Chapter 5: Receivables and Revenue Reporting, and Analyzing Sales

Chapter 5: Receivables and Revenue Reporting, and Analyzing Sales

Learning Objectives

  • Apply the criteria for revenue recognition.

  • Measure and report net sales revenue.

  • Explain the principal types of receivables.

  • Measure and report bad debt expense and the allowance for doubtful accounts.

Timing of Revenue Recognition

  • Cash-Basis Accounting:

    • Revenue is recognized in the period when payment is received.

    • Such recognition is typical for tax returns.

  • Accrual-Basis Accounting:

    • Revenue is recognized when it is:

    • Realized or realizable: Non-cash resources, such as inventory, have been exchanged for cash (or near cash-like accounts receivable).

    • Earned: The earnings process is substantially complete.

Conditions for Revenue Recognition

  • Five conditions must be met for revenue to be recognized:

    1. The significant risks and rewards of ownership have been transferred to the purchaser by the seller.

    2. The amount of revenue can be readily measured.

    3. The seller has not retained continuing managerial involvement to the degree usually associated with ownership or effective control over the goods sold.

    4. It is probable that the economic benefits (usually payment) associated with the transaction will flow to the seller.

    5. Costs incurred or to be incurred with respect to the transaction can be reliably measured.

Amount of Revenue Recognized

  • The appropriate amount of revenue generally recognized is typically the cash received or the cash equivalent of the receivable.

  • Four changes to sales revenues are accounted for:

    • Sales discounts

    • Credit card discounts

    • Sales returns

    • Sales allowances

Sales Discounts and Credit Card Discounts

  • Sales Discounts:

    • Offered to encourage prompt payment.

    • Reduction of the normal selling price beneficial to both seller and buyer:

    • For buyers, it reduces the cost of goods/services.

    • For sellers, it improves cash flow and reduces collection costs.

  • Notation of Discounts:

    • Standard notation for sales invoices indicates discount terms.

    • Example: An invoice stating terms of 2/10, n/30 means:

    • 2% discount if paid within 10 days, net amount due in 30 days.

  • Most companies record the sale and receivable at the gross (pre-discount) amount of the invoice.

  • When a discount is taken, the amount of the discount is recorded in a contra-revenue account called Sales Discounts.

Recording Sales Discounts: Example

  • Information:

    • On May 5, 2022, GCD Advisers billed Richardson's Wholesale Hardware $15,000 for consulting services; 2/10, n/30 terms.

  • Journal Entries:

    1. Record the sale using the gross method:

    • Date: May 5, 2022

      • Debit: Accounts Receivable $15,000

      • Credit: Sales Revenue $15,000

    1. Assuming payment is received on May 15, 2022 (within discount period):

    • Debit: Cash $14,700

    • Debit: Sales Discounts $300

    • Credit: Accounts Receivable $15,000

    1. Assuming payment is received on May 25, 2022 (after discount period):

    • Debit: Cash $15,000

    • Credit: Accounts Receivable $15,000

  • Sales Revenue Disclosure:

    • Partial statement of earnings:

    • Sales revenue: $15,000

    • Less: Sales discounts: $(300)

    • Net sales: $14,700

Monitoring Sales Discounts

  • Important to track changes in customer behavior regarding discount usage:

    • Customers stopping the use of discounts may indicate cash flow issues or potential credit risks.

  • Distinction of Discounts:

    • Trade Discounts: Reduction in price for specific customer classes.

    • Quantity Discounts: Reduction for larger orders due to decreased selling costs per unit.

Sales Returns and Allowances

  • Occasionally, customers return goods as unsatisfactory, or they may accept goods with minor defects for an allowance or price reduction.

  • Goods delivered late or rendered less valuable may lead to accepting lightly defective items with an allowance.

  • A contra-revenue account called Sales Returns and Allowances is used to record these reductions in price.

  • Merchandise returned by customers is classified as sales returns, recorded simultaneously in the Sales Returns and Allowances account.

Types of Receivables

  • Receivables can typically be categorized in three dimensions:

    • Accounts Receivable vs. Notes Receivable:

    • Notes receivable is a legal document specifying repayment timing and amount and may include interest.

    • Accounts receivable does not involve a formal note.

    • Current vs Noncurrent Receivables:

    • Both accounts and notes receivable are typically classified as current, but accounts are usually due in 30-60 days without interest. Notes are often due in 3-12 months, including interest.

Valuation of Accounts Receivable and Accounting for Bad Debts

  • IFRS Requirement: Accounts receivable must be reported at their net realizable value (the cash expected to be collected considering impaired receivables).

  • Bad Debts: Arise when customers do not pay their accounts receivable; they are also known as uncollectible accounts or impaired accounts.

  • Methods to Record Bad Debt Expense:

    • Direct Write-Off Method

    • Allowance Method

Direct Write-Off Method

  • This method waits until an account is deemed uncollectible before reducing accounts receivable and recording bad debt expense.

  • Due to typically identifying accounts as uncollectible in periods subsequent to the sale, it is inconsistent with the matching concept.

Allowance Method

  • Under the allowance method, bad debt expense is recognized in the period of sale, following the matching concept whereby revenue and expense are matched.

  • The Allowance for Doubtful Accounts stores estimates of potentially uncollectible accounts.

  • When a specific account is deemed uncollectible, it is written off by debiting the Allowance account and crediting accounts receivable.

  • Common Methods to Estimate Bad Debt Expense:

    • Percentage of Credit Sales Method

    • Aging Method

Percentage of Credit Sales Method

  • This method estimates bad debt expense based on historical data where a percentage of current period's credit sales is expected to become uncollectible.

  • The formula used is:
    extEstimatedBadDebtExpense=extTotalCreditSalesimesextPercentageofCreditSalesEstimatedtoDefaultext{Estimated Bad Debt Expense} = ext{Total Credit Sales} imes ext{Percentage of Credit Sales Estimated to Default}

Aging Method

  • The aging method estimates bad debt expense by assessing the collectability of accounts receivable rather than taking a percentage of total credit sales.

  • Accounts receivable are categorized by age at the end of each accounting period.

  • Estimates of defaults are made for each age category, driven by historical data and considerations regarding future deviations.

  • The objective of the aging method is to estimate the ending balance in the Allowance for Doubtful Accounts, factoring in any existing balance.