Ch. 5 - Revenue and Receivables

Revenue Recognition Principle

1. identify the contract with a customer

2. identify the performance obligation(s) in the contract

3. determine the transaction price

4. allocate the transaction price to each performance obligation

5. recognize revenue when (or as) each performance obligation is satisfied

Performance obligation

• an obligation to pay the seller

• received legal title to the good or received the service

• physical possession of the asset

• assumed the risk and reward of ownership to the good or receiving the service

• accepted the goods or service

When to recognize revenue over a period of time

1. the customer consumes the benefit of the seller’s work as it is performed

2. the customer control the asset as it is created (e.g. constructing a building extension)

3. the seller is creating an asset that has no alternative use to the seller and the seller has the legal right to receive payment for progress to date

Net revenues

total revenues - sales returns - trade discounts - sales discounts

Trade discounts

reduction in list price of a product or service

Sales discounts

reduction in the amount to be received from a credit customer if collection on account occurs within a specified period

Credit sales

transfer goods or services to a customer today while bearing the risk of collecting payment from that customer in the future

Allowance method

• companies must:

  • 1. estimate the amount of current ARs that will prove to be uncollectible in the future

  • 2. report this estimate as a contra-asset to its AR (credit balance)

• companies report its AR for the net amount expected to be collected

Allowance Method Steps

1. at the end of the initial year, establish an allowance by estimating future uncollectible accounts

2. during the subsequent year, write off actual bad debts as uncollectible

3. at the end of the subsequent year, once again estimate future uncollectible accounts

Net accounts receivables

total accounts receivable - allowance for uncollectible accounts

Writing off ARs

• reduces the balance of AR

• reduced the balance of the contra-asset account AFUA

• has no effect on total assets (balance sheet) or total expenses (income statement)

• bad debt expense is NOT reported

Percentage-of-Receivables

method of estimating uncollectible accounts based on the percentage of accounts receivable expected not to be collected

Aging Method

• the older the account, the less likely it is to be collected

• bases the estimate of future bad debts on the various ages of individual AR, using a higher percentage for “old” accounts than for “new” accounts

Adjusting AFUA

• the year-end adjusting entry for future uncollectible accounts is affected by the current balance of AFUA before adjustment

• the current balance before adjustment equals the balance of the allowance account at the beginning of the current year (or end of last year) minus actual write-offs in the current year

Direct Write-Off Method

• bad bets are written off only at the time they actually become uncollectible

• NOT GAAP

Allowance Ratio

• AFUA / gross accounts receivables

• can provide indication of the quality of the net AR balance reported in the balance sheet