Revenue and Customers-Related

Transcription

1 Revenue and Customer-Related Balance Sheet Concepts 1 Revenue and Customers-Related Balance Sheet Concepts TABLE OF CONTENTS Framing the Issues 3 Revenue Recognition Criteria 3 Risks and Risk Sharing 4 Credit Risk 4 Customer Preference Risk and Demand Risk 7 Accounting Implication of Risks 10 Deferred Revenue 13 Receivables 16 Discounts for Early Payments 16 Interest Income 17 Writing off Bad Debts 18 Example 18 Recovering Write-offs 22 Replenishing the Allowance 22 Example 23 Analyzing Bad Debts 27 Searching for Bad Debt Information 27 Interpreting Disclosed Numbers 28 Measuring and Calibrating Credit Risk 30 Warranties 32 Standard Warranties 33 Example 34 Extended Warranties 37

2 2 Navigating Accounting Product Returns 38 Introduction 38 What Do I See? 38 What Happens When Products are Returned? 39 Allowance for Product Returns 42 Beginning Returns Allowance Balances 43 Using Returns Allowance 45 Replenishing Returns Allowance 45 Balance Sheet Presentation and Entries 46 Allowance Components Reported Separately 46 Allowance Components Netted 50 Financial Statement Effects 51 Allowance By-Passed 53 Allowance not Recognized 54 Outsiders Challenge 55 Take-Aways 62

3 Revenue and Customer-Related Balance Sheet Concepts 3 FRAMING THE ISSUES Here we take a deeper look into revenue recognition, the related risks, and the consequences for accounting. The judgments around revenue recognition are extremely complex. These issues often involve challenging business and accounting decisions and users of financial statements need to understand these when interpreting related disclosures. Revenue Recognition Criteria Recall from the Income Statement chapter that revenue must be deferred until four criteria are met: 1. Persuasive evidence of an arrangement: Companies can only recognize revenue when there is persuasive evidence the related sales arrangement and documentation follows normal business practice for the industry. In some industries, this means the buyer must have a purchase order approved by the appropriate level of management. In other cases, formal purchase orders are not required to establish a legitimate sale occurred. 2. Delivery has occurred or service has been rendered: Companies can only recognize revenue when products or services have been delivered. In applying this criteria, the SEC generally requires customer acceptance. Additionally, sellers must have sufficient information to reliably estimate product returns and establish related allowances before revenue can be recognized (as discussed later in this chapter). 3. Fixed or determinable sales price: This criteria aims to prevent revenue recognition when the ultimate price of a product or service is unknown or can not be estimated reliably. 4. Collectibility is reasonably assured: This criteria differs from the other three in that it centers on the customer s performance obligation in a sales arrangement to pay for the good or service rather than on the seller s performance obligations. These criteria apply to a broad range of sales arrangements; but they do not apply to contexts where revenue recognition is guided by specific GAAP such as banking, leasing, and motion picture productions. In fact, U.S. GAAP has over 160 standards that guide revenue recognition. Moreover, applying the four criteria often requires considerable judgment because the SEC recognizes they can not always be interpreted literally. For example, retailers often allow customers to return products for a full refund for a specified return period. Thus, strictly speaking, prices are not fixed at sales dates (they may end up being $0 if a customer

4 4 Navigating Accounting returns products) and thus, customers have not really accepted them. The SEC permits companies to recognize revenue at the sales date in these situations, providing they can reliably estimate returns, which can require considerable judgment, as do many of the revenue recognition criteria. Risks and Risk Sharing Applying the four revenue recognition criteria or industry-specific revenue recognition GAAP, is often complex. Generally, this complexity is due to provisions in the sales arrangements specifying how sellers and buyers assume risks, share risks, or try to protect themselves from bearing risks. This section focuses on two risks particularly important to revenue recognition and related balance sheet accounts (receivables, deferred revenues and various allowances discussed later in this chapter): credit risk and customer preference or demand risk. Credit Risk In addition to being one of the four criteria for revenue recognition, reasonable assurance of collectibility is a necessary condition for staying in business: a business could quickly find itself in bankruptcy if it failed to collect a big chunk of its receivables. While few companies are driven to bankruptcy by customers failing to pay their bills, companies with significant receivables can suffer large decreases in profitability even if a relatively small portion of their customers stop paying their bills. For example, Harley Davidson (HD) reports approximately $5.5 billion of gross receivables on its balance sheet at the end of 2009, which represents nearly 60% of its assets. Some of these receivables are associated with product sales: HD bills independent dealers and distributors outside the US and Canada when it sells them motorcycles. Revenues associated with these sales should only be recognized when HD is reasonably certain it will collect the related receivables and can reliably estimate the amounts that will not be collected the bad debts. The biggest portion of HD s receivables are related to loans or leases. For these receivables, HD should only recognize related interest revenue if it is reasonably assured it will collect the interest and principal on these loans and can reliably estimate the related bad debts. HD also recognized approximately $180 million of bad debt expense for We will discuss this type of expense in great detail later in the chapter. For now, all you need to know is bad debt expense tends to increase when customers are less likely to pay their bills.

5 Revenue and Customer-Related Balance Sheet Concepts 5 HD s $180 million bad debt expense was very significant relative to its $196 million of pretax operating income for To put this in perspective, bad debt expense could have wiped out HD s pretax income if it had increased by about 3% of HD s $5.5 billion of ending receivables. Thus, an outsider valuing HD s stock or an insider managing its receivables should carefully assess the risk of this occurring, which is called credit risk. Additionally, HD must carefully assess credit risk when deciding whether to recognize revenue. Credit risk refers to the possibility a debtor usually a customer for a receivable will not make payments on time, fail to meet covenants, or default on the debt altogether. When these events occur, creditors can usually take one or more legal actions to try and minimize their losses. For example, they can take the debtor to court or seize the collateral, providing the expected benefits from these actions exceed the expected costs. Credit risk depends on two factors that can offset or aggravate each other, depending on the context: Collateral risk: the risk the value of the collateral will decline. By definition, this risk pertains to the asset serving as collateral. General credit risk: the risk associated with the debtor s overall capacity to meet an obligation from its combined assets. This risk is less severe for agreements where the creditor has seniority is paid earlier in the event of bankruptcy. To understand how these risks can offset or aggravate one another, consider a motorcycle loan from Harley Davidson, which is reported as a financing receivable on HD s balance sheet. If the value of the motorcycle appreciates dramatically during the loan period, HD s credit risk is essentially zero, regardless of the debtor-customer s general credit risk: HD can avoid losses by repossessing the motorcycle, if the customer is foolish enough to default on the loan (rather than sell the motorcycle, pay the loan, and keep the balance). Similarly, if the value of the motorcycle depreciates completely, HD will not be overly concerned if the customer has low general credit risk with several other valuable assets and few other obligations: HD can threaten to take the customer to court if the customer tries to default on the loan. Both of these examples illustrate that these two risks can offset each other in some contexts. However, they can also aggravate each other if the value of the debtors assets are correlated. Credit risk is more problematic for some companies than others, depending on the portion of total assets that are receivables or other

6 6 Navigating Accounting debtor-creditor arrangements such as debt investment securities, the length of these agreements, the nature of the collateral, and the debtors financial circumstances. For companies with large receivables balances, estimating the allowance for bad debts requires considerable judgment and slight changes in the assumptions can have dramatic financial-statement consequences. You will know a company s estimates for bad debts require significant judgment if this is identified and discussed in the company s Management Discussion and Analysis (MD&A) sections of their annual reports. In response to the 2002 accounting scandals, the SEC requires companies to identify and discuss their most critical accounting estimates in their MD&A, where two criteria must be met for an estimate to be deemed critical: The estimate requires the company to make assumptions about issues that are highly uncertain at the time when the estimates are made. This criterion directly relates critical accounting estimates to risks. Different estimates the company reasonably could have used for the current reporting period, or changes in accounting estimates reasonably likely to occur from period to period, have a material impact on the company s financial statements and disclosures. Over 30% of the Fortune 100 companies (largest 100 companies measured by sales) and over 50% of Fortune companies included bad debt estimation as a critical accounting estimate in their 2004 annual reports. There are three key lessons here: Get in the habit of studying the critical accounting estimates in the management discussion and analysis sections of annual reports (and 10-Ks or 20-Fs, which are expanded versions of annual reports filed with the SEC) to identify where the accounting might be suspect because it requires considerable judgment, which provides opportunities for honest errors or manipulation. Estimating the allowance for bad debt is frequently listed as a critical accounting estimate and the uncertainty associated with these estimates depends directly on the company s exposure to credit risk. The more you understand the underlying credit risk, the better prepared you will be to assess the reliability of the allowance for bad debts and bad debt expense (discussed later in this chapter).

7 Revenue and Customer-Related Balance Sheet Concepts 7 Companies can take several steps to manage credit risk including: Screening customers carefully before extending credit. Setting credit limits, preventing sales persons from selling customers more goods and services on account once their outstanding receivables hit pre specified limits. Monitoring outstanding receivables and refusing to sell additional products to customers who do not pay their current balances in a reasonable amount of time. Outsourcing customer financing to third parties, who assume the related credit risk. Selling receivables to banks and other financial institutions, which is called factoring. Selling receivables to special purpose entities (SPE) legal entities created for a single purpose buying receivables with cash raised by issuing mostly debt securities. The receivables are said to be securitized because the SPE s investors have debt and equity security claims on only one asset the SPE s receivables. To assess the costs and benefits of taking these actions, insiders and outsiders must understand the accounting issues discussed in this chapter. Customer Preference Risk and Demand Risk Have you ever found yourself conflicted when trying to decide whether to purchase a big-ticket item such as a television, computer, automobile, or house? On the upside, you are beginning to get emotionally attached to the product, believing it has the potential to make a big difference in the quality of your life. On the downside, you are not sure you can afford it and even if you can, you are not sure it is the best way to spend your money or assume debt. Maybe you can get a better deal on the product elsewhere, find a close substitute from a competitor at a lower price, or find a completely different use for your money that gives you more satisfaction, including investing it because you are concerned about the economy or otherwise want to ensure you can consume more in the future. Your uncertainty about this product versus other alternatives for the same or less money reflects your preference risk uncertainty about your preference for a product or service. From the perspective of the person trying to sell you the product and more generally the supply chain he or she represents, the way you resolve this uncertainty has an upside you buy the product and a downside you take your business elsewhere.

8 8 Navigating Accounting From the seller s perspective, your preference risk combined with other customers preference risk increases demand risk uncertainty about the quantity of products that can be sold at various prices. For the most part, we will not be concerned about subtle distinctions between demand risk (that directly affects sellers but only affects buyers indirectly through prices) and customer preference risk (that directly affects both customers and sellers) and will use the terms interchangeably to mean the risk customers will prefer another alternative to a company s products, or buy its products and return them at a later date for a refund. Customer preference (demand) risk either encompasses or is affected by several other risks companies can manage to varying degrees. Some of these risks, such as downturns in the economy, commodity price increases, and increasing competition, are largely beyond companies control. They can take actions to mitigate their consequences; but they can not control them at the source. Regardless of whether companies respond pro actively or reactively, their success depends largely on their ability to manage risks better than their competitors. In the long-term companies can devise strategies to mitigate customer preference risk including, among other things, designing innovative products and/or cutting costs and passing some of the savings along to customers. Companies also frequently take shorter-term actions, which is the focus herein, including offering customers: Generous return policies, allowing customers to purchase products they are uncertain about, knowing they can return them at a later date if the products fail to meet their expectations, they find better substitutes, or they find themselves strapped for cash. Comprehensive warranties to alleviate customers concerns about defects and product quality. Price protection, rebates, and volume discounts to mitigate customers concerns about finding lower prices elsewhere. Customer loyalty programs such as frequent flyer programs to encourage repeat business. Below market interest rates and attractive payment terms to address customers concerns about financing. Competitive prices for all of the above features. Another way companies manage customer preference risk is advertising. By advertising companies can provide information about products, which

9 Revenue and Customer-Related Balance Sheet Concepts 9 reduces customers concerns as to whether the products will meet their needs. Advertising can also provide emotional comfort. Let s face it, ads frequently tell us very little about products but still strengthen our emotional bond to them. Companies must understand and manage customer preference risk to achieve sales growth a key driver of shareholder value. However, establishing return policies, credit terms, warranty policies, and taking other actions to stimulate sales growth entails taking on costs and risks that can affect the other two key determinants of shareholder value return on equity and the cost of capital favorably or adversely depending on how companies forecast and manage these costs and risks and implement related policies. For example, if a company were to offer lifetime warranties and return privileges for products only expected to last a few years, it would stimulate considerable sales growth in the short term, but ultimately it would likely go out of business. By contrast, if a company were to set return periods too short, restocking fees too high, or offer exchanges rather than refunds, it would run the risk customers would take their business to competitors offering more generous terms. Companies often shift risk from customers to themselves to lower customer preference risk. For example, this risk is generally lowered when companies offer return policies superior to their competitors. Customers feel more comfortable purchasing products knowing they can return them for refunds. However, companies are then stuck with the risk returned products will become obsolete or otherwise become impaired and bear costs to process, hold, and resale returned products. Similarly, warranties shift customer preference risks associated with product quality from customers to sellers and price protection shifts the risk prices will decline after purchases from customers to sellers (or the risk customers will find lower prices elsewhere). In other situations where companies take actions to mitigate customer preference risk such as offering coupons, sales rebates, or reward points, risk is not shifted from customers to sellers, but sellers still incur risks. For example, companies run the risk of offering costly rebates to customers who would have purchased the products without rebates or offering more generous rebates than needed to attract sales. Similarly, offering generous credit terms to customers to alleviate financing concerns can be risky because sellers assume not only credit risk, but also interest rate risk, and in some cases, foreign currency risk.

10 10 Navigating Accounting Many of the actions companies take to manage customer preference risk affect revenue recognition. For example, companies must estimate product returns and warranty costs when they make related sales. When these estimates are not reliable because a company does not have enough historical experience to establish reliable benchmarks, they can not recognize revenue on these sales when products are delivered. Thus, in assessing a company s performance, outsiders need to not only understand the financial-statement consequence of actions taken to manage customer preference risks, outsiders should also consider the extent to which the benefits from these actions more than compensate for the costs and risks. To this end, outsiders rely greatly on numbers reported in financial statement and footnotes. However, many of these numbers are based on estimates affected by the underlying risks and can require considerable judgment when these risks are severe. Accounting Implication of Risks The remainder of this chapter focuses primarily on record keeping and reporting associated with events and circumstances greatly influenced by credit risk, customer preference risk, and companies efforts to manage these risks. We will briefly discuss a few accounting implications of these risks to help you recognize the similarities in the measurements and entries in the subsequent sections. Credit risks and customer preference risks definitely have important income statement consequences. However, the measurement focus is primarily on balance sheets and, in particular, on ensuring the end-ofperiod balances in allowances are adequate to cover future costs associated with these risks or efforts to mange them. For example, the GAAP measurement goal associated with bad debts is to ensure the ending balance in the allowance for bad debts represents management s best estimate of future bad debts associated with the outstanding receivables on the balance-sheet date or, equivalently, net accounts receivable is management s best estimate of the expected future collections. To this end, companies typically record an adjusting entry at the end of the reporting period ensuring the allowance has the right balance. Thus, the amount recorded in this entry is determined by the target ending balance: the accountant first estimates the ending balance and then determines how much must be recorded to ensure this balance. This balance-sheet measurement approach contrasts with the accounting we have studied thus far, where ending balances simply totaled entries and did not influence the amounts recorded.

11 Revenue and Customer-Related Balance Sheet Concepts 11 Like bad debts, the measurement goal for warranties is to ensure the balance sheet records a warranty liability, also called a warranty allowance or warranty reserve, that is management s best estimate of the future warranty claims associated with products still under warranty sold in the current and prior periods. Also similar to bad debts, an adjusting entry is recorded at the end of the period to ensure this balance. Similarly, the accounting for sales returns, price protection, rebates, loyalty programs, and other sales incentives generally centers on getting the appropriate balances in allowances that are either contra assets (like the allowance for bad debts) or liabilities (like the warranty allowance). Another common concept of the accounting in this chapter is the adjusting entries ensuring the correct balance sheet numbers also affect income. For example, the adjusting entry to ensure the correct ending balance for the allowance for bad debts also increases bad debt expense. As you study the subsequent sections pay particular attention to which income statement line items are affected by these entries. Some increase contra revenues and thus reduce net revenues while others increase expenses. You do not need to understand much about credit risk and customer preference risk to understand the entries herein, their financial-statement consequences, and the underlying events and circumstances they aim to measure. However, you do need to calibrate the extent to which these risks are present to assess how reliably the numbers in these entries measure what they are intended to measure. Several factors affect the reliability of reported numbers, but three are particularly important: the extent to which the underlying events and circumstances are risky, the extent to which there are reliable measurement benchmarks market prices, historical measures of comparable activity, or other companies measures of comparable activity and the extent to which managers are motivated to report honestly. Generally, the riskier the activity being estimated (such as future bad debts, product returns, or warranty claims) and the less reliable the available benchmarks, the greater the possibility of measurement errors for all managers and the more opportunities there are for dishonest managers to manipulate measures. Historically, the measures we will be studying in this chapter have frequently been associated with earnings manipulation, with numerous managers facing the SEC s wrath for under reporting allowances to boost income or recognizing revenue when there was too much uncertainty about future returns or collections.

12 12 Navigating Accounting The measures in this chapter can be particularly suspect since they require the most judgment and are recorded at the end of the period, when managers are feeling particularly pressured to make their performance targets and know how close they are to making them. At this time, if they know they are going to fall short of their targets, they may be tempted to reduce allowances below what they should be to comply with GAAP and thus increase reported income. By contrast, if they know they will otherwise exceed their targets, they may be tempted to build a cushion for the future by increasing allowances above what they should be to comply with GAAP. Concerned about such manipulations, the SEC issued standards in 1999 and 2001 that tightened the guidelines for revenue recognition and measuring allowances. For example, prior to the 1999 standard, companies could decide when they had enough historical experience to reliably estimate returns, a prerequisite for recognizing revenue at the time of a sale. However, the SEC narrowed the latitude of these judgments: In general, the [SEC] staff typically expects a start-up company, a company introducing new services, or a company introducing services to a new class of customer to have at least two years of experience to be able to make reasonable and reliable estimates. Footnote 40, SEC Staff Accounting Bulletin No. 101, December 1999 Similarly, the 2001 standard tightened the guidelines for estimating allowances and, in particular, required companies to establish consistent policies, methodologies, and processes for estimating allowances and to document that they are following them consistently each year. Notwithstanding these tighter guidelines, you still need to exercise healthy skepticism when assessing the reliability of most of the numbers in disclosures related to topics discussed in this chapter. While completing these assessments is beyond the scope of this chapter, you will learn how to identify situations where the numbers require the most judgment are critical accounting estimates and the places where you should be most skeptical about reliability.

13 Revenue and Customer-Related Balance Sheet Concepts 13 DEFERRED REVENUE In the Income Statement Chapter, the deferred revenue examples we considered centered on situations were revenue was deferred until goods were delivered to customers (Starbucks value cards and gift cards). Here we are going to extend this discussion to situations where revenues are deferred when delivery occurs. For example, in some situations, manufacturers who sell products to distributors for resell to consumers must defer revenue recognition until the distributors sell through the products to consumers. This happens even though the manufacturers have delivered the products to the distributors and the distributors have accepted them. Why is revenue deferred at delivery? In the past, there have been several situations where manufacturers who had significant influence over their distributors pressured or otherwise motivated the distributors to purchase considerably more product than they needed to hold as inventory to meet consumer demand. The manufacturers did this so they could meet revenue targets. To curb this aggressive behavior, GAAP now requires manufactures who meet certain criteria to defer revenue until products are sold through by the distributors. Example Assumptions WXY company, an apparel manufacturer, sells products to DEF company, a distributor, who later sells them to customers. WXY defers revenue until DEF sells through products to consumers. DEF informs WXY when this occurs. On December 1, 2010, WXY sells DEF products for $25 cash. The sold merchandise was recorded in inventory at $10 prior to the sale. On January 15, 2011, DEF notifies WXY that it has sold the products through to consumers and WXY recognizes related revenues and cost of sales. WXY uses the accounts at the top of the next page for the entries recorded on December 1, 2010 and January 15, Entries Delivery Date: December 1, 2010 GAAP is silent regarding the accounting for inventoried costs in these situations. However, the Accounting Research Manager, a widely used GAAP reference that also provides interpretations in places where GAAP

14 14 Navigating Accounting WXY Company Chart of Accounts Excerpt ASSETS C FGI SIdr Cash Finished goods inventory Segregated inventory: deferred revenues LIABILITIES DefRev Deferred revenue OWNERS' EQUITY Cgs Rev Cost of goods sold Revenue is silent or imprecise, recommends the approach used in this example (segregating delivered inventory from finished goods and disclosing the amount segregated, either on the balance sheet or in footnotes) and opposes the only other logical alternative recognizing these inventoried costs in a contra liability to deferred revenue: In addition, it would generally not be appropriate to offset against deferred revenue any related deferred costs. Accounting Research Manager, Interpretations and Examples/18 The SEC also demonstrated a preference for this approach when it forced the pharmaceutical company Bristol-Myers Squibb (BMS) to restate its financial statements in Consistent with this approach, WXY transfers inventoried costs to segregated inventories: deferred revenue when goods are delivered and revenue is deferred. The argument in favor of this accounting is WXY is deemed to still have significant control over the inventory even though it has been delivered to the distributor. Recall, the necessity for deferral arose from situations where manufacturers had considerable influence over distributors. The following entries are recorded upon delivery on December 1, 2010: Defer revenue upon delivery Assets = Liabilities Debit Credit + C = + DefRev Cash $ $25 = + + $25 Deferred revenue $25 Segregate inventory related to deferred revenue Assets = Debit Credit + FGI + SIdr = Segregated inventory: deferred revenues $ $ $10 = Finished goods inventory $10

15 Revenue and Customer-Related Balance Sheet Concepts 15 Entries Products Sold Through to Consumers: January 15, 2011 Here are the entries when the goods are sold through to consumers and WXY recognizes revenues and cost of sales: Recognize previously deferred revenue = Liabilities Owners' Eq Debit Credit = + DefRev + Rev Deferred revenue $25 = + - $ $25 Revenue $25 Recognize previously deferred cost of good sold Assets = Owners' Eq. Debit Credit + SIdr = - Cgs Cost of goods sold $ $10 = - + $10 Segregated inventory: deferred revenues $10

16 16 Navigating Accounting RECEIVABLES In prior chapters, we have seen that receivables are increased when customers are billed and decreased when cash is subsequently collected. These entries typically explain most of the change in gross accounts receivable. These are operating events. We have also seen receivables generally increases when a company acquires another company and decreases when it disposes of one of its segments or divisions. These are non-operating events. This section examines record keeping and reporting associated with: Discounts for early payments Interest earned when customers do not pay their bills on time Bad debts: Writing off receivables associated with uncollectable bad debts Reinstating previously written off receivables recoveries Establishing or replenishing allowances for estimated bad debts Most companies record entries for discounts for early payments and interest associated with receivables, so we will quickly cover the related entries. However, with one exception, these entries are usually relatively immaterial compared to other events affecting net accounts receivable. The exception is accruing interest can be very important to companies such as GE, GM, and Ford with extensive financing receivables and to banks and other financial institutions with loans (which are essentially financing receivables). Most companies also record three entries for bad debts associated with receivables: write-offs, recoveries, and establishing or replenishing allowances. While these entries can also be relatively immaterial for some companies, understanding them and their financial-statement consequences is very important when analyzing companies particularly susceptible to credit risk. This is especially true during the global credit crisis. Receivables can also be affected by entries associated with product returns. We will discuss these when we study product returns later in the chapter. Discounts for Early Payments Customers can sometimes receive discounts for paying their bills quickly. For example, if a company permits its customers to pay their bills within

17 Revenue and Customer-Related Balance Sheet Concepts 17 sixty days to avoid an interest penalty, it might offer a 2% discount to customers who pay within ten days of being billed. The accounting is straightforward as illustrated by the following example. Example Assumptions ABC company offers customers a discount for paying their bills within ten days of the billing date. On December 1, 2010, ABC sells goods to DEF, bills DEF $100, and recognizes $100 of revenues. On December 10, 2010, ABC collects $98 from DEF, having given DEF a $2 discount for early payment. Ignore the inventory/cost of sales aspect of the sale on December 1. Entries On December 1, 2010, ABC recognizes $100 of gross revenues, meaning revenues before deducting discounts, rebates, and product returns. The entry is increase (debit) accounts receivable and increase (credit) gross revenues. On December 10, 2010, ABC collects $98 from the customer: $100 less the 2% discount. The entry is increase (debit) cash $98, decrease (credit) accounts receivable $100 to reverse the amount recorded on December 1, and increase (debit) a sales discount contra revenue account $2. The combined income-statement effect of these two entries is $98 of net revenues is reported. Recording the discounts to a separate contra revenue account helps ABC track discounts and thus manage discounts. Interest Income The entry to accrue interest income earned on accounts receivables when customers do not pay their bills on time is straightforward and described here for completeness: Increase (debit) accounts receivable, or a related account such as interest receivable, for the interest earned during the reporting period. Increase (credit) interest income for the same amount.

18 18 Navigating Accounting Writing off Bad Debts Why are we using the allowance to write-off bad debts before we create the allowance? Perhaps you expect allowances to be created before they are used. This would be a perfectly acceptable alternative to the approach we have taken here. Had we taken this alternative, we would have introduced three events: create the allowance when the company starts operations; use the allowance during each reporting period, starting with the first; replenish the allowance at the end of each period to ensure it covers expected future write-offs. We skip the first event here creating the allowance. The reason we took this approach is most of the companies you will be studying have been in business for years. As a result, their allowances have positive balances at the start of each period, having been replenished at the end of the previous period, and each period they use the allowances before replenishing them. Most companies have policies specifying when they will write off receivables associated with uncollectable bad debts. For example, the Management Discussion and Analysis section of General Electric s annual report indicates GE writes off receivables past due by either 120 or 180 days, depending on the nature of the receivables: We write off unsecured closed-end installment loans at 120 days contractually past due and unsecured open-ended revolving loans at 180 days contractually past due. We write down consumer loans secured by collateral other than residential real estate when such loans are 120 days past due. Consumer loans secured by residential real estate (both revolving and closed-end loans) are written down to the fair value of collateral, less costs to sell, no later than when they become 360 days past due. Unsecured consumer loans in bankruptcy are written off within 60 days of notification of filing by the bankruptcy court or within contractual write-off periods, whichever occurs earlier. Page 68, General Electric s 2009 Annual Report An important lesson is there is typically no judgment involved with write-offs once a company s policy is established. The following example illustrates the write-off entries under two scenarios: when there is no collateral and when there is collateral. Example Assumptions On January 31, 2011, ABC s allowance for doubtful accounts has a $25 balance and ABC will not replenish the allowance until February 28, The next few assumptions indicate ABC will write off more than $25 of receivables prior to replenishing the allowance. This will cause the allowance to have a negative balance prior to being replenished. An important lesson here, and the only reason we included this assumption, is it is not unreasonable nor unusual for allowances to have negative balances during the reporting period. The adjusting entry replenishing the account (discussed later) ensures a positive balance at the end of the period.

19 Revenue and Customer-Related Balance Sheet Concepts 19 On February 1, 2011, ABC writes off a $10 receivable owed by XYZ. There is no collateral associated with this receivable. On February 3, 2011, ABC writes off a $100 DEF receivable. The collateral is products ABC previously sold to DEF. ABC fully expects to repossess the collateral without incurring significant costs and to reinstate it to finished goods inventories. ABC values the collateral at $70 when it writes off the receivable on February 3, This is the replacement cost of comparable products ABC holds in inventory at that time: what it would cost to replace them. (This means no gain or loss is recognized when the collateral is recovered). On February 15, 2011, DEF turns over the collateral associated with the February 3, 2011 write-off to ABC. The replacement cost of comparable products in inventory is still $70. ABC reinstates the collateral to finished goods inventory at this $70 replacement cost. ABC uses the accounts below for related entries. ABC Company Chart of Accounts Excerpt Required ASSETS AR AllDA FGI Accounts receivable (gross) Allowance for doubtful accounts Finished goods inventories (a) Record the write-off of the XYZ receivable on February 1, (b) Identify line items on ABC s balance sheet, income statement, and cash-flow statement directly affected by the part (a) entry. (c) Record the write-off of the DEF receivable on February 3, (d) Record the receipt of collateral associated with the DEF write-off on February 15, (e) Identify the combined effect of the entries in parts (c) and (d) on ABC s balance sheet, income statement, and cash-flow statement. (f) The allowance for bad debts is associated with credit risk. How do write-off entries relate to credit risk?

20 20 Navigating Accounting Solution Part (a) Write-offs Entries, No Collateral On February 1, 2011, ABC will record the following entry to writeoff the XYZ receivable: Write off XYZ receivable (no collateral) Assets = Debit Credit + AR - AllDA = Allowance for doubtful accounts $ $ $10 = Accounts receivable (gross) $10 Part (b) Write-offs Entries Effects, No Collateral Balance Sheet There is a $0 net effect on accounts receivable, net of allowance for doubtful accounts: Gross accounts receivable decreases by $10, indicating ABC can no longer expect to collect $10 from XYZ. The allowance for bad debts decreases by $10, signifying $10 of the allowance was used to write off the XYZ receivable. Recording write-offs decreases gross accounts receivable and the allowance for bad debts, but it does not change net accounts receivable and has no visible effect on the balance sheet. Still, banks and companies such as GE, GM, and Ford with extensive financing receivables typically report write-offs in their footnotes and all companies registered with the SEC must report them in Schedule II (as discussed later in the chapter). Income Statement There is no effect. Statement of Cash Flows There is no income effect and no cash effect, so no adjustments are required. There is a $0 net effect on the accounts receivable adjustment. You might be thinking this entry is not very important because it has no net effect on any of the financial statements. This is true, but the entry can have a very important indirect effect: To the extent receivables were

21 Revenue and Customer-Related Balance Sheet Concepts 21 written off during the current period that were not anticipated when the allowance was replenished at the end of the last reporting period, the more the allowance will need to be replenished at the end of the current period and the related adjusting entry decreases net income (as we shall see shortly). Part (c) Write-offs Entries, with Collateral On February 3, 2011, ABC will record the following entry to writeoff the DEF receivable: $30 = $100 - $70 value of the collateral. Write off DEF receivable (with collateral) Assets = Debit Credit + AR - AllDA = Allowance for doubtful accounts $ $ $30 = Accounts receivable (gross) $30 Thus, ABC continues to recognize a $70 receivable, signifying the value of the collateral it expects to receive from DEF in the near future. Part (d) Receipt of Collateral Entries On February 15, 2011, ABC will record the following entry when it receives collateral associated with the DEF write-off: Write off DEF receivable (with collateral) Assets = Debit Credit + AR + FGI = Finished goods inventories $ $ $70 = Accounts receivable (gross) $70 Part (e) Effects of Write-offs with Collateral Received Balance Sheet The combined effect of the entries in parts (c) and (d) is a $70 decrease in Accounts receivable, net of allowance for doubtful accounts: Gross accounts receivable decreases by $100 ($30 + $70). The allowance for bad debts decreases by $30. When there is collateral, the allowance can be set lower because the value of the collateral reduces the downside of write-offs. Inventory increases by $70, the value of the collateral returned to inventory.

22 22 Navigating Accounting Income Statement There is no effect. Statement of Cash Flows Combined, the entries in parts (c) and (d) do not effect net income or cash from operations and thus the adjustments must net to $0. There is a + $70 net effect on the accounts receivable adjustment: Recording the write-off has a $0 effect on net accounts receivable and thus does not alter the adjustment. Reinstating the collateral to inventory decreases accounts receivable $70, which is associated with a positive adjustment. There is a - $70 net effect on the inventories adjustment, which is associated with the $70 increase in inventories. Part (f) Connection to Credit Risk All risks, including credit, are forward looking, centering on the possibility something could go wrong. Write-offs are realizations of credit risk. Something did go wrong: customers didn t keep their promises. The important accounting issue is whether these realizations were anticipated on the balance sheet. The ending balance in the allowance always reflects the consequences of current-period write-offs. The critical issue that insiders and outsiders must assess is whether the company also anticipates future losses: to what extent does the allowance reflect credit risk. Recovering Write-offs Occasionally, previously written off accounts receivable are reinstated (recovered) either because customers or other debtors pay their bills to maintain their credit standing or renegotiate the outstanding balance. Recoveries are recorded by reversing all or part of the prior write-off: Increase (debit) gross accounts receivable for the amount the customer will owe going forward. Increase (credit) the allowance for bad debts for the same amount. Replenishing the Allowance At the end of each accounting period, prior to creating financial statements, companies record adjusting entries to replenish the allowance for bad debts. The GAAP goal is to ensure that the allowance s ending balance reflects management s best estimate of the expected future writeoffs (net of recoveries) associated with the outstanding gross receivables at the balance sheet date.

23 Revenue and Customer-Related Balance Sheet Concepts 23 Provisions Under IFRS versus US GAAP Under IFRS, a provision is a liability of uncertain timing or amount 1, such as a provision for warranty. In contrast, in the U.S. a provision typically refers to an expense, such as provision for taxes or the provision for doubtful accounts. Thus, provision refers to a balance at a point in time under IFRS; but to a change over a period in the U.S. Beware of this significant difference: provision must be interpreted in context. 1 IAS The following adjusting entry to replenish the allowance will be illustrated in the example that follows: Increase (credit) the allowance for doubtful accounts for the amount needed to ensure the target ending balance of expected future writeoffs (net of recoveries). Increase (debit) in bad debts expense (also called the provision for bad debts by companies following US GAAP) for the same amount. Anticipating this financial-statement consequence, companies have been known to abandon the GAAP goal of reporting the number that reflects their best estimate of the future write-offs in favor of manipulating income through the expense associated with the entry. The SEC has taken several steps to try to curb such opportunistic behavior, but there is still plenty of room for dishonest managers to play games. Example Assumptions ABC starts fiscal 2011 with $100 of gross accounts receivable and a $5 allowance for bad debts, or $95 of net accounts receivable. Thus, assuming ABC was following GAAP, ABC s management expected it would write off $5 of its $100 of outstanding receivables at the end of fiscal During fiscal 2011, ABC: Billed customers $60 when it sold goods and services Collected $75 from customers related to previous sales on account Wrote off $7 of accounts receivable. ABC s credit department expects to collect $71 of the outstanding receivables at the end of ABC uses the accounts below for related entry. ABC Company Chart of Accounts Excerpt ASSETS AllDA Allowance for doubtful accounts Owners' Equity (temporary) Bdexp Bad debt expense

24 24 Navigating Accounting Required (a) Determine the bad debts expense to be recorded at the end of (b) Record the 2011 bad debts expense. (c) Identify line items on ABC s balance sheet, income statement, and cash-flow statement directly affected by the part (b) entry. (d) How does recording the bad debts expense relate to credit risk? Solution Part (a) Determining the bad debt expense The first step towards determining the expense is to derive the trial balances for gross accounts receivable and the allowance for bad debts immediately prior to recording the expense: Gross Accounts Receivable Allowance for Doubtful Accounts Net Accounts Receivable Beginning balance $100 $5 $95 Sales on account $60 $60 Collections ($75) ($75) Write-offs ($7) ($7) Trial balance $78 ($2) $80 ABC s credit department expects $71 of the $78 gross accounts receivable ending balance to be collected in the future, which means they expect $7 (=$78 - $71) of these receivables will be written off in the future (which happens to be the actual write-offs for fiscal 2011). Prior to recording the expense, the allowance balance is -$2 (as indicated above). The allowance must be increased by $9 to take it from -$2 to the +$7 target ending balance. As a result, the allowance and bad debt expense is increased by $9. Part (b) Bad Debts Expense Entry Here is the adjusting entry ABC records at the end of fiscal 2011 to recognize the bad debt expense and ensure the allowance for doubtful accounts is at the target balance: Replenish the allowance for doubtful accounts Assets = Owners' Eq. Debit Credit - AllDA = - Bdexp Bad debt expense $9 - + $9 = - + $9 Allowance for doubtful accounts $9

25 Revenue and Customer-Related Balance Sheet Concepts 25 Part (c) Effects of Bad Debts Expense Balance Sheet The expense increases the allowance for doubtful accounts and thus decreases accounts receivable net of the allowance, reducing the future benefits associated with this asset expected future collections. The expense decreases income and thus decreases retained earnings. Income Statement Most companies do not report bad debts expense separately on their income statements. Instead, it is typically included in an operating expense such as SG&A. Statement of Cash Flows Recording the expense decreases net income by $9 but does not affect cash from operations. Thus, a +$9 adjustment is needed to reconcile net income to net cash provided by operations. Some companies discloses this adjustment separately as bad debts or provision for bad debts (US GAAP companies). Banks and other companies with large receivables generally report a separate reconciliation adjustment for bad debt expense but most companies with relatively small receivables balances do not disclose a separate adjustment. Instead, the expense adjustment is included in the accounts receivable adjustment. By convention the net effects of all operating entries affecting working capital accounts, such as accounts receivable, are included in the adjustments. As a result, we typically can interpret the accounts receivable adjustment as the net effects of the operating entries affecting accounts receivable, or more precisely as the negative of these effects. When a separate adjustment is provided for the bad debts expense, it must be combined with the accounts receivable adjustment to determine the net effects of operating entries on accounts receivable. Part (d) Connection to Credit Risk In contrast to write-offs net of recoveries, which reflects realizations of credit risk, recording bad debts expense reflects three aspects of credit risk:

26 26 Navigating Accounting (1) Measurement error: More or less realizations of risk during the current period write-offs net of recoveries than was anticipated in the allowance at the start of the period. (2) Revisions to the allowance associated with the arrival of new information during the period about receivables outstanding at the start of the period. For example, suppose part of ABC s $5 allowance at the start of 2011 had pertained to non-current receivables not due until If the credit quality of these receivables deteriorated during 2011 because of previously unforeseen circumstances, the allowance would need to be increased to reflect the increased credit risk. (3) Management s estimate at the end of the period of the expected future write-offs (net of recoveries) associated with new receivables added during the period. Note, the first aspect of credit risk looks back at unanticipated risk realizations and the second and third look forward to expected future losses.

27 Revenue and Customer-Related Balance Sheet Concepts 27 Analyzing Bad Debts This section discusses where you can search for information that will help you assess bad debts and related credit risk, ways you can use it to assess a company s credit risk associated with receivables, and calibrate the relative importance of this risk in assessing a company s overall financial position. This discussion and the exercises at the end of the section will help you begin to assess companies exposure to credit risk associated with receivables. However, you will still have a good deal to learn to become an expert. Searching for Bad Debt Information Before you start creating ratios and comparing them across companies and time, it is important to analyze a company s exposure to credit risk qualitatively. For example, knowing Boeing sells a good deal of airplanes to airlines and many of these customers were in dire financial condition at the end of 2005, we would start an analysis of Boeing s credit risk knowing qualitatively it was likely severe. More generally, the first step in analyzing the credit risk associated with a company s receivables is to understand its business and the general health of its customers. If you are not already knowledgeable about a company and its customers, you can usually gain a pretty good general understanding from the Business and Risks sections of companies 10-Ks filings to the SEC (Sections I and IA, respectively). Another qualitative assessment you should make early on is the extent to which the company s receivables are concentrated in a few customers. Companies with concentrated receivables discuss the extent of this concentration in footnotes. For example, the Credit Risk section of the Significant Group Concentration of Risks footnote (Note 22) of Boeing s 2005 annual report states: Of the $15,252 in Accounts receivable and Customer financing included in the Consolidated Statements of Financial Position as of December 31, 2005, $9,711 related to commercial aircraft customers ($221 of Accounts receivable and $9,490 of Customer financing) and $2,797 related to the U.S. Government. Of the $9,490 of aircraft customer financing $8,917 related to customers we believe have less than investment grade credit. Air Tran Airways, United, and AMR Corporation were associated with 18%, 11% and 12%, respectively, of our aircraft financing portfolio. Financing for aircraft is collateralized by security in the

28 28 Navigating Accounting related asset, and historically we have not experienced a problem in accessing such collateral. Page 77, Boeing s 2005 Annual Report This quote also suggests another path you could follow at this point: analyze (at least qualitatively) customers financial statements and footnotes, especially those under financial duress. Customer concentration is not the only type of concentration you should assess up front. Moreover, relatively small amounts associated with retained interests in receivables transferred to special purpose entities (SPEs) are highly concentrated sources of credit risk. You should qualitatively gauge the extent to which this type of concentration is likely to be problematic early in your analysis. Once you have completed a qualitative assessment of a company s bad debts and credit risk, you should search for the numbers in bad debts entries. As we shall see, these can be useful for creating ratios reflecting credit risk that can be compared across companies and time. When can you locate the numbers we recorded in an earlier section for bad debts entries? The short answer is we can generally locate or reliably estimate write-offs, recoveries, and bad debt expense when they are important and, in particular, when companies include bad debts estimation as a critical accounting estimate in their management discussion and analysis section of their annual reports (or 10-K SEC filings). By contrast, you can typically not estimate these items reliably for companies with relatively small receivables balances. Between these extremes, you may or may not locate these numbers. The best place to start a search for this information for a company that is registered with the SEC is Schedule II in 10-Ks, Valuation and Qualifying Accounts. The SEC requires companies to include Schedule II when the related numbers are material. For example, the drug store chain Walgreens, the 32nd largest U.S. company by sales in fiscal 2010, includes estimating doubtful accounts as a critical accounting policy in its 2010 annual report (page 15). To determine if Walgreens includes Schedule II in its 10-K, we downloaded its fiscal K from the investor relations section of its web site. Searching for Schedule II in this file, we soon find the table on the next page. Interpreting Disclosed Numbers Knowing the entries we recorded earlier, we are tempted to conclude the $111 million Additions Charged to costs and expenses for 2010 is the bad debts expense.

29 Revenue and Customer-Related Balance Sheet Concepts 29 However, when we study product returns later in the chapter, you are going to learn some companies combine their allowances for returns and bad debts. This is appropriate when products are typically returned before customers pay their bills. By contrast, when customers tend to purchase products with third party credit cards or cash, the returns allowance is classified as a liability, rather than as a contra asset. Unfortunately, often it is impossible to determine how companies classify their product returns allowances. The adjusting entry to replenish the allowance for product returns differs from the one to replenish the allowance for bad debts. The entries are similar in they both increase an allowance (and perhaps the same allowance), but the offsetting accounts differ (as discussed in detail later in this chapter). Thus, based solely on the table, all we can reasonably conclude is the $111 million additions charged to costs and expenses could very well be explained by two adjusting entries (there could be other entries but they will usually have a much smaller impact on the allowance): (1) Recording bad debts expense and/or (2) Recording product returns contra revenue. For Walgreens, we can likely eliminate the hypothesis the returns contra revenue explains much, if any, of the $111 million because the company s K states: Customer returns are immaterial. Page 29, Walgreens 2010 Annual Report WALGREEN CO. AND SUBSIDIARIES SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED AUGUST 31, 2010, 2009 AND 2008 (Dollars in Millions) Classification Balance at Beginning of Period Additions Charged to Costs and Expenses Deductions Balance at End of Period Allowances deducted from receivables for doubtful accounts - Year Ended August 31, 2010 $ 110 $ 111 $ (117) $ 104 Year Ended August 31, 2009 $ 96 $ 116 $ (102) $ 110 Year Ended August 31, 2008 $ 69 $ 88 $ (61) $ 96

30 30 Navigating Accounting Thus, we are pretty confident the entry below is a reasonable estimate of the combined entries Walgreens recorded during fiscal 2010 to replenish its allowance for doubtful accounts. Summary of Walgreen's fiscal 2010 entries to replenish the allowance for doubtful accounts Assets = Owners' Eq. Debit Credit - AllDA = - Bdexp Bad debt expense $ $111 = - + $111 Allowance for doubtful accounts $111 Similarly, we are also confident the $117 million reported as Deductions is a good estimate of Walgreens write-offs net of recoveries. Measuring and Calibrating Credit Risk The importance of credit risk and related bad debts information for assessing a company s overall performance and financial position can vary greatly from one company to another and can vary significantly over time for the same company. Assuming for now the allowance for bad debts is a reasonably reliable estimate of future bad debts, one way to measure credit risk is to express the allowance as a percent of gross accounts receivable at each balance sheet date. This measure reflects credit risk concerns going forward. Similarly, we can measure credit risk realizations, which can be a good indicator of future realizations, by expressing write-offs as a percent of the average gross receivables balances during the reporting period. These measures can then be compared to those of comparable companies, to the same company over time, or to changes in economy wide or industry wide measures tending to correlate with credit risk. To illustrate how to locate information in these ratios and their limitations, we will derive Walgreens allowance to gross receivables ratios at the ends of fiscal 2009 and We could derive Walgreens gross receivables by adding the allowance balances in the earlier table to the net receivables on the balance sheet. Alternatively, we can get this information directly from the table reported in Walgreens Supplementary Financial Information footnote.

31 Revenue and Customer-Related Balance Sheet Concepts Supplementary Financial Information Non-cash transactions in fiscal 2010 include a $95 million increase in the retiree medical benefit liability, $29 million in dividends declared and $44 million in accrued liabilities related to the purchase of property and equipment. Non-cash transactions in fiscal 2009 include $25 million in dividends declared and $20 million in accrued liabilities related to the purchase of property and equipment. Included in the Consolidated Balance Sheets captions are the following assets and liabilities (In millions): Accounts receivable Accounts receivable $2,554 $ 2,606 Allowance for doubtful accounts (104) (110) $2,450 $ 2,496 Other non-current assets Page 38, Walgreens 2010 Annual Report We see the allowance decreased slightly from 4.22% of gross receivables at the end of fiscal 2009 (4.22% = $110/2606) to 4.07% at the end of fiscal These percentages are nearly twice those Ford typically report and other auto manufacturers, suggesting a few hypotheses an analyst might examine: (1) Walgreens receivables are riskier than Ford s receivables. (2) Walgreens receivables risk is more concentrated because it retains more credit risk associated with securitizations than Ford. (3) Ford either unintentionally or intentionally understate their allowances. (4) Walgreens either intentionally or unintentionally overstate its allowance. The first hypothesis likely explains most of the difference between Walgreens and automobile manufacturers. We would expect Ford s receivables to be less risky than Walgreens because they are collateralized while Walgreens are not collateralized.

32 32 Navigating Accounting WARRANTIES Companies providing warranties promise customers their products are free from defects and work as intended. Companies warranty policies state what types of problems are covered under warranty, the time period, and what remedies the company will provide and pay for, such as repairs or replacement of defective products. If you have purchased electronic equipment, home appliances, or big ticket items such as a car, you likely already know there are two types of warranties: standard and extended. Standard warranties come with the product and are typically short-term like one year, and extended warranties are optional and sold separately, usually when products are purchased and can cover many years. Warranties are similar to bad debts in they are a risky future cost companies incur to mitigate customer preference risk and increase current sales. However, while credit risk centers on problems with customers, warranty risk centers on problems with products. Warranty risk is typically larger for extended warranties because they cover longer periods. Also, extended warranty costs can be riskier because the further out in the future the warranty claims occur, the more uncertainty there is about the costs of parts and labor to honor them. Both types of warranties affect revenue recognition, but their effects differ significantly. For standard warranties, the revenue recognition issue is similar to the one arising with bad debts: revenue associated with sale of a product with a standard warranty can be recognized when warranty claims can be forecasted reliably and the four criteria for revenue recognition have been met. Also similar to bad debts, a warranty allowance is maintained to cover the cost of expected claims. However, as we shall see in the next section, the entries differ. Importantly, there are not separate revenue disclosures for standard warranties under GAAP. That is, the revenue associated with the sale of the product implicitly reflects revenue associated with the standard warranty. The logic here is that the customer bought a bundle for one price, which included the product and its warranty. This contrasts with extended warranties, which are purchased and thus priced separately from the related products. To summarize, there are three significant differences between extended and standard warranties that explain differences in the related accounting: 1. Extended warranties are riskier and, in particular, forecasting the costs of future warranty claims reliably is more difficult.

33 Revenue and Customer-Related Balance Sheet Concepts Extended warranty prices can generally be determined more reliably. 3. The services associated with extended warranties are delivered further in the future from the dates products are sold. Because of these differences, revenue recognition is deferred at the time customers purchase extended warranties and subsequently recognized ratably during the extended warranty period as service is delivered. Also in contrast to standard warranties, allowances for extended warranty costs are not accrued. Thus, accounting for extended warranties is conceptually the same as accounting for Starbucks Value Cards. Recall, revenue is deferred when customers purchase value cards and subsequently recognized as customers use the cards to purchase coffee, along with the cost to deliver the coffee. Standard Warranties Accounting for standard warranties and bad debts are similar in that an allowance is used up during the reporting period and replenished at the end of the period with an adjusting entry ensuring the ending balance will cover expected future costs. Also, similar to bad debts, estimating the allowance for warranties can require considerable judgment: over 10% of the Fortune-100 companies and 6% of the Fortune listed warranty allowance estimation as a critical accounting estimate in their 2004 annual reports. As with all critical accounting estimates, this provides opportunities for honest errors or manipulation. Similarities aside, accounting for standard warranties and bad debts differ in two ways: The adjusting entry replenishing the allowance impacts the income statement differently, increasing cost of sales for standard warranties and selling, general, and administrative expenses for bad debts provisions. On the balance sheet, the allowance is a liability for extended warranties and a contra asset (to gross accounts receivable) for bad debts. Here is an overview of the entries associated with standard warranties, which are illustrated in the following example: Using the allowance during the period when warranty claims are met: decrease (debit) the allowance for the total cost incurred for parts and labor, decrease (credit) inventories for parts costs, and increase

34 34 Navigating Accounting (credit) accrued liabilities or decrease (credit) cash for labor costs (and possibly other costs). Replenishing the allowance at the end of reporting periods: increase (credit) the allowance and increase (debit) cost of sales. Example Assumptions ABC provides a standard warranty with its products and maintains an allowance with a $1,000 balance on January 1, During 2013, ABC incurs parts and labor costs of $400 and $900, respectively, to meet warranty claims. On December 31, 2013, ABC estimates it will cost $1,100 to meet future claims associated with products under standard warranty at that time. ABC s financial-statements have the same line items as Cisco s fiscal 2012 statements. ABC uses the accounts below for related entries. ABC's Accounts for Standard Warranties ASSETS FGI Finished goods inventory LIABILITIES AcrWag WarAll Accrued wages Warranty allowance OWNERS' EQUITY CGS Cost of goods sold Required (a) Record the costs associated with 2013 warranty claims. (b) Identify line items on ABC s balance sheet, income statement, and cash-flow statement directly affected by the part (a) entries. (c) Determine the adjustment required at the end of 2013 to ensure the allowance will cover expected future warranty claims. (d) Record the adjusting entry at the end of 2013 to ensure the allowance will cover the expected future warranty claims. (e) Identify line items on ABC s balance sheet, income statement, and cash-flow statement directly affected by the part (d) entries.

35 Revenue and Customer-Related Balance Sheet Concepts 35 Solution Part (a) Meeting Warranty Claims Entry Here is the entry to record the warranty claims during 2013: + FGI = + AcrWag + WarAll + - $400 = + + $ $1,300 or Debit Credit WarAll $1,300 FGI $400 AcrWag $900 Part (b) Meeting Warranty Claims Effects Balance Sheet Inventories decreases by $400, reflecting the use of parts. Accrued compensation (current liability) increases by $900, reflecting the obligation to employees associated with labor costs. Other current liabilities decreases by $1,300. Cisco indicates this line item includes its warranty allowance (page 45 of its fiscal K). This decrease indicates ABC s warranty obligations have partly been met by settling claims. Income Statement No effect Statement of Cash Flows The entry does not affect net income or cash from operations, thus the adjustments must net to $0: $400 increase in Inventories adjustment. $900 increase in Accrued compensation adjustment. $1,300 decrease in Other accrued liabilities adjustment. Part (c) Determining Allowance Adjustment The table below explains how the $1,400 adjustment is determined. First, a ($300) trial balance is determined to assess the allowance prior to the entry. A $1,400 adjustment is needed to ensure the allowance has the $1,100 target ending balance:

36 36 Navigating Accounting Warranty Allowance Beginning balance $1,000 Used during year to cover warranty claims ($1,300) Trial balance before replenishing allowance ($300) Target ending balance needed to cover future claims $1,100 Adjustment needed to get from trial balance to target balance $1,400 Part (d) Replenishing the Allowance Here is the adjusting entry recorded at the end of 2013 to replenish the allowance: Debit Credit = + WarAll - CGS = + + $1, $1,400 or CGS $1,400 WarAll $1,400 Part (e) Replenishing Allowance Effects Balance Sheet Other current liabilities increases by $1,400, reflecting an increase in ABC s obligation to meet customers future warranty claims. Retained earnings decreases (pretax) by the $1,400 recognized in cost of sales, indicating the owners equity decreases in anticipation of future warranty costs. Income Statement Cost of sales increases by $1,400. Thus, the higher the warranty provision, the lower the company s gross margin. The warranty provision is not necessarily consistent with the matching principle. Rather, it can be affected by the size of the allowance at the beginning of the period, the cost of current and prior period warranty claims, and expected future warranty claims. Statement of Cash Flows Net income decreases by $1,400 but Net cash provided by operating activities is not affected by the entry. The Other liabilities reconciliation adjustment increases by $1,400 to reconcile the -$1,400 income effect to the $0 cash effect.

37 Revenue and Customer-Related Balance Sheet Concepts 37 Extended Warranties Accounting for extended warranties involves three entries similar to entries we covered extensively earlier in the chapter: Defer revenue when extended warranties are sold: increase (debit) accounts receivable or cash and increase (credit) a deferred revenue liability. Recognize revenue ratably during the extended warranty period: increase (credit) service revenue and decrease (debit) deferred revenues. Recognize costs to meet warranty claims as they are incurred during the extended warranty period: increase (debit) cost of sales, decrease (credit) inventories for parts costs, and increase (credit) accrued wages for labor costs (and possibly other costs).

38 62 Navigating Accounting TAKE-AWAYS Macy s K, page F-20 In this section, we are going to develop a schematic that highlights the key concepts associated with the customer-related allowances discussed in this chapter (bad debts, warranties, and product returns) and more generally with other allowances. Anticipating Losses Arguably the most important concept related to allowances is they are created or replenished when companies anticipate in the current period that an adverse event will happen in the future that will result in outflows of cash (or other assets) or otherwise de-recognition of previously recognized assets. For bad debt allowances, companies anticipate customers will fail to meet their obligations (the adverse future event), which will result in write-offs (de-recognition of receivables). For warranty allowances, companies anticipate customers will require warranty repairs (the adverse future event), which will result in outflows of cash and repair parts.

39 Revenue and Customer-Related Balance Sheet Concepts 63 Because the anticipated future outflows, or de-recognition of assets, are contingent on future adverse events occurring, they are called contingent losses. In this chapter, we studied contingent losses and allowances associated with customers. However, the concept extends to other areas and, in particular to contingent losses associated with pending legal disputes. Informing Stakeholders of Anticipated Losses Management has a responsibility to inform stakeholders of anticipated losses once its probable they will occur. They do this by recognizing an asset impairment ( or a contra asset, such as the bad debts allowance) or a liability associated with future asset outflows (such as warranty allowance). These result in a decrease in owners equity and, in particular, net income. For example, bad debt expense for receivables impairments, cost of sales for warranty obligations and two or more income items for product returns. Thus, management is telling owners the book value of their claims have decreased because anticipating adverse events has triggered impairing an asset or recognizing a liability.

40 64 Navigating Accounting Use the Allowance When Adverse Events Occur When previously anticipated adverse events occur in future periods, use the allowance to recognize the asset outflow or asset de-recognition. For example, use the bad debt allowance to write off receivables or the warranty allowance to pay for repairs. Here is the completed schematic: