Principles of Financial Accounting - Chapter 5: Sales and Receivables

Revenue Recognition

Under accrual accounting, revenue is recognized when the company's performance obligation is satisfied by transferring control of the promised good or service to the customer.

Cash-Basis Revenue Recognition

Revenue is recognized when cash is received.

Accrual-Basis Revenue Recognition

Revenue is recognized when the performance obligation is satisfied, even if cash has not yet been received.

GAAP and Revenue Recognition

GAAP requires accrual-basis accounting.

When Is Revenue Generally Earned?

When goods have been delivered or a service has been performed and control has transferred to the customer.

Does Cash Have to Be Received Before Revenue Is Recognized?

No. The company must have reasonable assurance that it will eventually collect the cash.

Service Company Revenue Recognition

Service companies recognize revenue in the period the service is provided.

Seller of Goods Revenue Recognition

Sellers of goods recognize revenue when control or title passes to the customer.

Performance Obligation

A promise in a contract to provide a good or service to a customer.

Five-Step Revenue Recognition Model

Identify the contract; identify performance obligations; determine transaction price; allocate transaction price; recognize revenue when the performance obligation is satisfied.

Revenue Recognition Step 1

Identify the contract with the customer.

Revenue Recognition Step 2

Identify the performance obligations in the contract.

Revenue Recognition Step 3

Determine the transaction price.

Revenue Recognition Step 4

Allocate the transaction price to the performance obligations.

Revenue Recognition Step 5

Record revenue when or as the entity satisfies the performance obligation.

Amount of Revenue Recognized

Generally the cash received or the cash equivalent of the receivable.

Factors That Reduce Amount of Sales Revenue

Sales discounts, sales returns, and sales allowances.

Sales Discount

A price reduction offered to encourage customers to pay promptly.

2/10, n/30

The customer receives a 2% discount if payment is made within 10 days; otherwise the full amount is due within 30 days.

n/30

The full gross invoice amount must be paid within 30 days.

2/10

A 2% discount is available if payment is made within 10 days.

Net Price

The invoice amount after subtracting a sales discount.

Why Do Sellers Offer Sales Discounts?

To receive cash more quickly and reduce collection costs.

Gross Method

Sales and Accounts Receivable are initially recorded at the full invoice amount when the customer is not expected to take the discount.

Net Method

Sales and Accounts Receivable are initially recorded at the amount after the discount when the customer is expected to take the discount.

When Should the Net Method Be Used?

When the customer is expected to pay within the discount period.

When Should the Gross Method Be Used?

When the customer is not expected to pay within the discount period.

Are Both Gross and Net Methods Acceptable?

Yes.

Gross Method Advantage

It simplifies communication with customers and allows discounts taken to be tracked separately.

Sales Discounts Account

A contra-revenue account that is subtracted from Sales Revenue.

Knowledge Check: $10,000 Sale, 2/10, Net Method

Debit Accounts Receivable $9,800; credit Sales Revenue $9,800.

Trade Discount

A reduction in selling price given to a particular class of customers.

Quantity Discount

A reduction in selling price because larger quantities are ordered.

Sales Return

Occurs when a customer returns goods because they are unsatisfactory or unneeded.

Sales Allowance

A reduction in the price charged because of a problem with the product or service.

Examples of Reasons for a Sales Allowance

Defective products, poor quality, or goods arriving late.

When Should Sales Returns and Allowances Be Recorded?

In the period of sale.

Why Estimate Returns and Allowances?

Some returns occur after the reporting period, so companies estimate them to report sales at the amount expected to be collected.

Net Sales Revenue

Gross sales less sales discounts, returns, and allowances.

Receivable

Money owed to a business by another business or individual.

Three Ways Receivables Are Classified

Accounts vs. notes receivable; current vs. noncurrent; trade vs. nontrade.

Accounts Receivable

Money owed for services performed or goods delivered, typically due within 30-60 days without a formal note or interest.

Notes Receivable

A formal receivable that generally specifies an interest rate and maturity date.

Current Receivable

A receivable expected to be collected within the company's normal current period.

Noncurrent Receivable

A receivable not expected to be collected within the current period.

Trade Receivable

A receivable arising from customers purchasing goods or services in the ordinary course of business.

Nontrade Receivable

A receivable arising from transactions outside the ordinary sale of goods or services.

Examples of Nontrade Receivables

Insurance reimbursements, tax refunds, and employee advances.

Example of a Trade Note Receivable

A 90-day note receivable from a customer purchasing in the normal course of business.

Knowledge Check: Nontrade Receivables

Insurance reimbursement, tax refund, and employee advance receivable.

Interest on a Note Receivable

Principal × Annual Interest Rate × Fraction of 1 Year.

Net Realizable Value of Accounts Receivable

The amount of cash the company expects to actually collect from accounts receivable.

Bad Debt

An account receivable that a customer fails to pay.

Bad Debt Expense

The expense resulting from receivables that are expected not to be collected.

Why Is Bad Debt an Expense Instead of a Reduction of Revenue?

The loss results from the customer's failure to pay rather than an action by the seller.

Two Methods for Bad Debts

Direct write-off method and allowance method.

Direct Write-Off Method

Waits until a specific account is determined to be uncollectible before recording bad debt expense.

Direct Write-Off Entry

Debit Bad Debt Expense; credit Accounts Receivable.

Main Problem With Direct Write-Off Method

Bad debt expense may be recorded in a later period than the related revenue, violating the matching concept.

When Is Direct Write-Off Allowed Under GAAP?

Only when bad debts are immaterial.

Allowance Method

Estimates bad debt expense in the same period as the related sales.

Why Is the Allowance Method Preferred?

It properly matches bad debt expense with related revenues.

Allowance for Doubtful Accounts

A contra-asset account used to accumulate estimated uncollectible receivables.

Normal Balance of Allowance for Doubtful Accounts

Credit.

Accounts Receivable Net Realizable Value

Accounts Receivable − Allowance for Doubtful Accounts.

Initial Allowance Method Adjusting Entry

Debit Bad Debt Expense; credit Allowance for Doubtful Accounts.

Write-Off Under the Allowance Method

Debit Allowance for Doubtful Accounts; credit Accounts Receivable.

Does a Write-Off Under the Allowance Method Create New Bad Debt Expense?

No. The expense was already estimated earlier.

Does a Write-Off Change Net Realizable Value?

No. Both Accounts Receivable and Allowance for Doubtful Accounts decrease by the same amount.

Two Ways to Estimate Bad Debts Under the Allowance Method

Percentage of credit sales method and aging method.

Percentage of Credit Sales Method

Estimates bad debt expense as a percentage of current-period credit sales.

Percentage of Credit Sales Formula

Total Credit Sales × Estimated Default Percentage = Bad Debt Expense.

Percentage of Credit Sales Method Focus

Income statement and bad debt expense.

Does Percentage of Credit Sales Consider the Existing Allowance Balance?

No. The existing allowance balance is ignored when calculating the adjusting entry.

Percentage of Credit Sales Adjusting Entry

The calculated amount is directly recorded as Bad Debt Expense and credited to Allowance for Doubtful Accounts.

Aging Method

Estimates the desired ending balance in Allowance for Doubtful Accounts based on the age of receivables.

Aging Method Focus

Balance sheet and net realizable value of Accounts Receivable.

Why Age Accounts Receivable?

Older receivables generally have a greater probability of being uncollectible.

Typical Aging Categories

Current or less than 15 days overdue, 16-30 days, 31-60 days, and over 61 days.

Aging Method Desired Ending Allowance

The total estimated amount of year-end receivables expected to become uncollectible.

Does the Aging Method Consider the Existing Allowance Balance?

Yes.

Aging Method Adjusting Entry

Desired ending allowance balance − existing credit balance = Bad Debt Expense.

Aging Method With Existing Debit Balance

Desired ending allowance + existing debit balance = required adjusting entry.

Knowledge Check: Aging Method With $35,000 Desired Balance and $4,500 Credit Balance

Bad Debt Expense = $35,000 − $4,500 = $30,500.

Percentage of Credit Sales vs. Aging

Percentage of credit sales estimates bad debt expense; aging estimates the desired ending Allowance for Doubtful Accounts balance.

Income Statement Approach

Percentage of credit sales method.

Balance Sheet Approach

Aging method.

Factor

A method of handling receivables in which the seller receives immediate cash minus a fee and transfers collection rights and risk to another party.

Factoring

Selling receivables to a factor in exchange for immediate cash.

Who Bears Collection Risk After Typical Factoring?

The factor.

Typical Factoring Fee

Approximately 1%-3%.

Why Do Companies Factor Receivables?

To obtain cash sooner instead of waiting for customers to pay.

Securitization

Packaging receivables into financial instruments or securities and selling them to investors.

Internal Control for Sales

Procedures used to ensure reported sales revenue and receivables are valid and accurate.

First Document in the Sales Process

A customer purchase order or similar document.

Purchase Order

Provides evidence that the customer ordered the goods and is obligated to accept and pay for them.

Shipping Document

Evidence that the ordered goods were shipped.

Invoice

A billing document sent to the customer.

When Should a Sale and Receivable Be Recorded?

When the order, shipping, and billing documents are all present.

Three Documents Supporting a Credit Sale

Purchase order, shipping document, and invoice.