality of earnings as a concept of evaluating generally accepted accounting evaluating generally accepted accounting principles discussed in Chapters 6 to 12.principles discussed in Chapters 6 to 12.

2.2. Understand why the allowance method for Understand why the allowance method for uncollectible accounts matches bad debts uncollectible accounts matches bad debts with revenues better than the direct write-with revenues better than the direct write-off method.off method.

3.3. Apply the allowance method for Apply the allowance method for uncollectible accounts.uncollectible accounts.

4.4. Analyze information on accounts receivable Analyze information on accounts receivable to evaluate a firm’s management of its to evaluate a firm’s management of its credit operation.credit operation.

1.1. Develop an introductory understanding of Develop an introductory understanding of the quality of earnings as a concept of the quality of earnings as a concept of evaluating generally accepted accounting evaluating generally accepted accounting principles discussed in Chapters 6 to 12.principles discussed in Chapters 6 to 12.

2.2. Understand why the allowance method for Understand why the allowance method for uncollectible accounts matches bad debts uncollectible accounts matches bad debts with revenues better than the direct write-with revenues better than the direct write-off method.off method.

3.3. Apply the allowance method for Apply the allowance method for uncollectible accounts.uncollectible accounts.

4.4. Analyze information on accounts receivable Analyze information on accounts receivable to evaluate a firm’s management of its to evaluate a firm’s management of its credit operation.credit operation.

Learning ObjectivesLearning Objectives

5.5. Develop a sensitivity to issues in Develop a sensitivity to issues in recognizing and measuring revenues recognizing and measuring revenues and expenses for various types of and expenses for various types of businesses.businesses.

6.6. Cement an understanding of the concept Cement an understanding of the concept that net income over sufficiently long that net income over sufficiently long periods equals cash inflows minus cash periods equals cash inflows minus cash outflows other than transactions with outflows other than transactions with owners (a measurement issue), owners (a measurement issue), regardless of when firms recognize the regardless of when firms recognize the revenues and expenses (a timing issue).revenues and expenses (a timing issue).

5.5. Develop a sensitivity to issues in Develop a sensitivity to issues in recognizing and measuring revenues recognizing and measuring revenues and expenses for various types of and expenses for various types of businesses.businesses.

6.6. Cement an understanding of the concept Cement an understanding of the concept that net income over sufficiently long that net income over sufficiently long periods equals cash inflows minus cash periods equals cash inflows minus cash outflows other than transactions with outflows other than transactions with owners (a measurement issue), owners (a measurement issue), regardless of when firms recognize the regardless of when firms recognize the revenues and expenses (a timing issue).revenues and expenses (a timing issue).

Chapter OutlineChapter Outline

1.1. Financial Reporting Environment Financial Reporting Environment

2.2. Quality of EarningsQuality of Earnings

3.3. Review of revenue recognition Review of revenue recognition principlesprinciples

4.4. Application of income recognition Application of income recognition principlesprinciples

5.5. Revenue recognition at time of saleRevenue recognition at time of sale

6.6. Analyzing information on accounts Analyzing information on accounts receivablereceivable

1.1. Financial Reporting Environment Financial Reporting Environment

2.2. Quality of EarningsQuality of Earnings

3.3. Review of revenue recognition Review of revenue recognition principlesprinciples

4.4. Application of income recognition Application of income recognition principlesprinciples

5.5. Revenue recognition at time of saleRevenue recognition at time of sale

6.6. Analyzing information on accounts Analyzing information on accounts receivablereceivable

Chapter OutlineChapter Outline

7.7. Income recognition at times different from Income recognition at times different from salesale

8.8. Summary illustration of income recognition Summary illustration of income recognition methodsmethods

9.9. Format and classification with the Income Format and classification with the Income StatementStatement

10.10. An International PerspectiveAn International Perspective

Chapter SummaryChapter Summary

Appendix 6.1 – Effects on the Statement of Appendix 6.1 – Effects on the Statement of Cash Flows of Transactions Involving Cash Flows of Transactions Involving Accounts ReceivableAccounts Receivable

7.7. Income recognition at times different from Income recognition at times different from salesale

8.8. Summary illustration of income recognition Summary illustration of income recognition methodsmethods

9.9. Format and classification with the Income Format and classification with the Income StatementStatement

10.10. An International PerspectiveAn International Perspective

Chapter SummaryChapter Summary

Appendix 6.1 – Effects on the Statement of Appendix 6.1 – Effects on the Statement of Cash Flows of Transactions Involving Cash Flows of Transactions Involving Accounts ReceivableAccounts Receivable

Quality of EarningsQuality of Earnings Refers to the ability managers have to use Refers to the ability managers have to use

discretion in measuring and reporting earningsdiscretion in measuring and reporting earnings

This discretion may involve:This discretion may involve:

– Choosing among alternative accounting Choosing among alternative accounting principlesprinciples

– Making estimatesMaking estimates

– Timing transactions in order to control Timing transactions in order to control recognitionrecognition

High quality earnings are presumed to be fair High quality earnings are presumed to be fair representations of the economic performance of representations of the economic performance of the firmthe firm

Low quality earnings overstate fair earnings Low quality earnings overstate fair earnings

Refers to the ability managers have to use Refers to the ability managers have to use discretion in measuring and reporting earningsdiscretion in measuring and reporting earnings

This discretion may involve:This discretion may involve:

– Choosing among alternative accounting Choosing among alternative accounting principlesprinciples

– Making estimatesMaking estimates

– Timing transactions in order to control Timing transactions in order to control recognitionrecognition

High quality earnings are presumed to be fair High quality earnings are presumed to be fair representations of the economic performance of representations of the economic performance of the firmthe firm

Low quality earnings overstate fair earnings Low quality earnings overstate fair earnings

Income Recognition PrincipleIncome Recognition Principle

Revenue is Revenue is recognizedrecognized (recorded) when (recorded) when both:both:

– The firm has performed all, or a The firm has performed all, or a substantial portion of, the services; substantial portion of, the services; that is, the revenue has been that is, the revenue has been earnedearned, , andand

– The firm has received cash, a The firm has received cash, a receivable or some asset capable of receivable or some asset capable of reasonable measurement; that is, the reasonable measurement; that is, the revenue is revenue is measurablemeasurable..

Revenue is Revenue is recognizedrecognized (recorded) when (recorded) when both:both:

– The firm has performed all, or a The firm has performed all, or a substantial portion of, the services; substantial portion of, the services; that is, the revenue has been that is, the revenue has been earnedearned, , andand

– The firm has received cash, a The firm has received cash, a receivable or some asset capable of receivable or some asset capable of reasonable measurement; that is, the reasonable measurement; that is, the revenue is revenue is measurablemeasurable..

Income Recognition PrincipleIncome Recognition Principle

Expenses are matched to the revenues Expenses are matched to the revenues that they generatethat they generate

– Since the firm only expends assets Since the firm only expends assets (causing expenses) in anticipation of (causing expenses) in anticipation of revenue, fair measurement of net revenue, fair measurement of net income calls for matching those income calls for matching those expenses against revenue.expenses against revenue.

– Expenses are recognized in the period Expenses are recognized in the period in which the revenue is recognized.in which the revenue is recognized.

Expenses are matched to the revenues Expenses are matched to the revenues that they generatethat they generate

– Since the firm only expends assets Since the firm only expends assets (causing expenses) in anticipation of (causing expenses) in anticipation of revenue, fair measurement of net revenue, fair measurement of net income calls for matching those income calls for matching those expenses against revenue.expenses against revenue.

– Expenses are recognized in the period Expenses are recognized in the period in which the revenue is recognized.in which the revenue is recognized.

Figure 6.1: Figure 6.1: Operating Process for Operating Process for a Manufacturing Firma Manufacturing Firm

When has the firm earned revenue?

When is the expense incurred?

Revenue Recognition RulesRevenue Recognition Rules

Different recognition rules may be Different recognition rules may be appropriate for different situationsappropriate for different situations

1.1. At time of saleAt time of sale

2.2. Percentage of completionPercentage of completion

3.3. Completed contractCompleted contract

4.4. Installment salesInstallment sales

5.5. Cost recovery firstCost recovery first

Different recognition rules may be Different recognition rules may be appropriate for different situationsappropriate for different situations

1.1. At time of saleAt time of sale

2.2. Percentage of completionPercentage of completion

3.3. Completed contractCompleted contract

4.4. Installment salesInstallment sales

5.5. Cost recovery firstCost recovery first

Revenue Recognition RulesRevenue Recognition Rules

Different industries or situationsDifferent industries or situations

1. Long-term contractors1. Long-term contractors

2. Forestry products2. Forestry products

3. Insurance3. Insurance

4. Franchisors4. Franchisors

Different industries or situationsDifferent industries or situations

1. Long-term contractors1. Long-term contractors

2. Forestry products2. Forestry products

3. Insurance3. Insurance

4. Franchisors4. Franchisors

Discuss Earning Revenue At Time Discuss Earning Revenue At Time of Saleof Sale

Merchandising firms earn revenue when Merchandising firms earn revenue when the sale is made.the sale is made.

Revenue is then recognized at the time of Revenue is then recognized at the time of the sale.the sale.

And expenses that contributed to that And expenses that contributed to that revenue are recognized at the same time.revenue are recognized at the same time.

This method is the general rule for sales of This method is the general rule for sales of goods.goods.

It has the advantage of being easily It has the advantage of being easily verified.verified.

Merchandising firms earn revenue when Merchandising firms earn revenue when the sale is made.the sale is made.

Revenue is then recognized at the time of Revenue is then recognized at the time of the sale.the sale.

And expenses that contributed to that And expenses that contributed to that revenue are recognized at the same time.revenue are recognized at the same time.

This method is the general rule for sales of This method is the general rule for sales of goods.goods.

It has the advantage of being easily It has the advantage of being easily verified.verified.

At Time of Sale (Cont.)At Time of Sale (Cont.)

A more technical version of this rule A more technical version of this rule recognizes revenue when the title to the recognizes revenue when the title to the goods passes from seller to buyer. This goods passes from seller to buyer. This may occur when the goods are moved may occur when the goods are moved from the seller’s loading dock to a shipper.from the seller’s loading dock to a shipper.

Management has incentives to recognize Management has incentives to recognize revenues as early as the account will revenues as early as the account will allow.allow.

A more technical version of this rule A more technical version of this rule recognizes revenue when the title to the recognizes revenue when the title to the goods passes from seller to buyer. This goods passes from seller to buyer. This may occur when the goods are moved may occur when the goods are moved from the seller’s loading dock to a shipper.from the seller’s loading dock to a shipper.

Management has incentives to recognize Management has incentives to recognize revenues as early as the account will revenues as early as the account will allow.allow.

Explain Recognition for Explain Recognition for Percentage of CompletionPercentage of Completion

Long-term construction companies may earn Long-term construction companies may earn revenue as they gorevenue as they go

For example, a contract to pave a road is For example, a contract to pave a road is earned as the final payment is laidearned as the final payment is laid

Expenses can be matched against this Expenses can be matched against this revenue and recognized in proportionrevenue and recognized in proportion

The difficulty lies in measuring the The difficulty lies in measuring the percentage of completingpercentage of completing

– Engineering estimates, orEngineering estimates, or

– Percentage of the budgeted costs incurredPercentage of the budgeted costs incurred

Long-term construction companies may earn Long-term construction companies may earn revenue as they gorevenue as they go

For example, a contract to pave a road is For example, a contract to pave a road is earned as the final payment is laidearned as the final payment is laid

Expenses can be matched against this Expenses can be matched against this revenue and recognized in proportionrevenue and recognized in proportion

The difficulty lies in measuring the The difficulty lies in measuring the percentage of completingpercentage of completing

– Engineering estimates, orEngineering estimates, or

– Percentage of the budgeted costs incurredPercentage of the budgeted costs incurred

Explain Recognition for Completed Explain Recognition for Completed ContractContract

If the percentage of completion cannot If the percentage of completion cannot reasonably be estimated, then recognition reasonably be estimated, then recognition of revenues should be delayed until the of revenues should be delayed until the contract is completed and accepted by the contract is completed and accepted by the customer.customer.

An example would be a contract to develop An example would be a contract to develop a computer program; it either works a computer program; it either works satisfactorily or it doesn’t; there is little satisfactorily or it doesn’t; there is little meaning to a percentage of completion.meaning to a percentage of completion.

In these cases, revenue is recognized upon In these cases, revenue is recognized upon completion of the contract.completion of the contract.

If the percentage of completion cannot If the percentage of completion cannot reasonably be estimated, then recognition reasonably be estimated, then recognition of revenues should be delayed until the of revenues should be delayed until the contract is completed and accepted by the contract is completed and accepted by the customer.customer.

An example would be a contract to develop An example would be a contract to develop a computer program; it either works a computer program; it either works satisfactorily or it doesn’t; there is little satisfactorily or it doesn’t; there is little meaning to a percentage of completion.meaning to a percentage of completion.

In these cases, revenue is recognized upon In these cases, revenue is recognized upon completion of the contract.completion of the contract.

Completed Contract (Cont.)Completed Contract (Cont.)

And expenses are matched; that is, they And expenses are matched; that is, they are recognized upon completion also.are recognized upon completion also.

So where are cash (and other asset) So where are cash (and other asset) outflows that are made before completion?outflows that are made before completion?

– Such outflows are Such outflows are capitalizedcapitalized; that is, ; that is, they are debited to an assetthey are debited to an asset

– This asset is credited (removing it) and This asset is credited (removing it) and an expense is debited upon completionan expense is debited upon completion

And expenses are matched; that is, they And expenses are matched; that is, they are recognized upon completion also.are recognized upon completion also.

So where are cash (and other asset) So where are cash (and other asset) outflows that are made before completion?outflows that are made before completion?

– Such outflows are Such outflows are capitalizedcapitalized; that is, ; that is, they are debited to an assetthey are debited to an asset

– This asset is credited (removing it) and This asset is credited (removing it) and an expense is debited upon completionan expense is debited upon completion

Revenue Recognition for Installment Revenue Recognition for Installment SalesSales

Recognized revenue as the seller collects Recognized revenue as the seller collects cash from periodic payments.cash from periodic payments.

A common example is a A common example is a rent-to-ownrent-to-own store store in which the customer takes possession of in which the customer takes possession of an asset and pays periodic payments like an asset and pays periodic payments like rent. The customer may return the asset rent. The customer may return the asset and stop payments at any time. After a and stop payments at any time. After a set number of payments is ownership of set number of payments is ownership of the asset is given. Some rent-to-own the asset is given. Some rent-to-own stores have been criticized because the stores have been criticized because the implicit rate of interest in many such implicit rate of interest in many such contracts is so high.contracts is so high.

Recognized revenue as the seller collects Recognized revenue as the seller collects cash from periodic payments.cash from periodic payments.

A common example is a A common example is a rent-to-ownrent-to-own store store in which the customer takes possession of in which the customer takes possession of an asset and pays periodic payments like an asset and pays periodic payments like rent. The customer may return the asset rent. The customer may return the asset and stop payments at any time. After a and stop payments at any time. After a set number of payments is ownership of set number of payments is ownership of the asset is given. Some rent-to-own the asset is given. Some rent-to-own stores have been criticized because the stores have been criticized because the implicit rate of interest in many such implicit rate of interest in many such contracts is so high.contracts is so high.

Installment Sales (Cont.)Installment Sales (Cont.)

In these cases, In these cases, revenue may be revenue may be recognized on a cash recognized on a cash basis, as the cash is basis, as the cash is received.received.

Matching of expenses Matching of expenses calls for recognition of calls for recognition of a proportional amount a proportional amount of the total cost of the of the total cost of the asset. asset.

In these cases, In these cases, revenue may be revenue may be recognized on a cash recognized on a cash basis, as the cash is basis, as the cash is received.received.

Matching of expenses Matching of expenses calls for recognition of calls for recognition of a proportional amount a proportional amount of the total cost of the of the total cost of the asset. asset.

Review Revenue Recognition for Review Revenue Recognition for Cost Recovery FirstCost Recovery First

A more conservative form of installment A more conservative form of installment sales method has the same revenue sales method has the same revenue recognition rule.recognition rule.

But recognized expenses equal to revenue But recognized expenses equal to revenue (and so zero income).(and so zero income).

Until the entire cost of the asset is Until the entire cost of the asset is covered.covered.

Income appears to be zero until the cost is Income appears to be zero until the cost is recovered and then is equal to revenue recovered and then is equal to revenue until the payments are completed.until the payments are completed.

A more conservative form of installment A more conservative form of installment sales method has the same revenue sales method has the same revenue recognition rule.recognition rule.

But recognized expenses equal to revenue But recognized expenses equal to revenue (and so zero income).(and so zero income).

Until the entire cost of the asset is Until the entire cost of the asset is covered.covered.

Income appears to be zero until the cost is Income appears to be zero until the cost is recovered and then is equal to revenue recovered and then is equal to revenue until the payments are completed.until the payments are completed.

Cost Recovery First (Cont.)Cost Recovery First (Cont.)

This method front-end loads expenses This method front-end loads expenses but results in a greatly delayed but results in a greatly delayed recognition of income.recognition of income.

This method is justified in sales where This method is justified in sales where the probability of default by the the probability of default by the customer is very high.customer is very high.

Since income in these cases is very Since income in these cases is very uncertain, no income is recognized until uncertain, no income is recognized until the cost is recovered.the cost is recovered.

This method front-end loads expenses This method front-end loads expenses but results in a greatly delayed but results in a greatly delayed recognition of income.recognition of income.

This method is justified in sales where This method is justified in sales where the probability of default by the the probability of default by the customer is very high.customer is very high.

Since income in these cases is very Since income in these cases is very uncertain, no income is recognized until uncertain, no income is recognized until the cost is recovered.the cost is recovered.

Different Industries -- What is the Different Industries -- What is the appropriate revenue recognition rule?appropriate revenue recognition rule?

1.1. Long term contractorsLong term contractors – –

Projects take several years to complete Projects take several years to complete and cash inflows and outflows may be and cash inflows and outflows may be made during the project.made during the project.

2.2. Forestry productsForestry products – –

Similar to a long term contract, forests Similar to a long term contract, forests take many years to mature but cash take many years to mature but cash inflow is typically at the sale.inflow is typically at the sale.

1.1. Long term contractorsLong term contractors – –

Projects take several years to complete Projects take several years to complete and cash inflows and outflows may be and cash inflows and outflows may be made during the project.made during the project.

2.2. Forestry productsForestry products – –

Similar to a long term contract, forests Similar to a long term contract, forests take many years to mature but cash take many years to mature but cash inflow is typically at the sale.inflow is typically at the sale.

Different Industries -- What is the Different Industries -- What is the Appropriate Revenue Recognition Appropriate Revenue Recognition

Rule?Rule?3.3. InsuranceInsurance – –

What is a prepaid asset to the insured is a What is a prepaid asset to the insured is a deposit paid in advance of services to the deposit paid in advance of services to the insurance company. Revenue is earned insurance company. Revenue is earned when the service is provided.when the service is provided.

4.4. FranchisorsFranchisors––

A franchisor sells rights to a franchisee who A franchisor sells rights to a franchisee who pays for them. These payments may be pays for them. These payments may be deferred until the franchisee earns deferred until the franchisee earns revenue.revenue.

3.3. InsuranceInsurance – –

What is a prepaid asset to the insured is a What is a prepaid asset to the insured is a deposit paid in advance of services to the deposit paid in advance of services to the insurance company. Revenue is earned insurance company. Revenue is earned when the service is provided.when the service is provided.

4.4. FranchisorsFranchisors––

A franchisor sells rights to a franchisee who A franchisor sells rights to a franchisee who pays for them. These payments may be pays for them. These payments may be deferred until the franchisee earns deferred until the franchisee earns revenue.revenue.

How does uncollectible accounts affect How does uncollectible accounts affect revenue recognition?revenue recognition?

For credit sales, revenue is recognized For credit sales, revenue is recognized (credited) at the time of the sale even (credited) at the time of the sale even thought the customer has not paid cash.thought the customer has not paid cash.

Instead, an account receivable is established Instead, an account receivable is established (debited).(debited).

An account receivable is an asset that An account receivable is an asset that represents a promise to pay.represents a promise to pay.

Not all customers are able or willing to fulfill Not all customers are able or willing to fulfill their promise.their promise.

When a customer defaults, the account When a customer defaults, the account becomes valueless and must be credited and becomes valueless and must be credited and removed.removed.

For credit sales, revenue is recognized For credit sales, revenue is recognized (credited) at the time of the sale even (credited) at the time of the sale even thought the customer has not paid cash.thought the customer has not paid cash.

Instead, an account receivable is established Instead, an account receivable is established (debited).(debited).

An account receivable is an asset that An account receivable is an asset that represents a promise to pay.represents a promise to pay.

Not all customers are able or willing to fulfill Not all customers are able or willing to fulfill their promise.their promise.

When a customer defaults, the account When a customer defaults, the account becomes valueless and must be credited and becomes valueless and must be credited and removed.removed.

Uncollectible Accounts (Cont.)Uncollectible Accounts (Cont.)

The offsetting debit could be considered a The offsetting debit could be considered a reversal of revenue:reversal of revenue:

– Most consider this a necessary and Most consider this a necessary and unpleasant expense of doing business.unpleasant expense of doing business.

– In these cases, an expense could be In these cases, an expense could be debited and the revenue would remain.debited and the revenue would remain.

The timing of the recognition of this The timing of the recognition of this expense depends on the accounting expense depends on the accounting method.method.

The offsetting debit could be considered a The offsetting debit could be considered a reversal of revenue:reversal of revenue:

– Most consider this a necessary and Most consider this a necessary and unpleasant expense of doing business.unpleasant expense of doing business.

– In these cases, an expense could be In these cases, an expense could be debited and the revenue would remain.debited and the revenue would remain.

The timing of the recognition of this The timing of the recognition of this expense depends on the accounting expense depends on the accounting method.method.

Uncollectible Accounts (Cont.)Uncollectible Accounts (Cont.) An uncollectible account is written-off (the asset An uncollectible account is written-off (the asset

is removed) and an expense is recognizedis removed) and an expense is recognized

When the expense is recognized depends on When the expense is recognized depends on the method of accounting for uncollectible the method of accounting for uncollectible accountsaccounts

There are two basic methods for accounting for There are two basic methods for accounting for uncollectible accounts:uncollectible accounts:

a. Direct write-offa. Direct write-off

The expense is recognized when the The expense is recognized when the account is written-offaccount is written-off

This method is required for most tax This method is required for most tax purposespurposes

An uncollectible account is written-off (the asset An uncollectible account is written-off (the asset is removed) and an expense is recognizedis removed) and an expense is recognized

When the expense is recognized depends on When the expense is recognized depends on the method of accounting for uncollectible the method of accounting for uncollectible accountsaccounts

There are two basic methods for accounting for There are two basic methods for accounting for uncollectible accounts:uncollectible accounts:

a. Direct write-offa. Direct write-off

The expense is recognized when the The expense is recognized when the account is written-offaccount is written-off

This method is required for most tax This method is required for most tax purposespurposes

Uncollectible Accounts (Cont.)Uncollectible Accounts (Cont.)

b. Allowance methodb. Allowance method

The expense is matched to the The expense is matched to the revenue by recognizing an revenue by recognizing an estimate of the expense in the estimate of the expense in the same period as the credit salesame period as the credit sale

Two variants:Two variants:

1. Credit sales basis1. Credit sales basis

2. Net receivables or aging of 2. Net receivables or aging of A.R. basisA.R. basis

b. Allowance methodb. Allowance method

The expense is matched to the The expense is matched to the revenue by recognizing an revenue by recognizing an estimate of the expense in the estimate of the expense in the same period as the credit salesame period as the credit sale

Two variants:Two variants:

1. Credit sales basis1. Credit sales basis

2. Net receivables or aging of 2. Net receivables or aging of A.R. basisA.R. basis

Explain Direct Write-OffExplain Direct Write-Off

Recognizes losses from uncollectible Recognizes losses from uncollectible accounts in the period in which the account accounts in the period in which the account is determined to be uncollectible:is determined to be uncollectible:

Recognizes losses from uncollectible Recognizes losses from uncollectible accounts in the period in which the account accounts in the period in which the account is determined to be uncollectible:is determined to be uncollectible:

Bad debt expense 134,000 Accounts receivable 134,000To record losses from know uncollectible accounts

Explain Direct Write-Off (cont.)Explain Direct Write-Off (cont.)Shortcomings:

Fails to match bad debt expense with revenue, the revenue is recognized at the time of the sale but the expense is delayed until the account is determined to be uncollectible.

Provides an opportunity to manipulate earnings each period by strategically writing-off accounts.

The amount of accounts receivable is not the best estimate of the expected cash inflow; that is, if the firm and one million dollars in accounts receivable but a high default rate, the expected cash inflow may be much less than one million dollars.

Shortcomings:

Fails to match bad debt expense with revenue, the revenue is recognized at the time of the sale but the expense is delayed until the account is determined to be uncollectible.

Provides an opportunity to manipulate earnings each period by strategically writing-off accounts.

The amount of accounts receivable is not the best estimate of the expected cash inflow; that is, if the firm and one million dollars in accounts receivable but a high default rate, the expected cash inflow may be much less than one million dollars.

Discuss the Allowance MethodDiscuss the Allowance Method GAAP requires that bad debts expense be matched GAAP requires that bad debts expense be matched

against the revenue to which it gives rise.against the revenue to which it gives rise.

When revenue is recognized, a bad debts expense When revenue is recognized, a bad debts expense is also recognized as an estimate of the amount of is also recognized as an estimate of the amount of revenue which may eventually prove uncollectible.revenue which may eventually prove uncollectible.

The offset to this expense is called the The offset to this expense is called the allowance allowance for uncollectible accounts:for uncollectible accounts:

GAAP requires that bad debts expense be matched GAAP requires that bad debts expense be matched against the revenue to which it gives rise.against the revenue to which it gives rise.

When revenue is recognized, a bad debts expense When revenue is recognized, a bad debts expense is also recognized as an estimate of the amount of is also recognized as an estimate of the amount of revenue which may eventually prove uncollectible.revenue which may eventually prove uncollectible.

The offset to this expense is called the The offset to this expense is called the allowance allowance for uncollectible accounts:for uncollectible accounts:

Bad debt expense 134,000 Allowance for uncollectible accounts 134,000To record losses from estimated uncollectible accounts

The allowance is a contra asset with a credit balance. And when it is subtracted from accounts receivable, the difference (net accounts receivable) represents an estimate of the cash value of accounts receivable.

Credit Sales BasisCredit Sales Basis

1.1. Begin with credit sales for the period.Begin with credit sales for the period.

2.2. Estimate the amount of uncollectible sales, Estimate the amount of uncollectible sales,

– Typically as a percentage of sales.Typically as a percentage of sales.

– This percentage may be based on This percentage may be based on experience coupled with current experience coupled with current economic conditions.economic conditions.

3.3. Debit an expense (sometimes called loss or Debit an expense (sometimes called loss or provision for bad debts) for this amount.provision for bad debts) for this amount.

1.1. Begin with credit sales for the period.Begin with credit sales for the period.

2.2. Estimate the amount of uncollectible sales, Estimate the amount of uncollectible sales,

– Typically as a percentage of sales.Typically as a percentage of sales.

– This percentage may be based on This percentage may be based on experience coupled with current experience coupled with current economic conditions.economic conditions.

3.3. Debit an expense (sometimes called loss or Debit an expense (sometimes called loss or provision for bad debts) for this amount.provision for bad debts) for this amount.

Credit Sales BasisCredit Sales Basis

4.4. Credit the allowance account for the Credit the allowance account for the same amountsame amount

5.5. When specific accounts are determined When specific accounts are determined to be uncollectible:to be uncollectible:

– Credit the specific account receivable Credit the specific account receivable removing it, removing it,

– Debit the allowance for uncollectible Debit the allowance for uncollectible accounts reducing it.accounts reducing it.

4.4. Credit the allowance account for the Credit the allowance account for the same amountsame amount

5.5. When specific accounts are determined When specific accounts are determined to be uncollectible:to be uncollectible:

– Credit the specific account receivable Credit the specific account receivable removing it, removing it,

– Debit the allowance for uncollectible Debit the allowance for uncollectible accounts reducing it.accounts reducing it.

Net Receivables & Aging of A.R. Net Receivables & Aging of A.R. BasisBasis

1.1. Estimate the net amount of receivables Estimate the net amount of receivables expected.expected.

2.2. Take this amount as the ending balance Take this amount as the ending balance in the allowance for uncollectible in the allowance for uncollectible accounts.accounts.

3.3. Credit the allowance account for the Credit the allowance account for the amount needed to bring the current amount needed to bring the current balance up to the amount that was balance up to the amount that was estimated in step 1.estimated in step 1.

1.1. Estimate the net amount of receivables Estimate the net amount of receivables expected.expected.

2.2. Take this amount as the ending balance Take this amount as the ending balance in the allowance for uncollectible in the allowance for uncollectible accounts.accounts.

3.3. Credit the allowance account for the Credit the allowance account for the amount needed to bring the current amount needed to bring the current balance up to the amount that was balance up to the amount that was estimated in step 1.estimated in step 1.

Net Receivables & Aging of A.R. Net Receivables & Aging of A.R. Basis (Cont.)Basis (Cont.)

4.4. Offset this credit with a debit to bad Offset this credit with a debit to bad debt expense for the same amount.debt expense for the same amount.

5.5. When specific accounts are determined When specific accounts are determined to be uncollectible:to be uncollectible:

– Credit the specific account receivable Credit the specific account receivable removing it, removing it,

– Debit the allowance for uncollectible Debit the allowance for uncollectible accounts reducing it.accounts reducing it.

4.4. Offset this credit with a debit to bad Offset this credit with a debit to bad debt expense for the same amount.debt expense for the same amount.

5.5. When specific accounts are determined When specific accounts are determined to be uncollectible:to be uncollectible:

– Credit the specific account receivable Credit the specific account receivable removing it, removing it,

– Debit the allowance for uncollectible Debit the allowance for uncollectible accounts reducing it.accounts reducing it.

Aging of Accounts ReceivableAging of Accounts Receivable

How do you estimate the net amount of How do you estimate the net amount of receivables?receivables?

One method is to analyze the accounts One method is to analyze the accounts receivable and apply the assumption receivable and apply the assumption that overdue accounts are more likely to that overdue accounts are more likely to eventually prove uncollectible and the eventually prove uncollectible and the more overdue the account, the more more overdue the account, the more likely it will prove uncollectible.likely it will prove uncollectible.

How do you estimate the net amount of How do you estimate the net amount of receivables?receivables?

One method is to analyze the accounts One method is to analyze the accounts receivable and apply the assumption receivable and apply the assumption that overdue accounts are more likely to that overdue accounts are more likely to eventually prove uncollectible and the eventually prove uncollectible and the more overdue the account, the more more overdue the account, the more likely it will prove uncollectible.likely it will prove uncollectible.

Aging of Accounts Receivable Aging of Accounts Receivable (cont.)(cont.)

An aging schedule separates the accounts An aging schedule separates the accounts receivable into layers. receivable into layers.

– The base layer is comprised of all the The base layer is comprised of all the accounts that are current or not overdueaccounts that are current or not overdue

– Layers are added at intervals of perhaps Layers are added at intervals of perhaps 30 days separating accounts according to 30 days separating accounts according to their agetheir age

– Different percentages are applied to each Different percentages are applied to each layer with higher percentages being layer with higher percentages being assigned to the older accountsassigned to the older accounts

An aging schedule separates the accounts An aging schedule separates the accounts receivable into layers. receivable into layers.

– The base layer is comprised of all the The base layer is comprised of all the accounts that are current or not overdueaccounts that are current or not overdue

– Layers are added at intervals of perhaps Layers are added at intervals of perhaps 30 days separating accounts according to 30 days separating accounts according to their agetheir age

– Different percentages are applied to each Different percentages are applied to each layer with higher percentages being layer with higher percentages being assigned to the older accountsassigned to the older accounts

Aging of Accounts Receivable Aging of Accounts Receivable (cont.)(cont.)

The sum of the The sum of the product of the product of the balance in a layer balance in a layer with its associated with its associated percentage gives percentage gives an estimate of the an estimate of the net amount of net amount of uncollectible uncollectible receivables.receivables.

The sum of the The sum of the product of the product of the balance in a layer balance in a layer with its associated with its associated percentage gives percentage gives an estimate of the an estimate of the net amount of net amount of uncollectible uncollectible receivables.receivables.

An Illustration of the Allowance An Illustration of the Allowance AccountAccount

Joe, a customer charges $5 of merchandise in Joe, a customer charges $5 of merchandise in year 1.year 1.

In year 1, we do not know whether a specific In year 1, we do not know whether a specific account may eventually prove uncollectible, so account may eventually prove uncollectible, so we recognize revenue for the amount of the we recognize revenue for the amount of the credit sale to Joe.credit sale to Joe.

At the end of year 1, we have to estimate the At the end of year 1, we have to estimate the bad debt expense associated with that year’s bad debt expense associated with that year’s sales. We may use either the percentage of sales. We may use either the percentage of sales method or the net receivables method. sales method or the net receivables method. Consider this amount to be estimated to be Consider this amount to be estimated to be $100. $100.

Joe, a customer charges $5 of merchandise in Joe, a customer charges $5 of merchandise in year 1.year 1.

In year 1, we do not know whether a specific In year 1, we do not know whether a specific account may eventually prove uncollectible, so account may eventually prove uncollectible, so we recognize revenue for the amount of the we recognize revenue for the amount of the credit sale to Joe.credit sale to Joe.

At the end of year 1, we have to estimate the At the end of year 1, we have to estimate the bad debt expense associated with that year’s bad debt expense associated with that year’s sales. We may use either the percentage of sales. We may use either the percentage of sales method or the net receivables method. sales method or the net receivables method. Consider this amount to be estimated to be Consider this amount to be estimated to be $100. $100.

An Illustration of the Allowance An Illustration of the Allowance Account (cont.)Account (cont.)

In year 2, we determine that the In year 2, we determine that the customer’s $5 receivable is uncollectible. customer’s $5 receivable is uncollectible. We write this account off but do not We write this account off but do not recognize an expense here. The recognize an expense here. The expense was anticipated by the journal expense was anticipated by the journal entry at the end of year 1.entry at the end of year 1.

Instead, we reduce the allowance Instead, we reduce the allowance account.account.

In year 2, we determine that the In year 2, we determine that the customer’s $5 receivable is uncollectible. customer’s $5 receivable is uncollectible. We write this account off but do not We write this account off but do not recognize an expense here. The recognize an expense here. The expense was anticipated by the journal expense was anticipated by the journal entry at the end of year 1.entry at the end of year 1.

Instead, we reduce the allowance Instead, we reduce the allowance account.account.

An Illustration of the Allowance An Illustration of the Allowance AccountAccount

year 1 account receivable -- Joe 5 sales revenue 5

year 1 bad debts expense 100 allowance for uncollectible accounts 100

year 2 allowance for uncollectible accounts 5 accounts receivable -- Joe 5

An Illustration of the Allowance An Illustration of the Allowance AccountAccount

A.R. -- Joe sales revenue bad debts exp. allow for u.a. 5 5

100 100 5 5

An International PerspectiveAn International Perspective The International Accounting Standards The International Accounting Standards

Committee (IASC) says that the firm should Committee (IASC) says that the firm should recognize revenue when:recognize revenue when:

1.1. The seller has transferred significant risks and The seller has transferred significant risks and rewards of ownership to the buyerrewards of ownership to the buyer

2.2. Managerial involvement and control has Managerial involvement and control has passed from seller to the buyerpassed from seller to the buyer

3.3. The seller can reliably measure the amount of The seller can reliably measure the amount of revenuerevenue

4.4. It is probable that the seller will receive It is probable that the seller will receive economic benefiteconomic benefit

5.5. The seller can reliably measure the costs The seller can reliably measure the costs (including future costs) of the transactions(including future costs) of the transactions

The International Accounting Standards The International Accounting Standards Committee (IASC) says that the firm should Committee (IASC) says that the firm should recognize revenue when:recognize revenue when:

1.1. The seller has transferred significant risks and The seller has transferred significant risks and rewards of ownership to the buyerrewards of ownership to the buyer

2.2. Managerial involvement and control has Managerial involvement and control has passed from seller to the buyerpassed from seller to the buyer

3.3. The seller can reliably measure the amount of The seller can reliably measure the amount of revenuerevenue

4.4. It is probable that the seller will receive It is probable that the seller will receive economic benefiteconomic benefit

5.5. The seller can reliably measure the costs The seller can reliably measure the costs (including future costs) of the transactions(including future costs) of the transactions

An International Perspective An International Perspective (cont.)(cont.)

In addition, the IASC recommendsIn addition, the IASC recommends

– The allowance method for The allowance method for uncollectiblesuncollectibles

– The percentage of completing method The percentage of completing method for servicesfor services

– The matching principle for timing of The matching principle for timing of expense recognitionexpense recognition

In addition, the IASC recommendsIn addition, the IASC recommends

– The allowance method for The allowance method for uncollectiblesuncollectibles

– The percentage of completing method The percentage of completing method for servicesfor services

– The matching principle for timing of The matching principle for timing of expense recognitionexpense recognition

Chapter SummaryChapter Summary This chapter has presented concepts of This chapter has presented concepts of

measurement of receivables and revenue.measurement of receivables and revenue.

Quality of earnings was defined as choosing Quality of earnings was defined as choosing those measurement methods that fairly those measurement methods that fairly present the economic performance of the firm.present the economic performance of the firm.

The income recognition principle was The income recognition principle was presented along with some income recognition presented along with some income recognition rules. rules.

Uncollectible accounts were presented Uncollectible accounts were presented including: allowance and direct-write-off including: allowance and direct-write-off methods of matching bad debt expense and methods of matching bad debt expense and aging of accounts receivable.aging of accounts receivable.

This chapter has presented concepts of This chapter has presented concepts of measurement of receivables and revenue.measurement of receivables and revenue.

Quality of earnings was defined as choosing Quality of earnings was defined as choosing those measurement methods that fairly those measurement methods that fairly present the economic performance of the firm.present the economic performance of the firm.

The income recognition principle was The income recognition principle was presented along with some income recognition presented along with some income recognition rules. rules.

Uncollectible accounts were presented Uncollectible accounts were presented including: allowance and direct-write-off including: allowance and direct-write-off methods of matching bad debt expense and methods of matching bad debt expense and aging of accounts receivable.aging of accounts receivable.

Chapter Summary (Cont.)Chapter Summary (Cont.)

The accrual basis of accounting provides measures of operating performance that are superior to those provided by cash flow basis:recognizing revenues when

earned and measurable rather than when cash is received,

matching expenses to revenues without regard for when the timing of the cash outflow.

The accrual basis of accounting provides measures of operating performance that are superior to those provided by cash flow basis:recognizing revenues when

earned and measurable rather than when cash is received,

matching expenses to revenues without regard for when the timing of the cash outflow.

Appendix 6.1 – Effects on the Appendix 6.1 – Effects on the Statement of Cash Flows of Statement of Cash Flows of

Transactions Involving Accounts Transactions Involving Accounts ReceivableReceivable

Transactions changing accounts Transactions changing accounts receivable are operating activities.receivable are operating activities.

Under indirect method, to compute Under indirect method, to compute cash flow from operations: cash flow from operations:

– Increase in accounts receivable is Increase in accounts receivable is subtracted from net income.subtracted from net income.

– Decrease in accounts receivable is Decrease in accounts receivable is added to net income.added to net income.

Transactions changing accounts Transactions changing accounts receivable are operating activities.receivable are operating activities.

Under indirect method, to compute Under indirect method, to compute cash flow from operations: cash flow from operations:

– Increase in accounts receivable is Increase in accounts receivable is subtracted from net income.subtracted from net income.

– Decrease in accounts receivable is Decrease in accounts receivable is added to net income.added to net income.

Appendix 6.1 (Cont.)Appendix 6.1 (Cont.) Most firms report changes in accounts Most firms report changes in accounts

receivable net of allowance for receivable net of allowance for uncollectible accounts as a single line in uncollectible accounts as a single line in Operating Activities….Operating Activities….

With no further adjustments in that With no further adjustments in that section for uncollectible accounts to section for uncollectible accounts to derive cash flow from operations.derive cash flow from operations.

Firms with significant uncollectibles may Firms with significant uncollectibles may disclose separately. If they report gross disclose separately. If they report gross changes in accounts receivable in the changes in accounts receivable in the Operating Activities section, they must Operating Activities section, they must add-back to net income for bad debt add-back to net income for bad debt expense.expense.

Most firms report changes in accounts Most firms report changes in accounts receivable net of allowance for receivable net of allowance for uncollectible accounts as a single line in uncollectible accounts as a single line in Operating Activities….Operating Activities….

With no further adjustments in that With no further adjustments in that section for uncollectible accounts to section for uncollectible accounts to derive cash flow from operations.derive cash flow from operations.

Firms with significant uncollectibles may Firms with significant uncollectibles may disclose separately. If they report gross disclose separately. If they report gross changes in accounts receivable in the changes in accounts receivable in the Operating Activities section, they must Operating Activities section, they must add-back to net income for bad debt add-back to net income for bad debt expense.expense.