Revenue Recognition issues

1
Revenue Recognition issues

• One of the biggest sources of
• misreporting relates revenue recognition issues

2
Recognition of Sales Revenue

• Most revenues are recognized at the point of sale
• Either cash is received or
• The company has a right to expect cash (acct.
  receivable)

3
Measurement of Sales Revenue

• Revenue is measured in terms of the cash
  equivalent value of the asset received.
• Journal entries
• Cash xxxx
• Sales revenue xxxx
• Accounts receivable xxxx
• Sales revenue xxxx

4
Merchandise Returnsand Allowances

• Sales returns - products returned by the
  purchaser
• The purchaser calls them purchase returns.
• Sales allowance - reduction of the selling price,
  which is the original price previously agreed
  upon
• The purchaser calls them purchase allowances.
• Sometimes, instead of returning merchandise, the
  customer demands a reduction in the selling
  price. That reduction is a sales allowance.

5
Merchandise Returnsand Allowances

• Gross sales - total sales revenue before
  deducting sales returns and allowances
• Net sales - total sales revenue reduced by sales
  returns and allowances

6
Merchandise Returnsand Allowances

• Usually, a contra account, Sales Returns and
  Allowances, is used to accumulate both sales
  returns and sales allowances.
• A contra account is used so managers can watch
  the level of returns and allowances. By using a
  contra account, the amount of gross sales is
  readily available.
• Returns happen after the original sale. Using
  the contra account avoids changing the original
  sales entry.

7
Merchandise Returnsand Allowances

• Journal entries
• To record the sale
• Accounts receivable 900,000
• Sales revenue 900,000
• To record the returns and allowances
• Sales returns and allowances 80,000
• Accounts receivable 80,000

8
Merchandise Returnsand Allowances

• Income statement presentation
• Gross sales 900,000
• Less Sales returns and allowances
  80,000
• Net sales 820,000

9
Merchandise Returnsand Allowances

• Discounts on sales also affect reported sales.
• Two major types of discounts
• Trade discounts
• Cash discounts

10
Merchandise Returnsand Allowances

• Trade discounts - reductions to the gross selling
  price for a particular class of customers to
  arrive at the actual selling price (invoice
  price)
• Trade discounts are generally price concessions
  or purchase incentives.
• The gross sales revenue recognized from a trade
  discount is the price received after deducting
  the discount.

11
Merchandise Returnsand Allowances

• Cash discounts - reductions of invoice prices
  awarded for prompt payment of the invoice
• encourage prompt payment
• reduce manufacturers or sellers need for cash
• reduces the risk of bad debts (nonpayment)
• Purchasers should always take purchase discounts
  if possible.

12
Examples of cash discounts

• N/30 full price is due 30 days after invoice
  date
• 2/10, n/30 a 2 discount can be taken if paid in
  10 days, otherwise the full price is due in 30
  days.
• 10 e.o.m. The full price is due within 10 days
  of the end of the month following the sale.

13
Accounting forNet Sales Revenue

• Cash discounts and sales returns and allowances
  are recorded as deductions from gross sales.
• Gross sales 20,000
• Deduct
• Sales returns and allowances (200)
• Cash discounts on sales ( 550)
• ( 750)
• Net sales 19,250

14
Revenue recognition problems

• Fraud, sales did not take place at all
• Buying party is not independent of seller Revenue
  recognition problems
• Sales are for credit and collection is doubtful
• Buyer can return merchandise returns are not
  estimable

15
Credit Sales andAccounts Receivable

• Accounts receivable - amounts owed to a company
  by customers as a result of delivering goods or
  services and extending credit in the ordinary
  course of business
• Also known as trade receivables or simply
  receivables

16
Uncollectible Accounts

• Uncollectible accounts (bad debts) - receivables
  determined to be uncollectible because debtors
  are unable or unwilling to pay their debts
• Uncollectible accounts are a major cost of
  granting credit to customers.
• Accountants call this cost bad debts expense or
  provision for bad debts
• Extent of nonpayment can vary greatly with size
  of companies and industries.

17
Decision to offer credit

• How does a business decide if credit will pay
  off?
• They should offer credit so long as the
  additional earnings from offering credit exceed
  the costs to offer it.
• Administrative cost
• Bad debt cost

18
Measurement ofUncollectible Accounts

• Two basic ways to record uncollectible accounts
• Specific write-off method - wait to see which
  receivables will not be paid and write them off
  at that time (required for tax purposes)
• Allowance method - make estimates of the portion
  of accounts receivable that will not be collected
  (required for financial accounting)

19
Allowance Method

• The allowance method estimates the amount of
  uncollectible accounts to be matched to the
  related revenue.
• It allows accountants to recognize bad debts
  during the proper period, before specific
  uncollectible accounts are identified in a
  subsequent period.

20
Allowance Method

• The allowance method has two basic elements
• An estimate of the amount of sales that will
  ultimately be uncollectible
• A contra account (allowance for uncollectible
  accounts), which records the estimate and is
  deducted from accounts receivable
• The allowance method is based on historical
  experience and the assumption that the current
  year is similar to prior years.

21
Allowance Method

• Presentation of Accounts Receivable under the
  allowance method
• Accounts receivable 40,000
• Less Allowance for uncollectible accounts
  2,000
• Net accounts receivable 38,000
• 
  

22
Using a Percentage of Sales

• Percentage of sales method - an approach to
  estimating bad debts expense and uncollectible
  accounts based on historical relations between
  credit sales and uncollectible accounts
• Bad debts are assumed to be some percentage of
  sales.

23
Example Using Percentage of Sales

• Martin Company has 150,000 in credit sales.
  Historically, 2 of credit sales are determined
  to be uncollectible. During the year, Martin
  Company determines that 2,000 of receivables are
  actually uncollectible. What are the entries to
  record the sales, establish the Allowance
  account, and write off the uncollectible accounts?

24
Using a Percentage of Sales

• The entry to record the sales
• Accounts receivable 150,000
• Sales 150,000
• The entry to record the estimate for bad debts
• Bad debts expense 3,000
• Allowance for uncollectible accounts
  3,000
• The entry to record actual uncollectible
  accounts
• Allowance for bad debts 2,000
• Accounts receivable 2,000

25
Percentage of Accounts Receivable

• Percentage of accounts receivable method - an
  approach to estimating bad debts expense and
  uncollectible accounts at year end using the
  historical relations of uncollectible accounts to
  accounts receivable

26
Percentage of Accounts Receivable

• The amount added to allowance for uncollectible
  accounts is the approximate amount of bad debts
  included in the ending accounts receivable.
• Additions to Allowance for Uncollectible Accounts
  are calculated to achieve a desired ending
  balance in the allowance account.
• An adjusting journal entry is made to adjust the
  balance in the Allowance account to the desired
  balance at the end of the year.

27
Using a Percentage of Accounts Receivable

• Calculating the allowance under the percentage of
  receivables method
• Divide average bad debts written off by average
  ending balance of Accounts Receivable to
  calculate the historical average uncollectible
  percentage.
• Apply the percentage from step 1 to ending
  accounts receivable balance to determine the
  desired ending balance in the Allowance account
  at the end of the year.
• Prepare an adjusting entry to bring the Allowance
  to the appropriate amount determined in step 2.

28
Example of percentage of Accounts receivable

• Teton Equipment company had credit sales of 6
  million during 19X7. On December 31, 19X7
  Accounts receivable were 450,000. The Allowance
  for Bad Debt account, before any recognition of
  19X7 bad debts, had a 1,200 debit balance. Over
  the last 6 year an average of 18 of the December
  31 accounts receivable has not been collected.
• Required Prepare the journal entry to record
  estimated bad debt expense for Teton

29
Teton Bad debt expense

• (Percentage of ending AR method)
• Target balance in ending accounts receivable
• 450,000 x .18 81,000 (credit balance)
• Current balance 1,200 debit balance
• Entry needed to bring the balance to the target
  balance- 81,0001,200 82,200 bad debt expense

30
Teton bad debt expense

• AR method continued
• Bad Debt Expense 82,200
• Allowance for uncollectible accounts 82,200

31
Aging of Accounts Receivable

• Aging of accounts receivable method - an analysis
  of the elements of individual accounts receivable
  according to the time elapsed after the dates of
  billing
• The more time elapses after the date, the less
  likely collection of the receivable becomes.
• The aging gives a desired balance in the
  Allowance account just as the percentage of
  accounts receivable method does.

32
Using the Aging of Accounts Receivable

• Accounts receivable aging schedule
• 1-30 days 31-90 days over 90 days Total
• Accounts
• receivable 70,000 30,000 2,000
• Percentage 1 2
  90
• 700 600 1,800 3,100
• 
  
  
• 3,100 is the desired amount in the Allowance
  account. A journal entry will be made to adjust
  the Allowance account to that amount.

33
Aging accounts receivable

• Supposed the balance in the allowance account
  prior to the adjustment is 1,000 credit balance.
  Then the adjusting entry needed is
• Bad debt expense 2,100
• Allowance for uncollectible 2,100

34
Bad Debt Recoveries

• Sometimes accounts will be collected after they
  have been written off.
• When this happens, the write-off should be
  reversed and the collection handled as a normal
  receipt on account.

35
Assessing the Level ofAccounts Receivable

• Management likes to monitor the ability of the
  company to control accounts receivable.
• Accounts receivable turnover - a measure of the
  ability of a company to control accounts
  receivable

36
Assessing the Level ofAccounts Receivable

• Accounts receivable turnover indicates how
  rapidly collections of accounts receivable occur.
• The ratio tells how many times, on average,
  accounts receivable turn over during the year.
• Higher turnovers indicate that receivables are
  collected quickly.
• Lower turnovers indicate that receivables are
  collected more slowly.

37
Assessing the Level ofAccounts Receivable

• Days to accounts receivable (average collection
  period) - how long it takes to collect money
  after a sale

38
Financing receivables

• Interest receivable on notes and borrowings
• Recorded as
• Interest receivable (an asset) (dr.)
• Interest income (revenue) (Credit)

39
Sale of receivables

• Many companies sell or finance their receivables.
  This is called factoring
• Receivables can be sold with or without recourse.
  If sold with recourse, then the buyer has the
  right to demand payment if the original debtor
  does not pay. If sold without recourse, then the
  buyer takes on the risk of nonpayment.
• GAAP requires that receivables cannot be recorded
  as sold if substantial risk remains with the
  selling entity.

40
Securitization

• A form of receivable sale where receivables are
  sold to a trust that is often fully or partially
  controlled by the selling entity.
• As in factoring, in order to report receivables
  as sold the risk of loss must not be on the
  selling entity.